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Foundation Course in Banking and Capital Markets Version - 2009
Foundation Course in Banking and Capital Markets Version - 2009
Markets
VERSION: 1.1
DATE: 26-MAY-2009
Cognizant Technology Solutions
500 Glenpointe Centre West
Teaneck, NJ 07666
Ph: 201-801-0233
www.cognizant.com
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Cognizant Confidential Foundation Course in Banking and Capital Markets
CONTENTS
1.0 BFS CONCEPTS .............................................................................................................................4
1.1 CONCEPT OF MONEY ........................................................................................................................... 4
1.2 FINANCIAL INSTRUMENTS........................................................................................................... 10
1.3 FINANCIAL MARKETS ................................................................................................................... 19
1.4 FINANCIAL STATEMENTS .................................................................................................................... 26
2.0 BANKING ................................................................................................................................... 39
2.1 INTRODUCTION TO BANKING...................................................................................................... 40
3.0 RETAIL BANKING........................................................................................................................ 47
3.1 INTRODUCTION................................................................................................................................ 47
3.2 DEPOSIT PRODUCTS....................................................................................................................... 49
3.3 RETAIL CHANNELS ............................................................................................................................ 51
3.4 INSTRUMENTS ............................................................................................................................. 56
3.5 RETAIL PAYMENTS ............................................................................................................................ 57
3.6 ELECTRONIC BANKING................................................................................................................. 58
3.7 SALES AND MARKETING..................................................................................................................... 60
3.8 A SCHEMATIC OF A RETAIL BANK ......................................................................................................... 61
4.0 MORTGAGES AND CONSUMER LENDING................................................................................... 63
4.1 MORTGAGE..................................................................................................................................... 63
4.2 OTHER RETAIL LOANS........................................................................................................................ 70
4.3 COMMUNITY BANKS, CREDIT UNIONS & BUILDING SOCIETIES................................................................... 78
4.4 FARM CREDIT................................................................................................................................... 80
4.5 RETAIL LENDING CYCLE ...................................................................................................................... 81
5.0 CARDS AND PAYMENTS ............................................................................................................. 85
5.1 INTRODUCTION................................................................................................................................ 85
5.2 CREDIT CARD MARKET OVERVIEW....................................................................................................... 90
5.3 MAJOR PLAYERS .............................................................................................................................. 97
5.4 RECENT DEVELOPMENTS.................................................................................................................... 97
6.0 WHOLESALE BANKING AND COMMERCIAL LENDING............................................................... 102
6.1 INTRODUCTION......................................................................................................................... 102
6.2 CORPORATE LENDING PROCESS ................................................................................................ 102
6.3 CREDIT DERIVATIVES ................................................................................................................. 109
6.4 TREASURY SERVICES .................................................................................................................. 111
6.5 CASH MANAGEMENT ................................................................................................................ 120
6.6 TRADE FINANCE......................................................................................................................... 128
6.6 PAYMENTS NETWORK...................................................................................................................... 139
7.0 INVESTMENT MANAGEMENT .................................................................................................. 143
7.1 INTRODUCTION.............................................................................................................................. 143
7.2 INVESTMENT MANAGEMENT PROCESSES.............................................................................................. 144
7.3 DIFFERENT CLASSES OF INVESTMENT MANAGEMENT FIRMS .................................................................... 157
8.0 INVESTMENT BANKING AND BROKERAGE............................................................................... 176
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Cognizant Confidential Foundation Course in Banking and Capital Markets
8.1 DEFINITION OF INVESTMENT BANKS......................................................................................... 176
8.2 FUNCTION OF INVESTMENT BANKS:.......................................................................................... 176
8.3 MAJOR INVESTMENT BANKS: .................................................................................................... 177
8.4 DIVISIONS WITHIN AN INVESTMENT BANK................................................................................ 177
8.5 INVESTMENT BANKING POST ECONOMIC CRISIS:...................................................................... 179
8.6 BROKERAGE............................................................................................................................... 179
8.7 UNDERWRITING ........................................................................................................................ 181
8.9 THE FLOOR OF THE EXCHANGE.................................................................................................. 184
8.10 ORDER TYPES ................................................................................................................................. 186
8.11 THE OVER-THE-COUNTER (OTC) MARKET.................................................................................. 187
8.12 HOW DOES A BROKERAGE FIRM LOOK LIKE?............................................................................. 188
8.13 MARKET INDICES ....................................................................................................................... 192
9.0 CUSTODY AND CLEARING......................................................................................................... 194
9.1 INTRODUCTION......................................................................................................................... 194
9.2 SECURITIES MARKETPLACE ............................................................................................................... 195
9.3 TRADING AND SETTLEMENT...................................................................................................... 198
9.4 ASSET SERVICING....................................................................................................................... 210
10.0 CLEARING AND SETTLEMENT ................................................................................................... 214
10.1 TRADING ...................................................................................................................................... 214
10.2 CLEARING ..................................................................................................................................... 216
10.3 SETTLEMENT.................................................................................................................................. 218
11.0 RISK MANAGEMENT ................................................................................................................ 224
11.1 CONCEPT OF RISK ........................................................................................................................... 224
11.2 TYPES OF RISK................................................................................................................................ 224
11.3 RISK MANAGEMENT ....................................................................................................................... 228
12.0 CORPORATE SERVICES ............................................................................................................. 240
12.1 BENEFITS ADMINISTRATION........................................................................................................... 240
13.0 RECENT DEVELOPMENTS ......................................................................................................... 246
13.1 USA PATRIOT ACT ...................................................................................................................... 246
13.2 SARBANES OXLEY ACT................................................................................................................ 250
13.3 SUB-PRIME MORTGAGE CRISIS ......................................................................................................... 251
14.0 GLOSSARY................................................................................................................................ 256
15.0 REFERENCES............................................................................................................................. 262
15.1 WEBSITES................................................................................................................................... 262
15.2 BOOKS ....................................................................................................................................... 262
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Cognizant Confidential Foundation Course in Banking and Capital Markets
1. 0 BFS CONCEPTS
1. 1 CONCEPT OF MONEY
1.1.1 DEFINING MONEY
Money is a standardized unit of exchange. The practical form of money is currency. It varies
across countries whereas money remains the same. For example, in India, the currency is the
Indian Rupee (INR) and in the US, it is the US Dollar (USD).
Due to various economic factors, the value of each countrys currency is not equal. For example,
if the exchange rate between US Dollars (USD) and Indian Rupees (INR) is USD 1 = INR 46.70, it
implies that one U.S dollar is equivalent to 46.70 Indian Rupees. The USD is normally taken as a
benchmark against which to compare the value of each currency.
1.1.2 THE CONCEPT OF INTEREST: SIMPLE INTEREST AND COMPOUND
INTEREST
Interest is the amount earned on money; there is such an earning because present consumption
of the lender is being sacrificed for the future; it is letting somebody else use the money for
present consumption. Using an analogy, interest is the rent charged for delaying present
consumption of money. Interest rates are not constant and will vary depending on different
economic factors
A. Simple interest
Simple interest is calculated only on the beginning principal. Simple Interest = P*r*t/100 where:
P is the Principal or the initial amount borrowed or deposited, to earn or charge interest on, r is
the interest rate and t is the time period.
Example
If someone were to receive 5% interest on a beginning value of $100, the first year they would
get:
0.05*$100 = $5
If they continued to receive 5% interest on the original $100 amount, over five years the growth
in their investment would look like this:
Year 1: (5% of $100 = $5) + $100 = $105
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Year 2: (5% of $100 = $5) + $105 = $110
Year 3: (5% of $100 = $5) + $110 = $115
Year 4: (5% of $100 = $5) + $115 = $120
Year 5: (5% of $100 = $5) + $120 = $125
B. Compound interest
With compound interest, interest is calculated not only on the beginning interest, but on any
interest accumulated with the initial principal in the meantime. Compound interest =
[P*(1+r/100)^t P], where: P is the Principal or the initial amount initially borrowed or
deposited, to earn or charge interest on, r is the interest rate and t is the time period.
Example
If someone were to receive 5% compound interest on a beginning value of $100, the first year
they would get the same thing as if they were receiving simple interest on the $100, or $5. The
second year, though, their interest would be calculated on the beginning amount in year 2,
which would be $105. So their interest would be:
.05 x $105 = $5.25
If this were to continue for 5 years, the growth in the investment would look like this:
Year 1: (5% of $100.00 = $5.00) + $100.00 = $105.00
Year 2: (5% of $105.00 = $5.25) + $105.00 = $110.25
Year 3: (5% of $110.25 = $5.51) + $110.25 = $115.76
Year 4: (5% of $115.76 = $5.79) + $115.76 = $121.55
Year 5: (5% of $121.55 = $6.08) + $121.55 = $127.63
Note that in comparing growth graphs of simple and compound interest, investments with
simple interest grow in a linear fashion and compound interest results in geometric growth. So
with compound interest, the further in time and investment is held the more dramatic the
growth becomes.
1.1.3 INFLATION
Inflation captures the rise in the cost of goods and services over a period of time. For example, if
Rs.100 today can buy 5 kg of groceries, the same amount of money can only buy 5/ (1+I) kgs of
groceries next year, where `I refers to the rate of inflation beyond today.
Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand & supply
and other market conditions hold), next year, one can only buy 5/ (1.05) worth of groceries.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
A quantitative estimate of inflation in a particular economy can be calculated by measuring the
ratio of Consumer Price Indices or CPI of two consecutive years. Thats right, the CPI that one
hear of, is the weighted average price, of a predefined basket of basic goods. The % increase of
the CPI this year vs. the CPI of last year, gives the inflation, or rise in price of consumer goods,
over last year.
Inflation results in a decrease in the value of money over time. The link between the interest
rates, nominal and real, and inflation enables one to identify this impact.
1.1.4 NOMINAL INTEREST
Nominal rate of interest (N) refers to the stated interest rate in the economy. For example, if
counter-party demands 110 rupees after a year in return for 100 rupees lent today, the nominal
rate of interest is 10%. This, as one see, includes the inflation rate.
Example A person lent out 100 rupees, at 10%, for one year. On maturity, he gets a profit, so
he thinks, of 10 rupees. But this sum of 110 rupees buys less than 110 rupees did a year ago, due
to inflation! Thus, the value of 110 rupees today is actually, or really, less than the value of 110
rupees a year ago, and it is less by the inflation rate. Thus the real interest he earned is less than
10%.
1.1.4 REAL RATE OF INTEREST
Real rate of interest (R) refers to the inflation-adjusted rate of interest. It is less than the
nominal rate of interest for economies having positive rate of inflation.
The relationship between the R (real rate of interest), N (nominal rate of interest) and I (rate of
inflation) is as:
R= N-I
(This is a widely used approximation; the exact formula takes into account time value of inflation
etc.)
Why is it important to know the real rate of return? Take an example where a business is
earning a net profit of 7% per annum. But, inflation is also standing at 7%. So, real profit is
actually at zero.
Example
Nominal rate (N) = 10%, Inflation (I) = 5%
Therefore, real interest is: R = N I = 5%
Therefore, the real rate of return is not 10% but 5%.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
1.1.5 TIME VALUE CONCEPT OF MONEY
Time value of money, which serves as the foundation for many concepts in finance, arises from
the concept of interest. Because of interest, money on hand now is worth more than the same
money available at a later point of time. To understand time value of money and related
concepts like Present value and future value, we need to understand the basic concepts of
simple and compound interest described above.
Future Value
Future Value is the value that a sum of money invested at compound interest will have after a
specified period.
The formula for Future Value is:
FV = PV*(1 + i)
n
Where:
FV
: Future Value at the end of n time periods
PV
: Beginning value OR Present Value
i : Interest rate per unit time period
n : Number of time periods
Example If one were to receive 5% per annum compounded interest on $100 for five
years,
FV = $100*(1.05)
5
= $127.63
Intra-Year Compounding
If a cash flow is compounded more frequently than annually, then intra-year compounding is
being used. To adjust for intra-year compounding, an interest rate per compounding period
must be found as well as the total number of compounding periods.
The interest rate per compounding period is found by taking the annual rate and dividing it by
the number of times per year the cash flows are compounded. The total number of
compounding periods is found by multiplying the number of years by the number of times per
year cash flows are compounded.
Example Suppose someone were to invest $10,000 at 8% interest, compounded
semiannually, and hold it for five years,
Interest rate for compounding period = 8%/2 = 4%
Number of compounding periods = 5*2 = 10
Thus, the future value FV = 10,000*(1+0.04) ^
10
= $14,802.44
Present value
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Present Value is the current value of a future cash flow or of a series of future cash flows. It is
computed by the process of discounting the future cash flows at a predetermined rate of
interest.
If $10,000 were to be received in a year, the present value of the amount would not be $10,000
because we do not have it in our hand now, in the present. To find the present value of the
future $10,000, we need to find out how much we would have to invest today in order to
receive that $10,000 in the future. To calculate present value, or the amount that we would
have to invest today, we must subtract the (hypothetical) accumulated interest from the
$10,000. To achieve this, we can discount the future amount ($10,000) by the interest rate for
the period. The future value equation given above can be rearranged to give the Present Value
equation:
PV = FV / (1+I) ^
n
In the above example, if interest rate is 5%, the present value of the $10,000 which we will
receive after one year, would be:
PV = 10,000/(1+0.05) = $ 9,523.81
Net Present Value (NPV)
Net Present Value (NPV) is a concept often used to evaluate projects/investments using the
Discounted Cash Flow (DCF) method. The DCF method simply uses the time value concept and
discounts future cash flows by the applicable interest rate factor to arrive at the present value of
the cash flows. NPV for a project is calculated by estimating net future cash flows from the
project, discounting these cash flows at an appropriate discount rate to arrive at the present
value of future cash flows, and then subtracting the initial outlay on the project.
NPV of a project/investment = Discounted value of net cash inflows Initial cost/investment.
The project/investment is viable if NPV is positive while it is not viable if NPV is negative.
Example An investor has an opportunity to purchase a piece of property for $50,000 at the
beginning of the year. The after-tax net cash flows at the end of each year are forecast as
follows:
Year Cash Flow
1 $9,000
2 8,500
3 8,000
4 8,000
5 8,000
6 8,000
7 8,000
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Cognizant Confidential Foundation Course in Banking and Capital Markets
8 7,000
9 4,500
10 51,000 (property sold at the end of the 10th year)
Assume that the required rate of return for similar investments is 15.00%.
NPV = - 50000 + 9000/ (1+0.15) ^
1
+ 8500/ (1+0.15) ^
2
+ .. +51000/ (1+0.15) ^
10
= $612.96
However, if we assume that the required rate of return is 16.00%,
NPV = - 50000 + 9000/ (1+0.16) ^
1
+ 8500/ (1+0.16) ^
2
+ .. +51000/ (1+0.16) ^
10
= ($1360.77)
Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a project:
Increases with increase in future cash inflows for a given initial outlay
Decreases with increase in initial outlay for a given set of future cash inflows
Decreases with increase in required rate of return
Internal Rate of Return (IRR)
Internal Rate of Return (IRR), also referred to as Yield is often used in capital budgeting. It is the
implied interest rate that makes net present value of all cash flows equal zero.
In the previous example, the IRR is that value of required rate of return that makes the NPV
equals zero.
IRR = r, where
NPV = - 50000 + 9000/(1+r)^
1
+ 8500/(1+r)^
2
+ .. +51000/ (1+r) ^
10
= $0.00
IRR can be calculated using trial and error methods by using various values for r or using the IRR
formula directly in MS Excel. Here, IRR = 15.30%. In other terms, IRR is the rate of return at
which the project/investment becomes viable.
1.1.6 COST OF CAPITAL
We have seen how different entities such as individuals, corporations and governments raise
money. We have also realized that there is a cost for raising money, known as cost of capital.
Costs will vary depending on the type of the financing such as equity or debt, who the borrower
is (their past record and repayment capacity), and finally the market timing of the borrowings. In
case of debt, additionally, the amount of collateral provided and how long the capital is required
is also considered.
The cost of capital includes interest payable in case of debt and expected returns including
dividends in case of equity, apart from the cost of raising such as investment banks fees,
regulatory fees and advertising. The tax factor is also considered while computing cost of capital
for debt capital since interest paid is a tax deductive expense. Computing cost for different
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Cognizant Confidential Foundation Course in Banking and Capital Markets
means of finance such as equity shares, preference shares, debentures or term loan is beyond
the purview of this learning program.
Since there is a limit to the amount of resources that corporations can raise from any source,
they use more than a single source for financing their needs. Also, funds will be raised at
different points in time depending on need, availability, and market timing etc. In such cases
after computing cost of each source, the firm arrives at a weighted average cost of capital,
commonly referred to as cost of capital. Let us take an example:
The Good works Company Inc. has Rs. 300 million through different means. The firm has raised
Rs. 107 mn through equity, Rs. 13 mn through preference capital, Rs. 80 mn by issuing
debentures and Rs. 100 mn by taking a loan a financial institution.
Source of finance Cost (per cent) Weight Product of cost and weight
Equity capital 16.64 107/300 5.93
Preference capital 15.73 13/300 0.68
Debenture capital 11.08 80/300 2.95
Term loan 10.25 100/300 3.42
Average cost of capital 12.99 per cent
Looked at it with a different perspective, the cost of capital is the rate of return the firm must
earn on its investments in order to satisfy the expectations of investors who provide long-term
funds to it. It is an important concept for financing decisions.
1. 2 FINANCIAL INSTRUMENTS
1.2.1 RAISING CAPITAL
Corporations need capital to finance business operations. They raise money by issuing Securities
in the form of Equity and Debt. Equity represents ownership of the company and takes the form
of stock. Debt is funded by issuing Bonds, Debentures and various certificates. The use of debt is
also referred to as Leverage Financing. The ratio of debt/equity shows a potential investor the
extent of a companys leverage.
Investors choose between debt and equity securities based on their investment objectives.
Income is the main objective for a debt investor. This income is paid in the form of Interest,
usually as semi-annual payments. Capital Appreciation (the increase in the value of a security
over time) is only a secondary consideration for debt investors. Conversely, equity investors are
primarily seeking Growth, or capital appreciation. Income is usually of lesser importance, and is
received in the form of Dividends.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on stock. It
also means that if the company ceases to do business and liquidate its assets, that the debt
holders have a senior claim to those assets.
1.2.2 SECURITY
Security is a financial instrument that signifies ownership in a company (a stock), a creditor
relationship with a corporation or government agency (a bond), or rights to ownership (an
option). Financial instruments can be classified into:
Debt
Equity
Hybrids
Derivatives
DEBT
Debt is money owed by one person or firm to another. Bonds, loans, and commercial paper are
all examples of debt.
BOND
An investor loans money to an entity (company or government) that needs funds for a specified
period of time at a specified interest rate. In exchange for the money, the entity will issue a
certificate, or bond, that states the interest rate (coupon rate) to be paid and repayment date
(maturity date). Interest on bonds is usually paid every six months (semiannually).
Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal Only and
Fully Registered Bonds.
Bearer bonds are like cash since the bearer of the bond is presumed to be the owner. These
bonds are Unregistered because the owners name does not appear on the bond, and there is
no record of who is entitled to receive the interest payments. Attached to the bond are
Coupons. The bearer clips the coupons every six months and presents these coupons to the
paying agent to receive their interest. Then, at the bonds Maturity, the bearer presents the
bond with the last coupon attached to the paying agent, and receives their principal and last
interest payment.
Bonds that are registered as to principal only have the owners name on the bond certificate,
but since the interest is not registered these bonds still have coupons attached.
Bonds that are issued today are most likely to be issued fully registered as to both interest and
principal. The transfer agent now sends interest payments to owners of record on the interest
Payable Date. Book Entry bonds are still fully registered, but there is no physical certificate and
the transfer agent keeps track of ownership. U.S. Government Negotiable securities (i.e.,
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Treasury Bills, Notes and Bonds) are issued book entry, with no certificate. The customers
Confirmation serves as proof of ownership.
Principal and Interest
Bondholders are primarily seeking income in the form of a semi-annual coupon payment. The
annual rate of return (also called Coupon, Fixed, Stated or Nominal Yield) is noted on the bond
certificate and is fixed. The factors that influence the bond's initial coupon rate are prevailing
economic conditions (e.g., market interest rates) and the issuer's credit rating (the higher the
credit rating, the lower the coupon). Bonds that are In Default are not paying interest.
The principal or par or Face amount of the bond is what the investor has loaned to the issuer.
The relative "safety" of the principal depends on the issuers credit rating and the type of bond
that was issued.
CORPORATE BOND
A bond issued by a corporation. Corporations generally issue three types of bonds: Secured
Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures.
All corporate bonds are backed by the full faith and credit of the issuer, but a secured bond is
further backed by specific assets that act as collateral for the bond.
In contrast, unsecured bonds are backed by the general assets of the corporation only. There
are three basic types of Secured Bonds:
Mortgage Bonds are secured by real estate owned by the issuer
Equipment Trust Certificates are secured by equipment owned and used in the issuers business
Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (Usually U.S.
Government securities)
Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor status; they
are the first to be paid principal or interest and are thus the safest of an issuers securities.
Unsecured Bonds include debentures and subordinated debentures. Debentures have a general
creditor status and will be paid only after all secured creditors have been satisfied. Subordinated
debentures have a subordinate creditor status and will be paid after all senior and general
creditors have first been satisfied.
Example
IBM can issue 10 year bonds with a coupon of 5.5%.
Priceline can issue similar 10 year bonds at 8%
The difference in coupon is due to their credit rating!
Case Study
Enron set up power plant at Dabhol, India
The cost of the project (Phase 1) was USD 920 Million
Funding
o Equity USD 285 mio
o Bank of America/ABN Amro USD 150 mio
o IDBI & Indian Banks USD 95 mio
o US Govt OPIC USD 100 mio
o US Exim Bank USD 290 mio
Enron US declared bankruptcy in 2002
Enron Indias assets are mortgaged to various banks as above.
Due to interest payments and depreciation, assets are worth considerably less
than USD 920 mio.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
2.1.3 MUNICIPAL BOND (MUNIS)
A bond issued by a municipality. These are generally tax free, but the interest rate is usually
lower than a taxable bond.
TREASURY SECURITIES
Treasury bills, notes, and bonds are marketable securities the U.S. government sells in order to
pay off maturing debt and raise the cash needed to run the federal government. When an
investor buys one of these securities, he/she is lending money to the U.S. government.
Treasury bills are short-term obligations issued for one year or less. They are sold at a discount
from face value and don't pay interest before maturity. The interest is the difference between
the purchase price of the bill and the amount that is paid to the investor at maturity (face value)
or at the time of sale prior to maturity.
Treasury notes and bonds bear a stated interest rate, and the owner receives semi-annual
interest payments. Treasury notes have a term of more than one year, but not more than 10
years.
Treasury bonds are issued by the U.S. Government. These are considered safe investments
because they are backed by the taxing authority of the U.S. government, and the interest on
Treasury bonds is not subject to state income tax. T-bonds have maturities greater than ten
years, while notes and bills have lower maturities. Individually, they sometimes are called "T-
bills," "T-notes," and "T-bonds." They can be bought and sold in the secondary market at
prevailing market prices.
Savings Bonds are bonds issued by the Department of the Treasury, but they aren't are not
marketable and the owner of a Savings Bond cannot transfer his security to someone else.
ZERO COUPON BONDS
Zeros generate no periodic interest payments but they are issued at a discount from face value.
The return is realized at maturity. Zeros sell at deep discounts from face value. The difference
between the purchase price of the zero and its face value when redeemed is the investor's
return. Zeros can be purchased from private brokers and dealers, but not from the Federal
Reserve or any government agency.
The higher rate of return the bond offers, the more risky the investment. There have been
instances of companies failing to pay back the bond (default), so, to entice investors, most
corporate bonds will offer a higher return than a government bond. It is important for investors
to research a bond just as they would a stock or mutual fund. The bond rating will help in
deciphering the default risk.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
COMMERCIAL PAPER
An unsecured, short-term loan issued by a corporation, typically for financing accounts
receivable and inventories. It is usually issued at a discount to face value, reflecting prevailing
market interest rates. It is issued in the form of promissory notes, and sold by financial
organizations as an alternative to borrowing from banks or other institutions. The paper is
usually sold to other companies which invest in short-term money market instruments.
Since commercial paper maturities don't exceed nine months and proceeds typically are used
only for current transactions, the notes are exempt from registration as securities with the
United States Securities and Exchange Commission. Financial companies account for nearly 75
percent of the commercial paper outstanding in the market.
There are two methods of marketing commercial paper. The issuer can sell the paper directly to
the buyer or sell the paper to a dealer firm, which re-sells the paper in the market. The dealer
market for commercial paper involves large securities firms and subsidiaries of bank holding
companies. Direct issuers of commercial paper usually are financial companies which have
frequent and sizable borrowing needs, and find it more economical to place paper without the
use of an intermediary. On average, direct issuers save a dealer fee of 1/8 of a percentage point.
This savings compensates for the cost of maintaining a permanent sales staff to market the
paper.
Interest rates on commercial paper often are lower than bank lending rates, and the differential,
when large enough, provides an advantage which makes issuing commercial paper an attractive
alternative to bank credit.
Commercial paper maturities range from 1 day to 270 days, but most commonly is issued for
less than 30 days. Paper usually is issued in denominations of $100,000 or more, although some
companies issue smaller denominations. Credit rating agencies like Standard & Poor rate the
CPs. Ratings are reviewed frequently and are determined by the issuer's financial condition,
bank lines of credit and timeliness of repayment. Unrated or lower rated paper also is sold in the
market.
Investors in the commercial paper market include private pension funds, money market mutual
funds, governmental units, bank trust departments, foreign banks and investment companies.
There is limited secondary market activity in commercial paper, since issuers can closely match
the maturity of the paper to the investors' needs. If the investor needs ready cash, the dealer or
issuer usually will buy back the paper prior to maturity.
EQUITY
Equity (Stock) is a security, representing an ownership interest. Equity refers to the value of the
funds contributed by the owners (the stockholders) plus the retained earnings (or losses).
COMMON STOCK
Common stock represents an ownership interest in a company. Owners of stock also have
Limited Liability (i.e.) the maximum a shareholder can lose is their original investment. Most of
the stock traded in the markets today is common. An individual with a majority shareholding or
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Cognizant Confidential Foundation Course in Banking and Capital Markets
controlling interest controls a company's decisions and can appoint anyone he/she wishes to the
board of directors or to the management team.
Corporations seeking capital sell it to investors through a Primary Offering or an Initial Public
Offering (IPO). Before shares can be offered, or sold to the general public, they must first be
registered with the Securities and Exchange Commission (SEC). Once the shares have been sold
to investors, the shareholders are usually free to sell or trade their stock shares in the Secondary
Markets (such as the New York Stock Exchange NYSE). From time to time, the Issuer may
choose to repurchase the stock they previously issued. Such repurchased stock shares are
referred to as Treasury Stock, and the shares that remain trading in the secondary market are
referred to as Shares Outstanding. Treasury Stock does not have voting rights and is not entitled
to any declared dividends. Corporations may use Treasury Stock to pay a stock dividend, to offer
to employees.
STOCK TERMINOLOGY
Public Offering Price (POP) The price at which shares are offered to the public in a Primary
Offering. This price is fixed and must be maintained when Underwriters sell to customers.
Current Market Price The price determined by Supply and Demand in the Secondary Markets.
Book Value The theoretical liquidation value of a stock based on the company's Balance Sheet.
Par Value An arbitrary price used to account for the shares in the firms balance sheet. This
value is meaningless for common shareholders, but is important to owners of Preferred Stock.
PREFERRED STOCK
Preference shares carry a stated dividend and they do not usually have voting rights. Preferred
shareholders have priority over common stockholders on earnings and assets in the event of
liquidation. Preferred stock is issued with a fixed rate of return that is either a percent of par
(always assumed to be $100) or a dollar amount.
Although preferred stock is equity and represents ownership, preferred stock investors are
primarily seeking income. The market price of income seeking securities (such as preferred stock
and debt securities) fluctuates as market interest rates change. Price and yield are inversely
related.
There are several different types of preferred stock including Straight, Cumulative, Convertible,
Callable, Participating and Variable. With straight preferred, the preference is for the current
years dividend only. Cumulative preferred is senior to straight preferred and has a first
preference for any dividends missed in previous periods.
Example When Cognizant Technology Solutions came out with its Initial Public
Offering on NASDAQ in June 1998, the Public Offering Price (POP) was set at $10 per
share. The stock was split twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003.
As of Dec 6, 2003, the Current Market Price stood at $46.26. However, if the stock-splits
are taken into consideration the actual market price would stand at 6 times the Current
Market Price at whopping $253.56!!
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Convertible preferred stock can be converted into shares of common stock either at a fixed
price or a fixed number of shares. It is essentially a mix of debt and equity, and most often used
as a means for a risky company to obtain capital when neither debt nor equity works. It offers
considerable opportunity for capital appreciation.
Non-convertible preferred stock remains outstanding in perpetuity and trades like stocks.
Utilities represent the best example of nonconvertible preferred stock issuers.
AMERICAN DEPOSITORY RECEIPTS (ADR)
The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is a receipt
for a specified number of foreign shares owned by an American bank. ADRs trade like shares,
either on a U.S. Exchange or Over the Counter. The owner of an ADR has voting rights and also
has the right to receive any declared dividends. An example would be Infosys ADRs that are
traded in NASDAQ.
HYBRIDS
Hybrids are securities, which combine the characteristics of equity and debt.
CONVERTIBLE BONDS
Convertible Bonds are instruments that can be converted into a specified number of shares of
stock after a specified number of days. However, till the time of conversion the bonds continue
to pay coupons.
WARRANTS
Warrants are call options variants of equity. They are usually offered as bonus or sweetener,
attached to another security and sold as a Unit. For example, a company is planning to issue
bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so
they sweeten the bonds by adding warrants that give the holder the right to buy the issuers
stock at a given price over a given period of time. Warrants can be traded, exercised, or expire
worthless.
Case Study
Tata Motors Ltd. (previously known as TELCO) recently issued convertible bond
aggregating to $100 million in the Luxemburg Stock Exchange. The effective interest rate
paid on the issue was just 4% which was much lower than what it would have to pay if it
raised the money in India, where it is based out of. The company would use this money
to pay-back existing loans borrowed at much higher interest rates.
Why doesnt every company raise money abroad if it has to pay lower interest rates?
Will there is
Will there be any effect on existing Tata Motors share-holders due to the convertible
issue? If Yes, when will this be?
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DERIVATIVES
A derivative is a product whose value is derived from the value of an underlying asset, index or
reference rate. The underlying asset can be equity, foreign exchange, commodity or any other
item. For example, if the settlement price of a derivative is based on the stock price, which
changes on a daily basis, then the derivative risks are also changing on a daily basis. Hence
derivative risks and positions must be monitored constantly.
FORWARD CONTRACT
A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a certain
future time for a certain price. No cash is exchanged when the contract is entered into.
FUTURES CONTRACT
A futures contract is an agreement between two parties to buy or sell an asset at a certain time
in the future at a certain price. Index futures are all futures contracts where the underlying is
the stock index and helps a trader to take a view on the market as a whole.
HEDGING
Hedging involves protecting an existing asset position from future adverse price movements. In
order to hedge a position, a market player needs to take an equal and opposite position in the
futures market to the one held in the cash market.
ARBITRAGE
Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he can
earn risk less profits. When markets are imperfect, buying in one market and simultaneously
selling in other market gives risk less profit. Arbitrageurs are always in the lookout for such
imperfections.
OPTIONS
An option is a contract, which gives the buyer the right, but not the obligation to buy or sell
shares of the underlying security at a specific price on or before a specific date. There are two
kinds of options: Call Options and Put Options.
Call Options are options to buy a stock at a specific price on or before a certain date. Call
options usually increase in value as the value of the underlying instrument rises. The price paid,
called the option premium, secures the investor the right to buy that certain stock at a specified
price. (Strike price) If he/she decides not to use the option to buy the stock, the only cost is the
option premium. For call options, the option is said to be in-the-money if the share price is
above the strike price.
Example The Infosys stock price as of Dec 6
th
, 2003 stood at Rs.5062. The cost of the
Dec 24
th
, 2003 expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was
Rs.90. This would mean that to break-even the person buying the Call Option on the
Infosys stock, the stock price would have to cross Rs.5290 as of Dec 24
th
, 2003!!
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Put Options are options to sell a stock at a specific price on or before a certain date. With a Put
Option, the investor can "insure" a stock by fixing a selling price. If stock prices fall, the investor
can exercise the option and sell it at its "insured" price level. If stock prices go up, there is no
need to use the insurance, and the only cost is the premium. A put option is in-the-money when
the share price is below the strike price. The amount by which an option is in-the-money is
referred to as intrinsic value.
The primary function of listed options is to allow investors ways to manage risk. Their price is
determined by factors like the underlying stock price, strike price, time remaining until
expiration (time value), and volatility. Because of all these factors, determining the premium of
an option is complicated.
Types of Options
There are two main types of options:
American options can be exercised at any time between the date of purchase and the
expiration date. Most exchange-traded options are of this type.
European options can only be exercised at the end of their life.
Long-Term Options are options with holding period of one or more years, and they are called
LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to control and
manage risk or even speculate, they are virtually identical to regular options. LEAPS, however,
provide these opportunities for much longer periods of time. LEAPS are available on most
widely-held issues.
Exotic Options: The simple calls and puts are referred to as "plain vanilla" options. Non-standard
options are called exotic options, which either are variations on the payoff profiles of the plain
vanilla options or are wholly different products with "optionality" embedded in them.
Open Interest is the number of options contracts that are open; these are contracts that have
not expired nor been exercised.
SWAPS
Swaps are the exchange of cash flows or one security for another to change the maturity
(bonds) or quality of issues (stocks or bonds), or because investment objectives have changed.
For example, one firm may have a lower fixed interest rate, while another has access to a lower
floating interest rate. These firms could swap to take advantage of the lower rates.
Currency Swap involves the exchange of principal and interest in one currency for the same in
another currency.
Forward Swap agreements are created through the synthesis of two different swaps, differing in
duration, for the purpose of fulfilling the specific timeframe needs of an investor. Sometimes
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Cognizant Confidential Foundation Course in Banking and Capital Markets
swaps don't perfectly match the needs of investors wishing to hedge certain risks. For example,
if an investor wants to hedge for a five-year duration beginning one year from today, they can
enter into both a one-year and six-year swap, creating the forward swap that meets the
requirements for their portfolio.
Swaptions - An option to enter into an interest rate swap. The contract gives the buyer the
option to execute an interest rate swap on a future date, thereby locking in financing costs at a
specified fixed rate of interest. The seller of the swaption, usually a commercial or investment
bank, assumes the risk of interest rate changes, in exchange for payment of a swap premium.
Case Study
The World Bank borrows funds internationally and loans those funds to developing countries. It
charges its borrowers a cost plus rate and hence needs to borrow at the lowest cost.
In 1981 the US interest rate was at 17 percent, an extremely high rate due to the anti-inflation
tight monetary policy of the Fed. In West Germany the corresponding rate was 12 percent and
Switzerland 8 percent.
IBM enjoyed a very good reputation in Switzerland, perceived as one of the best managed US
companies. In contrast, the World Bank suffered from bad image since it had used several times
the Swiss market to finance risky third world countries. Hence, World Bank had to pay an extra
20 basis points (0.2%) compared to IBM
In addition, the problem for the World Bank was that the Swiss government imposed a limit on
the amount World Bank could borrow in Switzerland. The World Bank had borrowed its allowed
limit in Switzerland and West Germany
At the same time, the World Bank, with an AAA rating, was a well established name in the US
and could get a lower financing rate (compared to IBM) in the US Dollar bond market because of
the backing of the US, German, Japanese and other governments. It would have to pay the
Treasury rate + 40 basis points.
IBM had large amounts of Swiss franc and German deutsche mark debt and thus had debt
payments to pay in Swiss francs and deutsche marks.
World Bank borrowed dollars in the U.S. market and swapped the dollar repayment obligation
with IBM in exchange for taking over IBM's SFR and DEM loans.
It became very advantageous for IBM and the World Bank to borrow in the market in which
their comparative advantage was the greatest and swap their respective fixed-rate funding.
1. 3 FINANCIAL MARKETS
1.3.1 WHAT ARE FINANCIAL MARKETS?
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Cognizant Confidential Foundation Course in Banking and Capital Markets
A financial transaction is one where a financial asset or instrument, such as cash, check, stock,
bond, etc are bought and sold. Financial Market is a place where the buyers and sellers for the
financial instruments come together and financial transactions take place.
1.3.2 TYPES OF FINANCIAL MARKETS
PRIMARY MARKETS
Primary market is one where new financial instruments are issued for the first time. They
provide a standard institutionalized process to raise money. The public offerings are done
through a prospectus. A prospectus is a document that gives detailed information about the
company, their prospective plans, potential risks associated with the business plans and the
financial instrument.
SECONDARY MARKETS
Secondary Market is a place where primary market instruments, once issued, are bought and
sold. An investor may wish to sell the financial asset and encash the investment after some time
or the investor may wish to invest more, buy more of the same asset instead, the decision
influenced by a variety of possible reasons. They provide the investor with an easy way to buy or
sell.
1.3.3 THE DIFFERENT FINANCIAL MARKETS
A financial market is known by the type of financial asset or instrument traded in it. So there are
as many types of financial markets as there are of instruments. Typical examples of financial
markets are:
Stock market
Bond (or fixed income) market
Money market
Foreign exchange (Forex or FX for short) market (also called the currency market).
Stock and bond markets constitute the capital markets. Another big financial market is the
derivatives market.
CAPITAL MARKETS
Why businesses need capital?
All businesses need capital, to invest money upfront to produce and deliver the goods and
services. Office space, plant and machinery, network, servers and PCs, people, marketing,
licenses etc. are just some of the common items in which a company needs to invest before the
business can take off. Even after the business takes off, the cash or money generated from sales
may not be sufficient to finance expansion of capacity, infrastructure, and products / services
range or to diversify or expand geographically. Some financial services companies need to raise
additional capital periodically in order to satisfy capital adequacy norms.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
What is the role of Capital Markets?
For businesses to thrive and grow, presence of vibrant and efficient capital markets is extremely
important. Capital markets have following functions:
1. Channeling funds from savings pool to investment pool channeling funds from those
who have money to those who need funds for business purpose.
2. Providing liquidity to investors i.e. making it easy for investors, to buy and sell financial
assets or instruments. Capital markets achieve this in a number of ways and it is particularly
important for institutional investors who trade in large quantities. Illiquid markets do not
allow them to trade large quantities because the orders may simply not get executed
completely or may cause drastic fluctuations in price.
3. Providing multitude of investment options to investors this is important because the risk
profile, investment criteria and preferences may differ for each investor. Unless there are
many investment options, the capital markets may fail to attract them, thus affecting the
supply of capital.
4. Providing efficient price discovery mechanism efficient because the price is determined by
the market forces, i.e. it is a result of transparent negotiations among all buyers and sellers
in the market at any point. So the market price can be considered as a fair price for that
instrument.
STOCK MARKETS
Stock markets are the best known among all financial markets because of large participation of
the retail investors. The important stock exchanges are as follows:
New York Stock Exchange (NYSE)
National Association of Securities Dealers Automated Quotations (NASDAQ)
London Stock Exchange (LSE)
Bombay Stock Exchange (BSE),
National Stock Exchange of India (NSE)
Stock Exchanges provide a system that accepts orders from both buyers and sellers in all shares
that are traded on that particular exchange. Exchanges then follow a mechanism to
automatically match these trades based on the quoted price, time, quantity, and the order type,
thus resulting in trades. The market information is transparent and available real-time to all,
making the trading efficient and reliable.
Earlier, before the proliferation of computers and networks, the trading usually took place in an
area called a Trading Ring or a Pit where all brokers would shout their quotes and find the
counter-party. The trading ring is now replaced in most exchanges by advanced computerized
and networked systems that allow online trading, so the members can log in from anywhere to
carry out trading. For example, BOLT of BSE and Super DOT of NYSE.
What determines the share price and how does it change?
The share price is determined by the market forces, i.e. the demand and supply of shares at
each price. The demand and supply vary primarily as the perceived value of the stock for
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Cognizant Confidential Foundation Course in Banking and Capital Markets
different investors varies. Investor will consider buying the stock if the market price is less than
the perceived value of the stock according to that investor and will consider selling if it is higher.
A large number of factors have a bearing on the perceived value. Some of them are:
Performance of the company
Performance of the industry to which it belongs
State of the countrys economy where it operates as well as the global economy
Market sentiment or mood relating to the stock and on the market as a whole
Apart from these, many other factors, including performance of other financial markets, affect
the demand and supply.
BOND MARKETS
As the name suggests, bonds are issued and traded in these markets. Government bonds
constitute the bulk of the bonds issued and traded in these markets. Bond markets are also
sometimes called Fixed Income markets. While some of the bonds are traded in exchanges,
most of the bond trading is conducted over-the-counter (OTC), i.e. by direct negotiations
between dealers. Lately there have been efforts to create computer-based market place for
certain type of bonds.
Participants in the Bond Market
Since Government is the biggest issue of bonds, the central bank of the country such as Federal
Reserve in US and Reserve Bank of India in India, is the biggest player in the bond market. Like
stock markets, one needs to be an authorized dealer of Govt. securities, to subscribe to the
bond issues. Typically, the Govt. bond issues are made by way of auctions, where the dealers bid
for the bonds and the price is fixed based on the bids received. The dealers then sell these
bonds in the secondary market or directly to third parties, typically institutions and companies.
If the interest rate is fixed for each bond, why do the bond prices fluctuate?
Bond prices fluctuate because the interest rates as well as the perceptions of investors on the
direction of interest rates change. Remember, bond pays interest at a fixed coupon rate
determined at the time of issue, irrespective of the prevailing market interest rate. Market
interest rates are benchmark interest rates, such as Treasury bill rates, which are subject to
change because of various factors such as inflation, monetary policy change, etc. So when the
prevailing market interest rates change, price of the bond (and not the coupon) adjusts, so that
the effective yield for a buyer at the time (if the bond is held to maturity) matches the market
interest rate on other bonds of equal tenure and credit rating (risk).
So when the market interest rates go up, prices of bonds fall and vice-versa. Therefore, price of
bonds changes when market interest rate changes, all bonds have an interest rate risk. If the
market interest rates shoot up, then the bond price is affected negatively and an investor who
bought the bond at a high price (when interest rates were low) stands to lose money or at least
makes lesser returns than expected, unless the bond is held to maturity.
Example
Bond Price calculation can be summed by an easy formula:
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Cognizant Confidential Foundation Course in Banking and Capital Markets
where B represents the price of the bond and CFk represents the kth cash flow which is
made up of coupon payments. The Cash Flow (CF) for the last year includes both the coupon
payment and the Principal.
What would be the bond price for a 3-Year, Rs.100 principal, bond when the interest
rate (i) is 10% and the Coupon payments are Rs.5 annually?
Would the bond price increase/decrease if the coupon is reduced? What would be
happen to bond price if the interest rates came down?
FOREIGN EXCHANGE MARKET
Foreign exchange markets are where the foreign currencies are bought and sold. For example,
importers need foreign currency to pay for their imports. Government needs foreign currency to
pay for its imports such as defense equipment and to repay loans taken in foreign currency.
Foreign exchange rates express the value of one currency in terms of another. They involve a
fixed currency, which is the currency being priced and a variable currency, the currency used to
express the price of the fixed currency. For example, the price of a US Dollar can be expressed in
different currencies as: USD (US Dollar) 1 = Indian Rupee (INR) 46, USD 1 = Great Britain Pound
(GBP) 0.6125, USD 1 = Euro 0.8780 etc. In this example, USD is the fixed currency and INR, GBP,
Euro are the variable currencies.
US Dollar, British Sterling (Pound), Euro and Japanese Yen are the most traded currencies
worldwide, since maximum business transactions are carried out in these currencies.
The exchange rate at any time depends upon the demand supply equation for the different
currencies, which in turn depends upon the relative strength of the economies with respect to
the other major economies and trading partners.
Participants
Only authorized foreign exchange dealers can participate in the foreign exchange market. Any
individual or company, who needs to sell or buy foreign currency, does so through an authorized
dealer. Currency trading is conducted in the over-the-counter (OTC) market.
The role of the Central Bank in the foreign exchange market
The central bank regulates the markets to ensure its smooth functioning. The degree of
regulation depends on the economic policies of the country. The central bank may also buy or
sell their currency to meet unusual demand supply mismatches in the markets.
The foreign exchange rate and transactions are closely monitored because the fluctuations in
Forex markets affects the profitability of imports and exports of domestic companies as well as
profitability of investments made by foreign companies in that country. Regulators try to ensure
that the fluctuations are not caused by any factor other than the market forces.
Example
The Bank of Japan plays the role of central bank in Japan. It strictly monitors the
exchange rates to ensure that the importers/exporters are not hurt due to any exchange
rate fluctuations. Still, the USD/JPY, which is the second most traded currency pair in the
world, maintains a long-standing reputation of sharp increases in short-term volatilities.
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MONEY MARKET
Money market is for short term financial instruments, usually a day to less than a year. The most
common instrument is a repo, short for repurchase agreement. A repo is a contract in which
the seller of securities, such as Treasury Bills, agrees to buy them back at a specified time and
price. Treasury bills of very short tenure, commercial paper, certificates of deposits etc. are also
considered as money market instruments.
Since the tenure of the money market instruments is very short, they are generally considered
safe. In fact they are also called cash instruments. Repos especially, since they are backed by a
Govt. security, are considered virtually the safest instrument. Therefore the interest rates on
repos are the lowest among all financial instruments.
Money market instruments are typically used by banks, institutions and companies to park extra
cash for a short period or to meet the regulatory reserve requirements. For short-term cash
requirements, money market instruments are the best way to borrow.
Participants
Whereas in stock market the typical minimum investment is equivalent of the price of 1 share,
the minimum investment in bond and money markets runs into hundreds of thousands of
Rupees or Dollars. Hence the money market participants are mostly banks, institutions,
companies and the central bank. There are no formal exchanges for money market instruments
and most of the trading takes place using proprietary systems or shared trading platforms
connecting the participants.
1.3.4 REGULATION OF CAPITAL MARKETS
There are many reasons why the financial markets are regulated by governments:
Since the capital markets are central to a thriving economy, Governments need to ensure
their smooth functioning.
Governments also need to protect small or retail investors interests to ensure there is
participation by a large number of investors, leading to more efficient capital markets.
Governments need to ensure that the companies or issuers declare all necessary
information that may affect the security prices and that the information is readily and easily
available to all participants at the same time.
Typically the government designates one or more agencies as regulator(s) and supervisor(s) for
the financial markets. Thus India has Securities and Exchange Board of India (SEBI) and the US
has Securities and Exchange Commission (SEC). These regulatory bodies formulate rules and
norms for each activity and each category of participant. For example,
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Eligibility norms for a company to be allowed to issue stock or bonds,
Rules regarding the amount of information that must be made available to prospective
investors,
Rules regarding the issue process,
Rules regarding periodic declaration of financial statements, etc.
Regulators also monitor the capital market activity continuously to ensure that any breach of
laws or rules does not go unnoticed. To help this function, all members and issuers have to
submit certain periodic reports to the regulator disclosing all relevant details on the transactions
undertaken.
1.3.5 FINANCIAL MARKET SYSTEMS
The demands of the capital market transactions, the need for tracking and managing risks, the
pressure to reduce total transaction costs and the obligation to meet compliance requirements
make it imperative that the functions be automated using advanced computer systems. Some of
the major types of systems in capital market firms are briefly described below.
TRADING SYSTEMS
The volume of transactions in capital markets demands advanced systems to ensure speed and
reliability. Due to proliferation of Internet technology, the trading systems are also now
accessible online allowing even more participants from any part of the world to transact, helping
to increase efficiency and liquidity. The trading systems can be divided into front-end order
entry and back-end order processing systems.
Order entry systems also offer functions such as order tracking, calculation of profit and loss
based on real-time price movements and various tools to calculate and display risk to the value
of investments due to price movement and other factors.
Back-office systems validate orders, route them to the exchange(s), receive messages and
notifications from the exchanges, interface with external agencies such as clearing firm,
generate management, investor and compliance reports, keep track of member account
balances etc.
EXCHANGE SYSTEMS
The core exchange system is the trading platform that accepts orders from members, displays
the price quotes and trades, matches buy and sell orders dynamically to fill as many orders as
possible and sends status messages and trade notifications to the parties involved in each trade.
In addition, exchanges need systems to monitor the transactions, generate reports on
transactions, keep track of member accounts, etc.
PORTFOLIO MANAGEMENT SYSTEMS
These systems allow the investment managers to choose the instruments to invest in, based on
the requirements or inputs such as amount to be invested, expected returns, duration (or
tenure) of investment, risk tolerance etc. and analysis of price and other data on the
instruments and issuers. The term portfolio refers to the basket of investments owned by an
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investor. A portfolio of investments allows one to diversify risks over a limited number of
instruments and issuers.
ACCOUNTING SYSTEMS
The accounting systems take care of present value calculations, profit & loss etc. - of
investments and funds and not the financial accounts of the firms.
SUMMARY
Financial markets facilitate financial transactions, i.e. exchange of financial assets such
stocks, bonds, etc.
Financial markets bring buyers and sellers in a financial instrument together, thus reducing
transaction costs, channeling funds, improving liquidity and provide a transparent price
discovery mechanism.
Each financial market is segmented into a Primary market, where new instruments are
issued and a Secondary market, where the previously issued instruments are bought and
sold by investors.
Stock markets, bond markets, money markets, foreign exchange markets and derivatives
markets are prominent examples of financial markets.
Shares (stock) of a company are issued and traded in the stock markets.
Bond markets are where bonds such as treasury bonds, treasury notes, corporate bonds,
etc. are traded.
Money markets, like bonds markets, are also fixed income markets. Instruments traded in
money markets have very short tenure.
Foreign exchange markets trade in currencies.
Derivatives markets trade derivatives, which are complex financial instruments, whose
returns are based upon the returns from some other financial asset called as the underlying
asset.
Price of any financial instrument depends basically on demand and supply, which in turn
depend upon multiple different factors for different markets.
Each financial instrument has a differing level of inherent risk associated with it. Money
market instruments are considered the safest due to their very short tenure.
Regulators play a very important role in the development and viability of financial markets.
Regulators try to ensure that the markets function in a smooth, transparent manner, that
there is sufficient and timely disclosure of information, that the interest of small investors is
not compromised by the large investors, and so on, which is critical for overall vibrancy,
efficiency and growth of the market and the economy.
1. 4 FINANCIAL STATEMENTS
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1.4.1 INTRODUCTION TO FINANCIAL ACCOUNTING
Why does the concept of Accounting and Financial Statements exist? Here are two main
reasons:
1. The managers of the business will want to know how things are going. They need
financial information in order to plan for the future; they need more up-to-date
information in order to check whether actual performance is on target. So accounting is
the first step in what we call management accounting.
2. There are several other groups of people who may have an interest in the finances of
the business (often referred to as 'stakeholders'). The law says that they have a legal
right to certain information. The whole process of providing this information (and of
maintaining a book-keeping system which is capable of providing it) is known as
financial accounting.
The stakeholders of any firm could be any or all of the following:
1. Shareholders
2. Employees
3. Management
4. Customers
5. Government
6. Trade Unions and others
Question: Who owns the firm - management or shareholders?
Answer: Shareholders of course, as they hold shares of the company. However Management
personnel/directors of a company are also encouraged to hold shares of the company to align
the interest of management and shareholders. )
For Accounting purpose, Company is considered as a Legal Entity that is, a person or
organization that has the legal standing to enter into contracts and may be sued for failure to
perform as agreed in the contract, e.g., a child under legal age is not a legal entity, while a
corporation is a legal entity since it is a person in the eyes of the law.
In order that the stakeholders mentioned above understand the financial position of a company,
there are standardized financial statements that are prepared. The main ones are:
1. Balance Sheet
2. Income Statement or Profit and Loss Account
3. Cash-Flow statement
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Now, let us study them one at a time (why do we need to do that? Well, one of the aims of this
course is to ensure that we are familiar with the basic concepts and terms used in Finance. And
the above statements are as basic as it gets. SO read on)
BALANCE SHEET
A Balance sheet is a statement that lists the total assets and the total liabilities of a given
business to portray its net worth at a given moment of time. Thus, if we look at any balance
sheet, it is As on March 31st 200X (Or whatever the financial year ending date)
So, it indicates the health of the firm at a point of time.
What are the individual items in a Balance Sheet?
First of all its called a balance sheet because the Asset and Liabilities in a Balance sheet balance,
meaning they equal each other its as simple as that!
An Asset is anything owned by an individual or a business, which has commercial value. Claims
against others also qualify as Assets. (That is, if someone owes us something, then it is also an
asset, as it actually belongs to us and is of commercial value)
A Liability is a debt payable by the firm to its creditors. It represents an economic obligation to
pay cash, or provide goods and services, in some future period. (Thus, if we buy a bike on
installments, Bike is of course an asset as it has capability to provide us service for next few
years, but the loan amount which we need to pay out in installments is a Liability we incur.)
The typical heads in a balance sheet are shown below with a sample:
Consolidated Statements of Financial Positions
(All number in thousands)
Assets Liabilities
Current Assets Current Liabilities
Cash and Cash Equivalents $100 Payables and Accrued Expenses $50
Short Term Investments 100 Short Term Loans 150
Receivables 200 Debt due in the next 1 year 100
Inventory 50 Other Current Liabilities 50
Other Current Assets 50
Total Current Assets 500 Total Current Liabilities 350
Long Term Assets Long term Liabilities
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Net Fixed Assets (Land, Properties
and Equipments)
200 Long term debt 200
Intangible Assets 100 Deferred Liabilities 50
Goodwill 50 Other Liabilities 100
Other Assets 50 Total Liabilities 700
Shareholders Equity
Equity 100
Retained Earnings 100
Total Long Term Assets 400 Total Shareholders Equity 200
Total Assets 900 Total Liabilities and Shareholders
Equity
900
Lets look at each item closely:
ASSETS:
CURRENT ASSETS
Current Assets are those assets of a company that are reasonably expected to be realized in
cash, or sold, or consumed in the next one year. Some current assets are listed below:
Cash and Cash Equivalents: Cash And Cash Equivalents means all cash, securities, which can be
converted into cash at a very short notice, and other near-cash items (E.g. checks, drafts, cash in
bank accounts etc).
Short Term Investments: All investments, which will be converted in Cash in the next one year.
All the assets (bonds etc) with less than one year time to maturity will be accounted under this
item (E.g. short term securities).
Receivables: Also referred to as Account receivables. This indicates the money due to the firm,
for service rendered or goods sold on credit.
Inventory: Inventory for companies includes raw materials, items available for sale or in the
process of being made ready for sale (work in process). For a stockbroker, it will be the
securities bought and held by him, for resale.
Other Current Assets: Anything else which could not be categorized in one of the items above
but we know that its a current asset can be accounted for here.
LONG-TERM ASSETS
Long-term assets are those assets that are not consumed during the normal course of business,
e.g. land, buildings and equipment, goodwill, etc. They include:
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Fixed Assets: Fixed Assets are assets of a permanent nature required for the normal conduct of
a business, and which will not normally be converted into cash during the next fiscal period. For
example, furniture, fixtures, land, and buildings are all fixed assets. Fixed asset is value of all
property, plant, and equipment, net of depreciation.
Depreciation
We all understand that if we buy a car today, after 5 years of service the value of the car would
not be same. We will not be able to sell the car after 5 years at the same price at which we
bought the car. This means that assets lose their value as they provide service. This loss of value,
or spreading of cost, is called depreciation.
Calculating deprecation can get complex, but heres one simple way of calculating depreciation.
Say, we know that life of a computer is 3 years and we bought it for $ 3000. So at the end of the
3 years the asset will have a Zero value. What is the true value of the asset at the end of each
year? Just depreciate the value of the Asset by $ 1000 (3000/3) each year. Thus:
Value of Asset End of Year
$ (3000-1000)=$ 2000 1
$1000 2
$ 0 3
Usually, instead of the value coming all the way down to zero, it is said to have a scrap value:
say, $100. At this point, the asset is removed from the business books, or said to be written off
.
INTANGIBLE ASSETS:
Intangible Asset is an asset that is not physical in nature. Examples are things like copyrights,
patents, intellectual property, or goodwill. We can look at more details through an example of
Goodwill below.
Goodwill
Goodwill is that intangible possession which enables a business to continue to earn a profit that
is in excess of the normal or basic rate of profit earned by other businesses of similar type. Say, a
company such as Hindustan levers, has built up a lot of goodwill over the years. Customers
would prefer to buy their products versus an unknown brand. This is an intangible factor, yet
worth a lot of money!
OTHER ASSETS:
Again, any other asset, which could not be classified under any of the categories above, but one
is sure its an asset, can be accounted for here.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
LIABILITIES
CURRENT LIABILITIES
Current Liabilities are amounts, or goods and services, to be paid or executed, within next one
year.
Payables and Accrued Expenses: A Company might have suppliers who supply on credit, and
this is an Account Payable. An accrued expense is an expense that the company has already
incurred but company has not paid for it so far.
Short Term Loans: All the loans that have to be paid in the next one year.
Debt payments due in the next year: Loans of 10-15 years duration are sometimes repaid in
installments every year, and so just the money that has to be paid in the next one year would be
accounted here.
Other Current Liabilities: Any liabilities, which cannot be categorized under any of the headings
above.
LONG-TERM LIABILITIES
Long-term debt: All debt, including bonds, debentures, bank debt, mortgages, deferred portions
of long-term debt, and capital lease obligations. Please note that part of the loan that is due
only after next one year is indicated here.
Deferred Liabilities/Provisions: Deferred, in accounting, is any item where the asset or liability
is not realized until a future date, e.g. annuities, charges, taxes, income, etc. So in this case, one
knows that there will be some expenses, but the exact amount and dates are not known.
Other Liabilities: Any liabilities, which cannot be categorized under any of the headings above.
Equity This is basically equity share capital, which is capital raised by an entity through the sale
of common shares in the primary market. This is also called share capital.
Retained Earnings
Retained Earnings are profits of the business that have not been distributed to the owners as of
the balance sheet date. The earnings have been "retained" for planned activities such as
business expansion - so they actually belong to the owners (shareholders), but have been
retained.
Quiz: How do the three items above change when company declares dividend?
Answer: Nothing changes till the company pays out dividends.
Quiz: How do these items change when company pays out dividends?
Answer: Retained earnings go down by amount of dividend.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Advanced Quiz: Are stock options same as shares held by employees? Are these captured in
these statements?
Answer: A stock option is the right of an employee to buy company shares at a pre-specified
price, which may be above or below the market price, as on date of the exercising of option. If
the option price is below the market price, the employee may buy at the option price & sell at
market price & thus realize a profit. If option price is above the market price as on that date,
obviously the employee will not prefer to exercise the option. Hence, the options cannot be
categorized as shares. However, in some balance sheets, provision may be made for these
stock options under the liability head.
INCOME (P & L) STATEMENTS
Profit And Loss Statement (P&L) is also known as an income statement. It shows business
revenue and expenses for a specific period of time (such as the financial year so if we look at
any P & L statement, it always specifies a period of time, as: For the Financial Year Ended 31st
December 2003. The difference between the total revenue and the total expense is the
business net income.
A key element of this statement, and one that distinguishes it from a balance sheet, is that the
amounts shown on this statement represent transactions over a period of time while the items
represented on the balance sheet show information as of a specific date (or point in time). So in
engineering terms, Balance sheet has a memory like Flip-flops, while Income statement doesnt
have a memory.
It is important to understand that for a company Profit need not equal the Cash it has
generated during a period. It might so happen that company has provided the service but the
client has not yet paid and so company makes a Profit but not Cash. To account for cash
generated during a period, companies also report Cash flow statement.
A sample P&L statement is shown below.
P&L ACCOUNT STATEMENT
Revenue A
Direct Cost B = (C+D)
Direct Material C
Direct Labor D
Gross Profit E = (A-B)
Operating Expenses (Based on the type of business, some of
these items would qualify as indirect Cost)
F = (G+ H+I+J+K)
Administration G
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Cognizant Confidential Foundation Course in Banking and Capital Markets
R & D H
Marketing and Selling Expenses I
Any one time expenses (e.g. ex-gratia etc) J
Other Expenses K
Operating Income L = (E-F)
Other Income M
Other Expenses N
EBIT (Earnings Before Interest and Taxes) O = (L+M-N)
Interest Expenses P
Profit Before Tax (PBT) Q = (O-P)
Income Taxes R
Net Income or PAT (Profit after Tax) S= (Q-R)
EPS (Earnings Per Share) T = S/ Number of shares
P/E Ratio Market price/T
Lets look at each item closely:
Revenue
Revenue is the inflows of assets (may be Cash or Receivables, Remember!) from selling goods or
providing services to customers. This is also referred to as the Top line (as it is the top line in
the P& L statement!)
Direct Cost
Direct Cost is that portion of cost that is directly expended in providing a product or service for
sale e.g. material and labor.
Gross Profit
Gross Profit is one of the key performance indicators. Gross profit shows the relationship
between sales and the direct cost of products/services sold. It is measured as indicated in the
table above.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Indirect Cost
Indirect Cost is that portion of cost that is indirectly expended in providing a product or service
for sale (cannot be traced to a given project, in our case, in an economically feasible manner)
e.g. rent, utilities, equipment maintenance, etc.
Operating Expenses
Operating Expenses is all selling and general & administrative expenses. This includes
depreciation, but not interest expense.
Operating Income
Operating Income is revenue less cost of goods sold (Direct and Indirect costs) and related
operating expenses that are applied to the day-to-day operating activities of the company. It
excludes financial related items (i.e., interest income, dividend income, and interest expense),
and taxes.
EBIT (Earnings before Interest and Taxes)
Its the earnings before any interest or taxes.
Interest Expenses
Interest expense captures all the finance charges incurred on any borrowed capital.
Profit before Tax (PBT)
Profit earned before accounting for Taxes.
Income Taxes
Amount of tax paid. This is a % of PBT.
Net Income or PAT (Profit after Tax)
This is the profit after all the obligations, which can be distributed to shareholders. This is also
referred as the Bottom-line (as this is the bottom line in a P &L statement, or the final profit
net of expenses & tax.
EPS (Earnings per Share)
Earnings per Share (EPS) is the amount of net income (earnings) related to each share;
computed by dividing net income by the number of shares outstanding during the period.
P/E Ratio
Price to Earnings Ratio (P/E) is a performance benchmark that can be used as a comparison
against other companies or within the stock's own historical performance. For instance, if a
stock has historically run at a P/E of 35 and the current P/E is 12, we may want to explore the
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Cognizant Confidential Foundation Course in Banking and Capital Markets
reasons for the drastic change. If we believe that the ratio is too low, we may want to buy the
stock.
There are a number of other ratios that help analysts to analyze the financial statements of
companies to understand the current performance and future prospects; we are not
discussing those here.
CASH FLOW STATEMENT
Statement accounting for all the inflows and outflows of cash is captured in this statement.
Why do we need a separate Cash-flow statement?
Isnt it covered in Balance sheet or Income statement?
All the accounting is done based on the method wherein, revenue and expenses are recorded in
the period in which they are earned or incurred regardless of whether cash is received or
disbursed in that period. So when a good is sold or some service rendered, it will show in
Balance sheet and Income statement, but it will not show in the Cash Flow statement till cash is
received for the same.
Quiz: How will we explain a scenario where company is reporting a large profit but company
doesnt have the cash to pay salary to its employees? Where is the cash going or did it come at
all?
Answer: It means that the company is selling goods and also making profits but has not received
cash payments from its customers!
Exercise
1. Day 1: We borrow Rs 100 from a bank for a business to produce t-shirts. How would our
balance sheet look like at the end of the day?
2. Day 2: We purchase raw material for your products for Rs 50. How would our balance
sheet look like at the end of the day?
3. Day 3 to 29: Workers work with the rented machines to produce the finished goods. The
product is ready to be shipped to customer.
4. Day 30: We pay the workers Rs 20 as their salary, pay Rs 10 as the machine rent, pay
other expenses such as floor rent, electricity bills etc totaling Rs 10. At the end of the
day the product is shipped to the customer. Customer has promised to pay you Rs 120
after checking the quality, which will take 5 days. How would our balance sheet look like
at the end of the day? How would our Income statement look like?
5. Day 35: You get Rs 120 from customer. You also get admission in a Business School and
so you plan to wind up the business. Prepare all the financial statements (Balance sheet
and Profit and loss statement at the end of day 35).
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Useful Information: Bank charges 12% simple interest rate. We need to pay tax @ 10% of the
net income. Inflation for the period was 5%.
Advanced Exercise
Infosys has all its revenue in Dollars. Direct cost for the company is 60% of its revenue. Of this
60%, 30% in incurred in dollars (onsite component) while 70% (offshore component) is incurred
in rupees. Indirect cost for the company is 20%. Of this 20%, 70% (Selling and Marketing, US
infrastructure etc) is incurred in dollars while rest (Indian infrastructure, entertainment etc) is
incurred in rupees. By what percentage, will the profit increase/decrease if the rupee
appreciates by 1% from its current level of Rs. 50 per dollar?
Understanding Cognizants Financial Statements
COGNIZANTS BALANCE SHEET
In Millions of USD
(except for per share
items)
As of 2008-12-31 As of 2007-12-31 As of 2006-12-31 As of 2005-12-31
Cash & Equivalents 735.07 339.85 265.94 196.94
Short Term Investments 27.51 330.58 382.22 227.06
Cash and Short Term
Investments
762.58 670.42 648.16 424.00
Accounts Receivable -
Trade, Net
579.64 436.46 298.48 176.70
Receivables - Other - - - -
Total Receivables, Net 579.64 436.46 298.48 176.70
Total Inventory - - - -
Prepaid Expenses - - - -
Other Current Assets,
Total
125.90 135.30 93.76 62.73
Total Current Assets 1,468.12 1,242.18 1,040.39 663.42
Property/Plant/Equipment
, Total - Gross
654.44 499.03 315.69 211.72
Goodwill, Net 154.03 148.79 27.19 18.22
Intangibles, Net 47.79 45.56 20.46 16.28
Long Term Investments 161.69 0.00 - -
Other Long Term Assets,
Total
87.67 45.73 17.78 24.99
Total Assets 2,374.56 1,838.31 1,325.98 869.89
Accounts Payable 39.97 36.18 27.84 16.42
Accrued Expenses 298.17 272.34 200.54 119.29
Notes Payable/Short
Term Debt
0.00 0.00 0.00 0.00
Current Port. of LT
Debt/Capital Leases
- - - -
Other Current liabilities,
Total
49.44 32.16 21.13 18.08
Total Current Liabilities 387.58 340.68 249.50 153.79
Long Term Debt - - - -
Capital Lease
Obligations
- - - -
Total Long Term Debt 0.00 0.00 0.00 0.00
Total Debt 0.00 0.00 0.00 0.00
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Deferred Income Tax 7.29 15.14 0.00 -
Minority Interest - - - -
Other Liabilities, Total 14.11 14.27 2.98 1.95
Total Liabilities 408.98 370.10 252.48 155.75
Redeemable Preferred
Stock, Total
- - - -
Preferred Stock - Non
Redeemable, Net
- - - -
Common Stock, Total 2.92 2.88 2.85 1.39
Additional Paid-In Capital 541.74 450.57 408.59 293.15
Retained Earnings
(Accumulated Deficit)
1,430.40 999.56 650.28 417.48
Treasury Stock -
Common
- - - -
Other Equity, Total -9.48 15.20 11.78 2.12
Total Equity 1,965.58 1,468.21 1,073.50 714.14
Total Liabilities &
Shareholders' Equity
2,374.56 1,838.31 1,325.98 869.89
Shares Outs - Common
Stock Primary Issue
- - - -
Total Common Shares
Outstanding
291.67 288.01 285.03 278.69
COGNIZANTS INCOME STATEMENT.
In Millions of USD (except for per
share items)
3 months
ending 2009-
03-31
3 months
ending 2008-12-
31
3 months
ending 2008-09-
30
3 months
ending 2008-06-
30
3 months
ending 2008-03-
31
Revenue 745.86 753.04 734.73 685.43 643.11
Other Revenue, Total - - - - -
Total Revenue 745.86 753.04 734.73 685.43 643.11
Cost of Revenue, Total 419.71 419.75 405.94 380.87 366.26
Gross Profit 326.15 333.30 328.79 304.56 276.84
Selling/General/Admin. Expenses,
Total
166.87 169.38 166.69 167.10 148.85
Research & Development - - - - -
Depreciation/Amortization 21.15 21.25 19.47 17.78 16.29
Interest Expense(Income) - Net
Operating
- - - - -
Unusual Expense (Income) - - - - -
Other Operating Expenses, Total - - - - -
Total Operating Expense 607.73 610.38 592.10 565.75 531.41
Operating Income 138.13 142.67 142.63 119.68 111.69
Interest Income(Expense), Net Non-
Operating
- - - - -
Gain (Loss) on Sale of Assets - - - - -
Other, Net -5.11 -12.34 -14.78 -0.48 3.95
Income Before Tax 135.49 136.09 133.20 124.06 121.87
Income After Tax 113.13 112.29 112.83 103.86 101.87
Minority Interest - - - - -
Equity In Affiliates - - - - -
Net Income Before Extra. Items 113.13 112.29 112.83 103.86 101.87
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Accounting Change - - - - -
Discontinued Operations - - - - -
Extraordinary Item - - - - -
Net Income 113.13 112.29 112.83 103.86 101.87
Preferred Dividends - - - - -
Income Available to Common Excl.
Extra Items
113.13 112.29 112.83 103.86 101.87
Income Available to Common Incl.
Extra Items
113.13 112.29 112.83 103.86 101.87
Basic Weighted Average Shares - - - - -
Basic EPS Excluding Extraordinary
Items
- - - - -
Basic EPS Including Extraordinary
Items
- - - - -
Dilution Adjustment - - 0.00 0.00 0.00
Diluted Weighted Average Shares 297.99 297.57 299.81 299.33 299.05
Diluted EPS Excluding Extraordinary
Items
0.38 0.38 0.38 0.35 0.34
Diluted EPS Including Extraordinary
Items
- - - - -
Dividends per Share - Common Stock
Primary Issue
0.00 0.00 0.00 0.00 0.00
Gross Dividends - Common Stock - - - - -
Net Income after Stock Based Comp.
Expense
- - - - -
Basic EPS after Stock Based Comp.
Expense
- - - - -
Diluted EPS after Stock Based Comp.
Expense
- - - - -
Depreciation, Supplemental - - - - -
Total Special Items - - - - -
Normalized Income Before Taxes - - - - -
Effect of Special Items on Income
Taxes
- - - - -
Income Taxes Ex. Impact of Special
Items
- - - - -
Normalized Income After Taxes - - - - -
Normalized Income Avail to
Common
- - - - -
Basic Normalized EPS - - - - -
Diluted Normalized EPS 0.38 0.38 0.38 0.35 0.34
COGNIZANTS CASHFLOW STATEMENT.
In Millions of USD (except for
per share items)
3 months
ending 2009-03-
31
12 months
ending 2008-12-
31
9 months
ending 2008-09-
30
6 months
ending 2008-06-
30
3 months
ending 2008-03-
31
Net Income/Starting Line 113.13 430.85 318.56 205.73 101.87
Depreciation/Depletion 21.15 74.80 53.54 34.07 16.29
Amortization - - - - -
Deferred Taxes 3.94 -5.03 9.90 7.01 -6.67
Non-Cash Items 10.63 37.97 24.47 12.45 10.58
Changes in Working Capital -73.76 -108.88 -169.69 -162.23 -99.82
Cash from Operating Activities 75.09 429.70 236.79 97.03 22.26
Capital Expenditures -20.47 -169.41 -146.32 -85.21 -53.42
Other Investing Cash Flow Items,
Total
-23.07 114.40 112.87 110.90 119.58
Cash from Investing Activities -43.55 -55.01 -33.45 25.69 66.16
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Financing Cash Flow Items 1.82 16.99 16.26 15.16 4.04
Total Cash Dividends Paid - - - - -
Issuance (Retirement) of Stock,
Net
-4.12 27.04 20.98 40.29 12.83
Issuance (Retirement) of Debt,
Net
- 0.00 - - -
Cash from Financing Activities -2.30 44.03 37.24 55.45 16.88
Foreign Exchange Effects -5.74 -23.51 -11.16 3.18 4.60
Net Change in Cash 23.50 395.22 229.42 181.35 109.89
Cash Interest Paid, Supplemental - - - - -
Cash Taxes Paid, Supplemental - 82.80 - - -
2. 0 BANKING
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Cognizant Confidential Foundation Course in Banking and Capital Markets
2. 1 INTRODUCTION TO BANKING
2.1.1 WHAT IS A BANK?
The term Bank is used generically to refer to any financial institution that is licensed to accept
deposits and issue credit through loans.
Banks are the backbone of any economy, as all monetary transactions end up touching banks.
The main functions of banks are to:
Channelize Savings
Provide credit facilities to borrower
Provide investment avenues to investors
Facilitate the trade and commerce dealings
Provide financial backbone to support economic growth of the country
Minimize Cash Transactions
Provide Services
2.1.2 WHY DO WE NEED A BANK?
They provide a return (pay interest) on our saving
Safety of principal and interest
Convenience of being able to write checks and use debit cards
Raising funds when we need
From the business or economic point of view, however, banks are the primary source of finance.
Since the deposits of the small investors are protected, bank deposits are considered a low risk
investment avenue. Due to their access to a large source of funds at very low cost, owing largely
to the low interest rate on savings and term deposits, banks are in the best position to lend to
businesses and individuals at competitive interest rates.
2.1.3 WHAT IS THE CENTRAL BANK AND WHAT ARE ITS ROLES?
The Central bank of any country can be called the bankers bank. It acts as a regulator for other
banks, while providing various facilities to facilitate their functioning. It also acts as the
Governments bank. The Federal Reserve is the central bank of the United States, while Reserve
Bank of India is the central bank in India.
The main objective of a central bank is to provide the nation with a safer, more flexible, and
more stable monetary and financial system. They have the following responsibilities:
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Conducting the nation's monetary policy. Central banks define the monetary policy and then
take necessary actions to create an environment to make those policies feasible. E.g. if the
central bank wants to maintain soft interest rate, they can reduce the CRR to pump in more
money in the economy.
Supervising and regulating banking institutions and protecting the rights of consumers
Maintaining the stability of the financial system, i.e. stability of interest rates and foreign
exchange rate.
Ensuring that the interest rates remain at such a level as to make business viable
Ensuring that sufficient funds are available for long term investment to businesses as well as
government, without causing inflation to rise
Providing certain financial services to the government, the public, financial institutions, and
foreign official institutions
Monitoring the foreign currency assets and liabilities and monitoring the inflow and outflow
of foreign currency
2.1.4 BANKS, ECONOMY AND AMOUNT OF MONEY
Banks facilitate the creation of money in the economy. The primary function of banks is to put
account holders' money to use by lending it out to others who can then use it to buy homes,
businesses etc.
Lets look at an example as how banks do this. The amount of money that banks can lend is
directly affected by the reserve requirement set by the Central Bank. That is, every bank needs
to maintain a certain percentage of its total deposits as cash, to ensure liquidity. This reserve
requirement is also known as the CRR (Cash Reserve Ratio). When a bank gets a deposit of $100,
assuming a reserve requirement of 10%, the bank can then lend out $90. That $90 goes back
into the economy, purchasing goods or services, and usually ends up deposited in another bank.
That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to
purchase goods or services and ultimately is deposited into another bank that proceeds to lend
out a percentage of it. In this way, money grows and flows throughout the community in a much
greater amount than physically exists. This is also called multiplier effect. In the picture below,
an initial deposit of $100 has created a reserve of $27, and loan of $244. Thus, banks facilitate
the investing/spending of money that multiply funds through circulation and this is known as
Money Multiplier effect.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
2.1.5 HOW DO BANKS MAKE MONEY?
Banks are like any other regulated business; the product they deal with is Money. So they
borrow money from individual or businesses who have money, and lend it to those who need
money, by adding a mark up, to pay for expenses and profit. The difference between the rates,
which banks offer to depositors and lenders, is generally referred to as Spread.
Understandably, the spread in this business is low; hence increasing the turnover (volume) is the
key to making profit. Hence, in practice, banks offer a number of options often termed as
products - to both investors and borrowers to meet their different requirements and
preferences and thus increase business. They also provide fee-based services such as managing
cash for corporate clients, to increase business and improve profit margin.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
2.1.6 SERVICE OFFERINGS OF BANKS
Service offerings of banks are organized along following divisions:
Corporate Banking
o Trade Finance
o Cash Management
Retail Banking
o Deposits Checking, Savings, Retirement accounts, Term deposits
o Branch & Electronic Banking
o Credit Card services
o Retail Lending Personal Loans, Home Mortgages, Consumer Loans, Vehicle Loans
o Private Banking & Wealth Management
o SME/Business Banking for SMEs
Investment Banking
o Private Equity
o Corporate Advisory
o Capital Raising
o Proprietary Trading
o Emerging Markets
o Sales, Trading & Research
Equity
Fixed Income
Derivatives
2.1.7 TOP 50 BANKS IN THE US BY ASSET SIZE
Listed below are the Top 50 bank holding companies (BHCs) as of 12/31/2008
Rank Institution Name Total Assets
1 JPMORGAN CHASE & CO. $2,175,052,000
2 CITIGROUP INC. $1,938,470,000
3 BANK OF AMERICA CORPORATION $1,822,068,028
4 WELLS FARGO & COMPANY $1,309,639,000
5 HSBC NORTH AMERICA HOLDINGS INC. $434,715,911
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Cognizant Confidential Foundation Course in Banking and Capital Markets
6 TAUNUS CORPORATION $396,659,000
7 PNC FINANCIAL SERVICES GROUP, INC., THE $291,092,876
8 U.S. BANCORP $267,032,000
9 BANK OF NEW YORK MELLON CORPORATION, THE $237,652,000
10 SUNTRUST BANKS, INC. $189,137,961
11 STATE STREET CORPORATION $176,632,334
12 CAPITAL ONE FINANCIAL CORPORATION $165,913,451
13 CITIZENS FINANCIAL GROUP, INC. $160,444,183
14 BB&T CORPORATION $152,015,025
15 REGIONS FINANCIAL CORPORATION $146,253,935
16 TD BANKNORTH INC. $122,745,454
17 FIFTH THIRD BANCORP $119,763,812
18 KEYCORP $105,231,004
19 HARRIS FINANCIAL CORP. $88,258,094
20 NORTHERN TRUST CORPORATION $82,053,626
21 BANCWEST CORPORATION $79,858,266
22 UNIONBANCAL CORPORATION $70,121,446
23 COMERICA INCORPORATED $67,912,580
24 M&T BANK CORPORATION $65,815,757
25 MARSHALL & ILSLEY CORPORATION $62,517,618
26 BBVA USA BANCSHARES, INC. $62,305,413
27 ZIONS BANCORPORATION $55,339,951
28 HUNTINGTON BANCSHARES INCORPORATED $54,355,998
29 POPULAR, INC. $38,883,000
30 SYNOVUS FINANCIAL CORP. $35,786,269
31 NEW YORK COMMUNITY BANCORP, INC. $32,488,105
32 RBC BANCORPORATION (USA) $32,434,425
33 FIRST HORIZON NATIONAL CORPORATION $31,022,768
34 COLONIAL BANCGROUP, INC., THE $25,816,306
35 ASSOCIATED BANC-CORP $24,198,697
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Cognizant Confidential Foundation Course in Banking and Capital Markets
36 BOK FINANCIAL CORPORATION $22,840,287
37 FIRST BANCORP $19,491,268
38 WEBSTER FINANCIAL CORPORATION $17,600,122
39 COMMERCE BANCSHARES, INC. $17,545,887
40 FBOP CORPORATION $17,346,706
41 TCF FINANCIAL CORPORATION $16,782,760
42 FIRST CITIZENS BANCSHARES, INC. $16,745,662
43 FIRST NATIONAL OF NEBRASKA, INC. $16,725,869
44 CITY NATIONAL CORPORATION $16,458,765
45 FULTON FINANCIAL CORPORATION $16,185,106
46 W HOLDING COMPANY, INC. $15,317,974
47 NEW YORK PRIVATE BANK & TRUST CORPORATION $14,744,507
48 SUSQUEHANNA BANCSHARES, INC. $13,682,988
49 SOUTH FINANCIAL GROUP, INC., THE $13,600,077
50 BANCORPSOUTH, INC. $13,499,414
2.1.8 UNIVERSAL BANKING
The universal banking concept permits banks to provide commercial bank services, as well as
investment bank services at the same time.
Glass-Steagall Act of 1933, created a Chinese wall between commercial banking and securities
businesses in US. That act was intended to address the perceived causes of bank failures during
the Great Depression of 1929.
Today, Glass-Steagall restrictions have become outdated and unnecessary. It has become clear
that promoting stability and best practices cannot be done through artificially separating these
business areas. Over the years, banks and securities firms have been forced to find various
loopholes in the Glass-Steagall barriers. The restrictions undermined the ability of American
banks to compete with the other global banks which were not covered by such legislation.
Most of Glass-Steagall provisions have been repealed in the US in 1990s enabling the banks to
offer a full range of commercial and investment banking services to their customers. Provisions
that prohibit a bank holding company from owning other financial companies were repealed on
November 12, 1999, by the Gramm-Leach-Bliley Act. The Glass-Steagall Act prohibited a bank
from offering investment, commercial banking, and insurance services. The Gramm-Leach-Bliley
Act (GLBA) allowed commercial and investment banks to consolidate
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Example
In the late 1990s, before legislation officially eradicated the Glass-Steagall Acts restrictions, the
investment and commercial banking industries witnessed an abundance of commercial banking
firms making forays into the I-banking world. The mania reached a height in the spring of 1998.
In 1998, NationsBank bought Montgomery Securities, Socit Gnerale bought Cowen & Co.,
First Union bought Wheat First and Bowles Hollowell Connor, Bank of America bought
Robertson Stephens (and then sold it to BankBoston), Deutsche Bank bought Bankers Trust
(which had bought Alex. Brown months before), and Citigroup was created in a merger of
Travelers Insurance and Citibank.
While some commercial banks have chosen to add I-banking capabilities through acquisitions,
some have tried to build their own investment banking business. J.P. Morgan stands as the best
example of a commercial bank that has entered the I-banking world through internal growth.
J.P. Morgan actually used to be both a securities firm and a commercial bank until federal
regulators forced the company to separate the divisions. The split resulted in J.P. Morgan, the
commercial bank, and Morgan Stanley, the investment bank. Today, J.P. Morgan has slowly and
steadily clawed its way back into the securities business, and Morgan Stanley has merged with
Dean Witter to create one of the biggest I-banks on the Street.
SUMMARY
Banks are an integral part of any economy channelizing savings from lenders to borrowers
Bank deposits are low risk investments
The Central bank is the Bankers Bank and it regulates other banks in an economy.
Central banks define a nations monetary policy
A bank makes a profit by investing or lending money that is earning a higher rate of interest
than it pays to its depositors.
A bank is required to keep a certain amount of "cash reserves" by regulation to maintain
liquidity, i.e. to ensure that the banking system does not face a cash crunch due to higher
withdrawals, which can lead to panic among investors and a run on a bank.
Banks create a Money Multiplier effect
Banks are generally organized as corporate banking, investment banking, retail banking, and
private banking functions.
Universal banks provide commercial banking as well as investment bank services under one
roof
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Cognizant Confidential Foundation Course in Banking and Capital Markets
3. 0 RETAIL BANKING
3. 1 INTRODUCTION
Retail banking addresses the banking and financial services needs of individuals also called
Consumers and small medium enterprises (SME) or Small Businesses with say less than 1 M USD
in revenue, otherwise called retail customers. Retail transactions are typically large volume low
value but strongly governed by consumer friendly regulations and are critical to a bank. Retail
banks or stores offer various services such as - Deposits (savings and checking accounts), Loans
(mortgages, personal), debit cards, credit cards, investment products and so on. This is a typical
mass-market banking in which individual customers use local branches, ATMs, Online banking,
Phone Banking, Contact Centers and recently mobile banking for their financial / banking needs.
In some geography such as Europe, APAC, Middle East retail banks also offer investment
services such as wealth management, brokerage accounts, private banking and retirement
planning for High Nett-worth Individuals.
3.1.1 VARIANTS OF RETAILS BANKS
There are various flavors of retail banks. Even though all of them cater to individual customers,
they basically differ in some aspects like regulating bodies, types of customer, services provided.
The US has Community Banks, Credit Unions and Savings Bank whereas Europe has Postal
Savings Bank, Offshore Banks, Private Banks and so on.
A. Community development banks (CDBs) In the United States, Community development
banks provide retail banking services to the residents of the community and spur
economic development in low- to moderate-income (LMI) geographical areas (typically
the underserved community of the economy) . CDBs can apply for formal certification as
a Community Development Financial Institution (CDFI) from the Community
Development Financial Institutions Fund of the U.S. Department of the Treasury.
E.g.: The largest and oldest community development bank is Shore Bank, headquartered
in the South Shore neighborhood of Chicago.
B. Credit Union: A credit union is a cooperative financial institution that is owned and
controlled by its members, and operated for the purpose of promoting thrift, providing
credit at reasonable rates, and providing other financial services to its members. Many
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Cognizant Confidential Foundation Course in Banking and Capital Markets
credit unions exist to further community development or sustainable international
development on a local level.
C. Private Banks manage the assets of high net worth individuals. Private Banks are banks
that are not incorporated, owned by either an individual or a general partner(s). In any
such case, the creditors can look to both the "entirety of the bank's assets" as well as
the entirety of the sole-proprietor's/general-partners' assets.
E.g.: There are a few private banks remaining in the U.S. One is Brown Brothers
Harriman & Co.
D. Offshore banks are banks located in jurisdictions with low taxation and regulation.
Many offshore banks are essentially private banks. An offshore bank is a bank located
outside the country of residence of the depositor, typically in a low tax jurisdiction (or
tax haven) that provides financial and legal advantages. E.g.: Banks in Channel Islands,
the Caribbean Islands, Jersey etc.
E. Savings banks primary purpose is accepting savings deposits. It also provides other
services such as payments, credit and insurance. They differ from commercial banks by
their broadly decentralized distribution network, providing local and regional outreach.
E.g.: The first chartered savings bank in the United States was the Boston Provident
Savings Institution, incorporated December 13, 1816.
F. Postal savings banks leverage the postal network with a broad distribution arm to
provide sales and service to its customers. Many nations' post offices operated, or
continue to operate postal savings systems, to provide depositors who did not have
access to banks a safe, convenient method to save money and to promote saving among
the poor. The first nation to offer such an arrangement was Great Britain in 1861. The
United States began a similar system in 1911 under the Act of 1910 but it was abolished
by the Act of 1966.
3.1.2 ASSETS AND LIABILITIES IN BANKING:
The money that a bank receives as deposits from its depositors becomes a banks liability. The
Loan provided by a Bank to its customers is a receivable and hence an asset to the bank .Further
Loans are a source of providing interest income and deposit interests are an expense to the
bank. The Bank further makes an income based on the lending rate-deposit rate spread. The
chart shown here depicts how this process works.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
This section of the document (Retail Banking) deals with only Retail Bank Liabilities or in other
terms Deposit Products and Services. The retail bank assets (Cards and Payments, Consumer
Lending, Mortgages) are dealt in separate sections.
3. 2 DEPOSIT PRODUCTS
Banks offer the facility of holding excess cash of a consumer and pay an interest for the money
placed with it. Deposits can be of two types Demand deposits are accounts that allow money
to be deposited and withdrawn by the account holder on Demand (Savings, Checking). Another
Class of deposits is placed with a bank for a specified term and is called Term Deposits. Banks
may charge a maintenance fee for this service, while others may pay the customer interest on
the funds deposited.
Features of Deposit Products:
1. A customer can deposit and withdraw money from his Deposit Account. The frequency
and limit of withdrawal differs from account to account.
2. Checks can be issued by the customer to withdraw or transfer money from his account.
There may be restrictions as to number of checks issued in a month.
3. Interest is generally paid for all deposit products except for certain type of accounts like
checking accounts.
4. A minimum balance needs to be maintained in most of the accounts, failing which the
bank will charge a penalty. But there are certain types of accounts like No frill accounts
or Zero Balance accounts in which the customer need not maintain any balance.
5. Given below is the snap shot comparison of all the major types of accounts in a retail
bank:
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Cognizant Confidential Foundation Course in Banking and Capital Markets
A. Basic or No Frill Banking Accounts
Many institutions offer accounts that provide a limited set of services for a low price
often referred to as "basic" or "no frill" accounts. They are usually checking accounts,
but they may limit the number of checks written and the number of deposits and
withdrawals made. Interest generally is not paid on basic accounts.
B. Credit Union Accounts
Credit unions offer accounts that are similar to accounts at other depository institutions,
but have different names. Credit union members have "share draft" accounts (rather
than checking), "share" accounts (rather than savings), and "share certificate" accounts
(rather than certificate of deposit).
C. Individual Retirement Accounts (IRA)
An Individual Retirement Arrangement (or IRA) is a retirement plan account that
provides some tax advantages for retirement savings in the United States. These allow a
customer to save for his retirement by investing it in the IRA and using it as a channel to
invest in other products. Withdrawal before the stipulated time incurs heavy penalty
and foregoing taxes for the period used.
There are a number of different types of IRAs, which may be either employer-provided
or self-provided plans. The types include:
Roth IRA - contributions are made with after-tax assets, all transactions within
the IRA have no tax impact, and withdrawals are usually tax-free.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Traditional IRA - contributions are often tax-deductible (often simplified as
"money is deposited before tax" or "contributions are made with pre-tax
assets"), all transactions and earnings within the IRA have no tax impact, and
withdrawals at retirement are taxed as income (except for those portions of the
withdrawal corresponding to contributions that were not deducted).
SEP IRA - a provision that allows an employer (typically a small business or self-
employed individual) to make retirement plan contributions into a Traditional
IRA established in the employee's name, instead of to a pension fund account in
the company's name.
SIMPLE IRA - a simplified employee pension plan that allows both employer and
employee contributions, similar to a 401(k) plan, but with lower contribution
limits and simpler (and thus less costly) administration. Although it is termed an
IRA, it is treated separately.
Self-Directed IRA - a self-directed IRA that permits the account holder to make
investments on behalf of the retirement plan.
3. 3 RETAIL CHANNELS
3.3.1 BRANCH BANKING
A banking system in which there is a head office and interconnected branches providing
financial services in different parts of the country
Branch networks have re-emerged as combined centers for advice-based product sales and
service, in addition to traditional banking transactions
These are full-service centers -- from banking products to brokerage services
Branches are being transformed from transaction processing centers into customer-centric,
financial sales and service centers
A typical Retail branch at a Bank has these two primary activities:
o Teller Operations
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Cognizant Confidential Foundation Course in Banking and Capital Markets
o Relationship Managers
TELLER OPERATIONS
A bank teller is an employee of a bank who deals directly with most customers. In some
places this employee is known as a cashier. Tellers are considered a "front line" in the
banking business. This is because they are the first people that a customer sees at the bank
and are also the people most likely to detect and stop fraudulent transactions in order to
prevent losses at a bank (i.e. counterfeit currency and checks, identity theft, con artist
schemes, etc.). The position also requires tellers to be friendly and interact with the
customers, providing them with information about customers' accounts and bank services.
Most tellers have a window (or wicket), a computer terminal, and a cash drawer from which
they perform their transactions. These transactions include, but are not limited to:
Check cashing, depositing
Savings deposits, withdrawals
Consignment item issuances (i.e. Cashier's Checks, Traveler's Checks, Money Orders,
Federal Draft issuances, etc.)
Payment collecting
Promotion of the financial institution's products (loans, mortgages, etc.)
Business referrals (i.e. Trust, Insurance, lending, etc.)
Cash advances
Savings Bonds purchase or redemption
Resolving customer issues
Balancing the vault, cash drawers, ATMs, and TAUs
May include ordering products for the customer (checks, deposit slips, etc.)
RELATIONSHIP MANAGERS/PRODUCT SPECIALISTS:
Relationship Managers are the Banks single point of contact to the customer. They have day-to-
day personal contact with the Client for new account opening, account maintenance and
product sales and also develop tailored banking solutions for each Client. Generally, a Banks
Global Relationship Manager coordinates the efforts of local Relationship Managers and Product
Specialists around the world. The Global Network of Relationship Managers ensures a global
level oversight of the client relationship.
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3.3.2 CORE BANKING/MULTI BRANCH BANKING
It is a special facility that allows a customer to operate his Accounts through a network of
branches of the bank where he has an account. All Multi Branch Banking account holders are
eligible for Multi City Check (Pay At par Check) facilities. Under this service, the customer of one
branch is able to transact on her account, from any other Networked branch of the Bank. The
advantages of this is that there are quicker turnarounds in clearing, payments and the customer
is not subjected to any systemic delays due to geographical constraints. This is usually facilitated
by the implementation of a set of software called banking applications which handle the
transactions end to end from booking to posting to the customer accounts and GLs and also
interface with other applications of the bank. Some core banking vendors of repute are Fidelity,
Temenos, Infosys (Finacle), Oracle (FLEXCUBE).
3.3.3 ATM
An automated teller machine (ATM) is a computerized telecommunications device that
provides the customers with access to financial transactions in a public space without the
need for a human clerk or bank teller. The customer is identified by inserting a plastic ATM
card with a magnetic strip or a plastic smartcard with a chip that contains a unique card
number and some security information, such as an expiration date or CVC (CVV). Security is
provided by the customer entering a personal identification number (PIN).
ATMs are known by various other names including automated banking machine, money
machine, bank machine, cash machine, hole-in-the-wall, cash point, Bancomat (in various
countries in Europe and Russia), Multibanco (after a registered trade mark, in Portugal), and
Any Time Money (in India).
Typical ATM Services
o Cash withdrawal Limit per day restricted by respective bank guidelines
o Money Transfer between accounts
o Cash/ Check Deposits
o Utility Bill Payments
o Balance enquiry /Account Statements
o Mobile Top Ups
An interbank network, also known as an ATM consortium or ATM network, is a computer
network that connects the ATMs of different banks and permits these ATMs to interact with
the ATM cards of non-native banks. E.g.: Cirrus, Maestro, Plus, etc
Debit cards and ATM cards are used to transact in ATMs and PoS (Point of Sale) Terminals.
Visa and Master networks are large global networks that service ATMs
The Bank / Entity that issue the card to the customer is called an Issuer while the
Bank/Entity that acquires the transaction through the ATM / PoS terminal is an acquirer. The
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Cognizant Confidential Foundation Course in Banking and Capital Markets
network handles the routing of the transaction from the Acquirers terminal to the
accounting systems of the Issuer and processes the settlements through the intermediary
networks.
3.3.4 TELEPHONE BANKING
Telephone banking allows customers to perform transactions over the telephone. Most
telephone banking configurations use an automated phone answering system (IVR/VRU)
with phone keypad response or voice recognition capability.
Voice Response Unit (VRU), is a computer telephony integration (CTI) term that refers to
the interaction between a human (typically a caller) and a computer that is programmed
to respond to the human's requests.
Also referred to as interactive voice response (commonly abbreviated to IVR), this is a
computer phone application that accepts touch-phone keypad selection input from the
caller and provides appropriate information in the form of voice answers or a
connection to a "live" operator in a Contact Center.
With the obvious exception of cash withdrawals and deposits, it offers virtually all the
features of an automated teller machine: account balance information and list of latest
transactions, electronic bill payments, funds transfers between a customer's accounts,
etc.
3.3.5 CONTACT CENTRE/CALL CENTRE
Usually, customers want to speak to a live representative located in a call centre, although this
feature is not guaranteed to be offered 24/7. In addition to the self-service transactions listed
earlier in Phone Banking, telephone banking representatives are usually trained to do what was
traditionally available only at the branch: loan applications, investment purchases and
redemptions, check book orders, debit card replacements, change of address, etc.
The contact centre /Call centre handle inbound service calls, technical support requests and
sales enquiries, Sell products and advice through outbound calls. Web enabled services too are
part of the mix. Outbound services originate at the lead generation teams which aim at
sales/marketing, collections and surveys. Apart from Telephonic services, the contact centers
provide web enabled services. - Email, Live chat and Live support.
3.3.6 ONLINE BANKING
Online banking (or Internet banking) allows customers to conduct financial transactions on a
secure website operated by their bank or credit union.
The common features fall broadly into the following broad categories:
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Account Management: - Enquiries , Transactions , Account Opening (Assets and Liability)
Investment Services and Advisory
Personal finance management
Bill Pay and Recurring payments
Statements : Monthly or quarterly bank statements
Fund transfer: Funds transfer between a customers own checking and savings accounts
or to another customers account
Secure mail and chat
Collaboration blogs , podcasts, RSS Feeds
3.3.7 MOBILE BANKING
Mobile banking (also known as M-Banking, mbanking, SMS Banking etc.) is a term used for
performing balance checks, account transactions, payments etc. via a mobile device such as a
mobile phone, PDA, Blackberry, iPhone etc. Given below is the list of services offered by retail
banks through mobile banking.
Account Information:
Mini-statements and checking of account history
Alerts on account activity
PIN Set, Reset, Change
Blocking of (lost, stolen) cards
Transactions:
Domestic and international fund transfers
Micro-payment handling
Bill payment processing
Investments:
Portfolio management services
Real-time stock quotes
Personalized alerts and notifications on security prices
Support:
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Check book and card requests
Exchange of data messages and email, including complaint submission and tracking
Content Services:
General information such as weather updates, news
3. 4 INSTRUMENTS
Instruments are used to move and /or transfer funds from one account to another. The account
can be of the same person or different individuals. Instruments are also modes of payment.
Some of the common instruments are as follows:
Checks
Cashiers check
Certified Check
Travelers Check
A check is a bill of exchange and is an instrument instructing a financial institution to pay a
specific amount of a specific currency from an account holders specific demand account held in
that bank. The receiver of the check is payee and the amount will be either credited into the
payee account or the payee can encash the check from the makers bank (drawer).
Given below are the various methods of processing a check.
3.4.1 PAPER CHECK PROCESSING
Paper check processing is the traditional physical check processing. The drawer issues
the check in the name of the Payee. The Payee presents the check in the
drawer/makers bank to the credit of his account.
3.4.2 CHECK IMAGING/CHECK TRUNCATION
When checks are deposited, they are converted into digital files. These images can be
then exchanged between financial intermediaries via the web, e-mail, CD-ROM or faxes
instead of actual transportation of paper checks. Once digitized, this information can be
used to settle and debit accounts. The image can be used as the check writers receipt
for the transaction. This clearing and settlement process is known as Check-truncation.
By introducing check-truncation, intra-city clearing turn-around-times can be reduced
dramatically.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
3.4.3 RETURNED/ITEM PROCESSING
Not all checks move easily through the check collection system, however. Sometimes a
check is returned for various reasons like insufficient funds, improper details, signature
not clear etc. If a bank refuses to honor a check, the check must be returned to the bank
where the check was first deposited within a certain period specified by law. The bank
then investigates the item and takes corrective action to process the check. These are
called exceptions or returned items.
3.4.4 ELECTRONIC CHECK CONVERSION
An electronic check is a transaction that starts at the cash register with a paper check
for payment, but the payment is converted to an electronic debit, which is processed via
the ACH network. ECC converts a paper check into an electronic payment at the point of
sale or elsewhere. The following are the typical steps followed in a check conversion
In a store, the customer can present a check to a store cashier.
The check can be processed through an electronic system that captures the
banking information and the amount of the check.
Once the check is processed, the customer signs a receipt authorizing the store
to present the check to the bank electronically and deposit the funds into the
stores account.
The customer gets a receipt of the electronic transaction and the check is
returned to the customer.
It should be voided or marked by the merchant so that it can't be used again.
3. 5 RETAIL PAYMENTS
Retail payments usually involve transactions between consumers and businesses. Although
there is no definitive division between retail and wholesale payments, retail payment systems
generally have higher transaction volumes and lower average dollar values than wholesale
payments systems. This section provides background information on payments typically
classified as retail payments. Consumers generally use retail payments in one of the following
ways:
Purchase of Goods and ServicesPayment at the time the goods or services are
purchased. It includes attended (i.e., traditional retailers), unattended (e.g., vending
machines), and remote purchases (e.g., Internet and telephone purchases). A variety of
payment instruments may be used, including cash, check, credit, or debit cards.
Bill PaymentPayment for previously acquired or contracted goods and services.
Payment may be recurring or nonrecurring. Recurring bill payments include items such
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Cognizant Confidential Foundation Course in Banking and Capital Markets
as utility, telephone, and mortgage/rent bills. Non-recurring bills include items such as
medical bills
P2P PaymentsPayments from one consumer to another. The vast majority of
consumer-to-consumer payments are conducted with checks and cash, with some
transactions conducted using electronic P2P payment systems.
Cash Withdrawals and AdvancesUse of retail payment instruments to obtain cash
from merchants or automated teller machines (ATMs). For example, consumers can use
a credit card to obtain a cash advance through an ATM or an ATM card to withdraw cash
from an existing demand deposit or transaction account. Consumers can also use
personal identification number (PIN)-based debit cards to withdraw cash at an ATM or
receive cash-back at some point-of-sale (POS) locations.
Important Trends in Retail Payments:
Shift from paper to electronic payments: Recent research has found that consumer use
of electronic payments has grown significantly in recent years, and the trend will
accelerate.
Increase in Online Transactions: Debit and credit cards were one of the key drivers for
much of the growth in electronic payments. Although on-line, or PIN-based, debit cards
were introduced in the early 1980s, rapid adoption has only occurred since the early
1990s. Off-line, or signature-based, debit cards, introduced in the late 1980s, have
experienced significant growth since the mid 1990s, and recent surveys have found that
off-line debit card transactions have now overtaken on-line debit card transactions by
almost a three-to-one margin.
Growth in ACH Payments: Consumers traditionally used checks for a large portion of bill
payments in the United States. However, consumers are increasingly using direct bill
payment through the ACH. Despite the increase in electronic bill payment, many
consumers still rely on checks to make a significant portion of their bill payments. More
recently, retail firms have employed check to ACH conversion processes to allow
electronic settlement, thus reducing the number of checks that flow through the
payment system.
Internet Banking and Internet Payment Processors PayPal, Google Expedited Bill
Payments Internet-based bill payment systems are transaction origination platforms
that allow customers to initiate bill payments using existing payment systems.
Depending on the bill payment software, service provider, and payment receiver used,
the payment transaction may be processed as an electronic funds transfer (EFT), ACH, or
check
3. 6 ELECTRONIC BANKING
For many of us, electronic banking means 24-hour access to cash through an automated teller
machine (ATM) or Direct Deposit of paychecks into checking or savings accounts. But electronic
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Cognizant Confidential Foundation Course in Banking and Capital Markets
banking now involves many different types of transactions like Electronic Bill presentment,
Mobile banking, Online Banking, Electronic Check Conversion etc.
Electronic banking, also known as electronic fund transfer (EFT), uses computers and payment
networks as a substitute for checks and other paper transactions. EFT is initiated through
devices like cards or codes that let the customer access their account. Many financial
institutions use ATM or debit cards and Personal Identification Numbers (PINs) for this purpose.
Some use other forms of debit cards such as those that require, at the most, signature or a scan.
The federal Electronic Fund Transfer Act (EFT Act) covers some electronic consumer transactions
-
Automated Teller Machines (ATMs)
Direct Deposit
Phone Banking/Mobile Banking- (IVR/VRU)
Internet Banking
Debit card purchase transactions
Electronic Check Conversion
Call centre/Contact centre
Check Imaging /Check Truncation
ELECTRONIC BILLING PRESENTATION AND PAYMENT (EBPP)
Electronic Bill Payment allows a depositor to send money from his / her demand account to a
creditor or vendor such as a public utility or a department store to be credited against a
specific account.
Presentment and Payment
Electronic bill presentment and payment (EBPP) is a process that enables bills to be created,
delivered, and paid over the Internet. Customers can pay their utility bills such as Electricity,
Telephone, Gas, and insurance premiums online.
The following figure shows the flow between various parties in EBPP.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Once a consumer has enrolled for EBPP services, the biller generates the electronic version of
the Consumers Billing information. The biller may outsource this using BSP (Bill Service
Provider). The BSPs /Billers provide such services as electronic bill translation, formatting, data
parsing, notifying the consumer of pending bill. The consumer logs on to the specified website
where he is allowed to view/print the E-bill. He can initiate payment directly from the same
website.
3. 7 SALES AND MARKETING
Banking has evolved from its traditional role as the place of Savings and Deposits. With the
prevailing competition in the market among the banks, a serious effort has to be made by each
bank to promote themselves and their products. A Retail bank will typically concentrate in the
following areas:
Product Development :
Increase the knowledge about the market place, Check the new product viability,
competitively price the product and identify new innovations.
Marketing, Sales and Customer Development :
Improve knowledge about the overall market, identify new customer segments,
improve effectiveness of sales force (salesmen, online ads, offers, etc), maintain
optimum product mix, increase effectiveness of marketing campaign, estimate and
improve the sales channel performance and maintain the sales collateral.
Customer Service and Branch Operations :
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Effectiveness of the Customer Service Manager or Relationship manager, Generate new
business from existing customers, retain the most valuable customers and maintain
customer satisfaction levels.
Transactions and Back-office support:
Improve the service quality, streamline transactions & optimize delivery through phone
banking, Net Banking, Mobile Banking, etc., effectively manage data and business
analysis.
3. 8 A SCHEMATIC OF A RETAIL BANK
The banking operations are basically divided in to three; Front office, Middle Office and Back
Office. Front office is what we otherwise call the Banking channels Branch, ATM, Banks
Website, etc. where the customers contact the Banks representatives for their financial
services. Middle Office is where the decisions are made about the product, interest rate, credit
policies, Compliance monitored etc. Back office mostly does the data base management, data
processing, transaction processing etc. The Middle Office and Back Office operations are
generally not exposed to the customers. The picture below gives an overview of all the
operations in retail bank.
SUMMARY
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Retail banking pertains to banking service to individuals and SMEs.
Retail banks have various flavors such as Community Development Banks, private Banks,
Offshore Banks, Savings Banks and Postal Banks.
Retail Banking has both assets and liabilities and only Liabilities (deposit products) are dealt
in this document
The various deposit products are
o Checking accounts
o Money Market Accounts
o Savings Accounts
o Time Deposits
o Basic or No frill Banking
o Credit Union Accounts
o IRA
Retail banking channels are
o Branch Banking
o Core Banking
o ATM
o Telephone Banking
o Call Centre
o Online Banking
o Mobile Banking
Checks can be processed in various modes: Paper check processing, check imaging /Check
truncation, Electronic Check conversion.
Consumers generally use one of these retail payments systems: Purchase of Goods and
Services, Bill Payment, P2P payments, Cash withdrawals and Advances.
Electronic banking, also known as electronic fund transfer (EFT), uses computer and
electronic technology as a substitute for checks and other paper transactions.
The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic customer
transactions.
EBPP is a mode of transaction involving the use of electronic means, such as email or a short
message, for rending a bill.
Sales and marketing strategies have gained importance currently. Every bank is seriously
working towards promoting their products in the market.
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4. 0 MORTGAGES AND CONSUMER LENDING
4. 1 MORTGAGE
A mortgage represents transfer of interest on a property/house to a lender as a security of debt
which is usually a loan taken for buying a house. This loan has to be paid over a specified period
of time. Think of it as customer personal guarantee that he will repay the money he has
borrowed to buy his home. Strangely enough, the word "mortgage" comes from the French
word "mort," which means "dead," and "gage," from Old English which means "pledge".
Nowadays, the term mortgage is commonly used to refer to a loan for the purpose of
purchasing a property. We don't associate anyone's death with it!
Most mortgage loans are negotiated for a set time period and Interest rate. Interest rate could
be fixed for the entire loan term or floating or Hybrid (Fixed for certain period). Generally,
customer can pay off a loan in full or in part at any time, although bank may charge a penalty
depending upon the terms and conditions.
4.1.1 RESIDENTIAL MORTGAGE
A residential mortgage is a loan made using residential property as collateral to secure
repayment. In United States, single family homes that have maximum up to 4 units qualify for a
residential mortgage. The residential mortgages are taken on by individual borrowers for buying
a house, an apartment, or renovation of house or apartment.
The majority of residential mortgages require the borrower to make a monthly payment which
is enough to pay off the loan over a 10 to 25 year time frame. There are many types of mortgage
loans in the market. These are designed to suit various requirements of the borrowers including
the length of mortgage, capability for initial payment, and the other financial obligations.
4.1.2 COMMERCIAL MORTGAGE
A commercial mortgage is a loan made using commercial real estate, like multifamily property,
or an office complex etc. as collateral to secure repayment. A commercial mortgage is similar to
a residential mortgage, except the collateral is a commercial building or other business real
estate, not residential property. In addition, commercial mortgages are typically taken on by
businesses instead of individual borrowers. The borrower may be a partnership, incorporated
business, or limited company, so assessment of the creditworthiness of the business can be
more complicated than is the case with residential mortgages.
The majority of Commercial Mortgages require the borrower to simply make a monthly
payment small enough to pay off the loan over a 20 to 30 year time frame. The borrower most
likely will attempt at that time to refinance the loan or sell the property. The length of the loan
can vary from a matter of days to 30 years.
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Common applications of commercial mortgage loans include acquiring land or commercial
properties, expanding existing facilities or refinancing existing debt.
4.1.3 MORTGAGE PROCESS FLOW
The various stages involved in a loan life cycle are shown below:
ORIGINATION
This is a process by which a mortgage is secured by a borrower is called origination. This involves
the borrower submitting an application and documentation related to his/her financial history
and/or credit history to the underwriter. A borrower is required to lock a certain rate scenario,
out of the given scenarios, after which his loan can go for processing.
PROCESSING
This process ensures that documentary requirements are fulfilled and regulatory checks are
done. The borrower may be asked for additional information and supporting documentary
proof(s) about his employment credentials, financial position, property details and other assets
and liabilities associated with the borrower. Various reports, like credit report, property
appraisal etc. are also required for file processing, which are fired at this stage.
UNDERWRITING
This is a process by which a lender determines if the risk of lending to a particular borrower
under certain parameters is acceptable. Most of the risks and terms that underwriters consider
fall under the three Cs of underwriting: Credit, Capacity and Collateral. To help the underwriter
assess the quality of the loan, banks and lenders create guidelines and even computer models
that analyze the various aspects of the mortgage and provide recommendations regarding the
risks involved. However, it is always up to the underwriter to make the final decision on whether
to approve or decline a loan.
CLOSING AND FUNDING
After the loan has been underwritten and the borrower agrees with the loan terms, the loan
moves into the Closing and Funding stage(s) when the actual contracts are signed and sent, the
property is registered and the seller payments are cleared.
LOAN SERVICING
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Loan servicing (sometimes also referred to a Loan Administration) refers to the part of the
mortgage value chain that starts after the closure of the loan and extends till the loan is fully
repaid and settled. It includes activities such as cash management for periodic payments and
disbursements, investor accounting, investor reporting, customer servicing, delinquency
management, records management etc.
As shown in the schematic above, Loan Servicing involves collecting monthly payments from
borrowers, remitting the payments to the investors (or security holders), handling contacts with
borrowers about payments & delinquencies, maintaining records, initiating foreclosure
procedures and handling taxes and insurance premiums (through escrow accounts as
applicable).
The collection of mortgage payments and the periodic remittance of these payments to the
investors (or conduits) is the major task of servicers. In addition, servicers are the primary
repository of information on the mortgage loans. Thus, they must maintain accurate and up-to
date information on mortgage balances, status and history and provide timely reports to
investors.
4.1.4 MORTGAGE LOAN TYPES BASED ON REPAYMENT PATTERNS
Lending industry has developed variety of mortgage loan programs based on interest rate
charged to borrowers. Following are widely used mortgage loan programs:
Loan Type How it works
Fixed Rate
A fixed Rate Mortgage (FRM) is a mortgage loan where the interest
rate on the note remains the same through the term of the loan
Balloon Payment Balloon Payment Mortgage has a fixed rate for the term of the loan
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Loan Type How it works
Mortgage followed by the ending balloon payment.
Adjustable Rate
Mortgage (ARM)
An Adjustable Rate Mortgage (ARM) is a mortgage loan where the
interest rate on the note is periodically adjusted based on a variety of
indices such as 1-year constant-maturity Treasury (CMT) securities, the
Cost of Funds Index (COFI), and the London Interbank Offered Rate
(LIBOR). A few lenders use their own cost of funds as an index, rather
than using other indices.
Graduated Payment
Mortgage
A graduated payment mortgage loan, often referred to as GPM, is a
mortgage with low initial monthly payments which gradually increase
over a specified time frame. These plans are mostly geared towards
young people who cannot afford large payments now, but can
realistically expect to do better financially in the future.
Interest Only Loan
An interest-only loan is a loan in which for a set term the borrower
pays only the interest on the principal balance, with the principal
balance unchanged. At the end of the interest-only term the borrower
may pay the principal, or (with some lenders) convert the loan to a
principal and interest payment loan at his option.
Negative
Amortization
Amortization refers to gradual decrease of principal balance of the
loan as the loan is repaid gradually over its term.
Negative Amortization occurs whenever the loan payment for any
period is less than the interest charged over that period and so the
outstanding balance of the loan increases. Such a practice is agreed
upon before shorting the payment so as to avoid default on payment.
Standard Variable
Rate with Cash Back
Same as a standard ARM loan - but one receive a substantial cash sum
(Example 35% of the amount borrowed) when we take up the loan.
Base Rate Tracker
Similar to a standard variable rate mortgage but the interest rate is
guaranteed to be a set amount above the base rate and alters in line
with changes in that rate.
Discounted interest
rate
The payments are variable, but they are set at less than that lenders
going rate for a fixed period of time. At the end of the period, one is
charged the lenders standard variable rate.
Capped rate
The payments go up and down as the mortgage rate changes but are
guaranteed not to go above a set level (the cap) during the period of
the deal.
Sometimes, they cannot fall below a set minimum level either (the
collar or floor). At the end of the period, one is charged the lenders
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Loan Type How it works
standard variable rate.
4.1.5 MORTGAGE LOAN TYPES BASED ON MORTGAGE LOAN PROGRAMS
Loan Program How it works
FHA Loan
FHA loans are meant for lower income Americans to borrow money for
the purchase of a home that they would not otherwise be able to
afford. FHA loan is a federal assistance mortgage loan in the United
States insured by the Federal Housing Administration. The loan may be
issued by federally qualified lenders.
VA Loan
The basic intention of the VA direct home loan program is to supply
home financing to eligible veterans in areas where private financing is
not generally available and to help veterans purchase properties with
no down payment. The VA loan was designed to offer long-term
financing to American veterans or their surviving spouses provided
they do not remarry.
Conventional Loans These are loans without any government backing.
Agency Loans
These are the loans issued by Government Sponsored Entities (GSEs)
such as Federal National Mortgage Association (Fannie Mae), Federal
Home Loan Mortgage Corporation (Freddie Mac) and Government
National Mortgage Association (Ginnie Mae).
4.1.6 MORTGAGE BACKED SECURITY
Mortgage backed Security (MBS) is a type of asset-backed security that is secured by a mortgage
or collection of mortgages. These securities must also be grouped in one of the top two ratings
as determined by an accredited credit rating agency, and usually pay periodic payments that are
similar to coupon payments. Furthermore, the mortgage must have originated from a regulated
and authorized financial institution.
When we invest in a mortgage-backed security we are essentially lending money to a home
buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its
customers without having to worry about whether the customers have the assets to cover the
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loan. Instead, the bank acts as a middleman between the home buyer and the investment
markets.
4.1.7 MORTGAGE LENDING: UNITED KINGDOM
There are currently over 200 significant separate financial organizations supplying mortgage
loans to house buyers in Britain. The major lenders include building societies, banks, specialized
mortgage corporations, insurance companies, and pension funds. Over the years, the share of
the new mortgage loans market held by building societies has declined. Between 1977 and
1987, it fell drastically from 96% to 66% while that of banks and other institutions rose from 3%
to 36%.
Though the building societies did subsequently recover a significant amount of the mortgage
lending business lost to the banks, they still only had about two-thirds of the total market at the
end of the 1980s. However, banks and building societies were by now becoming increasingly
similar in terms of their structures and functions. When the Abbey National building society
converted into a bank in 1989, this could be regarded either as a major diversification of a
building society into retail banking or as significantly increasing the presence of banks in the
residential mortgage loans market. Research organization Industrial Systems Research has
observed that trends towards the increased integration of the financial services sector have
made comparison and analysis of the market shares of different types of institution increasingly
problematical. It identifies as major factors making for consistently higher levels of growth and
performance on the part of some mortgage lenders in the UK over the years:
The introduction of new technologies, mergers, structural reorganization and the
realization of economies of scale, and generally increased efficiency in production and
marketing operations insofar as these things enable lenders to reduce their costs and
offer more price-competitive and innovative loans and savings products;
Buoyant retail savings receipts, and reduced reliance on relatively expensive wholesale
markets for funds (especially when interest rates generally are being maintained at high
levels internationally);
Lower levels of arrears, possessions, bad debts, and provisioning than competitors;
Increased flexibility and earnings from secondary sources and activities as a result of
political-legal deregulation; and
Being specialized or concentrating on traditional core, relatively profitable mortgage lending and
savings deposit operations.
Mortgage types
Since 1982, when the market was substantially deregulated, there has been substantial
innovation and diversification of strategies employed by lenders to attract borrowers. This has
led to a wide range of mortgage types.
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As lenders derive their funds either from the money markets or from deposits, most mortgages
revert to a variable rate, either the lender's standard variable rate or a tracker rate, which will
tend to be linked to the underlying Bank of England (BoE) repo rate (or sometimes LIBOR).
Initially they will tend to offer an incentive deal to attract new borrowers. This may be:
A fixed rate; where the interest rate remains constant for a set period; typically for 2, 3, 4, 5 or
10 years. Longer term fixed rates (over 5 years) whilst available, tend to be more expensive
and/or have more onerous early repayment charges and are therefore less popular than shorter
term fixed rates.
A capped rate; where similar to a fixed rate, the interest rate cannot rise above the cap but can
vary beneath the cap. Sometimes there is a collar associated with this type of rate which
imposes a minimum rate. Capped rate are often offered over periods similar to fixed rates, e.g.
2, 3, 4 or 5 years.
A discount rate; where there is set margin reduction in the standard variable rate (e.g. a 2%
discount) for a set period; typically 1 to 5 years. Sometimes the discount is expressed as a
margin over the base rate (e.g. BoE base rate plus 0.5% for 2 years) and sometimes the rate is
stepped (e.g. 3% in year 1, 2% in year 2, 1% in year three).
A cash back mortgage; where a lump sum is provided (typically) as a percentage of the advance
e.g. 5% of the loan.
To make matters more confusing these rates are often combined: For example, 4.5% 2 year
fixed then a 3 year tracker at BoE rate plus 0.89%.
With each incentive the lender may be offering a rate at less than the market cost of the
borrowing. Therefore, they typically impose a penalty if the borrower repays the loan within the
incentive period or a longer period (referred to as an extended tie-in). These penalties used to
be called a redemption penalty or tie-in, however since the onset of Financial Services Authority
regulation they are referred to as an early repayment charge.
Self Cert" mortgage
Mortgage lenders usually use salaries declared on wage slips to work out a borrower's annual
income and will usually lend up to a fixed multiple of the borrower's annual income. This
mortgage is similar to alt-doc (low-doc) mortgage in US market. Self Certification Mortgages,
informally known as "self cert" mortgages, are available to employed and self employed people
who have a deposit to buy a house but lack the sufficient documentation to prove their income.
This type of mortgage can be beneficial to people whose income comes from multiple sources,
whose salary consists largely or exclusively of commissions or bonuses, or whose accounts may
not show a true reflection of their earnings. Self cert mortgages have two disadvantages: the
interest rates charged are usually higher than for normal mortgages and the loan to value ratio
is usually lower.
100% mortgages
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Normally when a bank lends customer money, they want to protect their money as much as
possible; they do this by asking the borrower to fund a certain percentage of the property
purchase in the form of a deposit.
100% mortgages are mortgages that require no deposit (100% loan to value). These are
sometimes offered to first time buyers, but almost always carry a higher interest rate on the
loan.
Together/Plus mortgages
A development of the theme of 100% mortgages is represented by Together/Plus type
mortgages, which have been launched by a number of lenders in recent years.
Together/Plus Mortgages represent loans of 100% or more of the property value - typically up to
a maximum of 125%. Such loans are normally (but not universally) structured as a package of a
95% mortgage and an unsecured loan of up to 30% of the property value. This structure is
mandated by lenders' capital requirements which require additional capital for loans of 100% or
more of the property value.
4. 2 OTHER RETAIL LOANS
4.2.1 STUDENT LOANS
Student Loans are Loans availed by eligible students to pursue graduate and post graduate
studies in Schools/Colleges/Universities. These loans are usually provided by banks, Credit
Unions and other financial institutions. Often they are supplemented by student grants which do
not have to be repaid.
STUDENT LOANS - UNITED STATES
Students Loans offered can be categorized broadly into two types:
Federally sponsored loans These loans are federally insured and provide protection
against default. The department of Education guarantees up to 98% and even 100% in
some cases
Non-federally sponsored loans These are insured by the private sector and have no
government backing. The guarantee in this case is only from the private insurers or from
the reserves pledged to securitization
Federally sponsored loans are of two types
Federal Family Education Loan Program (FFELP) - These loans are made by financial
institutions primarily with a floating rate that is adjusted once a year. The interest rate is
capped at 8.25% and the Fed subsidizes the difference between the actual loan rate and
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the rate cap through Special Allowance Payments (SAP). The rates are usually specified
by indexing them to the US Treasury bill rates.
Federal Direct Loan (FDLP)- where the department of Education directly provides the
loans
FFELP or the Federal Family Education Loan Program can further be divided into four types
Federal Stafford Federal Stafford loans are the most common source of education loan
funds in the US. This is available to both graduate and undergraduate students. This loan
could be either subsidized or unsubsidized by the federal government. The interest rate
is a floating rate that is indexed to the 91 day T-Bill and is capped at 8.25%. Sample rates
of during the year 2003-04 were
1. 2.82% in school, grace and deferment
2. 3.42% in repayment and forbearance
Federal PLUS - PLUS loans are availed by the parents of a full- or half-time
undergraduate student. This requires a credit check and hence the parent must have a
good credit history and should have been a citizen or permanent resident of US. The
loans dont require any collateral and the interest payments are tax deductible.
Consolidation loans - A consolidation loan involves two or more existing federally
sponsored loans into one single loan. The interest rate for this is determined by the
weighted average of the loan rates prevailing at that time and capped at 8.25%
There are three principal advantages of consolidation
Convenience By combining loans the borrower is able to focus on repaying one
single loan than handle multiple loans
Interest rate In a low rate scenario the borrower can reduce his cost of borrowing
by taking a new loan at the low prevailing low rates
Repayment The repayment period is extended to 30 years and this reduces the
installment to paid each month
Graduate Plus - The Graduate PLUS loan or Grad PLUS loan is a low, fixed interest rate
student loan guaranteed by the U.S. Government. The Grad PLUS loan is a non-need
credit based loan similar to a private student loan, but with the benefit of having a fixed
interest rate and federal guarantee. The Grad PLUS Loan allows graduate students to
borrow the total cost for their graduate school needs, including tuition, room and board,
supplies, lab expenses, and travel, less any other aid.
The Key Entities in the Student Loan System are Federal government, Schools, Lenders, Servicers
and guarantors and the borrower.
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Federal government: Sponsors and authorizes funds for grants and loan programs.
School: The school is certified by the department of education as an eligible school
to participate in the FFELP or FDLP loan programs. Schools are responsible for
determining borrowers eligibility, recommends and certifies loan amounts,
monitors the enrollment status
Lenders: are the institutions approved by the DOE for voluntary participation in any
or all of the FFELP student loan programs. Typical lenders are usually Banks, credit
unions, S&L institutions, insurance companies and other institutions.
Servicer: is an entity that collects payments on a loan and performs other
administrative tasks associated with maintaining a loan portfolio. The normal
functions include disburse loans funds, monitor loans while the borrowers are in
school, collect payments, process deferments and forbearances, respond to
borrower inquiries and ensuring regulatory compliance.
Guarantor is a state agency, which guarantees or insures the loan and is a not-for-
profit agency. It protects the lenders against loss due to borrower default, death of
borrower, total and permanent disability, bankruptcy, closed school, and ineligible
borrower.
Borrower: is the student / parent who avails of the loan.
STUDENT LOANS OTHER COUNTRIES - AUSTRALIA
As a general rule, all students who attend Australian tertiary education institutions (universities)
are charged higher education fees. However, several measures are in place to relieve the costs
of tertiary education in Australia. Most students are Commonwealth supported. This means that
they are only required to pay a part of the cost of tuition, called the "student contribution",
while the Commonwealth pays the balance; and students are able to defer payment of their
contribution as a HELP (Higher Education Loan Programme) loan. Other domestic students are
full fee-paying (non-Commonwealth supported) and receive no other direct government
contribution to the cost of their education. They can also obtain subsidized HELP loans from the
Government up to a lifetime and up to a certain limit. Australian citizens and (with some
limitations) permanent residents are able to obtain interest free loans from the government
under the HELP which replaced the Higher Education Contribution Scheme (HECS).
HELP is jointly administered by the Department of Education, Science and Training (DEST) and
the Australian Taxation Office (ATO).
Overseas students are charged fees for the full cost of their education and are ineligible for any
loans from the Commonwealth, but may apply for international scholarships.
HELP debts do not attract interest, but are instead indexed to the Consumer Price Index (CPI) on
1 June each year, based on the annual CPI to March of that year. HELP account debtors can
make voluntary repayments. As making voluntary repayments does not exempt the person from
compulsory repayments, if the person intends to pay off the total debt voluntarily, it is
financially advantageous for them to do it before lodging the tax return. Even factoring in the
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10% bonus on voluntary repayments, many people elect not to pay off their debt in advance of
the required repayments because it still works out to be probably the cheapest loan someone
will ever receive. If a person with a HELP debt dies, the debt is cancelled.
STUDENT LOANS OTHER COUNTRIES - UNITED KINGDOM
British undergraduate and PGCE (postgraduate certificate of education) students can apply for a
student loan through their local education authority (LEA) in England and Wales, the Student
Awards Agency for Scotland (SAAS), or their local education and library board in Northern
Ireland. The LEA, SAAS, or education and library board then assesses the application and
determines the amount that the student is eligible to borrow, as well as how much tuition fees,
if any, the students' parents must pay. The family's income; whether the student will be living at
home, away from home, or in London; disabilities; and other factors are taken into account.
Loans are provided by the Student Loans Company and do not have to be repaid until the April
of the year after students have completed their course and are earning 15,000 a year. The
interest rate is updated annually and is tied to inflation. The loan is normally repaid using the
PAYE (Pay as you earn) system, with 9% of the graduate's gross salary over 15,000
automatically being deducted to pay back the loan.
The Higher Education Act 2004 made significant changes to the loans system in England, Wales
and Northern Ireland from 2006. Those with sufficient private funding can still pay tuition fees
'upfront' but everyone who satisfies residence criteria - regardless of their income - is now
entitled to take out a loan to pay their fees.
Student Finance England
For all students whose 'domicile' (family or full-time home base) is in England, radical changes
are underway to enhance and improve the student finance system. Now known as Student
Finance England, this is a comprehensive new service which is being phased in between 2008
and 2012 and is being based on widespread consultation with students, prospective students,
parents and other 'sponsors' helping a student through university. It seeks to reduce
significantly the amount of time and effort required to apply for finance. The time scale of
application is being changed, so that a student will be able to apply for finance at the same time
as they apply for a university place. First year students will have to deal with just two agencies
Universities & Colleges Admissions Service (UCAS, to apply for a place) and the Student Loans
Company, which will share much of the information, supplied to UCAS and will then assess the
applicant's eligibility for finance and make the appropriate payments.
4.2.2 AUTO LOANS
Retail Auto lending is basically lending to the individual customers for cars, two wheelers,
recreational vehicles and boats for their personal use. Now-a-days there are plenty of options
available for auto finance or auto loans. Banks, Credit Unions, Dealerships, and even auto
manufacturers are also into auto financing. Some of the auto finance companies are Citicorp, JP
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Morgan Chase, General Motors Acceptance Corporation, Ford Motor Credit, Bank of America,
Toyota Motor Credit, Hyundai Motor Finance Company (HMFC) etc.
On the other hand wholesale lending is about financing the auto dealer. The dealer is financed
with a variety of loan products, mainly floor plans for financing the purchase of cars from the
automobile manufacturer.
GMAC has definitely led the way in the car loan business. But, of course, the other major
manufacturers also recognized the profitability associated with the auto loan business and
entered the market. These companies are known as captive finance companies. Captive
Finance is a term to signify that the lending company is wholly owned by the automobile
manufacturer. Examples, other than GMAC, are NMAC (Nissan Motor Acceptance Corporation),
Ford Credit (Ford Motor Credit Company), Hyundai Motor Finance Company (HMFC), Chrysler
Credit (Daimler-Chrysler).
The following section describes the multiple mechanisms by which the financing for auto loans is
normally done.
Types of Financing Mechanism
Direct Lending: The Bank or the finance company directly lends to the buyer or the
borrower in this case. A number of lending institutions are offering such loans on their
websites.
Dealer financing: This is a type of loan available through the dealer. The lending and
repayments are done by/to the dealer. Basically the dealer tells the customer how much
down payment and monthly Installment is to be paid against the vehicle. The effective
cost to the customer most of the times is generally more than the original price.
Leasing: Vehicle/ Auto lease is a contract between the borrower and an auto leasing
company. The borrower agrees to pay the leasing company for the use of the vehicle for
a certain amount of time, usually 24 to 36 months. During that time the borrower
agrees to make monthly lease payments, keep the car in good repair, insure the car and
not drive the car more miles that stipulated in the contract.
The Key entities in a lease agreement are the lessee and the lessor.
Lessee or the borrower: The party to whom the vehicle is leased. In a consumer lease, the lessee
is the consumer. The lessee is required to make payments and to meet other obligations
specified in the lease agreement.
Lessor or the lender or the lending institution is the original owner of the vehicle or property
being leased
The lease can be closed ended or open ended as defined below:
Closed end lease - A lease agreement that establishes a non-negotiable residual value
for the leased auto and fee amounts due at the end of the lease term.
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Open End lease - A lease term that requires the lessee to pay the difference between
residual value and fair market value at the end of the lease term if the fair market value
is lower
In a lease, the factors such as the ownership, upfront costs and monthly payments as against the
direct lending are:
Ownership: We do not own the vehicle. We get to use it but must return it at the end of
the lease unless we choose to buy it.
Up-front costs: Up-front costs may include the first month's payment, a refundable
security deposit, a capitalized cost reduction (like a down payment), taxes, registration
and other fees, and other charges.
Monthly payments: Monthly lease payments are usually lower than monthly loan
payments because we are paying only for the vehicle's depreciation during the lease
term, plus rent charges (like interest), taxes, and fees.
The Key Entities in an Auto Loan process are:
Borrower: is the one who needs to use/own the automobile and approaches a
dealer/lender for getting financing for the same
Dealer: Typically a franchisee of the manufacturer, involved in selling and delivery of the
vehicle to the buyer
Lender: Provides capital to the borrower for buying the vehicle. This can be captive
financiers, the banks, Credit unions and auto finance companies.
Credit bureau: Tracks and maintains credit history of borrowers and forward it to
lenders during new application processing. This is used for deciding whether the loan
should be provided to a customer or not.
Appraiser: Assesses and establishes the fair market value of collateral offered as
underlying security to the credit asked for.
Insurer: The Insurance company insures the vehicle owner against specific liabilities
caused to and from the vehicle during the course of its use upon the payment of a
premium and signing of a contract
Loan servicer: is the one who provides various services during the life cycle of a loan
starting from loan origination to loan closure.
Collection agencies: These are typically third party agencies that assist auto lenders with
chronic delinquent accounts.
Repossession agencies: These are third party agencies which assist auto lenders with
repossession of vehicles.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Valuation agencies: Black book and ALG help auto lenders with valuation of vehicles
Auto loan process
The Auto Finance Loan process can be divided into Loan origination, Servicing, and Secondary
marketing.
Loan Origination is the process by which a borrower applies for a new loan, and a lender
processes that application. Origination generally includes all the steps from taking a loan
application through disbursal of funds (or declining the application). Credit decision is the major
milestone during loan origination process. This would depend on many factors like the credit
rating of the customer provided by the credit bureaus, capacity of the customer to repay back
the loan amount, the nature of the vehicle requested to be financed, and the amount of down-
payment offered. The credit decision can also be done for a very good application meeting all
credit policies and guidelines by the loan processing system automatically thereby reducing the
time required for manual processing by the Analysts. Or it would reject the application based on
these factors, the rejected application would be sent to Credit Analyst for further processing.
Once the decision is taken lender would contact the customer through phone, fax or e-mail to
let him know the decision. US Legislations mandate the distribution of hard-copy letters to the
Applicants informing them of the reasons in case of a denial of credit or for a counter offer.
Loan servicing generally covers the process post disbursement of the funds until the loan is fully
paid off or charged off. Some of the major sub processes under loan servicing are:
1. Managing monthly repayments
2. Customer Service Managing customer communication, communications sent to
customers at different events like late payment, change in customer details, making
changes in the loan terms and conditions etc.
3. Managing premature closure of loan partially or fully.
4. Managing payment defaults in case customer doesnt pay the installment amount. This
involves following up the customer for payments. In case of payment default the account
is termed to be a delinquent account. The lender can repossess the vehicle if payments
are not forthcoming despite follow up. The outstanding amount under a delinquent
account is charged off (off the books) beyond a certain amount of days past due.
Auto loan receivables can be securitized into pools called as Asset Backed Securities (ABS. This
offers liquidity advantages to an auto lender.
4.2.3 PERSONAL AND CONSUMER LOANS
Personal loans are amount borrowed by individuals to cover their personal expenses. The details
of such expenses are never of any interest to the lenders. Some of the features of personal loans
are:
The financer is not interested in the intention of the loan.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
No security
Short term loans
Rate of interest is very steep.
Ideally should be used only in case of an emergency
All banks/finance companies offer these loans
Loan amount is directly linked to borrowers repayment capacity.
4.2.4 LEASE AND HIRE PURCHASE
Lease is a long-term rental agreement for the asset, while Hire Purchase allows the user to own
the asset after all the payments have been made to the lender.
Lease
Two main types operating, financial
The Financier owns the asset.
Depreciation is claimed by the financier.
Tax deduction can be claimed for the full value of the rental paid.
Financier takes care of maintenance, insurance etc.
Hire Purchase
The asset is owned by the financier.
Depreciation can be claimed by the borrower.
Tax deduction can be claimed only to the extent of the interest repayment.
4.2.5 OPEN ENDED LOANS
Open ended loan allow the borrower to borrow additional amount subject to the maximum
amount less than a set value.
Similar to overdraft facilities provided by banks.
Interest is calculated on the daily outstanding balance.
Usually a card (similar to a Credit Card) is issued by the lending institution.
The lending institution has tie-ups with various merchant establishments.
Also allow us to withdraw Cash.
Important Terms;
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Cognizant Confidential Foundation Course in Banking and Capital Markets
a. Limit (L) max outstanding allowed
b. Margin (M) percentage of limit that can be drawn
c. Asset value (AV) value of underlying asset
d. Drawing Power (DP) - lower of L and (1-M)*AV
Example:
Limit =$ 1000; Margin = 30%; Asset Value (initial) = $1000
Date Asset Value (AV) Drawing Power (DP)
1st Jan 2004 $1000 $700
1st Feb 2004 $1600 $1000
1st Mar 2004 $2000 $1000
1st Apr 2004 $500 $350
4. 3 COMMUNITY BANKS, CREDIT UNIONS & BUILDING SOCIETIES
4.3.1 COMMUNITY BANKS
In the United States, Community development banks (CDBs) are banks designed to serve
residents and spur economic development in low- to moderate-income (LMI) geographical
areas. When CDBs provide retail banking services, they usually target customers from
"financially underserved" demographics. Community development banks can apply for formal
certification as a Community Development Financial Institution (CDFI) from the Community
Development Financial Institutions Fund of the U.S. Department of the Treasury.
All Federally chartered CDBs are regulated primarily by the Office of the Comptroller of the
Currency. According to the OCC Charter Licensing Manual, CDBs are required "to lend, invest,
and provide services primarily to LMI individuals or communities in whom it is chartered to
conduct business." State-chartered Community Development Banks are subject to regulations,
qualifications, and definitions that vary from state to state.
Some institutions use the terms CDB and community development financial institution, or CDFI,
interchangeably.
Notable community development banks
The largest and oldest community development bank is Shore Bank, headquartered in the South
Shore neighborhood of Chicago. Through its holding company Shore Bank Corporation, Shore
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Bank promotes its community development mission by operating CDBs and other affiliates in
certain U.S. cities.
Other CDBs include:
Albina Community Bank in Portland, OR
Carver Federal Savings Bank in New York, NY
Central Bank of Kansas City in Kansas City, MO
City First Bank of D.C. in Washington, D.C.
Dryades Savings Bank in New Orleans, LA
Liberty Bank & Trust in New Orleans, LA
Louisville Community Development Bank in Louisville, KY
Neighborhood National Bank in San Diego, CA
Southern Bancorp in Arkadelphia, AR
University National Bank in St. Paul, MN
4.3.2 CREDIT UNIONS
A credit union is a cooperative financial institution that is owned and controlled by its members,
and operated for the purpose of promoting thrift, providing credit at reasonable rates, and
providing other financial services to its members. Many credit unions exist to further community
development or sustainable international development on a local level. Worldwide, credit union
systems vary significantly in terms of total system assets and average institution asset size since
credit unions exist in a wide range of sizes, ranging from volunteer operations with a handful of
members to institutions with several billion dollars in assets and hundreds of thousands of
members. Yet credit unions are typically smaller than banks; for example, the average U.S.
credit union has $93 million in assets, while the average U.S. bank has $1.53 billion, as of 2007.
The World Council of Credit Unions (WOCCU) defines credit unions as "not-for-profit
cooperative institutions." In practice however, legal arrangements vary by jurisdiction. For
example in Canada credit unions are regulated as for-profit institutions, and view their mandate
as earning a reasonable profit to enhance services to members and ensure stable growth. This
difference in viewpoints reflects credit unions' unusual organizational structure, which attempts
to solve the principal-agent problem by ensuring that the owners and the users of the institution
are the same people. In any case, credit unions generally cannot accept donations and must be
able to prosper in a competitive market economy.
Credit unions differ from banks and other financial institutions in that the members who have
accounts in the credit union are the owners of the credit union and they elect their board of
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Cognizant Confidential Foundation Course in Banking and Capital Markets
directors in a democratic one-person-one-vote system regardless of the amount of money
invested in the credit union. A credit union's policies governing interest rates and other matters
are set by a volunteer Board of Directors elected by and from the membership itself. Credit
unions offer many of the same financial services as banks, often using a different terminology;
common services include: share accounts (savings accounts), share draft (checking) accounts,
credit cards, share term certificates (certificates of deposit), and online banking. Normally, only
a member of a credit union may deposit money with the credit union, or borrow money from it.
As such, credit unions have historically marketed themselves as providing superior member
service and being committed to helping members improve their financial health. In the
microfinance context, "Credit unions provide a broader range of loan and savings products at a
much cheaper cost [to their members] than do most microfinance institutions."
4.3.3 BUILDING SOCIETIES
A building society is a financial institution, owned by its members, that offers banking and other
financial services, especially mortgage lending. Building societies are prevalent only in UK.
The term building society first arose in the 19th century, in the United Kingdom, from co-
operative savings groups. In the UK today building societies actively compete with banks for
most personal banking services, especially mortgage lending and deposit accounts. At the start
of 2008, there were 59 building societies in the UK with total assets exceeding 360 billion.
Every building society in the UK is a member of the Building Societies Association. The number
of societies in the UK fell by four during 2008 due to a series of mergers brought about, to a
large extent, by the consequences of the financial crisis of 2007-2009, and further mergers are
planned for the first few months of 2009.
4. 4 FARM CREDIT
The Farm Credit System is a federally chartered network of borrower-owned lending institutions
composed of cooperatives and related service organizations. Cooperatives are organizations
that are owned and controlled by their members who use the cooperatives products, supplies
or services. The U.S. Congress authorized the creation of the first System institutions in 1916.
Their mission is to provide sound and dependable credit to American farmers, ranchers,
producers or harvesters of aquatic products, their cooperatives, and farm-related businesses.
They do this by making appropriately structured loans to qualified individuals and businesses at
competitive rates and providing financial services and advice to those persons and businesses.
Consistent with their mission of serving rural America, they also make loans for the purchase of
rural homes, to finance rural communication, energy and water infrastructures, to support
agricultural exports, and to finance other eligible entities.
Farm Credit institutions are chartered by the federal government and must operate within limits
established by the Farm Credit Act. The Farm Credit System is regulated by an independent
federal agency, the Farm Credit Administration, which has all of the enforcement, regulatory
and oversight authority as other federal financial regulators. Farm Credit is a government-
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Cognizant Confidential Foundation Course in Banking and Capital Markets
sponsored enterprise, or GSE a privately owned set of institutions established by Congress to
address the needs of a specific sector of the economy.
Farm Credit delivers the financial power of Wall Street to agriculture and rural America by
issuing debt in the national and international money markets and using this capital to provide
borrowers with access to reliable and competitive credit. The full financial strength of all of the
Farm Credit banks stands behind the debt issued on behalf of the System. In addition, investors
in Farm Credit debt are protected by the assets of the self-funded Farm Credit System Insurance
Fund, which is administered by an independent agency of the federal government.
The Farm Credit Systems total loans equaled $158.063 billion at September 30, 2008, an
increase of $15.157 billion since December 31, 2007. Approximately one third of the credit
needs of U.S. agriculture are financed by the 99 Farm Credit associations and banks nationwide.
4. 5 RETAIL LENDING CYCLE
1. Loan application management and processing
Receipt of loan/card application
Application Processing
o Duplicate check
o Negative list check
o Document Verification
o Calculate loan eligibility, IRR, processing fees
o Credit scoring
o Field Investigation
o Credit Approval
Disbursement
o Check issuance
o Credit to account
o Payment to third party
Formulating the repayment schedule.
2. Loan repayments and termination
Post-Dated checks
o PDCs are collected & their information captured.
o Checks are presented in clearing on due dates
o Bounced/ hold checks are marked for further action.
Salary deductions
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Cognizant Confidential Foundation Course in Banking and Capital Markets
o Employer wise receipt batches are created.
o Employer check details are captured
o Payment receipt is marked for corresponding employees.
Direct receipts
o Cash/Check information is captured
o Checks are cleared in batches.
Auto payments / Direct debits
o Bank wise receivable batches are created.
o Short receipts are marked.
o Release receipt batch to mark receipts
Kinds of repayments
o EMI same installment amount
o Fixed Principal constant principal, decreasing interest amt
o Step-up principal amount increases in steps
o Step-down principal amount decreases in steps
o Balloon notional amount initially, large last payment
o Bullet interest payment initially, entire principal at one shot
o Random schedule & amount of installments undecided
o Special products combination of above
3. Delinquencies identification and collections
Case Processing
o Categorization of cases based on predefined rules
o Allocation of cases to collectors
Standard Cases
o Collector follow-up (desk/field)
o Repayment by customer
o Check issuance
Exception Cases (death/fraud etc.)
o Initiate process based on case specifics (legal/other means)
o Track/follow up the case developments till repayment
o Case closed
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SUMMARY
The loans given to retail customer would come under Mortgages and other consumer loans
There are two types of Mortgages
o Residential Mortgages
o Commercial Mortgages
The main sub processes under Mortgage process flow are
1. Loan Production
o Origination
o Processing
o Under writing
o Closing and Funding
2. Loan Servicing
o Cash management
o Investor accounting and reporting
o Escrow Administration
o Document custodianship
o Delinquency management
o Customer service
The following are the various types of Mortgages based on repayment patterns
o Fixed Rate
o Balloon Payment Mortgage
o Adjustable Rate Mortgage (ARM)
Submit Proposal
OK
Appraisal
Decision
OK
Disbursement Compliance Conditions for borrower
Monitoring
NO
Repayment Follow-up/Action
Scrutinize
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Cognizant Confidential Foundation Course in Banking and Capital Markets
o Graduated Payment Mortgage
o Interest Only Loan
o Negative Amortization
o Standard Variable Rate with Cash Back
o Base Rate Tracker
o Discounted interest rate
o Capped rate
Mortgage backed Security (MBS) is a type of asset-backed security that is secured by a
mortgage or collection of mortgages.
There are five major types of other consumer Loans / Lease
o Student Loans
o Auto Loans
o Personal loans
o Lease and Hire purchase
o Open ended loans
Other than commercial banks there are Community development Banks, Credit Unions &
Building Societies which provides Mortgages and / or Consumer Loans.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
5. 0 CARDS AND PAYMENTS
5. 1 INTRODUCTION
Cards are the fastest growing means of non-cash payments, accounting for 55% of payment
volumes worldwide, demonstrating the importance of non-cash payment mechanisms to trade
and consumer spending in our globalised economy as a new research into the global payments
market has found.
As per Tower Group Research report for the period between 2005 to 2007, Usage of Pin Debit
grew by 18 %, Volume of credit card grew by 5%, Usage of check declined by 9%, Usage of EBPP
is increasing at a CAGR of 18%, Online bill payment increased at a CAGR rate of 29.6 %, Online
bill payments at bank and biller Web sites comprised 42% of total monthly payments, followed
by 31% of bills paid by check.
5.1.1 NON-CASH PAYMENT INSTRUMENTS
A. CHECK-BASED PAYMENTS
The traditional method of collecting a check is to deposit it at a depository institution, which, if
the check is drawn on a different institution (an interbank check), then collects the funds by
presenting the original paper check to the institution responsible for paying it, the paying
bank.
With the changes governing check processing resulting from the Check 21 law, banks may now
truncate all checks and replace them with electronic images, presenting them electronically to
paying banks that agree or as paper substitute checks to those that require paper.
During March April 2007, 13.3 billion original interbank checks and about 3.0 billion substitute
interbank checks were being presented .Another 6.6 billion interbank checks were being
presented electronically (28.3 percent of interbank checks). Most of these (6.4 billion) were
presented as images.
B. CARDS-BASED PAYMENTS
DEBIT
Debit cards enable the holder to make purchases and to charge those purchases directly to a
current account at the bank issuing the payment card. Debit cards are either on-line (PIN-based)
or off-line (Signature-based).
There are two types of debit card processing.
PIN or online debit card processing: The debit card holder is required to enter a PIN
(personal identification number) in to a PIN pad. This is used as a verification method and access
to account is provided instantaneously. The access to funds is real time.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Signature or offline debit card processing: In this method verification is done by the
signature of the card holder. A hold is placed on the funds available in some cases when this
method of processing is used.
ATM
An ATM card (also known as a bank card, client card, key card or cash card) is an ISO 7810 card
issued by a bank, credit union or building society. ATM cards provide a convenient way to get
cash, make deposits and check how much money is available in the bank account. ATMs make
cash available 24 hours a day, seven days a week at many locations. ATM cards can be used at
ATMs that are located at all of the bank's locations as well as those at other banks, grocery and
drug stores, office buildings, and street corners across the country and worldwide.
In other words, ATM cards cannot be used at merchants that only accept credit cards.
CREDIT
A Credit Card represents an account that extends credit to consumers, permits consumers to
purchase items while deferring payment, and allows consumers to make payments to multiple
vendors at one time. Credit cards can have revolving credit arrangements allowing customers to
make a minimum payment in each billing cycle (two to three % of their total balance) rather
than requiring payment of the full balance. However, if a cardholder revolves i.e. carries over a
balance to the next billing cycle, then the interest will be charged not only to the balance
amount but also to any new purchases in that billing cycle. There are cards that have a short-
term, fixed-period, and credit arrangement.
SMART CARD
A smart card is a plastic card about the size of a credit card, with an embedded microchip that
can be loaded with data and can be used to perform several functions. The most common smart
card applications are: Credit cards, Electronic cash, Computer security systems, Wireless
communication, Loyalty systems (like frequent flyer points), Banking, Satellite TV, Government
identification. Smart cards can hold all sorts of unique information about its carrier, such as
credit and debit account balances, insurance coverage, access credentials, and subscription
information.
CO BRANDED CARD
They are credit cards, which are associated with a particular firm like an airlines or retail outlet.
These cards can be used just like regular credit cards but they also offer benefits to users of the
relevant product like frequent travel points and special discounts. Cardholders may be given
incentives, such as discounts on merchandise, rebates, or discounts off purchases. A co-branded
card has a tie-in with a specific merchant rather than an association or professional group. It
also can be used at other merchants.
AFFINITY CARD
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These are Credit cards promoted under a sponsoring agreement between an organization and a
card issuing bank. In exchange for making available its membership list, the sponsor receives
some compensation from the issuing bank, usually part of issuer's net interest income. The
issuer may waive annual fees for affinity cardholders, or even offer the card at a lower rate than
ordinary bank cards.
CORPORATE / COMMERCIAL CARD
Corporate credit card is normally used for business purposes and it helps corporate consumers
to effectively organize their business expenditure. Most corporate credit cards, especially cards
which have been issued to employees of a company are termed as individual corporate cards
because these cards have individual responsibility, not any corporate obligations.
PREPAID CARD
Prepaid Credit Card originated in Canada. It is not a stereotype credit card but can be used in a
similar way. The consumer has to buy the credit card from a company and then has to load it
with the required amount of money. Only after that he/she could use it for further buying but
strictly within limit of the loaded money. Hence, it is also known as Stored-Value Cards. Some
common examples are Gift Cards, Phone Cards, Mall Cards, and Gas Cards.
C. THE AUTOMATED CLEARING HOUSE (ACH) NETWORK
NACHA The Electronic Payments Association oversees, the ACH Network which is a highly
reliable and efficient nationwide batch-oriented electronic funds transfer system. It is governed
by the NACHA OPERATING RULES which provide for the interbank clearing of electronic
payments for participating depository financial institutions. The Federal Reserve and Electronic
Payments Network act as ACH Operators, central clearing facilities through which financial
institutions transmit or receive ACH entries.
ACH payments include:
Direct Deposit of payroll, Social Security and other government benefits, and tax refunds;
Direct Payment of consumer bills such as mortgages, loans, utility bills and insurance
premiums;
B2B payments;
Electronic checks;
E-commerce payments;
Federal, state and local tax payments.
The following is a typical ACH payment processing cycle:
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Originator is individual, corporation or other entity that initiates entries into the Automated
Clearing House Network
Originating Depository Financial Institution (ODFI) is a participating financial institution that
originates ACH entries at the request of and by (ODFI) agreement with its customers. ODFI's
must abide by the provisions of the NACHA Operating Rules and Guidelines
Receiving Depository Financial Institution is any financial institution qualified to receive ACH
entries that agrees to abide by the NACHA Operating Rules and Guidelines
Receiver is an individual, corporation or other entity that has authorized an Originator to initiate
a credit or debit entry to a transaction account held at an RDFI.
NACHA the Electronic Payments Association
NACHA The Electronic Payments Association is a not-for-profit association that oversees the
Automated Clearing House (ACH) Network, a safe, efficient, green, and high-quality payment
system. More than 15,000 depository financial institutions originated and received 18.2 billion
ACH payments in 2008. NACHA is responsible for the administration, development, and
enforcement of the NACHA Operating Rules and sound risk management practices for the ACH
Network. Through its industry councils and forums, NACHA brings together hundreds of
payments system stakeholder organizations to encourage the efficient utilization of the ACH
Network and develop new ways to use the Network to benefit its diverse set of participants.
D. EMERGING PAYMENTS
ONLINE BILL PAY (EBPP, EIPP)
Online services that enable customers to receive, review, and execute payment of their bills
over the Internet.
PERSON-TO-PERSON PAYMENTS (P2P)
On-line P2P payments, or e-mail payments, use existing retail payment networks to provide an
electronically initiated transfer of value from one individual to another.
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INTERNET CURRENCIES / DIGITAL CASH / E-WALLETS
Similar to P2P payments, individuals can transfer electronic cash value to other individuals or
businesses. Most electronic cash applications exist on the Internet. Consumers can use the cash
payment instruments for purchases at retailers Web sites or they can transfer cash to other
individuals through e-mail. Individuals use a credit card or signature-based debit card number to
pre-fund the Web certificate or electronic account, and recipients redeem the value with the
Issuer.
ELECTRONIC BENEFITS TRANSFER (EBT)
Electronic system that allows a recipient to authorize transfer of his/her government benefits
from a Federal account to a retailer account to pay for products received. EBT is currently used
to issue food stamps and other benefits in the US.
MOBILE PAYMENTS
Mobile Payment is paying for goods or services with a mobile device such as a mobile phone,
Personal Digital Assistant (PDA), or other such device. They can be used in a variety of payment
scenarios. Typical usage entails the user electing to make a mobile payment, being connected to
a server via the mobile device to perform authentication and authorization, and subsequently
being presented with confirmation of the completed transaction. There are mainly two types of
mobile payments depending on the location of the user:
Remote Payments - These transactions are conducted independent of the users location.
Examples include prepaid top-up services, delivery of digital services, mTickets, digital cash,
peer-to-peer payments, etc.
Proximity/Local Payments - These transactions involve a mobile device communicating locally
(e.g., via Bluetooth, IrDA, RF, Near Field Communication) with a POS/ATM, e.g. payments at
unattended machines, mParking, payments at traditional POS, or money withdrawals from a
banks ATM.
CONTACTLESS PAYMENTS
Contactless payment system is a new emerging payment system where a payment transaction
can be initiated without the device coming in direct contact with the POS, such as swipe of a
card. This payment mechanism is made possible through use of new technologies such as Radio
Frequency (RFID), NFC (Near Field communication), Carrier Based or Bluetooth technology for
making payments. Payment using this technology can be made using Form Factors such as credit
cards, key fobs, smart cards or mobile phones. The consumer waves the device over a reader at
the POS and the embedded chip and antenna enables initiation of the transaction. The
consumer is not required to sign a slip or enter a PIN making it extremely convenient.
Contactless payments are typically useful for small value transactions and are targeted towards
eliminating or reducing cash transactions at the retail counter.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
5.1.2 GENERIC FRAMEWORK FOR PAYMENT INSTRUMENTS
The diagram below depicts the common model on which most payment systems are based.
While the flow of funds, information, and data are different, in most cases, the set of
participants are similar. The initiator of the payment (payer) is typically a consumer and the
recipient of the payment (payee), typically a merchant. The payer and the payee are shown to
have a relationship with their respective financial institutions. The payment network routes the
transactions between the financial institutions
5. 2 CREDIT CARD MARKET OVERVIEW
There were 984 million bank-issued Visa and MasterCard credit card and debit card accounts in
the U.S in 2006.The top 10 credit card issuers controlled approximately 88 percent of the credit
card market at the end of 2006, based on credit card receivables outstanding. U.S Visa
cardholders alone conduct more than $1 trillion in annual volume. Consumers carry more than 1
billion Visa cards worldwide. More than 450 million of those cards are in the United States.
2007 global market share of general-purpose cards (cards in distribution)
Total among these five brands: 3.03 billion, up 13.6 percent in one year
1. Visa -- 65 percent
2. MasterCard -- 30 percent
3. American Express -- unknown
Financial Institution
or Third party
Network
Financial Institution
or Third party
Payer
Payee
Four Corner Payment System Model
Goods / Services
Present Non-cash Payment instrument
Solid line indicates flow of information
Financial Institution
or Third party
Financial Institution
or Third party
Network Network
Financial Institution
or Third party
Financial Institution
or Third party
Payer
Payee
Four Corner Payment System Model
Goods / Services
Present Non-cash Payment instrument
Solid line indicates flow of information
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4. JCB -- unknown
5. Diners Club -- unknown
(Source: Nilson Report, May 2008)
2007 global market share of general-purpose cards (purchase volume)
1. Visa -- 60 percent
2. MasterCard -- 28 percent
3. American Express -- 10.5 percent
4. JCB -- 0.9 percent
5. Diners Club -- 0.5 percent
(Source: Nilson Report, May 2008)
A Credit card is a type of a payment card product. A payment card product is a set of
entitlements. It allows the client to access the features the provider (e.g., financial institution)
attaches to the card.
A sample of possible payment card entitlements is shown below:
Access Convenience Affordability
Credit Worldwide acceptance Interest rate
Deposits 24 hour availability Fees
Merchants Portability Benefits
ATMs Monthly statements Payment terms
To create an actual payment card product, these entitlements are grouped together to appeal to
a target segment consumer or business. A card is issued to a cardholder and usually displays
cardholder name, account number, expiration date, location acceptance logos (e.g.,
Visa/MasterCard) and issuing organization. Most cards are plastic with a magnetic stripe. Some
of the new cards contain chips that store information such as additional customer information
and stored value. A card usually is linked to some type of financial account (e.g., credit card to a
credit line and a debit card to a checking/savings account).
5.2.1 CREDIT CARDS
A credit card is a plastic card with a magnetic strip containing data, and is a financial instrument
allowing the holder for pay for goods or services on credit and in lieu of cash. While credit card
companies provide the infrastructure to settle the transactions, the cards are issued by banks
and increasingly by retail outlets and other consumer-oriented entities. Credit cards allow
customers to buy goods and services immediately and then settle the bill for aggregated
transactions at a later date.
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5.2.2 CREDIT CARD MARKET MAJOR BUSINESS ENTITIES AND THEIR
ACTIVITIES
The following diagram depicts typical activities in transaction processing using a card involving
all the entities described above -
The following table shows lists the description of the various entities involved in a Credit card
processing
Entity Description
Issuing Bank This is a bank / financial institution that issues a credit product
Cardholder
Account
Cardholder portfolio account is created when a credit application is
approved.
Business Portfolio
Account
This defines the processing rules for all the accounts under a business
venture of the same card offering type. This entity may hold billing rules,
auth limits, collection strategies, and other properties that can be defined
at this level. Examples of Business portfolio account may include Chase
Visa Classic, Chase Visa Gold, etc
Card Product Identifies the different card types that the Credit system supports.
Examples may be proprietary cards, Visa, MasterCard
Authorization
Engine
Authorization engines are used to authorize credit transactions. The
authorization engine uses the account information, merchant
information, and other related information to approve / decline / refer an
authorization transaction. There can be more than one authorization
engines for a business portfolio.
Credit Bureau Provides credit scores that are used by Issuers to process card
applications
Collection Agency Third party to whom Issuer outsources the cardholder collection activities
Issuer Processor An outside company with which the Issuer contracts to provide
cardholder transaction processing activities.
Issuer Clearing
Bank
Bank designated by the Issuer to receive the Issuers daily net settlement
advisement. The clearing bank (may be the Issuer itself) will also conduct
funds transfer activities with the net settlement bank and maintain the
Issuers clearing account.
Acquirer This is a bank / financial institution that acquires merchant transactions
Acquirer Clearing
Bank
Bank designated by Acquirer to receive the Acquirers daily net
settlement advisement. The clearing bank (may be the Acquirer itself) will
also conduct funds transfer activities with the net settlement bank and
maintain the Acquirers clearing account.
Acquirer Processor An outside company with whom the Acquirer contracts to provide
merchant processing services
Merchant Account A merchant account is created when a merchant application is approved.
A merchant account is necessary for a merchant to accept payment by
credit card
Clearing file Contains presentments and other financial messages that need to be
matched with corresponding authorizations
Funding file This file is for enabling member settlement
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The credit card process flow is illustrated with an example.
An individual, who desires to have a credit card, applies for one in MBNA. The issuer, MBNA
collects the applicants financial and other details and does the necessary credit appraisal
through assistance from its processor. The credit processing will involve a sequence of events
like verifications, credit scoring, credit check, etc. and a decision will be taken by MBNA on
whether a card can be issued to the applicant or not. If the applicant is found eligible to be given
a card, MBNA will issue a credit card with his card details embossed along with the logos of the
issuer and the association.
Now that the applicant has become a card member, he may wish to buy some commodity using
his VISA card, bearing the logo of the issuer MBNA, in payment. The merchant swipes the card
through a card reader, which reads the data on the magnetic stripe and adds information that
identifies the merchant and the dollar value of the purchase. This electronic message is
automatically sent via telephone line to an IT system maintained by the merchants acquirer,
also a member of the association. The message is then transmitted to the association's system,
which routes the request to the appropriate Issuer to verify that the cardholder has a credit
balance sufficient to cover the purchase. The response (approval or denial) from the issuer is
routed back along the same path to the originating POS terminal. This entire process typically
happens within 10 seconds and in case of an approval, the cardholder is expected to sign the
credit card charge slip.
The merchant submits a request for payment to its acquirer, who in turn sends it to VISA. VISA
consolidates the transaction with all other transactions that day and settles the accounts among
banks i.e. Funds are transferred from the Issuer to the Acquirer and to the merchant.
At the end of the credit period, the customer makes his settlement with the Issuer.
5.2.3 CREDIT CARD TRANSACTION ECONOMICS
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The credit card transaction starts when the merchant swipes a customer's credit card through a
dial-in terminal that would automatically dial the correct network depending on the association
being used. The card holder, in this way, informs the Issuer to pay the merchant.The merchant
then passes this message on to his acquirer, who then sends it through the Credit Card
Association to the card issuer. The return path of the $100 dollars is essentially the same except
that each party deducts some amount of money for its efforts. Following is the share of each of
the entities:
The card issuer will bill the card holder and keep an interchange fee which in this
example is 1.3%, or $1.30. However, he must pass the remaining money back to the
card association and pay an issuer transaction fee of .07% or $.07.
The card association takes the $98.77, deducts a merchant transaction fee (.09%) and
returns $98.61 to the acquirer.
The acquirer keeps .06% and deposits $98 in the merchants account.
The merchant then sees $98 dollars return from the $100 dollar purchase. This charge of
$2, or 2%, is called the discount rate and is the basis for much of the competition
between the banks of a credit card association.
5.2.4 TRANSACTION TYPES
Entity Transaction Type Remarks
Cardholder
transactions
Purchase
Authorization/Verification
Preauthorization
Merchandise return
Sale of Merchandise - Triggered by the
cardholder.
Authorization/Verification is the default
transaction type. Transaction approval
response from Issuer to Merchant
Preauthorization - The merchant is
provided with the ability to add a tip to
a credit card transaction after having
presented the cardholder with the
transaction record
Merchandise return Credit of
transaction amount to the Cardholder
System
Generated
Transactions
Reversal
This transaction is an action on a
previous transaction and is used to
cancel the previous transaction and
ensure it does not get sent for
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settlement.
Exception
Transactions
Adjustment
Chargeback & Chargeback
Reversal
Representment
Used to correct errors that occur at
point of transaction or in a participants
system
Others
Administrative
Network
Reconciliation
File Maintenance
Fee transactions
These are routine transactional
activities to ensure completion of the
various activities involved in a
transaction processing cycle
5.2.5 CHARGEBACK & CHARGEBACK REVERSALS
At any time (currently limited to 60 days after statement date), cardholder may contact the
Issuer to question whether a transaction is legitimate and request a copy of the transaction
from the merchant. If the cardholder does not receive a copy of transaction, she may request a
chargeback a financial reversal of the transaction. Even if the retrieval request is fulfilled,
cardholder still may request the Issuer to initiate a chargeback. However, if the merchant
disputes the chargeback, the disputed transaction is dealt with through a defined dispute
process. Following diagram depicts the process of chargeback and chargeback reversal
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5. 3 MAJOR PLAYERS
The following table shows some of the leading card organizations and their respective roles in
the Credit card industry:
Leading Card Organizations
Banks Non-Banks Association /
Organization
Citigroup
(Issuer)
MBNA America
(Issuer)
JPMorgan Chase /
Bank One
(Acquirer & Issuer)
Bank of America
(Acquirer & Issuer)
Capital One
(Issuer)
Wells Fargo
(Acquirer & Issuer)
Wachovia
(Issuer)
Natwest (Issuer)
Barclays (Issuer)
First Data Corp (Processor)
TSYS (Processor)
Vital (Acquirer & Processor)
American Express (Acquirer, Card
Organization & Issuer)
Discover (Acquirer, Card Organization
& Issuer)
Diners Club (Card Organization &
Issuer)
Equifax (Processor)
Sears ( Acquirer, Card Organization &
Issuer)
GE Card Services (Processor)
US Government (Acquirer & Issuer)
Visa
(Card Association,
Processor)
MasterCard
(Card Association,
Processor)
JCB (Card Association)
5. 4 RECENT DEVELOPMENTS
5.4.1 SEPA: IN A NUTSHELL
SEPA is an objective set by the European Union for the purpose of creating a single payment
market, within which everyone can make payments simply and safely, at the same cost and as
efficiently as those presently being made at the national level. The project will make it possible
for individuals, companies, government agencies and others, no matter where they are located
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in Europe, to make and receive Euro payments, to engage in direct debits and to use credit and
debit cards with standardized basic conditions, rights and obligations in every country.
The expanse of SEPA is all EU Member States (currently 27), other EEA Member States (Norway,
Iceland and Liechtenstein) and Switzerland.
There are three main payment instruments forming part of the SEPA objective:
Pan-European Credit Transfer (SEPA Credit Transfer (SCT))
Pan-European Direct Debit (SEPA Direct Debit (SDD))
Debit and account-linked cards (SEPA Cards Framework (SCF))
SCF: AN INTRODUCTION
SEPA Cards Framework (SCF) spells out high level principles and rules which when implemented
by banks, schemes, and other stakeholders, will enable European customers to use general
purpose cards to make payments and cash withdrawals in Euro throughout the SEPA area with
the same ease and convenience than they do in their home country.
The vision of SEPA Cards Framework is as follows:
There should be no differences whether European customers use their card(s) in their
home country or somewhere else within SEPA.
No general purpose card scheme designed exclusively for use in a single country, as well
as no card scheme designed exclusively for cross-border use within SEPA, should exist
any longer.
Impact
On Customers / Card holders - Since the beginning of the year 2009, all the newly issued cards
will be equipped with the chip technology and their usability within the SEPA zone will be the
same as of standard international bank cards. Cards will be used in compliance with the EMV
standard.
On Merchants / Traders - Traders will continue to be able to decide which offered card products
they will accept and with which bank a receiver - they will cooperate. The bank and the trader
will contractually agree on the trade terms and conditions for acceptance of bank cards, type of
accepted bank cards, including charges, and other relevant particulars. As long as a payment
terminal is owned by a bank, the bank is entitled to decide whether a trader may use a given
terminal also for cooperation with another bank. Payment terminals will accept both SCF
compatible products and products without the EMV chip technology due to the need to
safeguard the acceptance of bank cards issued in non- SEPA countries.
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On Banks - The preparatory phase for implementation of SEPA will mean investments into the
technologies used within the process of issue and acceptance of bank cards (cards, POS, ATM)
and adjustment of affected information systems
5.4.2 EMV-GLOBAL FRAMEWORK FOR SMART CARD PAYMENTS
EMV is the standard devised by Europay, MasterCard and Visa (EMVCo.) for smart card based
credit and debit cards to replace the existing magnetic based stripe cards. With the acquisition
of Europay by MasterCard in 2002, and JCB (Japan Credit Bureau) joining the organization in
2004, EMVCo currently comprises of JCB International, MasterCard Worldwide and Visa, Inc.
The primary aim of EMV is to define a set of specifications that will offer interoperability
between the smart card (chip based), POS terminals, and ATMs throughout the world. The key
purposes served by EMV can be summed up as
A set of specifications for global card interoperability
Enable cardholder verification and transaction authorization in a secure way
Offer multiple facilities and advantages on a single card making it easy to
operate
Benefits
Some of the Key benefits of EMV implementation are
Increased Interoperability of card acceptance, security and payment functions
Fraud Prevention
Reduce counterfeit and lost and stolen fraud
Avoid being the weakest link - prevent migration of fraud to own card base as
other banks implement
Avoid card scheme liability shift
Improved Control
Reduce and improve management of bad debt by utilizing chip parameters e.g.
to restrict below floor limit spending.
Apply different levels of control according to cardholder profile
Provides authentication and platform for ID
Customer centric decisions at the terminal, control managed within the
application on the chip
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Maintain Competitiveness
Maintain credibility in customers and competitors eyes.
Endorse Brand with reliable, secure and innovative product.
A migration path for loyalty and multi-application products.
Operational savings from reduced chargeback/authorization costs
Impact on existing cards
Master and Visa have planned a global migration scheme to initiate credit and debit card
transactions with the use of a chip in card and authenticating the transaction using a PIN
(Personal Identification Number) instead of the magnetic stripe. This will have a direct impact on
the existing credit and debit cards as they are based on card holder terminals which can read
magnetic stripes and performs cardholder verification through signature instead of PIN.
SUMMARY
Cards are one of the most widely used mechanisms for transactions worldwide. There are
several types of cards used
o Debit cards
o ATM cards
o Credit cards
o Smart cards
o Co Branded card
o Affinity card
o Commercial card
o Prepaid card
ACH enables batch-processed, value-dated electronic funds transfer between originating
and receiving financial institutions.
Emerging payments systems are
o Online Bill Payment (EBPP, EIPP)
o Person to Person Payments (P2P)
o Internet currencies, digital cash, e-Wallet
o Electronic Benefit Transfer (EBT)
o Mobile payments
o Contactless payments
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There are various entities involved in the credit card transaction processing cycle -
o Issuer
o Acquirer
o Third party Processor
o Independent Sales organization
o Association
o Merchant
o Card holder
Transaction Economics A credit card transaction involves various fees. / Charges such as
interchange fee, merchant transaction fee and issuer transaction fee. The merchant
discount rate is the basis for much of the competition between the banks of a credit card
association.
Chargeback and Chargeback reversals are legitimate ways to cancel the credit card
transactions within a limited time frame
SEPA Cards Framework and EMV Global Framework for Smart Card Payments are some of
the recent developments in the Cards arena.
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6. 0 WHOLESALE BANKING AND COMMERCIAL LENDING
6. 1 INTRODUCTION
Corporate Lending refers to various forms of loans extended by banks to corporate bodies like
proprietorship, partnership, private limited companies or public limited companies. Banks lend
to such entities on the strength of their balance sheet and business cash flows. Corporate loans
are provided by banks for various purposes like new projects, capacity expansion or plant
modernization, daily cash flow requirements (working capital) etc. Depending on the nature of
the requirement, loans may be long-term or short-term in nature.
Loans can be either secured or unsecured in nature. In case of secured loans, if the corporate
defaults on payment of principal or interest on the loan, the bank can take possession of the
security and sell off the same to meet principal or interest payment on the loan. Security is
usually in the form of land, buildings, plant and machinery, physical stock of the raw material,
goods for sale etc.
6. 2 CORPORATE LENDING PROCESS
The following is the typical stages in a corporate lending process:
Corporate approaches the relationship manager of the bank with a request for a loan. The
corporate provides details like: past financial statements, details of the loan requirement,
cash flow projection for the period of the loan, details of the security being provided etc.
Depending on the loan type and bank requirements, information should be provided by the
corporate.
The concerned division of the bank prepares the detailed analysis of the corporate financial
statements. A detailed study is also done on the corporates products, market segment,
competitors etc to ascertain the strength of the corporates business. A report is prepared
to capture the above details.
Based on the above report, the concerned division of the bank assigns a rating to the
corporate. The rating captures various factors like strength of business, financial state of
the corporate, ability to repay the loan based on cash flow projections, promoter
background etc.
A committee of the bank evaluates the loan proposal and decides to sanction/reject the
same.
Once sanctioned, the bank provides a sanction letter to the corporate providing details of
the loan terms and conditions.
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After the corporate accepts the same, a loan agreement is signed between the bank and the
corporate. The loan agreement captures various conditions of the loan like repayment
mode, repayment period, interest payable, security provided, other conditions etc. The loan
becomes committed at this stage.
The bank disburses the required amount under the loan committed. This amount is called
the disbursed amount under the loan.
Interest is usually paid on the disbursed amount of the loan. In some cases, a nominal interest if
also payable on the committed amount of the loan. Also, in most cases, the corporate would
have to pay a certain amount as processing fees for the loan. This would cover the banks
overhead costs in the loan process.
CORPORATE CREDIT RATING
Before sanctioning a loan to a corporate, the bank does a detailed assessment of its financials
and business strength as discussed in the earlier section. This process ends with the bank
assigning a rating to the corporate for the loan facility.
Ratings are usually specified in alphanumeric terminologies. Rating levels might vary from AAA
(highest), AA+, AA- to default ratings like D. Rating terminologies might vary across banks and
across various loan tenures. The rating level specifies a certain probability of default of the loan.
It also takes in to account the protection offered by the security of the loan.
For corporate with higher ratings, banks provide loans at lower interest rates and vice versa. In
most cases, banks do a rating process for each of its corporate clients at the end of say, every
year or every quarter. This helps banks to continuously track the financials and market position
of the corporate.
CREDIT ENHANCEMENTS
Credit enhancement is a mechanism used to increase the original rating of a loan for a
corporate. Credit enhancements can be in the form of pledge of shares, cash collateral,
corporate or bank guarantees etc.
Example:
A corporate rated BB (low rating) requires a loan of USD 5.0 million from a bank. To enhance the
loan rating and thus reduce interest payable on the loan, the promoters pledges their share
holding in the company with the bank. Thus, whenever there is a default on repayment of the
loan, the bank has the right to sell the shares in the market. Based on the historic volatility of
the shares and the current market value of USD 6.0 mn, the bank upgrades the rating of the loan
to BBB+.
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6.2.1 TYPES OF LOANS
TERM LOANS
These loans can either be short term loans or long term loans.
Long-term loans are extended for purposes like new projects, capacity expansion or plant
modernization. These loans are usually repayable over a 2-7 year period after an initial
moratorium period (period during which loan repayments are not required) to help the
corporate complete implementation of the project before revenue generation takes place.
Example
On April 15, 2004, AT&T borrows a term loan of USD 200 million from Citibank for funding their
IT modernization project across the nation. The loan is repayable in 16 quarterly installments
starting April 15, 2005, after an initial moratorium of 4 quarters. The interest payable would be
LIBOR+0.5% payable quarterly. The loans would be secured by AT&T equipment at their HQ,
worth USD 300 mn.
Short term loans are extended usually for meeting working capital requirements. The loans can
be repayable in various tenures starting from a week to as long as 1 year. The loans are either
repayable in fixed installments or in one bullet installment at the end of the period. In some
cases, short term loans are backed by promissory notes which are legal instruments that
guarantee payment of a certain amount on a specified due date.
CORPORATE BONDS
Corporate bonds are used for the same purpose as term loans, but the loan is backed by a
transferable instrument which guarantees payment from the corporate as per specified
conditions. Thus, corporate bonds are tradable and banks can sell them to a third party who
receives the right to get payments from the corporate. Bonds are rated depending on the rating
of the corporate and depending on the rating, the market demands varying amounts of interest.
A certain class of bonds called junk bonds is issued by corporate with very low credit ratings and
carry very high rates of interest.
WORKING CAPITAL
For any business, there would be current assets in the form of cash, receivables, raw material
inventory, goods for sale inventory etc while there would be current liabilities in the form of
payables and other short term liabilities. Part of the current assets would be funded through
current liabilities while the rest would have to be funded through a mixture of short term and
long term loans. As per norms, 25% of the working capital gap would have to be funded by long
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term sources like equity or term loans while the rest 75% can be funded through short term
loans and overdraft limits.
Banks conduct a detailed assessment of the current assets and liabilities for a corporate and
arrive at a suitable working capital limit. For purpose of calculating limits, banks typically include
only receivables which are less than 6 months old. Also within the specified limit, banks keep
reviewing the current asset and current liability position of a company to arrive at the drawing
power for each month. Corporate are allowed to borrow up to the working capital limit or the
drawing power, whichever is lower.
Overdraft limits are extended to help the corporate manage the day-to-day cash flow needs of
the business. The bank makes available a certain sum of money for a period of time (say, USD
20.0 million for a period of 1 year). There would be a separate account called the overdraft
account created to monitor withdrawals under this loan. Whenever the corporate has a deficit
in its main business account, it can draw money from the overdraft account (up to the limit of
USD 20.0 million). It can also put back money in the overdraft account as and when they have
surpluses in the business account. Interest is calculated by the bank on the various end-of-day
deficits in the overdraft account and is usually payable by the corporate at the end of every
month.
LINES OF CREDIT
These are short term loans sanctioned for a fixed validity period, allowing the corporate to draw
the loan as and when required within the validity period and repay the loan after a certain
period (repayment period). Interest is either repayable in certain intervals or in one bullet
installment at the end of the repayment period. In many cases, the lines of credit are of a
revolving nature. The same is explained via the example provided below:
Example
Citibank sanctions a line of credit of USD 10.0 mn to AT&T, valid for a period of 3 years. Within
the 3 year period, AT&T can borrow any amount at any point of time, such that the cumulative
outstanding is below USD 10.0 mn on any date. Each of these borrowals are repayable with
interest at the end of 30 days from the date of borrowals. Since AT&T can thus revolve the limit
any number of times within the specified limit and validity period, these are called revolving
lines of credit.
BILL DISCOUNTING
Bill discounting is another form of working capital financing. A bill (Bill of Exchange) is a financial
instrument by which one party promises to pay the other party a certain amount of money on a
specified due date. This is transferable and the final holder of the bill holds the right to receive
the payment from the concerned party. The corporate would have bills of exchange which are
drawn on their dealers, which entitle the corporate to receive certain amounts of money from
the dealer after a pre-defined credit period. The corporate can then transfer the bill to the bank
and get a discounted amount upfront. The bank collects the interest on the bill amount for the
specified period upfront in this process called bill discounting. On the due date, the bank collects
the payment from the concerned party directly.
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COMMERCIAL PAPER
Commercial Paper (CPs as commonly known) is an instrument by which a corporate borrows
money from banks for short periods of time. A CP binds the corporate to make a payment equal
to the face value of the CP to the issuing bank on a specified due date. In this sense, a CP is like a
short term unsecured loan. However, a CP is tradable in the market the bank can sell the CP to
a third party. For this reason, banks charge lesser interest on CPs than normal short term loans.
However, since CPs are unsecured and are to be tradable in the market, banks provide CP
lending to only highly rated corporate.
LEASING
Leasing is another form of bank financing. In leasing, the bank purchases real estate, equipment,
or other fixed assets on behalf of the corporate and grants use of the same for a specified time
to the corporate in exchange for payment, usually in the form of rent. The owner of the leased
property is called the lessor, the user the lessee. Lease payments (which include principal and
interest payments usually) can be shown by corporate as operating expenses and hence leases
are used by some corporate as a substitute for loans to get better tax benefits.
SUPPLIER AND DEALER LOANS
These are short term loans provided by banks to suppliers and dealers of large companies.
These loans usually have conditions which ensure that there is sufficient support from the
corporate in case the supplier or a dealer defaults. Thus, using the support from the corporate,
the suppliers/dealers can borrow money from the bank at a lower rate of interest than
otherwise possible. Such loans help the corporate to develop a stronger base of suppliers and
dealers, which often helps them in improving their business.
ASSET SECURITISATION LOANS
Asset Securitization loans are loans which are backed by specified future cash flows or other
assets of the corporate. These loans help corporate to release excess cash flows from existing
receivables or future receivables.
Example
Citibank provides a loan of USD 250.0 mn to Royal Dutch Shell, securitizing cash flows from
future monthly sale of oil explored from its specified offshore rig. In this case, there would be a
mechanism to ensure that money from monthly sale of oil explored from the specified rig for
the period of the loan would be used to service payment of interest and principal of the loan to
Citibank. Citibank would do a detailed assessment of oil exploration potential, study oil prices
and ensure proper cash flow trapping mechanisms before disbursing the loan to Royal Dutch
Shell.
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6.2.2 CLASSIFICATION OF LOANS BY THE BANK
CLASSIFICATION OF DRAWN LOANS
Loans are classified and accounted for as follows:
AccrualLoans that management has the intent and the ability to hold for the foreseeable
future or until maturity/loan payoff. Accrual loans are reported on the balance sheet at the
principal amount outstanding, net of charge-offs, allowance for loan losses, unearned income,
and any net deferred loan fees.
Held-for-saleLoan or loan portfolios that management intends to sell or securitize.
TradingLoans where management has the ability and intent to trade or make markets (i.e.,
sell/hedge the credit risk.) Loans held for trading purposes are included in Trading Assets and
are carried at fair value, with the gains and losses included in Trading Revenue provided that the
criteria outlined in this policy are met.
CLASSIFICATION OF UNDRAWN LOAN COMMITMENTS
Loan commitments are generally classified as accrual and recorded off-balance sheet.
6.2.3 LOAN SYNDICATION
A syndicated loan is a lending facility defined by a single loan agreement in which 2 or more
banks participate
WHY SYNDICATION
A borrower wants to raise relatively large amount of money quickly and conveniently
The amount exceeds the exposure limits or appetite of any one lender
The borrower does not want to deal with multiple lenders
KEY ENTITIES IN SYNDICATION
Differences between loan and commitment are as follows; -
Loans are reflected in the asset side of the banks balance sheet. Commitments are off-
balance sheet items and are reflected in the contingent asset side of the balance sheet.
The amount of the loan that is disbursed is credited to the account of the borrower. In
case of a commitment, there is no disbursement or credit to a borrowers account.
The fee charged on a loan is a function of the disbursed amount. The fee charged on
commitment is a function of the amount of commitment that is not utilized.
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1. Arranger / Lead Manager: This the bank / lender the prospective borrower has
mandated to arrange loan
2. Underwriting Bank: The bank that commits to supply funds to the borrower. If
necessary from own sources if the loans are not fully subscribed. It may the arranging
bank or another bank
3. Participating Bank: The bank that participates in the syndication by lending a portion of
the total amount required
4. Facility Manager / Agent: The entity who takes care of the administrative arrangements
over the term of the loan (Example: disbursements, repayments, compliance)
STAGES IN SYNDICATION
1. Pre-mandate Phase: Prospective borrower will liaise with a single bank and the bank
may agree to act as lead bank. The lead bank needs to;
a. Identify the needs of the borrower
b. Design an appropriate loan structure
c. Develop a persuasive credit proposal
d. Obtain internal approval
2. Placing the loan: The lead bank will start to sell the loan in the market place and to sell
the loan it needs to;
a. Prepare an information memorandum
b. Prepare a term sheet
c. Prepare legal documentation
d. Approach selected banks and invite participation
3. Post-closure phase: Post closure, agents will handle the day to day running of the loan
facility
FEES AND CHARGES
Fee Type Remarks
Arrangement fee Front end Also called praecipium.
Received and retained by the
lead arrangers in return for
putting the deal together
Legal fee Front end Remuneration of the legal
advisor
Underwriting fee Front end Price of the commitment to
obtain financing during the
first level of syndication
Participation fee Front end Received by the senior
participants
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Facility fee Per annum Received by the senior
participants
Commitment fee Per annum charged on
undrawn part
Paid as long as the facility is
not used, to compensate the
lender for tying up the capital
corresponding to the
commitment
Utilization fee Per annum charged on
undrawn part
Boosts the lenders yield;
enables the borrower to
announce a lower spread to
the market than is actually
being paid
Agency fee Per annum Remuneration of the agent
banks service
Conduit fee Front end Remuneration of the conduit
bank
Prepayment fee One-off if prepayment Penalty for prepayment
6. 3 CREDIT DERIVATIVES
Credit derivatives are financial contracts that transfer credit risk from one party to another,
facilitating greater efficiency in the pricing and distribution of credit risk among market players.
Example
The holder of a debt security issued by XYZ Corp. enters into a contract with a derivatives dealer
whereby he will make periodic payments to the dealer in exchange for a lump sum payment in
the event of default by XYZ Corp. during the term of the derivatives contract. As a result of such
a contract, the investor has effectively transferred the risk of default by XYZ Corp. to the dealer.
In market parlance, the corporate bond investor in this example is the buyer of protection, the
dealer is the protection seller, and the issuer of the corporate bond is called the reference
entity.
6.3.1 USES OF CREDIT DERIVATIVES
Like any other derivative instrument, credit derivatives can be used either to take on more risk
or to avoid (hedge) it. A market player who is exposed to the credit risk of a given corporation
can hedge such an exposure by buying protection in the credit derivatives market. Likewise, an
investor may be willing to take on that credit risk by selling protection and thus enhance the
expected return on his portfolio.
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Credit derivatives can be used to create positions that can otherwise not easily be established in
the cash market. For instance, consider an investor who has a negative view on the future
prospects of a given corporation. One strategy for such an investor would be to short the bonds
issued by the corporation, but the corporate repo market for taking short positions in corporate
is not well developed. Instead, the investor can buy protection by way of credit default swap. If
the corporation defaults, the investor is able to buy the defaulted debt for its recovery value in
the open market and sell it to its credit derivatives counterparty for its face value.
Banks use credit derivatives both to diversify their credit risk exposures and to free up capital
from regulatory constraints. As an example, consider a bank that wants to diminish its exposure
to a given client, but does not want to incur the costs of transferring loans made to that client to
another bank. The bank can, without having to notify its client, buy protection against default by
the client in the credit derivatives market: Even though the loans remain on the bank's books,
the associated credit risk has been transferred to the bank's counterparty in the credit
derivative contract.
The above example can also be used to illustrate banks' usage of credit derivatives to reduce
their regulatory capital requirements. Under current Basle standards, for a corporate borrower,
the bank is generally required to hold 8 percent of its exposure as a regulatory capital reserve.
However, if its credit derivatives counterparty happens to be a bank located in an OECD country,
and the bank can demonstrate that the credit risk associated with the loans has been effectively
transferred to the OECD bank, then the bank's regulatory capital charge falls from 8 percent to
1.6 percent.
Example
Let us visualize a bank, say Bank A which has specialized itself in lending to the office
equipment segment. Out of experience of years, this bank has acquired a specialized
knowledge of the equipment industry. There is another bank, Bank B, which is, say,
specialized in the cotton textiles industry. Both these banks are specialized in their own
segments, but both suffer from risks of portfolio concentration. Bank A is concentrated in
the office equipment segment and bank B is focused on the textiles segment.
Understandably, both the banks should diversify their portfolios to be safer.
One obvious option for both of them is: Bank A should invest in an unrelated portfolio, say
textiles. And Bank B should invest in a portfolio in which it has not invested still, say, office
equipment. Doing so would involve inefficiency for both the banks: as Bank A does not know
enough of the textiles segment as bank A does not know anything of the office equipment
segment.
Here, credit derivatives offer an easy solution: both the banks, without transferring their
portfolio or reducing their portfolio concentration, could buy into the risks of each other. So
bank B buys a part of the risks of the portfolio that is held by Bank A, and vice versa, for a
fee. Both continue to hold their portfolios, but both are now diversified. Both have
diversified their risks. And both have also diversified their returns, as the fees being earned
by the derivative contract is a return from the portfolio held by the other bank.
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6.3.2 TYPES OF CREDIT DERIVATIVES
Credit derivatives can be classified in two main groups: Single name instruments are those that
involve protection against default by a single reference entity. Multi-name credit derivatives are
contracts that are contingent on default events in a pool of reference units.
6. 4 TREASURY SERVICES
The Treasury Services department is concerned with managing the financial risks of the bank.
Hence, the treasurer's job is to understand the nature of these risks, the way they interact with
the business, and to minimize or to offset them. In many cases, the treasury services
department also provides cash management solutions for customers of the bank. The Treasury
services department of a bank performs the following functions:
Managing the cash position of the bank, managing liquidity and associated risks
Forex services: provides Forex services to corporate, enters in to deals with multiple
counterparties to maintain a risk-managed position for the bank.
Risk management services: provides risk management products like swaps, options etc to
corporate and enters in to multiple deals with various counterparties to maintain a risk-
managed position for the bank.
Conducts research on various market factors, monitors interest rate and economic scenario
etc
Cash Management services for corporate managing collections and payments
Typically, the treasury has a front office desk which enters in to trades (in Forex, money
markets, equity, treasury securities etc) with various market participants and a middle
office/back office desk which monitors positions and provides operational support.
Most large investment banks provide Treasury Services to their clients. Treasury domain
includes
Fixed Income: An investment that provides a return in the form of fixed periodic payments
and eventual return of principle at maturity. Unlike a variable-income security where
payments change based on some underlying measure, such as short-term interest rates,
fixed-income securities payments are known in advance.
Money Markets: The money market is a subsection of the fixed income market. The
difference between the money market and the fixed income market is that the money
market specializes in very short-term debt securities (debt that matures in less than one
year). Money market investments are also called cash investments because of their short
maturities. Some of the popular money market instruments include Certificates of Deposit
(CD), Commercial Paper (CP), Treasury Bills (T-Bills)
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Foreign Exchange: The market for buying and selling of currencies is called the Foreign
Exchange market (FX ). It is a 24 hour non-stop market. Some of the major Currency traded
include The US Dollar (USD), The Japanese Yen (JPY), The Euro (EUR), The Great Britain
Pound (GBP), The Swiss Franc (CHF). FX rates express the value of one currency in terms of
another currency. They involve
o The commodity currency - the currency being priced, usually 1 unit or a fixed amount of
currency.
o The terms currency - the currency used to express the price of the commodity, in
varying amounts of
OTC Derivatives: Over the counter (OTC) markets are a form of Secondary markets. World
over Secondary markets are classified as Listed and OTC. Listed markets typically are
exchanges where a security is listed and traded. A decentralized market of securities not
listed on an exchange where market participants trade over the telephone, facsimile or
electronic network instead of a physical trading floor or electronic order matching systems.
There is no central exchange or meeting place for this market. Typically Currency
instruments are traded OTC. A derivative contract derives its value based on the value of
some basic underlying. The underlying may be any instrument like a bond, a stock or a
market index, currency or interest rates. Some of the instruments traded OTC include
o Forward Rate Agreement (FRA) - A contract that determines the rate of interest,
or currency exchange rate, to be paid, or received, on an obligation beginning at some
future start date. It is also referred to as Future Rate Agreement.
o Interest Rate Swap (IRS) - A deal between banks or companies where borrowers switch
floating-rate loans for fixed rate loans in another country. These can be either the same
or different currencies. The motive may be the competitive advantage of one company
to have access to lower fixed rates than another company. The other company may be
competitively placed to have access to lower floating rates. A swap would be beneficial
to both. The swap is measured by its notional principal.
FX Options: Forex Options give the holder the right to buy or sell a currency in terms of
another currency at a particular rate on a particular date or within a period of time. The
option to buy is called as a Call Option and the option to sell is called as a Put Option.
Equity Options These are similar to FX options the only difference is the underlying. The
underlying in case of Equity Options are stocks or stock market indices. When the
underlying is a stock market index the term used is Index Option and the term used to refer
options on individual stocks is Stock Option
Credit Derivatives - Privately held negotiable bilateral contracts that allow users to manage
their exposure to credit risk. Credit Derivatives are financial assets like forward contracts,
swaps, and options for which the price is driven by the credit risk of economic agents
(private investors or governments). For example, a bank concerned that one of its
customers may not be able to repay a loan can protect itself against loss by transferring the
credit risk to another party while keeping the loan on its books.
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6.4.1 FUNCTIONS OF THE TREASURY MANAGER
Ensure availability of funds An integrated treasury typically would include debt market,
money market and Forex transactions. Treasury manager needs to ensure that adequate
funds are available to cover the settlement obligations of the said transactions.
Manage all foreign currency transactions for the bank
Manage various risks:
o Liquidity Risk of asset and liability cash flow mismatch. A bank may not have adequate
funds for the settlement of its transactions or to pay its customers because of
mismatches in the tenor of its receivables
o Interest rate Risk due to volatility of interest rates. A bank may have borrowed at
floating rates of interest and lent at fixed rate of interest and the interest rates moves
up
o Currency Risk due to volatility in exchange rates. A bank may have its payment
obligations in a currency say USD and the rate to purchase the said currency goes up
Commodity Risk due to volatility in commodity prices. A bank may have an obligation to
deliver a commodity in the future and the price of the commodity moves up
Cash Management Services - CMS is a service provided by banks to its corporate clients for a
fee to reduce the float on collections and to ease the bulk payment transactions of the
client. The three elements of CMS are:
o Receivables Management Helps the company to manage collection of its sale proceeds
from remote upcountry regions
o Payables Management Helps the company to manage its payments to its regular
suppliers without keeping numerous bank accounts for various locations and then
reconciles them periodically in a highly manual / paper-based environment
o Liquidity Management Helps the company by ensuring direct and instant access to its
bank accounts. It should not happen that a company has excess funds in one bank
account and it needs to pay through another bank account where there are no funds
Managing Liquidity & Interest Rate risks
o Asset Liability Management A banks assets and liabilities need to necessarily match.
If they dont the bank may have liquidity problems which would endanger its solvency.
The long term assets should not be financed by short term sources of funds. The bank
would not be able to serve its lenders if the timings of its inflows do not match its
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outflows. A bank typically uses mathematical tools like Duration, Gap Analysis to find
out mismatches and take corrective actions
Example
A bank borrows USD 100MM at 3.00% for one year
The bank uses this borrowed money to lend to a highly-rated borrower for 5 years at 3.20%.
For simplicity, assume interest rates are annually compounded and all interest accumulates to
the maturity of the respective obligations. The net transaction appears profitablethe bank is
earning a 20 basis point spreadbut it entails considerable risk.
At the end of one year, the bank will have to find new financing for the loan, which will have 4
more years before it matures. Assume interest rates are at 4.00% at the end of the first year.
The Bank will now have to pay a higher rate of interest (4.00%) on the new financing than
the fixed 3.20 it is earning on its loan. It is going to be earning 3.20% on its loan and paying
4.00% on its financing.
The problem in this simple example was caused by a maturity mismatch between assets and
liabilities. As long as interest rates experienced only modest fluctuations, losses due to asset-
liability mismatches are small or trivial. However, in a period of volatile interest rates, the
mismatches would become serious.
The treasury asset-liability management (ALM) group assesses asset-liability risk and all banks
have ALM committees comprised of senior managers to address the risk. Techniques for
assessing asset-liability risk came to include gap analysis, duration analysis and scenario analysis.
Gap analysis looks at amount of assets and liabilities in various maturity buckets while Duration
analysis looks at weighted average maturity of cash flows to compare assets and liabilities. Since
liquidity management is closely linked to asset-liability management, assessment and
management of liquidity risk is also a function of ALM departments and ALM committees. ALM
strategies often include securitization, which allows firms to directly address asset-liability risk
by removing assets or liabilities from their balance sheets. This not only eliminates asset-liability
risk; it also frees up the balance sheet for new business.
Interest rate risk management
o Manage risks due to volatility of interest rates - Demand and supply of money go on
changing from time to time making interests rates volatile. A bank may have accepted
deposits at a fixed rate of interest historically. However current market rates may be
lower when it wishes to lend. The banks portfolio value of investments in bonds and
treasury also varies inversely with the interest rates. A higher interest rate diminishes
the value of a banks portfolio and vice versa. Instruments like interest rate swaps and
currency swaps help to address Interest Rate risks
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6.4.2 CAUSES OF INTEREST RATE RISK
The causes of interest rate risk might vary:
Repricing risk: The primary form of interest rate risk arises from timing differences in the
maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-
balance-sheet (OBS) positions. For instance, a bank that funded a long-term fixed rate loan
with a short-term deposit could face a decline in both the future income arising from the
position and its underlying value if interest rates increase.
Yield curve risk: Yield curve risk arises when unanticipated shifts of the yield curve (a plot of
investment yields against maturity periods) have adverse effects on a bank's income or
underlying economic value. Yield curves can shift parallel or change in steepness, posing
different risks. For instance, the underlying economic value of a long position in 10-year
government bonds hedged by a short position in 5-year government notes could decline
sharply if the yield curve steepens, even if the position is hedged against parallel
movements in the yield curve.
Basis risk: Basis risk arises from imperfect correlation in the adjustment of the rates earned
and paid on different instruments with otherwise similar repricing characteristics. For
example, a strategy of funding a one year loan that reprices monthly based on the one
month U.S. Treasury Bill rate, with a one-year deposit that reprices monthly based on one
month Libor, exposes the institution to the risk that the spread between the two index rates
may change unexpectedly.
Optionality: An additional and increasingly important source of interest rate risk arises from
the options embedded in many bank assets, liabilities and OBS portfolios. Options may be
stand alone instruments such as exchange-traded options and over-the-counter (OTC)
contracts, or they may be embedded within otherwise standard instruments. They include
various types of bonds and notes with call or put provisions, loans which give borrowers the
right to prepay balances, and various types of non-maturity deposit instruments which give
depositors the right to withdraw funds at any time, often without any penalties. If not
adequately managed, the asymmetrical payoff characteristics of instruments with
optionality features can pose significant risk particularly to those who sell them, since the
options held, both explicit and embedded, are generally exercised to the advantage of the
holder and the disadvantage of the seller.
Managing interest rate risk
Bank treasuries measure interest rate sensitivity of securities (assets or liabilities) through
Duration analysis. Duration is a mathematical concept which can be used to measure the
sensitivity of a financial instruments price to changes in interest rate. On the basis of duration
analysis, banks can increase/decrease holdings of long term and short term securities in
response to anticipated changes in interest rate.
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Banks also use derivative instruments like interest rate swaps and options to manage interest
rate risks (A derivative is a generic term often used to categorize a wide variety of financial
instruments whose value depends on or is derived from the value of an underlying asset,
reference rate or index). Some of them are:
o Interest Rate Swap: An agreement to exchange net future cash flows. In its
commonest form, the fixed-floating swap, the counterparty pays a fixed rate
and the other pays a floating rate based on a reference rate, such as Libor.
There is no exchange of principal. The interest rate payments are made on an
agreed notional amount.
o Forward Rate Agreement (FRA): A FRA allows purchasers / sellers to fix the
interest rate for a specified period in advance. One party pays fixed, the other
an agreed variable rate. Maturities are generally out to two years and are priced
off the underlying yield curve. The transaction is done in respect of an agreed
nominal amount and only the difference between contracted and actual rates is
paid.
o Interest Rate Guarantee: An option on a forward rate agreement (FRA), also
known as a FRAtion. Purchasers have the right, but not the obligation, to
purchase a FRA at a predetermined strike. Caps and Floors are strips of interest
rate guarantees.
o Swaption: An option to enter an interest rate swap. A payer swaption gives the
purchaser the right to pay fixed (receive floating), a receiver swaption gives the
purchaser the right to receive fixed (pay floating).
Forex Management Similar to interest rates, the Forex rates of countries who have not
pegged their currencies vary from time to time. This exposes its market participants to risk
of adverse movements of exchange rates. FX Forwards and Forex Options provide a means
of reducing exchange rate risks by entering into contracts at fixed rates thereby making the
outcome predictable
Foreign exchange is essentially about exchanging one currency for another. Forex rates between
two currencies at any point of time are influenced by a variety of factors like state of the
economy, interest rates & inflation rate, exchange rate systems (fixed/floating), temporary
demand-supply mismatches, foreign trade position etc.
Foreign exchange exposures for a financial entity arise from many different activities. A
company which borrows money in a foreign currency is at risk when the local currency
depreciates vis--vis the foreign currency. An exporter who sells its product in foreign currency
has the risk that if the value of that foreign currency falls then the revenues in the
exporter's home currency will be lower. An importer who buys goods priced in foreign currency
has the risk that the foreign currency will appreciate thereby making the cost in local currency
greater than expected. Generally the aim of foreign exchange risk management is to stabilize
the cash flows and reduce uncertainty from financial forecasts.
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Since a bank is usually a counter party to the above transactions, it faces similar Forex Risk when
the reverse happens.
6.4.3 BASICS OF FOREX
Currencies are quoted in one of the two ways:
Direct Quotation (1 USD = INR 45.26) &
Indirect Quotation (INR 100 = USD 2.21).
Direct or Indirect are always vis--vis the US dollar perceptive. In practice, all currencies
except the British Pound are quoted in the direct quotation method. Since rates for all
currencies are quoted vis--vis the US dollar, cross currency rates (example: INR/Euro) would be
obtained by combining the two primary currency quotes vis--vis the US dollar.
Also, quotes usually have two parts: the bid rate (rate at which the bank will purchase US
dollars against home currency in case of direct quotes) and the ask rate (rate at which the bank
will sell US dollars against home currency in case of direct quotes). The bid rate will always be
lesser than the ask rate to cover for operational charges and profit margins of the banks.
Examples are:
INR/USD quote: 45.26/.36 (here, 0.01 is the smallest count, referred to as one pip)
EUR/USD quote: 1.2458/.2461 (here, 0.0001 is the smallest count, referred to as one pip)
While the derived cross currency rate would be:
INR/Euro quote: (45.26*1.2461)/ (45.36*1.2458) = 56.40/.51
Foreign currency deals in a particular currency necessary have to be settled in the home nation
of the currency. Hence, banks taking part in international transactions need to maintain
accounts in various countries to enable transacting in those currencies. These accounts are of
multiple types:
Nostro (Our/my account with you): Current account maintained by one bank with another
bank abroad in the latters home currency
Vostro (Their account with me/us): Current account maintained in the home currency by
one bank in the name of another bank based abroad
Typically, banks have vostro/nostro accounts with multiple foreign banks.
SPOT AND FORWARD FOREIGN EXCHANGE CONTRACTS
The most basics tools of Forex risk management are 'spot' and 'forward' contracts. These are
contracts between end users and financial institutions that specify the terms of an exchange of
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two currencies. In any Forex contract there are a number of variables that need to be agreed
upon and they are:
The currencies to be bought and sold - in every contract there are two currencies the one
that is bought and the one that is sold
The amount of currency to be bought or sold
The date at which the contract matures
The rate at which the exchange of currencies will occur
The exchange rates advertised either in the newspapers (and that mentioned above) or on the
various information services assume a deal with a maturity of two business days ahead - a deal
done on this basis is called a spot deal. In a spot transaction the currency that is bought will be
receivable in two days whilst the currency that is sold will be payable in two days. This applies to
all major currencies with the exception of the Canadian Dollar.
Most market participants want to exchange the currencies at a time other than two days in
advance but would like to know the rate of exchange now. This is done through a forward
contract to exchange the currencies at a specified exchange rate at a specified date. In
determining the rate of exchange in six months time there are two components:
the current spot rate
the forward rate adjustment
The spot rate is simply the current market rate as determined by supply and demand. The
forward rate adjustment is a slightly more complicated calculation that involves the interest
rates of the currencies involved.
Forward rate (Local currency/USD) = Spot rate *(1+ interest rate in US) / (1+ local interest rate),
with interest rates adjusted for the period of the forward rate. The concept behind this equation
is that if we defer the value date of a spot transaction each party will have the funds that they
would have paid to invest. The difference between a Forex spot rate and the forward rate for a
particular tenure is called the forward premium for that tenure. Currencies can have forward
premiums or forward discounts vis--vis the US dollar.
Forex risk can also be covered through Forex future contracts. Futures are exactly similar to
forwards, except for the fact that these deals are brokered through an exchange, non-
customizable (only standard deals available) and hence, not prone to counter-party risk.
BIFURCATION OF ALL MAJOR MARKETS (EQUITIES, BOND, FX, DERIVATIVES)
Small and Larger Orders Equity markets are characterized by smaller orders as compared
to the markets for other financial instruments because of more retail participation
Liquidity Exchange traded instruments are more liquid
Investor Profile Equity markets have a more retail investor profile as compared to markets
for other financial instruments
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Routing Deals in the Equity markets are routed to multiple destinations where as deals in
Forex as well as debt markets are matched internally
Public v/s Private - Markets for equities are listed whereas certain Derivatives are OTC
6.4.4 TREASURY APPLICATIONS SEGMENTS & VENDORS
TREASURY MANAGEMENT SYSTEMS INTER-BANK
Cross-Asset Trading and Risk
Sungard / Front Arena - FRONT ARENA is the definitive integrated solution for sales, trading
and risk management, operations and distribution across multiple asset classes. Its rich
functionality enables traders to make critical decisions with assurance. It is flexible across a
range of business areas gives which gives traders a competitive edge in trading activities.
Summit - Summit is a core solution for treasury management for both financial and
corporate institutions. Summits trading applications interact with operations and risk
management platforms to provide a straight-through-processing solution. This allows front
to back management of all products within four primary business areas viz Treasury, Fixed
Income, Derivatives and Commercial lending
Calypso - Calypso Technologies the worlds leading software provider of credit derivatives,
cross
asset trading, risk management, and processing. It offers a front-to-back office system that
allows traders flexibility to plug in their own products.
Wall Street Systems - Wall Street Systems delivers single-server, enterprise-wide solutions
to the world's leading financial institutions and corporations The Wall Street System
financial trading and treasury engine provides a multi-entity, multi-currency, multi-asset
class environment which supports all front, middle and back office operations.
TREASURY SALES BANK TO CUSTOMER
Single-bank platform
Cognotec Cognotec is the world's leading provider of automated trading solutions to
financial enterprises across the globe. They provide Forex dealing solutions. They have
partnered with world-leading technology providers, multi-bank platforms and industry
organizations.
Integral - Integral is at the forefront of the eFX market in developing new, highly innovative
products. Integral is the provider of integrated electronic trading systems, offering intuitive
and innovative products that automate and streamline the entire trading cycle.
Multi-bank platform
Reuters RET - Reuters Electronic Trading provides a comprehensive FX and money markets
trading solution for banks.. It includes Automated Dealing, an internet based FX and money
market automated dealing capability, to enable the Bank's dealing room to price, execute,
confirm and manage FX and money market trading.
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6. 5 CASH MANAGEMENT
Cash Management Service (CMS) is a service provided by banks to its clients for a fee to reduce
the float on collections and to ease the bulk payment transactions of the client. Large
Corporations like GM or Ford need to manage cash well since they have:
Payments to multiple parties at various locations Payments need to be made to suppliers
across the country. Typically these have suppliers across the country to reduce dependence
on one or a few suppliers
Collections from multiple parties at various locations - How does a company collect its sale
proceeds from remote upcountry regions?
Multiple banking accounts at various locations
o Ensure local deficits and surpluses are managed A corporate may be paying its
employees salaries out of one bank account whereas it may be banking its receivables
in another bank account another location leading to surpluses and deficits in their bank
accounts
o Ensure net surplus is invested properly If a corporate is unable to identify surpluses, a
corporate may risk keeping money idle leading to loss of interest income if it does not
prudently invest its net surpluses leading to
o Reduce operational costs associated with payments & collections A CMS would help
optimize wasted operational cost on payments and collections
Cash Management solutions help corporations:
o Devise an effective account & investment strategy to manage surpluses and deficits
Pooling, Netting, Zero-balance structures
o Automate collections and payments process flows
o Outsource collections and payments administration & reconciliation
Example
Consider a consumer goods company in Mid-west US, with dealerships spread through 12
states. The company has a manufacturing facility in Michigan and 4 depots, one each in Ohio,
Michigan, Illinois and Texas. The company transports goods to the 4 depots which serves the
respective local dealers and in some cases dealers in neighboring states. All the depots are
treated as independent cost centers, with sales from respective regions and salaries and general
expenses for these regions marked to the depot concerned. Collections from dealers in various
locations are managed by local sales teams, one team for each state. The company wants to:
Ensure daily monitoring of collections from various states
Sweep all local collections daily to a central bank account at Michigan
Ensure that local accounts do not remain in debit when the central account is in credit.
Provide facility for temporary intra-day overdraft for the local accounts
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Ensure that surplus money in the central account is invested in an optimal fashion while
allowing sufficient liquidity
All payments from local accounts above $10,000 require an approval from the CFO sitting in
Michigan
This is a typical case where the company needs the services of a bank to manage its cash
collections and payments. The company needs both cash management facilities and MIS of
collections and payments that can allow it to track revenue and expenses in the manner
required.
Companies rarely fail because they are insolvent. They do fail because they are illiquid.
Companies must focus on precise working capital management as a critical component of
treasury strategy. Companies require:
rich information, to parallel the companys cash flow cycle
global cash concentration, through pooling mechanisms
automated internal funding mechanisms for deficit positions
Investment options to match individual profiles for liquidity, risk and return.
6.5.1 OFFERINGS IN CASH MANAGEMENT SERVICES
PAYMENT / DISBURSEMENT OFFERINGS
Payment service for corporations/retail customers
o Banks process payments on behalf of corporations CMS provides its customers the
payment processing services which help corporations to reduce administrative hassles
and costs in doing so.
o Instruments - Checks/demand drafts/ Electronic Fund Transfer (EFT) help in processing
payments
Payment Initiation
o Manual instruction Banks can act on manual instructions given by the corporations to
their bankers for processing payments. They typically take the form of checks or drafts
o Floppy/Electronic media instructions A list of beneficiaries and the corresponding
amounts are given in either a floppy or another electronic media to their banks in the
required formats which are used by the banks for processing payments
o Electronic banking applications Electronic applications like ECS / EFT or individual bank
specific software packages can be made use of by corporations to effect transfers
Bulk payments
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CMS is very beneficial for processing repetitive / bulk payments in the nature listed below.
Economies of scale and reduction of administrative and related costs can be gained by
corporations
o Payroll processing
o Dividend warrants
o Redemptions
COLLECTIONS SERVICES
Collect funds around the globe CMS provides accurate and timely collection of receivables
worldwide
Funds are credited to the cash management account
o Local collections Refer to collections from suppliers / debtors who issue local checks
o Outstation collections - Refer to collections from customers not in the base location of
the corporation
Banks have responded to the call for evolved cash management concepts. Accelerating accounts
receivable and streamlining accounts payable via a single banking system interface provide the
stepping stone to achieve optimal cash flow management. Some banks also provide aligned cash
management with liquidity and investment offerings. They do so by:
developing optimal account structures
applying cash concentration techniques like pooling and sweeping
providing investment vehicles to maximize cash flows
implementing foreign exchange and interest rate exposure netting systems
Establishing regional treasury and shared service centers.
The final objective of most of these cash management solutions is to effectively outsource the
corporates receivables and payables process and ensure the best possible liquidity and short
term investment management strategy. Moreover, increasingly, cash management (both
payments and collections) are moving over to a web-based environment where the corporate
can manage his receivables, payables and liquidity position online. In many cases, there is
almost-complete integration between the bank and the companys supply chain/ERP system
which manages collection and payments data internally. Some of the common methods used for
cash management are described below.
CHECK COLLECTIONS LOCK BOX SERVICE
There are possibilities for optimizing and streamlining a companys incoming payment flows.
The most common collection mechanism is a checks lock box service a collecting service which
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enables companies to collect and settle checks locally (In a typical case, each of the corporates
debtors would send checks along with accepted invoices to a designated post box, hence the
lock box name). Banks undertake to collect checks at various pre-defined locations on behalf of
the customer, send them for clearing and credit the amount s to a specified customer account.
Once the checks are collected by the bank through person, courier or delivered by the company
representative:
the checks are sorted and batched
post dated checks are kept for processing on the value date
the image of the checks and the remittance advices are captured and sent to the corporate
checks are sent for clearing, if required
realized checks are tallied and amounts credited to the corporates bank account
the information on checks collected is transmitted to the corporate for electronic
reconciliation
In enhanced versions of this facility, the bank manage the receivable books of the corporate -
managing collections, monitoring receivables ageing and providing reconciled collection reports
which can be directly uploaded to corporate information/supply chain systems.
ZERO BALANCE STRUCTURE - POOLING
Pooling allows a company or several companies belonging to the same group profit from
efficient liquidity management, centralized treasury and credit-line management and
optimization of interest results. Banks offer both domestic and cross border zero balancing
whereby all value balances of a set of 'participating' accounts are centralized at the end of each
day in one central account. Thus the participating accounts will not bear any credit or debit
interest, and all balances are concentrated in the central account enabling optimal management
of our cash position.
NETTING
Netting is the fundamental method for centralizing and offsetting intra company and third party
payments. Netting not only significantly reduces payment flows and costs, but also provides
invaluable management information. Banks offer both domestic and cross-border netting
solutions.
CLEARING SERVICES
Banks offer clearing services to other banks. In such cases, a bank with strong local branch
coverage offers to participate in clearing arrangements on behalf of other banks with no
physical presence at these locations. Also clubbed under correspondent banking services, this
facility primarily helps use the branch networks of various banks on a complimentary basis.
NEW ACT - CHECK 21
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The Check Clearing for the 21st Century Act (Check 21) was signed into law on October 28,
2003, and became effective on October 28, 2004. The law facilitates check truncation by
creating a new negotiable instrument called a substitute check, which permits banks to
truncate original checks, to process check information electronically, and to deliver
substitute checks to banks that want to continue receiving paper checks. A substitute check
is the legal equivalent of the original check and includes all the information contained on the
original check. The law does not require banks to accept checks in electronic form nor does
it require banks to use the new authority granted by the Act to create substitute checks.
o Electronic transmission of checks by Check imaging - Banks find that exchanging
electronic images of checks with other banks is faster and more efficient than physically
transporting paper checks. To address this need, Check 21 allows a bank to create and
send a substitute check that is made from an electronic image of the original check.
o Faster / efficient check realization Since the electronic image of the check can be
quickly transmitted electronically, time required for transporting the physical paper
checks is greatly reduced thereby effecting faster check realizations
6.5.2 DEVELOPMENTS IN TREASURY & CASH MANAGEMENT
ASSET SECURITIZATION
Financial institutions and banks need to raise fresh capital to fund continuous asset growth and
portfolio management. This has become a major challenge for many financial institutions and
banks due to tough capital market conditions and other market related factors. Asset
securitization can offer an alternative cost efficient financing tool, enabling them to better
manage liquidity and funding requirements.
Asset securitization transactions have one basic concept: the identification and isolation of a
separable pool of assets that generate revenue streams independently from the originating
entity. The securities issued on these assets are then sold to investors who base their returns
exclusively on the underlying assets performance. The structure is illustrated below:
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All these entities need not be present in every transaction. The number of entities depends on
the complexity of the transaction. An example would help understand the concept better.
Example
Bank of America (Originator) has 5000 home loans totaling more than $600 million. The
individual loans are of various credit profiles and various repayment periods. Bank of America is
constrained by lack of funds and wishes to sell off its loans to raise money. Thus, it decides to
sell about 2000 home loans totaling $200 million. The steps followed are shown below:
Bank of America conducts an internal study of the portfolio and ascertains that the average
maturity of the pool of loans is about 12 years and the average credit rating would be AA-. It
realizes that historically 10% of the total home loan owners default. So it would only realize
$180 million instead of $200 million.
Bank of America wants to enhance the rating so that it can sell the loans at a better price.
It decides to provide cash security of $10 million (Credit enhancement) in the scenario of
any repayment default by home loan borrowers.
Bank of America appoints Credit rating agency X which analyses the pool of loans, and taking
into account the cash security provided rates it AA+.
Bank of America sells the pool of housing loans amounting to $200 million to an
independent firm, Plexus SPV Ltd.
Backed by these home loans future cash flows, Plexus SPV Ltd. issues debt certificates for
$200 million to investors. Plexus pays back the investors the money from the repayments
done by the home loan borrowers.
Plexus SPV Ltd. pays $198 million to Bank of America after deducting service charges to
cover operational costs.
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From now on, all EMI repayments on these home loans made by retail investors would flow
through Plexus SPV Ltd and then reaches the investors.
The above example captures the gist of any securitization transaction, but there are a lot of
structuring issues and legal and regulatory challenges involved in any such transaction.
Fannie Mae and Ginnie Mae are examples of institutions specializing in securitization
transactions of mortgage loans for US banks. They help US banks in having enough fresh funds
for home loan disbursements.
REAL TIME GROSS SETTLEMENT (RTGS)
The current payment system involves settlement of payments on a settlement day and interest
is invariably computed to accrue on a daily basis. Even in the wholesale markets for foreign
exchange and money markets contracts, spot transactions mean two-business days.
Settlement for clearing checks presented to the clearing houses takes place on a netting basis at
a particular time either same day or on the next day. This system gives rise to risks such as credit
risk, liquidity risk, legal risk, operational risk and systemic risk.
RTGS is a system provides online settlement of payments between financial institutions. In this
system payment instructions between banks are processed and settled individually and
continuously throughout the day. This is in contrast to net settlements where payment
instructions are processed throughout the day but inter-bank settlement takes place only
afterwards typically at the end of the day. Participant banks will have to maintain a dedicated
RTGS settlement account with the central bank for outward and inward RTGS payments.
RTGS systems do not create credit risk for the receiving participant because they settle each
payment individually, as soon as it is accepted by the system for settlement.
RTGS system can require relatively large amounts of intraday liquidity because participants need
sufficient liquidity to cover their outgoing payments.
CONTINUOUS LINKED SETTLEMENT (CLS)
The average daily turnover in global Forex transactions stand at almost USD 2 trillion, with
participants in the market spread across various geographies and time zones. However, the
difference in time zones and hence lack of synchronization of transactions has resulted in
considerable amount of systematic risk. Typically, one leg of a Forex trade is affected at one
point of time and there would be a delay before the other leg is executed because of time-zone
differences. In such a situation, there is a heightened risk of one party defaulting.
CLS eliminates this temporal settlement risk, making same-day settlement both possible and
final. This is made possible by leveraging on the fact that there are significant overlaps between
the main time zones. CLS provides a specific time window in which various settlement time
zones can interact and pass settlement messages. The CLS system consists of the following
entities:
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CLS Bank: The CLS bank is the central node for the CLS system. CLS Bank is owned by nearly
70 of the worlds largest financial groups throughout the US, Europe and Asia Pacific, who
are responsible for more than half the value transferred in the world's FX market.
Settlement Members: They are shareholders of the CLS bank, who can each submit
settlement instructions directly to CLS Bank and receive information on the status of their
instructions. Each Settlement Member has a multi-currency account with CLS Bank, with the
ability to move funds. Settlement Members have direct access and input deals on their own
behalf and on behalf of their customers. They can provide a branded CLS service to their
third-party customers as part of their agreement with CLS Bank.
User Members: User Members can submit settlement instructions for themselves and their
customers. However, User Members do not have an account with CLS Bank. Instead they are
sponsored by a Settlement Member who acts on their behalf. Each instruction submitted by
a user member must be authorized by a designated Settlement Member. The instruction is
then eligible for settlement through the Settlement Member's account.
Third parties: Third parties are customers of settlement and user members and have no
direct access to CLS. Settlement or user members must handle all instructions and financial
flows, which are consolidated in CLS.
Nostro agents: These agents receive payment instructions from Settlement Members and
provide time-sensitive fund transfers to Settlement Members' accounts at CLS Bank. They
receive funds from CLS Bank, User Members, third parties and others for credit to the
Settlement Member account.
The benefits of the CLS system are many:
Traders can expand their FX business with counterparty banks without increasing limits.
Treasury managers have more certainty about intraday and end-of-day cash positions.
Global settlement can rationalize nostro accounts and leverage multi-currency accounts.
The volume and overall value of payments is reduced, as are cash-clearing costs.
Costly errors are minimized and any problems can be resolved fast.
AUTOMATED CLEARING HOUSE FACILITIES (ACH)
ACH transactions are electronic clearing transactions in which information about debits and
credits are passed across the clearing system through electronic data files rather than physical
instruments like checks, drafts etc. ACH electronic transactions are distinguished from wire
transfers in that they are high volume, regularly scheduled, usually between the same parties,
and are initiated via specifically formatted electronic files. Such transactions must usually be
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initiated one to two days prior to the settlement date, since they are batch processed and not
for immediate payment. The most common ACH payment applications are:
Direct deposit of payroll, where the bank debits the corporate account and credits
employee accounts on the basis of a electronic file transmitted/provided by the corporate
Corporate Disbursement Service, where the bank debits a client's account to initiate
payments to vendors on their behalf
Corporate Collection Service, where the bank enables its clients to collect payments and
remittance data from vendors or trading partners.
Collection of consumer payments over the telephone, through the Internet or via check-to-
ACH conversion.
ACH Accounts Receivable Check Conversion enables converting checks collected at a lockbox
or remittance-processing center to ACH electronic debits, speeding payment collections and
improving funds availability.
These services allow the customer to increase transaction speed and improve accuracy and ease
of reconciliation by electronic means and avoidance of physical instruments and clearing delays.
ACH has been an area of very strong growth, with over 8.5 billion transactions being effected
through this route in 2002. However, several security issues remain to be resolved in this area.
6. 6 TRADE FINANCE
The main objective of trade finance is to facilitate transactions. There are many financing
options available to facilitate international trade such as pre-shipment finance to produce or
purchase a product, and post-shipment finance of the receivables.
PRE SHIPMENT LOANS
Banks provide Pre-shipment finance - working capital for purchase of raw materials, processing
and packaging of the export commodities.
POST SHIPMENT LOANS
Post-shipment financing assists exporters to bridge their liquidity needs where exports are made
under deferred payment basis. A typical example of post-shipment financing is bills discounting.
Bills discounting facility serves to provide liquidity to an exporter by advancing him/her a
portion of the face value of a trade bill drawn by the exporter, accepted by the buyer and
endorsed to the Bank.
In competitive supply situations, favorable terms of payment often ensure that the order is
won. An exporter usually wants to get paid as quickly as possible and an importer will want to
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pay as late as possible preferably after they have sold the goods. Trade finance is often
required to bridge these two disparate objectives.
FACTORS IN CHOOSING THE MODE OF FINANCING
Costs: The cost of different financing methods can vary, both in terms of interest rates and
fees. These costs will impact the viability of a transaction
Time Frame: Depending on the need, short, medium and long-term finance facilities may be
available. The different possibilities should be explored with the finance provider prior to
concluding a transaction. Long-term requirements should also be considered to ensure fees
are not being paid out on a revolving facility that could be saved by using a different
financing structure
Risk Factors: The nature of the product or service, the buyers credit rating and
country/political risks can all affect the security of a trading transaction. In some cases it will
be necessary to obtain export insurance or a confirmed letter of credit. Increased risks will
normally correspond to increased cost in a transaction and will normally make the funding
of a particular transaction, harder to obtain
Government Guarantee Programs: These can sometimes be obtained where there is some
question over the exporters ability to perform or where increased credit is needed. If
obtained, these may enable a lender to provide more finance than their usual underwriting
limits would permit.
Exporters Funds: If the exporter has sufficient resources, he/she may be able to extend
credit without the need for third party financing. However, an established trade finance
provider, offers other benefits like expert credit verification and risk assessment as well as
an international network of offices and staff to ensure that the transaction is completed
safely and satisfactorily
BILL OF LADING
A bill of lading or BOL is:
A contract between a carrier and a shipper for the transportation of goods.
A receipt issued by a carrier to a shipper for goods received for transportation.
Evidence of title to the goods in case of a dispute.
Question
Pre-shipment finance is liquidated only through realizations of export bills or amounts received
through export incentives. Pre shipment finance should not normally remain outstanding beyond
the original stipulated shipment date. In case it remains outstanding, can the non-adjusted
amount be then transferred as post shipment finance?
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The BOL grants the carrier the right to sub-contract its obligations on any terms and would bind
a shipper even if it meant that the shipper's goods could be detained and sold by the sub-
contractor.
CREDIT CHECK
Insuring payment starts long before a contract is signed. The seller, or his representative,
performs due diligence or a reasonable assessment of the risks posed by the potential buyer.
The sources of information include:
Chambers of commerce, Business Bureaus or their equivalents
Credit rating services such as TRW and Dun & Bradstreet which have international affiliates
Trade associations and trade promotion organizations
Freight forwarders, brokers, and banks
Direct references from the buyer
PAYMENT METHODS
Once acceptable risks have been determined then the most appropriate payment method can
be selected. The most common payment methods are described below:
Cash in advance
Letter of credit
Documentary collection
Open account or credit
Counter-trade or Barter
CASH IN ADVANCE
Cash in advance is risk-free except for potential non-delivery of the goods by the seller. It is
usually a wire transfer or a check. Although an international wire transfer is more expensive, it is
often preferred because it is speedy and does not bear the danger of the check not being
honored. The check can be at a disadvantage if the exchange rate has changed significantly by
the time it arrives, clears and is credited. On the other hand, the check can make it easier to
shop for a better exchange rate between different financial institutions.
For wire transfers the seller must provide clear routing instructions in writing to the buyer or the
buyers agent. These include:
Full name, address, telephone, and telex of the sellers bank
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Banks SWIFT and/or ABA numbers
Sellers full name, address, telephone, type of bank account, and account number.
COMMERCIAL LETTER OF CREDIT
The letter of credit (LC) allows the buyer and Seller to contract a trusted intermediary (a bank)
that will guarantee full payment to the seller provided that he has shipped the goods and
complied with the terms of the agreement.
Features
The LC serves to evenly distribute risk between buyer and seller. The seller is assured of
payment when the conditions of the LC are met and the buyer is reasonably assured of
receiving the goods ordered. This is a common form of payment, especially when the
contracting parties are unfamiliar with each other.
Since banks deal with documents and not with products, they must pay an LC if the
documents are presented by the seller in full compliance with the terms, even if the buyer
never receives the goods. Goods lost during shipment or embargoed are some examples.
Iraq for example, never received goods that were shipped before its embargo but the LCs
had to be paid anyway.
LCs are typically irrevocable, which means that once the LC is established it cannot be
changed without the consent of both parties. Therefore the seller, especially when
inexperienced, ought to present the agreement for an LC to an experienced bank or freight
forwarder so that they can verify if the LC is legitimate and if all the terms can be reasonably
met. A trusted bank, other than the issuing or buyers bank can guarantee the authenticity
of the document for a fee.
Disadvantages
If there are discrepancies in the timing, documents or other requirements of the LC the
buyer can reject the shipment. A rejected shipment means that the seller must quickly find a
new buyer, usually at a lower price, or pay for the shipment to be returned or disposed.
One of the most costly forms of payment guarantee Usual cost is 0.5% to 1%. Sometimes,
the costs can go up to 5 percent of the total value.
LCs take time to draw up and usually tie up the buyers working capital or credit line from
the date it is accepted until final payment, rejection for noncompliance, expiration or
cancellation (requiring the approval of both parties)
The terms of an LC are very specific and binding. Statistics show that approximately 50% of
submissions for LC payment are rejected for failure to comply with terms. For example, if
one of the required documents is incomplete or delivered late, then payment will be
withheld even if all other conditions are fulfilled and the shipment received in perfect order.
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The buyer can sometimes approve the release of payment if a condition is not fulfilled; but
changing terms after the fact is costly, time consuming and sometimes impossible.
The mechanism
Usually, four parties are involved in any transaction using an LC:
1. Buyer or Applicant
The buyer applies to his bank for the issuance of an LC. If the buyer does not have a
credit arrangement with this issuing bank then he must pay in cash or other negotiable
securities.
2. Issuing bank
The issuing or applicants bank issues the LC in favor of the beneficiary (Seller) and
routes the document to the beneficiarys bank. The applicants bank later verifies that
all the terms, conditions, and documents comply with the LC, and pays the seller
through his bank.
3. Beneficiarys bank
The sellers or beneficiarys bank verifies that the LC is authentic and notifies the
beneficiary. It, or another trusted bank, can act as an advising bank. The advising bank is
used as a trusted bridge between the applicants bank and the beneficiarys bank when
they do not have an active relationship. It also forwards the beneficiarys proof of
performance and documentation back to the issuing bank. However, the advising bank
has no liability for payment of the LC. The beneficiary, or his bank, can ask an advising
bank to confirm the LC. The confirming bank charges a fee to ensure that the beneficiary
is paid when he is in compliance with the terms and conditions of the LC.
4. Beneficiary or Seller
The beneficiary must ensure that the order is prepared according to specifications and
shipped on time. He must also gather and present the full set of accurate documents, as
required by the LC, to the bank.
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Letter Of Credit Diagram
1. Buyer and seller agree on a commercial transaction.
2. Buyer applies for a letter of credit.
3. Issuing bank issues the letter of credit (LC)
4. Advising bank advises seller than an LC has been opened in his or her favor. Seller sends
merchandise and documents to the freight forwarder.
5. Seller sends copies of documents to the buyer.
6. Freight forwarder sends merchandise to the buyers agent (customs broker).
7. Freight forwarder sends documents to the advising bank.
8. Issuing bank arranges for advising bank to make payment.
9. Advising bank makes payment available to the seller.
10. Advising bank sends documents to the issuing bank.
Letter of Credit Diagram and the 14 steps have been reproduced from www.web.worldbank.org
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11. Buyer pays or takes loan from the issuing bank.
12. Issuing bank sends bill of lading and other documents to the customs broker.
13. Customs broker forwards merchandise to the buyer.
Letters of credit can be flexible. Some LC variations include: Revolving, Negotiable, Straight, Red
Clause, Transferable, and Restricted. But perhaps the safest type of letter of credit from the
sellers point of view is the Standby letter of credit.
Example
An Asian Buyer from a Swedish Exporting company stated when he convinced the Exporter to
sell to them on open account terms. The Asian Buyer obtained 60 days credit, which was to be
calculated from the date of the invoice. The value of the order was USD 100, 000 and the goods
were dispatched and invoiced by the Swedish Exporter on the 15th July 2003.
The payment from Asia was due on the 14th Sept 2003. The payment eventually arrived on the
21st Nov 2003, over two months late. The delay in payment cost the Exporter USD 1700 as it
resulted in his account being overdrawn by this amount for 68 days at 9% per annum.
What if confirmed Letter of Credit had been required?
If Swedish exporter had insisted on receiving a confirmed Letter of Credit through Allied Swedish
Banks plc., the following costs (approximations) would have applied:
Confirmation Fee USD $250
Acceptance Commission (@ 1.5% pa for 60 days) USD $250
Negotiation / Payment Fee USD $150
Out of Pocket Expenses (estimate) USD $60
Total Letter of Credit Cost USD $710
Interest Cost as a result of late payment USD ($1,700)
Benefit of using Letter of Credit USD $990
Advantages of Letter of Credit
A Guarantee of payment on the due date from Allied Swedish Banks. (Provided the terms
and conditions of the Letter of Credit were complied with).
A definitive date for the receipt of funds, particularly important for devising proper currency
hedging strategies.
The opportunity to receive the payment in advance of the due date through non-recourse
discounting of the receivable.
Also note that the costs incurred in chasing the debt from the Asian buyer has not been
accounted for the Irish Exporter. In addition if the Exporter had sold his foreign currency
receivable on a forward basis to his bank for the original due date, they may have incurred a
further cost in canceling or rearranging the forward contract. Letters of Credit provide real and
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tangible benefits to companies. In this case the Swedish exporter only lost US$ 1700. Of course
if the Asian buyer had not paid at all they would have lost the whole USD 100,000
The standby LC is like a bank guarantee. It is not used as the primary payment method but as a
failsafe method or guarantee for long-term projects. This LC promises payment only if the buyer
fails to make an arranged payment or fail to meet pre-determined terms and conditions. Should
the buyer default, the seller must then apply to the bank for payment - a relatively simple
process without complicated documentation. Since the standby LC can remain valid for years
(Evergreen Clause) it eliminates the cost of separate LCs for each transaction with a regular
client.
Back to Back LC allows a seller to use the LC received from his buyer as collateral with the bank
to open his own LC to buy inputs necessary to fill his buyers order.
DOCUMENTARY COLLECTION
The seller sends a draft for payment with the related shipping documents through bank
channels to the buyers bank. The bank releases the documents to the buyer upon receipt of
payment or promise of payment. The banks involved in facilitating this collection process have
no responsibility to pay the seller should the buyer default unless the draft bears the aval (ad
valutem) of the buyers bank. It is generally safer for exporters to require that bills of lading be
made out to shippers order and endorsed in blank to allow them and the banks more flexible
control of the merchandise.
Documentary collection carries the risk that the buyer will not or cannot pay for the goods upon
receipt of the draft and documents. If this occurs it is the burden of the seller to locate a new
buyer or pay for return shipment. Documentary collections are viable only for ocean shipments,
as the bill of lading for ocean freight is a valid title to the goods and is a negotiable document
whereas the comparable airway bill is not negotiable as an ownership title.
DRAFTS
A draft (sometimes called a bill of exchange) is a written order by one party directing a second
party to pay a third party. Drafts are negotiable instruments that facilitate international
payments through respected intermediaries such as banks but do not involve the intermediaries
in guaranteeing performance. Such drafts offer more flexibility than LCs and are transferable
from one party to another. There are two basic types of drafts: sight drafts and time drafts.
SIGHT DRAFT
After making the shipment the seller sends a sight draft, through his bank to the buyers bank,
accompanied by agreed documentation such as the original bill of lading, invoice, certificate of
origin, phyto-sanitary certificate, etc. The buyer is then expected to pay the draft when he sees
it and thereby receive the documentation that gives him ownership title to the goods that were
shipped. There are no guarantees made about the goods other than the information about
quantities, date of shipment, etc. which appears in the documentation. The buyer can refuse to
accept the draft thereby leaving the seller in the unpleasant position of having shipped goods to
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a destination without a buyer. There is no recourse with the banks since their responsibility ends
with the exchange of money for documents.
TIME DRAFTS/BANKERS' ACCEPTANCES
Bankers' acceptances are negotiable instruments (time drafts) drawn to finance the export,
import, domestic shipment or storage of goods. It demands payment after a specified time or on
a certain date after the buyer accepts the draft and receives the goods. A bankers' acceptance is
"accepted" when a bank writes on the draft its agreement to pay it at maturity. A bank may
accept the draft for either the drawer or the holder.
An ordinary acceptance is a draft or bill of exchange order to pay a specified amount of money
at a specified time. A draft may be drawn on individuals, businesses or financial institutions.
An acceptance doesn't reduce a bank's lending capacity. The bank can raise funds by selling the
acceptance. Nevertheless, the acceptance is an outstanding liability of the bank and is subject to
the reserve requirement unless it is of a type eligible for discount by the Federal Reserve Bank.
HYBRID METHODS
In practice, international payment methods tend to be quite flexible and varied. Frequently,
trading partners will use a combination of payment methods. For example: the seller may
require that 50% payment be made in advance using a wire transfer and that the remaining 50%
be made by documentary collection and a sight draft.
OPEN ACCOUNT
Open account means that payment is left open to an agreed-upon future date. It is one of the
most common methods of payment in international trade and many large companies will only
buy on open account. Payment is usually made by wire transfer or check. This can be a very risky
method for the seller, unless he has a long and favorable relationship with the buyer or the
buyer has an excellent credit rating. Still, there are no guarantees and collecting delinquent
payments is difficult and costly in foreign countries especially considering that this method
utilizes few legally binding documents. Contracts, invoices, and shipping documents will only be
Example
Bankers Acceptances sell at a discount from the face value:
Face value of Bankers Acceptance $1,000,000
Minus 2% per annum commission for one year -$20,000
Amount received by exporter in one year $980,000
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useful in securing payment from a recalcitrant buyer when his countrys legal system recognizes
them and allows for reasonable settlement of such disputes.
OTHER PAYMENT METHODS
CONSIGNMENT
The consignment method requires that the seller ship the goods to the buyer, broker or
distributor but not receive payment until the goods are sold or transferred to another buyer.
Sometimes even the price is not pre-fixed and while the seller can verify market prices for the
sale date or hire an inspector to verify the standard and condition of the product, he ultimately
has very little recourse.
CREDIT CARD
Some banks offer buyers special lines of credit that are accessible via credit card to facilitate
even substantial purchases. It is convenient for both parties - but the seller should confirm the
bank charges and also bear in mind that the laws that govern domestic credit card transactions
differ from those govern international use.
COUNTER-TRADE AND BARTER
Counter-trade or barter is most often used when the buyer lacks access to convertible currency
or finds that rates are unfavorable or can exchange for products or services desirable to the
seller. Counter-trade indicates that the buyer will compensate the seller in a manner other than
transfer or money or products.
FACTORING
Factoring is a discounting method without recourse. It is an outright sale of export accounts
receivable to a third party, (the factor) who assumes the credit risk. The factor may be a
factoring house or a department of a bank. The advantage to the exporter is the removal of
contingent liabilities from its balance sheet, improved cash flow and elimination of bad debt
risk.
Factoring is for short-term receivables (under 90 days) and is more related to receivables against
commodity sales.
FORFAITING
The exporter sells accounts receivables to a forfaiter on a non-recourse discount basis, and
the exporter effectively passes all risks associated with the foreign debt to the forfaiter. The
forfaiter may be a forfaiting house or a department of a bank. The benefits are same as factoring
- maximize cash flow and eliminate the payment risk. It is a flexible finance tool that can be used
in short, medium and long-term contracts.
Forfaiting can be for receivables against which payments are due over a longer term, over 90
days and even up to 5 years.
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FOREIGN CREDIT INSURANCE UNDERWRITERS AND BROKERS
The purpose of foreign credit insurance is to insure repayment of export credit against
nonpayment due to political and/or commercial causes. It insures commercial risks of
nonpayment by importers because of insolvency or other business factors and political risks of
war, expropriation, confiscation, currency inconvertibility, civil commotion, or cancellation of
import permits.
THE BANKERS ASSOCIATION FOR FOREIGN TRADE (BAFT)
Example
An Asian Importer wants to purchase machinery that he is unwilling or unable to pay
for in cash until that machinery begins to generate income.
At the same time, the exporter wants immediate payment in full in order to meet his on-
going business commitments
Forfaiting solution works as follows
1. Commercial contracts are negotiated subject to finance;
2. The importer arranges for an Irrevocable Letter of Credit to be issued or for a
series of Promissory Notes or Bills of Exchange to be drawn in favor of the
exporter which the importer arranges to have guaranteed by his local bank;
3. The exporter contacts the discounting bank (the forfaiter) for a rate of discount
which is then agreed;
4. The goods are shipped;
5. The notes or bills are sent with shipping documentation and invoices to the
discounting bank via the exporter (who endorses the notes or bills "without
recourse" to the order of the discounting bank);
6. The discounting bank purchases the guaranteed notes or bills from the exporter
at the agreed rate.
Result: the exporter receives payment in full immediately after shipping (against
presentation of satisfactory documentation to the forfaiter); the importer gets his
goods and can pay for them in installments over time; and the forfaiter has title to an
asset which he may retain as an investment.
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The Bankers Association for Foreign Trade (BAFT) is a collection of banking institutions,
dedicated to promoting American exports, international trade, and finance and investment
between U.S. firms and their trading partners. BAFT has set up a trade finance database with a
grant from the U.S. Department of Commerce. The database serves as an essential resource for
assisting exporters seeking trade finance and banks that provide financial services.
6. 6 PAYMENTS NETWORK
6.6.1 FEDWIRE
Fedwire is an electronic transfer system developed and maintained by the Federal Reserve
System. The system connects Federal Reserve Banks and Branches, the Treasury and other
government agencies, and more than 9,000 on-line and off-line depository institutions and thus
plays a key role in US payments mechanism. The system is available on-line depository
institutions with computers or terminals that communicate directly with the Fedwire network.
These users originate over 99 percent of total funds transfers. The remaining customers have
off-line access to Fedwire for a limited number of transactions.
Fedwire transfers U.S. government and agency securities in book-entry form. It plays a
significant role in the conduct of monetary policy and the government securities market by
increasing the efficiency of Federal Reserve open market operations and helping to keep the
market for government securities liquid.
Depository institutions use Fedwire mainly to move balances to correspondent banks and to
send funds to other institutions on behalf of customers. Transfers on behalf of bank customers
include funds used in the purchase or sale of government securities, deposits, and other large,
time-sensitive payments.
Fedwire and CHIPS, a private-sector funds transfer network specializing in international
transactions, handle most large-dollar transfers. In 2000, some 108 million funds transfers
with a total value of $380 trillion were made over Fedwire -- an average of $3.5 million per
transaction.
All Fedwire transfers are completed on the day they are initiated, generally in a matter of
minutes. They are guaranteed to be final by the Fed as soon as the receiving institution is
notified of the credit to its account.
Until 1980, Fedwire services were offered free to Federal Reserve member commercial banks.
However, the Depository Institutions Deregulation and Monetary Control Act of 1980 required
the pricing of Fed services, including funds and securities transfers, and gave nonmember
depository institutions direct access to the transfer system. To encourage private-sector
competition, the law requires the Fed's fees to reflect the full cost of providing the services,
including an implicit cost for capital and profitability.
How Fedwire Works
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Cognizant Confidential Foundation Course in Banking and Capital Markets
Transfers over Fedwire require relatively few bookkeeping entries. Suppose an individual or a
private or government organization asks a bank to transfer funds. If the banks of the sender and
receiver are in different Federal Reserve districts, the sending bank debits the sender's account
and asks its local Reserve Bank to send a transfer order to the Reserve Bank serving the
receiver's bank. The two Reserve Banks settle with each other through the Inter-district
Settlement Fund, a bookkeeping system that records Federal Reserve inter-district transactions.
Finally, the receiving bank notifies the recipient of the transfer and credits its account. Once the
transfer is received, it is final and the receiver may use the funds immediately. If the sending and
receiving banks are in the same Federal Reserve district, the transaction is similar, but all of the
processing and accounting are done by one Reserve Bank.
6.6.2. CHIPS
CHIPS, Clearing House Interbank Payments System, are the premier bank-owned payments
system for clearing and settling large value payments. CHIPS is a real-time, final payments
system for U.S. dollars that use bi-lateral and multi-lateral netting for maximum liquidity
efficiency. CHIPS is the only large value system in the world that has the capability of carrying
extensive remittance information for commercial payments. CHIPS processes over 267,000
payments a day with a gross value of over $1.37 trillion. It is a premier payments platform
serving the largest banks from around the world, representing 22 countries worldwide.
6.6.3 SWIFT
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) runs a worldwide
network by which messages concerning financial transactions are exchanged among banks and
other financial institutions. As of December 2001, it linked over 7000 financial institutions in 194
countries and estimates that it carried payments messages averaging more than six trillion US
dollars per day. SWIFT network is used for transfers across different countries and in all
currencies.
SWIFT is a co-operative society under Belgian law, owned by its member financial institutions
with offices around the world. SWIFTs headquarters are located in La Hulpe near Brussels. It
was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to establish
a common language for financial for financial transactions and a shared data processing system
and worldwide communications network. Fundamental operating procedures, rules for liability,
etc. were established in 1975 and the first message was sent in 1977.
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Cognizant Confidential Foundation Course in Banking and Capital Markets
INTERNATIONAL PAYMENT INSTRUMENTS COMPARISON CHART
The Sarbanes-Oxley Act was signed into law on 30th July 2002, and introduced significant
legislative changes to financial practice and corporate governance regulation. The act is named