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Foundation Course in Banking & Capital


DATE: 26-MAY-2009

Cognizant Technology Solutions

500 Glenpointe Centre West
Teaneck, NJ 07666
Ph: 201-801-0233

Cognizant Confidential Foundation Course in Banking and Capital Markets


1.0 BFS CONCEPTS .............................................................................................................................4

1.1 CONCEPT OF MONEY ........................................................................................................................... 4
1.2 FINANCIAL INSTRUMENTS ........................................................................................................... 10
1.3 FINANCIAL MARKETS ................................................................................................................... 19
1.4 FINANCIAL STATEMENTS .................................................................................................................... 26
2.0 BANKING ...................................................................................................................................39
2.1 INTRODUCTION TO BANKING ...................................................................................................... 40
3.0 RETAIL BANKING........................................................................................................................47
3.1 INTRODUCTION ................................................................................................................................ 47
3.2 DEPOSIT PRODUCTS....................................................................................................................... 49
3.3 RETAIL CHANNELS ............................................................................................................................ 51
3.4 INSTRUMENTS ............................................................................................................................. 56
3.5 RETAIL PAYMENTS ............................................................................................................................ 57
3.6 ELECTRONIC BANKING................................................................................................................. 58
3.7 SALES AND MARKETING ..................................................................................................................... 60
3.8 A SCHEMATIC OF A RETAIL BANK ......................................................................................................... 61
4.0 MORTGAGES AND CONSUMER LENDING ...................................................................................63
4.1 MORTGAGE..................................................................................................................................... 63
4.2 OTHER RETAIL LOANS ........................................................................................................................ 70
4.3 COMMUNITY BANKS, CREDIT UNIONS & BUILDING SOCIETIES ................................................................... 78
4.4 FARM CREDIT................................................................................................................................... 80
4.5 RETAIL LENDING CYCLE ...................................................................................................................... 81
5.0 CARDS AND PAYMENTS .............................................................................................................85
5.1 INTRODUCTION ................................................................................................................................ 85
5.2 CREDIT CARD MARKET OVERVIEW ....................................................................................................... 90
5.3 MAJOR PLAYERS .............................................................................................................................. 97
5.4 RECENT DEVELOPMENTS .................................................................................................................... 97
6.0 WHOLESALE BANKING AND COMMERCIAL LENDING ............................................................... 102
6.1 INTRODUCTION ......................................................................................................................... 102
6.2 CORPORATE LENDING PROCESS ................................................................................................ 102
6.3 CREDIT DERIVATIVES ................................................................................................................. 109
6.4 TREASURY SERVICES .................................................................................................................. 111
6.5 CASH MANAGEMENT ................................................................................................................ 120
6.6 TRADE FINANCE ......................................................................................................................... 128
6.6 PAYMENTS NETWORK ...................................................................................................................... 139
7.0 INVESTMENT MANAGEMENT .................................................................................................. 143
7.1 INTRODUCTION .............................................................................................................................. 143
7.2 INVESTMENT MANAGEMENT PROCESSES.............................................................................................. 144
7.3 DIFFERENT CLASSES OF INVESTMENT MANAGEMENT FIRMS .................................................................... 157
8.0 INVESTMENT BANKING AND BROKERAGE............................................................................... 176

Cognizant Confidential Foundation Course in Banking and Capital Markets

8.1 DEFINITION OF INVESTMENT BANKS ......................................................................................... 176

8.2 FUNCTION OF INVESTMENT BANKS:.......................................................................................... 176
8.3 MAJOR INVESTMENT BANKS: .................................................................................................... 177
8.4 DIVISIONS WITHIN AN INVESTMENT BANK................................................................................ 177
8.5 INVESTMENT BANKING POST ECONOMIC CRISIS:...................................................................... 179
8.6 BROKERAGE ............................................................................................................................... 179
8.7 UNDERWRITING ........................................................................................................................ 181
8.9 THE FLOOR OF THE EXCHANGE .................................................................................................. 184
8.10 ORDER TYPES ................................................................................................................................. 186
8.11 THE OVER-THE-COUNTER (OTC) MARKET.................................................................................. 187
8.12 HOW DOES A BROKERAGE FIRM LOOK LIKE? ............................................................................. 188
8.13 MARKET INDICES ....................................................................................................................... 192
9.0 CUSTODY AND CLEARING......................................................................................................... 194
9.1 INTRODUCTION ......................................................................................................................... 194
9.2 SECURITIES MARKETPLACE ............................................................................................................... 195
9.3 TRADING AND SETTLEMENT ...................................................................................................... 198
9.4 ASSET SERVICING....................................................................................................................... 210
10.0 CLEARING AND SETTLEMENT ................................................................................................... 214
10.1 TRADING ...................................................................................................................................... 214
10.2 CLEARING ..................................................................................................................................... 216
10.3 SETTLEMENT.................................................................................................................................. 218
11.0 RISK MANAGEMENT ................................................................................................................ 224
11.1 CONCEPT OF RISK ........................................................................................................................... 224
11.2 TYPES OF RISK................................................................................................................................ 224
11.3 RISK MANAGEMENT ....................................................................................................................... 228
12.0 CORPORATE SERVICES ............................................................................................................. 240
12.1 BENEFITS ADMINISTRATION ........................................................................................................... 240
13.0 RECENT DEVELOPMENTS ......................................................................................................... 246
13.1 USA PATRIOT ACT ...................................................................................................................... 246
13.2 SARBANES OXLEY ACT................................................................................................................ 250
13.3 SUB-PRIME MORTGAGE CRISIS ......................................................................................................... 251
14.0 GLOSSARY................................................................................................................................ 256

15.0 REFERENCES............................................................................................................................. 262

15.1 WEBSITES................................................................................................................................... 262
15.2 BOOKS ....................................................................................................................................... 262

Cognizant Confidential Foundation Course in Banking and Capital Markets




“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.



Interest is the amount earned on money; there is such an earning because present consumption
of the lender is being sacrificed for the future; it is letting somebody else use the money for
present consumption. Using an analogy, interest is the ‘rent’ charged for delaying present
consumption of money. Interest rates are not constant and will vary depending on different
economic factors

A. Simple interest
Simple interest is calculated only on the beginning principal. Simple Interest = P*r*t/100 where:
P is the Principal or the initial amount borrowed or deposited, to earn or charge interest on, r is
the interest rate and t is the time period.


If someone were to receive 5% interest on a beginning value of $100, the first year they would

0.05*$100 = $5

If they continued to receive 5% interest on the original $100 amount, over five years the growth
in their investment would look like this:

Year 1: (5% of $100 = $5) + $100 = $105


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

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

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

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

B. Compound interest
With compound interest, interest is calculated not only on the beginning interest, but on any
interest accumulated with the initial principal in the meantime. Compound interest =
[P*(1+r/100)^t – P], where: P is the Principal or the initial amount initially borrowed or
deposited, to earn or charge interest on, r is the interest rate and t is the time period.


If someone were to receive 5% compound interest on a beginning value of $100, the first year
they would get the same thing as if they were receiving simple interest on the $100, or $5. The
second year, though, their interest would be calculated on the beginning amount in year 2,
which would be $105. So their interest would be:

.05 x $105 = $5.25

If this were to continue for 5 years, the growth in the investment would look like this:

Year 1: (5% of $100.00 = $5.00) + $100.00 = $105.00

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

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

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

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

Note that in comparing growth graphs of simple and compound interest, investments with
simple interest grow in a linear fashion and compound interest results in geometric growth. So
with compound interest, the further in time and investment is held the more dramatic the
growth becomes.


Inflation captures the rise in the cost of goods and services over a period of time. For example, if
Rs.100 today can buy 5 kg of groceries, the same amount of money can only buy 5/ (1+I) kgs of
groceries next year, where `I’ refers to the rate of inflation beyond today.

Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand & supply
and other market conditions hold), next year, one can only buy 5/ (1.05) worth of groceries.

Cognizant Confidential Foundation Course in Banking and Capital Markets

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

ratio of Consumer Price Indices or CPI of two consecutive years. That’s right, the CPI that one
hear of, is the weighted average price, of a predefined basket of basic goods. The % increase of
the CPI this year vs. the CPI of last year, gives the inflation, or rise in price of consumer goods,
over last year.

Inflation results in a decrease in the value of money over time. The link between the interest
rates, nominal and real, and inflation enables one to identify this impact.


Nominal rate of interest (N) refers to the stated interest rate in the economy. For example, if
counter-party demands 110 rupees after a year in return for 100 rupees lent today, the nominal
rate of interest is 10%. This, as one see, includes the inflation rate.

Example A person lent out 100 rupees, at 10%, for one year. On maturity, he gets a profit, so
he thinks, of 10 rupees. But this sum of 110 rupees buys less than 110 rupees did a year ago, due
to inflation! Thus, the value of 110 rupees today is actually, or really, less than the value of 110
rupees a year ago, and it is less by the inflation rate. Thus the real interest he earned is less than


Real rate of interest (R) refers to the inflation-adjusted rate of interest. It is less than the
nominal rate of interest for economies having positive rate of inflation.

The relationship between the R (real rate of interest), N (nominal rate of interest) and I (rate of
inflation) is as:

R= N-I

(This is a widely used approximation; the exact formula takes into account time value of inflation

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.


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%.


Cognizant Confidential Foundation Course in Banking and Capital Markets


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


FV : Future Value at the end of n time periods

PV : Beginning value OR Present Value

i : Interest rate per unit time period

n : Number of time periods

Example If one were to receive 5% per annum compounded interest on $100 for five

FV = $100*(1.05)5 = $127.63

Intra-Year Compounding
If a cash flow is compounded more frequently than annually, then intra-year compounding is
being used. To adjust for intra-year compounding, an interest rate per compounding period
must be found as well as the total number of compounding periods.

The interest rate per compounding period is found by taking the annual rate and dividing it by
the number of times per year the cash flows are compounded. The total number of
compounding periods is found by multiplying the number of years by the number of times per
year cash flows are compounded.

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

semiannually, and hold it for five years,

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

Number of compounding periods = 5*2 = 10

Thus, the future value FV = 10,000*(1+0.04) ^10 = $14,802.44

Present value

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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

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

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

Year Cash Flow

1 $9,000

2 8,500

3 8,000

4 8,000

5 8,000

6 8,000

7 8,000

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8 7,000

9 4,500

10 51,000 (property sold at the end of the 10th year)

Assume that the required rate of return for similar investments is 15.00%.

NPV = - 50000 + 9000/ (1+0.15) ^1 + 8500/ (1+0.15) ^2 + ….. +51000/ (1+0.15) ^10 = $612.96

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

NPV = - 50000 + 9000/ (1+0.16) ^1 + 8500/ (1+0.16) ^2 + ….. +51000/ (1+0.16) ^10 = ($1360.77)

Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a project:

• Increases with increase in future cash inflows for a given initial outlay
• Decreases with increase in initial outlay for a given set of future cash inflows
• Decreases with increase in required rate of return
Internal Rate of Return (IRR)
Internal Rate of Return (IRR), also referred to as ‘Yield’ is often used in capital budgeting. It is the
implied interest rate that makes net present value of all cash flows equal zero.

In the previous example, the IRR is that value of required rate of return that makes the NPV
equals zero.

IRR = r, where

NPV = - 50000 + 9000/(1+r)^1 + 8500/(1+r)^2 + ….. +51000/ (1+r) ^10 = $0.00

IRR can be calculated using trial and error methods by using various values for r or using the IRR
formula directly in MS Excel. Here, IRR = 15.30%. In other terms, IRR is the rate of return at
which the project/investment becomes viable.


We have seen how different entities such as individuals, corporations and governments raise
money. We have also realized that there is a cost for raising money, known as cost of capital.
Costs will vary depending on the type of the financing such as equity or debt, who the borrower
is (their past record and repayment capacity), and finally the market timing of the borrowings. In
case of debt, additionally, the amount of collateral provided and how long the capital is required
is also considered.

The cost of capital includes interest payable in case of debt and expected returns including
dividends in case of equity, apart from the cost of raising such as investment banks’ fees,
regulatory fees and advertising. The tax factor is also considered while computing cost of capital
for debt capital since interest paid is a tax deductive expense. Computing cost for different

Cognizant Confidential Foundation Course in Banking and Capital Markets

means of finance such as equity shares, preference shares, debentures or term loan is beyond
the purview of this learning program.

Since there is a limit to the amount of resources that corporations can raise from any source,
they use more than a single source for financing their needs. Also, funds will be raised at
different points in time depending on need, availability, and market timing etc. In such cases
after computing cost of each source, the firm arrives at a weighted average cost of capital,
commonly referred to as “cost of capital”. Let us take an example:

The Good works Company Inc. has Rs. 300 million through different means. The firm has raised
Rs. 107 mn through equity, Rs. 13 mn through preference capital, Rs. 80 mn by issuing
debentures and Rs. 100 mn by taking a loan a financial institution.

Source of finance Cost (per cent) Weight Product of cost and weight

Equity capital 16.64 107/300 5.93

Preference capital 15.73 13/300 0.68

Debenture capital 11.08 80/300 2.95

Term loan 10.25 100/300 3.42

Average cost of capital 12.99 per cent

Looked at it with a different perspective, the cost of capital is the rate of return the firm must
earn on its investments in order to satisfy the expectations of investors who provide long-term
funds to it. It is an important concept for financing decisions.



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 time) is only a secondary consideration for debt investors. Conversely, equity investors are
primarily seeking Growth, or capital appreciation. Income is usually of lesser importance, and is
received in the form of Dividends.

Cognizant Confidential Foundation Course in Banking and Capital Markets

Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on stock. It
also means that if the company ceases to do business and liquidate its assets, that the debt
holders have a senior claim to those assets.


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 is money owed by one person or firm to another. Bonds, loans, and commercial paper are
all examples of debt.

An investor loans money to an entity (company or government) that needs funds for a specified
period of time at a specified interest rate. In exchange for the money, the entity will issue a
certificate, or bond, that states the interest rate (coupon rate) to be paid and repayment date
(maturity date). Interest on bonds is usually paid every six months (semiannually).

Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal Only and
Fully Registered Bonds.

Bearer bonds are like cash since the bearer of the bond is presumed to be the owner. These
bonds are Unregistered because the 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.,

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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.

• IBM can issue 10 year bonds with a coupon of 5.5%.
• Priceline
The principal or parcan issueamount
or Face similar 10 yearbond
of the bonds at 8%the investor has loaned to the issuer.
is what
• The"safety"
The relative difference in principal
of the coupon isdepends
due to their credit
on the rating!
issuer’s credit rating and the type of bond
that was issued.

A bond issued by a corporation. Corporations generally issue three types of bonds: Secured
Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures.

All corporate bonds are backed by the full faith and credit of the issuer, but a secured bond is
further backed by specific assets that act as collateral for the bond.

In contrast, unsecured bonds are backed by the general assets of the corporation only. There
are three basic types of Secured Bonds:

Mortgage Bonds are secured by real estate owned by the issuer

Equipment Trust Certificates are secured by equipment owned and used in the issuers business

Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (Usually U.S.
Government securities)

Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor status; they
are the first to be paid principal or interest and are thus the safest of an 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

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A bond issued by a municipality. These are generally tax free, but the interest rate is usually
lower than a taxable bond.

Treasury bills, notes, and bonds are marketable securities the U.S. government sells in order to
pay off maturing debt and raise the cash needed to run the federal government. When an
investor buys one of these securities, he/she is lending money to the U.S. government.

Treasury bills are short-term obligations issued for one year or less. They are sold at a discount
from face value and don't pay interest before maturity. The interest is the difference between
the purchase price of the bill and the amount that is paid to the investor at maturity (face value)
or at the time of sale prior to maturity.

Treasury notes and bonds bear a stated interest rate, and the owner receives semi-annual
interest payments. Treasury notes have a term of more than one year, but not more than 10

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.


Zeros generate no periodic interest payments but they are issued at a discount from face value.
The return is realized at maturity. Zeros sell at deep discounts from face value. The difference
between the purchase price of the zero and its face value when redeemed is the investor's
return. Zeros can be purchased from private brokers and dealers, but not from the Federal
Reserve or any government agency.

The higher rate of return the bond offers, the more risky the investment. There have been
instances of companies failing to pay back the bond (default), so, to entice investors, most
corporate bonds will offer a higher return than a government bond. It is important for investors
to research a bond just as they would a stock or mutual fund. The bond rating will help in
deciphering the default risk.

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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

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

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 (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 represents an ownership interest in a company. Owners of stock also have
Limited Liability (i.e.) the maximum a shareholder can lose is their original investment. Most of
the stock traded in the markets today is common. An individual with a majority shareholding or

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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.

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!!

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

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.

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Convertible preferred stock can be converted into shares of common stock either at a fixed
price or a fixed number of shares. It is essentially a mix of debt and equity, and most often used
as a means for a risky company to obtain capital when neither debt nor equity works. It offers
considerable opportunity for capital appreciation.

Non-convertible preferred stock remains outstanding in perpetuity and trades like stocks.
Utilities represent the best example of nonconvertible preferred stock issuers.


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 are securities, which combine the characteristics of equity and debt.

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 known as TELCO) recently issued convertible bond
aggregating to $100 million in the Luxemburg Stock Exchange. The effective interest rate
paid on the issue was just 4% which was much lower than what it would have to pay if it
raised the money in India, where it is based out of. The company would use this money
to pay-back existing loans borrowed at much higher interest rates.

• Why 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 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

Cognizant Confidential Foundation Course in Banking and Capital Markets

A derivative is a product whose value is derived from the value of an underlying asset, index or
reference rate. The underlying asset can be equity, foreign exchange, commodity or any other
item. For example, if the settlement price of a derivative is based on the stock price, which
changes on a daily basis, then the derivative risks are also changing on a daily basis. Hence
derivative risks and positions must be monitored constantly.

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.

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 lookout for such

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!!

Cognizant Confidential Foundation Course in Banking and Capital Markets

Put Options are options to sell a stock at a specific price on or before a certain date. With a Put
Option, the investor can "insure" a stock by fixing a selling price. If stock prices fall, the investor
can exercise the option and sell it at its "insured" price level. If stock prices go up, there is no
need to use the insurance, and the only cost is the premium. A put option is in-the-money when
the share price is below the strike price. The amount by which an option is in-the-money is
referred to as intrinsic value.

The primary function of listed options is to allow investors ways to manage risk. Their price is
determined by factors like the underlying stock price, strike price, time remaining until
expiration (time value), and volatility. Because of all these factors, determining the premium of
an option is complicated.

Types of Options
There are two main types of options:

• American options can be exercised at any time between the date of purchase and the
expiration date. Most exchange-traded options are of this type.
• European options can only be exercised at the end of their life.

Long-Term Options are options with holding period of one or more years, and they are called
LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to control and
manage risk or even speculate, they are virtually identical to regular options. LEAPS, however,
provide these opportunities for much longer periods of time. LEAPS are available on most
widely-held issues.

Exotic Options: The simple calls and puts are referred to as "plain vanilla" options. Non-standard
options are called exotic options, which either are variations on the payoff profiles of the plain
vanilla options or are wholly different products with "optionality" embedded in them.

Open Interest is the number of options contracts that are open; these are contracts that have
not expired nor been exercised.

Swaps are the exchange of cash flows or one security for another to change the maturity
(bonds) or quality of issues (stocks or bonds), or because investment objectives have changed.
For example, one firm may have a lower fixed interest rate, while another has access to a lower
floating interest rate. These firms could swap to take advantage of the lower rates.

Currency Swap involves the exchange of principal and interest in one currency for the same in
another currency.

Forward Swap agreements are created through the synthesis of two different swaps, differing in
duration, for the purpose of fulfilling the specific timeframe needs of an investor. Sometimes

Cognizant Confidential Foundation Course in Banking and Capital Markets

swaps don't perfectly match the needs of investors wishing to hedge certain risks. For example,
if an investor wants to hedge for a five-year duration beginning one year from today, they can
enter into both a one-year and six-year swap, creating the forward swap that meets the
requirements for their portfolio.

Swaptions - An option to enter into an interest rate swap. The contract gives the buyer the
option to execute an interest rate swap on a future date, thereby locking in financing costs at a
specified fixed rate of interest. The seller of the swaption, usually a commercial or investment
bank, assumes the risk of interest rate changes, in exchange for payment of a swap premium.

Case Study
The World Bank borrows funds internationally and loans those funds to developing countries. It
charges its borrowers a cost plus rate and hence needs to borrow at the lowest cost.

In 1981 the US interest rate was at 17 percent, an extremely high rate due to the anti-inflation
tight monetary policy of the Fed. In West Germany the corresponding rate was 12 percent and
Switzerland 8 percent.

IBM enjoyed a very good reputation in Switzerland, perceived as one of the best managed US
companies. In contrast, the World Bank suffered from bad image since it had used several times
the Swiss market to finance risky third world countries. Hence, World Bank had to pay an extra
20 basis points (0.2%) compared to IBM

In addition, the problem for the World Bank was that the Swiss government imposed a limit on
the amount World Bank could borrow in Switzerland. The World Bank had borrowed its allowed
limit in Switzerland and West Germany

At the same time, the World Bank, with an AAA rating, was a well established name in the US
and could get a lower financing rate (compared to IBM) in the US Dollar bond market because of
the backing of the US, German, Japanese and other governments. It would have to pay the
Treasury rate + 40 basis points.

IBM had large amounts of Swiss franc and German deutsche mark debt and thus had debt
payments to pay in Swiss francs and deutsche marks.

World Bank borrowed dollars in the U.S. market and swapped the dollar repayment obligation
with IBM in exchange for taking over IBM's SFR and DEM loans.

It became very advantageous for IBM and the World Bank to borrow in the market in which
their comparative advantage was the greatest and swap their respective fixed-rate funding.




Cognizant Confidential Foundation Course in Banking and Capital Markets

A financial transaction is one where a financial asset or instrument, such as cash, check, stock,
bond, etc are bought and sold. Financial Market is a place where the buyers and sellers for the
financial instruments come together and financial transactions take place.


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 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


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.


Why businesses need capital?

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

Cognizant Confidential Foundation Course in Banking and Capital Markets

What is the role of Capital Markets?

For businesses to thrive and grow, presence of vibrant and efficient capital markets is extremely
important. Capital markets have following functions:

1. Channeling funds from “savings pool” to “investment pool” – channeling funds from “those
who have money” to “those who need funds for business purpose”.

2. Providing liquidity to investors – i.e. making it easy for investors, to buy and sell financial
assets or instruments. Capital markets achieve this in a number of ways and it is particularly
important for institutional investors who trade in large quantities. Illiquid markets do not
allow them to trade large quantities because the orders may simply not get executed
completely or may cause drastic fluctuations in price.

3. Providing multitude of investment options to investors – this is important because the risk
profile, investment criteria and preferences may differ for each investor. Unless there are
many investment options, the capital markets may fail to attract them, thus affecting the
supply of capital.

4. Providing efficient price discovery mechanism – efficient because the price is determined by
the market forces, i.e. it is a result of transparent negotiations among all buyers and sellers
in the market at any point. So the market price can be considered as a fair price for that

Stock markets are the best known among all financial markets because of large participation of
the “retail investors”. The important stock exchanges are as follows:

• New York Stock Exchange (NYSE)

• National Association of Securities Dealers Automated Quotations (NASDAQ)
• London Stock Exchange (LSE)
• Bombay Stock Exchange (BSE),
• National Stock Exchange of India (NSE)
Stock Exchanges provide a system that accepts orders from both buyers and sellers in all shares
that are traded on that particular exchange. Exchanges then follow a mechanism to
automatically match these trades based on the quoted price, time, quantity, and the order type,
thus resulting in trades. The market information is transparent and available real-time to all,
making the trading efficient and reliable.

Earlier, before the proliferation of computers and networks, the trading usually took place in an
area called a “Trading Ring” or a “Pit” where all brokers would shout their quotes and find the
“counter-party”. The trading ring is now replaced in most exchanges by advanced computerized
and networked systems that allow online trading, so the members can log in from anywhere to
carry out trading. For example, BOLT of BSE and Super DOT of NYSE.

What determines the share price and how does it change?

The share price is determined by the market forces, i.e. the demand and supply of shares at
each price. The demand and supply vary primarily as the perceived value of the stock for

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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.

As the name suggests, bonds are issued and traded in these markets. Government bonds
constitute the bulk of the bonds issued and traded in these markets. Bond markets are also
sometimes called Fixed Income markets. While some of the bonds are traded in exchanges,
most of the bond trading is conducted over-the-counter (OTC), i.e. by direct negotiations
between dealers. Lately there have been efforts to create computer-based market place for
certain type of bonds.

Participants in the Bond Market

Since Government is the biggest issue of bonds, the central bank of the country such as Federal
Reserve in US and Reserve Bank of India in India, is the biggest player in the bond market. Like
stock markets, one needs to be an authorized dealer of Govt. securities, to subscribe to the
bond issues. Typically, the Govt. bond issues are made by way of auctions, where the dealers bid
for the bonds and the price is fixed based on the bids received. The dealers then sell these
bonds in the secondary market or directly to third parties, typically institutions and companies.

If the interest rate is fixed for each bond, why do the bond prices fluctuate?
Bond prices fluctuate because the interest rates as well as the perceptions of investors on the
direction of interest rates change. Remember, bond pays interest at a fixed coupon rate
determined at the time of issue, irrespective of the prevailing market interest rate. Market
interest rates are benchmark interest rates, such as Treasury bill rates, which are subject to
change because of various factors such as inflation, monetary policy change, etc. So when the
prevailing market interest rates change, price of the bond (and not the coupon) adjusts, so that
the effective yield for a buyer at the time (if the bond is held to maturity) matches the market
interest rate on other bonds of equal tenure and credit rating (risk).

So when the market interest rates go up, prices of bonds fall and vice-versa. Therefore, price of
bonds changes when market interest rate changes, all bonds have an interest rate risk. If the
market interest rates shoot up, then the bond price is affected negatively and an investor who
bought the bond at a high price (when interest rates were low) stands to lose money or at least
makes lesser returns than expected, unless the bond is held to maturity.

Bond Price calculation can be summed by an easy formula:

Cognizant Confidential Foundation Course in Banking and Capital Markets

where B represents the price of the bond and CFk represents the kth cash flow which is
made up of coupon payments. The Cash Flow (CF) for the last year includes both the coupon
payment and the Principal.

• What would be the bond price for a 3-Year, Rs.100 principal, bond when the interest
rate (i) is 10% and the Coupon payments are Rs.5 annually?

• Would the bond price increase/decrease if the coupon is reduced? What would be
happen to bond price if the interest rates came down?


Foreign exchange 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.

Only authorized foreign exchange dealers can participate in the foreign exchange market. Any
individual or company, who needs to sell or buy foreign currency, does so through an authorized
dealer. Currency trading is conducted in the over-the-counter (OTC) market.

The role of the Central Bank in the foreign exchange market

The central bank regulates the markets to ensure its smooth functioning. The degree of
regulation depends on the economic policies of the country. The central bank may also buy or
sell their currency to meet unusual demand – supply mismatches in the markets.

The foreign exchange rate and transactions are closely monitored because the fluctuations in
Forex markets affects the profitability of imports and exports of domestic companies as well as
profitability of investments made by foreign companies in that country. Regulators try to ensure
that the fluctuations are not caused by any factor other than the market forces.

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.

Cognizant Confidential Foundation Course in Banking and Capital Markets

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.

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.


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,

Cognizant Confidential Foundation Course in Banking and Capital Markets

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

• Rules regarding the amount of information that must be made available to prospective
• 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


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.

The volume of transactions in capital markets demands advanced systems to ensure speed and
reliability. Due to proliferation of Internet technology, the trading systems are also now
accessible online allowing even more participants from any part of the world to transact, helping
to increase efficiency and liquidity. The trading systems can be divided into front-end order
entry and back-end order processing systems.

Order entry systems also offer functions such as order tracking, calculation of profit and loss
based on real-time price movements and various tools to calculate and display risk to the value
of investments due to price movement and other factors.

Back-office systems validate orders, route them to the exchange(s), receive messages and
notifications from the exchanges, interface with external agencies such as clearing firm,
generate management, investor and compliance reports, keep track of member account
balances etc.

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.


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

Cognizant Confidential Foundation Course in Banking and Capital Markets

investor. A portfolio of investments allows one to diversify risks over a limited number of
instruments and issuers.

The accounting systems take care of present value calculations, profit & loss etc. - of
investments and funds and not the financial accounts of the firms.


• 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
• 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.



Cognizant Confidential Foundation Course in Banking and Capital Markets


Why does the concept of Accounting and Financial Statements exist? Here are two main

1. The managers of the business will want to know how things are going. They need
financial information in order to plan for the future; they need more up-to-date
information in order to check whether actual performance is on target. So accounting is
the first step in what we call management accounting.

2. There are several other groups of people who may have an interest in the finances of
the business (often referred to as 'stakeholders'). The law says that they have a legal
right to certain information. The whole process of providing this information (and of
maintaining a book-keeping system which is capable of providing it) is known as
financial accounting.

The stakeholders of any firm could be any or all of the following:

1. Shareholders

2. Employees

3. Management

4. Customers

5. Government

6. Trade Unions and others

Question: Who owns the firm - management or shareholders?

Answer: Shareholders of course, as they hold shares of the company. However Management
personnel/directors of a company are also encouraged to hold shares of the company to align
the interest of management and shareholders. )

For Accounting purpose, Company is considered as a Legal Entity – that is, a person or
organization that has the legal standing to enter into contracts and may be sued for failure to
perform as agreed in the contract, e.g., a child under legal age is not a legal entity, while a
corporation is a legal entity since it is a person in the eyes of the law.

In order that the stakeholders mentioned above understand the financial position of a company,
there are standardized financial statements that are prepared. The main ones are:

1. Balance Sheet

2. Income Statement or Profit and Loss Account

3. Cash-Flow statement

Cognizant Confidential Foundation Course in Banking and Capital Markets

Now, let us study them one at a time (why do we need to do that? Well, one of the aims of this
course is to ensure that we are familiar with the basic concepts and terms used in Finance. And
the above statements are as basic as it gets. SO read on)

A Balance sheet is a statement that lists the total assets and the total liabilities of a given
business to portray its net worth at a given moment of time. Thus, if we look at any balance
sheet, it is “As on March 31st 200X” (Or whatever the financial year ending date)

So, it indicates the health of the firm at a point of time.

What are the individual items in a Balance Sheet?

First of all it’s called a balance sheet because the Asset and Liabilities in a Balance sheet balance,
meaning they equal each other – it’s as simple as that!

An Asset is anything owned by an individual or a business, which has commercial value. Claims
against others also qualify as Assets. (That is, if someone owes us something, then it is also an
asset, as it actually belongs to us and is of commercial value)

A Liability is a debt payable by the firm to its creditors. It represents an economic obligation to
pay cash, or provide goods and services, in some future period. (Thus, if we buy a bike on
installments, Bike is of course an asset as it has capability to provide us service for next few
years, but the loan amount which we need to pay out in installments is a Liability we incur.)

The typical heads in a balance sheet are shown below with a sample:

Consolidated Statements of Financial Positions

(All number in thousands)

Assets Liabilities

Current Assets Current Liabilities

Cash and Cash Equivalents $100 Payables and Accrued Expenses $50

Short Term Investments 100 Short Term Loans 150

Receivables 200 Debt due in the next 1 year 100

Inventory 50 Other Current Liabilities 50

Other Current Assets 50

Total Current Assets 500 Total Current Liabilities 350

Long Term Assets Long term Liabilities


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Net Fixed Assets (Land, Properties 200 Long term debt 200
and Equipments)

Intangible Assets 100 Deferred Liabilities 50

Goodwill 50 Other Liabilities 100

Other Assets 50 Total Liabilities 700

Shareholders’ Equity

Equity 100

Retained Earnings 100

Total Long Term Assets 400 Total Shareholder’s Equity 200

Total Assets 900 Total Liabilities and Shareholders’ 900


Let’s look at each item closely:

Current Assets are those assets of a company that are reasonably expected to be realized in
cash, or sold, or consumed in the next one year. Some current assets are listed below:

Cash and Cash Equivalents: Cash And Cash Equivalents means all cash, securities, which can be
converted into cash at a very short notice, and other near-cash items (E.g. checks, drafts, cash in
bank accounts etc).

Short Term Investments: All investments, which will be converted in Cash in the next one year.
All the assets (bonds etc) with less than one year “time to maturity” will be accounted under this
item (E.g. short term securities).

Receivables: Also referred to as Account receivables. This indicates the money due to the firm,
for service rendered or goods sold on credit.

Inventory: Inventory for companies includes raw materials, items available for sale or in the
process of being made ready for sale (work in process). For a stockbroker, it will be the
securities bought and held by him, for resale.

Other Current Assets: Anything else which could not be categorized in one of the items above
but we know that it’s a current asset can be accounted for here.

Long-term assets are those assets that are not consumed during the normal course of business,
e.g. land, buildings and equipment, goodwill, etc. They include:

Cognizant Confidential Foundation Course in Banking and Capital Markets

Fixed Assets: Fixed Assets are assets of a permanent nature required for the normal conduct of
a business, and which will not normally be converted into cash during the next fiscal period. For
example, furniture, fixtures, land, and buildings are all fixed assets. Fixed asset is value of all
property, plant, and equipment, net of depreciation.


We all understand that if we buy a car today, after 5 years of service the value of the car would
not be same. We will not be able to sell the car after 5 years at the same price at which we
bought the car. This means that assets lose their value as they provide service. This loss of value,
or spreading of cost, is called depreciation.

Calculating deprecation can get complex, but here’s one simple way of calculating depreciation.
Say, we know that life of a computer is 3 years and we bought it for $ 3000. So at the end of the
3 years the asset will have a Zero value. What is the true value of the asset at the end of each
year? Just depreciate the value of the Asset by $ 1000 (3000/3) each year. Thus:

Value of Asset End of Year

$ (3000-1000)=$ 2000 1

$1000 2

$0 3

Usually, instead of the value coming all the way down to zero, it is said to have a ‘scrap’ value:
say, $100. At this point, the asset is removed from the business’ books, or said to be “written off

Intangible Asset is an asset that is not physical in nature. Examples are things like copyrights,
patents, intellectual property, or goodwill. We can look at more details through an example of
Goodwill below.


Goodwill is that intangible possession which enables a business to continue to earn a profit that
is in excess of the normal or basic rate of profit earned by other businesses of similar type. Say, a
company such as Hindustan levers, has built up a lot of goodwill over the years. Customers
would prefer to buy their products versus an unknown brand. This is an intangible factor, yet
worth a lot of money!

Again, any other asset, which could not be classified under any of the categories above, but one
is sure it’s an asset, can be accounted for here.

Cognizant Confidential Foundation Course in Banking and Capital Markets

Current Liabilities are amounts, or goods and services, to be paid or executed, within next one

Payables and Accrued Expenses: A Company might have suppliers who supply on credit, and
this is an Account Payable. An accrued expense is an expense that the company has already
incurred but company has not paid for it so far.

Short Term Loans: All the loans that have to be paid in the next one year.

Debt payments due in the next year: Loans of 10-15 years duration are sometimes repaid in
installments every year, and so just the money that has to be paid in the next one year would be
accounted here.

Other Current Liabilities: Any liabilities, which cannot be categorized under any of the headings

Long-term debt: All debt, including bonds, debentures, bank debt, mortgages, deferred portions
of long-term debt, and capital lease obligations. Please note that part of the loan that is due
only after next one year is indicated here.

Deferred Liabilities/Provisions: Deferred, in accounting, is any item where the asset or liability
is not realized until a future date, e.g. annuities, charges, taxes, income, etc. So in this case, one
knows that there will be some expenses, but the exact amount and dates are not known.

Other Liabilities: Any liabilities, which cannot be categorized under any of the headings above.

Equity This is basically equity share capital, which is capital raised by an entity through the sale
of common shares in the primary market. This is also called share capital.

Retained Earnings

Retained Earnings are profits of the business that have not been distributed to the owners as of
the balance sheet date. The earnings have been "retained" for planned activities such as
business expansion - so they actually belong to the owners (shareholders), but have been

Quiz: How do the three items above change when company declares dividend?

Answer: Nothing changes till the company pays out dividends.

Quiz: How do these items change when company pays out dividends?

Answer: Retained earnings go down by amount of dividend.


Cognizant Confidential Foundation Course in Banking and Capital Markets

Advanced Quiz: Are stock options same as shares held by employees? Are these captured in
these statements?

Answer: A stock option is the right of an employee to buy company shares at a pre-specified
price, which may be above or below the market price, as on date of the exercising of option. If
the option price is below the market price, the employee may buy at the option price & sell at
market price & thus realize a profit. If option price is above the market price as on that date,
obviously the employee will not prefer to exercise the option. Hence, the options cannot be
categorized as ‘shares’. However, in some balance sheets, provision may be made for these
stock options under the ‘liability’ head.


Profit And Loss Statement (P&L) is also known as an income statement. It shows business
revenue and expenses for a specific period of time (such as the financial year – so if we look at
any P & L statement, it always specifies a period of time, as: For the Financial Year Ended 31st
December 2003. The difference between the total revenue and the total expense is the
business’ net income.

A key element of this statement, and one that distinguishes it from a balance sheet, is that the
amounts shown on this statement represent transactions over a period of time while the items
represented on the balance sheet show information as of a specific date (or point in time). So in
engineering terms, Balance sheet has a memory like Flip-flops, while Income statement doesn’t
have a memory.

It is important to understand that for a company “Profit” need not equal the “Cash” it has
generated during a period. It might so happen that company has provided the service but the
client has not yet paid and so company makes a Profit but not Cash. To account for cash
generated during a period, companies also report “Cash flow statement”.

A sample P&L statement is shown below.


Revenue A

Direct Cost B = (C+D)

Direct Material C

Direct Labor D

Gross Profit E = (A-B)

Operating Expenses (Based on the type of business, some of F = (G+ H+I+J+K)

these items would qualify as indirect Cost)

Administration G

Cognizant Confidential Foundation Course in Banking and Capital Markets


Marketing and Selling Expenses I

Any one time expenses (e.g. ex-gratia etc) J

Other Expenses K

Operating Income L = (E-F)

Other Income M

Other Expenses N

EBIT (Earnings Before Interest and Taxes) O = (L+M-N)

Interest Expenses P

Profit Before Tax (PBT) Q = (O-P)

Income Taxes R

Net Income or PAT (Profit after Tax) S= (Q-R)

EPS (Earnings Per Share) T = S/ Number of shares

P/E Ratio Market price/T

Let’s look at each item closely:


Revenue is the inflows of assets (may be Cash or Receivables, Remember!) from selling goods or
providing services to customers. This is also referred to as the ‘Top line’ (as it is the top line in
the P& L statement!)

Direct Cost

Direct Cost is that portion of cost that is directly expended in providing a product or service for
sale e.g. material and labor.

Gross Profit

Gross Profit is one of the key performance indicators. Gross profit shows the relationship
between sales and the direct cost of products/services sold. It is measured as indicated in the
table above.

Cognizant Confidential Foundation Course in Banking and Capital Markets

Indirect Cost

Indirect Cost is that portion of cost that is indirectly expended in providing a product or service
for sale (cannot be traced to a given project, in our case, in an economically feasible manner)
e.g. rent, utilities, equipment maintenance, etc.

Operating Expenses

Operating Expenses is all selling and general & administrative expenses. This includes
depreciation, but not interest expense.

Operating Income

Operating Income is revenue less cost of goods sold (Direct and Indirect costs) and related
operating expenses that are applied to the day-to-day operating activities of the company. It
excludes financial related items (i.e., interest income, dividend income, and interest expense),
and taxes.

EBIT (Earnings before Interest and Taxes)

It’s the earnings before any interest or taxes.

Interest Expenses

Interest expense captures all the finance charges incurred on any borrowed capital.

Profit before Tax (PBT)

Profit earned before accounting for Taxes.

Income Taxes

Amount of tax paid. This is a % of PBT.

Net Income or PAT (Profit after Tax)

This is the profit after all the obligations, which can be distributed to shareholders’. This is also
referred as the ‘Bottom-line’ (as this is the bottom line in a P &L statement, or the final profit
net of expenses & tax.

EPS (Earnings per Share)

Earnings per Share (EPS) is the amount of net income (earnings) related to each share;
computed by dividing net income by the number of shares outstanding during the period.

P/E Ratio

Price to Earnings Ratio (P/E) is a performance benchmark that can be used as a comparison
against other companies or within the stock's own historical performance. For instance, if a
stock has historically run at a P/E of 35 and the current P/E is 12, we may want to explore the

Cognizant Confidential Foundation Course in Banking and Capital Markets

reasons for the drastic change. If we believe that the ratio is too low, we may want to buy the

There are a number of other ratios that help analysts to analyze the financial statements of
companies to understand the current performance and future prospects; we are not
discussing those here.


Statement accounting for all the inflows and outflows of cash is captured in this statement.

Why do we need a separate Cash-flow statement?

Isn’t it covered in Balance sheet or Income statement?

All the accounting is done based on the method wherein, revenue and expenses are recorded in
the period in which they are earned or incurred regardless of whether cash is received or
disbursed in that period. So when a good is sold or some service rendered, it will show in
Balance sheet and Income statement, but it will not show in the Cash Flow statement till cash is
received for the same.

Quiz: How will we explain a scenario where company is reporting a large profit but company
doesn’t have the cash to pay salary to its employees? Where is the cash going or “did it come at

Answer: It means that the company is selling goods and also making profits but has not received
cash payments from its customers!


1. Day 1: We borrow Rs 100 from a bank for a business to produce t-shirts. How would our
balance sheet look like at the end of the day?

2. Day 2: We purchase raw material for your products for Rs 50. How would our balance
sheet look like at the end of the day?

3. Day 3 to 29: Workers work with the rented machines to produce the finished goods. The
product is ready to be shipped to customer.

4. Day 30: We pay the workers Rs 20 as their salary, pay Rs 10 as the machine rent, pay
other expenses such as floor rent, electricity bills etc totaling Rs 10. At the end of the
day the product is shipped to the customer. Customer has promised to pay you Rs 120
after checking the quality, which will take 5 days. How would our balance sheet look like
at the end of the day? How would our Income statement look like?

5. Day 35: You get Rs 120 from customer. You also get admission in a Business School and
so you plan to wind up the business. Prepare all the financial statements (Balance sheet
and Profit and loss statement at the end of day 35).

Cognizant Confidential Foundation Course in Banking and Capital Markets

Useful Information: Bank charges 12% simple interest rate. We need to pay tax @ 10% of the
net income. Inflation for the period was 5%.

Advanced Exercise

Infosys has all its revenue in Dollars. Direct cost for the company is 60% of its revenue. Of this
60%, 30% in incurred in dollars (onsite component) while 70% (offshore component) is incurred
in rupees. Indirect cost for the company is 20%. Of this 20%, 70% (Selling and Marketing, US
infrastructure etc) is incurred in dollars while rest (Indian infrastructure, entertainment etc) is
incurred in rupees. By what percentage, will the profit increase/decrease if the rupee
appreciates by 1% from its current level of Rs. 50 per dollar?

Understanding Cognizant’s Financial Statements


In Millions of USD As of 2008-12-31 As of 2007-12-31 As of 2006-12-31 As of 2005-12-31

(except for per share
Cash & Equivalents 735.07 339.85 265.94 196.94
Short Term Investments 27.51 330.58 382.22 227.06
Cash and Short Term
762.58 670.42 648.16 424.00
Accounts Receivable -
579.64 436.46 298.48 176.70
Trade, Net
Receivables - Other - - - -
Total Receivables, Net 579.64 436.46 298.48 176.70
Total Inventory - - - -
Prepaid Expenses - - - -
Other Current Assets,
125.90 135.30 93.76 62.73
Total Current Assets 1,468.12 1,242.18 1,040.39 663.42

654.44 499.03 315.69 211.72
, Total - Gross
Goodwill, Net 154.03 148.79 27.19 18.22
Intangibles, Net 47.79 45.56 20.46 16.28
Long Term Investments 161.69 0.00 - -
Other Long Term Assets,
87.67 45.73 17.78 24.99
Total Assets 2,374.56 1,838.31 1,325.98 869.89

Accounts Payable 39.97 36.18 27.84 16.42

Accrued Expenses 298.17 272.34 200.54 119.29
Notes Payable/Short
0.00 0.00 0.00 0.00
Term Debt
Current Port. of LT
- - - -
Debt/Capital Leases
Other Current liabilities,
49.44 32.16 21.13 18.08
Total Current Liabilities 387.58 340.68 249.50 153.79

Long Term Debt - - - -

Capital Lease
- - - -
Total Long Term Debt 0.00 0.00 0.00 0.00

Total Debt 0.00 0.00 0.00 0.00


Cognizant Confidential Foundation Course in Banking and Capital Markets

Deferred Income Tax 7.29 15.14 0.00 -

Minority Interest - - - -
Other Liabilities, Total 14.11 14.27 2.98 1.95
Total Liabilities 408.98 370.10 252.48 155.75

Redeemable Preferred
- - - -
Stock, Total
Preferred Stock - Non
- - - -
Redeemable, Net
Common Stock, Total 2.92 2.88 2.85 1.39
Additional Paid-In Capital 541.74 450.57 408.59 293.15
Retained Earnings
1,430.40 999.56 650.28 417.48
(Accumulated Deficit)
Treasury Stock -
- - - -
Other Equity, Total -9.48 15.20 11.78 2.12
Total Equity 1,965.58 1,468.21 1,073.50 714.14

Total Liabilities &

2,374.56 1,838.31 1,325.98 869.89
Shareholders' Equity

Shares Outs - Common

- - - -
Stock Primary Issue
Total Common Shares
291.67 288.01 285.03 278.69


In Millions of USD (except for per 3 months 3 months 3 months 3 months 3 months
share items) ending 2009- ending 2008-12- ending 2008-09- ending 2008-06- ending 2008-03-
03-31 31 30 30 31
Revenue 745.86 753.04 734.73 685.43 643.11
Other Revenue, Total - - - - -
Total Revenue 745.86 753.04 734.73 685.43 643.11

Cost of Revenue, Total 419.71 419.75 405.94 380.87 366.26

Gross Profit 326.15 333.30 328.79 304.56 276.84

Selling/General/Admin. Expenses,
166.87 169.38 166.69 167.10 148.85
Research & Development - - - - -
Depreciation/Amortization 21.15 21.25 19.47 17.78 16.29
Interest Expense(Income) - Net
- - - - -
Unusual Expense (Income) - - - - -
Other Operating Expenses, Total - - - - -
Total Operating Expense 607.73 610.38 592.10 565.75 531.41

Operating Income 138.13 142.67 142.63 119.68 111.69

Interest Income(Expense), Net Non-

- - - - -
Gain (Loss) on Sale of Assets - - - - -
Other, Net -5.11 -12.34 -14.78 -0.48 3.95
Income Before Tax 135.49 136.09 133.20 124.06 121.87

Income After Tax 113.13 112.29 112.83 103.86 101.87

Minority Interest - - - - -
Equity In Affiliates - - - - -
Net Income Before Extra. Items 113.13 112.29 112.83 103.86 101.87

Cognizant Confidential Foundation Course in Banking and Capital Markets

Accounting Change - - - - -
Discontinued Operations - - - - -
Extraordinary Item - - - - -
Net Income 113.13 112.29 112.83 103.86 101.87

Preferred Dividends - - - - -
Income Available to Common Excl.
113.13 112.29 112.83 103.86 101.87
Extra Items

Income Available to Common Incl.

113.13 112.29 112.83 103.86 101.87
Extra Items

Basic Weighted Average Shares - - - - -

Basic EPS Excluding Extraordinary
- - - - -
Basic EPS Including Extraordinary
- - - - -

Dilution Adjustment - - 0.00 0.00 0.00

Diluted Weighted Average Shares 297.99 297.57 299.81 299.33 299.05
Diluted EPS Excluding Extraordinary
0.38 0.38 0.38 0.35 0.34

Diluted EPS Including Extraordinary

- - - - -

Dividends per Share - Common Stock

0.00 0.00 0.00 0.00 0.00
Primary Issue
Gross Dividends - Common Stock - - - - -
Net Income after Stock Based Comp.
- - - - -
Basic EPS after Stock Based Comp.
- - - - -
Diluted EPS after Stock Based Comp.
- - - - -
Depreciation, Supplemental - - - - -
Total Special Items - - - - -
Normalized Income Before Taxes - - - - -
Effect of Special Items on Income
- - - - -
Income Taxes Ex. Impact of Special
- - - - -
Normalized Income After Taxes - - - - -
Normalized Income Avail to
- - - - -
Basic Normalized EPS - - - - -
Diluted Normalized EPS 0.38 0.38 0.38 0.35 0.34


In Millions of USD (except for 3 months 12 months 9 months 6 months 3 months

per share items) ending 2009-03- ending 2008-12- ending 2008-09- ending 2008-06- ending 2008-03-
31 31 30 30 31
Net Income/Starting Line 113.13 430.85 318.56 205.73 101.87
Depreciation/Depletion 21.15 74.80 53.54 34.07 16.29
Amortization - - - - -
Deferred Taxes 3.94 -5.03 9.90 7.01 -6.67
Non-Cash Items 10.63 37.97 24.47 12.45 10.58
Changes in Working Capital -73.76 -108.88 -169.69 -162.23 -99.82
Cash from Operating Activities 75.09 429.70 236.79 97.03 22.26

Capital Expenditures -20.47 -169.41 -146.32 -85.21 -53.42

Other Investing Cash Flow Items,
-23.07 114.40 112.87 110.90 119.58
Cash from Investing Activities -43.55 -55.01 -33.45 25.69 66.16

Cognizant Confidential Foundation Course in Banking and Capital Markets

Financing Cash Flow Items 1.82 16.99 16.26 15.16 4.04

Total Cash Dividends Paid - - - - -
Issuance (Retirement) of Stock,
-4.12 27.04 20.98 40.29 12.83
Issuance (Retirement) of Debt,
- 0.00 - - -
Cash from Financing Activities -2.30 44.03 37.24 55.45 16.88

Foreign Exchange Effects -5.74 -23.51 -11.16 3.18 4.60

Net Change in Cash 23.50 395.22 229.42 181.35 109.89

Cash Interest Paid, Supplemental - - - - -

Cash Taxes Paid, Supplemental - 82.80 - - -


Cognizant Confidential Foundation Course in Banking and Capital Markets



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


• 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.


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:

Cognizant Confidential Foundation Course in Banking and Capital Markets

• Conducting the nation's monetary policy. Central banks define the monetary policy and then
take necessary actions to create an environment to make those policies feasible. E.g. if the
central bank wants to maintain soft interest rate, they can reduce the CRR to pump in more
money in the economy.
• Supervising and regulating banking institutions and protecting the rights of consumers
• Maintaining the stability of the financial system, i.e. stability of interest rates and foreign
exchange rate.
• Ensuring that the interest rates remain at such a level as to make business viable
• Ensuring that sufficient funds are available for long term investment to businesses as well as
government, without causing inflation to rise
• Providing certain financial services to the government, the public, financial institutions, and
foreign official institutions
• Monitoring the foreign currency assets and liabilities and monitoring the inflow and outflow
of foreign currency


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.

Cognizant Confidential Foundation Course in Banking and Capital Markets


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.

Cognizant Confidential Foundation Course in Banking and Capital Markets


Service offerings of banks are organized along following divisions:

• Corporate Banking
o Trade Finance
o Cash Management
• Retail Banking
o Deposits – Checking, Savings, Retirement accounts, Term deposits
o Branch & Electronic Banking
o Credit Card services
o Retail Lending – Personal Loans, Home Mortgages, Consumer Loans, Vehicle Loans
o Private Banking & Wealth Management
o SME/Business Banking for SMEs
• Investment Banking
o Private Equity
o Corporate Advisory
o Capital Raising
o Proprietary Trading
o Emerging Markets
o Sales, Trading & Research
 Fixed Income


Listed below are the Top 50 bank holding companies (BHCs) as of 12/31/2008

Rank Institution Name Total Assets

1 JPMORGAN CHASE & CO. $2,175,052,000
2 CITIGROUP INC. $1,938,470,000
4 WELLS FARGO & COMPANY $1,309,639,000

Cognizant Confidential Foundation Course in Banking and Capital Markets


8 U.S. BANCORP $267,032,000
10 SUNTRUST BANKS, INC. $189,137,961
14 BB&T CORPORATION $152,015,025
16 TD BANKNORTH INC. $122,745,454
17 FIFTH THIRD BANCORP $119,763,812
18 KEYCORP $105,231,004
24 M&T BANK CORPORATION $65,815,757
26 BBVA USA BANCSHARES, INC. $62,305,413
29 POPULAR, INC. $38,883,000

Cognizant Confidential Foundation Course in Banking and Capital Markets


37 FIRST BANCORP $19,491,268
40 FBOP CORPORATION $17,346,706
46 W HOLDING COMPANY, INC. $15,317,974
50 BANCORPSOUTH, INC. $13,499,414


The universal banking concept permits banks to provide commercial bank services, as well as
investment bank services at the same time.

Glass-Steagall Act of 1933, created a Chinese wall between commercial banking and securities
businesses in US. That act was intended to address the perceived causes of bank failures during
the Great Depression of 1929.

Today, Glass-Steagall restrictions have become outdated and unnecessary. It has become clear
that promoting stability and best practices cannot be done through artificially separating these
business areas. Over the years, banks and securities firms have been forced to find various
loopholes in the Glass-Steagall barriers. The restrictions undermined the ability of American
banks to compete with the other global banks which were not covered by such legislation.

Most of Glass-Steagall provisions have been repealed in the US in 1990s enabling the banks to
offer a full range of commercial and investment banking services to their customers. Provisions
that prohibit a bank holding company from owning other financial companies were repealed on
November 12, 1999, by the Gramm-Leach-Bliley Act. The Glass-Steagall Act prohibited a bank
from offering investment, commercial banking, and insurance services. The Gramm-Leach-Bliley
Act (GLBA) allowed commercial and investment banks to consolidate

Cognizant Confidential Foundation Course in Banking and Capital Markets


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.


• 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

Cognizant Confidential Foundation Course in Banking and Capital Markets



Retail banking addresses the banking and financial services needs of individuals also called
Consumers and small medium enterprises (SME) or Small Businesses with say less than 1 M USD
in revenue, otherwise called retail customers. Retail transactions are typically large volume low
value but strongly governed by consumer friendly regulations and are critical to a bank. Retail
banks or stores offer various services such as - Deposits (savings and checking accounts), Loans
(mortgages, personal), debit cards, credit cards, investment products and so on. This is a typical
mass-market banking in which individual customers use local branches, ATMs, Online banking,
Phone Banking, Contact Centers and recently mobile banking for their financial / banking needs.
In some geography such as Europe, APAC, Middle East retail banks also offer investment
services such as wealth management, brokerage accounts, private banking and retirement
planning for High Nett-worth Individuals.


There are various flavors of retail banks. Even though all of them cater to individual customers,
they basically differ in some aspects like regulating bodies, types of customer, services provided.
The US has Community Banks, Credit Unions and Savings Bank whereas Europe has Postal
Savings Bank, Offshore Banks, Private Banks and so on.

A. Community development banks (CDBs) In the United States, Community development

banks provide retail banking services to the residents of the community and spur
economic development in low- to moderate-income (LMI) geographical areas (typically
the underserved community of the economy) . CDBs can apply for formal certification as
a Community Development Financial Institution (CDFI) from the Community
Development Financial Institutions Fund of the U.S. Department of the Treasury.

E.g.: The largest and oldest community development bank is Shore Bank, headquartered
in the South Shore neighborhood of Chicago.

B. Credit Union: A credit union is a cooperative financial institution that is owned and
controlled by its members, and operated for the purpose of promoting thrift, providing
credit at reasonable rates, and providing other financial services to its members. Many

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credit unions exist to further community development or sustainable international

development on a local level.

C. Private Banks manage the assets of high net worth individuals. Private Banks are banks
that are not incorporated, owned by either an individual or a general partner(s). In any
such case, the creditors can look to both the "entirety of the bank's assets" as well as
the entirety of the sole-proprietor's/general-partners' assets.

E.g.: There are a few private banks remaining in the U.S. One is Brown Brothers
Harriman & Co.

D. Offshore banks are banks located in jurisdictions with low taxation and regulation.
Many offshore banks are essentially private banks. An offshore bank is a bank located
outside the country of residence of the depositor, typically in a low tax jurisdiction (or
tax haven) that provides financial and legal advantages. E.g.: Banks in Channel Islands,
the Caribbean Islands, Jersey etc.

E. Savings banks primary purpose is accepting savings deposits. It also provides other
services such as payments, credit and insurance. They differ from commercial banks by
their broadly decentralized distribution network, providing local and regional outreach.

E.g.: The first chartered savings bank in the United States was the Boston Provident
Savings Institution, incorporated December 13, 1816.

F. Postal savings banks leverage the postal network with a broad distribution arm to
provide sales and service to its customers. Many nations' post offices operated, or
continue to operate postal savings systems, to provide depositors who did not have
access to banks a safe, convenient method to save money and to promote saving among
the poor. The first nation to offer such an arrangement was Great Britain in 1861. The
United States began a similar system in 1911 under the Act of 1910 but it was abolished
by the Act of 1966.


The money that a bank receives as deposits from its depositors becomes a bank’s liability. The
Loan provided by a Bank to its customers is a receivable and hence an asset to the bank .Further
Loans are a source of providing interest income and deposit interests are an expense to the
bank. The Bank further makes an income based on the lending rate-deposit rate spread. The
chart shown here depicts how this process works.

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This section of the document (Retail Banking) deals with only Retail Bank Liabilities or in other
terms Deposit Products and Services. The retail bank assets (Cards and Payments, Consumer
Lending, Mortgages) are dealt in separate sections.


Banks offer the facility of holding excess cash of a consumer and pay an interest for the money
placed with it. Deposits can be of two types – Demand deposits are accounts that allow money
to be deposited and withdrawn by the account holder on Demand (Savings, Checking). Another
Class of deposits is placed with a bank for a specified term and is called Term Deposits. Banks
may charge a maintenance fee for this service, while others may pay the customer interest on
the funds deposited.

Features of Deposit Products:

1. A customer can deposit and withdraw money from his Deposit Account. The frequency
and limit of withdrawal differs from account to account.

2. Checks can be issued by the customer to withdraw or transfer money from his account.
There may be restrictions as to number of checks issued in a month.

3. Interest is generally paid for all deposit products except for certain type of accounts like
checking accounts.

4. A minimum balance needs to be maintained in most of the accounts, failing which the
bank will charge a penalty. But there are certain types of accounts like No frill accounts
or Zero Balance accounts in which the customer need not maintain any balance.

5. Given below is the snap shot comparison of all the major types of accounts in a retail

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A. Basic or No Frill Banking Accounts

Many institutions offer accounts that provide a limited set of services for a low price
often referred to as "basic" or "no frill" accounts. They are usually checking accounts,
but they may limit the number of checks written and the number of deposits and
withdrawals made. Interest generally is not paid on basic accounts.
B. Credit Union Accounts

Credit unions offer accounts that are similar to accounts at other depository institutions,
but have different names. Credit union members have "share draft" accounts (rather
than checking), "share" accounts (rather than savings), and "share certificate" accounts
(rather than certificate of deposit).
C. Individual Retirement Accounts (IRA)

An Individual Retirement Arrangement (or IRA) is a retirement plan account that

provides some tax advantages for retirement savings in the United States. These allow a
customer to save for his retirement by investing it in the IRA and using it as a channel to
invest in other products. Withdrawal before the stipulated time incurs heavy penalty
and foregoing taxes for the period used.

There are a number of different types of IRAs, which may be either employer-provided
or self-provided plans. The types include:

• Roth IRA - contributions are made with after-tax assets, all transactions within
the IRA have no tax impact, and withdrawals are usually tax-free.

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• Traditional IRA - contributions are often tax-deductible (often simplified as

"money is deposited before tax" or "contributions are made with pre-tax
assets"), all transactions and earnings within the IRA have no tax impact, and
withdrawals at retirement are taxed as income (except for those portions of the
withdrawal corresponding to contributions that were not deducted).

• SEP IRA - a provision that allows an employer (typically a small business or self-
employed individual) to make retirement plan contributions into a Traditional
IRA established in the employee's name, instead of to a pension fund account in
the company's name.

• SIMPLE IRA - a simplified employee pension plan that allows both employer and
employee contributions, similar to a 401(k) plan, but with lower contribution
limits and simpler (and thus less costly) administration. Although it is termed an
IRA, it is treated separately.

• Self-Directed IRA - a self-directed IRA that permits the account holder to make
investments on behalf of the retirement plan.



• A banking system in which there is a head office and interconnected branches providing
financial services in different parts of the country
• Branch networks have re-emerged as combined centers for advice-based product sales and
service, in addition to traditional banking transactions
• These are full-service centers -- from banking products to brokerage services
• Branches are being transformed from transaction processing centers into customer-centric,
financial sales and service centers
• A typical Retail branch at a Bank has these two primary activities:
o Teller Operations

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o Relationship Managers


A bank teller is an employee of a bank who deals directly with most customers. In some
places this employee is known as a cashier. Tellers are considered a "front line" in the
banking business. This is because they are the first people that a customer sees at the bank
and are also the people most likely to detect and stop fraudulent transactions in order to
prevent losses at a bank (i.e. counterfeit currency and checks, identity theft, con artist
schemes, etc.). The position also requires tellers to be friendly and interact with the
customers, providing them with information about customers' accounts and bank services.
Most tellers have a window (or wicket), a computer terminal, and a cash drawer from which
they perform their transactions. These transactions include, but are not limited to:

• Check cashing, depositing

• Savings deposits, withdrawals

• Consignment item issuances (i.e. Cashier's Checks, Traveler's Checks, Money Orders,
Federal Draft issuances, etc.)

• Payment collecting

• Promotion of the financial institution's products (loans, mortgages, etc.)

• Business referrals (i.e. Trust, Insurance, lending, etc.)

• Cash advances

• Savings Bonds purchase or redemption

• Resolving customer issues

• Balancing the vault, cash drawers, ATMs, and TAUs

• May include ordering products for the customer (checks, deposit slips, etc.)
Relationship Managers are the Banks’ single point of contact to the customer. They have day-to-
day personal contact with the Client for new account opening, account maintenance and
product sales and also develop tailored banking solutions for each Client. Generally, a Banks’
Global Relationship Manager coordinates the efforts of local Relationship Managers and Product
Specialists around the world. The Global Network of Relationship Managers ensures a global
level oversight of the client relationship.

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It is a special facility that allows a customer to operate his Accounts through a network of
branches of the bank where he has an account. All Multi Branch Banking account holders are
eligible for Multi City Check (Pay At par Check) facilities. Under this service, the customer of one
branch is able to transact on her account, from any other Networked branch of the Bank. The
advantages of this is that there are quicker turnarounds in clearing, payments and the customer
is not subjected to any systemic delays due to geographical constraints. This is usually facilitated
by the implementation of a set of software called banking applications which handle the
transactions end to end from booking to posting to the customer accounts and GLs and also
interface with other applications of the bank. Some core banking vendors of repute are Fidelity,
Temenos, Infosys (Finacle), Oracle (FLEXCUBE).

3.3.3 ATM

• An automated teller machine (ATM) is a computerized telecommunications device that

provides the customers with access to financial transactions in a public space without the
need for a human clerk or bank teller. The customer is identified by inserting a plastic ATM
card with a magnetic strip or a plastic smartcard with a chip that contains a unique card
number and some security information, such as an expiration date or CVC (CVV). Security is
provided by the customer entering a personal identification number (PIN).
• ATMs are known by various other names including automated banking machine, money
machine, bank machine, cash machine, hole-in-the-wall, cash point, Bancomat (in various
countries in Europe and Russia), Multibanco (after a registered trade mark, in Portugal), and
Any Time Money (in India).
• Typical ATM Services
o Cash withdrawal – Limit per day restricted by respective bank guidelines
o Money Transfer between accounts
o Cash/ Check Deposits
o Utility Bill Payments
o Balance enquiry /Account Statements
o Mobile Top Ups

• An interbank network, also known as an ATM consortium or ATM network, is a computer

network that connects the ATMs of different banks and permits these ATMs to interact with
the ATM cards of non-native banks. E.g.: Cirrus, Maestro, Plus, etc
• Debit cards and ATM cards are used to transact in ATMs and PoS (Point of Sale) Terminals.
Visa and Master networks are large global networks that service ATMs
• The Bank / Entity that issue the card to the customer is called an Issuer while the
Bank/Entity that acquires the transaction through the ATM / PoS terminal is an acquirer. The

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network handles the routing of the transaction from the Acquirers terminal to the
accounting systems of the Issuer and processes the settlements through the intermediary


• Telephone banking allows customers to perform transactions over the telephone. Most
telephone banking configurations use an automated phone answering system (IVR/VRU)
with phone keypad response or voice recognition capability.

• Voice Response Unit (VRU), is a computer telephony integration (CTI) term that refers to
the interaction between a human (typically a caller) and a computer that is programmed
to respond to the human's requests.

• Also referred to as interactive voice response (commonly abbreviated to IVR), this is a

computer phone application that accepts touch-phone keypad selection input from the
caller and provides appropriate information in the form of voice answers or a
connection to a "live" operator in a Contact Center.

• With the obvious exception of cash withdrawals and deposits, it offers virtually all the
features of an automated teller machine: account balance information and list of latest
transactions, electronic bill payments, funds transfers between a customer's accounts,


Usually, customers want to speak to a live representative located in a call centre, although this
feature is not guaranteed to be offered 24/7. In addition to the self-service transactions listed
earlier in Phone Banking, telephone banking representatives are usually trained to do what was
traditionally available only at the branch: loan applications, investment purchases and
redemptions, check book orders, debit card replacements, change of address, etc.

The contact centre /Call centre handle inbound service calls, technical support requests and
sales enquiries, Sell products and advice through outbound calls. Web enabled services too are
part of the mix. Outbound services originate at the lead generation teams which aim at
sales/marketing, collections and surveys. Apart from Telephonic services, the contact centers
provide web enabled services. - Email, Live chat and Live support.


Online banking (or Internet banking) allows customers to conduct financial transactions on a
secure website operated by their bank or credit union.

The common features fall broadly into the following broad categories:

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• Account Management: - Enquiries , Transactions , Account Opening (Assets and Liability)

• Investment Services and Advisory

• Personal finance management

• Bill Pay and Recurring payments

• Statements : Monthly or quarterly bank statements

• Fund transfer: Funds transfer between a customer’s own checking and savings accounts
or to another customer’s account

• Secure mail and chat

• Collaboration blogs , podcasts, RSS Feeds


Mobile banking (also known as M-Banking, mbanking, SMS Banking etc.) is a term used for
performing balance checks, account transactions, payments etc. via a mobile device such as a
mobile phone, PDA, Blackberry, iPhone etc. Given below is the list of services offered by retail
banks through mobile banking.

Account Information:

• Mini-statements and checking of account history

• Alerts on account activity

• PIN Set, Reset, Change

• Blocking of (lost, stolen) cards


• Domestic and international fund transfers

• Micro-payment handling

• Bill payment processing


• Portfolio management services

• Real-time stock quotes

• Personalized alerts and notifications on security prices


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• Check book and card requests

• Exchange of data messages and email, including complaint submission and tracking

Content Services:

• General information such as weather updates, news


Instruments are used to move and /or transfer funds from one account to another. The account
can be of the same person or different individuals. Instruments are also modes of payment.
Some of the common instruments are as follows:

• Checks
• Cashier’s check
• Certified Check
• Travelers Check

A check is a bill of exchange and is an instrument instructing a financial institution to pay a

specific amount of a specific currency from an account holders specific demand account held in
that bank. The receiver of the check is payee and the amount will be either credited into the
payee account or the payee can encash the check from the maker’s bank (drawer).

Given below are the various methods of processing a check.


Paper check processing is the traditional physical check processing. The drawer issues
the check in the name of the Payee. The Payee presents the check in the
drawer/maker’s bank to the credit of his account.


When checks are deposited, they are converted into digital files. These images can be
then exchanged between financial intermediaries via the web, e-mail, CD-ROM or faxes
instead of actual transportation of paper checks. Once digitized, this information can be
used to settle and debit accounts. The image can be used as the check writers’ receipt
for the transaction. This clearing and settlement process is known as Check-truncation.
By introducing check-truncation, intra-city clearing turn-around-times can be reduced

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Not all checks move easily through the check collection system, however. Sometimes a
check is returned for various reasons like insufficient funds, improper details, signature
not clear etc. If a bank refuses to honor a check, the check must be returned to the bank
where the check was first deposited within a certain period specified by law. The bank
then investigates the item and takes corrective action to process the check. These are
called exceptions or returned items.


An electronic check is a transaction that starts at the cash register with a paper check
for payment, but the payment is converted to an electronic debit, which is processed via
the ACH network. ECC converts a paper check into an electronic payment at the point of
sale or elsewhere. The following are the typical steps followed in a check conversion

• In a store, the customer can present a check to a store cashier.

• The check can be processed through an electronic system that captures the
banking information and the amount of the check.

• Once the check is processed, the customer signs a receipt authorizing the store
to present the check to the bank electronically and deposit the funds into the
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.


Retail payments usually involve transactions between consumers and businesses. Although
there is no definitive division between retail and wholesale payments, retail payment systems
generally have higher transaction volumes and lower average dollar values than wholesale
payments systems. This section provides background information on payments typically
classified as retail payments. Consumers generally use retail payments in one of the following

• Purchase of Goods and Services—Payment at the time the goods or services are
purchased. It includes attended (i.e., traditional retailers), unattended (e.g., vending
machines), and remote purchases (e.g., Internet and telephone purchases). A variety of
payment instruments may be used, including cash, check, credit, or debit cards.

• Bill Payment—Payment for previously acquired or contracted goods and services.

Payment may be recurring or nonrecurring. Recurring bill payments include items such

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as utility, telephone, and mortgage/rent bills. Non-recurring bills include items such as
medical bills

• P2P Payments—Payments from one consumer to another. The vast majority of

consumer-to-consumer payments are conducted with checks and cash, with some
transactions conducted using electronic P2P payment systems.

• Cash Withdrawals and Advances—Use of retail payment instruments to obtain cash

from merchants or automated teller machines (ATMs). For example, consumers can use
a credit card to obtain a cash advance through an ATM or an ATM card to withdraw cash
from an existing demand deposit or transaction account. Consumers can also use
personal identification number (PIN)-based debit cards to withdraw cash at an ATM or
receive cash-back at some point-of-sale (POS) locations.

Important Trends in Retail Payments:

• Shift from paper to electronic payments: Recent research has found that consumer use
of electronic payments has grown significantly in recent years, and the trend will

• Increase in Online Transactions: Debit and credit cards were one of the key drivers for
much of the growth in electronic payments. Although on-line, or PIN-based, debit cards
were introduced in the early 1980’s, rapid adoption has only occurred since the early
1990’s. Off-line, or signature-based, debit cards, introduced in the late 1980’s, have
experienced significant growth since the mid 1990’s, and recent surveys have found that
off-line debit card transactions have now overtaken on-line debit card transactions by
almost a three-to-one margin.

• Growth in ACH Payments: Consumers traditionally used checks for a large portion of bill
payments in the United States. However, consumers are increasingly using direct bill
payment through the ACH. Despite the increase in electronic bill payment, many
consumers still rely on checks to make a significant portion of their bill payments. More
recently, retail firms have employed check to ACH conversion processes to allow
electronic settlement, thus reducing the number of checks that flow through the
payment system.

• Internet Banking and Internet Payment Processors – PayPal, Google – Expedited Bill
Payments Internet-based bill payment systems are transaction origination platforms
that allow customers to initiate bill payments using existing payment systems.
Depending on the bill payment software, service provider, and payment receiver used,
the payment transaction may be processed as an electronic funds transfer (EFT), ACH, or


For many of us, electronic banking means 24-hour access to cash through an automated teller
machine (ATM) or Direct Deposit of paychecks into checking or savings accounts. But electronic

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banking now involves many different types of transactions like Electronic Bill presentment,
Mobile banking, Online Banking, Electronic Check Conversion etc.

Electronic banking, also known as electronic fund transfer (EFT), uses computers and payment
networks as a substitute for checks and other paper transactions. EFT is initiated through
devices like cards or codes that let the customer access their account. Many financial
institutions use ATM or debit cards and Personal Identification Numbers (PINs) for this purpose.
Some use other forms of debit cards such as those that require, at the most, signature or a scan.
The federal Electronic Fund Transfer Act (EFT Act) covers some electronic consumer transactions

• Automated Teller Machines (ATMs)

• Direct Deposit
• Phone Banking/Mobile Banking- (IVR/VRU)
• Internet Banking
• Debit card purchase transactions
• Electronic Check Conversion
• Call centre/Contact centre
• Check Imaging /Check Truncation


Electronic Bill Payment allows a depositor to send money from his / her demand account to a
creditor or vendor such as a public utility or a department store to be credited against a
specific account.

Presentment and Payment

Electronic bill presentment and payment (EBPP) is a process that enables bills to be created,
delivered, and paid over the Internet. Customers can pay their utility bills such as Electricity,
Telephone, Gas, and insurance premiums online.

The following figure shows the flow between various parties in EBPP.

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Once a consumer has enrolled for EBPP services, the biller generates the electronic version of
the Consumer’s Billing information. The biller may outsource this using BSP (Bill Service
Provider). The BSPs /Billers provide such services as electronic bill translation, formatting, data
parsing, notifying the consumer of pending bill. The consumer logs on to the specified website
where he is allowed to view/print the E-bill. He can initiate payment directly from the same


Banking has evolved from its traditional role as the place of Savings and Deposits. With the
prevailing competition in the market among the banks, a serious effort has to be made by each
bank to promote themselves and their products. A Retail bank will typically concentrate in the
following areas:

• Product Development :

Increase the knowledge about the market place, Check the new product viability,
competitively price the product and identify new innovations.

• Marketing, Sales and Customer Development :

Improve knowledge about the overall market, identify new customer segments,
improve effectiveness of sales force (salesmen, online ads, offers, etc), maintain
optimum product mix, increase effectiveness of marketing campaign, estimate and
improve the sales channel performance and maintain the sales collateral.

• Customer Service and Branch Operations :


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Effectiveness of the Customer Service Manager or Relationship manager, Generate new

business from existing customers, retain the most valuable customers and maintain
customer satisfaction levels.

• Transactions and Back-office support:

Improve the service quality, streamline transactions & optimize delivery through phone
banking, Net Banking, Mobile Banking, etc., effectively manage data and business


The banking operations are basically divided in to three; Front office, Middle Office and Back
Office. Front office is what we otherwise call the Banking channels – Branch, ATM, Bank’s
Website, etc. where the customers contact the Bank’s representatives for their financial
services. Middle Office is where the decisions are made about the product, interest rate, credit
policies, Compliance monitored etc. Back office mostly does the data base management, data
processing, transaction processing etc. The Middle Office and Back Office operations are
generally not exposed to the customers. The picture below gives an overview of all the
operations in retail bank.


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• Retail banking pertains to banking service to individuals and SMEs.

• Retail banks have various flavors such as Community Development Banks, private Banks,
Offshore Banks, Savings Banks and Postal Banks.
• Retail Banking has both assets and liabilities and only Liabilities (deposit products) are dealt
in this document
• The various deposit products are
o Checking accounts
o Money Market Accounts
o Savings Accounts
o Time Deposits
o Basic or No frill Banking
o Credit Union Accounts
• Retail banking channels are
o Branch Banking
o Core Banking
o Telephone Banking
o Call Centre
o Online Banking
o Mobile Banking
• Checks can be processed in various modes: Paper check processing, check imaging /Check
truncation, Electronic Check conversion.
• Consumers generally use one of these retail payments systems: Purchase of Goods and
Services, Bill Payment, P2P payments, Cash withdrawals and Advances.
• Electronic banking, also known as electronic fund transfer (EFT), uses computer and
electronic technology as a substitute for checks and other paper transactions.
• The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic customer
• EBPP is a mode of transaction involving the use of electronic means, such as email or a short
message, for rending a bill.
Sales and marketing strategies have gained importance currently. Every bank is seriously
working towards promoting their products in the market.

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A mortgage represents transfer of interest on a property/house to a lender as a security of debt

which is usually a loan taken for buying a house. This loan has to be paid over a specified period
of time. Think of it as customer personal guarantee that he will repay the money he has
borrowed to buy his home. Strangely enough, the word "mortgage" comes from the French
word "mort," which means "dead," and "gage," from Old English which means "pledge".

Nowadays, the term mortgage is commonly used to refer to a loan for the purpose of
purchasing a property. We don't associate anyone's death with it!

Most mortgage loans are negotiated for a set time period and Interest rate. Interest rate could
be fixed for the entire loan term or floating or Hybrid (Fixed for certain period). Generally,
customer can pay off a loan in full or in part at any time, although bank may charge a penalty
depending upon the terms and conditions.


A residential mortgage is a loan made using residential property as collateral to secure

repayment. In United States, single family homes that have maximum up to 4 units qualify for a
residential mortgage. The residential mortgages are taken on by individual borrowers for buying
a house, an apartment, or renovation of house or apartment.

The majority of residential mortgages require the borrower to make a monthly payment which
is enough to pay off the loan over a 10 to 25 year time frame. There are many types of mortgage
loans in the market. These are designed to suit various requirements of the borrowers including
the length of mortgage, capability for initial payment, and the other financial obligations.


A commercial mortgage is a loan made using commercial real estate, like multifamily property,
or an office complex etc. as collateral to secure repayment. A commercial mortgage is similar to
a residential mortgage, except the collateral is a commercial building or other business real
estate, not residential property. In addition, commercial mortgages are typically taken on by
businesses instead of individual borrowers. The borrower may be a partnership, incorporated
business, or limited company, so assessment of the creditworthiness of the business can be
more complicated than is the case with residential mortgages.

The majority of Commercial Mortgages require the borrower to simply make a monthly
payment small enough to pay off the loan over a 20 to 30 year time frame. The borrower most
likely will attempt at that time to refinance the loan or sell the property. The length of the loan
can vary from a matter of days to 30 years.

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Common applications of commercial mortgage loans include acquiring land or commercial

properties, expanding existing facilities or refinancing existing debt.


The various stages involved in a loan life cycle are shown below:

This is a process by which a mortgage is secured by a borrower is called origination. This involves
the borrower submitting an application and documentation related to his/her financial history
and/or credit history to the underwriter. A borrower is required to “lock” a certain rate scenario,
out of the given scenarios, after which his loan can go for processing.

This process ensures that documentary requirements are fulfilled and regulatory checks are
done. The borrower may be asked for additional information and supporting documentary
proof(s) about his employment credentials, financial position, property details and other assets
and liabilities associated with the borrower. Various reports, like credit report, property
appraisal etc. are also required for file processing, which are fired at this stage.

This is a process by which a lender determines if the risk of lending to a particular borrower
under certain parameters is acceptable. Most of the risks and terms that underwriters consider
fall under the three C’s of underwriting: Credit, Capacity and Collateral. To help the underwriter
assess the quality of the loan, banks and lenders create guidelines and even computer models
that analyze the various aspects of the mortgage and provide recommendations regarding the
risks involved. However, it is always up to the underwriter to make the final decision on whether
to approve or decline a loan.


After the loan has been underwritten and the borrower agrees with the loan terms, the loan
moves into the Closing and Funding stage(s) when the actual contracts are signed and sent, the
property is registered and the seller payments are cleared.


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Loan servicing (sometimes also referred to a ‘Loan Administration’) refers to the part of the
mortgage value chain that starts after the closure of the loan and extends till the loan is fully
repaid and settled. It includes activities such as cash management for periodic payments and
disbursements, investor accounting, investor reporting, customer servicing, delinquency
management, records management etc.

As shown in the schematic above, Loan Servicing involves collecting monthly payments from
borrowers, remitting the payments to the investors (or security holders), handling contacts with
borrowers about payments & delinquencies, maintaining records, initiating foreclosure
procedures and handling taxes and insurance premiums (through escrow accounts as

The collection of mortgage payments and the periodic remittance of these payments to the
investors (or conduits) is the major task of servicers. In addition, servicers are the primary
repository of information on the mortgage loans. Thus, they must maintain accurate and up-to
date information on mortgage balances, status and history and provide timely reports to


Lending industry has developed variety of mortgage loan programs based on interest rate
charged to borrowers. Following are widely used mortgage loan programs:

Loan Type How it works

A fixed Rate Mortgage (FRM) is a mortgage loan where the interest

Fixed Rate
rate on the note remains the same through the term of the loan

Balloon Payment Balloon Payment Mortgage has a fixed rate for the term of the loan

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Loan Type How it works

Mortgage followed by the ending balloon payment.

An Adjustable Rate Mortgage (ARM) is a mortgage loan where the

interest rate on the note is periodically adjusted based on a variety of
Adjustable Rate indices such as 1-year constant-maturity Treasury (CMT) securities, the
Mortgage (ARM) Cost of Funds Index (COFI), and the London Interbank Offered Rate
(LIBOR). A few lenders use their own cost of funds as an index, rather
than using other indices.

A graduated payment mortgage loan, often referred to as GPM, is a

mortgage with low initial monthly payments which gradually increase
Graduated Payment
over a specified time frame. These plans are mostly geared towards
young people who cannot afford large payments now, but can
realistically expect to do better financially in the future.

An interest-only loan is a loan in which for a set term the borrower

pays only the interest on the principal balance, with the principal
Interest Only Loan balance unchanged. At the end of the interest-only term the borrower
may pay the principal, or (with some lenders) convert the loan to a
principal and interest payment loan at his option.

Amortization refers to gradual decrease of principal balance of the

loan as the loan is repaid gradually over its term.
Negative Negative Amortization occurs whenever the loan payment for any
Amortization period is less than the interest charged over that period and so the
outstanding balance of the loan increases. Such a practice is agreed
upon before shorting the payment so as to avoid default on payment.

Standard Variable Same as a standard ARM loan - but one receive a substantial cash sum
Rate with Cash Back (Example 3–5% of the amount borrowed) when we take up the loan.

Similar to a standard variable rate mortgage but the interest rate is

Base Rate Tracker guaranteed to be a set amount above the base rate and alters in line
with changes in that rate.

The payments are variable, but they are set at less than that lender’s
Discounted interest
going rate for a fixed period of time. At the end of the period, one is
charged the lender’s standard variable 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
Capped rate the deal.

Sometimes, they cannot fall below a set minimum level either (the
‘collar’ or ‘floor’). At the end of the period, one is charged the lender’s

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Loan Type How it works

standard variable rate.


Loan Program How it works

FHA loans are meant for lower income Americans to borrow money for
the purchase of a home that they would not otherwise be able to
FHA Loan afford. FHA loan is a federal assistance mortgage loan in the United
States insured by the Federal Housing Administration. The loan may be
issued by federally qualified lenders.

The basic intention of the VA direct home loan program is to supply

home financing to eligible veterans in areas where private financing is
not generally available and to help veterans purchase properties with
VA Loan
no down payment. The VA loan was designed to offer long-term
financing to American veterans or their surviving spouses provided
they do not remarry.

Conventional Loans These are loans without any government backing.

These are the loans issued by Government Sponsored Entities (GSEs)

such as Federal National Mortgage Association (Fannie Mae), Federal
Agency Loans
Home Loan Mortgage Corporation (Freddie Mac) and Government
National Mortgage Association (Ginnie Mae).


Mortgage backed Security (MBS) is a type of asset-backed security that is secured by a mortgage
or collection of mortgages. These securities must also be grouped in one of the top two ratings
as determined by an accredited credit rating agency, and usually pay periodic payments that are
similar to coupon payments. Furthermore, the mortgage must have originated from a regulated
and authorized financial institution.

When we invest in a mortgage-backed security we are essentially lending money to a home

buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its
customers without having to worry about whether the customers have the assets to cover the

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loan. Instead, the bank acts as a middleman between the home buyer and the investment


There are currently over 200 significant separate financial organizations supplying mortgage
loans to house buyers in Britain. The major lenders include building societies, banks, specialized
mortgage corporations, insurance companies, and pension funds. Over the years, the share of
the new mortgage loans market held by building societies has declined. Between 1977 and
1987, it fell drastically from 96% to 66% while that of banks and other institutions rose from 3%
to 36%.

Though the building societies did subsequently recover a significant amount of the mortgage
lending business lost to the banks, they still only had about two-thirds of the total market at the
end of the 1980s. However, banks and building societies were by now becoming increasingly
similar in terms of their structures and functions. When the Abbey National building society
converted into a bank in 1989, this could be regarded either as a major diversification of a
building society into retail banking – or as significantly increasing the presence of banks in the
residential mortgage loans market. Research organization Industrial Systems Research has
observed that trends towards the increased integration of the financial services sector have
made comparison and analysis of the market shares of different types of institution increasingly
problematical. It identifies as major factors making for consistently higher levels of growth and
performance on the part of some mortgage lenders in the UK over the years:

• The introduction of new technologies, mergers, structural reorganization and the

realization of economies of scale, and generally increased efficiency in production and
marketing operations – insofar as these things enable lenders to reduce their costs and
offer more price-competitive and innovative loans and savings products;

• Buoyant retail savings receipts, and reduced reliance on relatively expensive wholesale
markets for funds (especially when interest rates generally are being maintained at high
levels internationally);

• Lower levels of arrears, possessions, bad debts, and provisioning than competitors;

• Increased flexibility and earnings from secondary sources and activities as a result of
political-legal deregulation; and

Being specialized or concentrating on traditional core, relatively profitable mortgage lending and
savings deposit operations.

Mortgage types

Since 1982, when the market was substantially deregulated, there has been substantial
innovation and diversification of strategies employed by lenders to attract borrowers. This has
led to a wide range of mortgage types.

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As lenders derive their funds either from the money markets or from deposits, most mortgages
revert to a variable rate, either the lender's standard variable rate or a tracker rate, which will
tend to be linked to the underlying Bank of England (BoE) repo rate (or sometimes LIBOR).
Initially they will tend to offer an incentive deal to attract new borrowers. This may be:

A fixed rate; where the interest rate remains constant for a set period; typically for 2, 3, 4, 5 or
10 years. Longer term fixed rates (over 5 years) whilst available, tend to be more expensive
and/or have more onerous early repayment charges and are therefore less popular than shorter
term fixed rates.

A capped rate; where similar to a fixed rate, the interest rate cannot rise above the cap but can
vary beneath the cap. Sometimes there is a collar associated with this type of rate which
imposes a minimum rate. Capped rate are often offered over periods similar to fixed rates, e.g.
2, 3, 4 or 5 years.

A discount rate; where there is set margin reduction in the standard variable rate (e.g. a 2%
discount) for a set period; typically 1 to 5 years. Sometimes the discount is expressed as a
margin over the base rate (e.g. BoE base rate plus 0.5% for 2 years) and sometimes the rate is
stepped (e.g. 3% in year 1, 2% in year 2, 1% in year three).

A cash back mortgage; where a lump sum is provided (typically) as a percentage of the advance
e.g. 5% of the loan.

To make matters more confusing these rates are often combined: For example, 4.5% 2 year
fixed then a 3 year tracker at BoE rate plus 0.89%.

With each incentive the lender may be offering a rate at less than the market cost of the
borrowing. Therefore, they typically impose a penalty if the borrower repays the loan within the
incentive period or a longer period (referred to as an extended tie-in). These penalties used to
be called a redemption penalty or tie-in, however since the onset of Financial Services Authority
regulation they are referred to as an early repayment charge.

• Self Cert" mortgage

Mortgage lenders usually use salaries declared on wage slips to work out a borrower's annual
income and will usually lend up to a fixed multiple of the borrower's annual income. This
mortgage is similar to alt-doc (low-doc) mortgage in US market. Self Certification Mortgages,
informally known as "self cert" mortgages, are available to employed and self employed people
who have a deposit to buy a house but lack the sufficient documentation to prove their income.

This type of mortgage can be beneficial to people whose income comes from multiple sources,
whose salary consists largely or exclusively of commissions or bonuses, or whose accounts may
not show a true reflection of their earnings. Self cert mortgages have two disadvantages: the
interest rates charged are usually higher than for normal mortgages and the loan to value ratio
is usually lower.

• 100% mortgages

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Normally when a bank lends customer money, they want to protect their money as much as
possible; they do this by asking the borrower to fund a certain percentage of the property
purchase in the form of a deposit.

100% mortgages are mortgages that require no deposit (100% loan to value). These are
sometimes offered to first time buyers, but almost always carry a higher interest rate on the

• Together/Plus mortgages

A development of the theme of 100% mortgages is represented by Together/Plus type

mortgages, which have been launched by a number of lenders in recent years.

Together/Plus Mortgages represent loans of 100% or more of the property value - typically up to
a maximum of 125%. Such loans are normally (but not universally) structured as a package of a
95% mortgage and an unsecured loan of up to 30% of the property value. This structure is
mandated by lenders' capital requirements which require additional capital for loans of 100% or
more of the property value.



Student Loans are Loans availed by eligible students to pursue graduate and post graduate
studies in Schools/Colleges/Universities. These loans are usually provided by banks, Credit
Unions and other financial institutions. Often they are supplemented by student grants which do
not have to be repaid.


Students Loans offered can be categorized broadly into two types:

• Federally sponsored loans – These loans are federally insured and provide protection
against default. The department of Education guarantees up to 98% and even 100% in
some cases

• Non-federally sponsored loans – These are insured by the private sector and have no
government backing. The guarantee in this case is only from the private insurers or from
the reserves pledged to securitization

Federally sponsored loans are of two types

• Federal Family Education Loan Program (FFELP) - These loans are made by financial
institutions primarily with a floating rate that is adjusted once a year. The interest rate is
capped at 8.25% and the Fed subsidizes the difference between the actual loan rate and

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the rate cap through Special Allowance Payments (SAP). The rates are usually specified
by indexing them to the US Treasury bill rates.

• Federal Direct Loan (FDLP)- where the department of Education directly provides the

FFELP or the Federal Family Education Loan Program can further be divided into four types

• Federal Stafford –Federal Stafford loans are the most common source of education loan
funds in the US. This is available to both graduate and undergraduate students. This loan
could be either subsidized or unsubsidized by the federal government. The interest rate
is a floating rate that is indexed to the 91 day T-Bill and is capped at 8.25%. Sample rates
of during the year 2003-04 were

1. 2.82% in school, grace and deferment

2. 3.42% in repayment and forbearance

• Federal PLUS - PLUS loans are availed by the parents of a full- or half-time
undergraduate student. This requires a credit check and hence the parent must have a
good credit history and should have been a citizen or permanent resident of US. The
loans don’t require any collateral and the interest payments are tax deductible.

• Consolidation loans - A consolidation loan involves two or more existing federally

sponsored loans into one single loan. The interest rate for this is determined by the
weighted average of the loan rates prevailing at that time and capped at 8.25%

There are three principal advantages of consolidation

• Convenience – By combining loans the borrower is able to focus on repaying one
single loan than handle multiple loans
• Interest rate – In a low rate scenario the borrower can reduce his cost of borrowing
by taking a new loan at the low prevailing low rates
• Repayment – The repayment period is extended to 30 years and this reduces the
installment to paid each month

• Graduate Plus - The Graduate PLUS loan or Grad PLUS loan is a low, fixed interest rate
student loan guaranteed by the U.S. Government. The Grad PLUS loan is a non-need
credit based loan similar to a private student loan, but with the benefit of having a fixed
interest rate and federal guarantee. The Grad PLUS Loan allows graduate students to
borrow the total cost for their graduate school needs, including tuition, room and board,
supplies, lab expenses, and travel, less any other aid.

The Key Entities in the Student Loan System are Federal government, Schools, Lenders, Servicers
and guarantors and the borrower.

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• Federal government: Sponsors and authorizes funds for grants and loan programs.
• School: The school is certified by the department of education as an eligible school
to participate in the FFELP or FDLP loan programs. Schools are responsible for
determining borrower’s eligibility, recommends and certifies loan amounts,
monitors the enrollment status
• Lenders: are the institutions approved by the DOE for voluntary participation in any
or all of the FFELP student loan programs. Typical lenders are usually Banks, credit
unions, S&L institutions, insurance companies and other institutions.
• Servicer: is an entity that collects payments on a loan and performs other
administrative tasks associated with maintaining a loan portfolio. The normal
functions include disburse loans funds, monitor loans while the borrowers are in
school, collect payments, process deferments and forbearances, respond to
borrower inquiries and ensuring regulatory compliance.
• Guarantor is a state agency, which guarantees or insures the loan and is a not-for-
profit agency. It protects the lenders against loss due to borrower default, death of
borrower, total and permanent disability, bankruptcy, closed school, and ineligible
• Borrower: is the student / parent who avails of the loan.


As a general rule, all students who attend Australian tertiary education institutions (universities)
are charged higher education fees. However, several measures are in place to relieve the costs
of tertiary education in Australia. Most students are Commonwealth supported. This means that
they are only required to pay a part of the cost of tuition, called the "student contribution",
while the Commonwealth pays the balance; and students are able to defer payment of their
contribution as a HELP (Higher Education Loan Programme) loan. Other domestic students are
full fee-paying (non-Commonwealth supported) and receive no other direct government
contribution to the cost of their education. They can also obtain subsidized HELP loans from the
Government up to a lifetime and up to a certain limit. Australian citizens and (with some
limitations) permanent residents are able to obtain interest free loans from the government
under the HELP which replaced the Higher Education Contribution Scheme (HECS).

HELP is jointly administered by the Department of Education, Science and Training (DEST) and
the Australian Taxation Office (ATO).

Overseas students are charged fees for the full cost of their education and are ineligible for any
loans from the Commonwealth, but may apply for international scholarships.

HELP debts do not attract interest, but are instead indexed to the Consumer Price Index (CPI) on
1 June each year, based on the annual CPI to March of that year. HELP account debtors can
make voluntary repayments. As making voluntary repayments does not exempt the person from
compulsory repayments, if the person intends to pay off the total debt voluntarily, it is
financially advantageous for them to do it before lodging the tax return. Even factoring in the

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10% bonus on voluntary repayments, many people elect not to pay off their debt in advance of
the required repayments because it still works out to be probably the cheapest loan someone
will ever receive. If a person with a HELP debt dies, the debt is cancelled.


British undergraduate and PGCE (postgraduate certificate of education) students can apply for a
student loan through their local education authority (LEA) in England and Wales, the Student
Awards Agency for Scotland (SAAS), or their local education and library board in Northern
Ireland. The LEA, SAAS, or education and library board then assesses the application and
determines the amount that the student is eligible to borrow, as well as how much tuition fees,
if any, the students' parents must pay. The family's income; whether the student will be living at
home, away from home, or in London; disabilities; and other factors are taken into account.

Loans are provided by the Student Loans Company and do not have to be repaid until the April
of the year after students have completed their course and are earning £15,000 a year. The
interest rate is updated annually and is tied to inflation. The loan is normally repaid using the
PAYE (Pay as you earn) system, with 9% of the graduate's gross salary over £15,000
automatically being deducted to pay back the loan.

The Higher Education Act 2004 made significant changes to the loans system in England, Wales
and Northern Ireland from 2006. Those with sufficient private funding can still pay tuition fees
'upfront' but everyone who satisfies residence criteria - regardless of their income - is now
entitled to take out a loan to pay their fees.

Student Finance England

For all students whose 'domicile' (family or full-time home base) is in England, radical changes
are underway to enhance and improve the student finance system. Now known as Student
Finance England, this is a comprehensive new service which is being phased in between 2008
and 2012 and is being based on widespread consultation with students, prospective students,
parents and other 'sponsors' helping a student through university. It seeks to reduce
significantly the amount of time and effort required to apply for finance. The time scale of
application is being changed, so that a student will be able to apply for finance at the same time
as they apply for a university place. First year students will have to deal with just two agencies –
Universities & Colleges Admissions Service (UCAS, to apply for a place) and the Student Loans
Company, which will share much of the information, supplied to UCAS and will then assess the
applicant's eligibility for finance and make the appropriate payments.


Retail Auto lending is basically lending to the individual customers for cars, two wheelers,
recreational vehicles and boats for their personal use. Now-a-days there are plenty of options
available for auto finance or auto loans. Banks, Credit Unions, Dealerships, and even auto
manufacturers are also into auto financing. Some of the auto finance companies are Citicorp, JP

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Morgan Chase, General Motors Acceptance Corporation, Ford Motor Credit, Bank of America,
Toyota Motor Credit, Hyundai Motor Finance Company (HMFC) etc.

On the other hand wholesale lending is about financing the auto dealer. The dealer is financed
with a variety of loan products, mainly floor plans for financing the purchase of cars from the
automobile manufacturer.

GMAC has definitely led the way in the car loan business. But, of course, the other major
manufacturers also recognized the profitability associated with the auto loan business and
entered the market. These companies are known as “captive finance companies”. Captive
Finance is a term to signify that the lending company is wholly owned by the automobile
manufacturer. Examples, other than GMAC, are NMAC (Nissan Motor Acceptance Corporation),
Ford Credit (Ford Motor Credit Company), Hyundai Motor Finance Company (HMFC), Chrysler
Credit (Daimler-Chrysler).

The following section describes the multiple mechanisms by which the financing for auto loans is
normally done.

Types of Financing Mechanism

• Direct Lending: The Bank or the finance company directly lends to the buyer or the
borrower in this case. A number of lending institutions are offering such loans on their

• Dealer financing: This is a type of loan available through the dealer. The lending and
repayments are done by/to the dealer. Basically the dealer tells the customer how much
down payment and monthly Installment is to be paid against the vehicle. The effective
cost to the customer most of the times is generally more than the original price.

• Leasing: Vehicle/ Auto lease is a contract between the borrower and an auto leasing
company. The borrower agrees to pay the leasing company for the use of the vehicle for
a certain amount of time, usually 24 to 36 months. During that time the borrower
agrees to make monthly lease payments, keep the car in good repair, insure the car and
not drive the car more miles that stipulated in the contract.

The Key entities in a lease agreement are the lessee and the lessor.

Lessee or the borrower: The party to whom the vehicle is leased. In a consumer lease, the lessee
is the consumer. The lessee is required to make payments and to meet other obligations
specified in the lease agreement.

Lessor or the lender or the lending institution is the original owner of the vehicle or property
being leased

The lease can be closed ended or open ended as defined below:

• Closed end lease - A lease agreement that establishes a non-negotiable residual value
for the leased auto and fee amounts due at the end of the lease term.

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• Open End lease - A lease term that requires the lessee to pay the difference between
residual value and fair market value at the end of the lease term if the fair market value
is lower

In a lease, the factors such as the ownership, upfront costs and monthly payments as against the
direct lending are:

• Ownership: We do not own the vehicle. We get to use it but must return it at the end of
the lease unless we choose to buy it.

• Up-front costs: Up-front costs may include the first month's payment, a refundable
security deposit, a capitalized cost reduction (like a down payment), taxes, registration
and other fees, and other charges.

• Monthly payments: Monthly lease payments are usually lower than monthly loan
payments because we are paying only for the vehicle's depreciation during the lease
term, plus rent charges (like interest), taxes, and fees.

The Key Entities in an Auto Loan process are:

• Borrower: is the one who needs to use/own the automobile and approaches a
dealer/lender for getting financing for the same

• Dealer: Typically a franchisee of the manufacturer, involved in selling and delivery of the
vehicle to the buyer

• Lender: Provides capital to the borrower for buying the vehicle. This can be captive
financiers, the banks, Credit unions and auto finance companies.

• Credit bureau: Tracks and maintains credit history of borrowers and forward it to
lenders during new application processing. This is used for deciding whether the loan
should be provided to a customer or not.

• Appraiser: Assesses and establishes the fair market value of collateral offered as
underlying security to the credit asked for.

• Insurer: The Insurance company insures the vehicle owner against specific liabilities
caused to and from the vehicle during the course of its use upon the payment of a
premium and signing of a contract

• Loan servicer: is the one who provides various services during the life cycle of a loan
starting from loan origination to loan closure.

• Collection agencies: These are typically third party agencies that assist auto lenders with
chronic delinquent accounts.

• Repossession agencies: These are third party agencies which assist auto lenders with
repossession of vehicles.

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• Valuation agencies: Black book and ALG help auto lenders with valuation of vehicles

Auto loan process

The Auto Finance Loan process can be divided into Loan origination, Servicing, and Secondary

Loan Origination is the process by which a borrower applies for a new loan, and a lender
processes that application. Origination generally includes all the steps from taking a loan
application through disbursal of funds (or declining the application). Credit decision is the major
milestone during loan origination process. This would depend on many factors like the credit
rating of the customer provided by the credit bureaus, capacity of the customer to repay back
the loan amount, the nature of the vehicle requested to be financed, and the amount of down-
payment offered. The credit decision can also be done for a very good application meeting all
credit policies and guidelines by the loan processing system automatically thereby reducing the
time required for manual processing by the Analysts. Or it would reject the application based on
these factors, the rejected application would be sent to Credit Analyst for further processing.
Once the decision is taken lender would contact the customer through phone, fax or e-mail to
let him know the decision. US Legislations mandate the distribution of hard-copy letters to the
Applicants informing them of the reasons in case of a denial of credit or for a counter offer.

Loan servicing generally covers the process post disbursement of the funds until the loan is fully
paid off or charged off. Some of the major sub processes under loan servicing are:

1. Managing monthly repayments

2. Customer Service – Managing customer communication, communications sent to

customers at different events like late payment, change in customer details, making
changes in the loan terms and conditions etc.

3. Managing premature closure of loan partially or fully.

4. Managing payment defaults in case customer doesn’t pay the installment amount. This
involves following up the customer for payments. In case of payment default the account
is termed to be a delinquent account. The lender can repossess the vehicle if payments
are not forthcoming despite follow up. The outstanding amount under a delinquent
account is charged off (off the books) beyond a certain amount of days past due.

Auto loan receivables can be securitized into pools called as Asset Backed Securities (ABS. This
offers liquidity advantages to an auto lender.


Personal loans are amount borrowed by individuals to cover their personal expenses. The details
of such expenses are never of any interest to the lenders. Some of the features of personal loans

• The financer is not interested in the intention of the loan.


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• 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.


Lease is a long-term rental agreement for the asset, while Hire Purchase allows the user to own
the asset after all the payments have been made to the lender.


• Two main types – operating, financial

• The Financier owns the asset.
• Depreciation is claimed by the financier.
• Tax deduction can be claimed for the full value of the rental paid.
• Financier takes care of maintenance, insurance etc.
Hire Purchase

• The asset is owned by the financier.

• Depreciation can be claimed by the borrower.
• Tax deduction can be claimed only to the extent of the interest repayment.


Open ended loan allow the borrower to borrow additional amount subject to the maximum
amount less than a set value.

• Similar to overdraft facilities provided by banks.

• Interest is calculated on the daily outstanding balance.
• Usually a card (similar to a Credit Card) is issued by the lending institution.
• The lending institution has tie-ups with various merchant establishments.
• Also allow us to withdraw Cash.
• Important Terms;

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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



In the United States, Community development banks (CDBs) are banks designed to serve
residents and spur economic development in low- to moderate-income (LMI) geographical
areas. When CDBs provide retail banking services, they usually target customers from
"financially underserved" demographics. Community development banks can apply for formal
certification as a Community Development Financial Institution (CDFI) from the Community
Development Financial Institutions Fund of the U.S. Department of the Treasury.

All Federally chartered CDBs are regulated primarily by the Office of the Comptroller of the
Currency. According to the OCC Charter Licensing Manual, CDBs are required "to lend, invest,
and provide services primarily to LMI individuals or communities in whom it is chartered to
conduct business." State-chartered Community Development Banks are subject to regulations,
qualifications, and definitions that vary from state to state.

Some institutions use the terms CDB and community development financial institution, or CDFI,

Notable community development banks

The largest and oldest community development bank is Shore Bank, headquartered in the South
Shore neighborhood of Chicago. Through its holding company Shore Bank Corporation, Shore

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Bank promotes its community development mission by operating CDBs and other affiliates in
certain U.S. cities.

Other CDBs include:

• Albina Community Bank in Portland, OR

• Carver Federal Savings Bank in New York, NY

• Central Bank of Kansas City in Kansas City, MO

• City First Bank of D.C. in Washington, D.C.

• Dryades Savings Bank in New Orleans, LA

• Liberty Bank & Trust in New Orleans, LA

• Louisville Community Development Bank in Louisville, KY

• Neighborhood National Bank in San Diego, CA

• Southern Bancorp in Arkadelphia, AR

• University National Bank in St. Paul, MN


A credit union is a cooperative financial institution that is owned and controlled by its members,
and operated for the purpose of promoting thrift, providing credit at reasonable rates, and
providing other financial services to its members. Many credit unions exist to further community
development or sustainable international development on a local level. Worldwide, credit union
systems vary significantly in terms of total system assets and average institution asset size since
credit unions exist in a wide range of sizes, ranging from volunteer operations with a handful of
members to institutions with several billion dollars in assets and hundreds of thousands of
members. Yet credit unions are typically smaller than banks; for example, the average U.S.
credit union has $93 million in assets, while the average U.S. bank has $1.53 billion, as of 2007.

The World Council of Credit Unions (WOCCU) defines credit unions as "not-for-profit
cooperative institutions." In practice however, legal arrangements vary by jurisdiction. For
example in Canada credit unions are regulated as for-profit institutions, and view their mandate
as earning a reasonable profit to enhance services to members and ensure stable growth. This
difference in viewpoints reflects credit unions' unusual organizational structure, which attempts
to solve the principal-agent problem by ensuring that the owners and the users of the institution
are the same people. In any case, credit unions generally cannot accept donations and must be
able to prosper in a competitive market economy.

Credit unions differ from banks and other financial institutions in that the members who have
accounts in the credit union are the owners of the credit union and they elect their board of

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directors in a democratic one-person-one-vote system regardless of the amount of money

invested in the credit union. A credit union's policies governing interest rates and other matters
are set by a volunteer Board of Directors elected by and from the membership itself. Credit
unions offer many of the same financial services as banks, often using a different terminology;
common services include: share accounts (savings accounts), share draft (checking) accounts,
credit cards, share term certificates (certificates of deposit), and online banking. Normally, only
a member of a credit union may deposit money with the credit union, or borrow money from it.
As such, credit unions have historically marketed themselves as providing superior member
service and being committed to helping members improve their financial health. In the
microfinance context, "Credit unions provide a broader range of loan and savings products at a
much cheaper cost [to their members] than do most microfinance institutions."


A building society is a financial institution, owned by its members, that offers banking and other
financial services, especially mortgage lending. Building societies are prevalent only in UK.

The term building society first arose in the 19th century, in the United Kingdom, from co-
operative savings groups. In the UK today building societies actively compete with banks for
most personal banking services, especially mortgage lending and deposit accounts. At the start
of 2008, there were 59 building societies in the UK with total assets exceeding £360 billion.
Every building society in the UK is a member of the Building Societies Association. The number
of societies in the UK fell by four during 2008 due to a series of mergers brought about, to a
large extent, by the consequences of the financial crisis of 2007-2009, and further mergers are
planned for the first few months of 2009.


The Farm Credit System is a federally chartered network of borrower-owned lending institutions
composed of cooperatives and related service organizations. Cooperatives are organizations
that are owned and controlled by their members who use the cooperative’s products, supplies
or services. The U.S. Congress authorized the creation of the first System institutions in 1916.
Their mission is to provide sound and dependable credit to American farmers, ranchers,
producers or harvesters of aquatic products, their cooperatives, and farm-related businesses.
They do this by making appropriately structured loans to qualified individuals and businesses at
competitive rates and providing financial services and advice to those persons and businesses.

Consistent with their mission of serving rural America, they also make loans for the purchase of
rural homes, to finance rural communication, energy and water infrastructures, to support
agricultural exports, and to finance other eligible entities.

Farm Credit institutions are chartered by the federal government and must operate within limits
established by the Farm Credit Act. The Farm Credit System is regulated by an independent
federal agency, the Farm Credit Administration, which has all of the enforcement, regulatory
and oversight authority as other federal financial regulators. Farm Credit is a government-

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sponsored enterprise, or “GSE” – a privately owned set of institutions established by Congress to

address the needs of a specific sector of the economy.

Farm Credit delivers the financial power of Wall Street to agriculture and rural America by
issuing debt in the national and international money markets and using this capital to provide
borrowers with access to reliable and competitive credit. The full financial strength of all of the
Farm Credit banks stands behind the debt issued on behalf of the System. In addition, investors
in Farm Credit debt are protected by the assets of the self-funded Farm Credit System Insurance
Fund, which is administered by an independent agency of the federal government.

The Farm Credit System’s total loans equaled $158.063 billion at September 30, 2008, an
increase of $15.157 billion since December 31, 2007. Approximately one third of the credit
needs of U.S. agriculture are financed by the 99 Farm Credit associations and banks nationwide.


1. Loan application management and processing

• Receipt of loan/card application

• Application Processing
o Duplicate check
o Negative list check
o Document Verification
o Calculate loan eligibility, IRR, processing fees
o Credit scoring
o Field Investigation
o Credit Approval
• Disbursement
o Check issuance
o Credit to account
o Payment to third party
• Formulating the repayment schedule.
2. Loan repayments and termination

• Post-Dated checks
o PDC’s are collected & their information captured.
o Checks are presented in clearing on due dates
o Bounced/ hold checks are marked for further action.
• Salary deductions

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o Employer wise receipt batches are created.

o Employer check details are captured
o Payment receipt is marked for corresponding employees.
• Direct receipts
o Cash/Check information is captured
o Checks are cleared in batches.
• Auto payments / Direct debits
o Bank wise receivable batches are created.
o Short receipts are marked.
o Release receipt batch to mark receipts
• Kinds of repayments
o EMI – same installment amount
o Fixed Principal – constant principal, decreasing interest amt
o Step-up – principal amount increases in steps
o Step-down – principal amount decreases in steps
o Balloon – notional amount initially, large last payment
o Bullet – interest payment initially, entire principal at one shot
o Random – schedule & amount of installments undecided
o Special products – combination of above
3. Delinquencies identification and collections

• Case Processing
o Categorization of cases based on predefined rules
o Allocation of cases to collectors
• Standard Cases
o Collector follow-up (desk/field)
o Repayment by customer
o Check issuance
• Exception Cases (death/fraud etc.)
o Initiate process based on case specifics (legal/other means)
o Track/follow up the case developments till repayment
o Case closed

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Submit Proposal Scrutinize OK Appraisal

Repayment NO Follow-up/Action

Monitoring OK

Disbursement Compliance Conditions for borrower


• The loans given to retail customer would come under Mortgages and other consumer loans
• There are two types of Mortgages
o Residential Mortgages
o Commercial Mortgages
• The main sub processes under Mortgage process flow are
1. Loan Production
o Origination
o Processing
o Under writing
o Closing and Funding
2. Loan Servicing
o Cash management
o Investor accounting and reporting
o Escrow Administration
o Document custodianship
o Delinquency management
o Customer service
• The following are the various types of Mortgages based on repayment patterns
o Fixed Rate
o Balloon Payment Mortgage
o Adjustable Rate Mortgage (ARM)

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o Graduated Payment Mortgage

o Interest Only Loan
o Negative Amortization
o Standard Variable Rate with Cash Back
o Base Rate Tracker
o Discounted interest rate
o Capped rate
• Mortgage backed Security (MBS) is a type of asset-backed security that is secured by a
mortgage or collection of mortgages.
• There are five major types of other consumer Loans / Lease
o Student Loans
o Auto Loans
o Personal loans
o Lease and Hire purchase
o Open ended loans
• Other than commercial banks there are Community development Banks, Credit Unions &
Building Societies which provides Mortgages and / or Consumer Loans.

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Cards are the fastest growing means of non-cash payments, accounting for 55% of payment
volumes worldwide, demonstrating the importance of non-cash payment mechanisms to trade
and consumer spending in our globalised economy as a new research into the global payments
market has found.

As per Tower Group Research report for the period between 2005 to 2007, Usage of Pin Debit
grew by 18 %, Volume of credit card grew by 5%, Usage of check declined by 9%, Usage of EBPP
is increasing at a CAGR of 18%, Online bill payment increased at a CAGR rate of 29.6 %, Online
bill payments at bank and biller Web sites comprised 42% of total monthly payments, followed
by 31% of bills paid by check.


The traditional method of collecting a check is to deposit it at a depository institution, which, if
the check is drawn on a different institution (an ‘‘interbank check’’), then collects the funds by
presenting the original paper check to the institution responsible for paying it, the ‘‘paying

With the changes governing check processing resulting from the Check 21 law, banks may now
truncate all checks and replace them with electronic images, presenting them electronically to
paying banks that agree or as paper substitute checks to those that require paper.

During March – April 2007, 13.3 billion original interbank checks and about 3.0 billion substitute
interbank checks were being presented .Another 6.6 billion interbank checks were being
presented electronically (28.3 percent of interbank checks). Most of these (6.4 billion) were
presented as images.


Debit cards enable the holder to make purchases and to charge those purchases directly to a
current account at the bank issuing the payment card. Debit cards are either on-line (PIN-based)
or off-line (Signature-based).

There are two types of debit card processing.

• PIN or online debit card processing: The debit card holder is required to enter a PIN
(personal identification number) in to a PIN pad. This is used as a verification method and access
to account is provided instantaneously. The access to funds is real time.

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• Signature or offline debit card processing: In this method verification is done by the
signature of the card holder. A hold is placed on the funds available in some cases when this
method of processing is used.

An ATM card (also known as a bank card, client card, key card or cash card) is an ISO 7810 card
issued by a bank, credit union or building society. ATM cards provide a convenient way to get
cash, make deposits and check how much money is available in the bank account. ATMs make
cash available 24 hours a day, seven days a week at many locations. ATM cards can be used at
ATMs that are located at all of the bank's locations as well as those at other banks, grocery and
drug stores, office buildings, and street corners across the country and worldwide.

In other words, ATM cards cannot be used at merchants that only accept credit cards.

A Credit Card represents an account that extends credit to consumers, permits consumers to
purchase items while deferring payment, and allows consumers to make payments to multiple
vendors at one time. Credit cards can have revolving credit arrangements allowing customers to
make a minimum payment in each billing cycle (two to three % of their total balance) rather
than requiring payment of the full balance. However, if a cardholder revolves i.e. carries over a
balance to the next billing cycle, then the interest will be charged not only to the balance
amount but also to any new purchases in that billing cycle. There are cards that have a short-
term, fixed-period, and credit arrangement.

A smart card is a plastic card about the size of a credit card, with an embedded microchip that
can be loaded with data and can be used to perform several functions. The most common smart
card applications are: Credit cards, Electronic cash, Computer security systems, Wireless
communication, Loyalty systems (like frequent flyer points), Banking, Satellite TV, Government
identification. Smart cards can hold all sorts of unique information about its carrier, such as
credit and debit account balances, insurance coverage, access credentials, and subscription

They are credit cards, which are associated with a particular firm like an airlines or retail outlet.
These cards can be used just like regular credit cards but they also offer benefits to users of the
relevant product like frequent travel points and special discounts. Cardholders may be given
incentives, such as discounts on merchandise, rebates, or discounts off purchases. A co-branded
card has a tie-in with a specific merchant rather than an association or professional group. It
also can be used at other merchants.


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These are Credit cards promoted under a sponsoring agreement between an organization and a
card issuing bank. In exchange for making available its membership list, the sponsor receives
some compensation from the issuing bank, usually part of issuer's net interest income. The
issuer may waive annual fees for affinity cardholders, or even offer the card at a lower rate than
ordinary bank cards.


Corporate credit card is normally used for business purposes and it helps corporate consumers
to effectively organize their business expenditure. Most corporate credit cards, especially cards
which have been issued to employees of a company are termed as “individual” corporate cards
because these cards have individual responsibility, not any corporate obligations.

Prepaid Credit Card originated in Canada. It is not a stereotype credit card but can be used in a
similar way. The consumer has to buy the credit card from a company and then has to load it
with the required amount of money. Only after that he/she could use it for further buying but
strictly within limit of the loaded money. Hence, it is also known as Stored-Value Cards. Some
common examples are Gift Cards, Phone Cards, Mall Cards, and Gas Cards.


NACHA — The Electronic Payments Association oversees, the ACH Network which is a highly
reliable and efficient nationwide batch-oriented electronic funds transfer system. It is governed
by the NACHA OPERATING RULES which provide for the interbank clearing of electronic
payments for participating depository financial institutions. The Federal Reserve and Electronic
Payments Network act as ACH Operators, central clearing facilities through which financial
institutions transmit or receive ACH entries.

ACH payments include:

• Direct Deposit of payroll, Social Security and other government benefits, and tax refunds;
• Direct Payment of consumer bills such as mortgages, loans, utility bills and insurance
• B2B payments;
• Electronic checks;
• E-commerce payments;
• Federal, state and local tax payments.

The following is a typical ACH payment processing cycle:


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Originator is individual, corporation or other entity that initiates entries into the Automated
Clearing House Network

Originating Depository Financial Institution (ODFI) is a participating financial institution that

originates ACH entries at the request of and by (ODFI) agreement with its customers. ODFI's
must abide by the provisions of the NACHA Operating Rules and Guidelines

Receiving Depository Financial Institution is any financial institution qualified to receive ACH
entries that agrees to abide by the NACHA Operating Rules and Guidelines

Receiver is an individual, corporation or other entity that has authorized an Originator to initiate
a credit or debit entry to a transaction account held at an RDFI.

NACHA — the Electronic Payments Association

NACHA — The Electronic Payments Association is a not-for-profit association that oversees the
Automated Clearing House (ACH) Network, a safe, efficient, green, and high-quality payment
system. More than 15,000 depository financial institutions originated and received 18.2 billion
ACH payments in 2008. NACHA is responsible for the administration, development, and
enforcement of the NACHA Operating Rules and sound risk management practices for the ACH
Network. Through its industry councils and forums, NACHA brings together hundreds of
payments system stakeholder organizations to encourage the efficient utilization of the ACH
Network and develop new ways to use the Network to benefit its diverse set of participants.



Online services that enable customers to receive, review, and execute payment of their bills
over the Internet.


On-line P2P payments, or e-mail payments, use existing retail payment networks to provide an
electronically initiated transfer of value from one individual to another.

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Similar to P2P payments, individuals can transfer electronic cash value to other individuals or
businesses. Most electronic cash applications exist on the Internet. Consumers can use the cash
payment instruments for purchases at retailers’ Web sites or they can transfer cash to other
individuals through e-mail. Individuals use a credit card or signature-based debit card number to
pre-fund the Web certificate or electronic account, and recipients redeem the value with the


Electronic system that allows a recipient to authorize transfer of his/her government benefits
from a Federal account to a retailer account to pay for products received. EBT is currently used
to issue food stamps and other benefits in the US.

Mobile Payment is paying for goods or services with a mobile device such as a mobile phone,
Personal Digital Assistant (PDA), or other such device. They can be used in a variety of payment
scenarios. Typical usage entails the user electing to make a mobile payment, being connected to
a server via the mobile device to perform authentication and authorization, and subsequently
being presented with confirmation of the completed transaction. There are mainly two types of
mobile payments depending on the location of the user:

Remote Payments - These transactions are conducted independent of the user’s location.
Examples include prepaid top-up services, delivery of digital services, mTickets, digital cash,
peer-to-peer payments, etc.

Proximity/Local Payments - These transactions involve a mobile device communicating locally

(e.g., via Bluetooth, IrDA, RF, Near Field Communication) with a POS/ATM, e.g. payments at
unattended machines, mParking, payments at traditional POS, or money withdrawals from a
bank’s ATM.

Contactless payment system is a new emerging payment system where a payment transaction
can be initiated without the device coming in direct contact with the POS, such as swipe of a
card. This payment mechanism is made possible through use of new technologies such as Radio
Frequency (RFID), NFC (Near Field communication), Carrier Based or Bluetooth technology for
making payments. Payment using this technology can be made using Form Factors such as credit
cards, key fobs, smart cards or mobile phones. The consumer waves the device over a reader at
the POS and the embedded chip and antenna enables initiation of the transaction. The
consumer is not required to sign a slip or enter a PIN making it extremely convenient.
Contactless payments are typically useful for small value transactions and are targeted towards
eliminating or reducing cash transactions at the retail counter.

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The diagram below depicts the common model on which most payment systems are based.

Four Corner Payment System Model

Payer Payee
Present Non-cash Payment instrument

Goods / Services


Financial Institution Financial Institution

or Third party or Third party
Solid line indicates flow of information

While the flow of funds, information, and data are different, in most cases, the set of
participants are similar. The initiator of the payment (payer) is typically a consumer and the
recipient of the payment (payee), typically a merchant. The payer and the payee are shown to
have a relationship with their respective financial institutions. The payment network routes the
transactions between the financial institutions


There were 984 million bank-issued Visa and MasterCard credit card and debit card accounts in
the U.S in 2006.The top 10 credit card issuers controlled approximately 88 percent of the credit
card market at the end of 2006, based on credit card receivables outstanding. U.S Visa
cardholders alone conduct more than $1 trillion in annual volume. Consumers carry more than 1
billion Visa cards worldwide. More than 450 million of those cards are in the United States.

2007 global market share of general-purpose cards (cards in distribution)

Total among these five brands: 3.03 billion, up 13.6 percent in one year

1. Visa -- 65 percent

2. MasterCard -- 30 percent

3. American Express -- unknown


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4. JCB -- unknown

5. Diners Club -- unknown

(Source: Nilson Report, May 2008)

2007 global market share of general-purpose cards (purchase volume)

1. Visa -- 60 percent

2. MasterCard -- 28 percent

3. American Express -- 10.5 percent

4. JCB -- 0.9 percent

5. Diners Club -- 0.5 percent

(Source: Nilson Report, May 2008)

A Credit card is a type of a payment card product. A payment card product is a set of
entitlements. It allows the client to access the features the provider (e.g., financial institution)
attaches to the card.

A sample of possible payment card entitlements is shown below:

Access Convenience Affordability

Credit Worldwide acceptance Interest rate
Deposits 24 hour availability Fees
Merchants Portability Benefits
ATMs Monthly statements Payment terms
To create an actual payment card product, these entitlements are grouped together to appeal to
a target segment – consumer or business. A card is issued to a cardholder and usually displays
cardholder name, account number, expiration date, location acceptance logos (e.g.,
Visa/MasterCard) and issuing organization. Most cards are plastic with a magnetic stripe. Some
of the new cards contain chips that store information such as additional customer information
and stored value. A card usually is linked to some type of financial account (e.g., credit card to a
credit line and a debit card to a checking/savings account).


A credit card is a plastic card with a magnetic strip containing data, and is a financial instrument
allowing the holder for pay for goods or services on credit and in lieu of cash. While credit card
companies provide the infrastructure to settle the transactions, the cards are issued by banks
and increasingly by retail outlets and other consumer-oriented entities. Credit cards allow
customers to buy goods and services immediately and then settle the bill for aggregated
transactions at a later date.

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The following diagram depicts typical activities in transaction processing using a card involving
all the entities described above -
The following table shows lists the description of the various entities involved in a Credit card

Entity Description
Issuing Bank This is a bank / financial institution that issues a credit product

Cardholder Cardholder portfolio account is created when a credit application is

Account approved.

Business Portfolio This defines the processing rules for all the accounts under a business
Account venture of the same card offering type. This entity may hold billing rules,
auth limits, collection strategies, and other properties that can be defined
at this level. Examples of Business portfolio account may include Chase
Visa Classic, Chase Visa Gold, etc
Card Product Identifies the different card types that the Credit system supports.
Examples may be proprietary cards, Visa, MasterCard
Authorization Authorization engines are used to authorize credit transactions. The
Engine authorization engine uses the account information, merchant
information, and other related information to approve / decline / refer an
authorization transaction. There can be more than one authorization
engines for a business portfolio.
Credit Bureau Provides credit scores that are used by Issuers to process card
Collection Agency Third party to whom Issuer outsources the cardholder collection activities

Issuer Processor An outside company with which the Issuer contracts to provide
cardholder transaction processing activities.
Issuer Clearing Bank designated by the Issuer to receive the Issuer’s daily net settlement
Bank advisement. The clearing bank (may be the Issuer itself) will also conduct
funds transfer activities with the net settlement bank and maintain the
Issuer’s clearing account.
Acquirer This is a bank / financial institution that acquires merchant transactions

Acquirer Clearing Bank designated by Acquirer to receive the Acquirer’s daily net
Bank settlement advisement. The clearing bank (may be the Acquirer itself) will
also conduct funds transfer activities with the net settlement bank and
maintain the Acquirer’s clearing account.
Acquirer Processor An outside company with whom the Acquirer contracts to provide
merchant processing services
Merchant Account A merchant account is created when a merchant application is approved.
A merchant account is necessary for a merchant to accept payment by
credit card
Clearing file Contains presentments and other financial messages that need to be
matched with corresponding authorizations
Funding file This file is for enabling member settlement

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The credit card process flow is illustrated with an example.

An individual, who desires to have a credit card, applies for one in MBNA. The issuer, MBNA
collects the applicant’s financial and other details and does the necessary credit appraisal
through assistance from its processor. The credit processing will involve a sequence of events
like verifications, credit scoring, credit check, etc. and a decision will be taken by MBNA on
whether a card can be issued to the applicant or not. If the applicant is found eligible to be given
a card, MBNA will issue a credit card with his card details embossed along with the logos of the
issuer and the association.

Now that the applicant has become a card member, he may wish to buy some commodity using
his VISA card, bearing the logo of the issuer MBNA, in payment. The merchant swipes the card
through a card reader, which reads the data on the magnetic stripe and adds information that
identifies the merchant and the dollar value of the purchase. This electronic message is
automatically sent via telephone line to an IT system maintained by the merchant’s acquirer,
also a member of the association. The message is then transmitted to the association's system,
which routes the request to the appropriate Issuer to verify that the cardholder has a credit
balance sufficient to cover the purchase. The response (approval or denial) from the issuer is
routed back along the same path to the originating POS terminal. This entire process typically
happens within 10 seconds and in case of an approval, the cardholder is expected to sign the
credit card charge slip.

The merchant submits a request for payment to its acquirer, who in turn sends it to VISA. VISA
consolidates the transaction with all other transactions that day and settles the accounts among
banks i.e. Funds are transferred from the Issuer to the Acquirer and to the merchant.

At the end of the credit period, the customer makes his settlement with the Issuer.



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The credit card transaction starts when the merchant swipes a customer's credit card through a
dial-in terminal that would automatically dial the correct network depending on the association
being used. The card holder, in this way, informs the Issuer to pay the merchant.The merchant
then passes this message on to his acquirer, who then sends it through the Credit Card
Association to the card issuer. The return path of the $100 dollars is essentially the same except
that each party deducts some amount of money for its efforts. Following is the share of each of
the entities:

• The card issuer will bill the card holder and keep an interchange fee which in this
example is 1.3%, or $1.30. However, he must pass the remaining money back to the
card association and pay an issuer transaction fee of .07% or $.07.

• The card association takes the $98.77, deducts a merchant transaction fee (.09%) and
returns $98.61 to the acquirer.

• The acquirer keeps .06% and deposits $98 in the merchants account.

• The merchant then sees $98 dollars return from the $100 dollar purchase. This charge of
$2, or 2%, is called the discount rate and is the basis for much of the competition
between the banks of a credit card association.


Entity Transaction Type Remarks

Cardholder • Purchase Sale of Merchandise - Triggered by the

transactions cardholder.

• Authorization/Verification Authorization/Verification is the default

transaction type. Transaction approval
response from Issuer to Merchant

Preauthorization - The merchant is

• Preauthorization provided with the ability to add a tip to
a credit card transaction after having
presented the cardholder with the
transaction record

Merchandise return – Credit of

• Merchandise return transaction amount to the Cardholder

System • Reversal This transaction is an action on a

Generated previous transaction and is used to
Transactions cancel the previous transaction and
ensure it does not get sent for

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Exception • Adjustment Used to correct errors that occur at

Transactions • Chargeback & Chargeback point of transaction or in a participant’s
Reversal system
• Representment

Others • Administrative These are routine transactional

• Network activities to ensure completion of the
• Reconciliation various activities involved in a
• File Maintenance transaction processing cycle
• Fee transactions


At any time (currently limited to 60 days after statement date), cardholder may contact the
Issuer to question whether a transaction is legitimate and request a copy of the transaction
from the merchant. If the cardholder does not receive a copy of transaction, she may request a
chargeback – a financial reversal of the transaction. Even if the retrieval request is fulfilled,
cardholder still may request the Issuer to initiate a chargeback. However, if the merchant
disputes the chargeback, the disputed transaction is dealt with through a defined dispute
process. Following diagram depicts the process of chargeback and chargeback reversal

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The following table shows some of the leading card organizations and their respective roles in
the Credit card industry:

Leading Card Organizations

Banks Non-Banks Association /

• Citigroup • First Data Corp (Processor) • Visa

(Issuer) (Card Association,
• TSYS (Processor) Processor)
• MBNA America
(Issuer) • Vital (Acquirer & Processor) • MasterCard
(Card Association,
• JPMorgan Chase / • American Express (Acquirer, Card Processor)
Bank One Organization & Issuer)
(Acquirer & Issuer) • JCB (Card Association)
• Discover (Acquirer, Card Organization
• Bank of America & Issuer)
(Acquirer & Issuer)
• Diners Club (Card Organization &
• Capital One Issuer)
• Equifax (Processor)
• Wells Fargo
(Acquirer & Issuer) • Sears ( Acquirer, Card Organization &
• Wachovia
(Issuer) • GE Card Services (Processor)

• Natwest (Issuer) • US Government (Acquirer & Issuer)

• Barclays (Issuer)



SEPA is an objective set by the European Union for the purpose of creating a single payment
market, within which everyone can make payments simply and safely, at the same cost and as
efficiently as those presently being made at the national level. The project will make it possible
for individuals, companies, government agencies and others, no matter where they are located

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in Europe, to make and receive Euro payments, to engage in direct debits and to use credit and
debit cards with standardized basic conditions, rights and obligations in every country.

The expanse of SEPA is all EU Member States (currently 27), other EEA Member States (Norway,
Iceland and Liechtenstein) and Switzerland.

There are three main payment instruments forming part of the SEPA objective:

• Pan-European Credit Transfer (SEPA Credit Transfer (SCT))

• Pan-European Direct Debit (SEPA Direct Debit (SDD))

• Debit and account-linked cards (SEPA Cards Framework (SCF))

SEPA Cards Framework (SCF) spells out high level principles and rules which when implemented
by banks, schemes, and other stakeholders, will enable European customers to use general
purpose cards to make payments and cash withdrawals in Euro throughout the SEPA area with
the same ease and convenience than they do in their home country.

The vision of SEPA Cards Framework is as follows:

• There should be no differences whether European customers use their card(s) in their
home country or somewhere else within SEPA.
• No general purpose card scheme designed exclusively for use in a single country, as well
as no card scheme designed exclusively for cross-border use within SEPA, should exist
any longer.

On Customers / Card holders - Since the beginning of the year 2009, all the newly issued cards
will be equipped with the chip technology and their usability within the SEPA zone will be the
same as of standard international bank cards. Cards will be used in compliance with the EMV

On Merchants / Traders - Traders will continue to be able to decide which offered card products
they will accept and with which bank – a receiver - they will cooperate. The bank and the trader
will contractually agree on the trade terms and conditions for acceptance of bank cards, type of
accepted bank cards, including charges, and other relevant particulars. As long as a payment
terminal is owned by a bank, the bank is entitled to decide whether a trader may use a given
terminal also for cooperation with another bank. Payment terminals will accept both SCF
compatible products and products without the EMV chip technology due to the need to
safeguard the acceptance of bank cards issued in non- SEPA countries.

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On Banks - The preparatory phase for implementation of SEPA will mean investments into the
technologies used within the process of issue and acceptance of bank cards (cards, POS, ATM)
and adjustment of affected information systems


EMV is the standard devised by Europay, MasterCard and Visa (EMVCo.) for smart card based
credit and debit cards to replace the existing magnetic based stripe cards. With the acquisition
of Europay by MasterCard in 2002, and JCB (Japan Credit Bureau) joining the organization in
2004, EMVCo currently comprises of JCB International, MasterCard Worldwide and Visa, Inc.

The primary aim of EMV is to define a set of specifications that will offer interoperability
between the smart card (chip based), POS terminals, and ATMs throughout the world. The key
purposes served by EMV can be summed up as

 A set of specifications for global card interoperability

 Enable cardholder verification and transaction authorization in a secure way

 Offer multiple facilities and advantages on a single card making it easy to



Some of the Key benefits of EMV implementation are

 Increased Interoperability of card acceptance, security and payment functions

 Fraud Prevention

• Reduce counterfeit and lost and stolen fraud

• Avoid being the ‘weakest link’ - prevent migration of fraud to own card base as
other banks implement

• Avoid card scheme liability shift

 Improved Control

• Reduce and improve management of bad debt by utilizing chip parameters e.g.
to restrict below floor limit spending.

• Apply different levels of control according to cardholder profile

• Provides authentication and platform for ID

• Customer centric decisions at the terminal, control managed within the

application on the chip

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 Maintain Competitiveness

• Maintain credibility in customers and competitors eyes.

• Endorse Brand with reliable, secure and innovative product.

• A migration path for loyalty and multi-application products.

• Operational savings from reduced chargeback/authorization costs

Impact on existing cards

Master and Visa have planned a global migration scheme to initiate credit and debit card
transactions with the use of a chip in card and authenticating the transaction using a PIN
(Personal Identification Number) instead of the magnetic stripe. This will have a direct impact on
the existing credit and debit cards as they are based on card holder terminals which can read
magnetic stripes and performs cardholder verification through signature instead of PIN.


• Cards are one of the most widely used mechanisms for transactions worldwide. There are
several types of cards used –
o Debit cards
o ATM cards
o Credit cards
o Smart cards
o Co Branded card
o Affinity card
o Commercial card
o Prepaid card
• ACH enables batch-processed, value-dated electronic funds transfer between originating
and receiving financial institutions.
• Emerging payments systems are –
o Online Bill Payment (EBPP, EIPP)
o Person to Person Payments (P2P)
o Internet currencies, digital cash, e-Wallet
o Electronic Benefit Transfer (EBT)
o Mobile payments
o Contactless payments

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• There are various entities involved in the credit card transaction processing cycle -
o Issuer
o Acquirer
o Third party Processor
o Independent Sales organization
o Association
o Merchant
o Card holder
Transaction Economics – A credit card transaction involves various fees. / Charges such as
interchange fee, merchant transaction fee and issuer transaction fee. The merchant
discount rate is the basis for much of the competition between the banks of a credit card
• Chargeback and Chargeback reversals are legitimate ways to cancel the credit card
transactions within a limited time frame
• SEPA Cards Framework and EMV Global Framework for Smart Card Payments are some of
the recent developments in the Cards arena.

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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.


The following is the typical stages in a corporate lending process:

• Corporate approaches the relationship manager of the bank with a request for a loan. The
corporate provides details like: past financial statements, details of the loan requirement,
cash flow projection for the period of the loan, details of the security being provided etc.
Depending on the loan type and bank requirements, information should be provided by the
• 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
• Once sanctioned, the bank provides a sanction letter to the corporate providing details of
the loan terms and conditions.

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• After the corporate accepts the same, a loan agreement is signed between the bank and the
corporate. The loan agreement captures various conditions of the loan like repayment
mode, repayment period, interest payable, security provided, other conditions etc. The loan
becomes ‘committed’ at this stage.
• The bank disburses the required amount under the loan committed. This amount is called
the ‘disbursed amount’ under the loan.

Interest is usually paid on the disbursed amount of the loan. In some cases, a nominal interest if
also payable on the committed amount of the loan. Also, in most cases, the corporate would
have to pay a certain amount as processing fees for the loan. This would cover the bank’s
overhead costs in the loan process.


Before sanctioning a loan to a corporate, the bank does a detailed assessment of its financials
and business strength as discussed in the earlier section. This process ends with the bank
assigning a rating to the corporate for the loan facility.

Ratings are usually specified in alphanumeric terminologies. Rating levels might vary from AAA
(highest), AA+, AA- to default ratings like D. Rating terminologies might vary across banks and
across various loan tenures. The rating level specifies a certain probability of default of the loan.
It also takes in to account the protection offered by the security of the loan.

For corporate with higher ratings, banks provide loans at lower interest rates and vice versa. In
most cases, banks do a rating process for each of its corporate clients at the end of say, every
year or every quarter. This helps banks to continuously track the financials and market position
of the corporate.


Credit 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.

A corporate rated BB (low rating) requires a loan of USD 5.0 million from a bank. To enhance the
loan rating and thus reduce interest payable on the loan, the promoters pledges their share
holding in the company with the bank. Thus, whenever there is a default on repayment of the
loan, the bank has the right to sell the shares in the market. Based on the historic volatility of
the shares and the current market value of USD 6.0 mn, the bank upgrades the rating of the loan
to BBB+.

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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.

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 are used for the same purpose as term loans, but the loan is backed by a
transferable instrument which guarantees payment from the corporate as per specified
conditions. Thus, corporate bonds are tradable and banks can sell them to a third party who
receives the right to get payments from the corporate. Bonds are rated depending on the rating
of the corporate and depending on the rating, the market demands varying amounts of interest.
A certain class of bonds called junk bonds is issued by corporate with very low credit ratings and
carry very high rates of interest.

For any business, there would be current assets in the form of cash, receivables, raw material
inventory, goods for sale inventory etc while there would be current liabilities in the form of
payables and other short term liabilities. Part of the current assets would be funded through
current liabilities while the rest would have to be funded through a mixture of short term and
long term loans. As per norms, 25% of the working capital gap would have to be funded by long

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term sources like equity or term loans while the rest 75% can be funded through short term
loans and overdraft limits.

Banks conduct a detailed assessment of the current assets and liabilities for a corporate and
arrive at a suitable working capital limit. For purpose of calculating limits, banks typically include
only receivables which are less than 6 months old. Also within the specified limit, banks keep
reviewing the current asset and current liability position of a company to arrive at the drawing
power for each month. Corporate are allowed to borrow up to the working capital limit or the
drawing power, whichever is lower.

Overdraft limits are extended to help the corporate manage the day-to-day cash flow needs of
the business. The bank makes available a certain sum of money for a period of time (say, USD
20.0 million for a period of 1 year). There would be a separate account called the overdraft
account created to monitor withdrawals under this loan. Whenever the corporate has a deficit
in its main business account, it can draw money from the overdraft account (up to the limit of
USD 20.0 million). It can also put back money in the overdraft account as and when they have
surpluses in the business account. Interest is calculated by the bank on the various end-of-day
deficits in the overdraft account and is usually payable by the corporate at the end of every

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:

Citibank sanctions a line of credit of USD 10.0 mn to AT&T, valid for a period of 3 years. Within
the 3 year period, AT&T can borrow any amount at any point of time, such that the cumulative
outstanding is below USD 10.0 mn on any date. Each of these borrowals are repayable with
interest at the end of 30 days from the date of borrowals. Since AT&T can thus ‘revolve’ the limit
any number of times within the specified limit and validity period, these are called revolving
lines of credit.

Bill discounting is another form of working capital financing. A bill (Bill of Exchange) is a financial
instrument by which one party promises to pay the other party a certain amount of money on a
specified due date. This is transferable and the final holder of the bill holds the right to receive
the payment from the concerned party. The corporate would have bills of exchange which are
drawn on their dealers, which entitle the corporate to receive certain amounts of money from
the dealer after a pre-defined credit period. The corporate can then transfer the bill to the bank
and get a discounted amount upfront. The bank collects the interest on the bill amount for the
specified period upfront in this process called bill discounting. On the due date, the bank collects
the payment from the concerned party directly.

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Commercial Paper (CPs as commonly known) is an instrument by which a corporate borrows
money from banks for short periods of time. A CP binds the corporate to make a payment equal
to the face value of the CP to the issuing bank on a specified due date. In this sense, a CP is like a
short term unsecured loan. However, a CP is tradable in the market – the bank can sell the CP to
a third party. For this reason, banks charge lesser interest on CPs than normal short term loans.
However, since CPs are unsecured and are to be tradable in the market, banks provide CP
lending to only highly rated corporate.

Leasing is another form of bank financing. In leasing, the bank purchases real estate, equipment,
or other fixed assets on behalf of the corporate and grants use of the same for a specified time
to the corporate in exchange for payment, usually in the form of rent. The owner of the leased
property is called the lessor, the user the lessee. Lease payments (which include principal and
interest payments usually) can be shown by corporate as operating expenses and hence leases
are used by some corporate as a substitute for loans to get better tax benefits.


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


Asset Securitization loans are loans which are backed by specified future cash flows or other
assets of the corporate. These loans help corporate to release excess cash flows from existing
receivables or future receivables.

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

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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.


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.

• The fee charged on a loan is a function of the disbursed amount. The fee charged on
commitment is a function of the amount of commitment that is not utilized.


A syndicated loan is a lending facility defined by a single loan agreement in which 2 or more
banks participate

• A borrower wants to raise relatively large amount of money quickly and conveniently
• The amount exceeds the exposure limits or appetite of any one lender
• The borrower does not want to deal with multiple lenders



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1. Arranger / Lead Manager: This the bank / lender the prospective borrower has
mandated to arrange loan
2. Underwriting Bank: The bank that commits to supply funds to the borrower. If
necessary from own sources if the loans are not fully subscribed. It may the arranging
bank or another bank
3. Participating Bank: The bank that participates in the syndication by lending a portion of
the total amount required
4. Facility Manager / Agent: The entity who takes care of the administrative arrangements
over the term of the loan (Example: disbursements, repayments, compliance)

1. Pre-mandate Phase: Prospective borrower will liaise with a single bank and the bank
may agree to act as lead bank. The lead bank needs to;
a. Identify the needs of the borrower
b. Design an appropriate loan structure
c. Develop a persuasive credit proposal
d. Obtain internal approval
2. Placing the loan: The lead bank will start to sell the loan in the market place and to sell
the loan it needs to;
a. Prepare an information memorandum
b. Prepare a term sheet
c. Prepare legal documentation
d. Approach selected banks and invite participation
3. Post-closure phase: Post closure, agents will handle the day to day running of the loan


Fee Type Remarks

Arrangement fee Front end Also called praecipium.

Received and retained by the
lead arrangers in return for
putting the deal together

Legal fee Front end Remuneration of the legal


Underwriting fee Front end Price of the commitment to

obtain financing during the
first level of syndication

Participation fee Front end Received by the senior


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Facility fee Per annum Received by the senior


Commitment fee Per annum charged on Paid as long as the facility is

undrawn part not used, to compensate the
lender for tying up the capital
corresponding to the

Utilization fee Per annum charged on Boosts the lender’s yield;

undrawn part enables the borrower to
announce a lower spread to
the market than is actually
being paid

Agency fee Per annum Remuneration of the agent

bank’s service

Conduit fee Front end Remuneration of the conduit


Prepayment fee One-off if prepayment Penalty for prepayment


Credit derivatives are financial contracts that transfer credit risk from one party to another,
facilitating greater efficiency in the pricing and distribution of credit risk among market players.

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


Like any other derivative instrument, credit derivatives can be used either to take on more risk
or to avoid (hedge) it. A market player who is exposed to the credit risk of a given corporation
can hedge such an exposure by buying protection in the credit derivatives market. Likewise, an
investor may be willing to take on that credit risk by selling protection and thus enhance the
expected return on his portfolio.

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Credit derivatives can be used to create positions that can otherwise not easily be established in
the cash market. For instance, consider an investor who has a negative view on the future
prospects of a given corporation. One strategy for such an investor would be to short the bonds
issued by the corporation, but the corporate repo market for taking short positions in corporate
is not well developed. Instead, the investor can buy protection by way of credit default swap. If
the corporation defaults, the investor is able to buy the defaulted debt for its recovery value in
the open market and sell it to its credit derivatives counterparty for its face value.

Banks use credit derivatives both to diversify their credit risk exposures and to free up capital
from regulatory constraints. As an example, consider a bank that wants to diminish its exposure
to a given client, but does not want to incur the costs of transferring loans made to that client to
another bank. The bank can, without having to notify its client, buy protection against default by
the client in the credit derivatives market: Even though the loans remain on the bank's books,
the associated credit risk has been transferred to the bank's counterparty in the credit
derivative contract.

The above example can also be used to illustrate banks' usage of credit derivatives to reduce
their regulatory capital requirements. Under current Basle standards, for a corporate borrower,
the bank is generally required to hold 8 percent of its exposure as a regulatory capital reserve.
However, if its credit derivatives counterparty happens to be a bank located in an OECD country,
and the bank can demonstrate that the credit risk associated with the loans has been effectively
transferred to the OECD bank, then the bank's regulatory capital charge falls from 8 percent to
1.6 percent.


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

Here, credit derivatives offer an easy solution: both the banks, without transferring their
portfolio or reducing their portfolio concentration, could buy into the risks of each other. So
bank B buys a part of the risks of the portfolio that is held by Bank A, and vice versa, for a
fee. Both continue to hold their portfolios, but both are now diversified. Both have
diversified their risks. And both have also diversified their returns, as the fees being earned
by the derivative contract is a return from the portfolio held by the other bank.

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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.


The Treasury Services department is concerned with managing the financial risks of the bank.
Hence, the treasurer's job is to understand the nature of these risks, the way they interact with
the business, and to minimize or to offset them. In many cases, the treasury services
department also provides cash management solutions for customers of the bank. The Treasury
services department of a bank performs the following functions:

• Managing the cash position of the bank, managing liquidity and associated risks
• Forex services: provides Forex services to corporate, enters in to deals with multiple
counterparties to maintain a risk-managed position for the bank.
• Risk management services: provides risk management products like swaps, options etc to
corporate and enters in to multiple deals with various counterparties to maintain a risk-
managed position for the bank.
• Conducts research on various market factors, monitors interest rate and economic scenario
• Cash Management services for corporate – managing collections and payments
Typically, the treasury has a front office desk which enters in to trades (in Forex, money
markets, equity, treasury securities etc) with various market participants and a middle
office/back office desk which monitors positions and provides operational support.

Most large investment banks provide Treasury Services to their clients. Treasury domain

• Fixed Income: An investment that provides a return in the form of fixed periodic payments
and eventual return of principle at maturity. Unlike a variable-income security where
payments change based on some underlying measure, such as short-term interest rates,
fixed-income securities payments are known in advance.
• Money Markets: The money market is a subsection of the fixed income market. The
difference between the money market and the fixed income market is that the money
market specializes in very short-term debt securities (debt that matures in less than one
year). Money market investments are also called cash investments because of their short
maturities. Some of the popular money market instruments include Certificates of Deposit
(CD), Commercial Paper (CP), Treasury Bills (T-Bills)

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• Foreign Exchange: The market for buying and selling of currencies is called the Foreign
Exchange market (FX ). It is a 24 hour non-stop market. Some of the major Currency traded
include – The US Dollar (USD), The Japanese Yen (JPY), The Euro (EUR), The Great Britain
Pound (GBP), The Swiss Franc (CHF). FX rates express the value of one currency in terms of
another currency. They involve
o The commodity currency - the currency being priced, usually 1 unit or a fixed amount of
o The terms currency - the currency used to express the price of the commodity, in
varying amounts of
• OTC Derivatives: Over the counter (OTC) markets are a form of Secondary markets. World
over Secondary markets are classified as Listed and OTC. Listed markets typically are
exchanges where a security is listed and traded. A decentralized market of securities not
listed on an exchange where market participants trade over the telephone, facsimile or
electronic network instead of a physical trading floor or electronic order matching systems.
There is no central exchange or meeting place for this market. Typically Currency
instruments are traded OTC. A derivative contract derives its value based on the value of
some basic underlying. The underlying may be any instrument like a bond, a stock or a
market index, currency or interest rates. Some of the instruments traded OTC include
o Forward Rate Agreement (FRA) - A contract that determines the rate of interest,
or currency exchange rate, to be paid, or received, on an obligation beginning at some
future start date. It is also referred to as Future Rate Agreement.
o Interest Rate Swap (IRS) - A deal between banks or companies where borrowers switch
floating-rate loans for fixed rate loans in another country. These can be either the same
or different currencies. The motive may be the competitive advantage of one company
to have access to lower fixed rates than another company. The other company may be
competitively placed to have access to lower floating rates. A swap would be beneficial
to both. The swap is measured by its notional principal.
• FX Options: Forex Options give the holder the right to buy or sell a currency in terms of
another currency at a particular rate on a particular date or within a period of time. The
option to buy is called as a Call Option and the option to sell is called as a Put Option.
• Equity Options – These are similar to FX options the only difference is the underlying. The
underlying in case of Equity Options are stocks or stock market indices. When the
underlying is a stock market index the term used is Index Option and the term used to refer
options on individual stocks is Stock Option
• Credit Derivatives - Privately held negotiable bilateral contracts that allow users to manage
their exposure to credit risk. Credit Derivatives are financial assets like forward contracts,
swaps, and options for which the price is driven by the credit risk of economic agents
(private investors or governments). For example, a bank concerned that one of its
customers may not be able to repay a loan can protect itself against loss by transferring the
credit risk to another party while keeping the loan on its books.

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• Ensure availability of funds – An integrated treasury typically would include debt market,
money market and Forex transactions. Treasury manager needs to ensure that adequate
funds are available to cover the settlement obligations of the said transactions.
• Manage all foreign currency transactions for the bank
• Manage various risks:
o Liquidity – Risk of asset and liability cash flow mismatch. A bank may not have adequate
funds for the settlement of its transactions or to pay its customers because of
mismatches in the tenor of its receivables
o Interest rate – Risk due to volatility of interest rates. A bank may have borrowed at
floating rates of interest and lent at fixed rate of interest and the interest rates moves
o Currency – Risk due to volatility in exchange rates. A bank may have its payment
obligations in a currency say USD and the rate to purchase the said currency goes up
• Commodity – Risk due to volatility in commodity prices. A bank may have an obligation to
deliver a commodity in the future and the price of the commodity moves up
• Cash Management Services - CMS is a service provided by banks to its corporate clients for a
fee to reduce the float on collections and to ease the bulk payment transactions of the
client. The three elements of CMS are:
o Receivables Management –Helps the company to manage collection of its sale proceeds
from remote upcountry regions
o Payables Management – Helps the company to manage its payments to its regular
suppliers without keeping numerous bank accounts for various locations and then
reconciles them periodically in a highly manual / paper-based environment
o Liquidity Management – Helps the company by ensuring direct and instant access to its
bank accounts. It should not happen that a company has excess funds in one bank
account and it needs to pay through another bank account where there are no funds
• Managing Liquidity & Interest Rate risks
o Asset Liability Management – A bank’s assets and liabilities need to necessarily match.
If they don’t the bank may have liquidity problems which would endanger its solvency.
The long term assets should not be financed by short term sources of funds. The bank
would not be able to serve its lenders if the timings of its inflows do not match its

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outflows. A bank typically uses mathematical tools like Duration, Gap Analysis to find
out mismatches and take corrective actions

• A bank borrows USD 100MM at 3.00% for one year

• The bank uses this borrowed money to lend to a highly-rated borrower for 5 years at 3.20%.
For simplicity, assume interest rates are annually compounded and all interest accumulates to
the maturity of the respective obligations. The net transaction appears 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 maturity mismatch between assets and
liabilities. As long as interest rates experienced only modest fluctuations, losses due to asset-
liability mismatches are small or trivial. However, in a period of volatile interest rates, the
mismatches would become serious.

The treasury asset-liability management (ALM) group assesses asset-liability risk and all banks
have ALM committees comprised of senior managers to address the risk. Techniques for
assessing asset-liability risk came to include gap analysis, duration analysis and scenario analysis.
Gap analysis looks at amount of assets and liabilities in various maturity buckets while Duration
analysis looks at weighted average maturity of cash flows to compare assets and liabilities. Since
liquidity management is closely linked to asset-liability management, assessment and
management of liquidity risk is also a function of ALM departments and ALM committees. ALM
strategies often include securitization, which allows firms to directly address asset-liability risk
by removing assets or liabilities from their balance sheets. This not only eliminates asset-liability
risk; it also frees up the balance sheet for new business.

• Interest rate risk management

o Manage risks due to volatility of interest rates - Demand and supply of money go on
changing from time to time making interests rates volatile. A bank may have accepted
deposits at a fixed rate of interest historically. However current market rates may be
lower when it wishes to lend. The bank’s portfolio value of investments in bonds and
treasury also varies inversely with the interest rates. A higher interest rate diminishes
the value of a bank’s portfolio and vice versa. Instruments like interest rate swaps and
currency swaps help to address Interest Rate risks

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The causes of interest rate risk might vary:

• Repricing risk: The primary form of interest rate risk arises from timing differences in the
maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-
balance-sheet (OBS) positions. For instance, a bank that funded a long-term fixed rate loan
with a short-term deposit could face a decline in both the future income arising from the
position and its underlying value if interest rates increase.

• Yield curve risk: Yield curve risk arises when unanticipated shifts of the yield curve (a plot of
investment yields against maturity periods) have adverse effects on a bank's income or
underlying economic value. Yield curves can shift parallel or change in steepness, posing
different risks. For instance, the underlying economic value of a long position in 10-year
government bonds hedged by a short position in 5-year government notes could decline
sharply if the yield curve steepens, even if the position is hedged against parallel
movements in the yield curve.

• Basis risk: Basis risk arises from imperfect correlation in the adjustment of the rates earned
and paid on different instruments with otherwise similar repricing characteristics. For
example, a strategy of funding a one year loan that reprices monthly based on the one
month U.S. Treasury Bill rate, with a one-year deposit that reprices monthly based on one
month Libor, exposes the institution to the risk that the spread between the two index rates
may change unexpectedly.

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

Bank treasuries measure interest rate sensitivity of securities (assets or liabilities) through
Duration analysis. Duration is a mathematical concept which can be used to measure the
sensitivity of a financial 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.

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Banks also use derivative instruments like interest rate swaps and options to manage interest
rate risks (A derivative is a generic term often used to categorize a wide variety of financial
instruments whose value “depends on” or is “derived from” the value of an underlying asset,
reference rate or index). Some of them are:

o Interest Rate Swap: An agreement to exchange net future cash flows. In its
commonest form, the fixed-floating swap, the counterparty pays a fixed rate
and the other pays a floating rate based on a reference rate, such as Libor.
There is no exchange of principal. The interest rate payments are made on an
agreed notional amount.
o Forward Rate Agreement (FRA): A FRA allows purchasers / sellers to fix the
interest rate for a specified period in advance. One party pays fixed, the other
an agreed variable rate. Maturities are generally out to two years and are priced
off the underlying yield curve. The transaction is done in respect of an agreed
nominal amount and only the difference between contracted and actual rates is
o Interest Rate Guarantee: An option on a forward rate agreement (FRA), also
known as a FRAtion. Purchasers have the right, but not the obligation, to
purchase a FRA at a predetermined strike. Caps and Floors are strips of interest
rate guarantees.
o Swaption: An option to enter an interest rate swap. A payer swaption gives the
purchaser the right to pay fixed (receive floating), a receiver swaption gives the
purchaser the right to receive fixed (pay floating).

• Forex Management – Similar to interest rates, the Forex rates of countries who have not
pegged their currencies vary from time to time. This exposes its market participants to risk
of adverse movements of exchange rates. FX Forwards and Forex Options provide a means
of reducing exchange rate risks by entering into contracts at fixed rates thereby making the
outcome predictable

Foreign exchange is essentially about exchanging one currency for another. Forex rates between
two currencies at any point of time are influenced by a variety of factors like state of the
economy, interest rates & inflation rate, exchange rate systems (fixed/floating), temporary
demand-supply mismatches, foreign trade position etc.

Foreign exchange exposures for a financial entity arise from many different activities. A
company which borrows money in a foreign currency is at risk when the local currency
depreciates vis-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 cost in local currency
greater than expected. Generally the aim of foreign exchange risk management is to stabilize
the cash flows and reduce uncertainty from financial forecasts.

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Since a bank is usually a counter party to the above transactions, it faces similar Forex Risk when
the reverse happens.


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 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.


The most basics tools of Forex risk management are 'spot' and 'forward' contracts. These are
contracts between end users and financial institutions that specify the terms of an exchange of

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two currencies. In any Forex contract there are a number of variables that need to be agreed
upon and they are:

• The currencies to be bought and sold - in every contract there are two currencies the one
that is bought and the one that is sold
• The amount of currency to be bought or sold
• The date at which the contract matures
• The rate at which the exchange of currencies will occur
The exchange rates advertised either in the newspapers (and that mentioned above) or on the
various information services assume a deal with a maturity of two business days ahead - a deal
done on this basis is called a spot deal. In a spot transaction the currency that is bought will be
receivable in two days whilst the currency that is sold will be payable in two days. This applies to
all major currencies with the exception of the Canadian Dollar.

Most market participants want to exchange the currencies at a time other than two days in
advance but would like to know the rate of exchange now. This is done through a forward
contract to exchange the currencies at a specified exchange rate at a specified date. In
determining the rate of exchange in six months time there are two components:

• the current spot rate

• the forward rate adjustment
The spot rate is simply the current market rate as determined by supply and demand. The
forward rate adjustment is a slightly more complicated calculation that involves the interest
rates of the currencies involved.

Forward rate (Local currency/USD) = Spot rate *(1+ interest rate in US) / (1+ local interest rate),
with interest rates adjusted for the period of the forward rate. The concept behind this equation
is that if we defer the value date of a spot transaction each party will have the funds that they
would have paid to invest. The difference between a Forex spot rate and the forward rate for a
particular tenure is called the forward premium for that tenure. Currencies can have forward
premiums or forward discounts vis-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.


• Small and Larger Orders – Equity markets are characterized by smaller orders as compared
to the markets for other financial instruments because of more retail participation
• Liquidity – Exchange traded instruments are more liquid
• Investor Profile – Equity markets have a more retail investor profile as compared to markets
for other financial instruments

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• Routing – Deals in the Equity markets are routed to multiple destinations where as deals in
Forex as well as debt markets are “matched” internally
• Public v/s Private - Markets for equities are listed whereas certain Derivatives are OTC



Cross-Asset Trading and Risk

• Sungard / Front Arena - FRONT ARENA is the definitive integrated solution for sales, trading
and risk management, operations and distribution across multiple asset classes. Its rich
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• Summit - Summit is a core solution for treasury management for both financial and
corporate institutions. Summit’s trading applications interact with operations and risk
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to back management of all products within four primary business areas viz Treasury, Fixed
Income, Derivatives and Commercial lending
• Calypso - Calypso Technologies the world’s leading software provider of credit derivatives,
asset trading, risk management, and processing. It offers a front-to-back office system that
allows traders flexibility to plug in their own products.
• Wall Street Systems - Wall Street Systems delivers single-server, enterprise-wide solutions
to the world's leading financial institutions and corporations The Wall Street System
financial trading and treasury engine provides a multi-entity, multi-currency, multi-asset
class environment which supports all front, middle and back office operations.

Single-bank platform
• Cognotec – Cognotec is the world's leading provider of automated trading solutions to
financial enterprises across the globe. They provide Forex dealing solutions. They have
partnered with world-leading technology providers, multi-bank platforms and industry
• Integral - Integral is at the forefront of the eFX market in developing new, highly innovative
products. Integral is the provider of integrated electronic trading systems, offering intuitive
and innovative products that automate and streamline the entire trading cycle.
Multi-bank platform
• Reuters RET - Reuters Electronic Trading provides a comprehensive FX and money markets
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market automated dealing capability, to enable the Bank's dealing room to price, execute,
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Cash Management Service (CMS) is a service provided by banks to its clients for a fee to reduce
the float on collections and to ease the bulk payment transactions of the client. Large
Corporations like GM or Ford need to manage cash well since they have:
• Payments to multiple parties at various locations – Payments need to be made to suppliers
across the country. Typically these have suppliers across the country to reduce dependence
on one or a few suppliers
• Collections from multiple parties at various locations - How does a company collect its sale
proceeds from remote upcountry regions?
• Multiple banking accounts at various locations
o Ensure local deficits and surpluses are managed – A corporate may be paying its
employees’ salaries out of one bank account whereas it may be banking its receivables
in another bank account another location leading to surpluses and deficits in their bank
o Ensure net surplus is invested properly – If a corporate is unable to identify surpluses, a
corporate may risk keeping money idle leading to loss of interest income if it does not
prudently invest its net surpluses leading to
o Reduce operational costs associated with payments & collections – A CMS would help
optimize wasted operational cost on payments and collections
• Cash Management solutions help corporations:
o Devise an effective account & investment strategy to manage surpluses and deficits –
Pooling, Netting, Zero-balance structures
o Automate collections and payments process flows
o Outsource collections and payments administration & reconciliation

Consider a consumer goods company in Mid-west US, with dealerships spread through 12
states. The company has a manufacturing facility in Michigan and 4 depots, one each in Ohio,
Michigan, Illinois and Texas. The company transports goods to the 4 depots which serves the
respective local dealers and in some cases dealers in neighboring states. All the depots are
treated as independent cost centers, with sales from respective regions and salaries and general
expenses for these regions marked to the depot concerned. Collections from dealers in various
locations are managed by local sales teams, one team for each state. The company wants to:

• Ensure daily monitoring of collections from various states

• Sweep all local collections daily to a central bank account at Michigan
• Ensure that local accounts do not remain in debit when the central account is in credit.
• Provide facility for temporary intra-day overdraft for the local accounts

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• Ensure that surplus money in the central account is invested in an optimal fashion while
allowing sufficient liquidity
• All payments from local accounts above $10,000 require an approval from the CFO sitting in

This is a typical case where the company needs the services of a bank to manage its cash
collections and payments. The company needs both cash management facilities and MIS of
collections and payments that can allow it to track revenue and expenses in the manner

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.



• Payment service for corporations/retail customers

o Banks process payments on behalf of corporations – CMS provides its customers the
payment processing services which help corporations to reduce administrative hassles
and costs in doing so.
o Instruments - Checks/demand drafts/ Electronic Fund Transfer (EFT) help in processing
• Payment Initiation
o Manual instruction – Banks can act on manual instructions given by the corporations to
their bankers for processing payments. They typically take the form of checks or drafts
o Floppy/Electronic media instructions – A list of beneficiaries and the corresponding
amounts are given in either a floppy or another electronic media to their banks in the
required formats which are used by the banks for processing payments
o Electronic banking applications – Electronic applications like ECS / EFT or individual bank
specific software packages can be made use of by corporations to effect transfers
• Bulk payments

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CMS is very beneficial for processing repetitive / bulk payments in the nature listed below.
Economies of scale and reduction of administrative and related costs can be gained by
o Payroll processing
o Dividend warrants
o Redemptions


• Collect funds around the globe – CMS provides accurate and timely collection of receivables
• Funds are credited to the cash management account
o Local collections – Refer to collections from suppliers / debtors who issue local checks
o Outstation collections - Refer to collections from customers not in the base location of
the corporation

Banks have responded to the call for evolved cash management concepts. Accelerating accounts
receivable and streamlining accounts payable via a single banking system interface provide the
stepping stone to achieve optimal cash flow management. Some banks also provide aligned cash
management with liquidity and investment offerings. They do so by:

• developing optimal account structures

• applying cash concentration techniques like pooling and sweeping
• providing investment vehicles to maximize cash flows
• implementing foreign exchange and interest rate exposure netting systems
• Establishing regional treasury and shared service centers.
The final objective of most of these cash management solutions is to effectively outsource the
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.


There are possibilities for optimizing and streamlining a company’s incoming payment flows.
The most common collection mechanism is a checks lock box service – a collecting service which

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enables companies to collect and settle checks locally (In a typical case, each of the corporate’s
debtors would send checks along with accepted invoices to a designated post box, hence the
lock box name). Banks undertake to collect checks at various pre-defined locations on behalf of
the customer, send them for clearing and credit the amount s to a specified customer account.
Once the checks are collected by the bank through person, courier or delivered by the company

• the checks are sorted and batched

• post dated checks are kept for processing on the value date
• the image of the checks and the remittance advices are captured and sent to the corporate
• checks are sent for clearing, if required
• realized checks are tallied and amounts credited to the corporate’s bank account
• the information on checks collected is transmitted to the corporate for electronic
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.


Pooling allows a company or several companies belonging to the same group profit from
efficient liquidity management, centralized treasury and credit-line management and
optimization of interest results. Banks offer both domestic and cross border zero balancing
whereby all value balances of a set of 'participating' accounts are centralized at the end of each
day in one central account. Thus the participating accounts will not bear any credit or debit
interest, and all balances are concentrated in the central account enabling optimal management
of our cash position.

Netting is the fundamental method for centralizing and offsetting intra company and third party
payments. Netting not only significantly reduces payment flows and costs, but also provides
invaluable management information. Banks offer both domestic and cross-border netting

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.



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The Check Clearing for the 21st Century Act (Check 21) was signed into law on October 28,
2003, and became effective on October 28, 2004. The law facilitates check truncation by
creating a new negotiable instrument called a substitute check, which permits banks to
truncate original checks, to process check information electronically, and to deliver
substitute checks to banks that want to continue receiving paper checks. A substitute check
is the legal equivalent of the original check and includes all the information contained on the
original check. The law does not require banks to accept checks in electronic form nor does
it require banks to use the new authority granted by the Act to create substitute checks.
o Electronic transmission of checks by Check imaging - Banks find that exchanging
electronic images of checks with other banks is faster and more efficient than physically
transporting paper checks. To address this need, Check 21 allows a bank to create and
send a substitute check that is made from an electronic image of the original check.
o Faster / efficient check realization – Since the electronic image of the check can be
quickly transmitted electronically, time required for transporting the physical paper
checks is greatly reduced thereby effecting faster check realizations


Financial institutions and banks need to raise fresh capital to fund continuous asset growth and
portfolio management. This has become a major challenge for many financial institutions and
banks due to tough capital market conditions and other market related factors. Asset
securitization can offer an alternative cost efficient financing tool, enabling them to better
manage liquidity and funding requirements.

Asset securitization transactions have one basic concept: the identification and isolation of a
separable pool of assets that generate revenue streams independently from the originating
entity. The securities issued on these assets are then sold to investors who base their returns
exclusively on the underlying assets’ performance. The structure is illustrated below:

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All these entities need not be present in every transaction. The number of entities depends on
the complexity of the transaction. An example would help understand the concept better.


Bank of America (Originator) has 5000 home loans totaling more than $600 million. The
individual loans are of various credit profiles and various repayment periods. Bank of America is
constrained by lack of funds and wishes to sell off its loans to raise money. Thus, it decides to
‘sell’ about 2000 home loans totaling $200 million. The steps followed are shown below:

• Bank of America conducts an internal study of the portfolio and ascertains that the average
maturity of the pool of loans is about 12 years and the average credit rating would be AA-. It
realizes that historically 10% of the total home loan owners default. So it would only realize
$180 million instead of $200 million.

• Bank of America wants to enhance the rating so that it can ‘sell’ the loans at a better price.
It decides to provide cash security of $10 million (Credit enhancement) in the scenario of
any repayment default by home loan borrowers.

• Bank of America appoints Credit rating agency X which analyses the pool of loans, and taking
into account the cash security provided rates it AA+.

• Bank of America ‘sells’ the pool of housing loans amounting to $200 million to an
independent firm, Plexus SPV Ltd.

• Backed by these home 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 securitization transaction, but there are a lot of
structuring issues and legal and regulatory challenges involved in any such transaction.

Fannie Mae and Ginnie Mae are examples of institutions specializing in securitization
transactions of mortgage loans for US banks. They help US banks in having enough fresh funds
for home loan disbursements.


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

RTGS is a system provides online settlement of payments between financial institutions. In this
system payment instructions between banks are processed and settled individually and
continuously throughout the day. This is in contrast to net settlements where payment
instructions are processed throughout the day but inter-bank settlement takes place only
afterwards typically at the end of the day. Participant banks will have to maintain a dedicated
RTGS settlement account with the central bank for outward and inward RTGS payments.

RTGS systems do not create credit risk for the receiving participant because they settle each
payment individually, as soon as it is accepted by the system for settlement.
RTGS system can require relatively large amounts of intraday liquidity because participants need
sufficient liquidity to cover their outgoing payments.


The average daily turnover in global Forex transactions stand at almost USD 2 trillion, with
participants in the market spread across various geographies and time zones. However, the
difference in time zones and hence lack of synchronization of transactions has resulted in
considerable amount of systematic risk. Typically, one leg of a Forex trade is affected at one
point of time and there would be a delay before the other leg is executed because of time-zone
differences. In such a situation, there is a heightened risk of one party defaulting.

CLS eliminates this ‘temporal’ settlement risk, making same-day settlement both possible and
final. This is made possible by leveraging on the fact that there are significant overlaps between
the main time zones. CLS provides a specific time window in which various settlement time
zones can interact and pass settlement messages. The CLS system consists of the following

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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.


ACH transactions are electronic clearing transactions in which information about debits and
credits are passed across the clearing system through electronic data files rather than physical
instruments like checks, drafts etc. ACH electronic transactions are distinguished from wire
transfers in that they are high volume, regularly scheduled, usually between the same parties,
and are initiated via specifically formatted electronic files. Such transactions must usually be

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initiated one to two days prior to the settlement date, since they are batch processed and not
for immediate payment. The most common ACH payment applications are:

• Direct deposit of payroll, where the bank debits the corporate account and credits
employee accounts on the basis of a electronic file transmitted/provided by the corporate
• Corporate Disbursement Service, where the bank debits a client's account to initiate
payments to vendors on their behalf
• Corporate Collection Service, where the bank enables its clients to collect payments and
remittance data from vendors or trading partners.
• Collection of consumer payments over the telephone, through the Internet or via check-to-
ACH conversion.
• ACH Accounts Receivable Check Conversion enables converting checks collected at a lockbox
or remittance-processing center to ACH electronic debits, speeding payment collections and
improving funds availability.
These services allow the customer to increase transaction speed and improve accuracy and ease
of reconciliation by electronic means and avoidance of physical instruments and clearing delays.
ACH has been an area of very strong growth, with over 8.5 billion transactions being effected
through this route in 2002. However, several security issues remain to be resolved in this area.


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.


Banks provide Pre-shipment finance - working capital for purchase of raw materials, processing
and packaging of the export commodities.


Post-shipment financing assists exporters to bridge their liquidity needs where exports are made
under deferred payment basis. A typical example of post-shipment financing is bills discounting.

Bills discounting facility serves to provide liquidity to an exporter by advancing him/her a

portion of the face value of a trade bill drawn by the exporter, accepted by the buyer and
endorsed to the Bank.

In competitive supply situations, favorable terms of payment often ensure that the order is
won. An exporter usually wants to get paid as quickly as possible and an importer will want to

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pay as late as possible – preferably after they have sold the goods. Trade finance is often
required to bridge these two disparate objectives.


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?


• Costs: The cost of different financing methods can vary, both in terms of interest rates and
fees. These costs will impact the viability of a transaction
• Time Frame: Depending on the need, short, medium and long-term finance facilities may be
available. The different possibilities should be explored with the finance provider prior to
concluding a transaction. Long-term requirements should also be considered to ensure fees
are not being paid out on a revolving facility that could be saved by using a different
financing structure
• Risk Factors: The nature of the product or service, the buyers’ credit rating and
country/political risks can all affect the security of a trading transaction. In some cases it will
be necessary to obtain export insurance or a confirmed letter of credit. Increased risks will
normally correspond to increased cost in a transaction and will normally make the funding
of a particular transaction, harder to obtain
• Government Guarantee Programs: These can sometimes be obtained where there is some
question over the 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


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.

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The BOL grants the carrier the right to sub-contract its obligations on any terms and would bind
a shipper even if it meant that the shipper's goods could be detained and sold by the sub-


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


Once acceptable risks have been determined then the most appropriate payment method can
be selected. The most common payment methods are described below:

• Cash in advance
• Letter of credit
• Documentary collection
• Open account or credit
• Counter-trade or Barter

Cash in advance 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


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• Bank’s SWIFT and/or ABA numbers

• Seller’s full name, address, telephone, type of bank account, and account number.


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.

• 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.
• 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.

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The buyer can sometimes approve the release of payment if a condition is not fulfilled; but
changing terms after the fact is costly, time consuming and sometimes impossible.
The mechanism
Usually, four parties are involved in any transaction using an LC:

1. Buyer or Applicant

The buyer applies to his bank for the issuance of an LC. If the buyer does not have a
credit arrangement with this issuing bank then he must pay in cash or other negotiable
2. 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.

3. 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.

4. Beneficiary or Seller

The beneficiary must ensure that the order is prepared according to specifications and
shipped on time. He must also gather and present the full set of accurate documents, as
required by the LC, to the bank.

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Letter Of Credit Diagram‡‡

1. Buyer and seller agree on a commercial transaction.

2. Buyer applies for a letter of credit.

3. Issuing bank issues the letter of credit (LC)

4. Advising bank advises seller than an LC has been opened in his or her favor. Seller sends
merchandise and documents to the freight forwarder.

5. Seller sends copies of documents to the buyer.

6. Freight forwarder sends merchandise to the buyer’s agent (customs broker).

7. Freight forwarder sends documents to the advising bank.

8. Issuing bank arranges for advising bank to make payment.

9. Advising bank makes payment available to the seller.

10. Advising bank sends documents to the issuing bank.

Letter of Credit Diagram and the 14 steps have been reproduced from

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11. Buyer pays or takes loan from the issuing bank.

12. Issuing bank sends bill of lading and other documents to the customs broker.

13. Customs broker forwards merchandise to the buyer.

Letters of credit can be flexible. Some LC variations include: Revolving, Negotiable, Straight, Red
Clause, Transferable, and Restricted. But perhaps the safest type of letter of credit from the
seller’s point of view is the Standby letter of credit.
An Asian Buyer from a Swedish Exporting company stated when he convinced the Exporter to
sell to them on open account terms. The Asian Buyer obtained 60 days credit, which was to be
calculated from the date of the invoice. The value of the order was USD 100, 000 and the goods
were dispatched and invoiced by the Swedish Exporter on the 15th July 2003.

The payment from Asia was due on the 14th Sept 2003. The payment eventually arrived on the
21st Nov 2003, over two months late. The delay in payment cost the Exporter USD 1700 as it
resulted in his account being overdrawn by this amount for 68 days at 9% per annum.

What if confirmed Letter of Credit had been required?

If Swedish exporter had insisted on receiving a confirmed Letter of Credit through Allied Swedish
Banks plc., the following costs (approximations) would have applied:

Confirmation Fee USD $250

Acceptance Commission (@ 1.5% pa for 60 days) USD $250
Negotiation / Payment Fee USD $150
Out of Pocket Expenses (estimate) USD $60
Total Letter of Credit Cost USD $710
Interest Cost as a result of late payment USD ($1,700)
Benefit of using Letter of Credit USD $990
Advantages of Letter of Credit
• A Guarantee of payment on the due date from Allied Swedish Banks. (Provided the terms
and conditions of the Letter of Credit were complied with).
• A definitive date for the receipt of funds, particularly important for devising proper currency
hedging strategies.
• The opportunity to receive the payment in advance of the due date through non-recourse
discounting of the receivable.
Also note that the costs incurred in chasing the debt from the Asian buyer has not been
accounted for the Irish Exporter. In addition if the Exporter had sold his foreign currency
receivable on a forward basis to his bank for the original due date, they may have incurred a
further cost in canceling or rearranging the forward contract. Letters of Credit provide real and

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tangible benefits to companies. In this case the Swedish exporter only lost US$ 1700. Of course
if the Asian buyer had not paid at all they would have lost the whole USD 100,000

The standby LC is like a bank guarantee. It is not used as the primary payment method but as a
failsafe method or guarantee for long-term projects. This LC promises payment only if the buyer
fails to make an arranged payment or fail to meet pre-determined terms and conditions. Should
the buyer default, the seller must then apply to the bank for payment - a relatively simple
process without complicated documentation. Since the standby LC can remain valid for years
(Evergreen Clause) it eliminates the cost of separate LCs for each transaction with a regular

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.

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.


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.

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

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a destination without a buyer. There is no recourse with the banks since their responsibility ends
with the exchange of money for documents.


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.


Bankers Acceptances sell at a discount from the face value:

Face value of Bankers Acceptance $1,000,000

Minus 2% per annum commission for one year -$20,000

Amount received by exporter in one year $980,000


In practice, international payment methods tend to be quite flexible and varied. Frequently,
trading partners will use a combination of payment methods. For example: the seller may
require that 50% payment be made in advance using a wire transfer and that the remaining 50%
be made by documentary collection and a sight draft.


Open account 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

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useful in securing payment from a recalcitrant buyer when his country’s legal system recognizes
them and allows for reasonable settlement of such disputes.


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.

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 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 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

Factoring is for short-term receivables (under 90 days) and is more related to receivables against
commodity sales.

The exporter sells accounts receivables to a forfaiter on a “non-recourse discount” basis, and
the exporter effectively passes all risks associated with the foreign debt to the forfaiter. The
forfaiter may be a forfaiting house or a department of a bank. The benefits are same as factoring
- maximize cash flow and eliminate the payment risk. It is a flexible finance tool that can be used
in short, medium and long-term contracts.

Forfaiting can be for receivables against which payments are due over a longer term, over 90
days and even up to 5 years.

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An Asian Importer wants to purchase machinery that he is unwilling or unable to pay

for in cash until that machinery begins to generate income.

At the same time, the exporter wants immediate payment in full in order to meet his on-
going business commitments

Forfaiting solution works as follows

1. Commercial contracts are negotiated subject to finance;

2. The importer arranges for an Irrevocable Letter of Credit to be issued or for a

series of Promissory Notes or Bills of Exchange to be drawn in favor of the
exporter which the importer arranges to have guaranteed by his local bank;

3. The exporter contacts the discounting bank (the forfaiter) for a rate of discount
which is then agreed;

4. The goods are shipped;

5. The notes or bills are sent with shipping documentation and invoices to the
discounting bank via the exporter (who endorses the notes or bills "without
recourse" to the order of the discounting bank);

6. The discounting bank purchases the guaranteed notes or bills from the exporter
at the agreed rate.

Result: the exporter receives payment in full immediately after shipping (against
presentation of satisfactory documentation to the forfaiter); the importer gets his
goods and can pay for them in installments over time; and the forfaiter has title to an
asset which he may retain as an investment.


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) 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.



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

All Fedwire transfers are completed on the day they are initiated, generally in a matter of
minutes. They are guaranteed to be final by the Fed as soon as the receiving institution is
notified of the credit to its account.

Until 1980, Fedwire services were offered free to Federal Reserve member commercial banks.
However, the Depository Institutions Deregulation and Monetary Control Act of 1980 required
the pricing of Fed services, including funds and securities transfers, and gave nonmember
depository institutions direct access to the transfer system. To encourage private-sector
competition, the law requires the Fed's fees to reflect the full cost of providing the services,
including an implicit cost for capital and profitability.

How Fedwire Works


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Transfers over Fedwire require relatively few bookkeeping entries. Suppose an individual or a
private or government organization asks a bank to transfer funds. If the banks of the sender and
receiver are in different Federal Reserve districts, the sending bank debits the sender's account
and asks its local Reserve Bank to send a transfer order to the Reserve Bank serving the
receiver's bank. The two Reserve Banks settle with each other through the Inter-district
Settlement Fund, a bookkeeping system that records Federal Reserve inter-district transactions.
Finally, the receiving bank notifies the recipient of the transfer and credits its account. Once the
transfer is received, it is final and the receiver may use the funds immediately. If the sending and
receiving banks are in the same Federal Reserve district, the transaction is similar, but all of the
processing and accounting are done by one Reserve Bank.

6.6.2. CHIPS

CHIPS, Clearing House Interbank Payments System, are the premier bank-owned payments
system for clearing and settling large value payments. CHIPS is a real-time, final payments
system for U.S. dollars that use bi-lateral and multi-lateral netting for maximum liquidity
efficiency. CHIPS is the only large value system in the world that has the capability of carrying
extensive remittance information for commercial payments. CHIPS processes over 267,000
payments a day with a gross value of over $1.37 trillion. It is a premier payments platform
serving the largest banks from around the world, representing 22 countries worldwide.

6.6.3 SWIFT

The Society for Worldwide Interbank Financial Telecommunication (SWIFT) runs a worldwide
network by which messages concerning financial transactions are exchanged among banks and
other financial institutions. As of December 2001, it linked over 7000 financial institutions in 194
countries and estimates that it carried payments messages averaging more than six trillion US
dollars per day. SWIFT network is used for transfers across different countries and in all

SWIFT is a co-operative society under Belgian law, owned by its member financial institutions
with offices around the world. SWIFT’s headquarters are located in La Hulpe near Brussels. It
was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to establish
a common language for financial for financial transactions and a shared data processing system
and worldwide communications network. Fundamental operating procedures, rules for liability,
etc. were established in 1975 and the first message was sent in 1977.

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The above “International Payments Comparison Chart” is reproduced from US Department of
Agriculture website - Pub.

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• 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
• 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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Investment Management refers to the managing and investment of funds by financial

institutions, on behalf of their customers. The investment is done in securities like stocks, bonds
and derivatives, as well as other investment avenues like precious metals, real estate,
commodities, etc. The role of the investment manager is to obtain for their customers a superior
return on their capital. ‘Superior return’ means adding value in the following ways:

• Making better decisions than their clients could, due to their research capacity and
investment skills.

• Providing a level of investment diversification through the pooling of funds that their clients
could not achieve.

• Using their breadth of knowledge to fulfill the investment objectives of the portfolio, e.g.,
providing an acceptable pension for their client.

The return on investment is compared to a benchmark, often constructed from the returns
obtained by rival asset managers, this comparison being used by investors to assess the asset
manager’s performance. The investment manager is also responsible for ensuring that the
client’s individual preferences and needs are observed, e.g., level of risk-appetite, liquidity
needs, tax implications, etc. Investment Managers usually look after more than one client, each
client’s capital being segregated into a ‘fund’ or ‘portfolio’.

Investment Management is also referred to variously as Asset Management, Fund management

and Portfolio management; while managing of investment for high-net-worth individuals (HNI)
is called Wealth management or Private Banking.
Investment Management aims at the following goals:

• Manage investors money efficiently and cost effectively

• Generate superior investment returns

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• Ultimate objective is to deliver equity type returns with lesser volatility risk and achieve
capital preservation
In achieving the above goals, an Investment 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 worldwide stocks reduces risk and improves
• 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.
Investment management services are usually offered by firms that specialize in managing an
investor’s money. These firms employ individuals known as portfolio managers who are
responsible for taking the decision on which type of assets to invest it to best suit the investors


The end-to-end Investment Management process starts from acquisition of a client and opening
a customer account, and ends with portfolio accounting, updating of shareholder account
balances, and performance reporting.

Following is a high-level chart showing the typical Investment Management processes:


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The basic activity in any asset management process is to be able to get more and more people
to subscribe to his activities in order to enlarge the scope of his activities and earn a higher fee.

The Sales and marketing team of any Wealth Management company interfaces with the clients
and ensures widening to new relationships and deepening of the existing ones. This division in
turn draws heavily on the other functions of research, portfolio management and other areas in
order to sell the Investment management company’s services to the clients.

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Another related area for the Sales and Marketing team is often to be in touch with the issuers in
order to get into lucrative deals that enable the company to generate better returns for its
clients’ portfolio.

Wealth Management service providers usually have sales and marketing offices in all big
financial centers across the globe. The sales personnel keep in personal touch with prospects
and usually communicate via phone or personal meetings. This is important as the clients
usually are very rich and want to maintain secrecy about their financial matters.
Needs Analysis process focuses on definition of what shareholder wants to achieve in a defined
time frame. The Portfolio Manager would understand what needs the shareholder is trying to
fulfill by making investments. This is an important process because no two shareholders are
alike. The investments to be made should be channelized in instruments, which help the
shareholder achieve his overall investment objective.

The Portfolio Manager would also define the Life Events of the shareholder while doing needs
analysis. Life events can be any event which specifically needs extra money to achieve like a
wedding, buying a new house, buying the latest Porsche Carrera or retirement planning. The
aim is to account for any intermediate requirements before meeting the overall goal.

While a shareholder can define an objective and provide an initial sum of money to invest to
start off, not all objectives can be necessarily met. Objectives set by the shareholder may need a
certain amount of risk taking as otherwise the initial investment made by the shareholder might
not be enough to get to the objectives. This tie up with the basic financial premise: Higher the
risk involved in an investment, higher the expectation of the return from the investment.

Portfolio Manager would hence typically administer the shareholder a questionnaire, which
would help the manager decide what kind of the risk the shareholder can take. Using the
answers provided by the shareholder, the Portfolio Manager would arrive at a Risk Profile for
each individual investor. Risk profile defines how much risk the shareholder can take on a
sustainable basis. It is a function of demographic factors like age, years remaining until
retirement, and family structure, economic factors like current nature of job, earning potential
and psychological factors like response to financially negative events, risk appetite, etc.

At the heart of Investment management are the investment managers whose job is to invest
and divest client monies Asset allocation is an investment portfolio technique that aims to
balance risk and create diversification by dividing assets among major categories such as cash,
bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk,
so each will behave differently over time

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After rationalizing the shareholder’s investment objectives using the risk profile, the Portfolio
Manager would decide how to allocate the shareholder’s investment to various asset classes.

An asset class is a group of financial instruments with similar risk and return characteristics. For
example, Equities is an asset class. Similarly, Fixed Income instruments, Real Estate and
Derivatives can all be classified as asset classes.

Asset allocation is generally of two types:

• Passive -Depending on the risk preferences, cash needs and tax status of the investor a mix
of assets is determined for diversification of asset allocation and taking into account the
macro economic factors like recession and inflation

• Active - The mix of assets is determined by market views

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 macroeconomic events such as
recessions or inflation. Diversifying across asset classes will yield better tradeoffs 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.

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 overvalued and is ripe for a
correction, while real estate is undervalued, 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

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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.


Fund managers generally adopt an individual 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. 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

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 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

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"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.

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.


Portfolios are created after the asset allocation has been finalized. The next task is selecting
rationally the kind of stocks and other financial instruments that should form part of the
intended investment basket. Thereafter, it calls for constant revision of the portfolio depending,
if so called for by the style of management chosen. Of course, as with any other assignment,
there comes a time for the financial advisor to evaluate as to how the portfolio has fared both in
absolute and relative terms. While managing a client’s portfolio, it is imperative that the
financial advisor looks for avenues and opportunities for making additional money through non-
conventional ways for the client. Given the fact that a financial advisor is a fiduciary, he should
do everything that is professionally possible to immunize the client’s portfolio from unexpected
risks and events.

Performance of the portfolio is measured both in absolute and relative term. Portfolio
performance is always measured with respect to the risks taken. Also, performance should be
reckoned taking into account the circumstances and the restrictions.

Another important aspect of Portfolio Management is Portfolio Performance Reporting. These

reports contains details of annualized return, holding period return, dispersion of returns,
portfolio risk measure, asset-class wise return, performance attribution information, etc. In
respect of each asset class, there are drill-down reports made available to the client.


Research is one of the primary inputs towards deciding what kind of asset or financial
instrument to invest in. It involves performing a variety of qualitative and quantitative analysis
to determine the ideal portfolio mix. His includes an in depth analysis about the institution
issuing the instrument, estimating future growth, industry analysis, trend analysis of historical

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prices etc. Some of the pre-requisites for performing meaningful research to aid investment
decision making are as follows:

The first step is to put together a dedicated research team. It is critical that the team members
not only understand the financial market dynamics but also have knowledge on Model building
and Econometrics. The success of the research team is usually evaluated relative to a
benchmark return.

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.

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.

Investment firms have dedicated research teams, which take immense pride in data mining and
coming out with their views on all sorts of investment opportunities available in the market.
These research reports draw on a rich source of data, advice and statistical tools that are not
readily available to small individual and institutional investors.

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Assessment of Industry

Interview of Company

Analysis Report

Analysis of competition

Information as available from

Suppliers, Distributors, Major
Customers and other
Independent Sources



So an investor has established an asset-allocation strategy that is right for him, but at the end of
the year, he finds that the weighting of each asset class in his portfolio has changed! What
happened? Over the course of the year, the market value of each security within his portfolio
earned a different return, resulting in a weighting change. As the value of his investments
increases or decreases, or his life changes, he may want to modify his initial asset allocation. In
fact, there are several situations when that’s likely to be the case:

1. As he gets closer to retirement, he may want to shift some of his assets out of potentially
volatile growth investments, such as stocks, into income-producing investments with more
stable values.

2. He may want to rebalance his plan in response to major life events that have an impact on his
financial situation, such as getting married or divorced, having children, or changing jobs.

3. If market performance increases or decreases the value of one asset class so that his actual
portfolio allocation is significantly different from the allocation he selected, he may want to
realign his holdings to get them back in balance.

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Rebalancing is the process of buying and selling portions of one’s portfolio in order to set the
weight of each asset class back to its original state. In addition, if an investor's investment
strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the
weightings of each security or asset class in the portfolio to fulfill a newly devised asset
allocation. Portfolio rebalancing is like a tune-up for one’s car: it allows individuals to keep their
risk level in check and minimize risk.

Portfolio rebalancing helps to keep investments in line with the investment strategy. The idea
behind rebalancing is to reduce risks created by the buildup of an inconsistent sum of money in
any given market sector. Portfolio rebalancing is not an attempt to time the market, but rather a
timely reassessment and modification of an investor's target goals.


Rebalancing is a vital part of investment strategy. There can be no asset allocation target
without a stated pledge to preserve the target. It is necessary to achieve the value added
benefits of diversification. Periodically putting one’s investments back in order by shifting
money among asset classes is a necessary chore for investors who devise an asset-allocation
strategy--whether the market goes up or down. The primary purpose of rebalancing is to
maintain a consistent risk profile. It also provides a regular plan of action. Rebalancing
accomplishes the reduction of assets that performed best (or worst) and the reinvestment of
those proceeds into other assets to bring the portfolio to its original balance.

Portfolio rebalancing is a powerful risk-control strategy. Over time, as a portfolio’s different

investments produce different returns, the portfolio drifts from its target asset allocation,
acquiring risk and return characteristics that may be inconsistent with an investor’s goals and
preferences. A rebalancing strategy addresses this risk by formalizing guidelines about how
frequently the portfolio should be monitored, how far an asset allocation can deviate from its
target before it’s rebalanced, and whether periodic rebalancing should restore a portfolio to its
target or to some intermediate allocation.


Portfolio Risk Management is the process of measuring and assessing one’s portfolio's exposure
to market risk. There can be three views on risks, allowing us to compare our portfolio to the

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market portfolio (S&P 500) in terms of Risk-Adjusted Return, Value-at-Risk (VaR), and Market
Risk Exposure (Alpha, Beta and R-squared).

Portfolio Risk Analysis is important because it provides a powerful tool for assessing portfolio's
risk, both relative to the market and to the risk level we desire to maintain.

Various risks associated with an investment are as follows:

1. Business Risk: This is the risk associated with the uncertainty of a company's future cash
flows, which are affected by the operations of the company and the environment in
which it operates.
2. Financial Risk: This is the risk associated with the uncertainty of a company's ability to
manage the financing of its operations. Essentially, financial risk is the company's ability
to pay off its debt obligations.
3. Liquidity Risk: This is the risk associated with the uncertainty of exiting an investment,
both in terms of timeliness and cost. The ability to exit an investment quickly and with
minimal cost greatly depends on the type of security being held.
4. Exchange Rate risk: This is the risk associated with investments denominated in a
currency other than the domestic currency of the investor. For
example, an American holding an investment denominated in Canadian dollars is subject
to exchange-rate risk.
5. Country specific risk: This is the risk associated with the political and
economic uncertainty of the foreign country in which an investment is made. These risks
can include major policy changes, overthrown governments, economic collapses and


(VaR) is a category of risk metrics that describe probabilistically the market risk of a trading
portfolio. Value-at-risk is widely used by banks, securities firms, commodity merchants, energy
merchants, and other trading organizations. Such firms could track their portfolios' market risk
by using historical volatility as a risk metric. They might do so by calculating the historical
volatility of their portfolio's market value over a rolling 100 trading days. The problem with
doing this is that it would provide a retrospective indication of risk. The historical volatility
would illustrate how risky the portfolio had been over the previous 100 days. It would say
nothing about how much market risk the portfolio was taking today.

For institutions to manage risk, they must know about risks while they are being taken. If a
trader mis-hedges a portfolio, his employer needs to find out before a loss is incurred. Value-at-
risk gives institutions the ability to do so. Unlike retrospective risk metrics, such as historical
volatility, value-at-risk is prospective. It quantifies market risk while it is being taken.

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Any investment management process shall deal with the most important activity of buying and
selling of various securities depending upon the state of the market and the view taken by the
portfolio manager. Such trading activities need a lot of monitoring and have to be settled in
accordance with the market practices.

The Order Management system provides functions for deal recording, compliance and back
office integration. Dealers can record the detail of orders and track the confirmation process.
The status of the orders can be monitored across all workstations in the dealing room. The
system enables dealers to share a common database with the back office and provides the
dealers on-line access to shareholders actual cash and investment positions and limits. Allocated
deals are sent to the back office electronically for the computation of contract details (charges,
commissions, etc), for printing the contract notes and to start the settlement process.


An order represents intent to buy or sell. Market orders request execution at the most
advantageous price obtainable after the order is presented in the market (Trading Crowd). Limit
orders request execution at a specified price or better; they will be executed only if and when
that price is reached. In addition to these two basic types of orders there are several order types
specifying further conditions for execution (e.g., sell plus, buy minus, good ’til cancelled and stop
loss). Orders also carry qualifications regarding trade settlement (e.g., regular way, cash, and
next day). Finally, orders can be subdivided into member orders (for a member’s own account)
or public orders (submitted by a member on behalf of a non-member, such as a retail client).

Electronic trading system is replacing the earlier used Open outcry system. NYSE supports both
electronic trading as well as Floor broker trading (that is Open Outcry). Most European
exchanges support electronic trading.



Trade Reporting and Dissemination

The Exchange disseminates, in real time, trade information consisting of symbol, execution
price, trade size, and special trading conditions. Occasionally, the Exchange disseminates
additional messages indicating, for example, delayed openings and trading halts.

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Exchanges require member firms to report both own-account and customer-account trades
effected outside business hours as well as in foreign markets to the exchange. Member firms
need not report program trading transactions they already report to the Exchange. Member
firms must report the date and time of the transaction; symbol; price; number of shares; where
the transaction was executed; whether the transaction was a buy, sell or cross; whether it was a
principal or an agency transaction; and the name of the contra-side broker-dealer.

Position Maintenance

The function of Record Keeping and Position Maintenance is typically performed by Custodians.
Custodians are settling entities in a Trade Cycle. It is mandatory for institutional investment
managers to appoint a custodian. The custodian is responsible for the settlement of trades
done by the broker/dealers. In case of physical settlement all post trade activities like the
physical settlement of securities, getting the securities transferred; safe-keeping of the
securities is done by the Custodian. In case of a paperless or electronic settlement environment,
the Custodian maintains the securities account balances in electronic form. The account
balances may be held at a Position level as well as a Tax Lot level. A Custodian’s systematic
record keeping system helps to track the owner of the Security as on a particular date.
Trade Allocation

As described earlier, when a single investment manager is responsible for multiple fund
accounts, the order for similar securities from such fund accounts are normally consolidated and
sent to the trading desk. The trader can either place a single order for the portfolio order or
merge/split several orders and send it as a block order for execution. Since a trade order is
typically a block order on a security for multiple accounts or funds, when a notice of execution is
received, it has to be allocated back to the accounts in the form of allocations.
Portfolio Accounting
Given the fact that a Pooled Investment Vehicle invests more or less its entire corpus primarily
in such assets that undergo change in value every day, the overall value of its portfolio keeps
varying dynamically. In turn, this means, the pro rata value of units held by individual investors
also keeps changing from day to day. So, it is essential that pooled funds evaluate and publish
the value of the units issued by them to their investors. This value is arrived on the basis of Net
Asset Value (NAV) computation.
NAV is the actual value of the investments made by the pooled fund for each unit issued by it. It
changes almost on a daily basis as the market prices of individual securities in its portfolio
fluctuate. It is computed by the formula given below:

NAV = Market Value of Asset s – Liabilities___

Number of units outstanding

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More specifically it will be:

NAV = (Value of investments + Receivables +Accrued Income – Accrued Expenses +Other

Current Assets – Liabilities) / Number of units outstanding

Therefore a PIV’s NAV would be affected by 4 sets of factors:

• Purchase and sale of investment securities
• Valuation of all investment securities (portfolio) held
• Other assets and liabilities
• Units sold or redeemed

We know that the value of the mutual fund varies with the value of the portfolio, as the prices
of the securities, which constitute the portfolio, fluctuate day to day. As the intrinsic value of the
security represents the fair value of the security, the NAV represents the fair value of a unit in a
mutual fund.

The accounting team performs the all-important function of tracking the performance of the
firm and drawing up its P&L. It calculates the fees, charges and other such heads that are to be
recovered from the clients. The accounting team ensures that the overall financial impact of all
the activities of the Wealth Management firm is recorded and taken into account.

Fund performance is the acid test of investment management, and in the institutional context
accurate measurement a sine qua non. For that purpose, institutions measure the performance
of each fund (and usually for internal purposes components of each fund) under their
management, and performance is also measured by external firms that specialize in
performance measurement. The leading performance measurement firms (e.g. Frank Russell in
the USA) compile aggregate industry data e.g. showing how funds in general performed against
given indices and peer groups over various time periods.

In a typical case (let us say an equity fund), then the calculation would be made (as far as the
client is concerned) every quarter and would show a percentage change compared with the
prior quarter (e.g. +4.6% total return in US dollars). This figure would be compared with other
similar funds managed within the institution (for purposes of monitoring internal controls), with
performance data for peer group funds, and with relevant indices (where available) or tailor-
made performance benchmarks where appropriate. The specialist performance measurement
firms calculate quartile and decile data and close attention would be paid to the (percentile)
ranking of any fund.

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Generally speaking it is probably appropriate that an institution should persuade its clients that
performance be assessed over a longer period e.g. 3 or 5 years to smooth out very short term
fluctuations in performance and the influence of the business cycle. This can be difficult
however and, industry wide, there is a serious pre-occupation with short-term numbers and the
effect on the relationship with clients (and resultant business risks for the institutions).

Within each marketplace, a regulatory environment exists in order to ensure that the market
operates in a fair and orderly manner. The regulator is the rule-setter and ‘umpire’ of the game.
This encompasses a number of facets of operation relating to stock exchange / market members
such as:

• Transaction reporting

• Trading rule breaches

• Taking position that is disproportionate to the member’s financial position

Closely associated with reporting is compliance. Compliance refers to knowing and operating in
accordance with laws and rules existing in the country where the trade is taking place. In this
context we shall cover some of the relevant Acts which different entities in the securities
markets have to comply with.

Investment management is a fee based activity. In case of Fee based brokerage programs, the
active traders pay a flat asset-based fee (usually about 1%) for all trading activity instead of a
commission on individual trades. There is usually a limit on the number of trades per period.
After that, the client is usually charged a commission.

In case of hedge funds, the managers charge a fee based on performance rather than the asset



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

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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 $1 million of investable
assets. As per the World Wealth Report 2008 by Merrill Lynch / Cap Gemini, there are currently
over 10.1 million millionaires in the world with a combined asset base exceeding US$ 40.7
trillion which is projected to grow to reach US$ 59.1 trillion by the end of 2012.

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

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

Management of a Client’s liquidity (cash etc) needs through short-term 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 one’s current account into a higher yielding reserve account, optimizing his/her
return on short-term cash. Funds are on call so they remain easy to access.

Structured Lending

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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

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%.


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.



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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.

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.


• Sales and Marketing / Client Prospecting

• Client Management, Servicing and delivery
• Financial Planning
• Portfolio Analysis and Optimization
• Market Activities
• Research
• Compliance controls.


The high-level process flow for private banking is shown below. The roles and responsibilities of
the various players are outlined below.

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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 in a generic sense is the
systematic planning and control of any asset throughout its life. This may include the
specification, buying, holding, modification (change in holding quantities) while in use, and its
disposal when no longer required.

Asset Management is the art of professionally managing premium client’s assets with a view to
maximize client’s benefit. If the clients are large institutions like a corporation’s pension fund,
university endowment fund, insurance company portfolio etc., it is called Institutional Asset

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Institutional money managers are independent financial advisory firms organized and licensed
under the Security and Exchange Commission or Banking Laws' oversight agency of the country.
Institutional Asset Management service can be both Advisory or Fund handling and investing on
behalf of the customer.

Since, Institutional Asset Management is just another variant of Investment Management, so for
all practical purposes, the processes, entities, business organization etc. will remain the same.
The differences, if any, will be brought forward as we proceed along in the chapter.

Distinction from generic Investment Management

Institutional money managers are distinguished by the fact that:

• They are under greater regulatory scrutiny from both state and federal authorities

• They provide exclusive service to their clientele who are typically institutions having
portfolios in excess of several million dollars.

• They are very selective in the clientele they service and first do an independent analysis of
that client's financial needs, goals, objectives, and risk tolerance.

• They charge competitive fees due to the fact that their clients entrust millions of dollars to
them for investing. Accordingly they are under greater scrutiny to provide attractive
performance returns.

• They can most often take on the role of a treasury and cash manager for institutional clients,
to manage their day to day liquidity requirements.

• A custodian is appointed to oversee the responsibility of safe-keeping the assets. Custodian

also acts as trustee of the assets of the institutional clients in most cases.

Asset Management Goals

Asset Management aims to achieve the following goals:

• Manage investors’ money efficiently and cost effectively

• Generate superior investment returns

• Deliver equity type returns with lesser volatility risk and achieve capital preservation

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Capital preservation is an important consideration for all institutional clients. The reason is that
these institutions can themselves be listed companies. While they want to make returns from
their cash holdings, investing in markets is not their primary business objective. They are looking
for better than bank returns, without taking too much of risk. Institutions are answerable to
their shareholders and hence would never want to lose money in investments.

Hence for institutional clients risk and liquidity management are very important features of the
investment decisions. Risk levels in all investments should be carefully monitored and
investments should be liquid – that is it should be easy to buy and sell the instruments
identified. Institutions might need cash at any point of time for meeting their core business
objectives; hence they would not prefer to invest in illiquid instruments.


A mutual fund is a fund that pools together money from many investors and invests it on behalf
of the group, in accordance with a stated set of objectives. Mutual funds raise the money by
selling shares of the fund to investors that includes individuals and institutions, much like any
other company can sell stock in itself to the public. These funds take the proceeds of the money
from the sale of the shares and invest it in other instruments like bonds, stocks etc. In return for
the money they give to the fund when purchasing shares, shareholders receive an equity
position in the fund and, in effect, in each of its underlying securities. For most mutual funds,
shareholders are free to sell their shares at any time, although the price of a share in a mutual
fund will fluctuate daily, depending upon the performance of the securities held by the fund.

Now, one can raise a simple question: why do people buy mutual funds when they can directly
buy the instruments that these mutual funds invest in? After all what is the need of having a
middleman? There are numerous reasons for investing in the mutual fund. They are:

• Diversification: With a mutual fund one can diversify the investment both across
companies and across asset classes. When some assets are falling in price, others are likely
to be rising, so diversification results in less risk than if one purchased just one or two
• Liquidity: Most mutual funds are liquid and it is easy to sell the share of a mutual fund.
• Low Investment Minimums: One doesn’t need to be wealthy to invest in mutual funds.
Most mutual funds will allow one to buy into the fund with as little $1,000 or $2,000.
• Convenience: When someone own a mutual fund, he/she doesn't need to worry about
tracking the dozens of different securities in which the fund invests; rather, all he/she need
to do is to keep track of the fund's performance.

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• Low Transaction Costs: Mutual funds are able to keep transaction costs low because they
benefit from reduced brokerage commissions for buying and selling large quantities of
investments at a single time.
• Regulation: Mutual funds are regulated stringently by the government. Thus this reduces
the risk for the end investor.
• Professional Management: Mutual funds are managed by a team of professionals, which
usually includes one mutual fund manager and several analysts.
So mutual funds are full of benefits. Now one must be wondering if the mutual fund what
the disadvantages of mutual funds are. There are plenty of disadvantages:
• Fees and Expenses: Most mutual funds charge management and operating fees that pay for
the fund's management expenses (usually around 1.0% to 1.5% per year). Moreover a few
mutual funds charge high sales commissions.
• Poor Performance: Mutual funds do not guarantee a fixed or high return. On an average
more than half of the mutual funds fail to do better than the market returns.
• Loss of Control: The mutual fund managers are the people who decide upon the strategy to
invest. Thus the investor loses the control of his money to the fund manager.
• Inefficiency of Cash Reserves: Normally a Mutual fund maintains a large cash reserve to
provide protection against simultaneous withdrawals. This provides investors with liquidity,
but due to the large cash reserve the mutual funds do not invest all cash in asset and thus
provide investor with lowered returns.


The mutual fund schemes can be classified according to both their investment objective (like
income, growth, tax saving) as well as the number of units (if these are unlimited then the fund
is an open-ended one while if there are limited units then the fund is close-ended).


Open-ended plans do not have a fixed maturity period. Investors can buy or sell units at NAV-
related prices from and to the mutual fund on any business day. These schemes have unlimited
capitalization, there is no cap on the amount one can buy from the fund and the unit capital can
keep growing. These funds are not generally listed on any exchange.

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Open-ended plans are preferred for their liquidity. Such funds can issue and redeem units any
time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a
daily basis. The advantages of open-ended funds over close-ended are as follows:

Any time entry option: An open-ended fund allows one to enter the fund at any time and even
to invest at regular intervals.

Any time exit option: The issuing company directly takes the responsibility of providing any time
entry and exit option. This provides ready liquidity to the investors and avoids reliance on
transfer deeds, signature verifications and bad deliveries.

Close-ended plans have fixed maturity periods. Investors can buy into these funds during the
period when these funds are open in the initial issue. Such schemes cannot issue new units
except in case of bonus or rights issue. However, after the initial issue, investor can buy or sell
units of the scheme on the stock exchanges where they are listed. The market price of the units
could vary from the NAV of the scheme due to demand and supply factors, investors’
expectations and other market factors


Mutual funds can invest in financial and non-financial assets. Depending on the nature of
investment (i.e., the type of asset in which the money is invested) we can have the following
category of Funds:
"Index fund" describes a type of mutual fund or Unit Investment Trust (UIT) whose investment
objective typically is to achieve the same return as a particular market index, such as the S&P
500 Composite Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total Market

"Stock fund" and "equity fund" describe a type of Investment Company (mutual fund, closed-
end fund, Unit Investment Trust (UIT)) that invests primarily in stocks or "equities". The types of
stocks in which a stock fund will invest will depend upon the fund’s investment objectives,
policies, and strategies. For example, one stock fund may invest in mostly established, "blue
chip" companies that pay regular dividends whereas another stock fund may invest in newer,
technology companies that pay no dividends but that may have more potential for growth.


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"Bond fund" and "income fund" are terms used to describe a type of Investment Company
(mutual fund, closed-end fund, or Unit Investment Trust (UIT)) that invests primarily in bonds or
other types of debt securities. The securities that bond funds hold will vary in terms of risk,
return, duration, volatility, and other features.


A money market fund is a type of mutual fund that is required by law to invest in low-risk
securities. These funds have relatively low risks compared to other mutual funds and pay
dividends that generally reflect short-term interest rates. Unlike a "money market deposit
account" at a bank, money market funds are not federally insured.

Money market funds typically invest in government securities, certificates of deposits,

commercial paper of companies, and other highly liquid and low-risk securities. While investor
losses in money market funds have been rare, they are possible.


Mutual funds can be further classified based on their specific investment objective such as
growth of capital, safety of principal, current income or tax-exempt income. In general mutual
funds fall into three general categories:

Growth Funds are those that invest for medium term to long-term capital appreciation.

Income Funds invest for regular Income.

Growth and Income/ Balanced Funds that tries to generate both regular income and long term
capital appreciation.

Sector Funds that have unique investment objectives.

Special Funds are special types of Mutual Funds.


Net asset value," or "NAV," of an investment company or a mutual fund is the company/fund’s
total assets minus its total liabilities. For example, if an investment company has securities and
other assets worth $100 million and has liabilities of $10 million, the investment company’s NAV
will be $90 million. Because an investment company’s assets and liabilities change daily, NAV
will also change daily. NAV might be $90 million one day, $100 million the next, and $80 million
the day after.

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The investment company/fund calculates the NAV of a single share (or the "per share NAV") by
dividing its NAV by the number of shares that are outstanding.

Some of the leading companies that offer mutual funds are:

• Fidelity Investments
• Vanguard
• ING Direct
• Bank of New-York Mellon


A separately managed account is a portfolio of securities owned directly by the investor and
managed by professional money manager in lieu of an asset-based fee. SMA or the separately
managed accounts provides the individual investors the same quality of service as offered to
institutional investors.

Separately managed accounts help investors build and manage their wealth by focusing on the
investor's individual investment goals, time horizon, and risk tolerance. To determine these, a
risk profile questionnaire is used. Clients receive a personalized Investment Policy Statement
that outlines goals and the investment vehicles necessary to help achieve them. From there, the
financial consultant chooses an asset allocation strategy that is used as a road map to achieve
objectives. The financial consultant then recommends the investment managers’ best suited to
manage the overall portfolio. Lastly, ongoing monitoring and review of the portfolio takes place
at both the financial consultant and investment manager level.


The key features of SMA are -:

• Direct ownership: The portfolio is held in a personal account rather than held as a part of
fund, thereby giving direct control to the investors.
• Exclusivity: The arrangement gives exclusivity to the investor as investment preference,
objectives and tax liability are not necessarily shared across a pool of investors.
• Customization: The security to be held and the investment pattern can be customized to
individual needs. E.g. a customer may not want to invest in those companies that are in
tobacco business. The portfolio can be customized to cater to his individual needs and

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• Tax advantages: In the case of traditional mutual funds, individual taxes are not an issue.
However, in case of SMA tax advantages to investor results from tax loss harvesting


• Separately managed accounts provide the client with the following benefits:
• The investors get access to top Investment managers at an affordable rate that they would
have been difficult otherwise.
• The fee structure is asset based and not commission based which offer a significant value to
the customer.
• The client is relieved of portfolio management functionality and he can concentrate on
other matters.
• The client gets better tax planning because of the tax-harvesting element in SMA.
• The transactions and the operations are more transparent to the customer as compared to
traditional mutual fund.
• The client gets customized reports about his portfolio.
• There is no requirement for the reporting of the holding and there is no specific governing
regulation unlike the mutual funds.
• There is no board in case of SMA, one hires the manager to manage the asset and there is
no board to sue if something goes wrong.
• Closing an SMA would require moving the individual’s security to another manager, which is
a complicated and time consuming exercise.
• It is difficult to find an appropriate comparable to benchmark the performance of SMA.


The key difference between a mutual fund and an SMA is that an SMA offers investors a
customized approach to investing, rather than a generic product. Usually, the process begins
with an assessment by an adviser of the individual’s financial needs and goals. The adviser can
then recommend a variety of portfolio strategy options, which are customized to meet each
investor’s needs. Once the strategy has been agreed, a professional portfolio manager buys and
sells stocks and bonds in the portfolio on the investor’s behalf. The financial adviser then keeps
a close eye on the portfolio’s performance.

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As the portfolio is tailored to meet both long- and short-term cash needs, an SMA, unlike a
mutual fund, can take into account personal investment preferences, such as not investing in
particular stocks for personal, social or environmental reasons. For e.g. an investor may specify
that his/her portfolio should not contain any stock belonging to TOBACCO companies.

Also unlike mutual funds, the investor has direct ownership of the stocks and bonds within the
portfolio. This can facilitate tax management strategies.

Some of the leading investment managers offering SMA services are:

• Merrill Lynch Investment Management ( now acquired by BOA)

• Brandes Investment Partners
• Nuveen Investments
• Alliance Capital
• Morgan Stanley Investment Management


The first private pension plan in the United States was established in 1875 by the American
Express Company and was soon followed by pensions provided by utilities, banking, and
manufacturing companies. Almost all of the early pension plans were traditional pension plans
— known as defined benefit plans — that paid workers a specific monthly benefit at retirement.

A Retirement Pension Plan is any plan or program maintained and sponsored by an employer,
an employee organization or both. It is designed to provide retirement income to employees or
to give the employee an opportunity to defer income for retirement. Employer-sponsored
retirement plans are intended to supplement Social Security benefits and personal savings, a
concept often referred to as the "three-legged stool". The only leg of this stool that is
mandatory is Social Security benefits. A retirement plan could be qualified or non-qualified.

All private pension plans have favorable tax treatment. There are three tax advantages:

• Pension costs of a firm are, within limits, tax deductible;

• Investment income of a pension fund is tax exempt; and

• Pension benefits are taxed when paid to retirees, not when earned by workers.

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A qualified retirement plan is a plan that meets specific requirements of the Internal Revenue
Code (IRC), the Department of Labor (DOL) and Employee Retirement Income Security Act
(ERISA). Qualified plans are afforded favorable tax treatment in exchange for meeting these
requirements. The Internal Revenue Service (IRS) determines if the plan is qualified.

ERISA provides these minimum standards for plan qualification. It requires that a plan:

• Be a definite, written, permanent program;

• Be communicated to employees;

• Abide by the Exclusive Benefit Rule;

• Must not discriminate in favor of any particular group of employees, such as Highly
Compensated Employees (HCEs); and

• Must meet special nondiscrimination testing requirements.

When the IRS determines that a plan meets all the requirements for a qualified plan, it sends a
Letter of Determination to the plan administrator.

Employers who wish to provide benefits to certain key employees on a discriminatory basis can
do so through a non-qualified plan. A non-qualified plan may provide benefits to key employees,
while excluding other employees. Contributions made to non-qualified plans do not enjoy the
tax advantages of a qualified plan.



This promises a specified monthly benefit at retirement. The plan may state this promised
benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it
may calculate a benefit through a plan formula that considers such factors as salary and service

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— for example, 1 percent of average salary for the last 5 years of employment for every year of
service with an employer. The benefits in most traditional defined benefit plans are protected,
within certain limitations, by federal insurance provided through the Pension Benefit Guaranty
Corporation (PBGC).


This on the other hand, does not promise a specific amount of benefits at retirement. In these
plans, the employee or the employer (or both) contribute to the employee's individual account
under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These
contributions generally are invested on the employee's behalf. The employee will ultimately
receive the balance in their account, which is based on contributions plus or minus investment
gains or losses. The value of the account will fluctuate due to the changes in the value of the
investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans,
employee stock ownership plans, and profit-sharing plans.

Combine elements of both defined benefit and defined contributions plans, but do so in a way
that gives the employer a more precise projection of future obligations. Typically, an employer
contributes a defined amount annually, based on compensation and guarantees that the
account will grow by a fixed percentage annually. A worker reaching retirement age can typically
take the accrued amount either as a lump sum or an annuity. Converting existing defined
benefit plans into cash balance plans has spawned some thorny legal questions about how to
fairly deal with senior workers. After a spate of cash balance conversions by large employers,
political controversy and an absence of government guidance on what transition rules are
appropriate has deterred many employers interested in making such a change from doing so in
recent years.

These allow a person to set aside and invest a contribution each year in an individual account.
There are several different types of IRAs, and in recent years Congress has expanded them for
non-retirement purposes (such as education). IRAs are typically used as a holding vehicle for
money that is "rolled over" from another retirement plan upon job change, such as a 401(k).

These are tax-deferred retirement accounts for self-employed workers or persons employed by
unincorporated businesses.

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There is no exact definition to the term “Hedge Fund”; it is perhaps undefined in any securities
laws. There is neither an industry wide definition nor a universal meaning for “Hedge Fund”.
Hedge funds, including fund of funds are unregistered private investment partnerships, funds or
pools that may invest and trade in many different markets, strategies and instruments (including
securities, non-securities and derivatives) and are NOT subject to the same regulatory
requirements as Mutual funds.

The term is usually defined by considering the characteristics most commonly associated with
hedge funds. Usually, hedge funds -

• are organized as private investment partnerships or offshore investment corporations;

• use a wide variety of trading strategies involving position-taking in a range of markets;

• employ as assortment of trading techniques and instruments, often including short-

selling, derivatives and leverage;

• pay performance fees to their managers; and

• have an investor base comprising wealthy individuals and institutions and relatively high
minimum investment limit (set at US $100,000 or higher for most funds).

The term “Hedge Funds”, first came into use in the 1950s to describe any investment fund that
used incentive fees, short selling, and leverage. Over time, hedge funds began to diversify their
investment portfolios to include other financial instruments and engage in a wider variety of
investment strategies. Today, in addition to trading equities, hedge funds may trade fixed
income securities, convertible securities, currencies, exchange – traded futures, over the
counter derivatives, futures contracts, commodity options and other non-securities
investments. Furthermore, hedge funds today may or may not utilize the hedging and arbitrage
strategies that hedge funds historically employed, and many engage in relatively traditional,
long only equity strategies.

• Hedge funds are exempted from registration and disclosure requirements.

Mutual funds are regulated by the SEC, the IRS and other agencies and entities.

• Hedge funds can use techniques such as short selling, leverage, concentrated investments
and derivatives trading.

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Mutual funds have a limited choice of investment strategies and vehicles.

• Hedge fund managers are heavily invested in the funds they manage.

Mutual fund managers are not invested in the funds they manage.

• Hedge fund managers get remunerated based on the returns they earn (called “incentive
fee”). Thus, hedge fund managers get paid only when they generate positive returns.

Mutual fund managers get remunerated based on the size of the assets they manage,
regardless of performance.

• Hedge fund managers can change their investment strategy without prior investment
consent thus providing flexibility to investment managers.

Mutual fund managers require the consent of the investment committee of the fund in
order to change their strategy.

• The lack of regulation and disclosure can result in managers taking excessive risk or the kind
of risk whose nature they don’t fully appreciate.

Regulation and disclosure requirements result in fewer unpleasant surprises and lesser
downside risk.

Hedge funds can provide benefits to financial markets by contributing to market efficiency and
enhance liquidity. Many hedge fund advisors take speculative trading positions on behalf of
their managed hedge funds based extensive research about the true value or future value of a
security. They may also use short term trading strategies to exploit perceived miss-pricings of
securities. Because securities markets are dynamic, the result of such trading is that market
prices of securities will move toward their true value. Trading on behalf of hedge funds can thus
bring price information to the securities markets, which can translate into market price
efficiency. Hedge funds also provide liquidity to the capital markets by participating in the

Hedge funds play an important role in a financial system where various risks are distributed
across a variety of innovative financial instruments. They often assume risks by serving as ready
counter parties to entities that wish to hedge risks. For example, hedge funds are buyers and
sellers of certain derivatives, such as securitized financial instruments, that provide a
mechanism for banks and other creditors to un-bundle the risks involved in real economic
activity. By actively participating in the secondary market for these instruments, hedge funds

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can help such entities to reduce or manage their own risks because a portion of the financial
risks are shifted to investors in the form of these tradable financial instruments. By reallocating
financial risks, this market activity provides the added benefit of lowering the financing costs
shouldered by other sectors of the economy. The absence of hedge funds from these markets
could lead to fewer risk management choices and a higher cost of capital.

Hedge fund can also serve as an important risk management tool for investors by providing
valuable portfolio diversification. Hedge fund strategies are typically designed to protect
investment principal. Hedge funds frequently use investment instruments (e.g. derivatives) and
techniques (e.g. short selling) to hedge against market risk and construct a conservative
investment portfolio – one designed to preserve wealth.

In addition, hedge funds investment performance can exhibit low correlation to that of
traditional investments in the equity and fixed income markets. Institutional investors have used
hedge funds to diversify their investments based on this historic low correlation with overall
market activity.

From time to time, allegations are made by market participants about collusion among hedge
funds to manipulate markets. Like all other market participants, hedge funds are covered by
both criminal and civil regimes that outlaw various forms of market manipulation and abuse.

• Investment 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
• Front Office covers functions like Sales & Client prospecting, Contact Management, Account
Aggregation and Financial Advisory services.
• Middle/Back Office covers functions like Asset Allocation, Research, Portfolio Analysis, Risk
Management, Trade Processing, Compliance and Documentation
• An Asset Manager uses the following approaches/principles:
o Asset Mix
o International Diversification
o Screens/Filters
o Capital preservation
o Alternative Investments
• Asset Allocation can be done passively or actively.
o 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.

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o 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
• 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
• There are several variants of investment management that have manifested in terms of
firms offering products to suit specific needs of investors. Some of them are
o Private Banking\Wealth Management
o Institutional Asset Management
o Mutual Funds
o Separately Managed Accounts
o Hedge Funds
o Pension Funds

• 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
• Institutional money managers are independent financial advisory firms organized and
licensed under the Security and Exchange Commission or Banking Laws' oversight agency of
the country.
• A Mutual Fund (MF) is a type of Investment Company that pools the money of many
investors – shareholders and collectively invests that money in stocks, bonds, or money
market instruments.
• A separately managed account is a portfolio of securities owned directly by the investor and
managed by professional money manager for an asset-based fee. SMA or the separately
managed accounts provides the individual investors the same quality of service as offered to
institutional investors.

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• Hedge funds, including fund of funds are unregistered private investment partnerships,
funds or pools that may invest and trade in many different markets, strategies and
instruments (including securities, non-securities and derivatives) and are NOT subject to the
same regulatory requirements as Mutual funds.
• Pension funds may be defined as forms of institutional investor, which collect, pool and
invest funds contributed by sponsors and beneficiaries to provide for the future pension
entitlements of beneficiaries



An investment bank is a financial institution that raises capital, trades in securities and manages
corporate mergers and acquisitions. Investment banks profit from companies and governments
by raising money through issuing and selling securities in the capital markets (both equity, bond)
and insuring bonds (selling credit default swaps), as well as providing advice on transactions
such as mergers and acquisitions The major activities include

• Investment Banking
• Trading in Securities
• Research
The major activities of Investment Banking involve

• Securities Underwriting
• Corporate Advisory Services –M&A
• Securitized Products
• Structuring –complex structured products are offered which offers greater margins

The difference between an investment bank and a commercial bank is that a commercial bank
accepts deposits from retail investors whereas an investment bank does not accept deposits
from retail investors.


Some of the most important functions of investment banking are:

• Investment banks help public and private corporations in issuing securities in the
primary market, guarantee by standby underwriting or best efforts selling. Other
services include acting as intermediaries in trading for clients.

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• The brokerage division of Investment banking provides financial advice to investors and
serves them by assisting in purchasing securities, managing financial assets and trading
• Small firms providing services of investment banking are called boutiques. These mainly
specialize in bond trading, advising for mergers and acquisitions, providing technical
analysis or program trading


Prior to the financial crisis the bulge bracket investment banks were

• Goldman Sachs

• Merrill Lynch

• Bear Stearns

• Lehman Brothers

• JP Morgan Chase
The aftermath of the financial crisis has resulted in a lot of changes

• Bear Stearns’ has been acquired by JP Morgan Chase.

• Lehman Brothers has declared bankruptcy

• Merrill Lynch has been acquired by Bank Of America

• Until Sep 22, 2008 Goldman Sachs and Morgan Stanley were the largest investment
banks however they converted to traditional banking institutions due to the financial


Investment Banks have a number of divisions, some of which are listed below along with the


The bread and butter of a traditional investment bank, corporate finance generally performs
two different functions:

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• 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 - The process by which investment bankers raise investment capital from
investors on behalf of corporations and governments that are issuing securities (both equity
and debt).An Underwriter guarantees that the capital issue will be subscribed to the extent
of his underwritten amount. He will make good of any shortfall.

8.4.2 SALES

Salespeople take the form of:

1) The classic retail broker,

2) The institutional salesperson

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.

Private Client Service (PCS) representatives, have some of the characters similar to 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.


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 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

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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.


A very important part of investment banking is the syndicate. This provides a vital link between
salespeople and corporate finance. Syndicate helps to place securities in a public offering. The
process is a long one 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.


• There have been major changes in the investment banking field post the economic
crisis. Major investment banks Morgan Stanley and Goldman Sachs succumbed to a
collapse in confidence in their financial stability by converting themselves into lower
risk, tightly regulated commercial banks
• Universal banks, which marry investment banking and deposit-taking, are in the
• Strict regulatory limits will be imposed which will restrict the banks from dabbling with
exotic derivatives and credit instruments and decrease amount of debt
• Banks must also anticipate and manage regulatory changes as the shape new business
• There will be a lot of emphasis on risk management going forward
• Investment banks will continue to play a major role in the world of finance, however the
number of pure play investment banks will decrease.



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Broker is a party that mediates between a buyer and a seller. A "brokerage" or a "brokerage
firm" is a business that acts as a broker. A brokerage firm is a business that specializes in trading
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 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:


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.


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.

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.

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Successful IPOs trade up on their first day (increase in share price), and tend to succeed over the
course of the next few quarters.


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.

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)


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.


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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
Selling group comprises of broker/dealers chosen to assist the syndicate in marketing the issue
(in a broker 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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There are two basic types of commitments made by underwriters to issuers:


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.

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.)


The trading of outstanding issues takes place in the Secondary Markets. The secondary markets
are broken down into four market types:


These are exchanges where an Auction method is used and specialists provide liquidity on
the floor of an exchange. E.g. The New York Stock Exchange (NYSE)

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(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.

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 (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.

The trading of exchange-listed securities between institutions on a private over-the-counter

computer network, rather than over a recognized exchange such as the New York Stock
Exchange (NYSE) or NASDAQ. Trades between institutions will often be made in large blocks and
without a broker, allowing the institutions to avoid brokerage fees.
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 (self-regulatory
organization) for the second, third and fourth markets.

SRO is self-regulatory organization. It is an organization that exercises some degree of

regulatory authority over an industry or profession. The regulatory authority could be applied in
addition to some form of government regulation, or it could fill the vacuum of an absence of
government oversight and regulation


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

• 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/dealers 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.

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• 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
• 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
• 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

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
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

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• Play an important role in the secondary market as catalysts, particularly for enhancing stock

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



There are five basic order types.

1. 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

2. 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.

3. 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 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.

4. 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

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without guaranteeing the price. A stop limit order, once triggered, becomes a limit

5. 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


Day Order – The order is valid till end of day and if it is unfilled at day’s 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


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.


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 record transactions, OTC
price information is either published periodically in paper form, disseminated over telephone
lines, or displayed real-time electronically.

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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 we were selling stock, to whom would we 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.


A brokerage firm has the following departments:

• Sales
• New Accounts
• Order Room
• Purchase and Sales
• Cashiering
• Margin
• Corporate Actions
• Accounting
• Compliance

8.12.1 SALES

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Sales team is responsible for canvassing business. They are staffed with Account
Executives/Account Managers who solicit business from retail and wholesale customers.


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
• Margin Account
• Joint Account
• Power of Attorney Accounts


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 NameAccounts(Name&Address)
Accountexecutive •OpenAccounts
(HomeorBranchoffice •ExecutingChanges

Reports OrderTickets

OTCMarket Exchanges
• Executionrecording
Execution •ConfirmingGTCorders
Reports •PendingOrders

ClearingCorp • Recording Clients
(CNS) •Figuration(includingaccrued interest)

Cashiers Margin
• Receive&Deliver • AccountMaintenance
Banks •Vaulting •Salessupport
•BankLoan •Issuechecks
•StockLoan/borrow •Itemsdue
•Transfer •Extensions
•Reorganization •Close–Outs
Brokerages •Deliveryofsecurities

Transfer StockRecord Accounting

Agent • Accountnumbering&coding • Bookkeeping
•Audits •Dailycashrecord
•SecurityMovements •Adjustedtrailbalance

Dividend Proxy
• CashDividends • Proxyvoting
•Stocksplits • Informationflowtocustomers


This department is responsible for the following activities:

• Recording the trade with a unique number using codes and tickets.

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• Figuration to calculate the monetary value of the transaction

• Reconciliation of customer trades with counter-party transactions
• Customer Confirmation in a legally binding form.

8.12.5 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


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 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.


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.

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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.


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.


By Market Indices we mean the index of market prices of


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. E.g. Dow Jones Industrial Average



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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)


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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The custody service business evolved from safekeeping and settlement services provided by
banks to its customers for a fee. Banks, as a custodian originally provided only basic safekeeping
services to their customers. The banks routinely settled trades and processed income for their
own investments. Their customers kept and took their securities out of safekeeping to settle
trades or for bond maturities. As time evolved, the banks realized that their expertise in
securities processing and their image as a safe repository would be valuable to their customers
and they began to promote their securities processing ability as an enhanced value-added

Services offered by Custodians

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.

Users of Custody Services

Institutional investors, money managers and broker/dealers are the primary customers for
custodians and other market participants for the efficient handling of their worldwide securities

Assets held Under Custody

Custodians hold a range of assets on behalf of their customers. These include equities,
government bonds, corporate bonds, other debt instruments, mutual fund investments,
warrants and derivatives.

Business Drivers of Custody Services

The following are the key drivers in the growth of custody services:

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• The wide range of financial instruments and the emerging markets spreading across
geographies resulted in growing interest of investors. The potential benefits associated with
the investments resulted in growth of custody services.
• The increasing use of global custodians to replace their own networks of local custodians by
Investment managers and banks.
• The state withdrawing from its role of primary pension provider, causing citizens to invest in
defined contribution pensions and mutual funds in record numbers - with custody banks
serving the pension funds and mutual funds, their money managers and the banks acting for
high net worth individuals.
• The introduction of floating exchange rates and lifting of exchange controls in many major
economies resulted in rapid development of the market for international debt instruments.
• The specialist fund managers running dedicated portfolios of foreign equities have increased
in recent time.
• The gradual increase in equities and cross-border investments.


Securities marketplace is a mechanism for bringing together those seeking investment and those
seeking capital. These entities can be individual or institutional .The securities market can be
classified as primary market and secondary market. For the purpose of the discussion we would
concentrate on secondary market and its working mechanism.


An investor is an entity that owns a financial asset. In general there are two types of investor,
the individual and the institutional investor.

• Individual Investor

• Institutional Investor
o Mutual Fund Managers
o Pension Funds
o Insurance companies
o Hedge Funds
Broker is an intermediary who executes customer orders for a pre-defined commission. A
"broker" who specializes in stocks, bonds, commodities act as an agent and must be registered

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with the exchange where the securities are traded. The brokers can be classified based on the
types of the services offered.

Dealer is an entity who is ready and willing to buy a security for its own account (at its bid price)
or sell from its own account (at its ask price). They are individual or firms acting as a principal in
a securities transaction.

A custodian is responsible for safekeeping the documentary evidence of the title to property like
share certificates etc. The title to the custodian’s property remains vested with the original
holder, or in their nominee(s), or custodian trustee, as the case may be. On confirmation from
customers the clearing corporation assigns the obligation of settlement upon the custodian. In
general the services provided by the custodians are classified in two main areas:

• Holding of Securities and Cash

• Movement of securities and/or cash
Clearing Corporation
Clearing Corporation is responsible for post-trade activities of a stock exchange. Its responsible
for clearing and settlement and risk management of trades. The list of activities performed by a
clearinghouse is:

• Clearing of trades
• Determining obligations of members,
• Arranging for pay-in of funds/securities,
• Receiving funds/securities,
• Processing for shortages in funds/securities,
• Arranging for pay-out of funds/securities to members,
• Guaranteeing settlement.

Examples of important clearing corporations across the globe are National Stock Clearing
Corporation in USA (NSCC), Sega Intersettle in Switzerland, Clearstream & Euroclear of European
Union and so on.

The depository can be either domestic or international securities and depending upon that they
are known as either National Central Securities Depository or International Central Securities
Depositories (ICSDs).

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Country Depository Depository Full Name

India NSDL National Securities
Depository Ltd
USA DTC Depository Trust Company
Japan JASDEC Japan Securities Depository
Hong Kong CCASS Central Clearing and
settlement system
Clearing Banks

Clearing banks are a key link between the custodians and Clearing Corporation for funds
settlement. Every custodian maintains a dedicated settlement account with one of the clearing
banks. Based on his obligation as determined through Clearing Corporation, the clearing
member makes funds available in the clearing account for the pay-in and receives funds in case
of a payout. In most of the cases the custodians act as a clearing bank also.


Primary Market: It is a market for new security issue. In this market the securities are directly
purchased from the issuer. For e.g. an investor directly buying security issued by IBM.

Secondary Market: A market in which an investor purchases a security from another investor
rather than the issuer. We can divide the secondary market into wholesale and retail parts. The
wholesale market is the market in which professionals, including institutional investors, trade
with one another. Transactions are usually large. The retail market is the market in which the
individual investor buys and sells securities. The principal OTC market is the National Association
of Securities Dealers Automated Quotations (NASDAQ). The wholesale market for corporate
equities is conducted on a number of exchanges as well as over the counter (OTC). The New
York Stock Exchange (NYSE) dominates. Other U.S. exchanges include the American Stock
Exchange (AMEX), also in New York City, and five regional exchanges – the Midwest, Pacific,

Some other Markets are:-

• Dealer Markets
• Auction Markets
• Hybrid Markets

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A bank is responsible for maintaining the safety of custody assets held in physical form at one of
the custodian’s premises, a sub-custodian facility, or an outside depository. The banks may hold
assets either off-premises or on –premises


The banks hold the securities/assets in physical form in its vault. The securities (e.g., jewelry, art,
coins) are kept in physical form by the bank .The banks also holds the securities, which are not
maintained in the book entry form.

The banks providing the safekeeping services needs to follow certain norms related to the
security and movement of securities. The bank provides security devices consistent with
applicable law and sound custodial management. The bank ensures appropriate lighting, alarms,
and other physical security controls. The banks ensure that assets are out of the only vault when
it receives or delivers the assets following purchases, sales, deposits, distributions, corporate
actions or maturities.


The evolution of depository has resulted in vast majority of custodial assets being held in book
entry form. Custodians reconcile changes in the depository’s position each day as a change in
the position occurs, as well as completing a full-position reconcilement at least monthly.
Depository position changes are generally the results of trade settlements, free deliveries
(assets transferred off the depository position when no cash is received), and free receipts
(assets being deposited or transferred to the depository position for new accounts when no
cash is paid out).



The trade process is initiated in a variety of ways in which a customer decides either to buy or
sell securities. The customer goes to either a Broker/ Dealer or a bank’s trading desk through its
investment manager. The bank in turn would coordinate with a broker who has access to the
exchange. The client sends across his order details through communication network. The client
order contains standard features like:

• Buy or Sell
• Specific Quantity
• Specific Security

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The brokers typically record the order if the order has been placed through a broker or
otherwise the trader directly maintains the details of the order.


The order is placed by the client usually through a telecommunication network and is normally
passed to either the exchange floor or to over the counter-trading desk. The order management
process consists of Entering orders, order modification, order cancellation. The order capture
process is done through appropriate trade entry applications. The process is to capture the
order details i.e. identification of the security to be traded, the quantity, limit price, order
duration and exchanges. The client places the order and specify the Operation i.e. either
buy/sell, Quantity, Security Name and the Price. The order condition can be attached to the
timing; price and quantity of the order, which is considered when the broker executes/match
the trade .The client’s also modify/ cancel the order if the order has not been processed.

Order Types

There are two basic types of order: market orders and limit orders.

• Market orders are instructions to buy or sell stock at the best available price. They are the
most common types of orders.
• Limit orders tell our broker to buy or sell stock at the limit price or better. The limit price is a
price that the investor can set when placing the order. For a given purchase, it is the
maximum amount the investor will pay; for a given sale, it is the minimum amount the
investor will accept. A limit order can also be placed to buy along with one to sell. For
example, if XYZ Corporation is currently trading at $42 per share, a limit order can be placed
to buy 100 shares of XYZ at 40 or better (less) and to sell 100 shares XYZ at 45 or better
Order Conditions

A buyer/seller can specify order conditions with which the trade is to be executed. These are the
conditions that are typically an upper limit in buy price, a lower limit in sell price, stop loss trade
orders, quantity conditions and time criteria.

• Time Conditions
• Quantity Conditions
• Price Conditions
• Market
• Stop orders

Order Books

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An order book is a placeholder for every order entered into the system. As and when valid
orders are entered or received by the trading system, they are first numbered, time stamped
and then scanned for a potential match. If a match is not found, then the orders are stored in
the books as per the price/time priority. Price priority means that if two orders are entered into
the system, the order having the best price gets the higher priority. Time priority means if two
orders having the same price is entered, the order that is entered first gets the higher priority.
Best price for a sell order is the lowest price and for a buy order, it is the highest price

Order Matching

The buy and sell orders are matched based on the matching priority. The best sell order is the
order with the lowest price and a best buy order is the order with the highest price. The
unmatched orders are queued in the system by the following priority:


All stop loss orders entered are stored in the stop loss book. These orders can contain two

• Trigger Price. It is the price at which the order gets triggered from the stop loss book.
• Limit Price. It is the price for orders after the orders get triggered from the stop loss book. If
the limit price is not specified, the trigger price is taken as the limit price for the order. The
stop loss orders are prioritized in the stop loss book with the most likely order to trigger first
and the least likely to trigger last. The priority is same as that of the regular lot book.
• The stop loss condition is met under the following circumstances:

Sell Order - A sell order in the stop loss book gets triggered when the last traded price in the
normal market reaches or falls below the trigger price of the order.
Buy Order - A buy order in the stop loss book gets triggered when the last traded price in the
normal market reaches or exceeds the trigger price of the order. When a stop loss order with
IOC condition is there, the order is released in the market after it is triggered. Once triggered,
the order scans the counter order book for a suitable match to result in a trade or else is
cancelled by the system.


The trade execution is carried out on a stock exchange after an order is placed. Order
modification and/or order cancellation is required to handle any abnormality. An order in
entered into the trading system by the brokers and they specify the information regarding the
trade details. The trade details typically contain information like security Name, Quantity, Price,
Order Duration etc. The order is entered into the order book and gets executed as per the time
and price condition as specified in the order. The order matching for the execution takes place in

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the stock exchange. The order modification and order cancellation takes place before the order
gets executed i.e. if the order is there in the order books of the exchange and is waiting to be
executed the request for order modification is entertained by the stock exchange. The stock
exchange prepares a NOE (Note of Execution) with the trade details and sends it across to the
Broker/ Dealer and to the clearing corporation giving details of the trade. The date the trade is
executed is known as the Trade Date, and is referred as ”T“ or T+0.

The order execution process for a customer sell order (individual investor placing order through
a broker) goes through the following cycle:

• Customer places a sell order through the Internet or to the account executive of the
brokerage group.
• The account executive sends the order to its corresponding floor broker or to its trading
• The order execution takes place on the floor of the exchange such as on NYSE, AMEX etc.
• The exchange sends a Notification of sell to the Firm’s representative on the exchange as
well as the trading desk of the brokerage group..
• The Firm’s representative on the exchange floor send a notification of the sell to the floor
broker which is then matched with the counter party broker.

The trade execution results in identifying the following trade components:

• Trade Date
• Trade Time
• Value Date
• Operation
• Quantity
• Security
• Price


The process of trade enrichment involves the selection, calculation and attachment to a trade of
relevant information necessary for efficiently servicing the clients. The trade components, which
require enrichment, are:

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• Calculation of cash value: The cash value calculation is done keeping the trade components
in consideration.
• Counter party Trade confirmation requirement: The trade details needs to be enriched to
determine if the counter party needs the trade confirmation and if at all it needs the trade
confirmation, the format in which the confirmation would be send across to them.
• Selection of custodian details: The client might have multiple accounts with multiple or
single custodian. The investor would send the custodian details at which the settlement
would take place. The trade details are enriched with the account number of the custodian,
which will handle the cash/ securities settlement.
• Method of Transaction reporting: The transaction reporting depends upon the security
group as well as the country in which the transaction has occurred. For e.g. the UK equities
may require one method of reporting whereas the international bonds would require
another method.


Trade validation is a process of checking the data contained in the fully enriched trade, in order
to reduce the possibility of erroneous information being sent to the client (in case of
institutional client) also the wrong trade related information can lead to delay in the settlement
or even in settlement failure. The basic trade related information that are validated are

• Trade Date
• Trade Time
• Value Date
• Operation
• Quantity
• Security
• Price
• Trade Cash Value
Methods of Trade Validation: The validation of trade can be effected manually or automatically
according to the availability of the system.

• Manual Trade Validation

• Automatic Trade Validation



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Clearing process signifies the execution of individual obligations with respect to a buyer and
seller. Once the terms of a securities transaction have been confirmed, the respective
obligations of the buyer and seller are established and agreed. This process is known as
clearance and determines exactly what the counter parties to the trade expect to receive.
Clearance is a service normally provided by a Clearing Corporation (CC).

Clearance can be carried out on a gross or net basis. When clearance is carried out on a gross
basis, the respective obligations of the buyer and seller are calculated individually on a trade-by-
trade basis. When clearance is carried out on a net basis, the mutual obligations of the buyer
and seller are offset yielding a single obligation between the two counter parties. Accordingly,
clearance on a net basis reduces substantially the number of securities/payment transfers that
require to be made between the buyer and seller and limits the credit-risk exposure of both
counter parties.


The Settlement process for the securities is expensive as moving securities and money involves
costs. Since a given trader may engage in dozens or even hundreds of trades each day, these
costs soon add up. One way to reduce these costs is through netting.

If A sells 100 Microsoft shares to B on the expectation that the price of the Microsoft shares may
fall from 80 to 60 in one hour. After one hour the price does fall to 60 and A decides to buy the
same amount of Microsoft shares. By coincidence A buys the shares from B. Now instead of
executing both these trades individually, both A & B can save a lot on transaction costs if the
two transactions are netted and then executed. In that case B needs to pay 100*(80-60) = $2000
to A. B needs to pay only this amount and no shares transfer takes place.

Continuous Net Settlement

The Continuous Net Settlement (CNS) System is an automated book-entry accounting system
that centralizes the settlement of compared security transactions and maintains an orderly flow
of security and money balances. Throughout the CNS processing cycles, the system generates
reports that provide participants with a complete record of security and money movements and
related information. CNS provides clearance for equities, corporate bonds, Unit Investment
Trusts and municipal bonds that are eligible at The Depository Trust Company (DTC). DTC is an
institution that provides depository services in US.

Clearing Process
The process of clearing is explained in the following example:

A deal is struck between A and B on Monday. That night the back-office personnel of A and B
each send electronic notification of the trade to the computer of the National Securities Clearing
Corporation (NSCC).

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The NSCC computer checks the two “confirms” against each other. If they match, the trade is
“compared”. NSCC confirms to both A and B on Tuesday morning, with instructions for
settlement the same Thursday. If the trade does not compare, both A and B are notified for
sorting things out and resubmitting the trade before the settlement date.

On Wednesday, the day before the settlement, NSCC interposes itself between the two parties
to the transaction. That is, instead of the original deal between A and B, there are now two
deals – one between A and NSCC and the other between NSCC and B. Now, A has a deal to sell
10,000 shares of GE to NSCC at 80, and B has a deal to buy them from NSCC at the same price. A
receives a notice to deliver the shares to NSCC; B receives a notice to make payment. By
interposing itself in this way, NSCC is guaranteeing settlement to both A and B. Whether or not
B pays up, A will get the money on time. Whether or not A delivers the shares, B will get 10,000
shares of GE on Thursday.

The automated comparison is an important function of the clearing corporation because it

enables the participant to ensure that the trade details agree with those of counter party prior
to settlement.


The trade affirmation/confirmation process occurs when a depository forwards the selling
broker’s confirmation of the transaction to the buyer’s custodian. The custodian reviews the
trade instructions from the depository and matches the information to instructions for the trade
received from its customer. If the instructions match, the custodian affirms the trade. If the
instructions do not match, then the custodian will ”DK” (don’t know, or reject) the trade or will
instruct the selling broker how to handle the mismatch. The affirmation/confirmation process is
generally completed by T+1 in a normal T+3 settlement cycle. On day T+2, depositories send
settlement instructions to the custodian bank after affirmation and prior to settlement date.
The instructions contain the details of the trade that has been affirmed and agreed to by the
parties in the trade. Custodians will match the settlement instructions to their records and
prepare instructions to send funds or expect funds from the depository on T+3 of the settlement

The following media is used for the transmission of trade confirmation/affirmation

• Fax:
• Telex
• S.W.I.F.T
• e-mail
• Paper



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Trade settlement is the act of buyer and seller exchanging securities and cash on or after the
value date in accordance to the contractual agreement. Settlement is successful when the seller
is able to deliver the securities and buyer is able to pay the cash it owns to the seller. In some
cases the settlement fails primarily because the seller was awaiting the delivery of securities
from its purchase and therefore could not deliver the securities to the buyer.

It is mandatory now days to settle trade on the value date and whenever there is a settlement
failure the authority imposes penalties to the party concerned.

Causes of Settlement Failure

• Non–Matching settlement instruction
• Insufficient Securities
• Insufficient Cash


Trade settlement is the act of buyer and seller exchanging securities and cash on or after the
value date in accordance to the contractual agreement. Settlement is successful when the seller
is able to deliver the securities and buyer is able to pay the cash it owns to the seller. There are
different settlement methods depending upon the payment mechanism, security types etc.

In most of the markets the settlement is done on a rolling basis. In a Rolling Settlement, all
trades outstanding at end of the day have to be settled, which means that the buyer has to
make payments for securities purchased and seller has to deliver the securities sold. For
instance, USA and UK follow a T+3 systems which means that a transaction entered into on Day
1 has to be settled on the Day 1 + 3 working days, when funds pay in or securities pay out takes


The settlement process has evolved over the period. Traditionally the settlement used to take
place with the physical delivery of the shares, but with advent of Certificate Immobilization the
Book Entry settlement system has evolved.

• Physical Settlement
• Book Entry Settlement

The settlement period is the time between the execution of the trade and the settlement of
trade. It is time allowed before the securities sold must be delivered to the buyer. The

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settlement periods depend upon the type of the securities traded. Appendix C has the list of the
settlement period for different types of security.


Trade settlement occurs when securities and money are exchanged to complete the trade.
Settlement occurs on T+3 in a T+3 settlement cycle. Settlement of a securities transaction
involves the delivery of the securities and the payment of funds between the buyer and seller.
The payment of funds is effected in the settlement system via a banking/payments system. A
depository typically carries out the delivery of securities. A trade is not declared settled until
both (funds and securities) transfers are final.

Trade Accounting & Reconciliation

Trade accounting and Reconciliation is the internal control process used by custodians to
manage trade transactions. In this process, the custodian determines that the customer’s
account has the necessary securities on hand to deliver for sales, that the customer’s account
has adequate cash or forecasted cash for purchases. It maintains the records of trades internally
and tries to match it with outside world. It tries to match the positions by comparing positions of
trades (Open and settled both).

Risks associated with Trading & Settlement

There are multiple risk associated with the trade execution process .The following example
discusses the risk associated with the trading process from the point of view of a broker
associated with an exchange.

Broker A, on the floor of the Stock Exchange, has just agreed with broker B, to sell him 10,000
shares of GE at 80. To execute this transaction, the ownership of the shares needs to be
transferred to B, and B needs to transfer the cash to A. In reality, once A and B agree on the
terms, execution is handed over to others in the “back office”. The length of the process varies
from market to market.

• Principal Risk
• Replacement Risk
• Liquidity Risk
• Operational Risk
• Systemic Risk


The following example discusses how a typical equity trade takes place:

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Trade Date (T):

Step 1: The transaction begins with the investor wishing to invest in equity. He contacts his
broker (buy side) with an order to buy and similarly an investor contacts his broker (sell side) to
sell the securities.

Step 2: The brokers place trade request on the exchange.

Step 3: The trade execution takes place in the exchange as per the conditions specified in the
order. The exchange prepares a NOE (Notice of Execution) and sends out to the Brokers and the
clearing corporation.

Step 4: The clearing corporation receives the matched instruction i.e. the trade details (quantity,
price etc) from the exchange. The trade details are entered into the Continuous net settlement
system to obtain the net positions for a broker at the end of the day. The clearing corporation
prepares a contract sheet with end of day positions for broker and sends it across to the

Step 5: The Brokers sends a confirmation to the client about the trade details and the clients in
turn inform their custodians about the receipt/delivery of shares.

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Trade Date +1/2 (T+1/2)

Step 1: The broker receives trade details from the clearing corporation and it enriches it with the
fees, commission and other tax related details and send across the confirmation to the client.

Step 2: The client prepares an Affirmation order and sends it across to the custodians about the
possible pay in/out of securities and funds.

Step 3: The clearing corporation prepares a final pay in/pay out details based on the affirmation
received from the client and send it across to the depository.

Step 4: The custodians also confirm with the depository about the pay in/ pay out details about
the funds and securities.

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Trade date + 3(T+3)

Step 1: Pay In of securities: Clearing corporation advises depository to debit account of sell side
custodian and credit its account and the depository does it

Step 2:Pay in of funds (Clearing corporation advises clearing banks to debit account of buy side
custodian and credit its account and the clearing bank does it)

Step 3:Pay Out of securities (Clearing corporation advises depository to credit account of buy
side custodian and debit its account and depository does it)

Step 4: Pay Out of funds (Clearing corporation advises clearing banks to credit account of sell
side custodian and debit its account and clearing banks does it)

Step 5: The custodian 1 confirms the receipt of shares to the buying client.

Step 6: The custodian 2 confirms the delivery of shares to the selling client.

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Asset servicing is a ”core“ ongoing service provided by custodians. This service includes
collecting dividends and interest payments, processing corporate actions and applying for tax
relief from foreign governments on behalf of customers.


A corporate action is an event related to capital reorganization or restructure affecting a

shareholder. Custodians are responsible for monitoring corporate actions for the securities they
hold under custody. Once the Custodian gets notified of a corporate action, it identifies the
accounts that hold the security. If the account holder has a specified time to decide whether to
accept the corporate action, the customer should be promptly contacted. The custodians have a
process to monitor the corporate action to ensure that the customer has given a complete
response by the due date. When a customer’s instructions are received, the custodian sends the
instructions to the company for execution. The custodian monitors the status of the action to
ensure timely settlement. The custodian’s procedures for corporate actions also include
documentation of all customer directions.

Business Process of Corporate Action Processing

Receiving Corporate Action: The information regarding the corporate action is received from a
number of external sources. As the same corporate action data is supplied by many different
sources, a hierarchy of sources is maintained to prioritize the obtained data.

Maintaining Corporate Action: The Corporate actions are classified as either mandatory or

• Mandatory Actions
It is a type of corporate action wherewith the shareholders are not given the option to
conditionalize their tender. e.g. stock splits, mergers and acquisitions, liquidations, bankruptcies,
reorganizations, redemption’s, bonus issues etc

• Voluntary action
It is a type of corporate action wherewith the shareholders are given the option to
conditionalize their tender. They include rights offers, tender offer, purchase order, exchange
order etc.
Notification of Corporate Action: The notification is generated for the client of Voluntary and
Mandatory Corporate Actions. The notification process ensures that the client receives the
information of the corporate action. Maintaining Response of Corporate Action: The corporate
action response is maintained for voluntary corporate action responses against expiration dates
on a daily basis until the client responds with instructions.

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Processing of Corporate Action :In this stage the Processing of corporate action is done to
update the records of the banks. As per the feedback received from the client in case of
voluntary actions, the records for the client are updated in the records of the banks. A similar
method is followed for the mandatory types of corporate action.


Custodians are responsible for collecting income payments received from the assets held under
custody. The income payments typically take the form of dividends on equity securities and
interest on bonds and cash equivalents. Custodians calculate the projected payments and
inform the customers accordingly in advance. This enables the customers to plan investment
decisions and use the proceeds effectively. The bank’s internal controls for income collection
also include an income map procedure that details each client’s expected income from a
particular security.

Contractual income payments are posted to the customer’s account on the date they are due
rather than the date they are received by the custodian whereas the actual income payments
are posted to the customer’s account on the date they are received by the custodian

Business process of Income Processing

Receiving Corporate Announcement: The custodians are dependent on external vendors to

receive corporate action information. These vendors are specialized in providing information
across the globe. Some of the common vendor feeds used are from JJ Kenny, DTC, Telekurs, and
Reuters etc. The information collected is announcements regarding interest (coupon) payments
for registered bonds, dividend payment for equities, income payment for ADR securities, mutual
funds, private placement securities etc.

Generating Payment Obligation: A payment obligation is liability owned by a client. The payment
obligation for a client is generated from the data regarding the corporate announcement. The
payment obligation is generated for the pending payments that are due to the client. Also the
cash projection for the client depending upon corporate announcements is calculated.

Account Maintenance: Details regarding the trade are tracked and the corresponding account is
updated. The trade details are maintained and the details regarding the transaction are
captured and recorded.

Payment Settlement: The payment settlement stage encompasses entire process of Payment
receipt, payment reconciliation, and payment reversal


Custodians provide proxy-voting service to clients who want to exercise their rights as
shareholders of a company during the general meetings. If personal attendance is not possible,
the shareholder may appoint a representative to attend the meeting and vote by proxy. A

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custodian helps investor to exercise their votes by providing a proxy voting service for all
manner of general meetings wherever this service is available.

Business Process Involved in Proxy Services

Receiving Corporate Announcement: The corporate announcement regarding the agenda of

General Body Meeting or Extraordinary General Body Meeting is captured from external

Notification to Client: The custodians notify the clients about the proxy services by providing the
details of the corporate announcement.

Maintaining Response of Client: The client’s response to the corporate announcement is

maintained on a daily basis until the client responds with instructions. The client response is
typically obtained from either email, fax etc. The response is typically like receiving client
authorization to represent him at the meeting and vote on his behalf.


Custodians provide services to minimize foreign withholding taxes or reclaim taxes withheld for
their customers. The tax treaties between countries often reduce withholding taxes and exempt
capital gains from taxes. The purpose of tax treaties is to reduce the possibility of double
taxation on income earned in foreign countries. In addition, some countries provide reduced tax
withholding rates for certain types of investments (government bonds, for example) or for
certain types of investors (investors exempt from taxation in their home country, for example).
Tax treaty benefits may provide for reduced withholding tax at the time the interest or dividend
is paid (“relief at source”), while other treaties may require the investor to file for a refund after
the fact (“reclaim”). Custodian files a form or statement on behalf of the client, certifying the
investor’s tax status and country of residence for tax purposes. A custodian keeps track of the
tax rates for each of the countries in which it provides custody. Dividends, interest, and capital
gains may all be taxed at different rates. The custodian also maintains information about the tax
treaties within its custody network, and whether its customers qualify for relief under the

Business Process of Tax Handling

Maintaining Tax Information: The tax related information like standard tax rates, exemptions
and reductions available under local law are maintained. The details specifying the reduced
rates available by virtue of double taxation treaties are made available to the client. The market
tax reports, summarizing local taxes for each market are provided to the client.

Tax Calculation: The tax calculation process captures trade details and applies the corresponding
tax rates for computation of the tax.

Tax Reclamation: The tax reclamation process is used to reclaim the extra tax paid by the client.
It can be of two types:

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Contractual Tax Reclaims: In this kind of reclamation the client's cash account is credited with
entitlements to tax relief according to a pre-determined schedule of time-frames, in place of
when the tax refund monies are received. The contractual time frame may be ‘n’ months after
the income pay date (where the value of n varies according to the market concerned) or
payment may be made, less a discount, with income payment. This can greatly assist clients in
managing available funds.

Non-contractual Tax Reclaims: In this type where tax relief is not obtained at source, the excess
tax withholding is reclaimed. The bank prepares the required reclaim form and completes the
associated reclaim process, pursuing items as appropriate and reporting their status to clients.


Cash sweep is a value added service provided by custodian banks to its customers. This service
ensures that the surplus cash in customers’ accounts are effectively invested in short-term
investment funds i.e. STIF (may be as short as an overnight fund) to generate additional returns.
The sweep can be done intra-day based on projected earnings of the particular account or end-
of-day based on actual surplus cash in the account. The STIFs invest money in money market or
euro dollar Deposit.


Many banks currently offer custodian services. The primary risks associated with custody
services are: transaction, compliance, credit strategic and reputation.

• Transaction Risk
• Compliance Risk
• Credit Risk
• Strategic Risk
• Reputation Risk

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An exchange is a regulated market place, where buyers and sellers come together to exchange
what they want. Finding a buyer or seller for a trade by oneself will be difficult and expensive.
The exchange facilitates the process of buying and selling. Thus, like any other market,
exchanges reduce transaction cost and provide liquidity.

In simple terms, if one wants to buy/sell something, he/she can place an order with an
exchange. Exchange receives buy/sell orders from multiple parties and tries to match them,
based on the price quoted and quantity available/desired. If exchange is able to find counter-
party for his/her trade, it will bring together both the parties for transaction to happen.

Examples: Stock Exchanges: NYSE, AMEX

We have different exchanges that deal with different asset types (stocks, commodities, futures,


Over The Counter (OTC) market is different from the exchanges in the sense that there is no
single physical location for members, and members (generally called market makers in OTC
markets) negotiate price to finalize deals rather than use any auction mechanism to derive

In OTC markets, traders/dealers negotiate with each other through computer networks or
simply over the phone to strike deals. So traders/dealers assume the responsibility of exchanges
too, to find counter-party for a trade.

NASDAQ is a good example of OTC market.

Certain other asset types trade in markets that are typically not regulated (e.g., currencies).



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to trade

Security/Fund Place an
Transfer Order

Market Participants (e.g.

Exchange, Brokers/Dealers,
Custodians, Depositories,
Clearing Corporation etc)
Settlement Trade
of Trades Matching

Clearing Trade
of Trades Execution

Based on the market news, risk analysis and investment philosophy, a customer decides to place
an order to buy 100 IBM shares at the market price.

Customer calls his broker (or goes to the online trading interface provided by the broker), and
places the order with the broker dealer. Broker dealer in turn forwards the order to an

Exchange gets multiple orders from different broker dealers. They maintain all the orders in an
order book and use a matching system to find counter-party for an order. In this case, this order
lies in the order book of the exchange until someone places a Sell order for 100 IBM shares
(please note that even partial fill is possible, in case somebody places an order to sell 50 shares).
At this point in time, exchange finds a match between two trades.

Exchange matches these two orders to register a trade and informs the trade details to all the
associated parties.

At the end of the day, obligation for each participant is determined by the exchange and
communicated to each participant.

As per the settlement cycle, broker dealer provide the funds or security to the clearing house by
a particular date and time.

Clearinghouse transfers the security and funds to the appropriate party.


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Clearing in the securities business is the process that occurs between trading and settlement,
involving the balancing of positions between the different parties to establish agreement on
what each party is due, prior to the establishment of final positions for settlement.

Once a trade is executed, the next step is to ensure that the counterparties to the trade (the
buyer and the seller) agree on the terms of the transaction - the security involved, the price, the
amount to be exchanged, the settlement date and the counterparty. This step is referred to in
some markets as trade matching and in others as trade comparison or checking. In automated
trade execution systems counterparties often agree that trades will settle as recorded at the
time of execution unless both agree to a cancellation. Such trades are referred to as “locked-in”
trades. In other trade execution systems, Matching is typically performed by an exchange, a
clearing corporation or trade association, or by the settlement system. Direct market
participants may execute trades not only for their own accounts but also for the accounts of
customers, including institutional investors and retail investors. In this case, the direct market
participant may be required to notify its customer (or its agent) of the details of the trade and
allow the customer to positively affirm the details, a process referred to as trade confirmation or

Trade matching and confirmation set the stage for trade clearance, that is, for the computation
of the obligations of the counterparties to make deliveries or payments on the settlement date.
The obligations arising from securities trades are sometimes subject to netting. Multilateral
netting arrangements, for example, include position netting schemes as well as systems that
involve substitution of a central counterparty and novation of trades with that central

What are the benefits of “Netting”?

Settlement on “net” basis reduces the number of transactions to be settled drastically reducing
the overall transaction cost for everyone. As per an estimate, netting reduces the number of
settlements needed by more than 95%.

Role of Clearinghouses

We understand that there are two parties to a trade, one who buys something and the other
one who sells something. Now imagine a situation where one party (who had to deliver
securities) defaults on its obligation, what impact would it have on the other party? Other party
would not like to suffer because of this, as it’s the exchange that found a match. So clearing
house comes into the picture. To mitigate any counter-party risk (risk that a party involved in
the trading doesn’t meet its commitment), clearing house positions itself as the counter-party
for both the legs of the trade. Thus, buyer buys it from the clearinghouse and seller sells it to
clearing house. This way buyer and seller both are shielded from any “counter-party” risk, as
clearing house stands to meet its commitment to a trading party irrespective of whether the
other party meets its commitment or not.

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This process of transferring obligation from one party to the other is also known as “Novation”.

Let’s look at the following example of stock trades. Following table captures the activity of a
broker on a particular day at NYSE.

Time Buy/Sell Quantity Sock Price

10:00 Buy 100 IBM $10.00

10:30 Sell 50 IBM $10.50

11:00 Buy 100 MSFT $20.00

11:30 Sell 20 IBM $11.00

12:00 Sell 10 MSFT $20.50

3:30 Sell 30 IBM $9.00

Broker has completed 6 transactions on that particular date but exchange would not settle
these transactions individually and would apply the concept of “netting” to determine the
obligation of broker. Deals executed during a particular trading period (in this case one trading
day) are netted at the end of that trading period and settlement obligations are computed.

In the example above:

Net position for IBM: +100 – 50-20-30 = 0

Net position for MSFT: +100 – 10 = 90

So broker would not receive any IBM shares from the exchange as he sold all the shares that he
bought during the day. But exchange will need to deliver 90 MSFT shares to the broker.

This was what exchange owes to broker.

Now let’s look at what broker owes to exchange:

Buy/Sell Quantity Price Amount

Buy 100 $10.00 ($1,000.00)

Sell 50 $10.50 $525.00

Buy 100 $20.00 ($2,000.00)


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Sell 20 $11.00 $220.00

Sell 10 $20.50 $205.00

Sell 30 $9.00 $270.00

Total ($1,780.00)

So the broker has to pay $1780 only and he gets 90 MSFT shares from the exchange. It is
important to understand that netting across stocks is not possible, similarly netting across
different market (for examples trades executed at NASDAQ and NYSE) is not possible. Each
market would have its own rule to determine the “period”, for which transactions need to be

This concept of clearing based on netting is true for most financial transactions, and the case of
stock exchange has been taken just as an illustrative example. Even when one submits a check
issued by ICICI Bank in his/her HDFC bank account, it means that ICICI pays money to HDFC
bank, which in turn deposits the money in his/her HDFC bank account. But HDFC and ICICI have
millions of bank holders and so it doesn’t make sense to settle the individual transactions,
instead ICICI would aggregate (for different customers) its entire obligation to different banks
and then reduce it by amount that ICICI has to get from these banks and only the “net amount”
would be settled by the banks. Clearing house facilitates the whole process.

It is worth understanding that, we have some markets where settlement happens on a gross
basis, meaning no netting is done and all the transactions need to be settled individually. This is
prevalent in Fixed Income markets in the US and the settlement mechanism is known as Real
Time Gross Settlement (RTGS).


Settlement is the legal transfer of title, normally by exchanging a security against money or
assets. Depending on the system, there are several ways of paying. Delivery versus payment
(DVP) – the simultaneous exchange of cash and securities – and delivery free of payment (FOP) –
delivery of securities without payment of funds – are some of the more common. The typical
actor carrying out settlement is a Central Securities Depository (CSD).

The concept of a securities settlement system is generally defined in a wide sense to embrace
the full set of institutional arrangements in the settlement process, i.e. confirmation of terms for
securities trading, clearance/clearing of transactions and determination of rights and
obligations, settlement and custody/safekeeping of securities. In a narrower sense, settlement is
defined as the completion and finalization of a transaction through final transfer of securities

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and funds (payment) between buyer and seller. The interaction of these elements is illustrated
in more detail in Figure 1.


Most markets have the concept of a Settlement Cycle. The cycle starts immediately after the
trade execution. The length of the cycle determines the level of efficiency in the post trade
process and consequently the entire Trade life cycle in the country in question. Markets are said
to be efficient when the gap between the Trade Date and Settlement Date is as close as

Account Period Settlement

In an account period settlement cycle the Trading occurs for a period of time (number of days).
All the trades done during this period are aggregated as at the end of the predefined number of
days, netted and settled. For example trading may occur from Monday through Friday, All the
trades done till Friday from Monday may be netted on the following Monday and settled on the
following Friday.

Rolling Settlement
In this type of settlement every Trading Day is considered separately. Trades are not aggregated
for a period of time as is the case with Account Period Settlement. Thus every Trade Date will

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have a corresponding Settlement Date. Trades done on a given date are netted and settled on
the Settlement Date. Thus for instance a T+3 Rolling Settlement would indicate that for Trades
done on day T the settlement would occur on Day T+3

Once the obligations of the market participants have been calculated, whether on a gross basis
or on a net basis, the instructions to transfer the securities and funds (monies) necessary to
discharge the obligations are transmitted to the entity or entities that operate the settlement
system. These instructions may be prepared by the counterparties themselves or by an
exchange or clearing system. If trades have not previously been matched, the settlement system
would typically perform this function before initiating processing of the transfer instructions.
Other action may be required of participants before settlement can proceed, such as the pre-
positioning of securities, funds or collateral.

Settlement of a securities trade involves the transfer of the securities from the seller to the
buyer and the transfer of funds from the buyer to the seller. Historically, securities transfers
involved the physical movement of certificates. However in recent years, securities transfers
have increasingly occurred by book-entry. This has been possible due to establishment of
central securities depositories that provide a facility for holding securities in either a certificated
or an uncertificated (dematerialized) form and permit the transfer of these holdings through
book entry. A central securities depository may also offer funds accounts and permits funds
transfers as a means of payment, or funds transfers.

Often a transfer that has been executed by such Settlement Systems, in the sense that books
have been debited and credited, is a provisional transfer, that is, a conditional transfer in whom
one or more parties retain the right by law or agreement to rescind the transfer. If the transfer
can be rescinded by the sender of the instruction (the seller of the security or the payer of
money), the transfer is said to be revocable. Even if the transfer is an irrevocable transfer, some
other party (often the system operator) may have authority to rescind it, in which case it would
still be considered provisional. Not until a later stage does the transfer become a final transfer,
that is, an irrevocable and unconditional transfer that affects a discharge of the obligation to
make the transfer. Only the final transfer of a security by the seller to the buyer constitutes
delivery, while only final transfer of funds from the buyer to the seller constitutes payment.
When delivery and payment have occurred, the settlement process is completed.

What do T+1, T+2 and T+3 mean?

Whenever one buy or sell a stock, bond or mutual fund, there are two important dates of which
one should always be aware of: the transaction date and the settlement date. The abbreviations
T+1, T+2, and T+3 refer to the settlement date of security transactions and denote that the
settlement occurs on a transaction date plus one day, plus two days, and plus three days.

As its name implies, the transaction date represents the date on which the transaction occurs.
For instance, if one buys 100 shares of a stock today, then today is the transaction date. This
date doesn't change whatsoever as it will always be the date on which one made the

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However, the settlement date is a little trickier because it refers to the date on which ownership
of the security is actually transferred and money is exchanged between buyer and seller. Now,
it's important to understand that this doesn't always occur on the transaction date and varies
depending on the type of security with which one is dealing. Treasury bills are about the only
security that can be transacted and settled on the same day.

What's the reason behind this delay in actual settlement? In the past, security transactions were
done manually rather than electronically. Investors would have to wait for the delivery of a
particular security, which was in actual certificate form and would not pay until reception. Since
delivery times could vary and prices could fluctuate, market regulators set a period of time in
which securities and cash must be delivered. Some years ago, the settlement date for stocks was
T+5, or five business days after the transaction date. Today it's T+3, or three business days after
the transaction date in US and T+ 2 in India.


DVP is an important characteristic of efficient settlement systems. The goal of DVP is achieve a
simultaneous exchange of securities and payment. High quality of payments must be received
by the clearing and settlement organization. Certainty, finality, irrevocability and un-
conditionality are the characteristics of high quality payments. By far the largest source of credit
risk in securities settlement and, therefore, the most likely source of systemic risk is the
principal risk that may arise on the settlement date. Such principal risk can be eliminated if the
securities settlement system adheres to the principle of delivery versus payment (DVP), that is,
if it creates a mechanism that ensures that delivery occurs if and only if payment occurs.
Furthermore, by eliminating concerns about principal risk, DVP reduces the likelihood that
participants will withhold deliveries or payments when financial markets are under stress,
thereby reducing liquidity risk. However, not all securities settlement arrangements currently
achieve DVP. In some cases the linkage that exists between delivery and payment is,
nonetheless, sufficiently strong to make a loss of principal by a participant seem a remote
possibility. But in other cases book-entry securities transfer systems have been created that
neither provide, nor are linked to, a money transfer system.



Several institutions may be involved in the process of securities settlement. Most markets have
established central securities depositories (CSDs) which dematerializes physical securities and
transfer ownership by means of book entries to electronic accounting systems. However, other
institutions often perform additional critical functions in the settlement process. Confirmation
of trade is usually carried out by a stock exchange rather than by the CSD. In some markets, a
central counterparty (CCP) interposes itself between buyers and sellers. The CCP thus becomes
the buyer to every seller and the seller to every buyer. Accounts at the respective central bank

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or at one or more private commercial banks are used for settlements and transfers of funds.
Funds may nevertheless be transferred through internal accounts at the CSD. Securities can be
held at accounts at the CSD or through a custodian. The custodian may hold the securities of its
customer through a sub custodian.

The whole Clearing & Settlement process and other Post Trade Activities have been captured in
the diagram below:

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• The process of clearing and settling a securities trade includes several key steps:
o Confirmation of the terms of the trade by the direct market participants
o Calculation of the obligations of the counterparties resulting from the confirmation
process, known as clearance;
o Final transfer of securities (delivery) in exchange for final transfer of funds
(payment) in order to settle the obligations.

• The process begins with the execution of the trade.

• Once a trade is executed, the next step is to ensure that the counterparties to the trade (the
buyer and the seller) agree on the terms of the transaction - the security involved, the price,
the amount to be exchanged, the settlement date and the counterparty. This step is
referred to in some markets as trade matching and in others as trade comparison or

• Trade matching and confirmation set the stage for trade clearance, that is, for the
computation of the obligations of the counterparties to make deliveries or payments on the
settlement date. The obligations arising from securities trades are sometimes subject to

• Once the obligations of the market participants have been calculated, whether on a gross
basis or on a net basis, the instructions to transfer the securities and funds (monies)
necessary to discharge the obligations are transmitted to the entity or entities that operate
the settlement system.

• Settlement of a securities trade involves the transfer of the securities from the seller to the
buyer and the transfer of funds from the buyer to the seller.

• Only the final transfer of a security by the seller to the buyer constitutes delivery, while only
final transfer of funds from the buyer to the seller constitutes payment. When delivery and
payment have occurred, the settlement process is completed.

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Risk is the degree of uncertainty associated with an action, such as project implementation
within time and budget, profitability of a project, market returns on an investment etc.,. It’s an
exposure to uncertain future outcome, i.e. risk is the chance that the actual outcome will be
different from the expected. Risk is directly proportional to level of uncertainty. Higher the
uncertainty, higher is the risk.

The risk of an investment is equivalent to the distribution of potential outcomes, where the
distribution consists of all possible outcomes weighted by their relative probability of
occurrence. The more extreme the distribution of outcomes, the riskier the project. Two
projects could have the same expected return (the weighted average of all possible outcomes)
but differ in their risk, if one project had a broader range of outcomes or a higher probability of
extreme outcomes than the other.

Risk is often the single largest factor determining the rate of return that an activity will provide.
Annualized standard deviation of return is the generic measurement of risk in most markets, but
asset and liability managers also look at the entire probability distribution of returns and the
maximum cost of adverse developments to assess the risk.

Financial Institutions need to manage different kinds of risks, with seemingly opposing needs.
For example - providing liquidity to the depositors on demand as well as credits to its borrowers
with the ultimate objective to maximize returns.


The higher the risk, 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.


With respect to the financial institutions, risk can be classified into the following types

• Operational Risk

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• Credit Risk

• Market Risk

- Interest Rate Risk

- Currency Risk
- Equity Risk
- Commodity Risk

• Liquidity risk

• Legal Risk


Operational risk can be defined as the exposure to potential monetary losses resulting from
inadequate or failed people, systems and internal processes or from external events. As the
name implies, internal operational risk arises primarily from day to day operations and
transactions of a financial institution. The most important challenge in Operational risk is to
identify the risks and evolve procedures for managing the same. Managing operational risk
involves identifying causes for risk, adopting a formalized approach to monitor and control risk
and managing loss data.

The identification and measurement of operational risk is a real and live issue for modern-day
banks, particularly since the decision by the Basel Committee on Banking Supervision (BCBS) to
introduce a capital charge for this risk as part of the new capital adequacy framework (Basel II).


Credit risk is the risk due to uncertainty in counterparty’s (also called an obligor or creditor's)
ability to meet its obligations. The term obligation refers to making debt payments on a timely
basis. The failure to make these payments is called default. For this reason, credit risk is also
known as default risk. The payments can themselves be classified into two broad groups:

Principal: This is the amount borrowed by the counterparty, or that part of the amount
borrowed which remains unpaid.

Interest: This is the fee charged by the lender to the borrower for the use of the borrowed

Credit risk can be experienced by both companies as well as individuals.

Example - Companies carry credit risk when, for example, they do not demand up-front cash
payment for products or services. By delivering the product or service first and billing the
customer later, the company is carrying a risk between the delivery and payment.

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Different types of Market risk are


Interest rate risk captures the exposure of an institution or an individual’s financial condition to
adverse movements in interest rates. It captures the potential actual and notional monetary
losses arising from assets and liabilities due to changes in interest rates. Interest rate risk is
associated with fixed interest securities like bonds, whose prices drops as interest rates rise.
Financial Institutions face interest rate risk in their deposit taking and lending process - the risk
that spread income will suffer because of a change in interest rates. Interest rate risk can be
faced by both companies as well as individuals.

Example – When the inflation runs high, the central bank of the country will usually tighten the
grip on money supply by increasing the lending interest rates. Say a person had taken a home
loan under normal inflation scenario in the economy. After 1 year, inflation has considerably
increased and the central bank decides to intervene and pull inflation back to normal. One of
the measures it can adopt is to increase its lending rates to the banks. In turn the banks will
increase their lending rates. This will finally affect the person who has taken the floating rate
home loan because, due to the increase in the loan interest rate, now he has to pay an
increased sum of money as interest. This explains the fact that the person is exposed to interest
rate risk.

Currency Risk captures the potential losses arising from unanticipated exchange rate changes.
Financial institutions face currency risk mainly due to foreign exchange positions taken on behalf
of clients and indirect exposure as a result of conducting business with companies exposed to
currency risk.

Exchange risk can also be defined as a potential gain or loss that occurs as a result of an
exchange rate change.

Example, if an individual owns a share in Hitachi, the Japanese company, he or she will lose if
the value of the yen drops.

Equity Risk is the risk arising due to volatility in a stock price. The level of volatility of the
investment is directly proportional to the potential gains (and losses). Companies or Individuals
face equity risk due to holding equity shares for trading or investment purposes.

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Equity risk premium is the excess return that an individual stock or the overall stock market
provides over a risk-free rate. This excess return compensates investors for taking on the
relatively higher risk of the equity market. The size of the premium will vary as the risk
in a particular stock, or in the stock market as a whole, changes; high-risk investments are
compensated with a higher premium.

Commodity risk refers to the uncertainties of future market values and of the size of the future
income, caused by the fluctuation in the prices of commodities. These commodities may be
grains, metals, gas, electricity etc. Different types of commodity risks are Price risk, Quantity
risk, Cost risk and Political risk. The following entities can face Commodity risk

• Producers (farmers, plantation companies, and mining companies) face price risk, cost
risk on the prices of their inputs and quantity risk

• Buyers (cooperatives, commercial traders and trait ants) face price risk between the
time of up-country purchase buying and sale, typically at the port, to an exporter.

• Exporters face the same risk between purchase at the port and sale in the destination
market; and may also face political risks with regard to export licenses or foreign
exchange conversion.

• Governments face price and quantity risk with regard to tax revenues, particularly
where tax rates rise as commodity prices rise or if support or other payments depend on
the level of commodity prices.

Liquidity risk is the inability to meet financial commitments, as they fall due, through ongoing
cash flow or asset sale at fair market value. It is a financial risk due to uncertain liquidity.

An institution might lose liquidity if its credit rating falls, it experiences sudden, unexpected cash
outflows, or some other event causes counterparties to avoid trading with or lending to the
institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to
loss of liquidity.

The term liquidity is used in various ways, all relating to availability of, access to, or convertibility
into cash.

• An institution is said to have liquidity if it can easily meet its needs for cash either because it
has cash on hand or can otherwise raise or borrow cash.

• A market is said to be liquid if the instruments it trades can easily be bought or sold in
quantity with little impact on market prices.

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• An asset is said to be liquid if the market for that asset is liquid.

The common theme in all three contexts is cash. A corporation is liquid if it has ready access to
cash. A market is liquid if participants can easily convert positions into cash—or conversely. An
asset is liquid if it can easily be converted to cash.

The liquidity of an institution depends on:

• The institution's short-term need for cash;

• Cash on hand;

• Available lines of credit;

• The liquidity of the institution's assets;

• The institution's reputation in the marketplace—how willing will counterparty is to transact

trades with or lend to the institution.

Examples of assets that tend to be liquid include foreign exchange; stocks traded on the New
York Stock Exchange or recently issued (on-the-run) Treasury bonds. Assets that are often
illiquid include limited partnerships, thinly traded bonds or real estate.

A Legal Risk can be defined as a potential economical loss deriving from the infringement of a
legal norm. The loss can derive from a sanction or the deprival of possible advantages. Infringing
behavioral norms may cause pecuniary penalties or tort claims, whereas infringement of norms
regarding contracting may lead to unenforceable claims, damages or performance obligations.
Infringement of legal norms may also lead to economical loss caused by damaged reputation.
The expected loss due to the infringement of a legal norm can be calculated by multiplying the
potential loss with the probability of the loss being suffered.

Legal risk arises due to uncertainty of legal actions or uncertainty in the applicability or
interpretation of contracts, laws or regulations.


Risk management is a central part of any organization’s strategic management. It is the process
whereby organizations methodically address the risks attaching to their activities with the goal
of achieving sustained benefit within each activity and across the portfolio of all activities. The
focus of good risk management is the identification and treatment of these risks. Its objective is
to add maximum sustainable value to all the activities of the organization. It marshals the
understanding of the potential upside and downside of all those factors which can affect the

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organization. It increases the probability of success, and reduces both the probability of failure
and the uncertainty of achieving the organization’s overall objectives.

Risk management should be a continuous and developing process which runs throughout the
organization’s strategy and the implementation of that strategy. It should address methodically
all the risks surrounding the organization’s activities past, present and in particular, future. It
must be integrated into the culture of the organization with an effective policy and a program
led by the most senior management. It must translate the strategy into tactical and operational
objectives, assigning responsibility throughout the organization with each manager and
employee responsible for the management of risk as part of their job description. It supports
accountability, performance measurement and reward, thus promoting operational efficiency at
all levels.


The revised capital adequacy framework, commonly known as Basel II, sets out the details of the
agreed Framework for measuring capital adequacy and the minimum standards for adopting
more risk-sensitive minimum capital requirements for banking organizations. Basel II builds on
the Basel I Accord’s basic structure by aligning capital requirements more closely to the risk of
credit loss and by introducing a new capital charge for operational risk.

It is being prepared by the Basel Committee on Banking Supervision, a group of central banks
and bank supervisory authorities in the G10 countries, which developed the first standard, Basel
I, in 1988. The new framework, Basel II, reinforces the risk-sensitive requirements by laying out
principles & guidelines for banks:

• To assess the adequacy of their capital

• To review internal risk and capital assessment processes to ensure banks have adequate
capital to support their risk profile.

• To strengthen market discipline by enhancing transparency in banks’ financial reporting

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

This Framework will apply on a consolidated basis to internationally active banks in order to
preserve the integrity of capital in banks with subsidiaries, by eliminating double gearing. The

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Framework will include, on a fully consolidated basis, any holding company that is the parent
entity within a banking group to ensure that it captures the risk of the whole banking group.

All banking and other relevant financial activities, excluding insurance entities and activities,
(both regulated and unregulated) conducted within a group containing an internationally active
bank will be captured through consolidation. The Framework will also apply to all internationally
active banks at every tier within a banking group, also on a fully consolidated basis. Basel II will
impact the entire spectrum of banking, including corporate finance, retail banking, asset
management, payments and settlements, commercial banking, trading and sales, retail,
brokerage, and agency and custody services.


The underlying principle for the Basel II 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.

Basel II is based on three mutually reinforcing pillars viz., Minimum capital requirement,
Supervisory review and Market Discipline. The first pillar represents a significant strengthening
of the minimum requirements set out in the 1988 Accord, while the second and third pillars
represent innovative additions to capital supervision.

Minimum capital requirements: Focus is on the bank’s internal risk assessments and
management processes. Basel II improves the capital framework’s sensitivity to the risk of credit
losses generally by requiring higher levels of capital for those borrowers thought to present
higher levels of credit risk, and vice versa. Three options are available to allow banks and
supervisors to choose an approach that seems most appropriate for the sophistication of a
bank’s activities and internal controls.

Data must be sufficiently granular and capture historical trends to get a detailed view of risk
across the enterprise. It describes the calculation for regulatory capital for credit, operational
and market risk. Credit risk regulatory capital requirements are more risk based than the 1988
Accord. An explicit operational risk regulatory capital charge is introduced for the first time
while market risk requirements remain the same as in the Current Accord.

Supervisory review: Internal risk and capital assessment processes will be evaluated for sound
practices. Supervisors will evaluate the activities and risk profiles of individual banks to
determine whether those organizations should hold higher levels of capital than the minimum
requirements in Pillar 1 would specify and to see whether there is any need for remedial
actions. It intended to bridge the gap between regulatory and economic capital requirements
and gives supervisors discretion to increase regulatory capital requirements if weaknesses are
found in a lender's internal capital assessment process.

Market discipline: Enhanced reporting and disclosure requirements on items such as capital
structure, risk measurement and management practices, risk profile, and capital adequacy.

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Basel II strengthens the link between regulatory capital and risk management. Under the
advanced approaches, in particular, banks will be required to adopt more-formal, quantitative
risk-measurement and risk-management procedures and processes. For instance, Basel II
establishes standards for data collection and the systematic use of the information collected.
These standards are consistent with broader supervisory expectations that high-quality risk
management at large complex organizations will depend upon credible data. Enhancements to
technological infrastructure--combined with an appropriate database--will, over time, allow
firms to better price exposures and measure and manage risk. The emphasis on improved data
standards in the revised Accord should not be interpreted solely as a regulatory capital
requirement, but rather as a foundation for risk-management practices that will strengthen the
value of the banking franchise.

Even the best processes for evaluating risk and performance suffer if the data used are flawed.
In this broader sense, "data integrity" can refer not only to the consistency, accuracy, and
appropriateness of the information in the database and model, but also to the processes that
produce and use this information. Used this way, "data integrity" includes quality of credit files,
tracking of key customer characteristics, internal processes and controls, and even the training
that supports them all.

If banks do not create an appropriate environment in which their quantitative risk measures and
associated models are used--in other words, if an institution considers internal controls to be
just a checklist--risk measures will not provide the performance the bank hopes to achieve.

Pillar 2 requires each bank to develop its own viable internal process for assessing capital
adequacy that contributes to the determination of the amount of capital actually held. For
instance, each institution must correct for Pillar 1 assumptions that may not apply to that
particular bank--for example, if the "well diversified" assumption of Basel II is not met by an
individual bank because of its geographic or sectoral concentrations. In essence, the bank should
determine whether its capital levels are appropriate in light of any deviations from Pillar 1
assumptions. The added transparency in Pillar 3 should also generate improved market
discipline for these large organizations, in some cases forcing them to run a better business.
Market discipline is not possible if counterparties and rating agencies do not have good
information about banks' risk positions and the techniques used to manage those positions.
Indeed, market participants play a useful role by requiring banks to hold more capital than
implied by minimum regulatory capital requirements--or sometimes their own economic capital
models--and by demanding additional disclosures about how risks are being identified,
measured, and managed. Greater transparency also offers an opportunity for market
participants to monitor banks' progress over time and identify if they are keeping up with the
latest techniques.

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The four stages of the Risk Process are detailed under this topic, at each stage the key activities
and outputs are highlighted together with detail on the techniques and stakeholders involved.
The four stages are:

• Identify - Find, list and characterize elements of Risk.

• Analyze – Measure and Prioritize identified Risks against agreed criteria.

• Manage – Treating risk by developing relevant risk management strategies.

This stage of the iterative process identifies the widest possible range of risks associated with a
particular project.

Identification includes the preparation of lists of activities, the identification of risks associated
with each activity and possible counters to each risk.

All stakeholders should be consulted, and external opinions should be sought where appropriate
and practical. Also it is important to identify interdependencies between various risks and any
consequential risks i.e. those risks associated with mitigations to the primary risks.

After risks have been identified they should be validated in terms of both the probable truth of
the information as initially elicited about the risk and the accuracy of the description initially
built up of the risk's characteristics.

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

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.

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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”

The balance between qualitative and quantitative analysis will vary from project to project and
have to be determined by the availability of data and the need to remain cost-effective.

Credit Risk, Operational Risk and Market Risk are the 3 main risk types as defined by the Basel 2
norms. So it is important to know the measurement techniques adopted for each of these 3 risk

1. Market Risk

Measurement technique - 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.

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:

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

What is the probability of a loss of more than $20 million dollars by year end?

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.

VaR Calculation

A generic step-wise approach to calculate would be to:

Get price data for the portfolio holdings.


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Convert price data in to log return data. (Log Return: ui = ln (Si / Si-1) where Si is the price of the
asset on day i)

Calculate standard deviations of each instrument or each proxy.

Calculate preferred confidence level. 99% = 2.33 * standard deviation.

Multiply position holdings by their respective Standard Deviation at a 99% confidence level. This
results in a position VaR at a 99% confidence level.

Example VaR Calculation

Assume that you have a holding in IBM Stock worth $10 million. You have calculated the standard
deviation (SD) of change over one day in IBM is $ 0.20.

Therefore for the entire position, SD of change over 1 day = $200,000

The SD of change over 10 days = $200,000 * √(10) = $632,456

The 99% VaR over 10 days = 2.33 * 632,456 = $1,473,621

2. Operational Risk

2.1 Measurement technique – Basic Indicator Approach

The basic approach or basic indicator approach is a set of operational risk measurement
techniques proposed under Basel II capital adequacy rules for banking institutions.

Basel II requires all banking institutions to set aside capital for operational risk. Basic indicator
approach is much simpler compared to the alternative approaches (i.e. standardized approach
(operational risk) and advanced measurement approach) and this has been recommended for
banks without significant international operations.

Based on the original Basel Accord, banks using the basic indicator approach must hold capital
for operational risk equal to the average over the previous three years of a fixed percentage of
positive annual gross income. Figures for any year in which annual gross income is negative or
zero should be excluded from both the numerator and denominator when calculating the

The fixed percentage ‘alpha’ is typically 15 percent of annual gross income.

2.2 Measurement technique – Standardized Approach

Standardized approach falls between basic indicator approach and advanced measurement
approach in terms of degree of complexity.

Based on the original Basel Accord, under the Standardized Approach, banks’ activities are
divided into eight business lines: corporate finance, trading & sales, retail banking, commercial
banking, payment & settlement, agency services, asset management, and retail brokerage.

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Within each business line, gross income is a broad indicator that serves as a proxy for the scale
of business operations and thus the likely scale of operational risk exposure within each of these
business lines. The capital charge for each business line is calculated by multiplying gross income
by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for the industry-
wide relationship between the operational risk loss experience for a given business line and the
aggregate level of gross income for that business line.

The total capital charge is calculated as the three-year average of the simple summation of the
regulatory capital charges across each of the business lines in each year. In any given year,
negative capital charges (resulting from negative gross income) in any business line may offset
positive capital charges in other business lines without limit.

In order to qualify for use of the standardized approach, a bank must satisfy its regulator that, at
a minimum:

• Its board of directors and senior management, as appropriate, are actively involved
in the oversight of the operational risk management framework;

• It has an operational risk management system that is conceptually sound and is

implemented with integrity; and

• It has sufficient resources in the use of the approach in the major business lines as
well as the control and audit areas.

2.3 Measurement technique – Advanced Measurement Approach

Under this approach the banks are allowed to develop their own empirical model to quantify
required capital for operational risk. Banks can use this approach only subject to approval from
their local regulators.

In order to qualify for use of the AMA a bank must satisfy its supervisor that, at a minimum:

• Its board of directors and senior management, as appropriate, are actively involved
in the oversight of the operational risk management framework;

• It has an operational risk management system that is conceptually sound and is

implemented with integrity; and

• It has sufficient resources in the use of the approach in the major business lines as
well as the control and audit areas.

3. Risk type – Credit Risk

3.1 Measurement technique – Foundation Internal Ratings Based Approach


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The term Foundation IRB or F-IRB is an abbreviation of foundation internal ratings-based

approach and it refers to a set of credit risk measurement techniques proposed under Basel II
capital adequacy rules for banking institutions.

Under this approach the banks are allowed to develop their own empirical model to estimate
the PD (probability of default) for individual clients or groups of clients. Banks can use this
approach only subject to approval from their local regulators.

Under F-IRB banks are required to use regulator's prescribed LGD (Loss Given Default) and other
parameters required for calculating the RWA (Risk Weighted Asset). Then total required capital
is calculated as a fixed percentage of the estimated RWA.

3.2 Measurement technique – Probability of Default (PD)

Probability of default (PD) is a parameter used in the calculation of economic capital or

regulatory capital under Basel II for a banking institution. This is an attribute of a bank's client.

The probability of default is the likelihood that a loan will not be repaid and will fall into default.
PD is calculated for each client who has a loan or for a portfolio of clients with similar attributes.
The credit history of the counterparty / portfolio and nature of the investment are taken into
account to calculate the PD. There are many alternatives for estimating the probability of
default. Default probabilities may be estimated from a historical data base of actual defaults
using modern techniques like logistic regression. Default probabilities may also be estimated
from the observable prices of credit default swaps, bonds, and options on common stock. The
simplest approach, taken by many banks, is to use external ratings agencies such as Egan Jones,
Fitch, Moody's Investors Service, or Standard and Poor’s for estimating PDs from historical
default experience. For small business default probability estimation, logistic regression is again
the most common technique for estimating the drivers of default for a small business based on
a historical data base of defaults. These models are both developed internally and supplied by
third parties.

3.3 Measurement technique – Loss Given Default (LGD)

Loss Given Default or LGD is a common parameter in Risk Models and also a parameter used in
the calculation of Economic Capital or Regulatory Capital under Basel II for a banking institution.
This is an attribute of any exposure on bank's client.

LGD is the fraction of Exposure at Default (EAD) that will not be recovered following default.

Loss Given Default is facility-specific because such losses are generally understood to be
influenced by key transaction characteristics such as the presence of collateral and the degree of

'Gross' LGD is calculated by dividing total losses Exposure at Default (EAD).

3.4 Measurement technique – Loss Given Default (LGD)


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Exposure at default (EAD) is a parameter used in the calculation of economic capital or

regulatory capital under Basel II for a banking institution. This is an attribute of any exposure on
bank's client.

In general EAD can be seen as an estimation of the extent to which a bank may be exposed to
counterparty in the event of, and at the time of, that counterparty’s default. It is a measure of
potential exposure as calculated by a Basel Credit Risk Model for the period of 1 year or until
maturity whichever is sooner.

Under Basel II a bank needs to provide an estimate of the exposure amount for each
transaction, commonly referred to as Exposure at Default (EAD), in banks’ internal systems. All
these loss estimates should seek to fully capture the risks of an underlying exposure.

3.5 Other Risk Measurement Techniques

• 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. This should result in a set of portfolio revaluations
corresponding to the set of possible realizations of rates. From that distribution the 99th
percentile loss can be taken as the VaR.

• 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

It takes those actual changes, applies them to the current set of rates and then uses those to
revalue the portfolio. When done, a set of portfolio revaluations corresponding to the set of
possible realizations of rates is obtained. From that distribution, we can calculate the standard
deviation and take the 99th percentile loss as the VaR.

• 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 incorporate 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.

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There are multiple strategies to manage risks. Some of the commonly followed ones are:

o Diversification
o Hedging or Insurance

o Setting Risk Limits

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.

There are four options for handling risk

Option Description

Terminate Some risks will only be treatable, or containable to acceptable levels, by

(Avoid) terminating or avoiding the activity or activities that give rise to the risk.

Tolerate The ability to do anything about some risks may be limited, or the cost of
(Accept) taking any action may be disproportionate to the potential benefit gained. In
these cases the response may be toleration.

Transfer For some risks the best response may be to transfer them. Namely, shift the
responsibility or burden of loss to another party through legislation,
contract, insurance or other means. Partial transfers are known as risk
sharing or risk assignment.

Treat By far the greater number of risks will belong to this category. The purpose
(Reduce) of treatment is not necessarily to eliminate the risk, but more likely to
contain the risk to an acceptable level.

• Strategic risk

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Strategic risk is the current and prospective risk to earnings or capital arising from adverse
business decisions, improper implementation of decisions, or lack of responsiveness to industry

• Country risk

Country risk refers to the risk that a country won't be able to honor its financial commitments.
When a country defaults on its obligations, this can harm the performance of all other financial
instruments in that country as well as other countries it has relations with. Country risk applies
to stocks, bonds, mutual funds, options and futures that are issued within a particular country.
This type of risk is most often seen in emerging markets or countries that have a severe deficit.

• Political risk

Political risk represents the financial risk that a country's government will suddenly change its
policies. This is a major reason why developing countries lack foreign investment.

• Investment risk

This is defined as the risk that an investment's actual return will be lower than its expected
return. Investment risk includes the possibility of an investment losing market value, and may be
reduced through diversification.

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Employee benefit plans are established or maintained by an employer or by an employee

organization (such as a union), or both, that provides retirement income or defers income until
termination of covered employment or beyond. There are a number of types of retirement
plans, including the 401(k) plan and the traditional pension plan, known as a defined benefit

The Employee Retirement Income Security Act (ERISA) covers most private sector pension plans.
Among other things, ERISA provides protections for participants and beneficiaries in employee
benefit plans, including providing access to plan information. Also, those individuals who
manage plans (and other fiduciaries) must meet certain standards of conduct under the
fiduciary responsibilities specified in the law.

The Employee Benefits Security Administration (EBSA) of the Department of Labor is responsible
for Administering and enforcing these provisions of ERISA. As part of carrying out its
responsibilities, the agency provides consumer information on pension plans, as well as
compliance assistance for employers; plan service providers, and others to help them comply
with ERISA.

The primary employee benefits are

• Defined Benefits
• Defined Contribution
• Health and Welfare


Defined Benefit plans are the oldest retirement plans that exist in the Pension Industry. They
promise to pay a specified benefit at retirement age. They define the amount of retirement
income to be paid. The actual monthly (or annual) benefit is calculated using a specific formula
stated in the plan document. The benefit is usually paid at a specified time such as attainment of
age 65.

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A Defined Benefit Plan is an employer-sponsored retirement plan in which retirement benefits

are based on a formula indicating the exact benefit that one can expect upon retiring.
Investment risk is borne by the employer and portfolio management is entirely under the
control of the company. There are restrictions on when and how participant can withdraw these
funds without penalties.

A private defined benefit plan is typically not contributory i.e. there are usually no employees
contributions, no individual accounts are maintained for each employee. The employer makes
regular contributions to the entire plan to fund the future benefits of the entire cohort of
participants. The employer, rather than the participant, bears the investment risk. Usually, the
promised benefit is tied to the employee's earnings, length of service, or both.

A Defined Benefit plan provides a guaranteed level of benefits on retirement and the cost is
unknown for the employer. If the plan assets earn less than expected, the employer must make
larger contributions to ensure that the plan will have sufficient funds to pay promised benefits.
If the plan assets earn more than expected, the employer's contributions will decrease.


A Defined Contribution Plan is a type of retirement plan that sets aside a certain amount of
money each year for an employee. The amount to be contributed to each participant's account
under the plan each year is defined (by either a fixed formula or by giving the employer the
discretion to decide how much to contribute each year). The size of a participant's benefit will
depend on:

• The amounts of money contributed to the individual's account by the employer and,
perhaps, by the employee as well;
• The rate of investment growth on the principal;
• How long the money remains in the plan (in most cases, the employee, upon retirement,
has the option of either receiving the payment in a lump sum or by taking partial payments
on a regular basis while the balance continues to earn interest); and
• Whether the forfeitures of participants who leave before they are fully vested can be shared
among the remaining participants as a reward to long-term employees.

Since benefits accumulate on an individual basis, these plans are sometimes referred to as
"individual account plans." In these plans, unlike in defined benefit plans, the risk (and reward)
of investment experience is borne by the participant. Defined contribution plans can permit, and
sometimes require, that employees make contributions to the plan on either a pre-tax basis (as
in a 401(k) plan) or an after-tax basis (as in a thrift plan). They may also, but are not required to,
permit employees to decide how the monies contributed into their accounts will be invested.

Defined contribution plans have gained popularity as employers have begun to ask their
employees to share responsibility for their retirement. The main purpose of a defined

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contribution plan is to provide an investment vehicle for employees to accumulate retirement


Defined Benefit Plan Defined Contribution Plan

The employer funds it. Employee and employer contributions are

allocated to individual participants

The employer bears the investment risk The participant bears the investment risk.
(the potential for investment gain or

It is generally difficult to communicate. It is easier to communicate.

The final benefit is defined as it is The final retirement benefit is unknown as it is

formula driven taking definite decided by the performance of participant
parameters (like salary, number of years selected investment funds.
of service etc.) as input data

The benefit is expressed as an annuity (a The benefit is expressed as an account

specified annual or monthly payment to balance.
a pensioner over a specified period of
time or based on life expectancy)
payable at normal retirement age,
usually age 65.

The following plans are designated as defined contribution plans:

• Profit Sharing Plans
• Cash Or Deferred Arrangements Or 401(k) Plans
• Stock Bonus Plans And Employee Stock Ownership Plans
• Simplified employee pensions (SEP)
• Tax Sheltered Annuities Or 403(b) Arrangements
Business entities involved in the Defined Contribution Pension Administration process have
strong interdependency in-terms of flow of information, fund and assets (stocks).

The diagram below depicts the main entities in the plan administration business and their
relations with each other.

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Fig 2.1

• Sponsor delegates responsibilities to plan administrator

• Participant contributes for the plan to the sponsor.
• Trust owns the funds of the plan contributed by the sponsor and the participants and
delegates management of the same to Investment Manager
• Trust and plan administrator submit compliance reports to Federal Agencies which in turn
would qualify the plan.
• Participants direct the Investment manager on their investment preferences.
• Record Keepers provide information on Participant, plan and account information to Plan
Administrators, trustee, Sponsor and Participant.

Following diagram explains the basic processes involved in benefits administration


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In the early days when the Social Security was adopted, Health insurance was taken care by
private sectors. Later the escalating health costs and wage freezes of the post WW II era,
prompted many companies to offer non-cash rewards in the form of Health care benefits. The
challenges due to competitive benefits for maintaining the fiscal responsibility and changes in
tax code made the employers to offer greater benefit choices with certain tax incentives.

Health and Welfare benefit plans can be either Defined-Benefit or Defined Contribution plans.

Defined Benefit health and welfare plans specify a determinable benefit, which may be in the
form of reimbursement to the covered plan participant or a direct payment to providers or third
party insurers for the cost of specified services. Even when a plan is funded pursuant to
agreements that specify a fixed rate of employer contribution, it cannot be a Defined benefit
health and welfare plan.

Defined Contribution health and welfare plans on the other hand maintain an individual account
for each plan participant. The benefits a plan participant will receive are limited to the amount

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contributed to the participant’s account, experience, expenses etc. Health and Welfare plans
generally are subject to certain fiduciary, reporting and other requirements of the ERISA
(Employee Retirement Income Security Act, 1974).

Categories of health and welfare plans

• Health Care
o Medical
o Prescription drug
o Behavioral health
o Dental
o Vision
o Long-term care
• Disability Income
o Sick leave
o Short-term disability
o Long term disability
• Survivor Benefits
o Term life

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US Government passed the Uniting and Strengthening America by Providing Appropriate Tools
Required to Intercept and Obstruct Terrorism (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.


Federal communications privacy law currently 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

Extracted from Congressional Research Service, US and Federation of American Scientists -

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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.


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 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).


In federal law, money laundering is the flow of cash or other valuables derived from, or
intended to facilitate, the commission of a criminal offence. 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

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• 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 offence occurs.

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 harbouring 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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Anti Money Laundering 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


• 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.


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

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

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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.

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


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

Extracted from Sarbanes-Oxley forum

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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

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.



A subprime loan is a loan given to borrowers that are considered more risky, or less likely to be
able to make their loan payments, in relation to high quality borrowers because of problems

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with their credit history. When a person goes applies for a loan he needs to get a credit check,
and what results from this credit check is something that is known as the FICO score. A FICO
score is a number which represents how credit worthy that person is considered which is based
on factors such as the amount of money that he earns, his record of paying back past debts, and
how much debt he currently holds. The higher the score the better his credit is considered, and
the more likely he is to get a loan.



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The subprime mortgage crisis is an ongoing financial crisis triggered by the rapid fall in house
prices and an attendant rise in mortgage delinquencies and foreclosures in the United States,
particularly among a class of loans that grew dramatically in the closing years of the 20th
century - subprime mortgages. Major adverse consequences for banks and financial markets
have been felt around the globe. The crisis became apparent in 2007 and has exposed pervasive
weaknesses in financial industry regulation and the global financial system.

For more than a decade, a massive amount of money flowed into the United States from
investors abroad. This large influx of money to U.S. banks and financial institutions — along with
low interest rates — made it easier for Americans to get credit. Easy credit — combined with the
faulty assumption that home values would continue to rise — led to excesses and bad decisions.
Many mortgage lenders approved loans for borrowers without carefully examining their ability
to pay. Many borrowers took out loans larger than they could afford, assuming that they could
sell or refinance their homes at a higher price later on. Both individuals and financial institutions
increased their debt levels relative to historical norms during the past decade significantly.

Optimism about housing values also led to a boom in home construction. Eventually the number
of new houses exceeded the number of people willing to buy them. And with supply exceeding
demand, housing prices fell. And this created a problem: Borrowers with adjustable rate
mortgages (i.e., those with initially low rates that later rise) who had been planning to sell or
refinance their homes before the adjustments occurred was unable to refinance. As a result,
many mortgage holders began to default as the adjustments began.

These widespread defaults (and related foreclosures) had effects far beyond the housing
market. Home loans are often packaged together, and converted into financial products called
"mortgage-backed securities." These securities were sold to investors around the world. Many
investors assumed these securities were trustworthy, and asked few questions about their
actual value. Credit rating agencies gave them high-grade, safe ratings. Two of the leading
sellers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these
companies were chartered by Congress, many believed they were guaranteed by the federal
government. This allowed them to borrow enormous sums of money, fuel the market for
questionable investments, and put the financial system at risk.

The decline in the housing market set off a domino effect across the U.S. economy. When home
values declined and adjustable rate mortgage payment amounts increased, borrowers defaulted
on their mortgages. Investors globally holding mortgage-backed securities (including many of
the banks that originated them and traded them among themselves) began to incur serious
losses. Before long, these securities became so unreliable that they were not being bought or
sold. Investment banks such as Bear Stearns and Lehman Brothers found themselves saddled
with large amounts of assets they could not sell. They ran out of the money needed to meet
their immediate obligations. And they faced imminent collapse. Other banks found themselves
in severe financial trouble. These banks began holding on to their money, and lending dried up,
and the gears of the American financial system began grinding to a halt.

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The crisis has gone through stages. First, during late 2007, over 100 mortgage lending
companies went bankrupt as subprime mortgage-backed securities could no longer be sold to
investors to acquire funds. Second, starting in Q4 2007 and in each quarter since then, financial
institutions have recognized massive losses as they adjust the value of their mortgage backed
securities to a fraction of their purchased prices. These losses as the housing market continued
to deteriorate meant that the banks have a weaker capital base from which to lend. Third,
during Q1 2008, investment bank Bear Stearns was hastily merged with bank JP Morgan with
$30 billion in government guarantees, after it was unable to continue borrowing to finance its

Fourth, during September 2008, the system approached meltdown. In early September Fannie
Mae and Freddie Mac, representing $5 trillion in mortgage obligations, were nationalized by the
U.S. government as mortgage losses increased. Next, investment bank Lehman Brothers filed for
bankruptcy. In addition, two large U.S. banks (Washington Mutual and Wachovia) became
insolvent and were sold to stronger banks. The world's largest insurer, AIG, was 80%
nationalized by the U.S. government, due to concerns regarding its ability to honor its
obligations via a form of financial insurance called credit default swaps. These sequential and
significant institutional failures, particularly the Lehman bankruptcy, involved further seizing of
credit markets and more serious global impact. The interconnected nature of Lehman was such
that its failure triggered system-wide (systemic) concerns regarding the ability of major
institutions to honor their obligations to counterparties. The interest rates banks charged to
each other increased to record levels and various methods of obtaining short-term funding
became less available to non-financial corporations. It was this "credit freeze" that some
described as a near-complete seizing of the credit markets in September that drove the massive
bailout procedures implemented by world-wide governments in Q4 2008. Prior to that point,
each major U.S. institutional intervention had been ad-hoc; critics argued this damaged investor
and consumer confidence in the U.S. government's ability to deal effectively and proactively
with the crisis. Further, the judgment and credibility of senior U.S. financial leadership was
called into question.


The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, [9] with
over 7.5 million first-lien subprime mortgages outstanding. Approximately 16% of subprime
loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure
proceedings as of October 2007, roughly triple the rate of 2005. By January 2008, the
delinquency rate had risen to 21% and by May 2008 it was 25%.

Between 2004-2006 the share of subprime mortgages relative to total originations ranged from
18%-21%, versus less than 10% in 2001-2003 and during 2007. Subprime ARMs only represent
6.8% of the loans outstanding in the US, yet they represent 43% of the foreclosures started
during the third quarter of 2007.[16] During 2007, nearly 1.3 million properties were subject to
2.2 million foreclosure filings, up 79% and 75% respectively versus 2006. Foreclosure filings
including default notices, auction sale notices and bank repossessions can include multiple
notices on the same property. During 2008, this increased to 2.3 million properties, an 81%
increase over 2007. Between August 2007 and September 2008, an estimated 851,000 homes
were repossessed by lenders from homeowners. Foreclosures are concentrated in particular

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states both in terms of the number and rate of foreclosure filings. - cite_note-19Ten
states accounted for 74% of the foreclosure filings during 2008; the top two (California and
Florida) represented 41%. Nine states were above the national foreclosure rate average of
1.84% of households.

The mortgage market is estimated at $12 trillion with approximately 6.41% of loans delinquent
and 2.75% of loans in foreclosure as of August 2008. The estimated value of subprime
adjustable-rate mortgages (ARM) resetting at higher interest rates is U.S. $400 billion for 2007
and $500 billion for 2008. Reset activity is expected to increase to a monthly peak in March 2008
of nearly $100 billion, before declining. An average of 450,000 subprimes ARM are scheduled to
undergo their first rate increase each quarter in 2008.

An estimated 8.8 million homeowners (nearly 10.8% of the total) have zero or negative equity as
of March 2008, meaning their homes are worth less than their mortgage. This provides an
incentive to "walk away" from the home, despite the credit rating impact.

By January 2008, the inventory of unsold new homes stood at 9.8 months based on December
2007 sales volume, the highest level since 1981. Further a record of nearly four million unsold
existing homes was for sale, including nearly 2.9 million that were vacant. This excess supply of
home inventory places significant downward pressure on prices. As prices decline, more
homeowners are at risk of default and foreclosure. According to the S&P/Case-Shiller price
index, by November 2007, average U.S. housing prices had fallen approximately 8% from their
Q2 2006 peak and by May 2008 they had fallen 18.4%. The price decline in December 2007
versus the year-ago period was 10.4% and for May 2008 it was 15.8%. Housing prices are
expected to continue declining until this inventory of surplus homes (excess supply) is reduced
to more typical levels.

13.3.5 TARP
The Troubled Asset Relief Program (TARP) is a program of the United States government to
purchase assets and equity from financial institutions in order to strengthen its financial sector.
It is the largest component of the government's measures in 2008 to address the subprime
mortgage crisis.

The Act requires financial institutions selling assets to TARP to issue equity warrants (a type of
security that entitles its holder to purchase shares in the company issuing the security for a
specific price), or equity or senior debt securities (for non-publicly listed companies) to the
Treasury. In the case of warrants, the Treasury will only receive warrants for non-voting shares,
or will agree not to vote the stock. This measure is designed to protect taxpayers by giving the
Treasury the possibility of profiting through its new ownership stakes in these institutions.
Ideally, if the financial institutions benefit from government assistance and recover their former
strength, the government will also be able to profit from their recovery.

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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

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 generation of an
authorization code 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.

Cognizant Confidential Foundation Course in Banking and Capital Markets

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 (not paid) is added to the principal balance of
the loan is called Capitalized Loan. Capitalized interest becomes part of the principle of the
loans; 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

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.

Cognizant Confidential Foundation Course in Banking and Capital Markets

Dividend: A payment by a company to shareholders of its stock, usually as a way to distribute

profits to shareholders.

Fed: Fed means the Federal Reserve which manages the country's economy by setting interest

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.

Fixed income: Income from 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-Bailey 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 recession.

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.

Cognizant Confidential Foundation Course in Banking and Capital Markets

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.

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 our (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

Cognizant Confidential Foundation Course in Banking and Capital Markets

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 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.

Pitch book: 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).


Cognizant Confidential Foundation Course in Banking and Capital Markets

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

Cognizant Confidential Foundation Course in Banking and Capital Markets




15.2 BOOKS

Cognizant Confidential Foundation Course in Banking and Capital Markets

• 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