BANKING FOUNDATION COURSE v1.6

Foundation Course in Banking
Version : 1.6
Date : 01-June-2004
TABLE OF CONTENTS
1. THE CONCEPT OF MONEY.......................................................................7

DEFINING MONEY......................................................................................................8
THE CONCEPT OF INTEREST: SIMPLE INTEREST AND COMPOUND INTEREST.8
INFLATION................................................................................................................. 10
TIME VALUE CONCEPT OF MONEY........................................................................11
2. FINANCIAL INSTRUMENTS....................................................................15
RAISING CAPITAL.....................................................................................................16
SECURITY................................................................................................................. 16
DEBT.......................................................................................................................... 16
EQUITY...................................................................................................................... 20
HYBRIDS................................................................................................................... 22
DERIVATIVES............................................................................................................ 22
3. FINANCIAL MARKETS.............................................................................26
WHAT ARE FINANCIAL MARKETS?.........................................................................27
TYPES OF FINANCIAL MARKETS............................................................................27
CAPITAL MARKETS..................................................................................................27
STOCK MARKETS.....................................................................................................28
BOND MARKETS.......................................................................................................29
FOREIGN EXCHANGE MARKET..............................................................................30
MONEY MARKET......................................................................................................31
REGULATION OF CAPITAL MARKETS....................................................................32
FINANCIAL MARKET SYSTEMS...............................................................................32
SUMMARY................................................................................................................. 34
4. RISK MANAGEMENT...............................................................................35
THE RISK REWARD PRINCIPLE..............................................................................36
THREE PILLARS OF RISK MANAGEMENT..............................................................37
DEFINING RISKS.......................................................................................................37
MEASURING RISKS..................................................................................................38
MANAGING RISKS....................................................................................................41
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SUMMARY................................................................................................................. 42
5. INTRODUCTION TO BANKING...............................................................43
WHAT IS A BANK?....................................................................................................44
WHY DO WE NEED A BANK?...................................................................................44
WHAT IS THE CENTRAL BANK AND WHAT ARE ITS ROLES?..............................44
BANKS, ECONOMY AND AMOUNT OF MONEY......................................................45
HOW DO BANKS MAKE MONEY?............................................................................46
SERVICE OFFERINGS OF BANKS...........................................................................47
TOP 50 BANKS IN THE US BY ASSET SIZE............................................................47
UNIVERSAL BANKING..............................................................................................49
SUMMARY................................................................................................................. 50
6. RETAIL BANKING....................................................................................51
RETAIL BANKING......................................................................................................52
RETAIL LENDING......................................................................................................52
MORTGAGES............................................................................................................ 57
CREDIT CARDS.........................................................................................................60
RETAIL SERVICE......................................................................................................64
7. ELECTRONIC BANKING..........................................................................66
ELECTRONIC FUND TRANSFERS...........................................................................67
EFT REGULATIONS..................................................................................................68
FEDWIRE................................................................................................................... 70
OTHER TRANSFER SYSTEMS.................................................................................71
SUMMARY................................................................................................................. 72
8. PRIVATE BANKING/WEALTH MANAGEMENT......................................73
CLIENT SERVICES....................................................................................................74
COMMON PRIVATE BANKING PRODUCTS.............................................................75
WHO OFFERS PRIVATE BANKING SERVICES?.....................................................76
WHY GROW PRIVATE BANKING BUSINESS?........................................................77
CORE FUNCTIONS IN PRIVATE BANKING..............................................................77
PRIVATE BANKING WORKFLOW.............................................................................77
SUMMARY................................................................................................................. 80
9. ASSET MANAGEMENT............................................................................81
ASSET MANAGEMENT GOALS................................................................................82
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DISTINCTION BETWEEN PRIVATE BANKING & ASSET MANAGEMENT...............82

PLAYERS IN ASSET MANAGEMENT.......................................................................83
THE COMMON INGREDIENTS.................................................................................83
INVESTMENT MANAGEMENT CYCLE.....................................................................84
ASSET ALLOCATION................................................................................................85
APPROACHES TO ASSET ALLOCATION.................................................................85
PORTFOLIO EXECUTION.........................................................................................86
INVESTMENT PHILOSOPHIES.................................................................................87
SUMMARY................................................................................................................. 88
SUMMARY................................................................................................................. 89
10. CORPORATE LENDING...........................................................................90
CORPORATE LENDING............................................................................................91
CORPORATE LENDING PROCESS..........................................................................91
CORPORATE CREDIT RATING................................................................................92
TYPES OF LOANS.....................................................................................................92
CLASSIFICATION OF LOANS BY THE BANK...........................................................95
CREDIT DERIVATIVES..............................................................................................96
11. TRADE FINANCE......................................................................................98
PRE SHIPMENT LOANS............................................................................................99
POST SHIPMENT LOANS.........................................................................................99
FACTORS IN CHOOSING THE MODE OF FINANCING...........................................99
BILL OF LADING......................................................................................................100
CREDIT CHECK.......................................................................................................100
PAYMENT METHODS.............................................................................................100
CASH IN ADVANCE.................................................................................................101
COMMERCIAL LETTER OF CREDIT......................................................................101
DOCUMENTARY COLLECTION..............................................................................105
HYBRID METHODS.................................................................................................106
OPEN ACCOUNT.....................................................................................................107
OTHER PAYMENT METHODS................................................................................107
FOREIGN CREDIT INSURANCE UNDERWRITERS AND BROKERS....................108
THE BANKERS ASSOCIATION FOR FOREIGN TRADE (BAFT)............................109
INTERNATIONAL PAYMENT INSTRUMENTS COMPARISON CHART..................110
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12. TREASURY SERVICES & CASH MANAGEMENT...............................111

TREASURY SERVICES - LIQUIDITY & INTEREST RATE RISK MANAGEMENT. .112
TREASURY SERVICES - FOREX MANAGEMENT.................................................116
CASH MANAGEMENT SERVICES – COLLECTIONS AND PAYMENT..................119
ENHANCING TREASURY & CASH MANAGEMENT...............................................122
13. INVESTMENT BANKING........................................................................127
CORPORATE FINANCE..........................................................................................128
SALES...................................................................................................................... 128
TRADING................................................................................................................. 129
RESEARCH.............................................................................................................. 129
SYNDICATE............................................................................................................. 129
INITIAL PUBLIC OFFERINGS..................................................................................129
THE CHINESE WALL...............................................................................................130
UNDERWRITING.....................................................................................................131
SECONDARY MARKET TRADING..........................................................................132
THE FLOOR OF THE EXCHANGE..........................................................................133
THE OVER-THE-COUNTER (OTC) MARKET.........................................................135
HOW DOES A BROKERAGE FIRM LOOK LIKE?....................................................137
MARKET INDICES...................................................................................................141
14. INVESTOR SERVICES...........................................................................142
INVESTMENT MANAGEMENT................................................................................143
TRADING................................................................................................................. 145
CUSTODY & ASSET SERVICING...........................................................................146
SUMMARY............................................................................................................... 149
15. RECENT DEVELOPMENTS...................................................................150
USA PATRIOT ACT.................................................................................................151
AMR GUIDELINES...................................................................................................154
SARBANES OXLEY ACT.........................................................................................156
BASEL 2 CAPITAL ADEQUACY NORMS................................................................157
CHECK 21................................................................................................................ 160
GLOSSARY........................................................................................................162
REFERENCES...................................................................................................170
WEBSITES............................................................................................................... 171
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BOOKS..................................................................................................................... 171
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1.THE CONCEPT OF MONEY
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THE CONCEPT OF MONEY
DEFINING MONEY
“Money is a standardized unit of exchange”. The practical form of money is currency. It
varies across countries whereas money remains the same. For example, in India, the
currency is the Indian Rupee (INR) and in the US, it is the US Dollar (USD).
Due to various economic factors, the value of each country’s currency is not equal. For
example, if the exchange rate between US Dollars (USD) and Indian Rupees (INR) is
USD 1 = INR 46.70, it implies that one U.S dollar is equivalent to 46.70 Indian Rupees.
The USD is normally taken as a benchmark against which to compare the value of each
currency.
THE CONCEPT OF INTEREST: SIMPLE INTEREST AND COMPOUND INTEREST

Interest is the amount earned on money; there is such an earning because present
consumption of the lender is being sacrificed for the future; you are letting somebody
else use the money for present consumption. Using an analogy, interest is the ‘rent’
charged for delaying present consumption of money. Interest rates are not constant and
will vary depending on different economic factors
Simple interest
Simple interest is calculated only on the beginning principal. Simple Interest = P*r*t/100
where: P is the Principal or the initial amount you are initially borrowing or depositing, to
earn or charge interest on, r is the interest rate and t is the time period.
Example
If someone were to receive 5% interest on a beginning value of $100, the first year they
would get:
0.05*$100 = $5
If they continued to receive 5% interest on the original $100 amount, over five years the
growth in their investment would look like this:
Year 1: (5% of $100 = $5) + $100 = $105
Year 2: (5% of $100 = $5) + $105 = $110
Year 3: (5% of $100 = $5) + $110 = $115
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Year 4: (5% of $100 = $5) + $115 = $120
Year 5: (5% of $100 = $5) + $120 = $125
Compound interest
With compound interest, interest is calculated not only on the beginning interest, but on
any interest accumulated with the initial principal in the meantime. Compound interest =
[P*(1+r/100)^t – P], where: P is the Principal or the initial amount you are initially
borrowing or depositing, to earn or charge interest on, r is the interest rate and t is the
time period.
Example
If someone were to receive 5% compound interest on a beginning value of $100, the first
year they would get the same thing as if they were receiving simple interest on the $100,
or $5. The second year, though, their interest would be calculated on the beginning
amount in year 2, which would be $105. So their interest would be:
.05 x $105 = $5.25

If this were to continue for 5 years, the growth in the investment would look like this:
Year 1: (5% of $100.00 = $5.00) + $100.00 = $105.00
Year 2: (5% of $105.00 = $5.25) + $105.00 = $110.25
Year 3: (5% of $110.25 = $5.51) + $110.25 = $115.76
Year 4: (5% of $115.76 = $5.79) + $115.76 = $121.55
Year 5: (5% of $121.55 = $6.08) + $121.55 = $127.63
Note that in comparing growth graphs of simple and compound interest, investments
with simple interest grow in a linear fashion and compound interest results in geometric
growth. So with compound interest, the further in time an investment is held the more
dramatic the growth becomes.
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INFLATION
Inflation captures the rise in the cost of goods and services over a period of time. For
example, if Rs.100 today can buy 5 kg of groceries, the same amount of money can only
buy 5/(1+I) kgs. of groceries next year, where I refers to the rate of inflation beyond
today.
Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand
& supply and other market conditions hold), next year, you can only buy 5/(1.05) worth of
groceries.
A quantitative estimate of inflation in a particular economy can be calculated by

measuring the ratio of Consumer Price Indices or CPI of two consecutive years. That’s
right, the CPI that you hear of, is the weighted average price, of a predefined basket of
basic goods. The % increase of the CPI this year vs. the CPI of last year, gives the
inflation, or rise in price of consumer goods, over last year.
Inflation results in a decrease in the value of money over time. The link between the
interest rates, nominal and real, and inflation enables you to identify this impact.
Nominal Interest
Nominal rate of interest (N) refers to the stated interest rate in the economy. For
example, if counter-party demands 110 rupees after a year in return for 100 rupees lent
today, the nominal rate of interest is 10%. This, as you see, includes the inflation rate.
Example
You’ve lent out 100 rupees, at 10%, for one year. On maturity, you get a profit, so you
think, of 10 rupees. But this sum of 110 rupees buys less than 110 rupees did a year
ago, due to inflation! Thus, the value of 110 rupees today is actually, or really, less than
the value of 110 rupees a year ago, and it is less by the inflation rate. Thus the real
interest you earned is less than 10%.
Real rate of Interest

Real rate of interest (R) refers to the inflation-adjusted rate of interest. It is less than the
nominal rate of interest for economies having positive rate of inflation.
The relationship between the R (real rate of interest), N (nominal rate of interest) and I
(rate of inflation) is as:
R= N-I
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(This is a widely used approximation; the exact formula takes into account time value of
inflation etc.)
Why is it important to know the real rate of return? Take an example where a business is
earning a net profit of 7% per annum. But, inflation is also standing at 7%. So, real profit
is actually at zero.
Example
Nominal rate (N) = 10%, Inflation (I) = 5%
Therefore, real interest is:

R = N – I = 5%
Therefore, the real rate of return is not 10% but 5%.
TIME VALUE CONCEPT OF MONEY

Time value of money, which serves as the foundation for many concepts in finance,
arises from the concept of interest. Because of interest, money on hand now is worth
more than the same money available at a later point of time. To understand time value of
money and related concepts like Present value and future value, we need to understand
the basic concepts of simple and compound interest described above.
Future Value
Future Value is the value that a sum of money invested at compound interest will have
after a specified period.
The formula for Future Value is:

FV = PV*(1 + i)n
where:
FV : Future Value at the end of n time periods
PV : Beginning value OR Present Value
i : Interest rate per unit time period
n : Number of time periods
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Example
If one were to receive 5% per annum compounded interest on $100 for five years,
FV = $100*(1.05)5 = $127.63
Intra-year compounding
If a cash flow is compounded more frequently than annually, then intra-year
compounding is being used. To adjust for intra-year compounding, an interest rate per
compounding period must be found as well as the total number of compounding periods.

The interest rate per compounding period is found by taking the annual rate and dividing
it by the number of times per year the cash flows are compounded. The total number of
compounding periods is found by multiplying the number of years by the number of
times per year cash flows are compounded.
Example
Suppose someone were to invest $10,000 at 8% interest, compounded semiannually,

and hold it for five years.,
Interest rate for compounding period = 8%/2 = 4%

Number of compounding periods = 5*2 = 10
Thus, the future value FV = 10,000*(1+0.04)^10 = $14,802.44
Present value
Present Value is the current value of a future cash flow or of a series of future cash
flows. It is computed by the process of discounting the future cash flows at a
predetermined rate of interest.
If $10,000 were to be received in a year, the present value of the amount would not be
$10,000 because we do not have it in our hand now, in the present. To find the present
value of the future $10,000, we need to find out how much we would have to invest
today in order to receive that $10,000 in the future. To calculate present value, or the
amount that we would have to invest today, we must subtract the (hypothetical)
accumulated interest from the $10,000. To achieve this, we can discount the future
amount ($10,000) by the interest rate for the period. The future value equation given
above can be rearranged to give the Present Value equation:
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PV = FV / (1+I)^n
In the above example, if interest rate is 5%, the present value of the $10,000 which we
will receive after one year, would be:
PV = 10,000/(1+0.05) = $ 9,523.81
Net Present Value (NPV)

Net Present Value (NPV) is a concept often used to evaluate projects/investments using
the Discounted Cash Flow (DCF) method. The DCF method simply uses the time value
concept and discounts future cash flows by the applicable interest rate factor to arrive at
the present value of the cash flows. NPV for a project is calculated by estimating net
future cash flows from the project, discounting these cash flows at an appropriate
discount rate to arrive at the present value of future cash flows, and then subtracting the
initial outlay on the project.
NPV of a project/investment = Discounted value of net cash inflows – Initial

cost/investment. The project/investment is viable if NPV is positive while it is not viable if
NPV is negative.
Example
An investor has an opportunity to purchase a piece of property for $50,000 at the

beginning of the year. The after-tax net cash flows at the end of each year are forecast
as follows:
Year Cash Flow

1 $9,000
2 8,500
3 8,000
4 8,000
5 8,000
6 8,000
7 8,000
8 7,000
9 4,500
10 51,000 (property sold at the end of the 10th year)
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Assume that the required rate of return for similar investments is 15.00%.
NPV = - 50000 + 9000/(1+0.15)^1 + 8500/(1+0.15)^2 + ….. +51000/(1+0.15)^10 = $612.96
However, if we assume that the required rate of return is 16.00%,

NPV = - 50000 + 9000/(1+0.16)^1 + 8500/(1+0.16)^2 + ….. +51000/(1+0.16)^10 =
($1360.77)
Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a
project:
 Increases with increase in future cash inflows for a given initial outlay
 Decreases with increase in initial outlay for a given set of future cash inflows
 Decreases with increase in required rate of return
Internal Rate of Return (IRR)

Internal Rate of Return (IRR), also referred to as ‘Yield’ is often used in capital
budgeting. It is the implied interest rate that makes net present value of all cash flows
equal zero.
In the previous example, the IRR is that value of required rate of return that makes the
NPV equals zero.
IRR = r, where
NPV = - 50000 + 9000/(1+r)^1 + 8500/(1+r)^2 + ….. +51000/(1+r)^10 = $0.00
IRR can be calculated using trial and error methods by using various values for r or
using the IRR formula directly in MS Excel. Here, IRR = 15.30%. In other terms, IRR is
the rate of return at which the project/investment becomes viable.
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2.FINANCIAL INSTRUMENTS
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FINANCIAL INSTRUMENTS
RAISING CAPITAL
Corporations need capital to finance business operations. They raise money by issuing
Securities in the form of Equity and Debt. Equity represents ownership of the company
and takes the form of stock. Debt is funded by issuing Bonds, Debentures and various
certificates. The use of debt is also referred to as Leverage Financing. The ratio of
debt/equity shows a potential investor the extent of a company’s leverage.
Investors choose between debt and equity securities based on their investment
objectives. Income is the main objective for a debt investor. This income is paid in the
form of Interest, usually as semi-annual payments. Capital Appreciation (the increase in
the value of a security over ti[me) is only a secondary consideration for debt investors.
Conversely, equity investors are primarily seeking Growth, or capital appreciation.
Income is usually of lesser importance, and is received in the form of Dividends.
Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on
stock. It also means that if the company ceases to do business and liquidate its assets,
that the debt holders have a senior claim to those assets.
SECURITY
Security is a financial instrument that signifies ownership in a company (a stock), a

creditor relationship with a corporation or government agency (a bond), or rights to
ownership (an option). Financial instruments can be classified into:
 Debt
 Equity
 Hybrids
 Derivatives
DEBT
Debt is money owed by one person or firm to another. Bonds, loans, and commercial
paper are all examples of debt.
Bond
An investor loans money to an entity (company or government) that needs funds for a
specified period of time at a specified interest rate. In exchange for the money, the entity
will issue a certificate, or bond, that states the interest rate (coupon rate) to be paid and
repayment date (maturity date). Interest on bonds is usually paid every six months
(semiannually).
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Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal
Only and Fully Registered Bonds.
Bearer bonds are like cash since the bearer of the bond is presumed to be the owner.
These bonds are Unregistered because the owner’s name does not appear on the bond,
and there is no record of who is entitled to receive the interest payments. Attached to the
bond are Coupons. The bearer clips the coupons every six months and presents these
coupons to the paying agent to receive their interest. Then, at the bond’s Maturity, the
bearer presents the bond with the last coupon attached to the paying agent, and receives
their principal and last interest payment.
Bonds that are registered as to principal only have the owner’s name on the bond
certificate, but since the interest is not registered these bonds still have coupons attached.
Bonds that are issued today are most likely to be issued fully registered as to both interest
and principal. The transfer agent now sends interest payments to owners of record on the
interest Payable Date. Book Entry bonds are still fully registered, but there is no physical
certificate and the transfer agent keeps track of ownership. U.S. Government Negotiable
securities (i.e., Treasury Bills, Notes and Bonds) are issued book entry, with no certificate.
The customer’s Confirmation serves as proof of ownership.
Principal and Interest

Bondholders are primarily seeking income in the form of a semi-annual coupon payment.
The annual rate of return (also called Coupon, Fixed, Stated or Nominal Yield) is noted on
the bond certificate and is fixed. The factors that influence the bond's initial coupon rate
are prevailing economic conditions (e.g., market interest rates) and the issuer's credit
rating (the higher the credit rating, the lower the coupon). Bonds that are In Default are not
paying interest.
Example
 IBM can issue 10 year bonds with a coupon of 5.5%.
 Priceline can issue similar 10 year bonds at 8%
 The difference in coupon is due to their credit rating!
The principal or par or Face amount of the bond is what the investor has loaned to the
issuer. The relative "safety" of the principal depends on the issuer’s credit rating and the
type of bond that was issued.
Corporate bond
A bond issued by a corporation. Corporations generally issue three types of bonds:
Secured Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures.
All corporate bonds are backed by the full faith and credit of the issuer, but a secured
bond is further backed by specific assets that act as collateral for the bond.
In contrast, unsecured bonds are backed by the general assets of the corporation only.
There are three basic types of Secured Bonds:
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Mortgage Bonds are secured by real estate owned by the issuer

Equipment Trust Certificates are secured by equipment owned and used in the issuers
business
Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (usually U.S.
Government securities)
Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor
status; they are the first to be paid principal or interest and are thus the safest of an
issuer’s securities. Unsecured Bonds include debentures and subordinated debentures.
Debentures have a general creditor status and will be paid only after all secured
creditors have been satisfied. Subordinated debentures have a subordinate creditor
status and will be paid after all senior and general creditors have first been satisfied.
Case Study
 Enron set up power plant at Dabhol, India
 The cost of the project (Phase 1) was USD 920 Million
 Funding
o Equity USD 285 mio
o Bank of America/ABN Amro USD 150 mio
o IDBI & Indian Banks USD 95 mio
o US Govt – OPIC USD 100 mio
o US Exim Bank USD 290 mio
 Enron US declared bankruptcy in 2002
 Enron India’s assets are mortgaged to various banks as above.
 Due to interest payments and depreciation, assets are worth considerably
less than USD 920 mio.
 Who will get their money back? And how much?
Municipal bond (Munis)

A bond issued by a municipality. These are generally tax free, but the interest rate is
usually lower than a taxable bond.
Treasury Securities
Treasury bills, notes, and bonds are marketable securities the U.S. government sells in
order to pay off maturing debt and raise the cash needed to run the federal government.
When an investor buys one of these securities, he/she is lending money to the U.S.
government.
Treasury bills are short-term obligations issued for one year or less. They are sold at a
discount from face value and don't pay interest before maturity. The interest is the
difference between the purchase price of the bill and the amount that is paid to the
investor at maturity (face value) or at the time of sale prior to maturity.
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Treasury notes and bonds bear a stated interest rate, and the owner receives semi-
annual interest payments. Treasury notes have a term of more than one year, but not
more than 10 years.
Treasury bonds are issued by the U.S. Government. These are considered safe
investments because they are backed by the taxing authority of the U.S. government,
and the interest on Treasury bonds is not subject to state income tax. T-bonds have
maturities greater than ten years, while notes and bills have lower maturities.
Individually, they sometimes are called "T-bills," "T-notes," and "T-bonds." They can be
bought and sold in the secondary market at prevailing market prices.
Savings Bonds are bonds issued by the Department of the Treasury, but they aren't are
not marketable and the owner of a Savings Bond cannot transfer his security to
someone else.
Zero coupon bonds

Zeros generate no periodic interest payments but they are issued at a discount from face
value. The return is realized at maturity. Zeros sell at deep discounts from face value.
The difference between the purchase price of the zero and its face value when
redeemed is the investor's return. Zeros can be purchased from private brokers and
dealers, but not from the Federal Reserve or any government agency.
The higher rate of return the bond offers, the more risky the investment. There have
been instances of companies failing to pay back the bond (default), so, to entice
investors, most corporate bonds will offer a higher return than a government bond. It is
important for investors to research a bond just as they would a stock or mutual fund. The
bond rating will help in deciphering the default risk.
Commercial paper
An unsecured, short-term loan issued by a corporation, typically for financing accounts
receivable and inventories. It is usually issued at a discount to face value, reflecting
prevailing market interest rates. It is issued in the form of promissory notes, and sold by
financial organizations as an alternative to borrowing from banks or other institutions.
The paper is usually sold to other companies which invest in short-term money market
instruments.
Since commercial paper maturities don't exceed nine months and proceeds typically are
used only for current transactions, the notes are exempt from registration as securities
with the United States Securities and Exchange Commission. Financial companies
account for nearly 75 percent of the commercial paper outstanding in the market.
There are two methods of marketing commercial paper. The issuer can sell the paper
directly to the buyer or sell the paper to a dealer firm, which re-sells the paper in the
market. The dealer market for commercial paper involves large securities firms and
subsidiaries of bank holding companies. Direct issuers of commercial paper usually are
financial companies which have frequent and sizable borrowing needs, and find it more
economical to place paper without the use of an intermediary. On average, direct issuers
save a dealer fee of 1/8 of a percentage point. This savings compensates for the cost of
maintaining a permanent sales staff to market the paper.
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Interest rates on commercial paper often are lower than bank lending rates, and the
differential, when large enough, provides an advantage which makes issuing commercial
paper an attractive alternative to bank credit.
Commercial paper maturities range from 1 day to 270 days, but most commonly is
issued for less than 30 days. Paper usually is issued in denominations of $100,000 or
more, although some companies issue smaller denominations. Credit rating agencies
like Standard & Poor rate the CPs. Ratings are reviewed frequently and are determined
by the issuer's financial condition, bank lines of credit and timeliness of repayment.
Unrated or lower rated paper also is sold in the market.
Investors in the commercial paper market include private pension funds, money market
mutual funds, governmental units, bank trust departments, foreign banks and investment
companies. There is limited secondary market activity in commercial paper, since
issuers can closely match the maturity of the paper to the investors' needs. If the
investor needs ready cash, the dealer or issuer usually will buy back the paper prior to
maturity.
EQUITY
Equity (Stock) is a security, representing an ownership interest. Equity refers to the

value of the funds contributed by the owners (the stockholders) plus the retained
earnings (or losses).
Common stock
Common stock represents an ownership interest in a company. Owners of stock also
have Limited Liability (i.e.) the maximum a shareholder can lose is their original
investment. Most of the stock traded in the markets today is common. An individual with
a majority shareholding or controlling interest controls a company's decisions and can
appoint anyone he/she wishes to the board of directors or to the management team.
Corporations seeking capital sell it to investors through a Primary Offering or an Initial

Public Offering (IPO). Before shares can be offered, or sold to the general public, they
must first be registered with the Securities and Exchange Commission (SEC). Once the
shares have been sold to investors, the shareholders are usually free to sell or trade
their stock shares in the Secondary Markets (such as the New York Stock Exchange –
NYSE). From time to time, the Issuer may choose to repurchase the stock they
previously issued. Such repurchased stock shares are referred to as Treasury Stock,
and the shares that remain trading in the secondary market are referred to as Shares
Outstanding. Treasury Stock does not have voting rights and is not entitled to any
declared dividends. Corporations may use Treasury Stock to pay a stock dividend, to
offer to employees.
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Stock Terminology
Public Offering Price (POP) – The price at which shares are offered to the public in a
Primary Offering. This price is fixed and must be maintained when Underwriters sell to
customers.
Current Market Price – The price determined by Supply and Demand in the Secondary
Markets.
Book Value – The theoretical liquidation value of a stock based on the company's
Balance Sheet.
Par Value – An arbitrary price used to account for the shares in the firm’s balance sheet.
This value is meaningless for common shareholders, but is important to owners of
Preferred Stock.
Example
When Cognizant Technology Solutions came out with its Initial Public Offering on
NASDAQ in June 1998, the Public Offering Price (POP) was set at $10 per share.
The stock was split twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003. As of
Dec 6, 2003, the Current Market Price stood at $46.26. However, if the stock-splits
are taken into consideration the actual market price would stand at 6 times the
Current Market Price at whopping $253.56!!
Preferred Stock
Preference shares carry a stated dividend and they do not usually have voting rights.
Preferred shareholders have priority over common stockholders on earnings and assets
in the event of liquidation . Preferred stock is issued with a fixed rate of return that is
either a percent of par (always assumed to be $100) or a dollar amount.
Although preferred stock is equity and represents ownership, preferred stock investors
are primarily seeking income. The market price of income seeking securities (such as
preferred stock and debt securities) fluctuates as market interest rates change. Price
and yield are inversely related.
There are several different types of preferred stock including Straight, Cumulative,
Convertible, Callable, Participating and Variable. With straight preferred, the preference
is for the current year’s dividend only. Cumulative preferred is senior to straight preferred
and has a first preference for any dividends missed in previous periods.
Convertible preferred stock can be converted into shares of common stock either at a
fixed price or a fixed number of shares. It is essentially a mix of debt and equity, and
most often used as a means for a risky company to obtain capital when neither debt nor
equity works. It offers considerable opportunity for capital appreciation.
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Non-convertible preferred stock remains outstanding in perpetuity and trades like

stocks. Utilities represent the best example of nonconvertible preferred stock issuers.
American Depository Receipts (ADR)

The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is
a receipt for a specified number of foreign shares owned by an American bank. ADRs
trade like shares, either on a U.S. Exchange or Over the Counter. The owner of an ADR
has voting rights and also has the right to receive any declared dividends. An example
would be Infosys ADRs that are traded in NASDAQ.
HYBRIDS
Hybrids are securities, which combine the characteristics of equity and debt.
Convertible bonds
Convertible Bonds are instruments that can be converted into a specified number of
shares of stock after a specified number of days. However, till the time of conversion the
bonds continue to pay coupons.
Case Study
Tata Motors Ltd. (previously know as TELCO) recently issued convertible bond
aggregating to $100 million in the Luxemburg Stock Exchange. The effective interest
rate paid on the issue was just 4% which was much lower than what it would have to
pay if it raised the money in India, where it is based out of. The company would use
this money to pay-back existing loans borrowed at much higher interest rates.
 Why doesn’t every company raise money abroad if it has to pay lower interest
rates? Will there is
 Will there be any effect on existing Tata Motors share-holders due to the
convertible issue? If ‘Yes’, when will this be?
Warrants
Warrants are call options – variants of equity. They are usually offered as bonus or
sweetener, attached to another security and sold as a Unit. For example, a company is
planning to issue bonds, but the market dictates a 9% interest payment. The issuer does
not want to pay 9%, so they “sweeten” the bonds by adding warrants that give the holder
the right to buy the issuers stock at a given price over a given period of time. Warrants
can be traded, exercised, or expire worthless.
DERIVATIVES
A derivative is a product whose value is derived from the value of an underlying asset,
index or reference rate. The underlying asset can be equity, foreign exchange,
commodity or any other item. For example, if the settlement price of a derivative is
based on the stock price, which changes on a daily basis, then the derivative risks are
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also changing on a daily basis. Hence derivative risks and positions must be monitored
constantly.
Forward contract
A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a
certain future time for a certain price. No cash is exchanged when the contract is entered
into.
Futures contract
A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Index futures are all futures contracts where
the underlying is the stock index and helps a trader to take a view on the market as a
whole.
Hedging involves protecting an existing asset position from future adverse price
movements. In order to hedge a position, a market player needs to take an equal and
opposite position in the futures market to the one held in the cash market.
Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he
can earn risk less profits. When markets are imperfect, buying in one market and
simultaneously selling in other market gives risk less profit. Arbitrageurs are always in
the look out for such imperfections.
Options
An option is a contract, which gives the buyer the right, but not the obligation to buy or
sell shares of the underlying security at a specific price on or before a specific date.
There are two kinds of options: Call Options and Put Options.
Call Options are options to buy a stock at a specific price on or before a certain date.
Call options usually increase in value as the value of the underlying instrument rises.
The price paid, called the option premium, secures the investor the right to buy that
certain stock at a specified price. (Strike price) If he/she decides not to use the option to
buy the stock, the only cost is the option premium. For call options, the option is said to
be in-the-money if the share price is above the strike price.
Example
The Infosys stock price as of Dec 6th, 2003 stood at Rs.5062. The cost of the Dec
24th, 2003 expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was
Rs.90. This would mean that to break-even the person buying the Call Option on the
Infosys stock, the stock price would have to cross Rs.5290 as of Dec 24th, 2003!!
Put Options are options to sell a stock at a specific price on or before a certain date.
With a Put Option, the investor can "insure" a stock by fixing a selling price. If stock
prices fall, the investor can exercise the option and sell it at its "insured" price level. If
stock prices go up, there is no need to use the insurance, and the only cost is the
premium. A put option is in-the-money when the share price is below the strike price.
The amount by which an option is in-the-money is referred to as intrinsic value.
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The primary function of listed options is to allow investors ways to manage risk. Their
price is determined by factors like the underlying stock price, strike price, time remaining
until expiration (time value), and volatility. Because of all these factors, determining the
premium of an option is complicated.
Types of Options
There are two main types of options:

 American options can be exercised at any time between the date of purchase
and the expiration date. Most exchange-traded options are of this type.
 European options can only be exercised at the end of their life.
Long-Term Options are options with holding period of one or more years, and they are
called LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to
control and manage risk or even speculate, they are virtually identical to regular options.
LEAPS, however, provide these opportunities for much longer periods of time. LEAPS
are available on most widely-held issues.
Exotic Options: The simple calls and puts are referred to as "plain vanilla" options.
Non-standard options are called exotic options, which either are variations on the payoff
profiles of the plain vanilla options or are wholly different products with "optionality"
embedded in them.
Open Interest is the number of options contracts that are open; these are contracts that
have not expired nor been exercised.
Swaps
Swaps are the exchange of cash flows or one security for another to change the maturity
(bonds) or quality of issues (stocks or bonds), or because investment objectives have
changed. For example, one firm may have a lower fixed interest rate, while another has
access to a lower floating interest rate. These firms could swap to take advantage of the
lower rates.
Currency Swap involves the exchange of principal and interest in one currency for the
same in another currency.
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Case Study
 The World Bank borrows funds internationally and loans those funds to
developing countries. It charges its borrowers a cost plus rate and hence needs
to borrow at the lowest cost.
 In 1981 the US interest rate was at 17 percent, an extremely high rate due to the
anti-inflation tight monetary policy of the Fed. In West Germany the
corresponding rate was 12 percent and Switzerland 8 percent.
 IBM enjoyed a very good reputation in Switzerland, perceived as one of the best
managed US companies. In contrast, the World Bank suffered from bad image
since it had used several times the Swiss market to finance risky third world
countries. Hence, World Bank had to pay an extra 20 basis points (0.2%)
compared to IBM
 In addition, the problem for the World Bank was that the Swiss government
imposed a limit on the amount World Bank could borrow in Switzerland. The
World Bank had borrowed its allowed limit in Switzerland and West Germany
 At the same time, the World Bank, with an AAA rating, was a well established
name in the US and could get a lower financing rate (compared to IBM) in the US
Dollar bond market because of the backing of the US, German, Japanese and
other governments. It would have to pay the Treasury rate + 40 basis points.
 IBM had large amounts of Swiss franc and German deutsche mark debt and thus
had debt payments to pay in Swiss francs and deutsche marks.
 World Bank borrowed dollars in the U.S. market and swapped the dollar
repayment obligation with IBM in exchange for taking over IBM's SFR and DEM
loans.
 It became very advantageous for IBM and the World Bank to borrow in the market
in which their comparative advantage was the greatest and swap their respective
fixed-rate
Case Study funding.
 The World Bank borrows funds internationally and loans those funds to
developing countries. It charges its borrowers a cost plus rate and hence needs
Forward Swapatagreements
to borrow are created through the synthesis of two different swaps,
the lowest cost.
differing in duration, for the
 In 1981 the US interest rate purpose
was atof17
fulfilling
percent,theanspecific
extremelytimeframe
high rateneeds
due toofthean
investor. Sometimes swaps don't perfectly match the needs of investors wishing
anti-inflation tight monetary policy of the Fed. In West Germany theto
hedge certain risks. For example, if an investor wants to hedge for a five-year duration
corresponding rate was 12 percent and Switzerland 8 percent.
beginning one year from today, they can enter into both a one-year and six-year swap,
 IBM enjoyed a very good reputation in Switzerland, perceived as one of the best
creating the forward swap that meets the requirements for their portfolio.
managed US companies. In contrast, the World Bank suffered from bad image
since it had used several times the Swiss market to finance risky third world
Swaptions - An option to enter into an interest rate swap. The contract gives the buyer
countries. Hence, World Bank had to pay an extra 20 basis points (0.2%)
the option to execute an interest rate swap on a future date, thereby locking in financing
compared to IBM
costs at a specified fixed rate of interest. The seller of the swaption, usually a
 In addition,
commercial the problem
or investment bank,for the World
assumes Bank
the risk of was thatrate
interest thechanges,
Swiss government
in exchange
imposed
for payment of a limit on
a swap the amount World Bank could borrow in Switzerland. The
premium.
World Bank had borrowed its allowed limit in Switzerland and West Germany
 At the same time, the World Bank, with an AAA rating, was a well established
name in the US and could get a lower financing rate (compared to IBM) in the US
Dollar bond market because of the backing of the US, German, Japanese and
other governments. It would have to pay the Treasury rate + 40 basis points.
 IBM had large amounts of Swiss franc and German deutsche mark debt and thus
had debt payments to pay in Swiss francs and deutsche marks.
 World Bank borrowed dollars in the U.S. market and swapped the dollar
repayment obligation with IBM in exchange for taking over IBM's SFR and25DEM
Page of 172
loans.
 It became very advantageous for IBM and the World Bank to borrow in the market
in which their comparative advantage was the greatest and swap their respective
fixed-rate funding.
3.FINANCIAL MARKETS
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FINANCIAL MARKETS
WHAT ARE FINANCIAL MARKETS?
A financial transaction is one where a financial asset or instrument, such as cash, check,
stock, bond, etc are bought and sold. Financial Market is a place where the buyers and
sellers for the financial instruments come together and financial transactions take place.
TYPES OF FINANCIAL MARKETS
Primary Markets
Primary market is one where new financial instruments are issued for the first time. They
provide a standard institutionalized process to raise money. The public offerings are
done through a prospectus. A prospectus is a document that gives detailed information
about the company, their prospective plans, potential risks associated with the business
plans and the financial instrument.
Secondary markets
Secondary Market is a place where primary market instruments, once issued, are bought
and sold. An investor may wish to sell the financial asset and encash the investment
after some time or the investor may wish to invest more, buy more of the same asset
instead, the decision influenced by a variety of possible reasons. They provide the
investor with an easy way to buy or sell.
The Different Financial Markets

A financial market is known by the type of financial asset or instrument traded in it. So
there are as many types of financial markets as there are of instruments. Typical
examples of financial markets are:
 Stock market
 Bond (or fixed income) market
 Money market
 Foreign exchange (Forex or FX for short) market (also called the currency
market).
Stock and bond markets constitute the capital markets. Another big financial market is
the derivatives market.
CAPITAL MARKETS
Why businesses need capital?

All businesses need capital, to invest money upfront to produce and deliver the goods
and services. Office space, plant and machinery, network, servers and PCs, people,
marketing, licenses etc. are just some of the common items in which a company needs
to invest before the business can take off. Even after the business takes off, the cash or
money generated from sales may not be sufficient to finance expansion of capacity,
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infrastructure, and products / services range or to diversify or expand geographically.

Some financial services companies need to raise additional capital periodically in order
to satisfy capital adequacy norms.
What is the role of Capital Markets?

For businesses to thrive and grow, presence of vibrant and efficient capital markets is
extremely important. Capital markets have following functions:
1. Channeling funds from “savings pool” to “investment pool” - channeling funds

from “those who have money” to “those who need funds for business purpose”.
2. Providing liquidity to investors - i.e. making it easy for investors, to buy and sell
financial assets or instruments. Capital markets achieve this in a number of ways
and it is particularly important for institutional investors who trade in large quantities.
Illiquid markets do not allow them to trade large quantities because the orders may
simply not get executed completely or may cause drastic fluctuations in price.
3. Providing multitude of investment options to investors – this is important because
the risk profile, investment criteria and preferences may differ for each investor.
Unless there are many investment options, the capital markets may fail to attract
them, thus affecting the supply of capital.
4. Providing efficient price discovery mechanism – efficient because the price is
determined by the market forces, i.e. it is a result of transparent negotiations among
all buyers and sellers in the market at any point. So the market price can be
considered as a fair price for that instrument.
STOCK MARKETS
Stock markets are the best known among all financial markets because of large
participation of the “retail investors”. The important stock exchanges are as follows:
 New York Stock Exchange (NYSE)

 National Association of Securities Dealers Automated Quotations (NASDAQ)
 London Stock Exchange (LSE)
 Bombay Stock Exchange (BSE),
 National Stock Exchange of India (NSE)
Stock Exchanges provide a system that accepts orders from both buyers and sellers in
all shares that are traded on that particular exchange. Exchanges then follow a
mechanism to automatically match these trades based on the quoted price, time,
quantity, and the order type, thus resulting in trades. The market information is
transparent and available real-time to all, making the trading efficient and reliable.
Earlier, before the proliferation of computers and networks, the trading usually took place
in an area called a “Trading Ring” or a “Pit” where all brokers would shout their quotes
and find the “counter-party”. The trading ring is now replaced in most exchanges by
advanced computerized and networked systems that allow online trading, so the
members can log in from anywhere to carry out trading. For example, BOLT of BSE and
SuperDOT of NYSE.
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What determines the share price and how does it change?

The share price is determined by the market forces, i.e. the demand and supply of
shares at each price. The demand and supply vary primarily as the perceived value of
the stock for different investors varies. Investor will consider buying the stock if the
market price is less than the perceived value of the stock according to that investor and
will consider selling if it is higher. A large number of factors have a bearing on the
perceived value. Some of them are:
 Performance of the company
 Performance of the industry to which it belongs
 State of the country’s economy where it operates as well as the global economy
 Market sentiment or mood relating to the stock and on the market as a whole
Apart from these, many other factors, including performance of other financial markets,
affect the demand and supply.
BOND MARKETS
As the name suggests, bonds are issued and traded in these markets. Government
bonds constitute the bulk of the bonds issued and traded in these markets. Bond
markets are also sometimes called Fixed Income markets. While some of the bonds are
traded in exchanges, most of the bond trading is conducted over-the-counter (OTC), i.e.
by direct negotiations between dealers. Lately there have been efforts to create
computer-based market place for certain type of bonds.
Participants in the Bond Market

Since Government is the biggest issuer of bonds, the central bank of the country such as
Federal Reserve in US and Reserve Bank of India in India, is the biggest player in the
bond market. Like stock markets, one needs to be an authorized dealer of Govt.
securities, to subscribe to the bond issues. Typically, the Govt. bond issues are made by
way of auctions, where the dealers bid for the bonds and the price is fixed based on the
bids received. The dealers then sell these bonds in the secondary market or directly to
third parties, typically institutions and companies.
If the interest rate is fixed for each bond, why do the bond prices fluctuate?
Bond prices fluctuate because the interest rates as well as the perceptions of investors
on the direction of interest rates change. Remember, bond pays interest at a fixed
coupon rate determined at the time of issue, irrespective of the prevailing market interest
rate. Market interest rates are benchmark interest rates, such as treasury bill rates,
which are subject to change because of various factors such as inflation, monetary
policy change, etc. So when the prevailing market interest rates change, price of the
bond (and not the coupon) adjusts, so that the effective yield for a buyer at the time (if
the bond is held to maturity) matches the market interest rate on other bonds of equal
tenure and credit rating (risk).
So when the market interest rates go up, prices of bonds fall and vice-versa. Thus, since
price of bonds changes when market interest rate changes, all bonds have an interest
rate risk. If the market interest rates shoot up, then the bond price is affected negatively
and an investor who bought the bond at a high price (when interest rates were low)
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stands to lose money or at least makes lesser returns than expected, unless the bond is
held to maturity.
Example
Bond Price calculation can be summed by an easy formula:
where B represents the price of the bond and CFk represents the kth cash flow which
is made up of coupon payments. The Cash Flow (CF) for the last year includes both
the coupon payment and the Principal.
 What would be the bond price for a 3-Year, Rs.100 principal, bond when the
interest rate (i) is 10% and the Coupon payments are Rs.5 annually?
 Would the bond price increase/decrease if the coupon is reduced? What would
be happen to bond price if the interest rates came down?

FOREIGN EXCHANGE MARKET
Foreign exchange markets are where the foreign currencies are bought and sold. For
example, importers need foreign currency to pay for their imports. Government needs
foreign currency to pay for its imports such as defense equipment and to repay loans
taken in foreign currency.
Foreign exchange rates express the value of one currency in terms of another. They
involve a fixed currency, which is the currency being priced and a variable currency, the
currency used to express the price of the fixed currency. For example, the price of a US
Dollar can be expressed in different currencies as: USD (US Dollar) 1 = Indian Rupee
(INR) 46, USD 1 = Great Britain Pound (GBP) 0.6125, USD 1 = Euro 0.8780 etc. In this
example, USD is the fixed currency and INR, GBP, Euro are the variable currencies.
US Dollar, British Sterling (Pound), Euro and Japanese Yen are the most traded
currencies worldwide, since maximum business transactions are carried out in these
currencies.
The exchange rate at any time depends upon the demand – supply equation for the
different currencies, which in turn depends upon the relative strength of the economies
with respect to the other major economies and trading partners.
Participants
Only authorized foreign exchange dealers can participate in the foreign exchange
market. Any individual or company, who needs to sell or buy foreign currency, does so
through an authorized dealer. Currency trading is conducted in the over-the-counter
(OTC) market.
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The role of the Central Bank in the foreign exchange market

The central bank regulates the markets to ensure its smooth functioning. The degree of
regulation depends on the economic policies of the country. The central bank may also
buy or sell their currency to meet unusual demand – supply mismatches in the markets.
The foreign exchange rate and transactions are closely monitored because the
fluctuations in forex markets affects the profitability of imports and exports of domestic
companies as well as profitability of investments made by foreign companies in that
country. Regulators try to ensure that the fluctuations are not caused by any factor other
than the market forces.
Example
The Bank of Japan plays the role of central bank in Japan. It strictly monitors the
exchange rates to ensure that the importers/exporters are not hurt due to any
exchange rate fluctuations. Still, the USD/JPY, which is the second most traded
currency pair in the world, maintains a long-standing reputation of sharp increases in
short-term volatilities.
MONEY MARKET
Money market is for short term financial instruments, usually a day to less than a year.
The most common instrument is a “repo”, short for repurchase agreement. A repo is a
contract in which the seller of securities, such as Treasury Bills, agrees to buy them back
at a specified time and price. Treasury bills of very short tenure, commercial paper,
certificates of deposits etc. are also considered as money market instruments.
Since the tenure of the money market instruments is very short, they are generally
considered safe. In fact they are also called cash instruments. Repos especially, since
they are backed by a Govt. security, are considered virtually the safest instrument.
Therefore the interest rates on repos are the lowest among all financial instruments.
Money market instruments are typically used by banks, institutions and companies to
park extra cash for a short period or to meet the regulatory reserve requirements. For
short-term cash requirements, money market instruments are the best way to borrow.
Participants
Whereas in stock market the typical minimum investment is equivalent of the price of 1
share, the minimum investment in bond and money markets runs into hundreds of
thousands of Rupees or Dollars. Hence the money market participants are mostly banks,
institutions, companies and the central bank. There are no formal exchanges for money
market instruments and most of the trading takes place using proprietary systems or
shared trading platforms connecting the participants.
REGULATION OF CAPITAL MARKETS
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There are many reasons why the financial markets are regulated by governments:
 Since the capital markets are central to a thriving economy, Governments need
to ensure their smooth functioning.
 Governments also need to protect small or retail investors’ interests to ensure
there is participation by a large number of investors, leading to more efficient
capital markets.
 Governments need to ensure that the companies or issuers declare all necessary
information that may affect the security prices and that the information is readily
and easily available to all participants at the same time.
Typically the government designates one or more agencies as regulator(s) and

supervisor(s) for the financial markets. Thus India has Securities and Exchange Board of
India (SEBI) and the US has Securities and Exchange Commission (SEC). These
regulatory bodies formulate rules and norms for each activity and each category of
participant. For example,
 Eligibility norms for a company to be allowed to issue stock or bonds,

 Rules regarding the amount of information that must be made available to
prospective investors,
 Rules regarding the issue process,
 Rules regarding periodic declaration of financial statements, etc.
Regulators also monitor the capital market activity continuously to ensure that any
breach of laws or rules does not go unnoticed. To help this function, all members and
issuers have to submit certain periodic reports to the regulator disclosing all relevant
details on the transactions undertaken.
FINANCIAL MARKET SYSTEMS
The demands of the capital market transactions, the need for tracking and managing
risks, the pressure to reduce total transaction costs and the obligation to meet
compliance requirements make it imperative that the functions be automated using
advanced computer systems. Some of the major types of systems in capital market firms
are briefly described below.
Trading Systems
The volume of transactions in capital markets demands advanced systems to ensure
speed and reliability. Due to proliferation of Internet technology, the trading systems are
also now accessible online allowing even more participants from any part of the world to
transact, helping to increase efficiency and liquidity. The trading systems can be divided
into front-end order entry and back-end order processing systems.
Order entry systems also offer functions such as order tracking, calculation of profit and
loss based on real-time price movements and various tools to calculate and display risk
to the value of investments due to price movement and other factors.
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Back-office systems validate orders, route them to the exchange(s), receive messages
and notifications from the exchanges, interface with external agencies such as clearing
firm, generate management, investor and compliance reports, keep track of member
account balances etc.
Exchange systems
The core exchange system is the trading platform that accepts orders from members,
displays the price quotes and trades, matches buy and sell orders dynamically to fill as
many orders as possible and sends status messages and trade notifications to the
parties involved in each trade. In addition, exchanges need systems to monitor the
transactions, generate reports on transactions, keep track of member accounts, etc.
Portfolio Management Systems

These systems allow the investment managers to choose the instruments to invest in,
based on the requirements or inputs such as amount to be invested, expected returns,
duration (or tenure) of investment, risk tolerance etc. and analysis of price and other
data on the instruments and issuers. The term “portfolio” refers to the basket of
investments owned by an investor. A portfolio of investments allows one to diversify risks
over a limited number of instruments and issuers.
Accounting Systems
The accounting systems take care of present value calculations, profit & loss etc.- of
investments and funds and not the financial accounts of the firms.
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SUMMARY
 Financial markets facilitate financial transactions, i.e. exchange of financial

assets such stocks, bonds, etc.
 Financial markets bring buyers and sellers in a financial instrument together, thus
reducing transaction costs, channeling funds, improving liquidity and provide a
transparent price discovery mechanism.
 Each financial market is segmented into a Primary market, where new
instruments are issued and a Secondary market, where the previously issued
instruments are bought and sold by investors.
 Stock markets, bond markets, money markets, foreign exchange markets and
derivatives markets are prominent examples of financial markets.
 Shares (stock) of a company are issued and traded in the stock markets.
 Bond markets are where bonds such as treasury bonds, treasury notes,
corporate bonds, etc. are traded.
 Money markets, like bonds markets, are also fixed income markets. Instruments
traded in money markets have very short tenure.
 Foreign exchange markets trade in currencies.
 Derivatives markets trade derivatives, which are complex financial instruments,
whose returns are based upon the returns from some other financial asset called
as the underlying asset.
 Price of any financial instrument depends basically on demand and supply, which
in turn depend upon multiple different factors for different markets.
 Each financial instrument has a differing level of inherent risk associated with it.
Money market instruments are considered the safest due to their very short
tenure.
 Regulators play a very important role in the development and viability of financial
markets. Regulators try to ensure that the markets function in a smooth,
transparent manner, that there is sufficient and timely disclosure of information,
that the interest of small investors is not compromised by the large investors, and
so on, which is critical for overall vibrancy, efficiency and growth of the market
and the economy.
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4.RISK MANAGEMENT
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RISK MANAGEMENT
A ship is safe in the harbor…But that is not what ships are built for!
Risk is any element of the operating environment that can cause loss or failure. Risks
are difficult to define and they keep changing constantly. For example, if we ask two
derivative traders to identify the biggest risks faced by them, we may get different
answers.
Let us look at an example of an Export Oriented Unit. Most or all of their revenue is
earned in foreign exchange where as costs are in domestic currency. Expenses like cost
of raw material, salaries, are paid out in Indian Rupees. If rupee appreciates
significantly, the exporter’s profits may be significantly affected. This is summarized with
a numerical example in the following table:
Scenario 1 Scenario 2
INR/USD 50 45
Revenues in USD 100 million 100 million
Revenues in INR 5000 million 4500 million
Costs 4000 million 4000 million
Net Profit 1000 million 500 million
A 10% appreciation in rupee resulted in a 50% drop in profits. This is a case of

exchange rate risk. Of course, in times of dollar appreciation, the firm will end up making
pots of money!
THE RISK REWARD PRINCIPLE
The higher the risk you take, the higher is the potential reward and the lower the
risk, the lower is the potential reward. The lower the credit rating of the borrower, the
higher is the risk of lending money but higher also is the interest rate that can be
charged! Note that the word used here is “potential reward”. There is no set formula to
say how much reward will justify a certain amount of risk. Also, sometimes the reward
may depend upon the person’s or the organization’s ability to take advantage. However,
the risk-reward principle should be the guiding principle while deciding on a risk
management strategy.
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THREE PILLARS OF RISK MANAGEMENT
Define
What are the risks?
Measure Manage
How to estimate the risk? Set tolerance limits and act
DEFINING RISKS
The following are some of the possible risk types.
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Credit risk is the possibility of loss as a result of default, such as when a customer
defaults on a loan, or more generally, any type of financial contract.
Liquidity risk is the possibility that a firm will be unable to generate funds to meet
contractual obligations as they fall due.
Operational risk is the possibility of loss resulting from errors in instructing payments or
settling transactions.
Legal risk is the possibility of loss when a contract cannot be enforced -- for example,
because the customer had no authority to enter into the contract or the contract turns out
to be unenforceable in a bankruptcy.
Market risk is the possibility of loss over a given period of time related to uncertain
movements in market factors, such as interest rates, currencies, equities, and
commodities.
MEASURING RISKS
Once the risks have been identified, the next step is to choose the quantitative and
qualitative measures of those risks. Risk is essentially measured in terms of the
following factors:
a. The probability of an unfavorable event occurring (expressed as a number
between 0 and 1)
b. The estimated monetary impact on organization because of the event
The unfavorable events differ for different types of risk. For example, in case of market
risk, future events refer to market scenarios. These scenarios impact each portfolio
prices differently depending on its composition.
Risk measurement is a combination of management, quantitative analysis and

information technology. Serious technology investment is required for accurate
measurement and reporting.
One of the commonly used methodologies for market risk is “Value At Risk”
Value at Risk (VaR)
Value at Risk is an estimate of the worst expected loss on a portfolio under normal
market conditions over a specific time interval at a given confidence level. It is also a
forecast of a given percentile, usually in the lower tail, of the distribution of returns on a
portfolio over some period. VaR answers the question: how much one can lose.
Another way of expressing this is that VaR is the lowest quantile of the potential losses
that can occur within a given portfolio during a specified time period. For an internal risk
management model, the typical number is around 5%. Suppose that a portfolio manager
has a daily VaR equal to $1 million at 1%. This means that there is only one chance in
100 that a daily loss bigger than $1 million occurs under normal market conditions.
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Suppose portfolio manager manages a portfolio which consists of a single asset. The
return of the asset is normally distributed with annual mean return 10% and annual
standard deviation 30%. The value of the portfolio today is $100 million. We want to
answer various simple questions about the end-of-year distribution of portfolio value:
1. What is the distribution of the end-of-year portfolio value?

2. What is the probability of a loss of more than $20 million dollars by year end?
3. With 1% probability what is the maximum loss at the end of the year? This is the VaR
at 1%.
Value-at-Risk (VaR) is an integrated way to deal with different markets and different
risks and to combine all of the factors into a single number which is a good indicator of
the overall risk level.
Example Monte-Carlo Simulation
VaR Calculation
Monte-Carlo simulation is a computation process that utilizes random numbers to
A derive
generican step-wise
outcome. approach
So insteadto calculate
of havingwould be:inputs, probability distributions are
fixed
 assigned
Get price to data
some fororyou
all portfolio holdings.
of the inputs. This will generate a probability distribution for
 theConvert
output price
after the
datasimulation is ran.data.
in to log return Here(Log
is anReturn:
example.
ui = ln (Si / Si-1) where Si is the
price of the asset on day i)
 A Calculate
firm that sells product
standard X under
deviations of aeach
pure/perfect
instrument competition market* wants to know
or each proxy.
 theCalculate
probability distribution
preferred for the level.
confidence profit of
99%this= product and the probability
2.33 * standard deviation. that the firm
 willMultiply
loss money when
position marketing
holdings it. respective Standard Deviation at a 99% confidence
by their
The equation
level. for theinprofit
This results is: TP
a position VaR = TR
at a- 99%
TC = confidence
(Q*P) - (Q*VC+FC)
level.
Assumptions:
Example VaR Calculation
 The Quantity Demanded (Q) fluctuates between 8,000 and 12,000 units
Assume thatsimilar
All other you have a holding
Output factorsinare
IBMalso
Stock worth $10
simulated million.
to reflect theYou have calculated
change.
the standard deviation (SD) of change over one day in IBM is $ 0.20.
Therefore for the entire

A simple simulation position,isSD
worksheet of change
prepared over
to with 1 dayiterations
50000 = $200,000
for Q. It shows the
The
profitSDnumber
of change overfrequency)
(with 10 days = $200,000 * √(10)scenarios
under various = $632,456of quantity sold. This
translates into a near Normal Curve with a Mean and Standard Deviation.
The 99% VaR over 10 days = 2.33 * 632,456 = $1,473,621
Using the required confidence interval from the normal curve and the standard
deviation, a VaR limit is generated from this distribution.
A. Monte-Carlo Simulation
It is a simulation technique. First, some assumptions about the distribution of changes in
market prices and rates (for example, by assuming they are normally distributed) are
made, followed by data collection to estimate the parameters of the distribution. The
Monte Carlo then uses those assumptions to give successive sets of possible future
realizations of changes in those rates. For each set, the portfolio is revalued. When
done, you've got a set of portfolio revaluations corresponding to the set of possible
realizations of rates. From that distribution you take the 99th percentile loss as the VaR.
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B. Historical Simulation
Like Monte Carlo, it is a simulation technique, but it skips the step of making
assumptions about the distribution of changes in market prices and rates. Instead, it
assumes that whatever the realizations of those changes in prices and rates were in the
past is the best indicator for the future.
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It takes those actual changes, applies them to the current set of rates and then uses
those to revalue the portfolio. When done, you've got a set of portfolio revaluations
corresponding to the set of possible realizations of rates. From that distribution, we can
calculate the standard deviation and take the 99th percentile loss as the VaR.
C. Variance-Covariance method
This is a very simplified and speedy approach to VaR computation. It is so, because it
assumes a particular distribution for both the changes in market prices and rates and the
changes in portfolio value. It incorporates the covariance matrix (correlation effects
between each asset classes) primarily developed by JP Morgan Risk Management
Advisory Group in 1996. It is often called Risk Metrics Methodology. It is reasonably
good method for portfolio with no option type products. Thus far, it is the computationally
fastest method known today. But this method is not suited for portfolio with major option
type financial products.
MANAGING RISKS
There are multiple strategies to manage risks. Some of the commonly followed ones are:
1. Diversification
2. Hedging or Insurance
3. Setting Risk Limits
4. Ignore the risk!
All the above strategies will reduce the risk – but may not eliminate them. The top
management will determine its risk policy (i.e.) its appetite for risk. The Risk Manager in
a bank will be responsible for identifying the risks, setting up tolerance limits, measuring
the risk on a day to day basis and take action whenever the limits are breached.
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SUMMARY
 Risk, defined as the deviation from expectation, is an extremely important
concept for financial services industry.
 The nature of banking business gives rise to many different risks in this business.
Credit risk, Liquidity risk, Operational risk, Legal risk, Market risk are some
examples.
 Risk management is a 3-step process: Defining, Measuring and Managing risks.
Risk is measured in terms of the probability and the potential monetary impact
should the adverse event occur.
 Risk measurement is a combination of management, quantitative analysis and
information technology. Serious technology investment is required for accurate
measurement and reporting. One of the commonly used methodologies for
market risk is “Value at Risk”
 There are multiple ways of managing risks. Rejecting credit if the credit rating is
bad is one operational measure to avoid high risk. Diversification spreads the
total risk to the business over multiple markets, thus reducing the impact of risk
from any one market on the overall business. Another way to reduce risk is to
transfer or trade the risk, for example by buying insurance.
 However, any risk reduction measure has its own cost. Therefore, one has to
achieve a balance between the cost of risk management and the benefit of those
risk reduction measures.
 Risk managers aim to reduce the risk to a manageable and known level through
various risk reduction measures. They use risk management systems to track
and analyze the risks.
 A good risk management system not only calculates the risk based on a set of
parameters, but also allows the risk managers to drill down the risk to lowest
components, carry out sensitivity, what-if analyses, generates customizable
reports and sends alerts automatically when the risk crosses a defined tolerance
limit.
 The Risk Manager in a bank will be responsible for identifying the risks, setting
up tolerance limits, measuring the risk on a day to day basis and take action
whenever the limits are breached.
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5.INTRODUCTION TO BANKING
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INTRODUCTION TO BANKING
WHAT IS A BANK?
The term ‘Bank’ is used generically to refer to any financial institution that is licensed to
accept deposits and issue credit through loans.
Banks are the backbone of any economy, as all monetary transactions end up touching
banks. The main functions of banks are to:
 Channelize Savings
 Provide credit facilities to borrower
 Provide investment avenues to investors
 Facilitate the trade and commerce dealings
 Provide financial backbone to support economic growth of the country
 Minimize Cash Transactions
 Provide Services
WHY DO WE NEED A BANK?
 They provide a return (pay interest) on our saving

 Safety of principal and interest
 Convenience of being able to write checks and use debit cards
 Raising funds when we need
From the business or economic point of view, however, banks are the primary source of
finance. Since the deposits of the small investors are protected, bank deposits are
considered a low risk investment avenue. Due to their access to a large source of funds
at very low cost, owing largely to the low interest rate on savings and term deposits,
banks are in the best position to lend to businesses and individuals at competitive
interest rates.
WHAT IS THE CENTRAL BANK AND WHAT ARE ITS ROLES?
The Central bank of any country can be called the banker’s bank. It acts as a regulator
for other banks, while providing various facilities to facilitate their functioning. It also acts
as the Government’s bank. The Federal Reserve is the central bank of the United
States, while Reserve Bank of India is the central bank in India.
The main objective of a central bank is to provide the nation with a safer, more flexible,
and more stable monetary and financial system. They have the following responsibilities:
 Conducting the nation's monetary policy. Central banks define the monetary
policy and then take necessary actions to create an environment to make those
policies feasible. E.g. if the central bank wants to maintain soft interest rate, they
can reduce the CRR to pump in more money in the economy.
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 Supervising and regulating banking institutions and protecting the rights of

consumers
 Maintaining the stability of the financial system, i.e. stability of interest rates and
foreign exchange rate.
 Ensuring that the interest rates remain at such a level as to make business viable
 Ensuring that sufficient funds are available for long term investment to
businesses as well as government, without causing inflation to rise
 Providing certain financial services to the government, the public, financial
institutions, and foreign official institutions
 Monitoring the foreign currency assets and liabilities and monitoring the inflow
and outflow of foreign currency
BANKS, ECONOMY AND AMOUNT OF MONEY
Banks facilitate the creation of money in the economy. The primary function of banks is
to put account holders' money to use by lending it out to others who can then use it to
buy homes, businesses etc.
Let’s look at an example as how banks do this. The amount of money that banks can
lend is directly affected by the reserve requirement set by the Central Bank. That is,
every bank needs to maintain a certain percentage of its total deposits as cash, to
ensure liquidity. This reserve requirement is also known as the CRR (Cash Reserve
Ratio). When a bank gets a deposit of $100, assuming a reserve requirement of 10%,
the bank can then lend out $90. That $90 goes back into the economy, purchasing
goods or services, and usually ends up deposited in another bank. That bank can then
lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods
or services and ultimately is deposited into another bank that proceeds to lend out a
percentage of it. In this way, money grows and flows throughout the community in a
much greater amount than physically exists. This is also called multiplier effect. In the
picture below, an initial deposit of $100 has created a reserve of $27, and loan of $244.
Thus, banks facilitate the investing/spending of money that multiply funds through
circulation and this is known as “Money Multiplier” effect.
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HOW DO BANKS MAKE MONEY?
Banks are like any other regulated business; the product they deal with is “Money”. So
they borrow money from individual or businesses “who have money”, and lend it to those
“who need money”, by adding a mark up, to pay for expenses and profit. The difference
between the rates, which banks offer to depositors and lenders, is generally referred to
as “Spread”. Understandably, the spread in this business is low; hence increasing the
turnover (volume) is the key to making profit. Hence, in practice, banks offer a number of
options – often termed as “products” - to both investors and borrowers to meet their
different requirements and preferences and thus increase business. They also provide
fee-based services such as managing cash for corporate clients, to increase business
and improve profit margin.
SERVICE OFFERINGS OF BANKS
Service offerings of banks are organized along following divisions:
 Corporate Banking
 Trade Finance
 Cash Management
 Retail Banking
 Electronic Banking
 Credit Card services
 Retail Lending – Personal Loans, Home Mortgages, Consumer Loans,
Vehicle Loans
 Private Banking
 Asset Management
 Investment Banking
 Private Equity
 Corporate Advisory
 Capital Raising
 Proprietary Trading
 Emerging Markets
 Sales, Trading & Research
 Equity
 Fixed Income
 Derivatives
TOP 50 BANKS IN THE US BY ASSET SIZE

As of March 2004 ($ Million)
Si no. Company Name Total Assets Total Deposits
1 Citigroup, Inc. 1,317,877 499,189
2 J.P. Morgan Chase & Co. 1,120,668 502,826
3 Bank of America Corporation 1,016,247 573,356
4 Wachovia Corporation 410,991 232,338
5 Wells Fargo & Company 397,354 248,369
6 U.S. Bancorp 192,093 118,964
7 SunTrust Banks, Inc. 148,283 96,661
8 National City Corporation 128,400 77,122
9 ABN AMRO North America
Holding Company* 127,154 53,289
10 HSBC North America Inc.* 125,950 86,248
11 Citizens Financial Group, Inc.* 118,986 84,764
12 BB&T Corporation 94,282 64,125
13 Fifth Third Bancorp 93,732 55,250
14 State Street Corporation 92,896 53,512
15 Bank of New York Company, Inc. 92,693 55,961
16 KeyCorp 84,448 49,931
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17 Regions Financial Corporation 80,275 54,170

18 PNC Financial Services Group,
Inc. 74,115 48,125
19 Merrill Lynch Bank USA* 66,643 53,208
20 MBNA Corporation* 59,126 31,861
21 Comerica Incorporated 54,468 43,523
22 SouthTrust Corporation 52,673 35,515
23 M&T Bank Corporation 50,832 33,341
24 AmSouth Bancorporation 47,415 31,545
25 UnionBanCal Corporation 46,102 39,006
26 BancWest Corporation* 43,814 30,794
27 Northern Trust Corporation 40,179 28,448
28 Bankmont Financial Corp.* 38,767 21,908
29 Popular, Inc. 38,102 18,603
30 Marshall & Ilsley Corporation 35,476 23,151
31 Mellon Financial Corporation 33,898 20,306
32 Huntington Bancshares
Incorporated 33,875 20,935
33 Zions Bancorporation 29,790 21,486
34 Compass Bancshares, Inc. 27,481 16,524
35 First Horizon National Corporation 27,084 17,712
36 Banknorth Group, Inc. 26,880 17,958
37 North Fork Bancorporation, Inc. 26,178 19,164
38 Commerce Bancorp, Inc. 24,955 22,883
39 Capital One Bank 24,515 12,213
40 Synovus Financial Corp. 22,286 16,214
41 American Express Centurion
Bank 20,413 8,858
42 Associated Banc-Corp 19,254 12,375
43 RBC Centura Banks, Inc. 19,232 9,347
44 Discover Bank 19,107 13,490
45 Hibernia Corporation 18,717 14,882
46 TD Waterhouse Group, Inc. 17,007 9,630
47 Colonial BancGroup, Inc. 16,499 10,050
48 Webster Financial Corporation 15,090 8,638
49 Commerce Bancshares, Inc. 14,485 10,253
50 Merrill Lynch Bank & Trust
Company 14,377 12,252
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UNIVERSAL BANKING
The universal banking concept permits banks to provide commercial bank services, as
well as investment bank services at the same time.
Glass-Steagall Act of 1933, created a Chinese wall between commercial banking and
securities businesses in US. That act was intended to address the perceived causes of
bank failures during the Great Depression of 1929.
Today, Glass-Steagall restrictions have become outdated and unnecessary. It has
become clear that promoting stability and best practices cannot be done through
artificially separating these business areas. Over the years, banks and securities firms
have been forced to find various loopholes in the Glass-Steagall barriers. The
restrictions undermined the ability of American banks to compete with the other global
banks which were not covered by such legislation.
Most of Glass-Steagall provisions have been repealed in the US in 1990s enabling the
banks to offer a full range of commercial and investment banking services to their
customers.

Example
In the late 1990s, before legislation officially eradicated the Glass-Steagall Act’s
restrictions, the investment and commercial banking industries witnessed an
abundance of commercial banking firms making forays into the I-banking world. The
mania reached a height in the spring of 1998. In 1998, NationsBank bought
Montgomery Securities, Société Génerale bought Cowen & Co., First Union bought
Wheat First and Bowles Hollowell Connor, Bank of America bought Robertson
Stephens (and then sold it to BankBoston), Deutsche Bank bought Bankers Trust
(which had bought Alex. Brown months before), and Citigroup was created in a
merger of Travelers Insurance and Citibank.
While some commercial banks have chosen to add I-banking capabilities through
acquisitions, some have tried to build their own investment banking business. J.P.
Morgan stands as the best example of a commercial bank that has entered the I-
banking world through internal growth. J.P. Morgan actually used to be both a
securities firm and a commercial bank until federal regulators forced the company to
separate the divisions. The split resulted in J.P. Morgan, the commercial bank, and
Morgan Stanley, the investment bank. Today, J.P. Morgan has slowly and steadily
clawed its way back into the securities business, and Morgan Stanley has merged
with Dean Witter to create one of the biggest I-banks on the Street.
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SUMMARY
 Banks are an integral part of any economy channelizing savings from lenders to
borrowers
 Bank deposits are low risk investments
 The Central bank is the “Bankers’ Bank” and it regulates other banks in an
economy.
 Central banks define a nation’s monetary policy
 A bank makes a profit by investing or lending money that is earning a higher rate
of interest than it pays to its depositors.
 A bank is required to keep a certain amount of "cash reserves" by regulation to
maintain liquidity, i.e. to ensure that the banking system does not face a cash
crunch due to higher withdrawals, which can lead to panic among investors and a
run on a bank.
 Banks create a “Money Multiplier” effect
 Banks are generally organized as corporate banking, investment banking, retail
banking, and private banking functions.
 Universal banks provide commercial banking as well as investment bank
services under one roof
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6.RETAIL BANKING
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RETAIL BANKING
RETAIL LENDING
Retail Lending is one of the most important functions performed by a bank. It
encompasses the following:
1. Personal loans, consumer loans
2. Asset based loans - auto loans, home loans
3. Open ended loans
4. Lease, Hire Purchase
5. Credit cards
Personal Loans / Consumer Loans

Personal loans are amount borrowed by individuals to cover their personal expenses.
The details of such expenses are never of any interest to the lenders.
 The financer is not interested in the intention of the loan.
 No security
 Short term loans
 Rate of interest is very steep.
 Ideally should be used only in case of an emergency
 All banks/finance companies offer these loans
 Loan amount is directly linked to borrower’s repayment capacity.
Asset Based Loans

Such loans are amount borrowed by individuals to buy some asset, which is
hypothecated to the lender. Thus the lender is fully aware of the purpose of the loan.
The interest rate charged is lower than personal loans because the loan is secured by
the hypothecation of the asset to the lender.
Two main types – auto loans, housing loans

 Interest rate is lower as compared to Personal loans
 Hypothecation of the Asset to the financer.
 Repayment through EMI’s.
 Thumb rules for calculation of Maximum loan amount
a. Not greater than 3 times the yearly income OR
b. The EMI should be less than 60 pct of the gross monthly income.
Loan against Securities

 Overdraft facility can be availed against pledge of equity Shares, Mutual Fund units.
 Drawing power is usually 60-70 % of the value of the pledged instruments.
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Open Ended Loans

Open ended loan allow the borrower to borrow additional amount subject to the
maximum amount less then a set value.
 Similar to overdraft facilities provided by banks.
 Interest is calculated on the daily outstanding balance.
 Usually a card (similar to a Credit Card) is issued by the lending institution.
 The lending institution has tie-ups with various merchant establishments.
 Also allow you to withdraw Cash.
 Important Terms;
a. Limit (L) – max outstanding allowed
b. Margin (M) – percentage of limit that can be drawn
c. Asset value (AV) – value of underlying asset
d. Drawing Power (DP) - lower of L and (1-M)*AV
 Example:
Limit =$ 1000; Margin = 30%; Asset Value (initial) = $1000
Date Asset Value (AV) Drawing Power (DP)
1st Jan 2004 $1000 $700
1st Feb 2004 $1600 $1000
1st Mar 2004 $2000 $1000
1st Apr 2004 $500 $350
Lease / Hire Purchase

Lease is a long-term rental agreement for the asset, while Hire Purchase is allows the
user to own the asset after all the payments have been made to the lender.
Lease
 Two main types – operating, financial
 The Financier owns the asset.
 Depreciation is claimed by the financier.
 Tax deduction can be claimed for the full value of the rental paid.
 Financier takes care of maintenance, insurance etc.
Hire Purchase
 The asset is owned by the financier.
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 Depreciation can be claimed by the borrower.

 Tax deduction can be claimed only to the extent of the interest repayment.
Retail Lending Cycle

Loan application management and processing
Receipt of loan/card application
Application Processing
 Duplicate check
 Negative list check
 Document Verification
 Calculate loan eligibility, IRR, processing fees
 Credit scoring
 Field Investigation
 Credit Approval
Disbursement
 Cheque issuance
 Credit to account
 Payment to third party
Formulating the repayment schedule.
Loan repayments and termination

Post-Dated Cheques
 PDC’s are collected & their information captured.
 Cheques are presented in clearing on due dates
 Bounced/ hold cheques are marked for further action.
Salary deductions
 Employer wise receipt batches are created.
 Employer cheque details are captured
 Payment receipt is marked for corresponding employees.
Direct receipts
 Cash/Cheque information is captured
 Cheques are cleared in batches.
Auto payments / Direct debits
 Bank wise receivable batches are created.
 Short receipts are marked.
 Release receipt batch to mark receipts
Kinds of repayments
 EMI – same installment amount
 Fixed Principal – constant principal, decreasing interest amt
 Step-up – principal amount increases in steps
 Step-down – principal amount decreases in steps
 Balloon – notional amount initially, large last payment
 Bullet – interest payment initially, entire principal at one shot
 Random – schedule & amount of installments undecided
 Special products – combination of above
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Delinquencies identification and collections

Case Processing
 Categorization of cases based on predefined rules
 Allocation of cases to collectors
Standard Cases
 Collector follow-up (desk/field)
 Repayment by customer
 Cheque issuance
Exception Cases (death/fraud etc.)
 Initiate process based on case specifics (legal/other means)
 Track/follow up the case developments till repayment
 Case closed
Submit Proposal Scrutinize OK Appraisal
Repayment NO Follow-up/Action
Decision
Monitoring OK
Disbursement Compliance Conditions for borrower
Interest Rates
Fixed Rate of Interest

The rate of interest applicable is guaranteed not to change during the fixed rate period.
Borrower & bank protected from adverse interest rate movements.
Floating Rate of Interest

The rate of interest is linked to one of the rates prevailing in the market, for example it
can be linked to PLR (Prime Lending Rate) or LIBOR (London Interbank Offered Rate).
Borrower benefits from falling int. rate, exposed to upward movement of int. rate.
Important terms are; Cap, floor, collar, benchmark/base/anchor rate, mark-up/spread

rate, reset date & frequency
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Cap
Current rate
Interest rate 
Spread
Collar
Base rate
Floor
Collateral
An asset than can be repossessed by the lender if the borrower defaults. They are of the
following types
 Primary (same asset for which finance is taken)
 Secondary (asset backing the loan different)
Charge Types
 Pledge – gold, bank has possession
 Hypothecation – vehicle, borrower has possession
 Lien – against bank deposits
 Assignment – insurance policies, rights get transferred to bank
 Shares - periodic drawing power calculation
 Mortgage – immovable property
MORTGAGES
A loan secured by the collateral of some specified real estate property that obliges the
borrower to make a predetermined series of payments. If the borrower doesn’t keep up
the loan repayments, the lender can repossess the real estate property and sell it in
order to get the money back.
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The rate of interest applicable is lower than personal loans and comparable to other
asset based loans.
To compare the cost of different Mortgages deals one should look at the APR – Annual
Percentage Rates. All firms that quote an APR must calculate it in a standard way, so
one can compare like with like. The APR for a loan is a single figure, which takes into
account:
 The amount of interest you are charged
 When and how often the interest must be paid
 Other charges – for example, an arrangement fee or compulsory payment
protection insurance – if they must be bought from the lender as a condition of
the loan
 When and how often these charges must be paid
Kinds of Mortgages
Mortgages can be classified based on the interest rates deals:
Interest Rate Deal How it works
Standard variable The payments go up and down as the mortgage rate changes.
rate
Standard variable Same as a standard variable rate loan - but one receive a
rate with cash back substantial cash sum (Example 3–5% of the amount borrowed)
when you take up the loan.
Base rate tracker Similar to a standard variable rate mortgage but the interest rate
is guaranteed to be a set amount above the base rate and alters
in line with changes in that rate.
Fixed interest rate The payments are set at a certain level for a set period of time –
for example, one year, two years, or five years. At the end of the
period, one is usually charged the lender’s standard variable rate
(or sometimes a new fixed rate is offered).
Discounted interest The payments are variable, but they are set at less than that
rate lender’s going rate for a fixed period of time. At the end of the
period, one is charged the lender’s standard variable rate.
Capped rate The payments go up and down as the mortgage rate changes but
are guaranteed not to go above a set level (the ‘cap’) during the
period of the deal.
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Sometimes, they cannot fall below a set minimum level either

(the ‘collar’ or ‘floor’). At the end of the period, one is charged the
lender’s standard variable rate.
Repayment Methods
Repayment mortgage
 Monthly payments over the agreed number of years (Called the mortgage ‘term’)
goes partly towards the interest and partly towards the principal.
 If all the monthly payments agreed with the lender are made, the whole loan will
be repaid by the end of the term.
 Monthly payments could increase if interest rates rise.
Interest-only mortgage
 The monthly payments to the lender cover only the interest on the loan. They do
not pay off any amount one has borrowed.
 One usually makes separate payments into a savings scheme each month to
build up a lump sum, which is then used to pay off the whole amount one has
borrowed, in one go at the end of the mortgage term or sooner.
 This involves some investment risk in building up a sum of money to repay the
loan.
 It is one’s responsibility to save enough money to repay the loan at the end of its
term.
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Endowment mortgage
 To repay an interest-only loan, one can take an endowment policy, which is
designed to end at the same time as the mortgage.
 The money one pays into an endowment policy is invested in stocks and shares
and other investments. At the end of a set number of years (the policy ‘term’), the
policy ‘matures’ and one gets a lump sum, which is used to repay the mortgage
loan.
 An endowment policy provides life insurance and sometimes other insurance
benefits too.
Interest-only mortgage combined with stakeholder pension

 Alongside an interest-only loan, one can make payments into a personal or
stakeholder pension. When one start to take the pension (between age 50 and
75), one can take part of the pension fund as a tax-free lump sum, which is used
to pay off the mortgage loan.
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Important US Institutions in Mortgage Market
Freddie Mac, Ginnie Maes & Fannie Mae

Federal National Mortgage Association (FNMA or Fannie Mae), Government National
Mortgage Association (GNMA or Ginnie Mae) and Federal Home Loan Mortgage
Corporation (FHLMC or Freddie Mac) are all "secondary market lenders".
Banks issue loans/mortgages with some collateral for security. These loans/mortgages
are bought by the “secondary market lenders” from the banks thus freeing them to turn
around and issue mortgage to new customers.
Their core business consists of mortgage loan securitization. They buy mortgages from
banks and pool them into bonds to be sold or held. These companies guarantee the
creditworthiness of these bonds, but not the interest-rate risk. They hedge their own
exposure to interest-rate risk through derivative contracts.
Often many retail lenders actually receive their funds from a secondary market lender.
These secondary lenders have assisted the national mortgage market by allowing
money to move easily from state-to-state. The movement of loan funds helps to avoid a
situation where mortgages are only available in certain areas or states. Also, the
secondary lenders have established regulations and guidelines that help the general
public.
CREDIT CARDS
Credit Card allows the cardholder to make a purchase and pay for the same after a
period called credit period.
Parties involved
Acquiring Bank
The bank which approves a merchant for accepting credit cards, and then collects the
merchant's online payments. Acquiring Banks are generally members of the Visa and
MasterCard Associations
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Association
Visa and MasterCard are actually associations of member banks and financial
institutions. The associations specify membership rules, but do not issue credit cards;
the members issue the cards. American Express, Discover, and Diner's Club are single
corporations and not associations, and they issue their own cards.
Cardholder
The cardholder is the customer - someone who an issuing bank deems trustworthy
enough to extend some credit to.
Independent Sales Organization (ISO)

A third-party company that provides services to merchants on behalf of the acquiring
bank. These services include merchant accounts, funds processing, and account activity
reporting.
Issuing Bank
A bank or other financial institution that issues credit cards. Issuing banks are members
of the Visa and MasterCard Associations.
Merchant
A business that has a merchant account for accepting credit cards. Despite being called
"the merchant" in the credit card industry, this term really refers to the business, not the
owner though they may be the same in the case of a sole proprietor.
Payment Gateway
A company that provides an interface between the Internet and the secure banking
networks. A payment gateway authenticates the parties involved and acts as a channel
for moving credit card transactions from the store/shop to a payment processor.
Payment Processor
A corporation that manages the process of transferring authorized and captured credit
card funds between different financial accounts
Purchase Authorization Flow

These are the detailed steps required for the authorization of a purchase.
1. A customer initiates a transaction by placing an order in a shop using a credit card.
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2. The shop sends the transaction information to the merchant's payment gateway. The
info includes the store's identification info, the customer's name and address info,
and the amount of the purchase.
3. The payment gateway checks its database to see which acquiring bank/ISO the
store.
4. The gateway sends the transaction information to the acquiring bank's payment
processor.
5. The payment processor examines the customer's credit card number to determine
the issuing bank.
6. The payment processor sends the customer information and transaction amount to
the issuing bank.
7. The issuing bank checks to see if the customer information is valid and if there is
enough credit in the account to cover the transaction. At the same time, it verifies
that the billing address on the order matches the billing address on file for the credit
card (this is called Address Verification Service).
8. If the account is valid and there is enough credit and the address is verified, the
issuing bank sends an authorization code back to the payment processor and puts a
hold on the funds in the customer's account.
9. If the account is not valid or there isn't enough credit to cover the transaction or there
is a problem with the billing address, the issuing bank sends a "transaction declined"
message back to the payment processor.
10. The payment processor sends the authorization code (or declined message) back to
the payment gateway.
11. The payment gateway sends the authorization code (or declined message) back to
the shop.
12. The shop displays a receipt to the customer if the transaction was authorized, or a
"problem" message if declined.
13. The shop records the order as "authorized" in the store's orders database.
Capture and Settle Flow

These are the detailed steps required for a transaction to be captured and settled:
1. When the merchant clicks the Bill Orders button in the store to "capture" the funds,
the store sends the capture information to the merchant's payment gateway. The
information includes the store's identification, the transaction numbers and
authorization codes that were received back from the issuing bank, and the amount
of the transactions.
2. The payment gateway checks its database to see which acquiring bank the store
uses, which tells it which payment processor to send the capture request and
information to.
3. The payment gateway sends the information to the payment processor.
4. The payment processor examines each the information for each transaction to
determine which issuing bank to send it to. Remember that all of the orders were
placed in the same store, but they were probably all charged to different credit cards.
5. The payment processor forwards the information to the issuing banks.
6. The issuing bank transfers funds to the acquiring bank. This is called settling.
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7. The acquiring bank/ISO deposits the money in the merchant's local account, minus
the discount rate and transaction fee. This process could take from two days to two
weeks, depending on the policies of the acquiring bank/ISO.
Card Issuance
1. Credit Bureaus collect an individuals credit information and provide a Credit Report
a. E.g. :- Equifax, Experian & TransUnion
2. Information on a Credit Report
a. Personal Identifying Information
b. Credit History
c. Public Records
d. Report inquiries
e. Dispute Information
3. Bank account balances, Race, Religion, Health, Criminal records, Income & Driving
records do not appear on Credit Reports
4. FCRA (Fair Credit Reporting Act) specifies who can access the Credit Reports
5. Cards are issued based on customers financial history
6. Credit appraisal in mature markets like US
a. A credit score is used. Score is based on Credit Report.
b. A credit score is a number that is calculated based on your credit history to
give lenders a simpler "lend/don't lend" answer
c. Based on one’s consolidated financial information from your Credit Report
d. Formula is proprietary to Fair Isaac & Company
e. Weightages based on
i. Payment History
ii. Outstanding Debt
iii. Length of Credit
iv. Inquiries on the Credit Report
v. Type of Existing Credit
Cost of a Credit card

Annual Fees
The annual charge paid by the card holder to the issuing bank.
Annual Percentage Rate

The rate of interest charged on the outstanding amount per annum.
Credit Period
The maximum period during which the card holder enjoys free credit.
Late Payment Charges
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Fine paid by the card holder if, minimum amount due is not paid by him by the due date.
RETAIL SERVICE
Banking Accounts
Banking account can classified as below based on their features, cost and usefulness.
Checking Accounts
 Quick, convenient and, frequent-access to the money.
 Checks are used to withdraw money, pay bills, purchasing, transfer money to
another accounts and many other common usage.
 Some banks pay interest while many do not.
 Institutions may impose fees on checking accounts, besides a charge for the checks
ordered. Any combination of the following three ways can be used by the banks:
o Flat fee regardless of the balance maintained or number of transactions.
o Additional fee if average balance goes down below a specified amount.
o A fee for every transaction conducted.
Money Market Deposit Accounts

 An interest-bearing account with checks writing facility, called a money market
deposit account (MMDA).
 Pays a higher rate of interest than a checking or savings account
 MMDAs often require a higher minimum balance to start earning interest
 Each month, numbers of transactions are limited to six transfers to another account
or to other people, and only three of these transfers can be by check.
 Most institutions impose fees on MMDAs.
Savings Account
 Allows making withdrawals, but checks writing facility is not there.
 Number of withdrawals or transfers one can make on the account each month is
limited.
 Passbook savings – The pass book must be presented when you make deposits and
withdrawals
 Statement savings – Institution regularly mails a statement that shows withdrawals
and deposits for the account.
 Institutions may assess various fees on savings accounts, such as minimum balance
fees.
Time Deposits (Certificates of Deposit)
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 Guaranteed rate of interest for a term or length of time specified by the account
holder.
 Once the term specified, one cannot withdraw the principal without attracting
penalties.
 One can withdraw the interest earned on the principal.
 The rate of interest is often higher than savings or any other account
 CDs renew automatically, so if not notified before maturity, CDs will roll over for
another term. Most of the institutions notify the account holder before maturity.
Basic or No Frill Banking Accounts

 Checking accounts, but with a limit on the number of checks one can write and the
number of deposits and withdrawals one can make
 Interest is generally not paid.
 Fees is generally lower than checking accounts
Money Transfer
 Cheques/Checks
o Bearer Checks
o Account Payee Checks
o Travelers’ Checks
o Bankers Checks
 Debit Cards
 Demand Drafts
 Automated Clearing House (ACH)
 Standing Instructions
 Electronic Transfer
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7.ELECTRONIC BANKING
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ELECTRONIC BANKING
Electronic banking, also known as electronic fund transfer (EFT), uses computer and
electronic technology as a substitute for checks and other paper transactions. EFTs are
initiated through devices like ATM cards or codes that let one to access your account.
Many financial institutions use ATM or debit cards and Personal Identification Numbers
(PINs) for this purpose. 7
The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic
customer transactions. The Act does not cover “stored value” cards like prepaid
telephone cards, mass transit passes, and some gift cards. These "stored-value" cards,
as well as transactions using them, may not be covered by the EFT Act.
ELECTRONIC FUND TRANSFERS
EFT offers the following services to the customers:
Automated Teller Machines (ATMs)

ATMs are electronic terminals that let customers bank almost any time. The customer
generally inserts an ATM card and enters his/her PIN to withdraw cash, make deposits,
or transfer funds between accounts, Some financial institutions and ATM owners charge
a fee, particularly to customers who don't have accounts with them or on transactions at
remote locations.
Direct Deposit
Customers can authorize specific deposits, such as paychecks and Social Security
checks, to their account on a regular basis.
Direct Debits/Electronic Bills Presentment

Customers can pre-authorize direct withdrawals (ECS under Indian context) so that
recurring bills, such as insurance premiums, mortgages, and utility bills, are paid
automatically.
Pay-by-Phone Systems
They let customers call their financial institution with instructions to pay certain bills or to
transfer funds between accounts. For such transactions, customers need to have an
explicit agreement with their banks.
Personal Computer Banking

Customers do many banking transactions through their personal computer. For example,
customers can view their account balance, request transfers between accounts, and pay
bills electronically.
Point-of-Sale Transfers
Customers can pay for their purchases with a debit card, which also may also double up
as the ATM card. Debit card purchase transfers money - fairly quickly - from the
7
Excerpted from Federal Trade Commission website http://www.ftc.gov
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customer’s bank account to the store's account. So the customer should have the
required funds in his/her account before the use of debit card.
Electronic Check Conversion

ECC converts a paper check into an electronic payment at the point of sale or
elsewhere. In a store, the customer can present a check to a store cashier. The check
can be processed through an electronic system that captures the banking information
and the amount of the check. Once the check is processed, the customer signs a receipt
authorizing the store to present the check to the bank electronically and deposit the
funds into the store’s account. The customer gets a receipt of the electronic transaction
and the check is returned to the customer. It should be voided or marked by the
merchant so that it can't be used again.
EFT REGULATIONS
Disclosures
The documents (usually fine print) supplied by the issuer of the “access device” cover
the legal rights and responsibilities regarding an EFT account. Before using EFT
services, the institution must tell the customer the following information:
 A summary of customer’s liability for unauthorized transfers.

 The telephone number and address of the person to be notified in the event of an
unauthorized transfer, a list of the institution's "business days", and the number
of days to report suspected unauthorized transfers.
 The type of transfers, fees for transfers, and any limits on the frequency and
dollar amount of transfers.
 A summary of right to receive documentation of transfers, to stop payment on a
pre-authorized transfer, and the procedures to follow to stop payment.
 Procedures to report an error on a receipt for an EFT or periodic statement and
to request more information about a transfer listed on the statement, and the
number of days to report.
 A summary of the institution's liability if it fails to make or stop certain
transactions.
 Circumstances under which the institution will disclose information to third parties
concerning customer’s account.
 Charges for using ATMs where the customer does not have an account.
Receipts and Statements

The customers are entitled for terminal receipts and periodic statements. Customers are
entitled to a terminal receipt when they initiate an electronic transfer, whether it is an
ATM or a point-of-sale electronic transfer. The receipt must show the amount and date
of the transfer, and its type, such as "from savings to checking."
No terminal receipts would be issued for regularly occurring electronic payments that are
pre-authorized, like insurance premiums, mortgages, or utility bills. Instead, these
transfers will appear on your periodic statement.
Customers are also entitled to a periodic statement for each statement cycle in which an
electronic transfer is made. The statement must show the amount of any transfer, the
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date of credit or debit to their account, the type of transfer and type of account(s) to or
from which funds were transferred, and the address and telephone number for inquiries.
Errors
Customers have 60 days from the date a statement is received to notify errors to the
bank. The best way is to notify the financial institution by way of a certified letter, return
receipt requested. Under US federal law, the institution has no obligation to conduct an
investigation if the customer missed out the 60-day deadline.
The financial institution has 10 business days to investigate the error. The institution has
to communicate the results of its investigation within three business days after
completion and must correct the error within one business day after detecting the error.
If the institution needs more time, it may take up to 45 days to complete the investigation
- but only if the money in dispute is returned to the customer’s account with due
notification of the credit. At the end of the investigation, if no error has been found, the
institution may take the money back after sending a written explanation.
Lost or Stolen ATM or Debit Cards

Unlike a credit card, if someone loses the ATM or debit card, customer can lose much
more. If the customer reports the loss of an ATM or debit card to the card issuer before
it's used without his/her permission, he/she can't be held responsible for any
unauthorized withdrawals.
If unauthorized use occurs before reporting, the liability of the customer varies
depending on the delay in reporting the loss to the card issuer.
 Within two business days – Liability limited to $50 for unauthorized use.
 Between 2 - 60 days – Liability limited to $500 because of an unauthorized
transfer.
 If the loss is not reported within 60 days, the liability has no limits.
If the customer failed to notify the institution within the time periods allowed because of
extenuating circumstances, such as lengthy travel or illness, the issuer must reasonably
extend the notification period. In addition, if state law or the individual contract imposes
lower liability limits, those lower limits apply instead of the EFT act limits.
Limited Stop-Payment Privileges

The EFT Act does not give the right to the customer to stop payment. If a purchase is
defective or an order is not delivered, it's up to the customer to resolve the problem with
the seller.
The customer can stop payment only for regular payments out of his/her account to third
parties, such as insurance companies. The institution has to be notified at least three
business days before the scheduled transfer.
Although federal law provides only limited rights to stop payment, individual financial
institutions may offer more rights or state laws may require them.
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FEDWIRE
Fedwire is an electronic transfer system developed and maintained by the Federal

Reserve System. The system connects Federal Reserve Banks and Branches, the
Treasury and other government agencies, and more than 9,000 on-line and off-line
depository institutions and thus plays a key role in US payments mechanism. The
system is available on-line depository institutions with computers or terminals that
communicate directly with the Fedwire network. These users originate over 99 percent of
total funds transfers. The remaining customers have off-line access to Fedwire for a
limited number of transactions.
Fedwire transfers U.S. government and agency securities in book-entry form. It plays a
significant role in the conduct of monetary policy and the government securities market
by increasing the efficiency of Federal Reserve open market operations and helping to
keep the market for government securities liquid.
Depository institutions use Fedwire mainly to move balances to correspondent banks

and to send funds to other institutions on behalf of customers. Transfers on behalf of
bank customers include funds used in the purchase or sale of government securities,
deposits, and other large, time-sensitive payments.
Fedwire and CHIPS, a private-sector funds transfer network specializing in international

transactions, handle most large-dollar transfers. In 2000, some 108 million funds
transfers with a total value of $380 trillion were made over Fedwire -- an average of $3.5
million per transaction.
All Fedwire transfers are completed on the day they are initiated, generally in a matter of
minutes. They are guaranteed to be final by the Fed as soon as the receiving institution
is notified of the credit to its account.
Until 1980, Fedwire services were offered free to Federal Reserve member commercial
banks. However, the Depository Institutions Deregulation and Monetary Control Act of
1980 required the pricing of Fed services, including funds and securities transfers, and
gave nonmember depository institutions direct access to the transfer system. To
encourage private-sector competition, the law requires the Fed's fees to reflect the full
cost of providing the services, including an implicit cost for capital and profitability.
How Fedwire Works
Transfers over Fedwire require relatively few bookkeeping entries. Suppose an

individual or a private or government organization asks a bank to transfer funds. If the
banks of the sender and receiver are in different Federal Reserve districts, the sending
bank debits the sender's account and asks its local Reserve Bank to send a transfer
order to the Reserve Bank serving the receiver's bank. The two Reserve Banks settle
with each other through the Inter-district Settlement Fund, a bookkeeping system that
records Federal Reserve inter-district transactions. Finally, the receiving bank notifies
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the recipient of the transfer and credits its account. Once the transfer is received, it is
final and the receiver may use the funds immediately. If the sending and receiving banks
are in the same Federal Reserve district, the transaction is similar, but all of the
processing and accounting are done by one Reserve Bank.
OTHER TRANSFER SYSTEMS
Clearing House Interbank Payment System (CHIPS) is a private sector funds transfer
network mainly for international transactions. CHIPS transfers are settled on a net basis
at the end of the day, using Fedwire funds transfers to and from a special settlement
account on the books of the New York Fed.
In addition to Fedwire, the Federal Reserve Banks provide net settlement services for
participants in private-sector payments systems, such as check clearing houses,
automated clearing house associations (ACH), and private electronic funds transfer
systems that normally process a large number of transactions among member
institutions. Net settlement involves posting net debit and net credit entries provided by
such organizations to the accounts that the appropriate depository institutions maintain
at the Federal Reserve.
An automated clearing house processes and delivers electronic debit and credit
payments among participants.
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SUMMARY
 Electronic banking, also known as electronic fund transfer (EFT), uses computer
and electronic technology as a substitute for checks and other paper
transactions.
 EFTs are initiated through devices like ATM cards or codes that let one to access
your account. Many financial institutions use ATM or debit cards and Personal
Identification Numbers (PINs) for this purpose.
 The federal Electronic Fund Transfer Act (EFT Act) covers most (not all)
electronic customer transactions.
 EFT offers the following services to the customers:
 Automated Teller Machines (ATMs)
 Direct Deposit
 Direct Debits/Electronic Bills Presentment
 Pay-by-Phone Systems
 Personal Computer Banking
 Point-of-Sale Transfers
 Electronic Check Conversion
 Fedwire is an electronic transfer system developed and maintained by the
Federal Reserve System. The system connects Federal Reserve Banks and
Branches, the Treasury and other government agencies, and depository
institutions and thus plays a key role in US payments mechanism
Clearing House Interbank Payment System (CHIPS) is a private sector funds transfer
network mainly for international transactions. CHIPS transfers are settled on a net basis
at the end of the day, using Fedwire funds transfers to and from a special settlement
account on the books of the New York Fed.
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8.PRIVATE BANKING/WEALTH
MANAGEMENT
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PRIVATE BANKING / WEALTH MANAGEMENT
Private Banking covers banking services, including lending and investment

management, Private banking primarily is a credit service, and is less dependent on
accepting deposits than retail banking.
The Federal Reserve Supervisory Letter defines private banking as personalized

services such as money management, financial advice, and investment services for high
net worth clients.
Although high net worth is not defined, it is generally taken at a household income of at
least $100,000 or net worth greater than $500,000. Larger private banks often require
even higher thresholds - Several now require their new clients to have at least $1 million
of investable assets. As per the World Wealth Report 2001 by Merrill Lynch / Cap
Gemini, there are currently over 7.2 million millionaires in the world with a combined
asset base exceeding US$ 27 trillion which is projected to grow to over US$ 45 trillion by
the end of 2005.
CLIENT SERVICES
A typical private banking division of a large bank would offer the following financial
services to its Private clients:
Investment Management and Advice

A client relationship Manager understands the client’s liquidity, capital and investment
needs. He strives to develop an integrated approach to manage client investments and
capital markets trading. Access to specialist advice and extensive research is a key
feature of private banking.
Self-directed or non-discretionary: This is largely investment advisory in which the

bank offers investment recommendations based on the Client’s approval. The client
may choose to ignore this.
Discretionary: In this case, the bank’s portfolio managers make investment

decisions on behalf of the customer.
Risk Management
Strives to reduce exposures for its clients across the world through a variety of hedging
tools, taking positions in derivative markets etc
Liquidity
Management of a Client’s liquidity (cash etc) needs through short-tem credit facilities,
flexible cash management services etc. An exclusive cash management service with
"sweep" facility is a Private Banking feature. The sweep automatically transfers excess
funds over a pre-determined limit out of your current account into a higher yielding
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reserve account, optimizing your return on short-term cash. Funds are on call so they
remain easy to access.
Structured Lending
Provides tailored lending to provide long-term liquidity to clients, or investment capital
Enhanced banking facilities

Private clients enjoy a variety of exclusive banking services such as:
 Insurance
 Foreign exchange transactions
 Automatic credit entitlements etc
Issuer Capital formation

Providing clients with access to investment banking and other institutional services
Private Bankers are high-end relationship managers, as well as money managers and
advisors. Private clients trade in larger volumes, the fees and commissions are larger.
Changes in the regulatory environment have redefined the competitive landscape of

wealth management by allowing involvement of banks in insurance activities. A
successful wealth manager must harness and deploy not just the standard activities of
equity and fixed income investment management, but a plethora of other products and
services: tax and estate planning, insurance products, 401(k) rollovers, and more.
Most private banks segregate their clients based on net worth, investible assets, age etc.
For example, one classification could be between young affluent and retired affluent.
Private banking clients typically demand higher returns on their investment, and as a
result banks offering these services are heavily dependent on efficient Portfolio Analysis
and Asset Allocation techniques to achieve this. The consequent investment in
technology is also very high.
Private banking is a fee-driven business. Banks offering these services charge anything
between 1-4 % for their service, depending on the nature of the service rendered. Return
on equity for banks offering these services could be as high as 25%.
COMMON PRIVATE BANKING PRODUCTS
Personal Investment Companies (PICs)

A PIC is a shell company set up by a Private Bank’s offshore division (e.g. trust division)
for a client, usually in a tax haven like the Cayman Islands. The PIC has its own legal
entity and the investor enjoys confidentiality as well as tax benefits. There is substantial
startup fee involved for these, and banks charge annual administration fees.
Payable Through Account (PTA)
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PTAs are transaction deposit accounts that allow banks in one country to offer their
foreign clients of a foreign bank, such services as check-writing. The foreign bank in this
case plays the role of a correspondent bank. These accounts usually have a high
transaction volume and attract dollar deposits from the foreign customers.
Hedge Funds
This is a private investment partnership, and is usually run by Private Banks. Hedge
funds are highly speculative and they use a variety of techniques such as leverage,
short-selling, and use of derivatives. Several hedge funds also utilize some form of
arbitrage, such as those where they can take advantage of movements expected to
occur in the stock price of two companies undergoing a merger or other similar event. In
most cases, investors in a hedge fund need to be duly accredited.
How have average hedge fund returns performed vis-a-vis market levels?
“Multibillion dollar Quantum Fund managed by the legendary George Soros, for
instance, boasted compound annual returns exceeding 30% for more than a decade.”
“Off Shore Hedge Funds: Survival and Performance: 1989-1995," a study by Yale
and NYU Stern economists, indicates that, during that six-year period, the average
annual return for offshore hedge funds was 13.6%, whereas the average annual gain
for the S&P 500 was 16.5%. Even worse, the rate of closure for funds rose to over
20% per year, so choosing a long-term hedge fund is trickier even than choosing a
stock investment.
Are hedge funds not immune to risk?
Led by Wall Street trader John Meriwether and a team of finance wizards and Ph.Ds,
Long Term Capital Management imploded in the late 1990s. It nearly sank the global
financial system and had to be bailed out by Wall Street's biggest banks. In 2000
George Soros shut down his Quantum Fund after sustaining stupendous losses.
WHO OFFERS PRIVATE BANKING SERVICES?
Most Banks have separate divisions offering dedicated private banking services. There
may be Edge Corporations or Foreign subsidiaries of large national banks as well, which
offer these services.
The large European banks like UBS, Credit Suisse are industry leaders. There are a
number of standalone Private Banks as well. In banks such as Mellon and Bank One,
Private Banking takes place in the Trust or Investment Management division. Many
banks offer Private Client Services (PCS) to clients in other countries as well, through
foreign subsidiaries, or even affiliated banks.
WHY GROW PRIVATE BANKING BUSINESS?
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 Most private banks target return on equity of at least 25% which is considerably
higher than that of the average commercial bank.
 Opportunities for off-balance sheet income are an additional incentive. Unlike
depository accounts, securities and other instruments held in the clients’ investment
accounts are not reflected on the balance sheet of the institution because they
belong to the client.
 However, the institution can earn substantial fees for managing client assets or
performing other cash management and custodial services. To grow, private banks
need to lure new wealthy investors away from direct investing or from investing with
major mutual funds such as Fidelity or Merrill Lynch.
CORE FUNCTIONS IN PRIVATE BANKING
 Sales and Marketing / Client Prospecting

 Client Management, Servicing and delivery
 Financial Planning
 Portfolio Analysis and Optimization
 Market Activities
 Research
 Compliance controls.
PRIVATE BANKING WORKFLOW
The high-level process flow for private banking is shown below. The roles and
responsibilities of the various players are outlined below:
 Client Representative:
 Servicing specialist
 Middle office
 Back office
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The diagram below shows the various departments in the Private Banking division of a
bank.
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SUMMARY
 Private Banking covers personalized services such as money management,
financial advice, and investment services for high net worth clients. High net
worth is generally taken at a household income of at least $100,000 or net worth
greater than $500,000. Larger private banks often require even higher thresholds
of at least $1 million of investable assets
 A typical private banking division of a large bank would offer financial services
like:
Investment Management and Advice
Risk Management
Liquidity Management
Structured Lending
Enhanced banking facilities
Issuer Capital formation
 Most Banks have separate divisions offering dedicated private banking services.
There may be Edge Corporations or Foreign subsidiaries of large national banks
as well, which offer these services. Large European banks like UBS, Credit
Suisse are industry leaders. There are a number of standalone Private Banks as
well. In banks such as Mellon and Bank One.
 Core functions in private banking include the following:
Sales and Marketing / Client Prospecting
Client Management, Servicing and delivery
Financial Planning
Portfolio Analysis and Optimization
Market Activities
Research
Compliance controls
 Private Banking Front Office covers functions like Sales & Client prospecting,
Contact Management, Account Aggregation and Financial Advisory services.
 Private Banking Middle/Back Office covers functions like Asset Allocation,
Research, Portfolio Analysis, Risk Management, Trade Processing, Compliance
and Documentation
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9.ASSET MANAGEMENT
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ASSET MANAGEMENT
An Asset is a property or investment, such as real estate, stock, mutual fund, or

equipment that has monetary value that could be realized if sold.
ASSET MANAGEMENT GOALS
Asset Management aims at the following goals:
 Manage investors money efficiently and cost effectively

 Generate superior investment returns
 Investing Goal Ultimate objective is to deliver equity type returns with lesser
volatility risk and achieve capital preservation
In achieving the above goals, an Asset Manager uses the following

approaches/principles:
 Asset Mix is the primary determinant of portfolio return, optimum portfolios are
designed using asset allocation tools
 International Diversification - Investment in world wide stocks reduces risk and
improves returns
 Screens/Filters - Variety of quantitative and qualitative screens to identify candidate
investments, interviews with fund managers prior to investing and continuous due
diligence.
 Capital preservation - Preserve the wealth of investors and ensure erosion free
investment
 Alternative Investments - Investing in hedge fund and futures to have strong
returns. These assets generally earn returns consistent with those of equities. By
combining alternative investments with equities, the asset manager can generate
superior returns while reducing the ups and downs of the portfolio.
DISTINCTION BETWEEN PRIVATE BANKING & ASSET MANAGEMENT
Private Banking focuses on retail investors while asset management is targeted towards
institutional investors. Customers are large institutions. Asset Management service can
be either Advisory or Fund handling and investing on behalf of customer
Both private banking and asset management use extensive research and investment
management techniques.
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PLAYERS IN ASSET MANAGEMENT
All major international banks offer asset management services. Some key players
include:
 Deutsche Bank
 Aberdeen Asset Management
 UBS
 Citigroup
 JP Morgan Chase
THE COMMON INGREDIENTS
Research team
The first step is to put together a dedicated research team. It is critical that the team
members have knowledge on Model building and Econometrics. The success of the
research team is usually evaluated relative to a benchmark return.
Data
The research team must have easy access to a variety of data. The collection and
maintenance of the database is very important. Tactical decisions need to be made
quickly as new data keeps pouring in. It is best to invest in a database system that takes
the new data and automatically runs the quantitative analyses.
Computing
While most top-down data management exercises can be handled within Excel, the
bottom up projects are not feasible within a spreadsheet. The bottom-up projects may
include up to 10,000 securities along with vectors of attributes for each security.
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INVESTMENT MANAGEMENT CYCLE
Market and Analytical Portfolio Brokers and

Trade Orders
Data Management Trading
Networks
Research
and
Analysis Trading
Clearing and
Settlement
Data
External
Trading
Information
Providers
Monitoring Custodians
Trades Investment
Prices and Settlements Operations
Reporting
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ASSET ALLOCATION
Passive Approach
The portfolio manager has to decide on the mix of assets that maximizes the after-tax
returns subject to the risk and cash flow constraints. Thus the investor’s characteristics
determine the right mix for the portfolio. In coming up with the mix, the asset manager
uses diversification strategies; asset classes tend to be influenced differently by macro
economic events such as recessions or inflation. Diversifying across asset classes will
yield better trade offs between risk and return than investing in any one risk class. The
same observation can be made about expanding portfolios to include both domestic and
foreign assets.
Active Approach
Portfolio managers often deviate from the passive mix by using “Market timing”. To the
extent that portfolio managers believe that they can determine which markets are likely
to go up more than expected and which less than expected, they will alter the active-
passive mix accordingly. Thus, a portfolio manager who believes that the stock market is
over valued and is ripe for a correction, while real estate is under valued, may reduce
the proportion of the portfolio that is allocated to equities and increase the proportion
allocated to real estate. Market strategists at all of the major investment firms influence
the asset allocation decision.
There have been fewer successful market timers than successful stock pickers. This can
be attributed to the fact that it is far more difficult to gain a differential advantage at
market timing than it is at stock selection. For instance, it is unlikely that one can acquire
an informational advantage over other investors at timing markets. But it is still possible,
with sufficient research and private information, to get an informational advantage at
picking stocks. Market timers contend that they can take existing information and use it
more creatively or in better models to arrive at predictions for markets, but such
approaches can be easily imitated.
APPROACHES TO ASSET ALLOCATION
Fund managers generally adopt an individual investment management style. The

following are the two quantitative approaches to tactical global asset management:
Top Down Approach

The "top down" investor begins by looking at the “big picture” - economy or broad trends
in society to identify individual countries and then sectors that will benefit from the
prevailing conditions. For example, a "top down" investor might say that since the huge
baby-boomer generation is aging and moving toward retirement, companies that provide
products and services to older people should benefit from that trend. This might lead to
buying pharmaceutical stocks or health care shares or, stocks of insurers that provide
retirement annuities.
A "top down" investor may also make investments based on what he or she thinks lies
ahead for the economy. So, for example, if a "top down" investor believed that a
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resurgent economy might re-ignite inflation fears, then he or she might consider buying
gold or natural resource stocks, or jettisoning long-term bonds in favor of Treasury bills.
So a "top down" investor starts with a concept and then looks for stocks that are
compatible with it.
Then they work systematically down from this very broad perspective translating these
top-down views into more specific economic and market forecasts. This is an analytical
process; trying to identify those profound structural changes in global economies and
societies, seeing what effects are likely to filter down and in time affect the value of
ordinary investments.
An illustrative model of “top down” approach will look as follows:
 Build country-by-country forecasting models based on benchmark return

 Validation of models
 Forecast out of sample returns
 Sort country returns
 Invest in portfolio of highest expected return countries
 Information in both the volatility and correlation is used in determining optimal
portfolio weights
"Hedge" strategies are also possible. This involves taking long positions in the highest
expected returns countries and short positions in the lowest expected returns countries.
Bottom Up Approach
The idea is to select individual securities. From a variety of methods, forecasted winners
are purchased and forecasted losers are sold. “Bottom up" investor would try to find
investments that are attractive because of something particular to them -- i.e., their
terrific growth potential, say, or the fact that their assets are selling for less than their
intrinsic worth. So an investor who practices the "bottom up" approach might screen
through a long list of stocks to find ones that look like a buy on the basis of their
fundamentals.
PORTFOLIO EXECUTION
There are many individual strategies that may show promise in terms of beating the
market. However, very few portfolio managers actually accomplish the same objective.
One very important reason is the failure on the part of most studies to factor in both the
difficulties and the costs associated with executing strategies.
There are three dimensions to portfolio execution:
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Cost of execution
There are three components to this cost.
Bid-ask spread, which leads investors to buy at a high price and sell at a lower price. For
low-priced stocks, this cost can be as high as 20% of the price of the stock.
Price impact that investors have when they trade, pushing the price up as they buy and
down as they sell. In illiquid markets, this cost can be significant especially for large
trades.
Tax impact associated with trading, which becomes a factor when we consider the
objective in portfolio management is maximizing after-tax returns.
When considered in aggregate, the trading costs will work out to be high. The trading
costs will vary widely across different investment strategies, depending upon the trading
frequency and urgency associated with each strategy.
Trading speed
The need to trade fast and the desire to keep transactions costs low will come into
conflict. Investors who are willing to accept trades spread out over longer periods will
generally be able to have much lower trading costs than investors who need to trade
quickly. Long term value investors will be less affected by trading costs than short term
investors trading on information.
Portfolio Risk Management

Portfolio risk characteristics change over time and it is the portfolio manager’s job to
keep the portfolio risk at desired levels at minimum costs. The derivatives markets
provide portfolio managers with additional tools that can be used to hedge risk and add
to returns over time.
INVESTMENT PHILOSOPHIES
Portfolio Managers follow different investment philosophies. Some examples are:
Passive Diversification
Some Portfolio Managers believe that markets are efficient; even if they are inefficient,
the cost of exploiting the inefficiency is more the returns that can be earned. Hence, they
are willing to accept market returns. They try to construct portfolios that resemble the
market index, often indexing to broadest possible indices.
Passive Value Investing

Markets systematically undervalue certain companies. Portfolio Managers identify such
companies with parameters like low PE, High dividend yield, low Price to Book Value,
low Price/Replacement Value etc. The leading examples are the likes of Peter Lynch
and Warren Buffet. Such Portfolio Managers have long time horizons, low turnover (i.e.)
buying and selling, and transactions costs
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Momentum Investing
Markets tend to stay in trends: if prices have gone up (down) quickly, they will tend to
keep going up (down). Portfolio Managers who subscribe to this school, use price
momentum indicators, relative strength indicators and charts. They have short time
horizons and speedy execution styles.
Market Timing
It is possible to forecast the direction of markets (i.e. to time markets) using identified
variables like market timing models/indicators. Such Portfolio Managers usually take
large bets on the market (in either direction), attempt tactical Asset Allocation in sectors,
and use Hedge funds (selling overvalued and buying undervalued asset classes). An
example would be George Soros and his Quantum Fund.
Contrarian Investing
Markets tend to correct themselves; if prices have gone up (down) quickly, they will tend
to go down (up). If investors are too bullish (bearish), stocks are more likely to go down
(up). Such Portfolio Managers have usually short time horizons, are willing to hold
unpopular investments and use specialist short sales.
Example: In the middle of March this year, the war with Iraq was just starting. The
SARS epidemic was raging across Asia. Travellers, whether for business or pleasure,
were staying at home in fear of terrorism – whether in the guise of chemical or
biological warfare, or old fashioned high explosives. The airline, tourism, and hotel
industries were warning of the worst conditions in living memory. The FTSE 100
index fell to an eight-year low of 3,300.
The contrarians, meanwhile, were rubbing their hands with glee.
Guess what? If you had invested then, at the pit of misery you would have made 27
per cent in around three months to the middle of June.
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SUMMARY
 Asset Management aims at managing investors’ money efficiently and cost
effectively to generate superior investment returns. The ultimate objective is to
deliver equity type returns with lesser volatility risk and achieve capital
preservation
 An Asset Manager uses the following approaches/principles:
Asset Mix
International Diversification
Screens/Filters
Capital preservation
Alternative Investments
 Private Banking focuses on retail investors while asset management is targeted
towards institutional investors. Customers are large institutions. Both private
banking and asset management use extensive research and investment
management techniques.
 Asset Allocation can be done passively or actively.
 Passive Approach - The portfolio manager has to decide on the mix of assets
that maximizes the after-tax returns subject to the risk and cash flow constraints.
Thus the investor’s characteristics determine the right mix for the portfolio.
 Active Approach - Portfolio managers often deviate from the passive mix by
using “Market timing”. To the extent that portfolio managers believe that they can
determine which markets are likely to go up more than expected and which less
than expected, they will alter the active-passive mix accordingly.
 Fund managers generally adopt an individual "investment philosophy" which
overlays their investment management style. The following are the two
quantitative approaches to tactical global asset management.
 The "top down" investor begins by looking at the “big picture” - economy or broad
trends in society to identify individual countries and then sectors that will benefit
from the prevailing conditions.
 The “bottom up” investor selects individual securities. From a variety of methods,
forecasted winners are purchased and forecasted losers are sold. “Bottom up"
investor would try to find investments that are attractive because of something
special to the security.
 Portfolio Managers follow different investment philosophies. Some examples are:
Passive Diversification
Passive Value Investing
Momentum Investing
Market Timing
Contrarian Investing
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10. CORPORATE LENDING
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CORPORATE LENDING
CORPORATE LENDING
Corporate Lending refers to various forms of loans extended by banks to corporate

bodies like proprietorship, partnership, private limited companies or public limited
companies. Banks lend to such entities on the strength of their balance sheet and
business cash flows. Corporate loans are provided by banks for various purposes like
new projects, capacity expansion or plant modernization, daily cash flow requirements
(working capital) etc. Depending on the nature of the requirement, loans may be long-
term or short-term in nature.
Loans can be either secured or unsecured in nature. In case of secured loans, if the
corporate defaults on payment of principal or interest on the loan, the bank can take
possession of the security and sell off the same to meet principal or interest payment on
the loan. Security is usually in the form of land, buildings, plant and machinery, physical
stock of the raw material, goods for sale etc.
CORPORATE LENDING PROCESS
The following is the typical stages in a corporate lending process:

 Corporate approaches the relationship manager of the bank with a request for a
loan. The corporate provides details like: past financial statements, details of the loan
requirement, cash flow projection for the period of the loan, details of the security
being provided etc. Depending on the loan type and bank requirements, various
other information would need to be provided by the corporate.
 The concerned division of the bank prepares the detailed analysis of the corporate
financial statements. A detailed study is also done on the corporate’s products,
market segment, competitors etc to ascertain the strength of the corporate’s
business. A report is prepared to capture the above details.
 Based on the above report, the concerned division of the bank assigns a rating to the
corporate. The rating captures various factors like strength of business, financial
state of the corporate, ability to repay the loan based on cash flow projections,
promoter background etc.
 A committee of the bank evaluates the loan proposal and decides to sanction/reject
the same.
 Once sanctioned, the bank provides a sanction letter to the corporate providing
details of the loan terms and conditions.
 After the corporate accepts the same, a loan agreement is signed between the bank
and the corporate. The loan agreement captures various conditions of the loan like
repayment mode, repayment period, interest payable, security provided, other
conditions etc. The loan becomes ‘committed’ at this stage.
 The bank disburses the required amount under the loan committed. This amount is
called the ‘disbursed amount’ under the loan.
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Interest is usually paid on the disbursed amount of the loan. In some cases, a nominal
interest if also payable on the committed amount of the loan. Also, in most cases, the
corporate would have to pay a certain amount as processing fees for the loan. This
would cover the bank’s overhead costs in the loan process.
CORPORATE CREDIT RATING

Before sanctioning a loan to a corporate, the bank does a detailed assessment of its
financials and business strength as discussed in the earlier section. This process ends
with the bank assigning a rating to the corporate for the loan facility.
Ratings are usually specified in alphanumeric terminologies. Rating levels might vary
from AAA (highest), AA+, AA- to default ratings like D. Rating terminologies might vary
across banks and across various loan tenures. The rating level specifies a certain
probability of default of the loan. It also takes in to account the protection offered by the
security of the loan.
For corporates with higher ratings, banks provide loans at lower interest rates and vice
versa. In most cases, banks do a rating process for each of its corporate clients at the
end of say, every year or every quarter. This helps banks to continuously track the
financials and market position of the corporate.
Credit enhancements
Credit enhancement is a mechanism used to increase the original rating of a loan for a
corporate. Credit enhancements can be in the form of pledge of shares, cash collateral,
corporate or bank guarantees etc.
Example:
A corporate rated BB (low rating) requires a loan of USD 5.0 million from a bank. To
enhance the loan rating and thus reduce interest payable on the loan, the promoters
pledges their share holding in the company with the bank. Thus, whenever there is a
default on repayment of the loan, the bank has the right to sell the shares in the market.
Based on the historic volatility of the shares and the current market value of USD 6.0
mn, the bank upgrades the rating of the loan to BBB+.
TYPES OF LOANS
Term loans
These loans can either be short term loans or long term loans.
Long-term loans are extended for purposes like new projects, capacity expansion or
plant modernization. These loans are usually repayable over a 2-7 year period after an
initial moratorium period (period during which loan repayments are not required) to help
the corporate complete implementation of the project before revenue generation takes
place.
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Example
On April 15, 2004, AT&T borrows a term loan of USD 200 million from Citibank for
funding their IT modernization project across the nation. The loan is repayable in 16
quarterly installments starting April 15, 2005, after an initial moratorium of 4 quarters.
The interest payable would be LIBOR+0.5% payable quarterly. The loans would be
secured by AT&T equipment at their HQ, worth USD 300 mn.
Short term loans are extended usually for meeting working capital requirements. The
loans can be repayable in various tenures starting from a week to as long as 1 year. The
loans are either repayable in fixed installments or in one bullet installment at the end of
the period. In some cases, short term loans are backed by promissory notes which are
legal instruments that guarantee payment of a certain amount on a specified due date.
Corporate bonds
Corporate bonds are used for the same purpose as term loans, but the loan is backed by
a transferable instrument which guarantees payment from the corporate as per specified
conditions. Thus, corporate bonds are tradeable and banks can sell them to a third party
who receives the right to get payments from the corporate. Bonds are rated depending
on the rating of the corporate and depending on the rating, the market demands varying
amounts of interest. A certain class of bonds called junk bonds is issued by corporates
with very low credit ratings and carry very high rates of interest.
Working Capital
For any business, there would be current assets in the form of cash, receivables, raw
material inventory, goods for sale inventory etc while there would be current liabilities in
the form of payables and other short term liabilities. Part of the current assets would be
funded through current liabilities while the rest would have to be funded through a
mixture of short term and long term loans. As per norms, 25% of the working capital gap
would have to be funded by long term sources like equity or term loans while the rest
75% can be funded through short term loans and overdraft limits.
Banks conduct a detailed assessment of the current assets and liabilities for a corporate
and arrive at a suitable working capital limit. For purpose of calculating limits, banks
typically include only receivables which are less than 6 months old. Also within the
specified limit, banks keep reviewing the current asset and current liability position of a
company to arrive at the drawing power for each month. Corporates are allowed to
borrow up to the working capital limit or the drawing power, whichever is lower.
Overdraft limits are extended to help the corporate manage the day-to-day cash flow
needs of the business. The bank makes available a certain sum of money for a period of
time (say, USD 20.0 million for a period of 1 year). There would be a separate account
called the overdraft account created to monitor drawals under this loan. Whenever the
corporate has a deficit in its main business account, it can draw money from the
overdraft account (up to the limit of USD 20.0 million). It can also put back money in the
overdraft account as and when they have surpluses in the business account. Interest is
calculated by the bank on the various end-of-day deficits in the overdraft account and is
usually payable by the corporate at the end of every month.
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Lines of credit
These are short term loans sanctioned for a fixed validity period, allowing the corporate
to draw the loan as and when required within the validity period and repay the loan after
a certain period (repayment period). Interest is either repayable in certain intervals or in
one bullet installment at the end of the repayment period. In many cases, the lines of
credit are of a revolving nature. The same is explained via the example provided below:
Example
Citibank sanctions a line of credit of USD 10.0 mn to AT&T, valid for a period of 3 years.
Within the 3 year period, AT&T can borrow any amount at any point of time, such that
the cumulative outstanding is below USD 10.0 mn on any date. Each of these borrowals
are repayable with interest at the end of 30 days from the date of borrowal. Since AT&T
can thus ‘revolve’ the limit any number of times within the specified limit and validity
period, these are called revolving lines of credit.
Bill discounting
Bill discounting is another form of working capital financing. A bill (Bill of Exchange) is a
financial instrument by which one party promises to pay the other party a certain amount
of money on a specified due date. This is transferable and the final holder of the bill
holds the right to receive the payment from the concerned party. The corporate would
have bills of exchange which are drawn on their dealers, which entitle the corporate to
receive certain amounts of money from the dealer after a pre-defined credit period. The
corporate can then transfer the bill to the bank and get a discounted amount upfront. The
bank collects the interest on the bill amount for the specified period upfront in this
process called bill discounting. On the due date, the bank collects the payment from the
concerned party directly.
Commercial Paper
Commercial Paper (CPs as commonly known) is an instrument by which a corporate
borrows money from banks for short periods of time. A CP binds the corporate to make a
payment equal to the face value of the CP to the issuing bank on a specified due date. In
this sense, a CP is like a short term unsecured loan. However, a CP is tradeable in the
market – the bank can sell the CP to a third party. For this reason, banks charge lesser
interest on CPs than normal short term loans. However, since CPs are unsecured and
are to be tradeable in the market, banks provide CP lending to only highly rated
corporates.
Leasing
Leasing is another form of bank financing. In leasing, the bank purchases real estate,
equipment, or other fixed assets on behalf of the corporate and grants use of the same
for a specified time to the corporate in exchange for payment, usually in the form of rent.
The owner of the leased property is called the lessor, the user the lessee. Lease
payments (which include principal and interest payments usually) can be shown by
corporates as operating expenses and hence leases are used by some corporates as a
substitute for loans to get better tax benefits.
Supplier and dealer loans

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These are short term loans provided by banks to suppliers and dealers of large
companies. These loans usually have conditions which ensure that there is sufficient
support from the corporate in case the supplier or a dealer defaults. Thus, using the
support from the corporate, the suppliers/dealers can borrow money from the bank at a
lower rate of interest than otherwise possible. Such loans help the corporates to develop
a stronger base of suppliers and dealers, which often helps them in improving their
business.
Asset Securitisation loans

Asset Securitisation loans are loans which are backed by specified future cash flows or
other assets of the corporate. These loans help corporates to release excess cash flows
from existing receivables or future receivables.
Example
Citibank provides a loan of USD 250.0 mn to Royal Dutch Shell, securitizing cash flows
from future monthly sale of oil explored from its specified offshore rig. In this case, there
would be a mechanism to ensure that money from monthly sale of oil explored from the
specified rig for the period of the loan would be used to service payment of interest and
principal of the loan to Citibank. Citibank would do a detailed assessment of oil
exploration potential, study oil prices and ensure proper cash flow trapping mechanisms
before disbursing the loan to Royal Dutch Shell.
CLASSIFICATION OF LOANS BY THE BANK
1. Classification of Drawn Loans
Loans are classified and accounted for as follows:
Accrual—Loans that management has the intent and the ability to hold for the
foreseeable future or until maturity/loan payoff. Accrual loans are reported on the
balance sheet at the principal amount outstanding, net of charge-offs, allowance for loan
losses, unearned income, and any net deferred loan fees.
Held-for-sale—Loan or loan portfolios that management intends to sell or securitize.
Trading—Loans where management has the ability and intent to trade or make markets
(i.e., sell/hedge the credit risk.) Loans held for trading purposes are included in Trading
Assets and are carried at fair value, with the gains and losses included in Trading
Revenue provided that the criteria outlined in this policy are met.
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2. Classification of Undrawn Loan Commitments
Loan commitments are generally classified as accrual and recorded off-balance sheet.
Differences between loan and commitment are as follows; -

Loans are reflected in the asset side of the bank’s balance sheet.
Commitments are ‘off-balance sheet’ items and are reflected in the contingent
asset side of the balance sheet.
 The amount of the loan that is disbursed is credited to the account of the
borrower. In case of a commitment, there is no disbursement or credit to a
borrower’s account.
CREDIT DERIVATIVES
 The fee charged on a loan is a function of the disbursed amount. The fee
charged on commitment is a function of the amount of commitment that is not
Creditutilized.
derivatives are financial contracts that transfer credit risk from one party to
another, facilitating greater efficiency in the pricing and distribution of credit risk among
market players.
Example
The holder of a debt security issued by XYZ Corp. enters into a contract with a
derivatives dealer whereby he will make periodic payments to the dealer in exchange for
a lump sum payment in the event of default by XYZ Corp. during the term of the
derivatives contract. As a result of such a contract, the investor has effectively
transferred the risk of default by XYZ Corp. to the dealer. In market parlance, the
corporate bond investor in this example is the buyer of protection, the dealer is the
protection seller, and the issuer of the corporate bond is called the reference entity.
Uses of Credit Derivatives

Like any other derivative instrument, credit derivatives can be used either to take on
more risk or to avoid (hedge) it. A market player who is exposed to the credit risk of a
given corporation can hedge such an exposure by buying protection in the credit
derivatives market. Likewise, an investor may be willing to take on that credit risk by
selling protection and thus enhance the expected return on his portfolio.
Credit derivatives can be used to create positions that can otherwise not easily be
established in the cash market. For instance, consider an investor who has a negative
view on the future prospects of a given corporation. One strategy for such an investor
would be to short the bonds issued by the corporation, but the corporate repo market for
taking short positions in corporates is not well developed. Instead, the investor can buy
protection by way of credit default swap. If the corporation defaults, the investor is able
to buy the defaulted debt for its recovery value in the open market and sell it to its credit
derivatives counterparty for its face value.
Banks use credit derivatives both to diversify their credit risk exposures and to free up
capital from regulatory constraints. As an example, consider a bank that wants to
diminish its exposure to a given client, but does not want to incur the costs of
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transferring loans made to that client to another bank. The bank can, without having to
notify its client, buy protection against default by the client in the credit derivatives
market: Even though the loans remain on the bank's books, the associated credit risk
has been transferred to the bank's counterparty in the credit derivative contract.
The above example can also be used to illustrate banks' usage of credit derivatives to
reduce their regulatory capital requirements. Under current Basle standards, for a
corporate borrower, the bank is generally required to hold 8 percent of its exposure as a
regulatory capital reserve. However, if its credit derivatives counterparty happens to be a
bank located in an OECD country, and the bank can demonstrate that the credit risk
associated with the loans has been effectively transferred to the OECD bank, then the
bank's regulatory capital charge falls from 8 percent to 1.6 percent.
Example
Let us visualize a bank, say Bank A which has specialized itself in lending to the
office equipment segment. Out of experience of years, this bank has acquired a
specialized knowledge of the equipment industry. There is another bank, Bank B,
which is, say, specialized in the cotton textiles industry. Both these banks are
specialized in their own segments, but both suffer from risks of portfolio
concentration. Bank A is concentrated in the office equipment segment and bank B is
focused on the textiles segment. Understandably, both the banks should diversify
their portfolios to be safer.
One obvious option for both of them is: Bank A should invest in an unrelated portfolio,
say textiles. And Bank B should invest in a portfolio in which it has not invested still,
say, office equipment. Doing so would involve inefficiency for both the banks: as
Bank A does not know enough of the textiles segment as bank A does not know
anything of the office equipment segment.
Here, credit derivatives offer an easy solution: both the banks, without transferring
their portfolio or reducing their portfolio concentration, could buy into the risks of each
other. So bank B buys a part of the risks of the portfolio that is held by Bank A, and
vice versa, for a fee. Both continue to hold their portfolios, but both are now
diversified. Both have diversified their risks. And both have also diversified their
Types of Credit Derivatives

Credit derivatives can be classified in two main groups: Single name instruments are
those that involve protection against default by a single reference entity. Multi-name
credit derivatives are contracts that are contingent on default events in a pool of
reference units.
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11. TRADE FINANCE
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TRADE FINANCE
The main objective of trade finance is to facilitate transactions. There are many financing
options available to facilitate international trade such as pre-shipment finance to produce
or purchase a product, and post-shipment finance of the receivables.
PRE SHIPMENT LOANS
Banks provide Pre-shipment finance - working capital for purchase of raw materials,
processing and packaging of the export commodities.
POST SHIPMENT LOANS
Post-shipment financing assists exporters to bridge their liquidity needs where exports
are made under deferred payment basis. A typical example of post-shipment financing is
bills discounting.
Bills discounting facility serves to provide liquidity to an exporter by advancing him/her a

portion of the face value of a trade bill drawn by the exporter, accepted by the buyer and
endorsed to the Bank.
In competitive supply situations, favorable terms of payment often ensure that the order
is won. An exporter usually wants to get paid as quickly as possible and an importer will
want to pay as late as possible – preferably after they have sold the goods. Trade
finance is often required to bridge these two disparate objectives.
Question
Pre-shipment finance is liquidated only through realizations of export bills or amounts
received through export incentives. Pre shipment finance should not normally remain
outstanding beyond the original stipulated shipment date. In case it remains
outstanding, can the non-adjusted amount be then transferred as post shipment
finance?
FACTORS IN CHOOSING THE MODE OF FINANCING
 Costs: The cost of different financing methods can vary, both in terms of interest
rates and fees. These costs will impact the viability of a transaction
 Time Frame: Depending on the need, short, medium and long-term finance facilities
may be available. The different possibilities should be explored with the finance
provider prior to concluding a transaction. Long-term requirements should also be
considered to ensure fees are not being paid out on a revolving facility that could be
saved by using a different financing structure
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 Risk Factors: The nature of the product or service, the buyers’ credit rating and
country/political risks can all affect the security of a trading transaction. In some
cases it will be necessary to obtain export insurance or a confirmed letter of credit.
Increased risks will normally correspond to increased cost in a transaction and will
normally make the funding of a particular transaction, harder to obtain
 Government Guarantee Programs: These can sometimes be obtained where there
is some question over the exporter’s ability to perform or where increased credit is
needed. If obtained, these may enable a lender to provide more finance than their
usual underwriting limits would permit.
 Exporters’ Funds: If the exporter has sufficient resources, he/she may be able to
extend credit without the need for third party financing. However, an established
trade finance provider, offers other benefits like expert credit verification and risk
assessment as well as an international network of offices and staff to ensure that the
transaction is completed safely and satisfactorily
BILL OF LADING
A bill of lading or BOL is:
 A contract between a carrier and a shipper for the transportation of goods.

 A receipt issued by a carrier to a shipper for goods received for transportation.
 Evidence of title to the goods in case of a dispute.
The BOL grants the carrier the right to sub-contract its obligations on any terms and
would bind a shipper even if it meant that the shipper's goods could be detained and
sold by the sub-contractor.
CREDIT CHECK
Insuring payment starts long before a contract is signed. The seller, or his
representative, performs ‘due diligence’ or a reasonable assessment of the risks posed
by the potential buyer. The sources of information include:
 Chambers of commerce, Business Bureaus or their equivalents

 Credit rating services such as TRW and Dun & Bradstreet which have international
affiliates
 Trade associations and trade promotion organizations
 Freight forwarders, brokers, and banks
 Direct references from the buyer
PAYMENT METHODS
Once acceptable risks have been determined then the most appropriate payment
method can be selected. The most common payment methods are described below:
 Cash in advance
 Letter of credit
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 Documentary collection
 Open account or credit
 Counter-trade or Barter
CASH IN ADVANCE
Cash in advance is risk-free except for potential non-delivery of the goods by the seller.
It is usually a wire transfer or a check. Although an international wire transfer is more
expensive, it is often preferred because it is speedy and does not bear the danger of the
check not being honored. The check can be at a disadvantage if the exchange rate has
changed significantly by the time it arrives, clears and is credited. On the other hand, the
check can make it easier to shop for a better exchange rate between different financial
institutions.
For wire transfers the seller must provide clear routing instructions in writing to the buyer
or the buyer’s agent. These include:
 Full name, address, telephone, and telex of the seller’s bank

 Bank’s SWIFT and/or ABA numbers
 Seller’s full name, address, telephone, type of bank account, and account number.
COMMERCIAL LETTER OF CREDIT
The letter of credit (LC) allows the buyer and Seller to contract a trusted intermediary (a
bank) that will guarantee full payment to the seller provided that he has shipped the
goods and complied with the terms of the agreement.
Features
 The LC serves to evenly distribute risk between buyer and seller. The seller is
assured of payment when the conditions of the LC are met and the buyer is
reasonably assured of receiving the goods ordered. This is a common form of
payment, especially when the contracting parties are unfamiliar with each other.
 Since banks deal with documents and not with products, they must pay an LC if the
documents are presented by the seller in full compliance with the terms, even if the
buyer never receives the goods. Goods lost during shipment or embargoed are some
examples. Iraq for example, never received goods that were shipped before its
embargo but the LCs had to be paid anyway.
 LCs are typically irrevocable, which means that once the LC is established it cannot
be changed without the consent of both parties. Therefore the seller, especially when
inexperienced, ought to present the agreement for an LC to an experienced bank or
freight forwarder so that they can verify if the LC is legitimate and if all the terms can
be reasonably met. A trusted bank, other than the issuing or buyer’s bank can
guarantee the authenticity of the document for a fee.
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Disadvantages
 If there are discrepancies in the timing, documents or other requirements of the LC
the buyer can reject the shipment. A rejected shipment means that the seller must
quickly find a new buyer, usually at a lower price, or pay for the shipment to be
returned or disposed.
 One of the most costly forms of payment guarantee – Usual cost is 0.5% to 1%.
Sometimes, the costs can go up to 5 percent of the total value.
 LCs take time to draw up and usually tie up the buyer’s working capital or credit line
from the date it is accepted until final payment, rejection for noncompliance,
expiration or cancellation (requiring the approval of both parties)
 The terms of an LC are very specific and binding. Statistics show that approximately
50% of submissions for LC payment are rejected for failure to comply with terms. For
example, if one of the required documents is incomplete or delivered late, then
payment will be withheld even if all other conditions are fulfilled and the shipment
received in perfect order. The buyer can sometimes approve the release of payment
if a condition is not fulfilled; but changing terms after the fact is costly, time
consuming and sometimes impossible.
The mechanism
Usually, four parties are involved in any transaction using an LC:
a) Buyer or Applicant
The buyer applies to his bank for the issuance of an LC. If the buyer does not have a
credit arrangement with this issuing bank then he must pay in cash or other negotiable
securities.
b) Issuing bank
The issuing or applicant’s bank issues the LC in favor of the beneficiary (Seller) and
routes the document to the beneficiary’s bank. The applicant’s bank later verifies that all
the terms, conditions, and documents comply with the LC, and pays the seller through
his bank.
c) Beneficiary’s bank
The seller’s or beneficiary’s bank verifies that the LC is authentic and notifies the
beneficiary. It, or another trusted bank, can act as an advising bank. The advising bank
is used as a trusted bridge between the applicant’s bank and the beneficiary’s bank
when they do not have an active relationship. It also forwards the beneficiary’s proof of
performance and documentation back to the issuing bank. However, the advising bank
has no liability for payment of the LC. The beneficiary, or his bank, can ask an advising
bank to confirm the LC. The confirming bank charges a fee to ensure that the beneficiary
is paid when he is in compliance with the terms and conditions of the LC.
d) Beneficiary or Seller
The beneficiary must ensure that the order is prepared according to specifications and
shipped on time. He must also gather and present the full set of accurate documents, as
required by the LC, to the bank.
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Letter Of Credit Diagram8
1. Buyer and seller agree on a commercial transaction.

2. Buyer applies for a letter of credit.
3. Issuing bank issues the letter of credit (LC)
4. Advising bank advises seller than an LC has been opened in his or her favor.
5. Seller sends merchandise and documents to the freight forwarder.
6. Seller sends copies of documents to the buyer.
7. Freight forwarder sends merchandise to the buyer’s agent (customs broker).
8. Freight forwarder sends documents to the advising bank.
9. Issuing bank arranges for advising bank to make payment.
10. Advising bank makes payment available to the seller.
11. Advising bank sends documents to the issuing bank.
12. Buyer pays or takes loan from the issuing bank.
13. Issuing bank sends bill of lading and other documents to the customs broker.
14. Customs broker forwards merchandise to the buyer.
8
Letter of Credit Diagram and the 14 steps have been reproduced from www.web.worldbank.org
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Letters of credit can be flexible. Some LC variations include: Revolving, Negotiable,

Straight, Red Clause, Transferable, and Restricted. But perhaps the safest type of letter
of credit from the seller’s point of view, is the Standby letter of credit.
Example
An Asian Buyer from a Swedish Exporting company stated when he convinced the
Exporter to sell to them on open account terms. The Asian Buyer obtained 60 days
credit, which was to be calculated from the date of the invoice. The value of the order
was USD 100, 000 and the goods were dispatched and invoiced by the Swedish
Exporter on the 15th July 2003.
The payment from Asia was due on the 14th Sept 2003. The payment eventually arrived
on the 21st Nov 2003, over two months late. The delay in payment cost the Exporter
USD 1700 as it resulted in his account being overdrawn by this amount for 68 days at
9% per annum.
What if confirmed Letter of Credit had been required?
If Swedish Exporter had insisted on receiving a confirmed Letter of Credit through Allied
Swedish Banks plc. The following costs (approximations) would have applied:
Confirmation Fee USD $250

Acceptance Commission (@ 1.5% pa for 60 days) USD $250
Negotiation / Payment Fee USD $150
Out of Pocket Expenses (estimate) USD $60
Total Letter of Credit Cost USD $710
Interest Cost as a result of late payment USD ($1,700)
Benefit of using Letter of Credit USD $990
Advantages of Letter of Credit

 A Guarantee of payment on the due date from Allied Swedish Banks. (Provided
the terms and conditions of the Letter of Credit were complied with).
 A definitive date for the receipt of funds, particularly important for devising proper
currency hedging strategies.
 The opportunity to receive the payment in advance of the due date through non-
recourse discounting of the receivable.
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Also note that the costs incurred in chasing the debt from the Asian buyer has not been
accounted for the Irish Exporter. In addition if the Exporter had sold his foreign currency
receivable on a forward basis to his bank for the original due date, they may have
incurred a further cost in canceling or rearranging the forward contract. Letters of Credit
provide real and tangible benefits to companies. In this case the Swedish exporter only
lost US$ 1700. Of course if the Asian buyer had not paid at all they would have lost the
whole USD 100,000
The standby LC is like a bank guarantee. It is not used as the primary payment method
but as a fail safe method or guarantee for long-term projects. This LC promises payment
only if the buyer fails to make an arranged payment or fail to meet pre-determined terms
and conditions. Should the buyer default, the seller must then apply to the bank for
payment - a relatively simple process without complicated documentation. Since the
standby LC can remain valid for years (Evergreen Clause) it eliminates the cost of
separate LCs for each transaction with a regular client.
Back to Back LC allows a seller to use the LC received from his buyer as collateral with
the bank to open his own LC to buy inputs necessary to fill his buyer’s order.
DOCUMENTARY COLLECTION
The seller sends a draft for payment with the related shipping documents through bank
channels to the buyer’s bank. The bank releases the documents to the buyer upon
receipt of payment or promise of payment. The banks involved in facilitating this
collection process have no responsibility to pay the seller should the buyer default
unless the draft bears the aval (ad valutem) of the buyer’s bank. It is generally safer for
exporters to require that bills of lading be “made out to shipper’s order and endorsed in
blank” to allow them and the banks more flexible control of the merchandise.
Documentary collection carries the risk that the buyer will not or cannot pay for the
goods upon receipt of the draft and documents. If this occurs it is the burden of the seller
to locate a new buyer or pay for return shipment. Documentary collections are viable
only for ocean shipments, as the bill of lading for ocean freight is a valid title to the goods
and is a negotiable document whereas the comparable airway bill is not negotiable as an
ownership title.
Drafts
A draft (sometimes called a bill of exchange) is a written order by one party directing a
second party to pay a third party. Drafts are negotiable instruments that facilitate
international payments through respected intermediaries such as banks but do not
involve the intermediaries in guaranteeing performance. Such drafts offer more flexibility
than LCs and are transferable from one party to another. There are two basic types of
drafts: sight drafts and time drafts.
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Sight Draft
After making the shipment the seller sends a sight draft, through his bank to the buyer’s
bank, accompanied by agreed documentation such as the original bill of lading, invoice,
certificate of origin, phyto-sanitary certificate, etc. The buyer is then expected to pay the
draft when he sees it and thereby receive the documentation that gives him ownership
title to the goods that were shipped. There are no guarantees made about the goods
other than the information about quantities, date of shipment, etc. which appears in the
documentation. The buyer can refuse to accept the draft thereby leaving the seller in the
unpleasant position of having shipped goods to a destination without a buyer. There is
no recourse with the banks since their responsibility ends with the exchange of money
for documents.
Time Drafts/Bankers' acceptances

Bankers' acceptances are negotiable instruments (time drafts) drawn to finance the
export, import, domestic shipment or storage of goods. It demands payment after a
specified time or on a certain date after the buyer accepts the draft and receives the
goods. A bankers' acceptance is "accepted" when a bank writes on the draft its
agreement to pay it at maturity. A bank may accept the draft for either the drawer or the
holder.
An ordinary acceptance is a draft or bill of exchange order to pay a specified amount of

money at a specified time. A draft may be drawn on individuals, businesses or financial
institutions.
An acceptance doesn't reduce a bank's lending capacity. The bank can raise funds by
selling the acceptance. Nevertheless, the acceptance is an outstanding liability of the
bank and is subject to the reserve requirement unless it is of a type eligible for discount
by the Federal Reserve Bank.
Example
Banker’s Acceptances sell at a discount from the face value:
Face value of Bankers Acceptance $1,000,000

Minus 2% per annum commission for one year -$20,000
Amount received by exporter in one year $980,000
HYBRID METHODS
In practice, international payment methods tend to be quite flexible and varied.

Frequently, trading partners will use a combination of payment methods. For example:
the seller may require that 50% payment be made in advance using a wire transfer and
that the remaining 50% be made by documentary collection and a sight draft.
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OPEN ACCOUNT
Open account means that payment is left open to an agreed-upon future date. It is one
of the most common methods of payment in international trade and many large
companies will only buy on open account. Payment is usually made by wire transfer or
check. This can be a very risky method for the seller, unless he has a long and favorable
relationship with the buyer or the buyer has an excellent credit rating. Still, there are no
guarantees and collecting delinquent payments is difficult and costly in foreign countries
especially considering that this method utilizes few legally binding documents. Contracts,
invoices, and shipping documents will only be useful in securing payment from a
recalcitrant buyer when his country’s legal system recognizes them and allows for
reasonable settlement of such disputes.
OTHER PAYMENT METHODS
Consignment
The consignment method requires that the seller ship the goods to the buyer, broker or
distributor but not receive payment until the goods are sold or transferred to another
buyer. Sometimes even the price is not pre-fixed and while the seller can verify market
prices for the sale date or hire an inspector to verify the standard and condition of the
product, he ultimately has very little recourse.
Credit Card
Some banks offer buyers special lines of credit that are accessible via credit card to
facilitate even substantial purchases. It is convenient for both parties - but the seller
should confirm the bank charges and also bear in mind that the laws that govern
domestic credit card transactions differ from those govern international use.
Counter-trade and Barter

Counter-trade or barter is most often used when the buyer lacks access to convertible
currency or finds that rates are unfavorable or can exchange for products or services
desirable to the seller. Counter-trade indicates that the buyer will compensate the seller
in a manner other than transfer or money or products.
Factoring
Factoring is a discounting method without recourse. It is an outright sale of export
accounts receivable to a third party, (the factor) who assumes the credit risk. The factor
may be a factoring house or a department of a bank. The advantage to the exporter is
the removal of contingent liabilities from its balance sheet, improved cash flow and
elimination of bad debt risk.
Factoring is for short-term receivables (under 90 days) and is more related to

receivables against commodity sales.
Forfaiting
The exporter sells accounts receivables to a forfaiter on a “non-recourse discount” basis,
and the exporter effectively passes all risks associated with the foreign debt to the
forfaiter. The forfaiter may be a forfaiting house or a department of a bank. The benefits
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are same as factoring - maximize cash flow and eliminate the payment risk. It is a
flexible finance tool that can be used in short, medium and long-term contracts.
Forfaiting can be for receivables against which payments are due over a longer term,
over 90 days and even up to 5 years.
Example
An Asian Importer wants to purchase machinery that he is unwilling or unable to pay
for in cash until that machinery begins to generate income.
At the same time, the exporter wants immediate payment in full in order to meet his
on-going business commitments
Forfaiting solution works as follows
1. Commercial contracts are negotiated subject to finance;
2. The importer arranges for an Irrevocable Letter of Credit to be issued or for a
series of Promissory Notes or Bills of Exchange to be drawn in favour of the
exporter which the importer arranges to have guaranteed by his local bank;
3. The exporter contacts the discounting bank (the forfaiter) for a rate of discount
which is then agreed;
4. The goods are shipped;
5. The notes or bills are sent with shipping documentation and invoices to the
discounting bank via the exporter (who endorses the notes or bills "without
recourse" to the order of the discounting bank);
6. The discounting bank purchases the guaranteed notes or bills from the
exporter at the agreed rate.
Result: the exporter receives payment in full immediately after shipping (against
presentation of satisfactory documentation to the forfaiter); the importer gets his
goods and can pay for them in installments over time; and the forfaiter has title to
an asset which he may retain as an investment.
FOREIGN CREDIT INSURANCE UNDERWRITERS AND BROKERS
The purpose of foreign credit insurance is to insure repayment of export credit against
nonpayment due to political and/or commercial causes. It insures commercial risks of
nonpayment by importers because of insolvency or other business factors and political
risks of war, expropriation, confiscation, currency inconvertibility, civil commotion, or
cancellation of import permits.
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THE BANKERS ASSOCIATION FOR FOREIGN TRADE (BAFT)
The Bankers Association for Foreign Trade (BAFT) is a collection of banking institutions,
dedicated to promoting American exports, international trade, and finance and
investment between U.S. firms and their trading partners. BAFT has set up a trade
finance database with a grant from the U.S. Department of Commerce. The database
serves as an essential resource for assisting exporters seeking trade finance and banks
that provide financial services.
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INTERNATIONAL PAYMENT INSTRUMENTS COMPARISON CHART9
9
The above “International Payments Comparison Chart” is reproduced from US Department of
Agriculture website - www.ams.usda.gov/ Pub.
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12. TREASURY SERVICES & CASH

MANAGEMENT
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TREASURY SERVICES & CASH MANAGEMENT
The Treasury Services department is concerned with managing the financial risks of the
bank. Hence, the treasurer's job is to understand the nature of these risks, the way they
interact with the business, and to minimize or to offset them. In many cases, the treasury
services department also provides cash management solutions for customers of the
bank. The Treasury services department of a bank performs the following functions:
 Managing the cash position of the bank, managing liquidity and associated risks
 Forex services: provides forex services to corporates, enters in to deals with
multiple counterparties to maintain a risk-managed position for the bank.
 Risk management services: provides risk management products like swaps,
options etc to corporates and enters in to multiple deals with various
counterparties to maintain a risk-managed position for the bank.
 Conducts research on various market factors, monitors interest rate and
economic scenario etc
 Cash Management services for corporates – managing collections and payments
Typically, the treasury has a front office desk which enters in to trades (in forex, money
markets, equity, treasury securities etc) with various market participants and a middle
office/back office desk which monitors positions and provides operational support.
Some of the main functions of the treasury are explained below.
TREASURY SERVICES - LIQUIDITY & INTEREST RATE RISK MANAGEMENT
Bank treasuries perform the critical role of managing liquidity and ensuring that various
businesses of the bank have enough money to lend to customers. They also invest the
excess cash in a suitable mix of short term or money market instruments and long term
instruments to earn maximum return while taking care of liquidity and risk management.
Thus, the treasury:
 manages borrowings for the bank from various market entities – other banks, central
bank, corporates, mutual funds, insurance companies etc
 manages investment of cash surpluses in various market instruments – money
market instruments, deposits with other banks, equity, debt, treasury securities etc
 manages funds allocation and transfer pricing for various businesses of the bank
Apart from managing credit risk associated with investment options, some of the key
functions of the treasury are Asset Liability Management and Interest rate risk
management.
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Asset Liability Management

Banks take on liabilities, such as deposits or annuities. They would invest the proceeds
from these liabilities in assets such as loans, bonds or debentures.
Example
 A bank borrows USD 100MM at 3.00% for one year

 The bank uses the borrowed same money to lend a highly-rated borrower for 5
years.
For simplicity, assume interest rates are annually compounded and all interest
accumulates to the maturity of the respective obligations. The net transaction appears
profitable—the bank is earning a 20 basis point spread—but it entails considerable risk.
At the end of one year, the bank will have to find new financing for the loan, which will
have 4 more years before it matures. Assume interest rates are at 4.00% at the end of
the first year.
 The Bank will now have to pay a higher rate of interest (4.00%) on the new financing
than the fixed 3.20 it is earning on its loan. It is going to be earning 3.20% on its loan
and paying 4.00% on its financing.
The problem in this simple example was caused by a mismatch between assets and
liabilities. As long as interest rates experienced only modest fluctuations, losses due to
asset-liability mismatches are small or trivial. However, in a period of volatile interest
rates, the mismatches would become serious.
The treasury asset-liability management (ALM) group assesses asset-liability risk and all
banks have ALM committees comprised of senior managers to address the risk.
Techniques for assessing asset-liability risk came to include gap analysis, duration
analysis and scenario analysis. Gap analysis looks at amount of assets and liabilities in
various maturity buckets while Duration analysis looks at weighted average maturity of
cash flows to compare assets and liabilities. Since liquidity management is closely linked
to asset-liability management, assessment and management of liquidity risk is also a
function of ALM departments and ALM committees. ALM strategies often include
securitization, which allows firms to directly address asset-liability risk by removing
assets or liabilities from their balance sheets. This not only eliminates asset-liability risk;
it also frees up the balance sheet for new business.
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Interest rate risk management

Interest rate risk is the exposure of a bank's financial condition to adverse movements in
interest rates. Accepting this risk is a normal part of banking and can be an important
source of profitability and shareholder value. However, excessive interest rate risk can
pose a significant threat to a bank's earnings and capital base. Changes in interest rates
affect a bank's earnings by changing its net interest income and the level of other
interest-sensitive income and operating expenses. Changes in interest rates also affect
the underlying value of the bank's assets, liabilities and off-balance sheet instruments
because the present value of future cash flows (and in some cases, the cash flows
themselves) change when interest rates change. Accordingly, an effective risk
management process that maintains interest rate risk within prudent levels is essential to
the safety and soundness of banks.
Causes of interest rate risk

The causes of interest rate risk might vary:
 Repricing risk: The primary form of interest rate risk arises from timing differences in
the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities
and off-balance-sheet (OBS) positions. For instance, a bank that funded a long-term
fixed rate loan with a short-term deposit could face a decline in both the future
income arising from the position and its underlying value if interest rates increase.
 Yield curve risk: Yield curve risk arises when unanticipated shifts of the yield curve (a
plot of investment yields against maturity periods) have adverse effects on a bank's
income or underlying economic value. Yield curves can shift paralelly or change in
steepness, posing different risks. For instance, the underlying economic value of a
long position in 10-year government bonds hedged by a short position in 5-year
government notes could decline sharply if the yield curve steepens, even if the
position is hedged against parallel movements in the yield curve.
 Basis risk: Basis risk arises from imperfect correlation in the adjustment of the rates
earned and paid on different instruments with otherwise similar repricing
characteristics. For example, a strategy of funding a one year loan that reprices
monthly based on the one month U.S. Treasury Bill rate, with a one-year deposit that
reprices monthly based on one month Libor, exposes the institution to the risk that
the spread between the two index rates may change unexpectedly.
 Optionality: An additional and increasingly important source of interest rate risk

arises from the options embedded in many bank assets, liabilities and OBS
portfolios. Options may be stand alone instruments such as exchange-traded options
and over-the-counter (OTC) contracts, or they may be embedded within otherwise
standard instruments. They include various types of bonds and notes with call or put
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provisions, loans which give borrowers the right to prepay balances, and various
types of non-maturity deposit instruments which give depositors the right to withdraw
funds at any time, often without any penalties. If not adequately managed, the
asymmetrical payoff characteristics of instruments with optionality features can pose
significant risk particularly to those who sell them, since the options held, both
explicit and embedded, are generally exercised to the advantage of the holder and
the disadvantage of the seller.
Managing interest rate risk

Bank treasuries measure interest rate sensitivity of securities (assets or liabilities)
through Duration analysis. Duration is a mathematical concept which can be used to
measure the sensitivity of a financial instrument’s price to changes in interest rate. On
the basis of duration analysis, banks can increase/decrease holdings of long term and
short term securities in response to anticipated changes in interest rate.
Banks also use derivative instruments like interest rate swaps and options to manage
interest rate risks (A derivative is a generic term often used to categorize a wide variety
of financial instruments whose value “depends on” or is “derived from” the value of an
underlying asset, reference rate or index). Some of them are:
 Interest Rate Swap: An agreement to exchange net future cash flows. In its
commonest form, the fixed-floating swap, one counterparty pays a fixed rate and the
other pays a floating rate based on a reference rate, such as Libor. There is no
exchange of principal. The interest rate payments are made on an agreed notional
amount.
 Forward Rate Agreement (FRA): A FRA allows purchasers / sellers to fix the interest
rate for a specified period in advance. One party pays fixed, the other an agreed
variable rate. Maturities are generally out to two years and are priced off the
underlying yield curve. The transaction is done in respect of an agreed nominal
amount and only the difference between contracted and actual rates is paid.
 Interest Rate Guarantee: An option on a forward rate agreement (FRA), also known
as a FRAtion. Purchasers have the right, but not the obligation, to purchase a FRA at
a predetermined strike. Caps and Floors are strips of interest rate guarantees.
 Swaption: An option to enter an interest rate swap. A payer swaption gives the
purchaser the right to pay fixed (receive floating), a receiver swaption gives the
purchaser the right to receive fixed (pay floating).
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TREASURY SERVICES - FOREX MANAGEMENT
Foreign exchange is essentially about exchanging one currency for another. Forex rates
between two currencies at any point of time are influenced by a variety of factors like
state of the economy, interest rates & inflation rate, exchange rate systems
(fixed/floating), temporary demand-supply mismatches, foreign trade position etc.
Foreign exchange exposures for a financial entity arise from many different activities. A
company which borrows money in a foreign currency is at risk when the local currency
depreciates vis-à-vis the foreign currency. An exporter who sells its product in foreign
currency has the risk that if the value of that foreign currency falls then the revenues in
the exporter's home currency will be lower. An importer who buys goods priced in foreign
currency has the risk that the foreign currency will appreciate thereby making the local
currency cost greater than expected. Generally the aim of foreign exchange risk
management is to stabilise the cash flows and reduce uncertainty from financial
forecasts.
Basics of forex
Currencies are quoted in one of the two ways:
 Direct Quotation (1 USD = INR 45.26) &
 Indirect Quotation (INR 100 = USD 2.21).
‘Direct’ or ‘Indirect’ are always vis-à-vis the US dollar perceptive. In practice, all
currencies except the British Pound are quoted in the direct quotation method. Since
rates for all currencies are quoted vis-à-vis the US dollar, cross currency rates (example:
INR/Euro) would be obtained by combining the two primary currency quotes vis-à-vis the
US dollar.
Also, quotes usually have two parts: the bid rate (rate at which the bank will purchase
US dollars against home currency in case of direct quotes) and the ask rate (rate at
which the bank will sell US dollars against home currency in case of direct quotes). The
bid rate will always be lesser than the ask rate to cover for operational charges and profit
margins of the banks. Examples are:
 INR/USD quote: 45.26/.36 (here, 0.01 is the smallest count, referred to as one ‘pip’)
 EUR/USD quote: 1.2458/.2461 (here, 0.0001 is the smallest count, referred to as
one ‘pip’)
While the derived cross currency rate would be:
INR/Euro quote: (45.26*1.2461)/ (45.36*1.2458) = 56.40/.51
Foreign currency deals in a particular currency necessary have to be settled in the home
nation of the currency. Hence, banks taking part in international transactions need to
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maintain accounts in various countries to enable transacting in those currencies. These

accounts are of multiple types:
 Nostro (Our/my account with you): Current account maintained by one bank with
another bank abroad in the latter’s home currency
 Vostro (Their account with me/us): Current account maintained in the home currency
by one bank in the name of another bank based abroad
Typically, banks have vostro/nostro accounts with multiple foreign banks.
Spot and Forward Foreign Exchange Contracts

The most basics tools of forex risk management are 'spot' and 'forward' contracts. These
are contracts between end users and financial institutions that specify the terms of an
exchange of two currencies. In any forex contract there are a number of variables that
need to be agreed upon and they are:
 The currencies to be bought and sold - in every contract there are two currencies the
one that is bought and the one that is sold
 The amount of currency to be bought or sold
 The date at which the contract matures
 The rate at which the exchange of currencies will occur
The exchange rates advertised either in the newspapers (and that mentioned above) or
on the various information services assume a deal with a maturity of two business days
ahead - a deal done on this basis is called a spot deal. In a spot transaction the currency
that is bought will be receivable in two days whilst the currency that is sold will be
payable in two days. This applies to all major currencies with the exception of the
Canadian Dollar.
Most market participants want to exchange the currencies at a time other than two days
in advance but would like to know the rate of exchange now. This is done through a
forward contract to exchange the currencies at a specified exchange rate at a specified
date. In determining the rate of exchange in six months time there are two components:
 the current spot rate
 the forward rate adjustment
The spot rate is simply the current market rate as determined by supply and demand.
The forward rate adjustment is a slightly more complicated calculation that involves the
interest rates of the currencies involved.
Forward rate (Local currency/USD) = Spot rate *(1+ interest rate in US) / (1+ local
interest rate), with interest rates adjusted for the period of the forward rate. The concept
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behind this equation is that if you defer the value date of a spot transaction each party
will have the funds that they would have paid to invest. The difference between a forex
spot rate and the forward rate for a particular tenure is called the forward premium for
that tenure. Currencies can have forward premiums or forward discounts vis-à-vis the
US dollar.
Forex risk can also be covered through forex future contracts. Futures are exactly similar
to forwards, except for the fact that these deals are brokered through an exchange, non-
customizable (only standard deals available) and hence, not prone to counter-party risk.
What does the bank treasury do?

The bank treasury enters in to forex contracts with various corporates or other entities
who would like to cover their forex risk. Deals are typically communicated through
phone/fax; however, online forex deals are rapidly on the increase, where the
counterparty completes the deal online in a secure internet/VPN environment while the
deal ticket is remotely printed at the bank treasury. Also on the increase are ‘straight-
through’ deals, meaning corporates being able to do a trade and then obtain the data
about the trade back into the company’s accounting system without re-keying any
information.
The forex deal is managed by the treasury front office along with support from the back
office desk. In a typical transaction,
 Forex trader buys/sells foreign currency

 Forex trader passes deal slip to back office
 Back office obtains banks confirmation
 Back office transmits forex delivery instructions to the Nostro account-
maintaining banks
 Back office pays/receives inter-bank dues
 Back office computes Profit/loss on account of Forex trading
The bank treasury enters in to spot and forward contracts with various parties for various
tenures and amounts. However, the bank would be heavily exposed to forex risk if all
these positions are left unhedged/uncovered. The treasury monitors overall positions of
forex and enters in to counter party deals with other corporates, banks and other market
participants like hedge funds. They use forex derivatives to manage forex risks. Some of
the derivatives used are:
Cross Currency swaps: Involves the exchange of cash flows in one currency for those in
another. Unlike single-currency swaps, cross-currency swaps often require an exchange
of principal. Typically the notional principal is exchanged at inception at the prevailing
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spot rate. Interest rate payments are then passed on a fixed, floating or zero basis. The
principal is then re-exchanged at maturity at the initial spot rate.
Forex Options: Gives the buyer of the option the right, but not the obligation to sell or
purchase the forex, depending on whether the option is a put option or a call option.
European Options are exercised only at maturity of the option while American Options
are exercised any time during the option period.
FX Swaps (Sell with a Purchase): are transactions involving a purchase / sale at a spot
rate and a sale / purchase at a forward rate. This transaction enables the counterparty
holding a maturing Forward transaction to extend this Forward to an agreed future date.
The treasury needs to continuously monitor these and other derivatives positions and
ensure that forex risk is maintained within acceptable levels.
CASH MANAGEMENT SERVICES – COLLECTIONS AND PAYMENT
Example
Consider a consumer goods company in Mid-west US, with dealerships spread through
12 states. The company has a manufacturing facility in Michigan and 4 depots, one each
in Ohio, Michigan, Illinois and Texas. The company transports goods to the 4 depots
which serves the respective local dealers and in some cases dealers in neighboring
states. All the depots are treated as independent cost centers, with sales from respective
regions and salaries and general expenses for these regions marked to the depot
concerned. Collections from dealers in various locations are managed by local sales
teams, one team for each state. The company wants to:
 Ensure daily monitoring of collections from various states
 Sweep all local collections daily to a central bank account at Michigan
 Ensure that local accounts do not remain in debit when the central account is in
credit.
 Provide facility for temporary intra-day overdraft for the local accounts
 Ensure that surplus money in the central account is invested in an optimal fashion
while allowing sufficient liquidity
 All payments from local accounts above $10,000 require an approval from the CFO
sitting in Michigan
This is a typical case where the company needs the services of a bank to manage its
cash collections and payments. The company needs both cash management facilities
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and MIS of collections and payments that can allow it to track revenue and expenses in
the manner required.
Companies rarely fail because they are insolvent. They do fail because they are illiquid.
Companies must focus on precise working capital management as a critical component
of treasury strategy. Companies require:
 rich information, to parallel the company’s cash flow cycle
 global cash concentration, through pooling mechanisms
 automated internal funding mechanisms for deficit positions
 investment options to match individual profiles for liquidity, risk and return.
Banks have responded to the call for evolved cash management concepts. Accelerating
accounts receivable and streamlining accounts payable via a single banking system
interface provide the stepping stone to achieve optimal cash flow management. Some
banks also provide aligned cash management with liquidity and investment offerings.
They do so by:
 developing optimal account structures
 applying cash concentration techniques like pooling and sweeping
 providing investment vehicles to maximize cash flows
 implementing foreign exchange and interest rate exposure netting systems
 establishing regional treasury and shared service centers.
The final objective of most of these cash management solutions is to effectively

outsource the corporate’s receivables and payables process and ensure the best
possible liquidity and short term investment management strategy. Moreover,
increasingly, cash management (both payments and collections) are moving over to a
web-based environment where the corporate can manage his receivables, payables and
liquidity position online. In many cases, there is almost-complete integration between the
bank and the company’s supply chain/ERP system which manages collection and
payments data internally. Some of the common methods used for cash management are
described below.
Cheque Collections – Lock Box service

There are possibilities for optimizing and streamlining a company’s incoming payment
flows. The most common collection mechanism is a Cheques lock box service – a
collecting service which enables companies to collect and settle cheques locally (In a
typical case, each of the corporate’s debtors would send cheques along with accepted
invoices to a designated post box, hence the lock box name). Banks undertake to collect
cheques at various pre-defined locations on behalf of the customer, send them for
clearing and credit the amount s to a specified customer account. Once the cheques are
collected by the bank through person, courier or delivered by the company
representative:
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 the cheques are sorted and batched

 post dated cheques are kept for processing on the value date
 the image of the cheques and the remittance advices are captured and sent to the
corporate
 cheques are sent for clearing, if required
 realized cheques are tallied and amounts credited to the corporate’s bank account
 the information on cheques collected is transmitted to the corporate for electronic
reconciliation
In enhanced versions of this facility, the bank manage the receivable books of the
corporate - managing collections, monitoring receivables ageing and providing
reconciled collection reports which can be directly uploaded to corporate
information/supply chain systems.
Payments
There are several types of both domestic and cross border payments products. The
possibility to initiate these transactions remotely is enhanced via electronic banking
applications. The following payment types are common:
 Remote payments via online transfer, cheques or drafts printed at the bank end: The
company uploads the payment information to the bank’s website through a VPN
connection or mails the payment details to the bank. The bank effects the payments
to respective accounts after necessary checks. Payments can be effected through
direct account credits, cheques or drafts with facsimile signatures of authorized
company personnel.
 Bulk payments: Payment of salaries, multiple vendors, dividend warrants, interest
warrants through bulk upload of payment files and processing of instruments at bank
end.
 Intra company payments: through online funds transfer
 Standing order payments: periodic payments made to specified accounts at pre-
defined intervals.
In enhanced versions of this facility, the bank manage the payable books of the
corporate - managing payments through a direct information feed from the corporate’s
information/supply chain system, monitoring outstanding payments and providing
reconciled payment reports which can be directly uploaded to update the corporate’s
information/supply chain systems.
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Zero balance structure - Pooling

Pooling allows a company or several companies belonging to the same group profit from
efficient liquidity management, centralized treasury and credit-line management and
optimization of interest results. Banks offer both domestic and cross border zero
balancing whereby all value balances of a set of 'participating' accounts are centralized
at the end of each day in one central account. Thus the participating accounts will not
bear any credit or debit interest, and all balances are concentrated in the central account
enabling optimal management of your cash position.
Netting
Netting is the fundamental method for centralising and offsetting intra company and third
party payments. Netting not only significantly reduces payment flows and costs, but also
provides invaluable management information. Banks offer both domestic and cross-
border netting solutions.
Clearing services
Banks offer clearing services to other banks. In such cases, a bank with strong local
branch coverage offers to participate in clearing arrangements on behalf of other banks
with no physical presence at these locations. Also clubbed under correspondent banking
services, this facility primarily helps use the branch networks of various banks on a
complimentary basis.
ENHANCING TREASURY & CASH MANAGEMENT
Asset Securitisation
Financial institutions and banks need to raise fresh capital to fund continuous asset
growth and portfolio management. This has become a major challenge for many
financial institutions and banks due to tough capital market conditions and other market
related factors. Asset securitisation can offer an alternative cost efficient financing tool,
enabling them to better manage liquidity and funding requirements.
Asset securitisation transactions have one basic concept: the identification and isolation
of a separable pool of assets that generate revenue streams independently from the
originating entity. The securities issued on these assets are then sold to investors who
base their returns exclusively on the underlying assets’ performance. The structure is
illustrated below:
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All these entities need not be present in every transaction. The number of entities
depends on the complexity of the transaction. An example would help understand the
concept better.
Example
Bank of America (Originator) has 5000 home loans totaling more than $600 million. The
individual loans are of various credit profiles and various repayment periods. Bank of
America is constrained by lack of funds and wishes to sell off its loans to raise money.
Thus, it decides to ‘sell’ about 2000 home loans totaling $200 million. The steps followed
are shown below:
 Bank of America conducts an internal study of the portfolio and ascertains that the
average maturity of the pool of loans is about 12 years and the average credit rating
would be AA-. It realizes that historically 10% of the total home loan owners default.
So it would only realize $180 million instead of $200 million.
 Bank of America wants to enhance the rating so that it can ‘sell’ the loans at a better
price. It decides to provide a cash security of $10 million (Credit enhancement) in the
scenario of any repayment default by home loan borrowers.
 Bank of America appoints Credit rating agency X which analyses the pool of loans,
and taking into account the cash security provided rates it AA+.
 Bank of America ‘sells’ the pool of housing loans amounting to $200 million to a
independent firm, Plexus SPV Ltd.
 Backed by these home loan’s future cash flows, Plexus SPV Ltd. issues debt
certificates for $200 million to investors. Plexus pays back the investors the money
from the repayments done by the home loan borrowers.
 Plexus SPV Ltd. pays $198 million to Bank of America after deducting service
charges to cover operational costs.
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 From now on, all EMI repayments on these home loans made by retail investors
would flow through Plexus SPV Ltd and then reaches the investors.
The above example captures the gist of any securitisation transaction, but there are a lot
of structuring issues and legal and regulatory challenges involved in any such
transaction.
Fannie Mae and Ginnie Mae are examples of institutions specializing in securitisation
transactions of mortgage loans for US banks. They help US banks in having enough
fresh funds for home loan disbursements.
Real Time Gross Settlement (RTGS)

The current payment system involves settlement of payments on a ‘settlement day’ and
interest is invariably computed to accrue on a daily basis. Even in the wholesale markets
for foreign exchange and money markets contracts, ‘spot’ transactions mean two-
business days. Settlement for clearing cheques presented to the clearing houses takes
place on a netting basis at a particular time either same day or on the next day. This
system gives rise to risks such as credit risk, liquidity risk, legal risk, operational risk and
systemic risk.
RTGS is a system provides online settlement of payments between financial institutions.

In this system payment instructions between banks are processed and settled
individually and continuously throughout the day. This is in contrast to net settlements
where payment instructions are processed throughout the day but inter-bank settlement
takes place only afterwards typically at the end of the day. Participant banks will have to
maintain a dedicated RTGS settlement account with the central bank for outward and
inward RTGS payments.
RTGS systems do not create credit risk for the receiving participant because they settle
each payment individually, as soon as it is accepted by the system for settlement.
RTGS system can require relatively large amounts of intraday liquidity because
participants need sufficient liquidity to cover their outgoing payments.
Continuous Linked Settlement (CLS)

The average daily turnover in global forex transactions stand at almost USD 2 trillion,
with participants in the market spread across various geographies and time zones.
However, the difference in time zones and hence lack of synchronization of transactions
has resulted in considerable amount of systematic risk. Typically, one leg of a forex
trade is effected at one point of time and there would be a delay before the other leg is
executed because of time-zone differences. In such a situation, there is a heightened
risk of one party defaulting.
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CLS eliminates this ‘temporal’ settlement risk, making same-day settlement both
possible and final. This is made possible by leveraging on the fact that there are
significant overlaps between the main time zones. CLS provides a specific time window
in which various settlement time zones can interact and pass settlement messages. The
CLS system consists of the following entities:
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CLS Bank: The CLS bank is the central node for the CLS system. CLS Bank is owned
by nearly 70 of the world’s largest financial groups throughout the US, Europe and Asia
Pacific, who are responsible for more than half the value transferred in the world's FX
market.
Settlement Members: They are shareholders of the CLS bank, who can each submit
settlement instructions directly to CLS Bank and receive information on the status of
their instructions. Each Settlement Member has a multi-currency account with CLS
Bank, with the ability to move funds. Settlement Members have direct access and input
deals on their own behalf and on behalf of their customers. They can provide a branded
CLS service to their third-party customers as part of their agreement with CLS Bank.
User Members: User Members can submit settlement instructions for themselves and
their customers. However, User Members do not have an account with CLS Bank.
Instead they are sponsored by a Settlement Member who acts on their behalf. Each
instruction submitted by a user member must be authorized by a designated Settlement
Member. The instruction is then eligible for settlement through the Settlement Member's
account.
Third parties: Third parties are customers of settlement and user members and have no
direct access to CLS. Settlement or user members must handle all instructions and
financial flows, which are consolidated in CLS.
Nostro agents: These agents receive payment instructions from Settlement Members
and provide time-sensitive fund transfers to Settlement Members' accounts at CLS Bank.
They receive funds from CLS Bank, User Members, third parties and others for credit to
the Settlement Member account.
The benefits of the CLS system are many:

Traders can expand their FX business with counterparty banks without increasing limits.
Treasury managers have more certainty about intraday and end-of-day cash positions.
Global settlement can rationalize nostro accounts and leverage multi-currency accounts.
The volume and overall value of payments is reduced, as are cash-clearing costs.
Costly errors are minimized and any problems can be resolved fast.
Automated Clearing House facilities (ACH)

ACH transactions are electronic clearing transactions in which information about debits
and credits are passed across the clearing system through electronic data files rather
than physical instruments like cheques, drafts etc. ACH electronic transactions are
distinguished from wire transfers in that they are high volume, regularly scheduled,
usually between the same parties, and are initiated via specifically formatted electronic
files. Such transactions must usually be initiated one to two days prior to the settlement
date, since they are batch processed and not for immediate payment. The most common
ACH payment applications are:
Direct deposit of payroll, where the bank debits the corporate account and credits
employee accounts on the basis of a electronic file transmitted/provided by the corporate
Corporate Disbursement Service, where the bank debits a client's account to initiate
payments to vendors on their behalf
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Corporate Collection Service, where the bank enables it’s clients to collect payments
and remittance data from vendors or trading partners.
Collection of consumer payments over the telephone, through the Internet or via check-
to-ACH conversion.
ACH Accounts Receivable Check Conversion enables converting checks collected at a
lockbox or remittance-processing center to ACH electronic debits, speeding payment
collections and improving funds availability.
These services allow the customer to increase transaction speed and improve accuracy
and ease of reconciliation by electronic means and avoidance of physical instruments
and clearing delays. ACH has been an area of very strong growth, with over 8.5 billion
transactions being effected through this route in 2002. However, several security issues
remain to be resolved in this area.
Electronic Bill Presentment and Payment (EBPP)

Electronic Bill Presentment and Payment (EBPP) leverage the Internet to provide
companies and their customers a safe and efficient method for handling invoices.
A typical EBPP solution allows companies to electronically send invoices to their

customers who can then view, dispute, accept and pay their invoices through the same
channel. EBPP replaces traditional invoice processes, eliminating paper-related
expenses and reducing costs for both the company and its clients. By electronically
collecting funds, EBPP improves profitability and forecasting abilities, minimizes the level
of disputes and improves the cash collection process. EBPP simplifies data integration
by providing companies and their clients with a file download to update accounts
receivable/payable systems. In addition, companies are usually provided the flexibility to
design the service's functionality and determine rules for adjudicating disputes.
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13. INVESTMENT BANKING
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INVESTMENT BANKING
Investment Banks assist clients in raising money in order to grow and expand their
businesses. Their activities include:
 Originating and managing issues of securities

 Underwriting
 Market Making
 Principal buying or selling securities on a spread basis
The top-tier investment banks are:
 Goldman Sachs
 Merrill Lynch
 Morgan Stanley Dean Witter
 Credit Suisse First Boston
 UBS
 Salomon Smith Barney
 J.P. Morgan
 Lehman Brothers
Generally, the breakdown of an investment bank includes the following areas:
CORPORATE FINANCE
The bread and butter of a traditional investment bank, corporate finance generally
performs two different functions:
 Mergers and acquisitions advisory - Banks assist in negotiating and structuring a

merger between two companies. If, for example, a company wants to buy another
firm, then an investment bank will help finalize the purchase price, structure the deal,
and generally ensure a smooth transaction.
 Underwriting - An Underwriter is guarantees that the capital issue will be subscribed
to the extent of his underwritten amount. He will make good of any shortfall.
SALES
Salespeople take the form of: 1) the classic retail broker, 2) the institutional salesperson,
or 3) the private client service representative. Brokers develop relationships with
individual investors and sell stocks and stock advice.
Institutional salespeople develop business relationships with large institutional investors.

Institutional investors are those who manage large groups of assets, for example
pension funds or mutual funds.
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Private Client Service (PCS) representatives lie somewhere between retail brokers and
institutional salespeople, providing brokerage and money management services for high
net worth individuals.
Salespeople make money through commissions on trades made through their firms.
TRADING
Traders facilitate the buying and selling of stock, bonds, or other securities such as
currencies, either by carrying an inventory of securities for sale or by executing a given
trade for a client. Traders deal with transactions large and small and provide liquidity (the
ability to buy and sell securities) for the market. (This is often called making a market.)
Traders make money by purchasing securities and selling them at a slightly higher price.
This price differential is called the "bid ask spread."
RESEARCH
Research analysts follow stocks and bonds and make recommendations on whether to
buy, sell, or hold those securities. Stock analysts typically focus on one industry and will
cover up to 20 companies' stocks at any given time. Some research analysts work on
the fixed income side and will cover a particular segment, such as high yield bonds or
U.S. Treasury bonds.
Corporate finance bankers rely on research analysts to be experts in the industry in

which they are working. Salespeople within the I-bank utilize research published by
analysts to convince their clients to buy or sell securities through their firm.
Reputed research analysts can generate substantial corporate finance business as well
as substantial trading activity, and thus are an integral part of any investment bank.
SYNDICATE
The hub of the investment banking wheel, syndicate provides a vital link between
salespeople and corporate finance. Syndicate exists to facilitate the placing of securities
in a public offering, a knock-down drag-out affair between and among buyers of offerings
and the investment banks managing the process. In a corporate or municipal debt deal,
syndicate also determines the allocation of bonds.
INITIAL PUBLIC OFFERINGS
An initial public offering (IPO) is the process by which a private company transforms
itself into a public company. The company offers, for the first time, shares of its equity
(ownership) to the investing public. These shares subsequently trade on a public stock
exchange like the New York Stock Exchange (NYSE) or the Nasdaq. The primary
reason for going through the rigors of an IPO is to raise cash to fund the growth of a
company. Often, the owners of a company may simply wish to cash out either partially or
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entirely by selling their ownership in the firm in the offering. Thus, the owners will sell
shares in the IPO and get cash for their equity in the firm.
The IPO process consists of these three major phases:
Hiring the Managers

This choosing of an investment bank is often referred to as a "beauty contest."
Typically, this process involves meeting and interviewing investment bankers from
different firms, discussing the firm's reasons for going public, and ultimately nailing down
a valuation. In making a valuation, I-bankers, pitch to the company wishing to go public
what they believe the firm is worth, and therefore how much stock it can realistically sell.
Perhaps understandably, companies often choose the bank that provides the highest
valuation during this beauty contest phase instead of the best-qualified manager. Almost
all IPO candidates select two or more investment banks to manage the IPO process.
Due Diligence and Drafting

This phase involves understanding the company's business as well as possible
scenarios (called due diligence), and then filing the legal documents as required by the
SEC. The SEC legal form used by a company issuing new public securities is called the
S-1 (or prospectus) and Lawyers, accountants, I-bankers, and of course company
management must all toil to complete the S-1 in a timely manner.
Marketing
Once the SEC has approved the prospectus, the company embarks on a road show to
sell the deal. A road show involves flying the company's management coast to coast
(and often to Europe) to visit institutional investors potentially interested in buying shares
in the offering. Typical road shows last from two to three weeks, and involve meeting
literally hundreds of investors, who listen to the company's presentations, and then ask
scrutinizing questions. Often, money managers decide whether or not to invest
thousands of dollars in a company within just a few minutes of a presentation. The
marketing phase ends abruptly with the placement of the stock, which results in a new
security trading in the market.
Successful IPOs trade up on their first day (increase in share price), and tend to succeed
over the course of the next few quarters.
THE CHINESE WALL
Between corporate finance and research, firms build what is known as a Chinese Wall
separating research analysts from both bankers and Sales & Trading. Often, bankers
are privy to inside information at a company because of ongoing or potential M&A
business, or because they know that a public company is in registration to file a follow-
on offering. Either transaction is considered material non-public information and
research analysts, privy to such information cannot change ratings or mention it, as
doing so would effectively enable clients to benefit from inside information at the
expense of existing shareholders. When it comes to certain information, a Chinese Wall
also separates salespeople and traders from research analysts. The reason should be
obvious. Analyst reports often move stock prices - sometimes dramatically.
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Thus, a salesperson with access to research information prior to it being published

would give clients an unfair advantage over other investors. Research analysts even
disguise the name of the company on a report until immediately before it is published.
This way, if the report falls into the wrong hands, the information remains somewhat
confidential.
Insiders of the company cannot sell any shares for a specified period of time, this is
known as the _______? (Holding Period, Lockup Period, Buy & Hold Period)
UNDERWRITING
An Underwriter is a broker/dealer or an investment bank. He guarantees that the capital

issue will be subscribed to the extent of his underwritten amount. He will make good of
any shortfall. The contract between the issuer and the Lead or Managing Underwriter is
the Underwriting Agreement. The agreement states the terms and conditions of the
offering, such as, the Underwriting Spread (the amount the underwriters make on sales),
the Public Offering Price (POP), and the amount of proceeds from the offering that will go
to the issuer.
Three different levels of broker/dealers handle the underwriting process:
Managing Underwriters - The Manager (lead underwriter) is the broker/dealer awarded the
issue, who generally handles the relationship with the issuer and oversees the
underwriting process.
Syndicate - To share the risk, and more efficiently distribute the offering to the public,
broker/dealers will join together in a Joint Trading Account. The syndicate profits by selling
the securities and earning a Spread (i.e., the POP less the amount paid to the issuer).
Syndicate members share the risk and are responsible for any unsold securities.
Selling Group - comprises of broker/dealers chosen to assist the syndicate in marketing

the issue in a broker (agency) capacity. Selling Group firms are not members of the
syndicate, and are not at risk for the securities. All broker/dealers involved in the
underwriting of non-exempt securities must be NASD member firms.
Underwriters earn 3 types of Underwriting Spread:
Manager's fee - The lead underwriter receives this fee on all securities sold.
Underwriter's Allowance is the total spread minus the Manager's fee. This fee is shared
by syndicate members based on the type of syndicate account.
Concession - It is typically the largest part of the spread and is paid to the broker/dealer
that actually took the client’s order.
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Types of Underwriting
There are two basic types of commitments made by underwriters to issuers:
Firm commitment - The issue is purchased from the issuer, marked-up and sold to the
public. The underwriter here is acting as a dealer and is at risk for the unsold securities;
whatever securities are not sold will remain in the underwriter’s inventory. Standby
Underwriting is always used in a subsequent primary offering of stock that is preceded by
a subscription or pre-emptive rights offering. During the rights offering, the underwriter
“stands by”. After the rights offering period has ended and all rights have been either
exercised or expired, the underwriters must take any unsubscribed securities on a firm
commitment basis.
Best-efforts underwriting - The underwriters act as agents or brokers for the issuer, and
attempt to sell all the securities in the market. The best efforts underwriter is not at risk,
and any unsold securities remain with the issuer. Two sub-types of best efforts are All-or-
None and Mini-max. An all-or-none underwriting may be canceled by the issuer if the
entire issue is not sold in a given time period. A mini-max underwriting requires a minimum
amount to be sold. If the underwriter sells the minimum, they may then attempt to sell the
maximum (usually being the entire issue). However, if the minimum is not sold, the issuer
may cancel the underwriting.
What is an agreement in which the underwriter is legally bound only to attempt to sell
the securities in a public offering for the firm?
When the investment banker bears the risk of not being able to sell a new security at
the established price, what is this is known as?
On the day that a lock-up period expires, the market value of the stock will most likely
________. (Increase/decrease/remain same.)
SECONDARY MARKET TRADING
The trading of outstanding issues takes place in the Secondary Markets. The secondary
markets are broken down into four market types:
Listed Market – Exchanges where an Auction method is used at a physical location.

Specialists provide liquidity on the floor of an exchange. (Eg) The New York Stock
Exchange (NYSE)
Over-the-Counter Market (OTC, Second Market, Unlisted) – A negotiated market without

a physical location where transactions are done via telecommunications. Broker/dealers
acting as Market Makers provide the liquidity.
Third Market – Where listed securities are traded OTC (over-the-counter), and
broker/dealers acting as market markers offer an alternative to trading on the exchange
itself. An example would be a broker/dealer that maintained an inventory of IBM stock
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(which trades on the NYSE), and buys and sells that stock to other brokers and customers
using a negotiated, over-the-counter method of trading.
Fourth Market – The Instinet, a system for direct over-the-counter institutional trading that
bypasses broker/dealers and thus reduces the cost of large institutional Block Trades.
All the stock exchanges are registered with the SEC, and they have a “self regulation”
mechanism. The Maloney Act of1938 enabled the NASD to be the SRO for the second,
third and fourth markets.
THE FLOOR OF THE EXCHANGE
NYSE (partially) and London are the only major exchanges which still use a trading floor.
When an investor customer calls their broker to place a trade, the following sequence of
activities happen:
 Brokerage Firm checks the customer's account for cash balance, restrictions etc
 Enter the order in its Order Match System. The rep notifies the broker/dealer’s Order
or Wire Room to execute the trade.
 The Order room then wires the order to the Commission House Broker (CHB), an
employee of the broker/dealer who trades on the floor of the exchange for that
broker/dealer.
 The CHB makes their way over to the respective Trading Post.
 At the post, the CHB encounters other folks who want to trade IBM stock.
 Transaction Report Is sent to the originating brokerage firms (buying and selling). A
market order through SuperDot to the specialist takes an average 15 seconds to
complete.
 Reports are also sent to Consolidated Tape Displays world-wide, and to the Clearing
operations.
 Post Trade Processing Matching of buyers and sellers -- the Comparison process
-- takes place almost immediately.
 This is followed by a 3-day Clearing and Settlement cycle at which time transfer of
ownership (shares for dollars or vice versa) is completed via electronic record
keeping in the Depository.
 Brokerage Firm The transaction is processed electronically, crediting or debiting the
customer's account for the number of shares bought or sold.
 Investor Receives a trade confirmation from his/her firm. If shares were purchased,
the investor submits payment. If shares were sold, the investor's account is credited
with the proceeds.
Specialist
Specialists conduct the auction as a broker or dealer and maintain a fair and orderly
market by matching up buyers and sellers. The specialist is not an employee of the
exchange and may trade for their own account, as well as trading as an agent for CHB
orders.
Broker Dealer
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Executes orders for others Executes orders for themselves

Acts as an Agent Acts as a Principal (i.e., a market maker)
Charges Commission Charges Mark-up and Mark-down
An individual firm could act as a broker on one trade and a dealer on another. When acting
as a broker, the firm is taking customer orders and acting as their agent to buy or sell the
security. For this service, the broker charges a commission. A firm acting as a dealer is the
actual buyer or seller, taking the other side of a trade. The price at which market makers
will buy or sell a particular security is known as the Bid or Ask Price.
Market Maker
 Provide continuous bid and offer prices within a prescribed percentage spread for
shares designated to them
 4 to 40 (or more) market makers for a particular stock depending on the average daily
volume.
 Play an important role in the secondary market as catalysts, particularly for enhancing
stock liquidity
Registered Representatives
 An individual who has passed the NASD's registration process and is licensed to work
in the securities industry
 Usually a brokerage firm employee acting as an account executive for clients
 Sell to the public; they do not work on exchange floors
Order Types (Based on Price)

There are four basic order types.
Market Orders is executed at once, "at the market." A market order guarantees
execution, but does not guarantee a price. The final price is determined by supply and
demand.
Limit Orders - Some investors may want to buy or sell, but only at a specific price. A Limit
order is executed at a set price or better and will not be executed if that price is not met.
For example, a customer owns XYZ stock, which is currently trading at $50/share. They
would like to sell the stock, but only if they can get a price of $55 or more. The investors
would place a Sell Limit at $55/share, an order that will be executed only if a price of $55
or better is available. Similarly an investor who seeks to buy, but only at a certain price or
better, might enter a Buy Limit at $45/share.
Stop order - If the market price hits or passes through the stop price (Trigger), a market
order is Elected. For example, an investor bought stock at $50/share. The investor wants
the price of the stock to go up, but wishes to limit the losses if the stock price falls. Such an
investor might place a Sell Stop order at $45, and now if the market price falls to $45 or
below, the stop is triggered and a market order is elected. Another example might be a
Technical Trader who believes that if the stock goes up to a certain price, it is signaling the
beginning of a Bullish run. This investor might enter a Buy Stop at $51, for example. Now,
if the stock rises to $51 or above, a market order is triggered to buy the stock. A potential
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problem with a stop order is that it triggers a market order, which does not guarantee a
purchase or sale price. A stop order must be triggered (activated or elected) before
execution as a market order.
Stop Limit order - If the investors placed an order for $51 Stop, $52 Limit, the order
would be elected at $51, but would not be filled (executed) unless a price of $52 or better
was available. Now, the investor has eliminated the risk of buying the stock without
guaranteeing the price. A stop limit order, once triggered, becomes a limit order.
Do-not-reduce Order - Indicates that the order price should not be adjusted in the case of
a stock split or a dividend payout.
A sell limit order can be filled at a lower price than your limit e.g. your sell limit is at
21.07 & you can be filled at 21.06? True/False
If you want to limit your risk on a long position you can place a sell stop order?
True/false
If the market is currently bid 15.00 & offered at 15.01 you are guaranteed of buying at
15.01 if you place a market order? True/False
Order Types (Based on Time)

Day Order – The order is valid till end of day and if it is unfilled at days end, it gets
cancelled.
Open Order or Good Till Cancelled (GTC) – The order can remain open for up to six
months. It is the responsibility of the registered representative to cancel at the customer’s
direction. In addition, at the end of April and the end of October, all GTC orders must be
reconfirmed or eliminated.
Order Types (Based on Volume)

Fill or Kill (FOK) – The order must be immediately filled in one trade or canceled
completely.
All or None (AON) - The entire order must be filled or canceled completely, but unlike
FOK, AON can remain good till cancelled.
Immediate or Cancel (IOC) must immediately be filled for as much of the order as
possible in one trade, with the remainder being cancelled.
Market Not Held order – The floor broker has the discretion concerning time and price.
A key point is that Market Not Held orders are never on the Specialist's Book.
THE OVER-THE-COUNTER (OTC) MARKET
Unlike listed securities that trade on an exchange, unlisted securities trade Over the
Counter (OTC). Most securities actually trade OTC, since U.S. government, Municipal and
most corporate securities trade OTC. Since there is no specialist book and no post to
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record transactions, OTC price information is either published periodically in paper form,
disseminated over telephone lines, or displayed real-time electronically.
Liquidity in the OTC market is provided by Market Makers (i.e., broker/dealers who
maintain an inventory of a particular stock, and buy and sell the stock from and to
customers).
The largest system for displaying OTC market quotes is Nasdaq (The NASD’s Automated
Quotation system). Broker/Dealers subscribe to various levels of the Nasdaq system
depending on their functional needs. Level 1 service (i.e., the Inside Quote or
Representative Quote) is the highest bid and lowest ask prices of all market makers, and
is used by registered reps. Level 2 service is for traders, and lists all market makers' firm
quotes on price and size. Level 3 service also displays all quotes, and is used by market
makers to enter quotes.
The quotes look like the following:
Bid Ask
Dealer A 9 9.5
Dealer B 8.75 9.25
Dealer C 9.1 9.8
Dealer D 9 9.5
If you were selling stock, to whom would you sell? Dealer C has the highest bid of 9.1,
while a buyer would go to Dealer B who has the lowest ask of 9.25. The inside quote,
therefore, would be 9.1 – 9.25, the highest bid and the lowest ask.
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HOW DOES A BROKERAGE FIRM LOOK LIKE?
A brokerage firm has the following departments:
 Sales
 New Accounts
 Order Room
 Purchase and Sales
 Cashiering
 Margin
 Corporate Actions
 Accounting
 Compliance
Sales
Sales team is responsible for canvassing business. They are staffed with Account
Executives/Account Managers who solicit business from retail and wholesale customers.
New Accounts
New Account department is responsible for receiving customer account opening
applications and documenting the customer data. They are the custodians for various
documents like New account form, Signature cards, Margin Agreements, Lending
Agreements and Option Trading Agreements. Only when the required documents are
received, the account can legally operate.
New accounts can be of one of the following types:

 Individual Cash Account – Only cash transactions are permitted. No margin trading is
permitted.
 Margin Account
 Joint Account
 Power of Attorney Accounts
Order Room
Orders are taken by dealers in order room and they are executed in the best possible
manner. Every order has detailed instructions like:
 Buy/Sell
 Quantity
 Limit/Market
 Security details etc.
We have covered the different order types in the earlier pages.
The relationships among the various departments can be pictorially represented as below:
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Sales Name Accounts (Name & Address)
Account executive • Open Accounts
(Home or Branch office • Executing Changes
Reports Order Tickets
Order Room
OTC Market Exchanges
• Execution recording
Execution • Confirming GTC orders
Reports • Pending Orders
Contra Brokers
Purchase & Sales (P&S)

Confirmation
Clearing Corp • Recording Clients
(CNS) • Figuration (including accrued interest)
• Comparison (reconcilement)
• Booking
Depository
Cashiers Margin
• Receive & Deliver • Account Maintenance
Banks • Vaulting • Sales support
• Bank Loan • Issue checks
• Stock Loan/borrow • Items due
• Transfer • Extensions
• Reorganization • Close – Outs
Brokerages • Delivery of securities
Transfer Stock Record Accounting

Agent • Account numbering & coding • Bookkeeping
• Audits • Daily cash record
• Security Movements • Adjusted trail balance
• Trail Balance
• P & L Statement
Dividend Proxy
• Cash Dividends • Proxy voting
• Stock splits • Information flow to customers
• Due bills
• Bond Interest
Purchase and Sales
This department is responsible for the following activities:
 Recording the trade with a unique number using codes and tickets.
 Figuration to calculate the monetary value of the transaction
 Reconciliation of customer trades with counter-party transactions
 Customer Confirmation in a legally binding form.
Margin
Margin or Credit Department monitors the status of the customer accounts. As explained
in the previous pages, they are also responsible for margin calls. The typical activities of
this department are:
 Account Maintenance
 Sales Support
 Clearing Checks
 Items pending (Money due, stocks due)
 Closing out
Cashiering
They are responsible for movement of securities and funds within the brokerage firm. They
take care of the following functions:
 Receiving and delivering
 Vaulting
 Hypothecations
 Security Transfers
 Stock Lending
Corporate Action
Corporate Action refers to dividend declarations, stock splits etc. The Corporate Action
department makes sure that the rightful owners (as on the Record Date) receive the
dividends, Splits etc.
Accounting
The Accounting department records, processes and balances the movement of money in
the brokerage firm. They produce the Daily Cash Records and Trial Balance, Balance
Sheet and Profit & Loss statements on a periodic basis.
Compliance
The Brokerage firms are regulated by SEC, by state regulatory agencies and industry wide
Self Regulatory Organizations. The compliance department is responsible for ensuring
that all the rules and regulations are complied with and reported on time.
They also make sure that the newer regulations like Anti Money Laundering Act are
implemented inside the firm.
Questions
1. All of these are different types of brokerage accounts except?
a) Margin Account b) Cash Account c) IRA Account d) Nostro Account
2. A market order that executes after a specified price level has been reached is
called?
a) Market Order b) Stop Order c) Fill or Kill Order d) Day Order
3. A brokerage or analyst report will contain all of the following except?
a) a detailed description of the company, and its industry.
b) an opinionated thesis on why the analyst believes the company will
succeed or fail.
c) a recommendation to buy, sell, or hold the company.
d) a target price or performance prediction for the stock in a year.
e) a track record of the analyst writing the report.
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MARKET INDICES
Index of market prices of a particular group of stocks.
Index Types
Value Weighted Index is a stock index in which each stock affects the index in
proportion to its market value. Examples include Nasdaq Composite Index, S&P 500,
Hang Seng Index, and EAFE Index. They are also called capitalization weighted index.
Price Weighted Index is a stock index in which each stock affects the index in
proportion to its price per share. (Eg) Dow Jones Industrial Average
Key Market Indices

The important markets and the indices used are presented below:
US Diversified market Dow Jones Industrial Average (Dow)

US Technology NASDAQ 100
UK (London) Financial Times Stock Exchange Index (FTSE)
Germany (Frankfurt) DAX
France (Paris) CAC
Switzerland (Zurich) SMI
Japan (Tokyo) Nikkei
Hong Kong Hang Seng
Singapore Strait Times Index (STI)
Dow Jones Industrial Average (DJIA)

The Dow is made up of 30 large companies from various industries. The stocks in the
following chart comprise the index.
3M Alcoa
AlliedSignal American Express
AT&T Boeing
Caterpillar Chevron
Citigroup Coca-Cola
DuPont Eastman Kodak
Exxon General Electric
General Motors Goodyear
Hewlett-Packard IBM
International Paper J.P. Morgan
Johnson & Johnson McDonald
Merck Philip Morris
Procter & Gamble Sears
Union Carbide United Technology
Wal-Mart Walt Disney
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14. INVESTOR SERVICES
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INVESTOR SERVICES
Investor Services fall under 4 major areas:

 Investment Management
 Trading
 Custody & Asset Servicing
 Transfer Agency
INVESTMENT MANAGEMENT
The following services fall under this purview:
 Asset/Liability Analysis
 Asset Allocation
 Asset Manager Solutions
 Cash Projection
 Compliance Reporting
 Fund Administration
 Information Products & Services
 Investment Manager Universe
 Local Fund Servicing
 Performance Measurement
Asset/Liability Analysis
Asset Liability analysis helps clients understand the required rate of return and the effect
of return volatility in minimizing the present value of future contributions to the
investment plans. A quantitative and probability based approach is used to establish a
link between asset returns and the future economic wealth of the plan. Future
contributions are linked to future returns by actuarial methods.
Example
An insurer might use asset-liability analysis to analyze its portfolio of single premium
deferred annuities (SPDAs) and the assets supporting that liability. A scenario might
project paths over the next ten years for swap interest rates, policy surrender rates and,
if the assets include mortgage-backed securities, mortgage prepayment rates. Likely,
the scenario would reflect reasonable relationships between these variables—if the
scenario assumed interest rates were to drop, it would probably also assume that
prepayment rates would rise over the same period. A sophisticated analysis might
make other assumptions as to how the insurer would alter its investment portfolio in
response to changing market conditions, or specify how new SPDA sales might be
affected by the changing level of interest rates.
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Asset Allocation
Once an asset/liability analysis is completed, the next step is appropriate asset
allocation to generate the required rate of return. Proposed strategies may involve the
use of options, immunization, dynamic hedging, tactical asset allocation, and the
potential for superior management performance. Additional asset classes such as
emerging market equities, venture capital, real estate and managed futures may also be
included. The asset allocation process results in an investment policy designed to meet
plan objectives.
Example
Fidelity Portfolio Selector Global Balanced Fund is managed with a more
conservative approach towards providing capital growth primarily through investment
in a combination of equities and bonds. This fund will appeal to investors seeking
capital growth but who would prefer a lower level of risk than that normally associated
with equity investment only.
 Does Asset Allocation help reduce the investment risk and optimize potential
return because of a strategic mix of asset classes or by picking the best
performing investment?
Cash Projections
This aims at consolidating all known client portfolio events worldwide and gets up-to-the-
minute data by currency. Information can be obtained on-line, via proprietary network
interface such as S.W.I.F.T., or transmitted directly to client portfolio systems. Real-time,
interactive updates provide clients with the knowledge required to take advantage of the
best short-term investment opportunities.
Compliance Reporting
Compliance reporting provides covers automatic exception-based information
highlighting potential violations of pre-agreed investment guidelines, external regulations
and internal risk exposure limits. They should be fully integrated with fund accounting
system, this and if required should accept data feeds from clients' in-house or third-party
accounting platforms. The rules library will incorporate client-specific requirements for
compliance with regulations relating to the U.S. Securities Act of 1940, UK unit trusts,
and Open Ended Investment Contracts (OEICs). The service covers a wide range of
investment compliance categories, including:
 prohibited investments
 asset, currency, geographical, industry and security concentration limits
 shareholding, self-investment and credit-rating restrictions
 caps on holdings in non-listed securities
 weighted-average analytics
 derivative exposure monitoring, including hedging and gearing reports
Fund Administration
Fund admin covers the administrative and legal services to meet the needs of funds on
items like fund development, board meeting preparation and administration, compliance,
financial reporting, tax services and legal administration, portfolio evaluation, transfer
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agency and shareholder record-keeping for both institutional and retail accounts,
domiciliary administration services in the offshore location, and fiduciary and compliance
monitoring.
Information Products and Services

Includes value-added information products and decision support tools to the investment
community like global market data, analysis and information tools to help customers
make better decisions, increase productivity and achieve superior financial results.
Investment Manager Universe

Comparison of manager performance to a standard universe of fund managers to track
results against a plan's investment objectives.
Performance Measurement
Analytics such as risk-adjusted returns, information ratio, up/down market analysis, style
map scores, covariance matrices, Betas, standard deviation, country and currency
exposure can be analyzed by security, account, combination of accounts, composite,
asset class, industry, economic sector, country or security type for any time period.
TRADING
The following services fall under the Trading purview:
Brokerage Services
Cash & Short-Term Investments
Commission Recapture
Corporate Stock Repurchase
Foreign Exchange
Futures & Options Clearing and Execution
Transition Management
Transition management streamlines portfolio liquidation and transition processes,

leveraging client service and brokerage capabilities to minimize costs and maximize
efficiency.
The commission recapture involves returning a portion of the clients’ commission

expenses. It helps institutional investors reduce their trading costs
The corporate stock repurchase program allows clients to buy and sell their own
company's stock in an efficient, cost-effective manner.
Foreign Exchange services support custody clients' cross-border investment activities

in both freely traded and exotic currencies and third-party foreign exchange transactions.
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Futures & Options Execution and Clearing for full trade execution and clearing
capabilities on all major exchanges worldwide with multi-currency collateral management
and reporting.
CUSTODY & ASSET SERVICING
Services provided by a bank custodian are typically the settlement, safekeeping, and
reporting of customers’ marketable securities and cash. A custody relationship is
contractual, and services performed for a customer may vary.
Banks provide custody services to a variety of customers, including mutual funds and
investment managers, retirement plans, bank fiduciary and agency accounts, bank
marketable securities accounts, insurance companies, corporations, endowments and
foundations, and private banking clients. Banks that are not major custodians may
provide custody services for their customers through an arrangement with a large
custodian bank.
Core Custody Services

A custodian providing core domestic custody services typically settles trades, invests
cash balances as directed, collects income, processes corporate actions, prices
securities positions, and provides record keeping and reporting services.
Global Custody Services

A global custodian provides custody services for cross-border securities transactions. In
addition to providing core custody services in a number of foreign markets, a global
custodian typically provides services such as executing foreign exchange transactions
and processing tax reclaims. A global custodian typically has a sub-custodian, or agent
bank, in each local market to help provide custody services in the foreign country. The
volume of global assets under custody has grown rapidly in recent years as investors
have looked to foreign countries for additional investment opportunities.
Securities Lending and Other Value-Added Services

Institutional investors earn incremental income on their portfolios by lending their
securities to broker dealers. Securities lending experts specialize by combining market
information, individual expertise and solid negotiation skills to maximize profitability for
lenders while managing credit and interest rate risk.
Bank custodians have traditionally acted as the lending agent for customers’ securities
lending activities. However, because the market is extremely competitive, third-party
intermediaries have emerged. Wholesale intermediaries conduct transactions directly
with the lender and the borrower, becoming a principal to the transaction. Niche
intermediaries may specialize in particular types of securities loaned or aggressive cash
collateral reinvestment programs. Third-party intermediaries may target clients that are
dissatisfied with the performance of their custody banks. Internet auction systems for
securities lending, which bring lenders and borrowers together, may eliminate custodian
and third party intermediaries.
In the 1970s, U.S. custodian banks first began lending securities to brokers on behalf of
their clients. Demand for securities lending increased as new trading strategies
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emerged. In 1982, the collapse of a U.S. securities dealer led to a number of reforms,
including standardized agreements and collateral margins. The 1980s also saw a
dramatic increase in the size of government securities markets in the US and many
other countries. Growth of securities lending in some foreign markets was hampered by
concerns about the legalities of transactions, unfavorable tax treatment, and assorted
regulatory restrictions. This resulted in the development of “offshore” securities lending
markets, where securities lending transactions were settled on the books of foreign sub-
custodians. In the 1990s securities lending expanded into emerging markets.
An illustrative list of services under the custody and asset servicing umbrella is given
below:
Alternative Asset Servicing

Alternative investments include:
 hedge funds
 investment-grade and non-investment grade credit structures
 private equity
 real estate
 distressed debt
 leveraged buyouts
 venture and mezzanine capital
Consulting
Consulting services targets plan sponsors, investment managers and consultants to
thoroughly assess each client's needs and develop individualized solutions.
Corporate Actions
24-hour customer service center provides responses to all client inquiries on active
corporate events using the latest SWIFT 15022 corporate action messaging standards.
Custody
Custody service handles trade processing and settlement, asset servicing and electronic
information delivery in multiple time zones and languages on a fully integrated platform.
Financial Reporting
Fund companies meet their financial reporting requirements to shareholders and
regulators using real-time financial accounting systems.
Income Processing
Receiving global income payments on due dates in the client-specified currency. Daily
on-line reports keep clients informed of conditional dividend projection as well as the
status of provisional, confirmed and credited income payments.
Pricing/Holdings Valuation
Timely and accurate pricing, ratings, tranche types for various securities of clients.
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Tax Information Services

Changes in the world's various tax codes and tax treaty statuses create opportunities
and challenges for global investors. Tax information service integrates portfolio details
with the consequences of tax developments in multiple countries and enables clients to
understand entitlements of various statutory or treaty benefits as beneficial owners.
Tax Processing
To manage clients' investment-related tax issues, pursue tax relief at the source and to
make reclamations for client accounts with minimal intrusion.
Trade Instruction and Settlement

Custody clients' trade instructions are typically communicated through the S.W.I.F.T.
network, through mainframe-to-mainframe links supporting multiple data formats through
links to depositories.
Transfer Agency and Distribution Solutions Services
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SUMMARY
 Investor Services covers Investment Management, Trading, Custody & Asset
Servicing and Transfer Agency
 Investment Management has the following services under its purview:
Asset/Liability Analysis
Asset Allocation
Asset Manager Solutions
Cash Projection
Compliance Reporting
Fund Administration
Information Products & Services
Investment Manager Universe
Local Fund Servicing
Performance Measurement
 Trading service include:
Brokerage Services
Cash & Short-Term Investments
Commission Recapture
Corporate Stock Repurchase
Foreign Exchange
Futures & Options Clearing and Execution
 Services provided by a bank custodian are typically the settlement, safekeeping,
and reporting of customers’ marketable securities and cash.
 A custodian providing core domestic custody services typically settles trades,
invests cash balances as directed, collects income, processes corporate actions,
prices securities positions, and provides record keeping and reporting services.
 A global custodian provides custody services for cross-border securities
transactions.
 Institutional investors earn incremental income on their portfolios by lending their
securities to broker dealers. Securities lending experts specialize by combining
market information, individual expertise and solid negotiation skills to maximize
profitability for lenders while managing credit and interest rate risk.
 Custody & Asset servicing includes the following services:
Consulting
Corporate Actions
Custody
Financial Reporting
Income Processing
Pricing/Holdings Valuation
Tax Information Services
Tax Processing
Trade Instruction and Settlement
Transfer Agency and Distribution Solutions Services
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15. RECENT DEVELOPMENTS
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RECENT DEVELOPMENTS
USA PATRIOT ACT10
US Government passed the USA PATRIOT Act in response to the terrorists’ attacks of
September 11, 2001. The key features are:
 The Act gives federal officials greater authority to track and intercept
communications, both for law enforcement and foreign intelligence gathering.
 It vests the Secretary of the Treasury with regulatory powers to combat corruption of
U.S. financial institutions for foreign money laundering purposes.
 It seeks to further close our borders to foreign terrorists and to detain and remove
those within US borders.
 It creates new crimes, new penalties, and new procedural efficiencies for use against
domestic and international terrorists.
The anti money laundering rules are very important from a banking point of view. They
are described in greater detail later in the chapter.
Criminal Investigations: Tracking and Gathering Communications
Federal communications privacy law features a three tiered system, erected for the dual
purpose of protecting the confidentiality of communications while enabling authorities to
identify and intercept criminal communications. The first level prohibits electronic
eavesdropping on telephone conversations, face-to-face conversations, or computer and
other forms of electronic communications in most instances. However, in serious
criminal cases, law enforcement officers may seek a court order authorizing them to
secretly capture conversations on a statutory list of offenses for the permitted duration.
The next tier of privacy protection covers telephone records, e-mail held in third party
storage, and the like. The law permits law enforcement access, ordinarily pursuant to a
warrant or court order or under a subpoena in some cases. There is also a procedure
that governs court orders approving the government’s use of trap and trace devices and
pen registers, a secret “caller id”, which identify the source and destination of calls made
to and from a particular telephone.
Foreign Intelligence Investigations
The Act eases some of the restrictions on foreign intelligence gathering within the United
States, and affords the U.S. intelligence community greater access to information
unearthed during a criminal investigation, but it also establishes and expands
safeguards against official abuse. It permits “roving” surveillance (court orders omitting
10
Extracted from Congressional Research Service, US and Federation of American Scientists -
www.fas.org
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the identification of the particular instrument, facilities, or place where the surveillance is
to occur when the court finds the target is likely to thwart identification).
Money Laundering
In federal law, money laundering is the flow of cash or other valuables derived from, or
intended to facilitate, the commission of a criminal offense. Federal authorities attack
money laundering through regulations, criminal sanctions, and forfeiture. The Act
bolsters federal efforts in each area.
The Act expands the authority of the Secretary of the Treasury to regulate the activities
of U.S. financial institutions, particularly their relations with foreign individuals and
entities. Regulations have been promulgated covering the following areas:
 Securities brokers and dealers as well as commodity merchants, advisors and pool
operators must file suspicious activity reports (SARs);
 Requiring businesses, which were only to report cash transactions involving more
than $10,000 to the IRS, to file SARs as well;
 Imposing additional “special measures” and “due diligence” requirements to combat
foreign money laundering;
 Prohibiting U.S. financial institutions from maintaining correspondent accounts for
foreign shell banks;
 Preventing financial institutions from allowing their customers to conceal their
financial activities by taking advantage of the institutions’ concentration account
practices;
 Establishing minimum new customer identification standards and record-keeping and
recommending an effective means to verify the identity of foreign customers;
 Encouraging financial institutions and law enforcement agencies to share information
concerning suspected money laundering and terrorist activities; and
 Requiring financial institutions to maintain anti-money laundering programs which
must include at least a compliance officer; an employee training program; the
development of internal policies, procedures and controls; and an independent audit
feature.
Crimes: The Act contains a number of new money laundering crimes, as well as
amendments and increased penalties for earlier crimes.
 Outlaws laundering the proceeds from foreign crimes of violence or political

corruption;
 Prohibits laundering the proceeds from cybercrime or supporting a terrorist
organization;
 Increases the penalties for counterfeiting;
 Seeks to overcome a Supreme Court decision finding that the confiscation of over
$300,000 for attempt to leave the country without reporting it to customs
 Provides explicit authority to prosecute overseas fraud involving American credit
cards; and
 Permit prosecution of money laundering in the place where the predicate offense
occurs.
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Forfeiture: The act allows confiscation of all of the property of participants in or plans an
act of domestic or international terrorism; it also permits confiscation of any property
derived from or used to facilitate domestic or international terrorism. Procedurally, the
Act:
 Allows confiscation of property located in this country for a wider range of crimes
committed in violation of foreign law;
 Permits U.S. enforcement of foreign forfeiture orders;
 Calls for the seizure of correspondent accounts held in U.S. financial institutions for
foreign banks who are in turn holding forfeitable assets overseas; and
 Denies corporate entities the right to contest if their principal shareholder is a
fugitive.
Alien Terrorists and Victims
The Act contains provisions designed to prevent alien terrorists from entering the US, to
enable authorities to detain and deport alien terrorists and those who support them; and
to provide humanitarian immigration relief for foreign victims of the September 11.
Other Crimes, Penalties, & Procedures
New crimes: The Act creates new federal crimes, for terrorist attacks on mass
transportation facilities, for biological weapons offenses, for harboring terrorists, for
affording terrorists material support, for money laundering, and for fraudulent charitable
solicitation.
New Penalties: The Act increases the penalties for acts of terrorism and for crimes
which terrorists might commit.
Other Procedural Adjustments: The Act increases the rewards for information in
terrorism cases, authorizes “sneak and peek” search warrants etc
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AMR GUIDELINES
Treasury expects all financial institutions covered by the customer identification
regulations to have their customer identification program drafted and approved by
October 1, 2003 as scheduled.
Foreign issued identification documents:

 An effective program for identifying new customers must allow financial
institutions the flexibility to use methods of identifying and verifying the identity of
their customers appropriate to their individual circumstances. For example,
some financial institutions open accounts via the Internet, never meeting
customers face-to-face.
 Rather than dictating which forms of identification documents financial institutions
may accept, the final rule employs a risk-based approach that allows financial
institutions flexibility, within certain parameters, to determine which forms of
identification they will accept and under what circumstances.
 However, with this flexibility comes responsibility. When an institution decides to
accept a particular form of identification, they must assess risks associated with
that document and take whatever reasonable steps may be required to minimize
that risk.
 Federal regulators will hold financial institutions accountable for the effectiveness
of their customer identification programs.
 Additionally, federal regulators have the ability to notify financial institutions of
problems with specific identification documents allowing financial institutions to
take appropriate steps to address those problems.
Customer Identification Program

The rule requires that financial institutions develop a Customer Identification Program
(CIP) that implements reasonable procedures to:
1) Collect identifying information about customers opening an account
2) Verify that the customers are who they say they are
3) Maintain records of the information used to verify their identity
4) Determine whether the customer appears on any list of suspected terrorists or
terrorist organizations
Collecting information:
As part of a Customer Identification Program (CIP), financial institutions will be required
to develop procedures to collect relevant identifying information including a customer’s
name, address, date of birth, and a taxpayer identification number – for individuals, this
will likely be a Social Security number. Foreign nationals without a U.S. taxpayer
identification number could provide a similar government-issued identification number,
such as a passport number.
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Verifying identity:
A CIP is also required to include procedures to verify the identity of customers opening
accounts. Most financial institutions will use traditional documentation such as a driver’s
license or passport. However, the final rule recognizes that in some instances
institutions cannot readily verify identity through more traditional means, and allows them
the flexibility to utilize alternate methods to effectively verify the identity of customers.
Maintaining records:
As part of a CIP, financial institutions must maintain records including customer
information and methods taken to verify the customer’s identity.
Checking terrorist lists:

Institutions must also implement procedures to check customers against lists of
suspected terrorists and terrorist organizations when such lists are identified by Treasury
in consultation with the federal functional regulators.
Reliance on other financial institutions:

The final rule also contains a provision that permits a financial institution to rely on
another regulated U.S. financial institution to perform any part of the financial institution’s
CIP. For example, in the securities industry it is common to have an introducing broker
– who has opened an account for a customer – conduct securities trades on behalf of
the customer through a clearing broker. Under this regulation, the introducing broker is
required to identify and verify the identity of their customers and the clearing broker can
rely on that information without having to conduct a second redundant verification
provided certain criteria are met.
The following financial institutions are covered under the rule:

 Banks and trust companies
 Savings associations
 Credit unions
 Securities brokers and dealers
 Mutual funds
 Futures commission merchants and futures introducing brokers
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SARBANES OXLEY ACT11
The Sarbanes-Oxley Act was signed into law on 30th July 2002, and introduced
significant legislative changes to financial practice and corporate governance regulation.
The act is named after its main architects, Senator Paul Sarbanes and Representative
Michael Oxley, and of course followed a series of very high profile scandals, such as
Enron. It is also intended to "deter and punish corporate and accounting fraud and
corruption, ensure justice for wrongdoers, and protect the interests of workers and
shareholders"
It introduced stringent new rules with the stated objective: "to protect investors by
improving the accuracy and reliability of corporate disclosures made pursuant to the
securities laws". It also introduced a number of deadlines, the prime ones being:
- Most public companies must meet the financial reporting and certification mandates for
any end of year financial statements filed after June 15th 2004
- smaller companies and foreign companies must meet these mandates for any
statements filed after 15th April 2005.
The Sarbanes-Oxley Act itself is organized into eleven titles, although sections 302, 404,
401, 409, 802 and 906 are the most significant with respect to compliance. In addition,
the Act also created a public company accounting board, to oversee the audit of public
companies that are subject to the securities laws, and related matters, in order to protect
the interests of investors and further the public interest in the preparation of informative,
accurate, and independent audit reports for companies the securities of which are sold
to, and held by and for, public investors.
Section 201 prohibits non audit services like bookkeeping, financial information systems
design and implementation, actuarial services, management services etc from the scope
of practice of auditors. They can however be taken up with the pre approval of the audit
committee on a case by case basis.
Section 401 specifies enhanced financial disclosures specifically:

 Accuracy of financial reports
 Off-balance sheet transactions
 Commission rules on pro forma figures
Section 501 seeks to improve objectivity of research by recommending rules designed to

address conflicts of interest that can arise when securities analysts recommend equity
securities in research reports. These rules are designed to foster greater public
confidence in securities research, and to protect the objectivity and independence of
securities analysts.
11
Extracted from Sarbanes-Oxley forum
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BASEL 2 CAPITAL ADEQUACY NORMS12

Bank for International Settlements (BIS), headquartered in Basel, Switzerland represents
the G 10 banks. The non G 10 banks follow its recommendations and guidelines. The
first Basel Capital Accord was instituted in 1988 to coordinate global regulatory efforts
and institute minimum capital requirements to eliminate the threat posed by
undercapitalized banks.
The 1988 Capital Accord prescribed a single, standard measure of risk to determine
minimal capital requirements. The accord aimed, primarily to reverse the steady erosion
of bank capital ratios. As a basis for determining aggregate capital requirements, it has
performed reasonably well. However, this led to offsetting of over and under assessed
assets across a bank’s portfolio. The classification of obligors into sovereigns, banks and
others (further divided between OECD and non-OECD) bears only a tenuous connection
to comparative credit risk.
Post 1988, to address growing complexity, volatility, and interdependence among

international financial markets, and heightened institutional and systemic threats, a new
Capital Accord was proposed by the Basel Committee on Banking Supervision. The new
Accord was aimed at establishing a more sophisticated framework for banks to measure
risk and ensure sufficient capital to cover losses from market, credit, and operational
risk. The aim of Basel II is to promote safety and soundness in the financial system by
allocating capital in organizations to reflect risk more accurately.
Basel II will apply to all financial services providers in the 110 countries that have signed
the new Capital Accord, including security firms and asset managers with operations in
banking and Capital markets. EU member states will require all domestic and foreign
financial services providers to comply, and the G-10 countries are including it into their
regulatory environments in order to meet the Basel II implementation deadline of
December 2006. Many of the over 25,000 banks around the world are expected to
adopt Basel II as well, in order to maintain their competitiveness.
The coverage of Basel II is likely to be as wide as the Y2K effort. Analysts’ estimate that
IT spend would be around $22.5 billion to address Basel II requirements. A significant
portion of this cost would comprise of the new technological developments and
enhancements to the existing systems.
Three Pillars
The underlying principle for the Accord is that Safety and soundness in today’s dynamic
and complex financial system can be attained only by the combination of effective bank-
level management, market discipline, and supervision.
The New Accord proposal is based on three mutually reinforcing pillars that allow banks
and supervisors to evaluate the various risks that banks face.
12
Pillar 1 Pillar 2 Pillar 3
Extracted from Bank of International Settlements’ documents – www.bis.org
“Quantitative” “Qualitative” “Market Forces”
Page 158 of 172
Minimum Capital Supervisory Market Discipline

Requirements Review
• Calculation of • Overview of • Disclosure

capital supervisory requirements
requirements review • Capital
• Credit risk • Supervisory
Key principles Market Discipline
structure
• Operational • Review
Capital • Risk
risk management
Supervisory exposures
Market Discipline
• Trading book processes
Review • Capital
changes • Interest rate adequacy
(market risk) risk in the
banking book
• )
Pillar 1: Minimum Capital Requirements
The first pillar sets out minimum capital requirements. The New Accord has focused on
improvements in the measurement of risks. The credit risk measurement methods are
more elaborate than those in the current Accord. The new framework proposes for the
first time a measure for operational risk, while the market risk measure remains
unchanged.
Credit Risk: There is a choice between three increasingly sophisticated methods: the
Standardized, the Foundation Internal Ratings Based (‘IRB’) and the Advanced IRB
Approaches.
The Standardized Approach

The bank allocates a risk-weight to each of its assets and off-balance-sheet positions
and produces a sum of risk-weighted asset values.
Individual risk weights currently depend on the broad category of borrower (i.e.
sovereigns, banks or corporates). The risk weights are to be refined by reference to a
rating provided by an external credit assessment institution.
The Internal Ratings based Approach (IRB)

Under the IRB approach, banks will be allowed to use their internal estimates of
borrower creditworthiness to assess credit risk in their portfolios, subject to strict
methodological and disclosure standards. Distinct analytical frameworks will be provided
for different types of loan exposures, for example corporate and retail lending, whose
loss characteristics are different.
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Under both the foundation and advanced IRB approaches, the range of risk weights will
be far more diverse than those in the standardized approach, resulting in greater risk
sensitivity. A more complex approach (and therefore a more sophisticated risk
management process) should lead to a lower capital charge.
Operational Risk: Broadly, Operational Risk (OR) is defined as the risk of monetary
losses resulting from inadequate or failed internal processes, people, and systems or
from external events. The events characterize the inherent risks in doing business and
are mostly managed by putting in place controls. Some times controls may be ineffective
or also fail because of weakness in people, processes, systems or external events.
Some times inherent risks themselves may change because of the events in the external
environment. Thus,
Operational risks = Inherent risks for which controls are not in place + Control
risks
There is again a choice of approach: between a standardized and a more sophisticated

Internal Measurement Approach (‘IMA’).
Basic Indicator Approach

This approach links the capital charge for operational risk to a single risk indicator for the
whole bank. Gross income is proposed as the indicator, with each bank holding capital
for operational risk equal to the amount of a fixed percentage, alpha. The Basic Indicator
Approach can be applied for any bank regardless of its complexity or sophistication.
The Standardized Approach

In this Approach, a bank’s activities are divided into a number of standardized business
units and business lines. Within each business line, the capital charge is calculated by
multiplying a bank’s broad financial indicator by a ‘beta’ factor. The capital charge would
continue to be standardized by the supervisor. Now, for each business line gross income
is taken to calculate the capital charge.
The Internal Measurement Approach

This approach strives to incorporate an individual bank’s internal loss data into the
calculation of its required capital. Under the Internal Measurement Approach, a capital
charge for the operational risk of a bank would be determined using an Exposure
Indicator (EI) within each business line / loss type combination, Probability of loss Event
(PE), based on the banks’ internal loss data and Loss Given that Event (LGE) within
each business line / loss type combination.
CHECK 21
The Check Clearing for the 21st Century Act (Check Truncation Act, Check 21)
promotes check imaging through the introduction of a new payment instrument known as
the substitute check (also referred to as the Image Replacement Document or IRD). The
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substitute check, which contains an image of the check, will be the legal equivalent of
the original. Check 21 also abolishes the paying bank's right to demand presentment of
the original paper check as a condition of payment, which allows the bank of first deposit
to truncate the check upon image capture. The Act is expected to speed the transition
from traditional processing to imaged processing and encourage the use of electronic
check clearing.
Check 21 will reduce paper flow resulting from 45- 50 billion paper checks processed
each year, and, in many cases, will eliminate labor- and cost-intensive paper check
handling, transportation, and storage issues. Banks that convert to check imaging will
realize many other benefits, including:
 Savings associated with lower transit costs and courier charges

 Lower risk of lost items and/or transit delays
 Lower check processing errors resulting from reduced handling and automated
data capture from check images
 Fully automated Day 2 (return) processing enabled by image exception item
processing
 Compressed processing windows to enable later branch cutoff times
 Improved collection float due to faster clearing processes
Check 21 will lead to additional payment system efficiency industry-wide. It will allow
financial institutions to further leverage their investment in check imaging technologies.
Check 21 – Technology challenges for banks

Banks would require substantial technology investments in migrating to a Check 21
environment. Analyzing from a process flow perspective, the following are the main
systems required:
 Check image capture (with verification and receipt generation if required)

 Check image storage, archival & exchange
 Check image processing, pattern matching & signature verification
 CRM integration – check research and adjustment
Some of the investments can be avoided by going in for an ASP-based solution whereby
all processes like check image storage & archival, image exchange and processing
workflow can be managed by a third party service provider on a subscription basis.
However, the decision on outsourcing these activities have to be taken by banks after
considerable research on as-is process flow and technology analysis, capacity planning,
security analysis and benchmarking.
Investments for check capture and image processing would be incremental, whereas
there would be significant investment required for storage, archival and exchange of
check images in a secure environment. This would be a major hurdle for most of the
banks. Banks will also have to cope with multiple technology vendors and architectural
solutions while ensuring that they stick to implementation time lines.
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Page 162 of 172

GLOSSARY
Page 163 of 172

GLOSSARY
Agency bonds: Agencies represent all bonds issued by the federal government, except
for those issued by the Treasury (i.e. bonds issued by other agencies of the federal
government). Examples include the Federal National Mortgage Association (FNMA), and
the Guaranteed National Mortgage Association (GNMA).
Arbitrage: The trading of securities to profit from a temporary difference between the
price of security in one market and the price in another. This temporary difference is
often called market inefficiency.
Annualized Percentage or Return: The periodic rate times the number of periods in a
year. For example, a 5% quarterly return has an A.P.R. of 20%. It depends on the
following:
• How much repayment
• How frequently
• Which component of loan – interest or principal
Authorization (Credit Cards): The act of ensuring that the cardholder has adequate
funds available against their line of credit. A positive authorization results in an
authorization code being generated, and a hold being placed on those funds. A "hold"
means that the cardholder's available credit limit is reduced by the authorized amount.
Beauty contest: The informal term for the process by which clients choose an
investment bank. Some of the typical selling points when competing with other
investment banks for deals are: "Look how strong our research department is in this
industry. Our analyst in the industry is a real market mover, so if you go public with us,
you'll be sure to get a lot of attention from her."
Bloomberg: Computer terminals providing real time quotes, news, and analytical tools,
often used by traders and investment bankers.
Bond spreads: The difference between the yield of a corporate bond and a U.S.
Treasury security of similar time to maturity.
Bulge bracket: The largest and most prestigious firms on Wall Street like Goldman
Sachs, Morgan Stanley Dean Witter, Merrill Lynch, Salomon Smith Barney, Lehman
Brothers, Credit Suisse First Boston.
Buy-side: The clients of investment banks (mutual funds, pension funds) that buy the
stocks, bonds and securities sold by the investment banks. (The investment banks that
sell these products to investors are known as the sell-side.)
Capitalized Loan: A loan in which the interest due and not paid is added to the principal
balance of the loan. Capitalized interest becomes part of the principle of the loans;
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therefore, it increases the total cost of repaying the loan because interest will
accumulate on the new, higher principle.
Capture (Credit Cards): Converting the authorization amount into a billable transaction
record. Transactions cannot be captured unless previously authorized.
Commercial bank: A bank that lends, rather than raises money. For example, if a
company wants $30 million to open a new production plant, it can approach a
commercial bank for a loan.
Commercial paper: Short-term corporate debt, typically maturing in nine months or

less.
Commodities: Assets (usually agricultural products or metals) that are generally

interchangeable with one another and therefore share a common price. For example,
corn, wheat, and rubber generally trade at one price on commodity markets worldwide.
Comparable company analysis (Comps): The primary tool of the corporate finance
analyst. Comps include a list of financial data, valuation data and ratio data on a set of
companies in an industry. Comps are used to value private companies or better
understand a how the market values and industry or particular player in the industry.
Consumer Price Index: The CPI measure the percentage increase in a standard
basket of goods and services. CPI is a measure of inflation for consumers.
Coupon rate: The fixed interest paid on a bond as a percentage of its face value, each
year, until maturity. In Thailand the coupon is usually paid semi-annually or annually.
Discount rate: The rate at which federal banks lend money to each other on overnight
loans. A widely followed interest rate set by the Federal Reserve to cause market
interest rates to rise or fall, thereby causing the U.S. economy to grow more quickly or
less quickly.
Discount Rate for Credit Cards: A small percentage of each transaction that is
withheld by the Acquiring Bank or ISO. This fee is basically what the merchant pays to
be able to accept credit cards. The fee goes to the ISO (if applicable), the Acquiring
Bank, and the Associations.
Dividend: A payment by a company to shareholders of its stock, usually as a way to

distribute profits to shareholders.
Fed: The Federal Reserve, which manages the country's economy by setting interest
rates.
Federal funds rate: The rate domestic banks charge one another on overnight loans to
meet Federal Reserve requirements. This rate tracks very closely to the discount rate,
but is usually slightly higher.
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Fixed income: Bonds and other securities that earn a fixed rate of return. Bonds are
typically issued by governments, corporations and municipalities.
Float: The number of shares available for trade in the market. Generally speaking, the
bigger the float, the greater the stock's liquidity.
Floating rate: An interest rate that is benchmarked to other rates (such as the rate paid
on U.S. Treasuries), allowing the interest rate to change as market conditions change.
Glass-Steagall Act: Passed in 1933 during the “Depression” to help prevent future bank
failures. The Glass-Steagall Act split America's investment banking (issuing and trading
securities) operations from commercial banking (lending). For example, J.P. Morgan was
forced to spin off its securities unit as Morgan Stanley. Since the late 1980s, the Federal
Reserve has steadily weakened the act, allowing commercial banks such as
NationsBank and Bank of America to buy investment banks like Montgomery Securities
and Robertson Stephens. In 1999, Glass-Steagall was effectively repealed by the
Graham-Leach-Bliley Act.
Graham-Leach-Biley Act: Also known as the Financial Services Modernization Act of

1999. Essentially repealed many of the restrictions of the Glass-Steagall Act and made
possible the current trend of consolidation in the financial services industry. Allows
commercial banks, investment banks, and insurance companies to affiliate under a
holding company structure.
Gross Domestic Product: GDP measures the total domestic output of goods and
services in the United States. For reference, the GDP grew at a 4.2 percent rate in 1999.
Generally, when the GDP grows at a rate of less than 2 percent, the economy is
considered to be in boom.
Hedge: To balance a position in the market in order to reduce risk. Hedges work like
insurance: a small position pays off large amounts with a slight move in the market.
High grade corporate bond: A corporate bond with a rating above BB. Also called
investment grade debt.
High yield debt (a.k.a. Junk bonds): Corporate bonds that pay high interest rates to
compensate investors for high risk of default. Credit rating agencies such as Standard &
Poor's rate a company's (or a municipality's) bonds based on default risk. Junk bonds
rate below BB.
Institutional clients or investors: Large investors, such as pension funds or

municipalities (as opposed to retail investors or individual investors).
Lead manager: The primary investment bank managing a securities offering. An

investment bank may share this responsibility with one or more co-managers.
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League tables: Tables that rank investment banks based on underwriting volume in
numerous categories, such as stocks, bonds, high yield debt, convertible debt, etc. High
rankings in league tables are key selling points used by investment banks when trying to
land a client engagement.
Leveraged Buyout (LBO): The buyout of a company with borrowed money, often using
that company's own assets as collateral. LBOs were common in 1980s, when successful
LBO firms such as Kohlberg Kravis Roberts made a practice of buying up companies,
restructuring them, and reselling them or taking them public at a significant profit
LIBOR: London Inter-bank Offered Rate. A widely used short-term interest rate. LIBOR
represents the rate banks in England charge one another on overnight loans or loans up
to five years. LIBOR is often used by banks to quote floating rate loan interest rates.
Typically the benchmark LIBOR is the three-month rate.
Liquidity: The amount of a particular stock or bond available for trading in the market.
For commonly traded securities, such as big cap stocks and U.S. government bonds,
they are said to be highly liquid instruments. Small cap stocks and smaller fixed income
issues often are called illiquid (as they are not actively traded) and suffer a liquidity
discount, i.e. they trade at lower valuations to similar, but more liquid, securities.
Long Bond: The 30-year U.S. Treasury bond. Treasury bonds are used as the starting
point for pricing many other bonds, because Treasury bonds are assumed to have zero
credit risk taking into account factors such as inflation. For example, a company will
issue a bond that trades "40 over Treasuries." The 40 refers to 40 basis points (100
basis points = 1 percentage point).
Making markets: A function performed by investment banks to provide liquidity for their
clients in a particular security, often for a security that the investment bank has
underwritten. The investment bank stands willing to buy the security, if necessary, when
the investor later decides to sell it.
Market Capitalization: The total value of a company in the stock market (total shares
outstanding x price per share).
Merchant Account: A special business account set up to process credit card

transactions. A merchant account is not a bank account (even though a bank may issue
it). Rather, it is designed to 1) process credit card payments and 2) deposit the funds
into your (business) checking account (minus transaction fees).
Money market securities: This term is generally used to represent the market for
securities maturing within one year. These include short-term CDs, repurchase
agreements, commercial paper (low-risk corporate issues), among others. These are low
risk, short-term securities that have yields similar to Treasuries.
Mortgage-backed bonds: Bonds collateralized by a pool of mortgages. Interest and

principal payments are based on the individual homeowners making their mortgage
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payments. The more diverse the pool of mortgages backing the bond, the less risky they
are.
Municipal bonds ("Munis"): Bonds issued by local and state governments, a.k.a.
municipalities. Municipal bonds are structured as tax-free for the investor, which means
investors in muni's earn interest payments without having to pay federal taxes.
Sometimes investors are exempt from state and local taxes, too. Consequently,
municipalities can pay lower interest rates on muni bonds than other bonds of similar
risk.
Payment Gateway Fees (Credit Cards): The fees that payment gateways charge for
their services. This generally includes a monthly fee and a small flat fee per transaction.
These fees may be consolidated into a single bill by the acquiring bank or ISO, along
with their fees.
Pitchbook: The book of exhibits, graphs, and initial recommendations presented by

bankers to a prospective client when trying to land an engagement.
Pit traders: Traders who are positioned on the floor of stock and commodity exchanges
(as opposed to floor traders, situated in investment bank offices).
P/E ratio: The price to earnings ratio. This is the ratio of a company's stock price to its
earnings-per-share. The higher the P/E ratio, the more expensive a stock is (and also
the faster investors believe the company will grow). Stocks in fast-growing industries
tend to have higher P/E ratios.
Prime rate: The average rate U.S. banks charge to companies for loans.
Producer Price Index: The PPI measure the percentage increase in a standard basket
of goods and services. PPI is a measure of inflation for producers and manufacturers.
Proprietary trading: Trading of the firm's own assets (as opposed to trading client
assets).
Prospectus: A report issued by a company (filed with and approved by the SEC) that
wishes to sell securities to investors. Distributed to prospective investors, the prospectus
discloses the company's financial position, business description, and risk factors.
Red herring: Also known as a preliminary prospectus. A financial report printed by the
issuer of a security that can be used to generate interest from prospective investors
before the securities are legally available to be sold. Based on final SEC comments, the
information reported in a red herring may change slightly by the time the securities are
actually issued.
Retail clients: Individual investors (as opposed to institutional clients).
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Return on equity: The ratio of a firm's profits to the value of its equity. Return on equity,
or ROE, is a commonly used measure of how well an investment bank is doing, because
it measures how efficiently and profitably the firm is using its capital.
Risk arbitrage: When an investment bank invests in the stock of a company it believes
will be purchased in a merger or acquisition. (Distinguish from risk-free arbitrage.)
Road-show: The series of presentations to investors that a company undergoing an IPO

usually gives in the weeks preceding the offering. Here's how it works: Several weeks
before the IPO is issued, the company and its investment bank will travel to major cities
throughout the country. In each city, the company's top executives make a presentation
to analysts, mutual fund managers, and others attendees and also answer questions.
Sales memo: Short reports written by the corporate finance bankers and distributed to
the bank's salespeople. The sales memo provides salespeople with points to emphasize
when hawking the stocks and bonds the firm is underwriting.
Securities and Exchange Commission (SEC): A federal agency that, like the Glass-
Steagall Act, was established as a result of the stock market crash of 1929 and the
ensuing depression. The SEC monitors disclosure of financial information to
stockholders, and protects against fraud. Publicly traded securities must first be
approved by the SEC prior to trading.
Securitize: To convert an asset into a security that can then be sold to investors. Nearly
any income generating asset can be turned into a security. For example, a 20-year
mortgage on a home can be packaged with other mortgages just like it, and shares in
this pool of mortgages can then be sold to investors.
Short-term debt: A bond that matures in nine months or less. Also called commercial
paper.
Syndicate: A group of investment banks that will together underwrite a particular stock
or debt offering. Usually the lead manager will underwrite the bulk of a deal, while other
members of the syndicate will each underwrite a small portion.
Transaction Fee (Credit Cards): A small flat fee that is paid on each transaction. This
fee is collected by the acquiring bank or ISO and pays for the toll-free dial out number
and the processing network.
T-Bill Yields: The yield or internal rate of return an investor would receive at any given
moment on a 90-120 government treasury bill.
Tombstone: The advertisements that appear in publications like Financial Times or The
Wall Street Journal announcing the issuance of a new security. The tombstone ad is
placed by the investment bank as information that it has completed a major deal.
Yield: The annual return on investment. A high yield bond, for example, pays a high rate
of interest.
Page 169 of 172

Page 170 of 172

REFERENCES
Page 171 of 172

WEBSITES
WWW.BIS.ORG
WWW.IBRD.COM
WWW.SIAINVESTOR.COM
WWW.SIAC.COM
WWW.CNBC.COM
WWW.STOCKCHARTS.COM
WWW.MONEYCENTRAL.COM
WWW.MSNMONEY.COM
WWW.NYSE.COM
WWW.NASDAQ.COM
WWW.AMERITRADE.COM
WWW.ESCHWAB.COM
HTTP://FINANCE.YAHOO.COM
WWW.INVESTOPEDIA.COM
WWW.FT.COM
WWW.BLOOMBERG.COM
WWW.VANGUARD.COM
BOOKS
 The Bank Credit Card Business – American Bankers Association

 Value At Risk – Phillipe Jorions
 Principles of Corporate Finance – Brearley Myers
 Securities Operations – Michael T Reddy – New York Institute of Finance
 After the Trade is Made – David M Weiss – New York Institute of Finance
 Investment Analysis & Portfolio Management - Frank K. Reilly &
 Keith C. Brown
 The Warren Buffet Way – Robert Hagstrom Jr
 One Up on the Wall Street – Peter Lynch
Page 172 of 172

BANKING FOUNDATION COURSE v1.6

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BANKING FOUNDATION COURSE v1.6

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Foundation Course in Banking

1. THE CONCEPT OF MONEY.......................................................................7

DISTINCTION BETWEEN PRIVATE BANKING & ASSET MANAGEMENT...............82

12. TREASURY SERVICES & CASH MANAGEMENT...............................111

1.THE CONCEPT OF MONEY

THE CONCEPT OF MONEY

THE CONCEPT OF INTEREST: SIMPLE INTEREST AND COMPOUND INTEREST

Year 2: (5% of $100 = $5) + $105 = $110

Year 3: (5% of $100 = $5) + $110 = $115

Year 4: (5% of $100 = $5) + $115 = $120

Year 5: (5% of $100 = $5) + $120 = $125

Year 2: (5% of $105.00 = $5.25) + $105.00 = $110.25

Year 3: (5% of $110.25 = $5.51) + $110.25 = $115.76

Year 4: (5% of $115.76 = $5.79) + $115.76 = $121.55

Year 5: (5% of $121.55 = $6.08) + $121.55 = $127.63

A quantitative estimate of inflation in a particular economy can be calculated by

Real rate of Interest

Nominal rate (N) = 10%, Inflation (I) = 5%

Therefore, real interest is:

TIME VALUE CONCEPT OF MONEY

The formula for Future Value is:

Suppose someone were to invest $10,000 at 8% interest, compounded semiannually,

Interest rate for compounding period = 8%/2 = 4%

Net Present Value (NPV)

NPV of a project/investment = Discounted value of net cash inflows – Initial

An investor has an opportunity to purchase a piece of property for $50,000 at the

Year Cash Flow

However, if we assume that the required rate of return is 16.00%,

Internal Rate of Return (IRR)

Security is a financial instrument that signifies ownership in a company (a stock), a

Principal and Interest

Mortgage Bonds are secured by real estate owned by the issuer

Municipal bond (Munis)

Zero coupon bonds

Equity (Stock) is a security, representing an ownership interest. Equity refers to the

Corporations seeking capital sell it to investors through a Primary Offering or an Initial

Non-convertible preferred stock remains outstanding in perpetuity and trades like

American Depository Receipts (ADR)

There are two main types of options:

WHAT ARE FINANCIAL MARKETS?

TYPES OF FINANCIAL MARKETS

The Different Financial Markets

Why businesses need capital?

infrastructure, and products / services range or to diversify or expand geographically.

What is the role of Capital Markets?

1. Channeling funds from “savings pool” to “investment pool” - channeling funds

 New York Stock Exchange (NYSE)

What determines the share price and how does it change?

Participants in the Bond Market

The role of the Central Bank in the foreign exchange market

REGULATION OF CAPITAL MARKETS

Typically the government designates one or more agencies as regulator(s) and

 Eligibility norms for a company to be allowed to issue stock or bonds,

FINANCIAL MARKET SYSTEMS

Portfolio Management Systems

 Financial markets facilitate financial transactions, i.e. exchange of financial

A 10% appreciation in rupee resulted in a 50% drop in profits. This is a case of

THE RISK REWARD PRINCIPLE

THREE PILLARS OF RISK MANAGEMENT

The following are some of the possible risk types.

Risk measurement is a combination of management, quantitative analysis and

Value at Risk (VaR)

1. What is the distribution of the end-of-year portfolio value?

Therefore for the entire