D-MBA-FM-304: MANAGEMENT OF FINANCIAL SERVICES

FINANCIAL SERVICES: NATURE OBJECTIVES TYPES, FEATURES & SEBI

GUIDELINES AND FUTURE PROSPECTS IN INDIA

STRUCTURE
1. Introduction
2. Objectives
3. Presentation of Contents
3.1 Defining "Services Phenomenon
3.2 Conceptual View of Financial Service
3.3 Features of Financial Services
3.4 Types of Financial Services
3.5 The Status of Financial Services in India
3.6 Reasons for Growth of Financial Services
3.7 Surveillance of SEBI
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
The 1980s have been witness to a dizzying proliferation of innovative financial
techniques and new financial instruments in world financial market. It has been characterized
first in the United States and Europe, and then, in other developing countries. Indian financial
market is also not exception to the same. A novel way which has virtually revolutionized the
Indian financial market in these days is financial services. There is flood of huge financial
agencies in India which provide different kinds of financial services. The scene is to be never
ending. Surprisingly even most of the big manufacturing concerns have entered in this field. In
the words of a senior executive of such a particular financial agency, The financial services scene
increasingly resembles the advertising world. “The great swap game is in full swing.” The
statement is true in the sense that all the public or private sector units which are engaged in such
business are always in search of new activity which enables them to attract the large and
expanding investors in one way or other.
Any activity that facilitates individual economic agents to exchange resources to be
available at different points of time and firms to acquire investible resources can be called a
financial service. In other words, financial services may be referred to any such financial activity
being of such nature as assistance, advice, consultation, borrowing, lending, financing, managing
funds etc., which causes to transformation of saving to investment purposes.

2. OBJECTIVES
After reading this lesson, you should be able to
(a) Explain the meaning of financial services and its features.
(b) Discuss the various types of financial services.
(c) Identify the status of financial services in India.
(d) Find out the reasons for the growth of financial services.
3. PRESENTATION OF CONTENTS
3.1 DEFINING SERVICES PHENOMENON
The term “service” is very complicated term. In, 1960, the American Marketing
Association defined services as activities, benefits or satisfactions which are offered for sale or
provided in connection with the sale of goods'. This definition took a very limited view just
concentrating on the sale of goods. Service has been defined by W.J. Regan in 1963 as, "Services
represent either intangibles yielding satisfactions directly (transportation, housing), or intangibles
yielding satisfaction jointly when purchased either with commodities or other services (credit
delivery)." In this definition, the services have been treated as intangibles capable of providing
satisfaction to the customer and can be marketed like tangible goods.
The term “services” has been viewed by various experts, a few important among these
are as under: According to R.M. Bessom, "For the consumer, services are any activities offered
for sale that provide valuable benefits or satisfaction, activities that he cannot perform for
himself. According to W.J. Stanton, service as, "separately identifiable, intangible activities
which provide want satisfaction when marketed to consumers and/or industrial users and which
are not necessarily tied to the sale of a conduct or another service." By J. Lehtinen, "services as
an activity or a service of activities which take place in interactions with a contact person or a
physical machine or which provides consumer satisfaction." By Kotler and Bloom, "Service as
any activities or benefit that one party can offer to another that is essentially intangible and does
not result in the ownership of anything. Its production may or may not be tied to a physical
product."
From the above definitions, the following are important features of services:
(i) Services are by and large activities rather series of activities.
(ii) Services are usually intangible.
(iii)Services are produced and consumed simultaneously.
(iv) Services are provided in response to the problems of customers as solution.
(v) In contrast to manufacturing industry, the service industry normally sells the services directly
to the users.
(vi) The service industry has to provide service when the users need it

3.2 CONCEPTUAL VIEW OF FINANCIAL SERVICE

The basic objective of financial markets is to allocate savings efficiently to the ultimate
users in an economy. In other words, it is the function of the financial market to pursue such
financial activities which assist in channelizing the economy's savings in accordance with the
expectations of investors and needs of users. However, the nature and form of these activities
may be different in developed and developing economies due to different perceptions. In fact, the
principal force behind any such financial activities is the profit motive. In an economic sense, a
new financial activity will be profitable only if it makes the market more efficient and/or
complete.
Conceptually, a complete market exists when every contingency in the world corresponds
to a distinct marketable security and vice versa. in other words, more specifically, in an
incomplete market. There is unfilled desire for a particular type of financial instrument on the
part of the investors which assist the users to exploit the situation by tailoring security offerings
to the unsatisfied desire of investors caused to find out new financial activities. That is why
recently a lot of new financial instruments have been introduced in the market like zero coupon
 bonds, deep discount bonds, mutual funds, convertible bonds, non-voting equity shares, interest
rate swaps, options, warrants, factoring, commercial papers, secured premium notes, equipment
premium notes, venture capital, forfeiting, credit cards, etc. In fact in a world of fact changing
environment there is always possibility and availability of exploitable opportunities with respect
to inefficiencies and/or incompleteness.
In general, all types of activities which are of a financial nature could be brought under
the term "financial services”. The term “Financial Services” in a broad sense means "mobilizing
and allocating savings”. Thus, it includes all activities involved in the transformation of saving
into investment.
The financial service' can also be called ‘financial intermediation’ Financial
intermediation is a process by which funds are mobilized from a large number of savers and
make them available to all those who are in need of it and particularly to corporate customers.
Thus, financial services sector is a key are and it is very vital for industrial developments. A well
developed financial services industry is absolutely necessary to mobilize the savings and to
allocate them to various investable channels and thereby to promote industrial development in a
country.
From the above, it may be concluded that various kinds of financial activities are
originated due to changed perceptions and need of the investing community in a particular
economy. Sometimes, even to fulfill the desires of a particular class of investors/community, a
new financial increment is designed, as witnessed from the varied nature of investment schemes
of Unit Trust of India framed with different degree of risks and returns.

3.3 FEATURES OF FINANCIAL SERVICES

The financial services have the following characteristics.

(1) Intangible. Financial services cannot appeal to a buyer's sense of touch, taste, smell, sight or
hear. Thus an organization engaged in providing financial services is largely dependent on the
feedback from the public as to effectiveness, quality and attractiveness of the services rendered.

(2) Direct sale. Direct sale is the only possible channel of distribution. There are no middlemen in
between. In order to ensure that services are available at the right time and at the right place,
simultaneous production and distribution of financial services is undertaken by the service
organizations.

(3) Heterogeneity. In order to cater a variety of financial and related needs of different customers
in different areas, financial service organisations have to offer a wide range of products and
services. They provide a special pose one-off management service for industrial customers and
retail service covering insurance, money receipt or storage etc.

(4) Fluctuation in demand. The demand for certain categories of financial services eg., life
insurance, do fluctuate significantly, according to the level of general economic activity. This
factor puts extra pressures on the roles and functions of marketing in insurance organisations.
(5) Protect customer's interest. The responsibility of a financial services organisation to protect
customer's Interest is important not just in banking and insurance, but also in other sectors of the
financial services.
(6) Labour Intensive. Personalised service versus automation, in fact, is an important issue in
financial services. The financial services sector is highly labour intensive. It leads to increase in
the costs of production and consequently affects the price of financial products. Because of high
personnel costs involved and to enhance customer's convenience increased use of technology is
being made.

(7) Geographical dispersion. Financial services must have both appeal and wider application. To
ensure this, the service providing organizations must have massive branch network so that
benefits of convenience are enjoyed by international national and local customers.

(8) Lack of special identity. Customers usually approach a nearby branch of a bank or financial
Institution, because it is convenient to them. As the competing products offered by various
service organisations are similar, the emphasis is more on the package' than the product. The
package consists of branch location, staff, services, reputation, advertising and new services
offered from time to time. Thus, major competitors offering similar services place more
emphasis on the promotional aspects rather than on the inherent uniqueness of a particular
financial institution's service. Each organisation must find a way of establishing its identity and
implant this in the mind of public.

(9) Information based. Financial service industry is an information based industry. It involves
creation, dissemination, and use of information. Information is an essential component in the
production of financial services. Costs of processing information are quite relevant in the
profitable production of financial services.

(10) Require quality labour. Financial services require huge amounts of high quality labour to
deal with information and communication with the market. The types of labour range from
workers performing simple tasks to those undertaking complex analysis and negotiations require
years of training and experience. The importance of labour costs and the role of human inputs in
financial service production can be realised from the salaries paid in this industry. Financial
service firms have to make extra efforts to attract, motivate and retain the human resources they
require in order to survive, grow and prosper in future.

3.4 TYPES OF FINANCIAL SERVICES

As described in the preceding section, financial services may refer to any such financial
activity being of such nature as assistance, advice, consultation, borrowing, lending, financing,
managing funds, etc. which causes transformation of savings to investment purposes. The
financial services can be classified into various categories. One such classification can be fee-
based services and fund-based services. Fee-based services are those where fee is charged by the
financial services firm from the users against the services rendered, for example, issue
management, underwriting arrangement, portfolio management services, credit rating, custodial
service, counseling & consultancy etc. On the other hand, fund-based services are those where
financial service undertaking raises the funds to provide the financial services. Important among
these are mutual funds, leasing companies, venture capital fund, project financing, etc. On the
basis of financial services rendered by the various financial agencies in our country, these can be
classified into following categories:
A. Issue Management Services
(a) Preparation of prospectus
(b) Obtaining of SEBI consents/acknowledgement
(c) Management and Marketing of public/right issues
(d) Underwriting arrangements
(e) Syndication of underwriting stand-by support
(f) Press publicity
(g) Compliance of listing requirements

B. Investment Banking Services

(a) Portfolio management
(b) Placement/discounting of Commercial papers
(c) Placement of non-convertible debentures
(d) Securitisation of debts/bills
(e) Managing mutual funds
(f) Factoring services

C. Fund Management Services

(a) Project finance
(b) Preparation of project reports
(c) Capital structuring and appraisal of project reports
(d) Managing Públic deposits

D. Consultancy & Information Services

(a) Counselling and advisory services
(b) Leading Merger, acquisition and reorganization
(c) Advice on lease finance
(d) Collecting and providing information.
(e) Credit rating

E. Leasing & Hire-Purchase Services

(a) Equipment leasing
(b) Lease syndication
(c) Consumer finance
(d) Auto-finance
(e) Hire purchase services

F. International Operations Services

(a) Advising foreign exchange/loans
(b) Overseas Projects
(c) Import clearance
(d) Capital goods clearance
(e) Forfaiting

A few important financial services have been discussed below in brief:

A. Issue Management Services
Raising funds through sale of securities is highly specialized and tedious job. It requires a
lot of skill, experience and expertise in this field. That is why most of the companies while
issuing the securities take the assistance of other concerns who are specialised in that area.
Usually, this service is provided by merchant bankers. Issue management service includes
various types of activities like obtaining consent/ acknowledgement from the Securities &
Exchange Board of India (SEB) for issue of capital preparation of prospectus, making
arrangement for underwriters, appointment of brokers and brokers to the issue, advertisement
and press publicity, compliance of listing requirements with the stock exchanges, etc.

In our country, a large number of financial services agencies are doing this job
comprising both in public sector and private sector. For instance, at present SBI Capital Markets,
a subsidiary of State Bank of India's merchant banking division is leading among all others, as it
helped to raise approximately three-fourth of the total amount collected from the public amount.

It has been seen that in public issues, there exist lead managers, managers, co-managers
and advertisers or a combination of all these. The number of the lead managers, but usually,
issues below Rs. 50crores can have three and above Rs. 100crores issues, there can be four.
Eventually, the legal responsibility for the issue remains with one or more lead managers.

Apart from the public issues, the securities are also sold through private placement. In the
private placement system, the financial institutions, trusts, banks and other corporations directly
subscribe to the securities issued by the company. This does not require either a prospectus or
letter of offer. The terms and conditions relating to the subscription are decided by the financial
institutions and the issuing company which is the financial institution and the issuing company
which is normally initiated by a merchant banker. However, while transferring of the securities
under private placement, all the provisions of the SEBI Act are taken into consideration. The
exercise is, therefore, to be undertaken with great caution to see that final transfer is made to the
genuine concerns.

B. Underwriting
Underwriting is another important activity which comes under the head of issue
management service. Underwriting is an agreement between the issuing company and the
underwriting firm before the securities are placed before the public, that is, in the event of the
public not subscribing the whole or the number mentioned in the underwriting agreement then
the underwriter firm will take the allotment of such part of the unsold securities. In simple words,
the underwriting is an assurance to the issuing company for getting the funds against the sale of
securities.

C. Portfolio Management Services

One of the most important financial services which is attracting both to the investors and
merchant bankers in India is portfolio management services (PMS). With the growing up of
middle class investors (Specially white collar investors), the scope for this has increased in
multiplicity. A large number of such service units, both in private and public sector, has been
established to pave the way.
 Portfolio management is a technique of selecting securities and continuous revising/
shifting of the portfolio in the light of varying attractiveness of individual security to optimise. In
other words, portfolio management may be defined as the science and art of selecting and
revising the spectrum of securities to fit in with the characteristics of an investor. It requires up-
to-date knowledge of the market conditions and movement in stock market with a view to
maximise return on investment as perceived by the investors.

Modern investment management has become so complicated and difficult task that even
an educated person cannot manage his own investment portfolio efficiently as it requires a
reasonable diligence, knowledge, information and skill to analyse the various data/information
relating to economy, industries, companies, securities, government regulations, international
environment, etc. For an ordinary, small and genuine investor who is busy in his daily affairs or
job. it may not be possible to take appropriate decision in selecting the securities. Thus, the
portfolio management houses who are usually the merchant bankers or the bankers advise the
investors in building up an investment portfolio as per requirement.

Apart from advising the investors, other important services which are undertaken by the
portfolio managers are like securitisation of debts/bills, managing mutual funds, etc. At present,
in India, mutual fund is specific type of arrangement where a group of persons pool their funds in
order to invest in various types of assets preferably financial assets. In other words, when a large
number of individuals accumulate their savings of surplus funds to take advantages of large scale
sales and purchases of investment securities is known as mutual fund or managered fund or
noted fund. Such types of services are performed by investment companies, investment trusts,
public financial institutions, commercial banks, insurance companies etc. Now in India, private
corporate sector too has been allowed to establish such fund. Important institutions which have
established various types of mutual funds in India are Unit Trust of India, SBI Capital Market,
Canbank Financial Services, Bank of India, Indian Bank, PNB Mutual Fund, LIC Mutual Fund,
GIC Mutual Fund and private financial units like Birla, Morgan Stanley, Tauras, Tata etc.

D. Leasing Services
Leasing, in recent decade, has become a popular method of equipment financing
throughout the world covering a wide spectrum of assets. In addition to debt and equity
financing, leasing has also become another important option for the business firms to meet their
long term funds requirement. Rapid changes in technology and rising cost of machinery and
equipment replacement have supported in adoption of this source of financing.

Leasing is an arrangement that provides the lessee firm to use and control over the assets
without receiving the title of the same. In other words, leasing is a written agreement between the
owner of the asset known as lessor and the user of those assets known as lessee in which the
lessee is allowed to use the asset for a specified period of time as against the rental payment to
the lessor. Thus, leasing states the separation of the ownership of the asset from its uses.
Therefore, one can use the asset for a rental value without buying the same.
In India, leasing is currently practiced by both private and public sector companies. The
volume of leasing activities has been increasing tremendously recently. Today, leasing has taken
a pivotal position in capital market due to various reasons. A few important among these are as
follows:
 i. Certain types of the assets have been found more favourable through leasing such as
computers, data processing machines, vehicles, furniture & fixtures, office equipment,
electronic etc.

ii. Certain types of industries which are considered as low priority sectors in terms of
institutional financing but which nevertheless have a role to play in the Indian economy
can be financed through leasing mechanism.

iii. There is flexibility as well as simplicity in lease financing. It is not so rigid as in case of
term financing. Usually only one document, called the lease agreement is to be executed
both by the lessor and the lessee. Further it has lesser restrictive covenants.

In addition, 100% financing is made available in lease because lessee is to pay simply the
rental payment and no contribution towards the cost of the asset.

E. Hire Purchase & Consumer Finance Service

One of the financial services which is oldest one and most popular in our country is
consumer finance service. It is also known as financing consumer durables'. The word 'luxury' is
now obsolete in the sense that if you can afford the item you just get it. These amenities include
like stereo system, video cassette players/recorders, colour television sets, washing machines,
furniture, cameras, telephones, refrigerators, two wheelers, four wheelers, etc. One of the most
important and popular mode of financing for acquisition of these consumer durables is hire
purchase system.

The system of hire-purchase originated in the UK in the middle of 19th century when
rapid industrialisation enabled the people to enjoy high standard of living by buying articles of
utility and of luxury nature. Those who are not in a position to pay the whole amount of the
articles of utility and of luxury nature, they can pay down payment normally 10 to 25% of the
cost price, and rest later on in installments. This is what is done in hire purchase system.
Presently, financial houses have made it business to offer finance for the acquisition of various
consumer items and industrial machinery on the terms and conditions mutually agreed.
Hire-purchase business has been growing especially in metropolitan cities. It
is estimated that the total outstanding on hire purchase receivables of all private sector
companies by the end of 2005 was approximately Rs. 14000 crores. The popularity of this
system is mainly due to unexpected growth of the middle class in our country. In India, mostly,
finance companies and nationalised as well as foreign banks are undertaking this business. Hire-
purchase activity is regulated in our country through the Hire Purchase Act, 1972.

A few important conditions stated in the Act are as under:

1. The possession of the goods is delivered to the hirer by the owner, and the hirer will pay the
agreed amount in fixed periodical installments in future.

2. The title of the goods will be transferred to the hirer on payment of the last installment by the
owner.
3. The hire purchaser has the right terminate the agreement at any time before the transfer of the
title of the property.Then, the hirer will return the goods to the owner and need not pay
installments due thereafter. The amount already paid by him would be deemed to be forfeited.

4. The hirer will not make any damage, destruction, pledge or sell while having the possession of
the goods under the hire purchase. Further, he will also take care of that good as a prudent person
does of his own goods.

F. Corporate Counselling
Another important financial service is corporate counselling which aims at to advise the
business firms to operate their units efficiently at the maximum potential through effective
management. There is wide field of corporate counselling like financial aspects, government
regulations, restructuring of ailing units, policy changes, management of public issues and
underwriting, environmental reshuffles, etc.

The above mentioned areas are duly illustrative fields of corporate counselling. Its
coverage does not end here. It also covers other fields like expenditure control managerial
economics, investment and financial management, pricing methods, marketing strategy etc.

G. Project Counselling
Project counselling is very important and lucrative financial service. This service covers
all such matters which are related to project planning, implementation and control. It starts from
development of an idea into a project preparation of project report, estimation of the cost,
deciding upon the means of finance and techno-economic appraisal of project for capital issue
financing etc. Further, it also assists in taking various government consents and procedural steps
for implementation of the projects. In addition to these, the guidance is also provided to the
overseas investors and NRIS.

H. Loan Syndication
Loan syndication is also known as credit syndication refers to the financial service for
arranging and procuring the Rupee and 'Foreign Currency' loans from the financial institutions,
banks and other lending companies both in India and abroad. It also includes bridge finance and
other resources for cost escalation or cost over runs. So this activity involves identification of
sources wherefrom funds could be arranged, approaching these sources with requisite application
and supporting documents complying with all formalities involved in the sanction and disbursal
of loans.

I. Corporate restructuring
Corporate restructuring is concerned with such activities which are related with merger,
acquisition and amalgamation of the corporate units. This service follows in this respect
negotiating terms and conditions/legal, documentation, official approval, tax matters, etc. of
proposed merger. Besides these, it will also include to assist in formulating guidelines and
directions for future growth plans and exploratory studies on global basis through active
participation.
 Apart from above, this service will also advise the firm in restructuring its capitalisation
to make the same at the best possible least cost. After considering the turnover/sale, cost of
production, profitability required, marketing position, etc. a suitable capital structure is designed
for the firm.

J. Venture Capital
Venture capital is a specific form of equity financing concerning to high risk and high
technical projects, & expecting high reward later on. Various financial institutions have started
various schemes of Venture Capital funding like Risk Capital Schemes of ICICI, Risk Capital
Funding of IFCI (Now Risk Capital & Technology Finance Corp. Ltd.) etc.

K. Secondary Market Operations

Trading in old securities is most popular business throughout the world. Transactions of
sale and purchase of various types of securities like equity shares, debentures, bonds,
government securities and other financial instruments are done in the stock markets. In India, the
stock market is comprised of various stock exchanges, Over The Counter Exchange, National
Stock Exchange. This financial service is provided by the stock brokers to their clients, in turn,
they charge commission on the executed transaction.

3.5 THE STATUS OF FINANCIAL SERVICES IN INDIA

With the rising trend of savings in economy and growth of capital market, the role of
financial services in India has grown too much. Not only the public sector institutions but also
private sector units have entered in this field in a big way. The setting up of a separate division or
agency by them is witness for the said development. Today, it seems to be a lucrative business as
a large number of bank officials and corporate executives have established various financial
services units independently. For example, units like Fair Growth Financial Services, J.M.
Financial & Investment Consultancy Services Ltd. Boifin etc. have been established directly or
indirectly with the help of executives.
At present over 500 companies are engaged partially or fully, in providing these services
to both investors and business sector. These agencies can be broadly classified into four
categories: The first category comprises of nationalised commercial banks like State Bank of
India, Punjab National Bank, Canara Bank, Syndicated Bank, Indian Bank, Bank of India, Bank
of Baroda. etc. The second category consists of public financial and development institutions like
Industrial Credit & Investment Corporation of India (ICICI), Industrial Finance Corporation of
India (IFCI), Life Insurance Corporation of India (LIC), Industrial Development Bank of India
(IDBI), Unit Trust of India (UTI), General Insurance Corporation (GIC), a few State Industrial
Development Corporations (SIDC) etc. The third category consists of a few foreign banks like
Grindlays Bank, Citibank etc. The fourth category includes leading private concerns which have
started financial services directly or indirectly through subsidiaries such as Bazaz Auto, MRF,
Brook Bond, Ceat Tyres, Essar, broker firms like H.L. Financial Consultancy & Management
Services, CIFCO, DSP Financial Consultancy and so on. The growing popularity of these
agencies is a clear indication of the vast scope that lies ahead.

3.6 REASONS FOR THE GROWTH OF FINANCIAL SERVICES

The rising trend of financial services in our country has been earmarked with various
reasons. A few of them have been stated below:
(a) Growth in domestic savings
The biggest supporting factor for growth in financial services in India is a steady growth
of domestic savings during 1980s and 1990s. Through various statistical data, it is observed that
gross domestic savings, as a percentage of gross domestic products had increased above than 22
per cent which is highest in the world. Further household sector's savings in financial assets have
increased in comparison to the non-productive areas in the recent past. It is evident that domestic
savings in our country in relation to national income is at higher level which caused further
growth in financial market.

(b) Changes in Investors' Preferences

The nature and form of financial services usually depend upon the preferences of
investors in an economy. Incidentally the Indian savings structure is dominated by household
sector's savings as its share has increased from 71.8% in 1970-71 to above than 80 per cent in
1990s. Recently, the preferences of household investors have also shown a sign of change as, for
example, in assets holding pattern their share has increased from 56% in 1970-71 to about 60%
in 1990s for financial assets. As a result, the volume of financial services in the country
increased in multiples.

(c) Rise of White Collar Investors

Various financial services like consumer finance services, auto finance services, portfolio
management services, mutual fund services etc. increased due to unexpected growth in size of
middle class in India. For example, it was numbered a mere 10 million in 1947 as against almost
180 million in 1990s. It is as much as that of United States. Usually, middle class investors,
popularly known as White collar investors, prefer to invest in financial assets which give them
adequate return alongwith the reasonable capital gain to offset inflationary effect in the economy.
As a result, the multiple rise in middle class investors, the environment for financial services in
the country became favourable.

(d) Volatile inflation and interest rate

The regular increase in inflation rate and volatile interest rate structure in India have also
an important role in finding out various new financial services. The annual rate of inflation in
terms of Wholesale Price Index (WPI) has been increasing around 7 to 8% annually. It is also at
higher level in other categories. Consequently, inflation risk increased too much in the market.
Similarly frequent fluctuations in interest rates from time to time in the country have also
increased the risk factor associated with the securities. As a result, such financial instruments are
being designed which could compensate the above said risk. Recently, a few financial
instruments like zero coupon bonds, non-voting equity shares, convertible equity, index bond,
etc. are being floated in the market.

(i) Change in tax structure

Sometimes, changes in the tax laws are also responsible to develop new financial
services. For example, recently introduced new mutual funds by various public sector
undertakings like Unit Trust of India, Punjab National Bank, State Bank of India, Canara Bank,
Life Insurance Corporation of India etc. in the form of equity linked savings schemes (ELSS) are
 arisen just to defer the tax liability and to get relief from high rate of tax burden. Consequently, a
huge amount through these funds has been collected by these concerns.

(ii) Structural Transformation

Structural transformation of the economy is a direct outcome of the liberalisation process.
The role of financial services has become more important in the growing complexity of
investment pattern. That is why, portfolio management service have become more popular and
effective recently. Today each investor wants his savings to be invested in a pianned manner to
provide sufficient return with adequate safety. With the limited resource and skill, a single
investor cannot make a wise investment decision in such a complexive business world.
Therefore, the need of portfolio management, services financial consultancy services etc. is
chalked out.

(iii)Technological Advancement
Modern period is of advance technology and has also brought simultaneously various
complications in the business. Further, the computer age has brought with a continual broadening
of applications to the financial services industry and a lowering in cost per transaction. Various
technical instruments like electronic fund transfer, automatic teller machine, personal computer,
telecommunication have changed the investment pattern and objectives in the financial market.
Now all the financial service agencies provide such facilities with adequate information.

(iv) Regulatory changes

Another important factor which has initiated for new financial services is regulatory
changes and circumvention of regulations. Various financial services have arisen just due to
regulations. For example, a major and important financial service of issue management has
originate just due to lighten the burden of the promoters for completing huge and complicated
legal formalities required for the purpose.

3.7 SURVEILLANCE OF SEBI

Securities & Exchange Board of India is regulating the capital market in India. It has
framed various rules and guidelines for regulating the various market capital activities like issue
of new capital stock market functioning, mutual funds, venture capital funds, merger &
acquisitions, merchant banking, credit rating, portfolio management etc. The basic objective of
the SEBI is a smooth functioning of capital market and protection of investors interest in India.
A Presidential Ordinance promulgated on January 31, 1992 accorded statutory status as
an autonomous body to the SEBI Subsequently, the SEBI Bill was passed by the Parliament
giving official recognition, effective March 31, 1992 to the organisations as a surveillance body.
Under the act, the SEBI has been vested with wide ranging powers to oversee constitution as
well as to regulate the functioning of various financial activities/services of each category.

Since its inception, the SEBI has issued a series of guidelines. covering different aspects
of its jurisdiction and responsibility which would have, in their totality a significant bearing on
the future development of the capital market/financial services industry in India. It has issued
detailed guidelines separately almost on all various types of financial services so that these could
be functioned effectively. The SEBI has power to take action against the company/ promoters/
 director/management and such, other persons who are responsible for not fulfilling provisions
and guidelines issued for any financial service.

4. SUMMARY
Financial services can be defined as activities, benefits and satisfaction connected with
the sale of money that offers to users and customers, financial related value. Financial service
organizations render services to industrial enterprises and ultimate consumer markets. Efficiency
of emerging financial system largely depends upon the quality and variety of financial services
provided by the banking and non-banking financial companies. Since 1990's, there has been an
upsurge in the financial services provided by various banks and financial institution. Financial
service can be broadly classified into two categories namely fund based services and fee based
services. The important fund based services include leasing, hire purchase and consumer credit,
bill discounting, venture capital, housing finance. The fee based services include issue
management, portfolio management, corporate counseling, loan syndication, merger and
acquisition, capita restructuring etc. with the rising trend of savings in economy and growth of
capital market, the role of financial services in India has grown much. The rising trend of
financial services in our country has been earmarked with various reasons. SEBI has issued
number of guidelines covering different aspects which would have a a significant effect on the
future development of financial service industry in India.

5. SUGGESTED READINGS
1. Horne, James C. Van, Financial Management and Policy,Prentice-Hall of India (P) Ltd. New
Delhi, pp. 538-550.
2. Kuchhal, S. C., Corporation Finance, Chaitanya Publishing House, Allahabad. 1985, pp. 251-
255.
3. Gupta, A.K., Sen. Merchant Banking: Some Issues II, Financial Express. Jan. 23. 1991, New
Delhi.
4. Gupta, A.K. Sen., Merchant Banking: Some Issues, Financial Express, Jan. 24, 1991, New
Delhi.
5. Mohan Sule, The great exodus in Financial Services, The Economic Times, April 30, 1991, New
Delhi.
6. Mehta, D.D. Super Markets for Finance, The Economic Times, April 30, 1991, New Delhi.
7. Sunil Chopra, Middle class leads growth, The Economic Times. April 30, 1991, New Delhi.
8. Management of Financial Services by B.S. Bhatia & G.S. Batra.
9. A Manual of Merchant Banking by Dr. J.C. Verma.

6. SELF ASSESSMENT QUESTIONS

1. Define financial service and explain its features. Also state the reasons for the growth of such
industry in India.
2. Explain the various financial services rendered by various institutions in India.
3. Critically examine the functioning of financial service industry in India. Explain the role of SEBI
in this regard.
 LEASE FINANCING SERVICES: INTRODUCTION FEATURES, TYPES OF LEASE,
TAX, LEGAL; AND ACCOUNTING ASPECTS.

STRUCTURE
1. Introduction
2. Objective
3. Presentation of Contents
3.1 Concept of Leasing
3.2 Types of Lease
3.3 Legal Aspects of Leasing
3.4 Tax Aspects of Leasing
3.5 Accounting Aspects of Leasing
3.6 Advantages of Leasing
3.7 Limitations of Leasing.
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
Traditionally firms acquire productive assets and use them as owners. The sources of
finance to a firm for finance to a firm for procuring assets may be internal or external. Over the
years there has been a declining trend in the internally generated resources of Indian companies
due to low profitability. The financial institutions experience paucity of funds at their disposal to
meet the increasing needs of borrowers. Further, modern business environment is becoming
more and more complex. To succeed in the situation, the firms aim at growth with stability. To
accomplish this objective, firms are required to go for massive expansion, diversification and
modernisation. Essentially such projects involve a huge amount of investment. High rate of
inflation, severe cost escalation, heavy taxation and meagre internal resources forced many
companies to look for alternative means of financing the projects. Leasing has emerged as a new
source of financing capital assets.

2. OBJECTIVE
After reading this lesson, you should be able to

(a) Define leasing and explain the different types of leasing.

(b) Discuss the legal, tax and accounting aspects of leasing.
(c) Explain the advantages and limitations of leasing.

3. PRESENTATION OF CONTENTS
3.1 CONCEPT OF LEASING
A lease is a contract between a lessor and lessee for the hire of a specific asset selected
from a manufacturer or vendor of such assets by the lessee. The lessor retains ownership of the
asset. The lessee has possession and use of the asset on payment of specified rentals over a
period.
According to Graham Hubbard a lease is a contract between a lessor, who owns an asset,
and a lessee, such that the lessee:
a) selects the asset from a manufacturer or dealer;
b) makes specified payments for an obligatory period;
c) is granted exclusive use of the asset for that period; and
d) has not right or option to own the asset at any time.

Lessors are those individuals, partnerships, companies, corporations and financial

institutions, who lease assets, equipments, to the lessee, under a contract of lease for a
predetermined lease rental. Many companies with surplus cash resources and a significant tax
bill have found that leasing is a useful method of investing their cash profitably and also as a
means of deferring payments of their tax bills, Having seen and witnessed the success and
outstanding performance of the few lessors, many individuals, companies, partnerships, banks
manufactures have been allured and noticed towards this business.

Lessees are those individuals, companies, corporations, and institutions which lease
assets/equipments, from a leasing company for a predetermined lease rentals, under a contract of
lease.

Leasing involves separating the ownership of an asset/equipment from its economic use. It is a
contractual agreement under which the owner of asset/equipment (lessor) gives the exclusive
right to use the asset/equipment for a specified period of time to another party (lessee) for a
consideration called the lease rental. The terms and conditions concerning the lease period the
lease rentals, the terms of payment etc. are clearly specified in the contract. At the end of the
period of contract, the lessor takes back possession of the asset/equipment unless there is a
provision for the renewal of the contract. In simple terms, lease involves financing the cost of an
asset. The lessor purchases the asset/equipment that lessee require from a manufacturer/supplier
selected by him. Thus, the actual function of a lessor is not renting of asset but lending of funds.

Conceptually, leasing may be distinguished from hire-purchase and instalment purchase.

Under hire-purchase, the buyer acquires the ownership of goods only after he has paid the total
price in an agreed number of instalments. The buyer takes possessions of the articles on the
payment of the initial sum but does not become their owner until the last instalment has been
paid.

Under the instalment purchase, the ownership is asset/equipment passes to the buyer as
soon as the first instalment is paid. If the buyer fails to pay the instalments in accordance with
the agreement, the seller can sue the buyer for balance and cannot recover the asset/equipment.

In case of a lease transaction, however, the lessee (user). acquires only the usage of the
asset/equipment and is not the owner thereof; ownership vests with the lessor even if all
instalments (lease rentals) are paid.

The essential elements of leasing are as follows:

a) There must be two parties to a contract of lease financing viz., the lessor (owner) and the lessee
(user). In addition, there may be at a lease-broker acting as an intermediary in negotiating lease
deals.

b) The asset/equipment to be leased form the subject matter of the contract of lease financing. It
must be of the lessee's choice.

c) During the lease tenure, ownership of the asset/equipment vests with the lessor and its use is
permitted to the lessee. On the expiry of the lease tenure, the asset reverts to the lessor (owner).

d) Lease rentals paid by the lessee to lessor forms the consideration for the lease transaction.

Lease contract is for a stipulated time period, at the end of which the asset/equipment
reverts to the lessor in the absence of renewal of the lease.

Equipment lease (lease hereafter) can be defined as a contractual arrangement where the
owner (lessor) of an equipment transfers the right to use the equipment to the user (lessee) for an
agreed period of time in return for rental. At the end of the lease period, the asset reverts back to
the lessor unless there is a provision for the renewal of the contract or there is a provision for
transfer of ownership of the lessee.

3.2 TYPES OF LEASE

1. Financial Lease
A lease is defined as a finance lease if it transfers a substantial part of the risks and
rewards associated and ownerships from the lessor to the lessee. It is a short term lease that can
be cancelled by lessee at short notice. The economic life of the asset/equipment happens to be
more than the lease period. Further, the lease rentals paid under the contract are not enough to
cover fully the investment in the leased asset plus the rate of return required on the investments.
Because of these reasons the risk of obsolescence, remains with the lessor. Generally, the lessor
is responsible for maintenance and insurance. Usually, the shorter the lease period and/or higher
the risk of obsolescence, the higher will be the least rentals. Therefore, in an operating lease the
lessor retains the risks associated with the ownership of the equipment. Example are: lease
contracts for computers, office equipment, car, truck and mobile cranes.

According to the International Accounting Standards Committee (IASC), there is a

transfer of a substantial part of the ownership related risks and rewards if

i) The lessor transfers ownership of the asset to the lessee by the end of the lease term;(or)
ii) The lessce has the option to purchase the asset at a price which is expected to be
sufficiently lower than the fair market value at the date the option becomes exercisable
that, at the inception of the lease, it is reasonably certain that the option will be
exercised, (or)

iii) The lease term is for a major part of the useful life of the asset. The title may or nor
eventually be transferred, (or)
 iv) The present value of the minimum lease payments is greater than or substantially
equally to the fair market value of the asset at the inception of the lease. The title may
or may not eventually be transferred.

2. OPERATING LEASE
The International Accounting Standards Committee defines an Operating Lease as "any
lease other than a finance lease."
Title may or may nor, eventually, be transferred. Under this form of leasing, the lessee
selects the equipment, settles the price and other terms of sale and requests leasing company to
buy it. The lessee, then, takes the equipment from the leasing company on lease. He uses the
equipment, maintains and insures it and avails of the after sale service directly through an
arrangement with the manufacturer/original seller. The lessee also bears the risk of obsolescence.
He has to pay the rentals for the entire lease period even though the equipment may become
obsolete during the period of lease.

The rental paid by the lessee is expected to take care of the capital cost of the equipment,
the lessor's expenses, interest on money and lessor's margin of profit. Normally, the lessor and
the lessee enter into a non-concellable lease agreement for a fixed period of time called the
primary period depending upon the useful economic life of the equipment. Lessor recovers
almost the total investment in the leased asset during the primary period itself. Upon the expiry
of the primary period, either the equipment is returned to the lessor or the contract is renewed at
a nominal rental for whatever period of time he desires. This is known as secondary period and it
is, sometimes, an indefinite period.
From the standpoint of the lessee, a financial lease is not much different from financing
the acquisition of the asset with debt because both the lease payment and the payment of
principal and interest on debt are fixed obligations which must be met and inability to meet these
obligations will result in financial trouble.

An Operating Lease has the following characteristics :

a) The lease term is significantly less than the economic life of the equipment.

b) The lessee enjoys the right to terminate the lease at short notice without any significant
penalty.

c) The lessor usually provides the operating know-how, supplies, the related services and
undertakes the responsibility of insuring and maintaining the equipment is which case an
operating lease is called a "wet lease”. An operating lease where the lessee bears the costs of
insuring and maintaining the leased equipment is called a 'dry lease'.

3. Sale and Lease Back

Under the sale and leaseback agreement, a firm sells an asset to another firm, generally a
leasing company, which in turn leases it back to the former. The asset is sold at market price and
seller firm receives the sale price in cash. Through this transaction, the manufacturing firm
 releases its investment in the existing asset by its sale, realises liquidity but continues to enjoy
the use of the asset. The lessee firm, however, contracts to pay lease rentals which are fixed with
reference to the selling price. The sale and leaseback agreement can be operating lease or a
finance lease depending upon the agreement. An example of this type of leasing is the sale and
lease back of safe deposit vaults by banks under which banks sell them in their custody to a
leasing company at a market price. The leasing company in turn offers these lockers on a long
term basis to the bank.

4. Direct Lease

A direct lease can be defined as any lease transaction which is not a "sale and lease back”
transaction. In other words, in a direct lease, the lensee and the owner are two different entities.

5. Leveraged Lense

Such arrangements are made when capital intensive assets are to be acquired and a single
lessor cannot provide the entire purchase price of the asset. He provides only a percentage of the
necessary capital and yet becomes the owner of the equipment. The remainder of the capital is
borrowed by the lessor. Thus, there are three parties to the transaction: (i) lessor (ii) lender and
(iii) lessee. The leasing company purchases the asset through borrowing with full recourse to the
leasee and without any recourse to it. The transaction is routed through a trustee who on receipt
of the rentals from lessee, remits the debt-service component of the rental to the loan participant
and the balance to the lessor.

6. Domestic Lease and Cross Border Lease

A lease transaction is classified as a domestic lease if all parties to the transaction, the
equipment supplier, the lessor and the lessee are domiciled in the same country. On the other
hand if these parties are domiciled in different countries, the transaction is classified as an cross
border lease transaction.

An International lease transaction calls for

a) an understanding of the political and economic climate
b) a knowledge of the tax and the regulatory framework governing these transactions in the
countries concerned. Second, as the payments to the supplier and the lease payments are
denominated in different currencies, the economics of the transaction from the points of
view of both the lessor and the lessee tend to the affected by the variations in the relevant
exchange rates. In short, international lease transactions unlike domestic lease
transactions are affected by two additional sources of risk-country risk and currency risk.

3.3 LEGAL ASPECTS OF LEASING

Leasing transactions are of special nature. In the absence of any specific law, general law
is applicable to all leasing transactions.
 For the real estate, however, Transfer of Property Act provides a special treatment to
leasing of immovable property but for that matter also much reliance is to be made on the
provisions of general law like Indian Contract Act, Indian Easement, Specific Relief Act, etc.

Regarding movable assets, to be acquired on lease from indigenous or overseas sources,

no special enactment exists to provide certain rules and regulations to exercise Government
control over such transactions directly or indirectly. For procuring assets on lease from
indigenous sources, there is not much to be drawn from the special enactment as the nature of
transaction is of contractual type and mutual agreement between the contracting parties bind
them on the terms and conditions on which they have agreed to enter into such transaction. Such
conditions would cover their rights on occurrences of defaults in adhering to the terms and
conditions ar any other specific breach of the contract. Nevertheless, we have to draw upon some
of the relevant provisions of the Indian Contract Act and Sale of Goods Act so as to ensure that
the terms and conditions of such agreement do not violate the provisions of these enactments.

For corporate enterprise, Companies Act contains certain provisions which corporate
units should comply with before entering into contract of lease finance in addition to the
compliance the provisions of various enactments as relevants applicable to them as referred to
above:

In those cases, where the leasing company has been resorting to borrowed funds for
financing the purchase of equipments to be leased out against mortgage of such property, law
gives a different treatment to such transactions and provisions of Income Tax Act are attracted as
the lessor gets certain benefits of deductions out of profits through lease rentals for taxation
purposes.

The relevant laws that could be made applicable to leasing transactions irrespective of
nature of property covered here are as under:

1. Indian Contract Act, 1872

2. Indian Sale of Goods Act, 1930
3. Transfer of Property Act, 1882
4. Indian Registration Act, 1908
5. Companies Act, 1956
6. Indian Partnership Act, 1932
7. Income Tax Act, 1961
8. Urban Land (Ceiling and Regulation) Act, 1976
9. Indian Stamp Act, 1899
10. The Limitation Act, 1930
11. Arbitration Act, 1940
12. Sales Tax Legislations

The Central Government has been following the policy of economic liberalisation ever
since the announcement of New Industrial Policy in July, 1991. The basic objective behind the
Government policies remains to free the economic system from the clutches of beauracracy and
regulatory framework of licences and controls. It is in this context, the licensing system has been
 abolished making the Industries (Development and Regulation) Act, 1951 redundant.
Monopolies and Restrictive Trade Practices Act, 1969 has been relaxed and rendered
inapplicable due to the withdrawal of the concept of monopolies. Import liberalisation have been
done all through with abolition of Import Licensing existent so far excepting in few sensitive
areas. Imports and Exports (Control) Act, 1947 has been repealed.

The Indian Contract Act defines a bailment as "the delivery of goods by one person to
another for some purpose upon a contract that they shall, when the purpose is accomplished, be
returned or otherwise disposed off according to the directions of the person delivering them”.
The person delivering the goods is called "the bailor (the counterpart of the lessor) and the
person taking delivery of the goods is called the "bailee" (the counterpart of the lessee). The
delivery of goods as defined here will include both actual and constructive delivery.

3.4 TAX ASPECTS OF LEASING

The salient provisions of Income Tax Act, 1961 as to depreciation allowance are :

1) Depreciation on a business asset is allowed as a tax deductible expense if (a) the asset is
owned by the assessee and (b) the asset is used by the assessee for the purpose of business.

2) Assets which qualify for depreciation allowance are buildings, machinery, plant or furniture.
‘Plant' includes ships, vehicles, books, scientific apparatus and surgical equipments used for the
purpsoe of business.

3) Depreciation is computed with reference to the actual cost of the asset. The actual cost will
include (a) all expenses directly relatable to the acquisition of the asset, such as, the interest on
money borrowed for financing the acquisition of the asset for the period till the asset is first put
to use; (b) expenses necessary to bring the asset to the site, install it and make it fit for use like
carriage inwards, installation charges, etc; and (c) expenses incurred to facilities the use of the
asset, like expenses on training the operators of a new plant, or expenses on essential
construction work.

4) Depreciation is computed at the rates prescribed under the Income Tax Act, 1961 based on the
written down value (WDV) method, plant and machinery have been classified under three blocks
with rates of depreciation of 25%, 40% and 100%. In the case of office buildings, the rate of
depreciation is 10% and the general rate applicable to furniture and fittings is 10%. Where the
actual cost of plant and machinery does not exceed Rs. 5000/-, the entire cost is allowed as
depreciation in the year in which such plant and machinery is first put to use.

5) Prior to the enactment of the Finance Act, 1991, depreciation was treated as an annual
allowance not linked to the period of use during the year. But the Finance Act, 1991 has
introduced a provision that if an asset acquired during a year has been used for the purpose of
business for a period of less than 180 days during the year, depreciation on such asset will be
allowed at 50% of the depreciation computed as per the provisions of the Act.
6) The depreciation is charged not on an individual asset but on a block of assets. The term
"block of assets" is defined as "a group of assets falling within a class of assets being building,
machinery, plant or furniture in respect of which the same rate of depreciation is prescribed."

For example, all items of plant and machinery which qualify for a rate of depreciation of
25% p.a. will constitute a "block of assets and depreciation is computed with reference to the
actual cost of this block.

The rule pertaining to computation of taxable income under the Income Tax Act and
Rules are computation of taxable income under the Income Tax Act and Rules are common to all
business, and there are no provision which may be regarded as specific to leasing business.
Nevertheless, some of these provisions need to be studied closely in their application to leasing
business, in particular leasing of machinery and equipment. Amongst the allowable expenses as
specified under Sections 30 to 43 of the Income Tax Act, depreciation and interest on borrowed
income are most important expenses for the lessor and lease rentals for the lessces which appear
in their computation of income.

Sales Tax Aspects

Central Sales Tax Act, 1956, was enacted by Parliament with sole objective "to formulate
principles for determining when a sale or purchase of goods takes place in the course of inter-
state trade or commerce outside a state or in the course of import from India, to provide for the
levy, collection and distribution of taxes on sales of goods in the course of inter-State or
commerce and to declare certain goods to be of special importance in inter-State trade or
commerce and specify the restrictions and conditions to which State laws imposing taxes on the
Sales or purchase of such goods of special importance shall be subject."

Sales Tax on Inter-State Purchase of Equipment

When a lessor purchases an equipment from a supplier in another state (the purchase
results in the movement of the equipment from one state to another), is obvious that the
transactions will attract central sales tax. Therefore, the cost of the equipment to the lesser will
include sales tax at the rate of ten per cent or at the rate applicable to the sale or purchase of
goods within the appropriate state, whichever is higher. (Section 8).

Section 8 of the Central Sales Tax Act also states that if the goods sold by a registered
dealer to another registered dealer are used by the latter for one of the following purpose, the
dealer selling the goods can pay sales tax at a concessional rate of 4% of the sale price The
purposes are :
a) Resale;
b) Use in the manufacturing process of the purchasing dealer for manufacture of taxable goods;
c) Use in mining and
d) Use in the generation or distribution of electricity or any other form of power.
Sales Tax on Lease Rentals

One of the objectives behind legislating the Constitution Forty Six Amendment Act 1981
was to enlarge the concepts of tax on the sale or purchase of goods to enable the State
Government to levy tax on transaction which are not sales or purchase as conventionally
understood. This was accomplished by inserting a new clause (Clause 29 A) as a part of Article
366 and modifying Article 286. Among other things clause 29A states that the tax on purchase or
sale of goods includes a 'a tax on the transfer of the right to use the goods for any purpose
(whether or not for a specified period) for cash deferred payment or other valuable
consideration)". Thus, the Amendment brought within its scope leasing of all kinds of goods
from capital equipments to household utensils.

3.5 ACCOUNTING ASPECTS OF LEASING

Accounting for lease is a most controversial matter not only in India where lease industry
is yet to mature but in the developed countries also where it has already matured having crossed
two decades.

Survey of accounting practices done around the world has revealed in many countries
that accounting for lease is done in accordance with its legal from i.e. lease is a contract wherein
lessee acquires the right to use the asset by paying lease rentals and the legal ownership of the
asset is retained by the lessor. Thus, in the lessee's books of accounts payment of lease rentals for
using the asset is recorded as operating expense over the accounting period. Whereas in the
lessor's accounts, the leased asset is recorded as a fixed asset employed in business and
depreciated or amortised over the period during which it is expected to generate income.

The first attempt to evolve accounting standards for lease transactions was made by the
Financial Accounting Standards Board (FASB) of USA, and in 1976, this body published the
FASB statement 1 on 'Accounting for Leases'. The International Accounting Standards
Committee (IASC) perceived the need for evolving similar standards across countries and this
committee came out with its accounting standards titled IAS-17,, "Accounting for Leases" in
1982, drawing largely on the FASB Statement.

In India, the Institute of Chartered Accountants of India (ICA) came out with an
Exposure Draft on the subject in 1987 modelled on the lines IAS: 17. But this Exposure Draft did
not find favour with the Indian leasing industry and the Institute came with a revised Guidance
Note (Guidance Note on Accounting for Lease) in 1988. This Guidance Note which is applicable
for an unspecified interim period offers certain guidelines for refining the current accounting and
reporting practices followed by the lessors and the lessees.
The following are the salient feature of lease accounting and reporting practices followed
by the lessees and the lessors :

1. The lessee treats the lease rentals payable over the lease term as a charge to the Income
Statement. But then most of the lessee do not disclose the manner in which the aggregate rental
expense is spread over the intervening accounting periods. Likewise most of the lessee do not
report on the future financial commitments under the existing lease agreements.

2. The lessor treats the assets given on lease as part of the fixed assets. With regard to reporting,
some lessors follow the practice of distinguishing between the 'own assets and the 'assets given
on lease'. in the balance sheet while the others do not provide information on the break-up.
3. There is no one uniform method of depreciation followed by

the lessors for depreciating leased assets. While some lessors follow the WDV method of
depreciation, the majority follow the straight Iine method for depreciating the assets given on
lease. Very few leasing companies follow the practice of amortising the cost of the leased asset
over the primary period of the lease.

4. The lessor treats the lease rentals receivable over the lease term as income on the basic of
accrual. But the manner in which the aggregate rental income is spread over the intervening
accounting periods is nor reported by many lessors.

Assets under financial leases should be disclosed as "assets given on lease" as a separate
section under the head "fixed assets” in the balance sheet of the lessor. The classification of the
assets should correspond to that adopted for other fixed assets.

Lease rentals should be shown separately under gross income in the income statement of
the relevant period. It is appropriate that against the lease rental a matching lease annual change
is made to the income statement, which represents recovery of the net investment over the lease
period. This charge is calculated by deducting the finance income for the period from the lease
rental for the period. The annual lease charge would comprise minimum statutory depreciation.

There would be a lease equalisation charge where the annual lease charge is more than
the minimum statutory depreciation.

There would be a lease equalisation credit where the annual lease charge is less than the
minimum statutory depreciation. This would require a separate lease equalisation account (LEA)
with a corresponding debit or credit to lease adjustment account (LAA). The LEA should be
transferred every year to the income statement. Statutory depreciation must be shown separately
in the income statement. Accumulated statutory depreciation should be deducted from the
original cost of the leased asset on the balance sheet of the lessor to arrive at the net book value.

Balance standing in the LAA should be adjusted in the net book value of the leased
assets. The amount of adjustment in respect of each class of fixed asset could be shown in the
main balance sheet or in a schedule.
The finance income should be calculated by applying the interest rate implicit in the lease
to the net investment in the lease during the relevant period. Some lessors use a simpler method
of calculating by apportioning the total finance income from the lease in the ratio of minimum
lease payments outstanding during each of the respective periods comprising the lease term.

Leased asset for an operating lease should be depreciated on a basis consistent with the
lessor's normal depreciation policy.

In the case of a sale and lease back transaction, if the rentals and sale price are established
at fair value, profit or loss is normally recognised immediately. If the sale price is below fair
value, profit or loss is recognised except that if loss is compensated by future rentals at below
market price, it is deferred and amortized in proportion to the rental payments over the useful life
and vice versa.

A lessee should disclose assets taken under a finance lease by way of a note to the
accounts disclosing the future obligations of the lessee as per the agreement.

Lease rentals should be accounted for on an accrual basis over the lease period to
recognise an appropriate charge in this respect in the income statement, with a separate
disclosure thereof. The appropriate charge should be worked out with reference to the terms of
the lease agreement, type of asset, proportion of lease period to the life of the asset as per
technical or commercial evaluation and other such considerations.
The excess of lease rentals paid over the amount accrued in respect thereof should be
treated as pre-paid lease rental and vice versa.

In the case of operating lease, the aggregate lease rental payable over the lease term
should be spread over the term on straight-line basis irrespective of the payment schedule as per
the terms and conditions of the lease.

3.6 ADVANTAGES OF LEASING

To the Lessee: Lease financing has the following advantages to the lessee:

• Financing of Capital goods - Lease financing enables the lessee to have finance for huge
investments in land, building, plant, machinery, heavy equipments, etc., up to 100 per cent,
without requiring any immediate down payment. Thus, the lessee is able to commence his
business virtually without making any initial investment (of course, he may have to invest the
minimal sum of working capital needs).

• Additional Source of Finance : Leasing facilitates the acquisition of equipment, plant and
machinery, without the necessary capital outlay, and, thus, has a competitive advantage of
mobilizing the scarce financial resources of the business enterprise. It enhances the working
capital position and makes available the internal accruals for business operations.

• Less Costly :- Leasing as a method of financing is less costly than other alternatives
available.

• Off-Balance Sheet Financing :- Neither the leased asset is depicted on the balance sheet,
nor the lease liability is shown, except that the fact of lease arrangement is mentioned by way
of a footnote. Lease financing, therefore, does not affect the debt raising capacity of the
enterprise, the lessor's security being also confirmed to the leased asset.

However, the advantage is by, and large, more apparent than real. Development banks and
other lending agencies do not base their decision to lend solely on the apparent strength of the
balance sheet of the borrower. They certainly call for information regarding the off balance sheet
liabilities to assess the real borrowing capacity.
 But the off-balance sheet financing can be misleading to lenders who rely on the financial
statements. In brief, the non-disclosure of outstanding lease obligations and the value of the
leased assets in the balance sheet would result in (i) understatement of debt equity ratio and (ii)
Over statement of asset turnover ratio as well as return on investment. They under-estimate the
real risk and over-estimate the value of the firm as they are affected by these variables. In
recognition of the distortions implicit in the non-disclosures of finance lease in the financial
statements of the lessee, the IAS-17 has recommended capitalization of finance leases in the
books of the lessee.

 Ownership Preserved:- Leasing provides finance without diluting the ownership or control
of the promoters. Against it, other modes of long-term finance, viz, equity or debentures,
normally dilute the ownership of the promoters.

 Avoid Conditionalities:- Lease finance is considered preferable to institutional finance, as in

the former case, there are no conditionalities. Lease financing is beneficial since it is free
from restrictive covenants and conditionalities, such as, representations on the board,
conversion of debt into equity, payment of dividend, etc, which usually accompany
institutional finance and term loans from banks.

 Flexibility in Structuring of Rentals:- The lease rentals can be structured to accommodate

the cash flow situation of the lessee, making the payment of rentals convenient to him. The
lease rentals are so tailor-made that the lessee is able to pay the rentals from the funds
generated from operations. The lease period is also chosen so as to suit the lessee's capacity
to pay rentals and considering the operating life-span of the asset.

 Simplicity:- A lease finance arrangement is simple to negotiate and free from cumbersome
procedures with faster and simple documentation. As against it, institutional finance and term
loans require compliance of covenants and formalities and bulk of documentation, causing
procedural delays.

 Tax Benefits:- By suitable structuring of lease rentals, a lot of tax advantages can be derived.
If the lessee is in a tax paying position, the rental may be increased to lower his taxable
income. The cost of asset is thus amortized more rapidly than in a case where the asset is
owned by the lessee, since depreciation is allowable at the prescribed rates. If the lessor is in
tax paying position, the rentals may be lowered to pass on a part of the tax benefit to the
lessee. Thus, the rentals can be adjusted suitably for postponement of taxes.

 Obsolescence Risk is Averted :- In a lease arrangement the lessor being the owner bears the
risk of obsolescence and the lessee is always free to replace the asset with the latest
technology.
To the Lessor :- A lessor has the following advantages:

 Full Security:- The lessor's interest is fully secured since he is always the owner of the
leased asset and can take repossession of the asset if the lessee defaults. As against it,
realising an asset secured against a loan is more difficult and cumbersome.

 Tax Benefit: The greatest advantage for the lessor is the tax relief by way of depreciation. If
the lessor is in high tax bracket, he can lease out assets with high depreciation rates, and thus,
reduce his tax liability substantially. Besides, the rentals can be suitably structured to pass on
some tax benefit to the lessees.

 High Profitability: The leasing business is highly profitable since the rate of return is more
than what the lessor pays on his borrowings. Also, the rate of return is more than in case of
lending finance directly.

 Trading on Equity:- Lessors usually carry out their operations with greater financial
leverage, That is, they have a very low equity capital and use a substantial amount of
borrowed funds and deposits. Thus, the ultimate return on equity is very high.

 High Growth Potential:- The leasing industry has a high growth potential. Leasing
financing enables the lessees to acquire equipment and machinery even during a period of
depression, since they do not have to invest any capital. Leasing, thus, maintains the
economic growth even during recessionary period.

3.7 LIMITATIONS OF LEASING

Lease financing suffers from certain limitations too:

Restrictions on Use of Equipment:- A lease arrangement may impose certain restrictions on
use or the equipment, or require compulsory insurance, etc. Besides, the lessee is not free to
make additions or alterations to the leased asset to suit his requirements.

Limitations of Financial Lease:- A financial lease may entail higher payout obligations, if the
equipment is found not useful and the lessee opts for premature termination of the lease
agreement. Besides, the lessee is not entitled to the protection of express or implied warranties
since he is not the owner of the asset.

Loss of Residual Value:- The lessee never becomes the owner of the leased asset. Thus, he is
deprived of the residual value of the asset and is not even entitled to any improvements done by
the lessor or caused by inflation or otherwise, such as appreciation in value of leasehold land.

Consequences of Default:- If the lessee defaults in complying with any terms and conditions of
the lease contract, the lessor may terminate the lease and take over the possession of the leased
asset. In case of finance lease, the lessee may be required to pay for damages and accelerated
rental payments.
 Understatement of Lessee's Asset:- Since the leased assets do not form part of lessee's assets,
there is an effective understatement of his assets, which may sometimes lead to gross under-
estimation of the leasee. However, there is now an accounting practice to disclose the leased
assets by way or footnote to the balance sheet.

Double Sales Tax:- With the amendment of sale-tax law in various states, a lease financing
transaction may be charged to sales tax twice-once when the lessor purchases the equipment and
again when it is leased to the lessee.

4. SUMMARY

An arrangement whereby a person commands the use of an asset without owning the
same, in consideration of a periodic rental payment to another person is known as leasing. A
lease is of various types, such as financial lease, operating lease, sale and lease back etc. In a
financial lease, all the risks and rewards associated with the ownership of an asset are transferred
to the lessee. In the absence of any specific low, general law is applicable to all leasing
transactions. The 46th Amendment Act has brought lease transactions under the purview of sale
and has empowered the centre and state governments) to levy sales tax in this respect. From the
accounting point of view, a lease transaction represents an off-the balance sheet transaction and
this appears to be an important advantage associated with leasing.

5. SUGGESTED READINGS

1. Shri Ram K, Hand book of Leasing, Hire purchase and Factoring,The Institute of Chartered
Financial Analyst of India, Hyderabad.

2. Verma, J.C, Lease Financing and Hire purchase, Bharat Law House, Delhi, 1995.

3. Karuppiah K., Lease Finance, Sterling Publishers, Delhi.

4. Various Legislative acts relating to leasing.

5. Gupta, N.K., Leasing, Deep & Deep Publishers, Delhi.

6. SELF ASSESSMENT QUESTIONS

1. Define leasing and explain the various types of leasing.
2. "Leasing is beneficial to both, the lessor as well as the lessee". Examine.
3. Examine the income tax implications of leasing.
4. State the sales tax implication of leasing.
5. Write a detailed note on the accounting aspect of leasing.
 LEASE STRUCTURE, LEASE AGREEMENTS, FUNDING OF LEASE, FINANCIAL
EVALUATION OF LEASE, IMPORT LEASING ETC.

STRUCTURE
1. Introduction
2. Objective
3. Presentation of Contents
3.1 Lease Agreements
3.2 Funding of Lease
3.3 Financial Evaluation of Leasing
3.4 Methods of Computing Lease Rentals
3.5 International Leasing

4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
Leasing of residential houses and agricultural lands has been in vogue for several
centuries. However, the concept of leasing plant and machinery, vehicles, computers etc. has
gained momentum in recent years. Leasing all over the world is becoming an important source of
financing assets. In the liberalised economic environment of India, it has assumed an important
role. The corporate sector has considered leasing as a good alternative to purchasing capital
assets. Financial sector has responded quickly to emerging business opportunity through leasing.
In India financially strong commercial banks and several financial institution have started
financing leases.

2. OBJECTIVE
After reading this lesson, you should be able to:

(a) Discuss the contents of lease agreement.

(b) Explain the different sources of finance available to a leasing company.
(c) Make a financial evaluation of Lease.
(d) Explain about international Leasing.

3. PRESENTATION OF CONTENTS
3.1 LEASE AGREEMENT
Lease financing is governed by the relevant provisions of a number of legislations/acts.
Leasing agreement is primarily a bailment agreement for the following reasons:

i) The lessor and the lessee in a lease transaction are in the position of bailor and bailee
respectively.
ii) There is delivery of possession of goods from the lessor (bailor) to the lesser (bailee).
The ownership of the goods remains with the lessor (bailor).
 iii) The specific purpose of the transfer of goods is to allow the lessee (bailee) by the
lessor (bailor) to make economic use of the asset during the lease period.
iv) On accomplishment of purpose or on the expiry of the lease period, the assets are
returned to the lessor (bailor).

Contents of Lease Agreement

There is no standardized lease agreement. The following clauses are, however, found in
most of the lease agreement:

a) Name of the Lease

This clause specifies whether the lease agreements is operating lease, leveraged lease or a
financial lease etc.

b) Description
It specifies the detailed description of equipment, its actual condition, estimated useful
life, and the location where it is to be installed. For the purpose of easy identification, the
lessor may direct the lessee to affix plates or markings to the equipment indicating the
lessor's interest.

c) Period
This clause mentions the period for which equipment is leased.It also includes an option
clause to the lessee to renew the lease of the equipment. The renewal period is termed as
secondary lease period.

d) Lease Rentals
This clause mentions the amount of lease rentals, the periodicity of payment, and the
mode of such payment. It also clearly mentions the advance payment to be made, and the late
payment charge that is payable on lease rentals paid after the due dates,

e) Proper Usage
Under this clause, the leassee is made responsible for proper and lawful use of the
equipment/asset lensed.

f) Exemption
Since lessee has himself selected the equipment, the lessor expressly disowns
responsibility for any defects in the equipment or the operations thereof.

g) Manufacturer's Warranty
This clause authorises the lessce to enforce due performance by the manufacturer for any
warranties or performance guarantees relating to the equipment.

h) Ownership
As per this clause the lessee cannot sell, assign, pledge, hypothecate or otherwise create a
lien upon or against the equipment.
 i) Equipment Delivery
The responsibility for taking delivery and possession of the leased equipment from the
supplier lies with lessee. The lessor shall not be responsible for any loss suffered by the
lessee on account of the equipment not being delivered on the due date.

j) Repairs and Maintenance

This clause specifies the responsibility for repairs and maintenance. While all
replacements in the nature of maintenance will be deemed as part of the equipment, the
additions, attachments, and improvements made to the equipment by the leasce will belong to
the lessee, if not financed by the leasor,

k) Insurance
Generally the lessee is required to bear the insurance charges for getting the equipment
insured against all normal risks incidental to the equipment and to the business of the lessee.

l) Prohibition of Sub-leasing
This clause prohibits the lessee from the sub-leasing or selling the equipment to third
partics.

m) Inspection
This clause authorises the lessor or his representative to enter the lessee's premises for
the purpose of confirming the existence, condition and proper maintenance of the equipment.

n) Default and Remedies

It mentions the events of default and remedies available to the lessor upon the occurrence
of any such event.

o) Arbitration
It specifies the arbitration procedure to be followed in the event of any dispute between
the lessor and the lessee. It may also specify the country whose laws would prevail in case of
a dispute.

3.2 FUNDING OF LEASE

The success and growth of leasing business is largely dependent upon the ability of
leasing company to raise sufficient funds at economic cost. In case the lease rentals drop, the
leasing companies which have raised funds at high cost may find it difficult to maintain the
economic viability of their business. Leasing companies can raise funds from various sources.
The main sources of finance available to a leasing company are:
1. Equity Share Capital
2. Reserves and Surplus
3. Loans:
a) Debentures
b) Deposits
c) Bank Borrowings
d) Institutional Loans
1. Equity Share Capital
The equity share capital has been one of the important sources of finance to a leasing
company. However, raising funds from this source is not an easy proposition. The poor
performance record of some of the leasing companies and their inability to meet the rate of return
required by the equity shareholders resulted in lack of confidence in the leasing companies
prospects by the investors.

2. Reserves and Surplus

In India, leasing companies maintain reserves and surplus at a low level. This is mainly due to
the fact that most companies prefer to distribute a major portion of their profits as divided among
shareholders rather than retaining the same with them.

3. Loans
Loans are the largest source of finance for leasing companies. The various sources of
loaned funds available to leasing companies are as follows:

a) Debentures
Debentures of leasing companies are not very popular. It is attributed to the fact that
usually debentures are secured by immvable properties but the leasing companies in general do
not possess them in adequate quantity. Similarly, it is not easy for leasing companies to issue
either fully convertible or partly convertible debentures because these are closely linked with the
net worth and movement of equity share prices in the market.

b) Deposits
Public deposits have been accepted by almost all the leasing companies. The acceptance
and repayment of deposits, the minimum and the maximum maturity periods of the deposits, the
rate of interest and so on are governed by the provision of the Non-Banking Finance Companies
(NBFCs) directions of the RBI. As per new prudential norms for NBFCs, announced in January,
1998, Reserve Bank of India has linked the quantum of deposits raised by an NBFC to its credit
rating. Now an equipment leasing company rated 'AAA' can raise depoists upto three times its
net owned funds. An 'AA' company can raise deposits upto twice its net worth and an 'A'
company can raise deposits equal to its networth. Further, NBFCs with net owned funds of less
than Rs. 25 lakh and a rating below 'A' have been prohibited from accepting deposits.

In the past public deposits had been accepted by almost all the leasing companies
between 6 to 10 times of their net owned funds. large proportion of deposits were of short term
nature, ranging between six months to two years. However, these funds were deployed to
purchase long term assets for leasing. Such a policy had dangerous repercussions for leasing
companies.

c) Bank Borrowings
Bank borrowings that may be availed by leasing companies tak the form of cash credit
facility. The terms and conditions of the facility, such as the amount of cash credits that can be
availed of and the related terms and conditions, are regulated by RBI stipulations The relevant
RBI directions are furnished below:

i. Maximum Limit: The maximum borrowings by a leasing company from all sources
including deposits, debentures/bonds and borrowings from banks and financial institutions
should not exceed 10 times the 'net owned funds'. In respect of leasing companies which
are predominantly engaged in equipment leasing where a minimum of 75% of the
company's assets are in equipment leasing, and where 75% of its gross income is derived
from these activities as per the last audited balance sheet of the company, the maximum
borrowings from banks should not exceed three times net worth funds. In respect of other
equipment leasing companies, the limit is two times their net owned funds. For this
purpose, net owned funds (NOF) is compared as follows:

Paid up capital + Free reserves - Accumulated balance of loss (balance of deferred

revenue expenditure and also other intangible assets)
With effect from. April 1997, RBI removed the overall limits of bank credit to leasing
companies to fully comply with the requirements of registration, credit rating and prudential
norms. The banks would therefore determine the level of credit to such companies on their
own. The measure was aimed at providing greater operational freedom to banks.

ii. Nature of facility: Leasing companies are provided with financial assistance by banks
based on the expected flow of lease rental receivables. Receivables out of a lease
transaction therefore constitute the essential asset for a leasing company. The credit limit
for each and every individual leasing company is determined within the calculated
maximum permissible bank finance. The facility is extended on a revolving basis whereby
leasing companies are permitted to avail the limit for other lease transactions on the
liquidation or the reduction of lease finance liability.

Maximum Permissible Bank Finance

Maximum Permissible Bank Finance (MPBF), also known as Drawing Power (DP) is calculated
on the basis of lease rental receivables in the next five years of leasing concerns. The method
involves calculation of outstanding credit for a period of five years, and the relevant drawing
power against that particular transaction. While calculating the MPBF, the following items are
excluded when arriving at the ceiling for bank leading:

 Fund's raised from financial/investment institutions.

 Deferred payment guarantees provided by the banks on behalf of leasing companies.
 Assets created against deferred payment guarantees issued by banks.

All these imply that bank finance will be to the extent of 3 times (or 2 times, as the case
may be) of NOF, irrespective of the quantum of finance raised by leasing companies from
financial/investment institutions.

Requirements
Leasing companies are expected to adhere to the following norms while availing financial
facility from banks:
(i) Current Ratio: The minimum current ratio of 1.33 as prescribed by the second method of
lending must be adopted by all leasing concerns. The ratio is required to be maintained by the
leasing companies, both for the estimated projections as well as for the actuals, as per the
latest audited balance sheet.

(ii) Reports: Every leasing company is required to submit the following statements as part of the
quarterly information system':

• Monthly statement of leased assets and rentals receivables with details such as lessee,
description of equipment, date of lease agreement, value of equipment (origina1),
depreciate value, lease rentals due to be bifurcated as overdue, due within next 60
months, due beyond next 60 months and total.

• Quarterly statement of the summarized position of current assets and liabilities,

indicating the estimates at the beginning of each quarter and actual of the quarter that
ended, along the pattern of CMA Database Form.

• Half yearly operating the funds now statements containing data relevant to leasing
business, along the lines of CMA Database Form.

• A certificate from statutory auditors/chartered accountants to be submitted for figures of

outstanding credit under lease agreement for calculation of MPBF

• The banks cannot finance secondary and tertiary lease agreements for the same
equipment, the bank finance being made available only to ‘full pay-out' leases of new
equipments.

• The receipts of lease rentals are required to be routed through the bank accounts, with no
diversion of funds to other lines of activities such as manufacturing, investment etc.

• Multiple banking/consortium arrangements are permitted if the borrowing/leasing

concerns deals with more than one bank in accordance with general guidelines in this
regard.

RBI introduced the following changes in terms of financing to leasing companies:

a. Formation of a consortium by a bank is not necessary, even if the credit limit per borrower
exceeds Rs. 50 crore.
b. Banks are permitted to extend credit using the 'need-base approach'
c. Banks are permitted to adopt the syndication route instead of the consortium route
irrespective of the quantum of credit involved, if the arrangement suits the borrower and the
financing banks.
d. The loan component of the working capital limit (MPBF) is enhanced to 80% and 75% in
case of borrowers enjoying working capital credit limit of Rs.20 crore and more and between
Rs.:10-20 crore respectively, the balance being in the form of cash credit.
e. The level of loan and cash credit component in case of borrowers with a limit of less than
Rs. 10 crore would be settled between the banks and the borrowers

The MPBF framework has been dismantled/withdrawn, and banks are now free to evolve
their own methods of assessing the working capital requirements of the borrowers within the
prudential guidelines and exposure norms. For this purpose, banks may follow a cash budget
system for assessing the working capital finance in respect of large borrowers. However,
individual banks may also retain the present MPBF system with necessary modifications, or any
other system. This calls for the formulation of a loan policy by every bank regarding its lending.

d) Borrowings from Institutions

Leasing companies obtain financial assistance from Development Finance Institutions (DFIs)
such as IFCI, IDBI, ICICI, etc. The salient features of the lending schemes operated by these
institutions are as follows:

Eligibility Criteria
The criteria of eligibility to be satisfied by the leasing companies, which seek financial assistance
from the financial institutions are:

• Type of organization: The leasing company must be aregistered cooperative society or

an incorporated public or private limited company.

• Profitability: The leasing company should be in leasing and/or hire purchase business
for a minimum period of three complete accounting years, with a satisfactory track record
of its performance and sound financial position. The company must be a profit-earning
and divided-paying concern, with no statutory due outstanding or no defaults committed
in repayment of the loans obtained from banks and financial institutions or fixed deposits.

• Default position: An important criterion to be used for assessing the credit worthiness of
the leasing company is that its average recovery of lease rentals has never gone down
beyond the limit of 10 percent defaults.

• Debt-equity ratio: The leasing company should have a reasonable satisfactory debt-
equity ratio and debt service coverage ratio not exceeding 4:1, and debt service coverage
ratio of around 1.60

• Eligible businesses: In order to be eligible, the concerns must be engaged in leasing of

industrial plants, equipments, machinery, or other fixed tangible assets, including
vehicles, ship, and aircraft.

Terms and Conditions

The main terms and conditions relating to lending by financial institutions to leasing companies
are:
• Interest: The loans advanced by financial institutions bear fixed rate of interest,
calculated on an annual basis, on the outstanding principal amount. Interest rates are
flexible, but are fixed by institutions in consultation with each other.
 • Commitment Charge: Commitment charges are payable by leasing companies @ 1%
per annum from the date of the loan agreement. The purpose of levying commitment
charges is to ensure that leasing companies duly make use of the loan sanctioned by
financial institutions.

• Liquidated damages: Liquidated damages are payable by leasing companies where there
is a default committed in the payment of principal, interest, commitment charge or other
amount payable under the loan agreement. It is imposed @ 2% per annum. Moreover, the
arrears of liquidated damage also carry interest at the applicable rate of interest.

• Period of repayment: Repayment period is usually decided between the leasing

company and the financial institution, depending on the nature of cash flows from the
leasing business. Loans are to be generally repaid in a period of 3 or 5 years, in monthly
instalments. The instalment payment starts from the month following the procurement of
the loan amount. Wherever morotorium is allowed, the repayment will commence only
after the expiry of the said period.

• Security/Margin: Exclusive charge has to be created on all its immovable and movable
properties, subject to the existing charge created by the company thereon by the borrower
leasing company, in favour of the institution lending money on the acquisition of
equipment, plant and machinery and other assets by the company. A security margin to
the extent of 33.3% is required to be maintained. The margin may be maintained in the
form of additional assets with the lender, or by way of cash deposits.

• Personal guarantee: In order to ensure timely payment of the loan instalments, personal
guarantees of one or more promoters/directors will be required by the lending
institutions. Such guarantees will be irrevocable and unconditional, and may be joint or
several for the payment of the loan, all interests and other amount thereon.

• Assignment of lease rentals: Financial institutions may require the leasing company to
assign the right on the lease rentals. This may done as an additional precaution to ensure
zero default.

• Other conditions: In addition to the above terms and conditions, the lending agency may
also put forth terms such as proper utilization of loan amount, safety to the equipment
purchased with the loan amount, insurance of the leased assets purchased with the loan
amount, restricting utilization of loan amount to purchase the approved asset to be lease
out, etc.

3.3 FINANCIAL EVALUATION OF LEASING

Financial viability of a lease can be evaluated separately (i) from the point of view of the
lensee, and (ii) from the point of view of the lessor,
(1) Lessee's Point of view
Once a firm has evaluated the economic viability of an asset an investment and
accepted/selected the proposal, it has no consider alternate methods of financing the investment.
However, in making investment, the firm need not own the asset. It is basically interested in
acquiring the use of the asset. Thus, the firm may consider leasite of the asset rather than buying
it. In comparing leasing with buying the cost of leasing the asset should be compared with the
cost financing the asset through normal sources of financing, i.e. debt and equity. Since, payment
of lease rentals is similar to payment of interest on borrowings and lease financing is equivalent
to debt financing, financial analysts argue that the cost of borrowing. Hence lease financing
decisions relating to leasing or buying options primarily involve comparison between the cost of
debt-financing and lease financing.

The evaluation of lease financing decisions from the point view of the lessee involves the
following steps:
(i) Calculate the present value of net-cash flow of the buying option, called NPV (B).
(ii) Calculate the present value of net cash flow of the leasing option, called NPV(L)
(iii)Decide whether to buy or lease the asset or reject the proposal altogether by applying the
following criterion:
(a) If NPV(B) is positive and greater than the NPVL purchase the asset.
(b) IF NPV(L) is positive and greater than the NPV(B), lease the asset.
(c) If NPV(B) as well as NPV(L) are both negative, reject the proposal altogether.

Since many financial analysts argue that the lease financing decisions arise only after the
firm has made an accept-reject decision about the investment; it is only the comparison of cost of
leasing an borrowing options. The following steps are involved in such an analysis.

(i) Determine the present value of after-tax cash outflows under the leasing option.
(ii) Determine the present value of after-tax cash. outflows under the buying or borrowing
option.
(iii) Compare the present value of cash outflows from leasing option with that of
buying/borrowing option.
(iv) Select the option with lower presented value of after-tax cash outflows.

Illustration 1. A limited company is interested in acquiring the use of an asset costing Rs.
5,00,000. It has two options: (1) to borrow the amount at 18% p.a. repayable in 5 equal
instalments or (ii) to take on lease the asset for a period of 5 years at the year end rentals of Rs.
1,20,000. The corporate tax is 50% and the depreciation is allowed on w.d. v. at 20%. The asset
will have a salvage of Ra. 1,80,000 at the end of the 5th year.
You are required to advise the company about lease or buy decision. Will decision
change if the firm is allowed to claim investment allowance at 25%?

Note: (1) The present value of Rs. 1 at 18% discount factor is:

Ist year .847

2nd year .718
3rd year .609
4th year .516
5th year .437

(2) The present value of an annuity of Re. 1 at 18% p.a. is Rs. 3.127.

Solution:

(i) Calculation of Loan Instalment

𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝐿𝑜𝑎𝑛
Loan Instalment=
𝑃.𝑉.𝐹𝑎𝑐𝑡𝑜𝑟 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦

5,00,000
i. =
3,127
ii. = Rs. 1,59,898 appx.

(ii) Schedule of Loan Payment

Year Loan Balance At Loan Interes Principal Loan Balance at

beginning of the Instalment t Payment (Rs.) the end of the year
year (Rs.) (Rs.) (Rs.) (Rs.)

1. 5,00,000 1,59,898 90,000 69,898 4,30,102

2. 4,30,102 1,59,898 77,418 82,480 3,47,622
3. 3,47,622 1,59,898 62,572 97,326 2,50,296
4. 2,50,296 1,59,898 45,053 1,14,845 1,35,451
5. 1,35,451 1,59,832 24,381 1,35,451 Nil

The amount of loan instalment in the last year is different from the equal payments
because of compensation for rounding error.
 (iii) Calculation of Present Value of After-Tax Cash Outflows under Borrowings/Buying
Option

Year End Loan Tex Geving on Net Cash P.V. P.V. of after
Instalment (Rs.) Factor at tax net cash
Interest Dep. (after- Total 18% outflow(Rs.)
(Rs.) tax) (Rs.) (Rs.)

Col. 1 2 3 4=2-3 5
1. 1,59,898 45,000 50,000 95,000 64,898 .847 54,969
2. 1,59,898 38,709 40,000 78,709 81,189 .718 58,294
3. 1,59,898 31,286 32,000 63,286 96,612 .609 58,837
4. 1,59,898 22,527 25,600 48,127 1,11,771 .516 57,674
5. 1,69,832 12,190 20,480 32,670 1,27162 .437 55,570

Total : 2,85,344

75,660
Loss: P.V. of sedrap at the cad of ¹ year
2,06,684
(1,80,000x.437)

(iv) Calculation of Present Value of After-Tax Cash Outflows under Lease Option

Year Lease Tax savings on After-Tax P.V.Annuity Total P.V. of Cash

Rental Lease Rent Cash Factor at 18% Outflow
outflow

(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)

1-5 1,20,000 60,000 60,000 3.127 1,87,620

(v) Evaluation: As the present value of after-tax cash outflows under the leasing option are lesser
than the present value of after-tax cash outflows of the buying option, it is advisable to take the
asset on lease.

(vi) Decision If Investment Allowance is allowed: In case investment allowance is allowed on

purchase of asset the total of present value of net cash outflows will decrease by the present
value of tax savings on investment allowance as below:
 Investment Allowance
Rs
(allowed at the end of 1st year 5,00,000 x 25/100 1,25,000

Tax Savings (50%) 62,500

P.V. Factor of the end of year 1 .847

P.V. of Tax Savings on Investment Allowance 52,938

Hence, P.V. of Cash Outflows in Buying Option 1,53,746

shall be
- Rs. 2,06,684-52,938

In that case, the P.V. of cash outflows under buying option shall be lesser than the P.V. of
cash outflows under leasing option and the company should buy the asset.

(II.) Financial Evaluation From Lessor's Point of View

The financial viability of leasing out an asset from the point of view of lessor can be
evaluated with the help of the two time adjusted methods of capital budegeting:
(a) Present Value Method
(b) Internal Rate of Return Method.

(a) Present Value Method

This method involves the following steps:
(i) Determine cash outflows by deducing tax advantage of owning an asset, such as investment
allowance, if any.

(ii) Determine cash inflows after-tax as below:

Lease Rental (say) Rs.

1,00,000
Less: Depreciation (say) 20,000
Earnings Before Tax (EBT) 80,000
Less: Tax (say 50%) 40,000
Earnings After Tax (EAT) 40,000
Add: Depreciation 20,000
Cash Inflows After Tax (CFAT) 60,000

(iii) Determine the present value of cash outflows and after tax cash inflows by discounting at
weighted average cont of capital of the lessor.
(iv) Decide in favour of leasing out an asset if P.V. of cash inflows exceeds the P.V. of cash
outflows, i.e., if the NPV is +ve: otherwise in case N.P.V. is-ve, the lessor would loce on leasing
out the asset.
The above technique has been explained with the help of the following example.

Illustration 2. From the information given below, you are required to advise above leasing out of
the asset.

Cost of Equipment Rs. 4,00,000

Average Cost of Capital to the lessor 12%

Depreciation (Allowable) 20% on original

cost
Expected Life of Asset.
5 years
Salvage Value
Nil
Lease Rent payable at the end of each of 5 years
Rs. 1,50,000
Corporate Tax (applicable to lessor)
50%
P.V. of an annuity of Re. 1 for 5 years at 12% is Rs. 3.605
Solution:
(i) Calculation of Cash Outflow (Rs.)
Cost of Equipment 4,00,000
Less: Tax Advantage, if any Nil
Cash Outflow
4,00,000

(ii) Calculation of After-Tax Cash Inflows (Rs.)

Lease Rental 1,50,000
Less: Depreciation 80,000
Earnings Before Tax (EBT) 70,000
Less: Tax at 50% 35,000
Earnings After Tax (EAT) 35,000
Add: Depreciation 80,000
Cash Inflows After Tax (CFAT) 1,15,000

(iii) Calculation of Present Value (P.V.) of Cash Outflows

Year (Rs.) Cash Outflow P.V. Discount Factor P.V. of Cash Outflow
(Rs.) at 12% (Rs.)
0 4,00,000 1.00 4,00,000
 (iv) Calculation of P.V. of Cash inflows

Year Cash flow After Tax P.V. Annuity Discount P.V. of Cash Inflows
(CEAT) Rs Factor at 12% (Rs.)

1-5 1,15,000 3.605 4,14,575

(v) Calculation of Net Present Value

Rs.
Present value of cash inflows 4,14,575
Less: P.V. of Cash Outflows 4,00,000
Net Present value of Cash flows 14,575

Since the present value of cash inflows is more than the present value of cash outflows or
say N.P.V. is positive, it is desirable to lease out the asset.

(b) Internal Rate of Return Method

The internal rate of return can be defined as that rate of discount at which the present
value of cash-inflows is equal to the present value cash outflows, can be determined with the
help of following mathematical formula:

𝐴1 𝐴2 𝐴3 𝐴𝑛
C= + + +……….+
(1+𝑟) (1+𝑟)2 (1+𝑟)3 (1+𝑟)11

where, C=Initial Outlay at time Zero

A1,A2,………,An=Future net cash flows at different periods
2,3.......,= Numbers years
r= Rate discount internal rate return.

The internal rate return can also determined with the help of present value tables. The following
steps are required practice the internal rate return method:

1) Determine the future net cash flows for the period of the lease. The net cash inflows are
estimated future net cash flows for the period of the lease. The net cash inflows are estimated
future earnings, from leasing out asset, before depreciation but after taxes.

2) Determine the rate of discount at which the present value of cash inflows is equal to the present
value cash outflows. This may be determined as follows:

(i) When the annual net cash flows are equal over the life of the asset:
 Firstly, find out Present Value Factor dividing initial outlay (cost of the investment) by
annual cash flow,i.e.
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦
Present Value Factor=
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤

Then, consult present value annuity tables with the number of year equal to the life of the
asset and find out the rate at which the calculated present value factor is equal to the present
value given in table.

Illustration 3

Initial Outlay 50,000

Life of the Asset 5 years
Estimated Annual Cash-flow Rs. 12,000
Calculate the Internal Rate of Return

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦
Present Value Factor=
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤

50,000
= =4
12,500
Consulting Present Value Annuity Tables for 5 years periods at Present Value Factor of
4.(For Present Value Tables see Appendix A and B given at the end of the book)

Internal Rate of Return = 8% approx.

(as seen from the table that at 8% for 5 year period, the present value is 3.9927 which is
nearly equal to 4.)

(ii) When the annual cash flows are unequal over the life of the asset:
In case annual cash flows are unequal over the life of the asset, the internal rate of return
cannot be determined according to the technique suggested above. In such cases, the internal rate
of return is calculated by hit and trial and that is why this method is also known as hit and tried
yield method. We may start with any assumed discount rate and find out the total present value
of all the cash flows by consulting present value tables. The so calculated total present value of
cash inflows as compared with the present value of cash outflows which is equal to the cost of
the initial investment where total investment is to be made in the beginning.The rate at which the
total present value of all cash inflows equals the initial outlay, is the internal rate of return.
Several discount rates may have to be tried until the appropriate rate is found. The calculation
process may be summed up as follows.

(i) Prepare the cash flow table using an arbitrary assumed discount rate to discount the net
cash flow to the present value.

(ii) Find out the Net Present Value by deducting from the present value of total cash flows
calculated in (i) above the initial cost to investment
 (iii) If the Net Present Value(NPV) is positive, apply higher rate of discount.

(iv) If the higher discount rate still gives a positive net present value, increase the discount
rate further until the NPV becomes negative.
(v) If the NPV in negative at this higher rate, the internal rate of return must be between
these two rates:

3) Accept the proposal if the internal rate of return in higher than or equal to the minimum
required rate of return, is the cost of capital or cut off rate.

4) In case of alternative proposals select the proposal with the highest rate of return as long as
the rates are higher than the cost of capital or cut-off rate.

Illustration 4.

Initial Investment Rs.

60,000
Life of the Asset 4 year
Estimated Net Annual Cash Flows: Rs.
IstYear 15,000
2nd Year 20,000
3rd Year 30,000
4th Year 20,000

Compute the internal rate of return and also advise the lessor about the leasing out
décision if his expected minimum rate of return is 15%.
Note: Present Value Factor at various rates of discount.

Year 10% 12% 14% 15% 16%

1. .909 .892 .877 .869 .862
2. .826 .797 .769 .743 .756
3. .751 .711 .674 .657 .640
4. .683 .635 .592 .571 .552
Solution:
P.V. Cash Flowsa Table at Various Assumed Discount Rates of 10%,12%, 14% & 15%

Year Annual Discount Rate 10% 12% 14% 15%

Cash flow
Rs. P.V.P. P.V. P.V.P P.V. P.V.P P.V P.V.P P.V
(Rs.) (Rs.) (Rs.) (Rs.)
1. 15,000 .909 13,635 .892 13,380 .877 13,155 .369 13,035
2. 20,000 .826 16,520 .797 15,940 .769 15,380 .756 15,120
3. 30,000 .751 22,530 .711 21,330 .674 20,220 .657 19,710
4. 20,000 .683 13,660 .635 12,700 .592 11,840 .571 11,420
66,345 63,350 60,595 59,285
 The present value of cash flows at 14% rate of discount is Rs. 60,595 and at 15% rate of
discount it is Rs. 59,285. So the initial cost of investment which is Rs. 60,000 falls in between
these two discount rates. At 14% the NPV is + 595 but at 15% the NPV is - 715, we may say that
IRR= 14.5% (approx)
(1) As the IRR is less than the minimum required rate of return, the lessor should not lease
out the asset.

3.4 METHOD OF COMPUTING LEASE RENTALS

The following steps are involved in computing lease rentals:

(1) Determine the cost of the asset which includes the actual purchase price and expenses
like freight, insurance, taxes and installation, etc.

(2) Determine the cash flows to the lessor on account of ownership of the asset. These
include tax advantage provided by depreciation and investment allowance.

(3) Calculate the present value of cash flows as determined in step 2.

(4) Substract the present value of cash flows of ownership advantage from the cost of the
asset determined in step 1 so as to determine the minimum required net recovery through
lease rentals.

(5) Calculate the post-tax lease rentals by dividing the minimum required net recovery
through lease rentals by present value factor of annuity.

(6) Compute the pre-tax lease rentals by adjusting the post-tax lease rentals for the tax factor.
The above method of computing leasc rentals can be followed from the following
illustration.

Illustration 5.
Sunny Leasing is considering to lease out an equipment costing Rs. 10,00,000 for five
years, which is the expected life of equipment, and has an estimated salvage value of Rs.
1,00,000. Sunny Leasing can claim a depreciation of 20% on w.d.v. of the asset but is not
eligible for investment allowance. The firm falls under a tax rate of 50% and the minimum post-
tax required rate of return is 12%. You are required to calculate the lease rental which the firm
should charge.

Note: (1) Present Value Factor at 12% discount rate is as below:

Year 1 = .893; Year 2=.797; Year 3 = .712; Year 4 = 636 and Year 5 =.567

(2) Annuity Discount Factory at 12% for 5 years = 3.605.

Solution:
(i) The cost of the equipment = Rs. 10,00,000 (given)
(ii) Calculation of cash flows to the lessor on account of ownership of the asset.
 Year Amount of Tax advantage Tax advantage on Salvage Total
Depreciation on Dep. investment Allowance Value C.F.
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
1. 2,00,000 1,00,000 Nil - 1,00,000
2. 1,60,000 80,000 Nil - 80,000
3. 1,28,000 64,000 Nil - 64,000
4. 1,02,400 51,200 Nil - 51,120
5. 81,920 40,960 Nil - 1,40,960

(iii) Calculation of Present Value of Cash Flow:

Year Cash Flows P.V. Factors P.V. of Cash Flow

(Rs.) at 12% Rs.
1. 1,00,000 .893 89,300
2. 80,000 .797 63,760
3. 64,000 .712 45,568
4. 51,200 .636 32,563
5. 1,40,960 .567 79,924
Total 3,11,115

(iv) Minimum required net recovery through lease rentals:

MRLR = Rs. 10,00,000-3, 11, 115
= Rs. 6,88,885

(v) Post-tax Lease Rental (PTLR)= 6,88,885 / 3.605

= Rs. 1,91,092

(vi) Pre-tax Lease Rental (LR)= 1,91,092 x 100/50=Rs. 3,82,184

Lease Rent expressed in terms of lease financing.
1,000 1
3,82,184 x 10,00,000 x 12
= 31.85 per thousand per month.

3.5 INTERNATIONAL LEASING

If the parties to the lease transaction are domiciled in different countries, it is known as
international lease. It covers three separate types viz. Cross boarder leasing, import leasing and
overseas subsidiaries.
a) Cross Border Leasing
Leasing across national frontiers is cross border leasing where the lessee and lessor are
domiciled in different countries. The domicile of the supplier is immaterial. It includes export
leasing. A number of commercial banking groups including the Bank of America have been
involved in promoting the cross border market from London.

b) Import Leasing
In an import lease, the lessor and the lessee are domiciled in the same country, but the
equipment supplier is located in a different country. The lessor imports the asset and leases it to
the lessee.

c) Overseas subsidiaries
In this financial institutions sets up leasing subsidiaries overseas, each conducting purely
domestic business involving lessees in the same country. In this field, Barclays and Lloyeds
Bank International have set up their leasing subsidiaries in Canada, USA, Belgium, Hong Kong,
Australia, etc.
Since the parties to the lease transaction are domiciled in different countries, any
international lease transaction is affected by two additional risk factors i.e. country risk and
currency risk. The country risk arises from the changes in political and economic conditions and
the tax and other regulations governing the lease transactions in the foreign country concerned.
The payment to the supplier and the lease rentals are denominated in different currencies.
Currency risk will arise when any variation in the exchange rate occur.

4. SUMMARY
Leasing is an arrangement that provides a firm with the use and control over assets
without buying and owning the same. Leasing is governed by the relevant provisions of a
number of legislations and there is no standardised lease agreement. There are several sources of
funding that are available to leasing companies. The most important of these funding sources are
public deposits, bank borrowings and institutional borrowings. Financial viability of a lease can
be evaluated separately from the point of view of lessor as well as lessee. If the parties to the
lease transaction are domiciled in different countries, it is known as international lease.

5. SUGGESTED READINGS

1. Khan M.Y., Financial Services, Tata McGraw Hill Publishing Company Ltd., N. Delhi.

2. Pandey I.M., Financial Management, Tata McGraw Hill Publishing Company Ltd., New Delhi.

3. Prasan Chandra, Financial Management, Tata McGraw Hill Publishing Company Ltd., New
Delhi.

4. Johan J. Hampton, Financial Decision Making, Prentice Hall of India, New Delhi.

5. James C. Vem HorNe, Financial Management, Prentice Hall of India, New Delhi.
6. SELF ASSESSMENT QUESTIONS
1. What are the main clauses of a lease agreement ?
2. List the main sources of finance available to a leasing company.
3. Discuss the framework for lease evaluation from the point of view of a lessee.
4. Explain the steps involved in computation or case rentals.
 FACTORING: MEANING, FEATURES, TYPES,
FACTORING IN INDIA

STRUCTURE
1. Introduction
2. Objective
3. Presentation of Contents
3.1 Concept of Factoring
3.2 Nature of Factoring Services
3.3 Pricing of various services
3.4 Advantages and Disadvantages of Factoring
3.5 Operational Problems of Factoring
3.6 Potentiality for Factoring in India
3.7 Major Players in Factoring in India.
3.8 Legal Aspect of Factoring
3.9 Factoring in India
3.10 Recommendation of Kalyanasundaram Committee
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
Factoring is a financial service whereby an institution, called the Factor, undertakes the
task of realizing accounts receivables, book debts and bill receivables, and in the process
provides financial accommodation to traders. Factoring is of different types, such as domestic
factoring, export factoring, cross border factoring, with recourse factoring, without recourse
factoring, etc. Many advantages accrue from factoring, such as easy and convenient mode of
short term financing for a trader, facilitating accelerated cash flows, inculcating credit discipline,
facilitating information flow, etc. Factoring is considered a boon for the SSI sector too. However,
engaging a factor may be reflective of the inept management of receivables by a firm.

2. OBJECTIVE
After reading this lesson, you should be able to
(a) Define factoring and explain the nature of factoring
(b) Discuss the advantages and limitations of factoring.
(c) Explain the legal aspects of factoring.
(d) Present a picture of factoring in India.

3. PRESENTATION OF CONTENTS
3.1 CONCEPT OF FACTORING
One of the important effects of integration of Indian economy is the introduction of
various financial services which were till date alien, to India. Factoring is one of those services
which before liberalization was present only in UK and USA. In India the first factoring
 company was jointly formed by can Bank Financial Services Ltd. and RCF Ltd. Factoring is a
continuing arrangement between a firm supplying goods and services and a factoring enterprise.
Under this arrangement the factoring enterprise provide the following services in respect of
receivable management to the firm supplying goods and services. The services provided are

1. Maintaining sales ledger and other book keeping services.

2. Collecting the accounts receivable from company's customers
3. Assuming all the risk of default by firms customers
In addition to above services the factor also provides various advisory services. The
process involved in factoring are enumerated below:
1. The customer places an order with the seller (the client).
2. The factor and the seller enter into a factoring agreement about the various terms of factoring.
3. Sale contract is entered into with the buyer and the goods are delivered. The invoice with the
notice to pay the factor is sent along with.
4. The copy of invoice covering the above sale is sent to the factor, who maintains the sale ledger.
5. The factor prepays 80% of the invoice value.
6. Monthly statements are sent by the factor to the buyer. If there are any unpaid invoices, follow
up action in initiated.
7. The buyer settles the invoices on expiry of credit period allowed.
8. The balance 20% less the cost of factoring is paid by the factor to the clients.
Factoring is the time honored and increasingly utilized financial tool that speeds
businesses cash flow. To do this, factor purchase credit-worthy accounts receivable at a small
discount and convert invoices (sales) in to immediate cash. Factoring is not a loan. There is no
debt repayment, no compromise to balance sheet, no long-term agreements or delays associated
with other methods of raising capital.

Various Factoring Services

(1) Limited Factoring
In this case, the factor discounts only certain invoices on selective basis and converts
credit bills into cash in respect of the bills only.
(2) Factoring with Recourse
Here the factor acts as an agent for collection of bills and does not cover the risk of
customer's failure to pay debt or interest on it. The factor has a right to recover the funds from
the seller client in case of such defaults as the seller takes the risk of credit and credit worthiness
of buyer.
(3) Based on Maturity
This factoring service provides no advance credit or financing to the client. The maturity
date-wise bills collection work is entrusted to the factor who in turn for a charge arranges to
collect the funds due This can be done on a discounted basis which includes the coverage of risk
and the factor proceeds against the debtor as per the contractual forms and law.

(4) Based on Selected Buyer

In this case, the approved buyers of a company, based on their reputation and credit
worthiness approach the factor for discounting their purchases or bills to the company in
question. The claims on such buyers are paid by discounting the bills without resource to seller.
(5) Based on Selected seller
Here, the seller sells all his accounts receivables to the factor, after invoicing the
customers. The seller passes on all the documents like the invoice delivery challan, contracts, etc.
to the factor who takes over the remaining functions as reminders to the buyers, maintaining the
accounts, collecting the funds and do all consequential and incidental functions for the seller.

(6) Full Factoring

Under this system, the factor renders all services of collection of receivables,
maintenance of sales ledger, credit collection, credit control and credit insurance. The factor also
provides a drawing limit based on the bills outstanding maturity-wise and takes the
corresponding risk of default or credit risk and the factor will have claims on the client creditor.
There are a number of other variants of this service, in terms of maturity-wise bills
collection, maintenance of accounts, complete take over of all bills in the ledger, with or without
resource, etc. These methods are all prevalent in most advanced countries, but in India only a
beginning has been made. There is no insurance against risk of the debtor failure and as such
many factoring agencies like SBI Factors are doing factoring for good companies with recourse.

3.2 NATURE OF FACTORING SERVICES/OPERATIONS

The salient features of the factoring services in India in terms of the operations of the SBI
Factors and Canbank Factors are recapitulated as follows:

Domestic Factoring
This type of factoring service is advance recourse factoring. The factor undertake
collection and credit service. Deferred credit transaction type of credit sales are not eligible for
factoring which is confined only to short term debt. A seller can have his invoice converted into
instant cash up to 80 per cent. They also undertake to maintain sales ledger by using
computerized systems monthly analysis and overdue invoice analysis. Customers payment
reports are also provided to the clients. Once a line of credit is established availability in cash is
directly geared to sales. These services are provided against receivables, services, charges/fees
without guarantee/security being insisted upon.

Export Factoring
Export factoring is a service aimed at improving cash flow when sale in made on credit.
Export factoring offers:

1. 100% protection against non-payment through customer insolvency.

2. Invoice financing for approval customers.
3. Advance payment up to 90% of the invoiced amount.
4. Fully computerized accounting and collection services for each client in several
currencies.

Major advantages of export factoring

1. Immediate cash up to 90% of the value of assigned invoices can be available.
2. Payment collection responsibly is with the assigned receivables.
3. Protection against customer insolvency. If customer is unable to pay due to insolvency,
factor will reimburse full amount of the outstanding assigned invoices.
 4. Factor will provide weekly or monthly analysis of sales and payable invoices as well as
reports on customer payments.
5. Factor will also provide flexible financing services.
6. Factor also support to customer in, sales promotion by providing information about your
products to potential buyers.
7. No other collateral guarantees are required when factor provide finance to customer.
8. Factor provide cost effective funding in term of financial expenses

The Cost of Export Factoring

1. Factoring fee
2. Discount rate

Factoring Fee
It includes the administrative handling of invoices and the guarantee against customer
insolvency. It is based on the following criteria:
1. Degree of customer insolvency risk.
2. Total factored turnover.
3. The number of assigned invoices and their average value.
4. The value of claims issued.

Discount Rate
It is similar to the short-term credit rate set by commercial banks. However, it is
calculated only on the basis of actual funding used. In the cases of foreign currency financing,
interest rates are determined on the basis of LIBOR rates for individual currencies.
The RBI has approved the scheme evolved by the Export Credit Guarantee Corporation
of India Ltd., for providing a non-fund based export factoring service to the exporters who are
ECGC policy holders. Under the scheme the ECGC undertakes non-fund based export factoring
as an in-house service. It grants, by an endorsement to the policy, 100 per cent credit protection
for bills drawn on approved overseas buyers.
The ECGC concludes a tripartite agreement with the exporter and his authorized dealer to
the effect that:

(a) In the event of non-payment of any factored bill, the ECGC would unconditionally pay
the authorized dealer the value of the bill immediately after the expiry of 30 days from
the due date of the bill on the bank's advice of non-payment.
(b) In consideration of the above unconditional guarantee, the authorised dealer would
discount the bills without recourse to the exporter except as indicated at (d) below.
(c) The exporter would authorize the dealer to deduct the ECGC's factoring chares from the
proceeds of each bill and remit it to the ECGC.
(d) If non-payment of the bill is due to the fault of the exporter, the authorized dealer would
still be paid by the ECGC as per the guarantee contained in the tripartite agreement, but
the ECGC would have recourse to the exporters.
(e) The exporter, as also his bank, would be associated with the efforts to recover the debt
from the foreign buyer and all necessary expenses would be borne by the ECGC.
 (f) Till such time the payment is made by the overseas buyer on ECGC, the interest payment
on post-shipment credit would be as per the Reserve Bank's directives issued from time
to time.
(g) In the even of failure of the exporter to realize the export proceeds in the stipulated time
the ECGC would obtain direction from the Reserve Bank in their turnover entitling them
to recover the amount from the foreign party.

The RBI has approved a scheme proposed by the SBI Factors for providing export factoring with
recourse basis to its clients. The modalities of the schemes are:

The exporter should submit to SBI Factors a list of his customers with adequate details
together with his credit line requirements, which will select an import factor based in the
customers' country who will rate the importer and intimate the results to it. The Indian exporter
would apply for a credit limit in respect of the overseas importer. The import factor will grant the
credit based on the credit worthiness of the overseas importer. The exporter will then enter into
an export factoring agreement with the export factor (SBI Factor). All export receivables will be
assigned to it w will in turn assign them to the respective importer's country. Copies of the
invoices and shipping documents will be sent to the import factor through SBI Factors who will
make prepayment to the exporter against the approved export receivables. On receipt of sale
proceeds from the buyer on the due date of the invoice, the import factor will remit the funds of
the SBI Factors. The SBI Factors will convert the foreign currency remittances into rupees and
transfer the proceeds to the exporter. A service fee of 0.52 per cent of the value of the invoice
will be levied. If the importer is unable to pay the proceeds of the goods exported, the import
factor will pay the receivables to the export factor, 100 days after the due date. All such incidents
are to be reported by the SBI Factors to the RBI in half yearly statements. indicating the reasons
for delay on non-payment by the importer. The SBI Factors would act only as export factor. It is
not authorized to act as import factor.

From the beginning of 1997, for the first time a joint venture company-Foremost Factors
Ltd., has commenced offering export factoring to Indian exporters. As the first private sector
factoring company, the Foremost Factors Ltd., (FFL) is a joint venture between the Mohan
Exports and the Nations Bank Overseas Corporation, as a wholly owned subsidiary of National
Bank, (USA), 20th Century Finance Corporation and the ICDs group. It would provide the
exporter up to 80 per cent prepayment against his account receivables. The remaining 20 per cent
would be paid when the full payment is received from the customer/buyer. The exporter would
also get the additional benefits the open account trading without credit risk, since, the FFL would
arrange credit risk protection on agreed terms. The FFL is a member of Factors Chain
International, a group that includes nearly 120 of the world's leading financial institutions in 50
countries. Since the FFL uses EDIFACT, the standard International Electronic Data Intercharge
Factoring Network, it can provide speedy and reliable reporting on their overseas account.

Client: The domestic factoring by the Canbank Factors and SBI Factors is available to all forms
of business organizations engaged in manufacturing, services and trading. They include sole
proprietary concerns, partnership firms and corporations, the focus being on profit making
growing concerns.
Credit Limit: In order to limit the exposure, a ceiling on credit in terms of the value of the
invoice to be purchased is generally fixed for each client for medium/smail scale units. Presently,
the upper limit is in the range of Rs. 2.4.5 crore or approximately 15-25 per cent of the net worth
of the client. The period for which debts are factored ranges between 30-90 days.

Service Fee and Discount Charge: There is a credit rating system to evaluate the clients on
various criteria such as the level of receivables turnover and so on. The service fee payable in
advance on domestic factoring is at present in the range of 0.5-2 per cent of the invoice value for
different category of clients depending on the type of source and volume of business. In addition,
the factors also levy a monthly Payable usually in arrear discount charge on pre-payment draw
the client. It normally tallies with the bank lending rate. In the case of high rated clients it is
currently one percentage point lower than the rates on the working capital advances under the
cash credit system. The cost of funds with recourse option is generally higher by 1-2 per cent
over the cash credit rates. It is much higher in the without recourse option due to higher risk. The
service fee and the discount charge, as a price of the service provided by the factors, depend
upon their funding cost and the operation cost associated with the 'screening of the proposal,
collection and sale ledger administration and other overheads including depreciation.

Funding:The main source of the factors in India at present are: (i) equity capital and reserves,(ii)
public deposits.
The factors enjoy line of credit from the banks and the SIDBI. As per RBI guidelines, the
banks can lend to the factoring subsidiaries only at the prevailing commercial rate of interest.
Such finance to the factors is restricted to one time their net owned funds at par with residuary
non-banking finance companies. The line of credit from the sponsoring banks is available in
respect of their exposure to non-small scale industries (SSI) units only. According to RBI
guidelines, banks have to ensure that double financing of the same assets through factoring and
bank borrowing does not take place. The factors and banks should have share information about
common borrowers to avoid a situation in which a company may obtain working capital for an
asset from a bank and also get it factored by a factor. The banks have to issue letters of
disclaimer indicates the title of the receivable. The factor in turn route the proceeds of
prepayment and final adjustment through the borrower’s bank.

In the case of consortium financing, the proceeds have to be routed through the ledger of
the consortium. The factor must obtain a no-objection certificate from the borrower bank before
factoring receivables. The borrowers should declare separately the extend of book debts
proposed to be factored and those against which bank finance is to be obtained in their projection
for assessment of bank credit. While arriving at the MPBF, banks can deduct from current assets
the receivables to be factored. This has to be done before arriving at the minimum requirement of
net working capital and working gap.
Alternatively, amounts to be received from factor is to be essentially considered as a
source of funds while arriving at the cash gap or cash surplus portion. The banks have also to
obtain from the borrowers periodical certificates regarding factored receivables to avoid double
financing. It is also mandatory for factors to intimate the limits sanctioned to the borrower to the
concerned banks and details of debts factored. This could be cross-checked with the certificate
obtained by banks from the borrower. However, the extent of finance obtained from factors does
not come within the purview of the credit monitoring arrangement.
 The SIDBI, on the other hand, extends lien of credit to the factors to provide such
services to the SSI clients at a pre-determined concessional rate.
The factors can also accept public deposits in terms of the RBI guidelines which
presently restricts them to a maximum of 25 percent of their net worth at par with manufacturing
companies.
Thus, the funding of factors is presently dominated by equity capital with severe
restrictions on the use of debt.

3.3 PRICING OF VARIOUS SERVICES

The pricing of various services rendered by the factors depends upon the creditworthiness
of the customers, his track record, turnover etc. But, the cost of funds and other costs to be borne
by the factors influence the pricing. The pricing of financial services is suggested to be around
16% p.a. and for other services on the aggregate not to exceed 2.5% to 3% of the serviced debts.

3.4 ADVANTAGES AND DISADVANTAGES OF FACTORING

Advantages of Factoring
- Management adds cash to the bottom line and improves the debt-to-equity ratio. No long-
term negative implications to the balance sheet are recorded.
- Advance inventories can be purchased despite cash flow shortages. Temporary reversals
need not have a negative effect.
- Slow-paying customers can be carried at little or no charge.
- High-growth start-up can finance growth on a current basis.
- A seed company can, in effect, "borrow" money with no credit rating. The cost of money
is low or non-existent if the sales price of products can be marked up.
- Many factor companies require no minimum volume of amount. Factoring can be a one-
time-only strategy, although infrequent factoring results in higher rates and/or deeper
discounts on the asset.
- Prompt payment and reduction in debt Capital locked up in the form of outstanding
sundry debtors is available for use within the business, as all sales becomes cash sales.
- Improves current ratio: Improvement in the current ratio, an indication of improved
liquidity, enables better working capital management.

Disadvantages of Factoring
- Unless the company can mark up the sales price of its product, the cost of short-term
money can be high.
- Relations with customers might be jeopardized by the loss of personal contact especially
so if the factor company is not tactful in collecting the amounts owing.
- A bad credit rating can result in additional factor fees and less favorable contract terms.
- Factoring can revenue, earnings or accounts receivables unless there is a matching
increase in cash.

3.5 OPERATIONAL PROBLEMS OF FACTORING

The factoring service in India is at a nascent stage. Its quantitative growth is relatively
limited. Its future depends on the removal of a number of genuine operational obstacles.
 1. Credit Information: The factors do not have access to any authentic common source of
information. They have to depend on their own data-base for credit evaluation of clients.
The system multiple data-base by individual factors is not only expensive but is also
devoid of uniformity and obviously is a serious impediment in the growth of factoring
service. The establishment of specialized credit information agency/bureau is urgently
called for.

2. Stamp Duty: The assignment of debt attracts duty charged by the states which is as high
as 15 per cent on the amount exceeding Rs. 2 lakh. It inflates the cost of operations of
service and erodes the profitability of the factors. There is a very strong case for waiving
of stamp duty on assignment of debt factors.

3. Legal Framework: Changes are also called for in other components of the present legal
framework to ensure of factoring in India. The kalyanasundaram committee had listed
these which are summarized in the following page.

4. Funding: The factors in India are not allowed access to wider funding sources or scales
available to other finance companies. Virtual dependence on equity funds does not permit
them to have optimal funding. For a cost effective financing of these companies, greater
access to the debt and the money market like the leasing and other finance companies is
an urgent necessity.

5. Disclaimer Certificate: To purchase a book debt of its clients, a factor needs a

disclaimer certificate from banks. In the present context they are reluctant to issue such a
certificate. The factoring companies should be allowed to purchase book debts without
requiring such a certificate from banks.

6. Limited Coverage: At present only domestic factoring of the advance with recourse is
permitted and offered in India. Although the ECGC and SBI Factors have initiated
measures for export factoring, no headway has been made. It is high time to provide
export factoring to Indian exporters.

Financial Aspects
Factoring involves two types of costs (a) factoring commission and (b) interests on funds
advances.
Factoring commission represents the compensation to the factor for the administrative
services provided and the credit risk borne. The commission charged is usually 2-4 per cent of
the value of the receivables factored, the rate depending upon the various forms of service and
whether it is with or without recourse.
The factor also charged interest on advances drawn by the firm against uncollected and
non-due receivables. It is the practice to advance up to 80 per cent of the value of such
outstanding at a rate of interest which is 2-4 per cent above the base rate. This works out of near
the interest rate for bank overdrafts. The cost of factoring, varies from 15.2 to 16.20 per cent
(Singh 1988), 15.6 to 16.0 per cent(SBI Review, 1988), and the margin in which the factors will
have to operate would be extremely narrow.
3.6 POTENTIALITY FOR FACTORING IN INDIA
In Indian, factoring is being viewed as a source of short-term finance. In launching
factoring services, the thrust should be in the twin areas of receivables management, and credit
appraisal; factoring agencies should be viewed as vehicles of development of these skills. Since
the small scale lacks these sophisticated skill, factors should be able to fill the gap. Giving
priority to financing function would be self. defeating as receivable management would be given
the back seat.It is for the factors to generate the necessary surpluses to mop up the additional
resources and then embark on financing function. However, for policy reason, should these go
hand in hand, then the accent should on receivable management otherwise, these agencies would
be end up as financing bodies.
From the firm's point of view, factoring arrangements offer certain financial benefits in
the form of saving in collection cost, reduction in bad debt losses, and reduction in interest cost
of investment in receivables. On the other hand, the firm incurs certain costs in the form of
commission and interest on advances. Therefore, to assess the financial desirability of factoring
as an alternative to inhouse management of receivables, the firm must assess the net benefit of
this option, using the profit criterion on approach. The factors have to establish their credibility
in offering better management of receivables and financing at competitive rates to the clients.

3.7 MAJOR PLAYERS IN FACTORING BUSINESS IN INDIA

1. Canbank Factors Ltd. was promoted the Canara Bank, and Andhra Bank and SIDBI in August,
1992 to operate in the south zone. Its RS.10 crores paid up capital was contributed in the
proportion of 60:20:20 by three promoters respectively. The regional restriction on their
operations were subsequently removed by the RBI. They can, therefore, operate a wider market.
Canbank Factors provides factoring services to business enterprises. Bank lends against a client's
account receivables, at as agreed percentage, enabling the client to get cash as soon as he bills his
customer. For the client, this reduces the gap between sales and actual cash realization and
releases fund for working capital requirements. Can bank factors also undertakes services such as
collection of receivables and maintenance of sales ledger. Bank factoring volume grew 29.5
percent to Rs. 503.16 crore for half year ending September 2002 over the corresponding previous
period. For the year ending March 2002 the gross non-performing assets dropped to Rs. 1.49
crore from Rs. 2.42 crore of the previous year. NPAs, as a percentage of funds in use, came
down to 0.84 from 1.53. During the same period, the cost of borrowed capital fell to 9.67 per
cent from 10.60 while the spread rose to 5.51 per cent from 5.10 per cent. Canbank factors offers
cumulative and non cumulative fixed deposits schemes. The deposits are accepted for 12, 15, 18,
21 and 24 months. The interest rate is constant across all tenures but differs with interest
payment option. For half yearly and quarterly payment option (noncumulative), the yield 8.65
per cent respectively and the minimum deposit amount is Rs. 25000.The monthly minimum
deposit requirement is Rs. 40,000. The effective yield for the cumulative schemes works out to
6.84 per cent,8.93 per cent,9.03 percent, 9.13 per cent and 9.23 per cent for the same tenures.

2. SBI Factors and Commercial Services Ltd. Was floated jointly by the State Bank of India, Union
Bank of India and Small Industries Development Bank of India in March 1991. The SBI FACS
has become an associate member of the Factors Chain International, based in Amsterdam. It has
also joined EDIFACT-the communication electronic network of the Factor Chain International
for electronic data intercharge for speedy communication. ICRA has retained the A1+
(pronouned A one plus) rating for the Rs. 60crore (enhanced from Rs. 50crore) Short-term Debt
 Programme of SBI Factors and Commercial Services Pvt. Ltd. The rating indicates highest safety
in short term. The rating is based on the strong percentage of company, the conservating rearing
level and sound financial flexibility derived from unutilized lines of credit.

SBI Factors, a subsidiary of State Bank of India, is one of the two main players in the domestic
factoring industry in India. Domestic factoring involves purchase of book debts and the
provisions of finance. In 2001-02, SBI Factors volume of measures measured by its factored
turnover amounted to Rs.495 crore, a decline of 2% over the previous year. The main
contributing factors for the degrowth were the overall economic slowdown and tighter credit
checks by SBI Factors which included closure of certain account The decline in the average
prepayment advances the company primary carning assets base to Rs. 77 crore in 2001-02
resulted in the operating income dropping by 3% to Rs. 13.04crore as compared to Rs.
13.50crore in the previous year.
SBI Factors interest spread during 2001-02 increased as th company benefited from the
lower interest rates that prevailed during the period. The company continues to be conservatively
geared (Total Debt/Tangible Net worth of 1.4 times as on March 2002). SBI Factors posted a
profit after tax (PAT) of Rs. 46 lac in 2001-02 after writing off of NPAs amounting to Rs.
4.23crore.

3. ICL Certifications Limited in Association with Rockland Credit Finance LLC, offer international
factoring services to clients in India and neighboring countries. Rockland Credit Finance LLC
has more than twenty years of rich experience in the field of factoring.

3.8 LEGAL ASPECT OF FACTORING

The legal status of a factor is that of an assignee. Once the factor purchases the
receivables of a firm and this fact is notified to the customers, they are under a legal obligation to
make all remittances to the factor. A customer who by mistake remits the payments to the firms
is not discharged from his obligations to the factor until and unless the firm remits the proceeds
to the factor. The factoring agreement governs the legal relationship between a factor and the
firm whose receivables are to be factored, and is so drawn as to suit the various needs specifying
the period of validity of the contract and modalities of termination. Factoring contract is like any
other sale purchase agreement regulated under the law of contract. There is no codified legal
frame work/code to regulate factoring services in India. The legal relationship between a factor
and a client is largely determined by the terms of the factoring contract entered into before the
factoring process starts. Some of the contents of a factoring agreement and legal obligations of
the parties are listed as follows:

(1) The client gives an undertaking to sell and the factor agrees to purchase receivables subject
to terms and conditions mentioned in the agreement.
(2) The client warrants that the receivables are valid, enforceable, undisputed and recoverable.
He also undertakes to settle disputes, damages and deductions relating to the bills assigned to
the factor.
(3) The client agree that the bills purchased by the factor on a non-recourse basis will arise only
from transactions specially approved by the factor.
(4) The client agrees to serve notices of assignments in the prescribed form to all those
customers whose receivables have been factored.
(5) The client agrees to provide copies of all invoices, credit notes, etc., relating to the factored
accounts, to the factor in turn would remit the amount received against the factored invoices
to the client.
(6) The factor acquires the power of attorney to assign the debts further and to draw negotiable
instruments in respect of such debts.
(7) The time frame for the agreement and the mode of termination are specified in the
agreement.
(8) The legal status of a factor is that of an assignee. The customer has the same defence against
the factor as he would have against the client.
(9) The customer whose account has been factored and been notified of the assignment is under
legal obligation to remit the amount directly to pay the factors failing which he will not be
discharged from his obligations to pay the factor even if he pays directly to the client, unless
the client remits the amount to the factor.
(10) Before factoring a receivable, the factor requires a letter of disclaimer from the bank which
has been financing the book debts through bank finance to the effect that from the date of the
letter the bank can not create a charge against the receivables, i.e. the bank will not provide
post-sales finance as the factor provides the same.
(11) Priority over other claimants to book debts. It will be extremely important for the factor to
make sure that the book debts it handles are free from any encumbrances which would entitle
someone else to the money due. The firm has to guarantee that the book debts are free from
any rights of a third party in the factoring agreement.
(12) Other powers: The factor has sometimes to act quickly to recover money due on an invoice.
A customer with money outstanding to the factor may be in difficulty and any delays in
acting could see the money due. The firm has to guarantee that the book debts are free from
any rights of a third party in the factoring agreement.
(13) The factoring agreement sets out in detail how the firm is to be paid.
(14) Approved and unapproved debts: The attractions of factoring for many companies is that
non-recourse factoring can give a degree of insurance against the customer who does not pay.
This depends on whether the debt is approved or not, which is decided before the factoring
process starts.
(15) Where the factor may reclaim money already advanced: Factoring agreements provide for
payment by the customer directly to the factor. If any of the customers pay it to the client by
mistake, the agreement provides that the firm must hold the money for the factor. If he does
not do so, this is effectively a breach of trust and the firm may be held responsible for any
losses incurred by the factor.
(16) Warrants: Some warrants that are required are:
a) The firm should disclose any material fact that it known might effect the factor's
decision to approve a debt.
b) It has to warrant that the invoices sent for factoring represent a proper debt for goods
supplied.
(17) Disputed debts: The factor may require the customers to notify it immediately in case of
disputed debts. The firm may be expected to return any advances made to it in respect of the
disputed debt.
(18) The factor's power to inspect the firm's books and accounts and the period of the factoring
arrangement is usually laid down in the agreement.
(19) The client undertakes:
 (a) To have the factor serve as the sole factor (clients occasionally may have more than an
factor but that is more of an exception than the rule);
(b) To provide a satisfactory assignment together with actual invoices and evidence on
delivery;
(c) To submit all sales to the factor prior to shipping for credit approval.
(d) To warrant that each customers has received his merchandise and will accept the same
without any counter-claim and disputes, if any, will be the responsibility of the client.
(e) To grant the factor the right to hold any balances standing to its credit as security for any
debts owed by the client to the factor, no matter how it arises.

(20) The factor on the order hand undertakes:

(a) To purchase bonafide account receivables that it has previously approved;
(b) To advance against the purchase price, at its direction, a percentage thereof and to remit
the balance on the monthly average due date of receivables assigned, plus 5 to 10 days
for collection.
(c) To charge interest on sums advanced at a certain defined interest rate;
(d) To render a statement of account monthly.

A few other points of interest may be noted in the context of the legal implications of
factoring:

1. When a customer presents a bill of exchange or hundi along with his invoice, the factor must
first check if there is a genuine underlying trade transactions. This may be verified by
checking the invoice and other evidence of delivery.
2. The factor must check with the client's banker to ensure that there is no double financing
3. Situations may arise where the client receives payments from the customer in his name and
the factor may not be aware of this. The factoring agreement should provide for this
contingency and, further, in order to ensure against default the factor should obtain a
personnel guarantee of the proprietor or the directors of the company,
4. Regarding assignments of book debts of clients, provisions of Section 130 of the transfer of
property act protects the interests of the factor.

3.9 FACTORING IN INDIA

Factoring service in India is of recent origin. It owes its genesis to the recommendations
of the Kalyanaundaram study group appointed by the RBI. The first factoring company SBI
Factors and Commercial Ltd. Started operation in April, 1991.This section highlights the
important aspects of the factoring service in India.

Importance of Factoring in India

Factoring can play an important role in any developing economy. In India factoring can
play an important role in development of small scale industries and thus help in employment
generation, as SSI are labour intensive industries. The importance of factoring can be
summarized under below given heading.
1. In small scale industries
The small scale industries suffer from variety of problem which undermine their
efficiency. One of the important problems faced by these units is inadequate working capital
often caused by delayed collection of accounts receivable and bad debts. Most of these units face
cash flow problems because of their inability to recover the receivable in time and therefore need
factoring services. In coming years in this sector which is going to create volume for any
factoring agency especially in service and finance factoring.

2. Export traders
Export traders may go for factoring services on account of the availability of additional
services like-sales ledger maintenance and collection of accounts receivable. The services
provided by factoring agency may be extremely useful to small scale exporters and new entrants.

3. Prevention of industrial Sickness

The incidence of industries of industrial sickness in India has been on the rise during the
last decade. According to rough estimates the loss of production due to sickness in the country is
around Rs. 4000crores. Many of these medium and small units may not have been in red if they
had been able to recover their dues in time. Most of these units face cash flow problems because
of mounting overdue accounts and, therefore, need factoring services.

3.10 RECOMMENDATION OF THE KALYANASUNDARAM COMMITTEE

The main recommendations of the Kalyanasundaram Committee are listed as follows:
1) Taking all the relevant facts into account, there is sufficient scope for introduction of factoring
services in India which would be complementary to the services provided by banks.
2) The introduction of export factoring services would provide an additional facility to exporters.
1) While qualification of the demand for factoring services has not been possible, it is assessed
that it would grow sufficiently so as to make factoring business a commercially viable
proposition within period of two/three years.
2) On the export side, there would be a fairly good availment of various services offered by
export factors,
3) With a view to attaining a balanced dispersal of risks, factors should offer their services to all
industries and all sectors in the economy.
4) The pricing of various services by factors would essentially depend upon the cost of funds.
Factors should attempt a mix from among the various sources of funds to keep the cost of
funds as low as possible, in any case not exceeding 13.5 per cent per annum, so that a
reasonable spread is a available.
5) The RBI could consider allowing factoring organizations to raise funds from other approved
financial institutions, against their usance promissory notes covering receivables factored by
them, on the lines of revised procedure under bills rediscounting scheme.
6) The price for financing services would be around 16 percent per annum and the aggregate
price for all other services may not exceed 2.5 per cent to 3 per cent of the debts services.
7) In the beginning only select promoter institutions/groups of individuals with good track
record in financial services and competent management should be permitted to enter into this
new field.
8) Initially the organizations may be promoted on a zonal basis.
9) There are distinct advantages in the banks being associated with handling of factoring
business. The subsidiaries or associates of banks are ideally suited for undertaking this
business. Initially, it would be desirable to have only four or five organizations which could
be promoted, either individually by the leading banks or jointly by a few major banks having
a large network of branches.
10) Factoring activities could perhaps be taken up by the Small Industries Development Bank of
India, preferably in association with one or more commercial banks.
11) The business community should first be educated through bank branches about the nature
and scope of these services and the benefits accruing there from.
12) Factors cannot extent their services efficiently, effectively and economically without the
support of computers, as quick and dependable means of communication. Concurrent with
consideration of various aspects relating to commencement of factoring operations, the
promoters should initiate measures for organizing network of computers/dedicated lists
linking the branches/agents in different parts of the country for accounting, follow-up,
remittance and other activities involved in factoring business.
13) The Central Government and RBI should initiate appropriate measures immediately to set up
specialized agencies for credit investigation; until such agencies become fully operative,
factors may have to rely on such information about clients/customers as could be collected
through banks or other sources.
14) Since the suppliers would be able to obtain financial services from both banks and factors, it
is necessary to provide for proper linkage between banks and factoring organizations.
15) The factoring of small scale industrial (SSI) units could prove to be mutually beneficial to
both factors and SSI units and the factors should make every effort to orient their strategy to
crystallize, the potential demand for this sector.
16) Introduction of export factoring would certainly provide an additional window of facility to
the exporters. As factors would need uniform rules to operate in the international market,
India may ratify and accept the Unidroit coversion on international factoring. The export
factors should beneficially join on of the international chain of factors. Banks and the Export
Credit and Guarantee Corporation (ECGC) appear to be eminently suitable for handling
export factoring.
17) An element of competition is absolutely necessary for ensuring satisfactory service to the
exporters and they should have the opportunity to make their own choice regarding the
factors whose services to avail of.
18) An as efficient system, factoring service, can sustain itself on a viable basis only if a
conductive environment is created and fostered. Expeditious steps may be taken by the
government to promote legislation, as also to grant appropriate exemptions from, and make
amendments to, the existing laws to rebserve the objectives of promoting factoring.

RBI Guidelines
As a follow up to the recommendation of the Kalyanasundaram group, the Banking
Regulation Act, 1949 was amended to enable commercial banks to undertake factoring business.
In the interest of banking policy and public, the RBI issued in July 1990 guidelines, as detailed
below, to provide a statutory framework enabling banks to carry on such business:
 For the present, banks cannot directly/departmentally undertake the business of factoring. While
banks may invest in factoring companies, with the prior approval of the RBI, within specified
limits, they cannot act as promoter of such companies. Banks are permitted to set up separate
subsidiaries/invest in factoring companies jointly with other banks which would require the prior
approval of the RBI. However, they are now permitted to undertake factoring departmentally
also.

1. A factoring subsidiary/joint venture factoring company should not engage in financing of

other companies or other factoring companies.
2. Investment of a bank in the shares of factoring companies including its factoring
subsidiary cannot in the aggregate 10 per cent of the paid-up capital and reserves of the
bank.

4. SUMMARY
The concept of factoring in India is quite new. Many traders and manufacturers
particularly belonging to small scale and medium sectors are not fully aware of the concept of
factoring. Therefore it important to educate them factoring agencies. Again due to entrance of
foreign banks in India the margins for Indian Public Sector are reducing at a very high rate. So,
to diversify their operations, factoring can be a good investment. Thus, factoring as a tool for
assisting traders and manufacturers has an important role to play in a country like India where
bill market has not been systematically developed.

5. SUGGESTED READINGS
- Anantha Krishna E.P. (1990): Factoring: Central Bank of India Economic Bulletin,
October.
- Brandenbery Mary (1987) Why don't we use factoring?, Accountancy, January.
- SBI Monthly Review (2002): Report Study Group for Examining the Factoring Services
in India.
- Singh S (1988): How should factoring service be launched?, Vikalpa, July-September.
- MY Khan, Financial Services, Tata Mc Graw Hill Publishing Company Limited, New
Delhi.
- Figges Patrick (2001): Factoring, Pride of prejudice?, Accountancy, February.
- V.A. Avadhani, Marketing of Financial Services. Himalaya Publishing House, New
Delhi.
- HR Machiraju, Indian Financial System. Vikas Publishing House Pvt. Ltd. New Delhi.

6. SELF ASSESSMENT QUESTIONS

1. What do you mean by factoring. How it is useful for the businessmen?
2. "Factoring is important financial service in the present scenario". Justify this statement.
 HIRE PURCHASE CONCEPT, FEATURES, FINANCIAL, TAXATION, ACCOUNTING
& LEAGL REPORTING ASPECT, FINANCIAL EVALUATION OF HIRE PURCHASE,
FINANCE FEATURES OF CONSUMER CREDIT IN INDIA

STRUCTURE
1. Introduction
2. Objective
3. Presentation of Contents
3.1 Meaning of Hire Purchase
3.2 Features of Hire Purchase Agreement
3.3 Principal Types of Hire Purchase
3.4 Difference between Hire Purchase and Instalment System
3.5 Difference between Hire Purchase and Leasing
3.6 Significance of Hire Purchase
3.7 Legal Aspects of Hire Purchase
3.8 Tax Aspects of Hire Purchase
3.9 Accounting Aspects of Hire Purchase
3.10 Types of Consumer Finance
3.11 Consumer Finance in India
3.12 Regulation of Consumer Finance in India
3.13 Changing Consumer Behaviour

4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
Hire-purchase is one of the various asset-based financing plans offered by the finance
companies. In India, the road transport operators have dominated the market for hire purchase
and hire purchase has been always associated with financing of commercial vehicles. However in
the recent years, hire purchase has become a means of financing equipment also.

2. OBJECTIVE
After reading this lesson, you should be able to
(a) Define hire purchase and explain the feature of hire purchase.
(b) Differentiate between hire purchase and instalment system, and hire purchase and
leasing.
(c) Explain the legal tax and accounting aspects of hire purchase.
(d) Present a picture of consumer finance in India.
(e) Describe the regulation of consumer finance in India.

3. PRESENTATION OF CONTENTS
3.1 MEANING OF HIRE PURCHASE
 Hire purchase is a type of instalment credit under which the hire purchaser called the hirer,
agrees to take the goods on hire at a stated rental which is inclusive of the repayment of principal
as well as interest, with an option to purchase.
The Hire Purchase Act 1972 defines a hire purchase agreement as an agreement under
which the hirer has an option to purchase them in accordance with the terms of the agreement
and includes as agreement under which:

1. Possession of goods is delivered by the owner thereof to a person on condition that such
person pays the agreed amount in periodical instalments.
2. The property in the goods is to pass to such person on the payment of the last of such
instalment.
3. Such person has a right to terminate the agreement at any time before the property so
passes".

Thus a hire purchase transaction is one where the hirer (user) has, at the end of the fixed
team of hire, an option to buy the asset at a taken value.

3.2 FEATURES OF HIRE PURCHASE AGREEMENT

The main features of a hire purchase agreement are as follows:
1. The hire (the counterpart of the lessor) purchases the asset, gives it to the hirer (the
counterpart of the lessee).
2. The hire is required to pay the hire purchase instalment over specified period of time. The
typical repayment period is 3 years and the hire purchase instalments are payable monthly in
advance:
3. The ownership of the asset is transferred after the hire has paid the last instalment, exercises
his right to purchase the aseet by paying a nominal purchase consideration.
4. In the event of default by the hirer, the hiree has the right to repossess the asset. Likewise the
hirer also enjoys the right to terminate agreement and return the asset.
5. The terms and conditions relating to the usage of the asset, its maintenance insurance etc.,
and the rights and obligations of the parties to the agreement are described in the hire
purchase agreement.

3.3 PRINCIPAL TYPES OF HIRE PURCHASE

The ground for distinction here is whether the goods are producer goods or consumer
goods. Finance provided to consumer for acquisition of consumer durables is called consumer
instalment credit. Instalment credit for consumer is usually extended in the following forms:

A. PERSONAL LOAN
This is made directly by the lending company though the consumer may be introduced by
a dealer (where the loan is for the purchase of specific goods from the dealer). The loan may be
unsecured or secured for example, by a mortgage on the borrowers property.

B. HIRE PURCHASE OR CONDITIONAL SALE.

Here funds are advanced for the acquisition of particular goods, which the customer takes
under a hire purchase or conditional sale agreement, acquiring title on completion of payment.
Where title is reserved in this way the agreement usually used is a hire purchase agreement,
 though some companies use conditional sale agreement. Retail hire purchase finance takes three
different forms:
1. Direct Collection
The dealer sells the goods to the finance house, lets them on hire purchase to the
customers. This is the most common form of the instalments financing and is known in the trade
as 'direct collection because the instalments are collected under a hire purchase agreement
concluded direct between the finance house and the hirer, as opposed to an agreement between
the dealer and the hirer which is later discounted under block discounting arrangements. Usually
the finance house collects the instalments itself from the transaction. Such transactions are non-
recourse to the dealer.

2. Agency Collection
This is variant of direct collection. As before, the dealer sells the goods to the finance
company but in this case signs the agreement himself as undisclosed agent for the finance
company, usually in return for the appropriate commission. Where this type of financing is used,
it will usually be regulated by a master agreement which will set out the extent of the dealer's
authority and the machinery for instalments which he collects as agent.

3. Block Discounting
In this case, the dealer enters into the hire purchase agreement direct with the customer
and later discounts to the finance company. Agreements, are usually discounted in blocks at a
time; hence the phrase block discounting is used. Once the agreement is discounted the finance
company becomes entitled to receive the rentals from the hirer concerned but quite commonly, in
order not to disturb the business relationship existing between the dealer and the customer. The
dealer is made responsible for collecting the instalments and remitting these to the finance
company or making other arrangements with the finance company to ensure payment of sums
equivalent to what is due under the discounted agreements.

C. CREDIT SALE
Here title passes to the customer from the outset. Again the agreement may be with the
finance house from the beginning or it may be entered between the dealer and customer directly
and later assigned by the dealer to the finance house.

D. RENTAL
The renting (leasing) of domestic goods is fast developing as a form of instalment credit.
It is increasingly the practice and to the very large extent in the United States, finance house
enter direct rental agreements relating to domestic goods.

3.4 DIFFERNECE BETWEEN HIRE PURCHASE AND INSTALM SYSTEM

Hire purchase has to be distinguished from another form of instalment credit i.e. credit
sales or instalment sale. The essential distinction between the two lies in the fact that while in the
case of credit sale, ownership of property passes on to the purchase simultaneously with the
payment of the initial instalment. In hire purchasing, ownership is retained by the seller until the
the last instalment is paid.
3.5 HIRE PURCHASE AND LEASING
Hire Purchase is also different from leasing on following grounds:

1. Ownership
In a contract of lease, the ownership rests with the lessor throughout and the lessee (hirer) has no
option purchase the goods.

2. Method of Financing
Leasing is a method of financing business assets whereas hire purchase is a method of
financing both business assets and consumers articles.

3. Depreciation
In leasing depreciation and investment allowance can not be claimed by the leasee. In hire
purchase, deprecation and investment allowance can be claimed by the hirer.

4. Tax Benefits
The entire lease rental is tax deductible expense. Only the interest component of the hire
purchase installment is tax deductible.

5. Slavage Value
The lessee, not being the owner of the asset, does not enjoy the salvage value of the asset. The
hirer, in purchase, being the owner of the asset, enjoys salvage value of the asset.

6. Deposit
Lessee is not required to make any deposit whereas 20% deposit is required in hire purchase.

7. Rent-Purchase
With lease, we rent and with hire purchase we buy the goods.

8. Extent of Finance
Lease Financing is invariably 100 per cent financing. It requires no immediate down payment or
margin money by the lessee. In hire purchase, a margin equal to 20-25 per cent of the cost of the
asset is to be paid by the hirer.

9. Maintenance
The cost of maintenance of the hired asset is to be borne by the hirer himself. In case of finance
lease only, the maintenance of leased asset is the responsibility of the lessee.

10. Reporting
The asset on hire purchase is shown in the balance sheet of the hirer. The leased assets are shown
by way of foot note only.
3.6 SIGNIFICANCE OF HIRE PURCHASING
With the advancement of science and technology the modern market has gone a sea
change.
From the seller's market it has been transformed into the buyer's market. The customer
wants to raise his standard of living by acquiring status symbol articles, such as Fridge, Colour
Television, V.C.D., Scooter, Air Conditioner etc. but due to financial constraints, he cannot
purchase all these articles at once.
At the same time, the producer is faced with the problem of promoting the sales in the
modern competitive market. He cannot afford to sell the product on credit because that way his
capital gets blocked which can bring production activity to a halt. No producer has such a vast
reserve-of surplus funds at his disposal as to be able to sell on credit.
To tackle the problem of the customers on the hand and the producers on the other, the
middle way between cash sales system and credit sales has emerged.
Hire purchase system is a popular system in which goods are handed over to the
customers on partial payment at the time of delivery and the balance including interest is
recovered at regular intervals in "equated monthly instalments. Therefore to understand the easy
way of financing, the significance of hire purchasing is that in enables the producer to sell on
cash and the customers or consumer to buy credit.

3.7 LEGAL ASPECTS OF HIRE PURCHASE

As on date there is no legislation that exclusively deals with higher purchase transactions.
Although the Hire Purchase Act, was passed in 1972, it has so far not been enforced. In 1989, an
Amendment Bill was introduced to amend some provisions of the Hire Purchase Act. It is
expected that the amended version of the Act will be made operational in the near future.
The Hire Purchase Act 1972 has provisions for regulating;
1. Format & Contents of the Hire Purchase Agreement.
2. Warranties & Conditions underlying the Hire Purchase Agreement.
3. Ceiling of the Hire Purchase, Charges (total charge for credit).
4. Rights & Obligations of the hirer and the owner.

However, in the present context where the aforesaid Act is not operational, the legal
aspects of the Hire Purchase transactions have to be ascertained from the relevant provisions of
the judgement pronounced by the courts on issues related to the types of contracts.

The salient legal aspects of hire purchase transactions as follows:

1. Under a hire purchase contract, the owner has the following obligations:
(i) He must have a title to the goods let on hire at the time of delivering the goods.
(ii) He must ensure that the hirer has quite possessions of the goods and this quite possession is
not tampered with either by himself by the lawful acts of third parties.
(iii) He has delivered possession of the goods to the hirer because the hiring does not commence
until the goods have been delivered.
(iv) He has to ensure that the goods are of merchantable quality and that they are reasonably fit
for the purpose for which they are to be used. The obligation relating to ensuring fitness
 arises only where the hirer has made known to the owner the particular purpose for which the
goods are required.
(v) Where goods are let by description, the owner required to ensure that the goods actually let
on hire answer the description. Similarly, cases where the goods are let by reference sample,
the owner has to ensure that the bulk corresponds with the sample and also affords an
opportunity to the hirer compare the bulk with sample.

2. Under hire purchase contract, the hirer has the following implied obligations: (i) The hirer has to
take reasonable care of the goods. (ii) The hirer cannot sell the goods or pledge them or use them
for the purpose different from that stipulated in the contract during the currency of the contract.
(iii) The hirer must pay the sums stated in the contract at the specified points of time and in the
manner prescribed by the contract.

3. Apart from the implied obligation of the hirer, the hire purchase agreement expressly imposes
certain obligation the hirer. (a) He is required to arrange for comprehensive insurance cover for
the goods hired. The cover can be taken in, the joint names of the owner the hirer or in the name
of the hirer bearing an endorsements recording interest the goods. The hirer is required to pay the
insurance premium and do everything that is necessary to keep the insurance policy in force.
(b) He required indemnify the owner against any loss or damage that results from his negligence.
(c) He has to obtain all permits and consents necessary for the use goods and not contravene any
law or regulation that has a bearing on the usage of the asset. (d) He is required to bear all cost
incurred in connection with maintaining the goods in serviceable condition.

4. Usually, a hire purchase agreement provides for the owner's right for repossessions of the goods
upon breach of the hire purchase agreement by the hirer. The courts have held that in the absence
of a specific enactment governing hire purchase transaction, the owner is entitled to repossess the
goods through means specified in the hire purchase agreement and in the process he is entitled to
use such physical force as may be necessary.

5. A hire purchase agreement usually provides for (i) the right of the hirer to determine (terminate)
the hire purchase contract at any time before the final payment and (ii) the right of the hirer to
purchase the goods at any time before the final payment.

6. Since the owner, in a typical hire purchase transaction is a finance company which doesn't deal
in the class of the goods that are let on hire, usually the implied obligations of the owner stated in
(iv) and (v) of (1) are relevant. To prevent the possibility of the hirer invoking these implied
conditions, an exclusion class is included in the hire purchase agreement which states that no
liability can be attached to the owner (i) the goods are not of merchantable quality, (ii) the goods
are unfit for the particular purpose for which they are required, (iii) the goods fail to correspond
with the description.

3.8 TAX ASPECTS OF HIRE PURCHASE

The tax aspects of hire purchase can be divided into three parts. Income tax, sales tax and
interest rate aspects.

Income Tax Aspects

 The treatment of the hire purchase transaction from the Income Tax angle governed by
the provisions of CBDT circular.
According to this circular, the hirer is entitled to (a) the tax shields on description
calculated with reference to the cash purchase price; and (b) the tax shield on the "consideration
for hire”(total charge for credit). The circular defines consideration for hire the way we have
defined the total charge for credit and requires this amount to be spread evenly over the term of
the agreement. From the owners angle the consideration for hire received by him is liable to tax.
The provisions of the Income Tax Act governing depreciation can see a conflict between
the contents of the. CBDT circular and the relevant provisions of the Act. Section 32 of the
Income Tax Act states that an assesses can claim the depreciation on business assets if and only
if (i) the assets are owned by the assesses, and (ii) the assets are used for the purpose of business
of the assesses. In a hire purchase transaction, the hirer-is not legal owner until he exercises the
purchase option. Thus there is an apparent inconsistency in permitting the hierer to claim the
depreciation. This inconsistency has resulted in some litigations in the past. But, in such cases,
the courts had upheld the provisions of the circular issued by the CBDT.

Sales Tax Aspects

The sales tax aspects of hire purchase contracts have to be gleaned from the provisions of
the Constitution (46th Amendment) and High Court and Supreme Court rulings on the subject.
The subject of sales tax aspects are as follows:

1. The hire purchase transactions per se are liable to sales tax. The 46th Amendment Act,
clearly states that the "tax on the sale or purchase of goods includes a tax on the delivery of
goods on hire purchase or any other system of payment by instalments".
2. For the purpose of levying sales tax, a sale is deemed to take place only when the hirer
exercises the option to purchase.
3. The amount of sales tax must be determined with reference to the depreciated value of the
goods at the time when the hirer exercises the purchase option. The appropriate method for
computing the depreciated value is to be determined by the sales tax authorities.
4. The state in which' the goods have been delivered (to the hirer) is a state entitled to levy and
collect sales tax.
5. The sales tax cannot be levied on hire purchase transaction structured by finance companies
provided these companies are not dealers in the class of goods let on hire.
6. There is no one uniform rate of sales tax applicable to the hire purchase transactions.

Interest Rate Aspects

Interest tax is payable on the total amount of interest accuring to a hire purchase company
in the previous year at the rate of 3%.The amount of interest which is established to have become
a bad debt during the previous year can be deducted from the chargeable interest. The interest tax
is deductable expense for the purpose of computing the taxable income under the Income Tax
Act.

3.9 ACCOUNTING ASPECTS OF HIRE PURCHASE

In the book of the Hirer

The accounting mechanics from the hirer's angle is as follows:
 1. The cash purchase price of the hire purchase instalments is recorded as a liability.
2. Depreciation is charged on the cash purchase price of the assets in the line with the
depreciation policy pursued by the hirer with regard to other owned assets.
3. Total charge for credit are the unmatured charges at the inception of the higher purchase
transaction allocated over the hire period.

In the book of Finance Company

The accounting mechanics of hire purchase in the books of finance company is as
follows:
1. At the inception of the transaction, the finance company records the hire purchase
instalments receivables as a current assets.
2. At the end of each accounting period the finance company recognises and appropriate part of
the "unmatured finance income” as current income for the period. The methods that are
followed for allocating period are the ones we are familiar with-Effective rate of interest
method.
3. At the end of each accounting period, the hire purchase price less the instalment received is
shown as a receivable and the finance income component of these instalments shown as the
current liability.
4. The direct cost associated with setting up the transaction are either expensed immediately or
allocated against the finance income over the hire period.

3.10 TYPES OF CONSUMER FINANCE

Consumer credit has been playing an increasingly important role in financing consumer,
expenditure. For meeting, the growing requirements of the household for maintaining a higher
standard of living and producing the durable goods, the finance companies are always on the
outlook for providing the consumers new services to meet their demands for the funds for
purchasing durable goods, providing liquidity to them to meet their sudden pressing needs for
paying off the medical bills, insurance policies etc. This is being done through consumers
finance offered by the finance companies.
On the basis of the available information, the consumers' credit is being provided by the
finance companies in two main forms as under :
(i) Instalment Credit
(ii) Non-Instalment Credit

Instalment Credit
This credit is provided to the consumers to buy the durable goods for their consumption
purpose and the cost of the goods as net initially by the finance company. Instalments Credit
covers mainly credit segments like automobile, paper, other consumer goods, repair and
modernisation loans and personal loans. Quantum wise, automobile, paper and personal loans
and consumers goods have been main segments, of credit. After automobile, the main items
covered under the consumer plans are refrigerators, TV sets, where under the personal loans
covered were the servicing doctors bills, travels, education etc.;

Non-Instalment Credit
This credit included single-payment loans where no payment through instalments is
involved. It also covers the charge accounts and service credit.
 Main suppliers for consumers finance are the following:
(a) Commercial banks
(b) Sales finance companies
(c) Retail stores
(d) Consumer finance companies

For non instalment credit the suppliers include the following.

(a) Commercial banks
(b) Other financial institutions
(c) Retail Stores
(d) Credit Cards

3.11 CONSUMER FINANCE IN INDIA

Consumers credit is not new in India. Consumers have been borrowing indigenously
from local sources for meeting their temporary household needs. Consumers credit is available in
India in different ways, viz, direct personal loans, instalment sale, conditional sale, hire-
purchase, leasing and credit cards.
Source of providing consumers credit in above forms are mainly the sole-proprietorship
firms, dealer firms, hire-purchase companies and banks, as briefly covered below:

(i) Consumers credit in the form of direct personal loans is available from indigenous money
lenders. Such loans are available f purchasing consumer durable assets. Repayment of the
loan is secured by way of charge against the assets financed or pledge of securities or
assignment of life policies, hypothecation of movable, equitable mortgage by deposit of
title deeds with the lenders.
(ii) Dealers provide credit by way of instalment sale or a conditional sale.
(iii) Hire-purchase companies have been providing consumers credit to acquire the durable
household goods like TVs, refrigerators etc.
(iv) Employers do provide concessional short-term loans in the organised sector to their
employees to enable them to acquire durable goods to make the living more convenient
and comfortable. These credits are generally free of interest or bear very negligible
interest. Such schemes are meant to promote the welfare of the employees and make
them feel the belongingness to the institutions which they serve.
(v) Employees Co-operative Societies are also in line with providing the consumers crèdit for
financing the equation of durable goods and retail requirements of the members within
the organisation where they serve.
(vi) Banks in India provide consumers credit by way of direct loan to purchase duráble goods,
against hypothecation of acquired goods, personal guarantees, pledge of valuables, etc.
Besides credit cards issued by banks do carry this facility.

3.12 REGULATION OF CONSUMER FINANCE IN INDIA

Regulation for banks

There is no specific legislation so far adopted for regulating the institutions providing
consumers credit. However, banks are required to obtain the permission of Reserve Bank of
India. under Section 6(1) (0) of Banking Regulation Act, 1949.
 Following the representation in August 1989 from the banks chiefs to Governor of
Reserve Bank of India, the commercial banks have been allowed on 13th September, 1990 to
take up the hire purchase activities simultaneously with leasing which they have been executing
through subsidiaries.
Although commercial banks which were allowed to do leasing activity have been
permitted by the Union Government to take-up hire-purchase vide notification under Section
6(1) (e) of the Banking Regulation Act. Yet the Reserve Bank of India (RBI), has directed that
for the present, banks should not themselves take up hire-purchase but do this business through
subsidiaries (in which they hold not less than 51 per cent), which have been set up for merchant
banking, equipment leasing and other such purposes through a separate subsidiary.
It is now clear that Banks may also set up subsidiaries exclusively for transacting hire-
purchase business or for doing both leasing and hire-purchase.
Banks are barred from promoting a hire-purchase company, though they may invest in
shares of such companies within the limits specified in Section 19(2) of the Banking Regulation
Act. RBI has also prevented them from financing companies or concerns engaged in hire-
purchase if they themselves take up such business through their subsidiaries.

RBI has also stipulated that a banks investment in the share of its subsidiaries (which are
engaged in hire-purchase, leasing or both), together with the banks investment in shares of other
companies carrying on such business, should not in the aggregate exceed 10 per cent of the paid-
up capital and reserves of the bank.

The profitability of banks who take up hire-purchase business alongwith leasing will go
up. As is known, leasing is remunerative only up to a certain point, where the lesser can get tax
exemption on the depreciation. The returns on hire-purchase are actually much higher than from
leasing, and as such a mix of both is what most companies in the industry undertake.
With the entry of commercial banks into the hire-purchase industry, competition is bound
to increase and it is feared that non banking financial companies would be severely affected.
Bank subsidiaries will be able to borrow funds at a slightly lower rate than non-banking financial
companies and would, therefore, be in a position to change lower rates to customers. In this way
this would in cornering the cream of the business.

Regulations for non-banking companies

Non-banking finance companies are regulated by the RBI under Non-banking financial
companies Regulations, 1977. RBI brings out circular instructions from time to time under the
said regulations to monitor the activities of these companies.

Regulation of Money Lending Firms

Different States, as permitted under clause 30 of List II of the VII Schedule of the
Constitution of India have enacted money lending legislations to control activities of the money
lenders. A person who is in this activity should have a license from the State Government
authorities under the respective. Acts. The law provides for maximum limit of the returns to be
charged on such loan and maintain the proper books of accounts and file the returns to the
concerned authorities within stipulated time. The main objective of the legislation is to safeguard
the interest of the small borrowers.
3.13 CHANGING CONSUMER BEHAVIOUR
The following are the changes taking place in the attitude of the consumer in India:

(a) The Indian consumer is fast changing his habits, borrowing money to buy the products
he wants, not content with buying what he can afford. The resultant consumer boom is
what market strategists explain as the key to the success of the Indian consumer finance
market.
(b) Consumer finance today is a win-win system in which everyone stands to gain. For the
Indian consumer, it is an opportunity to upgrade his standard of living right now. instead
of waiting for years for his savings to accumulate. For manufacturers, it stimulates
demand and lowers inventory. For middlemen, it's a sales boosting device. For players of
consumer finance, it's a means of profit generation.
(c) The buy-now-pay-later culture is still fairly nascent in India, evolving through various
forms like consumer lending, consumer credit, consumer loans, friendly and family.
borrowings, kitties, daily payment schemes etc.
(d) The basic underpinning of consumer financing is that the consumer's present spending
habits tend to be geared to expectations of future income. They are losing their fear of
borrowing, riding surfboards of consumer finance.
(e) Along with buying a home, consumer prefer consumer finance (CF) to buy home
appliances and vehicles, opting for CF based on the rate of interest, administrative fee,
processing fee, commitment charges, pre-payment penalty, types of facilities, standard
and kind of services mix and sundry terms and conditions.
(f) These are the members of a growing breed of normally conservative middle-class Indians
who are shedding their inhibitors about opting for CF loans despite the high interest cost.

4. SUMMARY
Hire purchase refers to a transaction of finance, whereby goods are bought and sold under
certain terms and conditions. The terms agreement are drawn in accordance with the Hire
Purchase Act 1972. Another system, whereby the payment of the purchase price is deferred, to
be paid in reasonable instalments, is known as instalment system. Hire Purchase Act provides the
obligations to the owner. The tax aspects of hire purchase is divided into three parts namely
income tax, sales tax and interest rate. The granting of credit to consumers in order to enable
them to possess and own goods meant for everyday use is known as consumer finance,
Consumer finance is made available on the basis of a number of terms and conditions. Consumer
finance commands a lot of benefits to consumers and others.

5. SUGGESTED READINGS
1. Kothari Vinod, Lease Financing and Hire Purchase, Wadhwa Company, (Third Edition,
1991).
2. Chandra, Prasanna; Financial Management: Theory and Practice
3. Sri Ram, K. Handbook of Leasing, Hire Purchase and Factoring, Institute of Chartered
Financial Analyst of India, Hyderabad.
4. Verma, J.C., Lease Financing and Hire Purchase, Bharat law House, Delhi: 1995.
6. SELF ASSESSMENT QUESTIONS
1. Define hire purchase. Explain the features of hire purchase agreement.
2. Explain the principal types of hire purchase. Differentiate between hire purchase and
leasing.
3. Discuss the legal, tax and accounting aspects of hire purchase.
4. Define consumer finance. Explain the different types of consumer finance.
5. Explain the basic characterstics of consumer finance in India .What are the charges taking
place in the attitude of consumers in India now?
 HOUSING FINANCE IN INDIA

STRUCTURE
1. Introduction
2. Objective
3. Presentation of Contents
3.1 State of Housing in India
3.2 Demand and supply of fund for housing
3.3 Structure of Housing Finance in India
3.4 Policy of Housing Finance
3.5 Regulation of Housing Finance Industry
3.6 General Housing Finance Institutions
3.7 Housing Schemes
3.8 Procedure of Financing
3.9 Steps taken by the Government to improve the existing state of Housing Finance.
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
To a modern man no other problem is an intriguing and mind boggling as the housing
problem. The capital cost of house is very high multitude of the average income of salaried
persons and of people belonging to the middle income groups. Till 1970, for an individual the
only source of money for house building was one's own savings. For a lucky few who were in
the organized sectors like government or industry there was house building advance as an
additional source. As per the report of the Banking Commission of 1972, it was estimated that
even if a worker in India saved 10 per cent of his income it would take 49 years to finance the
construction of his house with his own savings. In most of the cases before completing such a
long period of service, the worker would be pensioned off. This shows that the cost of housing is
so high that for an ordinary individual it is next to impossible to have a house exclusively from
his life time earnings.

2. OBJECTIVE
After reading this lesson, you should be able to:
(a) Explain the importance of housing finance.
(b) Describe the structure of housing finance in India.
(c) Discuss the working of National Housing Bank.
(d) Define the role of public and private sector housing companies India.
(e) Describe the procedure to take housing loans.

3. PRESENTATION OF CONTENTS

3.1 STATE OF HOUSING IN INDIA

In macro perspective, demand for housing and, therefore, for housing finance is ever
increasing. The shortage of housing in India has been estimated to touch 21.23 million (7.57
million in urban areas and 13.66 million in rural). This, along with upgradation and additional
 houses, calls for a housing demand of 16.76 million in only urban areas. The urban demand only
would entail a funds need of Rs. 121371crores. For the country as whole, the funds requirement
by the hosing sector is estimated at Rs. 150000crores. And with demand expected to grow -
along with rising population - there is considerable room for growth for housing finance services
in the next millennium. Housing shortage in rural India will increase from 18 million in 1985 to
30 million in 2001, in urban areas from 6 million to 9 million in the five years plan period clearly
show that, private sector investment in housing has shown a sharp rise than in public sector. A
noticeable feature is that investment has come down sharply. The data lays stress on larger
investment in housing. The major financial institutions, which finance housing sector may be
classified into two broad groups depending upon whether housing finance is their (I) Primary,
function (specialised housing finance institutions) or (II) a seconrlary function (general housing
finance institutions).
The infrastructure sector, which contributes toward higher economic growth, has received
highest policy attention on a continuation basis since early 1990s. Considerably success has been
achieved over these years in some sectors like National Highway Development Programme
(NHDP), telecommunication sector and port sector. The other infrastructure sector and port
sector such as railways, power, urban & rural infrastructure and civil aviation need to see much
greater reforms before investment can be made for inducing further growth. In each case, the
regulatory mechanism is still inadequate, as is the provision of user charges. The 2001 census
shows the level of urbanization in India has increased from 25.7 per cent in 1991 to 27.8 per cent
in 2001. There are now 35 cities with a population of above 1 million, as compared to 23 in
1991. As the proportion of urban population continue to grow, investments in urban
infrastructure for the provision of services such as roads, water supply and sewerage, urban
transportation and the like will need to be much higher than they have been in the past.

Housing is the biggest problem for the underdeveloped or developing countries because it
requires huge investment. Position of housing is also not encouraging in India because of some
reasons like the lack of government initiative till 1978. Housing problem in India is the ever
widening gap between housing supply and housing need, resulting in multiplication of families
and hence high degree of congestion and over-crowding in houses. Another aspect of our
housing problem relates with ownership. There exists great inequality in the possession of
available housing property. The lowest two per cent of Indian households own only 0.4 per cent
of the aggregate market value of the residential housing property while the share of the highest
20 per cent was 87.3 per cent: with the top 10 per cent accounting for as much as 79.7 in 1961-
62. The situation is not much different since the percentage of owner occupied houses to total
houses is quite unsatisfactory in India. The large chunk of Indians live in rented houses by
paying exorbitant rates of rent, over and above the payment of "Pugree which amounts almost to
the value the house".

3.2 DEMAND & SUPPLY OF FUND FOR HOUSING IN INDIA

The housing sector in Indian is vastly undercapitalized. The organized sector accounts for
only about 25% of the total investment in the sector. The availability of funds for housing is far
outstripped by the sector. The housing shortage has grown at an alarming rate as a result. The
working group on housing finance for the ninth five-year plan (1997-2002) has recommended an
outlay of Rs. 520 billion, compared with Rs. 226.billion for the eighth five year plan (1992.
1997). This is huge outlay by any standard and represents an increase of more than 100% in the
 financing provided by the organized sector. Rs. 97350 crores were invested in housing sector till
the eighth plan period.

3.3 STRUCTURE OF HOUSING FINANCE IN INDIA

Indian Housing Market can effectively be divided into three types:
1) A legal private sector which caters for the higher and middle income groups,
2) Public Sector Housing for State employees and a limited amount of social housing for
the poor,
3) The unregulated sector, largely comprising squatter settlements and slums, generally
in which about 30 million people live.
Apart from this broad classification, Housing Market can be further subdivided into Rural
and Urban, Formal and Informal. This segmentation together with each, of their influencing
factors are presented in the diagram.

Influencing Factors
Resource Availability
Rural Formal

Affordability/Expenditure
Standards

Competing Demands
Social Status
Informal Availability of illegal
Resources for
Construction Availability

It clearly distinguishes between urban and rural markets. In both the category of the
people, availability of illegal inputs such as material for construction, land, etc., play a major
role. Access to land and finance is the major problem in the urban housing market, while in the
rural area it is of resource availability, income distribution, priorities within housing scrvices,
etc. In fact the rural and urban markets function in different manner as far as inputs are
concerned. Equilibrium in the housing market cannot be achieved even by an advanced country,
due to innumerable sub-markets such as inputs market, wherein there are different markets for
land, labour, materials, infrastructure etc. Often the interaction of these market forces decides the
unit price of a housing stock. The various aspects of the housing market operations are presented
in following diagram.
 Public
Sector Extent of Poverty social
Housing
Market Status Ability to Pay
Private Income Distribution
Sector Inputs availability

Availability of existing
Formal Housing Stock & Its
Urban suitability location stock
Priorities

Informal
Affordable locations
Social Integration
Political access to
Housing Market

The above flow chart shows a schematic diagram of how the housing market function.
Supply side agents such as landlords combine inputs such as land, labour, finance and
infrastructure, developers (which may be government agents, such as housing boards) produce a
qualitative, standard housing stock.

MARKET SHARE OF SPECIALIZED HOUSING FINANCE INSTITUTIONS

(IN 2000-2001)

Housing Finance Institutions % age of Share

HUDCO 40.9
HDFC 36.4
LICHF 13.3
GICHF 2.3
Can Home Finance 2.1
Dewan Housing 2.0
SBIHF 1.4
Others 1.6
Source: NHB Report, 2002

3.4 POLICY OF HOUSING FINANCE

Reserve Bank controls the commercial and cooperative banks in respect of the housing
schemes. The existing ceiling of any bank’s advances for housing purposes continues to be 1.5 of
incremental deposits. In order to provide flexibility to banks in the development of their
allocated funds, sub allocations into those for direct finance, or investment in bonds of
 NHB/HUDCO were completely removed. Besides any investment by banks in special bonds
issued by NHB or HUDCO were to be reckoned as part of priority sector advances of banks.
The RBI as a fully owned subsidiary set up the National Housing Bank (NHB). National
Housing Credit Fund was started to make fund available to NHB for refinance facilities that it
make fund available to banks, housing finance companies, co-operative housing finance societies
etc. The Government and Planning Commission have given a vital role to the provision of
housing finance in India. NHB has deregulated the interest rates paid on deposits accepted by
HFCs with network of Rs. 50 lakhs and above. Similarly their lending rates for all loans above
Rs. 50000 are freed even for the purpose of recognition by NHB for its refinance schemes. It has
also introduced a refinance scheme for the Regional Rural Banks for their housing finance
advances. The RBI has permitted banks to allot 1.5% of their incremental deposits for housing
finance purposes. The institutional engaged in housing finance, require long-term funds. That is
why LIC and GIC have entered this field as they have the long-term insurance funds with them.
Some public sector banks have set up subsidiaries for housing finance. Thus, SBI House
Finance, set up in April 1988 has lending in Eastern and Northeastern States in India. Canara
Bank has set up Canfin Home Limited and India Bank Housing Financial Services by Indian
Bank and Andhra Bank Homes Finance Ltd. by Andhra Bank. In May 1988, the National
Housing Policy was announced for promoting expansion of housing facilities in a planned way
for all classes of popultion, particularly the weaker and backward classes. The Eighth plan has
provided for an investment in housing sector of Rs. 97500crores of which 60-70% would be
expected from private sources. Easy access to institutional finance at affordable rates is an
essential prerequisite for accelerating the tempo of housing activity. This is more so in the
eastern and north eastern region where the general level of income is relatively low. It is,
therefore, imperative that a specialized housing finance system-albeit as an integral part of the
national finance system - be created for this region for the development of new housing stock as
well as for the renovation, up gradation and expansion of the existing housing stock in the rural,
semi-urban and urban areas. Out of the total outlay of Rs. 97,500crores for housing in the 8th five
year plan organized sector is expected to contribute about Rs. 25000crores. The emergence of a
number of HFCs in organized and unorganized sectors has brightened the economic scenario.
The potential for the HFCs is vast. The success of HFCs depends on how effectively they can tap
resources. Fortunately, during the last couple of years, lot of emphasis has been placed on
creating an integrated national housing finance system. With the creation of the National
Housing Bank, an apex housing finance institution, housing finance has received added impetus.

3.5 REGULATION OF HOUSING FINANCE INDUSTRY

Government of India has established the National Housing Bank for the development and
regulation of the housing finance industry in India. National Housing Bank (NHB) was set up in
July 1988, under an act of the Parliament. The Bank is wholly owned by the Reserve Bank of
India (RBI). The NHB at present has a capital of Rs. 300crores, fully paid up by the RBI. The
need to setup this institution as the apex body has recommended from various factors. More
eminent among them are :.

(a) The housing sector is facing dire shortage of funds resulting in serious gap in housing
supply.
(b) Absence of specialized and mature housing finance system has resulted in inadequate
finance for individual and institutions.
 (c) The Bank has principle mandate to establish a network of housing finance outlets across
the vast span of the nation to serve different income and social groups in different
regions and covering wide range of activities related to housing and human settlement.
(d) The Bank has been entrusted with primary responsibility of developing a healthy and
self-sustaining housing finance system in the country.
(e) NHB's endeavor is to create conducive and enabling environment for the efficient and
smooth functioning of the system.

Major Objectives of NHB

The major objectives of NBH are as follows
(a) To promote sound, healthy, viable and efficient housing finance system to cater to all
segments of the population;
(b) To establish a network of housing finance outlets to adequately serve different regions
and efficient income groups;
(c) To promote saving for housing;
(d) To make housing more affordable;
(e) To promote saving for developing appropriate technologies for housing;
(f) To augment the supply of land and of building material for housing;
(g) To enable the public agencies to emerge primarily as facilitators and suppliers of
serviced land;
(h) To augment and upgrade the housing stock in the country;
(i) To strengthen the backward and forward and forward linkage of the housing sector with
rest of the economy:
(j) To augment financial resources for the sector
(k) To enable the housing finance system to assess the capital market for resources.

Brief about the Functioning of SEB as Apex Body

NHB being the full owned subsidiary of RBI, have facility to borrow from the parent
organisation as per term; repayable on demand/on the expiry of fixed period not exceeding 18
months out of the National Housing Credit (long term Operation as) fund; receive for services
rendered, remuneration, commission, commitment charges, royalties, premier, license fees and
any other consideration, receive gifts, grants, donations/ benefactions from the governments or
any other source.
NHB believes in the full play of market forces but it is very conscious of the reality that
on their own, market forces cannot solve the problem of lower segment of the population, within
a reasonable time frame. It makes so distinction between public, private or cooperative sectors in
achieving its objectives. It promotes integration of the formal and informal sector housing, It
encourages participation of non-governmental organizations in its various programmes,
particularly those directed towards low income groups. It mobilizes savings specifically linked to
housing, while seeking allocation of a larger proportion of existing household savings like
insurance and provident funds.
The endeavor of NHB is to operate the housing finance system at non-subsidies rate of
interest with full cost recovery, however, internal cross-subsidization of interest rates continues
to be an important feature of the housing finance system. In consultation with the RBI and with
the prior approval of the Central Government, NHB can borrow in foreign currency from any
bank/financial institution in India or abroad. Such loans may be guaranteed, if necessary, by the
central government as to repayment of principal and the payment of interest and other incidential
charges. The NHB has the right to acquire by transfer or by assignment, the right and interest of
any housing finance institution in relation to any loan/advances made or any amount recoverable
by such institution either in whole or in part.

The NHB has the right to have been access to all the necessary records of any housing
finance institution, which seeks to avail of any credit facility from it; if directed by the RBI the
NHB can conduct an inspection by its officers of a housing finance institution to which it has
provided any loan/advance/any other financial assistance and its books, accounts and other
documents. The housing finance institutions can be directed by the NHB to submit specified
credit information; the amount of loans and advances and other credit facilities; the nature of
security taken for such loans; the guarantee furnished; it can also collect credit and other
information from the governments, local authorities, RBI, any other bank/FIIs/other institutions.
The NHB is empowered to provide advisory services to the government, local bodies and
other agencies connected with housing in respect of formulation of overall policies aimed at
promoting the growth of housing/housing finance institutions; legislation relating matters having
a bearing on shelter, housing and human settlements The NHB is empowered under the provision
of the NHB Act, 1987 in public interest by general/special order to regulate/prohibit issue of
advertisement to solicit deposits from public by HFC's. It can also specify the conditions subject
to which such advertisement is issued. It can direct HFC's to furnish in the prescribed form at
specified intervals, within the stipulated time, information/particular in the prescribed statements
relating to deposits collected by them. The information, inter alia, may relate to the amount of
deposits, purpose and period of deposits, rates of interest, direction can be given to HFCs in
general or in particular regarding matters such as receipt of deposits, rate of interest and period
of deposits and so on. If HFCs do not comply with any such directions, the NHB can prohibit the
acceptance of deposits by them. It is also empowered to direct HFC’s to send a copy of the
balance sheet, and profit and loss account/other annual accounts of depositors holding specified
amount of deposits.
They must furnish statement /information /particulars in compliance with directions in
the prescribed time. It is the duty of the auditors of HFC's to enquire about the compliance with
the NHB giving the aggregate deposits. Such reports should also form part of their statutory
reports under the Companies Act. The NHB can conduct an inspection by its officers/employees
or other persons (called inspecting authority) of HFC's to verify the correctness and
completeness of statements/information/particulars/ furnished/ by them. Such inspection can also
be conducted to obtain information, which the HFC's have failed to furnish in compliance with
the directions. The directors/ members of committees/other employees/ officers/ must provide to
the inspecting authority, all statement and information, within a specified time.

The NHB has launched various schemes to mobilize savings of households. This forms
à substantial part of its resources. It has formulated a loan linked savings scheme, namely Home
Loan Scheme (HLS) for the households, under which banks/HFC's are authorized to collect
deposits for the purpose of housing finance. It was permitted by the Government in 1989 to issue
capital gain bonds having a maturity period of three years and carrying an interest of 9% per
annum, payable half yearly, or on a discounted basis in the beginning itself. This constituted one
of the essential sources of financing housing loans at the lower end carryings subsidized interest
rates. The capital gains bond schemes was discontinued after Sept 30, 1992. Another sources of
funds for NHB is bonds which are guaranteed by the Central Government in respect of the
principal amount and the interest. These bonds qualify as approved securities for SLR purposes.

The NHB also receives financial assistance from international agencies like USAID and
OECF, Japan. It has been authorized to borrow from US capital markets $ 100 million with the
guarantee from USAID. Loan assistance has been also provided by the Overseas Economic
Cooperation Fund (OECF) of Japan to support its housing programmes.

A refinance scheme has been formulated for scheduled commercial banks in respect of
certain categories of housing loans extended by them. The reference scheme will be effective
from January 1,1989 and specified housing loans granted by the scheduled commercial banks as
from that date will be eligible for being covered under the scheme. Scheduled commercial banks
desirous of availing refinance facilities from the NHB will have to execute an agreement in the
prescribed form and have an appropriate resolution passed by their respective Boards of
Directors. The agreement will need to be stamped in accordance with the laws in force in a
particular state where the agreement is executed. After execution of the agreement, the bank
concerned will become eligible for refinance facility from NHB in respect of housing loans
sanctioned on or after January 1, 1989. The objective of this refinance scheme is to encourage
construction of new houses/flats as also extension and up gradation (including major repair) of
the existing stock by persons belonging to low income category i.e. the small man first.
Refinance will be provided only in respect of direct lending to individuals/groups of borrowers
(formal or informal, including cooperative societies). Housing finance routed through Regional
banks by sponsor bank will be treated as direct lending of the latter.

DISBURSEMENT BY NATIONAL HOUSING BANK UNDER ITS REFINANCE

SCHEMES.
(Rs. in Crore)
Years Housing Finance Companies Banks
Disbursement Outstanding Disbursement Outstanding
1989-90 115 115 8 8
1990-91 359 468 21 29
1991-92 581 952 38 64
1992-93 394 1284 32 92
1993-94 245 1437 19 105
1994-95 276 1604 4 82
1995-96 248 1719 11 66
1996-97 328 1893 5 48
1997-98 378 2114 8 38
1998-99 545 2476 24 52
1999-2000 652 2864 2 54
2001-2002 761 3375 101

Source: Handbook of statistics on Indian Economy, Reserve Bank of India,2001

Annual limits are fixed for the primary lenders based on various parameters such as
averages refinance drawn during the previous years, repayment of refinance earlier availed from
it and overall borrowing limit prescribed under the refinance policy. In the case of HFC's annual
 limit are so fixed that no HFC gets more than 25% of aggregate of such limits fixed for all
HFC's. The refinance made available to any HFC is not to be more than 60% of its outstanding
housing loans at any point of time. The HFC's whose over dues are over three months old and
exceed 55 of the aggregate demand for that year, are ineligible to draw further. Institution-wise
disbursement by NHB to various institutions during 1998 to 2001 reveals that major portion is
given to the Housing Finance companies for the further allocations fund. by way of Loan &
Advances especially to the individuals. Data shows that cooperative societies also play very
important role in the housing finance sector.

INSTITUTION-WISE DISBURSEMENTS OF REFINANCE BY NHB

(RS. IN CRORE) 1998-99 TO 2001-01)

Institutions Amount Cumulative Disbursement 2000-01

Disbursement (Upto June 30,2000)

July-June July-June
1998-99 1999-2000
Scheduled Banks 38.76 2.4 101.19
Co-operative Sector 163.09 187.81 140.57
Institutions
Housing Finance 545.16 651.47 761.37
Companies
Total 747.01 841.68 1003.13
Source: Annual Report 2001-2002, Ministry of Finance, and Govt. of India.

It has given several guidelines for the promotion of new HFC's in the private and joint
sectors. These guidelines are applicable to all the HFC's and relate to the overall operations of
the companies in the segment.

3.6 GENERAL HOUSING FINANCE INSTITUTIONS

This group includes namely specialized Housing Finance institutions like HDFC, Life
Insurance Corporation, General Insurance Corporation and its four subsidiaries, the commercial
Banks, National housing bank, Housing Urban and Development Corporation, the Provident
Fund. These general financial intermediaries and lend only a small portion of their funds towards
house construction.

1. Commercial Banks and Housing Finance

The commercial banking sector, consisting mainly of the nationalized banks, makes a small
contribution to house financing efforts. A overall quantum equivalent to about 0.5 per cent of
total bank credit is earmarked every year for housing finance for various category of borrowers,
excluding housing loans to bank's own employees. Commercial bank could also finance housing
cooperative societies, depending upon the feasibility of such housing projects. In case any
housing project requires big investment, a consortium may have to be arranged comprising
commercial banks, HUDCO, LIC, Housing boards and other bodies, depending upon the type of
scheme. The RBI's working group on housing (1978) in its report on "Finance for Housing
Scheme” estimated that the total annual advances of banking sector averaged at Rs. 75crores till
1980 and Rs. 100crores in 1981 but from last 5 years most of bank have stared their operation in
the housing finance sector or even started their own subsidiary for the housing finance sector.
RBI have also changed some provision for the housing finance so that commercial banks can
enter in the housing finance sector or can get refinance facility from the NHB.

2. Specialised Financial Institutions

These institutions have been set up with the sole purpose of financing house construction /
purchasing activities. The Housing and Urban Development Corporation (HUDCO) is a public
sector apex body which was set up in 1970. Its activities are to finance and undertake housing
and urban development programmes all over the country, build new satellite, towns, finance
building material industries, undertake consultancy in the areas of housing and urban
development, conduct research in low-cost etc. HUDCO's main aim among other things is to
serve the needs of the poor strata of society. It has adopted a "progressive interest rate" policy in
which, rates vary from 4 per cent to 15 per cent, depending on the level of income of borrowers.
It has longer repayment facility for the poor. In addition, the proportion of housing loan to the
poor is bigger. All these are aimed at achieving equity and redistribute justice among various
income classes.

3. HDFC and Housing Finance

Housing Development Finance Corporation (HDFC) was started in 1977 as a private
sector institution to make long-term housing, loans, its acts as a mortgage bank, i.e. it raises
long-term funds from institutional sources and lend these to homebuyers. HDFC follows a
variable rate of interest policy. A policy of variable interest rate is based on the amount of the
loans rather than on the income of the borrower. HDFC also receives assistance from USAID
and Aga Khan Foundation for housing for housing finance activities. The rate of interest for the
loan varies between 9.5 per cent to 12.5% with a maximum repayment period of 20 years. The
loans of HDFC account for about seven per cent of the institutional housing finance. Though it
directly lends to individual borrowers, the lending programmes are out of reach of many rural as
well as urban households. HDFC has the largest share in the housing finance sector as present
and it is largest company in the private sector housing finance companies.

4. Housing and Corporate Sector

The cooperative throughout the country have shown a capacity to provide a qualitative
superior housing product. By providing housing related community facilities, co-operatives
foster better social environment, thereby improving quality of life. They bring people together
from all communities and walks of life. Cooperative institution have emerged as major
organizational structures for harnessing human resources and have left indelible impression as
effective modes for management, production, processing and distribution in all sectors of
economics activity. Cooperative have now come of age and have a vast individual membership
of 165 million covering 65% household and 100% villages in the country. There are about
3.5lakhs cooperatives societies in India with a working capital of the order of Rs. 86,287 crores.
There exists a two-tier structure in the field of cooperative housing. At grass root level
there are primary cooperative housing societies and the state level apex cooperative housing
federation which provide funds to the primary housing cooperative in the respective jurisdiction.
 The Primary Societies
The primary cooperatives briefly be classified following four groups:
1. Tenant Ownership housing societies.
2. Tenant Co-Partnership housing societies.
3. House mortgage societies.
4. House construction or house building societies.
These housing cooperatives have collective ownership of houses together with common
facilities and services. They encourage members to save, collect capital requirement, assist
members in mobilising necessary financial and other resources, build houses at reduced costs and
promote healthy community living by creating an improved socio-economic enviornment.

Apex Cooperative Housing Federation (ACHF's)

ACHFS are the oldest housing finance institutions in the country. There are 25 state level
cooperative housing federation, which are in the State/Union Territories of Andhra Pradesh,
Assam, Andaman and Nicobar Islands, Bihar, Chandigarh, Delhi, Goa, Gujarat, Haryana,
Himachel Pradesh, Jammu & Kashmir, Kerela Karnataka, Maharashtra, Madhya Pradesh,
Manipur, Meghalaya, Mizoram, Pondichery, Punjab, Orissa, Rajasthan, Tamil Nadu, Uttar
Pradesh and West Bengal. All these apex federation are the members of the National
Cooperative Housing Federation of India, which is a national level organisation of the entire
Cooperative Housing Federation of India, which is a national level organisation of the entire
Cooperative Housing Federation of India. Most of the apex housing federation enroll primary
housing cooperative as their member. However, some of the apex federations can also enroll to
their membership cooperative institutions and other cooperative bodies and individuals. Other
institution and individual have been taken to the membership of apex housing federations with
the main objective of building up of its share capital and also providing loan to individuals for
construction of their dwelling units. The State Cooperative Banks do not appear to have shown
keen interest in the housing activities. Among the cooperative credit institutions, Urban
Cooperatives Banks have a very strong presence in India numbering about 1500 with working
capital of the order of Rs. 25000crores. Urban Cooperative Banks are required to direct 60% of
their credit to Priority Sector Financing of house building activities. Upto Rs. 2 lakhs per
applicant is treated as priority sector advance.

3.7 HOUSING SCHEMES

The housing schemes offered by these companies, some of them in a collaboration with
the builders will have many attractive features. The terms and conditions under which they offer
loans may very in details but in substance they are the same, There is also keen competition
among HFCs to attract the investors.
1. They sanction loans against first mortgage of the house/ flat bought with the loan
proceeds.
2. The minimum rate of interest on the highest slab of lending is 16.5% and the loan amount
is a maximum of Rs. 10 lakhs and repayment period ranges from 15 to 20 years.
3. Repayment schedule is adjusted to suit the requirements of the borrower.
4. Preferential treatment is given to the individuals who save with them in the form of
deposits with them.
 In the private sector, HDFC, sponsored by ICICI, has done commendable work in the
area of housing finance. It has schemes for societies, individuals and land development agencies.
The housing schemes offered by the HFCs fall under the following categories:
1. Straight loans against mortgage of the house either for purchase of a new house or for
undertaking extensions/repairs.
2. Loans linked to savings made by the customer over a period of time.
3. Preferential sanction of loans to those who have placed deposits with the company (such
as a concessional rate of interest)
All the HFCs charge interest on the total principal, compounded annually for the
duration of the repayment period. Only adjustments in instalment amount are allowed to
suit the capacity of the borrower In addition to interest cost, the borrowers have to bear
the processing fee for applications at a rate ranging from 0.5% to 1% and an
administration fee of another 1%. Thus although the customer has a wider choice and a
range of facilities for housing finance, the burden of servicing is higher and it increase
particularly in the higher slab of loan amounts.

Management Role
The management of HFC becomes a critical variable for the credibility and credit rating
of HFC. Credit rating will become compulsory in future for their deposit mobilization and
efficiency and integrity of management will improve the credit rating and their eligibility for
getting refinance from NHB. Public members who keep deposits with HFCs have to take care to
see that the management is honest and genuine. In particular they have to think twice before
putting their funds with HFCs which are not refinanced and regulated by the NHB. Besides,
when any of such companies are also in real estate business or have links with builders and
dealers in real estate the public will have to be extremely careful to see that they are not fly by-
night operators. In all these aspects, management's role become critical for public image and the
growth of their operations.

3.8 PROCEDURE OF FINANCING

The procedure of housing finance to individuals and promoters/developers is as follows:
(A) Finance to Individuals
The loans are granted for construction of houses, purchase of houses/flats and repairs,
renovations, extension, additions/alteration of existing houses/flats. The quantum of loan is the
70-90% of the cost including the cost of land and sum based on the repayment capacity of the
borrower as assessed by the housing institutions. Rate of interest tax 9.5 per cent on loan up to
Rs.25000 and 12.5 percent between Rs. 25000 to 200000. The housing institutions do not finance
the full cost of the house and the owners-borrowers have to bring in the margin money from their
own sources. It vary from the 10% to 40% of cost of project.
The loan is repayable in equated monthly instalments within a maximum period of 5-20
years, in any case, the loan must be repaid before retirement of the individual-borrowers or 65
years of age whichever is earlier. Initial moratorium period of 18 months or till completion of
construction whichever is earlier may also be allowed. The normal security for the housing loans
is mortgage of property purchased from the proceeds of loan. However where it is not feasible
the housing institution may accept security of adequate value, in the form of life insurance
policies, Government promisory notes, shares and debentures, gold ornaments and such other
securities. Request for additional finance for carrying out alternation/additions/repairs to the
 house/flat already financed by housing agency are also entertained by the housing agencies. In
the case of individuals who might have raised funds for construction/acquisition of
accommodation from other sources and need supplementary finance, banks may extend credit
after obtaining pari passu or second mortgage charge over the property mortgaged in favour of
other lenders and / or against such securities as the banks may require. The upper limit of loan is
Rupees one crore for the one applicant.

(B) Finance to Promoter and Developers

The purpose of housing loans given to this category of borrowers is an additional source
of finance to supplement their own resources, for constructions of residential housing projects.
The amount of such loans is the lowest of as requested applied for or 50 per cent of the project
cost or balance amount required for completion of the project and the repaying capacity of the
borrowers. The period of loan is based on the cash flow of the project. It, however, does not
normally exceed 24 months. The housing institution determines the rate of interest on the basis
of quantum of loan, average cost per housing unit, repayment period and so on. It also takes
prevailing conditions in the market. The nature of security for the loans is the same as in the case
of individual borrowers. Loans are disbursed in suitable instalments depending on the need and
progress of construction work of project. The promoter/developers have to pay relatively higher
processing fees as compared to the individual borrowers.

3.9 STEPS TAKEN BY THE GOVERNMENT TO IMPROVE THE EXISTING STATE OF

HOUSING FINANCE
HUDCO was established in 1970, as a fully owned Government of India enterprise with a
view to ameliorate the housing conditions in the urban and rural areas of the country, and assist
various agencies dealing with housing and urban development in a positive manner.
The Finance Minister announced very graciously to launch HDFC at the inaugural
function held in Bombay on Dassera day, Oct 22,1977. Formally it was launched and started
operation on July 18,1978.
India's insurance act was emended to allow LIC and GIC to directly issue mortgage loans
in 1987.
NHB was created in 1988 to implement Government's new vision of the housing finance
system. It is an apex housing development institution, created to regulate, monitor and foster
housing finance market. NHB gets its funds from long term loans from RBI, LIC, USAID,
bonds, equities and profits from mobilising household deposits.
RBI began to allow commercial banks to make large loans for housing without any
interest rate on loan quantity cap in 1989.
RBI asked these banks to devote 1.5% of their incremental deposits to direct mortgage
lending for housing and for loans to housing finance intermediaries in 1990.

In the last five years Government of India have concentrated on the housing sector by
offering relaxations in the rules and regulations for the housing finance companies and borrowers
through the budget provisions. Some of the provisions are as follows:

Budget 1999-2000
1. Increase in tax deduction on deduction on interest on loans for self-occupied houses from
Rs. 30000 to Rs. 75000.
 2. National Housing Bank (NHB) schemes for interest rate concessions for small borrowers.
3. NHB Act to be amended to introduce foreclosure laws and legislate primary and secondary
mortgage markets.
4. NHB Golden Jubilee Rural Housing Finance Scheme to target 1.25lakh units 1999-2000.
5. Commercial banks instructed to lend up to three per cent incremental deposits for housing.
6. Increase in built-up area for self-owned dwelling units from 1,000 sq.ft to 1500 sq. ft in cities
other than Mumbai and Delhi.
7. Housing finance companies to be taxed on actual basis instead of accrual basis, liberal tax
treatment of income on non-performing assets.
8. Proposal to increase flow of credit to HFCs.
9. Depreciation rate on new dwelling units purchased by sector for employees increased from
20% to 40%.

Budget 2000-2001
To boost up housing in India, the Union Government in the 2000-2001 financial
year's budget proposed a 20% rebate of tax under section 88 of the Income Tax act, which
would now be available for repayment of housing loans upto Rs. 20000 per year as against
Rs. 10000 earlier. Earlier, the exemption from tax on long-term capital was not available if
the capital gain from transfer of capital assets was invested in a house, if one house was
already owned. The restriction was removed. Even if the taxpayers own one house, they can
make an investment in a new house and claim exemption from capital gains tax on sale of
capital assets.

Budget 2002-2003
The initiative taken in the housing finance area in the last four years have shown positive
results. Total disbursement from housing finance institutions in 2000-2001 was Rs. 26300crore,
a growth of about 28 per cent in the year. This amount financed the construction of about 28lakh
houses, much higher than the annual target of 20lakh houses. In the current year the growth rate
is expected to be around 35 per cent. To further strengthen housing finance the following
measures are being taken:
1. Consequent to the amendment to the National Housing Bank Act NHB has commenced
securtisation of housing loans.
2. The NHB will launch a Mortgage Credit Guarantee Scheme, which would be provided to
all housing loans thereby fully protecting lenders against default. This will make housing
credit more affordable thereby also increasing access to housing credit in rural areas.
3. The target under the Golden Jubilee Rural Housing Finance Scheme is proposed to be
increased to 2.25lakhs for 2002-2003 up from 1.7 lakh in the current year. About 1lakh
units have already been financed up to December 2001.
The allocation of the Indira Awas Yojana is being increased by 13 per cent to Rs.
1725 crore for 2002-03.

4. SUMMARY
In the first 25 years of post independence, India has concentrated on agricultural
development. Only after the industrial revolution and the continuous shifting of rural population
to the urban areas, the need for development of housing sector has been emphasized. It is always
a dream to own a house, however a majority of the population does not have the required
 financial assistance to own a house. Eyeing this as an opportunity, many firms have opted for
extending housing loans not only to boost their bottom lines but also to reduce the prevailing
demand and supply gap. The genuine demand arising out of the individual need for housing,
together with the present boom in the housing sector it all set to provide a platform for the
housing finance companies to carve out a piece of fortune. What remained as a very low profile
sector in India is suddenly witnessing activity that is promising a bright future. Out of India's
new housing units, 20 per cent are financed through the housing financing institutions. With the
gap between the required number of houses and the actual, Government identified housing sector
as a core and it is only with the timely intervention of the Government that housing finance has
become a major industry in India. With the establishment of National Housing Bank, the
Government has provided the much needed boost to this sector. At present out of 380 odd HFIs
in India, 32 housing finance companies are registered with the National Housing Bank. This
number is going to increase in the near future with the industry growth. Throughout the second
part of the last decade, this sector has witnessed a growth of over 30 per cent and promises to
grown the same rate in the next couple of years. Recognizing the growing need of housing
finance in India, the Government has emphasized on housing and housing finance in its Ninth
five year plan.
Even the Asian Development Bank has embarked on a twofold strategy for Indian's
housing sector. One is focusing on providing funds to financial intermediaries who in turn, lend
to individual borrowers at the household level. The second objective is combining slum
upgrading and micro credit schemes for lower income groups in its stage level specific integrated
urban development projects.
To regularize the housing finance sector in India, the Government has set up HUDCO. It
was soon followed by setting up of the Housing Development. Finance Corporation (HDFC) in
1978 in the private housing finance sector with the support of ICICI, the International Finance
Corporation and the Aga Khan Fund. The major objective behind setting up of HDFC and
HUDCO has been to enhance the residential housing stock by providing an avenue for hosing on
a systematic and professional basis. Another inherent objective was to increase the flow of
resources to this sector by integration the domestic housing sector with the capital markets. Till
1988, HDFC was the only formal housing finance company operating in India and it is after
1988, the banks and insurance companies forayed into this sector. With the entry of insurance
giants like Life Insurance Corporation of India in 1989 and General Insurance Corporation in
1990, the sector witnessed a three fold increase in activity. Almost at a similar point of time,
public sector banks also forayed in to this sector (Canara Bank's Can fin home, State Bank of
India, SBI.Home Finance. No doubt, the market has immense untapped potential as well as
growth.

5. SUGGESTED READINGS.
Shelter, Vol.5 No.2, April 2002, Special Issue on Housing and Urban Development. A HUDCO-
HSMI Publication.

Nabhi, How to Borrow from Banks and Institutions, Nabhi Publications,New Delhi.

Khan M.Y. and Jain. P.K., Financial Management Tata McGraw Hill, New Delhi.

Bhole L.M., Financial Institutions and Markets, Tata McGraw Hill New Delhi.
 Vasant Desai, The Indian Financial System, Himalaya Publishing House, New Delhi.

V.A.Avadhani, Marketing of Financial Services, Himalaya Publishing House, New Delhi.

Brealey R.A. and Myers S.C. Principles of Corporate Finance, Tata McGraw Hill, New Delhi.

Buckley Robert M, Housing Finance in Developing Countries, Macmillan Press, Hampshire,

Great Britain.

Economic Times (The), Delhi, 1.11.99, 22.12.99, 6.1.2000, 14.2.2000, 3.3.2000, 12.3.2000,
19.4.2000, 3.10.2000.

Hindusatan Times (The), New Delhi, 13.06.2001,6.08.2001, 2.2001, 12.05.2002, 18.07.2002.

6. SELF ASSESSMENT QUESTIONS

1. What do you mean by Housing Finance? Define its importance to economy.
2. Explain about the National Housing Bank (NHB). Do you think it is working toward the
development of housing market in positive manner?
3. Define the complete structure of Housing finance market in India
4. What is role of Public and Private sector housing companies in India?
5. What is role of Government for the growth of housing finance market in India?
6. What are the procedure to take housing loan for the individual group or organization?
7. What are the various housing finance schemes available in India offered by various
agencies?
8. "Housing finance is important for the activity for the development of any economy".
Explain it clearly.
 Financial Inclusion & Microfinance

Structure:
1. Microfinance
 Introduction & Features
 Role and Importance
 Microfinance Delivery Models in India

Self Help Group Bank Linkage Programme

Micro Finance Institutions Model

2. Meaning of Self Help Groups(SHG's)

 Functions of SHG's
 Importance of SHG's
 Problems Faced by SHG's
3. Financial Inclusion
 Meaning of Financial Inclusion
 Strategies for Financial Inclusion
 Benefits of Financial Inclusion
 Challenges in Financial Inclusion

4. Conclusion
5. Suggested Readings/Reference Material
6. Self Assessment Questions (SAQ's)

Introduction to Microfinance
Micro finance is made up of two words. Micro and Finance, Micro means small and
finance refers to money. Thus, microfinance can be related to smaller finances Microfinance is
the provision of a broad range of financial services such as deposits, loans, payment services,
money transfers and insurance to the poor and low income households and their micro-
enterprises. Earlier, poor people in order to meet their financial needs had to resort to money
lenders who exploited them fully. So microfinance was introduced in banking sector on
recommendations of NABARD under which that alternative policies, systems and procedures
have been put in use to save the poor from the clutches of moneylenders.
Microfinance is defined as the provision of Financial Services such as credit, insurance,
finances etc. to poor and low income clients so as to help them raise their income, thereby
improving their standard of living.

Features of Microfinance

 It is an essential part of rural finance.

 Loan is given without security
 It caters to the need of poor households specifically those who live below poverty line
 It is expected to alleviate Poverty. Members of SHGS may benefit from micro finance.
 It relates to small loans. Maximum limit of loan under micro finance Rs. 25,000.
  Terms and conditions offered to poor people are decided by NGOs.
 It promotes self employment by providing funds to the skilled.
 It is more service-oriented and less profit oriented.
 It is meant to assist small entrepreneur and producers.

Micro credit and microfinance are different. Micro credit is a small amount of money, given as a
loan by a bank or any legally registered institution, whereas, Microfinance includes multiple
services such as loans, savings, insurance, transfer services, micro credit loans etc.

The inability of formal credit institutions to deal with the credit requirements of poor effectively
has led to emergence of microfinance as an alternative credit system for the poor. Microfinance
scheme is reaching the poor people especially women and has an impact on their socio-economic
development as well as their empowerment. In India, the beginning of microfinance movement
could be traced to Self Help Group (SHG) - Bank Linkage Programme (SBLP) started as a pilot
project in 1992 by NABARD. This programme proved to be very successful and has also
developed as the most popular model of microfinance in India.

With the support from both the government and the Reserve Bank of India, NABARD
successfully spearheaded the programme through partnership with various stakeholders in the
formal and informal sector. Since the time of its origin, NABARD provides policy guidance,
technical and promotional support for capacity building of NGOs and SHGs. Realizing the
potential in the field of microfinance, the government allowed various private players to provide
microfinance in the country. These private microfinance providers, commonly known as MFIs,
are various NGOs, Non-banking Financial Companies (NBFCs) and other registered companies.
Many state governments amended/passed their State Co-operative Acts to use co-operative
societies for providing microfinance. These days many public and private commercial banks,
regional-rural banks, co-operative, banks, co-operative societies, registered and unregistered
NBFCs, societies, trusts and NGOs are providing microfinance by using their branch network
and through different microfinance delivery models.

Role and importance of microfinance

1. Credit to Rural Poor: Rural poor depends on money lenders for their financial requirements.
Micro financing has been successful in taking organized banking to the doorstep of poor and
have them economically and socially sound.
2. Poverty: Alleviation: Due to provision of finances, people can get self employment. With
employment, income increases which in turn reduces poverty.

3. Women Empowerment: Loans are available at easy and economical terms. It leads to women
empowerment and helps in social and economic upliftment. It has been found that most of
the SHGs are formed by women.

4. Economic Growth: Finance plays a key role in stimulating sustainable economic growth. Due
to microfinance, production of goods and services increases which increases GDP and
contributes to economic growth of the country.
5. Mobilization of Savings: Microfinance develops saving habits among people. Now poor
people with meager income can also save and are bankable. The financial resources
 generated through savings and micro credit obtained from banks are utilized to provide loans
and advances to its members. Thus microfinance helps in mobilisation of savings.

6. Development of Skills: Micro financing has been a boon to potential rural entrepreneurs.
SHGs encourage its members to set up business units jointly or individually. They receive
training from supporting institutions and learn leadership qualities. Thus micro finance is
indirectly responsible for development of skills.

7. Mutual help and Cooperation: Microfinance promotes mutual help and cooperation among
members. The collective efforts of group promote economic interest and helps in achieving
socio-economic transition.

8. Social With: With employment the level income of people increases. They may go for better
education, health, family welfare etc. Thus micro finance leads to social welfare for
betterment of society.

Microfinance Delivery Models India

In India, microfinance provided through the SHG-Bank Linkage Model(SHGBLM) and
Microfinance Institution (MFI) Model. The SHG-BLM developed by NABARD is widely
prevalent throughout the country. In this model, the informal SHGs are credit linked with the
formal banking system. On the other hand, MFI model is used by the various MFIs which
emerge reach the rural poor people the areas not served by the formal banking sector. These
MFIs provide financial services to the individuals or to the groups like SHGs, Joint Liability
Groups, JLGs and Grameen groups
In India, the institutions which provides microfinance services includes:- NABARD
Commercial Banks, Regional Rural Banks, SIDBI, Rashtriya Mahila Kosh, Cooperative Banks
and Non Banking Financial(NBFCs). NABARD continued to provide 100% refinance assistance
to banks financing SHG.

SHG-Bank Linkage Programme (SBLP)

SHGs are small, informal groups of 10 to 20 members each formed by the bank officials and
other institutions the village level. Homogeneity social & economic status is the basis for
categorizing members into groups to minimize any mutual conflict. Each group is given a name
and each group has a head, cashier secretary, democratically elected by the group members.
The group members mutually decide about the amount and frequency for individual
savings to be deposited in the group account & use these resources to make small interest bearing
loans to their members Through this process, members learn to handle financial resources of a
size that is much beyond their individual capacities. Generally after six months of group
formation, banks provide loan to the SHG in certain multiples (three to four times) of their
accumulated savings. The bank loans are given without any collateral and at specified intrest
rates. Banks find it easier to lend money to the groups rather than providing small funds to
individual members. The peer pressure ensures timely repayments and replaces the collateral for
the bank loans. The SHG initiative provides a powerful vehicle in the upward socio-economic
transition of the poor. The main objective of SHGS is to provide small loans to poor in order to
help them invest in their livelihood.
SHG-Bank Linkage Model

In this with the formal SHGs are credit linked with the formal financial institutions. Due to
widespread rural bank branch network, the SHG-BLM is very suitable to the Indian context. The
programme uses SHGs as an intermediation between the banks and the rural poor to help in
reducing transaction costs for both the banks and the rural clients. Banks provide the resources
and bank officials/NGOs/government agencies organize the poor in the form of SHGs. Under
this programme, loans are provided to the SHGS with three different methodologies:

Model 1: SHGs Formed and Financed by Banks: In this model, banks themselves take up the
work of forming and nurturing the groups, opening their savings accounts and providing them
bank loans.

Model II: SHGs Formed by Agencies Other than Banks, but Directly Financed by Banks:
In this model, NGOs and other formal agencies in the field of microfinance facilitate organizing,
forming and nurturing of SHGs and train them in thrift and credit management. The banks
directly give loans to these SHGs.

Model III: SHGs Financed by Banks Using Other Agencies as Financial Intermediaries:
This is the model where the NGOs take on the additional role of financial intermediation along
with the formation of group. In areas where the formal banking system faces constraints, the
NGOs are encouraged to form groups and to approach a suitable bank for bulk loan assistance.
This method is generally used by most of the NGOs having small financial base.

MFI (Micro Finance Institutions) Model

The MFI model gained momentum in India in the recent past. MFI model is found worldwide
whereas the SHG-BLM model is an Indian model. MFIs include NGOs, trusts, social and
economic entrepreneurs; these lend small, sized loans to individuals or SHGs. They also provide
other services like capacity building, training, marketing of products etc.

Meaning of Self Help Group (SHG)

A self-help group is a small group comprising of 10-20 local women or men. Members make
small regular contributions over a few months until there is enough capital in the group to begin
lending after which Funds can be lent back to the members or to others in the village for
productive purpose.

Functions of SHGs
1) Group Formation: Members voluntarily form groups for generating employment and
reducing poverty. Groups are homogeneous in nature which promotes understanding and
cooperation.

2) Savings: SHG encourages its members save a part of their income on regular basis.
Savings are transferred to groups to be used for productive purposes.
 3) Lending: After saving for a minimum period, the funds are used for lending to its own
members.

4) Meetings: Group meetings are conducted regularly to solve the problems and difficulties
of its members.

5) Record: SHG keeps record of accounts. It organizes the unorganized rural sector.

Importance of SHGS
1) Reduction Of Poverty:- SHGs help to overcome the problem of poverty by providing
finance to the poor which can be used to generate income and contribute significantly to
their earnings.
2) Employment Generation :- SHG generates employment, including self employment. The
members are encouraged to start-Micro-enterprises. Small rural enterprises help in
reducing the disguised and seasonal unemployment.
3) Empowerment of Women: SHGs have been successful in making rural women
economically, socially and politically more empowered.
4) Promotes Savings and Banking Habit: SHGs play a very important role in linking them to
banking system by promoting savings habit in rural areas. People are motivated to save
because of benefits of SHGs.
5) Reduction of Unorganized Sector: Traditionally rural people were dependent on
moneylenders, indigenous bankers etc. for their financial requirements. Now SHGs have
made a difference in reducing the influence of this sector by providing bank support to
poor.
6) Social & Economic Justice: SHGs help to reduce poverty and promote economic justice.
They empower women, people belonging to scheduled castes, tribes and minorities. Thus
they promote social justice.
7) Community Actions: SHGs also makes rural poor aware about their rights and help them
to fight exploitation.
8) Improves Credit System: SHG has been promoted to improve credit delivery system. It
provides credit on large scale to very large no. of people. This reduces transaction cost
and promotes efficiency of credit system.
9) Mobilisation of Resources: A large number of rural poor do not have access to banks.
SHGS play an important role in mobilising savings of poor. They help them in linking
them to banking system by promoting savings.
10) Beneficial to Financial Sector: The linking of SHGs with financial sector benefitted the
banking sector. Banks are able to tap into a large market.

Problems faced by SHGs

1. Regional Imbalance: The success of SHG programme is limited. The Southern States
account for 70% of funds. There is a need for better linkage efforts in northern, central,
eastern and north eastern states. These states have high concentration of rural poor.
2. Poor Management: Many SHGS suffer due to poor management. In many cases internal
controls are lacking. There has been poor management of cash flows. Roles and
responsibilities of members and office bearers are not defined properly.
 3. Lack of skills Problem of Micro Enterprises: Many micro enterprises developed by
SHGS lack skills and strategy to survive. Even the NGOs fail to provide them with
necessary linkage and market survey report.
4. Dropouts: There are many incidences of dropouts from groups. The main causes are
migration for employment and inability to make regular savings. The dropout rate is
around 11% for very poor and 7% for non-poor.
5. Lack Of Business Attitude: Many banks supporting SHGs treat the projects as a social or
developmental programme and not as a business proposition. This has restricted the spirit
of entrepreneurship among members.
6. Regulations: SHGs are governed by multiplicity of regulations. This makes their
formation and functioning difficult.
7. Lack of Political Support: Usually political parties are after Cooperative Societies as they
serve vote banks. A SHG does not contain enough votes to be inspired by politicians.
8. Sustainability: Sustainability of SHGs depend on the quality of SHGS and the support
given by Self Help Promoting Institutions (SHPIs). Many SHPIs have been. supporting
SHGs, but only to achieve targets. This affects its sustainability in long run.

Financial Inclusion
Financial inclusion means ensuring access to cost-effective, appropriate financial services and
products in a fair and transparent manner to all sections of society, including the vulnerable,
poor, unbanked remotest villages.
Economic growth is not complete till all the sections of the society are uplifted & income
disparities and poverty is reduced. So, Financial Inclusion has been identified as a key factor
towards 'Faster, Sustainable and More Inclusive Growth" as envisaged in the 12th Five Year Plan
(2012-17).

Many initiatives have already been taken- such as nationalization of banks, the lead bank
scheme, setting up of regional rural banks, service-area approach. The banking industry has
shown tremendous growth during the last few decades but still banks have not been able to reach
vast segment of the society, especially the underprivileged sections. Financial inclusion is needed
as it can truly lift the standard of life of the poor and the disadvantaged.

A target group is considered as financially excluded if they do not have access mainstream
formal financial services such as banking accounts, credit cards, insurance payment services, etc.

Government of India had constituted a committee in 2006 under the chairmanship of Dr. C.
Rangarajan to study the pattern of exclusion from access to financial services. The committee
has given a working definition of financial inclusion as;

"Financial inclusion may be defined as the process of ensuring access to financial services
and timely and adequate credit where needed by vulnerable groups such as weaker sections
and low income groups at an affordable cost."

The various financial services identified by the Rangarajan Committee include credit, savings,
insurance and payments and remittance facilities. Financial Inclusion, broadly defined, refers to
universal access to a wide range of financial services at a reasonable cost. These include not only
banking products but also other financial services such as insurance and equity products.

Recently, the RBI directed banks to open 25 per cent of new branches in unbanked rural centres
and simplified know-your-customer norms. Besides providing all rural banks with the core-
banking solution, multichannel approach is encouraged, facilitating use of handheld devices,
mobiles, cards, micro-ATMs, branches, kiosks, integrating the front end devices' transactions
with the banks' core-banking solution.

Various facets of Financial Inclusion

Savings

Financial insurance
advice

financial
indusion
Savings
bank
accounts
affordable
credit

The essence of financial inclusion is in trying to ensure that a range of appropriate financial
services is available to every individual and enabling them to understand and access those
services.
In order to achieve a comprehensive financial inclusion, lot of initiatives have been taken by
Government of India, RBI and NABARD.

Strategies for Financial Inclusion

1. No-Frills' Account: No frills account means making available a basic banking account
either with NIL' or very minimum balances as well as charges that would make such
accounts accessible to vast sections of the population. The nature and number of
transactions in such accounts would be restricted and made known to customers in
advance in a transparent manner. All banks are required to give wide publicity to the
facility of such 'no frills' account, so as to ensure greater financial inclusion.
2. Simplification of Know Your Customer (KYC) Norms: The KYC procedure for
opening accounts for those persons who belong to low income group both in urban and
rural areas & who intend to keep balances not exceeding rupees fifty thousand in all their
accounts taken together and the total credit in all the accounts taken together is not
expected to exceed rupees one lakh in a year has been simplified. They are not required
to give documents of identity and proof of residence to open banks accounts. In such
cases banks can take introduction from an account holder on whom full KYC procedure
has been completed and has had satisfactory transactions with the bank for at least six
months. Photograph of the customer who proposes to open the account and his address
need to be certified by the introducer.

3. Ensuring reasonableness of bank charges: In order to ensure fair practices in banking

services, the RBI has issued made it obligatory for banks to display and continue to keep
updated, in their offices/branches, website, the details of various services charges in a
format prescribed by it. The Reserve Bank has also decided to place details relating to
service charges of individual banks for the most display common services in its website.

4. SHG-Bank Linkage Programme: The SHG initiative provides a powerful vehicle in the
upward socio-economic transition of the poor. The main objective of SHGS is to provide
small loans to poor in order to help them invest in their livelihood. SHGS are small,
informal groups of 10 to 20 members each formed by the bank officials, and other
institutions at the village level. Homogeneity in social & economic status is the basis for
categorizing members into groups to minimize any mutual conflict. Banks provide loan
to the SHG in certain multiples (three to four times) of their accumulated savings. The
bank loans are given without any collateral and at specified interest rates. Banks find it
easier to lend money to the groups rather than providing small funds to individual
members. The peer pressure ensures timely repayments and replaces the collateral for the
bank loans.

5. Mobile Banking: Mobile phones have become a significant communication tool for
every person throughout the world. In rural India, the mobile users far exceed the fixed
line subscribers due to better mobile infrastructure as compared to fixed line
infrastructure. Mobile banking is also referred as m-banking, SMS banking and so on.
Mobile banking is the term used for performing account transactions, balance checks,
credit applications, payments and more through a mobile device like tablet computer like
iPad or mobile phone. Mobile banking is a provision offered by financial and banking
institutions that help users avail their services with the help of devices like mobile phones
and other devices. The scope of offered services encompasses facilities to conduct stock
and bank market transactions, to access customized information and administer the
accounts. Mobile banking makes banking services and products immediately accessible.
It is also cost effective for banks & customers. Mobile banking as the channel of branch
banking is more helpful to rural customers in saving the travelling cost & precious time
to visit the distant branches for money transaction and it is an appropriate delivery door-
step banking model.
 6. Kisan Credit Cards (KCC): It is a credit card to provide affordable credit to the
farmers. It allows farmers to have cash credit facilities without undergoing time
consuming credit screening process. Under this repayments can be rescheduled if there is
a bad crop season with extension of upto 4 years. The card is valid for 3 years and can be
renewed annually.

7. Pradhan Mantri Jan Dhan Yojna (PMJDY): PMJDY is a national mission for
financial inclusion. To ensure access to financial services namely banking/ savings &
deposit account, remittance, credit, insurance, pension in an affordable manner. Under
this accounts can be opened in any bank branch or business correspondent outlet. PMJDY
accounts are being opened with zero balance called no frills account.

Benefits of PMJDY scheme:

I. Interest on deposit.
II. Accidental insurance cover of Rs. 1lakh
III. No minimum balance required.
IV. Life insurance cover of Rs. 30000.
V. Easy transfer of money across india.
VI. Beneficiaries of govt. schemes will get Direct Benefit Transfer in these accounts.
VII. After satisfactory operation of the account for 6 months, an overdraft facility will be
permitted.
VIII. Access to pension, insurance products.
IX. Accidental insurance cover, RuPay Debit Card must be used at least once in 45 days.
X. Overdraft facility upto Rs. 5000 is available in only one account per household,
preferably lady of the household.

Benefits of Financial Inclusion

Financial inclusion enables:

1. Economic growth of the country.

2. Improves standard of living.
3. Improves financial literacy.
4. Deal with financial distress effectively.

Challenges in Financial Inclusion

1. Extending credit in the name of financial inclusion can be dangerous for the economic
system. credit expansion should be to meet the actual requirement otherwise it could end up
harming rather than benefiting the economy.
2. Lending should be with great caution. Throwing easy credit can affect repayment of the loans
and thus can increase the NPA of the banks which can pose a threat to the stability of the
financial system.
3. Opening no-frills accounts result in very little revenue to the Bank and entail relatively
higher costs of service. Therefore, appropriate incentives should be given to banks to
encourage them to be supportive in this initiative.
4. Most importantly, poor sections should be made aware of their rights under this initiative.
5. Conclusion
Micro-financing is basically a tool for socio-economic up-liftment in a developing country like
India. It is expected to play a significant role in poverty alleviation and development. Micro-
financing & financial inclusion both are interlinked. Despite the marked progress made in the
direction of financial inclusion, the problem of exclusion still persist. For achieving the current
policy stance of "inclusive growth" the focus on financial inclusion is not only essential but a
pre-requisite. And for achieving comprehensive financial inclusion, the first step is to achieve
credit inclusion for the disadvantaged and vulnerable sections of our society. The three tiers of
government regulators, banks, mutual funds, industry associations, and NGOs should work for
financial inclusion.

6. Suggested Readings/Reference material

• K.P. Shashidharan(2011), "Mobile banking for financial inclusion", The Hindu Business
Line, 23rd Oct. 2011. Retrieved from,
http://www.thehindubusinessline.com/features/mentor/mobile-banking-for-financial-
inclusion/article2565331.ece
• http://study-material4u.blogspot.in/2012
• www.arthapedia.in
• the hindubusinessline.com
• pmjdy.gov.in

Reference books:
 Financial Services in India Rajesh Kothari, Sage Publications
 Financial Planning Theory and Practice by Mittra, Rai , Sahu & Starn, Sage Publications.
 Economic Development Finance by Karl F. Seidman, Sage Publications.

7. Self assessment Questions (SAQ's)

Q1 What do you mean by financial inclusion? Explain the strategies adopted for financial
inclusion.
Q2. What is micro finance? Explain role and importance of microfinance.
Q3. Explain the features of Pradhan Mantri Jan Dhan Yogna.
Q4. What are SHG's? Explain their importance & limitations.
 CREDIT RATING SERVICES: NATURE, FEATURES, PROCESS, AGENCIES
PROVIDING SUCH SERVICES IN INDIA, ADVANTAGES AND RECENT
DEVELOPMENT.

STRUCTURE
1. Introduction
2. Objective
3. Presentation of Contents
3.1 Concept and Nature of Credit Rating
3.2 Objectives of Credit Rating
3.3 Types of Credit Rating
3.4 Credit Rating - Historical Background
3.5 Credit Rating Agencies in India
3.6 Advantages of Credit Rating in India
3.7 Credit Rating Methodology
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
Since the early 1900s, bonds and debentures have been assigned quality ratings,
specifically in developed countries, which reflect their probability of going into default. In this
dynamic business environment judging the soundness of the various financial instruments like
bonds, debentures, public deposits, preference shares and short term instruments is becoming too
much difficult atleast for an individual investor. Growing defaults even in large and well known
established companies in payment of interest and instalments of principal amount of the raised
debts has further aggravated this problem. This situation has become too much critical
specifically in undeveloped and developing countries where the sickness graph has been rising in
both small and large enterprises. Therefore, the need of the hour is a credit rating agency which
will assess the creditworthiness of the borrowing companies.

2. OBJECTIVE
After reading this lesson, you should be able to
(a) Define credit rating and explain its nature.
(b) Discuss the objectives and types of credit rating.
(c) Describe the various credit rating agencies in India.
(d) Explain the advantages of credit rating

3. PRESENTATION OF CONTENTS

3.1 CONCEPT AND MATURE OF CREDIT RATING

 Credit rating is a specific activity of assessing the credit worthiness firm in terms of "Grade' or
"Standard". In fact, the basis purpose of credit rating is to provide an independent and unbiased
report on the credit worthiness of a company so that it can mobilise funds from the investors at
competitive cost. Simultaneously, it can provide other reliable financial information and
increased disclosure to the investors to buy securities with confidence. Basically, the problem of
credit rating arises in case of investment in debt instruments because benefits on these are limited
in comparison to potential loss arisen on the firm's liquidation. So rating in debt instruments is
popularly known as 'debt rating' or 'bend rating’: Credit rating has been defined by various
agencies which are as follows:
By Mody's Investor Services as "Ratings are designed exclusively for the purpose of
grading bonds according to their investment qualities. Further according to Standard & Poor's
Credit Overview, "Credit rating is a current assessment of the credit-worthiness of an enterprise
with respect to specific obligation.” In the words of another financial expert, "the purpose of a
rating exercise is to express a professional opinion on the degree of assurance as to the flow of a
future stream of cash from a debt instrument or other debt obligation."
In brief, debt rating assigns a numerical and, or alphabetical symbol which reflects the
probability of timely repayment of principle and interest by a borrowing firm. Focus of the rating
is on credit quality. The higher the debt rating the greater the chances that the borrower will fulfil
his debt obligation in time and vice-versa.
In the business world, a number of myths are associated with the concept of bond rating,
so here it is also essential to clarify What bond rating is not.'

1. A bond rating is not a recommendation for purchasing, selling or holding of debt security. While
investing in a debt security, various elements such as yield to maturity on the debt instrument,
risk tolerance of the investor, credit risk of the security etc. are considered. In fact, the focus of
credit ratings is only on the credit risk of the security. Hence, it can not be taken as the sole
criteria of investment decision-making in debt securities.

2. The credit rating is not a general evaluation of the borrowing concern rather it relates to
particular debt securities of the firm. If a particular borrowing company is rated ‘higher’ than the
other company it does not mean that the former company is better in all respects. Therefore,
credit rating, being security specific is direct to gauze the credit risk of a particular bond security
only.

3. The credit rating does not operate or create any legal relationship between the credit rating
agency and users of that rating. For instance, if any investor on the basis of a particular security
incurs losses later on, then he cannot hold responsible the rating agency for the same.

4. The credit rating is not similar to audit function. Both quantitative and qualitative factors are
usually taken into consideration for credit rating. So credit rating agency may use those such
informations which may not be taken into auditing process.

5. The credit rating which relates to evaluation of credit risk of a particular debt security is not a
full time, or till maturity of that debt security. Development in the national and international
economic and business scenario will obviously change the risk characteristic of the debt security.
 Hence, the rating will not be constant or fixed for a longer period, and so it may be reviewed
from time to time.
In view of the above, it is judicious to say that credit rating is an evaluation of credit risk
of a particular debt security for a specific period subject to further reconsideration, and which
does not create any legal relationship with the users of such rating.

3.2 OBJECTIVES OF CREDIT RATING

In the light of above discussion, the basis objectives of credit rating can be stated as
follows:
(a) To provide guidance to the investors/creditors in determining the credit risk associated with a
debt instrument/credit obligation. It will ensure to the credit investors about the degree of
safety of their investment in various debt instruments.
(b) It provides other relevant information and increased disclosure about the firm's financial
position credit-worthiness so that the investors can invest as per their risk aversion.
(c) It facilitates the direct mobilisation of funds and savings from savers to investors rather
through an intermediary since by credit rating the investors can assess the credit risk involved
in particular instrument.
(d) In enhances the credit-worthiness and reputation of the business firms which show better
performance in terms of their financial obligation. Not only this, they can also reduce their
interest costs too by having higher credit gradation rating.

3.3 TYPES OF CREDIT RATING

Credit ratings are of different types. Though most popular rating relates to debt
instruments, however, other instrument can also be got rated. Following are important types of
rating:

a) Bond rating
Rating the debentures/bonds or debt instruments issued by a company, government or semi-
government is called bond rating.

b) Equity Shares Rating

The rating of equity shares/stock issued by company, government or semi government is
called equity rating. However, this rating is also popular presently in the market.

c) Preference share rating

The rating of preference shares issued by a company, Government or semi government
agencies is known as preference shares rating. In some countries, the rating of preference shares
before their issuing is compulsory. However, it is not so popular in, capital market.

i) Public Deposits rating

Public fixed deposits is the debts raised by the firm from the public at large. The period
of fixed deposits normally varies from one year to three years. So rating of such public
deposits is called public/fixed deposits rating.
 ii) Commercial Paper : a rating
A commercial paper is a short term debt financial instrument issued by a company to
raise funds for meeting its working capital requirement. Getting rating of commercial papers is
mandatory in India: Such rating is known as commercial paper rating.

iii) Rating the Borrower

This includes rating a borrower/firm to whom a long/credit facility may be sanctioned. Here
instead of rating a financial instrument, the borrower or issuing firm is rated.

iv) Sovereign rating

This includes rating a country as to its credit worthiness, probability to risk, etc.

3.4 CREDIT RATING-HISTORICAL BACKGROUND

Since the early 1990s, the debts have been assigned quality ratings which reflect their
probability of going into default. In the year 1909, John Mody published his Analysis on Rail-
road investments, and since that time, quality rating of bonds and other debt instruments have
been prepared by various agencies. In the United States, three major rating firm i.e. Standard and
Poor's Corporation.(S&P), Mody's Investors Services (Mody's) and Fitch Investors Services
(Fitches) grade bonds for their level of default risk. These ratings have generally been valuable to
investors. Each debt rating, becomes an indication of the credit worthiness of the firm with
respect to a specific debt issue.
The Standard & Poor's also makes the rating of preferences shares. These ratings are also
designed in the same manner as of the bond ratings. Though preference shares are technically
treated as equality instruments becausé principal source of return from these securities is the
dividends received, and further generally the preference share-holders have no means to force the
firm to pay the dividends. In view of this, these ratings become even more valuable to the
investors.

In the year 1985, the State Bank of India was passing through an intellectual phase. It was
redefining its own presence and desirous to see how the bank looks like from abroad. It was also
planning at that time to issue commercial papers in the US capital market. For that purpose, the
bank had to get a rating from an internationally accepted rating agency. As a result, the bank's
then chairman, Dr. DN. Ghosh, approached Moody's rating agency. In the first instance, the
Moody's refused on the ground that it did not risk any organisation in that country which had a
per capital income of less than $500: However, after a lot of argument by the Chairman of the
SBI, the moody's accepted to rate. Eventually Moody's came out with rating which has proved
surprisingly comfortable. On approaching the Standard & Poor's; another internationally reputed
firm, by the State Bank of India, it also gave an equivalent rating. All this process and exercise
conceived the idea of credit rating services for Indian capital market. Consequently, Sh. D.N.
Ghosh proposed this idea to Sh. N. Vaghul, the then Chairman of the Industrial Credit and
Investment Corporation of India (ICICI) who accepted the new idea, and in this way, India's first
credit rating agency was planned to be established. As a result, on January 1, 1988, ICICI and
Unit Trust of India (UTI) joined hands to float a credit rating firm named Credit Rating and
Information Services of India Ltd. (CRISIL).
 After the establishment of CRISIL, in India another credit rating agency was established
by Industrial Finance Corporation of India.(IFCI) named Investment Information and Credit
Rating Agency of India Ltd.(ICRA) and it has started functioning in the year 1991.Another third
important rating agency is promoted by the Industrial Development Bank of India(IDBI) named
Credit Analysis and Research Limited (CARE).These have been discussed in brief here as under:

3.5 CREDIT RATING AGENCIES In India

A. THE CRISIL
The first credit rating agency in India named Credit Rating and Information Services of
India Ltd. (CRISIL) was established in January,1988 with a capital base of Rs. 4 crores.
The major share holders of the agency are as follows:

Percentage in Capital
1. Industrial Credit and Investment Corp. of India(ICICI) 15
2. Unit Trust of India(UTI) 15
3. Asian Development Bank(ADB) 15
4. Housing Development Finance Corp.(HDFC) 5
5. Life Insurance Corp. of India(LIC) 5
6. General Insurance Corporation(GIC) 5
7. State Bank of India(SBI) 5
8. Nine National Banks: 18
(Bank of India, Bank of Baroda, UCO Bank, Canara Bank, Central Bank of India, Allahabad
Bank, Overseas Bank, Vyasa Bank, Bank of Madura)
9. Ten Foreign Banks
(Mitsui, Bank of Tokyo, Standard Charted Bank, Grind lays, Indosvez, Deutsche, Societe
Generate, BNP, Citi Bank and Hongkong)

Crisil’s Objectives
The major objectives of the agency is to rate the different types of financial instruments
like equity shares, preference shares, bonds, debentures and other short term instruments.
However, at present, it is restricting its rating only to debt instruments like fixed deposits,
debentures (whether secured, unsecured, convertible or with other Features), short term debt
instrument like commercial papers, etc. Diferent types of symbol for different debt instruments
like 'A' for Debenture' ‘FA' for Fixed Deposits and ‘P' for commercial papers. The detail of all
these symbols have been stated in subsequent sections. Financial analysis does, of course, form
part of credit rating, but only a part. The stated rating a numeric and alphabetical symbol, will
convey a future risk opinion of the agency with regard to a particular instrument.
Focusing on specific credit quality, there is no compulsion on the corporate sector to
obtain or publicise the rating symbol assigned by the CRISIL. However, the agency (CRISIL) is
planning to entertain the rating of all types of securities, i.e., equity shares, preferences shares,
convertible debentures etc., once the requirement is made compulsory..
For the purpose of credit rating, CRISIL considers both qualitative and quantitative
criteria. It means besides evaluating various financial ratios and the cash flow and funds flow
statement, other qualitative aspects like company's competitive position, its strengths and
weaknesses, its management and business strategies etc are also examined. Further it also has a
detailed discussion with the concerned executives of the company. The detail of CRISIL's rating
methodology for manufacturing and finance companies has been stated in subsequent sections.
According to Pardeep Shah, Managing Director of the ICICI, yardstick is not just
financial performance but also included how the company is keeping with the problem of
succession or the transition from a family run business to a professionally managed one. All
ratings ultimately are done by taking into account the adequacy of future cash flows.
The CRISIL charges 0.1 per cent of the issue size for debentures and commercial papers
and 0.05 per cent in cash of public deposits. In subsequent years, it monitors the performance of
its clients for a surveillance fee, i.e. 0.05 per cent in the case of debentures and commercial
papers and 0.03 per cent for fixed deposits.

So far as period of the rating is concerned. Mr. Bhattacharya, an executive of the CRISIL,
says though there is no expiry period for the rating, the company's standing can register dramatic
turn around on the basis of factors which can be beyond its control. For example, change in
taxation or duty structure or announcement of a new policy which happened in the case of
cement and aluminium industries. Such fluctuations will now find a place in rating scan, though
the company concerned may find expedient not to mention the ratings.
After assigning the rating symbol to the company, the CRISI also clearly spells out the
rationale for assigning that specific rating, After that, the agency also keeps on monitoring the
rating as on going basis throughout the life of the instrument irrespective of its nature and kinds.
If the agency thinks to change the rating at any point of time, it will revise the rating and then the
same would be made public in the quickest possible time as well.

CRISIL'S Rating Symbols

The CRISIL uses the conventional rating symbols which ane generally used in the
developed countries. The following are the major symbols which are used for different types to
debt instruments:

a. Debenture Rating Symbols

i) Triple A - 'AAA' Highest Bafety

It signifies the highest safety of timely payment of interest and principal. In other words, it
indicates towards the most safety debt security for the investors. However, the circumstances
later on may provide to change this degree of safety, but such changes are, unlikely to adversely
affect the fundamentally strong position of such issues.

ii) Double A - 'AA' High Safety

It signifies the high safety or timely payment of interests and principal. In other words, it
implies a slightly lower degree of safety of interest and principal amount of debt thus, above
stated symbol, i.e. 'AAA' for the investors.

iii) Single A - 'A' adequate safety

It signifies adequate safety of timely payment of interest and principal, but certainly lower
than the above mentioned symbols i.e. AA Further change in circumstances can adversely affect
such issues.
iv) Tripple B- 'BBB' Moderate Bafety
It indicates towards the sufficient safety and timely payment of interest and principal at the
present time. Thus, any adverse development will weaken the capacity of the firm to pay interest
and principal in comparison to above stated symbols.

v) Double B-BB' Inadequate Safety

It signifies inadequate safety of timely payment of interest and principal. While these are less
subsceptible to default than other speculative grade securities in future, the uncertainty that the
issuer faces lead to inadequate capacity to make timely interest and principal payments.

vi) Single B-'B' High Risk

It indicates greater susceptibility to default. Though current interest and principal payments
are met but adverse business or economic conditions would lead to lack of ability or willingness
to pay interest or principal payments.

i) Single 'C'- 'C' Bubstantial Risk

It implies substantial risks. It is vulnerable to default. In other words, timely payment of
interest and principal is possible only if favourable business and economic conditions continue.

ii) Single 'D'- 'D' in default

It indicates towards possibilities of default. Securities rated in D' category are in fault and
in arrears of interest or principal payments or are expected to be in-default on maturity. In other
words, such securities are extremely risky and speculative and returns from these may be realised
only on reorganisation or liquidation.

Further, in addition to above-stated symbols, the CRISIL may apply plus (+) or minus (-)
for ratings from AA to D to reflect comparative standing of a company. Preferences share rating
symbols are identical to debenture rating symbols except that the letters PF are prefixed to the
debenture rating symbols.

b. Fixed Deposits Rating Symbols

The CRISIL has donated the rating symbols, like debentures, t fixed deposits in similar
form which are as follow:

FAAA. It signifies very strong degree of safety. It means highest safety principal and interest
payment to the investors.

FAA. It signifies lower degree of safety in comparison to F AAAA, otherwise strong degree
of safety of interest and principal payments to the investors.

FA. It indicates satisfactory degree of safety of interest and principal, but, of course, lower
safety in comparison to: FAAA and FAA symbol.
 FB. It signifies inadequate safety of interest and principal of the investors. In other words the
issue is not fully safe subscription.
FC. It signifies doubtful safety of interest and principal amount. It means the issue is risky
for subscription.

FD. It signifies that the issue is either in default or likely to default.

In addition to these symbols, the CRISIL may apply plus (+) or (-) signs for rating from
FAA to FC to indicate relative positions.

c. Rating for short term instruments (Commercial Papers)

The CRISIL is also rating the short term debt instrument like commercial papers. Rather
it is obligatory for issuing company to get rating from any agency before issuing the commercial
papers to the public. The following symbols are issued for these instruments:

P-1 This describes very strong degree of safety of principal and interest to the investor. In other
words, it indicates highest safety of the issue.

P-2 This describes strong degree of safety of principal and interest but slightly lower than P-1
rating.

P-3 It indicates towards adequate degree of safety of principal and interest payment to the
investors. It means the investment in the issue is safe.

P-4 This describes minimum safety of payments and likely to be affected by short term
adversities. In other words, the issue is safe only If favourable circumstances continue.

P-5 This signifies that issue is either expected to be in default or is in default. It means the issue
is risky and extremely speculative from interest and principal point of view.

Note: CRISIL may apply + (plus) or- (minus) for its rating symbols to indicate the relative
position within the rating category.

B. Investment Information and Credit Rating Agencies of India Ltd. (ICRA)

The second entrant in the credit rating field in India is Investment Information and Credit
Rating Agency (ICRA) which is launched by Industrial Finance Corporation of India (IFCI) in
the year 1994, with its headquarter at Delhi.
The rating methodology of ICRA is similar to that employed by international rating
agencies Moodys' or Standard and Poor'; various aspects such as the structure of the industry,
number of the players, case of entry, nature of competition, demand and supply position, powth
rate of demand for the industry's products. The effects of changes in excise and customs tariffs,
availability of raw materials and labour, etc. are examined in detail for such purpose.

ii) Capital Structure

IICRA is an independent company limited by shares with an authorised capital of Rs.
10crore against which Rs. 5crore is paid up, the IFCI has subscribed 26 per cent and rest by the
other financial institutions such as UTI, LIC, GIC, PNB, Canara Bank, Bank of Baroda, UCO
Bank etc. The Board consists of reputed professionals with in-depth knowledge in finance,
economic, industry and technology.

iii) Objectives
Like other credit rating agency, ICRA also fulfils the major objectives relating to credit
rating which are as under:
a) To help investors both institutional and individuals in making their investment decisions.
b) To assist issuing firms in raising huge funds from a wide investors base at a lower cost,
specifically which has high grades.
c) To enable banks, financial institutions and other brokers in placing debt with investors by
providing them with a marketing tool.
d) To provide regular, monitoring of the rated companies to encourage the healthy growth of the
financial markets in a disciplined manner.

iv) ICRA Rating Symbols ICRA

ICRA has been rating since its inception, important financial instruments like bonds &
debentures, preference shares, commercial papers, fixed deposits, etc. Similar to the CRISIL,
ICRA has also issued different symbols to different instruments which are stated below:

a) Debenture Rating Symbols

i) LAAA- Higher Safety
This symbol indicates high safety to the creditors in terms of payment of interest and
principal amount by the issuing company. Risk factors are negligible.

ii) LAA - Higher Safety

This symbol indicates high safety to the creditors. Risk factors are modest and may vary
slightly. The protective factors are strong enough and the prospect of timely payment of principal
and interest as per terms even under adverse conditions.

iii) LA-Adequate Safety

This symbol indicated adequate safety. Risk factors are more variable and greater in periods
of economic stress. However, the protective factors are average and any adverse changes may
change the fundamental strength.

iv) L BBB- Moderate Safety

This symbol indicate toward moderate safety for creditors due to owing considerable
variability in risk factors. The protective factors are moderate rather below average. Adverse
changes in business conditions may affect the timely payment of interest and principal.

v) L BB-Inadequate Safety
This symbol indicate inadequates safety for the creditors. The timely payment of interest
and principal are more likely to be affected by present or prospective changes in business factors.

vi) L B-Risk Prone T

 This symbol indicates towards less safety of the investors. It means that quite possible,
the issuing company may not be fulfilling its obligation when due. The protective factors are
narrow. Adverse changes in business conditions may ability/inwillingness to service debts as
per terms.

vii) LC-Substantial Risk

This symbol indicates towards inherent elements of riskness of the investment. The firm
either already in default of payment of interest and or principal as per terms or expected to
default. The possibility of recovery of due amount is likely only on liquidation or reorganisation
of the firm.

b) Medium term including Fixed Deposits Symbols

i) MAAA-Highest Safety
This symbol indicates highest safety for the investors for their timely payment of interest and
principal amount.

ii) MAA-High Safety

This symbol earmarks high safety for timely servicing of the interest and principal as per
terms and conditions but not as high as in M AAA rating.

iii) MA-Adequate Safety

The prospect of timely payment of the interest and principal amount is adequate. However,
debt serving may be affected by adverse changes in the business conditions.

iv) MB-Inadequate Safety

The safety of servicing debt seems to be inadequate. The prospects may be affected due to
changed business circumstances.

v) MC-Risk Prone
The safety of servicing debt seems to be inadequate. The prospects may be affected due to
changed business circumstances

vi) MD-Default
Extremey speculative. This indicates either the arm defaulted or likely to be defaulted.
Recovery is possible only on liquidation or re-organisation.

(c) Short term including Commercial Papers symbols

Likewise above symbols indicates for debentures and medium term deposits, almost the
same categorisation of symbols is done for commercial papers with different marks which
are as under:
A - 1 - Highest Safety
A - 2 - High Safety
A - 3 - Adequate Safety
A - 4 - Risk Prone
A - 5 - Default
Notes
i. The rating symbols group together similar but not necessarily indicated in terms of their
relative capability of timely payment of debts obligations as per terms of contract i.e., the
relative degree of safety risk.
ii. The signs of (+) plus or minus (-) may be used after the rating symbol to indicate the
comparative position of the firm with in the group covered by the symbol.
iii. The letter P' in parenthesis after the rating symbol indicates that is a provisional rating
symbol assuming successful completion of the project, which is being raised. Rating largely
depends on successful and timely completion of the project.
iv. The rating symbols for different instruments of the same company need not necessarily be
the same.

(C) Credit Analysis and Research Ltd. (CARE)

Another important credit rating agency which is established in India is Credit Analysis and
Research Ltd. (CARE). It is promoted by the IDBI (Industrial Development Bank of India) in
1992 in association with other financial institutions, banks and finance companies. Its paid-up
capital is Rs. 8crore. The main objective of the CARE is to provide information on any company,
industry or sector sought by a business enterprise, individual, mutual fund, investment
companies, residents and non-residents.
CARE has been rating almost all important financial instruments like bonds, debentures,
short term obligations like commercial papers, fixed deposits, structured obligations including
non-convertible portion of PCD preference shares, etc. Equity shares are not rated at present.

Credit Rating Symbols of CARE

Likewise CRISIL and ICRA, the CARE has also formulated rating symbols for different
categories of instruments. These have been indicated below as:

1. Long Term and Medium term Instruments Symbols

2.
Grades Debentars/Bonds FD/CDs/SOs
Highest Investment CARE AAA CARE AAA (FD)/(CD)/(SO)
CARE AA CARE AAA (FD)/(CD)/(SO)
Highest Investment CARE A CARE A (FD)/(CD)/(SO)
CARE BBB CARE BBB (FD)/(CD)/(SO)
Speculative CARE BB CARE BB (FD)/(CD)/(SO)
CARE B CARE B (FD)/(CD)/(SO)
Poor Grade CARE C CARE C (FD)/(CD)/(SO)
CARE D CARE D (FD)/(CD)/(SO)

Where FD- Fixed Deposits, CD= Certificate of Deponents, SO=Structure Obligations.

3. Short Term Instruments

Grade Commercial Paper

Superior Grade PR-1
Investment Grade PR-2
Adequate Grade PR-3
Risk Proven PR-4
Default Pr-5

Recent Guidelines
In India, credit rating has been made compulsory for certain debt instruments which are
as under:

1. It is obligatory to get the programme of issue related in case of public issue of

debentures/bonds where the conversions/redemption period exceeds 18 months.
2. The non-banking finance companies (NBFC) having net owned funds or more than Rs. 20
million, must get their fixed deposit programmes rated within 31 st March, 1995, in case of
NBFC having net owned funds between 5 million to 20 million the programme should be got
rated within 31st March, 1996.
3. One of the requirements of the issuance of commercial paper in India is that the issue must
have a rating not below the A-2 grade of ICRA (for its equivalent for other rating agencies of
the country)

3.6 ADVANTAGES OF CREDIT RATING IN INDIA

The Indian capital market is smaller in volume and under developed in view of
investment decision and information technology Mostly the Indian investors take the investment
decisions on the basis of broker's advice, company's name or image rather than on an analysis of
credit worthiness of the company. Moreover, most of the Indian investors are not well conversant
with the credit risk analysis. In such market environment the credit rating becomes an essential
requisite for smooth functioning and growth of capital market.
Credit rating can, thus, be helpful to both the lenders as well as the borrowers. A few
advantages of credit rating are as follow:
a) Modern investment decision is too much complicated. It requires appropriate technical
skill, knowledge, expertise for evaluation of credit worthiness of the company. Further, it
is time consuming process and costly affair which is not affordable by single or small
genuine investor. In lieu of this, credit rating agencies provide essential and valuable
services by evaluating the credit worthiness of business firms through ‘Rating symbols'.
The investor can choose the companies for investment depending on his risk criterion.
b) Credit rating will shift the primary moral responsibility of corporate credit quality from
the borrowers/brokers/underwriters/financial advisers etc. to the credit rating agency, and
thus, decreasing conflict of interest between underwriters and investors by providing
widely acceptable standards and uniform ratings.
c) The credit rating agencies, undoubtedly, will provides more reliable disclosures through
better accounting standards and improved financial information the various users such as
 individual investors, institutional investors, stock exchanges, corporate research bodies,
financial institutions etc.
d) It will facilitate direct mobilisation of savings from investors rather than through
intermediary lending institutions. Further, it will also be helpful in reducing the cost of
issue to the borrowing concerns.
e) By constantly monitoring the results and altering the grading symbols from time to time
in lieu of changed performance of the rated concerns, credit ratings will protect the
interest of the investors.
f) The high rate companies will undoubtedly be beneficial of issuing the debt at lower
interest. The investors will prefer in those companies, which have high gradation in
comparison to low rated concern.
g) For a high graded credit rating firm, it will provide a marketing tool is placing its debt
obligations with wide investor base, that is aware of and comfortable with different level
of risk.
h) By having a continuous check on the rated firm's financial performance, the rating
agencies will, no doubt create discipline among corporate borrowers to improve their
financial performance and operating risks in order to have a better rating of their debt
obligations in future.
i) It will also be beneficial to commercial banks and other public financial institution which
deal with a lot of public money in building up their investment portfolio at agreeable risk
levels. That is why, in most of the countries the credit rating has become mandatory.

3.7 CREDIT RATING METHODOLOGY

To rate a particular instrument or firm, the rating agency has to make a comprehensive
study. Though all the rating agencies have their own way of such investigation, but important
common factors which are analysed are stated below:
On the receipt of the request from the firm, the agency assign an analytical team of
professionally qualified persons. The team collects data, analyse information, meet key personnel
and evaluates certain other relevant matters. The key areas which are usually evaluated are
described in brief here as under:

a) Business Analysis
In this respect, the analysis will include business risk, industry risk, market position of the
company in industry, operating efficiency, legal status, etc.

b) Financial Analysis
It relates with all such items which affect the financial position and return of the firm. It
includes the evaluation of accounting, quality, earnings, adequacy of cash flows, liquidity
position, solvency position, financial flexibility, capital structure analysis, etc.

c) Management Evaluation
It is concerned with the management quality and performance. It includes track record of
management, planning and control system, depth of management talent, succession plans, goals,
philosophy and strategy etc.
 d) Regulatory and competitive environment
In this respect, various factors relating to structure and regulatory framework in which the
unit operates, trends in regulation, deregulation and their impact on future performance of the
company etc. are studied.

e) Fundamental Analysis
Various fundamental factors like asset quality, liquidity management, profitability and
financial position are investigated.

After evaluating both qualitative factors, the team presents its report to the top
management of the rating agency which further decides the ratings. The rating is then
communicated to the concerned firm.

4. Summary
The high levels of default in the US in the seventies gave impetus for the growth of credit
rating as a worldwide financial service. Credit rating is a process of assigning a symbol that acts
as an indicator of the current opinion regarding the relative capability of the issuer to service debt
obligation in a timely fashion, with specific reference to instrument being rated, credit rating is
advantageous to investors issuers, intermediaries and to regulators alike. Many factors have
contributed to the growth of the credit rating system in the world. Some of the credit rating
agencies in India include CRISIL, CARE, ICRA, etc. The rating framework consider both
business and financial factors while assessing credit worthiness and assigning grades. In addition
to bond rating, agencies also provide grades for equity instruments. Inspite of all the benefits of
rating one must remember the fact that rating is merely for guidance and is not a
recommendation to buy or sell or retain an instrument.

5. SUGGESTED READINGS
1. Manual of Merchant Banking by Dr. J.C. Verma, Bharat Law House, New Delhi.
2. Capital Market Management by V.A. Avadhani, Himalaya Publishing House.
3. Management of Financial Services by b.S. Bhatia & G.S. Batra, Deep & Deep Publications, New
Delhi.
4. Security Market in India, by Bal Krishan and S.S. Narta, Kanishka Publishers, New Delhi.

6. SELF ASSESSMENT QUESTIONS

1. Define credit rating. What are its important features? Also explain its kinds and significance.
2. Discuss the different agencies which are providing credit rating services in India. Are you
satisfied by their functioning?
3. Describe the various rating symbols which are assigned for various instruments. Also explain the
merits of the credit ratings.
 CREDIT CARDS SERVICES
STRUCTURE
1. Introduction
2. Objective
3. Presentation of Contents
3.1 Credit Cards
3.2 Debit Card
3.3 Benefits of Credit Cards
3.4 Agriculture Credit Card
3.5 Visa and Master Card
3.6 Smart Card
3.7 RBI and Credit Card Business
3.8 Tips for Card Holders
3.9 How to Select the Right Credit Card?
3.10 FAQs about Credit Card
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
If we ask single Americans in their 20s or early 30s what their financial worry is, most
will probably answer credit card debt, says Scott Bilker in his book Credit Card Debt
Management. The concept of credit was first used in Assyria, Babylon and Egypt 3000 years
ago. Plastic money first came into being in 1950 when Diners Club and American Express
launched their charge cards in USA. In 1951 Diners Club issued the first credit card to 200
customers. With the magnetic strip used in credit cards coming in 1970, credit card became more
popular. Credit cards are gaining ground in India too. More and more banks are encouraging
their people to go in for credit cards. Besides the various freebies and rewards doled out,
customers feel it very convenient to carry a plastic card rather than bundles of currency. The
expected growth rate of credit card business in India is 25-30% .With the advent of globalization
and privatization, the 25-30 concept of credit cards is gaining popularity. Customers no longer
have to carry huge sums in their wallet. Most of the bill payments including utility payments can
be taken care by credit cards. Further, in India at least, people perceive the card as a status
symbol. In India, Citibank and HSBC are the main players. However, various Indian banks, both
public and private, are entering into Joint Ventures with International names like Master Card
and Visa. Recently, BOBCARDS has launched a credit card, PARAS, in association with the
Master Card International. Citibank is still the largest issuer in the country with the banking
margins are falling, the banks are focusing more or the retail segment. SBI and ICICI are
capturing the market at a very fast pace.

2. OBJECTIVE
After reading this lesson, you should be able to
(a) Define Credit Card and debit card, and differentiate between the two.
(b) Explain the benefits of credit card.
(c) State the procedure for obtaining a credit card.
(d) List out the tips for card holders.
3 PRESENTATION OF CONTENTS
3.1 CREDIT CARDS
The word credit comes from a Latin word meaning trust. Customers can sure trust to
receive their purchases on time but banks cannot be very sure of getting their money back
always. The major problem in the credit card segment is the percentage of defaulters. This hits
profitability in a big way. Another problem is the low average spending per card. Moreover,
many careholders tend to settle their dues just before the deadline thereby not making use of the
rollover facility. This does not augur well for the banks, as only higher incidence of rollover will
be profitable for the banks. With recession at its worst, very few banks can make profits in the
situation. To add to the issuer's woes, the government has included credit card holders in the
economic criteria for filling the income tax returns. This is a major setback for the banks issuing
the cards. Also the credit card industry has come in the service tax net that mark the growth of
the credit cards in India. While banks are getting innovative in pushing their cards to customers,
cardholders too are getting smarter and taking care of their expenses. The low entry levels and
impressive rewards schemes do draw a lot of people to possess credit cards and make purchases.
The smart ones repay on time depriving the card issuer from making significant gains. Some
others spend a lot and then default and shift to another card. Many Indian and foreign banks have
issued credit cards to its customers. The issuing bank will have a tie up with a number of
establishment ranging from 5000 to 18000 inclusive of hotels, hospitals, shops and departmental
stores, which will honour the credit cards. This issuing bank will provide this facility of credit
cards to those having a regular monthly income beyond a limit, credit worthiness, judged by their
wealth and income and business executives and their top brass. The bank takes a risk is that card
holder is given a credit facility to repay within 30 to 45 days and there is a possibility of default
risk. Commercial banks in India, starting with many foreign banks have started issuing those
cards since the beginning of eighties. The use of credit card substitutes and replaces the use of
cash. It increases the money on hand and accelerates the velocity of money to the extent that idle
money is activated for purchase of goods and services. As the credit card gives the overdraft
facilities and additional borrowing power, it can supplement the existing money supply and
economic the use of cash, which has wear and tear risk.

Growth of Credit Card Business

The number of members using it and the number of establishments honoring this credit
card after joining the scheme have increased vastly over the past few years. Some Indian banks
joined with International banks to provide this credit card facility on a worldwide basis, or at
selected International Centers.
As per the latest date available for 1997 the number of banks having launched the credit
card rose to 12. Sixteen banks are issuing credit cards as part of their tie-up arrangements with
the existing banks in business, the details of the terms of issue and the participating members and
establishments honoring the credit cards changed from bank to bank.
Related Service (Electronic Banking)
As regards electronic banking service to customers, electronic clearing service (ECS or
credit clearing service) has become operational at the four Metropolitan Centers since 1996. It
has since been extended to four non-MICR centers, namely Ahmedabad, Banglore, Hyderabad
and Pune. In addition, ECS (Debit Clearing) is in operation in Mumbai and Chennai for
 collection of Telephone bills. Similarly the payment of electricity bills to the utility companies in
Mumbai is being brought under the purview of ECS in Mumbai.
IBA (Indian Banks Association) has sponsored the Shared Payment Network. System
(SPNS) in addition to a large network of ATMS, POS terminals and cash dispensers connected to
the Central Host to provide extended hour electronic Banking service to customers for
transacting on the network. The SPNS provides the services like deposit, withdrawal of cash,
balance enquiry, printing of statement of account, request for cheque book, standing instructions,
POS facility etc.

3.2 DEBIT CARD

Today more than 60 million people have debit cards that carry the logos of the two major
personal numbers. This number is expected to grow dramatically as debit cards become
increasingly popular and people are confuse debit cards with standard ATM cards. Not all debit
cards are equal. Debit cards with the logo of one of the two major payment cards with clout.
They can be used to obtain cash from ATM machines, and also to make logos on these cards are
accepted over 16millon merchants worldwide.
Increasingly, debit cards combine the key elements of ATM cards, and instant access to
cash and worldwide acceptance. The cards come directly out of you because purchase and ATM
withdrawals are listed on your monthly statement, you can transact Debit cards are typically used
as substitutes for cash and cheques to pay for everyday.
Recently Citi Bank has issued a debit card. Many bank including SBI, Indian Banks etc.
have issued ATM cards through which 24 hours banking can be done at specified branches. The
ATM will allow you to withdraw at specified branches through debit to your savings or current
accounts, by use of the Automatic Teller Machines Here electronically your card is identified by
code number and your account is debited and money is handled over to you. Debit card is most
advanced card then ATM card in that it can be issued specified retail or departmental stores also
in addition to specified bank branches. It can be used to make payments by use of debit card
which automatically debits your account in the specified bank. Have your drawl is on your own
assets or money whereas in the credit card it provides a borrowing limit against which you can
draw and pay interest and other charges on the use of this facility to withdraw up to a limit. If
you have own assets or a share portion with the bank, you can have an overdraft account them
which means you can have a overdraft account higher them which means that you can use your
own money rather than banks money through the debit cards.

RBI's Directive on Debit Card

In November 1999, the RBI has put additional restrictions on the issue of debit cards by
banks, The RBIs has barred banks from trying up with non-bank entities and to use cards to
withdraw cash/make deposits from points to sale. It has also imposed existing reserve
requirement to the acceptance or creation of deposits through the route of debit/smart cards.
Banks have to get their brands approval for issue these cards and have to advise the RBI about
the details of the operations, the term, and conditions of the Debit/Smart Card Scheme as
submitted to their board and the latter's approval.

Electronic Card
The master card issued by Citibank is being converted into electronic cards. Through an
electronic tape, it records all transactions done through it and can be used only in places and
electronic branches where electronic scan and identification is possible. The plastic money
leaders, Master Card have launched an electronic card, which is claimed to be the first of its kind
in India. The waiting time of customers is reduced by this. The card can be accepted at points of
ale with electronic authorization terminals. The electronic programme offers Indian consumers
the flexibility, designed to work at all points of sale with the facility and gives added
convenience of a new payment product and financial facility for easy transactions.

Some Major points for operating debit cards

1. Debit Card can be used at any merchant location displaying the Visa or Master Card
displaying the Visa/Plus or Master Card/Cirrus logo. Besides that, one can always use it
as a normal ATM Card.
2. All customers need to do is present your card to the merchant who will swipe it through
the elect the amount of your purchase. Cardholders only need to sign the transaction slip.
Your account will be debited for the amount of your purchase. At merchant location that
have a pin pad, Card Holder may have transaction by entering his pin.
3. Debit Card can be used to access your Account from over 5,000 shops, department and
restaurants and over 235 ATMs in India as far as HDFC Bank. You can also use I
Electron merchant locations and equally strong Master Card outlets.
4. There aren't many Debit Cards in India as of now. The HDFC International Debit Card
charge around Rs. 250/-. This charge is waived off on one additional card taken on your
account involved on cash withdrawals and balance queries. Normally, the cash
withdrawal charges a meager charge of Rs. 10/- for balance.
5. If customer already have a saving or current account, he can get very easily get debit card
by just filling one form and give it card company. The card company then couriers the
card across to customer in around a week's time otherwise firstly you will have to open
an account first and request for the debit card to be issued to.
6. Yes, the debit card does have a daily limit which could be somewhere around Rs. 15,000
at merchant locations. This again is subject to the balance available in your account.

Debit Cards Vs. Credit Cards

The spending power depends on the drawing capacity, which in the case of Debit Card is
your own assets with the bank. But in the case of credit card, it allows a borrowing power on the
bank, for which you have to pay some changes or fees. Both credit cards and debit cards
complement each other and are precursors to the electron card which may be the gold card,
which consolidates all your cash accounts in various branches of a bank, connected though the
Bank Internet and allow you to manage your payments most economically in tune with your
receipts and promotes efficient with the bank upto your credit worthiness. If you are averse to be
a borrower, Debit card has an advantage to you. Here there is no risk of overspending as you can
spend what you have. In the case of credit card borrowing in possible and you pay interest on the
overdrawn amount. Debit card does not involve any interest payment or cost to the holder. If you
carry the Debit Card, then there is no need for carrying cash or even travelers cheques. Debit
card is as good as money in the accounts with your bank. Credit card has the additional
advantage of your overdrawing if necessary; payments are made by the bank to the extent of
your purchases and if they exceed your limit, you pay interest on the excess amount.
 Key is opening up of the Treasury
Credit cards are the key to the opening of Bank accounts for daily payments by the card
holders. It enables the cardholders to have overdraft facility ranging from Rs. 2000 to Rs. 10,000
depending upon the credit worthiness of the party. Credit card is a substitute for cash, which can
be used by selected customers of banks issuing the cards for their use for payment for goods and
services. Many company executives, businessmen and high and middle-income individuals
found to be eligible member customers of banks for issue of these cards.
These plastic cards will have the photo identity and his signature embossed on the card.
It will also have the Issuing Bank's name and validity period of the card. The bank issuing the
credit card knows the customer well and his credit worthiness. The eligibility for getting the
credit card from the issuing bank depends on the following factors:
1. He should have a saving or current Account with the bank.
2. His annual or monthly incomes are regularly received and credited to his bank account.
3. His assets and liabilities are known and reported to the Bank
4. He is considered credit worthy upto a limit depending on his income, assets and
expenditure.
The eligible member will be asked to fill in an application form giving the details of
Account Number, name and address, income, wealth and status and an evidencing statement of
his income/wealth, etc.

Arrangement with Banker

The customer provides the details of his assets, expenditure, salary income and other
income, his dependents and his estimated expenditure and required overdraft facility. The bank
grants credit card subject to some rules and guidelines to the customer. He has to keep his drawl
upto the limit and pay interest as stipulated rate and clear the overdraft within 30-45 days, along
with interest and charges, if any. The cardholder is also given a chequebook, which he can use
for payment to establishment, which jointed this scheme and accept credit cards for any
payments. The signature on the credit card can be verified with that on the cheque and honoured
by proper recording of the credit card number on the back of the cheque. These cheques can be
issued upto the limits of overdrafts given by the bank. The bank gives monthly statements and
records, the extent of the utilization of overdraft by him, and due date for repayment of overdraft
with interest etc. The card invariably contains the details of name of the Account holder/card
holder, his photo, his specimen signature and the signature of the sanctioning Authority of the
bank. The extent of overdraft limit, interest rate and other terms are made known to the card
holder at the time of issue and the use of Credit or Debit card is subject to these terms and
conditions. There are different types of cards with different features. Some are for domestic use
and other for both domestic and international use. The terms of issue also vary from bank to
bank. These cards are called Gold Card, Master Card, Citi Card, etc., depending upon the issuing
bank. Some Credit cards are more popular like those of Grind lays, Citi Bank and American
Express. Among the non-bank intuitions, which issue credit cards mention, may be made of the
Thomas Cook, Morbank, etc,
3.3 BENEFITS OF CREDIT CARDS
How they benefits the banks
1. This will increase the credit granted by the Bank and its reputation with the public.
2. It will lead to growth of its interest income and total return to funds
 3. The business establishments, which accept these cards, also give some incentive or
commission to the bank, by which the bank gains.

How they benefits the Card Holder

1. They give credit upto a limit sanctioned just through the of his card and his signature on it.
2. They get some period of 30 to 40 days to clear the outstanding overdrafts.
3. They can avoid carrying cash and the risk of its loss.
4. They earn a status symbol to the holder.

Banks have to bear some risk similar to unsecured debt. They may have a problem of non-
payment or delayed payment of overdraft amount. The bank also suffers the risk of uncertainty
of payment and the time of payment. When banks found that they have surplus funds and the
industry off take has as in 1980s they resort the consumer finance. It was in much period that
credits cards have become a venue for banks to lend to individuals. Auto finance to business and
household individuals is another areas, which hat grown in 1990s, similar to credit cards in
1980s.
The number of credit card holders and the participating business establishments, hotels
etc. have also increased enormously over years to run into some million. Some Indian banks like
Andhra Bank and Canara bank have entered into agreement credit cards, which are particularly
useful to businessmen, export traders and foreign trade agencies, visiting many foreign countries.

3.4 AGRICULTURE CREDIT CARDS

Some top ranking agriculturists and cultivators were given credit cards by 21 public
sector banks. These cards were given to them after they produced documentary evidence of land
owned by them, cultivated by them and their titles and, other details. These cards are meant to
facilitate quicker and easier flow of credit to agricultural sector which is priority sector, as per
the guidelines of the Govt. The Agriculture credit cards business is encouraged by the RBI and
the Government. A pass book and credit card are provided to the selected agriculturists whose
credentials are well established. Pass book contains all the details of the holding of the
agriculturist, the annual output, income and other sources of income, if any, etc. Such pass book
evidencing the ownership of land, the extent of ownership, expected crop income and other
incomes will help the bank to decide on the extent of the credit that can be given to them.
These schemes of credit cards are not very popular with middle and low-income groups.
Income tax difficulties and high interest rates charged by banks and some rigorous terms as to
the repayment of overdraft facility have led to leas popularity of these credit cards in recent
years. But credit cards as a source of extending credit to individuals and households has come to
stay and credit cards should be counted as part of the total bank credit and money supply in the
economy.

3.5 VISA AND MASTER CARD

In the credit card World, there are market leaders namely Visa and Master Card issuers,
Master Card credit card base was larger at 1.97 Million as at end Dec. 1999, as a against Visa
Card Credit Card base of 1.91 million. But in 1999, Visa's base grew by 68% while the Master
Card's base was up by only 10%.
Master Card was the first payment services provider to bring debit card to India. During
1999, however Visa International has surpassed the performance of Master Card. People are
spending more on Visa card, as the table below shows. Volumes have risen by 57% to $616
million in 1999 in the case of Visa Card. While the same rose by 5% to $481 million in the case
of Master Card. The average card spend was higher as $392 in the case of Visa Card, while it
was only $256 in the case of Master Card, the market share of Visa (Visa international) was 58%
in 1999, which is expected to go up 66% in the next two years. There is neck-to-neck
competition between Visa International and Master Card issuers in their Indian operations.

The table below presents the supporting data on these two market leaders in the Credit
Card Business in India.

Who is the Master

1998 1999 Growth(%)
Numbers Visa 1.13m 1.91m 68
Master Card 1.79m 1.97m 10
Volumes Visa $392m $616m 57
Master Card $458m $481m 5
Transactions Visa 10.94m 15.80m 44
Master Card 13.33m 13.81m 4
Average Visa $390 $392 -
Card Spend Master Card $274 $256 -

3.6 SMART CARD

The smart cards are a relative new comer in the retail payment system. It is an e-money
with a huge potential usage. It has an integrated circuit with a microprocessor chip, embedded in
it, which gives it wide capacity in performing many calculations, more fast and accurately than
the accountant. It does maintain records, statements and acts as an electronic purse, storing e-
money. It is usable for drawing cash and making payments with the automatic facility of keeping
accounts of balances of the party.
During a loading operation, the deposit account of cardholder is debited and credit is
given to a centralized card account. In Europe, banks generally issue these cards but in the
U.S.A., non-banks also issue these cards. The issuer must have a strong and efficient supervisor
system to reduce the systemic risks. It is not yet introduced widely but is in an experimental
stage in India; SBI and Canada Bank are involved in a project in Mumbai conducted by IIT at
Powai. The project has used the Smart Card mode of receipts and payments for IIT with a
centralized account keeping system. To start with, the efficacy of this system was tested without
imposing any service charges or membership fees and given incentives to potentials users to give
confidence to the participants of the financial system about its efficacy and secrecy after
incorporating necessary security features in the system.

3.7 RBI AND CREDIT CARD BUSINESS

The RBI has announced in June 1998 that banks are allowed to undertake credit card
business either independently or in tie-up arrangement with other card issuing banks without
prior approval of the RBI. However, banks desirous of setting up a separate subsidiary for credit
card business will require prior approval of the RBI. In October 1998, SBI has set up a
subsidiary for carrying on its credit card business under the name of SBI Card and Payment
Services Pvt. Ltd. (SBICPS), jointly with the GE capital corporation of U.S.A. with a paid up
 capital of Rs. 100crores of which the share of SBI is 60%. The State Bank of India launched its
credit card with Visa International in 1999 and has a base of 3-4lakh cards by middle of 2000.

3.8 TIPS FOR CARD HOLDERS

For Credit Card holder some of points should taken in the mind for safe operation of card
and to avoid the misuse of Credit Card. Be careful while imparting information about the himself
and make sure of secrecy of your confidential numbers and other information. Some of the other
points must be taken care while operating credit cards are:

- Report lost or stolen cards immediately

- Never allow anyone else to use your card
- Ensure that your card is signed on the signature panel as soon as you receive it
- Never write down your PIN-memorize it
- Always check sales vouchers/charge slips including purchase amount when you sign the
vouchers and ATM receipts.
- Never give your credit card number over the phone or on the Net, unless you are dealing
company and gave initiated the call you.
- Always check your billing statement, especially after a trip Check the amounts of your
slips, specifically look for transactions which are not yours.
- Make a record of your credit card PIN numbers and telephone numbers for reporting lost.
- Know who has access to your cards. If your credit card is borrowed by a family member
(with or without your knowledge, you may be responsible for their purchase cash
withdrawal.

WHEN USING AN ATM

- After completing an ATM on debit transaction remember to take your card.
- Never disclose your PIN to anyone, No one from cart company, the police or a merchant
PIN. You are the only person who should know it.
- When traveling it is advisable that you only take one ATM card and memorize the PIN,
Prevent from damage by keeping it in a safe place-doesn't allow it in to bend or be
scratched.

READ BETWEEN THE LIKES

Most of the literature that flood your mailbox head straight into the dustbin. For instance
liability before reporting the loss for the cardholder. Often, what is the liability a before reporting
the liability is unlimited which means you are responsible for all the purchase stolen card till the
time it is reported. One important thing which is strange but true - you can spend several time
what you are actually entitled to spend. Sometimes renewal fees just billed in your statement. So
it is better to cross check the charge slip. Then the card companies give a mild notice about an
upgrade of class of card gold and they take it as a yes if you don't any No.

BE DISCREET
One often runs into people offering a free holiday package or doing a survey at a petrol
pumps to fill out forms that ask for details about your work, office, home, car, the kind of cards
you have and your date of birth. The card expiry date and your date of birth are the key
information and Read about Do's and don't while using a card.

DON'T AN OSTRICH
Don't trust the future to cure today's problems. Card users are often wishful spenders and
they will have the money to pay up by the time the bill comes. They don't look at their over all
that can be scary. Another common trap is to focus on monthly payments rather than the overall
debt. An amount not look that scray, but that's how a beginning is made, if only credit card
junkies saw the bill stop short of charging frivolous purchases.
If a person looking for a credit card of a particular bank, he should see the highlight and
offering of various additional services in various cards. Some of the card are as follows on the
basis of different cards:

Card Name Brand Type of Card

Allahabad Bank India Card Master Card International Card
American express gold Amex Card International Card
American express green Amex Card International Card
Bank of India Gold Navy Visa Card Domestic Card
Bank of India Standard Navy Visa Card Domestic Card
Bank of India Visa Gold Visa Card Domestic Card
Bank of Baroda Bharat Premium Visa Card Domestic Card
Bank of Baroda Exclusive Master Card Domestic Card
Bank of Baroda Global Visa Card International Card
Bank of Baroda Gold Visa Card Domestic Card
Bank of Baroda Own BOB Card Domestic Card
Citibank NA CRY Visa Card Domestic Card
Citibank NA Gold/Preferred Master Card International Card
Citibank NA Indian Oil Master Card Domestic Card
Citibank NA Jet Airways Master Card International Card
Citibank NA MTV Master Card International Card
Citibank NA Maruti Visa Card International Card
Citibank NA Silver/Classic Master Card International Card
Citibank NA Silver/Classic Visa Card International Card
Citibank NA Times Master Card International Card
Citibank NA WWF Visa Card Domestic Card
Citibank NA Women Visa Card Domestic Card
Citibank NA Card Visa Card International Card
Corporation Bank Canvisa Visa Card Domestic Card
HDFC Bank Silver Visa Card International Card
ICICI Bank HPCL Visa Card International Card
ICICI Bank Solid Gold Visa Card International Card
ICICI Bank Sterling Silver Visa Card International Card
ICICI Bank True Blue Visa Card Domestic Card
SBI Cards Classic Visa Card Domestic Card
SBI Cards Doctors Visa Card International Card
 SBI Cards Gold Visa Card International Card
SBI Cards International Visa Card International Card
SBI Card Mumbai Card Visa Card International Card
Standard Chartered Bank Classic Master Card International Card
Standard Chartered Bank Classic Visa Card International Card
Standard Chartered Bank Classic Visa Card International Card
Standard Chartered Bank Diva Visa Card International Card
Standard Chartered Bank Executive Master Card International Card
Standard Chartered Bank Executive Visa Card International Card
Standard Chartered Bank Gold Master Card International Card
Standard Chartered Bank Gold Visa Card International Card
Standard Chartered Bank Sapnay Master Card International Card
Standard Chartered Grindlays Classic Visa Card International Card
Standard Chartered Grindlays Classic Master Card International Card
Standard Chartered Grindlays Star TV Master Card International Card
Tata Finance Gold Amex Card International Card
Thomas Cook Classic Visa Card International Card
Tomas Cook Gold Visa Card International Card
UTI Bank Silver Master Card International Card

3.9 HOW TO SELECT THE RIGHT CREDIT CARD?

Decided to go in for a credit card. But not sure how to select one? The proliferation of
card simply clutter the process of choosing, You could, of course, choose to go with whatever
your friend recommends, but if you at least want a sense of some of the question you could
check to get a better deal, read on. Throw up the following questions to decide on the right Credit
Card:
1. How much is the joining fee and the annual fee?
Generally, a card with a higher annual fee enjoys more benefits like higher credit limit,
high cover, accessibility to airport lounges, travel discounts etc. Or at least this used to be the
competition between the card issuing banks, players are ready to waive joining fees and also fees
for anyone. Grab these offers, or negotiate this for yourself.

2. How much is the Add on Card fee?

If you are interested in buying add-on cards for your children, spouse or friend, ask for the
payment you will be setting the bills on the add-on card (as far as the credit card concerned).

3. What is the interest rate ?

This is actually a question that you should be asking fairly soon in the discussion.
Remember, while the upfront one off fees are bread. and butter for the credit card company, the
sort who forgets to pay on times, or likes to live it up and live off credit, the interest rate were
importance. Most credit card companies charge between 2% to 3% per month. That's where they
make their gravy, and that's where you pay!.
It is always advisable to pay off the entire amount on due dates, or, if you have a large
bank companies that provide the transfer balance facility, the balance transfer rate is lower for a
months and then the normal rates apply, but again this is a temporary solution to a chronic.
4. What is the reach ?
Note an important question, most outlet in India accepts both the Master Card and the
Visa. One thing you could do is to check out how far the automated teller machine is from your
house or work place the city/country/world).

5. Is it a global card?
Now this could be useful to you if you are an overseas traveller. A global card can be
used in foreign currency just like you use a credit card to pay in rupees. Nowadays, a Global card
has same cost as for a similar domestic one. It is better to have a global card.

6. How useful are branded or affinity cards?

A partnership between a card issuer and the non-profit, social or lifestyle association is
what card. This is for providing financial rewards to the group or association. E.g. Citibank
Women Card. Citibank WWF Visa Card donates a percentage of the transaction value made
through fund for its environmental conservation activities. A subscription to such cards helps
ease to provides no monetary value.
A partnership, between a bank card issuer and a commercial partner result in a co-
branded cardholder to lots of freebies, prizes, co-branded products. The logic is that if you were
loyal to a particular brand, it would make co-branded cards.

7. What's the lost card Hability?

Most card issuer mention in the brochures that lost card liability is Rs. 1000. Be careful,
and report to the Bank. The liability is actually unlimited before reporting. Avoid banks that
make you liable for card misuse for a single minute after reporting it.

8. Are there any freebies?

Citibank gives a Pond's gift hamper free on subscription to its Citibank Women Card.
Person for air, road or otherwise is packaged along with the subscription. Also Baggage cover.
Credit shield is bundled free of cost along with the card. If you feel one these parameters are
higher cost. important, and then settle for the one that gives a

9. Is immediate cash withdrawal possible?

Check out if the bank has any ATMs near your house or workplace. This surely helps in
time. The cost component for a cash withdrawal could be classified as follows: Service fee
(transact you pull out money), and interest rate for the period for which you have used the money
- you are going to withdraw cash frequently, better watch out for this cost.

10. How long is the free credit period?

The days of credit one gets depends on the statement date and the date of transaction. On
assume you'd get around 20 days of free credit. However, if you buy just after the statement
getting up to 50 days of credit. Look for cards that give you the highest free credit period.

11. Is a Help Hue available?

A-24 hour help line service from the card company helps the cardholders during the non
balance of theft, checking credit limit and other enquiries can be made by the card holder end,
like everything else in life, the card you want is really up to you what matters the most the
freebees. International reach or a combination of parameters. Use our card category on out the
names of the cards, or choose by bank name and see the cards they offer. On look out the names
of the cards, or choose by bank name and see the cards they offer. Off look lowest interest rate.
Of the lowest charges on cash withdrawal (believe me, if gets to be as one goes along). Go to our
shortlist card section, and search for cards based on any criteria hunting, and stay careful-you
may like to use our section on how to use the card carefully or avoid of its misuse by someone
else.

COMPARISON OF VARIOUS CREDIT CARDS

This section is very useful if you want to specifically compare credit or compare charge
for their features. It assumes that you have arrived at the names of the credit cards/charge cards
that you want.
Compare features across cards here, once you've decided which ones you want to check:

Card Issuers Brand Card Type Acceptance

Allahabad Bank India Card Master International
American Express Bank Limited Gold Amex International
American Express Bank Limited Green Amex International
Bank of India Gold Navy Visa Domestic
Bank of India Standard Navy Visa Domestic
Bank of India Visa Gold Visa Domestic
Bank of Baroda Bharat Premium Visa Domestic
Bank of Baroda Own Bob Domestic
Bank of Baroda Exclusive Master Domestic
Bank of Baroda Global Visa International
Bank of Baroda Gold Visa Domestic
Citibank NA CRY Visa Domestic
Citibank NA Ecard Master International
Citibank NA Gold/Preferred Master International
Citibank NA Gold/Preferred Visa Domestic
Citibank NA Indian Oil Master International
Citibank NA Jet Airways Master International
Citibank NA Maruti Visa International
Citibank NA MTV Master International
Citibank NA Silver/classic Master International
Citibank NA Silver/Classic Visa International
Citibank NA Times Master International
Citibank NA Women Visa Domestic
Citibank NA WFF Visa Domestic
Corporation Bank Canvisa Visa Domestic
HDFC Bank Limited Silver Visa International
ICICI Bank HPCL Visa International
ICICI Bank Solid Gold Visa International
ICICI Bank Sterling Silver Visa International
 ICICI Bank True Blue Visa Domestic
SBI Card and Payment Services Pvt. Classic Visa Domestic
Ltd.
SBI Card and Payment Services Pvt. Doctor Visa International
Ltd.
SBI Card and Payment Services Pvt. Gold Visa International
Ltd.
SBI Card and Payment Services Pvt. International Visa International
Ltd.
Standard Chartered Grindlays Bank Classic Visa International
Standard Chartered Bank Classic Master International
Standard Chartered Bank Classic Visa International
Standard Chartered Bank Cricket Visa International
Standard Chartered Bank Diva Visa International
Standard Chartered Bank Executive Master International
Standard Chartered Bank Executive Visa International
Standard Chartered Grindlays Bank Gold Master International
Standard Chartered Bank Gold Master International
Standard Chartered Bank Gold Visa International
Standard Chartered Bank Sapnay Master International
Standard Chartered Grindlays Bank Start TV Master International
Tata Finance Limited Gold Amex International
Tata Finance Limited Green Amex International
Thomas Cook India Classic Visa International
Thomas Cook India Gold Visa International
U.T.I Bank Silver Master International
Select charge cards for comparing
Card Issues Brand Cards type Acceptance
American Express Bank Limited Gold Amex International
American Express Bank Limited Green Amex International
Bank of India India Card Master Domestic
Bank of India Taj Premium Master Domestic
Canara Bank Cancard Master Domestic
Canara Bank Cancard Visa Domestic
Citibank NA Diner’s Club Diner’s Domestic
UNION BANK OF INDIA India card Master Domestic

3.10 FAQS ABOUT CREDIT CARD

Generally asked questions by individual about the Credit Card business in India and their
answers for the benefits of its Prospective customers of Credit cards,

1. What is a credit, charge card or debit card? How does one from the other?
A credit card, as the name suggests, gives you credit-obviously for a charge. The days of
range from 20-50 days depending on the date when one made the purchase. You can choose dues
at one go, or stagger them after paying the minimum amount due every month. Beside member
to plethora of benefits like travel discounts, discount on retail loans.
A charge card is pretty similar to a credit card with one major difference. With a charge
card entire dues within the credit period cannot carry over any balances like a credit card. A debit
card is basically like an ATM card on the move. When you make any purchases using a debit
card, it is instantaneously debited to the purchase amount.

2. How many types of cards are there in India?

In India there are basically three types of cards namely Visa, Master Card and Amex. Amex
is relatively new player in India as it issues its cards only through American Express.

3. What is the difference between a Gold, Silver and a Executive Card?

Gold, Silver and Classic/Executive are the terms used by issuing banks to differentiate
between services offered on each. On the premium segment is the gold card which gives higher
more privileges and discounts. Here an element of prestige does. Form an. important factor in
such cards. But it does come at a cost as these cards have the highest fees and service charges
with them.

4. What are the advantages of using a credit card?

Cash is always riskier to carry, besides the limit to the amount you can carry in your
wallet credit cards come handy. Not only can you spend up to your given credit limit without
having carrying cash, nowadays you can also issue cheques against your card limit and order
draft credit cards entitle you to other benefit like discount at shops, restaurants and airline ticket
cards also offer personal accident cover, lost baggage cover etc. You get interest free more days
A global card assures you of spending in any currency and setting your dues in your. But for a
shop-a-holic, a card could be akin to a drug. The hard fact is that a credit card can payment, not
waive it! The charges for carrying over the outstanding balance amount over credit period can
touch around 36% on an annulized basis.

5. What are the various types of insurance cover available credit cards?
A useful features, which is now standing for credit cards is an insurance cover, both
person and articles purchased on the credit card. The amount and the type of insurance cover is
determined by the type of credit card owned (whether gold, silver or executive). Gold cards
provide highest insurance cover for its members. Among the types of insurance are: Personal
accident insurance - this covers air accidents, etc. The amount of insured differs across the
categories and again varies from player to player to cover insurance for spouse/supplementary
card holder as well. Baggage Cover - this provides cover against the loss of one's baggage while
travelling. The standard on every credit card and frequent travelers may find this feature useful.

6. What is the procedure for owning a credit card?

Get in touch with an issuing bank like Standard Chartered, Citibank, or Bank of Baroda
and fill in application form. Submit the application from along with documents that basically
verify your place of stay. If the bank is satisfied with your credit worthiness, the bank will send
you credit card.

7. What is the minimum salary required for taking a credit card?

 Minimum salary criteria differs on the type of card you are applying for and is always
higher. But one could say that you need a salary of at least Rs. 70,000 per annum for an ordinary,
1,80,000 per annum for a gold card.

8. What are reward points?

To encourage frequent usages of cards, the card companies introduced the concept of
reward. Citibank cardholders, every 100 rupees worth of purchases made through the card, earns
the point. These points could be redeemed for gifts, select product purchases and even for pay
fees. So every point would be equivalent to one These rupee. For Standard Chartered cardholder
rupees worth of purchase made through the card makes one reward point.

9. How much does it cost to own a credit card?

The basis cost involved in applying for a card companies, the joining fee the annual fee,
fees (a one time payment), vary between Rs. 100 and Rs. 1,000. The annual fee is levied a
membership on the card. For example, Standard Chartered Classic charges Rs. 800. The lower
annual fees are around Rs. 400 while the higher ones are around Rs. 2,000. These are in advance
and the issuing banks automatically bill these to your credit card in the first statement, and
thereafter, each year.

10. What needs to be done in the event of losing the credit card?
Inform the bank immediately in the event of losing your credit card. The bank then
immediately takes precautions to prevent any fraud. But you will have to pay for all the
purchases fraudulently made on your card, the loss of your card. Normally, after reporting the
loss, your liability is restricted to Rs. 1,000 you will be expected to pay for the issue of a
replacement card.

11. Are there advantages in paying through a credit card even if I have cash handy?
With a credit card, you can delay payment of the bill by up to 50 days. Also, most card
issue discount on the next year's annual fees you make purchases over a certain specified sum.

12. What are the eligibility norms to get a credit card?

Any credit card issuer looks for a minimum income level, which serves as the starting
point. It also looks for a regular and steady source of income, as the crux of the decision.

13. What is the life insurance feature providing by credit cards?

Every credit card holder is insured for a certain sum of money, which is paid upon the
date. The insurance cover varies between bank to bank and depends upon the type of card. Each
member of ANZ Grindlays Gold is insured for a sum of Rs. 500,000.

14. What kind of insurance is given for a spouse/supplementary card holder?

Card issuing companies provide an insurance cover for the holder of a supplementary or a
one's spouse. The amount and the type of insurance cover provided is largely determined by
credit card owned (whether gold, silver or executive). Gold card typically carry highest for its
members. The insurance cover can very between Ra 50,000 to Rs. 500,000 depending upon bank
and the type of card owned. This feature however is not standard on all credit cards.
15. What is baggage cover?
The baggage cover provides the safety of insurance in the even of losing one's baggage
useful for frequent travelers. The cover is a normal of gold cards and International.

16. What does the purchase protection feature of credit cards mean?
A member of the card if provided this card automatic insured against all items bought.
The insurance is for damage of the product purchased, its loss due to fire or theft up to money.

17. What is a credit shield?

Sometimes due to death of the cardholder, the onus of payment of the card bills falls on
his parents. The credit shield feature provides for a waiver of payment of outstanding on the limit
of such cardholder. (This could be around Rs. 25,000 worth of cover).

18. What is a supplementary or an add-on card?

The supplementary card/add-on card fee is the fee payable per additional card that a member
for his close family member likes father, brother, sister or spouse. Any card under this head,
which varies between Rs. 150 to Rs. 800. One thing noteworthy in supplementary card is remain
the same. To be precise, your credit limit gets divided between the main card and an add-on card
does not get additional credit limit.

19. What in the entrance fee for a credit card?

The entrance fee or the joining fee is payable on approval of your application form.
Again depending upon the issuing bank and the type requested and is somewhere between 400.
More often than not, this fee is waived.

20. When do I have to pay the annual fee?

After approval of your application form, the card company bills the annual fees into the first.
The annual fee is not paid for in cash and is payable in advance.

21. Is it advisable to use the card advance facility?

Cash advance facility should be used only when absolutely necessary. The interest rate is
around 36%. Cash advance fees are chargeable on a daily basis. That's not all, besides this
company charges in the range of 2.5% per transaction as a transaction fee.

22. How much rink I am exposed in the event of losing the credit card?
You are protected from setting any expenses made through your card the moment you inform
the theft. But you will have to pay for all the purchases fraudulently before you report the loss of
your card. Besides this, you will be expected to pay for the issue of replacement card. Normally,
after reporting the loss, your liability is restricted to Rs. 1,000. So in the event that credit card is
stolen, inform the bank immediately. The bank then deactivates your credit.

23. How are the fees levied when I delay my repayments?

It is prudent to pay off at least the minimum amount due on outstandings every month.
This payment fees are very high around 15% of minimum payment due or 2.5% of the total
outstanding. Late payment fees are chargeable after the stipulated period.
24. What is a Global Card?
A Global card enables you to use your credit card even when you are overseas. You can have
other foreign currency and still settle the dues in your local currency. Point to note here is that
the limit will than be based on the basic travel quota (BTQ) entitlement.

25. What are the advantages of owning an international credit card?

A Global/International card enables you to use credit card when you are oversea,
withdraw cash up to US$ 500 against the card, you can spend in dollars or any other foreign
currency, settle the dues in your local currency. Point to note here is that your credit limit will be
basic travel quota (BTQ) entitlement.

26. Can a bank issue a single credit card usable throughout the world?
Yes, a bank can issue a single credit card which you can use throughout the world - the
global. The limits of the money that you can spend in foreign currency is determined by the RBI
norms.

27. Should I pay in foreign exchange for using the card in India?
No, the entire rupee related payments made through the credit card has to be settled in rupee.

28. Can I use my card to buy foreign exchange for my foreign travel?
Yes. This could be had from an authorized dealer or a money changer. This can be used
for business travel expenses or your basic travel quota.

29. Can I obtain foreign currency notes against my card?

Yes, you can obtain notes up to US$ 500 or its equivalent when going abroad.

30. Can I retain the warpeat forex on my return back to India?

Yes but up to a certain amount. It is permissible to retain foreign currency notes up to US$
2,000 and any currency notes exceeding this amount has be surrendered to an AD (Authorized
Deals) on your return to India.

31. Can the international credit card be used to make dollar payments to Nepal and
Bhutan?
One has to make payment in these countries in rupees only. Forex liability should not be in
credit card in these countries.

32. What is PIN?

PIN or the Personal Identification Number is unique to every card and is a combination of
normally a 16-digit number with the first 8 digits reserving information about the card issuer.
The next 8 stores customer information like the category for the member (whether is a business,
individual or NRI). The PIN serves as a key, which allows you to avail certain services like from
automatic teller machines. This number is very important and must be stored carefully. Issuing
banks instruct their clients to write the PIN in very safe place or better still, to sum digits.

33. What happens if I lose my PIN?

 If you lose the PIN get in touch with the bank as soon as possible. The bank will replace you
and issue a new PIN. This replacement process comes at a cost and gets billed in your next
statement.

4. SUMMARY
During the past decade, plastic cards have become increasingly popular in India. The
reason for their popularity has now shifted from being a status symbol to offering convenience
and security with worldwide acceptance. Of late, banks have been permitted into the credit card
business without even the prior approval of the RBI. Credit Cards provide convenience and
safety to the buying process. Besides, they enable an individual to purchase certain
products/services without paying immediately. The buyer needs only to present the credit card at
the cash counter and to sign the bill. A debit card is a plastic card similar to the credit card whose
the expenditure amount is automatically debited to the corresponding bank account. The use of
debit cards is fraught with danger especially to the users who fear that their bank balance may be
knocked off by card thieves. Any fraud committed with respect to the misuse of debit cards
entails complete draining of the funds of the customer.

5. SUGGESTED READINGS
1. Data Base Pvt. Ltd., Electronic data base company based on internet.
2. Block, Earnest, Inside Investment Banking, Dow Jones-Irwin Illinois, 1986.
3. Francis, John Clark, Manageme it of investments, Second edition McGraw Hill International.
4. Government of India, Report of the Banking Commission 1999, 460-463.
5. Machiraju H.R., Merchant Banking, Wiley, Nauyng Publication New Delhi.
6. Ramchandra Rao B., Merchant Banking, Eastern Economist, February, 1974, pp. 165-168.
7. Securities and Exchange Board of India, Guidelines for Merchant Bankers, 7-11-1990.
8. Warren, Law, Investment banking, in Altman, Edward I, editor, handbook of financial
markets and institution, sixth edition, New York, Wiley.

6. SELF ASSESSMENT QUESTIONS

1. What is a credit card, charge card or debit card? How does one different from the other?
2. What is the difference between a Gold, Silver and a Executive Card?
3. What are the major advantages of using Credit Cards?
4. What is the procedure for owning a credit card?
5. How the customer can protect his credit card from misuse?
6. How many types of cards are available in the market?
7. What are the advantages of owning an international credit card?
8. What is PIN? What happens if I lost my PIN?
9. Can I obtain foreign currency notes against my card?
 Book Building: Concept, Mechanism & Significance

Structure:
1. Introduction
2. Objective
3. Meaning of Book Building
4. Book Building Process
5. Regulatory Framework for Book Building
75% Book Building
100% Book Building

6. Price Discovery through Book Building: An Example

7. Summary
8. Suggested Readings/Reference Material
9. Self Assessment Questions(SAQ)

1. Introduction
Globalization & liberalization of the Indian economy made it necessary to bring the
Indian capital markets at par with the international standards. For this, it was necessary to being
some reforms in the Indian capital market. One step towards this direction was the Introduction
of the concept of book building for pricing of the new issues. The method helps to make a
correct evaluation of a company's potential and the price of its shares. It helps in avoiding
overpricing and under-pricing of the new issues. Book building was introduced by SEBI in 1995
for optimium price discovery of the corporate securities on the recommendations of the
committee chaired by Y. H. Malegam.

2. Objective of the lesson

The aim of this chapter is to acquaint the reader with the concept & process of book building. It
also discusses the regulatory framework of book building & the price discovery mechanism.

3. Meaning of Book Building

According to SEBI guidelines, 1995, book building is "a process undertaken by which a
demand for the securities proposed to be issued by a body corporate is elicited and buil up and
the price for such securities is assessed for the determination of the quantum of such securities to
be issued by means of a notice, circular, advertisement, document information memoranda or
offer document."

Book building refers to the process of determining the fair price of the issue by inviting bids
from the investors. The investor is informed of the price band and he then bids a price he thinks
appropriate. Investor quotes his bid for the price & quantity that de would like to bid at.

The issue is determined on the basis of the bids received after the bid closing date.
Book building helps in pricing the issue on the basis of the price at which investors are willing to
buy. It avoids underpricing and overpricing of the issues.

An issuer company proposing to issue capital through book building shall comply with the
guidelines prescribed by SEBI.

The principal intermediaries involved in a book building process are:

 The company or the issuer
 Book Running Lead Manager (BRLM)
 Syndicate Members

The company is the issuer company who wants to raise capital from the market. Every issuer
company has to appoint a merchant banker as the lead manager known a (BRLM) who manages
the entire issue. The BRLM forms a syndicate of members who assists him in the issue. The
syndicate consists of intermediaries registered with SEBI and eligible to act as underwriters. The
syndicate members are mainly appointed to collect the bid forms in the book built issue.

A company can raise funds from the primary market through different sources: Initial public
offering known as IPO, Private placement & Right issues. Out of these the most common
method of raising funds is through IPO's. Under IPO the company through prospectus, invites
the public to subscribe to its securities. There are two ways to price the new issue. One is fixed
price method and other is the method of book building.

Pricing of IPO's

Fixed Price Book Building

Method Method

Under the fixed price method, the company determines the price and then offers the securities to
the public at this pre determined price. This could lead to the issue being over priced or under
priced. Under Book building, the price is determined on the basis of the bids received from the
investors.

Book building is an alternative method of determining the price of the securities. The traditional
fixed price method suffered from two defects:

(a) Delays in the IPO process and

(b) Mispricing of issue.

The advantage of book building over fixed price issue is that:

 Majority of the public issues coming through the fixed price method are either under priced or
over-priced. Individual investors (i.e. retail investors), as such, were unable to distinguish good
issues from bad one. Also, the costs of book built issue is much lesser than the fixed price issues.

Through Book Building the company gets to know the demand for its securities and the issuer
company can withdraw from the market if demand for the security does not exist.

In case of Book Building process book demand for the issues is known every day on the basis of
the bids received along with quantity of shares whereas in case of fixed price of public issues, the
demand is known at the close of the issue.

Under book building, a portion of the issue is reserved for institutional and corporate investors.

4. Book Building Process

The steps involves in the process of book building are as follows:

1. For the purpose of book built issue it is obligatory for the issuer company to appoint a merchant
banker as a BRLM (book running lead manager) who is entitled to remuneration for conducting
the Book Building process.

2. The lead manager forms a syndicate of members which assists in the process of book building.

3. Initially, the draft prospectus is prepared which contains all the details about the company
except the price of the issue. But it mentions the price band within which the bids are to be
made to the company. The draft prospectus is then required to be filed with the SEBI. The
prospectus used in book building is known as Red Herring Prospectus. The red herring
prospectus mentions either the price band or the floor price. The cap price cannot be more than
120% of the floor price i.e. the gap between the cap price and floor price cannot be more than
20%.

4. A bid period is fixed by the company within which the bids are invited and the issue is
advertised. The bid period cannot be less than 3 working days and more than 10 working days.
The advertisement announcing the bidding contains the date of the opening of the issue and the
closing date. The issue document contains the name of syndicate members who are entitled to
receive the bids. It also mentions the conditions of accepting the bids and the procedure of
bidding. The bidding centers are electronically connected to maintain transparency and also
eliminate the time lag between making and receiving of the bid. Individual and institutional
investors have to place their bids only through the 'syndicate members'. The bids can be revised
any number of times before the closure of the issue.

5. Underwriter is appointed to underwrite the issues to the extent of "net offer to the public". The
securities available to the public after allotting to promoters are separately identified as "net
offer to the public".
6. The copy of the draft prospectus is circulated among the investors. The interested investors
submit their demand/ bids to the BRLM or the syndicate members or the company. The bids
may be revised any time during the bid period.

7. The BRLM builds a book called the ‘order book’ in which the details of feedback from the
syndicate members about the bid price and the quantity of shares applied at various prices are
entered. The syndicate members must also maintain a record book for orders received from
institutional investors for subscribing to the issue out of the placement portion.

8. On receipts of the above information, the BRIM and the issuer company determine the issue
price. The criteria for determination of price depend on the discretion of the company and the
BRLM. For e.g. it may be the price at which maximum quantity has been demanded or any
other criteria.

9. Since the company has already decided the quantity of funds it wants to raise it finalizes the
number of shares that will be issued at the price determined. The issue price for the placement
portion and offer to the public shall be the same.

10. The order book is closed after the determination of the issue price.

1. After that decision is taken about how the securities will be allocated among the:
(a) placement portion category and
(b) public portion category.
2. Then the Final prospectus which contains the issue price is filed with the registrar of companies
within 2 days of determination of issue price.
3. Two different accounts for collection of application money, one for the private placement
portion and the other for the public subscription should be opened by the issuer company.
4. The placement portion is closed a day before the opening of the public issue through fixed price
method.
5. After that the allotment for the private placement portion shall be made on the 2nd day from the
closure of the issue and the private placement portion is ready to be listed.
6. The allotment and listing of issues under the public portion (i.e. fixed price portion) as per the
existing statutory requirements is made.
7. Finally, the SEBI has the right to inspect such records and books which maintained by the
BRLM and other intermediaries involved in the Book Building process.
 STEPS in BOOK BUILDING

APPOINT BRLM

BRLM forms a SYNDICATE

DRAFT PROSPECTUS FILED with SEBI

CIRCULATION of RED HERRING PROSPECTUS

COLLECTION of BIDS WITH QUANTITY OF SHARES from INVESTORS

MAINTENANCE of ORDER BOOK BY BRLM

DETERMINATION OF ISSUE PRICE.

ALLOCATION OF SECURITIES

ALLOTMENT OF SECURITIES & THEIR LISTING ON STOCK EXCHANGE

5. Regulatory Framework for Book Building

According to the SEBI, a public issue through Book Building route should consist of two
portions: (a) the Book Building portion and (b) the fixed price portion. The fixed price portion is
conducted like normal public issues (conventionally followed earlier) after the book built portion
during which the issue price is fixed after the bid closing date.

Offer to public through Book building process: The process specifies that an issuer company
may make an issue of securities to the public through prospectus in the following manner:

(i) 100% of the net offer to the public through book building process, or
(ii) 75% of the net offer to the public through book building process and 25% of the net offer
to the public at the price determined through book building process.

75% Book Building

The main theme of SEBI guidelines regarding 75% book building are as follows:
Under 75% book building process, the price of 75% of the net offer to the public is
determined through book building process and 25% of the net offer to the public is made at the
price determined through book building process.
 TOTAL PUBLIC ISSUE
(Le.net offer to the public)

BOOKBUILDING FIXED PRICE METHOD

METHOD
(Le.net offer to the public)
(Le.net offer to the
public)
15% of the net offer to the public 15% of the net offer to the public
albertville table for allocation, to albertville table for allocation, to
Non Qualified Institutional Non Qualified Institutional
Dayers. Dayers.

BOOKBUILDING BOOKBUILDING
METHOD METHOD

(Le.net offer to the public) (Le.net offer to the public)

100% Book Building
In this, price of 100% of the net offer to the public is determined through Book Building process

TOTAL PUBLIC ISSUE

(i.e.net offer to the public)

The net offer to the public portion has to be fully underwritten by the syndicate members/book
running lead managers. BRLMs shall enter into an underwriting, agreement with the issuer
company and the syndicate members enter into an underwriting agreement with the BRLMs
indicating the number of securities which they would like to subscribe at the pre-determined
price. If the syndicate members are not able to fulfill their, underwriting obligations, the BRLM
is responsible for bringing in the amount involved.
 The date of opening as well as closing of the bidding, the names and addresses of BRLMs,
syndicate members, bidding terminals for accepting the bids must be mentioned in the
advertisement.
ICICI first used Book Building method in 1996 followed Larsen & Toubro.

Some Book Built issues India 2014:

Sr. no. Name of issuer company Price based

1. NCML Industries Limited Rs.80 to Rs.90
2. Monte Carlo Fashions Limited Rs. 630 to Rs.645
3. Shemaroo Entertainment Limited Rs. 155 to Rs.170
4. Sharda Corporate Limited Rs. 145 to Rs. 156
5. Snowman Logistics Limited Rs.44 to Rs.47
6. Wonders Holidays Limited Rs. 115 to Rs.125
7. Loha Ispaat Limited Rs. 74 to Rs. 77
8. Engineers India Limited Rs. 145 to Rs.150
Source: http://www.nseindia.com/products/content/equities/ipos/historical_ipo.htm

6. Price Discovery through Book Building: An Example

Suppose you own company and want to raise money the capital market. For this you go for book
built issue with floor price of Rs 30. (price band Rs.30-36). You decide to offer 5,000 shares.

Bids are received in the following manner:

Bid Quantity Bid Price Cumulative Quantity Subscription

500 36 500 500/5000*100=10%
1200 35 1700 1700/5000*100=34%
1300 34 3000 3000/5000*100=60%
2000 33 5000 5000/5000*100=100%
2500 32 7500 7500/5000*100=150%
3000 31 8000 8000/5000*100=160%
3500 30 9000 9000/5000*100=180%
Under book building, the issuers find out the price at which they can sell their And
obviously they would like to fetch maximum price for their offerings. In the above example, 500
bids have been received at the highest price of Rs.36. but at this price, can sell only 10% of its
issue. Company can sell its entire issue @33 per share. It would not like to fix any price below it.
So Rs. 33 will be decided as the cut off price

7. Summary:
Book-building mechanism was introduced in India is to discover the right price public issue,
which in turn would eliminate unreasonable issue pricing by p promoters. Book building
prevents the over pricing and under pricing of issues B building has become a very popular
phenomenon of pricing and almost all comp resort to this price discovery mechanism.
8. Suggested Readings/Reference material
 Siddhartha Sankar Saha (2004). "The Book Building Mechanism of 10 The Chartered
Accountant, August 2004, pp. 198-206
 www.nseindia.com

Reference books:

 Financial Services in India by G. Ramesh Babu, Concept Publishing Company.

 Financial Services by M. Y. Khan, Tata McGraw-Hill Education,
 Financial Services in India Rajesh Kothari, Sage Publications

9. Self assessment Questions (SAQ's)

Q1. What do you mean by a Book Built Issue? What are its advantages?
Q2. What is the role of BRLM in book built issue.
Q3. Explain the regulatory framework of Book Building in India
Q4. Explain the steps involved in the process of book building?
 BOUGHT OUT DEALS (BOD)
SERVICES IN INDIA - RECENT TRENDS AND SEBI GUIDELINE

STRUCTURE
1. Introduction
2. Objectives
3. Presentation of Contents
3.1 Concept of Bought Out Deals
3.2 Features of Bought Out Deals
3.3 Mechanism
3.4 Advantages of Bought Out Deals
3.5 Caution
3.6 Difference Between Bought Out Deals, Venture Capital and Private Placement
3.7 Indian Experience
3.8 Problems in Bought Out Deals
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
Primary market scene in India has undergone a sea change in last one decade. Capital issue
(Control) Act has been repealed. SEBI was made responsible to evolve a mechanism for capital
market issues of corporate sector. SEBI's guidelines on investor protection, dissuading retailing of
public issues by introduction of firm allotment to institutions, proportionate allotment, free
pricing etc. have altogether changed the public issues scenario. With liberalisation in India the
companies entered the phase of planning to diversify. integrate and expand and hence needed
substantially high volume of funds. The escalating cost of making public offers has been a matter
of concern particularly for small companies. Companies which were not very sound often spent
large sums to ensure a good response to their issues. In such situation 'Bought Out Deals' (BOD)
emerged as a suitable alternative. Bought Out Deals known as angels in U.K. and elsewhere
made a quiet entry into the Indian Corporate world. They are seen as a faster, cheaper and surer
method of mobilizing equity as opposed to the public offering route that comes with attendant
high costs and uncertainty. Bought out deals are assuming ever increasing significance in the
parlance of investments. Merchant Bankers have found 'Bought out as an acceptable and
effective intermediate solution.

2. OBJECTIVES
After reading this lesson, you should be able to
(a) Define bought out .deals and explain its features and advantages.
(b) Describe the process of bought out deals.
(c) Differentiate bought out deals with venture capital and private placements.
(d) Present an Indian experience of bought out deals.
3. PRESENTATION OF CONTENTS
3.1 CONCEPT OF BOUGHT OUT DEALS
Bought out deal envisages literally selling of the security in full or in lots to
intermediaries who later on offload it in the market for public participation. The scheme
operates in two stages:
 The company issues securities in wholesale to intermediaries
 These intermediaries, at an opportune time, issue in retail to investors.

The first stage of the issue does not involve any direct cost to the company, the second
involves cost to the company or institution or intermediary depending upon the bargaining power
of the parties involved and how initial pricing has been worked out. This process obviates direct
retailing thereby saving time and cost. The intermediator is technically called sponsor. Sponsor
can be a single organisation or there can be a lead sponsor heading a syndicate of sponsors. The
exit route for sponsors is stock exchanges, either recognised stock exchanges or Over the
Counter Exchange of India (OTCE). Thus the sponsor should be a member of a stock exchange
also. Further since sponsors are buying shares of a company in bulk for sometime, their financial
position should be sound. Retailing of securities is done to small investors after a gap of some
time to seek premium. Such premium can be charged if company's performance turns out to be
attractive. Thus sponsor should have capacity to appraise the project for which such deal is
struck. That is why BOD is opted by those industries or companies which hardly have an
element of uncertainty. Sponsor otherwise will not find himself comfortable to go in for the deal
being risky one.

3.2 FEATURES OF BOUGHT OUT DEALS

The following are the features of Bought Out Deals:
(a) Arrangement: The arrangement takes place between the merchant banker/sponsor and
the company, the shares being held by the sponsor until they are ready for public
participation.
(b) No retailing: BODs eliminate retailing, thereby saving time and cost. They are the
cheapest and quickest source of finance for small and medium companies.
(c) Fund-based activity: BODs convert a fee-based activity into a fund-based activity for
merchant bankers.
(d) Wholesale activity: The capital raised from public, which is a retail activity, is rendered
into a wholesale activity by the guidelines issued by SEBI in 1994, for reservation of
issues without lock-in periods.
(e) Reserved portions: From the reserved category for institutional investors, lead managers
can take a stake upto 5 percent of the post-issue equity. The reserved portion of the issue
need not be underwritten. The public offer is 25 percent of the issue and underwriting is
optional.

3.3 MECHANISM
Bought-out deals were initially thought of for small companies but now even the projects
costing more than Rs. 100crores are resorting to it. Such deals are normally undertaken by
companies not listed in stock exchange. As per eligibility the companies through such deals can
be quoted at OTCEI or recognised stock exchangs. The mechanism of 'bought out deals' is
projected in Chart-1. The companies interested in such deal first of all select a suitable sponsor
like in public issue a company looks out for lead managers.
The vital function of a sponsor attached with OTCEI involves the following
a) To appraise a company/its project to ensure that
- the company's project has technological and financial viability.
- All government regulations are satisfied, raw material and infrastructural inputs as well
as marketing and financial inputs are adequately tied up.
b) To certify to OTCEI as regard the investment worthiness company and its project.
c) To value the share of the company.
d) To comply SEBI guidelines for the issue of securities.
e) To manage the public issue of securities of the company.
f) Compulsory market making in the issue scrip for atleast three years from the date trading
commences.

The process of sponsorship of scrips is intended to screen companies before listing them
on the OTCEI, giving investors better scrips to invest. It also provides enforced liquidity for
investors, giving them a guaranteed exit.
The sponsor i.e., a broker should be financially sound. A sponsor who others the highest
price for deal may not be the best sponsor as he may fail to fulfil commitment later on. After
reasonable opportunity to appraise the project, if he finds it acceptable then agreement is
entered between the two. Such agreement contains besides other details the period after which
shares are to be off loaded in stock exchanges. If the issue is to be transacted at OTCEI such
agreement is to be registered with OTCEI but if it is to be off loaded in other stock exchanges,
such registration is not required. Thus the sponsor may have to consult OTCEi before entering
into final agreement.

CHART-I
Method of Offer (in general)

Company

Sponsor

Co-Sponsor

OTCET Public Stock Exchange

Bought Out Deal Mechanism Over OTCEI (detail)

Company appoints sponsor

 Sponsor appraises the issue

Sponsor Consults OTCEI

Sponsor Registers Agreement with OTCEI

Sponsor acquires equity for consideration

Notifies acquisition to OTCE!

Time Gap

Sponsor Makes Issue

Listing the Issue on OTCEI

OTCEI Approves Allotment

Listing granted on OTCEI

Two way trading commences

Once agreement is entered and registered, the sponsor acquires the securities. At
opportune time listing application is made and once listing is granted trading in scrip starts. Thus
in bought out deals to be handled by a sponsor on OTCEI starts much before than public issue.
Further his association continues for a longer than public issue. Further his association continues
for a longer time in contrast to a short tenure if these are to be off-loaded at the other stock
exchanges. This is so because there no market making is involved once shares have been offered
to public. Market making refers to giving two-way quotes i.e. buy as well as sell quotes, for the
same scrip.
It is a novel concept which makes the merchant banker a countable to the investors even
after an issue is over. It was a welcome proposition for the small investors who are left high and
dry by merchant banker once the issue subscription is closed. The two way quotes by the market
have to be accompanied by the volume/depth (quantity) for which or till which the quote is valid
respectively, depending upon the type of quote. On OTCEI there are three types of market
making namely.

- Compulsory market making

- Additional market making
- Voluntary market making

Under compulsory market making by a sponsor the market making concept is for a period
of three years from the date of public trading. During this period it can assign the market making
assignment to other dealers/members of OTCEL. After three years sponsor may withdrew.
Besides compulsory market making if the sponsor appoints a dealer for market making it is
known as additional market making which can be for atleast one year. Any dealer excluding
undertaking compulsory or additional market making may undertake voluntary market making
which has to continue for atleast 3 months.
Sometimes companies evaluate sponsor's strategy in market making to ensure that
investors do no lose interest in scrip. In this situation another peculiarity is the requirement of
holding atleast 25 per cent of the issue by the promoters in post-issue period. The sponsor must
hold upto 5 per cent of the floating stock himself or jointly with additional market maker. OTCEI
has recently amended its some rules for BOD of companies, requiring listing on the exchange.
These changes, as OTCEI envisages, will attract a large number of companies to opt for such
deals through listing on it.
To ensure proper off-load the new rules require the sponsor to give an unconditional
undertaking to OTCEI taking responsibility for offering the entire amount of bought out
including that of the co-investors, except the initial market making inventory, to the public on a
date previously agreed upon. OTCEI wants majority of bought out offer to be handled by its
members that is why it requires that offer of bought-out should first be made to OTCEI members
and dealers.
OTCEI, viewing its infant stage, has revised its bought-out guidelines. The revised
guidelines are under:
- The offer of the bought out deal should be initially made to OTCEI members and dealers. If
participation is not for the coming the same may be offered to the non OTCEI members and
dealers.
- The members and dealers are free to decide the rates in a brought out deal between OTCEI
members and dealers and non OTCEI members/dealers subject to the conditions that they
should participate in bought-out deals by taking up minimum 10 per cent of the total value
of securities for which the bought out is done.
- The earlier requirement of the entire bought out (except the market making inventory) to be
offered to the public at the time of offer for sale is no longer required. However the offer for
sale will have to comply with the provisions of Securities Contract (Regulation) Rules which
requires offer of minimum 25 per cent of the post issue paid up capital to the public.

Exit Route
In a bought out deal, the exit route is either the Over The Counter Exchange of India
(OTCEI) or a recognised stock exchange. The sponsor merchant banker, together with the co-
sponsors generally adopts OTCEI as an exit route. At present it is generally first stage
entrepreneurs who opt for bought out deals. The size of the capital of such companies being
small (equity of less than Rs.3crores, the minimum required for listing on a stock exchange), the
sponsor merchant banker opts for OTCEI for off-loading to the public Shares can also be off-
loaded on the floor of a stock exchange. But how does this compare with off-loading through the
mechanism of OTCEI? Off-loading of shares by the sponsor through the mechanism of OTCEI
ensures total fair play. When the sponsor enters into b out agreement with the company, this
agreement has to be registered with OTCEI. The sponsor has to give details in this agreement
regarding the period after which he will issue the shares to the public through OTCEI. There is,
however, a deeming clause in such agreements between the sponsor and the company, whereby
the sponsor keeps the option open to off-load only if the company has met its projections. This
ensures that the sponsor does not burn his fingers. In cases of default by the sponsor for reasons
which are 'not genuine', the matter is referred to an arbitration committee set up by OTCEI
 board. Being a quasi-judicial body, a member who fails to abide by the arbitration award can
even be expelled by the OTC committee.
On other hand, when the sponsor off-loads his stake on a recognised stock exchange no
market making is involved once the shares are offered to the public, his responsibilities are over.
However, for the company there is an element of fear of mal-practice by the sponsors. As the
agreement is not registered with any governing body the sponsor may not off-load the shares
directly to the public but to another intermediary. The possibility of the intermediary being a
rival group cannot be ruled out.
On the positive side, in such a bought out, where the agreement is not registered with the
OTCEI, the sponsor merchant banker has the freedom to hold on such scrips till an opportune
time.
To most crucial points in this mechanism are 'holding period and 'deal buy out price.
These points are of concern to all the three parties involved. Holding period decides the success
of scrip. Holding period basically depends on the projected performance level relevant time
period. Longer holding period is a matter of concern to sponsors since investment is blocked for
longer period longer period reflects inefficiency of company to run the show. But investors
probably prefer that a issue should come to them after a reasonable period of testing the
performance of company. There is no minimum statutory limit on holding period and no upper
side, normally this period does not exceed 3 years.
Another point of significance is the bargained buy-out price. Since bought out deal is a
joint exercise of the sponsor and company, the price fixed should be fair to both the parties. The
company is saving on account of issue cost and time whereas merchant banker invests money
and expects reasonable returns to recover cost of fund besides the return for bearing investment
risk. A higher buy-out price during market making period may show negligible growth. Many
quantitative factors like typical performance ratios for the industry are considered to guide price
fixation. These factors are also relevant for firing the unloading price of BOD.
Together with other inherent risks of not being able to offload shares at a later date,
mutual trust and cooperation is essential between both the promoter and the sponsor who picks
up the shares. When the sponsor picks up a major stake in the company with an intention to
offload the shares, it is quite possible that such power may be misused. Therefore, the promoter
consent is required before a sponsor can offload the shares to other over the OTCEI or any other
exchange. This is also because the relevant details of the company to be incorporated by the
sponsor in the 'offer for sale' document (akin to a prospectus) to be provided by the company,
details on the history and business of the company, its promoters, the project and the financial
performances, together with the audited and auditors report are incorporated in the offer for sale
document.

3.4 ADVANTAGES OF BOUGHT OUT DEALS

Bought out deal is an attractive proposition for all the three parties involved therein, i.e.
company, sponsor and investors.

The Company
i) Company need not wait for a long time before making use of funds which is usually the case
in public issue where it takes about 4 to 5 months on average for raising funds. In such deals
company gets funds directly from the sponsor without loss of time. The ban on bridge loans
 by the banks and financial institutions after M.S. Shoes episode bought out deal becomes
more attractive for promoters.
ii) The problem of cost and time can be checked. Since the cost of making public issue need not
be incurred, substantial amount can be saved for productive use as bought out deal costs
around 5 per cent in contrast to about 10-15 percent in the public issues.
iii) It is easier to convince a wholesale investor as compared as to general investor about the
merit of a project. The whole sale investor, i.e., sponsor/merchant banker has an
infrastructure and expertise at his disposal to assess the veracity of the claims of the
promoters. Thus it is easy for company to market their issue.
iv) Bought out deals are especially useful for a qualified technocrat who has a sound
professional background but lacks expertise about market sentiments and market
functioning. In such a scenario the sponsor instead of laying stress on past profitability
record and financial projections, lay more stress on the promoter's background and
government policies, which may make or mar a new project or expansion an existing
project.
v) As per SEBI's' guidelines new companies cannot issue their shares at premium to public.
Through bought out deals even the new companies can issue shares at premium to sponsor,
who in return at a later date can off-load their holdings even at a higher premium.

The Sponsor
For the sponsor, boughtout deals provide an opportunity to have substantial profits. The
sponsor also charges fee for such fund based activity. Profitability on retailing of course depends
on potential of the issues. Besides high profit selection of potential issues increases credibility
and builds images of the sponsor.

The Investor
The investors in primary market, the third party, have to depend on recommendations of
some reliable agency and in bought out deal sponsor comes to their rescue. The appraisal done
by a reputed sponsor convinces the investors and thereby reduces the investment risk. The
credibility to the issue increases with the increase in the number of merchant banks involved in
the issue. Thus all the three parties are put on better footings.

3.5 CAUTION
Bought out deals are not always profitable ventures. In following cases there can be losses of
such deals:
1. A Merchant Banker, if he does not do proper analysis of the company and prices the issue
unattractively has to bear loss which in many cases may be substantial.
2. The company, in a sense that larger shareholders like institutional investors may influence the
policy decisions/may have restrictive convenants in their initial subscription agreement which
may affect the functioning of the company.
In European countries such services are undertaken by merchant bankers. In USA
investment bankers get involved in such activities. British banks through their subsidiaries
undertake venture capital activities and assist the prospective entrepreneurs. Patel Committee
recommended such activity in India again through merchant bankers. 'SBI Capital Market'
entered this field during 1986-87 when capital market was at its low ebb But at that time
investment banking was in its infancy; thus concept of Bought out deal could not be popular with
 merchant bankers in India. But the maturity of capital market and reforms in financial services
sectors have given boost to bought out deals. Emergence of OTCEI made bought out deal more
simpler and dependable. SEBI's changes in public issue' which have made it wholesale affairs
activated BOD further. BOD is a fund base issue management job in contrast to lead manager's
non-fund based issue management. Bought out deal should not be confused with venture capital
activity. Private placement is by an already listed company but bought out deal is by a company
which is yet to be listed in any stock exchange.

3.6 DIFFERENCE BETWEEN BOUGHTOUT DEALS, VENTURE CAPITAL AND

PRIVATE PLACEMENTS
The line demarcation between venture capital and bought out deals is very thin. Both
involve participation in the equity of a company. However, venture capital funds have to
maintain a lock-in period of three years with regard to the equity investments made as per SEBI
guidelines, in a bought out deal, the sponsor has to maintain a mere 5 per cent of the public offer
to ensure buoyancy in the scrips. Norms for venture capital funds required them to fund only that
technology which is new or relatively untried. Additionally, the promoters are required to be
relatively untried. Additionally, the promoters are required to be relatively new, professionally or
technically qualified within adequate resources or banking to finance the project. These do not
apply to bought out deals.
The area between venture capital and bought out deals are clearly demarcated abroad.
Venture capital is viewed as a high risk high-potential investment where even a basic idea could
be founded. Whereas bought out deals are for projects that have taken off. In India however,
there is often an overlap. Through a bought out deal even a new company can issue shares at a
premium to the sponsors who can offload it at a higher premium at a later date.

A fine line of distinction between these three is drawn in Chart-II.

It lies between 'venture capital and public issue. Like venture capital BOD does not has a
lock in period of three years, if shares are to be issued to public. Similarly for BOD it is not
necessary that technology of project should be new or relatively untried and promoter should be
professionally or technically qualified.
 Chart II

How Bought Out Deals differ from venture capital and private placement

Points Bought Out Deals Venture Capital Private Placement

Projects New Project not listed on New Project not Already existing
Stock Exchange listed but in green company which is
field i.e. untested already listed on stock
area of industry exchanges.
Capital Promoters offload his holdings Original share It creates additional
to the sponsor capital is issued equity capital
Lock in period Compulsory market making by If exit route is to As per SEBI's
sponsor as per rules of OTCEI: public such period is guidelines the lock in
No such requirement if quoted 3 years. In case of period is five years.
on stock exchanges. buy back
arrangement with
promoters there is no
lock in period.
Exit Route Public offer over the OTCEI or Public offer over the Sale in secondary
recognised stock exchange. OTCEI or market.
recognised stock
exchanges.

3.7 INDIAN EXPERIENCE

It is the new promoters who normally opt for bought out deals. Depending on the size of the
project the exit route is selected i.e. for small companies with equity base less than Rs. 3 crores.
OTCEI is the course whereas bigger issues can be traded. Merchant bankers adopt OTCEI route
because technically it is more fair game. Popularity of OTCEI can be guessed from the fact that
out of 28 bought out deals till recently 22 have been transacted through it as compared to only 6
through Bombay Stock Exchange (BSE). Average holding period in these cases has been 247
and 251 days respectively. Gross annualised sponsor's return in percentage has been 117.64 and
89.05 respectively. OTCEI gave higher return to investor in terms of percentage being 39.22 as
compared to (-) 30.75 for bought out on BSE.
A study conducted by SRF Finance of OTCEI issues reveals that comparing direct issues and
bought out offloads, it can be observed that the former have higher returns than the latter. It is
conceptually obvious since risk associated with bought out offloads is comparatively lower than
otherwise since such projects are well evaluated beforehand. Consequently in long run higher
returns are associated with bought out deal. As per OTCE statistics gain per share to bought out
dealer has been varying between Rs. 2 and R 60. Holding period has been as long as about 700
days and as short as 70 days. Gross annualised yield to bought-out dealers has been between 31
to 310 per cent.
Bought out deals in real spirit started in mid of 1992 and till recently these have transacted
business around Rs. 500 crores. There was a great deal of excitement at initial stages. Since
beginning of 1995 no such deal has been struck since the capital market has been at its low ebb.
One general reason why bought out deals have not gained popularity are to be offloaded by the
sponsor. Since sponsor takes up the majority of shares of offload there is always a fear of
offloading these in favour of parties which may like to grab the management by acquiring,
sufficient equity stake in the company. OTCEI protects the companies interests since sponsor
cannot off-load without consent of promoters. On the other hand, there have been cases where
sponsors have not been able to offload all shares in future e.g. in the case of Grow Well Times
out of 5lakh shares, public subscribed for only 1.5 lakh shares. As long as there was bullish trend
in the market, merchant bankers rushed into any such deal they came across, to book profits by
early off loading. The hunger of appreciation in short run has discouraged sponsors to go in new
for bought out deals.
The recent changes in guidelines for "Venture Capital business, the experts observe, will shift
clientele to bought out deals. Venture capital companies see in turnaround financing and
management buyouts a whole new opportunity. Western experience also reveals that buyout are
preferred over. venture capital. Such attractive business proposition has forced the merchant
bankers to arrange sufficient liquidity with them. Few years back, Small Industries Development
Bank of India (SIDBI) introduced Line of Credit' for financing bought out deals on the OTCEI to
Non-Bank Finance Companies (NBFCs) engaged in merchant banking. The minimum size of
each deal would be Rs. 10 lakhs to be utilised within two years from the date of sanction. Interest
rate is 18 per cent with profit sharing and 20 per cent without profit sharing. Shares of the deal
will be the security. NBFC has to offload BOD shares within 18 months. Innovations are in
offing in managing bought out deals. On arranging funds, one of the OTCEI dealer has designed
a unique portfolio scheme exclusively for OTCEI bought out deals. In this portfolio with lock-in
period the individuals as well as corporates are invited to contribute for sponsoring BOD. At the
expiry of the period the entire principal and profits will be shared by contribution after leaving a
10 per cent commission to the dealer. On product side also innovations are being tried. A
merchant banker proposed the promoters to give out the whole of the equity initially in form of
convertible debentures assuring a fixed coupon rate and conversion later on before the public
issue at a price mutually agreed. Some innovations are being talked in mechanism also. First
merchant banker who can risk the investment for a long time but have me limitations on handling
the public issue, can with the prior consent of the promoters, sell of the deal to another banker
who has strength of handling the public issue but cannot afford to continue with investment for a
longer period.

3.8 PROBLEMS IN BOUGHT OUT DEALS

Such deals in the given free for all environment may not be a fair business. The investors
may be put to embarrassment due to undesirable attempts on part of companies or dealers. For
example there is no provision binding the company not to seek delisting from OTCEI even
during lock in period compulsory market making. These companies are not required even to give
a notice for such switching over to another exchange. There is no check on over pricing of the
'offer for sale'. Besides, some favours are sought by sponsors also. They do not appreciate the
limit put on by Companies Act-forbidding inter-corporate investments beyond a certain point. To
broaden the base of BOD even already listed company may be permitted to follow this
convenient route. Thus the most crucial point at this time is the absence of regulated bought out
deals except for board guidelines issued by OTCEI which are more recommendation in nature.
Since BOD is financial activity involving intermediaries, SEBI should come out earliest possible
with desired regulations like it has declared for mutual funds, merchant bankers, brokers etc.
Further financial institutions and commercial banks which till date, are not permitted to invest
BOD should be allowed to participate in this new field, reserve Bank of India is being pursued
by Association of Merchant Bankers of India to direct banks to provide funding for Bought out
Deals. will help the market makers to maintain larger inventory.

4. SUMMARY
An arrangement, whereby the entire equity or related security bought in full or in lots, with
the intention of off-loading it later in the market is called bought out deal. Bought out deal
operates in two stages, first when the company issues securities in wholesale to intermediaries
and secondly when these intermediaries issue there securities in retail to the In bought out deal,
the exist route is either the OTCEI or recognized stock exchange. Bought out deals involve
participation in the equity of company, but there is difference between venture capital, private
placement and bought out deals. First generation entrepreneurs normally opt for the bought out
deals in India and depending on the size of the project, exit route selected.

5. SUGGESTED
1. Bansal, L.K., Merchant Banking and Financial Services, Unistar Books Pvt. Ltd.,
Chandigarh.
2. Gurusamy, S., Financial Services and System, Thomson Learning.
3. Khan, M.Y., Indian Financial System, Tata McGraw Hill, Delhi.
4. Varshney, P.N. and Mittal, D.K., Indian Financial System, Sultan Chand and Sons, Delhi.

6. SELF ASSESSMENT QUESTIONS

1. Define bought out deals. Discuss the features of bought out deals.
2. What is the mechanism of bought out deals? Explain.
3. Discuss the advantages of bought out deals. Also explain the scene of bought out deal in
India.
4. Differentiate between venture capital, private placement and bought out deals.
 SECURITISATION OF ASSETS: CONCEPT, FEATURES, PROCESS, MERITS AND
RECENT DEVELOPMENTS IN INDIA

STRUCTURE
1. Introduction
2. Objective
3. Presentation of Contents
3.1 Concept of Securitisation
3.2 What can be Securitisation
3.3 Evolution and growth of Securitisation
3.4 Key elements in Securitisation
3.5 Mechanism
3.6 Forms of Securitisation
3.7 Merits of Securitisation
3.8 Developments in Indian Financial Market
3.9 Vast Scope of Securitisation
3.10 Problems in Implementation of Securitisation
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
The main objective of any country is economic growth. The greatest constraint the
developing country faces is that o resources for investment. Resources planning strategy in such
a context acquires a great signifiance. For this, a sound and vigorous financial system can play an
important role in mobilising resources from a diversified investor base.
Indian economy is passing through a critical situation. Inspite of a very significant
proportion of financial resources being promoted by the Government for its various socio-
economics programmes, it still finds itself large deficit situations. Not only this, a large number
or investors whose appetite for avenues investments with the right kinds of return, liquidity,
maturity and risk profiles, is still largely unsatisfied. Further, banks and financial institutions
whose resources are employed at low rates for priority sector are hard pressed to operate
profitability.
An important consideration the level the issues is that the mobilised funds have be
carefully managed because their utilisation takes place for longer period. The problem here,
however is that of inadequate returns and liquidity for the investors funds as also the lack of
required maturity. The essential issue bridging the gap between what borrowers want on one
hand and what lenders want on the other. One way, this regard suggested by the financial experts
transforming the credit assets of issuers into more liquid and marketable instrument which could
then further be sold to investors providing them with the required return, liquidity and maturities.

2. OBJECTIVE
 After reading this lesson, you should able to
(a) Define securitisation and explain the evolution and growth of securitisation.
(b) Describe the process of securitization.
(c) Explain the merits of securitisation to the issuers and the investors.
(d) Present position securitisation Indian financial system.

3. PRESENTATION OF CONTENTS

3.1 CONCEPT
The securitisation may be defined transformation of illiquid assets into securities which may
further tradeable in the capital markets. other words, process transforming the assets of lending
institutions into negotiable financial instruments. The securities instruments can be in the form
commercial papers, participation certificate other notes which can issued under the prevailing
laws of the country. For example certain assets like term loans, house loans, auto loans, credit
card loans, mortgage receivables, etc. can be converted into tradeable securities. In this
technique, the assets of lending firm are pooled and then securities are issued against the pool.
The cash flow is used to guarantee the payment of a security.
The securitisation facilities the issuing firm to raise more funds by selling its assets that
have already been created and appear in the balance sheet. For example, if a auto finance
company having disbursed a huge auto loans to the large number of persons, wants to raise more
funds, this can be done by transforming its auto loans into securities which can be further sold in
the capital market. The raised funds can be used by the concern to create further assets, and
hence, the cycle can be repeated. In fact, securitisation route helps to create and offers medium
term instruments which were hither to non existence. Thus, it is a synthetic technique of
conversion of assets into securities, securities into liquidity and liquidity into assets and assets
into securities and so on.
In securitisation, as noted above, assets are pooled together and securities are issued
against such pool. In that case, the investor has a direct claim on a portion of the mortgage pool.
In other words, interest and principal payments on the mortgage are passed directly along to the
investor. In creating such pools of mortgages, the lenders should be careful to put together those
assets with similar characteristics in relation to terms, rate of interest, quality, period and risk. In
the financial market, these securities are also known as mortgage-backed or asset backed'
securities.

3.2 WHAT CAN BE SECURITISED?

Which debt or asset can be securitised by a firm is an important issue in this method?
Basically any such asset or receivable which hap predictable cash flows can be securitiesed. The
following are important such items which can be included in this category:
i) Housing Loans
ii) Auto Loans
iii) Lease rentals
iv) Credit Card Loans
v) Government receivables
vi) Trade receivables
vii) Term Loans
 The essential features of a potential asset pool are:
(i) The pool should have asset of similar features in terms of nature of loans, payment
frequencies, origination, termination, periodically, etc.
(ii) The predictable or estimated cash flows in future should be well defined and properly
ascertained.
(iii)The underlying assets in the pool should have standard documentation.
(iv) There should be adequate historical record of the asset being pooled in respect of its
defaults, prepayments, losses, etc.
(v) It must have the feature of diverse obligators so that risk is diversified.
From the above, is observed that such loans or receivables which are to be received in
annuity form at specified time intervals are best suited for securitisation like housRe loans, auto
loans, etc.

3.3 EVOLUTION AND GROWTH OF SECURITISATION

The securitisation is very much popular in developed countries. It was originally confined
to residential mortgages. It came into existence in 1970 in United States of America when the
newly created, Government National Mortgages Association (GINNIS MAE) began publicly
trading in securities, back by pool of mortgage loans. These securities are known as mortgage
pass-through securities or mortgage back securities (MBS). In creating pools of mortgages, the
lenders were careful to put together those assets, with similar characteristics in regard quality,
term and interest The pool of mortgages placed with trust actually sold in the form of certificates
to investors either directly or through private placement.
Recently, more complex securitisation structures have been evolved to cater the needs of
various investors. New features are being. added to enhance the marketability of these securities
in a big way. The size of this market, in an estimate, has increased to almost $43 billion by the
end of 1990 in USA. Important debts which are securities include automobiles loans, computer
loans, auto loans, home loans, credit cards, insurance premiums, etc.
Securitisation has become more popular recently in U.K. The first mortgage
securitisation issue arranged in London for the international market was Mini a 50 million
launched in January, 1985 which was refinanced by certain banks. After that, a new variety of
instruments with different features came into existence. The major reasons of their tremendous
growth and popularity in USA and UK is simple legal procedures in respect of mortgage and
debt securitisation. Certain developed countries like France, Italy, Australia and Canada 'have
also made a good progress in this regard. In another estimate, the total U.S. Residential Mortgage
market was $ 25 trillion by the end of 1991 out of which about $ one trillion was securitised that
was almost 20 per cent of U.S. G.N.P. Today two out of every three mortgage loan are
securitised in USA.

3.4 KEY ELEMENTS IN SECURITISATION

The basic requisites needed for the process of securitisation are as under in brief:
i) identification of financial assets/loans representing a stream of future cash flows, initially
in a non-tradable form.
ii) The assets (being securitised should be of high quality, normally bearing 'AAA' rating.
iii) The pool of assets should be well diversified to reduce risk.
iv) The maturity composition of portfolio should be sufficiently long so that a medium term
instrument be created.
 v) Receivables with similar features in relation to terms, quality, period and risk should be
pooled together so that a homogenous pool be established.
vi) The periodicity of payments should be decided after taking into consideration the
collection and administration costs to the issuers.

3.5 MECHANISM OF SECURITISATION

As stated above, securitisation is the process of liquefying assets/loans and receivables of
financial institutions, banks and other institutions through issuance of negotiable instruments.
The operational mechanism of this process can be bifurcated into following steps:

(a) Origination
The first important step in this process is the ‘origination' by which assets are originated
through receivables, leases, loans or any other form of debt. The lending institution whose assets
are involved is called 'origination' and whose loans and receivables will be converted into
securities. In fact, the originator selects a pool of assets of homogeneous or similar nature, list
them from its balance sheet and pass then on to the special purposes vehicle (SPV), or trust
through which the former will liquefy its assets. As a precaution, it should be ensured that only
homogeneous type of assets should be pooled together so that cash flows arisen from them be
properly estimated for different intervals.

(b) Structuring
The next step in the process of securitisation is structuring through which the cash flows from
the selected assets or loans are pooled together, repackaged and held in a trust or a special
purpose vehicle (SPV). This is also termed as a pass through transaction which could be by way
of an outright sale for consideration or for a collateralised loan which in turn convert it them into
appropriate form of marketable securities. for investment. The nature of loans/assets put
together, their maturities, interest rates involved and frequency of repayments usually determines
the terms of securitisation.
It has been observed that the SPV is normally a separate organisation other than the
‘originator' and its main tasks are structuring the deal, raising proceeds by issuing pass through
certificates (PTC) or pay through security (PTS). It uses the proceeds of the issue of notes to the
investors, which are collectively represented by a trustee, who holds the various types of security
interest or charge on behalf of the investors, SPV is an extended arm of the originator and its
entire activities are managed and controlled by the originator.

(c) Credit Enhancement

To obtain an investment credit rating and make the transaction attractive to the investors,
some type of credit enhancement procedure is usually necessary. For this purpose, credit rating
from a credit rating agency of the issue should be obtained. The rating provides a message to the
investing public about the quality of issue concerning payment of interest and principal. Further,
sometimes, SPV also obtains certain support from a third party lender to guard against potential
credit losses. Usually credit support is provided by a pool insurance policy typically in the form
of a first loss guarantee from the originator of the primary assets and then a wrap guarantee.
Sometimes, a letter of credit is also arranged to make the issue more attractive.
(d) Placement
Next step in the process of securitisation is to make arrangement for the placement of the issue
in the market. For this, the service of one merchant banker on their syndicate depending on the size
of the issue, may be obtained. They will play a key role as they would decide on timing of issue,
their pricing, making arrangements for marketing and underwriting, etc. To underwrite the issue,
the merchant bankers will evaluate the originator's creditworthiness, the expected performance of
assets of sale, collection activities involved, etc. The merchant banker will advise to place the issue
publicly or privately which normally depend n the size of the issue.

(e) Trading
After making arrangement for placement of the issue by the merchant bankers, the
security enjoys high degree of liquidity. These securities may also be listed on the stock
exchanges. Sometimes, the merchant banker also works as the market maker to perform buying
and selling functions.
In the first instance of securitisation process, the originator identifies the assets to be
pooled and then get them rated from the approved credit rating agency. After that, he sells or
transfers these assets to a trust(special purpose vehicle) which splits the assets into tradable
instruments and also arrange credit rating symbol and guarantor for enhancing the creditability in
the market. Then these instruments are placed in the market privately or publicly to the financial
intermediary which further sells them into secondary market to the investors.

3.6 FORMS OF SECURITISATION

The securitisation can be initiated into two forms which are a under:

(A) Pass Throughs

In this form of securitisation, the issuer assigns the receivables to a special purpose
vehicle (SPV) which is generally a trust. It is also known as pass through certificates (PTC). It
has single purpose of holding the selected receivables on behalf of the investors. The investors
pay for the present value of the pool of receivables. The SPV issues certificates, known as pass
through certificates (PTC), to the investors indicating beneficial interest in the pool of
receivables. In other words, these certificates, directly reflect ownership rights in the underlying
assets, their payment pattern, interest rates with a spread, etc. The cash flows from the
underlying assets are passed through to the holders of the securities in the form of monthly
payments of interest, principal and prepayments. Normally, they are distributed on a pro-rata
basis to the holder of the security.
The homogenous pool is managed by the issuer who collects the instalments and after
deducting service charges, passes it through to the investors. This form of securitisation can be
with or without recourse securitisation, the trust can initiate legal proceeding against any
defaulting debtor. If any debt or holder of the asset makes prepayment the due amount before the
final schedule payment month, in that case amount of such prepayment will also be
proportionately passed on to the security holders.

(B) Pay-throughs
The major problem in the pass-throughs form is that the direct association of the
receivables with payments to the investors. The amount realised from the receivables is
distributed to the investors. But in this technique, the receivables are transferred to a trust and the
 same is deposited in Reinvestment account. From this account, the investors will be paid on the
basis of terms of securities issued, i.e. monthly, quarterly, half yearly etc. This form is also
known as pay-through securities (PTS). Under this method, the issuer is permitted to restructure
cash flows from the assets to offer a range of investment, maturities to the investors associated
with different yields and risks.
For example, if an originator 'A' has a group of re receivables with a 5 years average life
he may sell its receivables to other firm (trust) ‘B’ who may raise the funds to purchase these
receivables by issuing three branches of debt securities with different maturities like 3 years, 5
years and 8 years. Hence, it serves the needs of the firm to raise off balance sheet finance, and
simultaneously repay to the investors over periodic basis, not linked to the recoveries.

Distinction between Pass throughs and Pay throughs forms

Both the forms of securitisation are different on the following basis:
1. The pass-through form is precisely related with maturity of the receivables whose payments
are passed through the trust (SPV). It means, it is a single maturity instrument which will be
terminnted on the basis of retirement of underlying asset. Whereas, in pay through form, the
issuer (trust) owns various receivables on which basis he issues various types of securities.
He is free to restructure the cash flows of the underlying assets (receivables) into several debt
branches.
2. It is related with the principal payment process. In the pass through form, each investor
receives the amount on pro-rata basis which the issuer receives from the originator. On this
way, PTC holder gets some return of principal every month. However, final maturity of
PTCs do not occur until the final asset in the pool is retired. As a result, the uncertainly with
regards to the timing of principal return on a sequential basis. The additional cash flow arisen
(over the payment of interest) is used to redeem securities. Normally, one class of securities
at a time receives principal and after that second security is paid and so on.
It is observed from the above that the pay-through form is superior to pass-through to the
investers due to payment frequencies and range of maturities. Such investors who are not
interested in the pass-through due to payment characteristics will prefer pay-through form.
Further, credit quality is also superior in PTS due to higher collaterisation of assets.

3.7 MERITS OF SECURITISATION

Securitistion, also known as mortgage backed securities, is a popular technique of raising
funds in developed countries like USA, UK, France, Japan, etc. It has various merits to the
issuers as well as investors. A few of them have been stated below in brief:

A. For Issuers

(i) Through securitisation, the issuer (originator) can create multiple assets with a given equity.
In other words, assets create further new assets. Theoretically, the extent of ant that can be
created is solely dependent on the ‘Conversion cycle'. i.e. the time between the date of
security is created and marketed. The only limiting factor in this respect is the availability of
good rated assets.
 (ii) Through securitisation, the issuing firm is able to raise more funds without raising any new
debt funds or liability. It means the capital structure of the concern can be designed within its
desired limit. Hence it assists in improving the capital structure of the firm. Further, it minimises
the leverage as measured by debt ratios.
(iii)The issuer can increase their earnings as well as capital base through securitisation because the
additional funds raised by transferring such assets will be re-employed in the activities of the
firm.
(iv) Through securitisation, the issuer can transform its illiquid assets such as receivables, loans,
rentals etc. into liquid assets. This will assist the firm to grow faster and to face new challenges
ahead.
(v) The cost of raising additional funds through securitisation will be lower in compared to other
resources because the underlying security issued against receivables will enjoy a wider investor
base and certain liquidity.
(vi) This form, being an asset based financing, securitisation may make it possible even for a low
rated borrower to seek cheap finance, purely on the strength of the quality.
(vii) The issuing firm will focus its attention more on receivables (asset) management since y
default will have adverse impact on credit worthiness of and further, will give signals to the
investors.
(viii) This technique will be helpful to the issuing firm diversify their credit risks. It breaks down
the risk of credit portfolio namely, credit risk for expected losses, concentration risk,
catastrophic risk, etc. First risk is absorbed by the originator where as other two can be passed
on to SPV or trustee and investors.
(ix) Securitisation is more suitable for such firms which have major activities of issuing loans to
the public such as banks, financial institution, insurance companies etc. These institutions
owning to strict capital adequacy norms being enforced and the capital markets beginning to
charge more for debts in the absence of an increased equity base.
(x) Besides designing appropriate capital structure through securitisation, it will further assist the
originators in planning its assets structure. By transforming illiquid assets into liquid assets, it
change certain integral ratios of the balance as to make it more healthy.
(xi) Through securitisation, the additional revenue generated enables the issuer to take advantage
of more profitable investment opportunities. It retains its existing customer relationship at the
same level.

B. To the Investors
(i) The securitisation will also be helpful to the general investors because only the high quality
assets are securities. Normally, a well diversified pool is selected. The securities which are
going to be issued are usually rated by a credit rating agency. Only a good rating (AAA) debt
securities are usually allowed to issue in the market. In other words there ample safety for
inventor’s funds employed in such debt or securities.
(ii) Under securitisation various securities having different maturities are usually issued the
investors. The investors, as per their requirement, can select the securities, hence providing
ample opportunities for diversified investment to them.

In brief, the securitisation serves the multiple needs of good yield easy liquidity and reduced
risk for the investors.
3.8 DEVELOPMENTS IN INDIAN FINANCIAL MARKETS
Securitisation has already been popular in most of the developed countries like USA, UK,
Canada, France, Japan etc. Recently, it has been introduced in Indian financial market too.
Through it is still in initial stage, but the response is very much encouraging. The scope of this
technique seems to be very bright due to recent liberalisation process initiated in the country. The
acceptability and accessibility of diverse ways to raise resources has increased. Various financial
institutions and banks like Citi Bank, Housing Development Finance Corporation (HDFC),
Industrial Credit - and Investment Corporation of India (ICICI), Industiral Development Bank of
India (IDBI), Tata Engineering and Locomotive Company (TELCO), Housing Finance
Companies (HFCs) etc. have already made their beginning in this line.
Citi Bank took the lead in this field. securitised the bills portfolio of ICICI and hire
purchase receivables of TELCO. The first deal was done quietly whereas the second one was
publicly announced. Citi Bank has attempted to raise funds through the pass throughs form of
securitisation. For instance, in March, 1992 TELCO sold a pool of loans worth Rs. 60crore to
Citi Bank at a discounted price of Rs. 50crore. The cost was estimated in this deal was worked
out to 19 per cent on discounted cash flows basis. Further, Citi Bank has also securitied its own
auto loan worth Rs. 15.98crore out of Rs. 450crore portfolio, and out of which Rs. 5crore was
placed with GIC Mutual Fund.
Another Madras Based housing company - Alacrity Housing Ltd. Official loans worth
Rs. 3.45crore out of a portfolio of Rs. 63crore in May 1993 at a discount price of Rs. 3.10crore to
Citi Bank. The balance of Rs. 35lakh was the cost of deal which the Alacrity had to bear which
estimated to cost at 21 per cent per annum on a discounted cash flows basis. Another company
SRF Finance Ltd. has raised Rs. 10crore by placing its pool of hire-purchase receivables with
Citi Bank.
For the first time, a foreign currency loan amounting to $116 million of Essar Gujrat was
securitised and sold to institutional investors in the U.S.A. Further, US Export Import Bank has
given the guarantee to a private sector Indian company. Chase Investment Bank Ltd. a subsidiary
of Chase Manhattan, was the lead banker and Merrill Lynch and Paine Webber were the co-
managers. It will be listed on Luxemburg stock exchange. In another deal, in March, 1994, Tata
Finance Ltd. securitised Rs. 13crore of loan receivables of a three years maturity at a present
discounted value of Rs. 10crore with Citi Bank. The cost worked out at the rate of 14 per cent.
Further, 20th Century Finance securitised Rs. 8.30crore of receivables for Rs. 6.53crore at cost
of 16 per cent in December 1993.
The price and discount offered in a transaction of securitisation differ from deal to deal
which depend upon upto some extent on the size of the loan, period of loan, bargaining power of
the negotiators, creditability of the originator, etc. The major factor in such deals is the cost at
which the transaction is finalised. Then this cost is compared with the market rate of return
prevailing at that time on such similar loan.

3.9 VAST SCOPE OF SECURITISATION

The scope of securitisation in India financial market seems to be very positive due to
recent liberalization process in the country. The recent developments has opened up avenues for
financial intermediaries to raise funds through this instrument. Now, the developments banks
which had been subsidised by the Government so far are planning alternative ways of raising
funds. Further, the liberalisation of the financial system, the explosive growth of the capital
 markets and the vast increase in the investor base would also be helpful in the expansion of such
instrument.
There is vast scope of assets securitisation in banking industry, the bank will enable to
generate cash from the assets immediately rather than over a number of years, thus, enabling
recycling of funds faster than ever before. Further, they can bring improvement in their balance
sheets in the shortest possible time. The cash generated in this respect can be used for creation of
further assets or adding to either capital or reserves. Housing finance companies can be benefited
a lot from this instrument. These companies facing the problem of resource crunch can raise the
additional resources by securitising their-receivables. In brief, the securitisation has vast scope in
Indian financial markets if major obstacles in the way are handled carefully.

3.10 PROBLEMS IN IMPLEMENTATION OF SECURITISATION

As observed, there is vast scope for securitisation in Indian financial market, but the
progress in this regard is not very much encouraging. It has not been developed due to various
problems arisen in its implementation. A few important among these are as follows:

i. There is complex legal system and structure in respect of liquidating security in the event of
default. It is complicated and time consuming process which no individual can afford.
ii. There is no standardisation of loan documentation of similar loans in India. Thus, the
problem arises in case of sale or transfer of assets by the originator to the SPV.
iii. There is no clarity relating to legal implication arising due to insolvency of either originator
or the SPV. Further relationship between debtor and the SPV is not also legally specified.
iv. Accounting treatment in the securitisation deal is also not specified. The implication of
securitisation in the balance sheet of the originator treating the same as sale or financing is
still to be decided.
v. The Indian investors are still inadequately equipped and pathetically incapable of judging or
rating the debt offer. So rating is another important consideration in this process.
vi. The heavy stamp duty on sale or transfer of assets is another important problem in the growth
of asset securitisation.
vii. The success of securitisation depends upon the efficiency of secondary market and developed
merchant banking system. Unfortunately, Indian stock market position in this respect is not
satisfactory.

The problems stated above are no doubt significant but these can be removed by the regulatory
agencies by taking suitable measures. Further, the steps should be taken to popularise the
instrument in the investors at large.

4 SUMMARY
A financial technique concerned with trading in securities backed by pools of mortgage
loans is termed as securitisation. The securities so created are known as mortgages. Mortgages,
when issued, facilitate investors to purchase a fractional undivided interest in pool of mortgage
loans. Securitisation provides for a share in income and principal payments generated by the
underlying mortgages. A technique whereby assets are convested into securities, which are in
turn converted into cash on an ongoing basis, with a view to allow for increasing turnover of
business and profits, is known as asset securitisation. Securitisation financial instruments are
useful as they help small investors by facilitating liquidity. An entity called Special Purpose acts
 as an intermediary between the originator of the receivables and the end-investors. It also plays
an active role in reinvesting or reshaping the cash flows arising from the assets transferred to it.
Securitisation is beneficial in many ways. A well-developed capital market allows for the smooth
growth of securitisation.

5. SELECTED READINGS
1. Horne James C. Van, Financial Management and Policy, Prentice Hall of India (P) Ltd., New
Delhi, pp. 540-541.
2. Henning Charles, William Pigott, Robert Haray Scott, Financial Markets and the Economy,
Prentice Hall, Inc. N.J. pp. 244-45.
3. Francies Jack Clerk, Investment Analysis and Management, McGraw Hill International, pp. 20-
30.
4. Sandeep Devgon Vinod Swarup. The Securitisation of Debt, Chartered Financial Analyst, Vol.
6, No. 6, May-June, 1192, pp. 3-7.
5. Nair T.C., Scope for Asset Securitisation in Banks, The Journal of the Indian Institute of
Bankers, pp. 77-80.
6. Chandersekar, Securitisation of Debt, Fortune India, March 1-15, 1993, pp. 46-48.
7. Report on Mortgage Backed Securities (MBS), Euromoney, October 1992, pp. 52-58.

6. SELF ASSESSMENT QUESTIONS

1. Define securitisation. What are its features? Also explain basic elements of securitisation.
2. Explain various steps in the process of asset securitisation Explain with suitable example,
3. Discuss the various merits of securitisation to the issuers and the investors. Also explain
various problems in this regard.
4. Critically examine the position of securitisation in Indian financial markets. Give your
suggestions too.
 DEPOSITORY SERVICES, NATURE, FEATURES PROCESS, ELEMENTS,LEGAL
AND FINANCIAL ASPECT, ADVANTAGE AND RECENT DEVELOPMENT

STRUCTURE
1. Introduction
2. Objectives
3. Presentation of Contents
3.1 Concept of Depository System
3.2 Modus Operandi of Dematerialisation/Rematerialisation
3.3 Benefits of Depository System
3.4 Indian Scene
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
The economic growth and the liberalisation of economy specially deregulation of financial
sector has stimulated the growth of capital market's both segments primary market and secondary
market. The financing pattern of industry prior to 1980 was dependent primarily on loans from
financial institutions and internal accruals. It was only after mid eighties that primary market
became prominent. As a result secondary market also took a veritable quantum jump. New.
financial instrument such a convertible debentures appeared in the capital market. New financial
institutions such as merchant banks, leasing companies, mutual funds and venture capital
companies emerged in the scene and there has been growing institutional continuum between
money market and capital market with banks entering into business one normally associates with
the capital market by floating mutual funds and going into leasing, venture capital and factoring
finance. The proliferation of financial institutions and instruments has provided the saver with a
wider choice of asset depending upon his perception of risk, liquidity and yield, and has begun to
impart a measure of competition in financial services. In this background it was felt that if the
capital market is to continue to be a major source of finance for the growth of corporate sector, it
is necessary that all the players of the market i.e. issuers of securities, investors and
intermediaries, behave in a desirable manner. Thus need was there to set up a regulatory body
and in India emerged Securities and Exchange Board of India (SEBI), SEBI has given a right
direction and tried to create conducive environment for investment culture. SEBI constituted
various committees to review the existing systems in the capital markets. It was observed by G.S.
Patel Committee that the growth of capital market has not matched with supporting infrastructure
to handle the growing volume of paper.
The present system of transfer of ownership of securities is grossly inefficient as every
transaction is required to be executed as per the provisions of Section 108 of the Companies Act
which require physical movement of paper securities to the issuer for registration and ownership.
As per the said section a proper instrument of transfer (transfer deed) duly stamped and executed
 both by the transferor and the transferee must be delivered to the registered office of the
company or to its Registrar or transfer agents with relevant share certificates. Further, every
transfer deed must be presented to the prescribed authority for stamping. This transfer document
to be executed must be appropriately stamped. Without complying with Section 108 no transfer
could be executed. This process of transfer should not take more than two months, stipulated
time for transfer, in Section 113 of the Companies Act or Section 22A of Securities Contracts
(Regulations) Act 1956. Such a tedious system has caused problems like:

- Loss of security scrips

- Transfer by forging
- Delay in transfer
- Bad delivery
- Non-availability of transfer deeds
- High systematic risk exposure.

Besides the limitations stated above another dimension of the share transfer has been the
bottleneck in the manual based settlement system which is obsolete for rapidly growing market.
More than 70,000 transactions take place on Mumbai Stock exchange. Average daily turnover
has been as high 646crores (July 1996) and yearly daily average for 1996-97 was about
400crores. Market capitalisation of securities in India has been to the tune of Rs. 477425 crores
(December 1996).
All these underscored the need for streamlining the transfer of ownership of securities. It
was during 1978 that the then President of Bombay Stock Exchange mooted the idea of paper
free trading in capital market. The idea was to evolve depository system. A depository is an
institution which maintains electronic record of ownership of securities. The storage and
handling of certificates is hence immediately eliminated which generates a reduction in costs like
back office cost for handling, transporting and storing certificates.
It is an institution akin to bank for securities. When an investor hands over securities
depository, investors account credited. The investors depository system account will show their
holdings. His account updated for his transactions of sale and purchase but without physical
movement scrips or transfers deeds. In depository system share certificates belonging the
investors are dematerialised and their names are entered the records of depository as beneficial
owners. The beneficial ownership will be with investor but legal ownership will be with the
depository. Consequently benefits like interest, dividend, rights, bonus and voting rights will be
with the investors. Since depository is to get securities transferred in its name, the depository
name will be registered in the ownership register maintained by the company. Thus instead name
several owners, the name depository figures in the register of company. Since transfer will
affected only in depository, register of company need not updated on every transactions of sale
or purchase of company's share.

2. OBJECTIVES
After reading the lesson, you should be able to
(a) Define the concept of depository system and its benefits.
(b) Explain the modus operandi of materialization/rematerialisation.
 (c) Describe the amendments made in various Acts for the smooth operation of depositories.

3. PRESENTATION OF CONTENTS
3.1 CONCEPTS IN DEPOSITORY SYSTEM
There are certain concepts which are peculiar to depositary system. Investors in depository
system do not have direct contact with 'depository. They are to operate through a ‘participant’.
The depository 'dematerialise' the securities scrips which can also be 'rematerialise'. All the
securities held depository are ‘fungible’. These are certain concepts which are deliberated the
following pages in Indian context.

a) Depository
It is an organisation where the securities are held in the electronic form. A depository has to
- be registered itself as
- a corporate body under Companies Act, 1956
- Registered as depository with SEBI.
- Prepare the bye-laws with the previous approval SEBI.
- Obtain a certificate of commencement of business from SEBI.
- Develop automatic data processing systems project to project against unauthorised
access.
- Create network link up with depository participants, issuers and issuer's agent.
- Prepare detailed operations manual.

Depositories can render through participants, any service connected with recording of
(a) Allotment of securities; and
(b) transfer ownership securities

The depository services are available in respect of the securities as may be specified by
SEBI. The eligibility criteria for admission of securities into depository shall also be determined
by SEBI Regulations. Depository shall have a net worth of rupees one hundred crores.
Instruments for which depository mode is open need not be a security as defined in the Securities
Contract (Regulations) Act 1956. The depository holding securities shall maintain ownership
records in the name of the each participant. Despite that legal ownership is with depository. It
does not have any voting right against the securities held by it.

b) Depository Participant
Depository Participant (DP) is an agent of depository. It functions as a link between the
depository and the beneficial owner of the securities. DP has to get itself registered as such under
the SEBI Act. The relationship between the depository and the DP will be of a principal and
agent and their relation will be governed by the bye-laws of the depository and the agreement
between them. To be eligible as applicant for DP the applicant should belong to any of the
following categories:
i) Public Financial Institution
ii) Scheduled Commercial Bank
iii) Foreign bank with approval of RBI
iv) State Financial Corporation
 v) Any Finance Service agency promoted by institutions in (i) to (iv).
vi) Custodian of securities registered under SEBI.
vii) Clearing corporation of a stock exchange.
viii) Registered stock broker with minimum net worth of Rs. 50lakhs.
ix) NBFC with net worth not less than Rs. fifty lakhs.
Application for registration as DP is to be submitted through depository with
which it wants to be associated. The registration granted is valid for five years and can be
renewed. Depository holding the securities shall maintain ownership records in the name of each
DP. DP is return as an agent of depository shall maintain ownership records of every beneficial
owner (investor) in book entry form.

c.) Demateriallise
It is a process by which the physical certificates of an investor are taken back by the
company or its registrar, destroyed and an equivalent number of securities are credited in the
electronic holdings of that investor. Dematerialisation is also known as immobilisation of
securities. Dematerialisation can be done only on the request made by the investor through
participant in a Dematerialisation Request Form (DRF). On the other hand Rematerialisation' is a
process reverse to materialisation. If refers to the process of converting electronic holdings back
into physical share certificate. The DP forwards the request of the beneficial owner for
rematerialisation to the Depository, which after verifying the necessary securities balances will
intimate the registrar to print the necessary certificate and dispatch to the investor. This process
is undergone when the beneficial owner wants to disassociate from the depository system.

d.) Fungibility
Primarily Companies Act, 1956 requires every specific physical scrip of security as
shares or debentures should have distinctive number for each security when issued or transferred.
Under the depository system the securities are to be fungible. Securities have been made fungible
by deleting Section 83 of the Companies Act, 1956. Now the certificates will not carry a distinct
number and will form a part of a ‘fungible mass’. All the certificate of the same security will
become interchangeable in the sense that the owner of the security will lose the right to obtain
the exact certificate. The situation of certificate is now that of currency note. The number of
currency note does not matter what matters is ownership.

3.2 MODUS OPERANDI DEMATERILISATION OF REMATERIALISATION

It is not obligatory on the investor that he holds his securities only in depository mode.
He, when issue is made, is given an option either to accept depository or hold physical securities.
Similarly for existing securities he may opt for any of the two alternatives. In general the
mechanism of dematerialization and materialization is as under:-
An investor before getting his holding dematerialised has to enter into an agreement with
the depository through a participant This step is necessary whether investor already has securities
or securities are issued in a fresh issue. The investor contracts only with that depository which
accepts his securities in 'depository mode' since it is not necessary that all eligible securities must
be in depository mode and with all the depositories. The decision on whether or not to be hold
securities within the depository mode and if in depository mede, which depository or participant,
would be entirely with the investor. He will also have the freedom to switch from depository
mode to nondepository mode and vice-versa.
 Dematerialisation : Once agreement is entered for getting securities dematerialise and
his account is opened the investor makes an application to depository participant in a
dematerialise request form, which is designed by depository. Along with the application the
securities to be dematerialised are to be enclosed.

On receiving the request for dematerialization the depository participant intimates the
depository of the request through depository network with which DP is connected.
Simultaneously DP submits the securities certificates to the issuer or his Registrar for transfer.

The depository will electronically intimate the issuer or its Registrar and transfer agent of
the dematerialization request.

The issuer or the Registrar and transfer agent has to verify the validity of the security
certificates as well as the fact that the DRF has been made by the person recorded as a number in
its Registrar of Members, if the issuer or its Registrar is satisfied it dematerialises the scrip and
updates its record.

The issuer simultaneously has to inform the depository of the completion of

dematerialisation authorising an electronic credit or that security in favour of the investor.

On such information the depository shall cause the necessary credit entries to be made in
the account of the investor concerned. This intimation is sent to depository participant by the
depository. If the issuer, rejects any dematerialisation request it is again electronically
communicated to the depository by the issuer and by depository to depository participant.

The depository participant on receiving the information from the depository updates its
accounts and enters the name of the invester in its records as beneficial owner.

In this way dematerialisation is complete. Graphically it is explained in chart-I.

Investor
Updates records and
 Submit Confirms dematerialisation
Certificate

Deposilry Participant Updates

records and
Submit Certificate
confirms
Forwards Dematerialisation
Registrer dematerialisation
request
Depository
Confirms
request

Uploads records
and conforms
dematerialization

Chart-I Dematerialisation Process

Rematerialisation: Once security is dematerialised it is not obligatory to the investor to

continue to depository mode. He can switch over to rematerialisation thereby he gets back
physical possession of security scrips.

The client of DP has to submit a request for rematerialisation. This request is forwarded
for necessary action to depository. The depository confirms the rematerialisation request to the
Registrar and Transfer Agents. The Registrar updates the accounts and print the desired
certificates. The depository is informed by Registrar and certificate is sent to the investor. The
depository updates its records and communicate to DP to incorporate necessary changes in the
account of the client. This process is explained in Chart-II.

Investor
 Requests for
rematerialisation

Despatch
Certificates
Depository Participant

Intimate about
request for rematerialisation

Register Depository

Confirms
Rematerialisation

Free Transferability of Securities

It is a concept which constitutes the real strength of the depository system. It ensures
"Delivery Vs. Payment system wherein there is a simultaneous flow of share and money in
opposite directions. On receipt of information regarding settlement of purchase transaction, the
transfer of a security is effected immediately and the transferee enjoys all the rights and
obligations associated with the securities. In broader context also, if a purchase transaction is
settled, no one including the issuer, depositor, participant or even regulatory body can withhold
the transfer of security. This feature has been incorporated by inserting Section 111A in the
Companies a 1956. The company's right to use discretion in effecting transfer d securities has
been taken away by deleting Section 22A from Securities Contract (Regulation) Act, 1956. But
still a safety point s built in. If it is felt that the transfer has contravened any of the provisions of
SEBI Act 1992 or Regulations made there under of S Individual Companies (Special Provision)
Act, 1985, the company, depository, participant, investor or SEBI can move an application the
Central Government to determine if the alleged contravention has really taken place. After
inquiry if the Central Government is satisfied of the contravention, it can direct the company or
the depository acetify the ownership records of securities.

3.3 BENEFITS OF DEPOSITORY SYSTEM

The International Organisation of Securities Commission (IOSCO) has done a study of
stock markets in developed countries which showed that all emerging markets were typically
characterized by delays in settlement and clearness and trading inefficiencies. The conclusion
was that to set up a modern market system, a good clearance and settlement system is imperative.
And this is where the depository comes in. Depository does not guarantee to eliminate al the
problems of the market. But certainly, it gives a new life to market and ensures greater depth.
 Depository system is expected to improve the investment culture in the economy and benefit all
concerned with it. The main benefits can be mentioned as:

(a) Increased Liquidity

Depository system is expected to bring about much needed liquidity in the capital market.
It can be achieved since the system has features of speedier settlement and reduction in delays
in registration. The funds used to be blocked during the period of settlement and transfer is
released very quickly.

(b) Protection from Physical Risks of Becurition

Since depository is to have a scrip less capital market, exchange of physical scrips is not
desired. Thus the risk of loss, mutilation, theft and forgery of security certificates is nil.
Financial loss owing to loss of physical scrip will no longer haunt the investors.

(c) Faster and Safe Receipt of Benefits

Depositories pass on the benefits and rights to the transferee quickly since the whole system is
efficient and automated. Time lost in communication too is very low. Fraudulent encashment of
dividend warrants and loss of bonus or rights can be avoided.

(d) Reduced Cost

Due to greater efficiency the transaction cost is reduced. There would not be any stamp
duty. The charges by DP and depositories are also expected to be very nominal for the services
rendered by them.

(e) Innovative Instruments

When depository system will operate with complete infrastructure and all features, investors
will get greater opportunities for investment through new instruments.

(f) Tracking Takeover Bids is Easy

Once the dematerialisation is compulsory, it will be very convenient for the issuer to have
updated knowledge of shareholders names and addresses. Since every transaction is recorded
immediately, the parties making a bid to takeover can easily be identified.

(g) Check on Manipulation of Securities Process

By virtue of depository system, no one can hold shares for a longer period especially the
issuers who, many a times withheld securities which come to them for transfer. On account of
such withholding the market price of securities go up. Such ill practices can be eliminated
through dematerialisation.

(h) Attractive Propositions for FIIs

The growth of depository system is a signal of maturity of capital market to investors
especially foreign institutional investors. Moreover the issuer company need not make issues
in overseas.

(i) Restoring faith in Capital Market

 Depositories minimise the settlement risks and fraud due to least paper work and manual
handling. Payment defaults are minimised since the transactions recorded in depository is on
"Delivery Vs. Payment system"

(j) Pledging becomes Simpler

Many times investors pledge their securities to seek loans Since the investor has an account
with the DP and depository, he is just to inform the depository about such pledge and
communicate to bank about depository's consent about pledging. The entry in investors account
in DP is sufficient to give an evidence of pledge.

3.4 INDIAN SCENE

Depository in India is of very recent origin. The process started after Stock Holding
Corporation of India (SHCIL) circulated the concept paper on depository system. A technical
group was formed to review and suggest a modern settlement and depository system for
securities transactions. The group suggested multiple depositories while the then Finance
Minister Dr. Manmohan Singh in his budget speech hinted at setting up a Central Depository in
India which will suit Indian conditions. After a gap of more than two years on 20.9.1995 the
Depository Ordinance was promulgated by the President of India. It enabled the setting up of
multiple depository system. The Securities and Exchange Board of India (SEBI) issued
guidelines for depositories in May 1996. To facilitate the infrastructural set up for the
depositories Ordinance has amended many enactments which were hurdles in making the system
to go. To provide for smooth operation of the depositories the following Acts were amended:

The Income Tax Act, 1961

- The Benami Transaction (Prohibition) Act, 1988
- The Securities and Exchange Board of India Act, 1992
- The Indian Stamp Act, 1899
- The Companies Act, 1956
- The Securities Contracts (Regulation) Act, 1956
The implications of the these amendments are given below:

Income Tax Act, 1961

The depositories as well as the participants will not be liable to pay any capital gains tax
in respect of profits or gains arising from transfer of securities held in depositories and transacted
from time to time since these securities are held on behalf of the beneficial owners. In other
words, inter-se transfer of securities between the participants in the books of a depository as well
as between the depositories in the records of an issuer shall not be treated as transfer unless it
involves any change in the beneficial ownership, only the beneficial owner shall be chargeable to
capital gains tax, not the registered owner. Due to fungible characteristic of the securities, while
calculating capital gains tax, the cost of acquisition of securities and the period of holding the
securities shall not be determined of specific with reference to cost of acquisition identifiable
securities, but be ascertained on the principle of first out. That is, the securities acquired first by
the beneficial owner would be deemed to have been transferred first irrespective of the intention
of the investor. This principle is applicable only in respect of securities held in depository.

The Benami Transactions (Prohibition) Act, 1988

 The provision of Section 3 shall not apply to securities held by a depository as registered
owner of security or by a participant as an agent of a depository.

The Securities and Exchange Board of India Act, 1992

These sections have been amended to enlarge the jurisdiction of SEBI over participants.
SEBI has been authorised to register and regulate the working of participants as well.
The Central Government has been empowered to give directions under the Depositories
Ordinance to SEBI which will be bound by such directions.

The Indian Stamp Act, 1899

1. At the time of fresh issue of securities through the record of a depository, the issuer would
pay stamp duty even though there will be no security certificates which can be stamped.
2. Where an investor exits from a depository and seeks security certificates, stamp duty is
payable at the rate as if it is an issue of duplicate certificate.
3. Where an investor enters into a depository by surrendering share certificates, no stamp duty
is payable, even though registered ownership changes from the shareholder to the depository.
However, if the investor surrenders a security other than shares, he is liable to pay stamp
duty.
4. No stamp duty is payable on any transfer of shares within a depository. Stamp duty is,
however, payable on transfer of any security other than shares within the depository and on
transfer of any security outside the depository.

The Companies Act, 1956

1. Any person whose name appears on the records of a depository and who holds equity share
capital of a company is deemed to be a member of the concerned company even if his name
does not appear on the register of members of the company maintained by the company.

It may be noted that reference has been made only to holders of equity shares and persons
holding preference shares and whose names are entered as beneficial owners in the records of the
depository have not been covered, although Section 10 of the Ordinance provides that the
beneficial owner shall be entitled to all the rights including the right to vote in respect of the
securities held by the depository.

2. Section 49 requires that all investments made by a company on its own behalf shall be made
and held by it in its own name. The new clause (C) provides an exemption and enables a
company to hold the securities in the name of the depositories instead of its own name.

3. The depository can serve the records of beneficial owners of the company by means of
electronic made or by delivery of floppies or discs.

4. The requirement of distinguishing each share in a company by an appropriate number is no

more mandatory. However, a company can continue to have distinguishing numbers.

5. Section 108 requires that for registering a transfer of shares or debentures, a duly stamped
instrument satisfying the prescribed conditions should be delivered to the company
accompanied by the certificate or letter of allotment relating to the shares or debentures.
 These requirements shall not be applicable in respect of transfer of securities where both the
transfer or and the transferee are entered as beneficial owners in the records of depository.
Section Ill empowers a company to refuse to register security transfers in pursuance of any
power of the company under its articles or otherwise by providing notice and giving reasons
for refusal. These provisions would now apply to transfer of securities of a private company
or deemed public company only.

6. The securities of a company other than a private company or deemed public company have
been made freely transferable. The Board of Directors of such company or the concerned
depository does not have any discretion to refuse or withhold transfer of any security. The
transfer has to be effected immediately and automatically by the company/depository.
However, if it is felt that the transfer is an contravention of any of the provisions of the SEBI
Act, 1992 or any regulations made thereunder or SICA 1985, the concerned company,
depository participant, investor or SEBI can, within two months from the date of transfer on
the depository or from the date the instrument of transfer or the intimation of transmission
was delivered to the company, move an application to Central Govt. to determine if the
alleged contravention has taken place. After enquiry, if the Central Govt. is satisfied of the
contravention, it can direct the company/depository to rectify ownership records of
securities. However, before completion of enquiry, the Central Govt. can suspend voting
rights in respect of securities so transferred. The economic rights cannot be suspended even
if the security and such further transfer would entitle the transferee to the visiting rights also
under the voting rights in case of transfer have also been suspended by Central Govt. In
other words, a person in respect of whom voting rights have been suspended, can transfer the
security to another person who would be entitled to voting rights.

7. Section 113 provides time limit for issue of security certificates. These would continue to
apply to allotment of securities made directly to investors. However, where the securities are
allotted through a depository, the company is required to intimate the concerned depository,
the details of allotment made in favour of investors immediately on allotment.

8. The register of members shall indicate the shares held by member but such shares need not
be distinguished by a distinct number.

9. The register of debenture holders shall indicate the debentures held by a holder but such
debentures need not be distinguished by distinct numbers.

10. The register and index of beneficial owners maintained by depositories are deemed to be
register and index of members/debenture holders of the company, even though these are not
maintained by the company. The beneficial owners would exercise the same rights and be
subject to same liability as if they were members or debenture holders.

11. The company is required to indicate in the offer document that an vestor has the option to
subscribe for securities in the depository mode.

12. The Sections 153, 153A, 153B, 187B, 187C and 372 of the Companies Act have been made
inapplicable to securities held in a depository on behalf of the beneficial owners.
Securities Contract (Regulations) Act 1956

1. Spot delivery contract means a contract which provides either for actual delivery or
constructive delivery through a depository.
2. Section 22 A provided that a company may refuse to register transfer of any of its securities
in the name of the transferee for any of the reasons specified therein. The grounds for refusal
by companies have been deleted and the securities have become freely transferable.

Important Procedures of SEBI (Depositories and Participantal Regulations, 1996

On 16th May, 1996 SEBI came out with SEBI (Depository and Participant) Regulations
1996. It provides for registration of depositories and depository participants, the eligibility
requirements for sponsors and participants, the rights and obligations of depositories participants,
and issuers to make depository system function efficiently. (Main provisions are given an
Annexure-I) Depository Bill to replace the Depository Ordinance was introduced by the then
Finance Minister P. Chidambarm on 10-07-1996. India's first depository the National Securities
Depository Limited (NSDL) was inaugurated on 8 November, 1996. It was prompted by
Industrial Development Bank of India, Unit Trust of India and the National Stock Exchange.
29th November, 1996 was a red letter day for Indian Capital Market as in more than 100 years
history of stock exchanges in India, for the first time National Stock Exchange witnessed trade in
dematerialised scrips of and Indian Company i.e. Reliance Industries. The very first lot of
transaction was as expected at premium in comparison to prevailing price for physical delivery
due to inherent qualities of quick settlement, clean deliveries and the exemptions from stamp
duty. To make the system make operating on large scale, Government of India promulgated to
amend the Depository Act to enable the shares of statutory bodies such an IDBI, SBI, UTI and
other public sector banks and the units of mutual funds. The important provisions of SEBI
(Depositories and Participants) Regulations, 1996 are as follows:

Registration
After considering the application with reference to the qualifications specified (in
regulation 6) if the Board (SEB1) is satisfied that the company established by the sponsor is
eligible to act as depository subject to the following namely:

(a) The depository shall pay the registration fee specified in Part-A of the Second Schedule in
the manner specified in Part B thereof, within fifteen days of receipt of intimation from the
Board;
(b) The depository shall comply with the provisions of the Act, the Depositories Ordinance, the
bye-laws, agreement and these regulations;
(c) The depository shall not carry on any activity other than that of a depository unless the
activity is incidental to the activity of the depository.
(d) The sponsor shall, at all items, hold atleast fifty-one per cent of the depository and the
balance of the equity capital of the depository its participants;
(e) No participants shall at any time, hold more than five per cent of the equity capital of the
depository;
(f) if any information previously submitted by the depository or the sponsor to the Board is
found to be false or misleading in any material particular, or if there is any change in such
information, the depository shall forthwith inform the Board in writing:
(g) the depository shall redress the grievances of the participants and the beneficial owners
within thirty days of the date of receipt of any complaint from a participant or a beneficial
owner and keep the Board informed about the number and the nature of redressals;
(h) the depository shall make an application far commencement of business under regulation 14
within one year from the date of grant of certificate of registration under this regulation; and
the depositary shall amend its by laws as directed by SEBI.

Power of depositories to make bye-laws

(1) A depository shall, with the previous approval of the Board, make bye-laws consistent with
tile provisions of the Ordinance and the regulations.
(2) In particular and without prejudice to the generally of the foregoing power, such byelaws
shall provide for -
(a) the eligibility criteria for admission and removal of securities in the depositary;
(b) the conditions subject to which the securities shall be dealt with;
(c) the eligibility criteria for admission of any person as a participant;
(d) the manner and procedure for dematerialisation of securities;
(e) the procedure of transactions within the depositary;
(f) The manner in which securities shall be dealt with or withdrawn from a depository;
(g) the procedure for ensuring safeguards to protect the interests of participants and
beneficial owners;
(h) the conditions of admission into and withdrawal from a participant by a beneficial owner,
(i) the procedure for conveying information to the participants and beneficial owners on
dividend declaration, shareholder meetings, another matters of interest to the beneficial
owners;
(j) the manner of distribution of dividends, interest and monetary benefits received from the
company among beneficial owners.
(k) the manner of creating pledge or hypothecation in respect of securities held with a
depository;
(l) Inter-se rights and obligations among the depository, issuer participants and beneficial
owners;
(m) the manner and the periodicity of furnishing information;
(n) the procedure for resolving disputes involving depository, Issuer company or a beneficial
owner;
(o) the procedure for proceeding against the participant committing beach of the regulations
and provisions for suspension and expulsion of participants from the depository and
cancellation of agreement entered with the depository,
(p) the internal control standards including procedure for auditing reviewing and monitoring.

(3) Where the Board considers it expedient so to do, it may be order in writing, direct a
depository to make any bye-laws or to amend or revoke nay bye-laws already made within
such period as it may specify in this behalf.
(4) If the depository fails to neglects to comply with such order within the specified period, the
Board may make bye-laws or amend or revoke the bye-laws made either in the form
specified in the order or with such modifications thereof as the Board thinks fit.

Certificate of Commencement of Business

(1) The Board shall take into account for considering grant of certificate of commencement of
business, all matters which are relevant to the efficient and orderly functioning of the
depository and in particular, the following namely, whether –
(a) the depository has a net worth of not less than rupees one hundred crore;
(b) the bye-laws of the depository have been approved by the Board;
(c) the automatic data processing systems of the depository have been protected against
unauthorized access, alteration, destruction, disclosure of dissemination of records and
data ;
(d) the network through which continuous electronic means of communications are
established between the depository participants, issuers and issuers, agents is secure
against unauthorised entry or access.
(e) the depository has established standard transmission and encryption formats for electronic
communications of data between the depository, participants, issuers and issuers agents;
(f) the physical or electronic access to the premises, facilities, automatic data processing
systems, data storage sites and facilities including back up sites and facilities, and to the
electronic data communication network connecting the depository, participants, issuers
and issuers agents is controller, monitored and recorded.
(g) the depository has a detailed operations manual explaining all aspects of its functioning,
including the interface and method of transmission of information between the depository
issuers, issuer's agents, participants and beneficial owners;
(h) the depository has established adequate procedures and facilities to ensure that its records
are protected against the loss or destruction and arrangements have been made for
maintaining back up facilities at a location different from that of the depository;
(i) the depository has made adequate arrangements including insurance for indemnifying the
beneficial owners for any loss that may be caused to such beneficial owners by the
wrongful act, negligence of default of the depository or its participants or any employee
of the depository or participants and
(j) the grant of certificate of commencement of business is in the interest of investor in the
securities market.

(2) The Board shall, before granting a certificate of commencement of business makes a physical
verifications of the infrastructure facilities and systems established by the depository.

Records to be maintained by depository

(1) Every depository shall maintain the following records and documents namely;
(a) records of securities dematerialised and rematerialised;
(b) the names of the transfer or, transferee and the dates of transfer of securities;
(c) a register and an index of beneficial owners;
(d) records of instructions received from the sent to participants, issuers, issues agents and
beneficial owners;
 (e) records of approval, notice, entry and cancellation or pledge or hypothecation, as the case
may be;
(f) details of participants
(g) details of securities declared to be eligible for dematerialisation in the depository; and
(h) such other records may be specified by the Board for carrying on the activities as a
depository.

(2) Every depository shall intimate the Board the place where the records and documents are
maintained.
(3) Subject to the provisions of any other law, the depository shall reserve records and
documents for a minimum period of five years.

Co-operation with other entities

Every depository shall extend such co-operating to the beneficial owners, issuers, issues
agents, custodians of securities, other depositories and clearing organization as is necessary for
the effective, prompt and accurate clearance and settlement of securities transactions and conduct
of business.

4 SUMMARY
Depository system essentially aims at eliminating the voluminous and cumbersome paper
work involved in the scrip-based system and offers scope for paperless trading through state-of-
the-art technology. It is an institution akin to bank for securities. When an investor hands over
securities to a depository, investor's account is credited. A depository participant is investors
representative in the depository system. Dematerialisation is a process by which investors'
physical share certificates are taken back by the company through depository participant verified
and if found in order an equivalent number of shares are credited in the electronic holdings of
that investor. Rematerialisation is a process of converting electronic holdings of investor back
into share certificates in paper form. The emergence of depository system is a sign of prosperity
of financial market system and it makes the market more systematic and disciplined. To make
depository regulations effective amendments have been done on large scale in various states to
make the system work smoothly.

5. SUGGESTED READINGS

1. Khan, M.Y., Financial Services, Tata McGraw Hill, New Delhi.

2. Machiraju, H.R., Indian Financial System, Vikas Publishing H
3. ouse Pvt. Ltd., New Delhi.
4. Avadhani, V.A., Marketing of Financial Services, Himalya Publishing House, Delhi.
5. Bhole, L.M., Financial Institutions and Market, Tata McGraw Hill,Delhi.

6. SELF ASSESSMENT QUESTIONS

1. What is the concept and purpose of depository? What are the constituents of depository
system?
2. Explain the process of (a) dematerialization and (b) rematerialisation.
3. "SEBI has attempted to make depository system and efficient system". Comment.
 VENTURE CAPITAL

STRUCTURE
1. Introduction
2. Objective
3. Presentation of Contents
3.1 Concept of Venture Capital
3.2 Scope of Venture Capital
3.3 Steps to Provide Venture Capital
3.4 Importance of Venture Capital
3.5 Origin
3.6 Initiative in India
3.7 Methods of Venture Financing
3.8 Indian Experience
3.9 Suggestion for the growth of venture capital funds
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
Venture capital is a growing business of recent origin in the area of industrial financing in
India. The various financial institutions set up in India to promote industries have done
commendable work. However, these institutions do not come upto the benefit of risky ventures
when they are undertaken by new or relatively unknown entrepreneurs. They contend to give
 debt finance, mostly in the form of term loans to the promoters and their functioning has been
more firm, it is a simultaneous input of skill needed to set up the firm, design its marketing
strategy and organise and manage it. It is an association with successive stages of firm's
development with distinctive types of financing appropriate to each development.
Venture capital is long term risk capital to finance high technology projects which
involve risk but at the same time has strong potential for growth. Venture capitalist pool their
resources including managerial abilities to assist new entrepreneurs in the early years of the
project. Once the project reaches the stage of profitability, they sell their equity holdings at high
premium. A venture capital company is defined as "a financing institution which joins an
entrepreneur as a co-promote in a project and shares the risks and rewards of the enterprise."

Features of venture capital: Some of the features of venture capital financing are as under:

1. Venture capital is usually in the form of an equity participation. It may also take the form of
convertible debt or long term loan.
2. Investment is made only in high risk but high growth potential projects.
3. Venture capital is available only for commercialisation of new ideas or new technologies and
not for enterprises which are engaged in trading, booking, financial services, agency, liaison
work or research and development.
4. Venture capitalist joins the entrepreneur as a co-promoter in projects and share the risks and
rewards of the enterprise.
5. There is continuous involvement in business after making an investment by the investor.
6. Once the venture has reached the full potential the venture capitalist disinvests his holdings
either to the promoters or in the market. The basic objective of investment is not profit but
capital appreciation at the time of disinvestments.
7. Venture capital is not just injection of money but also an input needed to setup the firm,
design it's marketing strategy and organise and manage it.
8. Investment is usually made in small and medium scale enterprises.

Disinvest Mechanism
The objective of venture capitalist is to sell of the investment made by him at substantial
capital gains. The disinvestments options available in developed countries are: (i) Promoter's buy
back (ii) Public issue (iii) Sale to other venture capital Funds (iv) Sale in OTC market and (v)
Management buyouts..
In India, the most popular investment route is promoter's buy back. This permits the
ownership and control of the promoter in tact, The Risk Capital and Technology Finance
Corporation, CAN -VCF etc., in India allow promoters to buy back equity of their enterprise.
The public issue would be difficult and expensive since for a generation entrepreneurs are
not known in the capital market. The option involves high transaction cost and also less feasible
for small ventures on account of high listing requirements of the stock exchange. The OTC
Exchange in India has been set up in 1992. It is hoped that OTCEI would provide disinvestment
opportunities to venture capital firms. The other investment options such as management buyout
or sale to other venture capital fund are not considered appropriaté in India.

3.2 SCOPE OF VENTURE CAPITAL

 Venture capital may take various forms at different stages of the project. There are four
successive stages of development of a project viz. development of a project idea, implementation
of the idea, commercial production and marketing and finally large scale investment to exploit
the economics of scale and achieve stability. Financial institutions and banks usually start
financing the project only at the second or third stage but rarely from the first stage. But venture
capitalists provide finance even from the first stage of idea formulation. The various stages in the
financing of venture capital are described below:

(1) Development of an Idea - Seed Finance: In the initial stage venture capitalists provide
see capital for translating an idea into business proposition. At this stage investigation is
made in-depth which normally takes a year or more.

(2) Inplementation Stage - Start up Finance: When the firm is set up to manufacture a
product or provide a service, start up finance is provided by the venture capitalists. The
first and second stage capital is used for full scale manufacturing and further business
growth.
(3) Fledging Stage :- Additional Finance: In the third stage, the firm has made some
headway and entered the stage of manufacturing a product but faces teething problem. It
may not be able to generate adequate funds and so additional round of financing is
provided to develop the marketing infrastructure.

(4) Establishment Stage:-Establishment Finance: At this stage the firm is established in the
market and expected to expand at a rapid pace. It needs further financing for expansion
and diversification so that is can reap economics of scale and attain stability. At the end
of the establishment stage, the firm is listed on the stock exchange and at this point the
venture capitalist disinvests their shareholdings through available exist routes.

Before investing in small, new or young hi-tech enterprises, the venture capitalists
look for percentage of key success factors of a venture capital project. They prefer projects
that address these problems.
After assessing the viability of projects, the investors decide for what stage they should
provide venture capital so that it leads to greater capital appreciation. All the above stages of
finance involve varying degrees of risks-and venture capital industry, only after analysing such
risks, invest in one or more. Hence they specialize in one or more but rarely all.

3.3 STEPS TO PROVIDE VENTURE CAPTFAL

a) Selecting Investment proposal
Depending on thrust with which venture capitalist is operating the business plan of the
entrepreneur is studied by venture capitalist. Selection of the venture is made by viewing the
stage and types of investments it is evaluating. Internal as well as external factors are considered,
internal being management and technology and external are like industry environment, industry
structure, market- potential etc.

b) Financial analysis
Financial analysis of venture capital proposal is not similar to conventional investment
proposals. It has to be appreciated that such investment proposals are idea based and growth
 based rather than 'asset-based'. Venture Capitalist is more interested in the value of the company
at time of potential exit as this would form the basis of his own profitability, which depends
crucially on his capital gains at exit time.

c) Mode of investment
In what form venture capital is to be provided, is a crucial decision. All types of investment
instruments available are to be weighed against 'risk-return' model in the given context. The
venture capital deal has to be structured targeting maximum value of the venture capitalist.

d) Monitoring
Like other financing agencies, venture capitalist continue to have association with assisted
project. They play an active role in the management of the venture unlike other financing
agencies. Their target is 'investment nurturing’ so their involvement is more intimate and
constant during the entire life of the investment. They ensure proper utilisation of assistance
provided, check cost and time over run and make sure that no statutory defaults are made. They
seek periodical reports, visit the plant, have personal discussion with the entrepreneurs, get
feedback from resource persons and feed back through nominee directors.

e) Valuing the portfolio

Venture Capitalist has an ultimate target to exit at an opportune time. To decide opportune time
it is necessary that he constantly values his portfolio. Only on valuing the portfolio he gets an
idea about his capital gain. He targets to assess the fair value of the investment at a particular
point of time. The valuing technique should be such which incorporates accounting and financial
point of view as well as stages of investment The valuation basis should be consistent fair and
conservative.

f) Exit
Exit is a pre requisite for capital gain to the venture capitalist. Exit time has to be planned
broadly at the time of entering contract for venture capital. Exit time decision is not solely of
venture capitalist. Interest of the entrepreneur is also to be taken in account to decide exit time.
Exit can be by disposing of investment through many avenues like:
A) Making public issue
B) Sale to entrepreneurs
C) Private placement to a new investor

3.4 IMPORTANCE OF VENTURE CAPITAL

Venture Capital is of great practical value to every corporate enterprise in modern times.

I. Advantage to Investing Public

1. The investing public will be able to reduce risk significantly against unscrupulous
management, if the public invest in venture fund who in turn will invest in equity of new
business. With their expertise in the field and continuous involvement in the business they
would be able to stop malpractices by management.
 2. Investor have no means to vouch for the reasonableness of the claims made by the promoters
about profitability of the business. The venture funds equipped with necessary skills will be
able to analyses the prospects of the business.

3. The investors do not have any means to ensure that the affairs of the business are conducted
prudently. The venture fund having representatives on the Board of Directors of the company
would overcome it.

II. Advantages to Promoters

1. The entrepreneur for the success of public issue is required to convince tens of underwriters,
brokers and thousands of investors but to obtain venture capital assistance, he will be
required to sell his idea to justify the officials of the venture fund.

2. Public issue of equity shares has to be proceeded by a lot of efforts viz. necessary statutory
sanctions, underwriting and brokers arrangement, publicity of issue etc. The new
entrepreneurs find it very difficult to make underwriting arrangements which involves a great
deal of effort. Venture fund assistance would eliminate those efforts by leaving entrepreneur
to concentrate upon bread and butter activities of business.

3. Costs of public issues of equity share often range between 10 percent to 15 percent of
nominal value of issue of moderate size, which are often even higher for small issues. The
company is required, in addition to above, to incur recurring costs for maintenance of share
registry cell, stock exchange listing fee, expenditure on printing and posting of annual reports
etc. These items of expenditure can be ill afforded by the business when it is new. Assistance
from venture fund does not require such expenditure.

III. General
1. A developed venture capital institutional set up reduces the time lag between a technological
innovation and its commercial exploitation.
2. It helps in developing new processes/products in conducive atmosphere, free from the dead
weight of corporate bureaucracy, which helps in exploiting full potential.
3. Venture capital acts as a cushion to support business borrowings, as bankers and investors
will not lend money with, inadequate margin of equity capital.
4. Once venture capital start earning profits, will very easy them raise resources from primary
capital market in the form equity and debts. Therefore, the investors would be able to invest
in new business through venture funds and, at the same time, they can directly invest existing
business when venture fund disposes its own holding. This mechanism will help to
channelise investment in new high-tech business or the existing sick business. These business
will take-off with the help of finance from venture funds and this would help in increasing
productivity, better capacity utilisation etc.
5. The economy with well developed venture capital network induces the entry of large number
of technocrats in industry, helps in stabilizing industries and in creating a new set of trained
technocrats build and manage medium and large industries, resulting in faster industrial
development.
 6. A venture capital firm serves as an intermediary between investors looking for high returns
for their money and entrepreneurs in search of needed capital for their start ups.
7. It also paves the way for private sector to share the responsibility with public sector.

3.5 ORIGIN
Venture capital as new phenomenon originated in USA and developed spectacularly
world wide since the second half of the seventies. American Research and Development
Corporation, founded by Gen. Doriot soon after the Second World War, is believed to have
heralded the institutionalization of venture capital in the USA. Since then the industry has
developed in many other countries in Europe, North America and Asia. The real development of
venture capital took place in 1958 when the Business Administration Act was passed by the US
Congress. In USA alone there are 800 venture capital firms managing around $40b of capital
with annual accretions of between $1b and 5b. It is reported that some of the present day giants
like Apple, Micro soft, Xerox etc. are the beneficiaries of venture capital.
UK occupies a second place after US in terms of investment in venture capital. The
concept became popular in late sixties in UK. The Government's Business Expansion Scheme
which permitted individuals to claim tax relief for investment in companies not listed in stock
exchange led to the success of venture capital in UK. The CHARTER House Development
Limited is the oldest venture capital company established in 1934 in UK. The Bank of England
established its venture capital company in late 40's. The UK witnessed a massive growth of
industry during 70's and 80's. During 1988 there were over 1000 venture capital companies in
UK which provided Rs.3700crores to over 1500 firms.
The success of venture capital in these countries prompted other countries to design and
implement measures to promote venture capital and their total commitment have been rising.

3.6 INITIATIVE IN INDIA

Indian tradition of venture capital for industry goes back more than 150 years when many
of the managing agency houses acted as venture capitalists providing both finance and
management skill to risky projects. It was the managing agency system through which Tata Iron
and Steels and Empress Mills were able to raise equity capital from the investing public. The
Tata's also initiated a managing agency hours, named Investment Corporation of India in 1937
which by acting as venture capitalist, successfully promoted hi-tech enterprises such as CEAT
tyres, Associated Bearings, National Rayon etc. The early form of venture capital enabled the
entrepreneurs to raise large amount of funds and yet retain management control. After the
abolition of managing agency system, the public sector term lending institutions met a part of
venture capital requirements through seed capital and risk capital for hi tech industries which
were not able to meet promoters, contribution. However, all these institutions supported only
proven and sound technology while technology development remained largely confined to
government labs and academic institutions. Many hi-tech industries, thus, found it impossible to
obtain financial assistance from banks and other financial institutions due to unproven
technology, conservative attitude, risk awareness and rigid security parameters.
Venture capital's growth in India passed through various stages. In 1973, R.S. Bhatt
Committee recommended formation of Rs.100crore venture capital fund. The Seventh Five Year
Plan emphasized the need for developing a system of funding venture capital. The Research and
Development Cess Act was enacted in May 1986 which introduced a cess of 5% on all payments
made for purchase of technology from abroad. The levy provides the source for the venture
capital fund.
United Nations Development Programme in 1987 on behalf of government examined the
possibility of developing venture capital in private sector. Technology Policy Implementation
Committee in the same year also recommended the same provision. Formalized venture capital
took roots when venture capital guidelines were issued by Comptroller of Capital Issues in
November 1988.

Guidelines
The following are the guidelines issued by the Government of india.

1. The public sector financial institutions, State Bank of india, scheduled banks foreign banks
and their subsidiaries are eligible for setting the venture capital funds with a minimum size of
Rs.10crore and a debt equity ratio of 1:1.5. If they desire to raise funds from the public,
promoters will be required to contribute a minimum of 40 per cent of capital. Foreign equity
upto 25 per cent subject to certain conditions would be permitted.
The guidelines provide for Non Resident Indians investment upto 74 per cent on a
repatriable basis and 25 per cent to 40 per cent on a non repatriable basis. It should invest 60
per cent of its funds in venture capital activity. The balance amount can be invested in new
issue of any existing or new company in equity, cumulative convertible preference shares,
debenture, bonds or any other security.

2. The venture capital companies and venture capital funds can be set up as joint venture
between stipulated agencies and non institutional promoters but the equity holding of such
promoters should not exceed 20 per cent and should not be largest single holder.

3. Venture capital assistance should go to enterprises with a total investment of not more than
Rs.10crore.

4. The venture capital company (VCC) /Venture Capital Fund (VCF) should be managed by
professionals and should be independent of the parent organisation.

5. The VCC/VCF will not be allowed to undertake activities such as trading, brooking, money
market operations, bills discounting, inter corporate lending. They will be allowed to invest
in leasing to the extent of 15 per cent of the total funds developed. The investment on revival
of sick units will be treated as a part of venture capital activity.

6. Listing of VCCs/VCF can be according to the prescribed norms and underwriting of issues at
the promoter's discretion.

7. A person holding a position or full time chairman/president, chief executive, managing

director or executive director/whole time director in a company will not be allowed to hold
the same position simultaneously in the VCC/VCF.

8. The Venture Capital assistance should be extended to

(i) The enterprise having investment upto Rs.10crores in the project.
 (ii) The technology involved should be new and untried or it should incorporate significant
improvement over the existing technologies in India.
(iii)The promoters should be new, professionally or technically qualified with inadequate
resources.
(iv) The enterprise should be established in the company form employing professionally
qualified person for maintenance of accounts.

9. Share pricing at the time of disinvestment by a public issue or general sale offer by the
company or fund may be done subject to this being calculated an objective criteria and the
basis disclosed adequately to the public.

3.7 METHODS OF VENTURE FINANCING

Venture capital is available in three forms in India
1. Equity
2. Conditional Loan
3. Income Note.

1. Equity: All VCF's in India provide out generally their contribution does not exceed 49% of
the total equity capital. VCF's buy equity shares of an enterprise with an intention to
ultimately sell of to make capital gain.

2. Conditional Loan: A conditional loan is repayable in the form of royalty after the project
generates sales. No interest is paid on such loans. VCF's charge royalty ranging between 2
and 15 per cent. Some VCF's give a choice to the entrepreneur to pay a high interest rate
instead of royalty on sales once the project becomes commercially sound.

3. Income note: An income note combines the features of both conventional loan and
conditional loan. The entrepreneur has to pay both interest and royalty on sales. Funds are
made available in the form unsecured loans at 9 per cent per year during development phase.
In addition to interest, royalty on sales could also be charged.

3.8 INDIAN EXPERIENCE

The need of venture capital financing was highlighted by the then Union Finance
Minister while presenting the 1986-87 Finance bill. In May 1986, the Research and Development
Cess Bill was introduced in Parliament. The basic idea of this bill was to levy cess on import of
technology in order to raise resources for a venture capital fund to assist enterprises based on
indigenous technology and skill. The bill does not seem to have made much progress. However,
in the budget speech of 1988-89 the finance minister again referred to the need for venture
capital for new entrepreneurs. In the last week of November 1988, the Government of India
finally issued the long awaited guidelines for venture capital financing. These guidelines fulfill
the promise made by the finance minister. It stared getting momentum. By January 1994 ten
venture capital companies had already become operational. The present players can be broadly
classified into four categories:

a) Companies set up by financial institutions.

b) Companies set up by state level financial institution.
 c) Companies set up by commercial banks, and
d) Companies set up in the private sector.

Some of the companies raised resources under close ended. venture capital funds (with
maturity of around 10 to 12 years) and acted primarily as managers of these funds. The others
raised equity capital to support their investment operations.

The restrictions imposed in 1988 guideline did not let venture capital culture flourish. But
still appreciating potential of the medium, Finance Act 1995 provided income tax exemption on
any income by way of dividends or long term capital gains of a venture capital fund or company.
Such exemption is valid only if shares are transferred after 3 years. These exemptions were only
if the Venture Capital Companies are registered with SEBI. It was in February 1996 SEBI came
out with fresh guidelines in form of a consultative paper. These met most of the demands of the
Indian Venture Capital Association. In December 1996 SEBI (Venture Capital Fund)
Regulations 1996 were released.

3.9 SUGGESTION FOR THE GROWTH OF VENTURE CAPITAL FUNDS

Venture capital industry is at the take off stage in India. It can play a catalytic role in the
development of entrepreneurship skill that remains unexploited among the young an energetic
technocrats and other professionally qualified talents. It can help promote new technology and
hi-tech industries, which involve high risk but premises attractive rate of return. In order to
ensure success of venture capital in India, the following suggestions are offered:

1. Exemption/Concession for Capital Gains

Capital gains law represents a hurdle to the success of venture capital financing. The
earnings of the funds depend primarily on the appreciation in stock values. Further, the capital
gains may arise only after 3 to 4 years of investment and that the projects, being in new risky
areas, may not even succeed. Capital gains by corporate bodies in India are taxed at a much
higher rate than gains of individual investors. Taking into account the high investment risk and
long gestation period this is a deterrent to the development of VCF.
The benefit of capital gains, under section 48 of the Act is not significant. Hence, it
would be advisable that all long term capital pine earned by VCCs should be exempted from tax
or subjected to confessional flat rate. Further, capital gains reinvested in new ventures should
also be exempted from tax.

2. Development of Stock Markets

Guidelines issued by finance ministry provides for the sale of investment by way of
public issue at the price to be decided on the basis of book value and earning capacity. However,
this method may not give the best available prices to venture fund as it will not be able to
consider the future growth potential of the invested company.
One of the major factor which contributed to the success of venture funds in the West is
development of secondary and tertiary stock markets. These markets do not have listing
requirements and are spread over all important cities and towns in the country. These stock
markets provide excellent disinvestment mechanism for venture funds. In India, however, stock
market is not developed beyond a few important cities.
 Success of venture capital fund depends very much upon profitable disinvestment of the
capital contributed by it. In US and UK, secondary and tertiary markets helped in accomplishing
the above. However, in India, promotion of such makes is not feasible in the prevailing
circumstances as such laissez faire policy may attack persons with ulterior motives in the
business to the determent of the general public. However, stock market operation may be started
many more big cities where, say, the number of stock exchanges can be increased to 50. Further,
permission to transact in unlisted securities with suitable regulation will ensure first hand contact
between venture fund and investors.

3. Fiscal Incentives
Fiscal incentives may be given in the form of lowering the rate of Income Tax. It can be
accomplished by:

(i) Application of provisions applicable to non-corporate entities for taxing long term capital
gains.
(ii) An allowance to funds similar to Section 80-CC of Income Tax Act, say 20 per cent of
the investment in new venture which can be allowed as deduction from the income.
4. Private Sector Participation
In US and UK where the economy is dominated by private sector, development of venture fund
market was possible due to very significant role played by private sector which is often willing to
put money in high risk business provided higher returns are expected. The guidelines by finance
ministry provide that non-institutional promoter's share in the capital of venture fund cannot
exceed 20 per cent of total capital; further they cannot be the single largest equity holders. The
private sector, because of this provision, may not like to promote venture fund business.
Promotion of venture funds by private sector, in addition to public financial institution
and banks, is recommended as:
(a) Private sector is in advantageous position as compared to financial institutions and
bankes to pride managerial support to new ventures as leading industrial houses have a
pool of experienced professional managers in all fields of management viz. marketing,
production and finance.
(b) The leading business houses will be able to raise funds from the investing public with
relative ease.

5. Review the Existing Laws

Today’s need is to review the constraints under various laws of the country and resolve the issues
that could come in the way of growth of the innovative mode of financing. The initiative on the
part of the Government in the direction would see rapid growth of a new breed of venture capital
assisted entrepreneurs.

4. SUMMARY
A financial service that is concerned with the provision of financial and other assistance
to high technology, high-risk and high return ventures are called venture capital. Venture capital
is designed to suit the high expectation of entrepreneurs for high gains. The usual mode of
venture financing involves the equity/seed capital provision. Financing high-risk ventures is the
hallmark of venture financing. In addition to financing facility, venture capital also provides
value added services, such as business skills to investee firms. Venture capitalists employ certain
 methods to evaluate the desirability of their investments in new ventures. Venture capital
financing originated in USA after World War II, and thereafter spread to other countries. Venture
capital is quite popular in India too, with companies, both in the public and private sectors,
setting up venture capital funds. Financing by a venture capitalist involves different types such as
R & D financing, starting financing, expansion financing, replacement financing, turnaround
financing, etc. For a venture capitalist, the sources of funds include borrowings from banks and
financial institutions, besides their own capital. A popular mode of venture financing includes
buy-out deals' whereby a venture capitalist buys the management holding of an enterprise.
Venture capitalist provide investment-nurturing services as part of their efforts in building up a
strong relationship with the investee firms, with a view of optimizing the benefits of venture
capital investments.

5. SUGGESTED READINGS
Bansal, L.K., Merchant Banking and Financial Services, Unistar Books Pvt. Ltd., Chandigarh.

Bhole, L.M., Financial Institutions and Markets, Tata McGra Hill, New Delhi.

Chandra, P., Financial Management, Tata McGraw Hill, Delhi.

Khan, M.Y., Financial Services, Tata McGraw Hill, New Delhi.

Kothari, C.R., Investment Banking and Customer Service, Arihand Publishers, Jaipur.

Machiraju, H.R., Merchant Banking. New Age Internation Publishers, New Delhi.

Srivatsava, R.M., Essentials Business Finance, Hima Publishing, New Delhi.

Pandey, I.M., Financial Management, Vikas Publishing House New Delhi.

Varshney, P.N., and Mittal D.K., Indian Financial Systen Sultan Chand & Sons, New Delhi.

6. SELF ASSESSMENT QUESTIONS

1. What is venture capital? Discuss the scope of venture capital in India.
2. Discuss the strategic role of venture capital in the development of a country.
3. Explain the various stages of venture capital financing.
4. Make suggestions for the success of venture capital in India.
 MERCHANT BANKING: CONCEPT, NATURE, FEATURE,OBJECTIVE,FUNCTIONS,
ORIGIN AND GROWTH OF MERCHANT BANKING IN INDIA

STRUCTURE
1. Introduction
2. Objectives
3. Presentation of Contents
3.1 Concept of Merchant Banking
3.2 Nature and Features of Merchant Banking
3.3 Functions of a Merchant Bank
3.4 'Origin and Growth of Merchant Banking in India
3.5 Difference Between Merchant Banks and Commercial Banks
4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
Merchant banking is a relatively new concept in the area of financial services in India. It
caters to the needs of trade and industry by acting as intermediary, consultant, financial and
liaison agency. If a business has the capital (money) to purchase all that is needed to operate the
business, there is no need for financing, whether debt or equity. Many businesses neither have
adequate funds for this, nor have enough time. The expectations that the business will generate
money at some time in the future to repay the amount lent or invested, plus a return to the owner
of the funds, is the basis of banking.
Those with the ideas or the skills to operate the business may not have the money, and
those with the money may not have the skills, time or desire to operate the business successfully.
Historically, if the bank lends the money, it is commercial banking. If the bank is the agent that
brings those with money together with those who need it, it is investment banking, sometimes
called merchant banking because merchants were the first to need this type of funding,
2. OBJECTIVES

After reading this lesson, you should be able to

(a) Understand the concept of merchant banking.

(b) Explain the nature and feature of merchant banking,
(c) Familiarise with the various functions of a merchant banker.
(d) Trace the history of merchant banking,

3. PRESENTATION OF CONTENTS

3.1 CONCEPT OF MERCHANT BANKING

The term merchant banking is used much widely and loosely. Merchant banking
organisation may be a bank, cooperative body, firm or proprietary concern. Thus, it is not easy
task to evolve any precise definition of merchant banking.
Dictionary meaning of 'merchant bank' refers to an organization that underwrites
corporate securities and advises such clients on issues like corporate mergers, etc. involved in the
ownership of commercial ventures. This definition suits well in Indian context.
Different countries understood the term merchant banking differently. In America, the
merchant banking is called investment banking which in origin was different and purely an
America institution. However, it has now got intermingled with merchant savings of myriads of
thrifty people and directing the funds to business enterprises seeking capital for the acquisition of
plant and equipment and holding investors. It needs mention here that these institutions in USA
do not invest their own funds permanently nor are they depositories for individual's savings like
commercial banks. Bank primarily intermediates in the merchanting of securities; they provide
the services to buy the securities of companies and governmental bodies seeking capital and to
sell them to investors at large. They buy blocks of securities for their own account with the
expectation of reselling quickly. The US investment bankers deal only in capital securities.
The London counterpart of merchant banking refers to those who are members of the
Accepting House Committee. This Committee has now been renamed as the British Merchant
Banking and Securities Houses Association. Unlike traditional merchant bankers who have been
acting as accepting house, today, the merchant bankers do all money killing things from trading
to leasing. consultation, mergers and amalgamation advice, portfolio services, asset management,
loan syndication, Eurocredits and so on. Thus, the London merchant bankers operate both in the
short-term market as well as in the long-term one.
The merchant banking which originated in 1969 in India and which gained increased
popularity during the 1983-84 new issue boom, started with management of public issues and
loan syndication and has been slowly and gradually covering activities like project counselling,
portfolio management, investment counselling and mergers and amalgamation of the corporate
firms. The Indian concept of a merchant bank is of a merchant banking department, a department
of a commercial bank or the satellite of such a bank. A ‘Merchant Banker’ has been defined
under the Securities and Exchange Board of India (Merchant Bankers) Rules, 1992 as "any
person who is engaged in the business of issue management either by making arrangements
 regarding selling, buying or subscribing to securities as manager, consultant, advisor or
rendering corporate advisory service in relation to such management."

According to Random House Dictionary, "merchant bank is an organization that

underwrites securities for corporations, advises such clients on mergers and is involved in the
ownership of commercial ventures. These organizations are sometimes banks which are not
merchants and sometimes merchants who are not banks and sometimes houses which are neither
merchants nor banks.
According to Charles P. Kindlebrger, "merchant banking is the development of banking
from commerce which frequently encountered a prolonged intermediate stage known in England
originally as merchant banking."
According to the Securities and Exchange Board of India (Merchant Bankers) Rules,
1992, "A merchant banker has been defined as any person who is engaged in the business of
issue management either by making arrangements regarding selling, buying or subscribing to
securities or acting as manager, consultant, advisor or rendering corporate advisory services in
relation to such issue management."

Globally, merchant banks have grown independently of commercial banking sometimes

giving the latter a headlog competition although the trends are towards the integration of the two.
Further, Indian merchant banking has, by and large, been synonymous with issue management
whereas outside the country it is much more than that. Keeping in view the different meanings of
merchant banking in various countries it would be more appropriate to evolve a functional
definition of a merchant bank. Hence, a merchant bank may be defined as an institution which
performs a wide range of activities including issue management, credit syndication, acceptance
credit, counselling, insurance etc. The merchant bank acts as an intermediary for those who own
capital and to those who need it.

3.2 NATURE AND FEATURES OF MERCHANT BANKING

From the foregoing account, it can be observed that the merchant bank acts as an
intermediary. By way of their expertise in the field they bring together to the suppliers of capital
and to those who have a demand for the capital. Merchant Banker's role is very dynamic in the
wake of diverse nature of merchant banking services. They are dynamic as they attend very
promptly to the corporate problems and suggest ways and means to solve it. The nature of
merchant banking services is development oriented and promotional to help the industry and
trade to grow and survive. Merchant banker is, therefore, dedicated to achieve this objective
through his dynamism. He is always awake to renew his skills to develop expertise in new areas
so as to equip himself with the knowledge and techniques to deal with emerging new problems
of corporate business world. He has to keep pace with the changing environment where
Government rules, regulations and policies affecting business conditions frequently change.
Hence, Merchant bankers are individual experts who organise and manage the merchant banks.
The following are the main features of merchant banking:
(i) Merchant banking organisation may be a bank, corporate firm or proprietary concern.
(ii) Merchant bankers are individual experts who organize and manage the merchant banks.
(iii)Merchant bankers perform activities such as the management of customer's securities,
portfolio management, credit syndication, acceptance credit, counselling, insurance etc.
 (iv) Merchant banker acts as an intermediary whose main job is to transfer capital from those
who own it to those who need it.
(v) Merchant banking services are highly competitive business activities and to get business,
merchant bankers have to stand on their heels and run to grab the business opportunity.
(vi) Each of the officers in merchant banking department, division, cell or company should
have the requisite skills of marketing and salesmanship to ensure that the opportunity
once found is not lost without obtaining mandate from the client. Hence, a merchant
banker has got to be a social person with mixing nature and temperament of liking others.
(vii) Friendliness and cooperation must flow as natural traits in the merchant banker to win
over the trust of the clients like a doctor or lawyer who retain their clients permanently.
(viii) Success of merchant banker depends largely upon his sociable nature and the richness
of wider contacts. Thus, a merchant banker is supposed to be acquainted deeply with all
the constituents of merchant banking.

3.3 FUNCTIONS OF A MERCHANT BANK

Setting up of new industrial units, expansion, diversification and modernisation of
existing units have been the central plank of the rapid industrialisation in any economy. This
process besides adequate financial resources requires sound technical and managerial inputs.
Though, a number of financial agencies are instituted to cater to the needs of rapid
industrialisation, the task of financing has become more complicated, thus requiring a fresh look.
In view of increasing or specialisation in every sphere the process of industrialisation from the
diversification primary planning stages of setting up a new unit to that of research and
development including expansion, diversification or modernisation requires the services of
specialists or professionals, Thus, the need for having expert advice, guidance of specialists or
professionals in the field has become an absolute necessity with rapid economic growth and
spectacular industrial development in India. It has also been necessitated by the plethora of
regulations for industry, capital, issues, foreign investment and collaboration, amalgamations,
Companies Act, SEBI, Government policy regarding backward area development, export
promotion and import substitution etc. A few agencies are able to provide expert advice in the
diversified areas mentioned above. But it is inconvenient to entrepreneurs industrialists to knock
at the doors of several agencies in getting the guidance of specialists and professionals. Hence, it
is highly essential to provide expert advice in diversified areas under a single roof to provide a
comfortable cushion to entrepreneurs to accelerate industrial development. This is where
merchant bankers come to picture. Although is it is very difficult to spell out all the areas where
merchant bankers can interact, yet, some important areas where merchant bankers have decisive
role are discussed here. These roles can broadly be divided into two parts. One is service based
another is fund based.

A. Service based Functions

i) Project counselling
The first step to launch a business unit is selection of a viable project. Merchant bankers
undertake this assignment on a very large scale since they have experts with them in diverse
fields. Project counselling covers a variety of sub assignments. Illustrative list of services which
can be rendered under this category is:
• Guidance in relation to project viability i.e. project identification and counselling. It may be
for setting up new units, expansion or improvement of existing facilities.
• Selection of consultants for preparation of project reports/market surveys etc. Sometimes
merchant bankers also engage in preparation of project reports or market surveys.
• Advice on various procedural steps including obtaining of governmental approvals clearance
etc. e.g for foreign collaboration.
• Proposing a suitable capital structure laying broad as well as specific features.
• Techno-economic soundness of the project and marketing aspects. Financial engineering i.e.
selection of right mix of financing pattern specifically for short term requirements.
• Organisation and management net up for a strong base and efficient working of the project.

ii) Credit syndication

Normally every project has to raise debt funds for different sources as per need.
Substantial debt rising may be required for a new and capital intensive project. For such project
merchant bankers may undertake credit syndication. Credit syndication is credit procurement
service. As per the requirements, such syndication can be from national as well as international
sources. Some of the important credit syndication services offered are.

• Preparing applications for financial assistance to be submitted to financial institutions and

banks.
• Monitoring the sanction of funds while acting as a specialized liaison agency.
• Negotiating the term of assistance on behalf of client.
• Posts sanction formalities with these institutions and banks.
• Assistance in drawl of term loans and or bridging loans.
• Assessing working capital requirements and arranging it.

Need of syndication arises due to the fact that specially in big projects one institution may
hesitate to meet the whole debt requirement of the project. They want to spread the risk. Further
shortage of funds availability with one lender also requires credit syndication. The merchant
banker by rendering credit syndication services saves the time of the borrower.

The modus operandi of syndication is really quite simple. The borrower approaches
several banks which might be willing to syndicate a loan, specifying the amount and the tenor for
which loan is to be syndicated. On receiving a query, the syndicator scouts for banks who may
be willing to participate in the syndicate. Based on an informal survey, it communicates its desire
to syndicate the loan at an indicative price to the corporate borrower, all in a matter of days.
After reviewing the bids from various banks, the borrower awards the mandate to the bank that
offers him the best terms.

The syndicator, on his part, can underscore his willingness to syndicate the loan on a firm
commitment basis or on a best-efforts basis. The former is akin to underwriting and will attract
capital adequacy requirements. That may reduce the bank's flexibility. "In India, given the fact
that banks may not be willing to maintain capital. in the interim period, most syndicates the
likely to be done on a best efforts basis."
Best-efforts, as the name suggests, limits the obligation of the syndicator, as he is not
compelled to provide the loan on his own, in case he fails to arrange the loan. However, more
often than not, the syndicator would try to fulfill his commitments for the inability to do so
would tarnish his reputation. Once the syndicator has been awarded a mandate, the borrower has
to sign a 'clear market clause’ which stops him from seeking a syndicated loan from any other
bank, till such time as the documentation for the syndication is drawn up by the syndicate
manager. This may take about three-four' weeks.
In the interim period, the syndicate manager gets the banks to agree to syndicating the
loan. It can do this on a 'broadcast' basis, by sending taxes to the concerned banks inviting
participation. If the company is well known, the loan uncomplicated and the market liquid, such
a method would work well. However, if the corporate tends to keep a low profile and the loan
structure is complicated, the syndicate manager would have to woo the participant banks with
offer documents or an information memorandum on the company. The document is similar to a
prospect but less detailed. Nevertheless drawing up such a document does call for a lot of
homework. The syndicate manager has to be very careful because he can be held responsible for
any inaccuracy or omission of material facts.
The participants, after reviewing the prospects, decide whether or not to join the
syndicate. However, given the fact that most of the participants may be smaller Indian banks,
they may take weeks to give the final nod. Once the Bank decides to become a member of the
syndicate, it indicates the amount and the price that it is likely to charge on the loan. Based on
information received from all participants, the syndicate manager prepares a common document
to be signed by all the members of the syndicate and the borrowing company. The document
usually lists out details of the agreement with regard to tenor, interest prepayment clause,
security, covenants, warranties and agency clause.

iii) Issue management

Traditionally this is one of the main functions of merchant banker. When ever an issue is
made whether it is public issue or private placement and further whether it is for equity shares,
preference: shares or debentures, the merchant banker has a crucial role to play. Raising of funds
from public has many dimensions and formalities which are not possible for the concerned
companies to comply with, where merchant banker comes to their rescue. Marketing effort to
convince the prospective investor needs special attention. Here again merchant bankers are
specialists. The specific important activities related to issue management performed by merchant
banks are mentioned here:

• Advise the company about the quantum and terms of raising funds.
• Advise as to what type of security may be acceptable in the market as well as to the
concerned lending institutions at the time of issue.
• Advise as to whether a fresh issue to be made or right issue to be made or if both, then in
what proportion, obtaining the desired consents, if any, from government or other authorities.
• Advice on the appointment of bankers, brokers to the issue.
• Advice on the selection of issue house or Registrar to the issue, printer advertising agency
etc.
• Fixing the terms of the agencies engaged to facilitate making public issue.
• Preparation of a complete action plan and budget for total expenses of the issue.
• Drafting of documents like prospectus, letter of offer and getting approval from concerned
agencies.
• Assisting in advertisement campaigns, holding the press, brokers and investors' conferences
etc. for grooming the issue.
• Advise the company for the issue period and days of opening and closing the issue.
• Monitoring the collection of funds in public issue.
• Coordination with underwriters, brokers and bankers to and stock exchange etc.
• Strict compliance of post issue activities.

iv) Corporate counselling

Although the functions discussed up till now are also covered under corporate
counselling but here other dimensions will be deliberated. Corporate counselling is to rejuvenate
the corporate units which are otherwise having signals to low productivity, low efficiency and
low profitability. The merchant bankers can play a substantial role in reviving the sick units.
They make mergers and acquisition exercise smooth, They can advise on improvement in the
systems operating in managing the show of a corporate unit. Some of the specific assignments
for the merchant banker are:

 Rejuvenating old line and ailing/sick unit or appraising their technology and process,
assessing their requirements and. restructuring their capital base.
 Evolving rehabilitation programmes/packages which can be acceptable to the financial
institutions and banks.
 Assisting in obtaining approvals from Board for Industrial and Financial Reconstruction
(BIFR) and other authorities under the Sick Industrial Companies (special provisions) Act
1985 (SICA).
 Monitoring implementation of schemes of rehabilitation.
 Advice on financial restructuring involving redeployment of corporate assets to refocus
companies line of business.
 Advice on rearranging the portfolio of business assets through acquisition etc.
 Assisting in valuing the assets and liabilities.
 Identifying potential buyers for disposal of assets if required. Identify the candidates for take
over.
 Advice on tactics in approaching potential acquisition.
 Assisting in deciding the mode of acquisition whether friendly or unfriendly or hostile.
 Designing the transaction to reap the maximum tax advantages. Acting as an agent for
leveraged buyout (LBO) involving heavy use of borrowed funds to purchase a company or
division of a company.
 Facilitating Management Buy outs (MBO) i.e. selling a part of business to their own
managers by a company.
 Clearly spelling out organisation goals.
 Evolving corporate strategies to achieve the laid down goals.
 Designing or restructuring the organisational pattern and size.
 Evolving Management Information System.

Corporate advisory services should offer real value addition to the client. Highly
specialised in nature, these services should be clearly distinguished from the gamut of other
financial services offered by NBFCs such as underwriting or fund-based activities of leasing and
hire purchase. In India corporate advisory has a good potential. The Indian industry is going
through an unprecedented churning, bracing itself for global competition. The Indian corporate
sector has been on a restructuring spree. Groups have been shedding companies. Companies in
turn, have been dropping divisions as they struggle to become fit to survive in the new milieu.
Free pricing of issues and the opportunity to tap the international market through the Euro-issue
route has greatly enhanced the need for expert advisory services. In areas of restructuring,
strategic alliances and corporate planning is now advising foreign companies in their plans for
development of infrastructure in India. Merchant bankers have a great role to play.

Strategic product consolidation is another recent phenomenon. Units in which the

company does not plan to become a market leader are spun off to others. A good corporate
advisor is always on the alert to seize such opportunities. The process of acquisition cannot be
done overnight. It requires a patient search for the right company which can be acquired, the
proper evaluation of the financial impact of the acquisition, a sound strategy in blending the
business acquired within the fold of the group, followed by negotiation and execution of the
agreement. Occasionally, advisory services are required in cases of splits within the family
group. In such cases, there is a need to split the company into different units amongst the
disputing family members. At the same time, the shareholders interest is to be kept in mind by
the corporate advisor.

v) Portfolio management
Merchant bankers as a body of professionally qualified persons also undertake
assignments of managing an individual investor's portfolio Portfolio management is being
practiced as an investment management counselling in which the investor is advised to seek
financial assets like government securities, commercial papers, debentures, shares warrants etc.
that would grow in value and/or provide income. The investors whether local or foreigner with
substantial amount for investment in securities seek portfolio management services of authorised
merchant bankers. The functioning of portfolio manager can be regulated or unregulated.
Portfolio manager may use totally his discretion or may act only after getting signal from
investor for each transaction of sale or purchase. A diverse range of services which may be
rendered by merchant banker include: -

 Advising what and when to sell and buy.

 Arranging sale or purchase of securities.
 Communicating changes in investment market to the client investor
 Compliance of regulations of different regulating bodies for sale of purchase of portfolio.
 Collection of returns and reinvent as per directions of clients.
 Evaluating the portfolio at regular intervals or at direction of investors.
 Advising on tax matters pertaining to income from and investment in portfolio
 Safe custody of securities.

vi) Stock broking and dealership

The merchant bankers who have requisite professional knowledge and experience may
also act as share broker on a stock exchange and even as dealer for Over the Counter trading. To
venture into this area it is normally desired that the merchant banker has reasonable network.
Their actions and activities are regulated by rules and regulations of the concerned stock
 exchange. They are at liberty to appoint sub brokers and sub dealers to ensure wider net work of
their operations. They can be broker for inland as well as foreign stock exchanges. In India the
merchant bankers who desire to act as brokers are regulated by SEBI (Stock Broker and Sub-
brokers) Rules 1992.

vii) Joint venture abroad

Depending on economic and political considerations many countries may permit joint
ventures by local businessmen abroad. Here again merchant bankers can play a decisive role.
They facilitate meeting of foreign partner, get sanctions under various provisions, make techno
economic surveys, legal documentations under local as well as foreign legal provisions etc.

viii) Debenture trusteeship

The merchant bankers can get themselves registered to act as trustee. These trustees are
to protect the interests of debenture holders as per the terms laid down in trust deed. They are, as
trustees, to undertake redressal of grievances of debenture holders. They are to ensure that refund
monies are paid and debenture certificates are dispatched in accordance with the Companies Act.
Debenture trustees are expected to observe high standards of integrity and fairness in discharging
their functions. They can call for periodical reports from the body corporate. They charge fee for
such services.

B. Fund based Functions

(i) Bill discounting

Bill discounting is a service against which merchant banker has to arrange funds against
the bills which have been discounted. This service is undertaken by merchant bankers generally
if bill market is big as well as mature. Otherwise bill discounting is undertaken by banks only.
Depending on their credibility they may also undertake the assignment of bill acceptance. These
bills accepted and or discounted can be foreign and merchant bankers can specify what types of
bills they entertain. They charge commission for these services.

(ii) Venture capital

Venture capital is the organized financing of relatively new enterprises to achieve
substantial capital gains. Such new companies are chosen because of their potential for
considerable growth due to advance technology, new products or services or other valuable
innovations. A high risk is implied in the term and is implicit in this type of investment. Since
certain ingredients necessary for success of such projects are missing in the begging but are
added later on Merchant bankers undertake to arrange and if necessary, to provide such venture
capital since traditional sources of finance like banks, financial institutions or public issue etc.
may not be available. Since expected returns on projects involving venture capital is high, these
are normally provided on soft terms. Such scheme is also popular as seed capital or risk capital
scheme. Merchant bankers deeply study such proposals before releasing the money. At
opportune time such investment can be disinvested to keep the cycle of venture capital more on.

(iii) Bought out deals

 When a promoter envisages that if public issue made to raise capital will not clinch, may
approach merchant bankers (bought out dealer or sponsor) and places the shares company
initially with him which are offered to public at a later stage, this route is known as bought out
deal. Many a time a syndicate of merchant bankers jointly sponsor a bought out deal to spread
the risk involved. In contract to venture capital, there is no role to be played non traditional
technology. Such bought shares sponsor can be disposed off at an opportune time on ‘over the
counter' or other stock exchanges.

(iv) Lease financing and hire purchase

Depending on the funds available, merchant bankers can also enter the field lease or hire
purchase financing. Lease is an agreement where by the lessor (merchant banker in our case)
conveys to the lessee (the user), in return for rent, the right to use an asset for an agreed period of
time. On the other hand in hire purchase the user at the end of the agreed period has an option to
purchase the asset which he has used till date. The merchant bankers can advise the client to go
in for leasing hire purchase system financing an asset. A Comparative study may be
communicated to the prospective client showing benefits these alternatives. The client can also
depend on merchant banker for acquiring the needed asset and complying with all formalities.

(v) Factoring
Factoring is a novel financing innovation.It is a mixed service having financial well as
non financial aspects. On one hand it involves management and collection of books debts which
arise in process credit sale. The merchant bankers can take up this assignment and are required to
perform activities like sales ledger administration, credit collection, credit protection, evolving
credit policy, arranging letter of credit etc. On the other hand there is involvement of finance.
Against factored debts the merchant banker may provide advance with a certain margin. The
released funds can be used by client to manage liquidity and working capital. Merchant bankers
are entitled to service charges for factoring services. The merchant banker's role is thus to:

 Maintain the books of accounts pertaining to credit sales.

 Make a systematic analysis of relevant information for credit monitoring and control.
 Provide full or partial protection against bad debts and accepting the risk of non realization.
 Provide financial assistance to the client.
 Provide information about prospective buyers.
 Provide financial counseling and assisting managing the liquidity.

(vi) Underwriting
It refers to a contract by means of which merchant banker gives an assurance to the
issuing company that the former would subscribe to the securities offered in the event of non-
subscription by the persons to whom it was offered. The liability of merchant banker arises if the
issue is not fully subscribed and this liability is restricted to the commitment exterided by him.
The merchant bankers undertaking underwriting make efforts on their own to induce the
prospective investors to subscribe to the concerned issue. Such assignment is accepted after
evaluating viz:
 Company's standing and its past record.
 Competence of the management.
 Purpose of the issue.
  Potentials of the project being financed.
 Offer price and terms of the issue.
 Business environment.

The financial involvement of merchant banker in underwriting arises in case of

development. To get their blocked funds released, the merchant bankers have stock exchange as
exit route. They get underwriting commission.

These are some of the prominent activities being undertaken by merchant bankers world
over. The practices may differ from country to country depending on maturity of financial sector
of their economy. The multifarious activities of the corporate sector and spectacular growth of
industry gives new dimensions to merchant banking activities. In the phase of globalization of
economies merchant bankers are facing new challenges. The changing international financing
environment has rather pushed merchant bankers to operate at international level creating more
opportunities to serve the world business community in diverse ways.

3.4 ORIGIN AND GROWTH OF MERCHANT BANKING IN INDIA

The concept of merchant banking originated in 13th century in Italy. The first-known
firms to have been involved in merchant banking were Riccadi of Luca, Medici, Fugger, and so
on.
In olden times, merchant banks were also known as "accepting and issuing houses in the
U.K. and "investment banks” (IB) in the USA. Except for this distinction in nomenclature, there
is no essential functional difference between them. Usually, they handled coastal trade and
master's goods on a commission basis and financed risky venture projects, for which they
charged heavy interest. They often incurred heavy losses. They accepted bills for payment. These
were in addition to their Merchant Banking functions of commercial banking.

In fact, there was no distinction between the functions of merchant banking and
commercial banks until 1932. Later, the Glass Steagall Act, 1933, distinguished the functions of
merchant banking or investment banking from commercial banking. However, in 2000, the
Clinton Administration allowed investment banks to run the functions of commercial banks in
addition to their usual functions of investment banking. This was effected through an amendment
in the Glass Steagall Act.

Prior to the enactment of the Indian Companies Act, 1956, managing agencies acted as an
issue house for securities. They evaluated the projects before promoting them. They designed the
capital structures. They provided the venture capital in a small way. Few share broking firms
functioned as merchant bankers with small capital base.

Formal merchant banking activity in our country was originated in 1969 with the
Merchant Banking Division set up by the Grindlays Bank, the largest foreign bank in the
country. The main service offered at that time to the corporate enterprises by the merchant banks
included the management of public issues and some aspects of financial consultancy. Other
foreign banks like City Bank, Chartered Bank also started the merchant banking activity in India.
The State Bank of India was the first Indian Commercial Bank which set up the Merchant
Banking Division in 1972. Later, the ICICI set up its merchant banking division in 1973
 followed by a number of other commercial banks like the Syndicate Bank. Punjab National
Bank, UCO Bank, Bank of India, Bank of Baroda, Mercantile Bank, Canara Bank. The early and
mid-seventies witnessed boom in the growth of merchant banking organisation in the country
with various commercial banks, financial institutions, brokers, firms entering into the field of
merchant banking, capital market. Similarly, Canara Bank also promoted its merchant banking.
In 1986, SBI set up a separate broad-based financial service. In 1992-93, the IDBI started
merchant banking activities like acquisition of assets on lease and mergers/takeovers, to suggest
for raising funds from capital market etc.

Despite an increased competition among merchant bankers, the financial institutions and
banks still manage to get a major chunk of the business of lead managing issue. In recent years
merchant bankers have enlarged their activities from project generation or at inception stage to
its commissioning and running. They have started preferring for a small number but bigger in
size issues.

In India, the merchant bankers claim to be engaged in carrying out all operation of a
merchant bank such as counselling, preparation of project feasibility reports, preparation of term
loan application form, loan syndication, seeking requisite permission from statutory bodies for
starting industrial ventures, management of shares, bonds and debentures issue, arrangement of
working capital facility, portfolio management, arranging foreign currency loans, etc. However,
an analysis of their performance will reveal that they have acted more like issue houses than as
complete merchant banks. Most of the Indian commercial banks and their subsidiaries have
confined themselves mainly to management of public issues, loan syndication and private
placement of a few public sector undertakings bond.

5. DIFFERENCE BETWEEN MERCHANT BANKS AND COMMERCIAL BANKS

Merchant banking is the forerunner of modern commercial banking. Its foundational
value is being increasingly recognized and its resurrection seriously considered. The proof is that
this ancient form of merchant banking has begun to make a comeback in the UK and the USA.
Particularly when the limitations of contemporary commercial banks are gradually showing
through in the face of certain practical problems of present-day commercial banking.

1. The basic difference between merchant banking and commercial banking is that the merchant
banking offers mainly financial advice and services for a fee. It also collects deposits through the
non-cash mode of finance, i.e., security papers, Commercial banks accept deposits and lend
money in the mode of cash.

2. The merchant bank offers portfolio services to its customers (individuals and corporate). The
commercial bank provides retail trade banking services to its customers.

3. The regulatory body for commercial banks in India is Ministry of Finance/Reserve Bank of
India. The Banking Regulation Act has also guided those banks. On the other hand, the
regulatory body for merchant banks in India is the Securities Exchange Board of India (SEBI).
They define merchant banking as follows:
 "Merchant banks mostly provide advisory services, issue management, portfoilo management
and underwriting, which require less capital but generate more income (non interest
income)."

Since, these services require fewer funds, commercial banks could opt to provide these services
side by side with their traditional services/functions. Merchant banking services reduce the
pressure of supervision/monitoring activities that reduce the related cost.

4. Merchant banks invest their funds mostly in project-oriented and security papers. These security
papers are encashable in the stock market. This will solve the liquidity crises of merchant banker.
The liquidity problems of commercial banks cannot easily be solved as they lend their funds to
the trading of commercial houses in the form of Term Loan, Working Capital, etc.
4. SUMMARY
Financial service is rendered through numerous intermediaries who are known by
different names. One of the prominent intermediaries is known as merchant banker. Their scope
of operation differs from country to country. Merchant banking means any person who is
engaged in the business of issue management either by making arrangements regarding selling,
buying, underwriting or subscribing to the securities underwriter, manager, consultant, advisor or
rendering corporate advisory services in relation to such issue management. Services provided
towards ensuring efficient running of a corporate enterprise and called corporate counseling, Pre-
investment studies involve detailed feasibility explorations with a view to evaluating alternative
avenues. Credit syndication is concerned with extending finance, in both Indian rupees and
foreign currency, on a consortium busis. Mutual funds are engaged in the mobilization of the
savings of innumerable investors. Project appraisal is concerned with the assessment of the
validity of a project. The concept of merchant banking originated in Italy in 13 th century. In India
prior to enactment of Indian Companies Act, 1956, managing agents acted as issue houses for
securities, evaluated project reports, planned infrastructure and to some extent provided venture
capital for new firms. It gained prominence in India during 1983-84 due to new issue boom.

5. SUGGESTED READINGS
1. Verma, J.C. Manual of Merchant Banking, Bharat Law House, New Delhi.
2. Verma, LC. Merchant Banking, Tata Mc-Graw Hill Publishing Company Ltd., New Delhi.
3. Bhatia, B.S. &s Batra G.S. Management of Financial Services,Deep & Deep Publications, New
Delhi.
4. Merchant Banking and Financial Markets. A publication of the Institute of Chartered Financial
Analysts of India.
5. Bansal, R. Lalit. Merchant Banking and Financial Services, Unistar Books (P) Ltd., Chandigarh,
1997.
6. Avadhani, VA. Capital Market Management, Himalaya Publishing House, Bombay, 1997.
7. Machiraju, H.R. Merchant Banking, New Age International Publisher Ltd., New Delhi, 1995.

6. SELF ASSESSMENT QUESTIONS

1. Define merchant banking. Discuss the nature and features of merchant banking.
2. Explain in detail the various functions performed by merchant bankers.
3. What is credit syndication? What are the activities involved it?
4. Write short notes on:
(a) Origin of Merchant Banking.
(b) Difference between merchant banks and commercial banks.

REGISTRATION, CODE OF CONDUCT, DUTIES AND LIABILITIES OF LEAD

MANAGERS IN INDIA; SEBI GUIDELINE

STRUCTURE
1. Introduction
2. Objectives
3. Presentation of Contents
3.1 The Historical Merchant Bank
3.2 The Modern Merchant Bank
3.3 Lead Managers/Merchant Bankers
3.4 Categories of Merchant Bankers
3.5 SEBI and Merchant Banking
3.5.1 Authorisation criteria
3.5.2 Terms of Authorisation
3.5.3 Classification of Merchant Bankers
3.5.4 Report of SEBI
3.6 Basic Conditions for Registration of Merchant Bankers
3.7 Do's and Don'ts for Merchant Bankers
3.8 Separation of Merchant Banking Activities
3.9 Responsibilities/Obligations of Lead Managers/Merchant Bankers
3.10 Inspection by SEBI
3.11 Underwriters

4. Summary
5. Suggested Readings
6. Self Assessment Questions

1. INTRODUCTION
In late 17th and early 18th century, the largest companies of the world were merchant
adventurers. Supported by wealthy groups of people and a network of overseas trading posts,
they collected large amounts of money to finance trade across parts of the world. For example,
The East India Trading Company secured a Royal Warrant from England, providing the firm
with official rights to lucrative trading activities in India. This company was the forerunner in
developing the crown jewel of the English Empire. The English colony was started by what we
would today call merchant bankers, because of the firm's involvement in financing, negotiating,
and implementing trade transactions.
 The colonies of other European countries were started in the same manner. For example,
the Dutch merchant adventurers were active in what is now Indonesia; the French and
Portuguese acted similarly in their respective colonies. The American colonies also represent the
product of merchant banking, as evidenced by the activities of the famous Hudson Bay
Company. One does not typically look at these countries' economic development as having been
fueled by merchant bank adventurers. However, their progress stems from the business of
merchant banks, according to today's accepted sense of the word.

2. OBJECTIVES
After reading this lesson, you should be able to:
(a) Explain the authorization criteria and Terms of authorization.
(b) List out the requirements for the registration of merchant banker.
(c) Understand Do's and Don'ts for a merchant banker.
(d) Highlight the responsibility of a lead manager.
(e) Explain the procedure for inspection by SEBI.

3.1 THE HISTORICAL MERCHANT BANK

Merchant Banking, as the term has evolved in Europe from the 18th century to today,
pertained to an individual or a banking house whose primary function was to facilitate the
business process between a product and the financial requirements for its development. Merchant
banking services span from the earliest negotiations from a transaction to its actual
consummation between buyer and seller. In particular, the merchant banker acted as a capital
source whose primary activity was directed towards a commodity trader/cargo owner who was
involved in the buying, selling and shipping of goods. The role of the merchant bankers, who had
the expertise to understand a particular transaction, was to arrange the necessary capital and
ensure that the transaction would ultimately produce "collectale" profits. Often, the merchant
banker also became involved in the actual negotiations between a buyer and seller in a
transaction.

3.2 THE MODERN MERCHANT BANK

During the 20th century, however, European merchant banks expanded their services.
They became increasingly involved in the actual running of the business for which the
transaction was conducted. Today, merchant banks actually own and run businesses for their
own account, and that of others. Since the 18th century, the term merchant banker has, therefore,
been considerably broadened to include a composite of modern day skills. These skills include
those inherent in an entrepreneur, a management advisor, a commercial and / or investment
banker plus that of a transaction broker. Today a merchant banker is one who has the ability to
merchandise - that is, create or expand a need - and fulfil capital requirements. The modern
European merchant bank, in many ways, reflects the early activities and breadth of services of
the colonial trading companies. Most companies that come to a U.S. merchant bank are looking
to increase their financial stability or satisfy a particular immediate capital need. Professional
merchant bankers must have:

(a) an understanding of the product, its industry and operational management;

 (b) an ability to raise capital which might or might not be one's own (originally merchant
bankers supplied their own capital and thereby took an equity interest in the transaction);
and,
(c) most important, effective skill in concluding a transaction- the actual sale of the product and
the collection of profit. Some people might question whether or not there are many
individuals or organizations who have the abilities to fulfil all three areas of expertise.

3.3 LEAD MANAGERS / MERCHANT BANKERS

Merchant Banker has been defined under the Securities & Exchange Board of India
(Merchant Bankers) Rules, 1992 as "any person who is engaged in the business of issue
management either by making arrangements regarding selling, buying or subscribing to
securities as manager, consultant, advisor or rendering corporate advisory service in relation to
such issue management". Merchant Banking, as a commercial activity, took shape in India
through the management of Public Issues of capital and loan syndication. It was originated in
1969 with the setting up of the Merchant Banking Division by ANZ Grindlays Bank. The main
service offered at that time to the corporate enterprises by the merchant banks included the
management of public issues and some aspects of financial consultancy. The early and mid-
seventies witnessed a boom in the growth of merchant banking organizations in the country with
various commercial banks, financial institutions, broker's firms entering into the field of
merchant banking.

MERCHANT BANKING SERVICES

Advisory Market Operations Issue Mgt. Financial Services

(Non Fund)

The importance of merchant bankers as sponsors of capital issues is reflected in their

major services/ function such as determining the composition of the capital structure (type of
securities to be issued), drafting of prospectus and application forms, compliance with procedural
formalities, appointment of registrars to deal with the share application and transfers, listing
securities, arrangement of underwriting, placing of issues, selection of brokers, bankers to the
issue, publicity and advertising agents, printers, and so on. In view of the overwhelming
importance of merchant bankers in the process of capital issues, it is not mandatory that all
public issues should be managed by merchant banker (s) functioning as the lead manager (s). In
case of right issues not exceeding Ra. 50lakh such appointments may not be necessary.

3.4 CATEGORIES OF MERCHANT BANKERS

Merchant bankers were categorized as follows:

Category I. Those merchant bankers who can conduct all above mentioned activities, relating to
management of issues. They may, if they no choose, act as only an advisory/consultative
capacity or as co managers, underwriters or as portfolio managers.

Category II. Those merchant bankers who can act as consultants, advisers, portfolio managers
and co-managers.
 Category III. Those merchant bankers who can act only underwriters, advisers and consultants.

Category IV. Those merchant bankers who can act only as advisers or consultants to an issue.

Only category I merchant bankers were allowed to act as lead managers to an issue.

MERCHANT BANKERS BELOW CATEGORY I ABOLISHED

On September 5, 1997 SEBI abolished all categories of merchant bankers below category
I. Merchant bankers operating in the categories below one were allowed to continue till the end
of their existing terms, after which they may apply for category I status to take up some other
activity.

Those functioning as category II, III and IV merchant bankers were given an option to
upgrade themselves as the equivalent of the prevailing category I merchant bankers.
Alternatively, they could seek separate registration as underwriters or portfolio managers.
Merchant bankers currently carrying out underwriting and portfolio management, besides issue
management, would be required to get separate registrations as portfolio managers, while
underwriting could be done without any additional registration..

SEBI also decided that henceforth only body corporate would be allowed as merchant
bankers. The net worth requirement for category I merchant bankers, which in future would be
the only category, is Rs. 5crore. However, there is a move to increase net worth requirement.
Also it has been stipulated that there will be nothing called as an adviser to an issue. This has
with a strong protest from members of the association of merchant bankers in India (AMBI).
They want that category II, III and IV merchants should be regrouped as advisers/registered
institutional investors (RIIs).

3.5 SEBI AND MERCHANT BANKING

Any person or body of persons proposing to engage in the business of Merchant Banking
would need authorization by SEBI in the prescribed format. This will apply to those presently
engaged in the Merchant Banking activity, including as Manager, Consultants or Advisers to
issues. The legislation authorizes some activities to facilitate merchant banking. They are:

1. Issue Management
2. Corporate Advisory Services relating to the issue.
3. Underwriting
4. Portfolio Management Services.
5. Managers, Consultants or Advisers to the issue

3.5.1 AUTHORIBATION CRITERIA

All Merchant Bankers are expected to perform with high standards of integrity and
fairness in all their dealings. A code of conduct for the Merchant Bankers is prescribed by SEBI
which will take into account some of characteristics like professional competence, personal, their
adequacy and quality and other infrastructure; capital adequacy, past track record, experience,
general reputation and fairness in all their transactions.
3.5.2 TERMS OF AUTHORISATION
The following terms are laid down in SEBI guidelines regarding authorization:

1. All Merchant Bankers shall have a minimum net worth of Rs. One crore raised to Rs. five crores
at present.
2. The Authorization will be for an initial period of 3 years.
3. The Merchant Bankers shall exercise due diligence independently verifying the contents of the
prospectus. The Merchant Bankers of the issue shall certify to this effect to SEBI.
4. In respect of issues managed by the Merchant Bankers, they would be required to accept a
minimum 5% underwriting obligation in the issue subject to ceiling of Rs. 25lacs.
5. At least one authorized merchant banker as a sole manager or lead merchant bankers for issues
upto Rs. 50crores is restricted to two. If the issue goes to Rs. 400crores and beyond, the numbers
may go upto five. If the issue is below Rs. 50lakhs,companies need not appoint merchant
bankers.
6. Lead Managers would be responsible for ensuring timely refunds and allotment of securities to
the investors.
7. The merchant bankers involvement will continue till the completion of essential follow up steps
including listing of the investment and dispatch of certificates and refunds.
8. The Merchant Bankers shall make available to SEBI such information returns & reports as may
be called for.
9. Merchant banker shall adhere to the code of conduct laid down and prepared by SEBI.
10. Merchant Banker to ensure that publicity or advertisement material accompanying the
application form to the issue should meet the requirement of GOI/SEBI.
11. SEBI shall be informed well before the opening of the issue the inter se allocation of
activities/sub-activities among lead managers to the issue.
12. Merchant Bankers performing or planning to perform portfolio management service shall furnish
the details in the prescribed format.

3.5.3 CLASSIFICATION OF MERCHANT BANKERS

CATEGORY REQUIREMENT AUTHORISED TO ACT AS

Category I Minimum Net Worth Rs. 5Crores
Lead Manager/comanager /adviser
/consultant to an issue, portfolio
manager and underwritten an issue as
mandatory required.
Category II Minimum net worth Rs. 50Lacs Co-Manager/Adviser or Consultant to an
issue or portfolio manager.
Category III Minimum Net Worth of Rs. 20 Adviser/Consultant to an issue
Lacs
Category IV No Net Worth Only Advisor
 3.5.4 REPORT TO SEBI
A statement shall be furnished at quarterly intervals regarding the particulars of public
and rights on hand with company in the capacity of Lead Manager containing the following
details. The statement shall be furnished well before the beginning of the quarter. Reports to be
submitted to SEBI are two only, namely, 3 days' report and 18 days report from the day of
opening subscription. The SEBI has authorized the merchant bankers to have a stake up to 5% of
total issue.
1. Name of the company & address
2. Type & size of issue.
3. Likely dates when the issue will be opening public/shareholders.
4. Principal Stock exchange where securities will be listed.
5. Name of the other lead managers to the issue, if any.
6. Name of the co-manager & advisers to the issue, if any.

Thus, only category I merchant bankers could act as lead manager to an issue. With effect
from December 9, 1997, however, only category I merchant bankers are registered by the SEBI.
To carry on the activities as underwriters and portfolio managers, they have to obtain separate
certificates of registration from SEBI.

3.6 BASIC CONDITIONS FOR REGISTRATION OF MERCHANT BANKERS

Merchant bankers have to be compulsorily registered with SEBI. They should satisfy the
following conditions for their registration and continuation of their registration:

(1) Satisfy a prescribed minimum capital registered adequacy norm in terms of its net worth, i.e.,
paid-up capital and free reserves
(2) They have necessary infrastructure such an adequate office space, equipment and manpower
for effective discharge of their duties and responsibilities.
(3) They employ at least two persons competent to handle merchant banking business.
(4) They are not involved in any litigation connected with securities market.
(5) They possess professional qualification in finance, business management.
(6) Their registration is in the interest of the investors.
(7) They pay prescribed fee.
(8) They undertake to fulfil their obligations and responsibilities.
(9) They undertake to adhere to the prescribed code of conduct.

Capital Adequacy Requirement

Merchant banker adequacy norms in terms of its net worth comprising of paid up capital
and free reserves. The minimum net worth is Rs. 1crore (Category I), Rs. 50lakh (Category II),
Ra. 20lakh (Category III) and nil for Category IV. To monitor the capital adequacy, the SEBI
may require half yearly unaudited financial results of a merchant banker.

Fee
A merchant banker had to pay a fee, as detailed below, at the time of original registration
as well as renewal.
Registration Fee
(i) Category I: Rs. 2.5lakh annually for the first two years and Rs. 1lakh for the third year
(ii) Category II: Rs. 1.5lakh annually for the first two years and Rs. 50,000 for the third year,
(iii)Category III: Re. 1lakh annually for the first two years and Rs. 25,000 for the third year, and
(iv) Category IV: Rs. 5,000 annually for the first two years and Rs. 1,000 for the third year. Since
1999, the registration fee was raised to Rs. 5lakh.
Renewal of Registration
At the time of renewal of registration, the merchant banker should continue to fulfil all
the conditions required at the time of registration, pay the prescribed renewal fee, and also make
a declaration (to be signed by two directors) that:

(1) The applicant company, its promoter, director, partner or employee has not any offence
involving moral turpitude or has been found guilty of any economic offence.
(2) It is not involved in litigation connected with the securities market and there are no charges
against the merchant banker as on date.
(3) None of the associate, subsidiary, interconnected or group company of the applicant
company has applied or has been granted registration by SEBI to undertake merchant
banking activities.
(4) The merchant banking company or its directors are not facing any charges/disciplinary action
from any stock exchanges.
(5) The applicant company or its associates have not been found involved in the securities scam
and are not named in the Janakiraman committee report (for those involved, SEBI had
advised them to forward detailed comments).
(6) All investments indicated in the certified annual account are held in the name of the company
only (if not details of such holding are required to be forwarded).

Since a large number of merchant banking firms are also involved in stock broking they
would also have to comply with some additional conditions which require them to obtain a no-
objection certificate from the stock exchange for functioning as a merchant banker. In addition
the applicant company has to give details of the stock exchange membership indicating whether
it has paid registration fee as per SEBI (Stock brokers and sub-brokers) rules and regulations,
1992, and whether they are facing any charges/disciplinary action from exchanges or SEBI.
SEBI is in the process of broadening the checklist to include more points of compliance,
which would be noted at the time of granting the renewal.

Renewal Fee
The original registration of merchant bankers was for three years and it could be renewed
for further periods of three years each. The merchant banker had to apply for renewal of his
registration three months before the expiry of the period of registration. The schedule of renewal
fees was as detailed below:

Category of First two years (Rs.) Third Year

merchant bankers (Rs.)
I 1,00,000 20,000
II 75,000 10,000
III 50,000 5,000
IV 5,000 2,000
 With effect from 1999, the renewal fee is Rs. 2.5lakh every three years from the fourth
year from the date of initial registration. If a merchant banker fails to pay the annual fees, his
registration me be suspended by the SEBI.

3.7 DO'S AND DON'TS FOR A MERCHANT BANKER

Every merchant banker has to abide by a certain code of conduct which can be discussed as do's
and dont's for the merchant banker:

DO'S FOR MERCHANT BANKER

(1) Observe high standards of integrity and fairness in its dealings with the client and other
merchant bankers.
(2) Disclose to the clients possible sources of conflict of duties and interest, if any while
accepting the assignment and while providing the services.
(3) Try his best to render the best possible advice to the clients having due regard to the client's
needs and his own professional skill.
(4) Providing all professional services to the client in a prompt efficient and cost-effective
manner.
(5) Make available to the investors: (a) true and adequate information relating to the issue
without making any misguided or exaggerated claims, (b) attendant risks relating to the issue
before any investment decisions are taken by them, and (c) copies of prospectus,
memorandum and related documents.
(6) Take adequate steps for fair allotment of securities and refund of application money without
delay.
(7) Adequately deal with complaints from the investors.

DONT'S FOR MERCHANT BANKER

In addition to the above a merchant banker has to adhere to the following don'ts of his
code of conduct:
(1) Do not practice unfair competition i.e. do not make any statement or become party and act
which is likely to harm the interest of other merchant bankers.
(2) Do not make any exaggerated statement, whether oral or written, to the client regarding his
qualifications or capability to render services or achievements regarding services to other
clients.
(3) Do not divulge to other clients, press or any other party and confidential information about
his client, which has come to knowledge.
(4) Do not deal in securities of any client company without disclosing it to SEBI and board of
directors of the client company.
(5) Do not be a party to creation of false market or price rigging or manipulations.
(6) Do not take any action, which is unethical or unfair to the investors.

Restriction on Business
No merchant banker, other than a bank/public financial institution (PFI) is permitted to
carryon business other than that in the securities market with effect from December 9, 1997.
 However, RBI may permit a merchant banker who is registered with RBI as a Primary
Dealer/Satellite Dealer may carryon such business as with effect from November 1999.

Maximum Number of Lead Managers

The maximum number of lead managers to an issue depends on the size of the issue as
detailed below;

size of issue Maximum Number of lead Managers

(i) Below Rs. 50 crore Two
(ii) From Rs. 50 to below Rs. 100 crore Three
(iii)From Rs. 100 crore to below Rs. 200 crore Four
(iv) From Rs. 200 crore to below Rs. 400 crore Five
Rs. 400 crore and above More than five with SEBI approval

3.8 SEPARATION OF MERCHAFT BANKING ACTIVITIES

On September 5, 1997, SEBI banned merchant and non banking financial companies
(NBFCs) from straying into each others. No merchant banker can now carry on fund-based
activities other than those relating exclusively to the capital market like underwriting. They
cannot accept deposits, or undertake activities like leasing, bill discounting and hire purchase.
NBFCs carrying out merchant banking activities will be given time to restructure.

It is believed that the SEBI's decision on merchant bankers business segregation is a

reaction to the fixed deposit debacle of CRB capital markets, which was a registered merchant
banker but an unregistered NBFC. The Reserve Bank of India (RBI) disclaimed responsibility
for CRB's misdeeds, as it was not registered as a NBFC while SEBI would no longer be
accountable for misdeeds in other activities of the same company. In the case of merchant
banking NBFC's the RBI alone would be responsible for the fund based actions while
segregation is aimed at avoiding the conflict between the two regulatory authorities RBI, which
governs the fund based activities and SEBI which regulates the fee-based activities. This
facilitates better consumer protection by containing the misuse of interconnections between the
two types of activities.

However, merchant bankers complain that having off these two activities into two
separate divisions would means greater infrastructure costs for these units. Moreover, income
from merchant banking alone had not been enough to meet the operational costs of their set-ups
and thus would make their survival difficult. SEBI does not seem to agree with this.

Some merchant banker has already come under difficulty. During October - November
1997, credit rating agencies downgraded a few merchant-banking firms to a level indicating
inadequate safety. SEBI shot off letters asking them not to take on any fresh assignments till they
achieve some stability. This is the first instance of SEBI taking action against a merchant banker
whose, borrowing programmes have been downgraded by a rating agency. According to SEBI's
merchant banking regulations, action can be taken against an intermediary if its financial position
depletes to very low levels.
3.9 RESPONSIBILITIES 1 OBLIGATIONS MANAGERS/MERCHANT BANKERS
A lead manager has following responsibilities towards the OF LEAD issuing company,
SEBI and his own profession:
a) Enter into a contract with the issuing company clearly specifying their mutual rights, obligations
and liabilities relating to the issue, particularly relating to disclosures, allotment and refund.
b) Submit a copy of the above contract to SEBI at least one month before the opening of the issue
for subscription. In case of more than one lead manager, simultaneously submit a statement
detailing their respective responsibilities.
c) Refuse acceptance of appointment as lead manager, if the issuing company is its associate.
d) Not to associate with a merchant banker who does not hold SEBI registration certificate.
e) Accept a minimum underwriting obligation of 5 per cent of total underwriting commitment or
Rs. 25lakh, whichever is less, or else arrange for underwriting of an equal amount by a merchant
banker associated with the issue and intimate the same to SEBI.
f) Submit ‘Due Diligence Certificate' to SEBI at least two weeks before the opening of the issue for
subscription after verification of the contents of the prospectus/letter of offer regarding the issue
and reasonableness of the views expressed therein certifying that (a) they are in conformity with
the documents, materials and papers relevant to the issue, (b) All legal requirements relating to
the issue have been fully complied with, and (c) all disclosures are true, fair and adequate to
enable the investing public to make a well-informed decision regarding investment in the
proposed issue.
g) Submit to SEBI various documents much as particulars of the issue, draft prospectus/ letter of
offer regarding the issue and other literature to be circulated to the investors/shareholders, etc., at
least two weeks before the date of filing them the registrar of companies and regional stock
exchanges.
h) Ensure that modifications and suggestions made by SEBI regarding above documents have been
duly incorporated.
i) Continue to remain fully associated with the issue till the subscribers have received
share/debenture certificate or the refund of excess application money.
j) Not to acquire securities of any company on the basis of unpublished price sensitive information
obtained in the course of discharge of his professional assignment, whether obtained from the
client or any other person.
k) Submit complete particulars with SEBI within 15 days of the acquisition of securities of the
company whose issue the merchant banker is managing.
l) Disclose to SEBI the following: (a) its responsibilities regarding the management of the issue,
(b) any change in the information/particulars previously furnished with SEBI having bearing on
certificate of registration granted to it,(c) details relating to the breach of capital adequacy norm
(d) names and addresses of the companies whose issues it has managed or has been associated
with, and (e) information regarding its activities as manager, underwriter, consultant or adviser to
the issue.

Due Diligence Certificate

The lead manager is responsible for the verification of the comments of a prospectus/
letter of offer in respect of an issue and the reasonableness of the views expressed in them. He
has to submit to the SEBI at least two weeks before the opening of the issue for subscription a
due diligence certificate to the effect that (a) the prospectus/letter of offer are in conformity with
the documents, materials and papers relevant to the issue (b) all legal requirements connected
 with the issue have been fully complied with and (c) the disclosures are true, fair and adequate to
enable the investors to make a well informed decision as to the investment in the proposed issue.

Submission of Documents
The leads manager(s) to an issue has (have) to submit at least two weeks before the date
of filing with the registrar of companies/regional stock exchanges or both, particulars of the
issue, draft prospectus/letter of offer, other literature to be circulated to the investors/
shareholders and so on to the SEBI. They have to ensure that the modification / suggestion made
by it with respect to the information to be given to the investors are duly incorporated. The draft
prospectus/draft letter of offer should be submitted to the SEBI along with the prescribed fee
specified below:

Issue size including premium and intended Fee per document

retention of over subscription
Up to Rs. 5Crore Rs. 10,000
Rs. 5 Crore - Rs. 10Crore Rs. 15,000
Rs. 10 Crore - Rs. 100 Crore Rs. 50,000
Rs. 100 Crore - Rs. 500 Crore Rs. 2,50,000
More than Rs. 500 Crore Rs.5,00,000
They have to continue to be associated with the issue till the subscribers have received
the share/debenture certificates or the refund of excess application money.

Acquisition of Shares
A merchant banker is prohibited from acquiring securities of any company on the basis of
unpublished price sensitive information obtained during the course of any professional
assignment either from the client or otherwise. He has to submit to the SEBI, the complete
particulars of any acquisition of securities of a company whose is being managed by him within
15 days from the date of transaction.

3.10 INSPECTION BY SEBI

SEBI can inspect books of accounts, records and documents of a merchant banker with
the object of:
(a) Ensuring that the books are maintained in the manner required,
(b) Ensuring that the provision of the SEBI Act, rules and regulations are being complied with.
(c) Investigating into the complaints from investors, other merchant bankers, or any other person
relating to any matter having a bearing on his activities as a merchant banker.
(d) Taking up a suo moto investigation into the affairs of the merchant banker in the interest of
securities business or investors interest.

SEBI can get the inspection done by its own inspection authority or it can appoint auditor
with the power of the inspection committee to investigate into the books of accounts and the
affairs and obligations of the merchant banker.

Regarding such inspection, the merchant banker has an obligation to:

 (1) Furnish all information called for,
(2) Allow a reasonable access to the premises.
(3) Provide reasonable facility for examination of books/ records/documents/ computer data,
etc., and provide copies of the same, and
(4) Give the required assistance to the inspecting authority in connection with the inspection.
On the basis of the facts revealed in the inspection report and after giving due opportunity
to the merchant banker to make an explanation, SEBI can ask merchant banker to take such
measures as it deems fit in the interest of the securities market and for due compliance with the
SEBI Act, rules and regulations.

Default by Merchant Bankers and Penalty Points

The SEBI imposes penalties for non-compliance of conditions for registration and
contravention of the regulations on the basis of the registration is suspended/ cancelled. The
default is categorized into (a) General, (b) Minor, (c) Major and (d) Serious.

(1) General Defaults

For the purpose of penalty points, the following activities are classified under general
defaults and attract one penal point :
a) Non-receipt of draft prospectus/ letter of offer from the lead manager by SEBI before filing
with the registrar of companies/stock exchange.
b) Non-receipt of interest allocation of responsibilities of lead managers in an issue by SEBI
prior to the opening of issue.
c) Non-receipt of due diligence certificate in the prescribed manner by SEBI, before opening of
the issue.
d) Failure to ensure the submission of certificate of minimum 90 per cent subscription to the
issue.
e) Failure to ensure expediting of dispatch of refund orders shares/debenture certificates, by the
issuers.

(2) Minor Defaults

The following are the minor defaults attracting two points:
a) Advertisement, circular, brochure, press release and other issue related materials not being in
conformity with the contents of the prospectus.
b) Exaggerated information or information extraneous to the prospectus is given by issuer or
associated merchant banker in any press conference, investors' conference, brokers
conference or other such conference/ meet prior to the issue for marketing of the issue
arranged/participated by the merchant banker.
c) Failure to substantiate matters contained in highlights to the issue in the prospectus. Violation
of regulations relating to advertisement on capital issues.
d) Failure to exercise due diligence in verifying the contents of prospectus / letter of offer.
e) Failure to provide adequate and fair disclosure to investors and objective information about
risk factors in the prospectus and other issue literature.
f) Delay in refund/allotment of securities.
g) Non-handling of investor grievances promptly.
(3) Major Defaults
The following are the major defaults fetching three points
(a) Mandatory underwriting not taken up by lead manager.
(b) Excess numbers of lead managers

(4) Serious Defaults

The following activities are categorized under serious defaults and attract four penalty points.
a) Unethical practice by a merchant banker and/ or violation of code of conduct.
b) Non-cooperation with SEBI in furnishing desired information, documents, evidence as may
be called for.
A merchant banker on reaching cumulative penalty points of eight (8) attracts action from SEBI
in terms of suspension/cancellation of authorization. To enable a merchant banker to take
corrective action, the maximum penalty points awarded in a single issue managed by a merchant
banker are restricted to four. In the event of joint responsibility, the same penalty points awarded
in a single issue managed by a merchant banker are restricted to four. In the event of joint
responsibility, the same penalty points are awarded allocation of responsibility, point.

Default in Prospectus: If the highlights are provided, the following deficiencies attract negative
points.
(i) Absence of risk factors
(ii) Absence of listing
(iii) Extraneous contents to prospectus, if stated.

The maximum grading points of prospects can be 10 and prospectuses scoring greater than or
equal to 8 points are categorized as A+, those with 6 or less than 8 points as A, those with 4 or
less than 6 points as B and those with score of less than 4 points, the prospectus falls in category
C.

General Negative Marks if all highlights are provided in an issue

(i) Risk factors, should form part of the highlights, otherwise attracts a negative point of -1.
(ii) Listing details, should from part of highlights, otherwise creates a negative point of -0.5.
(iii)Any matter extraneous to the contents of the prospectus, if stated in highlights, attracts a
negative point of -0.5.

Penalty Points System

A maximum penalty of 4 points can be awarded in a single issue managed by Merchant bankers.
On reaching a cumulative point of 8 they shall attract action from SEBI under clause 4 (m) of the
guidelines and clause 12 of the terms of authorization.

Type Nature Penalty Points

I General Defaults 1
II Minor Defaults 2
II Major Defaults 3
Serious Defaults 4
 Action for Default
A merchant banker who (I) fails to comply with any of the conditions subject to which certificate
of registration has been granted by SEBI, and /or (II) acts in violation of any of the provisions of
the SEBI Act, rules or regulations is liable to (a) suspension of registration, or (b) cancellation of
registration.

(a) Penalty of Suspension of Registration

Registration of a merchant banker may suspend in case of following acts of commission or
commission:
(i) Violates the provision of the SEBI Act, rules or regulations.
(ii) Violates the conditions of registration.
(iii)Fails to furnish to SEBI the required information relating to its activities as merchant banker.
(iv) Furnishes wrong, false or misleading information.
(v) Fails to submit periodical returns required by SEBI.
(vi) Denies co-operation in any enquiry/inspection conducted by SEBI.
(vii) Fails to resolve the complaints of the investors and/ or fails to give a satisfactory reply to
SEBI in this regard.
(viii) Indulges in manipulating prices of securities, or price concurring activitica.
(ix) Fails to maintain capital adequacy requirement.
(x) Fails to pay fees.
(xi) Fails to carry out obligations as per the rules and obligations and
(xii) Is guilty of breach of prescribed code of conduct.

(b) Penalty of Cancellation of Registration

(i) Indulges in deliberate manipulation or price rigging or cornering activities detrimental to the
interest of the securities market and/or the investors.
(ii) The financial position of the merchant banker has deteriorated to such that SEBI believes that
its continuance as merchant banker would not be in the interest of investors.
(iii)Is guilty of fraud and/or has been convicted of a criminal offence.
(iv) Repeated defaults leading to suspension of registration may lead to cancellation of
registration provided SEBI furnished reasons for cancellation in writing.

A merchant banker cannot carry on any activity as merchant banker with effect from the date of
suspension or cancellation, till registration is restored by SEBI after due compliance of all
provisions under SEBI act, rules and regulations.

3.11 UNDERWRITERS
Another important intermediary in the new issue/primary market is the underwriter to issue of
capital who agrees to take up securities, which are not fully subscribed. They make a
commitment to get the issue subscribed either by the others or by themselves. Though
underwriting is not mandatory after April 1995, Its organization is an important element of the
primary market. Underwriters are appointed by the issuing companies in consultation with the
lead managers/merchant brokers to the issue. A statement to the effect that in the opinion of the
lead manager, the underwriters assets are adequate to meet their obligations should be
incorporated in the prospectus.
 Registration
To act as underwriter, a certificate of registration must be obtained from the SEBI. In
granting the certificate of registration, the SEBI considers all matters relevant/relating to the
underwriting and in particular,(a) the necessary infrastructure like adequate office space,
equipment and manpower to effectively discharge the activities;(b) past experience in
underwriting/employment of at least two persons with experience in underwriting; (c) any person
directly/indirectly connected with the applicant is not registered with the SEBI as underwriter of
a previous application of any such person has been rejected or any disciplinary action has been
taken against such person under the SEBI Act/rules/ regulations,(d) capital adequacy requirement
of not less than the net worth (capital + free reserves) of Rs. 20lakh, and (e) the applicant
/director /principal officer/partner has been convicted of offence involving moral turpitude or
found guilty of any economic offence.
Underwriters, had to, for grant or renewal of registration, pay a fee to SEBI from the date
of initial grant of certificate, Rs. 2lakh for the first and second years and Rs. 1lakh for the third
year. A fee of Rs. 20,000 was payable every year to keep the certificate in force for its renewal.
Failure to pay the fee would result in the suspension of the certificate of registration.

4. SUMMARY
Merchant bank is an institution or on organization which provides a number of services
including management of securities issues, portfolio services, underwriting of capital issues,
insurance, credit syndication, financial advices and project counseling etc. These are four
categories of merchant bankers. On September 5, 1997 SEBI abolished all categories of
merchant bankers below category I. SEBI has issued guidelines regarding authorization.
Merchant bankers have to be compulsion by registered with SEBI and should satisfy the
conditions for registration and continuation of their registration. Every merchant banker has to
abide by a certain code of conduct. SEBI has banned merchant and non-banking finance
companies from straying into each other's. A lead manager has responsibilities towards the
issuing company, SEBI and his own profession. SEBI can inspect books of accounts, records and
documents of a merchant banker. Penalties of non-compliance of conditions for registration and
contravention of the provision of merchant banking regulation include suspension or cancellation
of registration. SEBI has classified defaults and the penalty points they attract. To act as
underwriter in the new issue/primary market, a certificate of registration must be obtained from
the SEBI.

5. SUGGESTED READINGS

Baver, Hans Peter, What is Merchant Bank, the Banker, London, July, 1976, pp. 795-799.

Bloch, Barnest, Inside Investment Banking, Dow Jones-Irwin, Illinois, 1986.

Commerce, Momentum of Merchant Banking in Indian Commerce, June 5, 1976, pp. 835-837
and 857.

Francis, John Clark, Management of Investments, Second edition, McGraw Hill International.

Government of India, Report of the Banking Commission, 1972, pp. 396-398.

 Government of India, Ministry of Finance, Guidelines for Merchant Bankera, FNo.1 (44) se/ 86
pl, iii. 9-4-1990.

Government of India, Department of Company, Authorization for merchant bankers, by SEBI.

FNO.1.3.91 CL.V Cir No.7/91, 22 2-1991
Government of India, Merchant Bankers Rules 1992, notification 23 12- 1902.

Maharaja H.R., Merchant Banking, 2nd ed. (1991), Wiley, Kneeing Publication, New Delhi.

Ramchandra B., Merchant Banking, Eastern Economist, February, 1974, pp. 165-168. Securities
and Exchange Board of India, Guidelines for Merchant Bankers, 7-11-1990.

Securities Exchange Board India, Merchant Bankers Regulations, 1992, Notification,

Bombay,22-12 1992.

Warren, Law, Investment Banking, Altman, Edward I, editor, Handbook of financial markets and
institution, sixth edition, New York, Wiley, 1987.

6. SELF ASSESSMENT QUESTIONS

1. Explain authorization criteria discuss terms of authorization.
2. Enumerate procedure registration merchant banker/lead manager.
3. Highlight do's and don'ts a merchant banker.
4. Explain major responsibilities obligations of merchant banker in India.
5. Discuss penalties of non-compliance of conditions for registration and contravention of the
provision of merchant banking regulation.