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2 Author No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the author and publisher. First Edition : 2015 Published by : Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd., Ramdoot, Dr. Bhalerao Marg, Girgaon, Mumbai Phone: / , Fax: Website: Branch Offices : New Delhi : Pooja Apartments, 4-B, Murari Lal Street, Ansari Road, Darya Ganj, New Delhi Phone: , ; Fax: Nagpur : Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur Phone: , ; Telefax: Bengaluru Hyderabad : No. 16/1 (Old 12/1), 1st Floor, Next to Hotel Highlands, Madhava Nagar, Race Course Road, Bengaluru Phone: ; Telefax: : No , Lingampally, Besides Raghavendra Swamy Matham, Kachiguda, Hyderabad Phone: , ; Mobile: Chennai : No, 20 (Old No, 59) Thirumalai Pillai Road, T.Nagar, Chennai Mobile: , Pune Lucknow Ahmedabad Ernakulam Bhubaneswar Indore Kolkata Guwahati DTP by Printed at : First Floor, "Laksha" Apartment, No. 527, Mehunpura, Shaniwarpeth (Near Prabhat Theatre), Pune Phone: / ; Mobile: : House No 731, Shekhupura Colony, Near B.D. Convent School, Aliganj, Lucknow Mobile: : 114, SHAIL, 1st Floor, Opp. Madhu Sudan House, C.G. Road, Navrang Pura, Ahmedabad Phone: ; Mobile: : 39/104 A, Lakshmi Apartment, Karikkamuri Cross Rd., Ernakulam, Cochin , Kerala. Phone: , ; Mobile: : 5 Station Square, Bhubaneswar (Odisha). Phone: , Mobile: : Kesardeep Avenue Extension, 73, Narayan Bagh, Flat No. 302, IIIrd Floor, Near Humpty Dumpty School, Indore (M.P.). Mobile: : 108/4, Beliaghata Main Road, Near ID Hospital, Opp. SBI Bank, Kolkata , Phone: , Mobile: : House No. 15, Behind Pragjyotish College, Near Sharma Printing Press, P.O. Bharalumukh, Guwahati , (Assam). Mobile: , : Sri Siddhi Softtek Bengaluru : M/s. Aditya Offset Printers, Hyderabad on behalf of HPH.

3 Preface India has experienced an economic transformation since the liberalization process began in the early nineties. In the last few years, with a soaring stock market, significant foreign inflow of funds and a rapidly developing financial service market, the Indian financial system has been witnessing an exciting era of transformation and developing a more contemporary outlook. The Government of India has helped in this development by introducing reforms to liberalize, regulate and enhance the country's financial services sector. Today, India is recognized as one of the world's most vibrant capital markets. Notwithstanding the challenges, the sector's future seems to be in good hands. In this book, an attempt is made to provide a comprehensive outlook of banking and financial services in India. The book is divided into fourteen chapters dealing with different segments of banking and financial services sector. The first chapter provides an overview of Indian financial system. The next three chapters cover central banking and commercial banking activities in India. The remaining chapters provide an overview of different financial services such as merchant banking, credit rating, Insurance, housing finance, debt securitization, venture capital financing, depository services, mutual funds, leasing, etc. In short, the book covers the entire gamut of banking and financial services. The noteworthy highlight of the book is its wide coverage of contemporary topics, comprehensible presentation and reader-friendly approach. The book is designed primarily for students of graduate and postgraduate courses in the area of Banking, Finance and Economics. I invite constructive suggestions and criticisms from readers for further improvement of the book. My deep sense of gratitude goes to Dr. M R Suryanarayana Murthy and Dr. H R Appannaiah for their support and encouragement. I thank Sri. Niraj Pandey and Sri. Vijay Pandey for their everlasting zeal in bringing out this book. I also thank the staff of Himalaya Publishing House Pvt. Ltd., for their support in the publication of this book. My special thanks to Sri. Madhu of Sri Siddhi Sofftek for his excellent DTP work. Bangalore Dr. N. Mukund Sharma


5 C ontents Chapter 1 AN OVERVIEW OF INDIAN FINANCIAL SYSTEM Introduction to Financial System Major Components of the Financial System Interaction among Financial System Constituents An Overview of Financial Markets Classification of Financial Markets Primary Market Participants and Instruments of Primary Market The Secondary Market Functions of Secondary Market Stock Exchange Money Market and Capital Market An Overview of Financial Instruments Money Market Instruments Capital Market Instruments An Overview of Financial Institutions Banking Institutions Non Banking Institutions An Overview of Financial Services Reforms in Indian Financial System Chapter 2 CENTRAL BANKING Need for Regulations Types of Regulatory Framework Need for Central Banking Reserve Bank of India Structure, Organization and Governance of RBI Functions of RBI Currency Issue Banker to Government Banker's Bank and Lender of the Last Resort Monetary Policy (Controller of Credit) Regulating and Strengthening the Banking System Management of Foreign Exchange Developmental Functions Chapter 3 COMMERCIAL BANKING I Introduction to Banking Banking in India Banking Sector Reforms in Post Liberalization Era Commercial Banking in India

6 Functions of Commercial Banks Primary Functions Secondary Functions General Utility Services Non Banking Function Structure of Commercial Banks Banker Customer Relationship Rights and Obligations of the Banker Sources of Funds of Commercial Banks Investment Policy of Commercial Banks Asset Structure of Commercial Banks Chapter 4 COMMERCIAL BANKING II Recent Trends in Banking Core Banking Solution Cheque Truncation System ATM Electronic Fund Transfer NEFT RTGS IMPS Home Banking Telebanking Mobile Banking Internet Banking Credit Card Debit Card Universal Banking Retail Banking Chapter 5 THE SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI) Need for SEBI Objectives of SEBI Functions of SEBI Powers of SEBI Organization Structure, Committees and Administration of SEBI Role of the SEBI in Investors Protection Legal Framework of SEBI Important Categories of SEBI Regulations SEBI's Journey So Far and Challenges Ahead Chapter 6 MERCHANT BANKING Nature and Scope of Merchant Banking Services Provided by Merchant Banker Issue Management Project Management

7 Loan Syndication Portfolio Management Corporate Counseling Managing Joint Ventures Other Specialized Services Code of Conduct for Merchant Bankers SEBI Regulations Relating to Merchant Bankers Merchant Banking in India Chapter 7 MUTUAL FUNDS Meaning and Scope of Mutual Funds The Evolution of Mutual Funds in India Features of Mutual Funds Institutional Framework of Mutual Funds in India Mutual Fund Schemes/Classification of Mutual Funds Classification on the Basis of Operations/Structure Classification by Investment Objectives Classification by Nature of Investment Classification by Geography Other Classifications SEBI Regulations on Mutual funds Factors Contributing for the Growth of Mutual Funds in India Advantages and Drawbacks of Mutual Funds The Association of Mutual Funds in India (AMFI) Marketing of Mutual Funds Chapter 8 VENTURE CAPITAL FINANCING Nature and Scope of Venture Capital Financing Historical Background of Venture Capital Financing Features of Venture Capital Financing Steps Involved in Providing Venture Capital Financing The Venture Capital Financing Stages Advantages and Limitations of Venture Capital Financing Important Venture Financing Schemes in India The Indian Private Equity and Venture Capital Association SEBI Regulations for Venture Capital Funds Chapter 9 HOUSING FINANCE Nature and Scope of Housing Finance The Structure of Housing Finance Sector in India Key Features of Housing Finance Types of Housing Finance Merits and Demerits of Housing Finance Overview of Housing Finance Industry in India Key Trends in the Housing Finance Industry in India Home Loan Products offered by SBI Brief Profile of HUDCO and NHB

8 Chapter 10 DEPOSITORY AND STOCKBROKING SERVICES Nature and Scope of Depository Dematerialization Benefits of Dematerialization Depositories in India NSDL CDSL Benefits of NSDL and CDSL Depository Participants Stockbroking Services Code of Conduct for Stockbrokers Subbrokers Chapter 11 SECURITIZATION AND FACTORING SERVICE Nature and Scope of Securitization Securitization Process Rationale for Securitization Securitization in India Regulatory Framework of Securitization in India Advantages of Securitization Meaning and Scope of Factoring Functions of Factoring Factoring Process Types of Factoring Factoring Services in India RBI Regulations Relating to Factoring Reasons for Unpopularity of Factoring in India Chapter 12 LEASING AND HIRE PURCHASE FINANCE Nature and Scope of Leasing Essential Elements of Leasing Types of Leasing Advantages and Limitations of Leasing Lease Agreement Rights and Obligations of a Lessor in a Lease Contract Rights and Obligations of a Lessee in a Lease Contract Tax and Accounting Treatment of Leasing Leasing in India Structure of Leasing Companies in India (Lessors In India) Structure of Lessees in India Problems of Leasing in India Nature and Scope of Hire Purchase Forms of Hire Purchase Agreements Difference Between Leasing and Hire Purchasing The Right and Obligation of Hirer and Hiree

9 Chapter 13 CREDIT RATING Nature and Scope of Credit Rating Features of Credit Rating Services Provided by the Credit Rating Agencies The Credit Rating Process Advantages of Credit Rating To Issuers of Financial Instruments To Investors in Financial Instruments To Brokers and Financial Limitations of Credit Rating SEBI Regulations on Credit Rating Credit Rating in India Rating Agencies in India Types of Products/Instruments Rated by Different Agencies in India Rating Symbol of Different Credit Rating Agencies in India Chapter 14 INSURANCE SERVICES Nature and Scope of Insurance Functions of Insurance Primary Functions Secondary Functions Importance of Insurance Individual View point Business View point Society View point Principles of Insurance Life Insurance Life Insurance Products Life Insurance Companies Life Insurance Business Performance General Insurance General Insurance Products General Insurance Companies General Insurance Business Performance Insurance Sector Reforms in India

10 CHAPTER 1 AN OVERVIEW OF INDIAN FINANCIAL SYSTEM Learning Objectives After reading this chapter you should be able to understand the functioning of financia l system and its ma jor components the functioning of financia l ma rkets the va rious instruments tra ded in fina ncial ma rkets the va rious fina ncia l services provided the functioning of fina ncia l institutions in the fina ncia l system

11 2 Banking and Financial Services INTRODUCTION TO FINANCIAL SYSTEM One of the important requisites for the accelerated development of an economy is the existence of a dynamic and a resilient financial system. Fina ncial system acts as a nerve system of the country' s economy. A na tion' s economic development principally rely on the effective a nd efficient fina ncia l system. The fina ncial system consists of ma ny subsystems like fina ncial services, financia l ma rkets, fina ncia l institutions, etc. Genera lly, developing economies fina ncia l system is a lso in the process of development. In a ny economy, individuals a nd organiz a tions ea rn a nd spend money. Fina ncial system is the system, which induces sa vings, tra nsfer of those sa vings into a n industria l effort a nd stimula tes a n entrepreneur to underta ke va rious business ventures. It is a key wea pon in monitoring the economic progress of a ny country, beca use eventua lly a ll efforts a nd resources a re measured in fina ncial terms. Any economy in the world ca nnot function unless there is a well developed fina ncial system. Fina ncia l system fa cilitates the tra nsfer of economic resources from one section of the economy to a nother. The fina ncia l system or fina ncia l sector of a ny country consists of specializ ed a nd non-specia liz ed fina ncia l institutions, organiz ed a nd unorga niz ed financia l ma rkets, a nd fina ncia l instruments and services, which fa cilita te tra nsfer of funds from one ha nd to a nother. The word, " system" in the term " financia l system" implies a set of complex and closely connected or intermixed institutions, ma rkets, transa ctions, cla ims, a gents, pra ctices a nd lia bilities in the economy. The fina ncial system is concerned a bout credit, money a nd fina nce. The financia l inputs ema na te from the fina ncia l system, while rea l goods a nd services a re pa rt of the rea l system. The intera ction between the real system (goods and services) a nd the fina ncia l system (money and ca pita l) is necessa ry for the productive process. Tra ding in money a nd moneta ry a ssets constitute the a ctivity in the fina ncia l ma rkets a nd a re referred to a s the fina ncial system. Sa vings mobiliz a tion a nd promotion of investment a re functions of the money a nd ca pita l ma rkets, which are a pa rt of the orga niz ed fina ncial system in India. The objective of all economic a ctivity is to promote the well-being a nd sta nda rd of living of the people, which depends on the income a nd distribution of income in terms of rea l goods a nd services in the economy. The fina ncia l system is also geared to the mobiliz a tion of sa vings a nd ca na liz a tion of sa vings into productive a ctivity. The efficient functioning of the fina ncia l system fa cilitates these flow of funds. The financia l system provides the intermedia tion between investors a nd institutions and helps the process of investment leading to grea ter fina ncia l development tha t is prerequisite for fa ster economic development. A sound and effic ient financ ial syste m of any c ountr y contr ibute s to e c onomic gr owth and de velopme nt in number of ways by : Mobiliz ing savings a nd converting it into investment. Providing required ca pita l to the business orga niza tions to ca rry out their a ctivities. Genera ting income or profit Ra ising productivity of ca pita l through efficient a lloca tion

12 An Overview of Indian Financial System 3 The fina ncia l system of any economy consists of financia l institutions, fina ncial ma rkets, fina ncia l instruments a nd fina ncia l services. Functions of Financial System It helps to mobilize fina ncia l resources for the economy. It ensures effective a lloca tion of resources to different investment c h a n n e l s. It generates disposable income in the ha nds of people which in turn helps in excha nge of goods a nd services. It pla ys the role of transferor of resources from one pa rt of the economy to another. It a ccelera tes the ra te of economic development. It provides mecha nism to control risk a nd uncerta inties. Fina ncial system helps in pa ssing on fina ncial informa tion. It promotes self employment and improves employment level. Four ma jor components of Fina ncial System 1. Fina ncial Ma rkets 2. Fina ncial Institutions 3. Fina ncial Instruments 4. Fina ncia l Services Fina ncial Institutions mobiliz e sa vings either directly or indirectly through fina ncial ma rkets by using va rious fina ncia l instruments a nd in the process utiliz ing the services of va rious fina ncia l service providers. The brief outline of these four components is given below. A financial system can operate on a global, regional or firm specific level Financial System Financial Financial Financial Financial In stututions Markets Instr u ments Services (Claims, Assets; Securities) R e gu la t o r y I n t e r - Non Inter- O t h e r s P r i m ar y S e c o n d a r y m e d i a r i e s m e d i a r i e s B a n kin g N o n - B a n kin g O r g a n i s e d U n or g a n is e d S h o r t - M e d i u m - Long- T er m T er m T er m P r i m ar y S e c o n d a r y C a p i t a l M a r k e t s M o n e y M a r k e t s (Source: Financial Institutions and Markets, L M Bhole, TMH, New Delhi.)

13 4 Banking and Financial Services MAJOR COMPONENTS OF THE FINANCIAL SYSTEM Financial system provides an ideal linkage between depositors and investors, thus encouraging both savings and investments 1. Financ ial M arke ts: This is a pla ce or mecha nism where funds or sa vings a re tra nsferred from one section to a nother section of fina ncia l system. These ma rkets ca n be broadly cla ssified into (i) Money ma rket a nd ca pital ma rket (ii) Prima ry a nd seconda ry ma rket. Money market dea ls with short-term claims or fina ncia l a ssets(less than a yea r) whereas ca pita l ma rkets dea l with those fina ncial a ssets which ha ve ma turity period of more than a yea r This classifica tion is artificia l a s both these markets perform the same function of transferring surplus funds to needy units. Another cla ssification could be: Prima ry ma rkets dea l in new issue of securities whereas seconda ry ma rkets deal with securities which a re a lrea dy issued a nd a va ila ble in the ma rket. Prima ry ma rkets, by issuing new securities mobilise the sa vings directly wherea s seconda ry ma rkets provide liquidity to the securities a nd thereby, indirectly helping in mobiliz ing the sa vings. 2. Financial Institutions: These a re institutions which a re dea ling in the fina ncial ma rket. They mobiliz e a nd transfer the sa vings or funds from surplus units to deficit units and provide va rious fina ncia l services. These fina ncia l institutions include, Commercia l banks, Merchant banks, Insurance compa nies, Mutua l funds etc. They are the ba ckbone of the fina ncia l system. 3. Financ ial Instr ume nts: The instruments tha t a re tra ded or dea lt in a fina ncial ma rket are fina ncia l a ssets or securities or financia l instruments. There a re va rious type of securities which a re tra ded in the fina ncia l ma rket a s the requirements of lenders/ investors and borrowers a re va ried. Fina ncia l a ssets represent a cla im on the repa yment of principa l a t a future da te a nd or pa yment of a periodic or termina l sum in the form of interest or dividend. Fina ncial instruments may be cla ssified into ca pital ma rket instruments a nd money market instruments. Some of the exa mples of these fina ncial instruments a re equity sha res, preference shares, debentures, bonds, certifica te of deposits, commercia l pa pers etc. 4. Financial Ser vice s: Financia l services are the services offered by financial institutions in fina ncia l markets. The fina ncial services help not only to raise the required funds but a lso ensure their efficient use. The va rious fina ncia l services provided includes, lea sing, mercha nt ba nking, credit ca rds, factoring, ba nking, insura nce, etc. INTERACTION AMONG FINANCIAL SYSTEM CONSTITUENTS The four financia l system constituents, Financia l ma rkets, Fina ncia l instruments, Fina ncia l intermedia ries and fina ncial services a re rela ted to one a nother. They a re interdependent a nd a ct together continuously with ea ch other. Their interfa ce lea ds to the development of a n efficient a nd smoothly functioning fina ncia l system. Fina ncial institutions mobiliz e sa vings by issuing different types of fina ncia l instruments which a re tra ded in the fina ncia l ma rkets. To facilita te the movement of funds in the financia l system, these institutions perform specia liz ed fina ncia l services. Financia l institutions ha ve close a ssocia tion with the fina ncia l ma rkets in the economy. By tra ding in

14 An Overview of Indian Financial System 5 fina ncial instruments a nd providing fina ncial services, financia l institutions ma ke the financia l ma rkets bigger, more liquid, sta ble a nd diversified. W henever there is a need for funds, fina ncia l institutions rely on financia l ma rkets. The development of new sophistica ted fina ncia l ma rkets ha s led to the development of complex securities and portfolios. The eva luation of these complex securities, portfolios a nd stra tegies requires fina ncia l expertise which fina ncial institutions provide through fina ncial services. Technologica l developments in fina ncia l ma rkets ha ve dra stica lly cha nged the functioning of financia l institutions. Liquid and broa d ma rkets ma ke fina ncial instruments a more a ttra ctive a venue for sa vings, a nd fina ncia l services may encoura ge further sa vings if the net returns to investors a re increa sed. The deta iled discussion on the four constituents of fina ncial system is provided in subsequent pa rt of the cha pter. AN OVERVIEW OF FINANCIAL MARKETS A ma rket is a pla ce or mechanism which fa cilita tes the transfer of resources from one entity to a nother. A financia l ma rket is a n institution or a rra ngement that fa cilitates the excha nge of fina ncia l instruments, like sha res, debentures, loans, etc. A ma rket wherein financia l instruments such a s financia l cla ims, a ssets and securities are tra ded is known as a 'fina ncia l ma rket". Fina ncia l ma rket tra nsactions ma y ta ke pla ce either a t a specific pla ce or loca tion, e.g., ba nk stock excha nge or through other mecha nisms such a s telephone, telex, or other electronic media. According to Brigha m, Eugene F, "The place where people a nd organiz a tions wa nting to borrow money a re brought together with those ha ving surplus funds is ca lled a fina ncia l ma rket." One of the importa nt requisites for the a ccelera ted development of a n economy is the existence of a dyna mic a nd a resilient financia l ma rket. Financial markets are a mechanism enabling participants to deal in financial claims. Functions of Financial Markets Functions of a financia l ma rket ca n be cla ssified into two ca tegories: Economic Functions, a nd Fina ncial Functions. (1) Economic Functions It fa cilita tes the tra nsfer of rea l economic resources from lenders to ultima te borrowers in fina ncial system Lenders ea rn interest/ dividend on their surplus invisible funds, thereby, increa sing their ea rnings a nd as a result, enhancing na tiona l income of the country. Borrowers use funds borrowed in new ventures which increa ses, their income, spending and sta ndard of living. By fa cilita ting transfer of rea l resources, it serves the economy a nd fina lly the welfa re of the genera l public in the country. It provides a cha nnel through which new sa vings flow into the ca pita l ma rket which fa cilita tes smooth ca pita l forma tion in the economy.

15 6 Banking and Financial Services Intera ction of buyers and sellers in the fina ncial ma rket helps in price discovery of fina ncial a ssets. Fina ncial ma rkets provide a mecha nism for a n investor to sell a fina ncia l a sset a nd liquida te the funds invested. In the absence of liquidity, the owner will be forced to hold a debt instrument till its ma t ur i t y. Fina ncial ma rket reduces the search and information costs of transa cting fina ncia l instrument. Search costs include money spent to a dvertise the desire to sell purcha se a fina ncial a sset. (2) Financial Functions It provides the borrowers with funds which they will invest in some productive purpose. It provides the lenders with productive a ssets so tha t they ca n invest it in productive usa ge without the necessity of direct ownership of a ssets. It provides liquidity in the ma rket through which the cla ims a ga inst money can be resold by investors at a ny time a nd thereby, a ssets ca n be converted into cash. Thus, fina ncia l market is a primary constituent of the financia l system. The financia l ma rkets not only help in tra nsfer of sa vings from new industry/ production, but a lso provide opportunities for fina ncia l investment, to ea rn income. In other words, these ma rkets perform both financia l a nd non-fina ncia l functions. The fina ncial ma rkets ena ble financing of not only physica l ca pita l forma tion, i.e., tangible fixed a ssets a nd inventories, but a lso of consumption expenditure. That' s why fina ncia l markets ma na ge the flow of funds not only between individua l sa vers a nd investors but a lso between institutional sa vers a nd investors. The markets also provide a facility in which their demands and requirements interact to set a price for such claims. Classification of Financial Markets The financia l ma rket comprises of va rious types of institutions like ba nking a nd non ba nking fina ncia l institutions. The cla ssifica tion of financia l ma rkets a s shown in the following figure are: 1. Prima ry and Seconda ry Ma rkets; a nd 2. Capital Market and Money Market. Prima ry ma rket deals with the new issues of securities while the ma rkets for existing securities (financia l a ssets) a re known a s Seconda ry Ma rkets. In the prima ry ma rket, the government or corpora te sector issues securities tha t change ha nds from the issuer to the owner. In a seconda ry ma rket, there is no a dditiona l flow of funds for further investments. The tra nsactions in the seconda ry ma rket do not result in fresh ca pital forma tion a s they dea l in existing securities. The secondary market renders a very importa nt service to them. In a bsence of a ctive seconda ry ma rket, the long-term securities would become nearly perma nent investment in the ha nds of investors. Unless there is a n orga niz ed ma rket, the investors would ha ve to ma ke persona l efforts for the sa le

16 An Overview of Indian Financial System 7 a nd purcha se of their securities. In the case of a bsence of seconda ry ma rket, the sellers would ha ve to incur losses beca use true worth of the securities is not known. On the other ha nd, money ma rket dea ls with short-term cla ims or fina ncial a ssets (generally less tha n a yea r) wherea s ca pital ma rkets dea l with those fina ncial a ssets which ha ve ma turity period of more tha n a yea r. Financial M arket Money Market Capital Market P r i m ar y S e c o n d a r y P r i m ar y S e c o n d a r y M a r k e t M a r k e t M a r k e t M a r k e t C a ll M o n e y T r e a s u r y C o m m e r cia l S h o r t - S t o c k D e b t M u t u a l M a r k e t B i ll s B i ll s T er m M a r k e t M a r k e t M a r k e t M a r k e t M a r k e t L o a n M a r k e t M o r t ag e Term Cash Over the S t o c k N a t i o n a l C o u n t e r E xc h a n g estock Exchange (OTC) (SE) (NSE) In both money market as well as capital market there is a concept of pr imar y and sec ondar y mar ke t. For e xample, e quity shar es of a c ompany (par t of c apital mar ke t) is issued in pr imar y mar ke t and subse que ntly, it is tr ade d in se condary marke t (afte r listing). Same way the Tr e asur y bill (par t of mone y mar ket) is issue d for the fir st time by RB I in the pr imary marke t and subseque ntly, it is tr ade d in the se condary mar ke t. Primary and Secondary Markets - Similarities Both the primary a nd seconda ry ma rket a re closely interrela ted. This is clea r from the following: 1. Tr ading: If securities a re to be tra ded in the stock excha nge/seconda ry ma rket, it is importa nt tha t they a re first issued in the prima ry ma rket. 2. Listing: Only those sha res which a re ca pa ble of listing in some reputed stock excha nges will be fully subscribed in the prima ry ma rket 3. Re gulation: The regula tions rela ting to both primary a s well a s seconda ry ma rket is regula ted by the SEBI a nd stock exchanges. The object is to bring a bout orderliness in both prima ry a nd seconda ry ma r k e t. 4. M arke tability: The a dva nta ge of ma rketa bility provided by the seconda ry ma rket grea tly helps the subscribers in the prima ry ma rket. For insta nce, the positive trends prevailing in the seconda ry ma rket immensely help the investors to reduce their holdings and a cquire new shares in seconda ry ma rket. Primary market is also called New Issue Market (NIM).

17 8 Banking and Financial Services 5. Conditions Pr e vailing: The conditions prevailing in the seconda ry ma rket affect success or fa ilure of the issue ma de in the prima ry ma rket. Accordingly, where the conditions a re so fa vorable in the seconda ry ma rket tha t high market prices preva il, the issues ma de in the prima ry ma rket will turn out to be encoura ging a nd successful. Issues would fetch good premiums. 6. Survival: The surviva l of the seconda ry market depends upon the efficiency of the prima ry ma rket. There could be no stock excha nges if there is no prima ry ma rket, in the sa me ma nner there will be no prima ry ma rket in the a bsence of a n efficiently functioning stock excha nge. DIFFERENCE BETWEEN PRIMARY AND SECONDARY MARKET F e a t u r e s P r i ma r y S e c o n d a r y Issues made It deals only with new or fresh Deals in existin g securities, which issues made by companies for are already issu ed by companies for th e first time G eo g r ap h i ca l No fixed geographical Need fixed place for trading eg l o c a t i o n location for primary m arket Bangalore stock exchan ge Transfer of For th e first time Securities are tran sferred from one s e c u r i t i e s securities are created person to an other through stock e x c h a n g e Entry into All companies can enter On ly those companies w hich have m a r k e t primary market Issued securities in primary market can enter Ad m i n i st r a t i o n No definite administration Has a definite administration set up and man agem ent setup is available by stock exchanges R e g u l a t i o n Su bject to regulations mostly Su bject to regulation both from from SEBI, stock exchanges, within and ou tside the company Companies Act, etc. P u r p o s e Creating lon g-term Providing liq uidity for those in struments for savin gs in stru men ts w hich are already an d investm ents. Issued by th e companies D e p t h Depth of primary m arket Depth depends upon the depends on nu mber and the activities of th e primary market volume of issue of secu rities Primary Market The prima ry market is a n importa nt pa rt of capita l ma rket, which dea ls with issua nce of new securities. It enables corpora te, public sector institutions a s well a s the government to ra ise resources (through issua nce of debt or equityba sed securities), to meet their ca pital requirements. In a ddition, the prima ry ma rket a lso provides a n exit opportunity to priva te equity a nd venture capita lists by a llowing them to off-loa d their sta ke to the public.

18 An Overview of Indian Financial System 9 Features of Primary Markets 1. The primary market is the ma rket where the securities (both ca pita l ma rket a nd money market) a re sold for the first time. Therefore, it is a lso ca lled New Issue Market (NIM). 2. In primary ma rket, securities a re issued by compa nies a s well a s government (through RBI) 3. In a prima ry ma rket, the securities a re issued by the compa ny/ issuer directly to investors. 4. The primary ma rket is used by companies as a prima ry source of funding for the purpose of setting up new ventures/ business or for expa nding or moderniz ing the existing business 5. In India, prima ry ma rket is regulated by both SEBI a nd RBI 6. The successful functioning of prima ry market indica tes the efficiency of the fina ncia l system of the country. 7. Efficient prima ry ma rket is crucia l for fa cilita ting ca pital forma tion in the economy. Financial markets can be found in nearly every nation in the world. Some are very small, with only a few participants, while others - like the New York Stock Exchange (NYSE) trade trillions of dollars daily. Funds Mobilized by Government and Corporates in Primary Market I s s u e s (` bn) (` bn) (` bn) (US $ bn) (US $ bn) (US $ bn) Corporate Securities 2, , , Domestic Issues 2, , , Public Issues Private Placement 2, , , Euro Issues Government Securities 5, , , Central Government # 4, , , State Governments 1, , , T o t a l 8, , , Source: RBI and NSE Services of Primary Market A brief description of the va rious services rendered by the new issues ma rket is as follows. 1. The Tr ansfe r: An importa nt function rendered by primary ma rket is to a llow the tra nsfer of resources from investor to entrepreneurs who esta blish new compa nies/ ventures. It is a lso called the function of origina tion. The tra nsfer function is fa cilita ted by specialist a gencies that a ssist in va rious activities associa ted with such tra nsfer. 2. Inve stigative se r vic e s: The mercha nt ba nkers a nd other a gencies involved in prima ry ma rket provide the investiga tive services. These include, economic ana lysis, technica l a na lysis, fina ncia l a nalysis of the companies where a n investor wa nts to invest. These informa tion

19 10 Banking and Financial Services helps the investors in ma king a clea r choice a s to the type, quality a nd quantity of investment to ma ke. 3. Advisor y and information ser vic es: Various a dvisory services a re a vaila ble in prima ry ma rket with a view to improving the qua lity of ca pita l issues in prima ry ma rket. The relevant services include determining the type, the mix, the price, the timing, the size, the selling stra tegies, and the terms a nd conditions of issue of securities etc. 4. The Guarante e: If the compa ny entering ca pita l market is not sure of ra ising full a mount of funds from the ma rket, there a re certa in mecha nism whereby success of such issues will be guara nteed. It is the function of underwriting. Underwriting a ims a t gua ra nteeing the subscription of public issue. Underwriters ensure successful subscription of the issue by underta king to ta ke up the securities in the event of the public fa iling to subscribe to the same. It benefits a ll those involved in prima ry ma rkets like the issuing compa ny, the investing public a nd ca pita l ma rket in genera l. The function of underwriting is underta ken for a commission. 5. The Distr ibution: The function tha t facilitates the sa le of securities from compa ny to investors is called distribution. The function of distribution is rendered by the specia liz ed agencies like brokers a nd dealers in securities. They ma intain a constant a nd a close link with the issuers a nd the ultima te investors on the one ha nd, a nd issuers on the other. Advantages 1. Mobiliz a tion of sa vings 2. Channelizing sa vings for productive use 3. Source of la rge supply of funds 4. Ra pid industria l growth due to increa se in production a nd productivity in the economy. Disadvantages 1. Possibility of deceiving investors 2. No fixed norms for project appra isa l 3. La ck of post issue seriousness 4. Ineffective role of mercha nt ba nkers 5. Dela y in a llotment process. Capital market is composed of both the primary and secondary markets Players in Primary Market The importa nt pla yers in prima ry ma rket a re 1. Compa nies issuing sha res a nd debentures 2. SEBI (As a regula tor)

20 An Overview of Indian Financial System RBI (a s a regula tor a s well as issuer of money market instruments on beha lf of centra l government). 4. Commercia l Banks 5. Stock Exchanges 6. Different ca tegories of Mercha nt Ba nkers such a s Lead ma nager Co-ma na ger/ Advisers to the issue Underwriters to the issue Brokers to the issue Ba nkers to the issue a nd refund Ba nkers Registrar to the issue 7. Credit ra ting a gencies 8. Insura nce companies 9. D epos it or ies 1 0. Depository pa rticipants 1 1. Inves t or s Individua l investors Domestic institutiona l investors Foreign institutiona l investors The Primary Market Instruments Some of the importa nt prima ry ma rket instruments (which a re pa rt of both ca pita l a nd money ma rket) a re given below. 1. Equity sha res IP O Subsequent issue Right issue Priva te pla cement Preferencia l allotment 2. Preference shares 3. D e b e n t u r e s / B o n d s 4. Foreign currency convertible bonds 5. Pa rticipatory notes 6. Globa l depository receipts/ America n depository receipts 7. Commercia l pa pers 8. Certifica te of deposit The primary market is where new issues are first offered, with any subsequent trading going on in the secondary market

21 12 Banking and Financial Services 9. Treasury bills 1 0. Repo a nd reverse repo (N ote: Most of the instruments which are issu ed in p rimary market are sub seq uently traded in second ary market, hence, au tomatically th ey become seconda ry market i n s t r u m e n t s ) List of IPOs in India during the Year 2013 (Sou rce: NSE) Is s u e r Co m p a n y Iss u e Op e n Issu e Clos e The Secondary Market Offe r P ric e (` ) Iss u e Size (Crores re ` ) `) Ten tiwa l Wire Prod u cts Ltd Dec 1 1, Dec 1 6, / Power Grid Corp ora tion of In d ia Dec 0 3, Dec 0 6, / - to 9 0/ - 6, , Ca ptain Polyp la s t Ltd Nov 2 6, Nov 2 8, / S tella r Ca pita l S ervices Ltd Oct 1 5, Oct 18, / Am rapali Ca p ital a n d Fin a n ce S ervices Ltd MITCON Con s u ltan cy & E n gin eerin g Services Ltd Oct 1 5, Oct 18, / Oct 1 5, Oct 18, / VCU Da ta Ma n a gem en t Ltd Oct 0 4, Oct 08, / S u bh Tex In d ia Lim ited Sep 3 0, Oct 07, / Ace Tou rs World wid e Ltd Sep 0 9, Sep 1 2, / Ku s h a l Tradelin k Ltd Au g 1 4, Au g 21, / VKJ In fra develop ers Ltd Au g 1 2, Au g 16, / S ilverpoin t In fra tech Ltd Au g 1 2, Au g 14, / GCM Com m od ity & Deriva tives Ltd Au g 0 1, Au g 05, / Ala crity Secu rities Ltd J u l 2 9, Au g 01, / Mon ey Ma s ters Lea s in g & Fin a n ce Ltd J u l 2 3, J u l 2 6, / E d yn a m ics Solu tion s Ltd J u n 1 0, J u n 12, / In d ia Fin s ec Lim ited Ma y 2 4, Ma y 2 8, / GCM Secu rities Ltd Ma r 1 8, Ma r 2 0, / Both ra Meta ls a n d Alloys Ltd Ma r 1 2, Ma r 1 4, / Rep co Hom e Fin a n ce Ltd Ma r 1 3, Ma r 1 5, / - to 1 7 2/ HPC Bios cien ces Ltd Ma r 0 1, Ma r 0 5, / Ch a n n el Nin e E n terta in m en t Ltd Feb 2 2, Feb 2 6, / S u n s ta r Rea lty Develop m en t Ltd Feb 1 8, Feb 2 1, / Ka vita Fa b rics Ltd Feb 2 0, Feb 2 2, / S a i Silk s (Ka la m a n d ir) Ltd Feb 1 1, Feb 1 3, / - to 7 5/ V-Ma rt Retail Ltd Feb 0 1, Feb 0 5, / - to 21 5 / The financia l ma rket where existing securities a re tra ded is referred to a s the seconda ry ma rket or stock ma rket. It provides liquidity to fina ncia l instruments which are a lrea dy issued in primary market. In a stock ma rket,

22 An Overview of Indian Financial System 13 purcha ses a nd sa les of securities whether of Government or Semi-Government bodies or other public bodies a nd a lso sha res a nd debentures issued by priva te joint stock compa nies a re done. Prima ry ma rket deals with the new issues of securities while the ma rkets for existing securities (fina ncia l a ssets) a re known a s Seconda ry Ma rkets. In the prima ry ma rket, the government or corpora te sector issues securities tha t change ha nds from the issuer to the owner. In a seconda ry ma rket, there is no a dditiona l flow of funds for further investments. The tra nsactions in the seconda ry market do not result in fresh ca pital forma tion a s they dea l in existing securities. The seconda ry ma rket renders a very important service to them. In a bsence of a ctive seconda ry ma rket, the long-term securities would become nea rly perma nent investment in the hands of investors. Unless there is a orga niz ed ma rket, the investors would ha ve to ma ke persona l efforts for the sale a nd purchase of their securities. In the case of a bsence of secondary ma rket, the sellers would ha ve to incur losses beca use true worth of the securities is not known. If there is no liquidity a nd ma rketa bility then investors would not ha ve invested their funds in the securities. Consequently, the compa nies would ha ve fa ced a lot of problems in raising funds by issuing securities like shares a nd debentures. Consequently, the level of industria l development would ha ve been lower. Thus, a ctive secondary market stimula tes the a ctivity in the prima ry ma rket also by providing ma rketa bility a nd liquidity. The level of development in the secondary market determines the efficiency and growth of the prima ry ma r k e t. For the effective functioning of seconda ry ma rket, proper control must be exercised. At present, control is exercised through the following three importa nt pr ocesses: (i) Recognition of stock excha nges (ii) Listing of securities in stock excha nges (iii) Registra tion of brokers. (i) Re c ognition of Stoc k Exc hange s As a pa rt of seconda ry market operation, the stock excha nges need to be recognized by regula tory a uthority. The securities which a re issued in the prima ry ma rket will be tra ded only in recogniz ed stock excha nges like Bomba y stock excha nge, NSE, Ba nga lore stock excha nge, etc. In India, SEBI is recognizing the stock excha nges. (ii) Listing of Sec ur itie s in Stoc k Exc hange s Once the stock excha nges a re recogniz ed the securities which a re required to be traded like sha res debentures, etc., ha s to be listed in the stock excha nges. (iii) Recognition of Broker The intermediaries who fa cilita tes smooth functioning of the seconda ry ma rket like brokers, deal in seconda ry ma rkets. Subbrokers need to be recognized by SEBI, then only will they be able to tra de in stock excha nges. India s largest ever public offer was from Coal India Ltd which raised around ` 15,000 crores

23 14 Banking and Financial Services Functions/Services of Secondary Market / Stock Market The seconda ry ma rket or stock ma rket occupies a pivota l position in the fina ncial system. It performs severa l economic functions a nd renders inva luable services to the investors, compa nies, and to the economy a s a whole. They are: (1) Liquidity to Sec ur itie s Stock excha nges provide liquidity to securities since securities ca n be converted into ca sh a t any time a ccording to the discretion of the investor by selling them at the listed prices. (2) Marketability to Securities Seconda ry ma rket fa cilita tes buying a nd selling of securities a t listed prices by providing continuous ma rketa bility to the investors in respect of securities they hold or intend to hold. Thus, they create a rea dy ma rket for securities. (3) Safety of Funds B e longing to Inve stor s Stock excha nges helps in ma inta ining sa fety of funds invested because they ha ve to function under strict rules a nd regula tions a nd the bye-la ws a re meant to ensure sa fety of investible funds. These rules a re fra med by SEBI. This would strengthen the investor' s confidence and promote la rger investment. (4) Availability of Long-te r m Funds to Companie s The securities tra ded in the stock ma rket a re negotia ble a nd tra nsfera ble. As it is tra nsferred from one investor to a nother, i. e., one investor is substituted by a nother, but the compa ny is gua ra nteed of long-term a va ila bility of funds. (5) Flow of Funds to Pr ofitable proje cts The profita bility a nd popularity of compa nies a re reflected in stock prices. The prices quoted indica te the rela tive profita bility a nd performa nce of the compa nies. Funds tend to be a ttracted towards securities of profitable compa nies a nd this fa cilita tes the flow of ca pita l into profita ble cha nnels. (6) M otivation for Impr ove d Pe r for manc e by Companie s The performa nce of a compa ny is reflected on the prices quoted in the stock ma rket. Price of fina ncia l assets depends upon the compa ny's performa nce. These prices a re more visible in the eyes of the public. Stock market provides room for their price quota tions for those securities listed by it. This public exposure ma kes a compa ny conscious of its sta tus in the ma rket and it a cts a s a motivation to improve its performa nce further. (7) Pr omotion of Inve stme nt Oppor tunitie s Stock excha nges mobilise the sa vings of the public a nd promote investment through ca pita l issues. Unless there is a effective seconda ry ma rket, investment opportunities will not be a vaila ble to the investors. (8) Availability of B usine ss Infor mation The cha nging business conditions in the economy are immedia tely reflected on the secondary market/stock excha nges. Booms a nd depressions ca n be identified through the dea lings on the stock exchanges. Depending upon the

24 An Overview of Indian Financial System 15 preva iling informations, preventive policies ca n be ta ken by the government. Thus, a stock ma rket reflects the preva iling economic situa tion to a ll concerned so tha t suita ble a ctions ca n be ta ken. (9) Pr omotion and Mar ke ting of Ne w Issues by Companie s If the new issues a re listed in stock exchanges, they a re rea dily a cceptable to the public, since, listing is done a fter eva lua tion of such securities by concerned stock excha nge a uthorities. Costs of underwriting such issues would be less. Public response to such new issues would be rela tively very high. Thus, a stock ma rket helps in the ma rketing of new issues a lso. (10) Other Ser vice s Stock excha nge enables the investors to reduce their risks by diversified portfolio of investment. It a lso develops sa ving habits a mong the community a nd pa ves the wa y for capita l formation. It helps the investors in choosing securities by supplying the daily quota tion of listed securities a nd by disclosing the trends of dea lings on the stock excha nge. It ena bles compa nies a nd the Government to ra ise funds by providing a rea dy ma rket for their securities. Stock Exchange Stock Excha nge is a n orga nized marketpla ce, either corpora tion or mutua l orga niz ation, where members of the organiz a tion ga ther to tra de compa ny stocks or other securities. The members ma y a ct either as a gents for their customers, or a s principa ls for their own a ccounts. Stock excha nges also fa cilita tes for the issue a nd redemption of securities a nd other fina ncial instruments including the pa yment of income and dividends. The record keeping is centra l but tra de is linked to such physica l pla ce beca use modern ma rkets a re computerized. The tra de on an excha nge is only by members and stockbroker do ha ve a sea t on the excha nge. As per Securities Contract Regula tion Act of 1956, a n excha nge is defined a s a ny body of individual, whether incorpora ted or not, constituted for the purpose of a ssisting, regula ting or controlling the business of buying, selling or dea ling in securities. The SCR a ct stipula tes tha t a stock excha nge must be recognized by the government of India. The stock excha nge is mana ged by a governing body which consists of a president, a vice president, executive director, elected directors, public representa tives a nd nominees of the government. The governing body is responsible for policy formula tion a nd for ensuring smooth functioning of the excha nge. The executive functions a re discharged by executive director or s ecr eta r y. The legisla tive jurisdiction over stock excha nges is vested in the Union government by the Constitution of India. The Union government enacted the Securities Contra cts (Regula tions) Act in 1956 (SCR Act) for the regulations of stock excha nges a nd contra ct in securities tra ded on the stock excha nges. The SCR Act a nd the Securities Contra cts (Regula tions) Rules, 1957, constitutes the legal fra mework for the regula tion of stock excha nges a nd protection of investors interest. The Amsterdam Stock Exchange is considered the oldest in the world. It was established in 1602 by the Dutch East India Company

25 16 Banking and Financial Services (Sou rce: CR ISIL) M ajor Stoc k Exc hanges ( by M arke t Capitalization), as on Dec e mbe r 2012 Ra n k St oc k Exc h a n ge Ec on om y History of Indian Stock Market He a d - qu art e r s Ma rk e t c ap (USD bn ) Trad e volu m e (USD bn ) 1 New York Stock E xch an ge Un ited Sta tes New York 1 4,085 12,693 2 NASDAQ Un ited Sta tes New York 4,582 8,914 3 Tokyo Stock E xch a n ge J a pa n Tokyo 3,478 2, Lon d on Stock Exch an ge Grou p Un ited Kin gdom Italy 5 Eu ron ext Fra n ce Neth erlan ds Belgiu m Portu ga l Lon don 3,396 1,890 Am s terda m 2,930 1,900 6 Hon g Kon g Stock Exch an ge Hon g Kon g Hon g Kon g 2, Sh a n gh a i Stock Exch an ge Ch in a Sh a n gh a i 2,547 2,176 8 Toron to Stock Exch a n ge Can a da Toron to 2,058 1,121 9 Fra n kfu rt Stock Exch a n ge Germ a n y Fran kfu rt 1,486 1,101 Au stra lia n Secu rities Exch a n ge Au s tra lia Sydn ey 1, Bom ba y Stock Exch a n ge In dia Mu m ba i 1, Na tion a l Stock Exch a n ge of In dia In dia Mu m ba i 1, SIX Swiss Exch a n ge Switzerlan d Zu rich 1, BM&F Bovespa Bra zil São Pa u lo 1, Korea Exch a n ge Sou th Korea Seou l 1,179 1, Sh en zh en Stock Exch a n ge Ch in a Sh en zh en 1,150 2, BME Spa n ish Exch a n ges Spa in Ma drid J SE Lim ited Sou th Africa J ooh h aan n n ees s bbu u r gr g Moscow Exch a n ge Ru ss ia Mos cow Sin gapore Exch a n ge Sin ga pore Sin ga pore India n stock ma rket ma rks to be one of the oldest stock ma rket in Asia. It da tes back to the close of 18th century when the East India Compa ny used to transa ct loa n securities. In the 1830s, tra ding on corpora te stocks a nd shares in Ba nk a nd Cotton presses took pla ce in Bomba y. Though the tra ding wa s broa d but the brokers were hardly ha lf doz en during 1840 a nd An informa l group of 22 stockbrokers bega n tra ding under a ba nya n tree opposite the Town Ha ll of Bombay from the mid-1850s, ea ch investing a (then) princely amount of Rupee 1. This ba nya n tree still sta nds in the Hornima n Circle Pa rk, Mumba i. In 1860, the excha nge flourished with 60 brokers. In fa ct the ' Sha re Ma nia' in

26 An Overview of Indian Financial System 17 India bega n when the America n Civil W a r brokeout a nd the cotton supply from the US to Europe stopped. Further, the brokers increa sed to 250. The informa l group of stockbrokers orga niz ed themselves a s the The Native Sha re a nd Stockbrokers Associa tion which, in 1875, wa s forma lly orga niz ed a s the Bomba y Stock Excha nge (BSE). BSE was shifted to a n old building nea r the Town Hall. In 1928, the plot of la nd on which the BSE building now sta nds (a t the intersection of Da la l Street, Bombay Sa macha r Ma rg and Hamma m Street in downtown Mumbai) was a cquired, a nd a building wa s constructed a nd occupied in Premcha nd Roycha nd wa s a lea ding stockbroker of that time, a nd he a ssisted in setting out tra ditions, conventions, and procedures for the tra ding of stocks a t Bomba y Stock Excha nge a nd they are still being followed. Severa l stockbroking firms in Mumba i were fa mily run enterprises, a nd were na med a fter the hea ds of the fa mily. The following is the list of some of the initia l members of the excha nge, a nd who a re still running their respective b u s i n e s s : D. S. Prabhudas & Compa ny ( now known a s DSP, a nd a joint venture pa rtner with Merrill Lynch) Jamnadas Morarjee (now known as JM) Champa kla l Devida s (now ca lled Cifco Fina nce) Brijmohan La xmina raya n In 1956, the Government of India recogniz ed the Bomba y Stock Exchange a s the first stock exchange in the country under the Securities Contracts (Regula tion) Act. The most decisive period in the history of the BSE took pla ce a fter In the a fterma th of a ma jor sca nda l with ma rket ma nipula tion involving a BSE member na med Ha rshad Mehta, BSE responded to ca lls for reform with intra nsigence. The foot-dra gging by the BSE helped ra dicalise the position of the government, which encoura ged the crea tion of the Na tiona l Stock Excha nge (NSE), which crea ted a n electronic ma rketplace. NSE sta rted tra ding on 4 November, W ithin less tha n a year, NSE turnover exceeded the BSE. BSE ra pidly automated, but it never caught up with NSE spot ma rket turnover. The second stra tegic failure a t BSE ca me in the following two yea rs. NSE emba rked on the launch of equity deriva tives tra ding. BSE responded by politica l effort, with a friendly SEBI cha irma n (D. R. Mehta) aimed a t blocking equity deriva tives tra ding. The BSE a nd D. R. Mehta succeeded in dela ying the onset of equity deriva tives tra ding by roughly five years. But this trading, a nd the a ccompa nying shift of the spot ma rket to rolling settlement, did come a long in 2000 a nd helped by a nother ma jor sca nda l at BSE involving the then President Mr. Ana nd Ra thi. NSE scored nea rly 100% ma rket sha re in the runa wa y success of equity deriva tives tra ding, thus, consigning BSE into clearly second pla ce. Today, NSE ha s roughly 66% of equity spot turnover a nd roughly 100% of equity deriva tives turnover. Standard Settlement Instructions (SSIs) are the agreements between two financial institutions which fix the receiving agents of each counterparty in ordinary trades of some type. These agreements allow traders to make faster trades since time used to settle the receiving agents is conserved. Limiting the trader to an SSI also lowers the likelihood of a fraud.

27 18 Banking and Financial Services Sec ondary Marke t Trading in M ajor Countr ies (2012) More than 5000 companies are listed on BSE R a n k C o u n t r y Total Value Traded C o u n t r y Total Market (US $ mn) Ca pitalisation (US $ mn) 1 Unites States 21,37 5,2 80 United States 18,66 8, C h i n a 5,8 26, 50 6 C h i n a 3,6 97, J a p a n 3,6 05, 39 3 J a p a n 3,6 80, United Kingdom 2,4 88, 56 6 United Kingdom 3,0 19, K o r e a 1,5 13, 84 0 C a n a d a 2,0 16, H on g kon g 1,2 29, 42 3 F r a n c e 1,8 23, G e r n m a n y 1,2 25, 53 0 G e r m a n y 1,4 86, C a n a d a 1,2 07, 89 4 Au s t r a l i a 1,2 86, F r a n c e 1,1 26, 61 1 I n d i a 1,2 63, S p a i n 1,0 77, 02 9 B r a zil 1,2 29, Au s t r a l i a 1,0 51, 64 6 K o r e a 1,1 80, B r a zil 83 4,53 5 Hong kong 1,1 08, I t a l y 75 9,67 3 S w i t z e r l an d 1,0 79, R u s s i a 73 2,24 2 S p a i n 99 5, T aiw a n 65 9,81 1 R u s s i a 87 4, S w i t z e r l an d 64 1,00 1 T aiw a n 71 1, I n d i a 62 2,47 9 N e t h e r l a n d s 65 1, Saudi Arabia 51 4,42 3 South Africa 61 2, N e t h e r l a n d s 44 1,30 0 S w e d e n 56 0, S w e d e n 37 6,17 5 M ex ic o 52 5,05 7 Sou rce: S&P Global Stock Markets Factbook, Screen-based Trading System (SBTS)/ Online Trading System Before the NSE wa s set up, tra ding on the stock excha nges in India used to ta ke place through open outcry without use of informa tion technology for immedia te ma tching or recording of tra des. This wa s time consuming a nd inefficient. The pra ctice of physica l tra ding imposed limits on tra ding volumes a s well a s, the speed with which new information wa s incorpora ted into prices. To obviate this, the NSE introduced screen-ba sed tra ding system (SBTS) where a member can punch into the computer the quantities of sha res and the prices at which he wants to tra nsa ct. The tra nsa ction is executed a s soon as the quote punched by a trading member finds a matching sa le or buy quote from counterparty. SBTS electronically matches the buyer and seller in an order-driven system or finds the customer the best price a vaila ble in a quote-driven system, and hence, cuts down on time, cost and risk of error as well as on the cha nces of fraud. SBTS ena bles distant participa nts to trade with each other, improving the liquidity of the markets. The high speed with which trades are executed and the la rge number of pa rticipants who can tra de simulta neously allows faster incorporation of price-sensitive information into preva iling prices. This increases the informa tional efficiency of markets. With SBTS, it becomes possible for market pa rticipants to see the full market, which helps to ma ke the market more transpa rent, lea ding to increased investor confidence. The NSE started na tionwide SBTS, which have provided a completely transpa rent tra ding mecha nism. Regiona l exchanges lost a lot of business to NSE, forcing them to introduce SBTS.

28 An Overview of Indian Financial System 19 Online Trading Mechanism Bombay Stock Excha nge's trading system is popularly known as BOLT. The BSE has deployed a n OnLine Trading system (BOLT) on Ma rch 14, BOLT ha s a two-tier a rchitecture. The trader workstations a re connected directly to the backend server, which a cts a s a communication server and a Central Trading Engine (CTE). Other services like information dissemination, index computa tion, and position monitoring are a lso provided by the system. Access to ma rket-rela ted informa tion through the tra der worksta tions is essential for the market pa rticipants to act on rea l-time basis and ta ke immediate decisions. BOLT has been interfaced with va rious information vendors like Bloomberg, Bridge, and Reuters. Market informa tion is fed to news agencies in rea l time. It makes the tra de efficient, transpa rent a nd time sa ving. NSE provides its customers with a fully a utomated screen-ba sed tra ding system known as NEAT system, in which a member ca n punch into the computer quantities of securities a nd the prices a t which he likes to transa ct a nd the transa ction is executed a s soon a s it finds a ma tching sa le or buy order from a counter pa rty. It electronica lly ma tches orders on a price/ time priority a nd hence, cuts down on time, cost a nd risk of error, a s well a s on fraud, resulting in improved opera tiona l efficiency. It allows fa ster incorpora tion of price sensitive informa tion into preva iling prices, thus, increa sing the informa tiona l efficiency of ma rkets. The stocks a re hold in a demutua lised forma t helping in fa st, tra nsparent a nd efficient preserva tion a nd tra nsa ctions. BOLT (BSE's Online Trading System) Regulatory Framework of Stock Market The Securities Contra ct Regula tion Act, 1956 a nd the Securities a nd Excha nges Board of India Act, 1992, provided a comprehensive lega l fra mework. The responsibility for regulating the securities ma rket is sha red by Depa rtment of Economic Affa irs (DEA), Department of Company Affa irs (DCA), Reserve Bank of India (RBI) a nd Securities a nd Excha nge Boa rd of India (SEBI). The stock Excha nges Division of the Ministry of Fina nce ha s powers rela ted to the a pplica tion of the provision of the SCR Act a nd licensing of dea lers in the other a rea. According to SEBI Act, the Ministry of Fina nce has the a ppella te a nd supervisory powers over the SEBI. It ha s power to gra nt recognition to the Stock Excha nges a nd regula tion of their operations. Ministry of Fina nce ha s the power to a pprove the a ppointments of chief executives and nomina tions of the public representa tives in the Governing Boa rds of the stock excha nges. It ha s the responsibility of preventing undesira ble specula tion. The Se c ur ities and Exchange B oard of India: The Securities a nd Exchange Board of India even though esta blished in the yea r 1988, received sta tutory powers only on 30thJ a n Under the SEBI Act, a wide variety of powers is vested in the ha nds of SEBI. SEBI ha s the powers to regulate the business of stock excha nges, other security markets a nd mutua l funds. Registration a nd regula tion of ma rket intermedia ries a re a lso ca rried out by SEBI. It ha s the responsibility to prohibit the fra udulent unfa ir tra de practices a nd insider dealings. Ta keovers a re a lso monitored by the SEBI. Stock Excha nges ha ve to submit periodic a nd a nnua l returns to SEBI. The ma in objective of the SEBI is to promote the healthy growth of the capita l ma rket a nd protect the investors.

29 20 Banking and Financial Services RBI regulates money market operations in India Role of SEBI SEBI ha s been obliga ted to perform the aforesa id functions by such mea sures a s it thinks fit. In pa rticula r, it ha s powers for: Regula ting the business in stock excha nges a nd a ny other securities ma r k e t s Registering a nd regula ting the working of stockbrokers, subbrokers e t c. Promoting a nd regula ting self-regula tory orga niz a tions Prohibiting fra udulent and unfa ir tra de pra ctices Ca lling for information from underta king, inspection, conducting inquiries a nd a udits of the stock excha nges, intermedia ries, selfregula tory orga niz a tions, mutual funds a nd other persons associated with the securities ma rket. Major Recognized Stock Exchanges in India Sr. No. Name of the Exc hange 1 Ahmedabad Stock Exchange Ltd. 2 BSE Ltd. 3 Bangalore Stock Exchange Ltd. 4 Bhuba neswa r Stock Excha nge Ltd 5 Calcutta Stock Exchange Ltd. 6 Cochin Stock Exchange Ltd 7 Delhi Stock Excha nge Ltd., 8 Ga uha ti Stock Exchange Ltd., 9 Inter-Connected Stock Excha nge of India Limited 1 0 J a ipur Stock Excha nge Ltd 1 1 Ludhia na Stock Excha nge Ltd. 1 2 MCX SX Excha nge Limited 1 3 Ma dhya Pra desh Stock Excha nge Ltd 1 4 Madras Stock Exchange Ltd. 1 5 Magadh Stock Exchange Ltd. 1 6 Mangalore Stock Exchange 1 7 Na tiona l Stock Excha nge of India Ltd. 1 8 OTC Excha nge of India 1 9 Pune Stock Excha nge Ltd 2 0 The Va doda ra Stock Exchange Ltd. 2 1 U.P. Stock Exchange Limited 2 2 United Stock Excha nge of India Limited

30 An Overview of Indian Financial System 21 Selected Indicators of Secondary Market in India E n dcapital Market Segment of Stock Exchanges At the of Financial No. of Nifty 50 S en se x Market Cap- Market Market Turnover Turnover Turnover Year Brokers it al is at io n Capit ali- Capi- (` mn) (US $ mn) Ratio (` mn) s at i on t a l i s a t i on (per cent) (US $ mn) Ratio (per cent) , , , 6 8 8, , , 8 0 9, , , , , 4 9 2, , , 9 5 8, , , , , 3 1 9, , , 6 8 9, , , , , 1 8 7, , , 2 0 9, , , , , 9 8 4, , , 6 6 8, , , , , 2 2 1, , , 9 0 1, , , , , 4 8 8, , , 0 1 4, , , , , 4 9 7, , 2 8 8, , 3 0 8, , 2 8 3, , , , 9 2 9, , , 5 2 0, , , , , 7 0 4, , 3 6 6, , 1 6 8, , 2 2 2, , , , 4 3 0, , 5 3 2, , 8 5 0, , 0 4 9, , , , 1 9 1, , 2 1 5, , 8 4 3, , * 1 0, , , 8 7 8, , 1 7 4, , 5 7 0, , (Sou rce: SE BI annu al Report ) Money Market and Capital Market Money market refers to a ma rket in which borrowing a nd lending of shortterm funds a ga inst short-term credit instruments, such a s trea sury bills, bills of exchange, ba nkers accepta nces, short-term Government securities etc takes pl a c e. Functions of Money Market (1) It helps the Government to ra ise the necessa ry short-term funds through the issue of trea sury bills (2) It offers a cha nnel of investment to non-ba nking fina ncia l institutions, such a s insurance compa nies, fina ncia l houses etc. (3) Short-term funds a re ma de a va ila ble to industries to meet their working r e q u i r e m e n t s (4) It helps in the development of ca pital ma rket

31 22 Banking and Financial Services (5) It serves a s the medium through which the centra l ba nk ca n exercise its control over the creation of credit in the economy. Capital Market A capital market is one in which individuals and institutions trade financial securities. Ca pita l ma rket is, genera lly, referred to the market for long-term funds. It includes institutions and mecha nism for the effective pooling of long-term funds form individua ls and institutiona l investors a nd ma king them a va ila ble to industria l a nd commercial underta kings. Ca pita l market, in short, dea ls in shares, debentures, bonds a nd securities. Ca pita l ma rket ha s the following features: (1) It dea ls in long a nd medium-term funds (2) It consists of prima ry ma rket, seconda ry ma rket a nd specia l fina ncia l institutions (3) It covers both individua l a nd institutiona l investors (4) It makes funds a va ila ble to industria l a nd commercial underta kings Need and Importance of Capital Market (1) It helps in mobiliz ing the sa vings on a large sca le (2) It helps in the ca pita l formation in the country (3) It helps in effective distribution of the mobiliz ed funds for ba la nced economic development (4) It provides continues market for long-term funds Classification of Capital Market Capital market can be classified into Primary M arket and Secondary Mar ket Pr imar y M ar ke t: It is a lso ca lled new issues ma rket. In this ma rket, funds a re ra ised by industria l a nd commercia l enterprises from investors through the issue of sha res, debentures a nd bonds. Se condary M arke t (Stoc k Exc hange): Seconda ry ma rket is the ma rket in which existing securities a re bought and sold. Existing securities a re bought a nd sold on the stock excha nges with the help of brokers. Differences between Capital Market Money Market Capital Market Money Mark et 1. It dea ls in long-term a nd It dea ls in short-term funds medium-term funds 2. It provides funds for fixed It provides funds for working ca pi t a l ca pi t a l 3. It a cts as links between investors It crea tes a link between the a nd industria l a nd commercia l depositors and Borrowers e nt er p r i s e s 4. It a rra nges large amount of funds It a rra nges for sma ll a mount of funds 5. Ra te of interest is, genera lly, low Ra te of interest is, genera lly, high

32 An Overview of Indian Financial System 23 AN OVERVIEW OF FINANCIAL INSTRUMENTS Fina ncial claims or fina ncial a ssets like sha res debentures, etc., dea lt in a fina ncia l ma rket a re referred to a s fina ncia l instruments. Fina ncial a ssets refer to cla ims of periodica l pa yments of certain sum of money by wa y of payment of principa l, interest or dividend. The pa yments rela ting to fina ncial a ssets depending on the nature of fina ncial instruments held. For insta nce, in the ca se of bonds, debentures or ba nk deposits, the investor receives regula r interest a nd the principa l repa yment a t the end of a specified ma turity period. In the ca se of irredeema ble bonds, the holder regularly receives interest pa yments a nd the principa l is returned only a t the time of winding up of the compa ny. In the ca se of ordinary shares, companies ma ke regula r dividend pa yments a nd ca pita l a pprecia tion can be expected. Importa nt cha racteristics of fina ncia l instruments a re as below. 1. Liquidity: This feature a llows for the ea sy a nd fa st conversion of securities into ca sh 2. M arke tability: W hich facilita tes ea sy tra ding of the security in the seconda ry ma rket. 3. Collateral value: Which allows for pledging of instruments for obtaining loans from fina ncia l institutions. 4. M atur ity pe r iod: W hich is either long term, medium-term or short - term depending on the type of instrument held by the investor 5. Transfe rability: Which a llows for easy a nd quick transfer of instruments from one person to another without much forma lities 6. Cost: W hich implies the expenses involved in buying a nd selling of fina ncial instruments. 7. Pr ovision of options: Such a s ca llback or buyback options where by compa nies ca n buy or sell the securities from investors. 8. Tax pr ovision: Return ea rned on the instruments which a re dea lt is either ta xa ble or ta x-free Types of Financial Instruments Fina ncial instruments ca n be broa dly cla ssified into (a) Money ma rket instrument (b) Ca pita l ma rket instruments. (a) Money Market Instruments The most liquid, short-term debt obligations tha t a re tra ded in the money ma rket are called money ma rket instruments. Some of these instruments a re briefly described below: 1. Tr e asur y Bills (T-Bills): Treasury Bills, one of the safest money market instruments, are short-term borrowing instruments of the Centra l Government of the country issued through the Centra l Ba nk (RBI in India). They a re zero Money market investments are also called cash investments because of their short maturities.

33 24 Banking and Financial Services In India, Individual Investors cannot invest in money market instruments directly risk instruments, and hence, the returns a re not so a ttra ctive. It is ava ilable both in prima ry market as well a s seconda ry ma rket. It is a promise to pa y a said sum a fter a specified period. T-bills are short-term securities tha t ma ture in one yea r or less from their issue da te. They a re issued with three-month, sixmonth a nd one-yea r ma turity periods. The Centra l Government issues T- Bills a t a price less tha n their fa ce va lue (pa r va lue). They a re issued with a promise to pa y full fa ce va lue on maturity. T-Bills a re issued through a bidding process a t a uctions. At present, the Government of India issues three types of trea sury bills through a uctions, na mely, 91-da y, 182-da y a nd 364-da y. Trea sury bills a re a va ila ble for a minimum a mount of ` 25K a nd in its multiples. 2. Commer c ial Paper s: Commercia l pa per is a low-cost a lterna tive to ba nk loans. It is a short term unsecured promissory note issued by corpora te a nd fina ncial institutions a t a discounted va lue on fa ce va lue. They a re usually issued with fixed ma turity between one to 270 da ys and for fina ncing of a ccounts receiva bles, inventories a nd meeting short-term lia bilities. Commercia l paper being a n instrument not ba cked by a ny colla tera l, only firms with high qua lity credit ratings will find buyers ea sily without offering any substa ntia l discounts. They a re issued by corpora tes to impa rt flexibility in ra ising working ca pita l resources a t ma rket determined ra tes. Commercia l Papers a re actively traded in the seconda ry ma rket since they a re issued in the form of promissory notes a nd a re freely transferable in dema t form. 3. Ce r tific ate of De posit: It is a short-term borrowing more like a ba nk term deposit a ccount. It is a promissory note issued by a ba nk in form of a certifica te entitling the bearer to receive interest. The certifica te bea rs the ma turity da te, the fixed ra te of interest a nd the value. It can be issued in a ny denomina tion. They a re sta mped a nd tra nsferred by endorsement. Its term genera lly ra nges from three months to five yea rs a nd restricts the holders to withdra w funds on dema nd. However, on payment of certa in pena lty the money ca n be withdrawn on demand a lso. The returns on certifica te of deposits a re higher tha n T-Bills beca use it assumes higher level of risk. 4. Re po/ Re ve r se Re po: Repurcha se tra nsactions, ca lled Repo or Reverse Repo a re tra nsa ctions or short-term loa ns in which two parties a gree to sell a nd repurchase the sa me security. They a re usually used for overnight borrowing. Repo/ Reverse Repo tra nsa ctions can be done only between the pa rties a pproved by RBI and in RBI a pproved securities, v iz., GOI a nd Sta te Govt Securities, T- Bills, PSU Bonds, FI Bonds, Corpora te Bonds, etc. Under repurcha se agreement the seller sells specified securities with an a greement to repurcha se the sa me a t a mutua lly decided future da te a nd price. Simila rly, the buyer purchases the securities with a n agreement to resell the same to the seller on an a greed da te a t a predetermined price. Such a tra nsaction is ca lled a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities. Thus, whether a given a greement is termed a s a Repo or Reverse Repo depends on which party initiated the transa ction. The lender or buyer in a Repo is entitled to receive compensa tion for use of funds provided to the counterpa rty.

34 An Overview of Indian Financial System Call M one y: Ca ll money is ma inly used by the ba nks to meet their tempora ry requirement of ca sh. They borrow from a nd lend money to each other norma lly on a da ily ba sis. It is repa ya ble on dema nd a nd its maturity period va ries between one da y to a fortnight. The ra te of interest pa id on call money loan is known a s call rate. Ca ll Money Money lent for one da y Notice Money Money lent for a period exceeding one da y Term Money lent for 15 days or more on Interbank ma rket In t e res t Rat es on t h e Mon e y Ma rk e t In st r u m e n t s in In d ia (Percen t per an n u m : An n u a l Avera ges ) Re po Ra t e Ca ll Rat e CBLO Ra t e Ma rk e t Re po Ra t e 9 1 d ay T-Bills d a y T Bills CP Rat e CD Ra t e (So urce: RB I) (b) Capital Market Instruments Some of the importa nt instruments of ca pital ma rket are: 1. Equity Shares Equity sha res, commonly referred to a s ordina ry sha re a lso represents the form of fra ctiona l ownership in which a sha reholder, a s a fractional owner, underta kes the ma ximum entrepreneuria l risk a ssociated with a business venture. The holder of such sha res is the member of the compa ny and has voting rights. Equity shares, other tha n non-voting sha res, ha ve voting rights a t a ll genera l meetings of the company. These votes ha ve the affect on the controlling

35 26 Banking and Financial Services In U S A, the main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply Treasuries. of the compa ny. Equity sha res ha ve the right to sha re the profits of the compa ny in the form of dividend (ca sh) a nd bonus shares. However even equity shareholders ca nnot demand decla ration of dividend by the compa ny which is left to the discretion of the Boa rd of Directors. W hen the compa ny is wound up, pa yment towa rds the equity share capita l will be ma de to the respective shareholders only after pa yment of the cla ims of all the creditors a nd the preference sha re ca pita l 2. Preference Shares It is a n unique type of long-term fina ncing instrument which combines some of the cha ra cteristics of equity sha res a s well a s debentures. It is simila r to debenture beca use it ca rries fixed dividend, It is ra nked higher than equity on the ba sis of cla im a nd It does not ha ve any voting rights. It is simila r to equity ca pita l because Not obliga tory to pa y dividend a nd Irredeemable type does not ha ve a ny ma turity. Preference sha re can be Redeema ble a nd irredeema ble preference sha res, Convertible and non convertible preference shares and Pa rticipa tive a nd non-participa tive preference shares 3. Debentures/Bonds Section 2( 12) of the Compa nies Act, 1956, defines debentures a s " Debenture includes debenture stock, bonds a nd a ny other securities of a compa ny, whether constituting a cha rge on the a ssets of the compa ny or not." Debenture is a document evidencing the debt of an orga niz a tion. It is issued by a compa ny a s a certifica te of indebtedness a nd It usua lly indica tes the da te of redemption a nd a lso provides for the repayment of principa l a nd pa yment of interest a t specified da te or da tes. Debenture usua lly crea tes a cha rge on the underta king or the assets of the company. In such a ca se, the lenders of money to the company enjoy better protection a s secured creditors, i. e., if the compa ny does not pa y interest or repa y principa l amount, the lenders ma y either directly or through the debenture trustees bring a ction a ga inst the compa ny to rea lise their dues by sa le of the a ssets/ undertaking ea rma rked as security for the debt. Debentures a re issued in the following forms: Na ked or unsecured debentures. Secured debentures. Redeema ble debentures. Irredeemable/ Perpetua l debentures. Non convertible/ Fully convertible/ Pa rtly convertible debentures. Bearer debentures. Registered debentures. Zero interest debentures/ bonds ( ZIB). Deep discount bonds. Secured premium notes. Floa ting ra te bonds.

36 An Overview of Indian Financial System ADR/GDR An American Depositary Receipt (ADR) or Global Depositary Receipt (GDR) is a simple wa y for investors to invest in compa nies whose sha res a re listed a broa d. The ADR or GDR is essentia lly a certifica te issued by a ba nk tha t gives the owner rights over a foreign sha re. It can be listed on a stock excha nge a nd bought and sold just like a normal sha re. The holder of an ADR or GDR is entitled to a ll benefits such a s dividends a nd rights issues from the underlying sha res. They a re sometimes - but not a lways - a ble to vote. As we might expect from the na me, a n ADR is listed in the US. A GDR is typically listed in London or Luxembourg. A deposita ry receipt where the issuing ba nk is Europea n will sometimes be ca lled a Europe an De positary Re c eipt (EDR), although this term is less common. For a rea l exa mple, let' s look a t ICICI Ba nk. This stock is listed in India a nd isn' t a va ila ble to most foreign investors. However, it ha s a deposita ry receipt issued in New York a nd tra ded on the New York stock excha nge, which a lmost anyone ca n buy. The deposita ry receipt for ICICI is issued by Deutsche Ba nk. For ea ch deposita ry receipt in circulation, Deutsche Ba nk holds the equiva lent number of India-listed sha res on behalf of the owners of the ADR. One ADR or GDR does not alwa ys equal one sha re of underlying stock. And with ICICI, the ADR a ctua lly represents two India-listed shares of ICICI a nd is priced a ccordingly. 5. Foreign Currency Convertible Bonds (FCCBs) A Foreign Currency Convertible Bond (FCCB) is a qua si debt instrument which is issued by a ny corpora te entity, interna tiona l a gency or sovereign sta te to the investors a ll over the world. They are denomina ted in a ny freely convertible foreign currency. Euro Convertible Bonds a re usua lly issued a s unsecured obliga tion of the borrowers. FCCBs represent equity linked debt security which ca n be converted into sha res or into depository receipts. The investors of FCCBs ha s the option to convert it into equity norma lly in a ccorda nce with pre-determined formula a nd sometimes, also at a predetermined excha nge ra te. The investor a lso ha s the option to reta in the bond. The FCCBs by virtue of convertibility offers to issuer a privilege of lower interest cost than tha t of similar non-convertible debt instrument. By issuing these bonds, a compa ny ca n a lso a void any dilution in ea rnings per sha re tha t a further issue of equity might cause whereas, such a security still ca n be tra ded on the ba sis of underlying equity va lue. Poison pill: when a company issues more shares to prevent being bought out by another company, thereby, increasing the number of outstanding shares to be bought by the hostile company making the bid to establish majority 6. Term Loan Term Loan is a method of debt financing by banks or fina ncial institutions with ma turity period of over one yea r to about 10 yea rs. It provides for a fixed a nd often la rge a mount of loa n required either for setting up a new unit for fina ncing the expansion/diversifica tion/ moderniz ation of a project in terms of la nd, building, pla nt and machinery or perma nent a ddition to current a ssets. Hence, term loa n is a lso ca lled Project Financing. Term loan ca rries floa ting ra te of interest.

37 28 Banking and Financial Services 7. External Commercial Borrowing An Ex te rnal Comme rc ial Borrowing (ECB) is a n instrument used in India to fa cilitate the a ccess to foreign money by India n companies. ECBs include commercia l bank loa ns, buyers' credit, suppliers' credit, securitised instruments such a s floa ting rate notes a nd fixed ra te bonds etc. It a lso includes credit from officia l export credit a gencies and commercia l borrowings from the priva te sector window of multila tera l fina ncia l Institutions such a s Internationa l Finance Corpora tion (Wa shington), ADB, AFIC, CDC, etc. ECBs ca nnot be used for investment in stock ma rket or specula tion in rea l estate. The DEA (Depa rtment of Economic Affa irs), Ministry of Fina nce, Government of India a long with Reserve Ba nk of India, monitors a nd regula tes ECB guidelines a nd policies. AN OVERVEW OF FINANCIAL INSTITUTIONS Financial institutions are intermediaries that mobilize savings and facilitate the allocation of funds in an efficient manner Fina ncial system pla ys an indispensa ble role in the overa ll development of a country. The most importa nt constituent of this sector is the fina ncia l institutions, which a ct a s a medium for the tra nsfer of resources from net sa vers to net borrowers. The fina ncia l institutions ha ve tra ditionally been the major source of long-term funds for the economy. These institutions provide a va riety of fina ncia l products and services to fulfill the varied needs of the commercia l sector. Besides, they provide a ssista nce to new enterprises, small a nd medium firms a s well a s to the industries esta blished in ba ckwa rd a reas. Thus, they ha ve helped in reducing regiona l dispa rities by inducing widesprea d industria l development. Fina ncia l institutions provide a ll those fina ncia l services which a re a va ila ble in fina ncial system. Benefits of Financial Institutions These a re benefits a n individua l enjoys by investing through fina ncia l intermedia ries tha n involving directly in fina ncia l ma rket. (1) Ec onomy of sc ale: W hen fina ncia l institutions a re carrying out their investment or other a ctivities in la rge sca le out of pooled funds, they ca n a chieve economy of scale. (2) Lowe r tr ansac tion c ost: Because of economy of scale the cost of ea ch transa ction is much lower than wha t it would ha ve been, if those transa ction a re ca rried on by individua l investors on their own. (3) Dive r sific ation: As financia l institutions a re dea ling in huge a mounts of pooled funds, they diversify their investments in such a wa y tha t the risk involve would reduce considera bly. Banking and Non Banking Financial institutions in India The Government of India, in order to provide a dequa te supply of credit to va rious sectors of the economy, has evolved a well developed structure of fina ncial institutions in the country. A study of fina ncial institutions in India revolves a round RBI which is a centra l ba nk of India. Fina ncial Institutions ca n be broadly cla ssified a s Ba nking a nd Non- Ba nking Fina ncia l Institutions. A Ba nking Institution is a n organiz a tion tha t

38 An Overview of Indian Financial System 29 a ccepts customer ca sh deposits a nd then provides fina ncia l services like ba nk a ccounts, loans, sha re tra ding a ccount, mutua l funds, etc. A NBFC (Non Ba nking Fina ncial Compa ny) is an orga niz ation tha t does not a ccept customer ca sh deposits but provides a ll fina ncial services except ba nk a ccounts. Ba nking institutions a re subject to lega l reserve requirements (CRR, SLR), ca n a dvance credit by crea ting cla ims a gainst themselves, while Non ba nking fina ncia l institutions ca n lend only out of resources put a t their disposa l by the sa vers. Banking Institutions in India (1) Reserve Ba nk of India (2) Commerica l Banks (3) Co-opera tive Banks Non Banking Financial Institutions in India 1. Indigenous Bankers a nd Fina ncia l Agencies 2. Development Banks 3. Insura nce Companies 4. Mutua l Funds 5. Fina nce Compa nies 6. Mercha nt Ba nking Institutions 7. Pension Funds 8. Discount Houses 9. Accepta nce House 1 0. Housing finance compa nies 1 1. Leasing and hire purcha se compa nies 1 2. Venture ca pita l firms 1 3. Debt securitiza tion compa nies Conventionally, financial institutions are composed of organizations such as banks, trust companies, insurance companies and investment dealers. It is an establishment that focuses on dealing with financial transactions, such as investments, loans and deposits (1) Reserve Bank of India RBI being Centra l Ba nk of the country is the a pex moneta ry institution in the money ma rket. It regula tes a nd ma kes policy rela ting to moneta ry ma na gement in the country. It serves a s the government ba nk beca use it performs the ma jor financia l opera tions of the government it also pa rticipa te in a big way in the ma rket to purchase a nd sell va rious securities, specifically those issued by the Government. In brief, the RBI is a n constituent of the government which pa rticipa tes in financia l ma rkets in different wa ys. These a r e: (a) (b) (c) Issuing of currency notes: Agent a nd a dviser of the Government: Acting a s bankers' bank:

39 30 Banking and Financial Services (d) (e) Ma inta ining a dequa te foreign excha nge reserve: Credit control functions: (2) Commerical Banks Another significa nt pa rticipa nt in the financia l system is commercia l Bank. A ma jor portion of the tota l opera tions of the fina ncia l system is conducted through the commercia l ba nks. The ba sic functions of commercia l ba nks is a ccepting deposits a nd lending. Apa rt from this they perform va rious seconda ry a nd a gency functions. (3) Co-operative Banks Co-opera tive ba nks perform a lmost a ll the functions performed by a commercia l ba nks. They are constituted as a co-opera tive institutions. The over-thecounter (OTC) market is a type of secondary market also referred to as a dealer market. The term overthe-counter refers to stocks that are not trading on a stock exchange. Non-Banking Financial Institutions (1) Indigenous Bankers and Financial Agencies Indigenous fina ncia l a gencies a re importa nt pa rticipa nts in money ma rket, specia lly in unorga niz ed sector. They comprise of money lenders (Villa ge Sa huka rs) a nd indigenous ba nkers. Moneylenders a re norma lly referred to those persons whose ma in business is to provide fina ncial a ssista nce to rura l fa rmers a nd others. On the other ha nd, indigenous banker is referred to a n individua l or private firm receiving deposits a nd lending money. The ba sic function of these a gencies is to provide usua lly short-term loa ns to both urba n a s well a s rura l borrowers. Norma lly, they fina nce a gricultura l activities, business a nd other personal a ctivities. Sometimes, they also lend money by mortga ging immova ble property like houses, la nd, fixed a ssets, etc. The ra te of interest charged by them is norma lly very high in comparison to the ba nks. These moneylenders a nd indegeneous ba nkers constitutes a n integra l pa rt of fina ncia l system. They provide fina nce wherever commercia l ba nks fa ils to ca rry on ba nking activities efficiently. (2) Development Banks Development banks which ca me into existence in middle of 20th century a re now most a ctive pa rticipa nt in the fina ncia l markets a ll over the world a nd in India too. Development ba nks, also known as fina ncial institutions, a re prima rily enga ged in providing long-term financia l a ssista nce to the industria l units, usua lly by refinancing commercia l ba nks. The financia l a ssista nce is provided in va rious forms like extending term loa ns, subscription to sha res a nd debentures, underwriting ca pita l issues, gua ra ntee of term loa ns, gua ra ntee in respect of deferred payments by importers, etc. In India, some ma jor (a) (b) (c) (d) development ba nks a re Industria l Development Ba nk of India (IDBI) Industrial Finance Corporation of India (IFCI), Industria l Credit Investment Corpora tion of India (ICICI), State Fina ncia l Corporations (SFCs);

40 An Overview of Indian Financial System 31 (e) (f) Slate Industria l Development Corpora tion (SIDCs), Industrial Reconstruction Ba nk of India (IRBI). (3) Insurance Companies Insura nce compa nies ha ve emerged a s prominent pa rticipa nts in the fina ncial markets beca use of the a va ila bility of huge funds a t their disposa l genera ted by selling the insura nce policies for investment purpose. These compa nies ca n be cla ssified into ca tegories such a s Life insurance compa nies a nd Genera l insurance compa nies. Among these, life insura nce compa nies a re domina nt due to their la rge size a nd less risk a ssocia ted with their business. The ma jor source of funds of these compa nies is premium received from the policyholders. The investment policy is usua lly different from tha t of other institutions. The ma jor portion of the fund is norma lly invested in Government a nd Semi-government securities a nd some fixed income securities. Apa rt from life insura nce compa nies, genera l insura nce compa nies which a re in insurance business a lso ha ve huge investible funds to employ in the business sector. Prominent insurers in India includes (a) (b) (c) LIC of India GIC of India (GIC includes 4 fully owned subsidia ries) (i) New India a ssura nce (ii) Orienta l insurance (iii) United India insurance (iv) Na tiona l insurance compa ny ltd Insurers in priva te sector like Ta ta AIG, ICICI Lomba rd, etc 7 th February 2006 SENSEX closed above (4) Mutual Funds Investment compa nies a re such institutions which collect the funds from the people (Generally household sa vers) through a specific fina ncial instrument, i. e., unit, sha re, debenture, etc. a nd then invest these pooled funds in suitable securities like equity sha res, debentures, government securities, etc. The basic objective of mutual funds is to get enha nced benefits of huge a nd pooled resources through low risk a nd expertise. Mutua l funds provides va rious schemes to investors like debt fund, equity fund, ba la nced funds, etc., depends on risk a nd return profile of the investors. Important mutua l funds opera ting in India a re, Unit Trust of India, Ca nba nk mutua l fund, ICICI, TATA, etc. (5) Finance Companies Another importa nt pa rticipa nt in the fina ncia l ma rket is priva te sector fina nce companies. These compa nies collect funds from the people through shares, debentures, fixed deposits a nd short-term loans from banks and other corpora te units. Sometimes, a huge fund is also ra ised through inter corpora te deposits. These fina nce compa nies go for fina ncing of consumer dura ble goods, a utomobiles, furniture, etc., norma lly on insta llment scheme basis. Besides, they a lso provide short-term business credit to the business firms a nd professiona ls. Thus, these fina nce compa nies ha ve to compete with commercia l

41 32 Banking and Financial Services ba nks a nd other fina ncia l institutions which provide such loa ns. Ra te of interest on the loa n is higher a s compa red to the ba nkers, but still consumers prefer to go to these units due to ea sy a va ila bility a nd less forma lities. Some importa nt fina nce compa nies in India includes, Ba jaj Auto Finance, GE countrywide fina ncial systems ICICI fina ncials, etc. The forex market is where currencies are traded. The forex market is the largest, most liquid market in the world and it is open 24 hours a day (6) Merchant Banks Mercha nt ba nking a ctivities were firstly developed in early nineteenth centuries in western countries. Activities performed by these mercha nt ba nking institutions is vita l from the point of view of hea lthy development of fina ncia l system in the country. Ba sically merchant banking a ctivity is a n institutiona l a rra ngement providing fina ncia l a dvisory a nd intermedia ry services to the corpora te sector. Ea ch merchant banking institution may specia lise in one a ctivity. These mercha nt ba nking activities is either fees ba sed or commission ba sed. Activities performed by mercha nt ba nks includes (i) Issue (ii) Project (iii) Ca pita l Mana gement (iv) Under W riting (v) Corpora te (vi) Portfolio (vii) Corpora te Counselling Restructuring Counselling Mana gement Festructuring (viii) W orking Ca pital Finance (ix) Credit Bills Discounting Few importa nt mercha nt ba nking compa nies in India a re, Karvy Consulta ncy ltd, IL&FS, ICICI securities, etc. (7) Pension Funds A pension fund which a ccumulates funds from pension fund contributors ha s sta rted taking a ctive pa rt in fina ncia l system. These pension funds pa rticipa tes in money a nd capita l ma rkets by investing their funds. These pension funds invest in fixed income securities a nd recently, they ha ve sta rted investing in Equity ma rket a lso. (8) Discount Houses The ma jor function of discount houses is to discount tra de bills of tra ders so a s to provide adequate liquidity in the ma rket. These houses a re normally found in the developed money ma rket, e.g., London Money Ma rket. (9) Acceptance Houses Another pa rticipa nt in the fina ncial market is Accepta nce House. They play a significa nt role in fina ncial ma rket through borrowing long-term a nd short-term loa ns from the banks and lending the sa me to the tra ders. In other words, the a cceptance houses a ccept the bills of excha nge which a re dra wn on

42 An Overview of Indian Financial System 33 them either by the seller or the buyer of the goods so that the a ccepted bill ca n further be discounted from the discount house. AN OVERVIEW OF FINANCIAL SERVICES Fina ncia l services are the importa nt component of fina ncial system. Fina ncia l services ca ters to the needs of fina ncia l institutions, fina ncial ma rkets a nd financia l instruments. Fina ncia l system ca rries on its a ctivities through fina ncial institutions with the help of fina ncia l instruments. In this process, fina ncial system requires, a number of services of fina ncia l na ture. Fina ncia l services a re considered a s one of the key element of the fina ncia l system, other three elements being, fina ncia l ma rkets, fina ncial institutions a nd fina ncia l instruments. All these four elements should ha ve the proper coordina tion in order to a chieve the smooth functioning of fina ncial system. Effective functioning of fina ncial system depends upon wide ra nge of fina ncia l services provided by service providers. Fina ncia l services is a term used to refer to the services provided by the finance industry. Fina ncia l services is a lso the term used to describe the orga nisation tha t dea ls with the ma na gement of money. Ba nks, investment companies, insura nce companies, credit card compa nies, stockbroking firms a re the few exa mples of the firms comprising the fina ncia l services industry, which provides va riety of money a nd investment-related services. Fina ncial services includes services offered by asset ma na gement a s well a s lia bility ma na gement compa nies. Asset ma na gement compa nies includes, lea sing and hire purcha se, mutua l funds, investment ba nking mercha nt ba nkers, stockbroking, etc. Lia bility ma na gement compa nies includes, discounting compa nies, banking compa nies, a ccepta nce houses, etc. Features of Financial Services The term financial services became more prevalent in the United States partly as a result of the Gramm- Leach-Bliley Act of the late 1990s, which enabled different types of companies operating in the U.S. financial services industry at that time to merge 1. Intangibility All the fina ncia l services are inta ngible a nd invisible in na ture. Therefore, it becomes very essential for the service providers to ma inta in high sta ndards in service delivery to retain its customers. 2. Customer-oriented Fina ncial services a re customer-oriented. All fina ncia l services a re rendered keeping in mind, the needs of the customers. Before a ny service is provided, service provider conducts a survey, tries to know the preferences of a customer, then only a service is provided. 3. Inseparability This feature sta tes tha t there should be a perfect coordina tion between a service provider and their clients. The two ba sic functions of producing a nd supplying fina ncial services ha ve to be performed simulta neously. Therefore, production a nd supply a re insepa ra ble. 4. Performance Variability As fina ncia l services a re customer-oriented a nd people-intensive, there will be a va ria bility in performa nce. For example, there ma y be a cha nge in

43 34 Banking and Financial Services credit ca rd service provided by two compa nies to a different ca tegory of c u s t o me r s. 5. Dynamism Fina ncial services a re very dyna mic in na ture. They have to be consta ntly upda ted, a nd reefined on the ba sis of cha nges tha t a re ta king pla ce in the fina ncial system. Financial services are vital for creation of firms, industrial expansion, and economic growth. Advantages of Financial Services 1. It helps in ra ising the sufficient funds required for ca rrying out different development a ctivities. 2. It a lso a ssists to deploy the funds which a re ra ised through issue of different fina ncia l instruments. 3. They provides specia lised services like, credit ra ting, venture ca pita l, leasing etc. 4. Fina ncial services help in economic development of a country by contributing grea tly to GDP. 5. Fina ncial services industry provides lot of employment opportunities. 6. Fina ncia l services help in movement of resources from one sector of the economy to a nother. Problems/Limitations of Financial Services 1. Lack of Trained Staff Fina ncial service industry is suffering from la ck of tra ined a nd qua lified sta ff. The attrition ra te in fina ncial services industry is more, ma king the problem more severe. 2. Lack of Office Space Ma ny financia l service centers like Ba ngalore, Mumbai a re fa cing severe shorta ge of office spa ce. The office rent in these pla ces is very high which lea ds to increa se in the cost of providing fina ncia l services. 3. Inadequate Technology Although, there has been a rise in technology usage in financia l service industry, still there is some grey a rea s a s fa r a s technology is concerned. Still some more innova tions a re required to make fina ncial services industry more t e chn o- f r i e ndl y. 4. Lack of Innovative Services India n fina ncia l services industry is suffering from la ck of innova tive services. Most of the services a re outda ted a nd there is a need to add innova tive features to the existing services or introduce a ltogether new services to ma ke the services more a ttra ctive to the customers.

44 An Overview of Indian Financial System Lack of Regulatory Mechanism Presently RBI a nd SEBI a re the major regula tors. But still there is a la ck of regula tory mecha nism in fina ncia l service industry. More provisions should be introduced to make fina ncial service industry more customer-friendly a nd t r a n s pa r e nt. 6. Lack of Branding of Services Most of the fina ncial services, provided in unorga nised markets a re u n b r a n d e d. 7. Lack of Ethical Practices There is a need to follow ethica l pra ctices in fina ncial service industry. The recent IPO sca m involving certain reputed stockbroking firms is a n indica tion of the unethica l pra ctices in fina ncial service industry. Important Financial Services Offered in India 1. Mercha nt Ba nking 2. Project Ma na gement 3. Issue Mana gement 4. Portfolio Mana gement 5. Equipment Lea sing 6. B a n k i n g 7. Hire Purcha se Finance 8. Investment Services 9. Housing Fina nce 1 0. Mutual Fund 1 1. F a c t o r i n g 1 2. Credit Rating 1 3. Loan Syndica tion 1 4. S t o c kb r o k i n g 1 5. Depository services 1 6. Venture Ca pita l Fina ncing 1 7. I n s u r a n c e 1 8. Credit Card/Debit Card 1 9. Securitiz a tion of Debt 2 0. Corpora te Counseling Probably the greatest important financial service provided by financial institutions is acting as financial intermediaries REFORMS IN INDIAN FINANCIAL SYSTEM Until the beginning of LPG era in ea rly 1990s, the role of the fina ncia l system in India was ma inly constra ined to the purpose of cha nneling resources

45 36 Banking and Financial Services The stock market crash of 1929 and ensuing Great Depression caused the United States government to increase financial market regulation from the surplus to deficit sectors. Wherea s the fina ncial system performed this role convincingly well, its a ctivities ca me to be ma rked by some serious deficiencies over the period. The ba nking sector suffered from la ck of competition, low ca pita l ba se, low productivity and high cost. After the na tiona liz a tion of la rge ba nks in 1969 and 1980, public ownership dominated the ba nking sector. The role of technology wa s negligible a nd the qua lity of service wa s not given ample importa nce. Ba nks a lso did not follow a ppropria te risk ma na gement system a nd the prudentia l sta ndards were pa thetic. All these resulted in poor a sset qua lity a nd low productivity. Among non ba nking fina ncial intermedia ries, development fina nce institutions (DFIs) opera ted in a n over-protected environment. In the insura nce sector, there wa s negligable competition. The mutua l fund industry a lso suffered from la ck of competition a nd wa s dominated for long by one institution, v iz., the Unit Trust of India. Fina ncial ma rkets were cha racteriz ed by control over pricing of financia l a ssets, ba rriers to entry, high tra nsa ction costs a nd restrictions on movement of funds/ pa rticipa nts between the ma rket segments. Aga inst this ba ckground, extensive fina ncial sector reforms in India were introduced in the ea rly 1990s. Fina ncia l sector reforms in India were grounded in the belief that competitive efficiency in the rea l sectors of the economy will not be realiz ed to its full potential unless the financia l sector wa s reformed as well. Thus, the principal objective of financial sector reforms was to improve the efficiency of resources a nd a ccelerate the growth process of the rea l sector by removing structura l deficiencies a ffecting the performa nce of financia l institutions a nd fina ncia l ma rkets. The ma in thrust of reforms in the fina ncia l system wa s on the crea tion of efficient a nd stable fina ncia l institutions a nd ma rkets. The ma in objectives, therefore, of the fina ncial sector reform process in India initia ted in the ea rly 1990s ha ve been to: Remove fina ncia l repression tha t existed ea rlier Crea te an efficient, productive a nd profita ble fina ncia l sector industry; Enable price discovery, pa rticula rly, by the ma rket determina tion of interest ra tes tha t helps in efficient a lloca tion of resources. Provide operationa l a nd function autonomy to institutions; Prepa re the fina ncia l system for increa sing international competition. Open the externa l sector in a ca libra ted fa shion; Promote the maintena nce of fina ncia l sta bility even in the fa ce of domestic a nd externa l uncertinities. The initia tion of fina ncia l reforms in the country during the ea rly 1990s, wa s to a la rge extent conditioned by the a nalysis a nd recommendations of va rious committees/ working groups set up to a ddress specific issues. The process ha s been ma rked by 'gra dua lism' with measures being underta ken a fter extensive consulta tions with experts a nd ma rket pa rticipa nts. From the beginning of fina ncia l reforms, India ha s resolved to a tta in sta nda rds of interna tiona l best pra ctices but to fine tune the process keeping in view the underlying institutional a nd opera tional considera tions. Reform mea sures introduced a cross sectors a s well a s within ea ch sector were pla nned in such a

46 An Overview of Indian Financial System 37 wa y so a s to reinforce each other. Attempts were ma de to simulta neously strengthen for commercial decision ma king a nd ma rket forces in a n increa singly competitive fra mework. At the sa me time, the process did not lose sight of the social responsibilities of the financia l sector. The ma jor reforms ta ken pla ce in some of the ma jor sectors of fina ncial system in the post LPG era is given below. India n (1) New Industrial Policy Under the New Industria l Policy, the industries have been freed to a large extent from the licenses a nd other controls. In order to encoura ge modernisa tion, stress has been la id upon the use of latest technology. A grea t reduction ha s been effected in the role of the public sector. Efforts ha ve been ma de to encoura ge foreign investment. Investment decision by companies ha s been fa cilita ted by ending restrictions imposed by the MRTP Act. Simila rly, Foreign Excha nge Regula tion Act (FERA) ha s been repla ced with Foreign Excha nge Ma na gement Act (FEMA). Some importa nt points of the New Industria l Policy ha ve been highlighted h er e : (a) Abolition of Licensing Before the a dvent of the New Industria l Policy, the India n industries were opera ting under strict licensing system. Now, most industries have been freed from licensing a nd other restrictions. (b) Freedom to Import Technology The use of la test technology ha s been given prominence in the New Industria l Policy. Therefore, foreign technological colla bora tion ha s been a l l owed. (c) Contraction of Public Sector A policy of not expa nding unprofita ble industrial units in the public sector ha s been a dopted. Apa rt from this, the government is following the course of disinvestment in such public sector underta king. This is a medium of pr ivati sation. In 1991, after India faced a balance of payments crisis, it had to pledge 20 tonnes of gold to Union Bank of Switzerland and 47 tonnes to Bank of England as part of a bailout deal with the International Monetary Fund (IMF). (d) Free Entry of Foreign Investment Ma ny steps ha ve been ta ken to a ttract foreign investment. Some of these a re (i) In 1991, 51% of foreign investment in 34 high priority industries wa s a llowed without seeking government permission. (ii) Non-resident India ns (NRIs) were a llowed to invest 100% in the export houses, hospita ls, hotels, etc. (iii) Foreign Investment Promotion Boa rd (FIPB) was esta blished with a view to speedily clea r foreign investment proposals. (e) MRTP Restrictions Removed Monopolies a nd Restrictive Trade Pra ctices Act ha s been done awa y with. Now the companies do not need to seek government permission to issue sha res, extend their a rea of opera tion a nd esta blish a new unit.

47 38 Banking and Financial Services (f) FERA Restrictions Removed Foreign Excha nge Regula tion Act (FERA) ha s been replaced by Foreign Excha nge Ma nagement Act (FEMA). It regula tes the foreign tra nsactions. These transa ctions ha ve now become simpler. (g) Increase in the Importance of Small Industries Efforts ha ve been ma de to give importa nce to the sma ll industries in the economic development of the country. The lesson of every period of financial stress across economies has been that early recognition and resolution of problems gives the economy its best chance of robust recovery. India grows at slower pace than China, which has been liberalising its economy since (2) New Trade Policy Trade policy mea ns the policy through which the foreign tra de is controlled a nd regula ted. As a result of libera lisa tion, trade policy ha s undergone tremendous cha nges. Especia lly the foreign tra de ha s been freed from the unnecessa ry controls. The a ge-old restrictions have been elimina ted a t one go. Some of the chief cha ra cteristics of the New Tra de Policy a re a s follows: (a) Reduction in Restrictions of Export-Import Restrictions on the exports-imports ha ve a lmost disa ppea red lea ving only a few items. (b) Reduction in Export-Import Tax Export-import ta x on some items has been completely a bolished a nd on some other items it ha s been reduced to the minimum level. (c) Easy Procedure of Export-Import Import-export procedure ha s been simplified. (d) Full Convertibility on Current Account In , full convertibility beca me a pplica ble on current a ccount. In short, full convertibility mea ns unrestricted sa le a nd purcha se of foreign excha nge in the foreign excha nge market for the purpose of pa yments a nd receipts on the items connected with current a ccount. It means tha t there is no government restriction on the sa le a nd purcha se of foreign exchange connected with current a ccount. On the other ha nd, sa le a nd purcha se of foreign exchange connected with ca pita l account ca n be carried on under the rates determined by the Reserve Bank of India (RBI), (e) Providing Incentive for Export Ma ny incentives ha ve been a llowed to Export- oriented Units (EOU) a nd Export Processing Zones (EPZ) for increa sing export trade. (f ) Market-determined Exchange Rate Regime Evolution of excha nge ra te regime from a single currency fixed-exchange rate system to fixing the va lue of rupee a ga inst a basket of currencies a nd further to ma rket-determined floating excha nge ra te regime.

48 An Overview of Indian Financial System 39 (3) Fiscal Reforms The policy of the government connected with the income and expenditure is ca lled fisca l policy. The grea test problem confronting the India n government is excessive fiscal deficit. In , the fisca l deficit wa s 8% of the GDP. In order to ha ndle the problem of fisca l deficit, ba sic cha nges were made in the ta x system. The following a re the ma jor steps ta ken in this direction: (a) (b) (c) The ra te of the individua l a nd corpora te ta x ha s been reduced in order to bring more people in the ta x net. Ta x procedure ha s been simplified. Heavy reduction in the import duties has been implemented. (4) Monetary Reforms Moneta ry policy is a sort of control policy through which the centra l ba nk controls the supply of money with a view to a chieving the objectives of the general economic policy. Reforms in this policy a re ca lled moneta ry reforms. The major points with rega rd to the moneta ry reforms a re given below: (a) (b) (c) (d) (e) Statutory Liquidity Ra tio (SLR) ha s been lowered. The ba nks ha ve been a llowed freedom to decide the ra te of interest on the a mount deposited. New sta nda rds ha ve been la id down for the income recognition for the b a n k s. Permission to collect money by issuing shares in the ca pita l ma rket ha s been gra nted to na tiona lised ba nks. Permission to open ba nks in the priva te sector ha s a lso been gra nted. The fruits of liberalisation reached their peak in 2007, when India recorded its highest GDP growth rate of 9% (5) Capital Market Reforms Ca pita l ma rket is the pivot of the economy of a country. The government ha s ta ken the following steps for the development of this ma rket: (a) (b) (c) (d) (e) (f) Under the Portfolio Investment Scheme, the limit for investment by the NRIs a nd foreign compa nies in the sha res a nd debentures of the India n compa nies ha s been ra ised. In order to control the ca pita l ma rket, the Securities a nd Exchange Board of India (SEBI) has been established. The restriction in respect of interest on debentures has been lifted. Now, it is decided on the ba sis of demand a nd supply. The office of the Controller of Capita l Issue which used to determine the price of sha res to be issued ha s been dispensed with. Now, the compa nies a re free to determine the price of the sha res. Priva te sector ha s been permitted to esta blish Mutua l Fund. The registra tion of the subbroker ha s been made manda tory.

49 40 Banking and Financial Services (6) Dismantling Price Control The government ha s ta ken steps to remove price control in ca se of ma ny products. (Price Control mea ns that the companies will sell goods a t the prices determined by the government.) The efforts to remove price control were mostly in respect of fertiliz ers, steel a nd iron and petro products. Restrictions on the import of these products ha ve a lso been removed. Simila rly Ca sh Compensa tory Support (CCS) which wa s ea rlier given as export subsidy ha s been stopped. REVIEW QUESTIONS 1. Define fina ncia l system. W ha t a re its functions. 2. Briefly expla in a bout the constituents of fina ncia l system. 3. Differentia te between prima ry and seconda ry ma rket. 4. W hat a re the functions of seconda ry ma rket? 5. Briefly expla in a bout the money ma rket instruments. 6. Expla in the role of financia l institutions. 7. W hat a re the problems associa ted with fina ncia l services? 8. Briefly expla in the reforms in Indian fina ncial system. REFERENCES Ba nsa l, L. K., Me rc hant Banking and Financial Se rv ice s, Unista r Books Pvt. Ltd., Cha ndigarh. Bhatia, B. S., a nd Ba tra, G. S., Financ ial Serv ice s, Deep & Deep Publishers, New Delhi. Fina ncial Sector Legisla tive Reform Commission, Vol. 1 p. xxiv. India. Ministry of Fina nce, Ec onomic Surve y RBI, W orking Pa per on Fina ncia l Structure a nd Economic Development in India; An Empirical Evolution by S. Sa hoo, February RBI, speech on Regula tion for Financia l Consumer Protection, by Shri K. C. Chakra ba rty, da ted Redistributing Regula tory Power ; Fina ncia l Sector Legisla tive Reform Commission by C. P. Cha drasekha r, Ec onomic and Politic al We e kly, da ted SEBI Bulletins ( Various issues). Va rma, J. ( 2002): \The India n financia l sector a fter a deca de of reforms," Discussion pa per, Centre for Civil Society.

50 CHAPTER 2 CENTRAL BANKING Learning Objectives After reading this cha pter you should be able to understa nd the need for regulation and types of regulation the brief history of centra l banking the objectives of RBI the organizational structure of RBI the functioning of RBI

51 42 Banking and Financial Services THE NEED FOR REGULATIONS The basic objective of bank supervision is to ensure that banks are financially sound, well managed and that they do not pose a threat to the interest of their depositors. Regula tory institutions protect the interest of investors in fina ncial ma rket a nd promote overa ll development of financia l system in the country. Ea ch country ha s its regula tory mecha nism in place to regula te their financia l system. The need for regula tion in fina ncia l system in the economy arises because of the following rea sons. (1) Ec onomic gr owth : Adequa te and proper regulatory fra mework sha ll be put in pla ce for the process of smooth fina ncia l growth in the country. This is an essentia l requisite for the economy to grow a nd function smoothly. Unless a proper regula tory mecha nism is in pla ce the economic growth will be dera iled. (2) Pr omoting savings and inve stme nts in the countr y : The fina ncia l services industry, besides putting sa vings into investments, helps economic a ctivities to ta ke pla ce without much difficulty. (3) Pr ovision of e ffic ie nt financ ial ser vice s: The efficiency with which the va rious institutions in fina ncia l ma rket render services, such a s ba nkers, credit ca rd compa nies, insura nce compa nies, stockbrokers depends upon functioning of the regula tory fra mework (4) Inve stor pr ote c tion: Regula tions of ma ny types a re required to be put in pla ce for sa fegua rding a nd sustaining the interest of the investors, especia lly the sma ll a nd individua l investors, a nd thus ensuring economic sta bility. Regula tions ensure tha t every requirement of tra ding in fina ncia l services is strictly done with by the pa rties concerned with providing financia l services. TYPES OF REGULATORY FRAMEWORK A broa d cla ssification of the regula tory framework rela ting to fina ncia l services sector in India is a s follows: (1) Institutional regula tions (2) Investor regula tions (3) Interna l regula tions (4) S elf- r egul a t i ons (5) Legisla tive regula tions 1. Institutional r egulations: Institutiona l regula tions, a lso known a s structura l regula tions, a re those tha t flow from a host of regula tory institutions set up in a financia l ma rket by the government. The objective of these regula tions is to promote healthy development of fina ncial system in the country. The most importa nt a mong these is the constitution of the a gencies like SEBI a nd RBI. The Securities a nd Excha nge Boa rd of India (SEBI) the a gency ma inta in orderliness in ca pita l ma rket by controling mercha nt ba nkers and stockbrokers. The Reserve Ba nk of India (RBI), another structural entity, prescribes the a ctivities that commercia l banks could provide to the investors.

52 Central Banking Inve stor r egulations: Regula tions tha t a re designed to protect the interests of the sma ll and individua l investors, a re called investor regula tions. The ba sic objective of these regula tions is to ma inta in the confidence of investors. In this connection, the role of SEBI is va luable a s it comes out with periodic guidelines on investor protection. 3. Inte r nal r egulations: Regula tions rela ting to the interna l ma na gement of fina ncia l institutions a nd other fina ncia l service organiz a tions rega rding va rious aspects like fund ma nagement ca pita l adequacy, liquidity a nd solvency ma y be ca lled a s interna l/ prudentia l regula tions. RBI ha s come out with regula tions rela ting to the nonba nking fina nce compa nies in ra ising public deposits. Simila rly, SEBI is giving regula tions rela ting to mutua l funds, lead ma na gers etc 4. Self-re gulations: In a ddition to the regulations orda ined by the regula tory, institutions, legisla tions etc there a re self-imposed regula tions. For insta nce, the lea d ma na gers, stockbrokers, foreign excha nge dea lers ha ve their own self-regula tion, besides being governed by legisla tive guidelines. Similarly, the mercha nt ba nkers a ssocia tion in a ddition to SEBI regula tion ha s developed self-regula tion that governs their members. 5. Le gislative r e gulations: These regulations a re the legisla tive mea sures brought out by the government or government a gencies from time to time keeping in mind the need for a ll-round development of the fina ncial services industry in the country. Some of the importa nt regula tions include the Ba nking Regula tion Act, Securities Contracts (Regula tion) Act, etc, NEED FOR CENTRAL BANKING A central ba nk, reserve ba nk, or monetary a uthority is the term used to describe the a uthority responsible for policies tha t a ffect a country s supply of money a nd credit. More specifica lly, a centra l bank uses its tools of moneta ry policy open market operations, discount window lending, cha nges in reserve requirements to a ffect short- term interest ra tes a nd the moneta ry ba se (currency held by the public plus ba nk reserves) a nd to achieve importa nt policy goals. It is a n institution tha t ma nages a country s currency, money supply, a nd interest ra tes. Centra l ba nks a lso usua lly oversee the commercia l ba nking system of their respective countries. In contra st to a commercia l bank, a centra l ba nk possesses a monopoly on increa sing the amount of money in the na tion, a nd usually a lso prints the na tiona l currency, which usua lly serves a s the na tion s legal tender. Exa mples include the Europea n Central Ba nk (ECB), Reserve Ba nk of India a nd the Federal Reserve of the United Sta tes. The primary function of a central bank is to manage the nation s money supply (monetary policy), through active duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or The Preamble of the Reserve Bank of India Act, 1934 says The basic functions of the Reserve Bank of India are to regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.

53 44 Banking and Financial Services The RBI has, over the years transformed itself continuously, functionally and structurally in response to the changing needs of the economy and Government policies. fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political interference. Still, limited control by the executive and legislative bodies usually exists. The chief executive of a central bank is normally known as the Governor, President or Chairman. The story of central ba nking goes ba ck at least to the seventeenth century, to the founding of the first institution recogniz ed a s a central ba nk, the Swedish Riksba nk. Esta blished in 1668, a s a joint stock ba nk, it wa s cha rtered to lend the government funds a nd to a ct as a clearing house for commerce. A few deca des la ter (1694), the most fa mous centra l ba nk of the era, the Ba nk of Engla nd, wa s founded a lso a s a joint stock compa ny to purcha se government debt. Other centra l ba nks were set up la ter in Europe for simila r purposes, though some were esta blished to dea l with moneta ry disa rra y. For example, the Ba nque de France wa s esta blished by Na poleon in 1800, to stabilize the currency after the hyperinfla tion of pa per money during the French Revolution, a s well as to a id in government finance. Ea rly centra l ba nks issued priva te notes which served a s currency, and they often ha d a monopoly over such note issue. W hile these early centra l ba nks helped fund the government s debt, they were a lso priva te entities tha t enga ged in ba nking activities. Because they held the deposits of other ba nks, they came to serve a s ba nks for bankers, fa cilita ting transa ctions between ba nks or providing other ba nking services. They beca me the repository for most ba nks in the ba nking system beca use of their large reserves a nd extensive networks of correspondent ba nks. These factors a llowed them to become the lender of la st resort in the face of a fina ncia l crisis. In other words, they beca me willing to provide emergency ca sh to their correspondents in times of fina ncia l distress. The Federa l Reserve System belongs to a la ter wa ve of central ba nks, which emerged a t the turn of the twentieth century. These ba nks were created prima rily to consolida te the va rious instruments tha t people were using for currency a nd to provide financia l sta bility. Ma ny a lso were created to ma na ge the gold sta nda rd, to which most countries a dhered. Centra l banks were esta blished in ma ny Europea n countries during the 19th century. The W a r of the Second Coa lition led to the crea tion of the Ba nque de Fra nce in 1800, in a n effort to improve the public fina ncing of the wa r. Although centra l banks toda y a re genera lly a ssocia ted with fia t money, the 19th a nd ea rly 20th centuries centra l ba nks in most of Europe a nd J a pa n developed under the interna tiona l gold sta nda rd, elsewhere free ba nking or currency boards were more usua l a t this time. Problems with colla pses of ba nks during downturns, however, lea d to wider support for centra l banks in those nations which did not a s yet possess them, most nota bly in Austra lia. The US Federa l Reserve wa s crea ted by the U. S. Congress through the pa ssing of The Federa l Reserve Act in the Senate, December 23, Austra lia esta blished its first centra l ba nk in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New Zeala nd in the a fterma th of the Grea t Depression in By 1935, the only significa nt independent na tion that did not possess a central ba nk wa s Bra zil, which subsequently developed a precursor thereto in 1945 a nd the present centra l ba nk twenty yea rs la ter. Ha ving ga ined independence, Africa n and Asia n countries a lso esta blished centra l banks or moneta ry unions.

54 Central Banking 45 Activities of Central Banks The ba sic a ctivities of centra l ba nks remains more or less the sa me throughout the world, which includes implementing moneta ry policies. determining interest ra tes. controlling the nation s entire money supply. a cting as the Government s ba nker a nd the ba nkers bank. managing the country s foreign exchange and gold reserves. regula ting a nd supervising the commercia l ba nking a ctivities. controlling the interest ra te and infla tion. Country Name Aus t r a l i a Au s t r i a Bra zil B e l g i u m C a n a d a C u b a List of Central Banks of Different Countries of the World Name of the Central Bank Reserve Bank of Australia Osterreichische National Bank Banco Central do Brasil Nationale Bank van Belgie Bank of Canada Banco de Cuba Europea n Union Europea n Centra l Ba nk F i n l a n d F r a n c e Bank of Finland Banque de France G e r m a n y Deutsche Bundesbank G r e e c e Bank of Greece I c e l a n d Seolabanki Islands I n d i a I r e l a n d Isr a el Ita ly J a p a n Latvia L u x e mb ou r g M alaysi a M ex i co Reserve Bank of India Central Bank of Ireland Bank of Israel Banca d Italia Bank of Japan Latvijas Banka Banque Centrale du Luxembourg Bank Negara Malaysia Banco de Mexico The Netherla nds De Nederla ndsche Ba nk New Zea la nd Nor way OE CS Reserve Ba nk of New Zea la nd Norges Bank Ea stern Ca ribbea n Centra l Ba nk

55 46 Banking and Financial Services People s Republic of China People s Ba nk of China P h i l i pp i n es Central Bank of the Philippines P o l a n d Narodowy Bank Polski P o r t ug a l Banco de Portugal Republic of China The Centra l Ba nk of China R u s s i a Central Bank of the Russian Federation S i n g a po r e Monetary Authority of Singapore South Africa South Africa n Reserve Ba nk South Korea Ba nk of Korea S p a i n Banco de Espana S w e d e n Sveriges Riksbank T h a i l a n d Bank of Thailand T u r k e y Turkiye Cumhuriyeti Merkez Ba nka si United Kingdom Ba nk of Engla nd USA Federa l Reserve System Vatican City Vatican Bank RESERVE BANK OF INDIA A clear objective of the development role of the RBI was to raise the savings ratio to enable the higher investment necessary for growth, in the absence of efficient financial intermediation and of a well developed capital market. Though the need for a centra l ba nk in India wa s felt in nineteenth century, its importa nce a ctua lly ga ined essence in the beginning of the 20th century. A ma jor event in the evolution of central ba nking in India was the a ma lga ma tion of the three presidency Ba nks of Bomba y, Benga l and Madra s in This new ba nk wa s ca lled Imperia l Ba nk of India, Which functioned not only as a commercia l bank, but a lso a s a centra l ba nk. Its functions were sepa rated from the Imperia l Ba nk of India. Even when the Imperial Ba nk of India functioned a s a central ba nk, the monopoly of note issue wa s with the government. In 1925, Hilton Young Commission recommended for the esta blishment of a centra l ba nk of India. In complia nce with the recommenda tion the Reserve Ba nk of India Bill wa s introduced in the Legislative Assembly in The bill wa s aba ndoned in 1931 on a ccount of disa greement between the government a nd the Assembly. But the Act was pa ssed in The Reserve Bank of India wa s formally inaugurated in April Need for a Central Bank in India Before the esta blishment of the Reserve Ba nk, the currency a nd credit system of the country wa s opera ted by two different authorities, na mely, the government a nd the Imperia l Bank of India. Since the Imperia l Ba nk of India wa s not performing this function effectively, the government felt the need for a sepa ra te centra l ba nk. A centra l ba nk ha s the power to secure moneta ry sta bility beca use it ha s the right to issue currency notes a nd it ha s the a uthority to a dopt a credit policy which is best suited to the country. The Reserve Ba nk of India (RBI) was established with a view to secure monetary sta bility by mea ns of functioning as the other commercia l banks. The structura l instability of the ba nking system wa s na med with the esta blishment of the RBI.

56 Central Banking 47 The Reserve Bank of India started functioning a s a sha reholder s ba nk with a pa id up ca pita l of ` 5 crore, divided into 5 la kh sha res of `100 ea ch. The issue wa s oversubscribed by 100%. Though the Act provided for the setting up of a n independent Centra l Ba nk of Directors, the British rulers domina ted in a ll policy ma tters. After Independence, the Reserve Bank wa s na tiona lised with a view to secure moneta ry co-opera tion between the ba nk a nd the government. The government na tiona lised the ba nk by mea ns of pa ssing a n Act in It began to function a s a government owned centra l ba nk from The priva te sha reholders were given a compensa tion a t the ra te of ` 118 per sha re of 100. The na tiona lisa tion of Reserve Ba nk of India (RBI) wa s done with a view to follow interna tiona l a ttitude towa rds sta te ownership of central ba nks. Even before nationalisa tion, the Reserve Ba nk wa s functioning virtua lly as a government depa rtment. Na tiona lisa tion of a centra l bank in a developing country like India wa s felt necessa ry in view of the tremendous responsibilities that the government wa s ta king for the development of a na tion. Even though it ha s been na tiona lized, it is reta ining all independence in orga niz ation a nd chara cter a nd there is no direct interference by the government in day-to-da y a ffa irs of the bank. Origin of the Reserve Bank of India 1926: The Roya l Commission on India n Currency a nd Finance recommended crea tion of a centra l ba nk for India. 1927: A Bill to give effect to the a bove recommendation was introduced in the Legislative Assembly, but wa s la ter withdra wn due to la ck of a greement a mong va rious sections of people. 1933: The W hite Pa per on Indian Constitutiona l Reforms recommended the crea tion of a Reserve Ba nk. A fresh Bill wa s introduced in the Legislative Assembly. 1934: The Bill wa s pa ssed a nd received the Governor Genera l s a ssent 1935: The Reserve Ba nk commenced opera tions a s India s centra l ba nk on April 1, a s a priva te sha reholders bank with a pa id up ca pita l of rupees five crore (rupees fifty million). 1942: The Reserve Ba nk cea sed to be the currency issuing a uthority of Burma (now Mya nmar). 1947: The Reserve Ba nk stopped a cting a s ba nker to the Government of Burma. 1948: The Reserve Ba nk stopped rendering centra l banking services to Pa kista n. 1949: The Government of India na tiona lised the Reserve Ba nk under the Reserve Ba nk (Tra nsfer of Public Ownership) Act, Issue of bank notes in British India was the most important function of the Reserve Bank in the beginning. Accounting of currency chest money constituted a major part of the daily routine business of the Reserve Bank, employing about a third of the Bank s personnel. Objectives of the RBI The RBI functions within the fra mework of a mixed economic system a vaila ble in India. W ith regard to fra ming various policies, it is necessa ry to

57 48 Banking and Financial Services Evolution of central banking is essentially a twentieth century phenomenon as there were only about a dozen central banks in the world at the turn of the twentieth century. In contrast, at present, there are nearly 180 central banks. ma inta in close a nd continuous colla boration a nd rela tion between the government a nd the RBI. In the event of a difference of opinion or conflict, the government view or position ca n a lwa ys be expected to prevail. The Preamble of the RBI Act, 1934 sta tes that W herea s it is expedient to constitute a Reserve Ba nk for India to regulate the issue of ba nk notes a nd the keeping of reserves with a view to securing moneta ry sta bility in (India) a nd genera lly to operate the currency a nd credit system of the country to its a dva n t a ge To ela bora te, the ma in objectives of RBI a re (1) to ma inta in moneta ry stability in the country so tha t the business a nd economic a ctivities ca n be undertaken in mixed economic set up. (2) to ma inta in fina ncia l sta bility a nd ensure that fina ncial institutions ca n conduct their business with confidence. (3) to ma intain sta ble pa yments system in the economy so tha t fina ncia l transa ctions ca n be sa fely a nd efficiently executed. (4) to promote the development of fina ncia l infra structure of fina ncia l ma rkets and fina ncia l systems, a nd to enable if it opera te efficiently. (5) to ensure tha t credit a lloca tion by the fina ncia l institutions broadly reflects the na tional economic priorities a nd societal obliga tions. (6) to regula te the overa ll volume of money a nd credit in the economy with a view to ensure a rea sona ble degree of price sta bility. Umbr ella Ac ts Legal Framework of RBI Re se rv e Bank of India Act, 1934: Governs the Reserve Ba nk functions Bank ing Re gulation Ac t, 1949: Governs the fina ncia l sector Acts Gove r ning Spe cific Func tions Public Debt Act, 1944/ Government Securities Act ( Proposed): Governs government debt ma rket Securities Contra ct (Regula tion) Act, 1956: Regulates government securities ma rket India n Coina ge Act, 1906:Governs currency a nd coins Fore ign Exc hange Regulation Act, 1973/Fore ign Ex change Manage ment Ac t, 1999: Governs tra de a nd foreign excha nge ma rket Pay ment and Settle ment Sy ste ms Ac t, 2007: Provides for regula tion a nd supervision of pa yment systems in India Acts gove r ning B anking Ope r ations Companies Ac t, 1956: Governs ba nks a s compa nies Bank ing Companie s (Ac quisition and Transfe r of Undertak ings) Ac t, 1970/ 1980: Rela tes to na tiona lisa tion of banks

58 Central Banking 49 Ba nkers Books Evidence Act Ba nking Secrecy Act Negotia ble Instruments Act, 1881 Acts gove r ning Individual Institutions State Ba nk of India Act, 1954 The Industrial Development Bank (Tra nsfer of Underta king a nd Repea l) Act, 2003 The Industrial Finance Corpora tion (Transfer of Undertaking a nd Repea l) Act, 1993 Na tiona l Ba nk for Agriculture a nd Rura l Development Act Na tiona l Housing Ba nk Act Deposit Insurance and Credit Gua ra ntee Corporation Act STRUCTURE, ORGANIZATION AND GOVERNANCE OF RBI The Reserve Ba nk is wholly owned by the Government of India. The centra l board of directors oversees the Reserve Ba nk s business. Ma na gementaccording to the Reserve Ba nk of India Act, the ma na gement is vested with the Boa rd of Directors. The centra l boa rd consists of (a) one Governor a nd four Deputy Governors a ppointed by Central Government, (b) four directors nomina ted by the Centra l Government, one ea ch from the four loca l boa rds, (c) six directors nomina ted by the Central government, one Government Officer nomina ted by the Centra l Government. The Governor is the Cha irma n of the Boa rd of Directors a nd the chief executive of the bank. He is a ssisted by four deputy governors who in turn executed certa in specific opera tions. The Governor and the Deputy Governors a re a ppointed by the government for a period of 5 yea rs. They a re full time officers of the ba nk. The six directors nominated by the government of India hold the office for a period of four years. The Centra l Boa rd ha s prima ry a uthority for the oversight of the Reserve Ba nk. It delega tes specific functions through its committees a nd boards such a s. Committe e of Ce ntr al B oar d: Oversees the current business of the centra l ba nk a nd typica lly meets every week. The agenda focusses on current opera tions, including approva l of the weekly sta tement of accounts rela ted to the Issue a nd Ba nking Depa rtments. B oard for Financ ial Super vision: Regula tes a nd supervises commercia l ba nks, Non Ba nking Fina nce Compa nies (NBFCs), development finance institutions, urba n co-opera tive banks and prima ry dea lers. B oar d for Payme nt and Se ttle me nt Syste ms: Regula tes a nd supervises the pa yment a nd settlement systems. Subc ommitte es of the Ce ntr al Boar d: Includes those on Inspection a nd Audit; Sta ff a nd Building. Focus of each subcommittee is on specific a rea s of oper a t i ons. The total staff strength as on June 30, 2013 was 17,449 compared with 18,132 a year ago.

59 50 Banking and Financial Services Local Boar ds: In Chennai, Kolka ta, Mumba i a nd New Delhi, representing the country s four regions. Loca l boa rd members, a ppointed by the Centra l Government for four-year terms, represent regional a nd economic interests a nd the interests of co-operative and indigenous ba nks. Logo of RBI Dr. C.D. Deshmukh was the first Indian Governor of the Reserve Bank of India Organizational Structure of RBI Composition of RBI De par tme nts: These focus on policy issues in the Reserve Bank s functiona l a rea s and internal opera tions. 26 Re gional Office s and B r anc he s: These a re the Reserve Bank s opera tiona l arms and customer interfaces, hea ded by Regiona l Directors. Sma ller bra nches/ sub- offices a re hea ded by a Genera l Ma na ger/ Deputy General Ma nager.

60 Central Banking 51 Training c e ntr es: The Reserve Ba nk Staff College a t Chenna i a ddresses the tra ining needs of RBI officers; the College of Agricultural Ba nking a t Pune tra ins sta ff of co-opera tive a nd commercia l ba nks, including regiona l rura l ba nks. The Zona l Tra ining Centres, loca ted a t regiona l offices, tra in non-executive staff. Re se ar ch institute s: RBI-funded institutions to a dva nce tra ining a nd resea rch on banking issues, economic growth a nd ba nking technology, suchv a s, Nationa l Institute of Ba nk Ma na gement (NIBM) a t Pune, Indira Ga ndhi Institute of Development Resea rch (IGIDR) at Mumba i, a nd Institute for Development a nd Resea rch in Ba nking Technology (IDRBT) a t Hyderaba d. Subsidiar ie s: Fully-owned subsidia ries include Na tiona l Housing Ba nk (NHB), Deposit Insura nce a nd Credit Gua rantee Corpora tion (DICGC), Bhara tiya Reserve Ba nk Note Mudra n Private Limited (BRBNMPL). The Reserve Ba nk a lso ha s a ma jority sta ke in the Na tiona l Ba nk for Agriculture a nd Rura l Development (NABARD). Name s of the Dir ec tor s of the Ce ntr al Boar d of the Reser ve Bank of India Dr. Ra ghura m Raja n (Governor ) Shri H. R. Khan ( Deputy Governor) Dr. Urjit R. Patel (Deputy Governor) Shri R. Ga ndhi (Deputy Governor) Dr. Anil Ka kodka r Shri Kira n Ka rnik Prof M.V. Rajeev Gowda Dr Na chiket M. Mor Shri Y. H. Ma lega m Prof. Dipa nka r Gupta Shri G. M. Rao Ms Ela Bha tt Dr. Indira Ra ja rama n Shri Y. C. Deveshwa r Prof Da moda r Acharya Shri Arvind Ma ya ra m Shri Gurdia l Singh Sa ndhu Prior to the formation of the Reserve Bank, the Imperial Bank (established in 1921) functioned to some extent as a bankers bank. The Various Departments of RBI Moneta ry Policy Depa rtment Fina ncia l Ma rkets Depa rtment Interna l Debt Ma na gement Depa rtment Depa rtment of Externa l Investments a nd Opera tions Depa rtment of Ba nking Opera tions and Development

61 52 Banking and Financial Services Depa rtment of Ba nking Supervision Depa rtment of Non Ba nking Supervision Urba n Banks Depa rtment Depa rtment of Economic Ana lysis a nd Policy Depa rtment of Sta tistics a nd Informa tion Ma na gement Depa rtment of Government Ba nk Accounts Depa rtment of Currency Ma na gement Depa rtment of Pa yment a nd Settlement System Customer Service Depa rtment Depa rtment of Administration a nd Personnel Mana gement Huma n Resources Development Depa rtment Depa rtment of Communica tion Depa rtment of Expenditure a nd Budgeta ry Control Depa rtment of Informa tion Technology Premises Depa rtment Secreta ry s Depa rtment Ra jbha sha Depa rtment Lega l Depa rtment Inspection Depa rtment : Operations bagan Major Milestones in the History of RBI : Na tiona lisa tion of the Reserve Ba nk; Ba nking Regula tion Act ena cted 1950: India emba rks on pla nned economic development. The Reserve Ba nk becomes a ctive a gent andpa rticipa nt : Coopera tive banks come under RBI regula tion : Na tiona lisa tion of 14 major commercia l ba nks (six more were na tiona lised in 1980) : RBI strengthens excha nge controls by a mending Foreign Exchange Regula tion Act (FERA) : Introduction of priority sector lending ta rgets : Regional Rural Banks set up : Fina ncial ma rket reforms begin with Sukha moy Cha kra va rty a nd Va ghul Committee Reports : India faces ba la nce of pa yment crisis; pledges gold to shore up reserves. Rupee devalued : Excha nge ra te becomes ma rket determined : Board for Financia l Supervision set up

62 Central Banking : Ad hoc trea sury bills pha sed out ending a utoma tic monetiz a tion : Regula tion of Non-Ba nking Fina nce Compa nies strengthened : Multiple indica tor a pproach for moneta ry policy a dopted : Foreign Exchange Ma na gement Act replaces FERA : Clea ring Corpora tion of India Limited (CCIL) commences clea ring a nd settlement in government Securities : Fisca l Responsibility a nd Budget Ma na gement Act ena cted : Transition to a full-fledged da ily liquidity adjustment fa cility (LAF) completed. Market Sta bilisa tion Scheme (MSS) introduced to sterilise ca pita l flows : Real Time Gross Settlement system commences : Focus on financia l inclusion a nd increasing the outrea ch of the ba nking sector : RBI empowered to regulate money, forex, G-sec a nd gold-related securities ma rket : RBI empowered to regula te Pa yment System 2008/ 09: Proa ctive efforts to minimiz e impa ct of globa l fina ncia l crisis : Year-long Pla tinum J ubilee Celebra tions : Positioning RBI a s a knowledge institution FUNCTIONS OF THE RESERVE BANK OF INDIA The Preamble to the Reserve Ba nk of India Act, 1934 (the Act), under which it wa s constituted, specifies its objective a s to regula te the issue of Ba nk notes a nd the keeping of reserves with a view to securing moneta ry sta bility in India a nd genera lly to opera te the currency a nd credit system of the country to its a dva nta ge. A core function of the Reserve Ba nk in the la st 79 yea rs ha s been the formula tion a nd implementa tion of moneta ry policy with the objectives of ma inta ining price sta bility and ensuring a dequa te flow of credit to productive sectors of the economy. To these wa s added, in more recent times, the goa l of ma inta ining fina ncia l sta bility. The objective of ma inta ining fina ncia l sta bility ha s spa nned its role from externa l a ccount mana gement to oversight of banks a nd non ba nking fina ncial institutions a s a lso of money, government securities a nd foreign excha nge ma rkets. The Reserve Bank designs a nd implements the regula tory policy fra mework for ba nking and non ba nking fina ncia l institutions with the a im of providing people access to the ba nking system, protecting depositors interest, a nd ma inta ining the overa ll hea lth of the fina ncial system. Its function of regula ting the commercia l ba nking sector, which emerged with the ena ctment of the Ba nking Regula tion Act, 1949, ha s over time, expanded to cover other entities. Thus, a mendments to the Ba nking Regula tion Act, 1949 brought coopera tive ba nks a nd regiona l rura l ba nks under the Reserve Bank s jurisdiction, while a mendments to the Reserve Ba nk of India Act sa w development finance institutions, non ba nking fina ncia l compa nies a nd prima ry dea lers coming under its regula tion, as these entities beca me importa nt pla yers in the fina ncia l system a nd ma rkets. In December 1999, the Reserve Bank, in consultation with the Government of India, had also appointed a Standing Committee on International Financial Standards and Codes to identify and monitor developments in global standards and codes, to consider all aspects of applicability of these standards and codes to Indian financial system, and to periodically review the status.

63 54 Banking and Financial Services The development of a payments system is one development role that is common to most central banks. It is well recognized that an efficient payment and settlement system is essential for a well functioning modern financial system. Similarly, the global economic uncertainties during and after the Second World W ar warra nted conservation of scarce foreign excha nge reserves by sovereign intervention a nd allocation. Initially, the Reserve Bank carried out the regula tion of foreign exchange tra nsa ctions under the Defence of India Rules, 1939 and later, under the Foreign Excha nge Regula tion Act of Over the years, as the economy ma tured, the role shifted from foreign exchange regulation to foreign excha nge mana gement. Post-independence, a s the emerging nation tried to meet the aspirations of a large and diversified populace, the Reserve Bank, with its experience a nd expertise, wa s entrusted with a variety of developmental roles, particularly in the field of credit delivery. With the onset of economic planning in , the Reserve Bank undertook a variety of developmental functions to encourage savings a nd ca pital forma tion and widen a nd deepen the agricultural and industrial credit set-up. Institution building was a significa nt aspect of its role in the sixties a nd the seventies. The strategy for nearly four decades placed emphasis on the sta te-induced or sta te-supported developmental efforts. Subsequently, the role of the fina ncial sector a nd financia l markets was also given an explicit recognition in the development stra tegy. The a ftermath of the 1991 bala nce of payments and foreign excha nge crisis sa w a para digm shift in India s economic and financia l policies. The a pproa ch under the reform era included a thrust towa rds libera lisation, privatisa tion, globa lisation and concerted efforts at strengthening the existing and emerging institutions and ma rket participants. The Reserve Ba nk adopted international best practices in areas, such as, prudentia l regulation, banking technology, va riety of monetary policy instruments, external sector ma nagement and currency ma nagement to make the new policy fra mework effective. The ra pid pace of growth achieved by the financia l system in the deregulated regime necessita ted a deepening and widening of a ccess to ba nking services. The new millennium has seen the Reserve Bank play an a ctive role in balancing the relationship between ba nks a nd customers; focusing on fina ncial inclusion; setting up a dministrative ma chinery to ha ndle customer grievances; pursuing clean note policy a nd ensuring development and oversight of secure a nd robust payment a nd settlement systems. The last one-and-a-half decades ha ve also seen growing integra tion of the national economy and financial system with the globalising world. W hile rising global integra tion has its a dvantages in terms of expanding the scope a nd scale of growth of the Indian economy, it a lso exposes India to global shocks. Hence, mainta ining fina ncial sta bility became an importa nt ma nda te for the Reserve Ba nk. This, in turn, has brought forth the need for effective coordination and consultation with other regulators within the country a nd abroa d. The Reserve Bank of India discha rges a ll the functions of centra l ba nk. The ma in function of the Reserve Ba nk is to ma intain a nd regula te moneta ry mecha nism by mea ns of controlling the currency a nd credit systems in India. The ba nk enjoys complete monopoly of note issues. Under the Ba nking Regula tion Act of 1949, it regulates the uses of credit. It exercises all the weapons of credit control. It functions a s the banker to the government of India and India n states. It is a lso the banker to scheduled commercial ba nks. It ma inta ins sta bility in the externa l va lue of currency. It also has underta ken the responsibility of providing fina ncial a ssista nce to economic development a nd publishes va rious ma tters connecting on the economy.

64 Central Banking 55 The important func tions of RB I ar e as follows. 1. Currency Issue 2. Banker to Government 3. B anke r s Bank and Lender of the last Resor t 4. Mone tary Policy (Controlle r of c re dit) 5. Re gulating and Str e ngthe ning the B anking Syste m 6. Management of Foreign Exchange 7. De ve lopmental Func tions (1) Currency Issue The Reserve Ba nk of India enjoys the sole right of issue of ba nk notes of a ll denominations except one rupee note a nd coins. One rupee notes a re issued by the Reserve Ba nk on beha lf of the Government of India. Notes issued by Reserve of India a re ca lled ba nk notes, while the one rupee notes issued by the Government of India a re ca lled currency notes. The Depa rtment issues ba nk notes to the ba nking depa rtment or a ny other person in excha nge of bullion or securities a s permitted in the Act. The a ctua l issue of currency to the public a nd its withdra wa l from circula tion ta kes place through ba nking depa rtment. The issue depa rtment issues ba nk notes a ga inst the a ssets like gold coin a nd bullion, foreign securities a nd Government of India rupee securities. These a re the assets of the issue depa rtment. The liabilities of this depa rtment consists of ba nk notes issued by it. Coins and Note s in c ir c ulation (Recently 25 paise coins are withdrawn from circulation) The Reserve Bank is the sole authority for issuing banknotes in India under Section 22 of the Reserve Bank of India Act, 1934.

65 56 Banking and Financial Services Total Bank notes in circulation at the end of March 2013 was ` 11,648 billion (73,517 million pieces) The Reserve Bank is the nation s sole note issuing authority. Along with the Government of India, RBI are responsible for the design and production and overall management of the nation s currency, with the goal of ensuring an adequate supply of clean and genuine notes. The Reserve Bank also makes sure there is an adequate supply of coins, produced by the government. In consultation with the government, RBI routinely address security issues and target ways to enhance security features to reduce the risk of counterfeiting or forgery. To commence with, the issue depa rtment sta rted with proportiona l reserve system of note issue. Accordingly, the issue depa rtment ha d to cover 40% of the tota l note issue in the form of gold a nd foreign securities. There wa s a nother condition, namely tha t the va lue of the gold coin a nd bullion should not be less tha n `40 crore. This system of note issue continued up to 1956, when the RBI Act wa s a mended to incorpora te some changes. This resulted in a shift from the proportiona l reserve system to the minimum reserve system. The gold reserves were reva lued so as to suit the pa rity price a nnounced by Interna tiona l Moneta ry Fund (IMF). The sta tutory minimum reserve of gold a nd foreign securities a ga inst note issue wa s fixed at `115 crore. The origina l va lue wa s reva lued at ` 1l5 crore. The Act fixed no ma ximum limit of the a mount of currency tha t could be issued by the Reserve Bank. The minimum wa s further reduced to `200 crore in Of this, ` 115 crore of reserve shall be in the form of gold bullion a nd coin a nd the ba la nce in the form of foreign securities. This system of note issue is ca lled the Minimum Reserve System. The bank is a t present issuing notes on the ba sis of minimum reserve system. A nnua l Annua l Report RBI Publications Report on Currency a nd Finance Report on Trend a nd Progress of Banking in India Ha ndbook of Sta tistics on the India n Economy State Fina nces: A Study of Budgets Statistica l Ta bles Rela ting to Ba nks in India Ba sic Statistica l Returns of Scheduled Commercia l Ba nks in India Quarterly Ma croeconomics a nd Monetary Development Occa siona l Pa pers Quarterly Statistics on Deposits a nd Credit of Scheduled Commercia l Banks M o nt hl y RBI Bulletin Moneta ry a nd Credit Informa tion Review W e e k l y W eekly Sta tistica l Supplement

66 Central Banking 57 (2) Banker to Government The Reserve Bank of India serves a s the ba nker to the Centra l a nd Sta te Governments in the country. Focusing on banking tra nsa ctions of the government. It a ccepts all moneys due to government, ca rries out exchange remitta nces a nd other banking operations including the ma na gement of public debt a nd short-term government securities like trea sury bills. It performs simila r ba nking functions of the Sta te Governments, The ba nk performs these functions without a ny remunera tions. But it is given the a dva nta ge of keeping cash bala nce of the government without pa ying a ny interest. The ba nk also underta kes the responsibility of ra ising loa ns from the public a nd selling trea sury bills a s a nd when required. For this purpose, the ba nk is given a n a nnual commission of `2, 000 per crore of rupees of business t r a ns a ct ed. The ba nk ma inta ins currency chests a t pla ces prescribed by the government, where notes and coins are kept. The trea sury or the a gency where such a chest it kept is permitted to dra w funds from the chest whenever needed, a nd normally when the pa yments exceed the receipts, withdra wa ls from the chest is ma de. It there is a ny excess, then it is deposited in the chest. The Reserve Ba nk acts a s a banker to the State government too. The states a re permitted to overdraw from the Apex Ba nk, whenever there is urgency for funds. The discha rge of this function a s of ba nker to the government, whether it is centra l or sta tes, involves receipts a nd pa yments of money on beha lf of the governments. The public a ccounts depa rtment of the bank looks after the work rela ting to government business. The State Bank of India and its subsidiaries work a s the a gent of the Reserve Ba nk where the ba nk ha s no office. The Reserve Ba nk of India ra ises loa ns from where the public on beha lf of the Government of India a nd the sta te governments. As such, the ba nk ha s developed close conta ct with the constituents of the money market. The ba nk is in position to a dvice the governments on the qua ntum, timing a nd the terms of the loa ns. The ba nk a lso sells treasury bills whenever necessa ry on beha lf of the Government of India. They a re sold by mea ns of ca lling tenders every week. These bills ha ve a currency of 912 da ys. The sale of trea sury bills provides shortterm funds to the government a nd also impa rts liquidity in the banking system. The Reserve Ba nk of India provides ways a nd means, a dva nces to the Centra l a nd Sta te governments. They a re tempora ry loa ns pa ya ble within three months. The Centra l and Sta te governments a re resorting to this type of loan in order to fina nce the development expenditure under the Five Year plans. The Sta te government a re borrowing from the Reserve Ba nk of India over a nd above the limit prescribed by it. The ba nk a lso a cts as a n a dviser to the government on financia l a nd economic ma tters fa cing the country. The government is seeking the advice of the ba nk on va rious a spects such a s fina ncing pa ttern of five year plans, resource The RBI is a banker to the Central Government statutorily and to the State Governments by virtue of specific agreements with each of them.

67 58 Banking and Financial Services mobiliz ation a nd so on. The ba nk also provides a dvice on interna tiona l pa yments a nd sta blising the externa l va lue of money. The bank has a la rge resea rch sta ff to conduct economic resea rch on various a spects perta ining to the economy. These resea rches are being published periodica lly in the bulletin of Reserve Ba nk of India. The provisions of the Reserve Bank of India Act, 1934 authorizes the RBI to grant advances to the Government, repayable not later than three months from the date of advance. (3) Banker s Bank and Lender of the Last Resort The Reserve Ba nk (RBI) is a cting as the ba nker s ba nk. In a ccordance with the provisions of the Ba nking compa nies Act of 1949, every scheduled ba nk in the country must keep a ca sh ba lance with the RBI equiva lent to 5 per cent of dema nd lia bilities. The objectives of this requirement is two-fold. Firstly, to sa fegua rd the interest of the depositors and secondly it helps to centralise the ba nking reserves in order to regula te a nd control the credit position in the country. This provision a lso ena bles the scheduled ba nks to borrow from the Reserve Ba nk by discounting the bills of excha nge. As the lender of the la st resort, the Reserve Ba nk comes to the rescue of commercia l ba nks in times of their difficulties by mea ns of buying government securities. The Reserve Ba nk a s a ba nker bank regula tes the volume of credit by the scheduled ba nks. (4) Monetary Policy (Controller of Credit) One of the most importa nt functions of centra l ba nks is formula tion a nd execution of monetary policy. In the India n context, the ba sic functions of the Reserve Ba nk of India as enuncia ted in the Prea mble to the RBI Act, 1934 are: to regula te the issue of Ba nk notes a nd the keeping of reserves with a view to securing moneta ry sta bility in India a nd genera lly to opera te the currency a nd credit system of the country to its a dva nta ge. Thus, the Reserve Ba nk s ma nda te for moneta ry policy flows from its moneta ry sta bility objective. Essentia lly, moneta ry policy dea ls with the use of va rious policy instruments for influencing the cost a nd a va ila bility of money in the economy. As ma croeconomic conditions change, a centra l ba nk ma y change the choice of instruments in its moneta ry policy. The overa ll goa l is to promote economic growth a nd ensure price sta bility. The Reserve Ba nk of India is given wide powers by the Ba nking Regula tions Act of 1949 a nd the Reserve Bank of India Act of 1934 to control the volume of credit of the country. The Reserve Bank of India, by exercising the powers given by the a bove Acts, controls credit crea tion of the commercia l ba nks. As a supreme ba nking a uthority, the Reserve Ba nk exercises its authority through the following mea sures: (1) It holds the ca sh reserves for a ll commercial ba nks. (2) It controls and credit operations of scheduled ba nks through quantita tive and qua lita tive methods of credit control. (3) It controls the money ma rket through licensing a nd inspection. (4) It a cts a s the lender of la st resort by mea ns of rediscounting the bills of e x c h a n g e.

68 Central Banking 59 Over time, the objectives of moneta ry policy in India have evolved to include ma inta ining price sta bility, ensuring a dequa te flow of credit to productive sectors of the economy for supporting economic growth, and a chieving fina ncia l sta bility. The Reserve Ba nk of India controls ba nking opera tions of scheduled banks through directives. It exercises a ll the methods of credit control like Ba nk Ra te Policy, Open Ma rket Opera tions, changing the Reserve Ra tios and fina lly the Selective Credit Controls. Moneta ry policy (Controlling of Credit) ca n be exercised by the RBI using the following direct and Indirect tools. (A) (B) (C) Cash Reserve Ratio (CRR) Statutory Liquidity Ra tio (SLR) Open Ma rket Opera tions (OMO) (D) Ba nk Ra te Policy (E) (F) Va ria ble Reserve Ra tio Method Selective Credit Control Methods (G) Mora l Sa usion and Other Methods A. Cash Rese rve Ratio (CRR) In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercia l Banks a re required to mainta in with RBI a n a vera ge ca sh ba lance, the a mount of which shall not be less tha n three per cent of the total of the Net Dema nd a nd Time Liabilities (NDTL) in India, on a fortnightly ba sis a nd RBI is empowered to increa se the sa id ra te of CRR to such higher ra te not exceeding twenty percent of the Net Dema nd a nd Time Lia bilities (NDTL) under the RBI Act, At present, effective from the fortnight beginning J une 14, 2003, the ra te of CRR is per cent of the NDTL. Curre ntly CRR is 4% (M ay 2014) B. Statutory Liquidity Re quir e ments Apart from ca sh reserve requirements, a ll commercia l ba nks a re required to ma inta in liquid a ssets in the form of government securities equa l to certa in percentage of demand a nd time liabilities. According to the Ba nking Compa nies Act of 1949, origina lly it wa s 2 per cent. This is ca lled sta tutory liquidity requirement. The Reserve Ba nk of India holds powers to cha nge the minimum liquidity ra tio. The Reserve Ba nk increa sed this ra tio from 25 to 30 per cent in 1972, 32 percent in 1973 a nd 33 percent in SLR from is fixed at %. Cur re ntly SLR rate is 23% (May 2014) C. Open M arke t Ope r ations Open ma rket opera tions refer to the buying or selling of government securities by the Reserve Ba nk of India in the money market with a view to effect the cha nge in the volume of money in circula tion. Section 17(8) of the RBI Act empowers the Reserve Ba nk to buy a nd sell the Government of India securities a nd Sta te Government securities on the recommenda tion of the Centra l Boa rd. The RBI s responsibility as bankers bank was essentially two-fold. First, it acted as a source of reserves to the banking system and served as the lender of last resort in an emergency. The second, and more important responsibility, was to ensure that the banks were established and run on sound lines with the emphasis on protection of depositors interest.

69 60 Banking and Financial Services The RBI, like other central banks, has taken a keen interest in the development of financial markets, especially the money, government securities and forex markets, in view of their critical role in the transmission mechanism of monetary policy. Open ma rket opera tions in India has been a one- way traffic, i. e., to sell more a nd more government securities to reduce the ga p in the budgeta ry opera tions of the government. The scope of open ma rket opera tions in India is limited by the ca pa city of the market to a bsorb the system of government securities flowing from the pool with the Reserve Ba nk which is fed with the requisite distribution of ma turities a t the time of loa n flota tions or through specia l issues. In other words, they have been become prima rily an a ncilla ry to government debt ma na gement. The open ma rket opera tions a re fa cilita ting borrowings by the government. The Reserve Bank of India purcha ses a nd sells the securities in Mumba i, Kolka ta a nd Chenna i, through a pproved brokers. The ba nk does not dea l with the public directly. The brokers a re the recognised members of the Stock Excha nge of the pla ces and they a re in close conta ct with the public and hence they a re in a position to inform the ba nk rega rding da y to da y ha ppenings in the money ma rket. The Reserve Ba nk does not publish either the pa rticulars of va rious loa ns or the ra tes a t which it is prepa red to buy. The brokers a re informed about the deta ils. Prior to Second W orld W ar, the volume of open ma rket opera tions wa s very small. During the W a r, the commercia l ba nks used the surplus ca sh to buy government securities. The Reserve Ba nk, during this period, wa s floa ting loa ns only. After the W ar, the Reserve Ba nk sta rted buying these securities with a view to provide funds for expa nsion of credit. Later on, the ba nk formula ted a policy of granting loa ns a gainst securities. Thus, open market operations in India have been used to support the genera l moneta ry policy. The ba nk is resorting to other methods to restrict the credit crea tion by commercial ba nks. D. B ank Rate Polic y Section 49 of the Reserve Bank of India Act defines bank rate as the standard rate interest at which, the bank is prepa red to buy or rediscount bills of excha nge or other eligible commercia l papers. RBI regula tes the volume of credit by means of ma nipula ting the ba nk ra te. It increa ses the bank rate when it comes to know the price level rising owing to increase in credit crea tion by commercial ba nks. Right from its establishment, the Reserve Ba nk of India wa s keeping low ba nk ra te in order to implement chea p money policy. It wa s 3 per cent upto In November 1951, the ba nk increa sed the bank rate from 3 per cent to 3 1/ 2 per cent. In addition, the ba nk a nnounced that it would not buy government securities. This policy brought a bout a fa ll in the price level and securities prices. In 1957, the Reserve Ba nk of India further increa sed the ba nk ra te by ha lf percent following which the commercia l ba nks a lso increa sed the lending ra tes. Consequently, the infla tion to a certa in extent wa s brought under control. The following table shows the increase of bank rate from time to time: Change in ba nk ra te since 1935.

70 Central Banking 61 Table: Bank Rate s Effective from Bank rate (%) C h a n g e 1. November November May January September l Februa ry March January May July July At present 9.0 (May 2014) E. Variable Reserve Ratio Method The Reserve Bank is a pplying the tra ditiona l methods of credit control like ba nk ra te policy and open market operations very libera lly, but they ha ve not become effective beca use of the Peruvian beha viour of ba nking system in India. Therefore, the ba nk is enforcing another traditiona l method of credit control, na mely va ria tions in the reserve ra tes. The origina l Act provided certa in guidelines for commercia l banks to ma inta in ca sh with the Reserve Ba nk. Under this Act, the ba nks were required to ma intain 5 per cent of their dema nd a nd 2 per cent of their time lia bilities in deposit with the Reserve Ba nk. The Reserve Ba nk of India Act wa s a mended in 1958 to fa cilita te the ba nk to cha nge the a bove minimum reserve ra tios. The Act empowered the ba nk to va ry the reserve ra tios between 5 and 20 per cent in respect of dema nd lia bilities a nd between 2 and 8 per cent in respect of time lia bilities. In a ddition to this, the ba nk ma y a sk the commercia l ba nk to ma inta in reserves up to 100 per cent a gainst a ny increa se in deposits a s mea sure from a specific date. During the currency and bank deposits increa sed significa ntly a nd consequently the power of commercia l ba nks in credit crea tion also increa sed. The Reserve Ba nk felt the need for using the varia tion of reserve ra tios to control credit crea tion by commercia l ba nks. While presenting the a mendment to the RBI Act, the Minister for Revenue and Expenditure sa id Under the present economic conditions, the ba nk ra te policy a nd open ma rket opera tions may not be effective or fea sible mea ns of credit control. Therefore, the Reserve Ba nk should be authorised to va ry the percenta ge of deposits with the commercial ba nks from time to time. The Act wa s further a mended in 1962 to remove the distinction between dema nd a nd time lia bilities. To incorpora te these changes, the Reserve Bank of India a nnounced in Ma rch 1960 tha t a ll ba nks ma inta in 20 per cent of the increase in deposit with Prior to the Second World War, India was a net debtor country and the British introduced exchange controls to conserve foreign exchange. Exchange Control was introduced in India in September 1939 on the outbreak of the Second World W ar

71 62 Banking and Financial Services it. From tha t da y, in a ddition to the 7 per cent of the sta tutory minimum, the ba nk a lso a nnounced that interest would be pa id on these a dditiona l reserves. W hen there wa s a grea t stringency in the money ma rket in J a nuary 1961, the Reserve Ba nk revoked the provision of a dditiona l reserves. From 1962 onwa rds, the sta tutory minimum was kept a t 3 per cent of time a nd dema nd liabilities. The Ba nk increa sed the reserve ra tio from 3 to 5 per cent in June 1973, ta king into a ccount the economic conditions preva iling in the country. Table 4. 3: Bank Variable Re ser ve Ratio Ye a r % C h a n g e Historically, the rupee was linked with pound sterling, which continued even after the establishment of the RBI. It was only in late September 1975 that the rupee was delinked from pound sterling and the value was determined with reference to a basket of currencies until F. June to Sept to Sept to June to Dec to Dec to Sept to In to June Presen tly this method of credit control is not in use. Selective Credit Controls The Reserve Bank of India is using selective credit control, in a ddition to qualita tive credit controls to regula te the credit supply. The Pla nning Commission, while recogniz ing the importa nce of selective credit controls said, Centra l ba nking in planned economy can ha rdly be confined to the regula tion of bank credit. It would ha ve to ta ke a direct and a ctive role, firstly in helping to crea te the machinery needed for fina ncing development a ctivities a ll over the country a nd secondly in ensuring tha t the a va ila ble fina nce to flow into directions intended. The Ba nking Regula tions Act, 1949, ha s given wide powers to Reserve Ba nk of India to control the entire ba nking system. The Reserve Ba nk India may determine the policy in relation to a dva nce to be followed by the ba nking company. The Reserve Bank may give directions to commercia l ba nks with rega rd to the purpose for which a dva nces a re to be ma de, ma rgins to be ma intained a nd the ra te of interest to be cha rged, etc. In 1956, Reserve Bank found tha t ba nk credit wa s used for specula tive purposes. Hence it directed the commercia l ba nks to submit fortnightly sta tements of a dvances ma de aga inst certa in commodities and a lso increa sed the ma rgins to be ma inta ined a gainst rice a nd pa ddy. This policy wa s extended to a ll other a gricultura l commodities towards the close of the yea r.

72 Central Banking 63 In 1965, the Reserve Ba nk a nnounced the policy of selective liberalisa tion of credits. The Ba nk libera lised its control in respect of a dva nces ma de by scheduled ba nks to fina nce supplies for defense exports, etc. The Reserve Ba nk a lso directed the ba nks to obta in its prior sa nction before a single pa rt wa s permitted to exceed a credit limit of `l crore. In J a nuary 1970, the Reserve Ba nk issued directives with regard to a dva nces ma de a ga inst oil seeds, vegetables oils, cotton a nd food gra ins. During infla tiona ry pressures in the country, ma ny more commodities were brought under the purview ma rgin. The minimum lending ra te on a dva nces a ga inst commodities, covered by selective credit control wa s ra ised to 15 per cent. In the next few yea rs, the credit policy was libera lised in order to increa se production. When infla tiona ry pressure bega n to persist in 1980s, the selective credit controls were ma de more severe. Thus, the Reserve Ba nk ha s been opera ting selective credit controls in order to a bsorb the liquid-reserves to the ma ximum extent possible a nd thereby to keep down the pressure of goods in sca rce supply. The ba nk also is looking a fter interests of production sectors of the economy. It controls expansion of credit and money supply in such a wa y as to ensure the legitima te requirements of tra de a nd industry and curb the use of credit for unproductive a nd specula tive p ur po s es. G. M oral Sausion and Othe r M e thods The Reserve Bank has been ma king use of a ll the methods of selective credit control. It has extensively used the ma rgin requirements a nd mora l sa usion. In mora l sa usion, the Reserve Ba nk persua des the commercia l ba nks to coopera te with it in order to ma ke its credit policy successful. The Reserve Bank holds meetings with the commercia l ba nks periodically and issues circula r letters in order to persua de them to follow a pa rticula r line of a ction. In this method, there is no measure of compulsion. After deva lua tion of rupee in 1949, the Ba nk requested the commercia l ba nks not to encoura ge specula tive business. In J une 1957, the Governor of the Reserve Ba nk issued a circula r to all commercia l ba nks asking them to reduce adva nces a gainst a gricultura l commodities. He convened a conference of lea ding bankers in July 1957 and impressed upon them the need for reducing the qua ntum of a dvances. The Governor is a lso a dvising the commercia l banks informa lly to restra in the credit crea tion. In a letter to commercia l ba nks in 1971, the Governor of the Reserve Ba nk requested them not to a pproa ch the Ba nk for restoring to mora l session consta ntly to regula te the crea tion of credit. The selective credit controls ha ve become a prominent wea pon of credit control in recent yea rs. The commercial ba nks in India ha ve to formula te policies on the guidelines issued by the Reserve Bank. 5 Regulating and Strengthening the Banking System Ba nks a re funda menta l to the na tion s fina ncia l system. The centra l ba nk ha s a critical role to pla y in ensuring the sa fety a nd soundness of the ba nking system and in ma inta ining financia l sta bility a nd public confidence in this The Foreign Exchange Regulation Act (FERA), 1947, which was enacted under the British regime as a temporary measure, was later made a permanent Act in 1957

73 64 Banking and Financial Services system. As the regula tor a nd supervisor of the ba nking system, the Reserve Ba nk protects the interests of depositors, ensures a fra mework for orderly development a nd conduct of ba nking opera tions conducive to customer interests a nd ma inta ins overa ll fina ncia l sta bility through preventive a nd corrective me a s u r e s. Banks report details of sale/ purchase of foreign exchange by AD branches under the Foreign Exchange Transaction Electronic Reporting System (FETERS) which are used as input in the compilation and dissemination of the country s balance of payments (BoP) statistics. RBI s Regulatory Role includes L i c e n s i n g Prescribing ca pita l requirements Monitoring governance Setting prudentia l regula tions to ensure solvency and liquidity of the b a n k s Prescribing lending to certain priority sectors of the economy Regula ting interest rates in specific a reas Setting appropria te regula tory norms rela ted to Income recognition, a sset cla ssifica tion, provisioning, investment va lua tion, exposure Limits a nd the like Initia ting new regula tion The Reserve Ba nk ma kes use of severa l supervisory tools: On-site inspections Off-site surveillance, ma king use of required reporting by the regulated e n t i t i e s Thema tic inspections, scrutiny a nd periodic meetings The Reserve Bank of India ha s strengthened the ba nking system by encoura ging mergers of uneconomic ba nks in the via ble ba nks. It ha s the powers of gra nting licenses to opening of ba nks a nd bra nches of the existing ba nks. It ha s helped in the provision of bala nced ba nking service fa cilities throughout the country by exercising rigid control over the bra nch expa nsion progra mmes of na tiona lised, priva te sector and cooperative sector ba nks. The bra nches of a ll ba nks increa sed from 8232 in 1969 to 60, 884 on March 1993 a nd it has exceed one la kh presently. Bra nches ha ve been opened in the hitherto unbanked a rea s in order to extend the banking fa cilities to the rura l a rea s. In order to protect the interests of the depositors, Deposit Insurance Corpora tion ha s been promoted by RBI. It ha s established Ba nkers Tra ining College a nd National Institute of Ba nk Ma na gement to impa rt tra ining a nd to initia te a nd coordina te for the development of the banking profession in the c o u n t r y. 6. Management of Foreign Exchange RBI controls and mana ges foreign excha nge a ctivities in the country. W ith the tra nsition to a ma rket-ba sed system for determining the externa l va lue of

74 Central Banking 65 the India n rupee, the foreign excha nge ma rket in India ga ined importa nce in the ea rly reform period. In recent yea rs, with increa sing integra tion of the India n economy with the globa l economy arising from greater tra de a nd ca pital flows, the foreign excha nge market ha s evolved a s a key segment of the India n fina ncia l ma r k e t. The Reserve Bank pla ys a key role in the regula tion a nd development of the foreign exchange ma rket a nd assumes three broa d roles rela ting to foreign e x c h a n g e : Regula ting transa ctions rela ted to the external sector a nd fa cilita ting the development of the foreign excha nge ma rket Ensuring smooth conduct a nd orderly conditions in the domestic foreign excha nge ma rket Ma na ging the foreign currency a ssets a nd gold reserves of the country The Reserve Bank is responsible for a dministra tion of the Foreign Exchange Ma na gement Act, 1999 a nd regula tes the ma rket by issuing licences to banks a nd other select institutions to act a s Authorised Dea lers in foreign excha nge. The Foreign Excha nge Depa rtment (FED) is responsible for the regula tion a nd development of the ma rket. The Depa rtment of Externa l Investments and Opera tions (DEIO) invests the country s foreign exchange reserves built up by purcha se of foreign currency from the ma rket. In investing its foreign a ssets, the Reserve Ba nk is guided by three principles: sa fety, liquidity a nd return. 7. Developmental Functions In the India n ba nking structure, the Reserve Ba nk of India sta nds a t the pinna cle. The Reserve Bank of India Act a nd the Banking Regula tions Act of 1949 a nd the subsequent a mendments ha ve given a mple powers to the RBI in guiding the development of ba nking in India. The commercia l banks, the development banks and the coopera tive societies play a role in the economic development of the country. The role of commercial ba nks including coopera tive ba nks a nd societies a s mobilisers of sa vings a nd a s instruments of economic growth ha s been sta ted emphatica lly in the Five Yea r Pla n documents. The Government of India na tiona lised some big commercia l ba nks with a view to ma king them cha nneliz e credit for economic development. The First Pla n document sta tes tha t the centra l ba nking (RBI) in a pla nned economy can ha rdly be confined to the regula tion of the overa ll supply of credit or to a somewha t nega tive regula tion of the flow of ba nk credit It would have to ta ke a direct a nd a ctive role in crea ting a nd helping to crea te the machinery needed for fina ncing development activities all over the country and a lso to ensure tha t the finance a vaila ble flows in the directions intended. For the successful fulfillment of the planned objectives, it is necessa ry to direct special credit facilities to certa in lines of higher priority. The ba nking system will have to be filled increa singly into the scheme of development visua lised for the economy a s a whole; for it is thus that the process of mobilising savings a nd of utilising them to the best a dva nta ge becomes specia lly purposive. The Indian capital market was opened up for foreign institutional investors (FIIs) in In recent years, it has made consistent efforts to develop financial markets, build institutions and encourage use of technology in the financial system.

75 66 Banking and Financial Services Notes of denominations of ` 500 and ` 1,000 together accounted for around 83 per cent of the total value of banknotes in circulation during the year The Reserve Ba nk is one of the few centra l ba nks tha t ha s taken an a ctive a nd direct role in supporting developmenta l a ctivities in their country. The Reserve Ba nk s developmenta l role includes ensuring credit to productive sectors of the economy, creating institutions to build fina ncia l infra structure, a nd expanding a ccess to a fforda ble fina ncia l services. Over the yea rs, its developmenta l role ha s extended to institution building for fa cilitating the a vaila bility of diversified fina ncia l services within the country. The Reserve Ba nk toda y a lso pla ys a n a ctive role in encoura ging efficient customer service throughout the ba nking industry, a s well a s extension of ba nking service to a ll, through the thrust on fina ncia l inclusion. Reserve Ba nk ha s esta blished new institutions which contributed to the economic development of the country. 1962: Deposit Insurance Corpora tion 1963: Agricultura l Refina nce Corpora tion 1964: Unit Trust of India 1964: Industria l Development Ba nk of India 1969: Nationa l Institute of Ba nk Mana gement 1971: Credit Gua ra ntee Corpora tion 1978: Deposit Insura nce a nd Credit Gua rantee Corpora tion (The DIC a nd CGC were merged a nd renamed as DICGC) 1982: National Ba nk for Agriculture a nd Rural Development 1982: Export-Import Ba nk of India 1987: Indira Ga ndhi Institute of Development Research 1988: Discount a nd Finance House of India 1988: National Housing Ba nk 1990: Sma ll Industries Development Ba nk of India 1994: Securities Tra ding Corporation of India 1995: Bha ra tiya Reserve Ba nk Note Mudra n Priva te Limited 1996: Institute for Development & Resea rch in Ba nking Technology 2001: Clea ring Corpora tion of India Limited 2008: Nationa l Payments Corpora tion of India Initiative s take n by RB I for de ve lopme nt of the Countr y RBI ha s ta ken va rious initia tives for the overa ll economic development of the country. They a re A. Rural Credit Given the predominantly a gra ria n cha ra cter of the Indian economy, the Reserve Ba nk s role ha s been to ensure timely a nd a dequa te credit to the a gricultural sector a t afforda ble cost. Section 54 of the RBI Act, 1934 sta tes tha t the Ba nk ma y ma intain expert sta ff to study va rious a spects of rura l credit a nd development a nd in pa rticula r, it ma y tender expert guida nce a nd a ssistance

76 Central Banking 67 to the Na tiona l Bank (NABARD) a nd conduct specia l studies in such a rea s a s it ma y consider necessa ry to do so for promoting integra ted rural development. B. Priority Sector Lending The focus on priority sectors ca n be tra ced to the Reserve Ba nk s credit policy for the year , a nd institution of a scheme of socia l control over commercia l banks in 1967 by the Government of India to remove certa in deficiencies observed in the functioning of the ba nking system, such a s, bulk of ba nk a dva nces directed to la rge a nd medium-sca le industries a nd esta blished business houses. In order to provide access to credit to the neglected sectors, a ta rget ba sed priority sector lending was introduced from the yea r 1974, initially with public sector ba nks. The scheme was gradua lly extended to all commercia l ba nks by The scope a nd extent of priority sectors ha ve undergone several cha nges since the formalisa tion of description of the priority sectors in The guidelines on lending to priority sector were revised with effect from April 30, The guiding principle of the revised guidelines on lending to priority sector has been to ensure a dequa te flow of ba nk credit to those sectors of the society/ economy tha t impa ct la rge segments of the population and weaker sections, a nd to the sectors which a re employment-intensive, such a s, a griculture a nd small enterprises. The broa d ca tegories of adva nces under priority sector now include a griculture, micro a nd sma ll enterprises sector, microcredit, educa tion a nd housing. C. Lead Bank Scheme The Reserve Ba nk introduced the Lea d Bank Scheme in Here designa ted banks were made key instruments for loca l development a nd were entrusted with the responsibility of identifying growth centres, a ssessing deposit potential a nd credit gaps a nd evolving a coordinated approach for credit deployment in ea ch district, in concert with other banks and other agencies. The Reserve Bank has a ssigned a Lead District Ma na ger for ea ch district who a cts a s a ca ta lytic force for promoting financia l inclusion a nd smooth working between government and ba nks. Central banking is perhaps both an art and science. One needs to judge it in terms of current market practices and existing milieu of the economy under consideration, as well as in terms of analytical foundations. D. Special Agricultural Credit Plan W ith a view to a ugmenting the flow of credit to agriculture, Specia l Agricultura l Credit Plan (SACP) wa s instituted and has been in operation for quite some time now. Under the SACP, banks a re required to fix self-set ta rgets showing a n increa se of about 30 per cent over previous yea r s disbursements on yea rly ba sis (April Ma rch). The public sector ba nks ha ve been formula ting SACP since The scheme ha s been extended to Private Sector ba nks a s well from the yea r E. Kisan Credit Cards The Kisan Credit Card (KCC) Scheme wa s introduced in the yea r to ena ble the fa rmers to purcha se a gricultura l inputs a nd dra w ca sh for their production needs. On revision of the KCC Scheme by NABARD in 2004, the scheme now covers term credit a s well a s working ca pita l for a griculture a nd

77 68 Banking and Financial Services a llied activities and a rea sona ble component for consumption needs. Under the scheme, the limits a re fixed on the ba sis of opera tiona l la nd holding, cropping pa ttern a nd sca les of fina nce. Sea sonal sub-limits may be fixed a t the discretion of the ba nks. Limits ma y be fixed ta king into a ccount the entire production credit needs a long with a ncilla ry a ctivities rela ting to crop production, a llied a ctivities a nd a lso non-fa rm short-term credit needs (consumption needs). Limits a re va lid for three yea rs subject to a nnua l review. Security, ma rgin a nd ra te of interest a re a s per RBI guidelines issued from time to time. A number of significant steps have been taken relating to currency management like building up of the capacity of note printing presses, reforms in the operations of the Issue Department, introduction of new security features and a shift towards higher denomination notes in circulation. F. Natural Calamities Relief Measures In order to provide relief to ba nk borrowers in times of na tural ca la mities, the Reserve Ba nk ha s issued sta nding guidelines to ba nks. The relief mea sures include, a mong other things, rescheduling/ conversion of short- term loa ns into term loans; fresh loa ns; rela xed security a nd ma rgin norms; treatment of converted/ rescheduled a griculture loa ns a s current dues ; non- compounding of interest in respect of loa ns converted/ rescheduled; and mora torium of a t lea st one yea r. G. Micro, Small and Medium Enterprises Development W ith the ena ctment of the Micro, Sma ll a nd Medium Enterprises Development (MSMED) Act, 2006, the services sector has a lso been included in the definition of micro, sma ll a nd medium enterprises, apa rt from extending the scope to medium enterprises. The Act sought to modify the definition of micro, sma ll and medium enterprises engaged in ma nufa cturing or production a nd providing or rendering of services. Some of the ma jor mea sures by RBI/ GOI to improve the credit flow to the MSE sector are a s under: Colla tera l Free Loans; Credit Gua ra ntee Scheme for Sma ll Industries by SIDBI; Specia lised MSE Bra nch in every District; Formula tion of Ba nking Code for MSE Customers. H. Export Credit Recognising the importa nt role of exports in ma inta ining the via bility of externa l sector a nd in genera ting employment, the Reserve Ba nk ha d sought to ensure adequate a va ila bility of concessiona l ba nk credit to exporters. It took the lead role in setting up the Export Import Bank of India (EXIM Bank) in January In recent yea rs, with the libera lisa tion of rea l a nd financia l sectors of the economy, interest rates on export credit ha ve been ra tiona liz ed within the overall moneta ry a nd credit policy fra mework. In order to provide a dequa te credit to exporters on a priority ba sis, the Reserve Ba nk ha s a lso prescribed a minimum proportion of ba nks a djusted net ba nk credit to be lent to exporters by foreign b a n k s.

78 Central Banking 69 I. Financial Inclusion Post libera lisa tion a nd deregula tion of the fina ncial sector within the country, it was observed tha t ba nking industry ha s shown tremendous growth in volume a nd ra nge of services provided while making significa nt improvements in fina ncia l via bility, profita bility a nd competitiveness. However, ba nks ha d not been reaching a nd bringing vast segments of the popula tion, especia lly the underprivileged sections of society, into the fold of ba sic ba nking services to the desired extent. This prompted the need for the RBI to develop a specific focus towa rds Fina ncia l Inclusion for inclusive growth. Reserve Bank is planning to introduce `10 plastic banknotes in five cities of India on a trial basis. 1. W hat a re the types of regula tion? 2. W ha t a re the objectives of RBI? REVIEW QUESTIONS 3. Expla in the lega l fra mework of RBI. 4. Briefly explain the functions of RBI. 5. W hat a re the monetary tools used by RBI to control credit flow in the e c o n o m y? 6. Na me the institutions esta blished by RBI. 7. W hat a re Initia tives ta ken by RBI for overa ll economic development of the c o u n t r y? REFERENCES J a dha v, Na rendra D. (2003), Central Bank Strate gies, Cre dibility and Independenc e: Global Ev olution and the Indian Ex perience, Reserve Bank of India, Occa siona l Papers, Summer a nd Monsoon, J a ga nnatha n, S. (1970), Indian Bank ing Sec tor Asse ssment of Progre ss sinc e Nationalisation, Speech delivered a t the India n Mercha nts Chamber a t Ca lcutta, November. King, Mervyn (2004): The Institutions of Monetary Polic y, America n Economic Review, Vol. 94(May), pp Moha n, Ra kesh (2006): Coping With Liquidity Manage ment in India: A Practitioner s View, RBI Bulletin, April. Reserve Ba nk of India (2005a): Re port on Curre nc y and Finance: , Mumba i: Reserve Ba nk of India. Reserve Bank of India (2005b): (History of) Reserve Bank of India (3 volumes), Mumba i: Reserve Ba nk of India. Reserve Bank of India (1983), Func tions and Working of the Reserv e Bank of Ind ia.

79 70 Banking and Financial Services Reserve Ba nk of India, Re ports on Curre nc y and Financ e, va rious issues. Reserve Bank of India (1985), Report of the Committee to Review the Working of the Mone tary Sy stem (Cha irma n: Prof. Sukhomoy Cha kra va rty).

80 CHAPTER 3 COMMERCIAL BANKING I Learning Objectives After rea ding this cha pter you should be a ble to understa nd the mea ning and evolution of ba nking the ba nking in India n perspective the ba nking sector reforms in post libera liz ation era the functions of commercia l banks the structure of commercial ba nking the relationship between banker a nd customer the rights a nd obliga tions of ba nker

81 72 Banking and Financial Services INTRODUCTION TO BANKING The Oxford dictionary defines a bank as an establishment for custody of money received from or on behalf of its customers. It s essential duty is to pay their drafts on it. It s profits arises from the use of the money left employed by them. In the pa st, economic a dva ncement wa s unknown. Consequently, the use of money for buying a nd selling was very much restricted. W ith the development of communica tions, economic progress a nd the sprea d of science, and the growth of economic a nd political institutes, the use of money also expa nded. Along with the use of money, the use of credit instruments a lso developed. The origin of modern fina ncial institutes can be tra ced to a ntiquity, where the individua ls used to a ccept money in the form of deposit a nd lend it to people who needed for meeting their requirements which may be economic or socia l. As times a dva nced, the cha racter of economic tra nsitions a lso cha nged. Old order of borrowing a nd lending underwent meta morphic cha nges. Fina nce beca me a powerful instrument for a ny cha nge. In fa ct, the innova tions in the fields of transport a nd communica tions, development of energy a nd ma nufa cturing ha ve resulted in innova tions in the sphere of ba nking. Opinion is not uniform with regard to the origin of the word bank. According to some authors, the word ba nk is derived from the words banc us or banquet that is a bench. The ea rly bankers, the J ews in Ita ly tra nsacted their business on benches in the ma rket place, when a ba nker failed, his Bench was broken into pieces by the people which indica ted the ba nkruptcy of the individua l ba nker. But this expla nation wa s turned out on the ground tha t the Ita lia n money cha ngers a s such were never ca lled ba nkers in the Middle Ages. Some others sa y tha t the word ba nk origina lly derived from the Germa n word pac k meaning a joint stock fund, which wa s Italia nised into banco when the Germa ns were ma sters of a grea t pa rt of Ita ly. wha tever be the origin of the word ba nk, it would trace the history of ba nking in Europe from the Middle Ages. According to ancient Europea n history, the Ba bylonians were the ea rlier people to develop a systema tised banking system. It is sa id tha t temples of Ba bylon were used a s banks and a s such the temples of Ephesus a nd Delphi were fa mous grea t ba nking institutions. The a nti-religious feelings which developed a fterwa rds led to the colla pse of public confidence in depositing money in temples and the priests cea sed to perform the ba nking business. W henever pea ce a nd solida rity were threa tened, the sprea d of ba nking a lso wa s a ffected entirely. However, after the reviva l of civiliz a tion a nd with the development of socia l and economic instituting, money tra nsa ctions also were revi ved. It wa s in the 12th Century tha t some banks were esta blished in Venice a nd Genoa. These ba nks were simply receiving deposit a nd lending money to the people. In fact, they were not banks of the modern type, The origin of modern ba nking ma y be traced to money dea lers in Florence who received money in the form of deposits a nd lent it to business people. At this time, Florence wa s the centre of money ma rket in Europe. In Engla nd, money cha nging beca me a n importa nt function of ba nkers during the reign of Edward III. Money cha nging refers to conversion of foreign coins into British money. This function wa s performed by the Roya l Excha nger on beha lf of the Crown.

82 Commercial Banking I 73 In a nother development, goldsmiths of Engla nd prepa red the ground for modern banking in Engla nd during the period of Queen Eliz abeth. The goldsmiths used to receive va lua bles a nd funds of their customers and issue receipts a cknowledging the sa me. These receipts in course of time beca me promissory notes. The seiz ure of a huge sum of money kept a s safe custody by the city mercha nts a t Roya l mint by the government resulted in the esta blishment of public ba nking in Engla nd. As a result of this Roya l repudia tion, the mercha nts began to entrust their ca shiers with large sums but later they misa ppropria ted their master s money for their own benefit. Finding tha t their employees ha d not trea ted them better tha n their king, the city merchants decided to keep their ca sh with the goldsmiths. Issue and Deposit Banking The money business performed by the ea rlier goldsmiths in Engla nd ha s been considered a s the beginning of ba nking. The goldsmiths who received money for sa fe custody a ga inst their signed receipts ha d given an underta king to return the money to the depositor or to the bearer on demand. This development in course of time ga ve rise to the emergence of issue a nd deposit ba nking. The goldsmiths ha ving a ccepted the money for sa fe custody issued receipts which became bank notes. The bank notes were accepted in exchange of money a nd v ic e v e rsa a nd enjoyed considera ble circula tion. The goldsmith in due course found tha t the depositors of money were not withdrawing a s often a s possible. They rea lised tha t lending others money for a fixed period of time wa s profita ble. This ma rked the beginning of ba nking in Engla nd. W ith the development of interna tiona l tra de, the goldsmiths could not provide sufficient fina nces to the tra ders. This new development resulted in the esta blishment of joint stock ba nking compa nies. The Bank of England The Ba nk of Engla nd started its business in 1694, with a view to finance the government to ca rry on its war with Fra nce. The public distrust for the sa me wa s a lso responsible for this event. The ba nk received subscriptions from the people and provided loa ns to the government. The Government ena cted a legisla tion ca lled the Tomage Act to form the Ba nk of Engla nd. The Act provided certa in benefit to the ba nk such as dealing in bills of excha nge gold or silver bullion etc. The new ba nk proved fa r better tha n the ba nking firms esta blished by goldsmiths. The Webster s Dictionary defines a bank as an institution which trades in money, establishment for the deposit, custody and issue of money, as also for making loans and discounts and facilitating the transmission of remittances from one place to another. Evolution of Modern Banking The growth of ba nking in Engla nd in the nineteenth century pa ved the wa y for the esta blishment of systema tised banking system in the world. Ba nking institutions in the pa st performed, limited functions such a s receiving deposits a gainst ba nk notes a nd then issuing notes in the country. As time adva nced, commerce a nd industry expa nded a nd the scope of ba nking a lso expa nded. Ba nking institutions deal with a large number of services to the customers. They serve a s custodia ns of stocks a nd sha res a nd other va lua bles. They finance imports a nd exports. The documents relating to imports a nd exports pa ssed through banks. They dea lt not only bills of excha nge, but a lso with bills of lading,

83 74 Banking and Financial Services Credit unions are another alternative to regular commercial banks. Credit unions are almost always organized as notfor-profit cooperatives. ra ilwa y receipts, wa rehouse wa rrants and receipts, marine insura nce policies a nd so on. As ba nkers, they a dva nce money on securities a nd issue letters of credit, tra vellers cheques and circular notes to customers wishing to travel a broa d, a s a lso to effect purcha ses a nd shipment of goods. The ba nkers also countersign indemnities a nd provide gua ra ntees to the pa rties on beha lf of their customers. They undertake the a dministra tion of esta tes. They a ssume the position of trustees. They a ssist industria l underta kings by underwriting their debentures a nd sha res a nd provide for working ca pital a nd fixed ca pita l requirements. The more highly developed a country is, the grea ter is the instrumenta lity of the ba nker utilised to ca rry through commercia l tra nsa ctions. From its origina l na rrow scope a nd modest purpose, modern ba nking ha s developed into such a sta ture that it ca n truly be said tha t in countries such a s Engla nd a nd United Sta tes of America, there is ha rdly a single business dea l in which the a ssista nce of the ba nk is not sought for. Foundation of Modern Banking Modern Banking a s a service institution is a la rge corpora te gia nt with la rge resources a nd multifa ceted activities. Since the na tiona liza tion of some big commercia l ba nks in India, there ha s been a grea t surge in the ba nking industry throughout the world with the growing number of banking offices. The ba nking business toda y ha s become highly critica l a nd competitive between va rious cla ss of banks in offering a grea ter va riety of services na tiona lly a nd interna tiona lly. W ith the growth of tra de a nd commerce, ba nks a re also modernising opera tions with a view to sa tisfying their customers. India n banks ha ve a lso realised tha t to cope with enormously increa sed volume of business in a timely and efficient ma nner and to do effective business, like their counterpa rts in the western countries, by modernising their opera tions wa s deemed essentia l. Modern ba nking institutions have resorted to a utoma tion by means of introducing computers a nd other equipment a s well a s the wea lth of informa tion technology. The ma in a im of modernising ba nking system is to improve bank opera tions with a view to ma inta ining high sta ndard banking. This involves a pplica tions of better ma na gement techniques. In India, cla ss ba nking ha s given wa y to ma ss ba nking, thereby bringing in its fold a la rge number of customers. Ba nks a re now looked upon a s development agents instea d of purveyors of credit to the la rge industries and big business companies. More a nd more functions a re entrusted to ba nks, In India, the banks apa rt from providing credit to a griculture, trade industry a nd commerce, a re offering a good number of services to the customers such a s ma king pension pa yments to retired government servants a nd collection of wa ter a nd electricity bills, telephone bills, ta king buy a nd sell decisions on beha lf of their customers, ma naging public issues, etc. Meaning and Definition A Ba nk is a n institution which deals in money. It mea ns tha t ba nk receives money in the form of deposits from the public a nd lends money for the development of tra de a nd commerce. Severa l economists have defined the term ba nking in various ways. Crowther in his book, An Outline of Money says tha t

84 Commercial Banking I 75 the present day ba nker ha s three ancestors: merchant, moneylender a nd goldsmith. A modern ba nk is something of ea ch of these. It is round that it ca n circula te. The progeny of the moneylender a re concerned with fla t money sa vings. The progeny of the goldsmith a re concerned with round money, circula ting money ca sh. This definition shows the origin of modern ba nking. Prof. Ha rt sa ys that a ba nker is one who in the ordinary course his business, receives money which he repa ys by honouring the cheque of persons from whom or on whose a ccount he receives it. Prof. Kinley defines a bank a s a n esta blishment which ma kes individua ls such a dva nces of money as ma y be required a nd sa fely ma de a nd to which individuals entrust money which it is not required by the, for use. The India n Compa nies Act defines the term bank a s The a cceptor, for the purpose of lending or investment of deposits of money from the public, repa yable on dema nd or otherwise and withdrawa ble by cheques draft, order or otherwise. If we closely exa mine the a bove definitions, we come to conclusion that a ba nk performs two importa nt functions. One a ccepting the deposits, the other is lending the loa ns to the needy people. The purpose of a ccepting the deposits is to lend. If a n institution performs these two functions only, then it ca nnot be ca lled a ba nk. For exa mple, the Sa hukars or Ma rva dis in India perform these two functions, yet they a re not ca lled ba nkers. They a re simply ca lled moneylenders. As such, as suita ble definition of a ba nk should include one more very importa nt function, na mely, crea tion of credit. Accordingly, Ba nk is defined a s a n institution which dea ls with money a nd credit. Thus, a ba nk borrows money, lends money and credit. In other words, the ba nk, buys credit from its customers a nd sells its own credit to them. The ba nk creates credit when it lends to its customers. These loans later result in the creation of deposits a nd these deposits crea te the credit of the depositors. When a depositor dra ws a cheque on a ba nk, then the credit of the customers is converted into the credit of the ba nk. Thus, the credit is tra nsferred through the medium of loa ns. In these da ys, credit business is one of the specia lities of the ba nk. The a ccepta nce of deposits and lending money to the customers a re performed by Sahuka rs a s well. But there is a difference between the Sa huka r and the ba nk. Thus, every ba nk performs the functions of a Sa huka r, but every Sa huka r ca nnot perform all the functions of the bank. Therefore, wha t Professor Sa yers sa ys is very a ppropriate tha t banks are not merely tra ders in money but a lso important genera tors of money. The B anking Companie s Ac t of 1949, Se c tion 5(b) de fine s banking as acc e pting for the pur pose of le nding or inve stment of de posits fr om the public, r e payable on de mand or othe r wise and withdr awable by c he que s, dr afts, or de r s or othe r wise. This definition is more comprehensive tha n the definitions given by Ha rt a nd Kinley, for it includes investment of money deposited which is withdra wa ble by cheque, this indicates tha t banking is different from priva te money lending or indigenous ba nking. Section 6 of the Banking Companies Act of 1949, specifies a good number of business functions such as discounting, buying a nd selling, collecting a nd Industrial and Commercial Bank of China is the biggest bank in the world based on asset holding during the year 2013

85 76 Banking and Financial Services dealing business instruments like bills of excha nge, hundies, promissory notes, drafts, bills of la ding, wa rra nts, debentures and securities etc. Ba nks ca n also underta ke buying a nd selling of foreign exchange including notes. The banks ca n a lso a cquire, hold, issue, underwrite sha res, debentures of business compa nies etc. The ba nk is prohibited in ca rrying out tra ding a ctivities. Thus, a ba nking institution a ccepts deposits a nd crea tes credit with a view to lend and invest. Need for the Banks Before the esta blishment of banks, the fina ncia l a ctivities were handled by money lenders a nd individua ls. At tha t time the interest ra tes were very high. Again there were no security of public sa vings a nd no uniformity rega rding loans. So a s to overcome such problems the orga niz ed ba nking sector wa s esta blished, which wa s fully regulated by the government. The orga niz ed ba nking sector works within the fina ncia l system to provide loa ns, a ccept deposits a nd provide other services to their customers. The following functions of the ba nk expla in the need of the ba nk and its importa nce: To provide the security to the sa vings of customers. To control the supply of money a nd credit To encoura ge public confidence in the working of the fina ncia l system, increase savings speedily a nd efficiently. To a void focus of fina ncia l powers in the hands of a few individua ls a nd institutions. To set equal norms a nd conditions ( i. e., ra te of interest, period of lending etc) to all types of customers. BANKING IN INDIA The first ba nk in India, ca lled The Genera l Ba nk of India was esta blished in the yea r The Ea st India Compa ny esta blished The Bank of Benga l/ Ca lcutta (1809), Bank of Bomba y (1840) and Bank of Ma dra s (1843). The next ba nk wa s Ba nk of Hindusta n which wa s esta blished in These three individua l units (Ba nk of Calcutta, Bank of Bomba y, and Bank of Ma dra s) were ca lled as Presidency Ba nks. Alla haba d Ba nk which wa s esta blished in 1865, wa s for the first time completely run by India ns. Punjab Na tiona l Ba nk Ltd. wa s set up in 1894 with hea dqua rters at La hore. Between 1906 a nd 1913, Ba nk of India, Centra l Ba nk of India, Ba nk of Baroda, Ca na ra Ba nk, India n Ba nk, a nd Ba nk of Mysore were set up. In 1921, a ll presidency ba nks were a malga mated to form the Imperial Ba nk of India which wa s run by Europea n sha reholders. After that the Reserve Bank of India wa s esta blished in April At the time of first phase the growth of banking sector was very slow. Between 1913 a nd 1948 there were a pproximately 1100 sma ll ba nks in India. To strea mline the functioning and a ctivities of commercial ba nks, the Government of India ca me up with the Ba nking Compa nies Act, 1949, which wa s la ter changed to Ba nking Regula tion Act 1949, a s per a mending Act of 1965 ( Act No. 23 of

86 Commercial Banking I ). Reserve Ba nk of India wa s vested with extensive powers for the supervision of ba nking in India a s a Centra l Ba nking Authority. After independence, Government ha s ta ken most importa nt steps in rega rd of India n Ba nking Sector reforms. In 1955, the Imperia l Bank of India wa s na tiona liz ed a nd wa s given the na me Sta te Ba nk of India, to a ct as the principa l a gent of RBI a nd to handle ba nking transa ctions a ll over the country. It wa s esta blished under Sta te Ba nk of India Act, Seven ba nks forming subsidia ry of Sta te Ba nk of India wa s na tiona lized in On 19th J uly, 1969, ma jor process of na tiona liz a tion was ca rried out. At the sa me time 14 ma jor India n commercia l ba nks of the country were na tiona liz ed. In 1980, a nother six ba nks were na tiona liz ed, a nd thus ra ising the number of na tiona liz ed ba nks to 20. Seven more ba nks were na tiona liz ed with deposits over ` 200 crores. Till the yea r 1980 a pproximately 80% of the ba nking segment in India wa s under government s ownership. On the suggestions of Na rsimha n Committee, the Ba nking Regulation Act wa s a mended in 1993 a nd thus, the ga tes for the new priva te sector ba nks were opened. The following ar e the major ste ps take n by the Gove r nment during pr e- libe r alisation e r a to pr omote Banking institutions in the c ountry: : Sta rting of Reserve Ba nk of India 1949 : Ena ctment of Ba nking Regula tion Act : Nationa lisa tion of Sta te Ba nk of India : Na tionaliz a tion of SBI subsidia ries : Insura nce cover extended to deposits : Na tiona lisation of 14 ma jor ba nks : Crea tion of credit guara ntee corpora tion : Crea tion of regiona l rural ba nks : Na tionalisa tion of seven ba nks with deposits over, ` 200 crores Bankers, till the time of economic reforms, were used to the method (borrow at 4%; lend at 6%; go home at 4pm) of functioning. Nationalisation of Commercial Banks Na tiona lisa tion is considered to be one of the most importa nt milestone in India n Ba nking scena rio. By the 1960s, the India n ba nking industry ha s become an importa nt tool to fa cilita te the development of the India n economy. At the sa me time, it ha s emerged as a la rge employer, a nd a deba te ha s ensured a bout the possibility to na tiona lise the ba nking industry. Indira Ga ndhi, thethen Prime Minister of India expressed the intention of the Government of India (GOI) in the annua l conference of the All India Congress Meeting in a paper entitled Stray thoughts on Bank Nationalisation. The pa per wa s received with positive enthusia sm. Therea fter, her move wa s swift a nd sudden, a nd the GOI issued an ordina nce a nd na tiona lised the 14 la rgest commercia l banks with effect from the midnight of July 19, J aya praka sh Na ra ya n, a na tiona l leader of India, described the step as a Masterstroke of political sagacity Within two weeks of the issue of the ordina nce, the Pa rlia ment pa ssed the Ba nking Compa nies (Acquisition a nd Tra nsfer of Underta king) Bill, and it received the presidentia l a pprova l on 9 August, 1969.

87 78 Banking and Financial Services A second step of nationa lisa tion of 6 more commercial ba nks followed in The stated rea son for the nationalisa tion was to give the government more control of credit delivery. W ith the second step of na tiona lisation, the GOI controlled a round 91% of the ba nking business in India. La ter on, in the yea r 1993, the government merged New Ba nk of India with Punjab Na tiona l Ba nk. It wa s the only merger between na tiona lised banks and resulted in the reduction of the number of nationalised ba nks from 20 to 19. After this, until the 1990s, the nationa lised ba nks grew at a pa ce of a round 4%, closer to the a vera ge growth ra te of the India n economy. The nationalised ba nks were credited by some; including Home minister P. Chida mba ra m, to ha ve helped the India n economy withsta nd the globa l financia l crisis of BANKING SECTOR REFORMS IN POST LIBERALIZATION ERA Indian banks are considered to have clean, strong and transparent balance sheets relative to other banks in comparable economies in its region. India n ba nking is the lifeline of the na tion a nd its people. Ba nking ha s helped in developing the vita l sectors of the economy a nd guide in a new da wn of progress on the Indian horiz on. The sector ha s tra nsla ted the hopes a nd a spira tions of millions of people into rea lity. Government of India (GOI) set up va rious committees with the ta sk of a nalyz ing India s ba nking sector a nd recommending legisla tion a nd regula tions to ma ke it more effective, competitive a nd efficient. Two such expert Committees were set up under the cha irma nship of M. Nara simha m. a n ex-rbi governer They submitted their recommenda tions in the 1990s in reports widely known a s the Narasimham Committe e-i (1991) report and the Narasimham Committe e-ii (1998) Report. The first Na ra simha n Committee (Committee on the Financial System - CFS) was appointed by Manmohan Singh a s India s Fina nce Minister on 14 August 1991 a nd the second one (Committee on Banking Sector Reforms) was appointed by P.Chidambaram as Fina nce Minister in December Subsequently, the first one widely ca me to be known a s the Narasimham Committe e-i (1991) a nd the second one as Narasimham-II Committe e(1998) The purpose of the Nar asimham-i Committee wa s to study all a spects relating to the structure, orga niz a tion, functions and procedures of the financia l systems a nd to recommend improvements in their efficiency a nd productivity. The Committee submitted its report to the Fina nce Minister in November 1991 which wa s ta bled in Pa rlia ment on 17 December The Nar asimham-ii Committee wa s ta sked with the progress review of the implementa tion of the ba nking reforms since 1992 with the aim of further strengthening the fina ncia l institutions of India. It focussed on issues like siz e of ba nks a nd ca pital a dequa cy ra tio a mong other things. M. Nara simha m, Chairma n, submitted the report of the Committe e on Bank ing Se c tor Re forms (Committe e-ii) to the Fina nce Minister Ya shwa nt Sinha in April These recommenda tions helped considera bly in ba nking sector reforms. The Na rasimhan Committee made the following ma jor recommenda tions: The following pa ra gra phs discusses the some of the importa nt recommenda tion ma de by the committee a nd a ction ta ken by the government.

88 Commercial Banking I Autonomy in Banking Rec omme ndation: Grea ter autonomy was proposed for the public sector ba nks in order for them to function with equivalent professiona lism a s their interna tiona l counterparts. For this the pa nel recommended tha t recruitment procedures, tra ining a nd remuneration policies of public sector ba nks be brought in line with the best-ma rket-pra ctices of professiona l ba nk ma na gement. Secondly, the committee recommended GOI equity in na tiona liz ed ba nks be reduced to 33% for increa sed a utonomy. It also recommended the RBI relinquish its sea ts on the board of directors of these ba nks. The committee further a dded tha t given tha t the government nominees to the boa rd of banks are often members of pa rlia ment, politicia ns, burea ucrats, etc., they often interfere in the day to da y opera tions of the ba nk in the form of the be he st-le nding. As such the committee recommended a review of functions of ba nks boa rds with a view to ma ke them responsible for enha ncing shareholder va lue through formula tion of corpora te stra tegy a nd reduction of government eq ui t y. Ac tion Take n: To implement this, criteria for autonomous status wa s identified by Ma rch 1999 (a mong other implementa tion measures) a nd 17 banks were considered eligible for a utonomy. But some recommenda tions like reduction in Government s equity to 33%, the issue of grea ter professiona lism a nd independence of the boa rd of directors of public sector ba nks is still a waiting Government follow-through and implementa tion. 2. Reform in the Role of RBI Rec ommendation: First, the committee recommended tha t the RBI withdra w from the 91-da y trea sury bills market a nd tha t interba nk ca ll money a nd term money markets be restricted to ba nks a nd prima ry dea lers. Second, the Committee proposed a segrega tion of the roles of RBI a s a re gulator of ba nks a nd owner of ba nk. It observed tha t The Re serv e Bank as a regulator of the monetary system should not be the owner of a bank in view of a possible conflict of inte re st. As such, it highlighted tha t RBI s role of effective supervision wa s not a dequa te a nd wa nted it to divest its holdings in ba nks a nd financia l institutions. Ac tion Take n: Pursua nt to the recommenda tions, the RBI introduced a Liquidity Adjustment Fa cility (LAF) opera ted through repo a nd reverse repos in order to set a corridor for money ma rket interest ra tes. To begin with, in April 1999, a n Interim Liquidity Adjustment Fa cility (ILAF) wa s introduced pending further up gra dation in technology a nd lega l/ procedura l cha nges to fa cilitate electronic tra nsfer. As for the second recommenda tion, the RBI decided to tra nsfer its respective shareholdings of public ba nks like Sta te Ba nk of India (SBI), Na tiona l Housing Ba nk (NHB) a nd Na tiona l Ba nk for Agriculture a nd Rural Development (NABARD) to GOI. Subsequently, in , GOI decided to a cquire entire sta ke of RBI in SBI, NHB a nd NABARD. All banks which are included in the Second Schedule to the Reserve Bank of India Act, 1934 are Scheduled Banks. These banks comprise Scheduled Commercial Banks and Scheduled Co-operative Banks. 3. Stronger Banking System Re comme ndation: The Committee recommended for merger of la rge India n ba nks to ma ke them strong enough for supporting interna tiona l tra de. It

89 80 Banking and Financial Services recommended a three tier ba nking structure in India through esta blishment of three large ba nks with interna tiona l presence, eight to ten na tiona l ba nks a nd a large numbe r of regional and loc al bank s. This proposa l ha d been severely criticiz ed by the RBI employees union. The Committee recommended the use of mergers to build the siz e a nd strength of operations for ea ch ba nk. However, it ca utioned tha t la rge ba nks should merge only with ba nks of equiva lent siz e a nd not with wea ker ba nks, which should be closed down if una ble to revita liz e themselves. Given the large percenta ge of non-performing a ssets for weaker banks, some as high a s 20% of their total assets, the concept of narrow banking wa s proposed to a ssist in their reha bilita tion. Ac tion Take n: There were a string of mergers in ba nks of India during the la te 90s a nd ea rly 2000s, encoura ged strongly by the Government of India in line with the Committee s recommenda tions. However, the recommended degree of consolida tion is still a wa iting sufficient government impetus. Scheduled Commercial Banks in India are categorised into five different groups according to their ownership and/or nature of operation. 4. Non-performing Assets Re comme ndation: Non-performing a ssets ha d been the single la rgest cause of irrita tion of the ba nking sector of India. Ea rlier the Nara simha m Committee- I ha d broa dly concluded tha t the ma in rea son for the reduced profita bility of the commercial ba nks in India wa s the priority sector lending. The committee ha d highlighted that priority sector lending wa s lea ding to the build up of nonperforming a ssets of the ba nks a nd thus it recommended it to be phased out. Subsequently, the Na ra simha m Committee-II also highlighted the need for z ero non-performing a ssets for all India n ba nks with Interna tiona l presence. The 1998 report further bla med poor credit decisions, behest-lending a nd cyclica l economic factors a mong other rea sons for the build up of the nonperforming a ssets of these ba nks to uncomforta bly high levels. The Committee recommended crea tion of Asset Reconstruction Funds or Asset Reconstruction Compa nies to ta ke over the ba d debts of ba nks, allowing them to start on a cleanslate. The option of reca pita liz ation through budgetary provisions wa s ruled out. Overa ll the committee wanted a proper system to identify a nd cla ssify NPAs, NPAs to be brought down to 3% by 2002 a nd for an inde pe ndent loan re vie w me ac hnism for improved ma na gement of loa n portfolios. Ac tion Take n: The committee s recommenda tions let to introduction of a new legisla tion which wa s subsequently implemented a s the Securitisation a nd Reconstruction of Fina ncia l Assets a nd Enforcement of Security Interest Act, 2002 a nd ca me into force with effect from 21 June Capital Adequacy and Tightening of Provisioning Norms Re comme ndation: In order to improve the inherent strength of the India n ba nking system the committee recommended that the Government should raise the prescribed ca pita l a dequa cy norms. This would a lso improve their risk ta king a bility. The committee ta rgeted ra ising the ca pita l a dequa cy ra tio to 9% by 2000 a nd 10% by 2002 a nd ha ve pena l provisions for ba nks tha t fa il to meet these requirements. For a sset cla ssifica tion, the Committee recommended a ma nda tory 1% in case of sta nda rd assets a nd for the a ccrua l of interest income to be done every 90 days instea d of 180 days.

90 Commercial Banking I 81 Ac tion Take n: To implement these recommenda tions, the RBI in Oct 1998, initia ted the second pha se of fina ncial sector reforms by ra ising the ba nks ca pita l a dequa cy ratio by 1% a nd tightening the prudentia l norms for provisioning a nd asset cla ssification in a pha sed ma nner on the lines of the Na ra simha m Committee-II report. The RBI ta rgeted to bring the ca pita l a dequa cy ra tio to 9% by Ma rch The mid-term Review of the Monetary a nd Credit Policy of RBI a nnounced another series of reforms, in line with the recommenda tions with the Committee, in October Entry of Foreign Banks Re comme ndation: The committee suggested tha t the foreign ba nks seeking to set up business in India should ha ve a minimum sta rt-up ca pita l of $25 million a s a ga inst the existing requirement of $10 million. It sa id tha t foreign banks ca n be allowed to set up subsidia ries and joint ventures that should be treated on a pa r with private ba nks. Ac tion Take n: The government ha s allowed the foreign ba nks to opera te in I n d i a. Some of the other r ecommendations made by Narasimhan committee are given below Re duc tion in the SLR and CRR : The committee recommended the reduction of the higher proportion of the Sta tutory Liquidity Ra tio SLR and the Cash Reserve Ratio CRR. Both of these ratios were very high at that time. The SLR then wa s 38.5% a nd CRR was 15%. This high amount of SLR and CRR mea nt locking the ba nk resources for government uses. It wa s hindra nce in the productivity of the ba nk thus the committee recommended their gra dual reduction. SLR wa s recommended to reduce from 38. 5% to 25% a nd CRR from 15% to 3 to 5%. Phasing out Dir e c ted Cr edit Progr amme : In India, since na tiona liz a tion, directed credit programmes were adopted by the government. The committee recommended pha sing out of this progra mme. This progra mme compelled ba nks to ea rma rk their fina ncia l resources for the needy a nd poor sectors a t concessiona l ra tes of interest. It wa s reducing the profita bility of ba nks a nd thus, the committee recommended the stopping of this progra mme. Inte r e st Rate De te rmination : The committee felt tha t the interest rates in India a re regula ted a nd controlled by the a uthorities. The determina tion of the interest ra te should be on the grounds of ma rket forces such a s the dema nd for a nd the supply of fund. Hence, the committee recommended elimina ting government controls on interest ra te a nd pha sing out the concessiona l interest ra tes for the priority s ector. Establishme nt of the ARF Tr ibunal : The proportion of ba d debts a nd non-performing a sset (NPA) of the public sector Banks and Development Fina ncia l Institute wa s very ala rming in those da ys. The committee recommended the establishment of a n Asset Reconstruction Fund (ARF). Scheduled Commercial Banks in India State Bank of India and its Associates, Nationalised Banks, Private Sector Banks, Foreign Banks and Regional Rural Banks.

91 82 Banking and Financial Services This fund will ta ke over the proportion of the ba d a nd doubtful debts from the ba nks a nd fina ncia l institutes. It would help banks to get rid of ba d debts. Re moval of Dual Control : Those da ys banks were under the dual control of the Reserve Ba nk of India (RBI) and the Ba nking Division of the Ministry of Fina nce (Government of India). The committee recommended the stepping of this system. It considered a nd recommended tha t the RBI should be the only ma in a gency to regula te ba nking in India. A commercial bank is what is commonly referred to as simply a bank. Types of Banks in India Ba nking structure in India consists of Central Ba nk (RBI) which regulates almost all the banking a ctivities. Commercial ba nking activities in India a re performed by Public sector ba nks, private sector banks a nd foreign ba nks. Apa rt from commercial ba nks, there are development banks, specialized banks and cooperative ba nks. This chapter deals mainly with activitie s of comme rcial banks. COMMERCIAL BANKING IN INDIA A commercia l bank is a business firm, dea ling in money a nd credit. It is a fina ncial institution dea ling in money in the sense tha t it a ccepts deposits from the public to keep them in its custody for safety. So a lso, it deals in credit, i.e., it crea tes credit by making a dva nces out of the funds received as deposits to needy people. It thus, functions as a mobiliser of sa ving in the economy. Commercia l banks perform a ll the business tra nsa ctions of a typica l bank. Commercia l ba nks a ccept deposits a nd lend. Apa rt from these ba sic functions they perform va rious seconda ry a nd a gency functions which will be discussed in this cha pter. Role of Commercial Banks It encoura ges sa vings ha bit a mongst people a nd thereby makes funds a vaila ble for productive use. It a cts a s a n intermediary between people ha ving surplus money a nd those requiring money for va rious business a ctivities.

92 Commercial Banking I 83 It fa cilita tes business tra nsa ctions through receipts and pa yments by cheques instead of currency. It provides loa ns and a dva nces to businesses for short term and longterm purposes. It a lso fa cilita tes import export tra nsa ctions. It helps in na tiona l development by providing credit to farmers, smallscale industries a nd self-employed people a s well as to la rge business houses which lea d to ba lanced economic development in the country. It helps in raising the sta ndard of living of people in general by providing loans for purcha se of consumer dura ble goods, houses, a utomobiles, e t c. Nationalized Banks in India As of now, there are 26 Na tiona lized Banks in India: 1) State Ba nk of India 2) State Ba nk of Bika ner & J a ipur 3) State Ba nk of Hyderaba d 4) State Bank of Mysore 5) State Bank of Pa tia la 6) State Ba nk of Trava ncore 7) Allahabad Bank 8) Andhra Ba nk 9) Ba nk of Baroda 1 0 ) Bank of India 1 1 ) Bank of Maharashtra 1 2 ) Canara Bank 1 3 ) Centra l Ba nk of India 1 4 ) Corporation Bank 1 5 ) Dena Bank 1 6 ) Indian Bank 1 7 ) Indian Overseas Bank 1 8 ) Orienta l Ba nk of Commerce 1 9 ) Punjab National Bank 2 0 ) Punjab and Sind Bank 2 1 ) Syndicate Bank 2 2 ) Uco Bank 2 3 ) United Ba nk of India 2 4 ) Union Ba nk of India 2 5 ) Vijaya Bank 2 6 ) IDBI Bank Limited (A new generation Government-owned Bank)

93 84 Banking and Financial Services FUNCTIONS OF COMMERCIAL BANKS Func tions of comme rc ial banks c an be c lassifie d unde r Pr imar y (B asic) func tions, Sec ondar y (Age nc y) func tions and Ge ner al utility func tions. Apar t from the se banking func tions, c omme r cial banks pe rfor m var ious non banking func tions. Primary Functions Hybrid Deposits or Flexi Deposits are a combination of demand and fixed deposits, invented for meeting customer s financial needs in a flexible manner. (1) Accepting Deposits from the Public Accepting va rious types of deposits is a n importa nt function of the commercia l ba nks. Those who ha ve ca sh bala nces wa nt to keep them in a sa fe place, i. e., deposit the sa me with a ba nk. Commercia l ba nks not only protect the ca sh of the customers, but a lso provide a convenient method of tra nsferring funds through the use of cheques. W hen the ba nk accepts deposits from people, it is obliged to repa y the money either in pa rt or in full in lega l tender money. The ba nk a ccepts three types of deposits from a ll types of income ea rners. They a r e: (a) Fixed deposits (b) Sa vings deposits (c) Current de pos i t s deposits (d) Recurring (a) Fixed De posits: A fixed deposit is one where a customer keeps a certa in a mount of money in a ba nk for a specific period. It ma y be six months, one yea r, two years, three years or five yea rs. The fixed deposits carry higher rates of interest tha n that allowed to sa vings deposits. The fixed deposits a re not expected to be withdrawn before the expiry of the period. The ra te of interest va ries with the period the longer the period the higher is the ra te of interest a nd v ic e v ersa. In India, it va ries from 8% to 10%. Fixed deposits a re liked by depositors. The depositors a re given full security for his a mount by the ba nk. He is also entitled to a fa irly high return on investment. In times of emergency, he is permitted to withdra w the a mount. In tha t ca se, he has to forego higher interests previously dra wn. For the ba nk, fixed deposit is desirable for it ca n ma ke long period investment which is profita ble. Interest rate on Term deposits offered by S B I (Feb 2014) T e no r s For Public Existing for Se nior Citize ns 7 days to 90 days days to 179 days days to 210 days days to less than 1 year year to less than 2 years years to less than 3 years years to less than 5 years years and up to 10 years Source:

94 Commercial Banking I 85 (b) Savings De posits: Savings deposits a re those deposits on which the ba nk pa ys a certa in ra te of interest to the depositors subject to certa in conditions. A person ca n open the a ccount with a sma ll a mount and go on depositing a ny a mount. The customers a re expected to ma inta in a minimum ba la nce in the a ccount. There are certa in restrictions with rega rd to withdra wa ls. The banks fix the ma ximum number of withdra wa ls in a yea r. W ithdra wa ls ca n be ma de either by withdra wa l slips or cheques. Those customers who wa nt to use cheques ha ve to ma intain a ba la nce a t higher a mount. Sa vings ba nks a ccounts a re intended to those who have sma ll incomes. The ba nks a ttra ct huge deposits from sa vings ba nk accounts. The banks pool the fina ncial resources through sa vings ba nk account a nd provide funds for the development of tra de a nd commerce. These banks render very useful service to the nation by mobilising resources through sa vings ba nk accounts. (c) Curr e nt De posits: Current deposits a re those deposits which can be withdra wn a t any time by mea ns of cheques. The ba nks do not pa y interest on current account deposits. A customer who opens a current a ccount ha s to ma inta in a minimum credit bala nce. Any a mount ca n be deposited in this a ccount. There a re no restrictions for withdra wa ls. Genera lly tra ders a nd business entities keep their money with the ba nk under current accounts. The current deposits a re a lso ca lled dema nd deposits. Demand deposits ma y be crea ted in two wa ys-either by the depositors converting ca sh into dema nd deposit with a ba nk or by borrowing from a ba nk and using the a mount to crea te a dema nd deposit with it. (d) Re cur r ing De posits: Recurring deposits a re those deposits where in the depositor makes a equa l monthly deposit for a given period of time (Genera lly 5 to 8 Yea rs). At the end of the specified period the depositor gets ba ck his principal a mount along with interest. In ca se of emergency, the deposit ca n be closed prema turely. This deposit is useful to the small income group of depositor who would like to sa ve on a regular ba sis. The Deposit Insurance Corporation of India was established by an Act of Parliament to insure the deposits in the banks and the scheme of deposit insurance was introduced with effect from January 1, (2) Making Loans and Advances Ba nks receive deposits with a view to lend. Providing loa ns a nd a dva nces out of the money which the bank receives by wa y of deposits is the second major function of commercia l ba nks. They provide different types of loa ns. Direct loa ns a nd a dvances a re given to persons a ga inst the security of mova ble properties. The different types of loa ns given by the ba nks a re direct loa ns, ca sh credits, bills discounted and overdrafts etc. An overdra ft is an a rra ngement where the customer is allowed to overdra w from his account. It is done through discounting bills of excha nge. The depositors a re provided loa ns not only to protect surplus funds, but a lso for sa fe investments. Ca sh credit is given to ma nufactures a ga inst the security of goods or persona l security of one or more persons. Tra ders prefer ca sh credit direct loa ns. The interest is cha rged only on the a mount dra wn by the customer. Direct loans a re granted a ga inst the security of mova ble or immova ble properties. Banks also provide loa ns by discounting the bills of excha nge. This is the most common method of adva ncing loa ns to businessmen in western countries. The business community in India prefers ca sh credit loa ns to discounting the bills of excha nge.

95 86 Banking and Financial Services Interest charged by SBI on housing loan (w.e.f ) Know Your Customer (KYC) Guidelines of the RBI insists for establishment of the identity and residential address of the customers by specified documentary evidences Loan Am ou n t Up t o ` la c s Above ` la c s Source: Thus loans provided by commercia l ba nks ca n be ca tegoriz ed into a) Ca ll Money Advances b) Ca sh Credits c) Overdrafts d) Discounting Bills of Exchange e) Term Loans (for va rious purposes) f) Persona l loa ns F or Wom e n Borrowe rs Sp read ove r t h e Ba s e Rat e (Ba s e Rat e : 1 0 %) 10 bps a bove th e Ba se Ra te 25 bps a bove th e Ba se Ra te Effe c t ive Rat e % p.a % p.a. No fixed Fixed Ra ra te option will be a va ila ble in a n y lim it bra ckets. F or ot h e r Borrowe rs Sp read ove r t h e Ba s e Rat e (Ba s e Rat e : 1 0 %) 15 bps a bove th e Ba se Ra te 30 bps a bove th e Ba se Ra te Interest charged by SBI On Auto loan (As on April 2013) Effe c t ive Rat e % p.a % p.a. SBI Ca r Loa n Sc h e m e For a ll ten u res NRI Ca r Loa n Secondary (Agency) Functions For Term Loa n : For Overdra ft: 1.25% a bove Ba se Ra te, i.e % p.a. 1.75% a bove Ba se Ra te, i.e % p.a. For a ll ten u res 1.25% a bove Ba se Ra te i.e % p.a. Two- Wh e e le r Loan Up to 3 yea rs 8.25% a bove Ba se Ra te i.e % p.a. Use d Ve h ic le s Up to 3 yea rs 7.25% a bove Ba se Ra te i.e % p.a. Above 3 yrs 7.50% a bove Ba se Ra te i.e % p.a. Ce rt ifie d Pre-own e d Ca r Loa n sc h e m e Up to 3 yea rs 6.00% a bove Ba se Ra te i.e % p.a. Above 3 yrs 6.50% a bove Ba se Ra te i.e % p.a. Apart from these two prima ry functions, commercia l ba nks perform other seconda ry functions to society. They are a s follows:

96 Commercial Banking I Collection and Payment of Credit Instruments (Cheque): The commercial banks have developed and popularised the cheque system through which transfer of money is made possible. The cheque system has reduced the use of cash to a considerable extent. The cheque system is a highly developed system of credit instrument through which money can be transferred from one account to another anywhere in the country or abroad. 2. The commercial banks perform functions such as undertaking the payment subscriptions, insurance premium, rent, utility bills, etc., on behalf of the customers and collecting cheques, bills, salaries, pensions, dividends, interests, etc., belonging to customers are credited to the respective accounts of the customers. The Banks accept the standing instructions from the customers and make payments as and when directed. They charge a certain amount of fee by means of commission for these services. 3. The commercia l ba nks a lso underta ke to buy a nd sell securities on beha lf of the customers. Ba nks, through the instrument of ba nk dra fts, a rra nge for tra nsfer of money from one pla ce to a nother. 4. Banks a lso a ct like a representa tive of the customers, other ba nks a nd fina ncia l institutions. 5. Fina lly, the commercia l ba nker a cts a s a trustee, executor, a dministrator a nd a n attorney. As a trustee, the ba nk looks a fter the funds of the customers. It helps in the proper ma na gement of the trust. As a n executor, the ba nker fulfills the desires of the decea sed customers in terms of the will left by him. As a n a ttorney, the banker signs the documents on beha lf of the customers. Regional Rural Banks (RRBs) came to be set up under the act of They were set up to save the poor rural people from the grip of moneylenders and traders. Important Private Sector Banks in India 1. City Union Ba nk Ltd. 2. Ta milna d Mercantile Ba nk Ltd. 3. The Ca tholic Syria n Ba nk Ltd. 4. The Dhanalakshmi Bank Ltd. 5. The Federa l Ba nk Ltd. 6. The J a mmu & Kashmir Ba nk Ltd. 7. The Ka rnata ka Ba nk Ltd. 8. The Ka rur Vysya Ba nk Ltd. 9. The La kshmi Vila s Ba nk Ltd Nainital Bank Ltd The South India n Ba nk Ltd Axis Bank Ltd Development Credit Ba nk Ltd HDFC Bank Ltd ICICI Ba nk Ltd Indusind Ba nk Ltd Kota k Ma hindra Bank Ltd YES Bank 1 9. ING Vysya Ba nk Ltd.

97 88 Banking and Financial Services Foreign banks have their registered offices outside India, and through their branches they operate in India. Foreign banks are allowed on reciprocal basis. They are allowed to operate through branches or wholly owned subsidiaries. General Utility Services The commercia l ba nks render a good number of useful services known a s genera l utility services. The genera l utility services include 1. The ba nks provide sa fe deposit lockers to the customers to keep their securities, jewellery, documents, etc. The customers a re required to pa y a n annua l rent for this purpose. 2. The ba nks discount the foreign excha nge bills dra wn by India n exporters on the foreign importers a nd thus, help the exporters to get money in home currency. 3. The ba nks also help the importers by a ccepting the bills drawn by foreign expor ters. 4. A very useful service rendered to the customers by the ba nk is tha t of remitting the funds from one place to a nother in the form of drafts, letters of dra ft, credit notes a nd tra vellers cheques, etc. 5. The ba nks underwrite the issue of sha res a nd securities issued by joint stock compa nies. Non Banking Functions After the pa ssa ge of the Ba nking La ws Amendment Act 1983, banks ha ve started entering new lines of a ctivity, which a re not of ba nking na ture. These non-ba nking activities a re also ca lled non-funded business of ba nks. These a re briefly set out below: (1) Setting up Mutua l Funds subsidia ries a nd providing mutua l fund s er vi ces (2) Setting up subsidia ries or holding compa nies to do lea sing or lea se fina nce business. (3) Providing fa ctoring services to customers by a cting a s fa ctorisa tion a gents to ta ke risk in the collection of funds, without recourse, from the buyer firms. (4) Providing insura nce a nd credit ca rd services by setting up a subsidia ry c o mp a n i e s. Important Foreign Banks Operating in India AB Ba nk Ltd. Abu Dha bi Commercial Ba nk Limited America n Express Ba nking Corpora tion Austra lia & News Zeala nd Ba nking Group Limited Ba nk of America NA Bank of Bahrain and Kuwait B.S.C. Ba nk of Ceylon Ba rcla ys Ba nk PLC BNP Pa riba s

98 Commercial Banking I 89 China Trust Commercia l Ba nk Citiba nk N. A. Commonwealth Bank of Australia Credit Suisse AG DBS Ba nk Ltd. Deutsche Ba nk AG FirstRa nd Ba nk Ltd. Industria l & Commercial Ba nk of China Limited JPMorgan Chase Bank Societe Genera le Standa rd Cha rtered Ba nk State Ba nk of Ma uritius Limited The Ba nk of Nova Scotia The Ba nk of Tokyo-Mitsubishi UFJ Ltd. The Hongkong and Shangha i Ba nking Corporation Ltd. The Roya l Ba nk of Scotla nd NV UBS AG United Oversea s Ba nk Ltd. STRUCTURE OF COMMERCIAL BANKS The structure of banking is a lso called orga nisa tion of ba nking. It differs from country to country, depending upon economic and politica l conditions. Tradition a lso plays a n importa nt pa rt in the structure of ba nking. Over the years, the structure of ba nking a lso ha s undergone tremendous cha nges. Consequently, severa l systems of banking ha ve emerged in the group ba nking, chain banking correspondent ba nking, bra nch ba nking a nd unit ba nking. Of a ll these systems, bra nch ba nking a nd the unit ba nking a re very important. M ost of the banks ope r ating in India ar e str uc tur ed on the basis of B r anc h B a nki ng Branch Banking Branch ba nking is a system in which every ba nk work is a lega l entity, ha ving one boa rd of directors a nd one group of sha reholders a nd operates through a network of bra nches sprea d throughout the country. The head office of the ba nk is loca ted in a big city or sta te ca pita l a nd the branches opera te throughout the country. Bra nch ba nking is most common a mong Indian ba nks. Most of the India n ba nks ha ve got hea d office a nd branches sprea d throughout the country a nd a broa d. Unit Banking Unit banking is a system in which a bank opera tes in a specified a rea, which is sma ller a nd limited. It opera tes through a single office a nd functions within limited resources. Unit ba nking is often referred to a s loca liz ed ba nking. Unit

99 90 Banking and Financial Services ba nks may ha ve link with a correspondent ba nk in the city. This a rra ngement helps ea ch ba nk to ma ke remitta nces through the correspondent ba nks. In America, unit ba nking wa s very popula r a t one time. In tha t country, the opera tions of most of the banks were confined to specific pla ces. Only a few ba nks had branches in other cities of the sa me state. Banker-customer relationship is a contractual relationship between two parties and it may be terminated by either party on voluntary basis or involuntarily by the process of law. Group Banking In this system, two or three separa tely incorpora ted ba nks a re brought under the control of a holding compa ny. The holding compa ny controls effectively a ll the units in the group but each bank has a sepa ra te entity. The holding compa ny coordinates the a ctivities of the banks of the group. The ba nks so brought together ma y be unit ba nks or branch ba nks or both. There is one a dvanta ge in this system, na mely tha t it is possible to secure centralised ma nagement of both ba nking a nd non banking subsidia ries. In this system, a ll banks need not carry la rge cash reserves. The ca sh reserves ca n be ea sily tra nsferred from one Ba nk to a nother. In genera l, group ba nking enjoys economies of la rge-sca le opera tions. The only disa dva nta ge in this system is since both ba nking a nd non ba nking compa nies a re combined together, whenever non ba nking compa nies incur loss, it is tra nsferred to the ba nking compa nies a s well. During the great depression, severa l ba nking compa nies were liquidated beca use of their involvement with non ba nking compa nies. Chain Banking In this system, separa tely incorporated banks are brought under the common control by a device other tha n the holding compa ny. For exa mple, some group of persons may own three or four ba nk a nd or some persons ma y be directors of several ba nks. Though a number of ba nks a re brought under common control, each ba nk in the cha in reta ins the sepa ra te entity a nd ca rries out the functions without the interference of a nybody. This system of ba nking existed in the USA before the grea t depression. Correspondent Banking It is a system in which unit ba nk in small towns are linked with big banks in big cities a nd they a ct as correspondent ba nks to severa l unit banks. It mea ns that the unit ba nks ma inta in some deposits with the big banks in the metropolita n cities. The correspondent provide number of special services to unit banks such a s a ccepting the surplus reserves, remitta nce fa cilities to other ba nks such a s a ccepting of cheques, dra fts a nd bills for the unit ba nks a nd so on. This system is very common in USA. BANKER CUSTOMER RELATIONSHIP The relationship between a ba nker and a customer depends on the a ctivities; products or services provided by ba nk to its customers or ava iled by the customer. Trust pla ys a n important role in building hea lthy relationshi p between a ba nker and customer. As per Sec.5 (b) of the B R Act Banking mea ns a ccepting, for the purpose of lending or investment, of deposits of money from the public repa ya ble on dema nd or otherwise a nd withdra wa ble by cheque, draft,

100 Commercial Banking I 91 order or otherwise. Se c.5(c) of BR Act defines banking compa ny a s a company that transa cts the business of banking in India. The term customer of a ba nk is not defined by la w. Ordina rily, a person who ha s a n a ccount in a ba nk is considered a s customer. According to Dr. Hart, a customer is one who ha s a n a ccount with a ba nker or for whom a ba nker habitually underta kes to a ct a s such Supporting this viewpoint, the Kera la High Court observed: Broadly spea king, a customer is a person who ha s the ha bit of resorting to the sa me place or person to do business. So for a s ba nking transa ctions a re concerned he is a person whose money ha s been a ccepted on the footing tha t the ba nker will honour up to the amount sta nding to his credit. Irrespective of his connection being of short or long sta nding For the purpose of KYC policy, a Customer is defined a s a person or entity tha t ma intains a n a ccount a nd/ or ha s a business rela tionship with the bank; one on whose beha lf the account is ma inta ined (i. e., the beneficia l owner ); beneficiaries of tra nsa ctions conducted by professiona l intermedia ries, such a s Stockbrokers, Cha rtered Accountants, Solicitors, etc., a s permitted under the la w, a nd Rela tionship between the ba nker a nd the customer is that of a contra ctual relationship. The following a re the basic types of rela tionship between banker a nd c u s t o me r. 1. De btor s-cr e ditor s Re lationship: The rela tion of a ba nker and a customer is primarily tha t of a debtor a nd a creditor, the respective position being determined by the existing sta te of the a ccount. The money deposited by a customer with the ba nker becomes the la tter s property and is a bsolutely a t his disposa l. Hence, there exists a rela tionship of debtor a nd creditor; the ba nker, being the debtor, is bound to repa y the deposited a s a nd when the customer a sks for it. Sir John Paget said that the relationship of the banker and customer is primarily that of debtors and creditors, the respective positions being determined by the existing state of the account. Special Features of the Debtor-Creditor Relationship a) Ba nker is ca lled a dignified debtor. Virtua lly he borrows money but it is given a na me ca lled deposit. No security need be given for the b or r owi ng. b) Customer is not the secured creditor of the ba nk, a s he is not ha ving a ny cha rge on a ny asset of the ba nk. He is only a n unsecured creditor. c) Customer s bala nce a t ba nk is not repa ya ble until a dema nd for repa yment wa s ma de by the customer. There should be a n express demand for it. d) Ba nker should pa y the deposit money on dema nd by the customer. The deposit should be pa id at the a ppropria te place. e) The demand should be made by the customer on working da ys a nd during the business hours a nd it should be ma de in proper form.

101 92 Banking and Financial Services Apart from the nationalized banks, State Bank of India, and its associate banks, IDBI Bank and Regional Rural Banks are also included in the category of Public Sector Banks. A Banker as a Cr editor: The debtor-creditor rela tionship holds good in the ca se of a deposit account. But, in the case of loa n, ca sh credit a nd overdra ft the ba nker becomes a creditor a nd the customer assumes the role of a debtor. Here a gain the ba nker is a privileged person, because he is a cting a s a secured creditor. He insists upon the submission of adequate securities by the customer to a va il of the loan or ca sh credit fa cilities. Moreover, the la w of limita tion will opera te in such ca ses from the da te of the loa n unless it is renewed. 2. B anke r as a Tr ustee: The ba nker acts a s a trustee for ma na ging the a ssets of others. Toda y ma ny ba nks ha ve sepa rate depa rtments to look a fter this function. The customer may request the bankers to keep his va lua bles in sa fe va ults or one ma y deposit some a ccount a nd ca n request the ba nk to ma na ge tha t the fund for a specific become a trustee for debentures holders or the ba nk collects the cheques, hundies of the customers in the ca pa city of trustee. Thus, there a re wide va rieties of trustee s related functions discha rged by the ba nker. 3. B anke r as an Age nt: There are certa in a gency functions discha rged by the ba nker. He collects cheques, hundies, drafts of the customers, collects dividends, interest on securities, pa ys fees, duties, subscriptions, premiums on beha lf of the costumers, a cts a s a n a gent for buying a nd selling corpora te securities for his customers etc. in this ca se, the ba nker a nd customer rela tionship is in the form of a n Agent a nd Principa l. As far a s the lega l position is concerned, the la w rela ting to a gent a nd principa l will prevail. The ba nker being a n a gent enjoys a ll the rights of a n a gent and is bound by a ll responsibilities that the stipula ted in the la w rela ting to an a gent. Ba sica lly, he should carry out the instructions of his principal (customers) a nd give a ll profits a nd benefits to his principal, derived out of a gency transa ctions. He is entitled only to the commission stipula ted in the a g r e e me n t. 4. B anke r as a B ailee: The customers ca n keep his va lua bles or any secret documents in the ba nk for sa fe custody. W hen the ba nker a ccepts the same, he will be a ccepting it a s a Ba ilee. As a ba liee, he should protect the va lua bles in his custody with rea sona ble ca re. If the customer suffers a ny loss due to the negligence of the ba nker in protecting the va lua bles, the ba nker is liable to pa y such loss. If any loss is incurred due to the situa tion beyond the control of the ba nker, he is not lia ble for pena lty beca use, ba nker is not an insurer a nd he is only a ba liee. La stly, the ba nker should ha nd over these va lua bles on dema nd by the customer. 5. Banker as Le ssor: Section 105 of Transfer & Property Act deals with lease, lesser, lessee. In ca se of sa fe deposit locker a ccounts,the banker a nd customer rela tionship of lesser/ lessee is a pplica ble. Ba nks lea se the sa fe deposit lockers (ba nk s immova ble property) to the clients on hire ba sis. Ba nks a llow their locker a ccount holders the right to enjoy (ma ke use of ) the property for a specific period a ga inst payment of rent.

102 Commercial Banking I 93 RIGHTS AND OBLIGATIONS OF THE BANKER Specia l rela tionship between ba nker a nd customer is rela ted to rights a nd obliga tions of ba nker. Following are the rights and obliga tions enjoyed by the ba nker with rega rd to the customer s a ccount: Rights 1. Ba nker s right of genera l lien. 2. Right to cha rge interest, commission, incidenta l cha rges, commitment char ge s. 3. Right to set off or right to combine ba nk a ccounts. 4. Right to a ppropria te pa yments. 5. Right under Garnishee order. Obligations 1. To honour customer s cheques. 2. To ma inta in secrecy of customer s a ccount. 3. Receive cheques a nd other instruments for collection. 4. Honour the cheques of customers across the counter. 5. Give reasona ble notice before closing the customer s a ccount. 6. Obliga tion to provide a ll ba nking services to customer Some of these rights a nd obliga tions a re discussed below. Rights of the Banker Banker is called a dignified debtor. Virtually, he borrows money but it is given a name called deposit. No security need be given for the borrowing. 1. Banker s Right of General Lien Lien is a term used to identify the right to reta in a property belonging to a debtor till such time he discha rges the debt due to the reta iner of the property. Lien is simply a right to possess a property. Lien will be lost when the possession of the property is lost. The lien ma y be a particula r lien or genera l lien. Partic ular Lien: This lien refers to a pa rticula r property which is reta ined by the lender or creditor a ga inst the specific or pa rticula r loa n. The particula r property will be reta ined until the particula r debt is clea red by the debtor. For example, a tra nsport opera tor ca n retain the property sent for tra nshipment till such time the customer pays his tra nsport cha rges. Ge ne r al Lie n: Genera l lien is a right of the ba nker (creditors) to reta in a ll the properties of debtors (customers) till a ll the sums due to the ba nk a re recovered. In the a bsence of a ny a greement to the contra ry, ba nker may reta in a ny goods a nd securities ba iled to him as a security for genera l bala nce of a ccounts. The Indian Contra ct Act ( U/ s 171) provides, this right a nd this right is ca lled Genera l Lien. This extends to a ll properties lodged with the ba nker without a ny specific a ppropria tion. These properties a nd securities held by the ba nker la wfully can be liquida ted by him to liquida te the general ba la nce due from the customer.

103 94 Banking and Financial Services The ba sic object of genera l lien is to ha ve protection for the ba nk funds. The loa ns or a dva nces gra nted to customers ca n be recovered ea sily if genera l lien is exercised by the ba nker. According to Sec. 13 of Negotiable Instruments Act of Negotiable instruments means promissory notes, bills of exchange/ cheques payable either to order or to bearer. Exercising of Lien The ba nker should sa tisfy certa in conditions to exercise lien. They are: (i) The property should come to the possession of the banker. If the ba nker losses the possession of the property, the lien is lost. (ii) Security should belong to the customer, Genera l lien extends only to the customer s own securities. (iii) The property or security should not be lodged with a specific purpose. There should not be express or implied a greement between the ba nker a nd the customer which is inconsistent with the genera l lien. (iv) There should be the la wful possession of the goods or securities by the ba nker and they must come to the banker in his ca pacity a s ba nker (This mea ns the securities should be lodged a ga inst a dva nces). (v) The loa n must be due for pa yment when the lien ha s to be exercised. 2. Right to Charge Interest, Commission, Incidental Charges, Commitment Char ges (i) Inte r e st : The ba nker has a right to cha rge interest on a n implied right enjoyed by virtue of the custom. But most of the time, the ba nker enters into a n express a greement to cha rge interest on outsta nding ba la nces. It is the norma l pra ctice of every ba nker to ca lcula te interest a t every quarter or half-yea r a nd debit the same to the loa n a ccount. (ii) Commission: The ba nker ha s a n implied right to charge commission for the services he renders to the customers. (iii) Incide ntal Char ge s: Incidenta l charge is a levy imposed by the ba nker on unremunera tive current a ccounts. Aga in this is a n implied right enjoyed by the ba nker. Norma lly it is not charged on the current a ccounts whose ba lances ca n be profita bly employed by the banker. It is a lso not cha rged on time deposits a nd sa vings ba nk accounts whose opera tiona l cost is very mea gre. These cha rges need not be pa id in ca sh but will be debited to the customer s current a ccount. This is a right enjoyed by the ba nker. These cha rges ca nnot be debited to the current a ccounts on the da tes other than the prescribed da tes. (iv) Commitment Charges: This is a charge ma de by the ba nker on overdrafts a nd ca sh credit a ccounts. Besides cha rging interest on the utilised portion of the overdra ft, the commitment cha rge is cha rged on the unutilised portion of the sa nctioned limit which does not ea rn a ny profit to the ba nker.

104 Commercial Banking I Right of Set-off Right of set-off is a right to a djust the a ccounts of one a gainst the other between the debtor a nd the creditor to determine the net ba la nce due to either debtor or creditor. Supposing X ha s to pa y Y ` 10,000 and Y has to pa y X `4, 000. After a djusting `4, 000 to X s a ccount, as Y ha s to pa y a net ba lance of `6, 000. This a djustment, between the pa rties is ca lled set-off. The ba nker, a s a debtor ha s the right of set-off. This right empowers the banker to a djust the bala nces a t the credit of the customer s account towa rds the a mount due to the ba nker. If a customer holds two a ccounts in the sa me ca pacity, the a ccount can be a djusted one a ga inst the other or the a ccounts ca n be combined a s per the right of setoff. The right of set-off fa cilita tes the ba nker to know the net a mount due to him from the customer a nd ensures the safety of funds. Conditions to Exercise the Right of Set-off (i) (ii) The debts must be certa in a nd due on the da te. In the a bsence of a n a greement to the contra ry, the ba nker ca nnot exercise the right of setoff for contingent debts. He ca nnot withhold the customer s credit ba la nce to meet a debt tha t may a rise a t a further da te due to the dishonour of a bill, etc. The debts a re due as between the sa me pa rties a nd in the sa me right. This mea ns that the debt should be mutua l a nd due between the sa me pa rties. Even if the a ccounts are held by the customer in different ca pa cities the right of set-off ca nnot be exercised. This mea ns (a) debt due by a customer cannot be set-off a ga inst a joint a ccount or (b) against trust a ccount (c) or a ga inst partnership account or (d) a ga inst the account held a s a n agent or (e) held a s guardia n of a minor (f) or a ga inst the client s a ccount held by a n advoca te (g) or aga inst the a ccount of a client held in a n officia l ca pa city. (iii) The banke r e njoys the r ight of Automatic set-off in ce r tain c ase s. (a) W hen customer becomes insolvent or insane; (b) W hen customer dies; (c) On the insolvency of a pa rtner of a firm or on the winding up of a c o mp a n y ; (d) W hen ba nk receives a Ga rnishee Order from the court (this a spect is dealt elsewhere in deta il in this book); (e) On receiving the notice of a ssignment of a customer s credit ba lance; (f) On receiving the notice of second mortga ge on the security on which the ba nk holds first cha rge. Thus, the right of set-off is a sta tutory right. But to exercise this right it is the norma l pra ctice of the banker to obta in a letter of set-off from the customer. This letter is a n a greement between the ba nker a nd the customer which provides suita ble cla uses to protect the interest of the ba nker in future from the possible objections ra ised by exercising this right. As per Negotiable Instruments Act,1881, a cheque is a bill of exchange drawn on a specified banker and payable on demand

105 96 Banking and Financial Services The maker of a cheque is called the Drawer, the person thereby directed to pay is called Drawee and the person named in the instruments, to whom or to whose order the money is by the instrument direct to be paid, is called the Payee. 4. Right to Appropriate Payments W hen a customer ra ises more tha n one loa n a ccount, the question of a ppropria tion a rises. The payment ma de by the customer ma y not be sufficient to clea r a ll debts due by the customer. Simila rly, when a customer holds more than one current account a nd regula rly opera tes these a ccounts by depositing funds a nd ma king withdra wa ls simulta neously in all the a ccounts he holds, it will be a problem for the ba nker to a ppropriate which fund to which a ccount. In such circumstances, he ha s to follow the rules governing the a ppropria tion. The genera l rule is tha t the debtor (customer) ha s the first choice a nd he ca n a ppropriate the funds a ccording to his desire. Thus, he ca n close or reduce a ny debt he wa nts. The appropria tion should ta ke pla ce a t the time of pa yment. The India n Contra ct Act, 1872 provides under section 59 tha t when a pa yment is ma de by a debtor to his creditor with a n express or implied instruction tha t the pa yment should be applied towa rds the discha rge of a particula r debt, the creditor should apply the pa yment a ccording to the debtor s instruction. If the debtor does not take a ny decision regarding a ppropriation a t the time of pa yment, then the creditor (ba nker) has the choice. In this ca se, the creditor ca n a ppropria te the funds even for time ba rred debts. But to what a ccount the a ppropria tion is made should be informed to the customer. The right of a ppropria tion ca n be exercised a t a ny time the banker wa nts. It ca n be ma de a t the time of repa yment ma de by the customer or a t the time when the lega l proceedings a re going on a ga inst the customer. This right wa s upheld in the ca se. But a fter effecting the a ppropria tion, it ca nnot be cha nged, va ried or reappropria ted a nd under section 60 of the Indian Contra ct Act, the creditor ca n a ppropria te the funds to any lawful debt including the time-ba rred debt but not the unla wful or a disputed debt. 5. Right Under Garnishee Order The term ga rnishee is derived from the La tin word garnire which mea ns to wa rn. This order ba rs the holders of money of judgement debtor, not to ma ke a ny pa yment out of it till the court directs. Ga rnishee order is issued by the court a t the request of the judgement creditor. Let us ta ke a n exa mple to clearly expla in this procedure. A is a contractor and obta ins a loa n from B a money lender or banker. A fails to pay the money to B a s per the stipulation. Hence, B files a suit in the court of law for dues. B also knows that the money is due to A from the agency (third pa rty) with which he is doing his contra ct business. Now B ca n request the court to issue a n order directing the A a gency not to ma ke a ny payment. If the court issues the order, tha t becomes a ga rnishee order. In this suit A is judgement debtor and B is a judgement creditor. The third pa rty is ga rnishee. Provision of the issua nce of Ga rnishee Order ha s been ma de under Sec. 60 of the Code of Civil Procedure 1908 (Rule 46 of Order XXI of Schedule to the Code of Civil Procedure) Thus garnishee order is a direction given by the court to a third pa rty or ga rnishee, who is due to the judgement debtor a nd not to ma ke a ny pa yment till it gives a verdict regarding the paid money. This order is issued a t the request of the judgement creditor. The gar nishe e or de r is imple me nted in two stage s.

106 Commercial Banking I 97 In the first phase an order nisi is issued. This order nisi (mea ns unless ) directs the ga rnishee not to pa y the money of judgement debtor la ying in his (garnishee) hands till the court directs. Virtua lly, this is a n a tta chment of funds lying in the ha nds of ga rnishee. Court a lso a sks ga rnishee to give his sta tement in the court whether the funds in his hand be a ppropria ted towa rds the judgement debt. Garnishee should be present in the court on the appointed da te a nd time to file his objections. If the ga rnishee ha s no objection, the court will pa ss a n order directing the ga rnishee to ma ke pa yment to sa tisfy the judgement debt. This order is ca lled order absolute. Obligations of the Banker 1. Obligations to Honour Customer s Cheques The ba nker has a n obligation to honour customer s cheque a s a nd when they a re presetned a s long a s sufficient funds a re ava ilable at credit in customer s a ccount. According to the banker s prima ry contract is to repa y the money received fro his customer s account usually by honoring his cheques. This obliga tion a rises out of two implied situa tions between the parties: (1) The banker should repa y the borrowed fund whenever the customer demands it (2) The customer s reputa tion should not be da ma ged by the ba nker by dishonouring the cheques except on rea sona ble grounds. Section 31 of the Negotia ble Instruments Act, 1881, sta tes tha t the drawee of a cheque having sufficient funds of the dra wer in his ha nds must pa y the cheque when duly required to do. This provision clea rly indica tes tha t the ba nker should honour the customer s dema nd for pa yment by cheque on certa in conditions which a re sta ted below: (i) The customer should ha ve credit ba lance in his a ccount which should be equa l to the a mount sta ted in the cheque. But the cheque ca nnot be dishonoured, even when there is debit ba la nce in the current a ccount under overdra ft fa cilities. The ba nker is bound to honour the cheques upto the sa nctioned limit. If the overdraft (OD) facility is not given, the cheque ca n be dishonoured when sufficient fund is not a vaila ble in the credit of the customer s a ccount. (ii) The funds must be ca pa ble of being properly applied to the payment of customer s cheque. This mea ns, tha t the funds ma intained for a specific purpose or trust funds or the funds a ssigned in the na me of some other person cannot be a pplied for honouring the cheques. Thus, the funds so sought by the customer by cheque should be unencumbered, a nd must be ca pa ble for being properly a pplied. (iii) The instrument used for dra wing the a mount should be properly written a nd fulfil a ll legal obliga tions. (iv) The cheque drawn must be properly da ted a nd presented for pa yment in a reasona ble time. It is a convention followed by ba nkers in India to The payment of crossed cheque is not made over the counter at the bank. It is only credited to the bank account of the payee. A cheque can be crossed by drawing two transverse parallel lines across the cheque, with or without the writing Account Payee or Not Negotiable.

107 98 Banking and Financial Services honour the cheques for six months from the da te of dra wing the cheque. (presently it is three months). If this period passes, the cheque becomes a sta te cheque a nd the ba nker can dishonour such cheques. Even the postda ted cheques (cheque presented before the da te of pa yment stated in the cheque) a nd cheques presented a fter business hours ca n also be dishonoured. (v) W hen the bills or cheques a re presented for collection and if the customer presents a cheque for drawing the amount of collection even before it is collected, the ba nker ca n dishonour such cheque with the remark (ENC) (effect not clea red). Thus, a nother condition for honouring the order for the debts due by a pa rtner in his individua l ca pa city. (vi) Another condition is that there should not be a ny lega l restriction to pa ss the cheque for pa yment, sa y in ca se of the ga rnishee order when restriction is imposed on the a ccount. Material alteration of a cheque means altering the contents of the instrument in such a way that it becomes an invalid instrument. 2. Obligation to Maintain Secrecy of Customer s Account It is a general understa nding between the customer and banker, tha t the ba nker should ma inta in secrecy rega rding the customer s a ccount. It is believed a nd the fa ct is a lso tha t if the a ccounts a re disclosed to others, the image of the customer will be lost or it would a ffect the customer s business hea vily. Hence, it wa s the practice of the ba nkers not to disclose the accounts a nd ba nking opera tions of the customers to others and this was lega lised in a ca se Hardy v s Ve ase ay The court held that the ba nker must not disclose the sta te of his customer s a ccount or a ny other informa tion concerning the customer or his a ffairs except on rea sona ble a nd proper occa sions. In this ca se, da mages for breach of contra ct is awarded if it is found that customer s interest has suffered beca use of the disclosure of the a ccount which is not justified. But in the following cases the banke r can disc lose the details of the custome rs a c c o unt Disc losure as pe r law: The ba nker ca n disclose the accounts of the customer a s a nd when demanded by the a uthorities a s per the law. He ca n disclose the a ccounts to Income tax a uthorities under section 131 of the Income Ta x Act, Under section 133, the ta x a uthorities ca n call for informa tion useful for their exa mination in a ny proceedings under the Act. The investiga ting officer of a J oint Stock Compa ny as per the provisions of the India n Compa nies Act, 1956, can examine the ba nk accounts of the company under investiga tion. Simila rly under Foreign Excha nge Ma nagement Act, the bank a ccount of a customer ca n be exa mined for the purpose of investigation. Under the customs Act, under crimina l procedure code, under the Ba nking Regula tion Act, 1949, under the Industrial Dispute Act or under the provisions of any other Act, the investiga ting officer or a ny a uthorised officer ca n obta in informa tion rega rding the ba nk a ccount of a customer or a n orga nisation, which the ba nker ca nnot r efu s e. Disc losure at the will of c ustom e r : The ba nker ca n disclose the sta te of a ffa irs of the customer s a ccount when the customer gives his consent to disclose the a ccount. The auditor of the orga nisa tion ca n fully exa mine the customer s

108 Commercial Banking I 99 a ccount when an express consent is given by him. Similarly when a customer gives the na me of a guara ntor, the guara ntor ca n exa mine the a ccounts of the customer which the ba nker should furnish. W hen the ba nker a cts a s a reference, he ca n disclose the a ccounts of the customer. Disc losure in public inte re st: If a customer holds a n illega l account which is a ga inst the interest of the nation, the ba nker should disclose the a ccount to proper a uthorities. Disc losure in the inte re st of bank: The ba nker, in his own interest ca n disclose the a ccount of the customer. Supposing the customer fa ils to clea r the debt, the ba nker looks at the gua ra ntor a nd the gua ra ntor can a sk for the disclosure of the borrower s a ccount which the ba nker does, a nd he is justified in doing so. Disc losure as c om m on c ourte sy : If a fellow banker asks a bout the credit worthiness of a customer, the ba nker is obliged to disclose by a nswering credit enquiries. This is known a s common courtesy. However, while answering such enquiries, the banker should be ca reful. If the informa tion given is not justifia ble, he ma y be sued for libel by his customer. On the other ha nd, if his disclosure is highly fa vorable, the customer may cha rge him for negligence. Some court decisions bea r testimony to this. 3. Receive cheques and other instruments for Collection The ba nker is under obliga tion to receive a nd collect cheques, Dema nd draft, bills of excha nge a nd other instruments of simila r na ture on beha lf of his customer. For this service ba nker cha rge a ressona ble a mount of service char ge s. 4. Honour the Cheques of Customers Across the Counter Not only ba nker is under obliga tion to collect the cheque on beha lf of the customer, but a lso he should honour the cheque issued by customers a cross the counter and make payments. Cheque ma y be issued by the customer to self (where monye is withdra wn by the customer himself) or ma y be issued to a third pa rty (bea rer or open cheque). Before introduction of CTS there used to be a Service Branch which is a specialised branch of a bank for handling the clearing process. 5. Give Reasonable Notice before Closing the Customers Account For a ny rea son if ba nker ha s to close the a ccount of any customer, he ha s to give rea sona ble notice to the customer na rra ting in deta il the circumsta nces a nd rea sons forcing him to close the a ccount. 6. Obligation to Provide All Banking Services to Customer The ba nker is under obliga tion to provide a ll rea sona ble ba nking service to a ll its customers without any discrimina tion. SOURCES OF FUNDS OF COMMERCIAL BANKS Share Capital Commercial ba nks a re genera lly orga niz ed in the form of joint stock compa ny. As a joint stock compa nies collect ca pita l by selling sha res a nd

109 100 Banking and Financial Services debentures, so a lso commercial ba nks raise ca pital through the issue of shares to the public. This is ca lled sha re ca pita l. The sha re ca pital represents the initia l ca pita l provided by the public in the form of buying sha res. Rega rding the issue of sha res to the public, the ba nks a re expected to follow the regula tions of the Ba nking Regula tions Act, of According to this Act, the subscribed ca pita l should not be less tha n 50 per cent of the a uthorised ca pita l. The pa id-up ca pita l should not be less tha n 60 per cent of subscribed capit al. One of the statutory obligations of the bank is to maintain a prescribed percentage of its Demand and Time Deposits in the form of cash with RBI which is called as cash reserve ratio Reserve Fund and Other Reserves Reserve fund a nd other reserves form second item sources of funds for ba nks. Reserve fund constitutes the a ccumula ted profits of the ba nk. As a nd when the ba nks makes profit, a certa in percenta ge of profit should be set a pa rt to meet unforeseen contingencies. This forms the reserve fund. Reserve fund is genera lly used whenever the ba nk fa ces losses. Though this is not contributed by the sha reholders, it belongs to them a s it is the a ccumula ted profits of the orga nisation. According to the India n La w, the reserve fund should be equa l to its pa id-up ca pital. The la w stipula tes that 20 per cent of the profits should be transferred to the reserve fund. So long a s the ba nk ma intains higher reserve fund, the grea ter is the confidence the public ha ve in the ba nk. Generally, the reserve fund is not kept in the form of ca sh. It is invested in the form of government securities. In a ddition to the published reserve, the ba nk ma intains other secret reserves. Deposits The rea l resources for the bank a re va rious types of deposits a ccepted by the ba nk. The deposits are the la rgest single item on the lia bilities side. Deposits occupy an importa nt pla ce in the ba nking a ctivity. W ithout deposits ba nk ca nnot do ba nking business effectively. Deposits a re of va rious types such a s fixed or time deposits, current deposits, sa vings deposits, recurring deposits a nd so on. Borrowing from RBI and Other Banks Inter bank tra nsa ctions a re common in these da ys. Ba nks genera lly borrow from other banks during the times of need. Ba nks borrow from other ba nks for a short period only. Banks mostly borrow from centra l ba nk (RBI) for a fixed period through rediscounting the eligible bills of excha nge. Bills Payable This is a liability for, the ba nks a ccept the responsibility of making pa yments to bills from its resources. Bills for Collection, being Bills Receivable Bills for collection mea ns the bills received by the ba nks from the customers for collection. The a mount when collected is credited to the a ccounts of the customers. It is shown not only on a ssets side, but also on the lia bilities side. They a re the a ssets before collection. They are lia bilities a fter the collection. It is a counter item a ppea ring on both the sides.

110 Commercial Banking I 101 Acceptances and Endorsements One of the functions of the bank is to a ccept or endorse the bills of excha nge on beha lf of the customers. W hen the bill of excha nge is a ccepted, it gives guara ntee for the pa yment of the bill on ma turity. The bank a ccepts the responsibility of pa ying the bill in ca se the customers fa il to settle it a t the time of ma turity. Hence, this is a liability of the ba nk. They a re a lso a ssets to the ba nk, for the ba nk is entitled to recover the a mounts from the customers in due c o u r s e. Contingent Liabilities There a re unforeseea ble items which a re shown on the lia bilities. They ma y be of pension fund, uncla imed dividends, etc. These items a re shown sepa ra tely in the ba la nce sheet. For contingency, the banks provide some a mount, which is shown in the lia bilities column. INVESTMENT POLICY OF COMMERCIAL BANKS The investment policy of a commercia l ba nk dea ls with the technica lities of investment. The investment of ba nk funds especia lly the deposits is a difficult a nd risky ta sk beca use of the bank investing somebody s money, na mely the depositors. Whenever the depositors present cheques for enca shment, they must be immedia tely honoured. If the pa yment is delayed, the confidence of the public with the ba nk is threa tened. In fa ct, the a ctivities of the bank depend upon the confidence with which the depositors are ha ving with the bank. The banks ha ve to pa y rea sonable rate of interest in order to a ttract fixed deposits. If the banks mobiliz e more of fixed deposit, it ca n invest in profita ble ventures. The ba nk ha s the responsibility of pa ying handsome dividend to sha reholders too. The a dministra tion charges in the form of sa la ries, a nd bonus a nd incentives a re a lso quite high. All these compulsions ma ke the banker to invest the funds in a proper ma nner. It is said tha t the soundness of the ba nk is reflected in the distribution of funds on different types of a ssets. There a re no ha rd a nd fa st rules for the investment of funds. But some conventions ha ve been esta blished a nd the ba nks a re required to follow them. The investment policy of ba nks is not uniform throughout the world. The loca l conditions in which the ba nk functions influence profoundly in formula ting a suita ble investment policy. The na ture and a vaila bility of funds a lso pla y a crucia l role in a cquiring different types of a ssets. Conditions differ between individua l countries a nd also between the regions within country. The problem tha t ba nks fa ce in rura l a rea s are different from urba n a rea s. The dema nd for funds in the urban a rea s is more tha n in rura l area s including the dema nd for funds for a griculture a nd industry. These differences have their impa ct on the investment policy of the bank. A specified percentage of the bank s total Demand and Time Liabilities have to be maintained by way of investments in approved securities, cash in hand, gold or excess balance with the RBI. Principles to be Observed in Investment Policy The guiding principles of the investment policy of a commercia l ba nk a re liquidity, profita bility a nd security. These three principles are inter rela ted a nd a s such, the ba nk ca nnot ignore any one of these principles. Apart from these

111 102 Banking and Financial Services three conditiona l principles, there a re other minor principles which the ba nk is expected to look into. They a re productivity, diversity, sa la bility a nd sta bility which need to be monitored by the ba nk ma na gement while investing funds. As the banks have to maintain around % of the demand and time liabilities with RBI by way of CRR and SLR, RBI plays a role in controlling the country s economy. Also RBI keeps changing the CRR and SLR percentages depending on the movement of the economy. (a) Liquidity Liquidity is the most important principle tha t a ba nk ha s to bea r in mind while considering the a pplication of funds. Liquidity mea ns the ability of the ba nk to produce ca sh on dema nd. As a nd when the bank receives deposits, it intends to invest them on a ssets. W henever there is a dema nd for ca sh, the ba nk must be in a position to sell the a sset without a ny loss to meet the claims of depositors. Liquid asset is a n a sset is completely liquid, if its owner ca n count with a bsolute certa inty on turning it into ca sh a t a very short notice a nd without loss If the a ssets a re converted into ca sh quickly, then they a re sa id to be liquid. If the cla ims of the depositors a re to be sa tisfied, the ba nker s a ssets must be convertible into ca sh without loss. In normal times, a ssets ca n be sold either to the public or to other banks without any loss. But in times of fina ncia l crisis such as depression, the problem of finding potentia l buyers for the a ssets a rises. At such times, it is only the centra l ba nk tha t will be in position to buy the a ssets. But they will not buy a ll types of a ssets. It ma y buy the gilt-edged securities a nd not the bills of exchange of businessmen. Therefore, the considera tion of liquidity is very importa nt in the distribution of a ssets. Thus, ba nks must invest funds in those a ssets which a re liquid in chara cter. (b) Profitability Profita bility is the next importa nt objective of a commercia l ba nk. A commercia l ba nk is a business institution which a ims a t ma ximising profits. The commercia l ba nk is very much concerned with making a s high a profit a s possible. In a cquiring money, the sole considera tion of a commercia l bank is to ea rn a n income. The ba nk must ea rn sufficient income from its a ssets in order to meet a ll expenses of the ba nk including dividends to the sha reholders. The income will be greater if the yield from the assets is higher. Therefore, the ba nk will distribute the funds in such a ma nner a s to get higher income. If the ba nk keeps more cash reserves on the ground for meeting cla ims of the depositors, the ea rning ca pa city is reduced. Therefore, the ba nk does not keep more cash. In order to meet the immediate cla ims of the depositors, it ma inta ins a sma ll a mount of ca sh. The ba nk knows tha t a ll depositors do not come t o the ba nk to enca sh the deposit simulta neously. Therefore, it ta kes the liberty in ma king investment on profita ble a ssets. The ma in profit-ea rning a ssets a re loa ns a nd a dva nces. Even here, some reserva tions a re ma de by the ba nk. Only a rea sonable percentage of deposits a re used to lend a gainst bills of excha nge a nd overdra fts. Liquid and Profitability Conflicting Considerations Liquidity a nd profita bility a re conflicting considerations. Ca sh is a ba rren a sset for it does not bring any income to the ba nk. Loans a nd a dvances a re profit-ea rning a ssets but they cannot be readily convertible into ca sh. Thus, the ba nk fa ces these two conflicting considera tions. Therefore, a good ba nker

112 Commercial Banking I 103 is one who reconciles the opposing considera tions. The secret of successful ba nking is to distribute between the va rious forms of a ssets in such a wa y a s to get a sound ba la nce between liquidity a nd profita bility so that there is ca sh on ha nd or quickly realisa ble a ssets to meet every cla im and a t the sa me time enough income to pay its wa y a nd ea rn profits for its sha reholders. W hile a cquiring a ssets, the ba nker is required to bea r in mind two basic considera tions: (a) The a ssets should be distributed in such a wa y tha t they should bring in maximum a mount of profit for sha reholders a nd (b) There should a lwa ys be a dequa te a mount of ca sh or non-ca sh a ssets which should be ea sily convertible into ca sh so a s to meet the depositors dema nd at a ll times a nd in ful l. (c) Shiftability In course of time, a nother considera tion wa s a dded to the concept of liquidity, na mely, shiftability, that is a ssets a cquired by a ba nk should be ea sily shifta ble to other ba nks or to the centra l bank. In times of emergency, which a particula r ba nk may fa ce shiftability becomes very important. An a sset is shifta ble to central ba nk if it fulfils certa in norms of eligibility. Centra l ba nk being the lender of la st resort, commercia l ba nks look to the centra l bank for a ssista nce. The centra l bank re-discounts the bills of excha nge if they fa ll in the eligibility criteria. This fa cility ha s in recent times, enha nced the liquidity position a nd the prestige of the entire banking system. (d) Security The next importa nt principle is security or sa fety. Since the ba nk dea ls in other people s money, it ha s to give greater considera tion for security. Unsecured a ssets are a lwa ys da ngerous. In order to sa fegua rd the funds of the depositors, a ba nk should invest its funds on sa fe assets. If the bank wants to provide fina ncial a ssista nce to businessmen, it would discount short-da ted bills. The bills a lso should be genuine, bearing endorsements of two fina ncia l institutions, such a s ba nks or acceptance houses. Investments on short-da ted government securities or gilt-edged securities a re prefera ble beca use these a re sa fe from a ny point of view. The ba nk should never under-estima te the sa fety principle while deciding on investment of funds. If it neglects this principle, it may enda nger its very existence. If the ba nk lends to credit unworthy borrowers, it ha s to suffer very heavy losses. Tha t is why, the ba nking principle prohibits the bank in gra nting a dva nce to unsecured a ssets. The difference in interest received on the amount lent and the interest paid on the deposits collected. This difference between interest earned and paid is also called Spread. (e) Principle of Productivity This is a nother importa nt principle put forth by banking experts. According to them, the ba nk should invest its surplus funds in such a way a s to secure for itself an a dequa te a nd permanent income. The objective of the bank is to ea rn ma ximum profits a nd its income must be a cquired from productive investments. If the assets a re productive, the income to the ba nk will a lso be sta ble. This principle implies tha t under no circumsta nce, the ba nk should a dva nce funds for specula tive purposes.

113 104 Banking and Financial Services Narasimham committee on banking reforms recommended the reduction of SLR to 25% Demand and Time deposits (f) Principle of Diversity The principle of diversity implies tha t investa ble funds should be invested in a diversified ma nner. It mea ns tha t funds should be provided for a ll types of a ctivities. According to this principle, the banks should a s far a s possible invest its surplus funds in different types of securities a nd in different types of business enterprises. The rea son is tha t if a pa rticula r business orga nisa tion colla pses, the ba nk should not be made to suffer terrible losses. If the investment is evenly distributed among severa l economic a ctivities, then the risk also is distributed properly. If the ba nk invests in diversified securities or ma kes loa ns to different types of business enterprises, it ensures for itself a regula r flow of ca sh with the help of which it can meet the dema nds of its customers. (g) Principle of Saleability of Securities This principle ma inta ins that the ba nk should invest in those securities which could be ea sily sold in the money ma rket. If the ba nk invests in unsa leable securities, it ma y ha ve to suffer from severa l losses. Hence, it is very much desira ble for the ba nk to invest in government or first cla ss securities or in debentures of well-reputed firms. This principle a lso implies tha t the bank should not give loa ns to its customers a gainst immovable properties under a ny c i r c u ms t a n c e s. Thus, in formula ting a n investment policy, the ba nk is expected to strike a ba la nce between liquidity a nd profita bility. Equal importa nce has to be given for productivity a nd security. Conclusion Genera lly speaking, the investments a re cla ssified into non-profitable investments and profitable investments. Ca sh is a non-profita ble investment. But the ba nk ha s to ma inta in rea sona ble a mount of ca sh in order to fulfil lega l obliga tions. Then there is another item of non-profitable investment, na mely, buildings, sta tionery and furniture, etc. These a re dea d stores because they ca nnot be disposed off in the ma rket ea sily and quickly. However, the banks invest on buildings a nd decora tions with a view to mainta in its prestige a nd r e pu t a t i on. Then there a re profita ble investments, such a s ca ll money or short-term loans, discounting the commercia l bills of excha nge a nd trea sury bills, loa ns a nd a dvances to businessmen a nd investment in securities. In such investments, the bank is required to strike a proper ba lance between profita bility a nd liquidity. Investment Policy of Commercials Banks in India Ba nks a re financia l intermediaries a nd lending is a n importa nt function of a ba nk. The ba nk collects deposits of va rious kinds from people by mea ns of giving rea sonable, a nd sometimes, a ttra ctive interest and lend the sa me to industries tra de and tra nsport people a t a higher ra te of interest and thus makes some profit. Ba nks ha ve to ea rn money if they want to function effectively. Their sole interest is not to ma ke profit a nd decla re higher dividends to the shareholders. They a re guided by the statutory regula tions while employing

114 Commercial Banking I 105 ba nk funds. The Banking Regula tion Act a nd the credit regulation policy of the Reserve Ba nk of India and the socia l responsibility imposed by the Government on ba nks a re some of the pa ra meters on which the ba nks ha ve to lend. Lending sets in motion a cha in of economic activities both direct a nd indirect a nd fosters new services which a re conducive to a ccelera ted socio-economic growth. Ba nk fina nce results in increa sed production of goods and services, crea tion of more employment a nd income generation in the country. Further, ba nk lending helps in the crea tion of infra structure in a big wa y. After na tiona lisa tion, the credit policy is a imed a t a llevia tion of poverty. Government of India set up regiona l rura l banks with direct involvement of commercia l ba nks to provide more credit for development of rura l economy. Lending a lso increa ses the profits of c ompa ny, when higher profits a re tra nsferred to increa se the ca pita l base, ba nks ca n pla y crucia l role in the economic development of the country. If ba nks lend in risky enterprises, which secure sufficient profits, the recovery of loan will be doubtful. If the ba nks do not lend, they ca nnot ma ke their position safe. The lending policy of the commercia l banks is ba sed upon National Credit Policy promulga ted by the Government. The Reserve Ba nk of India (RBI) a nnounces the credit policy applica ble to commercia l banks both in sla ck season a nd busy sea son. During these sea sons, the RBI a s a part of its credit policy, formula te the priorities to be observed by ba nks in the deployment of credit. W hile investing the funds, the commercial ba nks including the public sector ba nks have to observe sta tutory obliga tions. Investments of Indian Commercial Banks can be categorized as SLR investments and Non-SLR investments Maintenance of Statutory Liquidity Ratio (SLR) Ba nks investments in Centra l and Sta te Government dated securities including treasury bills a re governed by the RBI guidelines rega rding ma intenance of minimum level of SLR securities as well a s their own a pproved poli cy. As sta ted ea rlier, under the Ba nking Regula tion Act, 1949, the RBI prescribes the minimum SLR level for Scheduled Commercia l Banks (SCBs) in India in specified a ssets a s a percentage of the ba nk s NDTL. The a ctua l percentage (tha t is, the va lue of such a ssets of a n SCB a s a percenta ge of its NDTL) must not be less tha n such stipulated percenta ge. The RBI may change the stipula ted percenta ge from time to time. Over the years, this ratio (SLR ratio) has changed a lot, but has broadly moved on a downward tra jectory, from the of 38.5% of NDTL in the early 90s (September 1990) to 25% by October 1997, with the financia l sector reforms giving banks grea ter flexibility to determine their respective a sset mix. The SLR wa s further reduced to 24 per cent of NDTL in November 2008, but ha s been ra ised ba ck to 25 per cent level since October Currently, it is a t 24 per cent level. Non Performing Asset means an asset of account of borrower, which has been categorized by a bank or financial institution as substandard, doubtful or loss asset, in accordance with the directions relating to asset classification issued by RBI. The RBI has prescribed that all Scheduled commercial banks ( SCBs) should maintain their SLR in the following instruments which will be referred to as statutory liquidity ratio (SLR) securities

115 106 Banking and Financial Services i. Da ted securities as notified by RBI; i i. Trea sury Bills of the Government of India; i i i. Da ted securities of the Government of India issued from time to time under the ma rket borrowing progra mme a nd the Ma rket Sta bilisa tion S c h e me ; iv. State Development Loa ns (SDLs) of the Sta te Governments issued from time to time under their ma rket borrowing progra mme; a nd Any other instrument a s ma y be notified by RBI. In accordance with the latest asset classification norms, a nonperforming asset (NPA) shall be a loan or an advance, where Interest and /or instalment of principal remain overdue for a period of more than 90 Days. Non-SLR Investments If there is a ny proposa l to invest or disinvest in non-slr securities, the concerned officia ls must refer these proposals to the Investment Committee of the ba nk. Upon vetting and clea ra nce by the Investment Committee, fina ncia l sa nction should be obta ined from the a ppropria te authority in terms of the Scheme of Delega tion of Financia l Powers. Non-SLR Investments can include Investments in Associa tes/ Subsidiaries a nd Regional Rura l Banks Stra tegic Investments Venture Ca pita l Investments PSU Bonds Corpora te Investments Mutua l Funds Bonds/ Debentures issued by Securitisa tion Compa nies ( SCs) a nd Reconstruction Compa nies (RCs) However, a s per RBI guidelines, the investments (SLR as well a s Non-SLR) will be disclosed in the ba lance sheet of the Ba nk a s per the six-ca tegory classifica tion listed below: a. Government securities, b. Other a pproved securities, c. S h a r es, d. Debentures a nd Bonds, e. Investment in subsidia ries/ joint ventures in the form of sha res, debentures, bonds, etc., a nd f. Others ( Commercia l Pa per, Mutual Fund Units, etc.). Sources of Commercial Bank s Income A ba nk is engaged in borrowing a nd lending money. A ba nk ca n ea rn income only if it borrows at a lower rate and lends a t a higher rate. The difference between the two ra tes will represent the costs incurred by the ba nk a nd the profit. Ba nk a lso provides a number of services to its customers for which it

116 Commercial Banking I 107 charges commission. This is also an importa nt source of income. The followings a re the va rious sources of a ba nk s profit: 1. Interest on Loans; 2. Interest on Investments; 3. Discounts; 4. Commission, Brokera ge, etc. ASSETS STRUCTURE OF COMMERCIAL BANKS The a ssets of the ba nk are shown on the right ha nd side of ba la nce sheet. The a ssets side shows how the ba nk ha s distributed the funds entrusted to it. The distribution of ba nk funds on va rious a ssets depends upon the investment policy. The funds of the ba nk a re the lia bilities, beca use they ha ve to be returned to their owners. W henever a depositor tenders a cheque for enca shment, the bank must be in a position to provide ca sh immedia tely. Further, since the ba nk is dea ling in somebody s money, it should ensure sa fety of the money. The sha reholders expect good dividends, the depositors expect a ttra ctive interest a nd a s such the ba nk must bear in mind, the three importa nt principles, na mely sa fety, profita bility a nd liquidity. A good ba nker is one who follows a wise investment policy, a policy which will bring in ma ximum profits for the shareholders and will provide ma ximum security to the depositors. The ma in items a ppea ring on the a ssets side of the ba lance sheet of a commercial ba nk a re as follows: 1. Cash Ca sh is the first a sset in the portfolio of a commercia l ba nk. Since ca sh is the most liquid a sset, it comes first. It is therefore considered a s the First line of Defence. It is also ca lled the prima ry reserve of the bank. If the ba nk fails to pa y ca sh whenever a depositor ma kes a dema nd for it, it loses the confidence of the la tter a nd the public a t la rge. Its very existence depends upon the rea diness with which cash is pa id to the depositors when dema nded. Therefore, the ba nk keeps sufficient ca sh reserve to meet the requirements of the depositors. Genera lly, the ba nks ca nnot keep la rge a mounts in ca sh, because it will a ffect profita bility. By experience, ba nks know how much is to be kept in cash. Genera lly, 9% to 11% of the tota l deposits is kept a s ca sh reserves. Banks keep a certa in percentage of the deposits in the ba nks premises, a certa in portion with other commercia l banks and a certain portion with the central ba nk of the country. A deposit with other ba nks a nd with the centra l ba nk is considered a s good a s ca sh by the commercial ba nk. Banks keep some cash with other commercia l banks either for the purpose of settling inter bank indebtedness or for the purpose of sa fety. Gross NPAs are the sum total of all loan assets that are classified as NPAs as per RBI guidelines as on Balance Sheet date. Gross NPA reflects the quality of the loans made by banks. Net NPAs are those non performing accounts in which the bank has deducted the provision 2. Money at Call and Short Notice Money a t ca ll a nd short notice is aga in considered a s a highly liquid a sset a nd it forms the second line of defense. It represents money lent to dea lers of

117 108 Banking and Financial Services money ma rket. These loa ns a re given to customers for a short period not exceeding two to three weeks. There are three types of ca ll loa ns: (a) loa ns which a re given for one night only. These loa ns a re given to specula tors, (b) loa ns which can be reca lled by the ba nk without notice and (c) short period loa ns a re loans repa ya ble within two weeks. These loa ns a re a lso very sa fe since they a re given only for a short period. They a re profita ble, beca use the interest cha rged on them is higher tha n other types of loans a nd a s such, these a ssets bring more income to the bank. 3. Investments Investments represent money invested in government securities a nd gold or gilt-edged securities. These investments are shown sepa rately in the ba lance sheet beca use they a re governed by sta tutory provisions. The investments on securities is considered very sa fe. It is beca use that the securities ca n be sold to the central ba nk. There is a lways a ma rket for these securities a nd they ca n be rea dily sold without a ny loss of va lue. Since they a re a pproved securities, they ca n be shifted to the central ba nk in times of emergencies. These securities a lso enjoy the cha ra cteristics of liquidity. Some of the main causes of NPA are Ineffective recovery, W ilful defaults, Natural calamities, Industrial sickness, Sluggish Legal System, Unfavourable Business Cycle, Defective lending process, Inappropriate technology, Poor Quality Management, Managerial deficiencies and Absence of Monitoring and Follow-up 4. Bills Discounted Bills discounted represents the money tha t the ba nk lends a ga inst bills of excha nge a nd trea sury bills. Bills of excha nge a re short-term commercial bills. Trea sury bills a re short-term government bills. The dura tion of government trea sury bills is three months, while the dura tion of trade bills va ries from 90 da ys to 180 days. Norma lly, the business people obta in fina ncia l a ssistance from the ba nk by mea ns of discounting the bills of excha nge. These bills ma y be inla nd bills or foreign bills. In India, whenever the government invites tenders for the subscription in government securities, the banks tender quotations for such tenders. These short-term government securities a re not only profita ble, but a lso liquid a nd they ca n be shifted to the central ba nk in times of need. They a re also very sa fe since they a re issued by the government. Apart from investing in short-term government securities, the commercia l ba nks invest a la rge portion of funds in discounting the genuine commercia l bills. They a re a lso more liquid a nd profita ble. These bills a lso ca n be shifted to the centra l ba nk. They are liquid beca use they ma ture ea rly. They a re also sa fe beca use they arise out of genuine commercia l tra nsa ctions. This represents the third line of defence. 5. Loans Advances and Cash Credit Loans a nd a dvances represent the loa ns given to customers. Ba nks generally a dva nce a ga inst proper securities. Ba nks ma y a lso be given loa ns a ga inst persona l security of men of repute. Loans a nd a dvances form a n importa nt a sset, beca use this item reflects the a ctivities of the bank. Loa ns a nd adva nces bring higher income to the ba nk a nd therefore ba nks a re interested in providing loa ns to sound customers. Loa ns a nd a dvances ta ke several forms such a s direct loans, overdra fts, ca sh credit, etc. In the case of loa n, a customer is gra nted a loa n

118 Commercial Banking I 109 either to purcha se ma chinery or a ny ca pita l a sset. W hen the ba nk gra nts a loa n to a businessma n, his a ccount is credited. The customer is required to pa y interest for the entire loa n. An overdra ft is a nother form of loa n, where the customer is permitted to overdra w his account up to a limit. Interest is charged only for the a mount overdra wn in the case of overdra fts. Genera lly, overdra fts a re given to businessmen. Ca sh credit is a form of loa n gra nted by the ba nk to businessmen a nd industria lists. The borrower can withdra w from this a ccount a s a nd when needed. In cash credit, interest is cha rged for the outsta nding debit bala nce in the a ccount. 6. Bills Receivables This is a contra item. Bills for collection represent the a mount due from the a cceptors of bills deposited into the ba nk for collection. There is a lso another item na mely customer s lia bilities for a ccepta nce a nd endorsements. This item represents the tota l dues of the ba nk s customers in respect of obliga tions which the ba nk ha s a ccepted on their beha lf. This item is also shown on the liabilities side of the ba la nce sheet. 7. Building, Furniture and Equipment Under this head is included the tota l value of the buildings, furniture a nd equipment owned by the ba nk. They represent the fixed investments. The value of the fixed a ssets is shown a t their origina l prices only. Their ma rket value might be greater tha n the origina l value. In fact, the bank genera lly underva lues them in the ba la nce sheet. This is done by the ba nk to build up secret reserves which can be ava iled of, if the ba nk fa ces a ny crisis. Though the bank owns a building a nd other a ssets, the tota l va lue of this item is very sma ll when compa red to other lia bilities. It is beca use the convention holds tha t the ba nk should not invest more money on them. This item suffers from the dra wback of ea rly liquidity. At the sa me time, the investment on buildings becomes dea d investment. Ba nks in these da ys a re ha ving ma gnificent buildings out of a ccumula ted profits a nd reserve funds. REVIEW QUESTIONS 1. Expla in the cla ssifica tion of the bank. 2. W hat a re the sources of funds for ba nks? 3. W hat a re the functions of commercial ba nks? 4. Expla in the investment policy of commercia l ba nks. 5. Define the structure of commercia l ba nks in India. 6. Discuss the recommenda tions ma de by Na ra simha m committee on ba nking sector reforms.

119 110 Banking and Financial Services REFERENCES Dr. Gopal Swa roop: Laws and Prac tic e s Re late d to Bank ing, Sulta n Cha nd a nd Sons, New Delhi, Second Rev. Edition, J habva la, N. H., Ne gotiable Instruments Ac t, 1881, C. J a mna da ss a nd Co. B omb a y. K. P. M. Sundhara m and P. N. Va rshney: Bank ing The ory, Law and Prac tic e, Sulta n Cha nd and Sons, New Delhi. Reserve Ba nk of India: 50 Ye ars of Central Banking, RBI, Mumba i, RBI, Re port on Tre nd and Progress of Bank ing in India, various issues. J a la n, Bimal (2000), Summary of the We lc ome Re mark s, a t the 11th CD Deshmukh Lecture, December.

120 CHAPTER 4 COMMERCIAL BANKING II Learning Objectives After rea ding this cha pter you should be a ble to understa nd the recent trends in Indian ba nking the functioning of core ba nking solutions the CTS mecha nism the role of ATMs in modern da y ba nking the electronic fund tra nsfer mecha nism a nd process the concept of Internet a nd mobile ba nking the difference between debit ca rd and credit ca rd the a ctivities of a universa l ba nk

121 112 Banking and Financial Services RECENT TRENDS IN INDIAN BANKING e-banking is one of the emerging trends in Indian banking and is playing a unique role in strengthening the banking sector and improving service quality. In view of libera liz a tion, priva tiz a tion a nd globa liz ation, the entire ba nking structure ha s undergone a major cha nge. As pa rt of the economic reforms, ba nking industry ha s been deregula ted a nd ma de competitive. New pla yers ha ve a dded to the competition. IT revolution ha s ma de it possible to provide ea se a nd flexibility in opera tions to customers. Ra pid strides in informa tion technology have, in fa ct, redefined the role a nd structure of ba nking in India. Further, due to exposure to global trends after Informa tion explosion led by Internet, customers - both Individua ls a nd Corpora tes - a re now dema nding better services with more products from their ba nks. Financia l ma rket has turned into a buyer s ma rket. Ba nks a re also cha nging with time a nd a re trying to become one-stop fina ncial superma rkets. Ma rket focus is shifting from ma ss ba nking products to cla ss ba nking with introduction of va lue added a nd customized products. A few foreign a nd priva te sector ba nks ha ve a lready introduced customiz ed ba nking products like Investment a dvisory services, SGL II a ccounts, Photocredit ca rds, Ca sh ma nagement services, Investment products a nd Ta x a dvisory services. A few banks have gone into mutua l fund schemes. Eventually, the Ba nks pla n to ma rket bonds a nd debentures, when allowed. Ba nks a lso offer a dvisory services termed a s priva te ba nking - to high rela tionship-va lue clients. The ba nk of the future has to be essentia lly a ma rketing organiz a tion that a lso sells ba nking products. New distribution cha nnels are being used; more a nd more ba nks a re outsourcing services like disbursement a nd servicing of consumer loa ns, Credit card business. Direct Selling Agents (DSAs) of va rious ba nks go out and sell their products. They ma ke house calls to get the a pplica tion form filled. Home ba nking has a lrea dy become common, where you ca n order a dra ft or ca sh over phone/ Internet and ha ve it delivered home. ICICI bank wa s the first among the new priva te ba nks to la unch its net ba nking service, ca lled Infinity. It a llows the user to a ccess a ccount informa tion over a secure line, request cheque books and stop payment, a nd even tra nsfer funds between ICICI bank a ccounts. Citiba nk ha s been offering net ba nking to its Suvidha progra m to customers. Products like debit ca rds, flexi deposits, ATM cards, persona l loa ns including consumer loa ns, housing loa ns a nd vehicle loa ns ha ve been introduced by a number of ba nks. Corpora tes a re also deriving benefit from the increa sed va riety of products a nd competition a mong the ba nks. Certifica tes of deposit, Commercial pa pers, Non-convertible Debentures (NCDs) that ca n be traded in the seconda ry ma rket a re ga ining popula rity. Recently, market ha s a lso seen ma jor developments in trea sury a dvisory services. W ith the introduction of rupee floa ting ra tes for deposits a s well a s a dvances, products like interest ra te swa ps a nd forwa rd ra te agreements for foreign excha nge, option contra ct, a nd currency swa p are offered by almost every a uthorised dealer ba nk in the ma rket. Banking Innovations During la st two deca des, India n ba nking sa w a tremendous cha nge, especia lly a fter economic reforms a nd ba nking reforms. Tra ditiona l banking in

122 Commercial Banking II 113 India n context wa s ma inly focusing on borrowing a nd lending of money. Gradua lly ba nks sta rted offering other fa cilities to its customers like, tra nsfer of Funds from one pla ce to another, offering cheque facilities, collection of electricity and telephone bills, sa fe deposit locker facilities etc. But, especially from la st one deca de there has been a n empha sis on e-banking or electronic ba nking. It is a process, whereby informa tion technology is used by the banks to provide various innova tive services to its customers. The various innovative and technology driven services offered by the banks are: A. Core Ba nking Solution B. Cheque Trunca tion Services C. Automatic Teller Ma chines (ATM) D. Electronic Fund tra nsfer E. Home Ba nking F. Teleba nking G. Mobile Ba nking H. Internet Ba nking I. Debit and Credit Ca rds J. Universa l Ba nking K. Reta il Ba nking The influence of Informa tion Technology on the banking industry ha s been fa r rea ching. Tra ditional ba nking still a ccounts for more tha n 80%-85% of ba nking opera tions in the rural a nd semi-urban a reas. But, cha nge over from ma nua l opera tions to computeriz ed ba nking ha s its impa ct more in urba n a nd metropolita n area s. Innova tions in ba nking opera tions ha ve ma de ma ximum impa ct on three a rea s. a. Customer Services. b. Interna l Accounting System. c. Expa nsion a nd Diversifica tion of Ba nking Business. (a) Custome r Se r vic e s: Traditiona l banking use to offer ma inly acceptance of deposit a nd lending money. W ith the computeriz a tion of ba nking opera tions new a nd innovative services are being offered to customers like Insura nce, Electronic Fund Transfer, a nd Depository Services etc. (b) Inter nal Ac c ounting Syste m: W ith the cha nge in ba nking technology, ba nks were a ble to ma ke dra stic cha nges in their interna l a ccounting system. As efficient interna l accounting procedures a re the ba se for quick a nd efficient customer services. (c) Expansion and Diver sific ation of B usine ss: Ba nks which were concentra ting only on tra ditiona l ba nking system, with the cha nge in ba nking technology started expa nding and diversifying their business. Expa nsion wa s done by increasing the number of bra nches a nd even going for oversea s opera tions. By providing more a nd more innovative services, diversification ha s been a chieved by ba nks. Over the years, especially in the later part of the 20th century, the Indian Banking Sector has undergone fast growth and with the advent of technological changes, Indian banks are adopting to the new environment.

123 114 Banking and Financial Services CORE BANKING SOLUTION (CBS) The Core Banking Solutions mainly work on the support of effective communication and good information technology. It is on account of merger of communication technology and information technology which enables the banks to offer core banking needs of the clients. Core Ba nking Solutions is new ja rgon frequently used in ba nking circles. The a dvancement in technology especia lly Internet a nd informa tion technology ha s led to new wa y of doing business in ba nking. The technologies ha ve cut down time, working simulta neously on different issues and increa sed efficiency. The pla tform where communica tion technology and information technology a re merged to suit core needs of ba nking is known a s Core Ba nking Solutions. Core Ba nking Solution (CBS) is networking of bra nches, which ena bles customers to opera te their a ccounts, a nd a va il ba nking services from a ny branch of the ba nk on CBS network, rega rdless of where he ma inta ins his a ccount. Core ba nking beca me possible with the a dvent of computer a nd telecommunica tion technology tha t a llowed informa tion to be sha red between ba nk branches quickly a nd efficiently. A few deca des a go it used to ta ke a t least a da y for a tra nsaction to reflect in the a ccount because ea ch bra nch ha d their loca l servers, a nd the da ta from the server in ea ch bra nch wa s sent in a ba tch to the servers in the datacenter only at the end of the day (EoD). Nowadays, most ba nks use core ba nking applica tions to support their opera tions where CORE ba nking ma y sta nd for centra liz ed online rea l-time electronic ba nking. This ba sica lly mea ns that a ll the ba nk s bra nches a ccess a pplica tions from centra liz ed da ta centers. This means that the deposits ma de a re reflected immedia tely on the ba nk s servers a nd the customer ca n withdra w the deposited money from a ny of the bank s bra nches throughout the world. These a pplica tions now a lso ha ve the ca pa bility to a ddress the needs of corporate customers, providing a comprehensive ba nking solution. The customer is no more the customer of a Bra nch. He becomes the Ba nk s Customer. Thus, CBS is a step towards enha ncing customer convenience through a nywhere and a nytime ba nking by providing the following services. Core Ba nking Solutions ha s helped ba nks to offer better customer service. It ha s a lso reduced the time a nd increa sed the efficiency. The Core Ba nking Solutions ma inly work on the support of effective communication a nd good informa tion technology. It is on account of merger of communica tion technology a nd informa tion technology which ena bles the ba nks to offer core ba nking needs of the clients. Core Ba nking Solutions a re computer-based banking a pplica tions (softwa re) which works on a pla tform. The computer software handles the different functions of the ba nk like, recording of transa ctions, updating the ba la nces in the a ccounts ba sed on the type of tra nsa ctions, ca lcula te interests a nd a pplica tion of interest, cha rges, etc. The softwa re is insta lled in the bra nches a nd the computer systems a re interconnected with a ma in computer server though communica tion lines (telephones, sa tellite, Internet, fibre optica l) CBS is a ba ck-end system, and it processes da ily ba nking tra nsactions a nd updates the records accordingly. CBS helps the clients to opera te their a ccounts from a ny CBS bra nch. CBS bra nch a ssist customers to ha ndle their funds tra nsfers in a quick turna round time. It a lso a ssists the client to withdraw a nd deposit funds in other branches a pa rt from the pa rent bra nch, where he ma inta ins his a c c o u n t.

124 Commercial Banking II 115 Core banking system software offered by different Indian companies Com p an y Na m e 3i In fotech Acu te Softwa res CMC Lim ited (TCS Grou p) Da ta Vision Softwa re Dim en sion s Fin an cials HCL In fos ystem s IDEALINVENT IDSSPL (In fo Dyn a m ic Softwa re) In fosys Tech n ologies In fra softtech La ser Soft In fos ystem s (LSI) Min dm ill Nu cleu s Softwa re Pola ris Proces s wa re Sys tem s Ses a m e Softwa re Solu tion s SIL Sa ra s wa t In fotech Lim ited TCS FS - Ta ta Con s u lta n cy Services Fin an cia l Solu tion s Th em e Tech n ologies Tru s t Sys tem s Ap p lic a t io n Soft wa re Sys t e m KASTLE Ea s yba n k Core co-opera tive ban kin g sys tem TC/ 4 Tota l Con cept - 4 core ban kin g BRAINS 2000 bra n ch sys tem reta il ban kin g Da ta Ma te core ban kin g (In dia ) - Micro Ma te m icrofin a n ce, coopera tive ban kin g Core Ba n kin g Dim en s ion s, Isla m ic Ba n kin g Dim en sion s HCL Ba n cma te CBS core ban kin g solu tion Con n ectcore - Core Ba n k, Bra n ch, Direct Ba n k IDSSPL Core Ba n kin g softwa re - Dyn a m ic Ba n ks oft, Dyn a m ic Cre ditsoft, Dyn a m ic CBS Fin acle OMNIEn te rprise La ser Pa n a cea core ban kin g, Proban ker CB (coopera tive b a n kin g), La ser Twig (s m a ll bra n ch es ), Proban ker PB (priva te ban kin g) Ba n kmill Fin n On e In tellect Su ite - OrbiOn e, Ban kwa re; Ba n know Ba n ksoft in tegra ted core ban kin g softwa re, m icrofin a n ce s olu tion s Bea con PRO core ban kin g solu tion web based CBS SwiftCore core ban kin g s olu tion TCS Ba NCS Un ivers al, Retail, Priva te, Wh oles ale core ban kin g a n d trea su ry su ite (xref. FNS cs -24, TKS Qu a rt z, Alph a Priva te) Th em epro Core Ba n kin g Fra m ework, Microfin a n ce Tru s tba n k on lin e core ban kin g, MicroFin S The two successive Committees on Computerization (Rangarajan Committees) were responsible for bank computerization in India.

125 116 Banking and Financial Services As per the recommendations of the Saraf Committee, the Reserve Bank of India has set up a country wide data communication network for banks linking major centers of the country, known as INFINET (Indian Financial Network) and this network uses satellite communication with very small aperture terminals (VSATs) as earth stations. Facilities Provided under CBS To ma ke enquiries a bout the ba la nce; debit or credit entries in the a ccount a t a ny bra nch of the ba nk To obta in ca sh pa yment out of his a ccount by tendering a cheque a n y w h e r e To deposit a cheque/ ca sh for credit into a ccount a t a ny branch To deposit cheques/ca sh into account of some other person who ha s a ccount in a CBS bra nch. To get sta tement of a ccount a t a ny branch To tra nsfer funds from his a ccount to some other account his own or of third pa rty, provided both a ccounts are in CBS bra nches. To obta in Demand Dra fts or Ba nker s Cheques from a ny bra nch on CBS a nd a mount sha ll be online debited to his a ccount. Customers ca n continue to use ATMs, teleba nking, Internet ba nking and other delivery channels, which are a lso interfaced with CBS pla tform. Advantages of CBS to Customers Customer ca n opera te his a ccount from any of the bra nch of the bank. More service cha nnels ca n be ma de a vaila ble to the customer. Customer gets immedia te credit if the tra nsa ction is between the branches of the bank. Even extension counters ca n provide a ll services to the customer Customer gets full a ttention a nd service sa tisfa ction at the bra nches a s the bra nches a re freed from a ll ba ck office functions, clea ring functions a nd almost a ll accounting functions. Customer ca n get SMS a lerts on his mobile or e-ma il a lerts through net for tra nsa ction ta king pla ce in his a ccount. This gives him comfort a nd s ec ur i t y. Advantages of CBS to Banks Consolida tion of MIS/ statements/ reporting a t one pla ce reducing duplica tion of ta sks a t bra nches a nd it is on rea l time. Quick informal decisions on rea l time MIS. Fa ster and pra ctica lly rea l time reconcilia tion of accounts. Centra liz ed ma rking a nd movement monitoring of NPA accounts. Centra liz ed follow-up a nd co ordina tion of overdue a nd NPA accounts. For sta tutory reporting a nd compliance no need to wa it for branch c o mp l i a n c e

126 Commercial Banking II 117 Better ALM, especially for short-term a ssets and lia bilities possible. Product-wise, customer-wise, customer profile-ba sed a na lysis a nd decision ma king possible. Reduced credit processing time for existing loa n a ccounts a s the Credit Depa rtment gets informa tion ha ndy. For processing of new loa n a ccounts the informa tion on product is a vaila ble tha t fa cilita tes proper decision. Real time credit tra cking by setting a lerts about dela ys, devia tions, penalties, etc. Centra liz ed rea l time Genera l Ledger a nd Profit a nd Loss Account a lmost eliminates a ccounting work. Deadlines of sta tutory compliance a nd submissions a re met in time. W ith reduced work at the bra nches they can focus on development of business, customer service a nd a ttenda nce a nd mea ningful lia ison with customer for getting new business. Since customer needs a re known with proper a na lysis, they ca n be well a ttended even before their dema nds, that boosts the image of ba nk a s customer savvy. CHEQUE TRUNCATION SYSTEM (CTS) The domina nt fea ture of the Indian ba nking system is its bra nch-centered ba nking. The va st network of bra nches implies that the logistics of collection a nd delivery of pa per payment instruments becomes formida ble. The clea ring infra structure is designed to a ddress the movement of instruments between the presenting a nd dra wee bra nches. Ea ch member ba nk in a centre is represented in the clea ring house by its service bra nch which collects a ll the instruments from various bra nches and consolida tes them for presenta tion to a ll the ba nks in the clearing house. Simila rly, it receives a nd distributes a mong its bra nches a ll the instruments dra wn upon its bra nches by other ba nks in the clea ring house. The service bra nch of a ba nk performs a crucia l intermedia ry role between the clea ring house a nd the bra nch of a bank. The clearing process begins with the deposit of a cheque/ other instruments in a ba nk. The cheque (along with other cheques) is delivered to the bank/ branch where it is dra wn. The cheque is pa ssed for pa yment if the funds a re a vaila ble a nd the ba nker is sa tisfied about the genuineness of the instrument. The cheques tha t a re unpa id are returned to the presenting ba nk through a nother clea ring ca lled the Return Clea ring. Cheques presented by customers dra wn on different bra nches of the sa me ba nk need not be sent to the clea ring house a s the tra nsfer of funds is interna l to the ba nk. The service bra nch usually acts a s a settlement branch for the bra nches a nd the instruments are sent to the drawee bra nches while the inter-branch a ccounts a re credited or debited i n t e r n a l l y. CTS is a system of cheque clearance and settlement between banks based on electronic data and/or images

127 118 Banking and Financial Services The Reserve Bank has implemented CTS in the National Capital Region (NCR), New Delhi and Chennai with effect from February 1, 2008 and subsequently the CTS was implemented in all major places by Colle c tion of outstation instrume nts: In this ca se, the cheques a re sent by post for collection to the representa tive bra nch or correspondent bra nch for presentation in the clearing house in the outsta tion centre. Once the cheque is realised, the proceeds a re remitted to the origina l presenting ba nk for credit to the customer a ccount. This lea ds to a significa nt dela y in the payment of these cheques a nd there is considera ble uncerta inty rega rding the time of rea lisa tion. Cheque Truncation is the process of stopping the flow of the physical cheque issued by a dra wer a t some point with the presenting ba nk en-route to the drawee ba nk branch. In its place a n electronic ima ge of the cheque is tra nsmitted to the dra wee bra nch by the clea ring house, a long with releva nt informa tion like da ta on the MICR ba nd, da te of presentation, presenting ba nk, etc. Cheque trunca tion thus obvia tes the need to move the physica l instruments a cross branches, other tha n in exceptiona l circumsta nces for clea ring purposes. This effectively eliminates the a ssociated cost of movement of the physica l cheques, reduces the time required for their collection a nd brings elega nce to the entire a ctivity of cheque processing. Cheque Truncation speeds up the process of collection of cheques resulting in better service to customers, reduces the scope for clearing-rela ted fra uds or loss of instruments in tra nsit, lowers the cost of collection of cheques, and removes reconciliation-rela ted a nd logistics-related problems, thus benefitting the system as a whole. W ith the other ma jor products being offered in the form of RTGS a nd NEFT, the Reserve Bank has crea ted the ca pa bility to ena ble inter-bank a nd customer pa yments online a nd in nea r- real time. However, a s cheques a re still the prominent mode of payments in the country and Reserve Ba nk of India ha s decided to focus on improving the efficiency of the cheque clea ring cycle, offering Cheque Truncation System (CTS) a s a n a lternative. As highlighted ea rlier, CTS is a more secure system vis-a-vis the excha nge of physica l documents. In a ddition to opera tiona l efficiency, CTS offers several benefits to ba nks a nd customers, including huma n resource ra tiona lisa tion, cost effectiveness, business process re-engineering, better service, a doption of la test technology, etc. CTS, thus, ha s emerged a s a n importa nt efficiency enha ncement initiative underta ken by Reserve Ba nk in the Pa yments Systems a rea. Process Flow in CTS In CTS, the presenting ba nk (or its bra nch) ca ptures the da ta (on the MICR ba nd) a nd the ima ges of a cheque using their Ca pture System (comprising of a scanner, core ba nking or other a pplica tion) which is internal to them, a nd ha ve to meet the specifica tions a nd sta nda rds prescribed for da ta a nd ima ges. To ensure security, safety a nd non-repudiation of da ta / ima ges, end-to-end Public Key Infra structure (PKI) ha s been implemented in CTS. As part of the requirement, the collecting ba nk (presenting ba nk) sends the da ta and captured images duly signed and encrypted to the centra l processing loca tion (Clea ring House) for onwa rd tra nsmission to the pa ying ba nk (destina tion or drawee ba nk). For the purpose of participa tion the presenting a nd dra wee ba nks a re provided with a n interfa ce / ga tewa y ca lled the Clea ring House Interfa ce (CHI) that ena bles them

128 Commercial Banking II 119 to connect a nd tra nsmit da ta a nd ima ges in a secure a nd sa fe ma nner to the Clea ring House (CH). The Clearing House processes the da ta, a rrives a t the settlement figure and routes the ima ges a nd requisite da ta to the dra wee ba nks. This is ca lled the presenta tion clea ring. The drawee ba nks through their CHIs receive the ima ges a nd da ta from the Clea ring House for pa yment processing. The dra wee CHIs a lso genera te the return file for unpaid instruments, if any. The return file/ da ta sent by the dra wee ba nks a re processed by the Clea ring House in the return clea ring session in the sa me wa y as presentation clea ring a nd return data is provided to the presenting ba nks for processing. The clea ring cycle is treated as complete once the presenta tion clea ring a nd the a ssociated return clea ring sessions a re successfully processed. The entire essence of CTS technology lies in the use of images of cheques (instea d of the physica l cheques) for pa yment processing. CTS 2010 Standard Cheques Standa rdiza tion of cheque forms (lea ves) in terms of size, MICR ba nd, qua lity of pa per, etc., wa s one of the key fa ctors tha t ena bled mecha niz ation of cheque processing. Over a period of time, ba nks ha ve a dded a va riety of pa tterns a nd design of cheque forms to a id segmenta tion, bra nding, identifica tion, etc., a s a lso incorpora ted therein a number of security features to reduce the incidence of cheque misuse, ta mpering, a ltera tions, etc. Growing use of multi-city a nd pa ya ble-a t-par cheques for handling of cheques a t a ny bra nches of a bank, introduction of Cheque Truncation System (CTS), increasing popularity of Speed Clea ring, etc., were a few a spects tha t led to prescription of certa in minimum security fea tures in cheques printed, issued a nd ha ndled by ba nks a nd customers uniformly a cross the banking industry. The set of minimum security features would not only ensure uniformity a cross a ll cheque forms issued by ba nks in the country but a lso help presenting ba nks while scrutinising/ recognising cheques of dra wee ba nks in an image-based processing scena rio. The homogeneity in security fea tures is expected to a ct a s a deterrent a ga inst cheque fra uds, while the standa rdisa tion of field placements on cheque forms would ena ble stra ight- through- processing by use of optica l/ ima ge cha ra cter recognition technology. The benchma rk prescriptions a re collectively known a s CTS-2010 Standar d. Accordingly, the cheques issued a re tested a nd certified by NPCI a nd only a fter such cerifica tion the cheques would be issued to the customers. All banks providing cheque fa cility (CTS) to their customers, were started issuing only CTS-2010 sta nda rd cheques Indian Banks Association (IBA) and National Payments Corporation of India (NPCI) are co ordinating with the banks on implementation of the new standard. Format of CTS-2010 Standard Cheque Benefits of CTS to Bank Customers 1. The ma in fea ture of the CTS 2010 cheque is tha t the physica l movement of the cheque is stopped a nd the images of cheques are tra nsmitted electronica lly thereby speeding up the process of cheque clea ra nce a nd settlement between ba nks. This obviously mea ns quicker clea ra nce, shorter clea ring cycle and speedier credit of the a mount to a ccount.

129 120 Banking and Financial Services The State Bank of India (SBI), the largest and oldest bank in India, had computerized its branches in the 1990s, but it was losing market share to privatesector banks that had implemented more modern centralized core processing systems. 2. W ith the movement of cheques from one bank to a nother having been stopped, there is no fear of loss of cheques in transit a nd cha nces of cheques being lost due to misha ndling, etc are tota lly a voided. 3. Under the CTS, there is a n integra tion of multiple clearing loca tions ma na ged by different ba nks in different centres so tha t cheques dra wn on upcountry ba nks too ca n be clea red electronica lly without a ny geogra phica l restrictions. Eventually, this will result in integra tion of clea ring houses into a na tion-wide sta nda rd clea ring system, thereby ma king clea ra nce of cheques dra wn on a ny ba nk in India within 24 hours possible. 4. The cheques in tra nsit are most susceptible to fra uds a nd customers of ba nks a re the worst sufferers in the system of physical movement of cheques from one pla ce to a nother. Under the CTS system moving of physical cheques a t different points is obvia ted as only electronic images a re tra nsmitted between ba nks, a nd this will considera bly reduce the scope for perpetua tion of frauds inherent in pa per instruments. 5. W ith the introduction of homogeneity in security fea tures under CTS standa rds 2010 such a s embedded verifia ble fea tures like ba r codes, encrypted codes, logos, wa terma rks, hologra ms, etc., in every cheque leaf, it is now possible to detect fra uds easily through interception of a ltered and forged instruments while pa ssing through the electronic imaging system. This is expected to considera bly reduce opera tiona l risks a nd risks a ssocia ted with paper clea ring for the benefit of a ll ba nk c u s t o me r s. 6. The CTS is expected to improve operationa l efficiency of the entire ba nking system, resulting in better customer service, improved liquidity position for ba nks customers a nd sa fe a nd secure ba nking for the entire ba nking public.

130 Commercial Banking II 121 AUTOMATED TELLER MACHINES (ATM) Introduction Ba nking being a service industry alwa ys should think of customer s needs. Only those banks who a re a ble to meet customer s requirement a re a ble to survive in the long run. One of the importa nt service that a bank need to give its customers is 24x7 ba nking, i.e., where ba nking services a re a va ila ble 24 hours a da y a nd 365 da ys a yea r. Similarly the ba nks should think of providing a nywhere ba nking. The answer to these two issues, i. e., 24x7 ba nking a nd a nywhere ba nking lies in ATMs. ATM is a computer-driven ma chine which is insta lled by ba nks a t different pla ces across the na tion, connected to one network. These ATMs a re mea nt for providing specific types of ba nking services to its customers at a nytime a nd at a ny pla ce. ATMs a re user-friendly systems a nd with little knowledge of its opera tions, it ca n be opera ted by a nybody. Presently there a re different ma nufa cturers, ma nufa cturing ATMs irrespective of ma ke; fa cilities provided in these ma chines a re a lmost same. The functions of ATMs a re a s follows: Withdraw cash Deposit a cheque or ca sh or any other instruments Request a mini-sta tement Ma ke a ba la nce inquiry Tra nsfer funds Cha nge PIN Request a cheque book or a ccount sta tement Request product informa tion Pa y utility bills, such a s telephone bills, electricity bills Sa le of sta mp pa pers Request for dema nd drafts etc. State Bank group has got the largest chain of ATMs in India Working of ATMs from User s Point of View W hen a customer opens a n a ccount in ba nks which a re computerized, he gets a ATM ca rd. This ca rd is simila r to Credit Ca rd, a nd includes a ll the relevant information like, Na me, Ca rd no., Signa ture photo of a ccount holder (optiona l) etc. The ATM ca rd can be used to get ma ny of the services offered by ba nks. The ATM ca rd ava ilable with the a ccount holder ca n be used a t a ny time or at a ny pla ce where the sa me ba nk s or other ba nks ATM s a re l oca t ed. ATM ca rds includes ma gnetic stripes or chip on its ba ck side, where in va rious informa tions a re stored in electronic form.

131 122 Banking and Financial Services Ea ch ATM ca rd is provided with a PIN (Persona l Informa tion Number) or popularly ca lled a s password. Unless the PIN is provided by the ca rd holder, ATMs do not work. By putting the ATN ca rd into ATMs a nd by giving pa ssword, the ca rd holder/ Account holder a ccesses va rious services, which a re mentioned above. RBI has vide notifications dated 20th June, 2012, permitted nonbanking entities to set up or start ATMs which are called White Label ATMs (WLA). Types of ATMs/Models of ATMs There a re ba sica lly three models of ATMs (1) Wall type (2) Lobby type (3) Drive-in-type (1) Wall Type: In ca se of this model, ATMs are loca ted in a closed lobby/ room. Inside the lobby, the ATM is either placed on the floor (ATMs of Corporation Ba nk)or inserted into walls of the lobby (in ca se of ATMs of Ca nara Bank). The entry into the lobby is restricted a nd only those who a re processing the ATM ca rd ca n ga in entry into the lobby by inserting the ca rd in a slot in the door of the lobby. Once the user enters the lobby, ATMs a re loca ted directly opposite to the door. Certain ATMs a re built up with video a nd still ca mera s and they ca pture the ima ge of the user. Once the user lea ves the lobby a fter completing the usage, the doors will get closed automatica lly. (2) Lobby Type: This type of ATMs are pla ced in banking ha ll, hotels, a irports, ra ilwa y sta tions or a ny other crowded pla ces. In some ca ses, these ATMs a re pla ced in secured rooms a lso. (3) Dr ive-in-type: In India this type of ATMs are still not found. This type ca n be found in some western countries. Drive-in-type of ATMs are loca ted on the roa dside of highwa ys, so tha t customer ca n use the ATM without getting out of the vehicle. This type of ATM is exposed to more risk. Components of ATM The va rious components a va ila ble in the ATMs a re a s follows: (a) (b) (c) Card Reade r: W hen ATM ca rd or any other ca rd is inserted, ca rd rea der starts functioning. Ca rd Rea der pulls inside, the ca rd inserted a nd it reads the informa tion ava ilable in the ma gnetic stripes of the ca rd. The ca rd rea der verifies the ca rd a nd only valid ca rd will be processed a nd a llowed to continue the opera tions. If there is a n inva lid card, it will be ca ptured in the ma chine. Sc re e n of ATM/ Vide o Display Unit: On the screen, the va rious instructions to opera ted the ATM and various informa tion rela ting to the a ccount like ba la nce in the a ccount is displa yed. Ke yboard: Keyboard contains va rious numbers a nd information keys. For operating the ATM, keyboa rd is essential. Va rious activities can be performed like, typing the pin code, a mount of ca sh to be withdrawn, e t c.

132 Commercial Banking II 123 (d) (e) (f) (g) (h) (i) Pr inte r: Printer performs the function of printing the instruction slip a vaila ble to ATM user. Slot: It is a pla ce from where the instruction slip comes out. Cash dispenser: It is the slot in the ATM from where the cash comes out. De pository: This is the box where the user ca n deposit the envelops conta ining ca sh/ cheque/ DD/telephone bill, etc. CPU: This is the most importa nt component in ATM, which contains the ha rd disk da ta of the ATM. Vide o/ Still Came r a: This is a pa rt of security device in ATMs. Some ATMs conta in ca mera s which a re used for the purpose of ta king video or still photos of the user. Number of ATM s of Scheduled Commercial Banks at various centers (March ) Bank group Rural Semi- Urban Metro- Total Urban politan Public Sector 8, , , , , B a nk s (12.3) (26.5) (32.3) (28.9) (100.0) N a t i on a l i s ed , B a n k s (12.5) (23.4) (30.8) (33.4) (100.0) SBI Group (12.4) (30.2) (33.5) (23.9) (100.0) Private Sector 2, , , , , B a nk s (6.9) (21.4) (31.0) (40.7) ) Old Private , Sector Banks (10.2) (36.5) (31.1) (22.3) (100.0) New Private Sector Banks (6.2) (18.2) (30.9) (44.6) (100.0) Foreign Banks , (2.4) (1.7) (19.3) (76.6) (100.0) Total 1 1, , , , , 1 4, (10.1) (24.3) (31.7) (33.9) (100.0) Gr owth over previous year Presently banks allow withdrawal of funds to individuals from its ATMs without an account in the bank as a part of domestic remittance service called Instant money transfer (IMT) that allows cardless cash withdrawal from its select ATMs which are tuned for this facility. Source: RBI

133 124 Banking and Financial Services Advantages of ATMs (1) ATMs provide the banking services to its customers on 24x7 ba sis. (2) Essential ba nking services like withdrawa l of ca sh, deposit of cash/ cheque can be a ccessed by customers, from a ny pla ce in the country. (3) Geogra phica l sprea ding of the ba nks ca n be a chieved by the usa ge of ATMs. (4) Usage of ATM reduces the work loa d at bra nches, a nd ba nks ca n think of downsizing of its sta ff. (5) Cost of opera tion is chea per in ca se of ATM. Correct IFSC code is essential for identifying the beneficiary s branch and bank as destination for fund transfers. Limitations of ATMs (1) In country like India, where ba nks a re ha ving la rge number of rural & noncomputerized branches, ATM services ca nnot be provided. (2) Illiterate customers find it very difficult to use ATMs. (3) Ca sh withdra wa ls permitted through ATMs a re very less (E. g., only up to ` 25, 000 in case of Ca na ra Ba nk). (4) Simila rly, ca sh deposit fa cility is a lso restricted; therefore huge a mount of funds ca nnot be deposited. (5) ATMs ca nnot perform certain functions like, safe deposit locker, ta king loa n, etc. (6) ATM ca rd if misplaced can be misused. (7) Persona l touch to the banking services ca nnot be provided here. ELECTRONIC FUND TRANSFER Cheques, ca sh a nd DDs continue to domina te the way still most of India ns pa y money to others. The interesting fa ct is tha t, for most India ns, ca sh a nd cheques are the most preferred mea ns for settling fina ncia l dues. These instruments ca uses delays a nd ca rry risks of fra uds a nd loss of money, besides commission, collection cha rges a nd other costs. Apa rt from we ha d ma il tra nsfer a nd telegra phic tra nsfer. The cheque a nd dema nd dra ft fa cility is pa per ba sed. The remitter, a fter purcha sing dema nd dra ft/ writing cheque, dispa tches the sa me by post/courier to the beneficia ry. The beneficiary, in turn, lodges the cheque/ dra ft to his ba nk for collection a nd clea ring. The time ta ken for completing the process is a bout 10 da ys. In the ca se of telegra phic tra nsfer, fund reaches the beneficia ry either on the sa me da y or the next; but both the remitter a nd the beneficia ry would ha ve to be a ccount holders of the same bank. If they a re customers of different ba nks, a good dea l of pa per processing is required. These payment methods used to results in dela y, fra uds, misuse a nd collection cost. The a nswer to these problems lies in electronic fund tra nsfer. There a re three types of electronic fund tra nsfer system a vaila ble to ba nk customers who wa nt to remit funds to others ba nk a ccounts a nywhere in India - the Nationa l Electronic Fund Tra nsfer (NEFT), Rea l Time Gross Settlement

134 Commercial Banking II 125 (RTGS) and Interba nk Mobile Payment Service (IMPS). Ba sica lly a ll a re wire transfer fa cilities for electronica lly tra nsferring money from one person or institution to a nother person or institution through bra nches of ba nks located within the country; a sort of domestic electronic pa yment gatewa y. As the na me indica tes the RTGS is rea l time, mea ning, the money sent is credited to the a ccount of the receiver without a ny dela y, ma king it the fa stest mea ns of fund transfer within the country. The NEFT route ta kes a batch processing approach, instea d of being continuous, in hourly ba tches. This mea ns tha t the recipient gets money in their a ccount within a n hour of sending a nd when the last batch of processing is missed will definitely get it on next da y morning. Though, there a re no upper limits for the a mounts to be tra nsferred under both the systems, the minimum amount tha t ca n be tra nsferred by using RTGS is `2, 00, 000. There is no minimum a mount for NEFT a nd hence, is the commonly used system for small tra nsa ctions by individua ls. On the other ha nd Interba nk Mobile Pa yment Service (IMPS) is ba sed on mobile ba nking platform. The deta ils a bout these fund transfer is provided in the following pa ra gra phs. The National Electronic Fund Transfer (NEFT) The na tiona l electronic fund tra nsfer (NEFT) system is a na tion-wide system that fa cilita tes individua ls, firms a nd corporates to electronica lly tra nsfer funds from a ny ba nk bra nch to a ny individua l, firm or corpora te ha ving a n a ccount with a ny other ba nk branch in the country covering a s a part of NEFT scheme. Individua ls, firms or corpora tes ma inta ining a ccounts with a bank bra nch ca n transfer funds using NEFT. Even such individuals who do not have a ba nk a ccount (wa lk-in customers) ca n a lso deposit ca sh a t the NEFT-ena bled branches with instructions to tra nsfer funds using NEFT. However, such ca sh remitta nces will be restricted to a ma ximum of `50,000/- per tra nsa ction. Such customers ha ve to furnish full deta ils including complete a ddress, telephone number, etc. NEFT, thus, fa cilita tes origina tors or remitters to initiate funds transfer tra nsa ctions even without ha ving a ba nk a ccount. There is no limit either minimum or ma ximum on the a mount of funds tha t could be transferred using NEFT. However, ma ximum a mount per tra nsa ction is limited to `50,000/ - for cash-based remittances a nd remitta nces to Nepa l. There is no restriction of centres or of a ny geogra phica l a rea within the country. The NEFT system ta kes a dva ntage of the core ba nking system in banks. NEFT operates in hourly ba tches - there a re twelve settlements from 8 a m to 7 pm on week da ys (Monda y to Friday) a nd six settlements from 8 a m to 1 pm on Sa turda ys. Ba nks cha rges ma ximum of ` 25 on each of the NEFT tra nsactions. The beneficiary can expect to get credit of the funds on the sa me da y. (Sometimes, the credit gets effected on the next working da y if the remittance happened on the la st few batches of the day.) Information Technology Act 2000, provides legal protection for transactions carried out by means of electronic communication. The originating bank branch can keep track of the status of the NEFT transaction. Process involved in NEFT Transaction Ste p-1: An individua l/ firm/ corpora te intending to origina te tra nsfer of funds through NEFT ha s to fill a n applica tion form providing deta ils of the beneficia ry (like na me of the beneficia ry, na me of the ba nk branch where the beneficia ry ha s a n a ccount, IFSC (IFSC or India n Financia l System Code is a n

135 126 Banking and Financial Services a lpha-numeric code tha t uniquely identifies a ba nk-bra nch participa ting in the NEFT system), account type a nd a ccount number and the a mount to be remitted. W a lk-in customers will, however, ha ve to give their contact deta ils to b a n k s. Ste p-2 : The origina ting ba nk bra nch prepa res a messa ge a nd sends the messa ge to its pooling centre (a lso ca lled the NEFT Service Centre). Ste p-3: The pooling centre forwa rds the message to the NEFT Clea ring Centre (operated by Na tiona l Clearing Cell, Reserve Bank of India, Mumba i) to be included for the next a vaila ble ba tch. Ste p-4 : The Clea ring Centre sorts the funds tra nsfer transa ctions destina tion bank-wise a nd prepa res a ccounting entries to receive funds from the origina ting ba nks (debit) a nd give the funds to the destination ba nks(credit). Therea fter, bank-wise remittance messa ges a re forwa rded to the destina tion ba nks through their pooling centre (NEFT Service Centre). Ste p-5 : The destina tion ba nks receive the inwa rd remitta nce messages from the Clearing Centre a nd pa ss on the credit to the beneficiary customers a c c o u n t s. Advantages of NEFT transaction The remitter need not send the physica l cheque or dema nd dra ft to the b eneficiar y. The beneficiary need not visit his/ her ba nk for depositing the paper i n s t r u me n t s. The beneficia ry need not be a pprehensive of loss/ theft of physica l i n s t r u m e n t s NEFT is cost effective. Credit confirma tion of the remitta nces sent by SMS or . Remitter ca n initiate the remitta nces from his home/pla ce of work using the Internet banking also. Near real time transfer of the funds to the beneficia ry account in a secure m a n n e r The RTGS, which provide for fund transfers across participants in electronic mode with reduced risk, will continue to be operated by the RBI. Real Time Gross Settlement (RTGS) RTGS system is a funds tra nsfer mecha nism where tra nsfer of money takes place from one ba nk to a nother on a rea l time a nd on gross ba sis. This is the fa stest possible money tra nsfer system through the ba nking cha nnel. It is a continuous (rea l-time) settlement of funds tra nsfers individua lly on a n order by order ba sis (without netting). Rea l Time means the processing of instructions a t the time they are received ra ther tha n at some la ter time ; Gross Settlement means the settlement of funds tra nsfer instructions occurs individua lly (on a n instruction by instruction basis). Considering tha t money tra nsfer ta kes pla ce in the books of the Reserve Ba nk of India, the pa yment is ta ken a s fina l a nd irrevocable. Fees for RTGS vary from bank to ba nk. Both the remitting a nd

136 Commercial Banking II 127 receiving must ha ve core ba nking in pla ce to enter into RTGS tra nsa ctions. Core Ba nking ena bled banks and bra nches a re a ssigned an India n Fina ncia l System Code (IFSC) for RTGS. RTGS is a large value funds transfer system where minimum a mount of tra nsfer is `2 lakh. It is used by fina ncia l intermediaries to settle interba nk tra nsfers for their own a ccount a s well a s for their customers. The system effects final settlement of interba nk funds transfers on a continuous, transa ction-by-transa ction basis throughout the working hours of the da y. Advantages of RTGS (a) Real Time Gross Settlement helps ba nks to settle interba nk and forex s e t t l e me n t s (b) It a lso helps ba nks in ha ndling fund tra nsfers (c) Since RTGS it is routed through RBI, the credit risk is minimiz ed (d) the tra nsfer mechanism works on rea l time and, therefore, the beneficia ry bra nch/ ba nk should receive the funds immedia tely, therefore beneficia ry s bra nch/ bank should give credit to the beneficiary s a ccount immedia tely. RTGS volume crossed 0.43 million transactions during March In view of the increasing volumes, as also other business requirements, the Reserve Bank is replacing the existing RTGS with NG-RTGS, which provides for improved functions and features. Difference between RTGS and NEFT The ba sic difference between them are settlement timings. RTGS is ba sed on the gross settlement where the tra nsa ction is settled on a n instruction by instruction basis. NEFT is a n electronic fund tra nsfer system tha t opera tes on a Deferred Net Settlement (DNS) basis which settles transactions in batches. As per the Reserve Ba nk of India for RTGS the minimum a mount should be a bove ` 2 la kh and NEFT ha s no limit either minimum or ma ximum on the amount of funds that could be transferred using NEFT. RTGS is done on continuous basis wherea s NEFT opera tes in hourly ba tches - there a re eleven settlements from 9 a m to 7 pm on week da ys (Monda y through Frida y) a nd five settlements from 9 a m to 1 pm on S a t ur d a ys. Interbank Mobile Payment Service (IMPS)/Immediate Payment Service (IMPS) Interba nk Mobile Payment Service (IMPS) is an initia tive of Na tiona l Pa yments Corpora tion of India (NPCI). It is a service through which money ca n be tra nsferred immedia tely from one a ccount to the other account, within the sa me ba nk or accounts a cross other ba nks. Before introduction of IMPS, ma jority of interba nk mobile fund tra nsfer tra nsactions were channelised through NEFT mecha nism. Under NEFT, the tra nsactions a re processed a nd settled in batches, hence a re not rea l time. Also, the tra nsa ctions ca n be done only during the working hours of the RTGS system. In the above context, NPCI (Na tiona l payment corporation of India) ha s carried out a pilot on mobile pa yment system initially with 4 member banks viz Sta te Ba nk of India, Ba nk of India, Union Bank of India a nd ICICI Ba nk in August Yes Ba nk, Axis Ba nk a nd HDFC Ba nk ha ve joined this pilot in month of September, October a nd November

137 128 Banking and Financial Services 2010 respectively. Immedia te Pa yment Service (IMPS) public la unch ha ppened on 22nd November IMPS offers a n insta nt, 24X7, interba nk electronic fund transfer service through mobile phones. IMPS fa cilita te customers to use mobile instruments a s a cha nnel for a ccessing their bank a ccounts a nd put high interba nk fund transfers in a secured ma nner with immedia te confirma tion features. This fa cility is provided by NPCI through its existing NFS switch. IMPS can be used for the following Sending a nd receiving money Utility Bills Mobile Top up and DTH Recharge Credit Card Bills Grocery Bills Travel and Ticketing Online Shopping Educa tiona l institutes (schools/ colleges) fees pa yment Net banking services of a bank can be accessed through a Personal Identification Number (PIN) and access password as in the case of ATMs. Objectives of IMPS To ena ble ba nk customers to use mobile instruments a s a cha nnel for a ccessing their ba nks a ccounts a nd remit funds Ma king pa yment simpler just with the mobile number of the b eneficia r y To sub-serve the goal of Reserve Bank of India (RBI) in electronification of reta il pa yments To fa cilita te mobile pa yment systems a lrea dy introduced in India with the Reserve Bank of India Mobile Pa yment Guidelines 2008 to be interopera ble a cross ba nks a nd mobile opera tors in a safe a nd secured m a n n e r To build the foundation for a full ra nge of mobile ba sed Ba nking services. Process of Fund Transfer under IMPS For a va iling this service the remitter ha s to Register for mobile ba nking service with ba nk and get Get Mobile Money Identifier (MMID) a nd MPIN from the bank. After this he has to Downloa d Softwa re (Applica tion) for mobile ba nking or use the SMS fa cility in their mobile if ba nk is providing IMPS on SMS. Simila rly beneficiary need to Link his mobile number to the a ccount in the respective bank a nd Get Mobile Money Identifier (MMID) from the ba nk. The transfer process includes the following a ctivities Remitter ha s to Login to the applica tion a nd select the IMPS menu from the IMPS or use the SMS fa cility in your mobile if ba nk provides IMPS on SMS

138 Commercial Banking II 129 Get Beneficia ry Mobile number a nd MMID Enter Beneficia ry Mobile number, beneficia ry MMID, Amount a nd MPIN to send Await confirma tion SMS for the debit in remitters a ccount a nd credit in beneficia ry a ccount Note the tra nsa ction reference number for a ny future query HOME BANKING Under home banking, the customer ca n get ba nking services sitting a t home without visiting the bra nch. Number of routine tra nsa ctions ca n be undertaken by the customer like, knowing the ba la nce, getting a statement of accounts, opening the a ccount, getting a persona l loa n etc. The home banking services ca n be broa dly cla ssified into two ca tegories, v iz. (a) Home Banking using IT a nd (b) Home Ba nking without using IT. (a) Home B anking using IT: The va rious facilities tha t can be enjoyed by a customer by using IT in Home Ba nking are: Browsing through his a ccount. Downloa ding a nd printing sta tement of a ccount. Order remitta nce or payment of bill. Electronic fund tra nsfer, etc. (Deta ils a bout this service is provided under the hea ding Internet ba nking) (b) Home B anking without using IT: Here ba nking fa cilities a re ava ilable to the customers sitting a t home without using IT/Internet. The instrument used here is telephone. By ca lling up bra nches, the customers can enjoy various fa cilities like, Opening the a ccount. Applying for cheque book. Requesting for sta tement of a ccount. Tra nsferring funds, etc. Each customer is provided with ID a nd password. Each time when a customer ma kes a telephone ca ll to the ba nk, he ha s to give the ID and password to get the services. In Indian context, private sector, a s well a s selected public sector banks a re providing Home Ba nking fa cilities. Certa in ba nks providing Home Ba nking fa cilities include, ICICI Bank, HDFC Bank, ABN Amro Bank, etc. An e-cheque is the electronic version or representation of paper cheque. The Information and Legal Framework on the e-cheque is the same as that of the paper cheques. Advantages of Home Banking (1) Provision of ba nking fa cility without visiting the bra nch. (2) Quick services ca n be provided. (3) Cost of providing services is less.

139 130 Banking and Financial Services Limitations of Home Banking (1) Home Ba nking fa cility cannot be given by the ba nks which a re not fully c ompu t e r i z ed. (2) Illiterate customers cannot ma ke use of Home Ba nking fa cility. (3) Misuse of facility by the customers or even by outsiders is a lso possible. TELEBANKING Development of technology over few deca des has changed the working of ba nks in India & a broa d. Here, a s a pa rt of tele ba nking, customer ca n get different ba nking services by using his la ndline telephone or mobile phone, without physica lly visiting the ba nk bra nches. In USA, it wa s a very popula r concept in 1980 s. This teleba nking is a n extension of Home Ba nking. IFSC is an alphanumeric code that identifies a bankbranch participating in the RTGS/ NEFT system. Procedure Adopted in Telebanking In this the customer is required to open a n account with the ba nk initially by visiting the ba nk. The customer is given an a dditiona l facility of using the telephone line for certain type of routine tra nsactions. Tele-ba nking services a re genera lly provided by the ba nk over the telephone on a special number. The number at the ba nk is connected to a termina l in the bank, which is either ma nua lly or is a utoma ted by connecting the sa me to the computer network. W hen a customer is provided with tele ba nking, the ba nks need to a dopt certa in technology in order to ha ve successful tele ba nking. The system a dopted by ba nk includes. (1) Voice r e cognition syste m: wherein the input is a huma n voice. The ca ller will ha ve to spea k to the system in a clea r voice to ena ble the system to record the input. This type of system is still in developmental stage. (2) Voic e r esponse syste m: under this, the input is in data form. The system is a ble to recogniz e a nd decode the data called for and response is in voice form. The simplest exa mple for this is the Electronic Token system, wherein the ca shier keys in the token number on a key boa rd, the system converts this to voice a nnouncement. (3) Numbe r r ec ognition syste m: Here the ba nks provide the services to its customers only if they ca ll from specific telephone numbers, which a re provided to ba nkers a t the time of opening the a ccount. Services Provided under Telebanking The Services provided in tele-ba nking includes (a) Public e nquiry facility: oth customers as well a s non-customers ca n a vail these fa cilities. The informa tion provided here includes Interest rate, fa cilities offered, types of deposits a va ila ble etc. For these fa cilities there is no need to a dopt a ny security fea tures. (b) Pr ivate e nquir y fac ilitie s: Here fa cilities a va ila ble only to selected customers. Enquiry ma de a nd informa tion revea led is of confidentia l in na ture. The priva te enquiry fa cility includes,

140 Commercial Banking II 131 (i) Status enquiry: These enquiry rela tes to sta tus or a ccount, sta tus or Cheque put for collection, sta tus of cheque issued, etc. (ii) Balanc e e nquiry: This system is generally a utoma ted by most of the ba nks. Once the customer establishes conta ct over a number he ha s to give his code number a nd a ccount number. The system then gives out the ba lance in the a ccount. (iii) Cash withdrawal: This fa cility ca n be made to the customer on a very selective basis by few of the banks. This facility is made on a specific phone number of the ba nk. The customer makes a request to the ba nk for withdra wa l of ca sh and ha s to give the a mount to be withdra wn a long with his identifica tion code. The customer is a lso required to issue a cheque for the amount a nd the cheque number is conveyed over the phone. La ter the ba nk a rra nges to deliver the ca sh through the sta ff/ courier who obta ins the cheque for the a mount. (iv) Re que st for statem e nt of acc ount: The customer ca n also request for sta tement of a ccount, which is genera lly ma iled to the customer. In ca se the customer ha s a fa x cum phone the sta tement ca n be faxed to him immediately. Alterna tively the customer ca n specify a sepa ra te fa x number where his sta tement could be sent to ma inta in the confident i a l i t y. (v) Re que st for c he que books: The customer ca n a lso request for issue of cheque books for his account. The ba nk la ter sends the cheque by courier or requests the customer to collect the cheque book la ter, depending upon the rela tionship with the customer. (vi) Issue of drafts: The customer ca n a sk for issue or dra ft by withdra wing the money from his a ccount. IFSC has 11 digit code and the first four alpha characters represents the bank, the 5th code is 0 (zero), which is reserved for future use and the last six digits are numeric characters represents the branch. E.g. Syndicate Bank Cuffe Parade Branch, Mumbai- SYNB Advantages of Telebanking (1) Provision of ba nking facility without visiting ba nk bra nches. (2) Ba nking services a re just a call a wa y. (3) Cost or providing the facility a s well a s expenditure involved in getting the fa cility is very less. (4) Quick services ca n be provided. Limitations of Telebanking (1) Fa ilure in telephone system ma y ha mper the ba nking services. (2) This system cannot be used in rura l a reas wherea s telephone connections a re not a dequate. (3) Misuse of funds is possible in this method. (Importan t N ote: Af ter introd uction of Internet ba nking and Mob ile ban kin g, the concep t of T eleb anking and Home b anking has lost its relevan ce and it no long er e x i s t s )

141 132 Banking and Financial Services MOBILE BANKING Mobile banking has until recently (2010) most often been performed via SMS or the mobile web. M obile banking is a service provided by a ba nk tha t a llows customers of a ba nk to conduct a number of fina ncial transa ctions through a mobile phone. The Initia l mobile ba nking services were offered over SMS, a service known a s SMS ba nking. W ith the introduction of sma rtphones with W AP support enabling the use of the mobile web in 1999, the first Europea n banks sta rted to offer mobile ba nking on this pla tform to their customers. Apple s initia l success with iphone a nd the ra pid growth of phones based on Google s Android (opera ting system) ha ve led to increa sing use of specia l client programs, ca lled a pps, downloa ded to the mobile device. W ith tha t said, a dva ncements in web technologies such as HTML5, CSS3 and J a va Script ha ve seen more ba nks launching mobile web based services to complement na tive a pplica tions. In India a lso initia l success of sma rt phones led to the popula rity of mobile ba nking. Mobile banking in India ca n be provided by a ny of the following means. 1. Mobile Banking Service over Application/Wireless Application Protocol (WAP) The Mobile Ba nking Applica tion is ava ilable for Ja va, Bla ckberry, Android, i-phones a nd Windows mobile phones. The service ca n a lso be ava iled via W AP on a ll phones with GPRS connection. The following services ca n be a va iled through the Mobile Ba nking a pplica tion a nd WAP: Funds tra nsfer (within a nd outside the bank) Immedia te Pa yment Services (IMPS). Enquiry services ( Ba la nce enquiry/ Mini sta tement) Dema t Account Services Requests ( Cheque book request/ Genera te OTP) Bill Pa y (Utility bills, credit cards, Insurance premium), Dona tions, S ub s c r i p t i on s Top- up/ Recha rge ( Mobile/ DTH/ MobiCa sh W a llet Top-up) M-Commerce (Mercha nt pa yments, life insura nce premium) All Current/ Savings ba nk a ccount holders a re eligible to a va il mobile ba nking services. Genera lly, Transa ction limit per da y is ` 50,000/- with a ca lendar month limit of ` 2,50, 000. Mobile banking service is a va ila ble over a ll telecom service providers. The service is free of charge. SMS/ GPRS cost will be borne by the customer. 2. Mobile Banking Service over SMS The service is a va ila ble on all phones. Customer by sending a SMS ca n a vail some ba nking services. The following services ca n be ava iled through SMS:

142 Commercial Banking II 133 Enquiry Services ( Ba la nce Enquiry/ Mini Sta tement) Prepa id Mobile/ MobiCa sh wa llet Top up DTH Recharge IMPS Fund transfer (Mobile number a nd MMID a nd Account Number a nd IFS Code) Cha nge MPIN IMPS Mercha nt pa yments All Current/ Savings Ba nk Account a re eligible for this service. Transa ction limit per da y is genera lly a round ` 1, 000/- with a ca lendar month limit of ` 5,000/-. However, customers desiring to tra nsa ct more ma y do so a fter obta ining a One Time Password (OTP). This service a vaila ble over a ll telecom service providers. The Service is free of charge. SMS cost will be borne by the customer. As a preca ution, customers are requested to delete a ll the messages sent to the ba nk number once the response for their request ha s been received. 3. Mobile Banking Service over USSD (Unstructured Supplementary Service Data) The service is a va ila ble on a ll phones except CDMA phones. Downloa ding of a pplica tion is not required in this ca se. This service ca n be used by dia ling a pa rticula r number and can a vail the service. The following services can be ava iled through USSD: Enquiry Services ( Ba la nce Enquiry/ Mini Sta tement) Mobile Top-up Funds Transfer (within Bank) All Current/ Sa vings Ba nk Account holders a re eligible for this service. Genera lly Transa ction limit per da y is ` 1,000/- with a ca lenda r month limit of ` 5,000/-. The Service is a vaila ble for subscribers of select telecom opera tors only. The Service is free of cha rge. USSD session cha rges will be borne by the customer. The service is session ba sed a nd requires a response from the user within a reasona ble time. An Ernst & Young report released in November 2011 on the current state of security threats noted that consumers who access sensitive data, such as banking information, on mobile devices at wi-fi hotspots are more susceptible to hacks. INTERNET BANKING It is a very recent concept in ba nking. This method of ba nking has become very popula r in last few years in India. It is ba nking by using Internet. All the ba nks especially priva te ba nks put up there Home pa ge in the website of their respective banks on the Internet. Customers ca n get the ba nking fa cilities by loging on to the respective websites. From any pla ce in the world the customer ca n a ccess his ba nk a ccounts 24 hours a da y a nd 7 da ys a week. The Internet ba nking porta l of bank, ena bles its reta il ba nking customers to operate their a ccounts from a nywhere a nytime, removing the restrictions imposed by geogra phy a nd time. It s a pla tform tha t ena bles the customers to ca rry out their banking a ctivities from their desktop, a ided by the power a nd convenience of the Internet.

143 134 Banking and Financial Services Using Internet ba nking services, customer ca n do the following norma l ba nking tra nsactions online: Funds tra nsfer between own accounts. Third pa rty tra nsfers to a ccounts mainta ined a t a ny bra nch of ba nk Group Tra nsfers to a ccounts Inter bank transfers to a ccounts with other banks Online sta nding instructions for periodica l transfer for the a bove Credit PPF a ccounts a cross bra nches Request for Issue of dema nd dra ft Request for opening of new a ccounts Request for closure of loa n a ccounts Request for issue of cheque book Society for W orldwide Interbank Financial Telecommunications (SWIFT) is a co-operative nonprofit making organization established under Belgian law with its headquarters at Brussels. SWIFT is wholly owned by its member banks. SWIFT is a paperless message transmission system. Apart from these, the other salient value added features available are Utility bill pa yments Online ticket booking for tra vel by toa d, ra il a nd a ir Life a nd other insura nce premia pa yments Mutua l funds investments Credit ca rd dues pa yments Ta x pa yment Income, service, sta te government Customs duty pa yment Online sha re tra ding Online applica tion for IPO Fee pa yment to select educa tiona l institutions including IITs a nd NITs Internet Banking in India The Reserve Bank of India constituted a working group on Internet Ba nking. The group divided the Internet ba nking products in India into three types based on the levels. 1. Infor mation Only Syste m: Genera l purpose information like interest ra tes, bra nch loca tion, ba nk products a nd their fea tures, loa n a nd deposit ca lcula tions are provided in the ba nks website. There exist fa cilities for downloa ding va rious types of a pplica tion forms. The communica tion is normally done through e-ma il. There is no intera ction between the customer a nd ba nk s a pplica tion system. No identifica tion of the customer is done. In this system, there is no possibility of a ny una uthorized person getting into production systems of the bank through Internet.

144 Commercial Banking II Ele c tr onic Infor mation Tr ansfe r Syste m: The system provides customerspecific informa tion in the form of a ccount ba la nces, tra nsaction details, a nd statement of accounts. The informa tion is still la rgely of the rea d only forma t. Identifica tion a nd a uthentication of the customer is through pa ssword. The informa tion is fetched from the bank s a pplica tion system either in batch mode or off-line. The applica tion systems ca nnot be directly a ccessed through the i n t e r n e t. 3. Fully Elec tronic Tr ansac tional Syste m: This system allows bi-directiona l ca pa bilities. Tra nsa ctions can be submitted by the customer for online update. This system requires high degree of security a nd control. In this environment, web server a nd a pplica tion systems a re linked over secure infrastructure. It comprises technology covering computeriz a tion, networking a nd security, interba nk pa yment gatewa y a nd lega l infra structure. Advantages of Internet Banking To Banks- 1. Genera tion of a dditiona l revenue. 2. Reduction in the cost of opera tions. 3. Effective utiliz a tion of resources, especia lly huma n resources. 4. Better coordina tion a mong different bra nches and different ba nks. 5. Reduction in the time involved in providing the ba nking services. 6. Increa se in the customers ba se. To the General Public- 1. Provision of new a nd innova tive ba nking services. 2. Ba nking a ctivities ca n be performed without physica l presence a t b r a n c h e s. 3. Time involved in getting ba nking services will be reduced. 4. Service cha rges paya ble on ba nking services will get reduced. Internet ba nking is a sma rt service to cover most of ba nking tra nsa ctions from the desktop/ laptop of the customer. Most of the ba nk bra nches a re ena bled for Internet ba nking. Some of the preca utiona ry mea sures while using Internet banking are 1) Never disclose pa ssword to others. 2) Pa ssword should be ra ndom a nd not something which ca n be ea sily guessed by others, like your da te of birth etc. 3) Customer need to change your password regularly. 4) Customers should not write their pa ssword on pieces of pa per, which a nybody ca n la y their ha nds on. 5) W hile logging in a lwa ys a dvisable to use virtua l keyboa rd option. This is option where there is ima ge of keyboard on computer screen a nd Tablet banking is still a young channel, but it is rife with potential. As with initial mobile forays, it may take banks some period of trial and error to determine how to build the best banking experience for the tablet environment.

145 136 Banking and Financial Services you a s customer need to press a ppropria te keys on tha t virtua l keyboa rd using your mouse. The order of cha ra cters in the virtua l keyboa rd changes everytime. This is to elimina te the risk of a hacker accessing system remotely, recording keyboa rd strokes a nd guessing pa ssword. 6) Once customers finish the task, they need to log-out properly from their a ccount. If you do not, a nybody who uses the system a fter you ca n misuse your a ccount. The global e-commerce activities include the interaction of traders (buyers/ importers and sellers/exporters) with banks and counterparties, manufacturers, service providers, etc. Banks across the globe provide payment and settlement services thereby, enable the rapid growth of global e-commerce. Reason for Low Usage of Internet Banking in India R i s k No perceived need La ck of knowledge a bout the service Ina ccess i b i l i t y La cking the huma n touch Pricing concerns IT fatigue I ne r t i a Ma na gerial implica tions Volume and Value of Electronic transactions by Scheduled Commercial Banks (Volume in million. Value in ` billion) Type of Volume % Value % Transaction change change ECS Credit ECS Debit Credit cards Debit cards NEFT RTGS Note: Percenta ge cha nge could be slightly different a s a bsolute numbers ha ve been rounded off to million or ` billion.

146 Commercial Banking II 137 CREDIT CARD After industria liz ation, ma nufa cturing sector sta rted growing a t a high speed. More a nd va ried types of goods were sta rted a va ila ble in the ma rket. Following the foot steps of ma nufa cturing industry, service industry a lso sta rted growing. As the expectations of people sta rted increasing, compa nies sta rted coming out with new a nd innova tive products a nd services to meet the expecta tions of the people. One of such innova tive services of 20th century is credit ca rd. Credit ca rd popula rly known a s pla stic money is most widely used wa y of pa ying for products and services. Credit ca rd as a n innova tive service started replacing the usa ge of cash a nd Cheque while ma king the pa yment. But it does not mea n tha t credit ca rd is the instrument used for ma king pa yment only, it comes out with combina tion of va rious a nd innovative fa cilities to meet the expecta tions of the people. Credit ca rds a re an extremely useful wa y of pa ying for products a nd services. They a re often more convenient tha n ca sh or cheques, and they a re a lmost universally accepted (including over the phone). Additiona lly, they a re a grea t wa y for you to establish your creditworthiness. And some ca rds offer a dditiona l benefits, such a s reba tes, frequent flier miles and insura nce. But credit ca rds a re a mixed blessing. They ca n encoura ge excessive spending (which often results in serious financia l pa in for those who carry ba la nces). Also, the interest sta rts a ccumulating immedia tely for new purchases on credit ca rds with bala nces. Additiona lly, unlike most loa ns, credit ca rd debt doesn t ha ve a required repayment schedule, which ca n be a tempta tion to pa y only the minimum amount required a nd never pa y off the full a mount owed. The system is designed this wa y; credit ca rd compa nies make most of their profits from ca rdholders who pay just the minimum amount required, since they charge extra ordina rily high interest ra tes on the money owed. Origin of Credit Card Being the worlds first Service Company USA is the place of origin for credit ca rds. In the yea r 1940, Mobil Oil wa s the first compa ny to issue credit cards to its customers. This helped to increa se its customers ba se, turnover a nd profit. Inspired by the success of Mobil Oil, others a lso sta rted thinking a bout credit ca rd. Followed by Mobil Oil, compa nies like, America n Express, Diners Club, Franklin Na tiona l Ba nk, Ba nk of America ca me out with their credit cards with new a nd innova tive cha racteristics. In la te 60s in USA, interna tiona l ba nk ca rd system ca lled Visa Inte r national wa s esta blished. Followed by this, a nother system ca lled M aste r c ar d wa s set up. Today ma jority of credit ca rd business is done by these two entities. Only banks with net worth of 100 crore and above should undertake credit card business. Banks desirous of setting up separate subsidiaries for undertaking credit card business would, however, require prior approval of the Reserve Bank. Banks should adopt adequate safeguards and implement the guidelines enunciated in this circular in order to ensure that their credit card operations are run in a sound, prudent and customer-friendly manner. Origin of Credit Card in India In the yea r 1964, Diners Club ca rd wa s the first credit card to enter India n territory. In 1981, Andhra Ba nk wa s the first bank to issue credit ca rds in India by ha ving a tie-up with VISA. Immedia tely, Central Ba nk of India ca me out with a credit card by having a tie up with MASTER CARD Corporation. Followed by success of these ca rds, various na tiona lized a s well a s priva te sector banks

147 138 Banking and Financial Services like Ca na ra Ba nk, SBI, Ba nk of India, Vysya Ba nk, Sta nda rd Cha rtered Ba nk a nd Citi Ba nk ca me out with their ca rds with set of innova tive fea tures. 75% of all card payments are concentrated in the top 20 cities with Delhi, Mumbai and their suburbs alone accounting for 43%. Working of Credit Cards Credit ca rd issuing a uthority, i.e., issuing ba nks conducts thorough enquiry of the applica nt seeking the credit card. After sa tisfying a bout his creditworthiness the ba nks issues the credit ca rd. As we ha ve a lrea dy discussed ea rlier, credit cards a re most widely used mea ns of making the payment. Credit ca rd holder can ma ke purcha ses a t va rious purcha se pla ces which a re ha ving fa cility of accepting credit ca rds. These a re ca lled a s Mercha nt Esta blishments (MEs). These MEs includes shops, depa rtmenta l stores, ra ilwa y, a ir tra nsport orga niz ations, hotels a nd even cinema thea ters a nd online purcha se portals. By using credit card, ca rd holder ca n a void the trouble of ca rrying ca sh with them. After purcha sing goods or getting a service, instea d of pa ying cash, customer presents the ca rd. The shop owner checks the identity of the ca rd holder by, seeing the photogra ph of the person on the ca rd (Most of the credit ca rds conta ins photograph of the holder a nd only the origina l holder ca n use the ca rd). After confirming the identity of the person, the reta iler swipes the ca rd in a specia lly designed swiping ma chine, insta lled in his shop. After swiping a nd entering the a mount of purcha se ma de, swiping ma chine genera tes a voucher in duplicate a nd ca rd holder ha s to put his signa ture on the voucher a cknowledging the purchases made by him. Retailer then presents the voucher to the issuing ba nk a nd collects his pa yment. Then the issuing ba nk sends the monthly sta tement of the transa ctions ma de, to the customers, indicating the a mount, pa yment to be made a nd la st da te of pa yment. The ca rd holder ha s to ma ke the pa yment within the due da te to a void pena lty. Thus, credit ca rd opening cycle consists of the following events. (1) After purcha sing, ca rd holder presents his card to mercha nt es t a b l i s hment. (2) Mercha nt esta blishment representa tive swipes the ca rd a nd ta kes the signa ture of the card holder on the voucher genera ted by the swiping ma chine, a s a n a cknowledgement of debt. (3) Mercha nt establishment ra ises the tota l bill of the purcha se ma de a t their mercha nt establishment by various ca rd holders. (4) Issuing ba nks immedia tely (within a week) ma kes the pa yment on such bill a fter deduction of a sma ll portion of commission. (5) After the end of credit cycle (usua lly a month) issuing ba nker sends the monthly sta tement which includes the tota l purcha ses ma de by the ca rd holder during the credit cycle a nd tota l a mount pa ya ble. (6) Ca rd holder ma kes the payment in full to the issuing bank or even he ca n ca rry the ba lance by ma king a minimum payment ( `100).

148 Commercial Banking II 139 Types of Credit Cards (1) On the ba sis of geogra phica l loca tion (a) Domestic Ca rd (b) Interna tiona l Ca rd (2) On the basis of users ca tegory (a) Individua l Cards (b) Corpora te Cards (3) On the basis of sta tus of ca rd (a) Standard Card (b) Business Ca rd (c) Gold Ca rd (4) On the basis of franchise/ tie-up/ issues (a) Ma ster Card (b) Visa Card (c) Proprieta ry Ca rd (5) On the basis of credit recovery (a) Revolving Credit Ca rd (b) Cha rge Card From 1st Jan 2011, RBI declared that for every transaction with debit card on ATM user has to enter password for every transaction. (1) On the Basis of Geographical Location (a) (b) Dome stic Car d: Most of the credit ca rds issued in India is va lid only in India a nd Nepal a nd ca nnot be used a nywhere else. Inte r national Car d: These a re the ca rds which ca n be used a nywhere in the world. This kind of ca rds is issued only to the persons of high

149 140 Banking and Financial Services net worth a nd high degree of credit worthiness. This kind of ca rd is used by people who a re going out of India frequently. W henever the ca rd is used outside India, by ma king purcha se or ca sh withdra wa l, it is covered under FEMA Act and RBI guidelines. (2) On the Basis of Users Category (a) (b) Individual Car ds: W hen a credit ca rd is issued to a n individua l person for his persona l use, it is termed a s individua l card. Corpor ate Car ds: Here the ca rd is issued by the ba nks to compa nies or business orga niz a tions. Any person who is employed in the compa ny (usua lly top officia ls) ca n ma ke use of the ca rd. The ca rd bill is issued in the name of the compa ny a nd a mount is a lso pa id from compa nies a c c o u n t. Credit card schemes normally operate at an international level too, meaning that cardholders belonging to card issuers in one country can make purchases at the place of business of merchants in another country. (3) On the Basis of the Status of the Card (a) (b) (c) Standar d Car d/classic Car d: This is the norma l credit ca rd issued wherein a modera te credit limit ( between ` 20, 000 to ` 50, 000) is provided on the credit ca rd. This type of credit ca rd ca n be used not only for ma king purcha ses, but a lso for few other usages like, ca sh withdra wa l a lso. This card is used mostly by middle cla ss people. B usine ss Car d / Exec utive Car d: This type of ca rd is genera lly issued to sma ll business firms, consulta ncies, etc. All the employees or persons a ssocia ted with such orga niz ations ca n use this ca rd especially when they a re on business tours. Credit limit offered on these ca rds is more than credit limit given on Sta nda rd Ca rds. Gold Car d: Gold ca rd is higher end credit ca rd issued to elite group of persons. The credit limit a nd other fa cilities provided on this type of ca rd is better tha n a ny other ca rds ava ila ble. (4) On the Basis of Franchise/Tie-up/Issues (a) (b) (c) M aste r Car d: Those ba nks which a re ha ving a tie-up with Master Ca rd Corporation of USA, if issues credit ca rd, it is called a Ma ster Card. The ca rd conta ins a logo of ma ster ca rd corpora tion a nd will be honored in the network esta blished by Ma ster Ca rd. VISA Car d: As in case of Ma ster Card, all those banks issuing credit ca rd, if ha s got tied-up with Visa Ca rd Corpora tion USA, such ca rds a re ca lled Visa Cards. This ca rd is opera ted with the help of Visa ca rd n et wo r k. Pr opr ietary Card: When a card issuer is ha ving his own bra nd reflecting his own bra nd na me, it is termed a s Proprieta ry Ca rd ( E.g., Ca n Card issued by Ca nara Ba nk). (5) On the Basis of Credit Recovery (a) Re volving Cre dit Car d: These ca rds a re ba sed on revolving credit limit principle. Here every ca rd ha s its own credit limit ( E. g., sta rting from 10,000 to 1, 00, 000). At the end of one credit cycle ( sa y 1 month), ca rd

150 Commercial Banking II 141 (b) holder ha s to pa y the a mount of credit limit used by him or he ca n pa y a minimum amount (say `100) a nd ca n ca rry the bala nce to next month. Interest va rying from 2% to 3% pm is cha rged on outsta nding ba lance on the card. Char ge Car d: In ca se of Charge Card, a consolida ted bill for specific period is presented to ca rd holder. Bill ha s to be pa yable in full on presentation. In this type of ca rd, ca rd holder ca nnot ca rry the ba la nce; therefore there will be no interest. The Best Credit Cards in India HDFC Credit cards ICICI Ba nk Credit cards City Ba nk Credit cards SBI Credit cards Standa rd Cha rtered Credit ca rds HSBC Credit cards Ca na ra Ba nk Credit cards Axis Ba nk Credit cards Kota k Mahindra Credit cards Ba nk of Ba roda Credit cards Facilities Available in Credit Card The ba sic purpose of having a credit card is to purchase from recogniz ed mercha nt esta blishment and payment of a mount la ter. Other tha n this, basic feature of credit ca rd, other new a nd innova tive fa cilities a re ava ila ble. They a r e, (1) Cash Withdr awal: Card holders ca n withdra w ca sh from any ATMs up to 60%-70% of their credit limit. For exa mple, a ca rd holder having a credit limit of ` 50,000 ca n withdra w up to ` 30,000 from a ny ATMs or bank bra nches having tha t fa cility. Interest ranging from 2%-3% pm is levied on the withdrawn ba la nce. (2) Online pur chase and Payme nts: Credit ca rd ca n be used to make online shopping through a ny of the online shopping porta ls. Simila rly, credit ca rd ca n be used to make pa yment such a s telephone bill, property ta x, electricity bill, etc. For this ca rd holder need to use one time password provided by card issuers. (3) Insur anc e to Car d Holde r s: Some ba nks issues credit ca rds which provides free a ccident/ persona l insura nce. The ca rd holder need not to pa y a ny a dditiona l insura nce premium. For exa mple, SBI ca rd provides insurance cover up to ` 4,00, 000 in ca se of air a ccident a nd ` 2,00, 000 in ca se of other a c c i d e n t s. (4) Pur chase Insuranc e Pr otec tion: Insura nce cover is provided on the a ssets which a re purcha sed by using the credit card. This innova tive fa cility, useful to the ca rd holder in case of loss of a sset due to theft or a ny other reason within a specific time. Customer s rights in relation to credit card operations primarily relate to personal privacy, clarity relating to rights and obligations, preservation of customer records, maintaining confidentiality of customer information and fair practices in debt collection.

151 142 Banking and Financial Services Each bank has a well documented policy and a Fair Practices Code for credit card operations. The Banking Codes and Standards of India (BCSI) has released a Code of Bank s Commitment to Customers (Code) in 2006 (5) Eme rge nc y me dical fac ility: Some credit card issuing ba nks ma y ha ve tie-up with some hospita ls, where by credit ca rd holder or his fa mily members ca n get trea tment fa cility without pa ying a ny bill immedia tely. This fa cility covers special discount va rying from 10%-20% on all types of trea tments. (6) Fr e e fuel facility: Credit card holders ca n buy petrol a t a ny specified petrol pumps without pa ying a ny interest. For exa mple, SBI card holders ca n buy petroleum products a t a ny IOC & IBD outlet and no interest is cha rged on such purchases. (7) Tr ave l pr ivile ge s: Credit ca rd issuing compa nies a re ha ving tie-up with travel agents, hotels, a irlines whereby card holders get fa cilities like, ticket booking, hotel room booking tour pa cka ge a t discount, etc. (8) Custome r car e fac ility: Credit ca rd issuing ba nks provides 24 hrs, customer ca re centers, whereby ca rd holders by ma king a phone ca ll ca n get informa tion rela ting to credit limit, due da te, fa cilities a vaila ble a nd host of other things. (9) Te mpor ar y c r edit enhance me nt: Ca rd holder ca n get a n increa se in credit a s well a s ca sh withdrawa l for tempora ry period on request. (10) Add-on c ar d: Existing ca rd holder gets Additiona l card, which can be used by spouse or children. Expenditure ma de or ca sh withdra wn on these cards a re billed a ga inst ma in ca rd. Existing ca rd holder is lia ble to ma ke the pa yment. Parties involved in Credit Cards The following importa nt pa rties involved in the opera tion of credit cards a r e: Cr edit c ar d holde r s: The person na med on the ca rd. This ma y be customer of a ba nk to whom the card has been issued or a ny such person to whom the ba nk ha s issued a ca rd a uthoriz ed by the customer of the bank to hold a nd use the ca rd. This individua l is a lso responsible for payment of all cha rges ma de to that ca rd. The holder of the credit ca rd who uses to ma ke a purcha se is ca lled the consumer. Card-issuing bank: The financia l institution or other organiz a tion tha t issued the credit ca rd and a lso responsible for billing the ca rdholders for charges. The ba nk bills the consumer for repa yment a nd bea rs the risk tha t the ca rd is used fra udulently. The issuing ba nk extends a line of credit to the consumer. Lia bility for non-pa yment is then sha red by the issuing ba nk a nd a cquiring ba nk. M e rc hant e stablishme nts: The individua l or business a ccepting credit ca rds for sold products or services to the ca rdholders. Ac quir ing bank: The fina ncial institution a ccepts pa yment for the products or services on behalf of the mercha nt esta blishments. Inde pe nde nt sale s or ganization: Resellers (to mercha nts) of the services of the a cquiring ba nk, i. e., outside services providers for marketing of ca rds.

152 Commercial Banking II 143 M er c hant ac count: This could refer to the a cquiring bank or the independent sa les orga niza tion, but in genera l is the orga niza tion tha t the merchant dea ls wi th. Cr edit c ar d association: An a ssocia tion of ca rd-issuing ba nks such a s Visa, Ma stercard, Discover, American Express tha t set tra nsa ction terms for mercha nts, ca rd-issuing ba nks, a nd a cquiring ba nks. Tr ansac tion ne twor k: The system tha t implements the mecha nics of the electronic transa ctions. Ma y be opera ted by an independent compa ny, a nd one compa ny ma y opera te multiple networks. Tra nsa ction processing networks include Ca rdnet, Naba nco, Oma ha, Paymentech, NDC Atla nta, Nova, Vita l, Concord EFSnet, a nd Visa Net. Affinity par tne r: Some institutions lend their na mes to an issuer to a ttra ct customers that ha ve a strong rela tionship with that institution, a nd get pa id a fee or a percenta ge of the bala nce for ea ch ca rd issued using their name. Examples of typical a ffinity pa rtners a re sports teams, universities, cha rities, professiona l orga niz a tions, and major reta ilers. Advantages of Credit Cards Advantages to card holders (1) Ca rd holder can a void ca rrying ca sh which is risky. (2) Ca rd holder can ma ke purcha se without a ctua lly ha ving the money. He ca n buy and pay la ter. (3) Ca rd holder in ca se of fina ncia l emergency can withdra w ca sh by using credit card. (4) Ca rd holders enjoy interest. Free credit up to ma ximum 45 days. (5) Amount outstanding on the ca rd ca n be ca rried forwa rd by just pa ying a minimum a mount of `100. (6) Ca rd holder gets free insura nce cover. (7) Add-on ca rd fa cility provides free ca rds to existing ca rdholder s spouse c h i l d r e n. (8) Certa in credit ca rds ca n be used even outside India and expenditure ca n be made in dolla rs a lso. (9) Ra il reserva tion, air ticket booking ca n be made by using credit card. (10) Credit ca rd holders ca n get host of other facilities like hotel booking, complimenta ry gifts, personal loans, etc. The RBIs guidelines relating to blocking of cards insists that cards should be blocked via easier methods like SMS and get a confirmation to that effect after blocking the card. Advantages of credit cards to issuing bank (1) Most of the ba nks ha ve set up subsidia ry unit ma inly for credit ca rd business a s credit ca rd business is highly profita ble. (2) Ca rd issuers cha rges 2-3% commission on mercha nt esta blishments.

153 144 Banking and Financial Services (3) If ca rd holders delay the pa yment or if he goes for ca sh withdrawa l interest up to 2. 5% is cha rged which constitutes high ra te of return to issuing ba nk. (4) Credit ca rd business improves the bra nd na me of the ca rd issuer. Limitations of credit card (1) For those who does not use the ca rd very frequently it is a wa ste a s they ha ve to pa y a nnua l ma intena nce fee on the ca rd va rying between 500 to ` 2000, whether they use the ca rd or not. (2) Credit ca rd prompts unnecessa ry spending by ca rd holder. (3) Some time excess interest charged by ca rd issuer puts ca rd holders in fina ncia l difficulties. (4) Credit ca rds ca n be used only in few selected establishments a nd ca nnot be used everywhere. Bank cards include both credit cards and debit cards. Bank of America is the largest issuer of bank cards DEBIT CARD Credit ca rd is suffering from certa in limitations, like high interest cha nges a nd limited credit limit. In order to overcome these limita tions the ba nks a nd credit ca rd compa nies in USA a nd western countries introduced a concept of debit card. The ca rd holder ca n use the ca rd for the purpose of ma king purcha se withdra wing ca sh, but still he is not going to ava il a ny credit from issuing a gencies. Here the ca rd holder is ma king use of his money a va ila ble in his own Current/ SB a ccount. As it is popula rly known, it is a n ATM card on the move. The Debit Ca rd gives the freedom to a ccess Sa vings or Current Account a t mercha nt loca tions a nd ATMs. W henever ca rd holder ma kes pa yments, the a mount will be insta ntly debited to a ccount. There a re a round more than 5. 3 la kh Visa/ PLUS ATMs a nd equa lly strong Ma stercard / Cirrus ATMs in over 140 countries worldwide. Debit Ca rd ca n be used a t a ny mercha nt loca tion displa ying the Visa or Ma terca rd logo or at a ny ATMs displaying the Visa/PLUS or Masterca rd/cirrus logo. Besides that, one ca n a lways use it at a ny of the bank ATMs a s a norma l ATM card. Toda y more tha n 60 million people ha ve debit ca rds that ca rry the logos of the two ma jor pa yment ca rd compa nies. Tha t number is expected to grow drama tica lly a s debit ca rds become increa singly popular. Many debit ca rd holders confuse with sta ndard ATM ca rds. Not a ll debit ca rds a re equa l. Debit ca rds with the logo of one of the two ma jor payment ca rd companies a re ATM ca rds with clout. They ca n be used to obta in ca sh from ATM ma chines, a nd a lso to ma ke purcha ses a nywhere the logos on these ca rds a re a ccepted in millions of mercha nt establishment worldwide. Increa singly, debit ca rds combine the key elements of ATM ca rds, credit ca rds a nd cheques - besides giving insta nt a ccess to ca sh a nd worldwide a ccepta nce. The funds come directly out of the ba nk a ccount a nd because purcha ses a nd ATM withdra wa ls a re listed on monthly sta tement, ca rd holders ca n tra ck spending ma de by them in the month. Debit ca rds a re typically used

154 Commercial Banking II 145 a s substitutes for ca sh a nd cheques to pa y for everyda y items such a s groceries, resta urant meals, and depa rtment store purcha ses. Ca rd holder doesn t ha ve to carry ca sh or cheques. And, unless customer dips into overdra ft line of credit, customers need not have to pa y a ny interest. Working of Debit Card Debit Card in look is very much similar to Credit Ca rd. It is a pla stic card, which conta ins the na me of the card holder, ca rd number, logo of the issuing bank ( for exa mple, Corporation Ba nk), logo of the service provider ( Master/ Visa). On the ba ck side of the ca rd, there is a ma gnetic stripe which conta ins va luable electronic data a nd below the ma gnetic stripes, the space for putting signa ture of the card holder. Following steps are involved in the usage of the debit card, (1) On ma king purcha ses, a t a ll merchant esta blishments, which a re eligible to a ccept ca rds, the ca rd holder presents the ca rd for ma king p a y me n t. (2) Shopkeeper swipes the ca rd in a swiping ma chine and enters the a mount of purcha ses made. (3) The customer is supposed to put his Persona l Identifica tion Number (PIN) in the ma chine. (4) Once the PIN ta llies, the swiping ma chine genera tes transa ction slip in duplica te. (5) After verifying the a mount a nd other details, ca rd holder puts his signa ture on the tra nsa ction slip a s a n a cknowledgement of purchases m a d e. (6) Origina l tra nsa ction slip is reta ined by the mercha nt establishment a nd duplica te is given to customers. (7) Immedia tely after the purcha ses, the a mount is a utoma tica lly debited to ca rd holders ba nk a ccount. Debit Cards in Indian Scenario Beca use of lack of technologica l adva ncement, especia lly, computerisa tion of ba nk bra nches, debit ca rd technology in India is still in its infa nt sta ge. Of la te, various commercia l ba nks, including priva te sector a nd na tiona lized banks started issuing debit ca rds to its customers. In India n context, the ca rd issued ia a combina tion of ATM a nd debit ca rd, a nd such ca rd ca n be used for ma king purcha ses a s well as for withdra wing money from ATMs. The banks which ha ve issued debit ca rds in India includes, SBI, Corpora tion Bank, Ca na ra Ba nk, ICICI, HDFC, etc. The issue of debit cards as a payment mechanism would also be subject to relevant guidelines including guidelines on security issues and risk mitigation measures, cardto-card fund transfers, merchant discount rates structure, failed ATM transactions, etc, issued by the Department of Payment and Settlement Systems under the Payment and Settlement Systems Act, 2007, as amended from time to time. Advantages of Debit Card (1) Inconvenience of carrying ca sh ca n be a voided by using the debit card. (2) At the time of ma king purchases, debit ca rds ca n be used.

155 146 Banking and Financial Services (3) Debit Cards can be used as ATM cards, for withdra wing cash from ATMs, depositing the money, depositing cheques/ drafts, pa yment of electricity, phone bills etc. (4) By using debit ca rd, the ba la nce in the a ccount ca n be known before spending the money, thereby control on the wa steful expenditure ca n be exercised. (5) Certa in debit ca rds ca n be used even outside the country. W ha tever the spending ma de in foreign currency will be a utoma tica lly converted into India n currency a nd get debited to the ca rd holder s a ccount. (6) Debit cards ma y be used for the purpose of pa ying insura nce premium, Income tax, telephone bills, credit ca rd bill, etc. (7) Debit cards are of immense use to those who a re a regula r tra veller. Credit and Debit cards Issued by Scheduled Commercial Banks in India Banks may issue only online debit cards including co-branded debit cards where there is an immediate debit to the customers account, and where straight through processing is involved. (in million) S r. Bank group O u t s t a n d i n g O u t s t a n d i n g No. Number of Number of Credit Cards Debit Ca rds I Public sector banks Nationalised banks* SBI Group II Private sector banks Old private sector banks New private sector banks III Foreign banks IV All SCBs (I+II+III) Source: RBI Differences between Credit Card and Debit Card Cred it Ca rd 1. Card h older is u s in g th e cred it fa cility from th e is s u er if h e u s es th e credit ca rd 2. Cred it lim it is res tricted; th erefore u s a ge of cred it ca rd is als o lim ited Debit Ca rd 1. No cred it facility is ava iled, as Deb it h older is u s in g h is own m on ey. 2. No lim it on u s a ge, as ca rd h old er is u s in g h is own m on ey.

156 Commercial Banking II Ca rd h older h as to p ay th e bill (m on ey) a t th e en d of th e sp ecified period 4. In teres t is ch arged on cas h with drawn or b alan ce carried. 5. Ca rd h older n eed to p ay a n n u a l m a in ten an ce fees. 3. As s oon a s th e p u rch ases are m ade, th e am ou n t will be debited to th e cu s tom er s accou n t. 4. No in teres t is ch arged as m on ey belon gs to th e cu s tom er. 5. No m ain ten a n ce fees is collected. UNIVERSAL BANKING Universal Ba nking, a concept tha t ha s gained a lot of accepta nce in recent times, ca n be defined a s a multi-purpose a nd multi-functional superma rket providing both ba nking and fina ncia l services through a single window. In simple words, a Universa l bank is a super store for fina ncia l products. Under one roof, corpora tes ca n get loa ns a nd ava il of other handy services, while individua ls ca n bank a nd borrow. As mentioned in the Discussion Pa per by Reserve Ba nk of India, the term Universal ba nking in genera l refers to the combina tion of commercia l ba nking and investment ba nking, i. e., issuing underwriting, investing a nd tra ding in securities. In a broa d sense, however, the term Universa l ba nking refers to those ba nks tha t offer a wide variety of fina ncial services especia lly insura nce. As per the World Bank, In Universa l Ba nking, la rge ba nks opera te extensive network of bra nches, provide ma ny different services, hold severa l cla ims on firms (including equity a nd debt) a nd pa rticipa te directly in the Corpora te Governa nce of firms tha t rely on the banks for funding or a s insura nce underwriters. In simple words, Universa l Ba nking means the fina ncial entities the commercia l banks, Fina ncia l Institutions, NBFCs tha t underta ke multiple fina ncia l activities under one roof, thereby crea ting a financia l super ma rket. Issue of international debit cards is subject to directions issued under Foreign Exchange Management Act, 1999, as amended from time to time. Activities of Universal Bank Presently, a ll the ba nking orga nisations a re ma rching towa rds Universa l ba nking a nd a s such the distinction in the opera tions of Commercial ba nks, Development Fina ncia l Institutions a nd Non Ba nking Fina ncia l Compa nies (NBFC) is gradua lly reducing. Universa l Ba nks a re cha racterised by the presence in the brea dth a nd depth of different segments of the fina ncial ma rket pa rticula rly debt ma rket. Banks in India a re present in the following a rea s of the universa l ba nking a ctivity. 1. Credit ma rket 2. Consumer fina nce ma rket 3. Sa vings ma rket 4. Money market 5. Capital market 6. Forex market 7. Commodities ma rket 8. Interna tiona l ba nking

157 148 Banking and Financial Services A universal bank participates in many kinds of banking activities and is both a commercial bank and an investment bank as well as providing other financial services such as insurance 9. Advisory service market (mercha nt ba nking) 10. Investment ba nking 11. Insura nce ma rket 12. Fa ctoring 13. Credit, debit and sma rt cards 14. Pension ma rket 15. Project fina ncing 16. Venture ca pita l 17. Online sha re broking 18. Internet ba nking 19. Telephone ba nking 20. Mobile ba nking 21. Securitisa tion In India, most of the commercial ba nks a re rendering a lmost a ll the a ctivities mention a bove. Except for the ICICI Bank Limited, which enjoys the status of India n Universa l Ba nk, the other ba nks which a re a lso rendering the a bove mentioned services, however, do not enjoy the sa me sta tus. Types of Universal Bank There a re four different types of Universa l Ba nks in the world. They a re a s follows 1. Fully Inte gr ate d Unive r sal B anks: Fully Integra ted Universa l banks a re those ba nks which function a s a single institutiona l entity offering a complete ra nge of ba nking and fina ncial products a nd services. 2. Partly Inte gr ated Financ ial Conglome r ate s: It is a n institutiona l setup where the ba nk offers a ra nge of services, with some of the services such a s mortga ge banking, leasing, a nd insura nce being provided through wholly owned or pa rtia lly owned subsidia ries. 3. B ank Subsidiar y Struc tur e: These are the ba nks tha t offer functions such a s investment ba nking a nd insura nce in a ddition to focussing on regula r commercia l ba nking functions. 4. B ank Holding Company Str uc tur e: Bank holding compa ny structure is a n institutiona l set-up where ba nking and fina ncial products a re offered through a fina ncia l holding company that owns both ba nking a nd non ba nking subsidia ries tha t a re lega lly sepa rate. Structure of Universal Banking followed in India In India, the fina ncia l services sector ha s been witnessing a growth in the emergence of fina ncia l conglomera tes. W ith increa sed competition in the fina ncial sector, the ba nking a s well a s non banking entities ha ve felt the need to opt for diversifica tion of their business line. In the process of offering both ba nking a nd fina ncia l products, they sta rted to experiment with orga nisa tiona l

158 Commercial Banking II 149 structures hitherto unfa milia r in India. However, it ha s been seen tha t in India, the Holding Compa ny structure is being commonly followed. Internationally there a re ma inly two holding compa ny models for ba nk rela ted conglomera tes, v iz., Ba nk Holding Compa ny Model a nd Fina ncia l Holding Company Model. (a) Bank Holding Company Mode l: Bank Holding Compa nies (BHCs) a re compa nies tha t own or control one or more ba nks. In USA these a re regula ted by the Federal Reserve. These compa nies were first introduced in Ba nk Holding Compa ny Act of These compa nies ca n ma ke only limited investments in the non ba nking compa nies. (b) Financ ial Holding Com pany Mode l: Fina ncia l Holding Compa nies (FHCs) are compa nies that own or control one or more ba nks or non ba nk fina ncia l compa nies. In USA, FHCs were crea ted by the Gramm- Leach-Bliley Act (GLBA) a s a wa y to expand the financia l services a ctivities of BHCs. GLBA permits banks, securities firms a nd insurance compa nies to affilia te with each other through the FHC structure. FHCs ca n engage in a ctivities other than ba nking a s long a s they a re fina ncia l in na ture. The most importa nt of these are securities underwriting a nd dealing, insura nce underwriting, insura nce a gency a ctivities a nd mercha nt ba nking. The requirement to ha ve ba nk in the fina ncia l group is pre-requisite for qualifying a s a n FHC in USA. In India, as per Reserve Ba nk of India, there are major motivations for ba nks/ fina ncial institutions to opt for BHCs/ FHCs. (a) (b) (c) First, in terms of existing instructions of RBI, a bank s a ggrega te investment in the fina ncia l services compa nies including subsidia ries is limited to 20% of the pa id up capita l a nd reserves of the ba nk. In a BHC/ FHC structure, this restriction will not a pply a s the investment in subsidia ries a nd a ssocia tes will be ma de directly by the BHC/ FHC. Once the subsidia ries a re sepa ra ted from the ba nks, the growth of the subsidia ries/ associa tes would not be constra ined on a ccount of ca pita l. Sec ondly, in the context of public sector ba nks, the Government holding through a BHC/FHC will not be possible in the existing sta tutes. However, if sta tutes a re a mended to count for effective holding then, the most importa nt a dva nta ge in shifting to BHC/ FHC model would be that the ca pita l requirements of banks subsidia ries would be delinked from the ba nks ca pita l. Thirdly, since the non ba nking entities within the ba nking group would be directly owned by the BHC, the conta gion a nd reputa tion risk on a ccount of a ffilia tes for the ba nk is perceived to be less severe a s compa red to the orga nisationa l structure where a bank is directly into the non ba nking business. The concept of universal banking is most relevant in the United Kingdom and the United States, where historically there was a distinction drawn between pure investment banks and commercial banks. In the US, this was a result of the Glass Steagall Act of 1933 Present Status of Universal Banking in India Keeping the recommenda tions of Na rsima ha m committee a nd of Kha n working group (KW G), RBI fa cilita ted DFIs a nd commercia l ba nks through legisla tive a mendments to underta ke the diversified fina ncia l activities. To a va il

159 150 Banking and Financial Services the opportunity a nd to domina te the ma rket position, number of ba nks set up subsidiaries for mercha nt ba nking, mutual fund a nd lea sing a long with commencing factoring a nd securitiza tion. Thus, PSBs a ssumed the cha ra cter of UB during the post reform period a nd SBI, Alla ha bad Ba nk, Panja b Na tiona l Ba nk, Bank of Ba roda, Union Bank of India, Orienta l Ba nk of Commerce beca me pioneer under different ca tegories. Among priva te sector ba nks during the initia l period, the ICICI ba nk, Development Credit Bank Ltd., HDFC Bank Ltd., Kota k Ma hendra Ba nk ha ve a dopted a ggressive a pproa ch towa rd universal ba nking a nd they tra nsformed themselves from term lending into virtua l universa l ba nk in respect to provide corporate a nd retail fina ncia l services like lending a ctivities, life and genera l insura nce, persona l fia ncé, investment ba nking, priva te equity, international ba nking, mortga ges, consumer credit, reta il credit, credit cards etc. For th purpose, they entered into stra tegic allia nce with severa l foreign gia nt insura nce compa nies a nd ba nks to sell their products. ICICI a nd IDBI a dopted merger route to convert themselves into universal ba nks. Universal banking and private banking often coexist, but can exist independently. The provision of many services by universal banks can lead to longterm relationships between universal banks and firms Advantages of Universal Banking 1. Inve stors Tr ust : Universa l ba nks hold sta kes (equity sha res) of ma ny compa nies. These compa nies ca n ea sily get other investors to invest in their business. This is beca use other investors ha ve full confidence a nd fa ith in the Universa l banks. They know tha t the Universa l banks will closely wa tch a ll the a ctivities of the compa nies in which they hold a sta ke. 2. Ec onomie s of Sc ale : Universa l banking results in economic efficiency. That is, it results in lower costs, higher output a nd better products a nd services. In India, RBI is in fa vour of universa l ba nking beca use it results in economies of scale. 3. Re sour c e Utilisation : Universa l ba nks use their client s resources a s per the client s ability to ta ke a risk. If the client ha s a high risk ta king ca pa city then the universa l ba nk will advise him to make risky investments and not sa fe investments. Similarly, clients with a low risk ta king ca pa city a re a dvised to ma ke sa fe investments. Toda y, universa l ba nks invest their client s money in different types of Mutua l funds a nd a lso directly into the share market. They a lso do equity resea rch. So, they ca n also ma na ge their client s portfolios (different investments) profitably. 4. Pr ofitable Dive rsific ation : Universa l ba nks diversify their activities. So, they ca n use the sa me fina ncial experts to provide different fina ncia l services. This sa ves cost for the universa l ba nk. Even the day-to-da y expenses will be sa ved beca use a ll financia l services a re provided under one roof, i. e., in the sa me office. 5. Easy M ar ke ting : The universa l ba nks ca n ea sily ma rket (sell) a ll their fina ncial products a nd services through their ma ny bra nches. They ca n a sk their existing clients to buy their other products a nd services. This requires less ma rketing efforts beca use of their well-esta blished bra nd na me. For e. g., ICICI may a sk their existing ba nk a ccount holders in

160 Commercial Banking II 151 a ll their bra nches, to take house loa ns, insura nce, to buy their Mutua l funds, etc. This is done very ea sily beca use they use one bra nd na me (ICICI) for a ll their fina ncial products a nd services. 6. One-stop Shopping : Universa l ba nking offers a ll fina ncial products a nd services under one roof. One-stop shopping sa ves a lot of time a nd transa ction costs. It also increases the speed or flow of work. So, onestop shopping gives benefits to both ba nks a nd their clients. Disadvantages of Universal Banking 1. Differ e nt Rules and Re gulations : Universa l banking offers all fina ncia l products a nd services under one roof. However, a ll these products a nd services have to follow different rules a nd regula tions. This creates many problems. For e. g., Mutua l Funds, Insurance, Home Loa ns, etc., ha ve to follow different sets of rules a nd regula tions, but they a re provided by the sa me ba nk. 2. Effe c t of Failur e on B anking Syste m : Universa l banking is done by very la rge banks. If these huge ba nks fa il, then it will have a very big a nd ba d effect on the banking system a nd the confidence of the public. For e. g., recently, Lehman Brothers a very la rge universal ba nk fa iled. It ha d very ba d effects in the USA, Europe a nd even in India. 3. M onopoly : Universa l ba nks a re very la rge. So, they ca n easily get monopoly power in the market. This will ha ve ma ny ha rmful effects on the other ba nks a nd the public. This is a lso ha rmful to economic development of the country. 4. Conflic t of Inte r est : Combining commercia l a nd investment ba nking ca n result in conflict of interest. Tha t is, Commercia l ba nking versus Investment ba nking. Some ba nks ma y give more importa nce to one type of ba nking a nd give less importa nce to the other type of ba nking. However, this does not ma ke commercia l sense Operational and Regulatory Issues A fina ncia l institution which is pla nning to convert itself into a universa l ba nk, need to consider the following opera tiona l a nd regula tory issues. a) Rese rve require m e nts. Compliance with the ca sh reserve ra tio a nd statutory liquidity ra tio requirements (under Section 42 of RBI Act, 1934, a nd Section 24 of the Banking Regula tion Act, 1949, respectively) would be ma nda tory for a n FI a fter its conversion into a universa l bank. b) Pe rm issible ac tiv itie s. Any a ctivity of an FI currently underta ken but not permissible for a bank under Section 6(1) of the B. R. Act, 1949, ma y ha ve to be stopped or divested a fter its conversion into a universa l b a n k.. c) Disposal of non banking assets. Any immovable property, howsoever a cquired by an FI, would, a fter its conversion into a universa l ba nk, be required to be disposed of within the ma ximum period of 7 yea rs from the date of a cquisition, in terms of Section 9 of the B. R. Act. ln India, two reports in 1998 mentioned the concept of universal banking. They are, the Narasimham Committee Report and the S.H. Khan Committee Report. Both these reports advised to consolidate (bring together) the banking industry through mergers and integration of financial activities. That is, they advised a combination of all banking and financial activities. That is, they suggested a Universal banking.

161 152 Banking and Financial Services Proponents of universal banking argue that it helps banks better diversify risk. Detractors think dividing up banks operations is a less risky strategy. d) Composition of the Board. Changing the composition of the Boa rd of Directors might become necessa ry for some of the FIs a fter their conversion into a universa l ba nk, to ensure complia nce with the provisions of section 10(A) of the B. R. Act, which requires at lea st 51% of the tota l number of directors to ha ve specia l knowledge a nd experience. e) Prohibition on floating c harge of asse ts. The floa ting cha rge, if crea ted by a n FI, over its a ssets, would require, after its conversion into a universa l bank, ra tifica tion by the Reserve Ba nk of India under section 14(A) of the B. R. Act, since a ba nking compa ny is not a llowed to crea te a floa ting charge on the underta king or a ny property of the compa ny unless duly certified by RBI a s required under the Section. f) Nature of subsidiarie s. If a ny of the existing subsidiaries of a n FI is enga ged in a n a ctivity not permitted under section 6(1) of the B R Act, then on conversion of the FI into a universa l ba nk, delinking of such subsidia ry/ a ctivity from the opera tions of the universa l ba nk would become necessary since section 19 of the Act permits a ba nk to ha ve subsidia ries only for one or more of the activities permitted under section 6(1) of B. R. Act. g) Re striction on inv e stm e nts. An FI with equity investment in companies in excess of 30 per cent of the pa id up sha re ca pita l of tha t compa ny or 30 per cent of its own paid-up sha re ca pita l and reserves, whichever is less, on its conversion into a universal ba nk, would need to divest such excess holdings to secure complia nce with the provisions of section 19(2) of the B. R. Act, which prohibits a ba nk from holding sha res in a compa ny in excess of these limits. h) Conne c te d le nding. Section 20 of the B. R. Act prohibits gra nt of loa ns a nd a dvances by a ba nk on security of its own sha res or gra nt of loa ns or a dva nces on beha lf of a ny of its directors or to a ny firm in which its director/ ma nager or employee or gua ra ntor is interested. The complia nce with these provisions would be manda tory a fter conversion of an FI to a universal bank. i ) Lice nsing. An FI converting into a universa l bank would be required to obta in a banking licence from RBI under section 22 of the B. R. Act, for ca rrying on ba nking business in India, a fter complying with the applicable conditions. j) Branc h ne twork An FI, after its conversion into a ba nk, would a lso be required to comply with exta nt branch licensing policy of RBI under which the new ba nks a re required to a llot a t lea st 25 per cent of their tota l number of branches in semi-urba n a nd rura l a rea s. k) Asse ts in India. An FI a fter its conversion into a universa l bank, will be required to ensure tha t a t the close of business on the la st Frida y of every qua rter, its tota l a ssets held in India a re not less than 75 per cent of its tota l dema nd a nd time lia bilities in India, a s required of a ba nk under section 25 of the B R Act.

162 Commercial Banking II 153 l) Form at of annual re ports. After converting into a universa l ba nk, a n FI will be required to publish its a nnual ba lance sheet a nd profit a nd loss a ccount in the forms set out in the Third Schedule to the B R Act, a s prescribed for a ba nking compa ny under section 29 a nd 30 of the B. R. Act. j) Priority se ctor le nding. On conversion of a n FI to a universa l bank, the obliga tion for lending to priority sector up to a prescribed percentage of their net ba nk credit would a lso become a pplica ble to it. k) Prude ntial norm s. After conversion of a n FI in to a ba nk, the exta nt prudentia l norms of RBI for the a ll-india financia l institutions would no longer be applica ble but the norms a s a pplica ble to ba nks would be a ttra cted a nd will need to be fully complied with. RETAIL BANKING All over the world, there is a shift in the economy from the ma nufa cturing to the service sector. The contribution of ba nking to the service economy is duly recognized. Ba nking industry includes a number of businesses such a s corpora te ba nking, investment ba nking, wea lth ma na gement, ca pital ma rket etc. Reta il ba nking is another segment of the ba nking industry. It is a typica l ma ss- market ba nking chara cteriz ed by a la rge customer ba se a nd a la rge volume of tra nsa ctions. There is a high level of co-opera tion between ba nks, reta ilers, customers a nd consumers in this segment. Reta il ba nking ha s brought in a drastic ma ke over in the overall banking scena rio in India. The exceptiona l improvement in the ba nking system in India is a result of strong initia tives ta ken up by both the government a nd priva te compa nies. Reta il Ba nking ha s been the new focus of the ba nking industry a cross the world. The emergence of new economies and their ra pid growth ha s been the most importa nt contributing fa ctor behind this resurgence in Reta il Ba nking. Changing lifestyles, fa st improvement in informa tion technology, other service sectors a nd increasing levels of income have contributed to the growth of reta il ba nking in countries like India tha t are developing at a good pa ce. In India, the Reta il Ba nking scena rio ha s been the ma rket cha nging from a seller s ma rket to a buyer s ma rket. Reta il ba nks offer services like a ccount opening, credit ca rd, debit ca rd, ATM, Internet ba nking, phone ba nking, insura nce, investment, stockbroking and so on. Reta il ba nking refers to the dea ling of commercial ba nks with individua l customers, both on lia bilities a nd a ssets sides of the ba la nce sheet. Fixed/ current/sa ving a ccounts on the lia bilities side, a nd mortga ges loa ns ( e.g., persona l, housing, a uto a nd educational on the a ssets side, a re the importa nt products offered by ba nks. Rela ted a ncilla ry services include credit ca rds or depository services. Reta il ba nking refers to provision of ba nking services to individua ls a nd small business where the financia l institutions a re dea ling with la rge number of low va lue tra nsa ctions. This is in contra st to wholesa le ba nking where the customers are large, often multina tiona l compa nies, governments and government enterprises a nd the fina ncia l institution dea l in Retail Banking may also be used to refer to a division of a bank dealing with retail customers and can also be termed as Personal Banking services. Retail banking is the most visible face of banking for the general public

163 154 Banking and Financial Services small number of high va lue tra nsa ction. Reta il ba nking ca n be defined as Re tail banking is ty pic ally m ass m arket banking whe re indiv idual c ustome rs use local branches of larger commercial banks. Services offered include savings and c he c king ac counts, m ortgage s, pe rsonal loans, de bit c ards, credit cards and so on. The concept of Reta il Banking is not new to ba nks but is now viewed a s a n importa nt a nd a ttra ctive ma rket segment that offers opportunities for growth a nd profits. Reta il ba nking a nd reta il lending a re often used a s synonyms but in fa ct, the la ter is just the pa rt of reta il ba nking. In retail banking a ll the needs of individua l customers a re ta ken ca re of in a well integra ted ma nner. Reta il ba nking in the country is chara cteriz ed by multiple products, multiple cha nnels a nd multiple customer groups. This multiplicity of the roles to be pla yed by the reta il ba nkers a dds to the excitement a s well a s the cha llenges fa ced by the b a n ke r s. Retail banking aims to be the one-stop shop for as many financial services as possible on behalf of retail clients. Some retail banks have even made a push into investment services such as wealth management, brokerage accounts, private banking and retirement planning. Multiple Products The products included in reta il ba nking are Va rious types of deposits/a ccounts. Credit and debit cards Loans ( Persona l, auto, housing, etc.) Insura nce, mutua l funds, etc. Multiple Channels of Distribution Internet ba nking Mobile ba nking Ca ll centers Multiple Customer Groups Individua l customers Petty businesses Small a nd Medium Enterprises (SMEs) The India n ba nks a re competing with one a nother to gra b a pie of the reta il ba nking sector, which has tremendous potentia l a s retail loans constitute only 8 % of GDP in India, wherea s their percenta ge is a bout 35 in other Asia n economies. Reta il ba nking environment toda y is changing fa st. The cha nging customer demogra phics dema nds to crea te a differentia ted a pplica tion based on sca lable technology, improved service a nd ba nking convenience. Higher penetra tion of technology a nd increa se in globa l literacy levels ha s set up the expecta tions of the customer higher than never before. Increa sing use of modern technology has further enha nced rea ch and a ccessibility. The ma rket toda y gives us a cha llenge to provide multiple a nd innova tive contempora ry services to the customer through a consolida ted window so a s to ensure tha t the ba nk s

164 Commercial Banking II 155 customer gets Uniformity a nd Consistency of service delivery a cross time a nd a t every touch point a cross a ll cha nnels. The pa ce of innova tion is a ccelera ting a nd security threat ha s become prime of a ll electronic tra nsa ctions. High cost structure rendering ma ss-ma rket servicing is prohibitively expensive. Present da y tech-sa vvy ba nkers are now more looking at reduction in their opera ting costs by a dopting sca la ble a nd secure technology thereby reducing the response time to their customers so a s to improve their client base a nd economies of s ca l e. Features of Retail Banking One of the prominent fea tures of Reta il Ba nking products is tha t it is a volume driven business. Further, Reta il Credit ensures tha t the business is widely dispersed among a la rge customer ba se unlike in the ca se of corpora te lending, where the risk ma y be concentra ted on a selected few plans. Ability of a ba nk to a dminister a la rge portfolio of reta il credit products depends upon such fa ctors: 1. Str ong Cr e dit Asse ssme nt Capability Beca use of la rge volume good infra structure is required. If the credit a ssessment itself is qua lita tive, then the need for follow-up in the future reduces con s i de r a b l y. 2. Sound Doc ume ntation A la test system for credit documenta tion is necessa ry pre-requisite for healthy growth of credit portfolio, a s in the ca se of credit a ssessment. This will a lso minimiz e the need to follow-up at future point of time. 3. Str ong Possessing Capability Since large volumes of tra nsactions a re involved, toda y tra nsa ctions, ma intena nce of ba ckups is required. 4. Re gular Constant follow-up Idea lly, follow-up for loa n repa yments should be a n ongoing process. It should sta rt from customer enquiry a nd la st till the loa n is repa id fully. 5. Skille d Human Re sour c e This is one of the most importa nt pre-requisite for the efficient mana gement of la rge a nd diverse reta il credit portfolio. Only highly skilled a nd experienced ma npower ca n withsta nd the river of a dministra ting a diverse a nd complex reta il credit portfolio. 6. Te c hnologic al Suppor t This is yet another vita l requirement. Retail credit is highly technologica l a nd intensive in nature. Because of la rge volumes of business, the need to provide instanta neous service to the customer, faster processing, ma inta ining da ta ba se, etc., is impera tive. According to the Federal Deposit Insurance Corporation (FDIC) the biggest U.S. retail bank is Bank of America followed by W ells Fargo

165 156 Banking and Financial Services Retail banking has been most impacted by technology, thanks to the proliferation of alternate channels of delivery (ATMs, internet and telephone banking). Scope for Retail Banking In India 1. All-round increa se in economic activity. 2. Increa se in the purcha sing power. The rura l area s ha ve the large purcha sing power a t their disposa l a nd this is a n opportunity to ma rket Retail Ba nking. 3. India has 200 million households a nd 400 million middlecla ss popula tion more than 90% of the sa vings come from the house hold sector. Fa lling interest ra tes ha ve resulted in a shift. Now People Wa nt To Sa ve Less And Spend More. 4. Nuclea r fa mily concept is ga ining much importa nce which may lea d to la rge savings, la rge number of ba nking services to be provided a re da y by da y increa sing. 5. Ta x benefits are a va ila ble, for exa mple, in ca se of housing loa ns the borrower ca n ava il ta x benefits for the loa n repa yment a nd the interest charged for the loa n. Significance of Retail Banking Resource Side Reta il deposits a re stable and constitute core deposits. They a re interest insensitive a nd less ba rga ining for additiona l interest. They constitute low cost funds for the ba nks. Effective customer rela tionship mana gement with the reta il customers built a strong customer base. Reta il ba nking increa ses the subsidia ry business of the ba nks. Asse ts Side Reta il ba nking results in better yield and improved bottom line for a b a n k. Reta il segment is good revenue for funds deployment. Consumer loa ns a re presumed to be of lower risk a nd NPA perception. Helps economic reviva l of the na tion through increased production activity. Improves lifestyle a nd fulfils a spirations of the people through afforda ble cr edi t. Innova tive product development credit. Reta il ba nking involves minimum marketing efforts in a dema nd-driven e c o n o m y. Diversified portfolio due to huge customer ba se enables ba nk to reduce their dependence on few or single borrower Ba nks can ea rn good profits by providing non fund-ba sed or fee-based services without deploying their funds.

166 Commercial Banking II 157 Retail Banking Activities Ba nks activities ca n be divided into reta il ba nking, dea ling directly with individuals; business ba nking, providing services to mid-siz e business; corpora te ba nking dea ling with large business entities; priva te ba nking, providing wea lth mana gement services to High Net W orth Individua ls; a nd investment ba nking, relates to helping customers raise funds in the Ca pita l Ma rkets a nd a dvising on mergers a nd a cquisitions. Ba nks a re now moving towa rds Universa l Ba nking, which is a combina tion of commercia l ba nking, investment banking a nd va rious other a ctivities including insura nce. Technology ha s brought a bout stra tegic tra nsforma tion in the working of ba nks. With yea rs, ba nks a re a lso a dding services to their customers. The India n ba nking industry is pa ssing through a pha se of customers ma rket. The customers ha ve more choices in choosing their ba nks. W ith stiff competition a nd a dva ncement of technology, the service provided by ba nks has become more ea sy a nd convenient. Internet Ba nking (e-ba nking) Informa tion Only System Fully Electronic Tra nsa ctional System Automa ted Teller Ma chine (ATM) Credit Ca rds/ Debit Cards Smart Card Core Ba nking Solutions Real Time Gross Settlement (RTGS) Electronic Clea ring Service Mobile Ba nking Challenges to Retail Banking in India The issue of money la undering is very importa nt in reta il ba nking. This compels all the ba nks to consider seriously a ll the documents which they a ccept while approving the loans. The issue of outsourcing ha s become very importa nt in recent pa st beca use va rious core a ctivities such as ha rdwa re a nd softwa re ma intenance have been outsourced. ATM set-up a nd opera tion ( including ca sh, refilling) etc., are being outsourced by Indian ba nks. Ba nks a re expected to take utmost ca re to reta in the ongoing trust of the public. Customer service should be the end-all in retail ba nking. Someone has rightly sa id, It takes months to find a good customer but only seconds to lose one. Thus, strategy of Knowing Your Customer (KYC) is important. So the banks are required to adopt innovative strategies to meet customer s needs a nd requirements in terms of services/products, etc. Retail Banking as a business model is adopted by all the banks in India on account of multiple comfort factors for the banks, viz., acquisition of a huge customer base, multiple product offerings, better pricing and profitability, scope for cross-selling and up selling financial and beyond financial products for increased per customer revenue and of course better risk proposition.

167 158 Banking and Financial Services The dependency on technology has brought IT depa rtments additiona l responsibilities and cha llenges in mana ging, mainta ining a nd optimiz ing the performa nce of retail ba nking networks. The increa sing use of ATMs a nd e-banking ha s pla ced enormous stra in on the working of the systems and procedures followed. Banks ha ve been forced to strike a fine ba la nce between speed a nd security. The efficiency of opera tions would provide the competitive edge for the success in reta il ba nking in coming years. The customer retention is of pa ra mount importance for the profita bility of reta il ba nking business, so ba nks need to reta in their customer in order to increase the ma rket share. One of the crucia l impediments for the growth of this sector is the a cute shorta ge of manpower ta lent of this specific na ture, a modern ba nking professiona l, for a modern banking sector. Reta il ba nking ha s tremendous potentia l for growth, even though there a re stiff cha llenges to be met. The ba nks have to judiciously use the ava ilable technologica l fa cilities to ea rn competitive a dvanta ge by crea ting successful products in their area of strength. If this is done successfully a long with proper ca re for customers security a nd confidence, the potentia l in reta il ba nking ca n be definitely rea lized. REVIEW QUESTIONS 1. Discuss the recent trends in India n ba nking. 2. W hat a re the fa cilities provided under core ba nking solution? 3. W hat a re the a dva nta ges of CTS over norma l clearing process? 4. List out the ba nking fa cilities provided through a n ATM. 5. Briefly describe the electronic fund transfer mechanism a va ila ble in India. 6. W hat a re the ba nking fa cilities provided through Internet ba nking in India? 7. W hat a re the types of credit ca rds? 8. Discuss the fea tures of Reta il ba nking. REFERENCES A Study of Net Ba nking provided by HDFC Bank, www. scribd. com/.../ a- study-of- netba nking-provided-by-hdfc-ba nk Birendra Kuma r (2009), Performa nce of Reta il Ba nking in India, Asoc he m Financial Pulse (AFP). India. Ca se Study: State Bank of India, W orld s Largest Centra lized Core Processing Implementa tion, Robert Hunt, (2009)

168 Commercial Banking II 159 Da ta Protection in Consumer E-banking, J ournal of Interne t Bank ing and Comme rc e, April 2006, vol. 11, no. 1 ( a rra ydev. com/commerce/ j i b c/) Diva nna, J.A. (2009), The Future Retail Bank ing, Pa lgra ve Ma cmilla n, New York. E-Ba nking: Risks And Responses Ca rol Sergea nt Director, Ba nks & Buildings Societies Financia l Services Authority www. fsa. gov. uk Electronic Ba nking Sa fety a nd Soundness Exa mina tion Procedures Federa l Deposit Insura nce Corporation Division Of Supervision ( www. fdic. gov/ regula tions) The Informa tion Technology Bill, 1999 ( bill 99.htm) Electronic Funds Tra nsfer System Procedura l Guidelines, Reserve Ba nk of India Depa rtment of Pa yment & Settlement Systems, Centra l Office, Mumba i, Ma rch 2005 ICICI Ba nk Consumer Ba nking in India, www. iciciba Internet Ba nking Comptroller s Ha ndbook, October 1999 Internet Banking in India part I by Dr. A.K. Mishra, Na tiona l Electronic Funds Tra nsfer System Procedura l Guidelines 92011), RBI. Project on SWOT a nalysis of ICICI Ba nk, com/doc/ / Swot-of- CICI-Ba nk Reta il Ba nking - Models, Strategies, Performances a nd the Future -The India n Scena rio, Dr. J. Sethura ma n, For India n Institute of Banking a nd Finance, Mumba i S. Sba nka ra n (2011), Universa l ba nking by DFI: ha ndy but no Solution to NPA s, Business Line, 2, International Journal of Latest Trends in Engineering and Te c hnology

169 CHAPTER 5 THE SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI) Learning Objectives After rea ding this cha pter you should be a ble to understa nd the need for SEBI the functions of SEBI the different depa rtments of SEBI a nd their a ctivities. the powers vested with SEBI the legal framework of SEBI

170 162 Banking and Financial Services NEED FOR SEBI The Preamble of SEBI Act, 1992 enshrines the objectives of SEBI - to protect the interest of investor in securities market and to promote the development of and to regulate the securities market. Presence of a n efficient securities ma rket is a n importa nt requirement for a country s ma rch towa rds industria liz ation. For, the ma rket offers a mecha nism for efficient mobiliz a tion of sa vings of the household sector into productive investment. By offering a ttractive rewards in the form of interest returns a nd ca pita l a pprecia tion, the securities ma rket encoura ges thrift and risk taking. It a lso helps enterprises to ra ise money in a cost effective manner. The emergence of securities ma rket in India da tes ba ck to the eighteenth century when the Bomba y Stock Exchange wa s set up in 1887 then followed by setting up of other stock excha nges. It wa s a vita l segment of the India n fina ncia l system. After setting up of stock excha nges they were regula ted by Capita l Issue Control Act. The need for setting up a regula tory body to oversee the opera tions of ca pita l ma rket was felt by government which resulted in setting up of SEBI. The Securities a nd Exchange Boa rd of India (SEBI) wa s constituted on 12th April, 1988, a s a non sta tutory body through a n a dministrative Resolution of the Government for dea ling with a ll ma tters rela ting to development a nd regula tion of the Securities ma rket a nd investor protection a nd to a dvise the government on a ll these ma tters. SEBI was given statutory status a nd powers through a nd ordina nce promulgated on J a nua ry 30, SEBI wa s esta blished a s a statutory body on 21st Februa ry, The ordina nce wa s repla ced by a n Act of Pa rlia ment a s 4th April, The sta tutory powers a nd functions of SEBI were strengthened through the promulga tion of the Securities La ws (Amendment) Ordina nce on 25th Ja nua ry, 1995, which was subsequently repla ced by a n Act of Parlia ment. Before SEBI Act, 1992, the three principa l Acts governing the securities ma rket were: (a) the Ca pita l Issues (Control) Act, 1947, which restricted issuer s a ccess to the securities ma rket and controlled the pricing of issues; (b) the Compa nies Act, 1956, which sets out the code of conduct for the corpora te sector in rela tion to issue, allotment and tra nsfer of securities, a nd disclosures to be ma de in public issues; and (c) the Securities Contra cts (Regula tion) Act, 1956, which provides for regula tion of tra nsa ctions in securities through control over stock excha nges. The Capita l Issues (Control) Act, 1947 ha d its origin during the wa r in 1943 when the objective wa s to cha nnel resources to support the wa r effort. The Act was retained with some modifica tions as a mea ns of controlling the ra ising of ca pita l by compa nies a nd to ensure tha t na tiona l resources were channelled into proper lines, i. e., for desira ble purposes to serve goa ls a nd priorities of the government, a nd to protect the interests of investors. Under the Act, a ny firm wishing to issue securities ha d to obtain a pproval from the Centra l Government, which also determined the a mount, type a nd price of the issue. Ma jor part of the libera lisation process wa s the repeal of the Ca pital Issues (Control) Act, 1947 in Ma y, W ith this, Government s control over issue of capita l, pricing of the issues, fixing of premia a nd ra tes of interest on debentures, etc., cea sed. The office which a dministered the Act wa s abolished and the ma rket

171 The Securities and Exchange Board of India (SEBI) 163 wa s a llowed to a lloca te resources to competing uses. However to ensure effective regula tion of the ma rket, SEBI Act, 1992 wa s ena cted to empower SEBI with statutory powers for (a) protecting the interests of investors in securities, (b) promoting the development of the securities ma rket, a nd (c) regulating the securities market. Its regula tory jurisdiction extends over corpora te in the issua nce of ca pital a nd tra nsfer of securities, in a ddition to a ll intermedia ries a nd persons associa ted with securities ma rket. SEBI can specify the matters to be disclosed and the standa rds of disclosure required for the protection of investors in respect of issues; can issue directions to a ll intermediaries a nd other persons a ssocia ted with the securities market in the interest of investors or of orderly development for securities ma rket; a nd ca n conduct enquiries, a udits and inspection of a ll concerned a nd adjudica te offences under the Act. In short, it ha s been given necessa ry a utonomy and a uthority to regula te a nd develop a n orderly securities ma rket. OBJECTIVES OF SEBI The B asic Objec tive s of the SEBI we r e Ide ntifie d as to protect the interests of investors a nd ensure sa fety to their i n ve s t ment ; to promote the development of Securities Ma rket; to regulate the securities ma rket; to prevent ma lpra ctices by ha ving a ba lance between self-regula tion of business a nd its sta tutory regula tions; a nd to regula te and develop a code of conduct for intermedia ries such a s brokers, underwriters, etc. Since its inception SEBI ha s been working targeting the securities a nd is a ttending to the fulfillment of its objectives with commendable z eal a nd dexterity. The improvements in the securities ma rkets like ca pita liz ation requirements, ma rgining, esta blishment of clea ring corpora tions, etc., reduced the risk of credit a nd a lso reduced the market. SEBI ha s introduced the comprehensive regula tory measures, prescribed registration norms, the eligibility criteria, the code of obliga tions and the code of conduct for different intermedia ries like, ba nkers to issue, mercha nt ba nkers, brokers a nd sub-brokers, registra rs, portfolio ma na gers, credit ra ting a gencies, underwriters a nd others. It has framed byela ws, risk identifica tion a nd risk ma na gement systems for clea ring houses of stock excha nges, surveilla nce system, etc., which has ma de dealing in securities both sa fe a nd tra nsparent to the end investors. The securities market is regulated by various agencies, such as the Department of Economics Affairs (DEA), the Department of Company Affairs (DCA), the Reserve Bank of India (RBI) and the SEBI.

172 164 Banking and Financial Services Capital Market Regulators of Different Countries Australia: Australian Securities and Investments Commission (ASIC) B anglade sh: Securities a nd Excha nge Commission (Ba ngla desh) Canada: Canadian Securities Administrators (CSA) China: China Securities Regulatory Commission (CSRC) Denmark: Financial Supervisory Authority (Denmark), Egypt: Egyptia n Fina ncia l Supervisory Authority France: Autorité de Controle Prudentiel (France) (ACPR) Ger many: Federa l Fina ncia l Supervisory Authority Gre e ce: Greek Ca pita l Ma rket Commission Hong K ong: Hong Kong Securities a nd Futures Commission India: Securities a nd Excha nge Boa rd of India (SEBI) Indone sia: Fina ncial Services Authority (Indonesia) Japan: Securities a nd Exchange Surveilla nce Commission K ore a South: Financia l Services Commission (FSC) M alaysia: Securities Commission Ma laysia (SC) Ne the r lands: Netherlands Authority for the Fina ncial Ma rkets New Zealand: Financial Markets Authority (New Zealand) Nigeria: Securities and Exchange Commission (Nigeria) Norway: Financial Supervisory Authority of Norway Oman: Capital Market Authority (Oman) Pakistan: Securities a nd Excha nge Commission of Pa kista n Russia: Federa l Fina ncia l Markets Service (Russia) Saudi Arabia: Capital Market Authority (Saudi Arabia) Singapor e: Moneta ry Authority of Singapore South Afr ica: Fina ncial Services Boa rd (South Africa) Spain: Investment sector regulator - Spa nish Securities Ma rket Commission Sri Lanka: Securities and Exchange Commission of Sri Lanka Swaziland: Ca pita l Ma rkets Development Unit (Centra l Ba nk of Swaziland) Sweden: Financial Supervisory Authority (Sweden) Switze r land: Swiss Fina ncia l Market Supervisory Authority Thailand: Office of the Securities and Excha nge Commission, Tha ila nd FUNCTIONS OF SEBI Section 11 of the SEBI Act specifies the functions a s follows: 1. Regulatory function Regula ting the business in stock excha nges a nd a ny other securities ma r k e t s,

173 The Securities and Exchange Board of India (SEBI) 165 Registering and regula ting the working of stockbrokers, sub-brokers, share tra nsfer a gents, ba nkers to a n issue, trustees of trust deeds, registrars to a n issue, merchant bankers, underwriters, portfolio ma na gers, investment a dvisers and such other intermedia ries who ma y be a ssocia ted with securities ma rkets in a ny ma nner. Registering and regula ting the working of the depositories, pa rticipa nts, custodians of securities, foreign institutiona l investors, credit ra ting a gencies a nd such other intermedia ries as the Boa rd ma y, by notification, specify in this behalf. Registering a nd regula ting the working of venture ca pita l funds a nd collective investment schemes including mutual funds; Prohibiting fra udulent a nd unfa ir tra de pra ctices relating to securities ma r ke t s ; Prohibiting insider tra ding in securities; Regula ting substa ntia l a cquisition of shares and ta keover of compa nies; Ca lling for information from underta king inspection, conducting inquiries a nd a udits of the stock excha nges, mutua l funds a nd other persons a ssocia ted with the securities ma rket a nd intermediaries a nd self-regula tory orga niz a tions in the securities ma rket; Ca lling for information and record from any bank or a ny other a uthority or boa rd or corporation esta blished or constituted by or under a ny Centra l, Sta te or Provincia l Act in respect of a ny tra nsa ction in securities which is under investigation or inquiry by the Board; Ca lling from or furnishing to a ny such a gencies, a s ma y be specified by the Boa rd, such informa tion a s may be considered necessa ry by it for the efficient discha rge of its functions; Performing such other functions a s ma y be prescribed. 2. Developmental Functions (a) (b) Promote investor s education to increa se pa rticipa tion in capita l ma rket. Training of intermedia ries such as brokers, sub-brokers, etc. (c) Conducting resea rch a nd publishing ma rket informa tion which a re useful to a ll ma rket pa rticipa nts. (d) Promoting self-regula tory orga nisa tions. The SEBI got legal teeth through an ordinance issued on 30th January, The ordinance conferred wideranging powers on the SEBI, including the authority to prohibit insider trading and regulate substantial acquisition of shares and takeover of business. 3. Protective Functions These functions a re performed by SEBI to protect the interest of investor a nd provide sa fety of investment. The following ar e the pr ote c tive func tions of SEB I. (i) Contr olling Pric e Rigging: Price rigging refers to ma nipulating the prices of securities with the ma in objective of infla ting or depressing the ma rket price of securities. SEBI prohibits such pra ctice a nd controls i t.

174 166 Banking and Financial Services (ii) Pr ohibition of Inside r tr ading: The insiders such a s directors employees who ha ve a ccess to price sensitive informa tion of the compa ny ma y use it to their personal benefit and ma ke profit out of it. For e. g.,: CFO of a company may purcha se the shares of a company just before announcement of results. SEBI keeps a strict check when insiders a re buying securities of the compa ny a nd ta kes strict a ction on insider tra ding. Cases taken up by SEBI for Investigations The SEBI has introduced an automated complaint handling system to deal with investor complaints. Year Cases Taken up Cases for Investigation C ompl e te d Total Source: SE BI Annual Report,

175 The Securities and Exchange Board of India (SEBI) 167 (iii) Prohibition of Fraudule nt and Unfair Tr ade Prac tic e s: SEBI does not a llow the compa nies to make mislea ding sta tements which are likely to induce the sa le or purcha se of securities by a ny other persons. (iv) SEBI promotes fa ir pra ctices a nd code of conduct in security ma rket by ta king following steps: SEBI ha s issued guidelines to protect the interest of debenture holders wherein compa nies cannot cha nge terms in midterm. SEBI is empowered to investigate cases of insider tra ding a nd ha s provisions for stiff fine a nd imprisonment. SEBI ha s stopped the practice of making preferential a llotment of shares unrela ted to ma rket prices. List of former Chairmans of SEBI Na m e Fro m T o C. B. Bh ave 1 8 Febr u ar y Febr u ar y M. Dam odar an 1 8 Febr u ar y Febr u ar y G. N. Ba jpai 2 0 Febr u ar y Febr u ar y D. R. Meh ta 2 1 Febr u ar y Febr u ar y S. S. Nad kar n i 1 7 J an u ary J an u ar y G. V. Ram akr is h na 2 4 Au gu st J an u ar y Dr. S. A. Dave 1 2 Apr il Au gu st POWERS OF THE SEBI SEBI ha s been a ssigned with following power : 1. Powe r of Civil Cour t - For ca rrying out the duties a ssigned to it under the a ct, the SEBI ha s been vested with the powers a s a re ava ila ble to a Civil Court under the Code of Civil Procedure Code, 1908 for trying a suit in respect of following ma tters: a) The discovery and production of books of a ccount a nd other documents, a t such pla ce a nd such time a s may be specified by SEBI; b) Summoning a nd enforcing the attenda nce of persons a nd exa mining them on oa th; c) Inspection of a ny books, registers a nd other docume nts of any person d) Inspection of a ny book, or register, or other document or record of the compa ny ; e) Issuing commissions for the exa mina tion of witnesses or documents. 2. Power s to Suspe nd and Re strain - SEBI ma y, by a n order, for reasons to be recorded in writing, in the interests of investors or securities ma rket, ta ke a ny of the following measures, either pending investiga tion or inquiry or on completion of such investiga tion or inquiry, na mely:- The SEBI set up a new institution in 2003 called the Ombudsman for the capital market. It has encouraged forming of investors associations.

176 168 Banking and Financial Services a) Suspend the tra ding of a ny security in a recognised stock excha nge; b) Restra in persons from a ccessing the securities ma rket a nd prohibit a ny person associated with securities ma rket to buy, sell or dea l in s e cur i t i e s ; c) Suspend any office-bea rer of any stock excha nge or self-regula tory orga nisation from holding such position; d) Impound a nd reta in the proceeds or securities in respect of a ny transa ction which is under investiga tion; SEBI has regulated the primary market through (i) the regulation of issuers access to market (ii) regulation of information production at the time of issue, and (iii) regulation of processes and procedures relating to issuance of securities. Source: SE BI Annual Report, Nature of Investigations Taken up by SEBI Particulars I n v e s t i g a t i o n s I n v e s t i g a t i o n s Taken up C o m p l e t e d Market man ipu lation and price rigging Issue related man ipu lation Insider trading T ak e o ve r s M i s c e l l a n e o u s T o t a l Powe r s to r e gulate or prohibit issue of pr ospe c tus, offe r docume nt or adve r tise me nt soliciting mone y for issue of sec ur itie s SEBI ma y for the protection of investors for (i) the ma tters relating to issue of ca pita l, tra nsfer of securities a nd other ma tters incidenta l thereto; a nd (ii) the ma nner in which such ma tters sha ll be disclosed by the compa nies. SEBI ma y by genera l or specia l orders prohibit a ny compa ny from issuing prospectus, a ny offer document, or a dvertisement soliciting money from the public for the issue of securities. SEBI ma y a lso specify the conditions subject to which the prospectus, such offer document or a dvertisement, if not prohibited, ma y be issued. It ma y specify the requirements for listing and transfer of securities a nd other ma tters incidenta l thereto. 4. Powe r to Issue Dir e c tions If a fter ma king enquiry, SEBI is sa tisfied tha t it is necessa ry in the interest of investors, or orderly development of securities market. Or to prevent the affa irs of a ny intermedia ry or other persons (stockbroker, subbroker, sha re tra nsfer a gents, etc.) being conducted in a ma nner detrimental to the interest of investors or securities ma rket. Or to secure the proper ma na gement of a ny such intermedia ry or person. It may issue such directions a. to a ny person or cla ss of persons referred to in section 12, or a ssociated with the securities ma rket; or b. to a ny compa ny in respect of ma tters specified in section 11A, a s ma y be a ppropria te in the interests of investors in securities a nd the securities ma rket

177 The Securities and Exchange Board of India (SEBI) Powe r to Inve stigate W here SEBI has rea sona ble ground to believe tha t the tra nsa ctions in securities a re being dealt with in a manner detrimenta l to the investors or the securities ma rket or a ny intermediary or a ny person a ssocia ted with the securities market ha s viola ted a ny of the provisions of this Act or the rules or the regula tions ma de or directions issued by SEBI, it ma y, at a ny time by order in writing, direct a ny person specified in the order to investiga te the affa irs of such intermedia ry or persons a ssocia ted with the securities market a nd to report thereon to SEBI. It sha ll be the duty of every ma na ger, ma na ging director, officer and other employee of the compa ny a nd every intermediary or every person a ssociated with the securities ma rket to preserve and to produce to the Investiga ting Authority or any person authorised by it in this beha lf, a ll the books, registers, other documents a nd record of, or rela ting to, the compa ny or, a s the ca se ma y be, of or relating to, the intermedia ry or such person, which are in their custody or power. The Investiga ting Authority may require a ny intermedia ry or a ny person a ssocia ted with securities ma rket in a ny ma nner to furnish such informa tion to, or produce such books, or registers, or other documents, or record before it or a ny person a uthorised by it in this behalf a s it ma y consider necessa ry if the furnishing of such informa tion or the production of such books, or registers, or other documents, or record is releva nt or necessa ry for the purposes of its i nvestiga t i on. 6. Powe r to Issue Ce ase and De sist Proc e e ding If SEBI finds, a fter ca using an inquiry to be ma de, tha t a ny person ha s viola ted, or is likely to viola te, a ny provisions of this Act, or a ny rules or regula tions made thereunder, it may pa ss a n order requiring such person to cease a nd desist from committing or ca using such violation: Provided tha t SEBI shall not pa ss such order in respect of a ny listed public compa ny or a public compa ny which intends to get its securities listed on any recognized stock excha nge unless SEBI has reasona ble grounds to believe tha t such compa ny ha s indulged in insider tra ding or ma rket ma nipula tion. 7. Re gulation of Inte rme diarie s Registration of Stockbroker, Subbroker, Sha re Transfer Agents. There a re number of intermedia ries which a re a ssocia ted with securities ma rket in buying, selling a nd otherwise dea ling in securities such a s :- (i) s t ockb r oker, (ii) s u b b r oke r, (iii) share tra nsfer a gent, (iv) ba nker to a n issue, (v) trustee of trust deed, (vi) registrar to an issue, Sometimes SEBI will have to get prior approval of the government for filing criminal complaints for violations of the regulations and this results in delay in prosecution.

178 170 Banking and Financial Services Insider trading is defined as a malpractice wherein trade of a company s securities is undertaken by people who by virtue of their work have access to the otherwise non public information which can be crucial for making investment decisions. (vii) mercha nt (viii) u n d e r wr i t e r, (ix) portfolio ba nker, ma na ger, (x) investment adviser, etc. 8. Powe r to Cance l Ce rtificate SEBI ma y, by order, suspend or ca ncel a certifica te of registra tion in such ma nner as ma y be determined by regula tions. However a s per proviso of this section, no order under this subsection sha ll be ma de unless the person concerned ha s been given a reasona ble opportunity of being heard. According to this section SEBI is empowered to suspend or ca ncel a certifica te of registra tion gra nted by it. However, this should be done a s per principle of na tura l justice a nd requires a rea sona ble opportunity of being hea rd to such person. Moreover, a ny order pa ssed by SEBI under this sub section would a ffect vita l rights of the concerned person, so, the order must be a spea king or reasoned order notwithsta nding the fa ct that the SEBI is not a judicia l or a quasi judicia l body. Type of Regulatory Actions taken by SEBI during the Year Particulars Numbers of Entries 1 2 S u s p e n s i o n 3 1 Warning issued 9 Prohibitive directions issued under Section 11 of SEBI Act (other tha n consent orders) C a n c e l l a t i o n 3 Adjudication orders passed Administra tive wa rning/ wa rning letter issued 3 1 Deficiency observa tions issued 1 4 Advice letter issued 2 3 Total Source: SE BI Annual Report, Powe r s to Pr ohibit the M anipulative and De c e ptive Devic e s, Inside r Tr ading and Substantial Ac quisition of Se cur itie s or Contr ol According to SEBI (a) a ct, no person sha ll directly or indirectly use or employ, in connection with the issue, purcha se or sa le of a ny securities listed or proposed to be listed on a recognised stock

179 The Securities and Exchange Board of India (SEBI) 171 (b) excha nge, a ny ma nipula tive or deceptive device or contriva nce in contravention of the provisions of this Act or the rules or the regula tions ma de thereunder; employ a ny device, scheme or a rtifice to defra ud in connection with issue or dea ling in securities which a re listed or proposed to be listed on a recognised stock exchange; (c) enga ge in insider tra ding; (d) deal in securities while in possession of ma teria l or non-public informa tion or communica te such ma teria l or non-public informa tion to a ny other person, in a ma nner which is in contravention of the provisions of this Act or the rules or the regula tions made thereunder; (e) a cquire control of a ny company or securities of more tha n the percentage of equity sha re ca pital of a compa ny whose securities a re listed or proposed to be listed on a recognised stock excha nge in contra vention of the regula tions ma de under this Act Powe r s to Impose Penaltie s and Adjudic ation Chapter VI of the SEBI Act, 1992 conta ins section 15A to section 15 J A which dea ls with pena lties which ca n be imposed under the Act for va rious fa ilures, defa ulters, non isclosures a nd other offences such a s Pena lties for fa ilures, disclosures Pena lties for fa ilure by a ny person to enter into a greement with Clients Pena lties for fa ilure to redress investor s grieva nces Pena lty for certa in defa ults in case of mutua l funds Pena lty for failure to observe rules a nd regula tions by a n a sset ma na gement compa ny Pena lty for insider tra ding Pena lty for non-disclosure of a cquisition of sha res a nd ta keovers Pena lty for fra udulent and unfa ir tra de pra ctices 1 1. Power to Make Regulations Section 30 of the a ct empowers the SEBI to ma ke regula tions to ca rry out the purposes of the a ct a nd every regula tion must be ma de a nd published as a notification in the Ga zette. Every rule a nd regula tion made under this Act sha ll be la id before ea ch House of Pa rlia ment. If houses modify rule and regula tion then that should be modified a ccordingly SEBI has the powers of a Civil Court under the SEBI Act

180 172 Banking and Financial Services ORGANIZATION STRUCTURE, COMMITTEES AND ADMINISTRATION OF SEBI Prior to the establishment of SEBI stock exchanges were under the administrative control of the Stock Exchange Division of DEA. A. Departments of SEBI Chapter II of the SEBI Act dea ls with establishment, incorpora tion, a dministra tion a nd ma nagement of the Boa rd of Directors etc. The SEBI Act provides for the esta blishment of a statutory board consisting of six members. The cha irma n and two members are to be appointed by the Centra 1 Government, one member to be a ppointed by the Reserve Ba nk a nd two members ha ving experience of securities ma rket to be a ppointed by the Centra l Government. Section II dea ls with the powers of the Board. SEBI ha s divided its a ctivities into six opera tiona l depa rtments na mely. (a) Prima ry ma rket depa rtment, (b) Issue ma na gement a nd intermedia ries depa rtment, (c) Seconda ry ma rket depa rtment, (d) Institutional depa rtment, (e) Lega l Depa rtment, a nd (f) Investiga tion Depa rtment, (a) (b) (c) (d) (e) (f) Pr imar y Mar ke t De par tme nt: Prima ry ma rket depa rtment dea ls with a ll policy ma tters a nd regula tory issues rela ting to new issue ma rket/ prima ry ma rket. Issue M anage ment and Inte r me diar ie s De par tme nt: This depa rtment is concerned with ma tters like registra tion, regulation a nd monitoring of issue rela ted to intermedia ries. Se condary M arke t De partme nt: It looks after all ma tters rela ting to the seconda ry ma rket; a dministra tion of the major stock excha nges registra tion of brokers, etc Institutional Inve stme nt De par tme nt: This depa rtment is concerned with framing rules a nd regulations relating to foreign institutiona l investors, mutua l funds a nd other ma tters like publica tions, membership in international organisa tions, etc. Le gal De par tme nt; this depa rtment dea ls witha l the lega l ma tters concerned with SEBI Inve stigation Depar tme nt; This department is concerned with va rious types of ma rket resea rch or investiga tions ca rried out by SEBI. B. Board of SEBI Upendra Kuma r Sinha wa s a ppointed cha irma n on 18th Februa ry, 2011 repla cing C. B. Bha ve. The Boa rd of SEBI is ma de up of Upendra Kuma r Sinha - Cha irma n Prasha nt Sa ra n - W hole Time Member

181 The Securities and Exchange Board of India (SEBI) 173 Ra jeev Kuma r Aga rwa l - W hole Time Member Dr. Thoma s Mathew - J oint Secretary, Ministry of Finance V. K. J aira th ma gya - Member Appointed Anand Sinha - Deputy Governor, Reserve Ba nk of India Na ved Masood - Secreta ry, Ministry of Corpora te Affairs C. SEBI Committees SEBI forms committees to look into va rious aspects of ca pital ma rket regula tion. Some of the committees include. 1. Technica l Advisory Committee 2. Committee for Review of Structure of Ma rket Infra structure Institutions 3. Members of the Advisory Committee for the SEBI Investor Protection a nd Educa tion Fund 4. Ta keover Regula tions Advisory Committee 5. Prima ry Ma rket Advisory Committee (PMAC) 6. Seconda ry Ma rket Advisory Committee (SMAC) 7. Mutua l Fund Advisory Committee 8. Corpora te Bonds a nd Securitiza tion Advisory Committee 9. Takeover Panel 1 0. SEBI Committee on Disclosures a nd Accounting Sta nda rds (SCODA) 1 1. High Powered Advisory Committee on Consent Orders a nd Compounding of O ffences 1 2. Deriva tives Ma rket Review Committee D. SEBI Administration The Securities a nd Excha nge Boa rd of India Act, 1992 is ha ving retrospective effect a nd is deemed to ha ve come into force on J anua ry 30, Rela tively a brief Act containing 35 sections, the SEBI Act governs a ll the Stock Excha nges a nd the Securities Tra nsa ctions in India. A Boa rd by the na me of the Securities a nd Exchange Boa rd of India (SEBI) wa s constituted under the SEBI Act to a dminister its provisions. It consists of one Chairma n a nd five me mb e r s. One ea ch from the depa rtment of Fina nce a nd La w of the Centra l Government, one from the Reserve Ba nk of India a nd two other persons a nd ha ving its head office in Bomba y a nd regiona l offices in Delhi, Kolka ta a nd Chenna i. The Centra l Government reserves the right to termina te the services of the Cha irman or a ny member of the Board. The Boa rd decides questions in the meeting by ma jority vote with the Cha irma n having a second or ca sting vote. Section 11 of the SEBI Act provides tha t to protect the interest of investors in securities a nd to promote the development of and to regula te the securities ma rket by such mea sures, it is the duty of the Board. It ha s given power to the Board to regula te the business in Stock Excha nges, register a nd regula te the SEBI draws some of its authority from the Companies Act, which empowers SEBI to administer a number of provisions of the Companies Act. These sections pretty much govern the capital mobilization process, liquidity creation process and the dividend payment process.

182 174 Banking and Financial Services working of stock brokers, sub-brokers, sha re tra nsfer a gents, ba nkers to a n issue, trustees of trust deeds, registrars to a n issue, mercha nt ba nkers, underwriters, portfolio ma na gers, investment a dvisers, etc., a lso to register a nd regula te the working of collective investment schemes including mutua l funds, to prohibit fraudulent a nd unfa ir tra de pra ctices a nd insider trading, to regulate takeovers, to conduct enquiries a nd a udits of the stock excha nges, etc. All the stock brokers, sub-brokers, sha re tra nsfer a gents, bankers to a n issue, trustees of trust deed, registra rs to an issue, mercha nt ba nkers, underwriters, portfolio ma nagers, investment a dvisers a nd such other intermedia ry who ma y be a ssocia ted with the Securities Ma rkets a re to register with the Board under the provisions of the Act, under section 12 of the Sebi Act. The Boa rd ha s the power to suspend or ca ncel such registra tion. The Boa rd is bound by the directions vested by the Centra l Government from time to time on questions of policy and the Centra l Government reserves the right to supersede the Board. The Boa rd is also obliged to submit a report to the Centra l Government ea ch year, giving true a nd full a ccount of its a ctivities, policies a nd progra mmes. Any one of the a ggrieved by the Boa rd s decision is entitled to a ppeal to the Centra l Government. ROLE OF SEBI IN INVESTORS PROTECTION In general, successive amendments to the SEBI Act have not just enhanced SEBI s functional autonomy but also signaled the intention of the GoI to empower SEBI. The Securities a nd Exchange Boa rd of India (SEBI) ha s been ma nda ted to protect the interests of investors in securities and to promote the development of a nd to regula te the securities ma rket so a s to esta blish a dyna mic a nd efficient Securities Market contributing to India n Economy. SEBI strongly believes tha t investors a re the ba ckbone of the securities ma rket. They not only determine the level of a ctivity in the securities ma rket but a lso the level of a ctivity in the economy. Investors protection is one of the most importa nt function performed by SEBI. SEBI ha s underta ken va rious steps to protect the interest of the sma ll investors. These steps are: (A) Relating to New Issue (i) SEBI securities dra ft prospects of compa ny for full a nd fa ir disclosures. (ii) It ma ke sure tha t issuing compa ny provides fair a nd correct i n for ma t i o n. (iii) It ensures transpa rent allotment mecha nism. (iv) SEBI ha s ensured tha t underwriting obliga tion is necessa ry to inspire confidence of investors. (v) It ensures timely a nd transferability of the issue. (B) Relating to Derivatives (i) Investor s money has to be kept sepa ra te a t a ll levels a nd is permitted to be used only a gainst the lia bility of the investor and is not ava ilable to the tra ding member or clearing member or even a ny other investor.

183 The Securities and Exchange Board of India (SEBI) 175 (C) (ii) The Tra ding Member is required to provide every investor with a risk disclosure document which will disclose the risks a ssocia ted with the deriva tives tra ding so tha t investors can ta ke a conscious decision to trade in deriva tives. (iii) Investor would get the contract note duly time stamped for receipt of the order a nd execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also dema nd the tra de confirma tion slip with his ID in support of the contract note. This will protect him from the risk of price fa vour, if a ny, extended by the member. (iv) In the deriva tive ma rkets a ll money pa id by the investor towa rds ma rgins on a ll open positions is kept in trust with the Clearing House/ Clea ring Corpora tion a nd in the event of default of the Tra ding or Clea ring Member the a mounts pa id by the client towa rds ma rgins are segregated a nd not utilised towa rds the defa ult of the member. However, in the event of a defa ult of a member, losses suffered by the Investor, if any, on settled/ closed out position a re compensa ted from the Investor Protection Fund, a s per the rules, bye-laws a nd regula tions of the deriva tive segment of the excha nges. (v) Presently, SEBI ha s permitted Derivative Tra ding on the Deriva tive Segment of BSE a nd the F& O Segment of NSE. Deriva tive products have been introduced in a pha sed ma nner sta rting with Index Futures Contra cts in June, 2000, Index Options a nd Stock Options introduced in J une, 2001 a nd J uly, 2001 followed by Stock Futures in November, SEBI ha s underta ken prohibition unfa ir tra de pra ctices by exercising strict control mecha nism. (D) SEBI ha s prohibited insider tra ding which is considered a s a milestone in protecting the interest of the investor. (E) Investors Educa tion is provided by SEBI through, va rious guida nce, a dvertisements, television ca mpa ign etc. It ha s also published a book on Investors Grieva nces Rights a nd Remedies. Status of Investor Grievances Received and Redressed by SEBI Financial Grievances Received Grievances Redressed Pending Year Actionable Year-wise C u mul a t i ve Year-wise C u mul a t i ve Gr ie vance s* , , 74, , , 03, , , , 06, , , 46, , , , 63, , , 12, , , , 10, , , 66, , , , 52, , , 21, , 41 0 Source: SE BI Annual Report, SEBI has set up grievance cells to handle different complants of investors.

184 176 Banking and Financial Services LEGAL FRAMEWORK OF SEBI SEBI s lega l fra mework consists of the following a cts, rules a nd regula tions (1) SEBI a ct 1992 (2) The Securities Contracts (Regulation) Act, 1956 (3) Securities Contra cts (Regula tion) Rules, 1957 (4) The Depository Act, 1996 (5) SEBI (Depositories And Pa rticipa nts) Regula tions, SEBI s initiatives starting with the committee headed by Mr Kumar Mangalam Birla and thereafter the two reports presented by the Committee headed Mr. N R Narayanamurthy, culminated in the introduction of very popular Clause 49 in the listing agreement. (1) The Securities & Exchange Board of India Act, 1992 The Securities & Excha nge Board of India ( SEBI ), which is the apex regula tory body in India for the securities ma rkets, wa s esta blished under the SEBI Act to protect the interests of investors in securities a nd to permit the development of, a nd to regulate, the securities ma rket. The Act is a comprehensive one. W hile ea ch a nd every section in the Act is importa nt, the following sections a re the most importa nt ones: Establishme nt, Inc or por ation and M anage ment of SEB I: Cha pter II of the Act prescribes deta iled rules as to the creation of SEBI, the members of the Boa rd, their qua lifica tions, credentials a nd term of office. It also prescribes the rules for conducting boa rd meetings a nd remova l of members from office. The Power s and Func tions of SEB I: Found in Cha pter IV, this section defines the role of the Boa rd. It deals with the regula tion of the securities ma rket in a ll its ma nifesta tions, a nd conta ins wide powers over Compa nies, Venture Ca pita l Funds, Stock Excha nges a nd Brokers. Pr ovisions Relating to Colle c tive Inve stment Sche me s: The Boa rd ha s the power to regula te Collective Schemes a nd Mutua l Funds. This means tha t Collective Schemes a nd Mutua l Funds fa ll under the purview of SEBI a nd ha ve to get a pprova l for floa ting schemes a nd ta pping funds in the ma rket. W ith such a ll-encompa ssing powers, the Board ha s impact on a broa d spectrum of persons including the sma ll i nvestor. Re gistr ation of an Inte r mediar y: Stock brokers, Sub-Brokers, Sha re Transfer Agents, Ba nkers to a n issue, Trustees of Debentures, Registra rs to a n issue, Merchant Bankers, Underwriters, Portfolio Ma na gers, Investment Advisers a nd such other intermedia ries need permission from SEBI to set up operations. These a re importa nt powers that ena bles SEBI to ensure tha t a ll securities tra nsa ctions a re subject to some measure of regula tion by forcing a ny intermedia ry to a pproa ch the Board for registra tion. Pe naltie s: A deta iled list of pena lties is listed in Chapter IVA to be imposed upon persons who breach the Act or the rules a nd regula tions under the Act. These include

185 The Securities and Exchange Board of India (SEBI) 177 Pena lty for fa ilure to furnish informa tion, documents, returns or reports to SEBI Pena lty for failure by a broker or other intermediary to enter into a n a greement with his clients Penalty for failure of a broker or other intermedia ry to redress investor s g r i e va n ce s Pena lty for defa ults in ca se of Mutua l Funds a nd Stockbrokers Pena lty for insider tra ding. For insider tra ding, the pena lty is ` 5 la kh a nd for other offences listed a bove the pena lty is imprisonment for one yea r or a fine or both. Dispute M e c hanism: Under the Act, a n Appella te Tribuna l ha s been crea ted to hear a ppea ls arising from the decisions of SEBI a nd also crea ted a post of an a djudicating officer. These provisions crea te a level of a djudica tion between the Boa rd a nd the High Court. An a ppea l from the Tribuna l lies to the High Court. The Tribuna l is not bound by the Code of Civil Procedure, but must follow principles of na tura l justice. A person is a llowed lega l representa tion before the Tribuna l. (2) The Securities Contracts (Regulation) Act, 1956 The Securities Contra cts (Regula tion) Act, 1956 ( SCRA ) wa s ena cted to prevent undesira ble transa ctions in securities by regula ting the business or dealings therein. The SCRA, a s origina lly ena cted, prohibited options in securities. However, with effect from Februa ry 25, 1995, this prohibition ha s been removed. This ha s ena bled the esta blishment of a deriva tives ma rket in securities. Among the importa nt cla uses of the SCRA a re : Re cognition of Stoc k Exc hange s: Broa dly covered by sections 3, 4 a nd 5 of the SCRA, these provisions detail the procedure for a Stock Excha nge to obta in recognition from the Centra l Government. This ena bles the Government to review the rules a nd bye-la ws of the Excha nge, a s well a s require the Exchange to confirm to certa in additiona l conditions that the Government ma y impose a s a condition for recognition. Section 5 also gives the Government the power to withdra w recognition a fter giving the Excha nge an opportunity to be heard. Fr aming of Stoc k Exchange Rule s: The Act, in sections 7A 10, la ys down the ba sic fra mework under which a n Exchange ca n frame rules a nd/ or byela ws. The Act a llows the Centra l Government to issue a fia t to the Excha nge to dra ft rules for themselves or send a cross rules for the Excha nge. It also allows SEBI to make or a mend bye-la ws of recognised Stock Excha nges. These sections ensure tha t there is a sembla nce of Government control over the interna l functioning of Stock E x change s. Supe r c e ding a Stock Exchange: Under section 11, the Centra l Government, can supersede the Governing Boa rd of a Stock Exchange Under Regulation 32 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 ( ICDR ), the promoters of an issuer company are required to contribute in the public issue to the extent of 20 per cent of the postissue capital, and such promoter contribution shall be locked up for a period of three years.

186 178 Banking and Financial Services The SEBI provides sufficient deterrents to those who may indulge in defaults and illegalities and malpractices on the market to the detriment of the investors. a nd replace them with a different set of persons to look a fter the E x c ha n ge. Pr eve nting Unauthor ise d Stoc k Exc hange s: This is a crucia l pa rt of the Act, enuncia ted in section 19. It sta tes tha t a nyone wa nting to opera te a Stock Excha nge should confirm to the regula tions a nd requirements of the Centra l Government and its a gencies such a s SEBI. Pr ohibition of Contr ac ts (othe r than spot de live r y c ontr ac ts) outside a Stoc k Exc hange: This section states tha t security tra nsactions ca n be tra ded only in a Stock Excha nge. By this the Centra l Government ma inta ins a level of control a nd regula tion over all the tra nsa ctions ta king pla ce in a n Exchange. As a result a ll securities tra ding (other than spot delivery contracts) ha ve to ta ke place through the members of the pa rticular excha nge, over which the Government ha s control. Appe al to the Se c uritie s Appe llate Tr ibunal against a Re fusal of a Stoc k Exc hange to List the Se cur itie s of a Public Company: This a llows compa nies which ha ve been refused listing by a stock excha nge, the fa cility to a ppea l to the Securities Appella te Tribuna l a ga inst the decision of the Stock Exchange. (3) Securities Contracts (Regulation) Rules, 1957 The Securities Contracts (Regulation) Rules, 1957 ( the SCRR ) were fra med pursua nt to the provisions of the SCRA. The SCRR clarifies some of the provisions of the SCRA. The SCRR la ys down deta ils of: Gr anting Re cognition to a Stoc k Exchange: The Rules specify the contents of a n a pplica tion, the form of the approva l to be gra nted to such a pplica tion and the documents to be filed along with the a pplica tion. Further, the Rules a lso detail the renewa l procedure. Q ualifications to be a M e mber of a Re cognise d Stoc k Exc hange: Detailed in Rule 8, these set out the exact eligibility criteria for obtaining the membership of a recognised Stock Exchange. These rules a re la id out for both individua ls a nd compa nies. The criteria that must be fulfilled by members subsequent to their obta ining membership a re also la id down. SEBI Nomine e s for Gove rning B odies of Stoc k Exc hange s: Rule 10 gives SEBI the power to nominate members to the governing body of Stock Excha nges. A ma ximum of three members ca n be nomina ted to the Excha nge. These members have the sa me powers a s other members of the governing body. Ac counting Pr oc e dur e s: This section la ys down rules on the type of books, a ccounts, their contents and the time period for which they must be ma inta ined. Requir eme nts for Listing Sec ur itie s on a Rec ognise d Stoc k Exc hange: Deta ils for listing a security on a recognised Stock Excha nge is la id

187 The Securities and Exchange Board of India (SEBI) 179 down in Rule 19. They include documenta tion, underta kings of the compa ny, sta tements required to ensure listing. A company wishing to list itself on a recogniz ed Stock Excha nge must fulfil all these. (4) The Depository Act, 1996 The Depository Act la ys the foundation for dema teria lisa tion of securities a nd provides for the regula tions of depositories in securities. It a llows the crea tion of the bodies involved in this process a s well a s outlining the moda lities of the functioning of the depository process. The Depository Act provides inte r alia for: The Re gistr ation of a De positor y: The Depository Act requires every depository to obta in a certifica te of commencement of business from SEBI. It a lso la ys down tha t such a certifica te will only be gra nted if SEBI is sa tisfied as to the sa fety a nd security of the systems of the depos i tory. The Rights and Obligations of De positorie s, Par tic ipants, Issue r and B e ne fic ial Owne r s: Chapter III of the Act la ys down the rela tionship between the va rious pa rties involved in the functioning of a depository. It ela bora tes the system of working of the depository with rega rd to the process of surrender of sha re certificates and the crea tion of beneficia l ow ne r s hi p. Pledge and Hypothe c ation of Se cur itie s he ld in a De positor y: Since a la rge number of transa ctions involving securities involve the crea tion of pa rtia l interests through tra nsa ctions such as a pledge or hypotheca tion, the Depositories Act ela bora tes on the process whereby such a n interest ca n be crea ted in securities held in a depository. Pe nalties Re lating to Depositor ie s: The pena lties for contra vention of the ma nda te of the Depositories Act ca n be imposed a ga inst a ny person, including a compa ny. Hence, viola tion of the Act could lea d to the imposition of pena lties even on the compa ny whose security is placed in the depository. SEBI is managed by a Board comprising a Chairman and eight members including one nominee each from the Ministry of Finance, Ministry of Company Affairs and from RBI. (5) SEBI (Depositories and Participants) Regulations, 1996 The Depository Regula tions ha ve been framed by SEBI in accordance with the Depository Act. This Act looks a t: The Re gistr ation of Depositor ie s: The Regulations prescribe the form in which the sponsor of a depository ma y a pply for its registra tion (a sponsor being the person proposing to set up a depository). It also prescribes the credentia ls of the sponsor a nd the conditions under which registration ma y be gra nted. Further, the form in which the certifica te of registration is to be gra nted is also provided. The Re gistr ation of De positor y Par ticipants: Simila rly, rules, forms a nd conditions a re listed for the registra tion of depository pa rticipants

188 180 Banking and Financial Services with SEBI. The a pplica tion must be ma de through the concerned depository in which the applicant proposes to act a s a pa rticipant. Proce ss of Sur re nde ring Cer tific ate s of Sec urities: Detailed procedures a re la id down for surrendering a security to the participa nt, the dema teria liz a tion of the security and the emergence of beneficia l ownership. This ca n be found in Regula tion 54. Proc edur e for De mate r ialisation, Cre ation, Ple dge and Hypothe cation of Se c uritie s: Deta ils a re provided a s to how a pledge or hypotheca tion interest ma y be ma rked on securities that ha ve been demateria lised. It includes the procedure to be followed by the depository in recording this interest, a nd the circumsta nces under which these securities ma y be tra nsferred. W henever the share markets have crashed in any country, the government enacted the Securities and Exchange Act to tighten the controls and ensure fair play in the market. Important Categories of SEBI Regulations Securities a nd Excha nge Boa rd of India { KYC ( Know Your Client) Registra tion Agency} Regula tions, 2014 SEBI (Issue of Ca pita l a nd Disclosure Requirements)(Amendment) Regula tions, 2014 SEBI (Issue and Listing of Debt Securities) (Amendment) Regula tions, SEBI (Procedure for Search and Seiz ure) Regula tions, 2014 SEBI (Collective Investment Schemes) Regula tions, 2014 SEBI (Investor Protection a nd Educa tion Fund) Regula tions, 2014 SEBI(Foreign Portfolio Investors) Regula tions, 2014 SEBI (Self-regula tory Orga niz ations) Regula tions, 2013 SEBI (Stockbrokers a nd Sub-brokers) Regula tions, 2013 Securities a nd Excha nge Boa rd of India (Alterna tive Investment Funds), Regula tions, 2013 Securities a nd Exchange Boa rd of India - (Prohibition of Fra udulent a nd Unfair Trade Pra ctices Rela ting to Securities Ma rket) Regula tions, Securities a nd Excha nge Boa rd of India (Mutua l Funds) Regula tions, SEBI(Buy-ba ck of Securities) Regula tions, 2013 SEBI(Substa ntia l Acquisition of Shares and Ta keovers)regula tions, SEBI (Investment Advisers) Regula tions, 2013 SEBI (Depositories a nd Pa rticipa nts) Regula tions 2012 SEBI Mercha nt Ba nkers Regula tions, 2012 SEBI(Portfolio Ma na gers) Regula tions, 2012 SEBI (Credit Ra ting Agencies) Regula tions, 2011

189 The Securities and Exchange Board of India (SEBI) 181 Securities a nd Excha nge Boa rd of India (Debenture Trustees) Regula tions, 2011 Securities a nd Excha nge Boa rd of India (Prohibition of Insider Tra ding) Regula tions, 2011 SEBI (Bankers to a n issue) Regula tions, 2011 SEBI (Depositories a nd Pa rticipa nts) Regula tions, 2011 SEBI (Underwriters) Regula tions, 2011 SEBI (Foreign Venture Capita l Investors) Regula tions, 2010 SEBI( Venture Ca pital Funds) Regula tions, 2010 Securities a nd Excha nge Boa rd of India (Foreign Institutiona l Investors) Regula tions, 2010 Securities a nd Exchange Boa rd of India (Delisting of Equity Sha res) Regula tions, 2009 Securities a nd Excha nge Boa rd Of India (Custodia n of Securities) Regula tions, 2006 Addresses of SEBI Offices and their Jurisdiction After IPO scam of 2005, SEBI further tightened the implementation of KYC norms and made PAN card compulsory for all categories of investors. Ad d ress o f SEBI Office s He ad Office: Mitt al cou rt A Win g, Grou n d floor 22 4, Nariman Poin t, Mu mba i PH: ,52,5 3,54,5 5 FAX: Nort h ern Region al Office: Block No.1, Rajen d ra Bh awan Rajen dra Place, District Cen tre New Delh i PH: , FAX: Ea s t e rn Re gion a l Office : FMC Fortu n a, 5th Floor, 234/ 3A AJ C Bose Roa d, Ca lcu tta PH: , 4307, 6105 FAX: Sou t h e rn Re gion a l Office : 3rd Floor, D Mon te Bu ildin g, 32 D Mon te Colon y, TTK Roa d, Alwa rpet Ch en n a i PH: , 5525, 7385, 7480, 7540 FAX: SEBI s Journey So Far and Challenges Ahead J u ris dic tion fo r t h e com p an ies h av in g t h eir reg is te red offices in Gu jarat, Mah arash tra, Mad h ya Prad es h, Goa, Dadra & Nagar Haveli an d Da man Diu Ha ryan a, Himacha l Prad es h, J am mu & Ka sh mir, Pu n jab, Rajas tha n, Utta r Prad es h, Delh i an d Cha n digarh As s a m, Bih a r, Ma n ipu r, Megh a la ya, Na ga la n d, Oris sa, Wes t Ben ga l, Aru n a ch a l Pra des h, Mizora m, Trip u ra, Sikkim a n d An da m a n & Nicoba r Is la n ds An d h ra Pra desh, Ka rn a ta ka, Kera la, Ta m iln a du, Pon dich erry a n d La k s h a dweep & Min icoy. From the outcry system of tra ding to screen-ba sed tra ding, from physica l share certifica tes to dema teria lised sha res, from two-week settlement cycle to T+2 system of settlement, from long-delays in getting refunds in sha re

190 182 Banking and Financial Services Keeping with the times, SEBI has also introduced e-ipo procedure for electronic bidding in public offers to help investors bid for shares in a costeffective manner. a pplica tions to a fa cility where IPOs ca n be a pplied for, without money lea ving the investors a ccount; SEBI ha s to its credit many a chievements tha t a re unpa ra lleled in the Indian fina ncia l spa ce. SEBI, in its short journey of 22 yea rs ha s ma de a rema rkable impression on investors a s well a s ca pita l ma rkets. Following a re some of the changes introduced by SEBI Se ttle me nt System: SEBI introduced rolling settlement on a T+5 ba sis for domestic a s well a s foreign institutiona l investors in Gra dua lly reducing the settlement time since then, India n ma rkets ha ve switched to T+2 tra ding n o w. De mate r ialization of Shar e Ce r tific ates: SEBI initia ted the process of dema teria liz ation of sha re certifica tes in The need for this initiative wa s felt to a void the threa t of forgery or theft of sha re certifica tes coupled with inordinate dela y by tra nsfer a gents a nd post offices. Foste r ing M utual Funds: SEBI regula rly issues revised guidelines for mutua l fund industry to help them flourish in India. Till early 90s, Unit Trust of India wa s the only pla yer in India s mutua l fund market. Sebi s efforts not only encoura ged hundreds of mutua l funds to enter the India n ma rkets, but also gave a n opportunity to not so savvy investors to invest in the ma rkets through a much sa fer wa y. To enha nce the popularity of mutua l funds, SEBI relaxed know your customer (KYC) norms for sma ll investors and widened the distribution network in rural India by roping in posta l agents. By ba nning entry loads for mutua l fund schemes in 2009, SEBI curbed mis-selling of mutua l fund products. Rolling out Red Carpet for FIIs: In order to keep a close eye on FII inflow; the ta sk of giving approva ls to FII registra tions wa s ha nded over to SEBI in 2003 a nd since then SEBI ha s been consistently revising the FII investment limit in both corpora te a s well a s government debt. Mea nwhile, in order to discoura ge FII investments made through P-notes, SEBI ha s imposed sufficient checks a nd ba la nces to a void the flow of bla ck money into the India n ma rkets. IPO Refor ms: SEBI ha d la st yea r notified wide-ra nging reforms in Initia l Public Offer -IPO ma rket which included a strict vigil on usa ge of issue proceeds, grea ter disclosure by compa nies and their ba nkers a nd a llotment of a minimum number of shares to retail investors. Surve illanc e and Risk M anage me nt: In , SEBI directed a ll excha nges to fix the da ily price ba nd at 10% a nd a weekly overa ll limit of 25% to curb undesira ble vola tility. To bring about a coordinated tra ding ha lt in a ll equity and deriva tives ma rket na tionwide, SEBI introduced an index-based circuit brea ker system applica ble a t 10%, 15% a nd 20% movement either wa y. Gr ie vance Redr e ssal and Inve stor Awar e ne ss: SEBI has a web-based centra liz ed grievance redress system ca lled SEBI Compla ints Redress System SCORES for a ssisting investors to lodge their compla ints in a structured wa y. Further, in its silver jubilee yea r, SEBI ha s la unched a ma ssive mass media exercise to inform investors a bout SCORES a nd its toll free helpline ( / 1XXX XX 7575, a va ila ble in 14 la nguages). To rea ch rura l ma sses, SEBI ha s tied up with the depa rtment of posts to print ca utionary messa ges on the

191 The Securities and Exchange Board of India (SEBI) 183 back of post office pa ssbooks while for urbanites Google India s Ad W ord facility displa ys pop-up investor a wa reness messages on its sea rch engine. Challenges Ahead W ith the a dvent of new technology, SEBI will ha ve to continuously upgra de its ma npower a nd improve its ca pa cities to dea l with situa tions tha t can a rise. Crea ting a more robust fra mework to successfully deal with the mena ce of insider trading a nd strict implementation of buy-ba ck norms will a lso play a n importa nt role in a ssuring a sustained investor interest. SEBI would further ha ve to strongly ha ndle the issue of fra udulent collective investment schemes. Although SEBI ha s a pproved a proposa l to pena liz e unregistered CIS entities a nd ha s decided to decla re the illegal mobilisation of funds a s a fra udulent a nd unfa ir trade pra ctice; the long-term results of these steps will only ensure their effectiveness. To ensure that FIIs continue to invest in India a nd to cha nneliz e household sa vings into the capita l ma rket will be a nother cha llenge. SEBI ha s improved a nd strengthened its mecha nisms after being stuck by difficult a nd a dverse situa tions every now and then. Just weeks after SEBI wa s born, the Securities Ma rket Sca m led by Ha rsha d Mehta hit Dala l Street lea ding to the introduction of several regula tory changes in prima ry a nd seconda ry ma rkets. It also brought it a notification prohibiting insider tra ding a nd ma king it a crimina l offence. In , a fter the Ketan Pa rekh sca m broke out, SEBI completely disca rded a ccount settlement and rolling settlement wa s introduced. Forwa rd tra ding was forma lly introduced in the form of exchange traded deriva tives a nd short selling in spot ma rkets wa s ba nned. Recently, a report published by International Orga nisation of Securities Commissions- IOSCO under its Fina ncia l Sector Assessment Progra m - FSAP a cknowledged tha t the comprehensive risk ma na gement fra mework prescribed by SEBI is one of the pilla rs of the Indian securities settlement system. It further sa id that the Indian ca pita l ma rkets regula tor has successfully prevented occurrence of a ny ma jor defa ults in the la st deca de. SEBI has welcomed the report and its ma ny recommenda tions. SEBI has a cknowledged the suggestion that it should focus more on strengthening the supervision of securities ma rket intermedia ries including fund ma nagers. It has a lso a greed to work on strengthening the stress-testing procedures of the central counterpa rties - CCPs a nd to improve the liquidity risk ma nagement. SEBI ha s further sa id tha t it will try to get lega l backing to further improve the clea ring a nd settlement process by a ddressing the issues of fina lity a nd netting at the level of la w. SEBI is currently facing one of its biggest legal battles against two Sahara companies regarding refund of public deposits.

192 184 Banking and Financial Services REVIEW QUESTIONS 1. W hat a re the different functions performed by SEBI? 2. Expla in different investor s protection a ctivities performed by SEBI. 3. W ha t a re the powers of SEBI? 4. Expla in the lega l fra mework of SEBI. 5. Discuss the ba sic cha nges introduced by SEBI in India n financia l system. REFERENCES Goya l, Ashima (2005), Regulation a nd Deregula tion of the Stock Ma rket in India, ava ilable at SSRN: ssrn. com/ a bstra ct= Gupta, L.C., (1996), Cha llenges before Securities a nd Excha nge Boa rd of India, Economic and Political We ek ly, Ma rch 23, Sa ba rinatha n, G., (2009), SEBI a nd the Regula tion of India n Ca pita l Ma rkets, Indian Journal of Capital Markets, Volume II, Issue I Securities Appella te Tribuna l (Procedure) Rules, 2000 Sen, Dilip Kuma r (2004), Cla use 49 of Listing Agreement on Corpora te Governa nce, The Charte red Ac countant, December 2004, pp Shah, Ajay (1999), Institutiona l Cha nge on India s Ca pita l Ma rkets, Ec onomic and Politic al We e kly, XXXIV (3-4): , J a nua ry 1999 Va rious Issues of Annua l Reports of SEBI W orld Bank (2004), Report on Observa nce of Sta ndards a nd Governa nce, Corpora te Governa nce Country Assessment, India.

193 CHAPTER 6 MERCHANT BANKING Learning Objectives After rea ding this cha pter you should be a ble to understa nd the na ture a nd scope of mercha nt ba nking the services provided by mercha nt ba nker the code of conduct a pplica ble to merchant ba nker the SEBI guidelines rela ting to merchant ba nker

194 186 Banking and Financial Services NATURE AND SCOPE OF MERCHANT BANKING It is mandatory under SEBI rules that every issuing company must appoint one or more SEBI registered merchant bankers as lead manager(s) for the management of issue. One of the importa nt financia l service tha t emerged in India n fina ncia l system is Mercha nt Ba nking. Amidst the ra pid cha nge in the fina ncial world, mercha nt ba nking has emerged a s indispensa ble financia l a dvisory pa cka ges. Mercha nt ba nking is a service-oriented function tha t tra nsfers ca pita l from those who own to those who can use it. They try to identify the needs of the investors a nd corpora te sector a nd a dvise entrepreneurs what to do to be a successful. A mercha nt ba nker is defined a s a ny person who is enga ged in the business of issue mana gement either by ma king a rra ngements rega rding selling, buying or subscribing to securities, or acting a s mana ger, consultant, a dvisor or rendering corporate advisory services in relation to issue management. The origin of mercha nt ba nking is to be tra ced to Ita ly in la te medieva l times a nd France during the seventeenth a nd eighteenth centuries. The Ita lia n mercha nt ba nkers introduced into Engla nd not only the bill of excha nge but a lso a ll the institutions a nd techniques connected with a n orga nized money ma rket during seventeenth a nd eighteenth centuries. In Fra nce, a mercha nt banker ( Le me rc hant banque r) wa s not merely a tra der but a n entrepreneur par e x ce lle nc e. He invested his a ccumulated profits in a ll forms of promising a ctivities. He a dded banking business to his mercha nt a ctivities a nd beca me a mercha nt ba nker. In the la te medieva l to ea rly modern times distinction existed in ba nking system between money cha nger and excha nger. Money cha ngers concentrated on the ma nua l cha nge of different currencies opera ted loca lly a nd la ter a ccepted deposits for security rea sons. In course of time, money changers evolved into public or deposit ba nks. Interna tiona l excha ngers enga ged in bill-broking, ra ising foreign excha nge a nd provision of long-term ca pital for public borrowers. The excha ngers were remitters a nd merchant ba nkers. During this period mercha nt ba nker wa s a dealer in bills of excha nge who opera ted with correspondent a broad a nd specula ted on the ra te of excha nge. Initia lly, mercha nt ba nks were not ba nks a t a ll a nd a distinction wa s dra wn between ba nks, mercha nt ba nks a nd other fina ncia l institutions. Among a ll these institutions, it wa s only ba nks tha t a ccepted deposits from public. In the United Kingdom, mercha nt s ba nks ca me into opera tion in the la te eighteenth century a nd ea rly nineteenth century. Industria l revolution ma de Engla nd into a powerful tra ding na tion. Rich mercha nt houses tha t made their fortunes in colonial trade diversified into ba nking. Their principa l a ctivity sta rted with the a ccepta nce of commercia l bills perta ining to domestic a s well a s interna tiona l tra de. The a ccepta nce of the tra de bills a nd discounting ga ve rise to a ccepta nce houses, discount houses a nd issue houses. Merchant ba nker wa s prima rily a mercha nt ra ther tha n a ba nker but he wa s entrusted with funds by his customers. Mercha nt ba nking activity was forma lly initia ted into the India n ca pita l ma rkets when Grindla ys ba nk received the license from Reserve Ba nk in Grindla ys started with ma na gement of ca pital issues, recogniz ed the needs of emerging cla ss of entrepreneurs for diverse financia l services, ra nging from

195 Merchant Banking 187 production pla nning a nd system design to market research. Citiba nk setup its mercha nt ba nking division in The va rious ta sks performed by this divisions na mely assisting new entrepreneur, eva lua ting new projects, ra ising funds through borrowing a nd issuing equity. Indian ba nks started mercha nt ba nking services as a pa rt of multiple services they offer to their clients from Sta te Bank of India sta rted the mercha nt ba nking division in 1972 a nd ICICI Bank in In the initia l yea rs, the SBI s objective wa s to render corpora te a dvice a nd a ssista nce to sma ll a nd medium entrepreneurs. Mercha nt ba nking a ctivities is of course orga niz ed a nd underta ken in several forms. Commercia l banks and foreign development fina nce institutions ha ve orga niz ed them through forma tion of divisions, na tiona lized ba nks have formed subsidiaries compa nies and sha rebrokers a nd consulta ncies constituted themselves into public limited compa nies or registered themselves a s priva te limited compa nies. Some merchant ba nking outfits ha ve entered into colla bora tion with mercha nt bankers a broa d with severa l bra nches. The services of merchant bank cover project counselling, pre investment a ctivities, fea sibility studies, project reports, design of ca pita l structure, issue ma na gement, underwriting, loan syndica tion, mobiliz a tion of funds, foreign currency finance, mergers, a ma lga ma tion, ta keovers, venture ca pita l a nd public deposits. Mercha nt ba nking is skill-ba sed a ctivities and involves serving fina ncia l need of every client. Mercha nt ba nkers ca n turn to a ny of the activities depending upon resources, such a s capita l, foreign tie-ups for oversea s activities a nd skills. The depth a nd sophistica tion in mercha nt ba nking business a re improving since the a venues for raising funds a re widening and dema nds for funds is increa sing. The a uthoriz ed a ctivities include issue ma nagement which consists of prepa ra tion of prospectus a nd other informa tion rela ting to the issue, determining fina ncing structure, and tie-up of fina nces a nd fina l a llotment or refund of subscription, corpora te a dvisors to the issue a nd underwriting. Other a uthorized a ctivities would be portfolio mana gement services. M er chant banking is de fined as what merc hant banke r does. A Mercha nt ba nker has been defined by SEBI (Merchant Ba nkers) Rules, 1992 as any per son who is e ngage d in the busine ss of issue manage me nt e ithe r by making arr ange me nts r e gar ding se lling, buying, or subsc r ibing to se cur itie s or ac ting as manage r, consultant, advisor, or r ende r ing c or por ate advisory se rvic e s in r e lation to suc h issue manageme nt. A ba nk tha t dea ls mostly in (but is not limited to) international fina nce, long-term loa ns for companies a nd underwriting. Mercha nt ba nks do not provide regula r ba nking services to the genera l public. Their knowledge in interna tiona l fina nces ma kes mercha nt ba nks specia lists in dea ling with multina tiona l corpora tions. In ba nking, a mer chant bank is a tra ditiona l term for a n Inv estme nt Bank. It ca n a lso be used to describe the private e quity a ctivities of ba nking. A ba nk tha t deals mostly in (but is not limited to) issue ma na gement, interna tiona l fina nce, long-term loans for compa nies a nd underwriting. Merchant banks do not provide regula r ba nking services to the general public. The Banking Commission in its Report in 1972 has indicated the necessity of merchant banking service in view of the wide industrial base of the Indian economy. The Commission was in favour of a separate institution (as distinct from commercial banks and term lending institutions) to render merchant banking services.

196 188 Banking and Financial Services Commercial bankers are basically a financing agency whereas merchant banks provide basically financial (not financing) services. The guidelines for Mercha nt Ba nkers (issued by Ministry of Fina nce, Deptt. of Economic Affa irs, Stock Excha nge Division on ) instead of defining mercha nt ba nking sta ted tha t these guidelines sha ll apply to those presently enga ged in mercha nt ba nking a ctivity including a s mana gers to issue a nd underta kes a uthoriz ed activities. These a ctivities inte r alia include underwriting, portfolio ma nagement, etc. Thus, to defines mercha nt ba nkers a definite better a pproa ch is to include those a gencies as mercha nt ba nkers which do wha t a mercha nt banker does. Mercha nt a nd Commercia l ha ve simila r connota tions, yet commercia l ba nking a nd mercha nt ba nking a re different. Commercial ba nkers a re compa ratively retail ba nking a ctivity where a s, mercha nt ba nking is a wholesa le ba nking (even if it provides fina ncing services a lso). A merchant banking firm does not underta ke commercia l ba nking wherea s, its reverse is possible. Commercia l banking involves collections of sa vings a nd puting it, to optimum use a s per pla ns a nd guidelines wherea s mercha nt ba nking refers to just a n a gency fa cilita ting tra nsfer capita l from those who own to those who ca n use it without handling the a mount of its own. Mercha nt ba nkers are more of a n intermediary. In the sa me context a mercha nt ba nk ca n be distinguished from a development bank since the latter is more involved in fundra ising a nd lending. Like commercia l ba nks, development ba nks ma y also ha ve sepa ra te merchant banking division. Need for Merchant Bankers Growing complexity in rules a nd procedures of the government. Growing industria liz a tion a nd increase of technologica lly a dva nced i n d u s t r i e s. Need for encoura gement of sma ll a nd medium industria lists, who require specia list services. Promoting the role of new issue ma rket in mobiliz ing sa ving. SERVICES PROVIDED BY MERCHANT BANKER Mercha nt ba nks provide the following specializ ed functions to their clients. 1. Issue Mana gement 2. Project ma na gement 3. Loan syndica tion 4. Portfolio mana gement

197 Merchant Banking Corpora te counselling 6. Ma na ging joint ventures 7. Other specia liz ed services 1. Issue management Most compa nies a re usua lly sta rted priva tely by their promoter(s). However, the promoters ca pita l and the borrowings from ba nks a nd fina ncial institutions ma y not be sufficient for setting up or running the business over a long-term. So companies invite the public to contribute towa rds the equity a nd issue shares to individua l investors. The wa y to invite sha re ca pita l from the public is through a Public Issue. Simply stated, a public issue is an offer to the public to subscribe to the sha re ca pital of a compa ny. Once this is done, the compa ny a llots shares to the applica nts a s per the prescribed rules and regula tions la id down by SEBI. W hile public a nd rights issues involve a detailed procedure, priva te pla cements or preferential issues are rela tively simpler. A compa ny ca n ra ise fina nce by issuing equity sha res in different forms like: IP O Subsequent issue/fpo Right issue Priva te pla cement Preferentia l allotment Bought out dea ls (offer for sale) The role of a mercha nt ba nker is predomina nt in a ll the forms of issue ma na gement, especia lly IPO a nd FPO. Mercha nt ba nker is the a gency tha t pla n, coordinate a nd control the entire issue a ctivity a nd direct different a gencies to contribute to the successful ma rketing of securities. The procedure of the ma na ging a public issue by a mercha nt ba nker is divided into two pha ses, v iz.; Pre-issue mana gement Post-issue mana gement Issue management is considered to be one of the most important functions performed by a merchant banker. Number of Merchant Banker required for Issue Management Size of Pu blic issues (R s. in crores) Less than ` 5 0 crores ` 50 crores but less than ` 100 crores ` 1 00 crores bu t less than ` 2 00 crores ` 2 00 crores bu t less than ` 4 00 crores ` 4 00 crores and above Pre-issue Management Activities No. of M erch ant Ba nkers The a ctivities performed by a mercha nt ba nker before the issue becomes open for public is ca lled a s pre-issue a ctivities which include Tw o T h r e e F o u r Fi v e Five or more as m ay be agreed by th e SE BI

198 190 Banking and Financial Services Merchant banks can play highly significant role in mobilizing funds of savers to investible channels assuring promising returns on investment activities. Ste p 1: Obta ining stock excha nge a pprova ls to memora ndum a nd a rticles of a ssocia tions a nd ta king permission of SEBI to go a hea d with the issue. Ste p 2: Fina liz ing the appointments of the following agencies: Co-ma na ger/ Advisers to the issue Underwriters to the issue Brokers to the issue Ba nkers to the issue a nd refund ba nker Advertising a gency Printers a nd Registra r to the issue Ste p 3: Advise the compa ny to appoint a uditors, lega l a dvisers a nd Boa rd of Directors which is a s per the SEBI norms. Ste p 4: Pr ic ing the Issue. Mercha nt ba nker ha s to price the issue in consultation with the compa ny a uthorities. Nowa days, in India most of the issues are ca rried out by book building mechanism. Book Building mea ns a process underta ken by which a dema nd for the securities proposed to be issued by a body corpora te is elicited and built up a nd the price for the securities is a ssessed on the basis of the bids obtained for the qua ntum of securities offered for subscription by the issuer. This method provides a n opportunity to the ma rket to discover price for securities. Step 5: Dr afting of Pr ospe c tus. Most importa nt function of mercha nt ba nker is fina liz ing the prospectus for the issue. The mercha nt ba nk is expected to exercise due diligence ensuring complia nce by compa ny in rega rd to prospectus a nd a fter the prospectus is rea dy, mercha nt ba nker in consulta tion with the company prepa res the prospectus and submits it to the SEBI for approval. Prospectus genera lly conta ins a lmost a ll the relevant information about the c o mp a n y. Ste p 6: Merchant banker ha s to obtain a pprovals for dra ft prospectus from the company s lega l advisers, underwriting financia l institutions/ ba nks. Simulta neously, he ha s to obta in consent from parties a nd agencies a cting for the issue to be enclosed with the prospectus. Step 7: Mercha nt banker ha s to file the prospectus with the SEBI a nd should get the a pprova l of prospectus from Securities a nd Exchange Boa rd of India. The next a ctivity is filing of the prospectus with Registrar of Companies a nd ma king an a pplica tion for enlistment with Stock Exchange along, with copy of the prospectus. Step 8: M ar ke ting of the Issue. The mercha nt ba nkers should arra nge a meeting with compa ny representa tives a nd a dvertising a gents to fina liz e a rra ngements rela ting to the publicity a nd ma rketing of the issue. It includes la unching publicity ca mpa ign. Publicity ca mpaign covers the prepa ra tion of a ll publicity ma teria ls a nd brochures, prospectus, a nnouncement, a dvertisements in the press, ra dio, TV, conferences, and hoa rding. Success of a n issue depends on the siz e of the publicity ma teria ls. Mercha nt ba nkers pla y a key role by helping them in the choice of media, siz e, and publications in

199 Merchant Banking 191 which a dvertising should a ppea r. Publicity is a function of siz e of issue, ima ge of issuer a nd company loca tion. Effective ma rketing include arra ngements of conferences at potential centers to expla in na ture a nd strength of the project to va rious cross section of investors a nd their counsellors. Step 9: Unde rwr iting the Issue. Securities issues a re underwritten to ensure tha t in ca se of under subscription they are taken by underwriters. No person ca n a ct a s a n underwriter without obta ining a certificate of registra tion from SEBI. Ma jor underwriters a re fina ncia l institutions, commercia l banks mercha nt ba nkers and members of stock excha nge. Fina ncia l strength is a major considera tion in selecting underwriters. Others fa ctors considered while a ppointing underwriters a re experience in the prima ry ma rket, pa st underwriting performance a nd defa ults, understanding underwriting commitments, the network of investor clientele of the underwriter a nd overa ll reputa tion. Issues Managed by Merchant banker in India P a r t i c u l a r s * No. of A m o u n t No. of A m o u n t * I s s u e s (` crore) i s s u e s (` core) Public Issues (i) + (ii) , ,5 1 0 (i) Public Issues , ,52 8 (Equity/ PCD/FCD) of which I P O s 3 4 5, ,52 8 F P O s 1 4, (ii) Public Issues (Bond/NCD) , , Rights Issues 1 6 2, ,94 5 Total Equity Issues (16)+2) , ,4 7 3 Total Equity and Bong (1+2) , ,4 5 5 Memo Items: Offer for Sale 5 2, ,58 9 Merchant banks have been procuring impressive support from capital market for the corporate sector for financing their projects. Source: SE BI Ann ua l Report Post-issue Management Activities Post-issue ma na gement a ctivities consist of collection of a pplica tion forms from ba nkers and the statement of amounts received, screening a pplica tions a nd deciding a llotment procedure in consultation with the stock excha nge. Post-issue mana gement a ctivity concludes with the ma iling of a llotment letters/ shares through electronic form a nd refund orders. Step1: Collecting and Processing of Application Registra rs to the issue ma na gement pla y a ma jor role in post issue ma na gement. They work in colla bora tion with ba nkers to issue. Merchant banks a ssist the compa ny by coordina ting this a ctivity till fina l a llotment is made. Registrar reconcile the total a pplica tions collected by the ba nkers to the issue.

200 192 Banking and Financial Services They should verify the applica tions received from the public a nd multiple a pplica tions a nd applica tions with the technical defects or which do not conform to the conditions stipula ted on the a pplica tion form are removed a nd rejected. They submit a proposed ba sis of a llotment with the details of a pplica tions received. a fter the ba sis of a llotment is approved by the stock excha nge a nd a llotted by the board, the a uditor ha s to certify a llotment. Registra rs ha ve to ensure tha t the a pplica tions a re processed a nd a llotment, within 30 da ys of the close of issue. In the case of book building process, the issuer appoints SEBI registered merchant bankers as book runner(s) and the lead merchant banker acts as the lead book runner and other eligible merchant bankers appointed by the issuer and lead managers are termed as cobook runners. Step 2: Allotment The a llotment a ga inst a pplication for sha res offered should be ma de fa irly a nd equita bly. An oversubscription a rises if the a pplica tions for sha res received a re more tha n the number of sha res offered. If it is ma rgina l, firm a llotment to the extent possible will be ma de to a ll categories of a pplica nts by reducing the a llotment to the applica nts who ha ve applied for a la rge number of sha res. In ca se of issues, which are hea vily oversubscribed, where the number of shares a pplied is much more tha n offered the a llotment ha s to be ma de on a proportiona te ba sis. Step 3: Listing Agreement Before the securities of a compa ny a re admitted for dea ling on a stock excha nge, the company has to execute with the stock excha nge a listing a greement which is in the form of a covena nt designed to fa cilitate smooth a nd orderly tra ding in the ma rket a nd to protect the interests of shareholders a nd others who invest or deal in securities. To this end the a greement requires the listed compa ny to ma ke certa in disclosures and perform certain a cts. Ste p 4: Mercha nt ba nker has to ensure the issue of refund notifica tion, a llotment confirmation/certifica tes within the prescribed time limit a nd report periodica lly to SEBI a bout the progress in the ma tters rela ted to a llotment a nd r e f u n d s. Ste p 5: Mercha nt banker ha s to a ttend the investors grieva nces rega rding the public issue. 2. Project Management Mercha nt ba nker ta kes ca re of project ma na gement right from pla nning to commission of the project. They render va rious services a s a part of project ma nagement a re C o u n s e l i n g Prepa ra tion of report Feasibility report Prepa ra tion of loa n application Government clea rance Foreign collabora tion, etc.

201 Merchant Banking Loan Syndication Mercha nt ba nker a rra nges huge a mount of loa ns for their clients from different ba nks a nd fina ncia l institutions this service is ca lled loan syndica tion. Mercha nt ba nker prepa res project report for loa n syndica tion, a pproa ches different institutions a nd fina lises the dea l. For this service, mercha nt ba nker charges some percenta ge of commission. Some of the important credit syndica tion services offered a re Prepa ring a pplica tions for fina ncia l a ssista nce to be submitted to fina ncial institutions and ba nks. Monitoring the sa nction of funds while acting a s a specia lised lia ison a g e n c y. Negotia ting the terms of a ssista nce on behalf of client. Post sa nction forma lities with these institutions a nd ba nks. 4. Portfolio Management Services Different mercha nt ba nkers provide portfolio ma nagement services, by ma na ging the portfolios of their clients. Mercha nt ba nker cha rges fees for providing portfolio services. Mercha nt ba nkers ma y or may not ha ve the discretiona ry power of investing the funds. The basic portfolio mana gement services includes Advising on time of buying a nd selling. Arra nging buying a nd selling of securities. Communica ting cha nges in investment ma rket to the client investor Meeting the compliance requirement of regulator for sa le of purcha se of portfolio. Evalua ting the portfolio a t regula r interva ls a s per the direction of i nvest or s. Providing ta x a dvisory services perta ining to income from a nd investment in portfolio Merchant bankers advise the investors of the incentives available in the form of tax reliefs, other statutory relaxations, good return on investment and capital appreciation in such investment to motivate them to invest their savings in securities. 5. Corporate Counselling Merchant banker provides different types of corpora te counselling to their clients. These counselling ma y be relating to areas such as product development, mergers and acquisitions, rehabilita tion of sick units, foreign collabora tion, etc. Some of the specific assignments for the merchant banker are: Rejuvenating old and a iling/ sick unit Evolving reha bilita tion progra mmes/ pa cka ges. Assisting in obta ining a pprova ls from Boa rd for Industria l a nd Fina ncia l Reconstruction (BlFR) Monitoring implementa tion of schemes of reha bilita tion. Identifying potential buyers for disposa l of a ssets Advice on ta ctics in a pproa ching potential a cquisition.

202 194 Banking and Financial Services 6. Managing Joint Ventures Mercha nt ba nkers pla y a key role in a rra nging a nd ma naging the joint venture of the client with foreign pa rtner. They fa cilita te meeting of foreign pa rtner, get sa nctions under va rious provisions, ma ke techno-economic surveys, lega l documenta tions under loca l as well a s foreign lega l provisions, etc. The SEBI has stated that merchant bankers must be involved more closely in the market making process as sharebrokers do not have the requisite expertise to evaluate the fundamentals of the scrips before taking over the role of market makers 7. Merchant Bankers Provides some of the Other Specialized Services such as a) Advic e on Expansion and M oder nization : Mercha nt ba nkers give a dvice for expa nsion a nd moderniz a tion of the business units. They give expert a dvice on mergers a nd ama lgama tions, acquisition a nd ta keovers, diversifica tion of business, foreign colla bora tions a nd jointventures, technology upgra da tion, etc. b) Handling Governme nt Conse nt for Industrial Pr ojec ts : A businessma n ha s to get government permission for sta rting of the project. Simila rly, a compa ny requires permission for expa nsion or moderniz a tion a ctivities. For this, many forma lities ha ve to be completed. Mercha nt ba nks do a ll this work for their clients. c) Spec ial Assistance to Small Companie s and Entre pr e ne ur s : Mercha nt ba nks a dvise sma ll companies a bout business opportunities, government policies, incentives and concessions ava ilable. It a lso helps them to ta ke adva nta ge of these opportunities, concessions, etc. d) Se rvic e s to Public Se ctor Units : Mercha nt ba nks offer ma ny services to public sector units a nd public utilities. They help in ra ising longterm ca pita l, ma rketing of securities, foreign colla borations a nd a rra nging long-term finance from term lending institutions. e) Revival of Sic k Industrial Units : Mercha nt ba nks help to revive (cure) sick industria l units. It negotiates with different a gencies like ba nks, term lending institutions, a nd BIFR (Boa rd for Industria l a nd Fina ncia l Reconstruction). It a lso pla ns a nd executes the full reviva l pa ckage. f) Corporate Restr ucturing : It includes mergers or acquisitions of existing business units, sa le of existing unit or disinvestment. This requires proper negotiations, prepa ra tion of documents a nd completion of lega l forma lities. Mercha nt ba nkers offer a ll these services to their clients. g) M one y M ar ke t Ope ration : Mercha nt ba nkers dea l with and underwrite short-term money ma rket instruments, such a s: Government Bonds. Certificate of deposit issued by ba nks a nd financia l institutions. Commercia l pa per issued by la rge corporate firms. Trea sury bills issued by the Government h) Arra nging Externa l Commercia l Borrowings (ECB) i) Arra nging a nd pa rticipa ting in interna tiona l loan syndica tion j) Loans backed by Export Credit Agencies

203 Merchant Banking 195 k) Foreign currency loa ns under the FCNR (B) scheme l) Import Fina nce for India n corpora te m) Arra nging lea sing and hire purcha sing dea ls n) Debt Issue Mana gement Number of Merchant Bankers registered with SEBI Ye a r Nu m be r of Me rc h a n t Ba n k e rs Regis t e re d Source: Ann ual Report of SEBI CODE OF CONDUCT FOR MERCHANT BANKERS The Mercha nt Ba nkers ha ve to a bide by the following Code of Conduct: 1. A mercha nt ba nker in the conduct of his business sha ll observe high standa rds of integrity a nd fa irness in a ll his dea lings with his clients a nd other mercha nt ba nkers. 2. A merchant ba nker sha ll render a t all times high sta nda rds of service, exercise due diligence, ensure proper ca re a nd exercise independent professiona l judgement. He sha ll wherever necessary, disclose to the clients, possible sources of conflict of duties a nd interests, while providing unbiased s er vi ces. 3. A merchant ba nker sha ll not make a ny statement or become privy to act, practice or unfa ir competitor, which is likely to be ha rmful to the interests of other mercha nt ba nkers or is likely to place such other mercha nt ba nkers in a disadva nta geous position in rela tion to the mercha nt ba nker, while completing or executing any a ssignment. 4. A merchant banker sha ll not ma ke a ny exa ggera ted sta tement, whether ora l or written, to the client either a bout the qua lifica tion or the ca pa bility to render certa in services or his a chievements in rega rd to services rendered to other clients. The role of merchant banker is dynamic in the wake of diverse nature of merchant banking services. Merchant banker s dynamism lies in promptly attending to the corporate problems and suggest ways and means to solve it.

204 196 Banking and Financial Services Merchant banking activities are regulated by (1) Guidelines of SEBI and Ministry of Finance, (2) Companies Act, 1956 and (3) Listing Guidelines of Stock Exchange and (4) Securities Contracts (Regulation) Act, A merchant ba nker sha ll a lwa ys endea vour to (a) (b) render the best possible advice to the clients having rega rd to the client s needs a nd the environments a nd his own professiona l skill; a nd ensure tha t all professiona l dea lings are effected in a prompt, efficient a nd cost effective ma nner. 6. A merchant banker sha ll not (a) (b) divulge to other clients, press or any other party a ny confidentia l informa tion a bout his client, which ha s come to his knowledge; a nd deal in securities of a ny client compa ny without ma king disclosure to the Boa rd a s required under the regula tions a nd also to the Boa rd of Directors of the client company. 7. A merchant ba nker sha ll endeavour to ensure tha t (a) (b) the investors a re provided with true a nd a dequa te informa tion without ma king any misguiding or exaggera ted cla ims a nd a re a wa re of a ttenda nt risks before any investment decision is ta ken by them; copies of prospectus, memora ndum a nd rela ted litera ture a re ma de a vaila ble to the investors; c) a dequa te steps a re ta ken for fa ir allotment of securities a nd refund of a pplica tion money without dela y; a nd d) compla ints from investors a re a dequa tely dealt with. 8. The mercha nt ba nkers sha ll not genera lly a nd pa rticula rly in respect of issue of a ny securities be pa rty to (a) (b) (c) crea tion of fa lse ma rket; price rigging or ma nipula tion; pa ssing of price sensitive informa tion to brokers, members of the stock e x c h a n g e. SEBI REGULATIONS RELATING TO MERCHANT BANKERS SEBI (Mercha nt Ba nkers ) Regula tions 1992, define mercha nt ba nker a s a ny person who is engaged in the business of issue mana gement either by ma king arra ngements rega rding selling, buying or subscribing to securities or a cting as ma na ger, consulta nt, a dviser or rendering corpora te a dvisory service in rela tion to such issue mana gement. Thus, regula tions are a pplicable only to limited a ctivities undertaken by mercha nt ba nkers. On the ba sis of regula tions, merchant banking a ctivities ca n be categorised a s authorised a nd not a uthorised a ctivities. Categories of Merchant Bankers The mercha nt ba nking regula tions ca tegoriz e the mercha nt ba nkers into four ca tegories for the purpose of registra tion and imposing regula tions

205 Merchant Banking 197 Cate gory 1 : These mercha nt ba nkers can ca rry on a ny activity of the issue ma na gement, which will inte r alia consist of prepa ra tion of prospectus a nd other informa tion rela ting to the issue, determining fina ncia l structure, tie up of fina nciers a nd final a llotment a nd refund of subscription. They ca n a lso a ct a s a dviser, consulta nt, mana ger, underwriter, portfolio ma na ger. Cate gory 2 : Such mercha nt ba nkers ca n a ct as a dviser, consulta nt, coma na ger, underwriter a nd portfolio ma na ger. This mea ns they ca nnot underta ke issue ma na gement of their own. Cate gory 3 : These mercha nt ba nkers ca n neither underta ke issue ma na gement nor a ct a s co-ma na ger. They ca nnot conduct business of portfolio ma na gement. Thus, the a rea of their opera tion restricts to act a s underwriter, a dviser a nd consulta nt to the issue. Cate gory 4 : Such mercha nt ba nkers do not underta ke a ny activities requiring funds. They ca n a ct only a s adviser or consulta nt to an issue. Some of the important SEBI guidelines rela ting to as follows merchant bankers a re A. Registration Mercha nt ba nkers require compulsory registra tion with the SEBI to carry out their a ctivities. Previously, there were four ca tegories of mercha nt ba nkers, depending upon the a ctivities. Now, since Dec. 1997, there is only one ca tegory of registered mercha nt ba nker a nd they perform a ll a ctivities. B. Grant of Certificate The SEBI gra nts a certifica te of registra tion to a pplica nt if it fulfills a ll the conditions like (i) it is a body corporate and is not a NBFC (ii) it ha s got necessa ry infra structure to support the business a ctivity (iii) it ha s appointed a t lea st two qua lified a nd experienced (in mercha nt ba nking) persons (iv) its registra tion is in the genera l interest of investors. The potential for merchant bankers to drive the growth of the Indian equity market is immense, but, there is a scope of merchant bankers manipulating the markets, leading to an erosion of trust amongst investors. C. Capital Adequacy Requirement A merchant ba nker must ha ve adequate ca pita l to support its business. Hence, SEBI gra nts recognition to only those mercha nt ba nkers who have paidup ca pita l a nd free reserves of minimum ` 1 crore. D. Fee A mercha nt ba nker has to pa y a registra tion fee of ` 5 la kh and renewa l fees of ` 2.5 la kh every three yea rs from the fourth yea r from the da te of r egi s t r a ti on. E. Restriction on Business No mercha nt banker, other than a ba nk/ public fina ncia l institution is permitted to ca rry on business other tha n that in the securities ma rket w. e. f., Dec However, a mercha nt ba nker who is registered with RBI a s a prima ry

206 198 Banking and Financial Services dealer/ sa tellite dea ler ma y ca rry on such business a s ma y be permitted by RBI w. e. f., Nov The ma ximum number of lead ma na gers is rela ted to the siz e of the issue. For a n issue of size less than ` 50 crores, two lead ma na gers a re a pp oi nt ed. For siz e groups of 50 to 100 crores a nd 100 to 200 crores, the ma ximum permissible lea d mana gers a re three a nd four respectively. A compa ny can a ppoint five and five or more (as a pproved by SEBI) lea d ma na gers in case of issue siz es between Rs. 200 to 400 crores and a bove Rs.400 crores respectively. SEBI has Created a separate whistle blower framework to restrain the merchant banker from involving in Insider trading F. Responsibilities of Lead Managers : Every lea d ma na ger ha s to enter into an a greement with the issuing companies setting out their mutua l rights, lia bilities a nd obligation rela ting to such issues a nd in pa rticular to disclosure, a llotment a nd r e f u n d. A sta tement specifying these is to be furnished to the SEBI a t lea st one month before the opening of the issue for subscription. It is necessa ry for a lead ma nager to a ccept a minimum underwriting obliga tion of 5% of the tota l underwriting commitment or ` 25 la kh whichever is less. G. Due Diligence Certificate The lea d ma na ger is responsible for the verifica tion of the contents of a prospectus/ letter of offer in respect of a n issue a nd the rea sonableness of the views expressed in them. He ha s to submit to the SEBI a t lea st two weeks before the opening of the issue for subscription a due diligence certificate. H. Submission of Documents The lea d ma na gers to a n issue ha ve to submit a t lea st two weeks before the da te of filing with the ROC, pa rticulars of the issue, draft prospectus/ letter of offer, other litera ture to be circula ted to the investors/ sha reh olders, a nd so on to the SEBI. They ha ve to ensure tha t the modifica tions/ suggestions made by it with respect to the information to be given to the investors a re duly incorpora ted. I. Acquisition of Shares A merchant banker is prohibited from a cquiring securities of a ny compa ny on the ba sis of unpublished price sensitive information obta ined during the course of a ny professiona l a ssignment either from the client or otherwise. J. Disclosure to SEBI As a nd when required, a merchant ba nker has to disclose to SEBI (i) his responsibilities with rega rd to the ma na gement of the issue, (ii) na mes of the companies whose issues he ha s ma na ged or ha s been a ssocia ted with,

207 Merchant Banking 199 (iii) the pa rticula rs rela ting to the brea ch of ca pita l a dequa cy requirements a n d (iv) informa tion rela ting to his activities a s mana ger, underwriter, consulta nt or a dvisor to a n issue. K. Action in Case of Default A mercha nt ba nker who fa ils to comply with a ny conditions subject to which the certificate of registra tion has been granted by SEBI a nd/ or contra venes any of the provisions of the SEBI Act, Rules or Regulations, is lia ble to a ny of the two pena lties (a) (b) Suspension of registra tion or Ca ncella tion of registra tion. MERCHANT BANKING IN INDIA In India, mercha nt ba nking a ctivities sta rted from the yea r 1967, following the footsteps of simila r a ctivities in UK a nd USA, (which started in the beginning of 20th century). Currently mercha nt ba nking a ctivity has mushroomed in the India n ca pita l ma rket with both public and priva te sectors setting up their respective mercha nt ba nking divisions. Currently, the tota l number of mercha nt ba nkers in India a re a pproxima tely 1450 with more tha n 930 registered with SEBI. The SEBI a uthorised mercha nt ba nkers include mercha nt ba nking divisions of a ll India fina ncia l institutions, nationalised a nd foreign ba nks, subsidiaries of commercia l banks, priva te mercha nt ba nks enga ged in stockbroking, underwriting a ctivities and fina ncia l consulta ncy a nd investment a dvisory service firms. Companies making large size issues of equity shares relied more on foreign merchant bankers than on Indian merchant bankers because of their vast international network. Organizational Set-up of Merchant Bankers From the point of Orga niz a tiona l setup, India s mercha nt ba nking orga niz ations ca n be ca tegoriz ed into four groups on the ba sis of their linka ge with pa rent a ctivity. They a re: (a) Institutiona l Ba se (b) (c) (d) Ba nker Ba se Broker Ba se Priva te Ba se a) Institutional Base W here mercha nt ba nks function a s an independent wing or a s subsidia ry of va rious Priva te/centra l Government/ Sta te Governments Fina ncia l institutions. Most of the financia l institutions in India a re in public sector a nd therefore such set-up pla ys a role on the lines of governmenta l priorities a nd pol icies. b) Banker Base These mercha nt ba nkers function a s division/ subsidia ry of ba nking orga niz ation. The pa rent ba nks a re either na tiona liz ed commercia l ba nks or

208 200 Banking and Financial Services foreign ba nks operating in India. These orga niza tions ha ve brought professiona lism in mercha nt ba nking sector a nd they help their pa rent orga niz a tion to ma ke a presence in ca pital ma rket. c) Broker Base In the recent pa st there ha s been an inflow of qua lified a nd professionally skilled brokers in va rious Stock Exchanges of India. These brokers underta ke mercha nt ba nking-rela ted operations a lso like providing investment a nd portfolio ma na gement services. d) Private Base These mercha nt ba nking firms origina ted in priva te sectors. These orga niz ations a re the outcome of opportunities and scope in mercha nt ba nking business a nd they a re providing skill-oriented specializ ed services to their c l i ents. Bank of America is one of the leading merchant banker In the world Some of the Leading Merchant Bankers in India are: 1. Public Sec tor ICICI Securities Ltd. (promoted by ICICI) SBI Ca pita l Markets Ltd. (promoted by Sta te Ba nk of India), Mercha nt Ba nking Divisions of IDBI and IFCI, PNB Ca pita l Services Ltd. (promoted by Punja b Na tiona l Ba nk) etc. 2. Private Sector Kota k Mahindra Capita l Co J. M. Fina ncia l & Investment Consulta ncy Pvt. Ltd. DSP Financial Consultants Enam Financia l Services J a rdine Fleming India Ltd Escorts Fina ncia l Services Ltd DCM Financia l Services Ltd. The qua lity a nd integrity of the mana ger is the key fa ctor to their success both in the medium term a nd long term. Only with keen perception for growth a nd ca pita l a dequa cy, mercha nt ba nkers a re able to ca rve out a niche for themselves in the competitive ca pita l ma rket. The success ca n no more be measured by the number of issues they have handled nor the tota l amount of the issues but the performa nce standa rds a nd the qua lity of the issues ha ndled. REVIEW QUESTIONS 1. Discuss the issue ma na gement activities performed by a mercha nt ba nker. 2. W hat a re the SEBI guidelines rela ting to Merchant Ba nking in India?

209 Merchant Banking Discuss the orga niz a tiona l setup of mercha nt ba nking in India. 4. Briefly discuss the service rendered by a mercha nt ba nker. 5. W hat a re the code of conduct for mercha nt ba nkers? REFERENCES Fitch, Thoma s P. (2000), Dictionary of Banking Te rms: Me rc hant Bank, 4th Edition, New York: Ba rron s Business Guides. Greenspan, Ala n Ba nking Evolution. Rema rks before the 36th Annua l Conference on Ba nk Structure a nd Competition of the Federa l Reserve Ba nk of Chicago, Chica go, Illinois. Ma y 4. J. C. Verma, A Manual of Merchant Bank ing, Bharath Publishing House, New Delhi, M. Y. Khan, Financ ial Se rv ic es, Ta ta McGra w Hill, 3rd Edition, RBI, (1992): Report of the W orking Group on Fina ncia l Compa nies (Cha irma n: A C Sha h), RBI, Mumba i. RBI, (1998): Report of the Working Group on Money Supply (Cha irma n: Y V Reddy). RBI, (2000): Report on Trend and Progress of Banking in India, RBI, Mumba i. RBI, (2011): Report of the W orking Group on Issues a nd Concerns in the NBFCs Sector, RBI, Mumba i. SEBI Annua l Report,

210 CHAPTER 7 MUTUAL FUNDS Learning Objectives After rea ding this cha pter you should be a ble to understa nd The na ture a nd scope of mutua l funds The evolutions of mutua l funds in india The mutual fund schemes the SEBI guidelines rela ting to mutua l funds the functioning of AMFI the fa ctors contributing for the growth of mutua l funds in India

211 204 Banking and Financial Services Frank Reilly defines, Mutual Funds as financial intermediaries which bring a wide variety of securities within the reach of the most modest investors. At one time investing in the stock ma rket was confined to high net worth Individua ls. Ordinary person with little income had no a ccess to the stock ma rket. W ith development of economy over the yea rs through Five Year plans, purcha sing power of the people increa sed. Savings rose to 28% of the ea rnings of the economy. Even individua ls ha ve personal sa vings which they were hitherto depositing in ba nks a nd other fina ncial institutions a nd were not very happy with the returns on their investments in ba nks. But Mutua l Funds which a ppea red on the economic scene a re pla ying a grea ter role in protecting the sa vings of the individuals a nd a lso offering better ra te of return on their investments. Besides the sa fety, liquidity and profitability, the sa vers could enjoy by investing in MFs, they ha d the opportunity of indirectly possessing blue chips compa ny sha res through MFs. Toda y people prefer MFs to ba nk deposits. Beca use, MFs a ssure sa fe return of principa l money coupled with better return annua l. Now a ny type of sha re is a ccessible by a n ordina ry person through MFs. For the investors who does not have the expertise to invest the money in equity ma rket, mutua l funds ha ve become the ta lk for them. Mutua l funds help the investors to rea p the benefit of equity investment without taking much risk a nd without possessing much expertise in capita l ma rket. MEANING AND SCOPE OF MUTUAL FUNDS The Fund is constituted under sta tutes for the mutua l benefit of unknown small investors. The orga nisa tion which floa ts the Fund, pools the sma ll sa vings of genera l public, ma na ges the pooled funds by investing in qua lity securities a nd pa ys return to investors and pays back the principa l a fter the la pse of stipula ted time period sta ted in Fund Certificate. It ca nnot be sa id that return will be constant on investment of sa vers. It depends upon the movement a nd beha viour of stock ma rket. If there is boom in stock ma rket, returns will be high a nd v ice-a-v e rsa in ca se of depression in the economy a nd in stock ma rket. If the stock ma rket is vola tile, returns will a lso oscilla te a nd investment will also be in trouble. But shrewd Fund ma na gers shift the securities quickly to better yielding securities, so tha t investment of sma ll investors a re protected a nd certa in return is a ssured. Simply put, mone y poole d by large numbe r of inve stor s is what make s up a mutual fund. This money is then managed by a professional fund manager, who use s his inve stme nt manageme nt skills to inve st it in various financial i ns t rume nts. Mutua l Fund is defined by Securities a nd Excha nge Boa rd of India (Mutua l Funds) Regulations, 1993, a s a fund esta blished in the form of a trust by a sponsor, to ra ise monies by the trustees through the sa le of units to the public, under one or more schemes, for investing in securities in a ccordance with these regula tions. Thus, a Mutua l Fund is a trust tha t pools the sa vings of a number of investors who sha re a common fina ncial goal. The money thus collected is then invested in capita l ma rket instruments such as shares, debentures a nd other securities. The income ea rned through these investments a nd the ca pita l a ppreciation rea lised are sha red by its unit holders in proportion to the number of units owned by them. Thus, a Mutua l Fund is the most suitable investment for the common ma n a s it offers a n opportunity to invest in a diversified,

212 Mutual Funds 205 professiona lly ma na ged ba sket of securities a t a rela tively low cost. The flow chart below describes broa dly the working of a mutua l fund. Scope MFs cover wide ra nge of a ctivities. They being the ma nagers of public funds, that too of sma ll investors, by a nd la rge, ca nnot opera te a rbitra rily. Though they provide funds for development of the economy, they ca nnot stretch their opera tions beyond unma na gea ble limits. They should mainta in strict fina ncia l discipline. They should alwa ys look for qua lity investments. If they feel tha t the portfolio they hold is vola tile or a ll on a sudden exposed to unma na gea ble risk, they should liquida te such scrips a nd invest in solid securities. The scope of their opera tion is restricted to the funds they hold. They should have good sprea d to possess rea dy liquidity. Good fina ncia l ana lysts who continuously study the ca pita l ma rket ca n be good ma rket opera tors. Dea ling in stock ma rket itself is a risky a ctivity. Mutua l Funds, while opera ting in this risk ma rket should better understand their strengths in tra nsa cting a nd ma na ging others funds. Scope here refers to as how fa r the MFs can stretch their opera tions. The limiting factors a re: (i) the siz e of the fund tha t they ca n collect, (ii) ma inta ining total fund to investment ratio, (iii) the ma rket beha viour of the scrips they hold, (iv) their strength in ta king ca lcula ted risk to hold certa in ca tegory of securities, (v) their ba la ncing ca pa city to ha ve diversified mix of scrips in their ba sket ( i.e., high yielding, low yielding but safe a nd medium or a vera ge yielding securities, (vi) the ca pacity of fund mana gers to hold liquid a ssets to meet the investors claims on time, (vii) clea n a nd transpa rent opera tions, a nd (viii) coura ge to handle the situa tion in times of turbulence. As defined by AMFI Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Anybody with an investible surplus of as little as a few thousand rupees can invest in mutual fund units according to their stated investment objective and strategy. Mutual Fund and Economy The impact of MF on the economy is very positive. In a developing country like India, the ca pita l for ma n has to a ccelera ted. It is fortunate enough tha t people of India, inspite of their low income level, a re able to sa ve something out of their ea rnings. Every drop of wa ter ma kes a mighty ocea n, is a sa ving. Accordingly, sma ll sa vings of the India ns toda y sta nds a t 24 per cent of GDP. This money ha s to be channa lised for development purposes of the country so

213 206 Banking and Financial Services The Mutual Fund Industry in India was started with a humble beginning by establishing the Unit Trust of India in the year 1963, by the Government of India. that a portion of ca pita l requirement of the country ca n be sa tisfied. Sma ll sa vings of the people will be preserved by them with little returns on it. It will be invested in fixed deposits of ba nks, postal sa vings certifica tes, stock exchange securities, etc. Majority of sma ll sa vers, do not know about stock-exchange securities a nd va rious other loa n bonds issued by the Government which a re secured ones a nd bring a minimum return. In most of the ca ses yield is better in stocks, sha res a nd bonds compa red to fixed deposit or NSC. But risk is equa lly high. In this situa tion, MFs pla y a vita l role in cha nna lising the sma ll sa vings of the people for a better yield a nd minimising the risk. Besides this, they form a strong source of ca pita l genera tion for development of the economy. MFs ha ve grown substa ntia lly a nd form a major source a capita l for the development of the country in different sectors. The mecha nism of MF opera tion is just like a ba nk (Accepting deposits from public and lending it for different sectors). But lending concept is not here. They pool the resources of sa vers a nd invest in different ca tegories of securities, ha ving different levels of risks. Thus, MFs indirectly contribute for the growth of different segments of the economy. They act a s lia isons between savers a nd compa nies involved in ma nufacturing a nd other services. Thus, MFs ha ve a grea ter impa ct in providing funds for the growth of the economy. They crea te dema nd for ca pita l ma rket instruments a nd supply huge funds to this ma rket at market rates. Origin of Global Mutual Fund Industry The first mutua l funds were esta blished in Europe. One researcher credits a Dutch mercha nt with crea ting the first mutua l fund in The first mutua l fund outside the Netherla nds wa s the Foreign & Colonial Government Trust, which was esta blished in London in It is now the Foreign & Colonia l Investment Trust a nd trades on the London stock excha nge. Mutua l funds were introduced into the United Sta tes in the 1890s. They beca me popular during the 1920s. These early funds were genera lly of the closed-end type with a fixed number of shares which often tra ded a t prices a bove the va lue of the portfolio. The first open-end mutual fund with redeema ble shares wa s esta blished on Ma rch 21, This fund, the Ma ssachusetts Investors Trust, is now pa rt of the MFS fa mily of funds. However, closed-end funds rema ined more popula r than open-end funds throughout the 1920s. By 1929, open-end funds accounted for only 5% of the industry s $27 billion in tota l a ssets. After the stock ma rket cra sh of 1929, Congress pa ssed a series of Acts regula ting the securities markets in general a nd mutua l funds in pa rticula r. The Securities Act of 1933 requires tha t a ll investments sold to the public, including mutua l funds, be registered with the Securities a nd Exchange Commission a nd that they provide prospective investors with a prospectus tha t discloses essentia l fa cts a bout the investment. The Securities a nd Exchange Act of 1934 requires that issuers of securities, including mutua l funds, report regula rly to their investors; this a ct a lso crea ted the Securities a nd Exchange Commission, which is the principa l regula tor of mutua l funds. The Revenue Act of 1936 esta blished guidelines for the taxa tion of mutual funds, while the Investment Compa ny Act of 1940 governs their structure.

214 Mutual Funds 207 W hen confidence in the stock ma rket returned in the 1950s, the mutua l fund industry began to grow aga in. By 1970, there were a pproxima tely 360 funds with $48 billion in a ssets. The introduction of money ma rket funds in the high interest ra te environment of the la te 1970s, boosted industry growth drama tica lly. The first retail index fund, First Index Investment Trust, wa s formed in 1976 by The Va nguard Group, hea ded by J ohn Bogle; it is now ca lled the Va ngua rd 500 Index Fund a nd is one of the world s largest mutual funds, with more than $100 billion in a ssets a s of J a nua ry 31, Fund industry growth continued into the 1980s a nd 1990s, a s a result of three fa ctors: a bull ma rket for both stocks a nd bonds, new product introductions (including ta x-exempt bond, sector, interna tiona l a nd ta rget da te funds) and wider distribution of fund sha res. Among the new distribution channels were retirement plans. Mutua l funds a re now the preferred investment option in certa in types of fa st-growing retirement pla ns, specifically in 401(k) a nd other defined contribution pla ns a nd in individua l retirement a ccounts(iras), a ll of which surged in popula rity in the 1980s. Total mutua l fund a ssets fell in 2008, a s a result of the credit crisis of In 2003, the mutua l fund industry wa s involved in a scanda l involving unequa l trea tment of fund sha reholders. Some fund ma na gement compa nies a llowed fa vored investors to engage in la te trading, which is illega l, or ma rket timing, which is a pra ctice prohibited by fund policy. The scanda l wa s initially discovered by then-new York Sta te Attorney General Eliot Spitz er a nd resulted in significa ntly increa sed regula tion of the industry. At the end of 2011, there were over 14, 000 mutua l funds in the United States with combined a ssets of $13 trillion, a ccording to the Investment Compa ny Institute (ICI), a trade a ssociation of investment compa nies in the United Sta tes. The ICI reports tha t worldwide mutual fund a ssets were $23. 8 trillion on the same date. Mutua l funds pla y an importa nt role in U.S. household fina nces a nd retirement pla nning. At the end of 2011, funds a ccounted for 23% of household fina ncial a ssets. Their role in retirement pla nning is particula rly significant. Roughly ha lf of a ssets in 401, 000 pla ns a nd individua l retirement a ccounts were invested in mutua l funds. The main aim of the UTI was to enable the common investors to participate in the prosperity of capital market through portfolio management aimed at reasonable return, liquidity and safety and to contribute to India s industrial development by channelising household savings into corporate investment. THE EVOLUTION OF MUTUAL FUNDS IN INDIA The origin of the Indian mutua l fund industry ca n be tra ced ba ck to 1964 when the Indian government, with a view to a ugment sma ll sa vings within the country a nd to cha nnelize these savings to the ca pita l ma rkets, set up the Unit Trust of India ( UTI ). The UTI was set up under a specific statute, the Unit Trust of India Act, The Unit Trust of India la unched its first open-ended equity scheme ca lled Unit 64 in the yea r 1964, which turned out to be one of the most popula r mutua l fund schemes in the country. In 1987, the government permitted other public sector ba nks a nd insurance compa nies to promote mutua l fund schemes. Pursua nt to this rela xation, six public sector ba nks a nd two insura nce compa nies, v iz., Life Insura nce Corpora tion of India and Genera l Insura nce Corpora tion of India la unched mutual fund schemes in the country.

215 208 Banking and Financial Services Subsequently in 1993, the Securities a nd Excha nge Boa rd of India ( SEBI ) introduced The Securities a nd Excha nge Boa rd of India (Mutual Funds) Regula tions, 1993, which pa ved way for the entry of priva te sector pla yers in the mutua l fund industry. The evolution/history of Indian mutua l fund industry is broa dly divided into four phases First Phase Unit Trust of India (UTI) was established in 1963 by an Act of Parliament. It wa s set up by the Reserve Ba nk of India a nd functioned under the Regula tory a nd a dministra tive control of the Reserve Ba nk of India. In 1978 UTI wa s delinked from the RBI a nd the Industria l Development Bank of India (IDBI) took over the regula tory a nd a dministra tive control in pla ce of RBI. The first scheme la unched by UTI wa s Unit Scheme At the end of 1988 UTI had ` 6,700 crores of a ssets under mana gement. Second Phase (Entry of Public Sector Funds) 1987 ma rked the entry of non-uti, public sector mutua l funds set up by public sector ba nks a nd Life Insura nce Corpora tion of India (LIC) a nd Genera l Insura nce Corpora tion of India (GIC). SBI Mutua l Fund was the first non-uti Mutua l Fund esta blished in J une 1987 followed by Ca nba nk Mutua l Fund (Dec. 87), Punja b Na tiona l Bank Mutua l Fund (Aug. 89), Indian Ba nk Mutua l Fund (Nov. 89), Bank of India (J un. 90), Bank of Ba roda Mutua l Fund (Oct. 92). LIC esta blished its mutua l fund in J une 1989, while GIC had set up its mutua l fund in December At the end of 1993, the mutual fund industry ha d a ssets under ma na gement of ` 47,004 crores. Third Phase (Entry of Private Sector Funds) W ith the entry of private sector funds in 1993, a new era sta rted in the India n mutua l fund industry, giving the Indian investors a wider choice of fund fa milies. Also, 1993 was the yea r in which the first Mutual Fund Regula tions ca me into being, under which a ll mutua l funds, except UTI were to be registered a nd governed. The erstwhile Kotha ri Pioneer (now merged with Fra nklin Templeton) was the first priva te sector mutua l fund registered in J uly The 1993 SEBI (Mutua l Fund) Regula tions were substituted by a more comprehensive a nd revised Mutua l Fund Regula tions in The industry now functions under the SEBI (Mutua l Fund) Regula tions The number of mutua l fund houses went on increasing, with ma ny foreign mutua l funds setting up funds in India a nd a lso the industry ha s witnessed several mergers a nd a cquisitions. As at the end of J anua ry 2003, there were 33 mutua l funds with tota l a ssets of ` 1,21, 805 crores. The Unit Trust of India with ` 44, 541 crores of a ssets under ma na gement wa s wa y a hea d of other mutual funds. Fourth Phase - since February 2003 In Februa ry 2003, following the repea l of the Unit Trust of India Act 1963 UTI wa s bifurca ted into two sepa rate entities. One is the Specified Underta king of the Unit Trust of India with a ssets under ma na gement of ` 29,835 crores as a t the end of J a nua ry 2003, representing broa dly, the a ssets of US 64 scheme, a ssured return a nd certain other schemes. The Specified Underta king of Unit

216 Mutual Funds 209 Trust of India, functioning under a n administra tor a nd under the rules framed by Government of India a nd does not come under the purview of the Mutua l Fund Regula tions. The second is the UTI Mutual Fund, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI a nd functions under the Mutua l Fund Regula tions. With the bifurca tion of the erstwhile, UTI which had in Ma rch 2000 more than ` 76, 000 crores of a ssets under ma na gement a nd with the setting up of a UTI Mutua l Fund, conforming to the SEBI Mutual Fund Regula tions, and with recent mergers ta king pla ce a mong different priva te sector funds, the mutua l fund industry ha s entered its current phase of consolida tion a nd growth. At the end of J a nua ry 2003, there were 33 mutua l funds with a ssets tota lling ` 1,21, 805 crores. The UTI still led the pa ck with ` 44, 541 crores worth of a ssets. In Februa ry 2003, fa ced with financia l mismana gement, opa que bookkeeping a nd huge, growing lia bilities a t the UTI, the Government of India suspended redemptions, gua ranteed the a ssets, unveiled a comprehensive suite of reforms a nd repea led the Unit Trust of India Act The UTI wa s split into two pa rts. One was ca lled the Specified Underta king of the Unit Trust of India with ` 29, 835 crores of a ssets la rgely belonging to the UTI s Unit 64 fund. The fund wa s rumoured to own property, commodities a nd a whole ra nge of unconventional a nd often undocumented assets. The fund would a ttra ct millions of investors by promising generous a nnual dividends that were fa r in excess of the returns on its a ctual portfolio. This Specified Underta king of Unit Trust of India, functioned under a n a dministra tor a ppointed by Government of India, outside of SEBI s purview, until it wa s eventually liquida ted in The Government a sked the SBI, PNB, BOB a nd LIC to step in a s sponsors of the second pa rt, now called UTI Mutua l Fund (in addition to being sponsors of their own mutua l funds) under SEBI s regula tion. As of 30 J une 2013, the India n mutua l fund industry ma na ges a ssets worth a pproxima tely ` 847, 000 crores. Re sour c e M obilize d by M utual Funds in India Source: SE BI Ann ual Repor t, (` in cr ores) P e r i o d Gross Mobilisation R e d e m p t i o n Net Inflow Assets at the end of period , , , , 0 7, , , , , , 6 4, , 5 7, , , 0 0, , 1 4, , 1 0, , , 0 9, , 9 0, , 4 3, , , 3 9, , 3 9, , 3 7, , , 4 9, , 9 8, , 4 5, , , 3 1, , 3 8, , 4 4, , , 2 6, , 6 4, , 1 0, , 5 3, , 0 5, , 2 6, , 5 4, , , 1 7, , 0 0, 1 9, , 3 5, , , 3 1, , 5 9, , 0 8, , , 9 2, , 1 9, , 4 1, , , 8 7, , 6 7, , 9 1, , , 0 1, By the year 1993, UTI occupied nearly 80 per cent of the market share and developed manifold in terms of number of investors, investable funds, reserves with wide marketing network and efficient leadership

217 210 Banking and Financial Services FEATURES OF MUTUAL FUNDS Mobilisation of Savings Mutua l funds mobiliz es funds by selling its sha res popula rly known as units. This in turn encoura ges the household sa vings a nd investment. Provides Investment Avenue Mutua l funds provides investment a venues for sma ll and reta il investors who does not ha ve the expertise of investing in equity ma rket. Diversification in Investment Mutua l funds invest the funds collected from reta il investors in securities of different industries. This diversifica tion lea ds to reduction in the risk a ssocia ted with investment. Mutual funds from the domestic and foreign private sectors have taken away a significant proportion of the market share of the UTI and public sector mutual funds. Professional Management Pa nel of experts who possesses professiona l knowledge ma na ges mutua l funds. This lea ds to professiona l a nd profita ble ma nagement of mutual funds. Reduces Risk Mutua l funds reduces the risk a ssocia ted with investment by going for better liquidity of units, professiona l mana gement and diversifica tion. Better Liquidity Mutua l fund units ca n be sold/ liquida ted ea sily a s they possess rea dy ma r k e t. Provides Tax Benefits Investing in many schemes of Mutua l funds provides tax exemptions under section 80C of Income Ta x Act STRUCTURE/INSTITUTIONAL FRAMEWORK OF MUTUAL FUNDS IN INDIA A mutua l fund is set up in the form of a trust, which ha s sponsor, trustees, a sset mana gement compa ny ( AMC ) and a custodia n. The trust is esta blished by a sponsor or more tha n one sponsor who is like a promoter of a compa ny. The trustees of the mutua l fund hold its property for the benefit of the unit holders. The AMC, a pproved by SEBI, mana ges the funds by making investments in va rious types of securities. The custodia n, who is registered with SEBI, holds the securities of va rious schemes of the fund in its custody. The trustees a re vested with the genera l power of superintendence a nd direction over AMC. They monitor the performa nce a nd complia nce of SEBI Regula tions by the mutua l f u n d s.

218 Mutual Funds 211 A typic al mutual fund str uc tur e in India c an be graphically r e pr e se nte d as follows: 1 Sponsor Sponsor of a mutual fund is a kin to the promoter of a company a s he gets the fund registered with SEBI. Under SEBI regulations, sponsor is defined a s a ny person who a cting a lone or in combina tion with a nother body corpora te esta blishes the mutua l fund. Sponsor ca n be India n companies, ba nks or fina ncial institutions, foreign entities or a joint venture between two entities. As Reliance mutua l fund ha s been sponsored fully by a n Indian entity. W herea s, funds like Fidelity mutua l fund and J P Morga n mutua l fund a re sponsored fully by foreign entities. ICICI Prudentia l mutua l fund has been set up as a joint venture between ICICI Bank a nd Prudential plc. Both sponsors ha ve contributed to the ca pita l of the Asset Ma na gement Compa ny of ICICI Prudentia l. SEBI ha s la id down the eligibility criteria for sponsor a s it should ha ve a sound tra ck record a nd at least five yea rs experience in the financia l services industry. SEBI ensures tha t sponsor should ha ve professional competence, fina ncial soundness a nd genera l reputation of fa irness a nd integrity in business transa ctions. Also, they identify a nd a ppoint the trustees a nd Asset Mana gement Compa ny. Sponsors a re also free to get incorporated a n AMC as well as to appoint a boa rd of trustees. They, either directly or acting through trustees, will a ppoint a custodia n to hold the fund assets. To submit trust deed a nd dra ft of memora ndum and articles of associa tion of AMC to SEBI is a lso a duty of sponsor. After the mutua l fund is registered, sponsors technica lly take a ba cksea t. At least 40 per cent of the capital of AMC has to be contributed by the sponsor. 2 Trustees Under the India n Trust Act 1882, a sponsor crea tes mutua l fund trust, which is the ma in body in crea tion of mutua l funds. Trustees ma y be appointed

219 212 Banking and Financial Services a s a n individua l or a s a trustee company with the prior a pproval of SEBI. As defined under the SEBI regula tions, 1996, trustees mea n boa rd of trustees or Trustee Compa ny who hold the property of mutua l fund for the benefit of the unit holders. A Trustee a cts a s the protectors of the unit holders interests a nd is the prima ry guardia ns of the unit holders funds a nd assets. Sponsor executes a nd registers a trust deed in fa vour of trustees. There must be a t lea st 4 members in the boa rd of trustees a nd lea st two third of them need to be independent. For example, HDFC Trustee Compa ny Limited is the Trustee of HDFC Mutua l Fund v ide the Trust deed da ted J une 8, It ha s five boa rd members, of whom three a re independent. To ensure fa ir dea lings, mutua l fund regula tions require that trustee of one mutua l fund ca nnot be a trustee of a nother one, unless he is a n independent trustee in both the ca ses, a nd ha s a pprova l of both the boa rds. AMC, its directors or employees sha ll not a ct a s trustees of a ny mutua l fund. Trustees must be the person with experience in financia l services and every trustee should be a person of integrity, a bility a nd sta nding. SEBI ha s also defined the rights a nd obligations of trustees. Under their rights, trustees a ppoint AMC with the prior approva l of SEBI. They approve each of the schemes floa ted by AMC in consultation with the sponsors. They ha ve the right to obta in from the AMC, such informa tion a s they consider necessa ry to fulfil their obliga tions. Trustees ca n even dismiss AMC with the a pprova l of the SEBI a nd in a ccorda nce with the regula tions. Under their obliga tions, trustees must ensure that the tra nsa ctions of mutual funds a re in a ccorda nce with the trust deed a nd its a ctivities a re in compliance with SEBI regulations. They must ensure that AMC ha s all the procedures a nd systems in pla ce, a nd that a ll the fund constituents a re a ppointed. Also, they must ensure due diligence on the pa rt of AMC in the a ppointment of business a ssocia tes a nd constituents. Trustees must furnish to SEBI, on ha lf-yearly ba sis a report on the a ctivities of the AMC. SEBI s regulation for AMC requires that it should have a net worth of at least ` 10 crores at all times and that a company can act as an AMC of one mutual fund only. 3 Asset Management Company (AMC) Asset Ma na gement Compa ny is the body engaged to run the show of a mutua l fund. The sponsor or trustees a ppoint AMC to ma nage the a ffa irs of the mutua l fund to ensure efficient ma na gement. SEBI desires that AMC must ha ve a sound tra ck record in terms of net worth, dividend pa ying ca pa city, profita bility, genera l reputa tion a nd fa irness in transa ctions. AMC is involved in ba sica lly three a ctivities a s portfolio ma na gement, investment a nalysis a nd fina ncia l a dministra tion. Therefore, the directors of AMC should be expert in these fields. Also, a t lea st 50 per cent of the members of the boa rd of a n AMC have to be independent a nd these can be the director of a nother AMC a lso. Its cha irma n should be a n independent person. AMCs can not engage in a ny business other than that of fina ncia l advisory a nd investment mana gement. Its memora ndum a nd articles of a ssocia tion ha ve to be approved by the SEBI. Sta tutory disclosures rega rding AMCs opera tions should be periodica lly submitted to SEBI. Prior a pprova l of the trustees is required, before a person is a ppointed a s a director on the boa rd of AMC. An AMC ca nnot invest in its own schemes until it is disclosed in the offer document. Moreover in such investments, AMC will not

220 Mutual Funds 213 be eligible for fees a lso. The a ppointment of a n AMC ca n be termina ted by the ma jority of trustees or by 75 per cent of unit holders. Exa mple: HDFC Asset Ma na gement Compa ny Ltd. was a pproved by SEBI v ide its letter da ted J une 30, 2000 to a ct a s a n Asset Ma na gement Company of the HDFC mutua l fund. In terms of investment ma nagement a greement, the trustee a ppointed this AMC. HDFC holds 60 per cent of the ca pita l and Sta nda rd Life Investments holds rema ining 40 percent of the capita l of the AMC. Its boa rd ha s 12 members of whom 6 are independent. Apa rt from three constituents discussed a bove, Custodians a nd tra nsfer a gents a re a nother two importa nt constituents of mutua l funds. These ha ve been discussed below. 4 Custodian SEBI requires tha t ea ch mutua l fund sha ll ha ve a custodia n who is independent and registered with it. SEBI regulations provide for the a ppointment of a custodian by trustees of the mutual fund who a re responsible for ca rrying on the activities of safe keeping of securities a nd pa rticipa ting in a ny clea ring system on behalf of mutua l fund. They should be independent of the sponsors. As for exa mple, ICICI Bank is a sponsor of ICICI Prudentia l Mutual fund. It is a lso a custodia n bank. But it ca nnot offer its services to ICICI Prudentia l Mutua l fund, beca use it is a sponsor of this fund. The a ppointment of a ny agency a s custodian depends upon its tra ck record, quality of services, experience, transpa rency, computerisa tion a nd other infra structure fa cilities. Custodia ns prima rily perform securities settlement functions. However, some a lso offer fund a ccounting a nd va lua tion services. The responsibilities of custodia n include delivering a nd a ccepting securities a nd ca sh, to complete transa ctions ma de in the investment portfolio of mutua l funds. Custodia ns a lso tra ck a nd keep pa youts a nd corpora te actions such a s bonus, rights, offer for sa le, buy ba ck offers, dividends, interest and redemption on the securities held by the fund. They a lso look a fter tha t the discrepancies a nd fa ilure must be timely resolved. Custodian is not permitted to act as a custodian of more than one mutual fund without the prior approval of SEBI. 5 Transfer Agent Registrar a nd tra nsfer (R& T) a gents a re responsible for creating a nd ma inta ining investor records kept in numbered a ccount ca lled folios a nd servicing them. They a ccept and process investor tra nsa ctions a nd a lso opera te investor service centre (ISCs) which acts a s a n officia l points for accepting investor tra nsa ctions with a fund. As for example, Computer Age Mana gement Services (CAMS) is the R& T agent for HDFC mutua l fund. R&T functions include issuing a nd redeeming the units a nd updating the unit ca pital a ccount. R& T perform crea ting, ma intaining a nd upda ting the investors records a nd ena bling their tra nsa ctions such a s redemption, purcha se and switches. Ba nking the pa yment instruments such a s dra fts a nd cheques given by investors a nd notifying the AMC is a lso done by them. R& T send sta tutory a nd periodic information to investors a nd process payouts to investors in the form of dividends a nd redemptions.

221 214 Banking and Financial Services Se ctor Wise Resour ce M obilization by M utual Funds in the Ye ar Source: SE BI Annual Report, (` in crores) Particulars Private Sector MFs Public Sector MFs UTI MF Gran Open- Close- Interval Total Open- Close- Interval Total Open- Close- Interval Total Total ended ended ended ended ended ended Mobilisation 58,62,749 58, 175 7,022 59,27,947 6,98,358 8, ,06,589 6,26,821 5, ,33,350 72,67,885 of Funds (55,59,558) (1,15,116) (9,069) (56,83,744) (5,96,696) (15,695) (1,091) (6,13,482) (5,14,272) (4,702) (3,479) (5,22,453) (68,19,679) Re p u r c h ase s / 57,76,161 80, 387 6,297 58,62,845 6,86,483 13, ,99,781 6,21,562 5,067 2,092 6,28,720 71,91,346 Redem ption (55,67,914) (1,13,318) (17,957) (56,99,189) (6,01,662) (13,926) (1,289) (6,16,877) (5,15,947) (4,829) (4861) (5,25,637) (68,41,702) Net Inflow/ 86, , , , 875-4, ,808 5, , 204 4,629 76, 539 Outflow (-8,356) (1,799) (-8,888) (-15,446) (-4,965) (1,769) (-198) (-3,394) (-1,675) (-126) (-1,382) (-3,184) (-22,024) of Funds Note: Figures in parentheses indicate corresponding figures for MUTUAL FUND SCHEMES/CLASSIFICATION OF MUTUAL FUNDS/TYPES OF MUTUAL FUNDS Depending upon the requirement/ expecta tions of the investors a ta ilored made. Scheme may be provided by the mutua l funds to investors. Mutua l funds ca n be broa dly classified a s shown in the chart. Types of Mutual Funds Schemes in India 1. Classification on the Basis of Operations/ Structure (a) Open-e nde d Sche me: In a n open-ended mutua l fund there a re no limits on the tota l siz e of the corpus (Fund ra ised). Investors a re permitted to enter (Buy) a nd exit (Sell) the open-ended mutua l fund a t any point of time a t net

222 Mutual Funds 215 a sset value (NAV). These schemes are opened throughout the year with no definite closing period. It provides, excellent liquidity, a lthough the units a re not listed. Axis Triple Adva nta ge Fund, Birla Sun Life Ba sic Industries Fund, IDBI India Top 100 Equity Fund, L& T Contra Fund, Taurus Ta x Shield, Templeton Floa ting Ra te Income Fund, UTI - G-Sec Fund a re some of the open-ended mutual funds. Characteristics 1. Accepts funds from investors on continuous ba sis. 2. Repurcha se fa cility ava ila ble. 3. No listing in stock excha nge. 4. Better liquidity due to continuous repurchase. 5. Sa le and purcha se ba sed on NAV of the units. (b) Close-ende d Sc he me s: Here the dura tion a nd amount to be ra ised from the funds is pre-fixed schemes a re opened for specific time period. Once the subscription rea ches the pre-determined level, the entry of investors is closed. After the expiry of the fixed period, the entire corpus is disinvested a nd the proceeds a re distributed to the va rious unit holders in proportion to their holding. Investors ca n tra nsa ct (buy or sell) the units of the scheme on the stock excha nges where they a re listed. The ma rket price a t the stock excha nges could va ry from the net asset va lue (NAV) of the scheme on a ccount of dema nd a nd supply situa tion, expecta tions of unit holder a nd other ma rket factors. Ca na ra Robeco Equity Ta x Sa ver-93, DSP Merrill Lynch Ta x Saver Fund, Ta ta Life Sciences a nd Technology Fund, J M Arbitra ge Adva nta ge Fund, Kota k Gold ETF a re some of the close-ended funds in India. Characteristics 1. Schemes a re opened only for short dura tion. 2. Corpus norma lly does not cha nge, throughout the yea r. 3. Normally these schemes a re listed in stock excha nges. 4. Liquidity is a vaila ble to investors at the time of redemption. 5. Ma rket price may be below or a bove pa r. (c) Inte r val Sc he me s: Ba sica lly it is a close ended scheme with a peculia r feature tha t every yea r for a specified period (interva l) it is ma de open. Prior to a nd a fter such interva l the schemes opera tes a s closed ended schemes. During the sa id period, mutua l fund is rea dy to buy or sell the units directly from or to the investor. Relia nce interva l fund, Taurus qua rterly interva l fund-series 1, ICICI-Pru s Interva l Fund II a re some of the interva ls funds in India. The Mutual fund Industry in India consisting of 44 fund houses. As of December 2012, top five fund houses comprised 54% of AUM while the top 10 fund houses comprised 77% of AUM. 2. Classification by Investment Objectives (a)inc ome Sche me s: To ma ximiz e the current income is the objective of this scheme. Periodica l income distribution is the feature. Investment in low risk securities is ma de in these schemes. Predomina ntly funds are invested in debt instruments. Scheme offers ma ximum current income, where by the income ea rned by units is distributed to unit holders periodicall y. Some of the exa mples

223 216 Banking and Financial Services of Indian income mutua l funds a re IDFC Ca pita l Protection Oriented Fund, Kota k Hybrid Fixed Term Pla n, Relia nce Fixed Horiz on Fund, SBI Ca pital Protectionoriented Fund, etc. (b) Gr owth Sc heme s: To a chieve capital a pprecia tion is the objective of this scheme. Investment is ma de in growth oriented securities like equity sha res. They concentra te ma inly on long run ga ins, i. e., ca pita l apprecia tion. They do not offer regula r income a nd they a im a t ca pita l apprecia tion in the long run. BNP PARIBAS Equity Fund, Ca na ra Robeco emerging equities, DW S Investment Opportunity Fund, Fidelity Equity Fund, HSBC Dynamic Fund, Qua ntum Longterm Equity Fund a re some examples of growth mutual funds in India. (c) Balance d Sche me s: To provide current income a s well as ca pita l a ppreciation is the objective. Investment in Equity a nd Fixed income securities a s per the offer document. HDFC Ba la nced Fund, UTI Ba la nced Fund, Ta ta Ba la nced Funds a re some of the exa mples of these funds in India. Numbe r of M utual fund sche me s as per Inve stment Obje c tive s as on March 2013 S c h e m e s O p e n - e n d e d C l o s e - e n d e d I n t e r v a l T o t a l A. In come/debt-oriented Schem es i) Liquid/Money Market (55) (0) (0) (55) ii ) G i l t (42) (0) (0) (42) iii) Debt (other than assured returns) (229) (512) (34) (775) iv) Debt ( assured return s) Subtotal (i+ii+iii) (326) (512) (34) (872) B. Growth/Equ ity-oriented Schem es i) E LSS (36) (13) (0) (49) ii ) O t h e r s (299) (4) (0) (303) Subtotal (i+ii) (335) (17) (0) (352) C. Balan ced Schem es Balan ced schem es (29) (1) (0) (30) D. Exchange Traded Fu nd i) Gold ETF (14) (0) (0) (14) ii ) Other ETFs (21) (0) (0) (21) Subtotal (i+ii) (35) (0) (0) (35) E. Fu nd of Funds In vesting Overseas Fu nd of Funds in vesting overseas (20) (0) (0) (20) TOTAL (A+B+C+D+E) (745) (530) 34 ) (1309) Note: Figures in p aren theses ind icate co rrespon d ing figures for Source: SE BI Annual Report,

224 Mutual Funds Classification by Nature of Investment (a) Equity Fund These funds invest a ma ximum pa rt of their corpus into equities holdings. The structure of the fund may va ry differently for different schemes a nd the fund ma na ger s outlook on different stocks. The Equity Funds a re sub cla ssified depending upon their investment objective, a s follows : Diversified Equity Funds Mid-Ca p Funds Sector Specific Funds Ta x Sa vings Funds (ELSS) Equity investments a re mea nt for a longer time horiz on, thus Equity funds ra nk high on the risk-return ma trix. (b) Debt Funds The objective of these Funds is to invest in debt papers. Government authorities, private companies, banks and financial institutions are some of the major issuers of debt papers. By investing in debt instruments, these funds ensure low risk and provide stable income to the investors. Debt funds are further classified as : Gilt Funds Invest their corpus in securities issued by Government, popularly known a s Government of India debt pa pers. These Funds carry zero defa ult risk but a re a ssocia ted with Interest Ra te risk. These schemes a re sa fer a s they invest in pa pers backed by Government. Income Funds Invest a ma jor portion into va rious debt instruments such a s bonds, corpora te debentures a nd Government securities. M IPs Invests ma ximum of their total corpus in debt instruments while they ta ke minimum exposure in equities. It gets benefit of both equity a nd debt ma rket. These scheme ra nks slightly high on the risk-return matrix when compared with other debt schemes. Shor t-ter m Plans (STPs) Meant for investment horiz on for three to six months. These funds prima rily invest in short-term papers like Certifica te of Deposits (CDs) and Commercia l Papers (CPs). Some portion of the corpus is also invested in corporate debentures. Liquid Funds Also known as Money Market Schemes, These funds provides easy liquidity and preservation of capital. These schemes invest in short-term instruments like Treasury Bills, inter bank call money market, CPs and CDs. These funds are meant for short-term cash management of corporate houses and are meant for an investment horizon of 1day to 3 months. These schemes rank low on risk-return matrix and are considered to be the safest amongst all categories of mutual funds. The mutual fund industry s average assets under management (AUM) grew by 15% in 2012 to ` 7.87 trillion in December, 2012

225 218 Banking and Financial Services (c) Balanced Funds As the name suggest they, a re a mix of both equity and debt funds. They invest in both equities a nd fixed income securities, which a re in line with predefined investment objective of the scheme. These schemes aim to provide investors with the best of both the worlds. Equity pa rt provides growth a nd the debt pa rt provides stability in returns. (4) Classification by Geography (a) (b) Dome stic M utual Fund Sc he mes: Schemes la unched with a view to mobiliz e sa vings of the citizens of the country. Offshore Sc he me s: Mutua l fund schemes la unched with a view to mobilize the sa vings of the foreign countires for the investments in loca l ma rkets. The aim is norma lly long-term ca pital growth by investing in local equities. Gold ETFs are passively managed mutual funds that invest money in standard gold bullion (99.5% purity). In India. (5) Other Classification (a) Tax Saving Sche me s: These schemes provide ta x incentives to Individual tax pa yers under section 80C of Income Ta x Act. By investing in these scheme the ta xpa yer ca n reduce his tax liability. These funds ha ve minimum lock in period of three years. (b) (c) (d) (e) (f) Se ctor Funds: These funds invest the funds in securities (equity sha res) of certa in sector of the economy like, IT, Pha rma, Automobile, etc. The risk is confined to one pa rticular sector. Inde x Funds: These funds invest the money in equity sha res of those compa nies which a re pa rt of indices such a s Sensex, Nifty, etc. The objective is to ma tch the performa nce of the stock market by tra cking a n index that represents the overa ll ma rket. M one y M ar ke t Funds: Investment of these funds is in securities of short-term na ture, which genera lly mea ns securities of less tha n oneyear ma turity. The ma jor a dva nta ges a re the liquidity a nd sa fety. Exchange Tr ade d Fund (ETF): An excha nge tra ded fund is a n open ended fund that tracks an index like a n index fund, but tra des like a stock on a n excha nge just like the sha res of a n individua l company. Unlike the sha re of a compa ny, each unit of an ETF represents a portfolio of stocks. Therefore, these funds a re similar to a unit of a n open-ended mutua l fund but with a big difference. The difference between a n ETF a nd a n open-ended mutua l fund is tha t the units of a n ETF trade on a n excha nge a nd therefore, the investor can trade in it during ma rket hours a nd the units ca n be sold short or ma rgined just like sha res. Another difference is the type of ma na gement. Mutua l funds employ a n a ctive ma na gement stra tegy wherein the fund ma na ger chooses portfolio of stocks and ma na ges them in a n endeavour to outperform the fund s b e n c h ma r k. Fund of Fund (FoF): A Fund of Fund invests in other funds. Its portfolio is not ma de up of securities but of other mutua l funds, selected to serve a given investment objective. A fund of funds a llows investors to a chieve

226 Mutual Funds 219 (g) a broa d diversification a nd an a ppropriate a sset alloca tion with investments in a va riety of fund ca tegories a ll wra pped up into one fund. However, if the fund of funds ca rries a n opera ting expense, investors may have to bea r double for an expense tha t is a lrea dy included in the expense figures of the underlying funds. Some fund of funds ma y invest in other mutua l funds, not necessa rily from the sa me fund house. These are called Multi Ma na ger Fund. Prudentia l ICICI wa s the first to introduce FoFs in India in November 2003 (SEBI Annua l Report a nd Bhole, 2005) [ 18]. Birla Sun Life Asset Alloca tion Fund, Fidelity Multi Ma na ger Ca sh Fund, ICICI Prudentia l Advisor Series, Qua ntum Equity Fund of Funds a re some of their exa mples in I n d i a. Gold Exc hange Tr ade d Funds: Gold ETFs a re excha nge traded funds that a re mea nt to tra ck closely the price of physica l gold. Ea ch unit of the ETF lets the investor own 1 gm of gold without physica lly owning it. Thus, investing in a gold ETF provides the benefit of liquidity a nd ma rketa bility which a re a limita tion of owning physica l gold. Gold ETF is highly liquid beca use these ca n be tra ded at a ny time during ma rket hours. Some of the Gold Excha nge Tra ded Funds in India a re Axis Mutua l Fund-Axis Gold ETF, Gold Benchmark Excha nge Traded Scheme, Birla Sun Life Gold ETF, HDFC Gold Excha nge Tra ded Fund, ICICI Prudentia l Gold Excha nge Tra ded Fund, KOTAK Gold ETF, Quantum Gold Fund Top Mutual Fund Houses in India ( As on March 2014) Fund House Sc heme Options Quarte rly Av e rage Asse t Under Management (AAUM) Cr. HDFC Mutual Fund , 1 3, 3 5, ICICI Prudentia l Mutual Fund , 0 6, 9 4, Reliance Mutual Fund , 0 5, 2 9, Birla Sun Life Mutual Fund , 1 3, UTI Mutual Fund , 2 3, B igge st Mutual Fund Sc he me s in India (As on M ar c h 2014) Assets managed under gold ETFs have increased nearly 15-fold in the past four years from Rs 7.80 bn in February 2009 to Rs bn in February 2013 (this also includes mark-to-market gains of 90% shown by the CRISIL Gold Index during the period). Sc he me Name Current NAV Scheme AUM ` Cr. B i r l a S L- D yn B o nd F u nd , 6 1, H D F C - T op F un d , 4 0, H D F C - E q ui t yfund , 3 3, F r a n k l i n Tmp l - S T In c ome P l a n , 2 8, Fr a nkl i ntmpl - C or p B ond O pp , 0 1,

227 220 Banking and Financial Services SEBI REGULATIONS ON MUTUAL FUNDS The Securities and Excha nge Boa rd of India (SEBI) as the regulator of India n ca pita l ma rket ha d come out with its first mutua l fund regula tions in The need for creation a nd complia nce mecha nism for mecha nism for mutua l fund industry wa s expressed by SEBI in these guidelines. These regula tions were revised a nd enla rged subsequently in These regula tions were a mended regula rly. The la test a mendment wa s ma de in Ja nua ry The crux of these regulation is that interest of Unit holders is supreme. With SEBI regulations, a ll mutua l funds ha ve been brought under a common regula tory fra mework to ensure grea ter degree of transpa rency in their opera tions a nd adherence to a common structure. This Act spells out numerous restrictions a nd requirements designed to protect the interests of the investors, a nd ensure tha t ea ch mutua l fund scheme is ma na ged a nd opera ted in the best interest of its unit holders. The regulation governing mutual fund have been developed over time and are fairly comprehensive. this development has been through periodic amendments to the regulation themselves and also through a continuous series of notification and circulars issued by SEBI. 1. Legal Character of Mutual Funds in India It is useful to understand the legal composition of a mutua l fund. A mutua l fund is a lega l entity. In India it is organized in form of a trust. The SEBI (Mutual Fund) Regula tions, define a mutua l fund a s a fund established in the form of a trust by a sponsor, to ra ise monies by the trustees, through the sa le of units to the public under one or more schemes for investing in securities in a ccordance with these regula tions. This imposes three limita tions on a mutua l fund a nd determines its ba sic lega l cha ra cter. First, it a llows the mutua l fund to raise resources through sa le of units to the public. Second, it permits the mutua l fund to invest only in securities prescribes in the SEBI (MF) Regula tions. This implies tha t mutual funds ca nnot invest in property or a real esta te or in a ny other a ssets, a s the securities prescribed in the regula tions a re only sha res, debentures a nd equity-linked instruments. Third, it requires the mutua l fund to be set up in the form of a trust under the India n Trust Act. In the context of India n mutua l funds, it needs to be mentioned tha t the India n Trust Act wa s enacted in 1882, essentially to govern priva te trusts a nd cha rita ble institutions. A trust is defined a s an obliga tion a nnexed to the ownership of property a nd a rising out of a confidence reposed in a nd a ccepted by the owner for the benefit of a nother. The person who crea tes the trust is called the author of the trust. The person for whose benefit the trust is crea ted is a beneficiary. 2. The Structure The SEBI Mutual Fund Regula tions have defined the structure of a mutua l fund a nd segrega ted the va rious constituents into separa te lega l entities. The mutua l funds are set up as trusts are to be mana ged by a sepa ra te a sset ma na gement compa nies (AMCs). The custody of the a ssets is to be with a custodian, which is independent of the sponsors and the AMCs. Arms-length rela tionships ha ve been sought to be built into the various constituents of a mutua l fund, primarily through the requirement tha t two third of the trustees a nd a lso 50% of the board of directors of the AMC must be independent a nd not a ssocia ted or a ffilia ted to the sponsor. Va rious documenta tion, v iz., trust deed, investment mana gement agreement, which a re to be executed, delinea te the responsibilities of the a sset ma nagement compa nies a nd the trustees.

228 Mutual Funds Independent Custodian Regula tion 25 of the SEBI (MF) Regula tions requires that mutua l funds should ha ve a custodia n who is not in a ny way associated with the AMC. Further, the regula tions require tha t the custodia n is not the sponsor or trustee of a ny mutua l fund and tha t the custodian or its directors will not be in a ny wa y be directly or indirectly affiliated or a ssocia ted with a ny AMC. The custodia n ca nnot act a s a sponsor or trustee of neither a ny mutual fund nor ca n it a ct a s a custodia n of more than one mutua l fund without the prior a pprova l of SEBI. The underlying purpose of these regula tions is to ensure tha t the custodia n meets the test of independence a long with the mutua l fund so a s to prevent a ny conflicts of interests. Trend in Transaction by Mutual Funds in Indian Stock Exchanges E q ui t y D e b t T o t a l (` in Crores) P e r i o d G r o s s G r o s s N e t G r o s s G r o s s N e t G r o s s G r o s s N e t P u r c h a s e S a l e s P u r c h a s e / P u r c h a s e S a l e s P u r c h a s e / P u r c h a s e S a l e s P u r c h a s e / S a l e s S a l e s S a l e s ,4 4, ,3 7, , ,2 7, ,4 5, , ,7 1, ,8 3, , ,9 5, ,0 6, , ,2 4, ,4 3, ,8 0, ,1 9, ,4 9, ,7 0, ,5 4, ,7 4, , ,6 2, ,1 3, ,4 9, ,1 6, ,8 7, ,2 9, ,3 2, ,3 3, , ,1 6, ,8 1, ,3 4, ,4 8, ,1 5, ,3 3, ,1 3, ,3 6, , ,2 3, ,4 9, ,7 3, ,3 7, ,8 6, ,5 0, 71 1 Source: SE BI Annual Report, Registration of Mutual Funds All mutua l funds a re required to register with the Securities a nd Exchange Board of India. Registration is intended to provide a dequa te a nd a ccura te disclosure of ma teria l fa cts concerning the mutual fund. SEBI regula tions ha ve la id down a n eligibility criteria u/ s 7, for the purpose of gra nt of a certifica te of registration with a view to ensure that pla yers ha ve a sound track record a nd genera l reputa tion of fa irness a nd integrity in a ll their business tra nsa ctions. Regula tion 20(e) sta tes tha t the AMC shall ha ve a minimum net worth of `10 crores. This is to serve both as a n entry barrier a s well as to ena ble the AMC to provide for its own infrastructure such a s office spa ce, personnel a nd systems independent of the sponsor. Any shortfa ll in the net worth would have to be ma de up by the sponsor immedia tely. The initia l contribution to the net worth should be in the form of ca sh a nd a ll assets should be held in the na me of the AMC. This is necessa ry to bring a bout a complete a rms length relationship with the sponsor and its a ffilia tes. In ca se the AMC wa nts to carry out other fund ma na gement businesses, it should sa tisfy the ca pita l adequa cy requirement for ea ch such business independently. In ca se the AMC wishes to floa t assured return schemes or la unch no loa d funds, it should sa tisfy SEBI that its present net worth would be a dequa te to meet a ny financia l obliga tion which may a rise; and if required the net worth The Indian mutual fund industry has about 1,250 unique funds across 44 AMCs, which further have around 8,000 options (growth, dividend, re-investment with multiple frequencies - daily, monthly, quarterly, etc.)

229 222 Banking and Financial Services The need of the hour for AMCs is to consolidate funds with similar objectives as well as provide fund names that are simple to understand and give some indication of the risk return trade-off and investment horizon. should be increa sed. The AMC is allowed to deploy its net worth profita bly a s it ma y deem fit, provided tha t there is no conflict of interest between its ma nner of deployment a nd the interest of the investors in the schemes ma na ged by it; a nd this would be overseen by the Trustees. The AMCs a re a lso a llowed to invest in the mutua l fund schemes launched by it; in ca se a n AMC chooses to do so either during the initia l offer period or subsequently in ca se of open ended schemes, the AMC s policy in this rega rd should be clea rly disclosed in the prospectus a nd in the director s report in the ba la nce sheet of the releva nt scheme of the mutua l fund. Mutua l funds are a llowed to launch schemes only when SEBI is convinced that the AMC ha s systems in pla ce for its ba ck office, dea ling room, a ccounting, complia nce a nd investor grieva nce redressa l, a ppointed a ll key personnel including fund ma na ger(s) for schemes a ppointed a complia nce officer to ta ke ca re of regula tory requirement a nd investor compla ints, prepa red a compliance ma nua l and designed interna l control mecha nisms including interna l a udit systems, instituted a mecha nism for ha ndling investor compla ints, appointed registrars a nd custodian a nd la id down pa ra meters for their supervision, la id down norms for empa nelment of brokers and marketing a gents a nd appointed a ud i t o r s. The bio-da ta of a ll the key personnel should be filed with SEBI a nd a n underta king given by the trustees/ boa rd of directors of the AMC tha t the AMC would file ha lf yearly sta tements of dealings in securities by the persons identified a s key personnel in the AMC or the Trustee Compa ny. No person who ha s a t any time been convicted for a ny offence involving moral turpitude or ha s been found guilty of a ny economic offence or of violation of securities la ws shall be a ppointed a s key personnel in a ny AMC or trustee company. 5. Governance of Mutual Funds Mutua l fund schemes a re repositories of trust a nd of investor s ha rd ea rned money. The task of providing protection to them is a difficult one. Mutua l funds a re unique in a wa y a s tha t they a re orga niz ed a nd operated by people whose prima ry loya lty a nd pecunia ry interest lies outside the enterprise. Consequently, the very structure of mutua l funds ha s inherent conflicts of interest, crea ting grea t potentia l for a buse. The existing SEBI Regula tions ha ve tried to a ddress the issue, through separa tion of va rious entities which constitute a mutua l fund sponsor, trustees, a sset ma na gement compa nies a nd custodia n, a nd also requiring that 2/ 3rd of the trustees a nd ha lf of the boa rd of directors of AMC must be independent of sponsor or its affilia tes. The beneficia l owners of the trust, i. e., the unit holders ha ve a lso been given a role, as their a pprova l is required by the fund/ AMC to ena ble it to bring a bout certa in cha nges in the fund or to wind up a scheme. The SEBI regulations ha ve ma de it ma nda tory that the trustees sha ll obta in the consent of the unit holders in importa nt ma tters. The trustees sha ll ensure tha t no cha nge in the funda menta l a ttributes of a ny scheme or the trust or fees a nd expenses pa ya ble or a ny other change which would modify the scheme a nd affects the interest of the unit holders, shall be ca rried out unless it is ma de known to the unit holders a nd the unit holders a re given a n option to exit a t the preva iling Net Asset Va lue without

230 Mutual Funds 223 a ny exit loa d. The unit holders have a right to termina te the a sset mana gement compa ny. The a ppointment of an a sset mana gement compa ny ca n be terminated by ma jority of the trustees or by 75% of the unit holders of the scheme. Any change in the a ppointment of the asset ma na gement company sha ll be subject to prior a pprova l of SEBI a nd the unit holders. 6. Operations of Mutual Funds This section will show the regulatory provisions pertaining to the opera tions of the mutua l fund a nd their implica tions on unit holders protection. The SEBI regula tions rela ting to opera tions a re as follows (a) B usine ss of the Asse t Manageme nt Company Regulation 23 of the SEBI provides tha t AMC sha ll not underta ke a ny business a ctivity other than ma na gement of the mutua l funds a nd such other a ctivities a s fina ncia l services consulta ncy, excha nge of resea rch a nd a na lysis on commercia l basis a s long a s these are not in conflict with the fund ma na gement a ctivity itself, without prior a pprova l of the trustees and SEBI. (b) Disc losur e Re quir e me nts Mutua l funds a re required to disclose to SEBI regula r, comprehensive disclosures of their opera tions. In addition, ea ch fund must provide unit holders with a nnua l report along with a sta tement on portfolio holdings, a nd it must furnish unit holders and prospective investors with a n up-to-da te prospectus. The prospectus conta ins full disclosures on the fund s ma na gement, investment objectives, purcha se redemption procedures a nd other business pra ctices, including loa d cha rges, if a ny. It is often criticiz ed that big investors tra de to the disa dva nta ge of sma ll investors. Mutua l funds sha ll disclose la rge unit holdings in the scheme, which a re over 25% of the NAV. The offer document discloses the constitution of the mutua l fund including the details rega rding the sponsor, the trustees, the AMC, the custodia n a nd the responsibilities a nd functions of ea ch constituent of the mutua l fund; the deta iled investment objective of the scheme a nd the investment pa ttern likely to be followed by the AMC, the risk profile of the investments; a nd risk fa ctors. The offer documents a lso conta ins other informa tion perta ining to the redemption of units, the ta x benefits a vaila ble to unit holders, the principles of va lua tion of investments, the method of ca lcula tion of NAV, frequency a nd mode of distribution of income, the dura tion of the scheme, the deta iled brea k-up of the expenses tha t will be incurred for the mana gement of the scheme a nd the extent to which expenses a re loa ded on the scheme. Mutual funds a re further required to disclose full portfolio of their schemes every ha lf yea r, either by sending a complete sta tement of scheme portfolio or by publishing it by wa y of a n a dvertisement in one English daily circula ting in the whole of India a nd in a newspaper published in the la ngua ges of the region where the hea d office of the mutual fund is situa ted. (c ) Adve r tise me nts Mutua l funds must a dhere to specific rules rega rding the sa le, distribution and a dvertising of mutua l funds. Advertisements or sales litera ture must be ca refully worded a nd expla ined. The a dvertisement for ea ch scheme sha ll disclose investment objective for each scheme. The offer document a nd a dvertisement ma teria ls sha ll not be mislea ding or conta in a ny sta tement or opinion, which is incorrect or fa lse. These steps ensure tha t potentia l With more than 80,000 bank branches spread across India, mutual fund penetration can significantly improve even if 50% of these branches are trained to sell mutual funds.

231 224 Banking and Financial Services All promotional material must contain an express warning note to the fact that risk is connected with the investment and returns to date are not a guarantee of future return. investors a re a wa re of the benefits a s well a s the potentia l risks involved in mutua l fund investing. With a view to ensure tha t a n a sset mana gement compa ny ma y not in promoting its schemes use untrue a nd mislea ding informa tion or withhold importa nt fa cts from investors SEBI ha s prescribed a n a dvertisement code. Advertisements in respect of every scheme shall be in conformity with the Advertisement Code. (d) AM FI Ce r tific ation For Age nts - Mutua l funds are a dvised to ensure that their a gents/ distributors do not indulge in a ny kind of ma lpractice or unethical pra ctice while selling/ marketing mutua l fund units. SEBI ha s prescribed a deta iled code of conduct for mutua l fund intermedia ries, i. e., a gents a nd distributors. With a view to implement this code of conduct effectively the AMFI certification exa mina tion wa s ma de ma ndatory for a ll distributors a nd a gents of mutua l funds. Mutua l funds ca nnot provide gua ra nteed return, unless such returns a re fully gua ranteed by the sponsor or the a sset mana gement compa ny. W hen gua ra nteed by the sponsor or the AMC a sta tement indica ting the na me of the person who will gua ra ntee the return, is ma de in the offer document; or the manner in which the guara ntee to be met ha s been sta ted in the offer document. (e) Inve stme nt Re str ic tions Investments by mutua l funds a re subject to investment restrictions. These restrictions a re essentia lly prudentia l investment norms, most of which a re universa lly followed by mutual funds to ensure portfolio risk diversifica tion. For exa mple, investment in equity sha res or equity-related instruments of a single compa ny are restricted to 10% of the NAV of a scheme. (f) Daily Pric ing In open-ended schemes unit holders a re a lwa ys free to vote with their rupees by not buying a product if the fees are too high or vote with their feet by redeeming the units if they a re unhappy over the performance of schemes. Mutua l funds a re required to upda te the NAV of the scheme a nd the sa le/ repurcha se prices of their schemes on the AMFI website on a daily ba sis in ca se of open-ended schemes. Price determina tion of units is not a n a rbitra ry process. SEBI ha s prescribed the a ccounting and valua tion norms. W hile determining the prices of the untis, the mutua l fund sha ll ensure tha t the repurcha se price is not lower tha n 93% of the NAV and the sa le price is not higher tha n 107% of the NAV. Provided tha t the difference between the repurchase price and the sa le price of the unit sha ll not exceed 7% calculated on the sale price. (g) Bor rowings By Mutual Funds Mutual funds ca nnot borrow except a s a mea sure of la st resort Since leveraging ha s risks a tta ched to it, mutua l funds ca n borrow only to meet the tempora ry liquidity needs for the purpose of repurchase, redemption of units or pa yment of interest or dividend to the unit holders. Provided tha t the mutua l fund sha ll not borrow more tha n 20% of the net a sset of the scheme a nd the dura tion of such a borrowing shall not exceed a period of six months. The trustees are required to ensure tha t borrowing is used a s a measure of last resort a nd determine whether the mutua l fund could borrow should be disclosed in the scheme s offer document.

232 Mutual Funds 225 (h) Re por ting Re quir e ment Every mutua l fund has to appoint complia nce officer. The complia nce officer ensures the complia nce of the mutua l fund schemes with SEBI regula tions. It receives circula rs notifica tions from SEBI a nd puts the sa me to the respective depa rtment for necessa ry a ction. The officer receives releva nt informa tion from various depa rtments/ officers of the trust, compiles the sa me into sta nda rd forma ts and submits to SEBI/ AMFI etc. he vets the offer document to ensure the offer document discloses a ll the informa tion a s required by SEBI. This helps SEBI to do continuous offsite i ns p ec t i on. (i) Risk M anage me nt System In M utual Funds Recognizing the need to esta blish a minimum level of risk ma na gement system conforming to interna tiona l sta nda rds, AMFI formed a committee for studying the present system of risk ma nagement a nd proposing wa ys and means of strengthening the sa me. They ha ve ma de certa in recommenda tions to ensure a minimum standa rd of due diligence or risk ma nagement system for a ll the mutua l funds in va rious a rea s of their opera tions like fund ma na gement, opera tions, customer service, ma rketing and distribution, disa ster recovery a nd business contingency, etc. the report ha s been submitted to SEBI a nd ha s been a dopted a s the regulatory fra mework for risk mana gement in the Indian mutua l fund i n d u s t r y. 7. Grievance Mechanism Mutua l funds need to specify in the offer document the na me of conta ct person whom unit holders ma y a pproa ch in ca se of a ny query, compla ints or grieva nces. The na mes of the directors of Asset Ma na gement Compa ny a nd trustees a re a lso given in the offer documents; a nd they ca n also be a pproa ched. Historica l information a bout the investor s compla ints a nd redressal form a pa rt of the offer document. Investors ca n a lso a pproa ch SEBI for redressa l of their comp l a i n t s. On receipt of complaints, SEBI takes up the matter with the concerned mutual fund and follows up with them till the matter is resolved. Top Mutual Funds in India as on March 2014 (Based on CRISIL Ranking) 1. Lar ge Cap (Equity Sc heme) N A V 1 yr Return AUM (` cr.) (`/Unit) (%) Mar 14 Birla SL Long Term Advan. (G) Birla Sun Life Top 100 (G) ICICI Pru Top 100 Fund (G) Quantum Long-Term Equity (G)

233 226 Banking and Financial Services 2. Small & M id Cap (Equity Sc heme) N A V 1 yr Return AUM (` cr.) (`/Unit) (%) Mar 14 Franklin (I) Smaller Cos (G) Mirae Emerging Bluechip Fund (G) SBI Magnum Midcap Fund (G) Inde x Fund N A V 1 yr Return AUM (` cr.) (`/Unit) (%) Mar 14 Kotak Nifty ETF Long Te r m De bt Fund N A V 1 yr Return AUM (` cr.) (`/Unit) (%) Mar 14 BNP Paribas Flexi Debt - RP (G) Reliance Dynamic Bond (G) , Tata Income Fund (App.) Mutual funds also have a facility to pledge or mortgage at banks to obtain loan and can be transferred in favour of any individual. FACTORS CONTRIBUTING FOR THE GROWTH OF MUTUAL FUNDS IN INDIA A slew of fa ctors ha ve contributed for the growth of mutual fund industry in India during the pa st two deca des. 1. Better Returns The first a nd foremost rea son is delivering of substantia l returns by equity a nd debt-oriented funds. Different periods of outsta nding performa nce a ided by strong bull runs in the late 1990s, which sa w the stock prices shooting through the roof, a s well a s the current bullish fervour which ha s helped equityoriented funds deliver substantia l returns. Debt funds too ha ve been benefited by the soft bia s in the interest ra tes. The vola tility in the bond prices ha s also helped debt-oriented funds deliver ha ndsome returns. 2. Change s in Investme nt Envir onme nt Significant cha nges in the investment environment such a s increased competition, on going reforms which a llow mutua l funds to invest abroa d a s well a s in deriva tive instruments helped for growth of the industry 3. Compe tition and Effic ienc y Unlike monopoly of UTI in the pa st, mutual fund industry now-a-da ys ha s been ba cked by FIIs a nd domestic ma rket. Early in the reforms process, it is recognized tha t grea ter competition a nd innova tion would be required so tha t

234 Mutual Funds 227 the public received better financia l services. It is true tha t some steps ha ve been ta ken to increa se competition between fina ncia l intermedia ries both within a nd a cross ca tegories. Ba nks a nd fina ncia l institutions have been a llowed to enter ea ch other territories. Fields like mutua l funds, lea sing a nd mercha nt ba nking ha ve been thrown open to the ba nks a nd their subsidia ries. The priva te sector ha s been a llowed into fields like ba nking a nd mutual funds. 4. Transparency The tra nspa rency in opera tions a nd disclosure pra ctices rela ted to the NAV, stock selection strategies, portfolio churning costs, ra tiona le for expense cha rges a nd investment related risks a lso fueled the growth of the industry. 5. Re gulation Stringent regula tory environment of the SEBI, investor awa reness progra mmes offered by the AMFI, entry of foreign pla yers with strong fina ncia l a nd resea rch ca pa bilities, potentia l entry of employee pension a nd provident funds and a slew of innova tive schemes to cater to the different needs ha ve a ttra cted the investors. 6. Standar dization of Ope r ations Mutua l fund opera tions like maintena nce of investment a ccounts a nd the scheme accounts by outsourcing is restricted. Ma rketing stra tegies in consultation with ma rketing a dvisors ha ve been established by the AMCs. The SEBI regula tions with respect to offer documents, NAV computa tion, NAV reporting, valua tion of investments, a ccounting sta nda rds, performa nce reports, etc., ha ve tended to create a certa in level of homogeniz ation of the India n mutua l fund products. 7. Te c hnology Ma jority of the mutua l funds ha ve their own websites providing basic informa tion rela ting to the schemes a nd ena ble purcha se a nd redemption of units online for clients in select loca tions. Most significant influence of technology is seen in servicing investors through a gencies. The adva nta ges of technology resulted in lower distribution costs through online transa ctions, more customiz ed a nd persona l advice to customers a nd rea ching out to the growing young a nd net-sa vvy popula tion of I n d i a 8. Pr oduc t Innovation The ta ilor-ma de innova tive schemes la unched by the mutua l fund houses ha ve given investors option to choose funds which choose his investment needs. Schemes with systema tic investment pla n, a utoma tic redemption pla n, linking current a ccounts to money ma rket mutua l funds, cheque writing fa cility etc. a re a ttempts to crea te homogeneity. Products such a s Index funds, Interna tiona l funds, Ethica l funds, Sectora l funds, Excha nge tra ded funds, Pension funds, Children funds, Reality funds ha ve ga lva niz ed the industry growth. HDFC Mutual Fund retained its top AUM position followed by Reliance Mutual Fund and ICICI Prudential Mutual Fund.

235 228 Banking and Financial Services ADVANTAGES OF MUTUAL FUNDS Mutual funds AUM so far has been mainly dominated by institutional investors and HNIs. Retail investors have been largely conspicuous by their meager presence as the share of mutual funds in household savings continues to be less than 5%. The a dvanta ges of investing in a Mutua l Fund are: Dive r sific ation: The best mutua l funds design their portfolios so individual investments will rea ct differently to the sa me economic conditions. For example, economic conditions like a rise in interest ra tes may ca use certa in securities in a diversified portfolio to decrea se in va lue. Other securities in the portfolio will respond to the sa me economic conditions by increasing in value. W hen a portfolio is ba la nced in this wa y, the va lue of the overall portfolio should gra dua lly increa se over time, even if some securities lose va lue. Pr ofe ssional M anage me nt: Most mutua l funds pa y topflight professiona ls to mana ge their investments. These ma na gers decide wha t securities the fund will buy a nd sell, when to buy or sell etc. Pe rforms as Substitute for Initial Public Offe rings (IPOs): As MFs a re a ssured certa in per cent of a llotment in IPOs, sma ll investors who a re unable to a pply for IPOs ca n enjoy the benefit of IPO through MF. Ma rketing cost of new shares can be reduced by MFs. MFs keep money ma rket a ctive by investing money on the money ma rket instruments and strengthen money ma rket opera tions. Thus, MFs provide sta bility to sha re prices, sa fety to investors a nd resources to b u s i n e s s. Suppor ts Capital Mar ke t: MFs cha nna lise priva te funds to the ca pita l ma rket and ma ke this ma rket active through susta ined supply of funds. They a lso provide valua ble liquidity to capita l ma rket a nd ma ke the ma rket stable. Re gulator y Ove r sight: Mutua l funds a re subject to ma ny government regula tions that protect investors from fraud. Liquidity: It s ea sy to get your money out of a mutua l fund. W rite a cheque, ma ke a ca ll, and you ve got the cash. Conve nie nc e: You ca n usua lly buy mutua l fund sha res by ma il, phone, or over the Internet. Low Cost: Mutua l fund expenses a re often no more tha n 1. 5 per cent of your investment. Expenses for Index Funds a re less tha n tha t, because index funds a re not a ctively ma na ged. Instea d, they a utoma tica lly buy stock in companies tha t are listed on a specific index. Tr anspare ncy: There is very little scope for malpractice a s it is regulated by SEBI. Flexibility: The funds ca n be ea sily shifted to different ca tegories or from one MF to a nother.

236 Mutual Funds 229 Choic e of Sche me s: Ea ch MF company will ha ve number of products. Most of the funds provide variety of schemes depending on the individua l requirement of the investors. Well Re gulate d: Security Excha nge Boa rd of India (SEBI) fully controls MF operations through its regula tions. Most of the MFs have tax saver schemes covered under section 80C of Income Tax Act. DRAWBACKS OF MUTUAL FUNDS No Guar ante e s: No investment is risk free. If the entire stock ma rket declines in value, the value of mutua l fund shares will go down a s well, no ma tter how ba lanced the portfolio. Investors encounter fewer risks when they invest in mutua l funds tha n when they buy a nd sell stocks on their own. However, a nyone who invests through a mutua l fund runs the risk of losing money. Fe es and Commissions: All funds cha rge a dministra tive fees to cover their da y to da y expenses. Some funds a lso cha rge sa les commissions or loa ds to compensa te brokers, fina ncia l consulta nts, or fina ncia l planners. Even if investor don t use a broker or other fina ncia l a dviser, they will ha ve to pa y a sa les commission in a Loa d Fund. Taxe s: During a typica l yea r, most a ctively mana ged mutua l funds sell a nywhere from 20 to 70 per cent of the securities in their portfolios. If fund ma kes a profit on its sales, investors will ha ve to pa y ta xes on the income received. M anage me nt Risk: W hen investment is done in a mutual fund, investor depend on the fund s ma nager to ma ke the right decisions rega rding the fund s portfolio. If the ma na ger does not perform a s well a s investor ha d hoped, they might not ma ke a s much money on investment a s you expected. Of course, if investor invest in Index Funds, they forego ma na gement risk, beca use these funds do not employ ma na gers. The va rious schemes of different MFs constitute the product-mix. These plans a nd types will cha nge the ma rket. Product will be designed by professiona ls a ppointed by MFs, introduced in the ma rket a nd gra dually popula rised after correcting the imba lances in the scheme. Sponsorship of mutua l funds ha s a bea ring on the integrity a nd efficiency of fund ma na gement which a re key to establishing investor s confidence. So far, only public sector sponsorship or ownership of mutua l fund organisa tions had ta ken ca re of this need. The increa se in the number of mutua l funds a nd va rious schemes ha ve increa sed competition. Hence, it ha s been rema rked by Senior Broker mutua l funds a re too busy trying to ra ce a ga inst ea ch other. As a result they lose their sta bilising fa ctor in the ma rket. Transpa rency is a nother a rea in mutua l fund which wa s neglected till recently. Investors ha ve right to know and a sset ma na gement compa nies ha ve a n obliga tion to inform where a nd how his money ha s been d eployed.

237 230 Banking and Financial Services The Largest Global Mutual Funds R a n k Sym bol Fund Name 1 SPY SPDR S&P 500 ETF 2 PTTRX PIMCO: Tot Rtn; Inst 3 FDRXX Fidelity Ca sh Reserves 4 VTSMX Va ngua rd TSM Idx;Inv 5 VMMXX Va ngua rd Prime MM;Inv 6 VINIX Va ngua rd Instl Indx; Inst 7 VTSAX Va ngua rd T StMk Idx;Adm 8 VFIAX Va ngua rd 500 Index;Adm 9 VIIIX Va ngua rd Instl Indx; InsP 1 0 FCNTX Fidelity Contrafund 1 1 VITSX Va ngua rd TSM Idx; Inst 1 2 AGTHX America n Funds Gro; A 1 3 AMECX America n Funds Inc; A 1 4 CAIBX America n Funds CIB; A 1 5 CJPXX J PMorga n: Prime MM;Ca p 1 6 DODFX Dodge & Cox Intl Stock 1 7 CWGIX America n Funds CW GI; A 1 8 DODGX Dodge & Cox Stock 1 9 AIVSX America n Funds ICA; A 2 0 VWENX Va ngua rd W ellington;adm 2 1 EF A isha res:msci EAFE ETF 2 2 IVV isha res:core S& P FKINX Franklin Cust: Inc; A 2 4 AWSHX America n Funds W a sh; A 2 5 VGTSX Va ngua rd Tot I Stk;Inv Sou rce: AMFI THE ASSOCIATION OF MUTUAL FUNDS IN INDIA (AMFI) The Association of Mutual Funds in India (AMFI) is dedicated to developing the India n Mutua l Fund Industry on professiona l, hea lthy a nd ethica l lines a nd to enha nce a nd ma inta in sta nda rds in a ll a rea s with a view to protecting a nd promoting the interests of mutua l funds a nd their unit holders. AMFI, the a ssocia tion of SEBI registered mutua l funds in India of all the registered Asset

238 Mutual Funds 231 Ma na gement Compa nies, was incorpora ted on August 22, 1995, as a non-profit orga nisation. As of now, a ll the Asset Ma na gement Companies tha t a re registered with SEBI, a re its members. Objectives of AMFI To define a nd ma inta in high professiona l a nd ethica l sta nda rds in a ll a rea s of operation of mutua l fund industry. To recommend a nd promote best business practices a nd code of conduct to be followed by members and others enga ged in the a ctivities of mutual fund a nd a sset ma nagement including a gencies connected or involved in the field of ca pita l ma rkets a nd fina ncia l services. To intera ct with the Securities a nd Excha nge Boa rd of India (SEBI) a nd to represent to SEBI on a ll ma tters concerning the mutua l fund i n d u s t r y. To represent to the Government, Reserve Ba nk of India a nd other bodies on a ll ma tters rela ting to the Mutua l Fund Industry. To develop a ca dre of well trained a gent distributors a nd to implement a programme of tra ining a nd certifica tion for a ll intermediaries a nd others enga ged in the industry. To underta ke na tion wide investor a wa reness progra mme so a s to promote proper understa nding of the concept a nd working of mutua l f u n d s. To dissemina te informa tion on mutua l fund industry a nd to underta ke studies a nd resea rch directly a nd/ or in a ssocia tion with other bodies. To ta ke regulate conduct of distributors including disciplina ry a ctions (cancella tion of ARN) for viola tions of Code of Conduct. To protect the interest of investors/ unit holders Mutual funds are popular because they provide an excellent way for anyone to direct a portion of their income towards a particular investment objective. The Sponsorers of AMFI Sponsor ing B anks SBI Fund Ma na gement Ltd. BOB Asset Ma nagement Co. Ltd. Ca nba nk Investment Ma na gement Services Ltd. UTI Asset Ma na gement Compa ny Pvt. Ltd. I ns titutions GIC Asset Ma nagement Co. Ltd. J eeva n Bima Sa ha yog Asset Ma na gement Co. Ltd. Private Sec tor (Indian) Benchma rk Asset ma na gement Co.Pvt. Ltd. Chola ma nda la m Asset Ma nagement Co. Ltd. Credit Capita l Asset Ma nagement Co. Ltd.

239 232 Banking and Financial Services Under Section 2(42A) of the ITA, a unit of a mutual fund is treated as a long-term capital asset if the same is held for more than 12 months. Under Section 112 of the ITA, capital gains chargeable on transfer of long-term capital assets are subject to tax at the rate of 20%. Escorts Asset Ma na gement Ltd. J M Fina ncia l Mutua l Fund. Kota k Ma hindra Asset Ma nagement Co. Ltd. Relia nce Ca pita l Asset Ma na gement Ltd. Sa ha ra Asset Mana gement Co. Pvt. Ltd. Sunda ra m Asset Ma nagement Compa ny Ltd. Ta ta Asset Ma na gement Priva te Ltd. Pr edominantly India Joint Ve ntur e s Birla Sun Life Asset Ma nagement Co. Ltd. DSP Merrill Lynch Fund Ma na gers Ltd. HDFC Asset Ma na gement Compa ny Ltd. Pr edominantly For eign Joint Ve ntur e s ABN AMRO Asset Ma nagement (I) Ltd. Allia nce Ca pita l Asset Mana gement ( India) Pvt. Ltd. Deutsche Asset Ma na gement ( India) Pvt. Ltd. Fidelity Fund Ma nagement Priva te Ltd. Franklin Templeton Asset Mgmt. (India) Pvt. Ltd. HSBC Asset Mana gement (India) Priva te Ltd. ING Investment Ma na gement ( India) Pvt. Ltd. Morga n Sta nley Investment Ma na gement Pvt. Ltd. Principal Asset Ma na gement Co.Pvt. Ltd. Prudentia l ICICI Asset Ma na gement Co. Ltd. Standa rd Cha rtered Asset Mgmt. Co.Pvt. Ltd. AMFI Code of Ethics The AMFI Code of Ethics, The ACE for short, sets out the standards of good practices to be followed by the Asset Ma na gement Companies in their opera tions a nd in their dea lings with investors, intermediaries a nd the public. SEBI (Mutua l Funds) Regula tion 1996 requires a ll Asset Ma na gement Compa nies a nd Trustees to abide by the Code of conduct a s specified in the Fifth Schedule to the Regula tion. The AMFI Code ha s been dra wn up to supplement tha t schedule, to encoura ge sta nda rds higher tha n those prescribed by the Regulations for the benefit of investors in the mutua l fund industry. 1. Integrity 1. 1 Members and their key personnel, in the conduct of their business sha ll observe high sta ndards of integrity a nd fa irness in a ll dea lings with investors, issuers, ma rket intermedia ries, other members a nd regula tory a nd other government a uthorities.

240 Mutual Funds Mutua l Fund Schemes sha ll be orga nized, opera ted, ma na ged a nd their portfolios of securities selected, in the interest of a ll cla sses of unit holders and not in the interest of s po n s or s directors of Members members of Board of Trustees or directors of the Trustee compa ny brokers and other ma rket intermedia ries a ssocia tes of the Members a special cla ss selected from out of unit holders 2. Due Diligence 2. 1 Members in the conduct of their Asset Ma nagement business sha ll a t all times render high sta nda rds of service. exercise due diligence. exercise independent professional judgement Members sha ll ha ve and employ effectively a dequa te resources a nd procedures which a re needed for the conduct of Asset Mana gement act iviti es. 3. Disclosures 3. 1 Members sha ll ensure timely dissemina tion to a ll unitholders of a dequa te, a ccura te, a nd explicit informa tion presented in a simple la ngua ge a bout the investment objectives, investment policies, fina ncia l position a nd general a ffa irs of the scheme Members sha ll disclose to unitholders investment pa ttern, portfolio deta ils, ra tios of expenses to net a ssets a nd tota l income a nd portfolio turnover wherever a pplicable in respect of schemes on a nnua l ba sis Members sha ll in respect of tra nsa ctions of purcha se a nd sa le of securities entered into with any of their a ssocia tes or any significa nt u n i t h o l d e r All tra nsa ctions of purcha se a nd sale of securities by key personnel who a re directly involved in investment operations sha ll be disclosed to the compliance officer of the member a t lea st on ha lf yea rly basis a nd subsequently reported to the Board of Trustees if found ha ving conflict of interest with the tra nsactions of the fund. Age of the mutual fund as an attribute that affect their return performance because of the economies of experience. Age of the mutual fund schemes at any particular time is determined by the time period since their inception date. 4. Professional Selling Practices 4. 1 Members sha ll not use a ny unethica l mea ns to sell, market or induce a ny investor to buy their products a nd schemes 4. 2 Members sha ll not ma ke any exa ggera ted sta tement rega rding performance of a ny product or scheme.

241 234 Banking and Financial Services An investor with a lower risk appetite (conservative) will have a higher allocation to debt while an investor with a higher risk appetite (very aggressive) will have higher allocation to equity 4. 3 Members sha ll endea vor to ensure that a t a ll times investors a re provided with true and a dequa te informa tion without a ny mis lea dingor exa ggera ted cla ims to investors a bout their ca pability to render certa in services or their a chievements in regard to services rendered to other clients, investors a re ma de a wa re of attenda nt risks in members schemes before a ny investment decision is ma de by the investors, copies of prospectus, memoranda a nd rela ted litera ture is ma de a vaila ble to investors on request, a dequa te steps a re ta ken for fa ir a llotment of mutua l fund units a nd refund of a pplica tion moneys without dela y and within the prescribed time limits a nd compla ints from investors a re fa irly a nd expeditiously dea lt with Members in a ll their communica tions to investors a nd selling a gents s ha l l not present a mutual fund scheme a s if it were a new share issue not crea te unrea listic expecta tions not gua rantee returns except a s sta ted in the Offer Document of the scheme a pproved by SEBI, a nd in such ca se, the Members shall ensure that a dequa te resources will be made a vaila ble a nd ma inta ined to meet the gua ranteed returns. convey in clear terms the ma rket risk a nd the investment risks of a ny scheme being offered by the Members. not induce investors by offering benefits which a re extra neous to the s c h e me. not misrepresent either by sta ting informa tion in a ma nner calculated to mislead or by omitting to sta te information which is materia l to ma king a n informed investment decision. 5. Investment Practices 5. 1 Members sha ll ma na ge a ll the schemes in a ccorda nce with the funda menta l investment objectives a nd investment policies sta ted in the offer documents a nd ta ke investment decisions solely in the interest of the unitholders Members sha ll not knowingly buy or sell securities for a ny of their schemes from or to any director, officer, or employee of the member 6. Operations 6. 1 Members sha ll a void conflicts of interest in ma naging the affa irs of the schemes a nd sha ll keep the interest of a ll unit holders pa ramount in a ll ma tters rela ting to the scheme.

242 Mutual Funds Members or any of their directors, officers or employees shall not indulge in front running (buying or selling of any securities ahea d of transa ction of the fund, with access to information rega rding the transa ction which is not public a nd which is material to ma king a n investment decision, so a s to derive unfair a dva nta ge) Members or any of their directors, officers or employees shall not indulge in self dea ling (using their position to enga ge in transa ctions with the fund by which they benefit unfa irly a t the expense of the fund a nd the unit holders) Members sha ll not enga ge in a ny a ct, practice or course of business in connection with the purcha se or sale, directly or indirectly, of a ny security held or to be a cquired by a ny scheme mana ged by the Members, a nd in purcha se, sa le a nd redemption of units of schemes ma na ged by the Members, which is fra udulent, deceptive or ma nipula tive Employees, officers a nd directors of the Members shall not work a s a gents/ brokers for selling of the schemes of the Members, except in their capa city a s employees of the Member or the Trustee Company Members sha ll not ma ke any cha nge in the funda menta l a ttributes of a scheme, without the prior a pprova l of unit holders except when such change is consequent on cha nges in the regula tions Members sha ll a void excessive concentra tion of business with a ny broking firm, a nd excessive holding of units in a scheme by few persons or entities. 7. Reporting Practices 7. 1 Members sha ll follow compa ra ble a nd sta ndardiz ed va lua tion policies in a ccorda nce with the SEBI Mutua l Fund Regula tions Members sha ll follow uniform performa nce reporting on the ba sis of tota l return Members sha ll ensure scheme wise segrega tion of ca sh a nd securities a c c o u n t s. A selective or risk- based inspection routine should be adopted whereby, the historically more compliant mutual fund are inspected less frequently than the less compliant smaller or newer mutual funds. 8. Unfair Competition Members sha ll not ma ke any sta tement or become privy to a ny a ct, pra ctice or competition, which is likely to be ha rmful to the interests of other Members or is likely to pla ce other Members in a disa dva nta geous position in rela tion to a ma rket pla yer or investors, while competing for investible funds. 9. Observance of Statutes, Rules and Regulations Members shall abide by the letter a nd spirit of the provisions of the Sta tutes, Rules a nd Regula tions which ma y be a pplica ble a nd releva nt to the a ctivities ca rried on by the Members.

243 236 Banking and Financial Services 10. Enforcement Offshore mutual funds that may not want to set up operations in India but are interested in participating in Indian capital markets can do so by investing through a scheme of an existing domestic mutual fund. Members shall: widely dissemina te the AMFI Code to a ll persons and entities covered by it ma ke observa nce of the Code, a condition of employment ma ke viola tion of the provisions of the code, a ground for revoca tion of contra ctua l arra ngement without redress a nd a ca use for disciplina ry a c t i o n require tha t ea ch officer a nd employee of the Member sign a sta tement that he/she ha s received a nd rea d a copy of the Code esta blish interna l controls and compliance mecha nisms, including a ssigning supervisory responsibility designa te one person with prima ry responsibility for excercising complia nce with power to fully investigate a ll possible viola tions a nd report to competent a uthority file regula r reports to the Trustees on a ha lf yea rly a nd a nnua l basis rega rding observa nce of the Code a nd specia l reports as circumsta nces r e q u i r e maintain records of all activities a nd transa ctions for a t lea st three yea rs, which records sha ll be subject to review by the Trustees dedica te a dequa te resources to ca rrying out the provisions of the Code MARKETING OF MUTUAL FUNDS Ma rketing a product or service involves va rious a spects. Of them importa nt ones a re; (1)Products offered for sa le, (2) Price fixing for ra nge of products offered for sa le, (3) Promotion through different cha nnels, (iv) Customer care, (v) Ma rketing resea rch, etc. All these importa nt a spects a re discussed in the following pa ra gra phs. 1. Mutual Fund Products MF product includes mainly corpora te ( i) securities, v iz., Equity sha res a nd Debentures, (ii) Government sponsored loa n bonds for carrying out specific infra structura l a nd other projects a nd (iii) other a pproved securities such a s money market instruments like Treasury Bills, Commercial Pa pers, etc. Ea ch MF will design its own ma rketing pla n for its products. However, the elements of ma rketing mix are helpful in developing a good ma rketing pla n. The products cited a bove are sold to the investors with different schemes. i. Closed-end Mutua l Funds i i. Open-end Mutua l Fund ii i. Large Cap Funds iv. Mid Ca p Funds

244 Mutual Funds 237 v. Equity Mutua l Funds vi. Balanced vi i. Growth Fund Funds viii. No Loa d Mutua l Funds i x. Excha nge Tra ded Funds x. Va lue Funds x i. Money Market Mutua l Funds xii. International Mutual Funds xiii. Regional Mutual Fund xiv. Sector Mutua l Funds xv. Index Funds xvi. Fund of Funds 2. Price Fixing MF certifica tes will have the fa ce va lue. The price is governed ba sica lly by the va lue of the underlying investments held by tha t fund. W henever MFs sell the certificates, the price of the unit may ha ve load or no-loa d concept. But in ca se of repurchase or resale of units, Net Asset Va lue (NPA) will be price for that unit. NAV is the ma rket price of ea ch unit of a pa rticular scheme in rela ting to a ll the a ssets of the scheme. NAV exhibits the intrinsic va lue of the unit a nd a lso indica tes the performa nce of that scheme. NAV is computed by adopting the following formula. Ma rket Va lu e of th e In vestm en t NAV Va lu e of Ea ch Un it Sch em e Size An Indian mutual fund registered with the SEBI, or schemes sponsored by specified public sector banks / financial institutions and approved by the Central Government or authorized by the RBI are tax exempt as per the provisions of section 10(23D) of the ITA. Supposing HDFC in one of its MF pla ns ha s a scheme of `50 crores. The ma rket value of the scheme is ` 150 crores. The value of the unit is ` 5 NAV will b e 15 0 crores ` 5 ` crores Pricing of any scheme of a ny MF is ba sed on the size of fund of tha t scheme. In ca se of re-issue or repurcha se ruling NAV is the price on the da y of purchase. NAV is published in news papers a nd periodica ls every week. 3. Promotion There is a keen competition to sell MF products. There a re different schemes for different purposes. MFs will a dopt a dvertising (Audio-Visua ls, Print media), persona l selling, tele- ma rketing, network ma rketing, publicity, semina rs, etc., to la unch a nd to continuously promote the schemes a nd pla ns of different MFs. To position the scheme of a MF, the promotion a ctivity in tha t segment should be a ggressive till such time the bra nd is crea ted for that MF. As MFs a re ma inly

245 238 Banking and Financial Services ca tering the sma ll sa vers, promotion policy ha s to be formula ted to bring this class of investors into scheme in a big wa y. Total expenses of the mutual funds are divided into three components as management fees, marketing and distribution fees and other expenses including securities custodian fees, transfer agent fees, shareholder accounting expenses, auditor fees, legal fees and independent directors fees 4. Customer Service This is a vital a spect in a fina ncia l product. As MFs ha ve to compete with fina ncial product like stocks, shares, ba nk deposits, loa n bonds etc. Customer ca re needs a ttention on priority ba sis. It is essential here to ca tegorise the customers to position the MF products in the ma rket. W ithout customer sa tisfa ction MF products ca nnot gain the ma rket. Customers ca n be cla ssified a s (i) overt consumer (consumers a re fully sa tisfied), (ii) covert consumer (consumer is sa tisfied with service but inhibits to express sa tisfa ction), (iii) consumer in dilemma (una ble to make up his mind on the overa ll ra ting of the product based on his pa st experiences), (iv) Dissa tisfied customer, (v) Dissa tisfied a nd disturbs other potentia l customers by sprea ding ba d word of mouth. Of these five categories of customers, the la st three a re the ones who really disturbs the ma rket for product or service. Therefore, service organiz a tions should develop promotion stra tegies to sell the fina ncial products to these customers. MFs norma lly open their customer ca re service centres in metros, big cities a nd even in la rge towns to service their clients. Both promotion a nd ma intenance of MF schemes a nd pla ns is essentia l. Beca use MFs ca n ga rner a major portion of na tional sa vings, pa rticula rly from sma ll investors, if they render quality service on sa le a nd a fter services like periodica l reminders to the customers a bout the ma turity of their holdings, or a ssisting them in conversion process from one pla n to a nother, or continuously informing a bout the ma rket beha viour of their holding, etc., will develop confidence in the unit holders a nd feel tha t they a re rea lly sa ved from the business ha za rds of MFs. Continuous servicing the customers by MFs is very essentia l. Still MF market is not developed in India. Small savers, who ca nnot directly enter the security ma rket with their mea ger savings, a re the ma jor customers of MFs. It is the duty of MFs to provide quality service to sma ll sa vers to develop the MF ma rket. It is only the qua lity service tha t ca n convert the dissatisfied, disturbing customers to become sa tisfied owners of MF plans. 5. Marketing Research Ma rketing resea rch at a juncture where MFs a re not developed in the country to the expected level ha s ga ined momentum. The potentia l for developing MF ma rket is being high, every MF opera tor involved in developing products, plans a nd schemes which ca ter to the needs of small investors. Diverting sma ll sa vings investment from long-term low-yielding rigidly operated fina ncia l instruments such as NSCs, posta l sa vings schemes, term deposit schemes of ba nks etc., to better- yielding, ea sily shifta ble MF products is a tough task. Still the people have not developed flair for investment in MFs. Therefore research in MF opera tions to identify the wea k area s of opera tiona l mecha nism including the defects in MF pla ns, ina ctive sa les promotion a spects, regiona l dispa rities in positioning the MF pla ns, defective prioritisation of pla ns in the regions where the pla ns a re promoted etc. Resea rch should also be conducted to a ssess the sa vings level of people in different regions, potentiality for developing MF market, the a ltitude of people in new regions to purchase MF products, etc.

246 Mutual Funds Strategic Marketing Plan MFs being service-oriented a ctivity, they ha ve to develop a ma rketing pla n which is innova tive to ca pture a nd susta in the market. They ha ve to ada pt one of the following stra tegies to develop a n effective marketing plan. (i) Growth through existing products in existing markets. (ii) Growth through existing products in new ma rkets. (iii) Growth through new products in existing ma rkets. (iv) Growth through ta pping new ma rkets through new products. These four stra tegies help the ma rketers to develop a specific stra tegic pla n for MFs products. This pla n helps the pla nner and the strategist to eva lua te strengths/ weaknesses v is-a-vis marketing opportunities in the environment. A stra tegic ma rketing plan for MF product ca n be prepa red a da pting the following procedure. a. Situational Analysis: W henever a strategy is to be a dapted to improve the ma rket situa tion for the existing product or to introduce a new product, the MF should ma ke a situa tiona l a na lysis. This mea ns, a s fa r is the scheme is considered, it should be a na lysed a s to how the scheme is moving in the ma rket. This is a ctua lly a problem identifica tion process. For exa mple, UTI Ma ster Growth -A scheme of Unit Trust of India, is a slow moving product in UTIs portfolio. Now, the Fund ma na gers wa nt to reposition it to ma ke it a fa st moving product in the ma rket. In order to develop a strategy, UTI ha s to ma ke a situa tiona l ana lysis a s to why it is moving slowly in the ma rket. Situa tiona l a nalysis gives informa tion on ma rket dema nd, market environment a nd performance. It enlightens the Fund on its ca pa bilities a nd limita tions. The ma rketing mix of this product is thoroughly reviewed to find out the wea kness in the mix. b. M ar keting Obje ctive s and Str ate gie s: Ma rketing stra tegies a re to be closely a llied with Fund objective. The ma rketing objectives tra nsla te the corpora te stra tegy. In our example of UTI Ma ster Growth, the Fund objective is to increa se the sa le of UTI-MG no-loa d which mea ns reducing commission to a gents by 2 per cent to enhance profita bility. This Fund stra tegy will now be the ma rketing objective a nd ma rketing strategy will be selling no-loa d unit to enha nce sa les. Selling cost will be reduced by bringing down percenta ge of Commission to a gents by 2 per cent a s they were paid high per cent to sell loaded units. c. Se gmentation and Targe t Mar ke t: In a new MF, segmenta tion ena bles the company to identify potentia l ta rget ma rkets. In a running concern, ma na gement rea ssesses the choice of ta rget ma rkets a nd modifies them, if necessa ry. The Fund ma y a lso reconsider segmenta tion stra tegy. It ha s to a scerta in sa les foreca st in its ta rget ma rkets. d. M ar ke ting-mix: A distinctive ma rketing-mix is now prepa red to sa tisfy ta rget ma rket dema nd a nd a tta in ma rketing objective for ea ch ta rget ma rket. Ma rketing-mix a nd its implementa tion constitute the bulk of compa ny s marketing efforts. Fund will ha ve the best integra tion of product, price, promotion a nd distribution stra tegies. The difference between an ETF and an openended mutual fund is that the units of an ETF trade on an exchange and therefore, the investor can trade in it during market hours and the units can be sold short or margined just like shares.

247 240 Banking and Financial Services Asse t Unde r Manageme nt of Indian M utual funds (` in crores) Mu tual Fun d s Decemb er March Cha nge % Change HDFC Mutual Fund 10 8, ,96 3 3, ICICI Prudential Mutual Fund 9 7, ,82 2 9, Reliance Mutual Fund 10 2, ,54 2 1, Birla Sun Life Mutual Fund 8 4, , , UTI Mutual Fund 7 4, , SBI Mutual Fund 6 4, , Franklin Templeton Mutual Fund 4 4, , , IDFC Mutual Fund 4 1, , Kotak Mahindra Mutual Fund 3 5, , , DSP BlackRock Mutual Fund 3 2, , , Tata Mutual Fund 1 9, , , Deutsche Mutual Fund 1 8, , L&T Mutual Fund 1 7, , , Sundaram Mutual Fund 1 6, , JPMorgan Mutual Fund 1 2, , , Axis Mutual Fund 1 4, , , Religare Invesco Mutual Fund 1 3, , LIC NOMURA Mutual Fund 1 0, , Major advantage of tax saving funds is that they grant its investors an opportunity to make investments in an avenue that is market linked and at the same time claim benefits in taxes. Some Key Terms Associated with Mutual Funds Net Asset Value (NAV) Net Asset Va lue is the ma rket va lue of assets of the scheme minus its liabilities. Per unit NAV is the net asset va lue of the scheme divided by the number of units outsta nding on the Va lua tion Da te. For ca lcula ting the mutua l fund s NAV, va lue of the tota l a ssets of the mutua l fund is subtra cted by its liabilities, a nd then this amount is divided by the tota l number of units in the mutua l fund, i.e., Mutua l Fund s NAV = ( Tota l Assets Lia bilities)/ Tota l number of units Entr y Load An entry loa d is a sa les cha rge investors pay when they buy units of a mutual fund scheme. In other words, it is a cha rge collected by a scheme when it sells its units. This cha rge reduces the a mount of their investment in fund. It is also ca lled as Front-end load or Sa les Loa d. Schemes tha t do not cha rge a loa d a re ca lled No Loa d schemes.

248 Mutual Funds 241 Exit Load Exit load is imposed on redemptions as this is the charge collected by a scheme when it buys back the units from its unit holders. Investors pa y this charge when they sell mutual fund units. This reduces the amount received by them a t the time of redemption. It is a lso called as Repurchase or Ba ck-end Loa d. Repurchase Price It is the price a t which units under open-ended schemes are repurchased by the Mutua l Fund. Such prices a re NAV rela ted. Redemption Price It is the price a t which close-ended schemes redeem their units on ma turity. Such prices a re a lso NAV rela ted. REVIEW QUESTIONS 1. Expla in the need for mutua l funds. 2. W hat a re sa lient fea tures of Mutual funds? 3. W hat a re the a dva nta ges a nd limita tions of mutual funds? 4. Expla in the different types of mutua l fund schemes. 5. Expla in the factors contributing to the development of Mutua l Funds in I n d i a. 6. Expla in the ma rketing a spects of mutua l funds. 7. W hat a re the SEBI guidelines on Mutual Funds? REFERENCES AMFI Qua rterly a nd Monthly Reports. AMFI Mutua l Fund test work book. Bhatt R.S. Unit Trust of India a nd Mutua l Funds A Study, UTI Institute of Capital Marke ts, Mumba i, 1996, p. 31. Jayanth R. Varma, Indian Financial Sector After a decade of Reforms, Centre for Civic Society. Mutua l Fund Industry in India-Current Issues, RBI Annual Re port

249 242 Banking and Financial Services Mutua l Funds in India-on a growth Tria l, Mutual Fund Spec ial 2005, Chartered Financia l Ana lyst. SEBI (Mutua l Fund) (Amendment) Regula tions, 2006 and SEBI Annua l Reports, Vyas, B.A. Mutual Funds- Boon to the Common Investors Fortune India, July 16, 1990.

250 CHAPTER 8 VENTURE CAPITAL FINANCING Learning Objectives After reading this chapter you should be able to understand the na ture a nd scope of venture ca pita l fina ncing the historica l ba ckground of venture ca pita l fina ncing the steps involved in providing VC fina ncing the venture ca pital fina ncing stages the a dvanta ges a nd limita tions a ssocia ted with venture ca pita l fina ncing the SEBI regula tions rela ting to venture ca pita l fina ncing

251 244 Banking and Financial Services NATURE AND SCOPE OF VENTURE CAPITAL FINANCING Risk finance and venture capital environment can bring about innovation, promote technology, and harness knowledge-based ventures. Venture ca pital plays a stra tegic role as a source of fina nce especia lly in ca se of sma ll sca le, high technology drivers a nd risky ventures. It is a very popula r concept in a dva nced countries and it is ga ining its importa nce in developing countries a lso. A business organiz a tion involving in new, innova tive, a nd risky business/ project ma y not be a ble to get its financia l requirements fulfilled from a ny tra ditional sources. Therefore, they a pproa ch a specia liz ed a gency specially mea nt for fina ncing such project. Such a gencies a re ca lled a s venture ca pita list or venture ca pita l firm. Venture Capita l is a form of " risk ca pita l". In other words, capita l tha t is invested in a project (in this ca se - a business) where there is a substantia l element of risk relating to the future crea tion of profits a nd ca sh flows. Risk ca pita l is invested a s sha res (equity) ra ther tha n as a loa n and the investor requires a higher "ra te of return" to compensa te him for his risk. This is a new type of fina ncial intermedia ry, which emerged during the 1970s in the United States. It emerged in the ea rly 1980s in the U. K., in the mid-1980s in Ja pa n a nd Ca na da, a nd a round 1987 in India. People now ta lk of venture ca pita l industry or venture capita l ma rket comprising a la rge number of Venture Ca pita l Funds (VCFs). The term venture ca pita l is evocative a nd suggestive but va gue. It suggests ta king risk in supplying ca pita l. However, supply of risk ca pita l ma y not be the prime function in certa in cases. The empha sis will be on supporting technocra ts in setting up projects, or on portfolio ma na gement. Moreover, every supply of ca pita l involves ta king risk. According to Interna tiona l Fina nce Corpora tion (IFC), venture capita l is a n equity or equity fea tured ca pita l seeking investment in new idea s, new compa nies, new production, new process or new services tha t offer the potentia l of high returns on investments. As defined in Regula tion 2(m)of SEBI (Venture Ca pita l Funds) Regula tion, 1996 " venture ca pita l fund mea ns a fund esta blished in the form of a compa ny or trust which ra ises monies through loa ns, dona tions issue of securities or units a s the ca se ma y be, a nd ma kes or proposes to ma ke investments in a ccorda nce with these regulations. According to Interna tiona l Fina nce Corpora tion (IFC), venture ca pital is a n equity or equity fea tured ca pita l seeking investment in new ideas, new compa nies, new production, new process or new services tha t offer the potential of high returns on investments. Thus venture ca pita l is the ca pital invested in young, ra pidly growing or changing companies tha t ha ve the potentia l for high growth. The VC ma y also invest in a firm tha t is unable to ra ise fina nce through the conventional means. Venture ca pita l provides long-term, committed share capita l, to help unquoted compa nies grow a nd succeed. If a n entrepreneur is looking to sta rt-up, expand, buy-into a business, buy-out a business in which he works, turnaround or revita liz e a compa ny, venture ca pita l could help do this. Obta ining venture ca pita l is substa ntia lly different from ra ising debt or a loa n from a lender. Lenders ha ve a lega l right to interest on a loa n a nd repa yment of the ca pita l, irrespective of the success or failure of a business. Venture ca pital is invested

252 Venture Capital Financing 245 in exchange for a n equity stake in the business. As a sha reholder, the venture ca pita list' s return is dependent on the growth and profitability of the business. This return is genera lly ea rned when the venture ca pita list " exits" by selling its sha reholding when the business is sold to another owner. Globa lly venture capita l investment is one of the most flexible form of fina ncing. It is a more wide wa y of getting fina nces for investment in business enterprises which hold a bright future in terms of profit a s well a s growth. Globa lly venture ca pita l investments a re experiencing enormous growth a nd over the yea rs a pproximately 70 counties ha ve sta rted providing venture ca pita l funds to business enterprises. In U. S.A., venture ca pita lists invested $28. 4 billion in 3,673 dea ls in 2011, an increa se of 22 per cent in dolla rs a nd a 4 per cent rise in dea ls over the prior yea r, a ccording to the Money Tree Report by Pricewa terhousecoopers LLP a nd the Na tiona l Venture Ca pita l Associa tion (NVCA), ba sed on data from Thomson Reuters. However in India, venture ca pita l wa s known since the nineties era. It is now tha t it ha s successfully emerged for a ll the business firms tha t ta ke up risky projects a nd ha ve high growth prospects a s well. It is one of the fina ncing a lterna tives in India. Venture ca pita l is provided as risk ca pita l in the forms of shares, seed ca pita l and other similar means. In India, venture ca pital firms invested a bout $1. 09 billion over 209 dea ls in The amount invested during 2011 wa s significa ntly higher compared to 2010, which wa s $699 million invested across 132 dea ls. (Venture Intelligence, India Venture Ca pital Report-2011) The Following ar e Ge ne r al Forms of Risk Capital Financ ie r s (1) Ange l Inve stor s: These a re typica lly high-net-worth individuals (HNIs) who ha ve often been successful entrepreneurs themselves. They re-deploy their wealth in next-genera tion businesses. They invest in new-idea enterprises (tha t do not yet have external va lida tion), help bring these idea s to ma rket, ta ke significa nt risks a nd invest a lot of time and energy in mentoring, mana gement guida nce a nd networking. Angel investors a re a lso governed by considera tions other tha n fina nce a lone, such a s belief in Entrepreneurship itself. (2) Ve ntur e Capital (VC) funding provides funds for ea rly sta ge compa nies. VC investments a re tra ditiona lly ma de for sca ling up opera tions ( i. e., developing, la unching a nd expanding new products or services). VCs ta ke lesser degree of risk a nd invest more money tha n angel investors. However, a VC is a bout more than fina ncia l support alone. VCs provide entrepreneuria l support a nd pa rtnership-based va lue-addition, often in the form of providing fina ncial a dvice, huma n resources, esta blishing networks with customers and overa ll guidance in company stra tegy. (3) Pr ivate Equity Playe rs a re established investment bankers a nd typically invest into proven/ esta blished businesses. PE funds/ pla yers a re among the la rgest sources of funding for enterprises tha t are rela tively secure with a n esta blished tra ck record, requiring significantly la rge funds for expa nsion a nd Venture capitalist combines risk capital with entrepreneurial management and advance technology to create new products, new companies and new wealth.

253 246 Banking and Financial Services Equity finance offers the significant advantage of having no interest charges. It is patient capital that seeks a return through long-term capital gain rather than immediate and regular interest payments. Venture capital investors are, therefore, exposed to the risk of the company failing. growth. As such, they ta ke rea sona bly well-defined risks a nd their exit stra tegy is usua lly up to the stage when the compa ny goes public or gets a cquired a t high va lue. PE funds a re genera lly seen to attra ct huge a mount of ca pita l from investors, including pension funds, insura nce funds, university founda tions a nd individuals. PE investors ca n be domestic or foreign priva te equity firms. Domestic PE firms are either esta blished a s trusts, or set up a s a compa ny. All Priva te Equity (PE) investments from outside the country are either cla ssified a s Foreign Institutional Investment (FII) for investments in listed compa nies or Foreign Direct Investment (FDI) for investment in unlisted companies. If a PE investment takes pla ce in a n unlisted firm, it fa lls under India's FDI rules. A PE fund ca n also buy into listed compa nies. However, in order to do such investments, the PE fund ha s to become a registered FII. (4) Inc ubators a re mostly non-profit entities tha t provide value a dded a dvisory, informa tiona l a nd certa in support infrastructure which includes productive office environment, fina nce a nd complementa ry resources. Incuba tors a re mostly promoted by government or professiona l orga nisa tions seeking to develop sma ll enterprises in a pa rticula r a rea. Sometimes venture ca pita l funds a lso ha ve their own incubators a nd compa nies also set up inhouse incuba tors. Incuba tors support the entrepreneur in the pre-venture ca pita l sta ge, that is, when he wa nts to develop the idea to a via ble commercia l proposition which could be fina nced a nd supported by a venture ca pita list. Difference between Venture Capital Financing and Bank Financing/Conventional Financing Conventiona l fina ncing generally extends loa ns to companies, while VC fina ncing invests in equity of the company. Conventiona l financing looks to current income i. e. dividend a nd interest, while in VC fina ncing returns a re by wa y of ca pital a pprecia tion. Assessment in conventiona l financing is conserva tive i. e. lower the risk, higher the cha nces of getting loa n. On the other ha nd, VC financing is a risk ta king fina nce where potential returns outweigh risk fa ctors. Venture Ca pita lists a lso lend mana gement support a nd provide entrepreneurs with ma ny other fa cilities. They even pa rticipa te in the ma na gement process. VC genera lly invest in unlisted compa nies a nd ma ke profit only after the compa ny obtains listing. VC extend need-ba sed support in a number of sta ges of investments unlike single round fina ncing by conventiona l fi na nc i er s. VC a re in for long run and ra rely exit before 3 years. To susta in such commitment VC a nd priva te equity groups seek extremely high return of 30% per yea r. A ba nk or a n FI will fund a project a s long as it is sure that enough ca sh flow will be genera ted to repa y the loa ns. VC is not a lender but an equity pa r t ne r. Venture ca pita lists ta ke higher risks by investing in a n ea rly-sta ge compa ny with little or no history, and they expect a higher return for their high-risk equity

254 Venture Capital Financing 247 investment. Internationally, VCs look at a n interna l rate of return (IRR) north of 40% plus. In India, the idea l benchmark is in the region of a n IRR of 25% for genera l funds a nd more tha n 30% for IT-specific funds. W ith respect to investing in a business, institutiona l venture capita lists look for a vera ge returns of a t least 40 per cent to 50 per cent for sta rt-up funding. Second a nd la ter sta ge funding usua lly requires a t lea st a 20 per cent to 40 per cent return compounded per a nnum. Most firms require la rge portions of equity in excha nge for sta rt-up f i n a nc i n g. Nature, Duration and Source of Venture Capital Investment Venture ca pita list prefer to invest in " entrepreneurial businesses". This does not necessa rily mean small or new businesses. Ra ther, it is more about the investment' s a spirations a nd potentia l for growth, ra ther tha n by current siz e. Such businesses a re a iming to grow ra pidly to a significa nt siz e. As a rule of thumb, unless a business ca n offer the prospect of significant turnover growth within five yea rs, it is unlikely to be of interest to a venture ca pita l firm. Venture ca pita l investors a re only interested in compa nies with high growth prospects, which a re ma naged by experienced a nd a mbitious tea ms who a re ca pa ble of turning their business pla n into rea lity. Venture ca pita l firms usua lly look to reta in their investment for between three a nd seven yea rs or more. The term of the investment is often linked to the growth profile of the business. Investments in more ma ture businesses, where the business performa nce ca n be improved quicker a nd ea sier, a re often sold sooner tha n investments in ea rly-sta ge or technology compa nies where it takes time to develop the business model. J ust a s ma na gement tea ms compete for fina nce, so do venture ca pital firms. They ra ise their funds from severa l sources. To obta in their funds, venture ca pita l firms ha ve to demonstra te a good track record a nd the prospect of producing returns grea ter than ca n be achieved through fixed interest or quoted equity investments. Most venture ca pital firms ra ise their funds for investment from externa l sources, ma inly institutiona l investors, such a s pension funds a nd insura nce compa nies. If innovation is the fuel for igniting the Entrepreneurial engine, Venture capital revs up the engine till it attains sustainable speed to change gears from idea to IPO stage. HISTORICAL BACKGROUND OF VENTURE CAPITAL FINANCING USA is the birth pla ce of Venture Capita l Industry. During most its historica l evolution, the ma rket for a rra nging such fina ncing wa s informa l. Entrepreneurs prima rily relied on the resources of wealthy fa milies. It was in 1946 tha t America n Research and Development Corporation (ARD), a publicly tra ded, closed-end investment compa ny wa s formed. The best known investment of ARD wa s the sta rt-up fina ncing it provided in 1958 for computer ma ker Digita l Equipment Corp. ARD provided its origina l investors with a percent a nnua l ra te of return over its twenty-five years a s a n independent firm though it ha d difficult times in the beginning. The number of such specia liz ed investment firms, which la ter were ca lled venture ca pital firms, bega n to boom in the la te 1950s. The creation of federa l Sma ll Business Investment Compa ny ( SBIC)

255 248 Banking and Financial Services In developed countries such as U.S.A. and U.K., venture capital financing, is mainly through private initiative, with hardly any involvement of government institutions. progra m in 1958 a ided the growth of venture ca pita l firms. Hundreds of SBICs were formed in the 1960s, a nd ma ny remain in opera tion today. During the 1960s a nd 1970s, venture ca pita l firms focused their investment a ctivity prima rily on sta rting a nd expa nding compa nies. More often tha n not, these compa nies were exploiting breakthroughs in electronic, medica l or dataprocessing technology. As a result, venture ca pital ca me to be a lmost synonymous with technology fina nce. Venture ca pita l firms suffered a tempora ry downturn in 1974, when the stock ma rket crashed a nd investors were na turally wary of this new kind of investment fund wa s the first big yea r for venture ca pita l when the industry raised a pproxima tely $750 million. Legisla tion ma de it possible for pension funds to invest in alterna tive a ssets cla sses such a s venture ca pita l firms only in Shortly therea fter, 1983 wa s the boom yea r - the stock ma rket rea ched new heights. During the yea r, there were over 100 initia l public offerings for the first time in U. S. history. This yea r has become memora ble a lso beca use ma ny of toda y' s la rgest and most prominent firms were founded. However, due to the excess of IPOs a nd the inexperience of ma ny venture ca pita l fund ma na gers, VC returns were very low during the 1980s. The VC firms retrenched, worked ha rd and crea ted new criteria for investment. The work pa id off a nd with the new criteria for investment the returns bega n climbing ba ck a nd portfolio compa nies started becoming successful. The initia l success genera ted further success in 1990s which were the best years for the Venture Capita l Industry. The fa voura ble economic clima te in the US coupled with the a dvent of the Internet boom wa s the engine for growth. The deca de sa w low interest ra tes a nd high P/ E ra tio compa red to historica l avera ges. This triggered Mergers a nd Acquisition a ctivities creating more opportunities for sma ll, venture-ba cked compa nies to exit (ca sh out) at high prices. The Internet beca me a new medium for both persona l a nd business communica tions. It crea ted tremendous opportunities for entrepreneurs a nd venture ca pitalists in the mid a nd la te 1990s. The industry, in turn, experienced extra ordina ry growth both in the number of firms, a nd in the a mount of ca pita l they ha ve ra ised. It is estima ted that over 1000 venture ca pital firms spra ng up in the United Sta tes. The 21st century, however, is seeing declining trend in venture ca pita l a ctivities. Globa l venture ca pita l (GVC) is a n importa nt phenomenon tha t ha s a significa nt impa ct on globa l entrepreneurship. Despite this, the understa nding a nd a na lysis of GVC is very limited in a ca demic a nd pra ctitioner resea rch. It is estimated that US$ 800 billion wa s ra ised globa lly between 1998 a nd 2002 out of which US$ 94 billion is currently under ma na gement in Asia. Though the sums under ma na gement is huge, very little ha s been studied tha t will ena ble these GVC firms to successfully deploy these funds in emerging Asia n ma rkets. Asia is a difficult ma rket for foreign investors, with its diverse sets of politica l systems, la ws a nd cultura l conundrums. This diversity ma kes successful investing in Asia a uniquely difficult proposition. Venture ca pita l firms toda y a re more globa lised tha n ever before. It ha s a n estima ted 5, 162 professiona ls in 1,560 firms opera ting in Asia, the ma jority being foreign firms (Asia n Priva te Equity, 2003). Thus, globa lisa tion of Venture Ca pita l is a n emerging field but very little study has been done in the field.

256 Venture Capital Financing 249 Venture Capital in India Resea rch a nd Development Cess Act, 1986 introduced in the fisca l budget for the yea r , is the precursor of the concept of venture ca pita l a s a new fina ncial service in India. This Act imposed 5 per cent cess on a ll know-how import payments to create a pool of funds for, inte r alia, venture capita l a ctivities. Technology Development Fund (TDF) wa s set up in the year , through the levy of this cess on all technology import payments. TDF was mea nt to provide fina ncial a ssista nce to innova tive a nd high-risk technologica l progra ms through the Industrial Development Bank of India. This mea sure wa s followed up in November 1988, by the issue of guidelines by the (then) Controller of Ca pita l Issues (CCI). These stipula ted the framework for the establishment a nd opera tion of funds/ compa nies tha t could a vail of the fiscal benefits extended to them. However, a nother form of venture ca pital which was unique to India n conditions a lso existed. Tha t wa s funding of greenfield projects by the sma ll investors by subscribing to the Initia l Public Offering (IPO) of the compa nies. Compa nies like J inda l Vija yna ga r Steel, which ra ised money even before they sta rted constructing their pla nts, were esta blished through this route. In Ma rch 1987, Industria l Development Ba nk of India (IDBI) ha d become the first to introduce Venture Ca pita l Fund (VCF) scheme for fina ncing ventures seeking development of indigenous technologies/ ada ptation of foreign technology to wider domestic a pplica tions. Therea fter, Industria l Credit and Investment Corpora tion of India (ICICI) sta rted fina ncing technology-oriented innova tive compa nies. ICICI in a ssocia tion with Unit Trust of India (UTI) formed a venture ca pita l subsidia ry ca lled TDICI - Technology Development and Information Company of India - with hea dqua rters at Benga luru, for ta king up venture ca pita l activity. Industria l Fina nce Corpora tion of India (IFCI) formed Risk Ca pital a nd Technology Finance Corpora tion (RCTC), with hea dqua rters at New Delhi. TDICI is now known a s ICICI Venture Funds Ma nagement Compa ny Ltd. or ICICI Venture; a nd RCTC is now known a s IFCI Venture Ca pita l Funds Ltd. (IVCF). Their main focus is on development a nd commercia lisa tion of viable indigenous, often, untried technologies. Almost a t the sa me time, Credit Ca pita l Venture Fina nce Limited wa s sta rted in the priva te sector. This ha s mobilised funding from globa l funding a gencies, with the joint sponsorship of Commonwealth Development Corpora tion, London (U. K.), Credit Capita l Finance Corpora tion, Asia n Development Ba nk (ADB), and Bank of India, a public sector bank in India. Government of India, in November 1988, announced the first venture ca pital guidelines in the Pa rlia ment. These guidelines provided venture fina ncing of technology startups, promoted prima rily by first genera tion entrepreneurs. Soon therea fter in 1989, four institutions were selected by the W orld Bank under its Industria l Technology Development Project to sta rt venture capita l a ctivities in different pa rts of the country. ICICI a t Mumba i, Guja ra t Industria l Investment Corpora tion (GIIC) in Ahmeda ba d, Andhra Pra desh Industria l Development Corpora tion (APIDC) in Hydera bad, a nd Ca nara Bank in Bengaluru were selected under this scheme. IFCI a t New Delhi, and Infra structure Leasing a nd Fina ncia l Services Ltd. (IL & FS) a t Mumba i were added la ter under the scheme. These institutions formed sepa ra te compa nies for ha ndling venture ca pita l a ctivity a nd ha ve been following Government of India guidelines. Venture Ca pita l Funds promoted under the scheme a nd their parent orga niz a tion a re ta bula ted below. In India, reliable estimates of VC funding are difficult, mostly because not all that is reported is real and because rules allow many VC transactions to fall outside official statistics by making them indistinguishable from routine foreign investment.

257 250 Banking and Financial Services Pa re n t In st it u t ion Ven t u r e Fu n d Prom o t e d ICICI TDICI, ren a m ed a s ICICI Ven tu re Fu n d s Ma n agem en t Com p a n y or ICICI Ven tu re IFCI RCTC, ren a m ed a s IFCI Ven tu re Cap ita l Fu n d s Ltd. IL & FS GIIC APIDC Can ara Ba n k IVCF Pa th fin d er Gu jara t Ven tu re Cap ita l Fin a n ce Ltd. (GVCFL), with all In d ia covera ge APIDC Ven tu re Cap ita l Ltd., with coverage ai s n An dh ra Prades h Ca n fin a - VCF, with focu s on sou th ern Ssta tes FEATURES OF VENTURE CAPITAL FINANCING Indian venture capital approach is modeled on the U.S.A./ U.K. pattern. Government not only plays a proactive role in creating a regulatory environment to secure benefits to the small and medium enterprises (SMEs) but also provides venture support through different arms. Venture ca pitalist or venture ca pita l firm is inclined to a ssume a high degree of risk for ea rning high return. They invest in high risk project/ business ha ving potentia l for high growth. Investment is usua lly made in sma ll a nd medium-scale businesses Venture ca pital is a va ilable only for commercia liz a tion/ implementa tion of new idea s or new technologies a nd not for regula r business Venture ca pitalist joins the business as a co-promoter a nd sha re the risks a nd rewards of the business. Venture ca pita l is usua lly in the form of a n equity participa tion. It ma y a lso ta ke the form of long term debt Venture Ca pital Firm (VCF) not only provides fund but a lso ta kes a ctive pa rt in ma na gement. Thus, they a re continuously involved in the or ga ni z a t i on. Fina ncia l burden of a ssisted firm is negligible in first few years. VCF norma lly pla ns to liquida te its investment once the potentia l venture rea ches its ma turity sta ge (3 7 years) VCF norma lly invests in equity ca pita l of a ssisted firm a nd tends to invest for long-term. Cumulative Ne t Investme nt by VCFs and FVCIs (Sou rce: SE BI Annu al Report, ) (` in crores a t the end of the period) Year VCF s FVCIs Total (*) , , , , , , , , , , , , , , , , , , # 3 1, , , 5 4 2

258 Venture Capital Financing 251 Types of VCs Genera lly there a re three types of orga nised or institutiona l venture ca pita l funds: venture ca pita l funds set up by a ngel investors, tha t is, high net worth individua l investors; venture ca pita l subsidia ries of corpora tions a nd priva te venture ca pita l firms/ funds. Venture ca pital subsidiaries a re esta blished by ma jor corporations, commercial ba nk holding companies a nd other fina ncia l institutions. Venture funds in India ca n be cla ssified on the ba sis of the type of pr omot er s Financ ial Institutions led by ICICI ventures, RCTC, ILFS, etc. Pr ivate Ve ntur e Funds like Indus, etc. Re gional Funds: W a rburg Pincus, J F Electra (mostly opera ting out of Hong Kong). Re gional Funds De dicate d to India: Dra per, W alden, etc. Offshore Funds: Barings, TCW, HSBC, etc. Corpor ate Ventur es: venture ca pita l subsidia ries of corpora tions Ange ls: High net worth individua l investors Merchant Bankers and NBFCs who specialize in "bought out" deals a lso fund compa nies. STEPS INVOLVED IN PROVIDING VENTURE CAPITAL FINANCING The fundamental principle underlying the operations of a venture capital fund is No return without risk and greater the risk, greater will be the returns The following a re the steps involved in providing venture ca pita l fina ncing by a venture ca pita list. The steps involved ma y va ry depending upon the na ture of project, a mount of fina ncing required, promoters involved etc. 1. Deal Origination and Screening of the Project Depending on thrust with which venture ca pitalist is opera ting the business plan of the entrepreneur is studied by venture ca pita list. Selection of the venture is ma de by viewing the sta ge a nd types of investments it is eva lua ting. Interna l a s well a s external fa ctors are considered, interna l being ma na gement a nd technology a nd externa l a re like industry environment, industry structure, ma rket-potentia l, etc. 2. Detailed Evaluation of the Project Ve ntur e capitalist c ar r ies out de taile d evaluation of the pr oje c t whic h includes technical aspect, marketing aspect and financial aspects. Project has to be te c hnic ally fe asible and financially viable. Venture Ca pita list is more interested in the va lue of the compa ny a t time of potentia l exit a s this would form the ba sis of his own profita bility, which depends crucia lly on his ca pita l ga ins a t exit time. 3. Financing the Project In wha t form venture ca pita l is to be provided, is a crucia l decision. All types of investment instruments ava ilable are to be weighed a gainst ' risk- return'

259 252 Banking and Financial Services model in the given context. The venture ca pita l dea l ha s to be structured ta rgeting ma ximum va lue of the venture ca pita list. The different mode of fina ncing by a venture ca pita list is discussed in subsequent part of the cha pter. 4. Post Investment Activity Like other fina ncing a gencies, venture ca pita list continues to ha ve a ssocia tion with assisted project. They pla y a n active role in the mana gement of the venture unlike other fina ncing a gencies. Their target is ' investment nurturing' so their involvement is more intima te a nd consta nt during the entirelife of the investment. They ensure proper utiliza tion of a ssistance provided, check cost a nd time overruns a nd ma ke sure tha t no statutory defaults a re ma de. They seek periodica l reports, visit the plant, ha ve persona l discussion with the entrepreneurs, get feedba ck from resource persons a nd feedba ck through nominee directors. The most crucial stage in any venture capital investment is its exit from the enterprise. Generally, the goal of the venture capitalist is to sell the investment in a period ranging from three to seven years at a considerable gain. 5. Valuation of Investment Venture Ca pitalist ha s an ultima te ta rget to exit a t a n opportune time. To decide opportune time it is necessa ry tha t he consta ntly va lues his portfolio. Only on va luing the portfolio he gets a n idea about his ca pital ga in. He ta rgets to a ssess the fair value of the investment a t a particula r point of time. The valuing technique should be such which incorporates accounting a nd fina ncia l point of view a s well a s sta ges of investment. The va lua tion ba sis should be consistent fa ir a nd conserva tive. 6. Liquidating the Investment Exit is a pre-requisite for ca pita l gain to the venture ca pita list. Exit time ha s to be planned broa dly a t the time of entering contra ct for venture ca pita l. Exit time decision is not solely of venture ca pitalist. Interest of the entrepreneur is a lso to be ta ken in account to decide exit time. Exit ca n be by disposing of investment through ma ny a venues like : (a) Going for IPO (b) Selling ba ck the stake to entrepreneur (c) Sa le of sta ke through priva te pla cement to other investors THE VENTURE CAPITAL FINANCING STAGES/SPECTRUM Venture ca pita lists ca ter to the needs of the entrepreneurs a t different stages of their enterprises. Depending upon the stage they fina nce, ve ntur e capitalists a re ca lled ange l inve stors or pr ivate e quity supplie r/inve stor. Venture ca pita l wa s sta rted as ea rly sta ge fina ncing of rela tively sma ll but rapidly growing compa nies. However, va rious rea sons forced venture ca pita lists to be more a nd more involved in expa nsion fina ncing to support the development of existing portfolio compa nies. W ith increa sing dema nd of ca pita l from newer business, Venture ca pita lists bega n to opera te across a broa der spectrum of investment interest. This diversity of opportunities ena bled Venture ca pita lists to ba lance their a ctivities in term of time involvement, risk a ccepta nce a nd rewa rd potential, while providing on going a ssista nce to developing business.

260 Venture Capital Financing 253 There a re different sta ges of entry for different Venture capita lists a nd they ca n identify a nd differentiate between types of Venture capita l investments, ea ch a ppropria te for the given stage of the investee compa ny, The ba sic type of fina ncing provided by venture capitalist a re 1. Ear ly Stage Financ e A. Seed Ca pita l B. Start-up Ca pita l C. Early/First Stage Capital D. Second Sta ge Finance 2. Late r Stage Financ e A. Seed Capital E. Expa nsion/ Development Sta ge Ca pita l F. Repla cement Fina nce G. Ma na gement Buy-out a nd Buy-ins H. T u r n a r o u n d s I. Mezz a nine/ Bridge Finance It is a n idea or concept a s opposed to a business. Europea n Venture ca pita l a ssocia tion defines seed ca pita l as " The fina ncing of the initia l product development or ca pita l provided to a n entrepreneur to prove the feasibility of a project a nd to qualify for sta rt up ca pital". The cha ra cteristics of the seed capita l ma y be enumera ted a s follows: Absence of rea dy product market Absence of complete ma na gement tea m Product/ process still in R& D sta ge Initia l period/ licensing sta ge of technology tra nsfer Broa dly spea king, seed ca pita l investment ma y ta ke 7 to 10 yea rs to a chieve realiz ation. It is the ea rliest a nd therefore riskiest stage of Ve nture c apital inve stme nt. The new technology a nd innova tions being a ttempted have equa l chance of success a nd fa ilure. Such projects, particula rly hi-tech, projects sink a lot of ca sh a nd need a strong fina ncia l support for their a da pta tion, commencement a nd eventual success. Typica lly, seed enterprises lack a sset ba se or tra ck record to obtain fina nce from conventiona l sources a nd a re la rgely dependent upon entrepreneur' s persona l resources. Seed ca pita l is provided a fter being sa tisfied tha t the entrepreneur ha s used up his own resources a nd ca rried out his idea to a sta ge of a ccepta nce a nd ha s initia ted research. The a sset underlying the seed ca pita l is often technology or a n idea a s opposed to huma n a ssets (a good mana gement tea m) so often sought by venture ca pita lists. Domestic venture capital funds have created their funds under the Indian Trust Act, An Asset Management Company (AMC) is formed which also acts as a trustee to the funds. The funds are settled as close-ended funds.

261 254 Banking and Financial Services Offshore Venture Funds are set up outside India in many countries like U.S.A., Hong Kong, Singapore, Mauritius, etc. These are very large funds, and make large investments. They generally invest in existing big companies. B. Start-up Capital It is the second sta ge in the venture capita l cycle a nd is distinguishable from seed ca pita l investments. An entrepreneur often needs fina nce when the business is just sta rting. The start-up sta ge involves sta rting a new business. Here in the entrepreneur ha s moved closer towa rds esta blishment of a going concern. Here in the business concept ha s been fully investiga ted a nd the business risk now becomes tha t of turning the concept into product. Sta rt-up ca pita l is defined as: "Ca pital needed to finance the product development, initia l ma rketing a nd esta blishment of product facility. " The cha ra cteristics of sta rt-up ca pita l are: Esta blishment of compa ny or business. The compa ny is either being orga niz ed or is esta blished recently. New business a ctivity could be ba sed on experts, experience or a spin-off from R& D. Esta blishment of most but not a ll the members of the tea m. The skills a nd fitness to the job and situa tion of the entrepreneur' s tea m is a n importa nt fa ctor for start-up fina nce. Development of business pla n or idea. The business pla n should be fully developed yet the a ccepta bility of the product by the ma rket is uncerta in. The company has not yet sta rted tra ding. In the sta rt-up preposition ve ntur e c apitalists inve stme nt cr ite ria shifts from idea to people involved in the venture a nd the market opportunity. Before committing a ny finance a t this sta ge, Ve ntur e c apitalist however, assesses the ma na geria l a bility a nd the ca pa city of the entrepreneur, besides the skills, suita bility and competence of the ma nagerial team a re a lso eva lua ted. If required they supply mana geria l skills a nd supervision for implementation. The time horiz on for sta rt-up ca pita l will be typica lly 6 or 8 yea rs. Fa ilure rate for startup is 2 out of 3. Sta rt-up needs funds by wa y of both first round investment a nd subsequent follow-up investments. The risk tends t0 be lower rela tive to seed ca pita l situation. The risk is controlled by initia lly investing a sma ller a mount of ca pita l in sta rt-ups. The decision on a dditional fina ncing is ba sed upon the successful performa nce of the compa ny. However, the term to realiz a tion of a start up investment rema ins longer than the term of fina nce norma lly provided by the ma jority of financia l institutions. Longer time scale for using exit route dema nds continued wa tch on sta rt-up projects. C. Early Stage Finance It is a lso ca lled first sta ge ca pita l is provided to entrepreneur who has a proven product, to sta rt commercial production a nd ma rketing, not covering ma rket expa nsion, de-risking a nd a cquisition costs. At this sta ge the compa ny pa ssed into ea rly success stage of its life cycle. A proven ma na gement tea m is put into this sta ge, a product is established a nd a n identifia ble market is being t a r geted. The cha racteristics of early sta ge fina nce ma y be: Little or no sa les revenue. Ca sh flow a nd profit still nega tive.

262 Venture Capital Financing 255 A sma ll but enthusia stic ma na gement tea m which consists of people with technica l a nd specia list ba ckground a nd with little experience in the ma na gement of growing business. Short-term prospective for drama tic growth in revenue a nd profits. The early stage fina nce usually ta kes 4 to 6 years time horiz on to rea liza tion. Ea rly sta ge fina nce is the ea rliest in which two of the funda menta ls of business a re in pla ce, i. e., fully a ssembled mana gement tea m a nd a ma rketa ble product. A compa ny needs this round of finance beca use of a ny of the following rea sons: Project overruns on product development. Initia l loss after sta rt-up phase. D. Second Stage Finance It is the ca pita l provided for marketing a nd meeting the growing working ca pita l needs of an enterprise tha t has commenced the production but does not ha ve positive ca sh flows sufficient to ta ke ca re of its growing needs. Second stage fina nce, the second trench of Ea rly Sta te Fina nce is also referred to a s follow on finance and ca n be defined a s the provision of ca pital to the firm which ha s previously been in receipt of externa l ca pita l but whose fina ncia l needs ha ve subsequently exploded. This ma y be second or even third injection of capit al. The cha racteristics of a second sta ge fina nce are: A developed product on the ma rket A full mana gement team in pla ce Sa les revenue being genera ted from one or more products There are losses in the firm or a t best there ma y be a brea k-even but the surplus generated is insufficient to meet the firm's needs. Second round fina ncing typica lly comes in a fter sta rt-up a nd ea rly sta ge funding a nd so ha ve shorter time to ma turity, genera lly ra nging from 3 to 7 yea r s. The offshore fund is set up usually either with the sole contribution from one company or with contributions channeled through the foreign investors. E. Expansion/Development Finance An enterprise esta blished in a given ma rket increa ses its profits exponentia lly by achieving the economies of sca le. This expa nsion ca n be a chieved either through a n orga nic growth, tha t is by expa nding production ca pa city a nd setting up proper distribution system or by way of a cquisitions. Anyhow, expa nsion needs finance and venture ca pita lists support both organic growth as well a s a cquisitions for expa nsion. At this sta ge the rea l ma rket feedba ck is used to a na lyz e competition. It ma y be found tha t the entrepreneur needs to develop his ma na geria l tea m for ha ndling growth a nd ma na ging a la rger business. Realiz a tion horiz on for expansion/ development investment is one to three years. It is fa vored by venture ca pitalist a s it offers higher rewa rds in shorter period with lower risk. Funds a re needed for new or larger fa ctories a nd

263 256 Banking and Financial Services wa rehouses, production capa cities, developing improved or new products, developing new ma rkets or entering exports by enterprise with esta blished business tha t ha s a lready a chieved brea k-even a nd ha s sta rted making profits. F. Replacement Finance It mea ns substituting one shareholder for a nother, ra ther tha n ra ising new ca pita l resulting in the change of ownership pa ttern. Venture ca pitalist purcha se shares from the entrepreneurs a nd their a ssocia tes ena bling them to reduce their sha reholding in unlisted compa nies. They also buy ordina ry shares from non-promoters a nd convert them to preference sha res with fixed dividend coupon. La ter, on sa le of the compa ny or its listing on stock excha nge, these a re re-converted to ordina ry sha res. Thus, Venture ca pita list makes a ca pita l gain in a period of 1 to 5 years. Of late, there has been a gradual shift away from start-up and early finance towards MBO opportunities. This shift is because of lower risk than start-up investments. G. Buy-out/Buy-in Financing It is a recent development and a new form of investme nt by ve ntur e c apitalist. The funds provided to the current opera ting ma na gement to a cquire or purcha se a significa nt share holding in the business they ma nage a re ca lled ma na gement buyout. Ma na gement Buy-in refers to the funds provided to enable a ma na ger or a group of ma na gers from outside the company to buy into it. It is the most popula r form of venture ca pita l a mongst la ter sta ge fina ncing. It is less risky a s venture capita list in invests in solid, ongoing a nd more mature business. The funds a re provided for a cquiring a nd revita liz ing a n existing product line or division of a ma jor business. MBO (Ma na gement buy-out) has low risk a s enterprise to be bought ha ve existed for some time besides ha ving positive ca sh flow to provide regula r returns to the venture capita list, who structure their investment by judicious combina tion of debt a nd equity. H. Turnaround Finance It is ra re form later sta ge finance which most of the ventur e c apitalist a void beca use of higher degree of risk. W hen a n esta blished enterprise becomes sick, it needs finance as well a s ma na gement a ssista nce foe a ma jor restructuring to revita liz e growth of profits. Unquoted compa ny a t a n early sta ge of development often has higher debt tha n equity; its ca sh flows a re slowing down due to la ck of ma na geria l skill and ina bility to exploit the ma rket potentia l. The sick compa nies a t the later sta ges of development do not norma lly ha ve high debt burden but la ck competent sta ff a t va rious levels. Such enterprises a re compelled to relinquish control to new ma na gement. The venture capita list ha s to ca rry out the recovery process using ha nds on ma na gement in 2 to 5 yea rs. The risk profile a nd a nticipa ted rewa rds are akin to early sta ge investment. I. Bridge Finance It is the pre-public offering or pre-merger/a cquisition fina nce to a company. It is the la st round of fina ncing before the pla nned exit. Venture ca pitalist help in building a sta ble a nd experienced ma nagement tea m tha t will help the compa ny in its initia l public offer. Most of the time bridge finance helps improve

264 Venture Capital Financing 257 the va lua tion of the compa ny. Bridge fina nce often ha s a rea liz a tion period of 6 months to one yea r a nd hence the risk involved is low. The bridge fina nce is pa id ba ck from the proceeds of the public issue. Stages in Venture Capital Financing Fin a n c in g St a ge Perio d (Lo c k in p e rio d ) Ris k le ve l Ac t ivit y t o be fin a n c e d Ea rly s ta ge fin a n ce Seed 7-10 Extrem e For s u pp ortin g a con cep t or id ea or R & D for prod u ct develop m en t Sta rt-u p 5-9 Very h igh In itia lizin g op era tion s or develop in g p rototyp es Firs t sta ge 3-7 High Sta rt com m ercia l prod u ction a n d m a rk etin g Secon d s ta ge 3-5 Su fficien tly h igh Exp a n d m a rket a n d growin g work in g cap ita l n eed La ter s ta ge fin a n ce 1-3 Med iu m Ma rk et exp a n s ion, a cqu is ition a n d p rod u ct develop m en t for profit m ak in g com pa n y / Bu y-ou t Bu y-in 1-3 Med iu m Acqu is ition fin a n cin g Tu rn a rou n d 3-5 Med iu m to h igh Cate gor y-wise Inve stor s in VCFs (Sou rce: SE BI Ann ual Report, ) Tu rn in g a rou n d a sick com p a n y Mezza n in e 1-3 Low Fa cilita tin g p u b lic iss u e C at e g o r y Number of Percentage to C u m u l a t i v e Percentage to I n v e s t o r s total investors I n v e s t m e n t s i n v e s t m e n t s (` Crore) C o r p o r a t e / I n s t i t u t i o n s / O t h e r s 4, , F V C I s , I n d i v i d u a l s 3 6, , N R I s T o t a l 4 0, , Many VCs have consultants and professionals on their staff that have deep knowledge of specific markets. These experts can help your business avoid many of the pitfalls that are usually associated with startups. ADVANTAGES OF VENTURE CAPITAL Venture ca pital ha s a number of a dva nta ges over other forms of fina nce, such as: Financ e - The venture capita list injects long-term equity fina nce, which provides a solid capita l ba se for future growth. The venture ca pita list ma y a lso be ca pa ble of providing additiona l rounds of funding should it be required to fina nce growth. B usine ss Partne r - The venture ca pita list is a business partner, sha ring the risks a nd rewa rds. Venture ca pita lists a re rewa rded by business success a nd ca pita l gain.

265 258 Banking and Financial Services M e ntor ing - The venture ca pitalist is a ble to provide stra tegic, opera tiona l and fina ncia l a dvice to the compa ny ba sed on pa st experience with other compa nies in simila r situa tions. Allianc e s - The venture capita list a lso ha s a network of conta cts in ma ny a reas that ca n a dd va lue to the company, such a s in recruiting key personnel, providing conta cts in interna tiona l ma rkets, introductions to stra tegic pa rtners a nd, if needed, co-investments with other venture ca pital firms when a dditional rounds of financing a re r eq u i r e d. Facilitation of Exit - The venture ca pita list is experienced in the process of prepa ring a compa ny for a n initia l public offering (IPO) a nd fa cilita ting in trade sa les. LIMITATIONS OF VENTURE CAPITAL FINANCING Most VC firms do not release all the needed funds upfront. Rather, they usually release funds in stages with an eye on the expansion of business. Because this approach may not be suitable for business s funding plans, it may ruin the business. Inadequacy of equity capita l fina ncing by venture ca pita lists. Focus on low risk ventures by venture ca pital firms. Conservative a pproa ch followed by venture ca pital firms. Dela y in project eva lua tion by venture ca pital firms. IMPORTANT VENTURE FINANCING SCHEMES IN INDIA Venture Ca pita l Funds (VCF) business is very new to India. A ma jority of them belong to financia l institutions and ba nks in the public sector. There a re only one or two venture ca pita l funds in the priva te sector. Some of the important VCFs a nd their schemes are a s follows: 1. VCF of IDBI It wa s sta rted with a n initia l capita l of Rs. 10 crores a nd is a pa rt of the technology depa rtment of the Industria l Development Bank of India. It is mea nt to a id projects, which promote commercia l use of developed technology, or which a dapt imported technology for wider a pplica tions. It supports high technology, a nd projects with a ma ximum cost or Rs crores. Such projects must employ technology tha t is new a nd untested in Indian compa nies. Fina ncia l a ssistance is provided right from the pilot sta ge a nd covers upto 90 per cent of the tota l cost, mostly in the form of equity a nd/ or conditional loans, where the return is in the form of roya lty on sales, a fter commercial success. In specific terms, the a ssista nce to the project ma y va ry between Rs. 5 la khs a nd Rs. 250 lakhs. It will cover both ca pita l and opera ting expenditures. 2. VCFs of UTI In , the Unit Trust of India set up a VCF of Rs. 20 crores in colla bora tion with the ICICI for fostering industria l development. Technology Development and Information Company of India Ltd. (TDICI) esta blished by the UTI jointly with the ICICI a cts a s a n adviser a nd ma nager of the Fund. The UTI la unched Venture Ca pital Unit Scheme to ra ise resources for this fund. It set

266 Venture Capital Financing 259 up a Second Venture Ca pita l Fund in Ma rch 1990 with a ca pita l of Rs. 100 crores, with the objective of fina ncing Greenfield ventures a nd steering industrial development. 3. Technology Development and Information Company (TDICI) It provides support to industries both directly a nd through venture funds. The TDICI ma na ges two venture capita l funds of the UTI. The UTI, ICICI, multila tera l institutions, India n ba nks, a nd the corpora te sector were encoura ged to subscribe to the fund. 4. Risk Capital and Technology Finance Corporation Ltd. (RCTFC) The IFCI sponsored the Risk Capital Foundation (RCF) in 1985 to give positive encoura gement to new entrepreneurs. The RCF was converted into RCTFC on 12 J a nuary It provides both risk ca pital a nd technology fina nce under one roof to innova tive entrepreneurs a nd technocrats for their technologyoriented ventures. Most of the projects it a ssisted were ba sed on new technology, or new usa ges of existing technology. They included manufa cture of a ntibiotic drugs, ra dio pa ging systems, pa y phones, ca lcium silica te bricks, polymer concrete, granite a nd ma rble processing ma chinery, a nd so on. 5. VCFs of Commercial Banks Standa rd Cha rtered Ba nk esta blished Indias first priva te sector venture ca pita l fund, na mely India Investment Fund with a n initia l ca pita l of Rs. 10 crores subscribed by NRIs. The Fund provides sta rt-up sha re ca pital to new ventures, a nd to their promoters. It also invests in fresh issues of esta blished compa nies with a good performance record. The object of the fund is to a ccomplish huge capita l growth for its investors by pa rticipa ting in fa st growing compa nies or high technology companies with potentia l for high growth. Amongst the India n banks, the subsidia ries of SBI a nd Ca na ra ba nk provide venture ca pita l funds. They provide equity ca pita l or conditiona l loa ns. The projects a ssisted by them belong to industries such as wa tches, sea mless meta l, cement, a nd cera mics. A flourishing venture capital industry in India will fill the gap between the capital requirements of technology and knowledge-based startup enterprises and funding available from traditional institutional lenders such as banks. 6. Credit Capital Venture Fund (India) Ltd. (CCVF) It wa s la unched in 1989 a nd it is the second VCF in the priva te sector in India. It is a joint venture between Credit Ca pita l Fina nce Corpora tion, Asia n Development Bank, and Commonwea lth Development Corpora tion of the U. K. Its thrust a rea s are sma ll export-oriented units a nd a ncilla ry units. Apa rt from ca pita l, it provides ha nds on ma na gement support to the projects. Numbe r of Re giste r e d Ve ntur e Capital Funds/ AIFs As on As on VCFs M ar c h M ar c h 31, , VCF FVCI AIFs N a 42 (Sou rce: SE BI Annu al Report, )

267 260 Banking and Financial Services Value of Investme nts by Indian Ve ntur e Capital Fir ms (in $ mn) In ves tor Total Sequ oia Ca p ita l In dia In tel Ca pita l Norwes t Ven tu re Pa rtn ers Helion Ven tu re Pa rtn ers Nexu s In d ia Ca pita l DFJ In d ia Ven tu rea s t NEA In d ous Ven tu res Ca n a a n Pa rtn ers Klein er Perkin s IDG In dia Ven tu res In ven tu s Ca p ita l Pa rtn ers INDIAN PRIVATE EQUITY AND VENTURE CAPITAL ASSOCIATION The IVCA was set up in 1993 and is based in New Delhi. Today, IVCA is working towards creating an enabling environment for VCs in India. The India n Priva te Equity a nd Venture Capita l Associa tion is the apex a ssocia tion of VC funds in the country, with a mission, to fa cilita te growth of Venture Ca pita l a nd Priva te Equity a ctivities in India. The ma in objectives of the a ssocia tion a re to encoura ge a nd assist creation of more Venture Ca pita l a nd Priva te Equity Funds in India a nd to foster a sense of coopera tion a mong the Venture Capita lists a nd Priva te Equity investors in India. Besides this a nother importa nt function tha t IVCA is performing is the collection, processing a nd dissemina tion of informa tion and knowledge a bout the development of VC a nd Priva te Equity a ctivities in India with the Government a gencies, professiona l bodies and use of interfa cing the informa tion with other rela ted a gencies both a t na tiona l and interna tiona l levels. IVCA, is trying to create a wareness a bout VC/PE expectations a nd entrepreneurs expecta tion so a s to fa cilita te deep understa nd with va rious interested group and to formula te code of conduct for co-investing by VC a nd PE funds. La st but not the lea st, to form, control a nd guide various institutions that might be needed for this end and to hold meetings for reading a nd discussing technical pa pers and other works of litera ture, science a nd a rts a nd a ny other a ctivities necessary, suita ble and proper for the fulfillment of these objectives.

268 Venture Capital Financing 261 IVCA Vision IVCA' s vision is to create a conducive environment in India for entrepreneurship to flourish a nd for globa l equity a nd venture ca pita l to flow to India. We would like to foster the creation of a la rge pool of domestic venture ca pita l a nd encoura ge the emergence of a ngel investors a nd VC firms to a ssist India n compa nies to go globa l. IVCA Membership IVCA welcomes members, venture funds a nd intermedia ries tha t a re incorpora ted, registered or opera ting in India. Membership is in the Corpora te a nd Affilia te member ca tegories. Corpora te members a re entitled to hold office bearer positions and be pa rt of the Executive Council, a s well a s vote a t Associa tion meetings. Membership Profile IVCA currently ha s over 40 members, including a ffilia tes. W ith venture ca pita l a ctivity rising in India a nd advisory compa nies also joining, membership in IVCA is poised for ma jor growth. The membership profile covers sta te-held funds, priva te funds, and international funds with a presence in India a nd a few intermediaries. Most of the leading funds in the country a re members of IVCA. Industr y wise Cumulative Inve stme nt De tails of SEB I Re giste r e d Ve ntur e Capital Funds (VCF) and For eign Capital Investors (FVCI) Under the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 1997 if the promoters want to buy back the shares from FVCIs, it would not come under the public offer requirements. Pa rt ic u lar s As as on Mar M arch c h 3 31, 1, (` (` in in Crores) r e) Se c t o rs of Eco n o m y VCF FVCI Tot a l* In form a tion Tech n ology Telecom m u n ica tion Ph arm a ceu ticals Biotech n ology Media / En tertain m en t Services Sector In du stria l Produ cts Rea l es ta te Oth ers Tot al

269 262 Banking and Financial Services Important Venture Capital Companies in India Accel Partners India Artheon Ventures Artima n Ventures August Capita l Pa rtners BlueRun Ventures DFJ India Epipha ny Ventures Helion Venture Pa rtners IFCI Venture Ca pita l Funds Incube Connect Fund India Innova tion Investors Infra Co Asia Development Pte Ltd. Inventus (India) Advisory Compa ny JAFCO Asia Netz Ca pita l Nexus India Ca pita l Nirva na Venture Advisors Ojas Venture Pa rtners Relia nce Venture SAIF Pa rtners Sequoia Ca pita l Srijan Capital Tusca n Ventures Trident Ca pita l Veddis Ventures Ve nt ur e E a s t La mbtech Ventures SEBI REGULATIONS FOR VCFs VCF a re regulated by the SEBI (Venture Capita l Fund) Regula tions, The regula tion clea rly sta tes that a ny company or trust proposing to ca rry on activity of a VCF shall get a grant of certifica te from SEBI. Section 12 (1B) of the

270 Venture Capital Financing 263 SEBI Act a lso makes it ma ndatory for every domestic VCF to obta in certifica te of registration from SEBI in a ccordance with the regula tions. Hence there is no wa y tha t a n India n Venture Ca pita l Fund ca n exist outside SEBI Regula tions. However registra tion of Foreign Venture Ca pital Investors (FVCI) is not ma nda tory under the FVCI regula tions. (i) VCF is a fund esta blished in the form of a trust/ a company including a body corpora te a nd registered with SEBI. It ha s a dedica ted pool of ca pita l, ra ised in the specified ma nner a nd invested in VCUs in a ccorda nce with the regula tions. VCU is a domestic company whose shares are not listed on a stock excha nge a nd is enga ged in specified b u s i n e s s. (ii) The minimum investment in a VCF from a ny investor would not be less than ` 5 la khs a nd the minimum corpus of the fund before it could start a ctivities should be a t lea st ` 5 crores. (iii) The norms of investment were modified. A VCF seeking to a va il benefit under the releva nt provisions of the Income Tax Act will be required to divest from the investment within a period of one yea r from the listing of the VCU. (iv) The VCF will be eligible to pa rticipa te in the IPO through book building route a s Qua lified Institutiona l Buyer. (v) The ma nda tory exit requirement by VCF from the investment within one yea r of the listing of the sha res of VCUs to seek tax pa ss-through wa s removed under the SEBI (VCF) Regula tion to provide for flexibility in exit to VCFs. (vi) The VCFs were directed to provide with the informa tion pertaining to their venture ca pita l a ctivity for every qua rter sta rting from the qua rter ending December 31, (viii) Automa tic exemption wa s gra nted from a pplica bility of open offer requirements in ca se of tra nsfer of shares form VCFs in Foreign Venture Ca pital Investors (FVCIs) to promoters of a VCU. Central Board of Direct Taxes (CBDT) and other guidelines state that a venture capital fund can invest up to 40 per cent of the paid-up capital of the invested company or up to 20 per cent of the corpus of the fund in one undertaking. SEBI (Alternative Investment Funds) Regulations, 2012 SEBI (Securities Excha nge Boa rd of India) ha s introduced the SEBI (Alternative Investment Funds) Regula tions, 2012 to bring unregula ted funds under its purview, ensure systemic stability, increa se ma rket efficiency a nd enable the forma tion of new ca pita l. These regula tions will be a pplica ble to a ll pooled investment vehicles apar t fr om Mutua l Funds, CIS Schemes, Fa mily Trusts, ESOP Trusts, Employee W elfare Trusts, holding compa nies, funds ma na ged by Asset Reconstruction Compa nies, Securitisa tion Trust or Funds directly regula ted by a ny other regula tor in India.

271 264 Banking and Financial Services SEBI regulations and the guidelines of CBDT require that at least 80 per cent of the corpus of the venture fund should be invested in unlisted equity shares of the VC undertakings. Some of the r egulations appr ove d by the boar d inc lude: (i) Re gistr ation: All Alterna tive Investment Funds (AIFs), whether opera ting a s Private Equity Funds, Rea l Estate Funds or Hedge Funds should be registered with SEBI. (ii) Withdr awal of old VC Fund Re gulations: The SEBI (Venture Ca pita l Funds) Regulations of 1996 is officia lly withdrawn, however existing venture ca pita l funds will continue to be regula ted by the regula tions until the fund winds down its opera tions a nd they will not be a llowed to ra ise a ny fresh funds, except for the previous investor commitments. That being sa id, Venture Ca pita l funds can a lso opt to re-register themselves under the new AIF regula tions, provided they receive the a pprova l to do so from % of their investors a nd ca n seek exemption from the boa rd from strictly adhering to these regula tions, in ca se they are not a ble to comply with a ll the new regula tions. (iii) Unre gister ed funds will not be allowe d to launc h ne w sc he me s without registering with SEBI under the new AIF regula tions. The existing schemes which were la unched by funds prior to the AIF regula tion a nnouncement, will however continue to be governed till it ma tures by contra ctua l terms, with no room for a rollover or a n extension. (iv) Cor pus: AIFs should ha ve a minimum corpus of ` 20 crores a nd they shall not a ccept a ny investment less than ` 1 crore from an investor. The fund should not have more than 1000 investors a nd the fund ma na ger should ha ve continuing interest of minimum 2. 5% of the initial corpus or ` 5 crores, whichever is lower. The fund ma nager is not a llowed to continue the interest through the waiver of mana gement fees. (v) Filings: Funds ca n la unch schemes, following the filing of informa tion memora ndum with the Boa rd a long with a pplica ble fees, a nd fund units ca n be listed on the stock exchange subject to a minimum trada ble lot of ` one crore, however they a re forbidden to ra ise funds through the excha nge. (vi) Limits To Investment: AIFs are not a llowed to invest more tha n 25% of the funds in one Compa ny a nd a re forbidden to invest in a ssociate compa nies. They should a lso provide investors with fina ncia l informa tion of portfolio compa nies a s also ma terial risks a nd how these a re ma na ged on a n a nnua l b a si s. Funds Under the New Regulation SEBI stated tha t the new regula tions broa dly cover all types of funds under three categories. All AIFs ca n a pply for registra tion under one of the categories below: Cate gory I AIFs: These funds a re close ended, a dhere to the investment restrictions a s instructed for each ca tegory a nd shall not enga ge in le ver age i. e., a ny a ctivity to multiply gains and losses like borrowing money, buying fixed a ssets a nd using deriva tives. SEBI sta ted tha t they or Government of India or other India n regula tors ma y consider certa in incentives or concessions for

272 Venture Capital Financing 265 these funds, depending upon the specific need of ea ch type of funds. Among the funds included in this category a re Venture Ca pital Funds, SME Funds, Socia l Venture Funds a nd Infrastructure Funds a nd the minimum tenure of these funds should be 3 years. Cate gory II AIFs: These funds sha ll be close-ended with no investment restrictions. However, these funds a re not allowed to enga ge in leverage other than meeting da y-to-da y opera tiona l requirements, a s per the regula tions a nd they will not a ttract a ny specific incentives or concessions from SEBI, Government of India or a ny other regula tor. Among the funds included in this ca tegory include Priva te Equity Funds, Debt Funds, Fund of Funds a nd uncla ssified funds tha t do not fa ll under either ca tegory I or category III a nd ha ve a minimum tenure of 3 years. Cate gor y III AIFs: These funds can be open ended or closed ended a nd a re a llowed to engage in levera ge within the prescribed boa rd limits. Among the funds included a re Hedge Funds which, a ccording to SEBI, ha ve ne gative e xte r nalitie s, i. e., these funds ma ke decisions which ma y impose a nega tive effect on other funds, thereby lea ding to inefficiencies in the ma rket. These funds will be regula ted through Boa rd' s directions in area s such a s opera tiona l standa rds, conduct of business rules, prudentia l requirements, restrictions on redemption a nd conflict of interest. REVIEW QUESTIONS 1. W hat is venture ca pita l fina ncing and how is it different from conventiona l f i n a n c i n g? 2. W hat a re the different risk ca pital fina ncing options ava ila ble? 3. Expla in the fea tures of venture ca pita l fina ncing. 4. Briefly explain the different steps involved in providing venture ca pita l f i n a nc i n g. 5. W hat a re the forms of ea rly sta ge fina ncing? 6. Expla in merits a nd demerits a ssociated with venture ca pita l fina ncing. REFERENCES Ca pvent, Venture Intelligence Report on ' Private Equity Impa ct, 2009'. KPMG, Priva te Equity Investing in India, 2008 A survey of priva te equity investor a nd their portfolio compa nies. Mitra D (2000), The Venture Capita l Industry in India, J ournal of Small Busine ss Manage ment, Vol. 38, No. 2, Pa ndey, I. M. et a l. ( 2003), Colloquium on Entrepreneurship a nd Venture Ca pita l, Vik alpa, 28(1), J a nua ry - Ma rch.

273 266 Banking and Financial Services Pricewa terhouse Coopers, Global Priv ate Equity Re port, SEBI ( 2000), ' Report of K. B Cha ndra shekha r on Venture Ca pita l' SEBI Annua l Report, SEBI, (2003), Dr. Ashok La hiri, Report on Venture Ca pita l in India. Va rshney, Vishnu (2001), Venture Fina nce - Highlights, in Sma ll Industries Development Bank of India (SIDBI) (ed.), Technology for Small-Scale Industries - Curre nt Status and Eme rging Ne eds, New Delhi, Ta ta McGra w-hill Publishing Compa ny Ltd. W orld Economic Forum Report (2009) on ' The Globa l Economic Impa ct of Priva te Equity

274 CHAPTER 9 HOUSING FINANCE Learning Objectives After reading this chapter you should be able to understand the na ture a nd scope of housing finance the structure of housing fina nce in India the types of housing fina nce provided the overview of housing fina nce industry in India the a dvanta ges a nd limita tions a ssocia ted housing finance

275 268 Banking and Financial Services NATURE AND SCOPE OF HOUSING FINANCE 2nd largest employment generated in this sector (after agriculture) Housing is in essence a significant component of the socia l a nd economic status of a n individua l or a household. It represents one of the three most funda menta l socia l needs, that is, food, clothing a nd shelter. In the simplest form, housing is an a bode a s much for the poorest a s for the most a ffluent of persons. This is so because housing comprises one of the prime a spira tions for progressive lifestyles a mong all income groups. The social a nd economic transforma tion of a n urba n centre is caused a s well a s ma nifested in the changing housing scena rio. Housing ha s evolved into a complex economic good, dema nded not merely a s a shelter but a s a lucra tive investment a sset. Not only does it render socia l returns in terms of achievement, socia l accepta nce a nd sa tisfa ction to its owner but is a lso a source of household income in the form of r e n t. Good housing is a pre-requisite for human development and welfa re. It provides shelter, security, a menities a nd privacy to the huma n beings for decent living. Without good housing, people ca nnot rea liz e their full potentia l a nd carry on the life they want to lea d. Good housing reflects the genera l welfa re of the community, wherea s, ba d housing leads to serious consequences such a s disea ses, immora lity, a nd juvenile delinquency. Depriva tion of a decent housing, in fa ct, becomes a threat to socia l ha rmony and economic prosperity. Housing is a lso a n investment a ctivity a nd provides impetus to economic growth. It ha s both forwa rd a nd ba ckwa rd linka ges. Beca use of its forwa rd a nd ba ckwa rd linka ges, even a sma ll initiative in housing will propel multiplier effect in the economy through the genera tion of employment a nd dema nd. Recogniz ing the critica l importa nce of huma n settlement in developing countries, the Universa l Decla ra tion of Human Rights a nd the Interna tiona l Covena nt on Economic, Socia l and Cultura l Rights, have recogniz ed the right to housing a s a huma n right. The UN a lso decla red the yea r 1987 a s Interna tiona l Yea r for Shelter for the Homeless a nd Poor. Since then, there ha s been a growing concern to a ddress va rious forms of housing depriva tion pa rticula rly in developing countries, where with the growing popula tion pressure, meeting the housing needs of a ll fa milies is a real cha llenge. The urban popula tion of India ha s been growing a t a ra pid pace. As per the Census 2011, per cent of the total popula tion is in the urba n a rea s. The shorta ge of housing units for the urba n a reas for 2012 is 1 estima ted a t million units. The report of the 11th Five-Yea r Pla n ( ) W orking Group on Urba n Housing sta tes tha t the overall employment genera tion in the economy on a ccount of a dditiona l investment in the housing/ construction sector wa s eight times the direct employment. The construction sector provides employment to 16% of the workforce with a n avera ge increa se of 7% per a nnum. The housing sector is second to a griculture in terms of employment genera tion with 58% of the total workforce employed in the construction sector working in the housing sector. The employment opportunities exist for the unskilled labour ca tegory a s well a s for a wide section of popula tion with varying degrees of skills, educa tion, a nd professiona l knowledge. Increase in house construction a ctivities lea ds to increa se in producers and dea lers in building materials;

276 Housing Finance 269 increa se in the number of professiona ls like developers, a rchitects, civil engineers, builders, contra ctors, interior designers, property eva lua tors, rea l esta te agents, etc., a s well as technicia ns such a s plumbers, electricians, pa inters, a nd furnishers; increa se in ma nufa cturers a nd dea lers in home a pplia nces, electronic and electrica l products, etc., ( Ca rdoz o, 2003). Housing requires continuous ma intena nce, repa irs a nd modifica tions. Therefore, a sma ll change in dema nd for housing ma y ha ve multiplier effect on the whole economy. The term housing fina nce is commonly referred to the loa ns a vailed by a household for the purchase or construction of a housing unit. It involves mortga ging of the property a s colla teral a ga inst which the loa n ha s been ta ken. Origina lly, a mortga ge wa s sa id to ha ve occurred when the owner pledged her right over a n a sset owned by her a s a security with the lender for a va iling a loan. However, a s housing loa ns a re given under the condition of mortga ging the property for which the loa n has been a va iled, the term mortgage fina nce ha s become synonymous to housing fina nce. Housing fina nce covers a wide ra nge of issues, a nd the concept often va ries in its coverage a cross different countries; however, it ha s been defined ma inly in terms of residentia l mortga ge credit. Housing fina nce includes a broa d a rra y of institutiona l arra ngements which include both genera l a nd specia liz ed institutions a cting a s primary or seconda ry lenders, with the common purpose of cha nneling funds from sa vers to households dema nding housing loans. Housing fina nce is the provision of long-term fina ncing for house purcha se or funds used for building a nd mainta ining the housing stock of a country. The NHB report on India n Housing Finance System (2000), describe housing finance to mea n fina ncing of home purchase. Housing finance is pr ovide d for the following pur pose s Purcha se/construction of new House/ Fla t Purcha se of a n existing House/ Fla t Purcha se of a plot of la nd for construction of House Extension/ repair/ renova tion/ altera tion of a n existing House/ Fla t Purcha se of Furnishings a nd Consumer Dura bles a s a pa rt of the project c o s t Ta keover of an existing loa n from other Ba nks/ Housing Finance C o m p a n i e s Housing loans as a percentage of GDP have remained at around 7 per cent, significantly lower than the levels achieved in most of the developed countries Housing Finance in India The Housing fina nce sector in India has no doubt, experienced unprecedented cha nge in its structure from its formulation sta ge. India n Housing Fina nce has fa r moved from the sta ge of being a solely government underta king provided service during the 1970s to a very competitive sector with more tha n 45 housing fina nce entities providing housing loa ns worth ` 7, 81, 000 million to home buyers across India. The housing fina nce revolution in India ca n be divided into five distinct pha ses:

277 270 Banking and Financial Services Phases of Indian Housing Finance Ph a se I Before Govern m en t Dom in a tion Ph a se II HUDCO an d HDFC esta b lis h es Ph a se III Estab lish m en t of NHB Ph a se IV Libera liza tion of In terest Ra te Ph a se V to presen t High Growth The establishment of public sector institutions such as HUDCO and NHB, and the HDFC in the private sector, in the 1970s and 1980s brought the much needed focus to the housing finance sector and propelled the system into a higher growth trajectory. The first pha se bega n before 1970, when the sole provider of any house building support was the government of India through its va rious socia l schemes for public housing. The government implemented these schemes through sta te housing boa rds which were responsible for a lloca ting serviced land a nd houses to individua ls ba sed on the principles of socia l equity. The second pha se sta rts with the esta blishment of the public housing compa ny, Housing a nd Urba n Development Corpora tion (HUDCO). HUDCO wa s crea ted to a ssist a nd promote housing and urba n development progra ms with government a gency. HUDCO still pla ys a n importa nt role in implementing government initia tives such a s the Va lmiki Ambedka r Awa s Yojna which wa s la unched by Government of India in to provide shelter or upgra de the existing shelter for the people living below poverty line in the urban slums. Another importa nt priva te player, Housing Development Fina nce Compa ny (HDFC) wa s esta blished in HDFC pioneered in individua l lending, based on ma rket principles. HDFC toda y is one of the largest home loa n providers of the country and its success displa yed tha t fina ncing homes ca n be a very profita ble business. The third pha se covers the deca de of 1980s, which is ma rked by the esta blishment of the country' s housing fina nce regula tor - Nationa l Housing Ba nk in The era a lso involved the government in directing va rious a gencies like insura nce compa nies, commercia l ba nks (Under priority lending requirements which a llowed banks to a lloca te 1. 5% of their incrementa l deposits to housing under RBI guidelines.), provident funds a nd mutua l funds to invest pa rt of their increment sources on housing. Two Insura nce companies, LIC a nd GIC, started supporting the sector both directly through their newly esta blished housing fina nce compa nies a nd indirectly by investing a proportion their net a ccretions in socia lly-oriented schemes. The fourth pha se is the era a fter libera liz ation a nd is chara cteriz ed by drama tic cha nges in pricing of loa ns. Before 1994, the pricing of home loa ns were regula ted by the NHB based on a differential ra tes cha rged a ccording to the siz e of the loa n. This policy wa s a mended in 1994 a nd providers were free to cha rge market ra tes for the loa ns a bove ` 25, 000. The fourth pha se sa w a domina nce of fixed interest ra tes, but va ria ble rate offers sta rted emerging a t the end of the decade. The fifth pha se of ra pid growth in the sector sta rted a fter the millennium. Home loan disbursements ra pidly grew during the first few yea rs of this phase.

278 Housing Finance 271 The lower interest ra te regime, rising disposa ble incomes, sta ble property prices a nd fisca l incentives ma de housing fina nce a n a ttra ctive business. Home loa n disbursements grew to ` 7,68, million in 2005 from ` 1, 47, 012 million in As per CRISIL estima tes, housing fina nce disbursements a re estimated to ha ve grown by a round 16. 1% in Fisca l 2012 to ` 2,044 billion ( a s compared with ` 1, 760 billion in Fisca l 2011). THE STRUCTURE OF HOUSING FINANCE SECTOR IN INDIA Ea sy a ccess to institutiona l fina nce a t a fforda ble ra tes is a critica l requirement for a dyna mic housing sector. W hile several financia l institutions a re involved in providing housing fina nce, the need for specia liz ed housing fina nce institutions for mobiliz a tion of resources a nd grea ter effica cy ca nnot be overempha siz ed, given the distinctive na ture of housing fina nce. The broa d structure of the India n housing fina nce system is shown in the cha rt below. The housing fina nce system in India comprises the National Housing Ba nk (NHB), the a pex housing institution which regula tes the housing-related functioning of other fina ncia l institutions such a s the HDFC, HUDCO, LIC, GIC a nd a host of HFCs a nd commercia l ba nks. Depending upon whether housing fina nce comprises their prima ry or seconda ry function, these institutions ca n be cla ssified into two ca tegories, na mely, specia liz ed housing finance institutions a nd general housing fina nce institutions (HFIs). HOUSING FINANCE SYSTEM IN INDIA Both central and state Governments have undertaken various schemes and put in place various reforms / measures for facilitation of improving and enhancing the level of housing in India GENERAL HOUSING FINANCE INSTITUTIONS SPECIALIZED HOUSING FINANCE INSTITUTIONS LIC G I C P RO V I D E N T BAN KS F U N D S N H B H D F C H U D C O H F C s C O - O P H F C s CO MMERCIAL CO-OPERAT IVE R R B s A RD B s BAN KS BAN KS General Housing Finance Institutions The genera l HFIs are called so a s they lend only a sma ll proportion of their funds for housing. Either regula tions do not permit them to lend beyond certa in limits or their prima ry function is other tha n housing fina nce. The foremost a mong these is the Life Insurance Corporation of India. 1. Life Insurance Corporation of India and General Insurance Corporation The Life Insura nce Corpora tion of India (LIC) a nd the Genera l Insurance Corpora tion (GIC) provide support to housing a ctivity directly a s well a s indirectly. The former is statutorily required to invest 25% of its net a nnua l a ccrua l in socia lly-oriented schemes which includes housing. LIC undertakes

279 272 Banking and Financial Services After the setting up of NHB in 1988, public insurance companies and the Scheduled Commercial Banks (SCBs) floated separate HFCs to avail the NHB s refinance facilities and tax concessions. projects of public residentia l housing in selected cities. Both LIC a nd GIC gra nt loans for the rural housing programmes of the State Governments and Sta te level Apex Cooperative Housing Fina nce Societies. LIC a lso subscribes to the bonds issued by HUDCO a nd the SHBs. It also lends to the NHB. Policyholders of LIC a re a lso extended the facility of loa ns. LIC is presently the single la rgest institutiona l lender to the housing sector. It invests a bout 12% of its total credit disbursa l to the housing sector la rgely indirectly through a gencies a nd institutions a s mentioned a bove. In June 1989, LIC promoted the LIC Housing Fina nce Company Limited a s its subsidiary. It wa s set up with the a im of supplying long term fina nce for purchase or construction of housing units to LIC policyholders in India. The Genera l Insura nce Corpora tion started its housing fina nce rela ted a ctivities in GIC and its subsidiaries a re statutorily required to dedica te 35% of their new funds in ea ch year for housing purpose. These funds flow to the housing sector indirectly through loa ns to state governments, HUDCO a nd other development a uthorities. It invests in bonds a nd debentures of these a uthorities tha t underta ke housing a ctivities. 2. Provident Funds Housing fina nce funds a re a lso ma de a va ila ble by the Provident Funds to its subscribers. In a wa y, they lend liquidity to the sa vings a ccumula ted in the a ccounts of the subscribers. Provident Funds such a s the Genera l Provident Fund, the Public Provident Fund a nd the Contributory Provident Fund finance the house purcha se of their members by gra nting adva nces or permitting pa rtia l withdra wa ls of their subscriptions. However, only a bout one per cent of their tota l a ccumula ted funds a re used for housing purpose. 3. Commercial Banks The commercial ba nking sector consists of public sector ba nks a nd priva te sector domestic a s well a s foreign ba nks. Traditiona lly, the mortga ge ma rket in India had been domina ted for ma ny yea rs by a diverse group of Housing Finance Compa nies (HFCs), with some focusing on specific regions in India a nd others ta rgeting specific consumer segments. The ba nking sector wa s not involved in housing credit, its role perceived to be limited to providing for the working ca pita l needs of industry a nd tra de. Besides, commercial ba nks face the typica l issue of misma tch between a ssets and lia bilities with rega rd to their ma turity term. It wa s only after na tiona liz a tion of ba nks in 1969, tha t social needs of the community were incorporated into the norma l course of business of the commercia l banks. The Reserve Ba nk of India initia lly encoura ged the commercia l banks to gra nt credit to the housing sector in the form of 'directed credit.' Under directed lending, the ma jor portion wa s provided in terms of subscribing to the bonds a nd debentures of HUDCO and SHBs, which were guara nteed by the government, a nd in the form of direct lending to individua ls a nd groups of borrowers belonging to the scheduled ca stes, scheduled tribes a nd the EW S. The rema ining a mount wa s contributed to HDFC. The na tiona liz ed ba nks a lso fina nced housing projects independently or through a consortium formed with other ba nks, HUDCO, LIC, SHBs and other bodies. Directed lending essentially mea nt tha t ba nks were ma nda ted to lend to housing finance intermedia ries a t subsidiz ed ra tes. The commercial ba nks' housing finance

280 Housing Finance 273 a ctivities take three discrete modes: direct lending in terms of home loans; indirect lending through a pproved housing fina nce compa nies or Sta te housing boards which lend the funds; a nd investments in mortga ge ba cked securities (MBS) issued by housing fina nce compa nies. 4. Other Banks As fa r as Co-operative Ba nks a nd the Regional Rura l Banks are concerned, they ha ve not been very a ctive in lending for housing although they a re a llowed to. Agriculture a nd Rural Development Ba nks (ARDBs) a re term lending institutions operating exclusively in the rura l sector. Though housing finance wa s a t first not within their scope, with the importa nce a tta ched to the housing sector in the la te eighties, especia lly a fter the setting up of the NHB, ARDBs started lending for housing in the rural a reas. In the yea r 2000, there were 19 ARDBs in the country opera ting through their own bra nches or through those of the prima ry coopera tive a griculture a nd rural development ba nks. Specialized Housing Finance Institutions Specia liz ed HFIs are those whose prima ry function is to lend for housing. W hile there are market oriented specializ ed HFIs involved in the business of home loans, the government ha s a lso set up specia lized HFIs in the public sector with the primary purpose of improving the housing situa tion in India by underta king housing projects, fina ncing house construction/ purcha se a ctivities a nd providing technical a nd financia l a ssista nce to va rious sta ke holders in the housing ma rket. 1. Housing and Urban Development Corporation (HUDCO) Housing and Urba n Development Corpora tion is a specializ ed HFI set up in 1970 as a public sector apex body with the basic objective to fund state governments in infrastructure development and to serve the shelter needs of the poor sections of the society. It finances a nd undertakes housing and urba n development programmes in the country by building satellite towns, providing finance to building materials industries, conducting research in low cost housing, etc. It also undertakes consultancy in the areas of housing a nd urban development. W ith a special focus on the economica lly weaker sections of the society, HUDCO pra ctices progressive interest rate policy wherein the ra tes of interest on home loa ns a re va ried between 4 to 15 per cent, a ccording to the income levels of borrowers. It extends the benefit of longer repa yment fa cility for the poor. Out of its tota l disbursal of home loa ns, it ensures tha t a higher proportion goes to the poor. It thereby seeks to foster grea ter equity a nd distributive justice a mong households belonging to different income cla sses. Indian HFCs have outperformed its peers on expectations of (a) stable balance sheet growth (b) adequate capital (c) comfortable asset quality and (d) superior return ratios. 2. Housing Development Finance Corporation (HDFC) One of the most importa nt specia liz ed HFI is the Housing Development Fina nce Corpora tion (HDFC) which wa s esta blished in 1977 as a priva te sector institution with the purpose of providing long term loa ns to home buyers. In fa ct, priva te sector pa rta king in reta il housing fina nce that provided housing loans to individua ls, cooperative societies and the corpora te sector, initiated

281 274 Banking and Financial Services with the establishment of HDFC. It ra ises long term funds from institutiona l sources. It ha s a lso entered into interna tiona l syndica tion. The USAID a nd Aga Khan Founda tion provide funds to HDFC for its housing fina nce a ctivities. HDFC ha s pla yed a significa nt role in promoting the esta blishment of The noticeable aspect is that there are only about 20 housing finance companies accounting for greater than 90% of total housing loans provided in India. 3. Housing Finance Companies (HFCs) The non-ba nking fina nce compa nies (NBFC) entered into the housing fina nce sector by incorpora ting a s Housing Fina nce Compa nies. A NBFC is classified a s a HFC if its principa l objective is to provide housing finance or in the ca se of competing objectives, where housing fina nce figures a s the major component of the compa ny' s a sset. In the mid a nd la te 1980s, HFCs were set up a s priva te limited compa nies like the Dewa n Housing Fina nce Limited or a s joint ventures with sta te governments like the Guja ra t Rural Housing Fina nce Corpora tion, or banksponsored HFCs like Ca n Fin Homes, SBI Home Fina nce, PNB Housing Fina nce, etc. State owned insura nce compa nies like the LIC a nd the GIC a lso set up their own housing fina nce subsidia ries. Some other HFCs are Globa l Home Fina nce Ltd., Birla Home Fina nce Ltd., Ta ta Home Fina nce Ltd., Ma harshi HFC Ltd., Para shwana th HFC, etc. W hile there a re close to 400 HFCs, 95% of the tota l housing loa ns sa nctioned by them are provided by 29 major compa nies. Some of the a bove mentioned HFCs were later merged with their pa rent banks or ha ve been a cquired by some other fina ncial institutions. The ma jor sources of funds for HFCs include loans from ba nks, debentures, fixed deposits a nd refina nce from the NHB. The problem of misma tch of a sset-liability a s they typica lly depended on public deposits a nd the genera l financia l institutions for funds wa s resolved to some extent with the esta blishment of the NHB. The NHB provided refinance assista nce which wa s synchronous with the repa yment tenure fixed by the HFCs for the ultimate borrower. Nevertheless, this does not solve the issue of sufficient long-term funds for the specia lized institutions a s there is a limit to which NHB ca n fund the entire portfolio of these compa nies. The eligibility for a pprova l of refina nce fa cility is that a minimum of 75% of the ca pita l employed should ha ve been by wa y of long-term fina nce for housing. Currently, 54 HFCs a re registered with the NHB. 4. National Housing Bank (NHB) The growing presence of private sector institutions necessita ted the establishment of a regulatory and supervisory agency specia liz ing in the furtherance a nd financial functions of housing finance. This role was being played by the RBI. Despite the la rge number of agencies providing housing finance to individuals, the flow of funds through formal institutional finance was not found to be a dequate. The housing sector was underserved in terms of the volume of loans to individua ls, sufficient serviced land, building materials, and effective low-cost technology. Na tiona l Housing Bank was instituted in July 1988 under an Act of Parlia ment (NHB Act, 1987) to crea te the desired system. The role of NHB ca n be divided under three hea ds, na mely, promotiona l a nd developmenta l function, regula tory function a nd financia l function. The funda menta l responsibility of the NHB is to develop a hea lthy and self-sufficient housing fina nce system in the country. For this, it sought to set up more loca l

282 Housing Finance 275 a nd regiona l level specia liz ed institutions so a s to have committed outlets for the supply of housing credit. These institutions, NHB believed, would be a ble to ta ilor forma l credit for the differing needs of va rious income groups. Households with a bove a vera ge income could well be served by ma rket based HFIs opera ting under manda tory prudentia l norms by the regula tor. The below poverty line households on the other ha nd, would need a n institutiona l approach to housing that not only incorpora tes the fa ctor of subsidy but tha t a lso integrates employment a nd poverty alleviation progra mmes. The middle income group comprising the low a nd moderate income households, a nd constituting nearly ha lf the total number of households a lso need to be catered. For this the NHB provides refina nce schemes to encoura ge the fina ncia l institutions to lend. 5. Co-operative Housing Finance Societies Co-operative Housing Fina nce Societies represent the third ca tegory of institutions in the structure of institutiona l housing fina nce intermediaries, the other two being, the commercia l banks and the HFCs. Among the three, cooperative societies are the most inclusive in terms of ca tering to the credit requirements of the common ma n; however they a re becoming insignificant with ea ch pa ssing year. Co-operative housing finance societies ha ve a two tier structure that includes the apex co-opera tive housing finance society at the state level and the primary co-operative housing fina nce society a t the reta il level. There are 26 state level a pex co- opera tive societies a nd more tha n 90, 000 registered coopera tive housing finance societies in the India. NHB provides fina ncial assista nce and support to help them cater to the housing needs of the community. Total Disbur se me nt of Housing Loan to Individuals by Housing Financ e C ompa nie s (` in crores) Co-operative housing finance societies are specialized institutions established and subsidized by NHB to cater to the housing needs of the masses P a r t i c u l a r s % to Total % to Total Upto ` 2,00, Above ` 2,00,000 and upto ` 5,00,000 1, , Above ` 5,00,000 and upto ` 10,00,000 9, , Above ` 10,00,000 and upto ` 15,00,000 9, , Above ` 15,00,000 and upto ` 25,00, , , Above ` 25,00, , , T o t a l 6 8, , (Sou rce: An nual Report of NH B) KEY FEATURES OF HOUSING FINANCE The following a re some of the key fea tures of housing fina nce different ba nks/ fina ncial institutions to Individua ls provided by No ca p on ma ximum loa n amount for purchase/ construction of house/ flat Option to club income of spouse a nd children to compute eligible loa n a m o u n t

283 276 Banking and Financial Services Repayment of housing loan is permitted upto 70 years of age Provision to club expected rent a ccrua ls from property proposed to compute eligible loa n a mount Provision to fina nce cost of furnishing a nd consumer dura bles a s pa rt of project cost Free persona l a ccident insura nce cover Optiona l Group Insura nce from insurance compa nies a t a concessiona l premium (Upfront premium financed a s part of project cost) Interest a pplied on da ily diminishing ba lance basis Different schemes which offer attra ctive pa cka ges with concessiona l interest ra tes to Govt. Employees, Tea chers, Employees in Public Sector Compa nies, etc. Specia l scheme to gra nt loa ns to fina nce Ea rnest Money Deposits to be pa id to Urba n Development Authority/Housing Board, etc., in respect of a llotment of sites/ house/ fla t No Administra tive Cha rges or a pplication fee Prepa yment pena lty is recovered only if the loa n is pre-closed before ha lf of the original tenure (not recovered for bulk pa yments provided the loa n is not closed) Provision for downwa rd refixation of EMI in respect of floa ting ra te borrowers who a va il Housing Loa ns of ` 5 la cs and a bove, to a va il the benefit of downwa rd revision of interest ra te by 1% or more In-principle approva l issued to give you flexibility while negotia ting purcha se of a property Indian Housing Finance Industry Reserve Bank of India

284 Housing Finance 277 TYPES OF HOUSING FINANCE Home loans a re a n attra ctive and popula r mea ns of buying a drea m house for most people. In India, the dema nd for home loa ns ha s increa sed ma nifold in the la st deca de. Everyday numerous people a pply for home loa ns to own a perfect a bode for themselves. The fa ct that home loans come with a dded a dva ntages (like tax benefits) is the icing on the cake. Lenders provide home loans not only for buying houses but for a variety of rela ted purposes. The home loa ns ma rket is brimming with diverse home loa n products which ca ter to different needs of individua l customers. The following a re some popula r types of home loa ns ava ilable in the India n housing finance ma r k e t : 1. Land Purchase Loans La nd purcha se loa ns a re ta ken to buy a plot of la nd on which a borrower wishes to construct his house. Most banks offer up to 85 per cent of the price of the la nd. Almost a ll leading ba nks offer this loa n like ICICI Ba nk (La nd Loan), Axis ba nk (Loan for la nd purcha se) etc. Land purchase loans can be availed for residential as well as for investment purposes. 2. Home Purchase Loans The home purcha se loa ns are the most popula r a nd the most commonly a vaila ble home loan va ria nts. These loa ns can be used to fina nce the purcha se of a new residential property or an old house from its previous owners. In this type of loa n a lso, lenders usua lly fina nce up to 85 per cent of the ma rket value of the house. These loans a re provided either on fixed interest ra tes or floa ting interest ra tes or as hybrid loa ns. All ba nking institutions a nd housing finance compa nies provide this type of loa n. 3. Home Construction Loans These loans can be a va iled by those individua ls who wa nt to construct a house a ccording to their wishes ra ther tha n purcha sing a n alrea dy constructed one. The loa n a pplica tion a nd a pprova l process for home construction loa ns a re somewha t different from those of the commonly a va ila ble housing loans. The plot of land on which the borrower wishes to construct the house should ha ve been bought within a yea r for the cost of the la nd to be included as a component for ca lcula ting the tota l price of the house. If the plot ha s been purcha sed more than a yea r ago, then the a bove cla use is not a pplicable. The borrower ha s to ma ke a rough estima te of the cost tha t will be incurred for the construction of the house a nd then a pply for the loa n with the sa me a mount. The lender then takes over and a na lyses the a pplica tion to decide whether or not to sa nction the loan. The a pprova l or disa pprova l of the same is intima ted by the lender to the a pplica nt. The loa n a mount ma y be disbursed a t one go or in severa l installments a ccording to the progress in the construction of the house. Ba nks like Ca na ra Ba nk, UCO Ba nk, Ba nk of Ba roda provide these loans.

285 278 Banking and Financial Services 4. Home Expansion/Extension Loans Home expa nsion or extension loa ns are useful in situa tions when people wa nt to expa nd their existing house. Expa nsion includes a ltera tion in the current structure of the residence to a dd extra spa ce such a s constructing a new room, a floor, a bigger bathroom or enclosing a ba lcony. Though ma ny ba nks provide loa ns for these purposes a s part of home expansion loa ns, some banks lend for the sa me purposes a s pa rt of their home improvement loa ns. It depends on how a ba nk ha s ca tegoriz es its loa ns. Some popula r ba nks which provide home expa nsion loa ns a re HDFC Ba nk (HDFC Home Extension Loa n), Ba nk of Ba roda, etc. Housing loans are generally given at floating rate and are directly linked to the base rate of the Bank. 5. Home Improvement Loans Home improvement loans a re a va iled by individuals who a lrea dy own a house but la ck the funds to renova te it. All kinds of renova tions a nd repa ir works can be fina nced using this varia nt of home loa ns such as interna l a nd externa l pa inting, externa l repa ir works, electrica l work, wa terproofing a nd construction of underground or overhea d wa ter ta nk, etc. ICICI Ba nk, Vija ya Ba nk a nd Union Ba nk of India a re a mong those ba nks which provide specia liz ed home improvement loans. 6. Home Conversion Loans Those borrowers who ha ve a lrea dy purcha sed a house by ta king a home loa n but now wa nt to buy and move to a nother house opt for the home conversion loans. Through these loans, they ca n fund the purcha se of the new house by transferring the current loan to the new house. There is no need to repa y the loan on the previous home. Though useful, this segment of home loa ns is a ccused of being quite expensive. This housing fina nce scheme is provided by HDFC Ba nk a mong others. 7. NRI Home Loans NRI home loa ns is a specia lized home loa n va ria nt which ha s been developed to a ssist non-residents in acquiring housing fina nce to buy residentia l property in India. These loa ns are mea nt exclusively for the non-resident India ns. The forma lities of a vailing this segment of home loans is simila r to the regula r home loans which are offered to residents, only the pa perwork is a bit ela bora te. Almost a ll public a nd priva te sector ba nks provide NRI home loans. 8. Balance Transfer Loans Ba la nce tra nsfer option ca n be a va iled when an individual wa nts to tra nsfer his home loa n from one ba nk to a nother ba nk. This is usua lly done to repa y the rema ining a mount of loa n a t lower interest ra tes or when a customer is unhappy with the services provided by his existing lender a nd wa nts to switch to a nother lender. Ba nks such a s Deutsche Ba nk, ICICI Bank, Kota k Ma hindra Bank offer this fa cility a mong other lenders. 9. Stamp Duty Loans Stamp duty loans a re provided to pay off the sta mp duty cha rges on the purcha se of a property. The a mount from this loa n ca n be used solely for this purpose. This segment of home loa ns ha s yet not ga ined much popula rity.

286 Housing Finance Bridge Loans Bridge loa ns a re short-term loa ns which a re mea nt for people who a lrea dy own a residentia l property but a re pla nning to buy a new house. It helps borrowers to fund the purcha se of the new house until a buyer is identified for the old house. It is extended for a period of less tha n two years a nd requires the mortga ge of the new house with the lender. Some ba nks offering this type of loan a re Vijaya Bank, HDFC Ba nk etc. Docume nts Re quir e d for Appr oval of home Loans: Busine ssm an/ Self- e mploy ed 1. Applica tion form with photogra ph 2. Educa tiona l qua lifica tion 3. Identity a nd residence proof Profe ssional 4. Proof of business existence with business profile and last three yea rs income ta x return 5. La st 3 yea rs income sta tement a nd ba la nce sheet. 6. La st 3 month's persona l a nd business bank statements. 7. Processing fee check Salarie d c ustome rs 1. Applica tion form with photogra ph 2. Identity a nd residence proof 3. La test sala ry slip 4. F o r m La st 6 months ba nk' s sta tement 6. Processing fee cheque. Important Housing Finance Companies in India Birla Home Fina nce Limited BOB Home Loa n Canara Bank Home Loan Dewa n Housing Home Loa n GIC Home Loa n HDFC Home Loa n HSBC Home Loa n ICICI Home Loa n IDBI Home Loa n LIC Home Loa n PNB Home Loa n The HFCs primarily depend on loans from banks and financial institutions besides their own funds, i.e., equity and reserves.

287 280 Banking and Financial Services SBI Home Loa n Sunda ra m Home Finance MERITS AND DEMERITS OF HOUSING FINANCE HFC NPAs have declined from more than 4% in FY04 to less than 0.75% in FY12 due to efficient loan appraisal system, robust recovery mechanism, and riskaverse profile of borrowers. Merits of Home Loan Home Loa n helps ma ny people to own their drea m home Home Loan improves housing a nd infra structure development in the c o u n t r y. Interest cha rged on Home Loa n is very rea sona ble. Home Loa n interest and principal repa yments a re eligible for Income Ta x sa vings. Ma ny unique schemes like insura nce cover is a va ila ble with Home Loa n Longer repa yment is a llowed on home loan ( upto 20 years) Demerits of Home Loan Amount of Home Loan repa yment ( EMI) becomes more with the increase in interest rate, especia lly when loa n is ta ken on floa ting interest ra tes. There is no uniformity in interest ra tes charged by different ba nks. Ea sy a va ila bility of Home Loa n ha s led to a tremendous increa se in prices of property OVERVIEW OF HOUSING FINANCE INDUSTRY IN INDIA India' s housing fina nce industry ma inly comprises ba nks a nd HFCs, a nd to a certa in limited extent, sma ller institutions such a s community-based orga nisations, self-help groups, etc. The NHB opera tes a s the principal a gency for promoting, regula ting a nd providing financia l a nd other support to HFCs a t loca l a nd regiona l levels, while ba nks and NBFCs are mana ged a nd regulated by the RBI. As of February 5, 2013, 56 compa nies ha ve been gra nted certificates of registra tion by NHB to act a s HFCs Historica lly, the housing fina nce industry was domina ted by HFCs. However, towa rds the end of the 1990s, the scheduled commercia l ba nks beca me very a ctive in lending to the housing sector in the ba ckdrop of lower interest ra tes, rising disposa ble incomes, sta ble property prices a nd fisca l incentives by the g o ve r n ment. W hile banks depend on their own equity and reserves a nd la rge deposit ba se for funding their housing loa n portfolios, HFCs prima rily depend on funding sources such a s loa ns from ba nks a nd financia l institutions, fina ncing from NHB, borrowing through bonds a nd debentures, commercia l pa per, subordina te debt and fixed deposits from public, besides their own equity a nd reserves. Increa sed competition in the housing fina nce industry ha s a lso led to the introduction of new mortga ge products in the ma rket, such a s va riable interest ra te loa ns, loa n for repa irs a nd renova tion, a nd customised products

288 Housing Finance 281 with features like ba llooning EMI, depending on the need a nd eligibility of the borrowers concerned. In a ddition, some ba nks a nd HFCs also offer home equity loa ns (loa ns a gainst the mortgage of existing property), which ma y be used for non-housing purposes. The va rious aspects of Indian housing fina nce industry is discussed b el ow. Disbursements As per CRISIL estima tes, housing fina nce disbursements a re estima ted to ha ve grown by a round 16.1% in Fisca l 2012 to Rs 2,044 billion (a s compared with ` 1,760 billion in Fisca l 2011). Increa se in transa ction volumes, rise in property prices and higher loa n to value ("LTV") ratios a re some of the key drivers behind the growth in disbursements in the housing fina nce industry. Outstanding Loans The qua ntum of outsta nding loa ns is impacted by a combina tion of disbursements, repa yments a nd pre-pa yments. As per CRISIL estima tes, housing fina nce outsta nding portfolio, i.e., the tota l loa n book of a housing finance player, grew by a round 19% Y-o- Y in fisca l 2012 ( to ` 6, billion a s compa red with ` 5, billion in fisca l 2011), due to a stea dy growth in disbursements a nd lower prepayments. The housing fina nce outsta nding portfolio is expected to grow at a CAGR of 17% to rea ch ` 13, billion in fiscal 2017 Over the next 3 years, housing finance disbursements are projected to grow at a CAGR of 16% to reach ` 4,269 billion by Fiscal Growth in Housing Stock For the housing fina nce industry to grow, there ha s to be a n a va ila ble stock of houses, which can be mortga ged. Any growth in this ava ilable stock of houses will provide a dditiona l impetus to the growth of the housing finance industry. The a nnua l a ddition to housing stock in India pea ked in Fiscal 2008 a fter a period of continued growth driven by increase in demand, especia lly in urba n a rea s. As per CRISIL Resea rch, housing stock is estima ted to grow a t a CAGR of 2. 3% over the next five yea rs ( Fisca l fisca l 2016) with a higher growth expected in the urba n segment ( CAGR of 3. 3% from fiscal fiscal 2016) a s compa red to the rura l segment ( CAGR of 1. 8% from fisca l fiscal 2016). The sha re of rura l housing stock, as a percenta ge of tota l housing stock is expected to fa ll ma rgina lly by fisca l 2016 a s compa red to fisca l 2011 on a ccount of increa sing migra tion from rura l to urba n regions beca use of better job oppo r t uni t i es. Interest Charged on Housing Finance Fluctua ting Home Purcha se Loa ns Interest ra tes: Keep cha nging with change in the prevailing ma rket rate or the prime lending rate. Fixed Loa ns Interest Ra te: As the na me suggests, do not cha nge during the entire loan period, irrespective of the preva iling ma rket rate. genera lly fixed loa n interest ra tes a re higher tha n the fluctua ting loa n r ate.

289 282 Banking and Financial Services Home Loan Interest Rates of SBI With effect from Loan Am ou n t Up t o ` la c s Above ` la c s Interest charged by S BI On housing loan (w.e.f ) F or Wom e n Borrowe rs Sp read ove r t h e Ba s e Rat e (Ba s e Rat e : 1 0 %) 10 bps a bove th e Ba se Ra te 25 bps a b ove th e Ba se Ra te Effe c t ive Rat e % p.a % p.a. No Fixed Ra te option will be a va ila ble in a n y lim it bra ckets. F or ot h e r Borrowe rs Sp read ove r t h e Ba s e Rat e (Ba s e Rat e : 1 0 %) 15 bps a bove th e Ba se Ra te 30 bps a bove th e Ba se Ra te Effe c t ive Rat e % p.a % p.a. Loan for purchase/construction of new house constitute more than 80% of total housing finance in India Key Trends in the Housing Finance Industry in India 1. HFCs Gaining Market Share Over the yea rs, the ma rket sha re of housing fina nce compa nies (HFCs) ha s significa ntly improved v is-à-v is banks on a ccount of robust growth in disbursements of the former. In recent times, with slowdown in corpora te credit, ba nks a re a ggressively focusing and competing with HFCs in the home loa n segment. However, with strong origina tion skills a nd diverse channels of sourcing business, HFCs will continue to ga in ma rket share. 2. Focus on Salaried Segment, Self-employed Borrowers Ignored Historica lly ba nks a nd HFCs ha ve la rgely focused on the sa laried cla ss, a s ca n be seen by the fa ct tha t sa la ried borrowers a ccount for 80-85% of the tota l outsta nding loa ns. The key reason behind this skew towa rds the sa la ried segment is the ea se in va lidating the income levels a nd the repa yment ca pa bilities of sala ried borrowers v is-à-vis self-employed persons. Further, lenders ha ve tra ditiona lly viewed the sa la ried segment a s one with stable ca sh flows a nd, hence, consider it a s lower risk. However, this ha s a lso resulted in the self-employed borrowers being la rgely ignored by the organised lenders, forcing them to rely on persona l loa ns or loans from unorga nised sources a t higher interest ra tes. 3. HFCs have been able to Maintain Net Profit Margins According to CRISIL, HFCs, despite having a higher cost of funds as compared to ba nks, ha ve been a ble to mainta in compa ra ble gross sprea ds a nd with improved efficiencies, lower opera ting costs and better risk ma na gement practices, have a net profit ma rgin slightly higher tha n the ba nks. As per their estima tes, HFCs a re expected to ma inta in a net profit margin of % of loan book a s a ga inst banks at % of loa n book based on incrementa l d i s b u r s e me n t s.

290 Housing Finance Diversification of Sources of Funds by HFCs The typica l funding sources for HFCs include ba nk loa ns, non-convertible debentures (" NCD"), fixed deposits, a nd commercia l pa pers, NHB refina ncing a nd other loa ns. Larger HFCs ha ve been able to build a more diverse funding base due to their superior credit ra ting a nd their a bility to ta rget the NCD ma rket for funds. In contra st, sma ller HFCs have levera ged the NHB refina nce fa cility for priority sector/ rura l lending, which is offered at lower tha n market interest ra tes. This ha s helped the sma ller HFCs to compete with ba nks a nd la rger HFCs by reducing their cost of funds. 5. Floating Rate Loans Account for Bulk of Market All housing loa ns in India typica lly carry a fixed interest ra te or a floa ting interest ra te. A fixed rate loan is one where the rate of interest rema ins consta nt throughout the tenure of the loa n or for a specific number of yea rs. W herea s, in a floa ting rate loa n, the borrower pa ys interest a t a ra te that is linked to the benchma rk prime lending ra tes of fina nciers. The rate cha rged on fixed ra te loans is genera lly higher than that charged on floa ting ra te loa ns, due to the higher interest ra te risk in ca se of the former. Due to the long-term na ture of the housing loa ns a nd medium- term na ture of the lender' s lia bilities, lenders prefer to lend a t floa ting ra tes, a s it a llows them to re-price the loa ns a s a nd when their cost of funds increa ses. The proportion of floa ting ra te loa ns ha s been increa sing for the la st severa l yea rs, primarily due to the indirect push from the lenders side by wa y of a higher sprea d between fixed ra te loa ns a nd floa ting ra te loa ns, which in some ca ses wa s a round 275 bps. Post , the rising interest ra te scena rio ma de borrowers opt for floa ting ra te loa ns in a nticipation of reduction or sta biliz ation of interest rates in the la ter years. According to CRISIL, the proportion of floating rate loans is expected to continue rising and reach around 97% in fiscal HOME LOAN PRODUCTS OFFERED BY SBI The following ar e the some of the home loan pr oduc ts offer e d by SB I, large st bank in India. A. SBI Maxgain (Home Loan as an Overdraft) An innova tive a nd customer-friendly product ena bling the customers to ea rn optima l yield on their sa vings by reducing interest burden on Home Loans, with no extra cost. The loa n is sa nctioned a s a n Overdra ft with a dded flexibility to operate the Home Loa n Account like SB or Current Account. Ba nk also provides Cheque Book/ Net Ba nking fa cility for the purpose. The product ena bles customers to pa rk their surplus funds/ savings in "SBI Ma xga in" (with a n option to withdra w whenever required), especia lly in the wa ke of low yields on other Deposit/Investment products. Loan Amount Minimum Loa n Amount: `5 la cs Ma ximum Loa n Amount: No Ca p

291 284 Banking and Financial Services Interest Rate A premium of 0. 25% over a nd a bove the applica ble Home Loa n interest ra te for Home Loa n a bove `1 crore is pa yable. B. SBI Yuva Home Loan (Tailor-made Home Loan Scheme for the Youth) SBI YUVA Home Loa n provides 20% higher loan a mount tha n tha t of norma l Home Loan eligibility to Sa la ried employees of Priva te Sector Compa nies/ MNCs/ Government Underta kings/psus a nd the Government employees. Eligib ility Age between 21 yea rs to 45 years. Minimum Net Monthly Income of a pplica nts should be ` 30, 000/- (expected renta l income from the proposed property should not be included in the monthly income of the borrower). Out of total individual housing loans disbursement, maximum loan was disbursed in the State of Maharashtra followed by Tamil Nadu Repayme nt Under SBI Yuva Home Loa n Scheme, only the interest applied on Home Loan is pa ya ble during the first 36 months. The regular EMIs start a fter completion of 36 months. 3. NRI Home Loans (Home Loans to Non Resident Indians (NRIs) & Persons of Indian Origin (PIOs) Eligib ility Non Resident Indians (NRIs) or Persons of India n Origin(PIOs) The a pplica nts should have a regular source of income. Minimum employment tenure in India/Abroad should not be less tha n 2 yea rs. Loan Amount Minimum Loan Amount: ` 3 la cs, Ma ximum Loa n Amount: No upper ca p. 4. SBI Realty (Home Loans for Purchase of Plot for Construction of a Dwelling Unit) SBI Rea lty provides a n opportunity to the customer to purchase a plot for construction of house. The construction of house should commence within two years from the date of a vailment of "SBI Realty Loan". Customers are also eligible to a va il a nother Home Loa n for construction of house on the plot fina nced under the SBI Rea lty with the benefit of running both the loa ns concurrently. Loan Amount: Re payme nt Pe r iod: Ma ximum Loa n Amount: `10 crores Upto 15 yea rs 5. SBI Pal (Pre-approved Home Loan) The SBI PAL provides sa nction of Home Loa n limits to the customers before fina liz ation of the property which ena bles them to negotia te with the Builder/ Seller confidently. The loa n eligibility will be a ssessed on the basis of income

292 Housing Finance 285 deta ils of the a pplica nt. Non-refunda ble processing fee a s a pplica ble to the Home Loan will be collected a t the time of sa nction. Validity Period Pre-a pproved loa n arra ngement letter (PLAL) will be va lid for a period of 4 months. Property papers will be required to be submitted by the borrower within the va lidity of PLAL. Processing fee will not be levied a gain. Loan Amount Pre-a pproved loa n a rra ngement letter (PLAL) will ca rry the eligible loa n a mount ca lcula ted on the ba sis of prevailing interest ra tes. Minimum Loa n a mount: `10 La cs. 6. SBI Tribal Plus (Special Home Loan Scheme For Hilly/Tribal Areas) ' SBI Triba l Plus' is a Specia l Home Loa n Scheme designed for Hill/ Triba l a rea s (where mortga ge of the property is not possible) for extending fina ncia l a ssista nce to individua ls. Loa n is sa nctioned for Purcha se or construction of a new house/ flat ( without mortga ge of la nd), Purcha se of a n existing ( old) house/ flat which is not more tha n 10 yea rs old a nd Repa ir/ Renova tion/ extension of a n existing house or fla t. Loan Amount Minimum Loa n Amount: Nil Ma ximum Loan Amount: ` 10 la cs Repayment Period Ma ximum repa yment tenure: 15 yea rs From the last few years, HFCs disbursements towards builders for their housing loan projects has been increasing. 7. Gram Niwas (Home Loans in Rural Areas) Scheme covers a ll Rura l a nd Semi-urba n centres ha ving popula tion upto 50,000 a s per 2001 census. Home Loa ns under " Gra m Niwa s Scheme" a re sa nctioned for purcha se/ construction/ repair a nd renova tion of house a nd purcha se of plot for construction of a house/ shed, etc. Loan Amount Minimum Loa n Amount: Nil Ma ximum Loa n Amount: ` 5 la cs Repayment Period Ma ximum repa yment period : 15 yea rs (Processing Cha rges a re wa ived under the Gra m Niwa s Scheme) 8. Sahyog Niwas (Home Loans to Self-help Groups in Rural Areas) The Sa hyog Niwa s Scheme provides Home Loa n to Self-help groups, ha ving good pa yment record of 2 years, for on lending to their members for Purcha se or construction of a house exclusively or including the housing needs of

293 286 Banking and Financial Services a ctivities ca rried by them ( Dairy shed, ta iloring shed/ shop, grocery stores, etc.) or for Renova tion or repa ir of an existing house/ shed or purcha se of a plot for the construction of house Loan Amount Home Loan amount under "Sa hyog Niwas Scheme" is restricted to 10 times of the saving corpus of SHG subject to a maximum amount of ` 50,000/ per member. BRIEF PROFILE OF HUDCO AND NHB As far as loan slab- wise disbursement of housing loan to builders is concerned, maximum disbursement was made to the builders in the loan slab of ` 25 crores and above Housing and Urban Development Corporation Housing and Urban Development Corporation Limited established on April 25, 1970 is a n organiza tion fully owned by the Government of India. The government institution cha nnelized their housing fina nce to HUDCO, as a financial technica l institution to bring resourcing power to housing boa rds a nd development a gencies under the jurisdiction of the sta te government with limited resources at its disposal HUDCO's performa nce, had been impressive. The project fina nce by HUDCO provided homes to three millions fa milies in India in year Also, most of the allocation went to the LIG. Moreover LIG had lower interest loan and longer repayment period as compa red to HIG. This meant subsidies in fa vour of LIG. The housing board, slums improvement agencies and other government developments institution had been largely dependent upon HUDCO. As mentioned ea rlier a large pa rt of funds was provided to HUDCO by LIC a nd GIC. Apart from this, the centra l government a lloca tes equity capita l to HUDCO through five years plan provisions. From 1987 onwards, the central government ha s ena bled HUDCO to ha ve a grea ter excess to ma rket funds. HUDCO receives applica tions to support projects from the housing boards and development agencies which are under the jurisdiction of the state governments. These projects are a ssessed for their technical and fina ncial feasibility. Then, loan agreements are signed and HUDCO monitors the performance of the project. The distribution of funds a mongst the states is formula based. In recent years HUDCO has widened its a ctivities like sea rching for cheaper building technology, running tra ining courses in housing administration with relevance to lower income housing. Objectives of HUDCO To extend long-term finance for construction of residentia l complexes To underta ke housing a nd urba n development progra ms in the country. To fina nce or underta ke building of new or sa tellite town, either wholly or partly. To subscribe for debentures a nd bonds to be issued by the Sta te Housing (a nd or Urba n Development) Boards, Improvement Trusts, Development Authorities, etc., specifically for the purpose of fina ncing housing a nd urba n development programs. To fund or ta ke on the setting up of industrial enterprises of building ma t er i a l.

294 Housing Finance 287 To ma na ge the money received from the Government of India a nd other sources a s gra nts or otherwise, for the purpose of financing or underta king housing a nd urba n development progra ms in the country. To promote, esta blish, a ssist, collabora te a nd provide consultancy services for the projects of designing a nd planning of works rela ted to Housing a nd Urba n Development progra ms in India a nd a broa d. The National Housing Bank During the 7th five yea r pla n, non a va ilability of long-term fina nce to individua l households was realised. It wa s on a significa nt sca le, a major limita tion a ffecting the progress of housing sector in India. Thus, on the basis of recommenda tions of a high level group under the na tiona l housing policy 1988, NHB a s the a pex level institution for housing finance wa s set up. The NHB is wholly owned by the RBI which has contributed the entire paid-up ca pita l. It ha s a Boa rd of Directors which looks a fter the genera l superintendents' directions a nd ma nagements of the NHB. The NHB has bee n e stablishe d to ac hie ve the following obje c tives:- To promote a sound, hea lthy, via ble a nd cost effective housing finance system to ca ter to a ll segments of the popula tion and to integra te the housing fina nce system with the overa ll financia l system. To promote a network of dedicated housing finance institutions to a dequa tely serve va rious regions a nd different income groups. To a ugment resources for the sector a nd cha nnelize them for housing. To ma ke housing credit more a fforda ble. To regula te the a ctivities of housing fina nce compa nies ba sed on regula tory a nd supervisory a uthority derived under the Act. To encoura ge a ugmenta tion of supply of builda ble la nd a nd also building ma teria ls for housing a nd to upgra de the housing stock in the c o u n t r y. To encoura ge the public a gencies to emerge as fa cilitators a nd suppliers of serviced land for housing. Indian HFCs are regulated and supervised by National Housing Bank under the provisions of the National Housing Bank Act, 1987 and the directions and guidelines issued thereunder from time to time. Functions of NHB 1. Regulation According to NHB Act, 1987, NHB is expected to regulate the housing fina nce system of the country to its a dva ntage a nd to prevent a ny housing fina nce institutions being conducted in such a ma nner which ma y be a ga inst the interest of depositors or of the housing fina nce institutions. For this purpose, NHB ha s been given power to determine the policy a nd to give directions to the housing fina nce institutions a nd their auditors. 2. Financing The financing of housing sector by the NHB is done by extending refinance to different primary lenders in respect of

295 288 Banking and Financial Services NHB, in partnership with KfW, Germany, is promoting energy efficiency in the housing sector. NHB also launched a Refinance Scheme for Installation of Solar Water Heating and Solar Lighting Equipment in Homes, to promote the use of solar equipment in the domestic context so as to conserve energy (i) Eligible housing loa ns extended by them to individua l beneficia ries. (ii) For project loa ns extended by them to va rious implementing agencies. (iii) Leading directly in ca se of projects underta ken by the public housing a gencies for construction of houses a nd development of housingrela ted infra structure (iv) Guara nteeing the repa yment of principal a mount and payment of interest on bonds issued by the housing fina nce company. (v) Acting a s specia l purpose vehicle for securitiz ing the housing loa n r eceiva b l es. 3. Promotion The NHB a lso contributes to improve or strengthen credit delivery network for housing fina nce in the country. As a pa rt of this role NHB ha s fra med a scheme for gua ra nteeing the bonds to be issued by the housing fina nce company. NHB ha s designed a nd conducted va rious tra ining progra mmes considering the need for tra ined personnels in this sector. NHB ha s been fina ncing the following housing schemes a t a ll India level:- (a) (b) (c) (d) (e) Indira Awa s Yojna Golden Jubilee Rural Housing Fina nce Scheme Bhara t Nirma n Productive Housing in Rura l Area s (PHIRA) 1% Interest Subvention Scheme 4. Urban Housing (a) (b) (c) Refina nce of construction fina nce for a fforda ble housing Interest subsidy scheme 1% Interest subvention scheme 5. The New Products Recently Introduced by NHB are (a) Residentia l mortga ge ba cked securities (b) Reverse mortga ge loa n (c) Reverse mortgage loa n ena bled a nnuity REVIEW QUESTIONS 1. Discuss the pha ses in Indian housing fina nce. 2. Expla in the structure of housing fina nce sector in India. 3. W hat a re the key fea tures of housing fina nce?

296 Housing Finance Discuss a bout the types of housing loa n provided. 5. Discuss the merits and demerits of housing fina nce. REFERENCES BIS, (2006). " Housing financ e in the global financial mark et." Committee on the Globa l Fina ncial System W orking Group Report. HUDCO Annua l Reports. Ma ha deva, M. (2001). " Housing Fina nce: Ca n Commercia l Banks Meet People' s Housing Fina nce Needs." Margin, 34( 1). NHB Annual Reports, www. nhb. org. in NHB, Re port on Tre nd and Progre ss of Housing in India, Na tiona l Housing Ba nk. Various Issues. Planning Commission, (2011). "Twelfth Five Year Plan Document", Government of India. RBI Handbook of Statistic s on Indian Ec onomy, Va rious Volumes. RBI Re port on Trend and Progress of Banking in India, Va rious Issues. Shanker, R. (2007). " Mortga ge Finance: Declining Afforda bility a nd Rising Debt Burden." CRISIL Ratings, Mumba i. Vora, P. P. (1999), "Indian Housing Financ e Syste m." National Housing Ba nk P u b l i c a t i o n.

297 CHAPTER 10 DEPOSITORY AND STOCKBROKING SERVICES Learning Objectives After reading this chapter you should be able to understand the na ture a nd scope of depository a ctivities in India the dema teria liz a tion process the benefits of Dema teria liz a tion the a ctivities of NSDL a nd CDSL the overview of stock broking services in India the code of conduct a pplica ble for Stockbrokers a nd subbroker

298 292 Banking and Financial Services NATURE AND SCOPE OF DEPOSITORY A Depository is a provider of facility for holding securities in book entry or electronic form. It is a kind of bank for securities like shares, debentures, bonds, etc. It also facilitates transactions in the securities held by it. The erstwhile settlement system on Indian stock excha nges was inefficient, risky a nd increa sed risk, due to the time tha t ela psed before tra des were settled. The tra nsfer wa s by physica l movement of pa pers. There ha d to be a physica l delivery of securities -a process fra ught with dela ys a nd resultant risks. The second aspect of the settlement rela tes to tra nsfer of sha res in fa vour of the purcha ser by the compa ny. The system of tra nsfer of ownership wa s grossly inefficient as every tra nsfer involves physica l movement of pa per securities to the issuer for registra tion, with the cha nge of ownership being evidenced by a n endorsement on the security certifica te. In ma ny ca ses the process of tra nsfer would take much longer tha n the two months stipula ted in the Compa nies Act, a nd a significa nt proportion of tra nsactions would end up as ba d delivery due to fa ulty complia nce of pa per work. Theft, forgery, mutila tion of certifica tes a nd other irregularities were ra mpa nt. In a ddition, the issuer ha s the right to refuse the tra nsfer of a security. All this added to costs a nd dela ys in settlement, restricted liquidity a nd ma de investor grieva nce redressa l time consuming and, a t times, intra cta ble. To obvia te these problems, the Depositories Act, 1996 wa s passed. It provides for the esta blishment of depositories in securities with the objective of ensuring free transfera bility of securities with speed, a ccura cy and security. It does so by (a) ma king securities of public limited companies freely transfera ble, subject to certain exceptions; (b) dema teria lising the securities in the depository mode; a nd (c) providing for maintena nce of ownership records in a book entry form. In order to strea mline both the sta ges of settlement process, the Act envisages transfer ownership of securities electronica lly by book entry without ma king the securities move from person to person. The Act ha s ma de the securities of a ll public limited compa nies freely tra nsfera ble, restricting the compa ny' s right to use discretion in effecting the transfer of securities, a nd the tra nsfer deed a nd other procedura l requirements under the Compa nies Act ha ve been dispensed with. Two depositories, viz., NSDL and CDSL, ha ve come up to provide insta ntaneous electronic tra nsfer of securities. A depository functions in India falls r egul a t i o ns : 1. The Depositories Act, 1996, 2. SEBI (Depositories a nd Pa rticipa nt) Regula tions. under the following rules a nd 3. Depository bye-la ws which a re fra med under the a bove two documents. 4. Prevention of Money La undering Act (PMLA), 2002 A depository is a n orga nisa tion which holds securities (like sha res, debentures, bonds, government securities, mutua l fund units, etc.) of investors in electronic form a t the request of the investors through a registered Depository Pa rticipa nt. It also provides services rela ted to tra nsactions in securities. In a ny stock excha nge, trades or transa ctions ha ve to be settled by either squa ring up the carrying forward positions or settling by payment of net cash or net delivery of securities. This a ccount settlement period, if it is long, leads to severa l price

299 Depository and Stockbroking Services 293 distortions a nd a llows for ma rket ma nipula tion. It increa ses the cha nces of specula tion resulting in volatility, which hurts the sma ll investors. W ith the a pplica tion of IT in the securities market - screen-based tra ding a nd tra ding through the Internet - it has been possible to reduce this settlement period. The Depository system to some extent works like the banking system. There is a centra l ba nk a nd the rules and regula tions rela ted to the working of a ll the commercia l, foreign, co-opera tive a nd other types of ba nks a re fra med by the centra l ba nk. In order to do the da ily tra nsa ctions, the investors open an a ccount with the a ssocia te ba nks, a nd not with the centra l one. Like a n investor ca n ha ve a ba nk account with more than one ba nk, simila rly one ca n ha ve more than one Demat Account. W e ca n further bring out the simila rities a s well a s the differences between the two in understa nding the depository system. Depository (NSDL/CDSL) - Bank: The Similarities BANK Hold s fu n d s in accou n ts Tra n sfers fu n d s between a ccou n ts Tra n sfers with ou t h a n d lin g ca sh NSDL Holds secu rities in accou n ts Tr an s fers secu rities between a ccou n ts Tr an s fers with ou t h a n dlin g p h ys ica l Secu rities Sa fek eep in g of m on ey Depository (NSDL/CDSL) - Bank: The Differences Sa fekeep in g of secu rities BANK Eith er of h olders ca n s ign In s tru ction s Min im u m b a la n ce to b e m ain ta in ed En titled for in teres t Us es ba lan ces in accou n ts Nom in a tion is k ept con fiden tial DEMATERIALIZATION NSDL All join t h olders to s ign in s tru ction s No m in im u m ba lan ce requ ired In teres t ca n be ea rn ed on ly by p articip a tin g in Stock Len d in g Sch em e Does n ot m ove ba lan ces in a ccou n t with ou t a ccou n t h older s a u th oriza tion Sign a tu re an d ph otogra ph of n om in ee to be p rovided Dema teria liz a tion is a process by which the physica l sha re certifica tes of a n investor are taken ba ck by the compa ny (Registra r tra nsfer a gent on beha lf of the compa ny) a nd a n equiva lent number of securities are credited in electronic form a t the request of the investor. The dema teria liz ed securities a re converted into electronic da ta a nd stored in computers by a Depository.. It is sa fe, secure and convenient buying, selling and tra nsa cting stocks without suffering endless pa perwork a nd delays.

300 294 Banking and Financial Services An investor will ha ve to first open a 'DEMAT' a ccount with a Depository Pa rticipa nt and then request for the dema teria lisa tion of his sha re certificates through the Depository Pa rticipa nt, so tha t the dema teria lised holdings ca n be credited into tha t a ccount. This is very simila r to opening a Ba nk Account. Dema teria lisation of sha res is optional a nd a n investor ca n still hold sha res in physica l form. However, he/ she ha s to dema t the sha res if he/ she wishes to sell the sa me through the Stock Excha nges. Similarly, if a n investor purchases shares, he/ she will get delivery of the shares in dema t form. Rematerialization is the process of converting securities held in electronic form in a demat account back in physical certificate form. Types of Securities Eligible for Dematerialization According to Regula tion 28 of the SEBI (Depositories a nd Pa rticipa nts) Regula tion 1996, the following securities sha ll be eligible for being held in dema terializ ed form in depository: a. Shares, scrip, stocks, bonds, debentures, debentures stock or other ma rketa ble securities of a ny incorpora ted compa ny or other body cor por a te. b. Units of Mutual Funds, Rights under collective Investment Schemes and Venture Ca pita l Funds, Commercial pa per, Certifica te of Deposit, Securities Debt, Money Ma rket Instruments a nd unlisted form in a depos i t or y Process of Dematerialization The following steps may be followed for getting physical securities converted into Dema t form. The following diagra m will ma ke the understa nding of the steps even better. Ste p 1: Client/ Investor submits the DRF ( Dema t Request Form) a nd physica l certifica tes (to be dema tted) to the DP. DP checks whether the securities a re a vaila ble for dema t. Client defa ces the certifica te by sta mping Sur re nde r e d for De mate rialisation. DP punches two holes on the name of the compa ny a nd draws two pa rallel lines a cross the fa ce of the certifica te. This ensures tha t your shares are not lost in tra nsit or misused till credit is received by client in their dema t a ccount. The DP upon receipt of the sha res a nd the DRF, will issue the client an a cknowledgement a nd will send a n electronic request to the Company. Ste p 2: DP enters the dema t request in his system to be sent to NSDL/ CDSL. Ste p 3: DP dispatches the physica l certifica tes a long with the DRF to the R& T Agent.

301 Depository and Stockbroking Services 295 Ste p 4: NSDL/ CDSL records the deta ils of the electronic request in the system and forwa rds the request to the R& T Agent. Ste p 5: R&T Agent, on receiving the physical documents a nd the electronic request, verify a nd check them. Once the R& T Agent is satisfied, dema teria liz ation of the concerned securities is electronica lly confirmed to NSDL. Ste p 7: NSDL/ CDSL credits the dema teria lised securities to the beneficia ry a ccount of the investor a nd intima tes the DP electronica lly. Ste p 8: The DP issues a sta tement of transa ction to the client. BENEFITS OF DEMATERIALIZATION Benefits of holding securities in the Dema teria lised Form a re (a) Elimination of all Risks Associate d with Physic al Ce r tific ate s: There is no risk of loss, mutila tion or theft of certifica tes. (b) Elimination of B ad De live r ie s: In the depository environment, securities ca nnot be returned " under objection" for a ny rea son a nd hence the question of ba d delivery does not arise nor does the investor fa ce a ny uncerta inty on the genuinity of securities purcha sed by him. (c) Imme diate Tr ansfe r and Re gistr ation of Se cur ities: After the pa yout, once securities a re credited to the investor's dema t a ccount, the investor becomes the owner of the securities, as there is no need to seek registra tion from the company or its registra r. (d) Faste r Settle me nt Cyc le s: All stock excha nges currently follow the T+2 rolling settlement cycle, i. e., settlement of tra des is done on the 2nd working da y from the trade da y. This has become possible because of demat, which ena bles fa ster tra nsfer of securities a nd enha nces liquidity. (e) Faster Receipt of Securities in Case of Bonus/Split/Merger, etc.: Direct credit of securities issued a s bonus or on a llotment of IPO/rights, split a nd merger ensures fa ster receipt of securities a nd elimina te the risk of loss of certifica tes in tra nsit. (f) Waive r of Stamp Duty: No sta mp duty is pa ya ble by the investors for transfer of a ny kind of securities in dema t form. (g) Fac ilitates Ease in Rec ording Change of Addr e ss, Tr ansmission, etc. - For a ll investments held in the BO's a/ c, instea d of informing ea ch compa ny sepa ra tely a bout the cha nge in a ddress, ba nk a ccount deta ils, nomina tion, one single instruction to the DP ta kes care of a ll such cha nges. (h) Ease of Por tfolio M onitor ing : The sta tement of a ccount periodica lly sent by the DP provides the investor the consolida ted position of a ll his investments in the demat a ccount. This ma kes it convenient for an investor to monitor his portfolio. When securities of a company are held in physical form by an investor, his/her name is recorded in the books of the company as a Registered Owner of the securities. When physical shares are converted into electronic form, the depository becomes Registered owner in the books of the company and investor s name is removed from books of the company.

302 296 Banking and Financial Services DEPOSITORIES IN INDIA There a re two depositories opera ting in India, NSDL esta blished in 1996 a nd co promoted by NSE and CDSL esta blished in 1999 a nd co-promoted by BSE. The brief profile of them is provided below. Depository functions in India is covered under: The Depositories Act, 1996, SEBI (D P) Regulations and Prevention of Money Laundering Act (PMLA), 2002 National Security Depository Limited NSDL ( National Security Depository Limited), the first a nd la rgest depository in India, esta blished in August 1996 and promoted by institutions of na tiona l stature responsible for economic development of the country ha s since esta blished a na tiona l infrastructure of interna tiona l sta nda rds tha t ha ndles most of the securities held a nd settled in dema teria lised form in the India n capital market. The pa per-ba sed settlement of tra des in India ca used substa ntia l problems like ba d delivery and dela yed tra nsfer of title till recently. The ena ctment of Depositories Act in August 1996 pa ved the wa y for esta blishment of NSDL, the first depository in India. This depository wa s promoted by institutions of na tiona l importa nce responsible for economic development of the country. Using innova tive a nd flexible technology systems, NSDL works to support the investors a nd brokers in the ca pita l market of the country. NSDL a ims a t ensuring the sa fety a nd soundness of India n marketpla ces by developing settlement solutions that increa se efficiency, minimise risk a nd reduce costs. NSDL, pla y a quiet but centra l role in developing products a nd services tha t will continue to nurture the growing needs of the financia l services industry. Promoters / Shareholders NSDL wa s promoted by Industrial Development Bank of India Limited (Now, IDBI Ba nk Limited), la rgest development ba nk of India Unit Trust of India, - the la rgest mutua l fund in India Na tiona l Stock Excha nge of India Limited, - the la rgest stock exchange in India. Some of the prominent banks in the country ha ve ta ken a sta ke (Sha re holders) in NSDL. They include State Ba nk of India HDFC Ba nk Limited Deutsche Ba nk A. G. Axis Ba nk Limited Citiba nk N. A. Standa rd Cha rtered Ba nk The Hongkong a nd Sha nghai Ba nking Corpora tion Limited Orienta l Ba nk of Commerce

303 Depository and Stockbroking Services 297 Union Ba nk of India Dena Ba nk Canara Bank Legal Framework of NSDL As a pa rt of its on-going ma rket reforms, the Government of India promulga ted the Depositories Ordinance in September Ba sed on this ordina nce, Securities a nd Excha nge Boa rd of India (SEBI) notified it' s Depositories and Participa nts Regula tions in Ma y The ena ctment of the Depositories Act the following August pa ved the wa y for the la unch of Na tiona l Securities Depository Ltd.( NSDL) in November 1996.The Depositories Act ha s provided demateria lisa tion route to book entry ba sed tra nsfer of securities a nd settlement of securities tra de. In exercise of the rights conferred by the Depositories Act, NSDL fra med its ByeLa ws and Business Rules. The ByeLa ws are a pproved by SEBI. W hile the ByeLa ws define the scope of the functioning of NSDL a nd its business pa rtners; the Business Rules outline the opera tiona l procedures to be followed by NSDL a nd its "Business Pa rtners". In view of the SEBI (Depositories a nd Pa rticipa nts) (Amendment) Regula tions, 2012, NSDL ha s adopted Code of Conduct for its Directors a nd Code of Ethics for its Directors a nd Key Ma nagement Personnel a s prescribed under Regula tion 9D of the aforesa id regula tions. The Code of Ethics for Directors a nd Key Ma na gement Personnel of NSDL, is a imed at improving the professiona l a nd ethica l sta nda rds in the functioning of the compa ny thereby crea ting better investor confidence in the integrity of the ma rket. According to the Depositories Act, 1996, an investor has the option to hold securities either in physical or electronic form. Part of holding can be inphysical form and part in demat form. Board of Directors (as on Nov 2013) 1 Mr. C.M. Vasu d e v Form er Secretary, Min is try of Fin a n ce 2 Mr. G.V. Na ges wa ra Ra o Na tion a l Secu rities Depos itory Lim ited 3 Mr. P. P. Vor a Form er Ch airm a n & Ma n agin g Director In du s tria l Developm en t Ba n k of In d ia Lim ited (Now, IDBI Ban k Ltd.) 4 Mr. Su d h ir Man k a d Form er Ch ief Secretary, Govern m en t of Gu ja rat 5 Mr. Ravi Nar ain Vice Ch a irm an Na tion a l Stock Exch an ge of In d ia Lim ited 6 Mr. B. Babu Rao Pres iden t Th e Specified Un dertak in g of th e Un it Tru s t of In d ia (SUUTI) Ch airm a n, Pu blic In t ere s t Dir ec t or Ma n a gin g Dir ec t o r & CEO Pu blic In t er est Direc t o r Pu blic In t er est Direc t o r Sh ar eh olde r Dire c t or Sh ar eh olde r Dire c t or

304 298 Banking and Financial Services NSDL: KEY MILESTONES Sept 1995 : Dra fting of the Depositories Ordinance Dec 1995 : NSDL Incorpora tion August 1996 : Depositories Act Dec 1996 : Commencement of Dema t tra ding a t NSE J une 1997 : Tota l va lue of dema t securities at NSDL crosses US$ 1 bn. Dec 1997 : Commencement of Dema t tra ding a t BSE J a n 1998 : Compulsory dema t tra ding for Institutiona l investors Ma rch 1998 : Tota l va lue of dema t securities at NSDL crosses US$ 5 bn. April 1998 : Dema t delivery in physica l segment at NSE a nd BSE Nov 1998 : Investor a ccounts with NSDL crosses 100,000 Dec 1998 : Introduction of Dema t of Government Securities J a n 1999 : Commencement of compulsory trading for reta il investors Ma y 1999 : NSDL launches NCFM - Depository Opera tions Module Feb 2000 : NSDL la unches internet ba sed service - SPEED - for CMs Ma y 2000 : Investor a ccounts with NSDL crosses 2. 5 million J une 2000 : Commencement of Dema t of Debt Instruments J une 2000 : 98% settlement in dema t form J uly 2001 : Introduction of T+5 Rolling Settlement a nd Uniform Settlement Cycle Sep 2001 : NSDL la unches SPEED-e April 2002 : Introduction of T+3 Rolling Settlement Nov 2002 : Launch of STEADY - An STP initiative by NSDL Dec 2002 : Investor Accounts crosses 5 million April 2003 : Introduction of T+2 Rolling Settlement Oct 2003 : Investor Accounts crosses 6 million Oct 2003 : Dema t of NSC / KVP Nov 2003 : Launch of Market Pa rticipants a nd Investors Database (MAPIN) Nov 2003 : Introduction of dema t of W a rehouse Receipts J une 2004 : Launch of Ta x Informa tion Network (TIN) September 2007: La unch of SMS Alert Fa cility for Investors August 2009 : Investor a ccounts with NSDL crosses 1 Crore December 2009: La unch of Submission of Power of attorney based Instructions for Clients Electronica lly (SPICE) Februa ry 2011: NSDL a ppointed a s Registrar for UID J a nua ry 2012: La unch of KYC Registra tion System by NSDL' s subsidia ry NDML

305 Depository and Stockbroking Services 299 Indian Depository Statistics P a r t i c u l a r s NSDL CDSL No. of Investor Accounts (lakh) No. of Companies Signed up (listed and unlisted) 9, , , , No. of Companies Available for Demat 9, , , , (listed and unlisted) Demat Quantity of Securities (lakh) 5 7, 9 8, , 6 4, , 3 5, , 1 7, No. of Shares Settled in Demat (lakh) 7, 2 0, , 3 7, , 7 8, , 2 7, Value of Shares Settled in Demat (` crore) 1 2, 4 7, , 7 2, , 9 0, , 1 9, Market Capitalisation of 6 2, 6 5, , 3 9, , 1 0, , 2 1, Companies in Demat (` crore) Ratio of dematerialized equity shares to total outstanding shares (listed) (Sou rce: SE BI Annu al Report, ) Central Depository Services Limited Central Depository Services Limited (CDSL), is the second India n depository ba sed in Mumba i. CDSL was promoted by BSE Ltd. jointly with lea ding banks such as Sta te Bank of India, Ba nk of India, Bank of Baroda, HDFC Bank, Standard Chartered Ba nk a nd Union Ba nk of India. CDSL wa s set up with the objective of providing convenient, dependa ble a nd secure depository services a t a ffordable cost to a ll ma rket pa rticipa nts. CDSL wa s promoted by BSE Ltd. in a ssocia tion with Ba nk of India, Ba nk of Ba roda, Sta te Ba nk of India and HDFC Ba nk. BSE Ltd. ha s been involved with this venture right from the inception a nd ha s contributed overwhelmingly to the fruition of the project. The initial ca pital of the company is crores(inr). SEBI has notified that settlement of market trades in listed securities should take place only in the demat mode. Board of Directors of CDSL A professional Board of Directors with va st a nd va ried experience in ca pita l ma rkets a nd banking is at the helm of a ffa irs a t CDSL. Shri N. Ra nga cha ry: Cha irma n: Former Cha irman, CBDT & IRDA Shri T. S. Na ra ya nasa mi: Director Former CMD of Bank of India, Andhra Bank and IOB Dr. R. N. Nigam: Director Principal Delhi College of Arts & Commerce (Retd). Shri Ashish Kuma r Cha uhan: Director, Ma na ging Director & CEO BSE Limit ed. Shri Neera j Swa roop: Director, Cha rtered Ba nk CEO India a nd South Asia, Sta nda rd Shri V. Ba la subra mania m: Director, Chief Business Officer BSE Limited Shri P. S. Reddy: Ma na ging Director & CEO

306 300 Banking and Financial Services Sr.No. Na m e of Sh areh olders Va lu e of Hold in g (in ` La cs ) % Term s to Tota l Equ ity 1 BSE Ltd. 5, Ba n k of In d ia Ba n k of Ba rod a Sta te Ba n k of In d ia 1, HDFC Ba n k Lim ited Sta n d a rd Ch a rtered Ba n k Ca n a ra Ba n k Un ion Ba n k of In d ia Ba n k of Ma h a ra sh tra Th e Ca lcu tta Stock Exch a n ge Lim ited Oth ers Tota l Depository does not levy any charge for dematerialization of securities. However, DPs may collect dematerialization charges towards postage / courier charges, etc., as per their tariff sheet. Milestones of CDSL CDSL received the certifica te of commencement of business from SEBI in February, Honoura ble Union Fina nce Minister, Shri Ya shwa nt Sinha fla gged off the opera tions of CDSL on July 15, Settlement of tra des in the dema t mode through BOI Sha reholding Limited, the clea ring house of BSE Ltd., started in J uly All lea ding stock excha nges like the Na tiona l Stock Excha nge, Ca lcutta Stock Excha nge, Delhi Stock Excha nge, The Stock Excha nge, Ahmeda ba d, etc ha ve esta blished connectivity with CDSL. As a t the end of J an 2012, Over 10, 000 issuers ha ve a dmitted their securities (equities, bonds, debentures, commercial pa pers), units of mutua l funds, certifica te of deposits etc. into the CDSL system. Depository Statistics relating to Debentures/Bonds and Commercial Papers (Sou rce: SE BI Annu al Report, ) Debentures/Bonds Commercial Papers P a r t i c u l a r s N S D L C D S L N S D L C D S L N S D L C D S L N S D L C D S L No. of Issuers No. of Active , , , , , I n s t r u m e n t s Demat Value 1 0, 2 9, , , 7 4, , , , , 0 8, (` crore)

307 Depository and Stockbroking Services 301 BENEFITS OF NSDL AND CDSL In the depository system, the ownership a nd tra nsfer of securities takes place by mea ns of electronic book entries. At the outset, this system rids the ca pita l ma rket of the dangers related to ha ndling of pa per. NSDL a nd CDSL provides numerous direct a nd indirect benefits like Elimination of bad de live r ie s - In the depository environment, once holdings of an investor a re dema teria lised, the question of ba d delivery does not a rise, i.e., they ca nnot be held "under objection". In the physical environment, buyer wa s required to ta ke the risk of transfer a nd fa ce uncerta inty of the qua lity of a ssets purcha sed. In a depository environment good money certa inly begets good qua lity of a ssets. Elimination of all r isks assoc iate d with physic al ce r tific ates - Dea ling in physica l securities ha ve associa ted security risks of theft of stocks, mutila tion of certifica tes, loss of certifica tes during movements through a nd from the registra rs, thus, exposing the investor to the cost of obta ining duplica te certificates, etc. This problem does not a rise in the depository environment. No stamp duty for tra nsfer of a ny kind of securities in the depository. This wa iver extends to equity sha res, debt instruments a nd units of mutua l funds. Imme diate tr ansfe r and re gistr ation of se c ur itie s - In the depository environment, once the securities a re credited to the investors a ccount on pa y out, he becomes the lega l owner of the securities. There is no further need to send it to the compa ny' s registra r for registration. Ha ving purcha sed securities in the physica l environment, the investor ha s to send it to the compa ny' s registra r so tha t the cha nge of ownership ca n be registered. This process usua lly ta kes a round three to four months a nd is ra rely completed within the sta tutory fra mework of two months thus exposing the investor to opportunity cost of dela y in transfer a nd to risk of loss in tra nsit. To overcome this, the norma lly a ccepted practice is to hold the securities in street na mes, i.e., not to register the cha nge of ownership. However, if the investors miss a book closure the securities a re not good for delivery a nd the investor would also stand to loose his corpora te entitlements. Faste r se ttle me nt c yc le - The settlement cycle follow rolling settlement on T+2 basis, i. e., the settlement of trades will be on the 2nd working da y from the tra de da y. This will ena ble fa ster turnover of stock a nd more liquidity with the investor. Faster disbur se me nt of non c ash c or porate be ne fits like r ights, bonus, e tc. - NSDL a nd CDSL provides for direct credit of non ca sh corpora te entitlements to a n investors a ccount, thereby ensuring fa ster disbursement and a voiding risk of loss of certifica tes in tra nsit. Reduction in brokerage by many broker s for trading in dematerialised se cur itie s - Brokers provide this benefit to investors a s dea ling in Registrar and Transfer Agent (RTA) is an agent of the issuer. RTA acts as an intermediary between the issuer and depository for providing services such as dematerialization, rematerialization, initial public offers (IPO) etc.

308 302 Banking and Financial Services Basic Services Demat Account (BSDA) is provided by DPs with effect from October 1, 2012 with limited services to achieve wider financial inclusion, encourage holding of demat accounts and reduce the cost of maintaining securities in demat accounts for retail individual investors. dema teria lised securities reduces their ba ck office cost of ha ndling pa per a nd a lso elimina tes the risk of being the introducing broker. Re duc tion in handling of huge volume s of pape r Per iodic status r epor ts to investors on their holdings a nd tra nsa ctions, leading to better controls. Elimination of pr oble ms r elated to c hange of addre ss of inve stor - In ca se of cha nge of address, investors a re sa ved from undergoing the entire cha nge procedure with ea ch compa ny or registra r. Investors ha ve to only inform their DP with a ll relevant documents a nd the required changes a re effected in the da ta base of a ll the compa nies, where the investor is a registered holder of securities. Elimination of pr oble ms re lated to tr ansmission of de mat shar e s - In ca se of dema teria lised holdings, the process of tra nsmission is more convenient a s the tra nsmission forma lities for a ll securities held in a dema t a ccount ca n be completed by submitting documents to the DP wherea s, in case of physica l securities the surviving joint holder(s)/ lega l heirs/ nominee ha s to correspond independently with ea ch compa ny in which sha res a re held. Elimination of pr oble ms r e late d to se lling se c ur itie s on be half of a minor - A na tura l guardia n is not required to ta ke court a pprova l for selling dema t securities on beha lf of a minor. Ease in por tfolio monitor ing since sta tement of a ccount gives a consolida ted position of investments in a ll instruments. DEPOSITORY PARTICIPANTS A Depository Pa rticipa nt (DP) is a n a gent of the depository through which it interfa ces with the investor a nd provides depository services. Public fina ncia l institutions, scheduled commercia l ba nks, foreign ba nks opera ting in India with the a pprova l of the Reserve Ba nk of India, sta te fina ncia l corpora tions, custodians, stockbrokers, clea ring corpora tions/ clea ring houses, NBFCs a nd Registrar to a n Issue or Share Tra nsfer Agent complying with the requirements prescribed by SEBI ca n be registered a s DP. Ba nking services ca n be a va iled through a bra nch wherea s depository services ca n be a va iled through a DP. DP is a n entity who is registered a s such with SEBI under the sub secton 1A of Section 12 of the SEBI Act. As per the provisions of this Act, a DP ca n offer depository-rela ted services only a fter obta ining a certifica te of registration from SEBI. SEBI ( D& P) Regulations, 1996 prescribe a minimum net worth of ` 50 la kh for stockbrokers, R& T a gents a nd non- ba nking fina nce compa nies ( NBFC), for granting them a certifica te of registra tion to a ct as DPs. The importa nt DP, s in India includes, ICICI Securities, Ka rvy Stockbroking, IL& FS etc.

309 Depository and Stockbroking Services 303 Axis Ba nk Ba rcla ys Securities (India) BNP Pa riba s Citiba nk N. A. C i t i g r oup Deutsche Ba nk A.G Geojit BNP Pa riba s HDFC Ba nk ICICI Ba nk IL&FS Securities Services India Infoline Intera ctive Brokers (India) J M Financia l Services Ka rvy Stock Broking Kota k Ma hindra Ba nk Kota k Securities Ma rwa di Sha res & Finance Orbis Fina ncia l Corpora tion Philipca pita l India Religa re Securities SBI-SG Globa l Securities Services S h a r e k h a n SMC Globa l Securities Standa rd Cha rtered Ba nk Impor tant DPs in India Standa rd Cha rtered Securities (India) Stock Holding Corpora tion STOCKBROKING SERVICES A stockbroker is a n individua l/ organiz a tion who a re specia lly given license to pa rticipa te in the securities ma rket on beha lf of clients. The stockbroker ha s the role of a n a gent. W hen the Stockbroker a cts a s a gent for the buyers a nd sellers of securities, a commission is charged for this service. As a n agent the

310 304 Banking and Financial Services The stock broker, subbroker and the client shall be bound by all the Rules, Byelaws and Regulations of the Exchange and circulars/ notices issued there under and Rules and Regulations of SEBI and relevant notifications of Government authorities as may be in force from time to time. stockbroker is merely performing a service for the investor. This mea ns tha t the broker will buy for the buyer a nd sell for the seller, ea ch time ma king sure tha t the best price is obtained for the client. An investor should rega rd the stockbroker a s one who provides va lua ble service and information to a ssist in making the correct investment decision. They a re a dequately qua lified to provide a nswers to a number of questions tha t the investor might need a nswers to a nd to a ssist in pa rticipa ting in the regiona l ma rket. Services provided by a stockbroker is wha t called as stockbroking services. Apart from buying a nd selling of sha res they provide va rious other services such a s, buying and selling of various types of deriva tive products, a dvising the clients on ma rket condition a nd ca utioning them on a dversities in the ma rket, collecting dividend a nd bonus sha res on beha lf of the client etc Stockbrokers are governed by SEBI Act, 1992, Securities Contracts (Regula tion) Act, 1956, Securities a nd Exchange Boa rd of India [SEBI (Stockbrokers a nd Sub brokers) Rules a nd Regulations, 1992], Rules, Regula tions and Bye-la ws of stock excha nge of which he is a member a s well a s va rious directives of SEBI and stock excha nge issued from time to time. Every stockbroker is required to be a member of a stock excha nge a s well a s registered with SEBI. For registering SEBI checks - eligibility of the a pplica nt to become the member of stock excha nge, ha s the necessa ry infra structure to effectively discha rge his duties, past experience, etc. Every broker displays registra tion details on their website a nd on a ll the officia l documents. You ca n confirm the registra tion deta ils on SEBI website. The SEBI website provides the deta ils of a ll registered brokers. A broker' s registration number begins with the letters " INB" a nd tha t of a subbroker with the letters "INS". Before sta rt of trading with a stockbroker, customers a re required to furnish your details such as na me, a ddress, proof of a ddress, etc. a nd execute a broker client a greement. Registered Stockbrokers (Numbe rs) D e ta i l s Registered Stockbrokers in the beginning of the year 9, , 3 07 Addition during the year , 0 81 Reconciliation/Cancellation/Surrender of Memberships Registered Stockbrokers as on March 31 9, , 12 8 (Sou rce: SE BI Annu al Report, ) CODE OF CONDUCT FOR STOCKBROKERS The intermediaries a nd persons a ssocia ted with securities ma rket sha ll buy, sell or dea l in securities a fter obta ining a certifica te of registra tion from SEBI, a s required by section 12 of SEBI Act. Tra ding in securities market requires some link from intermedia ries to client a nd stock excha nge. Therefore, it is necessa ry to wa tch on the working of these intermedia ries. The stockbrokers a re very importa nt link between stock excha nges a nd investor. Hence, in the

311 Depository and Stockbroking Services 305 exercise of powers conferred by section 30 of the Securities a nd Excha nge Boa rd of India Act, 1992, the boa rd ha s ma de regula tion to regula te the working of Stockbroker and Subbrokers. In this chapter, we will discuss the regulations of stock broker a nd sub broker imposed by the SEBI. Stockbrokers and subbrokers a re regula ted by SEBI (Stockbrokers a nd Subbrokers) Regula tions Presently it ia a mended a nd ca lled the Securities a nd Exchange Boa rd of India (Stockbrokers a nd Subbrokers) (Amendment) Regula tions, The following code of conduct a pplica ble to Stockbrokers a nd subbroker 1. Integr ity: A stockbroker, sha ll ma inta in high standa rds of integrity, promptitude and fairness in the conduct of a ll his business. 2. Exe r cise of Due Skill and Car e: A stockbroker, shall act with due skill, ca re a nd diligence in the conduct of a ll his business. 3. M anipulation: A stockbroker sha ll not indulge in ma nipula tive, fraudulent or deceptive tra nsa ctions or schemes or sprea d rumours with a view to distorting ma rket equilibrium or ma king personal ga ins. 4. M alpr ac tic e s: A stockbroker sha ll not crea te fa lse ma rket either singly or in concert with others or indulge in a ny a ct detrimenta l to the investors' interest or which lea ds to interference with the fa ir and smooth functioning of the ma rket. A stockbroker sha ll not involve himself in excessive specula tive business in the market beyond rea sona ble levels not commensura te with his fina ncial soundness. 5. Compliance with Statutor y Require ments: A stockbroker shall a bide by all the provisions of the Act and the rules, regulations issued by the Government, SEBI and the stock exchange from time to time as ma y be applicable to him. 6. Exe cution of Or de rs: A stockbroker, in his dea lings with the clients a nd the genera l investing public, shall faithfully execute the orders for buying a nd selling of securities a t the best a va ila ble ma rket price a nd not refuse to dea l with a sma ll investor merely on the ground of the volume of business involved. A stockbroker sha ll promptly inform his client a bout the execution or nonexecution of a n order, a nd ma ke prompt pa yment in respect of securities sold a nd a rra nge for prompt delivery of securities purcha sed by clients. 7. Issue of Contr act Note: A stockbroker sha ll issue without dela y to his client or client of the subbroker, a s the case may be a contra ct note for a ll transa ctions in the form specified by the stock excha nge. 8. B r e ach of Tr ust: A stockbroker sha ll not disclose or discuss with a ny other person or make improper use of the deta ils of persona l investments a nd other information of a confidential na ture of the client which he comes to know in his business relationship. 9. B usine ss and Commission: (a) (b) A stockbroker sha ll not encoura ge sa les or purcha ses of securities with the sole object of genera ting brokera ge or commission. A stockbroker sha ll not furnish fa lse or mislea ding quota tions or give a ny other fa lse or misleading a dvice or informa tion to the clients with The first stock brokerage house in the United States started in Philadelphia in Philadelphia Stock Exchange was the first organized body that brought brokers together and served to codify the rules and regulations under which business had been conducted.

312 306 Banking and Financial Services During , turnover in the cash segment of the equity market at ` 32,571 billion recorded a decline of 6.4 per cent, while market capitalisation of the BSE increased by 2.8 per cent to ` 63,879 billion. a view of inducing him to do business in pa rticula r securities a nd enabling himself to ea rn brokerage or commission thereby. 10. B usine ss of De faulting Clients: A stockbroker sha ll not dea l or tra nsact business knowingly, directly or indirectly or execute an order for a client who ha s fa iled to ca rry out his commitments in rela tion to securities with a nother s t ockb r oker. 11. Fairne ss to Clie nts: A stockbroker, when dealing with a client, sha ll disclose whether he is acting a s a principa l or a s a n agent a nd sha ll ensure a t the sa me time tha t no conflict of interest a rises between him a nd the client. In the event of a conflict of interest, he sha ll inform the client accordingly a nd shall not seek to ga in a direct or indirect persona l a dva nta ge from the situa tion a nd sha ll not consider clients' interest inferior to his own. 12. Inve stme nt Advice: A stockbroker sha ll not ma ke a recommendation to a ny client who might be expected to rely thereon to a cquire, dispose of, reta in a ny securities unless he ha s rea sona ble grounds for believing tha t the recommenda tion is suitable for such a client upon the ba sis of the fa cts, if disclosed by such a client a s to his own security holdings, fina ncia l situa tion a nd objectives of such investment. The stockbroker should seek such informa tion from clients, wherever he feels it is a ppropria te to do so. 13 Inve stme nt Advic e in Public ly Ac c e ssible M e dia: A stockboroker or a ny of his employees sha ll not render, directly or indirectly, any investment a dvice about any security in the publicly a ccessible media. 14. Compe te nce of Stoc kbr oke r: A stockbroker should have a dequa tely trained sta ff a nd arra ngements to render fa ir, prompt and competent services to his clients. 15. Pr ote c tion of Clie nts Inter e sts: A stockbroker sha ll extend fullest coopera tion to other stockbrokers in protecting the interests of his clients rega rding their rights to dividends, bonus sha res, right sha res a nd any other rights rela ted to such securities. 16. Tr ansac tions with Stoc kbroke r s: A stockbroker sha ll ca rry out his transa ctions with other stockbrokers a nd shall comply with his obligations in completing the settlement of tra nsa ctions with them. 17. Adver tise me nt and Public ity: A stockbroker sha ll not a dvertise his business publicly unless permitted by the stock excha nge. 18. Induce me nt of Clie nts: A stockbroker sha ll not resort to unfa ir mea ns of inducing clients from other stockbrokers. 19. False or Misleading Returns : A stockbroker shall not neglect or fail or refuse to submit the required returns and not make any false or misleading statement on any returns required to be submitted to the Board and the stock exchange. SUB BROKERS "Subbr oker" means a ny person not being a member of a Stock Exchange who a cts on beha lf of a member-broker a s a n a gent or otherwise for assisting the investors in buying, selling or dealing in securities through such member-

313 Depository and Stockbroking Services 307 brokers. To a ct as a subbroker, registra tion with SEBI is required. It gra nts a certifica te of registra tion to a subbroker subject to the conditions tha t (a) he ha s to pa y the prescribed fee, (b) he ta kes a dequa te steps for redressal of investor grieva nces within one month of the receipt of the compla int a nd keeps SEBI informed a bout the number, na ture a nd other pa rticula rs of the complaints (c) he is a uthoriz ed in writing by a broker for affilia tion in buying, selling or dealing in securities. It is manda tory for member-brokers to enter into a n agreement with a ll the subbrokers. The a greement la ys down the rights a nd responsibilities of member-brokers a s well as subbrokers. Registered Subbrokers with Different Stock Exchanges in India Stock Exchange N u m b e r Percentage of Total N u m b e r Percentage of Total Ah m e d a b a d B e n ga l u r u B h u b a n e s w a r B SE 3 3, , K o l k a t a Koc h i C o i m b a t o r e D e l h i G u w a h a t i I n t e r c o n n e c t e d J a i p u r L u d h i a n a Madhya Pradesh C h e n n a i N S E 4 2, , OTCEI P u n e Uttar Pradesh V a doda r a T o t a l 7 7, , The stockbroker shall not charge brokerage more than the maximum brokerage permissible as per the rules, regulations and bye-laws of the relevant stock exchanges and/or rules and regulations of SEBI. (So urce: SEBI Ann ual Report, [As on 31st March]) Leading Stockbrokers in India There a re a number of broking houses a ll over India. Ma ny of them ha ve Interna tiona l presence too. Following a re some of the lea ding Stockbroking firms in India. India Infoline ICICIdirect Share khan India bulls Geojit Securities HDFC

314 308 Banking and Financial Services Relia nce Money R eliga r e Angel Broking B roke r Char ge s of some Stockbroke rs in India Br o k e r Nam e Ac c ou n t Op e n in g Ye a rly Ma in t e n a n c e Bro k er a ge In t r ad a y An gel Brok in g ` 350 ` %.0 6% Bon a n za ` 600 ` %.0 5% Ca n m on ey ` 200 ` %.0 1% Geojit BNP Pa rib a s ` 800 ` %.0 3% HDFC Secu rity ` 999 ` 550 High er of 2 5 or.5 % High er of 2 5 or.05 % ICICI Direct ` 975 ` %.0 5% IDBI Paisa Bu ilder ` 700 ` %.0 8% In d iab u lls ` ` %.0 5% In d ia In folin e ` Free lifetim e.5 0%.0 5% Kota k Secu rities ` 750 ` %.0 6% Relia n ce Mon ey ` 950 ` %.0 35 % Motila l Oswa l ` 550 ` % Bu y - Nil Sell % to.4 % Religa re ` 499 ` %.0 6% SBI ` 500 ` %.0 5% Sh a rekh a n ` 750 ` %.1 % SMC In d ia ` 499 Nil.3 0%.0 3% Ven tu ra ` ` %.0 5%

315 Depository and Stockbroking Services 309 REVIEW QUESTIONS 1. W ho is a depository a nd how is depository different from a Bank? 2. W hat is Dema teria liz a tion a nd wha t type of securities a re eligible for de ma t er i a l i z a t i o n? 3. Expla in the process of Dema teria liz a tion. 4. W hat a re the benefits of Demateria liz a tion? 5. Expla in the services provided by a depository. 6. W hat a re the code of conduct a pplica ble for stockbrokers? CDSL Annua l Report, REFERENCES Chickodka, M. N. ( 2000), " Understa nding Demateria liza tion", The Management Accountant. Newsletters of NSDL, Va rious issues Ra ja, M.T. a nd Va rsha Mara the, ( 2000), " Tra nsa ction cost for equity shares in India", The Management Accountant. SEBI Annua l Report, Securities a nd Excha nge Boa rd of India (Stockbrokers a nd Subbrokers) (Amendment) Regula tions, 2013.

316 CHAPTER 11 SECURITIZATION AND FACTORING SERVICES Learning Objectives After reading this chapter you should be able to understand the na ture a nd scope of securitiz a tion the process of securitiz a tion the ra tiona le for securitiz a tion the securitiza tion in India n context the regula tory fra mework of securitiza tion in India the fa ctoring process the difference between securitiz a tion a nd fa ctoring the regula tory fra mework rela ting to fa ctoring

317 312 Banking and Financial Services NATURE AND SCOPE OF SECURITIZATION According to Kenneth Cox securitization is a process in which pools of individual loans or receivables or actionable claims are packaged, underwritten and distributed to investors in the form of securities. Securitiz a tion is the process by which fina ncia l a ssets such a s loa n receiva bles, mortga ge ba cked receiva bles, credit ca rd ba la nces, hire-purcha se debtors, lea se receiva bles, tra de debtors, etc., a re tra nsformed into securities. Securitiz a tion is different from ' fa ctoring' in tha t ' factoring' involves transfer of debts without tra nsformation thereof into securities. securitiz a tion mea ns the conversion of existing or future ca sh in-flows of a ny person into tra dable security, which then ma y be sold in the ma rket. It is a process of liquidiz ing a ssets appea ring in the ba lance sheet of a Ba nk or fina ncia l institution which represent long term receiva bles by issuing ma rketa ble securities there aga inst. It involves conversion of cash flow from a portfolio of a ssets in negotia ble instruments or a ssigna ble debts which a re sold to investors. The na me securitiz a tion is derived from the fact tha t the form of fina ncial instruments used to obta in funds from the investors is securities. All a ssets ca n be securitiz ed so long a s they a re a ssocia ted with ca sh flow. Hence, the securities which a re the outcome of securitiz a tion processes a re termed a sset-backed securities (ABS). From this perspective, securitiz a tion could also be defined a s a fina ncial process lea ding to a n issue of a n ABS. A very ba sic exa mple to understa nd securitiz ation would be as follows: ABC Ba nk gives loa n of ` 1 la kh ea ch to 10 people to buy homes. ABC Ba nk ha s invested in the success a nd fa ilure of those 10 home buyers, if the buyers ma ke their payments a nd pa y-off the loans, ABC Bank makes a profit. Also if we look a t it in a nother way, ABC Ba nk ha s ta ken the risk tha t some borrowers won' t repa y the loan. In excha nge for ta king tha t risk, the borrowers pa y ABC Ba nk interest on the money they borrow. From the perspective of ABC Ba nk, those loans a re 10 different a ssets. They have value-one, if the loa n fa ils, Bank takes ownership of the house. Two, if the loa n succeeds, ABC Ba nk gets their money ba ck a long with the interest they cha rge. ABC Ba nk ca n do two things with those loa ns. They ca n hold them for 20 years a nd, they would hope, ma ke a profit on their investment. Or they could sell them to some other investor and walk a wa y. In doing this, they would ma ke less profit tha n if they held onto them long-term, but they would benefit in tha t they ma ke some profit while a lso getting their original investment back. They give up some of the profit in excha nge for not ha ving fa ce the risk. So ABC Bank decides they would ra ther ha ve the ca sh now. They could sell those 10 loa ns to 10 investors. Ea ch investor would be ta king a risk in buying those loa ns, because if a ny loa n defa ults, tha t one investor loses. The financia l sector in India ha s witnessed a series of reforms a nd cha nges since 1991, tha t is, the period in which the government ensued upon a policy for la rger economic reforms allowing foreign direct a nd indirect investment in India. The need for the legal framework on securitiz ation ca n be traced ba ck wa y from 1991 onwards where va rious committees recommended to have a la w on securitiz ation a nd enforcement, this wa s followed by the enactment of the Securitiz a tion a nd Reconstruction of Fina ncia l Assets a nd Enforcement of

318 Securitization and Factoring Services 313 Securities Interest Act, 2002 ( Sarfae si Ac t, 2002). The Act encompasses the a rea s of: securitiz a tion of fina ncia l a ssets; reconstruction of financia l a ssets; recognition to a ny security interest crea ted for due repa yment of a loa n a s security interest under the Securitiz a tion Act, irrespective of its form; banks a nd financia l institutions have the power to enforce the security without intervention of the courts; setting up the Centra l Registry for registra tion of the transa ction of securitiz a tion, reconstruction a nd crea tion of security interests. Since the beginning of the 1980s, securitisa tion has become a global financing tool. Countries such a s Mexico, Bra zil, USA, Cana da, UK, France, Australia, Hong Kong, the Netherla nds, Japan, Germany, etc., have used some type of securitisa tion. Some of the a ssets securitised include credit ca rd receiva bles, airline tickets, residential mortgages, ca r loa ns, swap contracts, tax lien, trade a nd export receivables, insurance premia, telephone receivables, oil and gas receiva bles, time-sha re ca sh flows, parking fines, cinema tickets, hire purchase/lease receivables and trade receivables. Hence, the ra nge of a ssets that ca n be securitised is extensive. Securitisa tion is a rela tively new concept in India but is gaining ground quite rapidly. CRISIL rated the first securitisation program in India in 1991 when Citibank securitised a pool from its a uto loan portfolio and pla ced the paper with GIC Mutua l Fund. Since then, securitisation of a ssets ha s begun to emerge as a clear option of fund, raising by corporates and a few transactions of well-rated compa nies have taken pla ce in the country. Parties to a Securitization Transaction There a re prima rily three pa rties to a securitisation dea l, na mely - a. b. c. The Or iginator: This is the entity on whose books the a ssets to be securitised exist. It is the prime mover of the dea l, i. e., it sets up the necessa ry structures to execute the dea l. It sells the a ssets on its books a nd receives the funds generated from such sa le. In a true sa le, the Origina tor transfers both the lega l a nd the beneficia l interest in the a ssets to the SPV. The SPV: The issuer a lso known a s the SPV is the entity, which would typica lly buy the a ssets (to be securitised) from the Origina tor. The SPV is typica lly a low-ca pita lised entity with na rrowly defined purposes a nd a ctivities, a nd usua lly ha s independent trustees/ directors. As one of the ma in objectives of securitisa tion is to remove the assets from the ba la nce sheet of the Origina tor, the SPV pla ys a very importa nt role in a s much a s it holds the a ssets in its books a nd ma kes the upfront pa yment for them to the Origina tor. The Inve stors: The investors ma y be in the form of individua ls or institutiona l investors like FIs, mutual funds, provident funds, pension funds, insura nce compa nies, etc. They buy a pa rticipa ting interest in the total pool of receiva bles a nd receive their pa yment in the form of interest a nd principa l a s per a greed pa ttern. Besides these three prima ry pa rties, the other parties involved in a securitisa tion deal a re given below: Securitization in its present form originated in mortgage markets of USA in 1970.

319 314 Banking and Financial Services Securitisation in India, largely adopts a trust structure with the underlying assets being transferred by way of sale to a trustee company. The SPV, formed as a Trustee Company, issues securities that are either Pass through Certificates or Pay through Certificates (PTC). (a) (b) (c) (d) (e) The Obligor(s): The Obligor is the Origina tor's debtor (borrower of the origina l loa n). The a mount outsta nding from the Obligor is the a sset tha t is tra nsferred to the SPV. The credit sta nding of the Obligor(s) is of pa ra mount importa nce in a securitiz a tion tra nsa ction. The Rating Age ncy: Since the investors ta ke on the risk of the asset pool ra ther tha n the Origina tor, a n externa l credit ra ting pla ys a n importa nt role. The ra ting process would a ssess the strength of the ca sh flow a nd the mecha nism designed to ensure full a nd timely pa yment by the process of selection of loa ns of appropria te credit quality, the extent of credit a nd liquidity support provided a nd the strength of the lega l fra mework. Administrator or Servicer: It collects the payment due from the Obligor/s a nd pa sses it to the SPV, follows up with delinquent borrowers a nd pursues lega l remedies a va ila ble a gainst the defa ulting borrowers. Since it receives the insta lments a nd pa ys it to the SPV, it is a lso ca lled the Receiving and Pa ying Agent. Agent and Trustee: It a ccepts the responsibility for overseeing tha t a ll the pa rties to the securitisation dea l perform in a ccorda nce with the securitisa tion trust a greement. Ba sica lly, it is a ppointed to look a fter the interest of the investors. Struc tur er: Norma lly, a n investment ba nker is responsible a s structurer for bringing together the Origina tor, credit enha ncer/ s, the investors a nd other pa rtners to a securitisa tion deal. It a lso works with the Origina tor a nd helps in structuring deals. The different pa rties to a securitiz a tion deal ha ve very different roles to play. In fa ct, firms specia lise in those a rea s in which they enjoy competitive a dva nta ge. The entire process is broken up into sepa rate parts with different pa rties specia lising in origina tion of loa ns, raising funds from the ca pita l ma rkets, servicing of loa ns etc. It is this kind of segmenta tion of ma rket roles that introduces severa l efficiencies securitisa tion is so often credited with. SECURITIZATION PROCESS The following a re the ba sic activities involved in secura tisation. It is followed by a diagra mma tic presenta tion followed by a deta iled ana lysis. Assets are origina ted through various loans. The compa ny on whose B/ S the a sset exists is ca lled a s " origina tor". Once la rge portfolio of homogeneous ha ve been origina ted its securitiz ed and sold to a SPV ( owned by a trust/ origina tor). SPV issues trada ble securities to fund the purcha se of the a sset. Investor purcha se the security because they a re sa tisfied tha t security would be pa id in full a nd on time from the cash flow a va ila ble in the asset pool.

320 Securitization and Factoring Services 315 SPV a grees to pa y a ny surplus which ma y a rise during its funding of a ssets back to the origina tor. As ca sh flow a rises on the a sset, these a re used by the SPV to repa y funds to the investor in the securities. The pr oce ss involved in se c uritization tr ansac tion inc lude s se ve r al steps. (a) (b) (c) The origina tor pools the simila r set of a ssets that genera te a predictable strea m of pa yment a nd sells/ a ssigns them to specia l purpose vehicle (SPV). Any a sset having a cash flow profile over a period of time can be securitiz ed. Some of the a ssets which ha s the potential to be securitiz ed a re housing loa ns, ca r loa ns, term loa ns, export credits, a nd future receiva bles like credit ca rd pa yments, ticket sa les, a lbum sales, ca r renta ls, electricity a nd telephone bills receiva bles etc. These a ssets are known as 'financial assets' Under section 5(1) of the Sarfae si Ac t, 2002 only ba nks a nd fina ncia l institutions ca n securitiz e their fina ncia l a ssets, thereby restricting the origina tor of the securitiz ation. The SPV converts the fina ncia l assets into securities for the purposes of selling them to the investors. SPV ha s the option to ta ke the credit ra ting for the securities from the credit ra ting a gency a nd investor receives the return on capita l from the securities over the fina ncial a ssets Broa dly, securitiz ation tra nsa ction ca n be divided into ma in pla yers a nd the fa cilita tors. The ma in pla yers being the originator, obligor, SPV, In India, issuers have typically been private sector banks, foreign banks and non banking financial companies (NBFCs) with their underlying assets being mostly retail and corporate loans.