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FinanciaI System
Financial System is one of the industries in an economy. t is a particularly important industry that
frequently has a far reaching impact on society and the economy. The product of the financial
industry is not tangible rather it is an intangible service. Financial industry as a whole, produce a
wide range of services but all these services are related directly or indirectly to assets & liabilities,
that is, claims on people, organization, institutions, companies and government. These are the form
in which people accumulate much of their wealth. n simple terms we are referring to paper assets:
shares, debentures, deposits, mortgages and other securities. This financial system performs
certain essential function for the economy, including maintenance of payment system (through
which purchasing power is transferred from one participant to another i.e. from buyer to seller),
collection and allocation of the savings of society, and creation of a variety of stores of wealth to suit
the preference of servers. Performance of these function pre-suppose the existence of financial
assets, financial institutions (intermediaries) and financial markets. A combination of these three
constitutes financial system.
To interpret the financial system and evaluate its performance, it requires an understanding of its
functions in an economy. Financial systems in fact have the following functions:-
(A) Provision of Iiquidity:- The major functions of the financial system is the provision of
money and monetary assets for the production of goods & services. These should not be
shortage of money for productive ventures. n financial language, the money and monetary
assets are referred to as liquidity. The term liquidity refers to cash or money and other
assets which can be converted into cash readily without loss. Hence, all activities in a
financial system are related to liquidity either provision of liquidity or trading in liquidity.
(B) MobiIization of Savings: Another important activity of the financial system is to mobilize
savings and channelize them into productive activities. The financial system should offer
appropriate incentives to attract savings and make them available for more productive
ventures. Their the financial system facilitates the transformation of savings into investment
& consumption. The financial intermediaries have to play o dominant role in this activity.
(C) Service Functions: An effective financial system offers the economic segments services in
form of providing opportunities to hold wealth in secured and convenient way so that they
pay a positive role of return. The availability of these services of the financial system
contributes importantly, if in an intangible way to the satisfaction of customer.
Constituents of Financial System
(A) FinanciaI Intermediaries or Institutions:
The term financial intermediary includes all kind of organizations which intermediate and
facilitate financial transactions of both individual and corporate customers. Thus it refers to
all kinds of financial institutions and investing institutions which facilitate financial
transactions in financial markets. They may be in the organized sector or in the unorganized
sector. They may also be classified into two:-
There are three ways by which a company may raise capital in a primary market. They
are:
F Public issue
F Right ssue
F Private placement.
( b) Secondary Market: Secondary market is a market for sale of securities. n other words,
securities which have already passed through the new issue market are treated in this
market. Generally, such securities are quoted in the stock exchange and it provides a
continuous and regular market for buying and selling of securities. This market consists of
all stock exchanges recognized by the Govt. of ndia.
(ii) Government Securities Market: t is otherwise called Gilt-Edged securities market. t is a
market where govt. securities are traded. n ndia there are many kinds of Govt. Securities-
short term and long term. Long term securities are traded in this market while short term
securities are traded in the money market. Securities issued by the Central Govt., Stock
Governments, Semi-Government authorities like City Corporations, Post Trusts,
mprovement Trusts, State Electricity Boards, All ndia and State level financial institutions
and public sector enterprises are dealt in this market. Govt. securities are issued in
denominations of Rs. 100. nterest is payable half-yearly and they carry for exemptions
also.
The govt. securities are in many farmers. These are generally:
(a) Stock certificates or inscribed stock
(b) Promissory Notes
(c) Bearer Bonds which can be discounted.
Govt. securities are sold through the Public Dept Office of the RB while Treasury Bills
(short term securities) are sold though auctions.
(iii) Long Term Loan Market:
Development banks and commercial banks play significant role in this market by supplying
long term loans to corporate customers. Long term loans market may further be classified
into :
(a) Term loans market
(b) Mortgages market
(c) Financial Guarantees market
(a) Term Loan Market: n ndia, may industrial financing institutions have been created by the
Govt. both at the national and regional levels to supply long term and medium term loans
to corporate customers directly as well as indirectly. These development banks dominate
the industrial finance in ndia. nstitutions like DB, FC, CC and other state financial
corporation's come under this category. These institutions meet the growing and varied
long term financial requirements of industries by supplying long term loans.
(b) Mortgages Market: The mortgages market refers to those centers which supply mortgage
loan mainly to individual customers. A mortgage loan is loan against the security of
immovable property like real estate. The transfer of interest in a specific immovable
property to secure a loan is called mortgage. This mortgage may be equitable mortgage or
legal one. Again it may be a first charge or second charge. Equitable mortgage is created
by a mere deposit of little deeds to properties as security whereas in the case of legal
mortgage the little in the property is legally transferred to the lender by the borrower. Legal
mortgage is less risky.
The mortgage market may have primary market as well as secondary market. The
primary market consists or original extension of credit and secondary market has sales
and re-sales of existing mortgages at prevailing, prices. n ndia residential mortgages
are the most common ones. The Housing and Urban Development Corporation
(HUDCO) and the LC play a dominant role in financing residential projects. Besides the
Land Development Banks provide cheap mortgage loans for the development of lands,
purchase of equipment etc. These development banks raise finance through the sale of
debentures which are treated as trustee securities.
(c) FinanciaI Guarantees Market: A guarantee market is a center where finance is
provided against the guarantee of a repudiated person in the financial circle. Guarantee
is a contract to discharge the liability of a Third party in case of his default. Guarantee
acts as a security from the creditor's point of view. n case the borrower fails to repay the
loan, the liability falls on the shoulders of the guarantor. Hence the guarantor must be
known to bath the borrower and the lender and he must have the means to discharge his
liability.
Though there are many types of guarantees, the common forms are: (i) Performance
Guarantee and (ii) Financial Guarantee, performance guarantee cover the payment of
earnest money, Retention money, advance payments, non-completion of contracts etc.
On the other hand financial guarantees cover only financial contracts. n ndia, the
market for financial guarantees is well organized. The financial guarantees in ndia relate
to:
F Medium and long term loans raised abroad
F Deferred payments for imports and exports
F Loans advanced by banks and other financial institutions.
These guarantees are provided mainly by commercial banks, development banks,
government both central and states and other specialized guarantee institution like ECGC
(Export Credit Guarantee Corporation) and DCGC (Deposit nsurance and Credit
Guarantee Corporation) and
() Money Market:
Money market is a market for dealing with financial assets and securities which have a
maturity period of upto one year. n other words, it is a market for purely short term funders.
The money market does not refer to a particular place where short-term funds are dealt with.
t includes all individuals, institutions and intermediaries dealing with short term funds. The
transaction between borrowers, lenders and middleman take place through telephone,
telegraph, mail and agents,. No personal contact or presence of the two parties is essential
for negotiations in a money market. However, a geographical name may be given to a
money market operate from the Lombard Street and the New York money market operate
from Wall Street. But, they attract funds from all over the world to be lent to borrowers from
all over the globe. Similarly the Bombay money market is the centre for short-term loan-able
funds of not only Bombay but also for the whole of ndia.
According to Geottery Crowther, "The money market is the collective name given to the
various firms and institutions that deal in the various graders of near money."
Objectives of Money Market:
(i) To provide a parking place to employ short term surplus funds.
(ii) To provide room for overcoming short-term deficits.
(iii) To enable the Central Bank to influence and regular liquidity in the economy through
its intervention in this market.
(iv) To provide a reasonable access to users of short-term funds to meet their
requirements quickly adequately and at reasonable costs.
aracteristic/Features of a DeveIoped Money Market:
n order to fulfill the above objectives, the money market should be fully developed and
efficient. n every country of the world, some type of money market exists. Some of them are
highly developed while others are not well developed. Prof. S.N. Sen has described certain
essential features of a developed money market. They are as follow:
(i) HigIy Organized Banking System: The commercial banks are the nerve centre of the
whole money market. They are the principal suppliers of short term-funds. Their policies
regarding banks and advances have impact on the entire money market. The
commercial banks serve as vital link between the central bank and the various segments
of the money market.
(ii) Presence of a entraI Bank: The Central Bank Acts as the banker's bank. t keeps
their cash reserves and provides them financial accommodation in difficulties by
seconding their eligible securities. n other words it enables the commercial bank and
other institutions to convert their assets into cash in times of financial crisis. Through its
open market operations, the central bank absorbs surplus cash during off-seasons and
provides additional liquidity in the busy seasons. Thus the central bank is the leaders,
guide and controller of the money market.
(iii) AvaiIabiIity of Proper redit Instruments: t is necessary for the existence of a
developed money market continuous securities such as bill of exchange, treasury bills
etc. There should be a number of dealers in the money market to transact in these
securities.
(iv) Existence of sub-markets: The number of sub-markets determines the development of
a money market. The larger the number of sub markets, the broader and more
developed will be the structure of money market. The several submarkets together make
a coherent money market.
(v) AmpIe Resources: There must be availability of sufficient funds to finance transactions
in the sub-markets. These funds may come from within the country and also from foreign
countries. The London, New York and Paris money markets attract funds from all over
the world. The underdeveloped money markets are starved of funds.
(vi) Existence of Secondary Market: There should be an active secondary market in the
instruments.
(vii) Demand and SuppIy of funds: There should be a large demand and supply of short-
term funds. t presupposes the existence of a large domestic and foreign trade. Besides
it should have adequate amount of liquidity in the form of large amounts maturing within
a short period.
Importance of Money Market:
A developed money market plays an important role in the financial system of a country by
supplying short term funds adequately and quickly to trade and industry. The money market is
an integral part of country's economy. Therefore, a developed money market is highly
indispensible for the rapid development of the economy. A developed money market helps the
smooth functioning of the financial system in any economy in the following ways:
(i) DeveIopment of Trade and Industry: Money markets an important source of financing
trade and industry. The money market through discounting operations and commercial
papers, finances the short term working capital requirements of trade and industry and
facilitates the development of industry and trade both-national & international.
(ii) DeveIopment of apitaI Market: The short-term rates of interest and the conditions
that prevail in the money market influence the long term interest as well as resource
mobilization in capital market. Hence, the development of capital market depends upon
the existence of developed money market.
(iii) Smoot Functioning of ommerciaI Banks: The money market provides the
commercial banks with facilities for temporarily employing their surplus funds in easily
reliable assets. The banks can get back the funds quickly, in times of need, by resorting
to the money market.
(iv) Effective entraI Bank ontroI: A developed money market helps the effective
functioning of a Central Bank. t facilitators effective implementation of the monetary
policy of a Central Bank. The Central Bank though the money market, pumps new
money into the economy in slump and siphons it off in boom. The Central Bank, thus,
regulate the flow of money so as to promote economic growth with stability.
(v) FormuIation of SuitabIe Monetary PoIicy: Conditions prevailing in a money market
serve as a true indicator of the monetary state of an economy. Hence it serves as quid to
the Govt. in formulating and revising the monetary policy then and there depending upon
the monetary conditions prevailing in the market.
(vi) Non-infIationary source of finance to Government: A developed money market helps
the government to raise short-term funds through the treasury bills floated in the market.
n the absence of a developed money market, the Government would be forced to print
and issue more money or borrow from the Central Bank. Both ways would lead to an
increase in price and the consequent inflationary trend in the economy.
The money market may be further subdivided into four part. They are:
(a) Call money market (c) Treasury bills market
(b) Commercial bills market (d) Short term loan market
(a) aII Money Market: The call money market is a market for extremely short period loans say
one day to fourteen days. So it is highly liquid. The loans are repayable on demand at the
option of either the lender or the borrower. n ndia, call money markets are associated with
the presence of stock exchanges and hence, they are located in major industrial tours like,
Mumbai, Kolkata, Chennai, Delhi, Ahmadabad etc. The special feature of this market is that
the interest rate varies from day to day and even from hour to hour and centre to centre.
(b) ommerciaI BiIIs Market: t is a market for bills of exchange arising out of genuine trade
transactions. n the case of credit sale, the seller may draw a bill of exchange on the buyer.
n ndia the bill market is under developed. The RB has taken many steps to develop a
sound bill market. The RB has enlarged the list of participants in the bill market.
(c) Treasury BiIIs Market: t is a market for treasury bills which have short-term maturity. A
treasury bill is promissory note or a finance bill issued by the Government. t is highly liquid
because its repayment is guaranteed by the Government. t is an important instrument for
short term borrowing of the Govt. There are two types of treasury bills namely (i) ordinary or
regular and (ii) adhoc treasury bills popularly known as 'ad hoes'. Ordinary Treasury bill is
issued to the public banks and other financial institutions with a view to raising resources for
the Central Government to meet its short term financial needs. Adhoc treasury bills are
issued in favour of the RB only. They are not sold through tender or auction. They can be
purchased by the RB only. Adhoc are not marketable in ndia but holders of these bills can
sell them back to 364 days only.
(d) Sort-term Loan Market: t is market where short-term loans are given to corporate
customers for meeting their working capital requirements. Commercial banks play a
significant role in this market. Commercial banks provide short term loans in the form of
cash credit and overdraft. Overdraft facility is mainly given to business people whereas cash
credit is given to industrialists. Overdraft is purely a temporary accommodation and it is
given in the current account itself. But cash credit is for a period one year and it is
sanctioned in a separate account.
Money Market Vs apitaI Market
Money Market
(i) t is a market for short-term loan-able
funds for a period of not exceeding one year.
(ii) This market supplies funds for financially
current capital requirements of industries and
short period requirements of the Govt.
(iii ) The instruments that are dealt in a
money market are bills of exchange, treasury
bills, commercial papers, certificate of deposit
etc.
(iv ) Each single money market instrument is
of large amount minimum for one lakh. Each
CD or CP is for a minimum of Rs. 25 lakhs.
(v ) The Central Bank and commercial banks
are the major institutions in the money
market.
(vi ) Money market instruments generally do
not have secondary markets.
(vii ) Transactions mostly take place over-
the-phone and there is no formal place.
(viii ) Transactions have to be conducted
without the help of the brokers.
apitaI Market
(i) t is a market for long-term funds
exceeding a period of one year.
(ii) This market supplies funds for financing
the fixed capital requirements of trade and
commerce as well as the long-term
requirements of the govt.
(iii) This market deals in instruments like
shares debentures, Government bonds etc.
(iv) Each single capital instrument is of small
amount. Each share value is Rs. 10. Each
debenture value is Rs 100.
(v) Development banks and nsurance
companies play a dominant role in the
capital market.
(vi) Capital market instruments generally
have secondary markets.
(vii) Transactions take place at a formal
place viz, stock exchange.
(viii) Transactions have to be conducted only
through authorize dealers.
RBI
The RB as the Central Bank of the country, is the centre of the ndian financial and monetary
system. As the apex institution, it has been guiding, monitoring, relating, controlling and promoting
the destiny of the ES since its inception. t is quite young compared with such central banks as the
Bank of England, Rikrbank of Sweden, and the Federal Reserve Board of the U.S. However, it is
perhaps the oldest among the central bank in the developing countries. t started functioning from
April 1, 1935 on the terms of the Reserve Bank of ndia Act, 1934. t was a private shareholders/
institution till January 1949, after which it become a State-owned institution under the Reserve Bank
(Transfer to Public Ownership) of ndia Act 1948. This Act empowers the central government, in
consultation with the Governor of the Bank, to issue such directions to it as they might consider
necessary in the public interest. Further, the Governor and all the Deputy Governor of the bank are
appointed by the central government.
The bank is managed by a Central Board of Directors, four local Boards of Director and a
committee of the Central Board of Directors and a committee of the Central Board of Directors. The
functions of the local Boards are to advise the Central Board on matters referred to them; they are
also required to perform duties as are delegated to them. The final control of the bank vests in the
Central Board which comprises the Governor, four Deputy Governors, and fifteen Directors
nominated by the central government. The committee of the Central Board consists of the
Governor, the Deputy Governors, and other Director as may be presented at a given meeting. n
order to perform its various functions, the Bank has been divided and sub-divided into a large
number of departments. Apart from banking and issue departments there are at present 20
departments and three training establishments at the central office of the Bank.
Functions of RBI
The Preamble of the RB Act, 1934 states that "Whereas it is expedient to constitute a
Reserve Bank of ndia to regulate the issue of bank notes and the keeping of reserves with a view
to securing monetary stability in (ndia) and generally to operate the currency and credit system of
the country to its advantage."
The main functions of RB are as follows:-
(i) To maintain monetary stability so that the business and economic life can deliver welfare
gains of a properly functioning mixed economy.
(ii) To maintain financial stability and ensure sound financial institution so that monetary stability
can be safely pursued and economic units can conduct their business with confidence.
(iii) To maintain stable payments system so that financial transactions can be safely and
efficiently executed.
(iv) To promote the development of financial infrastructure of markets and systems, and to
enable it to operate efficiently i.e. to play a leading role in developing a sound financial
system so that it can discharge its regulatory functions efficiently.
(v) To ensure that credit allocation by the financial system broadly reflects the national
economic priorities and social concerns.
(vi) To regulate the overall volume of money and credit in the economy with a view to ensure a
reasonable degree of price stability.
RoIes of RBI
(1) Note Issuing Autority: The RB has, since its inception the sale register authority or
monopoly of issuing currency notes other than one rupee notes and coins, and coins of
smaller denominations. The issue of currency notes is one of its basic functions. Although
one rupee notes & coins, and coins smaller demonization's are issued by the Government of
ndia, they are put into circulation only through the RB. n order to discharge its currency
functions, the Bank has 15 full-fledged issue officer and two sub-officer, and 4127 currency
chests in which the stock of new and re-issuable notes and rupee coins are stored. Of
these, 17 chests are with the RB, 2877 with the SB and associate banks, 791 with
nationalized banks, 423 with treasuries, and 19 with private sector banks.
(2) Government Banker: The RB is the banker to the Central and state governments. t
provides to the governments all banking services such as acceptance of deposits, withdraw
of funds by cheques, making payments as well as receipts and collection of payments on
behalf of the government, transfer of funds and management of public debt. The Bank
receives government deposits free of interest and it is not entitled to any remuneration for
the conduct of the ordinary banking business of the Government.
As a banker to the government, the bank can make "ways and means advances"
(i.e. temporary advances and payments) to both the central & State Governments. The
maximum maturity period of these advances is three months. Apart from the ways and
means advances, the state governments have made heavy use of overdrafts from the RB.
At present, overdrafts upto and inclusive of the seventh day are charged at the Bank rate
and from the eight day onwards at 3 percent above the bank rate.
(3) Bankers' Bank: The RB, like all central banks, can be called a bankers' bank because it
has a very special relationship with commercial & co-operative banks and the major part of
its business is with these banks. The bank controls the volume of reserves of commercial
banks and there by determines the deposits/credit creating ability of the banks. The bank
holds a part or all of their reserve with the RB. t is, therefore, called "the bank of last resort"
or "the lender of last resort."
(4) Supervising Autority: The RB has vast powers to supervise and central commercial and
co-operative banks with a view to developing an adequate and sound banking system in the
country. t has, in this filed, the following powers: (a) to issue licences for the establishment
of new banks: (b) to issue licences for the setting up of bank branches, (c) to prescribe
minimum requirements regarding paid-up capital and reserves, transfer to reserve fund and
maintenance of cash reserve and other liquid assets; (d) to inspect the working of banks in
ndia as well as abroad. (e) to conduct ad hoc investigations, from time to time, into
complaints, irregularities and frauds in respect of banks: (f) to central methods of operations
of banks so that they do not fritter away funds in improper investments and injudicious
advances, (g) to control appointments, re-appointment, termination of appointment of the
Chairman and Chief executive officers of private sector banks, and (h) to approve or force
amalgamations.
(5) Excange entraI (E) Autority: One of the essential functions of the RB is to maintain
the stability of the external value of the rupee. t pursues this objective through its domestic
policies and the regulation of the foreign exchange market. As far as the external sector is
concerned the task of the RB has the following dimensions: (a) T to administer the "foreign
exchange control"; (b) to choose the exchange rate system and fix or manage the exchange
rate between the rupee and other currencies; (c) to manage exchange reserves; and (d) to
interact or negotiate with the monetary authorities of the sterling areas, Asian Clearing
Union and other countries, and with international financial institutions such as the ME,
World Bank and Asian Development Bank.
(6) Promoter of te FinanciaI System: Apart from performing the functions already
mentioned, the RB has been rendering 'developmental' or 'promotional' services which have
strengthened the country's banking and financial structure. This has helped in mobilizing
savings and directing credit flows to desired channels, thereby helping to achieve the
objective of economic development with social justice. t has helped in deepening and
widening the financial system. As a part of its promotional role, the Bank has been pre-
empting credit for certain sectors at concessional rates.
(i) Money Market: n the money market, the RB has continuously worked for the integration
of its unorganized and organized sectors by trying to bring indigenous bankers into the
mainstream of the banking business. n order to improve the quality of finance provided by
the money market, it introduced two Bill Market Schemes, one in 1952, and the other in
1970, with a view to increasing the strength and visibility of the banking system; it carried
out a programme of amalgamations and mergers of weal banks with the strong ones.
(ii) AgricuIture Sector: The RB has rendered service in directing and increasing the follow
of credit to the agriculture sector. t has been entrusted with the task of providing
agricultural credit in terms of the Reserve Bank of ndia Act, 1934. The importance with
which the RB takes these functions is reflected in the fact that since 1955, it has
appointed a separate deputy governor in charge of rural credit. As a part of its efforts to
increase the supply of agricultural credit, the bank has been working to strengthen co-
operative banking structure through the provision of finance, supervision, and inspection. t
established the Agricultural Refinance Corporation (now known as NABARD) in July 1963
for providing medium-term and long-term finance for agriculture. t also helped establishing
an Agricultural Faineance Corporation.
(iii) IndustriaI Finance: The role of the bank is diversifying the institutional structure for
providing industrial finance has been equally important. All the special development
institutions (SDs) at the Central and stock levels and many other financial institutions
mentioned earlier were either created by the Bank on its own or it advised and rendered
help in setting up these institutions. The UT, for example, was originally an associate
institution of the RB. Through these institutions, the RB has been providing short-term
and long-term funds to the agricultural and rural sectors, to small scale industries, to
medium and large industries, and to the export sector.
(iv) redit DeIivery: The bank has evolved and put into practice the consortium, co-operative
and participatory approach to lending among banks practice of inter-institutional
participation of expertise pealing and of geographical presence, it has helped to upgrade
credit delivery and service capacity of the financial system. By issuing appropriate
guidelines, in 1977, regarding the transfer of loans accounts by borrowers, it has evolved a
mutually acceptable system of lending, so that the banking business grow in a healthy
mummer and without cut-throat competition.
(v) FormuIating PrudentiaI Norms: To preserve and enhance the stability of the banking
and financial system is an important part of the "promotional" role of the RB. n fact,
financial stability has now assumed relatively greater importance as one of the tasks of the
RB. This is evident in its work to formulate prudential norms for banks and financial
institutions, its intervention in the foreign exchange market and its participation in the
operation of safety nets" i.e. the legal and organizational structure for overseeing the
safety and soundness of the banking & financial systems.
ReguIation of Money and redit
The regulation money and credit will be determined by the overall perception of the central
monetary authority on what the appropriate level of expansion of money and credit should be
depending on how the real factor in the economy are evolving.
The monetary and fiscal policies, although controlled by two different organizations, are the
ways that ndian economy is kept under control. Both policies have their strengths and weaknesses,
some situations favoring use of both policies, but most of the time, only one is necessary. The
monetary policy is the act of regulating the money supply by the Reserve Bank of ndia. One of the
main responsibilities of the RB is to regulate the money supply so as to keep production, prices
and employment stable. The RB has three tools to manipulate the money supply. They are the
reserve requirement, open market operations, and the discounter rate.
The functions of formulating and conducting monetary policy is of paramount importance for
any Central Bank. Monetary Policy regress to the use of techniques of monetary control at the
disposal of the Central Bank for achieving certain objectives.
Fiscal Policy refers to expenditure (used to provide goods and services), taxation (to finance
the various government expenses) and government borrowing. The main point of fiscal policy is to
keep the surplus or deficit swings in the economy to a minimum by reducing inflation and recession.
Monetary PoIicy
Monetary policy is basically concerned with the monetary system of the country. t deals with
monetary decisions and measures and such non-monetary decisions and measures as have
monetary effects.
Monetary policy is usually defined as the central bank's policy pertaining to the control of the
availability, cost and use of money and credit with the help of monetary measure in order to achieve
specific goals.
Monetary policy deals with the monetary system of a country. t is concerned with monetary
decisions and measure. Non-monetary decisions & measures having monetary effects are also
dealt with under the monetary policy. All those measures which affect the volume of money are
included under monetary policy. t controls, directs and guides the methods of cost and used of
money and credit. The central bank of the country is the traditional agent which formulates and
operates monetary policy.
Paul Einzig defined, "Monetary policy is the attitude of the political authority towards the
monetary system of the community under its control." According to Johnson, Monetary policy is
defined as "policy employing central bank's control of the supply of money as an instrument for
achieving the objectives of general economic policy."
There are two facts of monetary policy in a developing economy: (a) Positive, and (b)
Negative.
n its positive aspect, it sets out the promotional role of central banking in improving the
savings ratio and expanding credit for facilitating capital formation. n its negative approach it
implies a regulatory phase of restricting credit expansion, and its allocation according to the
absorbing capacity of the economy.
Objectives of Monetary PoIicy
There can be five major objectives of monetary policy:-
(1) Neutrality of Money.
(2) Price Stabilization.
(3) Exchange Stabilization.
(4) Full Employment.
(5) Economic Growth.
(1) NeutraIity of Money: This objective of monetary policy was first suggested by Wicksteed.
Later on, it was supported by Hayek and Robertson. According to these economists, the
monetary authority in a country should aim at complete neutrality of money vis-a-vis the
economy. The exponents of neutral money hold the view that monetary changes are the road
course of all economic fluctuations. The changes in money supply also cause imbalances
between demand and supply, production and consumption, in the economy. According to the
neutralists, the money changes are the real Villians of the peace. They believe that is somehow
the changes in money supply are criminated there will be perfect stability in the economic
system. There will be no cyclical fluctuations, no trade cycle, no inflation and no deflation in the
economy.
riticism of NeutraI Money PoIicy
(i) DifficuIties in impIementation: The concept of neutral money requires that the
supply of money be kept constant and adjustments be made in it on account of the
fundamental changes taking place in the economy. Now it is exceedingly difficult ot
keep the supply of money constant in actual price.
New it is difficult, say impossible, to ensure perfect stability in these two quantities. The
policy is also not practicable on the ground that during a period of deflation expansion of
money supply very often fails to push up the prices back to their original level.
(3) Excange Rate StabiIity: Maintenance of stable exchange rates is an essential condition for
the creation of international confidence and promotion of smooth international trade on the
largest scale possible. nstability in exchange rather might lead to undesirable effects such as
weakening of the value of currency in the world market, speculation and even flight of capital
abroad.
The objectives of exchange stability of a monetary policy could easily achieve equilibrium in the
balance of payment of a country under the gold standard. Traditionally, countries forces with
balance of payments problems have used monetary policy are a means of eliminating their deficits.
A restrictive monetary policy tends to reduces country's balance of payments deficit in the
following ways:-
(i) t tends to reduce demand in the country, which in turn tends to reduce the demand for
imports as well as for domestic goods.
(ii) Reduction in domestic demands holds down the rate of inflation or reduces prices which
makes imported articles less attractive and makes the deficit country's exports, more
attractive to foreigners. Thus, import is curtailed and export expanded.
(iii) Under dear money policy, higher interest rates make it less attractive for foreign countries to
borrow from the deficit country and induce them to invest there.
RITIISM: Though a policy of stabilization of exchange rates was justified in the interest of
maintaining stable international economic relations, the exchange stability goal of monetary policy
has been vehemently criticized on the following grounds:
(i) Exchange stability can be achieved only at the cost of internal price stability. But
fluctuations in the domestic price level or changes in the purchasing power of money
cause severe disturbances in the economy of a country. This may call for internal price
stability which is of prime importance for the smooth functioning and progress of the
domestic economy.
(ii) Since inflationary or deflationary movements in some countries are passed on to some
other through fixed exchange rates, it puts the affected country at the mercy of the
countries. This may seriously affect the economy of the country whose prosperity does
not depend upon foreign trade.
Today, when gold standard is no longer in vogue and most of the countries of the world are
members of the nternational Monetary Fund (MF), the exchange stability objective of monetary
policy has lost much of its force. Modern welfare states realize that their prime duty is to maintain
conditions of internal stability. The MF has established a system of free multilateral trade and
members countries can continue to have adverse balance of payments to be achieved through
exchange stability is not new an objective of the monetary policy of modern countries.
(4) FuII EmpIoyment: Full employment is considered the foremost and ideal objective of monetary
policy. Full employment is achieved where saving is equal to the investment. There are as
many jobs as there are persons seeking them. Full employment is not an end in itself. t is a
pre-condition of social welfare. t relates employment of not only human resources, but full
utilization of all the resources with maximum efficiency and productivity. Thus, it is an ideal
objective of monetary policy for maximizing economic welfare. Employment will be provided to
all the members of the society and economic resources will be utilized most efficiently. Under
the condition of full employment, under employed and half-employed are also getting
alternative employments and they are utilizing their time fully well. t does not mean that certain
persons are over employed. Similarly it does not indicate that unemployable boys, girls, aged
and incapable persons are also employed. t means that the willing members and able persons
of the society are getting jobs.
(5) Economic Growt: Economic Growth relates to physical or real output. t means that growth
involves quantitative and qualitative production of goods, so as to satisfy the consumers. n
brief, economic growth implies substantial increase in per capita output or real national income.
t does not mean more money in economic growth. t is not but the real production that makes
a nation economically advanced. Economic growth ultimately aims to total welfare of masses. t
can be achieved through equitable distribution of income between different social classes are
individuals.
To achieve this objective the monetary policy should satisfy the following two criteria:-
(1) The monetary policy should be flexible in nature. This flexibility is necessary to ensure the
establishment of equilibrium between aggregate money demand on the one side and the
aggregate supply of goods and services on the other side. n case the aggregate money
demand exceeds the aggregate supply of goods, the monetary authority should then apply
a restrictive policy remove the disequilibrium in the economy this restrictive monetary policy
necessitates the contraction of currency and credit to check any inflationary rise in the price
level. f, on the contrary, the aggregate supply of goods exceeds the aggregate money
demand, then the monetary authority should pursue an expansionist monetary policy with a
view to remove the disequilibrium in the economy. This expansionist monetary policy
necessitates the expansion of currency and credit to check the fall in the price level. This a
flexible monetary policy is essential to ensure the internal equilibrium in the economy. The
flexibility in the monetary policy will ensure price stabilization, and that price stabilization
will, in its turn, promote the economic growth of the country.
(2) The monetary policy should not only be flexible in nature, but it should also be capable of
promoting capital formation in the economy. As is well-know, capital formation is one of the
essential perquisites of economic growth. But this capital formation is possible only under
conditions of price stabilization in the economy. A fluctuating price-level always discover
age capital formation in the country. Hence the monetary policy should be such as to
promote capital formation in the country by rooting out recurring price fluctuation. The
monetary policy should also promote the inflow of foreign capital which is one of the
essential perquisites of the economic growth of a country.
RoIe of Monetary PoIicy in a DeveIoping Economy
n modern times, any newly developing country may be concerned with the problem of how
to use the monetary policy successfully to stimulate economic growth. n an underdeveloped
country, the monetary policy has to play a vital role in developing the economy from a stage of
primary backwardness to a stage of self-sustained growth. Monetary policy which is one thing in an
advance economy, may be quite another in an underdeveloped economy.
Under the growth-oriented monetary policy, monetary management by the central bank
becomes a strategic of development in an underdeveloped country, on the following counts:-
(1) When the country aspires for rapid economic development, it adopts economic planning.
n the process, financial planning needs the support of credit planning and appropriate
monetary management.
(2) Underdeveloped countries are most susceptible to inflation- nflation in an underdeveloped
economy generally occurs when there is an abnormal increase in the effective demand
exerted mainly by huge government expenditures under the planning process. However
the maintenance of stability in the domestic price level and a fixed, realistic exchanged
rate are very essential preconditions for achieving a maximum rate of sustained economic
growth. This needs equilibrium of saving and investment. n an underdeveloped country,
however, since the rate of savings is very low, government is usually tempted to raise the
level of investment by means of credit expansion and deficit financing. Development
efforts of the nature are generally confronted by inflationary prices increases. To some
economist this (inflation) is an inevitable price to be paid for economic growth.
(3) The growth objective of monetary policy in underdeveloped countries implies the
promotional role of monetary authorities, Briefly the promotional role of the monetary
authorities in an underdeveloped country may be to improve the efficiency of the banking
system as a whole or extend sound credit where needed and to respond promptly to
changing conditions.
(4) t is an important task of the monetary authority to improve the conditions of unorganized
money and capital markets in poor countries in the interest of rapid economic development
and the successful working of monetary management.
(5) An important function of monetary policy in an underdeveloped economy is to have and
also to make use of a most suitable interest role structure.
(6) Public debt management responsibility also lies with the monetary authority of the country.
n a growing economy, thus it is very important and difficult task.
(7) Underdeveloped countries are characterized with 20-30 percent of non-monetized sector.
Hence, it is the prime duty of the monetary authority to extend the process of monetization
in there barters sections of the economy. This will tend to improve the working and
effectiveness of the monetary policy.
Limitations of Monetary PoIicy in DeveIoping ountries
Monetary policy in a developing country is an important instrument in the hands of the
central bank, which may be used to ensure economic growths. However, the success of monetary
policy is subject to following limiting factors:-
(i) UnderdeveIoped Money and apitaI Market: The central bank cannot effectively
implement the various credit central measures in the absence of well-organized money
and capital markets. Underdeveloped countries do not have well developed and fully
organized money and capital market.
(ii) No integrated rate of interest structure: The banking sector in underdeveloped
countries is unorganized from where a sizeable financial resource comes. There is
therefore, no integrated rate of interest and therefore the central bank fails to influence the
market rate of interest by changing the bank rate. n fact, the change in bank rate must be
reflected in the form of increased or decreased market rate of interest.
(iii) Lack of ooperation between te ommerciaI Banks: The monetary policy cannot be
effectively implemented in the absence of cooperation between the commercial banks and
the central bank because the central bank can implement its monetary policy through
commercial banks. n developing countries there is no such cooperation of commercial
banking institutions with the central bank and in some case the bank flout the central bank
directives.
(iv) Banking Habits of te PeopIe: n developing countries, people are not habitual to bank
their savings due to law level of income and savings and lock of banking facilities.
Consequently most of the transactions are entered into cash and not through credit
instruments. t is for this reason that the credit control measures of the central bank do not
have desired effect on the business activities.
(v) IIIiteracy and SociaI ObstacIes: Most of the developing countries suffer from mass
illiteracy, superstition, dogmatism and many other, social evils. People do not understand
the significance of banking institutions hence they do not deposit their money into or take
loans from the banks. The success of monetary policy depends upon the wide people,
adequate development of credit facilities, entrepreneurial ability etc.
Tecniques/Instruments of Monetary PoIicy
General (Quantitative) Methods Selective (Qualitative) Methods
(1) Bank Rate
(2) Open Market Operations
(3) Variations in the reserve requirement
(4) Repo Rate
(5) Liquidity Adjustment Facility
(1) Rationing of Credit
(2) Margin Requirement
(3) Variable interest rate
(4) Regulation of Consumer Credit
(5) Licensing
(A) GeneraI (Quantitative) Metods: There are following general quantitative instruments of
credit control:-
(1) Bank Rate: The Bank Rate, also known the Discount Rate, is the oldest instrument of
monetary policy. Bank rate is the rate at which the central bank discounts or more
accurately, re-discounts-eligible bills. n a broader sense, it refers to the minimum rate at
which the central bank provides financial accommodation to commercial banks in the
discharge of its function as the lender of the last resort. The bank rate policy seeks to affect
both the cost and availability of credit.
(2) Open Market Operations: Open Market Operations refers broadly to the purchase and sale
by the central bank of a variety of assets, such as foreign exchange, gold, government
securities and even company shares.
Under the open market operations, the central bank seeks to influence the economy either
by increasing the money supply or by decreasing the money supply.
(3) Variations in te Reserve Requirement: The Reserve Bank also uses the method of
variable reverse requirement to control credit in ndia. By changing the ratio, the Reserve
Bank seeks to influence the credit creation power of the commercial banks. These
requirements of are of two types.
(i) as Reserve Ratio: Cash Reserve Ratio refers to that portion of total deposits of a
commercial bank which it has to keep with the Reserve Bank in the form of cash
reserves. The Reserve Bank is empowered to vary this ratio between 3 percent to 15
percent of the total demand & time liabilities.
(ii) Statutory Iiquidity Ratio: Statutory liquidity Ratio refers to that portion of total deposits
of a commercial bank, which it has to keep with itself in the form of liquid assets. The
SLR at present is 25 percent for on tire net demand and time liabilities of the scheduled
commercial banks.
(4) Repo Rate: Repo Rate are classified into interbank repo and RB repo rate:-
(i) Inter Bank Repo: Such repos are new permitted only under regulated conditions. Repos
are miscued by bankers/bankers during the 1992 securities scam. They were banned
subsequently, with the lifting of the ban in 1995l repos were permitted for restricted,
eligible participants and instruments. nitially, repo deals were allowed in T-bills and five
dated securities on the NSE. Repo are allowed to develop a secondary market in PSU
bonds, Fs bonds, corporate bonds and private debt securities if they are heed in demit
form and the deals are done through recognized stock exchange(s). Non-bank
participants are allowed to participate only in the reverse repo i.e. they can only lend
money to other eligible participant. The non-bank entities holding SGL accounts with the
RB can enter into reverse repo transactions with banks PDs, in all Government
securities.
(ii) RBI Repos: The RB undertakes repo/reverse repo operations with banks and PDs as
part of its OMOs to absorb/inject liquidity, with the introduction of the LAF the RB has
been injecting liquidity into the system through repo on a daily basic. The repo auctions
are conducted on all working days except Saturdays and are restricted to bank and PDs.
This is an addition to the liquidity support given by the RB to the PDs through re-
finance/reverse repo facility at a fixed price. Auctions under LAF were earlier conducted
on a uniform price basis, i.e., there was a single repo rate for all successful bidders.
The RB conducts repo auctions to provide banks with an outlet for managing short-term
liquidity, even-out short-term liquidity fluctuations in the money market and optimize
returns on short term surplus liquid funds.
(5) Liquidity Adjustment FaciIity: An array or instrument to transfer short-term liquidity and
interest rate signals in a more flexible and bidirectional manner. A liquidity Adjustment
Facility (LAF) has been introduced since June 2000 to precisely modulate short-term
liquidity and signal short-term interest rates. The LAF, in essence, operator through repo
and reverse repo auctions, thereby setting a corridor for the short-term interest rate
consistent with policy objectives. The RB is able to modulate the large market borrowing
program by combining strategic debt management with active open market operations. The
bank rate has emerged as a reasonable signaling rate, while the LAF rate has emerged as
both a tool for liquidity management and signaling of interest rates in the overnight market.
The RB has also been able to use open market operations.
(B) SeIective (Quantities) Metods:
The quantitative contracts explained above effect indiscriminately all sector of the economy,
which depend upon bank credit, they central volume of credit but leave the directionary
credit completely free. Selective controls are designed to regulate the direction of credit.
These controls by distinguished between essential and non-essential user of bank credit,
divert resources to essential and priority sectors. These are explained below:
(1) Rationing of redit: Credit rationing implies controlling and regulating the purpose for
which bank credit can be used. t generally provides for three things:-
(i) an overall ceiling on loans and advances for every commercial bank.
(ii) fixing the ratio which the capital of commercial bank should have and
(iii) fixing ceilings for specific categories of loans and advances.
Credit rationing is also exercised by placing restrictions on demand of accommodation
and rediscounting facilities for each bank. The central bank may charge a penal rate on
interest from banks, which cross the prescribed limits in relation to their overall liquidity
position. This method curtails the freedom and initiative of the commercial bank.
(2) Margin Requirement: The difference between the value of security and the amount
borrowed against this security is known as margin. The central banks are generally
empowered to fix margin limits for various uses of credit which the commercial banks must
observe. Margin requirements, while directly affecting the lender also put a restraint upon
the borrower and thus keep-down the volume of credit. By presenting different margin
requirements for different uses, the central bank can direct credit to more urgent uses.
(3) VariabIe Interest Rates: Variable interests rates changed selectively for different user,
places or borrower can be considered or selective or against a general dear or cheap
money policy pursued through changes in the bank rate ceiling are also provided for rates
which commercial banks can change from the borrower for specific user.
(4) ReguIation of onsumer redit: This is often practiced when there is either abundance or
shortage of certain consumer articles, extending or limiting the time for repayment or by
lowering or raising the limit of down payment to meet the situation of depression recession
on the one hand and inflation on the other.
(5) Licensing: The RB ensures proper regional coverage through licensing. Though this
incidentally is served the cause of selectively in regional development.
FiscaI PoIicy
Fiscal Policy may be defined or that part of governmental economic policy which deals with
taxation, expenditure, borrowing and the management of public debt in an economy. t is an
instrument of modern public finance.
According to a Arthur Smithies, "Fiscal policy is a policy under which government uses its
expenditure and revenue programs to produce desirable effects and avoid undesirable effects on
the national income, production and employment."
Features of FiscaI PoIicy of India
(1) RationaIization of Product cIassification odes: A very welcome change brought about
for administrative convenience is the adoption of a rationalized standard product code
structure for indirect taxes. The change has resulted in reduced disputes and ligations about
product classification.
(2) ommon Accounting Year for Income Tax: Taxation policy has adopted standard
accounting year (April-March) for the purpose of ncome Tax. The change is intended to
reduce the malpractices and raise tax revenues.
(3) Long Term FiscaI PoIicy: Since 1986 budget, the government of ndia has introduced long
term fiscal policy to provide greater certainties in its budgetary policies and to improve the
over all environment of business.
(4) Impact on RuraI EmpIoyment: Generation of employment has been an important objective
of fiscal policy. The Govt. of ndia has introduced new employment schemes like Jawahar
Rozgar Yojna or strengthened the existing schemes like ntegrated Rural Development
Program or National Rural Employment Program.
(5) BIack Money: Unaccounted money has been a constant feature of ndia's economy fiscal of
black money. Schemes like Voluntary Disclosure, Bearer Bonds or ndira Vikas Patra have
had marginal impact on the incidence and growth of black money.
(6) ReIiance on Indirect Taxes: The tax policy is increasingly becoming regressive in nature by
large dependence on indirect taxes like excise duty or custom duty as compared to that on
direct taxes like incomes taxes, corporation tax, capital gains tax etc.
(7) Inadequate PubIic Sector ontribution: Contrary to repeated arresting by the
Government of ndia public sector continues to be drain on the meager resources of the
Government. Plan schemes of finance have expected sizable contribution from public sector
which has not materialized in most cases.
(8) Introduction of MODVAT: n 1986 the introduction of MODVAT has helped to reduce the
cumulative impact of indirect taxes on manufactured products. Under MODAVAT the
manufacturer while charging full rate of excise duty on his while charging full rate of excise
duty on his output, get credit for tax paid on inputs. This reduces the cascading effect of
excise duty.
(9) InfIationary PotentiaI: With large budget deficits, indirect taxes, shortages, black money
and rising money incomes, inflationary trend in economy has been remarkable. The fiscal
policy instead of being a cure of inflation has become the cause if inflation.
(3) PubIic Debt.: Public debt can also be employed by the government as an instrument to fight
depression and unemployment. The deficits in government's budgets shall have to be met
partly if not wholly through public borrowings. But while adopting the fiscal policy of public
debt, the government shall have to keep the following two considerations in mind. Firstly in
order to keep the burden of public debt law, the government should aim at a policy of law
interest rates during depressions. Secondly, the govt. should try as far as possible to borrow
from those sections of the community with whom the funds are lying idle. The idea is to
utilize those idle funds through borrowing for productive purposes.
(4) PubIic Expenditures: An increase in public expenditure can also be employed by the
government as an instrument to fight against depression and unemployment. ncrease in
public expenditure at such a time may take the following two forms:
(i) Pump Priming: Pump Priming refers to that public expenditure which helps imitate and
reins supreme consequent upon depression. The object is to increase private investment
through an injection of purchasing power in the form of increasing in public expenditure.
(ii) ompensatory Spending: Compensatory spending refers to the government
expenditure which is undertaken with a view to compensating the decline in private
investment. Usually private investment suddenly declines at the time of depression.
Under these circumstances there is no alternative before the government except to
resort to public investment.
Advantage of FiscaI PoIicy
(1) apitaI Formation: Fiscal Policy has played a very important role in raising the rate of
capital formation in country- in private as well as public sector. A major part of budgetary
resources has been invested in public sector enterprises which have resulted in increase in
gross domestic capital formation as percent of GDP from 10.2 percent in 1950-51 to 22.9 in
1997-98 and to 23.7 percent in 2001-02.
(2) Resource MobiIization: Fiscal Policy has helped to mobilize resources through taxes,
sowings, public debt, etc. for economic development of the country. Resource Mobilization
which was 70 per cent in 1965-66 has increased to 40 percent in 2001-02.
(3) Incentives to Private Sector: Private Sector has been encouraged under fiscal policy for
investment and production. Tax concessions can subsidies exemptions in taxes have been
give as incentives to private sector units set up in backward areas and export oriented units.
(4) Encourages Saving: Various incentives have been given to raise the rate of savings in
household and corporate sector. To encourage savings in house hold sector various
concessions and tax benefits have been given on fixed deposits, live insurance schemes,
Kisan Vikas Patras (KVPs), National Saving Certificates (NSCs), Provident Fund etc. saving
have also been encouraged in corporate sector by offering them tax concessions and tax
exemptions.
(5) Poverty aIIeviation and EmpIoyment generation: To fulfill one of its major objectives of
providing full employment, allocation of huge amount has been made in fiscal policy to
eradicate poverty and generate employment. For this a huge amount has been sprat on
different schemes like twenty point programme, ntegrated Rural Development Programme
(RDP), Jawahar Rozgar Yojna (JRY), Prime minister Rojgar Yojna (PMRY), Employment
Assurance Scheme (EAS), encouraging small scale and cottage industries etc.
(6) Reduction in InequaIity of Income & WeaIt: Fiscal Policy of the country has been making
constant endeavor to reduce inequality of income and wealth, Resources have been
mobilized from rich class to poor by way of progressive taxes, wealth tax, corporation tax
and capital gain tax, etc and this money has been utilized for the welfare of poor people.
(7) Export Promotion: Exports have been encouraged by way of providing subsidies,
concessions, tax exemptions, cash subsidies, etc. Exports have shown a rise from 4.5
percent in 1960-62 to 23.4 percent in 2001-02. mport duty on raw material and capital
goods used for productions of goods meant for export has also been reduced with a view to
encourage exports.
Foreign Excange Market
The foreign exchange (currency or forex or FX) market refer to the market for currencies.
Transactions in this market typically in value one party purchasing a quantity of one currency in
exchange for paying a quantity of another. The FX market is the largest and most liquid financial
market in the world, and includes trading between large banks, central banks currency speculators,
corporative government and other institutions.
According to Kindleberger, "Foreign exchange market is a place where foreign moneys are
bought and sold."
Foreign exchange market is an institutional arrangement for buying and selling of foreign
currencies. Exporters sell the foreign currencies. mporters buy them..
aracteristics of Foreign Excange Market
(1) EIectronic Market: Foreign exchange market does not have a physical place. t is a market
whereby trading in foreign currencies takes place through the electronically linked network
of banks, foreign exchange brokers and dealers whose function is to bring together buyers
and sellers of foreign exchange.
(2) GeograpicaI DispersaI: A redeeming feature of the foreign exchange market is that it is
not to be found one place. The market is vastly dispersed throughout the leading financial
centers of the world such as London, Newyork, Paris, Zurich Amsterdam, Tokyo, Hong
Kong, Toronto and other cities.
(3) Transfer of Purcasing Power: Foreign exchange market aims at permitting the transfer of
purchasing power denominated in one currency to another whereby one currency is treated
for another currency.
(4) Intermediary: Foreign exchange markets provide a convenient way of converting the
currencies earned into currencies wanted of their respective countries. For this purpose, the
market acts as an intermediary between buyers and sellers of foreign exchange.
(5) VoIume: A special feature of the foreign exchange market is that out of the total trading
transactions that take place in the foreign exchange market, around 95 percent takes the
forms of crore-border purchase and sale of assets, i.c., international capital flows. Only
around 5 percent relates to the export and import activities.
(6) Provision of redit: A foreign exchange market provides credit through specialized
instruments such as banker's acceptances and letters of credit. The credit, thus provided is
of much help to the traders and businessmen in the international market.
(7) Minimizing Risks: The foreign exchange market helps the importable and exporter in the
foreign trade to minimize their risks of trade. This is being done through the provision of
'Hedging', facilities. This enables traders to transact business in the international market with
a view to earning a normal business profit without exposure to an expected change in the
anticipated profit. This is because exchange rates suddenly change.
Functions of Foreign Excange Market
(1) Transfer Function: The basic function of any foreign exchange market is to facilitate the
conversion of one currency into another i.e., to accomplish transfers of purchasing power
between two countries. This transfer of purchasing power is affected through a variety of
credit instruments, such as telegraphic transfers, bank draft and foreign bills.
(2) redit Function: This function of the foreign exchange market is to provide credit, both
national and international to promote foreign trade; obviously, when foreign bills of exchange
foreign trade; obviously, when foreign bills of exchange are used in international payments,
a credit for about 3 months, till their maturity is required.
(3) Hedging Function: A third function of the foreign exchange market is to hedge foreign
exchange risks. n a free exchange, market when exchange rate, i.e., the price of one
currency in terms of another currency change there may be a gain or loss to the party
concerned. Under this condition, a person or a first undertakes a great exchange risk if there
are huge amounts of net claims or net liabilities which are to be mat in foreign money.
Exchange risk as such should be avoided or reduced. For this the exchange market
provides facilities for hedging anticipated or actual claims or liabilities through forward
contracts in exchange.
Structure of Foreign Excange Market
Banks and Money
Changers (Currencies nter-bank (Bank Central
bank note, cheques) accounts or deposits) Bank
(1) RetaiI Markets: The exchange of bank notes, bank drafts, currency, ordinary and traveler's
cheques between private customers, tourists & banks takes place in the retail market. The
RB has granted two types of money changer's licenses to certain established firms, hotels,
shops and other organizations to deal in currency notes, coins and traveler's cheques to a
limited extent.
(2) WoIesaIe Market: The wholesale market is primarily an inter-bank market in which major
banks trade in currencies held in different currency-dominated bank accounts, i.e., they
transfer market is far larger than the bank notes market. Only the head offices and regional
officer of the major commercial banks are the market makers in the wholesale market. Most
of the small banks and the local offices of even the major banks do not deal directly in the
inter-bank market. Most of the small banks do not deal directly in the interbank market. They
usually have a credit line with large banks with their head officer and they serve their
customers through the latter. Through correspondent relationship with banks in other
countries, major banks have ready access to foreign currencies.
(i) Inter Bank Market: (a) Direct Market: n the direct market, banks quote buying and
selling prices directly to each other and all participating and selling prices directly to each
other and all participating banks are market makers. t has been some times,
characterized as a "decentralized, continuous, opens-bid, double auction" market.
(b ) Indirect Market: n the indirect market, the bank put orders with brokers who put them on
"books", and try to match purchases and sales orders for different currencies. They
charge commission to both the buyers and sellers. This market is characterized as
"quasi-centralized", continuous, limit book, "single-auction" market.
(ii) entraI Banks: Normally the monetary authorities of a country are not indifferent to
changes in the external value of their currency, and even through exchange rates of the
major industrialized nations have been left to fluctuate freely since 1973, central bank
frequently intervene to buy and sell their currencies in a bid to influence the rate at which
their currency is traded. Under a fixed exchange rate system the authorities are obliged
Foreign Excange Market
RetaiI WoIesaIe
to purchase their currencies when there is excess supply and sell the currency when
there is excess demand.
Participants of Foreign Excange Market
(1) RetaiI Iients: These are made up of business international investors, multinational
corporations and the like who need foreign exchange for the purpose of operating their
businesses. Normally, they do not directly purchase or sell foreign currencies themselves;
rather they operate by placing buy sell order with commercial banks.
(2) ommerciaI Banks: The commercial banks carry our buy/sell orders from their retail clients
and buy/sell orders from their retail clients and buy/sell currencies of their assets and
liabilities in different currencies.
(3) Foreign Excange Brokers: Often banks do not trade directly with one, another, rather
they offer to buy and sell currencies via foreign exchange brokers. Operating through such
brokers is advantageous because they collect buy and sell quotations for most currencies
from many banks, so that the most favorable quotation is obtained quickly and at very low
cost.
(4) entraI Banks: Normally the monetary authorities of a country are not indifferent to
changes in the external value of their currency, and even though exchange rates of the
major industrialized nations have been left to fluctuate freely since 1973, central banks
frequently intervene to buy and sell their currencies in a bid to influence the rate at which
their currency is traded.
(5) Firms engaged in Foreign Excange transactions: Firms engaged in foreign exchange
transactions have a stable demand of foreign currency and supply. According to rule
imposed they do not have direct access to the foreign exchange market. They conducted
their business through commercial banks.
(6) Investment Funds: These companies, represented by various international investments,
mutual funds, insurance companies and trusts, realize the policy of diversified management
of portfolio of assets by placing their money in securities of the governments and
corporations of different countries.
(7) Private Persons: Private persons realize a wide range of transactions in the area of foreign
trade, tourism, pension, royal etc. this is also the biggest group involved into such
transactions.
Factors Affecting Foreign Excange Market
(1) Economic Factors: These include economic policy disseminated by government agencies
and central banks, economic conditions, generally revealed through economic reports, and
other economic indicators. Economic Policy comprises government fiscal policy (budget's
pending practices) and monetary policy.
Economic conditions incIude:
(i) Government Budget Deficits or SurpIuses: The market usually reacts negatively to
widening government budget deficits, and positively to narrowing budget deficits. The
impact is reflected in the value of a country currency.
(ii) BaIance of Trade LeveIs and Trends: The trades flow between countries illustrates the
demand for goods & services, which in turn indicates demand for a country's currency to
conduct trade. Surplus and deficits in trade of goods and services reflect the
competitiveness of a nation's economy. For example: trade deficits may have a negative
impact on a nation's currency.
(iii) InfIation LeveIs and Trends: Typically, a currency will lose value if there is a high level
of inflation in the country or if inflation levels are perceived to be rising. This is because
inflation erodes purchasing power, thus demand for that particular currency.
(iv) Economic Growt & HeaIt: Reports such as Gross Domestic Product (GDP),
employment levels, retail sales, capacity utilization and others detail the levels of a
country's economic growth and health. Generally the more healthy and robust a
country's economy, the better its currency will performs and the more demand for it there
will be.
(2) PoIiticaI onditions: nternal, regional and international political conditions and events can
have a profound effect on currency markets.
(3) Market PsycoIogy: Market psychology and trader perceptions influence the foreign
exchange market in a variety of ways:-
(i) FIigts to QuaIity: Unsettling international events can lead to a "flight to quality", with
investors seeking a "safe haven". These will be a greater demand thus a higher price, for
currencies perceived as stronger over their relatively weaker counterparts. The Swiss
Fran has been a traditional safe heaven during times of political or economic uncertainty.
(ii) Long-Term Trends: Currency market often moves in visible long term trends. Although
currencies do not have an annual growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks at longer-term price trends that
may rise from economic or political trends.
(iii) "Buy te Rumar, SeII te Fact: This market tourism can apply to many currency
situations. t is the tendency for the price of a currency to reflect the impact of a
particular action before it occurs and, when the anticipated events come to pass, react in
exactly the opposite direction. This may also be referred to as a market being "oversold"
or "overbought". To buy the rumor or sell the fact can also be an example of the
cognitive bias known as anchor sing, when investors focus too much on the relevance of
outside events to currency prices.
(iv) TecnicaI Trading onsiderations: As in other markets, the accumulated price
movements in a currency pair such as EURUSD can form operated patterns that traders
may attempt to use. Many traders study price chart in order to identify such patterns.
Foreign Excange Transactions
(1) Spot transaction: A spot transaction is an outs right purchase and sale of foreign currency for
cash settlement not more than two business days after the date the transaction is recorded as
a spot dead.
(2) Forward Transaction: n this transaction, money does not actually change hands until some
agreed upon future date. A buyer and seller agree on an exchange rate for any date in the
future and the transaction occurs on that date, regardless of what the market sales.
(i) Futures: Foreign currency futures are forward transactions with standard contract sizes
and maturity dates-e.g. 5,00,000 British pounds for next November at an agreed rate.
These contracts are traded on a separate exchange setup for that purpose.
(ii) Swap: The most common type of forward transactions is the currency swop. n a swap,
two parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date.
(iii) Options: An option is similar to a forward transaction. t gives its owner the right to buy
or sell a specified amount of foreign currency at a specified certain date. An option that
gives the right to buy is known as 'call' while one that gives the right to sell is known as a
'put'.
FinanciaI Sector Reforms in India
The New Economic Policy of structural adjustments and stabilization programme was given
a big thrust in ndia in June 1991. The financial sector reforms have received special attention as a
part of this policy because of the perceived inter-dependent relationship between the real and
financial sectors of the modern economy. mmediately after the announcement of NEP, the
government had appointed a high level committee on financial system," to examine all aspects
relating to the structure, organization, functions and procedures of the financial system." The
committee submitted its main report in November 1991. Since then the authorities have introduced
a large number of changes or reforms in the ndian Financial sector in the light of the said report.
The need for financial reforms had arisen because the financial institutions and markets
were in a bad shape. The banking sector suffered from lack of competition, low capital base, low
productivity and high intermediation costs. The role of technology was minimal and the quality of
service did not receive adequate attention. Propose risk management system was not followed, and
prudential norms were weak. All there resulted in poor assets quality. Development financial
institutions operated in an over protected environment with most of the funding coming from
assured sources. There was little competition in insurance and mutual funds industries.
Objectives of FinanciaI Reforms introduced in 1991
(1) To develop a market-oriented, competitive, world integrated, diversified, autonomous,
transparent financial system.
(2) To increase the a locative efficiency of available savings and to promote accelerated growth
of the real sector.
(3) To increase or bring about the effectiveness, accountability, profitability, viability, vibrancy,
balanced growth, operational economy and flexibility, professionalism and de-politicization in
the financial sector.
(4) To increase the rate of return on real investment.
(5) To promote competition by creating level-playing fields and facilitating free entry and exit for
institutions and market players.
(6) To ensure that the rationalization of interest rates structure occurs, that interest rates are
flexible, market-determined or market related, and that the system offers to its users a
reasonable level of positive real interest rates. n other words, the goal has been to
dismantle the administered system of interest, rates.
(7) To reduce the levels of resource pre-emption and to improve the effectiveness of directed
credit programs.
(8) To build a financial infrastructure relating to supervision, audit, technology and legal matters.
(9) To modernize the instruments of monetary control so as to make them more suitable for the
conduct of monetary policy in a market economy.
Major Reforms After 1991 in FinanciaI System
(I) Systematica & PoIicy Reforms.
(1) Most of the interest rates in the economy deregulated, a beginning made to move towards
market rates on government securities.
(2) The perception of banks' resources through SLR in favour of the government was brought
down and the rate of return an SLR securities is maintained by and large at market rates.
(3) Capital Adequacy norms for banks, financial institutions, and virtually all market
intermediaries, introduced. The Basel Committee framework for capital adequacy adopted.
(4) A Board of Financial Supervision with an advisory council and an independent department
supervision established in RB.
(5) Recovery of Debts due to Banks and Financial nstitutions Act, 1993 passed to set up
special recovery tribunals to facilitate quicker recovery of loan arrears.
(6) The private sector was allowed to set up banks, mutual funds, money market mutual funds,
insurance companies etc. Public sector banks permitted diversified ownership by law subject
to 51 percent holding of government/RB, FC and RB converted into public limited
companies.
(7) Capital ssues (Control) Act, 1947 replaced and the office of controller of Capital ssues
abolished.
(8) Securities and Exchange Board of ndia (SEB) made a statutory body in February 1992 and
armed with necessary authority and power for regulation and reform of the capital market.
(9) The Reserve Bank of ndia (Amendment) Act, 1997 passed requiring all non-bank financial
companies (NBFCs) with net-owned funds of Rs 25 lacs and more to register with the RB.
(10) Over the Counter Exchange of ndia (OTCE) and the National Stock Exchange (NSE) with
nationwide stock tradition and electronic display, clearing and settlement facilities
established and made operational.
() Banking Reforms:
(1) nterest rates on deposits and advances of all co-operative banks including urban
cooperative bank deregulated. Similarly interest rates on commercial bank loans above Rs.
2 lacs, and on domestic term deposits above two years and Non-Resident (External) Rupee
Accounts [NRNR] deposits decontrolled.
(2) The State Bank of ndia and other nationalized banks enabled to access the capital market
for debt and equity.
(3) Prudential norms for income recognition, classification of assets and provisioning for bad
debts for commercial banks, including regional rural banks and financial institutions
introduced.
(4) Banks required making their balance sheets fully transparent and making full disclosures in
keeping with nternational Accounts Standards Committee.
(5) Banks gave greater freedom to open, shift and swap branches as also to open extension
counters.
(6) The budgetary support extended for recapitalization of weak public sector banks.
(7) Banks set free to fix their own foreign exchange open position limit subject to RB approval.
() Primary and Secondary Stock Market Reforms
(1) Primary ssue to be made compulsory through the Depositary Mode after a specified date.
(2) 100 percent Book Building in respect of issues of Rs 25 crore and above.
(3) Reduction in the number of mandatory collection centers in respect of issues above Rs. 10
crore to four metropolitan cities.
(4) The payment of any direct or indirect discounts or commissions to persons receiving firm
allotment prohibited.
(5) Housing finance companies considerate to be registered for issue purposes provided they
are eligible for refinance from the National Housing Bank.
(6) A ceiling of Rs. 10 crore imposed on stock market members doing business of financing
carry forwarded transactions.
(7) Stock lending scheme without attracting capital gains introduced. Under this scheme, short
sellers can borrow securities through an intermediary before making such sales.
(8) All stock exchanges required to institute the buy-in or auction process.
(9) The stock exchanges are being modernized, many of them have introduced electronic
trading system the Bombay Stock Exchange has started its on-line trading system, BOLT.
(10) Both long and short sales are required to be disclosed to the exchange at the end of each
day, and they are to be regulated through the imposition of margins.
(11) There are many other stock market reforms which have been introducing during the past
five to six years.
(V) Government Securities Market Reforms:
(1) A 364-day treasury bill (TB) replaced the 182-days TB in 1992-93, and it is being sold by
fortnightly auction since April 1992.
(2) Auction of 91 days TB commenced from January 1993.
(3) Maturity period for new issues of Central government securities shortened from 20 to 10
years and that for state government securities from 150 to 10 years.
(4) Funding of auction TBs into fixed coupon dated securities at the option of holders introduced
since April 14, 1493.
(5) Six new instruments were introduced:-
(i) Zero coupon bonds on 18-1-94
(ii) Top stock on 29-7-94.
(iii) Partly paid government stock on 15-11-94
(iv) An instrument combining the features of tap and partly paid stocks on 11.9.95.
(v) Floating rate bonds on 29.9.95
(vi) Capital ndexed Bonds in 1997.
(6) A scheme for auction of government securities from RB's own portfolio as a part of its open
market operations announced in March 1995.
(7) Reverse repo facility with RB in government dated securities extended to Discount and
Finance House of ndia (DFH) and Securities Trading Corporation of ndia (STC).
Please check to this matter for adjustment
(c) FinanciaI Assets & Instruments
FinanciaI Assets: n any financial transaction, there should be a creation or transfer of
financial assets hence the basic product of any financial system is the financial asset. A
financial asset is one which is used for production or consumption or for further creation of
assets. For instance, a buys equity share and there shares are financial assets since they
earn income in future. t is interesting to note that the objective of investment decides the
nature of the asset. For instance if a building is bought for residence purpose, it becomes a
physical asset. f the same is bought for hiring, it becomes a financial asset.
Iassification of FinanciaI Assets
Financial assets can be classified differently under different circumstances. One such
classification is:
(i) Marketable assets.
(ii) Non-marketable assets.
(i) MarketabIe assets: Marketable assets are those which can be easily transferred from one
person to another without much hindrance. Examples are sharers of listed companies,
Government securities, bonds of public sector undertaking etc.
(ii) Non-MarketabIe Assets: On the other hand, if the assets cannot be transferred easily, they
come under this category. Examples are bank deposits, provident funds, pension funds,
National Savings Certificates, nsurance Policies etc.
(iii) Yet another classification is as follows: (a) Money or cash asset (b) Debt asset (c) Stock
asset
(a) as Asset: n ndia, all coins and currency notes are issued by the RB and Ministry of
Finance, Government of ndia. Besides, commercial banks can also create money by means
of creating credit. When loans account is opened in the borrowers name and a deposit is
created. t is also a kind of money asset.
(b) Debt Asset: Debt asset is issued by a variety of organizations for the purpose of raising
their debt capital. Debt capital entails a fixed repayment schedule with regard to interest and
principal. There are different ways of raising debt capital. Examples are issue of debentures,
rising of term loans, working capital advance etc.
(c) Stock Assets: Stock is issued by business organizations for the purpose of raising their
fixed capital. There are two types of stock namely equity and preference. Equity
shareholders are the real owners of the business and they enjoy the fruits of ownership and
at the same time they bear the risk as well. Preference shareholders of debt asset) and at
the same time they retain some characteristics of equity.
FinanciaI Instruments: Financial instruments refer to those documents which represent
financial claims on assets. As discussed earlier, financial asset refers to a claim to the
repayment of a certain sum of money at the end of a specified period together with interest
or dividend. Examples are bill of exchange, Promissory Note, Treasury bill, Government
Bond, Deposit Receipt, Share Debenture etc. Financial instruments can also be called
financial securities. Financial securities can be classified into:-
(i) Primary or direct securities.
(ii) Secondary or indirect securities.
(i) Primary Securities: There are securities directly issued by the ultimate investors to the
ultimate severs. e.g. shares and debentures issued directly to the public.
(ii) Secondary Securities: These are securities issued by some intermediaries called financial
intermediaries to the ultimate savers, e.g. Unit Trust of ndia and mutual funds issue
securities in the form of units to the public and the money pooled is invested in companies.
Again these securities may be classified on the basic of duration as follows:
(a) Short-term securities
(b) Medium-term securities
(c) Long-term securities.
Short-term securities are those which mature within a period of one year. For example, Bill
of Exchange, Treasury Bill, etc. Medium-term securities are those which have a maturity
period ranging between one and five years like Debentures maturing within a period of 5
years. Long-term securities are those which have a maturity period of more than five years.
For example, Governments Bonds maturing after 10 year.
( D) Overview of FinanciaI Services
Financial services can be defined as the products as the products and services offered by
institutions like banks of various kinds for the facilitation of various financial transactions and other
related activities in the world of finance like loans, insurance, credit cards, investment opportunities
and money management as well as providing information on the stock market and other issues like
market trends.
NaturaI aracteristics of FinanciaI Services
Like any other service, financial services are characterized by the following:;
(1) IntangibiIity: The basic characteristics of financial services are that they are intangible in
nature. For financial services to be successfully created and marketed, the institutions
providing them must have a good image and the confidence of its clients.
(2) ustomer Orientation: The institution providing the financial services study the needs of
the customer's in detail. Based on the results of the study they come out with imitative
financial strategies that give due regard to costs liquidity and maturity considerations for
various financial products. This way, financial services are customer oriented.
(3) InseparabiIity: The function of producing and supplying financial services has to be carried
out simultaneously. This calls for a perfect understanding between the financial services
firms and their clients.
(4) PerisabiIity: Financial services have to be created and delivered to the target clients.
They cannot be stored. They have to be supplied according to the requirements of
customers. Hence, it is imperative that the providers of financial services ensure a match
between demand and supply.
(5) Dynamism: The financial services must be dynamic. They have to be constantly redefined
and refined on the basis of socio-economic changes occurring in the economy, such as
disposable income, standard of living, level of education etc.
(6) Derivatives and ataIysts: Financial services are derivatives of financial markets. They
form a part of the financial market and are, to an extent, catalysts in market operation.
(7) Act as Link: Financial services act as a link between investor and borrower. They provide,
various avenues to the investor for profitable investment and spreading out the risk. An
investor can exercise a high risk and high profit or low risk and low profit option, or can be
satisfied with a steady income pattern with reasonable risk.
(8) Distribution of Risks: Financial services make profitable deployment of funds and enable
the investor to distribute risk in multi-baskets, thereby, assuring a minimum rate of return.
Their market expertise enables them to advise investors in the selection of portfolio for an
assured return.
power that the commercial banks have been named the 'factories of creating credit/ or
manufacturers of money.
[2] Agency Functions: For these services, the bank charges a certain commission from its
clients. The various agency services rendered by the bank are as follows:
(i) Transfer of Funds: The bank helped its customers in transferring funds from one place to
another. The instrument used for this purpose is known as the "Bank Draft'. For this service
rendered the bank charges a small commission from the customers.
(ii) oIIecting ustomers Funds: The bank collects the funds of its customers from other banks
and credits them to their accounts.
(iii) Purcase and saIe of sares and securities for its customers: The bank buys and sells
stocks and shares of private companies as well as government securities on behalf of its
customers.
(iv) oIIecting Dividends: The bank collects dividends as well as interest on the shares and
debentures of its customers of its customers and credits them to their accounts.
(v) Payment of Prima: The bank pays Premia to the insurance companies on behalf of its
customers. t may also pay certain bills of the customers as per their directions.
(vi) Acts as Trustee: The banks preserve the 'Wills' of the customers and executes them after
their death.
(vii) Income Tax onsuItant: The bank may also give advice to its customers on income-tax
matters. t may even prepare the income-tax returns of its customers on payment of its fee.
[3] GeneraI UtiIity Function: n addition to basic functions and agency functions the commercial
banks also provide general utility services for their customers which are needed in the various
walks of life and the commercial banks provided a helping hand in solving the general
problems of the customers, like safety from loss or theft and so many other facilities, some of
them are as under :-
(i) Locker Facility
(ii) Traveler's Cheque Facility
(iii ) Gift Cheqe facility
(d) Letter of Credit
(e) Underwriting Contract
(f) Foreign Exchange Facilities
(g) Merchant Banking Services
(h) Acting as Referll.
Banking Sector Reforms (1992-2005)
Despite stiff from bank unions and political parties in the country, the government of ndia
accepted all the major recommendations of Narasimhan Committee (1991) and started
implementing them.
(1) Statutory Liquidity Ratio (SLR): Statutory Liquidity ratio on incremental net Demand and
Time Liabilities (DTL) has been reduced from 38.5 percent to 25 percent and SLR on
outstanding net domestic demand and time liabilities were reduced gradually from 38.5
percent to 25 percent in October, 1997; this was the minimum stipulated under section 24 of
Banking Regulation Act, 1949.
(2) as Reserve Ratio (RR): The ncremental Cash Reserve Ratio (CRR) of 10 percent
was abolished but RB could not reduce CRR immediately. When conditions eased and
money growth started slowing down since 1995-96, RB reduced CRR gradually from 15 per
cent to 5-5 percent in December 2001
(3) PrudentiaI Norms: Prudential norms have been started by RB as part of the reformative
process. The purpose of prudential system of recognition of income, classification of assets
and provisioning of bad debts is to ensure that the books of the commercial banks reflect
their financial position more accurately and in accordance with internationally accepted
accounting practices. There help in more effective supervision of banks.
(4) apitaI Adequacy Norms: Capital adequacy norms were fixed at 8 percent by RB in April
1992 and banks had to comply with them over a three years period. By end March 1996, all
public sector banks had attained capital to risk weight age assets ratio of 8 percent. The full
norm of 8 percent was also attained by foreign banks in ndia and by some ndian banks.
(5) Access to apitaI Market: The Government of ndia has amended the Banking Companies
(Acquisition and transfer of under takings) Act to enable the nationalized banks to access
the market for capital funds through public issues, subject to the provision that the holding of
the Central Government would not fall below 51 percent of the paid-up capital.
(6) Freedom of Operations: Scheduled commercial banks have now been given freedom to
open new branches and upgrade extension counters, after obtaining capital adequacy
norms and prudential accounting standards.
(7) LocaI Area Banks: n the 1996-97 budget, the Government of ndia announced the setting
up of new private Local Area Banks (LABs) with jurisdiction over three contiguous districts.
These banks would help to mobilize rural savings and to channelize them into investment in
local areas. The RB has issued guidelines for setting up such banks in 1996 and gave its
approval.
(8) Supervision of ommerciaI Banks: Supervision of commercial banks is being tightened
by RB, especially after the securities scam of 1992. The RB has set up a Board of
Financial Supervision with an Advisory Council under the chairmanship of the Governor to
strengthen the supervisory and surveillance system of banks and financial institutions. RB
has also established in December 1993 a new department known as Department of
Supervision as an independent unit for supervision of commercial banks and to as list the
Board of Financial Supervision.
(9) Recovery of Debts: The Government of ndia passed "Recovery of Debts due to Banks and
Financial nstitutions Act, 1993" in order to facilitate and speed up the recovery of debts due
to banks and financial institutions. Six Special Recovery Tribunals have been set up at
Calcutta, New Delhi, Jaipur, Ahmadabad, Bangalore and Chennai to facilitate quicker
recoveries of loan arrears with months and an Appellate Tribunal has also been set up in
Mumbai.
Management of apitaI Funds
The capital funds constitutes one of the sources of funds for a commercial banks. t
represents owned resources, and includes the share capital subscribed by its shareholders as well
as the reserves built up by the bank by plugging back a part of its business earnings. Further, we
considered the following three important aspects of the management of capital funds in a
commercial bank.
(1) What are the real functions of bank capital?
accepted by Central Banks in various countries including RB. n ndia it has been implemented by
RB w.e.f. 1.4.92.
The fundamental objective behind the norms is to strengthen the soundness and stability of
the banking system. t is a measure of a bank's capital. t is expressed as a percentage of a bank's
risk weighted credit exposures.
Tier one capital + Tier two capital
CAR =
Risk weighted assets.
This ratio is used to protect depositors and promote the stability and efficiency of financial
systems around the world.
A new capital framework was introduced for ndian scheduled commercial banks, based on
the Basel Committee recommendations presenting two tiers of capital for the banks:-
(1) Tier or core capital, considered the most permanent and readily available supported
against unexpected losses, includes paid-up capital, statutory reserves, share premium and
capital reserve; and
(2) Tier capital consisting of undisclosed reserves, fully paid-up cumulative perpetual
preference shares, revaluation reserves, general previsions and loss reserves, etc.
(3) t was also prescribed that Tier i capital should not be more than 100 percent of Tier
capital.
Minimum requirements of capital fund in ndia:
(1) Existing Banks 09%
(2) New Private Sector Banks 10%
(3) Banks undertaking nsurance Business 10%
(4) Local Areas Banks 15%
Tier capital should at no point of time be less than 50% of the total capital. This implies that
Tier cannot be more than 50% of the total capital.
BaseI Norms:-
BaseI I: The Basel Committee on Banking Supervision had published the first Basel Capital
Accord (popularly called as Basel framework) in July, 1988 prescribing minimum capital adequacy
requirements in banks for maintaining the soundness and stability of the nternational Banking
System and to diminish existing source of competitive inequality among international banks.
BaseI II Norms: Basel is the second of the Basel Accords, which are recommendations on
banking laws and regulations issued by the Basel Committee on Banking Supervision.
Three Pillars of Basel i Norms:
Basel user a "three pillars" concept
(i) Minimum capital requirements (addressing risk)
(ii) supervisory review
(iii) Market discipline to promote greater stability in the financial system.
BaseI III Norms: Basel is the third of the Basel Accords, which are recommendations on
banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose
of Basel , is to create an international standard that banking regulators can use when creating
regulations about how much capital banks need to put aside to guard against the types of financial
and operational risks banks face.
Te overaII goaIs of BaseI III norms are:
(i) To refine the definition of bank capital
(ii) Quantify further classes of risk.
(iii) To further improve the sensitivity of the risk measures.
Liquidity Management
Liquidity is essential in all banks to compensate for expected and unexpected balance sheet
fluctuations and to provide funds for growth. The recent liquidity crisis faced by banks and financial
institution has brought to the fore, the need to review their existing Liquidity Management policies,
Practices and Procedures.
Liquidity and ProfitabiIity
The basic problem facing a bank manager is to have a satisfactory tradeoff between liquidity
and profitability the two principal but conflicting goals of a bank. Liquidity and profitability are,
therefore, contrary to each other. Cash has perfect liquidity but lack yield. At the other end are
some loans and investments which yield a high rate of interest, but are hardly liquid at all. The
conflict between liquidity and income is not as sharp as it appears. n order to ensure long-run
earnings, the commercial bank must retain public confidence in order to continue to service and
provide of the liquidity needs of the bank.
A number of approaches ways and means of resolving the conflicts have been developed
from time-to-time. These approaches subsequently came to be known as theories of liquidity
management.
Teories of Liquidity Management
The traditional theorists believe that a golden mean between liquidity and profitability can be
struck by a judicious allocation of funds between different kinds of assets. However, a new theory
has recently emerged, according to which a prudent management of liabilities yields a solution of
the problem of liquidity management. A brief discussion is as follows:-
(1) Self-liquidating Paper Theory/Commercial Loan Theory
(2) Shift ability Theory
(3) Anticipated ncome Theory
(4) Liabilities Management Theory
[1] SeIf-Iiquidating Paper Teory: This is considered to be the traditional or conservative
theory. According to this theory earning assets of a bank should primarily consists of such assets
which are self-liquidity in the short-term viz. short-term government or semi-government securities,
short-term productive advancer etc. Such assets are fairly liquid and meet one of the very basic
cannons of lending by a commercial banks. Short-term securities help the banks in maintaining their
liquidity through continuous loan repayments. They can also be pledged with Central Bank if an
emergency arises. Short-term productive loans help the bank in preserving their liquidity through
continuous repayment of these loans out of the sale proceeds of the goods covered by such loans.
Moreover short-term loans have less of risk as compared short-term loans have less of risk as
compared to long-term loans because of better estimate of the likely future events.
[2] SiftabiIity Teory: According to Shiftability Theory the problem of liquidity is not so much
a problem of the maturity of bank but one of shifting the assets to others for cash without material
loss. The bank need not rely upon maturities if it has maintained a substantial amount of such
assets as can be shifted on to others to meet an unexpected heavy run on it. Liquidity is this
equivalent to shiftability.
According to the shiftability theorists, an asset, to be perfectly shift able, must fulfill the
attributes of immediate transferability to others, without appreciable capital loss for the purpose of
meeting a temporary liquidity crisis caused by a sudden demand on the part of customers. This
would, however, not be possible in times of a general liquidity crisis engulfing the entire banking
community. n such circumstances, a bank should in order to maintain its liquidity, possess such
assets as can be shifted on to the Central Bank the lender of the last resort, the ultimate source of
cash, Therefore in judging the shift ability of any assets, due regard must be paid to the shift ability
of assets on to the Central Bank. Generally, Central Banks give cash on demand against treasury
bills and certain bills of exchange which fulfill the eligibility conditions.
The commercial loan theory and the shift ability theory, both have failed to distinguish clearly
between the liquidity of an individual banks and that of the banking system as a whole. An
improvement in the liquidity of an individual bank by the traditional method or by the process of
shifting assets is possible at the expense of the liquidity of other banks.
[3] Anticipated Income Teory: This is considered to be the modern theory. This has particularly
gained prominence since 1930 when commercial banks in SA started granting long term loans to
trade, and industry. According to this theory the liquidity of loans is not simply guaranteed by the
period of the loan but the anticipated income the loan is intended to produce to the borrower in
future.
A term loan is one which is granted for a period of more than one year but not exceeding
five years. Such loan is usually accompanied by agreements between the bank and the borrower,
containing restrictive covenants with respect to the financial activities of the latter. Banks grant
these loans against the hypothecation of stocks, machinery, the potential earnings of the borrower,
which a bank takes into account while considering the loan request and deciding about the amount
of the lean to be granted. f a banker is satisfied that the borrowing concern has the potentiality to
earn a reasonably high income in the foreseeable future, it will grant the loans even though they are
not of a self-liquidating nature or if the assets, against which the loans are given, are not, shift able.
This is what the anticipated ncome Theory holds.
n other words, according to this theory the mere fact that the loan is for short period cannot
ensure its liquidity. As a matter of fact all loans, short-terms, are liquid provided the borrower has
the capacity to pay, i.e., he earns enough to meet the loan commitments.
[4] LiabiIities Management Teory: During the 1960's a new theory of bank liquidity emerged,
which may be labeled as the Liabilities Management Theory. According to this theory, it is
unnecessary to observe traditional standards in regard to self-liquidating loans and liquidity
reserves, for reserve money can be borrowed or "bought" in the money market whenever a bank
experiences a reserve deficiency.
According to the liabilities management view, an individual bank may acquire riversides
include a number of items, some of which are listed below.
(i) s assurance of time certificates of deposit?
(ii) Borrowing from other commercial banks.
(iii) Borrowing from the Central Bank.
(iv) Raising Capital Funds by issuing shares and by means of retained earnings.
Asset-LiabiIity Management
Management of assets and liabilities or Asset-Liability Management (ALM) can be termed as a risk
management technique designed to earn an adequate return while maintaining a comfortable
surplus of assets beyond liabilities. t takes into consideration interest rate, earning power and
degree of willingness to take on debt and hence is also known as Surplus Management.
But in the last decade the meaning of ALM has changed. t is new used in many different
ways under different contexts. ALM, which was actually pioneered by financial institutions and
banks are new widely being used in industries too.
n banking, asset and liability management is the practice of managing risks that arise due
to mismatched between the assets and liabilities (debts and assets) of the bank.
Banks face several risks such as the liquidity risk; Liability Management (ALM) is a 'strategic
management tool to manage interest rate risk and liquidity risk faced by banks, other financial
services' companies and corporations.
Need of Asset-LiabiIity Management
Asset-Liability Management (ALM) is the art and science of analyzing, interpreting and managing
the composition of a financial institution's balance sheet. ALM focuses on up to four challenges:-
1) Understanding the risks that a bank is exposed to due to the composition of its assets and
liabilities.
2) Forecast the future composition of the bank's balance sheet and its risk exposure.
3) Determine and attribute interest-related profits to individual assets or liabilities business
units or activities through Funds Transfer Pricing.
4) Forecast capital requirements and manage the balance sheet in a way to maximize
shareholder value.
While not all ALM departments will deal with all four of these activities, they are all closely
related and require the same type of information and skills making them the natural scope of
responsibilities for on ALM group.
Procedure of Asset-LiabiIity Management
A step-by-step approach of ALM examination in case of a bank has been outlined as follows:-
Step 1: The bank/financial statements and internal management reports should be reviewed to
assess the asset/liability mix.
Step 2: t is to be determined that whether bank management adequately assesses and plans its
liquidity needs and whether the bank has short-term sources of funds.
Step-3: The banks future development and expansion plans, with focus on funding and liquidity
management as pacts have to be looked into.
Step 4: Examining the bank's internal audit report in regards to quality and effectiveness in term of
liquidity management.
Step 5: Reviewing the bank's plan of satisfying unanticipated liquidity needs.
Step 6: Preparing an Asset/Liability Management nternal Control Questionnaire/
Tecniques for Assessing Asset-LiabiIity Risk
These are two techniques for assessing asset liability risk. They are as follows:
liquidity management can reduce the probability of an adverse situation. The importance of
liquidity transcends individual institutions, as liquidity shortfall in one institution can have
repercussions on the entire system.
(ii) Time Buckets: The Maturity Profile could be used for measuring the future cash-flows of a
financial institute in different time buckets. The time buckets shall be distributed as under:-
(a) 1 day of 30/31 days (one month)
(b) Over one month and upto two months.
(c) Over two months and upto three months.
(d) Over three months and upto six months.
(e) Over six months and upto one year.
(f) Over one year and upto three years.
(g) Over three years and upto five years.
(h) Over five years and upto seven years.
(i) Over seven years and upto ten years.
(j) Over ten years.
Within each time bucket there could be mismatches depending on cash inflows and
outflows. While the mismatches upto one year would be relevant since these provide early
warning signals of impending liquidity problems, the main focus should be on the short-term
mismatches, viz, 1-90 days.
(iii) RR/SLR Requirement: Every financial institute is required to maintain a Cash Reserve
Ratio (CRR) on its customer deposits. n addition, every financial institute is required to
maintain a Statutory Liquidity Reserve (SLR) OF 5% (including CRR) on all its liabilities. There
is no restriction on where these SLR will be maintained. The financial institutions holding
deposits are given freedom to place the mandatory securities in any time buckets as suitable
for them. These SLRs shall be kept with banks and financial institutions for different
maturities.
Non Performing Assets (NPAs)
An asset is classified as non-performing asset (NPAs) is dues in the forms of principal and
interest are not paid by the borrower for a period of 180 days. However with effect from March
2004, default status would be given to a borrower if dues are not paid for 90 days. f any advance or
credit facilities granted by bank to a borrow become non-performing then the bank will have to treat
all the advances/credit facilities granted to that borrower as non-performing without having any
regard to the fact that there may still exist certain advances/credit facilities having performing
status.
So an asset is classified as NPA if dues in the form of principal and interest are not paid by
the borrower for a period of 180 days. However with effect from Mar 31, 2004 it is 90 days.
With effect from year ending Mar. 31, 2004, a NPA shall be a loan or advance where:-
1) nterest/installment of principal remains overdue for a period of more than 90 days.
2) Account remains 'out of order' for a period of more than 90 days.
3) The bills remain overdue for a period of more than 40 days in the case of bills purchased
and discounted.
So an assets becomes non performing when it cases to generate income for the bank on
actual realization basis.
RBI PrudentiaI Norms
RB has introduced prudential norms to regulate NPA which involves assets classification,
recognition of income and provisioning norm.
(3) Improper SWOT AnaIysis: The improper SWOT analysis is another reason for rise in
NPAs, while providing unsecured advances the banks depend more on the honesty,
integrity and financial soundness and creditworthiness of the borrower.
(4) Poor redit AppraisaI System: Poor credit appraisal is another factor for the rise in NPAs.
Due to poor credit appraisal the bank gives advances to those who are not able to repay it
back. They should use good credit appraisal to decrease the NPAs.
(5) ManageriaI Deficiencies: The banker should always select the borrower very carefully and
should take tangible assets as security to safeguard its interests.
(6) Absence of ReguIar IndustriaI Visit: The irregularities in spot visit also increase the NPAs.
Absence of regularly visit of bank officials to the customer point decreases the collection of
interest and principals on the loan. The NPAs due to willful defaulters can be collected by
regular visits.
(7) Re-Ioaning Process: Non-remittance of recoveries to higher financing agencies and re-
loaning of the same have already the smooth operation of the credit cycle. Due to re-loaning
to the defaulters and CCBs and PACs, the NPAs of OSC B is increasing day by day.
ProbIems/Impact of NPAs
NPAs have their effect on both banks and depositor.
(1) Impact on te Bank: NPAs impact the profitability of the Bank in the following ways:
(i) NPAs do not generate any income forth Banks whereas the resources locked into
these unproductive asset have a cost.
(ii) Bank has to make provisions for NPAs out of its profits.
(iii) 100% risk weight has to be reckoned for Capital Adequacy thus blocking capital.
(iv) Other administrative and legal costs have to be incurred for maintaining these
assets.
(v) High level of NPAs in the balance sheet lead to low customer confidence and
consequently higher cost of deposits.
(vi) NPA may spill over the banking system and contract the money stock, which may
lead to economic contraction.
(2) Impaction Depositor: NPAs impact the profitability of the deposit in the following ways:-
(i) Owners do not receive a market return on their capital in the worst case, if the banks
fails, owners lose their assets. n modern times this may affect a broad pool of
shareholders.
(ii) Depositors do not receive a market return on swing. n the worst case is the bank
fails, depositors lose their assets or uninsured balance.
(iii) Banks redistribute losses to other borrowers by charging higher interest rates, lower
deposit rates and higher lending rates repress saving and financial market, which
hamper economic growth.
(iv) Non-performing loans epitomize bad investment. They misallocate credit from good
projects, which do not receive funding, to failed projects. Bad investment ends up in
misallocation of capital and by extension, labour and natural resources.
Management/strategy of NPA
(A) Preventive Management:
(1) redit Assessment and Risk Management Mecanism: A lasting solution to the
problem of NPAs can be achieved only with proper credit assessment and risk
management mechanism. The documentation of credit policy and credit audit
immediately after the sanction is necessary to upgrade the quality of credit appraisal in
banks. t is necessary that the banking system is equipped with prudential norms to
minimize if not completely avoid the problem of credit risk.
(2) OrganizationaI Restructuring: With regard to internal factors leading to NPAs the ones
for containing the same rest with the bank themselves. These will necessities
organizational restructuring improvement in the managerial efficiency, skills up gradation
for proper assessment of credit worthiness and a change in the attitude of the banks
towards legal action, which is traditionally viewed as a measure of the last resort.
(3) Reduce dependence on Interest: The ndian Banks are largely depending upon
lending and investments. The banks in developed countries do not depend upon this
income where as 86 per cent of income of ndian Bank is accounted from interest and
the rest of the income is fee based. The banks can earn sufficient net margin by
investing in safer securities though not at high rate of interest. t facilitates for limiting of
high level of NPAs gradually. t is possible that average yield on loans and advances net
default provisions and services costs do not exceed the average yield on safety
securities because of the absence of risk and service cost.
(4) PotentiaI and BorderIine NPAs under eck: The potential and borderline accounts
require quick diagnosis and remedial measures so that they do not step into NPAs
categories. The auditors of the banking companies must monitor all outstanding
accounts in respect of accounts enjoying credit limits beyond cut-off points, so that new
substandard assets can be kept under check.
B] urative Management: The curative measurers are designed to maximize recoveries so
that banks funds locked up in NPAs are released for recycling. The Central Government and RB
have taken steps for arresting incidence of fresh NPs and creating legal and regulatory environment
to facilitate the recovery of existing NPAs of banks, they are:
(1) Debt Recovery TribunaI (DRT): n order to expedite speedy disposal of high value claims
of banks Debt Recovery Tribunals were set up. The Central Govt. has amended 'the recovery of
debts due to banks and financial institutions Act' in January 2000 for enhancing the effectiveness of
DRTs. The provisions for placement of more than one recovery officer, power to attach dependents
properly before judgment, penal provision for disobedience of Tribunals order and appointment of
receiver with powers of realization management, protection and preservation of property are
expected to provide necessary teeth to the DRTs and speedup the recovery of NPAs in times to
come.
(2) Lok AdaIats: The Lok Adalats institutions help banks to settle disputes involving accounts in
doubtful and loss categories. These are proved to be an effective institution for settlement of dues
in respect of smaller loans. The Lok Adalats and Debt Recovery Tribunals have been empowered
to organize Lok Adalats to decide for NPAs Rs 10 lacs and above.
(3) Asset Reconstruction ompany (AR): The Narosimham Committee on financial system
(1991) has recommended for setting up of Asset Reconstruction Funds (
ARF). The following concerns were expressed by the Committee.
(i) t was felt that centralized all ndia fund will severely handicap in its recovery efforts by lack
of widespread geographical reach which individual bank posses, and
(ii) given the large fiscal deficits, there will be a problem of financing the ARF.
Subsequently, the Narsimham committee on banking sector reforms has recommended for
transfer of sticky assets of banks to the RAC. This enables a one-time clearing of balance
sheet of banks by sticky loans.
(4 ) orporate Debt Restructuring: The corporate debt restructuring is one of the methods
suggested for the reduction of NPAs. ts objective is to ensure a timely and transparent mechanism
for restructure of corporate debts of viable corporate entitles.
UNIT-3
Securitization
Securitization means the conversion of existing or future cash inflows of any person into
tradable security, which then may be sold in the market. The cash inflow from financial assets such
as mortgage loan, automobile loan, trade receivables, credit card receivables, fare collections
become the security against which borrowings are raised. n fact, even individuals can take the help
of securitization instruments for better economic efficiency.
According to Oxford Dictionary, "Securitization means to convert an asset (specially a loan)
into marketable securities for the purpose of rising cashed or funds." Thus, the process of
securitization involves 'pooling of assets and selling these to investors through a specialized
intermediary created for this purpose.
For exampIe: An individual having regular inflows by way of rent from property can raise a loan by
offering his rent receivables as security, i.e., the rent receipts will first be used to pay the loan and
then for other purposes. Since the lender is assured of regular cash inflows, there is an enhanced
element of credit worthiness and therefore, he may offer the loan at a lower rate of interest. The
importance of securitization lies in the fact that it helps convert illiquid assets or future receivable
into current cash inflows and that too at a low cost. The company may sell the receivables in the
market and raise loans.
ExampIes of Securitization:
(1) City Bank carved out car loan portfolios to CC Bank.
(2) The Housing and Urban Dev. Corporation Ltd. (HUDCO) which financer infrastructure
finance, wanted to securitize its future receivables.
Nature/Features of Securitization
(1) MarketabiIity: The very purpose of securitization is to ensure marketability to financial
claims. Hence the instrument is structured in such a way as to be marketable. This is one of
the most important features of a securitized only to ensure this feature.
(2) MercantabIe QuaIity: To be market-acceptable, a securitized product should be of
saleable quality. This concept in case of physical goods, is something which is acceptable to
merchants in normal trade. When applied to financial products, it would mean that the
financial commitments embodied in the instruments are secured to the investments
satisfaction.
(3) Wide Distribution: The basic purpose of secularization is to distribute the product. The
extent of distribution which the originator would like to achieve is based on a comparative
analysis of the costs and the benefits that can be achieved. Wider distribution leads to a
cost benefit, in that the issuer is able to market the product with lower return and hence,
lower financial cost to him.
(4) Homogeneity: To serve as a marketable instrument, the instrument should be packed into
homogenous last. Homogeneity, like the above features is a function of retail marketing.
Mist securitized instruments are broken into lots affordable to the marginal investor and
hence, the minimum denomination becomes relative to the needs of the smallest investor.
(5) Integration and Differentiation: Securitization is the process of integration and
differentiation where the entity that securitizes its assets first pools them together into a
common hatched (assuming it is not one asset but several assets, as is normally the case).
This is the process of integration. Then, the poal itself is broken into instruments of fixed
denomination. This is the process of differentiation.
(6) De-construction: Securitization is the process of de-construction of an entity wherein, if one
envisages an entity's assets as being composed of claims to various cash flows, the process
of securitization would split apart these cash flows into different buckets, classify them and
sell those classified parts to different investors according to their needs, Thus, securitization
breaks the entity into various subsets.
Need for Securitization
(1) HeIping SmaII Investor: Financial claims often involve sizeable sums of money, clearly
outside the reach of the small investor. The initial response to this was the development of
financial intermediation, whereby an intermediary, such as a bank, would poal together the
resources of the small investors and uses the same for a larger investment need of the user.
(2) FaciIitating Liquidity: Small investors are typically not in the business of investments and
hence, liquidity of investments is most critical for them. Underlying financial transactions
need investments over a fixed time ranging from a few months to may be a number of years.
This problem could not even be sorted out by financial intermediation, since if the
intermediary provided a fixed investment option to the seekers and itself sought funds with
an option for liquidity, it would get caught in a serious problem of mismatch. Hence the
answer is a marketable instrument.
(3) UtiIity of Instruments: Generally, instruments are easily understood than financial
transactions. An instrument is homogenous, usually made in a standard form and generally
containing standard issues obligations. Besides, an important part of investor information is
the quality and price of the instrument and both are for easier known in case of the
instruments than in case of underlying financial transactions.
Parties InvoIved in Securitization
(1) Originator: The Originator also interchangeably referred to as the Seller- is the entity whose
receivable portfolio forms the basis for Asset Backed Security (ABS) issuance.
(2) SpeciaI Purpose VeicIe (SPN): Special Purpose Vehicle (SPV), which as the issue of the
ABS ensures adequate distancing of the instrument from the originator.
(3) Investors: The investors may be the form of individuals or institutional investors like FRs,
mutual funds etc. They buy a participating interest in the total poal of receivables and
receive their payment in the form of interest and principal as per agreed pattern.
(4) Oter Parties:-
(i) ObIigor: The obligor is the originator's debtor (borrower of original loan).
(ii) Servicer: The Servicer, who bears all administrate responsibilities relating to the
securitization transaction.
(iii) Trustee: The trustee or the investor representative, who act, in a fiduciary capacity
safeguarding the interests of investors in the ABS.
(iv) redit Rating Agency: The Credit Rating Agency, which provides an objective
estimate of the credit risk in the securitization transaction by assigning a well-defined
credit rating.
(v) ReguIators: The regulators, whose principal concern relate to capital adequacy,
liquidity, and credit quality of the ABS, and balance sheet treatment of the
transaction.
(vi) Service Providers: Service provides such as Credit Enhancers and Liquidity
Providers.
(vii) SpeciaIist Functionaries: Specialist functionaries such, as legal and tax consuls,
accounting firms, poal auditors etc.
Securities Issued by SpeciaI Purpose Entity
Standard categories securities are:-
(1) Mortgage-Backed Securities (MBS), which are backed by mortgages;
(2) Asset-Backed Securities (ABS), which are mostly backed consumer debt;
(3) Collateralized Debt Obligations (CDO), which are mostly backed by corporate bonds or
other corporate debt.
Each segment of the market offers unique opportunities and risks, affecting the nature of the
underlying assets and market conventions that have evolved over time.
() Mortgage Backed Securities (MBS)
The securitization of assets historically began with, and in sheer volume remains dominated
by residential mortgages. The receivables are generally secured by way of mortgage over the
property being financed, thereby enhancing the compact for investors. This is because
mortgaged property does not normally suffer erosion in its value like other physical assets
through depreciation. Rather, it is more likely that real estate appreciates in value over time
further,
(1) The receivables are medium to long-term, thus catering to the needs of different categories
of investors,
(2) The receivables consist of a large number of individual homogenous loans that have been
underwritten using standardized procedures. t is hence suitable for securitization.
(3) n the US where it originated, these mortgages were also secured by guarantees from the
Government.
(4) The receivables also satisfy investor preference for diversification of risk, as the
geographical spread and diversify of receivables profile is very large.
- - - - - - - - - - - - - - - - - - - - ----
Excess Debt-Services-MBS
Collective Servicing
Agreement
ssuance of MBS
ssuance Proceeds
Purchase Price Purchase Receivables
Housing Finance
Loans
--------
Mortgage
(Mortgage-Backed Securitization)
[] Asset-Backed Securities:-
An asset-backed security is a security whose value and income payments are derived from
all collateralized (or "backed") by a specific pool of underlying assets. The poal of assets is typically
a group of small and illiquid assets that are unable to be sold individually. Poaling the assets into
financial instruments allows them to be sold to general investors; a process called securitization,
and allows the risk of investing in the underlying assets to be diversified because each security will
represent a fraction of the total value of the diverse poal of underlying assets. The poals of
underlying assets can include common payments from credit cards, auto loans, and mortgage
loans, to esoteric cash flows from aircraft lease, royalty payments and movie revenues.
(1) Housing/Home Equity Loans: Home Equity Loans allow a homeowner to borrow money by
pledging the house as collateral. Borrowers who want to borrow a relatively large amount of
money or who do not have good credit often find the home equity loan to be attractive.
Home equity is basically a second loan against the mortgage of a house. The
possibility of such a loan arises when the value of a house is more than the outstanding
value of a mortgage-quite likely situation after the first mortgage has been partly amortized.
The second lender takes a second mortgage over the house, normally secondary in priority
over the rights of the first lender, and provides funding. Normally, the home equity loan does
not find its application in the same house application of the money borrowed is normally not
controlled.
A home equity loan could either be a close-end loan, meaning the loan is paid off
over a stated period, or it may be a line of credit, i.e., one where the borrower pays regular
interest but continues to enjoy the line of credit as an overdraft against the value of the
house.
Servicer
Housing
Finance
Fund-ssuer
Founder
Holders
of MBS
Housing Finance
nstitution Originator
Consumers
The payment structure of auto loans normally ranges between three to six years
which is ideal for direct pass through as well as collateralized bonds.
Types of Auto Loans:
(i) Prime ABS: Prime auto ABS are collateralized by loans made to borrowers with strong
credit histories.
(ii) Non-Prime ABS: Non-prime auto ABS consist of loans made to lesser credit quality
consumers which may have higher cumulative losses.
(iii) Sub-Prime ABS: Sub-prime borrowers will typically have lower incomes, tainted
credited histories, or both.
() oIIateraIized Debt ObIigations: Collateralized Debt Obligations are securitized interests in
poals of generally non mortgage assets. Assets (called collateral) usually comprise loans or
debt instruments. A CDO may be called a Collateralized Loan Obligation (CLO) or
Collateralized Bond Obligation (CBO) if it holds only loans or bonds, respectively. nvestors
bear the credit risks of the collateral. Multiple trenches of securities are issued by the CDO,
offering investors various maturity and credit risk characteristics. Tender are categorized as
senior, mezzanine, and subordinated/equity, according to their degree of credit risk. f there
are defaults or the CDO's collateral otherwise under performs, scheduled payments to senior
trenches take precedence over those of mezzanine trenches and scheduled payments to
mezzanine trenches take precedence over those to subordinated/equity trenches. Senior and
mezzanine trenches are typically rated, with the former receiving ratings of A to AAA and the
latter receiving rating of B to BBB. The ratings reflect both the credit quality of underlying
collateral as well as how much protection a given trends is afforded by trenches that are
subordinate to it.
Instruments of Securitization
(1) Pass troug ertificates: A pass through certificate is an instrument which signifies
transfer of interest in the receivable in favour of the holder of the pass through Certificate.
The investors in a pass through transaction acquire the receivables subject to all their
fluctuations, prepayment etc. The material risks and rewards in the asset portfolio, such as
the risk of interest rate variations, risk of prepayments, etc, are transferred to the investors.
Features of Pass troug ertificate:
(i) nvestors get a proportional interest in a poal of receivables.
(ii) Collections months after months are divided proportionally.
(iii) All investors receive proportional payments-no slower or faster repayment, through in
some cases, some investors may be senior over others.
(iv) No investment of cash collected by the SPN.
(2) Pay troug ertificates: n case of Pay through Certificates, the SPV invested of
transferring undivided interest on the receivables issues debt securities such as bonds,
repayable on fixed dates, but such debt securities intern would be backed by the mortgages
transferred by the originator to the SPV. The SPV may make temporary reinvestment of
cash flows to the extent required for bridging the gap between the dates of payments on the
mortgages along with the income out of reinvestment to retire the bonds. Such bonds were
called mortgage backed bonds.
Mecanism of Securitization
The crucial link in the securitization chain is the creation of a special purpose Vehicle (SPV),
which intermediates between the primary market for the underlying asset and the secondary market
for the asset backed security. The steps involved in the securitization process are the following:-
(1) The originator or lending institution identifies the assets out of its portfolio for securitization.
The identification of the assets has to be done in a manner so that an optimum mix of
homogeneous assets having almost same maturity forms the portfolio.
(2) The aforementioned poal of identified assets is then "passed through" to another institution,
called a special purpose Vehicle (SPV) usually by way of trust. Such trust, which is usually
an investment banker, issues the securities to investors. So once the assets are
transference they are no longer held in the originator's portfolio.
(3) After acquisition of the assets, the SPV splits the pool into individual shares or securities
and reimburses itself by selling these to investors. These securities are known as pay of
pass through certificates. These securities are normally without resource to the originator
Thus, investor can hold only 'SPV' liable for principal repayment and interest recovery.
(4) n order to make the issues attractive, the SPV enters into credit enhancement procedures
either by obtaining an insurance policy to cover the credit losses or by arranging a credit
enhancement procedures either by obtaining an insurance policy to cover the credit losses
or by arranging a credit facility from a third party lender to cover the delayed payments. To
increase marketability of the securitized assets in the form of securities, these may be rated
by some reputed credit rotting agencies as CRSL, CARE and CRA etc. Credit rating
increases the trading potential of the certificate, thus, its liquidity is enhanced. The investor's
confidence is heightened owing to the third party objectivity of the rating agencies. The pass
through certificates before maturity is trade able in a secondary market to ensure liquidity
forth investors. Once the end investor gets hold of these investors. Once the end investor
gets hold of these instruments excreted out of securitization, he is to hold it for a specific
maturity period which is well defined with all other related terms and conditions. On maturity,
the end investors get redemption amount from the issuer along with interest due on the
amount.
Credit Enhancement, Liquidity
nterest and Support, Forex and nterest Rate
Principal Hedging, etc.
Sales of Asset ssues of Securities
Servicing of
Securities
Consideration for Subscription of
Assets Purchased Securities
Credit Rating
of Securities
Obligor(s)
Ancillary Service
Providers
Special Purpose
Vehicle
(SPV)
Originator
nvestor
Rating Agency
Structure
Securitization in India
Securitization is a relatively new conception ndia but is gaining ground quite rapidly. CRSL
rated the first securitization program in ndia in 1991 when Citibank securitized a poal from its auto
loan portfolio and placed the paper with GC Mutual Fund. Since then, securitization of assets has
begun to emerge as a clear option of fund raising by corporates and a few transactions of well rated
companies have taken place in the country.
CRSL has rated about 50 transactions till date with volume aggregating to well over Rs.
4,500 crore. Other rating agencies in ndia, viz., CRA, DCR, and CARE, have also been actively
involved in the process.
As per an estimate out of the total asset securitization attempted between 1992 and 1998, as
much as 35% relates to hire purchase receivable of truck and auto loan segment. The car loan
segment of the auto loan market has been more successful than the commercial vehicle loan
segment mainly because of factor such as perceived credit risk, higher volumes and homogeneous
nature of receivables.
So far, "Securitization in ndia was meant to imply any of the following distinct activities:
(1) Structured Obligations against receivables (whether loans or debentures/bends)
(2) Outright sale of financial/trade receivables without issue of securities.
(3) Securitization transactions involving assignment of receivables to any SPV and issue of
securities backed by these receivables.
DeveIopment FinanciaI Institution
Specialized and hybrid financial institutions that are engaged in the provision of financial and other
assistance for the purpose of undertaking long-term development activities in certain identified
sectors of the economy such as small scale sector, exports promotion, industrial development,
agricultural development etc are known as 'development banks'.
Development banks are financial agencies that provide medium and long-term financial
assistance and act as catalytic agents in promoting balanced development of the country. They are
engaged in promotion and development of industry, agriculture and other key sectors. They also
provide development services that can aid in the accelerated growth of an economy.
Objectives of DeveIopment Banks
(1) To serve as an agent of development in various sectors, viz., industry, agriculture, and
informational trade.
(2) To accelerate the growth of the economy.
(3) To allocate resources to high priority areas.
(4) To foster rapid industrialization, particularly in the private sector, so as t5o provide
employment opportunities as well as higher production.
(5) To develop entrepreneurial skills.
(6) To promote the development of rural areas.
(7) To finance housing, small scale industries, infrastructure and social utilities.
n addition, they are assigned a special role in:
(1) Planning, promoting and developing industries to fill the gaps in industrial sector.
(2) Coordinating the working of institutions engaged in financing, promoting or developing
industries, agriculture or trade.
(3) Rendering promotional services such as discovering project ideas, undertaking feasibility
studies and providing technical, financial and managerial assistance for the implementation
of projects.
DeveIopment FinanciaI Institutions (DFI) in India
The need for development financial institutions war felt very strongly immediately after ndia
attained independence. The country needed a strong capital goods sector to support and
accelerate the pace of industrialization. The existing industries required long-term funds for their
reconstruction, modernization expansion and diversification programs while the new industries
required enormous investment for setting up gigantic projects in the capital goods sector. However,
there were gaps in the banking system and capital markets which needed to be filled to meet this
enormous requirement of funds.
All ndia Specialized Financial nvestment Reference
Development Bank nstitutions nstitutions nstitutions
DB (1964) EXM Bank UT (1964) NABARD
CC (1955) CC Venture UC (1956) (1982)
SDB (1990) (Formerly TDC) (1988) GC & Subsi- NHB (1980)
B (1997) TFC (1989) daries (1972)
FC (1948) DFC (1997)
SFCs (18) SDCs(28)
ECGC (1957) DCGC(1962)
OrganizationaI Structuring of FinanciaI Institutions]
IndustriaI DeveIopment Bank of India (IDBI)
The ndustrial Development Bank of ndia was established under the ndustrial Development Bank
of ndia Act, 1964, as a wholly owned subsidiary of the Reserve Bank of ndia. The ownership of
DB has since been transferred to Control Government from February 16, 1976. The main objective
establishing DB has since been transferred to Control Government from February 16, 1976. The
main objective establishing DB was to set up an apex institution to co-ordinate the activities of
other financial institutions and to act as a reservoir on which the other financial assistance to
industrial units also to bridge the gap between supply and demand of medium and long term
finance.
Management of IDBI
The management of DB is vested with the Board of Director consisting of 22 members
nominated by the Central Government. Representation is also given to the RB, other financial
All ndia Financial nstitutions
All Financial
nstitutions
State Level nstitutions
Other nstitutions
institutions and employees in the Board of Directors. The Board constitutes different Committees in
order to assist in its operations.
Objectives of IDBI
(1) To co-ordinate, supplement and integrate the activities of other existing financial institutions
including commercial banks.
(2) To provide term-finance to industry.
(3) To provide direct financial assistance to industrial concerns.
Functions of IDBI
(1) To co-ordinate the activities of other institutions providing term finance to industry and to act
as an apex institution.
(2) To provide refinance to financial institutions granting medium and long-term loans to
industry.
(3) To provide refinance to scheduled banks or co-operative banks.
(4) To provide refinance for export credits granted by banks and financial institutions.
(5) To provide technical and administrative assistance for promotion, management or growth of
industry.
(6) To undertake market surveys and techno-economic studies for the development of industry.
(7) To grant direct loans and advances to industrial concerns.
(8) To render financial assistance to industrial concerns.
IndustriaI redit and Investment orporation of India
The World Bank was helping the setting up of development banks in underdeveloped
countries. CC was one of such banks which were set up in ndia in January, 1995 the ownership
of the corporation was entirely in private hands but certain safeguards were contemplated against
the acquisition of control by vested interests.
CC provides funds of various kinds. The primary purpose for which funds are made
available by the corporation is the purchase of capital assets such as land, building and machinery.
Management of III
A Board of Directors consisting of both ndian and Foreign Directors manages the CC. The
Board of Directors is assisted by a number of committees in day to day operations of the
corporation.
Objectives and Functions of III
The corporation has been established for the purpose of assisting industries in the private
sector by undertaking the following functions:-
(1) Assisting in the creation, expression and modernization of such enterprises.
(2) Encouraging and promoting the participation of private capital, bath internal and external.
(3) Encouraging and promoting private ownership.
(4) Expansion of investment market.
(5) Provide finance in the form of long or medium-term loans.
(6) Underwriting issues of shares and debentures.
(7) Making funds available for re-investment.
(8) Furnishing managerial technical and administrative, services to ndian ndustry.
(9) To advance loans in foreign currency towards the cost of imported capital equipment.
Functions of NABARD
The functions of NABARD have been divided into three categories:-
(1) Credit Distribution
(2) Development
(3) Regulatory
(1) redit Distribution: The NABARD provides refinance of various types to the following
institutions:-
(i) Sort Term redit: t provides short term credit to State Cooperative Banks (SCBs),
Regional Rural Banks (RRBs), and other financial institutions approved by the RB for the
following purposes:-
(a) Seasonal agricultural operations.
(b) Marketing of agricultural produce.
(c) Other activities related to rural/agriculture sector.
(d) Real commercial trade activities.
(e) Production and marketing of the following activities handicrafts, small industries, village
and cottage industries, artisans, silk industry etc.
(ii) Medium Term redit: The NABARD provides medium term credit to SCBs, KDBs, RRBs
and other approved institutions for a period ranging from 18 months to 7 years. The
medium term loans are given for investment schemes, relating to agriculture and rural
sector.
(iii) Long-Term redit: The NABARD provides long term credit to State Land Development
Banks, RRBs, Commercial Banks, SCBs and to any approved financial institution.
(iv) Refinancing of Industries in RuraI Areas: The NABARD provides refinancing facilities to
all small, village and cottage industries in rural areas.
(2) DeveIopment Functions: The NABARD performs the following development functions:-
(i) Coordinate the rural credit institutions.
(ii) Develops specialization to solve problems relating to agriculture and villages.
(iii) Helps the government, RB and other institutions in their rural development, RB and
other institutions in their rural development efforts.
(iv) Acts as an agent of the Government and RB for monitoring work in agricultural related
areas.
(v) Provides facilities for research and training to the staff of RRBs, SCBs, LDBs, etc, and
promotes research in agricultural and rural development activities out of its R&D Fund.
(vi) Spreads information regarding rural banking and development.
(vii) Provides direct credit incases approved by the Central Government connected with
agricultural and rural development.
(3) ReguIatory Functions:
(i) t inspects the working of RRBs and cooperative banks of all types except the primary
cooperative banks,
(ii) t also inspects apex cooperative marketing federations, state handloom weaving
societies etc. which are financed on voluntary basis.
(iii) All applications for opening of a branch by the RRB or a cooperative bank, other than a
primary cooperative society, are required to be submitted to the RB or a cooperative
banks, other than a primary cooperative society, are required to be submitted to the
RB through the NABARD.
(iv) t is empowered to obtain any information or statement from the RRBs and cooperative
banks.
etc. SFCs have been set up with the objective of catalyzing higher investment, generating
greater employment and widening the ownership base of industries. They have also started
providing assistance to newer types of business activities like floriculture, tissues culture,
poultry farming commercial complexes and series related to engineering, marketing etc.
Objectives of SFs
SFCs were established to provide financial assistance to medium and small-scale industrial
concerns which are outside the scope of the FC. The scope of the SFCs activities includes public
limited companies and also private limited companies, partnership firms and proprietary concerns.
Functions of SFs
The main functions of the SFCs is to provide loans to small and medium scale industries
engaged in the manufacture, preservation or processing of goods, mining, hotel industry,
generation or distribution of power, transportation, fishing, assembling, repairing or package articles
with the aid of power, etc. State Financial Corporation is authorized to grant financial assistance in
the following forms:-
(i) Granting of loans or advances to industrial concerns repayable within a period not
exceeding twenty years.
(ii) Subscribing to the debentures of industrial concerns repayable within a period not
exceeding twenty years.
(iii) Guaranteeing loans raised by industrial concerns repayable within a period not exceeding
twenty years.
(iv) Underwriting the issue of stock, shares, banks or debentures by the industrial concerns
subject to their being disposed off within seven years.
(v) Guaranteeing differed payments due from any industrial concerns in connection with
purchase of capital goods in ndia.
(vi) Acting as an agent of the Central Government or State Government.
[2] State IndustriaI DeveIopment orporation (SIDs)
SDCs have been established under the Companies Act, 1956, as wholly-owned undertakings
of State Governments. They have been set up with the aim of promoting industrial development in
the respective States and providing financial assistance to small entrepreneurs. They are also
involved in setting in setting up of medium and large industrial projects in the joint sector/assisted
sector in collaboration with private entrepreneurs or wholly-owned subsidiaries. They are
undertaking a variety of promotional activities such as preparation of feasibility reports, conducting
industrial potential surveys, entrepreneurship training and development programmes, as well as
developing industrial areas/estates.
Functions of SIDs
(i) Grant of Financial assistance.
(ii) Provision of industrial sheds or plots.
(iii) Promotion and management of industrial concerns.
(iv) Promotional activities such as identification of project idea, selection and training of
entrepreneur, provision of technical assistance during project implementation.
(v) Providing risk capital to entrepreneur by way of equity participation and seed capital
assistance.
afford to pay the price as a lump sum but can afford to pay a percentage as a deposit, the
contract allows the buyer to hire the goods for a monthly rent. f the buyer defaults in paying
the installments, the owner can repossess the goods. H.P. is a different form of credit
system among other unsecured consumer credit system and benefits.
(2) Leasing Services: A lease or tenancy is a contract that transfers the right to possess
specific property. Leasing service includes the leasing of assets to other companies either
on operating lease or finance lease. An NBFC may obtain license to commence leasing
services subject to, they shall not hold, deal or trade in real estate business and shall not fix
the period of lease for less than 3 years in the case of any finance lease agreement except
in case of computers and other T accessories.
First Century Leasing Company Ltd., Sundram Finance Ltd. is some of the Leasing
companies in ndia.
(3) Housing Finance Services: Housing Finance Services means financial services related to
development and construction of residential and commercial properties. An housing finance
company approved by the National Housing Bank may undertake the services/activities
such as providing long-term finance for the purpose of constructing, purchasing or
renovating any property.
CC Home Finance Ltd, LC Housing Finance Co. Ltd., HDFC are some of the housing
finance companies in ndia.
(4) Asset Management ompany: Asset management company is managing and investing
the poaled fund of retail investors in securities in line with the stated investment objectives
and provides more diversification, liquidity and professional management service to the
individual investors.
Mutual fund comes under this category. Most of the financial institutions having their
subsidiaries as Asset Management Company like SB, BOB, UT and many others.
(5) Venture apitaI ompanies: Ventures capital finance is a unique form of financing activity
that is undertaken on the belief of high-risk-high-return Venture capitalist invest in those
risky projects or companies (ventures) that have success potential and could promise
sufficient return to justify such gamble.
CC ventures and Gujarat venture are one of the first venture capital organizations
in ndia and SDB, DB and others also promoting venture capital finance activities.
Strategy/ReguIations/PoIicy of NBFs
NBFC have been rendering many useful services, several adverse, unhealthy features of
their working also have been observed. The protection of savers from malpractices has been one of
the appropriate regulatory/statutory framework to observe the operations of NBFCs.
NBFC have been rendering many useful services, several adverse, unhealthy features of their
working also have been observed. The protection of savers from malpractices has been one of the
important issues. The authorities have evolved an appropriate regulatory/statutory framework to be
serve the operation of NBFCs.
At present all NBFCs except HFCs are regulated by the RB. With the enactment of RB
(Amendment) Act, 1997, they have been brought under the jurisdiction of RB. All of them with net-
owned funds of Rs 25 lakh and above have to register with the RB now.
The major regulatory provisions currently in force are as given below:-
(1) The minimum net owned funds of Rs 25 lakh and RB registration are the entry points norms
now.
(2) NBFC have to maintain 10 and 15 percent of their deposits in liquid assets effective from
January 1 and April 1, 1998, respectively.
(3) They have to create reserve fund and transfer not less than 20 percent of their net deposits
to it every year.
(4) The RB can now direct them on issues of disclosures, prudential norms, credit, investment,
etc.
(5) Nomination Facility is now made available to depositors of these companies.
(6) Unincorporated bodies engaged in financial activity can not accept deposits from the public
from April 1, 1997.
(7) They have to achieve a minimum capital adequacy norm of eight percent by March 31,
1996.
(8) They have to obtain a minimum credit rating from any one of the three credit rating
agencies.
(9) A ceiling of 15 percent interest rate on deposits has been prescribed for NBFCs or niches,
effective from July 8, 1996.
urrent Status of NBF in India
NBFCs have improved their operations and strategies. ndustry experts opine that they are
much more mature today than they were during the last decade. Timely intervention of RB helped
to reduce the negative effect of credit crunch on banks and NBFCs. n fact, aggressive strategies
helped LC Housing Finance to grab new customers (including customers of the other banks) and
increase its market share in national mortgage market. Surprisingly it was able to maintain its profit
ability in 2009 (around 37%). HDFC, the largest NBFC in ndia, however experienced a slowdown in
customer growth due to stiff competition, especially from LC Housing Finance and tight monetary
conditions.
Other NBFCs that were stable during this period of credit crunch are nfrastructure
Development (PFC) and Rural Electrification Corporation (REC). Growth prospects are strong for
these companies given the acute shortage of power in the country and expected increase in
demand for infrastructure projects.
The segment which was hit hardest was Vehicle Financing. Companies financing new Vehicle
purchases experienced a drastic reduction in new customer's numbers. Fortunately, since vehicle
finance is asset based business, their asset quality did not suffer as against other consumer
financing businesses, Contrary to this, Shriram Transport Finance, the only NBFC which deals in
second-hand vehicle financing was able to maintain its growth primarily due to its business model
which does not entirely depends on health of the auto industry.
Meaning and Definition of Insurance
nsurance may be described as a social device to reduce or eliminate risk of loss to life and
property. nsurance is a collective bearing of risk. nsurance spreads, the risks and losses of few
people among a large number of people as people prefer small fixed liability instead of big uncertain
and changing liability. nsurance is a scheme of economic cooperation by which members of the
community share the unavoidable risks.
nsurance can be defined as a legal contract between two parties whereby one party called
insurer undertaken to pay a fixed amount of money on the happening of a particular event, which
may be certain or uncertain. The other party called insured pays in exchange a fixed sum known as
premium.
aracteristics of Insurance:
(1) Risk Saring: nsurance is considered as a device to share the financial loss which might
affect the individual or his/her family members. The unforeseen event may be death of a
breadwinner of a family in case of life insurance, dangers associated with the sea in case of
general insurance, theft or damage to vehicle in case of motor insurance. The loss arising
from these damages can be compensated if they are insured by paying the required
premium
(2) Risk Assessment: Evaluation of risk is the important factor that decides on the amount of
premium to be calculated. When the threat perception is more, a higher premium will be
charged. There are different ways of evaluating the risk and the probability of loss is
evaluated at the time of insurance.
(3) Payment at te time of ontingency: The insurance compensates the insured by paying
compensation in the event of loss; i.e., payment is made at the time of contingency. For
payment to be made there is a prerequisite of contingency to happen.
(4) Quantum of ompensation: The value of compensation depends on the extent of loss
suffered by the insured from a particular risk provided the maximum capped value is not
surpassed. n case of life insurance, the claim is settled for which it was inspired provided
that at the happening of the event the policy is valid and in force. n case of property and
general insurance, the dependents will be required to prove the happening and the extent of
damage caused.
(5) Large te Number, Better te are: The number if insured persons shall be large enough
to spread the loss immediately, smoothly and economically. When the number if insured is
smaller, it would translate into a higher premium and hence it becomes unaffordable and
unpopular.
(6) Insurance by oice and not by ance: The productivity of a community is increased by
means of insurance because it eliminates worry and increases the initiatives. The
uncertainty is changed to certainty because the insurance gives the assurance to
compensate the loss monetarily in the event of loss. For example, in the absence of
property insurance, the choice left to the property owner is limited and he could not get full
protection to the whole property. Similarly in case of life insurance, in the absence of life
coverage, the time taken to accumulate a considerable saving takes a longer time where as
death may happen at any time and in the event of loss of brad winner of the family, the other
members have to fend for themselves.
(7) Insurance, a arity: Charity is practiced without giving consideration whereas insurance is
a business and without premium it is not possible to run the business. t offers security and
safety to the individual and society in return of premium and thereby compensates the loss
suffered. t is a well laid out business or profession, wherein the loss is adequately
compensated in a timely manner.
Types/ategories of Insurance
Life nsurance General nsurances
There are mainly two types of insurance in ndia, i.e., life insurance and general insurance.
(1) Life Insurance: n a life insurance policy the amount of policy is paid either on the death
ever is earlier. LC has a monopoly of life insurance. Life private and foreign insurances. n
1956, life insurance was nationalized and LC was set-up by taking over the business of
about 245 large and medium companies doing business of life insurance.
Benefits of Life nsurance:
(i) Safeguards the insured family against an untimely death and provides for a secured
income.
(ii) s a means of compulsory savings.
(iii) s a source of income during old age.
(iv) Helps in meeting certain periodic financial needs, either for a Childs education or
marriage.
(v) mproves the life style of the insurance and his family.
(vi) Takes care of disabilities and uncertain future adversities of life.
(vii) Brings in tax-benefits under section 88 of the ncome Tax Act, 20 percent of the
contributions made towards life insurance premiums quality for deductions from total tax
payable.
Life Insurance Products
(i) Term Insurance: Term insurance provides for life insurance protection for the selected
term (period of years) only. n case the person (whose life is insured) dies during the
term, the benefits are payable under the policy and in case of his survival till the end of
the selected term the policy normally expires without any benefit becoming payable.
(ii) WoIe Life Insurance: As the name suggests, the whole life insurance policies are
intended to provide Life nsurance protection over one's lifetime. The essence of whole
life insurance is that it provides for payment of the assured amount upon the insured's
death regardless of when it occurs.
(iii) Endowment Assurance: These are the most commonly sold policies. These policies
assure that the benefits under the policy will be paid on the death of the life insured
during the selected term or on his survival to the end of the term. Hence the assured
benefits are payable either on the date of maturity or on death of the life insured, if
earlier.
(iv) Annuities: An annuity is a serious of periodic payments. An annuity contract is an
insurance policy, under which the annuity provides (insurer) agrees to pay the purchases
of annuity (annuitant) a series of regular periodical payments for a fixed period or during
someone's life time.
[2] GeneraI Insurance: n case of general insurance the loss is indemnified. There may or
may not be a loss in general insurance. The money received from people is in the custody of
insurance companies as trustees. The funds at the disposal of these companies are judiciously
used by keeping in view safety, and liquidity. Though return on these funds is important but safety
factor cannot be ignored. These funds cannot be speculative activities.
nsurance funds play an important role in the economic development of only country. This role
is all the more signifcant in ndia because of resource crunch. The development activities need
more and more finances and insurance companies can help in this area. These companies can
finance industrial ventures and thus add to the strength and stability to the national economy.
GeneraI Insurance Products
(i) Fire Insurance: Fire insurance provides protection against damage to property caused
by accidents due to fire, lightning or expansion, whereby the explosion is caused by
boilers not being used for industrial purpose.
(ii) AutomobiIe Insurance: Automobile insurance also known as auto insurance, car
insurance and motor insurance, is probably the most common form of insurance and
may cover both legal liability claims against the driver and loss of or damage to the
vehicle itself.
(iii) HeaIt Insurance: Health nsurance, or Health cover, is defined in the Registration of
ndian nsurance Companies Regulations, 2000, as the effecting of contracts which
provide sickness benefits or medical, surgical, hospital expenses benefits whether in
patient or out patient, on an indemnity, reimbursements, service, prepaid, hospital or
other plans basis, including assured benefits and long-term case.
(iv) Marine Insurance: Marine nsurance basically covers three rick areas, namely, hull,
cargo and collectively known as "perils of the Sea". These perils include theft, fire,
collision, etc.
(v) Business and commerciaI Insurance: This caters to the need of business insurance
requirement provides wide coverage to property at work, e.g. offers protection against
loss/damage to the building and its contents. t also covers liabilities of employers,
buyers and users.
(vi) PoIiticaI Risk Insurance: Political risk insurance can be taken out by businesses with
operations in countries in which there is a risk that revolution or other political conditions
will result in a loss.
(vii) ProfessionaI Indemnity Insurance: Professional ndemnity nsurance is normally a
mandatory requirement for professional practitioners such as Architects, Lawyers,
Doctors and Accountants to provide insurance cover against potential negligence claims.
(viii) Property/asuaIty Insurance: Provides Protection for properties like home, car and
household possessions. t may also protect from liability as a result of their use.
(ix) redit Insurance: Credit insurance pays some or all of a loan back when certain things
happen to the borrowers such as unemployment, disability or death.
(x) TraveI Insurance: Travel insurance is an insurance cover taken by those who travel
abroad, which covers certain losses such as medical expenses, lost of personal
belongings travel delay, personal liabilities, etc.
(xi) Locked Funds Insurance: Locked Funds nsurance is a little known hybrid insurance
policy jointly issued by governments and banks. t is used to protect public funds from
tamper by unauthorized parties.
(xii) MisceIIaneous: As per the insurance act, all types of general insurance other than fire
and marine insurance are covered under miscellaneous insurance. Some of the
examples of general insurance are theft insurance, personal accident insurance, money
insurance, engineering insurance etc.
Recent Status/Trends in Insurance Sector in India
With the de-regulation in ndia nsurance ndustry, the monopoly of public sector companies in life
insurance and general insurance has come to a end. This has augmented the innovative practices
invited by the private players Growth in the interactive technology such as internet has further
created a wave of excitement in the insurance market. ndian economy and nsurance sector is
committed to a double digit growth. n the year 2007 first online nsurance portal,
www.insurancemal, in, set up by an ndian nsurance Broker, Bonsai nsurance Broking Pvt. Ltd.
The Government of ndia liberalized the insurance sector in March 2000 with the passage of
the nsurance Regulatory and Development Authority (RDA) bill, lifting all entry restrictions for
private players are allowing foreign players to enter the market with some limits on direct foreign
ownership.
Minimum capital requirement for direct life and Non life nsurance Company is NR 1000
million and that for re-insurance company is NR 2000 million. n the 2004-05 budgets, the
government proposed for increasing the foreign equity stake to 49%, this is yet to be effected.
Under the current guidelines, there is a 26 percent equity cap for foreign partners in direct
insurance and Reinsurance Company.
(C ) Oter Scemes:
1) Tax-Saving Scemes: These Schemes offer tax rebates to investors under specific
provisions of the ndian ncome Tax Laws. nvestment made in Equity Linked Saving
Schemes (ELSS) and Pension Scheme is allowed as deduction U/s 88 of the ncome
Tax ACT 1961. The Act also provides opportunities to investors to save capital gains u/s
54EA and 54EB by investing in mutual funds.
2) Industry Specific Scemes: ndustry Specific Schemes invest only in the industries
specified in the offer document. The investment of these funds is limited to specific
industries like nfoTech, FMCG and Pharmaceuticals etc.
3) Index Funds: ndex funds attempt to replicate the performance of a particular index,
Such as the BSE, Sensex or the Nifty 50.
UNIT- 4
Leasing
Conceptually, a lease may be defined as a contractual arrangement/transaction in the asset
for use to another/transfer the right to use the equipment to another/transfer the right to use the
equipment to the user (lessee) over a certain/for an agreed period of time for consideration in form
of/in return for periodic payment (rentals) with or without a further payment (premium). At the end of
the period of contract (lease period), the asset/equipment reverts back to the lesser unless there is
a provision for the renewal of the contract. Leasing essentially involves the divorce of ownership
from the economic use of asset equipment.
t is a device of financing the cast of an asset. t is a contract in which a specific equipment
required by the lessee is purchased by the lesser (financier) from a manufacturer/vender selected
by the lessee. The lessee has possession and use of the asset on payment of the specified rentals
over a predetermined period of time. The lesser (financier) is the nominal owner of the asset as the
possession and the economic use of the equipment vests in the lessee.
EvoIution of Leasing Industry
Leasing activity was initiated in ndia in 1973. The first leasing company of ndia, named First
Leasing Company of ndia Ltd. was set up in that year by Farouk rani with industrialist A.C. Muthia.
For several years this company remained the only company in the century until 20
th
Century
Finance Corporation was set up around 1980.
By 1981, the trickle started and Shetty nvestment and Finance, Jaybharat Credit and
nvestment, Motor and General Finance and Sunderam Finance etc., joined the leasing game. The
last three names, already involved with hire purchase of commercial vehicles, were looking for a tax
break and leasing seemed to be the ideal choice.
The industry entered the third stage in the growth phase in late 1982, when numerous
financial institutions and commercial banks either started leasing or announced plans to do so.
CC, promenaded among financial institutions, entered the industry in 1983 giving a boost to the
concept of leasing. Thereafter, the trickle soon developed into flood and leasing became the new
gold mine. This was also the time when the profit performance of the two dozen companies. First
leasing and 20
th
Century had been made public, which contained all. The fascination for more many
companies to join the industry.
As per RB's records by 31
st
March, 1986, there were 339 equipment leasing companies in
ndia whose assets leased totaled Rs. 2395.5 million. One can notice the surge in number from
merely 2 in 1980 to 339 in 6 years.
Another significant phase in the development of ndians leasing was the Dahotre
Committee's recommendations based on which the RB formed guideline on commercial bank
funding to leasing companies. The growth of leasing in ndia has distinctively been assisted by
funding from banks and financial institutions. The post-liberalization era has been witnessing the
slow but sure increase in foreign investment into ndian leasing. Starting with GE Capital's entry, an
increasing number of foreign-owned financial firms and banks are currently engaged or interested in
leasing in ndia.
EssentiaI EIements of Lease Financing
(1) Parties to te ontract: There are essentially two parties to a contract of lease financing,
namely, the owner and the user, called the lesser and the lessee respectively.
(2) Asset: The asset, property or equipment to be leased is the subject matter of a contract of
lease financing. The asset may be an automobile, plant and machinery, equipment, land
and building, factory, a running business, aircraft and so on. The asset must, however be of
the lessee's choice suitable for his business needs.
(3) Ownersip Separated from User: The essence of a lease financing contract is that
during the lease-tenure, ownership of the assets vests with the lesser and its use is allowed
to the lessee. On the expiry of the lease tenure, the assets revert to the lesser.
(4) Terms of Lease: The term of the lease is the period for which the agreement of lease
remains in operation. Every lease should have a definite period otherwise it will be legally
inoperative. The lease period may sometimes stretch over the entire economic life of the
asset (i.e. financial lease) or a period shorter than the useful life of the asset (i.e. operating
lease). The lease may be perpetual, that is, with an option at the end of lease period to
renew the lease for the further special period.
(5) Lease RentaI: The consideration which the lessee pays to the lesser for the lease
transaction is the lease rental. The lease rentals are so structured as to compensate the
lesser for the investment made in the asset, the interest on the investment, repairs and so
forth-borne by the lesser and servicing charges over the lease period.
(6) Modes of Terminating Lease: The lease is terminated at the end of the lease period and
various courses are possibly namely,
(i) The lease is renewed on a perpetual basis or for a definite period, or
(ii) The asset reverts to the lesser, or
(iii) The asset reverts to the lesser and the lesser sells or leases it to a third party, or
(iv) The asset reverts to the lesser
Parties InvoIved in Leasing
Following are the two parties involved in leasing:-
(1) Lessee: The user or renter of the leased asset or property is called lessee. n case of
capital leases, the lessee is also the 'debtor' to the lesser. When real estate is leased, the
lessee is called a tenant.
Types of Lessee
(i) orporate ustomers wit very Hig redit Ratings: These essentially look at
leasing to leverage against assets which are otherwise not bankable, or for pure junk
financing.
(ii) PubIic Sector Undertakings: This market has witnessed a very high rate of growth in
the past. With budgetary grants to the PSUs coming to a virtual halt, there is an
increasing number of both centrally as well as state-owned entitles which have resorted
to lease financing. Their requirements are usually massive.
(iii) Mid-Market ompanies: The mid-market companies, i.e., companies with reasonably
good creditworthiness but with lower public profile have resorted to lease financing
basically as an alternative to bank/institutional financing which to them-consuming and
tedious.
(iv) onsumers: Retail funding for consumer durables was frowned-upon at one point of
time, but recent had experience with corporate financing has focused attention towards
consumer durables which incidentally, is the all time favorite of financiers world-over.
(v) ar ustomers: Car leasing world-over is a very big market, and the same is true for
ndia. So long, most car leases were plain-vanilla financial leases but one now finds few
instances of value-added car lease services also being offered.
(vi) ommerciaI VeicIes: Commercial vehicles customers have always relied upon
funding by hire purchase companies. The customer profile ranges from large fleet
owners to individual truckers.
(vii) Government Department and Autorities: One of the latest entrants in leasing
markets is the Government itself. The Department of Telecommunications of the Central
Government took the lead by floating tenders for lease finance worth about Rs 1000
crore. n its reforms' programme, ndia has limits to the extent to which it can resort to
deficit financing, and leasing is easily going to appeal to the Government, if not for cost
reasons, at least for the fact that it will not feature in national accounts as a commercial
financing.
[2] Lesser: Owner or the title holder of the leased asset or property, the lesser is also the lender
and secured party in case of capital leases and operating leases. n case of leveraged leases,
however, a third party (the lender) and not the lesser hold the title.
Types of Lesser:
(i) SpeciaIized Leasing ompanies: There are about 400 odd large companies which
have an organizational four on leasing and hence, are know as leasing companies. Till
recently, most of them were diversified financial houses, offering several fund-based and
non-fund based financial services. However recent SEB rules on bifurcation of fund
based and non-fund based activities have resulted into having off of merchant banking
divisions of these entities. Most of these companies also offer hire-purchase activities,
and some of them might have consumer finance division as well. These companies are
known as NBFCs.
(ii) Banks and Bank Subsidiaries: Till 1991, there were some ten bank subsidiaries active
in leasing, and over-active in stock-investing. The latter variety was ravaged in the
aftermath of the 1992 securities scam. n Feb., 1994, the RB allowed banks to directly
enter leasing. So long, only bank subsidiaries were a allowed to engage in leasing
operations, which was regarded by the RB as a non-banking activity. However, the
1994 notification saw an essential thread of similarity between financial leasing and
traditional lending.
(iii) SpeciaIized FinanciaI Institutions: There is a wide variety of financial institutions at the
Central as well as the state level in ndia. Apart from the apex financial institutions, viz.,
the DB, the FC, and the CC, there are several financing agencies devoted to
specific causes, such as sick-industries, tourism, agriculture, small industries, housing,
shipping, railways, roads, power, etc. n most states too, there are multiple financing
agencies for generic or focused cause.
(iv) One Off Lesser: Some of the companies engaged in some other business which give
them huge taxable profits, how resorted to one-off leasing on a causal basis to defer
their taxes. These people are interested only in leasing of high depreciation items,
preferably those entitled to 100% depreciation. The major items eligible for 100%
depreciation are gas cylinders, certain energy-saving devices, pollution control devices,
etc.
(v) Manufacturer-Lesser: This part of the lesser-industry is in highly under-grown form in
ndia, for simple reasons. Vendor leasing is a products of competition in the product
market. As competition forces the manufacturer to add value to his sales, he finds the
best way to sell the product is to sell it without the buyer having to pay for it instantly.
Product markets so far for most durables were oligopolistic and good products used to
sell seven otherwise at a premium, with the economy decisively moving towards market
orientation competition has become inevitable and competition brings in its wake sales-
aid tools. Hence, the potential for vendor leasing is truly great.
Iassification or Types of Lease
(1) Finance Lease: n a finance lease the lesser transfers to the lessee, substantially all the
risks and rewards incidental to the ownership of the assets whether or not the little is
eventually trans-furred. t involves payment of rental over an obligatory non-cancellable
lease period, sufficient in total to amortize the capital outlay of the lesser and leave some
profit. n such lease the lesser is only financier and is usually not interested in the assets. t
is for this reason that such leases are also called as "full payment leases" as they enable a
lesser to recover his investment in the lease and derive a profit. Types of assets included,
under such lease, are ships, aircrafts, railways wagons, lands, buildings, heaving
machinery, diesel generating sets and so on.
(2) Operating Lease: An operating lease in one which is not a finance lease. n an operating
lease, the lesser does not transfer all the risks and rewards incidental to the ownership of
the asset and rewards incidental to the ownership of the asset and the cost of the asset is
not fully amortized during the primary lease period. The lesser provides services (other than
the financing of the purchase price) attached to the leased asset, such as maintenance,
repair and technical advice. For this reason, operating lease is also called? 'Service lease'.
The lease rentals in an operating lease include a cost for the 'services' provided and the
lesser does not depend on a single lessee for recovery of his cost. Operating lease is
generally used for computers, office equipments, automobiles, trucks, some others
equipments, telephones and so on.
(3) SaIe and Lease Back: t is an indirect form of leasing. The owner of an equipment/asset
sells it to a leasing company (lesser) which leases it back to the owner (lessee). A classic
example of this type of leasing is the sale and lease back of safe deposits vaults by the
banks under which bank sell them in their custody to a leasing company at a market price
substantially higher than the book value. The leasing company in turn offers these lockers
on a long-term basis to the bank. The bank sub-leases the lockers to its customers.
(4) Direct Lease: n direct lease, the lessee and the owner of the equipment are two different
entities. A direct lease can be of two types: Bipartite and Tripartite lease.
(i) Bipartite Lease: There are two parties in the lease transaction namely equipment
supplier-cum-lesser and (b) lessee. Such a type of lease is typically structured as an
operating lease with inbuilt facilities, like up gradating the equipment, addition to the
original equipment configuration and so on. The lesser maintains the asset and if
necessary, replace it with similar equipment in working conditions.
(ii) Tripartite Lease: Such type of lease involves three different parties in the lease
agreement: equipment supplier, lesser and lessee.
(5) SingIe Investor Lease: There are only two parties to the lease transaction: the lesser and
lessee. The leasing company (lesser) funds the entire investment by an appropriate mix of
debt and equity funds, The debts raised by the leasing company to finance the asset are
without recourse to the lessee, that is, in the case of default in servicing the debt by the
leasing company the lender is not entitled to payment from the lessee.
(6) Leverage Lease: There are three parties to the transactions: (i) lesser (equity investor) (ii)
lender and (iii) lessee. n such type of lease, the leasing company (equity investor) buys the
asset through substantial borrowing with full recourse to the lessee and without any
recourse to it. The lender (loan participant) obtains an assignment of the lease and the
rentals to be paid by the lessee and a first mortgaged asset on the leased asset. The
transaction is routed through a trustee who looks after the interest of the lender and lesser.
On receipt of the rentals from the lessee, the trustee remits the debt-service component of
the rental to the loan participant and the balance to the lesser.
(7) Domestic Lease: A lease transaction is classifieds domestic if all parties to the agreement,
namely, equipment supplies, lesser and the lessee are domiciled in the same country.
(8) InternationaI Lease: f the parties to the lease transaction are domiciled indifferent
countries, it is known international lease. This type of lease is further sub-classified into (i)
mport Lease and (ii) Cross Border Lease.
(i) Import Lease: n an import lease, the lesser and the lessee is domiciled in the same
country but the equipment supplier is located in a different country. The lesser imports
the asset and leases it to the lessee.
(ii) Gross Border Lease: When the lesser and the lessee are domiciled in different
countries, the lease is classified as cross-border lease. The domicile of the supplier is
in material.
Advantages of Leasing
(A) To te Lessee: Lease financing has following advantages to the lessee:-
(B) Financing of apitaI Goods: Lease financing enables the lease to have finance for huge
investments in land, building, plant, machinery, heavy equipments, and so on, upto 100 per
cent, without requiring any immediate down payment. Thus the lessee is able to commence
his business virtually without making any initial investment (of course, he may have to invest
the minimal sum of working capital needs).
(2) AdditionaI Source of Finance: Leasing facilitates the acquisition of equipment; plant and
machinery, without the necessary capital outlay and thus, has a completive advantage of
mobilizing the scarce financial resources of the business enterprise. t changes the working
capital position and makes available the internal accruals for business operations.
(3) Less ostIy: Leasing, as a method of financing is less costly than other alternatives
available.
(4) Ownersip Preserved: Leasing provides finance without diluting the ownership or control
of the promoters. As Against it, other modes of long-term finance, for example, equity or
debentures normally dilute the ownership of the promoters.
(5) FIexibiIity in Structuring of RentaIs: The lease rental can be structured to accommodate
the cash flow position of the lessee, making the payment of rentals convenient to him. The
lease rentals are so tailor made that the lessee is able to pay the rentals from the funds
generated from operation. The lease period is also chosen so as to suit the lessees'
capacity to pay rentals and considering the operating life-span of the asset.
(6) SimpIicity: A lease finance agreement is simple to negotiate and free from cumbersome
procedures with faster and simple documentation. As against it, institutional finance and
term loans require compliance of covenants and formalities and bulk of documentation,
causing procedural delays.
(7) Tax Benefits: By suitable structuring of lease rentals a lot of tax advantage can be derived.
f the lessee is in a tax paying position the rental may be increased to lower his taxable
income.
(8) ObsoIescence Risk is Averted: n a lease arrangement, the lessor being the owner bears
the risk of obsolescence and the lessee is always free to replace the asset with latest
technology.
B) To te Lesser: A lesser has the following advantages:-
(1) FuII Security: The laser's interest is fully secured since he is always the owners of the
leased asset and can to be repossession of the asset if they lessee defaults. As against it,
realizing an asset secured against a loan is more difficult and cumbersome.
(2) Tax benefit: The greatest advantage for the lesser is the tax relief by way of depreciation. f
the lesser is in high tax bracket, he can lease out assets with high depreciation rates and,
thus, reduce his tax liability substantially. Besides, the rentals can be suitably structured, to
pass on some tax benefit to the assessed.
(3) Hig ProfitabiIity: The leasing business is highly profitable since the rate of return is more
than what the lesser pays on his borrowings. Also the rate of returns in more than in case of
lending finance directly.
(4) Trading on Eigty: Lesser usually carry out their operations with greater financial leverage.
That is they have a very low equity capital and use a substantial amount of borrowed funds
and deposits. Thus, the ultimate return on equity is very high.
(5) Hig Growt PotentiaI: The leasing industry has a high growth potential. Lease financing
enables the lessees to acquire equipment and machinery even during a period of
depression, since they do not have to invest any capital. Leasing, thus, maintains the
economic growth even during recessionary period.
Limitations of Leasing: Lease financing suffers from certain limitations too:-
(1) Restriction on use of equipment: A lease arrangement may impose certain restrictions on
use of the equipment or require compulsory insurance, and so on. Besides, the lessee is not
free to make additions or alteration to the leased asset to suit his requirement.
(2) Limitations of FinanciaI Lease: A financial lease may entail higher payout obligations, if
the equipment is found not useful and the lessee opts for premature termination of the lease
agreement. Besides, the lessee is not entitled to the protection of express or implied
warranties since he is not the owner of the asset.
(3) Loss of ResiduaI VaIues: The lessee never becomes the owner of the leased asset. Thus,
he is deprived of the residual value of the asset and is not even entitled to any
improvements done by the lessee or caused by inflation or otherwise, such as appreciation
in value of leasehold land.
(4) onsequences of DefauIt: f the lessee defaults are complying with any terms and
conditions of the lease contract, the lesser may terminate the lease and take over the
possession of the leased asset. n case of finance lease, the lessee may be required to pay
for damages and accelerated rental payments.
(5) DoubIe SaIes-Tax: With the amendment of sale-tax law of various states, a lease financing
transaction may be charged to sales-tax twice-once when the lesser purchases the
equipment and again when it is leaded to the lessee.
Hire Purcase
Hire-purchase is made of financing the price of the goods to be sold on a future date. n a
hire-purchase transaction, the goods are lot on hire, the purchase price is to be paid in installments
and the hirer is allowed an option to purchase the goods by paying all the installments. A hire-
purchase agreement is defined as peculiar kind of transaction in which the goods are let on hire
with an option to the hirer to purchase them, with the following stipulations:-
(a) Payment to be made in installments over a specified period.
(b) The possession is delivered to the hirer at the time of entering into the contract.
(c) The property in the goods passes to hire on payment of the last installments.
(d) Each installment is treated as hire charges so that if default is made in payment of any
installment the seller becomes entitled to take away the goods, and
(e) The hirer/purchases is free to return the goods without being required to pay any further
installments falling due after the return.
Thus, a hire-purchase agreement has two aspects, firstly, an aspect of bailment of goods
subject to the hire-purchase agreement and secondly, an element of sale which fructifies
when the option to purchase is exercise by the intending purchases. Though the option to
purchase is allowed in the very beginning it can be exercised only at the end of the
agreement. The essence of the agreement is that the property in goods does not pass at the
time of the agreement but remains in the intending seller and only passes later when the
option is exercised by the intending purchaser.
The finance (hire-purchase) company purchase the equipment from the equipment
supplier and lets it on hire to the hirer to use it who is required to make a down payment of
say, 20-25 percent of the cost and pay balance with interest in Equated Monthly nstallments
(EMT) in advance or arrears spread over 36-48 months. Alternatively, in place of the margin
in the down-payment plan, under a deposit linked plan, the hirer has to put an equal amount
as a fixed plan, the hirer has to put an equal amount as a fixed deposit with the finance
company which provides the entire finance on hire purchase terms repayable with interest
as EM over 36-48 months. The deposit together with the accumulated interest is returned to
the hirer after the payment of the last installment.
Partier in Hire-purcase
(1) Hire Purcaser: He is the customer who obtains possession of the goods at the outset and
can use it, while paying for it by installments over an agreed period of time.
(2) Hire Vendor: The time of ownership of the goods remains with the seller called hire vendor
until the hire purchase has made all the payment.
Types of Hire Purcase
(1) onsumer InstaIIment redit: Consumer nstallment credit is finance offered to consumers
for acquiring consumer durables. nstallment credit may be in the form of a personal loan
credit sale, rental or conditional sale in the form of hire purchase. The consumer acquires
goods by utilizing the funds being advanced under the hire purchase agreement. Retail hire
purchase may be different forms depending upon the mode of collection. t may be in the
form of direct collection, agency collection or block discounting.
(2) IndustriaI and ommerciaI redit: n industrial and commercial fields, finance may be
provided through loans, credit sales, leasing, factoring or hire purchase. The financing
house, desirous of financing a commercial concern for the purchase of equipments, itself
purchase. The financing house, desirous of financing a commercial concern for the
purchase of equipments, itself purchases the equipment from the manufacturer or dealer
through hire purchase and lets it on hire purchase to the said commercial concern instead of
lending money.
Advantages of Hire Purcase
(1) Spread te ost of Finance: Whilst choosing to pay in cash is preferable, this might not be
possible for consumer on a tight budget. A hire purchase agreement allows a consumer to
made monthly payments over a pre-specified period of time.
(2) Interest-Free redit: Some merchants offer customers the opportunity to pay for goods and
service on interest free credit. This is particularly common when making a new car purchase
or on white goods during an economic downturn.
(3) Higer Acceptance Rates: The rate of acceptance on hire purchase agreements is higher
than other forms of unsecured borrowing because the lenders have collateral security.
(4) SaIes: A hire purchase agreement allows a consumer to purchase sale items when they are
not in a position to pay in cash. The discounts secured will save many families money.
(5) Debt soIutions: Consumers that buy on credit can purchase a debt solution, such as debt
management plan, if they experience money problems further down the line.
Disadvantages of Hire Purcase
(1) Encourages Lavis Expenditure: On account of the easy payment facility, consumers go
in for articles, which may be beyond their means.
(2) Future Income is Mortgaged: As consumer have to pay installments over a period of time.
their future income is mortgaged.
(3) Higer instaIIment Price: The installment price is higher than the cash-down price.
(4) DifficuIty in re-saIe of goods: Even though the hire-sellers has the right to reposes the
articles in case of default, to sell them again is difficult as they are second hand goods.
(5) PersonaI Debt: A hire purchase agreement is yet another form of personal debt. t is
monthly payment commitment that needs to be paid each month.
(6) FinaI Payment: A consumer does not have legitimate title to the goods until the final
monthly payment has been made.
(7) Bad redit: All hire purchase agreements will involve a credit check consumers that have a
bad credit rating will either be turned down or be asked to pay a high interest rate.
Difference Between Leasing and Hire Purcase
Basis of Difference Leasing Hire-Purcase
1) Ownership Ownership is not
transferred to the lessee
Ownership is transferred to the
hirer on payment of last
installment.
2) Tax Deductibility Entire lease rentals are
tax-deductable expenses.
Only the interest component
and not the entire installment is
deductable.
3) Depreciation and Other
allowances
Cannot be claimed by the
lessee.
Can be claim by the hirer.
4) Salvage Value Lessee cannot realize
salvage value of the asset
on the expiry of the lease
of life of the asset.
Hirer can realize the salvage
value of the asset after payment
of last installment and expiry of
the life of the asset.
5) Magnitude The magnitude of funds
involved in the lease
finance is very large, for
ex. for the purchase of
aircrafts, ships and
machinery air conditioning
plants and so on.
The cost of acquisition in hire
purchase is relatively low, that
is, automobiles, office
equipments and generators and
soon is generally hire
purchased.
6) Margin Money Lease financing is
invariably 100 per cent
financing. t requires no
margin money or
immediate cash-down
payment by the lessee.
n a hire-purchase transaction
typically a margin equal to 20-
25 percent of the cost of the
equipment is required to be
paid by the hire.
7) Maintenance n case of finance lease
only the maintenance of
the leased assets is the
responsibility of the
lessee.
The cost of maintenance of
hire-dessert is to be born
typically by the hirer himself.
Factoring
The word 'factoring' has its origin from Latinword 'factor/ which means 'doer'. The Webster's
New Collegiate Dictionary defines a factor as, "one that lends many to producers and dealers on
the security of accounts receivables."
Factoring is financial transaction whereby a business sells its accounts receivables (i.e.,
invoices) to a third party (called a factor) at a discount in exchange for immediate money with which
to finance continued business.
So Factoring can broadly be defined as an agreement in which receivables arising out of
sale of goods, services are sold by a firm (client) to the factor (a financial intermediary) as result of
which the title to the goods/services represented by the said receivables passes on to the factor.
Hence, forth the factor accounting and debt collection from the buyers (s). n a full service factoring
(without recourse facility), if any of the debtor fails to pay the dues as a result of his financial
inability/insolvency/bankruptcy, the factor has to absorb the lesser.
Features of Factoring
(1) The period of factoring is 40 to 150 days some factoring companies allow even more than
15 days.
(2) Factoring is considered to be a costly source of finance compared to other sources of short-
term borrowings.
(3) Credit rating is not mandatory. But the factoring companies usually carry out of credit risk
analysis before entering into the agreement.
(4) Factoring is a method off balance sheet financing.
(5) ndian firms offer factoring for involvers as law as 1000 Rs.
Functions of a Factor
Depending on the type/form of factoring, the main functions of a factor, in general terms, can
be classified into five categories:-
(1) Maintenance/Administration of SaIes Ledger: The factor maintains the client's sales
ledger. On transacting a sales deal, an invoice is sent by the client to the customer and a
copy of the same is sent to the factor. The factor also gives periodic (fortnightly, weekly
depending on the volume of transaction) reports to the client on the current status of his
receivables, receipts of payments from the customers and other useful information.
(2) Provision of oIIection FaciIity: The factor undertakes to collect the receivables on behalf
of the client reliving him of the problems involved in collection and enables him to
concentrate on other important functional areas of the business. This also enables the client
to reduce the cost of collection by way of savings in manpower, time and efforts.
(3) Financing Trade Debts: The unique feature of factoring is that a factor purchases the book
debts of his client at a price and the debts are assigned in favour of the factor that is usually
willing to grant advances to the extent of 80-85 percent of the assigned debts. The balance
15-20 percent is retained as a factor reserve. Where the debts are factors with recourse, the
finance provided would become refundable by the client in case of non-payment by the
buyer. However, where the debts are factored without recourse, the factor's delegation to
the seller becomes absolute on the due date of the invoice whether or not the buyer makes
the payment.
(4) redit ontroI and redit Protection: Assumption of credit risk is one of the important
functions of a factor. This service is provided where debts are factored without recourse.
The factor in consultation with the client fixes credit limits for approved customers.
(5) Advisory Services: These services are spin-offs of the close relationship between a factor
and a client. By virtue of their specialized knowledge and experience in finance and credit
dealings and access to extensive credit information, factors can provide a variety of
incidental advisory services to their clients. Sc as:-
(a) Customer's perception of the client's product, changes in marketing strategies, emerging
trends and so on.
(b) Audit of the procedures followed for invoicing, delivery and dealing with sales returns.
(c) ntroduction to the credit department of a bank/ subsidiaries of banks engaged in
leasing, hire-purchase, merchant banking and so on.
Working/Mecanism of Factoring
The below mechanism of factoring can be explained as follows:-
(1) Customer places an order with the client for goods and or service on credit, client delivers
the goods and sends invoice to customers.
(2) Client assigns invoice to factor.
(3) Factor makes pr-payment upto 80 percent and sends periodical statements.
(4) Monthly statement of accounts to customer and follows-up
(5) Customer makes payment to factor.
(6) Factor makes balance 20 percent payment on realization to the client.
Working/Mecanism of Factoring
( 2) (3) (1)
Assign Payment Send nvoice
invoice upto 80% (6) Balance 20% to customer
to factor on realization
( 4) Statement to customer
(5 ) Payment to Factor
Types/Forms of Factoring
(1) Recourse Factoring: Under a recourse factoring arrangement, the factor has because to
the clients (firm) if the debt purchased/receivables factored turns out to be irrecoverable. n
other words, the factor does not assume credit risks associated with the receivables. f the
customer defaults in payment, the client has to make good the loss incurred by the factor.
The factor is entitled to recover from the client the amounted paid in advance in case the
customer does not pay on maturity. The factor charges the client for maintaining the sales
ledger and debt collection services and also for the interest for the period on the amount
drawn by the client.
(2) Non-Recourse Factoring: The factor does not have the right of recourses in the case of
non-recourse factoring. The loss arising out of irrecoverable receivables is borne by him, as
a compensation for which he charges a higher commission. The additional fee charges by
him as a premium for risk-bearing is referred to as a debt cruder commission. Additionally,
C||ent
Iactor
Customer
he is actively associated with the process of grant of the credit and the extension of line of
credit to the customers of the client.
(3) Advance Factoring: The factor pays a pre-specified portion, ranging between three-fourths
to nine-tenths, of the factored receivables a advance, the balance being paid upon
collection/on the guaranteed payment date. A drawing limit, as a pre-payment is made
available by the factor to the client as soon as the factored debts are approved the invoices
are accounted for. The client has to pay interest (discount) on the advance/repayment
between the date of such payment and the date of actual collection from the customer or the
guaranteed payment date.
(4) Maturity Factoring: The maturing factoring is also known as Collection Factoring. Under
such arrangements, the factor does not make a pre-payment to the client. The payment is
made either on guaranteed payment date or on the date of collection. The guaranteed
payment date is generally fixed taking into account the previous ledger experience of the
client and a period for slow collection after the due date of the invoice.
(5) FuII Factoring: This is the most comprehensive form of factoring combining the features of
almost all the factoring service specially those of non-recourse and advance factoring. t is
also known as old line factoring. Full Factoring provides the entire spectrum of services,
namely collection, credit protection, sales ledger administration and short-term finance.
(6) DiscIosed Factoring: n disclosed factoring, the name of the factor is disclosed in the
invoice by the supplier manufacturer of the goods asking the buyer to make payment to the
factor.
(7) UndiscIosed Factoring: The name of the factor is not disclosed in the invoice in
undisclosed factoring although the factor maintains the sales ledger of the supplier company
but all control remains with the factor. He also provides short term finance against sales
invoices.
(8) Export/ross Border/InternationaI Factoring: There are usually four parties to a cross-
border factoring transaction. They are: () exporter (client), (ii) importer (customer), (iii) export
factor and (iv) import factor.
Forfeiting
Forfeiting is a form of financing of receivables of pertaining to international trades. t denotes
the purchase of trade bills/promissory notes by a bank/financial institution without recourse to the
seller. The purchase is in the form of discounting the documents covering the entire risk of
nonpayment in collection. All risks and collection problems are fully the responsibility of the
purchaser (forfeiter) who pays cash to seller after discounting the bills/notes.
aracteristics of Forfeiting:-
(1) Forfeiting is 100 percent financing without recourse to the exporter. This means that the
exporter is insulated against the possibility of default in payment by the importer.
(2) Trade receivables are usually evidenced by bills of exchange, promissory notes, or a letter
of credit.
(3) The trade receivables are required to be denominated in a freely convertible currency. The
most common currency denominations are the US Dollar and Euro.
(4) Credit periods can range from 60 days to 10 years.
(5) An importer's obligation is normally supported by a local bank guarantee.
(6) Forfeiting is suitable for high value exports such as capital goods, consumer durables,
vehicles, consultancy and construction contracts, project exports and bulk commodities.
by scan Working Mechanism of Forfeiting (Figure) (Page 97 of Register)
1) At the request of the exporter, and normally nearer the time of shipment, the forfeiter
provides the exporter with a written commitment to purchase the debt from him on a without
recourse basis.
2) The exporter and the importer sign the commercial contract.
3) The goods under the contract are then dispatched to the importer.
4) The importer's bank provides guarantee at the request of the importer.
5) The Guarantee is forwarded by the importer to the exporter.
6) The exporter then assigns the guarantee in favour of the forfeiter and forwards other
documents relating to forfeiting.
7) On receipt of complete documentation, the forfeiter makes the payment to the exporter on a
without recourse basis.
8) On maturity, the forfeiter presents the documents to the importers bank for payment.
9) The importer makes the payment to his guaranteeing bank.
10) The importer's bank guaranteeing the transaction makes the payment to the forfeiter on due
date.
(3) Payee: The person named in the instrument to whom or to whose order the money is
directed to be paid by the instrument, is called the payee.
Suppose a seller sells goods or merchandise to a buyer. n most cases, the seller
would like to be paid immediately but the buyer would like to pay only after some time, that
is, the buyer would like to pay only after some time, that is, the buyer would wish to
purchase on credit. To solve this problem the seller draws a BE of a given maturity on the
buyer. The seller has now assumed the role of a creditor, and is called the drawer of the bill.
The buyer who is the debtor is called the drawer. The seller then sends the bill to the buyer
who acknowledges his responsibility for the payment of the amount on the terms mentioned
on the bill by writing his acceptance on the bill. The acceptance could be the buyer himself
or any third party willing to take on the credit risk of the buyer.
Working of Discounting of BiIIs
Following steps are involved in the discounting of commercial bills:-
(1) Examination of BiII: The banker verifies the nature of the bill and the transaction. The
banker then ensures that the customer has supplier all required documents along with the
bill.
(2) rediting ustomer Account: After the examining the genuineness of the bill, the banks
grants a credit limit, either on a regular or on ad hoc basis. The customer's account is
credited with the net amount of the bill, i.e., value of bill minus discount charges. The
amount of discount is the income earned by the bank on discounting/purchasing. The
amount of the bill is taken as advance by the bank.
(3) ontroI over Accounts: To ensure that no customer borrows more than the sanctioned
limit, a separate register is maintained for determining the amount availed by each
customer. Separate columns are allotted to show the names of customers, limit sanctioned,
bills discounted, Bills collected, loans granted and loans repaid. Thus at any given point in
time the extent of limit utilized by the customer can be readily known.
(4) Sending biIIs for coIIection: The bill, together with documents duly stamped by the banker,
is sent to the banker's branch (or some other bank's branch if the banker does not have a
branch of its own) for presenting the bill for acceptance or payment in accordance with the
instructions accompanying the bill.
(5) Action by te Branc: On receipt of payment, the collecting banker remits the payment to
the banker which has sent the bill for collection.
(6) Disonor: n the event of dishonor, the dishonor advice is sent to the drawer of the bill. t
would be appropriate for the collecting banker to the get the bill protected for dishonor. For
this purpose, the collecting banker or branch of the bank maintains a separate register in
which details such as date on which the bills are to be presented, the party to whom it is to
be presented, etc., are recorded. The banker then presents them for acceptance or
payment, as required. The banker debits the customers' (drawer/borrowers) account with
the amount of the bill and also all charges incurred due to dishonor of the bill. Such a bill
should not be purchased in the event of its being presented again. However, the banker,
may agree to accept it for collection.
Advantages of Discounting of BiIIs
(A) To Investors:-
(1) Short term sources of finance.
(2) Bills discounting being in the nature of a transaction is outside the purview of Section 370 of
the ndian Companies Act, 1956, that restricts the amount of loans that can be given by
group companies.
(3) Since it is not a lending, no tax source is deducted while making the payment charges which
is very convenient, not only from cash flow point of view, but also from the point of view of
companies that do not envisage tax liabilities.
(4) Rates of discount are better than those available on DCs.
(5) Flexibility, not only in the quantum of investments but also in the duration of investments.
(B) To Banks:
(1) Safety of Funds: The greatest security for a banker is that a BE is a negotiable instrument
bearing signatures of two parties considered good for the amount of bills, so he can enforce
his claim easily.
(2) ertainty of Payment: A BE is a self-liquidating asset with the banker knowing in advance
the date of its maturity, Thus, bill finance obviates the need for maintaining large unutilized,
ideal cash balances as under the cash credit system. t also provides banks greater control
over their drawls.
(3) ProfitabiIity: Since the discount on a bill is front-ended, the yield is much higher than in
other loans and advances, where interest is paid quarterly or half yearly.
(4) Evens out Inter-Bank Liquidity ProbIems: The development of healthy parallel bill
discounting market would have stabilized the violent fluctuations in the call money market as
banks could buy and sell bills to even out their liquidity mismatches.
(5) Discount Rate and Effective Rate of Interest: Banks and finance companies discounting
bills prefer to discount LC (letter of credit) backed bills compared to clean bills. The rate of
discount applicable to LC-based bills. The bills are generally discounted up-front, that is, the
discount is payable in advance. As consequences, the effective rate of interest is higher
than the quoted rate (discount). The discount rate varied from time to time depending upon
the short-term interest rate.
onsumer redit/onsumer Finance
Consumer credit includes all asset-based financing plans offered to primarily individulas to acquire
durable consumer goods. Typically, in a consumer credit transaction the individual-consumer-buyer
pays a fraction of the cash purchase price at the time of delivery of the asset and payes the balance
with interest over a specified period of time.
The consumer credit refers to the activities involved in granting credit to consumers to
enable them. Possess own goods meant for everyday use. t is known by several names such as
credit merchandising, differed payments installment buying, hire purchase, pay-out of income
scheme, pays-as-you earn scheme, easy payment, credit buying, installment credit plan etc.
According to E.R.A. Seligman, an authority on consumer credit, "The term consumer credit
refers to a transfer of wealth, the payment of which is diferred on whole or in part, to future, and is
liquidated piecemeal or in successive fractions under a plan agreed upon at the time of the
transfer."
Features of onsumer redit
The salient features of consumer credit are:-
(1) Parties to te Transaction: The parties to a consumer credit transaction depend upon the
nature of the transaction.
(i) Bipartite Arrangement: A bipartite arrangement, there are two parties, namely,
borrower-consumer-customer and dealer-cum-financer.
(ii) Tripartite Arrangement: A tripartite arrangement where the parties are dealer,
financer and the customer. The dealer in this type of arrangement arranges the credit
from the financer.
(2) Structure of te Transaction: A consumer credit arrangement can be structured in three
ways:
(i) Hire-Purcase: The customer has the option to purchase the assets. But he may
not exercise the option and return the goods according to the terms of agreement.
Most of the tripartite consumer credit transactions are of this type.
(ii) onditionaI SaIe: The ownership is not transferred to the customer until the total
purchase price including the credit charge is paid. The customer cannot terminate
the agreement before the payment of the full price.
(iii) redit SaIe: The ownership is transferred to the customer on payment of the grist
installment. He cannot cancel the agreement.
(3) Mode of Payment: Form the point of view of payment, the consumer credit arrangements
fall into two groups:-
(i) Down Payment Scemes: The down payment may range between 20-25 percent of
the cost.
(ii) Deposit-Linked Scemes: The deposit may vary between 15-20 percent of the
amount financed at compound rate of interest.
(4) Payment Period and Rate of Interest: A wide range of options are available. Typically, the
repayment period ranges between 12-16 monthly installments. The rate of interest is
normally expressed at a flat rate; the effective rate of interest is generally not disclosed. n
some schemes, the rate of interest is not disclosed; instead the EM associated with the
different repayment periods is mentioned. Most of the schemes provide for easy
repayments. They also provide for either a rebate for prompt payment and charge for
delayed payment.
(5) Security: Security is generally in the form of a first charge on the asset. The consumer
cannot sell/pledge/hypothecate the asset.
Types of onsumer redit: There are several types of credit facility available to consumers.
They are briefly explained below:-
(1) RevoIving redit: An on-going credit arrangement similar to a bank overdraft, whereby the
financier, on a revolving basis, grants credit, is called 'revolving credit'. The consumer is
entitled to avail credit to the extent sanctioned as the credit limit; an ideal example of credit
is credit cards.
(2) Fixed redit: t is like a term loan whereby the financier provide loan for a fixed period of
time. The credit has to be squared off within a stipulated period. Examples of fixed credit
include monthly installment loan, hire purchase etc.
(3) as Loan: Under this type of credit, banks and financial institutions provide money with
which the consumer buy articles for personal consumption, three the lender and the seller
are different. The lender does not have the responsibilities of s seller.
(4) Secured Finance: When the credit granted by a financial institution is secured by collateral,
it takes the form of 'secured finance'. The collateral is taken by the creditor in order to satisfy
the debt in the event of default by the borrower. The collateral may be in the form of
personal property, real property or liquid assets.
(5) Unsecured Finance: Where there is no secured offered by the consumer against which
money is generated by financial institutions it takes the form of 'unsecured finance.'
(6) Non-InstaIIment: Non-installment Credit is the simplest form of credit and is usually for a
very short term, such as thirty days. The buyer makes one payment at or before the end of
the credit period. This kind of credit enables consumers to take possession of property
immediately and pay for it within a short time. Many departmental stores offer non-
installment credit to their regular customers, this enables the store to make sales and gets
the money in the near future, thus generating better cash flow for the business that might
otherwise occur.
(7) InstaIIment Iosed-End redit: t is another form, where only a specified amount of money
is lent to the consumer, typically the total purchase price of the goods. This kind of credit is
also used by departmental stores for the sale of large items and by auto dealers for the sale
of automobiles.
Uses/Benefits of onsumer redit
Consumer credit plays an important role in the mass production and distribution of consumer
durables such as motorcars, refrigerators, TV sets, radio, typewriters, sewing machines, electrical
appliances and many other goods. Offering credit is a great convenience to consumers. Further,
credit has come to occupy an important place in the modern competitive market.
(1) Enjoying Possession: An important benefit of consumer credit is that it allows people to
enjoy the possession of goods without having to pay for them immediately. The user doesn
not have to wait and save money for purchasing a dream product.
(2) ompuIsory Saving: Consumer Credit allows for a mechanism of compulsory saving. This
has the effect of inducing people into using their income more wisely. t promotes thrift
among people and enables people with limited means to acquire goods.
(3) Meeting Emergency: Consumer Credit is useful in meeting emergencies, such as illness,
accident and death, which involve unexpected expenses. This also helps save the esteem
of the consumer in dire circumstances.
(4) Maximization of Revenue: Consumer credit facilitates speedy disposal of goods, which
would have remained unsold in the absence of credit facility to customers. Credit induces
more business. This is quite true with regard to non-essential or luxury goods, such as motor
cars, trucks, refrigerators typewriters, all kinds of electric appliances etc.
(5) ReaIization of Dreams: Consumer credit is a boon for a consumer who can enjoy the
possession of goods without paying for them immediately. The installments can be
conveniently paid, spread over a fixed future period. Consumers are in a position to budget
for the purchase of even expensive capital items out of their regular, fixed and limited
income.
PIastic Money
Plastic Money was introduced in the 1950s and is now an essential form of ready money
which reduces the risk of handling a huge amount of cash. t includes debits cards, ATMs smart
cards etc. The cards are introduced in the world to resolve the issue of carrying huge cash. These
cards are known as plastic money. The usage of plastic money (cards) has increased in the mode of
payment of huge amount and time by time there are lots of different types of plastic money has been
introduced which enhanced the features of plastic money like we can use it to anywhere in the world,
New the world is becoming globalize so every card is accepted everywhere with the power of VSA
which interconnect the different countries.
Plastic Money entered the ndian market, promising a cashless society. But if we evaluate it
after a decode, certain deviations are easily seen, like the change in focus from cashless society to
plastic money as a debt instrument. As a new product, people used to flash colorful cards. However,
the present plastic money definitely locks sufficient infrastructure.
Plastic money was designed to help society overcome the hassles of carrying too much cash.
But it seems the multinational banks came here with a mission of targeting the emerging and
enormous middle-class segment (around 200 million people).
(iii) Card must be signed and dated by wait staff for each dinner purchased.
(iv) Offer not good for corporate members.
8) Poto ard: f customer photograph is imprinted on a card then it is known as a photo card.
t helps in identifying the use of the credit card and is therefore considered safer. Besides, in
many cases, photo card can function as identity card as well.
9) GIobaI ard: A very special Gold Visa Card with all its prestige and additional services
especially designed for people looking for peace of mind in their second home.
10) o-Branded ards: Co-branding is essentially two major brands converging to enhance the
usefulness and image of the product. n the case of a credit card, it is a partnership between
the issues, say, City bank and a retail service provides or a goods provider to meet
customer demand more efficiently. A card issued through a partnership between a bank and
another company or organization is called a co-branded card. The card would have both the
bank name and the store name on it. Many co-branded cards are also rebate cards that
provide the consumer with benefits such as extra services, cash or merchandised every time
the card is used.
Advantages of PIastic Money
1) Offer free use of funds, provided the customer to pay full balance in time.
2) t is more convenient to carry than cash.
3) Helps in establishing a good credit history.
4) Provide a convenient payment method for purchases made on the internet and over the take
phone.
5) Give incentives, such as reward points, that we can redeem.
redit ards
The growing credit card awareness has made this age of plastic money. With a credit card
one can buy almost anything on credit. Credit cards are innovations aimed to aid certain conscious
customers of the higher income group worldwide to enhance their purchasing power. A credit card
system is a type of retail transaction settlement and credit system, named after the small plastic
card issued to users of the system. A credit card is different from a debit card in that the credit card
issues loans the consumer money rather than having the money removed from an account. Most
credit cards are the same shape and size, as specified by the SO 7810 standard.
A Credit card is plastic card bearing an account number assigned to a cardholder with a
credit limit that can be used to purchase goods and services and to obtain cash disbursement on
credit for which a card holder is subsequently billed by an issue for repayment of the credit
extended at once or on an installment basis.
Features of redit ard
1) Al credit cards provide cash availing facility.
2) Apart from member establishments, most of the cards are honored in a number of other
establishments, including the airlines, railways, car rentals, petrol pumps, hotels, shops,
restaurants, departmental stores and hospitals.
3) Most of the cards provide for personal accident insurance coverage.
4) All the credit cards generally provide free credit period.
5) Most of the cards have associate relationship with international credit card companies like
Diner's Club, Master Card and Visa nternational.
6) Most of the cars provide Automated Teller Machine (ATM) facility.
7) Service charge is levied.
users. Credit card companies generally do provide a guarantee the merchant will be paid on
legitimate transactions regardless of whether the consumer pays their credit card bill. However the
credit card companies generally will not pay a merchant if the consumer challenges the legitimacy
of the transaction and will fine merchants who have a large number of chargeback's.
The credit card was the successor of a variety of merchant credit schemes. The concept of
paying merchants using a card was invented in 1950 with Diners Club's invention of the charge
card, which is similar but required the entire bill to be paid with each statement. Credit card service
was first offered in 1951.
Advantages of redit ard
1) Money from transactions credited into supplier's account within 2-4 days.
2) No cash involved.
3) Enable customers to buy expensive products immediately and make 'impulse' purchases.
4) Enable customers to make a payment over the telephone or over the internet.
5) Once transaction confirmed payment to supplier guaranteed.
6) Credit card holders can use card to obtain cash from a cash machine-although they pay
interest on withdraws from the moment they make the transaction.
7) Credit card holders have additional protection if goods are faulty, provided each item cost
over a minimum amount.
Disadvantages of redit ards
1) Risk of fraud, the through the use of stolen cards.
2) Cost of installing and paying for an electric terminal.
3) Card holders may spend more than they can afford.
4) Cost of processing the transactions.
5) nterest can be high if card is not paid-off in full each month-and cash withdrawals are
expensive.
6) Because the method of calculating interest is complicated people may find the interest
charge higher than they first thought.
Debit ards
Debit Cards are substitutes for cash or cheque payments much the same way that credit
cards are. However, banks only issue them to people if they hold an account with them. When a
debit card is used to make a payment, the total amount charged is instantly reduced from the bank
balance. A debit card is only accepted at outlets with electronic swipe-machines that can check and
deduct amounts from the bank balance on-line.
SO 7810 card which physically resembles a credit card and like a credit card is used as an
alternative to cash when making purchases. However, when purchaser is made with a debit card,
the funder is withdrawn directly from the purchaser's checking or savings account at a bank.
Features of Debit ards
1) Obtaining a debit card is often easier than obtaining a credit card.
2) Using a debit card instead of writing cheques saves from showing identification or giving out
personal information at the time of the transaction.
3) Using a debit card means, no longer have to stock-up on traveler's cheques or cash while
traveling.
4) Using a debit card means, no longer have to stock-up on traveler's cheques or cash while
traveling.
5) Debit cards may be more readily accepted by merchants than checks especially in other
states or countries wherever the card brand is accepted.
6) The debit card is a quick, 'pay now' product, giving no grace period.
7) Returning goods or cancelling services purchased with a debit card in treated as if the
purchase were made with cash or cheque.
Types of Debit ards
1) OnIine Debit ards: Online debit cards use the same underlying technology as ATMs that
dispense cash; authentication may consist of the use of a numeric PN known only to the
cardholder. PNs can be used only where the POS (point of sale) terminal is prosperity
equipped; in particular, a separate keypad is needed to allow the customer to enter his or
her PN and select the account from which funds should be drawn. This is the only method
used in some countries, particularly Canada.
2) OffIine Debit ard: Offline debit cards carry the logo types of and can be used in a manner
nearly identical to, major credit cards (for example, visa or master card). The use of a debit
card in this manner may have a daily limit, with the maximum limit being the amount of
money on deposit. A debit used in this manner is similar t a secured credit card.
3) Prepaid Debit Card: n the 1990s, credit card companies incurred heavy losses because of
money credit card users defaulted on their payments. Thus, credit card companies had to
come up with a new way to collect debts. t was during this period that credit card
companies began offering secured credit cards and prepaid debit cards. Today, most credit
card companies such as Visa, Master card and American Express issue prepaid debit cards.
A prepaid debit card works similar to a prepaid phone card.
Advantages of Debit ard
1) No need to carry cash.
2) No need to make a trip to the bank every time the customer needs to withdraw money.
He/she can use the card just about anywhere he/she goes, and can access money at an
ATM machines any time of day or night.
3) t is accepted more readily than cheque, especially when out to state.
4) No interest is paid on purchases.
Disadvantages of Debit ards
1) There is no grace period to pay the bill.
2) Debit cards do not have as much protection as credit cards.
3) Not all debit cards may be helping to build the credit score.
4) Some banks are now charging over-limit fees or non-sufficient funds fees based upon pre-
authorization and even attempted but refused transactions by the merchant (some of which
may not even be known).
5) Since debit cards are typically linked to bank accounts, if a debit card and PN number is
stolen, the entire bank account could be drained of funds.