Unit 1

Structure

Merchant Banking and Financial Services: An Introduction

1.1 Introduction Objectives 1.2 Structure of the Financial System in India 1.3 Concept of Merchant Banking 1.4 SEBI Guidelines for Merchant Bankers 1.5 Book Building
Methods and Guidelines for Book Building Private Placement

1.6 1.7 1.8 1.9 1.10 1.11

Increase/Reduction of Capital Summary Glossary Terminal Questions Answers Case Study

Caselet
Flexibility of the Indian Financial System to Face the Global Economic Crisis As a consequence of the global economic scenario, several macroeconomic hazards facing the Indian financial system have increased, which include slower growth, persistent inflation, weak corporate profits, a falling rupee, weak equity prices and a growing fiscal deficit. Financial Stability Report released by the Reserve Bank of India (RBI) indicates that the Indian financial system is resilient enough to face global economic crisis. However, a macroeconomic stability map provided by RBI shows that six of seven types of risk have increased: global risk, external, growth, inflation, fiscal and corporate. It is only the household sector which has indicated a decline in the risk level. Apart from the risks identified at the macroeconomic level, RBI has identified several risks at the micro level as well which include decrease in bank capital adequacy, increasing bad loans, the need to closely monitor bank exposures to power and telecom companies, hazards arising from underwater convertible bonds, the difficulty in getting dollar funding and other unheeded corporate exposures. Despite all these factors, the Indian financial system is strong enough to face the global crisis. Stress

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test is the tool used by RBI to measure the ability of financial banks to withstand any kind of economic disturbance. The Indian financial system emerged unperturbed even under the toughest stress tests. For example, the worst-case scenario for March 2012 is GDP growth of 3.5 per cent, inflation of 9.4 per cent, call money rates of 11.9 per cent and export-GDP ratio of 14.3 per cent. Although the financial system will certainly feel the tremors of such tough economic crisis yet it will not be dismantled by it. Taking these factors into account, one can assume that risk management will be a crucial talked about topic whether you are an industrialist, or a banker, or a businessman. Source: Compiled by author

1.1 Introduction
Every organization thinks of increasing their capital to get more funds for their expansion plan, working capital requirements etc., by issuing securities in the primary markets. Primary markets provide opportunity to corporate entities to raise the required funds in different categories through issue of both debt and equity securities. Merchant bankers act as intermediaries between the issuers of capital and the investors, who purchase these securities. Financial system is a complex, well-integrated set of sub-systems of financial institutions, markets, instruments and services which facilitates the transfer and allocation of funds, efficiently and effectively. Financial system aims at establishing and providing a regular, smooth, efficient and cost-effective linkage between depositors and investors. In this unit, you will study about the structure of the financial system in India, concept of merchant banking, book building, types of shares and debentures and SEBI guidelines for merchant bankers.

Objectives
After studying this unit, you should be able to: discuss the structure of the financial system in India interpret the concept of merchant banking describe SEBI guidelines for merchant bankers explain book building discuss types of shares and debentures
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1.2 Structure of the Financial System in India

Indias prevailing financial system comprises of the organized sector and the unorganized sector. The financial services are provided by various banks, insurance companies, capital markets, developmental financial institutions, indigenous bankers, mutual fund companies etc. and these services are utilized by the government, business houses and households. Figure 1.1 explains the structure and organization of the financial system of India.

Figure 1.1 The Structure of the Financial System of India Source: Compiled by author

The organized financial system of India is composed of the entire banking system, i.e., commercial banks, cooperative banks, development banks (in public and private sectors), financial markets (money market and capital market), financial and investment companies and other institutions. These institutions work through their chains and branches which are established all over India. In addition to commercial banks, various primary and state level cooperative banks are also growing at a faster rate and helping in allocation of funds at the required places. Similarly, development banks are also working for land development activities in rural areas in addition to meeting the funds requirement of profitable ventures. The Reserve Bank of India (RBI) controls the various banking activities in India. The operations of financial markets are regulated by the Security and Exchange Board of India (SEBI). All the instruments traded in the financial market are operated under the strict surveillance of the Securities and Exchange Board of India.

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The unorganized financial system in India is composed of local money lenders, indigenous banks, local landlords and traders, unorganized lending pawn brokers, etc. These individuals and corporate houses do not come under a regulating body as all operational activities are conducted by a fiduciary system only. The only way to control the activities of the unorganized sector is through indirect control by RBIs interest rate policies. In India, the role of the unorganized sector has decreased tremendously but still it is an important constituent of the financial system.

Self Assessment Questions

1. The unorganized financial system in India is composed of local money lenders, indigenous banks, local landlords and traders, unorganized lending pawn brokers, etc. (True/False) 2. The ________ financial system of India includes commercial banks, cooperative banks, development banks (in public and private sectors), financial markets (money market and capital market), financial and investment companies and institutions.

1.3 Concept of Merchant Banking

Merchant banking was initiated and grew in Europe. It was enhanced by American patronage by offering services to both banking and non-banking institutions. Merchant banks are a kind of diversification of banking services and were originally the real form of banks. The ancient practice of merchant banking was associated with financing the long trading journeys of commodities invented by Italian merchants. In France, during the 17th and 18th centuries a merchant banker (marchandbanquier) was given the status of being an entrepreneur. But in the United Kingdom, merchant banks came into existence in the 19th century and Barings Bank was the oldest merchant bank. For hundred years merchant banking grew as a way of financing the trades and then extended to crop loans. After that the merchant bankers also got involved in future transaction in grains. This practice was continued and they started making settlements for other trades. In this way the merchants benches (bank is derived from the Italian word for bench) in the great grain markets became centres for holding money against a bill and these funds were kept for the settlement of trades in grains. This is how the activity of discounting of bill became a part of the merchant bankers activity.
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The increased trade and liberal policies by the sovereigns across the world helped the emergence of private merchant bankers in various countries. Moreover, the banks expanded their services beyond the traditional banking activities and started focusing on other functions like investment banking and issue management etc. Therefore, merchant banking has become an important activity done by banks these days. And these days merchant bankers have extended their services in various other areas also. Modern merchant bankers provide financial as well as advisory services. In India too, the same functions are performed by merchant banks. Initially the role of merchant bankers was played by major lead bankers like ICICI, IDBI, IFCI, LIC and UTI. All these banks helped to raise capital through the stock markets, but the scope of services provided by these lead bankers was very narrow and a strong need was felt to broaden the scope of merchant banks as a result of increased demand of the capital by the corporate. Merchant banking in India was formally introduced by the National and Grindlays Bank which was known as Grindlays Bank in 1967. The Reserve Bank of India issued a license of merchant banking to Grindlays Bank in 1967. The bank started with the functions like facilitation in capital issue and financial advice to the corporate.

Self Assessment Questions

3. Modern merchant bankers provide ______ as well as advisory services. 4. Merchant banking in India was formally introduced by the National and Grindlays Bank which was known as Grindlays Bank in 1967. (True/False) Activity 1 Assume that you are the head of a corporate house and you wish to take over another small size company. How will you proceed further in this course of action? Hint: Take assistance from merchant banks.

1.4 SEBI Guidelines for Merchant Bankers

Securities and Exchange Board of India (Merchant Bankers) Rules, 1992 The notification of the Ministry of Finance defines a merchant banker as, any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to the securities as

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manager, consultant, advisor or rendering corporate advisory service in relation to such issue management. Merchant banking is a combination of banking and consultancy services. Merchant bankers provide consultancy to their clients for financial, legal, marketing and managerial services. They help to raise finance and perform a slew of other activities. As of now there are 135 merchant bankers who are registered with SEBI and they include the public sector, private sector and foreign players. Some prominent public sector merchant bankers are SBI Caps, PNB etc., the private sector merchant bankers are ICICI Securities, Axis Bank, Kotak Mahindra etc. and some of the foreign players are Goldman Sachs, Deutsche Bank, Citigroup Global Markets etc. SEBI (merchant bankers) rules contains the following chapters:

CHAPTER CHAPTER I CHAPTER II CHAPTER III CHAPTER IV CHAPTER V

CONTENTS PRELIMINARY REGISTRATION OF MERCHANT BANKERS GENERAL OBLIGATIONS AND RESPONSIBILITIES PROCEDURE FOR INSPECTION PROCEDURE FOR ACTION IN CASE OF DEFAULT

Source: www.sebi.gov.in

Self Assessment Questions

5. Merchant banking is a combination of banking and consultancy services. (True/False) 6. Merchant bankers provide consultancy to their clients for financial but not legal services. (True/False) Activity 2 Suppose you are functioning as a merchant banker in India. Find out the list of regulations that a merchant banker needs to follow. Hint: Follow the SEBI guidelines

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1.5 Book Building

Book building is the process through which the prices of IPOs (securities issued first time for public) are obtained through the demand of market. Through the mechanism of book building, companies can raise capital from the general public by offering Initial Public Offers (IPOs) as well as by issuing Follow-on Public Offers (FPOs). In the process of book building, the investors send their bids at the price which seems reasonable within a price range. The prices quoted by both small investors (retail investors) and big investors (wholesale investors/ institutional investors) are considered to identify the right price of security. There is a closing date for the bid after which they are evaluated. The price thus obtained is the outcome of price generated by the demand of public issue.

1.5.1 Methods and Guidelines for Book Building

According to the SEBI guidelines, an issuer company can follow the process of book building in two ways. (i) 75 per cent of net offer to the public through book-building process and 25 per cent of the net offer to the public at the price determined through the book-building process. (ii) 100 per cent of net offer to the public through book-building process. Rules governing book building are covered in Chapter XI of the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000. 75 per cent book building A company is allowed 75 per cent book building of issue of capital to public by giving an offer in a prospectus if it follows the following: The company must be eligible to issue capital to the public. The issuer company can reserve book building for firm allotment as an option. The issue of securities through book-building process shall be separately identified/ indicated as placement portion category, in the prospectus. A minimum limit of 25 per cent must be mentioned for public issue in the prospectus of the company as net offer to public. There must be a provision of underwriting for the pubic issue. The prospectus of the public offer must give all information except for the price of security and this information is to be filed with SEBI.
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A lead merchant banker must be appointed as book runner and his name must be given in prospectus. The copy of draft prospectus must be circulated to the institutional investors eligible for firm allotment. The draft prospectus must mention the information about price band offered for public issue. The book runner maintains the necessary records. The underwriter will maintain the record of public issue order. The underwriter shall intimate the book runner about the aggregate amount of order. The institutional investors shall also forward its order to the book runner. The book runner and issuer company shall determine the price of the securities to be offered to the public. The issue price will be same for public and placement offers. 100 per cent book building A company can also make a 100 per cent of net offer to the public through bookbuilding process if the issue size is `25 crore or above this amount. The reservation of allotment is fixed as specified by the SEBI guidelines. The reservation is available for: (a) permanent employees of the issuer company and in the case of a new company the permanent employees of the promoting companies; (b) shareholders of the promoting companies in the case of a new company and shareholders of group companies in case of an existing company either on a competitive basis or on a firm allotment basis. In this case also, an (more than one) eligible merchant banker(s) is appointed as book runner(s) which works as the lead banker and ensures all the functions to be performed by a lead banker. But in such a case, the company has to compulsorily issue 10 per cent of the share capital to the public through an offer made by prospectus.

1.5.2 Private Placement

As discussed above, the issuer company can sell its securities directly to some investors. Generally, these are institutional investors and the sale is called private placement. The issuer company is exempted from issuing a prospectus in the
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case of private placements as the investors are presumed to have all necessary and relevant information about the company and the risk involved in the issue. In the case of private placements, merchant banks help in negotiations between the issuer company and the investors and for this an offer memorandum is also prepared by merchant banks. All negotiations are made only between the issuer company and the concerned intermediaries. Generally, commercial banks, financial institutions, merchant bankers and subsidiaries of various banks enter into an agreement of private placement. In India, shares and debentures are mostly used as financial instruments for private placements. There are certain benefits of issue of securities through private placements. It is a less time-consuming process in comparison with public issue. It is a less expensive method in comparison with public issue. It is a more effective method for new entrepreneurs to raise funds through stock market instruments. The issuer company can manage flexibility in the size of issue through private placement.

Self Assessment Questions

7. The prices quoted by both small investors (retail investors) and big investors (wholesale investors/ institutional investors) are not considered to identify the right price of security. (True/False) 8. In the case of private placements, merchant banks help in the negotiations between the issuer company and the ________ and for this an offer memorandum is also prepared by merchant banks.

1.6 Increase/Reduction of Capital

(i) Buyback of shares: A company can buy back its own shares under various circumstances and the process of buying its own shares by the company is known as buyback of shares. SEBI has provided detailed guidelines and regulations in case a company decides to buy back its shares. (ii) Stock split: Stock split is that activity where the face value of the stock is split into small denominations. It is an activity which is generally followed when the price of the share becomes very high and it becomes difficult for
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retail investors to trade in such stocks and return per share when the price becomes low. When shares are split into small denominations, it increases the trading frequency of that particular stock and the return per share increases. (iii) Rights issue: Any new issue of shares of existing class or new class results the dilution of ownership of the existing shareholders. Therefore, whenever a company issues new share capital, the existing shareholders of the company have the right to buy these shares first and if the existing shareholders do not execute this right, which is called right of pre-emption, only in that case the securities are offered to other parties. Such an issue is called rights issue and the additional share capital is offered on a proportionate basis to the existing shareholders. Several rules, regulations and guidelines are provided by regulatory bodies to issue right shares. Bought-out deals: When an underwriter/merchant banker executes his agreement of buying all the share of the company in an order to resale them then it is called as bought out deal. A bought-out deal is also called as offer for sale. An investment banker or sponsor or bought-out dealer agrees to buy the shares of promoter of the company for the purpose of placing them as an offer to the public at a later date. A company with surplus cash can also be a boughtout dealer for another company. The individuals and other companies can also participate in syndicate deals. The holding period by the sponsors may range from seventy days to more than a year. The sponsor of the issue decides about the price of the issue for the public which is generally at premium. This price is finalized only after checking the promoters profile, future forecasting etc.

Self Assessment Questions

9. When shares are split into small denominations, it increases the trading frequency of that particular stock and the return per share increases. (True/ False) 10. A bought-out deal is also called _________.

1.7 Summary
Let us recapitulate the important concepts discussed in this unit: Indias prevailing financial system comprises the organized sector and the unorganized sector.
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The ancient practice of merchant banking was associated with financing the long trading journeys of commodities invented by Italian merchants. SEBI has laid down a number of guidelines to be followed by merchant bankers. Book building is the process through which the prices of IPOs (securities issued first time for public) are obtained through the demand of market. In the case of private placements, the merchant banks help in the negotiations between the issuer company and the investors and for this an offer memorandum is also prepared by merchant bank.

1.8 Glossary
Reserve Bank of India (RBI): It is Indias central banking institution, which controls the monetary policy of the Indian rupee. SEBI: The regulatory body for the investment market in India. The purpose of this board is to maintain stable and efficient markets by creating and enforcing regulations in the marketplace. Buyback of shares: A company can buy back its own shares under various circumstances and the process of buying its own shares by the company is known as buyback of shares. Stock split: It is that activity where the face value of the stock is split into small denominations

1.9 Terminal Questions

1. Describe the structure of the financial system in India. 2. Explain some of the guidelines listed by SEBI. 3. Write short notes on: (i) Private placement (ii) Buyback of shares (iii) Stock split. 4. What is book building? Discuss the methods and guidelines for book publishing. 5. List the code of conduct guidelines laid down by SEBI. 6. What the procedure of registration is for merchant bankers as laid down by SEBI?

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1.10 Answers Self Assessment Questions

1. True 2. Organized 3. Financial 4. True 5. True 6. False 7. False 8. Investors 9. True 10. Offer for sale

Terminal Questions
1. Indias prevailing financial system comprises the organized sector and the unorganized sector. For more details, refer section 1.2. 2. There are several guidelines listed by SEBI. For more details, refer section 1.4. 3. Short notes on the following: (i) Private placement: As discussed above, the issuer company can sell its securities directly to some investors. Generally, these are institutional investors and the sale is called private placement. (ii) Buyback of shares: A company can buy back its own shares under various circumstances and the process of buying its own shares by the company is known as buyback of shares. (iii) Stock split: Stock split is that activity where the face value of the stock is split into small denominations. For more details, refer sections 1.5.2 and 1.6. 4. Book building is the process through which the prices of IPOs (securities issued first time for public) are obtained through the demand of market. For more details, refer section 1.5.
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5. There are several code of conduct guidelines laid down by SEBI. For more details, refer section 1.4. 6. The merchant bankers are registered under four different categories. For more details, refer section 1.4.

1.11 Case Study

Hazards Faced by the Financial System in India The fifth Financial Stability Report of the Reserve Bank of India (RBI) has indicated that hazards to the Indian financial system have increased considerably yet, the stress tests indicate that India is very unlikely to face banking crisis. Although the Indian financial system remains healthy, yet there are several factors (both external and internal) affecting the system. The external factors include the global scenario of recession, whereas the internal factors comprise the increasing fiscal deficit, the widening current account deficit, and the consistently increasing food inflation. However, the possibility of a good monsoon and globally declining oil prices are likely to have a positive impact on the Indian economy. According to RBI governor D. Subbarao, the report shows that inspite of downbeat indicators especially on asset quality, the Indian financial sector has remained firm and strong. Stress tests, which are used to compute the ability of domestic banks to resist economic crisis, indicate the strength factor of the Indian banks. Even though asset quality may decline under extreme conditions, including economic growth at 3.5 per cent by March 2013, inflation at 12.2 per cent, and a fiscal deficit of 7.9 per cent of gross domestic product, yet the capital held by Indian banks will still be above the required minimum. Hence, the stress tests put forward that India is unlikely to witness a domestic banking crisis even if economic conditions worsen badly. Algorithmic high-frequency trading is a major contributing risk factor to the Indian financial system, according to RBI. There have been several occasions of high volatility and disturbances in the Indian stock markets which can be implicitly or explicitly be attributed to algorithmic high-frequency trading. The bank also pointed out that these types of transactions accounted for only 17 per cent and 11 per cent of the cash market turnover on the National Stock Exchange (NSE) and BSE, respectively, which is significantly less when compared to developed markets in the US and Europe. The Securities and Exchange Board of India (SEBI), the regulatory body of the Indian stock exchange market, is also apprehensive about such transactions.
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The RBI report also stated that the ramifications of the failure of a large bank could be felt throughout the financial system because of greater correlation between various financial mediators such as banks, insurance companies and mutual funds. Insurance companies and asset management companies constituted the largest lenders of money whereas banks were the largest borrowers of funds. The failure of a bank, which has borrowed money from insurance companies and mutual funds, will have significant implications for the entire financial system. Hazards arising from transactions between banks are also on an increase. The RBI investigation has shown that the failure of the most connected bank poses considerable threat to the banking system. Therefore, a note of caution has been issued by RBI for the regulation of the most connected banks. Pressure is rising in the banking system due to bad asset quality and the lack of liquidity in the market. In the last few days, Indian banks have borrowed approximately `1 trillion. In addition, the global recession has squeezed liquidity, thereby making it difficult to borrow from overseas market. At the present, the declining asset quality is a major cause of concern for the Indian banking system. The report pointed out that an increase in slippage ratios, an elevation in the quantum of restructured assets, and a high rate of growth in non-performing assets (NPAs) relative to credit growth are a major cause of unease for the asset quality of banks. The gross NPA ratio for scheduled commercial banks rose to 2.9 per cent in March 2012 against 2.4 per cent a year ago. The growth in NPAs continued to surpass credit growth by a huge difference. While NPAs grew 43.9 per cent in the year 2011 till March, credit growth was only 16.3 per cent, according to the report. The discrepancy in the growth rates has increased recently, which can be another cause of concern for asset quality in the subsequent term. Important contributing sectors of the economy such as power (especially state electricity boards) and airlines were posing a considerable risk to the banks asset quality. Banks exposure to the power sector was close to `5 trillion at the end of March 2011. Nearly three quarters of more than 1 trillion of exposure to the airline sector was either impaired or restructured. The increasing number of gold loan companies coupled with the consistently increasing price of gold is a serious threat to Indian banks. Apart from this, banks are becoming increasingly reliant on fixed deposits. The economic crisis in Europe spells doom for the Indian banking system only to the extent that European banks are the major purchasers of Indian bonds and the
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tightening of money at their end makes it difficult for Indian banks to borrow from the overseas market. Discussion Questions 1. Do you think that the Indian financial system faces considerable risk from the global economic recession? 2. Advise some steps to be taken to overpower the hazards being faced by the Indian financial system. Source: Compiled by author References Bhole L.M., Mahakud, Jitendra. (2012). Financial Institutions and Markets. New Delhi: Tata McGraw-Hill Education. Khan, M.Y. ( 2004). Indian Financial System. New Delhi: Tata McGraw-Hill Education. Machiraju, H.R. (1995). Merchant Banking Principles and Practice. New Delhi: New Age International (P) Limited Publishers. Pathak, V. Bharati. (2003). Indian Financial System. New Delhi: Pearson Education. Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000. Financial Stability Report Released by Reserve Bank of India. E-References www.sebi.gov.in

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