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Indian Financia System

Indian Financia System

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Published by: mss_singh_sikarwar on Aug 10, 2010
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Formal (Organised) Financial System

Informal (unorganised) Financial System e.g.Money Lenders, Local Bankers, Traders, Landlords, Brokers

Formal System

Regulators, MOF, SEBI,RBI, IRDA

Financial Institutions (Intermediaries)

Financial Markets

Financial Instruments

Financial Services


Banking Institutions

Non-Banking Institutions

Mutual Funds Public Sector

Insurance & HFCs Private Sector

NBFCs Scheduled Commercial Banks Scheduled Co-operative Banks

DFIs National e.g.IDFC, SFCs, SIDCs, IFCI, NABARD, ICICI EXIM Bank, NHB, IDBI, SIDBI, ECGC Regional Rural Banks

Public Sector Banks

Private Sector Banks

Foreign Banks In India

Financial Markets

Capital Market

Equity Market

Debt Market (Corporate Debt, PSU Bonds, Govt. Securities Market) Both Primary & Secondary Segment

Money Market (Treasury Bills,Call Money, Commercial Bills, CPs, CDs, Term Money) Both Primary & Secondary Segment

Primary Market (Public Issues, Private Placement) Both Domestic & International

Derivatives Market Secondary (Exchange Traded) Market (NSE, BSE, OTCEI, F&O Regional SEs) (Index & StocK)

Financial Instruments

Term : Short, Medium, Long


Primary Securities (Equity, Preference, Debt & various combinations)

Secondary Securities (Time Deposits, MF units, Insurance Policies)

Financial Services
‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ Depositories Custodial Credit Rating Factoring Forfaiting Merchant Banking Leasing Hire Purchase Guaranteeing Portfolio Management Underwritting

KEY ELEMENTS OF A WELL-FUNCTIONING FINANCIAL SYSTEM ‡ ‡ ‡ ‡ ‡ ‡ ‡ Strong legal & regulatory environment Stable money Sound public finances & public debt management A central bank A sound banking system An efficient information system A well functioning securities market

A) Post-Independence Scenario (Upto1951) ‡ Traditional Economy, low per capital output. ‡ Lower activity levels of industrial entrepreneurship. ‡ Semi-organised and narrow industrial securities market. ‡ Devoid of securities issuing institutions. ‡ Virtual absence of participation by financial intermediaries. ‡ Financial system was not responsive to opportunities for industrial investment. ‡ Incapable of sustaining a high rate of industrial growth. B) 1951 TO MID-EIGHTIES ‡ Planned economic development. ‡ Public/Government ownership of FIs. ‡ Fortification of the institutional structure. ‡ Protection to investors. ‡ Participation of financial institutions in corporate management.

C) POST-NINETIES Major economic policy changes in post-nineties include -‡ Macroeconomic stabilisation ‡ Delicensing of Industries ‡ Trade Liberalisation ‡ Currecy Reforms ‡ Reduction in subsidies ‡ Financial Sector/capital market/banking reforms ‡ Privatisation/Disinvestments in public sector units ‡ Tax Reforms ‡ Amendments in Company Law ‡ Reduction of dominance of govt. in financial system and emergence of organised Capital Market. Some recent trends include‡ Private sector participation in equity of IFCI,IDBI,ICICI ‡ Establishment of private sector MFs under the guidelines of SEBI

‡ A number of private & foreign banks under RBI guidelines ‡ Implementation of R.N.Malhotra committee¶s scheme of reorganisation of the insurance sector & enactment of IRDA Act 1999. ‡ Private insurance companies sponsored by both domestic & foreign promoters have re-emerged. ROLE OF FINANCIAL INTERMEDIARIES ‡ Financial Intermediaries are business organisations serving as a link between savers and investors and so help in the credit allocation process. ‡ Lenders and borrowers differ in regard to terms of risk, return and terms of maturity. Intermediaries assist in resolving this conflict by offering claims against themselves and, in turn, acquiring claims on the borrowers. They provide three types of transformation services: ‡ Liability, asset and size transformation consisting of mobilisation of funds, and their allocation by providing large loans on the basis of numerous small deposits.

‡Maturity transformation by offering the savers tailor-made short-term claims or liquid deposits and so offering borrowers long-term loans matching the cash-flows generated by their investment. ‡ Risk transformation by transforming and reducing the risk involved in direct lending by acquiring diversified portfolios. Through these services, FIs are able to tap savings that are unlikely to be acceptable otherwise. Moreover, by facilitating the availability of finance, FIs enable the consumer to spend in anticipation of income and the entrepreneur to acquire physical capital. Since the process of economic reforms began in 1991, the role of FIs has undergone a tremendous transformation. Besides providing direct loans, they have diversified into other areas of financial services such as‡ Merchant Banking ‡ Underwritting ‡ Issuing guarantees

‡ Commercial Banks :- Collect savings primarily in the form of deposits and traditionally finance working capital requirements of corporate. However, in tune with the emerging needs of the economic & financial system, banks have also entered into i) Term lending business particularly in the infrastructure sector ii) Capital market directly/indirectly iii) Retail finance such as housing finance, consumer finance. For the same reason, they have also enlarged their geographical & functional coverage in terms of rural/agricultural and other priority sector financing, namely exports, SME and so on. ‡ Non-Banking Financial Companies (NBFCs) :- They provide a variety of fund/asset based and non-fund/advisory services. Most of their funds are raised in the form of public deposits ranging between one to seven years of maturity. Depending on the nature and type of service provided they are categorised inter-alia into: ‡ Leasing Companies

‡ Hire-Purchase and Consumer Finance Companies ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ Housing Finance Companies Venture Capital Funds Merchant Banking Organisations Credit Rating Agencies Factoring & Forfaiting Organisations Stock-broking Firms Depositories Mutual Funds :- It is a special type of investment institution which acts as an investment conduit. It pools the savings of relatively small investors and invests them in a well diversified portfolio of sound investment. Mutual funds issue securities (known as units) to the investors (known as unit-holders) in accordance with the quantum of money invested by them. The profit or losses are shared by the investors in proportion to their invetments. MF is set up in the form of a trust which has i) a sponsor ii) Trustees iii) AMC iv) Custodian. The trust is established by the sponsor who is like promoter of the company.

The trustees are vested with the general power of superintendence and direction over AMC. They monitor the performance and compliance of the SEBI regulations. The AMC manages the funds by making investment in various types of securities. The custodian holds the securities of the various schemes of the mutual fund in it¶s safe custody. As an investment intermediary, mutual funds offer a variety of services/advantages to the relatively small investors who, on their own, can¶t successfully construct and manage an investment portfolio due to size of the funds, lack of experience/expertise and so on. These, inter-alia include convenience in terms of lower denomination of investment and liquidity, lower risk through diversification, expert management and reduced transaction cost due to economies of scale. Insurance Companies :- They essentially invest the savings of their policyholders (insurance premium) and in exchange promise them a specified sum at a later stage (on maturity) or upon the happening of a certain event ( in case of life policies, death of the policyholder). They provide a risk cover to the policyholder. Insurance organisations universally induce the savings for variety of motives such as ± ‡ To assist the individual in the creation of an emergency fund.

‡ To assist in the accumulation of a fund by the time of retirement from active work. BANKING SYSTEM Section 5(1)(b) of the Banking Regulation Act defines banking as µthe 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. It defines banking company as any company which transacts the business of banking in India. The banking system is the fuel injection system which spurs economic efficiency by mobilising savings and allocating them to high return investment. FUNCTIONS OF BANKING ‡ DEPOSITS ± i) Demand Deposits ii) Time Deposits ‡ CREDIT CREATION- Leads to an increase in the total amount of money for circulation. ‡ LENDING OF MONEY- Facilitate not only flow of funds but flow of goods & services from producers to consumers.

ANCILLARY FUNCTIONS ± These include transfer of funds, collection, foreign exchange, safe deposit locker, gift cheques and merchant banking. TYPES OF BANKS The structure of banking sector in India divides the banks into two categories. A) Scheduled Commercial Banks B) Scheduled Co-operative Banks Scheduled Commercial Banks are of following types‡ Public Sector Banks (28) ‡ Private Sector Banks (27) ‡ Foreign Banks (29) ‡ Regional Rural Banks (102) Scheduled Co-operative Banks are of following types‡ Scheduled Urban Co-operative Banks ‡ Scheduled State Co-operative Banks

SCHEDULED COMMERCIAL BANKS :- Scheduled commercial banks are those included in the second schedule of RBI Act 1934. ‡ Public Sector Banks :- These banks are banks in which the govt. has a major holding. They are classified into two groups. i) State Bank of India & it¶s associates(7):- The SBI holds a dominant market position among all Indian Banks. It has the largest network of 14000 branches, 51 foreign branches,100million accounts and a workforce of more than 2lakh. SBI has 20% market share and asset base of more than Rs.4lakh crore. It has 54 offices in 28 countries and expansion planned for 70 offices in 36 countries. Amendment of SBI Act 1955, was done in Oct 1993 to enable the bank to access the capital market in order to meet capital adequacy norms. ii) Nationalised Banks(27) :- The major objectives of nationalisation were ± a) To widen the branch network particularly in rural & semi-urban areas. b) Greater mobilisation of savings & flow of credit to neglected sectors like agriculture, SSI With amendment to the Banking Companies Act, they are allowed to access capital markets to raise funds.

A ceiling of 20% on all types of foreign investment in the paid-up capital has been stipulated for these banks. Overall, public sector banks dominate with 75% deposits & 71% advances. ‡ Private Sector Banks :- There are 27 private sector banks- 19 old one & 8 new one. The new banks have brought in state-of-the art technology and aggresively marketed their products. The public sector banks are facing stiff competition from the new private sector banks. Pursuant to the guidelines issued in January 1993 the old private sector banks having net worth of less than 50cr were advised to attain the level of Rs.50cr by 31st March 2001 and prepare action plan for augmenting capital funds to the level of Rs.100cr. The guidelines for entry of new banks in the private sector were revised in Jan2001. The guidelines prescribed an increase in initial minimum paid-up capital from Rs.100cr to Rs.200cr. Moreover, the initial minimum paid-up capital shall be increased to Rs.300cr in subsequent three years after commencement of business. The guidelines also enable NBFCs to convert into a commercial bank, if it satisfies prescribed criteria of -

Minimum net worth of Rs.200cr A credit rating of not less than AAA or equivalent Capital adequacy of not less than 12% Net NPAs not more than 5%. Guidelines do not permit large industrial houses to promote any new bank, however they can participate in the equity upto a maximum of 10% but would not have controlling interest in the bank. The level of foreign participation in private banks has been enhanced to strengthen the corporate governance, risk management and technological competence of these banks. Foreign investment in private sector banks is permissible upto a composite ceiling of 74% of the paid-up capital. This would include FDI, investment under portfolio investment by FIIs, NRI investment, shares acquired by OCBs (prior to 16/09/2003), private placements, GDRs/ADRs. FII investment limit can¶t exceed 49% within the aggregate FI ceiling of 74%. All times atleast 26% of the paid-up capital would have to be held by residents. The recent draft guidelines on ownership in private banks, the RBI has proposed that no individual entity can hold more than 10% stake in a private sector bank. The cross-holding among private sector banks including foreign banks operating in India is capped at 5%.

Foreign Banks :- There are 29 foreign banks from 19 countries operating in India with 258 branches spread over 40 centres across 19 states/UT. Foreign bank can set up a wholly owned non-banking subsidiary if it brings in US $50 million. ‡ As per the norms a bank¶s exposure to a single corporate entity is restricted at 15% of it¶s capital while for a group it is at 40%. Foreign banks in India have a strong retail presence. They have also enabled large Indian companies to access foreign currency resources from their overseas branches. They are active players in money market & forex market. Foreign Banks may operate in India through any one of the three channels namely ± i) Branches ii) A wholly owned subsidiary iii) A subsidiary with aggregate foreign investment upto a maximum of 74% in a private bank. Regional Rural Banks :- These banks came into existence under RRB Act 1976. The main objective of RRBs is to develop the rural economy by providing credit for the purpose of development of agriculture, trade, commerce, industry & other productive activities in rural areas, credit & other facilities particularly to the small & marginal farmers, agricultural labourers, artisans and small entrepreneurs. The authorised capital of RRB is Rs 1crore & issued capital is Rs.25lakh

Of the issued capital, 50% is authorised by GOI, 15% by concerned state government and balance by the sponsor bank. Each RRB is sponsored by a PSU bank. RBI grant assistance to RRBs by way of loans & advances from National Agricultural Credit Fund, required to maintain CRR 3% & not liable to pay income tax as they are deemed to be co-operative societies. The no. of RRBs rose from six in 1975 to 196 in 2001. They operate in 500 districts with a network of 14,313 branches. RRBs are at par with scheduled commercial banks with respect to priority sector lending, investment avenues, credit discipline and transparency. Although RRBs have carved out a niche for themselves in terms of geographical coverage, clientele outreach, business volume and contributions for development of the rural economy but plagued by low productivity, high transaction costs, negative margins, low recovery rates and high NPAs.

‡ ‡ I) Co-operative banks came into existence with the enactment of the Co-operative Credit Societies Act. Co-operative Credit Sector comprises rural co-operative credit institutions & urban co-operative banks. Organisational Structure of Co-operative credit institutions Urban Co-operative Banks:- UCBs are mostly engaged in retail banking. They are not permitted to deal in foreign exchange directly due to high risk involved in forex business. UCBs are divided intoA) Scheduled UCBs B) Non-scheduled UCBs Both of them may be either single-state or multi-state. There are in all 2090 UCBs. They are included in the second schedule of RBI Act, 1934, if their NDTL are at least 250 cr and UCBs came under the purview of Banking Regulation Act only in 1966 & currently supervised by RBI. State registrars of co-operative societies also regulate certain functions. Multi-state UCBs are regulated by central government as well and are registered under the Multi-state Co-operative Societies Act. The area of operation is confined to a single district or the adjoining districts. Only UCBs with Rs.50 cr net worth or above can extend their area of operation.

UCBs are mostly engaged in retail banking. RBI grants licenses to cooperative banks based on certain entry point norms namely‡ A minimum share capital of Rs.4cr & membership of at least 3000 (for population more than 10 lakh) ‡ A minimum share capital of Rs.2cr & membership of at least 2000 (for population between 5 -10 lakh) ‡ A minimum share capital of Rs.1cr & membership of at least 1500 (for population between 1-5 lakh) ‡ A minimum share capital of Rs.25 lakh & membership of at least 500 (for population less than 1lakh) The scheduled UCBs are required to maintain CRR at 7% of the NDTL & SLR to be 25%. Out of this 15% of SLR requirements are to be maintained in govt. securities and the balance as cash deposits with other co-operative banks. From 01/04/2003 onwards only unscheduled UCBs will enjoy this facility while scheduled UCBs will have to deploy the entire SLR requirements in government/approved securities. With effect from February 2006 the non-scheduled UCBs having a deposit base of Rs,100cr or less would be exempted from minimum SLR in the form of prescribed assets upto maximum of 15% of their NDTL

‡ An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. A Non-Performing Asset (NPA) is a loan or an advance whwn one of the following is applicable. a) Interest and/or installment of principal remain overdue for a period of more than 90 days in respect of a term loan. b) The account remains µout of order¶ in respect of an overdraft/CC. c) The bill remains overdue for a period of more than 90 days in the case of bills purchased & discounted d) A loan granted for short duration crops will be treated as NPA, if the installment of principal or interest thereon remains overdue for two crop seasons. e) A loan granted for long duration crops will be treated as NPA, if the installment of principal or interest thereon remains overdue for one crop season.

‡ NPAs are classified into three categories based on ± a) The period for which the asset has remained non-performing b) The realisability of the dues. ‡ Substandard Assets :- W.E.F. 31st March 2005, a substandard asset would be one, which has remained NPA for a period less than or equal to 12 months. The following features are exhibited by substandard assets: the current net worth of the borrower/ guarantor or the current market value of the security charged is not enough to ensure recovery of the dues to the banks in full; and the asset has well-defined credit weaknesses that jeopardise the liquidation of the debt and are characterised by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected, ‡ Doubtful Assets :- An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full- on the basis of currently known facts, conditions and values ± highly questionable and improbable.

Loss Assets :- A loss asset is one which is considered uncollectible and of such little value that it¶s continuance as a bankable asset is not warranted ± although there may be some salvage or recovery value. Also, these assets would have been identified as µloss assets¶ by the bank or internal or external auditors or the RBI inspection but the amount would not have been written off wholly. PROVISIONING NORMS Adequate provisioning has to be made for impaired loans or NPAs. Taking into account the time lag between an account becoming doubtful of recovery, it¶s recognition as an impaired loan, the realisation the security charged to the bank and the likely erosion over time in the value of this security, banks should classify impaired loans into µsub-standard¶, µdoubtful¶. And µloss¶ assets and make provisions against these. Loss assets should be written off or 100% provided for. Doubtful Assets :‡ Provision of 100% to the extent the advance is not covered by the realisable value of the security (to which the bank has a valid recourse)

‡ That portion of the advances covered by realisable value of the security will provided for on the following basis. Period for which the advance has Remained in µdoubtful¶ category Upto 1 year 1 to 3 years More than 3 years i) Outstanding stock of NPAs as on 31st March 2004 ii) Advances classified as µdoubtful¶ more than 3 years on or after 1st April 2004 Provision Requirement (%) (for the secured portion 20% 30% 60% wef 31st March 2005 75% wef 31st March 2006 100% wef 31st March 2007 100% wef 31st March 2005

‡ Interest is the cost of funds from borrower¶s point of view while it is the yield on capital from the lender¶s point of view. ‡ ADMINISTERED INTEREST RATES REGIME :These are the rates which are not determined by the market forces but by the monetary authorities. Following are the features of these rates. ‡ The deposit & lending rates of commercial and co-operative banks were fixed by the central bank since 1969 and they were different for different types of banks. ‡ The CCI fixed the ceiling on the coupon rates on industrial debentures and preference shares. ‡ The Indian Banks Association had been fixing the ceiling on call rates since 1973 until Oct.1988. ‡ Govt. fixed the rates on Treasury Bills & long-term govt. securities. ‡ The govt. had a great say in in the rates of term-lending by FIs. ‡ RBI fixed different rates for different category of borrowers & on loans for different purposes. ‡ RBI also fixed rates on different financial instruments like BOE.

REASONS FOR ADMINISTERED RATES ‡ To avoid unhealthy competition for borrowing & deposit accounts. ‡ To maintain uniformity of interest rates in all types of banks. ‡ To keep deposit rates in alignment with the lending rates and with other market rates of interest. ‡ To aid deposit mobilisation. ‡ To lengthen the maturity structure of deposits. ‡ To enable the authorities to avoid frequent changes in the bank rate. ‡ MAJOR DIFICIENCIES IN THE ADMINISTERED RATES Chakravarty committee highligted major dificiencies in the administered rate system as follows. ‡ The system had grown to be unduly complex, and it contained features which had reduced the ability of the monetary system to promote the effective use of credit. ‡ The low yields on treasury bills and government securities had resulted in the high level monetisation of public debt and consequent monetary expansion.

‡ The captive market for government securities had adversely affected the growth of capital market and the profitability of banks ‡ Concessional rates of interest had allowed projects of doubtful viability to be undertaken. ‡ Quantitative credit controls had come under severe stress in the absence of support from any price rationing mechanism. ‡ The system had lacked the flexibility necessary for augmenting the pool of financial savings. DEREGULATION OF INTEREST RATES Following important changes in the direction of deregulating the entire interest rates structure have been made. ‡ The bank rate has been activated. ‡ Most of the money market rates have been deregulated ‡ The ceiling on the call rate was withdrawn w.e.f. May 1, 1989. ‡ The interest rates on treasury bills, certificates of deposits, commercial paper and inter-bank participations are allowed to be flexible, variable and market determined. ‡ The deposit & lending rates of commercial banks, RRBs, urban cooperative banks and other co-operative banks have been freed.

‡Interest rates on public deposits accepted by all non-banking companies (both financial & non-financial) have been deregulated. ‡ The coupon rates on govt. dated securities have been made marketrelated. ‡ The interest rates on convertible, non-convertible and other types of debentures have been made free. ‡ The term lending institutions can charge interest rates unhindered by the state intervention. BANK RATE :- It is the rate of discount fixed by the central bank of the country for rediscounting of eligible paper. This is an interest rate for the Reserve Bank¶s own market transactions with the financial institutions ± the rate at which the RBI will make short-term loans to banks and other financial institutions. The bank rate is the central bank¶s key rate signal, which banks use to price their loans. The impact of bank rate announcements have been pronounced in the PLRs of commercial banks. PRIME LENDING RATE :- The PLR is the minimum lending rate charged by the bank from it¶s best corporate customers or prime borrowers. PLRs have been deregulated gradually since April1992 and the interest rate structure for commercial banks simplified.

The norms relating to the PLR have been progressively liberalised. From October 18, 1994, interest rates on loans above Rs.2lakhs were freed and banks were permitted to determine their own PLRs. ‡ From April 1998 banks were given freedom to determine the interest rates on loans upto Rs.2lakhs subject to condition that small borrowers being charged at rates not exceeding the PLR. The RBI advised the banks to reduce the maximum spreads over their PLRs and announce it to public along with the announcement of their PLR. The freedom to evolve differential PLRs was also given. Differential PLRs are differential rates for different levels of maturities. ‡ In April 2001, banks were allowed to offer loans at sub-PLR rates. ‡ Banks¶ PLR presently is on a µcost plus¶ basis i.e. banks have to take into account their ± i) Actual cost of funds ii) Operating expenses and iii) A minimum margin to cover regulatory requirement of provisioning/capital charge and profit margin. PLR of the banks is based on the Bank Rate and has a positive correlation with it.

‡ RBI uses refinancing as an instrument ± 1) To relieve the liquidity shortages in the banking system. 2) Control the monetary & credit conditions. 3) To direct credit to selective sectors. The Reserve Bank has directed certain sector specific refinance facilities such as food credit, export credit, government securities and discretionary standby refinance to scheduled banks. The refinance rate has now been linked to the bank rate. Currently, there are only two refinance schemes available to banks ± ‡ Export credit refinance ‡ General refinance From April 1, 2002 export credit refinance is being provided to scheduled banks at 15% of their outstanding export credit eligible for refinance as at the end of preceding fortnight. General refinance is provided to tide over temporary liquidity shortages faced by banks. The general refinance window has now been replaced by a collteralised lending facility within the overall framework of the interim liquidity adjustment facility.

‡ The Narsimhan committee on Banking sector Reforms(Report II, 1998) recommended that the RBI provide support to the market through LAF scheme. This facility would help in the development of a short-term money market with adequate liquidity. As per the recommendations, the RBI decided to introduce the LAF in phases. ‡ The interim LAF, introduced in April 1999, provided a mechanism for liquidity management through a combination of repos, export credit refinance, supported by open market operations at set rates of interest. Banks could avail of a collateralised lending facility of up to 0.25% of the fortnightly average outstanding aggregate deposits available for few weeks at the bank rate. ‡ The interim LAF was gradually converted into full-fledged LAF scheme. LAF is operated through repos and reverse repos. The LAF is a tool of day-to-day liquidity management through the absorption or injection of liquidity by way of sale or purchase of securities followed by their repurchase or resale under the repo/reverse repo operations. ‡ Repo/Reverse Repo auctions are conducted on a daily basis (Except Saturday).

The following measures relating to LAF are announced. ‡ The standing liquidity facilities available from RBI are split into two parts. 1) Normal facility constituting about two-thirds of the limit at the bank rate. 2) Back-stop facility constituting about one-third of the limit at a variable daily rate, which is linked to cut-off rates emerging in regular LAF auctions. In the absence of such rates, the back-stop facility will be linked to NSE MIBOR. ‡ Minimum bid size for the LAF reduced from Rs.10 cr to Rs.5 cr to facilitate the participation from small operators. ‡ In order to provide quick interest rate signals, the RBI has chosen an additional option for switching over to fixed rate repos on an overnight basis. ‡ The RBI also has the option of introducing long-term repos of upto 14 days as and when required. It has introduced, a fortnightly repo auction.

‡ Repo is a useful money0market instrument enabling the smooth adjustment of short-term liquidity among varied market participants such as banks & financial institutiions. ‡ Repo refers to transaction in which a participant acquires immediate funds by selling securities and simultaneously agrees to the repurchase of the same or similar securities after a specified time at a specified price. In other words, it enables collateralised short-term borrowing and lending through sale/purchase operations in debt instruments. It is temporary sale of debt involving full transfer of ownership of the securities. Repo is also referred to as a ready forward transaction as it is a means of funding by selling a security held on a spot basis and repurchasing the same on forward basis. ‡ REVERSE REPO :- It is exactly the opposite of repo ± a party buys a security from anther party with a commitment to sell it back to the latter at a specified time & price. Here the transaction is repo for one party and reverse repo for another party. Reverse repo is undertaken to earn additional income on idle cash. In India, repo transactions are basically fund management/SLR management devices used by banks. ‡ It is also a good hedge tool because the repurchase price is locked in at the time of the sale itself.

‡ Repos are safer than pure call money and inter-corporate deposit markets which are non-collteralised. ‡ Repos are backed by securities and are fully collateralised. Thus the counter-party risks are minimum. ‡ Since repos are market-based instruments, they can be utilised by central banks as an indirect instrument of monetary control for absorbing or injecting short-term liquidity. ‡ Repos help maintain an equilibrium between demand & supply of short-term funds. The repos market serves as an equilibrium between the money market and securities market and provides liquidity and depth to both the markets. ‡ Monetary authorities can transmit policy signals through repos to the money market which has a significant influence on the government securities market and foreign exchange market. ‡ Internationally it is a versatile and the most popular money market instrument.

‡ Interest earned by banks on loans, advances and investments is the equivalent of revenues earned by a non-financial firm. ‡ The variable costs for financial product- the loan- are the cost of the bank¶s liabilities. The fixed costs include the transaction servicing costs plus a portion of the overheads utilised for maintaining and monitoring the account. The bank¶s desired profit margin corresponds to the profit margin inbuilt into the selling price of a good or service. ‡ Therefore, Loan price= Cost of funds + servicing costs + desired profit margin. LOAN PRICING MODEL ‡ Step-I : Arrive at Cost of Funds - The objective here is to ensure that the loan price covers variable costs. The cost of funds depends on bank¶s sources of funds- deposits or borrowings. ‡ Step ± II : Determine Servicing Costs for the Customer :‡ Identify the full list of services used by the customer. This list would include services related to the credit and non-credit facilities availed by the customer. E.g. activity in the demand deposit account maintained by the customer, usage of security custodial services, payment related services such as transfers or letters of credit. ‡ Assess the cost of providing each service.

‡Cost of credit services depends on the loan size and forms a major portion of the servicing costs. They include loan administration expenses, of which a large share is contributed by personnel, processing or delivery costs. Most banks calculate these costs as a % of the loan size. ‡ Step-III Assess Default Risk & Enforceability of Securities :‡ Based on the risk value assigned to the borrower, banks build models to assess the probability of default, arising out of the bank¶s prior experience with borrowers having similar risk profiles. The bank then puts a value to the enforceability and strength of the securities the bank holds or proposes to hold for the loan. ‡ Assigning these probabiliities to the loan amount and interest recoverable, the bank computes the risk premium that will fit the borrower. ‡ With probability of default the expected rate would be the aggregate ofE(r) = P(R) x r + P (D) x {R(P + P r)/P) ± 1} E(r) = Expected rate, P(R) = Probability of recovery, r = Contracted rate of interest, P(D) = Probability of default, P = Principal amount, R = Recovery rate in the event of default.

Step-IV Fixing the Profit Margin :The approach used to set the profit margin for loan transactions is to use the ROE which is based on market expectations & shareholders¶ required returns. Thus, ROE = ROA x Equity/Assets. FIXED VS FLOATING RATES ‡ When the interest rates are relatively stable and the yield curve slopes upward, banks would be willing to lend at fixed interest rates, which are the rates above that is paid for shorter term liabilities. ‡ In an environment where rates are volatile, and banks have to source funds from the market at varying interest rates, they would prefer to lend on floating rates and for shorter maturities. In effect, floating rate loans transfer the interest rate risk from the bank to the borrower. Though this appears desirable, it may result in heightened credit risk for the bank as the rising interest rates increase the borrower¶s interest expense. If it is not met out of operating cash flows or the borrower¶s own funds, may lead to a shortfall in debt service. ‡ It is evident that most borrowers would prefer fixed rate loans, due to the predictable cash flows for debt service, and allow the banks to bear interest rate risk. If the banks want to encourage borrowers to agree for floating rate pricing, they offer two alternatives.

‡ In the first alternative,banks may set the floating rate at a level below the corresponding fixed rate. The bank charges a µterm premium¶ to cover the risk on fixed rate loans. The size of the discount and the premium will have to depend on the bank¶s cost of funds and required rate of premium. ‡ In the second, banks set an interest rate cap on the floating rate loans to limit the possible increase in interest payments. The cap may be applicable for any interval, or for the entire maturity of the loan. The borrower pays the negotiated floating rate till the cap is reached. The inherent risk to banks lies in the market interest rates breaching this cap. The floating rate structure works well when linked to a reliable benchmark reference rate, representing the rate structure in the economy. The most widely used reference rates are the LIBOR and the prime rate in US markets.

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