Module-7

An Overview of the Financial System

Primary Function of the Financial System is Financial Intermediation

The channeling of funds from households, firms and governments who have surplus funds (savers) to those who have a shortage of funds (borrowers).

An Overview of the Financial System

Classifications of Financial Markets

Debt Markets

Short-term (maturity < 1 year) the Money Market Long-term (maturity > 10 year) the Capital Market Medium-term (maturity >1 and < 10 years)

Classifications of Financial Markets

Equity Markets - Common stocks

Primary Market - New security issues sold to initial buyers Secondary Market - Securities previously issued are bought and sold

Classifications of Financial Markets

(Contd)

Secondary Markets
Exchanges Trades conducted in central locations (e.g., Toronto Stock Exchange and New York Stock Exchange) Over-the-Counter Markets Dealers at different locations buy and sell

Financial System

An institutional framework existing in a country to enable financial transactions Three main parts

Financial assets (loans, deposits, bonds, equities, etc.) Financial institutions (banks, mutual funds, insurance companies, etc.) Financial markets (money market, capital market, forex market, etc.)

Regulation is another aspect of the financial system (RBI, SEBI, IRDA, FMC)

Money and Capital Markets

Money market: Short-term market for securities maturing in a year or less. Capital market: Long-term market for securities with maturities greater than one year. More often, companies search all capital markets including world markets for capital at the lowest cost.

Difference between Money & Capital Market

Not exceeding 1 year WC Requirements B/E,CP,CD & TB TB min 1L,CP/CD 25L Central & comercial bank Do not have secondr mkt Transactions over phone Without brokers

Exceeding 1 year LT &Trade Commerce Shares and debentures Min 2 max 100 Developme & insura Coms Have secondary market Thro Secondary market Only thru authorized broke

Financial Markets
Primary versus Secondary Markets Primary Market
When a corporation issues securities, cash flows from investors to the firm. Usually an underwriter is involved

Secondary Markets
Involve the sale of used securities from one investor to another. Securities may be exchange traded or trade overthe-counter in a dealer market.

Financial Markets
Stocks and Bonds Money Bob money Primary Market Secondary Market Investors securities Sue

Firms

Financial Markets

A Market is a place where buyers and sellers come together to exchange something Financial Markets are where financial Instruments/products are exchanged. A Financial Market is known by type of product traded in it

Financial Markets

Money Market- for short-term funds (less than a year)

Organised (Banks) Unorganised (money lenders, chit funds, etc.)

Capital Market- for long-term funds

Primary Issues Market Stock Market Bond Market

Organised Money Market

Call money market Bill Market

Treasury bills Commercial bills

Bank loans (short-term) Organised money market comprises RBI, banks (commercial and co-operative)

Purpose of the money market

Banks borrow in the money market to:

Fill the gaps or temporary mismatch of funds To meet the CRR and SLR mandatory requirements as stipulated by the central bank To meet sudden demand for funds arising out of large outflows (like advance tax payments)

Call money market serves the role of equilibrating the short-term liquidity position of the banks

Different Financial Markets

FINANCIAL MARKET

Money Market

Debt Market

Forex Market

Capital Market

Money Market

Markets for short term

Borrowing Lending

Primarily used by Banks Typical Financial Instruments

Bankers Acceptance Certificate of Deposit (CD) Treasury Bills Repos

Debt Market

Debt Contract One Party lends to another Party Predetermined

Interest Rates and Term

Participants Banks Financial Institutions Mutual Funds Insurance Companies etc. Instruments Government Securities (G-Secs) Public Sector Units Bonds Corporate Securities

Foreign Exchange Market

Foreign Goods

Payments in Foreign Currency Forex Market Government

Participants

Payments for Imports Repayment of Loans

Importers

Exchange Rates One Currency in terms of other (Eg. 1 US Dollar = 45 Rupees)

Bid Rate Offer Rate

Capital Market

Long Term Funds Raised by

Government Corporates Shares Derivatives Units of Mutual Funds

Trading Instruments used

Financial Markets

Primary Market

Instruments issued for first time Used by

Government/Corporates/PSUs Initial Public Offering

IPO

Secondary Market

Trading of already issued

Stocks Bonds

Stock Exchange

Bill Market

Treasury Bill market- Also called the T-Bill market

These bills are short-term liabilities (91-day, 182-day, 364day) of the Government of India It is an IOU of the government, a promise to pay the stated amount after expiry of the stated period from the date of issue They are issued at discount to the face value and at the end of maturity the face value is paid The rate of discount and the corresponding issue price are determined at each auction RBI auctions 91-day T-Bills on a weekly basis, 182-day TBills and 364-day T-Bills on a fortnightly basis on behalf of the central government

Money Market Instruments

(1)

Money market instruments are those which have maturity period of less than one year. The most active part of the money market is the market for overnight call and term money between banks and institutions and repo transactions Call money/repo are very short-term money market products

Certificates of Deposit

CDs are short-term borrowings in the form of UPN issued by all scheduled banks and are freely transferable by endorsement and delivery. Introduced in 1989 Maturity of not less than 7 days and maximum up to a year. FIs are allowed to issue CDs for a period between 1 year and up to 3 years Subject to payment of stamp duty under the Indian Stamp Act, 1899 Issued to individuals, corporations, trusts, funds and associations They are issued at a discount rate freely determined by the market/investors

Commercial Papers

Short-term borrowings by corporates, financial institutions, primary dealers from the money market Can be issued in the physical form (Usance Promissory Note) or demat form Introduced in 1990 When issued in physical form are negotiable by endorsement and delivery and hence, highly flexible Issued subject to minimum of Rs. 5 lacs and in the multiple of Rs. 5 lacs after that Maturity is 7 days to 1 year Unsecured and backed by credit rating of the issuing company Issued at discount to the face value

Call money market (1)

Is an integral part of the Indian money market where day-to-day surplus funds (mostly of banks) are traded. The loans are of short-term duration (1 to 14 days). Money lent for one day is called call money; if it exceeds 1 day but is less than 15 days it is called notice money. Money lent for more than 15 days is term money The borrowing is exclusively limited to banks, who are temporarily short of funds.

Call money market (2)

Call loans are generally made on a clean basis- i.e. no collateral is required The main function of the call money market is to redistribute the pool of day-to-day surplus funds of banks among other banks in temporary deficit of funds The call market helps banks economise their cash and yet improve their liquidity It is a highly competitive and sensitive market It acts as a good indicator of the liquidity position

Call Money Market Participants

Those who can both borrow and lend in the market RBI (through LAF), banks and primary dealers Once upon a time, select financial institutions viz., IDBI, UTI, Mutual funds were allowed in the call money market only on the lenders side These were phased out and call money market is now a pure inter-bank market (since August 2005)

The Indian Capital Market

Market for long-term capital. Demand comes from the industrial, service sector and government Supply comes from individuals, corporate, banks, financial institutions, etc. Can be classified into:

Gilt-edged market Industrial securities market (new issues and stock market)

The Indian Capital Market

Development Financial Institutions

Industrial Finance Corporation of India (IFCI) State Finance Corporations (SFCs) Industrial Development Finance Corporation (IDFC) Merchant Banks Mutual Funds Leasing Companies Venture Capital Companies

Financial Intermediaries

Industrial Securities Market

Refers to the market for shares and debentures of old and new companies New Issues Market- also known as the primary market- refers to raising of new capital in the form of shares and debentures Stock Market- also known as the secondary market. Deals with securities already issued by companies

Financial Intermediaries

Mutual Funds- Promote savings and mobilise funds which are invested in the stock market and bond market Indirect source of finance to companies Pool funds of savers and invest in the stock market/bond market Their instruments at savers end are called units Offer many types of schemes: growth fund, income fund, balanced fund Regulated by SEBI

Financial Intermediaries

Merchant banking- manage and underwrite new issues, undertake syndication of credit, advise corporate clients on fund raising Subject to regulation by SEBI and RBI SEBI regulates them on issue activity and portfolio management of their business. RBI supervises those merchant banks which are subsidiaries or affiliates of commercial banks Have to adopt stipulated capital adequacy norms and abide by a code of conduct

Conclusion

There are other financial intermediaries such as NBFCs, Venture Capital Funds, Hire and Leasing Companies, etc. Indias financial system is quite huge and caters to every kind of demand for funds Banks are at the core of our financial system and therefore, there is greater expectation from them in terms of reaching out to the vast populace as well as being competitive.

Developments in Money Market

Prior to mid-1980s participants depended heavily on the call money market The volatile nature of the call money market led to the activation of the Treasury Bills market to reduce dependence on call money Emergence of market repo and collateralised borrowing and lending obligation (CBLO) instruments Turnover in the call money market declined from Rs. 35,144 crore in 2001-02 to Rs. 14,170 crore in 2004-05 before rising to Rs. 21,725 crore in 2006-07

Indian Banking System

Central Bank (Reserve Bank of India) Commercial banks (222) Co-operative banks Banks can be classified as:

Scheduled (Second Schedule of RBI Act, 1934) - 218 Non-Scheduled - 4 Public Sector Banks (28) Private Sector Banks (Old and New) (27) Foreign Banks (29) Regional Rural Banks (133)

Scheduled banks can be classified as:

Progress of banking in India (3)

Diversification in banking: Banking has moved from deposit and lending to

Merchant banking and underwriting Mutual funds Retail banking ATMs Internet banking Venture capital funds Factoring

Profitability of Banks(1)

Reforms have shifted the focus of banks from being development oriented to being commercially viable Prior to reforms banks were not profitable and in fact made losses for the following reasons:

Declining interest income Increasing cost of operations

Profitability of banks (2)

Declining interest income was for the following reasons:

High proportion of deposits impounded for CRR and SLR, earning relatively low interest rates System of directed lending Political interference- leading to huge NPAs

Rising costs of operations for banks was because of several reasons: economic and political

Profitability of Banks (3)

As per the Narasimham Committee (1991) the reasons for rising costs of banks were:

Uneconomic branch expansion Heavy recruitment of employees Growing indiscipline and inefficiency of staff due to trade union activities Low productivity

Declining interest income and rising cost of operations of banks led to low profitability in the 90s

Bank profitability: Suggestions

Some suggestions made by Narasimham Committee are:

Set up an Asset Reconstruction Fund to take over doubtful debts SLR to be reduced to 25% of total deposits CRR to be reduced to 3 to 5% of total deposits Banks to get more freedom to set minimum lending rates Share of priority sector credit be reduced to 10% from 40%

Suggestions (contd)

All concessional rates of interest should be removed Banks should go for new sources of funds such as Certificates of Deposits Branch expansion should be carried out strictly on commercial principles Diversification of banking activities Almost all suggestions of the Narasimham Committee have been accepted and implemented in a phased manner since the onset of Reforms

Financial Market Instruments (Contd)

Other Money Market Instruments

Certificates of deposit Repurchase agreements Overnight funds

Financial Market Instruments (Contd)

Financial Market Instruments (Contd)

Other Capital Market Instruments

Canada savings bonds Provincial and municipal bonds Government agencies securities

Internationalization of Financial Markets

International Bond Market

Foreign bonds - sold in a foreign country and denominated in that country Eurobonds denominated in a currency other than the country in which it is sold Eurocurrencies foreign currencies deposited in banks outside the home country

Organization of the financial system Financial Intermediaries Financial Markets Financial Assets/Instruments

Banks

NBFC

Mutual Funds

Insurance Money Organization Market

Capital/Securities Market

Leasing Companies Hire-Purchase/Consumer Finance Companies Housing Finance Companies Venture Capital Funds Merchant Banking Organization Credit Rating Agencies Factoring and Forfeiting Org., Stock broking firms Depositories

Primary Market

Secondary Market Indirect

Mutual Fund-units

Primary/Direct
Equity Preference Debentures

Derivatives
Forward Futures Options SWAP

Innovative debt instruments

Security Receipts

Pass Through Convertible Debentures Certificates Non- Convertible Debentures Secured Premium Notes Warrants

Factoring
Definition: Factoring is defined as a continuing legal relationship between a financial institution (the factor) and a business concern (the client), selling goods or providing services to trade customers (the customers) on open account basis whereby the Factor purchases the clients book debts (accounts receivables) either with or without recourse to the client and in relation thereto controls the credit extended to customers and administers the sales ledgers.

Explanation

It is the outright purchase of credit approved accounts receivables with the factor assuming bad debt losses. Factoring provides sales accounting service, use of finance and protection against bad debts. Factoring is a process of invoice discounting by which a capital market agency purchases all trade debts and offers resources against them.

Different kinds of factoring services

Debt administration: The factor manages the sales ledger of the client company. The client will be saved of the administrative cost of book keeping, invoicing, credit control and debt collection. The factor uses his computer system to render the sales ledger administration services.

Different kinds of factoring services

Credit Information: Factors provide credit intelligence to their client and supply periodic information with various customer-wise analysis. Credit Protection: Some factors also insure against bad debts and provide without recourse financing. Invoice Discounting or Financing : Factors advance 75% to 80% against the invoice of their clients. The clients mark a copy of the invoice to the factors as and when they raise the invoice on their customers.

Different kinds of factoring services

Basically there are three parties to the factoring services as depicted below:
Buyer Client customer

Sel ler

factor

a n c eiF rn

Services rendered by factor

Factor evaluated creditworthiness of the customer (buyer of goods) Factor fixes limits for the client (seller) which is an aggregation of the limits fixed for each of the customer (buyer). Client sells goods/services. Client assigns the debt in favour of the factor Client notifies on the invoice a direction to the customer to pay the invoice value of the factor.

Services rendered by factor

Client forwards invoice/copy to factor along with receipted delivery challans. Factor provides credit to client to the extent of 80% of the invoice value and also notifies to the customer Factor periodically follows with the customer When the customer pays the amount of the invoice the balance of 20% of the invoice value is passed to the client recovering necessary interest and other charges. If the customer does not pay, the factor takes recourse to the client.

Benefits of factoring

The client will be relieved of the work relating to sales ledger administration and debt collection The client can therefore concentrate more on planning production and sales. The charges paid to a factor which will be marginally high at 1 to 1.5% than the bank charges will be more than compensated by reductions in administrative expenditure. This will also improve the current ratio of the client and consequently his credit rating.

Benefits of factoring

The subsidiaries of the various banks have been rendering the factoring services. The factoring service is more comprehensive in nature than the book debt or receivable financing by the bankers.

Forfaiting

The forfaiting owes its origin to a French term forfait which means to forfeit (or surrender) ones rights on something to some one else. Under this mode of export finance, then exporter forfaits his rights to the future receivables and the forfaiter loses recourse to the exporter in the event of non-payment by the importer.

Methodology

It is a trade finance extended by a forfaiter to an exporter/seller for an export/sale transaction involving deferred payment terms over a long period at a firm rate of discount. Forfaiting is generally extended for export of capital goods, commodities and services where the importer insists on supplies on credit terms.

Methodology

The exporter has recourse to forfaiting usually in cases where the credit is extended for long durations but there is no prohibition for extending the facility where the credits are maturing in periods less than one year. Credits for commodities or consumer goods is generally for shorter duration within one year. Forfaiting services are extended in such cases as well.

Mechanism

1. 2. 3. 4. 5.

There are five parties in a transaction of forfaiting. These are : Exporter Exporters bank Importer Importers bank and Forfaiter

Mechanism

The exporter and importer negotiate the proposed export sale contract. These are the preliminary discussions. Based on these discussions the exporter approaches the forfaiter to ascertain the terms for forfeiting. The forfaiter collects from exporter all the relevant details of the proposed transaction, viz., details about the importer, supply and credit terms, documentation, etc., in order to ascertain the country risk and credit risk involved in the transaction..

Mechanism

Depending upon the nature and extent of these risks the forfaiter quotes the discount rate. The exporter has now to take care that the discount rate is reasonable and would be acceptable to his buyer. He will then quote a contract price to the overseas buyer by loading the discount rate, commitment fee, etc., on the sale price of the goods to be exported. If the deals go through, the exporter and forfaiter sign a contract.

Mechanism

Export takes place against documents guaranteed by the importers bank. The exporter discounts the bill with the forfaiter and the forfaiter presents the same to the importer for payment on due date or even can sell it in secondary market.

Documentation and cost

Forfaiting transaction is usually covered either by a promissory note or bill of exchange. In either case it has to be guaranteed by a bank or, bill of exchange may be avalled by the importer bank. The Aval is an endorsement made on bill of exchange or promissory note by the guaranteeing bank by writing per aval on these documents under proper authentication. The forfeiting cost for a transaction will be in the form of commitment fee, discount fee and documentation fee.

DIFFERENCE BETWEEN
FACTORING AND FORFAITING 1.Suitable for ongoing open account sales, not backed by LC or accepted bills or exchange. 2. Usually provides financing for short-term credit period of upto 180 days. 1. Oriented towards single transactions backed by LC or bank guarantee. 2. Financing is usually for medium to long-term credit periods from 180 days upto 7 years though shorterm credit of 30180 days is also available for large transactions.

DIFFERENCE BETWEEN FACTORING AND FORFAITING

3.Requires a continuous arrangements between factor and client, whereby all sales are routed through the factor. 4. Factor assumes responsibility for collection, helps client to reduce his own overheads. 3. Seller need not route or commit other business to the forfaiter. Deals are concluded transaction-wise. 4. Forfaiters responsibility extends to collection of forfeited debt only. Existing financing lines remains unaffected.

DIFFERENCE BETWEEN FACTORING AND FORFAITING

5. Separate charges are applied for financing collection administration credit protection and provision of information. 5. Single discount charges is applied which depend on guaranteeing bank and country risk, credit period involved and currency of debt. Only additional charges is commitment fee, if firm commitment is required prior to draw down during delivery period.

DIFFERENCE BETWEEN FACTORING AND FORFAITING

6. Service is available for domestic and export receivables. 7. Financing can be with or without recourse; the credit protection collection and administration services may also be provided without financing. 6. Usually available for export receivables only denominated in any freely convertible currency. 7. It is always without recourse and essentially a financing product.

DIFFERENCE BETWEEN FACTORING AND FORFAITING

8. Usually no restriction on minimum size of transactions that can be covered by factoring . 9. Factor can assist with completing import formalities in the buyers country and provide ongoing contract with buyers. 8. Transactions should be of a minimum value of USD 250,000. 9. Forfaiting will accept only clean documentation in conformity with all regulations in the exporting/importing countries

Repo Transactions

Repo stands for Repurchase Repo Transaction: Under this transaction the borrower parts with securities to the lender with an agreement to repurchase them at the end of the fixed period at a specified price

At the end of the period, the borrower will repurchase the securities at the pre-determined price Purpose of Repo Transactions: Repo transactions are conducted in the money market to manipulate short term interest rate and manage liquidity levels.

Process of Repo Transactions

The eligible securities for the purpose are decided by RBI: Government promissory notes, treasury bills and public sector bonds. When RBI announces a fixed Repo Rate, for certain number of days/period it conveys its intention to market at the desirable level of short term interest rates.

When RBI conducts Repos the short term interest rate in the money market may not go below the RBI Repo rate. Repo transactions ensure stability in short- term interest rates in the money market. In case, the RBI wants to inject fresh funds in the market, it will conduct Reverse Repo transactions with primary dealers against Government securities. Repo Instruments

Repo Rate

Reverse Repo Rate

Repo Rate

Definition: The difference between the purchase price and the original price is the cost for the borrower. This cost of borrowing is called Repo Rate. Repo rate is the rate at which our-

Commercial Bank banks borrow money from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate.

Features of Repo Rate

A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from

RBI becomes more expensive.

Transactions involving repurchase agreements (known as repos and reverses) are used to manage the quantity of reserves in the banking system on a short term basis.

Reverse Repo Rate

A transaction is called a Repo when viewed from the perspective of the seller of the securities and

Reverse Repo when described from the point of view of the suppliers of funds. Thus whether a given agreement is
termed a Repo or Reverse Repo depends largely on which party initiated the transaction.

Call, Notice and Term Money

Call money market: It is a market for very short-term funds repayable on demand and with a maturity period varying between one day to a fortnight. Call Money: When this money is borrowed or lent for a day, it is known as call (overnight) money. Notice money: When money is borrowed or lent for more than a day and up to 14 days, it is known as notice money.

Features
Note that Intervening holidays and/or Sundays are excluded for this purpose. No collateral security is required to cover these transactions. The call money market is a highly liquid market, with the liquidity being exceeded only by cash. It is highly risky and extremely volatile as well. In order to provide some flexibility in the money market, the Discount and Finance House of India (DFHI) has been allowed with effect from July 28, 1988 to participate in the call and notice money market both as a lender and as a borrower.

Credit Card

A credit card is a card or mechanism which enables cardholders to purchase goods, travel and dine in a hotel without making immediate payments. The holders can use the card to get credit from the banks upto 45 days. A credit card is named after the small plastic card issued to users. It is a card entitling its holder to buy goods and services based on the holder's promise to pay for these goods and services. The issuer of the card grants a line of credit to the consumer (or the user) from which the user can borrow money for payment to a merchant or as a cash advance to the user. With a credit card, a person can make purchases without using cash.

Who can be a credit card holder?

Two criterias The general criteria applied is a persons spending capacity and not merely his income or wealth. The other criteria is the worthiness of the client and his average monthly balance. Most of the banks have clear out norms for giving credit cards. 1. A person who earns a salary of Rs.60,000 as per annum is eligible for a card. 2. A reference from a banker and the employers of the applicant is insisted upon.

Parties to a Credit Card

There are three parties to a credit card: 1. Issuer 2. Card Holder 3. Member Establishments

Facilities Offered to Card Holders

Making availing of services at any of the member establishments. Cash withdrawals at any of the branches of the issuer/member affiliate of the issuer to meet emergent requirements. Add-on facility for family members. The spouse or children are entitled to use the card for making purchases. Free credit period ranging from 15 to 45 days. ATM facility at selected centres.

Wide range of insurance facilities are available which include personal accident insurance, cover for accidental death, purchase protection cover against risk of fire, risk, strike, theft etc. during transportation and concessional premium rates for personal accident insurance and mediclaim.

Types of Credit card:

According

to the purpose for which the credit cards are used, they can be classified into three main categories: 1. Credit Card 2. Charge Card 3. In-Store Card

1. Credit Card

It is a normal card whereby a holder is able to purchase without having to pay cash immediately. This credit card is built around Revolving credit principle. Limit is set At the end of every month, the holder has to pay a percentage of outstanding amount Those consumers who prefer personal purchase as he is able to defer payments over several months.

2. Charge Card
A charge card is intended to serve as a convenient means of payment for goods purchased at Member Establishments rather than a credit facility. Instead of paying cash or cheque everytime the credit holder makes a purchase, this facility gives a consolidated bill for a specified period, usually one month. No interest charges and no preset spending limits Charge card is useful during business trips and for entertainment expenses which are usually borne by the company .

3. In-Store Card

The in-store card are issued by retailers or companies. These cards have currency only at the issuers outlet for purchasing products of the issuer company. Payment may be on monthly or extended credit basis. Incase of extended credit policy, interest is charged. Such cards in India are issued normally by Five Star Hotels and resorts.

Discounting

A trade bill arises out of a genuine credit trade transaction. The supplier of the goods draws a bill on the purchaser for the invoice price of the goods sold on credit. The buyer of the goods accepts the same and binds himself liable to pay the amount on the due date.

Benefits of bill discounting:

It

offers high liquidity i.e. funds could be recycled promptly and quickly through rediscounting.
It

offers quick and high yield. The bankers get income in the form of discount charges at the time of discounting the bills.
There

is every opportunity to earn the spread between the rates of discount and rediscount.
Bills

drawn by business people would never be dishonored and they are not subject to any fluctuation in their values.

Factoring
The word factor has been derived from the Latin word Facere which means to make or to do. In other words to get things done. According to Webster dictionary factor is an agent, as a banking or insurance company, engaged in financing the operations of certain companies or in financing wholesale or retail trade sale, through the purchase of account receivable

Thus, factoring is a method of financing whereby a company sells its trade debt at a discount to a financial institution. In other words, factoring is a continuous arrangements between a financial institution (namely factor) and a company (namely client) which sells goods and services to trade customers on credit. As per this arrangement factor purchases trade debts and the clients is paid immediately 80% of the trade debt and when customers repay their dues, the factor will make remaining 20% payment. Thus, a factor is an agent who collects the dues of his clients for a certain fee.

Functions
Purchase

and collection of debts. Sales ledger management. Credit investigation and undertaking of credit risk. Provision of finance against debts, Rendering consultancy services

Benefits

Financial services Collection services Credit risk services Provision of expertise sales ledger management service Consultancy services Off-balance sheet financing Trade benefits

Types of factoring

Full service factoring or without recourse factoring With recourse factoring Maturity factoring Bulk factoring Invoice factoring Agency factoring International factoring