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UNIT 1
OVERVIEW OF FINANCIAL INSTITUTION
LESSON 1:
INTRODUCTION TO INDIAN FINANCIAL
SYSTEM
Learning Objectives
After reading this lesson, you will understand
Significance and definition of financial system
Importance Of Financial Institutions
Role Of Financial Intermediaries
Financial System Various Types Of Classification
Functions Of Financial Institution
Dear students, today is our first lecture on Management of
Financial Institution. Before we get deep into the subject, the
primary basic thing for us to understand is the significance, role,
importance and function of financial institution.
What is the Significance and Definition of Financial
System?
We all know that the growth of output in any economy
depends on the increase in the proportion of savings/
investment to a nations output of goods and services. So the
financial system and financial institutions help in the diversion
of rising current income into savings/ investments.
We can define financial system as a set of institutions,
instruments and markets, which foster savings and channels
them to their most efficient use. The system consists of
individuals (savers), intermediaries, markets and users of
savings. Economic activity and growth are greatly facilitated by
the existence of a financial system developed in terms of the
efficiency of the market in mobilising savings and allocating
them among competing users.
Well-developed financial markets are required for creating a
balanced financial system in which both financial markets and
financial institutions play important roles. Deep and liquid
markets provide liquidity to meet any surge in demand for
liquidity in times of financial crisis. Such markets are also
necessary to derive appropriate reference rates for pricing
financial assets.
This lesson introduces the financial intermediary. Intermediaries
include commercial banks, savings and loan associations,
investment companies, insurance companies, and pension
funds. The most important contribution of intermediaries is a
steady and relatively inexpensive flow of funds from savers to
final users or investors. Every modern economy has
intermediaries, which perform key financial functions for
individuals, households, corporations, small and new
businesses, and governments.
What is the Importance of Financial Institutions?
Now coming to the importance of Financial Institution that i.e.
why is financial intermediaries so important in any country or
for that matter in any economy. The answer is simple. Business
entities include non-financial and financial enterprises. Non-
financial enterprises manufacture products (e.g., cars, steel,
computers) and/ or provide non-financial services (e.g.,
transportation, utilities, computer programming). Financial
enterprises, more popularly referred to as financial
institutions, provide services related to one or more of the
following: let us see what are those.
Transforming financial assets acquired through the market
and constitution them into a different, and more widely
preferable, type of asset-which becomes their liability. This is
the function performed by financial intermediaries, the
most important type of financial institution.
Exchanging of financial assets on behalf of customers.
Exchanging of financial assets for their own accounts.
Assisting in the creation of financial assets for their
customers, and then selling those financial assets to other
market participants.
Providing investment advice to other market participants.
Managing the portfolios of other market participants.
So now you are aware that financial intermediaries include
depository institutions (commercial banks, savings and loan
associates, savings banks, and credit unions), which acquire the
bulk of their funds by offering their liabilities to the public
mostly in the form of deposits: insurance companies (life and
property and casualty companies); pension funds; and finance
companies.
What are the Role of Financial Intermediaries?
Financial intermediaries obtain funds by issuing financial claims
against themselves to market participants, and then investing
those funds; the investments made by financial intermediaries-
their assets- can be in loans and/ or securities. These
investments are referred to as direct investments. Market
participants who hold the financial claims issued by financial
intermediaries are said to have made indirect investments.
We can elaborate this further by understanding that financial
institutions are business organisations that act as mobilisers
and depositories of savings, and as purveyors of credit or
finance. They also provide various financial services to the
community. They differ from non-financial (industrial and
commercial) business organisations in respect of their dealings,
i.e., while the former deal in financial assets such as deposits,
loans, securities, and so on, the latter deal in real assets such as
machinery, equipment, stocks of goods, real estate, and so on.
You should not think that the distinction between the financial
sector and the real sector is something ephemeral or
unproductive about finance. At the same time, it means that the
role of financial sector should not be overemphasised. The
activities of different financial institutions may be either
specialised or they may overlap; quite often they overlap. Yet you
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need to classify financial institutions and this is done on the
basis of their primary activity or the degree of their
specialisation with relation to savers or borrowers with whom
they customarily deal or the manner of their creation. In other
words, the functional, geographic, sectoral scope of activity or
the types of ownership are some of the criteria, which are often
used to classify a large
Financial System Various Types of Classification
We can classify financial institutions into banking and non-
banking institutions. You know that the banking institutions
have quite a few things in common with the non-banking ones,
but their distinguishing character lies in the fact that, unlike
other institutions, they participate in the economys payments
mechanism, i.e., they provide transactions services, their deposit
liabilities constitute a major part of the national money supply,
and they can, as a whole, create deposits or credit, which is
money. Banks, subject to legal reserve requirements, can advance
credit by creating claims against themselves, while other
institutions can lend only out of resources put at their disposal
by the savers, and the latter as mere purveyors of credit.
While the banking system in India comprises the commercial
banksand co-operative banks, the examples of non-banking
financial institutions are Life Insurance Corporation (LIC), Unit
Trust of India (UTI), and Industrial Development Bank of
India (IDBI). We shall discuss this in detail later.
There are also few other ways to classify financial institution.
Like they can be classified as intermediaries and non-
intermediaries. As we have seen earlier, intermediaries
intermediate between savers and investors; they lend money as
well as mobilise savings; their liabilities are towards the ultimate
savers, while their assets are from the investors or borrowers.
Non--intermediary institutions do the loan business but their
resources are not directly obtained from the savers. All banking
institutions are intermediaries. Many non-banking institutions
also act as intermediaries and when they do so they are known
as Non-Banking Financial Intermediaries (NBFI). UTI,
LIC, General Insurance Corporation (GIC) is some of the
NBFIs in India. Non-intermediary institutions like IDBI,
Industrial Finance Corporation (IFC), and National Bank for
Agriculture and Rural Development (NABARD) have come
into existence because of governmental efforts to provide
assistance for specific purposes, sectors, and regions. Their
creation as a matter of policy has been motivated by the
philosophy that the credit needs of certain borrowers might not
be otherwise adequately met by the usual private institutions.
Since they have been set up by the government, we can call them
Non-Banking Statutory Financial Organisations (NBSFO).
Let us now shift our focus to financial markets. Financial
markets are the centers or arrangements that provide facilities
for buying and selling of financial claims and services. The
corporations, financial institutions, individuals and
governments trade in financial products in these markets either
directly or through brokers and dealers on organised exchanges
or off--exchanges. The participants on the demand and supply
sides of these markets are financial institutions, agents, brokers,
dealers, borrowers, lenders, savers, and others who are
interlinked by the laws, contracts, covenants and
communication networks.
Financial markets are sometimes classified as primary (direct)
and secondary(indirect) markets. You all must be well aware
that primary markets deal in the new financial claims or new
securities and, therefore, they are also known as new issue
markets. On the other hand, secondary markets deal in securities
already issued or existing or outstanding. The primary markets
mobilise savings and supply fresh or additional capital to
business units. Although secondary markets do not contribute
directly to the supply of additional capital, they do so indirectly
by rendering securities issued on the primary markets liquid.
Stock markets have both primary and secondary market
segments.
Very often financial markets are classified as money markets
and capital markets, although there is no essential difference
between the two as both perform the same function of
transferring resources to the producers. This conventional
distinction is based on the differences in the period of maturity
of financial assets issued in these markets. While money
markets deal in the short-term claims (with a period of maturity
of one year or less), capital markets do so in the long-term
(maturity period above one year) claims. Contrary to popular
usage, the capital market is not only co-extensive with the stock
market; but it is also much wider than the stock market.
Similarly, it is not always possible to include a given participant
in either of the two (money and capital) markets alone.
Commercial banks, for example, belong to both. While treasury
bills market, call money market, and commercial bills market are
examples of money market; stock market and government
bonds market are examples of capital market.
The above classification can be tabulated in the table format as
given below:
Table 1
Classification bynatureof claim:
Debt Market
EquityMarket

Classification bymaturityof claim:
MoneyMarket
Capital Market

Classification byseasoningof claim:
PrimaryMarket
SecondaryMarket

Classification byimmediatedeliveryorfuturedelivery:
Cash orspot Market
DerivativeMarket

Classification byorganizational structure:
Auction Market
Over-the-counterMarket
IntermediatedMarket


What are the points of difference related to financial
instruments? These instruments differ from each other in
respect of their investment characteristics, which of course, are
interdependent and interrelated. Among the investment
characteristics of financial assets or financial products, the
following are important: (i) liquidity, (ii) marketability, (iii)
reversibility, (iv) transferability, (v) transactions costs, (vi) risk of
default or the degree of capital and income uncertainty, and a
wide array of other risks, (vii) maturity period, (viii) tax status,
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(ix) options such as call-back or buy-back option, (x) volatility
of prices, and (xi) the rate of return-nominal, effective, and real.
What are the Functions of Financial Institution?
After a detailed discussion on financial institution it becomes
easy for us to determine the functions of financial institution.
Financial institutions or intermediaries offer various types of
transformation services. They issue claims to their customers
that have characteristics different from those of their own
assets. For example, banks accept deposits as liability and
convert them into assets such as loans. This is known as
liability-asset transformation function. Similarly they
choose and manage portfolios whose risk and return they alter
by applying resources to acquire better information and to
reduce or overcome transaction costs. They are able to do so
through economies of scale in lending and borrowing. They
provide large volumes of finance on the basis of small deposits
or unit capital. This is called size-transformation function.
Further, they distribute risk through diversification and thereby
reduce it for savers as in the case of mutual funds. This is called
risk-transformation function. Finally they offer savers
alternate forms of deposits according to their liquidity
preferences, and provide borrowers with loans of requisite
maturities. This is known as maturity-transformation
function.
A financial system also ensures that transactions are effected
safely and swiftly on an on-going basis. It is important that
both buyers and sellers of goods and services should have the
confidence that instruments used to make payments will be
accepted and honoured by all parties. The financial system
ensures the efficient functioning of the payment mechanism.
In a nutshell, financial markets can be said to perform
proximate functions such as
1. Enabling economic units to exercise their time preference,
2. Separation, distribution, diversification, and reduction of
risk,
3. Efficient operation of the payment mechanism,
4. Transmutation or transformation of financial claims so as to
suit the preferences of both savers and borrowers,
5. Enhancing liquidity of financial claims through securities
trading, and
6. Portfolio management.
Questions to Discuss
1. What is the Significance And Definition of Financial System?
2. What is the Importance Of Financial Institutions?
3. What is the Role Of Financial Intermediaries?
4. What are the various classifications of Financial Institutions?
5. What are the functions of Financial Institutions?
Notes:
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LESSON 2:
INTRODUCTION TO INDIAN FINANCIAL SYSTEM
Learning Objectives
After reading this lesson, you will understand
Maturity Intermediation
Reducing Risk Via Diversification
Reducing The Costs Of Contracting And Information
Processing
Providing A Payments Mechanism
Asset/ Liability Management Of The Financial Institutions
Nature Of Liabilities
Liquidity Concerns
Brokerage and asset transformation
Advantages of financial institutions
Criteria To Evaluate Financial Institutions
After getting aware of the characteristics of financial institution,
let us understand some other related concepts.
What do you Mean by Maturity Intermediation?
The commercial bank by issuing its own financial claims in
essence transforms a longer-term asset into a shorter-term one
by giving the borrower a loan for the length of time sought and
the investor/ depositor a financial asset for the desired
investment horizon. This function of a financial intermediary is
called maturity intermediation.
You should understand that maturity intermediation has two
implications for financial markets. First, it provides investors
with more choices concerning maturity for their investments;
borrowers have more choices for the length of their debt
obligations. Second, because investors are naturally reluctant to
commit funds for a long period of time, they will require that
long-term borrowers pay a higher interest rate than on short-
term borrowing. A financial intermediary is willing to make
longer-term loans, and at a lower cost to the borrower than an
individual investor would, by counting on successive deposits
providing the funds until maturity. Thus, the second
implication is that the cost of longer-term borrowing is likely to
be reduced.
What is Reducing Risk Via Diversification?
Next shall discuss the way to reduce the risk through
diversification. Consider the example of the investor who places
funds in an investment company. Suppose that the investment
company invests the funds received in the stock of a large
number of companies. By doing so, the investment company
has diversified and reduced its risk. Investors who have a small
sum to invest would find it difficult to achieve the same degree
of diversification because they do not have sufficient funds to
buy shares of a large number of companies. Yet by investing in
the investment company for the same sum of money, investors
can accomplish this diversification, thereby reducing risk.
This economic function of financial intermediaries-
transforming more risky assets into less risky ones- is called
diversification. Although individual investors can do it on their
own, they may not be able to do it as cost-effectively as a
financial intermediary, depending on the amount of funds they
have to invest. Attaining cost-effective diversification in order to
deduce risk by purchasing the financial assets of a financial
intermediary is an important economic benefit for financial
markets.
Reducing the Costs of Contracting and Information
Processing
You can also reduce the cost of contracting and information
processing. Suppose you are an investor purchasing financial
assets. You should take the time to develop skills necessary to
understand how to evaluate an investment. Once these skills are
developed you should apply them to the analysis of specific
financial assets that are candidates for purchase (or subsequent
sale). If you as an investor wants to make a loan to a consumer
or business you will need to write the loan contract.
Although there are some people who enjoy devoting leisure
time to their task, most prefer to use that time for just that-
leisure. Most of us find that leisure time is in short supply, so
to sacrifice it, we have to be compensated; the form of
compensation could be a higher return that we obtain from an
investment.
In addition to the opportunity cost of the time to process the
information about the financial asset and its issuer, there is the
cost of acquiring that information. All these costs are called
information processing costs. The costs of writing loan
contracts are referred to as contracts are referred to as contracting
costs. There is also another dimension to contracting costs, the
cost of enforcing the terms of the loan agreement.
With this in mind, consider the two examples of financial
intermediaries- the commercial bank and the investment
company. People who work for these intermediaries include
investment professionals who are trained to analyse financial
assets and manage them. In the case of loan agreements, either
standardised contracts can be prepared, or legal counsel can be
part of the professional staff that writes contracts involving
more complex transactions. The investment professional can
monitor compliance with the terms of the loan agreement and
take any necessary action to protect the interests of the financial
intermediary. The employment of such professionals is cost-
effective for financial intermediaries because investing funds is
their normal business.
In other words, there are economies of scale in contracting and
processing information about financial assets because of the
amount of funds managed by financial intermediaries. The
lower costs accrue to the benefit of the investor who purchases
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a financial claim of the financial intermediary and to the issuers
of financial assets, who benefit from a lower borrowing cost.
Providing a Payments Mechanism
You have seen that most transactions made today are not done
with cash. Instead, payments are made using cheques, credit
cards, and electronic transfers of funds. These methods for
making payments are provided by certain financial
intermediaries.
At one time, non-cash payments were restricted to cheques
written against non-interest-bearing accounts at commercial
banks. Similar check writing privileges were provided later by
savings and loan associations and saving banks, and by certain
types of investment companies. Payment by credit card was also
one time the exclusive domain of commercial banks, but now
other depository institutions offer this service. Debit cards are
offered by various financial intermediaries. I am sure all of us
present over here must be having at least one debit card apart
from credit cards. And you all must also be aware that a debit
card differs from a credit card in that, in the latter case, a bill is
sent to the credit card holder periodically (usually once a month)
requesting payment for transactions made in the past. In the
case of a debit card, funds are immediately withdrawn (that is,
debited) from the purchasers account at the time the transaction
takes place
The ability to make payments without the use of cash is critical
for the functioning of a financial market. In short, depository
institutions transform assets that cannot be used to make
payments into other assets that offer that property.
Asset/ Liability Management of the Financial
Institutions
To understand the reasons mangers of financial institutions
invest in particular types of financial assets and the types of
investment strategies they employ, it is necessary that you have a
general understanding of the asset/ liability problem faced.
The nature of the liabilities dictates the investment strategy a
financial institution will pursue. For example, depository
institutions seek to generate income by the spread between the
return that they earn on assets and the cost of their funds. That
is, they buy money and sell money. They buy money by
borrowing from depositors or other sources of funds. They sell
money when they lend it to businesses or individuals. In
essence, they are spread businesses. Their objective is to sell
money for more than it costs to buy money. The cost of the
funds and the return on the funds sold is expressed in terms of
an interest rate per unit of time. Consequently, the objective of
a depository institution is to earn a positive spread between the
assets it invests in (what it has sold the money for) and the
costs of its funds (what it has purchased the money for).
Life insurance companies- and, to a certain extent, property and
casualty insurance companies- are in a spread business. Pension
funds are not in the spread business in that they do not raise
funds themselves in the market. They seek to cover the cost of
pension obligations at a minimum cost that is borne by the
sponsor of the pension plan. Investment companies face no
explicit costs for the funds they acquire and must satisfy no
specific liability obligations; one exception is a particular type of
investment company that agrees to repurchase shares at any
time.
Nature of Liabilities
By the liabilities of the financial institution we mean the
amount and timing of the cash outlays that must be made to
satisfy the contractual terms of the obligations issued. The
liabilities of any financial institution can be categorized
according to four typed as shown in the below table. The
categorisation in the table assumes that the entity that must be
paid the obligation will not cancel the financial institutions
obligation prior to any actual or projected payout date.
The descriptions of cash outlays as either known or uncertain
are undoubtedly broad. When you refer to a cash outlay as
being uncertain, you do not mean that it cannot be predicted.
There are some liabilities where the law of large numbers
makes it easier to predict the timing and/ or amount of cash
outlays. This is the work typically done by actuaries, but of
course even actuaries cannot predict natural catastrophes such as
floods and earthquakes.
Table 2
Natureof Liabilitiesof Financial Institutions
Liabilitytype Amount of Cash Outlay Timingof CashOutlay
TypeI Known Known
TypeII Known Uncertain
TypeIII Uncertain Known
TypeIV Uncertain Uncertain

Let us illustrate each one of them
Type I Liabilities
Both the amount and the timing of the liabilities are known
with certainty. A liability requiring a financial institution to pay
Rs.50, 000 six months from now would be an example. For
example, depository institutions know the amount that they are
committed to pay (principal plus interest) on the maturity date
of a fixed-rate deposit, assuming that the depositor does not
withdraw funds prior to the maturity date.
Type I Liabilities
however, are not limited to depository institutions. A major
product sold by life insurance companies is a guaranteed
investment contract, popularly referred to as a GIC. The
obligation of the life insurance company under this contract is
that, for a sum of money (called a premium), it will guarantee
an interest rate up to some specifies maturity date. For example,
suppose a life insurance company for a premium of Rs.10
million issues a five-year GIC agreement to pay 10%
compounded annually. The life insurance company knows that
it must pay Rs16.11 million to the GIC policyholder in five
years.
Type II Liabilities
The amount of cash outlay is known, but the timing of the
cash outlay is uncertain. The most obvious example of a Type
II liability is a life insurance policy. There are many types of life
insurance policies but the most basic type is that, for an annual
premium, a life insurance company agrees to make a specified
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dollar payment to policy beneficiaries upon the death of the
insured.
Type III Liabilities
With this type of liability, the timing of the cash outlay is
known, but the amount is uncertain. An example is where a
financial institution has issued an obligation in which the
interest rate adjusts periodically according to some interest rate
benchmark. Depository institutions, for example, issue
accounts called certificates of deposit, which have a stated
maturity, the interest rate paid need not be fixed over the life of
he deposit but may fluctuate. If a depository institution issues
a three-year floating-rate certificate of deposit that adjusts every
three months and the interest rate paid is the three-month
Treasury bill rate plus one percentage point, the depository
institution knows it has a liability that must be paid off in three
years, but the dollar amount of the liability is not known. It
will depend on three-month Treasury bill rates over the three
years.
Type IV Liabilities
There are numerous insurance products and pension
obligations that present uncertainty as to both the amount and
the timing of the cash outlay. Probably the most obvious
examples are automobile and home insurance policies issued by
property and casualty insurance companies. When, and if, a
payment will have to be made to the policyholder is uncertain.
Whenever damage is done to an insured asset, the amount of
the payment that must be made is uncertain.
What are the Liquidity Concerns?
By liquidity concerns what do you understand? Because of the
uncertainty about the timing and/ or the amount of the cash
outlays, a financial institution must be prepared to have
sufficient cash to satisfy its obligations. Here it has been
assumed that the entity that holds the obligation against the
financial institution may have the right to change the nature of
the obligation, perhaps incurring some penalty. For example, in
the case of a certificate of deposit, you as a depositor may
request the withdrawal of funds prior to the maturity date;
typically, the deposit-accepting institution will grant this request
but assess an early withdrawal penalty. In the case of certain
types of investment companies, shareholders have the right to
redeem their shares at any time.
Some life insurance products have a cash-surrender value. This
means that, at specified dated, the policyholder can exchange the
policy for a lump-sum payment. Typically, the lump-sum
payment will penalize the policyholder for turning in the policy.
There are some life insurance products that have a loan value,
which means that the policyholder has the right to borrow
against the cash value of the policy.
In addition to uncertainty about the timing and amount of the
cash outlays, and the potential for the depositor of policyholder
to withdraw cash early or borrow against a policy, a financial
institution has to be concerned with possible reduction in cash
inflows. In the case of a depository institution, this means the
inability to obtain deposits. For insurance companies, it means
reduced premiums because of the cancellation of policies. For
certain types of investment companies, it means not being able
to find new buyers for shares.
Brokerage and Asset Transformation
Now let us move ahead to discuss the services. Intermediary
services are of two kinds, brokerage function and asset
transformation activity. Brokerage function as represented by
the activities of brokers and market operators, processing and
supplying information is a part and parcel of all intermediation
by all institutions. Brokerage function brings together lenders
and borrowers and reduces market imperfections such as search,
information and transaction costs. The asset transformation
activity is provided by institutions issuing claims against
themselves, which differ, from the assets they acquire. Mutual
funds, insurance companies, banks and depositors with a share
of a large asset or issuing debt type liabilities against equity type
assets. While providing asset transformation, financial firms
differ in the nature of transformation undertaken and in the
nature of protection or guarantees, which are offered. Banks
and depository institutions offer liquidity, insurance against
contingent losses to assets and mutual funds against loss in
value of assets.
Through their intermediary activities banks provide a package of
information and risk sharing services to their customers. While
doing so they take on part of heir risk. Banks have to manage
the risks through appropriate structuring of their activities and
hedge risks through derivative contracts to maximize their
profitability.
Financial institutions provide three transformation services.
Firstly, liability, asset and size transformation consisting of
mobilization of funds and their allocation (provision of large
loans on the basis of numerous small deposits). Secondly,
maturity transformation by offering the savers the relatively
short- term claim or liquid deposit they prefer and providing
borrowers long-term loans which are better matched to the cash
flows generated by their investment. Finally, risk transformation
by transforming and reducing the risk involved in direct lending
by acquiring more diversified portfolios than individual savers
can. The expansion of the financial network or an increase in
financial intermediation as denoted by the ration of financial
assets of all kinds of gross national product accompanies
growth. To a certain extent, growth of savings is facilitated by
the increase in the range of financial instruments and expansion
of markets.
Finally What are the Advantages of Financial
Institutions?
After discussing the financial institution now tell me students
that is there any advantage of financial institution at all. I am
sure you all will have the same answer YES. Benefits provided
by financial intermediaries consist of reduction of information
and transaction costs, grant long-term loans, and provide liquid
claims and pool risks. Financial intermediaries economise costs
of borrowers and lenders. Banks are set up to mobilize savings
of many small depositors, which are insured. While lending,
the bank makes a single expert investigation of the credit
standing of the borrower saving on several investigations of
amateurs.
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Financial intermediaries make it possible for borrowers to
obtain long-term loans even though the ultimate lenders are
making only short-term loans. Borrowers who wish to acquire
fixed assets do not want to finance them with short-term loans.
Although the bank has used depositors funds to make long-
term loans it still promises its depositors that they can
withdraw their deposits at any time on the assumption that the
law of large numbers will hold. Bank deposits are highly liquid
and one can withdraw the deposit any time, though on some
kinds of deposits the interest previously earned on it has to be
foregone. Finally, banks by pooling the funds of depositors
reduce the riskness of lending. Indirect finance in some reduces
the information and transaction costs of lenders and
borrowers, renders deposits liquid and reduces the risk of
lending.
The ability of the financial intermediaries to ensure the most
efficient transformation of mobilized funds into real capital has
not, however, received the attention it deserves. Institutional
mechanisms to ensure end use of funds have not been efficient
in their functioning, leaving the investor unprotected. Efficient
financial intermediation involves reduction of the transaction
cost of transferring funds from original sabers to financial
investors. The total coat of intermediation is influenced by
financial layering, which makes the individual institutions costs
additive in the total cost of intermediating between savers and
ultimate borrowers. The aggregate cost of financial
intermediation from the original saver to ultimate investor is
much higher in developing countries than in developed
countries.
Criteria to Evaluate Financial Institutions
Given the controversy regarding the contribution of financial
sector, it is necessary to have a framework to evaluate the
performance of the countrys financial sector. Let us first look at
the criteria formulated, in the form of questions, by Richard D.
Erb, the former Deputy Managing Director of the International
Monetary Fund: (i) Do institutions find the most productive
investments? (ii) Do institutions revalue their assets and
liabilities in response to changed circumstances? (iii) Do
investors and financial institutions expect to be bailed out of
mistakes and at what price? (iv) Do institutions facilitate the
management of risk by making available the means to insure,
hedge, and diversify risks? (v) Do institutions effectively
monitor the performance of their users, and discipline those
not making proper and effective use of their resources? (vi)
How effective is the legal, regulatory, supervisory, and judicial
structure? (vii) Do financial institutions publish consistent and
transparent information?
These criteria, useful as they are, do not encompass social and
ethical aspects of finance which ought to be regarded as
important as economic aspects. Therefore, the relevant
normative criteria, organising principles, and value premises
which should guide the functioning of the financial system are:
Finance is not the most critical factor in development.
The use of finance must be imbued with the virtues of
austerity, self--limit, and minimisation.
Financial reforms are not merely a question of credit
limits; they encompass issues involved in limits of credit.
State intervention is not the best way to achieve a fair
distribution of credit.
Financial institutions must evolve from below rather than be
imposed from above. Financial development ought to take
place at a slow and steady pace rather than in spurts and in a
programmed or (time) encapsulated manner.
There should be a replacement of large-scale by small-scale,
wholesale by retail, and class by mass banking.
The sufficing principle rather than the maximising one
should power the financial system. The functioning of
different financial institutions must be on the basis of a
communitarian spirit, not competition and profit motive.
The financing of investment which results in the
displacement or retrenchment of labour should be
discouraged.
The scope for financing various sectors is ultimately
constrained by domestic saving. The substantial increase in
the total saving in India is unlikely to take place now.
The working of the Indian financial system should not be
corporate-sector-centric.
There are limits to the overall and industrial growth, and,
therefore, a ceiling on the targeted rate of growth has to be
imposed.
The only legitimate role of the financial markets is
infrastructural, hence they should not exist to provide
opportunities to make quick, disproportionate pecuniary
gains.
It is the primary markets activity of supporting new,
economically and socially productive real investment, trade,
and flows of goods and services, which is of foremost
importance. The enthusiasm, hyperactivity, and
preoccupation with the secondary markets ought to be
avoided.
Summary
Financial institutions provide various types of financial services.
Financial intermediaries are a special group of financial
institutions that obtain funds by issuing claims to market
participants and use these funds to purchase financial assets.
Intermediaries transform funds they acquire into assets that are
more attractive to the public. By doing so, financial
intermediaries do one or more of the following: (1) provide
maturity intermediation; (2) provide risk reduction via
diversification at lower cost; (3) reduce the cost of contracting
and information processing; or (4) provide a payments
mechanism.
The nature of their liabilities determines the investment strategy
pursued by all financial institutions. The liabilities of all
financial institution will generally fall into one of the four types
shown in Table 2.
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We shall discuss the classifications, roles, functions and
advantages of the financial institutions in detail in our later
lectures.
Questions to Discuss:
1. What do you mean by Maturity Intermediation?
2. What is Reducing Risk Via Diversification?
3. What is the nature Of Liabilities?
4. What are the Liquidity Concerns?
5. What are the Advantages of financial institutions?
6. What are the criteria To Evaluate Financial Institutions?
Notes:
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LESSON 3:
FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT
Learning objectives
After reading this lesson, you will understand
Effects of financial system on saving and investment
Relationship between financial system and economic
development
A cautionary approach-
The process of financial development
Criteria to evaluate financial sector
Students, today in the class let us discuss the correlation of
financial system and the economic development. The role of
financial system in economic development has been a much-
discussed topic among economists. Is it possible to influence
the level of national income, employment, standard of living,
and social welfare through variations in the supply of finance?
In what way financial development is affected by economic
development?
There is no unanimity of views on such questions. A recent
literature survey concluded that the existing theory on this
subject has not given any generally accepted model to describe
the relationship between finance and economic development.
The importance of finance in development depends upon the
desired nature of development. In the environment-friendly,
appropriate-technology-based, decentralised Alternative
Development Model, finance is not a factor of crucial
importance. But even in a conventional model of modem
industrialism, the perceptions in this regard vary a great deal.
One view holds that finance is not important at all. The
opposite view regards it to be very important. The third school
takes a cautionary view. It may be pointed out that there is a
considerable weight of thinking and evidence in favour of the
third view also. Let us briefly explain these viewpoints one by
one.
In his model of economic growth, Solow has argued that
growth results predominantly from technical progress, which is
exogenous, and not from the increase in labour and capital.
Therefore, money and finance and the policies about them
cannot contribute to the growth process.
You All Tell Me What are your Opinions Regarding
this?
Effects of Financial System on Saving and Investment
It has been argued that men, materials, and money are crucial
inputs in production activities. The human capital and physical
capital can be bought and developed with money. In a sense,
therefore, money, credit, and finance are the lifeblood of the
economic system. Given the real resources and suitable
attitudes, a well--developed financial system can contribute
significantly to the acceleration of economic development
through three routes. First, technical progress is endogenous;
human and physical capital are its important sources and any
increase in them requires higher saving and investment, which
the financial system helps to achieve. Second, the financial
system contributes to growth not only via technical progress
but also in its own right. Economic development greatly
depends on the rate of capital formation. The relationship
between capital and output is strong, direct, and monotonic
(the position which is sometimes referred to as capital
fundamentalism). Now, the capital formation depends on
whether finance is made available in time, in adequate quantity,
and on favourable terms-all of which a good financial system
achieves. Third, it also enlarges markets over space and time; it
enhances the efficiency of the function of medium of exchange
and thereby helps in economic development.
We can conclude from the above that in order to understand the
importance of the financial system in economic development,
we need to know its impact on the saving and investment
processes. The following theories have analyzed this impact: (a)
The Classical Prior Saving Theory, (b) Credit Creation or Forced
Saving or Inflationary Financing Theory, (c) Financial Repression
Theory, (d) Financial Liberalisation Theory.
The Prior Saving Theory regards saving as a prerequisite of
investment, and stresses the need for policies to mobilise saving
voluntarily for investment and growth. The financial system has
both the scale and structure effect on saving and investment. It
increases the rate of growth (volume) of saving and
investment, and makes their composition, allocation, and
utilisation more optimal and efficient. It activises saving or
reduces idle saving; it also reduces unfructified investment and
the cost of transferring saving to investment.
How is this achieved? In any economy, in a given period of
time, there are some people whose current expenditures is less
than their current incomes, while there are others whose current
expenditures exceed their current incomes. In well-known
terminology, the former are called the ultimate savers or
surplus--spending-units, and the latter are called the ultimate
investors or the deficit-spending-units.
Modern economies are characterized (a) by the ever-expanding
nature of business organisations such as joint-stock companies
or corporations, (b) by the ever-increasing scale of production,
(c) by the separation of savers and investors, and (d) by the
differences in the attitudes of savers (cautious, conservative, and
usually averse to taking risks) and investors (dynamic and risk-
takers). In these conditions, which Samuelson calls the
dichotomy of saving and investment, it is necessary to connect
the savers with the investors. Otherwise, savings would be
wasted or hoarded for want of investment opportunities, and
investment plans will have to be abandoned for want of
savings. The function of a financial system is to establish a
bridge between the savers and investors and thereby help the
mobilisation of savings to enable the fructification of
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investment ideas into realities. Figure below reflects this role of
the financial system in economic development.
Relationship Between Financial System and
Economic Development







































Economic Development
Savings & Investment or
Capital Formation
Surplus Spending
Economic Units
Deficit Spending
Economic Units
Income Minus
(Consumption +
Own investment)
Income Minus
(Consumption +
Investment)
Surplus or Saving Deficit or Negative
Saving
Financial System
A financial system helps to increase output by moving the
economic system towards the existing production frontier. This
is done by transforming a given total amount of wealth into
more productive forms. It induces people to hold less savings
in the form of precious metals, real estate land, consumer
durables, and currency, and to replace these assets by bonds,
shares, units, etc. It also directly helps to increase the volume
and rate of saving by supplying diversified portfolio of such
financial instruments, and by offering an array of inducements
and choices to woo the prospective saver. The growth of
banking habit helps to activise saving and undertake fresh
saving. The saving is said to be institution-elastic i.e., easy
access, nearness, better return, and other favourable features
offered by a well-developed financial system lead to increased
saving.
A financial system helps to increase the volume of investment
also. It becomes possible for the deficit spending units to
undertake more investment because it would enable them to
command more capital. As Schumpeter has said, without the
transfer of purchasing power to an entrepreneur, he cannot
become the entrepreneur.Further, it encourages investment
activity by reducing the cost of finance and risk. This is done by
providing insurance services and hedging opportunities, and by
making financial services such as remittance, discounting,
acceptance and guarantees available. Finally, it not only
encourages greater investment but also raises the level of
resource allocational efficiency among different investment
channels. It helps to sort out and rank investment projects by
sponsoring, encouraging, and selectively supporting business
units or borrowers through more systematic and expert project
appraisal, feasibility studies, monitoring, and by generally
keeping a watch over the execution and management of
projects.
The contribution of a financial system to growth goes beyond
increasing prior-saving-based investment. There are two strands
of thought in this regard. According to the first one, as
emphasized by Kalecki and Schumpeter, financial system plays a
positive and catalytic role by creating and providing finance or
credit in anticipation of savings. This, to a certain extent,
ensures the independence of investment from saving in a given
period of time. The investment financed through created credit
generates the appropriate level of income. This in turn leads to
an amount of savings, which is equal to the investment already
undertaken. The First Five Year Plan in India echoed this view
when it stated that judicious credit creation in production and
availability of genuine savings has also a part to play in the
process of economic development. It is assumed here that the
investment out of created credit results in prompt income
generation. Otherwise, there will be sustained inflation rather
than sustained growth.
The second strand of thought propounded by Keynes and
Tobin argues that investment, and not saving, is the constraint
on growth, and that investment determines saving and not the
other way round. The monetary expansion and the repressive
policies result in a number of saving and growth promoting
forces: (a) if resources are unemployed, they increase aggregate
demand, output, and saving; (b) if resources are fully
employed, they generate inflation which lowers the real rate of
return on financial investments. This in turn, induces portfolio
shifts in such a manner that wealth holders now invest more in
real, physical capital, thereby increasing output and saving; (c)
inflation changes income distribution in favour of profit
earners (who have a high propensity to save) rather than wage
earners (who have a low propensity to save), and thereby
increases saving; and (d) inflation imposes tax on real money
balances and thereby transfers resources to the government for
financing investment.
The extent of contribution of the financial sector to saving,
investment, and growth is said to depend upon its being free or
repressed (regulated). One school of thought argues that
financial repression and the low/ negative real interest rates
which go along with it encourage people (i) to hold their saving
in unproductive real assets, (ii) to be rent -seekers because of
non-market allocation of investible funds, (iii) to be indulgent
which lowers the rate of saving, (iv) to misallocate resources and
attain inefficient investment profile, and (v) to promote capital-
intensive industrial structure inconsistent with the
factor-endowment of developing countries. Financial
liberalisation or deregulation corrects these ill effects and leads to
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financial as well as economic development. However, as
indicated earlier, some economists believe that financial
repression is beneficial. The most recent thinking on this subject
says that the empirical foundations of financial liberalisation are
not robust enough, and that mild, moderate, small repression
is more growth promoting than either large-scale repression or
complete laissez-faire.
Financial Sector and Economic Development: a
Cautionary Approach
Many economists have taken a cautionary view of the role of
financial markets in development. The capital market
enthusiasm and optimism implicit in certain theories of
finance, viz., Capital Asset Pricing Model and Efficient Market
Hypothesis with their multiple unrealistic, restrictive
assumptions, have been questioned in different ways.
First, it has been argued that the financial sector can perform the
developmental role if it functions efficiently, but in practice, it is
not efficient. Tobins analysis in this respect is highly instructive.
With logic and examples, he has explained how the prices in
financial markets rarely reflect intrinsic values; how very little of
the work done by the securities industry has to do with
financing real investment; how the allocation of funds by
financial markets is hardly optimal; and that the services of
financial system do not come cheap. According to him, financial
system serves us all right. But its functioning does not merit
complacency. Financial activities generate high private reward
disproportionate to their social productivity. The casino effect
of financial markets cannot be forgotten. The speculation in
financial markets is a negative-sum game for the general public.
More recently, through the application of chaos and fractal
analyses to financial markets, it has been shown that they are
characterized by asymmetry, turbulence, discontinuity,
stampedes, non-periodicity, and inefficiency.
Second, it has been pointed out that the roles of capital
formation and finance in development have been unduly or
disproportionately stressed; that capital shortage is not the
single most important barrier to development. Empirically, it
has been very often found that the rate of capital formation
increased without raising the growth rate; and the relation
between capital and growth has been one of correlation rather
than causation. It is estimated that in industrialized countries,
capital accumulation could account for at most one--fourth of
the rate of economic growth in the 19th and 20th centuries.
Increase in capital without suitable social, economic, political
conditions cannot cause growth; and, on the other hand,
favourable developments in the conditions just mentioned can
achieve much growth with minimum of capital. The
conventional thinking has always stressed the need for
substitution of capital for other factors but the scope and
possibilities for this kind of substitution, particularly in the
light of factor endowments, have never been really explored.
For growth, much additional capital, and, therefore, much
finance, is not always required; through depreciation allowances,
better composition of capital, appropriate technology, and
higher productivity, a lot of growth can be achieved. The
methodology used for estimating the financial resource
requirements (incremental capital-output ratio) is also riddled
with many valuations, measurement, and other problems.
The thrust and message of the above analysis are clearly
expressed in the following statements:
Real growth cannot be bought with money alone (Chandler).
By and large, it seems to be the case that where enterprise
leads, finance follows (Joan Robinson). Societies in which
other conditions of growth were favourable were usually
capable of devising adequate financial institutions
(Habakkuk).
The role of finance in development is a subsidiary one
(Newlyn).
The Process of Financial Development
How does financial development occur? Is it influenced by
economic development? Does the former always precede the
latter? The literature talks about supply leading and demand
following financial development. Under the former, financial
development occurs first and stimulates economic growth.
Under the latter, as trade, commerce and industry expand, the
financial institutions, instruments, and services needed by them
also expand as a matter of response. The financial development
is said to be active in the first case, and passive in the
second one.
Such a characterisation of the process of financial development
is not very apt. It is difficult to establish precisely the sequence
of real and financial sector developments; the cause and effect
relationship between them is difficult to disentangle. It will be
more correct to say that their growths are intertwined,
symbiotic, and mutually reinforcing. While financial markets
accelerate development, they, in turn, grow with economic
development. In the words of Schumpeter, the money market
is always the headquarters of the capitalist system, from which
orders go out to its individual divisions, and that which is
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debated and decided there is always in essence the settlement of
plans for further development. All kinds of credit requirements
come to this market; all kinds of economic project are first
brought into relation with each other and contend for their
realization in it; all kinds of purchasing power flows to it to be
sold. This gives rise to a number of arbitrage operations and
intermediate manoeuvres, which may easily veil the
fundamental thing. Thus, the main function of the money or
capital market is trading in credit for the purpose of financial
development. Development creates and nourishes this market.
In the course of development, it becomes the market for
sources of income themselves.
Criteria To Evaluate Financial Sector
At the end of the discussion let us evaluate financial sector
critically. Given the controversy regarding the contribution of
financial sector, it is necessary to have a framework to evaluate
the performance of the countrys financial sector. Let us first
look at the criteria formulated, in the form of questions, by
Richard D. Erb, the former Deputy Managing Director of the
International Monetary Fund: (i) Do institutions find the most
productive investments? (ii) Do institutions revalue their assets
and liabilities in response to changed circumstances? (iii) Do
investors and financial institutions expect to be bailed out of
mistakes and at what price? (iv) Do institutions facilitate the
management of risk by making available the means to insure,
hedge, and diversify risks? (v) Do institutions effectively
monitor the performance of their users, and discipline those
not making proper and effective use of their resources? (vi)
How effective is the legal, regulatory, supervisory, and judicial
structure? (vii) Do financial institutions publish consistent and
transparent information?
These criteria, useful as they are, do not encompass social and
ethical aspects of finance, which ought to be regarded as
important as economic aspects. Therefore, the relevant
normative criteria, organizing principles, and value premises
which should guide the functioning of the financial system are:
(a) Finance is not the most critical factor in development. (b)
The use of finance must be imbued with the virtues of
austerity, self--limit, and minimization. (c) Financial reforms are
not merely a question of credit limits; they encompass issues
involved in limits of credit. (d) State intervention is not the
best way to achieve a fair distribution of credit. (e) Financial
institutions must evolve from below rather than be imposed
from above. Financial development ought to take place at a
slow and steady pace rather than in spurts and in a programmed
or (time) encapsulated manner. (f) There should be a
replacement of large-scale by small-scale, wholesale by retail, and
class by mass banking. (g) The sufficing principle rather than the
maximising one should power the financial system. The
functioning of different financial institutions must be on the
basis of a communitarian spirit, not competition and profit
motive. (h) The financing of investment, which results in the
displacement or retrenchment of labour, should be
discouraged. (i) The scope for financing various sectors is
ultimately constrained by domestic saving. The substantial
increase in the total saving in India is unlikely to take place now.
(j) The working of the Indian financial system should not be
corporate-sector-centric. (k) There are limits to the overall and
industrial growth, and, therefore, a ceiling on the targeted rate
of growth has to be imposed. (l) The only legitimate role of
the financial markets is infrastructural, hence they should not
exist to provide opportunities to make quick, disproportionate
pecuniary gains. (m) It is the primary markets activity of
supporting new, economically and socially productive real
investment, trade, and flows of goods and services, which is of
foremost importance. The enthusiasm, hyperactivity, and
preoccupation with the secondary markets ought to be avoided.
Questions to Discuss:
1. What are the effects of Financial System on saving and
Investment?
2. Discuss the relationship Between Financial System and
Economic Development?
3. Discuss a cautionary approach on Financial Sector and
Economic Development?
4. What are the criteria To Evaluate Financial Sector?
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LESSON 4:
FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT
Learning objectives
After reading this lesson, you will understand
Financial development: some concepts
Reforms model for economic growth
Today we shall discuss some important concepts most
frequently used in financial world..
Financial Development: Some Concepts
In this section we discuss a few concepts, which describe the
phenomenon of change and development in a financial system.
All these concepts are closely inter-related, and at present they are
widely referred to in the discussions on financial markets.
Efficiency
What do you mean by efficiency? The ultimate focus of the
efficiency in financial markets is on the nonwastefulness of
factor use and the allocation of factors to the socially most
productive purposes. The following five concepts are useful in
judging the efficiency of a financial system.
Information Arbitrage Efficiency
This is the degree of gain possible by the use of commonly
available information. If one can make large gains by using
commonly available information, financial markets are said to
be inefficient. Thus, the efficiency is inversely related to this type
of gain. Under conditions of perfect market, the possibilities of
such a gain are nil because the prices in such a market already
reflect fully and immediately all relevant and ascertainable
available information, and no one would know anything that is
not already known and therefore not reflected in market prices.
Fundamental Valuation Efficiency
When the market price of a security is equal to its intrinsic value
or investment value, the market is said to be efficient. The
intrinsic value of an asset is the present value of the future
stream of cash flows associated with the investment in that
asset, when the cash flows are discounted at an appropriate rate
of discount. This again would happen when markets are
perfectly competitive.
Full Insurance Efficiency
This indicates the extent of hedging against possible future
contingencies. The greater the possibilities of hedging and
reducing risk, the higher the market efficiency.
Functional or Operational Efficiency
The market which minimizes administrative and transaction
costs, and which provides maximum convenience (or minimum
inconvenience) to borrowers and lenders while performing the
function of transmission of resources, and yet provides a fair
return to financial intermediaries for their services, is said to be
operationally or functionally efficient.
Allocational Efficiency
When financial markets channelise resources into those
investment projects and other uses where marginal efficiency of
capital adjusted for risk differences is the highest, they are said to
have achieved allocational efficiency.
Innovations
Financial innovation can be variously defined as the
introduction of a new financial instrument or service or practice,
or introducing new uses for funds, or finding out new sources
of funds, or introducing new processes or techniques to handle
day-to-day operations, or establishing a new organisation-all
these changes being on the part of existing financial
institutions. In addition, the emergence and spectacular growth
of new financial institutions and markets is also a part of
financial innovation. The word new here means not only the
coming into being of what did not exist till then but also the
new way of using existing instruments, practices, technology,
and so on. Similarly, the use or adoption of an already existing
financial instrument, by financial institution(s), which
previously did not do, so is also regarded as an innovation. The
marked transformation in the roles of financial institutions and
the departure from the conventional notions regarding their
functions also constitute financial innovation. As per one
definition, financial innovations are unforecastable
improvements in the array of available financial products and
processes.
Financial innovations bring about wide ranging changes as well
as effects in the financial system. They lead to the broadening,
deepening, diversification, structural transformation,
internationalization and sophistication of the financial system.
They result in the financialisation of the economy whereby
financial assets to total assets ratio tends to increase. This
financialisation may occur with the growth of
institutionalisation or intermediation and securitisation
simultaneously, or it may occur with the growth of one at the
cost of other.
The process of financial innovation has been characterised
differently by different authors. These innovations are regarded
as responses to regulatory and tax regimes, financial constraints,
and so on. The literature on the subject suggests the following
groups of factors as being responsible for financial innovations:
(i) tax asymmetries that can be exploited to produce tax savings;
(ii) transaction costs; (iii) agency costs; (iv) opportunities to
reduce or reallocate risk; (v) opportunities to increase asset-
liquidity; (vi) regulatory or legislative change; (vii) level and
volatility of interest rates and prices; and (viii) technological
advances.
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Financial Engineering
This is perhaps the latest terminological addition to the world
of finance, which, incidentally, is a new example of the invasion
of social thinking by technology. After innovations, industrial
engineering and social engineering, we now have financial
engineering. It basically means financial innovations; the two
terms have often been used interchangeably. The dictionary
meanings of innovation and engineering perhaps give a clue to
the possible difference between financial innovations and
financial engineering. To innovate means to introduce new
methods, new ideas, and make changes. To engineer means to
arrange, contrive, to bring about artfully or skilfully.
Financial engineering thus connotes development of new
financial technology to cope with financial changes. It involves
construction, designing, deconstruction, and implementation
of innovative financial institutions, processes, and instruments.
It means the formulation of creative solutions to problems in
finance. The development and use of skills, means, techniques,
tools for changing and managing cash flows and investment
features of financial instruments form a part of financial
engineering. In todays highly volatile markets, it seeks to limit
financial risk by creating financial instruments for hedging,
speculation, arbitraging, and by fine-tuning portfolio
adjustments. It also seeks to maximise profits quickly. The
creation of financial derivatives and securitisation are its two
examples. Computer power and human insight are combined
to spot arbitrage opportunities, measure risk, and to react to
news very fast in financial engineering.
Financial Revolution
Some people believe that a veritable financial revolution has
taken place in the world of finance in the recent past. The
concept of financial revolution is an extension of the concepts
of financial innovations and engineering. It is meant to convey
that, of late, the magnitude, speed, and spread of changes in
the financial sector the world over has been simply tremendous,
prodigious, phenomenal; that it has undergone a future
shock. It indicates that life in the world of finance is no longer
easy and that financial markets now work 24 hours a day. The
innovations in computers and satellite communications, and
the linking up of the two have completely changed the
production, marketing, and delivery of financial products. And
as with every revolution, not all changes have been for the best,
and there have been unexpected consequences.
Diversification
In one sense, diversification means the existence or the
development of a very wide variety of financial institutions,
markets, instruments, services, and practices in the financial
system. In another but related sense, it refers to the presence of
opportunities for investors to purchase a large mix or portfolio
of varieties of financial instruments. With the diversified
portfolio, investors can minimise the risk for a given rate of
return, or they can maximise the return for a given risk.
Disintermediation
It refers to the phenomenon of decline in the share of financial
intermediaries in the aggregate financial assets in an economy
because people switch out of their liabilities into direct
securities in the open market. Such a flow of funds out of these
intermediaries may occur when they are subject to interest rate
ceilings while the open market rates of return are rising.
The terms securitisation and disintermediation are often used
interchangeably. Although these terms are very closely related,
one should be careful in using them interchangeably. A decline
in the share of only a particular type of financial intermediary,
say commercial banks, does not necessarily mean
disintermediation. Similarly, securitisation in the second sense
does not involve disintermediation.
Broad, Wide, Deep and Shallow Markets
All these are closely related terms. The broad and wide financial
market attracts funds in greater volume and from all types of
national and international investors. In such a market, financial
institutions offer, even globally, 24-hour sales and trading
capability in debt and equity instruments. The deep market is
one where there are always sufficient orders for buying and
selling at fine quotations both below and above the market
price, and where there are good opportunities for swap deals. A
swap deal is a medium-term or long-term arrangement between
two parties in which each party commits to service the debt of
the other. In other words, a swap is the exchange of future
streams of payment between two or more parties. The shallow
market, on the other hand, means an underdeveloped market,
its underdevelopment being the result of financial repression
or administered finance.
Financial Repression
It represents economic conditions in which the governments
regulatory and discretionary policies distort financial prices or
interest rates (i.e., the real interest rates are kept low or negative),
discourage saving, reduce investment, and misallocate financial
resources. The government-directed credit program, and direct
rather than indirect credit controls predominate in a repressed
system. As indicated above, it is also known as the system of
administered interest rates and finance.
Financial Reforms, Financial Liberalisation, and
Deregulation
Financial reforms involve instituting policies, which will increase
the allocative efficiency of available saving, promote the growth
of real sector, and enhance the health, stability, profitability, and
viability of the financial institutions. In theory, they need not
necessarily increase the market -orientation of the system, but in
practice at present, they have come to mean greater market
orientation. Therefore, liberalisation, deregulation, and reforms
mean the same thing currently. They refer to the policy of
reducing or removing completely the legal restrictions, physical
or administrative or direct controls, ceilings on interest rates,
restrictions on the flow of funds, official directives regarding
sectoral and other allocations of funds, restrictions on the scope
of activities of banks and other financial institutions, and so
on, which exist under the administered finance. It is obvious
that liberalisation is the process in which the intervention or
interference of the government in financial markets is reduced
and the markets are allowed, as far as possible, to function on
the basis of free market or competitive principles.
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Privatisation
It is regarded as a necessary part of financial reforms. It means
increasing the ownership, management, and control of the
financial sector by individuals and private incorporated and
unincorporated bodies. This may be achieved partly by
denationalisation, disinvestments by the state, allowing private
sector entry, and abstaining from new ownership by the state.
Prudential Regulation
This is another major element of financial sector reforms. It
means regulation without suppression, and supervision and
control without constriction. It implies that the authorities have
not abdicated the role of and responsibility for evolving a
healthy, strong, sound, safe, stable, and viable financial system.
It aims to impart greater transparency and accountability in
operation, and to restore credibility and confidence in the
financial system. It relates to income recognition, assets
classification, provisioning for bad and doubtful debts, and
capital adequacy. The prudential regulation is the policy of the
State with regard to macro and micro prudential concerns.
1ntegration
It refers to the establishment of close connections or effective
linkages between different constituents or parts, and between
different sub-parts of the financial system. As a result, there are
substantial flows of funds between them, and there is a greater
correspondence between interest rates in different parts of the
financial system. Financial integration is the opposite of the
maturitywise, geographical, institutional, seasonal, instrumental,
segmentation or partitioning or compartmentalisation of the
financial markets.
Internationalisation and Globalisation
These terms indicate the extension of activities of a financial
system beyond the national boundaries. The extension may
take place in the form of borrowing as well as lending, and it
may take place through official or private or commercial channel.
In the process of internationalisation, the domestic financial
institutions participate in foreign financial markets, and the
foreign institutions participate in domestic markets to a
significant extent. In other words, the domestic and foreign
financial markets get integrated and interlinked, and the supply
and demand curves of funds assume a different character.
When globalisation occurs, financial instruments may be
denominated in several currencies, and there would be a
convergence of interest rates in different national markets,
because interest rate changes originating in one financial centre
would be quickly transmitted to other centres.
Sometimes, a distinction is made between internationalisation
and globalisation. While the former term is used to indicate the
absence of regulation or control of any national authority on
financial markets, the latter is said to refer to the establishment
of interlinkages among national markets as a result of the
progressive liberalisation and the removal of exchange controls.
This distinction is not really convincing; it is based on the
ideology-induced narrowing down of the meaning of the term
internationalisation.
Securitisation
The term securitisation is used in financial literature in two
senses. First, it means the faster growth of direct (primary)
financial markets and financial instruments than that of
financial intermediaries. In other words, it refers to the growing
ability and practice of firms to tap the bond, commercial paper,
and share markets as alternatives to institutional financing.
Second, it refers to the process by which the existing assets of
the lending financial institutions are sold or removed from
their balance sheets through their funding by other investors. In
this process, investors are sold securities, which evidence their
interest in the underlying assets without recourse to the original
lender. The redemption of these securities does not become the
obligation of the original lender. The payments to the investors
are made to the extent of cash flows realised from the
underlying assets. What happens is that a number of assets of
a given lender having similar characteristics are pooled together,
and undivided interests in this pool are sold in the form of
what are called Pass Through Certificates (PTC). The tenor
(maturity) of the PTC generally matches the average maturity of
the pooled assets. The cash flows from the underlying assets are
passed through, after retaining management fees, to the holders
of PTC in the form of periodic (monthly) payments of interest
and principal. The redemption of securities is made only to the
extend of the cash flows realised from the underlying assets.
The securitisation essentially involves the collateralised
financing rather than the sale of assets. The ever-increasing
resource requirements and the desire to maintain high levels of
disbursements while keeping the overall size of assets within
certain limits have led financial institutions to innovate in the
form of securitisation. The deal between ICICI and Citibank to
securitise ICICIs Sellers Line of Credit Bills of Exchange, had
marked the first securitisation deal in India.
Indian Financial Markets and Banking System-
Reforms Model for Economic Growth
Cross-country evidence suggests that economic growth is
positively related to financial development. Recent economic
research studies by leading global investment bankers indicate
that, over the next few decades, the growth generated by the
large developing countries, particularly the BRICs (Brazil,
Russia, India and China) could become a much larger force in
the world economy than it is now. For India, the multi-
dimensional reforms model adopted for our financial sector a
decade ago is now bringing in a robust picture of the financial
system and our economy.
The pre-reforms phase of pre-emption of resources and micro-
management by Government, interest rate regulation, a licence
Raj and a closed economy gave way to a unique reforms model
with multiple dimensions for all-round development of the
financial sector. The financial sector reforms followed the
traditional pancha sutra approach of cautious and proper
sequencing; mutually reinforcing measures; complementarity
between reforms in the banking sector and changes in fiscal,
external and monetary policies; developing financial
infrastructure; and developing financial markets.
The reforms have covered key segments of the Indian financial
markets: capital markets, the money and Government securities
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markets and the forex markets. With prudential strengthening
of the banking system coupled with real sector reforms, there
has been a gradual transformation of the Indian economy.
The capital markets have demonstrated improved market
efficiency and transparency. The institutionalisation of SEBI,
the incorporation of NSE, the enactment of Depositories Act,
screen-based trading, entry of FIIs and mutual funds, access to
international capital markets through ADRs, GDRs, FCCBs etc.
have all contributed to this transformation. Inspite of the
Monday mayhem on our bourses following the election results,
the following weeks figures indicated that there were net
inflows through the FII route. Our systems for managing
market volatility in the Stock Exchanges also clicked into place as
was evident with the circuit breakers for sudden market
swings getting into operation.
The money markets have now gradually become a conduit for
providing an equilibrating mechanism for evening out short-
term surpluses and deficits in the financial system. Measures are
being taken to have a pure inter- bank call/ notice money
market. Collateralised borrowing and lending obligation
(CBLO) has been operationalised as a money market
instrument through the Clearing Corporation of India Ltd.
(CCIL).
The G-sec market has seen significant liquidity and depth post-
1990. The initial reforms of moving to an auction based system
for issuing Government debt, terminating the system of
automatic monetisation of fiscal deficit were complementary to
interest rate deregulation in the banking sector. Primary Dealers
were institutionalized. FIIs were allowed to invest in G-
securities and T-bills in primary and secondary markets subject
to certain ceilings. Other measures included issuance of uniform
accounting norms for repo and reverse repo transactions, facility
for anonymous screen-based order-driven trading system for G-
secs on stock exchanges, introduction of exchange-traded
interest rate derivatives on the National Stock Exchange (NSE),
relaxation in regulation relating to sale of securities by
permitting sale against an existing purchase contract, facilitating
the roll over of repos and switch over to the DVP III mode of
settlement. Market Stabilisation Scheme (MSS) has been
introduced to differentiate the liquidity absorption of a more
enduring nature by way of sterilisation from the day-to-day
normal liquidity management operations.
Our Forex policies are in line with global best practices. Forex
reserves of over $118 billion are now a buffer for crisis
prevention, providing confidence to the markets and protection
against exchange rate volatility. Substantial delegation of powers
to the banking system in the area of international trade,
remittances, borrowings and investments has helped bring
about greater openness and reassured the global market players
of our inherent strengths.
The impact of reforms on the banking industry has been
substantial. There has been an increase in operational efficiency
and profitability. NPA levels are coming down. There is greater
use of technology for transaction processing and information
management using computer and communication devices. Our
banks have now a greater awareness of credit risk management.
Further progress on this front would have to be taken up by
developing unique credit risk models for risk-rating and pricing
and real-time credit monitoring. The risk management
framework for market risk using internal models is being
developed by Indian banks. Use of derivatives for market risk
management is on the increase. Banks are now moving towards
the Basel II framework for capital allocation and risk
management. Banks are actively considering measures to contain
impact of operational risks to manageable limits.
The challenges for the banks in the times to come would be to
counter increased competition, meeting the demanding
standards of customers, stepping up of income and to move
towards becoming one-stop financial hyper-markets. The key
for this would be in technological advances, going in for risk-
bundling and rebundling through new financial products,
sound risk management architecture and enhancing share-
holder value.
Our reforms model would dynamically incorporate measures
for risk management, adequate capital allocation, sound
regulatory and supervisory practices. These would provide
necessary conditions for a long-term growth path towards our
country becoming one of the largest economies.
Summary
The ultimate goal of the financial system is to accelerate the rate
of economic development. While financial markets may
accelerate development, they themselves, in turn, develop with
economic development. The relationship between economic
development and financial development is thus symbiotic.
Efficient financial markets are characterised by the absence of
information-based gain, by correct evaluation of assets, by
maximisation of convenience and minimisation of transactions
costs, and by maximisation of marginal efficiency of capital. In
reality, the contribution of the financial system to growth is
highly constrained because it does not work efficiently and
capital is not the most important barrier to growth. The role of
finance in development is believed to be secondary by many
experts. A framework to evaluate the working of any financial
sector must include economic, commercial as well as social and
ethical criteria. Financial innovations refer to wide-ranging
changes in the financial system. The introduction of new
financial institutions, markets, instruments, services,
technology, organisation, and so on are parts of financial
innovations. Financial engineering connotes skilful
development and use of new financial technology, creative
solutions, and tools to cope with financial changes. It involves
construction, designing, deconstruction of innovative financial
instruments, institutions and processes to reduce risk and to
maximise profits quickly. Financial revolution means that the
magnitude, speed, and spread of changes in the financial sector
are simply phenomenal. The markets, which attract funds in
large volume and from all types of investors, are known as
broad financial markets. The markets, which provide
opportunities for sufficient orders at fine rates below and above
the market price, are called deep financial markets. Markets that
are underdeveloped due to governmental regulations and
controls are termed as shallow financial markets. Financial
repression exists when the regulatory policies of the
government distort interest rates, discourage saving, reduce
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investment, and misallocate resources. Financial reforms or
liberalisation aim at creating a market-oriented, competitive
financial system by removing physical, administrative, and direct
controls. Financial integration refers to the establishment of
close and effective interlinkages between various parts and sub-
parts of the financial system so that interest rates differentials in
the system are minimised. Securitisation refers to a fast growth
of direct (primary) financial instruments, and to a collateralized
financing through the sale of existing assets of financial
institutions. Disintermediation refers to the switch out of the
liabilities of financial intermediaries by the investors.
Internationalisation or globalisation of financial markets occurs
when national and foreign markets become integrated.
Questions to Discuss:
1. What do you mean by efficiency? Discuss five concepts are
useful in judging the efficiency of a financial system.
2. What do you understand by innovations, privatization and
securitisation?
3. Discuss the Indian Financial Markets & Banking System-
Reforms Model for Economic Growth.
Notes:
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LESSON 5:
THE INDIAN FINANCIAL SYSTEM ON THE EVE OF PLANNING
Learning Objective
After reading this lesson, you will understand
Evaluation of various constituents of Indian Financial
system prior to 1950.
Evaluation of currency and money supply
The Indian financial system has covered a long journey. It has
and always will hold an important position in our economy. Let
us understand how?
Currency and Money Supply
Currency and exchange form an essential part of any financial
system. Prior to Independence, the Indian currency had not
been standardised. For about 60 years till 1893, it had remained
on the silver standard and subsequently on the gold exchange
standard. During this period (with the exception of the war
years), even though gold could be procured through import
without any restrictions, the system did not fulfill the other
essential requirements of the gold standard. First, gold coins
were not very much in circulation. Second, the currency authority
did not accept the responsibility of selling gold without limit. It
had acquired legally the option of offering gold or sterling
against rupees. As sterling was on the gold standard, the rupee
can be said to have been on the gold exchange standard. With
the abandonment of the gold standard by England in
September 1931, the sterling exchange standard came to be
established in India.
Paper currency has been used in India since the beginning of the
19th century. Currency notes were issued by the commercial
banks and their use was extremely limited. In 1861, the
government acquired the monopoly of issuing notes. An idea
of the progress of monetisation can be obtained from the
volume of notes issued and their circulation. While the volume
increased from Rs 11 crore in 1874 to Rs 1199 crore in 1948, the
circulation increased from Rs 10 crore to Rs 1188 crore during
the same period. If we take the total money supply (currency
and demand deposits), it increased from Rs 285 crore in 1935
and to Rs 384 crore in 1939, and to Rs 2052 crore in 1945.
Thereafter, it declined to Rs 1970 crore in 1948, and to Rs 1833
crore in 1950.3 Thus the major increase in the volume of
money in India occurred during the Second World War.
Currency constituted a major portion of the money supply. The
percentage of currency to total money supply increased from
57.22 per cent in 1935 to 65.61 per cent in 1950 and 66.68 per
cent in 1952.
Banking Sector
The two most important constituents of the money market in
India are the modern banks and the indigenous bankers.
Modern banking became an effective force only after 1910.
Before that the indigenous bankers dominated the scene. Until
1860, they financed trade, acted as bankers to the company
government, collected revenue on behalf of the government,
managed the transfer of funds from one centre to another, and
some of them had the monopoly as mint-masters and money
changers. In later years, their direct contacts with the
government as financiers declined. They continue to perform
other functions, albeit in a declining proportion. The financial
instrument they have popularised is hundi. A notable feature
of this institution is that it functions with a personal touch that
is often lacking in a modern banking system.
Structure and Growth of Modern Banks
You know that the growth of the modern banking business in
India was negligible till the beginning of the present century.
During the second half of the 18th century, agency houses used
to perform banking business as an adjunct to their main
business. The foundation of modern banking was laid during
the early part of the nineteenth century with the establishment
of three Presidency Banks, namely the Bank of Bengal (1806),
Bank of Bombay (1840), and the Bank of Madras (1846).
During the second half of the 19th century, some exchange
banks and Indian joint stock banks also were set up. In 1900,
there were nine Indian joint-stock banks, eight exchange banks,
and three Presidency Banks. In the total private deposits of Rs
3146 lakh in 1900, the shares of each of these types of banks
were respectively 25.68 per cent, 33.38 per cent and 40.94 per
cent. The slow rate of growth of the banking business till the
beginning of the present century was due to (a) a high rate of
failure of banks, because most of them had been created in a
speculative rush; (b) stagnant economic conditions during this
period; (c) a decline in prices; and (d) the passing of the
Currency Act, 1861 which took away the power of banks to
issue notes.
During the first half of the present century, the banking system
progressed rapidly. The deposits in banks increased from Rs 82
crore in 1910 to Rs 957 crore in 1948. Except during the
depression of the 1930s, the rate of economic progress was
quite high in this period. The World Wars contributed to raising
the level of economic activity and the monetary resources in the
economy. In 1921, the three Presidency Banks were
amalgamated to form the Imperial Bank of India (IBI).
Although the IBI functioned as a quasi-central bank, the money
market was without a proper central bank until 1935 when the
Reserve Bank of India (RBI) was established. After the
establishment of the RBI, the IBI used to act as the agent of
the RBI in places where the RBI did not have any offices of its
own. Similarly, even after 1935, the IBI continued to act as a
banker for other banks (to a very limited extent). It used to
discount hundis and grant demand loans against government
securities. All these functions are now performed by the State
Bank of India (SBI), and the special position of SBI in the
banking system today stems from these historical antecedents.
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Around 1950, the banking system in India comprised the RBI,
IBI, cooperative banks, exchange banks, and Indian joint-stock
banks. Indian joint-stock banks were divided into four classes,
according to the amount of paid-up capital and reserves held by
them. Class A had Rs 5 lakh and over; Class B (Rs 1 lakh and
over but less than Rs 5 lakh); Class C (Rs 50,000 and over but
less than 1 lakh); and Class D (less than Rs 50,000). After the
creation of the RBI, banks were divided into scheduled and
non-scheduled banks. Class A banks, which became scheduled
banks were known as Class A
1
banks; while others came to be
known as Class A
2
banks. The relative importance of different
types of banks in 1950 is indicated in Table1.
Table1Structureof Commercial Bankingin 1950
Categoryof Banks No. of Banks Deposits
(Rslakh)
1 All banks 1205 130428
(8) (1251)
2 Commercial banks 605 100217
(8) (1249)
3 Indianjoint-stockbanks 584 82770
(5) (1197)
4. Imperial Bank 1 23164
(3) (1183)
5. (a) ClassA1 banks 74 52270
(b) ClassA2 banks 73 4659
(c) ClassB banks 189 2176
(d) ClassC banks 123 370
(e) ClassD banks 124 131
6. Exchangebanks 15 17039
(3) (52)

Note: Figures in brackets relate to the year 1870.
Source: RBI, Banking and Monetary Statistics in India, Bombay,
1954.
Although the number of commercial banks in 1950 was small,
they accounted for 77 per cent of deposits of the entire banking
system. The share of Indian joint-stock banks, and the Imperial
Bank in total deposits was 63.46 per cent and 13.06 per cent
respectively. During 1910-50, Indian joint stock banks expanded
rapidly at the expense of both the IBI and the exchange banks.
Within the joint-stock banking sector, scheduled banks
accounted for 63 per cent of deposits in that sector. Within the
class Al banks, the top 5 to 7 banks accounted for the major
portion of deposits. On the basis of the available evidence, the
following conclusions emerge with respect to the banking
system in India. (a) There was a high degree of concentration
in-the banking business. The top seven6 joint-stock banks and
the ill I accounted for most of the banking business. (b) The
degree of concentration increased till 1935 and declined
thereafter. (c) The smaller banks were responsible for providing
banking facilities in about two-thirds of the places on the
banking map of India. It was these banks that mobilised.
savings from sources which the big banks would not tap, and it
was they that catered to the financial needs of such borrowers
who would have been shunned by the big banks. Thus,
qualitatively, the services of smaller banks were of much
importance. (Bank of India, Central Bank of India, Allahabad
Bank, Punjab National Bank, Bank of Baroda, Bank of Mysore,
and Indian Bank of Madras)
Banking Portfolios
Comparable data on the liabilities and assets of various groups
of banks over a sufficiently long period of time is not available
to evaluate in precise terms the trends in portfolio management.
The preferences of different categories of banks in respect of
various items in the portfolio were not similar. For example,
class Al banks used to invest less in government securities than
did the IBI. Consequently, the credit/ deposit ratio of the
former used to be usually higher than that of the latter. Subject
to these limitations, certain broad features of portfolio
behaviour in the banking system are discussed below. The
analysis is based mainly on certain important banking ratios of
the IBI.
Deposits are the mainstay of any bank. The proportion of
fixed deposits with the banks appears to have declined
significantly over the period 1921-1950. Before the First World
War, fixed deposits of the five big banks were as high as 70 per
cent or more, of the total deposits. Later there was a decline in
this ratio. It was around 60 to 65 per cent till 1925, 45 percent in
1935, and 32 per cent in 1950. The most common maturity
period of fixed deposits then was one year. The major factors
behind this marked decline in fixed deposits were: (a) inflation
during the war years; (b) competition from post office savings
accounts and life insurance companies; (c) growing opportunity
and increasing preference for investment in industrial securities;
and (d) decline in interest rates on fixed deposits.
Table 2 presents some important banking ratios over the period
1921-1950. It will be observed that generally the credit/ deposit
ratio was pretty low. The most popular form of bank credit was
cash credit/ overdraft, followed by loans. The practice of bill
financing declined sharply over this period. Except at the end of
the Second World War, the call money market was not active.
Inactivity of bill and call markets meant that various
constituents of the organised money market were very loosely
linked and virtually functioned in isolation. As a result, the
money market was characterised by sharp imbalances between
the supply and demand for funds, both regionally and
seasonally. The spread of interest rates between regions and
seasons, therefore, varied sharply. As expected, unless compelled
by circumstances, banks did not invest heavily in government
securities. In 1935 and 1945, the ratios of investment in
government securities were high for different reasons. In 1935,
the lack of alternative investment opportunities due to a slack in
business must have led banks to utilise funds for holding
government securities. In 1945, the compulsions of war finance
must have forced them to invest in government securities. As
soon as the war was over, the ratio declined significantly.
From the other available information, it would appear that
there was a tendency to invest more in short--term government
securities (less than five years maturity) than in long-term
securities. While the share of the former increased from 21 per
cent in 1945 to 29 per cent in 1950, that of the latter declined
from 31 per cent to 17 per cent during the same years. The
banks did not invest in industrial securities to any significant
extent. The ratio of their investment in industrial securities to
total investments was around 4 per cent in 1949 and 1950.
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A study of the sectoral distribution of advances shows that the
shares in 1948 of commerce, industry, and agriculture were
about 46 per cent, 31 per cent, and 2 per cent respectively. The
major part of advances to the commercial sector was given to
wholesale trade (46 per cent). About 86 per cent of bank
advances were on a secured basis.
Table2SomeBankingRatiosof theImperial Bank of India(1921to 1950) (Percentage)
Ratio 1921 1935 1939 1945 1950
1. Credit/ Deposit 60.65 33.67 42.58 26.40 43.09
(50.95)* (55.93) (40.82) (51.22)
2. Loans/ total advances 36.22 23.99 25.05 28.50 93.79
3. Cash creditsoverdrafts/ Total advances 43.70 66.31 63.77 64.42 -
4. Bills discounted and purchased/ total
advances
20.07 9.70 11.18 7.00 6.21
(21.89)
5. Total advances/ tota1assets 53.98 21.16 37.25 25.00 39.97
(43.48) (46.28) (34.14) (39.77)
6. Government Securities/ Total assets 13.05 47.18 44.72 56.02 38.80
(34.33)* (32.19) (43.0) (31.0)
7. Moneyat call/ tota1advances 0.63 0.56 0.52 8.58 2.98
Notes: (i) Figuresin bracketsareforClassA1banks.
(ii)* Figuresarefor1936.
Source:RBI, BankingandMonetaryStatisticsof India,Bombay, 1954.

Notes
(i) Figures in brackets are for Class A
1
banks.
(ii) Figures are for 1936.
Source: RBI, Banking and Monetary Statistics of India,
Bombay, 1954.
An important aspect of the growth of commercial banking,
which serves as an indicator of the progress of the banking
habit, volume of transactions, and the velocity of deposits i.e.,
the number of times each deposit is used to settle transactions
in a given period of time is the volume of cheque clearances. By
1947, there were 29 clearing houses in the country of which
those at Bombay, Calcutta, Delhi, Kanpur, Madras were the
major ones. The volume of cheques (in terms of amount)
cleared at the clearing houses increased from Rs 212 crore in
1900 to Rs 2185 crore in 1939, and to Rs 6461 crore in 1947. The
number of cheques cleared increased from 153 lakh in 1939 to
246 lakh in 1947.
Questions to Discuss:
What do you understand by money supply?
Discuss the structure and growth of modern banks.
Notes:
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LESSON 6:
THE INDIAN FINANCIAL SYSTEM ON THE EVE OF PLANNING
Learning Objective
After reading this lesson, you will understand
Evaluation of banking system
Evaluation of insurance Funds
Evaluation of stock funds
Evaluation of Government securities
Let us evaluate some of the securities in todays lecture. We shall
discuss them in brief here and later on have a detailed
discussion on each of the banks.
Commercial Banks
Commercial banks provided mainly short-term credit to the
industrial sector. Further, they provided credits mainly to the
large-scale units. Thus, before 1950 there were two important
gaps in the field of industrial finance-the lack of supply of
long-term funds to all industrial units, and the lack of supply
of any form of capital to small-scale industrial units. Attempts
were made to bridge these gaps by setting up certain industrial
banks in the private sector. In 1923, there were about eight
industrial banks, of which four were liquidated by 1935. In the
intervening period, other banks came up with the result that
there were about seven such banks working in 1936-37. These
banks used to accept some deposits from the public. The
volume of their operations was quite limited. The lack of
institutional arrangements to supply adequate long-term
industrial finance remained, till the beginning of the planning
period, a persistent and important gap in the financial structure
in India.
Co-operative Banks
Apart from the inadequate supply of long-term finance to
industry, another serious gap in the financial system in India
that persisted till the end of the period under discussion was
the inadequate supply of short--term as well as long-term
funds to the agricultural sector. In order to supplant money
lenders and indigenous bankers, efforts were being made since
the second decade of the present century to organise co-
operative credit institutions. In the forty years since their
inception, cooperative banks made very little progress in
absolute terms; their progress was particularly negligible in
relation to the demand for funds in the agricultural sector. The
setting up of the RBI in 1935 and its efforts to channelise more
funds to this sector did help the cooperative movement, but
not to the desired extent. The total working capital, deposits
from individuals, and loans due to state, central, and primary
cooperative banks were, in 1950, only Rs 115 crore, Rs 44 crore
and Rs 68 crore, respectively. In the same year Land Mortgage
Banks (LMBs) had working capital, deposits, and loans of Rs
13 crore, Rs 12 crore, and Rs 10 crore, respectively.
Table Growth of CooperativeBanking(1916to 1950) (Amount in RsLakh)
Item
StateCooperative
Banks
Central Cooperative
Banks
Primary Agricultural
Societies
Land
Mortgage
Bank
1916 1935 1950 1916 1935 1950 1916 1935 1950 1938 1950
1. Number 6 11 14 239 615 498 14509 76045 116534 202 288
2. Total Working 77 1163 3045 323 2940 4987 375 2492 3522 411 1273
Capital
3.
Loansand
deposits
56 573 1625 220 1713 2397 40 185 393 375 1159

heldfrom
individuals

4. Loansdue '58 498 1412 288 2040 2892 402 2342 2496 370 1046

Notes
1. Data on primary agricultural credit societies separately was
not available for the years 1935, but was available for the year
1950. Assuming the ratio in 1950 to be applicable for other
years, the figures have been calculated for those years.
2. Loans and deposits in case of primary agricultural credit
societies are from both members and non members.
3. Data on land mortgage banks is for both primary and central
land mortgage banks.
Source: RBI, Banking and Monetary Statistics of India,
Bombay, 1954.
Small Savings
Small savings have been one of the oldest media for
community savings. In India, with its huge population and
varying low income levels of different groups of people, the
importance of this method was recognised by the company
government. It encouraged wage earners, small and medium
farmers, and the middle class to save through government-run
savings banks. These banks were attached either to the
Presidency Banks or district treasuries, or post offices. The Post
Office Savings Banks (POSB) took over the savings bank
business of district treasuries in 1886, and that of Presidency
Banks in 1896. Thus by 1896, the POSBs had monopolised the
small savings business.
Apart from the POSB deposits, the Postal Department did not
offer any other financial asset to the, investors till 1915.
Subsequently, it offered various certificates of different
maturities at different periods of time. The Government also
introduced, between April 1941 and April 1947, the Post Office
Defence Saving Deposits. Among these assets, deposits
remained, during the entire period under discussion, the major
financial asset issued by small savings organisations. In
comparison with the period after 1950, the diversity in schemes
offered was very limited.
The POSB deposit receipts increased from Rs 366 lakh in 1896
to Rs 9875 lakh in 1950. The outstanding deposits in these two
years were Rs 904 lakh, and Rs 16,866 lakh. The amount of
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outstanding certificates increased from Rs 57 lakh in 1939 to Rs
2,8211akh in 1950. Thus, the total volume of small savings was
Rs 17,687 1akh in 1950. The number of small savings banks
had increased from 6,343 to 9,256 between 1896 and 1950.
Insurance Funds
The life insurance business in India began on sound lines with
the enactment of the Indian Life Insurance Companies Act,
1912. It was carried on by Indian and foreign life insurance
companies, provident societies, and the Post and Telegraph
department. In addition, certain provinces transacted insurance
business for their own employees. Indian and foreign
companies conducted general insurance business also for
emergencies such as fire, marine and miscellaneous.
Over time, the volume of general insurance business declined
relatively to that of life insurance. As far as the business of life
insurance is concerned, the foreign companies share in it
declined significantly, and Indian companies share increased. Of
the total premium of all life insurance companies, the latters
share was 50 per cent in 1928 and 83 per cent in 1950. The
volume of business of provident societies, and of the Post and
Telegraph department has always been negligible.
The size and growth of the insurance business in India is
shown in Table below.
Table InsuranceFundsin Indiain 1928, 1948and1950(Rslakh)
Category 1928 1948 1950
1.
Lifeinsurancebusinessin force
(a) Numberof companies 70 275 244
(b) Suminsured 13502 73505 82545
(c) PremiumIncome 670 3607 4150
2. Non-LifeInsurance
(a) Numberof companies 128 157 174
(b) Premiumincome 354 1507 1663

Source: RBI, Banking and Monetary Statistics of India,
Bombay, 1954.
Stock Market
The private sector as well as the government raises large
amounts of funds on the stock market. The first Stock
Exchange in India was established at Bombay in 1887. The
volume of funds raised on the stock market by the private
sector industrial units and the government increased
significantly during the first half of the 20th century. The
increased pace of industrialisation during this period which was
caused by the two World Wars, protection to domestic
industries, and other fiscal measures adopted by the
government, led to the growth of active new issue markets and
stock exchanges. The expansion of government activity for
developmental purposes and the demands made by the two
wars also meant an increase in the amount of government
securities issued.
The growth of the private sector is reflected in the increased
number and paid-up capital of joint-stock companies. The
paid-up capital increased from a mere Rs 24 crore in 1890 to Rs
570 crore in 1948. We do not have very reliable figures on the
actual capital issues by the corporate sector for this period. It
can, however, be stated that on an average, the capital issues of
joint-stock companies amounted to Rs 70 crore per year during
the period 1918 to 1939. For the years 1945 to 1952, we have
figures for the amount of capital issues applied for and
sanctioned, but not for the actual capital issues. The per year
average amount of capital issues applied for and sanctioned
during 1945 to 1952, was Rs 193 crore and Rs 141 crore
respectively. Understandably, there were marked ups and downs
in the new issue activity. The three years following each of. the
two World Wars were characterised by an unusually high
amount of capital issues. The annual average amount of capital
issues was Rs 183 crore during 1918 to 1920; while during 1945-
47 this figure was Rs 255 crore. In both cases, the boom was
followed by a steep fall in capital issues in the subsequent 4-5
years. As expected, during the depression years, there was a
marked slack in the new issue activity.
A major proportion of capital was raised by the issuance of
ordinary shares. In contrast with the period after 1960,
debentures were not very popular in India during the period
before 1950. It has been pointed out by Muranjan that the
unpopularity of debentures was due to the following reasons-
unfamiliarity of the general public with this form of
investment, the preference of rich classes for speculative scrips,
heavy stamp duties on purchases and transfers of debentures,
and the avoidance of debentures by insurance and other
financial institutions with large investible resources.
The security prices also reflect the tenor of the working of stock
markets. The available data on index numbers of security prices
for the period 1927 to 1949 help us to draw some important
conclusions. First, unlike the later period, prices of government
securities and fixed-yield industrial securities showed marked
fluctuations. The index number of government security prices
varied in the range of 82 to123. It should, however, be noted
that these fluctuations occurred before the establishment of the
RBI. After 1935, the prices of government securities remained
quite stable. There is no doubt that this must have been due to
the RBIs policy because in the post-1935 period the prices of
other securities increased phenomenally. Debenture prices
fluctuated in the range of 95 to 196; the level of these prices was
higher than the level of prices of ordinary shares during 1927 to
1942. It was only after 1942 that the latter exceeded the former.
Third, there was an economic depression between 1927 and
1933. There was a boom between 1934 and 1946 (except 1938
and 1939); prices again declined substantially during 1947-49.
The ordinary share prices reached their nadir in 1932 (index was
64.4), and their zenith in 1946 (index was 264.9).
Public Deposits
It is appropriate here to draw attention to the then prevalent
practice which later assumed such significant dimensions as to
cause serious concern to the monetary authorities, namely, the
financing of fixed assets by companies with deposits from the
public. These deposits were for a fixed period of one to seven
years. Unlike in the later period, these deposits were then much
more local; they used to be offered on the basis of the
reputation for business integrity, or social and caste affiliations
of the concerned management. Around 1930, these deposits
accounted for about 11 per cent and 39 per cent of the total
finance of the Bombay and Ahmedabad mills respectively. It is
interesting to note that in some cases, the interest rates on these
deposits were equal to or lower than the average lending rates
of commercial banks of the time.
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Government Securities and Treasury Bills
The markets of government securities and treasury bills also
expanded phenomenally during this period. The amount of
gross issues of central and provincial government securities
increased from a meagre Rs 2 crore in 1890 to Rs 382 crore in
1947. By the 1940s, the gilt-edged market had become fairly
wide and active. Banks, life insurance companies, princes and
princely state governments, and private trusts, took an interest
in this market. Securities of different maturities were being
issued, and innovative steps like giving attractive names to these
issues were undertaken to make them popular. During the
Second World War, to ensure their sale, many issues were made
on a tap basis rather than by prescribing a specific subscription
period. The foundation of the policy of maintaining stability in
the gilt-edged market was laid down during the Second World
War when a large amount of funds was needed by the
government. In subsequent years, although the reasons for a
large amount of funds changed, the policy of maintaining
stability continued. The setting up of the RBI in 1935 facilitated
the pursuit of such a policy. Earlier the IBI used to buy and sell
securities depending on the position of its own resources. It
rarely operated in the market out of consideration for market
stability.
Treasury bills (TBs) were first issued in India in October 1917.
Originally, these bills were of different maturities-of three, six,
nine, and twelve months. On a few occasions, bills of maturity
of four and eight months were also issued. On several
occasions, joint issues of more than one maturity were also
made. Since 1933-34, only bills of three months duration have
been in vogue. Treasury bills used to be sold by tender and on
tap; the latter method was adopted generally for the purpose of
provincial governments, semi--government institutions, and
some foreign holders. During the pre-war years, these bills were
often issued to induce an inflow of foreign funds. During the
war years, the consideration changed to one of providing liquid
assets to the banks. Although the RBI offered the facility of
discounting TBs to banks, they did not have a wide appeal
among banks and other institutions. The IBI was the main
supporter of this market. Provincial governments also used to
issue TBs, but they were not preferred by any institution
including the RBI. This was reflected in the fact that the
discount rate on provincial TBs was higher than that on TBs of
the central government. The practice of issuing ad hoc TBs had
started during this period. The amount of TBs sold by tender
was Rs 87 crore in 1919 and Rs 85 crore in 1948. There was a
substantial decline in this amount in the intervening years (Rs
51 crore in 1947, for instance).
A rough consolidated picture about the relative sizes and
growth or different financial resources is presented in Table
below:
Table Financial Structurein India, 1890-1948(RsCrore)
Year Private
depositsof
all banks
Small saving
depositsand
certificates
(outstanding)
Total capital of
all co-op
societies.
Paid-up.
capital of
joint-stock
cos
Premium.
incomeof
Insurance
cos
Grossissues
of
Government
securities
State
Provident
Fund
1890 25 6
--
24 0.11 2.0 0.49
1900 31 10 -- 36 0.52 - 1.37
1910 82 16 3 63 2.0 2.50 3.59
1920 220 27 36 164 8.0 21.35 19.71
1930 221 75 91 282 25.0 37.25 58.24
1939 261 135 109 290 - 28.42 72.46
1941 364 95 112 302 59.0 147.36 75.03
1943 719 118 132 339 - 146.53 83.96
1945 109 221 146 389 - 221.79 93.02
1947 799 268 164 479 47.7 382.37 97.55
1948 957 247 -- 570 47.5 - 79.36

Note: If there is any discrepancy in figures in this Table and
figures quoted earlier on any item, it is not an error, it may be
due to differences in sources, definition of item and coverage,
etc. Figures for 1947 and later are for the Indian Union. Source:
Muranjan, S.K., op. cit., p. 32; and RBI, Banking and Monetary
Statistics of India, Bombay, 1954.
Interest Rates
A detailed study or the level and structure or interest rates
before 1950 is too big a topic to be attempted here. We would
like to point out here only three important features or the
interest rates during this period.
First, the interest rates on the same type or deposits and
advances differed for different banks. While the IBI did not pay
any interest on current deposits, exchange banks and Indian
joint-stock banks offered interest on them. The average rate of
interest on current deposits by one or the leading commercial
banks in India was 2.56 per cent in 1921, 1.29 per cent in 1935
and 0.26 per cent in 1943. Similarly, the interest rates on fixed
and savings deposits varied from one type of bank to another.
On advances also, these rates varied a great deal. In short, from
the point or view or interest rates, the banking system was not
homogeneous. This aspect of interest rates has certainly
undergone a definite change in the planning era during which it
has become much less heterogeneous.
Second, there was much variation in interest rates in different
regions. They were the highest in Chennai and South India; and
also quite high in the Indus and Gangetic plains. In Mumbai,
Ahmedabad, and Kolkata, which were the areas or
manufacturing, finance, and business, the rates were relatively
low. Such geographical differentials in the interest rates were
dependent on such factors as: (a) the degree or closeness or links
between the Central Bank and the concerned locality; (b) the size
of capital supply in general, and deposits in particular, in the
locality; (c) whether funds can be attracted and transferred to
different places; (d) whether the major activity in the area is
agriculture, manufacturing or commerce. With the progress
towards integration in the banking system, growth of branch
banking, increase in the spread of offices of the RBI,
improvement in remittance facilities, growth in transport and
communication and the resultant facilities for the quick transfer
of funds, geographical differentials in the interest rates have
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greatly diminished since 1950, although they have not
completely disappeared.
Third, the level of interest rates even in the organised sector
during the major part of this period was quite high. This needs
to be emphasised because during the planning period, a case has
been made in certain circles for a cheap money policy on the plea
that, historically, borrowers and lenders in India have been used
to a low cost of finance. A plea such as this is based on the
experience of a very brief period in the economic history of
India. The yield of 3.5 per cent government securities ruled
between 4 to 7 per cent during 1870--1949 except for the
periods, 1891-1915, and 1936-1949 when it varied between 3 to
4 per cent. The average interest rate charged by banks for lending
was 6 to 7 per cent during this period except for 1932-1949. The
rate of interest of the Bank of Bombay varied between 6.2 to
9.8 per cent during 1890 to 1899. Further, in the first decade of
the 19th century, agency houses charged 10 to 12 per cent on
their loans. Around the same time, investments in
governments fetched the high yield of 8 to 9 per cent, and
commercial bills were discounted at a rate between 6 and 12 per
cent. Similarly, even in the slack season, commercial banks
charged 10 to 11 per cent against wheat pits in the 1920s. On
current deposits, the Central Bank of India paid an interest rate
between 2 and 2.5 per cent till 1931. It is only after 1933 that
interest rates declined steeply; they have been maintained at a
low level since the beginning of the planning period.
Summary
On the whole, the Indian Financial system was fairly developed
even on the eve of planning. Though banking business was
concentrated in the hands of few large banks, yet the services of
smaller banks were of great importance. At that time banks did
not invest much in government securities, hence the major
beneficiaries of bank credit were commerce followed by
industry.
Questions to Discuss:
1. Evaluate the banking system.
2. Evaluate the insurance Funds.
3. Evaluate the stock funds.
4. Evaluate the Government securities.
Notes:
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LESSON 7:
TUTORIAL-1
Notes:
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UNIT 2
REGULATORY FRAMEWORK AND
PROMOTIONAL INSTITUTIONS
LESSON 8:
THE RESERVE BANK OF INDIA
Learning Objective
After reading this lesson, you will understand
Organisation and management of RBI
Function and Roles of RBI
Treasury Bills
Today we shall discuss one of the most important aspects of
Financial Institution in India.
Introduction
A study of financial institutions in India can appropriately
begin with a brief discussion of the regulatory framework of
the country. Since the financial markets are characterised by
various degrees of imperfections, the need for regulation-
prudential or otherwise-even in a liberalised framework cannot
be denied. The financial system deals in other peoples money
and, therefore, their confidence, trust and faith in it is crucially
important for its smooth functioning. Financial regulation is
necessary to generate, maintain and promote this trust. One
reason why the public trust may be lost is that some of the
savers or investors or intermediaries may imprudently take too
much risk, which could engender defaults, bankruptcies, and
insolvencies. Thus a regulation is needed to check imprudence
in the system.
The task of efficient regulation is rendered difficult by the very
nature of financial assets, which are mobile, easily transferable or
negotiable; and also by the nature of financial markets which are
prone to a systemic risk. The modern trading technology and
the possibility of high leveraging enable market participants to
take large stakes, which are disproportionate with their own
investments. There are also frequent instances of dishonest,
unfair, fraudulent, and unethical practices or activities of the
market intermediaries or agencies such as brokers, merchant
bankers, custodians, trustees, etc. The regulation becomes
necessary to ensure that the investors are protected; that
disclosure and access to information are adequate, timely, and
equal; that the participants measure up to the rules of the
market place; and that the markets are both fair and efficient. In
this context, it is said that fairness and efficiency are two sides of
the same coin; if the market is unfair, in the end, it is also
inefficient.
The regulatory framework or apparatus for the financial sector in
India broadly consists of the Ministry of Finance of the
Government of India which administers the Companies Act,
1956, and the Securities Contracts (Regulation) Act, 1956; the
Reserve Bank of India and the Board of Financial Supervision
(BFS) under its aegis; the Securities and Exchange Board of
India (SEBI), Insurance Regulatory Authority; the Governing
Boards of various stock exchanges and the apex financial
institutions such as the IDBI, SIDBI, NHB and NCB. Among
these, the RBI and SEBI have special role and responsibility. We
shall first discuss the functioning of the RBI followed by the
SEBI.
What is the Organisation and Management of RBI
The Reserve Bank of Indiawas established on April 1,1935,
under the Reserve Bank of India Act, 1934. The main functions
of the Bank are to act as the note-issuing authority. Bankers
Bank, Banker to the government and to promote the growth
of the economy within the framework of the general economic
policy of the government, consistent with the need to maintain
price stability. The Bank also performs a wide range of
promotional functions to support the pace of economic
development. The Reserve Bank is the controller of foreign
exchange. It is the watchdog of the entire financial system. The
Bank is the sponsor bank of a wide variety of top-ranking
banks and institutions such as SBI, IDBI, NABARD and NHB.
The Bank sits on the board of all banks and it counsels the
Central and State Government and all public sector institutions
on monetary and money matters. No central bank, even in the
developed world, is saddled with such onerous responsibilities
and functions.
The RBI, as the central bank of the country, is the centre of the
Indian Financial and Monetary System. As the apex institution,
it has been guiding, monitoring, regulating, controlling, and
promoting the destiny of the IFS since its inception. It is quite
young compared with such central banks as the Bank of
England, Riksbank of Sweden, and the Federal Reserve Board
of the US. However, it is perhaps the oldest among the central
banks in the developing countries. It started functioning from
April1, 1935 on the terms of the Reserve Bank of India Act,
1934. It was a private shareholders institution till January 1949,
after which it became a state-owned institution under the
Reserve Bank (Transfer to Public Ownership) of India Act,
1948. This act empowers the central government, in
consultation with the Governor of the Bank, to issue such
directions to it, as they might consider necessary in the public
interest. Further, the Governor and all the Deputy Governors
of the Bank are appointed by the Central Government.
The Bank is managed by a Central Board of Directors, four
Local Boards of Directors, and a committee of the Central
Board of Directors. The functions of the Local Boards are to
advise the Central Board on matters referred to them; they are
also required to perform duties as are delegated to them. The
final control of the Bank vests in the Central Board, which
comprises the Governor, four Deputy Governors, and fifteen
Directors nominated by the central government. The committee
of the Central Board consists of the Governor, the Deputy
Governors, and such other Directors as may be present at a
given meeting. The internal organisational set-up of the Bank
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has been modified and expanded from time to time in order to
cope with the increasing volume and range of the Banks
activities. The underlying principle of the internal organisation
is functional specialisation with adequate coordination. In order
to perform its various functions, the Bank has been divided and
sub-divided into a large number of departments.
The pattern of central banking in India was initially based on
the Bank of England. England had a highly developed banking
system in which the functioning of the central bank as a
bankers bank and their regulation of money supply set the
pattern. The central banks function as a lender of last resort
was on the condition that the banks maintain stable cash ratios
as prescribed from time to time. The effective functioning of
the British model depends on an active securities market where
open market operations can be conducted at the discount rate.
The effectiveness of open market operations however depends
on the member banks dependence on the central bank and the
influence it wields on interest rates. Later models, especially
those in developing countries showed that central banks play an
advisory role and render technical services in the field of foreign
exchange, foster the growth of a sound financial system and act
as a banker to government.
What are the Functions and Roles of RBI
Functions of the Bank
The RBI functions within the framework of a mixed economic
system. With regard to framing various policies, it is necessary
to maintain close and continuous collaboration between the
government and the RBI. In the event of a difference of
opinion or conflict, the government view or position can always
be expected to prevail.
The Preamble of the RBI Act, 1934 states that Whereas it is
expedient to constitute a Reserve Bank for India to regulate the
issue of bank notes and the keeping of reserves with a view to
securing monetary stability in (India) and generally to operate
the currency and credit system of the country to its advantage.
To elaborate, the main functions of the RBI are:
To maintain monetary stability so that the business and
economic life can deliver welfare gains of a properly
functioning mixed economy.
To maintain financial stability and ensure sound financial
institution so that monetary stability can be safely pursued
and economic units can conduct their business with
confidence.
To maintain stable payments system so that financial
transactions can be safely and efficiently executed.
To promote the development of financial infrastructure of
markets and systems, and to enable it to operate efficiently
i.e., to play a leading role in developing a sound financial
system so that it can discharge its regulatory function
efficiently.
To ensure that credit allocation by the financial system
broadly reflects the national economic priorities and societal
concerns.
To regulate the overall volume of money and credit in the
economy with a view to ensure a reasonable degree of price
stability.
Role of the Bank
In view of the Banks close contacts and intimate knowledge of
the financial markets, it is in a position to advise the Central and
State Governments on the Quantum, timing and terms of
issue of new loans. While formulating the borrowing program
for the year, the Government and the Bank take into account a
number of considerations such as the amount of Central and
State loans maturing for redemption during the year, the
estimate of available resources (based on the estimated growth
in deposits with the banks, premium income of insurance
companies and accretions to provident funds) and the
absorptive capacity of the market.
In India, banks, insurance companies and provident funds are
statutorily required to invest a portion of their liabilities,
premium income or accretions, as the case may be, in
Government and other approved securities, which ensures a
captive market for these securities, facilitating the easy
absorption of new issues. The Bank tries to ensure that over a
reasonably long period it will be neither a net purchaser of
securities from the market nor a net seller so that the loans
raised are absorbed by the market outside the Bank to the
maximum extent.
The Bank actively operates in the gilt-edged market to ensure
the success of Government loan operations. For instance, the
Bank grooms the market by acquiring securities nearing maturity
to facilitate redemption. If maturing stocks are held by
investors to the last, conditions in the money market are likely
to be disturbed as most of the cash paid out seeks avenues of
reinvestment, but, in practice, all the investors are not equally
eager to wait for cash repayment on the redemption date and
then undertake reinvestment, as they can reinvest the proceeds
at times of their own choosing if these were realized earlier, the
Bank, therefore, stands ready as the stock approaches maturity
to buy all the stocks offered for sale at these terms. Thus, in
carrying out the loan operations of the Government the Bank
endeavours on the one hand to minimize the effects of such
operations on the money market and Government securities
market, and on the other to obtain the best possible terms for
the Government concerned. The close involvement in the
market by its continuous presence and the willingness to deal in
the securities at process determined by it give the Bank a good
degree of flexibility when it is seeking occasions for
implementing a shift in policy on prices.
The timing of the issue of new loans is normally left to the
Reserve Bank. The Central Government and the state
Governments float market loans separately, but through the
Reserve Bank. For the management of the public debt of the
Government, the Bank charges a commission. In addition, the
Reserve Bank also charges for all new issues both by Central and
State Government loans, besides recovering brokerage and
expenses incurred by the Bank on account of printing of loan
notifications, telegrams, advertisements, etc.
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Treasury Bills
You must be well aware that Treasury Bills are the main
instrument of short-term borrowing by the Government, and
serve as a convenient gilt-edged security for the money market.
The qualities of high liquidity, absence of risk of default, and
negligible capital depreciation in case of sale before maturity
make them an ideal form of short-term investment for banks
and other financial institutions.
In certain countries, unlike in India, Treasury Bills are an
important tool for the central bank for influencing the level of
liquidity in the money market through open market operations.
Sale of Treasury Bills helps to absorb any excess liquidity in the
money market and, conversely, their purchase by the central
bank has the effect of relieving stringency. Since neither the
Government nor the money market wishes to hold surplus
cash, the central bank steps in and restores the equilibrium by
selling to or purchasing from the money market Treasury Bills
(and similar other securities) accordingly as the Government
payments are larger than its receipts or vice versa. In this way, the
Government is able to borrow cheaply to meet its immediate
needs and to use its temporary surplus to by back before
maturity some of its outstanding debt.
The Reserve Bank, as the agent of the Government, issues
Treasury Bills at a discount. These are negotiable securities and
can be rediscounted with the Bank at any time before maturity
upon terms and conditions determined by it from time to time.
Questions to Discuss:
1. Discuss the Organisation and Management of RBI.
2. What are the Functions of RBI?
3. What are the roles of RBI?
Notes:
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LESSON 9:
THE RESERVE BANK OF INDIA
Learning Objective
After reading this lesson, you will understand
The Reserve Bank as Banker and advisor to Government
Authorities invested with RBI
Autonomy for Central Bank
In todays lesson, we shall discuss the management the advisory
and promotional aspects of RBI, Treasury Bills, and finally the
autonomy of the Central Bank.
The Reserve Bank as Banker to Government
You have been studying since childhood that The Reserve Bank
is the Central Bank of India. It is the banker to the Central
Government statutorily and to the State Governments by virtue
of agreements entered into with them. The Bank provides a full
range of banking services for these Governments such as
acceptance of moneys on deposit, withdrawal of funds by
cheques, receipt and collection of payments to Government and
transfer of funds by various means throughout India. The
Governments main accounts are held in the Bank. A large
number of branches of agency banks, sub-agency banks and
Treasury agencies also undertake Government business because
the Bank has branches/ offices mainly in the State capitals and a
few big cities in the country. The Government revenue collected
through the agency banks is remitted to the Government
revenue collected through the agency banks are remitted to the
Government accounts at the Bank in due course.
Before the establishment of the Bank, the more important
current financial transactions of the Indian Government were
handled by the then Imperial Bank of India; the administration
of the public debt was the direct responsibility of the
Government although the Public Debt Offices were being
managed by the Imperial Bank. Both these responsibilities in
regard to Government finance were centralised in the Reserve
Bank on its formation. Further, the Bank acts as the banker not
only to the Government of India, but in view of the federal
character of the constitution of India, also to the Governments
of the States.
Adviser to Government
The Bank has ordinary banking relationship with the
Government, performing deposit and lending functions. It
manages the public debt on behalf of the Government.
Besides, the Bank is entrusted with a wide range of statutory
functions such as buying and selling of foreign exchange,
administration of exchange control and provision of rural
credit, the performance of which is attuned to the policies of
the Government in the relevant areas. It maintains close
coordination with the Government at all levels, especially with
the Ministry of Finance, both in the day-to-day affairs and
through participation in the official committees.
The fiscal operations of the Government exercise a direct and
significant impact on the monetary and credit system, which the
Bank is required to regulate. It follows that monetary and credit
policies can be implemented more effectively if there is
coordination between them and the economic policies of the
Government. Hence, the Bank takes an active interest in the
formulation of fiscal and other policies of the Government and
tenders advice calculated to promoter the attainment of the
national economic goals.
Daily operations in the gilt-edged and foreign exchange markets
and close contacts with the commercial banks and other financial
institutions and with the business world in general have
equipped the Reserve Bank with the technical knowledge of,
and practical experience in, these spheres which contribute
greatly to the Banks competence to give financial advice to
Government. Like all central banks, the Bank acts as adviser to
the Government not only on policies concerning banking and
financial matters but also on a wide range of economic issues
including those in the field of planning and resource
mobilisation. It has of course a special responsibility in respect
of policies and measures concerning new loans, agricultural
finance, co-operative organisaton, industrial finance and
legislation affecting banking and credit.
The Banks advice is sought on certain aspects of formulation
of the countrys Five Year Plans, such as the financial pattern,
mobilisation of resources and institutional arrangements with
regard to banking and credit matters. As the agency for
administration of exchange control, the Banks intimate
knowledge of the exchange markets, trade and balance of
payments position places it in a vantage position to offer sound
technical advice to Government in evolving policies on
international finance and regulations regarding foreign trade and
exchange. For the effective discharge of this advisory role, the
Bank has built up a research and statistical organisation.
The Bank is the main channel of communication between the
Government on the one hand and the banks and financial
institution on the other. The Bank, we now know, keeps the
Government informed of the developments in the financial
markets from time to time. Thus RBI being the banker to the
central and state governments provides to the governments all
banking services such as acceptance of deposits, withdrawal of
funds by cheques, making payments as well as receipts and
collection of payments on behalf of the government, transfer
of funds, and management of public debt.
The Bank receives government deposits free of interest, and it is
not entitled to any remuneration for the conduct of the
ordinary banking business of the Government. The deficit or
surplus in the central government account with the RBI is
managed by the creation and cancellation of treasury bills
(known as ad hoc treasury bills).
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As a banker to the government, the Bank can make ways and
means advances (i.e., temporary advances made in order to
bridge the temporary gap between receipts and payments) to
both the central and state governments. The maximum
maturity period of these advances is- three months. However,
in practice, the gap between receipts and payments in respect of
the central government used to be met by the issue of ad hoc
treasury bills, while the one in respect of the state governments
is met by the ways and means advances. The arrangements in
this regard have been changed in the recent past. The ways and
means advances to the state governments are subject to some
limits. These advances are of the following types: (a) normal or
clean advances i.e., advances without any collateral security; (b)
secured advances, i.e., those which are secured against the pledge
of central government securities; and (c) special advances, i.e.,
those granted by the Bank at its discretion. The interest rate
charged by the Bank on these advances did not, till May 1976,
exceed the Bank rate. Thereafter, the Bank has been operating a
graduated scale of interest based on the duration of the
advance.
Apart from the ways and means advances, the state
governments have made heavy use of overdrafts from the RBI.
An overdraft refers to drawals of credit by the state
governments from the RBI in excess of the credit (ways and
means advances) limits granted by the RBI. In other words,
overdrafts are unauthorised ways and means advances drawn by
the state governments on the RBI. The management of the
states overdrafts has gradually become one of the major
responsibilities of the RBI on account of the persistence of
large proportions of those overdrafts.
The issue, management and administration of the public
(central and state governments) debt are among the major
functions of the RBI as the banker to the government. The
Bank charges a commission from the governments for
rendering this service.
Note Issuing Authority
The RBI has, since its inception, the sole right or authority or
monopoly of issuing currency notes other than one rupee notes
and coins, and coins of smaller denominations. The issue of
currency notes is one of its basic functions. Although one rupee
coins and notes, and coins of smaller denominations are issued
by the Government of India, they are put into circulation only
through the RBI. The currency notes issued by the Bank are
legal tender everywhere in India without any limit. At present,
the Bank issues notes in the following denominations: Rs 5, 10,
20, 50, 100, 500 and 1000. The responsibility of the Bank is not
only to put currency into or withdraw it from circulation but
also to exchange notes and coins of one denomination into
those of other denominations as demanded by the public. All
affairs of the Bank relating to note issue are conducted through
its Issue Department. In order to discharge its currency
functions, the Bank has 15 full-fledged issue offices and 2 sub-
offices, and 4127 currency chests in which the stock of new and
re-issuable notes, and rupee coins are stored. Of these, 17 chests
were with the RBI, 2877 with the SBI and associate banks, 791
with nationalised banks, 423 with treasuries, and 19 with private
sector banks (these numbers are not fixed and can be varied as
per the requirement).
The Bank can issue notes against the security of gold coins and
gold bullion, foreign securities, rupee coins, Government of
India securities, and such bills of exchange and promissory
notes as are eligible for purchase by the Bank. The RBI notes
have a cent per cent backing or cover in these approved assets.
Earlier i.e., till 1956, not less than 40% of these assets were to
consist of gold coin and bullion and sterling/ foreign securities.
In other words, the proportional reserve system of note issue
existed in India till 1956. Thereafter, this system was abandoned
and a minimum value of gold coin and bullion and foreign
securities as a part of total approved assets came to be adopted
as a cover for note issue.
Supervising Authority
The RBI has vast powers to supervise and control commercial
and co-operative banks with a view to developing an adequate
and sound banking system in the country. It has, in this field,
the following powers: (a) to issue licenses for the establishment
of new banks; (b) to issue licenses for the setting up of bank
branches; (c) to prescribe minimum requirements regarding
paid-up capital and reserves, transfer to reserve fund, and
maintenance of cash reserves and other liquid assets; (d) to
inspect the working of banks in India as well as abroad in
respect of their organisational set-up, branch expansion,
mobilisation of deposits, investments, and credit portfolio
management, credit appraisal, region-wise performance, profit
planning, manpower planning and training, and so on; (e) to
conduct ad hoc investigations, from time to time, into
complaints, irregularities, and frauds in respect of banks; (f) to
control methods of operations of banks so that they do not
fritter away funds in improper investments and injudicious
advances, (g) to control appointment, re-appointment,
termination of appointment of the Chairman and chief
executive officers of private sector banks; and (h) to approve or
force amalgamations.
In keeping with the recommendations of Narasimham
Committee (1991), the RBI function of bank supervision was
separated from its traditional central banking function by the
creation of a separate Department of Supervision (DOS) from
22 November 1993. Similarly, following the securities scam
which showed the glaring weaknesses in the system for
monitoring the financial sector, the Board of Financial
Supervision (BFS) was set up on 16 November 1994 under the
aegis of the RBI to oversee the IPS. The DOS initially took over
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the inspection of commercial banks from the Department of
Banking Operations and Development (DBOD) of the RBI.
Since April 1995, it has been taking steps to extend its area of
supervision over the all-India financial institutions also. In July
1995, it took over the supervision of non-banking financial
companies (NBFCs), and in November 1995 the registration of
these companies, from the Department of Financial Companies
(DFCs). The BFS has a full-time vice chairman and six other
members; the RBI Governor is its chairman. It has powers to
supervise and inspect banks, financial institutions, and NBFCs.
There is five-member Advisory Council to render advice to it.
The DOS assists the BFS.
Exchange Control Authority
One of the essential functions of the RBI is to maintain the
stability of the external value of the rupee. It pursues this
objective through its domestic policies and the regulation of the
foreign exchange market. As far as the external sector is
concerned, the task of the RBI has the following dimensions:
(a) to administer the Foreign Exchange Control; (b) to choose
the exchange rate system and fix or manage the exchange rate
between the rupee and other currencies; (c) to manage exchange
reserves; and (d) to interact or negotiate with the monetary
authorities of the Sterling Area, Asian Clearing Union, and
other countries, and with international financial institutions
such as the IMF, World Bank, and Asian Development Bank.
The RBI administers the Exchange Control in terms of the
Foreign Exchange Regulation Act (FERA), 1947 which has been
replaced by a more comprehensive Foreign Exchange
Regulation Act, 1973. The FERA is now replaced by the
Foreign Exchange Management Act (FEMA), which is
consistent with full capital account convertibility and the
objective of progressively liberalising capital account
transactions. The objective of exchange control is primarily to
regulate the demand for foreign exchange within the limits set
by the available supply. This is sought to be achieved by
conserving foreign exchange, by using it in accordance with the
plan priorities, and by controlling flows of foreign capital. In
India, during most of the years since 1957, foreign exchange
earnings have been far less than the demand for foreign
exchange, with the result that the latter had to be rationed in
order to maintain exchange stability. This is done through
exchange control, which is imposed both on receipts and
payments of foreign exchange on trade, invisible, and capital
accounts. The problem of foreign exchange shortage has been
so persistent and acute that the scope of exchange control in
India has steadily widened and the regulations have become
progressively more elaborate over the years. The Bank
administers the control through authorised foreign exchange
dealers.
FEMA lays down that the exchange rates used for the conduct
of foreign exchange business must be those, which are fixed by
the RBI. The arrangements or the system under which exchange
rate is fixed by the RBI has undergone many changes over the
years. Till about 1971, as a member of the IMF, India had an
exchange rate system of managed flexibility. This
arrangement changed during the 1970s as a result of
international monetary crisis in 1971. Since 1975, the exchange
rate of the rupee was being fixed in terms of the basket of
currencies till early 1990s.
The RBI is the custodian of the countrys foreign exchange
reserves, and it is vested with the responsibility of managing
the investment and utilisation of the reserves in the most
advantageous manner. The RBI achieves this through buying
and selling of foreign exchange from and to scheduled banks,
which are the authorised dealers in the Indian foreign exchange
market. The Bank also manages the investment of reserves in
gold accounts abroad and the shares and securities issued by
foreign governments and international banks or financial
institutions.
The role of the RBI as a participant in the foreign exchange
market, and as the stabilizer of that market and the rupee
exchange rate has become all the more important with the
introduction of the floating exchange rate system and the rupee
convertibility on trade, current and capital accounts (the last one
to take place in the near future). In the recent past, it has
intervened significantly to achieve exchange rate stability
Promoter of the Financial System
Apart from performing the functions already mentioned, the
RBI has been rendering developmental or promotional
services, which have strengthened the countrys banking and
financial structure. This has helped in mobilising savings and
directing credit flows to desired channels, thereby helping to
achieve the objective of economic development with social
justice. It has helped in deepening and widening the financial
system. As a part of its promotional role, the Bank has been
pre-empting credit for certain sectors at concessional rates.
In the money market, the RBI has continuously worked for the
integration of its unorganised and organised sectors by trying
to bring indigenous bankers into the mainstream of the
banking business. In order to improve the quality of finance
provided by the money market, it introduced two Bill Market
Schemes, one in 1952, and the other in 1970. With a view to
increasing the strength and viability of the banking system, it
carried out a program of amalgamations and mergers of weak
banks with the strong ones. When the social control of banks
was introduced in 1968, it was the responsibility of the RBI to
administer it in the country for achieving the desired objectives.
After the nationalisation of banks, the RBIs responsibility to
develop banking system on the desired lines increased. It has
been acting as a leader in sponsoring and implementing the
Lead Bank scheme. With the help of a statutory provision for
licensing the branch expansion of banks, the RBI has been
trying to bring about an appropriate geographical distribution
of bank branches. In order to ensure the security of deposits
with banks, the RBI took the initiative in 1962 to create the
Deposits Insurance Corporation.
The RBI has rendered service in directing and increasing the
flow of credit to the agricultural sector. It has been entrusted
with the task of providing agricultural credit in terms of the
Reserve Bank of India Act. 1934. The importance with which
the RBI takes this function is reflected in the fact that since 1955,
it has appointed a separate Deputy Governor in charge of rural
credit. It has undertaken systematic studies on the problem of
rural credit and has generated basic data and information in this
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area. This was first done in 1954 by conducting an All-India
Rural Credit Survey. And that was followed by studies of the
All-India Rural Credit Review Committee in 1968, the
Committee to Review Arrangements for Institutional Credit for
Agriculture and Rural Development in 1978, and the
Agricultural Credit Review Committee in 1986.
As a part of its efforts to increase the supply of agricultural
credit, the Bank has been working to strengthen co-operative
banking structure through the provision of finance,
supervision, and inspection. It provides to co-operative banks
(through state co-operative banks), short-term finance at a
concessional rate for seasonal agricultural operations and
marketing of crops. It subscribes to the debentures of Land
Development Banks. It operates the National Agricultural
Credit (long-term operations) Fund, and the National
Agricultural Credit (Stabilisation) Funds through which it
provides long-term and medium-term finance to co-operative
institutions. It established the Agricultural Refinance
Cooperation (now known as NABARD) in July 1963 for
providing medium-term and long -term finance for agriculture.
It also helped in establishing an Agricultural Finance
Corporation.
The role of the Bank in diversifying the institutional structure
for providing industrial finance has been equally important. All
the Special Development Institutions at the central and state
levels and many other financial institutions mentioned earlier
were either created by the Bank on its own or it advised and
rendered help in setting up these institutions. The UTI, for
example, was originally an associate institution of the RBI. A
number of institutions providing financial and other services
such as guarantees, technical consultancy, and so on have come
into being on account of the efforts of the RBI.
Through these institutions, the RBI has been providing short-
term and long-term funds to the agricultural and rural sectors,
to small-scale industries, to medium and large industries, and
to the export sector. It has helped to develop guarantee services
in respect of loans to agriculture, small industry, exports and
sick units. It also co-ordinates the efforts of banks, financial
institutions and government agencies to rehabilitate sick units.
The Bank has evolved and put into practice the consortium, co-
operative, and participatory approach to lending among banks
and other financial institutions. By developing the practice of
inter-institutional participation, of expertise pooling, and of
geographical presence, it has helped to upgrade credit delivery
and service capability of the financial system. By issuing
appropriate guidelines, in 1977, regarding the transfer of loans
accounts by borrowers, it has evolved a mutually acceptable
system of lending, so that the banking business grows in a
healthy manner and without cut-throat competition.
To preserve and enhance the stability of the banking and
financial system is an important part of the promotional role
of the RBI. In fact, financial stability has now assumed relatively
greater importance as one of the tasks of the RBI. This is
evident in its work to formulate prudential norms for banks
and financial institutions, its intervention in the foreign
exchange market, and its participation in the operation of
safety nets i.e., the legal and organisational structure for
overseeing the safety and soundness of the banking and
financial systems. It plays an important role in building up and
maintaining confidence in the underlying stability of the IFS. In
short, the RBI helps to create and maintain a stable, efficient,
and well-functioning financial system in India.
Autonomy for Central Bank
Autonomy for Central Bank is a crucial issue. The Reserve Bank
of India Act does not assure autonomy to the bank. It is true
that the Central Bank can only be independent within the
government but not from the government. In US there are
adequate safeguards to ensure that the Federal Reserve is not
compelled to act against its own judgement. In India there have
been historic accords limiting this access of government to RBI
but they are breached in practice, RBI should not be involved in
underwriting government securities. It acts as a principal and as
an agent in the securities market. The dual role of RBI as an
issuer and regulator of debt gives rise to conflict of policies of
debt management and monetary policy. The advisory group on
monetary and financial policies headed by M. Narsimham
suggested (September, 2000) the separation of debt
management and monetary policy functions and the setting up
of an independent debt management office by the
Government.
Further the fiscal profligacy of the government is abetted by the
system of pre-emption of large portion on net accrual of banks
deposits through the prescription of statutory liquidity ratio.
The Indian banking system was operating for a long time with
a high level of reserve requirements in the form of Statutory
Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR). SLR and
CRR keeps in changing form time to time as the need be. As of
date the SLR is 25% and CRR is 4-4.5%. Reduction in statutory
pre-emption is constrained as long as fiscal deficit remains high.
The Report of the Committee on the Financial System, 1991
has pointed out that SLR should not be used to mobilise
resources for financing budgetary deficits but as a prudential
measure. It has also stated that CRR should be used for
pursuing monetary policy objectives.
In the context of globalisation of the financial system Reserve
Bank needs autonomy to define benchmarks or anchors such as
inflation and money supply to guide policy and use its
judgement to assess the impact of the ever changing financial
environment on the design and implementation of policy.
Reform of the banning system is not complete unless it
includes the Central Bank. The emphasis on market as a source
of financial discipline required an autonomous Central Bank,
which can strike right balance with the operation of market
forces. The responses would be quick and effective only if the
Central Bank is autonomous.
Central banks, which mandated to pursue monetary and
financial stability should enjoy autonomy in the execution of
policy and be accountable for the achievement of the objective.
There is consensus that the monetary authoritys primary
objective should be price stability, that the central bank should
have sufficient independence to vary its operational instrument
and its main instrument is its control over short-term interest
rates. The profound transformation of the financial
environment had a major effect both on the relationship
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between the monetary policies across countries and their design
within the countries. Central banks while defining benchmarks
or anchors to guide policy to achieve monetary and financial
stability have to take into account the increasing constraints that
result from the growing power of markets to arbitrage across
currencies, instruments and institutions as well as across legal,
regulatory and tax jurisdictions. The increasing power of
markets put a premium on transparency to guide market
expectations, market incentives and credibility of policies. The
market orientation of the framework has to be strengthened by,
Enlisting and upgrading the markets disciplinary mechanism
Enlarging the domain and improving the quality of public
disclosure
Designing regulatory constraints such as capital standards so
as to make them less vulnerable to financial arbitrage
Limiting the impact of those forms of intervention that
provide perfection without commensurate over sight which
reduce the incentive to prudent behavior
Central banks incentive for stability requires supporting policies
in terms of sustainable fiscal positions and greater flexibility in
labour market. Further the effectiveness of market forces
depends on fostering ownership structures through
privatisation, which are more responsive to market, and
removing obstacles to the adjustment of capital and labour.
The systemic orientation has to be sharpened by upgrading
payment and settlement systems to contain the knock on effects
of failures of institutions. A right balance between the market
and the central bank as a source of financial discipline has to be
struck.
Summary
Regulation of the financial system and its various component
sectors occurs in almost all countries. A useful way to organise
the many instances of regulation is to see it as having four
general forms: (1) enforcing the disclosure of relevant
information; (2) regulating the level of financial activity through
control of the money supply as well as trading in financial
markets; (3) restricting the activities of financial institutions and
their management of assets and liabilities; and (4) constraining
the freedom of foreign investors and securities firms in
domestic markets.
The most important players in financial markets throughout
the world are central banks, the Government authorities in
charge of monetary policy. Central banks actions affect interest
rates, the amount of credit, and the money supply, all of which
have direct impacts not only on financial markets but also on
aggregate output and inflation. To understand the role that
central banks play in financial markets and the overall economy,
we need to understand how these organizations work. Who
controls central banks and determines their actions? What
motivates their behavior? Who hold the rein of power?
Questions to Discuss:
Discuss the advisory role of RBI.
Discuss the authorities invested with RBI.
Discuss the autonomy for Central Bank.
Notes:
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LESSON 10:
MONETARY POLICY OF RBI
Learning Objectives
After reading this lesson, you will understand
Monetary policy of RBI
Objectives of monetary policy
Scope of monetary and fiscal policies
Monetary management
Banks and credit creation
Instruments of monetary control
Money supply
After the overview of the whole financial institutions let us
now get to the functioning of the financial system.
Monetary Policy of RBI
You must know that the monetary policy is regarded as an
indispensable tool of economic management. Monetary policy
refers to the use of official instruments under the control of the
central bank to regulate the availability, cost and use of money
and credit with the aim of achieving optimum levels of output
and employment, price stability, balance of payments
equilibrium or any other goals set by the State, an appropriate
monetary policy by adjusting money supply to the needs of
growth, directing the flow of funds in keeping with the overall
economic priorities, and providing institutional facilities for
credit in specific areas of economic activity, created a favourable
environment for economic growth. The central bank exercises
its influence on the availability and cost of credit primarily by
affecting the reserves position of commercial banks.
The efficacy of monetary policy depends on the prevailing
economic situation and structural factors like the proportion of
currency in money supply, size of public debt, non-monetised
sector in the economy and presence of active sub-markets.
Again, the manner in which monetary policy is operated hinges
on the particular needs of the situation, such as the degree of
imbalance in the overall supply-demand situation, trends in
agricultural and industrial production and the general price level,
and the balance of payments situation. Since these conditions
are constantly changing, the authorities have to adapt to the
circumstances the choice and mix of various techniques, putting
emphasis as required on controlling the sources of money
supply or interest rates policy.
Monetary policy also encompasses institutional changes in the
banking and credit structure. While the level of savings is
basically a function of the level of income, the absence or
underdeveloped state of financial institutions inhibits the
effective mobilization of savings for purposes of development,
the institutionalization of savings provides the potential saver
with a choice of financial assets with varying degrees of safety,
liquidity and yield, in this context, wider geographical and
functional coverage of institutional credit facilities, especially that
of banking, and the filling in of gaps in the financial structure
become necessary.
Objectives of Monetary Policy
In the present day, it is generally accepted that the main objective
of monetary policy is the promotion of economic growth with
price stability, to elaborate, monetary policy has to be directed
towards attaining a high rate of growth, while maintaining
reasonable stability of the internal purchasing power of money.
The central bank attempts to ensure an adequate level of
liquidity to support the rate of economic growth envisaged and
to assist in the fullest possible utilization of resources without
generating inflationary pressures. However, it is difficult to say
with any degree of precision as to what is adequate under a
given situation. But, as a working rule, the rate of increase in
money supply has to be somewhat higher than the projected
rate of growth of real national income to meet the demand for
money likely to arise as income grows and correspondingly the
savings component, after taking into account the degree of
monetisation in the economy, an excessive growth in liquidity
relative to the requirements of real output would result in the
build-up of inflationary pressures.
A central bank has necessarily to function within the ambit of
the current economic milieu of the country. If the dominant
emphasis is on planned development, as in a country like India,
monetary policy has in addition to take care of promotional
aspects such as monetary integration of the country, directing
credit flow according to policy priorities, assisting in
mobilization of the savings of the community, and promotion
of capital formation and, above all, extend support to the
authorities in the task of allocation of resources by assisting in
the maintenance of an appropriate structure of relative prices.
Scope of Monetary and Fiscal Policies
Monetary policy is but one aspect of the broader economic
policy of a country, the other important component being fiscal
policy. Both monetary and fiscal policies have repercussions on
the whole economy, affecting the price level, level of economic
activity, employment and balance of payments. While monetary
policy influences economic trends through the cost and
availability of credit, fiscal policy is a more important
determinant of aggregate demand in as much as it directly
affects the financial resources and purchasing power in the
hands of the public.
In the developing countries the central banks have been called
upon to play a positive and energetic role in administering
monetary policy to achieve the desired economic goals. In these
countries, fiscal policy is necessarily expansionary which means
that the central bank has to provide large funds to the
Government in the form of loans and advances for purposes
of economic growth. Resort to central bank credit for meeting
budgetary deficits results in an expansion of money supply and
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therefore in the cash reserves of banks. With the expansion of
bank reserves, the ability of the banking system to expand
credit also increased. In such a situation, monetary policy has to
be such as to moderate the secondary expansion that will occur
as a result of the increase in bank reserves, while at the same
time ensuring that sufficient credit facilities are made available
for meeting the genuine needs of agriculture, industry,
commerce and other productive activities. Thus, on the one
hand, the credit policy has to be evolved to meet the credit
needs of the growing economy, and, on the other, it has to be
restrictive in order to keep in check inflationary forces. Moreover,
while making any change in the structure of interest rates, public
debt policy considerations will have to be kept in view.
Therefore, the monetary and fiscal policies need to be properly
coordinated to be really effective.
Monetary Management
In recent years, the objective of monetary policy in India has
been twofold. It has to facilitate the flow of an adequate
volume of bank credit to industry, agriculture and trade to meet
their genuine needs and provide selective encouragement to
sectors which stand in need of special assistance such as the
weaker sections of the community and the neglected sectors and
areas in the country. Al the same time, to keep inflationary
pressures under check it has to restrain under credit expansion
and also ensure that credit is not diverted for undesirable
purposes. As the central monetary authority, the Reserves
Banks chief function is to ensure the availability of credit to the
extent that is appropriate to sustain the tempo of development
and promote the maintenance of internal price stability.
The focus of monetary policy had to be adjusted from time to
time so as to soften the impact of created money on the
economy and at the same time to achieve the objectives of
planned development. The first decade of the Plan era saw the
revival of the traditional weapons of monetary control; during
the second half of that decade the regulatory functions were
developed. In the sixties, the problems of stabilization were
replaced by a greater concern for economic growth and control
over the accompanying increases in money supply. By the 1970s
and through 1980, the twin objectives of provision of credit for
attaining faster economic growth and price stabilization
assumed importance. This policy has come to be known as
controlled expansion.
Instruments of Monetary Control
One of the most important functions of a central bank is
monetary management-regulation of the quantity of money
and the supply and availability of credit for industry, business
and trade. The monetary or credit management activities of the
bank are two types: general monetary and credit management
functions- total supply of money and credit and the general
level of interest rates. The central bank relies on two types of
instruments, the direct and the indirect, the direct instruments
of monetary control are reserve requirements, administered
interest rates and credit controls; and the indirect instrument of
control is open market operations.
Monetary policy refers to the use of these instruments of
control to regulate money supply and credit with a view to
influence the level of aggregate demand for goods and services.
Banks and Credit Creation
Deposits with banks may originate in two ways- through either
passive creation or active creation. The former occurs when
banks open deposit accounts for customers against receipt of
value either in cash or by cheques drawn on other banks. The
immediate effect is that there is no addition to the quantum of
money though its distribution may undergo a change; but
ultimately it serves as the base for banks to extend credit and
would thus lead to an increase in money supply. Active creation
of deposits takes place through the process of lending when
the money lent out by banks re-enters the system as deposits.
The capacity of banks to provide credit depends on their cash
reserves, comprising cash in hand and balances with the central
bank. (The amount of cash to be kept by banks will be
determined both by the legal requirements and the pattern of
the inflow and outflow of cash in a bank.) When a bank
extends credit, either the whole of it or a part, depending upon
the extent of banking habit would eventually find its way to the
deposit stream, either with itself or with other banking
institutions. Under the fractional reserve system, banks can
create deposits by a multiple of the reserves since the payments
made with the proceeds of bank loans are eventually
redeposited with banks leading to additional reserve funds.
Even in the countries with a widespread banking habit, there is
a limit to the ability of banks to generate deposits, which is set
by various economic and institutional factors. In developing
countries, the scope for credit creation by banks is much less
than in countries with a well-developed banking system. While
the Reserve Bank can regulate the amount of money creation by
banks through control of their cash reserves, in practice, the
regulation of money supply is not wholly under the Banks
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control. It is considerably affected by the budgetary operations
of the Government over which the Bank has no control,
although the Bank ahs opportunities of tendering advice to
Government on this matter. If the Government meets its
budgetary deficits by borrowing from the Reserve Bank, there
will be an increase in money supply, both in currency and bank
deposits; it may be relevant to note that there is no statutory
limit on the extension of credit by the Bank to Government,
another source of variations in money supply over which the
Banks, influence is restricted is the countrys external payments
position.
Money Supply
The total expansion of money supply depends on the creation
of high-powered money (reserve base) and the multiplier action
upon it, the components of the reserve money are currency
with the public, other deposits with the RBI, and bankers
deposits with the RBI. Money multiplier is the mean value of
the ratio of money supply or aggregate monetary resources to
reserve money. It is the interacting variable between these two
monetary aggregates. Reserve requirements consist of cash
reserve ratio and statutory liquidity ratio. The impact of any
variation in the ratio is direct, precise and certain. Reserve
requirements bear on the volume of credit by affecting the credit
base of bank reserves. Altering the ratios will affect the credit-
creating capacity of banks, volume of credit and therefore of
money supply. The impact of any change in reserve ratios on
money supply depends, besides the extent of multiple credit
creation by banks, on the ratio of bank reserves to total
reserves, which is defined as the currency with the public and
bank reserves.
The three important factors affecting money supply in India are
the net bank credit to Government, bank credit to the
commercial sector and net foreign exchange assets of the
banking sector.
Net bank credit to Government is composed of net Reserve
Bank credit to the Government and the holdings of
Government securities by commercial and co-operative banks.
The Reserve Banks net credit to Government is the sum of the
Reserve Banks net credit to the Central Government and net
credit to the State Governments and is arrived at after deducting
deposits of the Central and State Governments with the
Reserve Bank from the sum total of the Banks investments in
Treasury Bills and Government securities and the Banks loans
and advances to the State Governments. However, it should be
noted that the concept of net bank credit to the Central
Government is not the same as the Central Governments
budgetary deficit, especially since all term borrowings, including
the increase in the banks holdings of Central Government
securities, are treated in the budget as resources of the
Government while all holding of short-term paper (Treasury
bills) including the holding of non-bank institutions enter the
budgetary deficit.
Bank credit to the commercial sector, including that
extended to public sector commercial undertakings, represents
the gross commercial and co-operative banks credit and
investments in the commercial sectors shares, bonds and
debentures, and the Reserve Banks credit to the commercial
sector, viz., loans and advances to financial institutions, internal
bills purchased and discounted, holding of capital and bonds
of financial institutions, and investments in debentures.
The net foreign exchange assets of the Reserve Bank and the
foreign exchange assets of banks together constitute the net
foreign exchange assets of the banking sector. In the former are
included the Banks holdings of foreign securities, gold coin
and bullion and balances held abroad; from the total is
deducted the balance in IMF Account excluding the amount of
quota subscription in rupees, the effect of the external sector on
money supply is measured by the movement in net foreign
exchange assets. Whenever there is an increase in net foreign
assets this is an expansionary factor even as a decrease is a
contractionary factor.
Net bank credit to Government is determined by the
Governments budgetary policies, including the size of the
budgetary deficit which again depends on the actual behaviour
of revenue and expenditure during the year, as the Reserve
Bank is not able to influence the size of the budgetary deficit, it
has to formulate its credit policy within this overall constraint.
The banking system constitutes the major source of
institutional credit. Bank credit to the commercial sector can be
influenced by the RBIs credit policies via the capacity of banks
to create credit and thereby influence a part of aggregate demand
in the economy. As a general rule, to control the growth of
liquidity in the economy caused mainly by the Governments
budgetary deficits, the Reserve Bank acts primarily on bank
credit to the commercial sector.
Questions to Discuss:
1. What do you understand by Monetary Policy?
2. What are the objectives of monetary policy?
3. Discuss the scope of monetary and fiscal policies.
4. What is Monetary Management?
5. Discuss Money Supply in detail.
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LESSON 11:
TOOLS OF MONETARY POLICY
Learning Objectives
After reading this lesson, you will understand
Tools of monetary policy
Instruments of general credit control
Goals of monetary policy
Recent policy developments
After discussing the monetary policy in our last lesson let us
now discuss the tools of monetary policy.
What are Open Market Operations?
Open market operations can be continuous and flexible in
influencing bank reserves. Effects depend on the medium of
operation, short bills like Treasury Bills or long-term securities,
till the initiation of several measures to promote primary and
secondary markets in Government securities since 1992-93, the
market was quite narrow. There was no choice of amount. The
amount was determined by the budgetary requirements and the
interest rate by the need to keep the cost of borrowing low. As
the corollary to the financial liberalization measures, the
automatic monetisation of the fiscal deficit was limited to Ways
and Means Advances at market related interest rates form April
1,1997 and development of money market and securities
market by way of introduction of new instruments, auction
system for Government securities (including repos/ reverse
repos) and instituting a network of primary and satellite dealers
with a view to enabling the emergence of open market
operations as the principal instrument of liquidity
management.
REPOs
REPO and reverse REPO operated by RBI in dated
government securities and Treasury Bills (except 14 days) help
banks to manage their liquidity as well as undertake switch to
maximize the return. REPOs are also used to signal changes in
interest rates. REPOs bridge securities and banking business.
A REPO is the purchase of one loan against the sale of
another. They involve the sale of securities against cash with a
future buy back agreement. There are no restrictions on tenor of
REPOs. They are well established in US and spread to Euro
market in the second half of 1980s to meet the trading demand
from dealers and smaller commercial banks with limited access
to international interbank funding. REPOs are a substitute for
traditional interbank credit.
REPOs are part of open market operations undertaken to
influence short-term liquidity. With a view to maintain an
orderly pattern of yields and to cater to the varying requirements
of investors with respect to maturity distribution policy or to
enable them to improve the yields on their investment in
securities, RBI engages extensively in switch operations. In a
triangular switch, one institutions sale/ purchase of security is
matched against the purchase/ sale transaction of another
institution by the approved brokers. In a triangular switch
operation, the selling banks quota (fixed on the basis of time
and demand deposit liabilities) is debited (the Reserve Bank
being the purchaser). The objective behind fixing a quota for
switch deals is to prevent the excessive unloading of low
yielding securities on to the Reserve Bank. The Bank maintains
separate lists for purchase and sale transactions with reference to
its stock of securities and the dates of maturity of the different
loans.
REPO auction was allowed since 1992-93. Since November
1999 REPOs are offered on a daily fixed rate basis to provide
signals to money market rates and impart stability to short-term
interest rates by setting a floor to call rates.
REPOs and Reverse REPOS
In order to activate the REPOs market so that it serves as an
equilibrating force between the money market and the securities
market, REPO and reverse REPO transactions among select
institutions have been allowed since April 1997 in respect of all
dated Central Government securities besides Treasury Bills of
all maturities, a system of announcing a calendar of REPO
auctions to enable better treasury management by participants
was introduced in January 1997.
Reverse REPOs ease undue pressure on overnight call money
rates. PDs are allowed liquidity support in the form of reverse
REPO facility.
Reverse REPO transactions can be entered into by non-bank
entities who are holders of SGL accounts with the Reserve
Bank with banks, primary dealers in Treasury Bills of all
maturities and all dated central government securities. The first
step if the transaction by non-bank entites should be by way of
purchase of securities eligible for REPOs from banks/ primary
dealers and the second step will be by way of selling back
securities to banks/ primary dealers. Non-bank entities are
however not allowed to enter into REPO transactions with
banks/ primary dealers. The transactions have to be effected at
Mumbai.
Interbank REPOs
Commercial banks and select entities can conduct REPO
transactions in PSU bonds and private corporate debt securities.
These transactions provide liquidity support to the debt market
Delivery Versus Payment (DVP) was introduced in April 1999
as a regulatory safeguard.
In July 1999 non-bank participants in the money market were
allowed to access short-term liquidity through REPOs on par
with banks.
It may be noted that according to the international accounting
practices, the funds advanced by the purchaser of a security
under a firm repurchase agreement are generally treated as
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collaterised loan and the underlying security is maintained on
the balance sheet of the seller
What do you Understand by Discount Policy?
Discount loans are loans from the central bank to depository
institution and that the discount rate is the interest rate charged
on these loans. Discount policy, which primarily involves
changes in the discount rate, affects reserves in the banking
system because when a discount loan is extended, the central
bank increases a banks reserves by an equal amount.
In addition to its use as a tool to influence reserves in the
banking system and the money supply, discounting is
important in preventing financial panics. An important role of
RBI is intended to be as the lender of last resort; it was to
provide reserves to banks when no one else would in order to
prevent bank failures from spinning out of control, thereby
preventing bank and financial panics. Discounting is a
particularly effective way to provide reserves to the banking
system during a banking crisis because reserves are immediately
channeled to the banks that need them most.
What is the Reserve Requirement?
Changes in reserve requirements affect the demand for reserves:
A rise in reserve requirements means that banks must hold
more reserves, and a reduction means that they are required to
hold less. All depository institutions, including commercial
banks, savings and loan associations, mutual savings banks,
and credit unions, are all subject to reserve requirements.
Reserve requirements have been rarely used as a monetary policy
tool because raising them can cause immediate liquidity
problems for banks with low excess reserves. Continually
fluctuating reserve requirements would also create more
uncertainty for banks and make their liquidity management
more difficult,
Instruments of General Credit Control
Instruments of credit control are of two types: general of
quantitative and selective of qualitative. The instruments of
general credit control are the Bank rate, also known as the
discount rate, reserve requirements and open market
operations. All the three methods by affecting the lendable
resources of the commercial banks affect the total volume of
credit and hence total money supply. In the case of selective
credit controls the impact is not so much on the total amount
of credit as on the direction of credit, i.e., on the amount that is
put to use in a particular sector of the economy, and they bring
to bear a restraining influence on the borrowers.
The three instruments are designed to affect the liquidity in the
economy by acting on the quantum of bank reserves. Open
market operations and reserve requirements directly affect the
reserve base while the Bank rate produces its impact indirectly
through variations in the cost of acquiring the reserves. The
effects of Bank rate changes are not confined to the banking
system and the money market; they produce wider
repercussions on the economy as a whole. However, its action is
indirect, its influence on money and credit being through
primary changes in short-term money rates and secondary
repercussions on long-term interest rates or yields; i9t is not
also as flexible for day-to-day adjustments as open market
operations, which can also be used for carrying out changes on
even the smallest scale. Changes in reserve requirements operate
directly and immediately by affecting the quantum of loanable
resources with banks: an increase reduces the banks capacity to
lend and a reduction in effect places funds with them. The
effects of changing reserve requirements are similar in some
respects to but different in others from those of open market
operations. They are similar in that they both change instantly
the reserve position of banks and set in motion secondary
forces leading to multiple expansion or contraction of credit.
The two instruments differ in that changes in reserve
requirements are much more effective than open market
operations (and also discount rate) in situations where the
banks have a volume of reserves far in excess of the legal
requirements or where a large expansion of credit is desired, to
elaborate, where large-scale and widespread liquidity exists, a rise
in reserve requirements will be more useful in eliminating the
excess reserves. Once this is done, open market operations are
more suitable as a flexible instrument to tighten or ease credit
operations, as it is selective in its application and can also be
used on a day-to-day basis. Conversely, the reserve requirements
can be lowered to bring about an increase in general liquidity in
the banking system, and thereafter through open market
operations the liquidity can be maintained at the desired level.
Unlike the Bank rate whose effectiveness depends, among other
things, upon the attitude of the commercial banks and the
borrowers, open market operations can be so regulated that
bank reserves change to the level desired by the central bank. In
the final analysis, however, the use of one instrument rather
than another at any point of time is determined by the nature
of the situation and the range of influence it is desired to wield
as well as the rapidity with which the change is required to be
brought about. Rather, it has come it be recognized that in the
majority of circumstances, no single instrument is adequate to
meet the task; instead, all three need to be employed in
appropriate combination.
In India, the statutory basis for the regulation of the credit
system by the Bank is embodied in the Reserve Bank of India
Act and the Banking Regulation Act. The former confers on the
Bank the usual powers available to central banks generally, while
the latter provides special powers of direct regulation of the
operations of the commercial and co-operative banks.
Goals of Monetary Policy
Reserve Bank of India focuses on the following main six basic
goals of monetary policy:
High employment
Economic growth
Price stability
Interest-rate stability
Stability of financial markets
Stability in foreign exchange markets
High Employment
Promoting high employment consistent with a stable price level
is a worthy goal for two main reasons: (1) the alternative
situation, high unemployment, causes much human misery,
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with families suffering financial distress, lass of personal self-
respect, and increase in crime (though this last conclusion is
highly controversial), and (2) when unemployment is high, the
economy has not only idle workers but also idle resources
(closed factories and unused equipment), resulting in a loss of
output (lower GDP)
Although it is clear that high employment is desirable, how
high should it be? At what point can we say that the economy is
at full employment? At first, it might seem that full
employment is the point at which no worker is out of job, that
is, when unemployment is zero. But this definition ignores the
fact that some unemployment, called frictional
unemployment, which involves searches by workers and firms
to fund suitable matchups, is beneficial to the economy. For
example, a worker who decides to look for a better job might be
unemployed for a while during the job search. Workers often
decide to leave work temporarily to pursue other activities
(raising a family, travel, returning to school), and when they
decide to reenter the job market, it may take some time for
them to fund the right fob. The benefit of having some
unemployment is similar to the benefit of having a nonzero
vacancy rate in the market for rental apartments.
Another reason that unemployment is not zero when the
economy is at full employment is due to what is called
structural unemployment, a mismatch between job
requirements and the skills or availability of local workers.
Clearly, this kind of unemployment is undesirable.
Nonetheless, it is something that monetary policy can do little
about.
The goal for high employment should therefore not seek an
unemployment level of zero but rather a level above zero
consistent with full employment at which the demand for labor
equals the supply of labor. This level is called the natural rate
of unemployment.
Economic Growth
The goal of steady economic growth is closely related to the
high-employment goal because businesses are more likely to
invest in capital equipment to increase productivity and
economic growth when unemployment is low. Conversely, if
unemployment is high and factories are idle, it does not pay for
a firm to invest in additional plants and equipment. Although
the two goals are closely related, policies can be specifically aimed
at promoting economic growth by directly encouraging people
to save, which provides more funds for firms to invest, in fact,
this is the stated purpose of so-called supply-side economics
policies, which are intended to spur economic growth by
providing tax incentives for businesses to invest in factories and
equipment and for taxpayers to save more, there is also an active
debate over what growth role monetary policy can play in
boosting growth.
Price Stability
Over the past few decades, policymakers in India have become
more aware of the social and economic costs of inflation and
more concerned with a stable price level as a goal of economic
policy. The price stability is desirable because a rising price level
(inflation) creates uncertainty in the economy, and that may
hamper economic growth. For example, the information
conveyed by the prices of goods and services is harder to
interpret when the overall level of process is changing, which
complicates decision making for consumers, businesses, and
government, not only do public opinion surveys indicate that
the public is very hostile to inflation, but also a growing body
of evidence suggests that inflation leads to lower economic
growth. The most extreme example of unstable prices is
hyperinflation, such as Argentina, Brazil, and Russia have
experienced in the past. Many economists attribute the slower
growth that these countries have experienced to their problems
with hyperinflation. Further, inflation may strain a countrys
social fabric: Conflict may result because each group in the
society may compete with other groups to make sure that its
income keeps up with the rising level of prices.
Interest-Rate Stability
Interest-Rate stability is desirable because fluctuations in interest
rates can create uncertainty in the economy and make it harder to
plan for the future, fluctuations in interest rates that affect
consumers willingness to buy houses, for example, make it
more difficult for consumers to decide when to purchase a
house and for construction firms to plan how many houses to
build. Upward movements in interest rates generate hostility
toward central banks like RBI and lead to demands that their
power be curtailed.
Stability of Financial Markets
Financial crises can interfere with the ability of financial markets
to channel funds to people with productive investment
opportunities, thereby leading to a sharp contraction in
economic activity. The promotion of a more stable financial
system in which financial crises are avoided is thus an important
goal for a central bank.
The stability of financial markets is also fostered by interest-rate
stability because fluctuations in interest rates create great
uncertainty for financial institutions. An increase in interest rates
produces large capital losses on long-term bonds and
mortgages, losses that can cause the failure of the financial
institutions holding them. In recent years, more pronounced
interest-rate fluctuations have been a particularly severe problem
for savings and loan associations and mutual savings banks.
Stability in Foreign Exchange Markets
With the increasing importance of international trade to the
Indian economy, the value of the rupees relative to other
currencies has become a major consideration for the RBI. A rise
in the value of the rupee makes Indian industries less
competitive with those abroad, and declines in the value of the
rupee stimulate inflation in India. In addition, preventing large
changes in the value of the rupee makes it easier for firms and
individuals purchasing or selling goods abroad to plan ahead.
Stabilizing extreme movements in the value of the rupee in
foreign exchange markets is thus viewed as a worthy goal of
monetary policy,
Conflict Among Goals
Although many of the goals mentioned are consistent with
each other-high employment with economic growth, interest-
rate stability with financial market stability-this is not always the
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case. The goal of price stability often conflicts with the goals of
interest-rate stability and high employment in the short run
(but probably not in the long run). For example, when the
economy is expanding and unemployment is falling, both
inflation and interest rates may start to rise, if the central bank
tries to prevent a rise in interest rates, this may cause the
economy to overheat and stimulate inflation. But is a central
bank raises interest rates to prevent inflation, in the short run
unemployment may rise, the conflict among goals may thus
present central banks like RBI with some hard choices.
Recent Policy Developments
Although the above-given account of the long-term evolution
of monetary policy has referred to certain recent changes, a brief
critical update of the RBI policy will be useful for purposes of
study.
Major Changes
The recent monetary policy, particularly the one announced in
April 1997 and October 1997 can be said to have ushered in
the following changes:
It has encouraged greater market orientation in the financial
sector by empowering banks with greater operational
flexibility. Although the RBI will continue to prescribe
prudential guidelines, it has now moved out of
microregulation.
The borrowers also have been empowered to reinforce
marketisation, and this is bound to change the relationship
between borrowers and bankers.
The interest rates are now sought to be emphasised as
potential instruments for influencing the liquidity in the
system. The Bank rate is being made an important signal and
reference rate to define determine the stance of monetary
policy and the cost of funds ill the economy.
The policy is directed to integrate further the money market,
the government securities market, and the forex markets.
The government securities market is being made an active
segment of the IPS so that the conduct of monetary policy
could be rendered effective.
Fiscal-monetary relationship has been reformed in a major
way by abolishing the system of automatic monetisation of
fiscal deficit, which was taking place through the issuance of
ad hoc treasury bills. This has been achieved through the
signing of two agreements between the GOI and the RBI.
Interest rates structure has been simplified and deregulated.
Far-reaching changes in the external sector of the economy
have been effected. Substantial elimination of imports and
exchange controls, introduction of market-determined
exchange rate system, rupee convertibility, encouragement to
FDI, and greater access to external capital markets are some
of these changes.
Summary
The goals of monetary policy include a stable price level,
economic growth, high employment, stable interest rates, and
predictable and steady currency exchange rates. Unfortunately,
monetary policies involve difficult trade-offs, and policies that
help to achieve one goal may make another less attainable.
The conduct of monetary policy involves actions that affect the
RBIs balance sheet. Open market purchases lead to an
expansion of reserves and deposits in the banking system and
hence to an expansion of the monetary base and the money
supply. An increase in discount loans leads to an expansion of
reserves, thereby causing an expansion of the monetary base
and the money supply. The three basic tools of monetary policy
are open market operations, discount policy, and reserve
requirements. Open market operations are the primary tool.
Because predicting the Reserve Banks actions can help managers
of financial institution predict the course of future interest
rates, which has a major impact on the financial institutions
profitability, such managers value the services of RBI watchers,
experts on Central Bank behavior.
Questions to Discuss:
1. What are Open Market Operations?
2. What are the instruments of general credit control?
3. Discuss the goals of monetary policy.
4. Discuss the recent policy developments.
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LESSON 12:
TUTORIAL-2
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LESSON 13:
THE SECURITIES AND EXCHANGE BOARD OF INDIA
Learning objectives
After reading this lesson, you will understand
Securities contracts (regulation) act, 1956
Securities and exchange board of India
Objectives and regulatory approach
Powers, scope, and functions
Discussion on SEBI is important for our discussion. It is one
of most important regulatory authority in India. It is gaining
more importance day by day with new issues cropping up.
Securities Contracts (Regulation) Act, 1956
The objective of the Securities Contracts (Regulation) Act
(SCRA) is to regulate the working of stock exchanges or
secondary market with a view to prevent undesirable
transactions or speculation in securities, and thereby to build up
a healthy and strong investment market in which public could
invest with confidence. It empowers the GOI to recognise and
derecognise the stock exchanges, to stipulate laws and by-laws
for their functioning, and to make the listing of securities on
stock exchanges by Public Limited Companies (PULCOs)
mandatory. It prohibits securities transactions outside the
recognised stock exchanges. It lays down that all contracts in
securities except spot delivery contracts can be entered into only
between and through the members of recognised stock
exchanges. It prescribes conditions or requirements for listing
of securities on the recognised stock exchanges. It empowers
the GOI to supercede the governing bodies of stock exchanges,
to suspend business on recognised stock exchanges, to declare
certain contracts illegal and void under certain circumstances, to
prohibit contracts in certain cases, to license the security dealers,
and to lay down penalties for contravention of the provisions
of the Act. It is administered by the Ministry of Finance,
Department of Economic Affairs, GOI.
Securities and Exchange Board of India
Genesis
The year 1991 witnessed a big push being given to liberalisation
and reforms in the Indian financial sector. For sometime
thereafter, the volume of business in the primary and secondary
securities markets increased significantly. As a part of the same
reform process, the globalisation or internationalisation of the
Indian financial system made it vulnerable to external shocks.
The multi-crore securities scam rocked the IFS in 1992. All these
developments impressed on the authorities the need to have in
place a vigilant regulatory body or an effective and efficient
watchdog. It was felt that the then existing regulatory
framework was fragmented, ill coordinated, and inadequate and
that there was a need for an autonomous, statutory, integrated
organisation to ensure the smooth functioning of the IFS. The
SEBI came into being as a response to these requirements.
The SEBI was established on April 12, 1988 through an
administrative order, but it became a statutory and really
powerful organisation only since 1992. The CICA was repealed
and the office of the CCI was abolished in 1992, and the SEBI
was set up on 21 February 1992 through an ordinance issued on
30 January 1992. The ordinance was replaced by the SEBI Act
on 4 April 1992. Certain powers under certain sections of SCRA
and CA have been delegated to the SEBl. The regulatory powers
of the SEBI were increased through the Securities Laws
(Amendment) Ordinance of January 1995, which was
subsequently replaced by an Act of Parliament. The SEBI is
under the overall control of the Ministry of Finance, and has its
head office at Mumbai. It has now become a very important
constituent of the financial regulatory framework in India.
The philosophy underlying the creation of the SEBI is that
multiple regulatory bodies for securities industry mean that the
regulatory system gets divided, causing confusion among
market participants as to who is really in command. In a
multiple regulatory structure, there is also an overlap of
functions of different regulatory bodies. Through the SEBI,
the regulation model which is sought to be put in place in India
is one in which every aspect of securities market regulation is
entrusted to a single highly visible and independent
organisation, which is backed by a statute, and which is
accountable to the Parliament and in which investors can have
trust.
Constitution and Organisation
The SEBI is a body of six members comprising the Chairman,
two members from amongst the officials of the ministries of
the central government dealing with finance and law, two
members who are professionals and have experience or special
knowledge relating to securities market, and one member from
the RBI. All members, except the RBI member, are appointed
by the government, who also lays down their terms of office,
tenure, and conditions of service, and who can also remove any
member from office under certain circumstances. The central
government is empowered to supersede the SEBI in public
interest, or if, on account of grave emergency, it is unable to
discharge its functions or duties, or if it persistently defaults in
complying with any direction issued by the government, or if
its financial position and administration deteriorates.
The work of the SEBI has been organised into five operational
departments each of which is headed by an executive director
who reports to the Chairman. Besides, there is a legal
department and the investigation department. The departments
have been divided into divisions. The various departments and
the scope of their activities are as follows:
(i) The Primary Market Policy, Intermediaries, Self-Regulatory
Organisations (SROs), and Investor Grievance and Guidance
Department. It looks after all policy matters and regulatory
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issues in respect of primary market, registration, merchant
bankers, portfolio management services, investment
advisers, debenture trustees, underwriters, SROs and
investor grievance, guidance, education, and association.
(ii) The Issue Management and Intermediaries Department: It
is responsible for vetting of all prospectuses and letters of
offer for public and right issues, for coordinating with the
primary market policy, for registration, regulation and
monitoring of issue-related intermediaries.
(iii) The Secondary Market Policy, Operations and Exchange
Administration, New Investment Products and Insider
Trading Department: It is responsible for all policy and
regulatory issues for secondary market and new investment
products, registration and monitoring of members of stock
exchanges, administration of some of the stock exchanges,
market surveillance and monitoring of price movements and
insider trading and EDP and SEBIs data base.
(iv) The Secondary Market Exchange Administration,
Inspection and Non-member Intermediaries Department: It
looks after the smaller stock exchanges of Guwahati,
Magadh, Indore, Mangalore, Hyderabad, Bhubaneshwar,
Kanpur, Ludhiana and Cochin. It is also responsible for
inspection of all stock exchanges, and registration, regulation
and monitoring of non-member intermediaries such as sub-
brokers.
(v) Institutional Investment (Mutual Funds and Foreign
Institutional Investment), Mergers and Acquisitions,
Research and Publications, and International Relations and
IOSCO Department: It looks after policy, registration,
regulation and monitoring of Foreign Institutional
Investors (FIls), domestic mutual funds, mergers and
substantial acquisitions of shares, and IOSCO (International
Organisation of Securities Commissions) membership,
international relations, and research, publication and Annual
Report of SEBI.
(vi) Legal Department looks after all legal matters under the
supervision of the General Counsel.
(vii) Investigation Department carries out inspection and
investigation under the supervision of the Chief of
Investigation:
The SEBI has regional offices at Kolkata, Chennai and Delhi. It
has also formed two non-statutory advisory committees
namely, the Primary Market Advisory Committee and Secondary
Market Advisory Committee with members from market
players, recognised investor associations, and other eminent
persons.
SEBI is a member of IOSCO, an international body
comprising of security regulators from over 100 countries. It
participates in the Development Committee of IOSCO, which
provides a platform for regulators from emerging markets to
share their views and experiences.
Table 1: Details of Intermediaries Registered
Objectives and Regulatory Approach
The overall objective of the SEBI, as enshrined in the Preamble
of the SEBI Act, 1992 is to protect the interests of investors
in securities and to promote the development of, and to
regulate the securities market and for matters connected
therewith or incidental thereto. To elaborate, the SEBI
regulates stock exchanges and securities industry to promote
their orderly functioning. It protects the rights and interests of
investors, particularly individual investors, and guides/ educates
them. It prevents trading malpractices and aims at achieving a
balance between self-regulation by securities industry and its
statutory regulation.
Having regard to the emerging nature of the securities markets
in India, the SEBI necessarily has the twin task of regulation
and development. Its regulatory measures are always meant to
be subservient to the needs of the market development.
Underlying those measures is the logic that rapid and healthy
market development is the outcome of well-regulated
structures. In this spirit, the SEBI endeavours to create an
effective surveillance mechanism and encourage responsible and
accountable autonomy on the part of all players in the market,
who are expected and required to discipline themselves and
observe the rules of the market. The self-regulation and
regulation by exception are thus the comer stones of its
regulatory framework. The SEBI believes that self-regulation
can work only if there is an effective regulatory body overseeing
the activities of self-regulatory organisations.
The SEBI also aims at facilitating an efficient mobilisation and
allocation of resources through the securities markets,
stimulating competition, and encouraging innovations. Its
regulation is expected to be flexible, cost -effective and
confidence- inspiring. To investors, the SEBI provides a high
degree of protection of their rights and interests through
adequate, accurate, and authentic information and disclosure of
such information on a continuous basis. To issuers, it provides
a market place in which they can confidently raise all the finance
they need in an easy, fair, and efficient manner. To the market
intermediaries, it offers a competitive, professionalised and
expanding market with adequate and efficient infrastructure so
that they can render better and more responsible service to the
investors and issuers.
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Table 2: Exchange wise Brokers Registered with SEBI
Powers, Scope, and Functions
The scope of operations of the SEBI is very wide; it can frame
or issue rules, regulations, directives, guidelines, norms in
respect of both the primary and secondary markets,
intermediaries operating in these markets, and certain financial
institutions. It has powers to regulate (i) depositories and
participants, (ii) custodians, (iii) debenture trustees, and trust
deeds, (iv) FIls, (v) insider trading, (vi) merchant bankers, (vii)
mutual funds, (viii) portfolio managers, and investment
advisers, (ix) registrars to issue and share transfer agents, (x)
stock brokers and sub-brokers, (xi) substantial acquisition of
shares and takeovers, (xii) underwriters, (xiii) venture capital
funds, and (xiv) bankers to issues. The SEBl can issue
guidelines in respect of (a) information disclosure, operational
transparency, and investor protection, (b) development of
financial institutions, (c) pricing of issues, (d) bonus issues, (e)
preferential issues, (f) financial instruments, (g) firm allotment
and transfer of shares among promoters.
The SEBl is empowered to register any agency or intermediary
who may be associated with the securities market and none of
them shall buy, sell or deal in securities except under and in
accordance with the conditions of a certificate of registration
issued by the SEBI. However, the GOI is empowered to
exempt any person or class of persons from registration with
the SEBI. The SEBl can suspend or cancel a certificate of
registration issued by it to anyone, after giving him a reasonable
opportunity of being heard. The SEBl Act lays down the civil
and criminal penalties for contravention of the Act; anyone who
contravenes or attempts to contravene or abets contravention
of the provisions of the Act or of any rules or regulations
made thereunder, is punishable with imprisonment or fine or
both.
As said earlier, with the repeal of the ClCA, all matters related to
the issue of capital are now governed by the guidelines issued
by the SEBI. Similarly, as a result of the delegation of certain
powers under the SCRA to the SEBl, the latter can conduct
inquiries into the working of the stock exchanges which have to
-submit their annual reports to the SEBl and seek its approval
for amending their rules and bye-laws; it can direct them to
amend their bye-laws and rules including reconstitution of their
governing boards/ councils; and it is empowered to license
security dealers operating outside their jurisdiction.
Consequent on the amendments to the SEBl Act in 1995, the
regulatory powers over corporate in the issuance of capital,
transfer of securities and other related matters are now vested in
the SEBI. The amendments also provide for the deletion of
the existing provision relating to disqualification of a member
of the SEBl Board on his being appointed as a director of a
company. The SEBl has also been empowered to demand
explanations, to summon the attendance and call for
documents from all categories of market intermediaries in order
to enable it to investigate irregularities, impose penalties, and
initiate prosecution. The SEBl has also been empowered now
to notify its regulations and file complaints in courts without
the prior approval of the GOI.
However, in the exercise of its powers and in performing its
functions, the SEBl is bound by such directions on questions
of policy as the GOl may give in writing from time to time.
Although it has the opportunity to express its views before any
direction is given, the decision of the GOI is final in every case.
Questions to Discuss:
1. Discuss the constitution and organization of SEBI.
2. Discuss the objectives and regulatory approach of SEBI
3. What are the powers, scope, and functions of SEBI?
Notes:
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LESSON 14:
THE SECURITIES AND EXCHANGE BOARD OF INDIA
Learning objectives
After reading this lesson, you will understand
Highlights of SEBIs performance
Appraisal of SEBIs work
Let us move ahead with our discussion on SEBI. Let us now
discuss highlights and appraisal of SEBIs work.
Highlights of Sebis Performance
Since the enactment of the SEBl Act in 1992, financial
institutions, agencies, and market intermediaries mentioned
above are now being governed by the guidelines, rules, and
regulations notified by the SEBI from time to time. Due to lack
of space, it is not possible to present their exhaustive list here.
We give below only the major policy measures and reforms
introduced by the SEBl during 1992 to 1996.
Primary Securities Market
The issues of capital by companies no longer require any
consent from any authority either for making the issue or for
pricing it.
Efforts have been made to raise the standards of disclosure
in public issues and enhance their transparency. The SEBI
has accepted and implemented almost all the
recommendations of Malegam Committee appointed by it
in 1994-95 in this connection.
The offer document is now made public even at the draft
stage.
Companies making their first public issue are eligible to do
so only if they have three years of dividend-paying track
record preceding an issue. Those not meeting this
requirement can still make an issue if their projects are
appraised by banks or FIs with minimum 10 per cent
participation in the equity capital of the issuer, or if their
securities are listed on the OTCEI (Over-the-Counter
Exchange of India).
For issues above Rs 100 crore, book-building requirement
has been introduced.
The pricing of preferential allotment has to be at market
related levels, and there is a five-year lock- in period for such
allotments.
In case of proportionate allotment scheme, a minimum of
50 per cent of the net offer to the public is to be reserved for
individual investors applying for securities not exceeding
1000 securities, and the remaining part can be allotted
to applications for more than 1000 securities.
Initially, the underwriting of issues to public was made
mandatory, but now this stipulation has been removed.
During 1995-96, the SEBI granted registration to four
underwriters, bringing their total number to 40.
Bankers to an issue and portfolio managers have to be
registered with the SEBI. There were 77 bankers to issue
who were thus registered as of 31, March 1996. Similarly,
there were 13 registered and 100 permitted portfolio
managers at the end of March 1996.
Secondary Market and Intermediaries
The governing boards and various committees of stock
exchanges (SEs) have been recognised, restructured and
broad-based.
Inspection of all 22 SEs has been carried out to determine,
inter alia, the extent of compliance with the directives of the
SEBI.
Computerised 0r screen-based trading has been achieved on
almost all exchanges except some of the smaller ones.
Corporate membership of SEs is now allowed, encouraged,
and preferred. The Articles of Association of SEs have been
amended so as to increase their membership. All the SEs
have been directed to establish either a clearing house or a
clearing corporation.
The Bombay Stock Exchange (BSE) has been asked to reduce
trading period or settlement cycle from 14 to 7 days for B
group shares.
A process through which investor grievances against brokers
may find redressal through a complaint to the SEBI has
been put in place.
All the recommendations of the Dave Committee for
improving the working of the OTCEI have been accepted.
The SEs have been instructed to set up independent market
surveillance departments. The SEBI has strengthened its
own investigation and enforcement machinery.
In accordance with the recommendations of G.S. Patel
Committee, BSE has been allowed to introduce a revised
carry forward system (CFS) of trading. Other SEs can
introduce forward trading only with the prior permission of
the SEBI. Transactions are not allowed to be carried forward
for more than 90 days now. The shares received by financiers
funding carry forward transactions have to be deposited and
kept in the safe custody of the clearing house of the stock
exchange or its authorised agent. Every member is required
to keep books and records of the source of finance with the
sub accounts being maintained in the clearing house. The
scrip-wise carry forward position has to be disclosed to the
market. The SEs are required to introduce the twin track
system which will segregate transactions into carry forward
and cash transactions, and each one of the former will be
identified with a transaction identification number till its
final settlement.
The brokers are required to ensure segregation of client
account and own account.
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The capital adequacy norms of 3 per cent for individual
brokers and 6 per cent for corporate brokers introduced.
Both the brokers and sub-brokers have been brought within
the regulatory fold for the first time now; and the concept of
the dual registration of stock brokers with the SEBI and the
SEs has been introduced. The total number of registered
brokers and sub-brokers was 8,746 at the end of March
1996, of which 1917 were corporate members.
Penal action can now be taken directly by the SEBI against
any member of a stock exchange for violation of any
provision of the SEBI Act.
It has been made mandatory for the stock brokers to
disclose the transaction price and brokerage separately in the
contract notes issued by them to their clients.
The daily margin and additional margin for volatile scrips are
now levied on a weekly and marked-- to-market basis.
The SEs have amended their Listing Agreements such that
the issuers have now to provide shareholders with cash flow
statements in a prescribed format, along with the complete
balance sheet and profit and loss statement.
The trading hours in almost all the SEs have now been
increased from 21/ 2 hours to 3 hours per day.
Compulsory audit of the brokers books and filing of the
audit reports with the SEBI has now been made mandatory.
A system of market making in less liquid scrips on selected
SEs has been introduced.
Insider trading has been prohibited and such trading has
been made a criminal offence punishable in accordance with
the provisions of the SEBI Act.
Registrars to Issues (RI) and Share Transfer Agents (STA)
have now been classified into two categories: Category I with
a minimum net worth requirement of Rs 6 lakh who can
carry on the activities both as RI and STA, and category II
with a minimum net\ worth requirement of Rs 3 lakh who
can carry on anyone of these activities. There were 209 RI and
STA in Category I and 125 in Category II at the end of
March 1996.
Till end-August 1997, merchant bankers (MBs) were
classified into four categories, each with different
responsibilities and commensurate with capital requirements.
With effect from September 1997, such a classification has
been abolished and there will be only one entity now,
namely, merchant bankers. A system of penalty points for
MBs for defaults committed by them has been introduced. It
is provided that they can be suspended or deauthorised after
a maximum of 8 penalty points. The MBs have to fulfill
capital adequacy requirements also. During 1995-96, 231 MBs
were granted registration, while registration of nine MBs was
cancelled. The number of MBs was 1,012 in 1995-96 and 790
in 1994-95.
Mutual Funds
As on 31 March 1996, 26 mutual funds (MFs) excluding the
UTI were registered with the SEBI. MFs are required to have a
board of trustees or trustee company separate from the asset
management company, and securities belonging to the various
schemes are required to be kept with an independent custodian.
Ihere has to be an arms-length relationship between the
trustees, the asset management company, and the custodian.
The SEBI (Mutual Funds) Regulations, 1993 were revised to
provide for portfolio disclosure, standardisation of accounting
policies, valuation norms for determining net asset value and
pricing.
The UTI has been organised under the UTI Act, 1963, and it
has evolved as a distinct institution. Therefore, certain special
dispensations have been provided to it under the SEBI
regulatory framework. Subject to this, the UTI also has been
brought under the SEBI since July 1994. As a result, new
schemes of the UTI also now fall under the jurisdiction of the
SEBI.
Miscellaneous
FIls are also required to be registered with the SEBI. The
total number of them so registered were 367 as of 31 March
1996.
It is required that the capital of companies to be registered as
depositories must be Rs 100 crore. Similarly custodians are
required to have a net worth of Rs 50 crore, and they are to
get their systems and procedures evaluated externally.
Venture capital funds (VCFs) allowed to invest in unlisted
companies, to finance turnaround companies, and to provide
loans.
As per the approved modified takeover code recommended
by the Bhagawati Committee, the minimum public offer of
20 per cent purchase, when the threshold limit of 10 per cent
equity is crossed, is made mandatory. Those in control are
permitted to 2 per cent of shares per annum upto a
maximum of 51 per cent. The acquirers have to deposit a
certain value of cash and assets in an escrow account. The
escrow deposits have to be higher for conditional public
offers unless the acquirer agrees to buy a minimum of 20 per
cent.
Investor Protection Measures
The SEBI has introduced an automated complaints handling
system to deal with investor complaints. To create an awareness
among the issuers and intermediaries of the need to redress
investor grievances quickly, the SEBI has been issuing
fortnightly press releases publishing the names of the
companies against whom maximum number of complaints
have been received. To help investors in respect of delay in
receiving refund orders in case of oversubscribed issues, a facility
in the form of stockinvest has been introduced. To ensure that
no malpractice takes place in the allotment of shares, a
representative of the SEBI supervises the allotment process. It
has also accorded recognition to several genuine, active investor
associations. It issues advertisements from time to time to
guide and enlighten investors on various issues related to the
securities market and of their rights and remedies.
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The complaints received by the SEBI are categorised in five
types:
Type I: Non-receipt of refund orders/ allotment letters/
stockinvests.
Type II: Non-receipt of dividend.
Type III: Non-receipt of share certificates/ bonus shares.
Type IV: Non-receipt of debenture certificates/ interest on
debentures/ redemption amount of debentures/ interest on
delayed payment of interest.
Type V: Non-receipt of annual reports, rights issue forms/
interest on delayed receipt of refund orders/ dividends.
Appraisal of Sebis Work
How has the SEBI performed so far? Has it been effective? The
SEBIs task is no doubt challenging, complex and difficult, and
it needs to be fully supported in its efforts. But there are certain
aspects of its working which need improvement and correction.
1) The SEBIs Annual Report, 1995-96 claims an increasing and
a very high success rate in resolving investor complaints. But
the reality is different. The market surveys conducted by L.C.
Gupta revealed that 90 per cent of the respondent-investors
felt that the system of dealing with investor complaints was
not effective; 85 per cent of shareholders felt that they were
not adequately protected; and 70 per cent of investors
indicated that they had actually suffered because of weak
investor protection. Price rigging, a serious menace to the
investors, has, in fact, become more common in recent years.
2) On reading the rules, regulations, guidelines, directions and
norms issued by the SEBI, one doubts whether one is living
in the liberalised or prudential regulation as opposed to
statistic control environment at all. It is difficult to believe
that self-regulation and regulation by exception are really
the corner-stones of the SEBIs regulatory philosophy. The
number of rules, etc. prescribed by the SEBI has become too
large; it has been adding to, and changing them too often
and in a back and forth fashion. This has created a veritable
maze of a plethora of regulations. This has led to a very
high level of uncertainty and confusion. As L.C. Gupta has
rightly said, guidelines have grown by successive additions of
clarifications and further clarifications to clarifications. In the
process, the guidelines have become incomprehensible.
According to some, they are so chaotic and confusing that it
is difficult for anybody to determine what rules are currently
in force. As a result, SEBI officials may wield undue power
by providing their own interpretation of the rules.
3) There is a widespread feeling in the financial markets that the
SEBI is not really serious about reforming the system and
protecting the individual and small investors. It has quite
often failed to penalise the people responsible for causing
abnormal price fluctuations on the stock market. There has
been a lack of will, dithering and hesitancy on the part of
SEBI to strike against the wrong doers. Even certain well--
publicised market manipulations have gone unpunished.
There are many examples of this. The SEBIs rejection of the
Malegam Committees recommendation that new companies
should never be allowed to get listed on stock exchanges is one
such example. Its dispensing with the requirement of the
vetting of public and rights issues is another example. The
dispensing with the requirements of minimum promoters
contribution and lock-in in the case of a company whose shares
are listed on a stock exchange for at least three years is yet
another example. The appointment of another panel (J.R.
Verma panel) by the SEBI on the carry forward system within a
matter of one year of the presentation of the report by the G.S.
Patel Committee on the same subject, because of the
recalcitrance and pressures imposed by the stockbrokers, best
reflects the fallibility, weaknesses, and the failure of SEBI. The
Verma panel reversed the recommendations of the Patel
Committee and recommended the production of virtually the
old carry forward or badla system of trading. There have been
instances of issues and other market activities, which the SEBI
ought not to have allowed but did, although it knew about the
malpractices involved in them. The allotment of shares by
Sterling Tea, and making of a right issue by New World Medical
India Ltd. are recent instances.
4) The regulatory ineffectiveness of the SEBI in certain cases
has been due to its concentration on symptoms rather than
the root causes. The present settlement or delivery system is
highly conducive for manipulative operations and unhealthy
speculation. The SEBI has kept on tinkering with the trading
laws instead of doing away with such an outdated delivery
system.
The SEBIs failure appears to be partly deliberate also. There is a
feeling among market watchers that, as in many other countries,
the SEBI as a regulator has been rather soft and unduly
favourable to the securities industry; it has been more corporate-
friendly than investor-friendly.
5) It is imperative that the SEBI should become more effective,
efficient, socially accountable, and small-investor-friendly. It
has often complained of having insufficient authority and
powers.
Summary
Before the SEBI became a statutory body, the framework for
regulating the securities market or industry comprised of
Companies Act, 1956, Securities Contracts (Regulation) Act,
1956, and Capital Issues (Control) Act, 1947 .The SEBI was set
up in 1988 through an administrative order, and it became a
statutory body in 1992. The SEBI is governed by a six-member
Board of Governors appointed by the GOI and RBI.
Operationally, it is divided into seven departments. Its head
office is at Mumbai and regional offices are at Delhi, Kolkata
and Chennai.
Its objectives are to protect the investors, and to regulate the
financial system in order to bring about its healthy
development. Self-regulation and regulation by exception are
said to be the cornerstones of its policies. It seeks to increase
the efficiency of mobilisation and allocation of resources
through the securities market.
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It has wide powers to issue rules, regulations, and guidelines in
respect of both the primary and secondary securities markets, a
wide variety of intermediaries operating in these markets, viz.,
brokers, merchant bankers, underwriters, bankers to issues, etc.,
and certain financial institutions such as mutual funds.
Questions to Discuss:
1. Discuss the highlights of SEBIs performance.
2. Appraise the work of SEBI.
Notes:
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UNIT 3
COMMERCIAL BANK
LESSON 15:
COMMERCIAL BANKS
Learning objectives
After reading this lesson, you will understand
Introduction
Theoretical basis of banking operations
Functions of the commercial banks and the services rendered
by them
General structure and methods of commercial banking
Employment of funds by commercial bankers
Commercial banks are the oldest, biggest, and fastest growing
financial intermediaries in India. They are also the most
important depositories of public saving and the most
important disbursers of finance. Commercial banking in India
is a unique system, the like of which exists nowhere in the
world. The truth of this statement becomes clear as one studies
the philosophy and approaches that have contributed to the
evolution of the banking policy, programmes and operations in
India. This however is too big a subject to be discussed here in
detail. We will therefore confine ourselves to presenting only an
outline of the said philosophy and approaches, and discussing
the actual working of banks in detail.
Commercial banks are organised on a joint stock company
system, primarily for the purpose of earning a profit. They can
be either of the branch banking type, as we see in most of the
countries, with a large, network of branches, or of the unit
banking type, as we see in the United States, where a banks
operations are confined to a single office or to a few branches
within a strictly limited area. Although the commercial banks
attract deposits of all kinds-Current, Savings and Fixed-their
resources are chiefly drawn from current deposits, which are
repayable on demand. So they attach much importance to the
liquidity of their investments and as such they specialise in
satisfying the short-term credit needs of business other than
the long-term.
The banking system in India works under the constraints that
go with social control and public ownership. The public
ownership of banks has been achieved in three stages: 1955,
July 1969, and April 1980. Not only the public sector banks but
also the private sector and foreign banks are required to meet
targets in respect of sectoral deployment of credit, regional
distribution of branches, and regional credit-deposit ratios. The
operations of banks have been determined by Lead Bank
Scheme, Differential Rate of Interest Scheme, Credit
Authorization Scheme, inventory norms and lending systems
prescribed by the authorities, the formulation of the credit
plans, and Service Area Approach.
Theoretical Basis of Banking Operations
Commercial banks ordinarily are simple business or commercial
concerns which provide various types of financial services to
customers in return for payments in one form or another, such
as interest, discounts, fees, commission, and so on. Their
objective is to make profits. However, what distinguishes them
from other business concerns (financial as well as
manufacturing) is the degree to which they have to balance the
principle of profit maximisation with certain other principles.
In India especially, banks are required to modify their
performance in profit making if that clashes with their
obligations in such areas as social welfare, social justice, and
promotion of regional balance in development. In any case,
compared to other business concerns, banks in general have to
pay much more attention to balancing profitability with
liquidity. It is true that all business concerns face liquidity
constraint in various areas of their decision-making and,
therefore, they have to devote considerable attention to liquidity
management. But with banks, the need for maintenance of
liquidity is much greater because of the nature of their liabilities.
Banks deal in other peoples money, a substantial part of which
is repayable on demand. That is why for banks, unlike other
business concerns, liquidity management is as important as
profitability management.
This is reflected in the management and control of reserves of
commercial banks. They are expected to hold voluntarily a part
of their deposits in the form of ready cash, which is known as
cash reserves; and the ratio of cash reserves to deposits is
known as the (cash) reserve ratio. As banks are likely to be
tempted not to hold adequate amounts of reserves if they are
left to guide themselves on this point, and since the temptation
may have extremely destabilizing effect on the economy in
general, the Central Bank in every country is empowered to
prescribe the reserve ratio that all banks must maintain. The
Central Bank also undertakes, as the lender of last resort, to
supply reserves to banks in times of genuine difficulties. It
should be clear that the function of the legal reserve
requirements is two-fold: to make deposits safe and liquid, and
to enable the Central Bank to control the amount of checking
deposits or bank money which the banks can create. Since the
banks are required to maintain a fraction of their deposit
liabilities as reserves, the modem banking system is also known
as the fractional reserve banking.
Another distinguishing feature of banks is that while they can
create as well as transfer money (funds), other financial
institutions can only transfer funds. In other words, unlike
other financial institutions, banks are not merely financial
intermediaries. This aspect of bank operations has been
variously expressed. Banks are said to create deposits or credit or
money, or it can be said that every loan given by banks creates a
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deposit. This has given rise to the important concept of deposit
multiplier or credit multiplier or money multiplier. The import
of this is that banks add to the money supply in the economy,
and since money supply is an important determinant of prices,
nominal national income, and other macro-economic variables,
banks become responsible in a major way for changes in
economic activity. Further, as indicated in chapter one, since
banks can create credit, they can encourage investment for some
time without prior increase in saving.
Let us briefly discuss the basis and process of creation of
money by banks. In modem economies, almost all exchanges
are affected by money. Money is said to be a medium of
exchange, a store of value, a unit of account. There is much
controversy as to what, in practice in a given year, is the measure
of supply of money in any economy. We do not need to go
into that controversy here. Suffice it to say that every one agrees
that currency and demand deposits with banks are definitely to
be included in any measure of money supply. Thus, apart from
the currency issued by the government and the Central Bank,
the demand or current or checkable deposits with banks are
accepted by the public as money. Therefore, since the loan
operations of banks lead to the creation of checkable deposits,
they add to the supply of money in the economy. To
recapitulate, the money-creating power of banks stems from the
fact that modem banking is a fractional reserve banking, and
that certain liabilities of banks are accepted (used) by the public
as money.
The process of money creation works as follows. Assume that
the legally required reserve ratio is 10 per cent and that banks are
maintaining just that ratio. Assume further that a bank in the
economy receives a brand new input of Rs. 1,000 of reserves
either as a deposit or as proceeds of a sale of government bond
to the Central Bank or in some other form. There is thus a
creation of Rs. 1,000 of bank money, but there is yet no
multiple expansion of money. If banks were required to keep
100 per cent cash reserve balances, no bank would be in a
position to create extra money out of a new deposit of Rs.l,000
with it.
But since a bank is required to hold only 10 per cent of its
deposits as cash reserves, it now has Rs. 900 as excess reserves,
which it can utilise to invest or to give a loan. Assume that the
bank gives a loan of Rs. 900, and the borrower who takes the
loan in cash or cheque deposits it either with the same bank or
with some other bank. Either way, there has been a creation of
money and the total amount of bank money created at this
stage is Rs. 1,000 + Rs. 900 = Rs. 1,900. This process of
creation can continue till no bank anywhere in the system has
reserves in excess of the required 10 per cent reserve, and the
total money supply created in the economy is Rs. 10,000. The
ratio of new deposits to the original increase in reserves is called
the money multiplier or credit multiplier or deposit multiplier.
This multiplier will be equal to the reciprocal of the required
reserve ratio.
The process of creation of bank money does not work in
practice to the full capacity or to the full potential as has been
described above. Banks may have a reserve ratio, which is higher
than the required reserve ratio.
There may also be leakages in the form of cash holding when
the banks make loans. The process moves rather slowly and
with jerks, and not as promptly and smoothly as implied.
Subject to such qualifications, there is no doubt that modem
banks can create money in the process of their working.
Functions of the Commercial Banks and the Services
Rendered by Them
The two essential functions of commercial banks may best be
summarized as the borrowing and lending of money. They
borrow money by taking all kinds of deposits. Deposits may be
received on current account whereby the banker incurs the
obligation of paying legal tender on demand, or on fixed
deposit account whereby the banker incurs the obligation of
paying legal tender after the expiry of a fixed period, or on
deposit account hereby the banker undertakes to pay the
customer an agreed rate of interest on it in return for the right
to demand from him an agreed period of notice for
withdrawals. Thus a commercial banker whether it is through
current account or fixed deposit account, mobilizes the savings
of the society. Then he provides this money to those who are in
need of it by granting overdrafts or fixed loans or by
discounting bills of exchange or promissory notes. Thus the
primary function or a com-mercial banker is that of a broker
and a dealer in money. By discharging this function efficiently, a
commercial banker renders very valuable service to the
community by increasing the productive capacity of the country
and thereby accelerating the pace of economic development. He
gathers the small savings of the people, thus reducing to the
lowest limits idle money. Then he combines these
smallholdings in amounts large enough to be profitably
employed in those enterprises where they are most called for
and most needed. Here, he makes capital effective and gives
industry the benefits of capital, both of which rise would have
remained idle. Take for instance, the practice of discounting
bills. By converting future claims into present money, the
commercial banker bridges the time element between the sale
and the actual payment of money. This will enable the seller to
catty on his business without any hindrance and the buyer will
get enough time to realise the money.
Thus we have seen that a banker receives deposits, which he has
to repay according to his promise, and makes them affordable
to those people who are really in need of them. He is actually
distributing his deposits between the borrowers and his own
vaults. Herein lies the most delicate of the functions of
commercial bankers.
Besides these two main functions a commercial banker
performs a variety of other functions, which may be grouped
under two main heads viz., the agency services and the general
utility services.
Agency Services
A commercial bank provides a range of investment services.
Customers can arrange for dividends to be sent to their bank
and paid directly into their bank accounts, or for the bank to
detach coupons from bearer bonds and present them for
payment and to act upon announce-ments in the Press of
drawn bonds, coupons payable, etc. Orders for the purchase or
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sale of stock exchange securities are executed through the banks
brokers who will also give their opinions on securities or lists
of securities. Similarly, banks will make applications on behalf
of their customers for allotments arising from new capital
issues, pay calls as they fall due (that is, subscriptions to capital
issues made over a period), and ultimately obtain the share
certificate or other documents of title. On certain agreed terms
the banks will allow their names to appear on ap-proved
prospectuses or other documents as bankers for the issue of
new capital; they will receive applications and catty out other
instructions.
A commercial bank undertakes the payment of subscriptions
premia, rents and collection of cheques, bills, promissory notes
etc., on behalf of its customers. It also acts as a correspondent
or representative of its customers, other banks and financial
corporations.
Most of the commercial banks have an executor and trustee
depart-ment; some may have affiliated companies to deal with
this branch of their business. They aim to provide, therefore, a
complete range of trustee, executor or advisory services for a
small charge. The business of banks acting as trustees,
executors, administrators, etc., has continuously expanded with
considerable usefulness to their customers. By appointing a
bank as an executor or trustee of his Will the customer secures
the advantage of continuity, and avoids having to make
changes; impartiality in dealing with beneficiaries and in the
exercise of discretions; and the legal and specialised knowledge
pertaining to executor and trustee services. When a person dies
without making a Will the next-of-kin can employ the bank to
act as administrator and to deal with the estate in accordance
with the rules relating to intestacies. Alternatively, if a testa-tor
makes a Will but fails to appoint an executor, or if an executor
is unable or unwilling to act, the bank can usually undertake the
adminis-tration with the consent of the persons who are
immediately concerned. Banks will act solely or jointly with
others in these matters, as also in the case of trustee for stocks,
shares, funds, properties or other investments. Under a
declaration of trust, a bank undertakes the supervision of
invest-ments and distribution of income; a customers
investments can be trans-ferred into the banks name or control,
thus enabling it to act immediate-ly upon a notice of rights
issue, allotment letters, etc. Alternatively, where it is not desired
to appoint the bank as nominee, these services may still be
carried out by appointing the bank as attorney. Where business
is included in an estate or trust, a bank will provide for its
management for a limited period, pending its sale to the best
advantage as a going concern or transfer to a beneficiary.
Private companies wishing to set up pension funds may
appoint a bank as custodian trustee and investment adviser,
while retaining the administration of the scheme in the hands
of the management of the fund.
Most banks will undertake on behalf of their customers the
prepara-tion of income tax returns and claims for the recovery
of overpaid tax. They also assist the customers in checking of
assessments. In addition, to the usual claims involving personal
allowances and reliefs, claims are prepared on behalf of
residents abroad, minors, charities, etc.
General Utility Services
These services are those in which the bankers position is not
that of an agent for his customer; They include the issue of
credit instruments like letters of credit and travellers cheques,
the acceptance of bills of exchange, the safe custody of
valuables and documents, the transaction of foreign exchange
business, acting as a referee as to the respectability and financial
standing of customers and providing specialised advisory
service to customers.
By selling drafts or orders and by issuing letters of credit,
circular notes, travellers cheques, etc., a commercial banker is
discharging a very important function. A bankers draft is an
order, addressed by one office of a bank to any other of its
branches or by anyone bank to another, to pay a specified sum
to the person concerned. A letter of credit is a document issued
by a banker, authorizing some other banker to whom it is
addressed, to honour the cheques of a person named in the
document, to the extent of a stated amount in the letter and to
charge the same to the account of the grantor of the letter of
credit. A letter of credit includes a promise by the issuing banker
to accept all bills to the limits of credit. When the promise to
accept is conditional on the receipt of the documents of title to
goods, it is called a documentary letter of credit. Where the
promise is unconditional it is called a clean letter of credit.
Letters of credit may again be classified as revocable and
irrevocable. A revocable letter of credit is one, which can be
cancelled at any time by the issuing banker. But the banker will
still be liable for bills negotiated before cancellation. An
irrevocable letter of credit is, one, which cannot be cancelled
before the expiry of the period of its currency. Circular letter of
Credit is generally intended for travellers who may require
money in different countries. They may be divided into
travellers letters of credit and guarantee letters pf credit. A
travellers letter of credit carries the instruction of the issuing
bank to its foreign agents to honour the beneficiarys drafts,
cheques, etc., to a stated amount, which it under-takes to meet
on presentation. While issuing a guarantee letters of credit, the
banker secures a guarantee for reimbursement at an agreed rate
of interest or he may insist on sufficient security for the grant
of the credit. There is yet another type which is known as
Revolving Credit. Here the letter is so worded that the amount
of credit available automatically reverts to the original amount
after the bills negotiated under them are duly honoured.
Circular Notes are cheques on the issuing banker for certain
round sums in his own currency. On the reverse side of the
circular note is a letter addressed to the agents specifying the
name of the holder and referring to a letter indication in his
hands, containing a specimen signature of the holder. The note
will not be honoured unless the letter of indication is
presented. Travellers cheques are documents similar to circular
notes with the exception that they are not accompanied by any
letter of indication. Circular cheques are issued by banks in
certain Coun-tries to their agents abroad. These agents sell them
to intending visitors to the country of the issuing bank.
Another important service rendered by a modern commercial
bank is that of keeping in safe custody valuables such as
negotiable securities, jewellery, documents of title, wills, deed-
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boxes, etc. Some branches are also equipped with specially
constructed strong rooms, each containing a large number of
private steel safes of various sizes. These may be used by non-
customers for a small fee as well as by regular customers. Each
licensee is provided with the key of an individual safe and thus
not only obtains protection for his valuables, but also retains
full personal control over them, The safes are accessible at any
time during banking hours and often longer.
For shopkeepers and other customers who handle large sums
of mon-ey after banking hours, night safes are available at
many banks. Night safes take the form of a small metal door in
the outside wall of the bank, accessible from the street, behind
which there is a chute connecting with the banks strong room.
Customers who require this service are provided with a leather
wallet, which they lock before placing in the chute. The wallet is
opened by the customer when he calls at the bank the next day
to credit the contents into his account.
Another function of great value, both to bankers and to
businessmen, is that of a referee as to the respectability and
financial status of the customer.
Among the services introduced by modern commercial banks
during the quarter of a century or so, the bank giro and credit
cards deceive special mention. The bank giro is a system by
which a bank customer with many payments to make, instead
of drawing a cheque for each item, may simply instruct his bank
to transfer to the bank accounts of his creditors the sum due
from him, and he writes one cheque debiting his account with
the total amount. Credit advices containing the name of each
creditor with the name of his bank and branch will be cleared
through the credit clearing of the clearing house, which
operates in a similar way as for the clearing of cheques.
Even non-customers of a bank for a small charge may make use
of this facility. A direct debiting service is also operated by some
banks. This service is designed to assist organisations, which
receive large num-ber of payments on a regular basis. A creditor
is thereby enabled with the prior approval of the debtor, to
claim any money due to him direct from the debtors bank
account. To some organisations, for example, insur-ance
companies, which receive, say, six equal sums on six dates in a
year, the scheme is only an extension of the standing order
facility; but for the public utilities and traders which send out
invoices for valuable amounts at differing times, the scheme is
an entirely new one.
Credit cards are introduced for the use of credit-worthy
customers. Users are issued with a card on production of which
their signature is accepted on bills in shops and establishments
participating in the scheme. The banks thereby guarantee to
meet the bill and recover from the cardholder through a single
account presented periodically. In some cases users are required
to pay a regular subscription for the use of the service as well.
An extension of the scheme allows the repayment of large
sums (subject to a maximum) over a period at interest.
Some banks are opening budget accounts for credit worthy
custom-ers. The bank guarantees to pay, for a specific charge,
certain types of annual bills (for example, fuel bills, rates etc.)
promptly as they become due, whilst repayments are spread
over a 12-monthly period from the customers current account.
All these money transmission services have particular regard to
the developments in computerised book-keeping, which the
banks in some countries have already introduced. Some banks
are reported to be experi-menting with the use of electronic
machines, which will scan cheques and dispense notes or coins,
thus saving time at the counter.
Overseas Trading Services
Recognition of overseas trade has led modem commercial
banks to set up branches specializing in the finance of foreign
trade and some banks in some countries have taken interest in
export houses and factor-ing organisations. Assisted by banks
affiliated to them in overseas territo-ries, they are able to provide
a comprehensive network of services for foreign banking
business, and many transactions can be carried through from
start to finish by a home bank or its subsidiary. In places where
banks are not directly represented by such affiliated
undertakings, they have working arrangements with
correspondents so that the banks are in a position to undertake
foreign banking business in any part of the world.
The banks provide more than just a means for the settlement
of debts between traders both at home and abroad for the
goods they buy and sell; they are also providers of credit and
enable the company to release the capital which would otherwise
be tied up in the goods exported. The following is an outline
of some of the services provided by banks for overseas traders.
For centuries past the bill of exchange has been one of the chief
means of settlement in trade. Its function is to enable a seller or
exporter of goods to obtain cash as soon as possible after the
dispatch of goods, and yet enable the buyer or importer to
defer payment until the goods reach him, or later.
There are many ways in which trade may be financed with bills.
Two common ways are:
1. The exporter will draw a bill on the importer, or, by
arrangement between the parties, on the importers bank, for
the amount of the export-ers invoice for the goods, and to
the bill attach the shipping documents which will convey title
to the goods (usually an invoice, marine insur-ance policy,
and the ship owners receipt for the goods for the carriage,
called a bill of lading). The exporter will sell (negotiate) the
bill with the documents to local bankers, who with the
documents and thus, in effect, the goods in their possession,
will be willing to pay the exporter practi-cally the full amount
of his invoice and bill; they will immediately forward the bill
and documents to their banking correspondents or agents in
the importers country, to be presented to the importer, or
the import-ers bank as the case may be, for payment if the
bill is payable on demand, or for acceptance if the bill is a
term bill.
2. The importers bank, at his request, will arrange for its
banking correspondents or agents in the exporters country
to accept a term bill drawn on them by the exporter, and to
be accompanied by specified shipping documents mentioned
in the first example. (Such an arrange-ment is an example of
opening credit, which is mentioned below). When the bill is
accepted, it will be returned to the exporter, who can either
keep it until the period of the bill expires and then claim
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payment from the accepting bank, or, as is more likely in
practice, sell the bill to his own or other The accepting bank,
upon accepting the bill will detach the shipping docu-ments
and send them to the importers bank.
If a bill is payable on demand, the importer, or his bank on his
behalf if the bill is drawn on them, has to pay the whole sum
when the bill is presented.
If the bill is drawn payable at a later date, for example, three
months after presentation, it is, upon presentation, accepted by
the importer if it is drawn on him, or by his bankers on his
behalf if it is drawn on them by special arrangements. But the
importer is not called upon to pay until the three months are
up.
Usually the arrangement between the buyer and seller of the
goods will be that the shipping documents which accompany
the bill are to be detached upon payment or acceptance of the
bill, by whoever pays or accepts it namely, the importer or a
bank on his behalf. The documents thus become available to
the buyer, so that he can take delivery of the goods when the
ship arrives, re-sell them in the ordinary way, and from the
proceeds recoup himself or his bank, or make funds available to
meet the bill when it matures.
An overseas buyer may arrange through his bank in the home
coun-try to open a documentary credit in favour of the seller.
This is an undertaking that the bank will honour drafts drawn
in accordance with the terms of credit, if accompanied by
stipulated shipping documents, insurance policies, etc. and
presented not later than the date of expiry of the credit. The
terms usually cover the nature, price and quantity of the goods,
the methods of shipment, the documents to be attached and
the date by which shipment must be effected. The credit or may
undertake payment of a sight draft or acceptance of a term draft
and it may be expressed either in home currency or in foreign
currency, this depending on the condition of sale. It may be
either revocable or irrevocable. The former may be cancelled at
any time, but the latter cannot be cancelled without the consent
of both parties, and therefore provides much greater protection
to the exporter.
If, say, a foreign importer has no account with an Indian bank,
he will open the credit with his local bank. The exporter may,
however, prefer to receive a corresponding advice that the credit
is opened from an Indian bank. Consequently, it is usual for the
foreign bank to instruct its Indian banking correspondent to
advise the credit to the exporter. As an additional safeguard, an
Indian exporter may require his bank not only to advise but
also to undertake responsibility by adding its confirmation.
This is known as a confirmed credit. Having received the
advice, on shipment of the goods, the exporter must lodge the
documents within the time allowed by the credit. If the
documents are in order as stipulated in the credit, the exporter
will then receive immediate payment if it pro-vides for sight
payment; if it calls for a bill drawn payable after sight, the bank
will accept the bill, which will then be available for discount. If
for any reason the exporter in unable to present the document
he must request the importer to instruct bank to extend or
amend the credit.
In case where it is not possible to arrange a documentary credit
and the arrangement is for payment to be made only when the
goods have been sold, a bank can usually undertake the dispatch
of the shipping documents and arrange the goods to be
warehoused and insured in the name of a correspondent bank,
pending delivery of the goods in part or in whole to the
exporters agent against payment. The correspondent bank will
then remit proceeds of sales as and when they are made by the
agent. Exporters who are dealing With first-class agents may be
prepared to ship their goods on open account. In such cases,
the exporter usually sends the documents directly by air mail to
the consignee, who acts as his agent for tile sale of the goods.
Remittances, in order to avoid the inconveniences of collection,
may be by a cheque on an Indian bank or by a telegraphic
transfer.
Information and other Services
As part of their comprehensive banking services, many banks
act as a major source of information on overseas trade in all
aspects. Some banks produce regular bulletin on trade and
economic conditions at home and abroad, and special reports
on commodities and markets. In some cases they invite
enquiries for those wishing to extend their foreign trade, and are
able through their correspondents to furnish the names of
reputa-ble and interested dealers of goods and commodities
and to advise on the appointment of suitable agents. For
businessmen travelling abroad letters of introduction,
indicating the purpose of journey taken, can be issued
addressed to banking correspondents in the various centres it is
proposed to visit. In this way it is often possible to establish
new avenues of business. On request, banks obtain for
customers, for business purposes, confidential opinions on the
financial standing of companies, firms or individuals at home
or overseas.
Commercial bank furnish advice and information outside the
scope merely of trade. If it is desired to set up a subsidiary or
branch overseas (or for an overseas company to set up in the
home country) they provide detailed information on local legal
requirements on company formation, tax requirements,
exchange control and insurance, and they help to estab-lish
contact with local banking organisations.
To sum up, the service rendered by a modem commercial bank
is of inestimable value. It mobilizes the scattered savings of the
community and redistributes them into more useful channels.
It enables large pay-ments to be made over long distances with
minimum expenses. It consti-tutes the very life blood of an
advanced economic society. In the words of Walter Leaf: The
banker is the universal arbiter of the worlds econo-my,
General Structure and Methods of Commercial
Banking
Certain Sound Commercial Banking Principles
Just as in the case of any other commercial enterprise, the
commer-cial banks also strive to earn a profit. But is profitability
everything, which a banker should pay attention to? Can a
commercial banker employ his funds in a risky manner in
anticipation of wild fall profits? The answer is definitely in the
negative. He is a custodian of others surplus funds. Therefore
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while earning a profit he should never forget the fact that he is
doing business with others funds, which he acquires be-cause
of his credit. We have seen that these deposits are either
repayable on demand or after the expiry of a fixed period. In
either case he must be ready to meet the liabilities as and when
necessary and, as such, he has many outstanding contracts for
the future delivery of money.
In case of failure, he will suffer in his credit on which the very
foundation of his business stands. Not only will he feel the
shock of such a failure, but also it will be transmitted to the
other links of the banking organisation, thereby precipitating
nation-wide bank failures. So banker should always bear in
mind that he is guardian of a very delicate mecha-nism, which
paves the way for future economic development and. which, if
disturbed, will create monetary disequilibria with all the evil
effects incidental thereto. Obviously, a banker should take the
necessary precautions 10 keep his assets as liquid as possible.
But what is meant by liquidity?
By liquidity we mean the capacity to produce cash on demand.
No doubt the most liquid asset is cash in the vaults of a bank.
It is necessary for a banker to keep a certain percentage of the
deposits in the form of liquid cash as reserve, either in his own
vault or with his bank, generally the central bank. But such
liquid cash does not earn anything and it is purely idle money,
intended to provide the necessary liquidity by meeting the
immediate withdrawals of deposits. As a rule, successful
banking is dependent on the capacity of these reserves to meet
the immediate requirements. When liquidity is provided by
liquid cash, a banker should invest his excess money in. some
assets, which are liquid in nature and at the same time, which
earn an income.
Briefly, we may explain the liquid assets as those, which can be
turned into, cash quickly and without loss, to meet the
customers claims. But if an asset is to be turned into cash
quickly, it must be shift able in nature, i.e. the liquidity of an
asset depends on the question of shifting it to the central bank
or to others willing to supply cash. For instance if a blinker
holds a first class bill of exchange, among his other assets,
which satisfies the eligibility rules of the central bank, it can be
rediscounted with the central bank, when the banker is short of
funds. A government security satisfies the quality of an idle
asset, viz. shift ability because it is in great demand in the stock
exchange. But liquidity implies not only shift ability but also
shift ability without loss. To take an example, the ordinary
shares of an industrial concern may be shift able but only at a
discount. Here shiftability is possible only at a loss and hence
the asset cannot be considered as a sound banking asset.
The conclusion that we arrive at from the above discussion is
that commercial bankers, while employing their funds, should
pay regard both for profitability and liquidity. And liquidity in
its turn is dependent on shiftability without loss. It is a point
to be remembered always that liquidity should not be sacrificed
at the alter of profitability. At the same time no less important
is it to remember that to maintain excessive liquidity is to
sacrifice earnings, without which banking operations cannot be
carried on successfully. A good banker would, therefore, follow
a via media between liquidity and profitability while selecting his
assets.
Employment of Funds by Commercial Bankers
Generally, the following are the important items seen on the
asset side of the Balance Sheet of a bank.
Cash in hand.
Money at call and short notice.
Bills discounted.
Investments.
Advances to customers.
These items are given in the order of liquidity.
The first item appearing on the asset side of banks balance
sheet is cash in hand, including cash reserve at the central bank
and demand deposits with other banks. This is the most liquid
of all assets. From the point of view of profitability, a banker is
tempted to minimise his cash holdings; while from the point
of view of liquidity, he is tempted to maximise his cash
holdings. To maintain more resolves than what is necessary is
to impair the profits. The English bankers usually maintain a
cash ratio of 8 per cent while, in India, a higher cash ratio is
desirable owing to the undeveloped and unpredictable nature
of the money market.
A banker is generally guided by experience in deciding what
propor-tion of his deposits in cash will enable him readily to
meet all demands. In addition to the minimum requirements
indicated by experience, a good banker must necessarily allow
for unpredictable needs. In this con-nection certain important
considerations influencing the cash resolves of a banker may be
pointed out.
In the first place, if the customers are highly banking minded,
the need for liquid cash will be small because in that case
depositors will seldom demand the payment of legal tender
currency and will content themselves by the transfer of rights
which the bank can do by mere book entries. Secondly the
habits of the customers, and the business conditions of the
locality have an important bearing of the cash reserves. Certain
businesses carried on by the depositors may make heavy
occasional de-mands which the banker will have to meet with
adequate provision of liquid cash. Thirdly, it is also dependent
on the resolves kept by other banks of the locality. If certain
banks are keeping higher amounts of resolves, other banks will
be compelled to increase their cash ratio in their bid for
popularity. Further the nature of accounts and the size of
average deposits also influence the resolves. For instance, if the
accounts are of a fluctuating nature, a higher cash resolve may be
required. So also the resolves of a bank having only a few large
deposits will be generally large because of the chance of heavy
demands. On the other hand, if the bank has a large number
of small sized deposits, the danger of large withdrawals by any
individual customer will be less and hence it need not keep a
large amount of liquid cash. Again, the presence of a bankers
clearing house greatly reduces the need of liquid cash to be kept
by a bank because he has only to provide for the difference
between the cheques drawn by him on other banks. Lastly, the
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banker has to take into account probable receipts of cash by the
bank and probable demands upon it, in the near future.
Thus the ratio of liquid cash to deposits, which a banker
should maintain is dependent upon a number of
considerations. It varies from place to place and from banker to
banker. Therefore, no hard and fast rule can be laid down as to
the exact cash ratio, which a banker should maintain. He has to
give due consideration to the various factors dis-cussed above
and has to decide himself the amount of liquid cash which he
should maintain. In this connection, it may be pointed out that
commercial bankers, in most countries, are required to maintain
a minimum reserve of liquid cash, through legislation.
Questions to Discuss:
1. What is the theoretical basis of banking operations?
2. Discuss the functions of the commercial banks and the
services rendered by them.
3. Discuss the general structure and methods of commercial
banking.
4. Discuss the employment of funds by commercial bankers.
Notes:
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LESSON 16:
LENDING FUNCTION
Learning objectives
After reading this lesson, you will understand
Need for lending
Need for credit
Types of credit
Nature of Credit
Security Offered for Loans
Purpose of Loan
Need for Lending
Having raised the funds the banks will have to ensure that the
same will be deployed into proper avenues so that they sustain
profitably. The two major applications of banking funds are
credit accommodation and investments in securities. Of these,
the former has evolved as the prime function of the banks both
due to the regulatory prescriptions as well as for profitable
sustenance.
According to Section 6 of the Banking Regulation Act, 1949, the
business of banking is defined as follows:
Banking means accepting for the purpose of lending or
investment of deposits of money from the public, repayable
on demand or otherwise, and withdrawable by cheque, draft,
order or otherwise.
Thus, as per the statute, all banking firms will have to
necessarily perform the role of a lending organisation. While
other financial institutions and NBFCs also share the corporate
finance activity along with banks, there is, however, a marked
difference in the credit facilities offered by each type of these
intermediaries.
The other major reason of the lending function is to add value
to the bank. By lending the funds mobilized by it, a bank will
be in a position to earn spreads to sustain profitably.
Profitability through lending will be obtained if the bank is in a
position to take and manage credit risk that arises on account of
the quality of the borrower and liquidity risk that may arise by
borrowing short and lending long in order to attain greater
spreads. Further, the spreads earned in this activity will also be
exposed to risks arising both from interest rates and the
exchange rates.
Thus, while lending, the bank should essentially try to balance
its spreads and the risk levels. The significance of the lending
activity to the banking business can further be explained by the
fact that a shrinkage in the credit asset portfolio leads to greater
impact on the NII of the bank when compared to the
shrinkage in any other asset in its portfolio.
The need for lending thus arises both due to the regulatory
prescriptions as well as for profitability purpose. Having
understood the need for lending, let us also look into the need
for credit.
Need for Credit
Just as there are two reasons for the banks to extend the credit
function, there are also two reasons for the demand for credit.
Firstly, on the demand side of the economy are the consumers
of goods and services who require funds basically for acquiring
certain assets like consumer durables. And secondly, on the
supply side, the need for credit arises from the corporate in the
manufacturing, trading and services sectors. These corporate
basically require funds for long-term investment as well as for
day-to-day operations. Thus the need for credit arises from the
supply side as well as the demand side of the economy. Thus,
at any point of time, in the credit market, there will always be
some players to extend credit and a few others who will be
seeking credit. However, to ensure that the borrowing and
lending takes place in the credit market, the needs of the
borrower should be met by the lender. In order to facilitate this,
different types of credit facilities have originated in the credit
market.
Types of Credit
Most of the credit facilities that are offered in the credit market
are in the form of loans. A loan is a broad term used to explain
the different types of short/ medium and long-term credit
facilities extended in the credit market. Irrespective of their
nature, all loans are contractual agreements entered into by the
borrower of the funds with the lender of the funds. The
agreement states the terms and conditions such as loan
amount, repayment period, rate of interest, terms of
repayment, nature of security, penal provisions for breach of
contract, etc.
Depending on their need for credit, the borrower will select the
type of credit facility that suits their cash flow requirement and
that which is a low cost option. To meet the varied
requirements of the borrower, banks have also developed a
variety of credit facilities. The development of these credit
facilities essentially depends on three parameters: Purpose of
credit, Nature of credit and Security offered.
As mentioned earlier, the credit requirement arises from both
the demand and the supply side of the economy. The loans
that are extended to the supply side can be classified, as
commercial loans while the demand side loans will be
individual loans. Commercial loans are extended for two
purposes: Firstly, to acquire fixed assets and secondly, for the
purpose of maintaining/ running the business. Likewise, there
are broadly three purposes for the individual loans:
consumption, acquisition of durables and housing finance.
This classification of the credit facilities into commercial and
individual credit facilities is simple and broad but it does not
help understand the critical aspects of the lending activity. To
enable such understanding, we shall examine the loans as
described by the banks in their annual reports. Banks present
their entire advances in three different ways based on the nature
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of credit, the type of security and the purpose of the loan.
Using these parameters, there will be further classification of the
banks advances, which are examined here.
Nature of Credit
On considering the nature of the loan, the advances of banks
can be further classified into the following three types:
Installment Credit
Operating Credit
Receivable Finance
Installment Credit:
In this type of finance, once the credit amount is decided, the
bank will disburse the amount either at one go or in stages
depending on how a project gets implemented. The repayment
process, which is generally on installment basis, will commence
after the entire credit amount is disbursed. The installments can
be monthly, quarterly, half-yearly or annual payments. The
frequency of the installment depends on the cash flow stream
of the borrower. Based on this repayment schedule, the tenor
of the credit facility is decided. This forms the base for the
classification of the loans into short, medium or long-term
loans. When the tenor is less than three years, it is a short-term
loan. Such loans are generally extended to households for the
purchase of consumer durables. When the tenor ranges from 3-
5 years, it is a medium-term loan which is generally required by
the small and medium-sized firms for acquiring fixed assets.
And in cases where the repayment period exceeds 5 years then a
long-term loan facility that is extended to large corporate/
projects for the acquisition of fixed assets during project
implementation stage.
Operating Credit:
Unlike the installment credit, the operating credit is for meeting
the financial requirements of the daily operations. Since the firm
cannot know its exact requirements on any given day, the bank
provides an operating account (current account) after deciding
on the credit limit. The firm can withdraw from this account
using a cheque facility as and when it requires the funds. The
repayment mechanism for such credit facility is also different
from the installment credit. The firm will repay into the same
current account as and when it has surplus cash. Generally, this
credit is extended for a period of 1-2 years, but since the firms
are going concerns, this credit facility may actually be rolled over
every year. This makes the operating credit a permanent credit
facility. The forms of credit that can be categorised here are the
cash credit facility and the overdraft facility. The major
distinction between these two credit facilities is that the cash
credit facility is sanctioned against inventory while the overdraft
facility is generally against any other security.
Receivable Finance:
The other type of credit is receivable finance where the firm gets
credit in the form of bill finance. Sale transactions of a firm are
generally either in cash or credit form. In credit sales, as it is
observed, payment will be made at a predetermined time after
the sale has actually taken place. This results in the creation of
receivables for the selling firm. In cash sales, it is, however,
considered that the payment will be made immediately as in the
case of an over-the-counter sale. Such sale transactions are
normally seen in trading concerns and manufacturing concerns,
which may have a retail outlet, which is more an exception. This,
however, is not possible in the normal course and may happen
when there is a geographical distance existing between the seller
and the buyer. In such circumstances, there will be a time lag
before the buyer actually receives the goods, thereby leading to a
time gap between the time goods are dispatched and the
payment is received. Thus, it can be observed that even a cash
sale will result in receivables for the seller. Funding of these
receivables through internal sources by the company may not be
feasible, especially due to the volume of funds required for
extending such credit.
All receivables, created either due to cash or credit transactions,
will lock the funds of the firm. Banks offer receivable finance
facility, which imparts liquidity to these receivables. When there
is a payment lag due to the geographical consideration, the bank
acts as an intermediary, collecting funds from the buyer on
behalf of the seller. Such facility will be fee-based since the bank
does not actually extend any credit and only enables the
collection of funds. This does not result in extending credit.
When bank extends credit, it will instead of collecting funds
from the buyer and passing it over to the seller, will actually
provide credit for the sale and will collect the funds from the
buyer at a later point of time. This is the fund based receivables
financing facility offered by the bank.
When receivable finance is extended either for cash sales or credit
sales, there will be a few essential documents for bill financing
viz. bill of exchange document of title to goods (lorry/ rail way
receipt, airway bill), invoice, etc.
Bill of Exchange (B/E)
In most of the cases, when credit is sought through receivable
finance, a B/ E will be created. A B/ E is a negotiable
instrument. In terms of Section 5 of the Negotiable
Instruments Act, 1881, a B/ E is an instrument in writing
containing an unconditional order, signed by the maker (in this
case the seller), directing a certain person (in this case the buyer)
to pay a certain amount of money only to, or to the order of, a
certain person (in this case a bank) or to the bearer of the
instrument.
Lorry Receipt (LR)/Railway Receipt (RR)/Airway Bill
These documents are evidences of dispatch of goods and
holders of these documents are entitled to take delivery of the
underlying goods. These are also sometimes known as quasi-
negotiable instruments.
Invoice
The invoice that has been raised for the sale transaction indicates
the value of the underlying goods.
The requirement or non-requirement of each of the above
mentioned documents depend on the type of receivable finance
that is being offered. Further, depending on the key documents
involved in bill finance, the bills can be classified into two types
Demand Bills and Usance Bills. When there is a demand
bill, it means payment is to be made on demand. When the sale
is on a credit basis, the amount is payable on a specified due
date, it will usually involve a Usance Bill. If the specified due
date is after the bill date (every bill will be dated), the terms of
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payment is known as Days After Date and if the specified
date is after the bill is presented to the buyer, then the terms of
payment will be known as Days After Sight. Within this
broad classification, depending on the mode of financing, bills
can be further categorized as:
Clean Bills
Documentary Bills
Supply Bills
Clean Bills:
In transactions where the seller would have already delivered the
goods and the documents to the buyer, the seller can avail the
receivables finance facility using the Clean Bill. The seller can avail
this facility without any supporting documents. Since the
delivery of goods and documents has already taken place, it
implies that the transaction would have been on credit basis.
Hence, a Clean Demand B/ E can be raised in this case.
Documentary Bill:
In certain cases, the seller would have only dispatched the goods
without transferring the document of title for goods and/ or
invoice, etc. In such cases, the seller can avail the bill finance
facility through the Documentary Bill. To suit the cash and
credit sales, a Documentary B/ E can be either a Documentary
Demand Bill or a Documentary Usance Bill. When the
transaction is a cash sale, the Documentary Demand Bill is used
in which case the buyer has to pay the bank the amount and
collect the documents. In the case of a credit sale, using the
Documentary Usance Bill, the buyer collects the documents first
without payment by accepting the bill. On the due date of the
bill, the buyer has to pay to the bank the bill amount. In both
the cases the seller avails the finance from the bank.
Supply Bill:
A Supply Bill is used in a buyers market i.e. when the buyer is a
large corporation or a government body; the seller has to first
deliver the goods without raising the B/ E. After the buyer is
satisfied with the quality of the goods, then the invoice has to
be raised. The documents like B/ E and LR/ RR will not be
available in this case. In the absence of such supporting
documents, the seller can avail the receivable finance facility by
providing the evidence of the delivery of the goods.
The classification discussed above is based on the nature of
loan. The second parameter that is used for classifying the loans
is the security of the loan. Security for the loans can be personal
or impersonal. Based on the type of security, all advances made
by the banks to any type of borrower can be classified into
unsecured or secured advances.
Security Offered for Loans
Loans are generally c1assified into secured or unsecured loans.
The features of these two types of loans are discussed below:
Unsecured Advances:
When the advance given by the bank has a personal security of
any individual or the borrower with or without a guarantor, it
will be c1assified as an unsecured advance. In the absence of any
tangible security, though personal security is given by an
individual by way of an obligation for repayment, the loans are
treated as unsecured. However, all those loans that have the
guarantee of a bank/ government are categorised as Advances
covered by Bank/ Government Guarantees and hence are not
reported under unsecured loans category.
Secured Advances:
Secured advances on the other hand, have impersonal security
i.e. the security has to be a tangible asset against which the loan
is to be granted. Primary Security is an asset against which the
loan is given and Collateral Security is a security, which is given
in addition to the existing primary security. These primary and
collateral securities can be movable or immovable assets and
depending on the same the charge created on the security may
vary.
Charge on the movable properties can be created in the
following five different ways:
Pledge
Hypothecation
Assignment
Bankers Lien
Set-Off
A brief discussion on each of these methods of creating a
charge on security is followed hereunder.
Pledge:
According to Section 172 of the Indian Contract Act, 1872,
pledge is defined as: Pledge is a contract whereunder deposit
of goods is made a security for a debt and the right to property
vests in the pawnee so far as it is necessary to secure the debt.
In other words, a pledge arises when the lender or the pledgee
takes possession of the goods or bearer securities for extending
a credit facility to the borrower or the pledgor. The pledgee can
retain the possession of the goods until the pledgor repays the
entire debt amount and in case of a default, the pledgee has the
right to sell the goods in his possession and adjust its proceeds
towards the amount due.
The delivery of goods in a pledge can be either by actual delivery
or constructive delivery. In the former case, the pledgor will
handover the physical possession of the goods to the pledgee.
Such type of lending is done by the pawn broker. In the case of
constructive delivery, there is symbolic delivery of goods, i.e. for
example, the pledgee may be given possession of the key to the
store in which the pledged goods are present or there may be a
transfer of the bill of lading. Such type of lending is usually
considered by a bank.
While lending against pledge, the bank always maintains a
margin between the value of the goods and the amount of
credit allowed. For instance, if the bank is extending a credit of
Rs.l lakh against the pledge of goods, then the value of the
goods pledged should be more than Rs.l lakh. Further, in a
pledge transaction, the underlying goods are usually either the
raw material or the work-in-process or the finished goods.
These would be required by the borrower in the regular course
of business. In such a case the borrower needs to take prior
approval from the bank to withdraw any goods that are pledged
with the bank since the goods will be in the custody of the
bank. In addition to this, the borrower will also have to submit
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statements to the bank for additions or withdrawals made to
these goods that represent the pledge transactions.
Hypothecation:
Hypothecation is also a way of creating a charge against the
security of movable assets much similar to pledge. However,
pledge is a charge, which is defined by law whereas
hypothecation is not. In case of pledge, the assets are in the
custody of the lender, real or constructive, whereas in case of
hypothecation the assets are in the custody of the borrower.
Hypothecation is to be registered under Section 125 of the
Indian Companies Act, 1956 when the hypothecator is a
company, while no such provision exists in case of charges by
way of pledge. In case of Hypothecation, the goods are not
kept under the lock and key of the banker. The borrower,
however, will have to submit a statement on the goods
indicating the additions and withdrawals of the same to the
bank.
In addition to the fact that the bank does not have the
possession of the goods under Hypothecation, it is also a fact
that there is no statutory status given to a Hypothecation
transaction. In this regard, it is, however, to be noted that
Hypothecation has a close link to floating charge. While there is
no law governing the Hypothecation of goods, Section
125(4)(f) of the Companies Act, 1956 that refers to the Floating
Charge on undertaking or any property, may be related to
Hypothecation. As per this Section, floating charge, creates an
immediate charge on the property charged but however, allows
the borrower to use the property for its business just as in the
case of Hypothecation. This makes the charge in Hypothecation
transaction similar to the type of floating charge.
Assignment:
Assignment is a charge in case of an Actionable Claim which
is defined under Section 3 of the Transfer of Property Act, 1882
as follows:
Actionable claim means a claim to any debt, other than a debt
secured by mortgage of immovable property or by
Hypothecation or pledge of movable property, or to any
beneficial interest in movable property not in the possession,
either actual or constructive, of the claimant, which the civil
courts recognise as affording grounds for relief, whether such
debt or beneficial interest be existent, accruing, conditional or
contingent.
Assignment is a charge created on assets such as receivables,
debtors, etc. For example, policyholders can take a loan against
the Life Insurance policy from a bank. In such cases, the LIC
policy is assigned by the policyholder to the bank. If a bank
finances a firm against book debts, then such book debts are
assigned to the bank.
Lien:
Bankers Lien is a general lien and is defined under section 171
of the Indian Contract Act, 1872 as follows: Bankers, factors,
wharfingers, attorneys and policy-brokers, may, in the absence
of contract to the contrary, retain as a security for a general
balance of account, any goods bailed to them; but no other
persons have a right as a security for such a balance, goods
bailed to them, unless there is an express contract to that effect.
Thus, a bank has the right to retain all forms of securities or
negotiable instruments deposited by or on behalf of the
debtor in the ordinary course of its banking business and use
the proceeds of the same towards adjusting the debt obligation
of the borrower.
Set-off:
Set-off can be treated as the right of lien, the only distinction
being that lien relates to goods or any other property on which
the bank as a creditor has a right, while a set-off is a lien on any
amount of the debtor that is due from the bank. Simply put,
set-off is a legal right by which the bank as a creditor is allowed
to use its own debt obligation (i.e. amount that the bank is
allowed to set-off against the repayment of the credit facility it
had offered to the debtor). Such right exists when the amount
of the debts are certain, when the parties are the same and when
there is no contract, express or implied to the contrary.
All the above mentioned methods of offering security are
related to movable assets. However, apart from movable assets,
there can also be immovable properties that are offered as
security. The process of offering immovable, as security is
known as Mortgage.
Mortgage
According to Section 58 of the Transfer of Property Act, 1882, a
mortgage is defined as follows: Mortgage is the transfer of an
interest in specific immovable property for the purpose of
securing the existing or future debt, or the performance of an
engagement which may give rise to pecuniary liability. Thus
through a mortgage, the interest and the rights on the
mortgaged property are transferred from the mortgagor
(borrower) in favor of the mortgagee (bank). The principal and
the interest amount that has been secured for is known as
mortgage-money. There are essentially, six ways of
mortgaging:
Simple Mortgage
Mortgage by Conditional Sale
Usufructory Mortgage
English Mortgage
Equitable Mortgage
Anomalous Mortgage
Of the different types of mortgages mentioned above, simple
mortgage and equitable mortgage are the most important.
A simple mortgage takes place without delivering possession of
the mortgaged property. This type of mortgage binds the
mortgagor to pay the mortgage-money expressly or impliedly,
and in case of any failure to repay the amount, the mortgagee
has the right to sell the mortgaged property and use the
proceeds of the same towards the payment of the mortgage-
money. Such a mortgage is created through a document known
as Deed of Mortgage and is usually registered with the
Registrar of Assurances.
An equitable mortgage arises when a mortgagor delivers to the
creditor the documents of title to immovable property, in order
to create a security on the same at certain places, which are
notified, in the official gazette. It will be necessary to deliver the
documents at these specified places by the borrower to the
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creditor irrespective of location of the property and residential
status of the borrower or lender. Equitable mortgage is also
known as mortgage by deposit of title-deeds.
Having discussed the classification of loans based on the
security offered, we now proceed towards the last type of
classification of advances as given in a banks balance sheet
which is based on the purpose of the loan.
Purpose of Loan
There are basically three purposes for which the banks extend
their loans and based on these purposes the sectorial
classification of banks advances are made. Ever since
nationalisation, the banks have been providing financial
assistance to the neglected sectors of the economy. Accordingly,
the RBI has laid down specific guidelines to direct funding for
these sectors. Apart from this, advances are also made to the
public sector units. Based on such advances, the sectorial
classification of loans has accordingly been made as under:
Priority Sector
Public Sector
Banking Sector
Others
Priority Sector Advances
In order to channelise the flow of credit to certain key sectors of
the economy, the RBI, in the credit policy for 1967-68, has
identified the priority sectors. Initially, the priority sector
comprised of agriculture, exports and small-scale industries
(SSI). Following this, banks were given a target of one-third of
the outstanding credit to the priority sector by the end of
March, 1979. Subsequently, in 1985, the floor for the priority
sector advances was set at 40 percent and within this target, a
sub-target of 10 percent is set for the weaker sections. The RBIs
definitions for the priority sector and the weaker sections within
this priority sectors are given below:
Priority Sector - Agriculture., Small-Scale Industries SSI),
Transport, Retail trade, Small Business, Professional and
Self-Employed persons, Education, Housing and
Consumption.
Within this classification, the RBI has also defined the weaker
sections as follows:
Small and marginal farmers with land holding of 5 acres or
less, landless laborers, tenant farmers and share croppers;
Artisans or small industrial activity viz. manufacturing,
processing and servicing in villages and small towns with a
population not exceeding 50000 involving utilisation of
locally available natural resources and/ or human skills.
Individual credit requirement should not exceed Rs.25000 to
be considered as part of the weaker sections;
Scheduled Castes and Scheduled Tribes;
Beneficiaries of Differential Interest Rate (DRI) scheme;
Self-Employment Program for Urban Poor (SEPUP);
Beneficiaries of Integrated Rural Development Program
(IRDP).
For the above mentioned sectors, the RBI has issued guidelines
for the amount of financing that have to be done for various
sectors. Apart from such guidelines, RBI has identified the
sectors where the financing facility offered is much less than
what is required and set targets for the banks to meet while
financing these sectors. While there were many neglected sectors,
it was primarily the agricultural and the SSI sector that were of
major concern. India being an agrarian economy and with most
of its population living in the rural and semi-urban areas, the
development of the agricultural and the SSI sectors was crucial
for the economic development of the nation. Considering this,
the RBI has set targets as follows:
Agricultural Sector: The advances given to the agricultural
sector are classified into direct and indirect advances and the
combined target for these two types of advances was set at
18 percent.
SSI Sector: While there is no target set for the advances to
be made for the SSI sector as a whole, there is a sub-target of
40 percent set for the advances made to the cottage
industries, khadi and village industries, artisans, tiny
industries (plant and machinery outlay up to Rs.25 lakh) or
other SSI units availing credit up to Rs25 lakh.
The other guidelines issued by the RBI that govern the priority
sector lending to various sectors are given below.
Agriculture
As mentioned above, the advances made to the agriculture
sector are of two types -direct and indirect. Direct loans include
both short-term and medium-term loans. For the short-term,
farmers are given credit against Pledge/ Hypothecation of
agricultural produce (including warehouse receipts) for a period
not exceeding 6 months. The credit amount involved, for such
crop loans is Rs.1 lakh. The medium-term loans are extended
for the purpose of the purchase of agricultural implements and
machinery, development of irrigation potential, reclamation and
land development schemes, construction of farm buildings and
structures, etc., construction and running of storage facilities,
production of irrigation charges, etc.
Other types of direct advances made to the farmers include the
following:
Short-term advances made to cultivators of traditional
plantations (tea, coffee, rubber and spices) irrespective of the
size of holdings would be treated as direct agricultural
advances under priority sector.
Advances granted for development of sericulture and for
grainages under sericulture.
Advances up to Rs.5 lakhs granted for financing distribution
of input such as cattle feed, poultry feed, etc.
Apart from the above mentioned direct loans, the RBI has also
specified certain indirect loans that are to be categorized as
priority sector. The indirect advances in agriculture have,
however, been restricted to 4.5 percent of the overall target of
18 percent set for the agricultural sector. Within this upper limit
of 4.5 percent, the banks can give indirect agri-loans to
organisations/ boards/ individuals providing fertilizers,
electricity, spraying operations, etc. In addition to this, indirect
finance includes loans given to co-operative marketing societies,
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co-operative banks lending for such societies, agri-industries
corporations, agricultural finance corporations, etc.
Small-Scale Industries
All firms, which have a total outlay for the plant and machinery
not exceeding Rs.3 crore, and Rs.25 lakh fall into the category of
SSI and Tiny sector respectively. Apart from the target
mentioned above for the related activities of the SSI sector, the
indirect credit in this sector will be given to agencies assisting in
the supply of inputs and marketing of outputs of artisans,
village and cottage industries and to government sponsored
corporations/ organisations providing funds to the weaker
sections.
Retail Trade
Advances granted to (i) private retail traders dealing in essential
commodities (fair price shops) and consumer cooperative stores
and (ii) other private retail traders with credit limits not
exceeding Rs.5 lakh.
Services (small Business
The advances made to the firms providing services (other than
professional services) will be covered here. The original cost
price of the equipment used and the working capital limits of
such firms should not exceed more than Rs.10 lakh and Rs.5
lakh respectively. Further, the aggregate of these shall not exceed
more than Rs.1 lakh.
Transport
Advances given to the road transport operators coming under
this category will be given to the extent of financing ten vehicles.
Bank credit to NBFCs for the purpose of on-lending to small
road and water transport operators (fleet of vehicles. not more
than 10) is also considered as priority sector. This implies that if
a company XYZ Travels Ltd. has a fleet of nine vehicles and
takes credit for its 10th vehicle from a bank, then the credit
extended by the bank for financing this vehicle will be
considered as a priority sector advance for the bank. Having
purchased this 10th vehicle, XYZ Travels Ltd. has taken credit
from the bank for the purchase of yet another vehicle. The
credit advancement made by the bank for this vehicle will,
however, not be a priority sector advance since XYZ Travels Ltd.
already has a fleet of 10 vehicles and the finance is taken for the
11th vehicle.
Professional and Self-Employed Individuals
In the individual category, the total advances given to
professionals and self-employed, whose borrowing limits do
not exceed Rs. 5 lakh of which not more than Rs. l lakh for
working capital purpose are covered. However, in case of
professionally qualified medical practitioners (setting up practice
in rural and semi-urban areas), the borrowing limit shall not
exceed Rs.l0 lakh, of which, the working capital should not be
more than Rs.2 lakh. Within the above ceiling, the medical
practitioner will also be given an advance for the purchase of
one motor vehicle.
Housing
Direct housing loans only up to Rs.5 lakh in rural/ semi-urban
areas and up to Rs.l0 lakh in urban and Metropolitan areas, are
treated as priority sector advances. All investments in bonds
issued, by NHB/ Housing and Urban Development Authority
exclusively for financing of housing irrespective of the loan size
per dwelling unit will be reckoned for inclusion under private
sector advances. Loans up to Rs.50, 000 for repairing of houses.
RRBs
The net funds provided by the bank to the RRBs will also be
considered as a priority sector advance.
Investments
Banks investments in special bonds issued by certain specified
institutions such as SFCs/ SIDCs, REC, NABARD and NHB
would be reckoned as a part of priority sector advances under
the appropriate sub-head subject to certain conditions.
Finance extended to state electricity boards for systems
improvement scheme in the rural areas under special project
agriculture (SI-SPA) was classified as indirect finance to
agriculture under priority sector.
During February 1999, RBI had introduced the advances made
to food and agro-processing industries and investments in
venture capital into the priority sector lending.
Loans to the software industries (having credit limit not
exceeding Rs.1 crore from the banking system).
The above mentioned guidelines give the priority sector
advances that arc to be made by the scheduled commercial banks
(SCBs) only. The RBI has issued separate guidelines for the
priority sector advances of foreign banks. From July 1993,
foreign banks are required to make 32 percent of their net bank
credit to the priority sectors. The definition of priority sector to
foreign banks also includes the export credit. Within the overall
target set for the priority sector, a sub-target of 10 percent is set
for SSI and export credit. The shortfall, if any, in meeting the 10
percent target will have to be made by depositing the same with
the Small Industries Development Bank of India (SIDBI).
Public Sector/Banking Sector/Other Sectors
The other sectorial classifications are based on the constitution
of the borrowers and these include the loans extended to the
public sector, the banking sector and others. The residual of the
advances, after lending to priority, public and banking sectors
will appear in the category of others. Thus, advances that are
extended to individuals, private corporates and all other
institutions will be classified here.
By classifying the total advances in the above mentioned ways
i.e. based on the nature, security and purpose, the bank will be
in a better position to analyze its loan profile from various
angles. This kind of classification helps the reader of a balance
sheet to understand the bank better.
Having decided on the type of credit it will be offering, the bank
will then have to take crucial decisions regarding the loan
appraisal and disbursal, loan pricing and other loan
components. Once the bank decides on the type of credit
advances it will be making, the loan appraisal and disbursal
follows. We shall now try to get an insight into these aspects of
lending.
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Loan Appraisal and Disbursal
All the types of advances that are made by the bank, which are
discussed above, will be debt finances. And prior to the
disbursal of any amount as advances, the bank should be well
aware of the cash requirements of the borrower and the type of
advance it should make in order to suit such requirement of the
borrower. This type of appraisal differs greatly from the initial
appraisal that the bank conducts while deciding on the approval
of the loan. The initial appraisal basically involves an analysis of
the market, technological, financial, managerial analysis and
suggests the bank the feasibility of making any advances with
such analysis. Once the bank decides to sanction the loan
proposal, the other critical issues that need to be catered to are
the decisions relating to the way of financing, i.e. which mode
of funding will suit the clients cash requirements and the
manner in which the amount has to be disbursed.
Firms basically need bank funds as project finance or as working
capital. Project finance is generally used for financing, long-term
assets of the firm. Consider the following illustration:
Project details of LLG Steels Ltd.: (Rs. lakh)
Land 125.00
Site Development 15.00
Building 75.00
Plant and Machinery 25.00
Pre-operative Expenses 5.00

245.00
The above figures show the total financial requirement for the
project, which the firm submits, to the bank. In any type of
lending activity, banks do not fund the entire amount required
by the borrower. They require the borrower to bring in some
amount as the margin money. In case of the financing, of the
long-term assets, this margin will be normally 25 percent of the
total amount for each type of asset that the bank is willing to
finance. Thus in the above illustration, as the bank will be
financing, land, site development, building and plant and
machinery, the margin money will be Rs.60 lakh (240 x 0.25).
The balance of the amount i.e. Rs.180 lakh will be provided by
the bank as a term loan and/ or lease finance. Having decided on
the loan amount, the same will be disbursed in lumpsum on
an installment basis depending on the project requirement.
Similar type of appraisal is also conducted by banks while
deciding on the amount of the working capital. The borrower
will make projections of the market demand, etc. and arrive at
the amount of working capital it requires at a particular level of
production. Consider the working capital requirement of LLG
Steels Ltd.:

Rs. lakh
Inventory
Debtors
Receivables
Cash
Others
20.00
8.00
5.00
10.00
12.00

55.00
While the total working capital requirement of the borrower is
Rs.55 lakh, there will be the margin amount which is to be
brought-in by the borrower. To arrive at this margin money, the
bank will have to first arrive at Maximum Permissible Bank
Finance (MPBF).
The three methods that can be used to assess the credit amount
are
Turnover Method
Based on the forecasts made for the turnover of the firm, a
percentage of the same will be taken as the amount to be
financed for the working capital.
Earlier, banks were to assess the credit requirements of
borrowers with fund based working capital up to Rs.l crore
from the banking system in a simplified method of fixing a
limit of minimum of 20 percent of the assessed turnover with
a minimum margin of 5 percent to be brought in by the
borrowers. Now the method can be adopted for fund based
working capital liability of Rs.5 crore.
Cash Budget Method
This method assesses the requirement of the funds by the firm
at various periods and then decides on the MPBF. This method
suits the seasonal industries. Based on the seasonality, banks
can set the peak and non-peak limits for the bank finance.
Tandon Committee Method
Tandon gave three methods of assessing the MPBF, which are
as follows:
Method I 0.75 (CA - CL)
Method II 0.75 (CA) - CL
Method III 0.75 (CA - CCA) CL
Core current assets are to be financed by the long-term sources
of the borrowers.
CA and CL are Current Assets and Current Liabilities
respectively and CCA are the Core Current Assets.
Till the recent past, banks were required by the RBI to use the
Tondon Committees method II for assessing the MPBF.
However, banks are now free to adopt their own policy to
assess the MPBF. Hence, banks can use any of the above three
approaches depending on tile nature of the business and the
size of the firm and assess the MPBF.
Assuming that the current liabilities of LLG Steels Ltd. are
Rs.25 lakh the MPBF using the Tandon Committees method
II will be as follows:
The Current Assets = Rs.55 lakh
The Current Liabilities = Rs.25 lakh
MPBF = 0.75(CA) - CL = 0.75(55) - 25
= 16.25
The decision relating to the amount to be financed will be
followed by the method of financing, the same. Financing, of
the working capital will be through cash credit (CC), working
capital demand loan (WCDL) and/ or bill financing,
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mechanisms. In a CC approach, there will be a lot of uncertainty
for the bank about the cash inflows and outflows and so will be
the case with the interest income. To avoid this and to gain,
better control over the flow of credit, RBI had, in April 1995,
introduced the loan system of delivery of credit for borrowers
with working capital (fund based) limit of Rs.l0 crore. Since it is
a short-term loan, which has a minimum repayment/ maturity
period of 15 days, it is also known as the Working Capital
Demand Loan (WCDL). The bifurcation of the working capital
finance into CC and Loan component will be in the ratio of
20:80.
Questions to Discuss:
1. What is the need for lending and need for credit?
2. What are the types of credit?
3. Discuss the nature of credit?
4. What is the security offered for Loans?
5. Discuss the purpose of Loan.
6. Systems Hardware Ltd. Has submitted its project report for
getting credit facility from the Dhan Bank Ltd. The following
are the details relating to project finance and working capital
requirements of the firm:
Rsin Lakh
Land 75.00
Sitedevelopment 5.00
Building 55.00
Plant andmachinery 125.00
Pre-operativeexpenses 10.00
Total 270.00

The working capital requirement of the Company is as given
below:
RsinLakh
Inventory 45.00
Debtors 15.00
Receivables 10.00
Cash 10.00
Others 8.00
Total 78.00

1. Assess the margin amount that the company has to bring in
for its project and the amount of bank finance for the same.
2. Assess the Maximum Permissible Bank Finance (MPBF)
using the second method of Tandon Committee (current
liabilities are Rs. 30 lakh).
3. Give the details of the means of finance for the working
capital, if the actual bill finance required is Rs. 5 lakh.
Notes:
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LESSON 17:
LOAN POLICY
Learning Goals:
After reading this lesson, you will be understand
Need for a Loan Policy
Components of a Loan Policy.
Lending is a crucial activity for a bank as it enables it to sustain
profitably. But to sustain profitably, prudent decisions need to
be taken both prior to and after sanctioning the credit. These
decisions generally relate to the amount of credit to be extended
during a financial year, the industries to focus on, the
geographical spread, the type of credit to offer, the type of
proposals to finance, the disbursal mechanism, the collateral
value, the method of pricing, the repayment schedule, the
monitoring process, etc. These macro and micro level
considerations of the lending activity contribute to the
achievement of the banks objectives. The banks management
should thus, ensure that lending decisions fall in line to
subserve the banks overall objectives.
Need for a Loan Policy
While lending decisions are crucial for the bank, it is neither
feasible nor desirable for the top management to review and
clear every single loan proposal that the -bank receives. This
arises not only due to the process involved in such an activity
but also due to the numbers. Furthermore, for most of the
loan proposals, whichever industry they may belong to, the
modus operandi remains the same - analyzing, selecting,
sanctioning and monitoring. Hence, the, top management
needs to set the standards. Standards relating to the exposure
limits for individual / company / industry, credit quality of the
borrowers, lending rate, risk level, etc. enable decentralized
decision-making by the lending officers.
To enable such decision-making, there should actually be a
policy document that carefully specifies the dos and donts while
sanctioning the loan proposals. As loan proposals differ widely
from each other, there cannot be a strict methodology for
accepting or rejecting the proposals. Instead, guidelines can be
given within the loan policy for the decision makers to enable
them to screen out loans, which can be outrightly rejected, loans
that can be sanctioned without any involvement of the top
management and proposals that require a certain amount of
top level decision-making. Discussed below are a few
considerations that the loan policy may address.
Components of a Loan Policy
When a bank is developing its loan policy, there will be certain
significant issues, which it needs to incorporate in the policy.
Discussed below are a few considerations that the loan policy
may address.
Loan Objectives
The first step to framing a loan policy is formulating the
objectives of the lending activity. Due to the presence of
multifarious objectives like profitability, liquidity, volume of
business, risk levels, etc. there will be prioritization of objectives
while drafting the policy. But due to certain conflicting
situations, reconciliation/ trade-off between different objectives
may become necessary. Further, in the case of certain objectives,
there will be regulatory prescriptions like the capital adequacy
norms. Thus, while setting the loan objectives in. the policy,
adherence to the regulatory prescriptions will also be an
important consideration. By stating the related regulatory
aspects in the policy, the loan officers will be fully aware of the
importance of the policy measures. .
Volume and Mix of Loans
The policy should specify the targeted composition of the loan
portfolio, such composition being in terms of industry/
location/ size/ interest rate/ security. Decisions regarding the
loan portfolio will depend on the size of the bank, the credit
requirements in its operational areas and the expertise available
with the bank. In an agrarian type of economy most of the
loan demands may come from the farmers. Likewise, if the
bank size is small, it may have to put a limit to individual loan
proposals to be in proportion to its total loan portfolio.
Generally, exposure levels, which the banks can have for the
various types of borrowers, are given by the apex regulatory
body
.
While fulfilling the, regulatory prescription it is desirable
to develop more detailed limits within the bank.
Geographical Spread
There will be various locations from where a bank conducts its
operations. Of these locations, some may be weak credit
demand areas with a considerably high deposit potential and
vice versa. While operating in any area, the bank should have the
requisite funds and expertise to meet the credit demands. The
policy should thus, state the key trade areas of the bank for
extending credit. Further, within the trade areas, there may be
certain areas with a primary focus and a few others, which may
be given the secondary focus. Such a classification may also
enable the bank to switch on to the secondary trade areas when
the chief trade areas are not active.
Loan Evaluation Procedures
The policy document shall specify a process for eva1uation of
loan proposals, which will enable uniform evaluation across
areas/ people. Evaluation involves a careful selection of the
borrowers by understanding their creditworthiness. While
evaluating the proposal, banks should not only assess the
ability of the client to payback the loan but also their willingness
to repay. Banks need to consider the following variables while
evaluating a loan proposal:
Industry Prospects
To study the prospects of the industry, an industry level credit
analysis needs to be performed which most importantly
includes a study of the following:
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Industry cycles
Threat from substitutes
Shifts in consumer demands
Regulatory environment
Operational Efficiency
The company level credit rating is conducted to assess the
operational efficiency of the client company. The critical aspects
that are to be evaluated in this process fall into the following
categories:
Operating margins
Stability and growth of market share
Access to key raw materials
Benefit from economies of scale
Financial Efficiency
Repayment of the loan by the clients depends greatly on their
financial soundness. Hence, financial analysis becomes an
imperative part of credit risk analysis. It includes an analysis of
the following:
Financial leverage
Coverage ratios
Cost of capital
Ability to raise funds
Working capital management
Interest rate risk management
Management Evaluation
While the above mentioned factors assess the ability of the
client to repay, the management evaluation to a certain extent,
throws light on the willingness of the client to repay. Thus,
evaluation of management includes a study on the performance
of the promoter, top management and also the performance of
group companies under the same management.
Fundamental Analysis
Here, the fundamental factors that influence the working of the
client company are analyzed. These factors are listed below:
Capital structure
Asset/ liability position. Asset quality
Profitability
Sensitivity to interest rate structures, tax policies, etc.
Above is the broad classification of the various parameters used
to evaluate a loan proposal. The parameters used for evaluating
will vary depending on the type of the borrower, the nature of
the project and the purpose of funds. The list provided above
is not an exhaustive one and depending on the loan proposal,
the bank will select the evaluating variables. Once a broad list of
such parameters is identified, the loan policy may also specify
benchmarks so that uniform evaluation can be ensured.
Loan Administration
Efficient administration is the key to the success of the lending
policy. And for improving its efficiency, the authority of the
loan executives should be clearly stated as also their
responsibilities. The loan policy should state the sanctioning
powers of the loan officers regarding the credit limits. The credit
limits, which are generally set, based on the responsibility and
the experience of the loan officer should be done diligently. Too
Iowa limit will lead to a situation where a major part of the
senior managements time is spent on smaller quantum of
loans. In contrast to this situation, the risk of the bank may
increase when loan sanction powers are too high. Inexperienced
officers may commit the bank to undesirable loans.
Credit Files
The details regarding the borrower are not only essential during
the loan appraisal time but they are also required throughout
the tenor of the loan. This is essential especially since there may
always be a probability of default or a change in the risk-return
profile of the customer. Continuous evaluation is possible with
the help of a credit file, which keeps track of the historical record
of the borrower. In this context, the loan policy can specifically
mention the inputs required for maintaining the credit files for
varying types of loans. The credit file maintained for a borrower
should reveal all the parameters considered while accepting the
proposal. It is useful to keep a record of any specific events/
experiences which indicate whether the decision taken for
granting such a loan was sound or not. The contents of the
credit file should include all details of the borrower including
detailed financial statements and analysis, collateral provided
and the value of the same, details of compensating balances,
etc. Moreover, since most of the customers are not one time
borrowers, it will be all the more necessary for the bank to
maintain such credit files of the customers.
Lending Rates
The interest charged should reflect the credit risk present in the
credit disbursal. The major issue will thus be to adjust the rate
charged to the risk perception. For this, the loans can be
classified into different risk groups based on the risk involved.
Having done this, the policy should then state the returns a
particular loan should be giving at a particular level of risk. The
policy should also state the risk level at which no credit can be
extended. In addition to this, the policy should also give
guidelines for selecting a floating or a fixed rate of interest.
A loan policy will actually be a function of the size of the bank.
Hence, apart from the above mentioned considerations,
depending on the banks own requirements, there may be
several other issues/ parameters that may be included in its loan
policy. Given below are some of the other issues/ parameters
that the loan policy may contain:
Type and extent of collaterals
Compensating balances
2
/ margin.
Statutory limits for different types of loans
Monitoring mechanism
Loan-Deposit ratio
Incentive schemes for the loan officers.
Loan repayment pattern
Communication practices
Extension of renewals of past-due installment loans
(rescheduling the loan)
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Loan-loss reserves
Consumer laws and regulations
Role of credit department
Role of recovery department
Having drafted the loan policy, adequate measures should also
be taken to ensure that the policy is being effectively used in the
lending activity. For this, there need to be loan committees,
which review the loan policy from time to time and also, assess
the performance of the credit departments. These committees
should meet frequently to assess the loan policy, to assess the
loan proposals beyond a threshold limit and also those loan
proposals that do not comply with the normal credit
standards. It will have to suggest measures to cope with certain
grey areas and find a solution to the critical questions relating to
a bad loan before it drifts into an undesirable and
uncontrollable situation
Summary
By listing the lending parameters, defining responsibilities and
having in place a proper system of checks and balances, the loan
policy does provide a framework for bank lending. In addition
to this, a good loan policy should have two other features -
firstly, it has to establish the credit culture for the bank and
secondly, it has to be contemporary. If a loan policy is able to
establish a credit culture for the bank, then it will also enable a
new entrant into the organization to understand the procedures
of the bank easily. And due to the dynamic operating
environment, there may be certain changes in the bank
objectives, the pricing methodologies practiced, the exposure
levels, etc. and all these require a revision in the loan policy.
Hence, the loan policy needs to be contemporary so as to suit
the changing lending environment.
Questions to Discuss:
1. What is the need for a Loan Policy?
2. Discuss the components of a Loan Policy.
Notes:
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LESSON 18:
LOAN PRICING
Learning Goals:
After reading this lesson, you will be understand
Objectives of loan pricing
Cost plus loan pricing model
Being the purveyors of credit, primary activity of banks is
lending. Apart from ensuring proper application of the surplus
funds mobilized, lending also enables these banks to maintain
profitability. Deployment of funds should be at a rate that
covers the cost of funds and leaves a margin to the lender after
meeting the expenses. This margin should on one hand cover
the risks a bank is exposed to due to their lending activity and
on the other hand provide certain income. Pricing thus has an
implication on the profitability and the sustenance of the bank.
While a bank can adopt a pricing policy for greater margins, it
may, however, have an adverse affect on their business volume.
A bank needs to thus, adopt a pricing policy that ensures
profitability while increasing the business volumes. Arriving at
such a price level is difficult for the simple reason that there are a
number of factors, both internal and external to the bank that
influences such a decision. The aspects related to loan pricing
that are discussed in this lesson can be broadly categorised into
the following:
Determinants of loan pricing
Methodologies of loan pricing
Objectives of Loan Pricing
Prior to deciding the price of any product, it is essential to first
identify the objective the price of the product should attain for
the firm i.e. should it ensure high returns, higher business or
should it just enable a break even. Similar is the case when the
bank decides to fix its loan price. Banks generally have three
major objectives in loan pricing-
Maintain margins
Balance risk-reward profile
Ensure market rates
Margins ensure profitability, the balanced risk-reward profile
ensures sustenance, and the market rate ensures the presence of
the bank in the market. While all the three objectives are
important and interrelated, prioritizing them, however, will be a
policy decision to be taken by the bank.
Margins:
To ensure margins, the bank should have surplus income after
having met its cost of funds and cost of servicing. For this
purpose, the bank can ascertain the cost of its funds, add the
overall cost of servicing to which it can add the necessary
margins it would like to maintain for taking the risk and to earn
a profit. The total of this will give the rate at which the loan has
to be priced.
However, one issue that arises during such computation is
whether to use the average cost of funds or the marginal cost
of funds. This becomes a fairly simple issue if the liabilities and
the assets of the bank are examined. If we consider a banks
balance sheet, the liabilities of the bank will be deployed into
various assets including advances and investments. In certain
situations when the bank does not have suitable deployment
opportunity by way of loans or investments, it will temporarily
deploy the same into the money market and will utilize the
same for the future credit proposals. Along with these funds,
incremental deposits will also be used for offering credit. When
the funds deployed in the money market are used for extending
the credit, then it is desirable for the bank to consider the
average costs of funds while pricing the loans. This is basically
due to the fact that various sources of funds would have been
used for the deployment into the money market. An average
cost of funds will be essential since in a declining interest rate
scenario, by considering only the marginal cost of funds, the
higher interest rates on the banks funds will eat into the
profitability of the bank.
Alternatively, if the bank does not have any surplus funds
deployed into the money market, then the future credit
requirements will have to be funded using the incremental
deposits only. Under such circumstances the incremental or the
marginal cost of funds can be used while assessing the loan
price. Thus, in loan pricing, the use of the average cost of funds
and the marginal cost of funds will depend on the composition
of asset-liability position.
Risk-Reward
The relation between risks and returns will have to be
considered taking three different loan attributes- the tenor of
the loan, the credit risk of the customer and the size of the
loan. Form the theories of interest rates, it can be understood
that the interest rates increase with the increase in the tenor of
the loan. Thus, loans with longer maturity are charged a higher
interest rate when compared to the loans maturing in the short-
term. This is due to the fact that the risk involved in lending foe
longer periods is greater when compared to the lending for
shorter periods. Considering this, if a bank would like to earn
greater returns, it would have to lend for longer periods. But for
this, the bank should also have funds with marching maturity.
However, the sources of funds for a bank do not generally
include long-term funds. In such cases, the bank may borrow
short and lend long, which may lead to an enhanced level of
risk. Due to the presence of this risk, the bank should decide on
a level of risk-reward that it is prepared to accept and then
decide on the maximum tenor of its loans.
The second major attribute that influences the risk, reward
proportion of the bank is the credit risk involved in the lending
function. All loans have a certain element of risk involved in
them due to the probability of default. The level of risk,
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however, varies for each borrower, moving upwards from
sovereign debt to corporate debt. Due to the presence of this
risk, the returns will also vary, with greater returns being
attached to higher risk levels. This linkage between the credit risk
and the returns highlights the need for the bank to first decide
on the level of risk-reward it would prefer to maintain. Having
laid down the tolerable risk level and the approximate returns
for the same, the bank can accept or reject the loan proposals
based on the risk they are exposed to.
Apart from the above mentioned attributes, the size of the
loan also influences the risk-reward ratio. While the affect of
term to maturity and the credit risk on the risk-reward ratio
could be clearly observed, the same may not be possible in the
case of the size of the loan. The key issues to be considered
here will be the relationship, the servicing costs and the risk
involved have with the size of the loan.
Considering the servicing costs, as the size of the loan increases,
these costs come down as it will be cheaper to service a single
loan account of Rs. 10 lakh each. Loans which are made in small
denominations and which involve greater clerical and
management time, carry high cost per rupee of loan extended
and vice versa. Example of this can be a credit card facility where
the time involved for management is greater than the tem loan.
Compensation for this high service costs are the high interest
rates charged for the credit card facility. On the other hand, loan
of larger denominations will take comparatively lesser time for
management and may be a useful proposition. However, the
greater exposure to one client will result in higher risk. To
understand this, consider the Capital Structure theories. It can
be recalled form the traditional approach of capital structure that
the gains on account of increased leverage will be higher than
the increased cost of equity thus having a positive impact on the
value of the firm up to a particular level of leverage. Thus the
ratio of debt to equity, which does not adversely affect the value
of the firm, will be safe for the creditor/ bank. The bank can
lend to a single customer as long as this degree of leverage is
maintained. However, if the debt amount goes beyond this
level for the firm, then the credit risk for the bank will rise. The
rise in the credit risk will again lead to a rise in the servicing
costs, which have actually been falling due to the size of loan.
This is basically due to the fact that with the size of the loan
being large and the credit risk increasing, the bank will have to
mare closely monitor such loans. Thus, the higher returns
which are expected due to the fall in the servicing costs will be
off-set by the ruse in the credit risk, thus, the impact of the size
of the loan on the risk-reward ratio of the bank will have to be
examined both from the point of view of the company (capital
structure) and the bank.
Thus, the banks risk-reward ratio, as discussed above, depends
on the term to maturity of the loan, the credit risk of the loan
and the size of the loan. The returns and the risks of the bank
will undergo a change due to the changes that take place in these
three attributes of the loan. This requires the bank to have a
continuous monitoring on the risk level and the returns in
order to remain within the prescribed framework.
Market Rates:
The last factor that affects the loan pricing decision is the market
rate. If the rates charged by the bank are higher than the market
rates, then it will lose its business to those offering cheaper
rates. On the other hand, if it lowers its rates below the market
rates, then though the volume of the business may increase,
but the lower returns will reduce its profitability. To prevent loss
of business and lower profits, thee bank should ensure that
loan prices remain close to the prevailing interest rate structure
in the market.
Considering the various factors influencing the loan pricing
decision of the bank and the alternatives in pricing, the bank
will next have to develop loan pricing model. If the objective of
the bank is to earn spreads, then the pricing model will first
focus on the cost analysis of the bank and then ensure that the
price charged covers its costs and leaves a margin. Similarly,
when the risk-reward objective is set as the top priority, the
customer evaluation and a price that reflects the risk involved by
extending such credit becomes essential. And finally, if the
banks chief objective is market presence, then it will ensure that
its rates move in tandem with the rates of the other players in
the market. However, this cannot be pursued irrespective of its
ability to sustain.
However, prudence lies in actually integrating these three
objectives and emerging with a price that not only covers the
banks lending costs and gives a return on it, but also ensures
that the bank is able to sustain the risk level taken and at the
same time keeps itself close to the prevailing market rates.
Discussed below is a pricing model that uses various
approaches to build in these three objectives. The basic model
of the cost plus pricing is used to arrive at the loan price. Within
this, various methods of assessing the risk premium and the
required profit margin are discussed. Following this approach,
the bank can build in a pricing methodology that ensures a
price, which covers the costs and the risks and leaves a profit
margin.
Cost Plus Loan Pricing Model
This model basically focuses on arriving at a loan price that
ensures a certain margin after covering the cost of the funds,
operations costs, cost of servicing. The process involved in
arriving at a contractual rate based on this model consists of the
following steps:
Arrive at cost of funds
Assess the servicing costs
Quantify the credit risk and set premium
Assess the profit margin that ensures the targeted ROE
Relate the rate to a reference rate (Prime Rate)
Ensure market presence.
The word margin, however, connotes differently depending on
how the bank can segregate its costs and other risks. And
depending on what the word margin means to the bank the
pricing methodology varies slightly. The basic relationship,
however, is given as follows:
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Loan Price = Cost of funds + Margin(1)
Cost of Funds:
While assessing the cost of funds apart from deciding on the
average cost of funds and the marginal cost of funds, the bank
will also have to assess the same considering the average cost of
funds vs. the cost of pooled funds (funds having the same
interest rate). This decision depends on the ability of the bank
to identify the liabilities that are deployed into a particular asset.
In other words, if the bank is not in a position to identify the
source from which the funds are used to extend a particular
credit facility, then the average cost of funds will be the suitable
option. However, if the bank can clearly segregate its liabilities,
then it can pool funds with similar maturities and fund a credit
proposal with a similar maturity. The cost of funds will thus be
the average cost of pooled funds and not the average cost of
total funds. This approach to assessing the cost of funds will
enable price matching as well as maturity matching. However it
may not be possible to adopt a pooled funds approach in
respect of all sources of funds. It is, therefore, desirable to
adopt this pooled funds approach at least in respect of high
cost funds so that the price decided on the basis of average
funds does not result in reduction of spreads. Further, in the
case of average cost of funds, the bank cannot use the same rate
for loans of differing tenors.
While the price arrived based on the average cost of funds
results in a flat yield curve, it is not always seen in the market
and it will not be in tune with the concept of upward sloping
yield curve. Therefore, it is possible to change margins at
different rates to address this problem.
Thus, it can be observed that in the pooled cost of funds
approach the margins are fixed. However, when the average cost
of funds is considered, the margins for loans with higher
maturities will be less while the margins for the loans of lower
maturities will be higher. To avoid such fluctuations in the
actual margins when the average cost of funds is considered, the
bank will have to set margins based on the tenor of the loan
instead of having a fixed margin for loans of differing
maturities i.e. set higher margins for loans with higher
maturities.
Margins
The word margin is used in a very broad sense in the above
expression. Consider the following equation:
PBT = (Interest Income - Interest Expenses) + (Other
Income - Other Expenses) Provisions.(2)
From the above equation it can be observed that it is from the
interest income that the banks PBT and provisions arise and
also that it is from this income that the bank meets its interest
expenses and the Burden, which is the difference between the
other income and the other expenses. Thus, it implies that the
interest income includes margins. Depending on the break up,
which the bank will have for its loan price, the composition of
the margins will differ. Before proceeding towards a discussion
on the different connotations of the word margin, it would be
useful to understand the following:
Operating and Servicing Costs
These costs represent the other expenses that represent the
burden for the bank and comprise of the costs incurred while
servicing deposits, extending loans and other services. These
vary depending on the nature of the loan, the cash flow pattern,
and the maturity. All the administration cost incurred by the
bank while the loan is still live viz., salaries, costs incurred in
creating and perfecting a security interest in collateral, costs
incurred on documentation for security interest in collateral,
costs in establishing and managing the records, collection costs,
etc. will be considered here. Similar servicing costs are involved
both for deposits and other services. While the servicing costs
for other services maybe recovered from the fee income received
from such services, the servicing costs of deposits will also have
to be met from the interest income.
Risk Premium
Risk margin will be set after considering the different types of
risks the loan is exposed to. For a proper assessment of this,
risk unbundling becomes essential. Provisions are generally
made to tackle the risk element in the assets.
Profit Margin
After considering all the costs involved with the lending activity
as well as adjusting for the risk the bank will then look towards
including a profit margin. This margin would depend on the
returns it would like to earn from the lending activity.
Having considered the various components that the banks
margin can comprise of; it can be observed that the margin
mentioned in Eq.(1) is set to meet the other expenses
(operating ,and the servicing costs), the provisions for risk and a
residue which forms the profit margin. Since the cost of funds
represent the interest expenses, the margin will not require to
meet them. Thus, when a bank is unable to segregate its other
expenses and quantify its risks, this type of loan pricing can be
adopted. Based on the type of security, the nature of the loan
and the purpose for which the funds are borrowed, the bank
can set a range for the margins to be included in pricing. The
upper end margins can be used for loans with higher maturities,
more risk, etc. and vice versa.
Sometimes, the bank will be able to identify its operating and
servicing costs and build it into its pricing model as a percentage
to the size of the loan. The loan price can then be assessed as
follows:
Loan Price = Cost of funds + Costs of Servicing +
Margin...(3)
The loan price as per the above equation will have the margins
that should contribute to the profit margin after making
provisions for risks.
Moving one step ahead in arriving at the price, the bank will try
to quantify the risk it has taken while extending the loan. If the
risk is identified then the provisioning required for the risks can
also be assessed.
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When the bank is able to do so, then the pricing model can be
further disintegrated as follows:
Loan Price = Cost of Funds + Cost of Servicing +
Provisions for Risk + Profit Margin..(4)
Here the margin will be solely to meet the profits of the bank.
This can, be arrived at based on the Return on Equity, which the
bank would expect to maintain.
In its very basic framework, the cost plus pricing method
discussed above is based only on the costs and since costs set
the floor for pricing, the interest rate arrived at that first stage
(using (Eq. (3)) can be considered as the Hurdle Rate. This is
the rate below which a bank cannot offer any credit if it has to
remain profitable. To arrive at this hurdle rate, estimation of
costs, expenses incurred and expected returns become essential.
However, by assessing the risk premium and the required
returns, the bank can actually improvise on its pricing approach.
But to arrive at this price, the bank should be able to quantify its
risks and also decide on the required margin.
Discussed below is the procedure by which the bank can
gradually build a loan price that incorporates all parameters i.e.
the cost of funds, cost of servicing, risk premium and the
profit margin. The loan price using the Eq. (3) can be obtained
simply by assessing the cost of funds and its servicing costs and
adding the margin amount. The profit margin, which the bank
sets, should enable the bank to earn its required ROE. When
the ROE is met then the price charged which is known as the
Contractual Rate will become the expected return for that loan.
However, the bank will earn this expected return as long as there
is no default in the repayment of the loan. In case there is a
default, the contractual rate will not give the bank the expected
return. If the bank has to reach the targeted ROE, then the risk
should be quantified to arrive at a contractual rate that in turn
gives the bank the expected rate.
Quantifying Risk Premium
Generally, while performing the financial appraisal for the
proposal, the internal rate of return (IRR) is calculated. If the
payments are made regularly by the clients, then the expected
rate of return will be equal to the contractual rate.
Expected Return = P
1(r)..
(5)
where,
r = Contractual Rate
PI = Probability of repayment
In the above case, since the payments are made regularly by the
clients, P
1
will be equal to one.
However, there will always be some uncertainty attached to
future cash flows. This uncertainty attached to future cash flows.
This uncertainty relates mainly to the amount of cash inflows
and the timing of the cash flows. In such uncertain situations,
the bank can arrive at the probability of repayment/ default and
also the extent of recovery in case of a default.
While the probabilities can be assessed from the past data, the
recovery rate can be computed by considering the guarantees and
value of collaterals attached to the loan. The recovery rate refers
to the percentage of the outstanding balance that can be
recovered by measures such, as enforcement securities, legal
action, etc.
When a default is expected from a loan, the bank will adjust the
recovered amount towards the principal. Thus, based on the
probability of payment and recovery -rate, the expected rate
when the bank expects the payment of interest as well as the
principal amount, will be
Expected Return = P1(r) + P2 P (1 + r) x R .(6)
P
Where,

P2 = Probability of default
P = Principal component
R = Recovery rate.

In the above formula, P
1(r)
gives the returns using the
contractual rate and the probability of total repayment of the
loan in the normal course of payment while the second part i.e.
P
2
{ [P(l + r) x R]/ P 1 } gives the returns using the recovery
rate and the probability of default. The expected rate when there
is only principal repayment will be assessed as follows:
Expected Rate = P
1(r)
+ P
2
(R - 1).(7)
In the above equation, the second part i.e. P
2
(R - 1) gives the
principal that is recovered.
It is now understood that while pricing a loan proposal, it is
essential for the bank to adjust the contractual rate so that it
reflects the creditworthiness of the client. The bank should
thus, build into its pricing, mechanism probability of default.
Such an exercise will, to a certain extent, reduce the loss in return
due to defaults. From the above equations, for a given
contractual rate, the expected returns from the proposal can be
assessed by considering the probability of the repayment/
default and the recovery rate. Using this approach, it is also
possible to decide the contractual rate to be offered once the
required rate is determined. The required rate, which includes
the cost of funds, transaction costs and the spreads, can be used
as the expected rate.
Questions to discuss:
1. Which of the following approaches (A) Average cost of
funds (B) Pooled cost of funds should be used for financing
a 3 year loan proposal of Rs. 10 crore in order to maintain a
margin of 4 percent over the cost of funds? Given below are
the details of its liabilities portfolio.
Amount
(Rs.crore)
Maturity (year) Interest rate(%)
25 - -
40 0.5 5
35 1.0 9
20 2.0 12
20 3.0 14
140

2. Zenith Finance Ltd. assessed its cost of funds to be 15.75
percent. Further, the transaction cost for sanctioning a credit
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proposal is 0.5 percent. On this cost, it expects to maintain 2
percent as spreads. A proposal is received by the company for
financing a loan for Rs.950 lakh. The credit department in
their appraisal report have given the probability of
repayment as 0.95. However, on default, the recovery rate is
expected to be only 85 percent. From this information,
compute the expected rate of financing. Further based on the
creditworthiness of the client, what do you think the
contractual rate should be?
3. Venus Financials Ltd. had received a loan proposal for Rs. 12
crore. The contractual rate for the loan is 22 percent. In case
of a default, VFL expects to recover 90 percent of the
principal. If the probability of repayment is 0.9, then what
will be the expected return for VFL? Based on the answer
you get, assess the rate at which the loan should have been
financed to get a return of 22 percent.
4. L&M Bank Ltd. has received a 4-year loan proposal from a
Deep Mines Ltd., which has a A+ credit rating, attracting a
risk premium of 2 percent. The PLR for a 2-year loan of the
bank is at 13.5% and the implicit forward rate for two years
form now is 15 percent. If the bank follows a prime-time
pricing method, what should be the loan price?
Notes:
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LESSON 19:
NON PERFORMING ASSETS (NPA)
Learning objectives
After reading this lesson, you will understand
Introduction
Indian Economy and NPAs
Global Developments and NPAs
Meaning of NPAs
Why such a huge level of NPAs exists in Indian banking
system (IBS)?
Why NPAs have become an issue for banks and financial
institutions in India?
RBI Guidelines on income recognition (interest income on
NPA)
Accounting Standard 9 (AS 9)
Are RBI guidelines on NPAs and ICAI Accounting Standard
9 on revenue recognition, consistent with each other?
RBI guidelines on classification of bank advances
How to classify bank advances, if recovery is highly unlikely?
Credit Risk and NPAs
Public Trust and NPAs
How important is credit rating in assessing the risk of
default for lenders?
Usage of financial statements in assessing the risk of default
for lenders
Can Universal Banking solve the problem of NPA for DFIs?
Capital Adequacy Ratio (CAR) of RBI and Basle Committee
on Banking Supervision (BCBS)
Excess Liquidity?
High cost of funds due to NPAs
Conclusion
Introduction
Its a known fact that the banks and financial institutions in
India face the problem of swelling non-performing assets
(NPAs) and the issue is becoming more and more
unmanageable. In order to bring the situation under control,
some steps have been taken recently. The Securitisation and
Reconstruction of Financial Assets and Enforcement of
Security Interest Act, 2002 was passed by Parliament, which is an
important step towards elimination or reduction of NPAs.
Indian Economy and NPAs
Undoubtedly the world economy has slowed down, recession is
at its peak, globally stock markets have tumbled and business
itself is getting hard to do. The Indian economy has been much
affected due to high fiscal deficit, poor infrastructure facilities,
sticky legal system, cutting of exposures to emerging markets by
FIIs, etc.
Further, international rating agencies like, Standard & Poor have
lowered Indias credit rating to sub-investment grade. Such
negative aspects have often outweighed positives such as
increasing forex reserves and a manageable inflation rate.
Under such a situation, it goes without saying that banks are no
exception and are bound to face the heat of a global downturn.
One would be surprised to know that the banks and financial
institutions in India hold non-performing assets worth Rs.
1,10,000 crores. Bankers have realized that unless the level of
NPAs is reduced drastically, they will find it difficult to survive.
Global Developments and NPAs
The core banking business is of mobilizing the deposits and
utilizing it for lending to industry. Lending business is generally
encouraged because it has the effect of funds being transferred
from the system to productive purposes, which results into
economic growth.
However lending also carries credit risk, which arises from the
failure of borrower to fulfill its contractual obligations either
during the course of a transaction or on a future obligation.
A question that arises is how much risk can a bank afford to
take? Recent happenings in the business world - Enron,
WorldCom, Xerox, Global Crossing do not give much
confidence to banks. In case after case, these giant corporates
became bankrupt and failed to provide investors with clearer
and more complete information thereby introducing a degree
of risk that many investors could neither neither anticipate nor
welcome. The history of financial institutions also reveals the
fact that the biggest banking failures were due to credit risk.
Due to this, banks are restricting their lending operations to
secured avenues only with adequate collateral on which to fall
back upon in a situation of default.
Meaning of NPAs
An asset is classified as non-performing asset (NPAs) if dues in
the form of principal and interest are not paid by the borrower
for a period of 180 days. However with effect from March 2004,
default status would be given to a borrower if dues are not paid
for 90 days. If any advance or credit facilities granted by bank to
a borrower becomes non-performing, then the bank will have
to treat all the advances/ credit facilities granted to that borrower
as non-performing without having any regard to the fact that
there may still exist certain advances / credit facilities having
performing status.
Why such a Huge Level of NPAs Exists in the Indian
Banking System (IBS)?
The origin of the problem of burgeoning NPAs lies in the
quality of managing credit risk by the banks concerned. What is
needed is having adequate preventive measures in place namely,
fixing pre-sanctioning appraisal responsibility and having an
effective post-disbursement supervision. Banks concerned
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should continuously monitor loans to identify accounts that
have potential to become non-performing.
Why NPAs have become an Issue for Banks and
Financial Institutions in India?
To start with, performance in terms of profitability is a
benchmark for any business enterprise including the banking
industry. However, increasing NPAs have a direct impact on
banks profitability as legally banks are not allowed to book
income on such accounts and at the same time banks are forced
to make provision on such assets as per the Reserve Bank of
India (RBI) guidelines.
Also, with increasing deposits made by the public in the
banking system, the banking industry cannot afford defaults by
borrower s since NPAs affects the repayment capacity of banks.
Further, Reserve Bank of India (RBI) successfully creates excess
liquidity in the system through various rate cuts and banks fail
to utilize this benefit to its advantage due to the fear of
burgeoning non-performing assets.
RBI Guidelines on Income Recognition (interest
Income on NPAs)
Banks recognize income including interest income on advances
on accrual basis. That is, income is accounted for as and when it
is earned.
The prima-facie condition for accrual of income is that it should
not be unreasonable to expect its ultimate collection. However,
NPAs involves significant uncertainty with respect to its
ultimate collection.
Considering this fact, in accordance with the guidelines for
income recognition issued by the Reserve Bank of India (RBI),
banks should not recognize interest income on such NPAs until
it is actually realized.
What does Accounting Standard 9 (AS 9) on Revenue
Recognition Issued by ICAI say?
The Accounting Standard 9 (AS 9) on Revenue Recognition
issued by the Institute Of Chartered Accountants of India
(ICAI) requires that the revenue that arises from the use by
others of enterprise resources yielding interest should be
recognized only when there is no significant uncertainty as to its
measurability or collectability.
Also, interest income should be recognized on a time
proportion basis after taking into consideration rate applicable
and the total amount outstanding.
Are RBI guidelines on NPAs and ICAI Accounting Standard 9
on revenue recognition consistent with each other?
In view of the guidelines issued by the Reserve Bank of India
(RBI), interest income on NPAs should be recognised only
when it is actually realised.
As such, a doubt may arise as to whether the aforesaid
guidelines with respect to recognition of interest income on
NPAs on realization basis are consistent with Accounting
Standard 9, Revenue Recognition. For this purpose, the
guidelines issued by the RBI for treating certain assets as NPAs
seem to be based on an assumption that the collection of
interest on such assets is uncertain.
Therefore complying with AS 9, interest income is not
recognized based on uncertainty involved but is recognized at a
subsequent stage when actually realized thereby complying with
RBI guidelines as well.
In order to ensure proper appreciation of financial statements,
banks should disclose the accounting policies adopted in respect
of determination of NPAs and basis on which income is
recognized with other significant accounting policies.
RBI Guidelines on Classification of Bank Advances
Reserve Bank of India (RBI) has issued guidelines on
provisioning requirement with respect to bank advances. In
terms of these guidelines, bank advances are mainly classified
into:
Standard Assets
Such an asset is not a non-performing asset. In other words, it
carries not more than normal risk attached to the business.
Sub-standard Assets
It is classified as non-performing asset for a period not
exceeding 18 months
Doubtful Assets
Asset that has remained NPA for a period exceeding 18 months
is a doubtful asset.
Loss Assets
Here loss is identified by the banks concerned or by internal
auditors or by external auditors or by Reserve Bank India (RBI)
inspection.
In terms of RBI guidelines, as and when an asset becomes a
NPA, such advances would be first classified as a sub-standard
one for a period that should not exceed 18 months and
subsequently as doubtful assets.
It should be noted that the above classification is only for the
purpose of computing the amount of provision that should
be made with respect to bank advances and certainly not for the
purpose of presentation of advances in the banks balance sheet.
The Third Schedule to the Banking Regulation Act, 1949, solely
governs presentation of advances in the balance sheet.
Banks have started issuing notices under the Securitisation Act,
2002 directing the defaulter to either pay back the dues to the
bank or else give the possession of the secured assets
mentioned in the notice. However, there is a potential threat to
recovery if there is substantial erosion in the value of security
given by the borrower or if borrower has committed fraud.
Under such a situation it will be prudent to directly classify the
advance as a doubtful or loss asset, as appropriate.
RBI Guidelines on Provisioning Requirement of Bank
Advances
As and when an asset is classified as an NPA, the bank has to
further sub-classify it into sub-standard, loss and doubtful
assets. Based on this classification, bank makes the necessary
provision against these assets.
Reserve Bank of India (RBI) has issued guidelines on
provisioning requirements of bank advances where the recovery
is doubtful. Banks are also required to comply with such
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guidelines in making adequate provision to the satisfaction of
its auditors before declaring any dividends on its shares.
In case of loss assets, guidelines specifically require that full
provision for the amount outstanding should be made by the
concerned bank. This is justified on the grounds that such an
asset is considered uncollectible and cannot be classified as
bankable asset.
Also in case of doubtful assets, guidelines requires the bank
concerned to provide entirely the unsecured portion and in case
of secured portion an additional provision of 20%-50% of the
secured portion should be made depending upon the period
for which the advance has been considered as doubtful.
For instance, for NPAs which are upto 1-year old, provision
should be made of 20% of secured portion, in case of 1-3 year
old NPAs upto 30% of the secured portion and finally in case
of more than 3 year old NPAs upto 50% of secured portion
should be made by the concerned bank.
In case of a sub-standard asset, a general provision of 10% of
total outstandings should be made.
Reserve Bank Of India (RBI) has merely laid down the
minimum provisioning requirement that should be complied
with by the concerned bank on a mandatory basis. However,
where there is a substantial uncertainty to recovery, higher
provisioning should be made by the bank concerned.
Credit Risk and NPAs
Quite often credit risk management (CRM) is confused with
managing non-performing assets (NPAs). However there is an
appreciable difference between the two. NPAs are a result of
past action whose effects are realized in the present i.e. they
represent credit risk that has already materialized and default has
already taken place.
On the other hand managing credit risk is a much more
forward-looking approach and is mainly concerned with
managing the quality of credit portfolio before default takes
place. In other words, an attempt is made to avoid possible
default by properly managing credit risk.
Considering the current global recession and unreliable
information in financial statements, there is high credit risk in
the banking and lending business.
To create a defense against such uncertainty, bankers are expected
to develop an effective internal credit risk models for the
purpose of credit risk management.
How important is credit rating in assessing the risk of default
for lenders?
Fundamentally Credit Rating implies evaluating the
creditworthiness of a borrower by an independent rating agency.
Here objective is to evaluate the probability of default. As such,
credit rating does not predict loss but it predicts the likelihood
of payment problems.
Credit rating has been explained by Moodys a credit rating
agency as forming an opinion of the future ability, legal
obligation and willingness of a bond issuer or obligor to make
full and timely payments on principal and interest due to the
investors.
Banks do rely on credit rating agencies to measure credit risk and
assign a probability of default.
Credit rating agencies generally slot companies into risk buckets
that indicate companys credit risk and are also reviewed
periodically. Associated with each risk bucket is the probability
of default that is derived from historical observations of
default behavior in each risk bucket.
However, credit rating is not foolproof. In fact, Enron was
rated investment grade till as late as a month prior to its filing
for Chapter 11 bankruptcy when it was assigned an in-default
status by the rating agencies. It depends on the information
available to the credit rating agency. Besides, there may be
conflict of interest, which a credit rating agency may not be able
to resolve in the interest of investors and lenders.
Stock prices are an important (but not the sole) indicator of the
credit risk involved. Stock prices are much more forward looking
in assessing the creditworthiness of a business enterprise.
Historical data proves that stock prices of companies such as
Enron and WorldCom had started showing a falling trend
many months prior to it being downgraded by credit rating
agencies.
Usage of Financial Statements in Assessing the Risk
of Default for Lenders
For banks and financial institutions, both the balance sheet and
income statement have a key role to play by providing valuable
information on a borrowers viability. However, the approach
of scrutinizing financial statements is a backward looking
approach. This is because, the focus of accounting is on past
performance and current positions.
The key accounting ratios generally used for the purpose of
ascertaining the creditworthiness of a business entity are that of
debt-equity ratio and interest coverage ratio. Highly rated
companies generally have low leverage. This is because; high
leverage is followed by high fixed interest charges, non-payment
of which results into a default.
Capital Adequacy Ratio (CAR) of RBI and Basle
Committee on Banking Supervision (BCBS)
Reserve Bank of India (RBI) has issued capital adequacy norms
for the Indian banks. The minimum CAR, which the Indian
Banks are required to meet at all, times is set at 9%. It should be
taken into consideration that the banks capital refers to the
ability of bank to withstand losses due to risk exposures.
To be more precise, capital charge is a sort of regulatory cost of
keeping loans (perceived as risky) on the balance sheet of banks.
The quality of assets of the bank and its capital are often closely
related. Quality of assets is reflected in the quantum of NPAs.
By this, it implies that if the asset quality were poor, then higher
would be the quantum of non-performing assets and vice-
versa.
Market risk is the risk arising due to the fluctuations in value of
a portfolio due to the volatility of market prices.
Operational risk refers to losses arising due to complex system
and processes.
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It is important for a bank to have a good capital base to
withstand unforeseen losses. It indicates the capability of a
bank to sustain losses arising out of risky assets.
The Basel Committee On Banking Supervision (BCBS) has also
laid down certain minimum risk based capital standards that
apply to all internationally active commercial banks. That is,
banks capital should atleast be 8% of their risk-weighted assets.
This infact helps bank to provide protection to the depositors
and the creditors.
The main objective here is to build a sort of support system to
take care of unexpected financial losses thereby ensuring healthy
financial markets and protecting depositors.
Excess liquidity? no Problem, but no Lending Please
!!!
One should also not forget that the banks are faced with the
problem of increasing liquidity in the system. Further, Reserve
Bank of India (RBI) is increasing the liquidity in the system
through various rate cuts. Banks can get rid of its excess
liquidity by increasing its lending but, often shy away from such
an option due to the high risk of default.
In order to promote certain prudential norms for healthy
banking practices, most of the developed economies require all
banks to maintain minimum liquid and cash reserves broadly
classified into Cash Reserve Ratio (CRR) and the Statutory
Liquidity Ratio (SLR).
Cash Reserve Ratio (CRR) is the reserve which the banks
have to maintain with itself in the form of cash reserves or by
way of current account with the Reserve Bank of India (RBI),
computed as a certain percentage of its demand and time
liabilities. The objective is to ensure the safety and liquidity of
the deposits with the banks.
On the other hand, Statutory Liquidity Ratio (SLR) is the
one which every banking company shall maintain in India in the
form of cash, gold or unencumbered approved securities, an
amount which shall not, at the close of business on any day be
less than such percentage of the total of its demand and time
liabilities in India as on the last Friday of the second preceding
fortnight, as the Reserve Bank of India (RBI) may specify from
time to time.
A rate cut (for instance, decrease in CRR) results into lesser
funds to be locked up in RBIs vaults and further infuses greater
funds into a system. However, almost all the banks are facing
the problem of bad loans, burgeoning non-performing assets,
thinning margins, etc. as a result of which, banks are little
reluctant in granting loans to corporates.
As such, though in its monetary policy RBI announces rate cut
but such news are no longer warmly greeted by the bankers.
High Cost of Funds due to NPAs
Quite often genuine borrowers face the difficulties in raising
funds from banks due to mounting NPAs. Either the bank is
reluctant in providing the requisite funds to the genuine
borrowers or if the funds are provided, they come at a very high
cost to compensate the lenders losses caused due to high level
of NPAs.
Therefore, quite often corporates prefer to raise funds through
commercial papers (CPs) where the interest rate on working
capital charged by banks is higher.
With the enactment of the Securitisation and Reconstruction of
Financial Assets and Enforcement of Security Interest Act,
2002, banks can issue notices to the defaulters to pay up the
dues and the borrowers will have to clear their dues within 60
days. Once the borrower receives a notice from the concerned
bank and the financial institution, the secured assets mentioned
in the notice cannot be sold or transferred without the consent
of the lenders.
The main purpose of this notice is to inform the borrower that
either the sum due to the bank or financial institution be paid
by the borrower or else the former will take action by way of
taking over the possession of assets. Besides assets, banks can
also takeover the management of the company. Thus the
bankers under the aforementioned Act will have the much
needed authority to either sell the assets of the defaulting
companies or change their management.
But the protection under the said Act only provides a partial
solution. What banks should ensure is that they should move
with speed and charged with momentum in disposing off the
assets. This is because as uncertainty increases with the passage
of time, there is all possibility that the recoverable value of asset
also reduces and it cannot fetch good price. If faced with such a
situation than the very purpose of getting protection under the
Securitisation Act, 2002 would be defeated and the hope of
seeing a must have growing banking sector can easily vanish.
Conclusion
To conclude with, till recent past, corporate borrowers even after
defaulting continuously never had any real fear of bank taking
any action to recover their dues despite the fact that their entire
assets were hypothecated to the banks. This is because there was
no legal Act framed to safeguard the real interest of banks.
However with the introduction of Securitisation Act, 2002
banks can now issue notices to their defaulters to repay their
dues or else make defaulters face hard and tough actions under
the aforementioned Act. This enables banks to get rid of sticky
loans thereby improving their bottomlines. Also a hallmark of
a good business is approaching it with a fresh, new perspective
and requires management that is fully awake, fully alive and of
course fully focused on making things better.
Also, the passing of the Securitisation Act, 2002 came as a
bonanza for investors in banking sector stocks that in turn
resulted into an improvement in their share prices.
Questions to Discuss:
1. NPAs of the bank as on 31/ 03/ 2004 are as follows:
Assess the amount of Provisioning the bank has to make as on
31/ 03/ 2004
Natureof Asset Amount (RsLakh)
Standard 1450
Sub-standard 540
Doubtful asset(secured)
-1Year 210
-1-3Years -
-morethan3Years 90
Loss 45

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LESSON 20:
STATUTORY RESERVE REQUIREMENT
Learning objectives
After reading this lesson, you will understand
Introduction
Reforms
Cash reserve ratio
Reduction in CRR
Flexibility in the treatment of CRR
Statutory liquidity requirement (SLR)
Statutory liquidity ratio of regional rural banks
The core business of banks is mobilising the deposits and
utilising the same for credit accommodation. However, it
should be taken into consideration that the banks are not
allowed to use the entire amount for extending credit. In order
to promote certain prudential norms for healthy banking
practices, most of the developed economies require all banks to
maintain minimum liquid and cash reserves. As such, banks are
required to ensure that these statutory reserve requirements are
met before directing on their credit plans.
Statutory reserve requirements could broadly be classified into
Cash Reserve Ratio (CRR) and
Statutory Liquidity Ratio (SLR).
Cash Reserve Ratio (CRR) is the one which the banks have
to maintain with itself in the form of cash reserves or by way
of current account with the Reserve Bank of India (RBI),
computed as a certain percentage of its demand and time
liabilities. The objective is to ensure the safety and liquidity of
the deposits with the banks.
On the other hand, Statutory Liquidity Ratio (SLR) is the
one which every banking company shall maintain in India in the
form of cash, gold or unencumbered approved securities, an
amount which shall not, at the close of business on any day be
less than such percentage of the total of its demand and time
liabilities in India as on the last Friday of the second preceding
fortnight, as the Reserve Bank of India (RBI) may specify from
time to time.
In the pre reform period prior to 1991, given the command and
control nature of the economy, the Reserve Bank had to resort
to direct instruments like interest rate regulations, selective credit
control and the cash reserve ratio (CRR) as major monetary
instruments. These instruments were used intermittently to
neutralize the monetary impact of the Governments budgetary
operations. The administered interest rate regime during the
earlier period kept the yield rate of the government securities
artificially low. The demand for them was created through
intermittent hikes in the Statutory Liquidity Ratio (SLR). The
task before the Reserve Bank of India was, therefore, to
develop the markets to prepare the ground for indirect
operations. As a first step, yields on government securities were
made market related. At the same time, the RBI helped create an
array of other market related financial products. At the next
stage, the interest rate structure was simultaneously rationalized
and banks were given the freedom to determine their major
rates.
As a result of these developments, RBI could use OMO as an
effective instrument for liquidity management including to curb
short-term volatilities in the foreign exchange market. Another
important and significant change introduced during the period
is the reactivation of the Bank Rate by initially linking it to all
other rates including the Reserve Banks refinance rates (April
1997). The subsequent introduction of fixed rate repo
(December 1997) helped in creating an informal corridor in the
money market, with the repo rate as floor and the Bank Rate as
the ceiling. The use of these two instruments in conjunction
with OMO enabled RBI to keep the call rate within this
informal corridor for most of the time. Subsequently, the
introduction of Liquidity Adjustment Facility (LAF) from June
2000 enabled the modulation of liquidity conditions on a daily
basis and also short term interest rates through the LAF
window, while signaling the stance of policy through changes in
the Bank Rate.
Reforms
It has been possible to reduce the statutory preemption on the
banking system. The Cash reserve Ratio (CRR), which was the
primary instrument of monetary policy, has been brought
down from 15.0 per cent in March 1991 to 5.5 per cent by
December 2001. The medium-term objective is to bring down
the CRR to its statutory minimum level of 3.0 per cent within a
short period of time. Similarly, Statutory Liquidity Ratio (SLR)
has been brought down from 38.5 per cent to its statutory
minimum of 25.0 per cent by october 1997
It has also been possible to deregulate and rationalise the
interest rate structure. Except savings deposit, all other interest
rate restrictions have been done away with and banks have been
given full operational flexibility in determining their deposit and
lending rates barring some restrictions on export credit and
small borrowings. The commercial lending rates for prime
borrowers of banks has fallen from a high of about 16.5 per
cent in March 1991 to around 10.0 per cent by December 2001
CRR
Effective date (i.e. the fortnight beginning from)
CRR on net demand and time liabilities (per cent)
September 18, 2004
4.75
October 2, 2004
5.0
However, the effective CRR maintained by scheduled primary
(urban) co-operative Banks on total demand and time liabilities
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shall not be less than 3.00 per cent, as stipulated under the
Reserve Bank of India Act, 1934.
Interest on cash balances maintained with Reserve Bank of
India under Cash Reserve Ratio
At present, scheduled primary (urban) co-operative banks are
paid interest at the Bank Rate on eligible cash balances
maintained with Reserve Bank under proviso to Section 42 (1)
and 42 (1A) of the Reserve Bank of India Act, 1934. It has now
been decided that with effect from fortnight beginning
September 18, 2004, the scheduled primary (urban) co-operative
banks will be paid interest at the rate of 3.5 per cent per annum
on eligible cash balances maintained with the Reserve Bank of
India under CRR requirement.
Reduction in CRR
Among the unrealized medium-term objectives of reforms in
monetary policy, the most important is reduction in the
prescribed CRR for banks to its statutory minimum of 3.0 per
cent. The movement to 3.0 per cent can be designed in three
possible ways, viz., the traditional way of pre-announcing a
time-table for reduction in the CRR; reducing CRR as and when
opportunities arise as is being done in recent years; and as a one-
time reduction from the existing level to 3.0 per cent under a
package of measures. In the initial years, the first approach was
effective but had to be abandoned when the timetable had to be
disrupted to meet the eruption of global financial uncertainties
and pressures on forex market. Hence, the second approach of
lowering CRR when opportunities arise has been adopted, and
now it has been brought down to 5.5 percent. However, if it is
felt that this approach takes a longer time and a compressed
time-frame is desirable to expedite development of financial
markets, it is possible to contemplate a package of measures in
this regard. The package could mean the reduction of CRR to
the statutory minimum level of 3.0 per cent accompanied by
several changes such as in the present way of maintenance of
cash balances by banks with RBI. With the lagged reserve
maintenance system now put in place, banks can exactly know
their reserve requirements. With the information technology
available with banks and with the operationalisation of Clearing
Corporation of India Ltd. (CCIL) shortly and with the
development of repo market, it would be appropriate if CRR is
maintained on a daily basis. However, till banks adjust to such
changes in the maintenance of CRR, a minimum balance of 95
per cent of the required reserves on a daily basis may have to be
maintained when CRR is reduced to 3.0 per cent. The other
elements of package have to be worked out carefully. Access
Flexibility in the Treatment of CRR
Normally, banks maintain minimum cash in their own vaults
since it is an idle asset, without the benefit of earning any
interest. In the context of date change at the turn of the century,
in order to meet any additional demand for bank notes as a
contingency, banks may have to keep larger vault cash for
meeting their business transactions. At present, such cash in
hand with the bank though an eligible asset for SLR, is not
counted for CRR requirements. To facilitate banks to tide over
the contingency during the millennium change, it has been
decided to treat cash in hand maintained by the banks for
compliance of CRR for a limited period of two months
commencing from December 1,1999 to January 31,2000. It is
clarified here that the cash in hand which will be counted for
CRR purposes, during the above period cannot be treated as
eligible asset for SLR purposes simultaneously.(iii) As already
indicated, for operational convenience, the maintenance of CRR
by banks is being lagged by two weeks. As such, for
maintaining CRR during the fortnight beginning January 1,
2000, the NDTL base would be December 17, 1999. With the
leverage of two weeks available, banks should not have any
problem in complying with the CRR requirement around the
century date change. Nevertheless, any bank that expects a special
problem in meeting its CRR obligations at the end of the year
can approach the RBI for appropriate relaxation/ assistance
Cash Reserve Ratio - Reduction and Rationalisation
The Reserve Bank has been pursuing its medium-term
objective of reducing Cash Reserve Ratio (CRR) to the statutory
minimum level of 3.0 per cent. Taking into account the
progress achieved in the areas of enforcing prudential standards
and operationalising the LAF, RBI has reduced CRR from 11.0
per cent in August 1998 to 5.0 per cent in June 2002 while
withdrawing certain exemptions. Further, the modalities of
CRR maintenance have been rationalised with the introduction
of a lagged (by one fortnight) maintenance system. In addition,
RBI is remunerating the eligible CRR balances maintained by
banks at the Bank Rate. As a further step in this direction of
moving towards the statutory minimum level of CRR, it is
proposed:
To reduce CRR from 5.0 per cent to 4.75 per cent effective from
the fortnight beginning November 16, 2002. (With this
reduction, CRR has been reduced by as much as 3.75 percentage
points over the past two years).
At present, banks are required to maintain a minimum of 50
per cent of the required reserves in the first week and a
minimum of 65 per cent in the second week of the reporting
fortnight. Despite this flexibility given to banks on the daily
maintenance, the actual daily CRR maintenance of majority of
banks in relation to the prescribed level is now quite high. While
moving towards a low CRR, it is necessary that the demand for
bank reserves in the inter-bank market is modulated and the
volatility in CRR maintenance is minimised. In this direction:
Banks will be required to maintain a minimum of 80 per cent
of required CRR amount on a daily basis during a fortnight
with effect from the fortnight beginning November 16, 2002.
The minimum level of 80 per cent would be applicable for all
the days in a reporting fortnight.
Interest on Cash Balances Maintained with RBI
under CRR
At present, all scheduled commercial banks are paid interest at
the Bank Rate on eligible cash balances maintained with RBI
under CRR requirement, without detailed scrutiny by RBI, on
the basis of quarterly interest claim statement submitted by
banks. Such interest payment is made to all banks within one
month after the end of the quarter. Based on the
recommendations of the Regulations Review Authority, it has
been decided to:
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Pay interest on eligible CRR balances on a monthly basis with
effect from April 2003. In order to facilitate this, banks are urged
to put in place proper technology including adoption of the
software package which will help transmission of Form A data
by banks directly to RBI.
Statutory Liquidity Requirement (Slr)
SLR = statutory liquidity ratio. Banks in India are required to
maintain 25 per cent of their demand and time liabilities in
government securities and certain approved securites. These are
collectively known as SLR securities
The RBI has announced a Special Liquidity Support measure
under which banks will be eligible to avail of liquidity to the
extent of their holdings of dated Government of India
Securities/ Treasury Bills over the SLR required to be
maintained. The rate of interest on this facility would be 2.5 per
cent over the bank rate. This means that liquidity will be
available to the banking system at a cost of 10.50 per cent
(present bank rate is 8 per cent). The banking system is
estimated to hold securities in excess of the SLR requirements
to the extent of around Rs 600 billion. Thus, theoretically, this
amount of liquidity will be available to the banking system
during this period. The RBI has also asked those who do not
hold any significant amount of excess SLR, to get into standby
arrangement with banks who hold excess SLR securities.
During this period, the cash held by banks will be counted
towards the maintenance of CRR. Currently, banks holding of
cash in their vaults is reckoned for SLR purposes. It was feared
that during this period, banks may have to hold cash in hand
much in excess of their normal holdings. This would cause a
reduction in the banks balances in their current accounts with
the RBI. The reduced current account balances, which are
reckoned towards maintenance of CRR, could have caused an
additional demand for liquidity. By equating, for CRR
maintenance purposes, the current account balances with the
cash in hand, the RBI has not only dealt with this anticipated
liquidity problem but ensured an additional liquidity of around
Rs 50 billion, which is the current holding of cash with banks.
The RBI has also allowed overseas banks to freely access
liquidity from their respective head offices overseas during this
period.
Statutory Liquidity Ratio of Regional Rural Banks
Regional Rural Banks (RRBs) were required to maintain SLR at
25 per cent of their NDTL in cash or gold or in unencumbered
government and other approved securities. In this regard,
balances maintained in call or fixed deposits by RRBs with their
sponsor banks were treated as cash and hence, reckoned
towards their maintenance of SLR. As a prudential measure, it
was considered desirable on the part of all RRBs to maintain
their entire SLR portfolio in government and other approved
securities. Accordingly, in the annual policy Statement of April
2002, it was decided that all RRBs should maintain their entire
SLR holdings in government and other approved securities by
converting their existing deposits with sponsor banks into
government securities by March 31, 2003. While a number of
RRBs have already achieved the minimum level of SLR in
government securities, some RRBs and their sponsor banks
have expressed difficulty in premature withdrawal of deposits
reckoned for SLR purposes. Accordingly, it has been decided
that:
SLR holdings of RRBs in the form of deposits with sponsor
banks maturing beyond March 31, 2003 may be allowed to be
retained till maturity. These deposits may be converted into
government securities, on maturity, in case the concerned RRBs
have not achieved the 25 per cent minimum level of SLR in
government securities by that time.
Although deposits with sponsor banks contracted before April
30, 2002 would be reckoned for SLR purpose till maturity,
RRBs are advised to achieve the target of maintaining 25 per
cent SLR in government securities out of the maturity proceeds
of such deposits with sponsor banks as well as from their
incremental public deposits at the earliest
The RBI has announced a very strong support system for
anticipated enhanced liquidity needs during the century date
period. All the following measures announced by the RBI
would be valid for the period December 1, 1999 to January 31,
2000
Questions to Discuss:
1. What do you understand by statutory reserve requirement?
2. Explain cash reserve ratio (CRR).
3. Explain statutory liquidity requirement (SLR).
Notes:
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LESSON 21:
CAPITAL ADEQUACY OF REQUIREMENTS
Learning Objectives
After reading this lesson, you will understand
Capital adequacy of banks
Ratio of the paid-up capital to reserve
BIS Standards
Capital adequacy norms
Capital funds
Risk adjusted assets and off-balance sheet items
Foreign exchange and interest rate related contracts
A financial intermediary needs capital to commence its
operations and to continue its existence as a running business.
More so, a financial intermediary needs more capital to act as a
buffer, since the losses if and when they arise, may be
substantial. Capital provides a cushion to absorb possible
losses so that entities dealing with them are protected all the
time. This will help sustain the existence of the intermediary,
which is very vital for proper functioning of the economic
system. The capital will provide a margin of safety that
preferably would allow the intermediary to continue operations
without loss of momentum and at the least, would buy time
in which it may re-establish its operational momentum.
The significance for capital varies depending on the activity of
financial intermediary. A bank needs capital for servicing its
depositors, for maintaining net worth requirements, for
acquiring assets and establishing branch network as per the
requirements, etc. Comparatively for NBFCs is needed for
entering into fund based activities apart form servicing its
depositors and acquisition of assets.
Apart from specifying an entry capital for the intermediaries,
regulatory authorities (warranted by legislations) fixed a
proportion of capital and reserve to assets, on the basis of the
type of intermediary.
These requirements termed as Capital Adequacy Requirements
are specified for banks and for NBFCs in particular, this chapter
will dwell on the Capital Adequacy Requirements as applicable
to Commercial Banks.
Capital Adequacy of Banks
In the Indian context, the capital adequacy of banks is all the
more important in view of existence of nationalized banks and
the social status of bank management. An adequate capital fund
is needed to bring about solidarity, scope, operation and the
ultimate strength to a bank. As important players, involved in
helping of the capital formation in this era of intensive
infrastructural investment, banks need to possess adequate
capital funds to discharge this responsibility.
At the same time, a saver who is depositing his money in a
bank assumes that the risks associated with the investment of
the funds will be borne by this intermediary. Therefore, the
need for possessing healthy capital adequacy requirement is
essential for boosting the confidence of the savers.
If the saver gives money to the bank in the form of a deposit
and if it is insured, it would be the insurer who should be
concerned in the level of equity in the bank.
The following criteria should be used in determining the capital
adequacy of the bank:
Ratio of the Paid-up Capital to Reserve
The size of the reserve of banks in relation to their paid-up
capital is an important index of their financial position and
strength. It is also a pointer to the management policy regarding
the retention of earnings. However, since the banks carry on
their business mainly with the depositors funds, an increase in
the paid-up capital may not keep pace with that in the reserve.
Equity Ratio
Equity Ratio is the ratio of its equity capital over its loans and
investments, where loans and investments means all earning
assets, including loans and government securities.
Capital-Deposit Ratio
The capital-deposit ratio was used in past in the USA and in the
UK to measure capital adequacy. The banking authorities in
India have considered the adequacy of capital in relation to
deposit liabilities. A high capital-deposit ratio is indicative of
the fact that the depositors will face low risks. It has been
recognised by authorities that, with every decline in the ratio of
capital to deposits, the risks of depositors tend to increase
sharply. In the US, in early 20
th
Century banks were asked to
maintain a capital fund equal to 10 percent of its deposit
liabilities as a margin of safety. It should be noted that the
deposits by themselves contain no risks until they are used to
make loans and investments; and the extent of the risk varies
with the character of the assets into which deposits are
converted.
By following the above said thumb-rules, one may have an idea
on the extent of coverage of assets on the liabilities. Here it is
necessary to caution ourselves that it is practically impossible to
determine the capital adequacy of a particular bank or even of
the commercial banking system, since it is not possible to know
the future demand that will be made out of capital. Adequate
capital is desirable and necessary, but capital alone cannot ensure
the safety of a bank and due consideration has to be given to
the quality and character of its assets, the caliber of its
management and its modus operandi.
Capital to Risk-Weighted Assets Ratio
To assess the adequacy of capital based on the quality of assets,
the Capital to Risk-Weighted Assets Ratio (CRAR) or the
Capital Adequacy Ratio (CAR) is now being focused upon.
Introduced in 1988 by the Basle Capital Adequacy Accord, this
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ratio has become the keyword to comment on the stability of a
bank.
BIS Standards
As banking began to spread across nations and competition
began to heat up among banks from varied countries, it became
an unfair game for banks from the country imposing stricter
capital standards as they will be at a competitive disadvantage.
Therefore, a need for uniform capital standards for banks was
felt. As a result, regulators from 13 countries including the US
came together to formulate uniform standards that would
apply to all their banks. These standards, established under the
auspices of the Bank for International Settlements (BIS), an
international clearing bank for central banks, were adopted in
November 1988. The committee has adopted weighted risk
assets approach, which assigns weights to both on off-balance
sheet exposures of a bank according to the perceived risk. While
the framework is being applied by the banking supervisory
authorities in the G-10 countries, the committee has suggested
that the banking supervisory authorities of the non- G-10
countries could also try to adopt the framework, particularly, in
respect of banks conducting significant international business in
their jurisdictions.
Indian Standards: Narasimham Committee
Narasimham committee constituted by the Government of
India, to examine all aspects of banking procedures submitted
its reports in the early 90s. The committee observed that the
capital ratios of Indian banks are generally low and some banks
are seriously undercapitalized. The banks in India should
conform to the standards laid in the Basle Committee on
Banking Regulations and Supervisory Practices appointed by the
BIS in a phased manner. Previously, various groups of banks
were subject to different minimum capital requirements as
prescribed in the statutes under which they were set up and
operate. In addition, it has been prescribed that the foreign
banks operating in India should have foreign funds deployed in
Indian business equivalent to 3.5 percent of their deposits as at
the end of each year. The framework of risk weighted assets
ratio approach to capital adequacy measurement is more
equitable as it requires those institutions with a higher risk
profile to maintain a higher level of capital funds.
Capital Adequacy Norms
As mentioned earlier the Capital Adequacy Ratio is the ratio of
the banks capital to its risk weighted assets. To assess the capital
adequacy of banks based on this ration it is essential to
understand three aspects:
1. Composition of capital
2. Composition of Risk Weighted Assets
3. Assigning risk weights
Capital Funds
The Basle Committee has defined capital in two tiers: Tier I and
Tier II. While Tier I capital is the core capital, which provides the
most permanent and readily available support against
unexpected losses. Tier II capital will consist of element that are
not permanent in nature or are not readily available.
Tier I Capital
Tier I Capital in the case of Indian banks consists of
Paid-up capital
Statutory reserves
Disclosed free reserves
Capital reserves representing surplus arising out of sale
proceeds of assets
i. Equity investment in subsidiaries, intangible assets, and
losses in the current period and those brought forward from
previous periods, will be deducted from Tier I capital.
ii. Elements of Tier I capital in case of foreign banks:
iii. Interest-free funds from head office kept in a separate
account in the Indian books specifically for the purposes of
meeting the capital adequacy norms.
iv. Statutory reserves kept in Indian books.
v. Remittable surplus retained in Indian books which is not
repatriable so long as the banks function in India.
vi. Cap9ital reserve representing surplus arising out of sale of
assets in India held in a separate account and which is not
eligible for repatriation so long as the banks function in
India.
vii. Interest-free funds remitted form abroad for the purposes
of acquisition of property and held in a separate account in
Indian books.
The net credit balance, if any, in the inter-office account with
Head office / overseas branch will not be reckoned as capital
funds. However, any debit balance in Head Office account will
have to be set-off against the capital.
Tier II Capital
Tier II capital for both Indian and foreign banks consists of the
following:
Undisclosed reserves and cumulative perpetual preference
shares often have characteristics similar to equity and disclosed
reserves. These element have the capacity to absorb expected
losses and can be included in capital, if they present
accumulations of post-tax profits and not encumbered by any
known liability and should not be routinely used for absorbing
normal loan or operating losses. Cumulative perpetual
preference shares should be fully paid-up and should not
contain clauses, which permit redemption by the holder.
Revaluation reserves often serve as a cushion against
unexpected losses, but they are less permanent in nature and
cannot be considered as core capital. Revaluation reserves arise
from revaluation of assets that are undervalued in the books,
typically premises, and marketable securities. The extent to
which the revaluation reserves can be relied upon as a cushion
for unexpected losses depends mainly upon the level of
certainty that can be placed on estimates of the market values of
the relevant assets, the subsequent deterioration in values under
difficult market conditions, or in a forced sale, potential for
actual liquidation at those values, tax consequences of
revaluation, etc. Therefore, it would be prudent to consider
revaluation reserves at a discount while determining their value
for inclusion in Tier II capital. The revaluation reserves need to
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be discounted by a minimum of 55 percent when determining
their value for inclusion in Tier II capital. Such reserves will have
to be reflected on the Balance Sheet as revaluation reserve.
General provisions and loss reserves (GPLR) are not
attributable to the actual diminution in value or identifiable
potential loss in any specific asset and are available to meet
unexpected losses; they can be included in Tier II capital.
Adequate care must be taken to see that sufficient provisions
have been made to meet known losses and foreseeable potential
losses before considering general provisions and loss reserves to
be part of Tier II capital. General provisions/ loss reserves will
be admitted up to a maximum of 1.25 percent of weighted risk
assets.
In the category of Hybrid debt capital instruments fall in a
number of capital instruments, which combine certain
characteristics of equity and certain characteristics of debt. Each
has a particular feature which can be considered t affect its quality
as capital. Where these instruments have close similarities to
equity, in particular when they are able to support losses on an
on-going basis without triggering liquidation, they may be
included in Tier II capital.
For Subordinated Debt to be eligible for inclusion in Tier II
capital, the instrument should be fully paid-up, unsecured,
subordinated to the claims of other creditors, free of restrictive
clauses and should not be redeemable at the initiative of the
holder or without the consent of the banks supervisory
authorities. These instruments often carry a fixed maturity and.
As they approach maturity, they should be subjected to
progressive discount for inclusion in Tier II capital. The
subordinated debt instruments should have a minimum
maturity of 5 years and if the instruments are issued in the last
quarter of the year, i.e. form January to March; they should have
a minimum tenure of 63 months. Instruments with initial
maturity of less than 5 years or with a remaining maturity of
one year should not be included as part of Tier II capital. The
interest rate should not be more than 200 bp above the yield on
the Central Government securities of equal residual maturity at
the time of issuing bonds. Subordinated debt instruments will
be limited to 50 percent of Tier I capital. The progressive
amount for various maturities to be included into Tier II capital
is given in the table below:
Remainingtermto maturity Discount rate
1. Wherethedateof maturityisbeyond5
years
2. Where the date of maturity is
beyond4years but does not exceed5
years
3. Wherethedateof maturityisbeyond3
yearsbut doesnot exceed4years

4. Wherethedateof maturityisbeyond2
yearsbut doesnot exceed3years

5. Wherethedateof maturityisbeyond1
yearsbut doesnot exceed2years

6. Where the date of maturity does not
exceedoneyear

0percent

20percent


40percent


60percent


80percent


100percent

In February 1999, RBI has given all scheduled commercial
banks, including the foreign banks operating in India, the
autonomy to raise rupee subordinated debt as Tier II capital,
subject to certain terms and conditions. The instruments that
can be issued should be plain Vanilla type with no special
features like options, etc. Further, all nationalised banks have to
obtain permission from the Government for issuing the
instruments. Permission from RBI is also essential to issue
instruments to NRIs/ OCBs/ FII. RBIs approval is also
necessary for the issue of subordinated debt instruments in
foreign currency or borrowings from head office, to include in
Tier II capital. It is to be noted that investment by banks in the
subordinated debts of the other banks shall be subject to the
ceiling of 5 percent applicable to investments in shares of
corporate bodies and they would be assigned 100 percent of
total of Tier I elements for the purpose of compliance with the
norms.
Risk Adjusted Assets and off-Balance Sheet Items
Risk adjusted assets would mean weighted aggregate of funded
and non-funded items as detailed below. Degrees of credit risk
expressed as percentage weightings have been assigned to
balance sheet assets and conversion factors to of-balance sheet
items. The value of each asset/ item shall be multiplied by the
relevant weights to produce risk-adjusted values of assets and
of off-balance sheets. The aggregate will be taken into account
for reckoning the minimum capital ratio. The weights allotted
to each of the items of assets and off-balance sheet items are
furnished below
Risk Weights on Different Items of Assets and off-
Balance Sheet Items
I. Domestic Operations
A. Funded Risk Assets
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Assets Percentageweight
1. CashandbalancewithReserveBankof India 0
2. Balancesincurrent account withotherbanks 20
3. ClaimsonbanksandPublicFinancial Institutions 20
4. Investments in government securities, other Approved
Securities guaranteed by Central/ State government, other
securities where payment of interest and repayment of
principal areguaranteedbyCentral/ StateGovernment
2.5
In case of a default in interest/ principal by State Government, banks
should assign 100 percent risk weight on investments in securities of
theconcernedStateGovernment

5. Investments in other approved securities where payment of
interest and repayment of principal are not guaranteed by
Central/ StateGovernment
20
6. Investments in Government Guaranteed Securities of
Government undertakings which do not form part of the
approvedmarket borrowingprogram
20
7. Investmentsinbondsissuedbyotherbanks/ PFIs 20
8. Investments in securities which are guaranteed by banks or
PFIsasto payment of interest andrepayment of principal
20
9. Investments in subordinated debt in the form of Tier II
Capital Bondsissuedbyotherbanks/ PFIs
100
10. All otherinvestments 100
11. Loans andadvances includingbillspurchasedanddiscounted
andothercredit facilities
12. LoansguaranteedbyGovernment of India/ StateGovernment
13. In cases where guarantees have been invoked and the
concerned state Government has remained in default as on
31-03-2000, a risk weight of 20 percent on such advances
should beassigned. If StateGovernments continueto bein
default inrespect of suchinvokedguaranteesevenafter31-03-
2001, ariskweightof 100percentshouldbeassigned
14. Loans granted to public sector undertakings of Government
of India/ StateGovernment
15. Others



0













100


100
16. Premises, furnitureandfixtures 100
17. Other assets 100

Notes
1. Netting may be done only for advances collateralized by cash
margins or deposits credit balances in current or other
accounts which are not earmarked for any specific purpose
and free from any lien in respect of assets where provisions
for depreciation or for bad and doubtful debts have been
made.
1A for the purpose of computing risk adjusted values of
assets, banks may net off against the total outstanding
exposure of the borrower, the following items also:
i. Claims received from DICGC/ ECGC and dept in a
separate account pending adjustment
ii. Subsidies received against IRDP advances and kept in a
separate account.
2. Equity investments in subsidiaries, intangible assets and
losses deducted from Tier I capital should be assigned zero
weight.
3. Advances covered by the guarantee of DICGC / ECGC may
be assigned the risk weight of 50 percent. The risk weight of
50 percent should be limited to amount guaranteed and not
the entire outstanding balance in the accounts.
4. Advances against term deposits, life insurance policies, life
insurance policies, National Saving Certificates, Indira Vikas
Patras and Kisan Vikas Patras where adequate margin is
available, would carry zero risk weight.
5. Loans to staff of banks would also carry zero risk weight.
6. The under noted accounting heads should be assigned zero
risk weight under other assets:
a. Income tax deducted at source (net of provision)
b. Advance tax paid (net of provision);
c. Interest due on Government securities;
d. Accrued interest on CRR balances and claims on the
Reserve Bank on account of Government transactions (net
of claims of Government / Reserve Bank on banks on
account of such transactions).
7. The investments in subordinated debt instruments and
bonds issued by other banks or Public Financial Institutions
for their Tier II capital would carry 100 percent risk weight.
7A. Foreign exchange open position limit should carry 100
percent risk weight with effect from 31-3-1999. Open position
limit in gold should also carry 100 percent risk weight with effect
from 31-3-1999. Risk weights both in respect of foreign
exchange and gold open position limits should be added to the
other risk weighted assets for calculation of CRAR.
B. Off-Balance Sheet Items
The credit risk exposure attached to off-balance sheet items has
to be first calculated by multiplying the face amount of each of
the off-balance sheet items by the credit conversion factor as
indicated in the table below. This will have to be again
multiplied by the weights attributable to the relevant
counterparty as specified above.
Instruments Credit conversion factor
1. Direct credit substitutes, e.g. general
guarantees of indebtedness (including
standby letters of credit serving as
financial guarantees for loans and
securities) and acceptances (including
endorsements with the character of
acceptances)
100
2. Certain transaction-related contingent
items (e.g. performance bonds, bid
bonds, warranties and standby letters
of credit related to particular
transactions)
50
3. Short-termself-liquidatingtrade-related
contingencies such as documentary
credits collaterised by the underlying
shipments
20
4. Sale and repurchase agreement and
asset sales with recourse, where the
credit riskremainswiththebank
100
5. Forward asset purchases, forward-
deposits and parity paid shares and
securities, which represent
commitmentswith certain drawdown
100
6. Note issuance facilities and revolving
underwritingfacilities
50
7. Other commitments with an original
maturity of over oneyear (e.g. formal
standbyfacilitiesandcredit lines)
50
8. Similar commitments with an original
maturityup to oneyear, or which can
be unconditionally canceled at any
time.
0
9. Aggregate outstanding foreign
exchangecontractsof original maturity.

Of lessthanoneyear 2
Foreachadditional yearorpart thereof 3

Notes
1. Cash margins/ deposits shall be deducted before applying
the conversion factor.
2. After applying the conversion factor as indicated above, t he
adjusted off-balance sheet value shall again be multiplied by
the weight attributable to the relevant counterpart as
specified above.
3. In regard to off-balance sheet items, the following
transactions with non-bank counterparties would be treated
as claims on banks and carry a risk weight of 20 percent.
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a. Guarantees issued by banks against the counter
guarantees of other banks;
b. Rediscounting of documentary bills accepted by banks.
Bills discounted by banks, which had been accepted, by
another bank would be treated as a funded claim on a
bank.
4. Foreign exchange contracts with an original maturity of 14
calendar days or less, irrespective of the counterparty, may be
assigned zero risk weight as per international practice.
II Overseas operations (applicable only to Indian banks
having branches abroad)
A. Funded Risk Asset
Assets PercentageWeight
1. Cash 0
2. Balancewith monetaryauthority 0
3. Investmentsin government securities 0
4. Balances in current account with other
banks
20
5. All other claimson banksincludingbut
not limited to funds loaned in money
markets, deposit placements,
investmentsin CDs, FRNs, etc
20
6. Investment in non-banksectors 100
7. Loans and advances, bills purchased
and discounted and other credit
facilities

a. Claimsguaranteed byGOI 0
b. ClaimsguaranteedbyStateGovernments 0
c. Claimson publicsectorundertakingsof GOI 100
d. Claims on public sector undertakings of State
Governments
100
e. Others 100
8. All other banking and infrastructural
assets
100

Notes
1. Netting may be done only for advances collateralized by cash
margins or deposits and in respect of assets where
provisions for depreciation or for bad and doubtful debts
have been made.
2. Equity investments in subsidiaries, intangible assets and
losses deducted from Tier I capital should be assigned zero
weight.
3. The investments in subordinated debt instruments and
bonds issued by other banks or Public Financial Institutions
for their Tier II capital would carry 100 Percent risk weight.
4. Advances covered by the guarantee of DICGC/ ECGC may
be assigned the risk weight of 50 percent. The risk weight of
50 percent should be limited to amount guaranteed and not
the entire outstanding balance in the accounts.
5. Advances against term deposits, life insurance policies,
National Saving Certificates, Indira Vikas Patras and Kisan
Vikas Patras where adequate margin is available would carry
zero risk weight.
6. Loans to staff of banks would also carry zero risk weight.
7. The under noted accounting heads should be assigned zero
risk weight under Other Assets
a. Income tax deducted at source (net of provision);
b. Advance tax paid (net of provision);
c. Interest due on Government securities;
d. Accrued interest on CRR balances and claims on the
Reserve Bank on account of Government transactions
(net of claims of Government/ Reserve Bank on banks on
account of such transactions).
B. Non-funded Assets
Instruments Credit conversion factor(percent)
1. Direct credit substitutes and
acceptances
100
2. Certain transaction-related contingent
items
50
3. Short-termself-liquidatingtrade-related
contingencies
20
4. Sale and repurchase agreement and
asset sales with recourse, where the
credit riskremainwiththebank
100
5. Forward asset repurchase, forward
repurchases, forward deposits and
partly paidshares and securities which
represent commitments with certain
drawdown
100
6. Note issuance facilities and revolving
underwritingfacilities
50
7. Other commitments with original
maturityof overoneyear
50
8. Similar commitments with an original
maturity up to oneyear, or which can
beunconditionallycanceledat anytime
0

Note
Cash margins/ deposits shall be deducted before applying the
conversion factor. After applying the conversion factor as
indicated above, the adjusted off-balance sheet value shall again
be multiplied by the weight attributable to the relevant
counterparty as specified in funded risk assets above.
Foreign Exchange and Interest Rate Related
Contracts
Foreign exchange contracts include the following:
i. Cross-currency interest rate swaps
ii. Forward foreign exchange contracts
iii. Currency futures
iv. Currency options purchased
v. Other contract of a similar nature
As in the case of other off-balance sheet items, a two-stage
calculation prescribed below shall be applied.
Step 1
The notional principal amount of each instrument is multiplied
by the conversion factor given below:
Original Maturity Conversion Factor
Less than oneyear 2
Between oneand two years 5
For each additional year 3

STE
Setp 2
The adjusted value thus obtained shall be multiplied by the risk
weightage allotted to the relevant counterparty as given in
funded risks above.
Interest rate contracts
Interest rate contracts include the following:
i. Single currency interest rate swaps
ii. Basis swaps
iii. Forward rate agreements
iv. Interest rate futures
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v. Interest rate option purchased
vi. Other contracts of similar nature
Step 1
The notional principal amount of each instrument should be
multiplied by the percentage given below:
Original Maturity Conversion Factor
Lessthan oneyear 0.5
Between oneand two years 1.0
For each additional year 1.0

Step 2
The adjusted value thus obtained shall be multiplied by the risk
weightage allotted to the relevant counterparty as given in II A
above.
Maintenance of CRAR
After assessing the capital funds and the risk weighted assets,
the bank will have to compute the ratio of the capital to risk
weighted assets. The minimum CRAR was initially set at 8
percent. However, to meet the international standards, this is
being raised to 9 percent with effect from March 31, 2000.
Reporting
Banks should furnish an annual return commencing form the
year ended March 30, 1992, indicating:
a. Capital funds
b. Conversion of off-balance sheet/ non-funded exposures
c. Calculation of risk weighted assets and
d. Calculation of capital funds ratio.
The format for the returns is given as a break-up and aggregate
in respect of domestic and overseas operation will have to be
furnished. The returns should be signed by two official who are
authorized to sign the statutory returns submitted to the RBI.
Summary
The minimum capital adequacy requirement is given statutorily
by RBI. This minimum level is aimed to bring global standards
into the Indian markets. And as the global operations of the
Indian banks increase, it is essential for banks to meet these
standards. Apart from this advantage, banks will also have a
proper banking of their capital for the risks they face while
operating in the ever changing market environment.
Questions to Discuss
1. Discuss Capital Adequacy Norms.
2. What are foreign exchange and interest rate related contracts?
3. What do you understand by risk adjusted assets and off-
balance sheet items?
Notes:
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LESSON 22:
TUTORIAL-3
Notes:
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UNIT 4
DIFFERENT BANKING ASPECTS
LESSON 23:
COOPERATIVE BANKS
Learning objectives
After reading this lesson, you will understand
Introduction
Central Cooperative banks
State or provincial cooperative banks or apex banks
Agricultural credit-intensive development scheme
The agricultural refinance and development corporation
Nabard
Cooperative banks, another component of the Indian banking
organisation, originated in India with the enactment of the
cooperative credit societies act of 1904, a number of cooperative
active credit societies. Under the act of 1904, a number of
cooperative credit societies were started. Owing to the increasing
demand of cooperative credit, a new act was passed in 1912,
which provided for the establishment of cooperative central
banks by a union of primary credit societies or by a union of
primary credit societies or by a union of primary credit societies
and individuals.
The chief functions of these banks were: (1) attracting deposits
from non-agricul-turists, (2) using excess funds of some
societies temporarily to make up for shortage in other arid (3) to
supervise and guide the affiliated societ-ies. In 1914, the Mac
lagan Committee was appointed to examine the cooperative
movement and to make recommendations regarding the
improvement of the movement. It recommended the
establishment of a State Cooperative Apex Bank. On this
recommendation a Central Coop-erative Bank was established
in Bombay. Other provinces also took ac-tion on similar lines.
Although these may be considered as the early beginnings in the
direction of establishing cooperative banks to meet the financial
needs of agriculturists, the movement received momentum
only after the Second World War.
Cooperative banking India is federal in its structure. At the
lower rung, there are primary credit societies, then there are the
central unions or central cooperative banks and at the top there
are the Provincial Cooperative Banks or State Cooperative
Banks, otherwise known as Apex banks. The primary
societies may be compared with joint banks. Their main
function is that of lending money to villagers on easier terms.
Much of their work is done by members themselves on an
honorary basis. They have their own funds supplemented by
funds drawn from the Central Cooperative Banks through the
banking unions where such unions exist. The Banking unions
are federations of primary societies and they act as either
coordinating unions or supervisory unions between primary
societies and central cooperative banks. The central cooperative
banks obtain the funds from share capital, deposits, loans from
the apex banks, and where apex banks do not exist, from the
Reserve Bank Of India and commercial banks. The apex banks
or state cooperative banks obtain their funds from share capital,
deposits, loans from commercial banks, the Reserve Bank of
India and the Government.
Characteristics of Co-operative Banks
Some distinguishing characteristics of the nature of co-
operative banks are as follows:
1. They are organised and managed on the principles of co-
operation, self-help, and mutual help. They function with the
rule of one member one vote.
2. They function on no profit no loss basis. For commercial
banks also, profitability is no longer the main objective, but
in their case this change has been brought about as a result
of social or public policy, while co-operative banks, by their
very nature, do not pursue the goal of profit maximisation.
3. Co-operative banks perform all the main banking functions
of deposit mobilisation, supply of credit and provision of
remittance facilities. However, it is said that the range of
services offered is narrower and the degree of product
differentiation in each main type of service is much less in
the case of co-operative banks, compared to commercial
banks. In other words, co-operative banks are characterised
by functional specialization. It should be added that this is
true, with much less force now, because many changes have
taken place in the co-operative banking system since the
Banking Commission arrived at the above-mentioned
conclusion. For example, co-operative banks now provide
housing loans also. The UCBs provide working capital loans
and term loans as well. The State Co-operative Banks (SCBs),
Central Co-operative Banks (CCBs) and Urban Co-operative
Banks (UCBs) can normally extend housing loans upto Rs
lakh to an individual. The scheduled UCBs, however, can
lend upto Rs 3 lakh for housing purposes. The UCBs can
provide advances against shares and debentures also.
4. As said earlier, co-operative banks do banking business
mainly in the agricultural and rural sector. However, certain
types of banks viz., UCBs, SCBs and CCBs operate in semi-
urban, urban, and metropolitan areas also. The urban and
non-agricultural business of these banks has grown over the
years. The co-operative banks demonstrate a shift from rural
to urban, while the commercial banks, from urban to rural.
5. Co-operative banks are perhaps the first government-
sponsored, government-supported, and government-
subsidised financial agency in India. They get financial and
other help from the RBI, NABARD, central government and
state governments. They constitute the most favoured
banking sector with no risk of nationalisation. For
commercial banks, the RBI is a lender of last resort, but for
co-operative banks, it is the lender of first resort, which
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provides financial resources in the form of contribution to
the initial capital (through state governments), working
capital, and refinance. The promotional role Of the RBI can
be seen in respect of co-operative banks, and this role
supersedes its regulatory role, in respect of these banks.
A corollary of governments help to co-operative banks is that
there is much government intervention in their working. Co-
operative banks are subject primarily to the control, audit,
supervision and periodic inspection of the co-operative
department of the state government under the Co-operative
Societies Act, but less rigorously, by the RBI under the Banking
Regulation Act. The RBI and the state government lay down
rules for investment of surplus resources, reserves, and the loan
policy of co-operative banks. Consequently, compared to
commercial banks, they have less freedom and flexibility in
conducting their operations.
6. Cooperative banks belong to the money market as well as to
the capital market. Primary agricultural credit societies provide
short-term and medium-term loans. Land Development
Banks (LDBs) provide long-term loans, UCBs meet working
capital as well as fixed capital requirements, and SCBs and
CCBs also provide both short-term and term loans.
Similarly, they accept short-term and long-term deposits, and
some of them mobilise resources through the issue of
debentures.
7. Co-operative banks are financial intermediaries only partially.
The sources of their funds (resources) are: (a) central and
state governments, (b) the RBI and NABARD, (c) other co-
operative institutions, (d) ownership funds, and (e) deposits
or debenture issues. It is interesting to note that intra-
sectoral flows of funds are much greater in co-operative
banking than in commercial banking. Inter-bank deposits,
borrowings, and credit form a significant part of assets and
liabilities of co-operative banks. This means that intra-
sectoral competition is absent and intra-sectoral integration is
high for co-operative banks.
However, co-operative banks face stiff competition from
commercial banks and other financial intermediaries. Till their
nationalisation, commercial banks did not pose any
competition to co-operative banks. In fact, till then, certain areas
of operations were deliberately left to co-operative banks. But
recently, the competition from LIC, UTI, and small-savings
organisation has become quite tough, and co-operative banks
are in a disadvantageous position in this area of inter-sectoral
competition.
8. Co-operative banks have a federal structure of three-tier
linkages. Further, their operation is of mixed banking type.
Primary credit societies are unit banks; many DCBs also are
unit banks. But SCBs, DCBs (CCBs), and SLDBs, PLDBs
and many DCBs have a number of branches. Subject to this,
it can be said that each co-operative institution in each tier is a
separate entity with definite jurisdiction and has an
independent board of management.
9. Some co-operative banks are scheduled banks, while others
are non-scheduled banks. For instance, SCBs and some
DCBs are scheduled banks but other co-operative banks are
non-scheduled banks. At present, 28 SCBs and 11 DCBs
with Demand and Time Liabilities over Rs 50 crore each are
included in the Second Schedule of the RBI Act.
10. As said earlier, co-operative banks accept current, saving, and
fixed or time deposits from individuals and institutions
including banks. Some DCBs numbering about 40 in 1989
are allowed to open and maintain NRI accounts in rupees
but not in foreign currency. Deposits mobilized by them in a
given area are used for financing activities in that locality.
Some co-operative banks, namely, Land Development Banks
(LDBs), issue debentures to raise resources for their
operations. These debentures are secured by mortgaging
lands belonging to borrowers from LDBs and are often
guaranteed by the state government are regarded as trustee
securities and are treated on par with government securities
for making advance. There are three types of such
debentures: ordinary, rural, and special. These debentures are
almost entirely subscribed by such institutional investors as
banks, LIC, and the government.
Types, Structure and Growth of Co-Operative Banks
The following figure present the structure and progress of co-
operative banking in India.

As said earlier, the co-operative banking structure is federal in
character, with three-tier linkages between state, district and
village level institutions. At the state level, we have State Co-
operative Banks (SCBs) and the State Land Development Banks
(SLDBs); at the district level, the Central Co-operative Banks
(CCBs) or the District Central Co-operative Banks (DCCBs) and
the Central Land Development Banks (CLDBs); then at the
village level, the Primary Agricultural Credit Societies (PACSs),
the Primary Land Development Bank (PLDBs), and the
branches of SLDBs. The lower tiers are members and
shareholders of the immediate higher tier. Besides, there are the
Urban Co-operative Banks (UCBs) or the Primary Cooperative
Banks (PCBs), which are outside this federal structure. Though
federal in its organisational structure, the system is integrated
vertically on the basis of functional responsibilities of various
components of the system. The SCBs, CCBs and PACSs form
the short-term and medium-term credit structure and it is the
same in all the states. The land development banks at various
levels make the long-term credit structure, which is not uniform
in all the states.
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The state level co-operative banks are said to be the apex
institutions in this federal structure However, the apex
institutions from the point of view of promotion, supply of
resources, supervision and control, are the government, RBI,
NABARD, and National Co-operative Bank of India (NCBI).
The SCBs and SLDBs are in an intermediate position between
the institutions just mentioned on the one hand, and the co-
operative banks on the other.
The SCBs co-ordinate and regulate the working of CCBs. They
act as custodians of surplus funds of the CCBs and
supplement them by attracting deposits and by obtaining loans
from the RBI. The CCBs mobilise resources in districts to
finance their members, and they also charnels funds from the
SCBs to primary credit societies. The PACSs at the village1evel
form the base of the co-operative_ banking. Although they are
expected to be multi-purpose societies, they mostly deal in
credit.
Problems and Policy
As in the case of commercial banks, the quantitative growth of
co-operative banks has not been accompanied by a qualitative
growth. There have always been a number of weaknesses in
their performance. Many of these weaknesses were identified by
the All India Rural Credit Survey Committee (AIRCSC) in the
early 1950s. By that time, co-operative banks had been in the
business for 45 years and the AIRCSC had concluded that co-
operatives had failed, but that they must succeed. As a result,
special measures were introduced by the government and the
RBI to revive and strengthen co-operative banks. Even after a
span of 50 years, an assessment of the co-operative banks
shows that many of the weaknesses of the co-operative credit
system identified by the Rural Credit Survey Committee
continue to persist.
The Khusro Committee asserts: No credit system has been
subjected to as much experimentation at the dictates of those
outside the system as the co-operative credit system has
beenThe history of co-operative credit system has been the
history of alternating periods of growth, stagnation and
reorganization and yet quantitatively the achievements of the
co-operative systems have by no means been insignificant
Thus looking to the stake of the movement even in the limited
sphere of credit, the classic assertion of the Rural Credit Survey
made 35 years ago still seems valid that Co-operation has failed
but Co-operation must succeed

The main weaknesses of co-operative banks are as follows:

The vital link in the co-operative credit system namely, the
PACSs, remain very weak. They are too small in size to be
economical and viable; besides too many of them are
dormant, existing only on paper.
With the expanding credit needs of the rural sector, the
commercial banks have come in actively to meet the credit
requirements of this sector, and this has aggravated the
difficulties of co-operative banks. The theory that co-
operative banks would be buoyed up by the competition
from other financial institutions does not appear to have
worked.
Co-operative banks are not doing well in all the states; only a
few account for a major part of their business.
These banks still rely very heavily on referencing facilities
from the government, the RBI, and NABARD. They have
yet not been able to become self-reliant in respect of
resources through deposit mobilisation.
They suffer from dangerously low or weak quality of loan
assets, and from highly unsatisfactory recovery of loans.
They suffer from infrastructural weaknesses and structural
flaws. They do not look like banks and do not inspire
confidence in the potential members, depositors and
borrowers.
They suffer from too much officialisation and politicisation.
Undue governmental interventions have prevented them
from developing steadily as a self-reliant and resilient credit
system.
Central Cooperative Banks
The Central Cooperative Banks are independent units inasmuch
as the provincial cooperative banks have no powers to control
or supervise the affairs of central banks. They are of two kinds
viz pure and mixed. Those banks; the membership of which
is confined to cooperative organisations, only are Included in
the pure type, while those banks, the membership of which is
open to cooperative organisations as well as to individuals, ate
included in the mixed type. The Pure type of central banks can
be seen in Kerala, Bombay, Orissa, etc, while the mixed type can
be seen in the case of Andhra, Assam, Chennai, Mysore, etc.
The pure type of banks is based on strict cooperative principles,
while the mixed type does not adhere to any such strict
principles. However, the latter has an advantage over the former
in so far as they can draw their funds from the non-agricultural
section, too. But by allowing individuals to hold shares, loan
facilities are necessarily extended to them; and in case some of
them happen to be middlemen, who may utilise the proceed
of the loan to carry on their trading operations, then it would
be a hard blow on the very basic principles of cooperation,
which strive for the elimination of middle-men.
As mentioned earlier, the central cooperative banks draw their
funds from share capital, deposits, loan from the State
Cooperative Banks and where the State Banks do not exist,
from the Reserve Bank and other commercial banks: The main
function of the central banks is to finance the primary credit
societies. In addition to this, they carry on commercial banking
activities like acceptance of deposits, the giving of loans and
advances on the sculpt of first-class gilt-edged securities, fixed
deposit receipts, gold, bullion, goods and documents of title to
goods, the col-lecting of bills, cheques, handles, the receiving of
valuables for safe cus-tody and the performance of services as
an agent to the customer to purchase and sell securities etc. They
also act, as balancing centres making available temporary excess
funds of one primary to another, which is in need of them.
Defects of the working of the cooperative banks are not likely
to pass uncensored. The linking of commercial banking
activities with the central banks is often pointed out as against
the principles of coopera-tion. But it should be remembered
that the volume of work is not enough to keep these
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institutions fully occupied. The inadequacy of share capital has
been characterised as the Achilles heel of the central banks. It is
also said that these banks do not maintain expert staff of
examine the credit-worthiness of the primary societies, thereby
leading to accumulated overdues. Another criticism raised by the
Royal Commission on Agricul-ture was that the central banks
combined both the financing and supervi-sory work. They
recommended that the financing and supervisory work should
be separated, contending that the supervisory work of central
banks had been a failure. But against this, it may be argued that
since the central banks are to finance the primary societies the
supervisory work should be entrusted to them inasmuch as it is
their concern to see that primary credit societies are working in
order.
Further it has been found that certain cooperative central banks
are utilising the reserves funds as working capital. This is
definitely against fundamental principles, which will affect
adversely the working of these banks in the final end. It is
highly necessary that adequate reserves should be built up and
kept apart from working capital so that it may be used only in
times of emergencies.
The case against mixed societies has already been discussed in
detail. But at present, the mixed type of societies is inevitable,
since to raise enough capital from the agricultural masses itself
is not possible, because of their poor resources. So the aim
should be to convert the mixed societies into pure societies step
by step as the income of the agricultural masses increases so
that after a certain stage we can dispense with the mixed
societies.
Further, the lending rates of these banks arc said to be very
high. The high administrative costs of small and uneconomic
units of central cooperative banks, the difficulty experienced in
raising the necessary funds from the Money Market at low rates
of interest and the problem of raising enough local funds have
forced the central banks to charge high rates of interest. But in
order to make cooperative finance popular among agriculturists
and to make the movement a crowning success, the rates of
lending should necessarily be brought down. To reduce the
rates of inter-est, the Reserve Bank of India has suggested
certain measures such as strengthening the cooperative
movement and improving its efficiency, the mobilising of rural
savings and amalgamating of small uneconomic units into
viable units. The state governments can also add their
contribution in this direction by giving subsidies to the central
banks during the initial stages so that the loss arising from
charging low rates of interest may be compensated.
Recent trends in the working of central cooperative banks
indicate that there is a decline in their number, as a result of
amalgamation and reorganization of central banks with the
object of having one song central banks for each district. The
owned funds, apart from the bor-rowed funds, of these banks
show an overall increase during recent years. However, it is
deplorable that many of them were not able to reach the
standard of Rs. 3 lakhs per bank prescribed by the Standing
Advisory Committee on Agricultural Credit as a desirable
minimum limit of owned capital. In the matter of overdues,
there is a decline in the propor-tion of overdues to loans
outstanding, but this is mainly owing to a substantial increase
in fresh advances resulting in a Outspending in-crease in
outstanding.
State or Provincial Cooperative Banks or Apex Banks
State Cooperative Bank means the principal society in a state
which is registered or deemed to be registered under the
Government Societies Act, 1912, or any other law of the time
being in force in India relating to cooperative societies and the
primary object of which is the financing of the other societies in
the state which are registered or deemed to be registered. In
addition to such a principal society in a state or where there is no
such principal society in a state, the State Government may
declare anyone or more cooperative societies carrying on
business in that State to be a state cooperative bank (or banks).
As in the case of central banks the state cooperative banks may
be pare in which case, it will be a federation of central
cooperative banks only, or mixed in which case it will be a
federation of both central cooperative banks as well as
individual members. The state banks re-ceive current and fixed
deposits from its constituent banks as well as savings deposits
and fixed deposits from the general public and from local
boards, municipalities, etc. Further they receive loans at call and
short notice from the commercial banks at current rates of
interest and seasonal loans from the Reserve Bank of India to
finance seasonal agricultural operations. The State Governments
contribute a certain portion of their working capital.
The principal function of the state banks is to assist the central
banks and to balance excess and deficiencies in the resources of
central banks.
This function of the Apex bank to act as a balancing centre is
important since direct lending is prohibited among the central
banks. The connec-tion between the state banks and the
primary cooperative societies is not direct. The central banks are
acting as intermediaries between the Apex banks and primary
societies. Of course, in the absence of a central bank. The state
cooperative bank may act as a central bank and in that case its
connection with the primary societies will be direct.
The working of state banks is not free from complaints. Most
of the companies leveled against the central cooperative banks
are also valid against the state cooperative banks. Among them,
the important are the undesirability of linking commercial
banking activities with cooperative banking, inadequacy of share
capital, utilisation of reserve funds i as working capital and the
policy in allowing individuals to become share-holders of the
banks, which is against cooperative principles.
Agricultural Credit-Intensive Development Scheme
The ACID scheme was conceived with a view to concentrating
efforts on a selective basis to strengthen the co-operative
structure and link the credit programme with production
programmes. The scheme was ap-proved by the Reserve banks
Agricultural Credit Board in December 1976 and received the
support of the State Governments, All India Fed-eration of
State Co-operative Banks, the Planning Commission and the
Union Ministry of Agriculture, and other concerned agencies.
Under the first phase of the scheme, 41 districts (including
SFDA and DP AP dis-tricts) in 16 States have been selected for
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intensive credit development in various sectors of the rural
economy. Some of the important criteria followed in the
selecting the 41 districts were: (a) the districts which have scope
for development and a reasonable strong co-operative credit
structure; (b) the central co-operative banks of the district
should not have heavy overdues (i.e. ordinarily these should be
less than 40 per cent (c) existence of SFDA and DPAP schemes;
and (d) the districts where regional rural banks were not
functioning (though in a few districts, some parts of the
districts were covered by regional rural banks).
In particular, the central co-operative banks in these districts will
have the following main objectives viz., (I) to improve their
organisational and operational effectiveness; (2) to create an
awareness for grow III and need for diversification; (3) to build
up own resources and manpower so as to ensure gradual
independence from outside help; (4) to progressively
professionalism their managements and (5) to bring about
orientation of policies towards benefiting the common
interests of the rural population, especially the weaker ones.
The selection of the districts for the scheme was done in
consultation will the State Governments at a 2-day meeting in
Bombay in January 1977, Subsequently, four zonal meetings Of
senior officers of the State Governments, the Chairman and the
Chief Executive Officers of the state Co-operative Banks and
land development banks were held at Bombay, Madras, Calcutta
and New Delhi during February and March I 977 for explaining
the objectives of the scheme. As envisaged under the scheme,
quick surveys of the selected districts in 16 States were
conducted to collect basic data for preparation of district credit
plans for the districts.
Action programmes to be implemented during kharif 1977
were also prepared for the selected districts. Preliminary
guidelines were prepared for the formulation of district credit
plans and arrangements made to prepare such plans in one
district of each of the four zones in the country in the first
instance. Steps were also initiated to ensure full co-ordination
with commercial banks so that at the district level, where these
banks work as lead banks, duplication of efforts may be
avoided.
A sub-committee was set up by the Agricultural Credit Board in
its meeting held on IS July 1977 with Prof. M.L. Dantwala as
chainman to guide the Reserve Bank in matters of policy and
implementation. The main activity during 1977 -7S, under the
scheme pertained to the prepara-tion of Credit and Action
Programmes for the selected districts. In the programmes an
effort is made to: (1) identify the on-going bankable schemes
financed by various agencies and also that might be fom1ulated
in the near future, (2) assess their credit requirements in a
realistic man-ner, (3) suitably adjust the credit programmes of
the concerned financial institutions operating in the district, and
(4) specify the action that is necessary to implement the
programme,
Such programmes have already been prepared in respect of
various districts. In pursuance of the schemes objective to
strengthen the banks organizationally, staffing pattern studies
of state co-operative banks and the central co-operative banks
have also been undertaken in various States in consultation with
the concerned State Governments As decided by the sub-
committee in its second meeting held in April 1978, top priority
under the Action Programme is being given to (1) reduction of
overdues, (2) full coverage of small farn1ers and (3) increase in
borrow-ing members.
Since the introduction of the Scheme, there have been certain
developments requiring a review of the Scheme, The lead banks
have been advised to tern1inate the existing plans by December
1979 and formulate fresh District Credit Plans for their lead
districts from January 19S0 and Annual Action Plan by
December each year. The District Credit Plans would be a
comprehensive credit plan for the District and would indicate
total credit outlays (sector-wise, scheme-wise and institution-
wise) for technically feasible and economically viable schemes for
financing pro-duction and investments by the bank. Co-
operatives, among other finan-cial institutions, are also
participating agencies in the formulation and implementation
of the plans. In the context of these developments it has been
decided to integrate the ACID Programme with District Credit
Plans from 1980 onwards.
The Agricultural Refinance and Development
Corporation
In the sphere of long-term agricultural credit, an important
development during the Third Five Year Plan had been the
establishment of the Agri-cultural Refinance Corporation. The
Plan elaborated the functions of the Corporation in the
following terms.
The Corporation will purchase debentures floated by central
land mortgage banks in the normal course and will also provide
funds for schemes for increasing agricultural production which
are remunerative in character, but involve considerable invest-
ment or long periods of waiting, such as rubber, coffee, cashew
nut and areca nut plantations, irrigation, contour-bonding and
soil conservation, and development of orchards and fruit
gardens. The loans advanced by the corporation will be chal-
lenged through the Central Land Mortgage Banks.
The functions of the Corporation have since been transferred to
the National Bank for Agriculture and Rural Development.
National Bank for Agricultural and Rural
Development (Nabard)
NABARD started its operations in November 1982 by taking
over the developmental and refinancing functions of the
Agricultural Refinance and Development Corporation on the
one hand and the Reserve Bank of India on the other. The
National Bank was organised with the basic objective of
establishing an apex institution in the field of agricultural and
rural development finance in such a way as to integrate the
financing of various institutions involved the development of
rural areas.
The Bank has all authorised capital of Rs. 500 crores and a paid
up capital of Rs. 100 crores. Its paid up capital is shared equally
by the Government of India and the Reserve bank of India. It
can augment its resources by drawing funds from the Central
Government, the State Governments. The Reserve Bank,
international agencies including the World Bank Group and by
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raising funds from the market through bonds and debentures.
In addition the resources of the National Agricultural (Long
Term Operations) and the National Agricultural (Stabilisation)
Funds of the Reserve Bank stand transferred to the National
Rural Credit (Long Term Operations) and the National Rural
Credit (Stabilisation) Funds of the NABARD. It can also
borrow from the Reserve Bank for financing its short term
lending operations. In short, the Bank is well equipped with
adequate financial resources to meet its commitment in the field
of agricultural and rural development.
The management or the Board is vested in a Board of Directors
consisting of the following members.
a. A Deputy Governor of the Reserve Bank as Chairman.
b. Three nominees of the Reserve Bank.
c. Three nominees of the Central Government.
d. Three members, two Wit1l experience in cooperative banking
and one in commercial banking.
e. Two nominees of the State Governments.
f. Two experts in rural economics and rural development.
g. A managing director.
h. One or more whole time directors.
Functions
NABARD performs all the functions performed by the
erstwhile Agricultural Refinance and Development Corporation
as well as those performed by the Agricultural Credit
Department of the Reserve Bank in the field of agricultural and
rural credit. These include:
(i) provision of short term, medium term and long tem1
financial assistance of Land Development Banks, State
Cooperative Banks, RRBs, and commercial banks for
promoting agricultural and rural development:
(ii) provision of long term loans to State Governments for a
peri0d Upl.0 20 years for contribution to the share capital of
cooperative credit institutions;
(iii) provision of long term loans to any institutions approved
by the Central Government:
(iv) contribution to the share capital or ordinary rural
debentures issued by any institution involved in agricultural
and rural development:
(v) provision of necessary resources by way of refinance to the
primary lenders including State Cooperative Banks,
commercial banks and RRBs for facilitating integrated rural
development.
These cover all kinds of production and investment credit
agriculture, small scale, cottage and village industries, handi-
crafts, rural artisans and other allied economic activities in
rural area.
(vi) coordination of the activities of central and State
Governments the Planning Commission and other all-India
and State-level institutions entrusted with the development
of economic activities in rural areas;
(vii) promotion of research in agricultural and rural
development: (viii) formulation of projects and
programmes-to suit the requirements or different areas of
rural development; and
(viii) inspection of cooperative banks and RRBs.
During the short period of its existence, the Banks has played
its dual role as an apex institution and as a refinancing agency
creditably by participating actively in the development policy
formulation, planning, coordination, monitoring, research,
training and consultancy as well as refinancing areas relating to
agricultural and rural development. It may be noted in this
connection the Bank is a single integrated agency cater-ing to the
credit needs of all types of agricultural and rural development.
It is gratifying to note that the Research Cell of the National
Bank is paying particular attention to ensure that weaker
sections of the rural population benefit more by schemes of
refinance by the Bank, that there is simplification of the
procedures so that quick disposal of applications is possible
and that the Governments programmes for poverty eradica-
tion are supported in a meaningful way.
Assistance for Agriculture
As an apex refinancing agency in the field of rural credit, the
National Bank provides refinance assistance to the eligible
cooperatives and commercial banks for different purposes and
durations. It provides short term credit for periods not
exceeding 18 months to State Coopera-tive Banks/ Regional
Rural Banks for seasonal agricultural operations (crop loans)
marketing of crops, purchase and distribution of fertilizers and
working capital requirements of cooperative sugar factories. It
also provides medium term credit (I8 months to 7 years) to
State Cooperative Banks/ Regional Rural Banks for approved
agricultural purposes, pur-chase of shares of processing
societies and conversion of short term crop loans into medium
term loans in areas affected by natural calamities. Long term
credit for a period of 25 years is provided to State Coopera-tive
Banks/ land development banks/ Regional Rural Banks/
Commercial banks for investment in agriculture under
schematic lending. Lending term loans (for periods not
exceeding 20 years) are provided to State Governments to
enable them to contribute to the share capital of the cooperative
credit institutions.
Refinance Assistance
The aggregate credit limits sanctioned by NABARD for co-
operative and State Governments stood at Rs. 4,133.2 crore
during 1993-94. Drawals against these limits stood at Rs. 5358.7
crores, NABARD has revised the rates of interest on its
refinance with effect from March I, 1994 which would be
applicable to all fresh lending/ disbursements. The Bank
continues to pursue the policy of development and promotion
of agricultural investments in less developed and/ or under
banked States.
Co-operative Development Fund
An important development in the area of institutional
development during 1992-93 was the setting up of a Co-
operative Development Fund by NABARD with an initial
corpus of Rs. 10 crore contributed by it out of its profits for
1992-93 to provide financial assistance by way of grants loans to
co-operative banks for human resources development with suit-
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able training input and to build up better management
information sys-tems and infrastructural facilities for primary
agricultural societies for mobilising deposits. Upto March 1994,
a total assistance of Rs. 6.32 crore has been sanctioned to 10
State Co-operative banks and 3 State Land Development Banks
which include Rs. 3.62 crore in grants ado the balance of Rs.
2.70 crore in interest free loans.
Institutional Strengthening Programme
NABARD has prepared components and guidelines for
institutional strengthening programme aimed at making non
solvent and near non solvent banks solvent and viable as
per the recommendations of the Agricultural Review
Committee. The basic components of institutional
strengthening programme would comprise identification of
overdues and bad debts and to make provisions there against,
reduction in cost of management, rationalisation of loan
policies and procedures, expansion and diversification of loans
portfolio, mobilisation of resources both manpower and
financial and their development, etc.
Questions to Discuss:
1. Discuss Central Cooperative banks.
2. What do you understand by State or provincial cooperative
banks or apex banks?
3. Discuss Agricultural credit-intensive development scheme.
4. Discuss the agricultural refinance and development
corporation.
5. Explain the features of NABARD.
Notes:
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LESSON 24:
DEVELOPMENT FINANCIAL INSTITUTION
Learning objectives
After reading this lesson, you will understand
Role of DFls in the financial system
Operations of major Fls in India IFCI
Operations of major Fls in India IDBI
We will discuss the nature and operations of the present
financial institutions operating in India in todays class. Today
we shall focus on IFCI and IDBI.
Introduction
Financial Institutions play an important role in the Indian
financial system. In fact, most of the financial intermediation
taking place outside banks can be attributed to the operations
of the financial institutions. Financial Institutions (Fls) provide
project finance to the needy corporates and government
institutions, thereby performing an important role in the
infrastructural development in the country.
There are various kinds of financial institutions performing
their role in financial intermediation and infrastructural
development, differing on the basis of their inception and
operations. Broadly, the existing financial institutions may be
classified as (a) All India institutions like Industrial
Development Bank of India (lDBI) etc., or (b) Regional/ State
level institutions like the Gujarat State Financial Corporation etc
or (c) Other Institu1ions like DICGC etc.
It is to be noted that our definition of financial institutions
does not encompass Non-Banking Financial Companies. This
is because of the fact that the characteristic of a typical financial
institution, which we are discussing here, and the characteristics
of a NBFC differ in many ways.
Organisational Structure of Financial Institution

































All Financial Institution
All India Financial Institution State Level Institutions Other Institutions
All India
Development Banks
IDBI (1964)
ICICI (1955)
SIDBI (1990)
IIBI (1997)*
IFCI (1948)
Specialised Financial
Institution
EXIM Bank (1982)
IVCF (formerly
RCTC) (1988)#
ICICI Venture
(formerly TDICI)
(1988)
TFCI (1989)
IDFC (1997)
Investment
Institution
UTI (1964)
LIC (1956)
GIC &
subsidiaries
(1972)
Refinance
institutions
NABARD
(1982)
NHB (1980)
SFC
(18)
SIDC
(28)
DICGC
(1962)
ECGC
(1957)
Notes
1. * the erstwhile Industrial Reconstruction Bank of India
(IRBI), established in 1985 under the lDBI Act, 1984, was
renamed as Industrial! Investment Bank of India Ltd.
(IIHO with effect from March 27, 1997.
# IVCF-IFCI Venture Capital Funds Ltd.
2. Figures in brackets under respective institutions indicate the
year of establishment year of incorporation.
3. Figures in the brackets under SFCs/ SIDCs indicated the
number of institutions in that category.
Industrial Finance Corporation of India
At the time of Indian independence, there were lacunae in its
financial system. One among them was the lack of adequate
industrial financing, especially to meet the medium to long-
term requirements of the industries. In such a set up, it became
necessary to develop an institutional structure for meeting the
large fund requirements of the industry. The first step in this
direction was the incorporation of the Institute of Finance
Corporation under the Institute of Finance Corporation Act,
1948 (IFC Act). Subsequently the IFC Act, 1948 was repealed
and in its place, the Industrial Finance Corporation (Transfer of
Undertaking and Repeal) Act, 1992 (lFCI (Repeal) Act), was
formulated which came into force on July 1, 1993. lFCI was
converted into a public limited company and was registered
under the Companies Act in July, 1993. In December, 1993, it
also made its maiden public issue.
The erstwhile IFCI was set up under an Act of Parliament in
1948, with the share capital subscribed by Government of India
(GOl), RBI, Scheduled Commercial Banks, Insurance
Companies, Investment Trusts and Cooperative Banks. With
the establishment of the IDBI in 1964, the shareholding of
GOI and RBI was transected to IDBI. IDBI holds 30% of IFls
equity.
The management of IFCI is vested in its BODs, comprising
professionals drawn from diverse fields like banking, finance,
economics, insurance, etc.
IFCI is headquartered in New Delhi and has 17 regional offices.
Besides Delhi, regional offices are also located at Mumbai, Pune,
Kolkata, Hyderabad, Lucknow, Chennai, Ahmedabad,
Bangalore, Bhopal, Jaipur, Kochi, Punjab, Chandigarh,
Guwahati, Bhubaneswar and Patna.
Product Profile
The main functions of IFCI are to provide various kinds of
financial services to the industries. Primarily, its services focus
on project finance as it provides assistance to all viable industrial
projects above Rs.50m. IFCI provides assistance to industrial
concerns for their new projects, expansion, diversification and
modernization schemes. Loans are generally extended for a
period of 5-7 years with a moratorium of 2-3 years. Loans are
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extended both in rupee and foreign currency. The latter is
normally for import of capital equipment. Loans are provided
after a detailed project appraisal. Typically, the loans are secured
by the assets of the borrowers, in some cases along with
corporate/ personal guarantee, as additional collateral. After
performing the appraisal, depending on the borrower, the
interest rates are fixed. Apart from extending loans. IFCI also
underwrites/ directly subscribes to equity/ debentures of the
companies. offers financial assistance in the form of equipment
leasing, equipment credit, suppliers and buyers credit,
equipment procurement and installment credit. Besides IFCI
provides guarantees for deferred payment and offers
promotional services like support for technical consultancy,
housing development, management development,
entrepreneurial development etc. IFCI has introduced capital
subsidy scheme for converting palaces/ castles/ forts, etc. of any
size into heritage hotels. Disbursals during the year have
registered a growth of 13%. In terms of new sanctions major
sectors are power generation, textiles and iron and steel together
accounting for over 40% of sanctions in FY 1999. IFCIs loan
portfolio is well diversified across industries and geographic
locations.
IFCI has diversified from its traditional role in pJrojec1 finance
to provide finance for leasing and hire purchase concerns,
corporate loans and short-term loans. It also offers a wide range
of financial services including issue management, corporate
advisor and trusteeship. Wholly owned subsidiaries were set up
to enable this diversification of its product portfolio.
These include:
IFCI Financial Services Ltd. - Merchant Banking Stock
Broking and Allied Activities
IFCI Investor Services Ltd. - Registrar and Transfer Services
IFCI Custodial Services Ltd. - Custodial Services
Risk Capital & Technology Finance Corporation Ltd.
The IFCI Financial Services Ltd. undertakes merchant banking,
underwriting, issue management etc. IFCI is a Category-I
Merchant Banker and Debenture Trustee IFCI set up MBASD
(Merchant Banking and Allied Services Division) in July, 1986.
IFCI also provides underwriting and guarantees.
To face the challenges offered by the increasing competition a
need was felt to spruce up the activities of the Corporation.
Moving in this direction in 1998, IFCI has decided to merge the
wholly owned subsidiaries, IFCI Custodial Services Ltd. and
IFCI-Investor Services Ltd., with IFCI Financial Services Ltd.
Further, its wholly Owned subsidiary, Risk Capital &
Technology Finance Corporation Ltd., was renamed as IFCI
Venture Capital Funds Ltd., and its operations would
henceforth be concentrated on managing venture capital funds
in some select industries.
Apart from the above mentioned wholly owned subsidiaries.
IFCI has also promoted various specialised institutions such as
Management Development Institute (MDI)
Tourism Finance Corporation of India Ltd. (TFCI)
Rashtriya Gramin Vikas Nidhi (RGVN)
Investment information & credit rating agency (ICRA)
Tourism Advisory & Financial Services Corporation of India
(TAFSIL)
Institute of Labour Development (LTD.)
Other organizations in which the IFCI acts as a co-promoter
are
Stock Holding Corporation of India.
Entrepreneurship Development institute of India
OTC Exchange of India
National Stock Exchange of India
Securities Trading Corporation of India
Biotech Consortium India.
AB Home Finance
LIC Housing Finance
GIC Grih Vitta
Financial Resources
Equity, rupee and foreign currency loans and bonds form the
different types of finance resources for the IFCI. The resource
management function at IFCI is handled by a separate division
from the headquarters at New Delhi. The requirements for
funds are communicated by the accounts departments of
various divisions in the form of monthly cash flow statements
(current and projected) to the resources Department at New
Delhi. The targets are set in conformity with the projections for
sanctions and disbursements in various activities. Rs.42.6bn
rupee borrowings were raised- during 1998-99 (67.1%- long-
term; l1.4%-medium-term; and 21.5%- short-term funds). The
average cost of the aforesaid borrowings Was about 13.5%.
IFCI has also issued preference share capital of Rs.3.4bn. The
average maturity and average coupon rate of the preference share
capital raised during the year was about 4.5 years and 10.6%
respectively.
Performance
Amongst the 4 AIFIs, lFCI ranks 3
rd
in terms of asset -base.
The lower ranking of IFCI amongst its power group can be
attributed to its bad asset quality. The outstanding have been
mostly from (exiles, iron& steel; metal products, chemicals,
synthetic fibers & resins, and food products industries. The
factors that have led to such a high level of NPAs included the
slowdown in industrial growth, slack demand conditions,
excess capacity in a number of industries, technological
obsolescence and the loss of competitiveness in some
industries.
In an effort to control the rising NPAs, IFCI is now playing a
playing a proactive role in the restructuring of borrower
concerns for which it has set up the Corporate Restructuring
Division. The reduction of NPAs are made through the timely
grant of reliefs and concessions, encouraging mergers and
amalgamations with healthy companies, one-time settlement of
dues, etc. To take proactive measures and prevent any further
rise in the NPAs, the Corporate Monitoring Department has
been set up at the corporate office to oversee and monitor cases
with large exposure as well as likely problem loans.
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In addition, an Industry Research Division has been set up for
the purpose of carrying out industry, studies to facilitate the
work of the Credit Department Regional Offices. This research
studies provided by this division on various industries would
enable the IFCI to take more informed lending decisions. With
all these measures, the IFCI is trying to upgrade its asset quality.
Apart from these new divisions, IFCI has reconstituted its
internal management committees. The management
committees at the corporate office include the Business Review
Committee, the Credit and Investment Committee. Head
Office Loan Committee, the Asset Liability Committee, the
Disinvestment Committee and the Official Language
Implementation Committee. The setting up of the ALM
Committee was mainly to enable it to conform .to the RBI
guidelines on ALM for financial institutions.
In an effort to manage its interest rate risk, IFCI has been
following a policy of linking its interest rate to the prevailing
prime lending rate (PLR) at the time of disbursement. In the
case of Foreign currency loans the pricing is one at LIBOR +
spread. Further to tackle the foreign exchange risk management,
the repayment for the funds that are borrowed in a foreign
currency is made in the same currency resulting in no exchange
rate risk on the part of the Corporation.
Future
To face the competition, there is a need to reorient its strategies.
For this purpose, it is envisaged that in the due course of time
IFCI may operate as a universal bank that has a major focus on
corporate banking. And in order to tap on the other financial
services that offer greater scope for the corporation, IFCI is
diversifying into bill discounting, trade bills important financing
and working capital financing. Most important move in this
direction is the joint venture it is entering into with a foreign
partner to diversify into the insurance sector.
Industrial Development Bank of India
Industrial Development Bank of India (IDBI) is the largest
financial institution in India, with assets at the end of 1999
approximating to Rs.600 bn. This apex financial institution in
India, is also the 10th largest development bank in the world.
Industrial Development Bank of India (IDBI) owes its birth to
Industrial Development Bank Act (IDBI Act), 1964. As per its
charter IDBI is required to play a significant role in (a) planning,
promoting and developing industries to fill the gaps in the
industrial sector (b) co-coordinating the working of institutions
engaged in such activities and assisting in their development (c)
providing technical and administrative assistance for
promotion, management or expansion of industry (d)
undertaking market and investment research and techno-
economic studies to contribute to the development of industry.
Initially, IDBI was established as a wholly-owned subsidiary of
the Reserve Bank of India (RBI). In 1976, the ownership of
IDBI was transferred to the Government of India. The IDBI
Act was amended in October 1994 enabling IDBI to raise equity
from the public, subject to the holding of the Government or
India not falling below 51 % of the issued capital.
Operations
IDBI initially provided long-term assistance to industries such
as textiles, fertilizers, chemicals products and machinery. The
assistance was mainly in the form of long-term loans and to a
small extent, in the form of project lending. In 1964, IDBI also
began a role in assisting the State Finance Corporations (SFCs)
of various states, taking over from Refinance Corporation of
India. This assistance was in the form of providing refinancing
the term loans granted by the institutions. By 1965, IDBI
entered into rediscounting of -machinery bills to promote the
sale of indigenous machinery on deferred payment basis.
Subsequently, IDBI entered into finanancing exports on a
different payment basis, till the time Export- Import (Exim)
Bank of India was formed in 1982.
In 1986, IDBI created a Small Industries Development Fund
(SIDF) to provide a special focus to the needs of the small scale
sector. This fund is intended to provide financial as well as non-
financial inputs catered to the specific needs of the small scale
sector. In 1990, the operations of the fund were hived off in to
a wholly owned subsidiary, the small industries development
bank of India (SIDBI), in order to provide greater focus to the
sector.
Through the late 80s and the early 90s IDBI played a
significant role in the development of financial markets. While
it played a major role in setting up of the Stock Holding
Corporation of India Limited (SHCIL), for providing impetus
to the depository services to the financial institutions in 1987, it
was also the nodal agency for establishing the National Stock
Exchange (NSE) in 1992. Other institutions promoted by
IDBI by direct contribution of capita] include: Credit Analysis
and Research Limited (CARE) and Investor Services of India
Limited (ISIL). Both established in the early nineties, CARE
offers credit rating, information and equity research services to
Indian Industry and institutions, ISIL provides registrar
transfer and custodial services. IDBI joined other All India
Financial Institutions (AIFls) to promote: Over The Counter
Exchange of India (OTCEI). Shipping credit and Investment
Corporation of India (SCICI)- now merged with ICICI,
Tourism Finance Corporation of India (TFCI) and Biotech
Consortium of India Limited (which provides aid for
commercialization of indigenously developed processes and
products in the field of biotechnology.
Over the years IDBI evolved from being a government arm for
doling developmental credit to various slate finance institutions
and bodies to being a complete one stop shop for long-term
lending. By the mid-90s, when the first stage liberalization has
taken its full effect the strength of IDBI of being big came into
force. Core sector projects especially in Iron and Steel have been
major borrowers from IDBI. Approvals and disbursals during
the years) have grown at an average of 99f- and 8% per annum
respectively.
Financial Performance -
The Banks working during the year 2001 yielded a Profit Before
Tax of Rs.734 crore (Rs.1027 crore for the previous year). After
making a net provisioI1 of Rs.43 crore towards taxation for the
year, Profit After Tax was Rs.691 crore (Rs.947 crore). After
apparitions to reserves and reserve funds, the Board of
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directors have proposed a dividend of 45% on the equity
capital.
Total assets of the Bank as on March 31, 2001, increased by
15.3% to Rs.71,783crore.(Rs.72,285crore). IDBIs net worth as
on that date also recorded a rise of 8.6% to Rs. 9,126 crore
(Rs9,025 crore).
The Banks performance can be seen from various indicators.
The margin, measured by the difference between the average
return on assets and financial cost of liabilities was 2.6% in
1998-99 as against 3.9 % in 1997-98. The return on average
assets was 2lk as compared to 2.7%. Return on average net
worth for the year declined to 15.1 % (19.9%). Earnings per
Share and Book Value per Share at the year-end stood at Rs.9.37
and Rs.139.S0 respectively.
The Bank continued to maintain sound capital adequacy
requirement, as represented by the capital adequacy ratio (CAR),
which at end-March, 2001 stood at 15.8% as against 8(1() last
year. The Debt equity ratio (including contingent liabilities)
stood at 6.53:1 (6.08:1).
In 2000 -01, IDBI sanctioned and disbursed Rs.287.1 bn and
Rs.174.9 bn respectively. Of it direct finance constituted 95.4%
of total sanctions and 92.6% of total disbursements. Protect
Non-Project loans given for eligible industrial.
These types of loans are disbursed by IDBI either for a
particular project of as a-general Joan, either in foreign currency
or Indian Rupees. Normally, these loans are provided for a
period of 5-7 years with a moratorium of 2-3 years. Also, the
loans will be secured by a fixed charge on fixed assets. As in the
case of banks, the rate of interest that is charged will be a
markup to the Prime Lending Rate (PLR). IDBI also provides
direct assistance through underwriting of securities of corporate
enterprises. Such underwriting, though a small part of the
financing also provides an alternative avenue for investments in
securities.
In 1987, IDBI began providing venture capital essentially to the
technology oriented start up ventures, which was subsequently
broadened to provide assistance to wide spectrum of projects
which are not necessarily technology driven. The venture capital
assistance was provided to finance cost of fixed assets,
operating and market development expenditure, among other
venture capital related activities. -
IDBI provides indirect assistance through refinancing state level
institutions for small loans disbursed by them. For approved
loans IDBI makes a fixed spread with government providing a
guarantee for such refinance.
The share of different industries in total sanctions during FY
1998 were power 6.2% core (iron & steel, oil, cement, fertilizer)
24.7% chemicals 11.2%m textiles 12.2%, paper 5.48%, other
industries 30.44% and pharmaceutical 4.11%.
Funding
With its wide-ranging lending requirements with concentration
on long-term finance, IDBI needed huge money at a cheap rate.
In the 70s, to enable IDBI perform various developmental
activities and also to finance small scale industries, at
concessional rates, RBI created a separate National Industrial
Credit [Long-Term Operations]-(NIC[LTO]), fund out of its
profits. IDBI has been receiving loans from this fund on
concessional terms. In recognition of its development role,
IDBI was initially exempted from income tax, which was
subsequently placed in the tax bracket of 30 percent. This tax
bracket is applicable uniformly to all the AIFls.
Apart from the NIC[LTO] a separate Development Assistance
Fund (DAF) was created as per the requirement of the IDBI
Act. Funds from DAF were source to finance large infrastructure
projects, which, probably, would not have qualified for
assistance on commercial considerations.
In the pre-reform era, IDBI has been relying on the
Government of India for funding. IDBI was initially granted
an interest free loan amounting to Rs.10 crore at the time of its
setting up. Government of India has also been providing
various loans on a concessional basis, while providing
budgetary support to IDBI until 1970. Even after 1970, IDBI
enjoyed budgetary support towards the funds that were
disbursed through IDA line of credit from the World Bank. It
has to be noted that these loans met the foreign currency
requirement of the industry and in such borrowings. FIs
normally do not bear any direct exchange risk. which is borne
either by the borrower or the GOI. Government of India, in
order to further help IDBI augment its resources, introduced
Companies Deposits (Surcharge on Income Tax) Scheme. As
per this scheme companies were exempted from paying then
existing surcharge on income tax provided they deposit an
equivalent amount, repayable after five years, with IDBI. This-
scheme was discontinued in April, 1978. In 1981, in response to
the shortage of resources faced by the IDBI the Government
of India extended a budgetary support of Rs.50 crore.
Subsequent to the new thinking imbibed through the
liberalization measures in early 90s, concessional funding by the
Government of India and RBI began dwindling. Statutory
Liquidity Ratio (SLR) status for bonds issued by FIs was
withdrawn in 1993. These bonds, eligible for investments by
banks under the mandatory SLR category, were a major source
of funds for IDBI They carried a lower interest rates (10-11 %)
and had 15 year maturity period. IDBI then began relying
increasingly on the market borrowings sourcing money through
certificate of deposits, floating rate bonds, term money bonds
and other commercial borrowings in both rupees and foreign
currencies.
In 1994, IDBI act was amended through an ordinance, allowing
IDBI to raise equity capital form the market as long as the GOI
holding did not fall below 51 percent. Also, IDBIs status was
changed from a government Undertaking to a. company
registered under the Companies Act, 1956. Subsequent to the
amendment in the Act; IDBl made Rs.21.8bn IPO In July 1992
through public offerings of 168m equity shares of Rs. 10 each
at a premium of Rs.120. The issue was over subscribed
approximately 1.4 times. The share was quoted at
approximately Rs.25 on 28.6.2001.
Current Position
The valuation of IDBIs stock, relative to HDFC and ICICl,
itself shows that IDBI is not viewed favorably by the market.
Due to IDBIs relatively high exposure to iron and steel
projects, which are languishing due to over capacity and global
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recession, IDBI had to reconcile with high NPAs. NPAs have
been appropriately provisioned as per the regulations applicable
to banks. Sub-standard and doubtful. Assets constituted 7.7%
(7.0%) and 4.3% (3.1%)respectively of the assets. Loss assets
were fully written off. IDBI made full provisions/ write-offs in
respect of its non-performing assets as per RBI norms.
Questions to Discuss:
1. Discuss the role of DFls in the financial system.
2. What are the operations of major Fls in India namely IFCI?
3. What are the operations of major Fls in India namely IDBI?
Notes:
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LESSON 25:
DEVELOPMENT FINANCIAL INSTITUTION
Learning objectives
After reading this lesson, you will understand
Operations of major Fls in India ICICI
Regulatory framework for Fls.
We will discuss the nature and operations of the present
financial institutions operating in India in todays class. Today
we will focus on ICICI.
Industrial Credit and Investment Corporation of
India Ltd.
ICICI is Indias second largest Financial Institution with assets
totaling Rs.424.5 bn in 1999. Initially, playing a role of a typical
development financial institution-of giving long-term loans, it
has gradually evolved into a one-stop shop for most retail
finance instruments. The corporation has its presence in
investment and commercial banking, venture capital funding,
custodial services, InfoTech, brokerage, consultancy and
advisory services. Compared to IDBI, which is seen as
conservative, ICICI is of late being more aggressive. ICICI has
increased its market share to 42 percent in sanctions and 43
percent of disbursements:
ICICI was initially established as Industrial-Credit and
Investment Corporation of India in 1955. It was promoted by
the Government, the World Bank and a steering committee of
5 prominent businessmen and others. The objective of ICICI
was to assist the private sector. Later on, its services were
extended even to the public sector, joint sector and the co-
operative sector. Primarily, assistance was provided for the
following purposes:
Creation expansion and modernisation of companies in the
private sector.
Encouraging and promoting industrial investment and the
expansion of investment markets.
For these purposes, the ICICI provides long and medium term
loans or equity finance, sponsors and underwrites securities
issues, guarantees loans, providing managerial, technical and
administrative consultancy.
Headquartered in Mumbai, ICICI also has zonal offices at
Bangalore, Baroda, Calcutta, Chennai, Coiambatore, Hyderabad,
New Delhi and Pune.
Apart form providing assistance to the companies, ICICI has
also promoted a number of specialised financial institutions for
various other purposes. These include HDFC, CRISIL, TDICI
etc.
Financial Resources
Initially, the financial resources of ICICI included share capital,
interest free loan from Gal and foreign currency advances from
the World Bank. Subsequently, other rupee and foreign currency
resources added on to the list. Broadly, the financial resources of
ICICI are as follows:
Share Capital
ICICI is a public limited company and its six lakh shareholders
include Indian promoters (_9.1 %), Indian institutes/ Mutual
funds (7%), FIIs (34.8%), Public/ Free float (29.1%). These
figures are pre-IPO issue of 1999, when ICICI came out with a
issue priced at Rs.85. In middle of 1999, ICICI became the first
Indian company to have an ADR listing on the New, York
Stock Exchange (NYSE). American Depository Receipts
(ADRs) were issued in the ratio of 2:1 to the domestic equity
shares of ICICI traded on the Bombay Stock Exchange.
Reserves
Reserves which are the internal resources- contribute
significantly towards the fund requirements of the ICICI.
Generally, internal generations of ICICI meet 50-60% of its
funds requirement.
Borrowings
The borrowings of ICICI fall into the following three types:
Rupee Borrowings
Foreign Currency Borrowings
Commercial Borrowings
Borrowing storm the Government of India, institutional
borrowings, bonds guaranteed by Government and. other
public issue of bonds feature under the rupee borrowings
category of ICICl. The borrowings from GOI/ RBI were mainly
to support developmental objectives of industrial growth. The
bonds issued by the FIs, including the ICICI were guaranteed
by the Government and qualified as SLR investments for
commercial banks. They carried lower interest rates (10-11 %)
and had a 15-year maturity period. In addition to these low cost
Government borrowings, SLR bonds also were a major source
of funds for most of the FIs till 1993. However, in order to
ensure a level planning ground, access to such low cost funds is
slowly being cut off. Presently, about 10 percent of the FIs
balance sheet reflect these resources which are repayable by 2004.
The foreign currency borrowings of the ICICI comprises of the
multilateral/ bilateral borrowings. ICICI has been playing a
crucial role in canalizing the foreign currency borrowings it has
obtained from the Government, World Bank, KFW, IFC and
other international agencies to meet the foreign currency
requirements of the industry. While extending lines of credit,
the ICICI will not have to bear the exchange risk as it will be
borne either by the borrower or the Gar.
The other commercial borrowings of ICICI have been coming
from the international market, where it has been borrowing
funds in various currencies. These borrowings have enabled it
to reduce its interest costs and also diversify its currency risk.
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Deposits
Due to limited access to government borrowings which has
been a chief source of finance, ICICI is now looking at various
market borrowings as another source of finance. ICICI issues
certificate of deposits (CDs) in the wholesale market
an4.borrows in the retail market through fixed deposits (FDs)
schemes.
Deployment of Resources
Long-term lending, investment and commercial banking,
venture capital financing and consultancy and advisory services,
debenture trusteeship and customer services are all the major
financial service offered by ICICI and where most of its funds
are developed. As the objective of ICICI is to promote and
encourage industrial investment, project finance is the key area
for fund deployment.
ICICI is into equipment finance also as it supports financing of
imported and locally manufactured equipment by deferred
credit. Two types of credit facilities are offered (1) credit facility
that enables the manufacturer to extend credit to the customer
for purchasing the specified equipment, (2) asset credit facility
that enables the purchaser to get the credit and repay over a fixed
period of line. Further, as the cost of funds is rising, ICICI is
also entering into more profitable financing options. Having
began leasing Operations in 1983, ICICI has emerged as the
single largest lessor in India While offering this service, ICICI
buys the equipment, retains the legal title and leases it. The
average lease period is 5 years and the lease rentals are
determined as per the market rate. As the thrust on the
infrastructure sector is growing, big ticket leasing in
infrastructure is gaining interest due to the large size of
operations. Taking advantage of this, ICICI has enhanced its
operations in big ticket leasing.
The fee based services offered by ICICI include merchant
banking corporate advisory services, underwriting, corporate
finance, etc. In extending these services, ICICI has been
leveraging on in-house skill base, large client network and the
relationship with their clients. With the scope of these fee based
services rising. ICICI has spun off most of these activities into
subsidiary companies.
Subsidiaries and Acquisitions
In 1993, ICICI has floated a new company, the ICICI Securities
and Finance Company Ltd. (I-Sec) in joint venture with a
subsidiary of J.P.Morgan, with ICICI holding 60 percent of the
shares. I-Sec is a Category I merchant banker, and engages in
new issue management, underwriting, corporate advisory
services. Being a member of the OTCEI and NSE, it also
engages in securities trading and allied financial services.
The Technology Development and Information Company of
India (IDICI) is yet another wholly owned subsidiary of ICICI,
which it has acquired by taking up-the 50 percent stake of UTI.
This acquisition along with the 50 percent stake, which it already
has, made TDICI a wholly owned subsidiary of ICICI. It is
now renamed as ICICI Venture.
As the market began, to liberalise, the competition has also
been increasing. To counter the competition, ICICIs strategy
has been synergistic acquisition. In this context, the merging of
ITC Classic Finance and Anagram finance has resulted in
widening its retail network in the western and northern parts of
the country. In addition to this, the merger of ITC Classic
Finance has resulted in a tax shield of Rs.l billion as ITC Classic
was a loss-making unit.
Future
ICICI has been accepting the changes in the market and as also
in acting fast to keep pace with these changes. And to continue
this trend the FI now aims to move on to become a global
player. The strategic acquisitions and diversification activities
have played a great role in moving ICICI from the role played
by a traditional FI. The focus of ICICI is to become is to
become a universal bank and to offer a comprehensive range of
financial services.
Exim Bank
Export-Import Bank of India (Exim Bank), an apex financial
institution, was established in 1982 under an act of the
parliament to finance facilitate and promote Indias international
trade.
The vision of Exim Bank is to develop commercially viable
relationships with a targeted set of externally oriented
companies by offering them a comprehensive range of products
and services aimed at helping Indian companies to globalise.
The bank has five overseas offices at Washington DC.
Singapore, Rome. Budapest and Johannesburg. The overseas
offices are strategically located to enhance institutional linkages
with multilateral agencies viz., World Bank, International
Monetary Fund, European Bank of Reconstruction and
Development. Asian Development Bank, African Development
Bank and regional banks like the PTA in Africa and also
interacting with various Export Credit Agencies.
The overseas offices also assist Indian companies in identifying
partners of business or joint ventures. Exim Bank has forged
alliances with banks, trade and investment promotion agencies
in 31 countries through 53- co-operation agreements and
Memoranda of Understanding (MoU).
Exim Bank finances exports of Indian machinery, manufacture
goods, consultancy and technology services on deferred
payment terms. It also seeks to co-finance projects with global
and regional development agencies to assist Indian exporters in
their effort to participate in such overseas projects: Companies
can avail of facilities such as forfeiting, underwriting of issues,
import finance through lines of credit from other export credit
agencies and bulk import finance for import of raw materials
and intermediates.
Equity finance is available for acquiring or setting up companies
abroad for manufacturing, marketing. trading and other
services.
Companies can also avail finance from Exim Bank for export
market development activities and for export product
development.
Companies collaborating for technology particularly with the
companies from Asian countries can access concessional finance
through Exim Bank under the ACIP programs.
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Foreign governments and agencies in other developing
countries are offered buyers credit and lines of credit to import
Indian goods and services.
Exim Bank had posted a 6.6 percent dip in net profit at Rs.154
crore for the financial year ended March. 2001 from its previous
year net profit of Rs.165 crore. This is attributed to low lending
rate/ declining margins and intense competition in financial
sector. Sanctions by Exim for the period grew by 20 percent at
Rs.2,174 crore as compared to Rs1,640 crore for 1999-2000.
The bank has introduced several new initiatives to promote
Indias international trade. Some of the recent initiatives are
A program to finance R&D of export oriented companies at
concessional interest rates;
Banks participation in the equity of Indian ventures abroad;
Working capital finance for exporting companies:
Financing packages for knowledge based industries such as
information technology computer software and
pharmaceuticals;
Co-operation agreement with US Exim Bank for promoting
bilateral trade between USA and India:
Co-operation agreement with PTA Bank - a regional
development bank in Africa to sponsor Indian consultants
for PTA Bank funded projects in Africa;
Co-operation agreements wit business promotion agencies
in Vietnam, Italy, China, UAE, Uzbekistan, African
Development Bank and Eastern & Southern African Trade
and National Association of Software & Services Companies.
Exim Bank plays the role of a consultant to share its own
experience in institution building. It has provided consultancy
to many developing countries. Some recent assignments are in
South Africa and Zimbabwe. In addition to finance, Exim
Bank provides a range of analytical information and related
services necessary for globalization of Indian companies.
The advisory services enable exporters to evaluate international
risks, export opportunities and enhance competitiveness. Exim
Bank through its wide network of alliances with financial
institutions, trade promotion agencies, information providers
across the globe assists externally-oriented Indian companies in
their quest for excellence and globalization. Services include
search for overseas partners, identification of technology
suppliers negotiating an alliance and consummating a joint
venture.
Over the years, the bank has evolved from financing and
facilitating and promoting Indias foreign trade to developing
commercially-viable relationship with a target set of externally-
oriented companies by offering them a comprehensive range of
products and services aimed at helping Indian companies
globalise.
The evolution from traditional export credit programs to
overseas investment credit, import credit, advisory and
promotional programs and global network of institutional
linkages, reflect the adaptation to the changing global trends.
The need to utilise all possible financing mechanisms to
promote export capabilities has motivated the bank to go
beyond provision of post-shipment credit, and operate
schemes involving short-term export finance, pre-shipment
finance, investment loans and. export marketing finance.
It provides competitive finance at various stages of the business
cycle, covering import of technology, export product
development export production, export marketing, export
credit at pre-shipment and post-shipment stage, and
investment overseas. Finance is provided in Indian rupees and
foreign currency.
The recent initiative of the government of India to create special
economic zones (SEZs) to provide an internationally-
competitive and hassle free environment for exports, have
opened a new avenue for establishing financing and banking
arrangements to attract foreign direct investments in SEZs.
Four export processing zones (EPZs) at Kandla, Santa Cruz,
Kochi and Visakhapatnam have been converted to SEZs. while
six more SEZs are being set up. Globally, Offshore Financial
Centers (OFCs) and offshore banks have come to play a vital
role in facilitating investment worldwide, and are a focal point
for the collection and channeling of wealth into onshore
financial centers. The Indian banking regulations require
amendments to enable banks and financial institutions to seek
exemption from a wide range of regulations.
It undertakes research studies on subjects concerning
international trade, international economics, sector and product
studies and country studies and publishes these studies in the
form of occasional papers (OPs). So far the bank has brought
out 79 OPs.
In addition to finance, Exim Bank provides a range of analytical
information and related services necessary for globalization of
Indian companies. The advisory services enable exporters to
evaluate international risks, export opportunities and enhance
competitiveness.
Exim Bank assists externally-oriented Indian companies in their
quest for excellence and globalization.
SIDBI
SIDBI was established in April, 1990 under an act of the Indian
Parliament to serve as the principal financial institution for
promotion, financing and development of industry in the
small scale sector ,and to coordinate with similar institutions
engage(in the same. SIDBI offers a wide range of assistance
through its direct finance, refinance, bills finance, equity finance,
venture capital, foreign currency loans, lines of credit and other
schemes of assistance besides support services. It has setup the
Technology Development and Modernization Fund to
encourage technology upgradation In small enterprises.
Set up under the SIDBI Act, 1989, SIDBIs operation have been
guided by its mandate of serving as the principal financial
institution for promotion, financing and development of.
Indian industry in the small scale sector which forms the
backbone of the Indian economy, contributing around percent
of Indias total manufacturing sector output, around 35 percent
of total manufacturing sector output, around 35 percent of
total exports and providing employment to nearly 17 million
persons. While entrusting the bank with the significant
responsibility of performing the role of an apex level
institution for the small scale industries (SSI) sector, the statute
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also empowers the Bank with considerable flexibility in its
operations. Since inception. SIDBI has been striving to enhance
the inherent strength and resilience of the SSI sector with
innovative measures and initiatives going beyond mere funding
of the sector.
Commencing its operations primarily as a refinance institution,
the Bank has transformed itself into a purveyor of wide range
of financial products aimed at plugging the gaps in the credit
delivery system. Direct financial assistance, wherein special
emphasis is given to technology development and
modernization as also marketing of SSI products, is offered
through SIDBIs network of 3.8 offices. Substantial assistance
is being channelised indirectly to the sector by way of refinance
mechanism through nearly 900 primary lending institutions
including commercial banks and State Level institutions, viz.
SFCs, SIDCs, etc. having over 65,000 outlets throughout India.
Besides funding of the sector, SIDBI has also been providing
developmental and support services aimed at improving the
inherent strength of the SSI units and employment generation
and economic rehabilitation of rural poor. The initiatives of the
Bank emphasize on entrepreneurship development, enterprise
promotion and strengthening, rural industrialization, human
resources development, technology upgradation, environment
management, etc.
Another feature of SIDBIs operations has been focused
initiatives and institution building in tandem with Government
of India, NGOs, technical/ management institutions,
international agencies and industry associations for reaching out
to the SSI sector. In this regard, the Bank has co-promoted 2
factoring companies, a commercial bank in the private sector viz.
IDBI Bank Ltd. and a Technology Bureau for Small Enterprises
in collaboration with Asian and Pacific Center for Transfer of
Technology. Besides, SIDBI and Ministry of S51 and ARI.
Government of India have jointly set up a Credit Guarantee
Fund Trust for Small Industries (CGTSI) to operationalise the
new credit guarantee scheme for ,small industries that would
cover octahedral free loans extended to tiny units up to a
maximum limit of Rs.2.5 million by scheduled commercial
banks and select Regional Rural Banks. SIDBI has also launched
a National Venture Fund for Software and IT Industries
(NFSIT) and has co-promoted several state level venture funds
in association with respective State Governments. The SIDBI
Foundation for Micro Credit aims at creating a national network
of strong, viable and sustainable Micro Finance Institutions
from the informal and formal financial sectors to; provide micro
finance services to poor. SIDBI also offers fee-based
consultancy to developing _ nations on appropriate strategy and
approach for growth of small industries including assistance for
joint ventures with Indian SSIs. With a view to fostering seed
stage projects in knowledge based sectors having high R&D
content and preparing them for venture capital assistance, the a
Bank has a program for-innovation and incubation for small
industries which is being taken up In situation with reputed
technical/ research institutions of the country.
For bridging the information gap in the small scale sector,
SIDBI has been presenting information relating to different
facets of the SS! sector in the form of SIDBI Report on S5I
Sector. The Report, which aims to serve as a single point
source of information on the SSI Sector, is being published
annually and has been well received and acclaimed both in India
and abroad. Furthering its initiatives in this area, the Bank also
proposes to publish a compendium on sector specific usage -of
technology and emerging needs of technologies of Indian SSIs.
SIDBI is a professionally managed institution functioning with
considerable emphasis on corporate governance. Although a
fairly young institution, its financials have kept pace with its
growing operations. As of March 31. 2000, the Banks asset
base stood at Rs.166 billion (US$ 3.81 billion) whereas its net
worth was over Rs.26 billion(US$ 0.61 billion). The Bank has
been rated as one of the top 25 Development Banks in the
world by the The Banker, London. SIDBI was the winner of
Asian Banking Award, 1999.
In order to help the Indian SSI sector cope up with the
challenges posed by the WTO regime, SIDBI would be
concentrating on certain specific industry segments for strategic
interventions where the sector has got inherent advantages. The
changes in the economy in the last decade which brought in
liberalization, deregulation, competition for the SSIs and
technology advances particularly in information technology, to
cite a few hold significance both for SIDBI as well as the SSI
sector, and the same have formed the underpinnings of the
Banks strategies and initiatives.
As a proactive apex level institution, the Bank will continue to
make its contribution towards strengthening the SSI sector
through innovative and tailor made programs.
NABARD
NABARD is an apex institution, accredited with all matters
concerning policy, planning and operations in the field of credit
for agriculture and other economic activities in rural areas in
India. It is an apex refinancing agency for the institutions
providing investment and production credit for promoting the
various developmental activities in rural areas.
It takes measures towards institution building for improving
absorptive capacity of the credit delivery system, including
monitoring, formulation of rehabilitation schemes,
restructuring of credit institutions, training of personnel, etc.
It co-ordinates the rural financing activities of all the
institutions engaged in developmental work at the field level
and maintains liaison with Government of India, State
Governments, Reserve Bank of India and other national level
institutions concerned with policy formulation.
It prepares, on annual basis, rural credit plans for all districts in
the country these plans form the base for annual credit plans of
all rural financial institutions. It undertakes monitoring and
evaluation of projects refinanced by it. It promotes research in
the fields of rural banking, agriculture and rural development.
The Committee to Review Arrangements for Institutional
Credit for Agriculture and Rural Development (CRAFICARD),
set up by the Reserve Bank of India (RBI) under the
Chairmanship of Shri B. Sivaraman, conceived and
recommended the establishment of the National Bank for
Agriculture and Rural Development. (NABARD). The Indian
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Parliament through the Act 61 of 1981, approved the setting up
of NABARD.
The Bank which came into existence on 12 July, 1982, was
dedicated to the service of the Nation by the Honble Prime
Minister, Smt. Indira Gandhi on 5th November, 1982.
NABARD was established, in terms of the preamble of the
Act, for providing, credit for the promotion of agriculture,
small scale industries, cottage any village industries, handicrafts
and other rura1 crafts and other allied economic activities in rural
are as wife a view to promoting integrated rural development
any securing prosperity of rural areas and for material connected
therewith or incidental thereto.
NABARD took over the functions of the erstwhile Agricultural
Credit Department (ACD) and Rural Planning and Credit Cell
(RPCC) of RBI and Agriculture Refinance and Development
Corporation (ARDC). Its subscribed and paid-up Capital was
Rs.100 crore which was enhanced to Rs.500 crore, contributed
by to Government of India (GOI) and RBI in equal
proportion It is now enhanced to Rs.2,OOO crore.
Refinance Support
The National Banks refinance support to co-operative banks,
commercial banks and RRBs and loans to state governments
and NGOs during the year 19992000 aggregated Rs.14,178
crore compared to Rs.l2366 crore during the previous year
registering a growth of 1.6 percent.
Long-Term Loans to State Governments
The National Bank provides long-term loans to state
governments for contribution to the share capital of co-
operative credit institutions subject to certain norms. During
the year 1999- 2000, loans aggregating Rs.91.07 crore were
sanctioned to 13 state government for contribution to the share
capital of 4 SCBs. 1 SLDB. 46 DCCBs, 61 PLDBs and 9112
PACS/ LAMPSIFSS compared to. sanction of Rs.65.33 crore
during; the previous year.
Credit Authorization Scheme
During 1999-2000, authorizations were granted in respect of
218 proposals for working capital assistance of Rs.4,678.53
crore, of which the SCBs accounted for 68 percent while DCCBs
accounted for 32 percent. Commodity wise, sugar accounted for
Rs. 3,305.89 crore (71%) cotton Rs. 992.00 crore (21 %) and
fertilizer Rs.245.00 crore (5%) while other commodities
accounted for Rs.135.64crore (3%). For block capital finance,
authorizations aggregating Rs.167.49 crore were granted in
respect of 34 proposals.
Investment Credit
The refinance budget for schematic lending for the year1999-
2000 was originally fixed at Rs.5,200 crore. However, during the
course of the year taking into account the availability of funds
and additional demand from client institutions as also the need
to maintain a positive growth rate in the various states as
compared to the previous year, the refinance budget was
enhanced to Rs.5, 215 crore. The total disseminates during the
year reached the programmed level of Rs.5.215 crore registering
a growth of 15 percent compared to the disbursement
ofRs.4.521 crore disbursed during 1998-99.
Regulatory Framework
The reforms taking Place in the financial sector have been
affecting all the players in the market, DFIs being no exception
to it. While the deregulations have unleashed the competition,
the guidelines introduced to streamline the Indian market
players operations with that of the international player have
posed significant challenges for the profitable sustenance of
these players.
Significant changes that have been witnessed in the operational
environment of the Fls are as follows:
Capital adequacy requirements: the capital to risk
weighted assets ratio (CRAR) that the Fls are supposed to
maintain is 9 percent. The details relating to the computation
of CRAR remain the same as for banks. In addition to this,
the non-cumulative preference shares permissible for issue
under the companies act and which have a maturity of 20
years will form a part of the tier-1 capital. However, the Fl
will have to create a corpus to be invested in the government
securities having maturity of such preferences shares to
eliminate the reinvestment risk. The corpus should be a
minimum amount, which when invested will equal the
preference shares amount. Adjustment will have to be made
in this corpus for the changes taking place in the tax rates. If
a shortfall arises, it has to be provided from the reserves.
Further, transfers from the reserve will also have to be made
for the differential interest rates i.e. if the yield on the G-Secs
at the time of the initiation of the corpus and the yield at
which the interest proceeds are reinvested each year the
corpus should not be used for the other operations of the
FI. The amount and the purpose of the corpus, will have to
be disclosed separately in the balance sheet, prospectus for
raising resources, etc. The amount of preference shares less
the amount of corpus created as above will be considered as
Tier-I capital.
Prudential Norms: FIs are also subjected to the prudential
norms on the same lines as banks. The asset classification.
Income recognition and the provisioning norms with effect
from 31-3-2002 are: interest and/ or principal remain overdue
for 180 days (earlier it was 365 days).
However, in addition, to those guidelines, the Reserve Bank has
also released prudential norms for takeout financing by financial
institutions in India. Under a takeout finance management, the
FII Bank financing an infrastructure project transfers the
outstanding loan amount to another on a pre-determined
basis. The taking over institution will have to make provisions
on the NPAs being taken over in their accounts from the date
of it turning into a NPA in the lending institutions books.
Further, in cases of unconditional takeover, the lending
institutions should prescribe a risk weightage of 20% in its
books when the credit risk is taken over entirely. The taking over
institution has to prescribe a risk weightage of 100% in such
cases. The weightage for the lending institution in cases of
assumption of partial credit risk has been prescribed at 20% on
the loan to be taken over and 100% on amount not taken over.
The central bank has also prescribed 100% risk weightage in
cases of conditional takeover financing for both lending and
taking over institution.
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ALM Guidelines: The Reserve Bank of India has issued
comprehensive guidelines on asset liability management
(ALM) system for the ten all-India term lending and
refinancing institutions (Fls) on December 31, 1999. The
guidelines, which will be effective from April 1, 2000, will
ensure a structured asset liability management (ALM) system
by the Fis
Exposure Norms: While deploying funds the exposure
norms that need to be adhered to are - Industry - 15 percent
of the net worth, Individual Company - 25% of the net
worth and.; Group of Companies - 50% of the net worth.
For participating in the equity, ICICI undertakes direct
subscription, underwriting, loan conversion etc. Extension
of credit by Fls does not have any restrictive clauses relating
to the priority sector lending but however, they have to
ensure balance regional development, export promotion etc.
Summary
During 1999-2000, financial assistance sanctioned and disbursed
by All India Financial Institutions (AIFIs) at Rs.1, 03,567 crore
and Rs.67, 066 crore, respectively, registered increases of 26.3
percent and 19.1 percent, as compared with 8.6 percent and 8.5
percent during 1988-99. The substantially higher growth in
both sanctions and disbursements during 1999-2000 was an
indicator of improved investment activity. Financial assistance
sanctioned by All India Development Banks (AIDBs), which
accounted for the bulk of the sanctions (84.6 percent of total
sanctions of AIFls) grew by 22.2 percent, while their
disbursements grew by 16.5 percent. During 1999-2000,
specialized financial institutions increased their disbursements
by 61.6 percent. Many of them are entering into venture capital
activity. Investment institutions also recorded a gimlet of 31.1
percent in their disbursements.
Apart from these measures, various high powered committees
are being set up to review the role, structure and operations of
the DFIs and banks. Significant recommendations have been
made by the working group under the chairmanship of Shri
S.H.Khan. The committee has recommended a progressive
move towards Universal Banking and the development of an
enabling regulatory framework for this purpose. The measures
taken relating to the CRAR, prudential norms, etc. are to ensure
the international standards for the Indian FIs. Based on these
recommendations, RBI will bring in more measures to ensure
the strengthening of Fls in India. And taking cue from these
developments, Fls are also making moves to ensure a smooth
transition from their traditional role of Fls into Universal
Banking.
Questions to Discuss:
1. Discuss the operations of one of a major Fls in India
namely ICICI
2. Discuss the Regulatory framework for Fls.
Notes:
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LESSON 26:
INSURANCE COMPANIES
Learning objectives
After reading this lesson, you will understand
Introduction
Fundamentals of insurance
Adverse selection and moral hazard in insurance
Selling insurance
Growth and organisation of insurance companies
The practicing financial institution manager
Today we shall discuss the insurance companies, why should
these investment companies be considered as an important
investment alternative.
Insurance Companies
Insurance companies are in the business of assuming risk on
behalf of their customers in exchange for a fee, called a
premium. Insurance companies make a profit by charging
premiums that are sufficient to pay the expected claims to the
company plus a profit. Why do people pay for insurance when
they know that over the lifetime of their policy, they will
probably pay more in premiums than the expected amount of
any loss they will suffer? Because most people are risk averse:
they would rather pay a certainty equivalent (the insurance
premium) than accept the gamble that they will lose their house
or their car. Thus it is because people are risk-averse that they
prefer to buy insurance and know with certainty what their
wealth will be (their current wealth minus the insurance
premium) than to incur the risk and run the chance that their
wealth may fall.
Consider how peoples lives would change if insurance were not
available.
Instead of knowing that the insurance company would help if
an emergency occurred, everyone would have to set aside
reserves. These reserves could not be invested long-term but
would have to be kept in an extremely liquid form.
Furthermore, people would be constantly worried that their
reserves would be inadequate to pay for catastrophic events such
as the loss of their house to fire, the theft of their car, or the
death of the family breadwinner. Insurance allows us the peace
of mind that a single event can have only a limited impact on
our lives.
Fundamentals of Insurance
Although there are many types of insurance and insurance
companies, all insurance is subject to several basic principles:
There must be a relationship between the insured (the party
covered by insurance) and the beneficiary (the party who
receives the payment should a loss occur). In addition, the
beneficiary must be someone who may suffer potential
harm. For example, you could not take out a policy on your
neighbours driver because you are unlikely to suffer harm if
the teenager gets into an accident. The reason for this rule is
that insurance companies do not want people to buy policies
as a way of gambling.
The insured must provide full and accurate information to
the insurance company.
The insured is not to profit as a result of insurance coverage,
If a third party compensates the insured for the loss, the
insurance companys obligation is reduced by the amount of
the compensation.
The insurance company must have a large number of
insured so that the risk can spread out among many different
policies.
The loss must be quantifiable. For example, an oil company
could not buy a policy on an unexplored oil field.
The insured company must be able to compute the
probability of the loss occurring;
The purpose of these principles is to maintain the integrity of
the insurance process. Without them, people may be tempted
to use insurance companies to gamble or speculate on future
events. Taken to an extreme, this behavior could undermine the
ability of insurance companies to protect persons in real need.
In addition, these principles provide a way to spread the risk
among many policies and to establish a price for each policy that
will provide an expectation of profitable return.
Adverse Selection and Moral Hazard in Insurance
The implication of adverse selection is that loss probability
statistics gathered for the entire population may not accurately
reflect the loss potential for the persons who actually want to
buy policies.
The adverse selection problem raises the issue of which policies
and insurance company should accept. Because someone in
poor health is more likely to buy a supplemental health
insurance policy than someone in perfect health, we might
predict that insurance companies should turn down anyone
who applies. Since this does not happen, insurance companies
must have found alternative solutions. For example, most
insurance companies require physical exams and may examine
previous medical records before issuing a health or life insurance
policy. If some previous illness is found to be a factor in the
persons health, the company may issue the policy but exclude
this preexisting condition. Insurance firms often offer better
rates to insure groups of people, such as everyone working at a
particular business, because the adverse selection problem is
then avoided.
In addition to the adverse selection problem, moral hazard
plagues the insurance industry. Moral hazard occurs when the
insured fails to take proper precautions to avoid losses because
losses are covered by insurance. For example, moral hazard may
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cause you not to lock your car doors if you will be reimbursed
by insurance if the car is stolen.
One way that insurance companies combat moral hazard is by
requiring a deductible. A deductible is the amount of any loss
that must be paid by the insured before the insurance company
will pay anything.
Selling Insurance
Another problem common to insurance companies is that
people often fail to seek as much insurance as they actually need.
Human mature tends to cause people to ignore their mortality,
for example. For this reason, insurance, unlike many banking
services, does not sell itself. Instead, insurance companies must
hire large sales forces to sell their products, the expense of
marketing may account for up to 20% of the total cost of a
policy. A good sales force can convince people to buy insurance
coverage that they never would have pursued on their own yet
may have a need for.
Insurance is unique in that agents sell a product that commits
the company to a risk. The relationship between the agent and
the company varies: independent agents may sell insurance for
a number of different companies. They do not have any
particular loyalty to any one firm and simply try to find the best
product for their customer. Exclusive agents sell the insurance
products for only one insurance company.
Most agents, whether independent or exclusive, are
compensated by being paid a commission. The agents
themselves are usually not at all concerned with the level of risk
of any one policy because they have little to lose if a loss occurs.
(Rarely are commissions influenced by the claims submitted by
an agents customers). To keep control over the risk that agents
are incurring on behalf of the company, insurance companies
employ underwriters, people who review and sign off on each
policy an agent writes and who have the authority to turn down
a policy if they deem the risk unacceptable.
Growth and Organisation of Insurance Companies
Types of Insurance
Insurance is classified by which type of undesirable event is
insured. The most common types are life insurance and
property and casualty insurance. In its simplest form, life
insurance provides income for the heirs of the deceased. Many
insurance companies provide retirement benefits as well as life
insurance. In this case, the premium combines the cost of the
life insurance with a savings program. The cost of life insurance
depends on such factors as the age of the insured, average life
expectancies, the health and lifestyle of the insured (whether the
insured smokes, engages in a dangerous hobby such as sky
diving, and so on), and the insurance companys operating
costs.
Property and casualty insurance protects property (houses, cars,
boats, and so on) against losses due to accidents, fire, disasters,
and other calamities.
Life Insurance
Life is assumed to unfold in a predictable sequence. You work
for a number of years while saving for retirement; then you
retire, live off the fruits of your earlier labour, and die at a ripe
old age. The problem is that you could die too young and not
have time to provide for your loved ones, or you could live too
long and run out of retirement assets. Wither option is very
unappealing to most people. The purpose of life insurance is to
relieve some of the concerned associated with either eventuality.
Although insurance cannot make you comfortable with the idea
of a premature death, it can at least allow you the peace of mind
that comes with knowing that you have provided for your heirs.
Life insurance companies also want to help people save for their
retirement. In this way, the insurance company provides for the
customers whole life.
The basic products of life insurance companies are life insurance
proper, disability insurance, annuities, and health insurance, life
insurance pays off if you die, protecting those who depend on
your continued earnings. As mentioned, the person who
receives the insurance payment after you die is called the
beneficiaryof the policy. Disability insurance replaces part of
your income should you become unable to continue working
due to illness or an accident. An annuity is an insurance
product that will help if you live longer than you expect. For an
initial fixed sum or stream of payments, the insurance company
agrees to pay you a fixed amount for as long as you live. If you
live a short life, the insurance company pays out less than
expected. Conversely, if you live unusually long, the insurance
company may pay out much more than expected.
Term Life
The simplest form of life insurance is the term insurance policy,
which pays out if the insured dies while the policy is in force.
This form of policy contains no savings element, once the
policy period expires, there are no residual benefits.
As the insured ages, the probability of death increases, so the
cost of the policy rises. Some term policies fix the premiums for
a set number of years, usually five of ten. Alternatively,
decreasing term policies have a constant premium, but the
amount of the insurance coverage declines each year. Term
policies have been historically hard to sell because once they
expire, the policyholder has nothing to show for the premium
paid. This problem is solved with whole life policies.
Whole Life
A whole life insurance policy pays a death benefit if the
policyholder dies. Whole life policies usually require the insured
to pay a level premium for the duration of the policy. In the
beginning, the insured pays more than if a term policy had been
purchased, this overpayment accumulates as a cash value that
can be borrowed by the insured at reasonable rates.
Survivorship benefits also contribute to the accumulated cash
values. When members of the insured pool die, any remaining
cash values are divided among the survivors. Of the
policyholder lives until the policy matures, it can be surrendered
for its cash value. This cash value can be used to purchase an
annuity. In this way, the whole life policy is advertised as
covering the insured for the duration of his or her life.
Universal Life
These types of policies combine the benefits of the term policy
with those of the whole life policy. The major benefit of the
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universal life policy is that the cash value accumulates at a much
higher rate.
The universal life policy is structured to have two parts, one for
the term life insurance and one for savings. One important
advantage that universal life policies have over many alternative
investment plans is that the interest earned on the savings
portion of the account is tax-exempt until withdrawn. To keep
this favorable tax treatment, the cash value of the policy cannot
exceed the death benefit.
Annuities If we think of term life insurance as insuring against
death, the annuity can be viewed as insuring against life, as we
noted earlier, one risk people have is outliving their retirement
funds. If they live longer than they projected when they initially
retired, they could spend all their money and end up in poverty.
One way to avoid this outcome is by purchasing annuities.
Once an annuity has been purchased for a fixed amount, it
makes payments as long as the beneficiary lives.
Annuities are particularly susceptible to the adverse selection
problem. When people retire, they know more about their life
expectancy than the insurance company knows. People who are
in good health, have a family history of longevity, and have
attended to their health all of their lives are more likely to live
longer and hence to want to buy an annuity than people in poor
or average health. To avoid this problem, insurance companies
tend to price individual annuities expensively. Most annuities
are sold to members of large groups where all employees
covered by a particular pension plan automatically receive their
benefit distribution by purchasing an annuity from the
insurance company.
Assets and Liabilities of Life Insurance Companies
Life insurance companies derive funds form two sources. First,
they receive premiums that represent future obligations that
must be met when the insured dies. Second, they receive
premiums paid into pension funds managed by Life Insurance
Company. These funds are long term in nature. Since life
insurance liabilities are predictable and long-term, life insurance
companies can invest in long-term assets. The pie chart below
shows the tentative distribution of assets of the average life
insurance company. Most of the assets are in long-term
investments such as corporate stocks and bonds.
Distribution of life insurance company assets
Corporate
Bonds
Stocks
Mortgages
Loans
Miscellaneous
Government
Securities
Health Insurance
Individual health insurance coverage is very vulnerable to
adverse selection problems. People who know that they are
likely to get ill are the most likely to seed health insurance
coverage. This causes individual health insurance to be very
expensive. Most policies are offered through company-
sponsored programs in which the company pays all or part of
the employees policy premium.
Most life insurance companies also offer health insurance.
Health insurance premiums account for about 25% of the total
premium income. There has been an extensive debate over
medical insurance reason being the spiraling costs of health care.
For most of the past decade, the cost of health care has risen
much faster than the cost of living and real wages. One factor
contributing to this increase is the more sophisticated and
expensive treatments constantly being offered. Another way
that insurance companies are attempting to deal with increased
medical costs is by controlling them. This is done by
negotiating contracts with physician groups to provide services
at reduced cost and through managed care, where approval is
required before services can be rendered.
Property and Casualty Insurance
Property and casualty insurance was the earliest form of
insurance. It protects against losses from fire, theft, storm,
explosion, and even neglect. Property insurance protect
businesses and owners from the impact of risk associated with
owning property. This includes replacement and loss of
earnings from income-producing property as well as financial
losses to owners of residential property. Casualty insurance
(or liability insurance) protects against liability for harm the
insured may cause to others as a result of product failure or
accidents.
Property and casualty insurance is different form life insurance.
First, policies tend to be short-term, usually for one year or less.
Second, whereas life insurance is limited to insuring against one
event, property and casualty companies insure against many
different events. Finally, the amount of the potential loss is
much more difficult to predict than for life insurance. These
characteristics cause property and casualty companies to hold
more liquid assets than those of life insurance companies.
Reinsurance
One way that insurance companies may reduce their risk
exposure is to obtain reinsurance. Reinsurance allocates a
portion of the risk to another company in exchange for a
portion of the premium. Reinsurance allows insurance
companies to write larger policies because a portion of the
policy is actually held by another firm.
The Practicing Financial Institution Manager
Insurance Management
Insurance companies, like banks, are in the financial
intermediation business of transforming one type of asset into
another for the public. Insurance companies use the premiums
paid on policies to invest in assets such as bonds, stocks,
mortgages, and other loans; the earnings from these assets are
then used to pay out claims on the policies. In effect, insurance
companies transform assets such as bonds, stocks, and loans
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into insurance policies that provide a set of services (for
example, claim adjustments, savings plans, friendly insurance
agents). If the insurance companys production process of asset
transformation efficiently provides its customers with adequate
insurance services at low cost and if it can earn high returns on
its investments, it will make profits; if not, it will suffer losses.
In the case of an insurance policy, moral hazard arises when the
existence of insurance encourages the insured party to take risks
that increase the likelihood of an insurance payoff. For example,
a person covered by burglary insurance might not take as many
precautions to prevent a burglary because the insurance
company will reimburse most of the losses if the theft occurs.
Adverse selection holds that the people most likely to receive
large insurance payoffs are the ones who will want to purchase
insurance the most. For example, a person suffering from a
terminal disease would want to take out the biggest life and
medical insurance policies possible, thereby exposing the
insurance company to potentially large losses. Both adverse
selection and moral hazard to reduce these payouts is therefore
an extremely important goal for insurance companies.
Screening
To reduce adverse selection, insurance companies try to screen
out poor insurance risks from good ones. Effective information
collection procedures are therefore an important principle of
insurance management.
When you apply for auto insurance, the first thing your
insurance agent does is ask you questions about your driving
record (number of speeding tickets and accidents), the type of
car you are insuring, and certain personal matters (age, marital
status). If you are applying for life insurance, you go through a
similar grilling, but you are asked even more personal questions
about such things as your health, smoking habits, and drug and
alcohol use. The life insurance company even orders a medical
evaluation (usually done by an independent company) that
involves taking blood samples. Based on this information, the
insurance company can decide whether to accept you for the
insurance or to turn you down because you pose too high a risk
and thus would be and unprofitable customer for the insurance
company.
Risk-Based Premium
Charging insurance premiums on the basis of how much risk a
policyholder poses for the insurance company is a time-honored
principle of insurance management. Adverse selection explains
why this principle is so important to insurance company
profitability.
To understand why an insurance company finds it necessary to
have risk-based premiums, lets examine an example of risk-
based insurance premiums that at first glance seems unfair. Ram
and Sita, both college students with no accidents or speeding
tickets, apply for auto insurance. Normally, Ram will be charged
a much higher premium than Sita. Insurance companies do this
because young males have a much higher accident rate than
young females. Suppose, though, that one insurance company
did not base its premiums on a risk classification but rather just
charged a premium based on the average combined risk for
males and females. Then Sita would be charged too much and
Ram too little. Sita could go to another insurance company and
get a lower rate, while Ram would sign up for the insurance.
Because Rams premium isnt high enough to cover the
accidents he is likely to have, on average the company would
lose money on Ram. Only with a premium based on a risk
classification, so that Ram is charged more, can the insurance
company make a profit.
Restrictive Provisions
Restrictive provisions in policies are another insurance
management tool for reducing moral hazard. Such provisions
discourage policyholders from engaging in risky activities that
make an insurance claim more likely. One type of restrictive
provision keeps the policyholder from benefiting from behavior
that makes a claim more likely. For example, life insurance
companies have provisions in their policies that eliminate death
benefits if the insured person commits suicide. Restrictive
provisions may also require certain behavior on the part of the
insured that makes a claim less likely. A company renting motor
scooters may be required to provide helmets for renters in order
to be covered for any liability associated with the rental.
Prevention of Fraud
Insurance companies also face moral hazard because an insured
person has an incentive to lie to the company and seek a claim
even if the claim is not valid. For example, a person who has
not complied with the restrictive provisions of an insurance
contract may still submit a claim. Even worse, a person may file
claims for events that did not actually occur. Thus an important
management principle for insurance companies is conducting
investigations to prevent fraud so that only policyholders with
valid claims receive compensation.
Cancellation of Insurance
Being prepared to cancel policies is another insurance
management tool. Insurance companies can discourage moral
hazard by threatening to cancel a policy when the insured person
engages in activities that make a claim more likely. If your auto
insurance company makes it clear that if a driver gets too many
speeding tickets, coverage will be canceled, you will be less likely
to speed.
Deductibles
The deductible is the fixed amount by which the insureds loss
is reduced when a claim is paid off. Deductibles are an
additional management tool that helps insurance companies
reduce moral hazard. With a deductible, you experience a loss
along with the insurance company when you make a claim.
Because you also stand to lose when you have an accident, you
have an incentive to drive more carefully. A deductible thus
makes a policyholder act more in line with what is profitable for
the insurance company; moral hazard has been reduced. And
because moral hazard has been reduced, the insurance company
can lower the premium by more than enough to compensate
the policyholder for the existence of the deductible.
Another function of the deductible is to eliminate the
administrative costs of small losses by forcing the insured to
bear these losses.
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Coinsurance
When a policyholder shares a percentage of the losses along
with the insurance company, their arrangement is called
coinsurance. For example, some medical insurance plans
provide coverage for 80% of medical bills, and the insured
person pays 20% after a certain deductible has been met.
Coinsurance works to reduce moral hazard in exactly the same
way that a deductible does. A policyholder who suffers a loss
along with the insurance company has less incentive to take
actions, such as going to the doctor unnecessarily, that involve
higher claims. Coinsurance is thus another useful management
tool for insurance companies.
Limits on the Amount of Insurance
Another important principle of insurance management is that
there should by limits on the amount of insurance provided,
even though a customer is willing to pay for more coverage. The
higher the insurance coverage, the more the insured person can
gain from risky activities that make an insurance payoff more
likely and hence the greater the moral hazard. For example, if
Sitas car were insured for more than its true value, she might
not take proper precautions to prevent its theft, such as making
sure that the key is always removed or putting in an alarm
system. If her car were stolen, she comes out ahead because the
excessive insurance payoff would allow her to bur an even
better car. By contrast, when the insurance payment is lower
than the value of her car, she will suffer a loss if it is stolen and
will thus take the proper precautions to prevent this from
happening. Insurance companies must always make sure that
their coverage is not so high that moral hazard leads to large
losses.
Questions to Discuss:
1. What are the fundamentals of insurance?
2. Discuss the adverse selection and moral hazard in insurance.
3. What is selling insurance?
4. Discuss Growth and organisation of insurance companies?
5. Explain the characteristics of the practicing financial
institution manager?
Notes:
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LESSON 27:
MUTUAL FUND
Learning objectives
After reading this lesson, you will understand
Concept
Structure
Types of mutual fund
SIP or SWP or STP
Tax benefits in mutual fund
Net asset value (NAV) the concept
Importance of NAV to the investor
Advantages of investing in mutual fund
Disadvantages of investing in mutual fund
Students, today in the class we shall discuss one of the most
popular investment alternatives available in the market. It is
popular both with retail investors as well as high networth
individual because of its capacity to earn more returns with less
risk.
Let us start with the concept of Mutual Fund. What exactly do
we understand by mutual fund?
Concept
Investment can be done in different forms. An investor can
either invest directly in securities, or can invest through an
investment company. An investment company is a financial
intermediary that collects money from investors and invests in
various securities on their behalf. The returns from these
investments are passed on to the investors, either periodically,
or at the end of a specified time period. The investment
company charges fees for its services, referred to as management
fees.
There are two kinds of investment companies Open-end and
Close-end. OpenEnd investment companies are those, which
have an unlimited investment horizon. They sell and buy back
their shares at regular intervals through out their existence.
Hence their investible funds or portfolio size keeps on
changing. Close- End companies are those which have a limited
investment horizon. The investors invest in the company for a
specified time period, and the investment company manages for
the said period. At the end of the period the investments are
liquidated and the investors funds are returned along with the
returns.
In India both close-end and open-end investment companies
are called Mutual Funds. Thus Mutual fund is a trust that
pools the savings of a number of investors who share a
common financial goal. The money thus collected is then
invested by the fund manager on behalf of the investors in
different types of securities. The income earned through these
investments and the capital appreciated realized by the schemes
are shared by its unit holders in proportion to the number of
units owned by them.
A mutual fund uses the money collected from the investor to
buy those assets, which are specifically permitted by its stated
investment objective. Thus, an Equity Fund would buy mainly
equity assets- ordinary shares, preference shares, warrants etc; a
Bond Fund would mainly buy debt instruments such as
debentures, bonds, or government securities. It is these assets,
which are owned by the investors in the same proportion as
their contribution bears to the total contributions of all the
investors put together.
When an investor subscribes to the mutual fund, he or she
buys a part of the assets or the pool of funds that are
outstanding at that time. It is no different from buying
shares of a joint stock company, in which case the purchase
makes the investor a part owner of the company and its assets.
In India, a mutual fund is constituted as a Trust and the
investor subscribes to the units issued by the fund, which is
where the term Unit Trust comes from. In any case, a mutual
fund shareholder or unit-holder is a part owner of the funds
asset.
Since each owner is a part owner of a mutual fund, thus it is
necessary to establish the value of his part. In other words, each
share or unit that an investor holds needs to be assigned a
value. Since the units held by investor evidence the ownership
of the funds assets, the value of the total assets of the fund
when divided by the total number of units issued by the
mutual fund gives us the value of one unit. This is generally
called the Net Asset Value (NAV) of one unit or one share.
The value of an investors part ownership is thus determined
by the NAV of number of units held.
A mutual fund is the ideal investment vehicle for todays
complex and modern financial scenario. Markets for equity
shares, bonds and other fixed income instruments, real estate,
derivatives and other assets have become mature and
information driven. Price changes in these assets are driven by
global events occurring in faraway places. A typical individual is
unlikely to have the knowledge, skills, inclination and time to
keep track of events, understand their implications and act
speedily. An individual also finds it difficult to keep track of
ownership of his assets, investments, brokerage dues and bank
transactions etc. A mutual fund is the answer to all these
situations. It appoints professionally qualified and experienced
staff that manages each of these functions on a full time basis.
The large pool of money collected in the fund allows it to hire
such staff at a very low cost to each investor.
In effect, the mutual fund vehicle exploits economies of scale in
all three areas - research, investments and transaction processing.
While the concept of individuals coming together to invest
money collectively is not new, the mutual fund in its present
form is a 20
th
century phenomenon. In fact, mutual funds
gained popularity only after the Second World War.
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Globally, there are thousands of firms offering tens of
thousands of mutual funds with different investment
objectives. Today, mutual funds collectively manage almost as
much as or more money as compared to banks. This gives the
investor number of options and gives him optimal returns
accompanied by minimum risk.
All in all mutual fund is the best means to invest by not only
minimizing the risk but also maximizing returns.
The following flow chart would make our understanding very
clear.
The flow chart below describes broadly the working of a
mutual fund:

Structure
Now lets come to the structure of the overall functioning of
Mutual Fund.
The organisational set up of the Mutual Fund is as follows:
The structure of a mutual fund differs from country to country.
In India the structure of a mutual fund is determined by SEBI
regulations. These regulations are required to be established in
the form of a trust under the Indian Trust Act, 1882. In India
Mutual Fund industry can be divided into three categories- The
Unit Trust of India, the Asset Management Company floated
by Nationalized Banks and the Asset Management Company
floated by Private sector.
The Unit Trust of India dominates the Indian mutual fund
industry, which has a total corpus of Rs700bn collected from
more than 20 million investors. The UTI has many funds/
schemes in all categories i.e. equity, balanced, income etc with
some being open-ended and some being closed-ended. The
Unit Scheme 1964 commonly referred to as US 64, which is a
balanced fund, is the biggest scheme with a corpus of about
Rs200bn. UTI was floated by financial institutions and is
governed by a special act of Parliament. Most of its investors
believe that the UTI is government owned and controlled,
which, while legally incorrect, is true for all practical purposes.
The second largest category of mutual funds is the ones floated
by nationalized banks. Canbank Asset Management floated by
Canara Bank and SBI Funds Management floated by the State
Bank of India are the largest of these. GIC AMC floated by
General Insurance Corporation and Jeevan Bima Sahayog AMC
floated by the LIC are some of the other prominent ones. The
aggregate corpus of funds managed by this category of AMCs
is about Rs150bn.
The third largest category of mutual funds is the ones floated
by the private sector and by foreign asset management
companies. The largest of these are Prudential ICICI AMC and
Birla Sun Life AMC. The aggregate corpus of assets managed
by this category of AMCs is in excess of Rs250bn.
Further the Mutual Fund Industry has a Four tier structure.
The four parties that are required to be involved are:
Sponsor
Board of Trustees
Asset Management Company (AMC)
Custodian.
These four entities operate in the following manner:


SPONSOR




BOARD OF TRUSTEES/DIRECTORS OF TRUSTEES COMPANY




ASSET MANGEMENT COMPANY





CUSTODIAN



The Sponsor of a fund is the entity that sets up the mutual
fund. The fund is governed either by a Board of Trustees, or
The Directors Of A Trustees Company. The sponsor selects
them. The Board of Trustee is responsible for protecting the
investors interests. The sponsor or the trustee if so authorized
by the Trust Deed appoints the Asset Management Company
(AMC) for the investment and administrative functions. The
AMC does the research, and manages the corpus of the fund. It
launches the various schemes of the fund, manages them, and
then liquidates them at the end of their term. It also takes care
of the other administrative work of the fund. It receives an
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annual management fees from the fund from its services. The
Custodians are appointed by the sponsor for looking after the
transfer and storage of the securities and co-ordinate with the
brokers.
It is important for the people associated with the Mutual Fund
Industry to be aware of the special nature of its structure,
because it determines the rights and responsibilities of the
funds constituents viz. sponsors, trustees, custodians, transfer
agent and the fund and the asset management company. In the
following readings each component will be discussed in details:
The Fund Sponsor
Sponsor is defined under SEBI regulations as any person
who, acting alone or in combination with another body
corporate, establishes a mutual fund. The sponsor of a fund is
akin to the promoter of accompany as he gets the fund
registered with SEBI. The sponsor will form a trust and
appoint a board of trustees. The sponsor will also generally
appoint an Asset Management Company as fund managers.
The sponsor, either directly or acting through the trustees, will
also appoint a Custodian to hold the fund assets. All these
appointments are made in accordance with SEBI Regulations.
As per the existing SEBI regulations, for a person to qualify as a
sponsor, he must contribute at least 40% of the net worth
AMC and posses a sound financial track record over five years
prior to registration.
The Trustee
A mutual fund in India is constituted in the form of a Public
Trust created under the Indian Trusts Act 1882. The Fund
Sponsor acts as the Settler of the Trust, contributing to its
initial capital and appoints a trustee to hold the assets for the
benefit of the unit-holders, who are the beneficiaries of the
trust. The fund then invites investors to contribute their money
in the common pool, by subscribing to units issued by various
schemes established by the trust, units being the evidence of
their beneficial interest in the fund.
The trust the mutual fund- may be managed by a Board of
Trustees- a body of individuals, or a trust company- a corporate
body. The Board of Trustees manages most of the funds in
India. While the Provisions of the Indian Trusts Act, govern
the Board of Trustees where the Trustee is a corporate body, it
would also be required to comply with the provisions of the
companies Act, 1956. The Board or the trustee company, as an
independent body, acts as protector of the unit-holders interest
the trustees do not directly manage the portfolio of securities.
For this specialist function, they appoint an Asset Management
Company. They ensure that the fund is managed by the AMC
as per the defined objectives and in accordance with the Trust
Deed and SEBI Regulations.
The trustees being the primary guardians of the unit holders
funds and assets, a trustee has to be a person of high repute
and integrity. He acts as a watchdog over the AMC so that the
investors money is safe and secure.
The Asset Management Company
An AMC is the investment manager of the trust. The AMC
functions under the supervision of its own Board of Directors,
and also under the direction of the Trustees and SEBI. The
Trustees are empowered to terminate the appointment of the
AMC by majority and appoint a new AMC with prior approval
of SEBI and unit holder.
The AMC of a mutual fund must have a net worth of at least
Rs.10crs. at all times. Directors of AMC, both independent and
non-independent, should have adequate professional experience
in financial services and should be individuals of high moral
standing, a condition also applicable to other key personnel of
the AMC. The AMC cannot act as a trustee of any other mutual
fund. Besides its role as the fund manager it may undertake
specified activities such as advisory services and financial
consulting provided these activities are run independently of
one another and the AMCs resources are properly segregated by
activity.
The AMC are responsible to invest on behalf of the investors
who have entrusted them with their money .So they are
expected to act in the interest of the investors.
The Custodian
Mutual funds are in the business of buying and selling of
securities in large volumes. Handling these securities in terms of
physical delivery and eventual safekeeping is therefore a
specialized job. The custodian is appointed by the Board of
Trustees for safekeeping of physical securities or participating in
any clearing system through approved depository companies on
behalf of the mutual fund in case of dematerialized securities.
The mutual fund industry does not work with the help of one
entity. All the four constituents have to operate in harmony and
in co-operation with each other. One must not forget that they
are inter-related and has to function together.
Types of Mutual Fund
Mutual funds differ from each other on the basis of various
factors like their structure, their investment objectives, and the
types of investors, management style and load. The various
classes of funds are:



OPEN-ENDED
STRUCTURE

CLOSE-ENDED


EQUITY (GROWTH)

INCOME

INVESTMENT BALANCED
OBJECTIVE
LIQUID

GILT

OTHER SPECIALIZED FUNDS (MIP, SECTORAL,
etc.)


TYPES OF OFFSHORE FUNDS
INVESTORS
PENSION FUNDS




MANAGEMENT MANAGED FUNDS
S TYLE

INDEX FUNDS


LOAD FUNDS

LOAD
NO LOAD FUNDS



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Open- Ended Fund
An open-ended fund is a fund, which remains open for issue
and redemption of its shares throughout its duration. This
means an investor can invest or put in his money at any point
of time and similarly redeem or withdraw his investment at any
given time depending on the market and other factors.
Examples: Birla Advantage Fund, HDFC equity, Canaganag, etc.
As an open-ended fund is required to redeem its shares any
time the investors wish to liquidate their holdings, a relatively
higher portion of its assets need to be highly liquid.
Close-Ended Fund
A close ended fund can issue shares only in the beginning,
and cannot redeem them or reissue them till the end of their
fixed investment duration. This means that once an investor
puts in his money he cannot withdraw till the maturity period.
Example: UTIs US 92. A close-ended fund does not face the
problem of shortfall, as it does not require to redeem its shares
before the maturity period of the fund.
Equity or Growth Fund
The objective of Growth Fund Scheme is to provide capital
appreciation over the medium to long term. These schemes
normally invest a major portion of their fund in Equities and
are willing to bear short-term decline in value for future
appreciation in the net asset value of the scheme. These
schemes are not for the investors seeking regular income or
needing their money back in the short term and are suitable for
investors in their prime earning years or investors seeking
growth over the long term.
Growth or Equity funds offer two options-Dividend Option
and Growth Option. In Dividend Option, the investor gets the
dividend on a regular basis as and when declared by the AMC.
The dividend is calculated on the face value of that particular
scheme of the Mutual Fund. This dividend is tax-free in the
hands of investors. In the case of Growth Option, no
dividend is declared so the NAV continues to appreciate on a
regular basis.
Dividend option comprises of Dividend Pay-Out and
Dividend Reinvestment. In the case of Dividend Pay-Out
option, the investors receive the dividend when declared by the
AMC and the NAV of that scheme gets reduced in proportion
to the percentage of dividend declared. On the other hand, in
the case of Dividend Reinvestment Option, the dividend
amount gets automatically reinvested in the scheme instead of
coming in the hands of the investor. Here the number of units
gets increased accordingly. In this case too the NAV gets reduced
in accordance with the percentage of the dividend declared.
The Growth Option is bifurcated into Growth Plan and
Bonus Plan. In Growth Plan when the company declares
bonus the investors who have opted for this plan are not
entitled for the bonus shares. In this case the NAV of the
scheme keeps on appreciating. On the other hand investors who
have opted for bonus plan receive the bonus shares and the
NAV of the scheme decreases in the same proportion.
Some schemes can be aggressive, where the weightage is more
on mid-caps. Here the fluctuations are more, or there are
conservative funds where the weightage is on Blue-chip
companies, the performances of these funds are more
consistence. Then there are diversified schemes were the money
is invested over a wide area thus minimizing risk. So an investor
according to his risk taking ability can invest in these funds.
Income Fund
The aim of such fund is to provide regular and steady income
to investors. These funds or schemes generally invest in fixed
incomes such as bonds and corporate debentures. Capital
appreciation in such schemes may be limited. These are suitable
for retired people and others with a need for capital stability and
regular income.
The largest segment of the market in terms of traded volume
and outstanding debt is the government securities market. This
is the most liquid segment of the market with maturity of debt
issues ranging from 91day Treasury bill right up to 30 yr dated
securities. This class of securities would account for more than
90% of traded volume in the secondary market. People who are
very low risk takers can opt for these schemes. Here the investor
gets regular returns at minimum risk, but the returns are not as
high as equity.
Balanced Fund
They aim to provide both growth and income periodically
distributing a part of the income and capital appreciation to the
investors or reinvesting (in case of reinvestment scheme) such
income and capital appreciation to enhance the net asset value
of the fund. They invest in both shares and fixed income
securities in the proportion indicated in their offer document.
Such funds are suitable for investors, who are willing to take
some risk and seeks both income and capital appreciation.
Here a part of the investment is in debt market so the risk is
minimum, and the other part is invested in equities to
maximize returns. Hence the investors enjoy the benefit of high
returns along with security. The aim of balanced funds is to
provide both growth and regular income. In a rising stock
market, the NAV of these schemes may not normally keep pace,
or fall equally when the market falls. These are ideal for investors
looking for a combination of income and moderate growth.
Here the maximum exposure is towards Equity as compared to
debt. However the proportion of equity: debt may change from
time to time, as the market trend is as well as on the call of
fund manager. In the recent months the proportion of equity:
debt is 60: 40. This is because the equity market is doing well.
Balance fund tries to strike a balance between that equity offers
and the safety that debt provides, and thus maximizes
investments at moderate levels of risk.
Liquid Fund
Liquid funds are short-term investments, which are not marked
to market (not traded). In this case the investors instead of
keeping the money with them for a very short period say a
weekend invests in liquid fund. The aim of Liquid funds is to
provide easy liquidity, preservation of capital and moderate
income. These schemes generally invest in safer short-term
instruments such as treasury bills, certificates of deposit,
commercial paper and inter-bank call money. Returns on these
schemes may fluctuate depending upon the interest rates
prevailing in the market. These are ideal for Corporate and
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individual investors as a means to park their surplus funds for
short periods. However the amount of money invested in the
above mentioned areas might differ from one fund house to
the other.
Gilt Fund
These funds are majorly, investing in government securities, this
includes treasury bills. This fund is for those people who are
looking at investing in government securities, which enjoy no
credit risk, hence ensuring the safety of their money. Here the
primary objective is to generate credit risk free returns by
investing in a portfolio of securities issued and guaranteed by
Central and State Government.
Other Specialized Fund
These funds invest in particular industries, instruments sectors
or markets. If they are Industry Specific Schemes then they
invest only in the industries specified in the offer document.
The investment of these funds is limited to specific industries
like InfoTech, FMCG, and Pharmaceuticals etc. For Example:
Alliance Basic Industries fund, Prudential ICICI Technology
fund, etc.
If they are Sector Specific Schemes then they invest
exclusively in a specified sector. This could be an industry or a
group of industries or various segments such as A Group
shares or initial public offerings.
Then there is Tax Saving Schemes. These schemes offer tax
rebates to the investors under specific provisions of the Indian
Income Tax laws as the Government offers tax incentives for
investment in specified avenues. Investments made in Equity
Linked Savings Schemes (ELSS) and Pension Schemes are
allowed as deduction u/ s 88 of the Income Tax Act, 1961. The
Act also provides opportunities to investors to save capital
gains u/ s 54EA and 54EB by investing in Mutual Funds. The
objective of this scheme is to help the tax paying investors in
minimizing their tax liability.
Offshore Funds
Funds that invest solely in the foreign markets are referred to as
international funds (also called offshore funds) the majority of
funds have been routed through Mauritius. Funds that invest
in both domestic and international markets are referred to as
Global Funds. At present the Indian mutual funds are not
allowed to invest in the international market, nor are the foreign
investors are allowed to invest in the Indian mutual fund
directly.
Internationally, there is a category of funds, which invest in a
portfolio of other mutual funds. Such funds are called Multi-
Funds.
Pension Fund
There are some categories of funds that are different from other
funds because of their investor profile. They are the Pension
Funds. These funds manage the pension money of their
clients. These funds aims at investing the money of the
investor in areas, which give, assured returns with minimum
risk.
Managed Fund
The corpus of the fund can be managed actively or passively.
Active management of funds involves gathering of security
specific information, analyzing it, and selecting those securities
that are most expected to fulfill the investment objectives. This
process entails a heavy cost that is charged to the scheme.
Funds, which manage their corpus actively, are called Managed
Fund. Active management of funds is undertaken with the aim
of performing better than the Index Funds. However,
empirical evidence suggests that risk- adjusted after-cost returns
from managed funds may not be necessarily higher than the
returns from index fund.
Index Fund
Passive management of fund involves selection of a market
index. After an index is selected, the securities that form a part
of the index are bought in the proportion in which they are
represented in the index. No further transaction is done and
these securities are held till a need to liquidate the corpus arises.
If a part of the corpus is required to be liquidated for
redemption purposes, it is liquidated in the same proportion in
which the securities are held. The cost of managing funds
passively is quite less as compared to active management. Index
funds bases on BSE or NSE are examples of passively
managed funds. Index funds perform in line with the
performance of the index, which is reflective of the market as a
whole.
Load Fund
A fund incurs two types of costs- marketing costs and
operating costs. While the operating costs of the scheme are
charged to the schemes earnings, the marketing costs may not
be so charged. In case of Load Fund they charge the marketing
costs to the scheme. Further the load fund is of two types
Front Load and Back Load. In a front load fund, the load is
charged at the time the investors invest in the fund, this is also
called Entry Load. In the case of back load fund, investors are
required to pay the load charges while exiting from the fund.
This is also called the Exit Load. There can be a Partial Load
scheme, wherein a part of the load is borne by the scheme and
the rest by the Asset Management Company.
No- Load Fund
In these kinds of funds the marketing costs as a part of the
management fee. The management is allowed to charge an
additional management fees from the scheme up to 1% of the
weekly average corpus of the scheme in any financial year.
Further the management is entitled to charge a load on
redemptions during the first four years of the scheme, subject
to the following limits:
Duringthe1st year Maximum4% of theredemption proceeds.
Duringthe 2
nd
year Maximum3% of theredemption proceeds.
Duringthe 3
rd
year Maximum2% of theredemption proceeds.
Duringthe 4th year Maximum1% of theredemption proceeds.

SIP or SWP or STP
Rather than investing, disinvesting or switching the entire
portfolio at a single point of time, it is prudent to spread these
actions systematically over a period of time. This also curbs the
tendency of an investor to time the market -an investment style
that several researchers have statistically proved has a low
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probability of success. This principle has given rise to the
concepts of Systematic Investment Plan (SIP), Systematic
Withdrawal Plan (SWP) and Systematic Transfer Plan (STP).
Systematic Investment Plan (SIP)
SIP refers to the practice of investing a constant amount every
month. Thus, when the market goes up, then the money
invested gets translated into less number of units. If the
market goes down, then the same money invested gets
translated into-more number of units.
SIP ensures that your acquisition cost approximates the average
NAV. Therefore; this investment style is also called Rupee Cost
Averaging.
A related concept is Value Averaging. Here, the investor
operates with a certain target value for his investment. If the
investment appreciates beyond the target value, he encashes part
of the investment. If the investment depreciates below the
target value, the investor brings in fresh funds equivalent to the
difference.
Systematic Withdrawal Plan (SWP)
SWP is a mirror image of the SIP. In a SWP, the investor would
withdraw constant amounts periodically. The learning is the
same viz. that through a SWP the investor can temper gains and
losses, though it does not prevent losses.
Systematic Transfer Plan (STP)
Mutual funds make It convenient, and economical, to
systematically transfer Investments between schemes of the
same mutual fund.
Tax Benefits in Mutual Fund
The taxman has, over the years, been more or less kind to
Mutual Funds. With laws varying from time to time, the overall
objective has been to encourage the growth of the Mutual
Funds industry. Currently, a variety of tax laws apply to Mutual
Funds, which are broadly listed below: -
Capital Gains
Units of Mutual Fund schemes held for a period for more than
twelve months are treated as long-term capital assets. In such
cases, the unit holder has the option to pay capital gain tax at
either 20% with indexation or 10% without indexation.
Tax Deducted at Source (TDS)
For any income credited or paid by a fund, no tax is deducted or
withheld at source. The relevant sections in the Income Tax Act
governing this provision are Section 194K and 196A.
Wealth Tax
Mutual fund units are not currently treated as assets under
Section 2 of the Wealth Tax Act and are therefore not liable to
tax.
Income from Units
Any income received from units of the schemes of a mutual
fund specified under section 23 (D) is exempt under Section 10
(33) of the Act. While section 10(23D) exempts income of
specified mutual funds from tax (which currently includes all
mutual funds operating in India), Section 10(33) exempts
income from funds in the hands of the unit-holders. However,
this does not mean that there is no tax at all on income
distributions by mutual funds.
Income Distribution Tax
As per prevailing tax laws, income distributed by schemes other
than open-end equity schemes is subject to tax at 20 % (plus
surcharge of 10 %). For this purpose, equity schemes have been
defined to be those schemes that have more than 50 % of their
assets in the form of equity. Open-end equity schemes have
been left out of the purview of this distribution tax for a
period of three years beginning from April 1999.
Income Received from Mutual Funds
The Finance Bill 1999 made income (i.e. dividends) received
from all mutual funds tax free in the hands of investors).
Investors need not pay any tax on dividend received from a
mutual fund for a period of three years effective from April 1,
1999. For the investor it does not matter what kinds of mutual
fund scheme they have invested in. Dividend whether received
from equity, equity & debt or a debt scheme will all be tax-free
for the investors.
While dividends in the hands of the investor are free from tax,
mutual funds are now required to pay a distribution tax of
20% from the financial year 2000-2001 (instead of 10% as
distribution tax last year. The distribution tax is not to be paid
on all types of mutual fund schemes. Effective April 1,1999, for
a period of three years, open-end equity oriented schemes will
be exempt from paying the distribution tax
Tax Implication for Income Received on Open-end
Equity Oriented Scheme:
As per the Finance Bill 1999, income distributed under the US-
64 scheme and other open-ended equity oriented scheme of
UTI and Mutual Funds are exempt from the levy of this tax for
a period of three financial years starting from 1.4.1999. An
open-end equity oriented scheme is defined as one where more
than 50% of the schemes investible funds are invested in
domestic equities. The 50% is computed taking the annual
average of the monthly averages of the schemes equity
holdings. The monthly average, in turn, is calculated by taking
the opening and closing percentage of a particular months
equity holdings.
Difference Between TDS and Distribution Tax
The distribution tax is different from TDS or tax deducted at
source. In the case of TDS, the tax has to be deducted at the
time of payment or redemption by the issuer of the security
and deposited with the Government. The issuer from income
payable to the investor deducts this tax and the investor gets
credit of the same while filing his annual return of tax. In cases
where the investor is not liable to pay tax he may claim an
exemption from TDS by filing a Form 15H with the issuing
body of the security. Distribution tax is, however, a tax that has
to be paid by the mutual fund, not the investor. It is not a
direct tax paid by the investor therefore, he cannot file for
exemption from distribution tax. Hence, while the dividend pay
out will be tax-exempt in the hands of the investors, in all
schemes where the mutual fund has to pay a distribution tax,
the dividend pay out will be affected to that extent by the 22%
distribution tax.
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Long Term Capital Gains Arising from Sale of
Mutual
Fund Units
As per the current provisions of the budget, long-term capital
gains arising from the sale of listed securities and shares as
defined under the Securities Contracts (Regulation) Act, 1956
(SCRA) are now chargeable to tax at a maximum rate of 10 %.
As per the earlier Income Tax law, units of mutual funds did
not qualify as listed securities under the Securities Contracts
(Regulation) Act, 1956 (SCRA) but as per the provisions of
Union Budget 2000-2001 units of all Mutual funds will be
considered as listed securities and long-term capital gains from
units of mutual funds will be taxed at 20 per cent after giving
benefit of cost inflation indexation, or a flat rate of 10 % which
ever is lower. That is, persons would have the option of either
availing of cost indexation on the capital gains and paying 20
per cent capital gains tax or paying a flat rate of 10 per cent
without cost indexation. As a result, the maximum capital gains
tax payable has been capped at 10 per cent.
Deletion of Sections 54 EA and 54 EB of the Income
Tax Act, 1961
The above two sections provided relief from capital gains tax if
investments were made in specified securities and locked in for a
period of 3 years in the case of 54EA and 7 years in the case of
54EB. Mutual fund units were one of the specified securities
and this resulted in a lot of money realized as profit from sale
of securities being reinvested in the market through mutual
funds.
With the withdrawal of the exemption to mutual funds,
investors have lost out on a very viable alternative for tax saving
and funds also would be faced with the problem of hot
money as there would no longer be any lock in period for
investments. However this facility will be available till 30th
September 2000 for all capital gains accrued till 31st march 2000.
Net Asset Value (NAV) the Concept
The Net Asset Value is the market value of the assets of the
scheme minus its liabilities. It is calculated on a daily basis. The
NAV is usually below the market price because the current value
of the funds assets is higher than the historical financial
statements used in the NAV calculation. It is the cumulative
market value of the assets fund net of its liabilities. It
represents the market value or price of one fund share. In other
words, if the fund is dissolved or liquidated, by selling off all
the assets in the fund, this is the amount that the shareholders
would collectively own. This gives rise to the concept of net
asset value per unit, which is the value, represented by the
ownership of one unit in the fund. NAV It is calculated by
dividing the funds total net assets by the total number of
shares outstanding. Except for money market funds, which are
pegged to a constant NAV, a funds NAV may change every day
to reflect changes in the value of its portfolio holdings, which in
turn respond to changing market conditions. Further, mutual
funds are open-ended, meaning they allow for daily purchases
and redemptions, which affects the total number of shares
outstanding.
Fund companies typically calculate fund NAVs at the end of the
day, after the markets have closed. This allows the fund
company to value the holdings in each fund and determine the
total number of shares in which to base the NAV calculation.
NAVs are usually available two to three hours after market
close. Investors can track fund performance by looking at the
change in NAV, like they would if they were tracking stock
performance using stock prices.
When a fund has a sales charge, called load, the price you have to
pay is called the offering price and thats equal to the NAV plus
any sales charges (loads). Funds sold through financial advisors
often have sales charges. As for no-load funds, the NAV and
offering price are the same. If that is confusing, stick to no-load
funds and youll be safe.
Calculation of Nav
The most important part of the calculation is the valuation of
the assets owned by the fund. Once it is calculated, the NAV is
simply the net value of assets divided by the number of units
outstanding. The detailed methodology for the calculation of
the asset value is given below.
Asset Value is Equal to
Sum of market value of shares/ debentures + Liquid assets/
cash held, if any + Dividends/ interest accrued Amount due on
unpaid assets - Expenses accrued but not paid
Details on the above Items
For liquid shares/ debentures, valuation is done on the basis of
the last or closing market price on the principal exchange where
the security is traded
For illiquid and unlisted and/ or thinly traded shares/
debentures, the value has to be estimated. For shares, this could
be the book value per share or an estimated market price if
suitable benchmarks are available. For debentures and bonds,
value is estimated on the basis of yields of comparable liquid
securities after adjusting for liquidity. The value of fixed interest
bearing securities moves in a direction opposite to interest rate
changes Valuation of debentures and bonds is a big problem
since most of them are unlisted and thinly traded. This gives
considerable leeway to the AMCs on valuation and some of the
AMCs are believed to take advantage of this and adopt flexible
valuation policies depending on the situation.
Interest is payable on debentures/ bonds on a periodic basis say
every 6 months. But, with every passing day, interest is said to
be accrued, at the daily interest rate, which is calculated by
dividing the periodic interest payment with the number of days
in each period. Thus, accrued interest on a particular day is equal
to the daily interest rate multiplied by the number of days since
the last interest payment date.
Usually, dividends are proposed at the time of the Annual
General meeting and become due on the record date. There is a
gap between the dates on which it becomes due and the actual
payment date. In the intermediate period, it is deemed to be
accrued.
Expenses including management fees, custody charges etc. are
calculated on a daily basis.
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The Net Asset Value per unit on any business day is computed
as follows:


Market value of the funds investments +
Receivables + Accrued Income
Liabilities Accrued Expense

No of Shares or Units outstanding



Net Asset Value =
The calculation of the NAV may be illustrated with the help of
the following example:
Name of the scheme: AB Balanced
Size of the scheme: Rs.200 Crore
Face value of the Share: Rs 10
No. Of outstanding units: 20 Crore
Market value of the funds investments: Rs.280 Crore
Receivables: Rs.2 Crore
Accrued Income: Rs.2 Crore
Liability: Rs.1 Crore
Accrued Expense: Rs.1 Crore


NAV = 280+2+2-1-1
20

= Rs. 14.1 per share.
Importance of Nav to the Investor
What is NAV? Its the answer to the question, how am I
doing? After taking all the steps needed to find great
investment ideas, how do you then measure and compare the
success of those ideas as investments? At Marketocracy, we
think the best way to track your performance is to do it the
same way that mutual funds track their own performance, using
Net Asset Value per share.
If youre a typical investor, you want to know how well your
investments are doing over time. If you only buy one stock and
then hold onto it, its pretty easy to figure out how youre doing
by simply comparing the current value of the stock to the
amount you initially invested.
Things get a lot more complicated once you have multiple
stocks in your portfolio and youre buying and selling shares at
different times for different prices. Performance gets even harder
to measure if you invest additional cash or take money out of
the portfolio every once in a while.
Adding cash to the portfolio increases its value, but not its
performance. Net Asset Value provides a way to objectively
measure the performance over time in spite of all the changes
that an investor makes to his portfolio. Since other investment
vehicles like mutual funds use NAV, it also provides a way to
compare the investors investment performance to
professionally managed funds and indices, like the S&P 500.
For open-ended mutual funds, new shares are issued as money
flows into the fund. Likewise, the number of shares
outstanding is reduced as investments are redeemed. The NAV
increases as the value of the portfolios holdings increase. For
example, if a share of a stock fund costs Rs.30 today and Rs.18
one year ago, there has been a gain (or profit) of Rs.12 a share,
or about 66%, before fund expenses. The change in a funds
NAV determines its performance. Comparing NAV
performance enables investors to differentiate funds on a
relative basis. NAV per share is a reliable, credible, and accepted
measuring stick for portfolio performance.
Tracking Fund Performance
For the majority of investors, investment performance is
ultimately the most important factor in determining which
mutual fund to invest in. A mutual funds performance can be
measured in several different ways, depending on its investment
objectives. Whether a fund aims for long-term growth, current
income, or a combination of the two, investors can track fund
performance and judge profitability by:
Following changes in share price or net asset value (NAV)
Calculating total return
Figuring yield
While each calculation enables investors to compare a funds
performance to similar funds offered by different companies,
there is no simple calculation for comparing funds to individual
securities, because each return is figured differently depending
on the type of investment.
As individual investors, we are all investment managers- of our
own portfolios! Therefore, to accurately answer the question of
how are my investments doing? I we need to gauge our
investment performance at the portfolio level, rather than by
each individual security. Utilizing the net asset value (NAV)
method of performance tracking allows us to measure the
performance of our entire portfolio and accurately compare our
results with the universe of professionally managed funds.
The NAV method is also the only accurate means of accounting
for cash placed into, or taken out of, an investment portfolio.
New investments in the portfolio are made at the closing NAV
on the day of the investment. Similarly, money taken out of a
portfolio is taken out at the NAV on the day of the withdrawal.
In either case, because a fund s shares increase or decrease with
the flow of investments, accurate performance measurement is
assured. Remember, the net asset value equals the value of the
fund investments divided by the shares outstanding.
When new investments are made, look at the closing NAV on
that day and divide the amount of your new investment by it.
This will give you the correct number of shares to add to your
portfolio shares outstanding. The same calculation when the
investors takes money out of his investment portfolio, but
subtract the equivalent number of shares from the total
portfolio shares outstanding.
Through NAV it is possible to gauge the performance of the
scheme and thereby chose the best scheme for the portfolio.
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Advantages of Investing in Mutual Fund
Diversification benefits
Diversified investment improves the risk- return profile of the
portfolio. Small investors may not have the amount of capital
that would allow optimal diversification. Since the corpus of a
mutual fund is substantially big as compared to individual
investments, optimal diversification becomes possible. As the
individual investors capital gets pooled into a mutual fund, all
of them are able to derive the benefits of diversification.
Low Transaction Cost:
The transactions of a mutual fund are generally very large. These
large volumes attract lower brokerage commissions (as a
percentage of the value of the transaction) and other costs, as
compared to the smaller volumes of the transactions entered
into by individual investors. The brokers quote a lower rate of
commission due to two reasons. The first is competition for
the institutional investors business. The second reason is that
the overhead costsfor executing a trade does not differ much
for large and small orders. Hence, for a large order, these costs
spread over a large volume, enabling the broker to quote a lower
commission rate.
Availability of Various Schemes
Mutual funds generally offer a number of schemes to suit the
requirements of the investors. Thus the investors can choose
between regular income schemes and growth schemes, between
schemes that invest in the stock market and those that invest in
the stock market, etc. some schemes provide some added
advantages. For example: automatic reinvestment schemes
reinvest the distributed income automatically, thus making the
management of funds easier. In case of direct investment in
securities, the reinvestment of the income in the same
proportion as the assets held is very difficult and at times
impossible. Funds that invest in overseas markets offer the
additional advantage of international diversification, which may
otherwise may not be feasible to the lay investors. However in
India mutual funds cannot invest in overseas market.
Professional Management
Management of a portfolio involves continuous monitoring of
various securities and the innumerable economic and non-
economic variables that may affect the portfolios performance.
This requires a lot of time and effort on the part of the
functioning of the financial markets. Mutual funds are generally
managed by knowledgeable, experienced professionals whose
time is solely devoted to tracking and updating the portfolio.
Thus, investments in a mutual fund not only saves time and
effort for the investor, it is also likely to produce better results.
Liquidity
Liquidating a portfolio is not always easy. There may not be a
liquid market for all securities held. In case only a part of the
portfolio is required to be liquidated, it may not be possible to
sell all the securities forming part of the portfolio in the same
proportion as they are represented in the portfolio. Investing in
the mutual funds can solve these problems. A mutual fund
generally stands ready to buy and sell its units on a regular basis.
Thus, it is easier to liquidate holdings in a mutual fund as
compared to direct investment in securities.
Returns
In India, dividend received in the hands of the investor is tax-
free. This enhances the yield on mutual funds marginally as
compared to income from other investment options. Also in
the case of long term (more than one year) capital gains, the
investor gets the benefit of indexation and lower capital gains
tax.
Flexibility
Mutual funds possess features such as regular investment plan
(i.e. one can invest in installments), regular withdrawal plan and
dividend reinvestment plan. Because of these features, one can
systematically invest or withdraw funds according to ones needs
and convenience.
Well-Regulated
All mutual funds are registered with SEBI and they function
within the provisions of strict regulations designed to protect
the interest of investors. The options of mutual funds are
regularly monitored by SEBI.
Transparency
Mutual Funds have to disclose their holdings, investment
pattern and the necessary information before all investors under
a regulation framework. Other than this the Asset Management
Companies do not have any control over the money of the
investors. The bankers manage the entire money. This makes
mutual funds transparent and reliable.
Disadvantages of Investing in Mutual Fund
No choice to the Investors
The investors cannot choose the securities they want to invest
in, or the securities they want to sell. They are dependent on the
fund manager for this purpose. He decides where the
investments should be made.
Wrong Call of the Fund Manager
The investors face the risk of the fund manager not performing
well. Also, if the fund managers compensation is linked to the
funds performance, he may be tempted to show good results
in the shortterm without paying attention to the expected
long-term performance of the fund. This would harm the
long-term interests of the investors.
Expense Ratio
Management fees charged by the fund reduce the returns
available to the investor. Though the maximum limit of the
expense ratio is 2.5%. The higher the expense of the fund the
less return is given to the investor.
No Discretion in Withdrawal
While investor in securities can decide the amount of earnings
they want to withdraw in a particular period, investors in a
Mutual Fund have no such discretion as the amount of
earnings that are to be paid out to the investor in a particular
year is decided by the Mutual Fund.
Uncertainty
Todays environment is characterized by a deep industrial
recession and consequent high level of defaults on loans
provided by banking sector to industry. In such a scenario, it
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may be prudent to look at the credit quality aspect very carefully
before investing in an income mutual fund.
Questions to Discuss:
1. What is Mutual Fund?
2. Explain the structure of Mutual Fund?
3. What are the types of mutual fund?
4. Discuss SIP or SWP or STP?
5. What are the Tax benefits in mutual fund?
6. What is Net Asset Value (NAV)?
7. Discuss the importance of NAV to the investor.
8. What are the advantages of investing in mutual fund?
9. What are the disadvantages of investing in mutual fund?
Notes:
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LESSON 28:
SMALL SAVINGS AND PROVIDENT FUNDS
Learning objectives
After reading this lesson, you will understand
Introduction
Importance of small savings
Types and nature of small savings instruments
Innovations and instruments connected with the small
savings media
Growth and composition of small savings
Interest rates on small savings
Provident funds
Pension fund
Today you will get to know some facts and details about small
savings and provident funds. Though you must be quite aware
of what it is and what it does, nevertheless our discussion
today would help us make our understanding more clear.
Introduction
Before we turn to non-banking institutions, it is convenient
and useful to familiarise ourselves with two very important,
highly popular and diversified savings media namely, small
savings and provident funds. Post offices function as banks in
respect of mobilisation of savings and time deposits, but not
in respect of mobilisation of funds in the form of certificates.
Because of the difficulty of making a strict categorisation and
for convenience, post office savings are included here. Provident
funds are a category by them selves. Both small savings and
provident funds supply budgetary resources to the government.
Importance of Small Savings
If we compare forms of financial savings, next to commercial
banks, the small savings organisations mobilise the largest
volume of savings, followed by cooperative banks, and the unit
trust of India. (UTI). In a country like India, where small savers
predominate and where savers are dispersed over a vast area in
innumerable villages, the work of small savings organisations
assumes great significance not only in quantitative, but also in
qualitative terms. Even after two decades of nationalised
banking, it is the agency of post offices, through which small
savings schemes are administered, that has reached the largest
number of villages in India. On 31 march 1986, savings bank
facilities were available at 847 head post officers, 29,518 sub post
offices, and 1,11,766 branch post officers. Although post offices
have great potential for channelising resources into rural areas,
they appear to be draining resources form the rural to the urban
areas.
Small savings are directly available to the central government as a
part of its budgetary resources and they constitute the non-
marketable debt of the government. Although the entire
volume of small savings is technically available to the central
government, in practice to receive two thirds of net collections
raised in their respective areas as a loan for a period of ten years
since may 1970, for every 5 percent of receipts obtained in excess
of the national average of net or gross collections, the state
governments have been getting 2.5 percent as an additional
loan. This sharing of proceeds with the states, and the increase
in it, have been undertaken to induce states to mobilise greater
resources and meet their growing financial requirements.
Whether used by the central or state governments, there is at a
present no direct mechanism to ensure that the funds raised in a
particular area would be spent only there. The resources are
drained away from rural areas. It is surprising now that when
the government has set a target by which at least 60 percent of
deposits mobilised by banks in rural areas should be loaned
there, no similar step has been taken with regard to collections
of small savings. They also could be loaned in rural areas
through primary agricultural credit societies, commercial banks,
and unit banks, which ought to be set up in such areas.
Types and Nature of Small Savings Instruments
Small savings media can be divided into two groups:
(a)Post office deposits, and
(b) Savings certificates and bonds.
Over the years, quite a few changes have been introduced in the
media and the facilities made available to the public; some of
the schemes have been discontinued, others modified, and still
others newly introduced. Funds mobilised through some of
the schemes (known as incurrent schemes) and later
discontinued, have not yet been repaid. At present, we have
current and noncurrent media of small savings. The diversity of
financial assets offered by a small savings organisations is truly
remarkable, and except the Post Office Savings Bank (POSB)
deposits, all other schemes have been introduced during the
plan period. The real diversification of small savings claims has
occurred during the 1970s and 1980s.
A number of important characteristics the small savings media
are as follows:
(1)These assets represent medium term and long-term
investment opportunities. They are good substitute, from
the point of view of spread of maturity, liquidity and safety,
for other investment media such as bank deposits,
debentures, government securities and units.
(2)Many of them are in the form of reinvestment plans.
Therefore, they offer good opportunities to those investors
who can forgo current income they are also desirable from
the point of view of mitigating inflationary pressures. These
assets are liquid. With Cumulative Time Deposits (CTD), 50
per cent of the outstanding balance can be withdrawn twice,
which may be repaid in lump sum or in installments. With
Recurring Deposits (RD) also, one withdrawal. upto 50 per
cent of deposit is permitted. The interest rate charged-on the
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withdrawn amount with regard to both CTD and RD is 9.6
per cent per annum. Time deposits, if there is not more than
one deposit in the account, can be pledged for obtaining
loans/ advance from banks for meeting a temporary need or
furnishing a security for entering into a contract. Alternatively,
the deposit account can be, after the expiry of the year
prematurely closed in which case the depositor earns interest
at 2 per cent below the rate applicable to the deposit. There
are no facilities for borrowing against deposits from post
offices as there are from banks.
(3)Similarly, NSCs art also pledge able.
(4)POSB deposits are as liquid as bank demand deposits,
perhaps a little more so. They can be withdrawn by cheque,
and there are no restrictions on the number of withdrawals.
It is for tips reason that the RBI now includes these deposits
as one of the constituents of money supply in the economy.
(5)As with unit linked insurance plans, RD and CTD provide
insurance cover to the investor Rs A small saver (who saves
in one of the denominations of Rs 5, 10, 15, and 20) in RD
and CTD is eligible for the benefit of protection of his
contemplated savings in the event of his death before the
maturity value of the account. . His heir or nominee is
entitled to get the full amount of the account as if the
depositor had continued to make deposit till the end of the
maturity period.
(6)Finally, for those who belong to the income-tax brackets,
small savings carry excellent tax benefits.
Many of the innovations and instruments connected with the
small savings media-some of these have been recently
discontinued-are discussed below.
Post Office Savings Bank Deposit (POSBD)
This scheme has been in existence since 1896. At present it pays
5.5 per cent rate of interest. The limits of investment are a
minimum of Rs 20 and a maximum of Rs 50,000 in case of a
single account, and Rs 100,000 for a joint account. The interest
earned on this deposit is tax-free, but the amount of deposit
itself is not deductible for tax purposes. Further, the
investment in deposit qualifies for exemption from wealth-tax
within the prescribed limit of Rs 5 lakh but not beyond.
Post Office Cumulative Time Deposits (POCTD)
They were introduced in January 1959 but the opening of new
accounts for these deposits has been discontinued from
November 1973. The maturity period could be 5 or 10 or 15
years. The rate of interest was 6.25 per cent on compound basis,
and interest was paid on maturity of deposit. Interest income
on deposit was tax-free and deposit amount qualified for
income-tax rebate as well as wealth-tax exemption.
Post Office Time Deposits (POTD)
Post offices have been accepting time deposits of one-year,
three-year, and five-year maturity since March 1970, and two-year
maturity since August 1973. The current rate of interest on
these deposits ranges between 10.5 to 12.5 per cent. The interest
income is tax exempt. The deposit amount is eligible for
wealth- tax exemption (within the limit of Rs 51akh) but not
for income tax rebate. There is no limit on investment in these
deposits.
Post Office Recurring Deposits (PORD)
This scheme has been in existence since April 1970. Its maturity
period is 5 years; at present it carries an interest rate of 12.5 per
cent per annum, and it is subject to the same tax concessions as
POSBD and POTD. There is no limit to the amount that can
be invested in it.
National Savings Certificates (NSCs)
Three issues (II, III, IV) of seven-year NSCs were introduced in
1970, out of which II was discontinued from April 1989. Issue
V of seven-year NSCs was introduced in April 1974. Two six-
year NSCs (VI and VII issues) were introduced in 1981-82 but
they have been discontinued from April 1989. Another six-year
NSCs (VIII) issue was introduced in May 1989 on which a
compound rate of interest of 12 per cent is paid, and one can
invest unlimited amount in this. Interest income from NSCs is
not tax-free but the amount invested in them qualifies for
deduction while calculating taxable income.
Indira Vikas Patras (IVP)
These were introduced in November 1986. the IVP is a bearer
bond whose value doubles every 5
2
1
years giving a compound
rate of return of 13.43 per cent annum. Its purchase price,
therefore, is half of its face value. It is not a registered
instrument nor does it carry the name of the buyer or the
holder. It is transferable by mere delivery. There is no limit to
investment in them but this investment is not eligible for any
type of tax benefits.
Kisan Vikas Patras (KVP)
Introduced in April 1988, they also have a maturity period of 5
years and the interest paid on them is 13.43 percent. There is no
limit to investment in them but the investment does not enjoy
any tax benefits.
National Savings Scheme (NSS)
This was introduced in April 1987; it offers an interest rate of
11 percent annum; the maximum amount of investment is
Rs.40, 000; and 100 percent of the amount of deposit in a year
is eligible for deduction from the income of the depositor for
income-tax purposes. Similarly, the total amount (including
interest) withdrawn in a given year is considered as an addition
to the income of the depositor during the year of withdrawal.
Post-Office Monthly Income Scheme (POMIS)
This fixed deposit scheme was introduced in August 1987. Its
maturity period is 6 years; interest rate is.12 per cent per annum
and interest is payable every month; minimum investment is Rs
5000, and maximum investment is Rs 2,00,000 for single
account and Rs 4,00,000 for joint account. Interest income is
eligible for tax rebate. A bonus of 10 per cent on deposit
amount is payable at the end of 6 years when the deposit
matures.
The following instruments of post-office savings have not
assumed much importance as means of saving: National Saving
Annuity Certificates (NSAC); Social Security Certificates (SSC);
five-year National Development Bonds (NDB); Saving
(Deposit) Scheme for Retiring People; and Drought Relief
Bonds (DRB) or Rahat Patras (RP) replacing Capital Investment
Bonds (CIB).
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It goes without saying that not all these instruments are equally
popular with invest Rs The CTD, the two-year and three-year
TDS, II, III, IV, V and VII issues of NSCs, NSAC, SSC, NDB,
and DRB do not bring in much money every year.
Growth and Composition of Small Savings
The yearly receipts as well as outstanding of small savings have
increased phenomenally over the years In the total small
savings, deposits were far more important than certificates till
1985-86, but thereafter, deposits and certificates have been
maintaining an almost equal share in total receipts. Of the total
deposits, post-office savings bank deposits have a major share,
but this share has declined over the years. It was 83 per cent in
1970-71 and 57 per cent in 1988-89, and 50 per cent in 1995-96.
The monthly income and recurring deposits schemes have been
attracting many investors Small savings organisations, rather
surprisingly, have not been able to induce investors to hold
more time deposits with themselves. The competition from
commercial banks in rural areas appears to have had an adverse
effect on the growth of deposits with post offices. Table 10.3
shows that five-year deposits have accounted for 65 to 95 per
cent of total time deposits during 1980-81 to 1995-96. Among
the certificates, Kisan Vikas Patras (KVPs) are the most popular,
accounting for 50 to 73 per cent of total receipts from all
certificates during the 1990s. NSCs and Indira Vikas Patras
(IVPs) are the second and third most important certificates
respectively.
Interest Rates on Small Savings
The rates of return on small savings have undergone a distinct
change over the years, particularly after 1970. Before 1968-69,
interest rates on various small savings schemes were lower than
those offered by banks, private non-banking companies, and
others after 1969-70, however, interest rates on these schemes
have been made comparable; at present, they are more attractive
than the rates on bank deposits. What is more important is
that, unlike in the earlier period, interest rates on small savings
are now changed simultaneously with changes in the Bank rate
and other rates of interest in the economy Earlier, there was a
tendency for changes in interest rate on small savings to lag
behind changes in rates offered by competing financial
intermediaries. However, changes in these rates have now
become an integral part of changes in the interest rates structure
in the economy.
Provident Funds
This is way of saving mostly by people who earn their income
in salaries. However, recently, with the starting of the public
Provident Fund Scheme, it is possible for non-salaried earners
also to save in this form. Saving in PFs is a contractual
obligation, and the main motive behind saving in this form is
not to make profits nor to seek capital growth. Salaried people
can save in this form small amounts on a regular basis to
provide for old age or for the family after ones death.
There are a variety of PF schemes in operation in India. They
are:
(a)Employees Provident Fund Scheme (EPF) covering non-
exempted establishments (industrial),
(b) Provident Funds of exempted industrial establishments,
(c) Central and State Government Employees (non-industrial)
Provident Fund,
(d) Coal Mines Provident Fund,
(e)Assam Tea Plantations Provident Fund, and
(f) Public Provident Fund.
The EPF scheme for industrial workers was introduced with the
passage of the Employees Provident Fund Act, 1952.
Originally, public sector units were not covered under this Act,
but since 1958 type have also overbought under it. Among
these schemes, the volume of investible resources of PF of
exempted establishments is the largest followed by that of the
first category. The resources of the PFs of coal mines and
plantations are meager.
A novel scheme, namely, Public Provident Fund, was
introduced in 1968. This was earlier operated through the SBI
and its subsidiaries, but with effect from January 1979, PPF
account can also -be opened at head post offices. It was
originally meant for self-employed persons or the general
public, but now salaried employees can also take advantage of
it.
The nature of PPF and Employees PF can be understood better
by contrasting the provisions of the two schemes in some
important respects. The maturity period of the PPB is 15
years, while the maturity period of the EPF depends on the age
at which the employee joins the Fund. While in the case of
EPF, if the employee joins the contributory PF alternative there
is a specified contribution to be made by the employer to the
employees PF, no such provision is possible in the case of PPF.
During the term of the PPF scheme, withdrawals to the extent
of 50 per cent of the outstanding amount to the credit of the
concerned persons account are allowed at the end of the 7th,
11th and 15th year. Before the withdrawal facility begins, i.e.,
during the first six years, it is possible to get a loan upto 25 per
cent of the balance to ones credit provided two years have
expired after opening the PPF account. In the case of EPF,
withdrawal facilities are more restricted. The employee can
withdraw his part of the contributed only when he has reached
50 years of age. Meanwhile, although he can obtain a loan
against his PF account, the account holder has to repay the loan
in the form of an increased contribution, which does not enjoy
tax benefits. In the some of PPF, it is possible to vary the
amount of contribution, from year to year, while the flexibility
in the case of EPF In this respect is limited. The rules with
regard to loan, its repayment, and interest on loan are the same
for PPF and EPF. The loan has to be repaid in 24 equal
installments. Similarly, both schemes enjoy similar tax benefits.
The rate of return on contributions to PFs has become quite
attractive. The rate of interest was increased successively from l5
percent in 1955-56 to 4. 75 percent in 1965-67, and 9 per cent in
1978; it is 12 per cent at present. Earlier there was provision that
if the PF holder did not withdraw any amount by way of loan
for five consecutive years, he would get a bonus rate of interest
of one per cent per annum on the entire sum. This provision
has been withdrawn now. The effective rate OF return on PF is
much higher because of the income tax and wealth-tax benefits,
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which the yearly contribution to PF, interest on PF, and the
wealth in the form of PF enjoy.
The rules with regard to investments of PFs are laid down in
the Indian Trusts Act, 1882, and Employees Provident Fund
Act, 1952, which, in essence, specify that funds mobilised
through small savings and PF should be invested either wholly
or substantially in the central and state government securities,
and also the securities guaranteed by these governments. This
has been done to enhance the safety of these savings, but it has
also involved some sacrifice of return for the savers. The rules
governing investments by the government PF and private PF
have come to differ over the years. PF contributions of the state
and central government employees used to be and still are
merged with the funded debt of the government, and the
Ministry of Finance has recently ruled out changes in this
practice.
The rules or restrictions with regard to private provident funds,
superannuation and gratuity funds, however, have undergone
the following changes. The prescribed pattern of investment in
1955-56 was: NSCs 10 per cent, short-term government
securities 10 per cent, medium-term securities 30 per cent, and
long-term securities 50 per cent. The obligatory investment in
government securities was 50 per cent in 1970-71, which was
reduced to 45 percent in 1971-72, and the residual part (55 per
cent) of the PF resources could be invested in state government
securities, government guaranteed securities, small saving
certificates, and post-office time deposits since that year. The
Special Deposit Scheme (SDS) for this purpose was created
recently for a period of three years which was to end in 1996,
but was extended further. Private PF investment in SDS has
progressively reduced from 85 percent in April 1993 to 20 per
cent now. The SDS investment earns a standard rate of interest
of 12 per cent. There is now a view that upto 25 per cent of PF
collections should be invested in industrial debentures and
shares of financially sound companies. Investment of PF in
equities will have to be undertaken with extreme caution.
There has been a tremendous growth of investment in PFs
since the beginning of the planning period. The volume of
savings of the household sector in the form of PF has
increased from Rs 19 crore in 1950-51 to Rs 1,172 crore in 1976-
77, and Rs 7,194 crore in 1988-89 and Rs 25,438 crore in
1995-96. For many years now, PF has emerged as one of the
most important financial assets in the Indian economy; its
importance is excelled only by bank deposits and small savings.
PF accounted for 13 per cent of savings in financial assets of the
household sector in 1955-56, 24 per cent in 1975-76, and 18 per
cent in 1988--89, and 20.4 per cent in 1995-96.
Several factors have contributed to the growth of provident
funds in India:
(a)The adoption of statutory measures to make provident fund
compulsory for industrial and other establishments;
(b) The increase in the number of establishments covered
under the statutory provisions;
(c) The expansion in the industrial and service sector of the
economy and the consequent increase in the number of
salary-earners;
(d) The introduction of a novel scheme like PPF;
(e)The provision of tax benefits to such savers;
(f) The increase in the minimum rates of contribution by the
employees and employers;
(g)The changes in the pay structure, like raising the basic pay of
employees; and
(h) The increase in the level of money income in the economy.
Pension Funds
In other countries, pension funds are a, powerful financial
intermediary. It was estimated that at the world level, pension
funds controlled $6,700 billion in 1995. In India, private
pension funds still do not exist but many people have begun to
stress the need for setting up such funds; and a small beginning
was recently made in this respect. The setting up of the first
investment-based pension fund proposed by the UTI was
approved by the government in October 1994. This retirement
benefit plan is meant to enable self-employed people to
contribute to a pension fund so as to provide security in their
old age. It is as open-ended plan in which anyone between the
age of 18-52 years can contribute and receive regular monthly
income from 58 years onwards. The subscriptions to the fund
are expected to grow by investment in equities and debt in the
ratio of 40:60. The minimum subscription is to be Rs 10,000 to
be paid in not more than 20 instalments of a minimum of Rs
500 each. The withdrawal is permitted after 70 years of age, and
even a premature withdrawal is allowed at a discount.
Thus, a fund set up by a company, union, government entity, or
other organisation to invest the pension contributions of
members and employees, and pay out pensions to those people
when they reach retirement age is known as pension funds.
Pension funds accumulate huge pools of capital, which they
invest in the stock and bond markets. Because of the weight of
money, they exert considerable influence on the markets, and
their decisions on which shares to hold in which sectors have a
substantial impact on prices.
Some pension funds employ their own fund managers; others
delegate responsibility to external fund managers. Invariably
they will try to achieve a diversified portfolio of investments,
some in low risk areas, others in high-risk areas. Actuaries
determine how much is going to have to be paid out to
pension holders in forthcoming years, and the pension fund
has to try to achieve a rate of return on its capital that will meet
(or better still exceed) this target.
Questions to Discuss:
1. What do you understand by the small savings instruments?
2. Discuss the importance of small savings.
3. What are the types and nature of small savings instruments?
4. Discuss the innovations and instruments connected with the
small savings media.
5. Discuss the growth and composition of small savings.
6. What is the relevance of Interest rates on small savings?
7. What are Provident funds?
8. What are Pension fund?
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LESSON 29:
NON BANKING FINANCIAL COMPANIES
Learning objectives
After reading this lesson, you will understand
Definition
Regulatory Measures
Non-banking financial companies (NBFCs) in the Indian
financial sector are a force to reckon with rough estimates
indicates that there are about 40,700 non-banking finance
companies in the country. Of course, the number includes
many small companies operating in the unorganised sector such
as in this, chit funds, etc. The NBFCs registered with the
Reserve Bank of India number only about 745 of which about
121 have credit ratings with them. Till the others are also
brought under the ambit of the regulatory framework, the
guidelines and rules issued by the Re-serve Bank of India will
continue to be largely imposed on the registered NBFCs alone.
We have to appreciate the fact that it is a Herculean task to
supervise effectively all the 40,000 odd finance companies
scattered all over the country. This task becomes all the more
difficult since these companies do not have a transparent,
uniform or laid down accounting standards, strict vigilance or
audit systems or an effective supervisory system as compared to
those in the organised financial sector.
Definitions
A miscellaneous non-banking company is a company carrying
on all or any of the following types of business:
(a)Managing, conducting or supervising as a promoter,
foreman or agent of any transaction or arrangement by
which the company enters into an agreement with a specified
number of subscribers that every one of them shall
subscribe a certain sum in installments over a definite period
and that every one of such subscribers shall in his turn, as
determined by lot or by auction or by tender or in such
manner as may be provided for in the agreement be entitled
to the prize amount.
(b) Conducting any other form of chit, which is different from
the type of business referred to in (a).
(c) Undertaking or carrying on or engaging in or executing any
other busi-ness similar to the business referred to in (a) and
(b).
A residuary non-banking company is a company which receives
any deposit under any scheme or arrangement, by whatever
name called, in one lump sum or in installments by way of
contributions or subscrip-tions or by sale of units or certificates
or other instruments, or in any other manner and which,
according to the definitions contained in the Non Banking
Financial Companies (Reserve Bank) Directions, 1977 or the
Miscellaneous Non-Banking Companies (Reserve Bank)
Directions, 1977, as the case may be, is not (i) an equipment
leasing company, (ii) a hire purchase finance company, (iii) a
housing finance company, (iv) an insurance company, (v) an
investment company, (vi) a loan company, (vii) a mutual benefit
financial company, and (viii) a miscellaneous non-banking
company.
A non-banking non-financial company is an industrial concern
as defined in Industrial Development Bank of India Act or a
company whose principal activities are agricultural operations or
trading in goods and services or real estate and which is not
classified as financial or miscellaneous or residuary non-banking
company.
Regulated Deposit is a deposit, which is subject to certain
ceilings, and other restrictions as imposed by the regulatory
measures. It includes unsecured deben-tures, debentures
secured by movable assets, deposits received by public limited
companies from its shareholders, deposits guaranteed by
directors in their personal capacity and fixed deposits, etc.
received from public. Effective April 12, 1993 intercompany
borrowings and money received from directors/ shareholders of
private companies constitute regulated deposits. Exempted
Deposit signifies those types of deposits/ borrowings, which
are outside the scope of the regulatory pleasures. It includes
borrowings from banks and specified financial institutions,
money received from Central/ State/ foreign Governments,
security deposits, ad-vances received against orders, etc.
Taking into consideration the fact that the operations of the
NBFCs affect adversely the efficacy of fiscal and monetary policy,
a series of measures have been initiated during the last few
years to regulate their operations. The present chapter deals with
these measures in a chrono-logical order.
Regulatory Measures
The first serious attempt to regulate NBFCs (including non-
banking non-financial companies) was taken in October 1966,
by issuing two new directives, viz., (i) Non-Banking Financial
Companies (Reserve Bank) Directives, 1966 and (ii) Non-
Banking Non-Financial Companies (Reserve Bank) Directives,
1966. These directives extended the control of the Reserve Bank
to all: (i) non-banking financial companies and (ii) non-banking,
non-financial companies accepting deposits and they were
brought into force with effect from 1 January 1967. The
directives pro-vided for restricting acceptance of deposits to 25
per cent of paid-up capital and free reserves in the case of both
non-banking financial and non-banking non-financial
companies (other than housing finance and hire-purchase
finance companies).
To obviate hardships, particularly to industrial undertakings, in
com-plying with the provisions of the directives within the
specified time limit, the Reserve Bank made certain
modifications in the directives on 23 August 1967, as follows:
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(i) In the case of all non-banking companies, financial or non-
finan-cial; the Bank decided that any amount held in the
statutory development rebate reserve, created under section
4(3) of the Income Tax Act, 1961, may (notwithstanding the
fact that the period of 8 years specified in that section might
not have been completed in respect of all the assets) be
counted as a free reserve and
(ii)In the case of industrial concerns as defined in the directives
which (a) have paid dividends on their equity shares at, six
per cent or more per annum in the five years or in five out of
six years immediately preceding 1 January 1967, or (b) have
unencumbered fixed assets of a book value in excess of
twice the amount of deposits and the unsecured loans, the
time limit of two years, for the adjustment of the deposits
already received in excess of 25 per cent of the paid-up capital
and free reserves including the development rebate reserve,
will increase to five years, i. e., upto the end of December
1971.
The directives issued to non-banking companies were amended
in December 1971 so as to bring within their purview,
unsecured loans from shareholders as also loans guaranteed by
directors, ex-managing agents or secretaries and treasurers. Such
loans, hitherto exempted from the restrictions relating to
deposits, were subjected to a separate ceiling of 25 per cent of
the net owned funds of companies with effect from 1 January
1972. A period of 3 years and 3 months was provided for the
adjustment of excess, if any, over the ceiling prescribed, of the
unsecured loans mentioned above. To provide for the genuine
business requirements of companies, however, certain
categories of loans, particularly loans obtained on guarantees
furnished by Government and any loan obtained from foreign
source were specifically exempted from the purview of the
directives.
During 1973, the Reserve Bank issued a new set of directions
known as the Miscellaneous Non-Banking Companies (Reserve
Bank) Direc-tions, 1973 which sought to regulate the acceptance
of deposits by com-panies conducting prize chits, lucky draws,
savings schemes, etc. These directions which came into effect
from 1 September, 1973, had clarified that the amounts received
by such companies by way of contributions or subscriptions or
by sale of units, certificates, etc., or other instruments or any
other manner or as membership fees or service charges to or in
respect of any savings, or mutual benefit, thrift or any other
scheme or arrangement also constitute deposits. It was further
clarified that the usual ceiling on deposits (25 per cent of paid-
up capital plus free reserves less accumulated balance of loss),
would also apply to such deposits. Any amount in excess of
the ceiling existing on 1 September 1973 would have to be
adjusted before October 1976. All other requirements applicable
to other non-banking companies such as these relating to the
issue of advertisements, acceptance of deposits on the basis of
application forms, maintenance of registers of deposits and
furnishing of receipts to depositors, would also apply to these
companies. However, companys coming within the purview of
these directions would be re-quired to submit their returns to
the Reserve Bank twice a year.
The two principal notifications containing the directions issued
in October 1966, respectively to non-banking companies were
further amended during 1973. The principal features of the
amendments were: (i) any loan secured by the creation of a
mortgage or pledge of the assets of the company or any part
thereof would be exempt from the ceiling restrictions relating
to deposits only if there is a margin of only at least 25 per cent
of the market value of the assets charged as security for the
loan, the mortgage or pledge, as the case may be, is created in
favour, of a trustee which should either be a scheduled
commercial bank or an executor and trustee company which is a
subsidiary of such scheduled commercial bank and the
company has to execute a trust deed in favour of the scheduled
commercial bank or its subsidiary. If the Reserve Bank is
satisfied that the mortgage or pledge created by a company is
not in the public interest, it may declare that the deposits
sought to be secured by such mortgage of pledge shall not be
entitled to the benefit of the aforesaid provision. Companies
accepting such secured deposits will, however, have to comply
with all other provisions contained in the direc-tions as
applicable to ordinary deposits or unsecured loans. (ii) Loans
obtained from a registered moneylender would henceforth be
treated as deposits for the purposes of the directions.
After an examination of the recommendations of the Banking
Com-mission in regard to non-banking financial intermediaries
and the Reserve Banks view thereon, the Government of
India, decided that statutory powers shall be taken to prohibit
acceptance of deposits by all unincorporated non-banking
institutions and that the existing legal provi-sions and the
directions issued by the Reserve Bank must be tightened to
plug the loop-holes. In June 1974, the Reserve Bank
constituted a Study Group headed by Shri James S. Raj to
examine in depth all aspects of the matter and make suitable
recommendations for implementing Govern-ments decision.
In 1974, more powers were vested with the Reserve Bank to
exercise control over non-banking institutions receiving
deposits from the public and financial institutions under the
Reserve Bank of India (Amendment) Act, 1974. The
amendments:
(a) Empower the Reserve Bank to inspect non-banking financial
insti-tutions whenever such inspection is considered
necessary or expe-dient by the Bank;
(b) Cast a statuary obligation on the auditor of a non-banking
institu-tion to report to the Reserve Bank the aggregate
amount of deposits held by it where the institution had
failed to furnish to return etc., required to be submitted by it.
(c) Insert the definition of the term deposit in statute itself so
as to place beyond any doubt that any money received by
non-banking institutions otherwise than by way of share
capital constitutes deposits.
(d) Make the definition of the term financial institution precise
and comprehensive so as to plug the loop-holes;
(e) Make it compulsory not only for non-banking institutions
but also for brokers to disclose full particulars and
information before soliciting deposits; and
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(f) Provide for enhanced penalties for contravention of the
provisions of the Act and the directions issued by the Bank.
The ceiling of 25 per cent of the paid-up capital and free
reserves less the balance of accumulated loss, if any, imposed by
the Reserve Bank with effect from January 1972, in respect of
deposits accepted by non-banking companies in the form of
unsecured loans guaranteed by the directors, deposits raised
from shareholders (excluding those received by private
companies from their shareholders subject to certain
stipulations) etc., was lowered by the Bank to 15 per cent with
effect from the 27
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January 1975, by issue of three notifications
amending the directions in force. Non-banking financial and
non-financial companies having depos-its in excess of the
reduced ceiling were given time till 31st December 1975, to wipe
out the excess. Miscellaneous non-banking companies viz.,
those conducting prize chits/ lucky draws/ savings schemes etc.,
which had been allowed time up to the end of September 1976,
to wipe out the excess over the ceiling of 25 per cent fixed earlier
were allowed further time up to the 31st December 1976, to
bring down their outstanding in respect of the unsecured loans,
etc., within the reduced ceiling of 15 per cent.
The Companies (Amendment Act), 1974 which came into force
from the 1st February 1975, has inserted anew Section 58 A in
the Companies Act, 1955 regulating acceptance of deposits by
non-banking companies. Under the powers vested by the
aforesaid Section, the Cen-tral Government has in consultation
with the Reserve Bank, framed rules governing acceptance of
deposits by non-financial companies. The rules came into force
with effect from the 3rd February 1975. Conse-quently, the
directions issued by the Reserve Bank to non-financial com-
panies have since been withdrawn.
The Study Group headed by Shri James S. Raj referred to above
submitted its Report to the Reserve Bank on 14
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July 1975.
The main recommendations of the Study Group cover non-
financial companies, financial companies and companies
conducting prize chits and/ or con-ventional chits. These
recommendations had been accepted in principle by the Reserve
Bank and the Government of India.
With regard to non-financial companies, the Study Group
observed that the acceptance of deposits by such companies
may not be prohibited altogether but the measures should be
so designed as to ensure the effica-cy of monetary policy and to
avoid disruption of the productive process consistent with
need to safeguard the depositors interests. At the same time
the ultimate objective should be to discourage further growth
of these deposits and to roll them back gradually so that they
would cease to be a significant source of finance for industry
and trade.
In the case of non-banking financial companies, the Study
Group recommended effective regulation of their activities
considering the large number of depositors involved as well as
the incidence of malpractices in these companies. The Study
Group suggested that such companies should be subjected, by
and large, to the same type of controls as banks under the
Banking Regulation Act, 1949. As the operations of loan
companies are analogous to those of banks, the Study Group
recommended a ceiling of ten times the net owned funds. In
the opinion of Study Group, avail-ability of funds to that
extent would give them a reasonable chance of profitable
working and enable them to become, viable units. While in
regard to hire-purchase finance companies, which are at present
exempt from ceiling restriction, a ceiling (not exceeding ten
times their net owned funds) as in the case 01 loan companies
has been proposed, hous-ing finance companies, however, will
continue to be exempted from the ceiling restrictions. Since such
special considerations will not be relevant in respect of
investment companies, the existing composite ceiling of 40 per
cent of the net owned funds is proposed to be reduced to 25
per cent in two stages. The Group had (lot recommended any
Ceilings on deposits with nidhis which deal only with their
members. Apart from the restric-tions on the quantum of
deposits that may be accepted by the companies, the Group has
recommended minimum capital requirements for starting new
financial companies and also in respect of existing companies
other than nidhis. Some of the other recommendations made
by it relate to the creation of reserve funds, maintenance of
liquid assets, prohibition of grant of loans and advances to the
directors and firms and companies in which they are interested
and enactment of the Provisions on the lines of certain sections
of the Banking Regulation Act, 1949. In view of the
substantive nature of the recommendations made by it for the
purpose of tightening the control over the deposit acceptance
activities of the financial companies as also the operational
aspects relating to their working, it has been decided to enact a
separate comprehensive legislation in place of Chapter III B of
the Reserve Bank of India Act, 1934. The drafting of the
legislation is in progress and in the meantime, steps are also
being taken to implement such of the recommendations as
could be given effect to by invoking the power vested in the
Reserve Bank under the existing provisions of Chapter III B of
the said Act by suitable amend-ments to the directions now
force. The amendments to the directions have been finalised.
As regards companies conducting prize chits benefit savings
schemes, etc., the Group had come to the conclusion that such
schemes benefited primarily the promoters and did not serve
any social purpose. Such schemes were prejudicial to public
interest and also adversely affected the efficacy of fiscal and
monetary policy, It had, therefore, suggested that the conduct
of such schemes should be totally banned in the larger interests
of the public and suitable legislative measures should be taken
for the purpose, the provisions of the existing enactment were
considered inadequate.
Questions to Discuss:
1. Discuss some of the non-banking financial companies.
2. Discuss the Regulatory Measures.
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LESSON 30:
NON BANKING FINANCIAL COMPANIES
Learning objectives
After reading this lesson, you will understand
Activities Of NBFCs
Growth Of NBFCs
Problems
Prospects
Activities of NBFC
NBFCs with their diversified structure and methods of
business are serving the economy in a variety of ways. They
form an integral part of the Countrys financial system with
asset base in excess of 90,000 crore. The growth of NBFC
Sector in India has been accompanied by a corresponding
growth in the diversified range of financial services and
products they offer. NBFCs help to bridge the credit gaps in
several sectors which traditional institution are unable to fulfill.
NBFCs are more flexible in their operations and quick in
decision-making. This gives them a major advantage over Banks
since the latter follow lengthy procedures. In the area of deposit
mobilisation certain points work out to the advantage of
NBFCs. While Public Sector Banks wait for deposits to flow in,
NBFCs reach out to the customers to mobilise deposits.
In a broader sense, NBFC means a Company whose principal
business is financing in whatever form, but not qualifies
enough to be called a Bank as defined in Banking Regulation
Act, 1949.
NBFCs offer a variety or services. The table 1 gives the broad
range of services offered by important Finance Companies in
India. For the purpose of brevity description of individual
service is avoided.
Table 1
Activities of NBFCs

Fund-Based Activities Fee-Based Activities

1. Equipment leasing 1. Issue Management
2. Hire Purchase 2. Portfolio Management
3. Bill discounting 3. Corporate Counseling
4. Loan and Investment 4. Loan and Lease Syndication
5. Venture Capital 5. Project Counseling
6. House Finance 6. Arranging Foreign Collaboration
7. Factoring 7. Advising on acquisitions and mergers
8. Equity Participant 8. Advising on Capital restructuring
9. Short-term loans
10. Inter-Corporate Loans
The activity mix of NBFCs has all dimensions- Width, Depth
and Consistency, the three essential characteristics of any
product mix. Width refers to variety, depth refers to range in
each variety and consistency refers to over all synergy of the
service mix.
Growth of NBFCs in India
NBFCs started in a small way in the sixties and the seventies
and tries to serve the needs of the savers and investors whose
needs remained unfulfilled by the Banking system. Along with
the growth of India economy NBFCs have also grown
gradually into institutions that can provide services similar to
that of Commercial Banks in a Country.
The growth of NBFCs in India was more pronounces in last
two decades. Several factors have contributed to the growth of
these institutions. Their tailor made services, customer-
orientation, minimum procedures and simplicity, speed of
operations and higher rate of interest on their deposits have
attracted more and more customers to them. Further, the
monetary and credit policy followed in the Country in the recent
past has left a Section of borrowers outside the purview of
banking system and these NBFCs increasingly hatred to these
sections. Comprehensive regulation of the Commercial Banks
and the absence or less rigorous regulations over NBFCs have
also contributed to the phenomenal growth or the latter in
terms of heir numbers, clientele deposits and net owned fund
(NOF).
However, the growth was not uniform in the past. In the initial
years (early eighties) there was virtually a boom, when
Entrepreneurs suddenly wokeup to the tremendous
possibilities offered in an economy chronically affected by the
massive paucity of funds and a growing realization of
enormous resource mobilisation capacity offered by the capital
market. However, most of these new-borns ignored that
rendering financial services was a complicated and demanding
business, involving the continuous raising and deployment of
funds in a judicious manner and involved the consistent
identification and entry into newer and optimally lucrative areas
of financial returns. Sadly, most of these Companies did
possess neither the inclination nor the mental and attitudinal
ability to acquire these traits. A host of factors such as the
erosion of margins due to over concentration of blue chip
companies, a high rate of default by lessees, severe problems in
sustaining consistent and adequate utilisation of resources, sales
tax and turnover tax levied on lease by respective State
Government and dubious accounting practices by some
companies, all combined in an unholy alliance to sound the
death knell for most companies in this budding industry. As a
result, growth rate had slowed down, gradually leading to a
negative growth rate in 1988. However, from 1989 the trend has
changed for the better, there are a host of reasons that have led
to the revival of interest in financial services. Firstly, the
enormously progressive measured of liberalisation and
dismantling of the hitherto control ridden economy have to a
great extent opened up larger vistas of growth. The financial
service Sector also reacted very favorably and grew by leaps and
bounds, the revamping of MRTP Act has unleashed large
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corporate houses from the restraints earlier inhibiting their entry
and operations in this Sector.
The pre-scam era, i.e., the beginning of 90s saw the equity scrips
of such companies being fancied by investors. In this period
financial management was reduced to a dictum; the more the
borrowing s the greater the profits. Money was borrowed by all
means to earn a quick buck. This made the RBI suspect that via
these companies Banking Sector was using the bill route to
divert money to the stock market. The suspicion was partially
true and the scam burst out. Consequently, several restrictive
orders that affected this industry was clamped. The major
casualty being a ban on bill-discounting in August 1992. Along
with the ban the image of NBFCs also took a severe beating.
This in turn led to resource crunch, with even committed funds
not forthcoming from Banks. However, fiscal relief announced
in 1992-93 and 1993-94 created favourable climate again for this
industry. The ban on bill discounting, though affected some
players of the field adversely was blessing in disguise for others,
forcing them to explore other areas. Many turned their attention
from fund-based activities to the non-fund-based activities like
merchant banking activities, investment advisory services,
securitisation of debts, forex trading operations, etc.
All the major sectors had responded to economic reform with
dynamism and witnessed significant acceleration of their
respective growth rate and thereby widening the scope of
activities of NBFCs as well as improving their profit levels.
But the recent time have seen again a reversal of this trend, the
increased competition, depressed stock markets and the
prolonged recession have made life difficult for NBFCs. The
greed of a few players, sand long-term vision has made the
general public as well as the regulatory authorities view the entire
sector with suspicion. With international majors entering the
sector is in trouble. The extinction of most of the unfit is
inevitable.
Problems
Problems confronting NBFCs are essentially arising out of
growth and adjustment. Take the question of their mushroom
growth. A large number of Finance Companies came up
encouraged by the spurt in profit. A number of them went to
the Capital market for raising equity with inadequate
preparations and many promises. The quality and composition
of assets leave much to be desired, a situation of this kind
raised doubt about their credibility with both authorities and
the public. The CRB Fiasco has underscored the vulnerability of
the NBFCs. Even the high profile well managed Companies are
viewed with suspicion. Players with short-term approach
obstructed the long-term growth prospectus of the industry.
Better late than too late. The regulatory authorities have taken
steps in this direction by prescribing entry norms including new
owned funds (minimum Rs. 25 lakh, say) and capital adequacy
level. An environment is created in which of course entry is not
closed for new companies but the inefficient and loss-making
companies get weeded out. Reserve Bank of India regularly
comes out with a list of NBFCs and unincorporated bodies
who are soliciting deposits despite being prohibited from
accessing deposits. This list which will be published regularly
will enable prosecution against persons and companies
operating in violation of provisions when these offenses
become a cognizable offence.
Another pressing problem related to acquisition of funds.
Other than capital the various sources of funds for NBFCs are
fixed deposits, ICDs, selling a part of their asset portfolio, asset
securitisation and bank finance. Public deposits accounted for a
major chunk of funding for NBFCs. But the CRB fiasco and
the capabilities of the Finance Companies have severally
curtailed this source of funding to NBFCs. As far fund raising
through debenture their competition would be with Blue Chip
and Public Sector issues. There was a time when NBFCs
commanded hefty premium in the equity market. Today, they
cannot raise money via this route as the primary market
especially for finance companies scrips is virtually in a shambles.
Companies, in want of money, are forced to sell-off their asset
portfolio. Buyers usually banks and financial institutions might
seek favorable terms, which will mean a higher cost to NBFCs.
Mergers and acquisitions take place only when it makes business
sense. Since too many small companies will be looking for a
strong partner the deal which may emerge is likely to be
unfavorable to small NBFCs. Bank finance is available only to a
few big players.
However, there are reasons to cheer also. In the recent move, the
RBI has classified bank credit to NBFCs for on lending to small
transport operators as priority sector lending. This move has
prompted Bank to extend more credit to NBFC sector to meet
their priority sector lending. Further NBFCs are allowed to
explore opportunities of raising funds off shore. One more
thing for which NBFCs are really excited about is asset
securitisation. Presently at nascent stage, the concept of
securitisation is picking up very fast in Finance Service Industry,
especially in the auto-finance Sector. Given the various steps
taken in the current budget to revive the debt market, it will
grow further.
Ultimately, good and sound finance companies should aim at
long-term solutions by raising resources equally from net
owned funds borrowing and deposits from public. NBFCs
should give serious thought to broad base the sources of
funding as well as the cost of funding. Their future growth
depends to a large extent on the success they achieve in this area.
Another area of concern for NBFCs is to find matching
deployment avenues. As the economy sometimes reels under
recession finding quality borrowers has become a difficult task.
However there is no denying the fact that this is basically a
cyclical problem. As the correlation between the growth of
NBFCs and economy is well established, the moment the
economy picks up NBFCs would again be making money.
Another aspect, which is boosting the morale of the NBFCs
sector- the growth of an increasingly affluent middle class.
Hence a raise in demand for consumer electronics and durables
is expected. This urge has given way for a powerful potential
market segment for finance companies in the form of
Consumer Financing.
Banks look upon NBFCs as their competitors in terms of both
deposit mobilisation and credit expansion. This perception
needs to be corrected as soon as possible by the industry
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leaders. NBFCs are actually complementary to the Banking
System. They play a supportive role to the Banks and Financial
Institutions. While there could be a debate on whether NBFCs
play any useful role at all in the areas of equipment leasing,
share market operations, merchant banking, etc. There can be no
dispute on the conclusion that without NBFCs the credit
delivery system tot eh road transport sector particularly trucks
and commercial passengers carrying vehicles like buses will
collapse leading to a crisis in the total automobile sector. It is
also certain that a healthy NBFC Sector is vital for the growth of
the Consumer durable Industry, because Banks and Financial
Institutions cannot manage credit delivery to these Sectors as
cost effectively as NBFCs have demonstrated they can.
There are areas where NBFCs should not even dream of
competing with Bank and Financial Institutions let alone out
performing them. To amplify this point, with Banks and
Financial Institutions in the field of Corporate financing
NBFCs like ITC Classic have all ruined themselves. Bill
discounting to Corporate by NBFCs is another area where
mistakes have been made and will continue to be made if
NBFCs do not realise that Bank are much better equipped to
handle this business.
Now when almost every Bank is doing what NBFCs have been
doing, NBFCs will have to first identify areas where they can
build on the strengths and desist from operating in areas where
other entities (Bank and Financial Institution) have significant
strength. Retail Financing consisting of Car Loans, Consumer
Durable Finance, Commercial Vehicle Financing, Mortgage loans
to individuals, share loans, housing loans are areas where
NBFCs can have a more cost effective operation than what
Commercial Banks with their wide spectrum of activities can
achieve. The need of hour is that NBFCs should learn to
appreciate this limitation on the scope of operations and
develop skills needed for operating successfully by covering
these constraints into opportunities.
The regulatory framework specifies norms regarding Capital
Adequacy debt-equity ratio, credit concentration ratio, income
recognition, provision against doubtful debts, following the
sound and transparent accounting practices, uniform disclosure
requirements and asset valuation. The regulations also specify
eligibility criteria for entry, growth and exit of the Institutions.
No financial system anywhere in the World is unregulated. In
fact, with greater liberalisation of financial services there is a
greater need for effective non-discriminatory rule-bound
regulation. But one need to draw a distinction between the need
for regulation as such and the way it is to be carried out from
now on. The ever-changing regulatory environment of NBFC is
causing considerable hardship. It is creating confusion among
players. Regulation at the cost of killing the Sector would serve
no purpose. The regulations have to recognise that there are
limits to regulation. Of special relevance to the current Indian
scene, regulation over different entities is not going to be a
safeguard against frauds and other malfeasant acts. Frauds will
continue to be committed as long as businesses are run. No
regulatory system however well designed or comprehensive can
take care of each and every contingencies. What a regulatory
system should seek to achieve, is to bring order into a chaotic
system. It should enable regulators, investors and creditors, to
spot deviant behaviour so that corrective measures can be
undertaken swiftly. Further a strong self-regulatory framework is
definitely desired, and would improve the state of affairs.
Prospects
The sector is heading towards consolidation. Sound companies
with soundest of fundamental would emerge stronger, and
weak companies with poor Balance Sheets would be weeded
out of the system. NBFCs have survived all over the World and
would continue to survive even in our Country.
However, the coming time would be quite crucial for NBFCs.
From being a small business unit in a major industrial group,
the financial services are going through a phase where they
themselves are major business with each of its segment being a
separate industry in itself.
Size would be a major determinant of the survival of the
NBFCs along with promoters credentials and group backing. To
survive a lot of mergers and acquisitions are taking place in the
industry. It is evident that only the top few will be able to
withstand the test of times. Already more that 60% of the total
business of the NBFCs is in the hands of around 50 players.
However, there would also be a small NBFCs operating into
niche markets. They would take advantage of their expertise, in
their particular areas and operate at a premium. However, their
operations would be local in nature and their ability to grow
limited.
Questions to Discuss:
1. Discuss the activities of NBFCs.
2. Discuss the growth of NBFCs.
3. What are the problems and prospects of NBFCs?
Notes:
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LESSON 31:
THE INTERNATIONAL MONETARY SYSTEM
Learning objectives
After reading this lesson, you will understand
Objective of International Monetary Fund
Sources of fund
Now let us focus our attention to the International Monetary
System. You all must be having an overview of IMF. However,
our study of Management of Financial Institution is
incomplete without the discussion of IMF.
Introduction
The International Monetary System is the short-term wing of
the international financial system. It encompasses all relations as
between the national market sys-tems. I.M.F is the Apex body
for this system and acts as a central bank of central banks of the
nations.
The establishment of the International Monetary Fund (IMF)
in 1945 was a landmark in the international monetary field.
Before 1945 there was international monetary disorder,
exchange restrictions and a host of other undesirable trade and
exchange practices. The need for international monetary co-
operation and under-standing was felt soon after the war, and
the Bretton Woods Conference resulted in the establishment of
IMF and the World Bank. Originally 44 member countries met
at the Conference and the IMF was set up as per the agreement
reached among them in December 1945. It had an original
membership of 29 countries and by end of 2002 rose to cover
almost all the, countries, (182) barring a few smaller countries.
The IMF is governed by a policy-making body, viz. the Board
of Governors but the day-to-day affairs are looked into by the
Board of Executive Directors consisting of the representatives
of 16 elected countries and 6 nominated countries. . The Board
of Executives Directors meets as often as is necessary to decide
on all matters pertaining to the role of the Fund. The Managing
Director is the chief executive of the Fund and is appointed by
the Board of Executive Directors. It has a secretariat in
Washington.
Objectives of IMF
The IMF is primarily a short-term financial institution - a lender
and a borrower - and a central bank of central banks and
secondarily, aims at promoting a code of conduct among
members for orderly exchange arrangements and international
monetary management. The objectives of the Fund as laid
down in its Articles may be briefly set out as follows:
(1) To promote international monetary co-operation through
consultation and mutual collaboration.
(2) To promote exchange stability and maintain orderly
exchange arrange-ments and avoid competitive exchange
depreciation.
(3) To help members with temporary balance of payments
difficulties to tide over them without resort to exchange
restrictions.
(4) To promote growth of multilateralism in trade and
payments and thus expand world trade and aid.
(5) To help achieve the balance of payments equilibrium
shortens the duration of disequilibrium and promotes
orderly international relations.
The main object of the Fund is to promote exchange stability
and encourage multilateral trade and payments. It is also a
financing institution and has schemes for provision of short-
term finance for meeting the balance of payments purposes. It
provides international liquidity in tune with the requirements
of world trade and fosters the growth of world trade and freer
system of payments. Gold was originally the unit of account in
which the various currencies were denominated. This was
subsequently, replaced by Special Drawing Rights (SDRs), which
is a standard unit of account, whose value is fixed in terms of a
basket of currencies. These functions of the Fund are reviewed
briefly.
Funds Role of Consultation
In all matters of exchange rate changes, imposition of
restrictions on current account, use of discriminatory practices,
members are obliged to consult the Fund. Failing this, the
members could be ineligible to have recourse to financial
resources of the Fund. Such consultations may take the form
of supply of economic and financial data to the Fund by the
member country. Secondly, the staff of the Fund can call for
various types of data from a member country as and when they
require on an ad hoc basis. Thirdly, the staff teams visit
member countries at least once a year for a first-hand study of
economic and financial conditions in the member country. At
the time of annual general meeting or at the time of
negotiating a credit arrangement, representatives of member
countries hold consultations and discus-sions with the Board
of Executive Directors. Many times informal consultations also
take place between the members Governor or Executive
Director with the IMF staff, particularly at a time when the
member country approaches the Fund for a standby
arrangement or a credit drawn.
Sources of Funds Quotas
Every member country is given a quota in the Funds. These
quotas were fixed originally on a formula: (a) 2 per cent of the
national income; (b) 5 per cent of gold and dollar balances; (c)
10 per cent of average annual imports; (d) 10 per cent of
maximum variation in annual exports. The sum of the above,
increased by the percentage ratios of average annual exports to
national income of a member, is used as the basis for fixing the
quotas.
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Each members quota was thus fixed as his or her initial
contribution to the Fund. A member had to contribute its
quota to the Fund in the form of gold up to 25 per cent of its
quota or 10 per cent of its net gold holdings or U.S. dollars on
September 12, 1946, whichever was less and the rest of the
quota was payable in member currency. Since 1980, the clause of
25 per cent of the quota in gold or US dollar was replaced by
contribution of SDR and convertible currencies. At the time,
gold was valued at $ 35 per fine ounce and India paid $ 27,5
million in gold for a quota of $ 400 million. The quota of
India stood at 3056 million SDRs after the 10th General Quota
increase in 1995. IMF holds substantial gold reserves, which
were received as part of members contribution towards their
quotas, and liquid reserves in the form of convertible currencies
of member countries.
The total of quotas of 44 nations which gathered at Bretton
Woods in 1944 was fixed at $ 8800 million, By end December
1994, the membership rose to 178 with a total of quotas at
SDRs 144,620 million after the 9th General Review of quotas
made in 1990. The work of Tenth general Review of Quotas
was undertaken in 1994-95, and Eleventh quota review was
completed in 1998 and the quota increase of 45% was effected
in 1999. .
Share Capital of IMF
In January 1999, the increase of share capital or total quota of
IMF from SDR 145.6 billion (US $ 204; billion) to SDR 212
billion (US $ 297 billion) took effect, with the consent given by
the requisite 85% of the memberships. The funds usable
resources raised by SDR 45 billion or US. $ 63 billion. Indias
current quota is SDR 3055.5 million, which comes to about
2.098 per cent of the total IMF quota. This quota is now
increased to SDR 4158.2 million, which comes to about 1.961
per cent. Thus, in relative terms, the position of India came
down considerably in the Fund.
When it was set up, India was among the top five quota
holders. Now she has been pushed down to 13th position in
the list. The current top countries are U.S.A. Japan, Germany,
Prance, U.K, Italy, Saudi Arabia, Canada, Russia, Netherlands,
China Belgium and India.
The increase of IMP quotas has been affected by conventional
calculations for determining the quotas of countries, referred to
earlier. But, if economic strength of a country is determined by
relative purchasing power parity, it is understood that China
would be number two or three and India number five or six.
Other Sources of Funds
The IMF has, in addition to members quotas, other sources of
funds. In 1962 IMF concluded a General Agreement to borrow
(GAB) under which IMF could borrow from the participating
members (Group of Ten Developed Countries) specified
amounts of their currencies. The amounts which the Ten
Countries (Belgium, Canada, France, West Germany, Italy,
Japan, Netherlands, Sweden, U.K. and USA) undertook to
provide was set in the agreement. Interest and service charges
were payable on such loans in agreed terms (upto 5 years) in
gold, later replaced by SDR. The IMF borrowed not only from
above countries but also from others such as Saudi Arabia on
similar terms. The IMF can also acquire any members currency,
as desired, in exchange for the gold, which it holds.
Since August 1975, as agreed by the members in the Interim
Committee to reduce the role of gold, about one-sixth of its
gold holdings was sold in auctions and in non-competitive bids
and the proceeds realized amounted to US $ 5.7 billion of
which $ 1.1 billion representing the capital value of the original
gold was added to Trust Fund. About one-sixth of the gold
out of the Fund holdings has been distributed to members so
far. The Fund has still two-third of the original quantity of
gold with it.
Financial Assistance
Thus, the IMF lends money only to member countries with
balance of payments problems. A member country with a
payments problem can immediately withdraw from the IME
the 25 per cent of its quota. A member in greater difficulty may
request for more money from the IMF and can borrow up to
three times its quota provided the member country undertakes
to initiate a series of reforms and uses the borrowed money
effectively. The frequently used mechanisms by the IMF to lend
money are
1. Standby Arrangements
2. Extended Arrangements
3. Structural Adjustment Mechanism (with low interest rates)
Areas of Activity
Surveillance is the process by which the IMF appraises its
members exchange rate policies within the framework of a
comprehensive analysis of the general economic situation
and the policy strategy of each member. The IMF fulfils its
surveillance responsibilities through annual bilateral Article
N consultations with individual countries; multilateral
surveillance twice a year in the context of its World
Economic Outlook (WEO) exercise; and precautionary
arrangements, enhanced surveillance and programme
monitoring which provide a member with close monitoring
from the IMF in the absence of the use of IMF resources.
(Precautionary arrangements serve to boost international
confidence in a members policies. Programme monitoring
may include the setting of benchmarks under a shadow
programme but does not constitute a formal IMF
endorsement.)
Financial assistance includes credits and loans extended by
the IMF to member countries with balance of payments
problems to support policies of adjustment and reform. As
of July 31, 1999 the IMF had credit and loans outstanding
to 94 countries for an approved amount of SDR 63.6 billion
(about $87 billion).
Technical assistance consists of expertise and support
provided by the IMF to its members in several broad areas:
the design and implementation of fiscal and monetary
policy; institution building (such as the development of
central banks or treasuries); the handling and accounting of
transactions with the IMF; the collection and refinement of
statistical data; training officials at the IMF Institute together
with other international financial organisations, through the
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Joint Vienna Institute, the Singapore Regional Training
Institute, the Middle East Regional Training Programme and
the Joint Africa Institute.
Funds Lending Operations
As a financial institution, the Fund provides temporary financial
assistance for balance of payments purposes in the form of sale
of currencies. When a member borrows from the Fund it
purchases foreign currencies against its own currency. When it
repays loans, it is repurchasing its own currency against foreign
currency.
The Funds exchange operations are classified into four
categories as follows:
(1) Gold Tranche is upto the amount of gold paid by the
member towards its quota plus its credit position with the
Fund (which is the same thing as other countries borrowings
of its currency). If a country has 25 per cent of its quota in
gold, then upto this limit this member can draw upon the
Fund automatically. If that country has also a credit position
of l0 percent of its quota as borrowings by other countries,
then that country can borrow automatically upto 35 per cent
of its quota (gold tranche of 25 percent plus super gold
tranche of 10 per cent).
(2) Four Credit Tranches: There are four credit tranches, each
equivalent to 25 per cent of its quota. If gold payment is 25
per cent of the quota and the rest of the 75 per cent is paid
in own currency, the Fund can hold upto 200 per cent of a
members quota in its currency and credit tranches would
aggregate to 100 per cent of quota.
(3) Compensatory financing facility was started in February 1963
to provide credit in connection with any shortfalls in export
proceeds below some average annual figure. The member
was permitted credit upto 50 per cent of the members
quota, which was raised in stages to 100 per cent of the
quota in 1980.
(4) The international buffer stock financing facility was
established in June1969 in respect of any primary
commodity that the member country produces. The credit is
upto a limit of 50 per cent of its quota for special stocks of
sugar, tin, cocoa, etc, under various international
commodities agreements.
The above facilities, except in the case of gold tanche which is
automatic, are subject to the following conditions:
(1) No member should draw in any 12-month period more
than 25 percent of its quota.
(2) No member should draw in total beyond a point where the
Funds holdings of the members currency reaches 200 per
cent of its quota which it will have if it has borrowed upto
125 per cent of its quota with a gold subscription of 25 per
cent and its own currency upto 75 per cent.
(3) The combined drawal under compensatory financing and
buffer stock financing should not exceed 75 per cent of the
members quota.
(4) Total holding of IMF of any members currency under all
the above facilities should not exceed 275 percent of the
quota of that member, and this condition was waived many
times.
The conditionality of drawings under various credit tranches
and other finan-cial facilities will vary according to the state of
the country and the economic and financial policies pursued.
Requests for drawings beyond the first credit tranche require
substantial justification and the conditions laid down would be
more rigorous in terms of policies to be pursued by the
member country. These conditions are imposed with a fair
degree of flexibility.
Standby Arrangements
When a member feels that the need for credit might arise during
any year, it may enter into standby arrangements with the Fund.
This will give an assurance of financial support from the Fund
in time of need. This facility was introduced in 1952 to meet a
felt need for it although there was no specific provision for it in
the Funds Articles of Agreement. Since then such facility was
frequently used by the members and both the Fund and the
members are happy for such prior arrangement in the nature of
an overdraft limit. The standby facility is repayable generally in
three years, while other types of borrowings are repayable in 3
to 5 years. A members obligation to repurchase also arises if its
exchange reserves rise beyond a limit. The repurchase is made in
terms of the currency borrowed or in any convertible currency or
a currency, which is in demand, and the Funds holdings of it
are less than 75 per cent of that countrys quota. A members
indebtedness to the IMF can be repaid in three ways: (1)
Repurchase with gold and convertible currencies; (2) The
drawings of its currency by other countries; and (3) The offset
of an earlier creditor position.
IMF Charges
The schedule of IMF charges on the members drawings is such
that the rate varied with the period for which it is outstanding
and the tranche position of the country. For a long time the
maximum rate of interest was 5 per cent and now it varied
from time to time. The rates for supplementary financing facility
were higher at 10-11.5 per cent or even more, as these rates
depended on the rates at which the Fund borrowed from the
lender countries and on the money market conditions of the
major creditor countries. The margin kept by the IMF is about
0.2 to 0.325 per cent. Since May 1, 1981, IMF had adopted a
uniform charge of 7.0 per cent per annum on outstanding
borrowings of members from the Funds own resources and a
higher rate for those resources borrowed from outside. The
Fund makes a service charge of 0.5 per cent on all purchases
other than those in reserve tranche and 0.25 per cent on all
standby and extended Fund facilities.
These charges are payable normally in gold or US dollars or
SDRs but as in the case of other provisions of the Fund which
are operated with flexibility, this may be waived if the nations
external reserves are below half of its quota. Thus, Funds
charges were paid by India in rupees only. These charges are very
nominal in view of the fact that Fund does not pay any interest
on currencies held by it. Since 1969, IMF was paying about 11/ 2
per cent per annum to a creditor position of a member that is,
when its currency held by the Fund fell below 75 per cent of its
quota.
132 11.621.6
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Other Facilities
The oil facility was originally designed in 1974.These funds were
lent to countries in balance of payments difficulties due to oil
price escalation during 1970-73. Arrangements to borrow SDR
6.9 billion for this Fund from 17 member countries with a
strong external payments position were made in 1974. This
facility was extended from year to year and by 1982 borrowing
members have repaid most of the outstanding debt.
In 1974, the Fund also established an Extended Fund facility to
provide special medium-term loans to meet the balance of
payments deficits over a longer period and to help correct the
structural imbalances in the economy of a member country.
This assistance is up to three years and in amounts larger than
that permitted by the members quota. .
In August 1975, a Subsidy Account was set up with
contributions from 24 members for an amount of SDR 160
million to assist the member countries in balance of payments
difficulties due to a rise in oil prices and to provide subsidy to
interest payments on the use of resources made available to
them through the oil facility. The effective interest rate to
borrowing members, which include India, is 2.7 per cent as
against the original rate of 7.7 per cent. The final payment under
this Account was completed in August 1983.
In May 1976, a Trust fund was started for providing special
balance of payments assistance to developing countries at highly
concessional rates. The sources of funds for this Trust are the
realizations from the sale proceeds of one-sixth of IMF gold
holdii1g, income from investment and loans and proceeds of
repayment and donations. Only about 60 member countries
(including India), which are developing, were eligible for this
assistance. The first auction sale of gold by the Fund took place
in June 1976.
A Supplementary Financing Facility was established in August
1977 (Wittaveen Facility) with the objective of extending
financial assistance to members with large payments difficulties,
which are larger in relation to their incomes, and quotas with the
Fund. This is usable by members under a standby or under an
extended arrangement for a period of 1 to 3 years. Some 14-
member countries agreed to provide SDR 7.8 billion for this
facility. The borrowings on this Fund by members were started
in May 1979 and IMF has in turn borrowed from the lending
members at a rate calculated for each of the six months on the
basis of yield on US Government securities of 5-year maturity.
A subsidy account was also started in December 1980 for
subsidizing the interest rate on the borrowings of the low-
income developing members under this Wittaveen facility. This
facility could not be extended beyond 1982 due to further non-
committal of funds by lender-members. .
A new Structural Adjustment Facility (SAP) was established in
October 1985 and became operative in March 1986 financed out
of SDR 2.7 billion that are available during 1985-91 from
repayment of Trust Fund loans and interest dues. This facility is
confined to the lowest income countries with protracted balance
of payments problems needing a structural adjustment
programme. This loan carries a rate of 1/ 2% of 1 per cent with
a grace period of 5 years and subsequent semi-annual
repayments extending over five years. The programme of
adjustment is expected to be of about three years during which
the countrys balance of payments position would be
strengthened and its debt repayment capacity revived.
Enhanced structural adjustment facility was continued upto
1993 for helping the low-income countries, in strengthening
their payments position. Many additional Facilities were created
from time to time to suit to the changing conditions. Thus, in
April 1993, the Fund created a new temporary facility called
systemic transformation assistance to members with, systemic
disruption of economies moving from planned economies to
private market-oriented economies. In December 1997 the
fund, had set up the supplementary Reserve Facility to provide
additional finance to members facing exceptional balance of
payments problems due to loss of funds following the loss of
market confidence.
Exchange Rates and Par Values
An important aspect of IMF activities is to maintain orderly
exchange arrange-ments. The exchange rate system set up by the
Articles of Agreement was called par value system. Each
member is required to express the par value of its currency in
terms of gold as a common denominator or US dollar at a
value of $ 35 per fine ounce of gold. Thus, gold was the basis
of valuation and exchange rate fluctuations were to be kept
within a narrow margin of 1 per cent on either side. While the
USA performed this by buying and selling gold for US dollar,
other countries did it through an intervention currency, such as
US dollar of UK sterling.
The par value can be changed at the initiative of the country but
with the concurrence of the IMF. For any change up to 10 per
cent in the par value, to make adjustments in the balance of
payments, the Fund would not raise any objection. For any
change beyond 10 per cent, the country has to justify to the
Fund that it would be needed to correct a fundamental
disequilibrium - a concept that has not been defined by the
Fund but relates to a structural change in the economies and in
cost price parities.
Besides, members are obligated to avoid control on current
account except under Article XIV which permits member
countries to have such restrictions on a temporary basis. Some
members who opted for this clause continue to have these
restrictions in some form or the other. Article VIII enjoins on
the members to free current transactions from all restrictions,
which was adopted by the major developed countries in the
sixties. About 60 members have accepted Article VIII of the
Fund so far and India is one of them since 1994. But a majority
of members are still following Article XIV provisions, under
which some forms of control on Current Account transactions
were permitted.
The stable par value system has broadly served the purpose of
larger trade and greater international co-operation. This system
continued to prevail up to August 1971 during which time
there was international monetary stability and orderly growth in
world trade.
So long as the dollar convertibility into gold was maintained,
IMF served the purpose and dollar and gold shared the honour
of serving as an international medium of exchange. While the
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surplus countries have not been adjusting their economies, the
burden of adjustment fell on the deficit countries. When the
US was one of such deficit countries and found it difficult to
adjust the domestic economies to the requirements of the IMF
system and its role as an international banker, the fixed parity
system lost its credibility.
The Bretton Woods system in respect of exchange rates was
formally aban-doned in August 1971 when convertibility of the
US dollar into gold was with- drawn. The continued inflation at
home, deficits in balance of payments and persistent pressure
on the US dollar by its creditor countries along with speculative
attacks on the dollar particularly in Euro-currency market, led to
the suspension of its convertibility. The US abandoned its
obligation to buy and sell gold in interna-tional settlements
since August 1971. This was followed by a system of floating
rates and a temporary regime of central rates and wider margins
since December 1971.
The Smithsonian Agreement of December 1971 put back the
broken pieces of the system together into a new shape, based
on (I) A realignment of currency value against the dollar with a
small devaluation of $ (revaluation of gold $ 38 = 1 fine ounce)
and (ii) A return to fixed parity system by December 1971. But
this system was short-lived and UK sterling was the first to
abandon the fixed parity system in June 1972, followed by
others in favour of a floating system of exchange -rates. In
February 1973, there was a further devaluation of dollar by 10
per cent in terms of gold in the midst of rampant speculation
in dollar. A Committee of Twenty and subsequently the
Interim Committee took up to formulate in 1972 a package of
reforms in the international monetary system concerning
exchange rates, role of gold, SDRs etc. After years of
deliberation, they agreed on the following measures, in 1978.
Questions to Discuss:
1. What are the objectives of International Monetary Fund?
2. What are the sources of fund?
Notes:
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LESSON 32:
THE INTERNATIONAL MONETARY SYSTEM
Learning objectives
After reading this lesson, you will understand
International Monetary reforms and International liquidity
Special Drawing rights (SDR)
Today we shall discuss international monetary reforms and
international liquidity and also special drawing rights of the
IMF.
International Monetary Reforms
In respect of exchange rates it was agreed that the floating
exchange system, which was a fait accompli, should be legalised.
But members are still under an obligation to collaborate with
the Fund to ensure orderly exchange arrangements and
promote a system of stable exchange rates. It was also provided
that countries may return to a stable but adjustable par value
system at a future date. Meanwhile, floating rates with a wider
band of fluctuations of 2.25 per cent on either side, which was
prevailing since the Smithsonian Agreement would continue.
A new concept of international surveillance of the exchange
rate systems was developed arid accepted as a new approach to
the exchange rate systems. Of the 149 members in the Fund, as
at end December 1986, there were about 14 countries
independently floating 8 countries in a joint float and 32
countries linked to the US dollar, 14 to the French Franc, 12 to
SDR, 31 to a currency basket and the rest, linked to other
currencies. The fixed parity system had disappeared completely.
As regards gold, it would no longer function as an international
unit of value or medium of exchange for the purpose of the
Fund. The official price for gold is abolished and obligatory
payments and receipts in gold between the Fund and members
were withdrawn. Members are free, however, to deal in gold
among themselves, SDR will be the unit and medium of
exchange in future. The existing gold stocks of the fund are to
be disposed of by returning to members half of their original
contributions and by selling the other half in the market
through auctions and to use the proceeds for the Trust Fund.
Provisions are made for greater use and resort to SDRs, referred
to later.
Two amendments were made to the Articles of Agreement, in
connection with the reforms. Firstly, in 1969 an amendment
was made to create a system of SDRs, which will be referred to
later. Secondly, Articles were amended in 1978 to introduce
reforms in the international monetary system referred to earlier.
The principle of surveillance of the Fund over the members
exchange rate systems was embodied in the Second
Amendment. So also was the abandonment of gold as an
international unit of account or a medium of exchange for
which SDR .is redesigned.
Surveillance involves the following principles.
(1) A member shall avoid manipulating exchange rates to its
advantage or prevent effective balance of payments
adjustment.
(2) A member shall intervene in the exchange market if
necessary to counter disorderly conditions.
(3) Members should take into account the interests of other
members of the Fund in their intervention policy.
Members are free to choose their exchange rate arrangements
except to main-tain values in terms of SDR and co-operate with
the Fund in the orderly exchange arrangements.
International Liquidity
International liquidity is defined to include all the assets gold
and currencies that are freely and unconditionally usable in
meeting the balance of payments deficits and other
international obligations of countries. Gold has for long served
as a unit of account, measure of value and medium of
exchange. In the narrow official sense, the liquid assets used to
meet balance of payments deficit by governments or monetary
authorities include gold, convertible foreign exchange assets and
reserve position with the IMF. In a sense, all owned and
potential borrowings should be included as liquidity. These
potential borrowings are vast and the scope for them is
expanding with the passage of time. Besides, in a wider sense,
all currencies and currency deposits and credits, actual and
potential are part of the liquidity whether available to the
governments and monetary authority or private parties. But
since reserves held by private parties are not available monetary
authorities for meeting balance of payments requirements, only
gold, official reserves, gold tranche and super-gold tranche
(creditor position) with the IMF are considered as freely usable
liquid assets by the authorities. Gold and super-gold tranche
positions are drawable without conditions like the current
account position with banks. SDRs, which have been created by
the IMF since 1969, are also included as liquid assets. In a
narrow sense, thus, the official foreign exchange assets include
gold, foreign currency deposits and investments in currencies
which are freely convertible if that country has accepted Article
VIII of the IMF Articles of Agreement, whereby no current
account restrictions are used. India has accepted this position in
March 1994.
Need for Reserves
With the growth of world trade and payments, the need for
reserves increases to meet the payments and deficit
requirements. Just as in the case of domestic cash requirements
for transactions, precautionary and speculative motives, and
international reserves also serve these three motives. Under a
system of fixed par values adopted by the IMF and operative
upto 1971, intervention in the markets to maintain the
exchange rates stable used to require a large volume of liquid
assets by the authori-ties. However, under the system of
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floating rates with a wider band of fluctuations, a larger need
for reserves exists for various reasons. Firstly, the larger the
balance of payments deficits, the larger is the need for reserves,
and these deficits are growing. Secondly, then existing exchange
rate system called managed float requires a larger official
intervention, which depends on the official holding of reserves.
Thirdly, the IMF has put an obligation on members to return
to the fixed par value system as and when conditions permit,
for which a comfortable stock of reserves is necessary. Fourthly,
increasing deficits in balance of payments of non-oil producing
countries in more recent years require to be financed by reserves.
Fifthly, a large number of poor countries have their exchange
rates pegged to a currency or basket or currencies for which
central banks intervention in the market is necessary, particularly
when their deficits are growing. The demand for reserves for
precautionary motives emerges out of the need for
contingencies and to maintain their credit standing. The
speculative demand for reserves may not be felt in a country
where all exchange dealings are strictly controlled and supervised
by the authorities.
Composition and Level
The official reserve composition of India in 1971 and the latest
position are presented below:

End March End March Jan. Dec.
(Rs. crore;)
June
1971 1981 1994 1999 2002
Gold* 182 226 12,665 12,790 16,272
Foreign Exchange
.

Assets 438 4,822 61,440 1,39,134 2,67,333
SDR Units 112 497 233 18 47
Total 732 5,545 74,338 1,51,942 2,83,652
Valued at London market price.
Source: RBI Bulletins.
Historically, the role of gold was taken by the US dollar and UK
Sterling in interwar and post-war periods and was replaced by
SDR in the seventies. Gold is now completely replaced by SDR
in the international monetary system.
Adequacy of Reserves
The currency composition of foreign exchange has also
undergone substantial changes since 1975. The role of the US
dollar was replaced partly by other currencies such as DM, Swiss
franc and Japanese yen and partly by SDR.
If reserves are important, the adequacy of reserves of
international liquidity is equally important. Firstly, adequacy of
reserves may be judged by the relationship of reserves to
imports, secondly, by the rate of growth of world trade as
compared to the rate of growth of reserves and thirdly, by the
magnitude of balance of payments deficit today as against a
base year. Reserves as percentage of imports for all countries
stood at 85 per cent in 1950 but declined to 38 per cent by 1966.
By 1970 when SDR allocation started the inadequacy of reserves
in relation to imports was glaring.
The adequacy of reserves is also assessed sometimes with
reference to the degree of fluctuations in exports earnings. The
symptoms of inadequacy include increased restrictions on
current account transacti0l1s such as imports, efforts to curtail
foreign aid, depreciation of currency and greater reliance on trade
credits etc. With increased access to international capital markets,
more recently by creditwor-thy countries like India, the question
of adequacy of reserves became less important to them.
At end September 2003 total reserves of India totaled about
$88 billion, which covers all import bill for about 11 months.
Problems of Liquidity
The basic problems of international liquidity are as follows:
1.Inadequacy of Growth: Compared to the growth of world
trade and increased deficits in balance of payments or judged
by any other criteria, the inadequacy of reserves was felt more
in the sixties and seventies than before. This was the justifi-
cation for the creation of SDRs by the IMF.
2. Unsatisfactory Distribution of Reserves. The bulk of the
reserves, namely, around 60 percent, was held by the
developed world and more recently by the combined groups
of developed countries oil-producing developing countries.
The poor developing countries and non-oil producing
countries are left with inadequate reserves.
3. Unsatisfactory Composition of Reserves: The proportion of
gold to total re-serves in 1952 was 68 per cent, which fell to
53 per cent in 1968 and future to 23 per cent in 1973. Since
then gold was completely replaced in official transactions by
the SDRs. Gold, however, continued to play an important
role with some countries because of its intrinsic worth,
despite its demonetisations by IMF in 1973. Gold was
revalued in terms of the US dollar from $ 35 to $ 38 per
fianc ounce in 1971 and again to $ 42.2 per fine ounce in
Febl11ary 1973.
In December 1997, the fund establishes the supplementary
Reserve Facility to provide additional financial assistance to
countries in financial crisis due to balance of payments
difficulties and loss of market confidence. From time to time
many facilities were added while some have lapsed.
Augmentation of Liquidity
The methods of augmenting the liquidity adopted by the Fund
are the quota increase; borrowing from members under GAB
and creation of SDRs. Increase, in quotas of all members with
the IMF would improve global liquidity as their borrowing
operations could simultaneously increase. Normally, quota
reviews are held at intervals of not more than 5 years. Then the
Fund would consider the growth of world economies, growth
of international transactions and world trade and judge the
adequacy of existing international liquidity. The quotas of
members would determine their existing subscriptions to the
Fund, their drawing rights on the Fund under both regular and
special facilities and their share of allocation of SDRs and their
voting power in the Fund.
So far eleven quota increases took place in the past. The eighth
General Review of quotas made in 1984 raised the total quotas
with the Fund by 47.5 per cent to 90 billion. Under the ninth
quota increase, in 1990, total quotas increased further by 51.7%
to SDR 136.7 billion. Even so, the ratio of Fund quotas to
world imports is still lower at 4 per cent at present as compared
to 9 per cent in 1970 and 12 percent in 1965. Such general
increases in quotas had taken place earlier in addition to some
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special increases of quotas of a few members whose currencies
were supposed to be lower than the general requirements.
Special Drawing Rights (SDR)
The Special Drawing Rights (SDRs) are another source of
augmenting inter-national liquidity. This is an asset specially
intended to take the place of gold and as such called paper gold,
Each SDR is equal to O.88671 gms of fine gold, equivalent to
one US dollar prior to devaluation in 1971. The value of SDR
was changed with the devaluation of dollar in 1971 and 1973.
During 1974 to 1980 the value of SDR was fixed on a daily
basis as a weighed average value of a basket of 16 currencies of
countries with more than 1 per cent of world trade. In 1981
these 16 were replaced by 5 major currencies, namely US $ DM,
UK French Franc and Yen.
These reserve assets have been created by the Fund since 1969 as
and when required as part of the long-term strategy of
augmenting world liquidity to keep pace with the requirements
of a growing world economy and world trade. The actual
allocation of SDRs to members would depend on the then
quotas with the Fund. The acceptability of the SDR as an
international liquid asset would depend upon the
unconditional acceptance of this asset by the members of the
Fund. The Fund members have been given the option to join
the SDR scheme and those who have joined are bound to abide
by the rules of unconditional acceptance for international
payments, conversion into reserve currencies, payment and
receipt of interest etc. About US members had joined it
originally in 1970 but now all its members have accepted and are
allotted the SDRs.
SDR accounts are kept separate from the General Account of
the Fund. The SDR is like a coupon or a credit facility, which can
be exchanged for reserve currency as, needed by the user and
approved by the Fund. The governments of the countries are
holders of the SDR and their accounts in SDRs are maintained
by the Fund through book-entries. If a member wants to use
the SDR, it requests the Fund to designate another member to
accept them in exchange for a reserve currency to use
international payments and the latter member is obliged to
accept as designated by the Fund. This would then tantamount
to a credit granted by the latter member to the former for which
an interest rate of 1 per cent is paid to the creditor by the
debtor through the Fund. In this sense, SDRs are better than
gold as no interest was received on gold. In order to encourage
acceptability of these SDRs, a member country may be required
to hold in all 300 percent of the cumulative allocations 100 per
cent representing the original allocation and 200 percent
representing the part received from others as designated by the
Fund. These SDRs are the liability of the member borrowing
currencies in exchange for SDRs and not of the Fund, which
keeps only the accounts with surveillance over the operations.
The members are not expected to transfer SDRs for changing
the composition of its international reserves. The Fund may
also acquire SDRs in the process of its operations on General
Account as the members may repurchase in SDRs or pay
interest or service charges in SDRs. Further with a view to put
limit on the use of this facility by deficit countries, the principle
of reconstitution is laid down under which a members net
use of SDRs must be such that the average of its daily holdings
over a five year period should be not less than 30 per cent
(reduced to 15 per cent and later removed altogether) implying
thereby that it could use only 70 per cent of the allocation on
average. This puts an obligation on the members using SDRs
to repurchase them also.
SDR Allocation
Starting with January 1970, SDRs were allotted to all member
countries of the IMF who accepted the SDR scheme. The first
SDR allocations were made during each of the years 1970-72
totaling SDR 9.3 billion. Further allocations were made for each
of the years during 1979-81, totaling SDR 12 billion. The
cumulative allocations since the beginning of the scheme were
SDR 21,433 million. Such cumulative allocations amounted to
only 5-7 per cent of the total world reserves other than gold. In
timing of the allocations, the Fund kept in view the global need
to supplement the existing reserve assets. Since then, in
September 1997, a special one-time allocation of SDR 21.4
billion was made which raised all participants cumulative
allocations to a common benchmark ratio of29.3157 88813 per
cent of the quotas based on the Ninth General Review.
Limitations
The SD Rs cannot be used directly as reserves as they have to be
converted into reserves of one or other currency before use for
payments. They can be used by official agencies and for
designated purposes only. These are not money as such but are
comparable to near money or credit instruments. The fact that
interest is payable on SDRs used by the debtors to the creditors
would indicate that the SDRs are credit facilities.
Uses
Countries have made considerable use of these facilities since
their first alloca-tion in 1970. These transfers were partly
designations by the IMF or by voluntary agreements among the
members or in transactions with the Fund by members and
partly in transactions by other international bodies who are
holders of SDRs. Since then gold has been replaced by SDR in
the Funds transactions as we has in the international
transactions of members. The SDRs cannot, however, be
exchanged for gold or for changing the composition of reserves
of a country.
There are charges payable for use of SDRs. The charge for a
creditor position in SDRs with the Fund is paid to the member
holding excess SDRs than allocated. This charge of 1 per cent
was raised to 5 per cent in June 1974. Subsequently, the interest
rate on borrowings in SD Rs is determined quarterly by
reference to a combined market interest which is weighted
average rate on specified short-term instruments in the money
markets of the same five countries in whose currencies the SDR
value is determined, namely, the USA, West Germany, UK,
J1rance and Japan. The interest rates in the money markets of
these five countries are weighted according to the same weights
as used for SDR valuation. The IMF rate of remu-neration to
creditor countries was fixed in terms of SDR interest rate.
SDRs can also be used in swap arrangements and in forward
operations, as a unit of account or measure of value or a means
of payment. The SD R is used as a currency peg by some
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countries and as security or pledge. The Asian Currency Union
and a number of international and inter-regional bodies are
using SD Rs in the above applications.
SDRs in India
India was allocated SDRs in the name of the Government of
India since January 1970. These SDRs do not enter into the
accounts of the RBI. During 1979--81, India was given further
allocations on the basis of its quota with the Fund beginning
with January 1979. India had a total allocation of about SD R
681 million during 1970-81.
India has used the SDRs in a very active manner since their
inception and as at end July 2003, SDRs stood at Rs. 36 crores.
SDR was used by India for payment of interest and repurchases
from the Fund. India has also accepted them under the
Designation Plans of the Fund. India has very comfortable
exchange reserve position due to economic reforms affected
since July 1991.
Indias IMF Net Position
India actively participated in IMF operations since 1947 when
they were started. India has drawn IMF credits under most of
its schemes. Any country can count as its reserves its IMF
position in gold and super-gold tranches. Similarly, its
repurchase obligations with the IMF are to be deducted from its
official gross -reserves. It is in this context that Indias IMF
position becomes relevant. Indias repurchase obligations were
nil in 1970-71, when it had repaid Rs. 154 crores due to IMF.
But India had a major drawal of about Rs. 815 crores in August
1980 under two credits, namely, Rs. 540 crores from the Special
Trust Fund and Rs. 275 crores from the compensatory financing
facility. Our gold tanche position was about 25 per cent of the
quota, which stood at 2207 million SDRs taking into account
the 8th General Quota increase granted in January 1984. India
has drawn into its credit tranches and stand by credit
arrangement, Extended Fund Facility also the compen-satory
and contingency financing facility, oil facility and special Trust
Fund facility. In June 2002, we have a reserve position in the
IMF at $ 651 million and outstanding use of IMF credit (net)
stood at nil SDR our net debt position to IMF is zero as at end
June 2003. Our foreign exchange reserves stood at US. $ 66.9
billion at end Nov. 2002, which were roughly equal to 11
months of imports.
Additional SDRs
SDRs allocation to India was increased in 1997 by an additional
240 million SDRs due to special. One time SDR allocation
amounting to 21.4 billion. The principle of equitable shares of
cumulative SDR allocation to member countries as agai.1st the
earlier principle of allocation as a ratio of quotas benefited
India. As against the earlier share of 22%, it has now got 29%,
which secured for India an additional 240 million SDR in 1997.
Besides in the 11th general quota review, the present quota
funds would be increased by 45%, in which India will also
benefit. The total of IMF quotas will be increased and 75% of
the overall increase will be distributed in proportion to the
present quotas of member countries, as against the earlier
proportion of 60%. India will stand to gain in this respect also.
The IMF and the World Bank - How do
they Dif f er?
IMF Supported Programmes and the Poor (Low
Income Countries)
In 1987, the IMF established the Enhanced Structural
Adjustment Facility (ESAF) to provide resources to low income
countries for longer periods on concessional terms. Like its
predecessor, the Structural Adjustment Facility (SAF), the ESAF
was created in response to a need to better address the
macroeconomic and structural problems of low income
countries.
Concessional Imf Facility
Enhanced Structural Adjustment Facility (ESAF) was
established in 1987 and enlarged and extended in 1994.
Designed for low-income member countries with protracted
balance of payments problems, ESAF drawings are loans and
not purchases of other members currencies. They are made in
support of three year programmes and carry an annual interest
rate of 0.5 per cent, with a 5 year grace period and a 10 year
maturity. Quarterly benchmarks and semi-annual performance
criteria apply; 80 low income countries are currently eligible to
use the ESAF.
Other Facilities
Systemic Transformation, Facility,(STF) was in effect from
April 1993 to April, 1995. The STF was designed to extends
financial assistance to transition, economies experiencing
severe disruption in their trade and payments arrangements.
Repurchases are made over 4 to 10 years.
Compensatory and Contingency Financing Facility (CCFF)
provides compensatory financing for members experiencing
temporary export shortfalls or excesses in cereal. Import cost,
as well as financial assistance for external contingencies in
Fund arrangement Repurchases are made over 3 to 5 years.
Supplemental Reserve Facility (SRF) provides financial
assistance for exceptional balance of payments difficulties
due to a large short-term financing need resulting from a
sudden and disruptive loss of market confidence.
Repurchases are expected to be made within 1 to 1 years,
but can be extended, with IMF Board approval, to 2 to 2
years.
Contingent Credit Lines (CCL) is aimed at preventing he
spread of a crisis. Whereas the SRF is for use by members
already in the throes of a crisis, the CCL is intended solely for
members that are concerned with potential vulnerability. This
facility will enable countries that are basically sound and well
managed to put in place precautionary financing should a
crisis occur. Short-term financing - if the need arises - will be
provided under the CCL to help members overcome the
exceptional balance of payments financing needs that can
arise from a sudden and disruptive loss of market
confidence, largely generated by circumstances beyond the
members control. Repurchase terms are the same as under
the SRF.
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Saf /Esaf : A Concessional Facility to
Assist Poorer Countries
The IMFs executive board established the Enhanced Structural
Adjustment Facility (ESAF) in 1987 to better address the
macroeconomic and structural problems faced by low income
countries. It offers loans with lower interest rates and for longer
terms than the typical IMF market-related arrangements. The
principal objectives are
To promote balance of payments viability; and
Foster sustainable long-term growth.
Although the objectives and features of the ESAF are similar to
those of its predecessor, the Structural Adjustment Facility
(SAF) set up in. 1986, the ESAF was expected to be more
ambitious with regard to macroeconomic policy and structural
reform measures. The IMF no longer makes disbursements
under the SAP.
ESAF loans are disbursed semi-annually (as against quarterly for
regular IMF standby arrangements) initially upon approval of
an annual arrangement and subseq6ently on the observance of
performance criteria and after completion of a mid-term review.
ESAF loans are repaid in 10 equal semi-annual installments
beginning 5 years and ending 10 years after the date of each
disbursement, The interest on ESAF loans is 0.5 per cent a year.
By contrast, charges for standby arrangements are linked to the
IMFs SDR market determined interest rate and repayments are
made within 3 to 5 years of each drawing. A three-year access
under the ESAF is up to 190 per cent of members quota. The
access limits of standby arrangements are 100 per cent of quota
annually and 300 per cent cumulatively.
An eligible member seeking to use ESAF resources develops,
with the assistance of the IMF and the World Bank, a policy
framework paper (PEP) for a three-year adjustment
programme. The PEP, updated annually, sets out the
authorities macroeconomic and structural policy objectives and
the measures that they intend to adopt during the three years.
The PEP also lays out the associated external financing needs of
the programme, a process that is meant to catalyse and help
coordinate financial and technical assistance from donors in
support of the adjustment programme.
International Monetary Fund World Bank
Oversees the International
Monetary System
Seeks to promote the economic
development of the world's poorer
countries.
Promotes exchange stability and
orderly exchange relations
among its member countries
Assists developing countries through
long-term financing of development
projects and programmes.
Assists all members - both
industrial and developing
countries - that find themselves
in temporary balance of
payments difficulties by
providing short to medium term
credits.
Provides to the poorest developing
countries whose per capita GNP is
less than $865 a year special financial
assistance through the International
Development Association (IDA).
Supplements the currency
reserves of its members through
the allocation of SDRs (special
drawing rights); to date SDR
21.4 billion has been issued to
member countries in proportion
to their quotas.
Encourages private enterprises in
developing countries through its
affiliate, the International Finance
Corporation (IFC).
Draws its financial resources
principally from the quota
subscriptions of its member
countries.
Acquires most of its financial
resources by borrowing on the
international bond market.
Has 'at its disposal' fully paid-in
quotas now totalling SDR 212
billion (about $300 billion).
Has an authorised capital of $184
billion, of which members pay in
about 10 per cent.
Has a staff of 2,300 drawn from
182 member countries.
Has a staff of 7,000 drawn from 180
member countries.
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Questions to Discuss:
1. What do you understand by International Monetary reforms
and International liquidity?
2. Explain Special Drawing rights (SDR)?
Notes:
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Learning objectives
After reading this lesson, you will understand
The World Bank
A Global cooperatives
Economic Reform Programmes
International Monetary fund
Asian development bank
An international inspection of the financial institution would
ease your understanding of the functioning of the financial
institution.
Introduction
At the Bretton Woods Conference in 1944 it was decided to
establish a new monetary order that would expand international
trade, promote international capital flows and contribute to
monetary stability. The IMF and World bank were born out of
this Conference at the end of World War II .The World Bank
was established to help the restoration of economies disrupted
by War by facilitating the investment of capital for productive
purposes and to promote the long-range balanced growth of
International trade. On the other hand, the IMF is primarily a
supervisory institution for coordinating the efforts of member
countries to achieve greater cooperation in the formulation of
economic policies. It helps to promote exchange stability and
orderly exchange relations among its member countries. It is in
this context that the present lesson reviews the purpose and
working of some of the international financial institutions and
the contributions made by them in promoting economic and
social progress in developing countries by helping raise
standards of living and productitivity to the point at which
development becomes self-sustaining.
In this lesson, we will review the working and objectives of
some of the important international financial institutions. The
lesson begins with a comparison of the World Bank and its
affiliates. The lesson then gives a brief review of the five
international financial institutions - World Bank, IBRD, IDA,
IFC and MIGA. The next section discusses the various
dimensions of the World Bank in detail. A comparison of the
IMF and World Bank is also discussed. The lesson finally
concludes with a discussion of the Asian Development Bank
tracing its strategic objectives, operating objectives and financial
management.
One major source of financing is international nonprofit
agencies. There are several regional development banks such as
the Asian Development Bank, the African Development Bank
and Fund and the Caribbean Development Bank. The primary
purpose of these agencies is to finance productive development
projects or to promote economic development in a particular
region. The Inter-American Development Bank, for example,
has the principal purpose of accelerating the economic
LESSON 33:
INTERNATIONAL FINANCIAL INSTITUTIONS
development of its Latin American member countries. In
general, both public and private entities are eligible to borrow
money from such agencies as long as private funds are not
available at reasonable rates and terms. Although the interest
rate can vary from agency to agency, these loan rates are very
attractive and very much in demand.
Of all the international financial organizations, the most
familiar is the World Bank, formally known as the International
Bank for Reconstruction and development (IBRD). The World
Bank has two affiliates that are legally and financially distinct
entities, the International Development Association (IDA) and
the International Finance Corporation (IFC). Exhibit 1
provides a comparison among IBRD, IDA and IFC in terms of
their objectives, member countries, lending terms, lending
qualifications as well as other details. All three organizations
have the same central goals: to promote economic and social
progress in poor or developing countries by helping raise
standards of living and productivity to the point at which
development becomes self-sustaining.
Toward this common objective, the World Bank, IDA and IFC
have three interrelated functions and these are to end funds, to
provide advice and to serve as a catalyst in order to stimulate
investments by others. In the process, financial resources are
channelled from developed countries to the developing world
with the hope that developing countries, through this
assistance, will progress to a level that will permit them, in turn,
to contribute to the development process of other less
fortunate countries. Japan is a prime example of a country that
has come full circle. From being a borrower, Japan is now a
major lender to these three organisations. South Korea is
moving in a direction similar to that of Japan nearly a quarter
of a century ago.
Table:
The World Bank and its Affiliates
The World Bank
The World Bank group is a multinational financial institution
established at the end of World War II (I944) to help provide
long-term capital for the reconstruction and development of
number countries. The group is important to multinational
corporations because It provides much of the planning and
financing for economic development projects involving billions
dollars for which private businesses can act as contractors and
suppliers of goods and engine related services.
The purposes for the setting up of the Bank are
To assist in the reconstruction and development of
territories of members by facilitating the investment of
capital for productive purposes, including the restoration of
economies destroyed or disrupted by war, the reconversion
of productive facilities to peacetime needs and
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The World Bank
International
Bank for
Reconstruction
and Development
(IBRD)
International
Development
Association
International Finance
Corporation
(IFC)
Objectives of the institutions To promote economic progress in
developing countries by providing
financial and technical assistance,
mostly for specific projects in both
public and private sectors.
To promote economic
progress in developing
countries by helping to
mobilise domestic and
foreign capital to
stimulate the growth of
the private sector.
Year established 1945 1960 1956
Number of member
countries
(April 1983)
144 131 124
Types of countries assisted Developing
countries other
than the very
poorest. Some
countries
borrow a
blend of
IBRD loans
and IDA
credits.
The poorest: 80%
of IDA credits go
to countries with
annual per capita
Incomes below
$480. many of these
countries are too
poor to be able to
borrow part or any
of their
requirements on
IBRD terms
All developing
countries, from the
poorest to the more
advanced.
Types of activities assisted Agriculture and rural development,
energy, education, transportation,
telecommunications, industry, mining,
development finance companies,
urban development, water supply,
sewerage, population, health and
nutrition. Some non-project lending,
including structural adjustment.
Agribusiness,
development finance
companies, energy,
fertilizer, manufacturing,
mining, money and
capital market
institutions, tourism and
services, utilities.
Lending commitments (fiscal
1982)
$10,330 million $2,686
million
$580 million
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encouragement of the development of productive facilities
and resources in less developed countries.
To promote private foreign investment by means of
guarantees or participation in loans and other investments
made by private investors; and when private capital is not
available on reasonable terms, to supplement private
investment by providing, on suitable conditions, finance for
Equity investments (fiscal
1982)
IBRD and IDA do not make equity
investments.
$32 million
Number of operations (fiscal
1982)
150 97 65
Terms of lending:
Average maturity period
Generally 15 to
20 years
50 years 7 to 12 year
Grace period Generally 3 to
5 years
10 years An average of 3 years.
Interest rate (as of April
1, 1983)
10.97% 0.0% In line with market
rates.
Other charges Front-end fee
of 0.25% on
loan.
Commitment
charge of
0.75% on
undisbursed
amount of
loan.
Annual
commitment charge
of 0.5% on
undisbursed and
service charge of
0.75% on disbursed
amounts of the
credit.
Commitment fee of 1 %
per year on undisbursed
amount of loan.
Recipients of financing Governments,
government
agencies and
private
enterprises, which
can get a
government,
guarantee for the
IBRD loan.
Government.
But they may re-
lend funds to
state or private
organisations.
Private enterprises;
government
organisations that assist
the private sector.
Government guarantee Essential Essential Neither sought nor
accepted
Main method of raising funds Borrowings capital
markets.
Grants from in
world's
governments.
Borrowings and IFC's
capital, subscribed by m
governments.
Main sources of funds Financial markets
in US, Germany,
Japan and
Switzerland.
Governments of
US, Japan,
Germany,
France, other
OECD
countries and
certain. OPEC
countries.
Borrowings from IBRD.

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productive purposes out of its own capital, funds raised by
it and its other resources.
To promote the long-range balanced growth of international
trade and the maintenance of equilibrium in balance of
payments by encouraging international investment for the
development of the productive resources of members,
thereby assisting in raising productivity, the standard of
living and condition of labour in their territories.
To arrange- the loans made or guaranteed by it in relation to
international loans through other channels so that the more
useful and urgent projects, large and small alike, can be dealt
with first. -
To conduct its operations with due regard to the effect of
international investment on business conditions in the
territories of members and, in the immediate post-war years,
to assist in bringing about a smooth transition from a
wartime to a peacetime economy.
The World Bank is the International Bank for reconstruction
and development (IBRD)and the international Development
association (IDA). The IBRD has two affiliates, the
International Finance Corporation (IFC) and the Multilateral
Investment Guarantee Agency (MIGA). The Bank, the IFC and
the MIGA are sometimes referred to as the World Bank
Group.
International Bank for Reconstruction and
Development
The IBRD was set up in 1945 along with the IMF to aid in
rebuilding the world economy. It was owned by the
governments of 151 countries and its capital is subscribed by
those governments; it provides funds to borrowers by
borrowing funds in the world capital markets, from the
proceeds of loan repayments as well as retained earnings. At its
funding, the banks major objective was to serve as an
international financing facility to function in reconstruction and
development. With Marshall Plan providing the impetus for
European reconstruction, the Bank was able to turn its efforts
towards the developing countries.
Generally, the IBRD lends money to a government for the
purpose of developing that countrys economic infrastructure
such as roads and power generating facilities. Funds are directed
towards developing countries at more advanced stages of
economic and social growth. Also, funds are lent only to
members of the IMF, usually when private capital is unavailable
at reasonable terms. Loans generally have a grace period of five
years and are repayable over a period of fifteen or fewer years.
The projects receiving IBRD assistance usually require importing
heavy industrial equipment and this provides an export market
for many US goods. Generally, bank loans are made to cover
only import needs in foreign convertible currencies and must be
repaid in those currencies at long-term rates.
The government assisted in formulating and implementing an
effective and comprehensive strategy for the development of
new industrial free zones and the expansion of existing ones;
reducing unemployment, increasing foreign-exchange earnings
and strengthening backward linkages with the domestic
economy; alleviating scarcity in term financing; and improving
the capacity of institutions involved in financing, regulating and
promoting free zones.
The World Bank lays special operational emphasis on
environmental and womens issues. Given that the Banks
primary mission is to support the quality of life of people in
developing member countries, it is easy to see why
environmental and womens issues are receiving increasing
attention. On the environmental side, it is the Banks concern
that its development funds are used by the recipient countries in
an environmentally responsible way. Internal concerns, as well as
pressure by external groups, are responsible for significant
research and projects relating to the environment.
The womens issues category, specifically known as Women In
Development (WID), is part of a larger emphasis on human
resources. The importance of improving human capital and
improving the welfare of families is perceived as a key aspect of
development. The WID initiative was established in 1988 and it
is oriented to increasing womens productivity and income.
Bank lending for womens issues is most pronounced in
education, population, health and nutrition and agriculture.
International Development Association
The IDA was formed in 1960 as a part of the World Bank
Group to provide financial support to LDCs on a more liberal
basis than could be offered by the IBRD. The IDA has 137
member countries, although all members of the IBRD are free
to join the IDA. IDAs funds come from subscriptions from its
developed members and from the earnings of the IBRD. Credit
terms usually are extended to 40 to 50 years with no interest.
Repayment begins after a ten-year grace period and can be paid
in the local currency, as long as - it is convertible. Loans are made
only to the poorest countries in the world, those with an annual
per capita gross national product of $480 or less. More than 40
countries are eligible for IDA financing.
An example of an IDA project is a $8.3 million loan to
Tanzania approved in 1989 to implement the first stage in the
longer-term process of rehabilitating the countrys agricultural
research system. Cofinancing is expected from several countries
as well as other multilateral lending institutions.
Although the IDAs resources are separate from the IBRD, it has
no separate staff. Loans are made for similar projects as those
carried out by IBRD, but at easier and more favourable credit
terms.
As mentioned earlier, World Bank/ IDA assistance, historically,
has been for developing infrastructure. The present emphasis
seems to be on helping the masses of poor people in the
developing countries become more productive and take an
active part in the development process. Greater emphasis is
being placed on improving urban living conditions and
increasing productivity of small industries.
International Finance Corporation
The IFC was established in 1956. There are 133 countries that
are members of the IFC and it is legally and financially separate
from the IBRD, although IBRD provides some administrative
and other services to the IFC. The IFCs main responsibilities
are (i) To provide risk capital in the form of equity and long-
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term loans for productive private enterprises in association with
private investors and management (ii) To encourage the
development of local capital markets by carrying out standby
and underwriting arrangements and (iii) To stimulate the
international flow of capital by providing financial and technical
assistance to privately controlled finance companies. Loans are
made to private firms in the developing member countries and
are usually for a period of seven to twelve years.
The key feature of the IFC is that its loans are all made to
private enterprises and its investments are made in conjunction
with private business. In addition to funds contributed by IFC,
funds are also contributed to the same projects by local and
foreign investors.
IFC investments are for the establishment of new enterprises as
well as for the expansion and modernisation of existing ones.
They cover a wide range of projects such as steel, textile
production, mining, manufacturing, machinery production,
food processing, tourism and local development finance
companies. Some projects are locally owned, whereas others are
joint ventures between investors in developing and developed
countries. In a few cases, joint ventures are formed between
investors of two or more developing countries. The IFC has
also been instrumental in helping to develop emerging capital
markets.
The Multilateral Investment Guarantee Agency
(Miga)
The MIGA was established in 1988 to encourage equity
investment and other direct investment flows to developing
countries by offering investors a variety of different services. It
offers guarantees against noncommercial risks; advises.
developing member governments on the design and
implementation of policies, programmes and procedures
related to foreign investments; and sponsors a dialogue
between the international business community and host
governments on investment issues.
A Global Cooperative
The World Bank is comparable to a global cooperative which is
owned by member countries. The size of a countrys
shareholding is determined by the size of the countrys
economy relative to the world economy. Together, the largest
industrial countries (the Group of seven or G-7) have about 45
per cent of the shares in the World Bank and they carry great
weight in international economic affairs, generally. So it is true
that the rich countries have a good deal of influence over the
Banks policies and practices. The United States has the largest
shareholding - about 17 per cent - which gives it the power to
veto any changes in the Banks capital base and Articles of
Agreement (85 per cent of the shares are needed to effect such
changes). However, virtually all other matters, including the
approval of loans, are decided by a majority of the votes cast by
all members of the Bank.
The Banks board of executive directors, which is resident at the
Banks headquarters in Washington DC, represents all the
members. Policies and practices are regularly and frequently
debated and decided upon by the board, so every members
voice is heard. In fact, developing countries, together, have
about half the votes in the Bank. And the Banks cooperative
spirit is reflected in the fact that voting is rare because consensus
is the preferred way of making decisions.
Only developing countries can borrow from the Bank. But all
members, including the richer nations, gain from economic
growth in developing countries. A world increasingly divided
between rich and poor is in no ones interest. Everybody
benefits from increased trade and investment, higher incomes,
fewer social tensions, better health and education and
environmental protection. The Banks member countries -
particularly the industrial countries - also benefit from
procurement opportunities derived from World Bank financed
projects.
What does the World Bank do?
The World Bank is the worlds largest source of development
assistance, providing nearly $30 billion in loans, annually, to its
client countries. The Bank uses its financial resources, its highly
trained staff and its extensive knowledge base to individually
help each, developing country onto a path of stable,
sustainable and equitable growth. The main focus is on helping
the poorest people and the poorest countries but for all its
clients, the Bank emphasises the need for investing in people,
particularly through basic health and education; protecting the
environment; supporting and encouraging private business
development; strengthening the ability of the governments to
deliver quality services efficiently and transparently; promoting
reforms to create a stable macroeconomic environment
conducive to investment and long-term planning; focusing on
social development, inclusion, governance and institution
building as key elements of poverty reduction. The Bank is also
helping countries to strengthen and sustain the fundamental
conditions that help to attract and retain private investment.
With Bank support - both lending and advice - governments
are reforming their overall economies and strengthening
banking systems. They are investing in human resources,
infrastructure and environmental protection, which enhance the
attractiveness and productivity of private investment. Through
World Bank guarantees, MIGAs political risk insurance and in
partnership with IFCs equity investments, investors are
minimising their risks and finding the comfort to invest in
developing countries and countries undergoing transition to
market-based economies.
Where does the World Bank Get it$ Money?
The World Bank raises money for its development programmes
by tapping the worlds capital markets and in the case of the
IDA, through contributions from wealthier member
governments. IBRD, which accounts for about three-fourths of
the Banks, annual lending, raises almost all its money in
financial markets. One of the worlds most prudent and
conservatively managed financial institutions, the IBRD sells
AM-rated bonds and other debt securities to pension funds,
insurance companies, corporations, other banks and individuals
around the globe. IBRD charges interest from its borrowers at
rates which reflect its cost of borrowing. Loans must be repaid
in 15 to 20 years; there is a three to five year grace period before
repayment of principal begins. IDA helps to promote growth
and reduce poverty in the same ways as does the IBRD but
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using interest free loans (which are known as IDA credits),
technical assistance and policy advice. IDA credits account for
about one-fourth of all Bank lendings. Borrowers pay a fee of
less than 1 per cent of the loan to cover administrative costs.
Repayment is required in 35 to 40 years with a 10 years grace
period. Nearly 40 countries contribute to IDAs funding, which
is replenished every three years. IDAs funding is managed in the
same prudent, conservative and cautious way as is the IBRDs.
Like the IBRD, there has never been default op. an IDA credit.
Who Runs the World Bank?
The World Bank is owned by more than 180 member countries
whose views and interests are represented by a board of
governors and a Washington based board of directors. Member
countries are shareholders who carry ultimate decision making
power in the World Bank. Each member nation appoints a
governor and an alternate governor to carry out these
responsibilities. The governors, who are usually officials such as
ministers of finance or planning, meet at the Banks annual
meetings each fall. They decide on key Bank policy issues, admit
or suspend country members, decide on changes in the
authorised capital stock, determine the distribution of the
IBRDs net income and endorse financial statements and
budgets.
Economic Reform Programmes
World Bank programmes are designed to help the poor and the
record is good. The Bank has lent almost $400 billion since it
started more than 50 years ago. During this time, developing
countries, with the help of the international community,
including the Bank, have doubled their incomes, halved infant
mortality rates and increased life expectancy. The absolute
number of poor people is still rising; largely because of rapid
population growth. But as a percentage of the worlds
population, the number of poor is falling. Economic progress
has been faster than during any similar period in history.
Economic reform programmes are part of that progress. The
economic shocks of the 1970s . and early 1980s - high interest
rates, low commodity prices and sluggish growth in the world
economy - hit many developing countries hard. Countries
needed to make reforms in the way they ran their economies to
encourage long-term and sustainable development: not
spending more than a country can afford; ensuring the policy
that benefits, the whole country rather than only the elite;
investing where scarce resources have impact - for example, in
basic education, and health instead of excessive military
spending; and in encouraging a productive private sector.
Far from being the victims of reforms, the poor suffer most
when countries dont reform. What benefits the poor the most
is rapid and broad based growth. This comes from having
sound, macroeconomic policies and a strategy that favours
investment in basic humans capital -primary health care and
universal primary education. .
Reform is not unique to developing countries. The long
struggle to reduce the United States budget deficit, a struggle
mirrored in many other industrial countries, is also a form of
economic reform or structural adjustment. Such changes can be
painful. In the short-term unemployment may rise. Workers in
loss making state enterprises may lose their jobs. Civil servants
may be made redundant as a consequence of cuts in
government spending. Groups of poor people, are also
particularly vulnerable, for instance, poor pregnant women and
nursing mothers, young children and poor elderly people.
So, not surprisingly, Bank support for these developing
countries carrying out structural reforms generally includes
social; safety nets and other measures to ease the problems that
poor people may experience. The Bank helps governments in
financing unemployment compensation, job creation schemes
and retraining programmes. In addition it helps governments
target health and nutrition spending on the most needy people
and also finances investments that are specifically designed to
attack deep-seated poverty.
But poor people can also benefit quickly from adjustments:
farmers get higher prices for their crops and currency devaluation
helps, workers in export industries: And in the long run, these
adjustments lead to higher incomes, strengthen civil
institutions, and create a climate more favourable to private
enterprise - all of which benefit the poor. For example, in the
past few decades, East Asia has achieved some of the most
remarkable poverty declines in history -27% per cent from
1975-85 2 and 35per cent from 1985-95 - alongwith substantial
improvements in the education and health of the poor.
Asian Development Bank (ADB)
Introduction
The Asian Development Bank is a multilateral developmental
finance institution founded in 1966 by 31 member
governments to promote social and economic progress of
Asian and the Pacific region. The Bank gives special attention to
the needs of smaller or less developed countries and gives
priority to regional/ non-regional national programmes.
History
In early 1960, the United National Economic Commission for
Asia and Far East (UNECAFE) estimated that Asia and the
Pacific region had an annual deficit of US $ one billion. The
ADB was formed to fill this gap. The inaugural meeting was
held in Tokyo and the newly named bank was installed in
Manila (Philippines). The first President was Mr Wanatanade
and during his initial years the bank conducted regional surveys
to develop a fuller understanding of the social and economic
conditions of the Developing Member Countries (DMC).
In 1974, the Asian Development Fund was established to
streamline the banks means of financing. During 1972-76, the
Banks commitment to the DMCs increased from $316 million
to $776 million. In the late 70s, the bank recognised the need to
develop additional strategy to reduce poverty in the region, so
they evolved the concept of multi-project loans, which was a
cost-effective means for funding projects too small for the
Banks involvement.
In 1978, the Asian Development Fund was increased to 2.15
billion. 1986 was a significant year for the Bank because the
Peoples Republic of China joined the Bank and India received
her first loan of $100 million to the ICICI (Investment Credit
and Investment Corporation of India) for one lending to
private sector enterprises. In 1993, annual lending
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commitments rose to $5 billion and the cumulative total by
1991 was $37.6 billion for 1039 projects.
On the borrowing front, in 1991, the Bank offered Dragon
Bonds, which was a US $ 300 million offering in the capital
markets of Hong Kong, Singapore and Taipei.
The present President is Mr. Tadao Chino, who was Japans
former Vice Minister of Finance for International Affairs, before
he rook over in January 1999.
Bank Profile
Over the past 31 years, the banks membership has grown from
31 to 57, of which 41 are from within the region and 16 from
outside the region.
The Bank gives special attention to the needs of the smaller or
less developed countries and priority to regional, sub-regional
and national projects and programmes.
The Banks principal functions are
i. To extend loans and equity investments for the economic
and social development of its Developing Member
Countries (DMCS);
ii. To provide technical assistance for the preparation and
execution of development projects and programmes and for
advisory services;
iii. To promote and facilitate investment of public and private
capital for development purposes; and
iv. To respond to requests for assistance in coordinating
development policies and plans of its DMCs.
Shareholders
The two largest shareholders of the Bank, as of 31 December
1997, were Japan and the United States, each accounting for 16
per cent of the total subscribed capital. Forty one regional
members accounted for 63 per cent of total shareholding while
16 non-regional members contributed 37 per cent, of the total.
Location
The Banks head quarters are in Manila, Philippines. It has
resident missions in Bangladesh, Cambodia, India, Indonesia,
Nepal, Pakistan, Sri Lanka and Vietnam and has opened
resident missions in Kazakhstan and Uzbekistan. These
resident missions improve the Banks coordination with we
governments and donor agencies; assist with activities related to
country programming and processing of new loans and
technical assistance projects; and help ensure project quality.
Strategic Objectives
The Banks strategic development object1ves, as defined in the
Banks medium-term strategic framework (1995-1998) are
Economic Growth
In 1997, the Bank lent $6.4 billion for 28 traditional, growth
projects. The unusually large volume of lending for economic
growth, projects was because of the programme loan to the
Republic of Korea. Excluding the financial sector programme
for the Republic of Korea, the total lending for growth projects
was $2.4 billion. These projects covered most of the Banks
DMCs and were widely spread across sectors including
agriculture, energy, industry finance, transport and
communication.
Agriculture: In the agriculture sector, the projects with a
growth focus had diversified emphasis from building
irrigation systems in Indonesia to developing rural financial
institutions in the Kyrgyz Republic.
Energy: Energy projects financed power transmission in
Peoples Republic of China (PRC), Lao Peoples Democratic
Republic (Lao PDR), Maldives, Philippines and Vietnam and
LPG transmission in India. The broad focus for the energy
sector was restructuring of the power sector; expansion of
power supply and enhancement of power operational
efficiency.
Transport and communications: The largest number of
growth projects were in the transport and communications
sector (ten projects) including three airport projects
(Indonesia, Nepal and Philippines), two port projects
(Indonesia and the PRC), two railway projects (Bangladesh
and the PRG) and three road projects (Fiji, Lao PDR and Sri
Lanka). Significant emphasis was placed on promoting
sector and institutional reforms to enhance the
commercialisation of the private sector -participation in, the
provision and operation of transport and communications
infrastructure. The Bank also assisted in the improvement of
ports and air transport network in Indonesia to support
growth initiatives in the East Asian region.
Capital and financial markets: The numerous projects in
the capital and financial markets sector reflected the key role
that these sectors play in the development process and the
Banks emphasis on being a catalyst of financial resources
rather than simply a provider of financial assistance. The role
of the Bank in promoting reforms in the capital and financial
markets became particularly critical in the wake of the
financial crisis shaking East Asian markets. The five financial
sector loans included, among others, a $4 billion financial
sector programme for the Republic of Korea as part of a
total assistance package amounting to more than $57 billion
to be contributed by the ADB, IMF, World Bank and
bilateral sources. In addition, the Bank provided $300 billion
for the financial market reform programme in Thailand
which is part of the Banks pledge of $1.2 billion in the
context of the assistance package to be provided also by the
ADB, IMF, World Bank and several bilateral donors.
Technical assistance: The Banks technical assistance
programme was an integral component of efforts to
promote economic growth. Technical assistance operations
continued to support the preparation of numerous projects
promoting economic growth and to assist in policy reforms,
institution building and the creation of an enabling
environment for private sector development.
Poverty Reduction
Poverty reduction is a strategic objective of the Bank. Poverty
remains a trap for more than 950 million people in, the Asian
and Pacific region, with a large part, of this total facing absolute
poverty. The total number of poor in the region represents
nearly three-quarters of all the worlds poor. While the absolute
number of poor persons in the region is expected to decrease,
gradually, by the year 2000, the region will still have more than
half of the worlds poor. The roots of poverty lie in a complex
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fabric of social and economic factors, making poverty reduction
one of the most persistent development challenges the Bank
addresses. Further exacerbating the challenge of poverty is the
fact that with its complexity and multifaceted nature, there is
difficulty in defining and measuring the many aspects of
poverty.
Poverty reduction has been an implicit element of all operations
since the Bank was established. The Bank pays close attention to
poverty reduction issues in the formulation and
implementation of its project and technical assistance activities.
One approach in the Banks poverty reduction efforts is the
promotion of broad-based economic growth and support for
targeted interventions. This approach is based on the experience
of countries that have been most successful in reducing poverty.
Sustained rates of economic growth, in turn, provide
opportunities for the poor to participate in and benefit from
this growth. Support for basic social services, particularly
education and health services, helps the poor participate more
effectively. .
At the same time, the Bank pursues poverty reduction through
initiatives that are oriented toward the needs of specific
countries. These initiatives are based on particular country-level
conditions and concerns and have a specific country-based focus.
Poverty reduction efforts increasingly are becoming an element
of country strategy studies and country programming
processes.
Supporting Human Development
The Bank has continued to emphasise its strategic objective of
promoting human development by expanding investments in
the critical sectors of education, health and nutrition, water
supply and sanitation and urban development. Human
development is an expanding area of activity for the Bank. Of a
total of 72 projects approved during 1997, excluding private
sector and engineering technical assistance loans, 27 projects had
human development as either their primary (22) or secondary
(5) objective.
Supporting human development is not only a means to
achieving sustainable and 1ong-term development but is also
an end in itself. Sustained economic growth requires educated,
skilled and healthy people. At the same time, the objectives of
reducing poverty, meeting basic needs and providing access to a
better quality of life now and for future generations cannot be
achieved without investing in human development.
Education
The Bank aims to support the education sector in its DMCs by
investing in basic education, improving the quality of education
and making education in general and skills training in
particular - more relevant to market needs.
Health and Nutrition
The Banks main strategies for supporting the health
improvement efforts of its DMCs are to focus on primary
health care services, the control of communicable diseases and
capacity building.
Water Supply and Sanitation
The Banks main objective for the water supply and sanitation
sub-sector is to increase the availability of safe drinking water
and adequate sanitation facilities. Appropriate water and
sanitation services are essential for the health and well--being of
the population and the provision of such services should be
cost-effective, sustainable and affordable.
Urban Development
Addressing the rapid pace of urbanisation throughout Asia is a
formidable challenge facing the majority of the Banks DMCs.
The Bank encourages an integrated approach to urban
development by supporting investments for a balanced range
of infrastructure and services, targeted at meeting the basic
needs and improving the living conditions of the urban poor.
Gender Development
Improving the status of women is one of the strategic
objectives of the Bank. Gender development is no longer seen
as merely an issue of human rights or social justice; investment
in women now is widely recognised as crucial to achieving
sustainable development.
Economic analysis recognises that low levels of education and
training, poor health and nutritional status and limited access to
resources not only depress the quality of life for women but
also limit their productivity and subsequently, contribution to
economic efficiency, economic growth and development..
Public policies and investments that raise the status of women
have specific benefits such as improved public health, lower
infant and maternal mortality, lower fertility rates, increased life
expectancy and reduced welfare costs.
Development programmes -that include measures to expand
economic opportunities for women and increase their incomes,
combined with efforts to improve womens health and
education, result in greater economic efficiency and decreased
levels of poverty.
Environmental Protection
Commitment to the principles of sustainable development and
environment protection is one of the primary strategic
objectives of the Bank.
The Banks major environmental activities include
Providing financial and technical assistance to facilitate
institutional and policy reforms and build staff capacity in
environmental agencies, enabling them to effectively carry out
their mandate for environmental protection and
management;
Promoting cooperation among countries in the region or
subregion to address transboundary environmental concerns
and to enhance possible environmental benefits occurring
from sub regional cooperation;
Ensuring, through the use of environmental assessment
and review procedures, that Bank--funded projects are
environmentally sustainable;
Financing projects that promote the sound management of
natural resources and rehabilitate and protect .the
environment;
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Undertaking resource centered activities to enhance Bank and
DMC staff awareness on current and emerging
environmental issues; and
Ensuring inter-agency collaboration to avoid costly
duplication of efforts and to enable the Bank to focus its
assistance in critical areas.
Operating Objectives
Operating objectives in each DMC fall within four areas
1. Policy support;
2. Capacity building of development management;
3. Creating/ Strengthening productive capacity, infrastructure and
services;
4. Regional cooperation.
Sector Coverage
The Banks operations cover a wide spectrum of activities that
have been classified according to the following sectors
1. Agriculture and natural resources
2. Energy
3. Industry and non-fuel minerals
4. Finance
5. Transport and communications
6. Social infrastructure
7. Combinations of some of the sectors (1) to (6)
Project Process
Before any project is identified for Bank financing, Bank staff
review the countrys economy, particularly its national and
sectorial development programmes and determines the
prospects for its success. Country programming missions visit
DMCs regularly to discuss topics of mutual interest with
government officials and to select suitable projects for Bank
assistance. Since the levels of economic growth, as well as the
priorities for development, vary from one DMC to another, the
Bank tries to select those projects that will contribute most
effectively to the economic and social development of the
country concerned, in conformity with the country and,
Bankwide strategies. Once it is confirmed that investment in the
project is justified, the Bank evaluates the project.
In responding to requests from member governments for
loans, the Bank assesses the technical arid economic viability,
social impact and financial soundness of projects and the way in
which the projects fir into the economic framework and
development priorities of the borrowing countries. Standards
of accounting and project implementation are maintained.
Most contracts are awarded on the basis of international
competitive bidding, local competitive bidding or international
shopping, as appropriate. Projects are analysed and executed
and, where appropriate, external consultants are hired to ensure
that high standards of performance are achieved throughout
the life of the project.
Project Quality
The Bank aims to achieve better, project quality and
development impact. An important ingredient of project
quality is effective implementation. While implementation, of
projects is mainly the responsibility of its DMCs, the Bank
emphasises project administration and portfolio review to
enhance project effectiveness and efficiency. The four attributes
of project quality are
1. Economic and financial viability
2. Social impact
3. Implementability
4. Sustainability
Emphasis is placed on tile, broader objectives of capacity
building, beneficiary participation, and project performance,
rather than simply on the physical completion of projects.
Operation Evaluation
The Bank evaluates projects and programmes final1ced by it to
obtain a systematic and comprehensive assessment of the
extent to which the project or programme objectives have been,
or are likely to be, achieved. Feedback from this activity is used
to improve the Banks policies and procedures and quality of
the design and execution of its lending to DMCs.
Evaluation Activities Include
1. Project completion reporting and independent performance
evaluation of a project or programme, including evaluation
of the efficiency of its implementation after the project or
programme is completed; and
2. Intensive analysis of both ongoing and completed projects
concerning certain specific issues or subjects of broader
significance to the Banks strategic objectives and policies.
Private Sector Development
The Bank helps selected private enterprise to undertake
financially viable projects that have significant economic merit
and for which normal sources of commercial finance are not
available. Bank support is provided directly to private
enterprises and financial institutions through loans,
underwriting, investment in equity securities, cofinancing,
investment advisory services and guarantees. The Banks private
sector operations focus primarily on assistance to
1. Financial intermediaries involved in leasing, venture capital
financing, merchant banking, mutual funds, insurance,
securitisation, credit enhancement and credit rating;
2. Infrastructure projects such as in the power, water supply,
transport and telecommunications sectors, including build-
own-operate/ build-operate-transfer projects;
3. In limited cases, industrial, agribusiness and other projects
with significant economic merit.
Cofinancing
The Banks cofinancing and guarantee policy supports the
Banks emphasis on resource mobilisation and catalytic
investment strategy. The basic objective of confinancing
operations is to help leverage the Banks resources and expand
the banks catalytic role in directing official and private financial
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flows to its DMCs. The bank derives its confinancing funds
from
1. Official aid agencies
2. Export credit agencies and
3. Market institutions.
For every dollar lent by the Bank, an additional 49 cents have
been mobilised by way of cofinancing. The Banks cofinancing
operations include increasing emphasis on commercial
confinancing and the use of credit enhancements such as the
Banks complementary cofinancing scheme, guarantees and
related services.
Financial Management
Lending Policies
The Bank is authorised to make, participate in, or guarantee
loans to its DMCs or their governments or any of their
agencies, public or private enterprises operating within such
countries, as well as to international or regional entitles
concerned with economic development in the region. Loans are
approved by the Bank only for projects or programmes of high
development priority. The Bank provides financing to its
borrowers to cover foreign exchange expenditures and also
finances local currency expenditures in certain cases.
Financial Resources
The financial resources of-the Bank consist of Ordinary Capital
Resources (OCR) comprising subscribed capital, reserves and
funds raised through borrowings; and special funds,
comprising contributions made by member governments,
repayments from past loans and amounts previously set aside
from paid-in capital. Loans from OCR lending operations are
generally made to member governments which have attained a
somewhat higher level of economic development. Loans from
the Asian Development Fund (ADF) are made on highly
concessional terms and almost exclusively to DMCs with a low
per capita gross national product and limited debt-repayment
capacity.
Lending Windows
The Bank has three lending windows for OCR loans. These are
1. The pool based multicurrency loan window where loan
disbursements are made in a variety of currencies of the
Banks choice;
2. The pool based single currency loan window in US dollars;
and
3. The Market Based Loan (MBL) window which provides
single currency loans to private sector borrowers and to
financial intermediaries in the public sector.
The MBL window provides single currency loans in US, dollars,
Japanese yen, or Swiss francs to private sector borrowers and
government guaranteed financial intermediaries at current terms
prevailing in international financial markets. MBL borrowers
have the option of having the interest rates of their loans in
either fixed or floating rate terms. MBL lending to government
guaranteed financial intermediaries is limited to US $1 billion in
loan commitments.
Technical Assistance
The basic objective of the Bank is to maximise development
impact not only in terms of lending volume but also through
technical assistance that is not directly related to lending. The
emphasis is on support for various DMC programmes in terms
of policy reforms, fiscal strengthening, support for good
governance, capacity building, promotion of financial and
capital markets, subregional economic cooperation,
environmental protection and natural resource management.
Technical assistance activities are funded by the Bank through
grants, loans, or a combination of both.
Financial Policy
The Bank was established primarily to perform the financial
intermediation role of transferring resources from global
markets to developing countries to promote socio-economic
development. The ultimate goal of the financial policy of the
Bank is to achieve effective financial intermediation. Its major
elements include net income and reserves policy, liquidity policy,
loan product and credit risk policy, borrowing policy and capital
management policy.
Borrowings
The Bank has been an active borrower in world capital markets
since 1969. Its borrowing programme is broadly determined by
a number of factors, including the Banks lending operations,
cash flow requirements, its liquidity policy and its perception of
current and future market conditions. In the initial years of
operations, the Banks capital was the major source of funds for
ordinary lending but since the early 1980s, Bank borrowings
have accounted for a greater share than capital and reserves.
Liquidity Management
It is the policy of the Bank to maintain liquid assets amounting
to at least 40 per cent of the total of undisbursed balances of
pool based loans at the end of the year. The main purpose of
the liquidity policy is to ensure the uninterrupted availability of
funds to meet loan disbursements, debt servicing and other
expenditures. Investment of liquid assets is governed by the
Investment Authority approved by the board of directors.
Review Questions
1. What are the goals and function of World Bank, the IDA
and the IFC?
2. How did Bretton woods agreement provide a stable
monetary environment?
3. What does World Bank Do? What are its purposes?
4. What are the objectives of Asian Development Bank ?
5. How do inflation and interest rate determine the value of
currency?
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LESSON 34:
TUTORIAL-4
Tutorial on World Bank and IMF
For any socialist or for that matter propounder of Swadeshi,
the very mention of IMF
( International Monetary fund) and world bank would bring
out the images of a best feasting on a hapless and innocent
victim. The explanation would follow on how Indian was
nearly duped in accepting the norms set by IMF that made it
an easy Prey for multinationals( red US government) to sell
out India.
The fears are probably over exaggerated, but not unfounded
either. The packages suggested by the IMF and World Bank
were interpreted in some circles as a mere method of arm-
twisting by the west in accepting their norms and principles.
However, it cannot be forgotten how India was saved from a
near default in yester years, the 1991 bal out package being one
of them. Nor can one afford to see the other side of the story
when the IMF comes forward to lend in an hour of crisis. The
advocates of free market would not let us forget that the
measures suggested for IMF, as far as India is concerned
worked , at least till the present. If the measures suggested by
IMF or conditions set by World Bank seem like feeding the
turkey before the feast, is because of ignorance of working of a
free market economy, say the expert.
Questions for Discussion
1. With full flowering of the international capital market,
intermediation between First World lenders and third World
borrowers redundant. What is the role of these international
bodies in international intermediation and how does it end?
What are the sources and uses of funds for these financial
intermediaries.?
2. The Bail out package suggested by IMF for India in 1991
included financial sector reforms and devaluation of rupee.
India adhered to the package and seemed to forgot the
causes for such a crisis. If(we hope it would not) a similar
crisis recurs, what would be the list of measures that may be
suggested by IMF today? In such a case does India have any
choice?
3. The main argument against IMFs and World Banks
existence is that the factors that caused these entities to be
born are no longer in existence. Also, with improved crisis
management and rapidly changing domestic conditions,
these entities need not exit. What are the main functions of
the world Bank? Do both the entities perform same
functions? How is it different from other entities such as the
Asian Development bank(ADB)
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LESSON 35:
OFFSHORE BANKING
Learning Objectives
After reading this lesson, you will understand
Introduction
Purposes of offshore banking
Benefits of offshore banking
Offshore banking locations
Operational aspects of offshore banking
Advantages of offshore banking
Today we shall discuss offshore banking in detail.
An Introduction to Offshore Banking
Offshore banking can be explained as the carrying on of
banking and financial activities in an environment, which is
essentially free of fiscal, and exchange controls i.e. tax havens or
low tax areas, commonly referred to as offshore finance centres.
These conditions normally would also include favourable
banking regulations or banking laws considerably less stringent
than those in most domestic jurisdictions.
Offshore Banking - maybe this term conjures up images of
secret Swiss accounts, James Bond, and sipping Martinis at a
chalet in Lichtenstein. The fact is though that doing a portion
of your banking in a financial institution outside of your
national borders is not only easy, it also offers numerous
benefits to those who make their living via the internet. Here we
will also try to answer some of the most common questions
regarding offshore banking in the hopes of demystifying the
topic for the benefit of our fellow internet marketers and others
who make their income online.
Is Offshore Banking Legal?
This is among the first questions asked when discussing this
topic. The answer is YES. Many of the largest companies in the
USA do their banking offshore including Exxon and Boeing,
among others. You do not need to be a giant corporation
though to reap the benefits of an offshore bank account as we
will soon explain.
You may wonder why you dont see many ads for offshore
banking. If you live in the US, the reason is that federal law
denies international banks the right to advertise within the
borders of America. Of course this is to the benefit of
domestic banks. Remember, you have just as much legal right
to a bank account offshore as you do to a domestic account.
Why Bank Offshore?
For the internet marketer and any business that creates income
online, there are several benefits to having an offshore bank
account. These benefits encompass privacy, asset protection and
wealth building. One concern that offshore banking helps deal
with is privacy.
The current laws in some countries, including the USA, allow
the government full access to anyones domestic financial
information for almost any reason at all. The act of creating a
foreign bank account helps make some of your assets harder to
access by those who should be minding their own business. A
good foreign bank will usually not require your Social Security
number, they wont answer questions from US sources about
your credit and banking history, and they will not provide your
financial information to any domestic data collection agency.
An offshore account can also help you with wealth building.
First, there are the tax advantages. Offshore accounts can be
arranged in jursdictions that do not impose taxes on income
earned abroad. This can be very beneficial when arranged
correctly. There is also the ability to earn a higher return on your
investments with an offshore account.
Many foreign banks are not as tightly regulated as domestic
ones and can offer higher interest rates on accounts. This is due
to their ability to make more lucrative investments and also the
fact that the overhead to operate a bank is lower in many
countries.
Finally, the ability to expand your business globally increases
when you create an additional bank account outside your own
borders. Many offshore banks allow you to do business and
hold your funds in multiple currencies. This allows expansion
of your customer base which in return can help increase profits.
What Country Should You Bank in?
Choosing the jurisdiction to do your offshore banking in will
depend on a combination of your business situation, asset
planning goals and even to some extent your personal taste.
There are several factors that should certainly be considered
when doing your initial reasearch though. Is the country your
are considering a stable country? You usually do not want your
account in a country where coup detats are a regular occurrence.
On the other hand, if the financial system is strong enough, it
will withstand even political turmoil as in Panama when Manuel
Noreiga was forcibly removed by an outside government.
Most of those with bank accounts and corporations in Panama
were not affected by this, since the financial system had a solid
backbone. What are the countrys banking secrecy laws? There
are still several countries with strong banking secrecy laws who
will go all out to protect your financial privacy as long as you are
not breaking the law.
Switzerland and Panama come to mind immediately for not
bending to international pressure to allow outside government
agencies to peer into their customers accounts whenever they
want. How far away is the country? Some individuals prefer
their offshore accounts to be geographically close, since the time
zones are often similar and communication is a little more
convenient.
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Americans might prefer their offshore accounts to be located in
the Carribean or Latin America, while a citizen of the U.K.
might prefer an account at an institution located on the Isle of
Man, all other considerations being equal.
Accessing and Managing Your Money
Thanks mainly to the internet and advances in international
communication technology, offshore banking is fairly
straightforward. Most accounts can be arranged with online
access to your information.
Transfers of funds can be done online as well. As far as
accessing your money, most offshore banks will offer a debit
card with your account so you can retrieve your money whenever
you want, wherever you are from most ATMs. As you can see,
accessing and managing your funds in an offshore account need
not be any more difficult than doing the same with a domestic
account.
Acquiring an Offshore Bank Account
Once you decide that an offshore account is right for you and
you have done some further investigating to select the
appropriate country to open your account in, the actual process
of acquiring the account can be relatively straightforward.
There are a number of legitimate offshore financial planning
and asset management firms who will complete and submit all
the paperwork for you for a reasonable fee. The advantage to
this is they usually have connections with the banks they
represent and can arrange your accounts more quickly and easily.
Also, they can often offer you added perks such as secured credit
cards, merchant accounts and incorporation services. Be sure to
compare the fees charged and services offered and always get
feedback from previous customers. Of course, be wary of any
offers that sound too good to be true, such as outfits offering
unsecured credit cards with your offshore bank account.
This is almost impossible to arrange with a new account, and
anyone offering an unsecured credit card offshore may just be
planning on taking your money and disappearing. Otherwise,
do your research, ask questions and check testimonials. Deal
with a reputable firm and you will be well on your way to
reaping the benefits of an offshore bank account.
Offshore Banks are used for a Variety of Purposes.
Frequently they may be formed as a subsidiary of a domestic or
international bank to:
1 Accept deposits outside the controlled environment. This is
an increasingly popular activity, particularly for foreign
currency deposits.
2 Book transactions which do not fall within the domestic
jurisdiction such as large internationally syndicated loans
particularly where the participating banks are located in
various jurisdictions.
3 Make loans which are tax effective to their clients.
4 Avoid onerous debt-equity ratios and lending restrictions
applicable in the more severely regulated jurisdictions in
which they operate.
5 Provide their clients with banking secrecy.
6 Many other offshore banks are created by corporate groups
to handle external borrowing or to consolidate intra-group
finance or banking transactions. Corporations involved in
international trade may use an offshore bank as a foreign or
multi-currency management centre. Eurocurrency market
underwriting are often raised through captive offshore banks
or finance companies.
The activities of international finance companies also fall within
the category of offshore banking. These activities may include
external loan raising, provision of confirming finance to clients
and group entities, discounting or factoring of intra-group and
other debts, and tax effective intra-group loans.
The leasing of equipment through an offshore based captive
finance company is another useful offshore banking concept.
This activity may be for the purpose of providing vendor lease
finance to group customers or to fund group asset acquisitions.
Benefits of Offshore Banking
The benefits of offshore banking can accrue to the banking
institution and its clients. Freedom from taxation and exchange
controls are important reasons for the formation of an offshore
bank and usually these will be of significant advantage and
mutual benefit to both the offshore bank and its client.
A tax free or low tax environment will not only allow the
offshore bank to generate a better bottom-line but will also
provide it with a stable operating base by avoiding the vagaries
or contingencies of onshore fiscal policies. The earnings of the
offshore bank from currency management, participation in
syndicated loans, money market and securities dealings and
deposit-taking activities can be protected from the high rates of
income taxes applicable in domestic banks or financial
institutions which may well be subject to interest withholding
taxes imposed by the domestic fiscal authority. However, these
can usually be minimised by careful forward planning.
The absence of exchange controls will obviously enable the
offshore bank to move funds with a greater degree of freedom
and flexibility than from within an exchange controlled area.
The offshore bank should benefit from this enhanced flexibility
by being able to conclude transactions promptly, particularly in
volatile market conditions.
The banking institution which offers offshore banking facilities
to its clients should be able to increase its deposit base at a
greater rate that its wholly domestic competitors, its clients will
benefit by receiving their interest income free of any
withholding tax and the lower tax base of the offshore bank
should enable it to be more competitive with its interest rates.
If the client is also able to structure his own assets through an
offshore trust or investment holding company then his interest
income may also be free from tax in his domestic jurisdiction
and his deposits not subject to onshore exchange controls. The
availability of banking secrecy in the offshore banking
environment may be a further benefit to the client.
Corporate groups which establish offshore banks benefit in a
variety of ways, including the tax advantages outlined above. In
general, the corporate group will aim to maximise interest
deductions against profits in high-tax areas whilst protecting
group interest income from tax by accumulation in an offshore
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environment The offshore bank is therefore a most effective
means of deploying accumulated group funds. Eurobond
issues and foreign currency loans are often raised through the
medium of an offshore bank to maximise the overall tax effect
by enabling the corporate group to disperse the funds as
appropriate within the group. Fee income from intra-group
confirming finance, discounts from debt factoring and interest
derived from leasing or hire purchase transactions can be
protected from the high tax rates applicable in the onshore
jurisdictions.
By conducting its banking ordinance activities through an
offshore bank the corporate group will be able to carry out these
operations essentially without interference from domestic
regulatory authorities. The absence of banking laws requiring
minimum debt-equity ratios, high capitalisation, and arms
length rules as imposed by most onshore central monetary
authorities, will undoubtedly be of benefit to the corporate
group.
The use of an offshore bank as the currency management centre
of a corporate group will provide a flexible and fiscally effective
means of controlling foreign exchange exposure. Group
exchange gains or losses, whether realised or unrealised, can be
consolidated into one entity with resultant cost and
administration benefits Overall foreign exchange risk can be
reduced and hedging or borrowing costs minimised. Exchange
gains, fees, discounts, and interest income can be treated on a
group basis in the most tax effective way. Centralisation of the
currency management function allows more direct involvement
by the group treasurer and the offshore environment permits
him greater flexibility.
Offshore Banking Locations
The principal criteria in determining the location of an offshore
bank are:
Legislation
All countries have legislation which regulates the carrying on of
banking activities within their respective jurisdictions and in
some cases also extends their authority to the external activities
of domestic based banks. Locations which are suitable for
offshore banking normally limit their primary regulations to
control banking operations within the domestic sphere and
provide a more relaxed set of banking rules for activities
conducted with non-residents. Many offshore banking centres
have a dual licensing system with full licences for domestic
banking operations and restricted licences for offshore banks
which conduct their banking activities with non-resident
entities.
The banking legislation of a suitable offshore banking centre
should permit:
Low capitalisation without statutory minimum capital and
reserve requirements
Loan raising without mandatory debt-equity ratios
Unrestricted lending activities
Complete foreign ownership of offshore banks
Cash management without minimum liquidity rules
Administration free from excessive reporting obligations
Non-disclosure of client activities
Obviously some of these benefits will not be required by all
offshore banks, particularly those, which are owned by
international banking groups.
The corporate legislation or the offshore banking centre is also
an important factor and should complement the banking laws.
Preferably the corporate law should be consistent with that
adopted in jurisdictions in which the banking or corporate
group operates. Special factors, such as anonymity of
ownership, corporate secrecy provisions, transfer of corporate
domicile and minimal reporting requirements may be attractive
for some offshore banks.
Taxation
In order to obtain the benefits previously outlined the offshore
bank requires an operating environment which is tax free, has a
low tax rate or provides concessional rates of tax to an offshore
bank. Normally the former is preferred. The need for specific tax
factors will vary with the requirements of the offshore bank. In
some instances it may be desirable to utilise double tax treaties.
However, in many circumstances they will be of no benefit and
their exchange of information provisions may be detrimental to
the activities of the offshore bank.
An offshore banking centre which does not impose interest
withholding taxes will normally be preferred by clients of the
offshore bank and will also be attractive to the offshore bank as
interest withholding taxes are often part of its funding costs.
The absence of a dividend withholding tax will also be an
important consideration for the shareholders of the offshore
bank.
Taxes other than income taxes must also be considered. Stamp
duty on loan or mortgage documents, receipt taxes and stamp
duty on securities transfers can be significant cost factors where
appropriate. Capital registration fees and business or banking
licence fees should be kept to a minimum.
Exchange Controls
The flexible banking policies available under suitable offshore
banking legislation will be severely restricted unless they are
complemented by free movement of moneys. The offshore
bank must be able to move its funds freely through the
international banking network and the offshore banking centre
should provide direct access to that network.
Other Criteria
Various other factors should be considered in selecting a
location suitable for offshore banking. These include:
Political and economic stability
Availability of banking and professional expertise
Access to telecommunications
Operational Aspects of Offshore Banking
Formation
The procedures for incorporation of an offshore bank vary in
each location. However, most of the more suitable jurisdictions
the incorporation of an offshore bank is effected by the usual
English law registration system. An application for a permit to
incorporate must be lodged together with an application for an
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offshore bank or financial institution licence. Licence
applications must be accompanied by the information specified
in the offshore bank guidelines. If the application satisfies the
guidelines then a licence will be issued promptly. Normally the
application is a confidential document and may be subject to the
secrecy provisions of the relevant corporate legislation.
Banking Activities
Subject to the terms of its licence the offshore bank will be able
to undertake any form of banking activity but the most
common offshore banking operations include:
Deposit taking
Syndicated loans or Eurocurrency under writings
Corporate loan raising
Intra-group lending
Foreign currency management
Provision of confirming finance
Lease finance
Debt factoring
Management
The management and administration of the offshore bank
should not be conducted in the domestic jurisdictions of the
corporate group and care must be taken to ensure that offshore
deposit-taking activities do not breach domestic banking laws.
If too many of the management activities of the offshore bank
are effected in the domestic locations the offshore bank may be
deemed to be carrying on business there through a branch, with
adverse consequences under both tax and banking legislation.
The management functions should therefore be carried out by
the offshore bank.
The offshore bank can either employ its own permanent staff
and base them in the offshore location or in another suitable
management location. Alternatively it can engage the services of
a local trust company or professional management firm who
would work closely with the management of the corporate
group.
Most offshore banks choose the latter alternative which keeps
management on an arms length basis. It should also be
remembered that the appointment of local management in the
offshore location will avoid potential complications with tax
and banking authorities in the domestic jurisdictions.
THE GLOBAL SOLUTIONS GROUP INC., provides a full
range of offshore bank management services and manages a
number of international offshore banks, and has many years
experience of selecting the most suitable offshore banking
jurisdiction for its clients.
THE GLOBAL SOLUTIONS GROUP INC., has several ready
made Licensed Offshore Banks & Financial Companies available
for immediate purchase and delivery. Clients wishing to
establish or purchase an offshore bank are invited to contact our
offices where they will receive prompt and personal attention
from an experienced staff.
What Makes Owning an Offshore Bank so Special...
Offshore banks operate on an offshore basis. Offshore banks
provide services only to non-residents of the jurisdiction where
such banks are established. For example a Belize-registered
offshore bank can provide services to clients from any country,
except to permanent residents of Belize. This is the main
formal difference between offshore and onshore banks.
What is more important is the environment in which offshore
banks operate. Offshore banks carry on banking and financial
activities in an environment which is free of fiscal and exchange
controls, i.e. tax havens or low tax areas, commonly referred to
as offshore finance centers. These conditions normally also
include favorable banking legislation which is considerably less
strict than those in most onshore jurisdictions.
Offshore banks can be controlled by residents of any country in
most offshore banking jurisdictions. It is much easier to obtain
a banking license in an offshore location than in strictly
controlled domestic jurisdictions. You can enhance your
business structure and gain extra advantages compared to your
competitors by establishing an offshore bank.
The Purposes of Offshore Banks
Offshore banks are used in many typical situations. Offshore
banks are often established by already existing onshore banking
or financial institutions for the following reasons:
Access international credit market
Access international correspondent account networks
Provide clients with tax effective loans
Provide clients with actual banking secrecy
Provide clients with other services that would be impossible in
severely regulated onshore jurisdictions
Provide Letters of Guarantee
Accept deposits outside the controlled environment
Avoid strict debt-equity ratios and lending restrictions imposed
by more severely regulated onshore jurisdictions
Avoid huge minimum capital requirements imposed by more
severely regulated onshore jurisdictions
Operate in the securities market without limitations
By-pass intermediaries while carrying out certain financial
operations
Minimize political risk (that could be higher in some East
European countries for example)
Enhance groups image
Offshore banks are established not only by banking or financial
institutions, but also by corporate groups to handle external
borrowing or to consolidate the groups financial or banking
transactions. For example, when your company is involved in
international trade and financial resources are handled through
an outside bank, it may seem quite reasonable to establish your
own offshore bank. You may well want to use an offshore
bank as a foreign or multi-currency management center.
Frequently large, and very often, medium sized, companies have
their own offshore banks, which handle their liquid assets and
current accounts of their branches. Thus, if a group of your
companies requires banking services, it really makes sense to
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establish your very own offshore bank as you can conduct all
your transactions with regular clients or suppliers, provide
Letters of Credit, etc. through your own bank. The activities of
international finance companies also fall within the category of
offshore banking. These activities may include external loan
raising, provision of confirming finance to clients and group
entities, discounting or factoring of the group and other debts,
and tax effective corporate groups loans. The leasing of
equipment through an offshore based captive finance company
is another useful offshore banking concept. This activity may be
for the purpose of providing vendor lease finance to group
customers or to fund group asset acquisitions.
However, offshore banks are established also to satisfy the
needs of small groups or even one person. Offshore banking
is traditionally oriented towards fulfilling the needs of the
wealthy.
Advantages
The advantages of offshore banks are two-dimensional. Both -
the banking institution and its clients - benefit from the
advantages of an offshore bank.
Low Tax or Tax Free Environment
Offshore banks are either tax exempt or taxes are reduced to
several per cent of the amount of the profit. This enables an
offshore bank not only to generate a better bottom-line but will
also provide it with a stable operating base by avoiding the
vagaries or contingencies of onshore fiscal policies. No taxes are
levied at the source of income, e.g. on bank interest, dividends
and other similar payments. Expenses are limited to
administrative expenditures and annual dues necessary to renew
an off-shore status. The earnings of the offshore bank from
currency management, participation in syndicated loans, money
market and securities dealings and deposit-taking activities can
be protected from the high rates of income taxes applicable in
domestic banks or financial institutions which may well be
subject to interest withholding taxes imposed by the domestic
fiscal authority. No taxes are levied at the source of income, e.g.
on bank interest, dividends and other similar payments.
Expenses are limited to administrative expenditures and annual
fees necessary to renew an offshore status.
No Exchange Control
The absence of exchange control will obviously enable the
offshore bank to move funds with a greater degree of freedom
and flexibility than from within an exchange controlled area.
The offshore bank should benefit from this enhanced flexibility
by being able to conclude transactions promptly, particularly in
volatile market conditions.
Less Strict License Requirements
The license requirements for offshore banks are simplified to a
large extent and quite a lot of applicants are eligible for such a
license. Unlike the majority of the countries throughout the
world, a foreign applicant does not have to be a world class
bank to get a banking license in an offshore jurisdiction. Such
a license could be issued to a small bank, financial institution,
trading company or even an individual.
More Competitive Interest Rates
An offshore bank is able to increase its deposit base at a greater
rate than its wholly onshore competitors. Its clients will benefit
by receiving their interest income free of any withholding tax
and the lower tax base of the offshore bank should enable it to
be more competitive with its interest rates. If the client is also
able to structure his own assets through an offshore trust or
investment holding company then his interest income may also
be free from tax in his domestic jurisdiction and his deposits
not subject to onshore exchange controls.
Maximum Confidentiality
Offshore banks provide the highest level of confidentiality.
There are some cases, when an anonymous offshore company
opens an anonymous account in an anonymous offshore bank.
This way, triple-layered protection of confidential commercial
information is achieved. Nominee owners and directors are
often assigned to ensure anonymity.
Small Amount of Required Equity Capital
In offshore banking jurisdictions, it is significantly lower than in
the onshore locations of the world. For the majority of
businessmen it is the only opportunity to establish a foreign
commercial bank, since other possibilities are unacceptable due
to the requirement of high capital, personnel, reputation and
business-planning of the bank. It is no secret that by
establishing an offshore bank large companies and banks can
keep their expenses low and business opportunities are
boosted.
No Reserve Requirements and Liberal Bank Control
There are no requirements, or they are minimal, on required
reserves, capital structure, liquidity of funds, compulsory
deposit insurance, etc. Auditors and local agencies control is
very moderate. Offshore banks are operated via management
companies and other banks on special agreement basis.
Effective Currency Management.
The use of an offshore bank as the currency management center
of a corporate group will provide a flexible and fiscally effective
means of controlling foreign exchange exposure. Group
exchange gains or losses, whether realized or unrealized, can be
consolidated into one entity with resultant cost and
administration benefits. Overall foreign exchange risk can be
reduced and hedging or borrowing costs minimized. Exchange
gains, fees, discounts, and interest income can be treated on a
group basis in the most tax effective way. Centralization of the
currency management function allows more direct involvement
by the group treasurer and the offshore environment permits
him greater flexibility.
Enormous Business Opportunities
Eurobond issues and foreign currency loans are often raised
through the medium of an offshore bank to maximize the
overall tax effect by enabling the corporate group to disperse the
funds as appropriate within the group. Free income from the
groups confirming finance, discounts from debt factoring and
interest derived from leasing or hire purchase transactions can be
protected from the high tax rates applicable in the onshore
jurisdictions. By conducting its banking ordinance activities
through an offshore bank the corporate group will be able to
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carry out these operations essentially without interference from
domestic regulatory authorities.
In general, the corporate group will aim to maximize interest
deductions against profits in high-tax areas whilst protecting
group interest income from tax by accumulation in an offshore
environment. The offshore bank is therefore a most effective
means of deploying accumulated group funds.
Choosing the Right Jurisdiction
The main in determining the location of an offshore bank are:
Taxation
In order to obtain the benefits previously outlined the offshore
bank requires an operating environment which is tax free, has a
low tax rate or provides concessional rates of tax to an offshore
bank. Normally the former is preferred. The need for specific
tax factors will vary with the requirements of the offshore bank.
In some instances it may be desirable to utilize double tax
treaties. However, in many circumstances they will be of no
benefit and their exchange of information provisions may be
detrimental to the activities of the offshore bank. An offshore
banking center which does not impose interest withholding
taxes will normally be preferred by clients of the offshore bank
and will also be attractive to the offshore bank as interest
withholding taxes are often part of its funding costs. The
absence of a dividend withholding tax will also be an important
consideration for the shareholders of the offshore bank. Taxes
other than income taxes must also be considered. Stamp duty
on loan or mortgage documents, receipt taxes and stamp duty
on securities transfers can be significant cost factors where
appropriate.
Capital registration fees and business or banking license fees
should be kept to a minimum.
Legislation.
All countries have legislation which regulates the carrying on of
banking activities within their respective jurisdictions and in
some cases also extends their authority to the external activities
of domestic based banks. Locations which are suitable for
offshore banking normally limit their primary regulations to
control banking operations within the domestic sphere and
provide a more relaxed set of banking rules for activities
conducted with non-residents. Many offshore banking centers
have a dual licensing system with full licenses for domestic
banking operations and restricted licenses for offshore banks
which conduct their banking activities with non-resident
entities.
The banking legislation of a suitable offshore banking center
should permit:
Low capitalization without statutory minimum capital and
reserve requirements;
Loan raising without mandatory debt-equity ratios;
Unrestricted lending activities;
Complete foreign ownership of offshore banks;
Cash management without minimum liquidity rules;
Administration free from excessive reporting obligations;
Non-disclosure of client activities.
Obviously some of these advantages will not be required by all
offshore banks, particularly those which are owned by
international banking groups.
The corporate legislation or the offshore banking center is also
an important factor and should complement the banking laws.
Preferably the corporate law should be consistent with that
adopted in jurisdictions in which the banking or corporate
group operates. Special factors, such as anonymity of
ownership, corporate secrecy provisions, transfer of corporate
domicile and minimal reporting requirements may be attractive
for some offshore banks.
Exchange Controls
The flexible banking policies available under suitable offshore
banking legislation will be severely restricted unless they are
complemented by free movement of funds. The offshore bank
must be able to move its funds freely through the international
banking network and the offshore banking center should
provide direct access to that network.
Other Criteria
Various other factors should be considered in selecting a
location suitable for offshore banking. These include:
Political and economic stability;
Availability of banking and professional expertise;
Access to telecommunications.
Operational Aspects
Banking Activities
Subject to the terms of its license the offshore bank will be able
to undertake any form of banking activity but the most
common offshore banking operations include:
Deposit taking
Syndicated loans or Eurocurrency under writings
Corporate loan raising
Intra-group lending
Foreign currency management
Provision of confirming finance
Lease finance
Debt factoring
In other words, an offshore bank can carry out all usual banking
operations of an ordinary onshore bank. However, in some
jurisdictions an offshore banking license is issued on a special
condition that the bank may accept deposits from only a limited
circle of clients. Usually these are the banks share-holders or
persons mentioned in the banks charter or license. Such a
license is defined as limited. In this case the bank may have a
limited number of clients. Sometimes, an off-shore bank may
begin its activities with limited operations and widen the
spectrum of its services by acquiring a less regulated license in
the future.
Foundation documents of an offshore bank usually provide
for trust operations. The bank functions as a trustee and
manages the clients securities portfolios. Investment
portfolios may include not only financial resources but also
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precious metals and other assets. Clients are serviced on a trust
contract basis.
The following structures are often used: combinations of an
offshore bank and an offshore investment fund, or offshore
bank and an insurance company. Business activities of
commercial banks are becoming more and more international
and trust operations constitute a large part of these activities.
Formation
The procedures for incorporation of an offshore bank vary in
each location. However, most of the more suitable
jurisdictions the incorporation of an offshore bank is effected
by the usual English law registration system. An application for
a permit to incorporate must be lodged together with an
application for an offshore bank or financial institution license.
License applications must be accompanied by the information
specified in the offshore bank guidelines. If the application
satisfies the guidelines then a license will be issued promptly.
Normally the application is a confidential document and may be
subject to the secrecy provisions of the relevant corporate
legislation.
Banks with a solid international standing get preferential
treatment and certainly can obtain offshore banking licenses in
any jurisdiction in the world. However, Eastern European
banks for example, even the largest ones, could face some
difficulties. Its much easier for them to obtain a limited
offshore banking license. Not only large but medium or small
sized banks, non-banking companies and even individuals are
eligible for an offshore banking license in more liberal
jurisdictions like Nauru and Vanuatu in the South Pacific.
Usually recommendations from other banks, as well as lawyers
and auditors are required to register an offshore bank. Proof of
the applicants solvency and, in some cases, business plan of
proposed offshore bank is required.
An off-shore bank must have a registered office, minimum
number of Directors and shareholders. A Registered Agent is a
must in all offshore banking locations. Management and the
accounting department are usually located in the place of the
owners domicile. In some offshore banking locations the
management of the offshore bank must actually be located
within the jurisdiction.
Management
Business activities of an off-shore bank are often conducted via
its representations (registered or non-registered) around the
world, through which business partners and clients can be
contacted. The management and administration of the
offshore bank should not be conducted in the domestic
jurisdictions of the corporate group and care must be taken to
ensure that offshore deposit-taking activities do not breach
domestic banking laws. If too many of the management
activities of the offshore bank are effected in the domestic
locations the offshore bank may be deemed to be carrying on
business there through a branch, with adverse consequences
under both tax and banking legislation. The management
functions should therefore be carried out by the offshore bank.
The offshore bank can either employ its own permanent staff
and base them in the offshore location or in another suitable
management location. Alternatively it can engage the services of
a local trust company or professional management firm who
would work closely with the management of the corporate
group.
Most offshore banks choose the latter alternative which keeps
management on an arms length basis. It should also be
remembered that the appointment of local management in the
offshore location will avoid potential complications with tax
and banking authorities in the domestic jurisdictions.
Questions to Discuss:
1. What do you understand by offshore banking?
2. What are the purposes of offshore banking?
3. What are the benefits of offshore banking?
4. Discuss offshore banking locations.
5. Discuss operational aspects of offshore banking.
6. What are the advantages of offshore banking?
Notes:
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LESSON 36:
E-BANKING
Learning Objectives
After reading this lesson, you will understand
Definition of e-banking
Internet banking
Electronic bill payment
Online brokerage
Online delivery of financial products
E-banking components
E-banking support services
Security challenges in e-banking
Definition of E-banking
E-banking is defined as the automated delivery of new and
traditional banking products and services directly to customers
through electronic, interactive communication channels. E-
banking includes the systems that enable financial institution
customers, individuals or businesses, to access accounts, transact
business, or obtain information on financial products and
services through a public or private network, including the
Internet. Customers access e-banking services using an
intelligent electronic device, such as a personal computer (PC),
personal digital assistant (PDA), automated teller machine
(ATM), kiosk, or Touch Tone telephone. While the risks and
controls are similar for the various e-banking access channels,
this booklet focuses specifically on Internet-based services due
to the Internets widely accessible public network. Accordingly,
this booklet begins with a discussion of the two primary types
of Internet websites: informational and transactional.
Introduction
Internet has touched almost all aspects of our lives. The
emergence of e-commerce has revolutionized the way we live,
shop, entertain and interact. Therefore, it should not come as a
surprise if it tries to influence the way we save and the way we
invest.
Today, when the customer is king and the service providers are
rushing to pay obeisance to the king, financial service providers
cannot be left behind. In their quest to differentiate their
services and gain competitive advantage over their competitors,
the financial service providers are trying to provide their services
to the customers in the comfort of their homes. The Internet
has emerged as a convenient channel for these service providers.
Living in India, we might find these ideas too far fetched but
the truth is that Internet has changed the way these services are
delivered, particularly in countries where the Internet
penetration is high. The different ways in which Internet is
trying to revolutionize the delivery of the financial services and
products are given below: -
Common E-Banking Services
1. Internet Banking
2. Electronic Bill Payment
3. Online Brokerages
4. Online Delivery of Financial Products like Mortgages
Internet Banking
Two distinct trends can be discerned in the realm of Internet
Banking. On one hand, Banks and Financial Institutions are
trying to enter into new areas and consolidate their hold on the
entire financial sector. On the other hand, new Dot Coms are
entering the financing business and challenging the banks. It
could be said that two opposite things are happening at the
same time. The banks, via their consolidation moves are trying
to preserve their strongholds, while the Dot Coms are trying to
fragment the market by providing superior services. Banks and
Financial Institutions are trying to leverage their Brands and
their position in the industry. While, the Dot Coms are using
their competency in superior service design and experience of
competing in this highly unstable environment. All the players
share the same objectives: acquiring customers, providing them
with new financial information, services, and products, and
doing so in a way that enhances the value proposition of their
products and services.
Internet Banking allows the Banks (and other Financial Service
providers) to overcome the tradeoff between content and reach.
With the use of Internet, banks can provide their services to a
much wider audience then they could do without it. Even
before the coming of Internet, competition had shifted from
products to services. This was due, in large part, to the advent
of Private Sector Banks.
Before the entry of these banks, the retail banking was more of
a commodity with hardly any differentiation on the basis of
products or services. Banks offered similar products and similar
service. But the new private sector banks changed the scenario
by differentiating on the basis of service. They started providing
Telephone based banking and introduced the concept of home
banking. The superior service being provided by these banks
was the main reason for their rapid growth. But their reach was
limited due to logistics of setting up branches and increasing
the reach of their service. Any attempt to increase the branch
network would have increased their overheads and any attempt
to widen the areas being served by a branch was likely to lead to
deterioration in the service levels. In other words, these banks
were caught in a dilemma as they faced the Reach and content
tradeoff. With the advent of Internet these banks have been
able to overcome this tradeoff.
By using the Internet, these banks can expand their reach as well
as maintain the standards of their services.
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Electronic Bill Payment
From the point of view of Banks, Electronic Bill Payment
(EBP) represents something of a threat, in that it could lead to
customer attrition and reduce revenue. Among other revenue
streams, the following sources of funds for the banks could be
affected:
Float associated with processing in the physical form,
Cash Management Services
The Banks can protect itself by providing this service to their
customers. But EBP also has an important strategic dimension,
as it can become an integral part of a banks portfolio of
services. EBP can attract customers to the bank by making
transactions more efficient and enabling customers to access
their financial information more easily. Moreover, online
interactions allow use of such tools as e-CRM to create a more
intimate relationship with the customer and promote and
deliver other online products and services.
If the Banks do not establish control on EBP, they are likely to
loose customers to the new providers of financial services, thus
affecting other sources of revenue.
In India, HDFC Bank, ICICI Bank and Citibank are trying
setup an EBP portal. ICICI has already started a portal called
BillJunction.com. Banks are planning to use the Net for
payment of utility bills. They are entering into tie-ups with
utilities like MTNL, Airtel, Orange, and BPL Mobile etc. Right
now, a customer whos received a bill in the physical form logs
into the network in order to make an online payment. In the
future, these bills will be sent to customers through the Net.
Consumers and Businesses can derive economic benefit on
account of reduction in transaction costs and a reduction in the
float resulting from physical processing of the Bills. In
addition, many are likely to adopt it mainly for the convenience.
They can pay bills electronically in the same way they do today,
but by consolidating their bills, they can reduce the effort
involved in the whole process. They can also access their account
at the same time. They can conveniently access all billers from a
single portal that also provides them banking facilities. This
would enable them to view their account balance while paying
bills. For portals or the intermediaries that consolidate bills
from multiple billers at a single online location EBP is a tool to
acquire customers and provide them other financial services also.
Dominance of the EBP market can lead to an entry into other
financial services markets such as credit or debit card payments,
or indeed into a much broader range of e-commerce markets,
such as payments gateways.
Online Brokerage
Online Broking is emerging as another field where traditional
service providers are likely to face tough competition from the
Dot Coms. In Taiwan and Korea, 30% of the stock trading has
already moved online. This is posing a threat to the traditional
Full-Service Brokerages. By leveraging the power of the web,
Charles Schwab has emerged as a major threat to Full-Service
brokers like Merrill Lynch. In order to preempt the moves into
these areas by new players, many Banks have already tied up
with Online Brokerages.
The Banks have entered the e-trading business. Since many
banks are also Depositary participants, they have tied up with e-
traders so that a customer is able to buy or sell shares online
and make and receive payments through the Net.
In India, HDFC Bank has tied up with Investsmart.com and is
offering its services to all the clients of the brokerage. ICICI
Bank has gone a step ahead and launched ICICIDirect.com.
These banks have become exclusive providers of banking and
depositary/ custodial services to the clients of these online
brokerages.
Online Delivery of Financial Products
The Banks have started offering banking services like checking
your account status fund transfer, ordering demand drafts and
writing out cheques, via the net. Soon these will form only a
small part of the total array of services being offered by them.
These Banks have embarked on a number of new initiatives to
protect their stronghold and to leverage the net. They are
offering value-added services to their customers and at the same
time are trying to get into B2C and B2B e-commerce. They are
even trying to get their finger into various transactions between
the Government on one side and the business and the
customer on the other. Banks are trying to become a part of the
online value chain. For example, they are trying to tie up with
corporates so as to become a part of their supply chain and
enable electronic transfer of funds between the different
components of the Supply Chain. They are doing this by acting
as an intermediary between the corporations and their vendors
by enabling online transactions at one place.
Some Banks are trying to setup portals for routing payments
like Excise Duty and Sales Tax. Not content with that Banks are
setting up secure payment gateways to tap the B2C online
market.
Banks have taken the application process for personal loans, car
loans, and mortgage, online. They plan to offer other financial
products like Bonds and Mutual Funds through their financial
service portal. This strategy is aimed by pre-empting the entry
of new startups into this business.
Another bit of the Net strategy, involves providing
infrastructure for B2C as well as B2B e-commerce. Banks are
setting up secure payment gateways that will allow online retail
shops to obtain instant credit card verifications. Once the buyer
hits the pay button at a B2C portal, the buyers credit card details
will get encrypted and travel securely to the Visa or MasterCard
approval system through the banks payment gateway.
The banks are also setting up their own shopping portals.
HDFC has a stake in a portal called easy2buy.com where HDFC
bank customers can buy using their bank account number.
Federal Bank has similar arrangements with Rediff.com and
Fabmart.com. ICICI has setup Magiccart.com, an e-tailing site.
At the B2B end, Banks are offering Net Banking service that
allows electronic fund transfers among a company, its vendors
and dealers. Another service being targeted at this segment is
cash management. This will reduce the float, which is present in
physical processing of the payments.
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The Banks are also trying to integrate their systems with the
ERP/ Supply Chain system of their clients. This will enable the
bank to benefit from the movement towards e-procurement.
E-Procurement involves making transactions online and
processing the payment electronically.
Security Controls for Safeguarding Customer
Information;
Authentication processes necessary to initially verify the identity
of new customers and authenticate existing customers who
access e-banking services;
Liability for unauthorized transactions;
Losses from fraud if the institution fails to verify the identity
of individuals or businesses applying for new accounts or credit
on-line;
Possible violations of laws or regulations pertaining to
consumer privacy, anti-money laundering, anti-terrorism, or the
content, timing, or delivery of required consumer disclosures;
and
Negative public perception, customer dissatisfaction, and
potential liability resulting from failure to process third-party
payments as directed or within specified time frames, lack of
availability of on-line services, or unauthorized access to
confidential customer information during transmission or
storage.
E-banking Components
E-banking systems can vary significantly in their configuration
depending on a number of factors. Financial institutions
should choose their e-banking system configuration, including
outsourcing relationships, based on four factors:
1 Strategic objectives for e-banking;
2 Scope, scale, and complexity of equipment, systems, and
activities;
3 Technology expertise; and
4 Security and internal control requirements.
Financial institutions may choose to support their e-banking
services internally. Alternatively, financial institutions can
outsource any aspect of their e-banking systems to third parties.
The following entities could provide or host (i.e., allow
applications to reside on their servers) e-banking-related services
for financial institutions:
Another financial institution,
Internet service provider,
Internet banking software vendor or processor,
Core banking vendor or processor,
Managed security service provider,
Bill payment provider,
Credit bureau, and
Credit scoring company.
E-banking systems rely on a number of common components
or processes. The following list includes many of the potential
components and processes seen in a typical institution:
Website design and hosting,
Firewall configuration and management,
Intrusion detection system or IDS (network and host-based),
Network administration,
Security management,
Internet banking server,
E-commerce applications (e.g., bill payment, lending,
brokerage),
Internal network servers,
Core processing system,
Programming support, and
Automated decision support systems.
These components work together to deliver e-banking services.
Each component represents a control point to consider.
Through a combination of internal and outsourced solutions,
management has many alternatives when determining the
overall system configuration for the various components of an
e-banking system. However, for the sake of simplicity, this
booklet presents only two basic variations. First, one or more
technology service providers can host the e-banking application
and numerous network components as illustrated in the
following diagram. In this configuration, the institutions
service provider hosts the institutions website, Internet
banking server, firewall, and intrusion detection system. While
the institution does not have to manage the daily
administration of these component systems, its management
and board remain responsible for the content, performance, and
security of the e-banking system.
E-banking Support Services
In addition to traditional banking products and services,
financial institutions can provide a variety of services that have
been designed or adapted to support e-commerce. Management
should understand these services and the risks they pose to the
institution. This section discusses some of the most common
support services: weblinking, account aggregation, electronic
authentication, website hosting, payments for e-commerce, and
wireless banking activities.
Weblinking
A large number of financial institutions maintain sites on the
World Wide Web. Some websites are strictly informational,
while others also offer customers the ability to perform financial
transactions, such as paying bills or transferring funds between
accounts.
Virtually every website contains weblinks. A weblink is a
word, phrase, or image on a webpage that contains coding that
will transport the viewer to a different part of the website or a
completely different website by just clicking the mouse. While
weblinks are a convenient and accepted tool in website design,
their use can present certain risks. Generally, the primary risk
posed by weblinking is that viewers can become confused about
whose website they are viewing and who is responsible for the
information, products, and services available through that
website. There are a variety of risk management techniques
institutions should consider using to mitigate these risks. These
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risk management techniques are for those institutions that
develop and maintain their own websites, as well as institutions
that use third-party service providers for this function. The
agencies have issued guidance on weblinking that provides
details on risks and risk management techniques financial
institutions should consider.
Account Aggregation
Account aggregation is a service that gathers information from
many websites, presents that information to the customer in a
consolidated format, and, in some cases, may allow the
customer to initiate activity on the aggregated accounts. The
information gathered or aggregated can range from publicly
available information to personal account information (e.g.,
credit card, brokerage, and banking data). Aggregation services
can improve customer convenience by avoiding multiple log-ins
and providing access to tools that help customers analyze and
manage their various account portfolios. Some aggregators use
the customer-provided user IDs and passwords to sign in as
the customer. Once the customers account is accessed, the
aggregator copies the personal account information from the
website for representation on the aggregators site (i.e., screen
scraping). Other aggregators use direct data-feed arrangements
with website operators or other firms to obtain the customers
information. Generally, direct data feeds are thought to provide
greater legal protection to the aggregator than does screen
scraping.
Financial institutions are involved in account aggregation both
as aggregators and as aggregation targets. Risk management
issues examiners should consider when reviewing aggregation
services include:
Protection of customer passwords and user IDs both those
used to access the institutions aggregation services and those
the aggregator uses to retrieve customer information from
aggregated third parties to assure the confidentiality of
customer information and to prevent unauthorized activity,
Disclosure of potential customer liability if customers share
their authentication information (i.e., IDs and passwords) with
third parties, and
Assurance of the accuracy and completeness of information
retrieved from the aggregated parties sites, including required
disclosures
Additional information regarding management of risks in
aggregation services can be found in appendix D.
Electronic Authentication
Verifying the identities of customers and authorizing e-banking
activities are integral parts of e-banking financial services. Since
traditional paper-based and in-person identity authentication
methods reduce the speed and efficiency of electronic
transactions, financial institutions have adopted alternative
authentication methods, including:
Passwords and personal identification numbers (PINs),
Digital certificates using a public key infrastructure (PKI),
Microchip-based devices such as smart cards or other types of
tokens,
Database comparisons (e.g., fraud-screening applications), and
Biometric identifiers.
The authentication methods listed above vary in the level of
security and reliability they provide and in the cost and
complexity of their underlying infrastructures. As such, the
choice of which technique(s) to use should be commensurate
with the risks in the products and services for which they
control access. Additional information on customer
authentication techniques can be found in this booklet under
the heading Authenticating E-Banking Customers.
The Electronic Signatures in Global and National Commerce
(E-Sign) Act establishes some uniform federal rules concerning
the legal status of electronic signatures and records in
commercial and consumer transactions so as to provide more
legal certainty and promote the growth of electronic commerce.
The development of secure digital signatures continues to
evolve with some financial institutions either acting as the
certification authority for digital signatures or providing
repository services for digital certificates.
Website Hosting
Some financial institutions host websites for both themselves
as well as for other businesses. Financial institutions that host a
business customers website usually store, or arrange for the
storage of, the electronic files that make up the website. These
files are stored on one or more servers that may be located on
the hosting financial institutions premises. Website hosting
services require strong skills in networking, security, and
programming. The technology and software change rapidly.
Institutions developing websites should monitor the need to
adopt new interoperability standards and protocols such as
Extensible Mark-Up Language (XML) to facilitate data exchange
among the diverse population of Internet users.
Risk issues examiners should consider when reviewing website
hosting services include damage to reputation, loss of
customers, or potential liability resulting from:
Downtime (i.e., times when website is not available) or inability
to meet service levels specified in the contract,
Inaccurate website content (e.g., products, pricing) resulting
from actions of the institutions staff or unauthorized changes
by third parties (e.g., hackers),
Unauthorized disclosure of confidential information stemming
from security breaches, and
Damage to computer systems of website visitors due to
malicious code (e.g., virus, worm, active content) spread
through institution-hosted sites.
Payments for E-commerce
Many businesses accept various forms of electronic payments
for their products and services. Financial institutions play an
important role in electronic payment systems by creating and
distributing a variety of electronic payment instruments,
accepting a similar variety of instruments, processing those
payments, and participating in clearing and settlement systems.
However, increasingly, financial institutions are competing with
third parties to provide support services for e-commerce
payment systems. Among the electronic payments mechanisms
that financial institutions provide for e-commerce are
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automated clearing house (ACH) debits and credits through the
Internet, electronic bill payment and presentment, electronic
checks, e-mail money, and electronic credit card payments.
Additional information on payments systems can be found in
other sections of the IT Handbook.
Most financial institutions permit intrabank transfers between a
customers accounts as part of their basic transactional e-
banking services. However, third-party transfers with their
heightened risk for fraud often require additional security
safeguards in the form of additional authentication and
payment confirmation.
Bill Payment and Presentment
Bill payment services permit customers to electronically instruct
their financial institution to transfer funds to a businesss
account at some future specified date. Customers can make
payments on a one-time or recurring basis, with fees typically
assessed as a per item or monthly charge. In response to the
customers electronic payment instructions, the financial
institution (or its bill payment provider) generates an electronic
transaction usually an automated clearinghouse (ACH) credit
or mails a paper check to the business on the customers
behalf. To allow for the possibility of a paper-based transfer,
financial institutions typically advise customers to make
payments effective 37 days before the bills due date.
Internet-based cash management is the commercial version of
retail bill payment. Business customers use the system to
initiate third-party payments or to transfer money between
company accounts. Cash management services also include
minimum balance maintenance, recurring transfers between
accounts and on-line account reconciliation. Businesses typically
require stronger controls, including the ability to administer
security and transaction controls among several users within the
business.
This booklet discusses the front-end controls related to the
initiation, storage, and transmission of bill payment
transactions prior to their entry into the industrys retail
payment systems (e.g., ACH, check processing, etc.). The IT
Handbooks Retail Payments Systems Booklet provides
additional information regarding the various electronic
transactions that comprise the back end for bill payment
processing. The extent of front-end operating controls directly
under the financial institutions control varies with the system
configuration. Some examples of typical configurations are
listed below in order of increasing complexity, along with
potential control considerations.
Financial institutions that do not provide bill payment services,
but may direct customers to select from several unaffiliated bill
payment providers.
Caution customers regarding security and privacy issues through
the use of on-line disclosures or, more conservatively, e-
banking agreements.
Financial institutions that rely on a third-party bill payment
provider including Internet banking providers that subcontract
to third parties.
Set dollar and volume thresholds and review bill payment
transactions for suspicious activity.
Gain independent audit assurance over the bill payment
providers processing controls.
Restrict employees administrative access to ensure that the
internal controls limiting their capabilities to originate, modify,
or delete bill payment transactions are at least as strong as those
applicable to the underlying retail payment system ultimately
transmitting the transaction.
Restrict by vendor contract and identify the use of any
subcontractors associated with the bill payment application to
ensure adequate oversight of underlying bill payment system
performance and availability.
Evaluate the adequacy of authentication methods given the
higher risk associated with funds transfer capabilities rather than
with basic account access.
Consider the additional guidance contained in the IT
Handbooks Information Security, Retail Payment Systems,
and Outsourcing Technology Services booklets.
Financial institutions that use third-party software to host a bill
payment application internally.
Determine the extent of any independent assessments or
certification of the security of application source code.
Ensure software is adequately tested prior to installation on the
live system.
Ensure vendor access for software maintenance is controlled
and monitored.
Financial institutions that develop, maintain, and host their
own bill payment system.
Financial institutions can offer bill payment as a stand-alone
service or in combination with bill presentment. Bill
presentment arrangements permit a business to submit a
customers bill in electronic form to the customers financial
institution. Customers can view their bills by clicking on links
on their accounts e-banking screen or menu. After viewing a
bill, the customer can initiate bill payment instructions or elect
to pay the bill through a different payment channel.
In addition, some businesses have begun offering electronic bill
presentment directly from their own websites rather than
through links on the e-banking screens of a financial
institution. Under such arrangements, customers can log on to
the businesss website to view their periodic bills. Then, if so
desired, they can electronically authorize the business to take
the payment from their account. The payment then occurs as an
ACH debit originated by the businesss financial institution as
compared to the ACH credit originated by the customers
financial institution in the bill payment scenario described
above. Institutions should ensure proper approval of
businesses allowed to use ACH payment technology to initiate
payments from customer accounts.
Cash management applications would include the same control
considerations described above, but the institution should
consider additional controls because of the higher risk
associated with commercial transactions. The adequacy of
authentication methods becomes a higher priority and requires
greater assurance due to the larger average dollar size of
transactions. Institutions should also establish additional
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controls to ensure binding agreements consistent with any
existing ACH or wire transfer agreements exist with
commercial customers. Additionally, cash management systems
should provide adequate security administration capabilities to
enable the business owners to restrict access rights and dollar
limits associated with multiple-user access to their accounts.
Person-to-Person Payments
Electronic person-to-person payments, also known as e-mail
money, permit consumers to send money to any person or
business with an e-mail address. Under this scenario, a
consumer electronically instructs the person-to-person payment
service to transfer funds to another individual. The payment
service then sends an e-mail notifying the individual that the
funds are available and informs him or her of the methods
available to access the funds including requesting a check,
transferring the funds to an account at an insured financial
institution, or retransmitting the funds to someone else.
Person-to-person payments are typically funded by credit card
charges or by an ACH transfer from the consumers account at a
financial institution. Since neither the payee nor the payer in the
transaction has to have an account with the payment service,
such services may be offered by an insured financial institution,
but are frequently offered by other businesses as well.
Some of the risk issues examiners should consider when
reviewing bill payment, presentment, and e-mail money services
include:
Potential liability for late payments due to service disruptions,
Liability for bill payment instructions originating from
someone other than the deposit account holder,
Losses from person-to-person payments funded by transfers
from credit cards or deposit accounts over which the payee does
not have signature authority,
Losses from employee misappropriation of funds held
pending access instructions from the payer, and
Potential liability directing payment availability information to
the wrong e-mail or for releasing funds in response to e-mail
from someone other than the intended payee.
Wireless E-banking
Wireless banking is a delivery channel that can extend the reach
and enhance the convenience of Internet banking products and
services. Wireless banking occurs when customers access a
financial institutions network(s) using cellular phones, pagers,
and personal digital assistants (or similar devices) through
telecommunication companies wireless networks. Wireless
banking services in the United States typically supplement a
financial institutions e-banking products and services.
Wireless devices have limitations that increase the security risks
of wireless-based transactions and that may adversely affect
customer acceptance rates. Device limitations include reduced
processing speeds, limited battery life, smaller screen sizes,
different data entry formats, and limited capabilities to transfer
stored records. These limitations combine to make the most
recognized Internet language, Hypertext Markup Language
(HTML), ineffective for delivering content to wireless devices.
Wireless Markup Language (WML) has emerged as one of a few
common language standards for developing wireless device
content. Wireless Application Protocol (WAP) has emerged as a
data transmission standard to deliver WML content.
Manufacturers of wireless devices are working to improve device
usability and to take advantage of enhanced third-generation
(3G) services. Device improvements are anticipated to include
bigger screens, color displays, voice recognition applications,
location identification technology (e.g., Federal Communications
Commission (FCC) Enhanced 911), and increased battery
capacity. These improvements are geared towards increasing
customer acceptance and usage. Increased communication
speeds and improvements in devices during the next few years
should lead to continued increases in wireless subscriptions.
As institutions begin to offer wireless banking services to
customers, they should consider the risks and necessary risk
management controls to address security, authentication, and
compliance issues. Some of the unique risk factors associated
with wireless banking that may increase a financial institutions
strategic, transaction, reputation, and compliance risks are
discussed in appendix E.
Security Challenges in E-banking
Establishment of a comprehensive security control process
A comprehensive set of security policies and procedures should
be developed based on a threat and vulnerability analysis of e-
banking assets.
The Following are Key Elements of an Effective E-
banking
Security Process:
Explicit responsibility should be assigned for establishing and
maintaining corporate security policies
Sufficient physical controls should be established to provide a
secure area to house the e-banking systems including armed
guards, CCTV with motion sensors, smoke and fire alarm
systems, and biometric authentication like fingerprint or retina
scan
Security profiles should be created and specific authorization
privileges assigned to all users of e-banking systems including
customers, internal users, and system administrators and
outsourced service providers. LDAP-based directory solutions
or Identity management solutions can be used for an effective
implementation of this requirement.
Storage of sensitive data on organizations desktop and laptop
systems should be minimized and properly protected by
encryption, access control and data recovery plans
Appropriate techniques should be employed to mitigate
external threats, including the use of:
Firewalls to separate all DMZs, internal networks and external
untrusted networks
Virus-scanning software at all critical entry points (like firewalls,
remote access servers, e-mail servers) and on each desktop
system
Host- and network-based intrusion detection systems to detect
violations of security polices and controls
Periodic penetration testing of internal and external networks
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Regular monitoring and correlation of access and activity logs
should be performed for all perimeter devices, intrusion
detection systems, applications and databases
Current industry security developments should be continuously
tracked and appropriate software upgrades and service packs
should be installed
A rigorous background check should be performed for all
employees, service providers and contractors
Authentication of e-banking customers
To ensure legitimate access and reduce the risk of identity theft,
banks should use reliable methods for verifying the identity and
authorization of new and existing customers.
Banks can use a variety of authentication mechanisms, including
PINs, passwords, smart cards, biometrics and digital certificates.
Multi-factor authentication systems generally provide greater
assurance, although they may pose greater implementation
complexities. The selection of an authentication method
should be based on careful risk analysis of the e-banking
systems transactional capabilities, the sensitivity and value of
the stored e-banking data and customers ease of usage.
Measures to Ensure Segregation of Duties
By their very nature, e-banking systems and applications require
that traditional controls should be reviewed and adapted to
ensure effectiveness. To establish and maintain segregation of
duties in an e-banking environment, banks should take into
consideration the following issues:
Transaction processes and systems should be designed to
ensure that no single employee can enter, authorize and
complete a transaction
Segregation should be maintained between those initiating
static data (including web page content) and those responsible
for verifying its integrity
Segregation should be maintained between those developing
and those administrating e-banking systems
Internal authorization controls within e-banking systems,
applications and databases
In order to maintain segregation of duties, banks need to
strictly control authorization controls and access privileges. The
following are sound practices relating to authorization controls:
Specific authorization and access privileges should be assigned
to all individuals
No individual, agent or system should have the authority to
change his own authority or access privileges in an authorization
database
Any modification to an authorization database should be duly
authorized by an authenticated source
Authorization databases should be resistant to tampering and
corruption and sufficient audit trails should exist to document
any modification or tampering
Data integrity of e-banking transactions and information
Data integrity refers to the assurance that information that is in-
transit or in storage is not altered without authorization. Banks
should ensure that appropriate measures are in place to ascertain
the accuracy, completeness and reliability of e-banking
transactions, records and information that is either transmitted
over public networks or stored in internal bank databases.
Banks can use one-way hash functions to compute and verify
checksums for in-transit or stored data. File integrity checkers are
also useful tools to ascertain any modified files and restore last
known good copies, if required.
Establishment of Clear audit Trails for E-banking
Transactions
Banks are not only challenged to ensure that effective internal
controls can be provided in highly automated environments,
but also that controls can be independently audited, particularly
for all e-banking events and applications. The following should
be considered, to determine if clear audit trails are maintained:
Opening, modification or closing of a customer account
Any transaction with financial consequences
Any authorization granted to a customer to exceed a limit
Any modification in access rights and privileges of e-banking
systems
Sufficient logs should be maintained for all e-banking
transactions to help establish a clear audit trail and assist in
dispute resolution. Also, it should be ensured that audit trails
are not tampered with and can be used as evidence in a court of
law.
Confidentiality of Bank Information
To preserve confidentiality of key e-banking information, banks
should ensure that:
Data is classified into different groups and are only accessed by
duly authorized and authenticated individuals, agents or
systems
During transmission over public or private networks, all
confidential bank data are protected from unauthorized viewing
or modification using industry standard encryption algorithms
and technologies
All access to restricted data is logged and efforts are made to
ensure that access logs are resistant to tampering
Privacy of Customer Information
To meet the risk challenges concerning the preservation of
privacy of customer information, banks should ensure that:
The banks customer privacy policies and standards comply with
all privacy regulations and laws applicable to the jurisdictions to
which it is providing e-banking services
Customers are made aware of the banks privacy policies
concerning use of e-banking services
Customers may decline (opt out) from permitting the bank
to share with a third party for cross-marketing purposes any
information about the customers personal needs, interests,
financial position or banking activity
Customer data are not used for purposes beyond which they are
specifically allowed or for purposes beyond which customers
have authorized
The banks standards for customer data use must be met when
third parties have access to customer data through outsourcing
relationships
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Availability of e-banking systems
Banks have to maintain high availability and continuity of e-
banking systems, considering the potential for high transaction
demand (especially during peak time periods) and high
customer expectations regarding short transaction processing
cycle times and constant 24x7 availability. To provide customers
with the continuity of e-banking services they expect, banks
should ensure that:
Current and future capacity of critical e-banking delivery systems
are assessed on an ongoing basis
E-banking transaction processing capacity estimates are
established, stress tested and periodically reviewed
E-banking systems, applications and infrastructure are designed
and implemented keeping in mind the need for high-availability
for e.g., multiple redundant Internet links, routers, switches,
web servers with an external hardware load balancing device,
high-availability databases with fail-over, etc
Appropriate processing alternatives for managing demand
should be developed when e-banking systems appear to be
reaching defined capacity checkpoints
Appropriate business continuity and disaster recovery plans for
critical e-banking processing and delivery systems are in place
Regular disaster recovery drills are performed to check
effectiveness of disaster
One of the challenges before a Bank, which is trying to become
e - enabled is that the data is scattered across the countries.
Integration of this data is necessary if the banks have to succeed
on the net. The second challenge is related to the move towards
expanding the basket of financial products being offered by
Financial Service providers. In developed countries, Financial
Service providers are using the Internet as a media for
expanding into new products. Banks are getting into Mutual
funds and vice-versa. However, in India, archaic regulations do
not allow companies to have a close relationship with the Banks
owned by them or to offer products, which are offered by
another category of service providers. As a result, companies
like ICICI are forced to keep their Banking arms separate from
the main company. They are also prevented from offering
products, which fall under the purview of Banks. This is a
serious impediment for innovation in the financial service
sector. Moreover, it prevents Indian Financial Service Providers
from exploiting the power of the web.
Given these challenges, only a Bank (or Financial Service
provider) which moves fast and tries to capture the first mover
advantage can think of succeeding in this sector. Another Key
Success Factor will be the Value, which the online operations of
the Banks will be offering to the consumer. This is what will
differentiate between similar offerings from many providers of
financial products and services. Starting now, will give the
organization an advantage in terms of the networking it will be
able to achieve. This will help it in meeting the first challenge.
Banks (or Financial Service providers) should be ready to launch
their operations within days of the liberalization of the sector.
This will allow them to reach a critical mass and establish
themselves in the e-World.
Marketing Challenges in E-Banking
One of the most significant developments in bank marketing
in recent years has been the use of technology in creating new
channels through which customers can transact their accounts
and interact with their bank. The literature shows how e-
banking has developed rapidly and become a mainstream
channel, but concerns have been raised about the ability of
banks to manage customer relationships effectively through this
new channel. However, while the need to manage customers far
more holistically is recognised ,this has not yet been achieved in
practice. The reasons for this highlight challenges for marketing
in the banking sector.
Questions to Discuss:
1. What do you understand by e-banking?
2. Discuss the characteristics of Internet Banking.
3. What do you understand by Electronic Bill Payment?
4. What are Online Brokerages?
5. Discuss Online Delivery of Financial Products.
Notes: