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Investment Banking and
Financial Services
Volume I
The Icfai University Press

© The Icfai University Press. May 2009, All rights reserved.
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ISBN : 81-7881-644-X
Ref. No. IBFS-Vol-I – 052009MSF05
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Contents
Investment Banking, Financial Systems

Chapter 1 :
and Financial Markets
Lesson 1 : Investment Banking Industry 1
Lesson 2 : Financial Systems and Financial Markets 5
Chapter 2 : Credit Markets 17
Chapter 3 : Money Markets
Lesson 1 : Introduction to Money Markets 23
Lesson 2 : Call Money 53
Lesson 3 : Treasury Bills 79
: 94
Lesson 4 Commercial Paper (CP)
Lesson 5 : Certificates of Deposit (CDs) 114

Lesson 6 : Bill Financing 127
Chapter 4 : Debt Markets

Lesson 1 : Gilt-edged Securities Market 139
Lesson 2 : Repurchase Agreements (REPOs) 173
Lesson 3 : Public Deposits 190
Lesson 4 : Financial Guarantees 196
Chapter 5 : Capital Markets
Lesson 1 : An Overview of Capital Markets 206
Lesson 2 : Regulation of the Capital Market 221
Chapter 6 : Investment Banking
Lesson 1 : An Overview of Investment Banking 242
: Management of Public Issues, Initial Public Offerings and Pricing of

Lesson 2 262
Various Instruments
: Rights Issues, Bonus Issues, Private Placements

Lesson 3 315
and Bought-out Deals
Chapter 7 : International Markets
Lesson 1 : International Market Instruments 343
Lesson 2 : Non-Resident Indians (NRIs) 401
Lesson 3 : Foreign Institutional Investors (FIIs) 408
Chapter 8 : Credit Rating 447
Glossary 493
Detailed Curriculum
Investment Banking, Financial Systems and Financial Markets: Investment Banking Industry:
Meaning of Investment Banking – Coverage of Investment Banking Industry – Investment
Banking Industry Abroad.
Financial Systems and Financial Markets: Meaning and Functions of Financial System –
Constituents of Financial System – Financial Markets – Financial Assets – Financial
Intermediaries.
Credit Markets: Need for Credit – Lending Rates in the Credit Market – Indian Credit Market.
Money Markets: Introduction to Money Markets: The Need for a Money Market – Money
Market Instruments and Features – Risk Exposure in Money Market Instruments – Monetary
Policy on Money Markets – Indian Money Market Regulatory Framework – Recent Developments
in the Monetary and Credit Policy.
Call Money: Features of Call Market – Developments in Indian Call Markets – Movements of
Participants from Call to Repo Markets – Role of Reserve Bank of India – Call Markets in Other
Countries.
Treasury Bills: Features of Treasury Bills – Types of Treasury Bills – Issuing Procedure of
Treasury Bills – Primary Market and Settlement Procedures – T-Bills in International Markets.
Commercial Paper (CP): Features of Commercial Papers – Issuing Procedure – Evolution and
Development of Commercial Paper Market – Commercial Papers in International Markets –
Innovations of Commercial Paper.
Certificates of Deposit (CDs): Features of CDs – Purpose of Issue – The Issuing Procedure –
Process of Redemption – CDs in Other Countries.
Bill Financing: Concept and Features of Bills of Exchange – Classification of Bills – Discounting
of Bills by NBFCs – Commercial Bill Financing – Bill Markets in India.
Debt Markets: Gilt-edged Securities Market: Features of Government Securities – Primary

Market – Payment of Interest and Redemption – Trends in the Government Securities Market –
Role of RBI.
Repurchase Agreements (REPOs): Repo Market – Issue Procedures – Secondary Market

Transactions in Repos.
Public Deposits: Regulatory Framework Governing Acceptance of Public Deposits – Definition of

Public Deposits – Marketing of Deposits.
Financial Guarantees: Definition of Guarantee – Sources of Guarantees – Specialized Public

Guarantee Institutions.
Capital Markets: An Overview of Capital Markets: Trends in the Capital Markets – Returns in
Primary Markets – Trends in Primary Markets.
Regulation of the Capital Market: Historical Perspective – Securities and Exchange Board of India –
Regulatory Framework – Self-Regulation of the Markets – International Organization of Securities
Commissions.
Investment Banking: An Overview of Investment Banking: Brief History of Investment Banking –
Scope of Investment Banking – Evolution of Investment Banking in India – Current State of
Investment Banking in India.
Management of Public Issues, Initial Public Offerings and Pricing of Various Instruments:
Reasons for going Public Issue – Management of Public Issues and Initial Public Offerings –
Marketing of the Issues – Post-issue Activities – Innovations in Financial Instruments.
Rights Issues, Bonus Issues, Private Placements and Bought-out Deals: Legal Aspects for Rights
Issues – Regulatory Framework for Bonus Issues – Private Placements and Bought-out Deals.
International Markets: International Market Instruments: Types of Instruments in International

Markets – Players in International Markets – India’s Presence in International Markets – Eurodollar
Market – Forex Finance.
Non-Resident Indians (NRIs): The Meaning of Non-Resident Indians – How to Open NRI
Accounts – Types of NRI Accounts.
Foreign Institutional Investors (FIIs): Investments by Foreign Institutions – Foreign Direct

Investments in India – The Approval Process for Foreign Direct Investments in India.
Credit Rating: Concept of Credit Rating – Types of Credit Rating – Indian Credit Rating
Agencies – International Credit Rating Agencies.
•
•
Investment Banking and Financial Services
INTRODUCTION
Investment banking is a very vast area in the field of banking and finance.
Typically, investment banking includes the following activities: Advising,
administration, and intermediate at raising financial resources. It provides advisory
services at mergers, acquisition, sale, reconstruction and other financial
transactions of a firm.
In short, investment banking includes the activity of raising funds, managing them,
advising about investments and marketing of financial products. While there are
separate investment banks in the US and Europe, in India, mostly the commercial
banks undertake investment banking in toto or a part of it. Mostly merchant
banking is undertaken in India and the same is taken to be investment banking. It
is to be understood that merchant banking is just a part of investment banking and
not the other way round.
THE COVERAGE OF INVESTMENT BANKING INDUSTRY

Whether investment banking is performed by a company as its sole activity or
simply as a department in a commercial bank, the main activities remain the same,
as follows: Advising the Clients, Administration of Funds, Underwriting of Issues
and Distribution of Financial Products. Other related activities which most of the
investment bankers undertake are: mergers and acquisitions, spin-offs, investment
management, foreign exchange management, securities sales and securities trading
as well as insurance product designing, pension plans designing, hedging foreign
currency positions, financial swap, real estate dealing and other asset management
services.
While an investment banker charges some fees to its client, which could be a fixed
sum or a percentage of the funds raised or managed, and it may seem that the fees
charged are high in money terms, it is always cheaper and wiser to go to a
professional money manager to raise/manage funds, than to do it on one’s own, as
the latter option may lead to a disaster and major loss of funds.
Let us discuss each of the main activities of the investment banking industry in
more detail.
ADVISING FUNCTIONS
The advising function starts with the investment banker assessing the fund
requirements of its client, whether an individual or a corporate. The requirements
are not only related to the amount of funds required, but also the purpose and time
for which the requirement is there. After that, the investment banker will advise
the client about the costs and benefits of various sources of finance which are
viable and the timing of each one for raising the required funds. Finally, it will
advise the client about the best source and recommend a group of institutions that
can assemble the package and fulfill the funding needs.
ADMINISTRATIVE FUNCTIONS
After deciding on the funding strategy, the second function is the administrative
function, under which the investment banker has to prepare the documentation and
a myriad of details associated with the regulatory framework of the country in
which the funds are being raised. As the financial regulations and covenants are
routine considerations to the investment banker but may be obscure issues to the
general business community, the investment banker can provide a valuable service
in this area.
As such, an investment banker is expected to know the legal and regulatory
framework of the country as well as thorough knowledge of the success history of
past issues. Among the administrative functions that an investment banker is
supposed to render are the preparation of the documentation of the issue and the
prospectus.
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Investment Banking, Financial Systems and Financial Markets
UNDERWRITING FUNCTIONS
Underwriting means giving guarantee for a fixed price to the security issuer in
exchange for its securities. Investment bankers undertake underwriting of the
issues that are brought to the market by their clients. This activity involves risk to
the investment banker if the underwriting price is very high. In addition,
investment bankers get involved into bought-out deals and private placement of
issues.
DISTRIBUTION FUNCTIONS
Distribution function involves the placement of newly issued securities in the
hands of investors. The investment banker is expected to build-up a proper channel
for the distribution of the issue and form a syndicate of underwriters to minimize
the risks on the issue as well as to stabilize the price. It also involves the printing
of the security papers, allotment, registrars work among others.
INVESTMENT MANAGEMENT FUNCTIONS
Given the fact that investment managers are involved with the issues from the
beginning, they have the strength to analyze the securities and firms that issue
them. As such, they can leverage their ability in other areas also. As the
management of primary issues in various countries is dwindling, investment
bankers are getting attracted towards the secondary market and investment
management on their own.
The investment management function also includes the management of funds
entrusted by clients to the investment banker. An investment banker also invites
funds from the public in general and manages the same under guarantee to provide
a certain percentage of returns which is normally higher than the returns that the
individual can obtain on his own. Funds thus received are invested in various stock
and bond issues, as well as gilt-edged instruments. Such investment bankers are
also known as Money Managers.
A study of investment bankers worldwide has shown that they provide the
following types of management services in a number of different ways: individual
investment services, money management, pooling of funds for joint investment,
index fund investments and consultancy services.
MERGERS AND ACQUISITIONS
Mergers and acquisitions is another area where investment bankers have been
active for quite a long time. They help their clients find out prospective merger
partners or an acquisition target or prospective clients for sale. In addition, they
may be asked to devise appropriate strategies for the acquisition, including the
raising of sufficient funds for the same.
OTHER ACTIVITIES
In addition to the above-mentioned activities, investment bankers are also
interested in designing insurance products, pension plans, hedging risk and risk
management, foreign exchange management, dealings in foreign currency features,
real estate dealings, etc. The scope of an investment banker has been growing fast
owing to the fact that the finance industry is seeing a lot of innovations and new
concepts are fast emerging.
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INVESTMENT BANKING INDUSTRY ABROAD

Investment banking in the US is an age-old industry. Full-fledged companies like
Merrill Lynch, Goldman Sachs, J.P. Morgan, Chase Manhattan, Salomon Smith
Barney, Bear Stearns, Morgan Stanley Dean Witter, CS-First Boston and Charles
Schwab have become well-known names across the globe. While some are active
on the retail side, others are highly active in trading securities. Specialized
discount broking is also one of the main activities of investment bankers in the US.
The financial crises of 2008 has hit this industry very badly.
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SUMMARY
• Investment banking is a very vast area in the field of banking and finance.
• It includes raising and managing funds, advising clients about investments
and marketing financial products.
• The main activities under investment banking are: advisory functions,
administrative functions, underwriting functions, distribution functions,
investment management functions, mergers and acquisitions and other
finance related activities.
• Investment banking in the US is a very old industry and the top investment
banking firms have become MNCs with presence in most of the countries
across the globe.
4
•
•
The economic development of a nation is reflected by the progress of the various

economic units, broadly classified into corporate sector, government and
household sector. While performing their activities, these units will be placed in
surplus/deficit/balanced budgetary situations.
While the corporates will have a surplus arising from the retained earnings, their
need for funds will be for investment in new projects, for expansion/
diversification/modernization, etc. On the other hand, the government which is
always in a deficit budgetary situation will be in need of funds for public
expenditure, to finance its developmental projects and other PSUs, etc. Apart from
these two economic units, even the household sector will require funds for varied
purposes for example, for acquiring assets. However, the surplus funds of the
households will normally be more when compared to the other units.
Hence, it can be observed that, at any given point of time there would be some
units having idle funds and a few others which would be in need of funds. The
volume of funds required for the investment activity of the corporates and for the
public expenditure of the government is very large when compared to the
household requirements. And if funds are not provided for these activities, it will
hinder economic progress. On the other hand, there are surplus budget units which
have excess funds in the form of savings.
Mere act of saving will, however, not guarantee economic progress. This is due to
the fact that savings and investments will usually be carried out by different
groups, savings come from the household sector and the investments are being
made by the corporate sector. Hence, there should be a mechanism to ensure that
savings flow from those who save to those who wish to invest. This process would
enable the utilization of excess idle funds, thereby enhancing their value. Enabling
such a transfer of funds from the savers to the borrowers is the Financial System.
MEANING AND FUNCTIONS OF FINANCIAL SYSTEM

A financial system represents a channel through which savings are mobilized from
the surplus units and routed to the deficit units. The functions of the financial
system can be broadly classified into the following:
• Savings Function: Mobilize savings in a way to provide a potentially
profitable and low risk outlet.
• Policy Function: Through the policy function, the government ensures a
smooth flow of funds from savings into investments in order to stabilize the
economy.
• Credit Function: After mobilizing, the savings and laying down the
necessary policies for the transfer of these funds, the credit function of the
financial system will then ensure that these savings will transform into the
necessary credit for investment and spending purposes.
Complexities may arise while performing these functions, especially when the
requirements of the savers and those of the borrowers do not match. The main
considerations of the savers will be with regard to the safety of funds, returns and
liquidity. On the other hand, the needs of the borrowers will be relatively
diversified. Their concerns will relate to the term for which the funds are available
and the cost of funds.
These varied requirements of the lenders and the borrowers will lead to a
mismatch in periods – lending period may differ from the needs of the borrower.
Similarly, the risk exposure and the corresponding returns may not suit the lender.
Due to these factors there arose a need to develop the financial system in such a
way that it matches the requirements of the borrowers and lenders. This led to the
evolution of the financial system thereby widening its scope of operations.
6
CONSTITUENTS OF A FINANCIAL SYSTEM
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Proper allocation of funds is essential for the transactions taking place in the
financial system to have a developmental impact on the economy. And to enable
proper allocation of resources, various financial markets are being developed.
Accordingly, to match the transactions taking place in these financial markets,
various financial instruments were born. Over time, these developments have
made the operations of the financial system complex. Specialized services were
offered in these markets with newer and better instruments. This further enhanced
the necessity of specialized intermediaries to perform the various financial
transactions. Thus evolved the various market intermediaries.
Yet another feature of the financial system that needs to be understood is the
manner in which the flow of funds takes place. In an environment where the
borrowers and lenders are easily accessible to each other, the financial system will
be in a disintermediation stage, i.e., there will not be any intermediary involved for
the funds to flow from the saver to the ultimate borrower. Contrary to such a
situation will be the intermediation stage where the financial system will have a
few specialized intermediaries enabling the transfer of funds from the savers to the
borrowers. However, now-a-days the financial requirements are so varied and
large that the system generally operates through both intermediation and
disintermediation mechanisms. Irrespective of how the transfer of funds takes
place, it is the central bank of the country along with the government which
generally regulates the financial system by regulating the markets, instruments and
players operating in it.
With such revolutionary changes taking place in the financial system and with the
broadening of its operations, the impact of the same on the economy will be
tremendous. This enhances the need for a closer examination of the networking
taking place between the various financial markets, intermediaries and the
financial assets available in these markets.
7
FINANCIAL MARKETS
Being entrusted with different functions having macro level implications on the
nation’s economy, the financial system tries to fulfill its role through the financial
markets. The financial markets channelize the savings of the households and other
surplus budget units to those individuals and institutions that need funds. While
performing this role, the financial markets aid in increasing production and income
for the various units. The importance of these markets to the financial system can
be understood from the quantum of funds that are made available to the borrowers.
TYPES OF MARKETS
The financial markets that are present today have come a long way from the
informal markets that have existed earlier. According to the changing and
increasing needs of the lenders and borrowers, the financial markets have also
developed. These markets have witnessed remarkable changes in the nature of
transactions, the type of participants, the magnitude of operations and various
other characteristics. And depending on the differing requirements, various
sub-markets have developed.
The main segments of the organized financial markets are as follows:
• Money Market: The money market is a wholesale debt market for low-risk,
highly-liquid, short-term instruments. Funds are available in this market for
periods ranging from a single day up to a year. This market is dominated
mostly by government, banks and financial institutions.
• Capital Market: The capital market is aimed at financing the long-term
investments. The transactions taking place in this market will be for periods
over a year.
• Forex Market: The forex market deals with the multicurrency requirements
which are met by the exchange of currencies. Depending on the exchange
rate that is applicable, the transfer of funds takes place in this market. This is
one of the most developed and integrated market across the globe.
• Credit Market: Credit market is a place where banks, FIs and NBFCs
purvey short-, medium- and long-term loans to corporates and individuals.
• Derivatives Market: This market provides various financial instruments
to manage financial risk of corporates. Hedging, financial swap etc., are
possible here.
Such a segregation of the financial market into various sub-groups has enhanced
the efficiency of resource allocation. Each market is unique in terms of the nature
of participants, instruments, etc. An insight into the operations of these markets
can be obtained in the subsequent chapter of this book. Table given below briefly
explains the characteristics of the markets.
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Within the above-mentioned sub-markets, based on the transactions, the financial

markets can further be categorized into an Open Market and a Negotiated
Market. The basic distinction between these two types of markets is based on how
the securities are bought and sold. In an open market, the securities will be offered
to a large number of investors who can buy and sell them any number of times
before the maturity period. The public issue of securities takes place in an open
market. On the other hand, the negotiated market will have only a selected group
of investors to whom the securities are offered and sold. It will generally be a
private contract between the seller and the buyer. A bought-out deal and a car loan
are good examples of the negotiated market.
Yet another useful and important distinction between markets in the financial
system is the Primary Market and the Secondary Market. The primary market is
a place for the fresh issue of securities. Corporates, banks, FIs and government can
issue new securities and raise funds for investment purposes.
The transactions like selling and buying involving the securities issued in the
primary market take place in the secondary market. Thus, secondary market deals
in securities previously issued in the primary market and thereby provides liquidity
to the investors. Investors can either buy securities that are already issued or sell
securities held by them in the secondary market on a continuous basis. Due to this,
the volume of transactions taking place in the secondary market are far greater
than those taking place in the primary market. Except for the capital market, the
other sub-markets present in the financial system either do not have a secondary
market or their operations in the same are negligible. The secondary market
transactions of the capital market take place at the stock exchanges. All securities
that are issued in the primary market will have to be listed on the stock exchanges
to enable trading activity. The secondary market helps in undertaking ‘Maturity
Intermediation’, by bringing together savers and users with conflicting maturity
targets.
Unlike the open and negotiated markets, the primary and secondary markets
complement each other. The primary and secondary markets are so closely
interlinked that the level and the nature of operations taking place in one market
affect the other. For instance, if the price of a security issued by a particular
company is high in the secondary market, its impact will be felt on the primary
issues of that company.
MARKET EFFICIENCY
Though there are various markets present in the financial system, the ease with
which the transfer of funds take place depends on the level of efficiency present in
the financial markets. A market is considered as perfect if it has the following
characteristics:
• All players in the market are price takers,
• No significant regulations on the transfer of funds exists,
• Very low/insignificant transaction costs.
The first situation will be possible when all the players in the market have all the
information relating to the security and the market price of the security reflects all
the available information.
The flow of funds within the market and between the markets should not be
restricted by government regulations. There should be free flow of funds from one
market to the other.
Finally, transaction costs will depend on the trading and settlement processes.
Transparency in the trading mechanism and shorter settlement periods are critical
for low transaction costs.
9
However, most of the financial markets are still imperfect and are yet to be
developed. The imperfections present in the markets may have an adverse impact
on the players of these markets. Further, due to the interlinkage of the financial
markets, the factors affecting one market may have a direct or indirect impact on
the others also.
INTERLINKAGE IN THE FINANCIAL MARKETS
The interlinkage present in the financial markets is essentially due to the fact that
all these markets are in the process of assisting the flow of funds. Some of the
commonalties are:
Credit
One of the prime unifying factor of the various financial markets is credit. Since
all markets provide credit, borrowers and lenders can switch from one market to
another seeking the most favorable credit terms. Such shifting of borrowings from
one market to another may take place to reduce the credit costs.
Speculation
Yet another common feature present in these markets relates to speculation.
Investors in securities will get returns in the form of interest or capital gains in the
long-term. Speculators in securities are always on the look out for speculative
gains that can arise either due to certain market sensitive information or through
their forecasts on certain future market developments. Such forecasts may be about
interest rate movements, security prices, government policies, etc.
Arbitrage
Arbitrage is the other unifying factor of the financial markets. Arbitrageurs take
advantage of the price differentials existing between the markets. When the prices
of securities in one market appear to be out of line with the other markets,
arbitrageurs switch over to that market offering the best of prices. Thus,
arbitraging enables transfer of funds from one market to another.
In spite of such linkages, the guidelines regulating the various sub-markets in few
economies, however, insulate them to a certain extent from the influence of the
other markets. Contrary to these economies are the free economies where the
financial markets are freely accessible.
GLOBALIZATION OF FINANCIAL MARKETS
Most of the economies of the world have opened their gates for foreign
participants and companies. Trading takes place not only in the securities of
domestic companies, but also in the securities of foreign companies that are listed
in these markets. There will also be multiple listing of the same securities on all
major stock exchanges. Due to these reasons, financial markets witness non-stop
activity with transactions taking place round the clock. Financial markets in the
US, UK, Tokyo and Sydney are examples of such markets.
However, for a financial market to globalize its operations, its level of efficiency
has to meet the global standards. For the foreign companies and investors to
operate, there should be a level playing field for foreigners as well as domestic
investors. Open access to membership on all exchanges and suitable technology
that ensures transparency in transactions, efficient payment and settlement system,
easy flow of information etc., are some of the features that help globalization of markets.
Irrespective of being a national or a global market, the suppliers of funds in these
markets will essentially look for adequate returns, high safety and high levels of
liquidity while lending their funds. Thus, the borrowers of funds will have to
design suitable financial instruments that meet the requirements of the lenders. It is
based on such features of the financial assets that the transactions taking place in
the financial markets are grouped.
10
FINANCIAL ASSETS
Financial assets/instruments represent the financial obligations that arise when the
borrower raises funds in the financial market. In exchange for the funds lent, the
supplier will have a claim on the income/wealth of the borrower which may be a
corporate, a government body or a household. This financial claim will be
packaged in the form of a certificate, receipt or any other legal document.
Financial assets play a key role in developing the financial markets in particular
and the financial system in general. Their importance to the system can be
understood while distinguishing these assets from the real assets. All assets are
financed by liabilities as the accounting concept advocates. While the assets can be
either financial or real assets, the liabilities will be either in the form of savings or
financial liabilities. Financial assets represent the obligations on the part of the
issuer of such financial asset. Hence, all financial assets will be equal to the
financial liabilities. The funding of assets will be done either by using savings or
by borrowing. Since borrowings represent financial liabilities, the accounting
equation can be altered as follows:
Assets = Liabilities + Capital
Financial Assets + Real Assets = Financial Liabilities + Savings
Since financial assets equal to financial liabilities, the real assets will be financed
by savings. This relationship has the following implicit assumptions:
i. There are no external borrowings in the system.
ii. Financial liabilities include stock issued to the outsiders.
From the above equation, it can be understood that the surplus funds of an
economic unit will either be used by the saver to purchase a real asset or will be
lent to other economic units to buy real assets. Thus, all real asset purchases within
the system will be made from the savings in the system.
An important aspect that is to be noted here is the process through which the
savings are transformed into real assets since it has an important bearing on the
economic progress. This can be explained by the fact that savings can be
transformed into real assets for consumption purpose or they can also be
transformed into real assets through the investment channel. Though these two
activities, i.e. consumption and investment are essential for the economy, using
excess of savings for consumption purpose will be detrimental for the economic
progress since it will result in scarcity of funds for investment purpose. While both
demand and supply are necessary for economic growth, the deployment of savings
should be such that it ensures equilibrium.
It thus implies that stimulating savings into financial assets for ultimate purchase
of real assets promotes the role of the financial markets in the system.
TYPES OF FINANCIAL ASSETS
Majority of financial assets used worldwide are in the form of deposits, stocks and
debt.
Deposits
Deposits can be made either with banking or non-banking firms. In return, the
lender will receive a certificate in case of a fixed deposit and a checking account in
case of a savings/current deposit. These serve as payment mechanism to the
supplier of funds. Interest will be earned on such deposits.
Stocks
When financial assets are in the form of stock, they represent ownership of the
issuing company. Due to this right to ownership, the holder of the stocks will have
a share in the firms’ profits.
11
Debt
Unlike the stocks, financial assets in the form of debt raise an obligation on the
borrower to repay the amount borrowed. The debt instrument will be a contract
entered into by the borrower of funds with the lender of funds, to repay the amount
borrowed after a predetermined period and at a certain rate of interest. If there is
an asset serving as a collateral to the borrowing, then the holder of the debt
instrument will have a priority claim on the asset.
Within this broad classification, financial innovations have brought about a variety
of instruments. In stocks, there are preferred stocks and common stocks, with the
latter having voting rights. In case of debt instruments, the classifications are much
more varied depending on the issuer of securities and other terms and conditions
present in the contract for example, gilt-edged securities are the debt instruments
issued by the government. Other classifications of the debt instruments are made
as follows: fixed/floating rate bonds, negotiable/non-negotiable instruments,
redeemable/irredeemable bonds, convertible/non-convertible debentures etc.
Further, these instruments, both stock and debt, enable the issuer to raise funds in
domestic and foreign currencies.
There will be a certain amount of uncertainty attached to future cash flows. This
makes lending a risky business. To compensate for this risk and the uncertainty
attached to future cash flows, suppliers of funds will be provided income in the
form of dividends, interest, etc. Thus, issuers of the financial assets can mobilize
the requisite funds from the financial markets by promising future income to the
subscribers of the financial assets issued by them.
The ability of an issuer to fulfill the promise of future cash flows depends mainly
on the inherent financial strength of the issuer. The financial assets are rated to
indicate the safety levels (levels of risk) by specialized rating agencies.
Apart from the safety, suppliers of funds also expect to earn good returns. And
since risk and return are positively correlated, financial assets having greater risk
generally carry higher yields and vice versa. With this basic understanding, the
suppliers will deploy their funds into the financial markets by selecting the
financial asset that matches their risk-return preferences.
Liquidity is also an important criteria for asset selection. Suppliers of funds
generally deploy their surplus funds into such financial assets until the time the
requirement for these funds arises. And when the need arises, the lenders of funds
should be able to liquidate the financial assets held by them whenever they intend
to do so.
These three basic features of the financial instruments: returns, risk and liquidity –
have a major impact on the financial system. Firstly, the variety of financial assets
with varying risk-return profiles influence the interest rate structure of the
economy. Secondly, the liquidity offered by these financial assets will influence
the amount of funds that can be mobilized from the markets.
In addition to these features, instruments are being designed with various other
features to suit the issuer as well as to attract the investor. Listed below are the
considerations of the issuer while designing the instrument and that of the investor
while investing in the financial instrument.
Derivatives
Derivative contracts are the financial instruments whose values are derived from
the value of the underlying assets. The underlying assets may be commodities,
equity stock, interest rates, stock market indices, residential mortgages,
commercial real estate, loans, bonds, etc., Derivatives can be used to mitigate the
risk of economic loss arising from changes in the value of the underlying asset.
This activity is known as hedging. Alternatively, derivatives can be used by
investors to increase the profit arising if the value of the underlying asset moves in
the direction they expect.
12
ISSUER’S CONSIDERATIONS
Cash Flows: Issuers may consider the period for which the funds are required and
try to spread the borrowings in a way to minimize the costs. Generally, the
requirements of funds will depend on the purpose for which the funds are raised.
Taxation: Issuers may have to assess the tax liability of the company and try to
design the instrument in order to get the benefit of certain tax incentives for the
company and to the investors. The attempt would be to minimize the tax liability
of the issuer.
Leverage: Issuers may assess the debt to equity ratio of the company since excess
of debt may burden the company with debt servicing. Further, in a falling interest
rate scenario a debt contracted for a long-term will increase the cost of funds for
the company.
Dilution of Control: Likewise, excess of equity will dilute the control over the
company and this will be a disincentive especially if the promoters prefer the
company to be closely held.
Transaction Costs: The instrument should have adequate liquidity so that
investors costs while transacting are minimal.
Quantum of Funds: Issuers may target the investors based on the quantum of
funds required and the time within which the funds are to be raised.
Maturity Plan: Depending upon the future requirement of funds and also on the
availability of funds to repay the lenders, the repayment schedule of the instrument
has to be designed.
Market Conditions: One of the important considerations for the issuer will be the
environment, both economic and political. Notwithstanding the credibility of an
issuer, it is important that the market should be conducive to facilitate raising of
funds. The market experiences cyclical trends of boom and depression even if the
long-term trend is of growth. While it is easier to raise funds in a booming market,
the same becomes extremely difficult in a depressed market.
Investor Profile: Instrument design should necessarily suit the target investors for
the issue. For instance, if the retail investor is targeted, then the minimum
subscription is generally kept low.
Past Performance: The performance of the previous issues of the same company
or performance of the previous issues of companies in the same industry will have
to be considered before designing the instrument.
Cost of Funds: Raising funds is a costly affair, so based on the above factors the
company should ensure to choose an option which minimizes its cost of funds.
Regulatory Aspects: Finally, creation of the instrument after considering all the
possible factors, will have to be done in the light of the regulatory aspects. For
example, rating has to be done for debt instruments, capital adequacy norms have
to be met, etc.
INVESTOR’S CONSIDERATIONS
Risk: The primary consideration for the investor will be the safety of the funds
lent. Every investment option will have an element of risk.
Liquidity: The investor will also give due consideration to the liquidity of the
instrument, which depends mainly on the secondary market.
Returns: The investor generally expects to earn a return that compensates for
the risk exposure taken by investing in the security. Unorganized sector
generally offers high returns, but the associated risks are also high. Investors
generally stick to the risk-return preferences since multiple investment options
are available.
13
Tax Planning: To get certain tax benefits, investors can invest in those
securities that offer tax incentives, as the post-tax returns are of significance to
an investor.
Cash Flows: The investment decision of the investor will also depend on the
period for which the surplus funds are available for investment. The investor
will, therefore, consider the repayment schedule by way of interest and
principal.
Simplicity: The salient features of the instrument should be easily understood
by the investor in order to take the investment decision.
While it may not be possible to get the best of all the above in a single instrument,
issuers and investors consider those which are of more priority to them. However,
these considerations keep changing depending on the changing environment. In
such a scenario, instrument designing itself becomes a subject of specialization.
FINANCIAL INTERMEDIARIES
Having designed the instrument, the issuer should then ensure that these financial
assets reach the ultimate investor in order to garner the requisite amount. When the
borrower of funds approaches the financial market to raise funds, mere issue of
securities will not suffice. Adequate information of the issue, issuer and the
security should be passed on to the supplier of funds for the exchange of funds to
take place. There should be a proper channel within the financial system to ensure
such transfer.
To serve this purpose, Financial Intermediaries came into existence. In the initial
stages, the role of the intermediary was mostly related to ensure transfer of funds
from the lender to the borrower. This service was offered by banks, FIs, brokers,
and dealers. However, as the financial system widened along with the
developments taking place in the financial markets, the scope of its operations also
widened. Major changes were witnessed in the type of issuers and investors
participating in the markets. Financial innovations, technological upgradations and
most importantly changing regulatory mechanism made the process of raising
funds from the market place a complex task. Investors’ preferences for financial
assets have also changed. Designing instruments that catch the investors’ attention
has now become a specialized service. Likewise, proper expertise is also necessary
for establishing transactions in the financial markets. Large volume of transactions
taking place in the markets will have to be recorded promptly and accurately.
Finally, since the money raised through these markets comes from various sectors
including the individual investors, there is a need to ensure that these funds flow
into proper investment channels.
Change has become a constant phenomena of a financial system as it has to relate
to the shifting demands of the lenders and the borrowers, the technological
developments etc. Due to this, the dynamics of the financial system keep changing,
thereby requiring the services of specialized agencies to operate in the market.
Some of the important intermediaries operating in the financial markets include:
investment bankers, underwriters, stock exchanges, registrars, depositories,
custodians, portfolio managers, mutual funds, financial advertisers, financial
consultants, primary dealers, satellite dealers, self-regulatory organizations, etc.
14
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Though the markets are different, there may be a few intermediaries offering their
services in more than one market for example, underwriters. However, the services
offered by them vary from one market to another.
Intermediaries do ease the funds flow process taking place in the financial markets.
But, there are costs associated with these intermediaries. Firstly, the cost of
lending and borrowing in the market may rise due to the presence of these
intermediaries. Secondly, in a market that is not well regulated these
intermediaries increase the risks for the investor. Technological developments and
proper infrastructure facilities may help in bringing down the increase in costs.
However, to prevent any misappropriation of the lenders funds and reduce the
risks of the investors, a well regulated environment has to be developed.
Generally, these regulations also keep changing according to the changes taking
place in the markets.
With markets in various countries harmonizing their regulations, these financial
intermediaries are now becoming global players. While competition has intensified
with such globalization, these intermediaries are also honing their skills. Some of
them are becoming specialized agencies while the others are diversifying
depending on the requirements of various markets.
SUMMARY
• The economic development of a country depends on the progress of its
various economic units, namely the corporate sector, government sector and
the household sector.
• The role of the financial sector can be broadly classified into the savings
function, policy function and credit function.
• The main types of financial markets are: money market, capital market, forex
market and credit market.
• The financial markets are further sub-divided into the primary market and the
secondary market.
• A market is considered perfect if all the players are price takers, there are no
significant regulations on the transfer of funds and transaction costs, if any,
are very low.
15
• The accounting equation Assets = Liabilities + Capital, can be altered as

Financial Assets + Real Assets = Financial Liabilities + Savings.
• The main types of financial assets are deposits, stocks and debt.
• While designing a financial instrument, the issuer must keep the following in
mind: cash flows required, taxation rules, leverage expected, dilution of
control facts, transaction costs to be incurred, quantum of funds sought,
maturity of plan required, prevalent market conditions, investor profile
targeted, past performance of issues, cost of funds to be borne, regulatory
aspects to abide by.
• While investing in a financial instrument, the investor must keep in mind the
following: risk involved, liquidity of the instrument, returns expected,
possible tax planning, cash flows required and simplicity of investment.
• Various financial intermediaries came into existence to facilitate a proper
channel for investment. The main ones are: stock exchanges, investment
bankers, underwriters, registrars, depositories, custodians, primary dealers,
satellite dealers and forex dealers.
16
•
•
INTRODUCTION
The financial system enables supply of funds to support purchase of goods and
services and to finance capital investments. In this way, it provides funds both to
the demand side (consumers) and the supply side (manufacturer) of the economy.
In a well-developed market with adequate infrastructural facilities, transfer of
funds takes place directly from the savers of funds to the users of funds. Thus, the
transfer takes place either through the disintermediation or the reintermediation
processes.
When the market allows direct flow of funds, it is known to be in
disintermediation stage. Such direct flow of funds will be made by the issue of
financial assets in the form of securities. Differentiating itself slightly from the
disintermediation process is the reintermediation process, where the funds flow to
an intermediary which invests in the securities issued by the corporates. For
instance, individuals invest in mutual funds, which in turn invest in the securities
issued by the corporates.
However, in economies where there is no adequate infrastructural support for such
direct flow of funds to take place, they generally operate through the
intermediation process. Operating in an intermediation stage to fulfill the credit
requirements of the different sectors of the economy is the Credit Market.
Intermediaries like banks, financial institutions and Non-banking Finance
Companies (NBFCs) provide credit for the varying requirements of the consumer
and corporate sectors of the economy. This credit extension will mostly be in the
form of loans.
NEED FOR CREDIT

On the demand side of the economy are the consumers of goods and services who
require funds basically for acquiring certain consumer durables. The credit facility
offered to the households will generally be in the form of auto-finance, educational
loans, credit card loans, housing loans and for the purchase of other consumer
durable items. Loans will also be provided to individuals against other financial
and real assets. Except for the housing loans all the other types of individual loans
range from short- to medium-term.
Similarly, on the supply side also, the credit market provides funds to the
corporates, though for entirely different purposes. Corporates basically require
funds for project finance while initiating an investment plan and working capital
finance for their day-to-day operations.
Credit extended for project finance would enable the corporates to acquire real
assets, plant and machinery, technological expertise, etc., required for expansion/
modernization/diversification purposes. It can be observed that the funds required
for these purposes will be large in amount and for periods ranging from medium-
to long-term.
In certain cases, where the project is very large and the funds cannot be provided
by a single institution, consortium lending will be resorted to. In this facility, two
or more intermediaries will join together to finance large project proposals. Such
funding requirements will generally arise while financing large infrastructure
projects, petroleum projects, etc.
In addition to the long-term requirements, firms would also require short-term
funds for meeting their working capital requirements. Firms require these funds to
meet their day-to-day operational requirements and for maintaining adequate
levels of current assets. Since these funds support the daily operations of the firms,
they are required on a continuous basis. The financial assistance for the working
capital requirements is generally provided by banks in the form of Cash Credit
(CC), Overdraft Facility (OD) and bill finance.
18
Credit Markets
Under the cash credit facility, limits are set based on the requirements of the firm
and the CC is sanctioned for one year. The CC limits sanctioned for a year, in
practice, will generally be renewed after assessing the working capital
requirements for the following year. Thus, the cash credit has a permanent feature,
though, technically the funds are repayable on demand. The CC limit sanctioned
based on the working capital estimates will have the combined features of a loan
and a current account. Funds will be made available through an account of the firm
from which the firm can withdraw (within the sanctioned CC limits) when funds
are required and deposit when funds are in excess. The interest charged will be on
the daily outstanding (net debit balances) in this account and will generally be paid
on a quarterly basis.
In the overdraft facility, the bank will allow the firm to overdraw from its current
account to a predetermined level of credit. This credit limit will be set based on the
security offered by the firm. Such type of credit facility will generally be
short-term in nature, not exceeding a year.
The other type of short-term credit will be in the form of bill financing. Here, the
intermediary will finance the trade bills of the firm for a maximum period of
6 months. The overdraft facility is either clean or against some security such as
real estate whereas cash credit account is invariably secured by inventory.
While the short-term and the long-term credit facilities mentioned above appear on
the balance sheet of the firm, there are a few contingent credit facilities which do
not appear on the balance sheet. These off balance sheet activities are generally in
the form of letter of credit or a standby facility or guarantees. The contingent claim
is transformed into a credit claim when the contractual obligation is activated. The
returns on such off balance sheet transactions are high, but so are the risks.
Apart from the above, the credit market in a few economies also facilitates priority
sector lending. As per the regulations of these economies, a prescribed percentage
of the total loanable funds of the intermediaries will have to be utilized to fund the
priority sector. In India, banks are required to allocate 40 percent of the total funds
provided as loans in that year towards the priority sector lending. Even the foreign
banks operating in India have to lend 32 percent of their net bank credit in India to
the priority sector. For a developing economy such selective credit control
becomes essential to ensure the proper use of institutional credit since a major
portion of the savings lies with these intermediaries as loanable funds.
Most of the credit facilities that are offered in the credit market are in the form of
loans. A loan is a broad term used to explain the different types of credit facilities
extended in the credit market. Irrespective of their type, all loans are contractual
agreements entered into by the borrower of the funds with the lender of the funds.
The agreement states the terms and conditions of repayment of the loan over a
predetermined period of time at a predetermined rate of interest.
While a variety of loan facilities are present in the credit market, the business firms
will have to, however, select the type of loan that suits their cash flow requirement
and is a profitable option when the expected rate of return is compared to the cost
of the loanable funds.
LENDING RATES IN THE CREDIT MARKET

One of the crucial decisions involved while extending loans is the lending rate.
Intermediaries will base their lending rate decisions on three important criteria –
their cost of funds, transaction costs and the required spreads. The sources of funds
will determine the cost of funds for the intermediaries. The major sources of funds
to banks and NBFCs are public deposits. Other than this, the intermediaries can
also raise funds from the other financial markets. Transaction costs will depend
mostly on the efficiency with which the transfer of funds is enabled. All costs
incurred in the decision-making process while approving a proposal and in
19
maintaining the clients’ accounts throughout the loan repayment period constitute
the transaction costs. Apart from ensuring that these costs are fully covered, the
lending rate fixed by the intermediaries will also include a certain percentage as a
spread for making the lending activity profitable.
Though this method of pricing seems to give the lender adequate returns for the
funds lent, it may not happen in all cases. In reality, the cost of lending may
actually rise based on the prevailing market conditions. For instance, the
transaction costs for the loan may rise during the repayment period. Further,
lending is a risky business. To ensure that the profits earned by way of interest
income sustains the risk exposures, the price should include a premium for the
risks involved in this business.
Thus, apart from satisfying the three basic criteria for fixing the lending rates,
intermediaries should also consider all the risk exposures. First and the most
important risk exposure in the lending activity relates to the credit risk. Proper
credit analysis of the client and the proposal is essential to counter such risks.
Based on the assessment of the creditworthiness, the lending rate should be fixed
in such a way that it reflects the credit risk present in the transaction.
In addition to this, lenders may also perceive an interest rate risk. In an
administered interest rate environment, the scope to manage interest rate risk will
be negligible/nil since the regulator fixes the rates leaving little scope for market
determination. However, in a free economy, where the market forces decide the
rates, the uncertainty relating to the movement in the rates will be high thereby
increasing the risk and along with this comes the scope to manage it.
The lending rate can be either fixed rate or a floating rate. Generally, short-term
loans have a fixed rate, while loans for longer tenure may have a floating rate.
Further, fixed rate is preferred in a declining interest rate scenario, while the
floating rate would be more suitable when the interest rates are sloping upwards.
The floating rate will also enable the intermediary to hedge against rate
fluctuations to a certain extent. However, to use the same, there has to be a proper
benchmark/reference rate. Internationally, the London Inter Bank Offered Rate
(LIBOR) is used as a reference rate for Euroloans, etc. In the Indian market, the
Bank Rate (BR) and the Prime Lending Rate (PLR) of the banks and the financial
intermediaries are used as a reference rate for loans and advances. Of these two
reference rates, PLR will be the most preferred reference rate since it is market
determined. The bank rate is given by the Central Bank and is not market
determined.
The lending rate should thus reflect the risk exposures present in the credit
disbursal. Apart from adjusting the rate charged to the risk perception,
intermediaries may sometimes, based on the creditworthiness of the client, demand
a collateral/security in the form of an asset/guarantee/co-obligation. The arrangement
of a collateral/security is generally made to minimize loss due to default of loans.
Sometimes, the amount of loan extended and the rate of interest charged will
depend on the security offered for the loan.
However, in spite of credit assessment and proper pricing, if the borrower defaults,
the intermediary has the option of altering the repayment schedule and make it
flexible enough for the borrower to repay. Such facility is generally not available
in other financial markets.
Since a major portion of the savings in the economy will be routed to the
intermediaries, it will be the responsibility of these intermediaries to ensure that
efficient transfer of funds takes place. Over the years, credit market has gained
tremendous importance as a place for raising funds. There has been an increase in
the quantum of credit extended by this market. Accordingly, there is also a rise in
the number of borrowers and lenders. Both these parties look for certain issues
while operating in this market.
20
Credit Markets
The borrowers generally prefer to have the following features while entering into
a deal:
• Low rates of interest.
• Minimum lead time when money is required.
• Access to funds up to the desired period of time.
• Minimum terms and conditions attached with the usage of funds.
• Minimum monitoring and interference from the lender.
• Freedom to set the repayment schedule according to the convenience of the
borrower.
On the other hand, the lender of funds in the credit market would generally aim to
meet the following objectives:
• Maximum spreads.
• Adequate coverage for the various risk exposures.
• Satisfy the statutory reserve requirements and the capital adequacy norms.
Maintaining adequate spreads is essential for these financial intermediaries, since
their sustenance depends on these spreads. Spreads can be enhanced by accepting
risky lending propositions. However, such risky loans may not always contribute
to the long run sustenance of the intermediary. To ensure that these intermediaries
operate within adequate risk levels, prudential norms have been set for their
operations. By conforming to these prudential norms, the intermediaries should be
able to fully meet the requirements of the productive sectors of the economy so
that the growth of the economy is not hindered by inadequate credit nor by misuse
of the same.
INDIAN CREDIT MARKET

Credit market plays a significant role in the Indian financial system. Banks play a
critical role in the Indian market by mobilizing the small savings and routing them
for corporate investment by extending working capital finance and other term
loans. A major portion of the individual loans are also catered to by the banks.
Sharing the corporate finance activity along with banks are the financial
institutions which cater to the long-term financial requirements of the business
firms. NBFCs also provide credit both to consumers and corporates but, their level
of participation is comparatively lower than that of other intermediaries.
Apart from this broad classification, there are a few institutions offering certain
sector-specific credit facilities. Various types of credit facilities and the varying
credit demands have led to the development of a plethora of financial institutions.
The institutions operating in the Indian credit market can be classified as follows:
• Developmental Financial Institutions:
IFCI, IDFC – Industrial Credit.
• Specialized Sector-Specific Development Banks/Apex Institutions:
Exim Bank – Export finance.
SIDBI – Small industries development.
NABARD – Agro-rural based project finance.
• Agricultural and related activities predominantly in rural and semi-urban
areas:
– Regional Rural Banks.
– Cooperative Banks.
21
With the varied credit facilities available in the credit market, the intermediaries
have the option to operate in niche areas. However, if regulations set-up rigid
institutional boundaries and cause segmentation, it would not be of much benefit
as there may not be a level playing field for all the players. Segmentation should
thus, evolve as a natural process as per the requirements of the markets.
Giving due importance to such process of evolution, the Indian financial sector
is also being liberalized. Few measures that were taken to enhance the level of
efficiency of the credit market are listed below:
• Withdrawing the government funds as a source of funds to Fis.
• Restricting the dependence of NBFCs on public deposits.
• Setting prudential norms for the intermediaries.
• Deregulating the interest rate environment.
• Allowing private sector banks to operate.
• Widening the scope of the financial institutions.
• Adopting newer technologies.
• Permitting access to overseas funds.
• Permitting offshore banking.
Due to the various measures taken, the Indian credit market has witnessed a
qualitative and quantitative upgradation. This process of upgradation has further
increased the competitive forces in the market. In the present credit market
scenario, the intermediaries will have to hone their skills so as to increase spreads,
while watching their risk exposure levels.
SUMMARY
• Credit market plays a significant role in the Indian Financial system.
Intermediates like banks, financial institution and non-bank finance
companies provide credit for the varying requirements of the consumer and
corporate sectors of the economy. This credit extension will mostly in the
form of cash.
• Lending rate is one of the important criteria while extending loans.
Intermediaries base their lending rate decision on three important criteria –
their cost of fund, transaction cost and required spread.
22
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The market that deals with short-term fund requirements is called the money
market. The funds are available for the period of a single day to one year. The
government, banks and the financial institutions are main players in the money
market. The instruments in the money market are of short-term nature and highly
liquid.
THE NEED FOR A MONEY MARKET

The evolution of different financial markets has been mostly due to the varied
financial requirements. Business units in their day-to-day operations will be placed
generally in a surplus or a deficit position in terms of liquidity or cash. This
liquidity mismatch is inevitable in the short-run since the timing of the cash
outflows rarely synchronizes with that of the inflows. For instance, when the
statutory reserve requirements are increased, banks may experience a short-term
funds deficit to meet the requirements while the accumulated funds for paying tax
liability by the corporate suggests a short-term cash surplus position. Since this
short-term liquidity mismatch is a regular feature of the business activity, it is all
the more important for corporates to manage the same. Any delay in taking timely
and appropriate action in managing the mismatches may seriously impact on the
business unit’s liquidity and to a certain extent on its profitability also. When
short-term deficits are not adjusted immediately, it may eventually lead to a
liquidity crisis. The situation will be worse for financial institutions and banks
since their transactions generally involve large sums of money. Further, if the
deficit of funds is in large proportions and is not tackled properly, it will add on to
the costs of the firm.
On the other hand, in a surplus short-term funds situation, the businesses will be
left with idle funds for short periods of time making them non-interest bearing.
This goes against the fundamentals of financial management, which does not
suggest the maintenance of a high level of idle funds as they eat into the
profitability of the firm. The effect of this will be felt greatly on banks/financial
institutions and other finance companies, which earn profits through spreads. To
avoid idle maintenance of funds, there should be proper avenues to deploy them.
Similarly, funds should also be available to tackle short-term liquidity crisis. These
short-term fund requirements of the individuals/corporate houses were initially met
by small time lenders or consortium lenders. This transfer of short-term funds in
the unorganized sector could not, however, meet the rising volume of transactions
and also the quantum of funds required. This paved the way for the evolution of
Money market, a formal financial market that deals with short-term fund
management.
MONEY MARKET PLAYERS
By nature, the transactions that take place in the money market are of high
volumes, involving large amounts. Hence, the market is dominated by a relatively
small number of large players. Given below is the list of intermediaries
participating in the money market:
• Government
• Central Bank
• Banks
• Financial Institutions
24
Money Markets
• Corporate Units
• Other Institutional Bodies – MFs, FIIs, etc.
• Discount Houses and Acceptance Houses
• Market Makers (Primary Dealers etc.).
The role and the level of participation by each type of player in the money market
differs greatly from that of the others. Further, the institutional nature of operators
indicates that the money market is a wholesale market. Government is an active
money market player and in most economies, it constitutes the biggest borrower in
the money market. The government needs to borrow funds mainly when the
budgeted expenditure goes beyond the budgeted revenue. To adjust this budget
deficit, it generally issues securities in the money market and raises funds. Apart
from this regular deficit adjustment, the government still has to make certain short-
term adjustments. For instance, consider the advance tax receipts of the
government. In anticipation of these cash inflows, it incurs expenses thus creating
a deficit. This deficit will later be adjusted with the advance tax receipts.
The government issues other securities of varying maturities to adjust its deficit
borrowings. The Central Bank of a country generally operates in the money market
on behalf of the government. It issues government securities based on the present
and future requirements of the government and the market conditions. In certain
cases, it also underwrites the issues of the government. Apart from functioning as a
merchant banker to the government, the central bank also dons the role of a
regulator in the money market and issues guidelines to govern the money market
operations and operators. It is through these regulations, that the central bank
keeps a vigil on the money market activities. Such regulatory mechanism becomes
essential especially since the impact of the money market is felt on the economy as
a whole and on money supply and interest rates in specific. One of the most
significant segments of the money market players is the banking industry. Banks
mobilize deposits and utilize the same for credit accommodation. However, banks
are not allowed to use the entire amount of deposits received for extending credit.
Most of the developed economies/markets, in order to promote certain prudential
norms for healthy banking practices, require all banks to maintain minimum liquid
and cash reserves. Thus, banks should first ensure that these reserve requirements
are met before deciding on their credit plans. If banks fall short of these statutory
reserve requirements, they can raise the same from the money market since it is a
short-term deficit. Sometimes, it so happens that the banks receive certain
attractive loan proposals but do not have the funds for immediate disposal. In such
cases also, banks will tap the money market to make temporary adjustment of funds
for the loan. Further, banks also lend their short-term surplus funds into the money
market rather than keeping them idle. The collective operations of the banks on a
day-to-day basis are particularly predominant and hence have a major impact on
the interest rate structure and the money position. Like banks, financial institutions
also undertake lending and borrowing of short-term funds. Due to the large
volumes these FIs transact in, they have a significant impact on the money market.
Corporates also transact in the money market mostly to raise short-term funds for
meeting their working capital requirements. This segment partly utilizes both the
organized and the unorganized sector of the money market.
25
Money market operators also include other institutional players viz., Mutual Funds
(MFs), Foreign Institutional Investors (FIIs), etc. The level of participation of
these players varies largely depending on the regulations. For instance, the level of
participation of the FIIs in the Indian money market is restricted to invest in
government securities only. In addition to the various borrowers and lenders, few
players act as intermediaries in the money market. Discount and Acceptance
Houses and Market Makers/Primary Dealers/Satellite Dealers come under this
category and have certain specific roles to play in the money market.
Discount houses perform the function of discounting/rediscounting the commercial
bills and T-Bills. On the other hand, acceptance houses are specialized agencies
which accept the bills of exchange on behalf of their clients for a commission. This
service enhances the liquidity of the bill. However, an active bill market becomes a
prerequisite for the services of the discount and acceptance houses. In addition,
some of these intermediaries act as underwriters to the government securities and
also have the option to be their market makers. The above-mentioned various
money market players, can be segregated into different categories based on their
activity in the market, i.e., they can be only lenders, lenders and borrowers/issuers,
investors or intermediaries. Certain players may have more than one role to play.
The Table 1 defines the role of the various players in the money market.
MONEY MARKET INSTRUMENTS AND FEATURES

Just as any other financial market, money market also involves transfer of funds in
exchange for financial assets. Because of the nature of the money market, the
instruments used in it represent short-term financial claims. Though there is no
statutory definition for the money market instruments, it is accepted that the
maturity profile of money market instruments varies from one day to one year,
thus enabling a short holding period between entrance and exit, paving the way for
liquidity. At times, the liquidity of a security may make it a part of the money
market even though the maturity may be beyond a year. With short-term liquidity
being the main purpose of the money market, various instruments have been
developed to suit these short-term requirements. For instance, the amount required
of funds by banks to meet their statutory reserves will vary from one day to a
fortnight. Similarly, corporates may require funds for their working capital
purpose for any period up to a year. Given below is a broad classification of the
money market instruments depending upon the type of issuer and the requirements
they meet.
• Government and Quasi-government Securities:
– Treasury Bills (T-Bills)
– Government Dated Securities/Gilt-Edged Securities
(covered in Debt Market).
• Banking Sector Securities:
– Call and Notice Money Market
– Term Money Market
– Certificates of Deposit
– Participation Certificates.
• Private Sector Securities:
26
Money Markets
– Commercial Paper
– Bills of Exchange (commercial and trade bills/factorization bills)
– Inter-Corporate Deposits/Investments
– Money Market Mutual Funds
– Bonds/Debentures by the corporate.
Except for their debt nature, the securities listed above differ from each other in
their characteristics relating to maturity, issuer, type of investors, the risk-return
profile, liquidity, marketability, negotiability, transferability, etc. Money market
instruments, however, do not include any equities. Given below is a brief
discussion of various money market instruments.
GOVERNMENT SECURITIES
The Central Bank on behalf of the government issues all T-Bills and Government
dated securities. Being risk-free securities, they set the benchmark for the interest
rates of the other money market instruments. Though the government issues these
two categories of securities, they serve different purposes while meeting the
government’s fund requirement.
Treasury Bills
T-Bills are issued to enable the government to tide over short-term liquidity
requirements with maturities varying from a fortnight to a year. These instruments
are issued at a discount to the face value. Being issued by the government they are
considered to be risk-free. Due to this, they are highly marketable. Investors in
T-Bills generally include banks, and other institutional investors.
Government Dated Securities
These are medium-to long-term government securities. Unlike the T-Bills which
are issued at a discount, these securities carry a coupon rate. In spite of being
long-term instruments, these government securities form a part of the money
market due to their liquidity. As mentioned earlier, the chief characteristic of the
money market instruments other than enabling short-term fund management, is to
provide liquidity. Being government securities, these dated securities have fairly
high liquidity and hence form part of the money market. These instruments set a
benchmark for the long-term interest rates. Issuers will clearly be the central/state
government and other quasi-governmental bodies while the investors will be
banks, FIs, other institutional investors and individuals.
Banking Sector Securities
The banking system has a very vital and active role in the money market. The
transactions taking place in these securities are large in size, both in terms of the
volumes traded and the amount involved in the transactions. The short-term
requirements of banks vary from a single day to up to a year to meet the reserves
and accommodate credit. Based on this requirement, various instruments/markets
with differing maturities have developed.
Call and Notice Money
These funds represent borrowings made for a period of one day to up to a
fortnight. However, the mechanism adopted to lend funds to the call and the notice
money markets differs. In the call money market, funds are lent for a
predetermined maturity period that can range from a single day to a fortnight.
However, with identical range of maturity period, the funds lent in the notice
money market do not have a specified repayment date when the deal is entered
into. The lender simply issues a notice to the borrower 2-3 days before the funds
are to be repaid. On receipt of this notice, the borrower will have to repay the
funds within the given time. While both these funds meet the reserve requirements,
banks, however, mostly rely on the call money market. It is here that they raise
overnight money, i.e., funds for a single day.
27
Term Money
Short-term funds having a maturity of 15 days to one year are borrowed and lent
without collateral are categorized as term money. Banks access this term money
route to bring greater stability in their short-term deficits. While making a forecast
of the fund requirements, banks will be in a position to assess the likely surplus
and deficit balances that are to occur during the forecasted period. In view of such
forecast, banks assess the amount that needs to be borrowed/lent in order to
prevent any severe liquidity mismatch.
Certificates of Deposit (CDs)
Banks issue CDs to raise short-term funds having a maturity of 7 days to 1 year.
These instruments are issued to individuals/corporates/institutions, etc. These are
unsecured promissory notes which require the holder to establish his identity
before redeeming the amount. Being negotiable instruments they are easily
transferable. They are issued at a discount to face value. The funds raised through
certificate of deposits form a part of the deposits and hence attract reserve
requirements. Financial Institutions can issue CDs for a period not less than 1 year
and not exceeding 3 years.
Participation Certificates (PCs)
The major activity of a bank is credit accommodation. This service of the banks,
apart from increasing the risks, may place them in a tight liquidity position. To
ease their liquidity, banks have the option to share their credit asset(s) with other
banks by issuing Participation Certificates. These certificates are also known as
Inter Bank Participations (IBPs). With this participation approach, banks and FIs
come together either on risk sharing or non-risk sharing basis. Thus, while
providing short-term funds, PCs can also be used to reduce risk. The rate at which
these PCs can be issued will be negotiable depending on the interest rate scenario.
PRIVATE SECTOR SECURITIES
Commercial Papers (CPs)
Commercial Papers (CPs) are promissory notes with fixed maturity, issued by
highly rated corporates. This source of short-term finance is used by corporates as
an alternative to the bank finance for working capital. Corporates prefer to raise
funds through this route when the interest rate on working capital charged by
banks is higher than the rate at which funds can be raised through CP. The
maturity period ranges from 7 days to 1 year. CPs are normally issued in
denomination of 5 lakh (face value) or multiples thereof.
Bills of Exchange
It is a financial instrument that facilitates funding of a trade transaction. It is a
negotiable instrument and hence is easily transferable. Further, depending on the
repayment period and the documents attached, these bills of exchange are
classified into different types. The duration of these bills generally ranges between
1 to 6 months.
Factorization Bills
This instrument was formed due to the factoring of the bills of exchange. Factors,
who are generally banks or FIs, purchase the bills from the creditors with or
without a recourse facility and collect the dues from the debtors. The market for
factorization of bills depends on the level of activity in the bill market.
Inter Corporate Investments/Deposits (ICDs)
Corporates generally raise funds from the Inter Corporate Deposit (ICD) markets.
These instruments generally carry interest rates higher than the other short-term
sources since the risk is higher.
28
Money Markets
Money Market Mutual Funds (MMMFs)

The money market is the market for short-term debt securities. Short-term debt
securities are loans governments and corporations sell to investors Money market
funds invest in Treasury bills, commercial paper, banker’s acceptances, negotiable
certificates of deposit, and repurchase agreements and in short-term debts of
Government securities. Since institutional players dominate the operations in the
money market, the retail investor’s participation in the market seems to be limited.
To overcome this limitation, the Money Market Mutual Funds (MMMFs) provide
an avenue to the retail investor to invest in the money market. Retail investors
normally deposit short-term surplus funds into a savings bank account, the returns
from which are relatively low. The returns from MMMFs will be higher than the
interest earned in a bank. Further, this provides adequate liquidity and the investor
can plan for short-term deployment of funds. These funds have high safety levels,
due to their low volatility and as the investments are in high quality securities, i.e.,
government/bank/highly rated corporate securities. Thus, MMMFs represent a
low-risk and high-returns avenue to the retail investor in the money market.
Bonds/Debentures
Bond is a formal certificate issued by government, credit institutions
acknowledging the indebtedness. To the investor, it is a proof of investment. In the
current scenario the words bond and debentures are being used interchangeably.
The public sector enterprises, financial institutions and the private corporates
approach the public to finance their requirements through loans. They can issue
either short- or long-term bonds and debentures. The bond market consists of three
different categories of issuers – government owned Financial Institutions (FIs),
Public Sector Units (PSUs) and private corporates. Some examples of bonds are
Regular bonds, Tax saving bonds, floating rate bonds by ICICI, priority sector
bond by NABARD, capital gains bond by National Housing Bank, Deep Discount
bonds by IDBI, etc.
Repo Transactions
Another popular mechanism to deploy/borrow short-term funds in the money
market is the repo transaction. Repo transaction comprises securities repurchase
transactions (repo) and securities reverse repurchase transactions (reverse repo). A
Repo or Reverse Repo is transaction in which two parties enter into a contract,
which may include the RBI, a bank or primary dealers agree to sell and repurchase
the same security. Under such an agreement one party sells certain securities to the
second party with an agreement to buy them back on a predetermined future date
at a predetermined rate. Similarly, the buyer purchases the securities with an
agreement to resell the securities on a predetermined future date at a
predetermined rate. This transaction raises short-term funds to the party selling the
securities. The transaction is ‘Repo transaction’ when viewed from the seller’s
angle and becomes a ‘Reverse Repo transaction, from the buyer perspective. A
repo transaction is similar to secured loan, with the seller receiving securities as
collateral to protect against default. The rate of interest agreed between the parties
is called the ‘Repo Rate’ and the rate is influenced by overall money market
conditions. The yield on a repo transaction is implicit in the price difference
between sale and repurchase of the transaction. Reverse repo transaction helps to
adjust the short-term surplus. The underlying securities that are bought and sold
are generally government securities. The nature of the transactions and the time
involved in the repo/reverse repo transaction generally varies depending upon the
regulations. The Indian money market repos/reverse repos are for a minimum
period of one day. While there is no statutory limit to the maximum period, it
29
normally does not exceed 3 months. Repos with RBI, can be for the minimum
period of one day at the discretion of the RBI. Money market instruments, have
been designed generally to manage short-term mismatch, meet the reserve
requirements and enable credit extension with short-term funds. With instruments
of varying features, players can lend using one type of money market instrument
while at the same time borrow using another type of money market instrument.
Thus, during a particular period, institutions can play on both sides of the market.
MATURITY OF THE INSTRUMENTS
Selection of the right instrument, however, depends on the prudence of the player.
Mere deployment and raising of funds does not suffice. What also matters is the
ease with which the firm can get in and out of the market. To explain further,
consider a firm that has a surplus in its short-term funds for a period of 3 months
and hence deploy the same into the money market. However, if at the end of
3 months, the firm is not able to liquidate its investments from the money market,
it will have to borrow the same. And if these funds are borrowed at a rate higher
than the yields on the investments either due to an increasing interest rate scenario
or other market conditions, the entire spread will be wiped off. Thus, to
appropriately select the instrument, it is essential to distinguish the original
maturity from the actual maturity. Original maturity refers to the period between
the date of issue of the security and the redemption date, while actual maturity
refers to the time interval between the date of investment in the instrument and the
date of disposing/redeeming the same. For example, if a firm issues CPs having 3
months maturity, then it will remain the same for all investors who have
subscribed to that particular instrument. However, the actual maturity reduces as
the instrument approaches the date of redemption. This implies that the actual
maturity represents the remaining term to maturity/outstanding period of the
security.
Further, the presence of a secondary market will result in varied actual maturities
for different investors since it enables the purchase and sale of instruments within
the redemption period. With this basic understanding of the different maturities,
the money market players can make their investment decisions depending on the
period for which the short-term funds management is required.
One important point to make note of regarding these maturities, is their impact on
the yields of the instruments. The outstanding/actual maturity of government
securities enables price setting. Thus, if the original maturity of a money market
instrument is similar to the actual maturity of a G-Sec, then the rate of the
government security forms the base price for that money market instrument. In this
regard it is also essential to note that the yields on securities are higher for longer
actual maturities because the prices of instruments with longer actual maturities
will fluctuate more in response to changes in interest rates. This enhances the price
risk for the investors.
RISK EXPOSURE IN MONEY MARKET INSTRUMENTS

Apart from ensuring appropriate liquidity, investors should also consider the risks
present in the money market investments. Investments in the money market are
basically unsecure in nature. While the unsecured nature does indicate a higher
risk, the risks associated with money market, however, are not necessarily due to
the unsecured nature but more due to the fluctuations in the rates. The level and
the type of risk exposures that can be associated with money market instruments/
investments are discussed below.
MARKET RISK/INTEREST RATE RISK
30
Money Markets
These risks arise due to the fluctuations in the rates of the instruments, and are of
prime concern in money market investments. Due to the large quantum of funds
involved in the money market deals, and the speed with which these transactions
are executed, the value of the assets are exposed to fluctuations. Further, if these
fluctuations are wide, it may lead to a capital loss/gain since the price of the
instruments, including the government securities, declines. This risk can be
minimized by enhancing liquidity since easy exit can help curb the capital loss.
REINVESTMENT RISK
Reinvestment risk arises in a falling interest rate scenario. Investors who park their
funds in short-term instruments will, at the time of redemption, have to reinvest
these funds at a lower rate of interest. And since the existing securities will be
having higher coupons/YTMs, their value generally rises in such situations to
bring down the yields. All money market instruments are exposed to this risk.
Default Risk
Lending decisions primarily focus on assessing the possibility of repayment since
the first risk that the lender will be exposed to is the default risk. Except for the
sovereign securities, all other investment/lending activities have the probability of
default by the borrower in the repayment of the principal and/or interest. It is due
to the absence of the default risk, that the government securities are considered as
risk-free securities.
Inflation Risk
Due to inflation, the average prices for all goods and services will rise thereby
reducing the purchasing power of the lender. The risk that arises due to the
inflationary effect is known as inflation risk/purchasing power risk. All money
market instruments are exposed to this risk. Lenders will generally ensure that
their contractual rate of interest offsets this risk exposure. Though the capital
market has designed instruments to hedge against this risk, they are yet to be
introduced into the money market. However, considering the short-term nature of
the money market instruments, their level of exposure to this inflation risk can be
minimal when compared with other long-term instruments. The Capital Indexed
Bonds (CIBs) issued by RBI is an instrument designed to minimize/eliminate the
inflation risk. With a maturity of 5 years, these CIBs earn a 6 percent return on the
investments. The principal amount is adjusted against inflation for each of the
years and the interest is then calculated on this adjusted principal. Further, upon
repayment, the principal amount is adjusted by the Index Ratio (IR) as announced
by the RBI.
Currency Risk
A risk of loss is inherent in the multi-currency dealings due to the exchange rate
fluctuations. Currency risk refers to this type of risk exposure. The money market
players operating in overseas money market instruments will be exposed to this
risk. Also, when the institutional investors like banks sell foreign currencies to
play in the money market, they may be exposed to currency risk.
Political Risk
Most of the measures adopted to bring economic stability will have a
direct/indirect implication on the money market instruments and operations. This
is due to the fact that the money market activity reflects the money supply position
in the economy, the interest rate and the exchange rate structures, etc. Thus, any
policy decisions adopted by the Central Government will have an impact on the
money market. In the Indian context, it is the policy measure taken by the RBI,
and sometimes the Ministry of Finance (MoF) that have an impact on the money
market. For instance, in order to build-up forex reserves, the government may
31
prevent repatriation of investments made by FIIs/NRIs in the money market. This

measure will have a definite impact on the operations of these players in the
money market. Depending on the guidelines issued by the government, all or few
of the instruments will be affected. Though the above-mentioned risks that the
money market instruments are exposed to, seem to be similar to the risk profile of
other financial markets, their level of exposure, varies. For instance, due to the
short-term nature of the market, reinvestment risk and default risk will be minimal.
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There is yet another important and rather interesting feature of the money market
that explains the lower level of the default risk. Money market players have to
honor obligations as a universally accepted code of conduct. Irrespective of the
volume of transactions in the market, the quantum involved in such transactions,
and the mode in which these transactions take place, the participants in the money
market will strictly adhere to this code of conduct. Since defaulting in the money
market virtually expels the player from the market, in spite of being unsecured
transactions, the obligations are definitely met. However, as observed earlier, the
money market players are mostly large institutional players, having a good
standing in the market with a good rating. Of the risks that the money market
instruments are exposed to, the volume and the quantum of transactions generally
put the market/interest rate risk at a higher level.
INTEGRATION IN THE MONEY MARKET
Presenting itself as the market for short-term funds, money market should
essentially incorporate features of adequate liquidity and minimum price
fluctuation. These can, however, be attained when the market is wide enough and
there are a large number of transactions taking place to ensure adequate liquidity
and price stability. In addition to the volumes of the transactions, the pace with
which they are entered into also is of utmost importance especially to attain greater
32
Money Markets
depth in the market. To understand this concept better, consider the following
features that are reflected by a developed money market.
• Sub-markets within the money market are well integrated to ensure free flow
of funds. Such integration also extends to the various instruments within the
sub-market.
• Specialization has essentially become a feature of the money market
operators and instruments.
Thus, it can be observed that integration and specialization should necessarily be
the features of a developed money market to provide adequate depth for its
operations. As mentioned above, integration results in a free and quick flow of
funds between markets/sub-markets/segments within the sub-market. This flow of
funds is, however, possible when there is no gap between the various markets. To
eliminate/reduce the gaps present between the various segments, specialized
agencies/operators are being introduced into the money market. These operators,
who are generally registered dealers with the central banks, maintain continuous
contacts with other market players and ensure a spillover of funds from one
sub-market to another due to their access to various markets. Further, by bridging
the gaps and increasing the volume of transactions a single price (not considering
the variances due to brokerage charges, taxes, etc.) can be set for each asset
category. Thus, integration coupled with specialization will enhance the volumes
of transactions taking place in the money market and ensure greater depth for the
same. One major advantage of such integrated markets is that it enables a better
control/supervision by the regulator. However, such integration is possible only
when all the money market operators have a level playing field. In the Indian
markets a few players enjoy a special standing when compared to the rest, for
example, Development Finance Institutions (DFIs), Public Sector Banks, etc. With
such drawbacks, the Indian money market is yet to be integrated.
Before considering the structure of the Indian money market and the operations
taking place in the same, it would be useful to have a brief roundup of the overseas
money markets.
OVERSEAS MONEY MARKETS
In the global scenario, few money markets have been operating since a long time,
while the others are of recent origin. The money market evolved during the
19th century in London. In the US, regulations prohibited interstate and intrastate
branching of banks. This led to a fragmented banking system which had no proper
funds transmission process. To satisfy the credit requirements, the money market
was developed initially in the call loan market and commercial paper market. Later
due to changing regulations in the US, call loans were not much active. However,
the CP market was quite active. London also had a thriving bill market. Discount
houses have played a major role in developing the sterling money market.
The growth of these two money markets, i.e., the US and the UK was restricted for
sometime due to the depression of the 1930s and the deregulation in the banking
system. However, today these two markets being the oldest, have become global
markets offering a variety of instruments.
Most of the other money markets have developed based on UK and US lines. In
the Paris money market, discount houses played an active role in developing the
bill market. Money Market Mutual Funds (MMMFs) have gained greater
momentum. The Japanese money market also has developed its bill market on the
lines of the London market. Interbank loans play a key role in this market. Due to
an increase in the pressure for developing the Euroyen market, the Japanese had
deregulated their money market. Based on the requirement and the regulatory
structure, various instruments have been developed in these overseas money
markets. The stock in trade of these markets include Government Securities,
Municipal Notes, Federal Agencies Securities, Repos, CDs and Deposit Notes,
Eurodollars, Eurodollar CDs, Yankee CDs, Bankers’ Acceptances, Short-term
Loan Participations, CPs, Commercial Bills, etc. A few of these instruments are
discussed below.
33
GOVERNMENT SECURITIES
The treasury securities issued by the US Treasury can be classified into T-Bills and
treasury notes. T-bills which are issued at a discount to the face value have
maturities extending up to 3 months, 6 months and 1 year. The discount on these
T-Bills is not set by the Treasury. The Federal Reserve auctions each of the new
bill issued to investors and dealers and bills are sold to those bidders offering the
highest price. This reduces the interest cost to the Treasury. It also enables the
current prevailing market conditions to establish the yield for the new issue.
Other securities of the US Treasury include interest bearing notes. The original
maturity of these discount treasury notes can be anywhere beyond 2 years and their
prices and yields are decided by the auction mechanism. Subscribers to these
Treasury securities are FIs, insurance companies, pension funds, corporates,
foreign central banks, and other foreign institutions. These markets also have
dealers who act as market makers for governments by actively trading in huge
volumes of these securities. These dealers trade with investors and also with each
other. With high liquidity, low credit risk and tax exemptions, these government
securities set the base for money market yields.
In addition to the above Treasury securities, the Thirty-Year Bills or STRIPS
(Separate Trading of Registered Interest and Principal Securities) are also
permitted. STRIPs are created out of the standard T-Bills, Treasury notes and
bonds that are issued in bearer form after delinking the coupon on these
instruments. These bearer bonds are then sold at a discounted price as non-interest
bearing securities with a fixed maturity. These stripped instruments are known as
zero-coupon bonds. Due to the demand for the Treasury securities, these STRIPS
have become popular among the dealers who act as market makers of the regular
Treasury notes, bonds and bills. The volume of transactions taking place in these
US Treasuries has enhanced the depth of the US money market. It has literally
become a 24 hour international market with active markets for these Treasuries
existing in Tokyo, London and to a lesser extent in other foreign financial centers.
MUNICIPAL NOTES
Municipal Notes are issued by state and local governments and their authorities.
These interest-bearing securities are generally issued with maturities ranging from
three months to a year. Sometimes they may also be issued for periods beyond a
year.
Federal Agencies Securities
Earlier, all the federal agencies used to raise funds by selling their own securities
in the open market. This process has, however, changed with most of the agencies
borrowing from the Treasury through an institution called the Federal Financing
Bank. Larger agencies which still borrow from the market do so by issuing notes
and bonds. These federal agencies securities are known as Agencies. They are
interest bearing and are issued at a discount to the face value. These federal
agencies price their securities after assessing the best yield the market would
determine for its new issue. The agency securities are less liquid than the Treasury
securities since the agency issues are smaller than the Treasury issues. Further,
unlike all Treasury securities, all agencies do not have the de facto backing from
the federal government and they may not be entitled to any tax exemptions. All
these reasons, make the yields of the federal agencies securities slightly higher
than the Treasury securities. After deciding on the yield for the issue, the securities
are sold through a syndicate of dealers.
34
Money Markets
CALL LOANS MARKET

The surpluses of the small local banks are absorbed by the large banks. These large
banks with their presence in major financial centers viz., New York and London
extend call loans. However, unlike in India, these call loans are routed to the
capital market for stock transactions rather than the money market. The reason for
this is explained by the large volumes involved in the call loans and the inability of
the money market to absorb the same.
Repos and Reverses
Repo financing facility is mostly resorted to by bank and non-bank dealers to raise
overnight funds. The underlying securities are generally, government agencies
securities and Bankers’ Acceptances. The overnight repos are more popular since
their rates are generally less. Apart from the overnight repos, there are repos for
30 days and longer which enable the dealer to take a speculative position. Such
agreements are known as Term Repos. In addition to this, dealers in a market for
reverse repos buy the securities from the investor with an agreement to sell them
back.
Certificates of Deposit (CDs)
In US, Certificates of Deposit (CDs) are available for terms ranging from 30 days
to 5 years or 10 years at different competitive rates. Interest on CDs start accruing
on the 1st business day after the banking day of deposit. The investor will have the
option to compound his interest back into the CD, have the interest placed into his
checking or savings account, have a cheque sent to him each month, or one cheque
at maturity for the interest. The minimum amount to purchase a CD is $1,00,000
although a $1 million denomination is more common. Unlike in India, the investor
can close the CD before its maturity but with substantial penalty. The money
garnered by the bank by issuing these notes is not considered as a deposit and
hence is exempted from the insurance premiums of the Federal Deposit Insurance
Corporation (FDIC).
Eurodollars
A Eurodollar deposit is a deposit denominated in dollars in a bank/bank’s branch

outside the US. Most of these Eurodollar deposits are for large sums and are made
by corporations – domestic, foreign and multinational, foreign central banks and
other official institutions, the US domestic banks and wealthy individuals. These
Eurodollar deposits have a fixed term ranging from overnight to 5 years.
Eurodollar CDs
To enhance the liquidity of the Eurodollar time deposits, banks in London that
accepted such deposits began to issue Eurodollar CDs. These resemble domestic
CDs except that instead of being the liability of a domestic bank, they are the
liability of the London branch of a US bank or some other foreign bank with a
branch in London. With lower levels of liquidity as compared with domestic CDs,
these Eurodollar CDs offer higher returns. Eurodollars are issued in London and
are purchased by banks operating in the Euromarkets, US corporations and other
US institutional investors. They are generally issued through dealers and brokers
who constitute a secondary market.
Yankee CDs
These refer to the issue of dollar denominated CDs by foreign banks not only in
the Euromarket but in the domestic market through branches established there.
These have a higher yield due to lower liquidity and higher risk.
35
Loan Participations
Banks sometimes distribute loans extended by them. Loans sold by banks are
categorized into two types. The first type represents high quality, short-term loans
extended to issuers of CPs. These loans are sold to traditional money market
investors as a substitute for CPs. The second type involves selling participations in
large but lower credit quality loans that banks extend to customers doing
Leveraged Buyouts (LBOs). These have a maturity ranging up to 7 years and
actually cannot be considered as money market instruments. The buyers include
domestic banks and foreign banks.
Bankers’ Acceptances (BAs)
These instruments come into existence when a bank accepts a trade bill. These are
short-term, non-interest bearing notes sold at a discount and on maturity are
redeemed at face value by the accepting bank. BAs are highly liquid since they
have an active secondary market. Japanese banks are major issuers of BAs in the
US money market.
Commercial Papers (CPs)
CPs in the US have a maximum maturity of 270 days and a minimum maturity of
one day. CPs with a higher maturity than this need to be registered with the
Securities and Exchange Commission. The most popular CPs are, however, for
30 days and less. The minimum denomination of a CP is usually $100,000. The
typical denominations are in multiples of $1 million. Due to the short-term nature,
these CPs are generally rolled over by issue of new CPs to meet the maturing CPs.
Euro Commercial Papers in Europe
These instruments are issued in London. However, their growth is restricted by the
tight spreads maintained by the London banks while extending loans. These
securities are traded mostly in Europe and the US.
Commercial Bills
London had a thriving bill market which was initially organized by bill brokers
who brought the buyers and sellers together without taking any position
themselves. These brokers evolved into dealers who purchased the bills themselves
to resell them to others. These dealers were later transformed into discount houses
which apart from functioning as dealers also invested in bills on their own account.
Funds for such activity were raised by way of call loans from banks. The excess
funds available with these banks were thus used to extend call loans instead of
directly purchasing the bills. However, with the banking system being deregulated,
the excess funds available with the small banks were absorbed by large banks. The
larger banks transferred these funds internally thus, drying up the funds for the
commercial bills and call loans. With the decline in the funds for money market,
the discount houses moved into the government securities and the acceptance
houses into the capital market. One feature of these overseas money markets, that
is essential to take note of, is their global presence. The US money market is
increasingly becoming an international short-term financial market. Oil imports of
French companies, other trades of Japan and a lot of other non-US trades are
financed through this market. This activity can also be witnessed in the London
36
Money Markets
market. With the opening of the economies, all financial markets including the
money market are becoming closely related. This expansion of the market has also
witnessed a growth in the number of players and instruments.
While money markets worldwide, differentiate themselves based on the features

like the instruments offered, players, interest rate structure, etc., a universally
common aspect relating to these markets, however, is the inter-linkage they have
with the prevailing economic conditions. Tables 2 show the risk characteristics of
money market instruments in the American market.
! #
0 7 8- ! 7 '
1
! ' 9% : 8 % ' . ; # 7 '
)( " 6 5
7 #
7
),)( 8 % ' 8 ; # 7 '
" 5
7 #
7
),)( 8 % ' ; 7 #
" # 7
# 7 #
'<
7
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7 ' '<
' 7
" # 7 '
# %
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37
),)3> & ' 8 ; 5

#
Source: Financial Markets, Instruments & Institutions, by Santomero and Babbel, McGraw Hill
Int’l Edition 2nd Edition, 2001, page 242.
MONETARY POLICY ON MONEY MARKETS

Due to the mutual dependence of the economic environment and the money
markets, the policies adopted by the government/central bank are of utmost
importance to the money market. The fiscal and the monetary policies announced
by the government/central bank constitute the major economic policies. Of these
two policies, the fiscal policy focuses on the structural changes in the economy
through a proper budget planning mechanism. It is through this policy that the
government aims to maintain economic activity and employment, which enable it
to take long-term investment decisions especially in infrastructural areas.
Distinguishing itself from the fiscal policy is the monetary policy which
concentrates on issues that are contemporary to the economy in nature. Relating
itself to the short-term economic adjustments, the monetary policy has greater
flexibility and ability to respond to the conditions that affect the economic factors.
The roles of the monetary and the fiscal policies can thus be regarded as
complementary in nature. While both the policies enable government intervention
in the economic process, it is the monetary policy, which is more critical to the
money market operations. The measures taken to meet the monetary policy
objectives have a definite and immediate impact on the money market. Thus, an
insight into the monetary policy objectives, the various tools used to attain them
and the implications of the same would enable a better understanding of the money
market.
Most of the changes that the monetary policy intends to bring about in the
economic conditions relate directly or indirectly to the interest rate structure and
the availability of credit. Due to this, the impact of these measures will be
transmitted to the money market thereby affecting both, the volumes in the money
market and the interest rates of the instruments. The overview obtained on the
overseas money markets and the factors influencing them, can help assess the role
played by the Indian money market in economic development and the scope for
improving its efficiency. Since liberalization, the Indian money market has
actually begun to grow. Characterized by limited number of players and
instruments, it had been operating in a strict regulatory environment.
The developments taking place in the Indian money market, the regulatory
environment, its role in the economic progress, the players operating in it and the
instruments it offers are discussed below.
INDIAN MONEY MARKET – REGULATORY FRAMEWORK
The Reserve Bank is the monetary authority of the country and the public debt
manager of the Government. The development and regulation of money markets
in the Indian financial system is an important function of the Reserve Bank. The
primary aim of the Central Bank in the money markets is to maintain the liquidity
and short-term interest rates at levels consistent with the monetary policy
objectives. In recent years, to foster a balanced development in different segments
of the money markets, RBI introduced new instruments reducing dependence of
participants on uncollaterlized exposure, facilitate price discovery in the short-end
and upgrade the payment system infrastructure. For the past few years, the RBI has
been trying to develop a proper short-term rupee yield curve with deep liquidity in
the money markets. RBI broad policy strategy for the development of Indian
Money Market focused.
38
Money Markets
• On development of pure call/notice money market by instituting full-fledged

Liquidity Adjustment Facility (LAF) with a view to modulating short-term
liquidity under diverse market conditions, promoting transparency, and
various measures pertaining to instruments for non-bank participants
combined with outright transactions under Open Market Operations (OMO)
and through Market Stabilization Scheme (MSS) launched in April 2004 for
controlling and ensuring stability in the short-term interest rates within a
certain range and minimizing volatility.
• Transferring the call/notice markets into a pure inter-bank market with
participation of banks and primary dealers, phasing out non-banks from these
markets.
• Rationalizing of the traditional sector-specific refinance schemes and
introducing of market based recourse to RBI’s standing liquidity facilities.
• The development of the payment system infrastructure was strengthened with
the introduction of the Negotiated Dealing System (NDS) and formation of
the Clearing Corporation of India Ltd. (CCIL) and the implementation of
Real Time Gross Settlement (RTGS) system in March 2004.
• Measures to make various other money market instruments (such as CDs,
CPs, etc.) freely accessible to non-bank participants.
Originating as an informal market for the short-term requirements, the Indian
money market has come a long way by adding greater dimensions to
operations/transactions. Like the other overseas markets, the Indian money market
is affected by the various policy decisions taken by the Government/RBI. The
fiscal and the monetary policies announced by the Ministry of Finance (MoF) and
the RBI respectively, constitute the major economic policies formulated in India.
The focus is on the monetary policy since it has a significant role in the
development of the Indian money market.
The Indian economy having been historically an agrarian economy, the
agricultural output has an important bearing on the price situation in India. Due to
this, a distinct aspect of seasonality can be observed in the demand for funds in the
Indian markets. The April-September period is considered as the slack season
since the demand for funds reduces when compared to the period between
October-March. This seasonality has a major impact on the economy and to adjust
to the consequent implications, the RBI issues its monetary policy twice a year –
The Slack Season Monetary Policy for the period April-September and the Busy
Season Monetary Policy for the period October-March. Though the monetary
policy has been a constituent of the economic policies since a long time, it was
only during the early 1970s that it assumed greater role/significance in achieving
economic growth. Since then, the policy measures have aimed at controlling
inflation and enhancing economic growth while at the same time mobilizing
savings for productive investments. To attain these objectives, the RBI has various
tools at its disposal. However, the most important and widely used relate to the
interest rate structure, foreign exchange reserve position and money supply
position. Through the various policy measures, the interest rates, which were
tightly regulated till recently, are being freed. While some rates have been totally
deregulated, a few others are still in the process of being deregulated. For instance,
while the deposit rates have been totally deregulated, the advance rates have been
only partially deregulated.
Alternatively, RBI also aims to regulate the capital inflows and outflows to attain
the monetary policy objectives. This is mostly done by revising the guidelines
relating to FCNR (Foreign Currency Non-Resident) accounts, NRE (Non-Resident
39
External) accounts, etc. Any change in the guidelines relating to these foreign
currency denominated deposits may have an impact on the capital inflows and
outflows thereby affecting the money supply position. While these measures aid in
adjusting the money supply position to the policy target, there are various other
measures that are more widely adopted to adjust the money supply position. The
RBI can alter the statutory reserve requirements, can resort to the open market
operations to buy/sell government securities or enter into repo/reverse repo
transactions to make desired changes to the liquidity position in the system. The
RBI, as the chief monetary authority, will regularly examine the liquidity present
in the system. Further, it will also study the behavior of interest and the exchange
rates and accordingly adopt suitable policy measures.
These monetary policy measures taken by the RBI may either have an indirect
impact on the money market operations or may directly affect its
operations/players/instruments. Discussed below are the measures that may
indirectly affect the money market.
Changes in CRR: A cut in the CRR enhances loanable funds with the banks and
reduces their dependence on the call and term money market. It also brings down
the call rates. On the contrary, when the CRR is increased, the liquidity in the
system comes down. Consequently, the banks have to reduce their credit
operations. And those banks which do not have enough funds to meet the CRR
either have to borrow from the market or raise additional deposits. It is difficult to
raise funds during a liquidity crunch. Hence, there may also be an increase in the
interest rates.
Changes in SLR: The changes in SLR will have to be examined in two different
situations:
i. Banks maintain SLR investments just up to the amount necessary.
ii. The SLR securities that are maintained are in excess of the statutory
prescriptions.
Consider the first case along with an increase in the SLR. This will reduce the
liquidity of the banks since there will be transfer of assets in the form of cash into
securities. And as the demand for the SLR securities increases, their prices will
increase thereby reducing the yields earned on them. Now, if the first case exists
and there is a decrease in the SLR requirement, then the banks will have an excess
investment in the SLR securities.
Disinvesting the same may not be profitable since there will be more sellers. This
will bring down the prices of the securities while increasing its yields. In the
second case, when the banks maintain excess of SLR securities, an increase in
SLR will not have a significant impact on the liquidity, prices and yields of the
instruments. Likewise, when there is a decrease in the SLR, there might not be
much effect on the liquidity, prices and yields of the instrument since banks tend to
keep excess SLR securities. However, in the long run, there may be an increase in
the liquidity. Excess SLR investments will enable the banks to present better
capital adequacy ratios and also since the government securities are now market
determined, the yields offered by them would be encouraging.
THE OPEN MARKET OPERATIONS (OMO)
The RBI can also adjust the liquidity in the system by its open market operations.
OMO involves the sale and purchase of government securities by RBI through its
open window. While the open market purchase of gilts will ease the liquidity of
banks, the open market sale of the same will contract their liquidity. Apart from
this, the RBI may also alter the interest rate structure using these OMOs. This can
be possible through RBI’s pricing policy for its open market sale/purchase.
For instance, if the interest rate structure is to be moved upwards, the prices of
securities in the OMO can be set at higher levels thereby signalling an upward
40
Money Markets
movement in the interest rates. Likewise, if the RBI decides to cool the rising
interest rates, its open market operations should indicate a downward movement in
the rates. However, this effort to cool the interest rate volatility through OMOs
may sometimes lead to an interest differential loss to the RBI.
Bank Rate: Bank rate is the rate at which the banks get finance or refinance
facility from the RBI. Prime Lending Rate or PLR is the rate at which the banks
will lend to the public. A cut in the bank rate will eventually be followed by a cut
in the PLR by banks. This will tend to move down the interest rate structure. Thus,
the yields offered on the short-term instruments traded in the money market also
will be affected. For instance, if the PLR is reduced, the CP rate may also come
down, IBPs and CDs may also be affected.
Repos: A cut in the repo rates will result in bringing down the call rates and also
other term money rates. The various monetary policy measures mentioned above
can be classified into those measures which have a direct impact on the
liquidity/interest rates/exchange rates and others which indirectly affect them. The
direct measures mostly act as regulations imposed by the governing bodies and
such measures go against the free economic policy, which suggests regulations
coming from within the market. In order to minimize control and make the
financial sector more market driven, direct measures are paving the way for
indirect measures. Few measures taken in this direction are as follows:
• Administered structure of interest rates is paving the way for a deregulated
interest rate regime.
• Auction based pricing mechanism of the gilts.
• Reduction on the dependence of SLR and CRR for fiscal deficit.
• Progressive elimination of capital controls.
Other measures taken by the RBI, which have a direct impact on the money market
are aimed to develop it and bring it in line with the liberalization process. They are
aimed to enhance the depth in the existing market and further provide an active
secondary market. Towards this end, RBI’s policy measures are effectively
resulting in financial innovation. They are also broadening the spectrum of players
in the market and widening their scope of operations. Most importantly primary
dealers have been introduced in the market.
RECENT DEVELOPMENTS IN THE MONETARY AND

CREDIT POLICY
PRIMARY DEALERS
The Reserve Bank of India introduced a system of Primary Dealers (PDs) in
government securities market in 1995. One of the prime characteristics of any
financial market is liquidity. And in case of the money market, which provides
short-term funds there should be greater levels of liquidity. As the various
instruments traded in the Indian money market did not have an active secondary
market, Primary Dealers (PDs) were introduced into the market to develop the
same.
Objectives Of PDs
i. Strengthen the infrastructure facilities of the money market in order to
enhance its liquidity and to broad base its operations.
ii. To gradually take up the role of the RBI as an underwriter and market maker
to the G-Secs.
41
iii. To activate the secondary market for G-Secs and thereby enable price
discovery and enhance liquidity and turnover. These operations should widen
the investor base by encouraging voluntary holding of government securities.
iv. To aid the RBI in conducting OMO.
Eligibility Criteria
The following institutions are eligible to apply for Primary Dealership:
i Subsidiaries of scheduled commercial bank/s and all India financial
institution/s dedicated predominantly to the securities business and in
particular to the government securities market.
ii. Companies incorporated under the Companies Act, 1956, and engaged
predominantly in the securities business and in particular the government
securities market.
iii. Subsidiaries/joint ventures set up by entities incorporated abroad with the
approval of the Foreign Investment Promotion Board (FIPB).
iv. Banks which do not have a partly or wholly owned subsidiary undertaking
PD business and fulfill the following criteria:
a. Minimum Net-Owned Funds (NOF) of Rs.1,000 crore.
b. Minimum CRAR of 9 percent.
c. Net NPAs of less than 3 percent and a profit making record for the last
three years.
• Indian banks which are undertaking PD business through a partly or wholly
owned subsidiary and wish to undertake PD business departmentally by
merging/taking over PD business from their partly/wholly owned subsidiary
may do so subject to fulfilling the criteria stipulated above.
• Foreign banks operating in India who wish to undertake PD business
departmentally by merging the PD business being undertaken by a group
entity may do so subject to fulfillment of the criteria stipulated above.
• A non-bank entity applying for permission to undertake PD business shall
obtain Certificate of Registration as an NBFC under Section 45-IA of the
RBI Act, 1934 from the Department of Non-Banking Supervision, Reserve
Bank of India.
• A non-bank applicant shall have net owned funds (NOF) of a minimum of
Rs. 50 crore. In the case of a PD intending to diversify into permissible
activities, the minimum NOF shall be Rs.100 crore. NOF will be computed in
terms of the explanatory note to Section 45-IA of Chapter III-B of the
Reserve Bank of India Act, 1934.
• Primary Dealers are not permitted to set up step-down subsidiaries.
List of some major Primary Dealers in India:
1. SBI – Discount and Finance House of India Ltd.
2. Securities Trading Corporation of India Ltd.
3. ICICI Securities Primary Dealer ship Ltd.
4. HDFC Bank Ltd.
5. PNB Gilts Ltd.
6. ABN Amro Securities (India) Pvt. Ltd.
7. JP Morgan Securities India Pvt. Ltd.
8. Kotak Mahindra Bank Ltd.
42
Money Markets
9. DSP Merrill Lynch Securities Trading Ltd.

10. Deutsche Securities (India) Pvt. Ltd.
11. IDBI GLLTS Ltd.
12. Corpbank Securities Ltd.
13. HSBC Primary Dealership (India) Pvt. Ltd.
14. Canara Bank
15. Standard Chartered Bank.
16. BOB Capital Markets Ltd.
17. Citicorp Capital Markets Ltd.
18. Bank of America.
ROLE AND OBLIGATIONS OF PRIMARY DEALERS
Primary Dealers (PDs) are required to have a standing arrangement with RBI
based on the execution of an undertaking and the authorization letter issued by
RBI from time to time. The major roles and obligations of PDs are:
1. PDs are required to support auctions of Government dated securities issues
and Treasury Bills as per the minimum norms and successive ratio prescribed
by RBI from time to time.
2. The minimum success ratio for the PDs should be 40% for dated Government
securities and 40% for T-Bills auction on the annual basis. The successive
ratio in respect of T-Bills is monitored on a half-yearly basis separatively.
(April-September and October-March)
3. Primary dealers underwrite a portion of the issue of government security that
is floated for a predetermined amount. At time PDs may have to take up a
greater role in underwriting and may accordingly need to underwrite
100 percent of the notified amounts. The underwriting commitment of each
primary dealer is broadly decided on the basis of its size in terms of its net
owned funds, its holding strength, the committed amount of bids and the
volume of turnover in securities.
4. A PD is required to maintain Net Owned Fund (NOF) at a minimum of
Rs.50 crore at all times. The NOF constitutes the paid-up equity capital, free
reserves, balance in share premium account and capital reserves arising out of
sale proceeds of assets. The accumulated balance of loss, deferred revenue
expenditure and other tangible items are deducted from owned fund to arrive
at NOF.
PDs are required to maintain a turnover ratio of 5 times for Government
dated securities and 10 times for Treasury Bills. The turnover will be
calculated as under:
– Total purchases and sales during the year/Average of month-end stocks
during the year.
– The target should be achieved by the end of the first year of operations
after authorization by RBI.
Of the total, turnover in respect of outright transactions shall not be less
than 3 times in respect of government dated securities and 6 times in
respect of Treasury Bills.
5. PDs invest in Government Securities and Treasury Bills on a daily basis
should be atleast equal to net call borrowing plus net RBI borrowing plus the
minimum prescribed NOF.
43
6. A primary dealer shall achieve a sizable portfolio in government securities

before the end of the first year of operations after authorization.
7. A primary dealer shall maintain physical infrastructure in terms of office,
computing equipment, communication facilities like Telex/Fax, Telephone,
etc., and skilled manpower for an efficient participation in primary issues,
trading in the secondary market and to provide advice and education to
investors.
8. A primary dealer shall have an efficient internal control system for fair
conduct of business and settlement of trades and maintenance accounts.
9. A primary dealer will provide access to RBI to its records, books,
information and documents.
10. A primary dealer shall subject itself to prudential and regulatory guidelines
by RBI from time to time.
11. A primary dealer shall submit periodic returns prescribed by the RBI.
12. Authorized primary dealers should form a Self-Regulatory Organization
(SRO), which would evolve a code of conduct and a system securities
transactions.
13. In respect of transactions in government securities, a primary dealer should
have a separate desk and should maintain separate accounts for himself and
customers and have external audit of annual accounts.
14. The primary dealer should bring to the attention of the Reserve Bank any
major complaint against him or action initiated/taken against him by
authorities, such as the Stock Exchanges, Securities and Exchange Board of
India, Central Bureau of Investigation, Enforcement Directorate, Income Tax,
etc.
15. The primary dealers should determine prudential ceilings, with the prior
approval of their board of directors.
! " #$ %&'
' "() %' !* % + ' ' %+ ' &'
!, 6 !, 6 !, 6 !, 6 !, 6 !, 6
) ( 9 * + : = 3 2 )> )) )( )9
$ % '
$ !
$ )%+>> )%>>> )%(+> 9>> :>> *>> )3> )+> )3> ((> *>> +>>
$ ! B =%3:9 (%))9 9%((> 9(: (%9+* )%:(3 *%*(9 )%+=+ (%:3: )%293 9%:3* )%:2+
$ B 9%+=( )%+(9 )%:(9 (*> )%>*) )%)*= (%=:) )%+>2 )%+92 )%+)9 )%29) )%+2=
$ 6 *+$*9 =($>3 +>$*> =9$:( **$(( =>$*+ :($*( 2+$3) +=$(2 =3$>* +($*( 2*$((
$ =: )+: )2+ *) =: :> 93 9> :> *( 93 9>
$ ! " 0 C 1 9%:*3 )%:=2 )%3)3 (3) )%))= )%(>= (%=22 )%+92 )%+22 )%++* )%2:2 )%:(=
'$ '
$ " $$$ $$$ (%:(+ 3%(:* )+> )%9(3 * 2>2 (*9 +:3 2:= 9%>)2
$ 6 $$$ $$$ 9%3:* 3%92: )%9): (%*)3 (%3>( (%9(= )%=*= )%2:) (%*99 9%2:9
! 0 C 1 # " "/ D " )>%+=2 9>%+=) :%*32 ):%::> )%*:: 9%=*: (%3>: 9%(9: )%22> (%+(3 9%*>> :%23(
$ " 2=) (%>=) )%9=( 3: )9> )%)=* E =9: )=2 *== 3:+ (%(3)
$ 6 9%2)3 9%=>+ (%:9> 929 )%((9 (%)(: (%=23 (%)+* )%:39 )%3=> (%*>+ 9%*=)
! 0C 1 *%332 +%==: *%>>( *=2 )%9+9 9%9>> (%=23 (%32> )%3:9 (%9*: 9%(=> +%=+(
44
Money Markets
$
$ D 9:$22 +:$3* )=$)2 (2$(= *2$:2 (3$(* 9*($3> *+$>> (3$=3 9($+: *3$2( (2$3*
$ D " (($)2 )=$)2 )($+) ($>9 *+$3+ (*$3= 9*($9> *=$>> (=$=: 9)$92 *=$>* (*$+3
$ ,*
$ )%3>%*>* :%)=%:=( ()%)>2 )=%=9: )2%)3+ 9:%)>: 9:%)>:
$ 8 29%2*> *%(=%2+3 )%>9= (%9:+ )%(=( )%=+) )%=+)

!, E! $ 6E 6
B ' #7 , $
F & ' $
*
6! 6 ! # 8 $% # 8 $
6! 6 ! 8 $% ,6@ 6 8 $
Source: Annual Report of RBI, 2007-2008.
CAPITAL ADEQUACY STANDARDS
Currently, the capital adequacy requirements for PDs for credit risk are based on
the same norms as applicable to NBFCs. Market risk, has separate requirements as
given in the “Guidelines for the PDs in the Government Securities Market”. As
these do not still adequately address the risks being faced by the PDs in the
market, comprehensive capital charges on the portfolio risks are considered
essential. Taking into account the principles for capital adequacy for market risk
evolved by regulatory bodies such as the International Organization of Securities
Commissions (IOSCO) and the Bank for International Settlements (BIS), fresh
guidelines for capital adequacy standards for PDs are being evolved, which will be
finalized in consultation with PDs.
A primary dealer shall maintain capital adequacy standards as prescribed by the
RBI for Non-Banking Financial Companies and Residuary Non-Banking
Companies subject to the following requirements:
The following risk-weights will apply to government and other approved securities
as defined in the Banking Regulation Act, 1949 in the portfolio of PDs:
a. The risk-weight applicable will be zero in respect of balances held with banks
as cash and other bank balances including fixed deposits and money at call
and short notice and Investment in approved securities.
b. Investment in Bonds of public sector banks and fixed deposits, CDs, and
bonds will be 20 percent.
c. In the case of all other assets including equity and all off-balance sheet items,
the risk-weight applicable will be 100 percent.
FACILITIES TO PRIMARY DEALERS
The Reserve Bank extends the following facilities to PDs to enable them to
effectively fulfill their obligations.
Primary dealers are provided with current account facility with and two Subsidiary
General Ledger (SGL) accounts for government securities to enable them to
effectively fulfill their obligations with RBI. One SGL account can be used by the
primary dealer for its own operations and the other for operations on behalf of its
constituents. PDs are also permitted to borrow and lend in the money market
including call money market and trade in all money market instruments. They are
also provided access to liquidity adjustment facility of RBI and provided liquidity
support from RBI subject to market condition and evolvement.
REPOS AND REFINANCE
45
Primary dealers can access finance through Repos operations/refinance with the
Reserve Bank of India in Central Government dated securities and Auction
Treasury bills up to a limit fixed by the RBI.
PERMITTED TO RAISE FUNDS THROUGH CPS
Primary Dealers (PDs) can raise funds through commercial papers. Further, they
can also access finance from commercial banks as any other corporate borrower.
Transfer of Funds
Primary dealers can transfer funds from one center to another under the Reserve
Bank’s Remittance Facility Scheme. Further, they have the facility to clear
cheques arising out of government securities transaction, tendered at Reserve
Bank’s counters. Furthermore, they are proposed to be given favored access to the
Reserve Bank’s open market operations.
Liquidity Support
Presently, the RBI extends the liquidity support to the PDs against the collateral of
government securities. The quantum of liquidity support is based on the bidding
commitment and other norms as notified by the RBI. This is classified as Level I
and Level II support. For Level I, the quantum of liquidity support is provided at
the bank rate. The liquidity support decided by the RBI for Level II is extended at
the bank rate plus two basis points.
About 75 percent of the total assured liquidity support is provided on the basis of
bidding commitments. The ratio for dated securities to treasure bills is 3:1. And the
remaining assured liquidity support is provided on the basis of primary and
secondary market performance in the ratio of 2:3. The total assured liquidity
support to PD is given to maximum of thrice of the net owned funds. The assured
liquidity support to PD is available at the ‘repo rate’ announced by the RBI.
In general, the liquidity support is availed by the PDs has to be repaid within
90 days and in case of failure to repay within 90 days a penal interest rate of
5 percentage points plus the bank rate is charged against the PDs.
The standing liquidity facilities by the RBI in the form of liquidity support to PDs
come in addition to the facilities through LAF as also outright sales/purchases of
the government securities as part of Open Market Operations (OMO).
PERMISSION TO BORROW AND LEND IN THE CALL MONEY
MARKET
Presently, the Primary Dealers (PDs) are allowed to borrow and lend in the money
market that includes call money market and to trade in all money market
instruments. The funds so raised form call money markets and repo markets and
also the funds availed form liquidity support form RBI should necessarily be
invested in Government Securities and Treasury Bills. According to new norms
prescribed by the RBI in its annual policy 2005, permitted PDs to borrow fund
from call/notice money markets, on average in a reporting fortnight up to
200 percent of their NOF at the end March of the preceding financial year. PDs are
allowed to lend up to 25 percent of the NOF. Their lending limit is determined on
an average basis during a reporting fortnight. The RBI is in view moving towards a
pure interbank call/notice money market.
The RBI in its annual policy Statement of April 2001 highlighted its intention to
move towards a pure interbank call/notice money market in four stages by
gradually phasing out non-bank participation. In stage I, non-bank participants
were allowed to lend, on average in a reporting fortnight, up to 85 percent of their
average daily lending during 2000-01. The implementation of stage I has not
caused any strain on the market or created undue volatility in call/notice money
rate. Except for the Life Insurance Corporation of India, which has large liquid
46
Money Markets
funds and is also subject to certain prudential constraints in investing its large
surpluses in other non-bank institutions, by and large, most non-bank institutions
have not faced any difficulty in adhering to the stage I guidelines.
Subsequently, in the annual policy Statement of April 2002, it was stated that the
RBI would announce the date of effectiveness of stage II, wherein non-bank
participants would be allowed to lend, on average in a reporting fortnight, up to
75 percent of their average daily lending in call money market during 2000-01,
depending on the date when NDS/CCIL becomes fully operational. In view of the
encouraging developments in NDS/CCIL, it would be desirable to accelerate the
process of moving towards a pure interbank call/notice money market and facilitate
further deepening of repo market. Accordingly, it is proposed that stage II of the
transition to a pure interbank call/notice money market will be effective from the
fortnight beginning June 14, 2003, wherein non-bank participants would be
allowed to lend, on average in a reporting fortnight, up to 75 percent of their
average daily lending in call/notice money market during 2000-01.
Illustration 1
The commitment for aggregative bidding for G-Secs and Auction T-Bills of 4 PDs
are as follows:
0 $ $1
6" 8 $ !66 8 $ &8 $ ;8& 8 $
,6 :>> =>> 9>> *+>
!, 3>> )>>> (9>> )3>>
,6 /
! =>> 2>> (+> +>>
9+> ((+ 3> (9>
!, /
! 2>> =>> ((>> )2>>
(=+ 9+> 2>> =>>
Based on the data provided above, answer the following:

i. Assess the required amount of successful bids for the year for these PDs in
each of the instruments.
ii. State whether the PDs have adhered to the commitment to go for aggregative
bidding and achieve the required amount of successful bids during the year.
Solution
i. The success ratio to be maintained by PDs in G-Secs = 33.33%
The success ratio to be maintained by PDs in auction T-Bills = 40%
ii. G-Secs.
0 $ $1
6" 8 $ !66 8 $ &8 $ ;8& 8 $
,6
0 7 99$99G1 (>> (99 )>> )+>
!,
0 7 *>G1 9(> *>> 2(> =(>
From the above table, it can be observed that GHN Ltd. and TSS Ltd. did not
adhere to the commitment on aggregative bidding or on the required amount of
successful bids.
47
0 $ $1
" " 6 #
-
"
" 0H &1
0H &1
!
0 1 0 1 0 1 0 1
6" 8 $ =>> I :>> H 9+> I (>> H
!66 8 $ 2>> I =>> H ((+ J (99 &
&8 $ (+> J 9>> & 3> J )>> &
;8& 8 $ +>> I *+> H (9> I )+> H
0 $ $1
" " 6 #
-
"
" 0H &1
0H &1
!
0 1 0 1 0 1 0 1
6" 8 $ 2>> I 3>> H (=+ J 9(> &
!66 8 $ =>> J )>>> & 9+> J *>> &
&8 $ ((>> J (9>> & 2>> J 2(> &
;8& 8 $ )2>> I )3>> H =>> J =(> &
Auction T-Bills
Thus, it can be observed from the table that Shares Ltd., and KLN Ltd., have
adhered only to their commitment on aggregative bidding but not to the required
amount of successful bids. However, GHN Ltd. and TSS Ltd. have not adhered to
either their commitment on aggregative bidding nor to the required amount of
successful bids.
Illustration 2
AHB Ltd. is a PD in the Government Securities. During the auction of dated
securities and 91 day T-Bills, AHB Ltd. has, in agreement with the RBI, given an
underwriting commitment of 10% of the shortfall in case of government dated
securities and 5% of the shortfall in case of the 91 day T-Bills. The amounts
notified for the bids were Rs.700 cr. for the dated securities and Rs.300 cr. for the
91 day T-Bills. From the various cases given below, identify those cases where
development has occurred and assess the amount devolved on (a) all PDs,
(b) AHB Ltd., and (c) RBI.
Solution
0 $ $1
, ##
,6 2) !, ,6 2)
!,
48
Money Markets
) )>>> *>> =>> 9>>
( )>>> *>> :>>B (+>B
(* Include non-competitive bids)

Case 1: There is no shortfall in the subscription of G-Secs and 91 day T-Bills
since the bids received for G-Secs and the T-Bills are equal to the notified amount.
Hence there is no devolvement.
0 $ $1
,6 2) !,
& # =>> 9>>
=>> 9>>
Case 2: It can be observed that the bids accepted for the G-Secs and 91 day T-
Bills fall short of the notified amount by Rs.100 cr. and Rs.50 cr. respectively.
Hence, there is a devolvement in the issues.
0 $ $1
,6 2) !,
& # =>> 9>>
:>> (+>
The devolvement on PDs, AHB and RBI will be assessed based on the following:
• Devolvement on RBI in case of G-Secs = 75% of the devolvement.
• Devolvement on RBI in case of T-Bills = 80% of the devolvement.
• Devolvement on PDs in case of G-Secs = 25% of the devolvement.
• Devolvement on PDs in case of T-Bills = 20% of the devolvement.
• Devolvement on AHB Ltd. in case of G-Secs = 10% of the amount devolved
on PDs.
• Devolvement on AHB Ltd. in case of T-Bills = 5% of the amount devolved on
PDs.
,6 2) !,
# )>>$>> +>$>>
" #
$ )>> 7 >$(+ K (+$>> +> 7 >$(> K )>$>>
'$ 8 $ (+ 7 >$)> K ($+> )> 7 >$>+ K >$+>
$ )>> 7 >$=+ K =+$>> +> 7 >$3> K *>$>>
INTEREST RATE STRUCTURE IN THE INDIAN MONEY MARKET

The underlying strength that rules the money market is its ability to transfer
temporary cash surplus of one party to the other party, which has a temporary cash
deficit. This process, is helped by a variety of instruments having varying risk
profiles and maturities. The yields for these instruments are determined based on
their maturity and the risk level.
The pricing mechanism of these instruments is critical not just for the individual
securities but for the interest rate structure in the economy. The money market
rates affect and are affected by the liquidity in the system. This is due to the
49
quantum of funds involved in transactions. A few factors play a significant role in

setting the yields for the money market instruments.
Among the money market instruments, a few securities carry coupon rate while
others are issued at a discount to their face value. Rates are determined by other
factors, most importantly the rates of other closely related instruments.
To start with, consider the government securities comprising T-Bills and
Government Dated Securities. Being risk-free instruments they set the base price
of the other securities of the money market. Considering the original maturity and
outstanding maturity periods, the government securities can give price range
beginning from 1 day to 364 days. With such a wide range, these instruments set a
benchmark for the various short-term instruments. They also enable the formation
of a continuous yield curve for risk-free instruments.
Next in line are the securities of banks. Call/Notice money are the very short-term
instruments used by banks to raise money. One major factor that determines the
borrowing rates in the call/notice money market, is the demand-supply condition.
Banks’ liquidity depends on various factors that affect cash flows. Sudden increase
in outflows tightens liquidity while a sudden increase in the inflows eases
liquidity. An increase in reserve requirements, advance payment of tax,
subscription to government securities, repayment of external obligation, forex
outflows reduce liquidity. Similarly, a decrease in reserve requirements, payment
of interest redemption of government securities, forex inflows, etc., will result in
easing the liquidity position. A very tight liquidity position will increase the call
rates while excess liquidity will give fairly low and stable rates. Further, if this
liquidity crunch of the banks is passed on to the system, it may lead to a high
volatility in call rates.
These call rates under normal liquidity conditions, are the floor rate for the term
money market. And since the maturity of these instruments is similar to that of the
CDs, their rates are closely related. The rates of Inter-Bank Participations (IBPs)
are also influenced by the call rates. In a volatile call market situation, lending will
return high yields, and by selling IBPs, the bank will have more money to play in
the call market. To benefit from such a situation, banks may also offer rates that
may be higher than the contractual rate of the underlying asset. On the other hand,
banks, which have a conservative approach, would prefer to invest in these IBPs
rather than in a volatile call market. In addition to this, the prevailing PLR will
also influence the IBP rate since the underlying security is a loan asset.
Another short-term instrument issued by banks is the CD. The minimum maturity
period is 7days. Low liquidity to the depositor and certainty in cash flows explain
the higher rate of interest on CDs when compared to the term deposits.
The money market instruments with highest risk levels are those issued by the
corporate. And due to this nature, they certainly earn higher yields for the
investors. CPs are issued by corporates to raise funds for working capital
requirement. Generally, corporates borrow these funds from the banks at the bank
lending rates. However, due to higher rating, if the corporate is able to raise the
amount from the market at a lesser rate, it opts to issue CPs. Hence, the PLR will
set the cap for the CPs. On the other hand, considering the maturity, the yields on
CDs will set the lower limit for the CPs.
A short-term instrument issued by banks is a derivative promissory note for the
purpose of rediscounting the bills. Since these instruments are secured in nature
due to the presence of underlying securities which are bills of exchange drawn by
business entities and discounted with the bank, the rate should be lower than other
instruments having a corresponding maturity period, i.e., call and term money.
However, with the perceived risk of the call money and the term deposits being
lower, the difference in yields between the call/term rates and the bills of exchange
50
Money Markets
cannot be observed. Hence, the minimum and maximum rates for the bills of
exchange are set by call/notice and term deposit rates respectively.
Finally, the two important features relating to the yields of the money market
instruments can be listed as follows:
• The government securities set the benchmark for other money market
instruments, i.e., given the yields on government securities, there will be
higher yields on the other instruments.
• The rates of interest of the various money market instruments are generally
linked to each other either due to their risk profile or due to maturity periods.
Thus, as the maturities of the money market instruments increase, the yields also
rise indicating an upward sloping yield curve. However, in a declining interest rate
scenario, there may be an inverted yield curve since borrowers prefer to borrow
short-term funds while lenders tend to offer long-term securities. This clash
between the supply and demand will shoot up the short-term rates above the
long-term rates resulting in an inverted curve. This does happen predominantly
when the market experiences a liquidity crunch.
INTERLINKAGES IN THE MARKETS
All financial markets have a definite interlinkage. And since the money market
allows short-term parking of funds, there is scope for money from all the other
markets, i.e., the capital market, credit market and forex market to find their way
into it. This flow of funds, however, depends to a considerable extent on the
liquidity it offers. To be more specific about the interlinkages, consider the money
market and the forex market. These two markets influence each other to a greater
extent since both markets involve trading in funds. Besides, banks are the major
players in both these markets and act as a balancing force. Banks may use their
forex deposits to lend in the call money market by converting the foreign currency.
Due to this activity, banks develop an exposure for their forex deposits. To
overcome this, the bank will have to cover the same through forward purchases at
a premium. If this process of routing money into the call market continues, it
might lead to higher premiums in the forex market. The link between the money
and the capital market seems to be limited mainly because the players in the
capital market are large in number when compared to the money market and
establish the only link with large organizations operating in both the markets.
These inter linkages within the markets may also lead to fluctuations in the money
market.
SUMMARY
• Liquidity mismatch often occurs in the short run as cash inflows and outflows
rarely synchronize.
• It is important to manage the same carefully, to avoid liquidity crisis in case
of deficit and idle funds that do not bear interest in case of surplus.
• The money market is a formal financial market that deals with short-term
fund management.
• The money market involves high volumes and is dominated by a relatively
small number of players, namely: Governments, central banks, banks,
financial institutions, corporates, mutual funds, foreign institutional investors,
discount houses, acceptance houses and market makers (primary dealers).
• The main money market instruments are: Government and quasi-government
securities, banking sector securities and private sector securities.
• Government and quasi-government securities include Treasury bills and
Government dated securities or Gilt-edged securities.
51
• Banking sector securities include call and notice money market securities,
term money market securities, certificates of deposit and participation
certificates.
• Private sector securities include Commercial paper, Bills of exchange,
Inter-corporate deposits/Investments and Money market mutual funds.
• Repo transactions are popular mechanisms to deploy/borrow short-term funds
in the money market, by selling securities to another party with an agreement
to buyback the same at a later date.
• The main risks associated with money market instruments/investments are:
Market risk, interest rate risk, reinvestment risk, default risk, inflation risk,
currency risk and political risk.
• The main money market securities in the US market are: Government
securities (T-bills), municipal notes, federal agency securities, call loan
market, repos and reverses, certificates of deposit, Eurodollar deposits and
Eurodollar CDs, Yankee CDs, loan participations, bankers’ acceptances,
commercial papers, Euro commercial papers in Europe and commercial bills.
• The main objectives of the monetary policy are: Price stability and economic
growth.
• The most critical factors in a monetary policy are: Money supply, interest
rate stability and exchange rate stability.
• Monetary contraction can be resorted to control inflation, by adopting one of
the following measures: Increase the statutory reserves (CRR and SLR),
undertake repo transactions or go in for open market operations.
• The RBI controls the money market in India by adopting the following
measures: Changes in CRR, changes in SLR, open market operations,
reduction in bank and repo rates.
• The main objectives of the primary dealers are: Enhance liquidity of the
money market, become underwriters and market makers for government
securities, activate the secondary market for government securities and aid
the RBI in open market operations.
• Subsidiaries of nationalized banks, FIs and security business companies can
become primary dealers, if they have a minimum of Rs.50 crore as net owned
funds. Subsidiaries of FIIs can become primary dealers subject to permission
from the FIPB.
• The RBI extends the following support to the PDs: Liquidity support,
permission to borrow and lend in the market, access to current and subsidiary
general ledger accounts, repos and refinance, permission to raise funds
through commercial papers and permission to transfer funds from one center
to the other.
52
:
•
•
• ! "
• " " #
• $
INTRODUCTION
The call money market is a part of the money market and refers to the overweight
funds lent and borrowed, mostly by banks for daily liquidity management.
Call/Notice money is an amount borrowed or lent for a very short period. If the
period is more than one day and up to 14 days it is called ‘Notice Money’,
otherwise the amount is called ‘Call Money’. Under call money market, funds are
transacted on overnight basis and under notice money market, funds are transacted
for the period between 2 days and 14 days.
FEATURES OF CALL MARKET
The call money market is most liquid of all short-term money market segments
and it is also the most sensitive barometer measuring the liquidity conditions
prevailing in financial markets. The call money is the money repayable on
demand. The maturity period of call loans varies between 1 to 14 days. The money
that is lent for one day in call money market is also known as ‘overnight money’.
The number of days is specified and the call money has to be repaid on the due
date. The intimation for repayment enables the borrower to arrange the money on
the due date and the duration of notice money is similar to that of call money i.e.,
up to 14 days. Therefore, the notice money is not seen in the market. The
call/notice money market forms an important segment of the Indian Money
Market. The money that is lent for more than 14 days is referred to as ‘term
money’. In call money market, any amount could be lent or borrowed at an interest
rate, which is acceptable to both borrower and lender. These loans are considered
as highly liquid; as they are repayable on due date which is usually the next day.
Initially, banks were only permitted to deal in this market; it was then referred as
‘Inter bank market’.
PARTICIPANTS
All scheduled commercial banks (private sector, public sector and cooperative
banks), Primary Dealers (PDs), development finance institutions, select insurance
companies and select mutual funds operate in call/notice markets.
Intermediaries like Discount and Finance House of India (DFHI) and Securities
Trading Corporation of India Limited (STCI) and Primary Dealers (PDs) are the
participants in the local call money markets. The corporate participation in call
money market has been very small.
Previously, the non-bank participants like the financial institutions and the mutual
funds were also allowed to participate in the call market. The Non-bank
institutions are given specific permission to operate in call/notice money market
can, and operate as lenders only. The banks and Primary Dealers (PDs) can borrow
and lend money in this market but mutual funds and select corporate can
participate only in lending money. The participants under the category of banks
can be divided into two types: pre-dominant lenders (mostly the public sector
banks) and pre-dominant borrowers (foreign and private sector banks). Based on
the Committee Report on Banking Sector Reforms (1998), suggestion, RBI carried
out a “basic restructuring of call money market” to make it a pure inter bank
market and no new non-bank institutions are permitted to operate (i.e., lend) in the
call/notice money market with effect from May 5, 2001. The RBI decided to
completely phase out non-banking participants from call/notice money markets
with effect from August 06, 2005.
54
Money Markets
!
" # $ #
" #
" % $
Hence based on the recommendation of the Technical Group on Phasing Out of

Non-banks from Call/Notice Money Market a complete withdrawal of non-bank
participants from the call/notice money market was taken up by the RBI
simultaneously operationalizing the Clearing Corporation. Their operations were
phased out in a gradual manner so as to cause no disruption in the call money
market.
The intermediaries like DFHI and STCI and Primary Dealers (PDs) namely, SBI
Gilts, Punjab Gilts, Gilt Securities Trading Corporation (GSTC) and ICICI
Securities and Finance Corporation Ltd., are the only institutions besides
commercial banks which have been permitted to operate both as borrowers and
lenders in this market. Those who form a part of the market by being borrowers as
well as lenders are collectively referred to as the “banking system”.
PURPOSE
In India, call money is lent mainly to even out the short-term mismatches of assets
and liabilities and to meet CRR requirements of banks. Some banks may borrow
and lend simultaneously from the market if they find an opportunity to arbitrage.
Firstly, the short-term mismatches arise due to variation in maturities, i.e., the
deposits mobilized are deployed by the bank at a longer maturity to earn more
returns and duration of withdrawal of deposits by customers vary (since it is
effectively a demand liability). Thus, banks borrow from call money markets to
meet short-term maturity mismatches such as large payments and remittances.
Secondly, the banks borrow from this market to meet the Cash Reserve Ratio
(CRR) requirements, which they should maintain with RBI every fortnight. Cash
Reserve Ratio (CRR) represents the balances to be maintained by banks with the
RBI, which is computed as a percentage of the Net Demand and Time Liabilities
(NDTL).
Thirdly, money is borrowed in the call/notice market for short periods to discount
commercial bills. The volume of call loans is thus very small in India, due to
underdeveloped bill markets. Thus, the utility of the call money to meet short-term
mismatches forms a significant volume when compared to other purposes.
CALL RATES
The interest paid on call loans is known as the call rates. Though the rate quoted in
the market is annualized one, the rate of interest on call money is calculated on a
daily basis. The call rate is expected to freely reflect the day-to-day market
scarcities or lack of funds. These rates vary from day-to-day and within the day,
often from hour-to-hour. High rates indicate a tightness of liquidity in the financial
system while low rates indicate an easy liquidity position in the market. The rate is
largely subjected to influence by the forces of supply and demand for funds. In
India, rates in the call market are prone to fluctuations, which are unidirectional.
This is due to limited number of players with similar needs.
55
Operational Mechanism
Once the deal is struck the funds are immediately available to the borrowing bank
and are repaid with interest on the next/due date. The funds are lent and paid back
through a banker’s pay order, which is cleared by the special high value clearing
cell in the RBI.
Location
In India, call money markets are mainly located in main commercial and big
industrial centers such as Mumbai, Kolkata, Chennai, Delhi and Ahmedabad. This
is due to the existence of stock markets at these places. Mumbai and Kolkata play
a significant role in trading as compared to the other places. Due to the location of
the biggest stock exchange, various head offices of the RBI and many other banks,
Mumbai plays a predominant role in determining the call rates based on demand
and supply volumes of call loans.
Role of Primary Dealers in the Call Market
Primary Dealers have a significant role in the call market. Some commercial banks
including co-operative and regional rural banks, which are not allowed to
participate directly in the call market can access the market through Primary
Dealers. The Primary Dealers offer a two-day quote, take spread and allow the
banks to participate in the call money market. The call rates can be “spot rate” or
the “weighted average rate”. As the Indian call market usually opens high and
closes low, the average rate received by the lender will be normally lower than the
middle rates.
Recently, the working group constituted by the RBI to examine the necessity of
prudential regulations on exposure to call/notice money market so as to preserve
the integrity of the financial system has suggested the limits for transactions of
Primary Dealers (PDs) in call/notice money market as also the roadmap for
phasing them out from call/notice money market. The notification issued by the
RBI “Access to Call/Notice Money Market for Primary Dealers: Prudential
Norms” on July 31, 2002 states the prudential limits as following:
• With effect from October 5, 2002, PDs are permitted to lend in call/notice
money market up to 25 percent of their Net Owned Funds (NOF).
• Access of PDs to borrow in call/notice money market would be gradually
reduced in two stages:
– In Stage I, PDs would be allowed to borrow up to 200 percent of their
NOF as at March end of the preceding financial year. However, this
limit would not be applicable to the days on which government dated
securities are issued to the market. Stage I would be operational upon
the finalization of uniform accounting and documentation procedures
for repos, allowing rollover of repos, introduction of tripartite repos or
Collateralized Borrowing and Lending Obligation (CBLO) to the
satisfaction of the RBI and permitting repos out of Available For Sale
(AFS) category.
– In Stage II, PDs would be allowed to borrow up to 100 percent of their
NOF. Days on which government dated securities are issued to the
market will continue to be exempted from this limit. The implementation
of Stage II will commence from one month after permitting sale of
repoed securities.
• On implementation of the Real-time Gross Settlement (RTGS) system, the
above exemptions would be reviewed.
56
Money Markets
DEVELOPMENT OF CALL MONEY MARKET

CHARACTERISTICS OF INDIAN CALL MARKETS IN
PRE-LIBERALIZATION PERIOD
A closes look into the early workings of this market reveals the following salient
features:
• The Indian call market was a restricted market with a narrow base and limited
number of participants. Banks and a few all India Financial Institutions
participated in the market and the entry of others into the market was tightly
regulated.
• The existing participants, lacked an active market as there were few lenders
and a large number of borrowers.
• Another feature was that the market was considerably organized with a large
part of the dealings taking place in Mumbai and Kolkata. Chennai and Delhi
played a secondary role in this activity.
• There was no ceiling on the call money rates and the movements were quite
erratic.
The forces of supply and demand for funds largely influenced the call rates. In
India, call rates are prone to fluctuations, which are unidirectional, due to the
presence of a large number of players with similar needs. The call loans were also
subjected to seasonal fluctuations, and the call rates usually climbed high during
busy seasons than in slack seasons. The seasonal ups and downs were reflected in
the volume of money at call and short-notice, at different periods of time in a year.
These seasonal variations were high due to a limited number of lenders and many
borrowers.
The following were the factors attributed for the high volatility:
i. Large borrowings by banks to meet the CRR requirements on certain dates
cause a great demand for call rates. These rates usually go up during the first
week when banks borrow mostly to meet CRR requirements and subside in
the second week once the CRR requirements are met.
ii. Due to over-extension of loans in excess of their own resources, the banks
depend on call market. They use the call market as a source of funds to meet
structural disequilibria in their sources and uses of funds. No bank may
continuously rely on call market for funding credit since it attracts adverse
comments from the RBI. However, the market may experience the presence
of a few at any point of time.
iii. The withdrawal of funds to meet business requirements by institutional
lenders and payment of advance tax by the corporate sector leads to increase
in call money rates in the market.
iv. The banks invest funds in Government securities, units of Money Market
Mutual Funds, public sector bonds in order to maximize the earnings from
their funds management. But with no buyers in the market, these instruments
tend to become illiquid which leads to the liquidity crises. Call money being
highly liquid, banks use it to pool the funds from the call market,
significantly pushing up the call rates.
57
Thus, liquidity crisis or illiquidity in the money markets also contributes to the
volatility in call market.
EARLY LIBERALIZATION SCENARIO
Several significant efforts were made to develop money markets after 1985. Two
committees were set-up to review the working of the Monetary System and Money
Market, which provided fresh insights to improve the working of the call money
market. In 1985, the Sukhamoy Chakravarthy Committee which was set-up to
review the working of the Monetary System, suggested that additional non-bank
institutional participants should be brought into the call money market. In 1987,
the Vaghul Committee, set-up to review the money markets in India, suggested
that the discount house should be set-up and ceiling on the interbank call money
rate should be removed to activate the money market. The RBI had taken few steps
following the Vaghul Committee recommendations:
• In May, 1988, the interbank rates both on the call money and term money
were freed/deregulated.
• In October, 1988, Discount and Finance House of India (DFHI) was set-up. It
was permitted to borrow/lend and also arrange funds in the call money
market.
• In May 1990, the RBI allowed all the financial institutions such as GIC, IDBI and
NABARD, etc., to operate as lenders in the overnight call and notice money
market.
• In April, 1991, the RBI permitted corporate entity with surplus lendable
resources to access the call money through the DFHI. It set a minimum size
of Rs.5 crore for each transaction and, further, the lender had to give an
undertaking that he had no outstanding loans from the banking sector to
operate in this market. The entry of financial institutions, permitting of public
sector and private sector mutual funds, money market mutual funds, primary
dealers and others into the market, channelized the funds flow into call
markets, thereby reducing the demand-supply gap in the recent years.
The few significant changes initiated by the Central Bank brought greater
integration of the various segments of the money market. The base of call market
has been widened by selective increase in the participants as lenders, especially,
led to an increase in supply of funds in the call money market. The entry of DFHI
and STCI and primary/satellite dealers promoted an orderly development of the
call market.
VOLUME OF ACTIVITY IN THE CALL MARKET
The volume of activity and the size of the call money market in India can be
assessed by looking at the turnover of the market. Looking at the call market
turnover it can be said that size appears to be very large considering the basic
objective of the call market, which is to offset the momentary imbalances in the
banking sector.
The average daily turnover (borrowings) of the call markets as on the fortnight
ended March 29, 1996 was Rs.9,465 crore Rs.18,941 crore during fortnight ended
15 October, 2004 and Rs.24,562 crore for the week ended November 11, 2005.
But it was Rs.12,600 crore in March 13, 2009. Total turn is Rs.25,199 crores.
58
Money Markets
The following reasons can be ascribed to the small size of the Indian call market
compared to the American and UK markets.
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• The volume of activity in the bill market is directly related to the call market
activity. Because the bill market is small in India the size of call market
borrowings to the bill market is also small.
• Secondly, the banks can approach the central bank as a lender of last resort
and the availability of the direct discounting facilities with the RBI implies
little need for borrowings from the markets. Also the large cash holdings of
the Indian commercial banks show a lesser need for loan in a call market.
59
• Various regulations prevent the banks from advancing loans against shares.
Hence, the sources for securities trading are mostly private. Therefore,
advances to the security dealers are much less when compared with the US
market.
INSTITUTIONAL PARTICIPATION IN THE CALL MONEY MARKET
Table 2 gives an overview of the average turnover of the call loans for a fortnight
according to the type of the institution. The supply of loans in the call money
market has increased due to the entry of other institutions like LIC, GIC and UTI,
etc. This has also enabled those institutions to have more choice in investing their
funds and have more return on the investments. Another advantage is the
integration of the financial markets in the economy.
There are some critical issues in this regard. One is whether the long-term funds
can be allowed in the short-term market. It becomes tough to match maturities
when the participants having short-term liabilities create long-term assets. Another
issue relates to the impact on the effectiveness of the monetary policy due to direct
participation of these institutions in the market. Because these institutions are
outside the banking system they can weaken the controls laid down by the RBI.
Consequently, the working group on the money market has advised that the ceiling
on call rates should be removed and the call money market should be exclusive to
only commercial banks. The RBI has regulated other institutions like LIC, GIC,
UTI to participate in the call market as lenders only. The minimum size of
operations is Rs.20 crore per single transaction. Later it was gradually reduced to
Rs.3 crore. Prior permission of the RBI is compulsory to participate in the market
and they have to participate through the DFHI only. A critical view of the call
market holds is that the lenders are less and borrowers are many.
MOVEMENT OF PARTICIPANTS FROM CALL TO REPO

MARKETS
The RBI has initiated the measures to make the call money market a pure
interbank market including PDs by gradual elimination of non-bank participants
from the call markets. This was announced by the RBI in “Mid-Term Review of
Monetary and Credit Policy for 1998-99” announced in October, 1998. It was also
proposed that measures would be taken simultaneously to ensure the development
of repo market and enhance the participation of non-banking institutions in various
other financial instruments. And consequently the non-bank participants were not
allowed to participate in the call markets, through PDs, after June, 2001.
Following are the recommendations of the Technical Group on Phasing Out of
Non-banks from Call/Notice Money Market:
• The participation of non-bank participants like financial institutions and
mutual funds in the call money market may be eliminated gradually in three
stages by restricting their average daily lending in the period April, 2000 –
March, 2001.
• For an initial period of three months, each non-bank participant should lend
only up to 70% of their average daily lending in call money market during
2000-01. Later, in the second stage it should be further reduced to 40%.
• After a period of three months from the conclusion of the second stage or the
establishment of a Clearing Corporation, latest of these two, the final stage
would commence. It should last for a period of three months. The access was
reduced up to 10% of their average daily lending during 2000-01. This
process helped the non-bank participants as they could familiarize with the
operations of the Clearing Corporations. After this stage, no non-banking
entity is permitted to lend in the call money market.
60
Money Markets
The RBI announced the following permissions in the Monetary and Credit Policy
2005-06 in view of the recommendations of the Group and the feedback: In order
to review the recent developments and current status of money market in the
context of evolving monetary policy framework, a Technical Group on Money
Market was constituted. The Report of the Group was discussed in the Technical
Advisory Committee on Money, Foreign Exchange and Government Securities
Markets (TAC). Accordingly, the following measures are proposed.
CALL/NOTICE MONEY MARKET
• With effect from the fortnight beginning June 11, 2005, non-bank
participants, except PDs, would be allowed to lend, on average in a reporting
fortnight, up to 10 percent of their average daily lending in call/notice money
market during 2005-06.
• With effect from August 6, 2005, non-bank participants, except PDs, would
be completely phased out from the call/notice money market.
• With effect from the fortnight beginning April 30, 2005, the benchmark for
fixing prudential limits on exposures to call/notice money market in the case
of scheduled commercial banks would be linked to their capital funds (sum of
Tier I and Tier II capital).
• From April 30, 2005, all NDS members are required to report their term
money deals on NDS platform.
• A screen-based negotiated quote-driven system for all dealings in call/notice
and term money market transactions is proposed.:
Earlier in its Monetary and Credit Policy 2001-02, RBI resolved to gradual
phasing out of non-bank institutions from the call market:
– Stage I Commencing from May 5, 2001; access to non-banks would be
reduced to 85% of the average daily lending in call market during 2000-01.
– Stage II Commencing from the date of operationalization of Clearing
Corporation; access will be reduced to 70% of the average daily lending in
call market during 2000-01.
– Stage III Commencing three months after stage II and the access is further
reduced to 40%.
The process was gradually phased out over a period of time to allow the market
participants in both the lending and borrowing functions to adjust themselves to
the new system without any disturbances in the market activities. Clearing
Corporation was established to improve the repo market and make the repo
operations efficient and also to introduce the non-government securities in repo
transactions.
RECENT MONETARY POLICY ON PHASING OUT PROCESS
The RBI is strictly monitoring the limits prescribed for the non-bank participants.
By any means if a non-bank participant could not divert its funds into other
avenues of investment, the RBI can permit that institution to lend more than the
limit for a certain period with appropriate limits. A review by the RBI found that
phasing out of non-banks was going on smoothly without any strain on the market.
There is a reduction in the volatility of call rates and an increase in the average
daily turnover of the market. At the same time, the non-banking financial
institutions and mutual funds have increased their net lending through the repo
market. In the light of these improvements and the NDS and CCIL, the RBI has
felt the need to accelerate the progress of phasing out so as to facilitate further
deepening of the repo market.
61
EFFICIENT CALL MONEY MARKET

An efficient call money market should be less volatile and provide an opportunity
to its players to transact at comparatively stable rates of interest. In such a market,
players (i.e., both lenders and borrowers) would resort to certain amount of self
regulation bringing discipline into the market in their own interest. A call market
being the nerve center of the financial system has its direct linkages with other
money market segments and indirect linkages with credit, capital and forex
markets should make it possible for the monetary authority to instantaneously
identify areas where corrective actions are required and act upon without delay.
ROLE OF RESERVE BANK OF INDIA

The Reserve Bank of India (RBI) functions as a market regulator and it does not
lend or borrow funds in the call market, but it intervenes in the call market when
the market is overheated. It adopts ‘Repos’ and ‘Open Market Operations’ to cool
the heated market. Intermediaries such as DFHI, STCI and Primary Dealers in the
money markets play an active and vital role in maintaining the liquidity in primary
as well as secondary markets in call money market.
LIQUIDITY ADJUSTMENT FACILITY
Important signals for the interest rate changes and the prominent tools useful for
the liquidity management in the Indian money market are the bank rates, CRR and
repo rate changes. In this direction the Liquidity Adjustment Facility (LAF) by the
RBI has been an effective mechanism in the RBI’s liquidity management scheme
where it can absorb or inject liquidity on a day-to-day basis in a very flexible way,
which in turn provides a passage for the call money market. The RBI in its
monetary and credit policy of April, 2000 announced the introduction of the LAF
(Liquidity Adjustment Facility). The Scheme of Liquidity Adjustment Facility
(LAF) will include (i) Repo Auctions and (ii) Reverse Repo auctions.
As per the scheme, Repo and Reverse Repo auctions will be conducted on a daily
basis except for Saturdays. The Repo tenor is one day except for the holidays and
the Fridays. To account for the following Saturday and Sunday the maturity of
auctions on Friday will be three days. The funds available to the banks under the
facility are supposed to be used by them to even out the day-to-day imbalances in
liquidity.
As per the policy statement, the RBI has taken the launch of LAF in three
convenient and progressive stages so as to ensure a smooth transition. In the first
stage variable rate Repo auctions with the same day settlement were introduced
replacing the Additional Collateralized Lending Facility (ACLF) to banks and
Level II support to Primary Dealers (PDs). In the second stage of the scheme
Collateralized Lending Facility (CLF) to banks and Level I support to PDs is to be
replaced by variable rate Repo auctions. It was indicated that the effective date for
the second stage would be decided in consultation with banks and PDs.
As the market developed most of the constraints in the operations of the LAF were
removed. Hence, the RBI is trying to make LAF much more efficient. On the basis
of the previous LAF operations and also on long discussions with the market
participants the RBI has revised the earlier LAF Scheme, dated October 24, 2005.
and switchover to the international usage of the terms ‘repo’ and ‘reverse repo’.
The fixed reverse repo rate was raised to 5.25 percent in October 2005 and the
fixed repo rate with a spread of 100 basis points over the fixed reverse repo rate,
will stand at 6.25 percent. The RBI with effect from November 1, 2004
discontinued 7-day and 14-day reverse repo auction.
THE SCHEME
Under the LAF announced in October 2004, (i) Repo auctions (for absorption of
liquidity) and (ii) Reverse Repo auctions (for injection of liquidity) will be
conducted on a daily basis (except Saturdays). But for the intervening holidays and
62
Money Markets
Fridays, the Repo tenor will be one day. On Fridays, the auctions will be held for
three days maturity to cover the following Saturday and Sunday. The funds under
LAF are expected to be used by the banks for their day-to-day mismatches in
liquidity.
FIXED RATE REPO AUCTION
The RBI will henceforth have an additional option to switchover to fixed rate
Repos on overnight basis; but this option is expected to be sparingly used. For the
purpose of such Repos, the rates of interest intended to be offered would be
announced as part of auction announcement on the previous evening or before
10 a.m. on the day of auction, if necessary.
Long-Term Repo
In addition to overnight Repos, the RBI will also have the discretion to introduce
longer-term Repos up to 14-day period as and when required.
Rate of Interest
At present, auctions under LAF are conducted on “uniform price” basis. It has
been decided to introduce “multiple price” auction, in place of existing uniform
price auction on an experimental basis for one-month period during May 2001.
Interest rates in respect of both Repos and Reverse Repos will be, accordingly,
based on the bids quoted by participants and subject to the cut-off rates as decided
by the Reserve Bank of India, at Mumbai. The Repo/Reverse Repo rate in percent
per annum expected by the tenderer will be expressed up to two decimal points
rounded off to the nearest 5 basis points. As there will be no adjustment
for accrued coupon, the cash flow will depend upon the Repo rate emerging on a
day-to-day basis.
Mechanics of Operations
i. The LAF auction timing is being advanced by 30 minutes. Bids will be
received in tender forms at IDM Cell before 10.30 a.m., as against 11 a.m. at
present. A separate box for the purpose will be kept at the reception on the
Ground floor of the Central Office Building, the RBI, and Mumbai.
Processing of the bids will be done at IDMC. The auction results will be
displayed by the Mumbai Office by 12 noon as against 12.30 p.m. at present.
ii. The Repo will be conducted as “Hold in Custody” type, wherein the Reserve
Bank of India will act as a custodian for the participants and hold the
securities on their behalf in the Repo/Reverse Repo Constituents’ Accounts.
In pursuant to this, the participants will have to give an undertaking as given
in the respective tender forms authorizing the RBI to act on behalf of them.
The Reserve Bank of India shall not, however be responsible for any loss,
damage or liability on account of acting as the custodian on behalf of the
participants. A Repo Constituents’ SGL Account (RC SGL Account) and
Reverse Repo Constituents’ SGL Account (RRC SGL Account) will be
opened and held in the Securities Department in Mumbai Office for this
purpose which will have institution-wise subsidiary records of the securities
sold under Repo and securities bought under Reverse Repo. The RBI will
have Subsidiary Accounts in the case of both of these Accounts.
iii. Upon successful auctions in Repos, the tenderer’s RC SGL Account will be
credited with the required quantum of securities debiting the Bank’s
Subsidiary Account/Investment Account. Likewise, the tenderer’s Current
Account will be debited for the resultant cash flows and credited to the
Bank’s Account. The transaction will be reversed in the second leg.
iv. In the case of Reverse Repos, on acceptance of bid, the tenderer’s SGL
account/RRC SGL Account will be debited with the required quantum of
securities and credited to Bank’s Investment Account/Subsidiary RRC SGL
Account. Accordingly, the tenderer’s Current Account will be credited with
the Reverse Repo amount, debiting the Bank’s account. The transactions will
be reversed in the second leg.
63
v. Transactions between the RBI and the counterparties including operation of

the RC SGL Account and RRC SGL Account would not require separate
SGL forms as provision will be made in the application form for the purpose.
Likewise, transfer of securities from/to the RBI’s Investment Account and
Subsidiary Accounts in the Repo and Reverse Repo SGL account will not
require signing of SGL transfer forms. However, transfer from tenderer’s
SGL Account to the RRC SGL Account will require completion of SGL
form. In the case of Reverse Repos, tenderers will have the option to either
use the RRC SGL Account route or get their SGL Accounts debited for the
purpose of transferring securities to the RBI.
vi. All securities including Treasury Bills will be priced at face value for
Repo/Reverse Repo operations by the RBI. Accrued interest as on the date of
transaction will be ignored for the purpose of pricing of securities. Coupon, if
any, will be transferred to the RBI in the case of Repos, and the RBI will
collect the coupon, if any, on the due date and credit the same to the party’s
Current Account in the case of Reverse Repos.
ELIGIBILITY
All Scheduled Commercial Banks (excluding Regional Rural Banks) and Primary
Dealers (PDs) having Current Account and SGL Account with the RBI, Mumbai
will be eligible to participate in the Repo and Reverse Repo auctions.
Minimum Bid Size
To enable participation of small level operators in LAF and also to add further
operational flexibility to the scheme, the minimum bid size for LAF is being
reduced from the existing Rs.10 crore to Rs.5 crore and in multiples of Rs.5 crore
thereafter.
Eligible Securities
Repos and Reverse Repos will be undertaken in all transferable Government of
India dated Securities/Treasury Bills (except 14 days Treasury Bills).
Margin Requirement
A margin will be uniformly applied in respect of the above collateral securities
comprising the Government of India dated securities/Treasury bills. The amount of
securities offered or tendered on acceptance of a bid for Rs.100 will be Rs.105 in
terms of face value.
Settlement of Transactions
The settlement of transactions in the auction will take place on the same day.
SLR AND SECURITIES HELD IN REPO SGL ACCOUNT
Securities held by the RBI on behalf of banks’ Repo Constituents’ SGL account
and credit balance in the RRC SGL Account will be counted for SLR purpose and
a certificate will be issued to banks by the RBI on a fortnightly basis. As far as
valuation etc., for SLR purpose is concerned, extant DBOD instructions will apply.
DISSEMINATION OF INFORMATION
For a smooth transition to full-fledged operation of LAF, banks and PDs are being
provided a back-stop facility at variable rate of interest, as a cushion over the
normal liquidity facility at Bank Rate. Along with the auction results, the rate of
interest applicable to the back-stop facility for the concerned day will also be
announced for the benefit of the participants who wish to avail of such facility.
Further, to facilitate better bidding by the participants, additional information on
the aggregate cash balances of scheduled commercial banks maintained with the
RBI, during the fortnight, on a cumulative basis with a lag of two days as also
weighted average cut-off yield will also be released as a part of the press release
on money market operations.
64
Money Markets
TERM MONEY MARKET

Term money market is the interbank market of more than 14 days maturity. This
market is also affected by the reserve requirements of the banks. The RBI has
taken two initiatives to develop the market.
The All India Financial Institutions can take loans from the permitted lenders. The
criteria of the banks and financial institutions, which participate in this market is
such that there are no defaults in the market. The deposits are non-transferable and
non-negotiable and the interest rate on the deposits is settled by the participants.
These deposits improve the depth of the market and increase the scope of the
banks to invest their short-term money in the market.
The removal of reserve requirements on the interbank borrowings except a
minimum CRR of 3% has enabled the banks to finance their requirements up to a
period of 3 months. The Inter Bank Deposit rates are determined after comparison
with other market rates and adjusted to the CRR factor.
With these two initiatives the call market was stabilized as the fund requirements
for more than 15 days are financed through the Inter Bank Deposits in this
market.
CALL MARKETS IN OTHER COUNTRIES

Two markets which form the call money market in the USA: (a) Federal funds
market (b) Call money market.
FEDERAL FUNDS MARKET
Federal funds are defined as money available for immediate payment. The
principal source of immediately available money is the reserve balance. This is the
balance which each bank maintains at the Federal Reserve Bank in its region of the
United States. Hence, this market was termed as federal funds market. Funds are
transferred from one bank to the other only through the Federal Reserve Bank.
These funds are readily transferred into the appropriate reserve account
immediately through the computer. The duration of a federal funds transaction is
usually one day (overnight) and it is extended if necessary.
Participants
Savings and loan associations, credit unions, and savings banks maintain deposits
with commercial banks or with the Federal Reserve banks, which are made
available for immediate transfer to a customer or to another financial institution on
need basis. Business corporations and state and local governments lend federal
funds by executing repurchase agreements with securities dealers, banks and other
funds traders.
Borrowers of federal funds include securities dealers, corporations, state and local
governments and non-bank financial intermediaries such as savings and loan
associations and insurance companies.
Purpose
Banks and other depository institutions must hold liquid assets in a special reserve
account, equal to a certain fraction of the funds with Federal Reserve Bank. Supply
of federal funds arises because some member banks have reserves on a given day
in excess of reserve requirement. Demand for funds arises as other member banks
on the same day have reserve deficits, which are generally transferred from one
depository institution to another when required. Apart from the commercial banks,
the savings and loan associations, credit unions, savings banks, securities dealers
and non-bank financial intermediaries borrow from this market. Though the fed
funds are borrowed by many other users, this instrument is mainly used by
commercial banks to maintain legal reserves with Federal Reserve Bank.
65
Operational Mechanism
The funds are transferred readily by telephone, online computer or by wire, from
one account to the other after securities are purchased or whenever a loan is
granted.
Federal funds transactions take the following forms. If both institutions have
Federal Reserve (lender and the borrower) bank accounts, they may instruct the
Federal Reserve to transfer funds from the account of the lender to the account of
the borrower over Fedwire, the wire-transfer system of the Federal Reserve. Either
of the party may initiate the transaction. Alternatively, another institution
(respondent) may maintain an account with an institution, which acts as a federal
funds broker (correspondent). In such a case, the respondent bank informs the
correspondent of its desire to sell federal funds, at which point the correspondent
reclassifies the respondent’s balance from demand deposits to federal funds
purchased. The correspondent frequently resells the funds to a third party in the
market. At times, if the transacting institutions/banks, both are not located within
the same Federal Reserve district, then, the two Federal Reserve banks are
involved in the transfer of funds. In such a case, loan transaction proceeds in much
the same way except that two Federal Reserve banks are involved.
Interest Rates on Federal Funds
The federal funds interest rate is highly volatile every day; it tends to be most
volatile towards the close of the reserve maintenance period, depending on
whether larger banks are flush with or short of reserves. There are no seasonal
patterns/fluctuations with which the funds rate tends to rise or fall.
Government Policy towards Federal Funds Market
This market is riskless and it is easy to invest excess reserves for short periods and
still earn some interest income. It is basically a daily management of daily bank
reserves, and credit can be obtained in a matter of minutes to cover emergency
situations. Fed funds serve the principal means of payment for securities and loans,
and the funds market transmits the effects of Federal Reserve Monetary Policy
quickly throughout the banking system.
Traditionally, the call money market comprises an interbank call market, and the
market between banks on the one hand and security brokers and dealers on the
other hand, but call money in the US market performs a different function. The
call loans represent short-term loans by banks to security brokers and dealers for
the purpose of financing their customers’ purchases of common stock. Bank loans
to dealers in government securities also form part of the call loans. These loans are
secured loans and the call provision allows the termination of the loan by either the
lender or the borrower on one day’s notice. Similarly, dealers in securities obtain
loans from non-financial corporations, miscellaneous lenders such as state and
local governments, foreign institutions, and insurance companies. This type of call
money market does not exist elsewhere except in the US. This market forms a part
of capital market rather than money market, as the money that is pooled here is
lent to invest/purchase the common stock. Since the money does not roll into
money markets, federal markets in international markets are known for high
liquidity and returns.
In the UK, the call money market consists of interbank loans, loans by the clearing
banks to the discount house (given on call basis) and surplus/deficit positions
between the clearing houses before approaching for final settlement with the Bank
of England (central bank of the country). This market is more similar to the
American market than to the Indian market.
66
Money Markets
SUMMARY
• The call money market is the part of the money market where the surplus
funds of the banks are traded on a daily basis. Borrowers use funds to match
short-term mismatches of assets and liabilities and to match the CRR
requirements. This market is a measure of the liquidity of the overall money
market.
• Maturity period varies from 1 to 7 days.
• Money that is lent for a day is called overnight money.
• All private sector, public sector and co-operative banks, term lending
institutions, insurance companies and mutual funds participate in this market.
Primary dealers, DFHI and STCI can participate only in the local call money
markets.
• Interest paid on call loans is known as call rates and is calculated on a daily
basis.
• Call money markets are located in the cities that have the major stock
exchanges in India, namely, Mumbai, Kolkata, Delhi, Chennai and
Ahmedabad. Mumbai has the largest market in India.
• The RBI acts as a regulator of the call money market, but neither borrows
from nor lends to it. It uses repos and open market operations to control the
market.
• An efficient call money market should be less volatile and provide an
opportunity to the players to transact at comparatively stable rates of interest.
67
Appendix
Prudential Limit for Transactions in Call/Notice Money Market
&7 &
)& 6 8 / 0 6 8 / 0
/ )11 *-
8 8 & &0 8 8 : 0/
8( # ( ## 8 8 -1
/ & 9 0 8 8
/ / 0 8 &
8 )*- 8
8 0
8 &
*& / 7 &
;
; </ &
;
/ *&1
8
% 8
8 &
+& / 0 ;
8 0
*11 8 7 6 8 0 *- 8
$ 76$ % 8 76$&
8 &
,& $ # 0
-& # 8 0 )1 8
;
.& % $ *111 1)
7 & 88 8 ' .0 *11-0 /
/
8
; &
Source: RBI/2005-06/14.Ref.MPO.No.269/07.01.279/2005-06. 01/07/2005.
I. List of Institutions Permitted to Participate in the Call/Notice Money
Market both as Lenders and Borrowers as on July 1, 2005
a. All Scheduled Commercial Banks (excluding RRBs).
b. All Co-operative Banks other than Land Development Banks.
c. All Primary Dealers (PDs).
Primary Dealers are:
1. SBI – Discount and Finance House of India Ltd.
2. Securities Trading Corporation of India Ltd.
3. PNB Gilts Ltd.
4. Gilt Securities Trading Corporation Ltd.
5. ICICI Securities and Finance Company Ltd.
6. ABN Amro Securities (India) Pvt. Ltd.
7. J.P. Morgan Securities India Pvt. Ltd.
8. Kotak Mahindra Capital Company (Unlimited)
9. DSP Merrill Lynch Ltd.
10. Deutsche Securities (India) Pvt. Ltd.
11. IDBI Capital Markets Services Ltd.
12. Corpbank Securities Ltd.
68
Money Markets
13. HSBC Primary Dealership (India) Pvt. Ltd.

14. Bank of America Securities Pvt. Ltd.
15. Standard Chartered - UTI Securities India Pvt. Ltd.
16. BOB Capital Markets Ltd.
17. Citicorp Capital Markets Ltd.
II. List of Institutions Permitted to Participate in the Call/Notice Money
Market only as Lenders as on July 1, 2005
A. Financial Institutions
1. Export Credit Guarantee Corporation of India Ltd.
2. Export Import Bank of India
3. Industrial Finance Corporation of India Ltd.
4. Industrial Investment Bank of India
5. National Bank for Agriculture and Rural Development
6. National Housing Bank
7. Small Industries Development Bank of India
8. Special Undertaking of Unit Trust of India
9. Tourism Finance Corporation of India.
B. Insurance Companies
1. General Insurance Corporation of India
2. ICICI Prudential Life Insurance Co.
3. Life Insurance Corporation of India
4. National Insurance Co.
5. New India Assurance Co.
6. Oriental Insurance Co.
7. Royal Sundaram Alliance Insurance Co. Ltd.
8. United India Insurance Co.
9. IFFCO -TOKIO General Insurance Co. Ltd.
C. Mutual Funds
1. Alliance Capital Mutual Fund
2. BOB Mutual Fund
3. BOI Mutual Fund
4. Birla Mutual Fund
5. Canbank Mutual Fund
6. Chola Mutual Fund
7. DSP Merrill Lynch Mutual Fund
8. Escorts Mutual Fund
9. GIC Mutual Fund
10. HDFC Asset Management Co. Ltd.
11. IDBI Mutual Fund
12. IL and FS AMC Mutual Fund
13. ING Assets Management
14. JM Capital Management
15. Jardine Fleming Mutual Fund
69
16. Kotak Mahindra Mutual Fund

17. LIC Mutual Fund
18. Morgan Stanley Mutual Fund
19. PNB Mutual Fund
20. Prudential ICICI Mutual Fund
21. Reliance Capital Mutual Fund
22. SBI Mutual Fund
23. Sriram Mutual Fund
24. Sun F & C Mutual Fund
25. Sundaram Mutual Fund
26. Tata Mutual Fund
27. Taurus Mutual Fund
28. Templeton Mutual Fund
29. UTI Mutual Fund
30. Standard Chartered Mutual Fund
31. SBI Offshore Mutual Fund.
Report of the Technical Group on Phasing Out of Non-banks from
Call/Notice Money Market (March 2002)
Introduction
The call/notice money market is the most important segment in the Indian money
market. In this market, while banks and Primary Dealers (PDs) are allowed to both
borrow and lend, non-bank participants such as financial institutions, mutual funds
and select corporates are permitted to only lend. Though non-bank participants
holding current account and SGL account with the RBI are permitted to undertake
both repo and reverse repo, the ease of transactions as well as low transaction costs
arising from least documentation and same day settlement of funds in call/notice
money market act as strong incentives for non-bank participants to prefer the latter
to the former. This is impeding the development of a risk-free short-term yield
curve and, hence, the pricing in other segments of the debt market. Therefore, a
“basic restructuring of call money market” to make it a pure interbank market, as
put forward by the Report of the Committee on Banking Sector Reforms (1998),
was considered necessary. Towards this end, the Reserve Bank of India (RBI) has
already initiated a number of steps to widen the repo market in terms of increasing
the eligible securities and participants. While there is a consensus that complete
withdrawal of non-bank participants from the call/notice money market
(henceforth, only call money market for convenience) should be co-terminus with
full fledged operationalization of the Clearing Corporation, it is felt that during the
intermediate period, their operations should be phased out in such a manner that
their migration to repo/reverse repo market becomes smooth and there is no
disruption in the call money market. In order to accomplish this restructuring
process, the mid-term review on Monetary and Credit Policy in October 2000
indicated that a Technical Group comprising officials from both banks and
non-banks should be constituted in order to suggest ways for planned reduction in
access by non-bank participants to call money market such that their transition to
repo market become smooth. Following this, a Technical Group was constituted by
Dr. Y.V. Reddy, Deputy Governor with appropriate representations from banks,
non-banks and the RBI on December 9, 2000.
70
Money Markets
The Report is organized in four Sections. While Section I discusses

recommendations of the three committees with regard to participation of
non-banks in call money market followed by international experiences in this
regard, Section II analyzes the typical characteristics of Indian call money market.
Section III delineates the circumstances in which the non-bank participants were
allowed entry into the call money market during 1990s despite recommendations
to the contrary by the Working Group on the Money Market (Chairman: N Vaghul)
in 1987 as discussed in Section I. This Section also discusses the shift in stance of
the RBI during the later part of 1990s and the efforts made by it to phase out
non-bank participants from the call money market since then. Finally, Section IV
presents policy perspectives and recommendations of the Technical Group.
Section I
Recommendations of Three Committees
The issue of whether non-bank participants should constitute part of
call/notice/term money market could be traced to the Report of the Committee to
Review the Working of the Monetary System (Chairman: S Chakravarty) in 1985.
Since then, the Report of the Working Group on the Money Market (Chairman: N
Vaghul) in 1987 and the Report of the Committee on Banking Sector Reforms
(Chairman: M Narasimham) in 1998 had also deliberated on this issue. It needs to
be appreciated that the particular set of recommendations from these three
Committees have to be assessed against the specific objectives for which these
Committees had been constituted as well as the differing initial conditions
reflecting the state of Indian financial market which were prevailing at that
particular point of time.
The Chakravarty Committee (1985) viewed this issue essentially from the angle of
efficacy of monetary regulation by the Central Bank. It felt that allowing
additional non-bank participants into the call market would not dilute the strength
of monetary regulation by the RBI as resources from non-bank participants do not
represent any additional resource for the system as a whole and their participation
in call money market would only imply a redistribution of existing resources from
one participant to another. Therefore, the monopoly power to affect the system’s
reserves continues to rest with the RBI. In view of this, the Chakravarty
Committee recommended that additional non-bank participants may be allowed to
participate in call money market.
The Vaghul Committee (1987) on the other hand suggested that call money market
should be purely an interbank market and therefore, the restrictions on entry into
call market prevailing at that point of time should continue. The essential rationale
for such recommendation was that freedom to enter into the call market coupled
with allowing call money rates to be determined entirely by market forces at a time
when deposit rates of banks were administered would lead to, substantial diversion
of funds from the bank deposit segment to the call money market segment. This
could markedly raise the cost of funds to banks. Therefore, while the Vaghul
Committee decided in favor of making the call money market a pure interbank
market, it felt that LIC and UTI which had been permitted to operate as lenders in
the market would gradually come out of the market as other money market
instruments developed with wider array of maturities.
The Narasimham Committee II (1998) concurred with the Vaghul Committee that
call/notice/term money market in India, like in most other developed markets,
should be strictly restricted to banks. It, however, felt that exception should be
made for Primary Dealers (PDs) who have been acting as market makers in the
call money market and are formally treated as banks for the purpose of their
inter-bank transactions and, therefore, they should remain as part of the call money
market. With regard to non-banks, it expressed concern that these participants “are
not subjected to reserve requirements and the market is characterized by chronic
lenders and chronic borrowers and there are heavy gyrations in the market”. It felt
that allowing non-bank participants in the call market “has not led to the
71
development of a stable market with liquidity and depth ……… and the time has
come to undertake a basic restructuring of call money market”. Like the Vaghul
Committee, it had also suggested that the non-bank participants should be given
full access to bill rediscounting, Commercial Paper (CP), Certificates of Deposit
(CDs), Treasury Bills (TBs) and Money Market Mutual Funds (MMMFs) for
deploying their short-term surpluses.
International Experiences
USA
Federal funds market in USA is the counterpart of the call/notice money market in
India. In this market, only those depository institutions that are required by the
Monetary Control Act of 1980 to hold reserves with the Federal Reserve Banks are
permitted to borrow. These include commercial banks, savings banks, savings and
loan associations and credit unions. Non-bank participants such as corporates, state
and local governments are prohibited from participating in the federal funds
market directly. They supply funds to the overnight market through repurchase
agreements (RPs) with their banks. Banks’ borrowings from federal funds market
as well as from RPs are free of reserve requirements. It is found that RP rates
closely follow the federal funds rate with the former being lower than the latter as
RP market is collateralized and, therefore, safer than the federal funds market and
RP involves additional transaction costs in the form of documentation.
It was found that as resources raised under RPs were free of reserve requirements,
banks attempted to minimize their burden of reserve requirements by raising more
resources through the RP avenue vis-á-vis deposits thereby reducing the volume of
required reserves that banks had to hold with the Federal Reserve Banks. This in
turn reduced the size of the Federal Reserve Banks’ balance sheet and, therefore,
reduced the interest payments that it could transfer to the US Government. In order
to obviate this situation, the Federal Reserve Board passed a resolution in 1969
restricting the collateral to be used for RPs to only direct obligations of the US
Government or its agencies. This somewhat offset the revenues that are likely to
be lost due to reduced volume of reserves held by banks.
France
Initially, some non-bank entities were allowed in the money market which were
able to obtain a market rate of return on their investments. These non-bank entities
included insurance companies, pension funds, stock brokers’ boards, etc. In order
to encourage the spread of negotiable securities among the public as well as to
restrict the access to the market (for “central bank money”) the authorities favored
the creation of a pure interbank money market accessible only to credit
institutions. The non-bank entities who are no longer part of the interbank money
market have moved to the repo market as well as sales of negotiable securities as
part of their short-term liquidity management. The authorities felt that this sort of
restructuring of the market should help in fostering development of short-term
securities in the economy.
Among emerging economies also, overnight money markets in countries like
Singapore, Malaysia and Thailand have only banks as participants.
Section II
Characteristics of the Indian Call Money Market
As indicated above, call money is the most important segment of the Indian
financial system. It consists of overnight money and money at short notice for a
period of up to 14 days. The call money market essentially serves the purpose of
equilibrating the short-term liquidity position of banks and other participants. It is
also the focal point through which the RBI attempts to influence the short-term
interest rates. Its average daily turnover at more than Rs.40,000 crore in recent
72
Money Markets
period is the highest among all money market instruments including Government
securities market. In this market, while banks and Primary Dealers (PDs) are
allowed to both borrow and lend, non-bank participants such as financial
institutions, mutual funds and select corporates are permitted to only lend. The
demand for funds in this market is mainly governed by the banks’ need for
resources to meet their statutory reserve requirement; it also offers some
participants a regular funding source to build-up short-term assets. It is, however,
felt that the demand for funds for reserve requirements dominates any other
demand in the market. Viewed from this angle, it may be noted that total reserves
transacted (i.e., aggregate borrowings) in the call money market as proportion of
aggregate cash balances maintained by commercial banks with the RBI, on
average, ruled around 32 percent in the recent period.
As regards the number of participants, apparently the market is very broad based
as on the borrowing side, there are as many as 169 participants (banks – 154 and
PDs – 15) while on the lending side, apart from these 169 participants, there are
additional 105 participants taking the total to 274 (Table A1).
! " # $$ %
$# %$ (
#& )-, )- " " " ).3
##& )-, )- *1 +- -1 *4,
A typical characteristic of this market is that except PDs who are participating in
both sides of the market, there is hardly any bank that operates both as a borrower
and lender simultaneously on any given day. It is generally found that public
sector banks with their vast branch network in the country are generally the
supplier of funds in the market while foreign and private sector banks with their
urban-centric structure coupled with their relatively advanced treasury operations
are regular borrowers in the market.
Keeping this in perspective, the overall shares of various constituents based on
their daily transactions during the last two years are as follows:
&"
) * + ,
= 6
)333 .2 +* -* )) +4
*111 .. +, ,- )) ,,
& $ 8 / &
/& >6 ? 8 0 8 &
An analysis of participant-wise shares in both borrowings and lendings in

call/notice money market reveals a highly skewed nature of the market. On the
lending side, State Bank of India (SBI) is the largest participant accounting for as
much as 15 percent in 1999 which, however, declined to 13 percent in the
following year (Table A3). On the whole, four public sector banks and five
Financial Institutions (FIs) supplied to the tune of 38 percent of the aggregate
supplies of funds in the market in 1999 which dropped to 31 percent in 2000. What
is important to note here is that though there are as many as 274 participants
(Table A1) who are eligible to lend in the market, there are only 9 participants as
indicated above who control about one-third of aggregate lendings in the market.
73
' &" & ( )
= $# (
)333 *1 )- )2 +2
*111 )4 )+ ), +)
Source: Banks : Canara Bank, Central Bank, PNB and SBI.
$# ! # # #0 # #0 # 0 # # <(#&
8 8 #&
Similarly, on the borrowing side, the shares of only ten foreign and private sector
banks accounted for as much as 36 percent of aggregate borrowings in 1999 which
increased further to 39 percent in the following year (Table A4).
* &" & + + ,
=
)333 +.
*111 +3
Select banks include ABN-AMRO Bank, Bank Nationale De Paris, Centurion
Bank, Citi Bank, Deutsche Bank, Grindlays Bank, HDFC Bank, Hongkong Bank,
IDBI Bank and Standard Chartered Bank.
From this analysis, it needs to be noted that though apparently the market is quite
broad based, in reality, it is quite lopsided in both borrowing and lending
segments. In other words, despite the market having the highest turnover in Indian
money market, it lacks depth and liquidity as absence of one or two major
participants in either of the segments may have the potential to cause sharp
volatility in the market. This not only impairs efficient price discovery process in
the market, but also necessitates more active liquidity management practices by
the RBI in order to keep interest rates within a reasonable corridor.
Section III
Position since 1990s
Following the freeing of interest rates in call money market in June 1989, there
had been bouts of extreme volatility in call rates on many occasions during
1989-90. Despite the Vaghul Committee recommendation that call money market
should be made purely an interbank market, with a view to reduce volatility and
widen the market, the policy relating to the entry into the call/notice money market
was gradually liberalized since 1990. In May 1990, three more financial
institutions (viz., GIC, IDBI and NABARD) besides LIC and UTI were permitted
to participate in the call/notice money market as lenders. In October 1990, with a
view to further widen the call/notice money market and to bring about a greater
integration in various segments of the money market, all the participants in the
Bills Rediscounting Scheme who were not operating in the call/notice money
market till then, were granted entry as lenders. Subsequently, eight mutual funds
sponsored by public sector banks/financial institutions were also permitted to
participate in the call/notice money market as lenders.
In April 1991, the policy relating to entry in the call/notice money market was
further liberalized and it was decided to provide access as lenders to such entities
as were able to provide evidence to the RBI of bulk lendable resources. Such
entities were required to observe a minimum size of operations of Rs.20 crore per
transaction and such transactions were to be routed through Discount and Finance
House of India (DFHI) only. Furthermore, such entities were also required to give
an undertaking that they had no outstanding borrowings from the banking system.
In April 1997, the facility of routing transactions by these entities was extended
74
Money Markets
to all the PDs as against only DFHI earlier. The minimum size of operations was
also reduced from Rs.20 crore to Rs.10 crore and ultimately to Rs.5 crore and
finally to Rs.3 crore in October 1997 and in May 1998 respectively. Consequent
upon the relaxations granted to entities for routing call transactions, the number
of entities routing their call transactions through PDs rose sharply. At present,
there are 50 such entities.
Earlier only the public sector mutual funds were allowed to operate as lenders in
the call/notice money market but with a view to facilitate a level playing field, it
was decided in April 1995 to provide access to mutual funds set-up in the private
sector and approved by the Securities and Exchange Board of India (SEBI) also as
lenders in the call/notice money market after these entities obtained specific
permission from the Reserve Bank. In 1996, 4 primary dealers, in addition to
DFHI and STCI were permitted to operate both as lenders as well as borrowers in
the call/notice money market. As of now, the number of PDs has increased to 15.
As on July 01, 2005, there were 9 financial institutions, 9 insurance companies and
31 mutual funds are operating in the market as lenders, besides all scheduled
commercial banks, co-operative banks and primary dealers which operate as both
lenders as well as borrowers.
Shift in Stance in the RBI
There has been a change in policy stance regarding permission to non-bank
participants to operate in the call/notice money market. This issue was also
examined by the “Internal Group to Examine the Development of Call Money
Market” in 1997 which had observed that the call money market was an interbank
market the world over. Furthermore, when non-banks are allowed to participate in
the call money market, it partly distorts the signals of liquidity conditions in the
system. Analysis done by the group revealed that intermediate lenders in call
money were in a position to exploit the situation of tight money conditions and
dictate terms to the banking system thereby causing undue volatility in the
call/notice money market. The view was that non-bank institutions should instead
be allowed to deploy their short-term funds in alternative money market
instruments like Repos, Money Market Mutual Funds (MMMFs) and Certificates
of Deposit (CDs), etc., and until these markets develop, the existing non-bank
participants may be allowed to continue in the call money market.
Similarly, following the recommendations of the Narasimham Committee II
(1998), the general consensus of members of the Standing Committee on Money
Market (which was since reconstituted as Technical Advisory Committee on
Money and Government Securities Markets) was that ultimately we should move
towards a pure interbank market along with only primary dealers, and in the
meantime steps should be taken to widen the repo market and increase non-bank
participation in other money market instruments.
Accordingly, in the “Mid-Term Review of Monetary and Credit Policy for 1998-99”
announced in October 1998, the Reserve Bank indicated its intention to ultimately
move towards a pure inter-bank call/notice/term money market including PDs. It
was indicated that measures would be taken simultaneously to widen the repo
market and improve non-bank participation in a variety of other instruments and
this would be implemented in a manner that existing lenders in the market would
have operational flexibility to adjust their asset-liability structures.
It was decided, as a first step, that permission only to non-bank participants for
routing their call transactions through PDs be withdrawn and other non-bank
institutions (financial institutions and mutual funds) be allowed to continue in the
call/notice money market until such time the other avenues for short-term
deployment of funds are available. Accordingly, in April 1999, it was indicated
that permission given to non-bank entities to lend in the call/notice money market
by routing their transactions through PDs would be available only up to
end-December 1999. This permission was, however, extended in stages up to
June 2001.
75
Simultaneously, the Reserve Bank has taken several steps to widen the
participation in repo market as indicated below:
i. Following the amendment to the Securities Contract (Regulations) Act,
1956 (SCRA) in March, 2000 delegating regulatory powers to the RBI to
regulate, inter alia, dealings in Government securities and money market
securities, all those non-bank entities maintaining current account and SGL
account with the RBI, Mumbai had been permitted to undertake both repo
and reverse repo.
ii. Minimum maturity for repo transactions was reduced to 1 day.
iii. State Government securities have been made eligible for undertaking repos.
iv. The RBI also opens its purchase window to impart liquidity to Treasury Bills
whenever the situation warrants.
v. Clearing Corporation is being set-up for money and securities settlement.
In addition to the above, the minimum period for transferability in case of
Certificates of Deposit has recently been abolished. This would provide an
additional avenue to non-banks to lend short-term funds to the banking system.
Section IV
Policy Perspective and Recommendations
The Technical Group appreciated the need for non-banks to be phased out of the
call/notice money market in the interest of development of a risk-free short-term
yield curve in the economy. Towards this end, the Group concurred fully with the
view expressed by Dr. Y.V. Reddy, Deputy Governor of the RBI that complete
withdrawal of non-banks from call money market should be co-terminus with the
full fledged operationalization of the Clearing Corporation. Keeping this in
perspective, the Group deliberated on various suggestions in order to achieve a
smooth transition to the repo/reverse repo market. These suggestions broadly relate
to call money market and Government securities market including repo market.
Call Money Market
With regard to gradual phasing out of access to call money market by such
non-bank participants as financial institutions and mutual funds, the Group
recommends that such access may be reduced in three stages by placing cap in
relation to their average daily lendings during April 2000 – March 2001. In the
first stage, each such non-bank participant should be allowed to lend only up to
70 percent of their average daily lendings in call money market during 2000-2001
for a period of three months which should come into effect at the earliest after
March 31, 2001. In the second stage, access should be reduced further to
40 percent of their average daily lendings during 2000-01. The final stage should
commence with the setting up of Clearing Corporation or after a period of three
months from the conclusion of the second stage whichever is later. The final stage
by which time the Clearing Corporation is expected to be established should last
for a period of three months. During this phase, the Group feels that access to call
money market should be permitted to these participants to the extent of 10 percent
of their average daily lending during 2000-01. This is considered necessary to
enable these particular classes of non-bank participants to be familiar with the
operations of the Clearing Corporations. After the end of this stage, these entities
would not be permitted to lend in call money market at all.
The Group appreciates that there is a strong need to gradualize the process of
phasing out non-banks from the call money market for ensuring their smooth
transition to the repo market as has been indicated above. However, there is a
consensus that among the non-bank participants, select corporates who route their
funds through PDs may be withdrawn immediately as these entities could always
place their funds with PDs through the Inter-corporate Deposits (ICDs) route.
Accordingly, the Group recommends that corporates lending in call money market
should not be permitted to lend after end-June 2001.
76
Money Markets
Government Securities/Repo Market

With the phasing out of non-bank participants from call money market to
repo/reverse repo market, it is expected that the latter would emerge as a vibrant
short-term money market for both banks and non-banks. In fact, it is envisaged
that in future, both call money market and repo/reverse repo market would
constitute a unified market to equilibrate short-term funds positions for both banks
and non-bank participants because repo/reverse repo (henceforth, it is indicated as
repo market for convenience unless otherwise stated) market would afford both
borrowing and lending facility to non-bank participants. However, during the
intermediate period, it is apprehended that funds flow between these two markets
may not be as smooth as one expects it to be eventually. This is because
distribution of surplus liquidity and that of surplus securities over Statutory
Liquidity Requirements (SLR) in the banking sector are such that those who are
persistent borrowers in the market (i.e., foreign and private sector banks) do not
maintain sufficiently large volume of surplus securities in their portfolio (Table 5)
so as to enable them to borrow easily from the repo market.
Table A5: Distribution of Excess SLR Securities among Categories of Banks
&
@ 8 ' 9
8A (
)333 *111 )333 *111

)& #@ *20+*, +-041+ +.&, +4&+
*& 7 B +30+-- ,.0,-- -1&. ,2&-
#@
+& .01-, 204,3 4&2 3&)
,& $ ,0*)3 ,02)3 -&, -&1
( 4403-* 3-04*. )11 )11
$ 0 C /
*- 8> / 6 ?8 8/ &A
/ 8 ># @ ' ? C
&
It may be worthwhile to note that while the average daily aggregate lending in call
money market by non-bank participants stood at Rs.7,672 crore during the years
1999 and 2000, average net borrowings by banks and PDs were Rs.3,488 crore and
Rs.4,184 crore, respectively, during the period. As against this, the average surplus
securities available with the foreign and private sector banks were at Rs.11,920
crore of which the average volume of surplus securities with foreign banks was at
Rs.4,519 crore during the period. Moreover, a part of securities held by PDs would
also be available for undertaking repo transactions. Again, since these classes of
entities are also more active in trading in Government securities market, the
effective volume of surplus securities available for repo for borrowing of funds
would be lower for them. While the Group is aware that chronic borrowers should
need to reduce their call money borrowing keeping in view the Asset-Liability
Management (ALM) guidelines, it is generally perceived that these borrowers
could face some transition problems. However, considering the fact that non-bank
participants such as financial institutions and mutual funds would be permitted to
lend up to 70 percent of their average daily lending during 2000-2001 for three
months in the first phase, it is expected that market participants on both lending
and borrowing sides would have sufficient time to adjust their portfolios
accordingly without any disruption in the market. Moreover, with the
establishment of Clearing Corporation, repo operations would not only become
more efficient and the need for securities would be relatively less, it would also be
possible to undertake repo transactions in non-Government securities. Non-bank
participants under the new set-up may also like to build-up a portfolio of repoable
securities for meeting their occasional short-term borrowing needs over time.
77
This may represent an additional demand in the debt market including Government
securities. Eventually, it is envisaged that since call money rates would be higher
than the repo rates, banks with surplus SLR securities may act as conduits for
funds from the repo market to call market.
Under the ambit of the Clearing Corporation, rollover of securities in repo
transactions would also become possible (provided it is not considered a short
sale). Similarly, the Group feels that securities obtained under reverse repo may be
allowed to be used for undertaking repo. These apart, at present repo is permitted
only at Mumbai. Such activities may be allowed in other centers as well. The
Group feels that since repo market will attract larger volume of transactions in the
wake of phasing out of non-bank participants from the call money market, there is
a strong need to introduce a master repo agreement with uniform documentation
and accounting standards. The Group, however, appreciates that such an effort is
underway under the aegis of the Fixed Income Money Market and Derivatives
Association of India (FIMMDA). Though non-bank participants are allowed to
invest in all other money market instruments with a much wider array of
maturities, the Group has suggested that floating stock of Treasury Bills
particularly at the shorter end may be increased for providing an additional avenue
to non-bank participants for deploying their short-term surplus funds.
78
•
•
•
• ! " #
• $ ! "
INTRODUCTION
Corporate short-term requirements are met through raising short-term funds with
various instruments like CPs, Bill Finance, CDs, etc., and long-term needs through
equity and long-term debt. Similarly, government issues Treasury bills (T-bills)
and dated securities as a means to raise funds, in short-term and long-term markets
respectively. T-Bills constitute a major portion of short-term borrowings by the
Government of India.
FEATURES OF TREASURY BILLS

Treasury Bills are short-term, rupee denominated issued by the Reserve Bank of
India (RBI) on behalf of the Government of India. T-bills are issued in the form of
promissory notes or finance bills (a bill which does not arise from any genuine
transaction in goods is called a finance bill) by the government to tide over
short-term liquidity shortfalls.
These short-term instruments are highly liquid and virtually risk-free. They are the
most liquid instrument after cash and call money, as the repayment guarantee is
given by the central government.
Treasury bills do not require any grading or further endorsement like ordinary
bills, as they are claims against the Government. These instruments have distinct
features like zero default risk, assured yield, low transactions cost, negligible
capital depreciation and eligible for inclusion in SLR and easy availability, etc.,
apart from high liquidity.
ISSUER
The Reserve Bank of India acts as a banker to the Government of India. It issues
T-bills and other government securities to raise funds on behalf of the Government
of India, by acting as an issuing agent.
INVESTORS
Though various groups of investors including individuals are eligible to invest, the
main investors found in treasury bills are mostly banks to meet their Statutory
Liquidity Ratio (SLR) requirements. Other large investors include:
• Primary Dealers,
• Financial Institutions (for primary cash management),
• Insurance Companies,
• Provident Funds (PFs)(as per investment guidelines),
• Non-banking Finance Companies (NBFCs),
• Foreign Institutional Investors (FIIs), and
• State Governments.
NRIs and OCBs are also allowed to invest but only on non-repatriable basis. The
RBI issues both bids on competitive and non-competitive basis. Eligible Provident
Funds (i.e., the non-government provident funds governed by the Provident Fund
Act, 1925 and employees PFs and Miscellaneous Provisions Act, 1952 whose
investment pattern is decided by Government of India), State governments, and the
Nepal Rastra Bank can participate in the auctions on ‘non-competitive’ basis. The
scheme of non-competitive bidding to encourage mid-segment investors like
individuals, HUFs, PFS, UCBs, NBFCs, Trusts, etc., to participate in the primary
market of government securities, were operationalized in January 2002.
All other participants excepting above mentioned investor classes participate in
competitive bidding.
80
Money Markets
PURPOSE
Treasury bills are raised to meet the short-term requirements of Government of
India. As the Government’s revenue collections are bunched and expenses are
dispersed, these bills enable the Government to manage cash position in a better
way. T-bills also enable the RBI to perform Open Market Operations (OMO)
which indirectly regulate money supply in the economy.
Investors prefer treasury bills because of high liquidity, assured returns, no default
risk, no capital depreciation and eligibility for statutory requirements.
Form
T-bills are issued either in the form of promissory note (or scrip) or credited to
investors’ SGL account. For every class, a standardized format is used. T-Bills are
issued at a discount and are redeemed at par.
Size
The treasury bills are issued for a minimum denomination of 91 day T-Bills is
Rs.25,000 while that of the 364-day. T-Bills Rs.1,00,000. The 91-day T-Bills
auction has a notified amount, while there are no notified amounts for 364 day
T-bills auction.
TYPES OF TREASURY BILLS

Treasury bills are issued at various maturities, generally up to one year. Thus, they
are useful in managing short-term liquidity. At present, the GOI (Government of
India) issues 3 types of T-bills viz., 91-day, 182-day and 364-day. In 1997, in
order to enhance the depth of the money market in India, the RBI decided to
introduce 14-day and 28-day T-bills. However, so far, only 14-day T-bills have
seen the light. Latter, the RBI had withdrawn the 14-day and 182-day T-bills
with effect from May 14, 2001. With effect from April, 2005, the Government
reintroduced 182-day TBs.
Yield
T-bills do not carry a coupon rate, but they are issued at a discount. Though the
yields on T-bills are less when compared to other money market instruments, the
risk averse investors and banks prefer to invest in these securities.
Yields on T-bills are considered as benchmark yields. It is considered as a
representative of interest rates in the economy in general, while arriving at an
interest rate or yield on any short-term instrument.
Considering the risk-free nature of T-bills all other instruments in money market
will have to provide for higher yields.
Illustration 1
The yield is calculated on the basis of 365 days a year. If the face value of a 364-day
T-bill is Rs.100, and if the purchase price is Rs.88.24 for a Treasury Bill, then the
yield is calculated as below:
Days x Yield Face Value
+1 =
365 Price
100 365
Yield = −1 x = 0.1336 = 13.36%
88.24 364
The T-bills can be categorized into three types based on the nature of issue.
AD HOC TREASURY BILLS
Ad hoc T-bills are issued in favor of the RBI when the Government needs cash.
They are neither issued nor available to the public. These bills are purchased by
RBI at discount and are held in its Issue Department and the RBI issues currency
notes against these bills to the Government if required, and bills are renewed at
maturity.
81
Ad hoc T-bills are issued to serve two purposes. Firstly, to replenish cash balances
of the Central Government and secondly, to provide a medium of investment for
temporary surpluses to State Governments, semi-government departments and
foreign central banks.
The RBI acts as a banker to the Central Government, hence, the Government needs
to maintain a minimum balance of Rs.50 crore on Fridays and Rs.4 crore on other
days free of obligation to pay interest thereon and further whenever the balance in
the account of the Government falls below the minimum agreed amount, the
account will be replenished by the creation of ad hoc Treasury Bills in favor of
Bank. Ad hocs have maturity period of 91-day and carry a discount rate of
4.6 percent. These bills can be extinguished before maturity.
The maximum incremental outstanding limit of T-bills at the end of the year
should be Rs.5,000 crore and within the year, the incremental ad hoc T-bills
cannot exceed Rs.9,000 crore for a period greater than ten consecutive days. In
case this is not adhered to, the RBI would automatically reduce the level of ad hoc
T-bills by auctioning them or selling fresh Government of India dated securities in
the market thereby, bringing down the level of ad hocs to the maximum level
permitted. This is essentially an arrangement between Central Government and
RBI and the actual operational aspects may vary from time to time. It is adequate
to state that this is essentially a mechanism through which the Central Bank (RBI)
funds the government.
T-bills have to be repaid by the government when it has adequate cash flows.
However, there was no compulsion that they have to be repaid. When they were
outstanding for more than 90 days, the RBI used to convert them into dated
securities. As the expenditure of the government always exceeded its income,
some amount of T-bills remain unpaid at the end of the year thus becoming a
permanent source to finance the budget deficit, which can lead to fiscal
indiscipline resulting in serious imbalances in the economy. As there was no limit
on the amount that can be raised by the government on its own, the government
itself decided to put a cap on it.
Consequently, the Union Budget 1994-95 stated that automatic monetization of
budget deficit through creation of ad hoc T-Bills would be phased out completely
over three years period with an objective to reduce inflation. Subsequently, a
limit on the issue of ad hocs was imposed under an agreement between the Union
Government and the RBI. The Union Government and the RBI have, therefore,
entered into an agreement to change the way the budget deficit is financed. The
agreement was signed in March 1997, bringing into existence the new system of
Ways and Means Advances (WMA) – replacing the system of ad hoc treasury bills.
Ways and Means Advances (WMA)
WMA is not a permanent source of financing government deficit. But, this is likely
to provide greater autonomy to the RBI in conducting monetary policy.
According to the agreement, the RBI will no longer monetize the fiscal deficit and
the government should borrow from the market to finance the fiscal deficit. But,
the RBI will extend the advances to the Central and State governments to tide over
temporary or short-term finance requirements which needs to be repaid in three
months. Drawals in excess of the WMA limit will be allowed for a maximum of
ten consecutive days. The RBI allows for three types of ways and means advances:
the clean WMAs (unsecured), the secured WMAs (which are secured against
central government securities) and the special WMAs which are allowed in
exceptional circumstances against the pledge of government securities.
82
Money Markets
The system of WMA broadly works as follows:

• The limit of WMA is decided in terms of mutual consultations between the
RBI and the central government.
• The interest charged up to the WMA limit would be three percent less than
the average implicit yield at the cut-off prices of 91-day T-bills in the
previous quarter and for the amount in excess of WMA limit, it is two
percent more than the normal rate.
• The interest rate is decided on, and can be altered by mutual agreement
between the RBI and the government.
The outstanding balance of WMA at the end of the year should be repaid by the
central government (it should be brought down to zero). If the balance remains
unpaid for more than two weeks after the end of year, the RBI converts the amount
into dated securities at the market rate of interest.
If 75 percent of limit is utilized, the RBI should initiate a fresh flotation of central
government securities.
! "#
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+ ( , ' % - .
. ( . $
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$ #- .% "$ /
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Source www.rbi.org.in / press release 2004-05/1024

ON TAP TREASURY BILLS (DISCOUNTED TREASURY BILLS)
The RBI issues discounted T-bills to investors on any working day. There is no
limit to the amount of investment in these types of securities. These types of T-bills
have a maturity of 91 days. The discount rate is around 4.6 percent and they are
redeemable at face value on maturity. These bills can also be rediscounted after a
minimum period of 14 days with the RBI. Generally the state governments, banks
and provident funds use these T-bills as a liquidity management tool as the RBI is
willing to rediscount at any point of time for any amount. These treasury bills are
discontinued with effect from 1st April, 1997 along with the ad hoc T-bills.
83
AUCTIONED TREASURY BILLS

The Government of India has decided to move towards a weekly auction system
for 91-day T-Bills from January, 1993. Auctions in respect of 14-day and 91-day
treasury bills are held on Fridays and payments in respect of allotments made on
Saturdays. In October, 2000, considering the request from the market participants,
the day of payment has been changed from Saturday to the next working day in
respect of both 14-day and 91-day Treasury Bills. However, this will be reviewed
after six months. On the other hand, 182-day and 364-day T-bills are auctioned
every alternative week on Wednesdays. The RBI issues a calendar of T-bill
auctions. Further, the RBI, by issuing press releases prior to every auction, also
announces the exact dates of auction, the auction amount and dates of payment.
The bids are tendered and accepted at the auction. As the participants in the
auction are the players in the market, the market perceptions about an acceptable
yield get reflected in this process. Then the yield on T-bills becomes more a
market determined one rather than a regulated one. The unsubscribed portion is
subscribed by the RBI at a cut-off rate, that is evolved in the process of auction.
The issuing procedure of auctioned T-bills are discussed below.
ISSUING PROCEDURE OF TREASURY BILLS

As discussed above, the RBI on behalf of central government, announces the
auctioning of T-bills by tender notification through the press. The bills are sold by
the RBI, Public Accounts Department (PAD), Mumbai, on an auction basis. The
date of auction and notified amount are announced by the RBI from time to time.
Though the tender is invited for competitive bids, bids will be allotted to both
competitive and non-competitive bids. Under Non-competitive bidding, bidders
such as State Governments, PFs would be able to participate in the auctions of
dated government securities without having to quote the yield or price in the bid.
They will not have to worry about whether this bid will be on or off-the-mark; as
long as they bids in accordance with the scheme, they will be allotted securities
fully or partially. A non-competitive bidder will submit only one bid. There is no
need for bidding in case of non-competitive bids. These bids are accepted at the
weighted average of the successful bids if the notified amount is not fully
subscribed to. Non-competitive bidders will Telex\Facsimile the amount of tender
before the day of auction or on the day of the auction before the close of banking
hours to the Manager, RBI, Mumbai.
Eligible investors intending to procure the instruments need to submit their tender
for the issue of bills in the form as prescribed for the purpose, which can be
obtained from RBI, PAD, Mumbai. An investor can submit multiple tenders filling
separate forms stating different prices. Successful competitive bids will be
accepted up to the minimum discounted price called ‘cut-off’ price determined at
the auction. Partial pro rata allotments are common for bids submitted at cut-off
price. The bids above the cut-off price are accepted completely and other bids at
offer prices lower than cut-off price are rejected.
Result of the auction is displayed at RBI, PAD, Mumbai. Reserve Bank has the
full discretion to accept or reject any or all the bids, both competitive and non-
competitive bids either wholly or partially if deemed fit without assigning any
reason. The tenderer needs to check for himself the result of the auction and if
successful, should collect the letter of acceptance of the tender from the RBI. The
bidders will be allotted the Treasury Bills at the respective prices at which the bids
have been made. For 91-day T-bills, the successful bidders at the auction have to
make the payment on the next working day following the Friday auction; and for
364-day T-bills, the payment has to be made by successful bidders on Thursday
following the Wednesday auction. Successful bidders at the auction are required to
make the payment by cash/cheque drawn in favor of the Reserve Bank of India or
by Banker’s Pay Order. Payments by competitive bidders are effected by debiting
their current account with PAD, Mumbai, if RBI is authorized to that effect.
84
Money Markets
If the day of payment falls on any public holiday, the payment is made on the day
after the holiday. Otherwise, the required amount shall be deposited with RBI,
PAD, on the following working day of the announcement either in cash or through
crossed Banker’s cheque.
In case of State Governments, the payment would be effected by debiting their
account with the CAS, RBI, Nagpur.
PRIMARY MARKET AND SETTLEMENT PROCEDURES

PAYMENT
On expiry of the tenure, the bills are presented at RBI, PAD, Mumbai for payment.
DEVELOPMENT OF THE MARKET
Until 1950s, T-Bills were issued by both the Central and State Governments and
from 1950s, it is only the Central Government that is issuing Treasury bills. Up to
1965, the mode of issue of T-bills to the public were through bi-weekly auctions or
tenders. In 1965, the concept of ‘intermediate’ T-bills were introduced and were
sold for few years. According to this mode, T-bills had a maturity of 91 days and
the rates were fixed by the RBI. The day succeeding the day of the usual weekly
auction till the day preceding the next auction, was fixed for receiving the
tenders for the next auction. The mode of issuing T-bills has changed from 12th
July, 1965. Instead of inviting tenders, the T-bills were made available
throughout the week at specified rates from time to time. This change in issuance
has facilitated an increase in selling of T-bills (as the commercial banks were
investing their short-term surpluses in these instruments). As the government
raised its finances by issuing ad hoc T-bills to RBI, which is technically a short-
term source, but, in practice, it is long-term in nature. In the sense, the ad hoc
treasury bills are notionally discharged and renewed on maturity. Therefore,
finance raised by the government in this form is technically short-term finance,
but in reality ends as a long-term finance.
PRIMARY MARKET IN INDIA
In India, till April, 1992, T-bills of 182 days maturity were issued along with 91-day
T-bills. These have since been phased out in favor of 364-day T-Bills. There are
five types of treasury bills based on maturity dates but the 28-day bills have not yet
been launched as stated below and the development of each maturity dated T-bill
is as follows:
91-Day T-Bills
Starting from July, 1965, 91-day T-bills were issued at a discount rate ranging
from 2.5-4.6 percent per annum. Till July, 1974, the discount rate was 4.6 percent.
Even later, the discount rate hovered around the same. The extremely low yield on
these bills was totally out of alignment with the other interest rates in the system.
Moreover, the Central Bank readily rediscounted these bills due to which the yield
for these bills remained more or less artificial. The banks used these instruments to
park their funds for a very short period of 1-2 days. This resulted in violent
fluctuations of volumes of outstanding T-bills. The RBI had introduced two
measures in order to cope with the situation. Firstly, to recycle the T-bills (from
October, 1986) under which the bills are rediscounted by the RBI and are resold to
the banks. Secondly, an additional early rediscounting fee was imposed, if the
banks rediscounted the T-bills within 14 days of purchase. Although this resulted
in a decline in weekly fluctuations, the T-bills market did not become an integral
part of the money market and the interest rates did not rise considerably as the bulk
of T-bills continued to be held by the RBI. The weekly auctions of 91-day T-bills
were started in January 1993, which in due course resulted in gradual decline of
the T-bills outstanding with the RBI.
85
182-Day T-Bills
Following the Sukhamoy Chakravarty Committee recommendations, in
November, 1986, 182-day T-bills were introduced in order to develop the
short-term money market and also to provide an additional avenue for the
Government to raise financial resources for its budgetary expenditure. Initially,
these were the first type of treasury bills to be auctioned on monthly basis without
any rediscounting from the RBI. Thus, the first step of market oriented discount
rate has come into existence. The state governments and provident funds were not
allowed to participate in these auctions. To impart an element of flexibility, the
Central Bank was not announcing the amount in advance. The market participants
were allowed to bid the amount and price of their choice. The authorities would
determine the cut-off discount rate and the amount of T-bills sold in an auction.
They were issued with a minimum lot size of Rs.1 lakh and multiples thereof.
These auctions were monthly in the beginning but later in 1988, they were made
fortnightly. These bills were eligible securities for Statutory Liquidity Ratio
purpose and for borrowing under standby refinance facility of the RBI.
The 182-day T-bills had an interest rate that was relatively market determined and
this made it possible for the development of a secondary market for it.
Nevertheless, till 1987, 182-day T-bills market could not emerge as an integral
part of the money market. These bills were discontinued and in place of which
364-day T-bills emerged.
In April, 1998, these bills were reintroduced in order to obtain a continuous yield
curve for a period of one year. These bills were again discontinued from May, 2001
up to March, 2005. These bills were reintroduced with effect from April, 2005.
364-Day T-Bills
The Government considered that it is important to develop government securities
market for monetary control. It also had an intention to ensure that government’s
credit needs are met more and more directly from the market instead of pre-emption
of deposit resources. With this view, treasury bill was developed as a monetary
instrument with market related rates. As a part of the overall development of
Government securities market, the Government of India proposes to float treasury
bills of varying maturities up to 364 days on auction basis.
The Government, with an intention to stabilize the money market in the country,
introduced the 364-day T-bills on 28th April, 1992. The RBI neither discounted
these bills nor participated in the auction. 364-day T-Bills are auctioned
fortnightly, but the amount, however, is not notified in advance. These T-bills have
become popular due to their higher yield coupled with liquidity and safety. The
yield on 364-day T-bills is used as a benchmark by the financial institutions such
as IDBI, ICICI, etc., for determining the rate of interest on floating bonds/notes.
These bills widened the scope of money market and provided an innovative outlet
for surplus funds. The introduction on treasury bills of varying maturities would
offer investors a wider choice for investing in different instruments and thereby
foster the development of Government securities market.
14-Day and 28-Day T-Bills
The presence of 91-day, 182-day and 364-day T-bills provided an opportunity for
investors to choose varying maturities either from the primary market or from the
secondary market. However, an investor who is interested in a maturity less than
91 days had to necessarily look for secondary market. In order to enhance the
breadth of the market, RBI decided to introduce 14-day, 28-day T-bills in 1997.
However, till now RBI has introduced 14-day Treasury Bills only. In accordance with
monetary and credit policy of April, 2001, the 14-day T-bill auctions has been
discontinued and instead, the notified amount in the 91-day T-bill auctions has
been increased with effect from May 14, 2001.
86
Money Markets
Clearing and Settlement

The Treasury Bills are available in physical form if an investor desires so. The
market is mostly dominated by institutional players who have a facility to hold the
T-bills in scripless form. For this purpose, the investor opens an SGL Account
(Subsidiary General Ledger) with RBI who credits the accounts with T-bills
subscribed. When a transaction of sale is undertaken between two institutional
players, the seller issues an SGL (Subsidiary General Ledger) transfer form
specifying the details of the transaction. The SGL transfer form is then lodged by
the buyer with the Public Accounts Department of RBI to credit its account by
debiting the value of the securities to the seller’s account. Usually, interbank trades
are settled on the same business day, whereas trades with non-bank counterparties
are settled either on the same day or one business day after trade date.
Commercial Papers, Certificates of Deposits, short-term debentures and inter-
corporate deposits are alternatives to T-bills. In spite of the low returns, T-bills
constitute a viable investment opportunity for cash rich PSUs and corporates due
to their liquidity, eligibility for SLR, nominal risk weightage. The scope for capital
erosion is almost insignificant. Hence, it is essential to develop treasury bill market
as it would provide appropriate ancillary facilities to foster the development of
money market instruments.
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State Government Securities
Like other government securities, the issues of state government securities are also
managed and serviced by the RBI.
In general, the tenure of state government securities is 10 years. These securities
are available for a minimum amount of Rs.1,000 and in multiples thereof. State
government securities are available at a fixed coupon rate. However, at present,
some state governments have started auctioning their own securities. These
securities can be brought through a wide network of offices of both, the RBI and
the SBI and its associate banks.
T-BILLS IN INTERNATIONAL MARKETS

PRIMARY MARKET
T-bills are important money market instruments in the US. In US, the minimum
denomination of T-bills is $10,000 and thereafter in multiples of $5,000.
They are debt obligations of the US government and constitute almost 20% of the
marketable debt of the country.
87
In UK, the treasury bills are called gilts and they are issued in the market by the
government through the debt Management Office. The gilts are marketable and
fall into three types viz., conventional, index-linked and rump stocks. The bank of
England holds the gilts on its behalf and on behalf of its clients. The bank also
acts as a registrar for gilts and started postal buying and selling of the securities
in 1998.
' % % ()
9. !) ' !- %- =
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( $ (
( $ !- ( $ = ' !-
5& ' 4"> $ 0 !-
% $ ' $
Types of T-Bills
In the US markets, though there are many types of T-bills, they can be broadly
classified into two types – regular-series bills and irregular-series bills.
Regular-series bills are issued routinely by competitive auctions, either on a
weekly or on a monthly basis. These bills are issued in regular series. They are
issued by Federal Reserve district banks and their branches with different
maturities of 3 months (13 weeks), 6 months (26 weeks) or 12 months (52 weeks).
New issues of three or six month bills are auctioned weekly; whereas, new issues
of one year bills are normally sold once in each month.
Irregular-series bills are issued when a special cash need arises for the Treasury.
These T-bills are of two types – strip bills and cash management bills. Strip bills
are nothing but a package of bills requiring investors to bid for an entire series of
bills with different maturities. Investors who bid successfully must accept bills at
their bid price each week for several weeks running. Cash management bills, on
the other hand, consist simply of reopened issues of bills that were sold in prior
weeks. The reopening of a bill issue normally occurs when there is an unusual or
unexpected treasury need for more cash.
Issuing Procedure
Treasury bills are sold using the auction procedure. The Treasury entertains both
competitive and non-competitive tenders for T-Bills. Government securities firms,
individuals, financial and non-financial companies usually participate in the
bidding. In competitive bids, the quantity of desired T-bills are specified with
lowest interest rates which the buyer is willing to accept. (However, treasury rules
prohibit any single bidder from obtaining more than 35 percent of any new issue.)
The competitive tenders are typically submitted by large investors, banks and
securities dealers. The non-competitive bids are submitted by small investors and
their bidding amount is limited to $1 million or less. A non-competitive bidder
accepts the weighted average interest rate of the competitive bids and these bids
state only the quantity of bills desired.
In UK, all new issues are scheduled and are made through auctions with the details
being announced in advance. Private investors may bid for gilts at auctions on a
non-competitive basis and receive the gilt at the weighted average of the price paid
by successful competitive bidders. The minimum for this type of application is
1000 nominal of the gilt and the maximum is 500,000. Investors making
non-competitive bids at the auction are asked to enclose a cheque for a specified
amount per 100 nominal bid for. If the eventual price is less, the difference is
refunded – if greater, a further payment will be asked for.
88
Money Markets
Discount Pricing
The T-bills are issued at a discount to face value and hence have no coupon.
Commission rates on round lots generally range from $12.50 to $25.00 per $1 million
of T-Bills, depending on the maturity of indebtedness is issued with the T-Bill and
there is no engraved matter on the T-Bill specifying the terms. The purchase is
simply recorded by a book-entry system by the Federal Reserve Bank.
Interest earned is the difference between the price paid to purchase the instrument
and the amount received upon maturity. The value of T-bill price is face value less
discount at a given interest rate. The discount is based on a 360-day year and the
number of days between date of purchase and maturity date and is quoted per $100
of face value.
T-Bill purchases are maintained electronically by the Treasury and the Federal
Reserve System. As there is no physical delivery, transaction costs are
significantly reduced, thereby, eliminating the need to handle, ship and store
physical documents.
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Source: Debt market, www.nseindia.com

SECONDARY MARKET
The major participants in secondary market are banks, brokerage firms and bond
houses. They buy and sell T-bills on behalf of customers and themselves. The
customers include depository institutions, insurance companies, pension funds,
non-financial firms, and state and local governments.
Government dealers help to maintain an orderly market mechanism through trades
of T-bills for their own accounts. They are the market makers for these instruments
by providing Bid-Ask quotes. The US Treasury Bill market attracts both domestic
and international investors because of the perceived strength of the US$ apart from
the liquidity, maturity profile and the risk-free nature which are true for most of
the sovereign securities.
The Fed (Federal Reserve Bank) usually holds more than $100 billion worth of
T-Bills at any given point of time and buys large quantities of bills from the
dealers in the secondary market when it wants to inject more money in the
economy.
In UK, Gilts are traded in a very active market centered on a group of firms known
as ‘Gilt-Edged Market Makers’ (GEMM). The GEMMs deal continuously with
major professional investors life pension funds and insurance companies, across
the entire list of gilts. GEMMs, along with institutional investors and custodians
who may hold stock on behalf of private investors, hold gilts in computerized form
using the CREST settlement system (The CREST system is a computerized system
to settle the registration and transfer of dematerialized securities including UK and
Irish corporate securities, UK government securities and international securities).
Some of the GEMMs make special provision for deals in small amounts.
89
SUMMARY
• Treasury bills are issued by the government to raise short-term funds in the
money market. They are a major portion of the borrowings of the Government
of India.
• The RBI acts as the banker to the Government of India to issue the T-bills.
• The investors in T-bills include: Banks (to meet their SLR requirements),
primary dealers, financial institutions (for primary cash management),
insurance companies, provident funds (as per the investment guidelines),
non-banking finance companies, corporations, FIIs, state governments and
individuals (to a very minor extent).
• T-bills are issued in the form of promissory notes or credited to the SGL
account. They are for a minimum of Rs.25,000 and multiples thereof, issued
at a discount and redeemed at par and do not carry any yield.
• There are five types of T-bills: 14-day, 28-day, 91-day, 182-day and 364-day,
out of which the 28-day T-bills have not yet been launched. 14-day T-bills
were discontinued from May, 2001. 182-day T-bills were discontinued in
May 2001, and reintroduced with effect from April 2005. The bills are
available in paper as well as in scripless form.
• Ad hoc T-bills are issued in favor of the RBI when the government needs to
replenish the cash balances and to provide temporary surpluses to state
governments and foreign Central Banks. These are not available to the public.
• On tap T-bills were issued by the RBI to investors on any day and with no
limit on investment. They were for a minimum of 91 days and the discount
rate was around 4.6% redeemable at par. They were discontinued from
April 1, 1997.
• 91-day T-bills are auctioned weekly on Fridays and payment in respect to the
allotments is made on Saturdays.
• The auction for and 364-day is held weekly on Wednesdays and payment in
respect to the allotments is made on Thursdays.
• T-bills are important market instruments in the US, where the minimum
denomination is $10,000 and in multiples of $5,000 thereof. The American
T-bills are mainly classified as ‘regular-series T-bills’ and ‘irregular-series
T-bills’.
• Regular-series of 13-week, 26-week and 52-week maturities are issued
weekly or monthly while irregular-series are issued for a special cash need of
the treasury.
• The US T-bills are sold in auctions and issued at a discount to face value.
90
Money Markets
Appendix*
Auction Procedure
Let us consider an example to understand the process of bidding in treasury bills.
Say on 2nd November, RBI issued a tender notification for 91-day T-bill for
Rs.500 crore. There were 4 competitive bidders namely, A, B, C and D who
responded to the notification of T-bills, and submitted sealed tenders to the RBI.
The overall amount quoted through the tender is Rs.1,900 crore. A General
Manager from Public Debt Office (Mumbai) opened the tenders, and compiled the
following information to determine the cut-off point.
B : =
)$B $
- % $ % $ $ % $ $
& - 58$5
58$5 > 5
4 58$8 " &
> = 58$8 8 4
- 58$+ 8
" = 58$" & >
+ = 58$ "
8 58$ & +
5 - 58$ & 8
& 58$> &
&& - 58$> & &&
& = 58$4 8 &>
&4 A 58$> + &>+
&> A 58$4 & & 5
& A 58$4 & &+>
&" A 58$ &" &5
Based on the above information, the GM needs to decide the cut-off price and
allocate the T-bills to bidders at respective rates. The GM decides an optimal cut-
off price as Rs.98.50. Below this point, amount of bids is short by Rs.100 crore
and at this point, it has a surplus of Rs.300 crore. The first six bids given by A, B
and C are accepted completely, and the next quote given by the three bidders being
the same, RBI allots T-bills proportionately. The fully accepted bids are:
B - : C ((
58$5 >
58$8 "
- 58$5
- 58$+
= 58$8 8
= 58$" &
>
91
The RBI allots the three bidders proportionately in the following manner:
B - : : ( $
58$ &
- 58$ &
= 58$
> &
100
x 100 = 25.
400
Thus, a proportionate allotment is made to the three bidders.
The yield is calculated as:
Face Value 365
Yield = −1 x
Price Days to Maturity
Weighted Average Yield for the Issue
B : : ( $: ; $;
- 7 D
58$5 > $ 8 +$5 > $ >>" $ 4 "
58$8 " $& &&$8 " $ >8+ $ 8>
58$ $ >$5 $ "& $ 4
- 58$5 $& 5$85 $ > $ >
58$+ $& 5$8+ $ + $ +8
58$ $ >$5 $ "& $ 4
= 58$8 8 $&" & $8 8 $ >8+ $ ++5
58$" & $ > 4$"+" $ >8 $ &4&
58$ $& &5$+ $ "& $ "&
&$ 58$+ $ &8+"
The non-competitive bidders would have to pay weighted average cut-off price
which is obtained by taking the average of prices, which works out to be 98.72
in this particular issue. The non-competitive bidders would get an yield of
5.1876 percent.
Let us calculate the yield based on the above inputs for each of the bidders:
a. Average Yield for A:
(98.90 x 40/125 + 98.80 x 60/125 + 98.50 x 25/125) = 98.77
100 365
Yield = − 1 x = 4.99% or
98.77 91
(0.0446 x 40/125 + 0.0487 x 60/125 + 0.0610 x 25/125) = 4.984%
b. Average Yield for B:
(98.95 x 50/125 + 98.75 x 50/125 + 98.50 x 25/125) = 98.78
100 365
Yield = − 1 x = 4.95% or
98.75 91
(0.0425 x 50/125 + 0.0507 x 50/125 + 0.0610 x 25/125) = 4.948%
92
Money Markets
c. Average Yield for C:

(98.80 x 80/250 + 98.65 x 120/250 + 98.50 x 50/250) = 98.668
100 365
Yield = − 1 x = 5.414% or
98.668 91
(0.0487 x 80/250 + 0.0548 x 120/250 + 0.0610 x 50/250) = 5.41%
As per the RBI guidelines issued on November 6, 1998 the 91-day T-bills only
would follow uniform price auction method, instead of multiple price auction
method. In uniform price auction method, all successful bidders would pay a
uniform cut-off price that would emerge in the course of auction. In this example,
all the bidders would be paying a price of Rs.98.72 uniformly. This would avoid
price discrimination among the successful competitive bidders.
* Source: Icfai Research Center.
93
•
•
• !
" #
• " #
•
Money Markets
The money market is relevant to the corporate world in terms of short-term surplus
or deficit of funds, which it experiences. If a corporate has a short-term surplus, it
invests and if it faces deficit, then it borrows. A corporate needs short-term funds
to manage its working capital requirements, pay taxes and meet other short-term
commitments. These needs are fulfilled, usually, by obtaining short-term finance
from banks, trade credit from creditors, loans from Inter Corporate Deposits
(ICDs) market, bill discounting and factoring, etc. Corporates are always in search
of new instruments to raise funds that provide them with an optimal combination
of low cost, flexible and desired maturity. Introduced common paper in 1990.
DEFINITION
Commercial Paper (CP) is an unsecured usance money market instrument issued in
the form of a promissory note issued at a discount, and is transferable by
endorsement and delivery and is of fixed maturity. It is a short-term money
instrument issued to corporate, who have a high credit rating and have a strong
financial background. It is an unsecured obligation issued by a bank or a
corporation to finance its short-term credit requirements like accounts receivable
and inventory. In other words, the Commercial Paper is an unsecured, short-term
loan issued by a corporation typically to finance accounts receivable and
inventories and it is usually issued at a discount reflecting the prevailing market
interest rates.
Issuers
Any private sector company, public sector unit, non-banking company, All-Indian
Financial Institutions (FIs) Primary Dealers (PDs), Satellite Dealers (SDs), etc., can
raise funds through the Commercial Paper. But, the company has to satisfy the
eligibility criteria prescribed by RBI as discussed later. The conditions laid by the
RBI restrict the entry of issuers into the CP market.
Investors
CPs may be issued to and held by individuals, banking companies, other corporate
bodies registered or incorporated in India and unincorporated bodies, Non-Resident
Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by
FIIs would be within the limits set for their investments by Securities and
Exchange Board of India (SEBI). FIIs were allowed to invest their short-term
funds in such instruments too. Within a ceiling of the $1.5 billion of the total FIIs
were inflows for debt funds set down by the RBI. When NRIs subscribe to CP
issue, the conditions regarding non-repatriability and non-endorsability are
indicated on the CP. Though the market is open to the above segments, usually,
banks, large corporate bodies, public sector units with investible funds function in
the market.
FEATURES OF COMMERCIAL PAPERS

Commercial paper favors both borrowers and investors. It is considered as an
optimal combination of liquidity and returns in the short-term market. To borrowers,
it implies low cost of funds, and to investors it implies liquidity, marketability and
returns.
1. Commercial paper does not originate from a specific self-liquidating
transaction like normal commercial bills, which generally arise out of
specific trade transactions.
2. CPs are backed by the liquidity and earning power of the issuer, but are not
backed by any assets, and hence they are unsecured.
3. The CP market provides the borrower (i.e., highly rated corporates) a cheaper
source of funds with less paperwork/formalities when compared to bank
finance. Corporates prefer this mode of finance as they can determine the
cost and maturity. Similarly, CP involves less paperwork/formalities, as it is
an unsecured liability, unlike bank finance, which is secured.
95
4. Investors prefer to invest in CPs due to high liquidity, varied maturity and
high yield (when compared to bank deposits). The liquidity is high because it
can be transferred by endorsement and delivery.
5. The CP market has the advantage of giving highly rated corporate borrowers
cheaper funds that they could obtain from the banks while still providing
institutional investors with higher interest earnings than they could obtain
from the banking system.
6. CDs can be issued by Corporate, Primary Dealers (PDs), and the all-India
Financial Institutions (FIs) that have been permitted to raise short-term
resources under the umbrella limit fixed by the Reserve Bank of India are
eligible to issue CP. Satellite dealers have been discounted from issuing CPs
with effect from June 1, 2002.
7. All eligible participants have to obtain the credit rating from either the Credit
Rating Information Services of India Ltd. (CRISIL) or the Investment
Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit
Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd., or
any such other credit rating agencies as may be specified by the Reserve
Bank of India for issuance of Commercial Paper. The minimum credit rating
should be P-2 of CRISIL or such equivalent rating by other agencies. The
issuers shall ensure at the time of issuance of CP that the rating obtained is
current and has not fallen due for review.
9. A corporate would be eligible to issue CP provided,
i. its tangible net worth of the company is not less than Rs.4 crore as per
the latest audited balance sheet.
ii. company has been sanctioned working capital limit by bank/s or all-India
financial institution(s) and the borrowed account of the company is
classified as a standard asset by the financing bank(s)/institutions.
10. Financial institution can issue CP within the overall umbrella limit fixed by
the RBI, i.e., issue of CP together with other instruments, viz., term money
borrowings, term deposits, certificates of deposit and inter-corporate deposits
should not exceed 100 percent of its net owned funds, as per the latest
audited balance sheet.
11. The total amount of CP to be issued should be raised within a period of two
weeks from the date on which the issuer opens the issue for subscription. The
amount of CP to be issued should be raised on a single date or in parts on
different dates. In case of issuing in parts on different dates, each CP so
issued will have the same maturity date.
12. Every issuer must appoint an Issuing and Paying Agent (IPA) for issuance of
CP and only scheduled bank can act as an IPA for issuance of CP. On
maturity of CP, the holder of CP shall present the instrument for payment to
the issuer through the IPA. However, when CP is held in demat form, the
holder of CP will have to get it redeemed through the depository and receive
payment from the IPA. IPA monitor defaults in redemption of CP. Scheduled
banks which act as IPA have to report to RBI in case of such occurrence
giving full particulars of default of repayment of CPs.
13. Both issuers and subscribers to issue/hold CP in dematerialized or physical
form, however with effect from June 2001, banks, FIs and PDs are required
to issue and hold CP in dematerialized form only. With effect from July 2005
CP can also be issued in dematerialized form through any of the depositories
approved by and registered with SEBI. No issuer shall have the issue of CP
underwritten or co-accepted.
96
Money Markets
MATURITY
Commercial paper has a minimum maturity period of 15 days and a maximum of
one year. Unlike CD, the issuer can buy-back his CP. The RBI reduced on June 30,
2005 in its guidelines for issue of Commercial paper has reduced the minimum
maturity period to 7 days. The maturity date of the CP should not go beyond the
date up to which the credit rating of the issuer is valid.
DENOMINATION AND SIZE
CPs are issued at a discount to face value as may be determined by the issuer and
no issuer shall have the issue of CP underwritten or co-accepted. CP are issued in
denominations of Rs.5 lakh or multiples thereof. A single investor should not
invest not less that Rs.5 lakh of face value.
Issue Price
The CPs are issued to the investors at a discount to the face value. The discount
actually is the effective interest rate. The Issue Price is determined by the
corporate issuing it in the following manner: Generally, the merchant banker/IPA
(Issuing and Paying Agent) on behalf of the corporate client, approaches various
investors and takes quotes, and expected amount of investment for the proposed
CP for various maturities. After obtaining the quotes, the merchant banker and
issuing company compile the data and arrive at an optimal discount rate with a
feasible maturity date of the paper. While determining a discount rate, it considers
factors such as – Prevailing call money rates, Prime lending rate, T-bill rate,
maturity of the paper and other relevant expenses (such as brokerages, rating
agency fees, stamp duty, etc.). Once the issue price and maturity are decided, the
IPA places the CP with the investors. The Issue Price is calculated as below:
F
P=
1+
(I x N)
100 x 365
Where,
F = Face/Maturity Value
P = Issue Price of CP
I = Effective Interest p.a.
N = Usance Period (No. of days).
For example, a corporate issues a CP at an effective rate of 10.00% for 90 days.
This is a discounted instrument and hence is actually issued at Rs.97.5936 per
Rs.100. This means that the corporate gets Rs.97.5936 on issuance and has to
redeem Rs.100, on the maturity date after 90 days. This is calculated as follows:
Rs.100/(1+10.00% x 90/365) = Rs.97.5936
Interest is calculated on an actual/365-day year basis. Typically, CPs are issued for
periods of 15/30/45/60/90/120/270/360 days.
FACTORS AFFECTING THE PRICING
CP being a short-term instrument, its primary and secondary market
determination of the interest rate, i.e., the discount rate, depends upon conditions
in short-term money market. The following are the principal factors in pricing
the CPs.
Interbank Call Rates: Since call rates affect all the other short-term rates and
banks are the most important investors in CPs, its pricing is affected very much by
call rates. Also, as the lenders in the CP market are predominantly banks, call
markets affect the CP market rate; lower call rates mean cash surplus. Banks thus
view CPs as an alternative investment route.
97
Competing Money Market Investment Products: Interest rates on CPs are

determined by the demand and supply factors in the money markets and the
interest rate on the other competing money market instruments such as Certificates
of Deposit, Commercial Bills, Short-term Forward Premia and Treasury Bills. The
investments in CPs give comparably higher yields than those obtained in bank
deposits of similar maturities.
Liquidity: Pricing and availability of funds under CPs are determined by the
liquidity amongst banks and mutual funds, which are the principal investors.
Credit Rating: The initial credit rating requirement was P1 later in May 1992.
RBI changed the minimum credit rating to P2 of Crisil. However, two P1+
companies may not attract the same rate, due to relative credit perception by the
public and also, to an extent, the company’s long-term credit ratings.
RATING NOTCHES FOR CPS
The 5-notch scale on which the credit rating agencies rate the CPs is given below:
P1: The degree of safety regarding timely payment is strong.
P2: The degree of safety is strong, but relatively lower than that of P1.
P3: An adequate degree of safety regarding timely payment; but the adverse
affects due to the unforeseen circumstances will have more impact on the
instrument than on the instrument rated as P1 and P2.
P4: The degree of safety regarding timely payment on the instrument is minimal
and the effect of unfavorable conditions may be adverse.
P5: The instrument is expected to be in default on maturity or is in default.
By adding “+” and “–” symbols after the rating, it is further fine-tuned.
TYPES OF PAPERS
Commercial paper can be issued either directly or through a dealer. If the company
issues the paper directly to the investors without dealing with an intermediary, it is
referred to as direct paper. The companies going for direct paper will announce the
current rates of CPs with various maturities so that the investors can choose the
CPs based on the requirements. If a CP is issued by an intermediary (i.e.
dealer/merchant banker) on behalf of its corporate client, it is known as dealer
paper. The role of dealer in the CP market is to arrange for the private placement
of the instrument. Generally, dealers also play advisory roles in timing the issue,
determining discount rate and appropriate maturity period.
In India, the CPs are usually placed with the investors with the help of Issuing and
Paying Agents. Market making in CPs has not reached the desirable levels.
However, it is possible for any dealer to pick up the entire issue of CP of a
company and then sell it in the market.
ISSUING PROCEDURE
A corporate planning to issue CP requires to fulfill the eligibility criteria
prescribed by the RBI, then it needs to select a merchant banker and an Issuing and
Paying Agent (IPA) (mandatory) and obtain a resolution from the company board
to issue the commercial paper. After the resolution is passed, the company needs to
get the CP credit rated by one of the approved credit rating agencies like
CRISIL/ICRA/CARE/DCR, as prescribed by RBI. The company then has to
approach its principal banker with a proposal (in the form of schedule-II given in
Appendix) along with the credit rating certificate for approval. The banker will,
then, scrutinize the same and verify whether all conditions stipulated by the RBI
are met, and forward the application to the RBI for intimation (as the approval
from RBI is no longer required).
On the other hand, the Merchant Banker or Issuing and Paying Agent (at times,
company appoints IPA as a dealer) will locate the clients and get their quotes for
different maturity periods as discussed above. Then the company and merchant
98
Money Markets
banker/IPA decide the maturity, discount rate and the quantum of the issue. A
company can opt for various maturity periods within the stipulated span, i.e., if a
company plans to issue a CP for a span of 6 months, it can raise the money in
tranches with different maturity periods of either 1 month, 2 months or 3 months,
etc., based on the market quotes. If a company decides on a 2 month CP, it can
raise the finance within a period of 2 weeks from the date on which the proposal is
taken on record by the bank and it can issue the paper on a single day or in parts on
different dates (but the whole issue should be redeemed on the same date).
The issue proposed should be completed within a span of 2 weeks and the
company should intimate the banker to reduce the working capital limit to the
extent of the amount raised. The company should pay the applicable stamp duty
based on the maturity. After the issue is completed, within 3 days, the company
needs to intimate the RBI the actual amount raised through CPs. The CP is not
allowed to be underwritten. On maturity, the holder of the CP presents the
instrument to the paying agent, who arranges the payment. The agent will receive
the amount and brokerage for the services provided (the brokerage fee charged by
them is given below). No grace period is allowed for the repayment of the paper. If
the maturity date falls on a holiday, the issuer is supposed to make the payment on
the following working day. Every issue of CP is treated as a fresh issue (including
roll over) and the issuer needs to intimate the RBI while doing so.
THE ROLE OF ISSUING AND PAYING AGENT
Generally, banks act as Issuing and Paying Agents (IPA). The role of IPA becomes
mandatory while issuing CP. Apart from the above discussed functions, it holds
CP notes, safeguards on behalf of the issuer, delivers the notes to the investor and
arranges for redemption on behalf of the corporate client.
ISSUE EXPENSES
The issue expenses of the CP include payment of stamp duty, brokers’ fees or
issuing and paying agents’ fees, rating agencies fees and other expenses like
charges levied by the banks for providing redemption facilities, etc. All the
expenses related to the issue of CPs are borne by the issuers. The brokerage varies
depending on the size of the issue and the maximum prescribed brokerage is as
follows:
The other charges borne are as follows:

STAMP DUTY ON COMMERCIAL PAPER
The stamp duty payable by the issuer on CP is based on the period for which the
CP/UPN is issued.
There is certain concession in stamp duty applicable under Art.12 of Indian Stamp
Act, 1899 available to certain class of investors (Commercial and Co-op Banks
and specified FIs like IFCI, IDBI, SFCs) as per Central Government Notification
dt: 16.05.1976.
Where an eligible class of investor is the 1st subscriber, then the applicable stamp
duty structure is given below:
1. If the CP is issued for a period up to 3 months – Rs.0.50 per Rs.1,000 or each
part thereof (Maturity Value).
2. If the CP is for above 3 months up to 6 months – Rs.100 per Rs.1,000 or each
part thereof (Maturity Value).
3. If the CP is for above 6 months up to 9 months – Rs.1.50 per Rs.1,000 or
each part thereof (Maturity Value).
99
4. If the CP is for above 9 months up to 12 months – Rs.2.00 per Rs.1,000 or

each part thereof (Maturity Value).
5. In other class of investors stamp duty applicable would be Rs.1.25, Rs.2.50,
Rs.3.75, and Rs.5.00 per Rs.1,000 (Maturity Value) for respective slabs
stated above.
Every renewal is considered as a fresh issue and it involves expenses. Hence, a
company needs to optimize between the interest cost and issue cost while deciding
the terms of maturity, i.e., if an issue is raised for a long period, the company may
have to pay more interest and if it raises for a short period, it has to incur issue
expenses each time. Hence, a company must consider interest paid and issue
expenses borne while determining the duration of CP.
UNDERWRITING AND STANDBY FACILITY
From the beginning, the RBI did not permit underwriting of CPs. However, it
allowed banks to sanction standby arrangement to the company issuing a CP. As
the amount raised by CP is utilized to reduce the working capital finance, a
company may experience a liquidity crunch when the CP matures. In such
instances, banks provide standby facility to redeem the sum at maturity. When
such a facility is provided by the banks the instrument is secured indirectly. The
real risk associated with corporates was not assessed properly, as the banks
indirectly assured repayment of the CPs to the investors. Hence, the RBI attempted
to rectify this anomaly by abolishing standby facility in October, 1994, to make the
CP market more realistic.
SECONDARY MARKET AND TRADING
The transactions in secondary market take place in lots of 5 lakh each. Banks trade
in secondary market as CPs are generally placed with them. The secondary market
transactions do not attract stamp duty. The CP being a discount paper does not
attract income tax, but the trading income, which is the difference between the cost
of acquisition and resale value, attracts income tax. There are very few market
makers who offer two-way quotes in Commercial Paper. For the intermediary
market deals, the brokerage charged is in the range of 0.05%-0.20%.
SETTLEMENT
The transfer is done through endorsement and delivery. On maturity, the instrument
is presented to the paying agent for receiving payments. The company cannot have
any grace period and it is liable to make payment whenever the paper matures. As
there is no roll over, every issue of commercial paper including renewal is treated
as a new/fresh issue.
TAXATION
For the Corporate: The discount is treated as an interest expense, deductible for
tax purpose.
For the Investor: Profit/loss on sale of investment – Income is taxed under the
head “Profits and Losses from Business and Profession”. Losses are allowed as
business losses for banks and investment companies. For, corporates that invest in
other company CPs, this would amount to other Income/Interest Income.
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100
Money Markets
Advantages of Commercial Paper

The paper work involved in raising the funds through the Commercial Paper is
very less because more funds can be procured without any underlying transaction.
The flexibility provided by the instrument enables the company to raise additional
funds especially when the market is favorable. The cost of funds for the company
is reduced because it can raise 75% of its working capital through the Commercial
Paper issue, at an interest rate lower than the interest rate on borrowings from the
banks. In the cash credit system of lending, the borrower can reduce the
outstanding amount as and when he gets surplus funds. This results in a reduced
effective interest cost.
The companies, which borrow funds through the issue of CP, can take advantage
of a situation by following the money market rates. This is because of the
administrative lag in aligning the bank’s lending rates with the overall interest
rates. The company’s image will be improved, casting a positive effect on the
long-term borrowing program of the company. The level of access to the national
by banks gives CP market is considered as a key factor to accept the issues in the
international market.
From the investor’s point of view, the CPs yield relatively higher returns than a
similar maturity bank deposit. Though these securities are unsecured, the standby
facility its holders confidence to get the return on the due dates. The holders can
get quick payments from the company’s banker on its behalf as soon as the
permissible working capital limit is achieved.
EVOLUTION AND DEVELOPMENT OF COMMERCIAL

PAPER MARKET
The concept of raising funds through commercial paper is new to Indian
corporates. The introduction of CPs is a result of the suggestions of the Working
Group on Money Market in 1987. The working group was of the opinion that the
CP market had the advantage of giving high-rated corporate borrowers cheaper
funds than they could obtain from banks, while providing the investors higher
yields than they could obtain from the banking system.
In 1989, the RBI announced its decision to introduce CPs. It was launched “with a
view to enable highly rated corporate borrowers to diversify their sources of
short-term borrowings and also provide an additional instrument to investors”, by
which certain categories of borrowers could issue CPs in the Indian Money
Market. It was also allowed because the RBI desired to discourage the practice of
lending in the Inter Corporate Deposit (ICD) market. As ICDs were unsecured and
the transactions were not transparent, the RBI felt that CPs may serve as a good
substitute for such funds. Initially, the RBI issued guidelines on issue of CPs in
January, 1990, and these guidelines later were revised many times to facilitate the
growth of the market.
It was indicated in April, 2000 policy statement that the current guidelines to issue the
CPs would be modified in the light of recommendations made by an Internal Group.
Accordingly, a draft of the revised guidelines as also the Report of the Internal
Group was circulated in July, 2000. Taking into account the suggestions received
from the participants, the guidelines have now been finalized.
The new guidelines are expected to provide considerable flexibility to participants
and add depth and vibrancy to the CP market while at the same time ensuring
prudential safeguards and transparency. In particular, the guidelines will enable
companies in the services sector to more easily meet their short-term working
capital needs. At the same time, banks and FIs will have the flexibility to fix
working capital limits duly taking into account the resource pattern of companies’
finances including CPs. The changes in the guidelines originally issued are
summarized hereunder.
101
Earlier, a company was eligible to issue CP only if it had a tangible net worth
of Rs.10 crore as per the latest balance sheet. In April, ’90, it was reduced to
Rs.5 crore and, further to Rs.4 crore in October, ’93.
Similarly, the working capital requirement limit, which was Rs.25 crore, was
reduced to Rs.15 crore and later to Rs.4 crore in October ’93. The minimum credit
rating required was A1 and P1 and the same was reduced to A2 and P2 in
October,’93. The amount a company was allowed to raise through CP was limited
to 20 percent of its Maximum Permissible Bank Finance (MPBF) and the same
was raised to 75 percent in October, ’93. Since the concept of MPBF was
abolished recently, now a corporate can raise up to 100 percent of its fund-based
working capital (without increasing its overall short-term credit). The RBI initially
stipulated that the company should be listed on one or more of the stock
exchanges. Later, it permitted even unlisted companies to issue CPs.
According to the initial guidelines, the maturity period of CP was a minimum of
3 months and a maximum of 6 months from the date of issue. The maximum limit
was extended to 1 year in October, 1993 and the minimum was reduced to 30 days
in 1997. However, in later guidelines, the minimum was further reduced to
15 days and now it is 7 days. Earlier, the denomination was Rs.10 lakh and the
minimum size of an issue to a single investor was Rs.50 lakh (face value). In
October, 1993 the minimum amount for a single investor was reduced to Rs.25
lakh in multiples of Rs.5 lakh. At present, it is Rs.5 lakh in multiples of Rs.5 lakh.
Earlier, the company which was listed on a stock exchange was eligible to issue a
CP; later this condition was relaxed. Similarly, the company willing to raise CP
had to take prior approval from the RBI which is not essential now. The standby
facility which was allowed to facilitate redemption has now been abolished to
activate the market. Though the above conditions were relaxed/modified for the
growth of CPs, the growth was not as appreciable as expected. The RBI had taken
further steps to activate the market for CPs as there were hardly any market
makers offering two-way quotes in CPs. The Discount and Finance House of India
(DFHI) was expected to be a market maker by giving two-way quotes. The RBI
permitted the Primary Dealers (PDs) to raise the funds for their operations by
issuing CPs hoping that this would, in turn, enable the PDs to access greater
volumes of funds thereby enhancing the level of activity in the secondary market.
MARKET POTENTIAL AND INTEREST RATES OF COMMERCIAL
PAPER
The following table presents an overview of the outstanding amounts and the
effective interest rates for CPs in the years from April 2006 to July 2008. It can be
observed that the size of the market is very small. Also, there were many inter year
and intra year fluctuations on the amount of CPs.
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102
Money Markets
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REASONS FOR UNDERDEVELOPMENT
The experts attribute the following reasons for underdevelopment:
• Restricted entry of corporates into this market. The stringent conditions laid
down by the RBI have made entry of good but small companies difficult.
• A company is prompted to issue a CP if the cost of funds is lower than the
PLR of the banks, which is usually the rate the top class companies will be
obtaining. Since the cost of CP includes rating charges, stamp duty, IPAs’ fee
in addition, to the discount, the effective cost should be lower than the PLR.
Otherwise, it will not be prudent for a corporate to issue CP. All these costs
have to be incurred each time a company issues a CP thus increasing the
effective cost. Hence, a company may not be able to come out with a CP
issue if the difference in the effective cost and PLR is marginal.
• The minimum size of investment for an individual investor is too high, there
are no tax benefits. Hence, the individuals and other small investors are away
from this market.
SCHEDULED COMMERCIAL BANK’S INVESTMENTS IN
COMMERCIAL PAPERS
The outstanding amounts of scheduled commercial banks and their investments in
the commercial paper, bonds, debentures, shares, etc., are given in the following
table. The outstanding amount as on March 22, 2002 was Rs.8,506 crore and
Rs.17,017 crore as on January, 30, 2009. When compared with the investments in
other instruments like bonds – debentures by private and public sector – the
investment in the commercial paper is very less.
103
FUTURE OUTLOOK
The RBI is constantly watching the growth of the CP market, and it is
modifying/relaxing the guidelines for the enhancement of the same. While doing
so, the RBI can consider the following measures to facilitate the growth of the
market:
• Relax stringent conditions to reduce the overall cost of a CP. For example,
the rating fees charged by rating agencies is relatively high, in spite of which
the RBI insists upon a fresh rating (less than 2 months old) every time a CP is
issued; this in turn pushes up the cost of issue to the issuer.
• Banks were earlier permitted to sanction standby facility to the companies
issuing CPs so that upon redemption the working capital limits would be
automatically restored. While RBI disallowed sanction of standby facility, it
has not delinked the amount to be raised from fund-based working capital
limits. As the concept of MPBF has also been abolished, the limit to raise
funds under CP may be delinked from the fund-based working capital limits.
• The validity of the credit rating may also be extended beyond two months.
• If the CP is allowed to be underwritten, it can facilitate more corporates to
issue CPs thereby widening the market.
• The scope to develop the CP market is high in view of the flexibility a
corporate enjoys and the liquidity available in the system.
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!! >) > 4 4
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!! > + > , !! 2, !!4) > 4, 4 ! 4)
+ 4 ! = , + ! !>
( 4 -, , !!4.) )+ ! ! 4 4 + 4)
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4 !4 , A2# ! A2#
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! ! 4 ) 4 ! 3 , B 3 ) B
, >= B ,
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) > $, =+ ! + !!
104
Money Markets
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% + 4 ) B > ! + !
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! !, , ) , !! !!3! > ) ,
+ ! ,,4 ! 4 ,,!4 , , ) 4 3C3 ! + >
, ! " > ! ,,4 ! + )
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, ) ) @0 D0 ) + ,! ) $ !4
COMMERCIAL PAPERS IN INTERNATIONAL MARKETS

The concept of raising money through Commercial Papers has been known to the
US markets since the 18th century. Other nations came to know of it only in the
earlier part of the 19th century. The US firms started selling open market paper as
a substitute to the customary bank loan that was required for working capital.
Commercial Papers (CPs) are defined as short-term, unsecured usance promissory
notes issued at a discount to face value with fixed maturity by well-known
companies that are financially strong and carry high credit ratings. They are
referred by different names such as Industrial Paper, Finance Paper and Corporate
Paper depending on the nature of the issuing firm.
ISSUERS AND BUYERS
Commercial paper is the second largest money market instrument in the US, after
Repos, surpassing T-bills, with a total value exceeding $1.4 trillion, by the end of
1999. American commercial paper is rated by one or more credit rating agencies
and as such the credit risk on it is perceived to be low, but existent. The liquidity
of the instrument is also very low. The CPs are generally issued by the public
utilities, bank holding companies (corporations organized to acquire and hold the
stock of one or more banks), insurance companies, transportation companies, and
finance companies. Banks, liquid business concerns, insurance companies, state
and local governments and non-banking financial institutions mostly buy CPs.
By the end of 1998, the investors in commercial paper were:
0 , &'
0 ,
): D ( , !" 8
" >
,
2
!
Purpose
The funds raised by means of CPs by corporates are used for current transactions –
such as purchase of inventories, payment of taxes, meeting payrolls and to meet
other short-term rather than long-term obligations.
TYPES OF COMMERCIAL PAPER
There are two major types of commercial paper – direct paper and dealer paper.
The direct paper is issued by large finance companies and bank holding
companies deal directly with the investor rather than use a dealer as an
intermediary.
Though the issuers of direct paper do not have to pay any dealers’ commission,
these companies must operate a marketing division to maintain constant
interaction with active investors. And also these companies need to pay fees to
banks for supporting lines of credit, to the rating agencies and to agents (i.e., bank
trust departments). Hence, this paper must be sold in large volumes to cover the
substantial costs of distribution and marketing.
105
The dealer paper is issued by dealers on behalf of their corporate customers. It is

mainly issued by non-financial companies and finance companies. The issuing
company sells the paper directly to the dealer at a discount and commission. The
dealer will resell it at the highest possible price in the market. Companies using
dealers to place their paper are generally smaller, less frequent borrowers than
issuers of direct paper. An open rate method is followed by which the company
receives some money in advance but the balance depends on the performance of
the issue in the open market.
Rate of Return
The rate of return on a commercial paper is computed by using the following
formula in a secondary market transaction:
Par Value − Purchase Price 360
D= x
Par Value Days to Maturity
This could be well understood by the following example.
Illustration
Mr. A purchased a commercial paper of Maxwell Inc., issued for 3 months in the
market for $976,000. The company issued CP with a face value of $1,000,000.
Determine the rate of return which A earns.
Par Value − Purchase Price 360
DR = x
Par Value Days to Maturity
1,000,000 − 976,000 360
= x = 0.048 or 4.8%
1,000,000 180
COMMERCIAL PAPERS IN UK
Various aspects relating to the issue, regulatory, accounting and tax matters are
provided in the London Market Guidelines on commercial paper issued by the
BBA (British Bankers Association) in April, 2000. Some aspects of these
regulations were modified when the FSMA (Financial Services and Markets Act,
2000) came into force in December, 2001.
In UK, the Commercial Paper (CP) is regarded as a flexible short-term
instrument through which a cost-effective funding of requirements can be done.
The markets for Euro Commercial Paper (ECP) emerged in the early 1980s as a
derivative of underwritten Note Issuance Facilities (NIFs), which resulted in the
development of uncommitted US Dollar based ECP programs. One important
feature of ECP was that it did not meet the terms of Securities Exchange
Commission in the US and hence could not be sold to US investors. Since then
the ECP market is being transformed into the only truly multi-currency short-
term market, encompassing a number of currencies, including Sterling, Swiss
Francs, Japanese Yen and the Euro.
The London Market Guidelines for the Commercial Paper market issued by the
BBA in April, 1999 altered the earlier CP issuance guidelines made in 1997. These
guidelines stood as the standard practice in Europe’s most active CP market.
INNOVATIONS OF COMMERCIAL PAPER

Master note is a new financial paper issued by finance companies to bank trust
departments and other permanent money market investors. In an arranged
agreement, the investing firm notifies the issuing company as to how much paper
it will purchase on that particular day, and the issuing company in turn issues a
paper on the maximum agreed amount. The interest on daily papers is pooled and
taken by the investors during the current month.
Medium-term notes are unsecured obligations, papers with a maturity period of
9-10 months. These are issued by investment grade corporations at a fixed interest
rate. These papers suit companies with substantial quantities of medium-term
assets as they have longer maturities when compared to conventional CPs and
106
Money Markets
IOUs. Asset-backed commercial paper gives credit at a lower interest rate to the
corporates. This paper is nothing but, a pool of loans or credit receivables made
into packages. These packages are issued in the form of a paper, and these loans or
receivables are removed from the issuing companies’ balance sheet and are placed
in a Special-Purpose Entity (SPE). SPE issues the commercial paper to cover
discount price and uses the proceeds for purchase of the receivables. The issuing
customer usually services the underlying receivables, collects interest and
principal payments and passes the funds to SPE. In the process a bank is chosen to
service the receivables supporting the paper issue. CPs are likely to have good
future so long as they can be tailored to meet the needs of both the buyers and
issuers in terms of maturity, liquidity and returns.
COMMERCIAL PAPER – LATEST DEVELOPMENTS
The RBI in its mid-term Review of the Annual Policy Statement for the year
2004-05, base on the discussion with market participants and Recommendations of
the Technical Advisory Committee on Money, Foreign Exchange and Government
Securities Markets had issued notification of reporting of issuance of CP on the
Negotiated Dealing System (NDS) platform by the end of the day and holding of
CPs in denaturalized form. The RBI is has set-up a group under the Chairmanship
of C.E.S Azariah, the Chief General Manager, State Bank of India within
FIMMDA for viewing the settlement on T+1 basis. Preference for Dematerialized
Holding – Banks, FIs, PDs and SDs were advised to invest and hold CP only in
dematerialized form, as soon as arrangements for such dematerialization are put in
place. As the existing arrangements for dematerialized holding for CP are now
considered adequate and satisfactory, banks, FIs, PDs are permitted to make fresh
investments and hold CP only in dematerialized form. Similarly, they are also
permitted to make fresh investments and hold bonds, debentures, privately placed
or otherwise only in demat form. As regards the equity instruments they are
permitted to be held by the above-mentioned institutions only in dematerialized
form, from the date notified by SEBI.
SUMMARY
• Commercial Papers (CPs) are short-term unsecured usance promissory notes
issued at a discount to face value by reputed corporates with high credit
rating and strong financial background.
• CPs are open to individuals, corporates, NRIs and banks, but the NRIs can
invest on non-repatriable/non-refundable basis. FIIs have also been allowed
to invest their short-term funds in CPs.
• The features of CPs are: They do not originate from specific trade
transactions like commercial bills. They are unsecured, involve much less
paper work and have very high liquidity.
• CPs have a minimum maturity of 15 days and a maximum maturity of 1 year.
They are available in denomination of Rs.5 lakh and multiples of Rs.5 lakh
and the minimum investment is Rs.5 lakh per investor.
• CPs can be direct paper if issued directly to the investors by the corporate or
dealer paper if issued through an intermediary/merchant banker. CPs are
usually placed with the investors by issuing and paying agents.
• Secondary market trading takes place in lots of Rs.5 lakh each usually by the
banks. The transfer is done by endorsement and delivery.
• The main reasons for poor development of the CPs market are: restricted
entry of corporates, tendency to issue CPs only if the total cost is lower than
the PLR of banks, high minimum investment of individual investors and no
tax benefits.
107
• In the US markets, CPs are defined as short-term, unsecured usance

promissory notes issued at a discount to face value with fixed maturity by
financially strong companies with high credit ratings.
• The main purpose of issuing CPs in the US is to finance current assets.
• The main features are: high liquidity and safety, high quality instruments
negotiable by endorsement and delivery, issued in multiples of $1,000 as
bearer documents at a discount to the face value. They are unsecured by
nature and tailored to the user requirement as far as maturity period is
concerned.
• Two types of CPs exist in the US: direct paper (issued directly by the
corporates and large banks) and dealer paper (issued by the dealers on behalf
of their corporate clients).
• The innovations in the American CP market are: master note (financial paper
issued by finance companies to bank trust departments with interest pooled
by the investors), medium-term notes (unsecured obligation papers with
maturity of 9-10 months issued by investment grade corporations at fixed
rate) and asset-backed commercial papers (packages of pooled loans or credit
receivables with lower rates of interest and placed with a special purpose
entity).
108
Money Markets
Appendix*
SCHEDULE I
(Specimen)
Stamp to be
Affixed as in force
in the State in which
it is to be issued
---------------------------------------------------------
(NAME OF THE ISSUING COMPANY/INSTITUTION)
SERIAL NO.
Issued at:--------------------------------------------- Date of issued: ------------------------

(PLACE)
Date of Maturity:------------------------------------------without days of grace.
(If such date happens to fall on a holiday, payment shall be made on the immediate
preceding working day)
For value received --------------------------------------------------------------------hereby
Promises to pay ------------------------------------------------------------- or order on the
(NAME OF THE INVESTOR)
maturity date as specified above the sum of Rs.-------------------------------------------
(in words) upon presentation and surrender of this Commercial Paper to-------------
----------------------------------------------------------------------------------------------------
(NAME OF THE ISSUING AND PAYING AGENT)
For and on behalf of --------------------------------------------------------------------------
AUTHORISED AUTHORISED
SIGNATORY SIGNATORY
* Source: RBI/master circular/commercial paper/July 1, 2005

RBI/2005-06/17 July 1, 2005.
109
ALL ENDORSEMENTS UPON THIS COMMERCIAL PAPER MUST BE

CLEAN AND DISTINCT
EACH ENDORSEMENT SHOULD BE WRITTEN WITHIN THE SPACE

ALLOTED
Pay to ------------------------------------------------------------------------ or order the

amount within named.
(NAME OF TRANSFEREE)
For and on behalf of

----------------------------------------------------------------------------------
(NAME OF THE TRANSFEROR)
----------------------------------------------------------------------------------
1. ”
2. ”
3. ”
4. ”
5. ”
6. ”
7. ”
8. ”
110
Money Markets
Schedule II
Proforma of information to be submitted by the

Issuer for issue of Commercial Paper
(To be submitted to the Reserve Bank through the Issuing and Paying Agent (IPA)
within 3 days of the completion of issue of CP to MPD, RBI, Mumbai)
To:
The Adviser-in-Charge
Monetary Policy Department
Reserve Bank of India
Central Office
Mumbai – 400 001.
Through: (Name of IPA)
Dear Sir
Issue of Commercial Paper

In terms of the guidelines for issuance of commercial paper issued by the
Reserve Bank dated August 19, 2003, we have issued Commercial Paper as per
details furnished hereunder:
i. Name of the Issuer :

ii. Registered Office and Address :
iii. Business activity :
iv. Name/s of Stock Exchange/s
with whom shares of the
issuer are listed (if applicable) :
v. Tangible networth as per latest
audited balance sheet :
vi. Total Working Capital Limit :
vii. Outstanding Bank Borrowings :
vii. a. Details of Commercial Paper
issued (Face Value) : Date of Date of Amount
Rate Issue Maturity
i.
ii.
b. Amount of CP outstanding
(Face Value) including the
present value :
111
ix. Rating(s) obtained from the i.

Credit Rating Information
Services of India Ltd. (CRISIL) ii.
or any other agency as specified
by Reserve Bank iii.
x. Whether standby facility has been
provided in respect of CP issue?
xi. If yes
i. the amount of the : Rs. crore
standby facility
ii. provided by
(Name of bank/FI)
xii. Whether unconditional and irrevocable
guarantee has been provided in
respect of CP issue?
xiii. If yes
i. the amount of the guarantee : Rs. crore
ii. provided by (Name of guarantor)
iii. Credit rating of the guarantor
For and on behalf of
--------------------------
(Name of the issuer)
112
Money Markets
(Specimen)
CERTIFICATE**
1. We have a valid IPA agreement with the----------------------------------------------

(Name of Issuing Company/Institution)
2. We have verified the documents viz., board resolution and certificate issued
by Credit Rating Agency submitted by ------------------------------------------------------
(Name of the Issuing Company/Institution)
and certify that the documents are in order. Certified copies of original
documents are held in our custody.
*
3. We also hereby certify that the signatures of the executants of the attached
Commercial Paper bearing Sr.
No._____________date____________________for
Rs.___________________(Rupees_________________________________)
(in words)
tally with the specimen signatures filed by_____________________________
(Name of the issuing Company/Instittuion)
(Authorised Signatory/Signatories)
(Name and address of Issuing and Paying Agent)
Place :
Date :
* (Applicable to CP in physical form)
** Source: RBI/master circular/ commercial paper/ July 1, 2005

RBI/2005-06/17 July 1, 2005.
113
•
• ! "
• #
Money Markets
The primary function of banks and financial institutions is to mobilize funds from
the surplus economic units and lend them to the users or the deficit spending
economic units. In the process, banks charge interest or brokerage based on the
type of transaction. They pay interest to the saving public, and receive interest
from the borrowers and in the process make a spread.
The depositors/savers maintain account with banks in the form of demand and
time deposits. Savers (who need high liquidity) generally opt for demand deposits
as they consider them to be as liquid as cash. Banks invest these deposits in
short-term instruments to gain a return over them. Otherwise, they have to
maintain idle funds losing the interest on those funds. The banks are exposed to
interest rate risk when they deploy their demand liabilities in short- or medium-
term investments/credit because of maturity mismatch.
The RBI introduced Certificates of Deposit (CDs), in 1989 based on the Vaghul
Committee recommendations. The CDs were introduced ‘with a view to further
widen the range of money market instruments and give investors greater flexibility
in the deployment of their short-term surplus funds’. The RBI had assigned
FIMMDA (Fixed Income Money Market and Derivative Association for India),
the task of framing standardized procedures and documentations for CDs in
consultation with depositories and market participants. The RBI taking into
FIMMDA’s recommendation issues the final guidelines for the issue of certificates
of deposit. This chapter discusses the features, purpose and market developments
of Certificates of Deposit.
DEFINITION
Certificates of Deposit (CDs) are the instruments issued by banks in the form of
usance promissory notes. These bank deposits are negotiable, and are in
marketable form bearing specific face value and maturity. They are transferable
from one party to the other unlike term deposits. Due to their negotiable nature,
these are also known as Negotiable Certificates of Deposit (NCDs). A Certificate
of Deposit can also be referred to as a money market instrument, a receipt for
funds deposited in a financial institution for a specific time for a specific interest
rate.
ISSUERS
Scheduled commercial banks, selected all India financial institutions are permitted
by RBI to issue CDs for raising short-term resources. Regional Rural Banks
(RRBs) and Local Area Banks (LABs) are excluded from issuing CDs. While
banks have freedom to issue CDs depending on their requirement, FIs are allowed
to issue CDs with in the overall umbrella limit as fixed by the RBI from time to
time. As per the RBI guidelines the issued CDs together with other instruments
like term money, term deposits, commercial papers and inter-corporate deposits
should not exceed 100 percent of its Net Owned Fund (NOF). The NOF is
considered as per the latest audited balance sheet.
SUBSCRIBERS
CDs are available to individuals, corporations, companies, trusts, funds,
associations, etc., for subscription. Non-resident Indians can also subscribe to
these instruments, but only on non-repatriable basis, which cannot be endorsed to
another NRI in the secondary market (if mentioned on the certificate). CDs are
issued only in the dematerialized form. However, according to the Depositories
Act, 1996, investors have the option to seek certificate in physical form. If investor
insists on physical certificate, the issuer should to the RBI. The issuance of CD
will attract stamp duty. Physical CDs are freely transferable by endorsement and
delivery while dematted CDs are transferred as other demat securities. There is no
lock-in period for the CDs.
115
FEATURES OF CDs
The distinct features of CDs are:
• CD is a document of title to a time deposit and is distinct from conventional
time deposit with respect to negotiability and marketability.
• CDs are considered as virtually riskless instruments as the default risk is
almost nil, and investors are sure of receiving the invested amount with
interest.
• The liquidity and marketability features are considered as the hallmarks of
CDs.
• CDs are issued at a discount to face value.
• CDs are maturity-dated obligations of banks forming a part of time liabilities,
and are subjected to usual reserve requirements.
• CDs may be either registered or in a bearer form. The latter form, however, is
considered better for secondary market operations.
• CDs attract stamp duty and there is no grace period, as in the case of bill
financing.
• CDs are freely transferable by endorsement and delivery.
• The CDs issued are within the limit as specified by Reserve Bank of India.
• CDs are also issued in demat forms only. Only the request of Investors they
can be issued in physical form.
• CDs held in the demat form can be transferred as per the procedure
applicable to other demat securities.
• The trade settlement will take place on T + 1 day basis; however, the
settlement period will be subject to the ceiling of T + 5 days or such period of
settlement as specified by the exchanges, whenever the trade is done on a
recognized stock exchange.
PURPOSE OF ISSUE
CDs benefit both issuers and investors. From the issuers (banks) point of view,
CDs are issued foreseeing the advantages over conventional deposits. The motives
behind issuing CDs are control over cost of funds and assured availability of funds
for specific period. The banks are constrained to define an interest rate structure
for their customers across the board. It is operationally difficult to offer different
rates of interest for different deposits, especially with a wide network as seen on
the Indian scenario. Consequently, most of the depositors will be paid the same
rate of interest. However, in case of Certificates of Deposit the interest is
determined on a case-to-case basis. Since the volumes are large, the rates offered
on CDs are more sensitive to call rates than the rates on term deposit. It is possible
to discriminate between two customers and give different rates, which is not
normally possible in case of term deposits. The conventional deposits though
having a fixed maturity can be withdrawn prematurely; whereas, investors have to
wait till the CDs mature or approach the secondary market to sell them. Issuance
of CD helps banks to maintain the market share. From the investors’ point of view,
CDs form a better way of deploying their short-term surplus funds. CDs offer
higher yields when compared to conventional deposits, while the secondary market
offers liquidity. They can be assured of interest and principal payment normally.
116
Money Markets
Minimum Size and Denomination

CD should be issued in denomination of Rs.1 lakh (1 unit) of Maturity Value
(MV)/Face Value (FV). The minimum marketable lot for a CD, whether in
physical or demat form will be Rs.1 lakh or multiples of Rs.1 lakh.
Term/Maturity
Banks can issue CDs for a minimum period of 7 days to a maximum of one year,
whereas a financial institution can issue it for a minimum of one year and a
maximum of 3 years. The RBI on July 1, 2005 in its guidelines for issue of
Certificates of Deposit by banks reduced the minimum period of CDs to 7 days.
Discount
CDs are issued at a discount to face value. Bank CDs are always discount bills,
while CDs of DFIs (Development Financial Institutions) can be coupon bearing as
well. The discount rate is freely determined by the issuing bank, considering the
market conditions. While determining the discount rate of a CD, the issuing bank
considers the prevailing call money rates, treasury bill rate, maturity of the CD, the
amount of funds available, and its relation with the customer. The discount rate
varies from one customer to the other, from time to time and even for the same
customer based on the above factors.
The discount rate is calculated as follows:
F
DR =
1+
(I x N)
100 x 365
Where,
DR = Discounted value
N = Issuance period
F = Face value
I = Effective interest rate per annum.
THE ISSUING PROCEDURE

Brief Process of Issue of Certificates of Deposit
The investor will make an application to the issuer for investing in the CD. CDs
are issued in demat form only.
Demat Issue
In case of a demat issue the issuer has to enter into an agreement with the
depository. The depository will require an agreement to be executed with the
issuer and its registrar. The issuer shall comply with the formalities of the
depository. The investor will be required to fill the prescribed application form and
submit it along with cheque/pay order for the appropriate amount to the issuer.
CD in a Physical Form
CDs are issued in physical form only on request of the matter. The issuer after
receiving the money from the investor will issue the CD in a physical form directly
to the investor. The physical form of the CD will bear a declaration that the CD
has been adequately stamped. The eligible issuers can issue and accept the CD at
any one of its branches.
Stamp Duty
CD being a usance promissory note is subject to stamp duty, which is paid by the
issuer.
117
The applicable stamp duty structure will be as under:
! "
" ! # $
# !
Maturity and Payment

Banks are not permitted to buyback their CDs prematurely, nor allowed to grant
loans against CDs. On maturity the instrument is presented to the issuing bank, by
the holder for receiving payments who receives the face value of certificate. As
there is no provision for grace period, the bank has to redeem its CDs on the
stipulated due date (and if the due date is a holiday, it redeems it on the next
working day).
Secondary Market and Trading
CDs are freely transferable by endorsement and delivery, immediately after the
date of issue and can be traded in secondary market from the date of issue unlike
conventional deposits. In case the CD is issued in the Demat form, the seller would
promptly give a copy of the delivery instruction given to its DP to transfer
securities and also the details of Issuer’s CD Redemption A/C to enable the buyer
to submit the CD for redemption.
In case of secondary market purchase of CD in physical form, the buyer is entitled
to receive the duly endorsed original CD in his favor from the seller.
Unless otherwise mutually agreed upon by the buyer and seller, trade settlement
will take place on T + 1 day basis; however, the settlement period will be subject
to the ceiling of T + 5 days or such period of settlement as specified by the
exchanges, whenever the trade is done on a recognized stock exchange.
Transfer of Certificates of Deposit
CDs held in physical form are freely transferable by endorsement and delivery. CD
held in the demat form can be transferred as per the procedure applicable to other
demat securities.
PROCESS OF REDEMPTION
For the Investors who are Holding the CDs in the Demat Form
Investors who are holding CDs in the demat form approach their respective DPs
and give instructions to transfer the demat security to the CD redemption account,
maintained by the issuer. It is important to note that this redemption account will
be common for all CDs issued by the issuer. It is the responsibility of the holder to
communicate to the issuer by enclosing a copy of the delivery instruction it had
given to its DP and intimate the place at which the payment is requested to
facilitate prompt payment.
Once the demat credit of CD, in the CD redemption account is received, the issuer,
on maturity date, would arrange to repay to holder/transferor by way of Banker’s
cheque, etc., as the case may be, the FV of the CD.
After the payment of the CD to the transferor of the CD, the issuer should confirm
to the depository that the payment has been made. The payment to the investors
will be made on a first come first served basis. The issuer would co-ordinate with
R&TA to extinguish the securities.
118
Money Markets
If CD is in Physical Form
In case the CD is in physical form, it should be presented by the holder to the
issuer, at the specified place therein on the maturity date or on a working day
before the maturity date, for payment on maturity date, along with payment
instructions. The issuer will repay the CDs on the first come first served basis and
would arrange to cancel the redeemed CDs with proper notings on it.
Both physical CDs and demat CDs shall be given equal treatment and the payment
will be made on ‘first come first served’ basis.
Conversion of Physical to Demat
The following is the procedure for the conversion of a physical CD into a Demat
form:
Step 1
The holder of CD will fill up the Dematerialization Request Form (DRF), and
submit it to the DP along with the original CD certificate/s to be dematerialized.
Then the DP would give an acknowledgment to the client confirming the
acceptance of the CD for dematerialization.
Step 2
DP enters the ISIN of the CD in the ‘DRF’. The DP stamps the certificate
“Surrendered for Dematerialization” on the face of the CD and sends the
certificate and DRF to the R&TA/issuer along with a covering letter for further
processing.
It is important to note that the CD is a negotiable instrument. Hence, the investor
should see that proper notings have been made on the reverse of the CD so as to
avoid any chance of its misuse in case of loss in transit.
Step 3
The DP would send all the documents received to the issuer/R&TA at his address
appearing on the face of the physical CD. Once the original CDs, DRF are
received by the R&TA, arrangement is made for the credit of the Demat CD to the
holder of the security. Then the electronic credit of CD would come to demat
account of the holder, directly from the registrar in accordance with the normal
depository procedure for demat. The latest guidelines are in Annexure.
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Development of the Market
When CDs were first launched, they were expected to give banks an opportunity to
mobilize high volume deposits. It was contemplated that corporate would deploy
their short-term surpluses in CDs, as they were offering a high interest rate (around
15-16% initially) and were freely tradable. However, trading in CDs never caught
up in a big way as 90% of the investors were holding the instrument till maturity.
119
DFHI was set-up by RBI in 1989 to develop the money market. DFHI, being a
discount house, was expected to play the role of a market maker to all the money
market instruments including CDs. However, the secondary market in CDs
remained more or less stagnant. As stated earlier, the maturity of a CD is mostly
determined by the investor rather than the issuer since a bank has greater flexibility
in managing the maturity profile of its assets and liabilities unlike the companies.
Hence, most of the investors tend to hold the CDs till maturity. This has hindered
the development of a secondary market. DFHI also has not been active in this area
by choosing to remain a buyer rather than a seller of CDs.
The move to establish a discount house to activate the secondary market for money
market instruments, however, was not successful. The following are certain
impediments in the way of DFHI. First, the yield on CDs being high, the investors
hold the instrument till the end of maturity to gain maximum benefit. Secondly,
lack of information to the investors (to those outside Mumbai) regarding the
facilities available with the DFHI.
Thirdly, when the banks have highly liquid funds at their disposal due to the
prevailing economic scenario, they do not choose to issue CDs because they need
to pay high interest when compared to conventional deposits. Hence, the primary
market is also not very active in such a scenario. Lastly, CDs are issued by major
banks to a few corporations/customers and hence, the primary market is not widely
spread. Experts opine that there is still potential for their growth in spite of the
weak secondary market, the reason being that Many PSUs and private sector
corporate bodies are believed to have substantial floating cash flows due to
prevailing inflationary environment in the country. Similarly, many financial
institutions such as UTI, LIC, etc., are flooded with huge funds for investment and
do not have ready outlets to invest (which were partly gathered from corporate
funds and household savings).
These funds have to be deployed in money market till the final deployment takes
place. Then, the inter-corporate funds which form a substantial amount could be
invested in short-term liquid instruments. The ICD market never experienced any
default for decades. However, the early ’90s have witnessed defaults in ICD which
made many cash rich corporates more cautious. Considering the high level of risk
in ICD market, CDs form a suitable lucrative medium to meet the above
requirements. Thus, there is scope for their growth. Given these demand supply
conditions and the support of the RBI, and institutions like DFHI and PDs to the
CD markets, the potential for growth in CD market cannot be ruled out.
CDS MARKET SIZE AND INTEREST RATES
The outstanding amount of CDs issued by scheduled commercial banks is greater
than those issued by the FIs. The total amount outstanding has been subjected to
various inter year and intra year fluctuations. The CD market is much bigger when
compared to the CP market. The interest rates on CDs were higher than those on
the bank deposits.
CDs IN OTHER COUNTRIES

Different kinds of CDs are issued by banks and other depository institutions in the US.
But, negotiable CDs are considered as true money market instruments. Negotiable
CDs are issued in bearer form and are registered in the books of the issuing
depository institution in the name of the investor. Since they are issued in bearer
form, trading in the secondary market becomes more convenient for an investor.
Negotiable Certificates of Deposit (NCDs) are tradable time deposits. Most NCDs
carry a fixed rate of interest till maturity. However, a few NCDs are now being
120
Money Markets
issued with variable interest rates, where the period of the instrument is divided
into equal sub-periods and the rates are decided at the beginning of each sub-period.
Issuers
Banks and depository institutions issue CDs. Depository institutions use CDs as a
supplement to federal funds when additional reserves are needed.
Buyers
Corporates, state and local governments, foreign central banks and governments,
wealthy individuals, and financial institutions such as insurance companies,
pension funds, investment companies, savings banks and money market funds,
etc., are principal buyers of CDs.
Features of CDs
• CDs are issued in bearer form, thus making it convenient for an investor to
resell them in the secondary market.
• The discount rate on a negotiable CD is arrived at by negotiation between the
issuing institution and the customer, and generally, the rate is based on the
market prevailing conditions.
• CDs carrying a minimum denomination of $1,00,000 are traded usually in the
market.
• The maturity ranges from 30 days to 5 years, depending on the customer’s
needs. CDs with maturities beyond one year are referred as ‘Term CDs’.
They can be discounted any number of times before maturity.
CD Market in London
For orderly trading and efficiency in the markets, The Bank of England and the
British Bankers’ Association (BBA) have issued guidance notices on CDs and the
CD market in London. A notice given by the Bank on 1st November, 1996 gave
guidance on the nature of such CDs and other matters relevant to orderly issuance
and trading. Many issues like formats of CDs, security aspects, minimum London
good delivery standards, tax and approved currency denominations were
mentioned in the guidelines.
CDs are issued in London subject to some standard terms and conditions. They are
issued by authorized institutions, issued and payable in the United Kingdom and
primarily traded in London. London CDs are short-term marketable instruments
with maturity up to five years. Minimum denomination is not less than £100000 or
its equivalent in foreign currency.
These CDs can also be issued at a discount. Subject to some terms and conditions,
the CDs can contain put or call option. London CDs can also be guaranteed where
the guarantor is an authorized institution in the United Kingdom issuing CDs or is
a European authorized institution, eligible to issue guarantees in the United
Kingdom. The name of the guarantor has to be clearly marked on the face of the
certificate in the case of physical paper, and in the case of any other mode the
name should be marked in the records of any clearing system or depository.
Any institution that is involved in the first issue of London CDs has to inform the
Gilt-Edged & Money Markets Division of the Bank of England prior to such issue.
Innovations in CD Market
Innovative CDs such as Asian Dollar CDs, Jumbo CDs, Yankee CDs, Brokered
CDs, Bear and Bull CDs, Installment CDs, Rising Rate CDs, and Foreign-Index
CDs have flooded the money market abroad.
• Asian Dollar CDs carry both fixed and floating interest rates based on the
current level of the Singapore Interbank Offer Rate (SIBOR) and paid at the
New York clearing house. Similar to domestic CDs, they are normally traded
in $1 million units but at higher yields.
121
• Jumbo CDs are issued by savings and loan associations in large volumes such
as $100,000 and above.
• Yankee CDs are issued by foreign banks such as Japanese, Canadian, and
European institutions in the US who usually have offices in US cities.
• Brokered CDs are sold through brokers or dealers in denominations of
$100,000 (maximum) to qualify for federal deposit insurance. Many brokers
participate in exchanges in which their investing customers can purchase
packages of the highest yielding CDs issued by banks and thrifts.
• Return on Bear and Bull CDs are linked to stock market performance
allowing depositors to seek variable equity like returns.
• In Installment CDs, target level for the amount is built-up in the account by
allowing the customers to make a small initial deposit.
• In Rising Rate CDs, investors can withdraw the permitted amount of
promised yields (which increases overtime) on selected yearly dates. These
deposits are usually long-term in nature and withdrawals are penalty-free.
Recently, Foreign-Index CDs were offering a return linked to fluctuations in
foreign currency values and economic developments abroad.
• Thrift CDs are issued by large savings and loan associations. Usually, they
are issued in denominations of $100,000 so that they can be covered under
the FDIC. Sometimes, a large thrift CD is made out of various CDs of
$100,000 or less packed into one, but as all of them are covered under the
FDIC, the risk is minimal. More innovations in CDs are likely to emerge in
the future since banks try to maintain/improve their market share in the face
of increasingly stiff competition for funds. These instruments would be more
lucrative when foreign interest rates rise significantly above the US interest
rates.
SUMMARY
• Certificates of Deposit (CDs) are usance promissory notes, negotiable and in
marketable form bearing a specified face value and number. Scheduled
commercial banks and the major financial institutions can issue CDs.
• Individuals, corporates, trusts and NRIs are the main investors in CDs (on
non-repatriable basis).
• The features of CDs are: it is a title document to a time deposit, riskless,
liquid and highly marketable, issued at a discount to face value, being part of
the time liabilities of banks, either in registered or bearer form, freely
transferable by endorsement and delivery. It does attract stamp duty.
• The benefits of issuing CDs to the banks are: interest can be determined on a
case to case basis, there is no early maturity of a CD, rates are more sensitive
to call rates.
• To the investors the benefits of subscribing to CDs are: it is a better way of
deploying short-term funds as higher yield is offered, secondary market
liquidity is available and repayment of interest and principal is assured.
• CDs are issued for a period of 15 days to one year (normally one to three
years by the financial institutions) at a minimum amount of Rs.1 lakh and in
multiples of 1 lakh thereafter with no upper limit.
• There is no specific procedure to issue the CDs. It is available, on tap, with
the bankers.
122
Money Markets
• CDs are the largest money market instruments traded in dollars. They are
also issued by either banks or depository institutions, mostly in bearer form
enabling trading in the secondary market.
• Individuals, corporates and other bodies also buy the CDs in the US.
• The features of American CDs are: they are bearer instruments, negotiable,
with a minimum denomination of $100,000, maturity of 30 days to 5 years.
CDs with more than one year maturity are known as term CDs.
• CDs have undergone various innovations: Asian dollar CDs, jumbo CDs,
yankee CDs, brokered CDs, bear and bull CDs, installment CDs, rising rate
CDs and foreign index CDs, all have different features. Many more
innovations are expected in this upcoming market.
123
Appendix
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124
Money Markets
Annexure I
Name of the Bank/Institution

No. Rs.-----------------
-
Date---------------------------
NEGOTIABLE CERTIFICATE OF DEPOSIT
----------------------months/days after the date hereof, ------<Name of the

Bank/Institution>-------------, at --------<name of the place>---------, hereby
promise to pay to---------<name of the depositor>----------- or order the sum of
Rupees----------------<in words>--------------- only, upon presentation and surrender
of this instrument at the said place, for deposit received.
For--------<Name of the
Institution>-------
Date of maturity----------------------------- without days of grace.
----------------------------------------------------------------------------------------------------
Instructions Endorsements Date
1. 1.
2.
3.
4.
125
Annexure II
Fortnightly Return on Certificates of Deposit(CDs)
(SFR III – D)
Name of the Bank/Institution :

For the Fortnight ended :
Issue of Certificates of Deposit (CDs)
Total amount of CDs outstanding as at the end of the fortnight (Rs. Crore)
1. On Discount Value Basis
Face Value :
Discounted Value :
2. On Coupon Bearing Basis
Face Value :
Particulars of CDs issued during the fortnight
I. CDs issued on Discount Value Basis

/ ?.. / %
9
& ; 3 & .0 / / &0
% % @
"
II. CDs issued on Floating Rate Basis

5 / *
< / 3 & . 9
& ; / &0
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% @
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126
•
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Availability of finance in adequate quantity at the right time and at a reasonable

cost helps to produce economic goods, either for immediate consumption or for
capital formation and thus, fosters economic development. Finance is made
available by the financial system of the country which comprises financial
institutions, financial markets and financial instruments created from time to time.
Money markets comprising banks and other financial institutions and government
cater to the short-term credit requirements of trade, commerce and industry in the
form of cash credits, overdrafts and purchase/discounting of commercial bills.
Monetary Policy and Bill Financing

The RBI, the central monetary authority of the financial system with its monetary
policy, regulates the credit creation of the financial institutions and ensures the
availability of credit to the extent that is appropriate to sustain the tempo of
economic development. Monetary policy refers to the use of the official
instruments under the control of the Central Bank to regulate the availability, cost
and use of money and credit.
The bank rate or the discount rate is the traditional weapon of the central bank,
which operates on the cost of credit indirectly by altering the cost at which the
central bank’s facilities are available to the commercial banks. The bank rate or the
discount rate, is the standard rate at which the bank is prepared to buy or
rediscount bills of exchange or other commercial paper eligible for purchases. The
effect of a change in the discount rate is to make the cost of securing funds from
the central bank cheaper or more expensive and thereby, bring about changes in
the structure of market interest rates.
Out of the modes of financing, the banks and financial institutions rely mostly on
cash credit form of lending. Up to the mid-eighties, the development of a bill
market was not a reality despite its well known advantages to lenders and
borrowers alike. The various impediments in the way of developing a bill market
were payment of stamp duty, difficulty in obtaining supplies of stamp paper,
reluctance on the part of government departments and other large buyers to accept
bills, predominance of the cash credit system of lending and the administrative
work involved in handling documents of title of goods. However, in comparison
with other methods of supplying credit, the method of bill finance is believed to
impart flexibility to the money market and balance liquidity within the banking
system. Considering its importance, the RBI has made efforts to enlarge the use of
bills of exchange as an instrument of credit and develop the bill market. New Bill
Market Scheme introduced Bill Market Scheme in 1952 and the Bill
Rediscounting Scheme in 1970. To provide a secondary market and to ensure and
promote the extensive use of bills, Discount and Finance House of India (DFHI)
was established.
CONCEPT AND FEATURES OF BILLS OF EXCHANGE

The origin and concept of bills can be traced back to the 4th century BC, when the
Greeks made use of bills. From times immemorial, banks and business houses
have been using ‘Hundi’, the indigenous kind of bills of exchange. There were two
kinds of hundis which were in vogue. Of the two, darshani hundi is similar to the
bill of exchange of today with respect to the purpose for which it is drawn. Its
place of origin may be quite different from the place of operation. In this context,
muddati hundi is quite different. It is confined to local limits in which it is drawn.
Section 5 of the Negotiable Instruments Act, 1881, defines Bills of Exchange as
‘an instrument in writing containing an unconditional order, signed by the maker,
directing a certain person to pay a certain sum of money only to, or to the order of,
a certain person or to the bearer of the instrument’.
128
Money Markets
A bill attains the character of negotiability only if it contains the features of

negotiable instruments. The specific features of a negotiable instrument are as
follows:
i. Parties to a bill of exchange – drawer, drawee and payee. The maker of the
instrument who directs to pay is the drawer, the person to whom the direction
is given is the drawee (when he accepts the bill, he becomes the acceptor)
and the person to whom payment is to be made is the payee. In some cases,
the drawer and the payee may be the same person.
The drawer or the payee who is in possession of the bill is called the holder.
When the holder endorses it, he is called the endorser. The person to whom it
is endorsed is called the endorsee. When in the bill or any endorsement
thereon, the name of any person is given in addition to the drawee (to be
resorted to in case of need), such person is called a drawee in case of need.
Drawee in case of need can be resorted to only when the bill is dishonored by
non-acceptance or non-payment.
ii. The instrument must be in writing.
iii. It must contain an order to pay and not a request.
iv. A bill of exchange cannot be drawn so as to be payable conditionally.
v. The sum payable must be certain.
vi. The person to whom the direction is given or to whom the payment is to be
made must be certain.
vii. It must be signed by the drawer and presented to the drawee for acceptance.
viii. The order to pay should be in legal tender money.
ix. All other formalities like date, number, place and consideration are usually
found in bills though not essential in law.
CLASSIFICATION OF BILLS
There are various types of bills of exchange in vogue today in the market: (a) They
can be classified as ‘demand’ and ‘usance’ bills on the basis of when they are due
for payment, i.e., immediately, ‘at sight’ or ‘on presentation’, as in case of
demand bill or at a specified later date (usually three months) as in case of a
usance bill. (b) Bills again are classified as ‘documentary’ and ‘clean’ on the basis
of whether they are accompanied by documents of title to goods such as railway
receipts/lorry receipts/bills of lading, etc., or not accompanied by such documents.
(c) Some bills are classified as ‘D/A’ and ‘D/P’ bills on the basis of whether the
documents are Deliverable just against Acceptance (D/A) or Deliverable only
against Payment (D/P), usually through a bank. A D/A bill, however, becomes a
clean bill immediately after the delivery of the documents. (d) Bills are classified
as ‘Inland’ and ‘Foreign’. Inland bills must be drawn or made in India, and must
be payable in India or drawn on any person resident in India. On the other hand,
foreign bills are drawn outside India and may be payable in and by a party outside
India or are drawn in India and made payable outside India. A related
classification of bills is export bills and import bills. While export bills are those
drawn by exporters on any country outside India, import bills are those drawn on
importers in India by exporters outside India. The inland bills may be further
divided into ‘local’ and ‘outstation’. (e) Besides, there are what are known as
‘Supply Bills’, ‘Government Supply Bills’ and ‘Accommodation Bills’. The
supply bill arises out of supply of goods by manufacturing concerns and the
government supply bills out of the supply of goods to the government or any of its
departments. An accommodation bill is the one accepted by the drawee to
accommodate the drawer without having received any consideration. Banks have
to be cautious while extending credit against accommodation bills as they are
prone to frauds.
129
STEPS IN BILL FINANCING

How does a bill of exchange come into existence? Suppose, seller A sells goods to
buyer B on credit but wants to have money immediately, so he draws a bill of a
given maturity on B and sends the bill to B. A is known as the drawer of the bill
and B, the debtor, acknowledges his responsibility for the payment of the amount
on terms mentioned on the bill, by writing on the bill his “acceptance’’. When B
has “accepted’’ the bill, he is known as the acceptor or drawer of the bill. A, in
need of immediate money takes the “accepted bill’’ to a bank which exchanges it
for ready money. This act of handling over the endorsed bill in exchange for ready
money is called “discounting the bill of exchange’’. The difference between the
money paid to the seller or creditor or drawer of the bill and the amount of the bill
is called the “discount’’ which is calculated at a rate percent per annum on the
maturity value. In this context, we can draw a distinction among the following
categories of bills:
• Trader’s Bill: (a) Seller supplies goods and submits bill to the buyer for the
value of goods supplied, (b) Buyer accepts the bill along with the goods
supplied,(c) Seller receives the accepted bill from the buyer and discounts the
bill with the seller’s bank, and (d) Buyer makes the payment on due date.
• Bills with Co-acceptance: (a) Seller supplies goods and submits bill to the
buyer for the value of goods supplied, (b) Buyer accepts the bill along with
the goods supplied, (c) Buyer’s bank also co-accepts the bill, and (d) Seller
receives the bill accepted by the buyer and co-accepted by the buyer’s bank
and discounts with the seller’s bank.
• Bills accompanied by Letter of Credit (LC): (a) Seller supplies goods and
submits bill to the buyer for the value of goods supplied, (b) Buyer accepts
the bill along with the goods supplied, (c) Buyer’s bank opens LCs in favor
of the seller, and (d) Seller receives the accepted bill along with the LC
opened by the buyer’s bank in favor of the seller and discounts the same with
the seller’s bank.
• Drawee Bills: (a) Seller supplies goods and submits bill to the buyer for
the value of goods supplied, (b) Buyer accepts the bill along with the goods
supplied, and (c) Buyer’s bank discounts the bill for the account of the
buyer.
BENEFITS AND COSTS OF BILL FINANCING
Advantages of Bills Finance
Following are some of the major advantages to the banks providing bills finance:
• Self liquidating mode of financing
• Liquidity management of the banks becomes easier
• Easy to monitor the genuineness of the transactions
• Monitoring of borrowers’ receivables becomes easy
• Quality of receivables can be ascertained
• Bank has recourse, both to the drawer as well as the drawee
• Sale transactions are routed through the bank
• Effective yield is higher since discount is deducted upfront
• Bank earns fee-based income
• Facility of rediscounting
• Disciplined way of financing.
130
Money Markets
The usage of Discounting of Bills is not free of costs. The following are some of
the costs associated with the discounting of bills:
i. Operational and Procedural Constraints
Some of the major difficulties faced while drawing usance bills on customers
are:
• Wide geographical spread of the buyers.
• Procedural delays on the part of both the drawer’s and the drawee’s
banks.
• Cumbersome documentation formalities.
• The usual 90 days usance allowed by the banks is not sufficient.
• Difficulties in submitting supporting documents.
• Banks are hesitant to discount bills on new buyers.
ii. Difficulties Experienced in Getting Bills Accepted
The difficulties in getting usance bills accepted by the customers could be
classified into the following categories:
a. Cost related: About 60% of the respondents said high cost was an
important aspect coming in the way of their customers accepting usance
bills.
b. Reluctance on the part of the buyers: It was mainly due to the reasons
such as commitment to pay the amount on due date, buyers themselves
not realizing their due in time, government departments/PSUs and some
multinationals not accepting bills as a matter of policy, etc.
c. Formalities involved: The areas identified were stamping, requirement
of board resolution, attested specimen signature, etc.
d. Delays: They were mainly due to operational and logistical difficulties
in sending and receiving the documents and delays in acceptance of
bills by buyers.
e. Other difficulties: They covered areas such as:
• Buyers’ reluctance to accept bills for fear of problems in accounts
reconciliation in case the materials were rejected.
• Banks insist upon production of original documents (e-mail or fax
not accepted).
• Buyers’ reluctance due to general slow down in the economy.
iii. Discounting of Bills with Banks Cumbersome
The procedure for discounting of bills with banks was cumbersome. Some
specific areas mentioned are:
• Stamping of documents.
• Banks not accepting bills of smaller values.
• Non-acceptance by government agencies (as buyers) of power of
attorney given by the seller to his bank.
• Procedural delays.
• Delays in receiving information from collecting bank regarding
acceptance/non-acceptance of bills.
• Banks not discounting bills without verifying the credentials of the
buyers.
131
iv. Dishonor of Bills

The major reasons for dishonor of bills are:
• Buyers do not have funds
• Return of the materials
• Deliberate dishonor
• Adverse business conditions.
A majority of the respondents (56%) felt that the existing laws were not
sufficient to deal with the defaulters. The main reasons attributed by them
were – legal delays and high costs. Naturally, many of the respondents did
not feel adequately secured legally in case of default.
v. Payment of Bills – Strengthening the Payment Mechanism
The existing bank mechanism for payment of bills is considered inadequate
by most of the bankers. Some suggestions for strengthening the payment
mechanism are:
• Speedy remittance of collected amounts.
• Introduction of electronic clearing and settlement mechanism between
banks.
vi. Banking Practices
The following are some of the practices being followed by most of the banks.
• Cash management services offered by some of the banks.
• Use of courier services, telex, fax, e-mail for speedy clearance.
Some measures to bring the cost of bill financing at par with cash credit
facility.
• Handling charges may be reduced.
• Stamp duty may be levied only for bills having usance period of more
than 180 days.
• Rate of penal interest on overdue bills may be reduced.
DISCOUNTING OF BILLS BY NBFCS

Quite a few such concerns throughout India are engaged in bill discounting
activity on regional basis; Marwari Hundi at Kolkata, Delhi, Kanpur, Jaipur,
Ahmedabad and even at Mumbai and Chennai is discounted by investment
companies, provided the parties’ drawer and drawee are acquainted companies to
the investment companies. Similar is true with Chettiar Hundi at Chennai and
other principal towns in southern states. Shroff Hundi is in vogue in entire
Maharashtra and Gujarat. The discounting firm earns handsome income from
discounts depending on case to case basis, the urgency of funds, the type of
transaction and the financial risk involved therein.
REDISCOUNTING
Banks can rediscount the bills, which were originally discounted with them by
their corporate clients, with eligible financial institutions. The only prerequisite is
that the originally discounted bills should have arisen out of genuine trade
transactions. Banks compute the total amount of eligible bills discounted by them
after deducting the rediscounts already booked on the bills and approach the
approved rediscounting institutions to verify the availability of funds and the
prevailing rate.
132
Money Markets
Role of DFHI in Rediscounting

The efficiency of money market instruments to continue as going concerns
depends on their ability to command liquidity in times of need or crises.
Traditionally, in all countries central banks help banks in their liquidity
management by providing them discounting, rediscounting and refinancing
facilities. The central bank performs this function through its discounting
mechanism. Banks borrow funds temporarily from the central bank against eligible
papers such as treasury bills, commercial bills, etc., which the central bank stands
ready to rediscount to provide financial accommodation. In many countries, the
facilities of discounting, rediscounting and refinancing are provided by banks of
various sizes. In UK, a unique, specialized, institutionalized set-up namely
discount houses perform this task. A similar set-up has been initiated in India by
creating Discount and Financing House of India (DFHI).
The development of the money market is an important objective of monetary
policy. Pursuant to this objective, the Reserve Bank of India, based on Vaghul
Committee’s recommendations has jointly set-up with the public sector banks and
other all India financial institutions, the Discount and Finance House of India
(DFHI) to deal in money market instruments in order to provide liquidity in the
money market.
DFHI commenced its business operations from April, 1988 with an authorized
capital of Rs.250 crore and a paid-up capital of Rs.200 crore. Presently, it deals in
money market instruments such as 182-day treasury bills, commercial bills, call
money, commercial papers and certificates of deposit. The aim of DFHI, as
regards short-term commercial bills are concerned, is to provide liquidity to such
bills which have already been discounted by banks and financial institutions and
thus, generate ‘bill culture’ and ‘bill discipline’ amongst banks, financial
institutions and corporate managements.
The objective of DFHI is to increase the transactions in secondary market and not
to become a mere repository of money market instruments.
Right from the commencement of business, DFHI has been endeavoring to provide
depth to the bill rediscounting market. It varied the bid and offered rediscount rates
depending upon the cost of funds and conditions in the money market, and
thereby, achieved a high turnover in this market.
After the scam on 27.7.1992, the RBI instructed the banks to restrict bill
discounting facility outside the consortium of banks and prohibited banks from
rediscounting bills that were discounted by finance companies and merchant
bankers. The basic objective behind the instruction was to stop the misuse of bill
discounting facility by banks, by rediscounting bills arising out of share deals.
Some of the instructions given by RBI are:
• No fund or non-fund based facilities should be provided by a bank outside
the consortium arrangement.
• Bill finance should be a part of the working capital/credit limit.
• Only bills covering purchase of raw materials/inventory for production
purposes and sale of goods should be discounted by banks.
• Accommodation bills should never be discounted.
SIMPLIFIED PROCEDURE OF REDISCOUNTING
Owing to the administrative problems faced by banks in following the
rediscounting procedure of lodging and endorsing bills (to be rediscounted) with
the rediscounting banks/institutions, RBI has simplified the procedure. Under the
new system, banks are permitted to issue usance promissory notes in convenient
lots and maturities on the strength of genuine trade bills discounted by them and to
rediscount these derivative notes with rediscounting institutions.
133
COMMERCIAL BILL FINANCING

Commercial Bill had its origin in Europe as an early medieval financial innovation
evolved over centuries from a personal bond executed by debtor before a Court or
a public notary to its present form of a commercial financial instrument, acquiring
at various stages of evolution its distinctive characteristics of easy transferability
and negotiability, and thus lending itself to discounting by banks to provide
liquidity to the holder.
In India, too, indigenous bankers and other business houses have been historically
using some kind of Bill-like instruments written in vernacular languages, known as
‘Hundies’ in their many variants to pay and receive the value of goods exchanged
in the course of trade. However, with the development of organized financial
markets over the years, and the spread of commercial banking, the role of
indigenous bankers in the financial system diminished in importance and Hundies
too gradually started losing their status as the principal instrument of credit and
were replaced by Bill of Exchange in its present form.
With the dominance of cash credit system in financing domestic trade and
industry, Bill Finance, despite its inherent advantages from the point of view of the
lending banker, has been relegated to play only a marginal role in the credit
delivery system of the country. The need for the development of Bill culture
among borrowers was stressed by the various committees, appointed by the
Government of India and the Reserve Bank of India, while examining certain
aspects pertaining to bank lending/money market/banking sector reforms.
BILL MARKETS IN INDIA

The characteristic of easy transferability of the Bill was the key feature of the
instrument, which really paved the way for its development as a full-fledged
commercial and financial instrument. It enabled the Bill to be assigned to a bank
for the drawer to obtain cash immediately and thus, evolved the practice of
Discounting of Bills. A further landmark in the evolution of Bill was its being
accorded the characteristic of negotiability. With the development of organized
financial markets over the years, and the spread of commercial banking, the role of
the indigenous bankers in the financial system diminished in importance and
Hundies too gradually started losing their status as the principal instrument of
credit and were replaced by Bill of Exchange in the present form.
With the dominance of cash credit system in financing domestic trade and
industry, Bill finance despite its inherent advantages from the point of view of the
lending bankers, has been relegated to play only a marginal role in the credit
delivery system of the country. The need for the development of Bill culture
among borrowers was stressed by the various committees appointed by the
Government of India and the Reserve Bank of India, while examining certain
aspects pertaining to bank lending/money market/banking sector reforms. The
Committees, which had gone into the different aspects of working capital
financing, stressed the need to promote the Bill culture, so as to inculcate some
measure of financial discipline among borrowers. The Group was handicapped in
its task of tracking the recommendations on Bill Financing by the various
Committees. Therefore, it felt that it would be useful to capture below the key
recommendations of such committees to serve as a single point referencer.
Even though the role of Commercial Bill Market as an important component of
the money market was recognized as early as in the 1930s, concerted efforts were
not made in this direction till 1952. In fact, the Bill Market Scheme of 1952 was
floated in an altogether different context. The RBI’s decision in November 1951
to hike the bank rate from 3% to 3.5% and to refrain from making open market
purchases of government securities, save in special circumstances and at its
discretion, closed the liquidity window that was available to commercial banks,
under Section 17(4)(a) of the RBI Act, 1934, enabling them to tide over their
seasonal liquidity pressures.
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Money Markets
However, banks faced with seasonal stringency of funds in the busy season tapped
the RBI window and hence RBI on January 16, 1952 introduced the first Bill
Market Scheme under Section 17(4)(c) of the RBI Act, 1934; it enabled RBI to
make advances to scheduled banks against the security of usance promissory
notes or bills drawn on and payable in India, provided they arose out of bona fide
commercial or trade transactions, bearing two or more good signatures, one of
which shall be that of a scheduled bank, and maturing within 90 days from the date
of advance. In order to avail of refinance under the above Section, the scheduled
banks were required to convert a portion of the demand promissory notes obtained
by them from their constituents in respect of loans, overdrafts and cash credits
granted to them into usance promissory notes maturing within 90 days. The
accommodation, which was initially restricted to licensed scheduled commercial
banks having deposits (including deposits outside India) of Rs.10 crore or more,
was later extended to all the licensed scheduled commercial banks, irrespective of
the size of the deposits on the basis of a certification from the bank applying for
accommodation to the effect that the paper presented by it as collateral arose out of
bona fide commercial transactions and that the party was creditworthy. Later, in
1958, the RBI extended the Bill Market Scheme to export bills also to encourage
banks to extend credit facilities to exporters on a more liberal basis. The Banks,
however, could not avail of these facilities, as exporters were reluctant to draw
usance promissory notes as required by the RBI, after having tendered to banks for
purposes of negotiation, documentary usance export bills, which the banks sent
abroad for acceptance and collection. The RBI, therefore, introduced in March
1963, a new Exports Bills Credit Scheme, whereby advances could be made by the
RBI to scheduled banks against their promissory notes only and upon their
declaration of holdings of eligible usance export bills, drawn in foreign currencies
or Indian Rupees and purchased or negotiated by them.
The next significant measure taken by the RBI for promotion of a Bill Market was
in November 1970. Based on the recommendations of the Study Group on
enlarging the use of Bill of Exchange as an instrument of credit and creation of a
Bill Market chaired by Sri M Narasimham, the RBI introduced the New Bill
Market Scheme (NBMS in short). The scheme was restricted to genuine trade
bills only and provided for rediscounting of four types of bills having at least two
good signatures, one of which had to be that of a licensed scheduled bank or a
State Co-operative bank.
The four types of eligible bills were:
a. Bills drawn on and accepted by the purchaser’s bank.
b. Bills drawn on the purchaser and the purchaser’s bank jointly and accepted
by them jointly.
c. Bills drawn and accepted by the buyer under an irrevocable letter of credit.
d. Bills drawn on and accepted by the buyer and endorsed by the seller in favor
of his bank.
However, bills arising out of transactions in commodities covered under selective
credit controls were kept outside the purview of the scheme.
The bills rediscounted by RBI under the above scheme were negotiable and
marketable; in fact, their negotiability was an essential condition for the
development of a sound bill market. The scheme was expected to impart flexibility
to the money market, help in evening out surpluses and deficits in the banking
system and thereby enable the RBI to exercise an effective control over the money
market, since recourse to the Central Bank would normally be only when the
banking system, as a whole, was short of funds, rather than when a few banks
alone were in need of funds. Thus, the Reserve Bank’s role was designed to be a
‘lender of the last resort’ instead of first resort. Expansion and contraction of
money by the Reserve bank as a result of rediscounting of such bills was also
expected to be in relation to the needs of the economy.
135
Since the introduction of the New Bill Market Scheme, the RBI introduced several
measures to encourage and widen the use of Bills such as:
• Simplification of the rediscounting procedures by dispensing with the actual
lodgment of bills in respect of bills below the face value of Rs.10 lakh and
replacing it with derivative bills. The minimum amount of bill at Rs.5,000
prescribed under the scheme was also done away with.
• Promotion of Drawee Bills Scheme, by making it mandatory for banks to
extend at least 25% of the cash credit limit to borrowers in the form of bills
and requiring banks to ensure that their corporate borrowers financed their
domestic credit purchases from SSI units, at least to the extent of 25%, by
way of acceptance bills drawn on them by their suppliers, and advising banks
to monitor the compliance of this requirement through a suitable monitoring
system. (These mandatory stipulations were subsequently withdrawn with
effect from 2nd November, 1999.)
• Remission of Stamp duty by the Government of India on bills of exchange
drawn on or made by or in favor of a commercial bank or a co-operative bank
and payable not more than three months after date or sight.
• Permitting the licensed scheduled commercial banks to rediscount bills with a
few financial institutions such as Life Insurance Corporation of India (LIC),
General Insurance Corporation of India (GIC) and its subsidiaries and Unit
Trust of India (UTI) and such other financial institutions, incorporated in
India, as may be approved by the RBI on a reference made to it.
• Selectively increasing the participants in Bill Rediscounting Market in
November 1981, to include all-India Financial Institutions and Mutual Funds,
thus augmenting the supply of funds in the secondary market.
• Setting up of the Discount and Finance House of India (DFHI) by the RBI
jointly with public sector banks and All-India Financial Institutions.
• Enabling multiple rediscounting of bills through introduction of a revised
procedure, under which derivative usance promissory notes (which were
exempted from payment of Stamp Duty) drawn by banks for suitable
maturities up to 90 days on the strength of underlying bills discounted by the
banks’ respective branches could be rediscounted with other banks, approved
financial institutions and DFHI.
• Delinking interest rates applicable on discounting of bills from the prime
lending rates of banks thus giving the commercial banks freedom to charge
market determined interest rate on bills.
Neither the incentives like the remission of stamp duty on usance bills,
simplification of procedures for rediscounting and strengthening of the
institutional infrastructure, nor the mandatory prescription of fixation of Drawee
Bills limit under cash credit gave the desired impetus to the bill market. The recent
measure of delinking PLR with reference to bill financing however, has made
trade and industry evince interest in bill financing if sub-PLR interest were
charged. In sum, bill financing has not so far taken off as the preferred mode of
financing in any significant manner.
BILL MARKET RATES
The cost of bill finance was determined earlier by the following rates:
a. Bank rate,
b. The SBI hundi rate,
c. Bazaar bill rate,
d. Commercial banks’ bill finance rate, and
e. The SBI discount rate.
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Money Markets
The rate at which the RBI rediscounts eligible bills from commercial banks is
known as bank rate. The SBI hundi rate is the rate at which the SBI discounted
hundis of indigenous bankers. The bazaar bill rate was used by Shroffs in
discounted bills of small trades. The commercial banks’ bill finance rate is the
minimum rate fixed by the RBI at which commercial banks can discount bills. The
SBI discount rate is the rate at which the SBI discounts first class commercial
usance bills.
FACTORS BEHIND UNDERDEVELOPMENT
In spite of the encouraging official policy, the bill market has not developed in
India. The factors responsible for its underdevelopment are:
i. Borrowers have found other forms of financing such as cash credits,
overdrafts, etc., cheaper to bill financing.
ii. Bill markets were mostly established for the purpose of financing foreign
trade and the share of foreign trade in the national income has remained quite
small.
iii. Participation of government in the economic activity has led to an increase in
‘supply bills’ but not that of genuine bills of exchange.
iv. Bill market in India has been dominated by indigenous bankers whose funds
were limited.
Cumbersome procedures of discounting and rediscounting, the absence of
specialized credit information agencies, the growth of competing money market
instruments, etc., are among other factors which have impeded the growth of bill
market in India.
MARKET FOR LONG-TERM BILLS
Bills of exchange are normally treated as short-term instruments. Long-term
instruments in India have started their operations in India with the introduction of
Bills Rediscounting Scheme of IDBI.
The Scheme was introduced in April 1965 by the Industrial Development Bank of
India. The scheme covers bills/promissory notes arising out of the sales and
purchases of indigenous capital equipment and machinery. Its objective is to
enable the manufacturer get the value of the machinery within a few days of the
delivery of the machinery by discounting with his banker the bills of exchange or
promissory notes and also enable the purchaser – user of the machinery the facility
to utilize the machinery acquired and repay its cost over a number of years. The
bills/promissory notes to be eligible for rediscounting by IDBI must be drawn,
made, accepted or endorsed by an industrial concern as defined by the IDBI Act,
1964.
The period of maturity of the bill should not be less than 6 months and not more
than 5 years (7 years in certain cases). The minimum amount of a transaction
covering a set of bills or promissory notes eligible for rediscounting has been fixed
at Rs.10,000.
Mechanism of the Scheme
The rediscounting facilities at the IDBI are available at rates of interest fixed by it.
Different rates are fixed for bills of different maturities and different users of the
scheme. Rates are usually lower for longer maturities, than for shorter maturities.
IDBI’s rediscount rate is lower than the RBI discount rate in absolute terms.
i. Buyer or user of the capital equipment/machinery, not in a position to make
full cash payment, approaches seller/manufacturer for deferred payment who
agrees to supply.
ii. Supplier, however, supplies the machinery subject to an advance payment
and acceptance by the buyer for bills drawn for the balance amount and
interest. Buyer makes the advance payment and delivers the accepted bills.
137
iii. The supplier gets the bills discounted by his bank and realizes the cost of
equipment.
iv. Seller’s bank in turn gets the bill rediscounted with the IDBI [in case of
short-term or commercial bills the same procedure applies. However, the
rediscounting institute in such a case may be the DFHI/other Commercial
Banks/DFIs].
v. Three days to maturity, the seller’s bank makes the payment and takes back
the rediscounted bills.
vi. Seller’s bank, on the due date, obtains the payment from the acceptor.
Since the seller’s bank is primarily responsible to IDBI, with a view to safeguard
its own position, it generally requires that the bills be acceptable or guaranteed on
behalf of the buyer by its banker. On the due date, it can obtain the payment either
from the buyer or its banker.
SUMMARY
• Monetary policy refers to the use of the official instruments under the control
of the Central Bank of the country to regulate the availability, cost and use of
money and credit.
• The bank standard rate is the rate at which the bank is prepared to buy or
rediscount bills of exchange or other commercial paper eligible for
purchases.
• A bill of exchange has been defined as an instrument in writing containing an
unconditional order, signed by the maker, directing a certain person to pay a
certain sum of money only to, or to the order of, a certain person or to the
bearer of the instrument.
• The specific features of a negotiable instrument are: there must be three
parties to the exchange, namely drawer, drawee and payee, the instrument
must be in writing, containing an order (not a request) to a certain person to
pay, unconditionally, a certain sum of tender legal money, duly signed by the
drawer and presented to the drawee for acceptance. It should also have date,
number, place and other considerations found in the bills of exchange.
• Bills of exchange can be classified as demand or usance bills, documentary
or clean bills, D/A or D/P bills, inland or foreign bills, supply bills or
government bills or accommodation bills.
• Bills can also be classified as traders bills, bills with co-acceptance, bills
accompanied by letter of credit and drawee bills.
• Originally, discounted bills can be rediscounted by banks for their corporate
clients with financial institutions, as long as such bills arise out of genuine
trade transactions.
• The RBI has instructed banks to restrain from rediscounting bills outside the
consortium of banks and initially discounted by finance companies and
merchant bankers. Further, discounting should be only for the purpose of
working capital/credit limits and for the purchase of raw materials/inventory.
Accommodation bills are not to be discounted under any circumstances.
138
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INTRODUCTION
Government securities are the most important and unique financial instruments in
the financial markets of any economy. Government of India Securities (GOI Sec)
include debt obligations of the central government, state governments and other
financial institutions owned by central and state governments. As the repayment of
principal as well as interest is secured by government or its guarantee, these
instruments are usually referred to as ‘Gilt-edged Securities’. Literally, gilt means
gold, therefore, a gilt-edged security implies ‘security of the best quality’. As the
government securities are loans floated by the government, they become a part of
the national debt of the country and the payment of interest on them and also their
repayment has a first charge on a nation’s purse. Hence, it is an absolutely secured
financial instrument, which guarantees the capital as well as the interest income.
The central government securities are considered as the safest claims amongst
stocks of local authorities and industrial debentures, etc. Thus, investors prefer to
invest in these securities though the rate of interest is relatively low, when
compared to other money market instruments. In the absence of default risk, they
are regarded as risk-free investments.
FEATURES OF GOVERNMENT SECURITIES

ISSUERS
The government securities are issued by the central government, state
governments, and semi-government authorities like municipal corporations and
municipalities, autonomous institutions like the port trusts, improvement trusts,
state electricity boards, metropolitan authorities, public sector corporations, and
government agencies such as the IDBI, SFCs, SIDCs, NABARD, housing boards, etc.
ELIGIBLE INVESTORS
Individuals, firms, companies, corporate bodies, institutions, state governments,
provident funds and trusts are allowed to invest in government securities. The
Non-resident Indians, overseas corporate bodies and Foreign Institutional Investors
(FIIs) registered with SEBI and approved by RBI are also eligible to invest in
government securities. Though different segments are permitted to invest,
commercial banks, insurance companies and Non-Banking Financial Companies
(NBFCs) are the major buyers of gilts in the market.
Purpose
Government securities play a vital role in the open market operations conducted by
the Central Bank of the country. These instruments facilitate implementation of the
fiscal policy of the government. The major investors such as commercial banks,
NBFCs, insurance companies hold GOI securities to meet their statutory
requirements. In spite of low yields, they are bound to invest in these bonds.
Minimum Subscription
The minimum amount of investment in government securities for a single investor
is Rs.10,000 (face value) and in multiples thereof.
Maturity
The government securities are issued with various maturity periods. These were
issued with maturities ranging from 2 to 31 years since independence. In the early
90s the average maturity period was shortened to 10 years by the RBI. At present,
government securities run with a tenure upto 20 years in the market. They can be
classified into three categories depending upon their maturities viz., long-dated,
medium-dated and short-dated. Long-dated securities have maturities exceeding
10 years from the issue date, medium-dated securities have maturities ranging
from 5 to 10 years and short-dated securities mature within 5 years.
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Debt Markets
Form of Security
The Reserve Bank issues Government Stock to the investors by crediting their
Subsidiary General Ledger Account maintained with it or in the form of Stock
Certificate (if needed).
Yield
Yield implies the actual return on the investments. Different types of yield are
discussed below:
• Coupon Yield: The fixed interest rate on a government security or bond is
called coupon yield. For example, 12.00% GOI 2008 implies that 12.00% is
the coupon yield. Change in the interest rates, inflation rate or any other
economic factor will not be represented by this yield.
• Current Yield: Current yield is the present return available on the government
security or bond based on its purchase price. It is the ratio of annual interest
payment to the current market price. This can be explained with an example;
‘X’ has purchased 12.00% GOI 2008 at Rs.100 and ‘Y’ purchased the same
instrument at Rs.110. The current yield of ‘X’ = 12.00%, the current yield of
‘Y’ will be 10.91%.
• Yield to Maturity (YTM): Yield to maturity is the rate at which all the future
cash inflows of the bond have to be discounted to equate the cost price of the
bond. This can also be termed as the Internal Rate of Return (IRR) of the
government security or bond.
These securities are essentially fixed income securities. They are mostly issued in
the form of coupon bearing securities where the coupon may be determined by
RBI or the market. At times they are also issued in the form of zero coupon
securities and floating rate securities. The yield on these securities consists of
coupon income and redemption yield. The coupon income is paid half-yearly in
case of coupon bearing securities to the holder. The redemption yield is return on
investment from discounted cash flows up to redemption. Table below shows the
weighted average coupon rates on GOI securities.
Source: RBI Annual Report, 2004-05.

The coupons offered on these securities were predetermined by the Central Bank
until 1993 and were kept lower than market interest rates in order to minimize the
cost of servicing public debt. From April 1993, the Reserve Bank has begun
auctioning the securities competitively and since then the interest rates have been
increasingly set at market determined levels. The weighted average yield offered
on government securities which was 11.90% during 1994-95 rose to 13.75% in
1995-96. Then again it started falling. In 2000-01, it hovered around 10.95% and
141
in 2004-05 it stood around 6.11 percent. Thus, it is observed that the yield curve
for all maturities has shown subsequently a downward trend. In spite of moving
away from the regulated and subsidized interest rates to market determined rates, it
can be seen from the above data that the average yield moved in a narrow range
over the last 12 years. While the government’s decision to pay market determined
yield should have increased the yields, the following factors worked in the
opposite direction.
i. A decreasing level of inflation which in turn reduced the level of interest
rates.
ii. Introduction of prudential norms for banks which resulted in greater demand
for gilts in view of the zero risk weightage assigned to them till the end of
1997-98.
ADVANTAGES AND DISADVANTAGES OF INVESTING IN GILTS
Advantages
i. As the security is issued by the GOI, it has a minimal default risk.
ii. Investors have the opportunity to invest in very long-term debt sometimes up
to 20 years because of the long maturity periods.
iii. Almost all issues by the government have adequate liquidity except for a few.
With the primary dealer authorized to deal in the buying and selling, he can
take care of the liquidity.
Tax Benefits
Tax benefits under Section 80L upto Rs.3,000 are available with no TDS
(tax deducted at source). Currently, this benefit has been withdrawn from the
Assessment Year 2005-06. At present, amount investment in these securities can
claim a deduction under section 80C.
Disadvantages
The inflation will decrease the real return on the security and the possibilities of
higher interest rates erode the value of the bond.
PRIMARY MARKET
The Reserve Bank on behalf of issuers may issue different types of stocks from
time to time depending on their requirements.
TYPES OF GOVERNMENT STOCKS
Issue of Stock through Auction
The RBI, on behalf of the government, issues notification to auction government
securities, stating the amount and time. An applicant may submit more than one
bid at different yields through separate applications for each bid. The aggregate
amount of bids submitted by a person should not exceed the aggregate amount of
Government Stock offered for sale. (The format of application form is given in the
Appendix.) On the basis of the bids received, the Reserve Bank of India will
determine the cut-off rate of yield at which offers to purchase the Government
Stock will be accepted at the auction depending upon the notified amount. The
coupon of the stock is decided in an auction. The successful bids offered at the
cut-off rate of yield as determined by the RBI will be accepted at par. Other bids
tendered at rates lower than the cut-off rate of yield determined by the RBI will be
accepted at cut-off rates as quoted in the bid. The bidders will be issued these
securities at a premium which will be determined in such a way that yield-to-
maturity to the bidder will be equal to the rates at which they have put in their
funds in the Government Securities. Bids quoted at rates higher than the cut-off
rate of yield determined by the RBI will be rejected. The stock carries the same
coupon till maturity.
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Debt Markets
Issue of Stock with Pre-announced Coupon Rates

The RBI also announces the coupon on stock before the date of floatation and the
stock is issued at par. The interested bidders need to submit the application form to
RBI (format of application is given in Appendix III). If the total subscription
exceeds the aggregate amount offered for sale in respect of a fixed coupon stock,
the RBI will make a partial allotment to all the applicants.
Stock with Variable Coupon Rates, viz., Floating Rate Bonds, etc.
In case of floating rate bonds, the stock will carry a coupon rate which will vary
according to the change in the Base Rate to which it is related. The description of
the Base Rate and the manner in which the coupon rate is linked to the Base Rate,
floor and cap to the rate, if any, will be announced by RBI at the time of issue. The
procedure for issuance is similar to that of pre-announced coupon rates.
Zero-Coupon Bonds
Zero-coupon bonds are issued at a discount and redeemed at par. No interest is
paid on such bonds before maturity. Zero-coupon bonds are issued by means of
auction, with a face value of say Rs.100. The bidders need to clearly specify the
purchase price expressed up to two decimal points in the application. An applicant
needs to submit more than one bid at different prices through separate applications
for each bid (but, the aggregate amount of bids submitted by a person should not
exceed the aggregate amount of bonds offered for sale). The RBI will determine
the cut-off price at which tenders to purchase Zero-Coupon Bonds will be accepted
at the auction. All the bids at prices lower than the cut-off price will receive full
allotment, while the bids at prices higher than the cut-off price will be rejected.
The bids at the cut-off price may receive full or partial allotment depending on the
total amount of bids and the notified amount.
Stock on Tap
Stock on tap is issued by the RBI with predetermined price, maturity and coupon
with no aggregate amount indicated in the notification. Sale of such stock will be
kept open so long as the RBI desires and closed at any time at its discretion.
Stock for which the Payment is made in Installments
The stock is issued either by auction or by pre-announcing a coupon rate. The
special feature of the stock is that the payment can be made by the investors in
installments. It means that the stock will be initially issued as partly paid stock
which will become fully paid at the end of the last installment. The total amount
is usually paid in four installments. The interest is paid on the paid-up value of
the stock.
Issue of Government Stock in Conversion of Maturing Treasury Bills/Dated Securities
In this mode, the RBI gives an option to the holders of the Treasury Bills of certain
specified maturities, to convert the respective Treasury Bills at specified prices
into a new stock offered for sale. The conversion prices are predetermined by RBI
depending on the remaining term to maturity of the respective Treasury Bills.
SECONDARY MARKET
Most of the players who invest in these securities are institutions and hence the
volumes are high. Considering that these securities are the first choice for banks to
comply with SLR requirements, the demand is continuous. As all the institutional
players deal with these securities in the demat form, the settlement procedures are
also simple and thus enhance the liquidity. The secondary market transactions are
essentially negotiated transactions between the players and hence they can be
classified as OTC transactions.
The secondary market transactions in government securities are given in Table 1
of Appendix I. It is also known as the telephone market. In addition, the National
Stock Exchange (NSE) has a wholesale debt market segment on which all the
143
government securities are traded. Trading on NSE is screen-based. This facilitates

all the participants to have online information about the trading. A participant who
wants to initiate a deal or respond to an offer displayed on the screen, contacts one
of the brokers who through his system places the order to buy or sell. The terms of
the deal specify the details of the security, price, volume and date of settlement.
There is no prescribed settlement period in case of debt market as in the capital
markets. Hence the deals may be entered for settlement on the same day or 1 or 2
days after the date of trading. Often, interbank GOI Sec trades settle on the same
business day, whereas trades with non-bank counterparties settle either on the
same day or up to five business days after the trade. If both the parties to the trade
do not have current account but only an SGL account with the RBI, then the seller
gives an SGL note detailing the transaction to the buyer. An SGL note is lodged
with the RBI who makes the entries in the accounts of the two parties. All the
institutional participants such as banks, FIs, Mutual Funds have an SGL account
and Current Account with RBI. Both the buyer and the seller execute an SGL form
under Delivery Versus Payment (DVP) system which is presented to the RBI. The
RBI ensures the availability of funds with the buyer and security with the seller
and posts these transactions in the Current Accounts and SGL Accounts.
Transfer is done through book entry method in SGL account maintained at PDO1.
If the investors do not have an SGL account, then they can open a constituent
account with any registered bank authorized by the RBI for the purpose. The
brokerage charged by the bank is around 0.01%, which is negotiable, i.e., it can be
taken only from buyer, or seller or from both depending on whose SGL is
maintained by the banks.
PAYMENT OF INTEREST AND REDEMPTION

The coupons are fixed and paid out semi-annually to the holder. Specified interest
on government stock will be paid at the Public Debt Offices of RBI, branches of
SBI and associate banks (conducting government business). If the investors are
holding the securities in the SGL account, interest is credited by RBI to their
Current Account with RBI on the due date. If investors are holding the securities in
physical form then the securities are to be presented at the Public Debt Office, RBI
for interest payment. The same procedure is applicable to redemption of securities.
TRENDS IN THE GOVERNMENT SECURITIES MARKET
VOLUME OF ISSUES OF CENTRAL AND STATE GOVERNMENT
SECURITIES
The growth of government securities market in India and the investor response to
the government bond issues can be known from various indicators. One of such
indicators is the volume and composition of the government securities. The
volume of annual issues by the central government in 1960-61 was Rs.175 crore
which increased to Rs.6,95,135 crore in 2000-01, registering a 30 percent increase
as compared with Rs.5,35,602 crore in 1999-2000. This reflects increasing depth
in the Government securities market. The deepening of the market was attributable
to several factors such as generally stable call rates, favorable market expectations,
more active trading by the new PDs, mutual funds and some traditional
participants like banks and LIC and active open market operations by Reserve
Bank. During 2000-01, the total outright transactions amounted to Rs.5,69,174
crore or 82 percent of the aggregate transactions and the balance of Rs.1,25,961
crore or 18 percent by way of repos. In respect of state governments it increased
from Rs.75 crore to Rs.2,986 crore during the same period.
In the 1940s and 1950s the market was characterized by poor public response to
the government issues. Issues where kept open for a long time and the public
1 RBI decided to limit SGL facility only to institutions who are also eligible to have Current Account with
them. All others are advised to open SGL accounts in other banks.
PDO: Public Debt Office.
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Debt Markets
subscription always fell short of the required amount. But this has changed, as the
absorptive capacity of the market being very high, the government issues were
oversubscribed. This trend continued almost every year till the beginning of the
nineties. The state governments, securities were oversubscribed than the central
government, which indicates the marketability and popularity of the state
government securities over the central government securities.
Sometimes it is questioned whether the improvement in the G-Sec market is
authentic or it is due to the support of the Central Bank. Earlier the RBI used to
subscribe to a substantial part of the issues by the government. But in the recent
years the share of RBI in the government securities has witnessed a decline.
Some important conclusions that can be drawn from the trends of the government
securities market are given below:
• The government resorted to higher and higher loans every year and could not
retire the issues as prescribed.
• There is a change in the method used to refund the securities. Previously new
securities were given on the maturity of old securities but now the cash
received from the sale of the issues is being utilized to retire the securities.
• Because of the rise in the cash needs, the government is increasingly focusing
on the cash subscriptions.
! " # $
! " ##
$" % & ' " ( $" ) (% *
!+,# !+,# !+,#
- $" % 0 0 0 0 0 0 0 0 0 0 0 0 0
! ./#
#1 2 ' 0 0 0 0 0 0 0 0 0 0 0 0
/# (3 '(+ 0 0 0 0 0 0
2 $" % 4 0 0 0 0 0 0 0 0 0
$ 3" ! . # 0 0 0 0 0 0 0 0 0 0 0 0 0 0
+, 5 +' , %
4 5 6 ' " /" "7 "8 0 " 0 " 8" 1 / 27 ) 2 %
% 5 ' ) + 9 "
Source: Central Government budget documents and Reserve Bank records.

Ownership and Maturity Pattern of Government Securities
The following categories are the major participants in the government securities
market:
• Central and State governments;
• Banking sector including the Reserve Bank of India;
• Insurance companies;
• Provident funds; and
• “Others” which include individuals, local authorities, financial institutions,
non-residents; etc.
Earlier, the share of the institutions being very less the individuals had the largest
share in the government securities markets. The lower interest rates on the
securities made the interest of the individuals on the government securities to
decline gradually.
Table 3 presents the ownership and maturity pattern of the central government
securities.
145
& " # $
' ( ) *
$
! " #
- " ( "8 "
' +*
6 + 9 "8
6 !"7 "' #
66 -"%% + 9
:8 7 5
2 '
-"%% + 9
! . . # 44
2 + 9 "8 6
"
* " + 9
: 2 '
-"%% + 9
666 ; 8 6 '
-" )" " "8 6 <
6= > 3 ' "8 6
= * + 1
=6 ,%) "(
?" '
2 %
=66 -" @
?" '
2 %
=666 ? % (
6A :
$
! " #
- " ( "8 "
' , *
6 + 9 "8
6 !"7 "' #
66 -"%% + 9
"8 7 5
2 ' -"%%
+ 9 ! . . # 44
2 + 9 "8 6
"
* " + 9
: 2 '
-"%% + 9
666 ; 8 6 '
-" )" " "8 6 <
6= > 3 ' "8 6
= * + 1
=6 ,%) "(
?" '
2 %
=66 -" @
?" '
2 %
=666 :
$
! " #
146
Debt Markets
- " ( "8 "
' +*
6 + 9 "8
6 !"7 "' #
66 -"%% + 9
"8 7 5
2 ' -"%%
+ 9 ! . . # 44
2 + 9 "8 6
"
* " + 9
: 2 '
-"%% + 9
666 ; 8 6 '
-" )" " "8 6 <
6= > 3 ' "8 6
= * + 1
=6 ,%) "(
?" '
2 %
=66 -" @
?" '
2 %
=666 ? % (
6A :
4 ) 8 ' "8 / "' ') ' B ' 3 ' (+ 02 1 )" - 8 0"

)" "/ " 0 ? C +" 0 B) " 8 " " / ' "8 $" % "8 6
44 ,B ' " ' + 9
< ) -" )" " D % "8 8' "8 8 /' ) %) " ' /' $" %
'
% 5 E: D "( ' '/ ) " % /( "8 " "%( ' 0 0 6 "% 2 8
' " & " )" " ) " )" 8' 8 ' "
Source: Data are compiled from:
+ 9 "8 6 " 8" " "8 + 9 "8 6 " "7 "'
' 8 /( "%% / 9 7 + 9 8" " "8 "%% / 9
2 + 9 "8 6 8" ,%) "( D?" ' 2 %
+ 9 "8 6 "88 "8 " % ?" ' "%% " 0 1 / !F 9 # 8" -" @ ?"
' 2 %
1 8 "% "' 8 6 ' " 8" "
Also it is evident that the share of state governments has declined over the time
and the commercial banks are now the major investors in the G-Sec. The Share of
the insurance sectors in the government securities has been increasing over the
time. A sharp decline is observed in the portion of securities held by the other
sectors.
The shares of financial institutions in the government securities has affected
the operation of the market for government securities. One effect is that the
government bond market has become narrow. Secondly, the institutional
holding creates lesser activity in the secondary market because it tends to hold
the securities till their maturity. So it is primarily the banks and corporates
who are involved in the trading of the securities in the secondary market. This
decreases the activity in the market and the major dealings are limited only to
the Mumbai market.
Government securities usually have fixed maturities. Undated or perpetual
securities are very rare and even if they exist they can be redeemable on three
147
months prior notice at the government’s option. One of the special features about
government securities is that a major portion of the government debt securities
does not mature because the securities are converted into new securities.
- ./ # $
! " #
> > + 7 : 3"
! @ # ( ( ( %"'
0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0
0 0 4 0 0 0 0 0 0 G
2 *" " 3 /
456 ' 0 " % ' 8 (
G56 ' 0 " ) "8 " +"
However, the maturity pattern of the government securities has undergone a great
change. Government debt is shifting towards the short-term maturity securities.
The central government debt maturities above 10 years formed 85.8 percent in
1990-91. Securities maturing within the next 5 years constitute nearly 45 percent
of the marketable borrowings. The piling up of securities maturing at a time would
necessitate corresponding gross borrowing and puts pressure on both resources and
interest rates. Hence the central bank has been making efforts to lengthen the
maturity profile since the year 1998-99, by issuing long-term loans of maturities
ranging from 15 to 20 years. Regarding the maturity preferences it can be said that
the insurance companies and provident funds prefer to hold the long-term
government securities.
Prices and Yields
The face value of the government security is Rs.100 or Rs.1,000. Earlier, that is,
before 1950s the government bonds were issued at a discount. There was no fixed
relation between the maturity pattern and the discount offered. A discount was
availed from the state government securities due to the great need for the funds.
The minimum price of issue being 97 percent, the majority of the issues by the
state government securities were below par. But after the 1980s all the issues were
being made at par. Only in one instance, that is, in 1980 the bonds were issued
above the par.
The coupon rate or the bond rate is the interest rate mentioned on the bond,
and paid on its face value. If the value on issue and redemption are the same, the
coupon rate is equal to the redemption yield. The redemption yield would be
higher than the bond rate when the investor purchases the bond at a value lesser
than the face value or the bond rate, that is, at a discount. Running yield is
obtained by correlating the market price of the bond with the bond rate and the
discount or premium. The redemption yield represents the return available to
the investor if he retains the bond till maturity and the running yield is the
return available when the investor sells it in the secondary market at the
current price.
The behavior of the yields and prices can be observed from the Tables 5 and 6.
148
Debt Markets
0 $ 1
!? ) '%#
- $" % 2 ' 2 $" % 2 '
Source: RBI Annual Report 2004-05/Statistics on Indian Economy.

From the above table, it can be observed that the gross redemption yield, coupon
rate and the running yield have increased over the time period considered. It can
also be observed that the yield for the long-term securities is usually higher. But in
the earlier nineties, this trend was reversed, that is, yield on the short-term
securities was higher. Also, the difference between the rates of interest on the
government securities and other securities significantly reduced between the
period 1980 to 1990. The gross mismatch or misalignment in the interest was
corrected in the nineties.
149
NEED TO WIDEN AND DEEPEN THE GOVERNMENT SECURITIES

MARKET
The importance of the Government Securities markets can be evaluated,
• from the Government’s point of view, which is the borrower;
• from their contribution to the financial markets especially debt markets; and
• from the working of monetary policy.
From the Government’s viewpoint, a well-developed, broad and deep Government
Securities market is vital to make public borrowings at reasonable costs and to
avoid the automatic monetization of Government deficit by the central bank. This
is essential in the case of secondary markets if the Government’s borrowing needs
are significant. The benefits of an efficient and well-functioning government
securities market are optimization of maturity and interest costs, minimum affect
of huge Government borrowings on the market and smooth co-ordination between
monetary and public debt policy.
The Government Securities are taken as benchmarks for pricing various financial
instruments and hence have become essential contributors to the fixed income
markets all over the world. They facilitate proper risk evaluation in various debt
instruments and uniformity of interest rates in several other markets. They help to
integrate different markets in the financial system of a country and provide better
inter linkage between the domestic and foreign financial markets. Countries where
no funding requirements for the government are required, have evolved other
standards. In such countries non-government markets have resorted to price
discovery. Some examples of benchmarks in such markets are interbank repo rates,
collateralized obligations, interest rate swaps and top rated corporate bonds.
Finally, several countries are now using indirect instruments such as repos and
open market operations instead of direct instruments. A well-developed
government securities market enhances the implementation of the monetary
policy. Repurchase agreements in many developing economies are conducted
through Treasury Bills and Government Dated Securities. Apart from generating
finances for the government the T-Bills market also stimulates the money market.
Also the development of money market depends upon the central bank’s terms for
liquidity adjustment. The banks may not transact with each other if there is a
certain liquidity adjustment support leading to obstructions in the progress of the
money market.
The Government Securities market occupies the major part of the debt market and
as already cited the rates in this market are benchmarks for the whole system. The
RBI is the regulator of the monetary system, Government securities market,
manager of Government borrowings, and regulator of money markets and forex
markets. Hence from the view point of regulation the development of the
Government Securities market is in RBI’s jurisdiction, whereas the regulation of
the whole debt market in the context of public issues by corporates and trading in
stock exchanges is regulated by the SEBI. Accordingly, RBI has initiated a
number of measures for the development of the primary and secondary markets for
Government Securities.
KEY ISSUES RELATING TO THE GOVERNMENT SECURITIES
MARKET
The significance of the issues involved in the development of the government
securities market by the central bank vary from one country to the other. The key
issues are:
• The development of the money market,
• The primary market operations,
• Importance of secondary markets,
• Policy conflicts in debt and monetary management, and
• Dilemmas in market intervention.
150
Debt Markets
Relevance of Development of Money Market

The development of the money market is important for the debt market especially
through the process of liquidity. The money market provides the required finances
and enhances the liquidity in the market and leads to the short end of the yield
curve. Various components of the money market foster the development in various
ways. The repo market contributes to the development of an active Government
Securities market and vice versa because the lending and borrowing processes are
conducted safely through repos. There must be a necessary coordination between
the Government Securities and money markets where the interest rates are market
determined and the central bank manages the debt and monetary policy functions.
Many measures have been taken in recent years to develop a short-term yield
curve with deep liquidity in the money market in India. The four important
measures in this regard are as follows:
• First, a Liquidity Adjustment Facility (LAF) has been introduced, comprising
repo and reverse repo operations through auctions conducted. This was done
to equilibrate the liquidity and to control the short-term interest rates.
• Second, the non-bank participants in the call market who are currently
lenders are withdrawn gradually so as to make the call money market a pure
interbank market.
• Third, refinance support facility is being streamlined and a market-based
approach is being brought in. Removal of system of liquidity support on
fixed terms and shifting it to a full-fledged Liquidity Adjustment Facility
(LAF), is being considered seriously.
• Fourth, the other parts of the money market, particularly the repo market is
being broadened by allowing the players other than banks into lending as
well as borrowing in these markets. For further assistance in this direction, a
Clearing Corporation of India Ltd. (CCIL) was established.
The Primary Market Operations
Prices of a financial product are discovered through trading activities among
market participants. This process by which prices adjust to incorporate new
information is referred to as the price discovery process. The basic and major aim
of the operations in primary markets is to ensure the efficiency of the price
discovery process. This requires credible systems and transparent mechanism in
the market.
Auction Technique and Central Bank Participation in Auctions
Auction is the most common method to sell Government Securities. Other
methods include tap sales, syndication and book building process. Presently many
countries do not allow the direct participation of all investors in an auction.
Instead, they are permitted to participate in the auctions through authorized
intermediaries like banks and Primary Dealers (PDs). Actually, the investor base
that participates in the auction process is determined by the practical situation of
the process and in some cases the controlled investor base determines the evenness
in the auction techniques and combinations. Discriminatory price auction is one of
the options due to which the investors keep away because of the winners curse.
The disadvantage is that there is a danger of irresponsible bidding and uniform
collusion.
One cannot say which is better: discriminatory or uniform price auction.
A combination, that is, discriminatory auction with a ceiling can be considered as
important in this context, as it reduces the winners curse.
Usually the central bank does not participate in auctions, but if the situation
necessitates, it has to take part in the auctions without competing with other
bidders. Sometimes the central bank is involved in buying Government Securities
on its own and sometimes it is compelled to do so. In countries such as Indonesia
151
and Peru, the laws eliminate the participation of central bank in primary auctions
and in countries like Malaysia, Philippines and Hungary the central banks restrict
themselves from participating in the primary market.
As already mentioned the auction method is the most common in India, and it can
be based on yield, price or discount. The RBI underwrites the commitment of
Primary Dealers at its discretion. Even though the auction is carried out through
both the discriminatory and uniform price auction techniques, the former is most
common. Multiple price auctions are largely used to issue the Government
Securities and uniform price auction is used for 91-day T-Bills. With the rising
need for the retail investors, a cut off is determined at the weighted average yields
derived in an auction for the bids received on non-competitive basis within the
specified limits.
Since in India, the RBI itself conducts the auction, the issue of central bank
participation as an outsider does not arise.
Instruments
Different types of instruments are traded in different countries, so as to match their
unique situations in the markets and to develop the broad markets. For example,
Hungary has shifted to long-term Government bonds with fixed interest rates from
short-term bonds, which enabled the economy to avoid hyperinflation. Similar is
the case with Israel, which favors the plain vanilla bonds, though it has a wide
variety of instruments. Inflation-indexed bonds are popular in Chile.
In India too many instruments are experimented which include fixed coupon
bonds, zero coupon bonds, capital indexed bonds and more recently floating rate
bonds. Most of them are like fixed coupon type and also the recent Floating Rate
Bonds have proved to be attractive.
Maturity Profile
Even though there is no ideal theory/concept of the maturity of the instruments,
some important issues that should be considered while balancing the long-term and
short-term maturities are: market preference, government costs, grouping of
maturities, and development of yield curve. Benchmarking of the government
securities is necessary considering its well-functioning market. This requires a
careful approach to avoid disintegration and increase consolidation. The typical
benchmark securities in our market are of 2, 3, 5 and 10 year’s maturity, whereas
in countries like the USA, the securities can have a maturity period upto 30 years.
When the government in 1992-93 revived the borrowings at market rates, the
maturities of most of the securities were made below 10 years. High interest rate
cyclic implementation of the auction system to achieve the market determined
interest rates has made this compression necessary as it requires a market with
short maturity structure. The result is the bunching of maturities with a tough task
of managing liquidity. Since the last three years the RBI has made efforts towards
longer maturities, and fixed rates to balance the maturity pattern. Some situations
exist when the government does not confine to the perceived high rates of interest,
and large mismatches occur between the asset liability of the banks and also
greater risk of interest rates. The RBI has developed floating rate bonds and also
taken steps to develop the STRIPS market in the Government Securities segment.
To consolidate the maturity profile of the securities the RBI followed the method
of re-opening the existing securities on price-based auction approach. Thus, the
large borrowing (gross) program has proved advantageous to RBI to elongate and
strengthen the profile.
Issuance Calendar
Issuance calendar gives clear and timely information about the borrowing program
of the government. It clearly conveys the maturity profile of outstanding stock,
redemption schedule. It has to achieve balance between providing flexibility to the
government and maintaining market certainty with regard to market timing.
152
Debt Markets
The main constraint for the publication of issuance calendar is the fluctuating or
uncertain trends in the returns pattern of the Government of India. In the case of
Government Treasury Bills, the auction schedule is governed by a pre-notified
issuance calendar. It was proposed by the Finance Minister that there would be a
calendar of auctions of government securities beginning from the financial year
2002-03. The issuance calendar will help reduce volatility in the market with
regard to speculation on government borrowings as the timings of the issuance will
be intimated in advance.
Role of Primary Dealers
To promote the investment activity in the Government Securities market, several
countries have adopted licensed Primary Dealers (PDs) as important intermediaries
in the market. The typical responsibilities of PDs are:
• meeting the minimum bidding requirements,
• giving two-way quotes,
• providing information of the market activity to the central bank etc.
In some instances PDs have special rights to different activities in the money
market like primary auctions, or some special facilities in market operations, open
market operations, underwriting commission etc. PDs have an important role to
play in the development of the secondary market for government securities. The
prices of PDs account for all the available information, they trade in the market,
and also provide the central bank with the latest market information, and design
new instruments, etc. The vital role of PDs in the market requires some regulatory
control and the central banks periodically review the performance of PDs and
make their operations performance-based. Rating of PDs as established in Poland
is a laudable feature.
The RBI designed the system of Satellite Dealers (SDs) from 1996 as a second
player in the Government Securities market after the PDs. The specific objective
of SDs is to promote retail investments. However, the system could not prove as
useful as expected and was eliminated.
Gilt Mutual Funds
Gilt Mutual Funds were established in India in April, 1996 and they invest only in
government securities. At present, 13 gilt mutual funds operate in the country.
SEBI is the regulator for the mutual funds. Currently the RBI is reviewing the
working of the Gilt funds scheme in view of the developments in the debt markets
since 1996. Because of the limited size of the repo market and the resulting
uncertainty in the liquidity of the market during that period, RBI’s liquidity
support was very limited to the Gilt Funds. With the development of the repo
market, and the liquidity support being made extraordinary, a review of the
liquidity support by the RBI is being considered.
Significance of Secondary Markets
High liquidity and constant demand in the market need a diversified investor base
with different preferences of demand, maturity and risk. Apart from the present
players like banks, PDs and mutual funds, if the retail investors and foreign
investors are also allowed to enter, the investor base can be widened. One of the
significant aspects of the overall plan to develop a more diversified investor base is
to meet the needs of retail investors, as it often reduces volatility in the market and
ensures stable demand.
The liquidity in the secondary market can be increased by developing the repo
markets, the role of benchmarks in the market valuation, and short selling in the
market, etc. Some markets have prohibited the short selling of securities and the
rationale behind this act should be recognized. Though the short selling has a
positive effect on the liquidity and price efficiency in the market it may also
increase the market volatility and risks particularly so if the market takes larger
position than what it is capable of handling.
153
The RBI has initiated many measures to better the secondary market liquidity in
the Government Securities market. Some of them allow a variety of participants,
like reopening of bonds, Liquidity Adjustment Facility (LAF), repo market, setting
up of Clearing Corporation of India Ltd., negotiated dealing system for trading,
Delivery vs Payment system for settlement of Government Securities in scripless
form, and communication of information relating to all Government Securities
traded in the market on a daily basis.
Initially, the RBI was the announcer of the yield curve but now FIMMDA, a
self-regulatory organization, announces the yield curve, based on a methodology
that is approved by the RBI. Incidentally, banks are holding around 37% of their
liabilities in Government Securities as against the Statutory Liquidity Ratio (SLR)
of 25 percent. The Reserve Bank of India (RBI) has taken steps and given a
direction to banks to achieve the targeted reserve created for investment fluctuation.
Policy Conflicts in Debt and Monetary Management
Co-ordination of operations is important so as to avoid differences in the policies
of cash and debt management of the government and central bank. This is
particularly required keeping in view the fact that the timing and volume of issues
of Government Securities need not always coincide with the monetary regulations
of the central bank. The central bank needs to consider the liquidity provision if
the Government wants to issue securities at a time when the market is illiquid. In
such cases the central bank can provide liquidity through the secondary market or
through the primary market where the central bank manages both the debt and
monetary policy.
At present it can be said that, almost in all countries the central banks are working
in tune with the fiscal authority, both at the policy formulation and implementation
levels of debt management. Generally it is said that being an agent to the fiscal
authority can be problematic for central bank and this can be reduced if the debt
management function is separated from the central bank. Such separation should
be preceded by institutional and technological infrastructure, fiscal control and
developing financial markets otherwise, high fiscal deficit could increase the risk
of instability in the economy.
In its recent monetary policy statement, the RBI made its intentions clear about the
separation of the debt management function in this regard and the conditions that
have to be fulfilled to separate the debt management function. The conditions are:
development of financial markets, adequate control over the fiscal deficit and
necessary legislative changes. Also, institutional framework for setting up a
separate Debt Office for managing the debt functions should be planned. The debt
of both central and state governments can be managed by setting up an
independent corporate structure.
Interference in Markets
Some dilemmas exist in the issue of central bank intervention in the market to
correct the volatilities in the prices. In some countries the central banks never
interfere in the bond markets to even out the volatility in the bond market. Looking
the other way, reduction of volatility in the market obstructs the progress of
secondary markets as it rules out the development of hedging instruments, which
in turn are used to offset volatility.
On the other hand, some instances justify the interference approach by central
banks. For example, the incident on September 11, 2001 has sought the close
intervention of the Federal Reserve in the market. India too, experienced many
such circumstances and some as: border conflicts, US sanctions, and other
exigencies where the RBI had shown its intent to intervene in the market. Hence
the difference between the normal market conditions and external shocks should
be taken into consideration while deciding about the interference of the central
bank. If the exogenous shocks exist, interference or willingness to intervene may
be required whereas in the normal market conditions the choice of intervention
must be available, but the evolving forces in the market should guide its actual
development.
154
Debt Markets
Regarding the RBI’s intervention policy, three important areas need mention. First,
the liquidity management concern in the money market. The RBI does it through
the Liquidity Adjustment Facility, operating an interest rate corridor in the rates of
interest of the repo and reverse repo markets. Second, the RBI’s responsibility of
government debt makes the RBI intervene through private placement in the
exceptional situations. That is, if RBI thinks that the market cannot provide entire
borrowing without any disruption, it offers private placement. Third, if the auction
bids of the treasury bills are unacceptable the RBI transfers to itself some amount
of finance, which is called devolvement. Primary dealers underwrite the issues of
government securities and receive commission. Thus, if the government requires
funds due to high fiscal deficit and the market is not so liquid, the RBI intervenes
to provide stability in the system. It is at its will to divest the securities it has taken
through private placement.
The RBI also conducts operations to offset the external shocks in the forex
markets, and also makes efforts to prevent the transmission of the effect to the
bond market. Thus, whenever the RBI has taken monetary actions on the exchange
market, expectations of liquidity action have risen in the bond markets.
ROLE OF RBI
The Reserve Bank of India undertakes multifarious activities and consequently
plays a significant role in the GOI securities market. At the outset, it is a banker to
the government and hence manages the finance of the central government. It floats
the GOI securities and state government securities and hence plays the role of a
merchant banker. It is the central bank for the country and has the responsibility to
manage the economic health in general and monetary policy in particular. As a
merchant banker it advises the timing of the GOI securities issues, coupon and
maturity and type of instrument. The objective, here, is to raise funds for the
government at the lowest possible cost with an eye on the maturity management so
as to ensure smooth management of debt servicing by the biggest debtor. These
activities have direct impact on the money supply and an indirect impact on
interest rates and exchange rate. Considering the impact that money supply has on
other macroeconomic variables the RBI attempts to regulate the same in such a
way that it is conducive to achieve the desired economic growth. The large
volumes of GOI securities can have an impact by increasing or reducing the
money supply depending on whether they are redeemed or issued. In view of the
same, RBI undertakes the following transactions mostly with banks:
• Open Market Operations.
• Repo Transactions.
• Switch Deals.
OPEN MARKET OPERATIONS
As a part of the open market operations RBI may buy or sell specified government
securities at prices determined by the RBI. The prices determined are usually at
variance with the market rates, the direction depending on the objectives of the
RBI. If the RBI wants to reduce the money supply it can offer yields on specified
securities, which are higher than those prevailing in the market, which can be an
incentive to buy securities from RBI, which in turn reduces the money supply. If
the RBI wants to increase the money supply it can offer to buy securities at yields
lower than the market related rates thus inducing participants to sell the securities
to RBI, thereby increasing the money supply. Apart from the above objectives the
open market operations coupled with the interest rates in the primary market can
be used by RBI to signal changes in interest rates.
155
REPO DEALS
Repo transaction involves a simultaneous buying and selling of the same security
at predetermined prices. This essentially results in cash moving from the buyer to
the seller, at the beginning of the transaction which will be reversed at the end of
the transaction. There are no regulations prescribing the minimum or maximum
duration for a repo transaction. Hence the minimum period can be even a day,
while the maximum period is normally 14 days though repos for longer-term are
also seen in the market. When the RBI undertakes Repo transactions it will sell the
securities in the first leg and buy them back later. In case RBI undertakes Reverse
Repos it will be buying the securities, in the first leg, which will be sold back.
Hence, Repos will involve reduction in money supply for the period of repo while
reverse repo will increase the money supply.
Hence, RBI will use Repos as a means to influence the level of money supply
when the objective is to make changes for a short-term unlike open market
operations.
SWITCH DEALS
Switch Deals involve simultaneous purchasing and selling of different securities
by a person so that the composition of the portfolio can be changed without
significant costs. RBI used to provide an opportunity to the banks to reshuffle their
portfolio by undertaking switch deals. Of late RBI has not been announcing such
facility. However, these deals will not have any impact on the money supply
though the same can be used by RBI in influencing the yields on the securities
undertaking switch deals.
RECENT DEVELOPMENTS
Continuous efforts have been taken by the RBI to deepen and widen the
government securities market both in primary and secondary segments. Some of
the significant steps taken by the RBI are as follows:
Uniform Price Auction
The government securities auction is based on uniform price auction. This is done
on experimental basis keeping in mind the uniform price auction in the issuance of
91-day T-Bills. The RBI has decided to continue the uniform price auction on an
experimental and selective basis as considered necessary.
Negotiated Dealing System
In a move to facilitate online electronic bidding, the Negotiated Dealing System
has been introduced and operationalized, early this year. The following are the
features of negotiated dealing system:
i. It provides online electronic bidding facility in the primary auctions of
Central/State Government securities, OMO/LAF auctions, screen-based
electronic dealing and reporting of transactions in money market instruments
including repo, secondary market transactions in government securities.
ii. There is proper dissemination of information on trades with the least time
lag.
iii. It facilitates “paperless” settlement of transactions in government securities
with connectivity to CCIL.
GOVERNMENT SECURITIES ACT
A proposal to replace the existing Public Debt Act, 1944, by the Government
Securities Act was made by the Reserve Bank of India to simplify the procedures
for transactions in government securities, allow lien-marking/pledging of securities
and also electronic transfer in dematerialized form. This proposal was approved by
the Government of India and requisite resolutions were passed, empowering the
Parliament to enact the Government Securities Bill.
156
Debt Markets
Retailing of Government Securities through Non-competitive Bidding

The RBI had announced finalization of a scheme to encourage retail participation,
in particular by mid-segment investors like UCBs, Non-banking Financial
Companies (NBFCs), Trusts, etc. in the primary market of government dated
securities. Accordingly, the scheme of non-competitive bidding facility with a
provision for allocation up to 5.0 percent of the notified amount to retail investors
at the weighted rate that evolves in the case of competitive bidding was announced
on December 7, 2001.
Banks and PDs have taken useful initiatives to promote retail investment in
government securities by offering these securities for sale at retail outlets with
facility of holding investments and servicing thereof through existing demat
account with depositories or in CSGL accounts. Banks also promote retail sale of
government securities along with schemes to avail automatic finance against such
investment at attractive rates, thereby providing ready liquidity.
Floating Rate Bonds
In order to cater to the diverse needs of investors in government securities, various
instruments, like Zero Coupon Bonds, Floating Rate Bonds (FRBs), Index Linked
Bonds, etc., were issued in the past. It is important to note that currently all
outstanding government market loans are in the form of plain vanilla fixed rate
bonds. Keeping in mind the risk weight elements and the asset liability
management needs of the major investors such as banks, two FRBs of 5-year and
8-year maturity were issued in December 2001, which were fully subscribed.
Floating rate bonds serve as a diversifying instrument in debt management as it
takes advantage of the term premium while minimizing refinancing risk. However,
FRBs are vulnerable to interest rate risks. Considering both the advantages and the
risks, issue of further FRB’s in the current year would be examined.
Calendar for Dated Securities
Calendar for dated securities for the year 2002-03 has been announced by the
government to enable both institutional and retail investors to plan their
investments better. This calendar imparts transparency to the Government’s
borrowing program and is expected to bring stability in the government securities
market.
Separate Trading for Registered Interest and Principal of Securities (STRIPS)
A separate working group has been constituted to operationalize the scheme of
STRIPS. The group comprises of banks and market participants to suggest
operational and prudential guidelines with respect to STRIPS.
Satellite Dealer System
The Reserve Bank of India had undertaken a review of the satellite dealer system.
After obtaining the views of the Primary Dealers Association of India (PDAI) and
after consultations with the market participants, it has been decided to discontinue
the system. Accordingly,
• No new SDs will be licensed.
• Existing SDs were required to make action plans, satisfactory to the RBI and
have terminated their operations from May, 2002 onwards.
Automatic Debit Mechanism
In some cases, State Governments have given instructions to RBI to debit their
accounts on specified dates either as a matter of course to meet certain obligations
or in case of specified events. Such automatic debits carry an overriding priority
over other payments. After examining the past experience with automatic debits, a
Technical Committee of State Finance Secretaries on State Government
Guarantees had observed that pre-emption through automatic debit mechanism
157
runs the risk of resulting in insufficient funds for financing critical minimum
obligatory payments such as salaries, pensions, amortization and interest
payments. In view of the recommendation of the Committee, and keeping in view
the need to maintain integrity of the public debt segment of debt markets, it is
proposed that:
• In future, as a general policy, with prospective effect, to dispense with such
automatic debits where there are no legal or other compulsions.
• Where there is a legal compulsion for creation of such mechanism, to suggest
amendments to such provisions.
• To review all the existing automatic debits in consultation with State
Governments and others concerned, with a view to dispense such
mechanisms wherever feasible.
Other Steps
• Important developments like operationalization of NDS and CCIL in
infrastructure facilitating trading and settlement in money and government
securities markets have taken place.
• The market has also become more diversified with the entry of new
participants such as high net worth individuals, co-operative banks, large
corporates, mutual funds and insurance companies.
• The uniform valuation basis, as announced by FIMMDA, provides
transparency to the market and facilitates active management of portfolios.
• The regulatory and supervisory framework for the PDs has been strengthened
in accordance with the risks perceived in the market, in line with
international practices.
• Development of new benchmark government securities by consolidating new
issuances in key maturities.
• Enhancing liquidity through consolidation by reissuances of existing loans.
Statutory Provisions for Regulation of Government Securities Market
The RBI manages internal debt and the issue of new loans on behalf of central
government according to Sections 20 and 21 of the Reserve Bank of India Act,
1934. The bank also sees the matters relating to the public debt of state
government as per the bilateral agreements entered into with the state
governments. Also the Public Debt Act, 1944, delegates the administration of
public debt to the bank. As a result, the Reserve Bank has been taking all efforts
towards facilitating price discovery and liquidity to government securities. The
efforts are mainly focused on the promotion of institutional infrastructure and legal
framework regarding the manner of issue and trading of government debt
instruments. All matters relating to the issue, interest payment, repayment, and the
registration, custody, transfer, conversion, sub-division, etc. of government debt
holdings are covered under RBI’s public debt management. Further, Bank advises
the government about the size and timing of the issue of borrowing. RBI has 15
public debt offices functioning at various centers.
In the process of developing the securities market and facilitating price discovery
in the market, RBI daily discloses the prices of secondary market transactions in
government securities that are settled through the SGL account. This has
established sovereign yield curve, enhanced the market transparency and improved
price discovery for government securities in the market. Still the RBI has to take
measures to develop a deep and liquid secondary market through effective public
debt management.
158
Debt Markets
2 . $
'3 , *4
! %"' " 0 3@ ) ) '%#
9 $" % "8 6 1 2 ' @ ' ( 2 $"
+ (" 2 '
6 ' ' 0
%"' H 0 0 0 0
/ 3@4
@ H
@ B H
66 ' ' 0
%"' 0 0 0 0
/ 3@4
@
@ B
666 ' ' 0
%"' H H 0 0 0 0
/ 3@4
@ H H
@ B H H
6= ' ' 0
%"' 0 0 0 0
/ 3@4
@
@ B
I 5 )" 2'/ ($ ; !2$;# "' +60 @'%/ 7 ) ( "' 8" ( ) "8 "
" "' (
3@ 5 "@ ' (
4 5 @ %'% @ B %'% 3@ !J? # / B ' " "8 " " C ! " #
Source: RBI Bulletin, October 2005.
SUMMARY
• Gilt-edged securities mean securities of the best quality, where the
government secures the repayment of principal and interest. They are risk-
free investments.
• Government securities are issued by central and state governments,
semi-government authorities and government financial institutions.
• Individuals, corporates, other bodies, state governments, provident funds and
trusts are allowed to invest in government securities.
• Government securities play a vital role in the open market operations
conducted by the central bank of the country.
• The minimum investment is Rs.10,000 and multiples thereof and they can be
long-dated, medium-dated and short-dated, with maturities of 10-20 years,
5-10 years and less than 5 years respectively.
• In the primary market, government securities can be issued through auctions,
pre-announced coupon rates, as floating rate bonds, as zero-coupon bonds, as
stock on tap, as stock for which payment is to be made in installments or as
stock on conversion of maturing treasury bills/dated securities.
• There is a huge demand for government securities in the secondary market as
they are the first choice of banks to comply with the SLR requirements.
• The RBI usually undertakes the following transactions with banks: open
market operations, repo transactions and switch deals.
159
Appendix I
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160
Debt Markets
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161
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Debt Markets
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163
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164
Debt Markets
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165
Appendix II
+ " , - . /
01 2
1 3
4/ 5 ($ ) )$ # #$ ($ ) )$ # #$ ($ ) )$ # #$
0,62 0,62 0,62
% & ' ( ) # %
-& * , & 0& * 1'!
! % *&2 +& /*/&3 4 4
'! 2 5& 3 $/ 3
+* *& , & 0& *3 6 6
* 0 %7 2 % # #' &' #' )' ('# ) %% %4 % ' %( ) # % '& )&) 4
$7 8 $ 2(&* 73*/0 *&3
48 2&3 #3 & &* / / (* 3& /* 9/*: 2 * */
6 8 7; 2&3 *: && +* *&3 < 9:/ : = 3< & &* * '& </ /3&2
8 #&3& & $ > & 23 2 $ 2(&* % 0& *3 < *:& -& * , & 0& *
Source: Reserve Bank Annual report, 2007-08.
166
Debt Markets
+ " *
)$/3 )$+ )$9 )$9 )$/ )$ 3 )$! )$ )$ #$9 #$ #$+ #$/3 #$+ #$9 #$9
% & ' ( ) # % %% % %& %' % %( %)
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+* *& , & 0& * +& /*/&3
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167
)$/3 )$+ )$9 )$9 )$/ )$ 3 )$! )$ )$ #$9 #$ #$+ #$/3 #$+ #$9 #$9
% & ' ( ) # % %% % %& %' % %( %)
! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !
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5 * 1 1 !
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1/ *!*/ 0 7 2 &% ' & &# &) ' %# # & ) % ( & & #) )( ' & ' ) ' &( ( &( %( ' &&) ' ' #' %# ( ) & && & %# &
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=& & * (& < * ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !
=& & * (& < * ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !
8
"/( &3 / & *:&3&3 / 2/ *& & & * (&3 * * * * /(:* & * 3 */ 3 #& * 3 */ 3 &; 2& 3& 2 &( < * 3 */ 3
2 5& 3 $/ 3 : & '&& & / * 2 &2 < 0 *:& &
168
Debt Markets
Appendix III#
The Chief General Manager

Reserve Bank of India,
Public Debt Office,
Fort,
Mumbai – 400001.
Application for ____ percent Government Stock _____
Pursuant to Government of India, Ministry of Finance, Department of Economic Affairs

Notification _________ dated ________, I/We _______ /on behalf of _________ $$ (full name(s)
in Block letters) herewith tender*. Cash/Cheque drawn on Reserve Bank of India,
Mumbai/Banker’s Pay Order for Rs._____ (Rupees ____________) and request that securities of
the _____ percent Government Stock _____ of the nominal value of Rs._____ may be issued to
*me/us in the form of *Stock Certificate/Credit to *my/our/our constituents SGL Account
(No.______).
2. *I/We desire that interest be paid at ________.
3. *I/we have read the terms and conditions governing the issuance of Stock in the aforesaid
Government Notification and undertake to abide by the same and also by the terms and conditions as
included in the prescribed Form of Application.
N.B.: The applicant should not write anything in Signature__________________________
this page. The entries will be filled in by the
Public Debt Office.____________________
Initials Date Name in full____________________
Application No. _____________ (Block letters)
Time of receipt. _____________
Cash/Cheque drawn on
Reserve Bank of India _____________
Mumbai/Banker’s Pay Order
received/realized on
Credited to special Current _____________
Account on Office Stamp
Examined _____________ Address: _____________
Cash applications Register posted _____________
Indent No. _____________ _____________
Scrip No. _____________ _____________
Card No. _____________ Tel No. _____________
Voucher on _____________ Date: _____________
Notes:
1. If the applicant’s signature is by thumb mark, it should be witnessed by two persons. The
full name, occupation and address of the witnesses should be appended to their signature.
2. If the application is made in the name of a registered body, the undernoted documents, if
not already registered at the Public Debt Office, should be submitted to the Public Debt
Office along with the investment amount:
i. Certificate of Incorporation/Registration in original or a copy thereof certified as
true by the Issuing authority under his official seal.
ii. Certified copies of Memorandum and Articles of Association or the rules and
regulations/Bye-Laws of the Company/body.
* Delete what is not required.
** $$ If the application is on behalf of a constituent, indicate the name of the constituent.
169
iii. Certified copy of resolution in favor of person/s authorised to deal in

Government Securities on behalf of the company/body together with his/their
duly attested specimen signature(s).
3. Applicant should also complete a Mandate Form (obtainable from Public Debt Office) for
remittance of half-yearly interest on Stock Certificate/s issued to them.
Terms and Conditions
1. Government Stock will be issued for a minimum amount of Rs.10,000 and in multiples
thereof.
2. The Reserve Bank of India will have the discretion to accept or reject any or all
applications either wholly or partially without assigning any reason.
3. Government Stock will be issued to the parties by credit to their Subsidiary General
Ledger Account maintained with Reserve Bank of India and in the form of Stock
Certificate to others.
# Source: RBI
170
Debt Markets
Appendix IV*

Public Debt Office,
Fort,
Mumbai – 400001.
Dear Sir,
Tender for _____ year Government Stock, ______, for an aggregate amount of
Rs. _______crore: Auction to be held on ___________.
Pursuant to Government of India, Ministry of Finance, Department of Economic Affairs

Notification No. _________ dated ________ and the tender notice issued by you, I/We, the
undersigned hereby offer to purchase ________ year Government Stock, ________, at the auction
to be held by you on the captioned date as set out below:
i. Name/Constituents Name $$ _________________

ii. Address _________________
iii. SGL Code, if any _________________
iv. Telephone No.
v. Nominal value of the Government Stock required Rs. _________________
vi. Yield percent per annum desired to be earned
thereon (expressed upto two decimal points
rounded off to multiples of one) _________________
vii. Place at which interest should be paid
Undertaking
1. On your acceptance of my/our bid, I/we agree/undertake to immediately collect the letter
of acceptance from your office and deposit the requisite amount at Reserve Bank of
India, Fort, Mumbai on the day/time as indicated therein.
2. I/We have read the terms and conditions of bid for the auction to be held on the captioned
date and undertake to abide by them.
3. I/We have also submitted another bid(s)/not submitted any other bid (strike out which is
not necessary) for the auction to be held on the captioned date.
Yours faithfully,
Dated: Signature and

Office Stamp of the Bidder/s
$$ If the application is on behalf of a constituent, indicate the name of the constituent.
171
Notes:
1. If the applicant’s signature is by thumb mark, it should be witnessed by two persons. The full
name, occupation and address of the witnesses should be appended to their signature.
2. If the application is made in the name of a registered body, the undernoted documents, if not
already registered at the Public Debt Office, should be submitted to the Public Debt Office
along with the investment amount:
i. Certificate of Incorporation/Registration in original or a copy thereof certified as true by
the Issuing authority under his official seal.
ii. Certified copies of Memorandum and Articles of Association or the rules and
regulations/Bye-Laws of the Company/body.
iii. Certified copy of resolution in favor of person/s authorised to deal in government
securities on behalf of the company/body together with his/their duly attested specimen
signature(s).
3. Application should also complete a Mandate Form (obtainable from the Public Debt Office)
for remittance of half-yearly interest on Stock Certificate/s issued to them.
Terms and Conditions
1. Government Stock will be issued for a minimum amount of Rs.10,000 (face value) and in
multiples thereof.
2. Separate tender form should be submitted for each bid.
3. Results of the auction would be displayed at the Reserve Bank of India, Fort, Mumbai.
4. The Reserve Bank of India will have full discretion to accept or reject any or all bids either
wholly or partially, without assigning any reason.
5. Tenderer should check for himself the result of the auction and, if successful, collect the
letter of acceptance of the tender from the Reserve Bank of India, Fort, Mumbai.
6. In the case of accepted tenders, the Government Stock would be issued for the nominal
amount applied for at a price arrived at with reference to the yield percent per annum desired
to be earned thereon as given in the bid.
7. Payment shall be made at the Reserve Bank of India, Fort, Mumbai, in cash or by cheque
drawn on it, or by Banker’s Pay Order and the required amount shall be deposited by the
close of banking hours on ___.
8. The Government Stock will be issued to the parties by credit to their Subsidiary General
Ledger Account maintained with Reserve Bank of India and in the form of Stock Certificates
to others.
* Source: RBI
172
•
• !
Repo (Ready Forward Deal) is an agreement, which involves a sale of a security

with an undertaking to buyback the same at a predetermined price at a future date.
The transaction is called Repo from the seller side and viewed as reverse repo
from the buyer’s side. In other words, repo is an agreement with a commitment by
the seller to buy a security back from the purchaser at a specified price at a
designated future date. The repo represents a collateralized short-term loan, where
the collateral may be a treasury security, money market instrument, federal agency
security, or mortgage-backed security. Repos may be contracted for as short a
period as overnight.
REPO MARKET
A repo transaction essentially involves borrowing money at a price like other
money market instruments. A repo will help the holder of a security to acquire
liquidity for a short-term without necessarily liquidating the security. The buyer of
the security will have an avenue to deploy the surplus funds for a short-term. The
government introduced Repurchase Agreements (Repos) in order to manage the
excess of liquidity in the system, and also to even out interest rates in the
call/notice money market.
Following is the diagrammatic representation of a Repo deal.
Figure 1
(1) Stage I
Bonds or G-sec
Lender Borrower
Collateral (Cash)
(2) Stage II Settlement
Lender Bonds or G-sec
Rental Fee
Collateral (Cash) Borrower
Interest
RENTAL FEE
MARKET PARTICIPANTS
Earlier, only banks, Discount and Finance House of India Ltd. (DFHI) and other
financial institutions, which maintain both an SGL (Subsidiary General Ledger)
account as well as current account with RBI were eligible to participate in the repo
market. However, subsequent to the amendment of the Securities Contracts
(Regulation) Act (SCRA), 1956, the repo market has been widened to cover all
such non-bank entities holding both current and SGL accounts with RBI including
mutual funds, thus, increasing the number of eligible non-bank participants to 64
from the earlier 35. These entities can now borrow as well as lend in the repo market.
These measures are expected to give a fillip to the repo market, besides enabling better
cash and asset-liability management by non-bank institutions.
REPO VS. CALL MONEY
Banks borrow in the call market to meet their requirements and these borrowings
are unsecured in nature. However, if a bank borrows the same amount through a
repo, the lender will receive a security duly transferred which will be held in his
name till the reversal of the transaction takes place. Though very unlikely, in the
event of the reversal not taking place, the lender does not suffer any loss since the
transaction is tantamount to an outright purchase of a security. Hence, the
borrowing under Repo is a secured borrowing. These transactions are undertaken
mostly between the bankers on the same lines as call money transactions, but they
174
Debt Markets
may also be undertaken on the NSE Wholesale Debt Market segment. Considering
the secured nature of borrowing, the interest rate is likely to be lower than the rate
prevailing in call. However, the difference is not very conspicuous since the
default risk in a call loan is also significantly low.
The following describes the operational aspects of a Repo.
Size of the Loan: It is usually the borrower who initiates the transaction and
decides the quantum of the borrowing depending on the requirement. However,
there will also be instances where banks would like to buy the securities for a
short-term as part of their SLR management, in which case the size depends on the
need for securities to make up for the SLR shortfall of the Bank.
In case of RBI, tenders should be submitted for a minimum amount of Rs.1 crore
(worked out on the basis of face value of securities) and in multiples of Rs.1 crore.
Selection of Security: The RBI announces the nature of securities eligible for
Repo transactions. All the GoI securities and Treasury Bills and PSU bonds which
are in the demat form are eligible for Repo transaction, subject to the condition
that the transaction takes place at Mumbai and is reported to the RBI, Mumbai. As
of now, consequent upon the delegation of powers by the government and as a part
of development of the repo market, even State Government Securities have been
made eligible for undertaking repos.
Interest Rate: The interest rate on the borrowing will be mutually negotiated
depending on the term, amount and the prevailing call money and term money
rates.
SETTLEMENT
The RBI operates the government securities settlement system for those having
SGL accounts in the public Debt Office through delivery versus payment. Under
this system, trades are settled on a gross “trade by trade” basis with irrevocable
final settlement taking place simultaneously for securities and funds, after ensuring
that there are sufficient funds in buyer’s account and sufficient securities in seller’s
account. In view of increased volumes in transactions, the RBI proposed to
introduce a scheme for automatic invocation by the SGL account holder of
undrawn refinance/liquidity support from the RBI for facilitating smooth securities
settlement. The facility will be available only to banks and PDs, subject to
adequate safeguards. The SGL also provides for details of the reversal transaction.
RBI will maintain a Constituents’ Repo SGL account for the purpose of
settlement. Securities held by the Reserve Bank of India on behalf of banks in the
Repo SGL accounts will be eligible for SLR purposes. The Reserve Bank will
issue SGL Balance Certificate indicating the details of total holdings of
bank/institution and total loan-wise securities held in the Repo Constituents’ SGL
account as on any date. To simplify the provision of liquidity, in case of reverse
repo auctions, successful participants who are eligible to draw refinance from the
RBI will be granted refinance against collateral as per the existing procedures. The
other successful banks/institutions not eligible for refinance will be provided
liquidity support in the form of reverse repo as per the existing procedures.
The following example explains the computation involved in a Repo transaction.
Illustration 1
Bank A proposes to borrow on 20.03.20x5 an amount of Rs.100 crore from Bank
B under repo for a period of 14 days at an interest rate of 12%. The security for
this transaction is 13.40% GOI 20x5 whose interest payments are due on 24th June
and 24th December. The current market price of the security is Rs.102.50.
175
Bank A sells 13.40% GOI 20x5 for a face value of Rs.100 crore to Bank B at the
current market price of Rs.102.50. The cash outflow to Bank B will be as under.
! "
# $
The actual amount borrowed will, therefore, be Rs.105,70,11,111.

Since the contract envisages payment of interest on the borrowing at 12% for
14 days, the amount of interest is Rs.48,65,147. Hence, the amount to be paid by
Bank A to Bank B on the reversal date is Rs.106,18,76,258. Hence, the price of
the buyback of the security will now be worked out as under:
%& ' ! $!
& " $
( ! !
The following points need to be borne in mind while working out the cash flows:
a. While the amount of borrowing is decided by the borrower the actual cash
flow depends on the security selected due to its market price, and the interest
accrued on the security from the last date of interest payment till the date of
transaction. The holder of the security is entitled from the last interest
payment date till the date of sale.
b. Once the actual cash flow is determined, the interest cost is worked out based
on the terms of agreement with reference to interest rate and the term of
borrowing.
c. Once the amount of the reverse flow is determined, the price of the security is
to be worked out depending on the accrued interest on the security from the
last date of interest payment till the date of reversal of the transaction.
d. Interest with respect to GOI securities is computed on the assumption of
30 days a month and 360 days a year whether transaction is an outright sale
or a repo. Hence, January and February are assumed to have 30 days each.
Similarly, the remaining number of days for December is considered as
7 (30 – 23) since, interest is paid on 24th December till 23rd December.
e. Interest with respect to borrowing is calculated for the actual number of days
based on 365 days a year.
A repo is transacted as follows: Suppose Bank ‘X’ needs funds for a short-term. It
sells T-Bills to Bank Y (sale agreement) and simultaneously agrees to buy the
same after a specified time at a slightly higher price (purchase agreement). The
difference between the prices represents the interest payable by Bank X to Bank Y.
The transaction helps Bank Y since it gets the yield on the funds deployed though
it runs the risk that the price of the security may drop in the meantime. The RBI
makes funds available to the banks under repos, directly or through DFHI
(Discount and Finance House of India) and Securities Trading Corporation of
India. The RBI allows repo transactions only between banks. In addition to
T-bills, all dated central government securities can be used for repos.
REPO RATE
The annualized interest rate at which the funds were transferred by the lender to
the borrower is called the repo rate. The possible rate of borrowing through a repo
transaction is lower than the rate on the same amount borrowed in the unsecured or
interbank loan. This is because the repo is a collateralized transaction where the
rate depends upon the creditworthiness of the issuer of the security and it is
somewhat higher than the creditworthiness of the seller. Some other factors also
influence the repo rate like liquidity of the security or guarantee and relevant rates
of other financial instruments in the money market.
176
Debt Markets
The repo transaction can be divided into two stages (first leg and second leg) viz.
selling of the security and repurchasing of the same security. Sale price of the
security in the first stage depends upon the market price for outright deals and for a
date, which is very near in the future. Sale price is determined on the basis of cash
inflow and tax aspects on the transacted funds in the second stage, which is for a
future date. This is because of two reasons. First, as the instrument is sold to the
buyer in the first stage, the ownership right transfers to the buyer from the seller
for the period of repo agreement. The coupon rate of interest accumulated for that
period also has to be transferred to the seller. The amount of interest accrued for
the broken period has to be remitted to the seller by the buyer in the first stage. In
the second or repurchase stage, the initial seller or the present buyer has to pay the
accrued interest for the broken period to the earlier buyer or the current seller.
Both spot and forward transactions are present in the repo agreements. The
required repo rate is found by calculating the sale and repurchase prices after
adjusting the accrued coupon rate of interest. The excess of the coupon rate in the
first stage of repo over the second stage of the repo gives the coupon rate of
interest for the total period of repo agreement. Hence the method of price
adjustment of a repo transaction varies directly with the relationship between the
net coupon interest rate and the total amount of repo transaction, which is
determined on the basis of the agreed amount of funds transferred. If the current
yield is lower than repo rate a capital loss will occur due to the adjustment in the
repurchase price. On the other hand, capital gain will occur if the repo rate is lower
than the current yield resulting in the downward adjustment of the repurchase price.
Adjustments in price at the repurchase stage are not required if both the repo rate
and coupon interest are equal in which case the repurchase price will be equal to
the selling price of security.
Though the repo agreements are based on the collateral there is still some element
of risk, related to the guarantee in the form of counterparty risk and the issuer risk.
The investor can offset the counterparty risk by liquidating the securities kept as
collateral.
Both seller and lender usually hold cash or some other securities against the risk of
non-return of the lent securities according to the repo agreement. Generally the
realizable value of the guarantee or securities should be more or equal to the
amount of the exposure of the risk. Another risk that is possible is the illiquid
collateral.
Standard accounting practices exist for treating repo agreements and the valuation
of collateral. However, the collateral securities are generally calculated on the
basis of current market price plus accrued interest (on coupon bearing securities)
in the period up to the maturity date of the agreement excluding a “margin” or
“haircut”. The haircut is an adjustment for offsetting the market risk to save the
borrower or lender from the transaction price movements. The amount of the
haircut is determined by the period of repo, coupon rate of interest of the securities
and the risk exposure involved in the securities.
As the variations in the market prices of securities have effect on both the lender
and borrower, marking to market is the most popular method that is used by both
of them to act accordingly. Based on this if the market values of the repo securities
drop beyond a specified point further collateral is to be supplied by the borrower.
In contrast the lender returns all the excess collateral remitted by the borrower if
the market values go up substantially.
177
ADVANTAGES OF REPOS
Repos have the following advantages:
• The amount of activity in the repo market will increase the turnover of the
money market, resulting in the enhanced liquidity and depth in the market.
• As a tool of financing the Repos would cause an increase in the turnover in
the debt market. It also causes increase in the volumes of dealings by the
dealers. Hence the repos are a cost effective and efficient way of improving
the liquidity of the securities transacted in the secondary markets.
• As repos enable the traders to take convenient positions to go short or long in
the market the activity of debt markets increases. This flexibility enables one
to manage efficiently the cash flows by acquiring in a bullish scenario and
disposing off in a bearish environment.
• Institutions and corporates see repos as an inexpensive way of financing and
can borrow and invest at market rates.
• In India the growth of the debt markets and hedging activities are on low ebb
because of the absence of active term money market. A money market can be
effectively formed if a large number of repo transactions for varying
structures are traded in the market particularly in the interbank market.
• Repos are also useful to the Central Bank in the way they can use them as a
part of their open market operations to maintain the liquidity of the market
and also to reduce fluctuations in the money market especially call money
rates. The central bank uses the bank reserves and call rates in such cases.
DEVELOPMENTS IN REPO MARKET
While the above describes the transactions between banks, Repo transactions may
also be entered into by the RBI and NBFCs. Earlier, NBFCs were only permitted
to enter into Reverse Repo transactions. It meant that NBFCs could buy securities
in the first stage and then reverse the transaction in the second stage, but they can
now enter into Repos. Thus, Repo is an avenue of NBFCs to develop short-term
surplus funds, but not an avenue to raise funds.
However, on 10th October, 2000, following the recommendations of the
Narasimham Committee II, the Reserve Bank took several steps to widen the
participation in repo market such as:
i. Permission to non-bank participants maintaining current and SGL accounts
with the RBI, Mumbai to undertake both repo and reverse repo;
ii. Reduction in minimum maturity for repo transactions to 1 day;
iii. State government securities being made eligible for undertaking repos; and
iv. Opening of its purchase window to impart liquidity to government securities
whenever the situation warrants.
The RBI undertakes Repos with banks as part of its monetary management. When
the RBI enters into Repo transactions, it sells the securities to banks with an
undertaking to buy them back. Thus, the liquidity in the system is sucked out for
the term of the Repo. The RBI can add liquidity to the system by entering into
reverse repos with banks. Either of these actions depend on the objective of the
Central Bank. The RBI can also use these transactions as a signaling mechanism
for short-term interest rates. These transactions can also help banks manage their
SLR requirements.
178
Debt Markets
) * * &' +
, , " + "' + + ' +
' - & - # +
- , & ' & - . %
, , / , 0 .
' & ' ' . . &
' + '
, ' 1 .' + - ,
+ +. , . .' + - #
2 ' ' & 3 # + -
& 3 %
- , , 4
+ ' ' +
+ & 3 # & + -
0 + & ' /
& 3 ' - - 3 + , - , + & 3 &
& 5, .# .6 5#6" 0
+ & 3
ISSUING PROCEDURES
The Reserve Bank of India issues press releases indicating the date of auction, the
last date and time for submission of tenders, details of securities offered – such as,
the nomenclature of the securities, their sale prices and the Repo period from time
to time. The participants interested in quoting the bids need to duly fill the tender
form (format given in Appendix I) and send it to the Reserve Bank of India,
Securities Department, Mumbai. Separate tender forms need to be submitted for
each bid in case of multiple bids by a single tenderer. Tenderers are required to
state Repo rate expected by them in percentage (up to two decimals) per annum
(365 days). The total amount payable by a successful tenderer to the RBI on
purchase of securities will include the sale price quoted by the Reserve Bank in
addition to the accrued interest on the security.
ACCEPTANCE OF TENDER
The Reserve Bank will determine the total amount of Repos to be offered at each
auction on the basis of tenders received, and it will have the full discretion to
accept or reject any or all of the bids or make partial allotment without assigning
any reason.
The setting up of Clearing Corporation of India (CCI) has upgraded the cash
settlements to the Real Time System. The wholesale investors, banks and mutual
funds settle cash transactions in government securities, T-Bills, bonds, in the CCI.
The entities have to pay after netting the transactions. This allows the banks and
other wholesale investors to leverage their enhanced cash position. The
corporation wants to build a war chart by way of settlement guaranteed fund, by
the entity exposures to their contribution to the fund. CCI wants to make the
process of transacting settlements by building a data link-up (pipe line) with the
RBI’s Negotiated Dealing System, besides providing a platform to boost Repo
transactions. It seeks to remove the risk in trading non-equity derivatives by
guaranteeing all trades.
179
ANNOUNCEMENT OF AUCTION RESULTS

The result of the auction, viz. the Repo rate (cut-off rate) up to which bids have
been accepted, would be displayed at the Reserve Bank of India, Mumbai on the
same day. Repos will be offered to all the tenderers who have tendered bids at or
below the cut-off rate, at the respective rates quoted by them. The successful
tenderers can collect the Acceptance-cum-Deal Confirmation Advice (specimen in
Appendix II) and SGL transfer forms immediately after announcement of auction
results on the date of the auction. They can also take delivery of SGL transfer
(credit) advice from PDO, RBI on the same day. The amount to be paid to
successful bidders will be debited to their current account with the RBI.
! "#
% 7& 8' + ' ' , ) 3
9 &' -, :6 / - % ;%/<
% ' = , & # ) + ' -'
) + ' , & & & & &
% 1 6 && ) 3 - ) " ( & > (> " & -

1=; 6 + ) 9 &' + ' -'
) ' '& ' & ,

- 7/ - % 8 , 6
= 9 - > ' 9 - & 6 ! / , ) 3
6 5 9 &' . ' 3
= / 6 5 ' - ) ' &
! 1 - 9 ' & ' ? & '
'& '
$ # & ' ' +
& '
# + ' :@ . .6 < % < 1=; %

7 6 < 1=; % 8+ ' + , ) 3
1 + ' ' ) '
# ) + = , & 1 ' ) 3
< 6 < 1=; % " '
-
/ @ . .6 + , 0 )
A & ' -A ' - '
A' & # + , 0 ) , +
B & - ) % ' 3 A(> + , 0
) - A ' 6 < 1=; %
& ' % + ' - -
6 + ' )
5 ' , ) + & . + '
+ '
# + ' & - = , & -' # )
# & ' ' + '
& ,
180
Debt Markets
# < 6 % + ) + ' '

# < 6 < 1=; % + '
& 5 < 6 1=;
% + ' ' 6 % &
& ' / + ' &
! &
+ - & + - + "+ '
; - C# < 6 % >
# < 6 1=; % 6
D %& ' "A
; - C# < 6 1=; % >
# < 6 % 6 ! D %& ' E
! F"
1 ' , ) 3 ' ' 3 6 < 1=;
% + ' 1; % 1
> & , ) 3 + 1=; ' + +
-, - ' 3 .+
6 < 1=; %
# & + 3 &
# + ' - ( >, '
& + ' 9 &' 5 ) 9 ) - /
9 &'
! # 3 & A
& & , &1 > & ) / 9 &'
' &
$ + ' ' - ' &
& - - '
& + ' 'B ' - ' &
-
# , ) 3 , - B +
& + - -
, ) 3 ' ' & - '
- 6 '
Source: RBI Bulletin, July 2002.
PAYMENT
On the date the RBI repurchases the securities the tenderers’ current account will
be credited with the amounts (that is specified in the acceptance-cum-confirmation
advice), while debiting their SGL account with the face value of the security. The
tenderers can collect the relative SGL transfer (debit) advice from the Public Debt
Office on the same day.
REPO/REVERSE REPO AUCTIONS UNDER LIQUIDITY ADJUSTMENT
FACILITY
The Fixed Rate Auction system and ACLF for banks along with Level II support
for PDs was replaced by a variable interest rate auction system on “uniform price”
basis conducted by the Reserve Bank of India. In case of the RBI, tenders should
be submitted for a minimum amount of Rs.1 crore and in multiples of Rs.1 crore.
Only banks and PDs maintaining SGL and current accounts with the Reserve Bank
of India at Mumbai are eligible to participate in the repo auction. Bids for repos
have to be submitted before 10.30 a.m. on all working days, Monday through
Friday. Multiple bids can be submitted. There will be no auction on Saturdays. The
results of the auctions will be announced by 1.00 p.m. The settlement of
181
transactions in the auctions will take place on the same day. But for intervening
holidays, the repo auctions will be for one day except on Fridays; on Fridays, the
auction will be for three days or more maturing on the following working day.
The objective of the RBI in conducting the Repo/Reverse repo auctions is to
improve the short-term liquidity management in the system and to remove the
imbalances in the interest rates of the call/notice money market.
$ % ! & #
# , & & & . , 'B , * &
= , & < ' + -
- & . & - 2 2
& - , & * & ' +
- &' , & &
( - 6;/ - ' 3 &
& 3 ' + - - -, ' & 3 # &'
- 2 & 3 - ' + - -
& & 3 ' - + ' - & ' 9 , 6 ,
) 3 @ , ) 3 < ' & -
& & 3 + . &
2 & - & ? & 2 & - ' + -
' , 2 '
+ ' 6 -6
; 66 ;" 6);5 0 ' + - - ' - " -+ &
- + - . - - - &
, & & & 6);5 + ,
+ ' & & 3 ' & +
, & && & 3
66 ;< 0 ) & - & '
- # - & '
, , & - 3 +
-, & ' 3 & 3 & + ' 3
# ' 3 ' & + &
-' & , ' & - - 3 -
-/ - ) / )" &
+ 3 - - + ' -- - -
0 - 1# (1 - & & - -
' & - & ' ' 3
) - - + 3 -- & & ' + - ' (>
, + - & 2 ' + & ' 3.
' 3 - 2
& & 3 ' + - & - ;3
(> & , , & & 3 & &
(> , ' - , & & 3
3 & + & 3 ' 5 - &
& ' + - + , -+ ' -
& 3 + & & 3. . - 2 &
9 , & 1=; & - & + & .
. ,
# - 6);5 ' ' 66 ; + &
%- - - , ' & &' 61=;
66 ; + & ' + - - 6);5 ' ? 6);5 + '
' & & 3
5 & , ' ' 3 + 6);5 2 ' + - -
& &' + ' 61=; . +
' ' ' &' ' & 1 - & +
(> & . ' . .
% , - 1=; ' - , ' & & &' G>1 -
- & )"' 9 # & B =. + -
- 66 ; 4 66 ; + - & 3 3 & ' 3 =.
G>1 + - ' ,
&+ & , + ' 3 # - & 3
+
182
Debt Markets
% - , & '
&& ' 3 - ' + 3
# ' 3 & + ' ' - & 3
& 3 , ' - , - + .+ 2 ) & - & + ' ' 3
' & & & - - - - ' 3 -
- ' ' , =. - -&
/ + - + 1 > 1>" & #
& , 3 4 ' 1> +
& 3 2 -
4 & 3 2 , ' 2 1> ,
'B , - =. , 9 + (> , & +
+ + - - - H, ' 3
& 3 1>? '
&
Source: www.hinduonnet.com, May 20, 2002.
SECONDARY MARKET TRANSACTIONS IN REPOS

The RBI through the SGL accounts settles the secondary market trading in the
repos and notifies the volume, rates and the period of repos on a weekly basis. The
weekly average of repo volumes in the secondary markets (based on the SGL) was
at Rs.788 crore in 1998-99 and increased to Rs.1,591 crore in 1999-2000. The
average weekly transactions in the first six months of 2000-01 were Rs.1,782
crore. In the secondary market repos are being traded primarily on the Central
Government securities. The volume of repos on T-bills have also shown increasing
trend from Rs.29 crore average amount in 1998-99 to Rs.134 crore of weekly
average in 1999-2000.
When the volume of transaction of repos is very high the rates fall to a low of 2%
and normally the average rate is 6-8%. With the central bank deciding to make the
call market a pure interbank market, the movement of participants from the call
market to the repo market is poised to increase the activity and the volumes in the
repo market. The important blocks in the growth and smooth operation of the repo
market are the improvement of liquidity for only a few securities and lower
volumes when compared to other markets.
' " # ! ( ! ))' )*
/ + - & & . & , + G , &' ;2 % B &
/ ;%/" + , + 3 - && -
-- & & 3 # ,
& & &9 % , & $.
' + + ' '
, ) 3 & & & 5 , + & & , &
' 3 $. & + , '
, 1 & ) + , , -
- & , ' - & 3
, # , ) 3 + , -
' + , +
+ ,# " -# ! . / &
/ + - &
& . & , + G , &' 7
= ;2 % B & / 8+ ' & > &'
+ & && # + , + & 3
# 3 - && =
-- & & 3 , ;%/ & +
, 9 - C " $. " , -
, + 3 / ' & 3
& && & ' - .
- , ' - + - & & #
- 7 8 7 , 8 & + ' ' & -, -
& 3 2 & & -
Source: RBI Monetary Policy 2004-05.
183
REPOS IN OTHER COUNTRIES

In the US, repos could be treasury obligations, agency issues, mortgage-backed
securities, corporate debt issues or money market instruments such as NCDs. The
period could be between one day and several months. At the end of the period, the
seller gets back the security and the purchaser gets back the funds that he provided
together with the accrued interest. The major players in the repo market are banks,
savings and loan institutions and non-bank security dealers.
In Europe, the stock lending and Repo Committee will constantly review the
guidelines on the operations of the repo market. Some specific and additional
issues are to be covered by the parties to the contract. These include legal
documentation, credit risk assessment and the margin levels. Information
regarding the collateral is to be exchanged by the parties at the point of trade. The
pricing system is also determined at this stage. The benchmarking rate for the large
European repo market is known as Europe. The collateral or the gilt-edged security
underlying the repo transaction is known as the Europe GC. A representative panel
of prime banks provides daily quotes of the rate, rounded to two decimal places,
that each Panel Bank believes one prime bank is bidding another prime bank (and
offering money) for term repo on Europe GC. Europe is quoted for spot value
(T + 2) and on an Act/360-day count convention. It is displayed up to two decimal
places. The range of Europe quoted maturities is overnight, 1, 2 and 3 weeks and
1, 2, 3, 6, 9 and 12 months.
* % !
'- 0 &
& ' - # - & ' & &
' - ) 3 1 &
1 9 3 % - & I1J
' ' , - + /
- - , & + ' &
+ - ' 0 , - - - & + &
& - - 3 , + , ' . ,
, , 3 & & & & , -
, , , B
, , & - - - 3
SUMMARY
• Repos are ready forward deals or agreements involving sale of a security with
an undertaking to buyback the same at a predetermined price and time in
future. To the seller, it is known as a repo and to the buyer it is known as a
reverse repo.
• The market participants in repos are: banks, DFHI, financial institutions, non-
banking entities like mutual funds that hold current and SGL accounts with
the RBI.
• The operational aspects of a repo depend on: size of the loan, selection of
security, interest rate and settlement system.
• The procedure to issue repos involves the acceptance of tenders,
announcement of auction results and the payment.
184
Debt Markets
Appendix I**
Tender Form for Fortnightly Repo Auction
(Specimen Tender Form)

Internal Debt Management Cell
Mumbai.
Tenderer’s RC S.G.L. A/c.

No. with Securities ______________
Department
Tenderer’s Current
A/c. No. with D.A.D. ______________
Dear Sir,
Tender for Fortnightly Repurchase Agreements (Repos) Auction to be held on

___________by Reserve Bank of India.
I/We* the undersigned hereby submit tender as set out below for the purchase of Government of
India dated securities/eligible Treasury Bills from you on ___________________ with the
undertaking that the same securities will be sold back to you on ______________________.
G & K%
%& ' L - " MMMMMMMMMMMMMMMMMM

+ " MMMMMMMMMMMMMMMMM
&
+ &
' "
# G
/ G
@ Indicates the nominal amount offered in Repo against securities.
Undertaking
On your acceptance of my/our* tender,
1. I/We* agree and undertake to immediately collect the Acceptance-cum-Deal confirmation

advice from your office and to deposit the requisite amount at Reserve Bank of India,
Mumbai in the manner and on the day/time indicated therein.
2. I/We* also authorize the Reserve Bank of India to be our custodian, to hold the securities
purchased by us from Reserve Bank of India under the Repos, and to transfer them by
debiting/crediting my/our Current Account and Repo Constituents’ Accounts based on
our application/bid form.
3. I/We* agree the beneficial interest, viz., Coupon, if any, in respect of securities
transferred by Reserve Bank of India to us and held in the Repo Constituents’ SGL
Account will rest with Reserve Bank of India.
185
4. I/We* agree that the Reserve Bank of India shall not be held responsible for any loss,
damage or liability on account of acting as the Custodian of our securities. I/We* also
agree that I/We* shall indemnify and keep indemnified the Reserve Bank of India at all
times against any loss, damage or liability whatsoever arising out of acting as Custodian
of our securities as above.
I/We* have also submitted another bid(s)/not submitted any other bids* for the auction.
Terms and conditions

I/We* have read the terms and conditions for the auction and undertake to abide by them.
Yours faithfully,
i) Signature of official authorized to operate on

SGL/Current Account _______________________________
ii) Name _______________________________
iii) Designation _______________________________
iv) Office stamp of the tenderer _______________________________
*: Strike out whichever is not applicable.
** Source: RBI November 03, 2001/forms
186
Debt Markets
Appendix II*
Mumbai
Acceptance-Cum-Deal
Confirmation Advice
Date:
To,
____________________________
____________________________
____________________________
____________________________
____________________________
Ref. No.
Dear Sirs,
Repo auction dated ___________________
Acceptance of tender ___________________
We advise that your tender dated _______________ for Repos has been accepted as per details
shown hereunder. Accordingly, you are requested to deposit a sum of Rs._______________ by
cheque drawn on your account with the Reserve Bank of India, Mumbai along with a letter (in the
form enclosed) with Securities Department, Reserve Bank of India, Fort, Mumbai before 12.30
p.m. on_______________. On receipt of the amount in full, your SGL account will be credited
and the relative credit advice may be collected from the Public Debt Office at the close of business
the same day.
You are requested to return to us the duplicate copy of this letter duly signed in confirmation.
Details of Deals
Deal Date ___________________
Our sale to you on ___________________

and Repurchase from you on ___________________
%-- - /
1 1 ( (
" & ! "
/ "
%& ' ' C
187
6 ' , C MMMMMMMMMMMMMMMMMMMMMMMMMM
% C ) 3 MMMMMMMM MMMMMMMMMMMMMMMMMMMMMMMMMM
; C & L $ F MMMMMMMMMMMMMMMMMMMMMMMMMM
# & ' ) MMMMMMMMMMMMMMMMMMMMMMMMMM
%& , ' ' MMMMMMMMMMMMM
6 ' , MMMMMMMMMMMMMMMMMMMMMMMMMM
% C ) 3 MMMMMMMM MMMMMMMMMMMMMMMMMMMMMMMMMM
; C & L $ F MMMMMMMMMMMMMMMMMMMMMMMMMM
# & ' ) MMMMMMMMMMMMMMMMMMMMMMMMMM
P. Manager
We confirm the Deal Mentioned Above
i. Signature of official authorized to operate SGL Account
ii. Name
iii. Designation
iv. Office Stamp of the tenderer
* Source: RBI November 03, 2001/forms
188
Debt Markets
Appendix III*
Application for Transfer
Name and address of Date:

the tenderer
Ref. No.
The Manager,
Securities Department,
Mumbai.
Dear Sir,
Repo Auction dated _________________________________
1. We return herewith the duplicate copy of your Acceptance-Cum-Deal Confirmation Advice

No. __________ dated __________ duly signed in confirmation. We also return the SGL
transfer form signed by us for completion at your end. We also enclose Cheque No.
__________ dated __________ for Rs. ________on our Current Account with the Reserve
Bank of India, Mumbai.
2. The securities as specified in the aforesaid Advice may please be transferred to our SGL
Account No. ____.
3. We also enclose SGL transfer form duly completed at our end to enable you effect the
repurchase of the securities on __________ by debit to our SGL Account.
Signature
Name:
Designation:
Encl: 1. Duplicate copy of your Acceptance-Cum-Deal Confirmation Advice.

2. SGL Transfer form for credit to our account.
3. Cheque for Rs._________
4. SGL transfer form for debit to our account.
* Source: RBI November 03, 2005/forms
189
•
!
• ! !
• " !
Debt Markets
Historically, deposits from the public is an important mode of finance for the
corporate sector. Companies prefer to raise finance by accepting deposits rather
than borrowing from banks and financial institutions because these were in the
nature of unsecured debts and not backed by any security in the form of
hypothecation, mortgage, lien, etc. Further deployment of funds raised through
deposits is at the discretion of the company unlike loans from Banks and Financial
Institutions. There was no control over such deposits till Reserve Bank of India
assumed the power to regulate acceptance of public deposits from February, 1964.
REGULATORY FRAMEWORK GOVERNING ACCEPTANCE

OF PUBLIC DEPOSITS
For the purpose of exercising regulatory control over the public deposit market,
companies are classified as
Non-Banking Finance Companies: These have been defined by Reserve Bank of
India as “Non-banking institution which is a loan company or an investment
company or a hire purchase finance company or an equipment leasing company or
a mutual benefit financial company.” The regulations governing these companies are:
i. Non-Banking Financial Companies (Reserve Bank) Directions, 1998.
ii. The Miscellaneous Non-Banking Companies (Reserve Bank) Directions, 1977.
iii. Residuary Non-Banking Companies (Reserve Bank) Directions, 1987.
iv. Non-Banking Financial Companies Prudential Norms (Reserve Bank)
Directions, 1998.
v. Non-Banking Financial Companies Auditors Report (Reserve Bank)
Directions, 1998.
vi. Housing Finance Companies (NHB) Directions, 1989.
Non-Banking Non-Finance Companies: These include all manufacturing
companies, trading companies and companies engaged in the services sector.
These companies are regulated by Companies (Acceptance of Deposit) Rules, 1975.
DEFINITION OF PUBLIC DEPOSITS

The Companies (Acceptance of Deposit) Rules, 1975 defines public deposit as any
deposit of money including any amount borrowed by a company but excludes:
i. Any amount received from or guaranteed by Central or State Government.
ii. Amount received from foreign government or foreign citizens.
iii. Any borrowings from banks and financial institutions.
iv. Inter Corporate Deposits.
v. Security deposit received from an employee or an agent.
vi. Advance received for supply of goods or services.
vii. Amount received towards subscription to shares or debentures pending
allotment and calls in advance.
viii. Any amount received from a local authority.
ix. Any amount received in trust or amount in transit.
x. Any amount received from a director of the company.
xi. Bonds or debentures secured by mortgage of immovable property of the
company or with conversion option.
xii. Any unsecured loan brought in by promoters in pursuance to any stipulation
by financial institutions to that effect.
191
TENURE OF THE DEPOSITS

The minimum tenure for which public deposits can be accepted or renewed is
12 months. It is also stipulated that the maximum maturity period for the deposits
cannot exceed 60 months.
It is, however, provided that a company, for the purpose of meeting its short-term
requirement of funds, may accept or renew deposits for less than 3 months, but
such deposits should not exceed 10% of the aggregate of the paid-up capital and
free reserves. The repayment of such deposits before 3 months from the date of
acceptance or renewal is also prohibited.
No deposit repayable on demand or on notice can be accepted by a company.
Interest and Brokerage on the Deposits
At present there is no ceiling on rates of interest. However, NBFCs cannot pay
more than 11% p.a.
The maximum amount of brokerage payable for soliciting public deposits is as
follows:
!" # $
The payment of such brokerage is on a one-time basis.
MAXIMUM AMOUNT OF DEPOSITS
The total amount of public deposits that can be outstanding at any point of time
cannot exceed 25% of the aggregate of paid-up capital and free reserves. In
addition to the above limits, it can accept deposits from its shareholders up to a
maximum limit of 10% of the aggregate of paid-up capital and free reserves.
No government company shall accept any deposits in excess of 35% of its paid-up
capital and free reserves.
Maintenance of Liquid Assets
The company shall maintain liquid assets to the extent of 15% of the deposits
maturing during the financial year ending 31st March next. The amount shall be
deposited or invested before 30th April.
The permitted investments are:
i. Deposits held with a scheduled bank, free from lien or charge.
ii. Unencumbered securities of central or state government.
iii. Unencumbered securities approved under Indian Trusts Act, 1882.
iv. Unencumbered bonds issued by Housing Development Finance Corporation
Ltd.
The amount held in liquid assets can be used only for the purpose of repayment of
deposits outstanding and repayable within next 31st March. It is further provided
that the amount held in liquid assets shall not, at any point of time, fall below 10%
of the amount of outstanding deposits maturing before 31st March next.
Issue of Deposit Receipts
The company shall, on acceptance or renewal of deposit, furnish to the depositor a
receipt within a period of 8 weeks. The receipt shall be signed by a duly authorized
official of the company and shall contain the following particulars:
i. Date of the deposit
ii. Name and address of the depositor
iii. The amount of deposit
iv. The rate of interest
v. The date on which the deposit is repayable.
The deposit receipt issued by a company is not negotiable implying that it cannot
be transferred to another person by endorsement and delivery.
192
Debt Markets
PREMATURE WITHDRAWAL OF DEPOSIT

Under Rule 8(1) of the Companies (Acceptance of Deposits) Rules, 1975, a
company can make premature repayment only after a period of 3 months from the
date of the deposit. The interest payable on premature withdrawals is as under:
% " & ' ()
" & " ' ( *
* !" # $ ' ) * *
) # "
** *
* ))
If, for example, a deposit was received for a period of 4 years and the interest rate
was 12 percent. If the deposit is repaid on the expiry of 3rd year and the rate of
interest paid for 3-year maturity deposit was 11 percent, then the interest rate
payable on such deposit will be 10 percent (11% – 1%).
REGISTER OF DEPOSITS AND RETURNS
Every company accepting deposits shall maintain a Register of Deposits at its
registered office. The Register shall contain the following particulars of each
depositor separately:
i. Name and address of the depositor.
ii. Date and amount of each deposit.
iii. The term of the deposit and the date on which the deposit is repayable.
iv. The rate of interest.
v. The dates on which interest payment is to be made.
Every company shall file a return of deposits with the Registrar of Companies, on
or before 30th June every year. A copy of the return shall be simultaneously filed
with Reserve Bank of India. The register of deposits shall be kept for a minimum
period of 8 years from the financial year in which the latest entry has been made in
the register.
ADVERTISEMENT
Every company intending to invite deposits shall issue an advertisement in a
leading English and a vernacular newspaper circulating in the state in which the
registered office of the company is situated. The advertisement inviting the
deposits shall include the following particulars:
i. Name of the company
ii. Date of incorporation
iii. The business of the company and its subsidiaries
iv. Details of the branches of the company
v. Management of the company
vi. Board of Directors
vii. Profits and dividends for the last three financial years
viii. Summarized financial position for the last two years
ix. The maximum amount of deposits which the company can accept and the
amount of deposits held as at the end of the preceding financial year.
The Board of Directors should also make a declaration that the company is not in
default in the repayment of deposits and interest thereupon.
The validity of the advertisement is up to a period of 6 months from the closure of
the financial year for which it was issued. A fresh advertisement shall be issued for
every succeeding financial year.
193
MARKETING OF PUBLIC DEPOSITS

A company has to develop a mix of factors like product differentiation, pricing,
promotion, service and distribution to successfully market their public deposit
schemes.
Product Differentiation: Fixed deposit is an intangible financial product. The
needs of the potential depositors have to be kept in mind, while designing the
product. Generally, the target market is the middle class household. They normally
look for safety and security of their savings. Safety factor can be projected by
highlighting the credit rating. Different saving schemes may be developed to suit
varying financial needs. Some of the popular schemes include regular income
scheme where interest is paid at monthly, quarterly, half-yearly or annual intervals,
cumulative deposits where the interest along with the principal is paid on maturity
and recurring deposit schemes where a fixed amount is invested regularly and a
lump sum is paid on maturity. Some company deposit schemes have sweeteners
like free accident insurance cover for their depositor.
Pricing: The pricing aspect is regulated by the Government and the maximum
coupon is capped at 15% p.a. Hence scope for innovation is limited. However,
companies can design schemes with various maturities and differential interest
rates can be offered subject to the statutory ceiling.
Promotion: The company should first identify the segment of the market that it
would like to tap. Unlike consumer goods, where mass marketing is required,
financial products should attempt target marketing. This strategy enables it to
focus on specific target segments instead of scattering their marketing efforts.
At any point of time, potential depositors are in different stages of readiness –
some are unaware, some aware, some informed, some interested, some curious and
some intending to invest. Thus the promotion effort should aim at building high
awareness through advertising. The promotional campaign can be carried through
various media like print media, audio-visual media, outdoor displays like
hoardings and posters, direct mailers, novelties like calendars and key chains,
catalogues and brochures, circulars, etc.
Most companies hire a professional advertising agency to carry out the campaign.
The objectives for promotional campaign are different for different companies.
Companies entering the public deposit market need informational advertising to
build primary demand. Companies which already have a presence in this segment,
go for persuasive campaign for building selective demand. Companies with a long
standing track record in the deposit market should adopt reminder advertising.
Another strategy is the use of catchy message or slogan as a tool of
communication. The advertisement has to put the message across in a way that
captures the attention and interest of the potential investors. The message has to be
exclusive, desirable and believable to create the necessary impact. Some
companies have attempted to create an identity for their public deposits by
providing them with brand names.
Quality Service: Good and courteous service helps in earning the goodwill of the
depositors. The depositors are provided with post-dated interest warrants payable
at par, prompt repayment on maturity, loans against deposits, etc. A mechanism
for prompt redressal of depositor grievances should also be created. Companies are
investing huge sums of money to create infrastructure, so that they can render
quality service. Some companies sub-contract the work to specialized agencies.
Personalized and prompt service would have a self-propelling effect and can bring
in more depositors by word of mouth. It acts as pseudo-marketing.
Distribution: A company should decide on the geographical areas that it needs to
focus on. However, careful attention should be paid to variations in geographical
needs and preferences.
194
Debt Markets
Many companies depend on their existing depositor base for their continued
patronage. These companies have developed a loyal depositor base over a period
of time and retain them through excellent service. Though the existing depositors
do not add much to the net accretion, a large depositor base is definitely a strong
selling proposition while campaigning for further deposits. This enables
prospective depositors to repose confidence in the company.
Some companies practice direct marketing of their deposits. The company staff
directly contacts the potential depositors and explains to them the salient features
of their schemes. Sometimes the companies canvass by holding depositor meets
and make presentation about the company and its deposit products. Normally, such
companies have a clearly defined target segment for example, pensioners, double
income households, young managers, etc.
Most of the companies depend heavily on brokers and agents for mobilization of
deposits. These intermediaries constitute a vital link between the company and the
depositors. Most of these agents are full-time intermediaries and also sell a wide
range of financial products like shares, mutual fund units, insurance schemes, etc.
They generally have a loyal investor base who rely upon them for investment
advise. The drawback of agency system is that they are inclined to promote
deposits of those companies which pay them the highest brokerage.
SUMMARY
• Corporates prefer public deposits to bank loans because they are unsecured
debts and the funds can be deployed at the discretion of the company.
• Non-banking finance companies have been defined as loan companies or
hire purchase finance companies or investment companies or equipment
leasing companies or mutual benefit financial companies, while non-banking
non-financial companies are those involved in manufacturing, trading or
service sector.
• Public deposit is any money borrowed by a company, but does not include
advances, guarantees from any government, bank borrowings, security
deposits, funds from the promoters or directors, share capital or debenture
funds.
• Public deposits should be of 12 to 60 months tenure.
• The maximum rate of interest is decided by the RBI and the brokerage paid
to the agents depends on the duration of the deposit. The maximum amount
of deposits cannot exceed 25% of the paid-up capital and free reserves. In
addition, the company can accept deposits from shareholders up to 10% of
the paid-up capital and free reserves.
• The company must maintain liquid assets to the extent of 15% of the deposits
maturing by the end of the financial year (March 31). The liquid assets can be
deposits with scheduled banks without any lien, unencumbered securities of
central and state governments, other unencumbered securities or bonds of
HDFC. The liquid amount can never fall below 10% of the maturing
deposits.
• Receipts of deposit must be issued within 8 weeks of acceptance and
premature deposits are allowed after a period of 3 months from the date of
deposit, subject to the penalty for early withdrawals.
• Every company accepting deposits should maintain a register of deposits at
the registered head office with the basic details of each deposit-holder, for a
period of 8 years from the financial year in which the latest entry is made.
• A company inviting public deposits must advertise the details of the company
and the profitability in an English and a local language newspaper.
• In order to market its public deposits successfully, a company has to develop
a mix of the following factors: product differentiation, pricing, promotion,
quality service and distribution.
195
•
•
Debt Markets
In a loan transaction, the fund provider may face credit ‘risk’, as the debtor may
not always honor the commitment. Hence, the lender seeks a ‘Guarantee’ and it is
nothing but, a form of security demanded by the creditor. The purpose of seeking
guarantee is to reduce the default risk.
DEFINITION OF GUARANTEE
According to Section 126 of the Indian Contract Act, ‘The guarantee is a contract
to perform or to discharge the liability of third person in case of his default’, which
also specifies the rights and responsibilities of parties to a guarantee.
In a transaction, that is accompanied by a guarantee, three parties are involved –
the lender or creditor, borrower or principal debtor and the guarantor. The
guarantor becomes a debtor, in case of a default by the principal debtor.
A guarantee can be given either by one person or more than one, jointly or by an
organization. A guarantor must be worthy in the eyes of the creditor. Guarantee
being a contract can be oral or in writing. Usually, the latter is preferred by the
creditors.
SOURCES OF GUARANTEES
There are three major sources of guarantees:
a. Personal
b. Governmental
c. Financial Institutional.
PERSONAL
It is the oldest form of guarantee. It is extended both in unorganized and organized
sectors, for a short period. Usually, in an unorganized sector, loans for agricultural
purposes, (loans extended by co-operative institutions and agro-industries corporations)
consumption and social purposes are given against personal guarantees.
In an organized sector, banks and term lending institutions extended loans to
industrial concerns on the basis of guarantees from managing agents, directors and
managerial personnel. Later, this practice declined, the reasons attributed for
decline in personal guarantees are – firstly, the abolition of the managing agency
system, which led to the disappearance of reputed, prestigious and creditworthy
guarantors. Secondly, the rise of new entrepreneurial class, professionalization of
managerial cadres and improvement in the technical and financial appraisals have
reduced the need for personal guarantee.
GOVERNMENTAL
Usually, state and central co-operative banks are short of funds. They have a high
rate of default on their loans. To rescue these co-operative banks, the commercial
banks and RBI supplement the former; i.e. by investing in debentures, long-term
deposits or by extending loans to them. Usually, this is done only after acquiring a
guarantee from State and Central governments. Apart from the above, the
Government also extends guarantees on behalf of public sector units to cover the
latter’s borrowings.
FINANCIAL INSTITUTIONS
In India, commercial banks, insurance companies and most of the statutory
financial institutions at the State and Central level provide guarantees. Credit
markets are regarded as well developed, as there are a number of financial
institutions providing guarantees. For the institutions offering guarantees, this
forms only a part of their business. Usually, guarantees are offered on behalf of
their clients, who are institutional clients in some other areas.
197
Banks
Banks extend financial and performance guarantees on behalf of their clients.
Financial guarantee involves an undertaking by a bank to pay a certain sum of
money in the event of a failure on the part of the bank’s client. For example, a
contractor who wants to bid for a tender needs to deposit a specified sum of money
known as Earnest Money Deposit (EMD). This amount will be refunded to him if
the work is not allotted to him. This involves blocking of funds for a specified
period which varies depending on the nature of the contract. This can be avoided
by submitting a Bank Guarantee in the place of EMD. The bank undertakes to pay
the money if the contractor is awarded the work but fails to pay the EMD. If the
contract is awarded, then the agency awarding the contract seeks an assurance that
the contract completed is up to their satisfaction. Hence, they insist for a bank
guarantee where a bank undertakes to compensate the agency for any loss suffered
consequent to poor performance/non-performance. Such guarantees are known as
Performance Guarantees.
Banks also undertake to pay for the cost of goods bought by their client
(imports/domestic goods) provided, that certain predetermined conditions are
satisfied. In all such transactions, banks issue letters of credit and the contract is
governed by uniform customs and practices for documentary credits. However,
these transactions do not qualify as guarantees because in these transactions the
liability of the bank is primary whereas in case of guarantees it is secondary. In
other words, default by the client is a prerequisite for the bankers’ liability to come
into existence, in case of guarantees.
Banks also issue solvency certificates for their clients, though they do not take up
any liability on account of their clients.
Insurance Companies
Insurance companies issue generally four types of guarantees:
a. Guarantees extended to non-financial contracts.
b. Insurance companies extend guarantee on behalf of hire purchase companies
to banks and other institutions.
c. Guarantees to cover deferred payments to supplier of equipment, to bankers
(either to suppliers or buyers’ bankers).
d. To cover term loans from banks (long-term loans only).
SPECIALIZED PUBLIC GUARANTEE INSTITUTIONS

Apart from the above financial institutions and government itself offering
guarantee services, it was felt that there was need to establish specialized
guarantee institutions. In sequence with nationalization, the policy to extend the
credit to small borrowers was implemented (though it was risky). Hence, it became
essential to set-up an organization which could cover a common and centralized
guarantee scheme. Thus, in the past three decades, the government has set up and
reorganized different institutions to provide guarantees; among them are DICGC
and ECGC.
Deposit Insurance and Credit Guarantee Corporation (DICGC) undertakes the
following activities:
• Insurance of Deposits of Banks.
• Guarantee for credit extended by Banks to Priority sector.
• Guarantee for credit extended by Banks to Small Scale Industries.
198
Debt Markets
INSURANCE OF DEPOSITS
The Scheduled Commercial Banks, Cooperative Banks and Regional Rural Banks
do accept deposits from general public as a part of their normal banking activity.
The majority of the banking system in India is owned by the Government and
hence failure of a bank is more an exception rather than a rule. Notwithstanding
the same there are a number of small banks who undertake banking and obviously
all the banks are not equally strong. After the securities scam in 1992 the Bank of
Karad was liquidated and the depositors of the bank lost money in the process.
However, the problem is not definitely as acute as is the case with Non-Banking
Finance Companies. In order to protect the interests of the depositors it was
considered necessary to have the scheme of insuring the bank deposits. The
scheme was originally undertaken by Deposit Insurance Corporation which was
subsequently merged to become DICGC. As of now all banks have to take the
insurance cover on the deposits accepted by them.
The premium payable for the insurance is at the rate of 2.5 paise per half-year for
every 100 rupees and the same is paid by the bank on behalf of the depositors.
Hence there is no additional cost to the depositors. The deposit will have an
insurance cover for the actual amount of the deposit subject to a maximum of
Rs.1,00,000 for each depositor irrespective of the number and amount of deposits
one has with a Bank. For this purpose all the deposits of a depositor at different
branches of the same bank are clubbed together. However, if a deposit held in the
name of a person individually and the same depositor also holds a deposit jointly
with another person then they are treated as two different deposits. Every bank has
to pay the above premium at the end of December and June every year for the
following period covering January to June and July to December.
GUARANTEE OF ADVANCES EXTENDED BY BANKS
After the nationalization of banks the government played a key role through RBI
in ensuring that credit is allocated to target segment. This was done by defining
Priority Sector and advising all the banks that they should ensure at least 40% of
the net bank credit be extended to priority sector. However, the banks were
unwilling to experiment lending without collateral security which was the theme of
the priority sector lending. In order to provide comfort to the risk averse bankers
the government thought it necessary to take up measures to reduce the risk to the
banker. Consequently, two schemes have come into existence, one for advances to
Small Scale Industries and the other for all advances under priority sector other
than SSI. These schemes are more popularly known as SSI Scheme and Small
Loans Scheme. Though both the schemes were launched independently they have
been subsequently handed over to the DICGC which administers both the schemes
separately. However, the steps involved essentially remain the same with minor
changes in the operational aspects:
• All the loans which are eligible for guarantee will have to be covered and
there is no choice to the bank to selectively cover the loan accounts.
• The Bank extends a credit facility based on its own appraisal.
• The particulars of all loans outstanding at the end of a fiscal year are to be
reported to DICGC.
• Premium at the stipulated rate has to be paid on the outstanding balances for
the next year.
• No claim can be made by the bank for a minimum period of three years.
• If the borrower defaults then the bank has to submit the prescribed claim
forms to DICGC.
• The DICGC entertains the claim if it is satisfied that there is no laxity on the
part of the bank in supervision and follow-up.
199
The amount of claim paid will be the stipulated (usually 50%) amount in default.
However, the experience of the bankers has been that they are paying more
premium than their claims and DICGC’s experience reveals that they are paying
more claims than the premium received by them. The reality is that most of the
banks were disillusioned with the scheme and hence in late 90s decided to
withdraw from the scheme. However, both the schemes are in existence as of now
and still form the largest block of institutional guarantee in the country. In the
budget 2002-03, it was announced that the DICGC would be converted into the
Bank Deposits Insurance Corporation (BDIC).
EXPORT CREDIT AND GUARANTEE CORPORATION
In a developing economy, usually, the inadequate infrastructure and capital
equipment hinders economic growth. In order to enhance the economic growth, the
country needs foreign exchange to import capital equipment. The inflow of foreign
exchange depends on the country’s exports. However, the companies may not be
able to withstand global competency because of the quality. The need to promote
exports was recognized by the Government of India and a number of incentives
were given to exporters. The Government formulated the promotion under two
umbrellas:
i. To extend monetary incentives.
ii. To undertake risk protection.
In case of the former, the monetary benefits are extended to the exporters and the
latter is extended to exporters through ECGC (which is discussed in detail here).
In order to provide export credit insurance support to Indian exporters, the
Government of India set-up Export Risks Insurance Corporation (ERIC) in July,
1957. It was transformed into the Export Credit and Guarantee Corporation
(ECGC) in January, 1964, with the objective of offering financial protection to
the exporter and also improving exporters’ financial standing. ECGC is a
company wholly-owned by the Government of India. It functions under the
administrative control of the Ministry of Commerce and is managed by Board of
Directors representing Government, Banking, Insurance, Trade and Industry.
Exporters are exposed to payment risk most of the times. These risks may arise
due to political uncertainties or economic changes in any country. The exporters
who export their commodities or services are prone to these kind of risks which
are not insured. Thus, the risks prone to exporters can be broadly categorized into
commercial and political risks.
ECGC covers the following risks:
• Commercial risks such as:
– Insolvency of the buyer.
– Failure of the buyer to make the payment with a specified period,
normally 4 months from the due date.
• Political risks:
– Imposition of restrictions by the Government of the buyer’s country or
any blockages due to Governments’ action or delay in the transfer of
payment made by the buyer.
– War, civil war, revolution or civil disturbances in the buyer’s country.
– Cancelation of valid import license or new import restrictions.
– Additional freight or insurance charges that result due to interruption or
diversion of voyage outside India, which cannot be recovered from the
buyer.
– Loss occurring outside India due to any other reasons that are not
insured are generally covered.
200
Debt Markets
• ECGC does not cover losses arising due to the following risks:
– Commercial disputes including quality disputes raised by the buyer,
unless the exporter obtains a decree from a competent court of law in
the buyer’s country in his favor.
– Causes inherent in the nature of the goods.
– Incapability of the buyer to obtain necessary import or exchange
authorization from authorities in his country.
– Default or insolvency of any agent of the exporter or of the collecting
bank.
– Loss or damage to goods which can be covered by general insurers.
– Fluctuations in exchange rate.
– Failure of the exporter to fulfill the terms of the export contract or
negligence on his part.
The services offered by the ECGC are:
i. Standard policy.
ii. Small exporters’ policy.
iii. Specific policies.
iv. Guarantees to banks.
v. Special schemes.
Standard Policy
Standard policy, which is also known as Shipments (Comprehensive Risks) Policy,
is designed to cover risks in respect of goods exported on short-term credit (credit
not exceeding more than 180 days). The standard policy covers two types of risks
namely, commercial and political risks (mentioned in the above paragraphs).
Small Exporters’ Policy

This policy is similar to the standard policy excepting in terms of tenure of the
policy, minimum premium paid, declaration of shipments and percentage of cover,
etc. The prime focus of small exporters’ policy is to improve and encourage small
exporters (whose anticipated export turnover for the future 12 months does not
exceed Rs.50 lakh).
Specific Policies
Specific policies cover contracts for export of capital goods or turnkey projects or
construction works or rendering services abroad which are not of repetitive nature
and which involve medium- to long-term credits. Thus, such projects are insured
by ECGC on a case to case basis.
Guarantees to Banks
Exporters need adequate credit facilities during the pre- as well as post-shipment
period. Usually, the banks extend a financial support by extending the credit to
companies. However, this is not seen in case of exporters. Exporters may not be
able to obtain credit facilities from banks for several reasons. However, ECGC
created favorable atmosphere by allowing the following types of guarantees:
Packing Credit Guarantee

This is the loan extended for manufacturing, purchasing or packing of goods for
export against a firm order or letter of credit which qualifies for packing credit
guarantee. Pre-shipment credit is also extended to banks, who enter into contracts
for export of services or for construction works abroad.
201
Export Production Finance Guarantee

According to this scheme, the banks can sanction advances during pre-shipment
period to the full extent of cost of production when it exceeds the f.o.b. value of
the contract/order, the differences representing incentives receivable.
Post-Shipment Export Credit Guarantee

Banks extended post-shipment finance to exporters through purchase, negotiation
or discount of export bills or advances against such bills qualifying for guarantee.
However, it is essential that the exporter should hold suitable policy of ECGC for
covering the overseas credit risks.
Export Finance Guarantee

This type of guarantee covers post-shipment advances granted by banks to
exporters against export incentives receivable in the form of cash assistance, duty
drawback, etc.
Export Performance Guarantee

The exporters may have to execute bank guarantee at various stages of export
business. If an exporter wins a contract, he may have to furnish a bank guarantee
to ensure the due performance or against advance payment or in lieu of retention
money by an exporter or to a foreign bank in case he has to raise overseas finance
for his contract.
Further, for obtaining import licenses for raw materials of capital goods, exporters
may have to execute an undertaking to export goods of a specified value within a
stipulated time, duly supported by bank guarantees. They also require guarantees
to the customs, central excise or sales tax authorities for the purpose of clearing
goods without payment of duty or for exemption from tax for goods procured from
export. They are also required to produce guarantee in support of their export
obligations to Export Promotion Councils, Commodity Boards, STCI or
recognized export houses, etc.
Thus, viewing the above situations, ECGC has designed few schemes of
guarantees to banks to enhance the creditworthiness of the exporters so that they
would be able to secure better and large facilities from their bankers, i.e. ECGC
provides guarantees to banks (to protect them from the risk of loss inherent in
granting various types of finance facilities).
Export Finance (Overseas Lending) Guarantee

If a bank financing an overseas project provides a foreign currency loan to the
contractor, it can protect itself from the risk of non-payment by the contractors by
obtaining export finance guarantee.
Special Schemes
The following are the services rendered by ECGC to exporters under special
schemes:
Transfer Guarantee
Transfer guarantee is issued, at the option of the bank, either to cover political
risks alone, or to cover both political and commercial risks. Under this scheme,
political risks such as war, transfer delays or moratorium which may delay or
prevent the transfer of funds to the bank in India are covered. The transfer
guarantee seeks to safeguard losses against the mentioned risks.
202
Debt Markets
Overseas Investment Insurance

According to this scheme, ECGC protects Indian investments abroad which are
made for the setting up or expansion of overseas projects. The risks of war,
expropriation and restriction on remittances are covered under this scheme.
Exchange Rate Fluctuation Risk

It has been designed to protect the exporters of capital goods, civil engineering
contractors and consultants who have often received payments over a period of
years for their exports, construction works or services from exchange rate
fluctuation. The risk cover against exchange rate fluctuation is available for
payments scheduled over a period of 12 months or more, up to a maximum of
15 years on the basis of reference rate agreed upon (reference rate can be the rate
prevailing on the date of bid or a rate close to it).
SUMMARY
• A guarantee is a contract to perform or to discharge the liability of a third
person in case of his default. There are three parties involved in a guarantee:
the lender, the borrower and the guarantor.
• There are three major types of guarantees: personal, governmental and
institutional (usually by financial institutions, banks, insurance
companies, etc.).
• The government of India has also set up two specialized public guarantee
institutions: Deposit Insurance and Credit Guarantee Corporation (DICGC),
and Export Credit and Guarantee Corporation (ECGC).
• While DICGC undertakes insurance of deposits on banks, guarantee for
credit extended by banks to priority sector and guarantee for credit extended
to small scale industries, ECGC offers cover to exporters against commercial
risks and political risks.
• The main services offered by ECGC are: standard policy, small exporters’
policy, specific policy, guarantees to banks and special schemes (transfer
guarantee, overseas investment insurance and exchange rate fluctuation risk).
203
Appendix I
Statement showing the Extent of Protection
Afforded to the Depositors of Insured Banks
(Commercial Banks, Regional Rural Banks, Local Area Banks and Co-operative Banks)
(As on last working day of June 1990 to June 2003 and September 2004.)
#
! ! $ %
" "
& ' $ % (
&)%& $$ ' (* $+ (+ $ ) &%) (' &
&))*,)& )+ $ *+) & )% $ &*) &$ $ &$%+)& )* %) (
&))&,) &%) &+ +( ** )% ' & () ' )& &+% *( ) %+ (
&)) ,) )$ * $' * )$ + &%'$ % $( '' ($ + %(
&)) ,)' ')( &* $ )* )) & &%+'*' + ')* + %( %
&))',)$ ')$% *$ ')) )) )) %%('% %$ %'*$( %* (
&))$,)% '+&+ % '+%+ *( )) * )$$(' )( ) *(& %) ($ '
&))%,)( ' ( ' $& % )+ (%(& ** '$*%(' &( (' )
&))(,)+ (& * '&*+ ( )* ' (*$ & & ') () +% ($
&))+,)) '$'' '%'& ) )( ) ' )%*) &* %*))% *+ ( &
&))),** ' * && ''&( * )( ' ')+$$+ (*'*%+ % (* +
***,*& ' ' $) ''%& +' )% ) $( ' ' *) +*% $) +' (& *
**&,* '%'' $ '+&% ( )% ' %('*$* ++ )%+($& % %) %
** ,* $(+ & %**& %& )% + +++' %$ & & &% '$ %+
** ,*' $&+) '' $' ) %% )$ ' +(*)'* & &+ %( +( %% *(
**',*$ %&)$ * %')$ '* )$ ' ))& %$ *) &%&)+&' %' %& *
* Number of accounts with balance not exceeding Rs.1,500 till the end of 1967, Rs.30,000 from 1981
onwards till 1992-93 and Rs.1,00,000 from 1993-94 onwards.
Source: RBI Annual Report 2004-05.
204
Debt Markets
Appendix II
Statement Showing the Extent of Protection
Afforded to the Depositors of Insured Banks (Category Wise)
for the Years 2002-03, 2003-04, 2004-05
- . ! #
. ! . " !
" !
#
!
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- , ! 2 *' &()% &&'&)' '+ &'$**) &) (+ ($
.
**',*$ - // .
0. 1 ! + ( $*% ' +( %))+ ($ %( ('
# 0 &) &+ '(%%%& *) ('$%) * % )
. & * & ( )( %(+&' + &) %$
2 2 . * + (++)) & *+$& (' ' &+
2 3 ' ($ %( &*) &' %)
.
" " &)% &(* '(%)( ($ $* (* $ )' ++

.
- , ! 2 $) &++% & '*(+ % &$$*)' '% +* **
.
Source: RBI Annual Report 2004-05.
205
•
• ! "
• ! "
Capital Markets
INTRODUCTION
The lack of depth in our domestic capital markets was one of the major obstacles
that hindered India’s drive to increase the level and efficient usage of domestic
savings and investments to achieve economic growth. The crucial role of the
financial markets in attaining sustainable economic growth has now been
recognized. The present emphasis on developing a vibrant capital market is based
on the premise that, while long-term foreign capital flows are required to meet the
country’s investment needs, the bulk of the requirements have to be met by
mobilizing domestic resources. To enable the capital markets to mobilize and
allocate these savings efficiently, it must be appropriately broadened and
deepened. This calls for establishing an institutional framework capable of
attracting domestic savings and channeling them into productive investments. The
efficient allocation of savings flow entails development of appropriate mechanisms
for pricing, intermediation and settlement of financial transactions. A wide
spectrum of financial instruments designed to meet various risk-reward levels and
liquidity preferences are needed to meet the requirements of the issuers and
investors. An enabling legal and regulatory framework coupled with effective
enforcement is necessary for the market to function in a fair and transparent
manner.
Capital market reforms have been at the forefront of the reforms agenda of various
Governments since 1991. As greater faith was placed on the allocative efficiency
of the markets, they progressively liberalized controls that had created severe
distortions and impeded market functioning in the past.
TRENDS IN THE CAPITAL MARKETS
DISINTERMEDIATION
The major fallout of the reforms is the increasing disintermediation in the capital
markets. There has been a marked shift from staid and conventional sources of
funding to bold initiatives in the capital markets. The corporate sector directly
accesses the market rather than relying excessively on institutional and bank
borrowings. The abolition of the control on capital issues in the year 1992 has
given a big boost to this process.
INSTITUTIONALIZATION
Another major visible trend is the institutionalization of the market. The market is
being increasingly pervaded by institutional entities. The dominant players in the
market are Mutual Funds, Foreign Institutional Investors, Financial Institutions,
Venture Capital Funds, Private Equity Funds, Debt Funds, Portfolio Managers, etc.
The intermediaries like Brokers and Merchant Bankers are in the process of
becoming corporate entities. The system of proportionate allotment and book
building has strengthened this productivity. The proposed entry of pension funds
and provident funds into the market will further accelerate this process.
The institutionalization of the market has had a positive impact on the quality of
intermediation services and disclosure standards. The institutional investors have
become an important source of pressure on the companies they invest in, to
improve the quality of their corporate governance.
GLOBALIZATION
Another notable feature is the gradual integration of the Indian capital markets
with the global markets. The process started with the opening of our capital
markets to foreign portfolio investment. However, only institutional investors like
foreign Mutual Funds and Pension Funds are permitted to invest subject to certain
conditions. These conditions in general and the ceilings for investments in
207
particular have been progressively liberalized. The ceilings for investment by Non-
Resident Indians (NRIs) and Overseas Corporate Bodies (OCBs) in Indian
companies have also been increased. The Government also permitted Indian
corporates to directly tap the international markets for raising capital. This
measure enabled listing of Indian papers on international stock exchanges. The
Government has also allowed Indian Mutual Funds to invest in foreign markets as
a part of global diversification of their portfolios.
RETURNS IN PRIMARY MARKETS

MODERNIZATION
The impact of reforms is most pronounced in the area of modernization of the
market. The main drawback of the Indian capital markets was the prevalence of
obsolete systems and practices. Modernization involved replacing them with new
systems, which are in line with those existing in advanced capital markets.
Technology has played a vital role in the whole process. The changes are aimed at
establishing transparent trading system, efficient clearing and settlement system,
reducing transaction costs, introducing risk management products, eliminating
paper by setting up of depository, etc.
i. Free Pricing: The abolition of the office of the Controller of Capital Issues
resulted in the emergence of a new era in the primary markets. All controls on
the pricing, designing and tenure of the instruments were abolished. A wide
variety of instruments were designed to meet the specific requirements of the
issuers and the investors. The issuers were also given the freedom to price the
instruments. It was left to the market forces to decide the appropriateness of
the pricing.
ii. Entry Norms: Hitherto there were no restrictions for a company to tap the
capital markets. This resulted in a massive surge of small cap issues. Many of
the companies were promoted by persons with dubious credentials. Most of
these shares were not even traded in the secondary markets after listing.
Several investors lost heavily by investing in these shares. The need for
transparent entry barriers was felt. SEBI introduced eligibility norms in the
form of dividend track record for existing companies and compulsory
appraisal of projects for new companies.
iii. Disclosures: The quality of disclosures in the offer documents was extremely
poor. Vital adverse information was not disclosed in the offer document.
SEBI introduced stringent disclosure norms. The Malegam Committee was
appointed to suggest measures to increase the levels of disclosures by Indian
issuers. Most of the recommendations of the Committee have been
implemented. The attempt is to make Indian disclosure norms conform to
global standards.
iv. Book Building: Book building is the process of price discovery. One of the
drawbacks of free pricing was the pricing mechanism. The issue price had to
be decided around 60-70 days before the opening of the issue. Further, the
issuer has no clear idea about the market perception of the price determined.
Introduction of book building helps overcome this limitation and results in
market driven pricing of securities.
v. Streamlining the Procedures: All the procedural formalities were
streamlined. Many of the operational aspects were hitherto unregulated and
different practices were being followed. SEBI has issued guidelines to ensure
uniform procedures. Many aspects of the operations have been made more
transparent.
vi. Registration of Intermediaries: SEBI started the process of registration of
some of the intermediaries associated with the process of issue management.
This is done to ensure professionalization of the intermediaries and to curb
208
Capital Markets
the malpractices indulged by some of the intermediaries. Registration has

been made mandatory for the following primary market intermediaries:
• Merchant Bankers
• Registrars and Share Transfer Agents
• Brokers to the Issue
• Bankers to the Issue
• Debenture Trustees.
TRENDS IN THE PRIMARY MARKETS

The primary market experienced a major boom after the initiation of the reforms
process. During 2007-08, 124 companies accessed the primary market and raised
Rs.87,029 crore through initial public offers and rights issues as against Rs.33,508
crore in 2006-07. While the number of issues remained the same in both the years,
the amount mobilized was more than twice in 2007-08 as compared to 2006-07.
The details are presented in Table 1. The number of public issues in 1990-91 was
141 and in 1995-96, it was 1428 issues. Though the number of issues were more in
that period from now, the amount raised is very small when compared with
2007-08. The total capital mobilized in 1990-91 was Rs.1,704.35 crore and in
1995-96, it was Rs.11,822.18 crore. However, there has been a sharp fall in the
market both in terms of number of public issues and amount mobilized after 1995-96.
! " #
$ %& ! " "!
' ( $# " # " $#)# # " )"
* ( $ )! $) ! ! )
! ! ! ! # ! !
!! # # ## ## ## ##
Source: SEBI Annual Report 2007-08.
SIZE-WISE RESOURCE MOBILIZATION
About 87.8 percent of resource mobilization was through issues of above Rs.500
crore (Table 2). The number of issues above Rs.500 crore category doubled from
11 in 2006-07 to 24 in 2007-08. The average size of the issue was Rs.702 crore in
2007-08 as against Rs.270 crore in 2006-07. The mean issue-size of the public
issues increased from Rs.351 crore in 2006-07 to Rs.593 crore in 2007-08. The
larger size of the issues reflected high capital expenditure plans of companies in
view of strong economic and industrial expansion.
$ % & '
' +
! " #
, # ! " !
-. # /, "# "
-. /, # " $ ) !! ) !!
-. # /, ! $! # $ ) )
-. /, # !! $#! ! $))) ") ) )
-. # $" " $" #
" !!$# " $ )
209
SECTOR-WISE RESOURCE MOBILIZATION

Sector-wise classification reveals that private sector companies were in forefront
in resource mobilization through the primary market. These companies raised
Rs.67,311 crore through 120 issues in 2007-08 compared to Rs.31,728 crore
through 122 issues in 2006-07. However, the share of private sector in total
resource mobilization declined from 94.7 percent in 2006-07 to 77.3 percent
during 2007-08. There were four issues from public sector companies which raised
Rs.19,718 crore in 2007-08 which increased the share of public sector companies
in resource mobilization from 5.3 percent in 2006-07 to 22.7 percent in 2007-08.
Of the four public sector issues, two were from public sector banks and other two
were those of Rural Electrification Corporation Ltd., and Bharat Earth Movers
(BEML) Ltd.
! $ (% ) *( + ' , +
! " #
0 ! $ $! )" ) !"
1 $ ) " )$ #!
" !!$# " $ )
TRENDS IN SECONDARY MARKETS

TRADING SYSTEM
Trading on all the stock exchanges was being carried out by “public outcry” in the
trading ring. This was an inefficient system and also resulted in lack of
transparency in trade. The Over The Counter Exchange of India (OTCEI) was the
first exchange to introduce screen based trading in India. Listing on OTCEI was
restricted to small and midcap companies. Screen based trading got a big boost
with the setting up of the National Stock Exchange. NSE provided nationwide
access to investors by setting up trading terminals all over the country. These
terminals were networked through satellite links. The fully automated trading
system enabled market participants to login orders, execute deals and receive
on-line market information. The competition from NSE forced the regional stock
exchanges including the BSE to switch over to screen based trading. The NSE
trading system is order driven while the OTCEI system is quote driven. In an order
driven environment, the system captures all the orders and matches them with each
other to execute the transaction. A quote driven system is based on market making
concept (dealer giving two way quotes) and the order logged in is matched against
the best quote given by the market maker. BSE On-line Trading (BOLT) is a
mixture of both quote driven and order driven system as the system permits both
jobbing and direct matching of orders.
DEPOSITORY
One of the major drawbacks was/is that the securities were/are held in the form of
certificates. This led to problems in physical storage and transfer of securities.
There was also the risk of bad delivery for the buyer. The transaction costs were
also higher due to physical movement of paper and the incidence of stamp duty.
National Securities Depository Ltd. (NSDL) was set up in 1996 as India’s first
depository. A depository is an entity which holds the securities in electronic form
on behalf of the investor. This is done through dematerialization of holdings at the
210
Capital Markets
request of the investor. Dematerialization is a process by which physical

certificates of the investor are destroyed and an equivalent number of securities are
credited to the account of the investor. This also enables transfer of securities by
book entries. The risk of bad deliveries is also eliminated. The transaction
costs are also reduced due to less flow of paper and transfer of securities
through depository does not attract stamp duty. Further, the depository also
handles all the corporate actions like exercising for rights, collection of
dividends, credit for bonus, exercising of warrants, conversion option, etc., on
behalf of the investor.
CLEARING MECHANISM
The clearing houses attached to stock exchanges functioned only as conduits to
delivery of securities and money. The default risk by the counter party in the
transaction continued to remain. The NSE was the first stock exchange to set up a
clearing corporation. The National Securities Clearing Corporation (NSCC)
assumes the counterparty risk in all trading deals made on the exchange. NSCC
acts as the counterparty for all the trades and the default risk in the deal is borne by
it. NSE has created a special Trade Guarantee Fund for this purpose and loss due
to defaults will be met by drawing from its corpus.
SETTLEMENT SYSTEM
Trading in equities is internationally done on rolling settlement basis. The
settlement is done on T + 2 system (i.e., the trade will be settled on the 2nd day
from the date of execution of the transaction). SEBI has encouraged the stock
exchanges to shorten their settlement cycle further to T + 1. Typically, trades
taking place on Monday are settled on Wednesday, while trades on Tuesday settled
on Thursday and so on. In case of trading in dematerialized securities, rolling
settlement has been introduced. Further, with the availability of the facility of
electronic funds transfer, Delivery Versus Payment (DVP) system is being
introduced. These facilities brought down settlement costs markedly and ushered
in greater transparency in market transactions.
A tabular representation of the settlement cycle for rolling settlement is given
below:
0 2 3 2
/ /
/ % 4 & 5 / 2
3 0 26 4 & 5 / 2
/* / 7 2 4 & 5 / 2
/* / 7 2 4 & 5 / 2
8 3 1 4 & 5 / 2
4!& 5 / 2
9 /3 0 2 7 4"& 5 / 2
4#& 5 / 2
% /1 // 0 27 2 /7 2 4 & 5 / 2
1 // 0 2 7 /7 5 7 4 & 5 / 2
% 1 // 0 2 /% / 7 2
4)& 5 / 2
/7 2
Source: www.nseindia.com
211
Carry Forward System1

The Indian Stock Exchanges have been an amalgam of cash market and forward
market. The prices of the scrips on the exchange did not reflect their ‘true’ price in
the underlying cash market. Further, there was indiscriminate and rampant
speculation in the market. Defaults were common and other members were forced
to “accommodate” the defaulting member. Often, the defaults had a snowballing
effect and the entire market would be in the throes of a major payment crisis. This
frequently resulted in the closure of the exchanges for a few days. In order to curb
the prevailing malpractices, SEBI banned carry forward transactions on all stock
exchanges.
Margin System
The role of the margin system for smooth running of any stock exchange cannot be
overemphasized. The margin system was dysfunctional in most of the stock
exchanges. The lack of stringent margin requirements and the laxity in collection
of the margins resulted in utter chaos, whenever there was a default. The margin
system has now been streamlined. SEBI has introduced the concept of mark-to-
market margin. In addition to this, other margins like initial margin, carry
forward margin, concentration margin, etc., have been introduced.
Capital Adequacy
Most of the brokers in stock exchanges operated on a small capital base. They
were, therefore, unable to bear the risks associated with the business. The result
was the high incidence of defaults in the Stock Exchange. SEBI has now
introduced minimum capital norms for all brokers. Further, the capacity of a
broker to assume a position in the market would be a function of his capital.
Liquidity for Debt
An important feature of good capital market is the existence of a vibrant secondary
debt market. Indian markets were characterized by lack of liquidity for corporate
debt. This called for widening and deepening of the debt market. NSE set up a
separate trading system called Wholesale Debt Segment for trading in all debt
instruments. This has provided nationwide trading access to debt investors. Market
Making would further enhance the liquidity in the debt market.
) - , '. * / -0' $1 1 , + , 1+
% / / 7 7 / 0 5 :; :
/ 0 < / 2$ / & 0 7 1 % / ;
$ $ 7 1 % 7 % 5
' / % / 7 1 $ 9 1 2 5 :; $ /* / %' /
5 :; *' : $ & 7 5 :; 2$ 0 7 7 /
% % 5 /' / ; % / / 7 7
/ 7 7 $ % 7 & 7 / 7 7 7 / /
/ / 9 : /0 7 7 : & /1 / / 5
/ 1 5 9(= 2 %9 :
9 : / : 1 & /1 1 7 7 / 5 $ 7 %&
& /1 / 12 9 : 9 : / *' : & /1 > 2 1 / /7 7 :9'
/ 9 9 : / *' : / > 0 $ & & /
< / 2 % / / 7 7 & / 7 0 $ 7
/ & 5 % 1 1 % : $& 0 % % %
2$ 1 / 0 7 % 7 5 5 1
% 1 & 9 : / : $% & % 7 5 2
Source: Icfai Research Team.
1 The System of carry forward of positions was banned from July 2, 2001. This is given for academic
information only.
212
Capital Markets
Indices
An index is an important tool to measure the price behavior of the overall market.
The return on the index provides a benchmark for portfolio risk-return analysis.
Several new indices have been constructed based on various parameters. The
30 share BSE Sensex and the 50 share S&P CNX Nifty are the popular sensitive
indices to measure the daily market volatility. Some of the new indices like BSE
Dollex and NSE Defty are denominated in dollars. The S&P CNX 500 is a more
broad based index covering a larger portion of the total market capitalization. The
CNX Midcap 200 was designed to capture the price movements in scrips with
relatively smaller market capitalization. The Skindia GDR Index tracks the price
movements of Indian GDRs on the global exchanges. ICICI Securities has
constructed an index called i-Bex for the debt markets. Some industry specific
indices have also been constructed to reflect the price volatility of the shares of the
companies in a particular industry. The construction and maintenance of
well-designed and responsive indices has become critical with the proposed move
to introduce index futures.
Volatility Index
Volatility Index is a measure of market’s expectation of volatility over the near
term. Volatility is often described as the “rate and magnitude of changes in prices”
and in finance often referred to as risk. Volatility Index is a measure of the amount
by which an underlying Index is expected to fluctuate, in the near term, (calculated
as annualized volatility, denoted in percentage e.g. 20%) based on the order book
of the underlying index options. Volatility Index is a good indicator of the
investors’ perception on how volatile the markets are expected to be in the near
term. Usually, during periods of market volatility the market moves steeply up or
down and the volatility index tends to rise. As volatility subsides, option prices
tend to decline, which in turn causes the volatility index to decline. NSE launched
volatility index with name ‘India VIX’ on 08th April, 2008, based on the Nifty 50
Options prices. From the best bid-ask prices of Nifty 50 Options contracts (which
are traded on the F&O segment of NSE), a volatility figure (%) is calculated which
indicates the expected market volatility over the next 30 calendar days. The higher
the implied volatility, the higher the India VIX value and vice versa.
Regulation
SEBI has taken a number of steps to maintain the integrity of the markets and to
ensure investor protection. Insider trading has been declared as a criminal offence
and prosecutions have been initiated in cases of violations of the insider trading
regulations. SEBI has also started investigating into instances of price rigging and
penal action is taken against the guilty. SEBI has also attempted to bring
transparency into broker-client relationships. The system of circuit breakers has
been introduced to prevent excessive volatility in price movements.
Derivatives
Derivatives are important tools for portfolio management. The introduction of
derivatives resulted in a paradigm shift in the investment strategies of Indian
investors. The L C Gupta committee had recommended the introduction of options
and futures in India. SEBI initially wanted to allow the introduction of index based
futures. In the light of the experience gained, options were to be introduced at a
later stage. Trading in options and futures started from July 2, 2001. Futures
contracts are now available on 250 securities (like Reliance Industries, DLF,
RNRL, etc.,) stipulated by the Securities and Exchange Board of India (SEBI).
213
) - . %& 2 2
' / 7 2 5 / % 1 / 5 & /% ;
/ // 0 0 7 / ' / %
/ 7 / 0 0 5 /
& / % 0 % 7// 0 0 7 / $ :9' / / / 7
& &7 / $ 7 & % ? /0 2
' / ; 7 / & / 7 0/ 0 % ;1 2 % ;
/
@ / 0 0 & / 1 0 & ;7 5 $
/ 7 ' 2$ / ;% / 7 $ 2$ ; / A B
% 2$ & + % 5 1 / / @
:; 7 0/ &/ %: % / 5 / < $ A # $
A @/ 7 " / * ; 7 $: A # % %% %
+ % / / A # %
2$ ; / / < 2 7 0 ; % % ' &
% / ? 7 & / 1 0 5 0 &
7 /7 & / 1 % 7
0 0 = 7 0 1 / /& ;7
/ 7 2 $ / 2$ ; / %2 = < 2 7
& / / ))! =: < 2 7 12 9 / %
(7 :; 9(: A $ A # / & ;7 7
2 @ :; / < 2 7 & ;7
7 2
8 2' / ; % 5 ;7 % 0 2 0 2 / 12 7
% 5 / ; 7 1 5 % 7 5 0 2 / ; / / 1
5 / % / % 0 $ & 0 72 7 / & 0
72 7
8 2 ' / ; 7 0/ % 7 % ;7 / 5 5 0 2 0 7 % /
7 / 8 2 ' / ; / / 2/ /
/ / 2 ' 0 7 / 0 2 % 0 12
/ ;$ / %2 7 / 7 ' ))!$ 9 / (7 :; 9(:
/ / 9(: 8 2 ' / ; 8'B & 1 1 5 % 5 5
0 2 9(: % 2 %/ 0 0 7 / 1 / / ; & 9(: 8'B
7 / 0 2 / ; 5 C ;7 % ! / 2 A # / ;
0 2 7 7 % A # / ; 7
0 2 / ;& / 7 0 5 0 & 0 2
5 ' 2% 7 2 0 1 /< / % 5
0 2 % % / ;& / 7 5 7 7 / 5 %
0 2
Source: SEBI 2007-08 annual report –part one.
SUMMARY
• Of late, trends like disintermediation, institutionalization, globalization and
modernization are being observed in the capital markets in India.
• Primary markets in India have witnessed major changes such as free pricing
of instruments, introduction of entry norms, improvement in the quality of
disclosures, introduction of the book building process to price new share
issues, streamlining of all the procedures, and registration of intermediaries
like merchant bankers, registrars and share transfer agents, brokers to issue,
bankers to issue and debenture trustees.
• Secondary markets in India have witnessed the following major changes:
computerized trading system, depository participants and dematerialization of
issues, establishment of clearing corporations, change in the settlement
system, banning of carry forward system, introduction of the margin system,
minimum capital norms for brokers, implementation of a vibrant secondary
market for debt issues, review of the share indices, strict regulations to
maintain integrity of the markets, introduction of derivatives and introduction
of the daily rolling settlement process.
214
Capital Markets
Appendix I*
A New Dawn in Benchmarking
Indian capital markets have seen a sea change in the past decade. First, it was the
decision to allow companies to freely price their issues. Then dematerialization of
shares led to a lot of ease to investors. The turn of the century saw the introduction
of derivative products in India. First, the introduction of futures, and then options
gave a new dimension to the Indian capital markets. With the introduction of retail
participation in the Government securities markets, fixed-income markets have
also seen the changes erstwhile experienced by equity markets. These are
developments that will have far reaching effects. The international move to adopt a
free-float approach for index construction is one such move. The old way of
constructing indices was to build a sampled portfolio according to the market
capitalization of companies listed on the exchange. The presumption was that
these indices would adequately reflect the investable universe. However, if the
purpose of a benchmark is to measure the real life opportunity set to the investor, it
needs to include everything that can be invested in, and nothing that cannot. There
is a clear international and local demand for indices that more accurately represent
the investable equity universe.
Come September 1, 2003, and the country’s benchmark Index Sensex would also
shift to the free-float methodology. The move is a culmination of more than two
years of debates and discussions among the major Indian market participants.
Globally, the free-float methodology of index construction is considered to be the
best industry practice. All major index providers like MSCI, FTSE, S&P and Dow
Jones STOXX have adopted it. The MSCI India Standard Index is also based on
the freefloat methodology.
The Genesis
The process of testing the waters for freefloat methodology was started in July
2001 with the launch of the BSE TECk Index, India’s first free-float Index. This
was followed by the launch of Bankex in June 2003. BSE TECk Index brought to
the Indian markets a quality benchmark for the TMT sectors. It has been well
received by the markets as it rationally reflects the trends in the new economy
sector stocks.
A significant outcome of using the free-float methodology for BSE TECk Index
has been the impact on weightage of closely held companies in the Index. For
example, the weightage of Wipro Ltd., in BSE TECk index is lower than that of
Satyam Computers though the market capitalization of Wipro Ltd., is more than
three times the market capitalization of Satyam Computers. This is due to the fact
that the free-float for Wipro Ltd., is only 16% whereas it is around 80% for
Satyam Computers. In other words, the absolute free-float market capitalization of
Satyam Computers is higher than that of Wipro Ltd. This ensures that a single
stock in index, like Wipro in the case of BSE TECk, does not exert influence on
the index disproportionate to its investment opportunity set.
Free-float being a new concept in the Indian capital markets, market participants
needed to familiarize themselves with this new concept before it was applied to
benchmark Sensex. Thus the BSE TECK and Bankex worked as training grounds
for the market participants to appreciate and absorb the merits of the new
methodology.
It may be recalled that in order to generate a nation-wide debate on the issue of
free-float, BSE had organized a “Roundtable on free-float Index” in March 2002,
which was chaired by Mark Makepeace, President and CEO of FTSE Group. The
Round table was followed by a series of discussions with a cross-section of market
participants. The feedback was overwhelming for shifting benchmark indices to
the free-float methodology.
215
Why Free-Float?
The Sensex has been the barometer of the Indian stock market. The rationale
behind changing it to the free-float methodology is to further enhance the
benchmarking properties of Sensex. Firstly, a free-float index reflects the market
trends in a more rational manner by taking into consideration only those shares
that are available for trading in the market.
Secondly, it aids both active and passive investing styles. It aids active managers
by enabling them to benchmark their fund returns vis-à-vis an investable index.
This enables an apple-to-apple comparison thereby facilitating better evaluation of
performance of active managers. Being a perfectly replicable portfolio of stocks, a
free-float index is best suited for the passive managers as it enables them to track
the index with the minimum tracking error.
Thirdly, a free-float index prevents any closely held company from unreasonably
influencing the movement of an index by restricting its impact on the free-float
shares.
Lastly, it gives the index provider the flexibility to include any stock from the
universe no matter how large it is in terms of market capitalization (even though
the free-float may be small). Such flexibility facilitates creating a quality portfolio
with improved sector and market coverage of the index.
Comparability with History
There has been apprehensions from several quarters that the character of the
Sensex will change post shift to the freefloat methodology and that it will lose
comparability with its own history.
In reality, a smooth transition has been planned based on globally accepted
transition practices, without compromising on the comparability of Sensex over its
history. The smooth transition will ensure that on September 1, 2003, when Sensex
shifts to free-float methodology, the index will open at the same value as on the
previous day’s close. This will be achieved by adjusting the base value of Sensex
in proportion to the change in market capitalization as a result of free-float. A
correlation study undertaken by BSE between the hypothetical free-float Sensex
and the full market capitalization weighted Sensex shows a very high correlation
of 99.6% between the two indices over the past one year (August 2002 to July
2003). It essentially means that the movement of Sensex in terms of points would
remain more or less the same, with more desirable qualities. Even a comparison of
volatility of the two indices over the one year period shows that the daily volatility
of free-float Sensex was 0.948% as compared to 0.945% for full market
capitalization weighted Sensex.
Impact on Sensex Constituents
The new methodology will alter the weights of stocks in the Sensex depending on
their available float. However, these weight changes would be minor. Since the
new economy companies like Infosys, Satyam and certain financial stocks like
HDFC and ICICI Bank have higher floats, their weightings would improve while
the weightings of companies like HLL, RIL, and SBI would fall due to their
relatively low float.
The changes in weights would be minor because the average free-float of Indian
companies is in the range of 50-60%, barring a few exceptions. As a result, in a
free float scenario, the market capitalization of all these companies gets reduced
proportionately, thereby having a minor impact on their ultimate relative
weightings in Sensex.
* Source: Portfolio Organizer, September 2003.
216
Capital Markets
Appendix II*
Central Listing Authority: A New Facilitator
The regulators all over the world are facing the challenge of low performing
regional exchanges and India is not an exception. The general perception is that a
healthy environment in the capital market can be created by a limited number of
exchanges. For facilitating effective and speedy transactions in the exchanges,
each exchange needs to be well-equipped with modern technologies. Can all the
stock exchanges afford upgrading the existing technological environment to keep
themselves in the race? Technological know-how available in many regional
exchanges is another concern let alone the cost of setting up of the required
technological infrastructure.
The need for a lesser number of exchanges is argued on one more point. With the
advanced technologies, capital market activity can reach easily to every nook and
corner of the country without much of a problem. If an exchange has to function
efficiently, it needs to attain a minimum turnover. This is required to ensure
adequate liquidity and price discovery to the investors. As revenues from trading
on the majority of the exchanges in India is moving southwards, these exchanges
are not placed comfortably to invest in the required infrastructures.
Evolution
In the scenario, as many of the Indian stock exchanges have failed to discharge
their minimum responsibilities associated with listing of securities efficiently, a
Central Listing Authority (CLA) was proposed to be set-up by Sebi in April 2002
and it came into existence from April 2003. The purpose of establishing a Central
Listing Authority is to formulate common guidelines for listing of securities in the
stock exchanges of the country. It will not be a regulatory body and may work
under the supervision of the Sebi. It is proposed that the CLA will bring uniformity
in the due diligence process and in scrutinizing listing applications across the stock
exchanges. With the establishment of the CLA, it is not required for a company to
list in as many stock exchanges in which it is to be traded. The cumbersome
process of undergoing the procedure of listing in each of the stock exchanges is
solved. This is expected to save time and reduce costs. In addition, delisting
exercise is also made simpler by the CLA.
Constitution of CLA
The CLA will be headed by the former Chief Justice of India,
M N Venkatachallaih. He will be assisted by nine committee members who could
be selected from different disciplines with expertise in the areas of finance,
accounting, law, investment etc. Nine committee members are: S A Dave (Trustee,
Center for Consumer Education and Research Center), G Muniappan (Deputy
Governor, RBI), Dr. Amit Mitra (Secretary General, FICCI), Raju P Chitale
(Chartered Accountant) and Prof. RS Nigam (Academician and Economist),
Prithvi Haldea (Managing Director, Prime Database), Ravi Narain (Managing
Director and CEO, NSE) Dr. Manoj Vaish (Executive Director and CEO, BSE)
and Manjit Singh (Executive Director, Ludhiana Stock Exchange). Term of Office
for the President and Members of CLA will be three years. The main function of
CLA will be to process applications made by any corporate body, mutual fund or
collective investment scheme for a letter of listing on a stock exchange. It will
make recommendations for listing. Obtaining a letter of recommendation from
CLA by these organizations has been made mandatory.
Need for CLA
Sebi was the sole regulatory authority for the companies to meet their listing
requirements with the stock exchanges. The corporates were monitored by Sebi
through the listing agreement. Thus compliance of listing agreement was of great
significance for the companies vying to operate in the capital market. Initial listing
demand a high level of due diligence in order to contain potential frauds.
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As per the earlier regulations, it was mandatory for a company to list its securities
on its regional stock exchange and listing can be done in any number of
exchanges, but for each listing, the company had to pay the requisite fees. This
made listing difficult for small companies and they were able to list only in small
exchanges. Listing in small exchanges was also a bottleneck for the stocks of these
companies to be actively traded. Some companies adopted a different strategy by
opting for listing in the small exchanges in the initial stage and when most of the
shares come under the control of the promoters, they resorted to price rigging. This
facilitate, these companies’ entry into the country’s two national stock exchanges
(BSE and NSE). Subsequently, the promoters used to offload their shares to the
gullible investors.
Demerits of the Regional Listing Requirement
In the last decade, it was observed that very little or effectively no time was spent
on either screening the initial listing application or on ensuring listing compliance
by the exchanges on which the listing was proposed. Exchange officials never used
to go to the field for a physical inspection of the companies listed. As a result, the
companies were seen to shift their offices, misused issued funds, did not file
annual reports, etc. Unsurprisingly, exchanges were ignorant about these facts
about the companies. Even when the letters addressed to these companies returned
undelivered, no action was taken by the exchanges to suspend their stocks’ listing
in the exchanges. Exchanges remained dormant even when the companies
defaulted the payment of their annual listing fees. In short, a majority of the small
regional exchanges failed to enforce the listing agreements.
Faced with resource crunch aggravated by very low turnover every year in the last
three years, these small exchanges are seen to be accepting “weak” issues to go
public to effectively earn some revenue in terms of listing fees. This situation is
not healthy. Many of the regional exchanges have non-business income (income
from listing, interest and rent) as the only source of income and is fixed too. For
instance, the listing income accounted for as much as 84% of total income of
Guwahati Stock Exchange and 73% of total income of Madhya Pradesh Stock
Exchange last year. Surprisingly, some exchanges like Bhubaneshwar, Cochin,
Guwahati, Madhya Pradesh, Madras, Mangalore, SRSE even managed to earn a
profit with the non-business income and zero or almost negligible turnover.
Small exchanges have also failed to desseminate the information provided by the
companies to the investors and to redress the investors’ grievances. Lack of
uniformity among the regional exchanges is also another issue of concern. This is
more pronounced particularly when companies opt to be listed in more than one
exchange. A company rejected for listing by one exchange is accepted by another.
This may sound ironical as all the exchanges are regulated by Sebi. Naturally, this
will create concern for investors as they would feel more insecured about their
investments in such companies. Ideally, a security should be suitable for listing in
all the exchanges or not suitable for listing in any exchange at all.
Operational duplication is another issue of concern. A company approaches, say
five stock exchanges at a time and applies for its listing in them. Each exchange
goes through the offer document independently and scrutinizes the application for
the compliance of listing requirements. If these operations can be centralized, then
the procedure of security by the exchanges can be simplified. This much would
benefit both the exchanges and the companies. Centralization will also reduce the
duplication of efforts in monitoring and surveillance. Thus need for quality,
uniformity and coordination among exchanges was found to be more critical to
ensure that information is not used by unscrupulous operators to obtain benefits at
the expense of hapless small investors.
A growing trend of delisting of shares from the Indian stock exchanges is also
observed in the recent past. This is another reason for establishing a centralized
listing authority thereby making delisting process simpler. Delisting of shares is
more common among the Multi-National Companies (MNCs) for a number of
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reasons. A general opinion is that permanent delisting of shares would curtail the
activity in the stock market which would in turn affect the depth and liquidity of
the market, resulting in loss of investment opportunities for the public. The main
argument against delisting per se is that the exit price offered to the shareholders is
not consistent with the company’s fundamentals.
Committee on Delisting Starter for CLA Set-up
In view of the aforesaid concerns and issues, a committee on delisting was set up
under the Chairmanship of Pratip Kar, Executive Director, Sebi which came out
with the following terms of references:
i. Review of the current regulations governing the delisting of securities of
companies listed on the recognized stock exchanges and suggestion of new
norms and procedures regarding the same.
ii. Review and standardization of the listing agreement.
iii. Establishment of a listing authority across the stock exchanges in place of
independent listing in each stock exchange.
iv. Suggestion of ways for effective implementation of listing conditions and
penal provisions for non-compliance.
v. Recommendation of changes in laws, rules, regulations, etc., in order to give
effect to the recommendations of the above issues.
Recommendations of the Committee
The recommendations of the committee are:
a. No prohibition against delisting securities provided that the securities of the
company have been listed for a minimum period of three years on any stock
exchange.
b. No selective restriction or discrimination against any class of companies for
delisting. But regulatory framework should be made stringent so as to ensure
investor protection.
c. Any acquisition of shares or scheme resulting in delisting of securities would
be in compliance with the provisions in the Sebi regulation and the provisions
of the listing agreement to ensure investor protection.
d. Assurance that no company could use the buy-back provision to delist the
company.
e. Comprehensive provisions that include procedures governing the entire
subject of delisting of securities of companies from one or more stock
exchanges in which they are listed.
f. The exit price for delisting should be decided based on the price arrived by
the process of book building to ensure investor protection.
g. Provision for delisting of a company listed on any stock exchange without an
exit offer being made to its shareholders if the securities of the company are
listed on BSE or NSE.
h. An exit offer is mandatory in all other cases if a company listed on any stock
exchange or stock exchanges other than BSE or NSE seeks delisting.
i. Allowance for fixed income securities of the company to continue to be listed
on the stock exchange even if the shares of the company are delisted.
j. Empowerment of stock exchanges to delist those companies which have been
suspended for a minimum period of six months for non-compliance with the
listing agreement.
k. The department of Company Affairs will be requested to amend the
Companies Act for allowing the stock exchanges to make an application for
winding up of the company.
l. Establishment of a separate agency designated as the Central listing
Authority (CLA) to bring about the uniformity in the exercise of due
diligence in scrutinizing listing application.
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Expectations from CLA

CLA should be charged with approvals related to listing of all types of offerings
including IPOs, rights issues, public debt issues, public equity issues by listed
companies, preferential issues, debt private placements opting for listing, private
placements of equity or hybrid by listed companies and bonus issues and also
shares out of mergers and acquisitions, equity swaps, etc. CLA should also give
approvals to already listed companies seeking listing on other exchanges. CLA
should also be charged with the approvals of all suspensions and delistings. In
addition, CLA should bring international standards and best practices to the fore.
The monitoring and surveillance of companies listed at the regional stock
exchanges where trading is almost nil should be transferred to CLA without any
procedural delay. This would give CLA, a complete control over the process of
listing and therefore monitoring becomes easier. This will also ensure transparency
in the system. Another critical area that CLA should be entrusted with is the
redressal of investors' grievances. CLA’s only source of funds is the listing fees as
on today and hence the entire listing fees, both initial and annual should accrue
only to CLA. In addition, 1% deposit which the companies require to keep with
the regional stock exchanges can now be kept with CLA. This will serve as an
additional source of funds.
With the emergence of a Central Listing Authority, the concept of multiple listing
should be completely abolished. The alleged fear among the investor community
and the traders in the capital market is that, this will lead to complete
disappearance of small regional exchanges. But this fear is unwarranted as with the
advancement in the technologies, trading from any where, any part in any
exchange should be possible without any hassles. Emergence of CLA would
encourage the competition between the national level exchanges in line with the
US model where a company lists either at the NYSE or the Nasdaq.
Benefits to Stock Exchanges
In whatever way one may look at, establishment of CLA seems to be a major
milestone in the Indian capital market. Because of this authority, stock exchanges
stand to gain as they would now be able to concentrate on their major function of
providing a trading and settlement platform and save time and money in screening
of listing applications as well as compliance of listing agreements.
Benefits to Corporate World
Corporates stand to gain as their listing costs come down drastically because of the
elimination of independent listing fees in each of the exchanges. The cumbersome
procedure of following up the process with each exchange is also dispensed with.
Benefits to Investors
Investors stand to gain because it creates a more conducive investment climate due
to better quality of listings and transparency. They would also be able to get
corporate information from a single window and they can address their grievances
to a single place.
Conclusion: Last but not the least, Indian economy too stands to gain as the
situation in the capital market would improve with more participants in the market.
The stock exchanges become more active and because of the assured quality of
listing, huge inflows are expected in the capital market both from domestic and
foreign institution investor. CLA is certainly a good news to the capital market and
is no doubt ready to make a significant impression in the saga of Indian capital
market.
* Source: Portfolio Organizer, July 2003.
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INTRODUCTION
The major thrust of the securities market reforms is upon the improvement of the
operational and allocative efficiency of the markets by correcting the exogenous
and structural factors impeding the functioning of the system. Efficient
intermediation is of paramount importance in making the capital markets more
vibrant and dynamic. To sustain the growth of the markets and crystallize the
increased awareness and interests of a discerning and growing pool of investors, it
was essential to overcome the inadequacies and curb the malpractices in the
market. It can be observed from the global experience that capital markets cannot
develop in a healthy manner without effective regulations for disclosures, listing,
trading, liquidity, intermediation, settlements, accounting, etc. The regulatory
policy must focus on visible and effective maintenance of market discipline and
professionalization of intermediation and support services.
The Government felt the need to set-up a regulatory body to ensure investor
protection and promotion and growth of vibrant securities market. The Securities
and Exchange Board of India (SEBI) was constituted on 12th April, 1988 and
established as a statutory body on 21st February, 1992. Regulation of Indian
securities market required SEBI to simultaneously perform both disciplinary and
developmental roles. The two roles ought to be complementary and carefully
synthesized. The disciplinary dimension involves providing for disincentives and
penalties for errant and unfair behavior which harm the market. The development
dimension is a positive aspect that involves providing incentives to market
participants to engage in a constructive role.
HISTORICAL PERSPECTIVE
Securities market in India has a long history spanning over a century. The Bombay
Stock Exchange is the oldest stock exchange with its origins in the informal
trading of stocks in the 1850s and 60s. Its formal operations commenced in 1875.
The securities market was largely unregulated, prior to independence. In 1947, the
Capital Issues (Control) Act was passed which formalized and continued its
control over the issue of securities imposed during the second world war. This Act
was administered by the Office of the Controller of Capital Issues (CCI), which
was a part of the Ministry of Finance in the Central Government. In 1956, The
Securities Contract (Regulation) Act, 1956 (SCRA) was enacted which brought
stock exchanges, their members and contract in securities which could be traded,
under the regulation of the Central Government through the Ministry of Finance.
In India, the incorporation, regulation and liquidation of companies is under the
purview of The Companies Act, 1956. This Act is administered by the Department
of Company Affairs(DCA) in the Ministry of Law, Justice and Company Affairs
of the Central Government. The Companies Act, 1956 specifies the form and
contents of the prospectus which is required to accompany an issue of securities.
Legislations were also enacted which provide statutory role for Chartered
Accountants, Cost Accountants and Company Secretaries. Matters relating to form
and contents of financial statements and other matters relating to the disclosures of
information to the members are governed by DCA, in some instances through the
professional bodies.
For the first four decades of independence, securities markets in India remained in
the backwaters of the Indian financial system. The capital markets did not develop
in consonance with the rest of the economy due to the limitations imposed on the
role of private sector and the control on issue of securities. Dilution of the holdings
of multinational companies at low prices in the late seventies kindled the interests
of the lay investors. However, the interest soon dampened and could not be
sustained for long. It was not until the middle of the next decade that the interest
livened again and became widespread to have a palpable impact on the growth of
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Capital Markets
the securities market. The changes introduced in the economic policies by the
Rajiv Gandhi Government also provided an active stimulus to the market. Paucity
of resources of the financial institutions, hitherto the sole purveyors of long-term
capital, also forced companies to tap capital markets.
PHILOSOPHY OF REGULATIONS
Markets depend upon credibility and fairness. A sound regulatory framework is
expected to provide transparency, maintain market integrity, fairness and ensure
investor protection. There is a school of thought which believes that if markets are
inherently efficient and over-regulation leads to inefficiency in the market. This
school of thought argues for minimal or no regulations. However, it is seen that
lack of adequate regulations can lead to manipulations and market abuses, which
endanger the integrity of the market and damages the confidence of the investors.
Besides, fairness in the market is essential for price discovery, which in turn leads
to better investor participation. Regulation also helps in reducing the systemic risk
in the market.
The perception of sound regulation is as important as the reality of regulation. The
very existence of a regulatory body improves the confidence of the market
participants and investors.
SECURITIES AND EXCHANGE BOARD OF INDIA

OBJECTIVES OF SEBI
According to the preamble of SEBI Act 1992, the objectives of SEBI are threefold:
• To protect the interest of the investors in securities.
• To promote the development of securities market in India.
• To regulate the securities market.
ORGANIZATION OF SEBI
The affairs of SEBI shall be managed by a Board. The Board shall consist of the
following members:
i. A Chairman.
ii. Two officials of the Central Government from the Ministry of Finance and
Ministry of Law, Justice and Company Affairs.
iii. One official nominated by the Reserve Bank of India.
iv. Two other members nominated by the Central Government.
The Chairman and the members should be persons of ability, integrity and
standing who have shown capacity in dealing with problems of the securities
market. They are required to have good knowledge or experience in the areas of
finance, law, economics, accountancy, administration, etc.
FUNCTIONS OF SEBI
According to SEBI Act, 1992, the main functions of SEBI are:
• Regulating the securities market.
• Recognition and regulation of the Stock Exchanges.
• Registering and regulating the working of various intermediaries including
Merchant Bankers, Registrars, Share Transfer Agents, Stock-brokers, Sub-
brokers, Debenture Trustees, Bankers to the Issue, Underwriters, Portfolio
Managers, etc.
• Registering and regulating the functioning of Depositories, Custodians and
Depository Participants.
• Registration of Foreign Institutional Investors.
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• Registering and regulating the working of Venture Capital Funds, Mutual

Funds and other collective investment schemes including plantation schemes.
• Promotion and regulation of Self-Regulatory Organizations.
• Prohibiting fraudulent and unfair trade practices relating to securities market.
• Prohibiting insider trading in securities.
• Regulating substantial acquisition of shares and takeover of companies.
• Promoting investor education and training of intermediaries.
• Conducting research relating to securities market.
POWERS OF SEBI
For the purpose of regulation of the securities market, SEBI has been vested with
all the powers of a Civil Court as per Code of Civil Procedure, 1908. The powers
include:
• The discovery and production of any books of account and other documents.
• Summoning and enforcing the attendance of persons and examining them on
oath.
• Inspection of any books, registers and other documents.
In addition to the above, the other powers of SEBI are:
• Call information, undertake inspection, conduct inquiries and order audit of
stock exchanges, intermediaries, mutual funds or any other person associated
with the securities market.
• Perform the functions and exercise the powers of Central Government under
The Securities Contract (Regulation) Act, 1956. These powers have now
been delegated to SEBI.
• Levy penalties for certain offenses.
• Levy fees and other charges.
• Issue orders/directions in the interest of investors or orderly development of
securities market. However, such orders can be issued only after conduct of
an inquiry.
• Hear appeals by companies against the decision of stock exchanges for
refusal of listing of their securities.
• Suspend or cancel the registration of any intermediary.
REGULATORY FRAMEWORK
SEBI also has two advisory committees for primary and secondary market, to
provide advisory inputs in framing policies and regulations. These committees are
constituted from among the market players, recognized investor associations and
eminent persons associated with capital markets. These committees are
non-statutory and their advise is only recommendatory in nature.
Under internal administrative arrangements, SEBI has divided its activities into
various operational departments:
PRIMARY MARKET DEPARTMENT
This Department looks after all policy matters and regulatory issues concerning
primary market and the intermediaries. This Department also looks after matters
relating to the formation and working of Self-Regulatory Organizations (SRO).
This Department is also responsible for redressal of investor grievances.
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Capital Markets
ISSUE MANAGEMENT AND INTERMEDIARIES DEPARTMENT

This Department looks after filing and registration of offer documents. This
department was earlier responsible for vetting offer documents. This Department is
also responsible for registration and monitoring of issue related intermediaries.
SECONDARY MARKET DEPARTMENT
One wing of this department looks after all the policy and regulatory issues and
operations of the secondary market. It is also responsible for new investment
products, market surveillance, insider trading, registration of brokers and
administration of major stock exchanges. The other wing looks after inspection of
exchanges and regulation of non-market intermediaries like sub-brokers. It also
oversees the functioning of smaller stock exchanges.
INSTITUTIONAL INVESTMENT DEPARTMENT
This Department is responsible for policy matters, registration, regulation and
monitoring of Foreign Institutional Investors (FII) and Mutual Funds. It also looks
after the regulation and administration of the Takeover Code. This Department’s
responsibilities include research, membership of international organizations like
International Organization of Securities Commissions (IOSCO), relations with
foreign regulatory bodies and publications.
INVESTIGATION DEPARTMENT
This Department carries investigations in market abuses like price rigging, insider
trading, grey market operations, etc.
LEGAL DEPARTMENT
This Department advises SEBI on various legal matters and handles all litigations
and other legal issues.
The head office of SEBI is located at Mumbai and it has established regional
offices at New Delhi, Kolkata and Chennai.
APPEAL AGAINST SEBI ORDER
Any person aggrieved by an order of SEBI can file an appeal petition to the
Central Government. Such appeal has to be filed within 30 days from the date of
communication of the order. However, the Central Government may extend the
period by a further 15 days if it is satisfied that the appellant had sufficient cause
for not preferring the appeal within 30 days.
MAJOR STEPS INITIATED BY SEBI
Registration of Intermediaries
All the intermediaries operating in the primary market were hitherto unregulated.
SEBI started the process of regulation of these intermediaries by making their
registration mandatory. The following categories of market participants have been
brought under the ambit of registration:
• Merchant Bankers
• Registrars and Share Transfer Agents
• Brokers
• Bankers to the issue
• Debenture Trustees
• Underwriters
• Portfolio Managers
• Mutual Funds and Venture Capital Funds
225
• Depositories
• Custodians of Securities and Depository Participants
• Foreign Institutional Investors
• Collective investment schemes like plantation schemes.
In addition to the above, SEBI is in the process of bringing Sub-brokers and Credit
Rating Agencies within the registration framework. Though SEBI has made
registration of sub-brokers vide SEBI (Stock-brokers and Sub-broker) Rules, 1992
mandatory, an effective enforcement of the same has not been impossible. The
problem of unregistered sub-brokers continues to be prevalent due to operational
constraints in implementing the rules. Hence, SEBI has decided that stamping of
transfer deed by an unregistered sub-broker would render the delivery void.
Further, SEBI has cautioned the investors, not to deal with unregistered
sub-brokers as this would deny them access to arbitration and other grievance
redressal mechanism of Stock Exchanges, in case of any dispute. As regards credit
rating agencies, the Vijay Ranjan Committee has suggested limited regulations of
credit rating agencies. The Report is currently under the consideration of SEBI.
The process of mandatory registration brings about some entry barriers for the
intermediation industry. The norms include minimum capital adequacy, adequate
infrastructure, association of qualified and experienced personnel, etc. This enables
SEBI to effectively monitor their functioning and enforce the regulatory fiats.
Redressal of Investor’s Grievances
SEBI has instituted a mechanism for redressal of investor grievances related to
issue of securities. The grievances are in the nature of delays extending beyond the
permitted time-frame by issuers in transfer of securities, dispatch of certificates to
allottees, refund of application money and payment of dividends. SEBI enjoys the
power to prosecute companies for these violations. SEBI has now made it
mandatory for all issuers to deposit 1% of the size of the issue as security deposit
with the regional stock exchange. This amount will be released only after all the
investor grievances have been redressed to the satisfaction of SEBI. A new product
called Stockinvest was introduced which allows investors to use funds earmarked
for interest bearing bank deposits (held in their own name) to apply for primary
market issues. SEBI has also reduced the maximum time period for allotment to 30
days from the closure of the issue. In order to prevent fraudulent encashment of
refund orders, applicants are required to indicate their bank account numbers in the
application form, on which the refund orders are to be drawn.
SEBI has also recognized investor associations to further the cause of investor
protection. The use of Consumer Courts to bring class action suits against erring
issuers is being encouraged. SEBI is educating the investors and making them
aware of the availability of institutional mechanisms to solve their problems.
Primary Markets
The major change brought about by SEBI was improvement in the quality of
disclosure norms. SEBI’s attempts are directed at ensuring full and fair disclosure
by issuers. The offer documents have to be drafted in accordance with the
guidelines for disclosure issued by SEBI. These guidelines provide entry norms for
IPOs, specify disclosure of all material facts, lay down minimum contribution by
promoters and also specify the lock-in period for such contribution. The guidelines
also provide that the risk factors associated with the issue be prominently
displayed in the offer document. SEBI has made justification of pricing mandatory
in case of issues at premium. Further, SEBI has prohibited companies from giving
future profitability projections in the offer document, to prevent investors from
being misled.
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Capital Markets
Filing all the offer documents with SEBI has been made mandatory. SEBI reserves
the right to direct any amendment to the draft offer document within 21 days from
filing. SEBI has also decided to treat all the offer documents filed with it as public
document and put the same on internet. This enables SEBI to deal with public
complaints of misstatements before the opening of the issue. SEBI has now
delegated the task of vetting the offer document to the Lead Manager. The Lead
Manager is required to exercise due diligence with regard to the accuracy and
adequacy of the disclosures made in the offer document.
SEBI has allowed issuer companies to access the market through the book building
route. Book building facilitates the process of price discovery and also reduces
transaction costs. SEBI raised the limits for listing on regular stock exchanges to
Rs.5 crore. Issues below Rs.5 crore in size are permitted to be listed only on
OTCEI. As market making is mandatory to list on OTCEI, this move provides
liquidity to securities of small cap companies. SEBI issued guidelines for issue
related advertisements to prevent fraudulent inducements to invest. It permits
reservation for certain categories of investors of public issues both on firm and
competitive basis. Further, in case of private placement of equity by listed
companies, it has directed that they take place only at market related prices.
Secondary Markets
The ability of companies to mobilize capital from the market depends, to a large
extent, on the efficiency and liquidity of the secondary market. Investors must
have confidence that they will be able to exit from the investment at prices
reflective of its future earning potential. The main focus of SEBI’s efforts have
been the modernization of market infrastructure and to introduce risk containment
measures.
The major reform initiated by SEBI is to direct all the stock exchanges to
introduce on-line screen based trading. Further, to ensure effective clearing
mechanism, SEBI has directed all stock exchanges to set-up clearing house/
clearing corporation to settle all trades through them only. Almost all stock
exchanges have already set up clearing house and the NSE has set up a clearing
corporation viz., National Securities Clearing Corporation Ltd. NSCCL assumes
the counterparty risk for all the trades executed on the capital market segment of
NSE. SEBI has also advised the stock exchanges to set-up a Trade Guarantee
Fund. This would ensure timely completion of settlement in the event of defaults
by member brokers. The trading cycle has been shortened to 7 days. Rolling
settlement has already been introduced on OTCEI and trading in dematerialized
securities takes place on T + 2 basis. The system of margin collection has been
streamlined and the concept of mark to market margin has been introduced. The
carry forward and badla system have been banned. A number of checks and
balances have been introduced in the modified system to prevent its abuse. SEBI
has also introduced the Stock Lending Scheme to facilitate timely delivery of
securities. The introduction of depositories has helped overcome the problems of
bad deliveries and reduce the transaction costs. SEBI is encouraging the investors
to dematerialize their holdings.
SEBI has introduced capital adequacy norms for brokers. SEBI set intra-day
trading limits on trading members. SEBI has been encouraging the process of
corporatization of broking houses. SEBI directed that the upper limit for gross
turnover (buy + sell) intra-day should not exceed 25 times the base capital.
SEBI has directed Stock-Exchanges to amend their listing agreements to enforce
continuing disclosures. The cash flow statement, which is a part of financial
statements in several countries, is not mandatory under The Companies Act, 1956.
The inclusion of cash flow statement has been made a condition for continuation
of listing. The listing agreement has also been modified requiring companies to
provide shareholders with complete unabridged accounts. Companies have been
227
directed to disclose actual utilization of funds and actual profitability against the
projected utilization of funds and profitability projections given in the offer
document. SEBI has also accepted the Bhave Committee recommendations for
quarterly disclosure of financial performance and disclosure of material events by
companies immediately after their occurrence.
Short Selling and Securities Lending and Borrowing
Finance Minister in his Budget speech for 2007-08, had proposed “to introduce
short selling settled by delivery, and securities lending and borrowing to facilitate
delivery, by institutions. Accordingly, SEBI had specified a broad regulatory
framework for short selling and a full-fledged securities lending and borrowing
scheme (SLB) by institutional investors. The short selling and SLB came into
existence with effect from April 21, 2008. In past, short sale was permitted for
retail investors in 1996 subject to the disclosure requirements. It was banned twice
in 1998 and 2001 in response to market volatility. With the introduction of rolling
settlement, with effect from July 2, 2001, SEBI permitted short sales by retail
investors.
Short selling is defined as selling a stock which the seller does not own at the time
of trade. The seller would have either borrowed the securities temporarily for
delivery to the buyer or would not have made any provision at all i.e. naked short
sale.
Short selling is used for many purposes, including to profit from an expected
downward price movement, to provide liquidity in response to unanticipated buyer
demand, or to hedge the risk of a long position in the same security or a related
security. Short selling is considered as a desirable feature as it enhances market
efficiency through price discovery and improves liquidity in the permitted
securities.
Securities Lending and Borrowing (SLB)
Securities lending is a temporary transfer of securities from the owner of the
securities to a third party, for a fee. At the end of loan term, securities must
generally be returned to the owner. Securities lending arrangements are governed
by commercial agreement entered into between the lender and borrower. Securities
lending and borrowing has become an inevitable mechanism in capital markets.
SLB complements short selling in securities and also enables the investors to earn
returns on their idle securities. SLB was first introduced in United States in the
1980s. It now supports trading and settlement in all developed and emerging
markets. SLB confers liquidity and improves efficiency of securities markets.
Securities lending provides the lender of securities with a low risk yield
enhancement to his portfolio, while enabling the borrower to cover failed trades
and to hedge/ arbitrage in the market. In most markets, the securities lending and
borrowing transactions are by and large, over-the counter (OTC) contractual
obligations executed between lenders and borrowers. Regulators do not directly
regulate the lending and borrowing transactions. SLB has been introduced by
SEBI within the overall framework of Securities Lending Scheme, 1997. All
market participants are eligible to participate in the scheme. The SLB takes place
on an automated, screen-based, order-matching platform which will be provided
by the approved intermediaries (AIs). The AIs includes Clearing
Corporation/Clearing House of stock exchanges having nation-wide terminals. The
securities traded in F&O segment are eligible for lending & borrowing under the
scheme. Here it is noted that SLB transactions would not attract capital gains tax
and Securities Transaction Tax.
Derivatives Market Review Committee
Derivatives Market Review Committee (DMRC) was set up on April 3, 2007
under the Chairmanship of Professor M. Rammohan Rao to carry out a
comprehensive review of the developments in the derivatives market in India and
to suggest the future course of action. SEBI on November 14, 2007, approved, in
228
Capital Markets
principle, the interim recommendations on ‘New products for futures and options
segment’. Accordingly, four new derivative products have been introduced. It is
expected that these new derivative products will provide investors with a wider
range of risk mitigation products and create more activity in the Indian derivatives
markets. The four products are as follows:
• Mini Contracts in equity indices
• The Options contracts with longer life/tenure
• Volatility index and F&O contracts
• Bond Index and F&O contracts
Mini Contracts in Equity Indices: Exchanges (NSE and BSE) were permitted to
introduce mini contracts in equity indices with minimum contract size of Rs. One
lakh. It was expected that the availability of mini contracts with lower contract size
i.e. Rs one lakh will facilitate small retail investors to effectively hedge their
portfolios. The existing risk containment and other measures applicable for
existing exchange traded equity Index derivative contracts were also extended to
the mini derivative contract on Index.
The Options Contracts with Longer Life/Tenure: Exchanges (NSE and BSE)
were permitted to launch options contracts with longer tenure up to five years. To
begin with, at any point in time, there would be options contract with at least three
year tenure available for investors. The options cycle would be as under:
• the three serial month contracts would continue to exist.
• the following three quarterly months of the cycle March/June/
September/December would be available.
• after these, five following semiannual months of the cycle June/ December
would be available, so that at any point in time there would be options
contract with at least three year tenure available for investors.
The risk containment and other measures applicable for existing exchange traded
equity Index option contracts would be extended suitably to long term option
contracts on Index. It was expected that these contracts will provide liquidity at the
longer end of the market and will enable investors to hedge their positions for a
longer duration.
Volatility Index and F&O Contracts: Exchanges (NSE and BSE) were existing
risk containment and other measures applicable for existing exchange traded
equity Index derivative contracts were also extended to the mini derivative
contract on Index. Permitted to construct volatility index and disseminate the
same. The Exchanges were free to decide whether they want to adopt any of the
Volatility Index computation models available globally or may like to develop
their own model for computation of Volatility Index. Based on experience gained
and awareness generated, derivatives on Volatility Index would be considered for
introduction in due course of time.
Bond Index and F&O Contracts: Exchanges were permitted to construct the
bond index (both corporate and GOI) and disseminate the same. Bond index
reflects expectations about the term structure of interest rate in the economy. It
was expected that futures and options on bond index will enable market
participants to hedge their interest rate risk. The exchanges were free to decide
whether they want to adopt any of the Bond Index computation models available
globally or may like to develop their own model for computation of Bond Index.
Regulation of Takeovers
In order to provide an equitable exit route to minority shareholders in the takeover
process and to protect companies from surreptitious acquisitions of stakes by
unscrupulous raiders, SEBI has notified the Takeover Code. This code regulates
the process of substantial acquisition of shares in a listed company. Takeovers and
substantial acquisition of shares were subject to the provision of the listing
229
agreement, prior to the introduction of the Takeover Code. There is no provision to

enforce the stipulations of the listing agreement in case of defaults. The code
brings all the parties to the takeover under SEBI’s regulatory purview. The
takeover code is triggered when an acquirer obtains 15% equity stake in a
company. The code makes it mandatory for the acquirer to make a public offer to
acquire a further 20% of equity in the target company. The tender offer should be
handled by a SEBI registered Merchant Banker. The Code also requires the
acquirer to open an escrow account before making the public offer and the amount
in the escrow account shall be forfeited in case of non-compliance of the
provisions of the Takeover Code.
Emergence of Institutional Investors
The mutual fund industry was open to the public sector till 1992. The notification
of SEBI (Mutual Fund) Regulations 1993 heralded the entry of private sector into
the mutual fund industry. The entry of private sector resulted in product innovation
and improved levels of investor service. The regulations also brought about
structural changes in the mutual fund industry. It brought the relationship between
the various components of the mutual fund – the trustees, the custodian and the
asset management company within an arms’ length. SEBI has also introduced
uniform valuation and accounting norms.
The Finance Minister announced the opening of the capital markets for foreign
portfolio investment during his 1992-93 Budget. However, the opening was
limited to “reputed” institutional investors. FIIs include investors such as pension
funds, investment trusts, mutual funds, asset management companies, nominee
companies and incorporated portfolio managers. The investments were subject to
certain specified ceilings for investment in a single corporate. A positive feature of
these guidelines was that there was no restriction on the volume of investment and
no prescribed lock-in period. FIIs are also permitted by the RBI to hedge against
exchange rate risk by forward cover on their entire debt portfolio and a part of
their equity portfolio.
Maintaining the Fairness and Integrity of the Markets
Before the formation of SEBI, the breach of regulations was the norm and
compliance was an exception. It was vital from the point of view of promoting the
investor’s confidence that the situation needed to be reversed. SEBI sent a strong
message to the market participants that the strict observance of regulations was
essential. The success of any regulator in exercising enforcement depends on its
effectiveness in investigating market abuses and in imposing different penalties.
SEBI has been empowered to conduct inspections, investigate violations of
regulations and take punitive actions.
SEBI has been authorized to enforce the prohibition of manipulative and unfair
trade practices. Price rigging on the stock exchanges through fraudulent practices
leads to loss of investor confidence. With the computerization of the trading and
settlement system, it has become more difficult to abuse the process. It is virtually
impossible to conceal the audit trail of such manipulations. SEBI has also directed
the stock exchanges to set-up market surveillance systems backed by adequate
infrastructure and manpower. The concept of circuit breakers and price bands have
been introduced to check excessive volatility due to speculation. In addition SEBI
itself monitors and investigates irregular price movements.
It is difficult to prove cases of insider trading without conclusive evidence. The
use, for profit, of privileged access to price sensitive information by insiders,
before it is in the public domain, constitutes insider trading. In an effort to curb
this malpractice, SEBI has issued SEBI (Insider Trading) Regulations, 1992 which
empowers it to start criminal prosecution against the accused. In addition to this,
SEBI has encouraged continuous disclosures and timely dissemination of price
sensitive information.
230
Capital Markets
SEBI has been empowered to carry out inspection of stock exchanges, market
intermediaries, mutual funds, etc. The operations of stock exchanges are subject to
regular inspection by SEBI. The focus of this inspection is on exchange
administration, compliance with all SEBI regulations and directives and
enforcement by the exchange of its own rules, bye-laws and listing agreements.
The various deficiencies noticed during the inspections are taken up with the
Governing Board. Further, the SEBI nominees on the Governing Board are
advised to pursue these matters. SEBI also conducts inspections at random on
market intermediaries. In case of serious lapses or violations being noticed on
inspections, inquiry proceedings are initiated. Appropriate punitive action like
suspension or cancellation of registration is also taken. SEBI has initiated penal
action against issuers for misstatements in the offer documents and against
merchant bankers failing to exercise their due diligence obligations. In certain
cases, SEBI has even directed the companies to refund the entire issue proceeds to
the investors.
CENTRAL LISTING AUTHORITY
The Central Listing Authority (CLA) has been empowered to make
recommendations to the Sebi on issues concerning the protection of interests of
investors in securities and the development and regulation of the securities market.
The main objective behind the setting up of a CLA was to bring about uniformity
in the exercise of “due diligence” in scrutinizing listing applications.
Under the current laws, while it is mandatory for a company to list its securities on
its regional stock exchange (a provision which the Sebi Committee has now
recommended to be scrapped), it can also list on any number of other exchanges.
There are 23 stock exchanges in our country of different heritage, constitution and
size. Each interprets and enforces the listing agreement in a different manner; and
set out different listing criteria. Moreover, the skill sets at the various exchanges
are widely different.
As a result, many companies mostly small, to avoid closer pre-issue scrutiny as
well as post-issue monitoring, are able to list easily only at the small exchanges.
With most shares in control of the promoters, they rig up their share prices and try
to graduate to either of the two national exchanges in order to offload the
promoters-held shares to the gullible investors and even to the funds.
Besides the principal function of receiving and processing applications for “letter
precedent to listing”, the CLA can now specifically make suggestions on investor
protection, development and regulation of the securities market, including listing
agreements, listing conditions and disclosures to be made in offer documents.
India’s stock regulator, the Sebi is playing more of a development role rather than
being merely a watchdog. It has come up with a new set of regulations on CLA
that has broad-based the functions of the authority, besides making alterations in
its composition. Interestingly, the revamped regulations have dispensed with the
self-regulatory character of the CLA, which was enshrined in the previous
regulations issued in February 2003.
SELF-REGULATION OF THE MARKETS

There is no clear-cut and accepted definition of a SRO in India. However, The
Financial Services Act, 1986 of the UK states “A Self-Regulatory Organization
means a body (whether a body corporate or an unincorporated association) which
regulates the carrying on of investment business of any kind by enforcing rules
which are binding on persons carrying on business of that kind either because they
are the members of that body or because they are otherwise subject to control.”
Self-Regulatory Organizations (SROs) form an important layer of the regulatory
structure in the developed markets. The SRO model has been most successful in
the the UK. There are 4 active SROs which come under the overall framework of
Securities Investment Board (the equivalent of SEBI in the UK). There is
231
Investment Management Regulatory Organization (IMRO) which is an association

of Mutual Funds, the Securities and Futures Association (SFA) for stock-brokers,
the Financial Intermediaries Managers and Brokers Regulatory Authority
(FIMBRA) for market intermediaries and the Life Assurance and Unit Trust
Regulatory Authority (LAUTRO).
In India, SEBI has been attempting to accelerate the process of self-regulation and
encouraging the formation of SROs. The following SROs have been formed in
India by the various market participants:
1. Association of Merchant Bankers of India (AMBI)
2. Association of Mutual Funds of India (AMFI)
3. Registrars Association of India (RAIN).
Most of the stock exchanges also function as SROs though they have not been
given that nomenclature.
The important self-regulatory activities are:
Code of Conduct: Most of the SROs have a code of conduct for their members.
Though a different code exists for each SRO, they normally include some common
principles. All codes advise their members to observe the principles of fairness,
integrity and ethics in their business dealings. They are advised to ensure
compliance with all the laws and regulations. The members are expected to
maintain high standards of professionalism and exercise independent professional
judgment. They shall exercise due diligence and proper care while discharging
their professional responsibilities. They shall not divulge any confidential
information regarding their clients. They are also expected to consistently strive to
upgrade their knowledge and skills.
Regulation of the Members: The SROs monitor the functioning of their members
with regard to compliance of laws, statutory regulations as well as their own code
of conduct. Disciplinary proceedings are initiated against members in case any
lapses are noticed. Certain SROs also establish common professional standards to
ensure uniformity in the functioning of their members.
Professional Matters: The SROs assist SEBI in formulation of policies as well as
various regulations and rules. In addition, some SROs also provide for arbitration
in cases of dispute among their members. SROs also conduct professional
development and training programs for their members.
In addition to SROs at the institutional level, the individuals operating in the
securities market are also governed by the professional body from which they
acquired their professional qualification. The members of The Council of
Chartered Financial Analysts (CCFA) operate in the securities market. The CFAs
engaged in practice offering professional services like consultancy, portfolio
management, research, etc., have to strictly abide by the Code of Conduct issued
by CCFA. The CFAs employed by firms operating in the securities industry are
expected to maintain high standards of professionalism and ethical behavior in
their professional dealings. They are governed by the Code of Conduct of their
employers as well as that of CCFA.
INTERNATIONAL ORGANIZATION OF SECURITIES

COMMISSIONS (IOSCO)
IOSCO is an international organization of securities regulatory bodies and SROs
of various countries. The main purpose of forming IOSCO is to ensure
coordination at the global level among the various national regulators. The
Secretariat of IOSCO is located at Montreal in Canada.
The main objectives of IOSCO are:
• To cooperate and promote high standards of regulation in order to maintain
just, efficient and sound markets;
• To exchange information on their respective experiences in order to promote
the development of domestic markets;
232
Capital Markets
• To unite their efforts to establish standards and effective surveillance of

international securities transactions;
• To provide mutual assistance to promote the integrity of the markets by a
rigorous application of the standards and by effective enforcement against
offenses.
MEMBERSHIP
IOSCO has three categories of membership – ordinary member, associate member
and affiliate member. A Securities Commission or a similar Government body is
eligible for ordinary membership. If the national regulatory body of a country is
already an ordinary member, any other regulatory body with responsibilities for
securities regulation or has jurisdiction over any subdivisions of the securities
market can become an associate member. An SRO or an international body with
interests in securities regulation is eligible to be the affiliate member of IOSCO.
FUNCTIONING OF IOSCO
IOSCO members meet every year at an Annual Conference to discuss important
issues relating to international securities and futures market. In addition, IOSCO
functions through the committee system. Some of the important committees are:
The President’s Committee which is made up of the Presidents of members
(ordinary and associate) meets once in a year. The main purpose of this Committee
is to achieve the objectives of IOSCO.
The Executive Committee consists of 19 members and meets at periodical
intervals. It looks after the day-to-day functioning of the organization and strives
to attain the objectives.
The Technical Committee, consisting of 16 members, addresses major regulatory
issues and generates practical responses to these concerns. This Committee has
set-up working groups to look into five major functional areas:
• Multinational disclosures and accounting.
• Regulation of secondary markets.
• Regulation of market intermediaries.
• Enforcement and exchange of information.
• Investment management.
The Emerging Markets Committee endeavors the promotion and development of
efficient securities and futures market in developing countries. It discharges its
responsibilities by setting up minimum professional standards, facilitating
exchange of information, transfer of technology and expertise and organizing
training programs.
The SRO Consultative Committee is constituted by the affiliate members of
IOSCO. This Committee enables SROs to provide constructive and substantial
inputs to the regulatory initiatives of the organization.
IOSCO also has 4 Standing Regional Committees to address specific regional
issues of members. They are:
• The Africa and the Middle-East Regional Committee.
• The Asia-Pacific Regional Committee.
• The European Regional Committee.
• The Inter-American Regional Committee.
233
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234
Capital Markets
SUMMARY
• SEBI was instituted by the Government of India to perform disciplinary
(disincentives and penalties for errant and unfair behavior) and
developmental (incentives for constructive activities) roles.
• The main objectives of SEBI are: protection of the interests of investors in
securities, development of the securities markets in India and regulation of
the securities markets.
• The activities of SEBI are divided into: primary market department, issue
management and intermediaries department, secondary market department,
institutional investment department, investigation department and legal
department.
• The major steps initiated by SEBI include: registration of intermediaries,
redressal of investors’ grievances, improvement in the functioning of primary
and secondary markets, regulation of takeovers, emergence of institutional
investors and entry of private mutual funds in the markets, maintenance of
fairness and integrity of the markets.
• The main objectives of the International Organization of Securities
Commission (IOSCO) are: promotion of high standards of regulations,
exchange information on past experiences, establishment of standards of
conduct and provision of mutual assistance for promotion of integrity.
• IOSCO has three types of members: ordinary members, associate members
and affiliate members and various committees that meet every year to discuss
important issues relating to international securities and futures markets.
235
Appendix I
Margin Trading: Trading on Borrowed Money
The Ketan Parekh scam was the final straw in Sebi banning the 100-year old badla
system. The system allowed carrying forward speculative trades by borrowing
money on interest. After the ban on badla trading, which coincided with a lull in
the markets after the dotcom bubble, brokers were complaining of both lower
profits and volumes. Margin trading has been introduced now as a refined version
of the badla system suited to the T+2 settlement mechanism.
What is Margin Trading?
Margin trading is nothing but borrowing money to invest in stocks. Here, the
investor borrows money from his or her broker to invest in stocks through the
same broker. The “Margin” here is the money actually borrowed from the broker,
who uses the investors’ stocks thus purchased as collateral for the funds advanced.
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In margin trading, the investor buys shares taking a ‘margin loan’ from the broker.
The margin loan can be up to 50% of the total amount invested. This effectively
means that you can invest in shares worth Rs.100 by borrowing Rs.50 from your
broker. This is called buying shares on a 50% margin. If the value of the shares
goes down, the investor has to pay a “maintenance margin” to bring the margin up
to 40% of the market value of the shares. This margin is paid when the broker
makes a “margin call” to the investor, and the investor has to pay the difference
between current margin and the maintenance margin to take it to 40%. If the
margin falls below 30%, the broker has the discretion of liquidating the client’s
holdings and thus recovering the loan advanced.
236
Capital Markets
Mechanics of a Margin Trade

Buying shares on margin is a fairly simple process. Say you want to buy
100 Infosys Technology shares at Rs.5,500 (price as on January 16 ). You would
need Rs.5,50,000 for the transaction. Now, you have just Rs.3,00,000 of cash
readily available. Enter your broker, who will invest money on your behalf, taking
interest for the same. Now you invest 50% of the amount (i.e., Rs.2,75,000) and
your broker puts in the other half on your behalf and buys 100 Infy shares in your
name.
Now let us assume that the price of Infy (unfortunately for you) falls to Rs.4,500
during the course of the succeeding week. Your 100 Infy stocks are now worth
only Rs.4,50,000, and you have suffered an absolute loss (excluding brokerage
and margin fee) of Rs.1,00,000. Now, your margin loan from the broker would
remain at Rs.2,75,000, but your own account equity will fall to Rs.1,75,000
(Rs.2,75,000 less Rs.100,000). Now your maintenance margin equals 38.88%
(Equity Account/Market Value of Holding x 100 i.e., 1,75,000/4,50,000 x 100). If
the maintenance margin falls below 40%, your broker can ask you for the balance
to take the margin to the 40% mark. This he/she does by sending you a ‘margin
call’ of Rs.5,000 to increase your margin account balance from Rs.1,75,000 to
1,80,000 (1,80,000/4,50,000 x 100 = 40%).
Now, assume that Infy suddenly crashes (God forbid) to Rs.3,750. Now your
entire holding is worth only Rs.3,75,000. Your margin loan still remains at what
you originally took, i.e., Rs.2,75,000, but now your equity account falls to
Rs.1,00,000. The maintenance margin has come down to only 26.67%
(1,00,000/3,75,000 x 100). As your margin has fallen below the minimum
prescribed limit of 30%, your broker can sell your entire holdings even without
intimating you, and realize Rs.3,75,000. The broker now takes back his/her
Rs,2,75,000 advanced to you, as well as 500 as interest (assuming that the total
interest is 2% of the sum borrowed). In addition to all this, you always had to pay
the 1% brokerage on each leg of your transaction. This amounts to Rs.9,250
(Rs.5,500 + Rs.3,750). After meeting all costs, you get back Rs.85,250
(i.e., Rs.3,75,000 (selling price) – Rs.2,75,000 (margin loan) – Rs.5,500 (interest) –
Rs.9,250 (brokerage)). Remember, you had invested Rs.2,75,000 in the risky game
of margin trading, and ended up paying for the money invested as well as the
money your broker invested on your behalf. Your total loss stands at Rs.1,89,750
or 69%, whereas your stock decreased only by 31.81%.
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You have 100 Infy shares at Rs.5,500 each, that you purchased by forwarding 50%
cash and buying the rest on margin. Infy announces that it has made a strategic
alliance with Tata Consultancy Services (TCS) to take on their global rivals
Accenture and IBM, and the stock spurts to Rs.6,500. Your margin loan, as ever,
remains at Rs.2,75,000, but the Rs.2,75,000 cash you had invested is now worth
Rs.3,75,000 (Rs.6,50,000 – Rs.2,75,000), returning a good Rs.1,00,000 or 36.36%.
From this notional profit, after you pay about 1% brokerage on each leg of your
transaction (Rs.12,000) and 2% interest charges (Rs.5,000) your entire profit
amounts to 30% (Rs.82,500). Compare this figure with the 18.18% (excluding
brokerage) appreciation in Infy, and you will literally laugh all the way to the
bank.
How Margin Trading is Different from Vyaj Badla
Badla and Margin Trading are forms of leveraging oneself to purchase stocks.
Badla was prevalent in the weekly settlement system, and was used when an
investor wanted to carry forward his position on the settlement date to the next
settlement without blocking money. Vyaj Badla is a mechanism that enables roll
over of speculative positions from one settlement to another. The word “badla”
meaning change is derived from the switch in positions between the trader and
financier in a roll over. “Vyaj” means interest. A trader who is bullish and has
bought without having the money to take delivery, sells to the financier in
one-settlement, concurrently buying it back in the next settlement at a higher rate,
the difference being the interest element, or badla charge.
However, Margin Trading is not linked to the settlement system (which is
currently the T+2 system and not weekly settlement like in the days of badla
trading). In a margin transaction, the broker forwards money to the client, and this
is only a one-way transaction, and the broker does not buy shares as he does while
undertaking a Vyaj Badla transaction.
238
Capital Markets
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239
Benefits of Margin Trading

The main benefit of Margin Trading for the investors is that it serves as an avenue
for the investor who wants to buy more shares than the cash available. The
investor leverages the transaction and aims to make more money on the investment
than the interest payable on the margin loan. Margin trading can be a very
effective tool in the hands of the experienced and heavy trader, who can invest up
to double his investible sum in the hope to earn high profits.
Margin trading has a two-fold benefit for capital markets. Firstly, it acts as a
deterrent to unofficial badla and dabba transactions. After Sebi banned badla
trading, some unscrupulous brokers are still running quasi-badla trades and
chasing the ‘sky-high’ returns achieved during the days of the badla system.
Others are still running parallel exchanges or ‘dabbas.’
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Secondly, trading on margin improves liquidity in the market. With lesser amounts
of cash with investors, they can assume higher risk and can invest in higher value
of stocks. This would increase the volumes of stocks traded on the bourses and
thus give a fillip to the already healthy liquidity in the market.
The official and structured market for margin trading will most likely lead to an
expansion of day trading activity in the market. Day trading provides the much-
needed liquidity to the equity market.
The stock lending mechanism proposed by Sebi will also facilitate short-selling. In
the present system, short-selling is possible only when one owns the stock. In the
new system, holding a stock for selling it short will not be required, and an
investor can short-sell without owning a stock in the first place. This mechanism
will allow for actively trading on contrarian views.
Margin trading is likely to take off, even with its additional risk, because it
provides scope for leveraged trades in the 97 Group A securities on which
derivatives are not available. The lure of having high returns will draw seasoned
traders to Margin Trading.
240
Capital Markets
A Step in the Right Direction

Margin trading is certainly an improvement in the Indian capital markets and
serves as a further enhancement to the contemporary nature of the Indian equity
market. Capital markets are projected to become even more liquid, enabling better
price discovery in the days to come. Sebi has introduced Margin Trading with a
relatively high maintenance margin of 40% (it is 25% in the US markets), but with
a promise to review the scheme after six months. Now that this scheme is offered
to investors and brokers, let us hope that it is taken in the right spirit by the
markets and does not become an avenue for fraudulent trading practices like badla
had become. If this happens, Margin Trading can make the Indian capital markets
a better place for investors.
Source: Portfolio Organizer.
241
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Investment Banking
BRIEF HISTORY OF INVESTMENT BANKING

Investment banking is not a new subject in the field of finance. It started in the
fifteenth century in Italy and later on spread to France and the UK in the
eighteenth century. The name Merchant Banking originates from the fact that it
was started by merchants who added banking activities to their operations, and
through innovations, came up with what is the real merchant banking of the
modern ages. The main activities of these middle ages merchant bankers were to
remit foreign currencies from one place to the other.
In the UK, merchant bankers started with bill discounting for their customers, even
though they were more of merchants than of bankers. Barings Brothers was the
oldest merchant banker in the UK while in the US indigenous merchant bankers
started operating by 1880 and started helping the conversion of privately held
companies into public companies. Kidder Peabody, Drexel, Brown Brothers and
Morgan & Co., were the major merchant bankers at the beginning of the twentieth
century.
When the great crash took place in 1929, most merchant bankers were left with
heavy losses and with the introduction of the Glass-Steagall Banking Act in 1933,
the government separated merchant banking from commercial banking. Further,
the Securities Act, 1934 prohibited depositories from underwriting and tried to
correct the malpractices in securities trading.
The Glass-Steagall Act restricts even investment bankers from owning a firm
dealing in securities and from underwriting. Owing to the legal challenge created
by the investment bankers in America, the government in 1987 has allowed banks
to float subsidiaries to undertake the merchant banking and investment banking
activity of the bank, whereby the total income from these subsidiaries can be up to
25% of the total income of the bank.
AN OVERVIEW OF INVESTMENT BANKING INDUSTRY
Corporates raise capital by issuing securities in the market. Investment Bankers act
as intermediaries between the issuers of capital and the ultimate investors who
purchase these securities. Investment Banking can be broadly defined as financial
intermediation that matches the entities that need capital and those that have
capital. Investment Banks facilitate the process of flow of capital in the market.
The Securities and Exchange Board of India (Merchant Bankers) Rules 1992
define Merchant Banker as:
“A person who is engaged in the business of issue management either by making
arrangements regarding selling, buying, or subscribing to securities as Manager,
Consultant, Advisor or rendering corporate advisory services in relation to such
issue management.”
SCOPE OF INVESTMENT BANKING

The Investment Banker plays a vital role in channelizing the financial surplus of
the society into productive investment avenues. The Merchant Banker has a
fiduciary role in relation to the investors. He has to ensure that only quality paper
emanates from his firm. He is required to exercise due diligence to ensure the
adequacy and appropriateness of the disclosures made in the offer document.
243
The Investment Banker is the leader among all the intermediaries associated with
the issue. He is required to guide and co-ordinate the activities of the Registrar to
the issue, Bankers to the issue, Advertising Agency, Printers, Underwriters,
Brokers, etc.
The Investment Banker has to ensure the compliance of all the laws and
regulations governing the securities market. He may also be called upon to assist
the statutory authorities in developing a regulatory framework for orderly growth
of capital markets.
MANAGEMENT OF DEBT AND EQUITY OFFERINGS

This is the traditional ‘bread and butter’ operations for most of the Investment
Bankers in India. The role of the Investment Banker is dynamic and he has to be
nimble-footed to capitalize on available opportunities. He has to assist his
corporate clients in raising funds from the market. He may also be required to
counsel them on various issues that affect their finances. The main area of his role
includes:
• Instrument designing;
• Pricing the issue;
• Registration of the offer document;
• Underwriting support;
• Marketing of the issue;
• Allotment and refund; and
• Listing on stock exchanges.
PLACEMENT AND DISTRIBUTION
The distribution network of a Investment Banker can be classified as institutional
and retail. The network of institutional investors consist of Mutual Funds, Foreign
Institutional Investors, Banks, domestic and multilateral Financial Institutions,
Private Equity Funds, Pension Funds, etc. The size of this network represents the
wholesale reach of the Investment Banker. The basic requirement to create and
service the institutional segment is the existence of good in-house research
facilities. The investment proposal should be accompanied by high quality
research reports of the Investment Banker to justify the investment
recommendation. The retail distribution reach depends upon the networking with
the investors. Many Investment Banks have associate firms which are brokers on
the stock exchange. These brokers appoint sub-brokers at various geographical
locations to service both the primary market and secondary market needs of the
local investors. Thus, a large base of captive investors is created and maintained.
244
Investment Banking
The distribution network can be used to distribute various financial products like:
• Equity shares : Retail and institutional investors
• Debt instruments : Retail and institutional investors
• Mutual fund products : Retail investors
• Fixed deposits : Retail investors
• Insurance products : Retail investors
• Commercial paper : Institutional investors.
CORPORATE ADVISORY SERVICES
Investment Bankers offer customized solutions to the financial problems of their
clients. One of the key areas for advisory role is financial structuring. The process
includes determining the appropriate level of gearing and advising the company
whether to leverage, de-leverage or maintain its current debt-equity levels. The
asset turnover ratios may be analyzed to study whether the company is over-
trading or under-trading. The company’s working capital practises are studied and
alternative working capital policies suggested. The Investment Banker may also
explore the possibility of refinancing high cost funds with alternative cheaper
funds. Another area of advise is rehabilitation and turnaround management. In case
of sick units, Investment Banker may design a revival package in co-ordination
with the banks and financial institutions. They play an advisory role in
securitization of receivables. Investment Bankers assist their clients in
management of risks by suggesting appropriate hedging strategies. And they also
help their cash rich clients in deployment of their short-term surpluses.
PROJECT ADVISORY
Investment Bankers are sometimes associated with their clients from the early
stage of their project. They assist the companies in conceptualizing the project idea
when it is in a nebulous stage. Once the project is conceptualized, they carry out
the initial feasibility studies to examine its viability. Investment Bankers provide
inputs to their clients in preparation of the Detailed Project Report. They also offer
project appraisal services to clients.
LOAN SYNDICATION
Investment Bankers arrange to tie-up loans for their clients. The first step involves
analyzing the client’s cash flow patterns so that terms of borrowings can be
defined to suit the cash flow requirements. The important loan parameters include
amount, currency, tenure, drawdown, moratorium and the amortization. The
Investment Banker then prepares the detailed loan memorandum. The loan
memorandum is then circulated to various banks and financial institutions and they
are invited to participate in the syndicate.
The banks indicate the amount of exposure they are willing to take and the interest
rates thereon. The terms are further negotiated and fine-tuned to the satisfaction of
both parties. The final allocation is done to the various members of the syndicate.
The Investment Banker also helps the client in loan documentation procedures.
VENTURE CAPITAL AND MEZZANINE FINANCING
The Venture Capital business has emerged from a fragmented industry dominated
by wealthy individuals/families to an increasing institutionalized sector. The size
of the deals has increased and it is possible for even start-up companies to raise
huge capital from venture firms. The number of Venture Capital firms has
significantly risen and several industry specific venture funds have been set-up.
Some large-sized funds, to specifically-finance huge infrastructure projects, have
entered the Indian market. The returns on venture financing are bimodal – huge
profits on some deals and losses in other deals. The institutionalization of venture
financing has altered the dynamics of the business.
245
The association of an investment banker to handle the entire deal flow is becoming
increasingly imperative. The role of the investment banker in the deal is as
follows:
• Preliminary screening of the company to study its viability and its
attractiveness as an investment opportunity;
• Identifying the venture funds whose investment policies match with the
requirements of the company. In case of large, deals, the merchant banker
arranges to form a syndicate of venture financiers;
• Assistance to venture investors in conducting their due diligence exercise;
• Valuation of the company;
• Structuring the terms of the deal which include, inter alia, the pricing, the
holding period, the divestment procedure, the right of first refusal to the
promoters, etc.;
• Follow-up advise particularly on financial aspects;
• Handling the divestment process to enable the venture investors to liquidate
their investments; and
• Handling venture capital placements differs from the routine equity
placements of existing companies. In the venture realm, the business risks are
significantly higher, the assessment of progress is more strenuous and the
valuation judgments more difficult.
Mezzanine Financing refers to the late stage financing. At this stage, the company
is usually profitable and has a business track record. The company needs fresh
induction of capital to finance its growth plans. However, the conditions in the IPO
market may not be favorable to make an offering. The state of the IPO market
affects both, the availability of capital and pricing. Mezzanine Financing acts as a
viable funding alternative. This round of financing is usually in lieu of going
public. Some Venture Funds and Private Equity Funds offer mezzanine finance to
potential IPO companies. These funds act as a warehouse for investments and later
divest their stake through a public offering. Sometimes, the Investment Banker
provides similar financing on their own account in the form of Bridge Loans
against the proceeds of the proposed IPO.
MERGERS AND ACQUISITIONS
Mergers and Acquisitions are becoming increasingly significant in terms of
services offered by Investment Bankers in India. During the licensing era, several
companies had indulged in unrelated diversifications depending on the availability
of the licenses. The companies thrived in spite of their inefficiencies because the
total capacity in the industry was restricted due to licensing. The companies, over a
period of time, became unwieldy conglomerates with a suboptimal portfolio of
assorted businesses. The policy of decontrol and liberalization coupled with
globalization of the economy has exposed the corporate sector to severe domestic
and global competition. This has been further accentuated by the recessionary
trends which resulted in falling demand. This has resulted in overcapacity in
several sectors of the economy. The industry is currently passing through a
transitionary phase of restructuring. Companies are currently engaged in efforts to
consolidate themselves in areas of their core competence and to divest those
businesses where they do not have any competitive advantage. Investment Banks
have been quick to capitalize on these opportunities. The areas of advisory services are:
ACQUISITIONS
Internationally, the role of an investment banker is that of a financial engineer
rather than a business consultant. Most Merchant Bankers try to identify targets
which will help their clients to achieve specified objective. It is very rare that a
merchant banker has the expertise from the operational standpoint to effectively
combine two entities by identifying the synergies and value drivers.
246
Investment Banking
Understanding the Objectives: The Investment Banker must try to understand

the motive of the client to go in for an acquisition. The ultimate objective of any
corporate management is to maximize the wealth to the shareholders. Acquisition
needs to be viewed as one more tool available for achieving the above objective.
The following are some of the significant factors which will make an acquisition a
potential tool for wealth maximization:
Financial:
i. Benefits on account of tax shields like carried forward losses or unclaimed
depreciation;
ii. Restructuring and strengthening the balance sheet;
iii. Profiting from Leveraged Buyouts;
iv. Reduction of volatility of earnings in a cyclical industry; and
v. Investment of surplus cash.
Marketing:
i. Enhancement of the market share;
ii. Elimination/reduction of competition;
iii. Diversification to reduce risk; and
iv. Growth without creating surplus capacities in the industry.
Production:
i. Horizontal or vertical integration;
ii. Acquisition of new technology.
Acquisition Search: The first step is to determine the universe of potential target
companies. Information is gathered about these companies based on their
published data, industry-specific journals, databases, past prospectuses, etc. If the
acquisition involves buying only a part of the target company, segmental data may
be difficult to obtain. Similarly, information about private companies may not be
readily available. Once the universe is determined, targets may be shortlisted based
on certain parameters.
Approaching the Target: This is one of the most critical roles played by the
Investment Banker in the deal. There are broadly two methods of approaching
targets:
• Passive Strategy: This approach is based on the premise that an
overwhelming majority of firms are not for sale and are unreceptive to any
inquiries. The acquirer is unwilling to pursue any acquisition on an
aggressive basis. In such an approach, the investment banker passively waits
till the time a potential target is available for sale.
• Active Strategy: This is a more proactive approach by the acquirer. The
active approach may be either friendly or hostile. In the friendly way, a
private and confidential line of communication may be opened with the CEO,
Director or Investment Banker of the target company. It is also made clear
that if the target company is not interested, no further action will be taken. In
the hostile approach, the acquirer assumes the role of a raider and actually
starts accumulating the shares of the target. This approach assumes that while
the management may be averse to the takeover, the shareholders would be
receptive to the offer. When shares are accumulated by the acquirer, it is
financially beneficial even if it is outbid in a counter-offer.
247
Valuation: Valuation of the target company is the most critical task performed by
the investment banker. A conservative valuation can result in collapse of the deal
while an aggressive valuation may create perpetual problems for the acquiring
company. The commonly used valuation methods are:
• Discounted Cash Flow Method: In this method, valuation represents the
present value of the expected stream of future cash flow discounted for time
and risk. This is the most valid methodology from the theoretical standpoint.
However, it is very subjective due to the need to make several assumptions
during the computations.
• Comparable Companies Method: This method is based on the premise that
companies in the same industry provide benchmark for valuation. In this
method, the target company is valued vis-á-vis its competitors on several
parameters.
• Book Value Method: This method attempts to discover the worth of the
target company based on its Net Asset Value.
• Market Value Method: This method is used to value listed companies. The
stock market quotations provide the basis to estimate the market
capitalization of the company.
Investment Bankers rarely rely on a single method for valuation. Normally, the
target companies are valued based on various methods. Different weightages are
assigned to the valuations computed by various methods. The weighted average
valuation helps in eliminating the errors that may creep in, if a single method is
relied on.
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Negotiation: This is the process of formulating the structure of the deal. The
investment banker plays a vital role in closing the financial side of the
negotiations. From a financial standpoint, the key elements of negotiations are the
price and the form of consideration. Both the elements are interrelated and affect
the attractiveness of the deal. The merchant banker must ensure that the final price
paid should not exceed the perceived value of the target to the acquirer.
Acquisition Finance: Once the negotiations are complete and the price is
finalized, the merchant banker has to assist the acquirer in arranging the required
finance. The purchase consideration can be paid in the form of cash, debt securities
or equity of the acquiring company. Cash may be raised from internal accruals,
sale of assets, etc. It may also be refinanced by bank borrowings, public issue or
private placement of debt and equity. As timing is a critical factor in such deals,
248
Investment Banking
the merchant banker often gives/arranges for a bridge loan against the subsequent
refinancing. In case, shares of the acquirer are directly offered as purchase
consideration to the shareholders of the target company, the investment banker has
to determine the appropriate exchange ratio.
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DIVESTITURES
Divestitures involve sale of assets or business entities. The assets may be tangible
like manufacturing unit, product line, etc., or intangible assets like brand, distribution
network, etc. Sometimes the business entity as a whole may be sold to third party.
The reasons for divestitures are varied. They can be broadly classified as:
Opportunistic: In such cases, the vendor company has no intentions to divest in the
normal course. However, the management is tempted by the buyer with a very high
bid. If the company feels that the price offered is substantially more than the worth
of the asset/business, it may divest. The reason for the sale is solely profit motive.
Forced: The reason for the sale is the prevalence of circumstances beyond the
control of the company. The company may be facing a severe liquidity crunch and
the only solution to raise cash may be through divestiture. Sometimes, the
asset/business may be sold to avoid a takeover or to make a takeover bid
unattractive. Sometimes a divestiture may be a part of a rehabilitation package for
turnaround of a sick company.
Planned: A company may plan for sale of a particular asset/business. The reasons
may be varied:
• Strategic decision to exit from a certain industry.
• Poor business fit with other operations of the company.
• Severe competition.
• Technological factors.
• Continuous losses in a particular line of activity.
• Shrinking margins.
Investment bankers have a vital role to play in the divestiture process. Some of the
important functions are:
Developing Sale Strategy: The Investment Banker has to advise the company on
the type of sale process to be adopted. The two different sale processes are:
Negotiated Sale: In this method, the potential buyers are directly approached by
the investment banker. In case they show serious interest in acquisition, the
negotiations are conducted between the seller and the buyer. On successful
completion of the negotiation, the deal is publicly declared. This process ensures
secrecy, avoids staff unrest and controls market receptivity.
249
Auction Sale: In an auction sale, the intention to sell is publicly announced.

Competitive bids are invited from various interested buyers. The companies select
the most favorable bid and divestiture is made in favor of the bidder. The biggest
advantage of the auction process is that it enables the realization of the maximum
possible price. It also draws the attention of a large universe of potential buyers
and eliminates the biases in the selection of target buyers. It also makes the entire
sale process time bound.
Valuation: The investment banker undertakes the task of valuation of the
asset/business. This helps as an anchor in the later process of negotiation. This is
the basis on which the minimum cut-off price for the divestiture is determined.
Drafting of Offer Memorandum: A detailed Offer Memorandum is drafted by
the Investment Banker for the benefit of potential buyers. The contents of the same
are:
Executive Summary: It summarizes the key points about the business, assets on
offer and reason for the sale. It emphasizes on the benefits that would accrue to the
buyers.
Sale Procedure: It explains in detail the procedure for divestment. It also sets the
dates for indication of interest, initial bid submission, detailed presentation and
submission of final bids. It also clarifies on the expected mode of payment and the
acceptable and unacceptable deal structures.
Background: This section describes the history of the seller, details of the
asset/business on offer, geographical coverage, existing management structure,
reasons for divestment, etc. It also states the past contractual obligation which
would be binding the buyer.
Operations: This part gives the details of technology, capacity, production
processes, quality policy, research and development, scope for
expansion/integration, patents, systems and schedule of fixed assets.
Marketing: This section explains about the products, size of the market, industry
life cycle, entry barriers, market share, growth rate, customer profile, competition,
seasonality, pricing policies, brands and trademarks, etc.
Human Resources: It gives details of the employees, managers, remuneration
policies, industrial relations, etc.
Financial: The information provided includes:
• Balance sheet for the last 5 years
• Profit and loss account for the last 5 years
• Cash flow statement for the last 5 years
• Future projections
• Revenue analysis – product-wise, month-wise, region-wise, customer-wise
• Expense analysis – product-wise, region-wise, break even point, cost
behavior (fixed and variable)
• Receivables analysis – age-wise, bad debts.
Identify Potential Buyers: The most obvious target segment is competitors.
Normally, they pay the highest price for acquiring rival business. The primary
motive is to obtain additional market share. It also helps the buyer in enjoying the
economies of scale. Buying up competitors also reduces future competition in the
market. Another target group is suppliers and customers. This would enable the
buyers to increase earnings by capturing value addition by vertically integrating
the business. Other potential buyers are companies looking for diversification,
technology, venture capitalists, etc.
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Investment Banking
Negotiation and Closing the Deal: The preliminary discussions with the potential
buyers should help in shortlisting a few serious buyers. The company can negotiate
with the shortlisted buyers simultaneously or sequentially. Once there is an
agreement with a particular buyer over the broad terms, an in principle agreement
is signed and negotiations with other buyers are stopped. The buyer immediately
commences his due diligence exercise. All the key points are resolved by further
negotiations. A formal agreement is signed on successful completion of the
negotiations. The agreement should be as detailed as possible to avoid any future
litigations.
TAKEOVER DEFENSE
With high level of hostile takeover activity in recent years, takeover defense, both
pre-emptive and reactive, has become an important product for investment
bankers. It is difficult to prevent a takeover by a determined, well financed bidder
who is prepared to make a cash tender offer for its shares. However, measures can
be taken to reduce the likelihood of unfair takeover bids, to slowdown the takeover
process (giving the target company more time to negotiate or seek out alternatives)
and to reduce the takeover incentive by reducing the gap between market price and
its intrinsic value.
DEFENSIVE AUDIT
The speed at which a raider can execute a hostile tender offer or purchase shares
from the market, puts the target company at a disadvantage. The acquirer can plan
his strategy for months, with the target company being totally unaware. Once the
process begins, the target company has very little time for evasive actions.
Investment Bankers carry out defensive audit for companies to assess their
vulnerability to takeovers. It normally includes:
• Analysis whether the market price reflects the intrinsic value of its share and
if not, the reason for undervaluation.
• Analysis whether the valuation of the company can be enhanced by restructuring.
• Review of the company’s shareholders’ profile.
• Review of the Memorandum and Articles of Association.
CORRECTIVE ACTION
Pre-emptive defensive actions may be taken to reduce the vulnerability of the
company. Some strategic responses may be thrown up like:
• Increasing the promoters stake by allotting warrants/shares at market related
prices.
• Comprehensive equity buy-back program.
• Corporate restructuring like asset sales and spin-offs.
• Increasing disclosure levels in case the market price of the scrip is
substantially below its intrinsic worth.
FINANCIAL ENGINEERING BY INVESTMENT BANKERS
Over the last two decades, financial engineering has brought about a remarkable
change in the global financial markets. The deregulation of the financial services
sector has resulted in increasing stress being placed on ability to design new
products, develop superior processes and implement structured solutions to
complex financial problems. A number of factors have accelerated the process of
financial innovation. They include:
• Interest rate volatility
• Exchange rate volatility
• Price volatility
251
• Regulatory and tax changes

• Globalization of the markets
• Increased competition among investment bankers.
According to John Finnerty1, “Financial engineering involves design, development
and implementation of innovative financial instruments and processes and the
formulation of creative solutions to the problems in finance.” The soul of this
definition is captured by the words ‘innovative’ and ‘creative’. This may involve a
quantum leap through the introduction of a revolutionary new idea like the first
swap deal or the first Leveraged Buy Out transaction. At other times, it may
involve adding a new dimension to an existing product or novel extension of an
existing idea. For example, a new variant of a derivative.
Miller characterizes financial engineering as unpredictable improvement in the
variety of available financial products resulting from unforeseen changes. Kane
views financial engineering from the point of view of regulatory dialectic. He sees
regulatory dialectic as a cyclical process in which opposing forces of regulation,
and avoidance by regulators perpetually try to outwit each other. Silber perceives
innovative financial instruments and processes as endeavors by corporations to
mitigate the financial constraints they face. According to him, the cost of
following the rules provides the impetus for innovative activities. Financial
engineering relaxes the constraints and thereby reduces the cost of compliance.
Van Horne takes a more critical view, maintaining that a new product or process
cannot be considered ‘truly’ innovative unless it makes the financial markets
operate more efficiently or makes them more complete. According to him,
financial markets are made more complete by the introduction of new securities
whose contingent after-tax cash flows cannot be replicated by any combinations of
existing securities.
The following are some of the factors which drive financial engineering:
• Reducing transaction costs
• Reducing agency costs
• Leveraging tax asymmetries
• Unbundling and reallocation of risks
• Enhancing liquidity
• Overcoming regulatory constraints
• Technological advances
• Advances in financial theory
• Arbitrage opportunities.
EVOLUTION OF INVESTMENT BANKING IN INDIA

The origin of Investment Banking in India can be traced back to the late 19th century
when European Merchant Banks set-up their agency houses in the country to assist
in the setting up of new projects. In the early 20th century, large business houses
followed suit by establishing managing agencies which acted as issue house for
securities, promoters for new projects and also provided finance to greenfield
ventures. The peculiar feature of these agencies was that their services were
restricted only to the companies of the group to which they belonged. A few small
brokers also started rendering Merchant Banking services, but their role was
limited due to their small capital base.
1 John D Finnerty: “Financial Engineering in Corporate Finance: An Overview”, l Financial Management, Vol,
17 No.4, Winter 1988, Page 14-33.
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Investment Banking
In 1967, ANZ Grindlays Bank set-up a separate Merchant Banking Division to

handle new capital issues. It was soon followed by CitiBank, which started
rendering Merchant Banking services. The foreign banks monopolized merchant
banking services in the country. The Banking Commission, in its report in 1972,
took note of this with concern and recommended setting up of merchant banking
institutions by commercial banks and financial institutions. State Bank of India
ventured into this business by starting a Merchant Banking Bureau in 1972. In
1973, ICICI became the first financial institution to offer Merchant Banking
services. JM Finance was set-up by Mr. Nimesh Kampani as an exclusive
Merchant Bank in 1973. The growth of the industry was very slow during this
period. By 1980, the number of Merchant Bankers rose to 33 and were set-up by
Commercial Banks, Financial Institutions and private sector. The industry
remained more or less stagnant in the eighties.
The capital market witnessed some buoyancy in the late eighties. The advent of
economic reforms in 1991 resulted in a sudden spurt in both the primary and
secondary market. Several new players entered into the field. The securities scam
in May, 1992 was a major setback to the industry. Several leading Merchant
Bankers, both in public and private sector were found to be involved in various
irregularities. Some of the prominent public sector players involved in the scam
were Canbank Financial Services, SBI Capital Markets, Andhra Bank Financial
Services, etc. Leading private sector players involved in the scam included
Fairgrowth Financial Services and Champaklal Investments and Finance (CIFCO).
The markets turned bullish again in the end of 1993 after the tainted shares
problems was substantially resolved. There was a phenomenal surge of activity in
the primary market. The registration norms with SEBI were quite liberal. The low
entry barriers coupled with lucrative opportunities lured many new entrants into
this industry. Most of the new entrants were undercapitalized entities with little or
no expertise in merchant banking. These players could hardly afford to be
discerning and started offering their services to all and sundry clients. The market
was soon flooded with poor quality paper issued by companies of dubious
credentials. The huge losses suffered by investors in these securities resulted in
total loss of confidence in the market. Most of the subsequent issues started failing
and companies started deferring their plans to access the primary market. Lack of
business resulted in a major shake-out in the industry. Most of the small firms
exited from the business. Many Foreign Investment Banks started entering Indian
markets. These firms had a huge capital base, global distribution capacity and
expertise. However, they were new to Indian markets and lacked local penetration.
Many of the top rung Indian Merchant Banks, who had strong domestic base, started
entering into joint ventures with the Foreign Investment Banks. This arrangement
resulted in synergies as their individual strengths complemented each other.
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Some of the successful tie-ups are:

• JM Finance-Morgan Stanley
• DSP Financial Consultants-Merrill Lynch
• Kotak Mahindra-Goldman Sachs
• Ind Global Fin Trust-Salomon Bros
• Creditcapital-Lazard Bros.
Some of the alliances failed due to cultural differences, varied aspirations of the
partners, etc. Some of the notable failures are:
• IDBI-Asian Capital Partners
• ICICI Securities-J P Morgan
• ITC Classic-Peregrine.
In India Merchant Bankers can be segregated as follows, depending on the sector
to which they belong:
i. Public Sector Merchant Bankers:
a. Commercial Banks
b. National Financial Institutions
c. State Financial Institutions
ii. Private Sector Merchant Bankers:
a. Foreign Banks
b. Indian Private Banks
c. Leasing Banks
d. Financial and Investment Companies.
The current status of the investment banking industry is in a state of flux. The
current transitionary phase is witnessing a paradigm shift in the nature and
composition of this industry. The industry was hitherto synonymous with issue
management and underwriting. Investment Bankers have started diversifying into
new functions (M&A), new products (risk management tools), new techniques
(securitization)and new markets (global).
The new order is resulting in the emergence of well capitalized Investment Banks
with a strong domestic franchise, sound skill base and global distribution reach.
CURRENT STATE OF INVESTMENT BANKING IN INDIA
INTERMEDIARIES ASSOCIATED WITH THE CAPITAL MARKETS
Primary Market Intermediaries
Investment Bankers: Investment bankers play an important role in issue
management process. Lead managers (Category I merchant bankers) have to
ensure correctness of the information furnished in the offer document. They have
to ensure compliance with SEBI rules and regulations as also Guidelines for
Disclosures and Investor Protection. To this effect, they are required to submit to
SEBI a due diligence certificate confirming that the disclosures made in the draft
prospectus or letter of offer are true, fair and adequate to enable the prospective
investors to make a well-informed investment decision. The role of merchant
bankers in performing their due diligence functions has become even more
254
Investment Banking
important with the strengthening of disclosure requirements and with SEBI giving
up the vetting of prospectuses. SEBI’s various operational guidelines issued during
the year to merchant bankers primarily addressed the need to enhance the standard
of disclosures.
It was felt that a further strengthening of the criteria for registration of merchant
bankers was necessary, primarily through an increase in the net worth
requirements, so that their capital would be commensurate with the level of
activities undertaken by them. With this in view, the net worth requirement for
Category I merchant bankers was raised in 1995-96 to Rs.5 crore. In 1996-97, the
SEBI (Merchant Bankers) Regulations, 1992 were amended to require the payment
of fees for each letter of offer or draft prospectus that is filed with SEBI.
Underwriters: Underwriters are required to register with SEBI in terms of the
SEBI (Underwriters) Rules and Regulations, 1993. In addition to underwriters
registered with SEBI in terms of these regulations, all registered merchant bankers
in categories I, II and III and stock-brokers and mutual funds registered with SEBI
can function as underwriters.
Bankers to an Issue: Scheduled banks acting as bankers to an issue are required
to be registered with SEBI in terms of the SEBI (Bankers to the Issue) Rules and
Regulations, 1994. These regulations lay down eligibility criteria for bankers to an
issue and require registrants to meet periodic reporting requirements.
Portfolio Managers: Portfolio managers are required to register with SEBI in
terms of the SEBI (Portfolio Managers) Rules and Regulations, 1993. The
registered portfolio managers exclusively carry on portfolio management
activities. In addition all merchant bankers in categories I and II can act as
portfolio managers with prior permission from SEBI.
Debenture Trustees: Debenture trustees are registered with SEBI in terms of the
SEBI (Debenture Trustees) Rules and Regulations, 1993. Since 1995-96, SEBI has
been monitoring the working of debenture trustees by calling for details regarding
compliance by issuers of the terms of the debenture trust deed, creation of security,
payment of interest, redemption of debentures and redressal of complaints of
debenture holders regarding non-receipt of interest/redemption proceeds on due
dates.
Registrars to an Issue and Share Transfer Agents: Registrars to an Issue (RTI)
and Share Transfer Agents (STA) are registered with SEBI in terms of the SEBI
(Registrar to the Issue and Share Transfer Agent) Rules and Regulations, 1993.
Under these regulations, registration commenced in 1993-94 and is granted under
two categories: Category I – to act as both registrar to the issue and share transfer
agent and Category II – to act as either registrar to an issue or share transfer agent.
With the setting up of the depository and the expansion of the network of
depositories, the traditional work of registrars is likely to undergo a change.
Secondary Market Intermediaries
Stock-brokers and Sub-brokers: All stock-brokers dealing in securities are
registered with SEBI in terms of SEBI (Stock-brokers and Sub-brokers)
Regulation 1992.
In many cases, individual investors transact in securities through sub-brokers. It is,
therefore, absolutely imperative to regulate this class of intermediary. The main
reason for the limited success in registering large number of sub-brokers is that
brokers are reluctant to take responsibility of the acts of the sub-brokers. Measures
initiated by SEBI for bringing sub-brokers more fully under the ambit of
regulatory oversight have been described earlier in this Report.
255
RECENT CHANGES IN REGULATORY FRAMEWORK

Recently, major changes were made in the registration process to strengthen and
streamline the regulatory role of SEBI.
Hitherto, most Investment Bankers were carrying on both fund based and fee
based activities. Fund based activities include leasing, hire purchase, bills
discounting, factoring, etc., whereas fee based activities consist of issue
management, underwriting, advisory services, etc. The losses in the fund based
activities resulted in erosion of net worth to levels below the minimum limits
prescribed by SEBI. Further, the fund based activities were regulated by Reserve
Bank of India while, the investment banking activity which is essentially fee based
is regulated by SEBI. This resulted in a single entity being regulated by two
different regulatory authorities for its operations. Therefore, it was decided to
segregate the activities to be regulated by RBI and SEBI to prevent dual
regulations on the operations of a single entity. With effect from 1st July, 1998, an
Investment Banker is disallowed from carrying on any business other than those
relating to the securities market. The new regulation stipulates that a merchant
banker has to discontinue fund based activities or the merchant banking operations
should be hived off to a separate company. The segregating of merchant banking
and fund based operations is expected to facilitate greater accountability and better
monitoring. This regulation is not applicable to banks and financial institutions
engaged in merchant banking.
Another major change was the abolition of the existing multiple categories of
Merchant Bankers. Henceforth there will only be a single uniform category, i.e.,
Merchant Banker. All the eligibility norms and rules applicable to the erstwhile
Category I Merchant Bankers are now applicable to all Merchant Bankers. The
Merchant Bankers in Categories II, III and IV were given time till 30th June, 1998
to upgrade themselves to the new norms. In case they fail to meet the new norms,
they would cease to function as Merchant Bankers. However, as a temporary
measure, Category II Merchant Bankers are allowed to carry on activities as
Portfolio Manager and Underwriter till the expiry of their current registration.
Category III Merchant Bankers are allowed to carry on activities as Underwriter
till the expiry of their current registration. Category IV Merchant Bankers are to
discontinue all their activities.
REGISTRATION WITH SEBI
Registration with SEBI is mandatory to carry the business of Investment Banking
in India. An application for grant of Certificate of Registration must be made to
SEBI in Form A. The applicant should comply with the following norms:
i. The applicant should be a body corporate.
ii. The applicant should not carry on any business other than those connected
with the securities market. (This norm is not applicable to Banks and
Financial Institutions).
iii. The applicant should have necessary infrastructure like office space,
equipment, manpower, etc.
iv. The applicant has at least 2 employees with prior experience in Merchant
Banking.
v. Any associate company, group company, subsidiary or interconnected
company of the applicant has not been registered as Investment Banker.
vi. The applicant should have a minimum net worth of Rs.5 crore.
vii. The applicant, its directors or principal officers should not have been
involved in securities scam.
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Investment Banking
viii. The applicant, its directors or principal officers should not have been
convicted for any offense involving moral turpitude or be found guilty of any
economic offense.
ix. The applicant should be a fit and proper person.
x. Every Merchant Banker shall pay a sum of Rs.5 lakh as registration fees at
the time of the grant of certificate by the board. A merchant banker to keep
registration in force shall pay renewal fee of Rs.2.5 lakh every three years
from the fourth year from the date of initial registration.
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After processing the application, SEBI will grant the Certificate of Registration.
The registration is valid for a period of 3 years. At the end of 3 years, the Merchant
Banker has to apply for renewal of registration. The Merchant Banker is required
to file half-yearly returns with SEBI, during the period of registration.
STRUCTURAL ANALYSIS OF INVESTMENT BANKING INDUSTRY
Every industry functions in an environment, which to a great extent, determines
the strategies to be adopted by it for survival. The term environment includes both
internal as well as external factors, such as the level of competition within the
industry, the level of technology used, government policy, etc., which could affect
its ability to function effectively. These forces and the interplay amongst them
constitute the structure of an industry.
Given the industry structure, competition in an industry has its basis in the
underlying economic structure and goes well beyond the behavior of its current
players.
In reviewing the influence of competitive settings, we have utilized the framework
developed by Michael Porter to examine competitive advantages enjoyed by the
Investment Banking Industry.
Five forces which determine collectively the profit potential of the industry and
are measured in terms of the long run return on invested capital are:
• Threat of entry
• Competition
• Pressure from substitute products
• Bargaining power of buyers
• Bargaining power of suppliers.
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THREAT OF ENTRY
New entrants into the industry may pose a threat to the existing players. Major
threats to entry into an industry depend on:
Entry Barriers
Barriers to entry may be because of:
• economies of scale
• product differentiation
• capital requirements
• switching costs
• access to distribution channels
• government policy
• relationships with customers
• efficiency of employees.
Economies of Scale: Investment Bankers are in the business of providing financial
intermediation service. This requires a team of good professionals well-equipped
with infrastructure facilities for research, distribution, etc. It is an expensive
proposition to build and sustain the skill base of the firm. The firm can justify the
investments in developing them and expenses to sustain them, only if the firm is
able to generate adequate number of deals. A new firm may not be able to match
an existing firm in terms of size and number of mandates.
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Product Differentiation: In Investment Banking Industry, product expertise on

both the issuing and investing side needs to be developed or acquired. Generally,
product differentiation is not very high, because the ultimate deal structure is
designed as per the advise of the client. The area where an Investment Banker can
make the difference, is in the execution of the deal. Though new financial
innovations also help a firm to differentiate from others, but they are easily
imitated in this industry.
For example, Videocon Leasing and Industrial Finance Ltd., introduced the
concept of Bought-Out Deal for the first time for raising capital for Patheja
Forgings Ltd., and later on many Investment Bankers followed it by raising money
for their clients through this route.
JM Financial has designed and executed several innovative deals. In 1979, JM
designed Fully Convertible Debentures (FCDs) for TISCO. It was also
instrumental in introducing Zero coupon FCDs in Mahindra & Mahindra’s issue,
Deep Discount Bonds for IDBI and ‘Triple Option Convertible Bonds’ in 1993 for
Reliance Petroleum. It is however difficult to differentiate between services
rendered by various Investment Banking outfits in India.
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Investment Banking
Capital Requirements: SEBI has fixed the minimum net worth norm at Rs.5 cr.
for Investment Bankers. The earlier norm of Rs.1 cr. was considered too low and
the market witnessed entry of several new players. SEBI was then forced to raise
the figure to Rs.5 cr. to make it an effective entry barrier. The capital of the
investment banker determines the quantum of underwriting exposure that he can
take. Further, the underwriter’s ability to accept devolvements is a function of his
capital.
Switching Costs: Switching costs are one-time costs incurred by the customer in
switching from one supplier to another. Investment Banking, basically being a
services industry, clients are free to choose the Investment Banker of their choice
depending on the services offered by them. There are absolutely no switching
costs. Hence this acts as a low entry barrier to new firms. If the new firms have got
the capacity to satisfy the client’s needs, innovate new products and customize
deal structures, they can easily attract clients of other firms.
Access to Distribution Channels: Existing firms have already built-up good
distribution channels and good customer relationships on a long-term basis which
might act as a major barrier to the new entrant.
For example, Public Sector Investment Bankers like Financial Institutions and
Nationalized Banks have very good retail network in India thus putting them at an
advantage.
After Indian Companies were allowed to tap Foreign Capital markets, Indian
Investment Bankers played only an advisory role, while the issues were lead
managed by Foreign Investment Bankers. Domestic Investment Bankers never had
distribution channel networks in foreign countries. In addition to that, they lacked
necessary expertise and reputation to compete with international players.
This is a major prerequisite for the industry and this definitely acts as a major
barrier to the entry of new firms.
Government Policy: The Investment Bankers have to be registered with SEBI and
no firm shall carry on any activity as an Investment Banker unless it holds a
certificate granted by the Board under the regulations of SEBI.
Relationships with Customers: It is the major asset of all existing Investment
Bankers. The reputation of the Investment Banker, the quality of services offered,
the research facilities developed by the organization, the human assets which a
Investment Banking firm has puts the existing firm in an advantageous position. In
order to compete with such an established firm, the new Investment Banking outfit
might experience all these as major barriers. Here the concept of relationship
management holds good.
Efficiency of Employees: All those working here are professionals with great
analytical abilities and their efficiency is going to increase with the increase in
experience. Ability to offer services effectively as a result of experience must also
be considered.
Hence, it can be concluded that entry barriers are very low in this industry.
COMPETITION
Competition based on factors such as prices, advertising, goodwill, product
innovations, customer services, after sales services, etc., also act as major entry
barriers to new firms.
A unique feature of this industry is the extent of ties among the investment banks
themselves. They share customers, work together, jointly underwrite deals, and
negotiate with each other in Mergers and Acquisitions transactions. However, the
investment banks compete for business from the same customer.
In India, only 25% of the Investment Bankers are active in issue management,
while rest are involved in underwriting. The smaller Investment Bankers usually
take care of issues of low size. Low entry barriers into the industry have led to the
mushrooming of Investment Banking outfits in India.
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PRESSURE FROM SUBSTITUTE PRODUCTS

Substitute products to issue management may be new innovations in the methods
of raising funds. For instance, companies might prefer privately placing the issue
instead of a public offering.
Previously, all the public issues were routed through regional stock exchanges. But
with establishment of Over The Counter Exchange of India in the year 1990 with a
facility for screen-based automated computerized trading system, it has acted as a
substitute to smaller public issues. In OTCEI, sponsors place the scrips with
members of OTC who will in turn offload the scrips to public thus reducing the
issue costs. So establishment of such exchanges like NSE, and OTCEI also will
act as substitutes to other stock exchanges.
BARGAINING POWER OF BUYERS
Here customers of Investment Bankers mainly include promoters on one side and
investors on the other side. The main job of Investment Banker is to act as an
intermediary between these two sides. In designing new instrument or executing
the public issue it has to keep in mind the requirements of promoters as well as of
the investors. The success of an Investment Banker or reputation of an Investment
Banker depends on the success of the issue. So, the most important attribute of an
Investment Banker is to have good expertise in his field of specialization and the
ability to know the pulse of the market and put together a deal.
Abolition of CCI resulted in free pricing, increasing the responsibility of the
Investment Banker. Investment Banker in consultation with the company will fix
up the premium on the issue. Hence, companies can have the option of
approaching that Investment Banker who will fix up maximum premium. But
considering the other customers i.e., Investors, Investment Bankers must fix up a
reasonable premium. Issues with unduly high premiums even if fully subscribed
perform badly later on, affecting the relations between Investment Bankers and
investors. So, Investment Bankers must try to balance between the two types of
customers.
BRAND EQUITY
In the above paragraph, it was explained that success of Investment Banker will
depend on the success of the issue. The vice versa is also true, i.e., in India,
success of issue may also be determined by the reputation of its lead manager.
Reputation is most important in this business. In a service business of unique
deals, the customer is not interested in purchasing a finished product that can be
inventoried, he wants perfect execution of the deal. So, in the process of selecting
an investment banker, he might look for quality service which takes the form of
‘quality people’ (skilled professionals), ‘Commitment to relationships’, ‘team
work’ and ‘Communication’. All these features help in differentiating two firms
and hence establishing an image for itself which can be termed as a major asset or
‘Brand Equity’ which is unique or exclusive to itself.
So, ultimately, it can be concluded that bargaining power of buyers is very high
because they are free to approach any Investment Banker who is ready to offer him
quality services.
BARGAINING POWER OF SUPPLIERS
Investment Banking industry being a service industry, no definite suppliers can be
identified as skills of professionals are utilized in the process. But persons who
support the Investment Banker in successful execution of the issue like registrars,
printers, advertisers, underwriters, bankers, legal advisors, etc., can be considered
as suppliers because without their co-operation and support the public issue cannot
see light.
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Investment Banking
People rendering these services are in large number in the market, hence
bargaining power of suppliers can be considered to be very less.
It can be concluded that Investment Banking Industry in India is characterized by
low entry barriers, high competition, high bargaining power of customers and
finally the success of the Merchant Banking firm depends on the relationships with
clients, image of the firms and quality of services offered.
SUMMARY
• Investment bankers act as intermediaries between the issuers of capital and
the ultimate investors who purchase the securities. Investment banker is a
person who is engaged in the business of issue management either by making
arrangements regarding selling, buying or subscribing to securities as
manager, consultant, advisor or rendering corporate advisory services in
relation to such issue management.
• The scope of investment banking in India covers: management of debt and
equity issues, placement and distribution of investment proposals, corporate
advisory services, project advisory services, loan syndication, venture capital
and mezzanine financing, mergers and acquisitions, divestitures of assets,
takeover defense activities and financial engineering.
• In order to control the trend of mushrooming investment bankers, SEBI came
up with stricter guidelines, like making the same rules for all classes of
investment bankers, increasing the net worth requirements and the fee
structure. This resulted in some control over the mushrooming trend of
fly-by-night operators in the capital markets.
• Entry barriers in the investment banking business are still low; competition is
high; pressure from substitute options is fast growing; bargaining power of
buyers (clients) is very high; and the bargaining power of suppliers
(investment bankers) is very low.
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•
• !
• "
Investment Banking
An Initial Public Offering (IPO) is the first public offer of securities by a company
since its inception. The security offered in an IPO is generally either equity or
convertible instrument. The decision to go public is a critical one as it results in
dilution of ownership stake and diffusion of corporate control. An IPO can be used
both as a financing strategy and exit strategy. In a financing strategy, the main
purpose of the IPO is to raise funds for the company. An IPO can be used as an
exit strategy when the existing investors offload their equity holdings to the public.
REASONS FOR GOING PUBLIC ISSUE

• Raising funds to finance capital expenditure programs like expansion,
diversification, modernization, etc;
• Financing of increased working capital requirements;
• Financing acquisitions like a manufacturing unit, brand acquisitions, tender
offers for shares of another firm, etc;
• Debt refinancing;
• Exit route for existing investors.
ADVANTAGES OF GOING PUBLIC ISSUE
• Facilitates future funding by means of subsequent public offerings;
• Enables valuation of the company;
• Provides liquidity to existing shares;
• Increases the visibility and reputation of the company;
• Commands better pricing than placement with few investors;
• Enables the company to offer its shares as purchase consideration or as an
exchange for the shares of another company.
DISADVANTAGES OF GOING PUBLIC ISSUE
• Dilution of ownership stake makes the company potentially vulnerable for
future takeovers;
• Involves substantial expenses ranging between 4% to 15% of the size of the
issue;
• Need to make continuous disclosures;
• Increased regulatory monitoring;
• Listing fees and documentation;
• Cost of maintaining investor relations;
• Takes substantial amount of management time and efforts.
MANAGEMENT OF PUBLIC ISSUES AND INITIAL PUBLIC

OFFERINGS
ELIGIBILITY NORMS FOR AN IPO
The companies issuing securities through an IPO should satisfy the following
conditions:
• The company intending to make a public issue of securities should file a draft
prospectus with the Board, through an eligible Investment Banker, at least
30 days prior to the filing of prospectus with the Registrar of companies.
• No listed company can make issue of securities through right issue in case
the aggregate value of securities (including premium), exceeds Rs.50 lakh,
provided the letter of offer is filed with Board, through an eligible Merchant
Banker, at least 30 days prior to the filing of the letter of offer with Regional
Stock Exchange.
263
• Any company prohibited from accessing the capital market under any order
or direction passed by the Board, should not make any issue of securities.
• The company should make an application for listing of its securities on the
stock exchange(s).
Getting Grading from Credit Rating Agencies
SEBI had made mandatory to get grading of IPOs from May 1, 2007. The grading
can be done by the SEBI-registered credit rating agencies include, Crisil, Care,
Icra and Fitch. This grading has to be done before submitting offer document to
SEBI.
PRE-ISSUE OBLIGATIONS
The company selects the Investment Banker(s) for handling the issue. The lead
investment banker should maintain a standard of due diligence that he would
satisfy himself about all the aspects of offering, veracity and adequacy of
disclosure in the offer documents. The investment banker is also liable even after
the completion of issue process. The lead investment banker should pay a requisite
fee in accordance with regulation 24A of the SEBI (Investment Bankers) Rules
and Regulations, 1992, along with draft offer document filed with the Board.
The following documents should be submitted along with the offer document by
the Lead Manager:
Memorandum of Understanding (MOU): The Lead Investment Banker has to
enter into an MOU with the issuer company specifying their mutual rights,
liabilities and obligations relating to the issue. The Lead Manager should ensure
that a copy of MOU entered into with the issuer company is submitted to the
Board along with the draft offer document.
Inter se Allocation of Responsibilities: If the public issue is managed by more
than one Investment Banker, the rights, obligations and responsibilities of each
Investment banker shall be demarcated in accordance with the activities/sub-
activities as follows:
a. Capital structuring with the relative components and formalities such as
composition of debt and equity type of instruments.
b. Drafting and design of the offer document and of advertisement/publicity
material and brochure/memorandum containing salient features of the offer
document.
c. The designated investment banker should ensure compliance with the
guidelines for disclosure and investor protection and other stipulated
requirements and completion of prescribed formalities with the stock
exchange, Registrar of companies and SEBI.
d. Formulating of marketing strategies, preparation of publicity budget,
arrangements for selection of (i) ad-media (ii) centers of holding conferences
of brokers, investors, etc., (iii) bankers to issue (iv) collection centers
(v) brokers to issue and (vi) underwriters. Deciding upon the underwriting
arrangement, distribution of issue material like application form, prospectus
and brochure is also a part of the marketing of the issues.
e. Selection of various agencies connected with the issue, namely the Registrars
to the Issue, printers and advertising agencies.
f. Follow-up with bankers to the issue to get quick estimates of collection and
advising the issuer about closure of issue, based on the correct figures.
Due Diligence Certificate: The lead investment banker should submit a due
diligence certificate certifying that all suggestions and observations made by
Board have been incorporated in the offer document. He should furnish a due
diligence certificate at the time of filing the prospectus with the registrar of
companies. He should also furnish a fresh certificate immediately before the
opening of the issue stating that no corrective action is needed and a fresh
certificate should also be submitted after the opening of the issue but before it
closes for subscription.
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Investment Banking
Undertaking: The issuer should submit an undertaking to the Board to effect the
transactions in securities by the ‘promoter’, the ‘promoter group’ and the
immediate relatives of the promoter during the period between the date of filing
the offer documents with the Registrar of Companies or Stock Exchanges and the
date of closure should be reported to the stock exchanges concerned within
24 hours of the transactions.
List of Promoter’s Group: The issuer should submit to the Board a list of persons
who constitute the promoter’s group and their individual shareholdings. He should
also submit the permanent Account Number, Bank Account Number and passport
number of the promoters to the stock exchanges on which securities are proposed
to be listed at the time of filing of draft offer document.
Appointment of Investment Bankers and Other Intermediaries
Along with the Investment Banker, other intermediaries are appointed who are
duly registered with the Board. The company first selects the Investment Banker(s)
for handling the issue. The Investment Banker should have a valid SEBI
registration to be eligible for appointment. The criteria normally used in selection
of the Investment Bankers are:
i. Past track record in successfully handling similar issues;
ii. Distribution network with institutional and individual investors;
iii. Trained manpower and skills for instrument designing and pricing;
iv. General reputation in the market;
v. Good rapport with other market intermediaries;
vi. Value added services like providing bridge loans against public issue
proceeds.
A Investment Banker can be associated with the issue in any of the following
capacities:
• Lead Manager to the issue;
• Co-manager to the issue;
• Underwriter to the issue;
• Advisor/Consultant to the issue.
SEBI has set certain limits on the maximum number of intermediaries associated
with the issue:
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Source: www.sebi.gov.in/acts/actogmaiss.html
The number of Co-managers cannot exceed the number of Lead Managers
appointed for that issue. There can be only one Advisor/Consultant to the issue.
There is no limit on the number of underwriters to the issue. An associate company
of the issuer company cannot be appointed either as Lead Manager or Co-manager
to the issue. However, they can be appointed as Underwriter or Advisor/Consultant
to the issue.
The Lead Investment Banker enters into a Memorandum of Understanding (MOU)
with the issuer company. The MOU specifies the mutual rights, liabilities and
obligations relating to the issue. The Lead Investment Banker has to ensure that a
copy of MOU is submitted to the Board along with the draft offer document.
265
In case of more than one Lead Manager is appointed, all the Lead Managers have a
meeting and the entire issue-related work is distributed among themselves. The
proceedings of the meeting are minuted and a statement is signed for allocation of
work. This agreement is called as ‘Inter se Allocation of Responsibilities.’
Once the Lead Manager(s) is/are appointed, the other intermediaries are appointed
in consultation with them. The selection of the intermediary is based on their past
track record, their ranking, infrastructure facilities, previous relationship with the
issuer company, fees charged, etc. The other intermediaries appointed are:
• Registrar to the Issue.
• Bankers to the Issue.
• Debenture Trustees (if applicable).
• Underwriters to the Issue.
• Brokers to the Issue.
• Advertising Agencies.
• Printers of Issue Stationery.
• Auditor.
• Legal Advisor to the Issue.
Before advising the issuer on the appointment of other intermediaries, the Lead
manager should independently assess the capability and capacity of various
intermediaries to carry out assignments. He should also ensure that issuer
companies enter into a memorandum of understanding with the intermediary(ies)
concerned whenever required.
Registrar to the Issue
Registration with SEBI is mandatory for acting as Registrar and Share Transfer
Agent. A Category I Registrar can act as both Registrar to the Issue and as a Share
Transfer Agent. A Category II Registrar can act either as Registrar to the Issue or
as a Share Transfer Agent (to be specified at the time of registration with SEBI).
The minimum net worth requirement is Rs.6 lakh for a Category I Registrar and
Rs.3 lakh for Category II Registrar. In addition to net worth requirement, SEBI
also looks at the infrastructure facilities before giving registration.
The promoter or director of the issuer company cannot act as a registrar to the
issue. If the number of applicants is more then the issuer company can appoint
more than one Registrar registered with the Board, in consultation with the Lead
Investment Banker. The registrar is solely responsible for the management of the
issue.
The Registrar provides administrative support to the issue process. The company
enters into an MOU with the Registrar to the Issue, which lays down the terms and
conditions of appointment. The main functions of the Registrar include:
• Assist the Lead Manager in selection of the Bankers to the Issue and the
Collection Centers;
• Assist the Lead Manager in devising application form (Form 2A) for various
categories of investors (separate application forms for NRIs, applicants in
reserved categories and general public), with particular reference to the
instructions to the applicants;
• Detailed instructions to the Collecting Branches about the procedure to be
followed and despatching of bank schedules;
• Collection of daily subscription figures from collecting branches and
reporting the same to the company and the Lead Manager;
• Arrange to collect application forms, bank schedules, collection certificate,
stock invests, etc., from the various collection centers;
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Investment Banking
• Verify and reconcile bank schedules and application forms;

• Data entry of the contents of all the application forms;
• Screen for invalid and multiple applications;
• Prepare the basis of allotment in consultation with the company, Lead
Manager and SEBI nominee (if applicable);
• Assist the Lead Manager in obtaining stock exchange approval for the basis
of allotment;
• Printing and despatch of refund orders, allotment advices and share
certificates, canceled stock invests;
• In case of allotment to NRIs, obtain RBI approval for export of share
certificates;
• Send stock invests of successful applicants for collection;
• Assisting the company in listing of the security on stock exchanges;
• Assist the company in computation and payment of underwriting commission
and brokerage;
• Redressal of investor grievances.
Bankers to the Issue
This was one capital market activity which lacked regulatory clarity for a long
time. The ambiguity arose, because it was unclear as to whether it was RBI or
SEBI which regulated public issue banking. An anomalous situation prevailed as
SEBI issued guidelines to the banks, while it had no means to ensure compliance
of the same. Though RBI had regulatory jurisdiction over the banks, compliance
with the provisions of the banking law and its own directives took precedence over
enforcement of SEBI guidelines. As a consequence, investors suffered from a
spate of irregularities involving refund orders, acceptance of late applications after
the closure of the issue, etc. The situation was set right, with the notification of
SEBI (Bankers to an Issue) Rules, 1994, by bringing issue banking under the
regulatory ambit of SEBI. Registration with SEBI is mandatory for offering
services as Banker to an issue. SEBI has also been given powers to suspend or
cancel the registration granted, in case of violations of its regulations and
guidelines. The entire thrust of the notification was to make the banks more
accountable and give the much needed transparency to the public issue related
operations of banks.
SEBI takes into account the following factors before granting Certificate of
Registration as Banker to an Issue:
• The bank should have adequate infrastructure, communication and data
processing facilities;
• The bank should have adequate competent manpower to effectively discharge
the obligations;
• The bank is a scheduled bank;
• The bank and its directors have not been involved in any irregularities in the
securities market and have not been convicted for any economic offenses.
There are no restrictions on the number of banks that can be associated with an
issue. Each Banker to the issue designates one particular branch as the Controlling
Branch. The other branches which act as collection centers are called as Collecting
Branches.
The main functions of the Collecting Branches are as follows:
• Receive the duly completed application forms along with the application
money;
• Sending the cheques and drafts for collection;
267
• Giving a daily report on the collection figures to the Registrar to the Issue;
• Transferring the proceeds to the share application money account maintained
by the Controlling Branch;
• Forwarding the duly completed Bank Schedule along with a Collection
Certificate, application forms and stock invests to the Registrar.
The Banker to the Issue also performs the following functions:
• Open the Share Application Money Account of the company. All the issue
proceeds are transferred only to this account. The company cannot withdraw
the money from this account till the entire process of allotment and listing is
completed.
• Issue of Certificate of final collection figures for meeting the minimum
subscription criterion;
• Refund of application money to unsuccessful applicants;
• Acceptance of money payable on allotment and on calls.
Debenture Trustees
The Debenture Trustees are required to obtain a Certificate of Registration from
SEBI. The SEBI (Debenture Trustee) Regulations, 1993 provides for the following
responsibilities for the debenture trustees:
• Call for periodical reports from the company;
• Inspection of records and accounts of the company and particularly the trust
property;
• Take possession of the trust property in accordance to the provisions of the
trust deed;
• Enforce security in the interest of the investors;
• Resolve grievances of debenture holders;
• Ensure that refund orders and debenture certificates are despatched on time;
• Ensure timely payment of interest and redemption of debentures;
• Exercise due diligence whether the assets of the company are sufficient and
adequate as security to discharge the dues to debenture holders;
• To ensure that the conversion is made in accordance to the terms of the issue;
• To ensure continuous listing of the debentures;
• To inform SEBI about any breach of the trust deed, listing agreement, any
other law or regulations by the company.
Underwriters to the Issue
The SEBI (Underwriters) Rules, 1993, define underwriting as “an agreement with
or without conditions to subscribe to the securities of a body corporate, when the
existing shareholders of such body corporate or the public do not subscribe to the
securities offered to them.” In other words, the underwriter agrees to subscribe a
specified number of securities in an issue, in the event of non-subscription of the
same. Thus, underwriting is in the nature of contingency planning in issue
management.
The lead managers should ensure that the underwriters are capable enough to
discharge their underwriting obligations. Usually the lead manager assesses the
capability of the underwriter to meet the underwriting obligations by looking at the
underwriter’s assets.
The following class of market participants can extend underwriting to an issue:
• SEBI registered Investment Bankers;
• Members of any Stock Exchange and holding SEBI registration;
• Registered as an Underwriter under SEBI (Underwriters) Rules, 1993.
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Investment Banking
An underwriter should have a minimum net worth of Rs.20 lakh and the total
outstanding underwriting obligation at any point of time cannot exceed 20 times
the underwriter’s net worth.
The underwriters are exposed to the risk of undersubscription and for assuming the
risk they are remunerated by underwriting commission. The underwriting
commission is payable on the issue price of the security, i.e., face value plus
premium. The maximum rate of underwriting commission payable is as under:
Underwriting an issue is optional and not mandatory. However, in case of
underwritten issues, the minimum underwriting commitment of the Lead Manager
shall be to the extent of 5% of the size of the offer or Rs.25 lakh, whichever is less.
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Brokers to the Issue

Any member of any recognized stock exchange can be appointed as Broker to the
Issue. Appointment of Brokers to the Issue is not mandatory as per SEBI
guidelines. The information regarding the brokers to the issue and the rate of
brokerage payable is to be mentioned in the prospectus. The brokers often appoint
sub-brokers to assist them in their work. They share the brokerage earned with
their sub-brokers. The Lead Manager and the issuer company are not concerned
with the sub-brokers. The main functions of the brokers to the issue are:
• Offer marketing support for the issue;
• Providing for distribution of issue stationery at the retail investor level;
• Disseminate information to the investors about the issue;
• Extend underwriting support to the issue;
• Provide advance market intelligence on the expected response to the issue.
Advertising Agencies
The success of many a public issue can be attributed to savvy advertising
campaign. The role of advertising agency is of crucial importance in determining
the fate of the issue. Normally, companies call upon various advertising agencies
asking them to make a presentation on their advertising and publicity strategy.
Based on their presentations and further consultations with the lead manager, the
advertising agency is selected. The main functions of the advertising agency are as
follows:
• Devising of advertising and publicity strategy;
• Designing and running the advertisement campaign;
• Designing the corporate brochure and publicity material;
• Drafting and distribution of press releases;
• Arranging press conferences and road shows;
• Maintaining media relations to ensure adequate press coverage for the issue;
• Arranging for hoardings, posters, banners, etc.
269
Printers of Issue Stationery

The printers are involved in the process of printing and distribution of issue-related
stationery. The primary criteria in selection of the printer are the cost factor and
the quality of service. The main functions of the printer are as follows:
• Layout and designing of the offer document;
• Designing of Form 2A (application form);
• Printing of offer documents, application forms, posters, brochures, etc.
• Distribution of issue stationery to stock exchanges, underwriters, brokers,
bankers, etc.
Auditor
The regular auditor of the company acts as the Auditor for the purpose of the
public offering. The auditor has to give the following certificates and report for the
issue:
• The Auditors’ Report along with the financial statements for inclusion in the
prospectus. The financial statements should be in the format prescribed in the
Part 2 of Schedule II of The Companies Act, 1956;
• The tax benefit report describing the tax implications of investing in the
proposed issue of securities;
• The Certificate stating that the promoters’ contribution has been brought in
before the opening of the issue;
• The Certificate stating that the entire amount of reservation on firm basis has
been brought in before the opening of the issue.
Legal Advisor to the Issue
The appointment of Legal Advisor is not mandatory under the law. However, legal
advisors are generally appointed to ensure compliance of all legal and regulatory
provisions related to the public offering. The main role of the Legal Advisor is as
follows:
• Ensure that the offer document is drawn up in accordance with the provisions
of The Companies Act, 1956, SEBI guidelines and other statutory provisions
relating to the issue of capital;
• Scrutinize the offer document to ensure that there is no legally incorrect
statement;
• Provide legal advice to the company on other legal matters related to the
public offering.
REGISTRATION OF THE OFFER DOCUMENT
Ten copies of the draft prospectus have to be filed with SEBI. The draft prospectus
has to be accompanied by the following:
• Due Diligence Certificate from the Lead Manager;
• Statement of Inter se Allocation of Responsibilities;
• Copy of the MOU between the company and the Lead Manager(s);
• Undertakings from the issuer company –
a. That the complaints received in respect of the issue would be attended
to expeditiously and satisfactorily;
b. That the company will get the instruments of the proposed issue listed
within the prescribed time period and would take necessary steps in
time for this purpose;
c. That the company would apply in advance for the listing of shares
which would be generated by the conversion of the debentures/bonds
(wherever applicable);
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Investment Banking
d. That the requisite funds for the purpose of despatching refund orders,
allotment advices and certificates by registered post, will be made
available to the Registrar to the Issue;
e. That the promoters’ contribution including premium (if any), in full,
will be brought in advance before the issue opens.
• A certificate from the Company Secretary of the issuer-company confirming
that:
a. All refund orders against the previous issues have been despatched to
the applicants;
b. All share/debenture certificates have been despatched to the allottees;
c. The instrument(s) have been listed on all the stock exchanges mentioned
in the concerned offer documents.
The registration fee payable to SEBI is as under:
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The draft prospectus filed will be treated as a public document. The Lead Manager
is also required to simultaneously file the draft prospectus with all the stock
exchanges where listing is proposed. SEBI makes a copy of the same available to
the public at its website http://www.sebi.gov.in on the internet. The Lead
Managers should furnish to the Board, an in-principle approval of the stock
exchanges for listing of the securities within 15 days of filing of the draft offer
document with the stock exchanges. SEBI also gives a weekly press statement of
the list of draft prospectuses filed with it. Though SEBI has given up vetting of
draft prospectuses, SEBI reserves the right to order any amendments to the draft
prospectus. SEBI would make the observations within 21 days from the date of
filing. In case no observations are received from SEBI within the stipulated period
of 21 days, the offer document is deemed to have been cleared by SEBI. Any person
can make a complaint to SEBI during the period of 21 days about any non-disclosure
or misstatements made in the draft prospectus. SEBI, in turn, would forward the
complaint to the Lead Manager. The Lead Manager is expected to exercise due
diligence about the authenticity of the complaint. In case the complaint is valid, the
Lead Manager would make appropriate amendments to the draft prospectus. In
case of false complaints, the matter would be informed to SEBI.
PROMOTER’S CONTRIBUTION
In case of unlisted companies, the promoters shall contribute not less than 20% of
the post-issue capital. The promoter’s shareholding for after offer for sale should
not be less than 20% of the post-issue capital. In case of public issues of a listed
company, the promoters can participate either to the extent of 20% of the proposed
issue or ensure post-issue shareholding to the extent of 20% of the post-issue
capital.
271
Securities not Eligible for Computation of Promoter’s Contribution

i. If the promoters of any company issuing securities acquire equity for
consideration other than cash during the preceding three years before filing
the offer documents and if it involves revaluation of assets or capitalization
of intangible assets, then such securities are not eligible for computation of
promoter’s contribution.
ii. Shares resulting from bonus issues out of revaluation reserves or reserves
without accrual of cash resources are not eligible for computation of
promoter’s contribution.
iii. In case of public issue by unlisted companies, securities, which have been
issued to the promoters during the preceding one year, at a price lower than
the price at which equity is being offered to public are not eligible for
computation of promoter’s contribution. If the difference between the offer
price and issue price of the shares is brought in by the promoters, then the
shares are considered eligible for computation of promoter’s contribution.
iv. In case of companies formed by the conversion of partnership firms and if there
is no change in the management, the shares allotted to the promoters during
previous one year out of the funds brought in during that period are not eligible
for computation of promoter’s contribution. If the partners’ capital existed in
the firm for a period of more than one year on a continuous basis, the shares
allotted to promoters against such capital are considered eligible.
v. If the shares, which are not eligible in the above four cases are acquired in
pursuance of a scheme of merger or amalgamation approved by a High Court
are eligible for computation of promoter’s contribution.
vi. The securities, which lack a specific written consent from the respective
shareholders for inclusion of their subscription in the minimum promoter’s
contribution subject to lock-in are not eligible for promoter’s contribution.
Lock-in Requirements: The minimum promoters’ contribution shall be locked-in
for a period of three years. In case the promoters’ contribution in the proposed
issue exceeds the minimum specified contribution, such excess contribution will
also attract lock-in for a period of one year. The lock-in period commences from
the date of allotment or from the date of commencement of commercial production
whichever is later.
The following class of shares issued to the promoters but not forming part of
promoters’ contribution are required to be locked-in for a period of three years:
• Shares issued for revaluation of assets or capitalization of intangible assets,
during the preceding three accounting years;
• Bonus shares issued out of revaluation reserves during the preceding three
accounting years;
• Shares issued at a price lower than the current issue price during the
preceding 12-month period.
The shares forming part of the promoters’ contribution and issued last will be
locked-in first. The specification of shares for lock-in will thus follow reverse
chronological order.
The following are the other provisions associated with lock-in requirement:
• Pledge of securities forming part of promoter’s contribution: Locked-in
securities held by promoters may be pledged only with banks or financial
institutions as collateral security for loans granted by such banks or financial
institutions, provided the pledge of shares is one of the terms of sanction of
the loan.
• Inter se transfer of securities amongst promoters: Transfer of locked-in
securities amongst promoters as named in the offer document can be made,
subject to the lock-in being applicable to the transferees for the remaining
period of lock-in.
• Inscription of non-transferability: The securities, which are subject to
lock-in, shall carry inscription “non-transferable” along with duration of
specified non-transferable period mentioned in the face of the security
certificate.
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Investment Banking
Mandatory Collection Centers

The minimum number of collection centers for an issue of capital shall be –
• The four metropolitan cities viz., Mumbai, Delhi, Kolkata and Chennai;
• At all such places where stock exchanges are located, in the region where the
registered office of the company is situated. For this purpose, the country has
been divided into 4 regions viz., Eastern, Northern, Southern and Western
region. The locations of stock exchanges in each of the regions are:
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SEBI Guidelines on Subscription

An issue should be kept open for a minimum period of three days and maximum
period of 10 days. The minimum size of application should be at least Rs.2,000.
The applicant is required to quote his Permanent Account Number (PAN) in the
application form. The minimum amount of application money should not be less
than 25% of the issue price. The balance can be made payable on allotment and on
calls. The market lot depends upon the issue price of the share. The details of the
same are as follows:
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The minimum subscription required for an issue is 90%. In case the issuer-
company fails to get the minimum subscription, including devolvements on the
underwriters, the entire issue amount should be refunded to the investors.
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Special Provisions for Issue of Debentures

The following additional provisions are applicable for issue of debentures:
• Credit rating is mandatory for any debenture issue where the redemption/
conversion period exceeds 18 months;
• Appointment of SEBI registered Debenture Trustee is mandatory if the
maturity period of the instrument exceeds 18 months;
273
• Creation of Debenture Redemption Reserve is mandatory if the maturity

period of the instrument exceeds 18 months;
• In case the non-convertible portion of the NCD/PCD is to be rolled over, a
compulsory option is to be given to the debentureholders to redeem and
encash their debentures;
• Any conversion of the whole or part of the debenture will be optional at the
instance of the debentureholder, if the conversion period exceeds 18 months;
• No issue of FCDs having conversion period exceeding 36 months unless
conversion is made optional with put and call options.
MARKETING OF THE ISSUES

The marketing strategy is a crucial factor in determining the success of the issue.
The various components of the strategy are:
i. Timing of the issue;
ii. Retail distribution;
iii. Reservations in the issue; and
iv. Advertising campaign.
TIMING OF THE ISSUE
The timing of the issue is of critical importance to ensure success of the issue.
Timing refers to the general sentiment prevailing in the market at the time of the
issue. It is extremely difficult in practice to determine the right time for the issue.
The decision regarding the timing is a futuristic decision as it involves predicting
the expected market sentiment during the time of the issue. There is no structured
process to determine the “appropriate” timing for the issue. The Lead Manager
normally depends upon the following factors to determine the issue timing:
• Prevailing market sentiments;
• Market forecasts by research reports of reputed outfits;
• Market intelligence about the expected response to the issue;
• Response to some of the recent public offerings in the primary market;
• Avoid clashing with mega-issues or major economic or political events like
budget, elections, etc.
RETAIL DISTRIBUTION
The retail distribution is an important success variable in an issue. Normally, the
retail distribution is done through a network of brokers. This involves identifying
the geographical area where the Lead Manager expects the subscription flows. The
brokers who have a strong distribution network in these areas are identified. The
brokers generally appoint the sub-brokers at various places. The sub-brokers
interact with the investors and procure subscriptions for the issue. The maximum
brokerage payable is 1.5% on the amount subscribed and allotted. The brokers are
free to pass on the whole or part of the brokerage to their sub-brokers.
The issuer company also conducts road shows at various places. Here the lead
manager accompanied by a team of senior officials of the companies holds a
conference. The high net worth investors, brokers and sub-brokers attend these
road shows. The team makes a presentation about the company and answers the
queries raised by the participants. Road shows give an opportunity for the
investors and the brokers to directly interact with the issuer company. The
following points are normally highlighted in the road shows:
• Past performance of the company;
• Promoters and their track record;
• Appraisal and funding by banks and financial institutions;
• Foreign collaboration, if any;
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Investment Banking
• Promoters stake in the company;

• Industry prospects;
• Current stage of project implementation;
• Special features like marketing tie-up, tax benefits, brand equity, patents
held, etc.
• Market price behavior in case of listed companies (not applicable to IPOs).
Some of the companies use direct mailers to market the issue. A database of target
investors is prepared. The application along with the prospectus is directly mailed
to the investors. Though the company incurs the cost of mailing, it can save on the
brokerage costs.
RESERVATIONS IN THE ISSUE
A portion of the issue can be reserved for specific class of investors. This helps in
pre-selling the issue and reduces the net offer to the public. The class of investors
to whom reservations can be made are as follows:
• Mutual funds;
• Banks and financial institutions;
• Non-resident Indians and Overseas Corporate Bodies1
• Foreign institutional investors;
• Employees;
• Group shareholders.
The following regulations have to be complied with regard to reservations in the
issue:
a. The Net Offer to the Public (total issue size less all reservations) should not
be less than 25% of the post-issue equity capital of the company.
b. Reservation for a single NRI/OCB cannot exceed 5% of the post-issue capital
and the total reservation for all NRIs and OCBs cannot exceed 10% of the
post-issue capital as per RBI guidelines.
c. Reservation for a single FII cannot exceed 5% of the post-issue capital and
the total reservation for all FIIs cannot exceed 10% of the post-issue capital.
d. The reservations for employees of the issuer company cannot exceed 10% of
the total size of the issue.
e. The reservations for group shareholders cannot exceed 10% of the total size
of the issue.
Reservation in a public issue can be either on firm basis or competitive basis. If the
amount is reserved for a specific investor, it is called as firm reservation. The
identity of the investor should be disclosed in the offer document. If the
reservation is made for a particular class of investors, it is called as reservation on
competitive basis. For example, reservation in an issue for Morgan Stanley Mutual
Fund or JM Mutual Fund is reservation on firm basis. If there is a reservation for
mutual funds in general without identifying a specific mutual fund, it is reservation
on competitive basis. In case of oversubscription in the competitive category, the
allotment to the various applicants in that category will be made on proportionate
basis. In case of undersubscription of the portion reserved on competitive basis,
the amount will be added to the net offer to the public. In case of
undersubscription of the portion reserved on firm basis, the amount has to be
brought in by the promoters with 3-year lock-in period.
1 An Overseas Corporate Body (OCB) is a foreign firm where at least 60% of the ownership stake is held
directly or indirectly by Non-resident Indians or an overseas trust in which at least 60% of the beneficial
interest is irrevocably held by such persons.
275
ADVERTISING CAMPAIGN
The main function of the advertising agencies is to give wide publicity to the issue.
The company decides on the size of the advertising budget in consultation with the
Lead Manager. Once this is decided the agency and the Lead Manager draw up a
publicity campaign. The common channels of publicity are:
• Advertisement insertions in the print media;
• Advertisements in audio-visual media viz., radio and television;
• Press releases and press conferences;
• Hoardings, banners and posters at important locations;
• Investor conferences.
The following advertisements have to be statutorily released:
i. Issue announcement advertisement at least 10 days before opening of the
issue. This advertisement contains an abridged version of the prospectus.
ii. Issue opening advertisement on the day of opening of the issue.
iii. Issue closing advertisement on the day of closing of the issue.
iv. The basis of allotment advertisement after finalizing of the allotment.
The following guidelines have to be observed with regard to issue advertisement:
• The advertisement shall not contain any information or language which is
extraneous to the prospectus;
• No models, celebrities, fictional characters, landmarks or caricatures shall be
displayed in any advertisement;
• The advertisement should not include any issue slogans or brand names for
the issue except the commercial brand names of its products;
• The advertisement shall not contain statements which promise or guarantee
rapid profits;
• No advertisement of the company, from 21 days of filing of the prospectus
with SEBI till the closure of the issue, shall be released without containing
the risk factors;
• The risk factors will be given equal prominence in all respects in relation to
the issue highlights;
• No advertisement stating that the issue is fully subscribed or oversubscribed
will be issued during the period when the issue is open for subscription;
• No announcement about the closing of the issue will be made, except on the
date of closure of the issue.
POST-ISSUE ACTIVITIES
This section deals with explaining the post-issue activities. Post-issue activities
commence with the collection of subscription figures and go on till the securities
are listed on the stock exchange.
PRINCIPLES OF ALLOTMENT
The post-issue work starts with the closure of subscription lists. Within three days
of closure of the issue, the investment banker is required to inform the SEBI
whether the issue is subscribed to at least 90 percent of the amount in the 3-day
Provisional Report. If the issue is not subscribed up to 90 percent, underwriters
should bring in the shortfall amount within 60 days after the closure of the issue.
On receipt of applications from collecting banks, the registrar’s duty would then be
to determine the number of successful applicants. The registrar to the issue would
scrutinize all applications to check for multiple applications and rejections, to see
whether the application is complete in all respects.
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Investment Banking
Issue processing involves:

• Report collection figures
• Collect applications from bank branches
• Receive applications, bank schedules and final certificates
• Reconcile application and bank schedules
• Data entry of the details of the applicants
• Reconcile the total figures, update corrections, check for multiple
applications, etc.
• Reconcile consolidated final certificates
• Identify and separate invalid applications
• Segregate applications category-wise
• Prepare the basis of allotment
• Obtain approval of the stock exchange
• Separate allottees and non-allottees
• Sort out stock invests and send them for collection
• Print refund orders, allotment notices, share certificates
• Dispatch the refund orders
• For NRIs, obtain endorsement along with FCIR certificates and forward to RBI
• Obtain RBI approval for export of share certificates
• Prepare register of successful stock invest applicants
• Process, verify and print underwriting and brokerage pay orders together with
detailed brokerage statements
• File return of allotment with ROC.
The share applications are then grouped category-wise and the relevant details are
fed into the computer. The Stock Exchange Division of the Ministry of Finance
instructs issuers to adopt the following procedure to ensure uniformity. All valid
applications are segregated on the basis of number of shares applied for. The
applications are then given distinct serial numbers. This is done for each group.
The printed serial number on the application is inverted and arranged in a
serial order. Normally, the application number should have six digits. If it has
less than six digits, zeros are added to make it six. This order is used for
drawing lots. A catalogued list containing the revised serial numbers, the inverted
application numbers, the original application numbers and the serial numbers
given by the bank are prepared.
In the case of oversubscription, the basis of allotment should be finalized in
consultation with the Regional Stock Exchange. A SEBI nominated public
representative is associated in the process of finalization of the basis of allotment
when par issues are oversubscribed more than 5 times and premium issues are
subscribed more than 2 times.
BASIS OF ALLOTMENT
In a public issue, the Executive Director/Managing Director of the Regional Stock
Exchange along with the post-issue lead Investment banker and Registrar to the
issue are responsible to ensure that the basis of allotment is finalized in a fair and
proper manner.
The company should hold a board meeting to pass the resolution regarding the
allotment of shares. The Register of members is then prepared giving the details of
shareholders of the company. The Registrar then dispatches certificate of
allotment/refund orders. The company should then file a Return of Allotments
with the Registrar of Companies within 30 days from the date of allotment.
277
The proportionate allotment of shares is followed in order to ensure that the

allotment procedure is fair and unconditional and further, it would not result in an
undue concentration of shares in the hands of a few investors.
Procedure for Proportionate Allotment
The following procedure is followed to allot the shares on a proportionate basis:
i. The applicants are categorized according to the number of shares applied for.
ii. The total number of shares to be allotted to each category as a whole is
arrived at on a proportionate basis, i.e., the total number of shares applied for
in that category (number of applicants in the category x number of shares
applied for) multiplied by the inverse of the oversubscription ratio.
iii. Number of shares allotted to the successful allottees is also arrived at on a
proportionate basis, i.e., total number of shares applied for by each applicant
in that category multiplied by the oversubscription ratio.
iv. All the applications where the proportionate allotment works out to be less
than 100 shares per applicant, the allotment is made as follows.
a. Each successful applicant is allotted a minimum of 100 securities and
b. The successful applicants out of the total applicants for that category are
determined by drawal of lots in such a manner that the total number of
shares allotted in that category is equal to the number of shares worked
out as per (2) above.
v. If the proportionate allotment to an applicant works to a number that is more
than 100 but not a multiple of 100 (which is the marketable lot), the number
in excess of the multiple of 100 is rounded off to the higher multiple of 100 if
that number is 50 or higher.
vi. If that number is lower than 50, it is rounded off to the lower multiple of 100.
For example, if the proportionate allotment works out to be 250, the
applicant is allotted 300 shares. If the proportionate allotment works out to be
240, the applicant is allotted 200 shares.
vii. All applicants in such categories are allotted shares arrived after such
rounding off.
viii. If the shares allocated on a proportionate basis to any category are more than
the shares allotted to the applicants in that category, the balance available
shares for allotment is first adjudged against any other category, where
allocated shares are not sufficient for proportionate allotment to the sufficient
applicants in that category.
ix. The balance shares if any, remaining after such adjustment are added to the
category comprising applicants applying for minimum number of shares.
x. As the process of rounding off to the nearest multiple of 100 may result in the
actual allocation being higher than the shares offered, it is sometimes
necessary to allow a 10% margin i.e. the final allotment may be higher by
10 percent of the net offer to public.
Reservation for Small Investors
The proportionate allotment of securities in an issue that is oversubscribed is
subject to the reservation for small individual investors, which is as follows:
A minimum of 50% of the net offer to the public is initially made available for
allotment to individual applicants who have applied for allotment equal to or less
than 10 marketable lots of securities.
The balance net offer of the securities to public is made available for allotment to:
i. individual applicants who have applied for allotment of more than
10 marketable lots of securities offered, and
ii. other investors including corporate bodies/institutions irrespective of the
number of shares applied for.
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Investment Banking
The unsubscribed portion of the net offer to any categories mentioned above is
made available for allotment to applicants in the other category.
Note: If the category of individual applicants up to 10 marketable lots is entitled to
get 70% of the net public offer in accordance with the proportionate
formula, the category gets 70%, but if the category is entitled to get only
30% of the public offer in accordance with the proportionate allotment
formula, there should be a reservation of a minimum of 50% of the net offer
to the public.
In case of public issues by unlisted companies, at least 10% of the securities issued
by each company is offered to the public only if a minimum twenty lakh securities
are offered to the public.
The Issuer Company can make reservations and firm allotments to various
categories of persons. The reservation is on a competitive basis where the
allotment of shares is made in proportion to the shares applied for by the
concerned reserved categories. Reservation on a competitive basis can be made in
a public issue to the following category of persons:
• Permanent employees of the company and in the case of a new company the
permanent employees of the promoting companies.
• Shareholders of the promoting companies in the case of a new company and
shareholders of group companies in the case of existing company.
• Indian mutual funds.
• Foreign institutional investors.
• Indian multilateral developmental institutions.
• Scheduled banks.
Specified categories for firm allotment is made to the following categories:
• Indian and multilateral developmental financial institutions.
• Indian mutual funds.
• Foreign institutional investors.
• Permanent/regular employees of the Issuer company.
• Scheduled banks.
Illustration 1
In case of an oversubscription, the procedure for proportionate allotment of shares
is explained below:
• Size of the public offer made through the prospectus – Rs.7 crore
• Shares reserved and subscribed on firm basis – Rs.3.5 crore
• Thus, the net offer to the public is Rs.3.5 crore (i.e. Rs.7 crore – Rs.3.5 crore)
Subscription as multiple of the entire net offer to the public – 3 times.
This implies that the total subscription received is for Rs.10.5 crore (Rs.3.5 crore x 3)
Step 1: Applicants will be categorized according to the number of shares
applied for (columns 1 and 2).
Step 2: Calculate the total number of shares applied for, by that category and
the overall applications received for 1000 and less shares (column 3).
Now, according to SEBI’s guidelines 50 percent of the net offer to the
public should be reserved for applications of up to 1000 shares. In this
particular issue Rs.1.75 crore (50 percent of Rs.3.5 crore) will have to
be reserved to the small investor. The total applications received from
this class of investors is Rs.15.48 crore. Thus, the oversubscription ratio
for this category of investors is 8.8457142 (15.48/1.75).
279
Step 3: Calculate the proportionate shares that can be allotted to each category
of applicants (column 4). This can be obtained by multiplying the total
shares applied for each category i.e., column 3, by the inverse of the
oversubscription ratio.
Step 4: Calculate the shares that are to be allotted per applicant (column 5).
This time the number of shares applied in each category i.e., column 1
has to multiplied by the inverse of the oversubscription rate. The value
obtained here has to be rounded off to the nearest hundred. Since the
minimum shares that can be allotted is 100, any value that falls below
100 has to be rounded to 100.
Step 5: After finding the proportionate number of shares and the proportionate
number of applicants, shares will be allotted by adjusting the surplus
and deficit. In this particular case, the number of shares applied by the
900 and 1,000 category of applicants is less than the proportionate
allotted shares. This surplus is allotted to that category applying for the
least number of shares i.e. 100 category. Thus, the surplus of 923 shares
(8,140 – 8,000; 6,783 – 6,000) will be added to the 100 category.
Applications received category-wise for 1,000 and less shares and the
proportionate allotment of shares is as follows:
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DEALING WITH UNDERSUBSCRIPTION

If the issue is not subscribed to the extent of 90 percent, the company was earlier
forced to refund the subscription amount. This 90 percent also includes the
subscription from underwriters if the issue was underwritten and the subscriptions
from the promoters in case of non-underwritten issues. Each underwriter agrees to
guarantee a portion of the public issue for which an underwriting fee is paid. If the
issue is not fully subscribed, underwriters are obligated to take up the unsubscribed
portion. For arriving at the amount to be taken up by the underwriters, the amount
received from successful applicants which bear the stamp of underwriter shall be
excluded. The exact amount is calculated by computing the shortfall between the
amount committed and the amount procured. Underwriting of primary issues is no
longer compulsory.
280
Investment Banking
The following illustration explains the procedure for ascertaining the underwriters
liability in case of undersubscription:
Gamma Limited issued 25,00,000 equity shares of Rs.10 each at par. The issue
was fully underwritten by Alpha – 40%, Beta – 40% and Zeta – 20%.
Applications were received for 24,00,000 equity shares. The marking on the
applications were as follows:
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6 C ?2 2
D C 2 2
Determine the underwriters’ liability.
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. 0 //% 2 2 ?2 2 2 2 2 2
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D
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Liability is to be met by Zeta for 1,00,000 shares or Rs.10,00,000.
Post-Issue Activities
Once the lead investment banker is through with the formalities of the subscription,
he submits the post-issue monitoring reports within 3 days from the due dates. The
due date for the 3-day post-issue monitoring report is the 3rd day from the date of
closure of subscription of the issue and for the 78-day post-issue monitoring report, it
is the 78th day from the date of closure of subscription of the issue.
The post-issue lead investment banker actively associates himself with post-issue
activities like allotment, refund and dispatch and regularly monitors redressal of
investor grievances. The post-issue lead investment banker also maintains close
coordination with the registrars to the issue and arranges to depute its officers to
offices of various intermediaries at regular intervals after the closure of the issue in
order to monitor the flow of applications from collecting bank branches,
processing of the applications including those accompanied by stock invest and
other matters till the basis of allotment is finalized.
Stock Invest
The lead investment banker ensures compliance with the instructions issued by the
RBI on handling of stock invest by any person including the Registrar.
The lead investment banker should satisfy himself that the issue is fully subscribed
before announcing the closure of the issue. If there is any devolvement on
underwriters, the lead investment banker ensures that the underwriters honor their
commitments within 60 days from the date of closure of the issue. In case of
unsubscribed issues, the lead investment banker furnishes information in respect
of the underwriters who have failed to meet their underwriting devolvements in a
281
specified format. The post-issue lead investment banker also ensures that the
money received from the issue is kept in a separate bank. The lead investment
banker makes an advertisement of the issue mentioning about the oversubscription,
basis of allotment, number, value and percentage of applications received along
with stock invest, number, value and percentage of successful allottees who have
applied through stock invest, date of completion of despatch of refund orders, date
of despatch of certificates and date of filing of listing application in one national
English daily, one Hindi daily and a regional newspaper where the office of the
issuer company is situated.
The lead investment banker makes an advertisement stating that the subscription is
closed only after the closure of the issue.
Capital Structure
For the purposes of presentation of the capital structure in the specified format, the
lead manager takes the following into consideration:
a. Proposed issue amount = (Promoters’ contribution in the proposed issue)
+ (Firm allotment)
+ (Offer through the offer document).
b. Offer through the offer document includes net offer to the public and
reservations to the permitted reserved categories and does not include the
promoters’ contribution in the proposed issue.
c. Net offer to public means the offer made to the Indian public and does not
include reservations/firm allotments/promoters’ contribution in the proposed
issue.
Share Buy-back
Many large companies usually go for buy-back of their outstanding equity capital
through open offers in the market.
The five most commonly cited reasons to set-up a share repurchase program are:
i. To increase share price. This is often a strategy that management adopts
when it believes the company’s stock is undervalued by market analysts.
ii. To rationalize the company’s capital structure. In this case, a share
repurchase program allows the company to sustain a higher debt-equity ratio.
iii. To substitute share repurchases for cash dividend pay-outs. Since capital
gains may be taxed at lower rates than dividend income, a share repurchase
program offers long-term shareholders some major tax advantages.
iv. To prevent dilution of earnings. Share repurchases can enhance a company’s
growth in earnings per share, or conversely, it can prevent an EPS decrease
that may be caused by exercises of stock option grants.
v. To deploy excess cash flow. Stock buy-backs can be attractive alternative
investments for any cash flow left over once the company has met its capital
investment needs.
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282
Investment Banking
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Penalties to Investment Bankers for Defaults
SEBI has prescribed various penalties for non-compliance of the provisions,
contravention of rules and regulations and wrong-doings. The following are the
penalty points awarded for various types of default:
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< %
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A investment banker accumulating 8 points on this scale may have his
authorization canceled or be suspended. In case of multiple Investment bankers,
the penalty may be awarded to all of them jointly.
The above-mentioned defaults have been explained as under:
i. General Default: General default involves mostly the following types of
discrepancies:
• Not sending the draft prospectus/offer letter to SEBI before filing with
the ROC/Stock Exchange.
• Non-disclosure to SEBI of allocation of responsibilities to the lead
managers before the opening of the issue.
• Non-receipt of the due diligence certificate by SEBI before the opening
of the issue.
• Non-submission of the certificate of 90% subscription to SEBI.
• Non-publication of the dispatch of refund orders, certificates, etc.
283
ii. Minor Default: The following are the faults that may be charged under
minor defaults:
• Publication of information in the advertisements and other printed
matter that does not conform with the prospectus.
• Exaggeration of information about the issue in press conferences and
other meets.
• Failure to substantiate matters contained in highlights to the issue in the
prospectus.
• Violation of government regulations on advertisements on capital issues.
• No due diligence in the verification of the matter contained in the
prospectus.
• Failure to provide adequate information to the investors or about the
risk factors of the company or its business.
• Delay in refund/allotment of shares.
• Investor grievances not handled properly.
iii. Major Default: Major defaults are the following:
• Mandatory underwriting not undertaken by the lead managers.
• Number of lead managers in excess of the prescribed numbers.
• Any unauthorized Investment bankers linked to the issue.
iv. Serious Defaults: The following are the serious defaults as per SEBI:
• Resorting to unethical practices.
• Non-cooperation with SEBI in furnishing the required information.
Instrument Designing and Pricing
Issue of securities involves effective channelizing of savings towards investment
in corporate paper and enlisting the same on Stock Exchanges to provide liquidity.
The Indian capital market is becoming increasingly discerning and the dexterity of
the Investment banker in capital structuring, instrument designing and pricing is
assuming critical importance in determining the success of the issue.
Capital Structuring
The capital structure is to be designed so as to integrate well with the financial
goals at the corporate level. The objective of a business enterprise is to enhance the
wealth of its owners. In case of a company it is accomplished through payment of
dividends and appreciation in the value of its shares. While the quantum of
dividend is determined by the company itself, it does not exercise any direct
control over the market valuation of its shares. Therefore, the financial structure
should be designed with the aim of maximizing the market valuation of the firm in
the long run.
The important determinants in designing of capital structure are:
i. Type of Asset Financed: Ideally short-term liabilities should be used to
create short-term assets and long-term liabilities for long-term assets.
Otherwise, mismatch develops between the time to extinguish the liability
and the assets generating returns. This mismatch may introduce elements of
risks like interest rate movements and market receptivity at the time of
refinancing.
ii. Nature of the Industry: A firm generally relies more on long-term debt and
equity if its capital intensity is high. All short-term assets need not be
financed by short-term debt. In a non-seasonal and non cyclical business,
investments in current assets assume the characteristics of fixed assets and
hence need to be financed by long-term liabilities. If the business is seasonal
in nature, the funding needs at seasonal peaks may be financed by short-term
debt. The risk of financial leverage increases for businesses subject to large
cyclical variations. These businesses need capital structures that can buffer
the risks associated with such swings.
284
Investment Banking
iii. Degree of Competition: A business characterized by intense competition

and low entry barriers faces greater risk of earnings fluctuations. The risks of
fluctuating earnings can be partially hedged by placing more weightage for
equity financing. Reductions in the levels of competition and higher entry
barriers decrease the volatility of the earnings stream and present an
opportunity to safety and profitably increase the financial leverage.
iv. Obsolescence: The key factors that lead to technological obsolescence
should be identified and properly assessed. Obsolescence can occur in
products, manufacturing processes, material components and even marketing.
Financial maneuverability is at a premium during times of crisis triggered by
obsolescence. Excessive leverage can limit the firm’s ability to respond to
such crisis. If the chances of obsolescence are high, the capital structure
should be built conservatively.
v. Product Life Cycle: At the venture stage, the risks are high. Therefore
equity, being risk capital perse, is usually the primary source of finance. The
venture cannot assume additional risks associated with financial leverage.
During the growth stage, the risk of failure decreases and the emphasis shifts
to financing growth. Rapid growth generally signals significant investment
needs and requires huge sums of capital to fuel growth. This may entail large
doses of debt and periodic induction of additional equity capital. As growth
slows, seasonality and cyclicality become more apparent. As the business
reaches maturation stage, leverage is likely to decline as cash flows
accelerate.
vi. Financial Policy: Designing an optimum capital structure should be done in
response to overall financial policy of the firm. The management may have
evolved certain financial policies like maximum debt equity ratio, targeting
or maintaining of certain credit rating, predetermined dividend pay-out, etc.
Designing of capital structure will become subservient to such constraints
and the solution provided may be sub-optimal.
vii. Past and Current Capital Structure: The proposed capital structure is often
determined by past events. Prior financing decisions, acquisitions, investment
decisions, etc., create conditions which may be difficult to change in the short
run. However, in the medium to long-term, capital structure can be changed
by issuing or retiring debt, issuing equity, equity buy-backs securitization,
altering dividend policies, changing asset turnover, etc.
TYPES OF INSTRUMENTS
Designing the Instrument
The abolition of the office of Controller of Capital Issues resulted in removal of all
statutory restrictions on the design of new financial instruments. A wide array of
financial instruments designed for varying risk-reward levels and liquidity
preferences have been developed. Designing of financial products call for exacting
skills in financial engineering. The limitations imposed by the legal framework
have also to be taken into consideration.
There are various factors that influence the choice of instrument decision, a few of
which are listed below:
i. Purpose of the Offer: While designing an issue, the purpose for which the
issue is made will largely determine the type of security to be used. Tangible
assets are more readily financed by debt, while growth opportunities which
involve intangible assets such as intellectual property rights are better
financed with equity.
ii. Debt Servicing: The choice of security issued is also dictated by the ability
of the firm to service periodic payments for interest and principal for debt
securities. While debt securities help in leveraging the firm’s earnings per
share, it also entails the additional financial risk of not being able to meet
285
future obligations. The existence of excess debt capacity in the firm will
favor debt as suitable, other things being constant. The lead manager should
weigh the pros and cons before deciding on the selection of the security.
iii. Tax Considerations: The tax implications to the issuer and the investor
should be examined. The implications vary depending on the nature of the
instrument. In case of debt instruments, the amount of interest paid is tax-
deductible to the issuer. However, the amount of interest received is taxable
in the hands of the investor. In case of equity, no tax deduction for the
amount of dividend paid is available to the issuer. On the other hand, the
issuer has to pay a special dividend tax on the amount distributed as
dividends. However, the dividends are totally tax free in the hands of the
investor. If the investor sells the security at a profit, after holding it for a
period exceeding 12 months, the profit is treated as long-term capital gains
and is taxed at lower rates. In case, the holding period is less than 12 months,
it will be treated as short-term capital gains and taxed at higher rates.
iv. Credit Rating: The riskiness of the firm also has an impact on the
debt/equity choice. Firms whose debt issues have high ratings will be able to
borrow at a lower interest cost. Such firms may also be able to price
favorably their equity issues. The best alternative would be based on the
precise impact of the choice of debt/equity on the firm’s projected EPS and
its effect on expected stock price.
v. Asset Cover: Lenders of debt normally insist on adequate security. Debt
securities, secured and backed by tangible assets are more attractive to
lenders. Debenture/bond trustees often indicate the minimum asset cover.
Therefore, companies without adequate asset cover are forced to issue equity.
vi. Dilution of Ownership: Equity offers dilute the ownership control of the
promoter group. Companies susceptible to takeover threats prefer issuing
debt to equity.
INNOVATIONS IN FINANCIAL INSTRUMENTS
In the recent past, there have been innovations in the financial instruments witnessed
by the Indian capital market, owing mainly to the liberalization measures.
Zero Coupon Bonds and Cash Pay Bonds: Cash Pay Bonds are simple debt
instruments, which pay interest in cash. On the other hand, the Zero Coupon
Bonds, as the name suggests, have no coupons attached to them. They are issued at
a deep discount and redeemed at par. Hence, the difference between the two is the
return to the investor. The companies in an early stage of growth but with a sound
business plan should prefer ZCBs. The companies, by issuing ZCBs, successfully
avoid any additional burden on their profit by not having to pay interest and they
utilize the funds raised for capital investment. Subsequently, when the date of
maturity of the bonds approaches, the revenue stream of the company absorbs the
cash outflow. The Zero Coupon Bonds (often called the Deep Discount Bonds) are
appropriate for growth companies or start-ups like those in the Telecommunication
industry or in the Biotechnology sector which may not have a sound stream of
revenue at present but boast of a bright future.
Secured Premium Notes: SPNs are issued at face value and do not carry any
interest. They are redeemed by repayment in a series of installments at a premium
over the face value. The premium amount is distributed equally over the period of
maturity of the installment. SPN’s may also be issued with a detachable warrant
which may be converted into share(s) for cash after a certain period. They are
secured by mortgage on all immovable properties of the company. Example,
SPN’s were used by TISCO in June, 1992.
Deep Discount Bonds: These bonds are sold at a large discount on their face value
and mature at par value. There are no interest payments and investors obtain their
return as accretion to the par value of the instrument over its life. The advantage to
the issuer is that it does not entail any cash outflow till the time of redemption.
286
Investment Banking
This instrument is similar to ZCB described above. However, the term of this
instrument is usually around 20 to 25 years and it provides an option to the
investor to exit say at the end of 5 years, 10 years, etc. Financial Institutions
regularly tap the market with this instrument, which is in the nature of unsecured
bond.
Optionally Convertible Debentures: These debentures carry a predetermined
coupon and have a stated tenure. The debenture can either be redeemed or be
converted into equity shares on maturity. The option for conversion or redemption
is vested with the investor.
Third Party Convertible Debentures: In the third party convertible debt, a warrant
is issued with the debt, which allows the investor to subscribe to the equity shares
of another company. Normally, the equity, which the investor is entitled to, is that
of one of the established names in the group companies to which, the original debt
issuer belongs. This method is useful for a start up to mobilize large amounts of
debt to undertake a capital-intensive project. The issuer in this case makes use of
the market reputation of the group company. If the company whose shares are
being allotted against warrants is a company with a good credit standing the
issuing company would not have difficulty in coming up with a successful issue.
This process of fund raising is appropriate for a small company with a perfect
business plan and enjoying the reputation of being a part of a bigger group. Again
the question of paying back the debt raised to the investor does not arise. However,
such kind of an arrangement depends on the relationship of the start-up with the
other company. Normally, this kind of a facility is possible when an established
company forms a subsidiary with an objective of streamlining the value chain and
hence helps the start-up with all kinds of support, including the third party debt-
equity swap. For example, established business groups who wish to set up
subsidiary in the fields of internet technology or tap the potential of the
biotechnology sector would find such an avenue handy.
Zero Coupon Convertible Note or LYONS: This is a Zero Coupon Bond, which is
convertible into the common stock of the issuer. If the investors of such securities
choose to convert, they have to forgo all accrued and unpaid part of the interest.
Issuance of this stock helps the issuer to take advantage of the convertible debt
without too much dilution of the common stock. The issuer gets tax advantage
even if he is not paying any interest till maturity, as according to US laws,
provisions made for the difference between the issue price and the fair value is
considered as expenses for tax purposes. The issuer has to look at the reaction of
the investor, because if the underlying stock (against which, the debt has been
issued) fails to appreciate, the investor would demand interest for the period of
holding. If the investor chooses to convert, the company will have to pay
dividends. By issuing such an instrument, the company earns a lump sum in the
initial period for which, it does not have to meet any immediate outflow of
interest. The funds so raised from the initial offer may be utilized for a project, the
duration of which should tally with the period of maturity of the bond. When the
cash flow from the project starts coming in, such cash inflows should be utilized
for the payment of the principal if the investor so desires. Issue of such instrument
would be successful for a large company with a higher credit rating. The investors’
confidence in these kinds of cases are of great significance as the investor risks his
money for nothing in return for a certain period and assumes the interest rate risk
as the price of the ZCBs are more sensitive to the interest rate movements than the
normal bonds with periodic distribution of interest. Therefore, a company with a
huge requirements of fund, a capital intensive project, a continuous track of
profitability and a good practice of corporate governance would be able to attract
funds through this route.
287
Tax Saving Bonds: The investor in these bonds is entitled to certain tax shields.
The issuer can, therefore, offer lesser coupon on these bonds. The issue of such
bonds require the prior approval of the Central Board of Direct Taxes (CBDT). For
example, the interest earned on these bonds may be deductible under Section 80L.
Some bonds provide for exemption from Capital Gains Tax under Section 54EA
and Section 54EB, if such amount is invested in these approved bonds.
Cumulative Convertible Preference Shares (CCPS): CCPS are similar to
convertible bonds in the sense that both are eventually converted into equity. The
difference is that CCPS pays fixed dividend and Cumulative Deposits attract
interest till conversion. The major advantage of CCPS is that it is considered as
part of net worth even before its conversion.
This instrument is suitable for companies which want the equity component to
remain low, maintain its EPS without becoming overcapitalized, increase the
leveraging capacity of the company as it is considered as owners’ capital. This, in
turn, increases the net worth of the company and allows the issuer to go in for
more debt.
One inherent advantage presented by this instrument is that promoter’s stake does
not get diluted during the public issue.
Further, there is a lot of flexibility with this instrument as various sweeteners can
be attached to increase investor attractiveness and could serve as a perfect hedge
between debt and equity during times of high interest rates and prevailing
illiquidity in the market.
Instances of some companies which took this route for fund raising include Jindal
Photofilms and New India Sugar Mills Limited.
Non-voting Shares: A non-voting share is more or less similar to the ordinary
equity shares except for the voting rights. It is different from a preference share in
the sense that in case of a possible winding up of the company, the preference
shareholders get their shares of dividends repaid before the owners of the non-
voting shareholders. The companies with constant track record and a strong
dividend history can issue these kinds of instruments. Non-voting shares are aimed
at the small investors, who are normally not interested in the management of the
firm. Hence, non-voting shares are a good tool for the promoters of the company
to increase the share capital without diluting their stakes in the company.
However, if the company fails in its commitment of paying higher dividends to the
owners of the non-voting shares, they automatically get converted to shares with
voting rights. Hence, the issuer has to assess the characteristics of the future cash
flows and determine whether paying a higher rate of dividend is practicable for
them or not. Companies with irregular revenue streams and those with seasonal
fluctuation of demand should not issue non-voting shares.
Detachable Equity Coupons/Warrants: Detachable equity warrants/coupons
issued by the companies entitle the holder to buy a stated number of equity shares
of the issuing company at a stated price at any time during an initial defined
period. These detachable warrants can be issued with non-convertible debentures
or with any other debt or equity instruments. The conversion ratio and the price at
which the shares would be given are pre-decided during the allotment stage itself.
The warrants attached to the instruments are freely tradable in the market as
individual securities. Detachable equity warrants are most appropriate for the
companies that expect a higher growth rate in future, but require funds to support
the growth plans. The advantage of these instruments is that, the company receives
funds during the seed stages and rewards the investor handsomely when the fruit
of the labor is visible. We have a similar instrument of this kind; a ‘Convertible
Debenture’, which gets converted to equity shares at the predetermined price. The
difference is the feature of the warrant/coupon in case of the Detachable Equity
Coupons, which is not in case of a Convertible Debenture. But while issuing this
instrument, the issuer has to pay attention to the course of the capital markets,
288
Investment Banking
because the investor would subscribe to the underlying shares if the ruling market
price of the share were more than the subscription price. Way back in 1990s,
Malvika Steel Limited came out with a public issue of shares at Rupees Forty
(10 + 30) which carried an equity warrant entitling the shareholders to further
subscribe to the equity of the company within a specified time limit. However, due
to the slump in the capital markets and also due to the dismal results by the
company, the market price of the share dropped below the price at which the
warrantholders could exercise their rights. As a result, the shareholders did not
subscribe to the warrants and the offer lapsed.
Preference Shares: Preference shares are instruments issued by the company,
which entitle the investor with regular dividends and a preference of payment of
capital over the equity shareholders in case of a winding up of the company. The
preference shares come in various forms like cumulative or non-cumulative
preference shares, participating or non-participating preference share, redeemable
or irredeemable preference shares and voting or non-voting preference shares. The
company can issue any of these variations depending upon their specific
advantages to the company. Financial engineers tend to look at the preference
shares as a hybrid security, i.e., a combination of debt and equity. Not being a pure
equity instrument, issuing preference shares does not dilute the EPS estimates of
the company. The issuer can issue as much preference shares, as he may need
without having to bother about the key balance sheet ratios of the company.
Secondly, the preference shares not being pure debt instruments, the issuer, while
issuing them does not have to maintain an asset cover for the same. The promoters
of the company need not worry of losing control of the company over a preference
issue. It is easy for the issuer of the preference share to attract institutional
participation during the stage of offer because there are no restrictions on the
banks in US to participate in preference shares which is not so in case of an equity
investment. Therefore, raising funds by the way of preference share from the
institutional investors is always easier for the company with a good contact with
such institutions. The preference shares come with a bundle of disadvantages also.
The maximum tenure for which a preference share can be issued is twenty years.
Hence, companies with a project spanning over a longer duration of time might not
find it useful. The medium of preference shares to tap the funds is suitable for
large companies with proven track record of profitability, having large duration
projects in hand and for whom the key balance sheet ratios are vital for the
valuation by analysts for further issue of debt.
Differential Shares: The differential shares are a class of shares that carry varying
voting rights with fluctuating rates of dividends. They are the shares those which
do not have any voting rights but claim a higher rate of dividend as compared to
ordinary shares. The distinctive features of the differential shares are that the
voting right of the investor is linked to the rate of return of the shares. In other
words, the investor with a normal voting right will get normal dividend and an
investor with lower voting right will get a higher dividend. The issue of
differential shares, apart from providing the company with the funds, acts as a
takeover defense for the company. Because the promoters, by issuing such shares,
can consolidate their control by not sharing proportionate control over the
organization even after raising additional capital. The company can make
differential issue to its group companies or friendly financial institutions who
would subscribe to such an issue and the proceeds can be used for the open market
purchases of the shares of the company. However, there is a caution attached to
these kinds of issue. The moment, a company comes up with a differential issue,
the market looks at the company with suspicion suspecting it to be under an
anti-takeover bid. Hence, such issues may not always succeed. Most often, the
companies utilize this route as a precautionary measure and not as an aid to
maximize the shareholders’ wealth. Therefore, any company expecting a takeover
attempt may place such an issue with the institutions and may not try to raise funds
289
through it from the public. Even though Section 86 of the Indian Companies Act,
1956 permits the issue of differential shares by the companies, the practice of issue
of such shares by the corporate in India is not yet in vogue.
Convertible Debentures Redeemable at Premium: This is a convertible bond issued
at a face value with a put option entitling the investor to resell the bond to the issuer
at a premium at a future date. The face value of the bonds at the issue date is higher
than the market value of the common stock into which they are converted. The
purpose of these securities is similar to the convertible debt. The issuer attracts
attention of the investor by putting the bonds at a premium to the face value, which
eliminates the downside risk for the investor. These types of instruments are
beneficial to the issuer also, because the conversion of the bond is at a premium,
which means a lower cost of funds to him. There is a possible disadvantage as well
for the issuer. In case during the maturity, the underlying stock fails to appreciate
sufficiently to make the conversion attractive for the investors, the issuer might end
up redeeming the debentures at a premium. This instrument is most suited for the
companies, where the cost of capital is a big factor for the sustenance for the
company. The industries where cut-throat competition is witnessed and mega deals
are made on the basis of price competitiveness, would find this instrument quite
helpful because of the low cost of funds.
Debt for Equity Swap: Strictly speaking, ‘Debt for Equity Swap’ is not an
instrument, rather it is a mechanism. However, in the discussion of different
instruments it is worth mentioning. Debt for Equity Swap is an offer from the
issuer of debt securities to the debt holders to exchange the debt for the common
stock or preferred stock. This process is advisable for the companies who wish to
make improvements to the debt-equity ratio and reduce the interest outflow on
account of the debt service burden. From the point of view of the issuer, the
interest outflow is replaced by the dividends which are payable at the discretion of
the issuer. This helps the issuer to conserve cash which otherwise would have gone
to service debts. Instead the company gets a chance to deploy it. From the point of
view of the investor also, it looks attractive, as he can expect rapid capital gains,
which is more frequent in case of an equity product. The flip side for the issuer is
the dilution of earning per share and the loss of tax advantage the issuer might
have received on account of the interest payment. The mechanism of debt to equity
swap is highly suitable for large companies with huge balance sheets and for the
companies that wish to make improvements to the debt-equity ratio at any cost.
For example, a financial institution, which wishes to open a banking subsidiary
may not be given the approval to start its bank, if the capital adequacy (or, simply
put, debt-equity) is ill-shaped. The mechanism of debt-equity swap would be of
great help for such a financial institution.
Receivable Backed Securities: The Receivable Backed Security is an instrument,
which is supported by a bundle of receivables linked to various assets with
different maturities and bearing different interest rates. The issuer holds the future
cash flow streams and issues a debt instrument against those, on which the interest
is payable to the investor. The issuer repays the principal to the investor at the end
of the term, which normally coincides with the date of inflows from the credit sale,
etc. This process is useful for an issuer who has a lot of credit sales in his business
cycle and there is pressing need for cash infusion. In other words, the company
gets a chance to use its own cash even when it is not available until a near future.
These instruments are a highly reliable source of finance for the companies that
wish to reduce their working capital cycle by coming up with a securitized
instrument like this. For example, retailers, manufacturing firms, etc., can make
use of this method to take care of their short-term cash flow needs.
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Investment Banking
Non-convertible Debenture with Equity Warrants: The instrument issued is a

non-convertible debenture along with a detachable equity warrant. The investor
has the option of exercising the warrant by surrendering the debenture. The
company can price the instrument at a lower coupon rate, as the detachable
warrant acts as a sweetener. Further, the instrument does not result in immediate
dilution of equity. The instrument is attractive to the investor in spite of the lower
yield, because he can either sell the warrant or has an opportunity to acquire equity
in the company at a price which is usually less than the prevailing market price.
Triple Option Convertible Debentures: Reliance Petrochemicals Ltd., issued these
bonds where every debentureholder had an opportunity to acquire two equity
shares at par for each debenture. As regards the non-convertible portion with
warrants, they had three options:
i. To retain the non-convertible portion and sell warrants.
ii. Surrender the non-convertible portion with warrants and get shares in return.
iii. Retain non-convertible portion, surrendering the warrants and applying for
equity shares in cash.
Zero Coupon Bonds with Equity Warrants: The bond is issued at discount to face
value and is redeemable at par/premium. This bond entails no regular cash outflow
as interest to the issuer. The warrant entitles the holder to acquire certain number of
shares either by surrendering the bond or by paying the requisite amount in cash.
For instance, Dhampur Sugars entered the market with Rs.35 crore zero coupon
bond issued at discount of Rs.63 to the face value of Rs.100 and redemption at
Rs.270 at the end of 7th year and it carried an equity warrant convertible into
5 shares at the end of 1st or 7th year.
Floating Rate Instruments: Traditionally, most of the debt instruments in India
carried a predetermined coupon rate. The coupon rate remained fixed throughout
the tenure, irrespective of the general changes in the interest rate structures. An
alternative method of fixing the coupon emerged in the form of floating rate. In
floating rate instrument, the coupon payable is in the form of mark-up over a
market driven reference rate. The steps involved in the process are:
a. Identifying the appropriate reference rate.
b. Determining the exact level of mark-up over the reference rate,
commensurate with the risks associated.
c. The intervals at which the coupon rate is reset.
Auction Rated Debt: These are fully redeemable non-convertible short-term
debentures, secured by specific movable and immovable assets of the company. It
is redeemed at regular intervals and then reauctioned. Interest rate will be
determined by the market. Other features include:
i. Useful for companies as it gets long-term funds at short-term rates.
ii. There is no dilution of equity.
iii. Attractive for investor for parking short-term funds as it is secured.
iv. This instrument is privately placed at competitive bids.
v. It does not require a credit rating as the tenure is less than 18 months.
Ashok Leyland is the pioneer in launching this instrument in India.
ISSUE PRE-WRITING – TOWARDS WHOLESALE MARKETING
What it Means
The concept originated primarily to lessen high costs of selling issues, to eliminate
uncertainty on the public issue response and to market issues to informed investors
with a long-term investment perspective.
291
Under issue pre-writing the lead manager sells the entire issue to leading finance
companies, brokers and persons with a high net worth. It is selling the issue to
wholesale investors before it opens, who commit to invest based on their own
financial muscle or one that is derived from their client base. Pre-writing ensures
one time subscription to the issue.
A pre-condition to pre-writing any issue is that the company has to be fundamentally
strong. With the basic premise being met the procedure could vary as per specific
marketing schemes adopted by the pre-writers. The schemes include making
presentations to portfolio managers, non-banking financial companies, corporates,
research outfits, high net worth individuals, large broking outfits, etc.
The presentations involve interaction on a one-to-one basis with the promoters. A
response time is given, i.e., the deadline by which the abovementioned parties
have to get back, with the amount of subscription they would be interested in
investing known as the ‘pre-writing commitment’.
Role of a Lead Manager
The lead manager is the main coordinator and the brain behind the pre-writing
process, as pre-writing is very case specific. All activities such as presentation,
preparation about the company, selecting the right profile of wholesale investors,
deciding on the right amount of commission that would encourage flow of
pre-writing commitment and overall supervision to ensure smoothness of
operations are taken care by the lead advisor.
Pre-writing vs. Underwriting
Pre-writing differs from underwriting in the sense that there is no recourse to the
pre-writers unlike underwriters, who are statutorily required to pay up if the issue
devolves.
Pre-writing vs. Bought-out Deals
Under bought-out deals shares are placed with the intermediaries for a longer
period, the exit route might be an issue or further placement and the off-loading
price is higher than the purchase price, i.e., acquisition price plus the profit factor.
Pre-writing is a marketing scheme which might be used for selling a bought-out
deal at the time of off-loading the shares.
The concept of pre-writing also signifies an important step towards wholesale
marketing of issues. The worldwide stress is on wholesale marketing and the same
trend can now be observed in India too, since retail marketing is neither viable nor
practical as far as big issues are concerned.
Pricing the Issue
Pricing the instrument is the most critical element of an issue. Since the abolition of
CCI, the onus of pricing the issue has fallen on Investment Bankers. Companies are
now allowed to freely price their issues. The idea behind free pricing was that if
companies overpriced their issues, the market would penalize it by not subscribing
and by underpricing, the company would have to forego the potential premium.
The Era of Controller of Capital Issues (CCI)
The CCI regime, when all the issues coming with a public issue had to price their
issue based on the CCI formula, was a case of anti-market practice, where all
companies whether fundamentally sound or not had to price their issues very
conservatively. As a result of this all the issues coming into the market were easily
oversubscribed leaving a few devolvements. The Investment Bankers’ role during
this period was very limited.
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Investment Banking
With the abolition of CCI in June, 1992, the restriction was removed and
companies were allowed to price the equity at a premium subject to certain
conditions. This free pricing regime had its own quota of boons and banes. The
sound companies with good fundamentals were able to tap funds from the capital
market at a premium. On the other hand, companies with dubious credentials,
issued capital with rosy projections and fleeced the uninformed investor.
The Investment Banking community too, moved into the numbers game and became
less concerned about the quality of the issues. This resulted in the overpricing of
many issues which often gave negative initial returns to the investors.
SEBI Guidelines on Pricing
The companies eligible to make public issue can freely price their securities
according to the following rules:
• Any listed company whose equity shares are listed on a stock exchange can
freely price its equity shares and any security convertible into equity at a later
date, offered through a public issue.
• An unlisted company eligible to make a public issue and desirous of getting
its securities listed on a recognized stock exchange pursuant to a public issue,
can freely price its securities convertible at a later date into equity shares.
• An eligible infrastructure company can freely price its equity shares if it
complies with the disclosure norms specified by the SEBI.
The banks (public sector/private sector) can freely price their issue of equity
shares or any securities convertible at a later date into equity share on
approval by the Reserve Bank of India.
• Any company (listed/unlisted) making public issue of securities can issue the
securities to the applicants in the firm allotment category at a price different
from the price at which the net offer to the public (offer made to the Indian
public and does not include firm allotment or reservations or promoters’
contributions) is made, if the price at which the security is being offered to
the applicants in the firm allotment category is higher than the price at which
securities are offered to public.
• Any listed company making a composite issue of capital may issue securities
at differential prices in its public issue.
• Price Band: The issuer company can mention a price band of 20% (cap in
the price band should not exceed 20% of the floor price) in the offer
documents filed with the Board and actual price can be determined at a later
date before filing the offer document with the Registrar of Companies (ROCs).
• If the Board of Directors has been authorized to determine the offer price
within a specified price band, then such a price band is determined by a
Resolution to be passed by the Board of Directors.
• The final offer document shall contain only one price and one set of financial
projections.
• In case of initial public offer by an unlisted company, if the issue price is
Rs.500 or more, the issuer company shall have a discretion to fix the face
value below Rs.10 per share subject to the condition that the face value shall
in no case be less than Rs.1 per share; and if issue price is less than Rs.500
per share, the face value shall be Rs.10 per share.
• The companies, which have already issued the shares in the denomination of
Rs.10 or Rs.100, can change the standard denomination of the shares by
splitting or consolidating the existing shares.
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Basis for Issue Price: Post-Malegam Recommendations

a. i. Earnings per share, i.e., EPS pre-issue for the last three years (as
adjusted for changes in capital);
ii. P/E pre-issue and comparison thereof with industry P/E where available
(giving the source from which industry P/E has been taken);
iii. Average return on net worth in the last three years;
iv. Minimum return on increased net worth required to maintain pre-issue

EPS;
v. Net Asset Value per share based on last balance sheet;
vi. Net Asset Value per share after issue and comparison thereof with the
issue price.
Provided that projected earnings shall not be used as a justification for the
issue price in the offer document.
b. The accounting ratios disclosed in the offer document in support of basis of
the issue price shall be calculated after giving effect to the consequent
increase of capital on account of compulsory conversions outstanding as well
as on the assumption that the options outstanding, if any, to subscribe for
additional capital will be exercised.
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Source: ICFAI Research Center.
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Investment Banking
An illustrative format of disclosure as per Schedule XV is given below.

Schedule XV
[Clause 6.13.1(g)]
Basis for Issue Price
i. Adjusted Earning Per Share (EPS)
a. 1992-93 Rs.0.41
b. 1993-94 Rs.8.39
c. 1994-95 Rs.13.82
d. Weighted Average Rs.10.94
ii. Price/Earning Ratio (P/E) in relation to Issue Price
a. Based on 94/95 EPS 37.63
i. Highest 61.20
ii. Lowest 0.80
iii. Average 25.30
(Based on Economic Times of 26-06-1995)
iii. Return on Net Worth
a. 1992-93 27.36%
b. 1993-94 28.77%
c. 1994-95 33.45%
d. Weighted Average 30.88%
iv. Minimum Return on Total Net Worth after Issue needed to maintain EPS at
Rs.13.82 is 14.65%
v. Net Asset Value (NAV)
a. As at 31-3-1995 Rs.4,640
b. After issue Rs.94.29
c. Issue price Rs.520.00
Various Premia-Fixing Bases
Usually, the company coming out with an IPO fixes the premia in consultation
with the Investment Banker. The following is a list of factors considered by Indian
companies for fixing premium:
• The average EPS from the company’s projections is taken and then
multiplied by its P/E adjusted – in comparison to the industry P/E – to give
the offer price.
• Apart from this, other qualitative aspects like quality of the management,
their marketing network, technical collaborations, low cost of production,
their brand equity, etc., lend sufficient support in the fixation of the premium.
• Other indicators like Return on Net Worth (RONW) and Return on Capital
Employed (ROCE) in the projections are also taken as indicators for fixing
the premium as these indicators form important inputs for investment
decision-making by the investors.
• The margin indicators like Gross Profit Margin (GPM) and Operating Profit
Margin (OPM) are compared with the industry average as well the other
companies in the same industry as these tell upon the efficiency of company
vis-á-vis others in the field.
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Various Alternatives for Pricing

Based on Dividend Discount Model
D0 (1 + g )
P0 =
r −g
Where,
P0 = Price of the share
D0 = Current dividend per share
r = Return expected by the investor
g = Expected growth in dividends.
This method would again be subjective due to different yields expected by
different investors:
• Based on the shareholding pattern and yields expected by different categories
of investors. Usually, the yield expectation of the public (being uninformed
investors) differs from that of the financial institutions and mutual funds.
Based on these demand scenarios, the premia could be fixed.
• Premia may also be fixed depending on the Book Value of the share.
• In case of listed companies, the current market price and the past price
behavior can be used as benchmarks.
• The auction based process followed by the Japanese could also help in
premium fixation. In this process there is no offer price or suggested price
and the participants are allowed to select a price for the company using their
own information and analysis. Half the shares are auctioned through this way
where shares are allocated based upon their bid pricing and the unauctioned
shares are priced at the weighted average price of the auction.
• Another method which can be followed in the fixation of premium is through
a process of book-building. Here the issuers in consultation with Investment
Bankers fix the floor rate which can be either the face value of share or the
rate fixed after consultations. After this the issue is auctioned to the investors.
The investors put in their bids at different rates. All the bids are arranged in a
descending order and the cumulative order position is computed at various
rates. The cut-off rate is then determined so as to raise the required sum of
money. All the investors who have bid at or higher than the cut-off rate are
given full allotment. However, the allotment is made at a uniform price
(cut-off rate) to all the investors. This type of a bidding system is called as a
dutch auction. At present, companies are supposed to offer 10% of the IPO
by book-building method.
• Another method for garnering higher premiums than their earnings foretell is
through the brand equity of the companies. Although this aspect is difficult to
quantify, one method of valuation of the brand would be to reduce from the
market capitalization the tangible assets of the company and residual would
be the value of the brands.
A few of the companies have gone public solely on the strength of the brands like
the Zodiac Clothing Company, Vadilal Dairy International Ltd., Yankee Doodle’s, etc.
The logic behind this process of premium fixation is that the strong brand equity of
their products will translate into higher P/E and higher earnings for the companies.
Justification of Premium
Dividend Yield Approach – A New Way to Price IPOs
Using the dividend yield-based pricing methodology is possible only where there
is a consistent cash flow stream expected in future. And this is possible only for
natural monopolies or for companies with a long-term pool of lease or hire
purchase receivables.
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Investment Banking
Pricing it Right
Dividend yield is simply the ratio of the dividend to the market price at a given
point in time. Yield-based pricing implies factoring in not just the dividend but
also the consistency of this dividend over a three-or-five-year time-frame. When
an IPO is floated, the projected dividend and market prices should enable the
market to work out the yield.
Adopting a pricing based on dividend yield is done exactly in the same manner as a
debt security would be priced. For instance, if a Triple A-rated company has been
giving 17 percent dividend and if it can sustain this dividend flow even in future on
an expanded equity, then the pricing would have to take this factor into account.
Natural monopolies fulfill that criteria, as long as they remain natural monopolies.
A classic instance of this is the Indian Railway Finance Corporation (IRFC).
IRFC has not come out with an initial public offer. But it has not ruled out the
future possibility, either. IRFC is not only an unlisted enterprise. It is also the only
enterprise of its kind in the country. Therefore, pricing in this case would have to
factor the dividend yield that can be realized. Adopting the yield-based pricing of
a possible IRFC equity issue, the effective pricing at current market trends would
be around Rs.24 per share (which means a premium of Rs.14). And this pricing
would tend to be directly related to the dividend pay-out. The higher the dividend
yield, the better would be the possibility of price realization at the IPO.
Market-based pricing simply does not take these factors into account. Pricing in this
kind of situation would have to be done either using the Price Earnings (PE) ratios of
the Financial Institutions (FIs) or that of non-bank finance companies. The average
PE of financial institutions is currently around 6. IRFC’s earnings per share is Rs.9.
This would effectively imply a price of Rs.54 or a premium of Rs.44.
Indian companies tend to justify the premium through qualitative as well as
quantitative factors.
The Qualitative Factors Mainly Include:
• Company’s past record in consistent dividend pay-out and continuous profit
making.
• Experience of the promoters in the relevant field.
• The company’s Unique Selling Proposition which would include their
marketing edge over the competitors, their distribution network, brand equity
for their product, reputation of clients, etc.
• Company’s entitlement to sales tax and income-tax exemption for a particular
period particularly if the project is in some backward area.
• The industry scenario and the demand-supply gap.
• The awards received by the company for its past performance in the Indian
and in the international arena for its quality, etc.
• Credit rating received for its debt.
The Quantitative Factors Include:
The Malegam Committee has prohibited the use of future projections for fixing the
premium. Hence pricing is done based on the historical track record:
• The current market price and the high/low for the last 3 years.
• The P/E multiple based on its offer price and comparing the same with the
industry P/E.
• The growth rate in PAT and EPS for the past year.
297
• The Book Value of the share and the Book Value multiple in relation to offer
price.
• The return on net worth and the return on capital employed for the past years.
• The level of promoter’s contribution and the price at which shares have been
allotted to the promoters.
We can thus argue that both quantitative and qualitative factors have an impact on
the pricing of IPOs.
Pricing of an IPO
Pricing an IPO in the Indian primary market starts with the conception of the
project where the promoter of the issuing company specifies the amount he is
willing to put into the project and the control level the promoter wants to retain
with himself.
Usually, the pricing of an IPO is done at least twice or thrice. Once, when the firm
is planning to go public it has to select a Investment Banker and it asks the
consortium of Investment Bankers to suggest an offer price for the issue. Then
later when, after selecting the Investment Banker, they have to decide upon a price
band which they have to report to the regulatory authority while filing the
prospectus and the third time when they have to actually find a price for the issue.
The importance of pricing increases through the three stages, as discussed below.
Stage I: To Estimate the Preliminary Price During the Early Phase: During
this phase, where the issuing company asks the prospective Investment Bankers to
suggest an offer price for the firm’s public issue, the Investment Bankers have to
consider and evaluate all the factors involved in valuing the company and placing
a price on the stock. The factors to be considered here may include special risk
factors, use of proceeds, financial leverage, operating leverage, reasons for
changes in the company’s financial condition, principal products and services,
patents, marketing, production, management, composition of the Board of
Directors, regulation, litigation, etc. Apart from these factors, the future earnings
and cash flow from operations is also considered and compared with similar
companies in the same industry.
The lacuna in this method is that companies normally tend to select that
Investment banker who offers them the highest price. Investment Bankers, in order
to get the mandate, price the IPO as aggressively as possible. The process, very
often, is reduced to a competitive bidding, and later the Investment banker and the
company realize that the issue was priced much higher than its intrinsic value.
Stage II: Deciding upon the Price Band: In this stage, the Investment Bankers
have been appointed by the issuing company. The lead manager exercises his due
diligence by checking all the important aspects of the company going public.
Alongwith this exercise, he compares the company with other companies whose
shares are being publicly traded and develops his own forecasts of prices at which
the scrip would be traded. The price band is agreed upon after negotiations
between the issuing company and the Investment banker. Usually, the Investment
banker approves on the price band based on the following indicators about the
company:
• Past track record of performance.
• Comparison of issuing company with other similar companies with respect to
future earnings, cash flow from operations and fundamental asset values.
• SWOT analysis of the issuing company.
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Investment Banking
• Half-yearly or quarterly earnings of the company during the current year and
its expectations in the next quarter.
• Information on retail and institutional interest in the proposed offering and an
indication of buying at different levels.
• Information on the overall trend in the IPO market and the success rate of
similar issues during the period.
• Taking into account the shareholding pattern before and after the issue and
identifying the potential selling shareholders upon listing the stock.
• Taking into account, the part of the issue which has to be underwritten and
finding out market-making to the issue.
• Feasibility of perceptions about the company’s management from the brokers
and prospective investor from the road shows and investor conferences.
• Company’s products and services and what the future holds for them. Are
they exciting and unique?
• The company’s accounting methods and whether there had been any changes
in recent years and reasons behind the change.
Stage III: Determining the Actual Offer Price: The Investment Banker, who at
this stage is equipped with all relevant information about the company, negotiates
for the final price setting with the company. At this stage, the number of shares in
the offering and shareholding pattern might be adjusted depending on the demand
for the IPO and the actual negotiated offering price. The final pricing tends to
focus on current market conditions and specific demand for the offering at
alternative price levels from institutional investors.
In finalizing the price, the Investment Banker has to assess the after-market
performance of the scrip. For this he has to consider whether the buying interest
for the public offering is coming from long-term or short-term investors.
Apart from these factors the free pricing era witnessed some anomalies by all the
players operating in the IPO market. Some of them are listed down as follows:
• Inadequate disclosure in the prospectus by the promoters.
• For instance, in the Shriji Cotton issue the prospectus did not disclose the
legal suits filed against the promoters and that they were co-guarantors in bad
loans in excess of Rs.10 crore.
• Misleading the investing public by decorating the prospectus with attractive
projections which were often inflated.
• For instance BEML, the Bangalore-based public sector company had made a
pre-tax projection of Rs.49 crore for 1994-95, during their issue in 1995, but
the actual figure realized was Rs.12 crore only.
• Price rigging is resorted to by the promoters by colluding with the brokers to
justify higher prices to the investor. This was possible in the following ways:
i. Buying shares through intermediaries to camouflage the identity of
promoters and thereby succeed in showing a healthy trend for their
shares in the market.
ii. This large-scale buying triggers all-round buying and prices of these
shares soar to new heights.
iii. Later these-firms show inflated results as basis for the jump in their
share prices.
iv. Further a rights issue announcement justifies stepped up buying at
higher prices.
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Recent Market Development

Let us have a look at the general development of the primary market in nineties.
There have been many regulatory changes in the regulation of primary market in
order to save investors from fraudulent companies. The most pathbreaking
development in the primary market regulation has been the abolition of CCI
(Controller of Capital Issues). The aim was to give the freedom to the company to
decide on the pricing of the issue and this was supposed to bring about a set
managing culture in the financial system. But the move was hopelessly misused in
the years of 1994-1995 and many companies came up with issues at sky-high
prices and the investors lost heavily. That phase took a heavy toll on the investor’s
sentiment and the result was the amount of money raised through the route. Then
came the general economic slowdown and this also played its part in the subdued
growth in this segment of market. However, with the advent of normal economy
and the abnormal growth of software players again made investors to have a good
look at the IPOs of these companies. The 51 times oversubscription of TV18 issue
and 27 times oversubscription of HCL Technology issue stands testimony. The
change has also been seen in the composition of the IPO floats last one-and-a-half
years. Almost 90% of the new issues have been from new economy, consisting of
software, telecom and media sectors. The newest development in the primary
market has been the Indian players’ thirst for more satiating offshore. Many
players like Infosys, Satyam and Wipro have tried this route successfully.
Book-building, the Latest Method of Price Discovery
The basic motto of the book-building is that the market knows the best. Ever since
SEBI allowed the companies with no profitability record to come out with IPO vs.
book-building route, there has been a good rush of such issues. But what is
book-building and what purpose it serves?
Book-building refers to the collection of bids from investors, which is based on
indicative price range, the issue price being fixed after the bid closing date. The
principal intermediaries involved in a book-building process are the company,
Book Running Lead Manager (BRLM) and syndicate members who are
intermediaries registered with SEBI and eligible to act as underwriters. Syndicate
members are appointed by the BRLM. The basic difference between IPO and
book-building is that in an IPO, the Lead Managers decide the price of the issue.
In book-building offer, the syndicate members decide the indicative price range
and the investors decide the price of the issue through a tender method. In an IPO,
the payment for securities is made while subscription but the refund for the same is
done after allocation, while in book-building process payment is made only after
allocation.
Pricing of Public Issue through the Book-building Process
Companies lately are resorting to the book-building process for raising capital by
issuing securities. According to the SEBI guidelines 2001, “Book-building” means a
process undertaken by which a demand for the securities proposed to be issued by a
body corporate is elicited and built-up and the price for such securities is assessed for
the determination of the quantum of such securities to be issued by means of a
notice, circular, advertisement, document or information memoranda or offer
document. An issuer company may, subject to the requirements specified, make an
issue of securities to the public through a prospectus in the following manner:
a. 100% of the net offer to the public through book-building process, or
b. 75% of the net offer to the public through book-building process and 25% at
the price determined through book-building.
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Seventy Five Percent Book-building Process: In an issue of securities to the

public through a prospectus the option for 75% book-building shall be available to
the issuer company and the following rules are applicable:
• The option of Book-building is available to all the bodies’ corporate making
issue to the public.
• The book-building facility is available as an alternative to the extent of the
percentage of the issue, which can be reserved for firm allotment. The issuer-
company has the choice to reserve the securities for firm allotment or to issue
the securities through the book-building process.
• The issue of securities is identified as “placement portion category” in the
prospectus.
• The securities available to the public are identified as “net offer to the
public”. This includes the required minimum 25% of the securities to be
offered to the public.
• If the book-building route is adopted, then underwriting is mandatory to the
extent of net offer to the public.
• The draft prospectus containing all the information except the information
regarding the price at which the securities are offered are filed with the
Board.
• One of the lead Investment bankers is appointed as a book runner whose
name is mentioned in the prospectus.
• The copy of draft prospectus filed with the Board may be circulated by the
book runner to the institutional buyers who are eligible for firm allotment and
to the intermediaries eligible to act as underwriters inviting offers for
subscribing to the securities. The draft prospectus that is circulated indicates
the price band within which the securities are being offered for subscription.
• The book runner maintains a record of the names and the number of
securities ordered and the price at which the institutional buyer or
underwriter is willing to subscribe the securities under the placement portion.
The book runner also maintains a record of orders received by him for
subscribing to the issue out of the placement portion.
• The underwriters aggregate the offers received for subscribing to the issue and
intimate to the book runner the aggregate amount of the orders received by
him. The institutional investors also forward their orders to the book runner.
• Once the information is received, the book runner and the issuer company
determine the price at which the securities are to be offered to the public.
• The issue price to the placement portion and offer to the public are same.
• After the price is determined, the underwriter enters into an underwriting
agreement with the issuer indicating the number of securities as well as the
price at which the underwriter shall subscribe to the shares.
• The prospectus of the company is to be filed with the registrar of companies
two days after the determination of the issue price.
• The issuer opens two different accounts for collection of application money,
one for the private placement portion and the other for public subscription.
• The Issuer Company appoints eligible Investment bankers as book runners and
their names are mentioned in the draft prospectus. The lead Investment banker
acts as the lead book runner and the other Investment bankers are termed as co-
book runners. The primary responsibility of building the book is that of the lead
book runner.
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• The book runners can appoint intermediaries registered with the Board as
syndicate members to carry out “underwriting” activities.
• The total size of the issue is mentioned in the draft prospectus, which is filed
by the Lead Investment banker with the SEBI.
• In the event of appointment of more than one lead Investment banker/book
runner for book-building, the rights, obligations and responsibilities of each
should be delineated.
• In the case of undersubscription in an issue the book runners must make up
the shortfall to the issue and the fact should be incorporated in the inter se
allocation of responsibility.
• The Board should suggest modifications to the draft prospectus within
21 days of receiving it and the lead Investment banker is responsible to
incorporate the modifications in the draft prospectus.
• The book runners and the Issuer Company determine the issue price based on
the bids received through the ‘syndicate members’. After the determination
of the issue price, the number of securities to be offered is determined by
dividing the issue size by the determined price.
• Only successful bidders (whose bid is at and above the final price) are
entitled for allotment of securities.
• No incentive, either in cash or kind, is paid to investors who have become
entitled for securities allotment.
• The final prospectus containing all disclosures including the price and
number of securities proposed to be issued are filed with the Registrar of
Companies.
UNDERPRICING AND OVERPRICING
i. Underpricing: To test whether a stock has been priced at its intrinsic worth
or not, returns are computed. If these returns are positive, the indication is
one of underpricing.
The returns on the stock Rit (in %) for stock i in period t is calculated using
the equation
Pit
Rit = − 1 × 100
Pio
Where,
Pit = Price of stock i in period t
Pio = Offer price of stock i.
Return on Market Index is given by
Pmt
Rmt = − 1 × 100
Pmo
For adjusting the return on stock i to the market return, we calculate the
market adjusted return.
ARit = Rit – Rmt
ii. Overpricing: Similarly if the returns on the stock is negative, then it is an
indication of overpricing.
Apart from these indicators, another indicator called the “Wealth Relative”
can be used to indicate the performance of IPOs vis-á-vis the market.
n
1
1+ rit
N i =1
WRit = n
1
1+ rmt
N t =1
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Where,
N = Total number of IPOs in the sample
rit = Rit/100
rmt = Rmt/100.
A wealth relative greater than 1 indicates that IPOs have outperformed the
market in that period and vice versa.
Implications and Consequences of Underpricing
• Underpricing can be related to timing of the issue and prevailing market
conditions particularly in the secondary market.
• An empirical study conducted at different periods (both bullish as well as
bearish) indicates that initial returns in bullish phase are greater than that in
the bearish phase. This may be attributed to the behavior of secondary market
during the period of listing.
• As a result of underpricing, the promoter or the company loses the
opportunity to raise more funds.
• Since an IPO is mainly intended as a long-term financing strategy,
underpricing would give its shareholders good returns thereby enhancing its
credibility. This would enable it to tap the market again for its future
ventures.
• Underpricing could result in a lower net worth on an increased equity, which
might make dividend pay-outs or investments in the future difficult.
Implications and Consequences of Overpricing
• Overpricing might leave a bad feeling in the minds of the investors
particularly if initial returns to them are negative.
• The logic behind overpricing may have to do something with conditions
prevailing in the secondary market. Promoters may want to take advantage of
the boom in the primary market and would price the issue very high.
• The consequences of overpricing could be really vital, resulting in the
devolvement of the issue thereby making the promoters guilty of
overestimation which would degrade the image of the company in the
market.
• Another logic behind this practice could be to lend credibility to the
organization by getting the issue oversubscribed.
• The overpricing is done through rosy projections compared to its past
performance and, in the present scenario, the blame goes on to the Investment
bankers who price the issues without due diligence and ignore the market
rules and regulations thereby leading to strained relations between Investors
and Investment Bankers.
• Therefore, underpricing or overpricing may be related to the problem of
information asymmetry which in turn depends upon an efficient market
setting, which, in the Indian context today, is questionable.
Factors underlying Underpricing and Remedies
i. Asymmetric information: The most basic problem of the IPO process is the
presence of both ‘good’ and ‘bad’ firms going public, coupled with
asymmetric information between firms and investors. Firms know themselves
reasonably well but investors do not. When information and analysis is
costly, it is difficult for investors to learn about a firm thoroughly.
Superior information disclosures can reduce this asymmetry and should help
reducing underpricing.
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ii. Fixing the offer price early: The firm sets the offer price at time 0 and the
issue opens at time T. Firms are likely to be risk-averse with respect to the
prospects of issues falling. Hence, they underprice to forestall this possibility.
The delay between choosing an offer price and the issue date has diminished
in some sense with the current SEBI policy allowing firms to choose a price
band at the time of vetting the prospectus instead of a precise price.
iii. Interest rate float: The issuing company controls the application money for
a month. Even if stock invest were widely used, the interest rate on stock
invest is quite low. At equilibrium, markets would compensate investors for
this low rate of return, through underpricing.
This problem can be solved if issuing firms and Investment bankers become
more efficient and shorten the lags between issue date and listing date.
iv. Liquidity premium: Investors who apply for public issues lose liquidity on
the amount paid at issue price. Usually at equilibrium, the markets would
compensate them for this by paying a liquidity premium, which would show
up in IPO underpricing.
v. Building loyal shareholders: Firms may have an incentive to underprice
when they expect to return to the capital market to raise further resources at a
later date, via a rights issue or a public issue.
Though firms may want to build loyal shareholders at equilibrium the
Japanese auction system if prevalent prevents from using underpricing as a
means towards this end.
vi. Investment Banker rewarding favored clients: The interaction between the
Investment banker and the company going public is typically a one shot
interaction, but the Investment banker is in a repeated game with many of his
clients, especially the large institutional investors. In this situation, the
Investment banker has an incentive to underprice to retain his established
clients.
The repeated game between the Investment banker and his institutional clients is
irrelevant in Japanese auction system.
Another method of reducing this underpricing would be by making the IPO market
more institutionalized where wholesale buyers in turn offload it to the lay investors.
UNDERPRICED IPOs
There are several reasons behind IPOs getting underpriced. The primary reason is
the combined presence of both ‘good’ and ‘bad’ issues tapping primary market,
coupled with the asymmetric information between firms and investors. While firms
know everything about themselves, most of the investors know very little about the
fundamentals of the firms. To compensate for this asymmetric information, IPOs
are often underpriced. Another reason is the time gap between setting up of the
offer price of the IPO and the actual offer of the IPO to the public. Here firms
underprice the issue to discount the risk of possible forestalling of the issue.
One more reason is once the issue is over, the company controls the issue proceeds
for about a month. Here the investors would be compensated for their loss of
interest or the low rate of return (if they apply through stock invest) by the
underpricing of the issue. Also, the investors lose liquidity of their application
amounts for quite some time and this has to be compensated by the underpricing of
the issue. Another reason is when a company again wants to tap the market for
additional funds it would like to keep some loyal shareholders. Sometimes this is
done through the underpricing of the initial public issue.
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IPOs Abroad
The US market has also witnessed a very erratic trend in the last decade, as a result
of the increased importance of new debt instruments coming into the market.
When a new security is sold in the American markets to more than 25 buyers, it is
known as Public Securities Issue, and it must be registered with the SEC. While
the process of IPO is more or less the same as in India, the investment bankers
usually opt for the book building method of pricing the issue for their institutional
and large clients.
Formalities Associated with Listing
The company executes a listing agreement with the stock exchange before formal
trading can begin. Through these regulations the stock exchange aims to protect
the interests of shareholders. The listing agreement requires the listing company to
make certain disclosures and perform certain deeds. The information disclosures
relate to annual reports, periodic statements of Profit and Loss, Balance Sheet,
information pertaining to distribution of dividends, rights issues, bonus shares and
other relevant information deemed essential for the shareholders. The company
should also provide for prompt transfer, registration, subdivision and consolidation
of shares.
SEBI has issued guidelines to the stock exchanges to amend the compliances that
are necessary for a company to enlist its equity shares. These revised guidelines
which were announced in April, 1996 are as follows:
i. The listing agreement should provide for payment of interest by companies to
investors from the 30th day after the closure of a public issue. This has been
reduced from the earlier requirement of 70 days. The interest payable by the
company is 15 percent, in case the allotment letters/refund orders are not
dispatched to the applicants within 30 days from the date of closure of the
issue.
ii. Further, it has been prescribed as an initial and continuing listing requirement
that, there should be at least 5 public shareholders for every Rs.1 lakh of
fresh issue of capital and at least 10 shareholders for Rs.1 lakh in case of
offer for sale.
The issuing company has to mention in the prospectus the names of all stock
exchanges, where the securities are to be listed. However, if any of the stock
exchanges within 10 weeks from the date of closing of the subscription list, have
not granted permission for listing of such securities, the allotment will be void and
the entire issue proceeds should be refunded forthwith.
The issuing company is also required to deposit percent of the issue price of the
securities offered for subscription with the regional stock exchange. Fifty percent
of this amount will be paid by cash (subject to a maximum of Rs.3 crore) and
balance by way of bank guarantee. This deposit will be refunded after getting
confirmation from the company duly supported by the certificate from the auditors
of the company/practising company secretary that all allotment letters, share
certificates and refund orders have been dispatched within the stipulated period.
From the point of view of the investors, the holder of equity capital is no doubt
interested in the dividend but the main attraction for an individual to invest in a
company is capital appreciation. Since the value of a company can be gauged from
the equity capital, investors normally prefer exiting from the investment after their
investments have shown the required rate of appreciation. To ensure that there is
no change in the share capital of the company, exit by a shareholder with a
particular number of shares has to be matched by the investments of one or more
other investor(s) in the share.
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With the geographic spread of the investor community, there has got to be a
common place where the present and prospective investors of all the companies in
operation can effect the buying and selling of the security. This place of trading is
called a stock exchange in technical terms. A Company has to get itself listed so as
to avail the benefits of secondary trading by its investors. Listing, in other words
means admission of a security for the purpose of dealing on a recognized stock
exchange. The security so listed could belong to anybody, securities belonging to
financial institutions, manufacturing concerns, central or state undertakings,
municipalities, etc. Stock Exchanges in India have separate listing departments
which decide on allowing a company to list in their exchange. The listing
arrangements are done in accordance with the Securities Contracts (Regulation)
Act, 1956/1957, Indian Companies Act, 1956, guidelines issued by the Securities
and Exchange Board of India (SEBI) and the listing norms of the exchange where
the company is going to be listed. Listing of a company has several benefits:
• Listing provides liquidity to the security.
• It helps to mobilize savings for the overall development of the economy.
• A listed company has to adhere to several disclosure agreements. This
ensures transparency and better corporate governance.
• Listing and subsequent trading allows the investors who had missed the
opportunity or could not get allotment during the IPO stage to buy the shares
of the company through the stock exchange.
• A listed company has to inform any significant developments pertaining to its
business to the stock exchange. This helps in the process of information
dissemination and draws attentions of the academicians, consultants,
analysts, etc.
A Company desirous of getting its security listed has to enter into an agreement
with the stock exchange, known as the listing agreement. The listing agreement
aims to protect the interest of the shareholder or whoever deals with the security.
The agreement requires the company to do certain periodic disclosures with the
exchange. These disclosures in turn are accessible to the members of the
investment community. A listed company is bound to submit the annual statements
of accounts to the exchange.
LISTING CRITERIA OF IMPORTANT EXCHANGES
The following are the listing criteria considered by the National Stock Exchange of
India:
Qualifications for Listing Initial Public Offerings (IPOs)
i. Paid-up Capital: The paid-up equity capital of the applicant shall not be less
than Rs.10 crore* and the capitalization of the applicant’s equity shall not be
less than Rs.25 crore**.
* Explanation 1
For this purpose, the post-issue paid-up equity capital for which listing is
sought shall be taken into account.
** Explanation 2
For this purpose, capitalization will be the product of the issue price and the
post-issue number of equity shares.
ii. Conditions Precedent to Listing: The issuer shall have adhered to
conditions precedent to listing as emerging interalia from Securities
Contracts (Regulations) Act, 1956, Companies Act, 1956, Securities and
Exchange Board of India Act, 1992, any rules and/or regulations framed
under foregoing statutes, as also any circular, clarifications, guidelines issued
by the appropriate authority under foregoing statutes.
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iii. At least three years of operating track record of either

• the applicant seeking listing; or
• the promoting company, incorporated in or outside India.
For this purpose, the applicant or the promoting company shall submit audited
balance sheet of three preceding financial years of the company to the NSE.
iv. The Project/Activity plan of the applicant must have been appraised by a
financial institution u/s 4 A of the Companies Act, 1956 or a state financial
corporation or a scheduled commercial bank with a paid-up capital exceeding
Rs.50 crore or a category I Investment Banker with a net worth of at least
Rs.10 crore, or a venture capital fund with a net worth of at least Rs.50 crore:
Provided that this clause 4 shall not be applicable to listing of securities
issued by Government Companies, Public Sector Undertakings, Financial
Institutions, Nationalized Banks, Statutory Corporations, Banking Companies
and subsidiaries of scheduled commercial bank who are otherwise bound to
adhere to all the relevant statutes, guidelines, circulars, clarifications, etc.,
that may be issued by various regulatory authorities from time to time and in
case of an Offer for Sale.
v. The applicant desirous of listing its securities should satisfy the exchange on
the following:
a. No disciplinary action by other stock exchanges and regulatory
authorities in past three years:
The promoting company (if any) has not been in default in payment of
listing fees to any stock exchange in the last three years or has not been
delisted or suspended in the past, and has not been proceeded against by
SEBI or other regulatory authorities in connection with investor-related
issues or otherwise.
b. Redressal Mechanism of Investor Grievance
The points of consideration are:
• promoting company’s (if any) track record in redressal of investor
grievances.
• promoting company’s arrangements envisaged are in place for
servicing its investor.
• promoting company’s general approach and philosophy to the
issue of investor service and protection.
c. Distribution of shareholding
The promoting company’s (if any) shareholding pattern as on March 31
of last three calendar years separately showing promoters and other
groups’ shareholding pattern should be as per the regulatory
requirements.
d. The promoting company’s (if any) litigation record, the nature of
litigation, status of litigation during the preceding three years preceding.
The stock exchanges charge listing fees to provide the service of trading to the
scrips through their exchanges. Listing fees of the exchange depends on the
demand and supply factor. Due to this reason, listing fees vary from exchanges to
exchanges.
BOMBAY STOCK EXCHANGE
The BSE has a separate Listing Department to grant approval for listing of
securities of companies in accordance with the provisions of the Securities
Contracts (Regulation) Act, 1956, Securities Contracts (Regulation) Rules, 1957,
Companies Act, 1956, Guidelines issued by SEBI and Rules, Bye-laws and
Regulations of the Exchange.
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A company intending to have its securities listed on the Exchange has to comply
with the listing requirements prescribed by the BSE. Some of the requirements are
as under:
Minimum Listing Requirements for new companies are as follows:
• Minimum Capital
Category I (for companies with post-issue equity of Rs.10 crore and above):
i. Post-issue capital of Rs.10 crore.
ii. Post-issue networth of Rs.20 crore.
Category II: For new companies in high technology (i.e., information
technology, internet, e-commerce, telecommunication, media including
advertisement, entertainment etc.) the following criteria is applicable
regarding threshold limit:
i. The total income/sales from the main activity, which should be in the field
of information technology, internet, e-commerce, telecommunication,
media including advertisement, entertainment etc., should not be less
than 75% of the total income during the two immediately preceding
years as certified by the Auditors of the company.
ii. The minimum post-issue paid-up equity capital should be Rs.5 crore.
iii. The minimum market capitalization should be Rs.50 crore. (The
capitalization will be calculated by multiplying the post-issue
subscribed number of equity shares with the Issue price).
iv. Post-issue networth (equity capital + free reserves excluding revaluation
reserve) of Rs.20 crore.
• Minimum Public Offer: As per Rule 19(2)(b) of the Securities Contracts
(Regulation) Rules, 1957, securities of a company can be listed on a Stock
Exchange only when at least 25% of each class or kind of securities is offered
to the public for subscription.
In case of IPOs by unlisted companies in the IT & entertainment sector, at
least 10% of the securities issued by the company may be offered to the
public subject to the following:
– Minimum 20 lakh securities are offered to the public (excluding
reservation, firm allotment and promoters contribution).
– The size of the offer to the public is minimum 50 crore.
For this purpose, the term “offered to the public” means only the portion
offered to the public and does not include reservations of securities on firm or
competitive basis. SEBI may, however, relax this condition on the basis of
recommendations of stock exchange(s), only in respect of a Government
company defined under Section 617 of the Companies Act, 1956.
Minimum Listing Requirements for Companies Listed on other Stock Exchanges
The Governing Board of the Exchange at its meeting held on 6th August, 2002
amended the direct listing norms for companies listed on other Stock Exchange(s)
and seeking listing at BSE. With effect to the amendment, the companies listed on
other Stock Exchanges and seeking listing on Bombay Stock Exchange are
required to fulfill the following criteria:
• Minimum issued and paid-up Equity Capital of Rs.3 crore.
• Profit making track record for last three years.
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• Minimum networth of Rs.20 crore (networth includes Equity capital and free
reserves excluding revaluation reserves).
• Minimum market capitalization of the listed capital should be at least two
times of the paid-up capital.
• Dividend paying track record for the last 3 consecutive years and the
minimum dividend should be at least 10%.
• Minimum 25% of the company’s issued capital should be with
Non-Promoters shareholders as per Clause 35 of the Listing Agreement. Out
of above Non Promoter holding no single shareholder should hold more than
0.5% of the paid-up capital of the company individually or jointly with others
except in case of Banks/Financial Institutions/Foreign Institutional
Investors/Overseas Corporate Bodies and Non-Resident Indians.
• At least two years listing record with any of the Regional Stock Exchange.
• The company should sign an agreement with CDSL & NSDL for demat
trading.
Minimum Requirements for Companies Delisted by the BSE and Seeking Relisting
The companies delisted by BSE and seeking relisting are required to make a fresh
public offer and comply with the prevailing SEBI’s and BSE’s guidelines
regarding initial public offerings.
Permission to use the name of the Exchange in an Issuer Company’s Prospectus
The Exchange follows a procedure in terms of which companies desiring to list
their securities offered through public issues are required to obtain its prior
permission to use the name of the Exchange in their prospectus or offer for sale
documents before filing the same with the concerned office of the Registrar of
Companies. The Exchange has since last three years formed a “Listing Committee”
to analyze draft prospectus/offer documents of the companies in respect of their
forthcoming public issues of securities and decide upon the matter of granting
them permission to use the name of “Bombay Stock Exchange Limited” in their
prospectus/offer documents. The committee evaluates the promoters, company,
project and several other factors before taking decision in this regard.
Submission of Letter of Application
As per Section 73 of the Companies Act, 1956, a company seeking listing of its
securities on the BSE is required to submit a Letter of Application to all the Stock
Exchanges where it proposes to have its securities listed before filing the
prospectus with the Registrar of Companies.
Allotment of Securities
As per Listing Agreement, a company is required to complete allotment of
securities offered to the public within 30 days of the date of closure of the
subscription list and approach the Regional Stock Exchange, i.e., Stock Exchange
nearest to its Registered Office for approval of the basis of allotment. In case of
Book-building issue, allotment shall be made not later than 15 days from the
closure of the issue failing which interest at the rate of 15% shall be paid to the
investors.
Trading Permission
As per Securities and Exchange Board of India Guidelines, the issuer company
should complete the formalities for trading at all the Stock Exchanges where the
securities are to be listed within 7 working days of finalization of Basis of
Allotment. A company should scrupulously adhere to the time limit for allotment
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of all securities and dispatch of Allotment Letters/Share Certificates and Refund

Orders and for obtaining the listing permissions of all the Exchanges whose names
are stated in its prospectus or offer documents. In the event of listing permission to
a company being denied by any Stock Exchange where it had applied for listing of
its securities, it cannot proceed with the allotment of shares. However, the
company may file an appeal before the Securities and Exchange Board of India
under Section 22 of the Securities Contracts (Regulation) Act, 1956.
Requirement of 1% Security
The companies making public/rights issues are required to deposit 1% of issue
amount with the Regional Stock Exchange before the issue opens. This amount is
liable to be forfeited in the event of the company not resolving the complaints of
investors regarding delay in sending refund orders/share certificates, non-payment
of commission to underwriters, brokers, etc.
Payment of Listing Fees
All companies listed on the Exchange have to pay Annual Listing Fees by the
30th April of every financial year to the Exchange as per the Schedule of Listing
Fees prescribed from time to time.
Compliance with Listing Agreement
The companies desirous of getting their securities listed are required to enter into
an agreement with the Exchange called the Listing Agreement and they are
required to make certain disclosures and perform certain acts. As such, the
agreement is of great importance and is executed under the common seal of a
company. Under the Listing Agreement, a company undertakes, amongst other
things, to provide facilities for prompt transfer, registration, sub-division and
consolidation of securities; to give proper notice of closure of transfer books and
record dates, to forward copies of unabridged Annual Reports and Balance Sheets
to the shareholders, to file Distribution Schedule with the Exchange annually; to
furnish financial results on a quarterly basis; intimate promptly to the 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. The Listing Department of the Exchange monitors the
compliance of the companies with the provisions of the Listing Agreement,
especially with regard to timely payment of annual listing fees, submission of
quarterly results, requirement of minimum number of shareholders, etc., and takes
penal action against the defaulting companies.
“Z” Group
The Bombay Stock Exchange has introduced a new category called “Z Group”
from July 1999 for companies who have not complied with and are in breach of
provisions of the Listing Agreement. The number of companies listed at the
Bombay Stock Exchange are around 6000. This is the highest number among the
Stock Exchanges in the country and in the world.
SUMMARY
• An Initial Public Offering (IPO) is the first public offer of equity shares by a
company since its inception.
• An IPO is used as a financing strategy (to raise funds) or as an exit strategy
(to offload holding to the general public).
• There are various advantages and disadvantages of going public. It is to be
noted that despite so many issues hit the Indian markets, most of them get
subscribed.
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Investment Banking
• The eligibility norms for IPO are: the company should be in existence for the
last 5 years with dividend payment for at least 3 years or the project for
which funds are required should be appraised by a bank or financial
institution who should invest in at least 10% of the equity or debt capital of
the company. The issue size does not exceed 5 times the pre-issue net worth.
• The company has to appoint various intermediaries like: Investment bankers,
registrars and share transfer agents, bankers to the issue, debenture trustees
(if applicable), advertising agency and printers of stationery, underwriters to
the issue, brokers to the issue, auditors and legal advisor to the issue.
• The contribution of the promoter should be 20% of the post-issue equity
capital. The percentage of holding for a new company coming out with an
issue at a premium depends on the size of the issue. The lock-in requirement
for the promoters’ holdings is 3 years.
• Contribution of the promoters should not include: shares issued within one
year of filing prospectus with SEBI if the price is below the issue price;
bonus shares out of revaluation reserves; shares issued in consideration other
than cash.
• SEBI has made some special mandatory provisions for debenture issues:
mandatory credit rating; appointment of SEBI registered debenture trustee;
creation of debenture redemption reserve; option of redemption in case of
roll-over of NCD/PCD; optional conversion of debentures above 18 months;
availability of optional conversion of debentures after 18 months or before
36 months for debenture-holders; no issue of FCD for more than 3 years
without optional conversion with put and call option facility.
• The marketing of a public issue depends on: timing of the issue, retail
distribution network, reservation portion in the issue and advertising
campaign for the issue.
• The allotment of shares in case of over-subscription should be tilted towards
the small investors (those with applications up to 1000 shares) in order to
avoid concentration of power in few hands. There ought to be at least
5 investors per Rs.1 lakh of equity capital.
• In case of under-subscription of less than 90% of the issue size, the company
must refund the proceeds to the investors. In order to avoid refunds, the
company can take the help of underwriters who have to subscribe to the
balance shares as per their pre-decided commitments.
• While designing the capital structure of a company, the following points must
be kept in mind: type of asset being financed, nature of the industry in which
operating, degree of competition, obsolescence of one’s products, product life
cycle, financial policy and past/current capital structure.
• While deciding about the financial instrument, the following points must be
kept in mind: purpose of the offer, debt servicing, tax considerations, credit
rating, asset cover and dilution of ownership.
• The Indian capital markets have seen the following innovative financial
instruments in the recent past: zero coupon bonds, secured premium notes,
deep discount bonds, optional convertible bonds, third party convertible
bonds, zero coupon convertible notes, tax saving bonds, cumulative
convertible preference shares, non-convertible debentures with equity
warrants, floating rate instruments, auction rated debt, zero coupon bonds
with equity warrants, among others.
• New companies should price their issues at par, but private companies with
profitability track record can price their issues at a premium and listed
companies can price their issues freely. At present, 10% of the issue has to be
made by the book building method.
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• There are various alternatives to price an issue: dividend discount model,

yield expectation of the public, book value of share, current market price,
past price behavior, Japanese auction pricing, book-building method, brand
equity of the company, etc.
• Indian companies tend to justify their premiums through qualitative as well
as quantitative factors.
• The pricing of an IPO in the Indian capital market is as follows: estimation of
the preliminary price, deciding on the price band and determining the actual
offer price.
• An issue could be overpriced, rightly priced or underpriced. The factors
underlying underpricing are: asymmetric information, early fixation of offer
price, interest rate float, liquidity premium, building shareholders loyalty,
rewarding the favored clients of the Investment bankers and to attract the
financial institutions.
• The factors responsible for persistent underpricing in the market are: the
Winner’s curse, information disclosure in the pre-selling period,
informational cascades, avoidance of litigation (not in India), signaling for a
future issue, information asymmetry between firms and investment bankers,
regulatory constraints, political goals and market incompleteness.
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Investment Banking
Appendix*
Clarificatory Examples
i. In case of an issuer making an initial public offer: Suppose the post-issue
capital is Rs.100 crore. As per the extant guidelines the promoters’
contribution shall not be less than 20% of the post-issue capital subject to the
condition that at least 25% of the post-issue capital shall be offered to the
public. In case, the promoters bring in only the minimum specified
contribution, then Rs.20 crore shall be allocated to the promoters. In such a
scenario, Book Building facility may be for Rs.80 crore, which is the issue
size offered to the public through the prospectus.
Allocation in such a scenario shall be as follows:
• Allocation for individual investors applying for up to 10 tradeable lots
through the syndicate members shall be at least 15% of the post-issue
capital (Rs.100 crore) i.e., at least Rs.15 crore.
• Allocation to Institutional investors as well as other investors applying
through the syndicate members shall be Rs.65 crore (Rs.80 crore – Rs.15
crore).
• Allocation to individual investors applying not through the syndicate
members but during the time when the issue is open would be
10 percent of the issue size offered to the public through the prospectus
(Rs.80 crore) i.e., Rs.8 crore.
• Due to allocation to individual investors applying not through the
syndicate members the post-issue capital would increase to Rs.108 crore
and, therefore, the promoters need to bring in extra capital of Rs.2.4
crore to ensure that their post-issue holding (Rs.20 crore + Rs.2.4 crore
= Rs.22.4 crore) does not fall below the minimum specified percentage
(20 percent of Rs.110.4 crore i.e., Rs.108 crore + Rs.2.4 crore).
• Allocation to individual investors would, therefore, total at least Rs.23
crore (Rs.15 crore + Rs.8 crore).
Similarly, the computation can be worked out for varying levels of promoters’
contribution.
The point that needs to be understood is that in the case of a company going
in for an initial public offer and availing of the facility of book-building, the
allocation to individual investors applying through the syndicate members
shall be with reference to the post-issue capital, while the allocation to
individual investors applying not through the syndicate members shall be
with reference to the issue size offered to the public through the prospectus.
ii. The allocation process shall be as follows for a listed company: Suppose a
listed company with a capital of Rs.50 crore makes a further issue of capital
to the public of Rs.50 crore. As per the guidelines, the promoter has to
participate to the extent of 20 percent of the proposed issue or ensure that his
post-issue holding does not fall below 20 percent of the expanded capital.
In case the promoters participate to the extent of 20 percent of the proposed
issue, then the promoters contribution shall be Rs.10 crore. The amount
available for book building, in such a case, shall be Rs.40 crore, which is the
issue size offered to the public through the prospectus.
Allocation for individual investors applying for up to 10 tradeable lots
through the syndicate members shall be at least 15 percent of the proposed
issue size (Rs.50 crore) i.e., at least Rs.7.5 crore.
Allocation to Institutional investors as well as other investors applying through
the syndicate members shall be Rs.32.5 crore (Rs.40 crore – Rs.7.5 crore).
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Allocation to individual investors applying not through the syndicate

members but during the time when the issue is open would be 10 percent of
the issue size offered to the public through the prospectus (Rs.40 crore) i.e.,
Rs.4 crore.
Due to allocation to individual investors applying not through the syndicate
members the capital issue through the present issue would increase to
Rs.54 crore and therefore the promoters need to bring in extra capital of
Rs.1.2 crore to ensure that their post-issue holding (Rs.10 crore + Rs.1.2
crore = Rs.11.2 crore) does not fall below the minimum specified percentage
(20 percent of Rs.55.2 crore, i.e., Rs.54 crore + Rs.1.2 crore).
Allocation to individual investors would, therefore, total at least
Rs.11.5 crore (Rs.7.5 crore + Rs.4 crore).
In the case of a listed company going in for a further issue of capital and
availing of the facility of book-building, the allocation to individual investors
applying through the syndicate members shall be with reference to the
proposed issue, while the allocation to individual investors applying not
through the syndicate members shall be with reference to the issue size
offered to the public through the prospectus.
iii. The allocation process shall be as follows for an unlisted company going
in for an offer for sale: Suppose an unlisted company with a capital of
Rs.100 crore makes an offer for sale. As per the guidelines, the promoters
shall ensure that their shareholding after disinvestment shall not be less than
20 percent of the total issued capital of the company subject to the condition
that at least 25 percent of the total issued capital of the company shall be
offered to the public.
In case the promoters shareholding after disinvestment remains at 20 percent
of the total issued capital, then the promoters contribution shall be
Rs.20 crore. The amount available for book-building, in such a case, shall be
Rs.80 crore, which is the issue size offered to the public through the
prospectus.
Allocation for individual investors applying for up to 10 marketable lots
through the syndicate members shall be at least 15 percent of the post-issue
capital (Rs.100 crore) i.e., at least Rs.15 crore.
Allocation to individual investors applying not through the syndicate members
but during time when the issue is open would be 10 percent of the issue size
offered to the public through the prospectus (Rs.80 crore) i.e. Rs.8 crore.
Allocation to Institutional investors as well as other investors applying
through the syndicate members shall be Rs.57 crore (Rs.80 crore – Rs.15
crore – Rs.8 crore).
Allocation to individual investors would therefore total at least Rs.23 crore
(Rs.8 crore + Rs.15 crore).
In case of an unlisted company going in for an offer for sale and availing the
facility of book-building, the allocations to the individual investors applying
through the syndicate members shall be with reference to the post-issue capital,
while the allocations to the individual investors not applying through the syndicate
members shall be with reference to the issue size offered to the public through the
prospectus.
* Source: www.sebi.gov.in.
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Lesson 3
• ! "
INTRODUCTION
According to Section 81 of the Companies Act, 1956, if a public company wants
to increase its subscribed capital by allotment of further shares after two years
from the date of its incorporation or one year from the date of first allotment,
whichever is earlier, such further shares should be first offered to the existing
equity shareholders, in proportion to the capital paid-up on the shares held by them
at the date of such offer. The shareholders to whom the offer is made are not under
any legal obligation to accept the offer. On the other hand, they have a right to
renounce the offer in favor of any person. Shares so offered by a public company
to its existing equity shareholders, are called rights shares because they are offered
to the shareholder as a matter of legal right. Rights shares are usually offered on
terms advantageous to the shareholders. For example, shares of the face value of
Rs.10 may be offered at par value, while the market price of the shares at the time
of announcing offer may be more than Rs.10 per share.
LEGAL ASPECTS FOR RIGHTS ISSUES

According to Section 81 of the Act, the following conditions have to be satisfied
by a public company for issuing rights shares:
i. Such shares must be offered to holders of equity shares in proportion, as
nearly as circumstances admit, to the capital paid up on the share.
ii. The offer must be made by giving a notice specifying the number of shares
offered.
iii. The offer must be made to accept the shares within a period specified in the
notice which shall not be less than 15 days and not more than 30 days. A
Renouncement form in favor of someone else is also given in the composite
application form.
iv. Unless the articles of association of the company provide otherwise, the
notice must also state that the shareholders have the right to renounce all or
any of the shares offered to them in favor of one or more of the nominees.
v. After the expiry of the time specified in the notice or on receipt of intimation
earlier from the shareholder declining to accept the shares offered, the Board
of Directors may dispose of the unsubscribed shares in such manner as they
think most beneficial to the company.
EXCEPTIONS TO THE ABOVE RULES
According to Section 81(A), such new shares may be offered by the company to a
person other than its equity shareholders, if a special resolution is passed by the
company in general meeting to that effect or an ordinary resolution is passed by
the company to that effect and the approval of the Central Government is obtained
thereof on the ground that such a proposal is most beneficial to the company.
The rule laid down in Section 81 of the Act, namely, that further shares should be
offered to existing equity shareholders does not apply:
i. to a private company.
ii. to the increase of the subscribed capital of a public company caused by the
exercise of an option attached to debentures or loans raised by the company
to convert such debentures or loans into shares of the company or to
subscribe for shares in the company, provided that the terms of such issue are
approved by (a) special resolution of the company; (b) the Central
Government, or be in conformity with the rules made by the Central
Government. [Section 81 (3)].
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Investment Banking
The Objectives of Section 81 of the Companies Act, 1956 are:

i. There should be an equitable distribution of shares, the existing shareholders
being given first priority in getting the new shares.
ii. The voting right of shareholders should not be affected by the issue of further
shares, and
iii. The shareholders’ interest in the reserves/net worth of the company should
not be impaired.
REGULATORY FRAMEWORK FOR LISTED COMPANIES
i. The SEBI Guidelines for Disclosure and Investor Protection apply only to
rights issue made by listed companies.
ii. These Guidelines do not apply to rights issue of any amount by existing
private companies and unlisted public companies.
iii. Private companies or unlisted companies therefore, only need to comply with
the requirements laid down in the Companies Act, 1956.
iv. Where any company has withdrawn the rights issue after announcing the
record date, such a company is not permitted to make application for listing
of any of its securities for a minimum period of 12 months from the
announced record date.
v. Underwriting of rights issue is not mandatory. However, stand-by
underwriting support can be extended to a rights issue.
vi. These guidelines are not applicable to composite issues, i.e., an issue of
securities on a rights basis made either simultaneously or preceded or
followed by an issue of securities to public, within a period of three months
before or after closure of rights issue, as the case may be.
Gap between Rights and Public Issues
vii. The gap between the closure dates of rights issue and public issue should not
exceed 30 days. No bonus issue should be made within 12 months from the
date of issue.
Appointment of Merchant Banker
viii. Where issue of shares by way of rights by a listed company does not exceed
Rs.50 lakh, appointment of merchant banker is not mandatory.
ix. For rights issues by listed companies exceeding Rs.50 lakh, the issue should
be managed by a SEBI-registered merchant banker.
Minimum Subscription
x. If the company does not receive at least 90 percent of the issued amount
including accepted devolvement from underwriters, if any, within 42 days
from the date of closing of the issue, the amount of subscription received is
required to be refunded.
If there is any delay in the refund of amount collected by more than 8 days,
the company and directors of the company shall be jointly and severally
liable to repay the amount due by way of refund with interest @ 15 percent
p.a. for the delayed period.
xi. Rights of FCDs/PCDs Holders
a. The proposed rights issue should not dilute the value or rights of the
fully or partly convertible debenture holders.
b. If the conversion of FCDs/PCDs is due within a period of 12 months
from the date of rights issue, reservation of shares out of rights issue
should be made in proportion to the convertible part of FCDs/PCDs.
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xii. Vetting of Letter of Offer by Lead Manager

a. The letter of offer pertaining to rights issue has to be vetted by the lead
manager before approaching stock exchange for fixing the record date
for the proposed issue.
b. If managers to the issue have not been appointed in case of rights issue
not exceeding Rs.50 lakh, the copy of the letter of offer should be
forwarded to SEBI for its information.
c. The Code of Advertisements issued by SEBI should be strictly
observed.
xiii. Salient Features of Offer Documents
• General Information –
a. Name and address of registered office of the company
b. Issue listed on [Name(s) of the Stock Exchanges]
c. Opening, closing dates of the issue
d. Name and address of lead managers
e. Name and address of trustees under debenture trust deeds (in the
case of debenture/issue)
f. Rating for the debenture/preference shares, if any, obtained from
CRISIL or any recognized rating agency.
• Capital structure of the company –
a. Authorized, issued, subscribed and paid-up capital
b. Size of present issue
c. Number of instruments, description, aggregate nominal value and
the issue amount
d. Paid-up capital –
i. After the present issue
ii. After conversion of debentures (if applicable)
e. Share Premium Account (before and after the issue).
• Terms of the Present Issue –
a. Authority for the issue, terms of payment and procedure and time
schedule for allotment and issue of certificates
b. How to apply – availability of forms, letter of offer and mode of
payment
c. Special tax benefits to company and shareholders under the
Income-tax Act, 1961, if any.
• Particulars of the Issue –
a. Objects of the issue
b. Project cost
c. Means of financing (including contribution of promoters).
• Company Management and Project –
a. History, main objects and present business of the company
b. Promoters and their background
c. Names, address and occupation of manager, managing directors/
whole-time director and names of nominees of institutions, if any,
on the Board of Directors including key management personnel
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d. Location of the project

e. Plant and machinery, technology, process, etc.
f. Collaboration, performance guarantee, if any, or assistance in
marketing by the collaborators
g. Infrastructure facilities for raw materials and utilities like water,
electricity, etc.
h. Schedule of implementation of the project and progress made so
far, giving details of land acquisition, execution of civil works,
installation of plant and machinery, trial production, date of
commercial production, if any.
i. The Products–
a. Nature of product(s) – consumer/industrial and end-users
b. Existing, licensed and installed capacity of the product,
demand of the product – existing and estimated in the coming
years as estimated by a Government authority or by any other
reliable institution, giving source of information
c. Approach to marketing and proposed marketing set-up
In the case of company providing services, relevant information
in regard to nature/extent of services, etc., to be furnished.
j. Future prospects – The expected year when the company would be
able to earn net profit, declare dividends.
• Financial performance of the company for the last five years: (figures to
be taken from the audited annual accounts in tabular form) –
a. Balance sheet data: equity capital, reserves (state revaluation
reserve, the year of revaluation and its monetary effect on assets)
and borrowings
b. Profit and loss data: sales, gross profits, net profit, dividend paid, if
any
c. Any change in accounting policies during the last three years and
their effect on the profits and the reserves of the company
d. Stock market quotation of share/debentures of the company, if any
(high/low price in each of the last three years and monthly
high/low price during the last six months)
e. Information as required by Stock Exchange regarding working
results for last but one month before dating of the offer document
and the last four weeks closing price of the shares
f. Details of any pending litigations, default against the company,
group companies and the business relationship of group companies
with the issuing company
g. Promise versus performance for the earlier public/rights issues of
the company, or group companies
h. Financial performance of the subsidiary company/group company
i. Justification of premium
j. Risk factors and management perception of risk factors.
• Whether all payments/refunds, debentures, fixed deposits, interest on
fixed deposits, debenture interest, institutional dues have been paid-up
to date, if not, details of the arrears, if any, to be stated.
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• Following particulars in regard to the listed companies under the same

management within the meaning of Section 370 (1B) which made any
capital issue in the last three years –
a. Name of the company
b. Year of issue
c. Type of issue (rights)
d. Amount of issue
e. Date of closure of issue
f. Date of dispatch of share/debenture certificates completed
g. Date of completion of the project, where object of the issue was
financing of a project
h. Rate of dividend paid.
• Management perceptions of risk factors, (for example, sensitivity to
foreign exchange rate fluctuations, difficulty in availability of raw
materials or in marketing of products, cost/time overrun).
xiv. Oversubscription not to be Retained
No part of over-subscription should be retained under any circumstances, i.e.,
quantum of rights issue should not exceed as specified in the letter of offer.
xv. Issue to be Made Fully Paid-up
a. As per the SEBI Guidelines capital issues have to be made fully paid-up
within 12 months.
b. Where the total issue size exceeds Rs.500 crore:
i. it is not necessary to make the capital issue fully paid-up within
12 months.
ii. the amount to be payable on application, allotment and on each
call should not exceed 25 percent of the total quantum of the issue.
iii. the company should make arrangements for monitoring of the use
of proceeds the issue by one of the financial institutions.
iv. copy of the monitoring report must be filed with SEBI by the
financial institutions and by the company for the purpose of
record.
xvi. Preferential Allotment of Rights Issue
a. No preferential allotment should be made along with the rights issue.
b. If any preferential allotment to the employees or any identified persons
has been proposed to be made, this should be done independent of the
rights issue by complying with the provisions of the Companies Act,
1956. The consent of the shareholders at the general meeting should be
obtained under Section 81 (1A) of the Companies Act, 1956 for making
preferential allotment to the employees or any identified person by
name. As offer for preferential allotment is proposed to be made to
specified persons, such offer will not be deemed to be a prospectus. It
may also be stated that the said preferential allotment shall be in the
nature of Private Placement and in terms of clause (b) of second
provision to sub-section (3) of Section 56, the form of application for
shares or debentures need not be accompanied by an abridged
prospectus.
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Investment Banking
xvii. Additional Facility for Applying

a. An advertisement should be prominently issued in not less than two All
India Newspapers at least one week before the date of opening of the
subscription stating the following:
i. The date of despatch of letters of offer together with composite
application forms by registered post.
ii. Date of opening and closing of subscription list, etc.
iii. The centers other than registered office of the company where the
shareholders or the persons entitled to rights may obtain duplicate
copies of composite application forms in case they do not receive the
original within reasonable time even after opening of the rights issue.
iv. Details of the additional facility for making the application to
subscribe to the rights on a plain paper where any shareholder has
neither received the original composite application form nor is he
in a position to obtain a duplicate form.
v. Necessary particulars which have to be mentioned by shareholders
making application on plain paper, like name, address, ratio of
right numbers, number of shares entitled and applied for,
additional shares, if any, amount to be paid along with the
application, particulars of cheque, etc., to be drawn in favor of the
Company’s Rights Issue account.
vi. The instruction that such applications on plain paper should be
directly sent by Registered Post to the company’s designated
official at the address given in the advertisement.
b. The advertisement should clearly state that the shareholders making
application for the rights on plain paper shall not be entitled to renounce
their rights and they shall not utilize the standard form for any purpose
including renunciation even if it is received subsequently.
c. The advertisement should warn the shareholders making application on
plain paper that if any of these requirements is violated by any
shareholders, he shall face the risk of rejection of both the applications.
It may be stated here that the issuer-company is free to provide a clause
for forfeiture of the amounts remitted along with the application forms
in violation of the above requirements.
xviii.Promoters’ Contribution in Case of Rights issue at Premium and Lock-in
Period
Where the issue is by way of rights of shares at a premium or FCDs and
PCDs carrying a term for conversion at a premium on allotment or at a future
date including warrants convertible into shares at a premium at a future date,
the following requirements in regard to promoters’ contribution should be
fulfilled:
a. Where the promoters’ shareholdings in the equity at the time of the
rights issue is more than 20 percent of the issued capital of the
company, promoters’ equity holdings should not fall below 20 percent
of the expanded capital (including convertible portion of
debentures/warrants).
b. Where the promoters’ existing equity holdings is less than 20 percent of
the issued capital, the promoters should subscribe to the unsubscribed
portion, i.e., the portion of the rights issue which has not been taken up
by the existing shareholders or by the renouncees to such an extent as is
necessary to enable the promoters to reach at least 20 percent of the
expanded capital. The balance of the unsubscribed portion can be
disposed of by the Board of Directors in such manner as they deem fit.
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c. If the unsubscribed portion of the rights issue is not sufficient to enable

the promoters to reach 20 percent of the issued capital, the promoters
should take the entire unsubscribed portion of the rights issue.
d. Promoters’ shareholdings to the extent of 20 percent should be
subjected to a lock-in period as under:
i. Shareholding held prior to the rights issue to a lock-in period of
two years from the date of allotment in the rights issue; and
ii. Shares acquired by way of additional contribution to the
unsubscribed portion of the rights issue to a lock-in period of three
years from the date of allotment in the rights issue.
e. In case of professionally managed companies, which have not identified
persons or groups as promoters or shareholders who have control over the
management of the affairs of the company, the requirements with regard to
promoters’ contribution to rights issue at premium are not applicable.
xix. Odd Lots
a. Whenever any issue results in issue of shares in odd lots, certificate in
the denomination of 1-2-5-10-20-50 shares should be issued.
b. Where any arrangements have been made by the issuer-company for
providing liquidity for and consolidation of shares held in odd lots
through any investment or finance company, broking firms or through
any other agency, particulars of such arrangement should be disclosed
in the offer documents relating to the concerned issue of capital. Such
odd lots may arise on account of issue of rights, conversion of
debentures/warrants, etc.
xx. Compliance Reports
The Lead Manager must ensure that the letter of offer for rights contains all
the informatin specified under the Companies Act. He has to submit the draft
of the Letter of Offer to SEBI six weeks before the issue is scheduled to open
for subscription. If SEBI makes any modifications within 3 weeks of
submission of letter of offer then such modifications have to be incorporated
before filing the letter of offer. The copy of letter of offer shall be submitted
by the lead manager to SEBI two weeks before the issue opens for
subscription.
ACTION PLAN FOR RIGHTS ISSUES
1. Hold the Board Meeting to issue Notice to call extraordinary general meeting to:
a. increase the authorized capital;
b. pass special resolution under section 81 (1A) for reservation in favor of
employees.
2. Send notices to all the shareholders at least 25 days before the date of
extraordinary general meeting together with explanatory statement as
required under section 173 of the Companies Act, 1956.
3. Hold General Meeting and pass resolutions for:
a. Increase in authorized capital
b. Amendment in capital clause of memorandum and articles
c. Special resolution under section 81 (1A).
4. Get Form No. 5 stamped with requisite stamp fee for increase in authorized
capital.
5. File Form No. 5 and Form No. 23 with Registrar of Companies.
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Investment Banking
6. Send intimation to Stock Exchange(s) where the shares of the company are
presently listed, about the date of Board meeting in which the Rights Issue is
to be taken up for consideration.
7. Convene Board Meeting to decide:
a. the ratio in which the rights shares are to be issued
b. pricing of the shares
c. rate of dividend, date of redemption, etc., in case of preference shares to
be issued
d. the record date
e. reservation in favor of employees.
8. Intimate the stock exchange(s) where the shares are listed, of the Board’s
decision about the issue of rights shares including the ratio, the price and
record date if fixed.
9. Make an application to Reserve Bank of India for permission under section
19(1)(d) of FERA, 1973 in case the shares are to be issued to non-residents.
10. Obtain approval from Reserve Bank of India under section 19(1)(d) of
FERA, 1973.
11. Finalize the appointment of Lead Managers to the Issue, if any.
12. Finalize the appointment of underwriters, if any.
13. Get the working results of the company prepared and approved by its
auditors.
14. Prepare draft of following documents:
a. Letter of Offer
b. Chairman’s Appeal
c. Allotment/Refund Letters
d. Share Certificates
e. Chairman’s Appeal.
15. Finalize the appointment of:
a. Printers
b. Advertising agents
c. Registrars to issue
d. Underwriters
e. Bankers to issue.
16. Submit the Letter of Offer to the Lead Manager for vetting.
17. File the draft Letter of Offer, along with the Due Diligence Certificate of the
Lead Manager with SEBI. Despatch the draft Letter of Offer and Composite
Application Form to the Regional Stock Exchange for approval.
18. Finalize the issue campaign in consultation with the Managers to issue and
advertising agents.
19. Obtain approval from the stock exchange for Letter of Offer and Composite
Application Form.
20. Place order for printing of Composite Application Form on continuous
printers stationery.
21. Place order for printing of Letter of Offer, Chairman’s appeal and brochures.
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22. Hold Board Meeting for:

a. Approving and signing of Letter of Offer
b. Opening accounts with bankers to the issue
c. Empowering director(s) to decide upon the closure of offer
d. Authorise signing of listing application
e. Appointment of Managers and Registrars to Issue
f. Accept letters of underwriting.
23. Give press releases in newspapers about the company’s rights issue.
24. File printed copy of Letter of Offer and Composite Application Form to the
stock exchanges where the listing is sought and with SEBI.
25. Registrars to collect composite application forms from the continuous
stationery printers and get the required particulars about rights, etc., filled in
by computer.
26. Registrars to mail Letters of Offers, Composite Application Form and
Chairman’s appeal to all shareholders/debenture holders as on the record
date.
27. Release advertisements in Newspapers.
28. Open special bank accounts with the controlling branches of the bankers to
the issue.
29. Send confirmation to the controlling branches of the bankers to the issue
informing them about their branches where the applications are to be
accepted and send copy of such letters to all collecting branches.
30. Registrars to prepare and send procedures and bank schedules to bankers and
their collecting branches.
31. Opening of rights issue announcement to appear in newspapers.
32. Review the position with regard to the number of shares/debentures
subscribed.
33. Company is generally required to keep rights issue open for a minimum
period of 30 days from date of opening of the rights issue.
34. Write to stock exchanges and advise all the collecting branches of bankers
about the extension of offer period, if so requested.
35. Company can keep the rights issue open for a maximum period of 60 days
from the date of opening of issue.
36. Announce in the Newspapers about the closure/extension of last date.
37. File letter of application with the stock exchange(s) where the shares are to
be listed.
38. Registrars to collect applications from the bankers to the issue and make
analysis of share/debentures subscribed.
39. Collect certificate from the Managers/Merchant Bankers to the effect that the
issue has been subscribed up to 90 percent of the total.
40. Send the above stated certificate duly signed by the Chief
Executive/Company Secretary to the regional stock exchange and also to
SEBI.
41. Obtain letter from the stock exchange accepting the letter of application and
granting permission to make allotment of shares.
42. Registrars to prepare basis of allotment in case the rights issue is
over-subscribed and get it approved by the stock exchange.
324
Investment Banking
43. Make application to the Superintendent of Stamps for payment of

consolidated stamp duty on shares to be allotted to applicants.
44. Hold the Board Meeting to:
a. dispose of unsubscribed shares, if any;
b. make allotment of shares.
45. Obtain receipt from the stamp office and make the endorsement giving
reference thereof for payment of consolidated stamp duty on share certificate
to be printed.
46. The shares not subscribed are to be distributed to the applicants who have
applied for additional shares on pro-rata basis having regard to the existing
shareholdings.
47. Get the following stationery printed on continuous stationery:
a. Allotment letters/Refund orders;
b. Share/Debenture certificates.
48. File detailed listing application along with three copies of Distribution
Schedule, specimen of share certificate and an analysis of shares issued to the
stock exchange within six weeks from the date of closure of issue.
49. Registrars to dispatch allotment letters/Refund orders/share certificates
within 6 weeks from the closure of issue to all applicants by registered post.
50. File return of allotment with Registrar of Companies in Form No. 2.
51. Confirm to the stock exchange(s) that all the share/debenture certificates have
been posted and that the register of member is open for recording transfer.
52. Registrars to ensure that register of members is posted up to date after
making entries for any allotments in the members folios.
53. Make payment of underwriting commission and fees of Managers and
Registrars to issue.
PSU RIGHTS RENUNCIATION MODALITIES SPECIFIED
Faced with a flood of rights issue proposals from Public Sector Undertakings
(PSUs) the Government has issued firm instructions about the modalities of
renunciation of rights of the PSU.
In a memorandum issued to all ministries and PSU chiefs, the Department of
Public Enterprises has stated that the decision to renounce the rights is substantive
one, which will be taken by the ministry concerned with the concurrence of the
Finance Ministry.
However, the merchant banker managing the issue will be given the freedom to
decide which parties should be invited to submit bids to buy the shares.
If the ministry takes a decision to renounce, it will advise the PSU concerned to
arrange with the merchant banker to invite bids from both private and public
mutual funds and financial institutions and other agencies which in the opinion of
the merchant banker will be keen to buy the renunciation.
The bids to be addressed to the PSU will be evaluated by the PSU and the
merchant bank in the descending order of the renunciation premium offered.
Thereafter, the Administrative Ministry will issue an acceptance, based on which
the PSU will collect the amount from one or more successful buyers and credit the
amount to the designated account of the Union Government.
The reserve price for renunciation of rights would be decided by the
Administrative Ministry concerned in consultation with the merchant banker
taking into account all factors including the market situation. This will be the
minimum price at which the rights could be renounced by the Administrative
Ministry in the auction method to be handled by the same merchant banker, who is
entrusted with the rights issues management.
325
In case some rights could not be sold in the auction, the merchant banker can be
offered first these unsold rights at the reserve price. On his acceptance at this price
these rights may also be renounced.
However, the Administrative Ministry can take a decision with the concurrence of
the Finance Ministry whether the government could still subscribe to the unsold
rights instead of offering them to the merchant banker at the reserve price or in
case the merchant banker is not interested in accepting the same fully or partly.
Further, all steps required for selling the rights issue of Government on
renunciation will be undertaken by the merchant banker as per the instruction from
the Administrative Ministries in accordance with the provision of Company law,
guidelines of the Securities and Exchange Board of India (SEBI) and the rules in
force.
The Government has decided that no fees will be payable to the merchant banker for
this service, which should be a part of the package to manage the PSU rights issue.
CONSEQUENCES OF A RIGHTS ISSUE
What are the likely consequences of a rights issue on the market value per share,
value of the rights, earnings per share, and wealth of shareholders? To answer this
question, let us look at the illustrative data of the Right and Left Company given in
the following table.
VALUE OF SHARE
The value of a share, after the rights issue, is expected to be
NPo + S
N +1
Where,
N = Number of existing shares required for a rights share.
Po = Cum-rights market price per share.
S = Subscription price at which the rights shares are issued.
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The rationale behind this formula is as follows: For every N shares before the
rights issue, there would be N + 1 shares after the rights issue. The market value of
these N + 1 shares is expected to be the market value of N cum-right shares plus S,
the subscription price.
Applying this formula to the data given in Table, we find that the value per share
after the rights issue is expected to be:
5×40 + 20
= Rs.36.67
5 +1
326
Investment Banking
VALUE OF RIGHTS
Since the offer of rights is a call option, and options are valuable it will have a
positive value prior to its expiration. The value of a right is a function of the strike
price, the value of underlying stock, the time of expiration, the variance of the rate
of return of the underlying stock and the riskless rate of interest. The value of
rights also depends on the dilutive effect which is the difference between the strike
price and the market value of the existing equity.
To encourage subscription the issuer sets the subscription price at less than the
market price of its stock on the record date. In the Indian market, rights offers are
normally kept open for a period of one month. Due to the short time to expiration
the exercise value, i.e., the difference between strike price and share price is a
major determinant of the value of the right. The initial value of the right just after
the offering is announced, and when the stock is trading rights-on, i.e., the rights
are still attached to the stock is calculated by
Pr − S
R=
N +1
where R is the value of the right, Pr is the market value of a share trading rights,
S is the strike price and N is the number of rights to purchase one new share. For
example a company “X” wants to make a rights offer and has decided on the strike
price of Rs.15 and currently has a market price of cum rights of Rs.16.50 and has
fixed five rights for one new share. Then the initial value of each right will be
16.50 − 15
R= = 0.25
5 +1
After the specified date the share is said to trade ex-rights because of the shares is
not entitled to receive the rights. On the specified date the share price decreases by
the value of the right, which is no longer attached to it. Therefore, the share price
ex-rights is denoted as Pe, where Pe = Pr – R.
In a perfect capital market environment the offering of rights does not affect the
shareholders wealth, the value of a right plus the value of a share ex-rights just
equals the value of a share rights-on. Immediately thereafter the market value of
each right will vary with the price of the firm’s common stock.
P −S
R= r
N
WEALTH OF SHAREHOLDERS
The wealth of existing shareholders (per se) is not affected by the rights offering,
provided, of course, the existing shareholders exercise their rights in full or sell
their rights. To illustrate this point, consider what happens to a shareholder who
owns 100 equity shares of the Left and Right Company that have a market value of
Rs.40 each before the rights issue. The impact of her wealth when she exercises
her rights, when she sells her rights, and when she allows her rights to expire is
shown below:
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327
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SETTING THE SUBSCRIPTION PRICE

Theoretically, the subscription price is irrelevant because the wealth of a
shareholder who subscribes to the rights shares or sells the rights remains
unchanged, irrespective of what the subscription price is. To illustrate this point,
consider a shareholder who has N shares valued at Po and who enjoys the right to
subscribe to an additional share for S. His total investment would be:
The value of his shareholding after subscription would be:
NPo + S
Number of shares x Market value per share after rights issue
This is equal to:
NP − S
(N+1) = NPo + S
N +1
The value of his shareholding after subscription is equal to the value of his
investment, irrespective of the subscription price S.
In practice, however, the subscription price is important. Existing shareholders do
not like the idea of S being higher than Po because when S is higher than Po, the
market value after issue would be lower than S. Non-shareholders, who have an
opportunity to subscribe to shares not taken by existing shareholders, will have no
interest in the shares if S is higher than Po because they would then suffer a loss
when the market value falls below S after the issue.
Due to the above considerations, S has to be set equal to or lower than Po. A value
of S equal to Po is not advisable because it has no appeal to existing shareholders
and other investors as they do not see any opportunity of gain in such a case. So, S
has to be set lower than Po. In determining S, the following considerations should
be borne in mind:
i. The lower the S in relation to Po the greater is the probability of success of
the offering.
ii. When S is set low, a large number of rights shares have to be issued to raise a
given amount of additional capital. If the company wishes to maintain a
certain level of earnings per share and/or dividend per share, it would find it
difficult to do so when S is set low.
iii. The expectations of investors, the fluctuation of the share price, the size of
rights issue in relation to existing equity capital and the pattern of
shareholding are important factors in determining what S is acceptable to
investors.
328
Investment Banking
ADVANTAGES AND DISADVANTAGES OF A RIGHTS OFFERING

A rights offer provides the shareholders with the option of retaining their
proportionate ownership in a company when it sells additional shares. It is
probably beneficial only to large shareholders because of the separation of
ownership and control. A rights offering can be more beneficial to the company as
it need not have a broad market appeal and can be only concentrated on investors
who already have shares in the company. On the other hand, a rights offerings
generally takes longer time to complete and the offering eliminates the possible
transaction cost savings of selling large blocks of shares to institutions not
currently holding the stock. The cost of making rights offerings is less when
compared to public issues.
BONUS ISSUES
The issue of bonus shares is a common feature for certain profitable companies.
Normally, companies do not distribute their entire earnings earned, to the
shareholders, as dividends. A part of the profit is ploughed back into the company
in the form of retained earnings. When a company is prosperous and accumulates a
large surplus, it converts some of this surplus as capital and divides this capital
among the members in proportion to their holdings. This is done by issuing fully
paid shares representing the increased capital. The shareholders, to whom the
shares are allotted, do not have to pay anything to acquire the share. This process
of capitalization of reserves converts the quasi-capital into capital. Issue of Bonus
Shares is generally made to bring in line the paid-up capital with the capital
employed by the company.
Impact of Bonus Issue on Valuation
In perfect market conditions, the market capitalization of the company remains
constant. Both the Earnings Per Share (EPS) and the book value per share get
diluted due to the issue of bonus shares. This would result in a fall in the market
price per share. However, the loss to the investor will be offset due to the increase
in the number of shares that he possesses. The wealth of the shareholders should
remain constant.
Illustration 1
The following are the financial data of XYZ Ltd:
- # ! 3 $
1 3 $
, 7 3 0$
+ ) 3 (
The company decides to capitalize reserves of Rs.25 cr. by issuing 1 bonus share
for every 2 shares held.
PAT Rs.15cr.
EPS = = =Rs.3
No. of Shares 5cr.
Market Price = EPS x P/E multiple = Rs.3 x 8 = Rs.24

Net worth Rs.15cr.+ Rs. 75cr.
Book Value Per Share = = = Rs.25
No. of Shares 5cr.
329
Rs.15cr.
After the bonus issue = = Rs.2
7.5cr.
EPS = Rs.2
Market Price = Rs.2 x 8 = Rs.16
Rs.75cr.+ Rs. 50cr. 125

Book Value per share = = = Rs.16.66
7.5cr. 7.5
If Mr. A held 100 shares in the company, Pre-Bonus

Market Value = Rs.24 x 100 = Rs.2,400
Post Bonus Market Value = Rs.16 x 150 = Rs.2,400
There is no change in the wealth of Mr. A.
REGULATORY FRAMEWORK FOR BONUS ISSUES

SEBI believes that the Board of Directors of the companies wishing to make bonus
issues will take into due consideration the relevant financial factors while deciding
on bonus issues and observe the following guidelines:
i. SEBI guidelines are applicable to existing listed companies.
ii. Issue of bonus shares after any public/rights issue is subject to the condition
that no bonus issue shall be made which will dilute the value or rights of the
holders of debenture, convertible fully or partly.
In other words, no company shall pending conversion of FCDs/PCDs issue
any shares by way of bonus unless similar benefit is extended to the holders
of such PCDs/FCDs, through reservation of shares in proportion to such
convertible part of PCDs or FCDs. The shares so reserved may be issued at
the time of conversion(s) of such debentures on the same terms on which the
bonus issues were made.
iii. The bonus issue is made out of free reserves built out of the genuine profits
or share premium collected in cash only.
iv. Bonus shares cannot be issued out of revaluation reserves and they cannot be
capitalized.
v. The declaration of bonus issue, in lieu of dividend, is not made.
vi. The bonus issue is not made unless the partly-paid shares are made fully
paid-up.
vii. The company –
a. should not have defaulted in payment of interest or principal in respect
of fixed deposit and interest on existing debentures or principal on
redemption thereof, and
b. has sufficient reason to believe that it has not defaulted in respect of the
payment of statutory dues of the employees such as contribution to
provident fund, gratuity, bonus, etc.
viii. A company which announces its bonus issue after the approval of the Board
of Directors must implement the proposals within a period of six months
from the date of such approval and shall not have the option of changing the
decision.
330
Investment Banking
ix. There should be a provision in the Articles of Association of the company for
capitalization of reserves, etc., and if not, the company shall pass a
Resolution at its General Body Meeting making provisions in the Articles of
Association for capitalization.
x. Consequent to the issue of bonus shares if the subscribed and paid-up capital
exceed the authorized share capital, a resolution shall be passed by the
company at its General Body Meeting for increasing the authorized capital.
xi. A certificate duly signed by the issuer company and counter signed by
statutory auditor or by the company secretary that above provisions have
been complied with shall be forwarded to the Board.
PRIVATE PLACEMENTS AND BOUGHT-OUT DEALS

Private placement of securities is one of the most popular avenues of raising
capital. Private placement is a method of raising capital in which companies
directly sell their securities to a limited number of “sophisticated and discerning”
investors. Historically, the private placement market has been as popular as the
public issue market. In 2001-02, the amount raised through IPOs has been very
meagre as compared to the nineties. Reasons for this could be the scam created by
broker Ketan Parekh and attacks on New York that made the stock markets fall
from their level of 6000 points (sensex) to a level of 2600 points. It is expected
that funds raised through private placements and bought-out deals may increase as
a result.
Features
i. There are no entry barriers for the private placement market.
ii. There is no need for registration of the offer document with SEBI. The
procedural formalities are simple.
iii. The terms of the issue can be negotiated between the issuers and the
investors.
iv. The company has a choice of investors in private placement.
v. The transaction costs are low.
vi. Credit Rating is optional in case of debt instruments.
vii. The execution of the deal is faster.
PLAYERS IN THE PLACEMENT MARKET
The main investors in the private placement market are:
i. Mutual Funds;
ii. Financial Institutions;
iii. Banks;
iv. Insurance Companies;
v. Foreign Institutional Investors;
vi. High Net Worth Individuals;
vii. Unit Trust of India; and
viii. Private Equity Funds.
The main issuers in the private placement market are:
i. Listed Companies;
ii. Financial Institutions;
iii. Unlisted and closely held companies;
iv. Public Sector Undertakings; and
v. Government Corporations, i.e., institutions created by Special Act of
Parliament/State Legislatures for a specific purpose.
331
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Source: www.sebi.gov.in/aro304/policies.pdf
332
Investment Banking
MERITS OF PRIVATE PLACEMENT

The inherent advantages of private placement as an efficient route for raising
capital and profitable avenue for investments makes it acceptable to both the
issuers and the investors:
i. Accessibility: There are no entry barriers for a company to access the private
placement market. Unlike the public issue market, an existing company does
not require a dividend track record for 3 years nor does a greenfield project
mandatory appraisal and funding by a Bank/Financial Institution. This route
is also available to unlisted and closely held public companies. Further,
public offering may not be viable if the amount proposed to be raised is very
small.
ii. Speed: A private placement deal can be successfully executed much faster
than a public offering. The procedural formalities for a private placement
transaction are minimal. The time-frame required to plan and complete a
public offering ranges between 4 and 6 months (or even more in some cases).
On the other hand, a private placement deal can be successfully closed in 4 to
6 weeks. This results in substantial saving of time and energy for the issuer.
iii. Flexibility: In a private placement, there is greater flexibility in working out
the terms of the issue. In addition to greater flexibility at the time of
structuring the issue initially, there may be more latitude to re-negotiate the
terms of the issue subsequently and even roll-over the debt. This is because
the issuer has to deal with only a few institutional investors in the Private
Placement Market (PPM).
Besides, one of the most attractive features of PPM is that it can be tailored to
the needs of first generation entrepreneurs who are comparatively less known
to the public which makes their public issue less attractive. It also satisfies
investors who want large holdings, but whose needs cannot obviously be met
in case of public issue. Thus, for large investors, stocks will be available in
the quantity they desire at reasonable transaction cost compared to secondary
market buying.
iv. Lower Transaction Cost: A public issue entails several statutory and
non-statutory expenses associated with underwriting, brokerage, printing,
mailing, announcements, promotion and so on. In the absence of
advertisement and prospectus, the issue expense in case of private placement
is as low as 2 percent of the total issue amount as compared to 10 to 12
percent in case of public issues.
v. Confidentiality: Private placements also have the advantage of
confidentiality of information. In a competitive environment, keeping
strategic business secrets pertaining to a firm is of crucial importance.
Figure 1: Methods Adopted for Private Placement
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333
The procedure normally adopted by companies for private placement is that a

General Body Meeting is held where the shareholders approval is sought for
privately placing the shares. The modalities of it are discussed and the amount of
premium that should be charged is put-up for discussion. In doing so, the share
price is either fixed through consensus or by making marketability assessments at
road shows.
Then a clearance is sought from the RBI for various categories to which the issue
is targeted viz., mutual funds, financial institutions, foreign institutional investors,
OCBs, etc.
For any Merchant Banker, the return on investment would be the sole criterion for
striking a deal on private placements. As such he examines each issue
scientifically and objectively. The usual procedure adopted by a Merchant Banker
would be:
First, a detailed research is done on the company vis-à-vis the feasibility of new
project, projected earnings potential, industrial scenario, etc. If the research reports
favors a “buy”, he proceeds further. He establishes a network with clients viz.,
MFs, FIIs, FFIs, OCBs, etc., to ascertain their inclination towards the project.
Collectively or individually, they make a visit to the plant to check for the facts
and have a first hand information. If satisfied, price negotiations between clients,
company and banker take place. If the response is positive, the deal on private
placement is struck.
Figure 2: Procedure Normally Adopted by
Merchant Bankers for Private Placement
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THE REGULATORY FRAMEWORK

There are no comprehensive guidelines on private placements by SEBI. However,
SEBI has stipulated certain norms and guidelines on preferential shares which are
given as below.
On 4th August, 1994 the Securities Exchange Board of India (SEBI), announced
that the issue of shares on a preferential basis can be made at a price not less than
the average of the weekly high and low of the closing prices on a stock exchange
during the six months or two weeks preceding 30 days prior to the general body
meeting of shareholders, whichever is higher.
Alarmed by the increasing practice of making preferential allotments at a price
unrelated to the prevailing market price, the SEBI has issued the guidelines
governing the issue of shares or other financial instruments made on a preferential
basis to a select group of persons.
334
Investment Banking
These guidelines are issued under Section 81 (1A) of the Companies Act and are in
terms of Section 11(1) read with Section 20 of the SEBI Act, 1992, for orderly
development of the securities market and to protect the interest of the investors at
large:
• The issue of shares on a preferential basis can be made at a price not less than
the higher of the following:
The average of the weekly high and low of the closing prices of the related
shares quoted on the stock exchange during the six months preceding the
relevant date or the average of weekly high and low of the closing prices of
the related shares quoted on a stock exchange during the two weeks
preceding the relevant date. Relevant date for this purpose means the date
30 days prior to the date on which the meeting of general body of
shareholders is convened to consider the proposed issue.
Where warrants are issued on a preferential basis with an option to apply for
and get allotted shares, the issuer company shall determine the price of the
resultant shares in accordance with the above. However, the relevant date for
this purpose may, at the option of the issuer, be either the one referred in
explanation to the above or a date 30 days prior to the date on which the
shareholder of the warrants becomes entitled to apply for the said shares.
• An amount equivalent to at least 10 percent of the price fixed in terms of the
above would become payable for the warrants on the date of their allotment.
This amount will be adjusted against the price payable subsequently for
acquiring the shares by exercising an option for the purpose. This amount
will stand forfeited if the option to acquire shares is not exercised.
Where PCDs/FCDs/other instruments are issued on a preferential basis,
providing for the issuer to allot shares at a future date, the issuer shall
determine the price at which the shares could be allotted either by conversion
or otherwise in the same manner as provided for pricing of shares allotted in
lieu of warrants.
• In case of warrants/PCDs/FCDs/or any other financial instruments with a
provision for the allotment of equity shares at a future date, either through
conversion or otherwise, the currency of the instrument should not exceed
beyond 18 months from the date of issue of the relevant instrument.
• SEBI has issued clarification according to which the lock-in period will not
be applicable to preferential issues except in those cases where preferential
issues are made to the promoters and even in such cases where the lock-in
period is for 3 years from the date of their allotment.
• Action on any resolution passed at a meeting of shareholders of a company
granting consent for preferential issues of any financial instrument shall be
completed within a period of three months from the date of passing of the
resolution. If such a resolution is not acted upon within the stipulated period,
a fresh consent of the shareholders will have to be obtained and the relevant
date referred to in explanation above will relate to the new resolution.
• In case of every issue of shares/warrants/FCDs/PCDs/or other financial
instruments, the statutory auditors of the issuer company must satisfy that the
issue of said instruments is being made in accordance with the requirements
contained in these guidelines. Copies of the certificate shall also be laid before
the meeting of the shareholders convened to consider the proposed issue.
• The share warrants/FCDs/PCDs or other financial instruments issued on a
preferential basis will be eligible for listing only if such instruments were
issued in accordance with these guidelines.
335
PRIVATE PLACEMENT BY COMPANIES

Some Examples
• Reliance Industries raised the highest amount in history by way of private
placement of equity shares. It raised Rs.945 crore by privately placing shares
with three domestic financial institutions of whom UTI was the most
important. Around 24.5 million shares were placed at a price of Rs.385 per
share as against the price of Rs.377 then prevailing.
• Alpic Finance raised Rs.85 crore by privately placing its equity shares with
domestic financial institutions. The shares were placed at Rs.300 as against
the ruling price of Rs.370 on the date of placement.
• In the public sector, Konkan Railway Corporation placed tax-free bonds
worth Rs.70 crore with banks and financial institutions.
• Mukand Ltd., privately placed equity shares with FIIs at a price of Rs.315 per
share thereby raising Rs.109.53 crore.
• Similarly, Champdany Industries privately placed equity shares at a price of
Rs.250 per share thereby raising Rs.25 crore.
PRIVATE PLACEMENTS ABROAD
Whenever a security is sold to less than 25 investors in the US markets, it is known
as a private placement and it is not necessary to register the same with the SEC.
Most of the American private placements are for bonds, with only new and
relatively unknown companies going for private placements of equity stock, as
they may not be very sure of being successful in tapping the public markets. Also,
private placements are mostly done for issues up to $100 million and not for the
larger ones.
Bought-out Deals
Definition
A buy-out is a process whereby an investor or a group of investors buys-out a
significant portion of the equity of an unlisted company with a view to make it
public within an agreed time-frame. To put it simply, buy-outs are nothing but
wholesale investments.
Reasons for Bought-out Deals
As our financial markets get more sophisticated and liberalized, investors will
search for investment opportunities that will generate the desired return. When the
Securities and Exchange Board of India (SEBI) decided to make proportionate
allotment in the case of public issues, removing weightage for applicants for
smaller number of shares, the idea of bought-out deals in the primary market was
aired. Merchant bankers and operators in the primary market soon realized that the
bought-out deals in the primary market would be the easiest way to make money.
The higher returns can be attributed to a large extent, to lower transaction costs
and shorter holding period. Essentially, therefore, buy-outs are driven by
economics of investing. Apart from these generalized aspects, buy-outs happen
because of several specific aspects, such as:
• When the company needs money fast and market conditions are adverse.
• When the company is not yet ripe for a public issue, yet needs funds.
• When a company wants to go public at a premium but cannot due to
prevailing laws.
• When an investor group makes an offer to a company, which is more lucrative.
336
Investment Banking
DISTINCTIVE COMPETITIVE ADVANTAGES OF A BOUGHT-OUT

DEAL IN COMPARISON TO A PUBLIC OFFER
• The price privilege: One of the main advantages in a bought-out deal as
compared to a run-of-mill public issue is that the price is not subject to the
vagaries of the market place as the buyer of the stock is sophisticated enough
to gauge the future earnings capacity of a company without the help of
imperfect signals from the stock market. While this price may not necessarily
reflect a company’s earning potential to the fullest extent, the discount is the
price the issuing company has to pay to get the money upfront.
• The quick fix: The small investor, who had lost money in the primary
market due to companies with dubious record, has a general mood of
skepticism to all new issues. Often a promoter cannot convince the lay public
about the merits of a project, especially if it is an unknown company or a
greenfield project. In such a case, select investors in the form of one or several
investment bankers are easier to convince about a project’s future earnings
capacity. So, some companies will find it easier to go in for a bought-out deal.
• The cost advantage: If the size of an issue is small, it sometimes makes
sense for companies to avoid a public issue. The support for this contention is
based on the fact that the fixed costs of a retail capital offering like
mandatory advertisements, printing of forms, underwriting and the like are
steadily rising. Merchant bankers estimate that for a small issue of Rs.1.5-2
crore, costs may be as high as 15-20 percent of the issue size. This cost
advantage has already made its presence felt as a catalyst for private
placements. A bought-out deal takes the argument to its logical culmination.
• Time is money: For a company, public issue translates into a six months
ordeal of convincing merchant bankers, regulatory and investors. In a bought-
out deal, a company is normally saved the sweat. For an entrepreneur,
valuable time is wasted in raising money especially when he should be
concentrating on funds usage. The possible result: Faster implementation and
fewer chances of cost overruns.
ADVANTAGES OF BOUGHT-OUT DEALS
Bought-out deals generate all-round benefits for the issuer, intermediaries such as
merchant bankers, underwriters, and the investor.
Benefits to the issuer: For the issuer with a good project, it means obtaining funds
upfront at a minimal cost without the fear of undersubscription in a depressed
market. No longer will there be the need to wait for 6-7 months after floating a
public issue for collecting the monies minus the 10-12 percent spent as issue cost.
Benefits to the intermediary: For the intermediary, it could mean an annualized
return of 30-35 percent on a conservative basis, notches higher than the fee for
conventional merchant banking services, or, asset-backed leasing or hire purchase,
where the returns range is between 18-22 percent. But, by far the greatest benefit
for the merchant banker would be his graduation into an investment banker. This is
bound to come about, once the market gets organized, since taking a position
would naturally require more stringent project evaluation for the sponsor’s own
sake, if not for that of the investor.
Benefits to the investor: For the investors, the benefit would be two-fold. One, of
entering into a stock at the initial public offering stage with the comfort of
professional evaluation of a merchant banker who holds stakes in it, and two, the
assurance of entering at a time when the gestation should logically have been over.
337
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SOME EXAMPLES OF BOUGHT-OUT DEALS

The most symbiotic of the structured deals was the Rs.156 crore Infrastructure
Leasing and Financial Services’ variable premium BOD with UTI. In September,
1994, 19.6 lakh shares of ILFS were sold to UTI at a premium of Rs.50. UTI, as a
warehouser, will continue to hold the shares till the time of the IPO, to be floated
at a premium of Rs.100 or so. Part of the deal proceeds were given by UTI to ILFS
upfront. The rest will accrue to ILFS at the time of the IPO by way of share
premium. During the holding period, UTI will earn interest at the rate of
15.5 percent per annum on the entire consideration of Rs.156 crore. The benefit of
ILFS is that given the expectations of the good results, the premium could even be
as high as Rs.125-145, and that would accrue to ILFS. For UTI, the benefit is that
it would get interest on the entire consideration, though it was required to pay only
part of the sum to ILFS. Additionally, given the yields in the market, a rate of
15.5 percent is a bonanza. ILFS also benefits from the fact that the interest will be
paid to UTI from the premium of the IPO.
Consider the case of Unique Values whose equity was bought by JM Financials.
The bought-out price was Rs.10 per share. Having incurred an issue expense of
Rs.1.67 per share, JM offered it to the public at Rs.18 per share gaining an yield of
50.3 percent p.a. in the process.
Indbank Merchant Banking went for a buy-out agreement with a Madhya Pradesh-
based distillery by picking-up shares worth Rs.2.5 crore (at Rs.60 per share). The
buy-out was pegged at Rs.71.50 after six months and that translated into an
assured return of 38.33 percent for the sponsor, even under poor market
conditions. Indbank Merchant Banking also linked the issue expenses to
achievement of projections of the sponsored companies. In other words, the
sponsor takes on issue expenses in proportion to a company’s performance.
Gujarat Ambuja Cements Ltd., acquired 42 percent stake in DLF Cements Ltd.,
and a 14.4 percent stake in ACC Ltd., through its 60 percent subsidiary Ambuja
India Ltd., in bought-out deals involving an outlay of Rs.1,045 crore in 2000-01.
In June 2003, Bharti Tele-Ventures bought out Swedish firm Telia’s 26% stake in
Bharti Mobile, providing Bharti Tele full ownership of Bharti Mobile.
The Essar group bought 64% promoter’s stake in BPL Mobile for Rs.4,400 crore
in a deal. The company is now looking forward to buy the remaining 36% in BPL.
In June 2005, Videocon bought Thomson’s color picture tube business providing
Thomson a 14% stake in Videocon industries at a price of about ∈ 250 million.
338
Investment Banking
MECHANISM OF A BOUGHT-OUT DEAL

A bought-out deal works according to a mechanism which envisages a scenario
where the issuer of equity would approach the lead manager, who, after evaluating
the project, would buy off the entire issue at a negotiated price. The deal would be
funded by availing lines of credit from banks and financial institutions by placing
the shares as collateral.
The shares would be immediately listed on placement with the company receiving
the funds.
The lead manager, who would be tracking the market for a suitable timing of exit,
would offload in favor of a syndicate of underwriters. The underwriters would
have two options when the time to book profit arrives: One, to come out with a
public issue or, two, to place the shares directly with retail investors registered
with them.
Let us take a simple example. A company XYZ is the OEM supplier of radiator
grills for Maruti. Suddenly, Maruti decides to expand its capacity by 50,000
additional cars. It asks its OEM supplier to be prepared for additional 50,000
radiator grills. Now, XYZ is a small company with a turnover of Rs.2 crore a year.
To be able to expand its capacity by 50,000 grills, it requires a funding of, say
Rs.5 crore. That is, when the merchant bankers see potential business with the
firm. The banker realizes that if the company has Rs.10 crore, it can expand its
capacity by 1,00,000 grills. It also understands that with the boom in the
automobile industry, there will be more than adequate orders for grills coming the
company’s way. It asks the promoters of the company to sell 20 lakh shares of its
capital to the merchant bankers at a premium of Rs.40 per share. The company
gets Rs.10 crore and is able to expand. The merchant bankers are now holding 60
percent of the company’s entire capital of Rs.3.5 crore. The merchant banker,
however, knows that in 12 months’ time when the expansion is complete, the
prospects of XYZ company are going to hit the roof. In 18 months’ time when the
company has filled its order book for the next six months it decides to offload the
60 percent capital to the public at a premium of Rs.140 per share. In 18 months’
time, the merchant banker has earned a return of 200 percent on its investment of
Rs.10 crore, an annual rate of return of over 130 percent.
BOUGHT-OUT DEAL OVER OTCEI
Since the equity size of a company whose shares are bought-out is less, OTCEI is
preferred. No company listed on BSE has indulged in a bought-out deal, merchant
bankers had willy-nilly to rely on the OTC experience for precedents. Besides
making the system transparent, OTCEI compels for compulsory market making for
years. A market making system acts as a check since it not only makes better
evaluation of the company’s fundamentals necessary, but also keeps speculation at
bay. The system follows the moves as depicted in the flow chart. The company
appoints a sponsor who thoroughly appraises the project and registers an
agreement with OTCEI. He acquires the equity and notifies it to OTCEI. After
sometime he comes out with the public issue and files application with OTCEI for
listing. OTCEI approves the allotment and listing is granted after which the actual
trading starts.
PRICING AND TIMING OF BOUGHT-OUT DEALS
What is most crucial to shaking hands on the bought-out deal is the consensus on
the pricing of the deal. The pricing is a complex exercise that takes into account
the project, its viability, gestation period and most important, its financials, such as
the post-issue EPS, the industry P/E, etc. Even the approximate rate at which the
investment banker could subsequently offload to the public is calculated at the
same time. Take Siris Ltd., a bulk drug manufacturer, with promoters who have a
25-year track record. The sponsors, Videocon Leasing & Videocon Appliances,
picked-up 17.5 lakh equity shares of Rs.10 each at a premium of Rs.190 in March,
339
1994, and offloaded their stake (25 percent) in November, 1994 at Rs.275 per
share, making a profit of Rs.13.12 crore. This works out to an annualized
appreciation of 50 percent, calculated till the day the monies are received, 60 days
after allotment. The offer price discounted 1994-95 EPS of Rs.40.63 by 12.96
times as against an industry average of 43. It happened so in the case of Siris
where it arrived at a figure of Rs.275, which Videocon, the investment banker in
this deal, could offload to the public at a later date. They had assumed an EPS of
Rs.21 and a modest P/E of 12 when actually the industry average P/E was 35. The
soundness of the deal was reflected when Videocon went to the market in January,
1995, with the predetermined price still holding good.
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Apart from the conventional pricing parameters of demand and supply, book
value, industry P/E and the company’s projected earnings, another cost-benefit
analysis that needs to be worked out is the period of holding, since disinvestment
within a year will entail short-term capital gains tax of 30 percent. The time period
up to which the investment banker can hold the issue is very flexible. As a norm
the banker holds the shares for about six months to a year. But it is not unusual for
him to hold it longer or otherwise because the market fancy and stock market
mood to buy the shares at the said premium is more important to him as they play
a major role in influencing the profitability of the deal. Many merchant bankers
feel that timing is crucial to optimize capital appreciation. In the international
markets, shares, acquired through this route, are usually sold after the company has
come out with two balance sheets.
SEBI GUIDELINES AND SOME GREY AREAS
Unlike other concepts in vogue, the bought-out deals have evolved out of the
needs of the market and not by any design especially by SEBI. As of now, there
are no definite SEBI guidelines on BODs, which, while it does give latitude, also
leads to uncertainty.
340
Investment Banking
The following areas require regulatory clarity:

• Specification of the stake by sponsor
• Due diligence responsibility
• Registration of deals with stock exchanges (other than OTCEI)
• Regulation of buy-back at a fixed price deal
• Sponsor approval and registration
• Minimum period of holding.
IDENTIFICATION AND EVALUATION OF BOUGHT-OUT DEALS
A very interesting case for study in this emerging scenario would be the projects
that sponsors are going in for. Very few sponsors would like to go in outright for
greenfield projects promoted by promoters with no track record. Growth industries
such as oilfield and oil drilling (contract work and not the long gestation projects),
food processing projects with export potential, forging and auto ancillaries,
software, and stocks of turnaround scrips were riding the crest of the BOD wave.
Divestment should not be the criterion for making a bought-out deal. The attitude
of the merchant banker should be “I don’t mind owning the company.”
It is very important for sponsors to study bought-out proposals with diligence, to
avoid grief later. Special attention needs to be paid to information pertaining to
projected earnings. Future earnings is the biggest risk factor. When doing a
buy-out, it should be entirely on the confidence of company’s estimated earnings.
Returns on bought-outs are fixed on the basis of the company’s prospects, and cost
of funds for the sponsor. Since the risk element is greater in bought-outs, as
compared to, say, debt instruments or investing in the primary or secondary
markets, there is a promise of much higher returns.
A sponsor of a bought-out deal assumes that it would divest the equity within a
certain time when it would earn returns on investment. Cash flow calculations are
prepared accordingly. But, if the sponsor has to hold on to the bought-out longer
than expected, all other calculations go haywire. More than half of over twenty
BODs which have been offloaded in the market are already quoting below the
offer price. There is a feeling that bought-out scrips are overpriced and therefore,
should be treated with a great deal of caution.
SYNDICATION FOR BOUGHT-OUT DEALS
Merchant bankers have evolved innovative strategies to face, what one merchant
banker calls the “bought-out trauma”. They have started adopting a consortium
approach to bought-out deals which have been forced on the capital market
intermediaries primarily on account of the existence of the two regulations that
place a cap on the maximum exposure that a merchant banker and broker can take
in the company, in which the bought-out deal is being done.
While one of the regulations relates to the Companies Act, 1956, the other is
concerned with the Banking Regulations Act. Section 372 of the Companies Act,
1956 forbids a company from investing more than 30 percent of its paid-up capital
and reserves in any other company. The Banking Regulations Act prohibits a bank
from holding more than 30 percent of a company’s equity.
Further, since a bank cannot invest more than 5 percent of the incremental deposit
growth of the previous year in corporate assets (shares), these stipulations place a
severe restriction on bank and bank-related merchant banking divisions to
participate in bought-out deals.
341
Together, these regulations limit the ability of a small merchant banker to invest in
a large-sized bought-out deal. However, since the size of the deals have grown,
most merchant bankers are opting for a collective approach to bought-out deals.
“The collective approach not only spreads the risk, but the collective bargaining
also helps in firming-up a reasonable price”. Thus, the concept of syndication or
“Club Deal” where four to five merchant bankers subscribe jointly to the deal has
come into existence.
SUMMARY
• Rights shares are shares offered to the existing shareholders as a matter of
legal right.
• The objectives of Section 81 are: equitable distribution of shares, voting
rights not to be affected, shareholders interest in reserves/net worth not to be
impaired.
• SEBI has come out with detailed guidelines for rights issues as well as the
action plan on how to go about a rights issue.
• A rights issue affects the wealth of those shareholders who renounce
adversely, but does not change the wealth of those who exercise their rights
or sell the rights to someone else.
• The advantages of a rights issue are: it enables existing shareholders to retain
their proportionate ownership of the company, the company can also
concentrate on the existing shareholders without increasing the shareholder
base and its cost of making is lower than that of a public issue.
• The main disadvantage of a rights issue is that it takes a long time to
complete the transaction.
• Bonus issue is the process of capitalizing reserves to convert the quasi-capital
into equity capital, generally to bring the paid-up capital in line with the
capital employed.
• A bonus issue does not affect the wealth of a shareholder.
• SEBI has also come up with a regulatory framework for bonus issues.
• A private placement is a method to raise funds under which companies
directly sell their securities to a limited number of sophisticated and
discerning investors.
• The main features of a private placement are: no entry barriers, no need of
registration with SEBI, terms are negotiable between the parties, company
has a choice of investors, transaction costs are low, credit rating is optional
and the time lag is shorter.
• Mutual funds, FIs, banks, insurance companies, FIIs, rich individuals and
private equity funds are the players in the placement market.
• The main issuers are: listed companies, FIs, unlisted companies, closely-held
companies, PSUs and government companies.
• The merits of private placement are: accessibility, speed, flexibility, lower
transaction costs and confidentiality.
• A buy-out is a process whereby an investor buys a significant portion of the
equity of a company with a view to make it public within an agreed
time-frame. It is also known as a wholesome investment.
• The main reasons for bought-out deals are: funds requirement in adverse
market conditions, funds requirement when the company is not entitled to an
IPO, when the company cannot go for an IPO at a premium and when the
offer of an investor is more lucrative than an IPO.
• The advantages of a bought-out deal as compared to a public offer are: price
privilege, quick fix, cost advantage and time to realize the funds.
342
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The genesis of the present international markets can be traced back to 1960s, when
there was a real demand for high quality, dollar-denominated bonds from wealthy
Europeans (and others) who wished to hold their assets outside their home
countries or in currencies other than their own. These investors were driven by the
twin concerns of avoiding taxes in their home country and protecting themselves
against the falling value of domestic currencies. The bonds which were then
available for investment were subjected to withholding tax. Further, it was also
necessary to register the ownership of the bonds. Dollar denominated Eurobonds
were designed to address these concerns. These were issued in bearer forms and
so, there was no record of ownership and no tax was withheld.
The prefix “Euro” derives from the fact that these transactions originated in
Europe, mainly in London, but later on expanded fast to the Far East, to centers
like Hong Kong and Singapore. At present, more than half of the transactions in
the Euro markets take place outside Europe.
Also, until 1970, the International Capital Market focused on debt financing and
the equity finances were raised by the corporate entities primarily in the domestic
markets. This was due to the restrictions on cross-border equity investments
prevailing until then in many countries. Investors too preferred to invest in
domestic equity issues due to perceived risks implied in foreign equity issues
either related to foreign currency exposure or related to apprehensions of
restrictions on such investments by the regulators.
Major changes have occurred since the ’70s which have witnessed expanding and
fluctuating trade volumes and patterns with various blocks experiencing extremes
in fortunes in their exports/imports. This was the period which saw the removal of
exchange controls by countries like the UK, France and Japan which gave a further
boost to financial market operations. In addition to this, the application of new
technology to financial services, the institutionalization of savings and the
deregulation of markets have played an important role in channelizing the funds
from surplus units to deficit units across the globe. The international capital
markets also became a major source of external finance for nations with low
internal savings. The markets were classified into Euro Markets, American
Markets and other Foreign Markets.
The following figure shows the various sources of external finance and various
channels for accessing external funds:
IMF
IFC
ADB
Country Funds
Global Mutual Funds
Pension Funds
Commercial Banks, etc.
Surplus Deficit
Units Units
International Financial Markets
Money Capital
Markets Markets
344
International Markets
TYPES OF INSTRUMENTS IN INTERNATIONAL MARKETS

The various instruments used to raise funds abroad include: Equity, Straight Debt
or Hybrid Instruments. The following figure shows the classification of
international capital markets based on instruments used and market(s) accessed.
DEBT INSTRUMENTS
The issue of bonds to finance cross-border capital flows has a history of more than
150 years. In the 19th century, foreign issuers of bonds, mainly governments and
railway companies, used the London market to raise funds.
International bonds are classified broadly under two categories:
Foreign Bonds: These are the bonds floated in the domestic market denominated
in domestic currency by non-resident entities. Dollar denominated bonds issued in
the US domestic markets by non-US companies are known as Yankee Bonds, Yen
denominated bonds issued in Japanese domestic market by non-Japanese
companies are known as Samurai Bonds and Pound denominated bonds issued in
the UK by non-UK companies are known as Bulldog Bonds. Similarly, currency
sectors of other foreign bond markets have special names like Rambrandt Dutch
Guilder and Matador Spanish Peseta, etc.
Eurobonds: The term ‘Euro’ originated in the fifties when the USA under the
Marshall Plan was assisting the European nations in the rebuilding process after
the devastation caused by the second world war. The dollars that were in use
outside the US came to be called “Eurodollars”. In this context, the term ‘Euro’
signifies a currency outside its home country. The term ‘Eurobonds’ thus refers to
bonds issued and sold outside the home country of the currency. For example, a
dollar denominated bond issued in the UK is a Euro (dollar) bond, similarly a Yen
denominated bond issued in the US is a Euro (Yen) bond.
The companies wishing to come out with shorter maturities have an option to issue
Euronotes in the European Markets. The important ones being Commercial Paper
(CP), Note Issuance Facilities (NIF) and Medium-Term Notes (MTNs).
Euro-Commercial Paper issued with maturity of up to one year, are not
underwritten and are unsecured.
Note Issuance Facilities (NIFs) are underwritten and have a maturity of up to one
year. Standby NIFs are those formally designated instruments which back
Commercial Paper to raise short-term finances. A variation of NIF is the Multiple
Component Facility (MCF), where a borrower is enabled to draw funds in a
number of ways, as a part of overall NIF program. These options are referred to as
short-term advances and banker’s acceptances, and afford opportunities for
choosing the maturity, currency and interest rate basis.
345
Medium-term Notes, on the other hand, are non-underwritten and are issued for
maturities of more than one year with several tranches depending upon the
preferred maturities. It is to be noted that in similar circumstances, a typical CP
program allows for a series of note issues having regard to the maturity of the
overall program.
The borrowings in the international capital markets are in the form of Euro Loans
which are basically loans from the bank to the companies which need
long-term and medium-term funds. Broadly, two distinct practices of arranging
syndicated credits have emerged in Euromarkets, club loans and syndicated loans.
The Club Loan is a private arrangement between lending banks and a borrower.
When the loan amounts are small and the parties are familiar with each other,
lending banks form a club and advance a loan, hence the name club loan.
Syndicated Eurocredit, however, has a full-fledged public arrangement for
organizing a loan transaction. It is treated as an integral part of the financial market
mechanism with a wide network of banks participating in the transaction over the
globe. Typically, a syndicated loan is available for a maturity of seven years with
shorter period transactions having a maturity of 3 to 5 years.
EQUITY INSTRUMENTS
Until the end of 1970s, International Capital Markets focused on debt financing
and the equity finances were raised by the corporate entities primarily in the
domestic markets. This was due to restrictions on cross-border equity investments
prevailing until then in many countries. Investors too preferred to invest in
domestic equity issues due to perceived risks implied in foreign equity issue either
related to foreign currency exposure or related to apprehensions of restrictions on
such investments by the national authorities.
Early eighties witnessed liberalization of many domestic economies and
globalization of the same. Issuers from developing countries, where issue of
dollar/foreign currency denominated equity shares are not permitted, are now able
to access international equity markets through the issue of an intermediate
instrument called ‘Depository Receipt’.
A Depository Receipt (DR) is a negotiable certificate issued by a depository bank
which represents the beneficial interest in shares issued by a company. These
shares are deposited with a local ‘custodian’ appointed by the depository, which
issues receipts against the deposit of shares.
According to the placements planned, DRs are referred to as: (i) Global Depository
Receipts (GDRs), (ii) American Depository Receipts (ADRs), and (iii)
International Depository Receipts (IDRs). Each of the Depository Receipts
represents a specified number of shares in the domestic markets. Usually, in
countries with capital account convertibility, the GDRs and domestic shares are
convertible (may be redeemed) mutually. This implies that, an equity shareholder
may deposit the specified number of shares and obtain the GDR and vice versa.
The holder of GDR is entitled to a dividend on the value of the underlying shares
of the GDR (issued normally in the currency of the investor country). As far as
Indian companies are concerned, the dividends are announced as a percentage of
the value of GDR sans premium in rupee terms converted at the prevailing
exchange rate.
However, until the Global Depository Receipts (GDRs)/American Depository
Receipts (ADRs)/International Depository Receipts (IDRs) are converted, the
346
holder cannot claim any voting right and also, there is no foreign exchange risk for
the company. These types of instruments are ideal for the companies which prefer
a large shareholder base and international presence. The company will be listed at
the prescribed stock exchanges providing liquidity for the instrument.
QUASI-INSTRUMENTS
These instruments are considered as debt instruments for a time-frame and are
converted into equity at the option of the investor (or at company’s option) after
the expiry of that particular time-frame. The examples of these are Warrants,
Foreign Currency Convertible Bonds (FCCBs), etc. Warrants are normally issued
along with other debt instruments so as to act as a ‘sweetener’.
FCCBs have a fixed coupon rate with a legal payment obligation. They have
greater flexibility with the conversion option – at the choice of the investor – to
equity. The price of the conversion of FCCB closely resembles the trading price of
the shares at the stock exchange. Also, the company may incorporate a ‘call
option’ at the choice of the issuer to obtain FCCBs before maturity. This may be
due to the adverse market conditions, changes in the shareholding pattern, changes
of tax laws, etc.
A Euro Convertible Bond is issued for investment in Europe. It is a quasi-equity
issue made outside the domestic market and provides the holder with an option to
convert the instrument from debt to equity. An added feature nowadays is to allow
conversion of Euro Convertible Bond into GDR. Till conversion, interest is paid in
US dollars and bond redemption is also done in US dollars, thus while the investor
would prefer the convertible bond as an investment instrument, the issuing
company tends to prefer a GDR. An investor can exercise the conversion option at
any time or at specified points during the convertible life. The investor exchanges
the convertible bond for a specified number of shares.
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347
PLAYERS IN INTERNATIONAL MARKETS

Borrowers/Issuers, Lenders/Investors and Intermediaries are the major players of
the international markets. The role of these players is discussed below:
BORROWERS/ISSUERS
These are corporates, banks, financial institutions, government and quasi-government
bodies and supranational organizations, which need forex funds for various
reasons. The important reasons for corporate borrowings are, need for foreign
currencies for operation in markets abroad, dull/saturated domestic market and
expansion of operations into other countries.
Governments borrow in the global financial market for adjusting the balance of
payments mismatches, to gain net capital investments abroad and to keep a
sufficient inventory of foreign currency reserves for contingencies like supporting
the domestic currency against speculative pressures.
Further, the supranational organizations like the International Monetary Fund
(IMF), World Bank, International Finance Corporation, Asian Development Bank,
etc., borrow usually long-term funds to finance diversified financing, sometimes
linked to swaps for hedging current/interest rate exposures. These supranationals
are also typical examples of large entities appearing in the global markets as both
issuers and borrowers.
LENDERS/INVESTORS
In case of Euroloans, the lenders are mainly banks who possess inherent
confidence on the credibility of the borrowing corporate or any other entity
mentioned above.
In case of a GDR, it is the institutional investors and high net worth individuals
(referred to as Belgian Dentists) who subscribe to the equity of the corporates. For
an ADR, it is the institutional investor or the individual investor through the
Qualified Institutional Buyer who puts in the money in the instrument depending
on the statutory status attributed to the ADR as per the statutory requirements of
the land.
Investors in the global markets come in a large range who invest to suit their own
requirements, investment objectives, risk-taking abilities and liabilities. The
investor range includes private individuals investing through Swiss Banks, the
IMF and the World Bank. The other major investors are insurance companies,
professional pension fund managers and investment trusts. In the United Kingdom,
with London still a major force in the international finance market, it is the pension
fund and insurance companies which are the major investors in the equity markets
and bond markets. In the US and Japan, the private player has an important role in
the equity markets. In Germany, on the other hand, commercial banks play a
dominant role as investors.
Institutional investors can also be classified as:
Market-specific Investors: Who specialize in specific instruments like equity,
convertibles, fixed interest bonds, floating rate bonds, etc.
Time-specific Investors: Who specialize in specific maturity instruments like
long-term, medium-term, short-term, etc.
Industry-specific Investors: Who specialize in specific industries like chemical,
pharmaceutical, steel, automobiles, etc.
348
INTERMEDIARIES
The intermediaries involved in International Capital Markets include Lead
Managers/Co-lead managers, Underwriters, Agents and Trustees, Lawyers and
Auditors, Listing Agents and Stock Exchanges, Depository Banks and Custodians.
An overview of the functions performed by each of them is given below:
i. Lead and Co-managers: The responsibilities of a Lead Manager include
undertaking due diligence and preparing the offer circular, marketing the
issues including arranging the roadshows. Lead manager, sometimes in
consultation with the issuer, can choose to invite a syndicate of investment
banks to buy some of the Bonds/DRs and help sell the remainder to other
investors. ‘Co-managers’ are thus invited to join the deal, each of whom
agrees to take a substantial portion of the issue to sell to their investor clients.
Quite often there will be more than one lead manager as mandates are
sometimes jointly won, or the investment bank which actually won the
mandate from the issuer may decide that it needs another institution to ensure
a successful launch.
Two or more managers may also reflect the fact that a geographical spread of
placing power is required or deemed appropriate.
One of the lead manager will ‘run the books’ for the issue. This essentially
involves arranging the whole issue, sending out invitation telexes, alloting
Bonds/DRs, etc.
ii. Underwriters: The lead manager(s) and co-managers act as underwriters for
the issue, taking on the risk of interest rates/markets moving against them
before they have placed Bonds/DRs. Lead manager(s) may also invite
additional investment banks to act as sub-underwriters, thus forming a larger
underwriting group. A third group of investment banks may also be invited to
join the issue as members of selling group, but these institutions only receive
a commission in respect of any Bonds/DRs sold and do not act as
underwriters. The co-managers and the underwriters are also members of the
selling group.
Figure 3: Selling Group
iii. Agents and Trustees: These intermediaries are involved in the issue of
bonds/convertibles. The issuer of bonds/convertibles, in association with the
lead manager, must appoint ‘paying agents’ in different financial centers,
who will arrange for the payment of interest and principal due to investors
under the terms of the issue. These paying agents will be banks.
iv. Lawyers and Auditors: The lead manager will appoint a prominent firm of
solicitors to draw up documentations evidencing Bond/DRs issue. The
various draft documents will be scrutinized by lawyers acting for the issuer
and in due course by the co-managers and any other party signing a
document related to the issue. Many of these documents are prepared in
standard forms, but each needs to be reviewed carefully to ensure that all
parties to the transactions are fully satisfied with the wording. The issuer will
also appoint legal advisors to seek advice on matters pertaining to
Indian/English/American law and to comment on necessary legal
documentation and the issuer’s. Auditors or reporting accountants will
become involved as well, supplying financial information, summaries and an
349
audit report which will be incorporated into the ‘offering circular’. The
auditors provide comfort letters to the lead manager on the financial health of
the issuer. Further, they also provide a statement of difference between the
UK/US and the Indian GAAP in case of GDR issue.
v. Listing Agents and Stock Exchanges: The listing agent helps facilitate the
documentation and listing process for listing on stock exchange and keeps on
file information regarding the issuer such as Annual Reports, Articles of
Association, the Depository Agreement, etc.
The Stock Exchange (Luxembourg/London/AMEX/NYSE as the case may
be) reviews the issuers application for listing of the Bonds/DRs and provides
comments on offering circular prior to accepting the securities for listing.
vi. Depository Bank: Depository Bank is involved only in the issue of DRs. It is
responsible for issuing the actual DRs, disseminating information from the
issuer to the DR-holders, paying any dividends or other distributions and
facilitating the exchange of DRs into underlying shares when presented for
redemption.
vii. Custodian: The custodian holds the shares underlying DRs on behalf of the
Depository and is responsible for collecting rupee dividends on the
underlying shares and repatriation of the same to the Depository in US
dollars/foreign currency.
viii. Printers: The printers are responsible for printing and delivery of the
preliminary and final offering circulars as well as the DRs/Bond certificates.
INDIA’S PRESENCE IN INTERNATIONAL MARKETS
India has made its presence felt in The international financial markets though, to a
very small extent. There has been a total turnaround in the market sentiment for
Indian securities since 1991-92 – albeit with a difference.
So far, the traditional avenues for raising capital abroad have been through bank
borrowings, syndicated loans, lines of credit, bonds and floating rate notes. Access
to the international capital markets was only through debt instruments and was
mostly limited to financial institutions and public sector units, although there were
a few cases of private companies also. With the downward revision of India’s
credit rating to the non-investment grade, borrowing in the international capital
markets dried up with most lenders being off limits (crossing the exposure limit)
on India. The picture has since changed. There were a variety of reasons for the
international markets to view India differently, namely:
• Improved perception of India’s economic reforms
• Improved export performance
• Modest to healthy economic indicators
• Inflation contained to single digits
• Improved forex reserves position
• Improved performance of Indian companies
• Improved confidence of the FIIs in the economy
• Lack of investment opportunities worldwide, and
• Decline in rate of return on investments in developed markets.
350
It was in March, 1992 that the government first permitted a few Indian companies
to tap the international equity market and till date a number of Indian companies
have successfully taken the equity/equity-related route. The following table shows
the American Deposit Receipts and Global Deposits Receipts (ADRs/GDRs)
issues of Indian companies:
! "#$% #$
( ( %6 %
- ! ( 5
4 $ ' $ '
5 &-7 8 9#2:;2:##" " <= 9> ># > 9= "?
&@ A B 992:"2:##> C ?; : C
5588B 7B%5 8% &! & 5 %& #<2#;2:##= <D ?= 9 9 D "=
E! 88% #<29"2:##= :D "< : 9 9" =
%7B@ 8&F8 ! 8 #"2#929;;= 9: <; 9"< D " 9# <<
G H H A B8 992#929;;> := "" 99# 9 > >"
G H H 7 ! A% 7 ! 8 #=29:2:##= C 9## C :# D
G7 7B &8% 8 #=2:929;;? 9= 9; = : : ?#
GB G F F& ! 4 9:2#929;;" ;: =# 9 = >"
!AI - A ! -B 8
G%&% 8 9>> #"2#929;;? 9> > 9:= " D ?D
-&! A B! G !@ #<2#>2:##= >D D# 9= C
-&! A F &J 8&% ! #<2:D29;;> :=> 9## 9 # ";
! A% &% 8
-&%- 8 #>2#929;;> 9# ?< 9:= 9 99 <:
-B & 7& 8 7 - & 5 B A- % #?2:D29;;> 9: ? <# 9 = =?
- &3 GB% 5 B A- % 8 & #D2#"2:##= : <= = 9 C
- B 5 B! & E&% 8 #<2#929;;? < =? =# 9 ? ?9
-3 8 #?2#929;;> 9" == := = 9 D=
& FK% 8 GB B &% 8 #>2992:##9 99 9? >D 9 >"
& 5 F$! '8 #<2#929;;> D "; ># 9 > <<
&78 9#2#929;;> ;" ># 9 >"
&8&- B% &&8 - % ! % #;2"#2:##= D <= ># 9 > =<
I !B8&J - G8&% 8 #<2:<29;;> 9? ? == 9 " "9
I8&J ! A% &% 8 9:2#929;;= D #= "# : " <"
&! % 8@ 88% 8 #"2#929;;> :? :D =# = 9;
!A8&% ! #"2#"2:##= :" D< 9 " <?
% ! A% &% 8 #?2#;29;;> :# = 9## 9 > DD
& & % & ! %7 55 ! -B #:2#929;;> 9= ;> 9## = ? :<
AH GAH -& &! % 8 9:2#929;;= = ;= D# 9 9" >=
AH ! E 88&F 9#2#929;;> 9: <= ?: = > D?
7 I- G !@ #<2:#2:##9 9" D= 9=# " 9# D"
7 -7 8 IA A % - #<2"929;;= ;" =# > = "D
7! 8-B ! A% &% 8 #<2#929;;" 9? 9## 9 ? :=
7 ! A% ! &E&8B5 &! #;2#929;;> : #= <? 9 "< #<
-B 5
- 8 9#2:#29;;" < ?= ?; 9 ; #:
-- 8 #;2::29;;; ; D# :<= = :D #?
! GA88% I ! !- 8 %& E -&% #D2#=2:##= = >: 9"# 9 :" ;D
! -& &! % 8 9#29D29;;> > :: ;# 9 9# ??
! ! 8A ! A -B 8 #"2#929;;> ? <? ?# 9 D DD
! ! 7B &8 -B 8 #=2#=29;;= 9? ? D? : 9 = 9;
! ! 5& B-7& - 8 -B 5 9:2#929;;> 9" D< D= " ? 9"
! ! FB! 4 ! A% &% #92#929;;> :: =9 9:= 9 = ==
! B A8I I& 8 L& % ! #92#929;;> > =9 9## 9 :: 9<
-7& - 8
! B %F! 7& -% $ ! ' #"2#929;;? 99 "< =# 9# >>
8
! %3 I 8 GB B &% #D29?2:##= > := 9# ?: 9 :=
351
( ( %6 %
- ! ( 5
4 $ ' $ '
!IB%F% &-7!B8B &% 8 #"29?29;;; >: >= <# "D = :# <#
H H ! A% &% 8 #=2#929;;? 9" 9? "; :# 9 :?
H- 8 #D2#929;;> 9? ;? >= 9# : ?=
H@ -B 5 8 9#2#929;;> D == 9 ? DD
@&%B ! A% &% 8 #<2"929;;? 9? "# 9 9D <=
8 %&! 4 BAG B 8 992:D29;;> 9= "= 9=# : ; <<
7! 4 7! 8 9:29>29;;" > >D <= 9 9? <"
- B !@% 992#?2:##= 9" :< ># C C

B%-7 5 %& -B! A- B #>2:?2:##= 9? <" : >=
&-7!B8B F 8
B &! 8 7B &8% 9:29?29;;> 9: <= "# 9 : "=
!G JF 8 GB B &% #<2#929;;> 9; "< 9## 9 = 9?

&8 !-& ! A% &% 8 #?2#929;;: 9? "= 9=# : ; 9<
% F -B 5A & %& E -&% #=29>2:##9 9?9 ;9 :

%7 ! A% 8 9> ?> ># " : <"
&! & 5 %&% 8 9#29>29;;>
%7 ! A% 8 > DD ># " D :#
&! & 5 %&% 8 9#2#929;;>
% 8E& 8 !& &-7!B8B &% 8 #?2:#2:### := 9"# : =:
% & G !@ BI ! 9#2#"29;;? 9> 9= "?; ;D : :? 9=

% &&8 A 7B F BI ! 8 #"29>29;;? 9: ;< 9:= 9= ; ?>
% & 8 & ! A% &% 9:2#929;;> 9< DD 9## 9 = =;
A! & 57B%57B A% 8 #"2#"29;;> :# = == 9 = "?
A G !@ #"29<2:##= =; :"; " 9 ># >;

E &B-B! ! & ! B! 8 #92#929;;> D9 ;# 9 99 99
E &%7 % !-7 ! #:29#29;;; 9" ;" "< D#
35 B8 9#2:>2:### >9 "<= 9"# <= 9 " 9?

3B-@7 8 #:2#929;;> 9> "= <= 9 = :"
Source: CMIE (Prowess Software).
RESOURCE MOBILIZATION – THE DECISION CRITERIA
Resource mobilization at competitive cost is a critical issue which confronts every
management. In the past, Indian companies could access only the domestic capital
market. Liberalization process has opened new avenues for Indian companies in
terms of markets and instruments.
For an Indian company, the choice between the domestic and international market
would depend on a number of criteria, some of which are listed below:
i. Currency Requirements: A decision has to be taken about the currency
needs of the company, keeping in view the future expansion plans, capital
imports, export earnings/potential export earnings. A conscious view on the
exchange rate also needs to be taken.
ii. Pricing: Pricing of an international issue would be a factor of interest rates
and the value of the underlying stock in the domestic market. Based on these
factors, the issue price conversion (for convertible) premium would be
decided. Given the arbitrage available between interest rates in rupees and
say US dollars, and given the strength of the rupee, as well as the resilience a
company can have in its operations against exchange fluctuation risk, due to
export earnings, it is possible to take advantage of the low interest rates that
are prevailing in the international markets. The above is possible without
352
dilution of the value of the underlying stock. This is so, because, in the case
of international issues, open pricing/book-building is possible, which has the
advantage of allowing the company to maximize the proceeds, enabling the
foreign investors to set the premium ensuring transparency and creating
price tension.
iii. Investment: At present, greater flexibility is available in structuring an
international issue in terms of pure equity offering, a debt instrument or a
hybrid instrument like Foreign Currency Convertible Bond (FCCB). Each
company can take a view on instrument depending upon the financials of the
company and its future plans.
iv. Depth of the Market: Relatively larger issues can be floated, marketed and
absorbed in international markets more easily than in the domestic markets.
v. International Positioning: Planning for an international offering has to be a
part of the long-term perspective of a company. An international issue positions
the issuing company, for a much higher visibility and an international exposure.
Besides, it opens up new avenues for further fund-raising activities.
vi. Regulatory Aspects: For an international issue, approvals are required from
the Government of India and the Reserve Bank of India, whereas for a
domestic issue the requirements to be satisfied are those of the SEBI and the
stock exchanges.
vii. Disclosure Requirements: The disclosure requirements for an international
issue are more stringent as compared with a domestic issue. The requirements
would, however, differ depending upon the market addressed and the place
where listing is sought.
viii. Investment Climate: The international offering would be affected by factors
like the international liquidity and the country risk, which will not have an
effect in a domestic issue. With the current country rating, companies have to
depend on the strength of their balance sheets to raise funds at competitive
rates in the international markets.
EQUITY
Global Depository Receipts
The advent of GDRs in India has been mainly due to the balance of payments
crisis in early ’90s. At this time, India did not have enough foreign exchange
balance even to meet the requirements of a fortnight’s imports. International
institutions were not willing to lend because of non-investment credit rating of
India. Out of compulsions, rather than by choice, the government (accepting the
World Bank suggestions on tiding over the financial predicament) gave the
permission to allow fundamentally strong private corporates to raise funds in
international capital markets through equity or equity-related instruments.
Prior to this, the companies in need of the foreign exchange component or
resources for their projects had to rely on the Government of India or otherwise
rely partly on the government and partly on the financial institutions. These
foreign currency loans utilized by the companies (whether through the financial
institutions or through the government agency) were paid from the government
allocation from the IMF, World Bank or other Governments credits. This, in turn,
created liability for the remittance of interest and principal, in foreign currencies
which was to be met by way of earnings through exports and other grants received
by the government. However, with a rapid deterioration in the foreign exchange
reserves due to the oil crisis as a result of the Gulf war, the companies were asked
to get their own foreign currencies which led to the advent of the GDRs.
353
The Instrument
As mentioned earlier, GDRs are essentially those instruments which possess a
certain number of underlying shares in the custodial domestic bank of the
company. That is, a GDR is a negotiable instrument which represents publicly
traded local-currency-equity share. By the law, a GDR is any instrument in the
form of a depository receipt or certificate created by the Overseas Depository
Bank outside India and issued to non-resident investors against the issue of
ordinary shares or foreign currency convertible bonds of the issuing company.
Usually, a typical GDR is denominated in US dollars whereas the underlying
shares would be denominated in the local currency of the Issuer. GDRs may be –
at the request of the investor – converted into equity shares by cancellation of
GDRs through the intermediation of the depository and the sale of underlying
shares in the domestic market through the local custodian.
GDRs, per se, are considered as common equity of the issuing company and are
entitled to dividends and voting rights since the date of its issuance. The company
effectively transacts with only one entity – the Overseas Depository – for all the
transactions. The voting rights of the shares are exercised by the Depository as per
the understanding between the issuing company and the GDR-holders.
The sequence of events to be followed for issue of GDR takes the same procedure
and documentation as that of other equity instruments which are globally issued.
Issuance of GDR
The following is the sequence of activities that takes place during the issuance of
GDRs:
a. Shareholder Approval Needed: The issuance of an equity instrument like
the GDR needs the mandate of the shareholders of the company issuing it.
The terms of the issue will have to be decided before such mandate is sought
from the shareholders. There should be an authorization from the Board of
Directors for floating a Euro-issue and for calling a general meeting for the
purpose. A committee of directors is generally constituted and conferred with
necessary powers for the approval of: (i) offering memorandum;
(ii) fixation of issue price; (iii) opening of bank account outside India and
operation of the said account; and (iv) for notifying the stock exchange about
the date of the board meeting when the proposal will be considered and also
inform it about the decisions taken.
After all this, the shareholders should approve the issue by a special
resolution passed at a general meeting as per Section 81 of the Companies
Act, 1956. It stipulates that, if a company proposes any issue of capital after
two years from the formation of the company or at any time after one year
from the allotment of shares that the company has made for the first time
after its formation – whichever is earlier – the company has to offer such
issues first to the shareholder of the company.
b. Appointment of Lead Manager: Lead Manager is an important cog in the
wheel of the Euro-issue and is the vital link between the government and
investors with the issuers. Practically, it is the lead manager who is
responsible for the eventual success or failure of a Euro-issue while all the
other factors are same. Hence, the choice of a suitable lead manager is as
significant as any other issue activity. An ideal lead manager is selected after
preliminary meetings with merchant bankers. The merchant bankers are
evaluated on various parameters such as: (i) Marketing ability, (ii) Marketing
research capability, (iii) Market making capability, (iv) Track record,
(v) Competitive fee structure, and (vi) Placement skills. A beauty parade,
which is basically the presentations made by the various merchant bankers, is
held by the company to help it decide on the final choice of the lead manager
after they are filtered by the above parameters. The final appointment of lead
manager is done after the approval of the Government.
354
The lead manager advises the company in the following areas after taking
into consideration the needs of the company – the industry in which the
company is engaged; the international monetary and securities markets; the
general economic conditions; and the terms of the issue viz., quantum of
issue, type of security needed to be issued (GDR in this case), stages of
conversion, price of equity, shares on conversion, rate of interest, redemption
date, etc.
c. Finalization of Issue Structure: On completion of the formalities of issue
structure in consultation with the lead manager, the company should obtain
the final approval from the government. For this purpose, the company
should furnish the information about the entities involved in the GDR issue
and the following parameters to the government.
8 -(
- M ( ( (
(
-( ( (
( 5 $ %
' 3 .
I 8
! %
- 8 . .
( . (M M
8 (
B (
The government, after considering all the above information will give a final
approval for the issue – if satisfied.
THE DOCUMENTATION
Documentation for Euro equities is a complex and elaborate process in the
procedure of GDR launch. A typical Euro-issue consists of the following main
documents:
a. Prospectus
b. Depository agreement
c. Custodian agreement
d. Subscription agreement
e. Trust deed
f. Paying and conversion agency agreement
g. Underwriting agreement and
h. Listing agreement.
355
A brief discussion on the contents and the relevance of each of these documents is
given below:
a. Prospectus: As in domestic equity market, the prospectus is a major
document containing all the relevant information concerning the issues – like
the investment considerations, terms and conditions, use of proceeds,
capitalization details, share information, industry review and overall
description of the issuing company. As a marketing strategy, companies
generally issue a preliminary prospectus which is referred to as pathfinder
which will judge the potential demand for the equity that is being launched in
the markets.
The aspects that need to be covered in the main prospectus may be grouped
as follows:
i. Financial matters: Apart from the financials of the company, the
prospectus should include a statement setting out important accounting
policies of the company and a summary of significant differences
between Indian GAAP and the UK GAAP and the US GAAP (in case of
an ADR). (Refer to the table bringing out the differences between the
US, and Indian GAAP later in the chapter).
ii. Non-financial matters: This may cover all aspects of management with
the information relating to their background, names of nominee
directors along with the names of the financial institutions which they
represent and the names of the senior management team. All other non-
financial aspects that influence the working of the company need to be
mentioned in the prospectus.
iii. Issue particulars: The issue size, the ruling domestic price, the number
of underlying shares for each GDR and other information relevant for
the issue as such, may be mentioned here.
iv. Other information: Statement regarding application to a foreign stock
exchange for listing the securities and issuing of global certificates to
specified nominee as operator of the Euro-clear (international clearing
house in Euro-securities) system like Cedel (one of the major clearing
houses in Eurobond market clearing, handling and storing the
securities).
Option provided to the lead manager to cover over-allotments, exercisable on
or before the business day prior to the closing date to subscribe for additional
securities in the aggregate up to a specified limit.
b. Depository Agreement: This is the agreement between the issuing company
and the overseas depository providing a set of rules for withdrawal of
deposits and for their conversion into shares. Voting rights of a depository
are also defined. Usually, GDRs or Euro convertible bonds are admitted to
the clearing system, and settlements are made only by book entries. The
agreement lays down the procedure for the information transmission to be
passed onto the GDR-holders.
c. Custodian Agreement: It is an agreement between the depository and the
custodian. In this agreement, the depository and the custodian determine the
process of conversion of underlying shares into depository receipts and vice
versa. For the process of conversion of the GDRs into shares, (popularly
coined as Re-materialization) shares have to be released by the custodian.
d. Subscription Agreement: The lead manager and the syndicated members
form a part of the investors who subscribe to GDRs or Euro convertible
bonds as per this agreement. There is no binding, however, on the secondary
market transaction on these entities i.e., market-making facility.
356
e & f. Trust Deed and Paying and Conversion Agreement: While the trust deed
is a standard document which provides for duties and responsibilities of
trustees, the paying and conversion agreement enables the paying and
conversion agency which performs a typical banking function by undertaking
to service the bonds until the conversion, and arranging for conversion of
bonds into GDRs or shares, as necessary.
g. Underwriting Agreement: As in domestic equity market, underwriters play
the role of ‘assurers’ for picking the GDRs at a predetermined price
depending on the market response. The agreement is for this purpose,
between the company (guided by its lead manager) and the underwriter.
h. Listing Agreement: As far as the listing is concerned, most of the companies
which issue a GDR prefer Luxembourg Stock Exchange as the listing
requirements in this exchange are by far, the simplest. The New York Stock
Exchange (NYSE) and the Tokyo Stock Exchange (TSE) have the most
stringent listing requirements. London Stock Exchange and the Singapore
Stock Exchange fit in the middle with relatively less listing requirements than
the NYSE and TSE.
The listing agents have the onus of fulfilling the listing requirements of a chosen
stock exchange. The requirements of London Stock Exchange are provided in the
48-hour documents. The 48-hour documents are the final documents that have to
be lodged at the exchange not later than mid-day, at least two business days prior
to the consideration of the application for admission to listing. These documents,
among other things should include the following:
• An application for admission to listing.
• Declaration of compliance in the appropriate form issued by the exchange.
• Three copies of the listing particulars/equivalent offering document relating
to the issue. The contents of these documents should meet the relevant
requirements.
• A copy of any shareholders’ resolution that is relevant to the issue of such
securities.
• A copy of the board resolution authorizing the issue, the application for
listing and the publication of the relevant documents.
• In case of a new company, a copy of the incorporation certificate,
memorandum of association and articles of association.
THE LAUNCH
Two of the major approaches for launching of a Euro-Issue are Euro-Equity
Syndication and Segmented Syndication. Euro-Equity syndication attempts to
group together the placement strengths of the intermediaries, without any formal
regional allocations. Segmented syndication, on the other hand, seeks to form a
geographically targeted syndicate structure, so as to achieve broader distribution of
paper by approaching both institutional and retail investors. As compared to Euro
syndication, segmented syndication can be expected to achieve orderly and
coordinated placement by restricting the choice of syndicate members with
definite strengths in specific markets.
MARKETING
It is not only the Indian issues which thrive on suave marketing, but also the GDR
and other International bond offerings. A judicious mix of financials and
marketing would help in raising the investor’s interest in the issue. Most of the
marketing activities are handled by the lead manager in consonance with the
advertising agencies. A back-up material consisting of preliminary offering
circular, recent annual report, interim financial statements, copies of newspaper
articles about the business of the company and a review of the structure and
performance of the Indian stock market, among other things is prepared.
357
Road shows form a predominant facet of the launch of any GDR. They are a series
of face to face presentations with fund managers and analysts and is a vital part of
marketing process. Road shows, which involve much more than just informing
about the company are getting increasing attention from the investors and the fund
managers. Road shows for Euro equities acquire considerable relevance as
investors, who are invited, participate in the ownership and assume a greater
degree of risk than under any other financing instrument. Road shows are backed
by the information of the financials and operations and a view regarding the future
profitability and growth prospects. This gives an opportunity to the investors
(generally, fund managers) to interact with the senior management of the issuing
company and understand the activities of the issuer company which may
eventually lead to investment in the company. These are normally conducted at the
financial centers of the globe like London, New York, Boston, Los Angeles, Paris,
Edinburgh, Geneva, Hong Kong, etc.
The back-up material prepared will support presentations made by the company’s
senior personnel inviting the fund managers to invest in the company. The price
that is preferred for a particular number of shares is noted by the book-runner at
each of such presentations and the eventual price that is most likely to find favor
with the fund manager is finalized. This would go a long way in making the issue
acceptable.
PRICING AND CLOSING
This forms the most vital part of the whole process of a GDR issue. The pricing is
key to the overall performance of a GDR after the same has been listed. The price
is determined after the underwriters response has been considered and an inference
of the response may be drawn.
The final price is determined after the Book Runner closes the books after the
completion of the Road shows. The book-runner keeps the books open for
1-2 weeks, for the potential investors to start placing their orders/bids with details
of price and quantity. After analyzing all the bids at the end of the book-building
period, lead managers, in consultation with the issuer, will fix a particular price for
the issue which will be communicated back to the bidders/investors and a fresh
demand figure is arrived at. If there is excess demand, the company can go in for
‘green shoe option’ where it can issue additional GDRs in excess of target amount.
At the end of the issue, various documents will be signed with all the fund
managers at New York or London. Pursuant to this, the agreed number of
depository receipts will be delivered and the payments in lieu of such delivery will
be received by the issuer.
A tombstone advertisement will be issued in the financial press to publicize
syndicated loans and other funding deals. Following this, the GDRs will get listed
in the notified stock exchange signaling the consummation of the process of the
issue.
COSTS
The cost incurred by the company is proportional to the issue size. The lead
manager, justifiably, takes the lion’s share in the issue expenses of the GDR. With
the increased acceptance of marketing as a vital tool for the success of the issue,
the cost that is incurred on marketing is fast increasing.
Other expenses include lead manager’s expenses, printing costs, accounting fees,
listing fees, road show expenses, etc.
There has, however, been a considerable fall in the quality of the GDR issues
made by the Indian companies. The sole reason why some of the Indian companies
came out with a Euro-Issue was their eagerness to flaunt the GDR issue as a
symbol of being well known in the international markets. Some of the companies
coming out with GDRs could not explain the core business they are in and also
whether they have judiciously utilized the investment made by the GDR-holders.
358
Indian Depository Shares (IDRs)

American Depository Receipts/Shares and Global Depository Receipts/Shares
provide overseas investors the opportunity to invest in Indian companies from
within the regulatory framework of their respective domestic securities exchanges.
While this provides persons residing overseas an opportunity to hold equity in
domestic companies.
The government has introduced a mechanism to enable Indians to own overseas
stock through Indian Depository Receipts/Shares – derivative Indian securities,
where the underlying asset is the equity share in an overseas company.
The following are the eligibility norms for the issue of IDRs as specified in the
Companies (Issue of Indian Depository Receipts) Rules, 2004.
ELIGIBILITY FOR iSSUE OF IDRs
Without prejudice to anything contained in the Securities and Exchange Board of
India Act, 1992, an issuing company may issue IDRs only if it satisfies the
following conditions:
a. Its pre-issue paid-up capital and free reserves are at least US$100 millions
and it has had an average turnover of US$500 million during the 3 financial
years preceding the issue.
b. It has been making profits for at least five years preceding the issue and has
been declaring dividend of not less than 10 percent each year for the said
period.
c. Its pre-issue debt equity ratio is not more than 2:1.
d. It shall fulfill the eligibility criteria laid down by SEBI from time to time in
this behalf.
Procedure for Making an Issue of IDRs
i. a. No issuing company shall raise funds in India by issuing IDRs unless it
has obtained prior permission from the SEBI.
b. An application seeking permission under clause (a) shall be made to the
SEBI at least 90 days prior to the opening date of the issue, in such form
furnishing such information as may be notified from time to time with a
non-refundable fee of US$10,000:
Provided that, on permission being granted, an applicant shall pay an
issue fee of half a percent of the issue value subject to a minimum of
Rs.10 lakh where the issue is up to Rs.100 crore in Indian rupees.
Provided further where the issue value exceeds Rs.100 crore, every
additional value of issue shall be subject to a fee of 0.25 percent of the
issue value.
c. The SEBI may, on receipt of an application, seeking permission under
clause (a), call for such further information, and explanations, as may be
necessary, for disposal of such application.
d. The issuing company shall obtain the necessary approvals or exemption
from the appropriate authorities from the country of its incorporation
under the relevant laws relating to issue of capital, where required.
e. The issuing company shall appoint an overseas custodian bank, a
domestic depository and a merchant banker for the purpose of issue of
IDRs.
f. The issuing company shall deliver the underlying equity shares or cause
them to be delivered to an Overseas Custodian Bank and the said bank
shall authorize the domestic depository to issue IDRs.
g. The issuing company shall file through a merchant banker or the
domestic depository a due diligence report with the Registrar and with
SEBI in the form specified.
359
ii. a. The issuing company shall, through a merchant Banker file a prospectus
or letter of offer certified by two authorized signatories of the issuing
company, one of whom shall be a whole-time director and other the
Chief Accounts Officer, stating the particulars of the resolution of the
Board by which it was approved, with the SEBI and Registrar of
Companies, New Delhi, before such issue.
b. The draft prospectus or draft letter of offer shall be filed with SEBI,
through the merchant banker, at least 21 days prior to the filing under
clause (a).
Provided that, if within 21 days from the date of submission of draft
prospectus or letter of offer, SEBI specifies any changes to be made therein,
the prospectus shall not be filed with the SEBI/Registrar of Companies
unless such changes have been incorporated therein.
iii. The issuing company, seeking permission under sub-rule (i) above, shall
obtain in-principle listing permission from one or more stock exchanges
having nation wide trading terminals in India.
iv. The issuing company may appoint underwriters registered with SEBI to
underwrite the issue of IDRs.
OTHER CONDITIONS FOR THE ISSUE OF IDRs
i. The repatriation of the proceeds of issue of IDRs shall be subject to laws for
the time being in force relating to export of foreign exchange.
ii. IDRs shall not be redeemable into the underlying equity shares before the
expiry of one year period from the date of the issue of the IDRs.
iii. IDRs issued by any issuing company in any financial year shall not exceed
15 percent of its paid-up capital and free reserves.
iv. Notwithstanding the denomination of securities of an issuing company, the
IDRs issued by it shall be denominated in Indian Rupees.
IDSs have several applications, foremost that it would enable Indians to invest in
the equity and accordingly share the growth of overseas companies. More
importantly, it would provide domestic companies seeking mergers or acquisitions,
an alternative security (to ADSs/GDSs or cash) to settle such a transaction.
In the current Indian context, cross-border merger and acquisition transaction may
be the preferred method to:
a. fuel growth in the immediate and short-term by securing the complementary
skill-sets required for sustained growth in margins and invoicing rates;
b. gain access to leading technologies that have been developed by other
organizations, thus reducing the time to market and enhancing client service
delivery;
c. acquire brands in overseas markets, thereby reducing the risks associated
with brand-building; and
d. provide a strategic option to upstage potential buyers by acquiring their
targets.
Under present Indian outbound investment regulations, Indian companies cannot
raise capital outside the ADS/GDS mechanisms. Although ADSs/GDSs provide
Indian companies adequate currency, they cannot be the ideal mechanisms as:
a. ADSs/GDSs give rise to a large repatriable pool of foreign exchange that is
essentially “hotmoney”. The retiring of each ADS results in an outflow of
foreign exchange; and
b. Excessive issue of ADSs/GDSs would result in a continued dilution of the
stake Indian public have in their company, resulting in control shifting abroad
and the company getting an overseas domicile.
360
A practical framework for Indian companies to acquire companies abroad,

necessitates that Indian companies be given a potent currency of comparable rights
both in India and abroad. An ideal mechanism would be IDSs. The significant
advantages of IDS are, they:
• Increase the number of available potential targets, both in terms of quality
and strategic fit;
• Provide an engine for high velocity growth by increasing the flexibility to the
merged/combined company’s capital structure;
• Establishing the first mover advantage in the South Asian stockmarkets for
global trade in international securities. The first step would be taken in
making Indian securities markets global;
• Maintain the competitiveness of Indian bourses as a preferred/necessary
destination among global stockmarkets for international listing;
• Prepare the local markets for closer operational integration with counterparts
overseas;
• Provide experience prior to capital convertibility;
• Grow the pool of foreign currency assets belonging to the nation;
• Channel additional non-resident Indian investment into India;
• Reduce the flight of domestic capital overseas through invisible, un-administrable
modes;
• Provide Indian investors an opportunity to participate in the growth of world-
class Indian companies; and
• Allow Indian stakeholders to participate in global companies with significant
(by local standards) Indian operations partaking of international profits and
not just that of an MNC’s domestic operations.
AMERICAN DEPOSITORY RECEIPTS
Until 1990, companies had to issue separate receipts in the US (ADRs) and in
Europe (IDRs) to access both the markets. The weakness was that there was no
cross-border trading possible as ADRs had to be traded, settled and cleared
through the Depository Trust Company (DTC) in the US, while the IDRs could be
traded and settled via Euroclear in Europe. It was in April, 1990 when changes in
Rule 144A and Regulations of the SEC of the US allowed non-US companies to
raise capital in the US market without having to register the securities with the
SEC or changing the financial statements to reflect the US accounting principles.
Rule 144A is designed to facilitate certain investment bodies called Qualified
Institutional Buyers (QIBs) to invest in overseas (non-US) companies without
those companies needing to go through the SEC registration process.
THE INSTRUMENT
ADR is a dollar denominated negotiable certificate, it represents a non-US
company’s publicly-traded equity. It was devised in late 1920s to help Americans
invest in overseas securities and to assist non-US companies wishing to have their
stock traded in the Amercian Markets. ADRs are divided into three levels based on
the regulation and privilege of each company’s issue:
i. ADR Level-I: It is often the first step for an issuer into the US public equity
market. Issuer can enlarge the market for existing shares and thus diversify
the investor base. In this instrument only minimum disclosure is required to
the SEC and the issuer need not comply with the US GAAP (Generally
Accepted Accounting Principles). This type of instrument is traded in the US
OTC market. The issuer is not allowed to raise fresh capital or list on any one
of the national stock exchanges.
361
ii. ADR Level-II: Through this level of ADR the company can enlarge the
investor base for existing shares to a greater extent. However, significant
disclosures have to be made to the SEC. The company is allowed to list in the
American Stock Exchange (AMEX) or New York Stock Exchange (NYSE)
which implies that the company must meet the listing requirements of the
particular exchange.
iii. ADR Level-III: This level of ADR is used for raising fresh capital through
public offering in the US Capital Markets. The company has to be registered
with the SEC and comply with the listing requirements of AMEX/NYSE
while following the US-GAAP.
Intermediaries that are involved in an ADR issue perform the same work as in the
case of a GDR issue. Additionally, the intermediaries involved will liaison with
the QIBs for investing in ADRs. Some of the well-known intermediaries for
ADRs/GDRs are, Merrill Lynch International Ltd., Goldmann Sachs & Co., James
Capel & Co., Lehman Brothers International, Robert Fleming Inc., Jardine
Fleming, CS First Boston, JP Morgan, etc.
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Regulatory Framework
At the outset, it should be clear that the regulatory framework for the ADRs is
provided by Securities and Exchange Commission which operates through two
main statutes, the Securities Act of 1933 and the Securities Exchange Act of 1934.
The Securities Exchange Act provides for the disclosure and its periodic updating.
As far as Indian regularity procedures are concerned, the Ministry of Finance is yet
to come out with a comprehensive set of guidelines.
Rule 415 of the Securities Exchange Act of 1934 refers to Shelf Registration and
applies to the issue of ADRs. Under this rule, select foreign companies are offered
the facility to register the necessary documents before the actual issuance of
securities. For this, issuers are required to prepare the prospectus in two parts:
basic and supplementary. While the basic prospectus has to be filed at the time of
shelf registration, the supplementary prospectus has to be filed at the time of the
actual issuance of the securities. Wrapping around the basic prospectus, the
supplementary prospectus records the recent developments in addition to filing a
detailed financial condition statement. Underwriting arrangements, the
certifications of auditors and legal counsel have to be procured for the actual issue
of securities. New shelf filings, are required if the issuer seeks to raise larger
amounts than originally indicated. Also, the issuer has the option to go in for
de-registration.
Shelf registration has been found to be useful to issuers as it reduces the incidence
of fees considerably. More importantly, shelf registration affords the issuers
opportunities for quickly accessing the markets as the offering process is
substantially simplified.
Potential
Though there has been an increase in the limit of FII investment in an Indian
company to 10 percent with the increase in the overall investment limit to
30 percent, FIIs eager to invest in certain blue chip companies are finding the
GDR/ADR route as convenient to invest in such companies. The first company to
have received the approval to issue ADR is BPL Cellular Holdings.
DEBT INSTRUMENTS
Eurobonds
The process of lending money by investing in bonds originated during the
19th century when the merchant bankers began their operations in the international
markets. Issuance of Eurobonds became easier with no exchange controls and no
government restrictions on the transfer of funds in international markets. Slowly,
the US dollar came to be accepted as an international currency and New York
joined the family of money centers of the world. The first Eurobond was made for
US$15 million only for the Italian motorway company – Autostrada, and the total
Eurobond volume in the year of 1963 was US$150 million. World Bank entered
international markets in a big way to raise finance by issuing bonds.
The Instruments
All Eurobonds, through their features can appeal to any class of issuer or investor.
The characteristics which make them unique and flexible are:
a. No withholding of taxes of any kind on interests payments.
b. A fundamental requirement is that the bonds are in bearer form with interest
coupon attached.
c. The bonds are listed on one or more stock exchanges but issues are generally
traded in the over-the-counter market.
364
Typically, a Eurobond is issued outside the country of the currency in which it is

denominated. It is like any other Euro instrument and through international
syndication and underwriting, the paper is sold without any limit of geographical
boundaries. Eurobonds, are generally listed on stock exchange the world over,
usually on the Luxembourg Stock Exchange.
There were various innovations in the structuring of bond issues during the
eighties. These structures used swap technique to switch from one currency to
another, or to acquire multi-currency positions. Another variation was in the form
of equity-related bonds as convertibles or bonds with equity warrants. Zero-
coupon bonds were issued capitalizing on the tax treatment.
Bond issue structures can basically be classified into two broad categories:
Fixed-rate Bonds (also referred to as straights), and Floating Rate Notes (FRNs).
a. Fixed-rate Bonds/Straight Debt Bonds: Straights are fixed interest bearing

securities which are redeemable at face value. These unsecured bonds which
are floated in domestic markets or international markets, are denominated in
the respective currency with interest rates fixed on the basis of a certain
formula applicable in a given market. The bonds issued in the Euromarket
referred to as Eurobonds, have interest rates fixed with reference to the
creditworthiness of the issuer. The yields on these instruments depend on
short-term interest rates. LIBOR is the most commonly used benchmark for
measuring the yields on these bonds. The interest rate on dollar denominated
bonds are set at a margin over the US treasury yields. The redemption of
straights is done by bullet payment, where the repayment of debt will be in
one lump sum at the end of the maturity period, and annual servicing.
Further, there is no tax deduction at source on the income of these bonds.
These bonds are listed either on London, Luxembourg or Singapore stock
exchanges. In addition to the fixed rate bonds, there are the zero-coupon
bonds which do not pay the investors any interest and therefore are not
taxable on a year-to-year basis. Instead, the differential between maturity
value and the issue price could be treated as capital gains and taxed at a lower
rate accordingly. The first zero-coupon bond was floated in Euromarkets in
1981 for Pepsi Co. which was made at a price of 67.5 percent for a maturity
of three years, with repayment at 100 percent on the maturity date. This has
provided a yield of 14.14 percent to the investors.
b. Floating Rate Notes (FRNs): FRNs can be described as a bond issue with a
maturity period varying from 5-7 years having varying coupon rates – either
pegged to another security or re-fixed at periodic intervals. Conventionally,
the paper is referred to as notes and not as bonds. The spreads or margin on
these notes will be above 6 months LIBOR for Eurodollar deposits.
The bulk of the issues in the seventies were denominated in US dollars. Later, the
concept was applied to other currencies, like pound sterling, deutsche mark, euro
and others. Extensive usage of these FRNs is done by both American and Non-
American Banks who would borrow to obtain dollar without exhausting credit
lines with other banks. Thus, FRNs represent an additional way to raise capital for
them. To cater to the varying shifts in the investor preferences and borrowers’
365
financial requirements, variations have been introduced in the basic FRN concept.
FRNs have thus been restructured into the followings types:
• Flip-flop FRNs: The investors have the option to convert the paper into flat
interest paying instrument at the end of a particular period. The investor
could change his mind and convert the note into a perpetual note once again
at maturity. World Bank had come out with a FRNs issue with perpetual life
and having a spread of 50-basis points over the US treasury rate. Every
6 months the investors had the option of converting the FRN into a 3-month
note with a flat 3-month yield. The investor could also revert his decision and
change it to a perpetual note.
• Mismatch FRNs: These notes have semi-annual interest payments though the
actual rate is fixed monthly. This enables investors to benefit from arbitrage
arising on account of differentials in interest rates for different maturities.
They are also known as rolling rate FRNs.
• Mini-max FRNs: These notes include both minimum and maximum coupons.
The investors will earn a minimum rate as well as a maximum rate on these
notes. Depending on the differential between these rates the spreads are
earned on these notes. These notes are also known as collared FRNs.
• Capped FRNs: An interest rate cap is given over which the borrower is not
required to service the notes, even if LIBOR goes above that level. Typically,
the investors have margins higher than that is normally applicable.
• VRN-structured FRNs: These represent long-dated paper with variable
interest spreads, with margins over LIBOR. The margins rise for longer
maturities.
• Perpetual FRNs: These notes which are irredeemable are also known as
perpetual floaters or undated issues.
Procedure
Coming out with a bond issue is the most complex and elaborate of the procedures
of all the funding programs. Bonds need to be carefully designed and executed,
especially as these are placed with international clientele.
The success of the bond issue depends not so much on costs as on the position and
capabilities of the bidders for launching the issue. The cheapest bid therefore may
not be the best bid because the track record and current market standing of the
bidders would have to be carefully weighed while choosing the lead manager.
Therefore the mandate of the bond issue has to be awarded after proper deliberation
on the modalities involved. The bids should include all necessary information
relating to the placement strategy, market support operations, listing details, paying
agency arrangements, delivery and handling of notes and trustee arrangements.
After the receipt of a mandate, the mandated bank (referred to as lead manager or
arrangers) has to initiate steps for formation of a syndicate group to complete bond
issue formalities. Since it is the key member of the syndicate group, it is responsible
for a series of tasks starting with the launching of the issue till its closure.
a. Syndication: In particular, the Arranger’s (lead managers) duties commence
with a credit appraisal of the issuer on the basis of a financial and operational
data. The lead manager has to organize detailed negotiations with the issuer
for the purposes of settling various terms and conditions. A time-table too has
to be drawn for going through various stages of bond issue floatation.
It is also the lead managers’ responsibility for drafting documents with the
help of legal counsels. Bond issue documentation comprises, besides
prospectus, subscription agreement, underwriting agreement, selling agency
agreement, paying agency agreement, listing agreement and the trust deed.
These agreements have the same kind of properties as in the case of a GDR
issue mentioned earlier in the chapter.
366
Traditionally, international markets have been following open-priced

syndication procedures. Under this, the lead manager keeps pricing open until
the subscription agreement is actually signed. The lead manager assesses not
only the market mood but the precise level at which an issue would be
supported and subscriptions can be procured in adequate measure.
International markets have also come up with an innovative method of
syndication referred to as bought-out deal process. Under this system, pre-
priced issue (pre-priced by the lead manager and co-management group) are
presented to the market and the issuer knows the exact issue price and
coupon rate before the former is launched in the market.
b. Launching, Offering and Closing: Placement of new bond issues in
markets follows a standard route. On receipt of various approvals and
authorizations by the issuer, news concerning bond issue floatation, is carried
through the appropriate media. With the announcement of a bond issue
launch, invitation telexes are sent to underwriters and to selling group
members inviting their support. The main function of underwriters is to take
up the issue on execution of the underwriting agreement. It is customary for
them to sell the issue subsequently. Underwriting is done by three groups –
the managers, major underwriters and minor underwriters. While the
commitments on the first two categories of underwriters will be an average of
1 percent of the issue, the last category of underwriters will have a
commitment of 0.5 percent of the issue.
Compared to underwriting, selling is organized in a different manner. While
underwriters take title to the issue so underwritten, selling group members
does not take title as they undertake to sell the issue if support is obtained.
The selling group, therefore, does not carry any risk – in a technical sense –
compared to the underwriting group.
The next stage in bond issue floatation is the offering. During this phase,
terms consisting of coupon rate and issue price are finalized. Pricing is
determined on the basis of the underwriters’ response, and is undertaken one
day before the offering. The lead manager, jointly with co-managers, has to
assess the mood and response of the market and weigh the response of the
underwriters accordingly. The two-day period prior to the offer is, therefore,
very crucial and hectic discussions and negotiations are undertaken in order
to arrive at a correct bond issue pricing.
During the offering period, the issuer and the lead manager organize a sales
campaign. Various markets are tapped by means of road shows. These are in
fact investor meetings, where the offering of a bond is formally presented to
investors. Road shows are organized at various centers and are important
from the point of view of placing the issue. The offering phase is concluded
with the actual sale of bonds, signing of necessary agreements and when
publicity, regarding the transaction, is over.
Listing
Bond issues are listed at one or more stock exchanges depending upon the type of
bond issue, the currency of denomination and the desire of the issuer to seek a
quotation at various centers. Generally, the Eurobonds denominated in dollars are
listed at London/Luxembourg Stock Exchanges and those bonds denominated in
Euro at Luxembourg Stock Exchange and German Stock Exchanges. Bonds issued
in domestic markets like Japan, Switzerland or Germany have to be listed as per
the requirements. Bond issue procedures are finally concluded with the tombstone
advertisement and Bible compilation.
367
Clearing Arrangements
With a view to facilitating both new issue and secondary market operations,
clearing house arrangements have been made and systems laid down for handling
transactions. Eurobonds are usually handed over to either the Euroclear system
(Brussels) or Cedel (Luxembourg). The two systems have been linked by what is
known as an electric bridge.
Euroclear and Cedel follow two distinct practices, fungible and non-fungible
accounts, for concluding transactions between parties. While the fungible accounts
system is most popular in Euromarkets, the non-fungible system is useful for
control purposes. In a fungible account system, details regarding the identity of the
owners and location of individual securities are not provided. Euroclear system
handles trades on fungible basis, whereas Cedel permits both procedures.
The two clearing systems have been providing various other facilities, apart from
settlement of secondary market trading transactions. For instance, finance is
provided by them for facilitating market-making operations.
Syndication of Euro Loans
A loan syndicate usually refers to the negotiation where borrowers and lenders sit
across the table to discuss about the terms and conditions of lending. Over the
years, it has become more customized. Nowadays, large groups of banks are
forming syndicates to arrange huge amount of loans for corporate borrowers. The
amount of these loans is so huge that one bank alone cannot bear the whole
amount. At the same time, the syndication risk of the participating banks is
diversified and thus reduced.
The process of syndication starts with an invitation for bids from the borrower.
The borrower has to mention the amount of funds requirement, maturity period,
preferred currency, amortization period, etc. After receiving the bids from different
bidders, these bids are analyzed in terms of financial aspects generally based on
the effective cost and other aspects like guarantee, maturity, installment amount, etc.
Based on this analysis, a bidder will be selected and awarded a mandate. The
selected bidder has to perform the syndicate and documentation formalities. The
syndication process is of two types – direct loan syndication and participation loan
syndicate. In case of direct loan, participant banks advance based on a common
loan agreement and the obligation of the participant banks are several. On the
other hand, participation loan syndicate establishes a principal agent kind of
relationship among the participant banks. In that syndication process, a lead bank
will be appointed. A merchant banker may himself act as a lead manager. The lead
manager lends maximum portion of the total loan amount. There may be more
than one lead managers. The lead manager takes the initiative to arrange the loan
amount and on the basis of the terms and conditions provided by the borrower,
requests the other banks to lend a share in the loan amount. These subsequent
lenders are known as the participating banks. Often, some participating banks are
termed as managing banks. They provide assistance and suggestions to the lead
manager who is managing the loan because they provide a larger share than the
other participating banks. Another major party in the syndication process is the agent
bank. Agent bank generally refers to such bank, which maintains links between the
borrower and the lending banks. It is the duty of the agent bank to collect and
disburse payments, maintain communication between all participants, etc.
Generally, the lead manager plays the role of agent bank in the syndicate.
Syndication can be done on a best effort basis or on underwriting basis. In case of
best effort basis, the lead manager tries his best to get the amount from the market.
On underwriting basis, the lead manager gets the funds irrespective of the market
response towards the loan requirement. Generally, a mandate has to be fixed for
procurement of the loan amount. After a reasonable time (say two to three weeks)
the borrower withdraws himself from the market.
368
The lead manager has two tasks along with the formation of the syndicate-
documentation and loan agreement. In the documentation process, the lead
manager drafts a loan agreement and an information memorandum. In the
information memorandum, details of the company, its past borrowings, operations
and cash flows are mentioned. The loan agreement is to be signed by all the loan
participants and borrowers. This agreement clearly mentions the amortization
period, amount of funds raised, purpose for which the loan has been raised,
guarantee details, interest rate, draw-down facility, commitment fees, default
situations and the relationship with the participant and agent bank.
Pricing of Eurodollar Loans
Several types of costs are associated with an Eurodollar loan. These costs can be
classified as periodic costs and upfront costs. Periodic costs include interest
charges on the loan amount and commitment charge on the in-drawn portion.
Upfront charges include management fees, agency cost, reimbursement of out-of-
pocket expenses, etc.
Interest rate charged on the loan is linked with inter-bank rates, often with LIBOR
(London Inter-bank Offered Rate) or LIBID (London Inter-bank Bid Rate).
Sometimes, the mean of these two rates (LIMEAN) is also used as a reference rate.
A margin over this rate is added to get the required rate. The margin varies with
the market conditions. The referred rate can be revised after some intervals.
Other than that, Pibor (Paris), Nibor (New York) and other inter-bank rates are used
as reference rates. In the loan agreement, an alternative cost plus formula is also
mentioned in case of failure of the euro currency in the international currency market.
A Eurodollar loan permits draw-down facility, where, within a fixed time period
the borrower can withdraw the loan amount in installment basis. The undrawn
portion of the loan will carry a lesser interest rate than the available loan portion.
This charge is known as commitment charge. The borrower has to make a
commitment so that the total amount of loan can be withdrawn before the
termination period. After the termination period, the unused portion of the loan is
cancelled. In the revolving credit, this draw-down amount can be varied from 0%
to 100% but in case of term credit facility, it depends upon the terms of credit.
Other than these charges, some upfront charges are also payable. These are
management fees, agency fees, reimbursement of incidental charges, etc.
Management fees are paid to the lead manager and other managing banks for
arranging and managing the loan. Generally, the lead manager passes some portion
of the management fee to other participating banks. The biggest portion of the
management fees retained by the lead bank is known as ‘praecipium’.
Foreign Bonds
These are relatively lesser known bonds, issued by foreign entities for raising
medium- to long-term financing from domestic money centers in their domestic
currencies. A brief note on the various instruments in this category is given below:
a. Yankee Bonds: These are US dollar denominated issues by foreign
borrowers (usually foreign governments or entities, supranationals and highly
rated corporate borrowers) in the US bond markets. Yankee bond has certain
peculiar features associated with the US domestic market. SEC regulates the
international bond issues and requires complete disclosure documents in
detail than the prospectus used in Eurobond issues, foreign borrower will
have to adopt the US accounting practices and the US credit rating agencies
will have to provide rating for these bonds. These bonds are sponsored by a
US domestic underwriting syndicate and require Securities and Exchange
Board registration prior to selling them in the domestic US market. Reliance
Industries Ltd., has been the most successful Indian corporate to tap this
instrument with a 50-year, $50 million Yankee Bond issue.
369
b. Samurai Bonds: These are bonds issued by non-Japanese borrowers in the

domestic Japanese markets. Borrowers are supranationals and have at least a
minimum investment grade rating (A rated). The maturities range between
3-20 years. The priority for allowing issuance of Samurai bonds is given to
the sovereigns after the supranationals and their entities and to high quality
private corporations specifically if there are Japanese trade links. This is also
a registered bond and the settlement and administrative procedures make it
relatively costly. Among the Yen financing instruments, this instrument is the
most expensive in terms of issuing costs. As this instrument is issued for the
public, the arrangements for underwriting and selling have to be made which
involves large documentation.
There are two major parties to a Samurai bond issue, the securities house,
which acts as a lead arranger, and the bank, acting as a chief commissioned
company. The process followed is generally the same as is followed
elsewhere for the Eurobonds. However, it is to be noted that the
documentation and formalities are friendly and hospitable.
c. Bulldog Bonds: These are sterling denominated foreign bonds which are
raised in the UK domestic securities market. The maturity of these bonds will
be either for very short periods (5 years) or for very long maturities
(25 years and above). Bonds with intermediate maturity periods are rare.
These bulldog bonds are generally subscribed by long-term institutional
investors like pension funds and life insurance companies. These bonds are
generally redeemed on bullet basis (one time lump sum payment on
maturity), however, due to the long maturities, early amortizations, say 5
equal annual installments prior to the maturity date, may also be allowed. A
margin on the UK government bond will be the yield earned on this paper.
These bonds which are offered either by placing or offer for sale process, will
have to be listed on the London Stock Exchange.
d. Shibosai Bonds: These are the privately placed bonds issued in the Japanese
markets. The qualifying criteria is less stringent as compared to Samurai or
EuroYen bonds. Shibosai bonds are offered to a different market segment
that consists of institutional investors, including banks. The eligibility
criteria, amount, maturity and redemption as well as coupon rate and issue
price are all governed by Japan’s Ministry of Finance (MoF) guidelines. In
terms of eligibility, MoF has classified various borrowers (sovereign and
corporate) into different groups. The rated borrowers are divided into three
groups in accordance with the rating, while non-rated borrowers are
segmented on the basis of country rating or previous bond issue floatation
experience. The pricing formula is elaborate and starts with the computation
of base rate, spreads being added according to the credit rating of the
borrowers. The procedures for completing bond issue formalities are
elaborate and take about forty-five days after the mandate is awarded.
Euro Notes
In the early ’80s, the international capital markets were faced with problems of
country defaults, uncertain supply of OPEC deposits, which were the main source
of deposits in the ’70s, and the macroeconomic imbalances which were resulting in
rising inflation and volatility in exchange and interest rates. All these factors
enhanced the risks in the international financial sphere.
The search in mid-eighties for a paper that goes beyond the interbank market for
arranging funds and which has wider support for resource raising through primary
investors in various markets has contributed to the birth of Euro notes. A series of
developments during the eighties, triggered by the bank credit crisis provided
impetus to the process of origin of these notes.
370
The Instruments
Euro notes as a concept is different from syndicated bank credit and is different
from Eurobonds in terms of its structure and maturity period. Euro notes command
the price of a short-term instrument usually a few basis points over LIBOR and in
many instances at sub-LIBOR levels. The documentation formalities are minimal
(unlike in the case of syndicated credits or bond issues) and cost savings can be
achieved on that score too. The funding instrument in the form of Euro notes
possess flexibility and can be tailored to suit the specific requirements of different
types of borrowers. There are numerous applications of basic concepts of Euro
notes. These may be categorized under the following heads:
a. Commercial Paper: These are short-term unsecured promissory notes which
repay a fixed amount on a certain future date. Euronotes, underlying CP, are
unsecured and stand on the general creditworthiness of the issuers. Referred
to as Euro Commercial Paper, these papers are not underwritten and have
maturities up to one year, mostly by way of three-month or six-month paper.
Even though maturities are short, the overall funding program could be for
medium- to long-term. Usually, the borrowers plan a series of tranches to
match their funding needs throughout the life of the program once they are
established.
It takes about four to five weeks after the initial decision is taken by the
concerned parties. Issuer of CP initiates proceedings by selecting a dealer and
an issuing and paying agent. While it is not mandatory to have ratings,
issuers often seek ratings for successful launching of CP programs.
The documentation is simple and comprises an information memorandum,
dealer agreement, issuing and paying agency agreement and the actual notes.
The information memorandum is a fairly standard and routine document and
carries basic information concerning the issuer. The relevant operational
information and financials are summarized in an information memorandum
for CP, which has to be updated periodically. In terms of disclosure
requirements, the information memorandum is expected to help investors
independently judge the creditworthiness of the CP issuer.
A significant variation of commercial paper is the asset-backed CP which is
backed by financial assets such as mortgages or credit card receivables.
b. Note Issuance Facilities (NIFs): The currency involved is mostly US
dollars. A NIF is a medium-term legally binding commitment under which a
borrower can issue short-term paper, of up to one year. The underlying
currency is mostly US dollar. Underwriting banks are committed either to
purchase any notes which the borrower is unable to sell, or to provided a
standing credit. These can be re-issued periodically.
In a typical NIF program, the issuer instructs the lead manager to issue Euro
notes at desired intervals. Maximum and minimum amounts of each issue are
also specified. The lead manager sells the notes as per the placement
agreement of the sole placing agent, multiple agents or a tender panel that
bids competitively for the paper. In cases, where there is sole placing agency
arrangement, the structure is called a Revolving Underwriting Facility
(RUF). The notes are offered for sale during a specified selling period,
usually ranging between three to ten business days.
NIFs primarily appeal to professional investors. These include commercial
banks, and non-bank financial institutions such as insurance companies and
provident funds. The underwriting support is provided by commercial banks.
A small role is also played by savings banks, investment companies and
insurance companies.
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NIFs carry three major cost components, underwriting fees (payable on the
full amount of underwriting), a one-time management fee (for structuring,
pricing, syndication and documentation) and margin on the notes themselves.
The margin on Euro notes is expressed either in the form of spreads over
LIBOR or built into the NIF pricing itself.
c. Medium-Term Notes (MTNs): MTNs are defined as sequentially issued
fixed interest securities which have a maturity of over one year. A typical
MTN program enables an issuer to issue Euro notes for different maturities,
from over one year up to the desired level of maturity. These are essentially
fixed rate funding arrangements as the price of each preferred maturity is
determined and fixed up front at the time of launching. These are conceived
as non-underwritten facilities, even though international markets have started
offering underwriting support in specific instances.
A Global MTN (G-MTN) is issued worldwide by tapping Euro as well as the
US markets under the same program. In view of placement of certain
proportion of notes in the US markets, issuers are required to seek shelf
registration from SEC.
Under G-MTN programs, issuers of different credit ratings are able to raise
finance by accessing retail as well as institutional investors. In view of
flexible access, speed and efficiency, and enhanced investor base, G-MTN
programs offer numerous benefits to the issuers.
Spreads paid on MTNs depend on credit ratings, treasury yield curve and the
familiarity of the issuers among investors. Investors include Private Banks,
Pension Funds, Mutual Funds and Insurance Companies.
The Indian Scene
Till 1994, there were only a few banks and financial institutions that have come
out with a CP and RUF-type program. With the opening of the international
markets in 1994, serious attempts were made by the Indian borrowers to explore
this route as a drive towards resource diversification. In the overall context, there
is certainly a considerable scope for prime Indian corporates to access the Euro
note market.
EURODOLLAR MARKET
THE NATURE OF THE EURODOLLAR
Eurodollars are bank deposit liabilities denominated in US dollars but not subject
to US banking regulations. Banks that offered Eurodollar deposits were located
outside the United Sates, mostly in Europe and Far East Asia. However, since late
1981, non-US residents have been able to conduct business, free of US banking
regulations at International Banking Facilities (IBFs) in the United States.
Eurodollar deposits may be owned by individuals, corporations, or governments
from anywhere in the world, with the exception that only non-US residents can
hold deposits at IBFs. Originally, dollar-denominated deposits, not subject to US
banking regulations were held almost exclusively in Europe; hence, named as
Eurodollars. Most of these deposits are still held in Europe, and in such places as
the Bahamas, Bahrain, Canada, the Cayman Islands, Hong Kong, Japan, the
Netherlands Antilles, Panama, and Singapore. Regardless of where they are held,
such deposits are referred to as Eurodollar deposits.
Banks in the Eurodollar market, including US IBFs, compete with banks in the
United States to attract dollar-denominated funds. Since the Eurodollar market is
relatively free of regulation, banks in the Eurodollar market are able to operate on
narrower margins or spreads between dollar borrowing and lending rates than
those in the United States. This gives Eurodollar deposits an advantage relative to
deposits issued by banks operating under US regulations.
The Eurodollar market has grown largely as a means of avoiding the regulatory
costs involved in dollar-denominated financial intermediation.
372
THE SIZE OF THE EURODOLLAR MARKET

Eurodollar volume is measured as the dollar-denominated deposit liabilities of
banks located outside the United States. For example, the Bank for International
Settlements (BIS) defines and measures Eurodollars as dollars that have “been
acquired by a bank outside the United States and used directly or after conversion
into another currency for lending to a non-bank customer, perhaps after one or
more redeposit from one bank to another.”
The sum of all dollar-denominated liabilities of banks outside the United States
measures the gross size of the Eurodollar market. For some purposes, it is useful to
net some interbank deposits out of the gross to arrive at an estimate of Eurodollar
deposits held by original suppliers to the Eurodollar market. Roughly speaking, to
construct the net size measure, deposits owned by banks in the Eurodollar market
are netted out. But deposits owned by banks located outside the Eurodollar market
area are not netted out because these banks are considered to be original suppliers
of funds to the Eurodollar market. For other purposes, such as comparing the
volume of deposits created in the Eurodollar market with the US monetary
aggregates, it is useful to further net out all bank-owned Eurodollar deposits.
Doing so, leaves only the non-bank portion of the net size measure.
Incentives for Development of the Eurodollar Market
Banks may avoid some USA banking regulations by accepting dollar-denominated
deposits and making dollar-denominated loans outside the United States and at US
IBFs. For example, IBFs and banks located outside the United States do not have
to hold non-interest-bearing reserves against their dollar-denominated deposits.
Recently, reserve requirements have been eliminated on all time deposits in the
United States and have been reduced from 12 to 10 percent on transactions
deposits. However, US bank regulations have been strengthened as a result of the
banking problems encountered in the 1980s.
Regulatory initiatives such as stricter capital standards, higher deposit insurance
premiums, and more intense supervisory scrutiny have raised the cost of
depository intermediation in the United States.
Eurodollar banks hold balances with banks in the United States for clearing
purposes only and otherwise avoid reserve requirements. There is no deposit
insurance assessment on Eurodollars. Although stricter capital standards also have
been imposed internationally, the regulatory cost of depository intermediation in
the United States remains higher than in the Eurodollar market.
In most Eurodollar financial centers, entry into Eurodollar banking is virtually free
of regulatory impediments, so banks intending to do Eurodollar business can easily
be set-up in locations where tax rates are low. For example, to obtain more
favorable tax treatment, Eurodollar deposits and loans negotiated in London or
elsewhere often are booked in locations such as Nassau and the Cayman Islands.
Various states in the United States have amended their tax codes to grant relief to
IBFs from local taxes. Foreign monetary authorities generally are reluctant to
regulate Eurodollar business because by doing so, business would be driven away,
denying the host country income, tax revenue, and jobs. Even if the US monetary
authorities could induce a group of foreign countries to participate in a plan to
regulate their Euromarkets, such a plan would be ineffective unless there is an
agreement not to host unregulated Eurodollar business. In practice, competition for
aforementioned business has been fierce, so even if a consensus should develop in
the United States to regulate Eurodollar business, it would be extremely difficult to
impose regulations on the entire Eurodollar market.
373
Financial Instruments in the Eurodollar Market

An overwhelming majority of money in the Eurodollar market is held in fixed-rate
Time Deposits (TDs). The maturities range from overnight to several years,
although most of them are from one week to six months. Eurodollar time deposits
are intrinsically different from dollar deposits held at banks in the United States.
The former are liabilities of IBFs or of banks located outside the United States.
The bulk of Eurodollar TDs are inter-bank liabilities. They pay a fixed,
competitively determined rate of return.
The Eurodollar Certificate of Deposit (CD) is an important Eurodollar instrument.
A Eurodollar CD is a negotiable receipt for a dollar deposit at a bank located
outside the United States or in a US IBF. From their introduction in 1966, the
volume of Eurodollar CDs outstanding reached roughly $50 billion at the
beginning of 1980. By late 1990, Eurodollar CD volume was around $130 billion.
The 1990 elimination of the 3 percent reserve requirement on non-personal time
deposits and CDs in the United States has made the Eurodollar CD market a bit
less active. Recently, fixed-rate three-month Eurodollar CDs have yielded
approximately 10 basis points below the three-month London Inter-bank Offered
Rate (LIBOR). LIBOR is the rate at which major international banks are willing to
offer term Eurodollar deposits to each other. An active secondary market allows
investors to sell Eurodollar CDs before the deposits mature.
Secondary market-makers’ spreads for short-term fixed-rate CDs have been 1 to
3 basis points for European bank dollar CDs and around 5 basis points for
Japanese bank dollar CDs.
Banks issue Eurodollar CDs to “tap” the market for funds and are commonly
issued in denominations of $250,000 to $5 million. Tranche CDs (Eurodollar
CDs), are issued in very large denominations but marketed in several portions in
order to satisfy investors with preferences for smaller instruments. The latter are
issued in aggregate amounts of $10 million to $30 million and are offered by
banks to individual investors in $10,000 certificates, with each certificate having
the same interest rate, issue date, interest payment dates, and maturity.
In the late 1970s, Eurodollar Floating Rate CDs (FRCDs) and Eurodollar Floating
Rate Notes (FRNs) came into use as means of protecting both borrower and lender
against interest rate risk. By making their coupon payments float with market
interest rates, these “floaters” stabilize the principal value of the paper. The market
for FRCDs is no longer active. Eurodollar FRNs have been issued in maturities
from 4 to 20 years, with the majority of issues concentrated in the five- to
seven-year range. Eurodollar FRNs tend to be seen as an alternative to straight
fixed-interest bonds, but they can in principle be used like FRCDs.
Eurodollar FRNs have been issued primarily by banks and sovereign governments.
FRNs issued by governments are not Eurodollars proper since they are not bank
liabilities. They should be referred to as Eurodollar instruments together with the
NIFs and Euro commercial paper discussed below.
Eurodollar FRCDs and FRNs are both negotiable bearer papers. The coupon or
interest rate on these instruments is reset relative to the corresponding LIBOR
every three or six months. The rate is set below LIBOR for sovereign borrowers
and above for US banks. Yields on Eurodollar FRNs range from 1/8 percent under
the London Interbank Bid Rate (LIBID) up to LIBOR. To determine LIBOR for
Eurodollar FRNs, “the issuer chooses an agent bank who in turn polls three or four
Reference Banks – generally, the London offices of major international banks.
Rates are those prevailing at 11:00 a.m. London time, two business days prior to
the commencement of the next coupon period.” A secondary market exists in
FRNs. The spread quoted on FRNs in the secondary market is generally 10 cents
per $100 face value for the liquid sovereign issues. Other spreads are quoted on an
indicative basis and are somewhat higher.
374
In the mid-1980s, Note Issuance Facilities (NIFs) became a significant Eurodollar

instrument. A NIF is a medium-term, usually five- to seven-year arrangement
between a borrower and an underwriting bank under which the borrower can issue
short-term, usually three- to six-month, paper known as Euronotes in its own
name. According to such an arrangement, the underwriting bank is committed
either to purchase any notes the borrower cannot sell or to provide standby credit
at a predetermined spread relative to some reference rate such as LIBOR.
Underwriting fees are paid on the full amount of the line of credit, regardless of
the amount currently drawn. The fee is 5 basis points for top borrowers and ranges
up to 15 basis points for worse credit risks.
Euronotes can be issued at around LIBID by well-regarded borrowers. Top
borrowers can issue at yields 1/16 or 1/8 percentage points below LIBID.
Euronotes are comparable investments to Eurodollar CDs.
When the market initially matured around 1985, non-bank corporate borrowers
accounted for roughly 60 percent of NIFs arranged. Most borrowers were from
countries in the Organization for Economic Co-operation and Development. Most
papers were placed with smaller, non-underwriter banks. In 1985, about one-third
or more of the placements may have been with non-bank investors, including
money-market funds, corporations, insurance companies, wealthy individuals, and
central banks. As on April 1986, about $75 billion of NIFs had been arranged, with
only an estimated $10 to $15 billion having been drawn.
Since mid-1984, facilities similar to NIFs have been arranged without
underwriting commitments. In the second half of 1985, new non-underwritten
agreements equalled the new NIFs arranged. Non-underwritten agreements have
become much like US commercial paper programs. Note issuance has been
separated from the standby arrangement, notes are issued in shorter odd maturities,
and these notes can be marketed quickly. Under these arrangements, a bank is
simply a marketing agent. Euronotes issued under these conditions are known as
Euro commercial paper. Recently strengthened risk-based capital requirements
have, in part, induced the shift to Euro commercial paper because they have raised
the regulatory cost associated with NIFs. Euro commercial paper yields range from
LIBID minus 25 basis points for top-rated sovereigns to LIBOR plus 30 for
low-rated corporations.
For most US corporations, the US commercial paper market probably remains a
more cost effective source of funds than Euro commercial paper. For some non-US
corporations, however, Euro commercial paper may be as cost-effective as
US commercial paper, because of the premium that foreign issuers pay in the
US commercial paper market. The secondary market for Euro commercial paper
is, like the US commercial paper market, relatively underdeveloped. If a client
needs to sell paper before maturity, he will almost always sell it to the dealer who
sold the paper initially. Any trading usually occurs in the first few days after the
paper is issued. Trading is most frequent in the sovereign sector, which accounts
for about 20 percent of Euro commercial paper outstanding.
THE RISKS ASSOCIATED WITH EURODOLLAR DEPOSITS AND
DOLLAR DEPOSITS hELD IN THE UNITED STATES
There are three basic sources of risk associated with holding Eurodollars.
i. The chance that authorities where a Eurodollar deposit is held may interfere
in the movement or repatriation of the principal of the deposit or the interest
paid on it. But this risk factor does not necessarily imply that Eurodollar
deposits are riskier than dollar deposits held in the United States. Rather, the
relative riskiness can depend on the deposit-holder’s residence. For US
residents, Eurodollars may appear riskier than domestic deposits because of
the possibility that authorities in the foreign country where the deposit is
located may interfere in the movement or repatriation of the interest or
375
principal of the deposit. Some foreign residents may again feel that the US
government is more likely to block their deposits than the British
government. Consequently, they may perceive greater risk from potential US
government interference by holding dollar deposits in the United States than
by holding Eurodollar deposits in London.
ii. The potential for international jurisdictional disputes: For example,
uncertainty surrounding interaction between United States and foreign legal
systems compounds the difficulty in assessing the likelihood and timing of
payment on Eurodollar deposits in the event of an issuing bank’s failure.
iii. The soundness of deposits at banking offices located in foreign countries
related to banking offices located in the United States. Eurodollars can be
riskier than deposits held in the United States because deposits held in the
United States can carry explicit deposit insurance of some kind while
Eurodollar deposits generally do not. Also, in the event of a financial crisis,
banks located in the United States are more likely to be supported by the
Federal Reserve System, whereas neither the support of the Federal Reserve
nor that of foreign central banks for Eurodollar banking activities is certain.
Compounding the three basic risk factors identified above, cost of evaluating
foreign investments is greater than that in domestic investments. Acquiring
information on the soundness of foreign banks is generally more costly than
assessing the soundness of more well-known domestic banks. This means that for
a given level of expenditure on research, investors must generally accept more
ignorance about the soundness of a foreign bank than a domestic bank.
Therefore, we can conclude that Eurodollars including those at US IBFs are close
substitutes for dollar deposits at non-IBF banks located in the United States.
Eurodollar deposits are attractive because they are free of most regulatory burdens
imposed by the US authorities. In fact, the tremendous growth of the Eurodollar
market in the last two decades has largely resulted from efforts to move dollar
financial intermediation outside the regulatory jurisdiction of the United States.
Host countries have competed eagerly for Eurodollar business by promising
relatively few regulations, low taxes, and other incentives. Even the United States,
through IBFs introduced in 1981, is now competing for Eurodollar business.
Financial intermediation in US dollars will continue to move abroad or to IBFs as
long as incentives exist for it to do so.
EURO CREDIT SYNDICATION
The Genesis
Syndicated Euro credits are in existence since the late 1960s. The first syndicate
was organized by Bankers’ Trust in an effort to arrange a large credit for Austria.
During the early seventies, Euromarkets saw the demand for Euro credits
increasing from non-traditional and hitherto untested borrowers. The period after
first oil crisis was marked by a boom phase. To cope with the increasing demand
for funds, lenders expanded their business without undertaking due credit appraisal
of their clients or the countries thus financed. Further, the European banks had
short-term deposits while bulk of borrowers required long-term deposits. These
lendings were at fixed rates thus exposing these banks to interest rate risks. The
banks evolved the concept of lending funds for medium-/long-term i.e., 7-15 years
on a variable interest rate basis Linked to the Inter-bank Rate (LIBOR). Revision
of rates would take place every 3-6 months. These loans are extended in currencies
denominated by USD, Yen, Swiss Franc and Euros. Amortization of the loan
would be by way of half-yearly installments on completion of 2-3 years of grace
period. At present, this instrument on a variable interest rate basis has emerged as
one of the most notable and popular financing instruments in the international
financial markets. Syndicated Credit remains as the simplest way for different
types of borrowers to raise forex finances.
376
Syndicates are classified into 2 types – Club Loans and Syndicated Loans.
The Club Loan is a private arrangement between lending banks and a borrower.
Conventionally, the entry into Euromarkets for a funding deal is well-publicized.
When the loan amounts are small and parties familiar with each other, lending
banks form a club and advance a loan. Therefore, in view of this private
arrangement, an information memorandum is not complied and neither is the deal
publicized in the financial press.
Syndicate credits are created when lenders and borrowers come together and
execute an agreement, defining terms and conditions, under which a loan can be
advanced. These procedures and practices have, over the years, been developed
and perfected so that a standard package has now evolved.
Documentation Formalities
Along with the syndication process, the lead manager/lead bank also initiates
action of drafting the loan documentation, comprising an information
memorandum and loan agreement. The information memorandum describes the
borrowing entity, its formation, ownership and management. A somewhat detailed
account of operations, past and present, and the cash flow position (along with a
summary of the financials) find an important place in it. It must be noted that the
information memorandum does not have the same status and recognition as a
prospectus, neither does the lead manager take any responsibility for its accuracy.
The information memorandum also contains a detailed description of the
guarantor, in case loans carry a state guarantee. Many developing country
transactions carry the guarantee of their respective governments and conventions
have evolved for describing the guarantor.
Since the information memorandum is registered with any stock exchange, it does
not carry the weightage of a bond issue prospectus. However, it is an important
document from the commercial point of view. Prospective lenders rely upon the
statements it carries and hence due diligence must be observed.
The principal loan document is the loan agreement and it is the responsibility of
the lead manager to draft and conclude it satisfactorily. The agreement is signed by
all participating banks and the borrower. It describes the basic transaction,
draw-down arrangements, interest rate and its determination, commitment fees,
warranties and undertakings, default circumstances, financial covenants (if any),
‘agent bank’ and the participating banks. The loan is underwritten by a
management group assembled by the lead bank. Sometimes the lead bank itself
underwrites more than half of the loan amount.
Pricing Methodology
As mentioned earlier, the loan, will be charged at an interest rate that is linked to
the LIBOR. The rate will be LIBOR plus the spread the bank would like to
maintain. This spread which may be anywhere from 0.125 to 1.5 percent, may
remain constant over the life of the loan or may be changed after a certain fixed
number of years. In addition, the lead manager’s fee, which will be 0.125 percent
of the loan, the commitment fee of 0.5 percent on the undrawn loan amount and
agent’s fee will be the total annual charges. Front-end charges include
participation fee for the banks taking part in the loan and the management fees for
the underwriting banks and lead banks. These loans will require a bank guarantee
and the bank should confirm to the capital adequacy norms. However, there are no
other collaterals attached.
377
Indian Scenario
While the early ’80s saw the Indian PSUs, banks, and FIs raise funds by way of
syndicated loans, subsequent rating position of India, did not seem to be congenial
for the same. Future borrowings with this method of loan syndication will also
depend to a large extent on this sovereign rating.
FOREX FINANCE
SOURCES FOR RAISING FOREX FINANCE
In the modern financial context, various sources are available to raise forex
finances in international financial markets. These can be classified as follows:
• Official Channels
• Commercial Channels (Debt)
• Commercial Channels (Equity).
Official Channels
Flow of forex finances into a country due to the agreement between the
Governments or from the multilateral financial institutions such as World Bank,
African Development Bank, KfW of Germany, Inter America Development Bank,
and Asian Development Bank, can be termed as official funding. Initially, the fund
is available to recipient government, and hence this can be used in Macro level.
Big infrastructural and industrial projects of various countries that meet the
socio-economic and developmental objectives are funded by these methods.
Following are the methods available to raise finances through official channels:
Bilateral Funding Arrangements
Under these arrangements, funding is offered in the form of mixed credits. It
means the arrangement of funds from governments and private commercial banks.
Official funding constitutes forty to sixty percent of the total project cost; the rest
is being financed by commercial banks as export credits. There is no interest
charge on official funding. The maturity period of official funding is 25 years. It is
a long-term fund. But in case of commercial funding, it is mid-term fund, it carries
interest applicable on export credits. So, the mixed credit comprises subsidized
credit and commercial credit and it offers for specific purposes that satisfy certain
socio-economic criteria.
Multilateral Institutions Funding
Multilateral financial institutions (World Bank, Asian Development Bank, African
Development Bank, Inter American Development Bank and KfW of Germany)
provide credits on a much larger scale. Procedures and conditions of financing
vary from one institution to other. World Bank provides finances through the
following windows:
International Development Association (IDA): International Development
Association, the soft loan window of World Bank, provides long maturity loans
with no interest for infrastructure projects that satisfy the socio-economic
objectives of a nation.
International Finance Corporation (IFC): IFC provides loans for industrial
projects on commercial terms. These loans carry interest charges (fixed or
floating) and are designated in various currencies. Usually, IFC invests a small
proportion of its assistance in the equity of the assisted firm.
Development Bank Window: The main operations of the World Bank are in the
form of development bank providing loans to the borrowers with varying rates of
interest. Interest charges on World Bank loans are reviewed at six-monthly
intervals and it is based on weighted average cost of funds with a margin added.
The World Bank follows flexible financing approaches. In certain countries, it has
financed the projects based on their cash flows.
378
Commercial Channels (Debt)

Debt is the most important source of finance in the international financial markets.
Over the years, global markets have brought out various innovations in
international markets as well as liberalized the lending practices to attract the
borrowers from all over the world. Various financing instruments that are in vogue
can be classified under three main categories:
• Syndicated loans
• Bonds
• Euronotes.
To meet the diverse requirements of investors and markets and to manage the
finances properly, the world markets have come up with various innovative
financial instruments such as swaps, options, and futures. These instruments are
employed by many end-users for hedging their risks. These instruments are called
financial derivatives and the process is called financial engineering.
Commercial Channels (Equity)
Successful efforts made by few leading international borrowers to raise equity
capital in foreign markets, led the emergence of international equity issues in the
early eighties. This success encouraged the markets and market players to perfect
the practices for issuance of international equities. The end of the eighties not only
witnessed the remarkable growth in the international equity issues but also
increased the investors’ interests in those practices. Various financial instruments
have been adopted to issue equities in international financial markets. These
instruments comprise:
• America Depository Receipts (ADRs).
• Global Depository Receipts (GDRs).
• Euroconvertible Bonds (can be converted into equities).
Traditionally, the cross-border equity investments are arranged directly through
foreign investments and indirectly in the form of portfolio investments.
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STRATEGIC CONSIDERATIONS
The companies that are contemplating to tap the avenues of international finance
should consider the factors that assess the ability of the particular instrument to
raise finances for the company. One important factor that needs to be considered is
the instrument maturity and its consequent impact on the asset-liability balance.
However, external financing is subject to a series of uncertainties concerning the
basic element of cost in terms of interest rate and exchange rate changes between
currency and in the margins payable in respect of Euronote issuance programs.
379
Hence, a thorough strategy has to be chalked out to avoid any pitfalls and to help
the company garner. For such a strategy, each of the instruments need to be
analyzed from the various points. The table below compares each of the instrument
on the basis of critical parameters.
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Therefore, from the above table, the company may decide on the various
parameters before deciding on the instrument. For example, for a company which
hopes to get the state guarantee and which has a capability to go-in for the bullet
repayment may opt for the bonds as the instrument. Credit rating also plays a
major role in deciding the type of instruments that the company selects for its
international finance. Typically, debt rating of the company is a current assessment
of the creditworthiness of an obliger with respect to a specific obligation. Standard
& Poor and Moody are two major rating agencies which assess the companies
380
which tap the international market. The rating process analyzes the financials of
the company, present as well as future, since in the ultimate analysis the financial
strength of the company acts as an indicator of bond issues. The credit rating that
the company obtains from the agencies will ultimately decide the investment
strategy of the fund manager interested in the company.
Last but not the least, the market which the company prefers to tap is also a
consideration to be looked into.
Again, the company which has the capability to go through the complex process of
SEC and which can claim popularity among the QIBs of the US may go-in for the
American market gaining the advantage of large market.
Hence, it is clear that unless the company ponders and ruminates over the
parameters listed above and arrives at a strategy, it cannot evolve its financing
plan.
Limitations of International Capital Borrowings
In addition, the following limitations of borrowing in the international financial
markets should be kept in mind:
i. Foreign borrowings may not be used properly in the country and may not
result in the expected benefits of increase in the productivity, employment
and infrastructure. Sometimes, the inflows of foreign capital may be used for
investment in low social returns projects and this results in inefficient and
undesirable allocation of resources.
ii. The inflow of foreign funds may increase the instability or volatility of the
home currency and the exchange rate. As the foreign capital can be
withdrawn usually at short notices of time, instability may occur.
iii. The cost of foreign finance may be much higher than the cost of internal
sources of funds, due to the existence of floating rates and volatility in the
exchange rates.
iv. Some of the investments may be for the short-term period and their
withdrawal can affect the flow of funds in the economy.
v. If the inflows of outside sources are very huge, the central bank of the
country may have difficulty in implementing the monetary policies.
However, despite all these limitations, one has to keep in mind that for capital
starved developing countries like India and China, tapping the international capital
markets is the only viable possibility to grow.
Multi-currency Loans vs. Eurodollar Loans – Provisions for Loan
Agreements
Multi-currency Loans
Multi-currency loans are loans denominated in one currency with an option to
borrow in one or more other currencies. Multi-currency loans are being
increasingly used as businesses attempt to take advantage of the growing
international economy. Also, to some extent, multi-currency loans represent a
natural expansion of the use of Eurodollar loans; i.e., dollar loans based on LIBOR
pricing. Certain currency risks are inherent in the multi-currency loans. In order to
protect the lender against the currency risks that are present, the loan
documentation for multi-currency financing contains unique provisions. This paper
highlights those provisions by contrasting relevant loan terms with those typically
found in Eurodollar loan documentation.
381
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384
The Loan documentation in both the cases contain the following provisions:
General: Multi-currency loans, like Euro-currency loans, are based on a match-
funding model. Provisions of the loan agreement reflect the assumption that, on
receipt of notice of an anticipated draw from the borrower, the lender will enter the
market and solicit an equal and offsetting deposit in the same currency. In practice,
however, a large money-center bank is likely to match its assets and liabilities in a
particular currency on a global basis. Nevertheless, loan agreements continue to
reflect the lender’s potential risks in accordance with a loan-by-loan match-
funding assumption.
In a multi-currency loan agreement, the borrower may elect to borrow in one or
more specified currencies, and will typically be expected to repay in the currency
in which the loan is actually denominated. In order to provide against the risk that
payment of foreign currency in a particular location may become illegal or,
because of foreign exchange control regulations disadvantageous to the lender, the
lender may be permitted to elect the place of payment. The lender’s options will
typically include the country where the currency is a legal tender. In order to
provide against the risk of market disruption in the European Currency Unit
(ECU), provision may also be made for payment of an ECU-denominated loan in
an alternative currency. Other options are possible as well, and the lender may be
permitted to elect from among several currencies, as well as to elect both the
currency and the place of payment.
Business Day: The definition of “business day” has greater importance in a multi-
currency agreement than it does in a LIBOR-priced loan. The reason is that the
definition will be used in provisions relating to the date on which rates of exchange
are determined. Because, wide fluctuations in the exchange rate may take place
within a short period of time (specially, when such fluctuations occur as the result of
government intervention rather than market forces), the day on which the rate is
determined may have a material impact on the amount the borrower is required to
repay.
The drafter’s objective in defining “business day” should be to include as a
business day only a day on which banks are in fact open for the transaction of
business and currency markets are operating relative to each of the currencies in
which the borrower may elect to draw funds.
Currencies: In addition to the definition of “dollars” that appears in LIBOR-
priced loans, it is necessary to define each of the currencies in which the loan may
be drawn. Currencies other than the Euro are typically defined with reference to
the country in which they are a legal tender, thus: “Sterling” means “the lawful
currency for the time-being of the United Kingdom.”
The Euro, however, is an artificial currency, or “currency basket.” It is a weighted
composite of the currencies of states that are members of the European Monetary
System (EMS), a supernational governmental entity with rule-making authority
over its constituent member states. The currency (or currencies) in which the
borrower is permitted to draw is/are known as “optional” currencies. The optional
currency is defined with reference to the currency in which the facility is granted.
However, the Euro currency notes and coins have replaced most of the EMS
countries’ currencies since 1-1-2002.
The Year: For Eurodollar loans, interest is calculated on the basis of a year of 360
days and the actual number of days elapsed. For sterling and certain other
385
currencies, a 365-day year is used. Therefore, the calculations of interest provision

in a multicurrency loan should take into account prevailing market practices.
Setting the Rate: Like Eurodollar loans, the interest rate for each drawing is based
on the LIBOR (or “LIBO”) rate with respect to the currency in which the loan is to
be denominated, plus the agreed-upon margin. The definition of the LIBOR rate,
as used in multi-currency loans, thus turns on many of the same considerations that
apply to the establishment of a LIBOR rate for dollar-denominated loans. It is
frequently assumed that the rate at which the lender offers its deposits (the
“offered-by” or “asked” rate) will ordinarily be greater than the rate at which other
banks offer deposits to it (the “offered-to” or “bid” rate) and, therefore, that the
lender should bargain for the first rate and only reluctantly accept the second.
This approach ignores several factors. One being the significance of the tiered
market among banks: Depending on the size of a bank and its perceived strength, a
second- or third-tier bank may have to pay a higher rate to attract deposits of prime
banks than it will receive for deposits placed with prime banks. Another factor
often ignored is that the effective rate is established by adding a margin to the
LIBOR rate. A lender may accept the “offered-to” rate if it then compensates for a
presumed lesser rate by increasing its margin.
In a syndicated multi-currency loan, as in a Eurodollar loan, the rates of three
reference banks, chosen to represent the mix of banks in the syndicate, may be
averaged.
Some multi-currency agreements provide for the use of a published rate. This
mechanism does not link the interest rate to the lender’s actual cost of funding,
but it serves as a useful mechanism in the event that a bank wishes to offer a
LIBOR-priced facility, but cannot use an “offered-by” or “offered-to” rate because
it has no London office.
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Restrictions: Because of the number of currencies in which multi-currency loans
may be drawn, and the fact that revolving credits contemplate that renewals,
conversions, and adjustments will be made prior to the commitment termination
date, lenders frequently insert restrictions intended to reduce the administrative
burden on the agent or lender.
386
As in the case of a Eurodollar loan, the borrower is typically permitted to elect a

one-, three-, or six-month interest period. Because the market for some currencies
may be thin for maturities longer than six months, longer interest periods are rarely
permitted. In order to avoid multiple interest rate determinations, interest periods
may be consolidated. As in the case of all Eurodollar loans, advance notice of a
drawing must be given by the borrower. Since interest rates are established two
days prior to the contemplated drawing, the required minimum notice might be as
little as three days. For purposes of administrative convenience, to provide for the
possibility of market disruption, and to permit funding arrangements to be made by
syndicate members, longer notice periods, extending five days or more, are
frequently specified.
Other provisions intended to reduce the borrower’s options to manageable
proportions may limit the time, number, or size of drawings.
Exchange Rate or Equivalent Amount: If the facility is denominated in one
currency, such as dollars, and the borrower wishes to make a drawing in an
optional currency, such as francs, the loan agreement must specify the exchange
rate to be used to convert dollars into francs. As with interest rate determinations,
there is normally some spread between selling and buying prices. While in a given
instance the lender might prefer to “sell” francs to the borrower, for the purpose of
meeting its funding requirement, at the same price at which it sells francs to third
parties, the borrower may argue that a fairer rate is the purchase rate (or the rate at
which the lender could obtain the optional currency from a third party) or, as a
compromise, the mean of the buy and sell rates.
Revaluation: As with any revolving credit facility, the multi-currency loan may
be renewed (or “rolled over”) at the expiration of an interest period. However, if
the exchange rate at the end of the interest period is different from the rate at the
beginning, the lender will require a loan denominated in an optional currency to be
revalued at the then current rate. Revaluation is achieved by calculating the
amount (in the optional currency) of the borrower’s original drawing, at the
exchange rate applicable to the upcoming interest period. If the amount of optional
currency, as thus calculated, exceeds (or is less than) the amount outstanding, the
borrower or lender will make the required payment in the optional currency at the
time of renewal. (For convenience, adjustments may not be required if the
difference between these amounts does not exceed a specified minimum amount,
such as 5 percent.)
Illegality: The illegality clause in a multi-currency agreement, like that in a
Eurodollar loan, is intended to address the possibility that the laws of the United
States or of the foreign country where the bank’s lending office is located may
restrict the branch or subsidiary from accepting the deposits required to match-
fund the loan, or from making the loan. Foreign branches and subsidiaries are not
only regulated by the Federal Reserve Board, but are also regulated and licensed
by the jurisdiction in which they are situated. They may be restricted as per the
sources or amounts of deposits they may accept, or the nature of the loans they
may make. The illegality clause is intended to address future changes that may
render it impossible for the lender to fulfill its obligations.
Disaster: In a Eurodollar loan, the disaster clause contemplates that the lender
may not be able to obtain the quotations in the London inter-bank market required
to ascertain the LIBOR rate, or may be required to pay a premium in the London
inter-bank market to obtain the deposits required to fund the loan. Disaster clauses
anticipate that the lender will be able to obtain dollars, however, by funding itself
in some other manner, and will be able to make the loan if it can be priced at the
reference rate or at some other substitute or negotiated rate acceptable to both
parties.
387
In a multi-currency loan, the disaster provision must also contemplate that the
currency the borrower has elected to borrow is unavailable, either because the
lender or lenders cannot obtain deposits in that currency in the relevant inter-bank
market, or because there has been a generalized and widespread disruption in the
market for that currency. The borrower will not wish the lender to be excused from
providing the optional currency at the agreed-upon rate because of a problem
peculiar to that lender. The borrower, therefore, will wish the disaster clause to be
invoked only in the event of a generalized market disruption.
The lender will want to be protected against circumstances affecting its ability to
fund the drawing in the relevant interbank market, even if its inability stems from
the perception other banks have of the lender’s stability as a banking institution, or
from political or economic uncertainty in the lender’s country.
If the disaster clause is invoked, the loan agreement may provide that no further
drawings in the affected currency shall be made, and that outstanding drawings in
that currency shall be repaid at the end of the relevant interest period. Or as in the
case of Eurodollar loans – the agreement may provide that the borrower and the
lender will negotiate in good faith to attempt to agree on a suitable replacement for
which the relevant drawing can be maintained and/or the currency in which it will
be maintained. If the disaster clause does not expressly suspend the borrower’s
right to elect a drawing in the affected currency during the pendency of the
circumstance that has triggered the clause, the borrower would be free to reinstate
its request for a drawing in the currency for the succeeding interest period, and the
process of arriving at a substitute or negotiated rate would be repeated.
Increased Costs: As in the Eurodollar loan, provision is typically made for the
borrower to reimburse the lender for the effect of legal or regulatory changes that
increase the lender’s costs or reduce its effective yield. Increased cost provisions in
multi-currency agreements, however, rarely make specific reference to the
possibility of a change in foreign exchange regulations that would not prohibit the
borrower from making the agreed-upon payment in the required currency, but that
might affect the free convertibility of that currency. A provision, elsewhere in the
agreement, enabling the lender to designate the place of payment or the currency
in which payment is to be made is useful to the lender in lieu of a specific
provision addressing convertibility. However, a lender should consider including a
provision, giving the lender the flexibility to cancel its lending commitment if
changes to the financial markets or applicable law materially affect the
convertibility and liquidity of any loan currency.
Liquidation of Contracts: In a multi-currency agreement, the lender may have
match-funded the loan by accepting a deposit of equivalent size and maturity, but
it may also have entered into a futures or option contract or interest-rate swap.
Therefore, the concept of “breakage” should be expanded in a multi-currency
agreement to encompass the liquidation of financial contracts.
Covenants Related to Currency Risk Management System: Unless the
borrower has an established and workable currency risk management system, the
loan agreement should specifically require the borrower to adopt hedging devices
that the lender considers appropriate in light of the risk level, the size of the
transaction and the type of the currency involved. The lender may require that such
currency protection agreements cover the entire borrowing and be in place
throughout the term of the loan. Alternatively, the lender may require the borrower
to hedge a percentage of the total borrowing or to hedge, for example, the term or
bridge loan portion and leave the letter of credit portion of the facility unprotected.
388
In order to ensure that the currency protection agreements will indeed help the
borrower to repay its foreign currency loans, the lender should require the
borrower to assign its currency protection agreements, including the settlement
proceeds, if any, to the lender.
Judgment Currency: In a situation where suit is necessary to enforce the loan
agreements, the value of lender’s recovery directly relates to: (i) whether a
judgment for the lender may be entered in the currency in which the payment was
originally due or a currency the lender selects, and (ii) if the court refuses to issue
a judgment in such currency, have the court convert the loan currency into the
judgment currency. Except for Great Britain, courts in common law jurisdictions,
particularly American courts, have refused to enter judgments in foreign
currencies. Instead, they will convert the foreign currency liabilities into the
domestic currency. The important issue is which exchange rate a court uses to
determine the amount of the lender’s recovery. In order to prevent an unfavorable
result on this issue, the loan agreement should stipulate the method of conversion.
For example, most loan agreements state that where the borrower pays its
obligations in a currency other than the loan currency pursuant to a judgment, the
borrower’s obligations to the lender can be discharged only if the amount the
lender receives, allows the lender to purchase the loan currency in an amount equal
to the obligations originally due on the day when the lender receives the payment.
If the judgment amount under the exchange rate effective on the recovery day
turns out to be less than the foreign currency liabilities originally due, the borrower
has a separate and independent obligation to compensate the lender for the
shortfall.
Multi-lender Considerations: Various issues arise in a multi-lender facility,
which has multi-currency funding requests, and various structures are used to deal
with the issues. In some instances, a principal agent and funding bank’s structure is
used where certain banks provide the required loans in the stipulated currencies.
The funding lenders are treated like participants for most matters; however,
specific provisions are inserted to give direct protection for currency risk. In other
instances, a sub-group of the bank group will fund currency loans. In these
instances, particular attention is paid to what the pro rata share of the various
lenders are in particular instances (for example, collateral sharing, voting
requirements, etc.), and whether there is an obligation to readjust the percentages
at particular points. Finally, in most multi-lender facilities, each lender is required
to make its pro rata part of multi-currency loans and to accept the applicable
currency risks. This paper does not provide a detailed explanation of the various
issues and applicable loan provisions related to multi-lender issues in multi-
currency financings.
Adjustments of Collateral and Availability: To protect lenders from increased
exposure due to exchange rate fluctuations, loan agreements may provide for
periodic adjustments. If exchange rate movements have increased the dollar
equivalent of the lender’s outstanding foreign currency loans or foreign currency
loan commitment, or if movements have decreased the dollar equivalent of the
foreign currency collateral, then the periodic adjustment provision would allow the
lender to reduce or increase the revolving loan availability or to demand additional
collateral.
Depending upon whether the lender’s increased exposure is due to a decrease in
the collateral value or an increase in the outstanding loans, the lender may or may
not need to make adjustments. Adjustments appear to be necessary if the collateral
389
value decreases because such a decrease makes the loans undersecured. If the
increase in the dollar equivalent of the outstanding foreign currency loans is the
lender’s sole exposure, however, adjustments may not be necessary if the lender
has matching foreign currency liabilities. In such case, the lender has an increased
exposure only if the borrower defaults in the repayments. An adjustment
mechanism that functions by reducing borrowing availability is effective if the
financing is a revolving facility or has a revolving component. If the financing
consists of only term loans or bridge loans, the lender may require the borrower to
deposit additional collateral or make mandatory pre-payments. To make the
adjustment mechanism administratively manageable, adjustments should be made
when exchange rates have changed by a percentage that represents more than a
negligible risk.
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Source: www.kshitij.com
TYPES OF LOANS FACILITY
There are several main groups of instruments in the syndicated loan market. The
most often selected is the term loan:
Term Loan: It is a medium-term facility with a typical 6 or 7 years maturity.
Revolving Credit Facility: A revolving credit facility gives the borrower more
flexibility about how much principal is outstanding during the loan’s life. As
tranches of the loan mature or are called, the borrower has the right to redraw up
until the loan matures.
Evergreen Facility: A loan that can be extended after pre-set periods. For
example, a five-year evergreen loan would be extendable every year for another
year.
Back-stop Facility: A back-stop facility protects a company against a liquidity
crunch: it is a loan designed to be drawn only as the last resort. Many borrowers
regard back-stops as an insurance policy in case they suffer a temporary shortfall
in funds or a failure of one of their normal funding sources. All issuers in the US
commercial paper market are required to have a stand-by facility.
Swingline: Most back-stops also include a swingline facility which gives the
borrower same day money.
390
Front-end Charges
The following front-end charges are collected as a part of loan syndication:
Arrangement Fee: Arrangement fee is a front-end fee. This is the total up-front
fee paid to the bank that is mandated to arrange a syndication for its work in
structuring, syndicating and negotiating the documentation. It is a normal market
practice that the arranger will keep part of this fee as a praecipium.
Commitment Fee: This is charged on the undrawn element of either a term loan
or revolving credit to compensate banks for the contingent liability. The
commitment fee is normally set at a level equal to half of the margin. However, it
is unlikely that the fee will exceed 0.5%.
Agency Fee: This is an annual service charge paid to the agent bank for
processing payments.
Utilization Fee: This is a fee the borrower should pay when the drawn portion
exceeds 50%.
Division of the Arrangement Fee
Underwriting Fee: If a loan is underwritten as opposed to a best efforts
placement, then members of the underwriting group are paid a flat fee based on
their initial underwriting commitment prior to general syndication.
Participation Fee: This is an up-front fee paid to participant banks joining a
facility in the syndication process and is payable on the amount of each banks’
final commitment to the loan.
Residual Pool: If there is a residual fee left after syndication, this “pool” may also
be distributed to the underwriting group.
Documentations
Pari-passu: Most loans include standard clauses to protect the lenders from
default.
Negative Pledge: The borrower will undertake not to take on other debts which
will subordinate the interests of the lenders.
Cross-default: The cross-default clause will be triggered and the loan will be in
technical default if the borrower fails to pay other debts. There will be a minimum
default size required for this clause to be triggered.
Secondary Market
Novation: The existing loan is cancelled and a new agreement substituted
transferring all the sellers rights and obligations to the new lender. Normally, the
borrower’s consent is required.
Assignment: This is similar to novation, except that it applies when the loan has
already been drawn-down. The rights and obligations are passed on to the new
lender.
Sub-participation: This technique allows banks to sell without disclosure or
consent. None of the original rights or obligations are passed on; the sale is
achieved by a separate agreement between the buyer and the seller.
Advantages of Syndicated Loans
• Size of loan
• Speed and certainty of funds
• Maturity profile of the loan
• Flexibility in repayment
391
• Lower cost of funds

• Diversity of currency
• Simpler banking relationship
• Possibility of renegotiation.
SUMMARY
• The Indian companies have many opportunities to raise funds in the
international equity markets for the right kind of usage.
• There are various types of instruments in the international markets like:
Yankee bonds, Samurai bonds, Bulldog bonds, Euro bonds, etc., as well as
ADR/GDR/IDRs for equity issues.
• The major players in the international markets are: borrowers/issuers,
lenders/investors and intermediaries. The institutional investors can be
classified as: market-specific investors, time-specific investors and industry
specific investors.
• Intermediaries are mainly: lead and co-managers, underwriters, agents and
trustees, lawyers and auditors, listing agents and stock exchanges, depository
banks, custodians and lastly, printers.
• Resource mobilization depends on the following factors: currency
requirements, pricing of the issue, investment, depth of the market,
international positioning, regulatory aspects, disclosure requirements and
investment climate.
• The issuance of GDRs requires the following steps: approval of the
shareholders, appointment of lead manager, finalization of the structure,
documentation (prospectus, depository agreement, underwriting agreement,
subscription agreement, custodian agreement, trust deed, paying and
conversion agreement, listing agreement), the launching of the GDR,
marketing and road shows, pricing and finally closing.
• Eurodollars are liabilities denominated in US dollars, but not subject to US
banking regulations. Mostly banks located outside the US issue Eurodollar
deposits.
• There are various advantages of Eurodollar deposits, the main being, lesser
regulatory impediments, lower cost of deposit intermediation and less intense
supervisory scrutiny by the authorities.
• The main instruments in the Eurodollar market are: Eurodollar Certificates of
Deposits (CDs), Eurodollar Floating Rate CDs (FRCDs), Eurodollar Floating
Rate Notes (FRNs), Note Issuance Facilities (NIFs) and Euro Commercial
Papers (CPs).
• The three basic risks with Eurodollar deposits are: chances of interference of
transfer of funds by the host country government, potential jurisdiction of
international disputes and soundness of deposits of banking offices of foreign
countries with relation to the US.
• Most of the Euro loans are today sourced through a syndicate of banks or
lenders. The process is almost similar to the process of syndication of loans
from internal sources.
• The advantages of syndicated loans are: size of the loan, speed and certainty
of funds, maturity profile of the loan, flexibility in repayment, lower cost of
funds, diversity of currency, simpler banking relationships and possibility of
renegotiation.
• The costs associated with the Euro loan are periodic costs (interest charges
and commitment charges on the indrawn portion) and upfront costs
(management fees, out-of-pocket expenses and agency costs).
392
• Multi-currency loans are loans denominated in one currency with an option

to borrow in one or more currencies. They are basically an expansion of the
Eurodollar loans. The documentation of multi-currency loans is similar to the
Eurodollar loans.
• The following are the main types of multi-currency loans: term loan,
revolving credit facility, evergreen facility, back-stop facility and swingline.
• The fee charged for the multi-currency loans is almost similar to the fee
charged on the Eurodollar loans.
• External Commercial Borrowings (ECBs) are borrowings of Indian
corporates made outside India. The advantages of ECBs are: longer maturity,
low borrowing cost, useful in infrastructure projects and export financing.
• The Government of India has recently liberalized the regulations for ECBs in
order to attract more foreign investment in the country. However, the uses of
ECB funds for investment in the stock market and speculation in real estate is
still restricted.
• After analyzing the performance of the Indian issuers, the following factors
are identified for successful international equity/convertible issues: the
fundamentals of the company, the experience of the lead manager, the size of
the issue, the innovative packaging of the instrument, the timing of the issue,
the care taken in the pricing, the effectiveness of the marketing/salesmanship,
the after-market-services and up-to-date information about the developments
in the global market.
393
Appendix I*
Issue of Foreign Currency Convertible Bonds (FCCBs) and
Ordinary Shares (Through Depositary Receipt, Mechanism) Scheme, 1993
and Guidelines for Euro Issues (Amended till September 5,2005)
G.S.R. No.700 (E) – Central Government hereby notifies the following scheme,
for facilitating issue of Foreign Currency Convertible Bonds and ordinary shares
through Global Depository Mechanism by Indian Companies, namely:
Short Title and Commencement
1. (1) This scheme may be called the Issue of Foreign Currency Convertible
Bonds and Ordinary Shares (Through Depository Receipt Mechanism)
Scheme, 1993.
(2) It shall be deemed to have come into force with effect from the first day
of April, 1992.
Definitions
2. In this scheme, unless the context other wise requires–
(a) “Domestic Custodian Bank” means a banking company which acts as a
custodian for the ordinary shares or foreign currency convertible bonds
of an Indian Company which are issued by it against global Depository
receipts or certificates;
(b) “Foreign Currency Convertible Bonds” means bonds issued in
accordance with this scheme and subscribed by a non-resident in foreign
currency and convertible into ordinary shares of the issuing company in
any manner, either in whole, or in part, on the basis of any equity
related warrants attached to debt instruments;
(c) “Global Depository Receipts” means any instrument in the form of a
Depository receipt or certificate (by whatever name it is called) created
by the Overseas Depository Bank outside India and issued to
non-resident investors against the issue of ordinary shares or Foreign
Currency Convertible Bonds of issuing company;
(d) “Issuing Company” means an Indian Company permitted to issue
Foreign Currency Convertible Bonds or ordinary shares of that
company against Global Depository Receipts;
(e) “Overseas Depository Bank” means a bank authorized by the issuing
company to issue global Depository receipts against issue of Foreign
Currency Convertible Bonds or ordinary shares of the issuing company;
(f) The words and expressions not defined in the Scheme, but defined in
the Income Tax Act, 1961 (43 of 1961), or the Companies Act, 1956
(1 of 1956), or the Securities and Exchange Board of India Act, 1992
(15 of 1992), or the Rules and Regulations framed under these Acts,
shall have the meaning respectively assigned to them, as the case may
be, in the Income-Tax Act or the Companies Act, or the Securities and
Exchange Board of India Act.
Eligibility for Issue of Convertible Bonds or Ordinary Shares of Issuing Company
3. (1) An issuing company desirous of raising funds by issuing Foreign
Currency Convertible Bonds or ordinary shares for equity issues
through Global Depository Receipts is required to obtain prior
permission of the Department of Economic Affairs, Ministry of
Finance, Government of India.
(A) An Indian company, which is not eligible to raise funds from the
Indian capital market including a company which has been
restrained from accessing the securities market by the Securities
394
and Exchange Board of India (SEBI) will not be eligible to issue

(i) Foreign Currency Convertible Bonds and (ii) Ordinary Shares
through Global Depositary Receipts under the Foreign Currency
Convertible Bonds and Ordinary Shares (Through Depositary
Receipt Mechanism) Scheme, 1993.
(B) Unlisted Indian Companies issuing Global Depositary
Receipts/Foreign Currency Convertible Bonds shall be required to
simultaneously list in the Indian Stock Exchange(s).
(C) Erstwhile Overseas Corporate Bodies (OCBs) who are not eligible
to invest in India through the portfolio route and entities prohibited
to buy, sell or deal in securities by SEBI will not be eligible to
subscribe to (i) Foreign Currency Convertible Bonds and
(ii) Ordinary Shares through Global Depositary Receipts under the
Foreign Currency Convertible Bonds and Ordinary
Shares(Through Depositary Receipt Mechanism) Scheme, 1993.
(2) An issuing company seeking permission under sub-paragraph (1) shall
have a consistent track record of good performance (financial or
otherwise) for a minimum period of three years, on the basis of which
an approval for finalizing the issue structure would be issued to the
company by the Department of Economic Affairs, Ministry of Finance.
(3) On completion of finalization of issue structure in consultation with the
Lead Manager to the issue, the issuing company shall obtain the final
approval for proceeding ahead with the issue from the Department of
Economic Affairs.
Explanation
For the purposes of sub-paragraph (2) and (3) “issue structure” means
any of the requirements which are provided in the paragraphs 5 and 6 of
this Scheme.
(4) The Foreign Currency Convertible Bonds shall be denominated in any
freely convertible foreign currency and the ordinary shares of an issuing
company shall be denominated in Indian rupees.
(5) When an issuing company issues ordinary shares or bonds under this
Scheme, that company shall deliver the ordinary shares or bonds to a
Domestic Custodian Bank who will, in terms of agreement, instruct the
Overseas Depository Bank to issue Global Depository Receipt or
Certificate to non-resident investors against the shares or bonds held by
the Domestic Custodian Bank.
(6) A Global Depository Receipt may be issued in the negotiable form and
may be listed on any international stock exchanges for trading outside
India.
(7) The provisions of any law relating to issue of capital by an Indian
company shall apply in relation to the issue of Foreign Currency
Convertible Bonds or the ordinary shares of an issuing company and the
issuing company shall obtain the necessary permission or exemption
from the appropriate authority under the relevant law relating to issue of
capital.
Limits of Foreign Investment in the Issuing Company
4. The ordinary shares and Foreign Currency Convertible Bonds issued against
the Global Depository Receipts shall be treated as direct foreign investment
in the issuing company. The aggregate of the foreign investment made either
directly or indirectly (through Global Depository Receipts Mechanism) shall
not exceed 51% of the issued and subscribed capital of the issuing company.
Provided that the investments made through Offshore Funds or by Foreign
Institutional Investors will not form part of the limit laid down in this
paragraph.
395
Issue Structure of the Global Depository Receipts

5. (1) A Global Depository Receipt may be issued for one or more underlying
shares or bonds held with the Domestic Custodian Bank.
(2) The Foreign Currency Convertible Bonds and Global Depository
Receipts may be denominated in any freely convertible foreign
currency.
(3) The ordinary shares underlying the Global Depository Receipts and the
shares issued upon conversion of the Foreign Currency Convertible
Bonds will be denominated only in Indian currency.
(4) The following issues will be decided by the issuing company with the
Lead Manager to the issue, namely:
(a) Public or private placement;
(b) Number of Global Depository Receipts to be issued;
(c) The issue price;
c (a) Listed Companies: The pricing should not be less than the
higher of the following two averages:
c (a) (i) The average of the weekly high and low of the
closing prices of the related shares quoted on the
stock exchange during the six months preceding the
relevant date;
c (a) (ii) The average of the weekly high and low of the
closing prices of the related shares quoted on a stock
exchange during the two weeks preceding the
relevant date.
The “relevant date” means the date thirty days prior to the date
on which the meeting of the general body of shareholders is
held, in terms of Section 81(lA) of the Companies Act, 1956,
to consider the proposed issue.
c (b) Unlisted Companies: The pricing should be in accordance
with Reserve Bank of India Regulations notified under Foreign
Exchange Management Act, 1999.
(d) The rate of interest payable on Foreign Currency Convertible
Bonds; and
(e) The conversion price, coupon, and the pricing of the conversion
options of the Foreign Currency Convertible Bonds.
(e) (i) Listed Companies: The conversion price of the Foreign
Currency Convertible Bonds should be in accordance with para
5(4)(ca) ibid.
(e) (ii) Unlisted Companies: The conversion price of the Foreign
Currency Convertible Bonds should be in accordance with Reserve
Bank of India Regulations notified under Foreign Exchange
Management Act, 1999.
(5) There would be no lock-in-period for the Global Depository Receipts
issued under this scheme.
Listing of the Global Depository Receipts
6. The Global Depository Receipts issued under this scheme may be listed on
any of the Overseas Stock Exchanges, or Over-the-Counter Exchanges or
through Book Entry Transfer Systems prevalent abroad and such receipts
may be purchased, possessed and freely transferable by a person who is a
non-resident within the meaning of Section 2(q) of the Foreign Exchange
Regulation Act, 1973 (46 of 1973), subject to the provisions of the Act.
396
Transfer and Redemption

7. (1) A non-resident holder of Global Depository Receipts may transfer those
receipts, or may ask the Overseas Depository Bank to redeem those
receipts. In the case of redemption, Overseas Depository Bank shall
request the Domestic Custodian Bank to get the corresponding underlying
shares released in favor of the non-resident investor, for being sold
directly on behalf of the non-resident, or being transferred in the books of
account of the issuing company in the name of the non-resident.
(2) In case of redemption of the Global Depository Receipts into underlying
shares, a request for the same will be transmitted by the Overseas
Depository Bank to the Domestic Custodian Bank of India, with a copy of
the same being sent to the issuing company for information and record.
(3) On redemption, the cost of acquisition of the shares underlying the
Global Depository Receipts shall be reckoned as the cost on the date on
which the Overseas Depository Bank advises the Domestic Custodian
Bank for redemption. The price of the ordinary shares of the issuing
company prevailing in the Bombay Stock Exchange or the National
Stock Exchange on the date of the advice of redemption shall be taken
as the cost of acquisition of the underlying ordinary shares.
(4) For the purposes of conversions of Foreign Currency Convertible
Bonds, the cost of acquisition in the hands of the non-resident investors
would be the conversion price determined on the basis of the price of
the shares at the Bombay Stock Exchange, or the National Stock
Exchange, on the date of conversion of Foreign Currency Convertible
Bonds into shares.
Guidelines for Euro-issues
A scheme for issue of Foreign Currency Convertible Bonds and Ordinary Shares
(Through Depository Receipts Mechanism) was notified by Government of India
in November, 1993. Revisions/Modifications in the operative guidelines for
Euro-issues are announced from time to time.
On the basis of the periodic review and assessment of the current situation, the
following Euro-issue guidelines, the continuation of the Notification of November,
1993, shall come into effect for approvals granted on, or after the data of issue of
these guidelines, in supersessions of all previous guidelines on the subject.
Track Record
An issuing company seeking permission for raising foreign funds by Euro-issues
having a consistent track record of good performance (Financial or otherwise) for
a period of three years shall be allowed to issue GDRs/FCCBs.
In view of the importance of the infrastructure projects, and the need to encourage
equity financing of such projects, the three years track record requirement would
be relaxed in case of companies seeking GDR/FCCB issues to finance investments
in infrastructure industries such as power generation, telecommunication,
petroleum exploration and refining, ports, airports and roads.
Approvals
Euro-issues shall be treated as direct foreign investment (subject to extant policies
governing direct foreign investments) in the issuing company. Accordingly, a
company which is implementing projects not predominantly contained in
Annexure III of the New Industrial Policy of 1991, or a company which
undertakes a project contained in Annexure III but whose direct foreign investment
after the proposed Euro-issue us likely to exceed 51% of the post-issue subscribed
capital, will need to obtain prior FIPB clearance before final approval to the
Euro-issue is given by the Finance Ministry.
397
Number of Issues
Some restrictions had been imposed previously on the number of issues that could
be floated by an individual company or a group of company during a financial
year. There will henceforth be no restrictions on the number of Euro-issues to be
floated by a company or a group of companies in financial year.
END-USE: GDRS
In relaxation of earlier godliness GDR end-uses will include:
– Financing capital goods, imports;
– Capital expenditure including domestic purchased/installation of plant,
equipment and building and investments in software development;
– Prepayment or scheduled repayment of earlier external borrowings;
– Investments abroad where these have been approved by competent
authorities;
– Equity investment in JVs/WOSs in India.
However, investments in stock markets and real estate will not be permitted.
Within this framework, GDR raising companies will be allowed full flexibility in
deploying the proceeds.
Up to a maximum of 25% of the total proceeds may be used for general corporate
restructuring, including working capital requirements of the company raising the
GDR.
However, Banks, FIs, and Non-Banking Finance Companies (NBFCs) registered
with RBI will be eligible for DGR issues without reference to the end-use criteria
mentioned in para 7 to 10 above with the restriction that investments in stock
markets and real estate will not permitted.
A company shall be required to specify the proposed end-use of the issue proceeds
at the time of making their applications, and will be required to submit quarterly
statement of utilization of funds for the approved end-uses.
END-USE-FCCBs
Currently, companies are permitted to access foreign capital market through
Foreign Currency Convertible Bonds for restructuring of external debt which helps
to lengthen maturity and soften terms, and for end-use of funds which conform to
the norms, and prescribed by the Government for External Commercial
Borrowings (ECB) from time to time. In addition to these, not more than 25% of
FCCB issue proceeds may be used for general corporate restructuring including
working capital requirements.
FCCB Pricing
FCCBs are available and accessible more freely as compared to external debt, and
the expectation of the Government is that FCCBs should have a substantially finer
spread than ECBs. Accordingly, the all-in costs for FCCBs should be significantly
better than the corresponding debt instruments (ECBs).
Companies will not be permitted to issue warrants alongwith their Euro-issue.
Repatriation of Proceeds
Companies may retain the proceeds abroad or may remit funds into India in
anticipation of the use of funds for approved end-uses.
Validity
Both the in-principle and final approvals will be valid for three months from the
date of their respective issue.
Review
The policy and guidelines for Euro-issues will be subject to review periodically.
* Source: www.rbi.org.in/scripts/notification User.aspx?Mode = O&Id = 2498
398
Appendix II*
Issue of Shares by Indian Companies under ADR/GDR
(i) Depositary Receipts (DRs) are negotiable securities issued outside India by a
Depository Bank, on behalf of an Indian company, which represent the local
Rupee denominated equity shares of the company held as deposit by a Custodian
bank in India. DRs are traded in Stock Exchanges in the US, Singapore,
Luxembourg, etc. DRs listed and traded in the US markets are known as American
Depository Receipts (ADRs) and those listed and traded elsewhere are known as
Global Depository Receipts (GDRs). In the Indian context, DRs are treated as FDI.
(ii) Indian companies can raise foreign currency resources abroad through the issue
of ADRs/GDRs, in accordance with the Scheme for issue of Foreign Currency
Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism)
Scheme, 1993 and guidelines issued by the Government of India thereunder from
time to time.
(iii) A company can issue ADRs/GDRs if it is eligible to issue shares to persons
resident outside India under the FDI Scheme. However, an Indian listed company,
which is not eligible to raise funds from the Indian Capital Market including a
company which has been restrained from accessing the securities market by the
Securities and Exchange Board of India (SEBI) will not be eligible to issue
ADRs/GDRs.
(iv) Unlisted companies, which have not yet accessed the ADR/GDR route for
raising capital in the international market would require prior or simultaneous
listing in the domestic market, while seeking to issue such instruments. Unlisted
companies, which have already issued ADRs/GDRs in the international market,
have to list in the domestic market on making profit or within three years of such
issue of ADRs/GDRs, whichever is earlier.
(v) ADRs/GDRs are issued on the basis of the ratio worked out by the Indian
company in consultation with the Lead Manager to the issue. The proceeds so
raised have to be kept abroad till actually required in India. Pending repatriation or
utilisation of the proceeds,
the Indian company can invest the funds in -
a. Deposits with or Certificate of Deposit or other instruments offered by banks
who have been rated by Standard and Poor, Fitch, IBCA or Moody's, etc. and such
rating not being less than the rating stipulated by Reserve Bank from time to time
for the purpose, (current rating applicable is AA(-) by Standard and Poor/Fitch
IBCA or Aa3 by Moody’s);
b. Deposits with branch/es of Indian Authorised Dealers outside India; and
c. Treasury bills and other monetary instruments with a maturity or unexpired
maturity of one year or less.
(vi) There are no end-use restrictions except for a ban on deployment / investment
of such funds in Real Estate or the Stock Market. There is no monetary limit up to
which an Indian company can raise ADRs / GDRs.
(vii) The ADR / GDR proceeds can be utilised for first stage acquisition of shares
in the disinvestment process of Public Sector Undertakings / Enterprises and also
in the mandatory second stage offer to the public in view of their strategic
importance.
(viii) Voting rights on shares issued under the Scheme shall be as per the
provisions of Companies Act, 1956 and in a manner in which restrictions on
voting rights imposed on ADR/GDR issues shall be consistent with the Company
Law provisions. Voting rights in the case of banking companies will continue to be
in terms of the provisions of the Banking Regulation Act, 1949 as applicable to all
shareholders exercising voting rights.
399
(ix) Erstwhile OCBs who are not eligible to invest in India and entities prohibited
to buy, sell or deal in securities by SEBI will not be eligible to subscribe to ADRs /
GDRs issued by Indian companies.
(x) The pricing of ADR / GDR issues should be made at a price not less than the
higher of the following two averages:
i. The average of the weekly high and low of the closing prices of the related
shares quoted on the stock exchange during the six months preceding the relevant
date;
ii. The average of the weekly high and low of the closing prices of the related
shares quoted on a stock exchange during the two weeks preceding the relevant
date.
(ii) The “relevant date” means the date, thirty days prior to the date on which the
meeting of the general body of shareholders is held, in terms of section 81 (IA) of
the Companies Act, 1956, to consider the proposed issue.
Two-way Fungibility Scheme
A limited Two-way Fungibility scheme has been put in place by the Government
of India for ADRs / GDRs. Under this Scheme, a stock broker in India, registered
with SEBI, can purchase shares of an Indian company from the market for
conversion into ADRs/GDRs based on instructions received from overseas
investors. Reissuance of ADRs / GDRs would be permitted to the extent of ADRs /
GDRs which have been redeemed into underlying shares and sold in the Indian
market.
Sponsored ADR/GDR issue
An Indian company can also sponsor an issue of ADR / GDR. Under this
mechanism, the company offers its resident shareholders a choice to submit their
shares back to the company so that on the basis of such shares, ADRs / GDRs can
be issued abroad. The proceeds of the ADR / GDR issue is remitted back to India
and distributed among the resident investors who had offered their rupee
denominated shares for conversion. These proceeds can be kept in Resident
Foreign Currency (Domestic) accounts in India by the resident shareholders who
have tendered such shares for conversion into ADR / GDR.
Reporting of ADR/GDR Issues
The Indian company issuing ADRs / GDRs has to furnish to the Reserve Bank,
within 30 days from the date of closing of the issue. The company should also
furnish a quarterly return to the Reserve Bank within 15 days of the close of the
calendar quarter. The quarterly return has to be submitted till the entire amount
raised through ADR/GDR mechanism is either repatriated to India or utilized
abroad as per Reserve Bank guidelines.
* Source: www.rbidocs.rbi.org.in/rdocs/notification/DOCs/54740.doc
400
•
• !"
• "
THE MEANING OF NON-RESIDENT INDIANS

Non-Resident Indians (NRIs) are those individuals who are either Indian nationals
residing outside India and holding Indian passport or foreign nationals of Indian
origin residing in foreign countries (even if stateless, in case no foreign country
has accepted them as citizens).
A person may be even born outside India and never resided in India, and be termed
as an NRI as long as one of his parents or grandparents was an Indian. In order to
expand the definition of NRI, the Government of India included companies,
partnership firms, trusts, societies, other corporate bodies, HUFs and AOPs, where
at least 60 percent of the equity is owned by an Indian.
It is believed that there are more than 20 million NRIs all over the world, out of
which about 25 percent still hold an Indian passport.
HOW TO OPEN NRI ACCOUNTS
Non-residents including Indians (persons of Indian origin born and bought up
abroad even with foreign passport or Indian citizen residing abroad) overseas
HUFs/AOPs, partnership firms, companies, societies, trusts and Overseas
Corporate Bodies (OCBs) can maintain their accounts with Authorized Dealers.
Authorized Dealers include banks authorized to deal in foreign exchange (which
hold Authorized Dealers license) or banks permitted specifically by the Reserve
Bank of India for this purpose. The Reserve Bank of India permits some
co-operative banks also to open accounts of Non-Resident Indians. These
co-operative banks need to take assistance from the Authorized Dealer to fulfill the
foreign exchange obligations. Nowadays district central co-operative banks are
also permitted to open and maintain non-resident accounts in India.
Non-Resident Indians can maintain the following types of bank accounts:
i. Savings Account: Only individuals are permitted to open this kind of
account. These accounts are similar to any other saving account. These
accounts can be operated by cheques, without any limitation to the number of
deposits. Restrictions are imposed on the withdrawals. Interest rate is
provided at the market prevailing rate and no service charges are imposed.
ii. Current Account: No limitation is imposed on the number of withdrawals
and deposits, but a minimum balance has to be maintained in the account.
Banks may take service charges at their discretion to maintain the account.
Cheques can be used to operate this account. No interest is provided for
current account. Mostly opened for business purposes.
iii. Term Deposits: A fixed sum is accepted at an agreed rate of interest payable
after an agreed period of time. The sum along with the interest will be repaid
after the maturity period. No cheque facility is available for this type of
account. Rates of interest are higher than in savings account.
In India, various forms of term deposits are:
a. Fixed Deposit Account: Here, interest is payable every quarter (as per the
RBI guidelines) and the deposit amount is payable on the maturity date.
b. Reinvestment Deposit: Interest payable on quarterly basis is again
reinvested and at the end of the maturity period, a lump sum amount is paid.
c. Recurring Deposits: In this case, a fixed sum of amount is deposited on a
monthly basis and the total amount along with interest is paid after the
maturity period.
402
FACTORS TO BE CONSIDERED BEFORE OPENING AN ACCOUNT

In India, different schemes are offered by different banks. The following factors
are used to judge the schemes:
• Interest rate differential.
• Forex market volatility.
• Need to repatriate savings and earnings.
The decision has to be based upon individual’s priorities and requirements.
TYPES OF NRI ACCOUNTS

FOREX FACILITIES FOR NRIS/PIOS
A Non-Resident Indian or a Person of Indian Origin (PIO) can avail the following
forex facilities without the permission of RBI.
Deposits
NRIs and Persons of Indian Origins (PIOs) can open, hold and maintain the
following three types of accounts with an authorized dealer in India, i.e., a bank
authorized to deal in foreign exchange:
i. Foreign Currency Non-Resident (Bank) Account – FCNR (B) Account
ii. Non-Resident (External) Rupee Account – NRE Account
iii. Non-Resident (Ordinary) Rupee Account – NRO Account.
i. Foreign Currency Non-Resident (Bank) Account – FCNR (B) Account
Only NRIs and Overseas Corporate Bodies (OCBs) can open this type of
account. Currency in which account is denominated in – Pound Sterling, US
Dollar, Japanese Yen or Euro. This account is of time deposit nature. The
duration of these accounts varies between 1 and 3 years. Repatriation of
principal and interest is allowed. Nomination is permitted. Regarding interest
rates, the banks are free to determine the rates, however, within the ceiling
prescribed by the RBI. At present, the interest rates on FCNR (B) deposits
are subject to a ceiling of LIBOR rates for the corresponding maturities
minus 25 basis points. Loans and overdraft facilities are available to the
account-holders. Since the FCNR (B) account is denominated in foreign
currency, the account holder is protected against changes in Indian Rupee
value against the currency in which the account is denominated.
Main characteristics of the account are:
• Principal as well as interest is freely repatriable.
• Nomination in favor of resident/non-resident.
• Loan can be availed against deposit.
• Pound Sterling, US dollar, Japanese Yen or Euro denomination.
ii. Non-Resident (External) Rupee Account – NRE Account
Like FCNR (B) Account, NRE Account is also open to only NRIs and OCBs.
This type of account can be in any form i.e., savings, current or term deposits
account. The account is denominated in Indian Rupees only. Deposit
accepting banks have enough discretion regarding the duration of the fixed
deposit. There is normally no ceiling on interest rates, i.e., banks are free to
determine the interest rates. But, in a move to stem the arbitrage opportunity
that existed in the Indian financial market, the RBI imposed a ceiling on
interest on the NRE account. The ceiling is put at 0.25 percent plus LIBOR in
October 1, 2003. It is been revised at LIBOR. Loans and overdraft facilities
are available to the account-holders.
403
Main features of the account are:

• Principal as well as interest is freely repatriable.
• Nomination in favor of resident/non-resident.
• Loan can be availed against deposit.
• Indian Rupee denomination.
iii. Non-Resident (Ordinary) Rupee Account – NRO Account
Any person resident outside India can open NRO Account. NRO Account can
be in any form – savings, current or term deposits account. Deposit accepting
banks have enough discretion regarding the duration of the fixed deposit. NRO
Accounts are denominated in Indian rupees. The interest is freely repatriable,
but the principal is not repatriable except in the following cases:
• Current income and interest.
• Bonafide purposes – $100,000 per year (subject to payment of
applicable taxes).
• Sale proceeds of immovable property held for 10 years – $10,00,000 per
year. In case the property is held for less than 10 years, remittance could
be made if sale proceeds have been held for balance period in eligible
investments.
Main features of the account are:
• Only interest is freely repatriable.
• Loans and overdrafts can be availed against deposit in India only.
• Indian Rupee denomination.
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INVESTMENTS IN INDIA
NRIs can freely invest in government securities or company shares or debentures
with repatriation rights. They also allowed parking their funds in shares/debentures
of Indian companies through stock exchange under portfolio investment scheme
with repatriation rights.
Immovable Property
a. An NRI can acquire any immovable property in India other than agricultural
land/farm house/plantation property.
b. A PIO can acquire any immovable property other than agricultural land/farm
house/plantation property in India out of repatriable funds only.
NRIs/PIOs are allowed to repatriable sale proceeds of the immovable property out
of the repatriable funds without any lock-in period.
On Return to India
NRIs are allowed to hold/own/transfer or invest in foreign currency, foreign
security or any immovable property located outside India, if such asset is acquired
when he/she was resident outside India.
They are allowed to hold Resident Foreign Currency (RFC) Account to keep their
foreign currency assets. The funds in RFC accounts can be freely used without any
restrictions including investments outside India.
SUMMARY
• The Non-Resident Indians (NRIs) are persons of Indian origin, even if born
and brought up abroad, with or without Indian passport, including HUFs,
AOPs, partnership firms, companies, societies, trusts and Overseas Corporate
Bodies (OCBs) who maintain accounts with Authorized Dealers.
• The NRIs can open savings accounts, current accounts and term deposit
accounts (fixed deposit, recurring deposit and reinvestment deposit).
• The NRIs can open NRO, NRE and FCNR in India. These accounts have
various features like repatriation of interest, non-taxability of interest and
higher interest rates.
405
Appendix*
Features of Various Deposit Schemes Available to Non-Resident Indians (NRIs)
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407
•
•
A developing country like India has a tremendous requirement for capital, which
cannot be optimally generated in the country. The other viable option is to rely on
Foreign Direct Investments and investments by Foreign Institutional Investors
(FIIs).
With the liberalization of the Indian economy in the post-Gandhi family era, the
country witnessed an increase in the FII and FDI investments which also led to the
formation of the FIPB (Foreign Investment Promotion Board), to assist those
investments that were not through the automatic approval route.
INVESTMENTS BY FOREIGN INSTITUTIONS

Foreign (Non-Indian) Financial Institutional Investors (this includes Mutual Funds,
Pension Funds, Investment Trusts, Endowment Funds, Insurance Funds,
University Funds, Foundation or Charitable Societies) can invest in Indian stock
markets. The investments are governed by rules and regulations of the Reserve
Bank of India (RBI) and the Securities Exchange Board of India (SEBI).
As per the guidelines of the RBI for Foreign Institutional Investors (FII):
• All FIIs need permission (approval) to invest in India and must apply for the
aforesaid permission through SEBI to the RBI.
• Invest up to 10 percent of the paid-up capital of the Indian company
individually. (This means the upper limit for each individual FII is 10 percent.)
• Total FII investment in an Indian company should not exceed 24 percent.
However, the aforesaid percentage can be increased up to 49 percent of the
paid-up capital of the company, if approved by the Board of Directors of the
company and ratified by the shareholders of the company.
• No permission from RBI is needed so long as the FIIs purchase and sell on
recognized stock exchange. All non-stock exchange sales/purchases require
RBI permission.
• Payments for the above should be made by inward remittance in foreign
exchange through normal banking channels or out of funds held in accounts
maintained in India with designated branch of Authorized Dealer (An
Authorized Dealer is a person or a company or a bank authorized by the
Reserve Bank of India to deal in foreign exchange). All scheduled banks are
Authorized Dealers in India. FII’s registered with SEBI have to apply to RBI
to open a Foreign Currency account and/or Non-Resident Rupee Account
with designated branch of Authorized Dealer in India for routing the receipts
and payments for transactions relating to purchase and sale of shares, subject
to following restrictions:
i. The account shall be funded by inward remittance through normal
banking channel or by credit of sale proceeds of the shares sold on
recognized Stock Exchange in India.
ii. The funds in this account can be utilized for purchase of shares or for
remittance outside India.
iii. The funds from the Foreign Currency account of FII may be transferred
to Non-Resident Rupee Account of the same FII and vice-versa.
iv. The designated branch of the Authorized Dealer may allow remittance
of net sales proceeds of shares or credit the net amount of sales
proceeds of shares to foreign currency account or Non-Resident Rupee
account of registered FII concerned.
409
All FII investors must also register with the SEBI (Securities Exchange Board of
India) and follow the guidelines framed by the SEBI for FII investments. The main
requirements are as follows:
i. FIIs can invest in primary as well as secondary markets, in all shares listed
and traded on recognized Stock Exchanges. The registration and approval is
in blocks of five-year periods after which it must be renewed.
ii. FIIs must pay the stipulated fee of USD 5,000 and register with SEBI and
obtain approval from the RBI prior to making any investments in India.
iii. All sale transactions must be routed through a registered broker of a
recognized Stock Exchange.
iv. FII investors are not permitted to engage in short-selling of securities. Also,
they shall not be permitted to carry forward their transactions on Stock
Exchanges.
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SIGNIFICANCE AND ROLE OF FOREIGN DIRECT INVESTMENT

The dramatic increase in the annual global flow between 1985 and 1995, from
around $60 billion to an estimated $315 billion had resulted in the rise of its
relative importance as a source of investment funds for a number of countries.
The keen interest in FDI is also part of a broader interest in the forces propelling
the ongoing integration of the world economy, or what is popularly described as
‘globalization’. Together with the more or less steady rise in the world’s trade-to-
GDP ratio, the increased importance of foreign-owned production and distribution
facilities in most countries is cited as tangible evidence of globalization.
IMPORTANCE
Foreign direct investment is viewed as a way of increasing the efficiency with
which the world’s scarce resources are used. A recent and specific example is the
perceived role of FDI in efforts to stimulate economic growth in many of the
world’s poorest countries. Partly, this is because of the expected continued decline
in the role of development assistance (on which these countries have traditionally
relied heavily), and the resulting search for alternative sources of foreign capital.
More importantly, FDI, very little of which currently flows to the poorest
countries, can be a source not just of badly needed capital, but also of new
technology and intangibles, such as, organizational and managerial skills, and
marketing networks. FDI can also provide a stimulus to competition, innovation,
savings and capital formation, and through these effects, to job creation and
economic growth. Along with major reforms in domestic policies and practices in
the poorest countries, this is precisely what is needed to turn around an otherwise
pessimistic outlook.
410
At an institutional level, the growing importance of FDI, coupled with the absence
of binding multilateral rules on national policies towards FDI, has created what in
many quarters is viewed as an obstacle that could slowdown the pace of further
integration of the world economy.
Renewed interest in FDI within the trade community has been stimulated by the
perception that trade and FDI are simply two ways – sometimes alternatives, but
increasingly complementary – of servicing foreign markets, and that they are
already interlinked in a variety of ways.
CRITICISMS ABOUT FOREIGN DIRECT INVESTMENTS

Critics are concerned about the possible negative effects of FDI. Some of the ways
in which the FDI affects the nations are:
• In ‘home’ countries (where the outflow of capital originates), there are claims
that FDI exports jobs and puts downward pressure on wages.
• In ‘host’ countries (which receive the FDI), there are worries about the
medium-term impact on the balance of payments, about potential
monopolization of the domestic market, and more generally about the impact
of FDI on the government’s ability to manage the economy.
• The implications of having a multilateral agreement that lays down common
standards for national FDI rules, requires each signatory to bind its rules
under the agreement. Having to bind national FDI policies under a
multilateral agreement would be instrumental in further pre-empting a
country’s right to manage inflows of FDI.
NATURE OF FOREIGN DIRECT INVESTMENT

Foreign Direct Investment (FDI) occurs when an investor based in one country
(the home country) acquires an asset in another country (the host country) with the
intent to manage that asset. The management dimension is what distinguishes FDI
from portfolio investment in foreign stocks, bonds and other financial instruments.
In most instances, both the investor and the asset it manages abroad are business
firms. In such cases, the investor is typically referred to as the ‘parent firm’ and the
asset as the ‘affiliate’ or ‘subsidiary’.
CATEGORIES OF FDI
There are three main categories of FDI:
• Equity capital is the value of the MNC’s investment in shares of an
enterprise in a foreign country. An equity capital stake of 10 percent or more
of the ordinary shares or voting power in an incorporated enterprise, or its
equivalent in an unincorporated enterprise, is normally considered as a
threshold for the control of assets. This category includes both merger and
acquisitions and ‘greenfield’ investments (the creation of new facilities).
Mergers and acquisitions are an important source of FDI for developed
countries, although the relative importance varies considerably.
• Reinvested earnings are the MNC’s share of affiliate earnings not
distributed as dividends or remitted to the MNC. Such retained profits by
affiliates are assumed to be reinvested in the affiliate. This can represent up
to 60 percent of outward FDI in countries, such as, the United States and the
United Kingdom.
• Other capital refers to short- or long-term borrowing and lending of funds
between the MNC and the affiliate.
411
SOURCES OF FDI DATA

i. The statistics from the records of ministries and agencies, which administer
the country’s laws and regulations on FDI. The request for a license or the
fulfillment of notification requirements allows these agencies to record data
on FDI flows. Typically, re-invested earnings, intra-company loans, and
liquidations of investment are not recorded, and not all notified investments
are fully realized in the period covered by notification.
ii. The FDI data taken from government and other surveys evaluate financial
and operating data of companies. While these data provide information on
sales (domestic and foreign), earnings, employment and the share of value
added of foreign affiliates in domestic output, they often are not comparable
across countries because of differences in definitions and coverage.
iii. The data taken from national balance-of-payments statistics.
HOW FDI IMPROVES THE EFFICIENT USE OF HOST COUNTRY

RESOURCES?
FDI is very often associated with secondary benefits through the diffusion of
technology to firms in the host country. This diffusion may be deliberate, such as,
when technology is licensed by the affiliate to a domestic firm. An example of a
deliberate diffusion is the upgrading of the technological capabilities, by the MNC,
of local firms doing business with the MNC, for example, when such upgrading is
required to meet specifications demanded by the MNC.
FDI can also be in the form of a technological spillover, which occurs when the
activities of the multinational firm yield benefits for local economic agents
beyond those intended by the multinational firm. Technological spillovers can be
horizontal or vertical. A horizontal technological spillover occurs, for example,
when the affiliate has a new technology that is subsequently copied or learned by
competing firms. A vertical spillover occurs when the affiliate transfers, free of
charge, technology to firms supplying inputs or servicing ‘downstream’
operations (for example, distribution or retailing). The distinguishing feature of
technological spillovers, which are an example of what economists term
“positive externalities”, is that the benefits they bring to the host country are not
taken into consideration in the MNC’s investment decision. Such benefits will be
captured in full by the host country unless they are “competed away” in a
bidding process to attract the FDI, in which case a part – perhaps all – of these
indirect benefits will be captured by the MNC.
Apart from the diffusion of MNC technology through spillovers, FDI may also
produce other unintended efficiency-enhancing effects, as when local rivals are
forced to upgrade their own technological capabilities as a consequence of
competitive pressure from the local affiliate of the MNC.
FOREIGN DIRECT INVESTMENT IN INDIA

OPENNESS TO FOREIGN INVESTMENT – POST-INDEPENDENCE
SCENARIO
India’s post-independence economic policy has given more emphasis on the public
sector. Operations of the private sector were controlled heavily. In that scenario
prior to 1991, foreign firms were allowed to enter the Indian market only if they
possessed technology unavailable in India. Almost every aspect of production and
marketing was tightly controlled. Many foreign companies abandoned their
projects due to such type of vigilance by the government. Before the industrial
policy of 1991, foreign equity participation was allowed up to 40 percent in high
priority areas. For investment in other areas, approval had to be obtained from the
Foreign Investment Promotion Board (FIPB) and a cabinet committee. Other than
that, foreign investors had to comply with different legal obligations.
412
New Policies
The industrial policy of 1991 changed the total scenario. It is vastly simpler, more
liberal and more transparent than other industrial policies announced earlier. It
aimed to promote the foreign investment. It considered foreign investment as
indispensable to India’s international competitiveness. The policy permitted
automatic approval for foreign equity investments up to 51 percent in 35 high
priority sectors accounting for the lion’s share of industrial activity. The
government had the option to cancel a request for any foreign equity investment
over 51 percent. NRIs and Overseas Corporate Bodies (where NRIs hold
maximum ownership) were allowed to make 100 percent equity participation
except in the following reserved areas where only public sector companies are
allowed. From the year 2000 onwards, up to 100% foreign investment is permitted
under ‘Automatic Route’ in all activities/sectors except the following which
require approval of the Government:
• Activities/items that require an Industrial Licence such as:
– When the proposed location attracts locational restriction,
– Items reserved for small-scale sector, and
– Industries retained under compulsory licensing:
a. Distillation and brewing of alcoholic drinks;
b. Cigars and cigarettes of tobacco and manufactured tobacco
substitutes;
c. Electronic Aerospace and defence equipment: all types;
d. Industrial explosives including detonating fuses, safety fuses, gun
powder, nitrocellulose and matches;
e. Hazardous chemicals;
f. Drugs and Pharmaceuticals.
• Proposals in which the foreign collaborator has an existing venture/tie-up in
India in the same or allied field.
• Proposals for acquisition of shares in an existing Indian company in the
– Financial services sector, and
– Where SEBI (Substantial Acquisition of Shares and Takeovers)
Regulation 1997 is attracted.
• All Proposals falling outside notified sectoral policy/caps or under sectors in
which FDI is not permitted.
Improved Conditions
To allow more NRI investments, the GOI recently allowed repatriation of investment
in all activities, subject to certain conditions, except agriculture and plantations.
Investment in India – Foreign Direct Investment
Foreign Direct Investment (FDI) is permitted as under the following forms of
investments:
i. Through financial collaborations.
ii. Through joint-ventures and technical collaborations.
iii. Through capital markets via Euro-issues.
iv. Through private placements or preferential allotments.
Foreign Direct Investment
Foreign Direct Investment (FDI) has been recognized as one of the important
drivers of the economic growth of our country. Government has, therefore, been
making all efforts to invite and facilitate FDI and investment from Non-Resident
[NRIs which also includes Persons of Indian Origin (PIO)] to complement and
supplement domestic investment.
413
Foreign direct investment is freely allowed in all sectors including the services
sector, except a few sectors where the existing and notified sectoral policy does
not permit FDI beyond a ceiling. FDI for virtually all items/activities can be
brought in through the Automatic route under powers delegated to the Reserve
Bank of India (RBI), and for the remaining items/activities through Government
approval. Government approvals are accorded on the recommendation of the
Foreign Investment Promotion Board (FIPB).
Policy for Automatic Route

a. New Ventures
All items/activities for FDI/NRI investment up to 100 percent fall under the
Automatic route except the following:
i. All proposals that require an Industrial Licence which includes:
a. The item requiring an Industrial Licence under the Industries
(Development & Regulation) Act, 1951;
b. Foreign investment being more than 24 percent in the equity
capital of units manufacturing items reserved for small scale
industries; and
c. All items which require an Industrial Licence in terms of the
locational policy notified by Government under the New Industrial
Policy of 1991.
ii. All proposals in which the foreign collaborator has a previous/existing
venture/tie-up in India in the same or allied field, the modalities
prescribed in Press Note No. 18 dated 14.12.1998 of 1998 Series, shall
apply to such cases (the definition of “same” and “allied” field would be
same as per 3 and 4 digits NIC 1987 codes). However, this shall not
apply to investment made by multilateral financial institutions, such as,
ADB, IFC, CDC, DEG, etc., as also investment made in IT sector.
iii. All proposals relating to acquisition of shares in an existing Indian
company by a foreign/NRI investor.
iv. All proposals falling outside notified sectoral policy/caps or under
sectors in which FDI is not permitted.
Whenever any investor chooses to make an application to the FIPB and does
not want to avail of the automatic route, he or she may do so.
Investment in public sector units as also for EOU/EPZ/EHTP/STP units
would also qualify for the automatic route. Investment under the automatic
route shall continue to be governed by the notified sectoral policy and equity
caps and RBI will ensure compliance of the same. The National Industrial
Classification (NIC) 1987 shall remain applicable for description of activities
and classification for all matters relating to FDI/NRI investment:
The RBI has granted general permission under Foreign Exchange
Management Act (FEMA) in respect of proposals approved by the
Government. Indian companies getting foreign investment approval through
FIPB route do not require any further clearance from RBI for the purpose of
receiving inward remittance and issue of shares to the foreign investors. Such
companies are, however, required to notify the Regional office concerned of
the RBI of receipt of inward remittances within 30 days of such receipt and to
file the required documents with the concerned Regional offices of the RBI
within 30 days after issue of shares to the foreign investors.
For inward remittance and issue of shares to NRIs up to 100 percent equity
also, prior permission of RBI is not required. These companies have to file
the required documents with the concerned Regional offices of RBI within
30 days after the issue of shares to NRIs.
414
b. Existing Companies
Besides new companies, automatic route for FDI/NRI investment is also
available to the existing companies proposing to induct foreign equity. For
existing companies with an expansion program, the additional requirements
are that: (i) the increase in equity level must result from the expansion of the
equity base of the existing company without the acquisition of existing shares
by NRI/foreign investors, (ii) the money to be remitted should be in foreign
currency, and (iii) proposed expansion, program should be in the sector(s)
under automatic route. Otherwise, the proposal would need Government
approval through the FIPB. For this, the proposal must be supported by a
Board Resolution of the existing Indian companies.
For existing companies without an expansion program, the additional
requirements for eligibility for automatic approval are: (i) that they are
engaged in the industries under automatic route, (ii) the increase in equity
level must be from expansion of the equity base, and (iii) the foreign equity
must be in foreign currency.
The earlier SEBI requirement, applicable to public limited companies, that
shares allotted on preferential basis shall not be transferable in any manner
for a period of 5 years from the date of their allotment, has now been
modified to the extent that not more than 20 percent of the entire contribution
brought in by promoter cumulatively in public or preferential issue shall be
locked-in.
The automatic route for FDI and/or technology collaboration would not be
available to those who have or had any previous joint-venture or technology
transfer/trademark agreement in the same or allied field in India.
Equity participation by international financial institutions, such as, ADB,
IFC, CDC, DEG, etc., in domestic companies is permitted through automatic
route subject to SEBI/RBI regulations and sector-specific cap on FDI.
Procedure of Automatic Approval for New and Existing Companies

The proposals for approval under the automatic route are to be made to the
Reserve Bank of India in the FC (RBI) form. In a major drive to simplify
procedures for foreign direct investment under the ‘automatic route’, RBI has
given permission to Indian Companies to accept investment under this route
without obtaining prior approval from Reserve Bank of India. However, investors
are required to notify the concerned Regional offices of RBI of receipt of inward
remittances within 30 days of such receipt and will have to file the required
documents with the concerned Regional office of the RBI within 30 days after issue
of shares to foreign investors. This facility is available to NRI investment also.
Policy for Government Approval

For all activities which are not covered under the automatic route above, the
Government approval for FDI/NRI through the FIPB shall be necessary.
Areas/sectors/activities hitherto not open to FDI/NRI investment shall continue to be
so unless otherwise decided and notified by the Government. Any change in sectoral
policy/sectoral equity cap is notified from time to time by the Secretariat for
Industrial Assistance (SIA) in the Department of Industrial Policy and Promotion.
For greater transparency in the approval process, Government has announced
guidelines for consideration of FDI proposals by the FIPB.
Procedure for Obtaining Government Approval – Foreign Investment Promotion

Board
i. All proposals for foreign investment requiring Government approval are
considered for approval by the Foreign Investment Promotion Board (FIPB).
The FIPB also grants composite approvals involving foreign investment/
foreign technical collaboration.
415
ii. For seeking the approval applications in form FC-IL for FDI other than NRI
Investments and 100 percent EOU should be submitted to the Department of
Economic Affairs (DEA), Ministry of Finance.
iii. FDI applications with NRI Investments and 100 percent EOU should be
submitted to the Entrepreneur Assistance Unit (EAU) of Secretariat of
Industrial Assistance (SIA), Department of Industrial Policy and Promotion.
iv. Plain paper applications carrying all relevant details are also accepted. No fee
is payable. The following information should form part of the proposals
submitted to FIPB:
a. Whether the applicant has had or has any previous/existing
financial/technical collaboration or trademark agreement in India in the
same or allied field for which approval has been sought; and
b. If so, details thereof and the justification for proposing the new
venture/technical collaboration (including trademarks).
v. Applications can also be submitted to Indian Missions abroad who will
forward them to the Department of Economic Affairs for further processing.
vi. Foreign investment proposals received in the DEA are placed before the
Foreign Investment Promotion Board (FIPB) within 15 days of its receipt.
The recommendations of FIPB in respect of project proposals involving a
total investment of up to Rs.6 billion are considered and approved by the
Finance Minister. Projects with a total investment exceeding Rs.6 billion are
submitted to the Cabinet Committee on Economic Affairs (CCEA) for
decision.
vii. The decision of the Government in all cases is usually conveyed by the DEA
within 30 days.
REPATRIATION OF INVESTMENT CAPITAL AND PROFITS EARNED
IN INDIA
i. All foreign investments are freely repatriable except for the cases where
NRIs choose to invest specifically under non-repatriable schemes. Dividends
declared on foreign investments can be remitted freely through an Authorized
Dealer.
ii. Non-residents can sell shares on stock exchange without prior approval of
RBI. They can approach a bank for repatriation of the sale proceeds if they
hold the shares on repatriation basis and if they have necessary NOC/tax
clearance certificate issued by Income Tax authorities.
iii. For sale of shares through private arrangements, regional offices of RBI grant
permission for disinvestment of foreign equity in Indian company in terms of
guidelines indicated in Regulation 10.B of Notification No. FEMA.20/2000
RBI dated May 3, 2000. The sale price of shares on disinvestment is to be
determined in accordance with the guidelines prescribed under Regulation
10B(2) of the above notification.
iv. Profits, dividends, etc., (which are remittances classified as current account
transactions) can be freely repatriated.
ISSUE AND VALUATION OF SHARES IN CASE OF EXISTING
COMPANIES
Allotment of shares on preferential basis shall be as per the requirements of the
Companies Act, 1956, which will require special resolution in case of a public
limited company.
In case of listed companies, valuation shall be as per the RBI/SEBI guidelines as
follows:
The issue price shall be either at:
a. The average of the weekly high and low of the closing prices of the related
shares quoted on the stock exchange during the six months preceding the
relevant date; or
416
b. The average of the weekly high and low of the closing prices of the related
shares quoted on the stock exchange during the two weeks preceding the
relevant date.
The stock exchange referred to is the one at which the highest trading volume in
respect of the share of the company has been recorded during the preceding six
months prior to the relevant date.
The relevant date is the date thirty days prior to the date on which the meeting of
the General Body of the shareholder is convened.
In all other cases, a company may issue shares as per the RBI regulation in
accordance with the guidelines issued by the erstwhile Controller of Capital Issues.
Other relevant guidelines of Securities and Exchange Board of India (SEBI)/RBI
including the SEBI (Substantial Acquisition of Shares and Takeover) Regulations,
1997, wherever applicable, would need to be followed.
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THE APPROVAL PROCESS FOR FOREIGN DIRECT

INVESTMENTS IN INDIA
GLOBAL DEPOSITORY RECEIPTS (GDR)/AMERICAN DEPOSIT
RECEIPTS (ADR)/FOREIGN CURRENCY CONVERTIBLE BONDS
(FCCB)
Indian companies are allowed to raise equity capital in the international market
through the issue of GDR/ADRs/FCCBs. These are not subject to any ceilings on
investment. An applicant company seeking Government’s approval in this regard
should have a consistent track record for good performance (financial or
otherwise) for a minimum period of 3 years. This condition can be relaxed for
infrastructure projects such as power generation, telecommunication, petroleum
exploration and refining, ports, airports and roads.
There is no restriction on the number of GDRs/ADRs/FCCBs to be floated by a
company or a group of companies in a financial year. A company engaged in the
manufacture of items covered under Automatic route, whose direct foreign
investment after a proposed GDRs/ADRs/FCCBs issue is likely to exceed the
percentage limits under the automatic route, or which is implementing a project
falling under Government approval route, would need to obtain prior Government
clearance through FIPB before seeking final approval from the Ministry of Finance.
There are no end-use restrictions on GDR/ADR issue proceeds, except for an express
ban on investment in real estate and stock markets. The FCCB issue proceeds need to
conform to external commercial borrowing end use requirements; in addition,
25 percent of the FCCB proceeds can be used for general corporate restructuring.
418
Procedure for Raising Capital from Abroad and Seek Listing in

Foreign Exchanges – FCCBs and ADRs/GDRs
Foreign Currency Convertible Bonds
FCCBs are issued in accordance with the scheme [the Scheme for issue of Foreign
Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt
Mechanism) Scheme, 1993] and subscribed by a non-resident in foreign currency
and convertible into ordinary shares of the issuing company in any manner, either
in whole, or in part, on the basis of any equity related warrants attached to debt
instruments;
The eligibility for issue of Convertible Bonds or Ordinary Shares of Issuing
Company is given as under:
i. An issuing company desirous of raising foreign funds by issuing Foreign
Currency Convertible Bonds or ordinary shares for equity issues through
Global Depository Receipt,
ii. Can issue FCCB’s up to USD 50 million under the Automatic route,
iii. From USD 50-100 million, the companies have to take RBI approval,
iv. From USD 100 million and above, prior permission of the Department of
Economic Affairs, Ministry of Finance, Government of India is required.
ADRs/GDRs
An Indian company can issue ADRs/GDRs without obtaining prior approval from
RBI if it is eligible to issue ADRs/GDRs in terms of the Scheme for Issue of
Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository
Receipt Mechanism) Scheme, 1993 and subsequent guidelines issued by Ministry
of Finance, Government of India. In terms of FEMA Notification No. 41 dated
March 2, 2001, an Indian company can sponsor an issue of ADR/GDR with an
overseas depository against shares held by its shareholders at a price to be
determined by the Lead Manager.
The Global Depository Receipts issued under this scheme may be listed on any of
the Overseas Stock Exchanges, or Over-the-Counter Exchanges or through Book
Entry Transfer Systems prevalent abroad and such receipts may be purchased,
possessed and freely transferable by a person who is a non-resident.
Preference Shares
Foreign investment through preference shares is treated as foreign direct
investment. Proposals are processed either through the automatic route or FIPB as
the case may be. The following guidelines apply to issue of such shares:
i. Foreign investment in preference share are considered as part of share capital
and fall outside the External Commercial Borrowing (ECB) guidelines/cap.
ii. Preference shares to be treated as foreign direct equity for purpose of sectoral
caps on foreign equity, where such caps are prescribed, provided they carry a
conversion option. If the preference shares are structured without such
conversion option, they would fall outside the foreign direct equity cap.
iii. Duration for conversion shall be as per the maximum limit prescribed under
the Companies Act or what has been agreed to in the shareholders agreement
whichever is less.
iv. The dividend rate would not exceed the limit prescribed by the Ministry of
Finance.
v. Issue of preference shares should conform to guidelines prescribed by the
SEBI and RBI and other statutory requirements.
419
Issue of Shares against Lump sum Fee, Royalty and ECB

Issue of equity shares against lump sum fee, royalty and External Commercial
Borrowings (ECBs) in convertible foreign currency are permitted, subject to
meeting all applicable tax liabilities and sector-specific guidelines.
Foreign Investment Promotion Board (FIPB)

The Government of India has set-up a special Board known as the Foreign
Investment Promotion Board. This specially empowered Board in the office of the
Prime Minister, is the only agency dealing with matters relating to FDI as well as
promoting investment into the country. It is chaired by the Secretary Industry
(Department of Industrial Policy and Promotion).
The objectives of FIPB are:
i. To promote the FDI into India by undertaking investment promotion
activities in India and abroad by facilitating investment in the country
through international companies, Non-Resident Indians and other foreign
investors.
ii. Early clearance of proposals submitted to it through purposeful negotiation
and discussion with potential investors.
iii. Reviewing policy and putting in place appropriate institutional arrangements
and transparent rules, procedures and guidelines for investment promotion
and approvals.
The FIPB is expected to meet every week to ensure quick disposal of the cases
pending before it. It endeavors to ensure that the Government’s decisions on the
FDI proposals are communicated to the applicant within six weeks. Foreign
Investment proposals received by the board’s secretariat should be put up to the
Board within 15 days of receipt and the Administrative Ministries must offer their
comments either prior to and/or in the meeting of the FIPB. It would function as a
transparent, effective and investor-friendly single window, providing clearance for
investment proposals.
Approvals
The recommendations of FIPB in respect of the project-proposals each involving a
total investment of Rs.600 crore or less would be considered and approved by the
Industry Minister.
The recommendations in respect of the projects each with a total investment of
above Rs.600 crore would be submitted to the Cabinet Committee on Foreign
Investment (CCFI) for decision. The CCFI would also consider the proposals
which may be referred to it or which have been rejected by the Industry Minister.
The approval letters in all cases will be issued by the Secretariat of FIPB. The
FIPB has accorded approval to the investments of a large number of corporations
such as McDonalds, General Electric, Coca-Cola and Fujitsu in the recent past. It
normally processes applications within 6 weeks.
Foreign Investment Promotion Council – Constitution and Functions
The Government has constituted a Foreign Investment Promotion Council (FIPC)
under the Management of Chairman of ICICI, to undertake vigorous investment
promotion and marketing activities. The Presidents of the three apex business
associations such as ASSOCHAM, CII and FICCI will be members of the Council.
A Ministry of Industry personnel will be Member-Secretary.
420
Setting up of the Council follows the Government’s decision to strengthen the

institutional mechanism relating to the consideration and approval of the Foreign
Direct Investment (FDI) proposals. The Common Minimum Program (CMP)
which states that the nation needs and has the capacity to absorb at least
US$10 billion a year as the FDI will require considerable promotional efforts apart
from facilitating foreign investment approvals.
Support to FIPB
The strategy adopted is a two-pronged one with one relating to the approvals and
clearance required as per the transparent guidelines and other relating to full time
investment promotion and marketing. Accordingly, a revamped Foreign
Investment Promotion Board (FIPB) with fresh guidelines was put under the direct
control of the Industry Minister thereby reducing one level in the decision-making.
As a secondary and supporting measure, a Foreign Investment Promotion Council
was conceived.
Functions
The Foreign Investment Promotion Council will undertake the investment
promotional activity which entails making extensive contacts with potential
investors, lobbying and interacting with individual companies, etc. The Council
with distinguished and well-known experts as the members will capitalize, manage
and coordinate investment promotion and marketing efforts.
Promotional Works
The promotional efforts have been mostly centered on addressing general
investment promotion seminars and conferences. Besides that, a more target-
oriented approach is now required, both to identify the sectors/projects within the
country requiring foreign direct investment and targeting the specific regions and
countries of the world from which the FDI would be brought in through special
efforts.
The Foreign Investment Promotion Council has to analyze the requirements of
various sectors and industries in India which are in need of modernization,
technology upgradation and capital requirement. Sectoral profiles and project
proposals for these industries will need to be prepared for presentation to the
selected international companies and foreign investors.
Getting Foreign Investors
It will also be necessary to undertake one-to-one dialog with individual foreign
investors at the Board-room level in order to motivate them to invest in the
specified industries and sectors. It is felt that the Government has to identify
specific regions/countries where surplus capital is available for investment
overseas. Target-oriented efforts will be necessary to contact individual companies
in those countries for persuading them to invest in India.
The revamping of FIPB as well as constitution of the FIPC have been done with
these objectives in view and in accordance with the commitment in the Common
Minimum Program.
External Commercial Borrowings: The external commercial borrowings occupy
a very important position as a source of funds for the corporate. The intention of
the government is to maintain prudent limits for total external borrowings and to
provide flexibility to corporates in external borrowings, which is reflected in its
guidelines. The main objective of the ECB guidelines is to:
a. Keep borrowing maturities long;
b. Keep borrowing costs low;
c. Encourage infrastructure; and
d. Export sector financing.
421
What is an ECB? ECB is the most fancied three-letter word in corporate India.
ECBs (borrowings from lenders and investors outside India) are being permitted
by the government as a source of finance for Indian corporates for expansion of
existing capacity as well as for fresh investment. ECBs are defined to include
commercial bank loans, buyers’ credit, suppliers’ credit, securitized instruments
such as Floating Rate Notes and Fixed Rate Bonds, etc., credit from official export
credit agencies and commercial borrowings from the private sector window of
Multilateral Financial Institutions.
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ECB Cap: With a view to manage the country’s external debt prudently, the
Finance Ministry sets an annual cap on the total ECBs that Indian corporates can
access in a year. Such a cap would be a constraint only in years of excess demand.
The government also puts restrictions on the maturity profile of the borrowings
with a view to discourage very short-term borrowings.
Definition of Average Maturity: According to the Finance Ministry, “average
maturity”of ECBs is the weighted average of all disbursements taking each
disbursement individually and its period of retention by the borrower.
Automatic Route: The Government has recently decided to place fresh ECB
approvals up to USD 50 millions under the automatic route. Under this scheme,
Indian companies are allowed to raise ECBs up to $50 million under the automatic
approval route – which means that corporates can raise loans up to $50 million
without any approval from the Government or the RBI. “Under the automatic route
arrangement, any legal entity, registered under the Companies Act, Societies
Registration Act, Co-operative Societies Act, including proprietorship and
partnership concerns, will now be eligible to enter into loan agreements with
overseas lender(s) for raising fresh ECB with an average maturity of not less than
three years for an amount up to $50 million and for refinancing of an existing ECB
contracted in compliance with both the ECB guidelines framed by the Ministry of
Finance and the regulations issued by the Reserve Bank in this regard”. After
signing the loan agreement with the overseas lender, the company has to submit
three copies to the concerned regional office of the RBI through an Authorized
Dealer. The regional office of the RBI would then acknowledge the receipt of the
copy of the loan agreement and allot a loan identification number to the company.
The onus of ensuring that the foreign loan raised is in conformity with the relevant
guidelines now lies with the company interested in the ECB rather than the
422
Government or the RBI. However, the RBI can, if it notices any violation of rules,
initiate action against the company under the Foreign Exchange Management Act
(FEMA). Companies can also make the necessary drawdowns under the automatic
route without seeking permission from the RBI. They would, however, be required
to file quarterly returns in a prescribed format through the Authorized Dealers. The
Finance Ministry would continue to be the agency that would accord withholding
tax exemptions. Application procedure has also been simplified. There is now only
one uniform format for ECB applications. Earlier, there were separate formats for
filing applications with the RBI and the government.
In case a borrower decides to raise more than one ECB in a given financial year
for the ECBs up to USD 20m, the minimum average maturity would be 3-5 years.
USD 5 million Scheme: Raising of ECB under the scheme will be considered by
RBI provided the amount to be raised does not exceed USD 5 million (USD
3 million earlier) or its equivalent and the borrowing should be for a minimum
simple maturity of three years. Corporates/institutions may utilize the proceeds of
such borrowings for their business related expenditure (including rupee
expenditure) subject to the caveat that only one such loan should be outstanding at
any point of time.
For ECB above $20m, the minimum average maturity is 5 years.
Exporters’/Foreign Exchange Earners: Corporates who have foreign exchange
earnings are permitted to raise ECB up to three times the average amount of
annual exports during the previous three years subject to a maximum of USD 200
million without end-use restrictions, i.e., for general corporate objectives
excluding investments in stock markets or in real estate. The minimum average
maturity will be three years up to USD 20 million equivalent and five years for
ECBs exceeding USD 20 million. The maximum level of entitlement in any one
year is a cumulative limit and debt outstanding under earlier approvals will be
netted out to determine annual eligibility.
Infrastructure Projects: Holding companies/promoters will be permitted to raise
ECB up to a maximum of USD 200 million equivalent to finance equity
investment in a subsidiary/joint venture company implementing infrastructure
projects. In case the debt is to be raised by more than one promoter for a single
infrastructure project, then the total quantum of loan by all promoters put together
should not exceed USD 200 million. Also, infrastructure projects are allowed to
have ECB exposure of up to 50 percent of the project cost as appraised by a
recognized financial institution/bank. The sectors of power, telecommunication,
railways, roads including bridges, ports, industrial parks and urban infrastructure –
water supply, sanitation and sewage projects will qualify as ‘infrastructure sectors’
under the ECB guidelines. The ‘all-in-cost ceilings’ for infrastructure projects is
400 basis points over six months LIBOR, for the respective currency in which the
loan being raised or applicable benchmark(s), as the case may be.
MOF’s prior approval is necessary for such borrowings. End use under this
window can be for general corporate purposes which include restructuring unlike
loans for shorter maturities which are only allowed for capital expenditure. DFIs
may raise ECB under this window in addition to their normal annual allocation
covered by the cap. Utilization of the ECB approved earlier under the regular
ECB cap will not be a limiting factor for considering proposals under the long-
term maturity window. However, additional borrowings under either of the
window, i.e., regular or under long-term maturity, is subject to utilization of
earlier approvals in the same window. Corporates may raise these borrowings
either through FRN/Bond Issues/Syndicated Loan, etc., as long as the maturity
and interest spread is maintained as per the guidelines. The ‘all-in-cost ceilings’
for long-term ECBs is 350 basis points over six months LIBOR, for the
respective currency in which the loan is being raised or applicable benchmark(s),
as the case may be.
423
Long-term Borrowers
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On-lending by DFIs and other Financial Intermediaries: While DFIs are
required to adhere to the average maturity criteria prescribed, namely, minimum
average maturity will be three years up to USD 20 million equivalent and five
years for ECBs exceeding USD 20 million, they are permitted to on-lend at
different maturities. They may on-lend for import of capital goods and for project-
related Rupee expenditure. However, other financial intermediaries are required to
adhere to the general ECB guidelines on maturity as well as end-use in their
on-lending programs. All financial intermediaries, including DFIs, are required to
on-lend their external commercial borrowings within 12 months of drawdown.
Bonds/FRNs and Syndicated Loans: Bonds and FRNs can be raised in tranches
of different maturities as long as the average maturity of the different tranches
within the same overall approval taken together satisfies the maturity criteria
prescribed in the ECB guidelines. In such cases, it is expected that longer-term
borrowings would necessarily precede that of the shorter tenors. The longer the
initial tenor, the shorter the subsequent tranches can be within the average
maturity. Corporate borrowers who have raised ECB for import of capital goods
and services through Bonds/FRN/Syndicated loans are permitted to remit funds
into India. The funds can be utilized for activities as per their business judgement
except investment in stock market or in real estate, for up to one year or till the
actual import of capital goods and services takes place, whichever is earlier.
End-use Requirements: ECBs can be used for any purpose (rupee-related
expenditure as well as imports) except the following:
Utilization of ECB proceeds have been specifically disallowed for:
i. Investment in stock market.
ii. Speculation in real estate.
New Projects: All infrastructure and greenfield projects are permitted to avail
ECBs to an extent of 50 percent of the total project cost, as appraised by a
recognized financial institution/bank. ECB limits for telecom projects are
50 percent of the total project cost including license fee. Infrastructure projects in
power and some other sectors will be permitted to have ECB exposure of more
than 50 percent depending on the merits of the case.
Structured Obligations: In order to enable corporates to hedge exchange rate
risks and raise resources domestically, Domestic Rupee Denominated Structured
obligations would be permitted to be Credit enhanced by International
Banks/International Financial Institutions/Joint Venture Partners subject to
i. In the event of default, foreign banks giving guarantee will make payment of
defaulted amount of principal and interest after bringing in the equivalent
amount of foreign exchange into the country. Prior clearance for rupee
bonds/debenture issue from the RBI/SEBI should be obtained.
ii. In the event of default, the default should be foreign exchange equivalent
amount equal to the principal and interest outstanding calculated in rupee
terms.
iii. The liability of Indian company will be rupee denominated and the debt
servicing may be done in equivalent foreign exchange funds. However,
denomination of debt service in a post-default situation may be in Rupees or
in Forex as envisaged initially in the contract document.
424
iv. The guarantee fee/commission/charges and other incidental expenses to the

Indian company should be in rupee terms only. All-in-cost on this account
should not exceed 3 percent p.a. in rupee terms.
v. In case of the proposals relating to sectors where conditions apply clearances
example, relating to the assignability licenses, etc., these should be obtained
in advance.
vi. In case of default, the interest rate could be coupon on the Bond/or 250 bps
over prevailing secondary market yield of 5-year GOI security, whichever is
higher.
Structured Obligation Facility for NBFCs: Non-Banking Finance Companies
(NBFCs) would also be eligible to avail of Credit Enhancement Scheme on
compliance with the following additional conditions:
a. NBFC should be registered with the RBI;
b. It should have earned profits during the last three years; and
c. It should have secured “AA” or equivalent rating from a reputed Credit
Rating Agency. However, in the case of NBFCs where a credit enhancement
guarantee has been provided by its parent company on ‘non-recourse and
non-repatriable basis’, the condition of three years’ track record of profit will
not be applicable and the credit rating of ‘A or equivalent’ would also be
acceptable in such cases.
Other Terms and Conditions: The other financial terms and conditions like
management fee, legal fee, penal charges, etc., of each ECB proposal are required
to be reasonable and market-related. The choice of the sourcing of ECB, currency
of the loan, and the interest rate basis (i.e., floating or fixed), will be left to the
borrowers. The choice of security to be provided to the lenders/suppliers will also
be the choice of the borrower. However, where the security is in the form of a
guarantee from an Indian Financial Institution or from an Indian Scheduled
Commercial Bank, counter-guarantee or confirmation of the guarantee by a
Foreign Bank/Foreign Institution will not be permitted. The Finance Ministry has
also decided to permit companies which have approval for ECBs to carry out
payments in foreign exchange to their overseas lawyers and bankers, through the
current account, even if the loan agreement has not been signed. There have been
cases in the past where the Indian firms have been unable to firm up their loan
agreements within the mandatory period of six months. However, these companies
have to abide by their commitment to pay fees to international lawyers and bankers
for documents and related issues even if the deal is not finalized. The Ministry has
decided to permit this after taking into account the fact that the outflows on this
account would be low.
Exemption from Withholding Tax: Interest payable by an industrial undertaking
in India, related to external commercial borrowings as approved by GOI/RBI
would be eligible for tax exemptions as per Section 10(15)(iv)(b), (d) to (g) of the
Income Tax Act, 1961. Exemptions under Section 10(15)(iv)(b), (d) to (g) are
granted by Department of Economic Affairs while exemption under
Section 10(15)(iv)(c) is granted by Department of Revenue, Ministry of Finance as
defined in the Income Tax Act, 1961 amended from time to time.
Repayment of Loan/Credit and Payment of Other Charges: With a view to
simplify procedures, Authorized Dealers have been delegated the powers to allow
remittance of penal interest, irrespective of period of default and number of
occasions. Hence, applications for remittance of penal interest for defaulting in
repayment of principal/payment of interest can be referred to the Authorized
Dealers.
425
Validity of Approval: All approvals are valid for a period of six months, i.e., the
executed copy of the loan agreement is required to be submitted within this period.
Bonds, Debentures, FRNs and other such instruments will have additional validity
period of three months for all the ECB approvals across the board. In case of
power projects, the approval is valid for one year and in case of telecom projects, it
is valid for nine months from the date of approval. Extension will not be granted
beyond the validity period. However, borrowers are free to reapply after a gap of
one month from the expiry of validity period. In case of infrastructure projects,
however, because financial closure may get delayed for reasons beyond the
investor’s control, extension of validity may be considered on merits.
Pre-payment: The corporate can prepay 100 percent of ECBs where the source of
funds is EEFC accounts. In addition, corporates can avail either of the following
two options for pre-payment of their ECBs:
i. Pre-payment of ECBs up to 10 percent of the outstanding borrowings is
permitted once during the life of the loan.
ii. In case of loans which are outstanding and have a residual maturity of one
year and less, the entire amount can be pre-paid.
Validity of permission under the above two options will be as follows:
i. Pre-payment approval for ECBs other than Bonds/Debentures/FRNs will be
15 days or period up to next interest payment date, whichever is later.
ii. In case of Bonds/FRNs, validity of permission will not be more than 15 days.
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In case of pre-payments, the borrower may submit an application for prepayment

of loan through designated Authorized Dealer to the Reserve Bank of India,
Exchange Control Department, Central Office, (ECB Division), Mumbai. The RBI
will give all such approvals, as per prevailing guidelines on prepayment, even in
cases where ECBs have been approved earlier by the Ministry of Finance. Request
for pre-payments should be forwarded with the following information duly
certified by the Statutory Auditors:
• Loan Amount, Sanction Letter No. and Date (Loan Key No.).
• Net amount drawn after making payment for fee/commission, etc.
• Amount utilized for approved end-use duly supported by a certificate from
the Statutory Auditors, indicating that the necessary documentary evidence
has already been submitted to the concerned Regional Office of the RBI and
the balance unutilized amount, if any.
• Amount of ECB proceeds parked abroad – Name of the Bank, Account No.,
the RBI’s Sanction Letter, certified copy of latest statement, etc.
• Amount of loan repaid and balance outstanding.
427
• Residual maturity of the loan and the last date of repayment.

• Whether any prepayment approval has been obtained by the company against
this loan in the past. If so, details thereof.
• Prepayment premium (excluding Bonds/FRN issues).
• Source of funds from which the prepayment is proposed to be effected.
• Date of proposed prepayment.
• If the prepayment is proposed to be made from EEFC account, a certificate
from the Authorized Dealer indicating the amount outstanding in EEFC
Account.
Refinancing the Existing Foreign Currency Loan: The government has decided
to allow all refinancing of existing ECBs under the automatic route. Rolling over
of ECB will not be permitted. Further, a corporate borrowing overseas for
financing its rupee-related expenditure can swap its external commercial
borrowings with another corporate which requires foreign currency funds.
Liability Management: Corporates can undertake liability management for
hedging the interest and/or exchange rate risk on their underlying foreign currency
exposure.
CAPITAL FLIGHT
Capital flight refers to the large capital outflows resulting from unfavorable
investment conditions in a country. The expected risk and return are the
determinants of the foreign investment. When the risk of investment in a country
rises sharply and/or expected return falls, large outflows of investment funds take
place, and the country experiences massive current account deficits. Such outflows
are descriptively referred to as capital flight. The change in the risk-return
relationship that gives rise to capital flight may be due to political or financial
crisis, tightening capital controls, tax increases, or fear of domestic-currency
devaluation.
One of the most important aspects of the capital flight is that fewer resources are
available at home to service the debts, and more borrowing is required. Also,
capital flight may be associated with a loss of international reserves and greater
pressure for devaluation of the domestic currency.
The capital flight serves the importance of political and economic stability for
encouraging domestic investment. A stable, growing developing country faces
little, if any, capital flight and attracts foreign capital to aid in expanding its
productive capacity.
INTERNATIONAL LIQUIDITY
International liquidity refers to the generally accepted means of international
payments available for the settlement of the international transactions.
International liquidity encompasses the international reserves and the facilities for
international borrowing for financing the Balance of Payments deficit. The
international reserves include official holdings of gold, foreign exchange, Special
Drawing Rights, and reserve position in the IMF. International reserves do not
include private holdings of gold, private holdings of foreign exchange and long-
term international financing.
428
The IMF provides international liquidity in accordance with the purpose of the
fund specified in the Articles of Agreement. Part of the liquidity takes the form of
reserve assets that can be used for Balance of Payments financing (unconditional
liquidity), while the other part takes the form of credit to members that is generally
subject to certain conditions (conditional liquidity).
Unconditional liquidity is supplied through allocation of SDRs and also in the
form of reserve positions in the fund which are claims corresponding to the
resources that countries have made available to the fund. Members holding SDRs
and reserve positions in the fund can use them to finance Balance of Payments
deficits without having to enter into policy commitments with the fund.
Conditional liquidity is provided by the IMF under its various lending activities.
Most of the fund’s credit extended under these arrangements requires an
adjustment program that is intended to promote a sustainable external position for
the member. In addition, it is often the case when the member obtains fund
financing under agreed conditions, its access to capital markets is enhanced. This
kind of a catalytic role of the fund has become more important in recent times
when private lending institutions have been less willing to engage in international
lending.
SUMMARY
• The sources to raise forex finance in the international markets are: Official
channels and Commercial channels (for equity and debt).
• Corporate finance managers must first ascertain the resource requirements
and define the borrowing criteria and then identify the right sources to
borrow funds.
• Foreign Institutional Investors (FIIs) including mutual funds, pension funds,
investment trusts, endowment funds, insurance funds, university funds,
charitable societies, etc., can invest in the Indian stock markets subject to the
RBI and SEBI regulations.
• Foreign Direct Investment (FDI) takes place when an investor based in one
country acquires an asset in another country with the intention of managing
it. Except arms and ammunition, atomic energy, mineral oils, atomic energy
minerals and railway transport, FDIs are allowed to invest in most of the
industries.
• The Foreign Investment Promotion Board (FIPB) has been set-up specially
to: promote FDI investments in India, grant speedy clearance to new projects
and promote transparency in the rules and regulations for FDI deposits.
429
Appendix I
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430
Appendix II
Foreign Direct Investments
1. Foreign Investment in India
Foreign Investment in India is governed by the FDI policy announced by the
Government of India and the provisions of the Foreign Exchange
Management Act (FEMA) 1999. Reserve Bank has issued Notification No.
FEMA 20/2000-RB dated May 3, 2000 which contains the Regulations in
this regard. This notification has been amended from time to time.
2. Entry Routes for Investments in India
i. Foreign investment is freely permitted in almost all sectors. Under
Foreign Direct Investments (FDI) Scheme, investments can be made by
non-residents in the shares / convertible debentures of an Indian
Company, under two routes; Automatic Route and Government Route.
Under the Automatic Route, the foreign investor or the Indian company
does not require any approval from the Reserve Bank or Government of
India for the investment. Under the Government Route, prior approval
of the Government of India, Ministry of Finance, Foreign Investment
Promotion Board (FIPB) is required. Entry route for non-resident
investors in India as well as sector specific investment limits in India are
given in Annex-1.
ii. FDI Policy is formulated by the Government of India. The policy
and procedures in respect of FDI in India is available in “the
Manual on Investing in India- Foreign Direct Investment, Policy &
Procedures”. This document is available in public domain and
can be downloaded from the website of Ministry of Commerce and
Industry, Department of Industrial Policy and Promotion–
http://www.dipp.nic.in/manual/fdi_text_manual_nov_2006.pdf.
FEMA Regulations prescribe the mode of investments i.e. manner
of receipt of funds, issue of shares/convertible debentures and
preference shares2 and reporting of the investments to RBI.
3. Prohibition on Investment in India
i. Foreign investment in any form is prohibited in a company or a
partnership firm or a proprietary concern or any entity, whether
incorporated or not (such as Trusts) which is engaged or proposes to
incorporated or not (such as Trusts) which is engaged or proposes to
engage in the following activities:
a. Business of chit fund, or
b. Nidhi Company, or
c. Agricultural or plantation activities, or
d. Real estate business, or construction of farm houses
e. Trading in Transferable Development Rights (TDRs).
ii. It is clarified that Real Estate Business does not include development of
townships, construction of residential/commercial premises, roads or
bridges. It is further clarified that partnership firms/proprietorship
concerns having investments as per FEMA regulations are not allowed
to engage in Print Media sector.
iii. In addition to the above, investment in the form of FDI is also
prohibited in certain sectors such as:
a. Retail Trading (except single brand product retailing)
b. Atomic Energy
c. Lottery Business
431
d. Gambling and Betting

e. Agriculture (excluding Floriculture, Horticulture, Development of
seeds, Animal Husbandry, Pisiculture and Cultivation of
vegetables, mushrooms etc. under controlled conditions and
services related to agro and allied sectors) and Plantations (Other
than Tea plantations).
4. Eligibility for Investing in India
i. A person resident outside India (other than a citizen of Pakistan) or an
entity incorporated outside India, (other than an entity incorporated in
Pakistan) can invest in India, subject to the FDI Policy of the
Government of India. A person who is a citizen of Bangladesh or an
entity incorporated in Bangladesh can invest in India under the FDI
Scheme, with prior approval of FIPB.
ii. Overseas Corporate Bodies (OCBs) are entities established outside India
and predominantly owned by NRIs (at least 60% of the paid up capital).
Erstwhile OCBs which are incorporated outside India and are not under
adverse notice of Reserve Bank can make fresh investments under the
FDI as incorporated non-resident entities, with the prior approval of
Government if the investment is through Government Route and with
the prior approval of Reserve Bank if the investment is through
Automatic Route.
5. Type of Instruments
i. Indian companies can issue equity shares / convertible debentures and
preference shares subject to pricing guidelines / valuation norms
prescribed under FEMA Regulations.
ii. Issue of other types of preference shares such as nonconvertible,
optionally convertible or partially convertible have to be in accordance
with the guidelines applicable for External Commercial Borrowing
(ECB). Since these instruments are denominated in rupees, the rupee
interest rate will be based on the swap equivalent of LIBOR plus the
spread permissible for ECBs of corresponding maturity.
iii. As far as debentures are concerned, only those which are fully and
mandatorily convertible into equity, within a specified time would be
reckoned as part of equity under the FDI Policy.
6. Investments in Small Scale Industrial Units
i. A foreign investor can invest in an Indian company which is a small
scale industrial unit provided it is not engaged in any activity which is
prohibited under the FDI policy. Such investments are subject to a limit
of 24 per cent of paid-up capital of the Indian company/SSI Unit. An
SSI Unit can issue equity shares / fully convertible preference shares /
fully convertible debentures more than 24 per cent of its paid-up capital if:
a. It has given up its small scale unit status,
b. It is not engaged or does not propose to engage in manufacture of
items reserved for small scale sector, and c) It complies with the
sectoral caps specified in Annex-1.
ii. It is clarified that the company/SSI Unit would be reckoned as having
given up its SSI status, if the investment in plant and machinery exceeds
the limits prescribed under the Micro, Small and Medium Enterprises
Development Act, 2006.
iii. An SSI Unit, which is an Export Oriented Unit or a unit in Free Trade
Zone or in Export Processing Zone or in a Software Technology Park or
in an Electronic Hardware Technology Park, can issue shares /
convertible debentures / preference shares exceeding 24 per cent of the
paid-up capital up to the sectoral caps specified in Annex-1.
432
7. Investments in Asset Reconstruction Companies (ARCs)

i. Persons resident outside India (other than Foreign Institutional Investors
(FIIs)), can invest in the equity capital of Asset Reconstruction
Companies (ARCs) registered with Reserve Bank under the
Government Route only. Automatic Route is not available for such
investments. Such investments have to be strictly in the nature of FDI.
Investments by FIIs are not permitted. Further, FDI is restricted to 49
per cent of the paid up capital of the ARC.
ii. However, FIIs registered with SEBI can invest in the Security Receipts
(SRs) issued by ARCs registered with Reserve Bank. FIIs can invest up
to 49 per cent of each tranche of scheme of SRs, subject to the condition
that investment by a single FII in each tranche of SRs shall not exceed
10 per cent of the issue.
8. Investment in Infrastructure Companies in the Securities Market
Foreign investment is permitted in Infrastructure Companies in Securities
Markets, namely stock exchanges, depositories and clearing corporations, in
compliance with SEBI Regulations and subject to the following conditions:
Foreign investment up to 49 per cent of the paid up capital, is allowed in
these companies with a separate FDI cap of 26 per cent and FII cap of 23 per
cent;
i. FDI will be allowed with specific prior approval of FIPB; and
ii. FII can invest only through purchases in the secondary market.
9. Investment in Credit Information Companies
Foreign investment in Credit Information Companies is permitted in
compliance with the Credit Information Companies (Regulations) Act, 2005
and subject to the following :
i. The aggregate Foreign Investment in Credit Information Companies is
permitted only up to 49 per cent of the paid up capital.
ii. Foreign Investment upto 49 per cent is allowed only with the prior
approval of FIPB and regulatory clearance from RBI.
iii. Investment by SEBI Registered FIIs is permitted only through
purchases in the secondary market to an extent of 24 per cent.
iv. Investment by SEBI Registered FIIs to an extent of 24 per cent should
be within the overall limit of 49 per cent for Foreign Investment.
v. No FII can individually hold directly or indirectly more than 10 per cent
of the equity.
10. Investment in Commodity Exchanges
Foreign investment in Commodity Exchanges is permitted subject to the
i. There is a composite ceiling of 49 per cent for Foreign Investment, with
a FDI limit of 26 per cent and an FII limit of 23 per cent.
ii. FDI is allowed with specific approval of the Government.
iii. The FII purchases in equity of Commodity Exchanges is restricted to
the secondary markets only.
iv. Foreign Investment in Commodity Exchanges is also subject to
compliance with the regulations issued, in this regard, by the Forward
Market Commission.
433
11. Investment in Public Sector Banks

FDI and Portfolio Investment in nationalized banks are subject to overall
statutory limits of 20 per cent as provided under Section 3 (2D) of the
Banking Companies (Acquisition & Transfer of Undertakings) Acts,
1970/80. The same ceiling would also apply in respect of such investments in
State Bank of India and its associate banks.
12. Investments from Nepal & Bhutan
NRIs, resident in Nepal and Bhutan as well as citizens of Nepal and Bhutan
are permitted to invest in shares and convertible debentures of Indian
companies under FDI Scheme on repatriation basis, subject to the condition
that the amount of consideration for such investment shall be paid only by
way of inward remittance in free foreign exchange through normal banking
channels.
13. Issue of Rights / Bonus Shares to Erstwhile OCBs
FEMA provisions allow Indian companies to freely issue Rights / Bonus
shares to existing non-resident shareholders, subject to adherence to
sectoral cap, if any. However, such issue of bonus/rights shares have to be
in accordance with other laws/statutes like the Companies Act, 1956, SEBI
(Disclosure and Investor Protection) Guidelines (in case of listed
companies), etc.
14. Rights Issue to Erstwhile OCBs
The price of shares offered on rights basis by the Indian company to non-
resident shareholders shall not be lower than the price at which such shares
are offered to resident shareholders. OCBs have been de-recognised as a class
of investors with effect from September 16, 2003. Therefore, companies
desiring to issue rights shares to such erstwhile OCBs will have to take
specific prior permission from the Reserve Bank6. As such, entitlement of
rights shares is not automatically available to OCBs. However, bonus shares
can be issued to erstwhile OCBs without RBI approval.
15. Additional Allocation of Rights Shares by Residents to Non-residents
Existing non-resident shareholders are allowed to apply for issue of
additional shares / convertible debentures / preference shares over and above
their rights share entitlements. The investee company can allot the additional
rights shares out of unsubscribed portion, subject to the condition that the
overall issue of shares to nonresidents in the total paid-up capital of the
company does not exceed the sectoral cap.
16. Acquisition of Shares under Scheme of Amalgamation/merger
Mergers and amalgamations of companies in India are usually governed by
an order issued by a competent Court on the basis of the Scheme submitted
by the companies undergoing merger/amalgamation. Once the scheme of
merger or amalgamation of two or more Indian companies has been approved
by a Court in India, the transferee company or new company is allowed to
issue shares to the shareholders of the transferor company resident outside
India subject to the conditions that :
i. The percentage of shareholding of persons resident outside India in the
transferee or new company does not exceed the sectoral cap.
ii. The transferor company or the transferee or the new company is not
engaged in activities which are prohibited in terms of FDI policy (refer
para 3 above).
434
17. Issue of shares under Employees Stock Option Scheme (ESOPs)

i. Listed Indian companies are allowed to issue shares under the
Employees Stock Option Scheme (ESOPs), to its employees or
employees of its joint venture or wholly owned subsidiary abroad who
are resident outside India, other than to the citizens of Pakistan.
Citizens of Bangladesh can invest with the prior approval of FIPB.
Shares under ESOPs can be issued directly or through a Trust subject
to the condition that:
a. The scheme has been drawn in terms of relevant regulations issued
by the Securities and Exchange Board of India; and
b. The face value of the shares to be allotted under the scheme to the
non-resident employees does not exceed 5 per cent of the paid-up
capital of the issuing company.
ii. Unlisted companies have to follow the provisions of the Companies
Act, 1956. The Indian company can issue ESOPs to employees who are
resident outside India, other than to the citizens of Pakistan. ESOPs can
be issued to the citizens of Bangladesh with the prior FIPB approval.
The issuing company is required to report the details of such issues to
the concerned Regional Office of the Reserve Bank, within 30 days
from the date of issue of shares.
18. Reporting of FDI
i. Reporting of inflow
a. An Indian company receiving investment from outside India for
issuing shares/convertible debentures/preference shares under the
FDI Scheme, should report the details of the amount of
consideration to the Reserve Bank not later than 30 days from the
date of receipt.
b. Indian companies are required to report the details of the receipt of
the amount of consideration for issue of shares / convertible
debentures, through an AD Category - I bank, together with a
copy/ies of the FIRC/s evidencing the receipt of the remittance
along with the KYC report on the non-resident investor from the
overseas bank remitting the amount. The report would be
acknowledged by the Regional Office concerned, which would
allot a Unique Identification Number (UIN) for the amount
reported.
ii. Time frame within which shares have to be issued
The equity instruments should be issued within 180 days from the date
of receipt of the inward remittance or by debit to the NRE/FCNR (B)
account of the non-resident investor. In case, the equity instruments are
not issued within 180 days from the date of receipt of the inward
remittance or date of debit to the NRE/FCNR (B) account, the amount
of consideration so received should be refunded immediately to the non-
resident investor by outward remittance through normal banking
channels or by credit to the NRE/FCNR (B) account, as the case may
be. Non-compliance with the above provision would be reckoned as a
contravention under FEMA and could attract penal provisions. In
exceptional cases, refund of the amount of consideration outstanding
beyond a period of 180 days from the date of receipt may be considered
by the Reserve Bank on the merits of the case.
435
iii. Reporting of issue of shares

a. After issue of shares/convertible debentures/preference shares, the
Indian company has to file Form FC-GPR not later than 30 days
from the date of issue.
b. Part A of Form FC-GPR has to be duly filled up and signed by
Managing Director/Director/Secretary of the Company and
submitted to the Authorised Dealer of the company, who will
forward it to the Reserve Bank. The following documents have to
be submitted along with Part A:
i. A certificate from the Company Secretary of the company
certifying that
a. all the requirements of the Companies Act, 1956 have
been complied with;
b. terms and conditions of the Government’s approval, if
any, have been complied with;
c. the company is eligible to issue shares under these
Regulations; and
d. the company has all original certificates issued by
authorised dealers in India evidencing receipt of amount
of consideration.
ii. A certificate from Statutory Auditors or Chartered
Accountant indicating the manner of arriving at the price of
the shares issued to the persons resident outside India.
c. The report of receipt of consideration as well as FC-GPR have to
be submitted to the concerned Regional Office of the Reserve
Bank under whose jurisdiction the registered office of the
company is situated.
d. Part-B of FC-GPR should be filed on an annual basis by the Indian
company, directly with the Reserve Bank7. This is an annual
return to be submitted by 31st of July every year, pertaining to all
investments by way of direct/portfolio investments/re-invested
earnings/others in the Indian company made during the previous
years (i.e. the information in Part B submitted by 31st July 2008
will pertain to all the investments made in the previous years up to
March 31, 2008). The details of the investments to be reported
would include all foreign investments made into the company
which is outstanding as on the balance sheet date. The details of
overseas investments in the company both under Direct / portfolio
investment may be separately indicated.
e. Issue of bonus/rights shares or stock options to persons resident
outside India directly or on amalgamation / merger with an
existing Indian company, as well as issue of shares on conversion
of ECB/royalty/lumpsum technical know-how fee /import of
capital goods by SEZs has to be reported in Form FC-GPR.
19. Issue Price
Price of shares issued to persons resident outside India under the FDI
Scheme, shall be on the basis of SEBI guidelines in case of listed companies.
In case of unlisted companies, valuation of shares has to be done by a
Chartered Accountant in accordance with the guidelines issued by the
erstwhile Controller of Capital Issues.
436
20. Foreign Currency Account

Indian companies which are eligible to issue shares to persons resident
outside India under the FDI Scheme will be allowed to retain the share
subscription amount in a foreign currency account, with the prior approval
of RBI.
21. Transfer of Shares and convertible debentures
i. Foreign investors can also invest in Indian companies by purchasing /
acquiring existing shares from Indian shareholders or from other non-
resident shareholders. General permission has been granted to non-
residents / NRIs for acquisition of shares by way of transfer subject to
the following:-
a. A person resident outside India (Other than NRI and OCB) may
transfer by way of sale or gift the shares or convertible debentures
to any person resident outside India (including NRIs).
b. NRIs and erstwhile OCBs may transfer by way of sale or gift the
shares or convertible debentures held by them to another NRI.
c. A person resident outside India can transfer any security to a
person resident in India by way of gift.
d. A person resident outside India can sell the shares and convertible
debentures of an Indian company on a recognized Stock Exchange
in India through a registered broker.
e. A person resident in India can transfer by way of sale, shares /
convertible debentures (including transfer of subscriber's shares),
of an Indian company in sectors other than financial service sector
(i.e. Banks, NBFC, Insurance, ARCs and infrastructure companies
in the securities market viz. Stock Exchanges, Clearing
Corporations and Depositories) under private arrangement to a
person resident outside India, subject to the guidelines.
f. General permission is also available for transfer of shares /
convertible debentures, by way of sale under private arrangement
by a person resident outside India to a person resident in India,
subject to the guidelines.
g. The above General Permission also covers transfer by a resident to
a non-resident of shares / convertible debentures of an Indian
company, engaged in an activity earlier covered under the
Government Route but now falling under Automatic Route of RBI,
as well as transfer of shares by a non-resident to an Indian
company under buy-back and/or capital reduction scheme of the
company. However, this General Permission is not available for
transfer of shares/debentures of an entity engaged in any activity in
the financial service sector (i.e. Banks, NBFCs, ARCs, Insurance
and infrastructure providers in the securities market such as Stock
Exchanges, Clearing Corporations, etc.),
ii. Reporting of transfer of shares between residents and nonresidents and
vice versa is to be done in Form FC-TRS. This Form needs to be
submitted to the AD Category – I bank, which will forward the same to
its link office. The link office will consolidate the Forms and submit a
report to the Reserve Bank.
iii. AD Category – I banks have been given general permission to open
Escrow account and Special account by non-resident corporates for
open offers/exit offers and delisting of shares. The relevant SEBI
(SAST) Regulations or any other applicable SEBI Regulations /
provisions of the Companies Act, 1956 will be applicable.
437
22. Prior permission of RBI in certain cases for transfer of shares/

convertible debentures
i. A person resident in India, who intends to transfer any security, by way
of gift to a person resident outside India, has to obtain prior approval
from Reserve Bank8. While forwarding applications to Reserve Bank
for approval for transfer of shares by way of gift. Reserve Bank
considers the following factors while processing such applications:
a. The transferee (donee) is eligible to hold such security under
Schedules 1, 4 and 5 of Notification No. FEMA 20/2000-RB dated
3rd May 2000, as amended from time to time.
b. The gift does not exceed 5 per cent of the paid-up capital of the
Indian company / each series of debentures/each mutual fund
scheme.
c. The applicable sectoral cap limit in the Indian company is not
breached.
d. The transferor (donor) and the transferee (donee) are close
relatives as defined in Section 6 of the Companies Act, 1956, as
amended from time to time.
e. The value of security to be transferred together with any security
already transferred by the transferor, as gift, to any person residing
outside India does not exceed the rupee equivalent of USD 25,000
during a calendar year.
f. Such other conditions as stipulated by Reserve Bank in public
interest from time to time.
ii. The following instances of transfer of shares from residents to non-
residents by way of sale requires RBI approval:
i. Transfer of shares or convertible debentures of an Indian company
engaged in financial sector (i.e. Banks, NBFCs, Asset
Reconstruction Companies, Insurance and Infrastructure providers
in the securities market such as Stock Exchanges, Clearing
Corporations, etc.),
ii. Transactions which attract the provisions of SEBI (Substantial
Acquisition of Shares and Takeovers) Regulations, 1997.
iii. The following instances of transfer of shares from residents to
non-residents by way of sale or otherwise requires Government
approval followed by permission from RBI: a. Transfer of shares
of companies engaged in sectors falling under the Government
Approval Route,
b. Transfer of shares resulting in foreign investments in the
Indian company, breaching the sectoral cap applicable.
23. Conversion of ECB / Lumpsum Fee/Royalty/ Import of capital goods by
SEZs into Equity
i. Indian companies have been granted general permission for conversion
of External Commercial Borrowings (ECB) into shares/ preference
shares, subject to the following conditions and reporting requirements.
a. The activity of the company is covered under the Automatic Route
for FDI or the company has obtained Government approval for
foreign equity in the company,
b. The foreign equity after conversion of ECB into equity is within
the sectoral cap, if any,
c. Pricing of shares is as per SEBI regulations or erstwhile CCI
guidelines in the case of listed or unlisted companies respectively.
d. Compliance with the requirements prescribed under any other
statute and regulation in force.
438
ii. The conversion facility is available for ECBs availed under the
Automatic or Approval Route. This would also be applicable to ECBs,
due for payment or not, as well as secured / unsecured loans availed
from non-resident collaborators. General permission is also available for
issue of shares/preference shares against lump-sum technical know-how
fee, royalty, under automatic route or SIA / FIPB route, subject to
pricing guidelines of SEBI/CCI and compliance with applicable tax
laws.
iii. Units in Special Economic Zones (SEZs) are permitted to issue equity
shares to non-residents against import of capital goods subject to the
valuation done by a Committee consisting of Development
Commissioner and the appropriate Customs officials.
iv. Reporting Details of issue of shares against conversion of ECB has to be
reported to the concerned Regional Office of the Reserve Bank, as
indicated below:
a. In case of full conversion of ECB into equity, the companyshall
report the conversion in form FC-GPR to the concerned Regional
Office of the Reserve Bank as well as in form ECB-2 to the
Department of Statistical and Information Management (DSIM),
Reserve Bank of India, Bandra-Kurla Complex, Mumbai – 400
051, within seven working days from the close of month to which
it relates. The words "ECB wholly converted to equity" shall be
clearly indicated on top of the ECB-2 form. Once reported, filing
of form ECB-2 in the subsequent months is not necessary.
b. In case of partial conversion of ECB, the company shall report the
converted portion in form FC-GPR to the concerned Regional
Office as well as in form ECB-2 clearly differentiating the
converted portion from the non-converted portion. The words
"ECB partially converted to equity" shall be indicated on top of the
ECB-2 form. In the subsequent months, the outstanding balance of
ECB shall be reported in ECB-2 form to DSIM.
c. The SEZ unit issuing equity as mentioned in para (iii) above,
should report the particulars of the shares issued in the form FC-
GPR.
24. Remittance of sale proceeds
AD Category – I bank can allow the remittance of sale proceeds of a security
(net of applicable taxes) to the seller of shares resident outside India,
provided the security has been held on repatriation basis, the sale of security
has been made in accordance with the prescribed guidelines and NOC / tax
clearance certificate from the Income Tax Department has been produced.
25. Remittance on winding up/liquidation of Companies
AD Category – I banks have been allowed to remit winding up proceeds of
companies in India, which are under liquidation, subject to payment of
applicable taxes. Liquidation may be subject to any order issued by the court
winding up the company or the official liquidator in case of voluntary
winding up; under the provisions of the Companies Act, 1956. AD Category – I
banks shall allow the remittance provided the applicant submits:-
i. No objection or Tax clearance certificate from Income Tax Department
for the remittance.
ii. Auditor’s certificate confirming that all liabilities in India have been
either fully paid or adequately provided for.
iii. Auditor’s certificate to the effect that the winding up is in accordance
with the provisions of the Companies Act, 1956.
439
iv. In case of winding up otherwise than by a court, an auditor's certificate

to the effect that there is no legal proceedings pending in any court in
India against the applicant or the company under liquidation and there is
no legal impediment in permitting the remittance.
26. Issue of shares by Indian companies under ADR / GDR
i. Depositary Receipts (DRs) are negotiable securities issued outside
India by a Depository Bank, on behalf of an Indian company, which
represent the local Rupee denominated equity shares of the company
held as deposit by a Custodian bank in India. DRs are traded in Stock
Exchanges in the US, Singapore, Luxembourg, etc. DRs listed and
traded in the US markets are known as American Depository
Receipts (ADRs) and those listed and traded elsewhere are known as
Global Depository Receipts (GDRs). In the Indian context, DRs are
treated as FDI.
ii. Indian companies can raise foreign currency resources abroad through
the issue of ADRs/GDRs, in accordance with the Scheme for issue of
Foreign Currency Convertible Bonds and Ordinary Shares (Through
Depository Receipt Mechanism) Scheme, 1993 and guidelines issued by
the Government of India thereunder from time to time.
iii. A company can issue ADRs/GDRs if it is eligible to issue shares to
persons resident outside India under the FDI Scheme. However, an
Indian listed company, which is not eligible to raise funds from the
Indian Capital Market including a company which has been restrained
from accessing the securities market by the Securities and Exchange
Board of India (SEBI) will not be eligible to issue ADRs/GDRs.
iv. Unlisted companies, which have not yet accessed the ADR/GDR route
for raising capital in the international market would require prior or
simultaneous listing in the domestic market, while seeking to issue such
instruments. Unlisted companies, which have already issued
ADRs/GDRs in the international market, have to list in the domestic
market on making profit or within three years of such issue of
ADRs/GDRs, whichever is earlier.
v. ADRs/GDRs are issued on the basis of the ratio worked out by the
Indian company in consultation with the Lead Manager to the issue. The
proceeds so raised have to be kept abroad till actually required in India.
Pending repatriation or utilisation of the proceeds, the Indian company
can invest the funds in -
a. Deposits with or Certificate of Deposit or other instruments
offered by banks who have been rated by Standard and Poor, Fitch,
IBCA or Moody's, etc. and such rating not being less than the
rating stipulated by Reserve Bank from time to time for the
purpose, (current rating applicable is AA(-) by Standard and
Poor/Fitch IBCA or Aa3 by Moody’s);
b. Deposits with branch/es of Indian Authorised Dealers outside
India; and
c. Treasury bills and other monetary instruments with a maturity or
unexpired maturity of one year or less.
vi. There are no end-use restrictions except for a ban on deployment/investment
of such funds in Real Estate or the Stock Market. There is no monetary
limit up to which an Indian company can raise ADRs/GDRs.
vii. The ADR/GDR proceeds can be utilised for first stage acquisition of
shares in the disinvestment process of Public Sector Undertakings /
Enterprises and also in the mandatory second stage offer to the public in
view of their strategic importance.
440
viii. Voting rights on shares issued under the Scheme shall be as per the
provisions of Companies Act, 1956 and in a manner in which
restrictions on voting rights imposed on ADR/GDR issues shall be
consistent with the Company Law provisions. Voting rights in the case
of banking companies will continue to be in terms of the provisions of
the Banking Regulation Act, 1949 as applicable to all shareholders
exercising voting rights.
ix. Erstwhile OCBs who are not eligible to invest in India and entities
prohibited to buy, sell or deal in securities by SEBI will not be eligible
to subscribe to ADRs / GDRs issued by Indian companies.
x. The pricing of ADR / GDR issues should be made at a price not less
than the higher of the following two averages:
i. The average of the weekly high and low of the closing prices of
the related shares quoted on the stock exchange during the six
months preceding the relevant date;
ii. The average of the weekly high and low of the closing prices of
the related shares quoted on a stock exchange during the two
weeks preceding the relevant date.
ii. The “relevant date” means the date, thirty days prior to the date on
which the meeting of the general body of shareholders is held, in
terms of section 81 (IA) of the Companies Act, 1956, to consider
the proposed issue.
27. Two-way Fungibility Scheme
A limited Two-way Fungibility scheme has been put in place by the
Government of India for ADRs / GDRs. Under this Scheme, a stock broker in
India, registered with SEBI, can purchase shares of an Indian company from
the market for conversion into ADRs/GDRs based on instructions received
from overseas investors. Reissuance of ADRs / GDRs would be permitted to
the extent of ADRs / GDRs which have been redeemed into underlying
shares and sold in the Indian market.
28. Sponsored ADR/GDR issue
An Indian company can also sponsor an issue of ADR / GDR. Under this
mechanism, the company offers its resident shareholders a choice to submit
their shares back to the company so that on the basis of such shares, ADRs /
GDRs can be issued abroad. The proceeds of the ADR / GDR issue is
remitted back to India and distributed among the resident investors who had
offered their rupee denominated shares for conversion. These proceeds can
be kept in Resident Foreign Currency (Domestic) accounts in India by the
resident shareholders who have tendered such shares for conversion into
ADR / GDR.
29. Reporting of ADR/GDR Issues
The Indian company issuing ADRs / GDRs has to furnish to the Reserve
Bank, within 30 days from the date of closing of the issue. The company
should also furnish a quarterly return to the Reserve Bank within 15 days of
the close of the calendar quarter. The quarterly return has to be submitted till
the entire amount raised through ADR/GDR mechanism is either repatriated
to India or utilized abroad as per Reserve Bank guidelines.
441
Appendix III
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•
•
CONCEPT OF CREDIT RATING

As the number of companies borrowing directly from the capital market increases,
and as the industrial environment becomes more and more competitive and
demanding, investors find that a borrower’s net worth or name are no longer
sufficient to ensure successful raising of funds from the market. In such a scenario,
to enable the investors to take informed decisions, Credit Rating has emerged as
one of the most factors in choosing. Offering this service is a Credit Rating
Agency which provides an impartial and objective opinion on the credit quality of
debt obligations of different companies and assists investors, individuals and
institutions in making investment decisions.
Rating is defined by a few well-known credit rating agencies in various ways:
Credit Rating Information Services of India Ltd. (CRISIL) Rating: “Credit
rating is an unbiased, objective and independent opinion as to an issuer’s capacity
to meet its financial obligations. The CRISIL rating symbols indicate in a
summarized manner CRISIL’s current opinion as to the relative safety of timely
payment of interest and principal on a debenture, preference share, fixed deposit or
short-term instrument”.
Moody’s Investor Service (USA): “Rating is designed exclusively for the
purpose of grading bonds according to their investment qualities”.
Standard and Poor’s (USA): “A Standard and Poor’s corporate or municipal debt
rating is a current assessment of the creditworthiness of an obligor with respect to
specific obligation”.
Australian Ratings: “A Corporate credit rating provides lenders with a simple
system of gradation by which the relative capacities of companies to make timely
repayment of interest and principal on a particular type of debt can be noted”.
Thus, a credit rating is not a general evaluation of the issuing organization. It
essentially reflects the probability of timely repayment of principal and interest by
a borrower company. The credit rating is not a one-time evaluation of credit risk
of a security. The rating company may change the rating considering the changes
periodically.
• •
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NEED FOR CREDIT RATING

The need for credit rating will be different for different parties depending on the
benefits it offers to the various parties utilizing these services viz., investors,
issuers, intermediaries and regulatory authority.
Investors
a. Will supplement the investors credit evaluation process.
b. Facilitates comparison of relative value between competing securities.
c. Recognition of risk involved in investment.
448
Credit Rating
Issuers
a. A company with highly rated instrument has the opportunity to reduce the
cost of borrowing by quoting less interest rates.
b. A company with high rating can approach a wider section of investors for
resource mobilization.
c. Companies with rated instruments can avail of the rating as a marketing tool
to create better image in dealing with its customers, lenders and creditors.
d. Rating encourages the companies to come out with more disclosures about
their accounting system, financial reporting and management pattern.
e. Smaller and not so well-known companies can access markets.
f. Encourages financial discipline as borrowers’ attempt to obtain better ratings
by improving financial structure and reducing operating risks.
Financial Intermediaries
a. Ratings help in pricing debt.
b. Shifts burden of establishing credit quality from intermediary to rating
agency thereby easing the due diligence requirement.
c. With high credit rating the brokers can convince their clients to select a
particular investment proposal. This saves their time, cost and manpower in
convincing their clients.
Regulatory Authority
a. By identifying the risks, rating helps in channelizing savings into productive
investments.
b. Credit rating subserves the objective of the regulator in protecting investors’
interest.
ESSENTIALS OF RATING SERVICE
Critical investment decisions may be taken based on the ratings offered by the
credit rating agency. In order to ensure that the ratings lead to good investment
decisions it is essential that the rating service has the following two important
factors:
• The quality of rating should be such that it wins the confidence and trust of
the users of such ratings.
• Rating agencies should be unbiased to both the investors and the corporates.
RATING ELEMENTS
Rating agency earns its reputation by assessing the client’s operational
performance, managerial competence, management and organizational set up and
financial structure. It should be an independent company with its own identity. It
should have no Government interference. Rating of an instrument does not give
any fiduciary status to the credit rating agency. It is desirable that the rating be
done by more than one agency for the same kind of instrument. This will attract
investors’ confidence in the rating symbol given.
RATING SYMBOLS
Since the ratings of the agencies will be used even by lay investors, the outcome of
the rating should be delivered in an understandable manner. To facilitate this,
rating symbols are provided. These rating symbols can be easily comprehensible
by investors and enable them to take decisions on investments. The investor will
not have to wholly depend on the broker’s advice as the rating symbol gives a clue
449
to the credibility of the issuer. Different rating agencies use different symbols and
distinct symbols will be assigned for different securities. The rating symbols,
however, will have to be clear and definite and without any ambiguity and without
leaving any scope for misinterpretation.
THE RATINGS SCALE
Ratings denote an issuer’s ability to respond to adverse changes in circumstances
and economic conditions. The rating scale is generally differentiated into various
levels of credit quality viz., high investment grade, investment grade and speculative
grade. The scale and corresponding definitions of CRISIL are as follows:
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450
Credit Rating
The table given below indicates the rating symbols and their meaning:
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To reflect comparative standing within a category, a “+” (plus) or a “–” (minus)

sign will be suffixed to the symbols given above.
RATING PROCESS
The following steps indicate the process involved in credit rating:
i. The rating process commences when a client approaches the credit rating
agency to analyze and provide a rating symbol/report to a security/
individual/borrower, etc.
ii. The rating agency then assimilates all the necessary information required for
this by meeting the management of the company/borrower. The information
provided for rating process will be highly confidential and will not be used
for any other purpose.
iii. Based on the analyses of the report, the rating will be decided.
iv. The rating will then be communicated to the client along with the reasons
supporting the rating. If this rating is not agreeable, the client may appeal for
reviewing the rating for which additional/new information will have to be
provided.
v. If the rating is accepted by the client it will then be declared to the public by the
credit rating agency.
vi. Since rating is not a one time process, there will be a continuous monitoring
of the client’s performance and its operational environment. Based on this
information the rating may be affirmed, upgraded or downgraded. Any
changes will, however, be informed to the public.
451
TYPES OF CREDIT RATING

The rating services in the international markets can be classified into Shadow
Rating, and Formal Rating.
The basic distinction between these two types of ratings is that the shadow rating
is an indicative rating and will give the issuer an idea of its formal rating and
suggests if it would be beneficial to go for a formal rating.
SHADOW RATING
The issuer will not have to disclose the rating to the public.
The firm can, either independently or with the help of its investment banker, assess
its shadow rating by proceeding in the following manner:
i. After collecting the relevant information, various financial ratios used by
rating agencies can be computed.
ii. Identify companies with similar projects having published ratings. The
financial ratios of these companies can be used for comparison.
iii. Apart from these financial ratios, assess the management quality,
performance of parent/group companies.
iv. Give more weightage to those factors/information that have a major impact
on the performance of the company. Based on this also identify the strengths
and limitations of the firm.
v. Use the ratings of the industry averages, other companies with similar
projects and assign an indicative rating.
vi. To this indicative rating apply the sovereign limitations to get the final
indicative rating. This rating should preferably be in the form of a range and
not as a specific rating.
FORMAL RATING
The issuer will have to announce the rating assigned in Formal Rating to the
public. The process involved in formal rating will be more detailed than the
shadow rating process, since there will be a need for more disclosures, and
sometimes even plant visits may be involved in it. Further, the shadow rating will
not require any annual fee and meetings. While on the other hand, since formal
rating will involve monitoring, there will be an annual fee for such ratings. In
addition to this there will also be annual meetings.
The information that a rating agency would be looking for while providing formal
ratings will include the following:
Financial Data: Here the agency would focus on both the current performance
and historical data. With the latest information, key ratios that indicate the credit
position of the company will be assessed and compared with the industry averages.
Supplementing this information will be the financial track record of the company.
This helps in identifying key factors that influence the business.
Financial Projections: By projecting the future financial performance of the
company, the rating agency will be able to assess the credibility of the company.
Financial Support: The extent of support obtained from outside sources,
including parent company, helps in assessing the strength of the company.
Market Position: The rating agency assesses the market position of the company
within the industry and studies its plans to maintain or expand its market share.
Management: Information relating to the role and responsibility of senior
management and their background will also be sought.
Business Environment: The rating agency collects information on the industry
outlook and assesses the factors influencing the business environment.
452
Credit Rating
In addition to the above classification depending upon what is rated, the ratings
can also be classified into the following types:
i. Security Rating
• Debt/Bond Rating: Rating the bonds or debt securities by a company,
governmental or quasi-governmental body is called bond rating. This
occupies the major business of credit rating agencies.
• Equity Rating: The rating of equity issued in the capital market is
called equity rating.
ii. Individual/Borrower Rating
This includes rating a borrower to whom a loan/credit facility may be sanctioned.
iii. Sovereign Rating
This includes rating a country as to its creditworthiness, probability of
default, etc.
DEBT RATING
Based on the period involved in repayment of the debt obligations, the debt
instruments could be classified into long/medium/short-term debt instruments:
i. Long-term Debt Instrument: Debt obligations for a period of more than
three years are known as long-term debt instruments. They are
Debentures/Bonds and Preference shares.
ii. Medium-term Debt Instruments: Medium-term obligations range for a
period between 1-3 years. The method of raising such funds will either be a
debt issue or through the “Fixed Deposit” program of the companies.
iii. Short-term Debt Instruments: Debt obligations for a short period payable
within one year or less than one year are covered under money market
instruments. They are Commercial Papers and Certificate of Deposits.
Regulatory Requirements
The following guidelines are applicable for the issue of fully convertible
debentures (FCDs), partly convertible debentures (PCDs)/and non-convertible
debentures (NCDs):
a. Compulsory credit rating is required if conversion is made for FCDs after 18
months.
b. In case of NCD/PCD credit rating is compulsory where maturity exceeds 18
months.
c. Before roll over of NCDs or non-convertible portion of PCDs, fresh credit
rating shall be obtained within a period of 6 months prior to the date of
redemption and communicated to debenture holders before roll over.
d. The rating of commercial paper and fixed deposit is also compulsory.
The rating process of debt instruments commences at the issuer’s request. Based
on the tenure of the instruments, the rating agency will gather the requisite data. The
rating methodologies of long/medium/short-term debt securities are discussed here.
453
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The key parameters taken into account while rating a debt instrument are as
follows:
I. Industry Evaluation – This involves an evaluation of the following:
• General profile of the industry, major competitors, extent of
competition, growth potential and trend of development both domestic
and international.
• Demand and supply position of the product, existing installed and
licensed capacities, capacities in the pipeline.
• Position of import and export, technological developments, price trends,
availability, source, quality and prices of major inputs.
• Government policies and regulations affecting the industry and other
major problems and constraints.
II. Unit Evaluation – This company level evaluation involves an assessment of
the following:
• Position of the unit in the industry, market share, competitive edge,
major strengths and weaknesses.
• Product range and quality, market segmentation and seasonality and
market, marketing strategies, channels and network.
• Future program, goals and targets. Product range and portfolio
diversification, need, scope and prospects of diversification and
expansion.
• Group/associate company performances, support and synergy.
III. Technical Evaluation – The technical competence of the company is
assessed by focusing on the following:
• Level of technology, operative efficiency of the plant, vintage of the
plant and level of maintenance.
• Need and plan for modernization and debottlenecking.
• Competence and support of technical collaborators, terms of
collaboration, royalty and buy-back.
• In-house expertise and expertise for absorption of technology.
• Efforts for skill development and productivity improvement.
• Locational advantages and disadvantages and infrastructural facilities.
• Yield analysis, extent of rejection at different stages including quality
complaints by the customers.
• Protection against hazards and other natural calamities.
IV. Financial Evaluation – The financial strength of the client is assessed by
examining the following aspects:
• Accounting policies, extent of disclosures, inventory valuation,
depreciation and other provisions, revaluation of assets, management of
assets and liabilities, asset quality, contingent and off balance sheet
liabilities.
• Auditor’s reports and Director’s report.
• Capitalization trends and policies.
• Cash flow trends and potential, future projections and underlying
assumptions in respect of profitability and liquidity management.
454
Credit Rating
• Return on capital employed, interest coverage, debt-service coverage

and fixed assets coverage.
• Practice of debt servicing, requirement of future debt servicing, major
fund commitments and overall liquidity.
• Financial flexibility, unutilized borrowing potential, standing in the
capital market, capability to raise resources and to absorb debts.
• Working capital management, control over receivables and inventory.
• Budgeting and cost control system.
• Sensitivity to changes in interest rates, tax rates and exchange rates,
hedging of risks.
V. Statutory Evaluation – The statutory status of the company will be evaluated
in the following manner:
• Compliance status in respect of Government regulations and directives
effecting the industry/unit, position of obtaining approvals and no
objection may be necessary.
• Terms of issue, debenture trustees, and trust deeds. Securities and
charges created over assets.
• Pending disputes by and against the concern.
• Practices regarding payment of statutory dues.
VI. Management Evaluation – The evaluation of the company’s management
will aid in assessing the willingness of the borrower to repay. The aspects
involved in such evaluation are:
• Shareholding pattern and controlling interest.
• Composition of the Board of Directors.
• Organizational profile, adequacy and quality of organizational set-up,
extent and effectiveness of delegation.
• Competence and integrity of management and its capability to face
crisis.
• Policies and practices regarding recruitment, training, motivation and
career planning of employees.
• Style of management functioning, approach and outlook, organizational
culture, employee morale and industrial relations.
• Management information and monitoring system.
In addition to the above mentioned parameters, the rating analysis of debt
instruments issued by finance companies may include the following parameters:
i. Regulatory and Competitive Environment Analysis – Affect of changes in
regulatory structure on the operations of the finance company.
ii. Fundamental Analysis – The fundamental issues that need to be evaluated
are:
• Assessment of the net worth and the capital adequacy of the finance
company.
• Details relating to the sources of finance, cost of funds, maturity of the
sources, etc.
• Analyzing the credit exposures to individuals/corporates, etc., and
examining the quality of credit risk management.
• Maturity matching process of assets and liabilities and the liquidity
management techniques.
• Track record of profits, spreads maintained, non-interest income, etc.
455
• Exposure to interest rate fluctuations and hedging mechanism.

• Revision of tax laws and the sensitivity of the company to such changes.
While the above credit analysis generally applies to long and medium-term debt
paper, the criteria for short-term debt paper will be slightly different. Discussed
below is the rating process of commercial paper.
COMMERCIAL PAPER RATING
Commercial Paper (CP) is a short-term, high quality, negotiable money market
instrument in the form of promissory note having fixed maturity and evidencing
short-term debt obligations of the issuer at interest rate that is freely negotiable. It
is a reliable source of short-term borrowings. Company accepts deposits through
use of commercial paper as an additional source of finance.
Regulatory Requirement
Credit rating is compulsory for issuance of CP, as per the RBI guidelines. The
guidelines stipulate the following:
• The company should obtain the specified credit rating from an agency
approved by the RBI for the purpose.
• Minimum credit rating of either A2 from ICRA, P2 from CRISIL, or Ind D-2
from DCR India.
• The rating so obtained should be current and not more than 2 months old.
Evaluation Criteria for Commercial Paper
Credit Rating Agencies (CRAs), offer their opinion on evaluation of CP, of the
issuer’s fundamental credit quality. The analytical approach is virtually identical to
that of rating the debentures or bonds.
The main emphasis in CP rating is liquidity as compared to bond rating.
When the CP matures, the company has to ensure that there is enough balance in
the cash credit account for it to be able to repay the CP, since not all banks may be
willing to reinstate cash credit limits.
Another important consideration is the purpose and the pattern of commercial
paper since rating will depend upon these factors. For example, if CP is used to
meet reasonable working capital requirements, the resultant rating could be higher.
Credit Rating Agencies, throughout the world, including Standard and Poor
suggest that companies should have alternate source of liquidity to support CP
program.
Credit Rating Agencies also look into 100 percent back-up credit support for CP
outstanding. This percentage could be lower for highest credit quality
companies. Issuers credit strength and its access to capital market are also
considered by credit rating agencies. Back-up finance could be in the form of
bank credit facilities like lines of credit specifically designated for the back up of
commercial paper. Back-up arrangements do not allow investors’ confidence to
shake up during such developments like bad business conditions, law suit or
litigation, management changes, rating change, because they protect investors’
interest against risk of default under the above circumstances. CRAs verify
bank’s commitment in writing, in this regard. Revolving line of credit may
provide flexibility in payback arrangements. Credit back-up should be arranged
from reputed and recognized financial institutions or banks to ensure credit lines
immediately and fully accessible to provide timely repayment of maturing paper.
Back-up must be sufficient to provide the appropriate level of coverage for other
maturing short-term debts also, along with commercial paper, which are
coinciding for payment with commercial paper maturity. In the USA, CPs are
456
Credit Rating
backed by Letters of Credit (LOC) from reputed creditworthy banks. Rating for
CP is kept under continuous surveillance under an agreement entered into
between the CRA and the issuer. The company issuing CPs is also under
obligation to provide continuous flow of information to CRA. The company
requesting rating for CP should submit all necessary data including the certified
copy of resolution of the commercial paper authorization given by the
company’s Board of Directors.
Standard and Poor have distinguished the issuers of CP as private sector
companies and public sector companies. Private sector companies are required to
have bank line in support of CP, whereas in case of public sector sovereign
guarantees are more important in addition to bank support, unless they can prove
their liquidity is overwhelming.
In the Indian context, banks are not permitted to sanction standby facilities for
repayment of CP. The company will have to apply afresh for restoration of
working capital limits.
Key Ratios for Rating Commercial Paper
Some of the key ratios that are generally looked into, while rating a commercial
paper are:
• Pre-tax interest coverage,
• Pre-tax interest and full rental coverage,
• Cash flow/long-term debt (%),
• Cash flow/total debt (%),
• Pre-tax return on average long-term capital employed (%),
• Operating income/sales (%),
• Long-term debt/capitalization (%),
• Total debt/capitalization including short-term debt (%),
• Total liabilities/tangible shareholders’ equity and minority interest (%).
As per S&P’s opinion there is some similarity between CP and bond rating.
Minimum credit quality associated with “A-1” CP rating is equivalent to an
“A+” bond rating, “A-1” CP rating has equivalent bond rating as ‘A’, for ‘A-2’ it
is BBB, for “B” it is BBB–, and for B it is BB+. Weaker the CP rating, stronger
should be the back-up finance in the form of revolving credit arrangements.
EQUITY RATING
Risk is an integral element of the financial business. While there can rarely be a
zero risk situation, there can, however, be several ways in which risk minimization
or even risk credit rating comes to play an important role as a signal for risk
assessment. Ratings are used primarily by investors to assess the risk level and
hence to optimize risk-return trade off. As credit rating is primarily assigned to
identify risks which may be worth avoiding and those risks worth taking, equities
are not assigned any rating.
However, one professional debt rating agency Investment Information and Credit
Rating Agency (ICRA), has ventured into rating equities, which it prefers to call
equity grading.
A separate division within ICRA, christened as Earnings Prospects and Risk
Analysis (EPRA) Group, has set itself to do two not entirely unrelated tasks –
grading for the primary market and assessment for the secondary market. Grading
is undertaken at the instance of the issuer and assessment at the instance of the
investor – the latter is better known as equity research.
457
ICRA’s grading is grouped into four categories – ERA, ERB, ERC and ERD – in
descending order of earnings prospects viz., excellent, good, moderate and poor.
Each has three sub-grades correlated with a degree of risk, measured as high,
moderate and low.
These gradings are depicted in the table given below:
+ A" / A" +
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• A 6+ / A ? ).
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• A 9+ ? A ? ).
Source: www.ICRA.com
Certainly, the concept of equity rating is not new, since many investment
magazines have been doing it by way of assigning scores to capital issues. But
what is new is that a professional rating agency has undertaken the task.
In debt rating, one is naturally concerned with the ability of an enterprise to service
its debt. But with that logic, it should be able to predict the default risk. Such a
concept does not hold true for equity, as expectations of earnings will vary
between the investors depending on their risk profile. But ICRA has strongly
defended this criticism saying that its range of twelve grades would effectively
take care of different risk profiles and in any case, it is not an invitation to
subscribe, but an information, which can be used at the discretion of the investor. It
further substantiates through an example, for instance, ERA 3 categorizes an issue
like this: investors can avail of a solid professional opinion on the risk related
earnings potential of an issue. So, the investor can at least know what he is getting
into. He has at his disposal the opinion of a professional body.
According to ICRA, the information it disseminates to the investors is superior to
any other, as it does not take a ‘position’, in the issue. It has no axe to grind. Apart
from this, ICRA is not targeting ‘buy today, sell tommorrow’, kind of investors,
but those who look for long-term returns. Though the grading is done at the
instance of the issuer, the merchant banker may well insist on it. In the absence of
458
Credit Rating
the Controller of Capital Issues and the obsession with high premium, equity
grades could well serve as a benchmark. This can probably improve the
negotiating skills of the merchant banker with the issuer who may insist on a
higher price than what the merchant banker feels comfortable about. It, thus, can
definitely improve the comfort level of the merchant banker. If the merchant
banker can ask for the grading before accepting the assignment, it can be an
extremely useful piece of information for obvious reasons.
Another reason for acceptability of EPRA is that the merchant banker cannot
himself undertake a comparable task. The reason is that the kind of research which
is at present undertaken by merchant bankers relates basically to marketing an
issue and there are only a handful of merchant bankers with a good research base.
They too would prefer to use equity grading as a second opinion, which either
confirms their own analysis, or adds value to it.
EQUITY GRADING PROCESS
The Equity Grading process commences at the request of the prospective issuer
and on receipt of the required information from the issuer and culminates in an
opinion from CRA expressed symbolically as an equity grade. A team of analysts
take up the work of collection of data and information from the books and records
of the company and meet with its executives. One of the goals of these meetings is
to provide the management the opportunity to explain its business and strategies to
the analysts. The support of in-house research and database of the CRA as well as
industry studies of reputable agencies are also availed of.
After interacting with management and analyzing the data, the analysts present
their findings to a Committee which then takes a decision on the relative Equity
Grade of the issuer. The process normally takes three to four weeks from the
time of receiving the required data from the management. The information
which is provided by the company to the CRA is on a confidential basis and
shall not be publicly shared. The issuer also has an option regarding use of the
grade. However, once the issuer decides to use the grade, the CRA monitors the
working of the company on a continuous basis. Based on the information
obtained from the company, or collected by the CRA on its own, during that
period, the Equity Grade may be changed suitably. The CRA reserves the right
to make such Equity Grade/change in Equity Grade, public.
EQUITY ASSESSMENT
The equity assessment process commences at the request of an investor and the
consent of the company being assessed. The CRA may or may not disclose the
investor’s identity to the company depending upon the investor’s preference. The
rest of the assessment process is similar to the Equity Grading process, except that
the end result is not in the form of a symbol but an assessment report specific to
the investor’s need and intended to be used by the investor only.
Methodology
The CRA analyzes and appraises all relevant factors that have a bearing on the
equity quality of the issuer/company. The key factors looked into depend on the
nature of the issuer company.
The opinions are based on an in-depth study of the economic and industry/business
environment, competence and effectiveness of management, promoters’ profile,
marketing strategies, size and growth of revenues, competitive edge, state of
technology, operational efficiency, liquidity, financial flexibility, asset quality as
also the accounting quality profitability and the hedging of risks. These factors
further suggest the level, growth and composition of earnings as also the financial
strength which may be expected in future.
459
Benefits to Issuers
The CRA’s opinions help the issuing company to broaden the market for their
equity. As the company’s brand image is replaced by objective opinions, the lesser
known companies are also able to access the equity market. Moreover, Equity
Grading/Equity Assessment may help in stabilizing issuers’ access to the equity
market in unfavorable market conditions.
Value to Investors
Equity Grading/Equity Assessment gives to the market participants a timely
access to independent, unbiased and dependable opinions on equity quality in a
user friendly manner and therefore, help investors design their portfolios by
choosing investment options in the equity market according to their profile and
preferences.
In a country like India where quantitative obsessions like EPS and P/E factor are
given more weightage, the CRA’s qualitative indicator could bring in a degree of
freshness. But it may involve a lot of time elaborating and explaining the system of
grading, so that the average investor becomes aware of its meaning and gets
convinced of a practice which is not prevalent.
Grey Areas in Equity Grading
Large or small, if merchant bankers more than issuers warm up to equity grading
offered by ICRA, we could be in for a totally different retailing of equity. SEBI
has passed on the responsibility of vetting the prospectus to the merchant banker.
Equity Grading could then be in a better position.
However, there appear to be certain issues which equity grading may highlight.
Some of them could be as follows:
• Equity grading should be done. But who should do it? Many experts argue
that it should not be done by a credit rating agency, but by merchant bankers.
• Another question is that of the issue price. Is the grading a qualification of
the issue price? In which case, does it not amount to an encroachment on the
merchant banker’s territory?
• In the case of projects, which have been appraised by the financial
institutions, what specific value addition can equity grading provide?
Considering that financial institutions make their own assessment of business
projections, can the CRA still make a contribution?
• As the issue has to be understood as being determined by the market, can the
market conditions be ignored? Will the merchant bankers welcome equity
rating and make use of it?
• Considering the fact that small issues are not cost-effective, will the smaller
issues be graded? Only large issues can go for grading, which means that
only large merchant bankers will make use of it.
Due to the issues raised above, the market perception towards equity grading did
not seem to be positive. The sole equity grading service offered by ICRA could not
take-off due to this.
IPO GRADING
IPO grading has been introduced as an endeavor to make additional information
available for the investors in order to facilitate their assessment of equity issues
offered through an IPO. It is the grade assigned by a Credit Rating Agency
registered with the SEBI, to the initial public offering (IPO) of equity shares or any
other security which may be converted into or exchanged with equity shares at a
later date. The grade represents a relative assessment of the fundamentals of that
460
Credit Rating
issue in relation to the other listed equity securities in India. An IPO grade is NOT
a suggestion or recommendation as to whether one should subscribe to the IPO or
not. IPO grade needs to be read together with the disclosures made in the
prospectus including the risk factors as well as the price at which the shares are
offered in the issue. This grading is generally assigned on a five-point scale with a
higher score indicating stronger fundamentals and vice versa:
• IPO grade 1: Poor fundamentals.
• IPO grade 2: Below-average fundamentals.
• IPO grade 3: Average fundamentals.
• IPO grade 4: Above-average fundamentals.
• IPO grade 5: Strong fundamentals.
IPO grading can be done either before filing the draft offer documents with the
SEBI or thereafter. However, the Prospectus/Red Herring Prospectus, as the case
may be, must contain the grade/s given to the IPO by all CRAs approached by the
company for grading such IPO. The expenses incurred to grade the IPO is born by
the company desirous of making the IPO. Grading the IPO is not optional. A
company which has filed the draft offer document for its IPO with the SEBI, on or
after 1st May, 2007, is required to obtain a grade for the IPO from at least one
CRA.
The IPO grading process is expected to take into account the prospects of the
industry in which the company operates, the competitive strengths of the company
that would allow it to address the risks inherent in the business(es) and capitalise
on the opportunities available, as well as the company’s financial position. While
the actual factors considered for grading may not be identical or limited to the
following, the areas listed below are generally looked into by the rating agencies,
while arriving at an IPO grade.
• Business Prospects and Competitive Position:
i. Industry Prospects
ii. Company Prospects
• Financial Position
• Management Quality
• Corporate Governance Practices
• Compliance and Litigation History
• New Projects – Risks and Prospects
It may be noted that the above is only indicative of some of the factors considered
in the IPO grading process and may vary on a case to case basis. Moreever, IPO
grading is done without taking into account the price at which the security is
offered in the IPO. Since IPO grading does not consider the issue price, the
investor needs to make an independent judgment regarding the price at which to
bid for/subscribe to the shares offered through the IPO.
INDIVIDUAL CREDIT RATING (ICR)

With liberalization in full swing, loans for cars and white goods are freely
available at the right price for India’s 200 million strong middle class. Today there
is no stigma attached to a loan for acquisition of status goods. The consumer
finance market is on boom and with it, the need to rate or assess an individual in
order to avoid the risk of default, is all the more necessary. The presence of so
many consumer finance companies like Countrywide is an indication of growing
need for consumer finance and with it the individual rating.
461
Individual Credit Rating (ICR) is an objective assessment of the risk attached to a

financial transaction with respect to an individual at a given point of time, based
on the quantification of parameters influencing credit risk. There is need for credit
rating of individuals who not only borrow from banks, but also from various other
creditors. Unlike companies, the risk perceptions are different in case of
individuals.
The lack of a proper legal framework concerning registration and hypothecation
of durables, implies that the consumer finance companies have to scrutinize
applications. This is where individuals’ ratings are poised to play an important
role. Individual credit rating is necessary in countries like the US and the UK.
No loan is sanctioned to an individual without a certification from a rating
agency. This system ensures that the same individual does not, on the strength of
a mere salary statement, gets finance from different agencies.
General Eligibility Criteria
Equifax Inc. of the US and ONICRA set-up by Onida Finance intend to make
individual ratings. However, the cost of such ratings and its authenticity will
be the prime consideration before a finance firm engages the services of such
outside agencies. Banks and financial institutions with their in-house appraisal
may not take kindly to an outside agency. In spite of these things, the finance
for consumer durables is extended only after proper authentication of
documents such as salary statements or income tax returns in case of self-
employed individuals.
Some of the factors generally looked into include:
• Duration of service
• Nature of service
• Income of the spouse
• Details of investments and property
• Past credit record, etc.
Greater preference is given to employees of a government entity or a public
limited company. Existing customers of a bank also get priority treatment.
ONICRA’s Model
Onida Individual Credit Rating Agency (ONICRA), a subsidiary of Onida Finance
was launched by Onida to give rating to the individuals.
ONICRA’s methodology is something different. To begin with, an individual
cannot approach ONICRA directly. It is the finance firm that will insist on its
customer obtaining an individual credit rating to reduce its risk exposure. Thus,
ONICRA signs tie-ups with several finance firms. Service charges will depend
upon the nature of assignment. Rating for the purpose of a credit card will be
charged on a case-to-case basis, depending upon the nature of work involved.
Tie-ups with several finance companies will ensure that rating of consumer
finance is charged on a monthly retainership basis. On the other hand, for
housing finance, where the loans sanctioned are larger in size and of a longer
duration, the fees will vary depending on the exposure taken by the housing
finance company. After obtaining and cross checking the information and
documentary evidence furnished, the rating process begins. The information is
fed into an automated credit rating model and the rating generated is sent back to
the finance company.
462
Credit Rating
Methodology
The three vital parameters adopted at ONICRA are the individual, the transaction
and the environment. The flow is depicted below:
Figure 1: ONICRA’S Model
Source: QMM, Aug-October, 1995 (Business Standard)

By adopting a top-down approach, the broad parameters are successively broken
down into focused sub-divisions, which minimize biases that arise in performing
the credit assessment of individuals. For example, the parameter “individual”, has
been subdivided into potential, capability and strength. The parameter ‘transaction’
has been broken-up into risk and mode of payment and finally, the environment
factor concentrates on the economic viability.
Various characteristics also play a determining role in the rating process.

Qualifications of a person, for instance, will be evaluated on various points such as
discipline, earning potential, mobility and even concern for reputation in society.
Each parameter also has a certain weightage associated with it. For example,
income would have a greater bearing on credit rating, than the place of residence.
Information collected and evaluated about an intricate network of parameters
ultimately determines the rating.
463
Advantages of ONICRA’s Individual Credit Rating

i. One of the main problems associated with consumer finance is that of bad
debts. More than 20 percent of the sales become bad debts due to customer
default. Unlike automobile finance, the recoveries for consumer durables are
possible only after prolonged civil suits. Besides, dealers are unwilling to
take any financial risk on the clients they recommend. In such a situation, the
credit rating of individuals provides scope to minimize risk of default. This
can, in turn, provide buoyancy to consumer finance companies.
ii. Determining the willingness and ability of the borrower to pay can be
assessed properly.
iii. Getting durables or any other products on loans/installments becomes easy to
borrowers, especially the middle class families.
iv. Rating of individuals by an outside agency, like ONICRA would be less
expensive than employing a team of personnel by banks to get each credit
appraisal. Today, a finance company is engaged in a variety of activities and
one of them is consumer finance. By utilizing the services of independent and
specialized credit rating agencies, finance firms can concentrate on other
areas of business activities and maximize their returns.
Disadvantages
i. It is not clear how the entire process will evolve. Unlike corporate ratings,
which are directly sought by a corporate before a public issue of debt,
individuals cannot approach ONICRA directly to obtain a rating. Also, it is
relatively easy to rate corporates owing to the availability of audited balance
sheets, market data about suppliers and customers, the industry scenario and
the quality of management. Individual credit rating requires a different
approach.
ii. The crucial issue in India is how much information individuals will
voluntarily disclose. The Indian laws do not allow access to information
needed for accurate rating. Obtaining information even from government
authorities such as the tax department will be difficult.
Can Banks Take-up Individual Credit Rating?
While making advances, banks do not rely on the credit ratings of other agencies,
but make a detailed credit appraisal of the proposals as per their lending norms to
assess the need for facilities and viability for repayment. All bank branches are
best suited for the credit rating of individuals who keep accounts in the branches.
The branches of banks have adequate information about their depositors and
greater details about their borrowers. A major segment consists of individuals. The
modus operandi could be like this:
Every individual should be given a Credit Rating Card (CRC) by the branch,
where he/she has an account. No bank branch should give a CRC to a person not
holding an account in that branch. This principle has its own advantage and will
prevent the misuse of CRCs. Whether it is the bank or the outside agency,
maintenance of individual files is a must. The file contains collection of all details
about the individual to work out his net worth. Copies of ration card, gas
connection card, passport identity card, etc. must be filed-in besides details of
assets and liabilities. Income Tax, Sales Tax and Wealth Tax assessment orders
besides financial statements, if any, should also be collected and kept in the file.
The net worth is worked out by deducting total liabilities from total assets. The net
464
Credit Rating
worth with previous annual income as against projected yield should determine
the level of credit entitlement for an individual in cash or in kind to repay with
interest. The ICR could also take into consideration the status of the relatives of
the individual, his educational background, his reputation in his field and reference
letters from two respectable persons in the society.
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Source: Chartered Financial Analyst, July 2001, pages 33-35.

UTILITY OF ICR
The concept of individual credit rating is useful for personal transactions like
credit card membership, leasing and hire purchase, housing finance, trade
advances, consumer durable financing and personal bank loans. But the rating may
not be so refined and sophisticated as in the case of companies, where the required
information for the rating exercise will be easily available.
The agencies which extend credit to individuals are banks, finance companies who
have expertise in credit assessment. Hence, the rating by an agency may not be of
great value unless it is found that it is more cost-effective. If the rating agency has
a large database so as to provide instant service, then the service may become
attractive to the lender. However, it is a big question mark whether the services
can be cost-effective. Though the concept was introduced a few years back it has
not taken-off since the entire NBFC segment underwent a painful transition and
the credit rating agencies have not taken up individual credit rating.
SOVEREIGN/COUNTRY RISK RATING
Developing nations lack financial resources. Meagre funds available at their
disposal are to be deployed sagaciously to earn better returns. These nations have
another alternative in the form of mobilizing financial resources through foreign
investment. Any company or financial institution willing to start its subsidiary unit
in a foreign country or any investor willing to invest in a foreign company would
generally look forward for the safety of their investments. Therefore, to motivate
savers to invest in industry and trade in their countries the general climate
encompassing social, political, economical and financial spheres should be
conducive to investment. It is only when the savers have developed confidence in
the country’s climate, they would invest their savings. Safety of their investment
can be pre-assessed, if the country’s economic, social, political and financial
position can be evaluated through a reliable agency. This is done through
sovereign or country risk rating.
The term “country risk” is often used interchangeably with the terms political
risk and sovereign risk. However, country risk is really a broader concept than
466
Credit Rating
either of the two, including them as special cases. Country risk involves the
possibility of losses due to country’s specific economic, political and social
events, and therefore political risk is in a way a subset of country risk. Sovereign
risk involves the possibility of losses of claims to foreign governments or
government agencies, whereas political risk involves the additional possibility of
losses on private claims as well as on direct investments. Sovereign risk exists
on bank loans and bonds.
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Sovereign borrowings involve both local and foreign currency borrowings. The
government control over the resources available in the financial system will affect
the servicing ability of its local currency borrowings. On the other hand, the
government’s foreign exchange position will influence its ability to repay foreign
currency loans.
Rating agencies, such as Standard and Poor, Japan Center for International Finance
(JCIF), and the London-based Economist carried out periodical studies of the
creditworthiness of various countries. Lenders and exporters use such reports to
467
fine-tune the rates at which funds are made available to the borrowing countries
and to add clauses of varying stringency in the export sales agreements. The higher
the risk associated with a country, the higher the margin charged above the
benchmark rates such as the LIBOR (London Inter Bank Offered Rate) or the
long-term prime rate at which financial institutions are willing to lend or borrow at
a particular point of time.
METHODOLOGY
The Economist follows the explicit judgment approach in sovereign rating. The
explicit judgmental approach broadly involves the following steps:
i. The set of factors, deemed relevant for rating purposes, is clearly defined.
ii. The weights assigned to these factors are specified.
iii. A quantitative assessment is made of the rated entity on each of the factors.
iv. A numerical credit score or index is arrived at, on the basis of the weights
and quantitative assessments.
The factors considered and the maximum points assigned to each of these factors
are given in Table 4. For each country, a score is assigned for each factor within
the range of zero and the maximum possible points. The score for all the factors
are added to get the aggregate risk score and higher the score, the greater is the risk
associated with the country. The countries, based on the risk scores, are also
classified into: Hyper-risk, Very high risk, Medium risk and Low risk, categories.
According to JCIF, an “A” rated country is fully capable of servicing existing debt
and will be able to continue to do so for the next four years. It will be able to meet
any fresh fund requirements. The “B” rated countries are also fully capable of
servicing the existing debt, but while “A” rated countries have the capacity to
service a higher level debt than the existing, the same cannot be said of “B” rated
countries. The “C” rated countries are also capable of making current debt
payments, but could have borrowing or debt servicing problems, if global financial
conditions change. Countries which would have imminent financing problems are
rated by JCIF as “D”, and those countries which have already run into problems in
servicing their external debt are rated as “E”.
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Credit Rating
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The Measurement of Country Risk
Among the country risks that are faced on an overseas direct investment, are those
related to the local economy, those due to the possibility of confiscation (which
refers to a government takeover without any compensation), and those due to the
possibility of expropriation (which refers to a government takeover with
compensation, which at times can be generous). Apart from the political risks of
confiscation and expropriation, there are political/social risks of wars, revolutions
and insurrections. While these are not the result of action by foreign governments
specifically directed at the firm, they can damage or destroy an investment. In
addition, there are risks of currency convertibility and restrictions on the
repatriation of income.
Key Factors Considered in S&P’s Sovereign Rating
Different variables need to be considered while rating a government’s local and
foreign currency debt. The key economic and political risk factors considered by
Standard and Poor while rating local currency debt are as follows:
Stability of Political Institutions: The decision-making relating to the various
economic policies aimed to bring about progress depend on the stability and the
level of participation of the government in the economic progress.
Economic Structure: This factor is essential since a free market economy enables
decentralized decision-making where the market forces play a key role, while in a
closely regulated economy, the government will be playing a key role in various
economic factors viz., interest rates, etc.
Fiscal and Monetary Policies: The purpose and the magnitude of the public
sector borrowings and its implication on inflation are the aspects related to fiscal
policy that may have a major influence on the government’s ability to service
public debt. Government may further, with its monetary powers mobilize funds for
deficit financing. However, heavy monetization of budget deficits will increase
the public debt burden of the government which may adversely affect its sovereign
creditworthiness.
469
Inflation: Apart from affecting economic progress, price rise may also lead to
political problems/ instability. To evaluate the inflationary pressures, S&P assesses
the inflation using the past behavior. Other factors that are considered here are
total borrowings of the government, the maturity structure of public debt, future
borrowing programs and the ability of the central bank to check fiscal imbalances.
Apart from the above-mentioned factors, the performance of the country’s
financial markets are also examined by S&P while conducting local currency
debt-rating.
While rating the foreign currency debt obligations of a country, S&P considers
most of the factors used while rating local currency debt. Other than these, it also
focuses on the following:
Balance of Payments (BoP): A nation’s BoP situation should be adequate and
should sustain any risk that might arise so as to enable the government to service
its debt. Changes in domestic and foreign environments influence the BoP. To
prevent any adverse impact on the BoP situation, timely and appropriate measures
need to be taken. Current account vulnerability to any changes in the environment
depend on the structure of the trade and service, the exports and imports,
international competitiveness, etc. On the other hand, flexibility to the BoP
position can be obtained by ensuring greater capital inflows by way of direct
investment in equity and other assets. Capital inflows by way of debt will expose
the country to interest rate, exchange rate and liquidity risks. S&P studies the past
data on the BoP situation and based on the likely policy measures, forecasts the
future trend.
External Financial Position: S&P focuses on the burden of public external debt,
contingent liabilities and the ability of the country’s reserves to service the debt.
The factors affecting external financial position are as follows:
• Net public/private external debt – Total public/private debt less public/private
sector financial assets.
• The invisible assets/liabilities, which have one way movement.
• Direct and portfolio equity investments.
Net external liabilities on the economy and comparing them against the positive
balances of net public and private transfers, exports, etc. Other considerations
involved while examining the external financial position include the policies
relating to currency convertibility, exchange rates and the accessibility to
concessional/market related foreign credit.
Economic and Political Prospects: The debt servicing ability of a nation is
strongly influenced by its economic and political prospects. The economic plans of
a nation are reviewed in the light of the various constraints, both internal and
external. By forecasting the economic scenario, the future borrowing requirements
of the nation are assessed.
COUNTRY RISK AND DISCOUNT RATES
Let us define CFt as the cash flow if confiscation (which refers to a government
takeover without any compensation) does not occur, and let us assume that
confiscation risk is the only risk and that the probability that complete confiscation
will occur in any year is a constant. We shall write this probability as P. When P is
the probability that confiscation will occur, 1 – P is the probability that it will not
occur. When 1 – P is the probability that income will continue in each individual
year, the probability that it will continue for two years is (1 – P)2, and for t years it
is (1 – P)t. For example, if there is a 0.95 probability of non-confiscation in any
individual year, the probability of non-confiscation for two years is 0.90 i.e.
470
Credit Rating
0.95 x 0.95. With CFt as the cash flow, if the investment has not been confiscated,
the expected cash flow, in year t adjusted for the probability that the investment
will survive is:
(1 – P)t CFt ... (1)
We see from this expression that because CFt is the cash flow if the investment is
not lost, the expected cash flow that is adjusted for the probability of losing the
investment is the smaller amount (1 – P)t CFt. For example, if the expected cash
flow is Rs.100 if confiscation has not yet occurred and the probability of
confiscation in each year is 0.02, then the probability-weighted expected cash
flow in year 5 is (1 – 0.02)5 x 100, i.e. Rs.90, and in year 10 it is Rs.82.
If we assume that the cash flow is a constant, CF, the expression (1) can be written
as follows:
T (1 − P) t CFt T (1 − P) t
V= Σ = CF Σ ... (2)
t =1 (1 + re ) t t =1 (1 + re ) t
where, V is the expected cash flow and re is the discount rate for cash flows,
assuming all equity financing. Let the summation
T (1 − P) t
Σ
t =1 (1 + r ) t
e
which is a geometric series be ‘G’. By expanding it we get,
(1 − P) (1 − P) 2 (1 − P) T
G= + + ....... + ... (3)
(1 + re ) (1 + re ) 2 (1 − re )T
(1 − P)
Multiplying both sides of the expression (3) by , we have
(1 + re )
(1 − P) (1 − P) 2 (1 − P)T 1 − P)T +1
xG= + .......... + T
+ ... (4)
(1 + re ) (1 − re ) (1 + re ) (1 + re )T +1
Subtracting expression (4) from expression (3), we get:
(1 − P) (1 − P) 1 − P)T +1
G 1− = −
(1 + re ) (1 + re ) (1 + re )T +1
As T approaches infinity on a project with an infinite life, we find that:
(re − P) 1−P
G=
(1 + re ) 1 + re
1−P
G=
re + P
We can, therefore, write equation (2) as follows:
CF (1 − P)
V=
(re + re )
As T approaches infinity, we find that we can allow for country risk by

multiplying the cash flows by the probability that the firm will survive each
year and dividing by the sum of the discount rate and the probability of
confiscation.
471
This can be compared with the value for the constant cash flow without country
risk:
T 1
V1 = CF Σ
t =1 (1 + re ) t
where, V1 is the expected cash flow without country risk. By repeating the method for
summing a geometric series, we get
CF
V2 =
re
INDIAN CREDIT RATING AGENCIES

The Indian economy has come a long way from the crisis years of 1990 and 1991.
Perhaps, the most impressive aspect of the turnaround has been in relation to the
external sector. The substantial improvement both in the trade account and the
invisible account of India’s balance of payments needs special mention. The fairly
substantial inflow of funds under the various investment channels, reflects the
growing confidence of the foreign investors in India. On the whole, the reform
process has begun to yield results. GDP is expected to grow beyond 5%; industrial
production which has been sluggish for the past three years has shown definite
signs of recovery. More and more companies are now raising funds from the
market. Owing to this, the role of the credit rating agencies also enhanced.
In India, the credit rating service is offered by four agencies which include:
i. The Credit Rating Information Services of India Ltd. (CRISIL)
ii. Credit Analysis and Research Ltd. (CARE)
iii. Investment Information and Credit Rating Agency of India Ltd. (ICRA)
iv. Duff and Phelps Credit Rating India Pvt. Ltd. (DCR India)
v. ONICRA Credit Rating Agency of India Ltd.
The services offered by these agencies and their ratings for various securities are
discussed below:
CREDIT RATING INFORMATION SERVICES OF INDIA LTD. (CRISIL)
CRISIL was the first credit rating agency established in India during 1987. It is
being promoted initially by ICICI, UTI, HDFC and its shareholders include ADB,
LIC, GIC and some nationalized and foreign banks. In 1993, CRISIL made its first
public offer of equity.
Objectives of CRISIL
• To assist both individual and institutional investors in making investment
decisions in fixed income securities.
• To enable corporates to raise funds in large amounts and at fair cost from a wide
spectrum of investors.
• To enable intermediaries in placing their debt instruments with investors by
providing them with an effective marketing tool.
• To provide regulators with a market-driven system for bringing about
discipline and healthy growth of capital markets.
472
Credit Rating
Rating Services
Services offered by CRISIL as a credit rating agency include:
– Corporate bond ratings
– CP ratings
– Rating Municipal Debt
– Infrastructural bond ratings
– Utilities ratings
– State Government ratings
– Rating of Asset Backed Securities
– Rating of Structured Obligations
– Rating of toll road bonds
– Rating of debt instruments of cellular service providers
– Mutual Funds ratings.
Rating Methodology and Rating Process
CRISIL’s rating methodology includes an analysis of the following risk exposures
of the corporate/borrower:
a. Industry Risk Analysis
b. Business Risk Analysis
c. Financial Risk Analysis
d. Management Risk Analysis
e. Fundamental Risk Analysis.
Figure: CRISIL’s Rating Process
473
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474
Credit Rating
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CREDIT ANALYSIS AND RESEARCH LTD. (CARE)
CARE is a credit rating and information services company promoted by Industrial
Development Bank of India jointly with investment institutions, banks and finance
companies. Its shareholders include IDBI, UTI, Canara Bank, First Leasing
Company of India Ltd., Kotak Mahindra Finance Ltd., etc. It commenced its
credit rating operation in October, 1993. CARE is offering a wide range of
products and services in the fields of credit information and equity research.
Shareholders
CARE credit rating covers all types of debt instruments such as:
• Debentures
• Fixed Deposits (FD)
• Certificates of Deposits (CD)
• Commercial Paper (CP)
• Structured Obligations (SO)
• Convertible Preference Shares (CPS)
• Redeemable Preference Shares (RPS)
• IPO Graders.
CARE also undertakes general Credit Analysis Rating of Companies for the use of
bankers, other lenders and business counterparties. Its rating methodology and
rating process are much similar to CRISIL.
475
Rating Symbols
Long-term and Medium-term Instruments
CARE AAA for (FD)/(CD)/(SO) (CPS)/(RPS)
Instruments carrying this rating are considered to be of the best quality carrying
negligible investment risk. Debt service payments are protected by stable cash
flow with good margin. While the underlying assumptions may change, such
changes as can be visualized are most unlikely to impair the strong position of
such instruments.
CARE AA for (FD)/(CD)/(SO) (CPS)/(RPS)
Instruments carrying this rating are judged to be for high quality by all
standards. They are also classified as high investment grade. They are rated
lower than CARE AAA securities because of somewhat lower margins of
protection. Changes in assumptions may have a greater impact or the long-term
risks may be somewhat larger. Overall, the difference with CARE AAA rated
securities is marginal.
CARE A for (FD)/(CD)/(SO) (CPS)/(RPS)
Instruments carrying this rating are considered upper medium grade instruments
and have many favorable investment attributes. Safety for principal and interest
are considered adequate assumptions that do not materialize and may have a
greater impact as compared to the instruments rated higher.
CARE BBB for (FD)/(CD)/(SO) (CPS)/(RPS)
Such instruments are considered to be of investment grade. They indicate
sufficient safety for payment of interest and principal at the time of rating.
However, adverse changes in assumptions are more likely to weaken the debt
servicing capability compared to the higher rated instruments.
CARE BB for (FD)/(CD)/(SO)
Such instruments are considered to be speculative with inadequate protection for
interest and principal payments.
CARE B for (FD)/(CD)/(SO) (CPS)/(RPS)
Instruments with such rating are generally classified susceptible to default, while
interest and principal payments are being met, adverse changes in business
conditions are likely to lead to default.
CARE C for (FD)/(CD)/(SO) (CPS)/(RPS)
Such instruments carry high investment risk with likelihood of default in the
payment of interest and principal.
CARE D for (FD)/(CD)/(SO) (CPS)/(RPS)
Such instruments are of the lowest category. They are either in default or are likely
to be in default soon.
Short-term Instruments
PR-1
Instruments would have superior capacity for repayment of short-term promissory
obligations. Issuers of such instruments will normally be characterized by leading
market positions in established industries, high rates of return on funds employed, etc.
PR-2
Instruments would have strong capacity for repayment of short-term promissory
obligation. Issuers would have most of the characteristics as for those with PR-1
instruments but to a lesser degree.
476
Credit Rating
PR-3
Instruments have an adequate capacity for repayment of short-term promissory
obligations. The effect of industry characteristics and market composition may be
more pronounced. Variability in earning and profitability may result in changes in
the level of debt protection.
PR-4
Instruments have minimal degree of safety regarding timely payment of short-term
promissory obligations and the safety is likely to be adversely affected by short-
term adversity or less favorable conditions.
PR-5
The instrument is in default or is likely to be in default on maturity.
Credit Analysis Rating
CARE-1
Excellent debt management capability. Such companies will normally be
characterized as leaders in the respective industries.
CARE-2
Very good debt management capability. Such companies would normally be
regarded as close to those rated CARE-1, but with a lower capability to withstand
changes in assumptions.
CARE-3
Good capability for debt management. Such companies are considered medium
grade; assumptions that do not materialize may impair debt management capability
in future.
CARE-4
Barely satisfactory capability for debt management, the capacity to meet
obligations is likely to be adversely affected by short-term adversity or less
favorable conditions.
CARE-5
Poor capability for debt management. Such companies are in default or are likely
to default in meeting their debt obligations.
An instrument’s characteristics or debt management capability could cover a wide
range of possible attributes whereas rating is expressed only in limited number of
symbols. CARE assigns “+” or “–” signs to be shown after the assigned rating
(wherever necessary) to indicate the relative position within the band covered by
the rating symbol.
INVESTMENT INFORMATION AND CREDIT RATING AGENCY OF
INDIA (ICRA)
ICRA has been promoted by Industrial Finance Corporation of India and other
financial institutions.
Objectives
The objective of ICRA is to provide guidance to investors/creditors in determining
the credit risk associated with a debt instrument. It has also formed a group called
Earning Prospects and Risk Analysis (EPRA) to provide authentic information on
the relative quality of equity. This leads to examine almost all parameters
pertaining to the fundamentals of the company including relevant sectoral
perspectives. This qualitative analysis is reinforced and completed by way of the
unbiased opinion and informed perspective of one analyst and wealth of judgment
of committee members. EPRA group offers two services like Equity Grading and
Equity Assessment.
477
Rating Methodology and Rating Process

Earnings Prospects and Risk Analysis is designed to comment upon the relative
inherent quality of equity reflected by the earnings prospects, risk and financial
strength associated with the specific company. These factors in turn are an outcome
of a complex combination of variables which can be broadly categorized as:
• Management quality.
• Industry outlook.
• Corporate operations and competitive character.
• Financial Strength.
Over the medium and long-term, the resource allocative dynamic of the capital
market determines the market performance of the company based on its
fundamentals. Therefore, ICRA’s Earnings Prospects and Risk Analysis guides
longer term investment in a company rather than investment for short-term gains.
By that logic, reliable information on equity quality can enhance the process of
efficient channelization of funds into productive and competitive enterprises.
The rating mechanism of debt instrument is similar to other credit rating agencies,
the method for Equity Grading commences on the requisite of the prospective
issuer and Equity Assessment process commences at the request of investor.
Although the scope of analysis is similar in both grading and assessment, the key
differences are:
• Equity grading is at the request of the issuer whereas equity assessment is at
the request of investor.
• Equity grading imparts greater visibility as it can be communicated to large
number of potential investors whereas equity assessment is for the use of the
specific investor only.
• Equity grading is in the form of symbolic indicator and a rationale whereas
equity assessment is in the form of a report.
• Equity grading is kept under surveillance once the issuer accepts and uses the
equity grade whereas equity assessment is a one time exercise.
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478
Credit Rating
FITCH INDIA RATINGS PVT. LTD

(Previously DCR India)
FITCH India is a joint venture company set up by Chicago based credit raters and
Alliance Credit Capital Company of India.
The company is slowly making its presence felt in the Indian markets. The rating
symbols and their significance as used by FITCH are provided in Appendix III.
FITCH acquired Duff & Phelps business in India, thus changing the name of DCR
India to FITCH India.
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INTERNATIONAL CREDIT RATING PRACTICES
The prime function of a rating agency is to serve investors’ needs while extending
credit. The rating agencies provide them the information on creditworthiness of
issuers of credit instruments in symbolic forms which are the conclusions of their
detailed analysis. Course of action followed by rating agencies in rating an
obligation associated with any credit instrument is alike.
All over the world rating process is similar and is based on the practices
established by the internationally known CRAs in particular, the Standard and
Poor’s Corporation and the Moody’s Investment Services. No doubt, methodology
might differ for different credit instruments, but there is no significant difference
in the rating process.
Both Standard and Poor’s and Moody’s follow more or less the same rating
process for rating new cases or reviewing the rated cases. Steps taken in
completing rating with practices followed by CRAs is as shown in the Flow charts
2-4 and Appendices I to IV.
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Some of the key factors generally considered by the Credit Rating Agencies for the
purpose of rating are:
Business Analysis:
• Industry risk
• Market position of the company
• Operating advantages of the company
• Legal position.
Financial Analysis:
• Accounting quality
• Financial ratios
• Adequacy of cash flows
• Financial flexibility.
Management Evaluation:
• Track record of management
• Crisis management
• Goals, philosophy and strategies.
480
Credit Rating
Regulatory and Competitive Environment:

• Structure and regulatory framework of the financial system
• Trends in regulation/deregulation and their impact on the company.
Fundamental Analysis:
• Capital adequacy
• Liquidity management
• Financial position
• Interest and tax sensitivity.
Rating System
The rating system of the CRAs consists of the instruments they rate and the grades
they assign to the obligations attached thereto.
Credit rating agencies throughout the world have their own rating systems. Credit
Rating Agencies (CRAs) have classified debt obligation for rating purposes
according to their convenience. Given below are the types of rating and
classification of debt obligation of world renowned credit rating agencies viz.,
Standard & Poor’s and Moody’s.
Rating Grades
There are two basic grades adopted internationally as well as domestically by the
rating agencies to demarcate the risk prone and risk free securities viz.,
a. Investment Grade, and
b. Speculative Grade.
a. Investment Grade: Securities which are judged as of best quality are put in
investment grade and are rated high. Such securities carry smallest degree of
investment risk i.e. interest payment is protected by exceptionally stable margin
and principal is secure and any change in the issuers conditions will not disturb
the fundamentally strong positions of such issues and default is deemed to be
unlikely. According to Standard & Poor’s, the issues rated in the four highest
categories “AAA”, “AA”, “A” and “BBB” are generally recognized as being
investment grade. Securities rated below “BBB” are generally referred to as
speculative grade. These grades are enhanced with plus (+) or minus (–)
symbols. “A” is highest rating which reflects issuers capacity to pay interest
and repay principal. Smaller differences in degree are symbolized in lower
symbols range from Aaa to C with designations of 1, 2, 3, to signify position
with the rating category much like S&Ps plus/minus symbols.
According to Moody’s rating, “Aaa” indicates best quality with smallest
degree of investment risk i.e. interest payments are protected by a large or by
an exceptionally stable margin and principal is secure. Changes in the issuer
company are most unlikely, to impair the fundamentally strong position.
Similarly, “Aa” creates a difference by “Degree” i.e. lower than the best
rating because margin of protection may not be as large as in “Aaa” securities.
Designations 1, 2 and 3 attached to rating symbols “Aaa” etc., would indicate
the degrees of difference i.e.
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481
b. Speculative Grade: Instruments which have speculative features are given

different grades to distinguish them from investment grade. Their features are
different, affording lesser protection to payment of interest and principal and
thus are not so well placed to safeguard the interest of the investors. High risk
and future uncertainty is reflected in speculative grade. Symbols are different
for marking speculative grade. There are down grade symbols further to
indicate comparatively more risky investment proposals.
According to the practices followed by S&P, debt rating of BB, B, CCC, CC
and C are regarded as having predominantly speculative characteristics with
regard to payment of interest and principal. Major uncertainties and mass risk
exposure and adverse conditions are reflected through different symbols with
difference in degrees escalated by use of plus and minus signs.
TYPES OF RATING AND DEBT OBLIGATIONS OF STANDARD AND
POOR’S CORPORATION
Standard & Poor’s have specialization in credit rating both long-term as well as
short-term obligations. They rate all public corporate bonds and preferred stock
issues of $10 million or above with or without a request of the issuer. Presently,
they have confined their rating operations to the following types:
RATING OBLIGATIONS
a. Long-term obligations:
i. US market long-term obligations.
ii. Non-US market long-term obligations.
iii. Euro-bond Rating.
b. Short-term obligations:
i. Commercial paper (maturity of not more than 365 days) of US and
Non-US issuers upon request.
c. Sovereign rating
d. Rating criteria.
Debt instruments covered under the above heading are described below:
a. Long-term Obligations
i. US Market Long-term Obligations: Standard & Poor rates the
following US market long-term obligations upon request of issuer and
have the publication right of the rating assigned to these obligations:
• Private placements of debt instruments.
• Mortgage-related financing such as mortgage backed bonds and
pass-through certificates of banks, and thrift institutions.
• Insured Certificates of Deposits.
• Uninsured Certificates of Deposit of US Banks.
• Besides above, S&P, on request of the issuer, rates (i) industrial
revenue or pollution control bonds regardless of size, (ii) “Best
Efforts Financing” where debt amount under issue is uncertain.
These instruments are rated at the request of issuer, but S&P
retains the right to publish such a rating in issues which are not
privately placed.
482
Credit Rating
ii. Non-US Market Long-term Obligations: Long-term obligations in the

non-US/capital market are rated on issuers’ request in overseas markets.
Such rating reflects an assessment of the probability of timely
repayment of principal and interest in the currency of denomination of
the issuer. There is no assessment of foreign exchange risk taken by
investor, while opting to make investment. The overseas market issues
for which S&P rate the debt obligations includes Euro-currency bonds,
domestic Pound Sterling, French Francs, Swiss Francs, and Deutsche
Mark issues.
iii. Euro-bond Rating: Euro-bond rating of both US and Non-US entities
has been undertaken by S&P with the internationalization of the world’s
capital market.
Since mid-1982 the rating can be done on request or without request of
issuer. No fee is charged by S&P where rating is unrequested. The main
advantage of rating on Euro-bond obligation is that the issuer can have access
to the US capital market, under the US Securities and Exchange
Commission’s Rules.
b. Rating of Short-term Obligations: S&P undertakes rating on request by US
or non-US issuers of short-term obligations, such as commercial paper
(having an original maturity of not more than 365 days). Issuer retains the
initial publication right of the rating, but once rating has been published, S&P
can publish the revised rating.
c. Sovereign Rating: Sovereign rating is done by S&P by assigning rating to a
country and this rating serves as a ceiling for the issuers domicile of that
country i.e. an instrument of an issuer company cannot be given higher rating
than its country’s rating. This principle is based on the logic that Government
of the country has higher rating, because it has superior powers as compared
to its nationals with regard to claim on the foreign exchange reserves to pay
debt obligations, to levy tax, to print national currency, etc.
d. Rating Criteria: Standard & Poor’s rating is based on the following criteria,
viz.,
i. Likelihood of default – It is examined with reference to capacity and
willingness of the issuer as to the timely payments of interest and
repayment of principal in accordance with the terms and conditions of
the issue of instrument or debt obligations.
ii. Nature and provisions of the obligations.
iii. Protection afforded to, and relative position of, the obligation in the
event of bankruptcy, reorganization, or other arrangements under the
laws of bankruptcy and other laws affecting creditors’ rights.
Ratings are based on the varying degrees of the above parameters. Debt rating is
done as per the debt status i.e. senior debt is rated above the subordinate debt and
subordinate debt is rated above the unsecured debt. Senior debt is one, which is
secured by first charge and subordinate debt is known to be secured subject to
prior charge or bears a second or third charge, as the case may be.
Standard & Poor’s debt rating definitions are given in Appendix 1.
483
RATINGS OF MOODY’S INVESTMENT SERVICES

Moody’s classification of long-term and short-term debt obligations is summarized
below.
Rating Obligations
a. Long-term debt rating like bonds applies to individual securities.
b. Short-term debt obligations include those having repayment period of less
than one year. Moody’s rating once done for any short-term instrument shall
apply to all short-term debt obligations. Short-term debt rating covers:
• Commercial paper.
• Euro-commercial paper.
• Bank deposit.
• Banker’s acceptances.
The classification excludes letter of credit and bond of indemnity as these
obligations rely upon support mechanism, unless explicitly requested for
rating.
c. Preferred stock ratings: Moody’s rating symbols are alike Standard & Poor’s.
Moody’s rating definitions are given in Appendix II.
SUMMARY
• Ratings serve as a benchmark to the risk involved in a particular instrument
of investors. A good rating can help a company raise money at a relatively
lower cost and from a larger body of individuals, leading to a broader
investor base.
• Till recently, ratings were mostly concentrated in the area of debentures,
fixed deposits and other short-term instruments. The changing economic
environment has thrown open new areas like equity rating, individual rating,
mutual fund scheme rating, chit funds rating, country risk rating and a
plethora of other new areas.
• There are three factors to be considered while conducting a rating review:
One, the performance of the industry; Two, the performance of the company;
Three, the performance of the stock market of the country.
• While companies sign a mandatory letter from the rating agency wherein
they undertake to provide information regularly, not all do so. While the good
ones are more than pleased to approach their raters with the required
information, the rating agencies have to run after the bad ones to seek
information.
• Another problem is of rating convenience. A company that is not satisfied
with the rating assigned to its instrument by a rating agency can approach
another rating agency for a fresh rating, and disclose only the second rating to
the public, if it proves to be favorable. The company is free not to disclose
the first rating or the fact that it went for a second rating. Unless a mechanism
of transparency is thrown open, rating will lose its charm.
• Today, CRISIL, ICRA and CARE are the main raters in the Indian market,
while STANDARD & POOR’S and MOODY’S are the main players in the
international markets.
• Rating has become innovative: ONICRA has even started rating individuals
in India and even the banks rate the individuals that come to them for loans.
Banks and financial institutions are also coming forward to being rated;
equities are being graded and a bunch of other players and instruments are
being rated.
484
Credit Rating
Appendix I*
Standard & Poor’s Rating
Debt Rating Definitions
The rating definitions are viewed from different angles viz., investment grade,
speculative grade, and commercial paper rating.
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Commercial Paper Rating Definitions

A Standard & Poor’s commercial paper rating is a current assessment of the
likelihood of timely payment of debt having an original maturity of no more than
365 days. Ratings are graded into several categories, ranging from ‘A’ for the
highest-quality obligations to ‘D’ for the lowest. These categories are as follows:
3 5
6
$3 (
(
1K2
$5 +
. & $3
$6 "
(
* &*
+ ( $
% % &% ( &%
, C?
* Source: Standard and poors.com/ratings.
486
Credit Rating
Appendix II*
Moody’s Ratings
( $
E F E F " (
E F E F $ (
$
E F E F $
' E F E F
"
E F E F $
A
" "
E F E F
$ A
H
-
E F E F
E F E F (
E F E F
EF (
% %
* ' " (
E F
* ' " (
$ (
*
$ $ @
"
* * * $ 1
2
"
,
* * * ' )
$ D
H -
* * *
+ * + ,
+ * +
,
+ * +
487
Moody’s applies numerical modifiers 1, 2, and 3 in each generic rating

classification from Aa through Caa. The modifier 1 indicates that the obligation
ranks in the higher end of its generic rating category; the modifier 2 indicates a
mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that
generic rating category.
Commercial Paper Rating Definitions
Prime-1: Issuers rated Prime-1 (or related supporting institutions) have a superior
capacity for repayment of short-term promissory obligations. Prime-1 repayment
capacity will normally be evidenced by leading market positions in well-
established industries; high rates of return on funds employed; conservative
capitalization structures with moderate reliance on debt and ample asset
protection; broad margins in earnings coverage of fixed financial charges and high
internal cash generation and well-established access to a range of financial markets
and assured sources of alternate liquidity.
Prime-2: Issuers have a strong capacity for repayment of short-term promissory
obligations. This will normally be evidenced by many of the characteristics cited
in Prime-1 ratings, but to a lesser degree. Earnings trends and coverage ratios,
while sound, will be more subject to variation. Capitalization characteristics, while
still appropriate, may be more affected by external conditions. Ample alternate
liquidity is maintained.
Prime-3: Issuers have an acceptable capacity for repayment of short-term promissory
obligations. The effect of industry characteristics and market composition may be
more pronounced. Variability in earnings and profitability may result in changes in
the level of debt protection measurements and the requirement for relatively high
financial leverage. Adequate alternate liquidity is maintained.
Issuers rated Not Prime do not fall within any of the Prime rating categories.
* Source: Moodys.com/ratings
488
Credit Rating
Appendix III*
Duff & Phelps Ratings
Fixed-Income Rating Scale
The Duff & Phelps alphabetical designations replace all long-term fixed income
ratings currently outstanding. This includes corporate debt, preferred stock, all
structured real estate and asset-backed financings and insurance company claims
paying ability ratings.
. " (
H, (
K . " ?
K ? " .
*** K *
*** *** +
G
** K * ?
**
** G D " "
*K *
@
*
! ? "
*G
+++ +
?
! !
%% % !
Preferred stocks are rated on the same scale as bonds, but the preferred rating gives
weight to its more junior position in the capital structure. Structured Financings are
also rated on this scale.
489
# ( ! 9# % !
%: ; . , "
!
' $ H, ( $
%: 4 B"
%: : . B"
# &
%: & / B"
"
# 0
%: 0 , " "
'
# /
%: / , B"
D '
# 1
%: 1 !
* Source: duffllc.com/ratings
490
Credit Rating
Appendix IV*
Rating Symbols of Other US-based CRAS
@ ; + ;
M !/ * ? +? @ ! , $
, ? , %
. @ $3 ;+; G ;+; G 3
. G ;+; G ;+; G 5
/ !; @ $5 ;+; G ;+; G 6
, !B $ *** *** @ $6 ;+; G * ;+; G 7
B G G G ;+; G * ;+; G 8
, ** ** * ;+; G * ;+; G 9
. , * * $$ ;+; G %? G
? % !. - +++ +++ G G G
. ? % ++ G + G G
% + G G G G
% % G % ;+; G %% G
* Source: Icfai Research Center.
491
Appendix V
Formulae for Key Ratios
Pre-tax interest coverage

Balance for pre-tax returns and coverages
=
Gross interest
Pre-tax fixed charge coverage
Balance for pre-tax returns and coverages
=
Gross interest + Gross rents
Funds flow interest coverage
Working capital from operations + Expenses
=
Gross interest
Funds from operations as % of long-term debt
Working capital from operations
=
Total debt
Funds from operations as % of total debt
Working capital from operations
=
Long-term debt
Operating income as % of sales
Operating income
=
sales
Long-term debt as a % of capitalization
Long-term debt
=
Long-term debt +Equity
Total debt as a % of capitalization
Long-term debt + Short-term debt
=
Total debt + Equity
492
Glossary
Actuarial Evaluation : A life expectancy calculation by a professional actuary.

Actuary : A specialist in the mathematics of risk, especially as it relates to
insurance calculations such as premiums, reserves, dividends,
insurance and annuity rates.
Add-on Service : The non-monetary services provided by a venture capitalist, such
as helping to assemble a management team and helping to prepare
the company for an IPO.
Adjustable Rate : A loan with an interest rate that is periodically adjusted to reflect
Mortgage (ARM) changes in a specified financial index.
Adjusted Cost Basis : The cost of any improvements the seller makes to the property.
Deducting the cost from the original sales price provides the profit
or loss of a home when it is sold.
Agent Bank : A participating bank in a syndicated loan, which handles all the
operations with the borrower, on behalf of the syndicate.
Alienation Clause : A provision that requires the borrower to pay the balance of the
loan in a lump sum after the property is sold or transferred.
Allotment Letter : A communication sent by a company (or its registrar) stating the
number and value of the securities allotted to the investor in
response to his application.
American Depository : A certificate issued by a US bank containing a statement that a
Receipt (ADR) specific number of shares in a foreign company has been deposited
with them. The certificates are denominated in US dollars and can
be traded as a security in US markets.
Amortization : The gradual elimination of a liability, such as a mortgage, in

regular payments over a specified period of time. Such payments
must be sufficient to cover both principal and interest. Also,
writing off an intangible asset investment over the projected life of
the assets.
Annual Percentage : A yearly rate which expresses the dollar amount you pay to use
Rate (APR) credit, including interest and other charges.
Annuity : A contract sold by an insurance company designed to provide

payments to the holder at specified intervals, usually after
retirement. Fixed annuities guarantee a certain payment amount,
while variable annuities do not, but do have the potential for
greater returns; but both are relatively safe, low-yielding
investments. All capital in the annuity grows tax-deferred. An
early withdrawal penalty often applies.
Average Daily Balance : A method of charging interest on a daily basis. The balance used is
the average amount you owe during each day of the billing period.
The daily balance includes the current outstanding balance plus
any new charges and minus any payments or credits. This method
is used by most card issuers and results in lower charges.
Balance Calculation : The method used by a credit card issuer to calculate the balance
Method owed and the interest due in each month.
Balance Transfer : A program offered by card issuers to entice cardholders to utilize
Program the card issuer’s credit card to pay-off other credit cards,
effectively transferring the balance of his existing cards to the new
card. Transfers of the balance owed may occur through the use of
special checks or may be handled directly by the issuer.
Bankruptcy : A proceeding in which an insolvent debtor can obtain relief from
payment of certain obligations. Bankruptcies remain on a credit
record for seven years and can severely limit a person’s ability to
borrow.
Bargain Renewal : A provision allowing the lessee, at his option, to renew the lease
Option for a rental sufficiently lower than the fair rental of the asset at the
date the option becomes exercisable.
Basis Point : One-hundredth of a percentage point i.e., 0.01%.
Bonus Issue : A company may choose to capitalize its reserves by issuing bonus
shares to existing shareholders in proportion to their holdings.
Bonus shares are issued free of cost, but since the number of
shareholders remains the same and their proportionate holdings do
not change, bonus shares do not increase the shareholder’s
ownership of the company.
Bought-out : A deal wherein an investor or a group of investors buys out a
significant portion of the equity of an unlisted company, with an
intention to divest by taking it public, within an agreed time-frame.
Bourse : A French stock exchange (from the French word bourse, meaning
purse). The Bourse originally referred to the stock exchange in
Paris, but later all stock exchanges came to be known by this
name. Members of the Paris Bourse are known as agents de
change.
Bridge Loan : Short-term financing extended against the proceeds of a proposed
public issue or loan disbursement.
Broker : A stock exchange member licensed to buy or sell shares on his
own or on his clients’ behalf. Commission brokers just execute
buy or sell orders against a commission, whereas full service
brokers offer facilities such as offering investment advice, safe
keeping of securities, managing portfolios, etc.
Bulldog Bonds : Bonds issued in United Kingdom by foreign issuers and are
denominated in Pound Sterlings.
Bullet Payment : Repayment of a debt in a single lump sum at the end of its maturity
period.
Call Option : A clause in a loan agreement that allows a lender to ask for the
balance at any time.
Cash Advance Fee : A charge for obtaining cash by charging the amount desired to
your card. Fees usually varies from 2-5% of the amount advanced.
Certificate of Deposit : These are also known as Negotiable Certificates of Deposit and
(NCDs) and represent bank deposit accounts which are
transferable from one party to another. These are marketable in
bearer or registered form and bear a specified rate of interest for a
specified period. In India, they are issued in the form of usance
promissory notes which are negotiable by endorsement and
delivery.
494
Commercial Bills : These are important financial instruments used for financing credit
sales. These are self liquidating and carry low degree of risk.
These are also known as banker’s acceptances, if co-accepted by
banks.
Commercial Paper : Short duration usance promissory notes with fixed maturity issued
mostly by the leading creditworthy and highly credit rated
companies. These are unsecured instruments negotiable by
endorsement and delivery.
Commitment Fees : Fees payable to the participating banks of the syndicate on the
undrawn amount of the loan.
Conditional Sales : A transaction which provides the seller with full ownership right in
Agreement the asset until the user has satisfied all the terms and conditions of
the agreement at which time the title passes automatically from the
seller to the buyer (user).
Consortium : A group of individuals or companies formed to undertake an
enterprise or activity that would be beyond the capabilities of the
individual members.
Consumer Price Index : An inflationary indicator that measures the change in the cost of a
(CPI) fixed basket of products and services, including housing,
electricity, food and transportation.
Contingent Rental : A rental that is not fixed in amount but is based on a factor other
than just the passage of time (e.g., percentage of sales, amount of
usage, price indices and market rates of interest).
Convertible ARM : An adjustable rate mortgage that can be converted to a fixed-rate
mortgage under certain circumstances.
Convertible Debenture : Fixed interest secured loan certificates which carry a provision of
conversion into a certain number of shares at par or at a premium
on a certain date. When only a part of the loan is converted the
certificate is called a partly convertible debenture, and when the
entire amount is converted it is called a fully-convertible
debenture.
Credit Limit : The maximum amount of charges you may incur on your card.
Credit Rating : An unbiased, objective and independent opinion as to an issuer’s
capacity to meet its financial obligation arising from a specific
instrument.
Daily Periodic Rate : The interest rate factor used to calculate the interest charges on a
daily basis. The factor is computed by dividing the yearly rate by
365 days. This method of computing interest can result in an
effective annual percentage rate which is approximately 2%
greater than the yearly stated rate of interest.
De Facto : A condition or situation treated as standard or official, even if not
explicitly stated.
Defeasance : A provision in an instrument that nullifies it if specified acts are
performed.
Dematerialization : The process of converting securities from their physical paper
form to computerized book entry form. In a dematerialized
environment, there is no such thing as a share certificate.
495
Depository : An institution which holds the security in electronic form on behalf
of the investor.
Domestic Custodian : A banking company which acts as a custodian for the ordinary
Bank shares or foreign currency convertible bonds of an Indian company
which are issued by it against global depository receipts or
certificates.
Equity Participant : The lessor, in a leveraged lease transaction is called an equity
participant. Also called owner participant.
Escalation Clause A clause in lease agreements which provides that lease rentals will
be increased on the occurrence of certain specified events like
increase in interest rates, or non-availability of certain tax benefits.
Estimated Economic : The estimated period for which the asset is expected to be
Life economically usable, by one or more users, with normal repairs
and maintenance, for the purpose for which it was intended at the
inception of the lease.
Euro-currency : A currency held in foreign country other than its country of origin.
For example, dollars deposited in a bank in Switzerland are
eurodollars, yen deposited in Germany are euroyen, etc. Euro-
currency is used for lending and borrowing; the euro-currency
market often provides a cheap and convenient form of liquidity for
the financing of international trade and investment.
Fair Market Value : The price for which the asset could be sold in an arm’s length
transaction between unrelated parties. Where the lessor is a
manufacturer or dealer, the fair market value at the inception of the
lease will be its normal selling price reflecting any volume or trade
discounts that may be applicable. When the lessor is not a
manufacturer or dealer, the fair market value of the asset at the
inception of the lease will ordinarily be its cost reflecting any
volume or trade discounts that may be applicable. However, there
is a significant lapse of time between the acquisition of the asset
and the inception of the lease, the determination of fair value will
be made in light of the market conditions prevailing at the
inception of the lease.
Finance Charge : The charge for the use of credit, consisting mainly of interest costs,
but also including other fees such as cash advance fees.
Financial Engineering : Financial Engineering involves design, development and
implementation of innovative financial instruments and processes
and the formulation of creative solutions to the problems in
corporate finance.
Financial Guarantees : A contract to perform or to discharge the liability of a third party
in the event of their default.
Fixed Interest Rate : An interest rate that changes only if the issuer notifies cardholders
through an amended cardholder agreement. Federal law stipulates
that a minimum of 15 days advance notice is required.
Flat Rentals : Equal periodic lease rentals over the lease term.
Floating Rentals : Rentals which are subject to upward or downward variations
during the lease term, the variations being directly proportional to
the changes in the market interest rates.
496
Foreign Currency : Bonds issued in accordance with this scheme and subscribed by a
Convertible Bonds non-resident in a foreign currency and convertible into ordinary
shares of the issuing company in any manner, either in whole; or in
part, on the basis of any equity-related warrants attached to debt
instruments.
Gilt-Edged Securities : Usually government securities and bonds; a very safe asset to hold,
as the government is responsible for the payment of interest and
refund.
Global Depository : Any instrument in the form of a depository receipt or certificate
Receipts created by the Overseas Depository Bank outside India and issued
to non-resident investors against the issue of ordinary shares or
Foreign Currency Convertible Bonds of issuing company.
Grace Period : A period of 20-30 days during which interest is not charged for
new purchases available on most cards. This feature is usually
available only to those cardholders who do not carry a balance
from the prior month but have paid the full amount due in the prior
month.
Grey Market : The unofficial public trading in the shares of a company prior to its
listing.
Index : An index number is a statistical device for measuring the
differences in the magnitude of a variable or a group of related
variables. A stock index is a statistical tool to capture and measure
the price behavior of the overall market. The return on the index
provides a benchmark for portfolio risk-return analysis.
Initial Public Offering : An IPO is the first public offer of securities by a company since its
inception. The company becomes a listed company as a
consequence of the IPO.
Insider Trading : The use, for personal profit, of privileged access to price sensitive
information before it is in public domain, by people closely
associated with the company. Insider trading may be in the form of
buying shares (in case of favorable information) or selling shares
(in case of unfavorable information).
Institutional Investor : Mutual funds, FIIs, insurance companies, banks, and other
institutions which invest in shares and bonds, are known as
institutional investors. They trade in large volumes.
Insurability : Acceptability of an insurance applicant.
Insurable Interest : The beneficiary who would suffer loss if the event insured against
occurs; without an insurable interest, an insurance company will
not issue a policy.
Insurance : A promise of compensation for specific potential future losses in
exchange for a periodic payment.
Insurance Agent : Individual who is licensed by a state to sell insurance for one or
more specific insurance companies.
Insurance Broker : An independent agent who represents the buyer, rather than the
insurance company, and tries to find the buyer the best policy by
comparison shopping.
Invisible Venture : Venture capital from angel investors.
Capital
497
Limean : Limean is the arithmetic mean of Libid and Libor.
Listed Shares : Shares which are registered with the stock exchange for the
purpose of public trading. The prices of listed shares are market
determined. The listed shares are governed by a rigorous
regulatory system to ensure investor protection.
Loan Amortization : Periodic repayment of a loan spread over its entire life after the
initial grace period.
Lock-in Period : The time period for which the shares forming part of promoter’s
contribution, cannot be transferred.
London Inter-Bank Bid : Libid is the rate at which the blue chip banks in London are willing
Rate (LIBID) to borrow funds from other banks.
London Inter-Bank : Libor is the rate at which the blue chip banks in London are
Offer Rate (LIBOR) willing to lend the funds to other blue chip banks.
Margin : Amount to be deposited with the exchange as a cushion against
default risk. It is the sum to be deposited by a player in the market,
which is computed as a certain percentage of the long/short
position.
Mark to Market : A continuous process of valuing the assets at the prevailing market
prices. Mark to market margin refers to the continuous process of
recomputing the margins required to be maintained by the market
participant, based on the outstanding exposure valued at the
changing market prices.
Merchant Bank : An organization that underwrites corporate securities, manages
public offerings and advises clients on issues like corporate
mergers, etc.
Minimum Payment : The smallest amount which you may pay and maintain a current
Due account. Minimum payments are usually 2-10% of the amount
owed.
Money Market : It is a wholesale debt market dealing in short-term instruments.

Funds are also available in this market for periods ranging from
overnight to one year.
Monthly Periodic Rate : The most common interest rate factor used to calculate the interest
charges on a monthly basis. The factor is computed by dividing the
yearly rate by 12.
Mutual Funds : Investment management entity, which collects money from
shareholders and invest in a large variety of securities like shares,
debentures, bonds set-up for a limited period, or with no winding-
up date. The investors thus have the advantage of owning a truly
diversified portfolio which offers attractive annual dividends and a
reasonable price appreciation with minimum risk involved.
Open Market : It is the means through which the Central Bank controls the
Operations liquidity in the economy, by the sale and purchase of Government
Securities. Sale of securities reduces the liquidity while purchase
of securities increases the liquidity.
Over-Limit Fee : A fee charged for exceeding your credit limit. The fee is frequently
$10-$20, and may not be assessed unless the credit limit is
exceeded by 10%.
498
Overseas Depository : A bank authorized by the issuing company to issue Global
Bank Depository Receipts against the issue of Foreign Currency
Convertible Bonds or ordinary shares of the issuing company.
Owner Participant : Same as Equity Participant.
Praecipium : Fees paid to the lead arranger in a syndicated loan.
Pre-foreclosure Sale : A procedure in which a lender allows a mortgagor to avoid
foreclosure by selling the property for less than outstanding
balance of the loan.
Premium : The amount by which a bond or stock sells above its par value.
Primary Market : A market for new issues of shares, debentures and bonds, where
investors apply directly to the issuer for allotment and pay
application money to the issuer’s account. It is different from the
secondary market where investors trade in shares on the stock
exchange through brokers.
Private Placement : A method of raising capital in which companies directly sell their
securities to a limited number of investors. Normally, the
minimum size of an investment in a private placement is higher.
Real Estate Investment : A corporation or trust that uses the pooled capital of many
Trust (REIT) investors to purchase and manage income property (equity REIT)
and/or mortgage loans (mortgage REIT). REITs are often publicly
held in USA.
Rebate Card : A credit card which supplies benefits based upon the card’s usage.
Benefits are usually in the form of services, such as air line tickets,
discounts on future purchases, or cash refunds and are based upon
a percentage of the purchase amounts.
Repo : An agreement which involves sale of a security with an
undertaking to repurchase the same security at a specific price on a
predetermined future date. The transaction would be a reverse repo
from the point of view of the buyer of the security.
Rights Issue : The issue of additional equity shares to the existing shareholders
on a pre-emptive basis. Typically, the subscription price of a rights
issue is significantly below the market price of the shares.
Risk : The quantifiable likelihood of loss or less-than-expected returns. It
is the deviation from the expected returns. Mathematically it is the
dispersion of a probability distribution.
Samurai Bonds : Yen denominated bonds issued in Japan by foreign corporates,
through a public offering.
SEC : Securities and Exchange Commission, USA. It is the regulatory
body similar to SEBI in India which monitors and regulates the
issue of securities in the US market.
Secondary Market : It is a place where securities already issued are traded. It is
different from the primary market wherein the issuer sells
securities directly to the investor.
Share Transfer Agent : A firm which maintains the records of ownership of the securities
of its client companies.
Shibosai Bonds : Yen denominated bonds issued in Japan by foreign companies by
way of private placements.
499
Tiered Interest Rate : A method of computing interest in which the rate is based upon the
amount of the outstanding balance, the amount of cumulative
charge made, or the cardholder’s credit rating.
Treasury Bill Rate : Rate of discount at which Treasury Bills are sold by the RBI.
Treasury Bills : These represent Central Government borrowings against a bill or a
promissory note. These are highly liquid and risk-free instruments.
Presently there are five types in vogue: 14 days, 28 days, 91 days,
182 days, and 364 days Treasury Bills.
Underwriting : Underwriting is a contract wherein the underwriter (usually a
merchant bank, broker or a financial institution) agrees to purchase
a certain number of shares in the event of undersubscription of the
issue. The consideration paid to the underwriter is called
underwriting commission.
Variable Interest Rate : An interest rate that automatically adjusts due to fluctuations in an
economic index, usually the prime rate of interest. Other indexes
include the 26 week Treasury Bill Rate, the Federal Funds Rate or
Discount Rate, and Libor.
Warrant : A warrant is a tradeable instrument giving its holder the right to
purchase specific security/securities from the issuer, subject to
certain specific conditions.
Yankee Bonds : Bonds issued in United States of America by foreign firms and are
denominated in dollars.
Yield-to-Maturity (YTM) : The return earned on a debt instrument if it is held till maturity. It
is computed using the discounted cash flow method.
Zero Coupon Bond : These bonds are issued at a discount to their face value and are
redeemed at par on maturity. The difference between their face
value and the issue price represents the return to the investors.
500

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Investment Banking and

The Icfai University Press

No part of this publication may be reproduced, stored in a retrieval

Ref. No. IBFS-Vol-I – 052009MSF05

Investment Banking, Financial Systems

Lesson 5 : Certificates of Deposit (CDs) 114

Chapter 4 : Debt Markets

: Management of Public Issues, Initial Public Offerings and Pricing of

: Rights Issues, Bonus Issues, Private Placements

Debt Markets: Gilt-edged Securities Market: Features of Government Securities – Primary

Repurchase Agreements (REPOs): Repo Market – Issue Procedures – Secondary Market

Public Deposits: Regulatory Framework Governing Acceptance of Public Deposits – Definition of

Financial Guarantees: Definition of Guarantee – Sources of Guarantees – Specialized Public

International Markets: International Market Instruments: Types of Instruments in International

Foreign Institutional Investors (FIIs): Investments by Foreign Institutions – Foreign Direct

THE COVERAGE OF INVESTMENT BANKING INDUSTRY

INVESTMENT BANKING INDUSTRY ABROAD

The economic development of a nation is reflected by the progress of the various

MEANING AND FUNCTIONS OF FINANCIAL SYSTEM

CONSTITUENTS OF A FINANCIAL SYSTEM

Within the above-mentioned sub-markets, based on the transactions, the financial

• The accounting equation Assets = Liabilities + Capital, can be altered as

NEED FOR CREDIT

LENDING RATES IN THE CREDIT MARKET

INDIAN CREDIT MARKET

THE NEED FOR A MONEY MARKET

MONEY MARKET INSTRUMENTS AND FEATURES

Money Market Mutual Funds (MMMFs)

RISK EXPOSURE IN MONEY MARKET INSTRUMENTS

prevent repatriation of investments made by FIIs/NRIs in the money market. This

!" " # # " #

!" . " % ' "

CALL LOANS MARKET

A Eurodollar deposit is a deposit denominated in dollars in a bank/bank’s branch

While money markets worldwide, differentiate themselves based on the features

& ' )% (% 9% 8 % 8 " "5 8 ;

" ) % & 8 % 7'

A ),2 " & ' . 5 < ;

),)3> & ' 8 ; 5

MONETARY POLICY ON MONEY MARKETS

• On development of pure call/notice money market by instituting full-fledged

RECENT DEVELOPMENTS IN THE MONETARY AND

9. DSP Merrill Lynch Securities Trading Ltd.

6. A primary dealer shall achieve a sizable portfolio in government securities

$ =: )+: )2+ *) =: :> 93 9> :> *( 93 9>

$ )%3>%*>* :%)=%:=( ()%)>2 )=%=9: )2%)3+ 9:%)>: 9:%)>:

$ 8 29%2*> *%(=%2+3 )%>9= (%9:+ )%(=( )%=+) )%=+)

Based on the data provided above, answer the following:

6" 8 $ =>> I :>> H 9+> I (>> H

!66 8 $ 2>> I =>> H ((+ J (99 &

&8 $ (+> J 9>> & 3> J )>> &

;8& 8 $ +>> I *+> H (9> I )+> H

!66 8 $ =>> J )>>> & 9+> J *>> &

&8 $ ((>> J (9>> & 2>> J 2(> &

;8& 8 $ )2>> I )3>> H =>> J =(> &

) )>>> *>> =>> 9>>

( )>>> *>> :>>B (+>B

(* Include non-competitive bids)

& # =>> 9>>

& # =>> 9>>

INTEREST RATE STRUCTURE IN THE INDIAN MONEY MARKET

quantum of funds involved in transactions. A few factors play a significant role in

Hence based on the recommendation of the Technical Group on Phasing Out of

$ =: )+: )2+ ) =: :> 93 9> :> ( 93 9>

$ )%3>%> :%)=%:=( ()%)>2 )=%=9: )2%)3+ 9:%)>: 9:%)>:

$ 8 29%2> %(=%2+3 )%>9= (%9:+ )%(=( )%=+) )%=+)

)333 111 )333 111