semester three second year master of commerce (as …

SEMESTER THREE

SECOND YEAR MASTER OF COMMERCE

(As per the prescribed syllabus of University of Mumbai)

Course Material by Krishnan Nandela, Associate Professor for Sir Dr. MS Gosavi Institute of

Post Graduate Studies and Research, Parel, Mumbai – 400 012

2

PROF. KRISHNAN NANDELA, DR. TK TOPE ARTS & COMMERCE COLLEGE, PAREL, MUMBAI - 12 2

UNIT

NAME

PAGE

NO.

I.

INTRODUCTION TO FINANCIAL SERVICES, LEASING AND

HIRE PURCHASE.

1. OVERVIEW OF FINANCIAL SERVICES IN INDIA. 04

Growth of Financial Services in India.

Structure of Financial Services in India.

Types of Financial Services in India.

2. MERCHANT BANKING. 20

Meaning, Nature and Functions of Merchant Banking.

Merchant Banking in India.

Role of Merchant banking in Issue Management.

Classification and Regulation of Merchant bankers by SEBI.

II. VENTURE CAPITAL AND SECURITIZATION

3. VENTURE CAPITAL. 34

Meaning and Definition.

Characteristics of Venture Capital.

Types or Forms of VC Assistance.

Process of Venture Capital.

Modes of Venture Capital Assistance.

4. SECURITIZATION. 39

Concept and Definition.

Need for Securitization.

Players involved in Securitization.

Structure of Securitization.

Instruments of Securitization.

Pass through and pay through securities.

Process of Securitization.

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III.

HIRE PURCHASE FINANCE AND HOUSING FINANCE

5. HIRE PURCHASE FINANCE. 56

Meaning and Concepts.

Installment credit and consumer credit.

Sources of hire purchase finance in India.

6. HOUSING FINANCE. 64

Need and nature.

Fixed and Floating Rate Home Loans.

Sources of Housing Finance in India.

Growth of housing finance in India.

Role of National Housing Bank.

Concept of Mortgage and Reverse Mortgage.

Housing loans and Mortgage Loans.

Types of Mortgage Loans.

IV.

STOCK BROKING AND DEPOSITORY SERVICES.

7. STOCK BROKING. 81

Meaning, Types of Stock Brokers and Sub-brokers.

Stock Broking in India.

E-broking – Meaning and Indian Experience.

8. DEPOSITORY SERVICES. 90

Meaning, Role of Depositories and their services.

Advantages of Depository System.

Functioning of Depository System.

Depositories in India – NSDL and CSDL.

Depository Participants and their Role.

9. CUSTODIAL SERVICES. 103

Meaning, Obligations and Responsibilities of Custodians.

Code of Conduct.

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MODULE ONE – I

CHAPTER ONE

PREVIEW.

Overview of Financial Services in India.

Growth of Financial Services in India.

Structure of Financial Services in India.

Types of Financial Services in India.

INTRODUCTION.

The Indian financial services industry has undergone a metamorphosis since1990. Before its

emergence the commercial banks and other financial institutions dominated the field and they met

the financial needs of the Indian industry. It was only after the economic liberalization that the

financial service sector gained some prominence. Now this sector has developed into an industry.

In general, all types of activities which are of financial nature may be regarded as financial

services. In a broad sense, the term financial services mean mobilization and allocation of savings.

Thus, it includes all activities involved in the transformation of savings into investment.

Financial services refer to services provided by the finance industry. The finance industry consists

of a broad range of organizations that deal with the management of money. These organizations

include banks, credit card companies, insurance companies, consumer finance companies, stock

brokers, investment funds and some government sponsored enterprises.

Financial services may be defined as the products and services offered by financial institutions for

the facilitation of various financial transactions and other related activities. Financial services 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 need it and

particularly to corporate customers. There are various institutions which render financial services.

Some of the institutions are banks, investment companies, accounting firms, financial institutions,

merchant banks, leasing companies, venture capital companies, factoring companies, mutual funds

etc. These institutions provide variety of services to corporate enterprises. Such services are called

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financial services. Thus, services rendered by financial service organizations to industrial

enterprises and to ultimate consumer markets are called financial services. These are the services

and facilities required for the smooth operation of the financial markets. In short, services provided

by financial intermediaries are called financial services.

OVERVIEW OF FINANCIAL SERVICES IN INDIA.

On the eve of the Independence, the financial system in the country was underdeveloped.

There were no issuing institutions and intermediary financial institutions. The industrial

sector had little access to the savings of the society. The capital market was also newly

emerging. The private organized and the unorganized sector played an important role in

supplying liquidity to the market. With the adoption of mixed economy, the development

of the financial system began taking place with an urgency to fulfill the socio-economic

and political objectives of the Government of independent India. The Government started

creating new financial institutions to supply finance both for agricultural and industrial

development and it also progressively started nationalizing some important financial

institutions so that the flow of the finance is channelized in the desired sectors and sub-

sectors of the Indian economy.

The RBI is the apex institution of the financial system in India. It was established as a

private institution in 1935 and was nationalized in 1948. It was followed by the

nationalization of the Imperial Bank of India in 1956 by renaming it as State Bank of India.

In the same year, 245 Life Insurance Companies were brought under Government control

by merging all of them into a single corporation called Life Insurance Corporation of India.

Another significant development in our financial system was the nationalization of 14

major commercial banks in 1969.Six more banks were nationalized in 1980. This process

was then extended to General Insurance Companies which were reorganized under the

name of General Insurance Corporation of India. thus, the important financial institutions

were brought under public control.

The Establishment of Mutual Fund Industry in India.

Mutual funds refer to the funds raised by financial service companies by pooling the

savings of the public and investing them in a diversified portfolio. They provide investment

avenues for small investors who cannot participate in the equities of big companies.

The Unit Trust of India was established in 1964 as a public sector institution to collect the

savings of the people and make them available for productive activities. It is governed by

its own statues and regulations. However, since 1994, the schemes of UTI have to be

approved by SEBI. It has introduced a number of open-ended and close-ended schemes. It

also provides re-purchase facility of units of the various income schemes of UTI are linked

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with stock exchanges. Its investment is confined to both corporate and non-corporate

sectors. It has established the following subsidiaries:

1. The UTI Bank Ltd., in April 1994.

2. The UTI Investor Service Ltd., to act as UTI’s own Registrar and Transfer agency.

3. The UTI Security Exchange Ltd.

Mutual funds have been set up by some public sector banks, LIC, GIC and by the private

sector also.

The Establishment of Development Banks.

Many development banks were started not only to extend credit facilities to financial

institutions but also to render advisory services. These banks are multipurpose institutions

which provide medium and long-term credit to industrial undertakings, discover

investment projects, undertake the preparation of project reports, provide technical advice

and managerial services and assist in the management of industrial units. These institutions

are intended to develop backward regions as well as small and new entrepreneurs.

The Industrial Finance Corporation of India (IFCI) was set up in 1948 with the object of

making medium and long-term credits more readily available to industrial concerns in

India, particularly under circumstances where normal banking accommodation is

inappropriate or recourse to capital issue method is impracticable. At the regional level,

State Financial Corporations were established under the State Financial Corporation Act,

1951 with a view to providing medium and long-term finance to medium and small

industries. It was followed by the establishment of the Industrial Credit and Investment

Corporation of India (ICICI) in 1955 to develop large and medium industries in private

sector, on the initiative of the World Bank. It adopted a more dynamic and modern

approach in industrial financing. Subsequently, the Government of India set up the

Refinance Corporation of India (RCI) in 1958 with a view to providing refinance facilities

to banks against term loans granted by them to medium and small units. Later on it was

merged with the Industrial Development Bank of India. The Industrial Development Bank

of India (IDBI) was established on July 1, 1964 as a wholly owned subsidiary of the RBI.

The ownership of IDBI was then transferred to the Central Government with effect from

February 16, 1976. The IDBI is the apex institution in the area of development banking

and as such it has to co-ordinate the activities of all the other financial institutions. At the

State level, the State Industrial Development Corporations (SIDCO)/State Industrial

Investment Corporations were created to meet the financial requirements of the States and

to promote regional development.

In 1971, the IDBI and LIC jointly set up the Industrial Reconstruction Corporation of India

(IRCI) with the main objective of reconstruction and rehabilitation of sick industrial

undertakings. The IRCI was converted into a statutory corporation in March 1985 and

renamed as the Industrial Reconstruction Bank of India (IRBI). In 1997, the IRBI has to be

completely restructured since it itself has become sick due to financing of sick industries.

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Now, it is converted into a limited company with a new name of Industrial Investment

Bank of India (IIBI). Its objective is to finance only for expansion, diversification,

modernization etc., of industries and thus it has become a development bank.

The Small Industries Development Bank of India (SIDBI) was set up as a wholly owned

subsidiary of IDBI. It commenced operations on April 2, 1990. The SIDBI has taken over

the responsibility of administrating the Small Industries Development Fund and the

National Equity Fund.

Institution for Financing Agriculture

In 1963, the RBI set up the Agricultural Refinance and Development Corporation (ARDC)

to provide refinance support to banks to finance major development projects such as minor

irrigation, farm mechanization, land development, horticulture, dairy development, etc.

However, in July 1982, the National Bank for Agriculture and Rural Development

(NABARD) was established and the ARDC was merged with it. The whole sphere of

agricultural finance has been handed over to NABARD. The functions of the Agricultural

Credit Department and Rural Planning and Credit Cell of the RBI have been taken over by

NABARD.

Institution for Foreign Trade

The Export and Import Bank of India (EXIM Bank) was set up on January 1, 1982 to take

over the operations of International Finance wing of the IDBI. Its main objective is to

provide financial assistance to exporters and importers. It functions as the principal

financial institution for coordinating the working of other institutions engaged in financing

of foreign trade. It also provides refinance facilities to other financial institutions against

their export-import financing activities.

Institution for Housing Finance

The National Housing Bank (NHB) has been set up on July 9, 1988 as an apex institution

to mobilize resources for the housing sector and to promote housing finance institutions

both at regional and local levels. It also provides refinance facilities to housing finance

institutions and scheduled banks. It also provides guarantee and underwriting facilities to

housing finance institutions. Again, its co-ordinates the working of all agencies connected

with housing.

Stock Holding Corporation of India Ltd. (SHCIL)

In 1987 another institution viz., Stock Holding Corporation of India Ltd. was set up to tone

up the stock and capital markets in India. Its main objective is to provide quick share

transfer facilities, clearing services, Depository services, support services, management

information services and development services to investors both individuals and

corporates. The SHCIL was set up by seven All India financial institutions viz., IDBI, IFCI,

ICICI, LIC, GIC, UTI and IRBI.

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Venture Capital Institutions

Venture capital is another method of financing in the form of equity participation. A

venture capitalist finances a project based on the potentialities of a new innovative project.

Much thrust is given to new ideas or technological innovations. It is a long-term risk capital

used to finance high technology projects. The IDBI venture capital fund was set up in 1986.

The IFCI has started a subsidiary to finance venture capital viz., The Risk Capital and

Technology Finance Corporation (RCTC). Likewise the ICICI and the UTI have jointly set

up the Technology Development and Information Company of India Limited (TDICI) in

1988 to provide venture capital. Similarly many State Financial Corporations and

commercial banks have started subsidiaries to provide venture capital. The Indus Venture

Capital Fund and the Credit Capital Venture Fund Limited come under the private sector.

Credit Rating Agencies.

Credit rating agencies have been established to help investors to decide investment in

various instruments and to protect them from risky ventures. At the same time it has the

effect of improving the competitiveness of the companies. Credit rating is now mandatory

for all debt instruments. Similarly, for accepting deposits, non-banking companies have to

compulsorily go for credit rating. Some of the credit rating agencies established are:

1. Credit Rating and Information Services of India Ltd. (CRISIL)

2. Investment Information and Credit Rating Agency of India Ltd. (ICRA).

3. Credit Analysis and Research Limited (CARE).

4. Duff Phelps Credit Rating Pvt Ltd (DCR India).

The rating is confined to fixed deposits, debentures, preference shares and short-term

instruments like commercial paper. The establishment of various credit rating agencies will

go a long way in stabilizing the financial system in India by supplying vital credit

information about corporate customers.

Variety of Financial Instruments.

The expansion in size and number of financial institutions has consequently led to a

considerable increase in the financial instruments. New instruments have been introduced

in the form of innovative schemes of LIC, UTI, Banks, Post Office Savings Bank Accounts,

Shares and debentures of different varieties, Public Sector Bonds, National Savings

Scheme, National Savings Certificates, Provident Funds, Relief Bonds, Indira Vikas Patra,

etc. Thus different types of instruments are available in the financial system so as to meet

the diversified requirements of varied investors and thereby making the system vibrant and

resilient.

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Legislative Support

The Indian financial system has been well supported by suitable legislative measures taken

by the Government then and there for its proper growth and smooth functioning. Though

there are many enactments, some of them are very important. The Indian Companies Act

was passed in 1956 with a view to regulating the function of companies from birth to death.

It mainly aims at giving more protection to investors since there is a diversity of ownership

and management in companies. It was a follow up to the Capital Issues Control Act passed

in 1947. Again, in 1956, the Securities Contracts (Regulations) Act was passed to prevent

undesirable transactions in securities. It mainly regulates the business of trading in the

stock exchanges. This Act permitted only recognized stock exchanges to function. To

ensure the proper functioning of the economic system and to prevent concentration of economic

power in the hands of a few, the Monopolies and Restrictive Trade Practices Act was

passed in 1970. In 1973, the Foreign Exchange Regulations Act was enacted to regulate

the foreign exchange dealings and to control Indian investments abroad and vice versa.

The Capital Issue Control Act was replaced by setting up of the Securities Exchange Board

of India. Its main objective is to protect the interest of investors by suitably regulating the

dealings in the stock market and money market so as to achieve efficient and fair trading

in these markets. When the Government adopted the New Economic Policy, many of these

Acts were amended so as to remove many unwanted controls. Bank and financial

institutions have been permitted to become members of the stock market in India. They

have been permitted to float mutual funds, undertake leasing business, carry out factoring

services etc.

Besides the above, the Indian Contract Act, The Negotiable Instruments Act, The Law of

Limitation Act, The Banking Regulations Act, The Stamp Act etc., deserve a special

mention. When the financial system grows, the necessity of regulating it also grows side

by side by means of bringing suitable legislations. These legislative measures have

reorganized the Indian financing system to a greater extent and have restored confidence

in the minds of the investing public as well.

GROWTH OF FINANCIAL SERVICES IN INDIA.

The services sector has been a great stimulus to the Indian economy accounting for 56.9 per cent

of the gross domestic product (GDP), wherein the financial services segment has been a major

contributor. The growth of the financial sector in India at present is nearly 8.5 per cent per year.

Dominated by commercial banks which have over 60 per cent share of the total assets, India's

financial sector comprises commercial banks, insurance firms, non-banking institutions, mutual

funds, cooperatives and pension funds, among other financial entities.

The financial sector has undergone transformation and development since the beginning of

economic reforms in the year 1991. The Government of India has helped in this development,

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introducing reforms to liberalize, regulate and enhance the country's financial services. India is

now recognized as one of the world's most vibrant capital markets.

The Government of India has introduced several reforms to liberalize, regulate and enhance this

industry. The Government and Reserve Bank of India (RBI) have taken various measures to

facilitate easy access to finance for Micro, Small and Medium Enterprises (MSMEs). These

measures include launching Credit Guarantee Fund Scheme for Micro and Small Enterprises,

issuing guideline to banks regarding collateral requirements and setting up a Micro Units

Development and Refinance Agency (MUDRA). With a combined push by both government and

private sector, India is undoubtedly one of the world's most vibrant capital markets. In 2017, a new

portal named 'Undynamic Mitra' has been launched by the Small Industries Development Bank of

India (SIDBI) with the aim of improving credit availability to Micro, Small and Medium

Enterprises' (MSMEs) in the country. India has scored a perfect 10 in protecting shareholders'

rights on the back of reforms implemented by Securities and Exchange Board of India (SEBI).

Insurance.

Digital channels will influence nearly 75 per cent of the insurance policies sold by 2020 during the

pre-purchase, purchase or renewal stages, according to a report by Boston Consulting Group

(BCG) and Google India. According to the report, insurance sales from online channels will be 20

times what it is today by 2020, with overall internet influenced sales expected to be around Rs.

Three to Four Trillion.

Indian insurance companies had spent Rs 12,100 crore (US$ 2.01 billion) on information

technology (IT) products and services in the year 2014, a 12 per cent increase over 2013, according

to Gartner Inc. This investment considers spending by insurers on internal and external IT services,

software, hardware and telecommunications. The software segment is predicted to be the fastest

developing external segment, which has increased at 18 per cent in 2014 overall, driven by the

growth of insurance-specific software.

The insurance industry has been expanding at a fast pace. The total first year premium of life

insurance companies grew 17.35 per cent year-on-year to reach US$ 25.44 billion during April

2017-February 2018. Furthermore, India’s leading bourse Bombay Stock Exchange (BSE) will set

up a joint venture with Ebix Inc to build a robust insurance distribution network in the country

through a new distribution exchange platform.

Banking.

Indian banks operating overseas saw higher credit growth in comparison to their foreign

counterparts operating in India, according to Reserve Bank of India's (RBI) survey on international

trade in banking services. The survey for 2012-13 showed growth of credit extended by Indian

banks' branches operating overseas to have increased by 31.7 per cent to Rs 585,570 crore (US$

98.18 billion).

Increased growth in agriculture and services sectors as well as in the personal loans segment,

helped bank credit grow during the April-November period of 2013 by 7.2 per cent; during the

same period of 2012, bank credit growth stood at 6.6 per cent.

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Mutual Funds Industry.

More than 80 per cent of Indian investors are satisfied with their mutual fund schemes, according

to a survey by Financial Intermediaries Association of India (FIAI). The survey also stated that 60

per cent of the mutual fund investors were satisfied with services of advisers and distributors of

investment schemes.

The Mutual Fund (MF) industry in India has seen rapid growth in Assets Under Management

(AUM). Total AUM of the industry stood at Rs 23.26 lakh crore (US$ 360.90 billion) as of April

2018. At the same time the number of Mutual fund (MF) equity portfolios reached a record high

of 2.27 billion in February 2018. Due to rising in investments in the Mutual Funds and other

financial instruments, the revenues of the brokerage industry in India are forecasted to grow by

15-20 per cent to reach Rs 18,000-19,000 crore (US$ 2.80-2.96 billion) in FY2017-18, backed by

healthy volumes and a rise in the share of the cash segment.

Capital Market.

The Indian capital markets have witnessed a transformation over the last decade. India is now

placed among the mature markets of the world. Key progressive initiatives taken by the Indian

market institutions has been the depository and share dematerialization systems that have enhanced

the efficiency of the transaction cycle, Replacing the flexible, but often exploited, forward trading

mechanism with rolling settlement, to bring about transparency, Corporatization of stock

exchanges etc.

Indian capital markets have rewarded Foreign Institutional Investors (FIIs) with attractive

valuations and increasing returns. Many new instruments have been introduced in the markets,

including index futures, index options, derivatives and options and futures in select stocks.

Along with the secondary market, the market for Initial Public Offers (IPOs) has also witnessed

rapid expansion. The total amount of Initial Public Offerings increased to Rs 84,357 crore (US$

13,089 million) by the end of FY18.

Venture Capital.

Technology and knowledge have been and continue to drive the global economy. Given the

inherent strength by way of its human capital, technical skills, cost competitive workforce,

research and entrepreneurship, India is positioned for rapid economic growth in a sustainable

manner. The Indian venture capital sector has been active despite facing a challenging external

environment in last decade and a competitive market scenario.

According to a survey conducted by Thomson Financial and Prime Database, India ranked as the

third most active venture capital market in Asia Pacific at the start of 20th century. There is an

increased interest in India. The amount has grown nearly twenty-fold in the past five years. VC

funds that operate in India with the total assets under management are nearly worth about US$ 6

billion. Most VCs believe that this decade will be driven by a relatively stable economy and new

initiatives that will boost the e-commerce sector, particularly online trading and e-banking sectors.

To realize the potential, there is a need for risk finance and venture capital (VC) funding to leverage

innovation, promote technology and harness knowledge-based ideas.

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Private Equity, Mergers & Acquisitions in India.

Mergers and acquisitions (M&A) activity between India and the European Union is poised to grow

in the years to come according to Mumbai-based investment bank Avendus Capital. The IT and

Business Process Outsourcing (BPO) industry are expected to lead the way in scouting for

acquisitions in Europe.

Private Equity (PE) firms invested US$ 2.27 billion in the period of January-March 2014, a 93 per

cent increase from the investments (US$ 1.18 million) made during the same quarter of 2013.

There were five investments of US$ 100 million or more in the quarter against one in the

corresponding period of 2013.

Over the past few years India has witnessed a huge increase in Mergers and Acquisition (M&A)

activity. The total value of M&A in India rose 53.3 per cent year-on-year to US$ 77.6 billion in

2017 from US$ 50.6 billion in the preceding year.

Foreign Institutional Investors (FIIs) in India

Non-resident Indians (NRIs) and FIIs will now be allowed to invest in the insurance sector, within

the overall 26 per cent cap on foreign direct investment (FDI). The department of industrial policy

and promotion (DIPP) in a press note confirmed that apart from insurance companies, the

relaxation would also cover insurance brokers, third-party administrators (TPAs), surveyors and

loss assessors.

FIIs were gross buyers of debt securities valued at Rs 30,266 crore (US$ 5.07 billion) and sellers

of bonds worth Rs 11,450 crore (US$ 1.91 billion) in, 2014, which resulted in a net inflow of Rs

18,816 crore (US$ 3.15 billion), according to data released by the Securities and Exchange Board

of India (SEBI). Also, during the same period, FIIs invested Rs 3,473 crore (US$ 582.21 million)

into the equity market, making their total investment in debt and stocks to be around Rs 22,289

crore (US$ 3.73 billion).Foreign investors invested about Rs 371,342 crore (US$ 62.25 billion)

into India's stock market in the four years ended December 2013.

Investments by FIIs in the Indian stock market crossed the Rs 1 trillion (US$ 16.77 billion) mark

in December 2013, the third time this has been achieved since FIIs' entry into the capital market

in 1992-93.

Investments/Developments.

1. Global payments solution giant Master card has launched its first technology lab in Pune,

which will enable India to move towards digital economy and financial inclusion.

2. Four metro cities of Delhi, Mumbai, Bangalore and Chennai can reap benefits of US$ 7.2

billion annually by increasing payments through digital means.

3. Bank Bazaar, a financial marketplace start-up in India, raised US$ 30 million in a funding

round led by Experian Plc, a credit rating agency based in UK, taking the company's total

funding to US$ 110 million.

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4. Private equity (PE) investments in India increased 59 per cent to US$ 24.4 billion in 2017,

with average deal size of US$ 42.8 million, according to data provided by Venture

Intelligence.

5. Private equity and venture capital firms recorded investments worth US$ 7.9 billion with

180 deals during January-March 2018.

6. In May 2018, total equity funding of microfinance sector grew at the rate of 39.88 to Rs

96.31 billion (Rs 4.49 billion) in 2017-18 from Rs 68.85 billion (US$ 1.03 billion).

Government Initiatives.

1. SEBI plans to allow investors to make mutual funds transactions worth up to Rs 50,000

(US$ 750) a month through digital wallets, as part of its efforts to digitize the distribution

processes for all financial products. It also plans to allow immediate credit to customer’s

bank accounts on liquid mutual funds redemption to attract retail customers as well as boost

inflows.

2. The Government of India has relaxed norms for small merchants with a turnover of up to

Rs 2 crore (US$ 300,000), allowing them to pay 6 per cent of deemed profit in tax instead

of 8 per cent of total turnover or gross receipts received through banking channels or digital

means for FY 2016-17, in a bid to encourage cashless transactions in the country.

3. The lending target has been fixed at Rs 244,000 crore (US$ 36.46 billion) for 2017-18.

4. The Government of India launched the 'Bharat 22' exchange traded fund (ETF), which will

be managed by ICICI Prudential Mutual Fund, and is looking to raise Rs 8,000 crore (US$

1.22 billion) initially.

5. In April 2018, the Government of India issued minimum FDI capital requirement of US$

20 million for unregistered /exempt financial entities engaged in ‘fund-based activities’

and threshold of US$ 2 million for unregistered financial entities engaged in ‘non-fund-

based activities.

FUTURE PROSPECTS.

India is one of the top 10 economies in the world with strong banking and insurance sectors. It is

expected to become the fifth largest banking sector in the world by 2020 and the third largest by

2025, according to a joint report by KPMG. The report expects bank credit to grow at a compound

annual growth rate (CAGR) of 17 per cent in the medium term leading to better credit penetration.

India is today one of the most vibrant global economies, on the back of robust banking and

insurance sectors. The relaxation of foreign investment rules has received a positive response from

the insurance sector, with many companies announcing plans to increase their stakes in joint

ventures with Indian companies. Over the coming quarters there could be a series of joint venture

deals between global insurance giants and local players.

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The Association of Mutual Funds in India (AMFI) is targeting nearly five-fold growth in assets

under management (AUM) to Rs 95 lakh crore (US$ 1.47 trillion) and a more than three times

growth in investor accounts to 130 million by 2025.

India's mobile wallet industry is estimated to grow at a Compound Annual Growth Rate (CAGR)

of 150 per cent to reach US$ 4.4 billion by 2022 while mobile wallet transactions to touch Rs 32

trillion (USD $ 492.6 billion) by 2022.

STRUCTURE OF FINANCIAL SERVICES IN INDIA.

Financial services in India can be classified into fund based and fee-based (or non-fund-based

services. These services are briefly explained below.

TYPES OF FINANCIAL SERVICES.

The financial services can be broadly classified into two: (a) fund-based services and (b) non-fund

services (or fee-based services).

Fund based Services

The fund-based or asset-based services include the following:

1. Underwriting 2. Dealing in secondary market activities 3. Participating in money market instruments like CPs, CDs etc. 4. Equipment leasing or lease financing 5. Hire purchase 6. Venture capital 7. Bill discounting. 8. Insurance services 9. Factoring 10. Forfaiting 11. Housing finance 12. Mutual fund

Non-fund-based Services

Today, customers are not satisfied with mere provision of finance. They expect more from

financial service companies. Hence, the financial service companies or financial intermediaries

15


provide services based on non-fund activities also. Such services are also known as fee-based

services. These include the following: 1. Securitization 2. Merchant banking 3. Credit rating 4. Loan syndication 5. Business opportunity related services 6. Project advisory services 7. Services to foreign companies and NRIs. 8. Portfolio management 9. Merger and acquisition

10. Capital restructuring 11. Debenture trusteeship 12. Custodian services 13. Stock broking

The most important fund based and non-fund-based services (or types of services) may be briefly

discussed as below:

A. Asset/Fund Based Services

1. Equipment leasing/Lease financing: A lease is an agreement under which a firm acquires

a right to make use of a capital asset like machinery etc. on payment of an agreed fee called

lease rentals. The person (or the company) which acquires the right is known as lessee. He

does not get the ownership of the asset. He acquires only the right to use the asset. The

person (or the company) who gives the right is known as lessor.

2. Hire purchase and consumer credit: Hire purchase is an alternative to leasing. Hire

purchase is a transaction where goods are purchased and sold on the condition that payment

is made in instalments. The buyer gets only possession of goods. He does not get

ownership. He gets ownership only after the payment of the last instalment. If the buyer

fails to pay any instalment, the seller can repossess the goods. Each instalment includes

interest also.

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3. Bill discounting: Discounting of bill is an attractive fund based financial service provided

by the finance companies. In the case of time bill (payable after a specified period), the

holder need not wait till maturity or due date. If he needs money, he can discount the bill

with his banker. After deducting a certain amount (discount), the banker credits the net

amount in the customer’s account.

Thus, the bank purchases the bill and credits the customer’s account with the amount of

the bill less discount. On the due date, the drawee makes payment to the banker. If he fails

to make payment, the banker will recover the amount from the customer who has

discounted the bill. In short, discounting of bill means giving loans on the basis of the

security of a bill of exchange.

4. Venture capital: Venture capital simply refers to capital which is available for financing

the new business ventures. It involves lending finance to the growing companies. It is the

investment in a highly risky project with the objective of earning a high rate of return. In

short, venture capital means long term risk capital in the form of equity finance.

5. Housing finance: Housing finance simply refers to providing finance for house building.

It emerged as a fund based financial service in India with the establishment of National

Housing Bank (NHB) by the RBI in 1988. It is an apex housing finance institution in the

country. Till now, a number of specialized financial institutions/companies have entered in

the field of housing finance. Some of the institutions are HDFC, LIC Housing Finance, Citi

Home, Ind Bank Housing etc.

6. Insurance services: Insurance is a contract between two parties. One party is the insured

and the other party is the insurer. Insured is the person whose life or property is insured

with the insurer. That is, the person whose risk is insured is called insured. Insurer is the

insurance company to whom risk is transferred by the insured. That is, the person who

insures the risk of insured is called insurer. Thus, insurance is a contract between insurer

and insured. It is a contract in which the insurance company undertakes to indemnify the

insured on the happening of certain event for a payment of consideration. It is a contract

between the insurer and insured under which the insurer undertakes to compensate the

insured for the loss arising from the risk insured against.

According to Mc Gill, “Insurance is a process in which uncertainties are made certain”. In

the words of Jon Megi, “Insurance is a plan wherein persons collectively share the losses

of risks”.

Thus, insurance is a device by which a loss likely to be caused by uncertain event is spread

over a large number of persons who are exposed to it and who voluntarily join themselves

against such an event. The document which contains all the terms and conditions of

insurance (i.e. the written contract) is called the ‘insurance policy’. The amount for which

the insurance policy is taken is called ‘sum assured’. The consideration in return for which

the insurer agrees to make good the loss is known as ‘insurance premium’. This premium

17


is to be paid regularly by the insured. It may be paid monthly, quarterly, half yearly or

yearly.

7. Factoring: Factoring is an arrangement under which the factor purchases the account

receivables (arising out of credit sale of goods/services) and makes immediate cash

payment to the supplier or creditor. Thus, it is an arrangement in which the account

receivables of a firm (client) are purchased by a financial institution or banker. Thus, the

factor provides finance to the client (supplier) in respect of account receivables. The factor

undertakes the responsibility of collecting the account receivables. The financial institution

(factor) undertakes the risk. For this type of service as well as for the interest, the factor

charges a fee for the intervening period. This fee or charge is called factorage.

8. Forfeiting: Forfeiting is a form of financing of receivables relating to international trade.

It is a non-recourse purchase by a banker or any other financial institution of receivables

arising from export of goods and services. The exporter surrenders his right to the forfeiter

to receive future payment from the buyer to whom goods have been supplied. Forfeiting is

a technique that helps the exporter sells his goods on credit and yet receives the cash well

before the due date. In short, forfeiting is a technique by which a forfeiter (financing

agency) discounts an export bill and pay ready cash to the exporter. The exporter need not

bother about collection of export bill. He can just concentrate on export trade.

9. Mutual fund: Mutual funds are financial intermediaries which mobilize savings from the

people and invest them in a mix of corporate and government securities. The mutual fund

operators actively manage this portfolio of securities and earn income through dividend,

interest and capital gains. The incomes are eventually passed on to mutual fund

shareholders.

Non-Fund Based/Fee Based Financial Services

1. Merchant banking.

Merchant banking is basically a service banking, concerned with providing non-fund-based

services of arranging funds rather than providing them. The merchant banker merely acts as an

intermediary. Its main job is to transfer capital from those who own it to those who need it. Today,

merchant banker acts as an institution which understands the requirements of the promoters on the

one hand and financial institutions, banks, stock exchange and money markets on the other. SEBI

(Merchant Bankers) Rule, 1992 has defined a merchant banker as, “any person who is engaged in

the business of issue management either by making arrangements regarding selling, buying

or subscribing to securities or acting as manager, consultant, advisor, or rendering

corporate advisory services in relation to such issue management”.

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2. Credit rating:

Credit rating means giving an expert opinion by a rating agency on the relative willingness and

ability of the issuer of a debt instrument to meet the financial obligations in time and in full. It

measures the relative risk of an issuer’s ability and willingness to repay both interest and principal

over the period of the rated instrument. It is a judgement about a firm’s financial and business

prospects. In short, credit rating means assessing the creditworthiness of a company by an

independent organization.

3. Stock broking.

Stock broking has emerged as a professional advisory service. Stockbroker is a member of a

recognized stock exchange. He buys, sells, or deals in shares/securities. It is compulsory for each

stock broker to get himself/herself registered with SEBI to act as a broker. As a member of a stock

exchange, he will have to abide by its rules, regulations and by-laws.

4. Custodial services.

In simple words, the services provided by a custodian are known as custodial services (custodian

services). Custodian is an institution or a person who is handed over securities by the security

owners for safe custody. Custodian is a caretaker of a public property or securities. Custodians are

intermediaries between companies and clients (i.e. security holders) and institutions (financial

institutions and mutual funds). There is an arrangement and agreement between custodian and real

owners of securities or properties to act as custodians of those who hand over it. The duty of a

custodian is to keep the securities or documents under safe custody. The work of custodian is very

risky and costly in nature. For rendering these services, he gets a remuneration called custodial

charges. Thus custodial service is the service of keeping the securities safe for and on behalf of

somebody else for a remuneration called custodial charges.

5. Loan syndication.

Loan syndication is an arrangement where a group of banks participate to provide funds for a

single loan. In a loan syndication, a group of banks comprising 10 to 30 banks participate to

provide funds wherein one of the banks is the lead manager. This lead bank is decided by the

corporate enterprises, depending on confidence in the lead manager. A single bank cannot give a

huge loan. Hence, banks join together and form a syndicate. This is known as loan syndication.

Thus, loan syndication is similar to consortium financing.

6. Securitization (of debt).

Loans given to customers are assets for the bank. They are called loan assets. Unlike investment

assets, loan assets are not tradable and transferable. Thus, loan assets are not liquid. The problem

is how to make the loan of a bank liquid. This problem can be solved by transforming the loans

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into marketable securities. Now loans become liquid. They get the characteristic of marketability.

This is done through the process of securitization. Securitization is a financial innovation. It is

conversion of existing or future cash flows into marketable securities that can be sold to investors.

It is the process by which financial assets such as loan receivables, credit card balances, hire

purchase debtors, lease receivables, trade debtors etc. are transformed into securities. Thus, any

asset with predictable cash flows can be securitized.

Securitization is defined as a process of transformation of illiquid asset into security which may

be traded later in the opening market. In short, securitization is the transformation of illiquid, non-

marketable assets into securities which are liquid and marketable assets. It is a process of

transformation of assets of a lending institution into negotiable instruments.

Securitization is different from factoring. Factoring involves transfer of debts without

transforming debts into marketable securities. But securitization always involves transformation

of illiquid assets into liquid assets that can be sold to investors.

Questions.

1. Give an overview of the financial services in India.

2. Explain the growth of financial services in India.

3. Explain the structure of financial services in India.

4. Explain the types of financial services in India.

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MODULE ONE – I

CHAPTER TWO

PREVIEW.

Meaning, Nature and Functions of Merchant Banking.

Merchant Banking in India.

Role of Merchant Banking in Issue Management.

Classification and Regulation of Merchant Bankers by SEBI.

MEANING AND NATURE OF MERCHANT BANKING.

A merchant bank is a financial institution which intermediates between the issuers and the ultimate

purchases of securities in the primary market. The SEBI (Merchant Bankers) Rules 1992 has

defined a Merchant Banker as “any person who is engaged in the business of issue management

either by making arrangements regarding selling, buying or subscribing to securities as

manager, consultant, advisor or rendering corporate advisory service in relation to such

issue management”.

Merchant banking is non-banking financial activity. It is a financial service. It includes the entire

range of financial services. Merchant banking may be defined as a process of transferring capital

from those who own it to those who use it. According to Random House Dictionary, “merchant

bank is an organization that Under-writes securities for corporations, advices 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 bankers and

sometimes houses which are neither merchants nor banks”. In short, “merchant bank refers to

an organization that underwrites securities and advises such clients on issues like corporate

mergers, involving in the ownership of commercial ventures”.

Merchant banking involves a wide range of activities such as management of customer services,

portfolio management, credit syndication, acceptance credit, counseling, insurance, preparation of

feasibility reports etc. It is not necessary for a merchant banker to carry out all the above-mentioned

activities. A merchant banker may specialize in one activity, and take up other activities, which

may be complementary or supportive to the specialized activity. Merchant banking therefore

involves servicing any financial need of the customer. Some of the world-famous merchant

banks are Goldman Sachs, Credit Suisse & Morgan Stanley etc. In India there are many banks

which are into the field of merchant banking some of the banks are ICICI, State Bank of India,

Punjab National Bank etc.

MERCHANT BANKING

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Nature of Merchant Banking.

The nature of any institution is determined by its functions. Merchant bankers provide a plethora

of financial services which includes project counseling, pre-investment activities, feasibility

studies, project reports, design of capital structure, issue management, underwriting, loan

syndication, mobilization of funds, foreign currency finance, mergers, amalgamation, takeover,

venture capital and public deposits. It is a skill-based activity and caters to the financial

requirements of any customer.

DISTINCTION BETWEEN MERCHANT AND COMMERCIAL BANK.

Merchant banks are different from commercial banks. The following are the important differences

between merchant banks and commercial banks:

1. Commercial banks are catering to the needs of the common man whereas the merchant

banks cater to the needs of corporate firms.

2. Any person can open a bank account in the commercial bank whereas it cannot be done in

the merchant bank.

3. Merchant bank deals with equities whereas the commercial bank deals with debt related

finance which includes the activities like credit proposals, loan sanctions etc.

4. The merchant bank is exposed to the market. Hence, it is more exposed to risk as compared

to commercial banks.

5. Merchant bank is related to the primary market whereas the commercial markets are more

into secondary markets.

6. Merchant banking activities are capital restructuring, underwriting, portfolio management

etc., whereas the commercial banks play the role of financers.

7. The activities of merchant banks have a direct impact on the growth and liquidity of money

markets.

8. Merchant Bank is management oriented whereas the commercial banks are asset oriented.

9. The commercial banks generally avoid risks and on the other hand the merchant banks are

willing to take the risks.

FUNCTIONS OF MERCHANT BANKING.

Merchant banks procure funds for capital market in order to finance the operations of the corporate

sector. The functions of merchant bankers can be broadly classified into pre-issue management

and post-issue management.

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The core competency of merchant banking is public issue of securities. When companies want to

raise resources for a new project, finance expansion or modernization or diversification of its

operations or fund long term capital requirement, they seek the services of a merchant banker. In

both pre-issue and post issue management, legal requirements must be complied with.

Types of Issues.

1. Public Issue. Public issues of shares, securities and debentures are made in the primary

market. An offer to public is made through issue of prospectus or subscribed directly.

Publicity exercise is undertaken to inform the public about the issue. The intermediaries

who organize these activities are merchant bankers. An initial public offer (IPO) is made

for the first time after incorporation or conversion from private limited to public limited

company. The initial and further issues may be offered for cash subscription or for

consideration such as change of ownership either of physical assets or technical know-how.

2. Exchange Issue. In an exchange issue, shares of one company are exchanged for another

as in the case of takeover or mergers. Exchange does not add to the funds of the company.

However, mergers and acquisitions may create synergy i.e. emergence of new found

advantages.

3. Bonus Issue. A bonus issue involves allocation of additional shares to the existing

shareholders from the profits made by the company. It does not lead to generation of

additional resources. However, it helps in using existing resources for financing the

operations of the company.

4. Rights Issue. Rights issue involves issue of new shares to existing shareholders at a

premium.

PRE-ISSUE MANAGEMENT.

Pre-issue management involves the following activities:

1. Issue by prospectus, offer for sale and private placement.

2. Marketing and underwriting.

3. Pricing of Issues.

CORPORATE COUNSELING.

One of the important functions of a merchant banker is corporate counseling. Corporate counseling

refers to a set of activities undertaken to ensure efficient functioning of a corporate enterprise

through effective financial management. A merchant banker guides the client on aspects of

organizational goals, vocational factors, organization size, choice of product, demand forecasting,

cost analysis, allocation of resources, investment decisions, capital and expenditure management,

marketing strategy, pricing methods etc. The following activities are included in corporate

counseling:

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1. Providing guidance in areas of diversification based on the Government’s economic and

licensing policies.

2. Undertaking appraisal of product lines, analyzing their growth and profitability and

forecasting future trends.

3. Rejuvenating old-line companies and ailing sick units by appraising their technology and

process, assessing their requirements and restructuring their capital base.

4. Assessment of the revival prospects and planning for rehabilitation through modernization

and diversification and revamping of the financial and organizational structure.

5. Arranging for the approval of the financial institutions/banks for schemes of rehabilitation

involving financial relief, etc.

6. Monitoring of rehabilitation schemes.

7. Exploring possibilities for takeover of sick units and helping in making consequential

arrangements and negotiations with financial institutions/banks and other

interests/authorities involved.

PROJECT COUNSELING.

Project counseling relates to project finance. This involves the study of the project, offering

advisory services on the viability and procedural steps for its implementation. Project counseling

involves the following activities:

1. Undertaking the general review of the project ideas/project profile.

2. Providing advice on procedural aspects of project implementation.

3. Conducting review of technical feasibility of the project on the basis of the report prepared

by own experts or by outside consultants.

4. Assisting in the preparation of project report from a financial angle and advising and acting

on various procedural steps including obtaining government consents for implementation

of the project.

5. Assisting in obtaining approvals/licenses/permissions/grants, etc., from government

agencies in the form of letter of intent, industrial license, DGTD registration, and

government approval for foreign collaboration.

6. Identification of potential investment avenues.

7. Arranging and negotiating foreign collaborations, amalgamations, mergers, and takeovers.

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8. Undertaking financial study of the project and preparation of viability reports to advice on

the framework of institutional guidelines and laws governing corporate finance.

9. Assistance in the preparation of project profiles and feasibility studies based on preliminary

project ideas, covering the technical, financial and economic aspects of the project from

the point of view of their acceptance by financial institutions and banks.

10. Advising and assisting clients in preparing applications for financial assistance to various

national financial institutions, state level institutions, banks, etc.

PREINVESTMENT STUDIES.

Another function of a merchant banker is to guide the entrepreneurs in conducting pre-investment

studies. It involves detailed feasibility study to evaluate investment avenues to enable to decide

whether to invest or not. The important activities involved in pre-investment studies are as follows:

1. Carrying out an in-depth investigation of environment and regulatory factors, location of

raw material supplies, demand projections and financial requirements in order to assess

the financial and economic viability of a given project.

2. Helping the client in identifying and short-listing those projects which are built upon the

client’s inherent strength with a view to promote corporate profitability and growth in the

long run.

3. Offering a package of services, including advice on the extent of participation,

government regulatory factors and an environmental scan of certain industries in India.

LOAN SYNDICATION.

A merchant banker may help to get term loans from banks and financial institutions for projects.

Such loans may be obtained from a single financial institution or a syndicate or consortium.

Merchant bankers help corporate clients to raise syndicated loans from commercial banks. The

following activities are undertaken by merchant bankers under loan syndication:

1. Estimating the total cost of the project to be undertaken.

2. Drawing up a financing plan for the total project cost which conforms to the requirements

of the promoters and their collaborators, financial institutions and banks, government

agencies and underwriters.

3. Preparing loan application for financial assistance from term lenders/financial

institutions/banks, and monitoring their progress, including pre-sanction negotiations.

4. Selecting institutions and banks for participation in financing.

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5. Follow-up of term loan application with the financial institutions and banks and obtaining

the approval for their respective share of participation.

6. Arranging bridge finance.

7. Assisting in completion of formalities for drawing of term finance sanctioned by

institutions by expediting legal documentation formalities, drawing up agreements etc. as

prescribed by the participating financial institutions and banks.

8. Assessing working capital requirements.

ISSUE MANAGEMENT.

Issue management involves marketing of corporate securities by offering them to the public. The

corporate securities include equity shares, preference shares, bonds, debentures etc. Merchant

bankers act as financial intermediaries. They transfer capital from those who own it to those who

need it. The security issue function may be broadly classified into two – pre-issue management

and post-issue management. The pre-issue management involves the following functions:

1. Public issue through prospectus.

2. Marketing and underwriting.

3. Pricing of issues.

These may be briefly discussed as follows:

1. Public issue through prospectus. To being out a public issue, merchant bankers have to

co-ordinate the activities relating to issue with different government and public bodies,

professionals and private agencies. First the prospectus should be drafter. The copies of

consent of experts, legal advisor, attorney, solicitor, bankers, and bankers to the issue,

brokers and underwriters are to be obtained from the company making the issue. These

copies are to be filed along with the prospectus to the Registrar Companies. After the

prospectus is ready, it has to be sent to the SEBI for clearance. It is only after clearance by

SEBI, the prospectus can be filed with the Registrar. The brokers to the issue, principal

agent and bankers to issue are appointed by merchant bankers.

2. Marketing and underwriting: After sending prospectus to SEBI, the merchant bankers

arrange a meeting with company representatives and advertising agents to finalize

arrangements relating to date of opening and closing of issue, registration of prospectus,

launching publicity campaigns and fixing date of board meeting to approve and pass the

necessary resolutions. The role of merchant banker in publicity campaigns to help selecting

the media, determining the size and publications in which the advertisement should appear.

The merchant bank shall decide the number of copies to be printed, check accuracy of

statements made and ensure that the size of the application form and prospectus are as per

stock exchange regulations. The merchant banker has to ensure that he material is delivered

to the stock exchange at least 21 days before the issue opens and to the brokers to the issue,

and underwriters in time.

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3. Pricing of issues: Pricing of issues is done by companies themselves in consultation with

the merchant bankers. An existing listed company and a new company set up by an existing

company with five years track record and existing private closely held company and

existing unlisted company going in for public issues for the first time with 2 ½ years track

record of constant profitability can freely price the issue. The premium can be determined

after taking into consideration net asset value, profit earning capacity and market price.

The price and premium have to be stated in the prospectus.

Post-issue management consists of collection of application forms and statement of amount

received from bankers, screening applications, deciding allotment procedures, mailing of

allotment letters, share certificates and refund orders. Merchant bankers help the company by

coordinating the above activities.

UNDERWRITING OF PUBLIC ISSUE.

In underwriting of public issue, the activities performed by merchant bankers are as follows:

1. Selection of institutional and broker underwriters for syndicating/ underwriting

arrangements.

2. Obtaining the approval of institutional underwriters and stock exchanges for publication of

the prospectus.

3. Co-ordination with the underwriters, brokers and bankers to the issue, and the Stock

Exchanges.

PORTFOLIO MANAGEMENT.

Merchant bankers provide portfolio management service to their clients. Today every investor is

interested in safety, liquidity and profitability of his investment. But investors cannot study and

choose the appropriate securities. Merchant bankers help the investors in this regard. They study

the monetary and fiscal policies of the government. They study the financial statements of

companies in which the investments have to be made by investors. They also keep a close watch

on the price movements in the stock market.

The merchant bankers render the following services in connection with portfolio management:

1. Undertaking investment in securities.

2. Collection of return on investment and re-investment of the same in profitable avenues,

investment advisory services to the investors and other related services.

3. Providing advice on selection of investments.

4. Carrying out a critical evaluation of investment portfolio.

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5. Securing approval from RBI for the purchase/sale of securities (for NRI clients).

6. Collecting and remitting interest and dividend on investment.

7. Providing tax counseling and filing tax returns through tax consultants.

MERGER AND ACQUISITION.

A merger is a combination of two or more companies into a single company where-in one survives

and others lose their corporate existence. A take-over refers to the purchase by one company

acquiring controlling interest in the share capital of another existing company. Merchant bankers

are the middlemen in setting negotiation between the offeree and offeror. Being professional

experts, they are apt to safeguard the interest of the shareholders in both the companies. Once the

merger partner is proposed, the merchant banker appraises merger/takeover proposal with respect

to financial viability and technical feasibility. He negotiates purchase consideration and mode of

payment. He gets approval from the government/RBI, drafts scheme of amalgamation and obtains

approval from financial institutions.

FOREIGN CURRENCY FINANCING.

The finance provided to fund foreign trade transactions is called ‘Foreign Currency Finance’. The

provision of foreign currency finance takes the form of export-import trade finance, euro currency

loans, Indian joint ventures abroad and foreign collaborations.

The main areas that are covered in this type of merchant activity are as follows:

1. Assistance to carry out the study of turnkey and construction contract projects.

2. Arranging for the syndication of various types of guarantees, letters of credit, pre-

shipment credit, deferred post-shipment credit, bridge loans, and other credit facilities.

3. Assistance in opening and operating bank accounts abroad.

4. Arranging foreign currency loans under buyer’s credit scheme for importing goods.

5. Arranging deferred payment guarantees under suppliers’ credit scheme for importing

capital goods.

6. Assistance in obtaining export credit facilities from the EXIM bank for export of capital

goods and arranging for the necessary government approvals and clearance.

7. Undertaking negotiations for deferred payment, export finance, buyers’ credits,

documentary credits, and other foreign exchange services like packing credit, etc.

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WORKING CAPITAL FINANCE.

The finance required for meeting the day-to-day expenses of an enterprise is known as ‘Working

Capital Finance’. Merchant bankers undertake the following activities as part of providing this

type of finance:

1. Assessment of working capital requirements.

2. Preparing the necessary application to negotiations for the sanction of appropriate credit

facilities.

ACCEPTANCE CREDIT AND BILL DISCOUNTING.

Merchant banks accept and discount bills of exchange on behalf of clients. Merchant bankers give

loans to business enterprises on the security of bill of exchange. For this purpose, merchant bankers

collect credit information relating to the clients and undertake rating their creditworthiness.

VENTURE FINANCING.

Another function of a merchant banker is to provide venture finance to projects. It refers to

provision of equity finance for funding high-risk and high-reward projects.

LEASE FINANCING.

Leasing is another function of merchant-bankers. It refers to providing financial facilities to

companies that undertake leasing. Leasing involves letting out assets on lease for a particular

period for use by the lessee. The following services are provided by merchant bankers in

connection with lease finance:

1. Providing advice on the viability of leasing as an alternative source for financing capital

investment projects.

2. Providing advice on the choice of a favorable rental structure.

3. Assistance in establishing lines of lease for acquiring capital equipment, including

preparation of proposals, documentations, etc.

RELIEF TO SICK COMPANIES.

Merchant bankers render valuable services as a part of providing relief to sick companies.

PROJECT APPRAISAL.

Project appraisal refers to evaluation of projects from various angles such as technology, input,

location, production, marketing etc. It involves financial appraisal, marketing appraisal, technical

appraisal, economic appraisal etc. Merchant bankers render valuable services in the above areas.

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MERCHANT BANKING IN INDIA.

Prior to the enactment of Indian Companies Act, 1956, managing agents acted as merchant

bankers. They acted as issue houses for securities, evaluated project reports, provided venture

capital for new firms etc. Few share broking firms also functioned as merchant bankers.

With the rapid growth in the number and size of the issues made in the primary market, the need

for specialized merchant banking service was felt. Grindlays Bank was the first to open its

merchant banking division in 1967, followed by Citibank in 1970. SBI started its merchant banking

division in 1972 and it followed up by setting up a fully owned subsidiary in 1980, namely SBI

Capital Markets Ltd. The other nationalized banks and financial institutions, like IDBI, IFCI,

ICICI, Securities and Finance Company Ltd., Canara Bank (Can Bank Financial Services Ltd.),

Bank of India (BOI Finance Ltd.) and private sector financial companies, like JM Financial and

Investment Consultancy Services Ltd., DSP Financial Consultancy Ltd. have also set up their

merchant banking divisions.

The merchant banking business got more importance in the year 1983 when there was a huge

boom in the primary market where the companies were going for new issue. Merchant banking

activities are organized and undertaken in several forms. Commercial banks and foreign

development finance institutions have organized them through formation divisions,

nationalized banks have formed subsidiary companies, share brokers and consultancies

constituted themselves into public limited companies or registered themselves as private

limited Companies. Some merchant banking companies have entered into collaboration with

merchant bankers of foreign countries abroad with several branches.

In India, apart from the overall control by the RBI, merchant bankers’ operations are closely

supervised by the SEBI for their proper functioning and investor protection.

Setting up and management of merchant banks in India

In India, a common organizational set up of merchant bankers to operate is in the form of divisions

of Indian and Foreign banks and financial institutions, subsidiary companies established by

bankers like SBI, Canara Bank, Punjab National Bank, Bank of India, etc. some firms are also

organized by financial and technical consultants and professionals. Securities and exchanges

Board of India

(SEBI) has divided the merchant bankers into four categories based on their capital adequacy.

Each category is authorized to perform certain functions. From the point of Organizational set up

India’s merchant banking organizations can be categorized into 4 groups on the basis of their

linkage with parent activity. They are:

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a) Institutional Base.

Merchant banks function as an independent wing or as subsidiary of various Private/ Central

Governments/ State Governments Financial institutions. Most of the financial institutions in India

are in public sector and therefore such set up plays a role on the lines of governmental priorities

and policies.

b) Banker Base.

These merchant-bankers function as division/ subsidiary of banking organization. The parent

banks are either nationalized commercial banks or the foreign banks operating in India. These

organizations have brought professionalism in merchant banking sector and they help their parent

organization to make a presence in capital market.

c) Broker Base.

In the recent past there has been an inflow of Qualified and professionally skilled brokers in various

Stock Exchanges of India. These brokers undertake merchant banking related operating also like

providing investment and portfolio management services.

d) Private Base.

These merchant banking firms are originated in private sectors. These organizations are the

outcome of opportunities and scope in merchant banking business and they are providing skill

oriented specialized services to their clients. Some foreign merchant bankers are also entering

either independently or through some collaboration with their Indian counterparts. Private Sectors

merchant banking firms have come up either as sole proprietorship, partnership, private limited or

public limited companies. Many of these firms were in existence for quite some time before they

added a new activity in the form of merchant banking services by opening new division on the

lines of commercial banks and All India Financial Institution (AIFI).

MERCHANT BANKERS IN INDIA.

As of now there are 135 Merchant bankers who are registered with SEBI in India. It includes

Public Sector, Private Sector and foreign players some of them are:

Public Sector Merchant Bankers

1. SBI capital markets ltd

2. Punjab national bank

3. Bank of Maharashtra

4. IFCI financial services ltd

5. Karur Vysya bank ltd,

6. State Bank of Bikaner and Jaipur

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Private Sector Merchant Bankers

1. ICICI Securities Ltd

2. Axis Bank Ltd (Formerly UTI Bank Ltd.)

3. Bajaj Capital Ltd

4. Tata Capital Markets Ltd

5. ICICI Bank Ltd

6. Reliance Securities Limited

7. Kotak Mahindra Capital Company Ltd

8. Yes Bank Ltd.

Foreign Players in Merchant Banking

1. Goldman Sachs (India) Securities Pvt. Ltd.

2. Morgan Stanley India Company Pvt. Ltd

3. Barclays Securities (India) Pvt. Ltd

4. Bank of America, N.A

5. Deutsche Bank

6. Deutsche Equities India Private Limited

7. Barclays Bank Plc

8. Citigroup Global Markets India Pvt. Ltd.

9. DSP Merrill Lynch Ltd

10. FEDEX Securities Ltd

ROLE OF MERCHANT BANKING IN ISSUE MANAGEMENT.

In issue management, the main role of merchant bankers is to help the company issuing securities

in raising funds for the purpose of financing new projects, expansion/ modernization/

diversification of existing units and augmenting long term resources for working capital

requirements.

The most important aspect of merchant banking business is to function as lead managers to the

issue management. The role of the merchant banker as an issue manager can be studied from the

following points:

1. Easy fund raising: An issue manager acts as an indispensable pilot facilitating a public/ rights

issue. This is made possible with the help of special skills possessed by him to execute the

management of issues.

2. Financial consultant: An issue manager essentially acts as a financial architect, by providing

advice relating to capital structuring, capital gearing and financial planning for the company.

3. Underwriting: An issue manager allows for underwriting the issues of securities made by

corporate enterprises. This ensures due subscription of the issue.

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4. Due diligence: The issue manager has to comply with SEBI guidelines. The merchant banker

will carry out activities with due diligence and furnish a Due Diligence Certificate to SEBI. The

detailed diligence guidelines that are prescribed by the Association of Merchant Bankers of India

(AMBI) have to be strictly observed. SEBI has also prescribed a code of conduct for merchant

bankers.

5. Co-ordination: The issue manger is required to co-ordinate with a large number of

institutions and agencies while managing an issue in order to make it successful.

6. Liaison with SEBI: The issue manager, as a part of merchant banking activities, should

register with SEBI. While managing issues, constant interaction with the SEBI is required by way

of filing of offer documents, etc. In addition, they should file a number of reports relating to the

issues being managed.

CLASSIFICATION AND REGULATION OF MERCHANT BANKERS BY SEBI.

Merchant bankers are classified into four categories according to the SEBI

(Merchant Banking) Regulations 1992. These are as follows:

1. Category – I: To carry on any activity relating to issue management and act as adviser,

consultant manager, underwriter and portfolio manager for capital issues.

2. Category – II: To act as adviser, consultant, co-manager, underwriter and portfolio

manager for capital issues.

3. Category – III: To act as underwriter, adviser, and consultant to an issue.

4. Category – IV: To act only as adviser or consultant to an issue.

PROBLEMS OF MERCHANT BANKS IN INDIA.

1. SEBI guidelines have authorized merchant bankers to undertake issue related activities only

with an exception of portfolio management. It restricts the scope of merchant bank activities.

2. SEBI guidelines stipulate a minimum net worth of Rs.1 crore for authorization of merchant

bankers. Small but professional merchant bankers are facing difficulty for adhering such net worth

norms.

3. Non-cooperation of the issuing companies in timely allotment of securities and refund

application money is another problem of merchant-bankers.

4. Unhealthy competition among large number of merchant banks compels them to reduce their

profit margin, commission etc.

5. There is no exact regulatory framework for regulating and controlling the working of merchant

banks in India.

33


6. Fraudulent and fake issue of share capital by the companies are also posing problems for

merchant banks who act as lead manager or issue manager of such issues.

QUESTIONS.

1. Explain the meaning and nature of merchant banking.

2. Explain the functions of merchant banking.

3. Explain the progress of merchant banking in India.

4. Explain the problems of merchant banking in India.

5. Explain the role of merchant banker.

34


MODULE TWO

CHAPTER THREE

PREVIEW.

Meaning and Definition of Venture capital.

Characteristics of Venture Capital.

Types or Forms of Venture Capital Assistance.

Process of Venture Capital.

Modes of Venture Capital Assistance.

MEANING AND DEFINITION OF VENTURE CAPITAL.

The term venture capital comprises of two words, namely, ‘venture’ and ‘capital’. The term

‘venture’ literally means a ‘course’ or ‘proceeding’, the outcome of which is uncertain (i.e.,

involving risk). The term capital refers to the resources to start the enterprise. Thus venture capital

refers to capital investment in a new and risky business enterprise. Money is invested in such

enterprises because these have high growth potential.

A young hi-tech company that is in the early stage of financing and is not yet ready to make a

public issue may seek venture capital. Such high-risk capital is provided by venture capital funds

in the form of long-term equity finance with the hope of earning a high rate of return primarily in

the form of capital gain. In fact, the venture capitalist acts as a partner with the entrepreneur.

Venture capital is the money and resources made available to start-up firms and small business

with exceptional growth potential (e.g., IT, infrastructure, real estate etc.). It is fundamentally a

long-term risk capital in the form of equity finance for the small new ventures which involve risk.

But at the same time, it has a strong potential for growth. It thrives on the concept of high-risk high

return. It is a means of equity financing for rapidly growing private companies. Venture capital

can be visualized as ‘your ideas and our money’ concept of developing business. It is ‘patient’

capital that seeks a return through long term capital gain rather than immediate and regular interest

payments as in the case of debt financing. When venture capitalists invest in a business, they

typically require a seat on the company’s board of directors. But professional venture capitalists

act as mentors and provide support and advice on a number of issues relating to management,

sales, technology etc. They assist the company to develop its full potential. They help the enterprise

VENTURE CAPITAL

35


in the early stage until it reaches the stage of profitability. When the business starts making

considerable profits and the market value of the shares go up to considerable extent, venture

capitalists sell their equity holdings at a high value and thereby make capital gains. In short, venture

capital means the financial investment in a highly risk project with the objective of earning a high

rate of return.

CHARACTERISTICS OF VENTURE CAPITAL.

The important characteristics of venture capital finance are outlined as bellow:

1. It is basically equity finance.

2. It is a long-term investment in growth-oriented small or medium firms.

3. Investment is made only in high risk projects with the objective of earning a high rate of

return.

4. In addition to providing capital, venture capital funds take an active interest in the

management of the assisted firm. It is rightly said that, “venture capital combines the

qualities of banker, stock market investor and entrepreneur in one”.

5. The venture capital funds have a continuous involvement in business after making the

investment.

6. Once the venture has reached the full potential, the venture capitalist sells his holdings at

a high premium. Thus his main objective of investment is not to earn profit but capital

gain.

TYPES OF VENTURE CAPITAL ASSISTANCE.

Generally, there are three types of venture capital funds. They are as follows:

1. Venture capital funds set up by angel investors (angels): They are individuals who

invest their personal capital in start-up companies. They are about 50 years old. They

have high income and wealth. They are well educated. They have succeeded as

entrepreneurs. They are interested in the start-up process.

2. Venture capital subsidiaries of Corporations: These are established by major

corporations, commercial banks, holding companies and other financial institutions.

3. Private capital firms/funds: The primary source of venture capital is a venture capital

firm. It takes high risks by investing in an early stage company with high growth

potential.

36


PROCESS OF VENTURE CAPITAL.

The process of venture capital consists of the following stages:

1. Exploring investment Opportunities. The investor creates a series of ‘deals’ or

investment opportunities that he or she would consider investing in through a network. The

network includes all the venture capital funds and investors. The venture capitalist may

also network with Research & Development institutions, Universities and Financial

Institutes. The composition of network would depend on the investment opportunities

sought by the venture capital funds and companies. For instance, venture capital funds

looking at early stage technology-based deals would develop a network of Research and

Development centers working in early stage technology. The venture capital company

must receive a large number of investment proposals so that the most potentially profitable

investment opportunity is selected. The venture capital investor focuses on opportunities

with a high degree of innovation. In India, venture capital funds have their own methods

of seeking investment opportunities. It ranges from promotional seminars with industry

associations and institutions to direct promotional campaigns.

2. Analyzing the Investment Proposal. The venture capitalist will carry out reference

checks on the proposal. He will study the management team, product technology and

market. The venture capitalist will set up an investment screen. The screen is a set of

qualitative criteria that helps the venture capitalist to select an investment opportunity. The

venture capitalist will try to maximize the upside potential of any project. He structures

his investment in such a manner so that he can make an exit at the appropriate time. The

venture capitalist must therefore conduct a due diligence on the investment project before

its selection.

3. Investment Valuation. The investment valuation exercise is undertaken to arrive at an

acceptable price for the deal. Under free pricing system, the valuation process is conducted

in the following manner:

a) Evaluate future revenue and profitability.

b) Forecast future value of the firm based on market capitalization or expected acquisition

proceeds.

c) Target an ownership position in the investee firm so as to achieve desired appreciation

on the proposed investment.

4. Structuring a Deal. Structuring refers to putting together the financial aspects of the deal

and negotiating with the entrepreneurs to accept a Venture Capitalist’s proposal so that the

deal is closed. The structuring process should consider the various commercial issues such

as what the entrepreneur wants and what the venture capitalist would require, to protect the

investment. The instruments used in structuring deals are many. The objective in selecting

the instrument would be to maximize Venture Capitalist’s returns and satisfy the

requirements of the entrepreneur. The instruments used in structuring a deal are given

Table 3.1 below.

37


Table 3.1 – Instruments used in Structuring a Deal.

Instrument Issues

Loan

Clean versus secured

Interest bearing versus non-interest bearing.

Convertible versus one with features (warrants).

First charge and second charge.

Loan versus loan stock.

Preference Shares

Redeemable (conditions under the Company Act)

Participating

Par value

Nominal shares

Warrants Exercise price, expiry period

Common shares

New or vendor shares

Par value

Partially paid shares

Options Exercise price, expiry period, call, put.

In India, equity and convertibles are commonly used. Warrants are also used to bring down

pricing.

5. Monitoring and Follow-up. The Venture Capitalist gives advice regularly to the

promoters and monitors the project continuously. Venture capitalists perform the dual

role of financial partner and a strategic advisor. They are actively involved in the

management of the invest4ee unit and provide expert business advice. Venture capitalists

may have innovative solutions to maximize the chances of success so that long term

profitability and viability of the investee is ensured.

6. Exit. Once the targeted returns are achieved, the venture capitalist may make an exit from

the venture. There are several exit routes such as: buy back by the promoters, sale to

another venture capitalist or sale at the time of initial public offer. The exit route is decided

by the specialists so that the interests of the stakeholders are protected.

38


MODES OF VENTURE CAPITAL ASSISTANCEE.

Venture capital is typically available in four forms in India: equity, conditional loan, income-note

and conventional loan.

1. Equity: All VCFs in India provide equity but generally their contribution does not

exceed 49 per cent of the total equity capital. Thus, the effective control and majority

ownership of the firm remain with the entrepreneur. They buy shares of an enterprise

with an intention to ultimately sell them off to make capital gains.

2. Conditional loan: It is repayable in the form of a royalty after the venture is able to

generate sales. No interest is paid on such loans. In India, VCFs charge royalty ranging

between 2 and 15 per cent; actual rate depends on the other factors of the venture, such as

gestation period, cost-flow patterns and riskiness.

3. Income-note: It is a hybrid security which combines the features of both conventional

loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales,

but at substantially low rates.

4. Conventional loan. Under this form of assistance, the enterprise is assisted by way of

loans. On the loans, a lower fixed rate of interest is charged, till the unit becomes

commercially operational. When the company starts earning profits, normal or higher rate

of interest will be charged on the loan. The loan has to be repaid as per the terms of loan

agreement.

Other financing methods: A few venture capitalists, particularly in the private sector, have started

introducing innovative financial securities like participating debentures introduced by TCFC.

QUESTIONS.

1. Explain the meaning and definition of Venture capital.

2. Explain the characteristics of Venture Capital.

3. Explain the types of Venture Capital Assistance.

4. Explain the Process of Venture Capital.

5. Explain the modes of Venture Capital Assistance.

39


MODULE TWO

CHAPTER FOUR

PREVIEW.

Concept and Definition of Securitization.

Need for Securitization.

Players involved in Securitization.

Structure of Securitization.

Instruments of Securitization.

Pass through and pay-through securities.

Process of Securitization.

CONCEPT AND DEFINITION OF SECURITIZATION.

Loans given to customers are assets for the bank. They are called loan assets. Loan assets are not

tradable and transferable and hence they are not liquid. The problem liquidity is solved by

transforming the loans into marketable securities. Marketability of illiquid assets is done through

the process of securitization. Securitization is a financial innovation. It is conversion of existing

or future cash flows into marketable securities that can be sold to investors. It is the process by

which financial assets such as loan receivables, credit card balances, hire purchase debtors, and

lease receivables, etc. are transformed into securities. Thus, any asset with predictable cash flows

can be securitized.

Securitization is defined as a process of transformation of illiquid asset into security which may

be traded later in the open market. Securitization is the transformation of illiquid, non- marketable

assets into securities which are liquid and marketable assets. It is a process of transformation of

assets of a lending institution into negotiable instruments.

Reserve Bank of India, in its Guidelines on Securitization, has defined securitization as a process

by which assets are sold to a bankruptcy remote special purpose vehicle (SPV) in return for

an immediate cash payment. The cash flow from the underlying pool of assets is used to service

the securities issued by the SPV. Securitization thus follows a two-stage process. In the first stage

there is sale of single asset or pooling and sale of pool of assets to a 'bankruptcy remote' special

purpose vehicle (SPV) in return for an immediate cash payment and in the second stage

repackaging and selling the security interests representing claims on incoming cash flows from the

SECURITIZATION

40


asset or pool of assets to third party investors by issuance of tradable debt securities. If the assets

are secured by real property such as automobiles or real estates, then these are called

mortgage backed securities. Here the lender has the right to sell the property if borrowers default.

If the assets are credit card receivables, then these are unsecured assets and the investor must rely

on the performance of the assets that collateralize these securities. These are known as assets

backed securities. Securitization of credit card receivables is an innovation that has found

acceptance around the world.

CREDIT ENHANCEMENT.

Investor in securitized instrument takes a direct exposure on the performance of the underlying

collateral and have limited or no recourse to the originator. Hence, they seek additional comfort in

the form of credit enhancement. It refers to the various means that attempts to buffer investors

against losses on the asset collateralizing their investment. The credit enhancements are often

essential to secure a high level of credit rating and for low cost funding. By shifting the credit risk

from a less known borrower to a well-known, strong and large credit enhancer, credit

enhancements correct the imbalance of information between the lenders and the borrowers. The

credit enhancer can either be external or internal. The external credit enhancer includes insurance,

third party guarantee and letter of credit. Since any of these services will be provided by the third

party, a fee is to be paid to it for the service received. The internal credit enhancement may include

various measures. The most popular is credit trenching which means that the Special Purpose

Vehicle Company (SPV) issues two or more tranches of securities and establish a pre-determined

priority in their servicing, where by first losses are borne by the holders of subordinate tranches.

The holders of other tranche i.e. senior class debt are at comfort. The securities belonging to the

subordinate tranche may be known as ‘B’ class securities whereas securities belonging to senior

class may be known as ‘A’ class securities. Other method of credit enhancement is over-

collateralization which means that the originator sets aside assets in excess collateral required to

be assigned to the Special Purpose Vehicle (SPV) Company.

Securitization is different from factoring. Factoring involves transfer of debts without transforming

debts into marketable securities. But securitization always involves transformation of illiquid

assets into liquid assets that can be sold to investors.

NEED FOR SECURITIZATON.

Advantages to issuer.

1. Reduces funding costs.

Through securitization, a company rated BB but with AAA worthy cash flow would be able to

borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can

have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can

be multiple hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's

rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in

January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying

collateral and other credit enhancements.

https://en.wikipedia.org/wiki/Basis_point

41


2. Reduces asset-liability mismatch.

"Depending on the structure chosen, securitization can offer perfect matched funding by

eliminating funding exposure in terms of both duration and pricing basis." Essentially, in most

banks and finance companies, the liability book or the funding is from borrowings. This often

comes at a high cost. Securitization allows such banks and finance companies to create a self-

funded asset book.

3. Lower capital requirements.

Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage can

be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these

firms will be able to remove assets from their balance sheets while maintaining the "earning

power" of the assets.

4. Locking in profits.

For a given block of business, the total profits have not yet emerged and thus remain uncertain.

Once the block has been securitized, the level of profits has now been locked in for that company,

thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.

5. Transfer risks (credit, liquidity, prepayment, reinvestment, and asset concentration).

Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one

that does. Two good examples of this are catastrophe bonds and Entertainment Securitizations.

Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company

has effectively freed up its balance to go out and write more profitable business.

6. Off balance sheet.

Derivative (finance) of many types have in the past been referred to as "off-balance-sheet." This

term implies that the use of derivatives has no balance sheet impact. While there are differences

among the various accounting standards internationally, there is a general trend towards the

requirement to record derivatives at fair value on the balance sheet. There is also a generally

accepted principle that, where derivatives are being used as a hedge against underlying assets or

liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged

instrument is recognized in the income statement on a similar basis as the underlying assets and

liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have

universally accepted market standard documentation. In the case of Credit Default Swaps, this

documentation has been formulated by the International Swaps and Derivatives

Association (ISDA) who have for a long time provided documentation on how to treat such

derivatives on balance sheets.

https://en.wikipedia.org/wiki/Credit_(finance)

https://en.wikipedia.org/wiki/Prepayment_of_loan

https://en.wikipedia.org/wiki/Catastrophe_bond

42


7. Earnings.

Securitization makes it possible to record an earnings bounce without any real addition to the firm.

When a securitization takes place, there often is a "true sale" that takes place between the

Originator (the parent company) and the SPE. This sale must be for the market value of the

underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's

balance sheet, which will boost earnings for that quarter by the amount of the sale. While not

illegal in any respect, this does distort the true earnings of the parent company.

8. Admissibility.

Future cashflows may not get full credit in a company's accounts (life insurance companies, for

example, may not always get full credit for future surpluses in their regulatory balance sheet), and

a securitization effectively turns an admissible future surplus flow into an admissible immediate

cash asset.

9. Liquidity.

Future cashflows may simply be balance sheet items which currently are not available for

spending, whereas once the book has been securitized, the cash would be available for immediate

spending or investment. This also creates a reinvestment book which may well be at better rates.

Disadvantages to issuer.

1. May reduce portfolio quality.

If the AAA risks, for example, are being securitized out, this would leave a materially worse

quality of residual risk.

2. Costs.

Securitizations are expensive due to management and system costs, legal fees, underwriting fees,

rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in

securitizations, especially if it is an atypical securitization.

3. Size limitations.

Securitizations often require large scale structuring, and thus may not be cost-efficient for small

and medium transactions.

4. Risks.

https://en.wikipedia.org/wiki/Legal_fees

https://en.wikipedia.org/wiki/Underwriting

43


Since securitization is a structured transaction, it may include par structures as well as credit

enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss,

especially for structures where there are some retained strips.

Advantages to investors.

1. Opportunity to invest in a specific pool of high-quality assets.

Due to the stringent requirements for corporations (for example) to attain high ratings, there is a

dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large

quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that

are required to invest in only highly rated assets, have access to a larger pool of investment options.

2. Portfolio diversification.

Depending on the securitization, hedge funds as well as other institutional investors tend to like

investing in bonds created through securitizations because they may be uncorrelated to their other

bonds and securities.

3. Isolation of credit risk from the parent entity.

Since the assets that are securitized are isolated (at least in theory) from the assets of the originating

entity, under securitization it may be possible for the securitization to receive a higher credit rating

than the "parent," because the underlying risks are different. For example, a small bank may be

considered riskier than the mortgage loans it makes to its customers; were the mortgage loans to

remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely,

the bank would be paying higher interest to its creditors, and hence less profitable).

Risks to investors.

1. Liquidity risk (Credit/default).

Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on

time. For ABS, default may occur when maintenance obligations on the underlying collateral are

not sufficiently met as detailed in its prospectus. A key indicator of a security’s default risk is its

credit rating. Different tranches within the ABS are rated differently, with senior classes of most

issues receiving the highest rating, and subordinated classes receiving correspondingly lower

credit ratings.[8] Almost all mortgages, including reverse mortgages, and student loans, are now

insured by the government, meaning that taxpayers are on the hook for any of these loans that go

bad even if the asset is massively over-inflated. In other words, there are no limits or curbs on

over-spending, or the liabilities to taxpayers. However, the credit crisis of 2007–2008 has exposed

a potential flaw in the securitization process – loan originators retain no residual risk for the loans

they make, but collect substantial fees on loan issuance and securitization, which doesn't encourage

improvement of underwriting standards.

https://en.wikipedia.org/wiki/Securitization#cite_note-Dwight-8

44


2. Event risk (Prepayment/reinvestment/early amortization).

Most of the revolving ABS are subject to some degree of early amortization risk. The risk stems

from specific early amortization events or payout events that cause the security to be paid off

prematurely. Typically, payout events include insufficient payments from the underlying

borrowers, insufficient excess spread, a rise in the default rate on the underlying loans above a

specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the

part of the sponsor or servicer.

3. Currency interest rate fluctuations.

Like all fixed income securities, the prices of fixed rate ABS move in response to changes in

interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate

securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the

economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans

that back some types of ABS, which can affect yields. Home equity loans tend to be the most

sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally

less sensitive to interest rates.

4. Moral hazard.

Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the

manager earns fees based on performance, there may be a temptation to mark up the prices of the

portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has

a claim on the deal's excess spread.

5. Servicer risk.

The transfer or collection of payments may be delayed or reduced if the servicer becomes

insolvent. This risk is mitigated by having a backup servicer involved in the transaction.

45


PLAYERS INVOLVED IN SECURITIZATION TRANSACTION.

There are three primary parties to a securitization deal. The first is the originator. This is the entity

on whose books the assets to be securitized exist. It is the prime mover of the deal. It sells the

assets on its books and receives the funds generated from such sale. In a true sale, the originator

transfers both the legal and beneficial interest in the assets to the SPV. The scheduled commercial

banks and the housing finance companies, which lend for the housing, are originator in

securitization transaction.

The second party to securitization transactions is SPV. It is the entity, which buys the assets to be

securitized from the originator. A SPV is typically a low-capitalized entity with narrowly defined

purposes and activities and usually has independent directors or trustees. It holds the assets in its

books and makes the upfront payment for them to the originator.

The third party to the securitization transaction are investors who may be individuals, financial

institutions, mutual funds, provident funds, pension funds, and the insurance companies. These

investors buy a participating interest in the total pool of receivable and receive their payments in

the form of interest and principal as per agreement.

The other parties to a securitization transaction are obligors, rating agency, administrators or

servicers and agents and trustees. The obligors are the borrowers of the original loan. Rating

agency would assess the strength of the cash flow and mechanism designed to ensure full and

timely payment. The administrator and servicers are responsible for collecting the payment and

passing it to SPV. Generally, the originator acts as an administrator or servicers. The agent and

trustee are responsible to look after the interest of the investor.

STRUCTURE OF SECURITIZATION.

1. Pooling and transfer.

The originator initially owns the assets engaged in the deal. This is typically a company looking

to either raise capital, restructure debt or otherwise adjust its finances (but also includes businesses

established specifically to generate marketable debt (consumer or otherwise) for subsequent

securitization). Under traditional corporate finance concepts, such a company would have three

options to raise new capital: a loan, bond issue, or issuance of stock. However, stock offerings

dilute the ownership and control of the company, while loan or bond financing is often

prohibitively expensive due to the credit rating of the company and the associated rise

in interest rates.

The consistently revenue-generating part of the company may have a much higher credit rating

than the company. For instance, a leasing company may have provided $10m nominal value of

leases, and it will receive a cash flow over the next five years from these. It cannot demand early

https://en.wikipedia.org/wiki/Corporate_finance

https://en.wikipedia.org/wiki/Loan

https://en.wikipedia.org/wiki/Bond_issue

https://en.wikipedia.org/wiki/Stock

https://en.wikipedia.org/wiki/Credit_rating

https://en.wikipedia.org/wiki/Interest

46


repayment on the leases and so cannot get its money back early if required. If it could sell the

rights to the cash flows from the leases to someone else, it could transform that income stream into

a lump sum today (in effect, receiving today the present value of a future cash flow). Where the

originator is a bank or other organization that must meet capital adequacy requirements, the

structure is usually more complex because a separate company is set up to buy the assets.

A suitably large portfolio of assets is "pooled" and transferred to a "special purpose vehicle" or

"SPV" (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the

assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator.

The issuer is "bankruptcy remote", meaning that if the originator goes into bankruptcy, the assets

of the issuer will not be distributed to the creditors of the originator. To achieve this, the governing

documents of the issuer restrict its activities to only those necessary to complete the issuance of

securities. Many issuers are typically "orphaned". In the case of certain assets, such as credit card

debt, where the portfolio is made up of a constantly changing pool of receivables, a trust in favor

of the SPV may be declared in place of traditional transfer by assignment (see the outline of the

master trust structure below).

Accounting standards govern when such a transfer is a true sale, a financing, a partial sale, or a

part-sale and part-financing.[6] In a true sale, the originator is allowed to remove the transferred

assets from its balance sheet: in a financing, the assets are considered to remain the property of the

originator. Under US accounting standards, the originator achieves a sale by being at arm's

length from the issuer, in which case the issuer is classified as a "qualifying special purpose

entity" or "SPE".

Because of these structural issues, the originator typically needs the help of an investment

bank (the arranger) in setting up the structure of the transaction.

2. Issuance.

To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund

the purchase. Investors purchase the securities, either through a private offering

(targeting institutional investors) or on the open market. The performance of the securities is then

directly linked to the performance of the assets. Credit rating agencies rate the securities which are

issued to provide an external perspective on the liabilities being created and help the investor make

a more informed decision.

In transactions with static assets, a depositor will assemble the underlying collateral, help

structure the securities and work with the financial markets to sell the securities to investors. The

depositor has taken on added significance under Regulation AB. The depositor typically owns

100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned

subsidiary of the parent which initiates the transaction. In transactions with managed (traded)

assets, asset managers assemble the underlying collateral, help structure the securities and work

with the financial markets to sell the securities to investors.

Some deals may include a third-party guarantor which provides guarantees or partial guarantees

for the assets, the principal and the interest payments, for a fee.

https://en.wikipedia.org/wiki/Special_purpose_vehicle

https://en.wikipedia.org/wiki/Bankruptcy

https://en.wikipedia.org/wiki/Orphan_structure

https://en.wikipedia.org/wiki/Securitization#Master_trust

https://en.wikipedia.org/wiki/Securitization#Master_trust

https://en.wikipedia.org/wiki/Accounting

https://en.wikipedia.org/wiki/Securitization#cite_note-fasb-6

https://en.wikipedia.org/wiki/Arm%27s_length

https://en.wikipedia.org/wiki/Arm%27s_length

https://en.wikipedia.org/wiki/Investment_bank

https://en.wikipedia.org/wiki/Investment_bank

https://en.wikipedia.org/wiki/Security_(finance)

https://en.wikipedia.org/wiki/Institutional_investor

https://en.wikipedia.org/wiki/Credit_rating_agency

https://en.wikipedia.org/wiki/Regulation_AB

47


The securities can be issued with either a fixed interest rate or a floating rate under currency

pegging system. Fixed rate ABS set the “coupon” (rate) at the time of issuance, in a fashion like

corporate bonds and T-Bills. Floating rate securities may be backed by both amortizing and non-

amortizing assets in the floating market. In contrast to fixed rate securities, the rates on “floaters”

will periodically adjust up or down according to a designated index such as a U.S. Treasury rate,

or, more typically, the London Interbank Offered Rate (LIBOR). The floating rate usually reflects

the movement in the index plus an additional fixed margin to cover the added risk.

3. Credit enhancement and trenching.

Unlike conventional corporate bonds which are unsecured, securities created in a securitization are

"credit enhanced", meaning their credit quality is increased above that of the originator's unsecured

debt or underlying asset pool. This increases the likelihood that the investors will receive the cash

flows to which they are entitled, and thus enables the securities to have a higher credit rating than

the originator. Some securitizations use external credit enhancement provided by third parties,

such as surety bonds and parental guarantees (although this may introduce a conflict of interest).

The issued securities are often split into tranches, or categorized into varying degrees

of subordination. Each tranche has a different level of credit protection or risk exposure: there is

generally a senior ("A") class of securities and one or more junior subordinated ("B", "C", etc.)

classes that function as protective layers for the "A" class. The senior classes have first claim on

the cash that the SPV receives, and the more junior classes only start receiving repayment after the

more senior classes have been repaid. Because of the cascading effect between classes, this

arrangement is often referred to as a cash flow waterfall. If the underlying asset pool becomes

insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan

claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain

unaffected until the losses exceed the entire amount of the subordinated tranches. The senior

securities might be AAA or AA rated, signifying a lower risk, while the lower-credit quality

subordinated classes receive a lower credit rating, signifying a higher risk.

The most junior class (often called the equity class) is the most exposed to payment risk. In some

cases, this is a special type of instrument which is retained by the originator as a potential profit

flow. In some cases the equity class receives no coupon (either fixed or floating), but only the

residual cash flow (if any) after all the other classes have been paid.

There may also be a special class which absorbs early repayments in the underlying assets. This is

often the case where the underlying assets are mortgages which are repaid whenever the properties

are sold. Since any early repayments are passed on to this class, it means the other investors have

a more predictable cash flow.

If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because

the principal and interest receipts can be easily allocated and matched. But if the assets are income-

based transactions such as rental deals one cannot categorize the revenue so easily between income

and principal repayment. In this case all the revenue is used to pay the cash flows due on the bonds

as those cash flows become due.

https://en.wikipedia.org/wiki/Interest

https://en.wikipedia.org/wiki/Coupon

https://en.wikipedia.org/wiki/London_Interbank_Offered_Rate

https://en.wikipedia.org/wiki/Credit_enhancement

https://en.wikipedia.org/wiki/Surety_bond

https://en.wikipedia.org/wiki/Guaranty

https://en.wikipedia.org/wiki/Tranche

https://en.wikipedia.org/wiki/Subordination_(finance)

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Credit enhancements affect credit risk by providing protection for promised cash flows for a

security. Additional protection can help a security achieve a higher rating, lower protection can

help create new securities with differently desired risks, and these differential protections can make

the securities more attractive.

In addition to subordination, credit may be enhanced through:

a) A reserve or spread account, in which funds remaining after expenses such as

principal and interest payments, charge-offs and other fees have been paid-off are

accumulated and can be used when SPE expenses are greater than its income.

b) Third-party insurance, or guarantees of principal and interest payments on the

securities.

c) Over-collateralization, usually by using finance income to pay off principal on

some securities before principal on the corresponding share of collateral is

collected.

d) Cash funding or a cash collateral account, generally consisting of short-term,

highly rated investments purchased either from the seller's own funds, or from

funds borrowed from third parties that can be used to make up shortfalls in

promised cash flows.

e) A third-party letter of credit or corporate guarantee.

f) A back-up servicer for the loans.

g) Discounted receivables for the pool.

4. Servicing.

A servicer collects payments and monitors the assets that are the crux of the structured financial

deal. The servicer can often be the originator, because the servicer needs very similar expertise to

the originator and would want to ensure that loan repayments are paid to the Special Purpose

Vehicle.

The servicer can significantly affect the cash flows to the investors because it controls the

collection policy, which influences the proceeds collected, the charge-offs and the recoveries on

the loans. Any income remaining after payments and expenses is usually accumulated to some

extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating

agencies publish ratings of asset-backed securities based on the performance of the collateral pool,

the credit enhancements and the probability of default.

When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of

the assets that are being held in the issuer. Even though the trustee is part of the SPV, which is

https://en.wikipedia.org/wiki/Insurance

https://en.wikipedia.org/wiki/Letter_of_credit

https://en.wikipedia.org/wiki/Probability_of_default

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typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and

those who own the assets, typically the investors.

5. Repayment structures.

Unlike corporate bonds, most securitizations are amortized, meaning that the principal amount

borrowed is paid back gradually over the specified term of the loan, rather than in one lump sum

at the maturity of the loan. Fully amortizing securitizations are generally collateralized by fully

amortizing assets, such as home equity loans, auto loans, and student loans. Prepayment

uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment

varies widely with the type of underlying asset pool, so many prepayment models have been

developed to try to define common prepayment activity. The PSA prepayment model is a well-

known example.

A controlled amortization structure can give investors a more predictable repayment schedule,

even though the underlying assets may be non-amortizing. After a predetermined "revolving

period", during which only interest payments are made, these securitizations attempt to return

principal to investors in a series of defined periodic payments, usually within a year. An early

amortization event is the risk of the debt being retired early.

On the other hand, bullet or slug structures return the principal to investors in a single payment.

The most common bullet structure is called the soft bullet, meaning that the final bullet payment

is not guaranteed to be paid on the scheduled maturity date; however, most of these securitizations

are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the

principal will be paid on the scheduled maturity date. Hard bullet structures are less common for

two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept

the lower yields of hard bullet securities in exchange for a guarantee.

Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based

on maturity. This means that the first tranche, which may have a one-year average life, will receive

all principal payments until it is retired; then the second tranche begins to receive principal, and

so forth. Pro rata bond structures pay each tranche a proportionate share of principal throughout

the life of the security.

INSTRUMENTS OF SECURITIZATION.

There is no uniform name for the securities issued by the special purpose vehicle (SPV) as such

securities take different forms. These securities could either represent a direct claim of

the investors on all that the SPV collects from the receivables transferred to it: in this case, the

securities are called pass through certificates as they imply certificates of proportional beneficial

interest in the assets held by the SPV. Alternatively, the SPV might be re-configuring the cash

flows by reinvesting it, so as to pay to the investors on fixed dates, not matching with the dates on

which the transferred receivables are collected by the SPV. In this case, the securities held by the

investors are called pay through certificates.

https://en.wikipedia.org/wiki/Fiduciary

https://en.wikipedia.org/wiki/Amortization

https://en.wikipedia.org/wiki/Home_equity_loan

https://en.wikipedia.org/wiki/Student_loan

https://en.wikipedia.org/wiki/PSA_prepayment_model

https://en.wikipedia.org/w/index.php?title=Sequential_pay_bond&action=edit&redlink=1

https://en.wikipedia.org/w/index.php?title=Pro_rata_bond&action=edit&redlink=1

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1. Pass Through Certificates

In case of pass through certificates payments to investors depend upon the cash flow from the

assets backing such certificates. In other words as and when cash (principal and interest) is received

from the original borrower by the SPV it is passed on to the holders of certificates at regular

intervals and the entire principal is returned with the retirement of the assets packed in the

pool. The investors in a pass-through transaction acquire the receivables subject to all their

fluctuations, prepayment etc. The material risks and rewards in the asset portfolio, such as the risk

of interest rate variations, risk of prepayments, etc. are transferred to the investors. Thus, pass

through have a single maturity structure and the tenure of these certificates is matched with the life

of the securitized assets. All investors receive proportional payments – no slower or faster

repayment, though in some cases, some investors may be senior over others.

2. Pay Through Certificates.

On the other hand pay through certificates has a multiple maturity structure depending upon the

maturity pattern of underlying assets. Thus, two or three different types of securities with different

maturity patterns like short term, medium term and long term can be issued. The greatest advantage

is that they can be issued depending upon the investor’s demand for varying maturity pattern. This

type of is more attractive from the investor’s point of view because the yield is often inbuilt in the

price of the securities themselves i.e. they are offer at a discount to face value as in the casa of

deep-discount bonds.

In case of Pay Through Certificates, the SPV instead of transferring undivided interest on the

receivables, issues debt securities such as bonds, repayable on fixed dates, but such debt securities

in turn would be backed by the mortgages transferred by the originator to the SPV. The SPV may

make temporary reinvestment of cash flows to the extent required for bridging the gap between

the date of payments on the mortgages along with the income out of reinvestment to retire the

bonds. Such bonds were called mortgage – backed bonds.

3. Preferred Stock Certificates

Preferred stocks are instruments issued by a subsidiary company against the trade debts and

consumer receivables of its parent company. In other words subsidiary companies buy the trade

debts and receivables of parent companies to enjoy liquidity. Thus trade debts can also

be securitized through the issue of preferred stocks. Generally these stocks are backed by

guarantees given by highly rated merchant banks and hence they are also attractive from the

investor’s point of view. These instruments are mostly short term in nature.

4. Asset Backed Commercial Papers

This type of structure is mostly prevalent in mortgage backed securities. Under this the SPV

purchases portfolio of mortgages from different sources (various lending institution) and they are

combined into a single group on the basis of interest rate, maturity dates and underlying collaterals.

They are then transferred to a Trust which in turn issued mortgage backed certificate to the

investors. These certificates are issued against the combined principal value of the mortgages and

they are also short-term instrument. Each certificate is entitled to participate in the cash flow from

underlying mortgages to his investments in the certificates.

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OTHER SECURITIZED INSTRUMENTS.

There are two more securitized instruments. They are:

1. Interest Only Certificates

2. Principal Only Certificates.

In the case of interest holding certificate payments are made to investors only from the interest

incomes earned from the assets securitized. As the very name suggest payment are made to the

investors only from the repayment of principal by the original borrower. In the case of principal

only certificates these certificate enables speculative dealings since the speculators know well that

the interest rate movements would affect the bond value immediately. For instance the principal

only certificate would increase the value when interest rate goes down and because of these it

becomes advantageous to repay the existing debts and resort to fresh borrowing at lower cost. This

early redemption of securities would benefit the investors to a greater extent. Similarly when the

interest rate goes up, interest holding certificate holders stand to gain since more interest is

available from the underlying assets. One cannot exactly predict the future movements of interest

and hence these certificates give much scope for speculators to play the game.

Securitization is a process of pooling and repackaging of similar or homogenous illiquid financial

assets into marketable securities that can be sold to investors. The process leads to the creation of

financial instruments that represent ownership interest in or are secured by a segregated income

producing asset or pool of assets. The pool of assets collateralizes securities. These assets are

generally secured by personal or real property such as automobiles, real estate, or equipment loans

but in some cases are unsecured, for example credit card debt and customer loans.

SECURITIZATION PROCESS.

The securitization process involves following steps:

1. Asset are originated through receivables, leases, housing loans, or any other form of debt

by a company and funded on its balance sheet. The company is normally referred to as

the originator.

2. Once a suitably large portfolio of assets has been originated, the assets are analyzed as a

portfolio and then sold or assigned to a third party, which is normally a special purpose of

funding the assets. It issues debt and purchases 189 receivables from the originator. The

SPV is owned by a trust / the originator.

3. The administration of the asset is then subcontracted back to the originated by the SPV. It

is responsible for collecting interest and principal payments on the loans in the

underlying pool of assets and transfer to the SPV.

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4. The SPV issues tradable securities to fund the purchase of assets. The performance of these

securities is directly linked to the performance of the assets and there is no recourse (other than in

the event of breach of contract) back to the originator.

5. The investors purchase the securities because they are satisfied that the securities would be paid

in full and on time from cash flow available in asset pool. The proceeds from the sale of securities

are used to pay the originator.

6. The SPV agrees to pay any surplus which, may arise during its funding of the assets, back to the

originator. Thus the originator, for all practical purposes, retains its existing relationship with the

borrowers and all of the economies of funding the assets.

7. As cash flow arise on the assets, these are used by SPV to repay funds to the investors in the

securities.

SECURITIZATION OR ASSET RECONSTRUCTION COMPANIES IN INDIA

(AS ON 30TH NOVEMBER 2017).

1. Asset Reconstruction Company

(India), Dadar (West), Mumbai.

2. Assets Care & Reconstruction

Enterprise Ltd, New Delhi.

3. ASREC (India) Limited Andheri (E),

Mumbai-400093

4. Pegasus Assets Reconstruction

Pvt Ltd, Nariman Point,

Mumbai

5. Alchemist Asset Reconstruction

Company Limited, New Delhi.

6. International Asset

Reconstruction Company Pvt

Ltd, New Delhi.

7. Reliance Asset Reconstruction

Company Limited, Ballard Estate,

Mumbai.

8. Prithvi Asset Reconstruction

And Securitization Company

Ltd, Hyderabad.

9. Phoenix ARC Private Limited, Kalina,

Santacruz (East) Mumbai.

10. Invent Assets Securitization &

Reconstruction Pvt Ltd,

Nariman Point Mumbai.

11. JM Financial Asset Reconstruction

Company Private Limited Prabhadevi

Mumbai.

12. India SME Asset

Reconstruction Company

Limited, Mumbai.

13. Edelweiss Asset Reconstruction

Company Limited Edelweiss House,

Kalina, Mumbai.

14. UV Asset Reconstruction

Company Limited, New Delhi-

110019

15. Meliora Asset Reconstruction

Company Limited, Visakhapatnam

Andhra Pradesh.

16. Omkara Assets Reconstruction

Private Limited, Tirupur, Tamil

Nadu.

17. Prudent Asset Reconstruction

Company Ltd, New Delhi.

18. MAXIMUS ARC Limited,

Vijaywada, Andhra Pradesh.

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19. CFM Asset Reconstruction Private

Limited, Ahmedabad

20. Encore Assets Reconstruction

Company Private Limited,

New Delhi.

21. Rare Asset Reconstruction Pvt. Ltd,

Gujarat College Road, Ahmedabad.

22. Suraksha Asset Reconstruction

Private Limited, Elphinstone

Road, Mumbai.

23. Ambit Flowers Asset Reconstruction

Private Limited, Lower Parel, Mumbai.

24. India bulls Asset

Reconstruction Private

Limited, New Delhi.

Source: https://rbidocs.rbi.org.in/rdocs/content/pdfs/LSCRCRBI07092016.pdf

SECURITIZATION OR ASSET RECONSTRUCTION COMPANIES IN INDIA.

An Asset Reconstruction Company is a specialized financial institution that buys the

NPAs or bad assets from banks and financial institutions so that the latter can clean up

their balance sheets. Or in other words, ARCs are in the business of buying bad loans

from banks.

ARCs clean up the balance sheets of banks when the latter sells these to the ARCs. This

helps banks to concentrate in normal banking activities. Banks rather than going after

the defaulters by wasting their time and effort, can sell the bad assets to the ARCs at a

mutually agreed value.

SARFAESI ACT 2002 – THE BEGINNING OF ARCs.

The Securitization and Reconstruction of Financial Assets and Enforcement of Security

Interest (SARFAESI) Act, 2002; enacted in December 2002 provides the legal basis for

the setting up ARCs in India. Section 2 (1) of the Act explains the meaning of Asset

Securitization. Similarly, ARCs are also elaborated under Section 3 of the Act.

The SARFAESI Act helps reconstruction of bad assets without the intervention of courts.

Since then, large numbers of ARCs were formed and were registered with the RBI which

has got the power to regulate the ARCs.

CAPITAL REQUIREMENTS OF ARCs.

As per amendment made on the SARFAESI Act in 2016, an ARC should have a minimum

net owned fund of Rs 2 crore. The RBI plans to raise this amount to Rs 100 crore by end

March 2019. Similarly, the ARCs have to maintain a capital adequacy ratio of 15% of

its risk weighted assets.

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FUNDING OF ARCs.

Regarding funds, an ARC may issue bonds and debentures for meeting its funding

requirements. But the chief and perhaps the unique source of funds for the ARCs is the

issue of Security Receipts. As per the SARFAESI Act, Security Receipts is a receipt or

other security, issued by a reconstruction company (or a securitization compa ny in that

case) to any Qualified Institutional Buyers (QIBs) for a particular scheme. The Security

Receipt gives the holder (QIB) a right, title or interest in the financial asset that is bought

by the ARC. These SRs issued by ARCs are backed by impaired assets.

ACQUISITION AND VALUATION OFASSETS BY ARCs.

NPAs shall be acquired at a ‘fair price’ in an arm’s length principle by the ARCs. They

have to value the acquired bad assets in an objective manner and use uniform process

for assets that have same features.

SARFAESI Act permits ARCs to acquire financial assets through an agreement. Banks

and FIs may receive bonds/ debentures in exchange for NPAs transferred to the ARCs.

A part of the value can be paid in the form of Security Receipts (SRs). Latest reg ulations

instruct that ARCs should give 15% of the value of assets in cash.

Bond or debentures can have a maximum maturity of six years and should have a rate of

interest at least 1.5% above the RBI’s ‘bank rate’. While dealing with bad assets, ARCs

should follow CAR regulations.

RESOLUTION STRATEGIES BY ARCs.

The guidelines on recovery of money from the resolution process by the ARCs say that

regaining the value through restructuring should be done within five years from the date

of acquisition of the assets. SARFAESI Act stipulates various measures that can be

undertaken by ARCs for asset reconstruction. These include:

h) taking over or changing the management of the business of the borrower,

i) the sale or lease of the business of the borrower

j) entering into settlements and

k) restructuring or rescheduling of debt.

l) enforcement of security interest

The last step of ‘enforcement of security interest’ means ARCs can take

possession/sell/lease the supported asset like land, building etc.

ARCs and the secured creditors cannot enforce the security interest under SRFAESI

unless at least 75% by value of the secured creditors agree to the exercise of this right.

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Besides restructuring, the ARCs can perform certain other functions as well. They are

permitted to act as a manager of collateral assets taken over by the lenders by receiving

a fee. Similarly, they can also function as a receiver, if appointed by any Court or DRT.

PERFORMANCE OF ARCs IN INDIA.

During 2013-14, because of multiple positive factors, the reconstruction business was

booming as ARCs bought large quantity of bad assets from banks.

During the early period of 2008 – 13 where reconstruction business was in infancy stage,

the conversion of NPAs was slow. According to an ASSOCHAM report, the average

recovery rate for ARCs in India is around 30% of the principal and the average time

taken is between four to five years.

But after 2014, the performance of ARCs in settling the NPAs became below par.

Especially in the recent periods, ARCs became underperformers in the context of the

present rising tide of bad assets. This has caused steep rise in NPAs in the banking sector.

The declining asset reconstruction activity was started from the second half of 2014,

when the RBI has raised certain norms for securi tization business. RBI released a

comprehensive ‘Framework for Revitalizing Distressed Assets in the Economy’. It

suggested a corrective action plan to fight NPAs. Later, the RBI raised the cash payment

to banks from 5% to 15%. Similarly, then it removed special asset classification benefits

to asset restructuring from April 1, 2015 to align with international norms. As a result

of these, the asset reconstruction business witnessed a slow-down.

At present, there are 24 ARCs in India. But collectively, thei r capital base is also

insufficient to tackle the country’s nearly Rs 8 lakh crores NPAs. The main problems in

the sector are: low capital base of ARCs, low funds with the ARCS, valuation mismatch

of bad assets between banks and ARCs etc.

Several steps were taken by the RBI and the government to bring life into the asset

reconstruction activities. In one such step, the Government raised FDI in the sector to

100%. Similarly, the ARCs may get a vital role for asset restructuring under the new

Insolvency and Bankruptcy Code. In 2016, the RBI has amended the SARFAESI Act to

give make the ARCs more efficient.

Questions.

1. Explain the concept of Securitization.

2. Explain the need for Securitization.

3. Explain the instruments and players involved in Securitization.

4. Explain the structure of Securitization.

5. Explain the process of Securitization.

6. Write a note on securitization business in India.

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MODULE THREE

CHAPTER FIVE

PREVIEW.

Hire Purchase – Meaning and Concept.

Installment and Consumer Credit.

Sources of Hire Purchase Finance in India.

HIRE PURCHASE – MEANING AND CONCEPT.

In a higher purchase transaction, the purchaser pays the price of the goods in instalments. The

instalments may be annual, six-monthly, quarterly, monthly fortnightly etc. The goods are

delivered to the purchaser at the time of agreement before the payment of instalments but the title

on the goods is transferred after the payment of all instalments as per the hire-purchase agreement.

The special feature of a hire-purchase transaction is that the payment of every instalment is treated

as the payment of hire charges by the purchaser to the hire vendor till the payment of the last

instalment. After the payment of the last instalment, the amounts of various instalments paid is

appropriated towards the payment of the price of the goods sold and the ownership or the goods is

transferred to the purchaser. Hire-purchase therefore is a transaction where the goods are sold by

vendor to the purchaser with the following conditions:

1. The goods will be delivered to the purchaser at the time of agreement.

2. The purchaser has a right to use the goods delivered.

3. The price of the goods will be paid in instalments.

4. Every instalment will be treated to be the hire charges of the goods which is being used by

the purchaser.

5. If all instalments are paid as per the terms of agreement, the title of the goods is transferred

by vendor to the purchaser.

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6. If there is a default in the payment of any of the instalments, the vendor will take away the

goods from the possession of the purchaser without refunding him any amount received

earlier in the form of various instalments.

Hire-purchase agreement means a contract between the hire vendor and the hire purchaser

regarding the sale of goods under certain conditions. The terms of reference of a hire-purchase

agreement shall be as follows:

1. The cash price of the goods i.e. the price at which goods may be purchased against cash

payment.

2. The hire-purchase price i.e. the total amount which is payable by the hire-purchaser under

the agreement.

3. The date on which the hire-purchase agreement will commence.

4. The description of the goods that will be delivered to the hire-purchaser at the

commencement of the agreement.

5. The number of instalments to be paid by the hire-purchaser along with the amount of each

instalment and the date of payment of each instalment.

6. Down payment if any, i.e. the amount which is required to be paid by hire-purchaser to the

hire vendor at the time of commencement of hire-purchase agreement.

7. The rate of interest charged by the hire vendor.

The characteristics of hire-purchase system are as follows:

1. Hire-purchase is a credit purchase.

2. The price in a hire-purchase transaction is paid in instalments.

3. The goods are delivered in the possession of the purchaser at the time of commencement

of the agreement.

4. Hire vendor continues to be the owner of the goods till the payment of last instalment.

5. The hire-purchaser has a right to use the goods as a bailer(one who possesses but not owns).

6. The hire-purchaser has a right to terminate the agreement at any time in the capacity of a

hirer.

7. The hire-purchaser becomes the owner of the goods after the payment of all instalments as

per the agreement.

8. If there is a default in the payment of any instalment, the hire vendor will take away the

goods from the possession of the purchaser without refunding him any amount.

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INSTALMENT CREDIT AND CONSUMER CREDIT.

Consumer credit is a debt that a person incurs when purchasing a good or service. Consumer credit

includes purchases obtained with credit cards, lines of credit and some loans. Consumer credit is

also known as consumer debt. Consumer credit is classified into: revolving credit and

installment credit. The most common form of consumer credit is a credit card.

Consumer credit is the portion of credit consumers use to buy consumption goods that depreciate

quickly. This includes automobiles, education, recreational vehicles (RVs), boat and trailer loans,

but it does not include debts obtained to purchase margin on investment accounts or real estate.

For example, a mortgage loan is not consumer credit. However, the 65-inch high-definition

television charged on a credit card is consumer credit. Consumer credit allows consumers to get

an advance or loan to spend money on products or services for family, household or personal uses

repaid at a specified future date. Retailers, department stores, banks and other financial

institutions offer consumer credit.

The advantage of consumer credit is that consumers can purchase goods and services and pay for

them later. Consumers can purchase items they need when their funds are low. The disadvantage

of using consumer credit is the cost. If a consumer fails to repay a loan or a credit card balance,

this impacts his credit scores, affects terms and conditions, and results in late fees and penalties.

Revolving credit is a loan offered on a continuous basis for purchases until the consumer reaches

his credit limit. Customers receive bills periodically to make at least a minimum monthly payment.

For example, a credit card company can approve a consumer for a Rupees One lakh credit card

limit with a twelve per cent interest rate. If the consumer defaults on payments, the credit card

company can charge late fees or other penalties.

Installment credit is used for a specific purpose, for a defined amount and for a specific period.

Payments are made in equated monthly installments. Examples of purchases made on installment

credit include large appliances, automobiles, furniture etc. Installment credit offer lower interest

rates than revolving credit. For example, a car company holds a lien on the car until the car loan is

repaid. The total amount of the principal and interest is repaid within a predefined period. If the

customer defaults on the loan payments, the company can repossess the car and charge penalties.

Difference between Hire Purchase and Installment Credit.

1. There are three parties in Hire Purchase trade namely the seller, the financier and the

buyer. There are only two parties involved in Installment sale namely the seller and buyer.

2. There are three agreements in a hire purchase, namely between (a) the seller and the

financier. (b) financier and the buyer and (c) the buyer and the seller. But in Installment

sale, there is only one agreement between the buyer and seller.

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3. Hire purchase is an agreement to hire and later to buy. Installment is an agreement to buy.

In hire purchase, the ownership transfers from the seller to the financier and then to the

buyer on the payment of the last installment. In Installment sale, the ownership transfers

on the first installment from the seller to buyer.

4. In hire purchase, when there is a payment default, the financier takes back the goods from

the buyer. In installment sale, if there is a payment default, the seller cannot take back the

goods, but can only sue the buyer.

5. In Hire purchase, any damage to the goods will only lead to claiming of insurance by the

financier from the insurance company since the ownership has not been transferred. In

installment sale, any damage to the goods will be claimed by the buyer from the insurance

company.

6. Buyer cannot sell the goods to any third party until he pays the last installment to the

financier in hire purchase. In case of installment sale, the buyer can sell to any third party

as he is the owner of the goods.

7. The interest rate in hire purchase will be on a flat rate basis and is included in the

installment and recovered as equated monthly installment (EMI). For instance, consumer

durable goods such as automobiles, refrigerators etc. The interest rate in installment sale is

on a declining basis as every installment paid will reduce the principal amount and hence

the total interest payable is lesser than on a hire purchase loan. For example, Bank finance

for purchase of consumer goods.

THE HIRE PURCHASE ACT, 1972.

The hire purchase finance companies come under non-banking finance companies (NBFCs) and

are subject to the regulations of Reserve Bank of India Act. Before 1998, the non-banking finance

companies were accepting deposits from the public by offering attractive interest rates and were

collecting higher interest rates from the buyers of durable goods on hire purchase. But in 1998,

certain restrictions were imposed on the acceptance of deposits by non-banking finance companies

involved in hire purchase finance. Since then, the acceptance of deposits by these companies has

been curtailed, as a result of which there has been some decline in the hire purchase activities in

India.

Automobile companies such as Maruti Udyog Limited and Tatas have promoted their own hire

purchase finance companies. Ashok Leyland Finance has been there already in the market. The

foreign banking companies are also undertaking hire purchase finance and they compete with the

Indian hire purchase finance companies. Housing Finance has also been taken up on hire purchase

by most of the commercial banks and with the introduction of floating interest rate, it is picking

up both in urban and rural areas. The floating rate of interest is beneficial to the customer in a

climate of falling interest rate. Banks are allowing swapping of the interest rate i.e., the old loan with

the higher interest rate is repaid and it is replaced by a new loan with a lower rate of interest.

https://accountlearning.com/consumer-goods-meaning-classification-characteristics/

60


Thus, in India hire purchase finance is mainly encouraged by the middle-income group consumers

in the purchase of houses and durable goods, whereas in industries, it is leasing which is becoming

very popular.

The Hire Purchase Act, 1972 defines a hire purchase agreement as an agreement under

which goods are let on hire and under which the hirer has an option to purchase them in

accordance with the terms of the agreement and includes an agreement under which:

1. Possession of goods is delivered by the owner there off to a person on a condition that such

person pays the agreed amount in periodic payments, and

2. The property in the goods is to pass to such person on the payment of the last of such

installments, and

3. Such person has a right to terminate the agreement at any time before the property so

passes. Section 3 of the Act provides that every hire purchase agreement must be in writing

and signed by all parties thereto.

Rights of Hirer:

In addition to the usual right of terminating the agreement at any time before the property passes

to him and returning the goods to the hiree, the Hire Purchase Act, 1972 has provided the following

rights to the hirer:

1. The hiree (vendor) cannot terminate the hire purchase agreement for default in payment of

hire or due to an un-authorized act or breach of expressed conditions unless a notice in

writing in this regard is given to the hirer. The period of notice will be one week where the

hire is payable weekly or less than that interval and two weeks in other cases.

2. The right to repossess the goods will not exist unless sanctioned by the Court in the

following cases:

a) Where the hire purchases price is less than Rs. 15,000, one half of the hire purchase

price has been paid.

b) Where the hire purchase is not less than Rs. 15,000, three fourth of hire-purchase

price has been paid.

However this proportion in case of motor vehicles is as under:

i) One half, where the hire purchase price is less than Rs. 5,000.

ii) Three fourths, where the hire purchase price is not less than Rs. 5,000 but less than Rs.

15,000.

iii) Three fourths or such higher proportion not exceeding nine-tenth where the hire purchase

price is not less than Rs. 15,000.

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3. The hirer has a right of receiving a statement from the owner against a payment of rupee

one showing the amount paid by or on behalf of the hirer, the amount which has become

due under the agreement but remains unpaid and the date upon which each unpaid

installment became due, and the amount of each such installment and the amount which is

to become payable under the agreement and the date or the mode of determining the date

upon which each future installment is to become payable, and the amount of each such

installment.

4. If the amount paid by the hirer till the date of repossession of the goods or the value of the

goods on the date of repossession of goods exceeds the total hire purchase price the excess

payment made by the hirer will be returned to the hirer by the owner of the goods.

The owner or vendor, for the purpose of calculating the value of the goods, has the right to

deduct the reasonable expenses for repossessing the goods, for storing the goods, or

repairing them, for selling them and for payment of arrears of taxes.

Method of Computing Installment under Hire Purchase.

Under Hire Purchase, interest is usually charged on a flat rate for the period of hire. We can

calculate the amount of installment by adding the amount of principal (cost of the asset) and the

total interest for the period, and further by dividing the total amount of payment to be made by the

number of installments.

For instance, an equipment costing Rs. 10,00,000 is sold on hire purchase on the terms that interest

will be charged at 15% p.a. on flat rate basis and the payment is to be made in 5 equal year-end

installments.

In the above example, the total Interest burden shall be Rs. 7,50,000 i.e. 10,00,000 × 15/100 × 5

and the yearly installment shall be 10,00,000 + 7,50,000/5 = Rs. 3,50,000.

Method of Splitting Hire Purchase Installment into Interest and Principal Repayments.

First of all interest included in each installment is calculated on the basis that interest in each

installment shall be in ratio of amounts outstanding. In case the installments are of equal amounts,

we can apply the sum of digit method.

We can determine the amount of principal repayment in the installment by deducting from it the

amount of interest calculated in as above.

The following example illustrates the method of splitting of hire purchase installment into

interest and principal repayments:

Example.

A company purchased an equipment costing Rs. 10,00,000 on hire purchase basis payable in 4

equal year end installments of Rs. 4,10,000 each. Splitting of the Installments into interest and

principal repayments.

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Solution:

In the above Illustration, the total amount payable is Rs. 16,40,000-10,00,000 = 6,40,000/-

The interest and principal amount can be calculated as follows:

SOURCES OF HIRE PURCHASE FINANCE IN INDIA.

The hire purchase finance companies come under non-banking finance companies (NBFCs) and

are subject to the regulations of Reserve Bank of India Act [Section 45(i)].

In the beginning, the non-banking finance companies were accepting deposits from the public by

offering high interest rates and were collecting higher interest rates in turn from the buyers of

durable goods on hire purchase. In 1998, certain restrictions were imposed on the acceptance of

deposits by non-banking finance companies involved in hire purchase finance. Since then, the

acceptance of deposits by these companies has reduced. Hence, there has been a decline in the hire

purchase activities in India.

To overcome the restrictions, many automobile companies such as Maruti Udyog Limited and

Tatas have themselves promoted their own hire purchase finance companies. Ashok Leyland

Finance has been there already in the market. The foreign banking companies are also undertaking

hire purchase finance and they are a big competitor to the Indian hire purchase finance companies.

Housing Finance has been taken up on hire purchase by most of the commercial banks and with

the introduction of floating interest rate, the business has been growing both in urban and rural

areas. The floating rate of interest is beneficial to the customer as long as the interest rate is

declining. Even banks are allowing the swapping of the interest rate. By this, the old loan with the

higher interest rate is repaid and it is replaced by a new loan with a lower rate of interest.

Installment Amount in INR Interest Amount

(in INR)

First 6,40,000 × 4/10 = 64000 × 4 2,56,000.00

Second 6,40,000 × 3/10 = 64000 × 3 1,92,000.00

Third 6,40,000 × 2/10 = 64000 × 2 128,000.00

Fourth 6,40,000 × 1/10 = 64000 × 1 64,000.00

Splitting of Hire Purchase Instalment into Principal and Interest

Components

Year Hire Purchase Installment Interest Principal Repayment

First 4,10,000 2,56,000.00 154,000.00

Second 4,10,000 1,92,000.00 218,000.00

Third 4,10,000 128,000.00 282,000.00

Fourth 4,10,000 64,000.00 346,000.00

Total 16,40,000.00 6,40,000.00 10,000,00.00

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Thus, in India hire purchase finance is mainly encouraged by the middle-income group consumers

in the purchase of houses and durable goods, whereas in industries, it is leasing which is becoming

very popular.

As on 01 March 2005, there were some 577 Hire purchase and leasing companies in India. Some

of the leading names in hire purchase finance are as follows:

1. Bajaj Auto Finance Ltd.

2. Abhinav Hire Purchase Ltd.

3. Bhatia Hire Purchase Pvt Ltd.

4. Centurion Bank.

5. Skyline Hire Purchase Ltd.

6. M&M Financials.

7. Cholamandalam Finance.

8. Sundaram Finance.

Bajaj Finance is the leading hire purchase finance company in India and had posted a net profit of

Rs.2646/- crore in the year 2017-18.

Questions.

1. Explain the meaning and concept of Hire Purchase.

2. Distinguish between Installment and Consumer Credit.

3. Explain the Sources of Hire Purchase Finance in India.

4. Explain the Hire Purchase Act of 1972.

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MODULE THREE

CHAPTER SIX

PREVIEW.

1. Housing Finance – Need and Nature.

2. Fixed and Floating Rate Home Loans.

3. Sources of Housing Finance in India.

4. Growth of Housing Finance in India.

5. Role of National Housing Bank.

6. Concept of Mortgage and Reverse Mortgage.

7. Housing and Mortgage Loans.

8. Types of Mortgage Loans.

NEED AND NATURE OF HOUSING FINANCE IN INDIA.

Housing finance is basically required by both house builders and house buyers. The builders need

finance for land acquisition, purchase of building materials and construction related activities. The

house buyers need finance for purchase / construction of new house or flat or house-site, for

repairs, renovation or extension of already existing houses. Housing being a long durable asset,

the finance required is generally a long-term credit in nature. As a durable asset, housing structure

provides security for house finance. Hence it is made usually against mortgage of house itself as

security. To become eligible for house finance, the borrower should be the owner of the house

with clear title of ownership. Housing finance, thus, enables individual households to acquire land

and build their own dwelling units with the basic amenities for a better standard of living.

The need and significance of increasing housing investment are two-fold: Firstly, the consideration

of human comforts, decency and dignity as well as social and economic welfare justifying adequate

investment to meet the growing demand for housing by the people, and secondly, with economic

development and increased income, the people become increasingly more consumer oriented,

which would raise the propensity for better quality housing services calling for larger investments

to improve housing (Cherunilam and Heggade, 1987). Investment in housing is not only socially

desirable but also economically indispensable. Increasing emphasis and demand for more

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investment in housing is, therefore, a direct off - shoot of the welfare state goals of the modern

governments all over the world (Heggade, Odeyar 1987).

Investment and financing in housing can be broadly divided into two categories: private and public.

There are three types of private investment in housing. They are:

1. The investment in owner-occupied housing.

2. The private investment in housing to earn regular income by way of rent and

3. The housing investment undertaken by the private industrialists / employers for housing

their employees.

The public investment in housing is, on the other hand, based on the socioeconomic considerations

and welfare objectives. The economic objective in housing investment is to promote employment

and to contribute to the development of national economy, whereas the social objective intends to

improve social welfare of people through a provision of better-quality housing to the resource poor

community. The owner-occupied private housing investment is motivated by the need for and the

ability to pay for housing. In other words, the magnitude of investment requirement depends on

the type of house constructed. Type of house constructed depends on the nature of access to

resources required. Generally, there are three categories of households, who would require

investment on owner-occupied housing.

1. The first group, comprising of the business class, industrialists and other rich class of

society require the construction of luxury housing units. Financing for construction of these

house models does not pose problems, as the owners from their own resources usually meet

them.

2. The second is the middle class and salaried families, who require semi-luxury decent

housing to live in. This class of households needs financial assistance on cost recovery

basis for construction of houses of the type they prefer.

3. The last is the resource poor families, who cannot afford the houses at market rate and

require financial support by the Government. There is a good case for credit to low-income

households through a subsidy program. This is entirely the responsibility of the

government, as the low-income households cannot get access to formal housing credit

(World Bank, 1984).

Three distinct housing finance systems are evolved worldwide namely public financing, market

financing and mixed financing (Mahadeva, 2004). Financing housing activities by government has

been the most common method since time immemorial. Most of the developing countries adopted

public financing system to meet the housing needs of urban poor and low income and resource

poor people in rural areas.

The direct public intervention is justified on two grounds : first, organized housing credit market

is underdeveloped and not responsive to vulnerable section of the society in most of the developing

countries, and second, on equity and welfare considerations, government housing finance

programs are considered the effective methods to spread the benefits and transfer resources

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towards low income groups (Habitat, 1996). Financing is provided by way of both subsidy and

loan. In this system, government intervened as regulator, provider of subsidies and a direct

investor. However, the empirical evidences have shown that “Public housing turned out to be

expensive, and limited funds meant that such housing could not reach the bulk of urban population.

High subsidies meant that only a chosen few benefited. Zoning and building standards were widely

flouted. Indeed, illegal housing and squatter colonies became the predominant source of new

housing in many cities” (The World Bank, 1972).

The second mode of housing finance system, which is commonly adopted in USA and advanced

European countries is the market financing. Housing production is largely dominated by private

sector in developed countries. Government, due to huge requirement of funds to meet the total

housing needs, restricts its role only as a facilitator. Finance is supplied to consumers at an

affordable price by different financial institutions. The main pillar of the market financing system

is the existence of a host of financial institutions with private capital. This includes commercial

banks, co-operative banks, insurance companies, trusts and mortgage loan companies. Commercial

banks raise short-term deposits and insurance and trust companies sell insurance bonds and

manage trust and pension funds to raise required funds for housing finance (Fallis, 1990). These

institutions control a huge part of the mortgage loans for housing. Mortgage insurance for the

housing loans has provided a greater confidence to the private investors and ensured uninterrupted

supply of finances. The facility of mortgage insurance has been extended for the acquisition of

apartments, purchase of existing building besides the newly constructed units. Notwithstanding

the present subprime housing finance crisis, this system of housing finance has succeeded in

resolving housing problem in developed countries.

Mixed-financing typically refers to co-existence of all major forms of housing finance

mechanisms : public financing, market financing and informal source of financing. This system of

house financing is largely found in developing parts of the world mainly for two reasons : First,

most of the developing countries have not attempted to organize a full-fledged housing finance

market with investment-friendly environment as in the market-driven developed economies, and

second, the governments of these countries do not have resource capacity to meet the total housing

financial needs The objective of mixed financing approach is to restrict the government housing

finance to social housing for weaker sections of the community and encourage private agencies to

finance those who can afford to repay from their income. Since the housing financial market is not

developed fully, the informal sources of financing play a major role in housing finance. The

informal sources include moneylenders, friends, relatives and family savings, which are estimated

to have met up to 80 percent of the housing finance in developing countries in general and South

Asian countries in particular (Okpal, 1994). With the development of financial market, their

importance would, however, decline gradually.

As per the RBI guidelines, housing finance is categorized into direct and indirect housing finance.

The direct housing finance refers to the finance provided to individuals or groups of individuals

including cooperative societies. Within this conceptual framework, the RBI has stipulated the

following types of bank finance

1. Direct Housing Finance. Bank finance extended to a person who already owns a house in

town / village, where he resides, for buying / constructing a second house in the same or

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other town / village for the purpose of self-occupation. Bank finance extended for purchase

of a house by a borrower, who proposes to let it out on rental basis on account of his posting

outside the headquarters or because he has been provided accommodation by his employer.

Bank finance extended to a person, who proposes to buy an old house, where he was

previously residing as tenant.

2. Bank finance granted only for purchase of plot, provided a declaration is obtained from the

borrower that he intends to construct a house on the said plot, with the help of bank finance

or otherwise, within a period of two years from the availment of the said finance.

3. Bank finance granted for carrying out alterations / additions / repairs to the house / flat

existing or already financed by the bank

The indirect housing finance refers to bank finance granted to housing finance institutions, housing

boards and other public housing agencies and private builders primarily for augmenting the supply

of serviced lands and constructed dwelling units. Housing finance is a typical market-oriented

system. Though, housing is considered as infrastructure development, housing finance

distinguishes itself from other forms of financing social goods such as education, health care, etc.

It is generally considered as a long-term credit as the investment is made for creation of durable

asset with a long-life period. Both land and house have markets and are saleable commodities.

However, for housing credit market to function efficiently, a well-functioning land and house

market is essential. Then only the financial market would be in a position to meet the housing

financial needs of households / people, who can afford the services including the cost on viable

basis.

FIXED AND FLOATING RATE HOME LOANS.

In a fixed rate loan, the interest rate is fixed at the time of taking the home loan.

Apart from a regular fixed rate product where the rate of interest is constant over the

entire term of the loan, there are variants available which allow you to fix your

interest rate for specific periods of 2, 3 or 10 years and is available with the right of

reset by the lender at any point in time.

Opting for a fixed rate home loan gives you a sense of certainty since you know what

your repayments will be right from the time of taking the loan, giving you the

confidence to budget accurately and plan your finances. So there is a reasonable

measure of predictability to your loan tenure, EMI commitments and the total interest

outflow.

Fixed rate loans are usually priced slightly higher than fl oating rate loans. If the

difference is quite large, you may be swayed toward a floating rate loan. But if they

are almost at par or if the difference is minimal, then you may want to assess your

situation and needs, to decide whether to opt for a fixed ra te loan or a floating rate

loan.

Fixed rate home loan should be opted in the following circumstances:

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1. You are comfortable with the EMI you are committing to pay. It should ideally

not exceed 25-30% of your take-home monthly income.

2. You perceive a scenario of rising interest rates in the future and hence, would

like to lock in your home loan at the existing rate.

3. If interest rates have come down recently and you are comfortable with the

current level of interest rates, lock in at this rate with a f ixed rate loan. For

example, if home loan interest rate was at 10% a couple of years ago and has

now declined to say 8.5% and you are mentally and financially comfortable

with this rate, you can avail a fixed rate loan.

Also referred to as ‘adjustable rate home loan’, these loans are linked to the lender’s

benchmark rate, which, in turn, moves in sync with the market interest rate. If there

is a change in the benchmark rate, the interest rate on the loan also changes

proportionately.

The interest rate on such loans is reset at specified intervals. It could be calendar

periods like every quarter or half of a financial year or it could be unique to each

customer depending upon the date of first disbursement of his home loan. Alternately,

the reset could also be linked to your loan anniversary. If there has been a change in

the market rates during the review period, your rates too would be reset higher or

lower as the case may be. In cases of such rate resets, it is usually the tenure of the

loan that gets re-adjusted to account for the changed interest rate. If the rate increases,

your remaining loan tenure would be extended and vice-versa. This is done to avoid

frequent revisions to your EMI which could impact your cash flow. But if you so

desire, you may request the lender to revise your EMI instead of the loan tenure .

Floating rate home loan should be opted in the following circumstances:

1. If you are expecting interest rates in general to fall over time, opting for a

floating rate loan in such a scenario will result in the interest rate applicable

to your loan falling too, thereby reducing the cost of your loan.

2. Floating rate loans are suitable for those who are unsure about interest rate

movements and would prefer to go with the market rates.

3. If you are looking for some savings on your interest cost in the near term,

floating rate loans are usually set at a marginally lower rate than fixed rate

loans thereby giving you some benefit in terms of cost of your loan.

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SOURCES OF HOUSING FINANCE IN INDIA.

Cities began to grow rapidly after Independence. With the growth of cities, the land and housing

prices began to rise rapidly. The supply of houses always fell short of the demand for housing.

The government recognized the significance of housing finance and need for development of

housing finance institutions to meet the growing investment needs of the housing sector.

In India, the evolution of organized housing finance began with the establishment of public sector

agencies for housing by both Central and State Governments. In the beginning, the government

financial support to housing had been centralized and directed through the State Housing Boards

(SHB) and development authorities. Attempts were also made to organize Co-operative Housing

Financing Societies (CHFS) at primary level, Apex Co-operative Housing Federations (ACHFs)

at state level and National Cooperative Housing Federation at national level with an Act of

Parliament to deploy housing credit to their members. Co-operatives were the only source of

financing for housing during the first three Five Year Plan periods. The National Cooperative

Housing Federation now operates through 26 Apex Co-operative Housing Federations in the states.

There are nearly 90,000 Primary Co-operative Housing societies with 6.5 million individual

members.

The nationalization of the insurance sector in late fifties and subsequently the commercial banks

in the 1960s and 70s, has further opened avenues for implementation of various social housing

schemes by the governments. The Life Insurance Corporation (LIC) was mandated to invest 25

per cent of its control funds in socially oriented schemes including housing development activities

through government. Similarly, the General Insurance Corporation (GIC) was statutorily required

to invest 35 percent of its investment funds through State governments for housing and for loans,

bonds, debentures and preference shares of Housing and Urban Development Corporation

(HUDCO). Employees’ Provident Fund (EPF) has been another important source of housing

finance for salaried class. The State Housing Boards and other housing agencies engaged in the

housing construction were facing the problem of inadequate finance. To augment residential

construction activity, Government of India decided in 1970 to establish the Housing and Urban

Development Corporation Ltd, (HUDCO) as a fully owned Central government enterprise with

the following objectives:

1. To provide long-term finance or undertake directly construction of houses for residential

purpose in urban and rural areas.

2. To finance or undertake wholly are partly, the setting up of new satellite towns.

3. To subscribe to the debentures and bonds to be issued by the State Housing Boards, ACHFs

and other housing agencies for the purpose of financing housing and urban development

programs.

4. To finance or undertake the settings up of building materials industries.

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5. To administer the funds received, from time to time, from Government of India and other

sources as grants or otherwise for the purpose of financing or undertaking housing and

urban development programs in the country.

6. To promote, assist, collaborate and provide consultancy services for designing and

planning programs for housing and urban development.

HUDCO was constituted as a national body to finance housing and urban infrastructure activities

including housing. The evolution of formal housing financial institutional development began with

the establishment of National Housing Bank (NHB) as an apex housing finance institution in 1988.

Based on the recommendations of the High-Level Committee set up by the Government of India

in June 1986 under the Chairmanship of Dr. Rangarajan, then Deputy Governor of RBI, the NHB

was set up as a subsidiary of Reserve Bank of India (RBI) to provide refinance facilities to banks,

housing finance companies, Co-operative Housing Finance Societies etc. As an apex body, it has

regulatory, promotional and refinance roles. Accordingly, the mandate of NHB was to promote a

sound, healthy, viable and cost-effective housing finance system to cater to all segments of the

population. It was expected to mobilize resources by issuing bonds besides share capital from RBI

along with a line of credit from RBI.

The United Nation's declaration of 1976 as the International Year of Shelter for the Homeless

prompted the Government of India to adopt multi-agency approach for housing finance. In 1977,

the Housing Development Finance Corporation (HDFC) was set up, as the first Company of its

kind in the private sector, to offer home loans in India. It was sponsored by the ICICI and IFC. It

has contributed to develop the housing finance for growing middle class as a viable banking

business. HDFC has a network of 4787 branches all over the country as on 31st March 2018. Dewan

Housing Finance Company Ltd. came into existence in 1984. Later Life Insurance Corporation of

India promoted LIC Housing Finance Co. Ltd. in 1989. The new economic policies launched in

early 1990s paved the way for the entry of commercial banks into the housing finance sector. The

entry of commercial banks has also laid the foundation for the expansion of the housing sector and

for evolving a vibrant housing finance market.

Entry of Commercial Banks to Housing Finance.

A study Group on Housing Finance Institutions set up by the RBI in September 1987 under the

Chairmanship of Dr. Rangarajan, then Deputy Governor, made recommendations on the role that

can be played by the commercial banks in housing finance. Based on the recommendations of the

Study Group and considering the growing importance of housing sector and the massive housing

shortage prevailing in the country, the Reserve Bank of India had advised banks in early 1990s to

enter the domain of housing finance. Banks were asked to allocate annually a minimum of 3 per

cent of their incremental deposits for housing finance.

In the beginning, the commercial banks entered the housing finance market on a small scale. Some

banks set up separate subsidiaries to specialize in housing finance. Canara Bank, Vijaya Bank,

Corporation Bank, and ING Vysya Bank adopted the subsidiary route and established their own

housing financed companies. Syndicate Bank opened specialized Housing Finance Branches

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dealing exclusively with housing finance. In the late 1990s, when interest rates were lower,

industrial slow-down has begun, credit off-take was sluggish and there was ample liquidity,

commercial banks recognized the potential of housing finance as an alternative avenue to lend

their surplus funds. The 5th Central Pay Commission was enforced. Many State Governments also

implemented the new pay scales. Hence there was a rise in the disposable incomes and demand

for housing was growing. Real estate prices were at an all-time low and stable and fiscal incentives

made housing finance an attractive bankable business. From April 2004, the banks were also

allowed to treat the direct housing finance extended up to Rs.10 lakh to individuals as priority

sector advances. With the entry of banks into housing finance, particularly private sector banks

such as the ICICI and the HDFC, the business of home loans changed dramatically. With the entry

of commercial banks, the institutional set up for housing finance in India underwent a

revolutionary change.

An Overview of Performance by Various Institutions

The housing finance as percentage of GDP increased from 3.4 percent in 2001 to 7.25 percent by

2005. The higher economic growth, growing middle class, increasing purchasing power, changing

demographics and increasing number of nuclear families, falling real estate prices and a lower

interest rate regime enabled the housing finance sector to grow at a phenomenal rate of around 41

percent on average during the five-year period (NHB, 2005). Table-4.1 shows the performance of

various agencies in housing finance in recent years. From the Table, it may be seen during the five-

year period, growth in housing finance was driven by commercial banks.

There was a nine-fold increase in the commercial banks' lending to housing sector. In absolute

terms, commercial banks' lending to housing has increased from Rs.5553 crore in 2000-01 to

Rs.50398 crore in 2004-05. As a result, the market share of commercial banks increased from 29

percent in 1999-2000 to 66 percent in 2004- 05. Although the amount disbursed by the HFCs

increased from Rs.12638 crore in 2000-01 to Rs.26000 crore in 2004-05, their market share

declined from 66 percent to 34 percent during this period. Similarly, there is a significant decline

in the market share of Co-operative Housing Financing Agencies. In their case, even the amount

disbursed for housing witnessed steady decline. Thus, the housing finance sector has grown

remarkably well during the recent years, mainly spearheaded by the keen interest evinced by the

commercial banks in this sector. The growth potential further gathered momentum as a result of

the higher economic growth, real estate boom, lower interest rate and fiscal incentives given to

housing loans. In order to increase the market share, in the absence of preferable alternative

avenues for investment, the lending institutions were competing with each other by offering very

attractive terms to customers in the form of lower rate of interest, liberal collateral requirements,

longer repayments period and higher loan-value ratio. This also contributed the growth of housing

finance by commercial banks. Till recently, many have offered options of floating rate interest

besides fixed rate ones. Besides, speedier processing and disbursement, efficient advisory services

and reduction or waiver of upfront fees have also facilitated their widening market penetration.

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Table - 4.1 : Housing Finance Disbursements by various Institutions (Rs in Crore)

Institutions 2000-01 2001-02 2002-03 2003-04 2004-05

Commercial Banks 5553 8566 23553 32816 50398

HFCs 12638 14614 17832 20862 26000

Co-operatives 868 678 642 623 421

Total 19059 23858 42027 54301 76819

Annual Growth (%) 35.07 25.18 76.15 29.21 41.47

Source : Report on Trends & Progress of Housing in India, June 2005.

ROLE OF NATIONAL HOUSING BANK.

The National Housing Bank (NHB) is an apex level financial institution catering to the housing

sector in the country. It was established on July 9, 1988. It works as a facilitator in promoting

housing finance institutions or helping other institutions of such type. It is headquartered in Delhi

and has offices in all the major cities of India.

The main objectives of NHB are as follows:

1. To promote a sound, healthy, viable and cost-effective housing finance system to cater to

all segments of the population and to integrate the housing finance system with the

overall financial system.

2. To promote a network of dedicated housing finance institutions to adequately serve

various regions and different income groups.

3. To augment resources for the sector and channelize them for housing.

4. To make housing credit more affordable.

5. To regulate the activities of housing finance companies based on regulatory and

supervisory authority derived under the Act.

6. To encourage augmentation of supply of buildable land and also building materials for

housing and to upgrade the housing stock in the country.

7. To encourage public agencies to emerge as facilitators and suppliers of serviced land, for

housing.

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The three main functions of NHB in the housing finance business are as follows:

1. Promotion and Development Function.

The institution had been set up when regional and local level housing finance institutions were

nearly-absent and the banking sector was not willing to do housing finance on any significant level.

As a result the sector was grossly capital deficient and the housing shortage in the country was

growing at an alarming level. There was a need to set up local and regional level financial

institutions for supply of housing credit. NHB is of the opinion that intervention through

institutional credit can be made more effective by adoption of different approaches to cater to the

needs of different income groups. The households above the average income could be well served

by an institution which raises resources through the open market and deliver credit with minimum

necessary prudential regulations by the regulator. For households below the poverty line, the

institutional credit will have to consider the employment and poverty alleviation programmes

having an element of subsidy. It is the middle group which constitutes nearly half of the total

number of households in the country that needs to be taken care of. NHB is encouraging the

financial institutions to lend to this segment through its refinance programmes. There has been a

sustained effort at creating and supporting new set of specialized institutions to serve as dedicated

centers for housing credit.

2. Regulatory Function.

The second most important function of NHB is the regulatory role assigned to it. This role assumes

more importance as the housing finance system in India enters a secondary phase of development

in terms of integration with the debt and capital markets. The case for regulation also emanates

from the need for credible and stable housing finance system in the country. Without in any manner

against the free market approach, NHB has attempted to put in place an effective system of

responsive regulation. The housing finance system as such is still developing in the country and

thus there needs to be a great amount of stability in terms of resource development, policy

development and institution building. NHB has come up with guidelines for recognizing HFCs for

its financial assistance, guidelines for financial assistance. Besides it has also issued guidelines for

prudential norms for income recognition, asset classification etc.

3. Financial Function

The third important role of NHB is to provide financial assistance to the various banks and housing

finance institutions. As an apex refinance institution, the principal focus is to generate large scale

involvement of primary lending institutions falling in various categories to serve as dedicated

outlets for assistance to the housing sector. It supports housing finance sector by extending

refinance to different lenders in respect of eligible housing loans extended by them to individual

beneficiaries and for project loans extended by them to various implementing agencies. It also

supports by lending directly in respect of projects undertaken by public housing agencies for

housing construction and development of housing related infrastructure. It helps by guaranteeing

the repayment of principal and payment of interest on bonds issued by housing finance

companies. Real Estate and Stock market fluctuations also are monitored. Finally it acts as a

special purpose vehicle for securitizing the housing loan receivable. So the major things under the

74


financial role that NHB plays are refinance operations, project finance, guarantee and

securitization.

Future Strategies

It has been estimated that the housing requirements till 2012 in India was around 74 million units

out of which nearly 90% of the total housing units in both the rural and urban areas are for the

poor and low-income segment households. Though the growth of housing finance is about 30% in

the last few years it has not been able to satisfy the requirements of the poor sections of the society.

So the NHB not only needs to develop a new financial architecture but also policy and regulatory

framework for affordable housing on sustainable lines for the weaker sections of the society. The

recent initiatives taken in this direction include interest subsidy scheme for urban poor, top up loan

scheme, emphasis on public private partnership, housing for poor, JNNURM for bringing

appropriate policy and legal reforms for providing affordable housing to poor. So for all these to

materialize synchronization is needed in the working of Government, RBI and NHB. Also public

agencies, financial institutions and builders need to be incentivized so that NHB can achieve the

goals that it has embarked on.

The role of the NHB can be summarized as follows:

1. National housing bank promotes, establishes and supports housing finance institutions.

2. It grants loans and advances. Housing finance or home finance is the provision of finance

to such institutions which are involved in housing finance. NHB purchases stocks shares,

bonds, and other securities of companies involved in housing finance.

3. Guarantees for loan. NHB Guarantees for the loan taken by housing finance companies

from the open market.

4. NHB Underwrites for the issue of securities of housing finance institutions.

5. National Housing Bank draws, accepts, discounts and re-discounts bills of exchange for

housing finance.

6. NHB buys or sells or deals in mortgage of immovable properties belonging to housing

finance institutions.

7. NHB may write off or set aside loans belonging to housing financing companies.

8. National housing bank Promotes mutual funds for undertaking housing finance.

9. NHB undertakes house mortgage insurance.

10. NHB Promotes mortgage banks or societies for providing housing finance.

11. It Undertakes research and survey on construction activities.

12. It formulates various schemes for the extension of housing credit.

13. National housing bank plays an important role in formulating housing schemes for EWS

(economically weaker sections) – single tenement and radial houses.

14. National housing bank Co-ordinates with LIC, UTI, GIC and other financial institutions.

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CONCEPT OF MORTGAGE AND REVERSE MORTGAGE.

Mortgage loans are defined as loans that are obtained by real estate purchasers to raise funds for

buying property or those that are obtained by existing property owners for some other financial

expense by pledging their owned property as collateral for security. Mortgage is one of the most

popular forms of loans applicable to real estate and other property buying. Mortgage loan

borrowers can both be individuals or business houses. The former may involve a piece of property,

flat or land while the latter includes commercial spaces and business premises.

With a standard mortgage a home buyer pays some percentage of the home value as a down

payment, then pays off the home over time. Traditional mortgages can be structured as fixed rate

or adjustable rate, and some loans can be designed around paying on principal or paying interest

only.

Some investors chose to pay interest only to minimize the capital outlay, whereas it is much more

common for the traditional home buyer to pay on the loan principal until the loan is paid off. Once

the loan is paid off the home buyer owns the home.

In India, the concept of Reverse Mortgage was introduced in the year 2007.

A reverse mortgage (or lifetime mortgage) is a loan available to senior citizens. Reverse mortgage,

as its name suggests, is exactly opposite of a typical mortgage, such as a home loan.

In a typical mortgage, you borrow money in lump sum right at the beginning and then pay it back

over a period of time using Equated Monthly Instalments (EMIs). In reverse mortgage, you pledge

a property you already own (with no existing loan outstanding against it). The bank, in turn, gives

you a series of cash-flows for a fixed tenure. These can be thought of as reverse EMIs.

The specific format National Housing Board (the facilitator for housing finance in India) is

promoting, is one in which, the tenure is 15 years and the owner of the house and his/her spouse

continue to live in the house till their death -- which can occur later than the tenure of the reverse

mortgage. Simply put, any senior citizen, opting for reverse mortgage will get annuity (the reverse

EMI) from the bank for 15 years. After that, the annuity payments stop. However, they can

continue to live in the house.

The draft guidelines of reverse mortgage in India prepared by the Reserve Bank of India have the

following features:

1. Any house owner over 60 years of age is eligible for a reverse mortgage.

2. The maximum loan is up to 60 per cent of the value of the residential property.

3. The maximum period of property mortgage is 15 years with a bank or HFC (housing

finance company).

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4. The borrower can opt for a monthly, quarterly, annual or lump sum payments at any

point, as per his discretion.

5. The revaluation of the property has to be undertaken by the bank or HFC once every 5

years.

6. The amount received through reverse mortgage is considered as loan and not income;

hence the same will not attract any tax liability.

7. Reverse mortgage rates can be fixed or floating and hence will vary according to market

conditions depending on the interest rate regime chosen by the borrower.

With a reverse home mortgage, no payments are made during the life of the borrower(s). Since no

payments are made during the term of the reverse home mortgage loan, the loan balance rises over

time. In most areas where appreciation is good, the value of the home grows at a much faster rate

than the loan balance. Therefore, the remaining equity continues to grow. When the last borrower

passes, or it is decided to sell the home and move, the loan becomes due. The ownership of the

home is then passed to the estate or directed by a living will or will to the beneficiaries. The

beneficiaries now own the home and have to sell the home or pay off the loan. If the home is sold,

the reverse home mortgage lender is paid off and the beneficiaries keep the remaining equity of

the home.

If one of the spouses dies, the other can still continue living in the house. If both die, the bank will

give their heirs two options -- settle the overall outstanding loan and retain the house, or the bank

will sell the house, use the proceeds to settle the outstanding loan and give the rest to the heirs.

The banks have so far not indicated the interest rates. However, we can safely assume that it will

not exceed the interest rates used for loan against property -- which is currently in the region of 12

per cent to 14 per cent.

The Loan to value ratio is the percentage of loan that you will get for the value of the property that

you pledge. The typical rate loan to value ratio is 60 per cent. So, for e.g., if you pledge a property

worth Rs 60 lakh (Rs 6 million), then the loan amount that you can get is Rs 36 lakh (Rs 3.6

million). The annuity paid to the borrower directly depends upon the age. Higher the age, higher

the annuity.

Recent reports seem to indicate that a very small percentage of senior citizens only seem to have

taken advantage of the facility since its inception. This could be perhaps because better awareness

had not been created about the product. Secondly, the Indian banking industry caps the available

loan amount at Rs 50 lakh (Rs 5 million), instead of providing for an equitable percentage of the

property's value and limits the loan period to a tenure of 15 years. The product is still evolving and

may take on new dimensions depending on how the banks wish to present its consumer appeal.

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TYPES OF MORTGAGE LOANS.

Fixed Rate Mortgages.

A mortgage in which the interest rate remains the same throughout the entire life of the loan is a

fixed rate mortgage. These loans are the most popular ones, representing over 75% of all home

loans. They usually come in terms of 30, 15, or 10 years, with the 30-year option being the most

popular. While the 30-year option is the most popular, a 15-year builds equity much faster.

The biggest advantage of having a fixed rate is that the homeowner knows exactly when the interest

and principal payments will be for the length of the loan. This allows the homeowner to budget

easier because they know that the interest rate will never change for the duration of the loan.

Not only are fixed rate mortgages the most popular of home loans, but they are also the most

predictable. The rate that is agreed upon in the beginning is the rate that will be charged for the

entire life of the note. The homeowner can budget because the monthly payments remain the same

throughout the entire length of the loan. When rates are high, and the homeowner acquires a fixed

rate mortgage, the homeowner is later able to refinance when the rates go down. If the interest

rates go down and the homeowner wants to refinance, the closing costs must be paid in order to

do so. Some banks wishing to keep a good customer account may wave closing costs. If a buyer

buys when rates are low they keep that rate locked in even if the broader interest rate environment

rises. However, homebuyers pay a premium for locking in certainty, as the interest rates of fixed

rate loans are usually higher than on adjustable rate home loans.

One Year ARMs.

A mortgage loan in which the interest rate changes based on a specific schedule after a “fixed

period” at the beginning of the loan, is called an adjustable rate mortgage or ARM. This type of

loan is considered to be riskier because the payment can change significantly. In exchange for the

risk associated with an ARM, the homeowner is rewarded with an interest rate lower than that of

a 30-year fixed rate. When the homeowner acquires a one-year adjustable rate mortgage, what they

have is a 30-year loan in which the rates change every year on the anniversary of the loan.

However, obtaining a one-year adjustable rate mortgage can allow the customer to qualify for a

loan amount that is higher and therefore acquire a more valuable home. Many homeowners with

extremely large mortgages can get the one-year adjustable rate mortgages and refinance them each

year. The low rate lets them buy a more expensive home, and they pay a lower mortgage

payment so long as interest rates do not rise.

The loan is considered to be rather risky because the payment can change from year to year in

significant amounts. Unless the buyer plans to quickly flip the property or has plenty of other assets

and is using an interest-only loan as a tax write off, almost anyone taking adjustable rates

should try to pay extra in order to build up equity in case the market turns south.

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10/1 ARMs.

The 10/1 ARM has an initial interest rate that is fixed for the first ten years of the loan. After the

10 years is up, the rate then adjusts each year for the remainder of the loan. The loan has a life of

30 years, so the homeowner will experience the initial stability of a 30-year mortgage at a cost that

is lower than a fixed rate mortgage of the same term. However, the ARM may not be the best

choice for those planning on owning the same home for over 10 years unless they regularly make

extra payments & plan on paying off their loan early.

2-Step Mortgages.

An adjustable rate mortgage that has the same interest rate for part of the mortgage and a different

rate for the rest of the mortgage is called a 2-step mortgage. The interest rate changes or adjusts in

accordance to the rates of the current market. The borrower, on the other hand, might have the

option of making the choice between a variable interest rate or a fixed interest rate at the adjustment

date.

Those borrowers who make the decision to take a two-step mortgage are taking the risk of the

interest rate of the mortgage adjusting upward after the expiration of the fixed-interest rate period.

Many borrowers who take the two-step mortgage have plans of refinancing or moving out of the

home before the period ends.

5/5 And 5/1 ARMs.

The 5/5 and the 5/1 adjustable rate mortgages are amongst the other types of ARMs in which the

monthly payment and the interest rate does not change for 5 years. The beginning of the 6th year

is when every 5 years the interest rate is adjusted. That’s every year for the 5/1 ARM and every 5

years for the 5/5. These particular ARMs are best if the homeowner plans on living in the home

for a period greater than 5 years and can accept the changes later on.

5/25 Mortgages.

The 5/25 mortgage is also called a “30 due in 5” mortgage and is where the monthly payment and

interest rate do not change for 5 years. At the beginning of the 6th year, the interest rate is adjusted

in accordance to the current interest rate. This means the payment will not change for the remainder

of the loan. This is a good loan if the homeowner can tolerate a single change of payment during

the loan period.

3/3 And 3/1 ARMs.

Mortgages where the monthly payment and interest rate remains the same for 3 years are called

3/3 and 3/1 ARMs. At the beginning of the 4th year, the interest rate is changed every three years.

That is 3 years for the 3/3 ARM and each year for the 3/1 ARM. This is the type of mortgage that

is good for those considering an adjustable rate at the three-year mark.

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Balloon Mortgages.

Balloon mortgages last for a much shorter term and work a lot like a fixed-rate mortgage. The

monthly payments are lower because of a large balloon payment at the end of the loan. The reason

why the payments are lower is because it is primarily interest that is being paid monthly. Balloon

mortgages are great for responsible borrowers with the intentions of selling the home before the

due date of the balloon payment. However, homeowners can run into big trouble if they cannot

afford the balloon payment, especially if they are required to refinance the balloon payment

through the lender of the original loan.

MORTGAGE LOANS IN INDIA.

Based on the rate of interest applicable on mortgage loans, they can be divided into two distinct

sub-heads

Fixed rate Mortgage Loans.

Fixed rate mortgage loans are offered to customers at a fixed rate of interest. These type of

mortgage loans give a good idea of loan liability to customers even before they have availed a

loan. This is because the fixed interest rate could be used to calculate the fixed monthly instalment

amount and the customer can then know his/her loan liability for sure.

Variable rate Mortgage Loans or Floating rate Mortgage Loans.

Variable rate mortgage loans are loans that are offered on variable rate of interest. This interest

rate fluctuates with movements in the base rate quoted by the bank which is directly dependent on

the repo rate quoted by the Reserve Bank of India. A lot of feedback on variable interest

rate Mortgage Loans comes from the performance of the economy and stock market. Measures

taken by RBI too are reflective of the status of the economy. So economies where customers are

sure about growth and progress are the ones where floating rate mortgage loans flourish better as

compared to stagnant or low growth economies. The risk of higher rates and the benefit of lower

rates both have the same probability in case of floating rate mortgage loans.

Adjustable-rate Mortgage Loan.

Adjustable rate mortgage loans are those for which the rate of interest is fixed for an initial period

of loan and then it correspondingly changes to a higher or a lower rate of interest depending upon

the performance of the economy. Some of the features of AR mortgage loans are:

1. Banks offer discounted rate of interest for an initial period but charge a higher processing

fee for the same.

2. Lower initial loan instalment translates to higher loan eligibility for customers.

3. Fixed interest rate for initial period offers higher loan liability certainty to customers for

the initial period of mortgage loan.

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Mortgage loans based on the nature of contract between the lender and the borrower with respect

to the terms and clauses of the mortgage loan are classified as follows:

Simple Mortgage Loan.

In a simple mortgage loan, the property does not get transferred from the borrower to the lender,

but the lender has the right to sell borrower’s property and retrieve the proceeds for loan

reimbursement, in case the borrower fails to pay back the mortgage loan.

Subprime or Sub Mortgage Loan.

Subprime mortgage loans are those that are offered to borrowers with a poor credit history. This

means that the interest charged on these loans is greater. This is to compensate the lender in case

the loan applicant defaults in repaying the mortgage loan.

English Mortgage.

In case of an English mortgage the borrower agrees to transfer his/her property absolutely to the

lender in case he/she is unable to repay the loan till a particular date. However, once the amount

is paid in full, the property is again transferred back to the borrower.

There are other types of mortgage loans also based on the time period of loan which is generally

long tenures like 15, 20 and 30 years for mortgage loans in India. Also, loans are segregated based

on the payment frequency of loan installment and the amount of loan installment too. Loans can

also be segregated as those which allow pre-closure for free and those that charge as fee for pre-

closure of mortgage loans.

Questions.

1. Explain the need and nature of Housing Finance.

2. Distinguish between Fixed and Floating Rate Home Loans.

3. Sources of Housing Finance in India.

4. Write a note on Growth of Housing Finance in India.

5. Explain the role of National Housing Bank in the field of housing finance in India.

6. Explain the concepts of Mortgage and Reverse Mortgage.

7. Explain the concept of mortgage loan and its types.

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MODULE FOUR

CHAPTER SEVEN

PREVIEW.

1. Meaning, Types of Stock Brokers and Sub-brokers.

2. Stock Broking in India.

3. E-broking – Meaning and Indian Experience.

STOCK BROKING.

Stockbroking is a service which gives retail and institutional investors the opportunity to buy and

sell equities.

A stockbroker is a regulated professional individual, usually associated with a brokerage firm

or broker-dealer, who buys and sells stocks and other securities for both retail and institutional

clients through a stock exchange or over the counter in return for a fee or commission.

The role of a stockbroker is to manage the financial portfolio of clients. On the advice

of investment analysts, the stock broker discusses with the clients on buying or selling of shares

with a view to get best return on investment.

A stock broker is an individual who makes stock trades on behalf of his or her clients. Typically,

full-service brokers are more commonly known as financial advisers who sell various financial

products such as insurance and stocks are one of the products that they sell. Most stock

brokers charge fee.

A stockbroker is a licensed and regulated financial firm that facilitates buying and selling

transactions in various financial instruments: stocks, derivatives, bonds, and IPOs for both retail

and institutional investors. All financial market transactions have to be executed through a broker

and they charge commission or brokerage charge for their services.

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TYPES OF STOCK BROKERS AND SUB-BROKERS.

There are two main types of stockbrokers, namely: the traditional brokers and the discount brokers.

The Discount Brokers charge relatively less, while full-service broker or traditional

broker relatively more but provides customized service.

Traditional Brokers.

Traditional stock brokers or full-service stock brokers offer a wide variety of services and

products, including financial and retirement planning, investing and tax advice, regular portfolio

updates and also offer margins to purchase investment products on credit which will be subjected

to necessary terms and conditions. Since traditional brokers offer personalized investment or

trading recommendations and services, brokerages charges can be high.

Some of the leading Traditional Brokerage firms that let customers invest and trade in stocks,

futures, options, currencies, bonds in the Indian Stock Market are as follows:

Items ICICI

Securities

HDFC

Securities

Share

Khan

Axis

Securities

Angel Broking

A/C Opening

Charges

Rs.975 Rs.999 Rs.750 Rs.900 Rs.600

Demat AMC

Charges

Rs.450 Rs.750 Rs.400 Rs.500 Rs.300

Equity

Delivery

0.25% -

0.5%

0.3% - 0.5% 0.2% -

0.4%

0.25% - 0.5% 0.1% - 0.3%

Equity Intra-

day

0.025% -

0.05%

0.03% -

0.05%

0.02%

-

0.04%

0.025% - 0.05% 0.01% - 0.03%

Equity &

Currency

Futures

0.03% -

0.05%

0.03% -

0.05%

0.02%

-

0.04%

0.025% - 0.05% 0.01% - 0.03%

Equity &

Currency

Options

Rs.65-Rs.90

per lot

Rs.50 - Rs

100 lot

Rs.20 -

Rs.50

per lot

Rs.50 - Rs.100

per lot

Rs.20 - Rs.50 per lot

Commodities NA NA 0.02%

-

0.04%

NA 0.01% - 0.03%

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Discount Brokers.

Discount stock brokers or online stock brokers allow clients to trade on their own with little or no

interaction with a live broker. Discount brokers could be a better choice for investor who prefers

to do it by themselves. Discount brokers will not offer investment advice but he or she will offer

free research and educational tools to help you make better-investing decisions. Since discount

brokers offer fewer services and/or support, brokerages come with lower fees than a traditional

brokerage firm.

Some of the leading Discount Brokerage firms and their brokerage charges, account opening

charges and annual maintenance charges are as follows:

Items Zerodha Upstock Samco 5 Paisa Flyers

A/C Opening

Charges

Rs.300 Rs.150 Nil Rs.650 Nil

Demat AMC

Charges

Rs.300 Rs.150 Rs.400 Rs.400 Rs.400

Equity

Delivery

Nil

Nil

0.2% or

Rs.20 per

Executed

Order

Rs.10 per

Executed

Order

0.1% or

Rs.20 per

Executed

Order

Equity

Intraday

0.01% or

Rs.20 per

Executed

Order

0.01% or

Rs.20 per

Executed

Order

0.02% or

Rs.20 per

Executed

Order

Rs.10 per

Executed

Order

0.01% or

Rs.20 per

Executed

Order

Equity &

Currency

Futures

0.01% or

Rs.20 per

Executed

Order

0.01% or

Rs.20 per

Executed

Order

0.02% or

Rs.20 per

Executed

Order

Rs.10 per

Executed

Order

0.01% or

Rs.20 per

Executed

Order

Equity &

Currency

Options

Rs.20 per

Executed

Order

Rs.20 per

Executed

Order

Rs.20 per

Executed

Order

Rs.10 per

Executed

Order

Rs.20 per

Executed

Order

Commodities

0.01% or

Rs.20 per

Executed

Order

0.01% or

Rs.20 per

Executed

Order

0.02% or

Rs.20 per

Executed

Order

Rs.10 per

Executed

Order

0.01% or

Rs.20 per

Executed

Order

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STOCK BROKING IN INDIA.

The stock exchanges facilitate trading members to trade in stock exchange. They play animportant

role in the secondary market by intermediating between the buyers and the sellers. The brokers

give buy/sell order either on their own account or on behalf of clients.

The Indian stock broking industry has a history that dates back to the eighteenth century. Till the

end of 19th century, trading was unorganized. The stock brokers started their trading in Bombay

and Calcutta. In Bombay, initially stock brokers traded bank shares and later on in the 1930s,

started trading in stock and shares of cotton presses. In 1860-61, there were only a few stock

brokers and they traded under a banyan tree in front of the town hall in Bombay. Due to the rapid

development of commercial enterprises in the 1850s, the number of stock brokers also increased.

In 1860, the number went up to 60 and thereafter, the number rose to 250. Due to the rapid

development of shares trading business, by 1874, brokers began to gather in Dalal Street, Bombay

for transacting their business. Subsequently the stock brokers organized an informal association in

1875 called “The Native Share and Stock Brokers’ Association, Bombay”. This association was

formed with 3128 members who paid an entrance fee of Rupee One. The genesis of the present-

day Bombay Stock Exchange can be traced to their humble beginnings. For the first time, a premise

was hired in 1875 and the practice of trading in public came to an end.

In the 1880s,many cotton mill factories were set up in several parts India especially in Maharashtra

and Gujarat. This led to the establishment of regional stock exchanges in India. In 1920,the Madras

Stock Exchange was established with 100 brokers. The government has been encouraging

corporatization of the broking industry in India. Responding to the encouragement, a number of

broker-proprietor firms and partnership firms have converted themselves into corporate entities.

As of end December 2013, 4811 brokers accounting for nearby 53.3% of the total brokers have

become corporate entities. More than 88 % of the brokers who registered under NSE were

corporatized followed by BSE with 83 corporate brokers. As at end December 2014, there were

44,540 sub-brokers registered with SEBI out of which 19,392 sub-brokers registered under BSE

and 24,522 under NSE and together constituted 98.59% of the total sub-brokers. Following figure

shows the number of stock broker registered with SEBI.

SNO BROKER 2004-05 2014-15

1. Broker(CS) 9128 7306

2. Corporate Broker (CS) 3764 4196

3. Sub-broker (CS) 13684 44540

4. Broker(ED) 3051 3008

5. Broker (CD) 2395 2406

Stock Brokers in BSE have undergone change since the inception of BSE in 1850. The practice of

conducting business orally to the current online trading is due to the massive growth of technology

and brokers’ initiatives. In the old trading system, brokers did the trading by getting telephonic

orders from the investors. In 1995, telephonic trading gave away to online trading.

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In 1875, about a dozen stock brokers formed an informal association called ‘The Native Share and

Stock Brokers of Bombay’. At present there are 9150 registered brokers in all the 26 stock

exchanges in India with BSE constituting 1349 brokers. The BSE has the highest number of

registered brokers. In 2004, the number of stock brokers registered with BSE was 726 and in 2013,

the registered brokers’ number grew to 1349 which shows that the number of brokers registered

with BSE almost doubled in the ten-year period. It indicates a good growth in stock broking

business and the performance of BSE.

FUNCTIONS OF STOCK BROKERS.

A stock broker or share broker is a regulated professional broker who buys or sells shares and

other securities through market makers or agencies on behalf of the investors. A broker may be

employed by a brokerage firm. The functions of stock brokers are as follows:

1. Acts as an agent. A stock broker acts as an agent of an investor and represents his clients

to buy or sell shares and other financial instruments. The primary role of a stock broker is

to execute transaction on behalf of investors. The broker will buy and/or sell securities in

the stock market. As a representative of his clients, a stock broker brings the best offer to

buy and sell stock.

2. Seeks best deal. A stock broker represents a client and his job is to find the best deal to

buy or sell stocks for investors. Most brokers deal in all types of securities and many also

handle commodity futures. The sub-broker may also advice a client on when to buy or sell

a stock or what to watch for in market dealing, but he is not a licensed investment adviser.

3. Handling the trade. A broker takes an order from a client to buy or sell a stock, passes it

through his brokerage firms-network to a floor trader. Through the software provided by

stock broking firm, investor/trader can directly place the order.

4. Receiving commission. Individual brokers are paid commission usually as a percentage of

the value of the trade. Commissions and fees vary.

5. Advice. Most of the individual brokers charge a certain percentage of the transaction of

buying and selling of stocks. There are two types of brokers, one is discount and another

one is full service broker. Discount broker mostly is individual broker who won’t give

advice and simply does the transaction. On the other hand, full service broker actually helps

the investors to choose the stock for investment by giving advice, and charges some

additional amount along with their regular commission.

6. Variety of Services offered. The following services are offered by the stock brokers:

a) Discount / online broker. The traditional discount/online broker is an order taker.

He will take investor’s order either over the phone or online. On the other hand, if

investor is dealing with them online, he will be there to communicate with the

investor.

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b) Discount/online with Assistant broker. This variation offers some help to

customers who do not opt for full services consulting.

c) Full service broker. The traditional full-service broker provides recommendation

of specific stocks for investors’ consideration. The broker begins with a financial

assessment of investors’ personal situation to determine the investors’ need and

suitability for various investments.

d) Money Manager. Money Manager takes over the responsibility for investing and

managing the entire portfolio in exchange for a percentage of the assets they

manage.

7. Products. Brokers offer many different types of products besides stock. Often, packaged

products such as mutual funds and annuities are important part of the recommendation.

8. Insurance protection. Majority of the brokerage firms are members of the Securities

Investor Protection Corporation (SIPC) which provides insurance to investors for losses

suffered in the event of financial difficulties and liquidation of brokerage firms.

9. Offers special accounts. Additional services and facilities may be available in special

accounts that give the stock broker discretion to make trades for investors without each

trade being approved by the investors, known as discretionary accounts. Credit for the

purchase of additional securities may also be provided by using margin accounts.

PERFORMANCE OF STOCK BROKERS IN THE CAPITAL MARKET.

In the last few years, the Indian Equity Markets witnessed extreme volatility which kept the retail

investors at bay and thus has witnessed lower participation from the small investors. However,

initiatives are being taken by the regulators, SEBI, Stock Exchanges and intermediaries to improve

accountability and transparency in order to safeguard the interests of the small investors, which is

likely to increase confidence and help the intermediaries to conquer the lost battle. The brokerage

industry is cyclical in nature and its fortunes are directly dependent on the performance of the

broader markets. However, the broking firm also acts as a financial service provider thereby

providing a broad range of services like wealth management, portfolio management, fund

manager, mutual fund distribution, NBFCs, and Advisory services. In addition to an overall

positive sentiment, the endeavor of the market regulator to boost retail participation in the capital

market has also given a fillip to the overall trading activities through broker terminals. The turnover

in cash segment of BSE is given in the following table:

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MUTUAL FUNDS.

The mutual funds are back in the limelight and the investor accounts or folios in the first ten months

of fiscal year 2014-15 has seen a surge of over 16 lakh accounts and the remaining 2 months saw

an increase of another 3 lakh accounts approximately, which is a very basic assumption as per the

accounts of the first 10 months of FY 2014-15. The AUM or the assets under management of

Mutual Funds hit a record high of INR 11.8 Lakh crores in Jan 2015 on the back of continuous

inflows across various categories especially in equity. Following figure shows equity folios from

financial year 2009 to 2015 and for financial year 2015, data was taken till December 2014. The

mutual fund is a comparatively safe option for new or small investors as the funds are managed

by fund manager or a stock broker who act as intermediary between the investor and stock market

The AUM of Mutual Funds from Feb to June 2015 is a modest INR 3 lakh crores approximately

which is a very healthy and a positive development. Till January 2015, there was a surge of AUM

of equity MFs to INR 3.4 lakh crores and has been a consecutive nine months of positive flows on

the back of robust sentiments and improving earnings outlook for India INC, which has been the

key driver for the Indian equity markets. The period from January 2015 to June 2015 has been

very positive for the stock market and the AUM equity MFs has risen close to Rs 1 lakh crore

approximately which is a very modest calculated average, which is based on the AUM of Mutual

Funds which was calculated till June 2015 at 3.4 lakh crores INR.

REGULALTORY EFFORTS.

SEBI along with other participants is constantly striving to improve investors’ confidence and

awareness in order to bring a change in the individual outlook towards equity market as a long

term and prudent investment destination rather than a place for speculative bets. Investors’

education and awareness, being one of the prominent and important steps to inculcate better

investment habits among retail investors is being introduced by way of higher number of investor

conferences across the country. The BSE Brokers’ Forum and other institutions have actively

participated in raising investor awareness by organizing seminars in colleges across the country.

TURNOVER IN

CASH SEGMENTOF THE BSE

YEAR TURNOVER

(INR CRORES)

2003-04 503053

2004-05 518717

2005-06 816074

2006-07 956185

2007-08 1578857

2008-09 1378809

2009-10 1100074

2010-11 1105027

2011-12 667498

2012-13 548774

2013-14 623162

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These seminars are funded by the Investor Education Fund constituted by SEBI. Further, to

accelerate fund raising activity, SEBI is going to introduce e-IPO. This will certainly enhance

overall efficiency in primary market and increase investors’ participation.

MOBILIZATION OF FUNDS.

With the help of stock broking industry, many companies raised financial resources to their

company equity and debt instruments like public issue, right issue, IPOs, CCPs, bonds, etc.

Following figure shows that total funds raised by corporate sector from March 2010 to December

2014.

RISE IN THE NUMBER OF DEMAT ACCOUNTS.

Rising number of investors have started opening de-mat accounts after the recent rally at the

indices. As on January 2015 there were a total of 12.9 lakh de-mat accounts opened during

financial year 2014-2015. Moreover, the residents of tier II and the tier III cities are also turning

to the stock markets and we have seen an increase in De-mat account holders in such cities and

also the rural areas which is seen as a very encouraging trend.

During the year under review, 12.57 lakh Beneficial Owner (BO) accounts were added, taking the

total number of such accounts to 130.87 lakhs with the net BO accounts at 96.10 lakhs as on 31

March 2015. The comparative figures of gross and net BO accounts as on 31 March 2014 and 31

March 2015 are 13,087,397 (Gross), net is 9,610,002 and Gross 11,829,968, net is 8,777,049

respectively. Following chart shows beneficial owner accounts opened through CDSL.

TECHNOLOGY IN CAPITAL MARKETS.

One of the major driving factors for the increase in the activities and business in the stock market

has been the internet penetration and also the use of smart phones everywhere. Internet

connectivity and also the internet penetration has helped the investor open De-mat accounts and

also trade in the share market with the help of online share brokers. This has liberated the investors

from being physically present and can trade from anywhere which has been a boon as the investor

can trade as per his convenience during the market hours. The smart devices (smart-phones) with

a data connection is another boon for the share brokers and also the share investors as he/she can

do the trading from anywhere with a login and is even easier than online trading using an internet

connection in a PC or a Lap-top.

MOBILIZATION OF FUNDS (DEBT & EQUITY)

YEAR FUNDS RAISED

(INR CRORES)

MAR 2010 39,820

MAR 2011 30,927

MAR 2012 25,172

MAR 2013 44,646

MAR 2014 46,430

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The smart phone penetration is increasing day by day and is expected to overtake the basic phone

completely and it is estimated that even if a small percentage of smartphone users use their phone

for trading, it is going to be a very significant number which will increase the stock market trading

tremendously. The launch of Mobile trading has also become focus area for brokerages. If data are

to be believed the average daily turnover through mobiles has increased 2.5 times to Rs.221 crore

as of November 2014, from Rs.88 crore in January 2014.

E-BROKING – MEANING AND INDIAN EXPERIENCE.

E-brokerage allows users to buy and sell stocks electronically and obtain information with the help

of a website. Almost all e-brokerage houses have simple sign-up and provide users the ability to

make them their own financial manager. With the advent of widespread Internet connectivity and

smart devices, e-brokerage has seen significant growth.

Two big factors have helped in the growth of e-brokerage, namely Internet access and lower prices.

The Internet has allowed users to have ready access to raw data. E-brokerage is capable of offering

lower prices than traditional brokerage techniques, as the need for brokers or financial advisers are

eliminated in the case of e-brokerage. To attract more customers and retain existing users, most e-

brokerage firms provide a number of tools, technical indicators which give real-time information

and help in research and decision making.

E-brokerage has many benefits for its users. Users can have more flexibility as well as control over

their portfolios and transactions. One can access their brokerage account at any time, even if

trading hours are over. The biggest advantage of e-brokerage is that the commission cost is

significantly lower than in case of services of a professional broker. Again, trades are processed

quickly in e-brokerage and there are no delays, unlike traditional brokerage methods.

However, there are a few disadvantages associated with e-brokerage. Unlike traditional brokerage,

the mentoring relationship between the account holder and professional broker is not there. All

financial choices must be made by the user. In essence, the level of service is less than with

traditional brokerages.

Questions.

1. Explain the meaning of stock broking and the types of Stock Brokers and Sub-brokers.

2. Write a note on Stock Broking in India.

3. Write a note on E-broking and Indian Experience.

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MODULE FOUR

CHAPTER EIGHT

PREVIEW.

1. Meaning, Role of Depositories and their Services.

2. Advantages of Depository System.

3. Functioning of Depository System.

4. NSDL and CSDL.

5. Depository Participants and their Role.

MEANING, ROLE OF DEPOSITORIES AND THEIR SERVICES.

The ‘depository’ system is a system in which securities are held in the electronic form. There was

a time when Companies used to issue share certificates in physical form. The investors were

supposed to keep the certificate safe and forward it to the buyer once the share is sold. Now, with

the introduction of Depositories Act 1996, there is no paperwork involved in this procedure, all

the entries are done electronically. The introduction of depositories system also gave rise to a new

type of stock trade called as ‘dematerialization’.

Dematerialization or ‘Demat’ is also called as ‘scripless trade’ or ‘scripless transfer’. It is the

conversion of physical certificates into electronic records. Under dematerialization, physical

transfer of shares is avoided and transaction only takes place through an electronic medium. This

is the most significant step taken for achieving a paperless securities market. Share transfer in

dematerialized form takes place freely through the electronic book-entry system.

Depositories registered with SEBI.

In India, various entities can provide a depository system. A depository must be formed under the

Companies Act and must obtain a certificate from the Securities and Exchange Board of India.

Two depositories which are already registered under SEBI are:

1. National Securities Depositories Limited (NSDL). NSDL was set up in 1996 by the NSE

(National Stock Exchange). IDBI and UTI helped to promote NSDL.

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2. Central Depository Service Limited (CDSL). The BSE (Bombay Stock Exchange)

promoted CDSL.

NSE introduced the rolling system in India for the first time. This helped the investors get payment

within 5 days of the sale. Previously, the investors used to get their payment on the eighth to the

twelfth day from the date of trading.

With the establishment of CDSL, the annual turnover in BSE also increased and the Badla system

also got abolished which increased the scope of depositories in India. Badla was the charge, which

the investor paid for carrying forward his position. It was a hedge tool where an investor could

take a position in a share without actually taking delivery of the stock. He could carry-forward his

position on the payment of a small margin. Badla trading was banned by SEBI in 1993 and the ban

was made effective from March 1994. It was again permitted in 1996 with some restrictions and

finally banned from July 2001 after introduction of Futures Contracts on NSE in the year

2000. Badla was effectively the premium paid to carry over the trade to the next fortnightly

settlement.

Important Concepts.

1. Depository Participant or a DP. The DP is an agent of the depositories which provides

depository services to the investors. Any foreign bank, public financial institution, a

commercial institution with the approval of the Reserve Bank of India (RBI), state financial

corporations, stock brokers, clearing houses, NBFCs that are complying with the rules

prescribed with SEBI can be registered as DP.

2. Securities eligible for Demat. Shares, stock, debentures, bonds, debenture stock, any

other marketable security, any incorporated company, units of the mutual fund, unlisted

security, commercial paper are some of the examples.

3. BO or Beneficial Owner. The benefits from the dematerialized securities are derived by

the actual investor of the shares, who are the beneficial owners (BO) as the depositories

hold the security on behalf of the investor and in a fiduciary capacity.

ADVANTAGES OF THE DEPOSITORY SYSTEM.

The first and the most important advantage of the depository is it eliminates the risk of holding

physical securities. Previously, the buyers had to keep checking if the shares had been transferred

or not. But since the depository system came about such risks had been reduced to a great extent

as everything is now done through electronic mode. Huge paperwork which was related with the

same also got reduced and from 1998 demat trading was also made compulsory. This also makes

the foreign investor confident to invest in the Indian market as it reduces the chances of any kind

of forgery and delay.

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Other advantages of depository system are as follows:

1. The transfers take place immediately unlike physical transfer. The beneficial owner also

transfers as soon as the shares are transferred from one account to the other.

2. It only holds the security listed in particular stock exchange.

3. The issue of fake certificates, the problem-related to bad delivery or any kind of issue

related to signature are also reduced.

4. Now there is no need to fill a transfer form and affix share transfer form in order to transfer

share.

5. The electronic system is time-saving.

6. The fear of losing the certificate or issue of fraud certificates are also eliminated.

7. Transfer of benami properties is also restricted.

Steps to dematerialize share certificate.

In order to dematerialize the share certificate the investor must:

1. Open a Demat account with a DP.

2. Then the Demat Request Form (DRF) is to be filled and along with it, the share certificate

must be submitted to the DP.

3. After this, the DP will send th ese certificates to the registrar who will issue the equivalent

number of securities.

4. DP after receiving the share certificate in physical form and the duly filed DRF must give

the counter acknowledgement to the BO.

5. The DP will capture all the detail from the DRF and certificate and then generate a DRN.

6. If the securities are in ‘lock-in’ status, then it must specify the ‘Lock –in-Reason’ and

‘Lock-in-Release date’.

7. The DP while affixing rubber stamp on the DRF must take care of the material information

such as – distinctive number or the folio numbers does not get smudged.

8. Next, the DP will give a “system generated acknowledgement” to the BO.

9. After the DRN is generated the CDSL must send the DRF data to the issuer. This process

is automatically done by the system.

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10. The DP must capture all the dispatch detail and must dispatch the physical document within

two days from the date of DRN generation.

11. The process of dematerialization must be completed within 15 days as specified by the

CDSL.

ROLE OF SEBI.

SEBI regulates the depositories. SEBI (Depositories and participant) Regulations 1996 Act is there

to regulate the investor accounts in demat form. In India, the entire depository system is governed

by the Securities Exchange Board of India (SEBI). The main aim of SEBI is investor protection.

The Depositories Act 1996 ensures free transferability of securities with proper accuracy, speed,

and security. It makes the securities of public limited company freely transferable. It dematerializes

the securities in depository mode. It maintains the ownership records in a book-entry form.

Before this act came up there was a settlement risk in the transaction. This was basically because

of the time taken for settlement. The SEBI Act 1992 provides SEBI with statutory power to protect

investor’s interest, promotes the development of the securities market or regulate the securities

market. It has full autonomy to conduct inspection and inquiry over any offence or violation of

any provision under the Act.

Krishanamurthy, R. (1996) in his paper “Depositories for Securities Transaction: An Overview

of the Depositories Act and Responsibilities of the Auditing Profession”, has stated that the

Act being a strict rule-based approach seeks to ensure that investors opting for the Depository

Model will at all times be protected from any abuse of the system.

Investment plays a very important role in shaping a developing economy like India. Developing

countries find it really difficult to get sufficient capital for development. India needs a high level

of saving and investment to leap forward and achieve the required growth of eight to nine per cent

per annum. There is a lot of risk related to investment. Hence, market efficiency and investor

protection are required to attract investors. A well-functioning securities market can lead to stable

economic growth. There was always a need for fully developed securities depository system to

enhance market efficiency. The settlement system also developed with the Depositories Act 1996.

Apart from holding securities, it provides services related to transactions in securities. This system

eliminates paperwork and promotes transparent trading. It also contributes to the liquidity of an

investment in securities. The stock exchanges too play an important role in the capital market and

these are the platforms to trade in securities. Indian economy is rapidly growing and modernizing.

The capital market must provide excellent investment opportunities to the investor and must take

care of their interest and security.

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FUNCTIONING OF THE DEPOSITORY SYSTEM.

The depository system functions as under:

1. The system envisages setting up of one or more depositories to hold securities of investors

in the electronic form.

2. The depository functions through its agents, who are called Depository Participants (DP).

3. The investor, who wants to avail the services of the Depository, has to open a beneficiary

account with the Depository through a DP. The account known as the “Demit” account can

be opened with more than one DP also.

4. After opening the demat account, the investor is required to dematerialize the securities

held by him in the physical form. To dematerialize the securities, the investor has to fill the

Dematerialization Request Form (DRF) and submit the same to the DP along with the

security certificate. The DP through the Depository will intimate the company/issuer and

surrender the security certificate. The process known as ‘dematerialization’ takes about 30

days.

5. The issuer/company on receipt of the intimation shall cancel the security certificate and

substitute the name of the Depository as the registered owner of the security.

6. The Depository on being intimated by the company/issuer enters the name of the investor

in its record as the beneficial owner of the security.

7. Whenever any rights, bonus or dividend is announced by a company for its particular

security, the Depository would furnish all the details of the investors having electronic

holdings of that security on the record date. The disbursement of the rights, dividends etc

are, thus done by the company based on the information provided.

8. In case of sale of the security under this mode, the investor/transferor (the client) has to

intimate the DP through issuing a Delivery Instruction Slip (DIS) duly signed and

containing the details of the security transaction. In case of purchase, the client will send

the intimation to the DP giving details of the security purchased. The Depository on

receiving the information through the DP will register the transfer of securities in the name

of the transferee in its record.

9. DP will also make book entries in the account of the investor to record sale/purchase of

securities.

10. DP is required to send statement of accounts to the clients at regular intervals and update

the account after each transaction.

11. The client/ investor has to pay charges to the Depository and the DP for availing the

services.

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The basic functions of a depository are to dematerialize securities and enable their transaction in

book entry form. In addition, the depository system performs the following functions:

1. To work as Custodian of electronic securities.

2. To enable the transactions in securities in book entry form by debiting transferor DP

Account and crediting the transferee DP A/c.

3. To record the allotment in case of IPOs, originally allotted in electronic form by the issuers

to the beneficial owners.

4. All the services provided by DPs for investors are facilitated through depository only.

5. To handle corporate actions in the following two ways:

a) It merely provides information to the issuer about the persons entitled to receive

corporate benefits (both monetary and non-monetary).

b) It itself takes the responsibility of distribution of non-cash benefits.

6. To provide information about the voting rights to the Issuers and the beneficial owners of

the securities.

7. To maintain a linkage with Clearing Corporation or Clearing House of a stock exchange to

give effect to Clearance and Settlement System for trades done in securities by the

investors.

Basically Depository is main constituent which interlinks all concerned constituents for all types

of depository services. It acts as a tunnel from where each and every act of demat service passes

and it does not permit direct linkage between its different constituents

DEPOSITORY PARTICIPANTS AND THEIR ROLE.

A Depository Participant (DP) is an agent of the depository. They are the intermediaries between

the depository and the investors. The relationship between the DPs and the depository is governed

by an agreement made between the two under the Depositories Act. In a strictly legal sense, a DP

is an entity who is registered as such with SEBI under the provisions of the SEBI Act. As per the

provisions of this Act, a DP can offer depository related services only after obtaining a certificate

of registration from SEBI.

The primary function of DPs is to provide securities related services offered by depository to its

business partners including investors. All the operational procedures under Depository System are

performed with the help of DPs. DPs are Depositories’ interfaces for investors. As per Section 4

of the Depository Act, 1996, ‘A DP is an agent of the depository who provides various services of

the depository to investors. Any investor who likes to avail the services of a depository has to enter

into an agreement with any DP of his choice. The DP will then make the depository services

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available to that investor in strict legal sense, Depository Participant is an entity which is registered

as a DP with SEBI under the provisions of SEBI Act. As per the provision of the SEBI Act, a DP

can function regarding depository related services only after obtaining a certificate of registration

from SEBI. On the basis of the prescribed eligibility criteria, Depository Participant may be of any

of the following categories:

1. Institutional participants e.g. banks and financial institutions.

2. Broker participants

3. Clearing Corporation.

4. Custodian participants.

5. Registrar and Share Transfer Agents.

6. Non- Banking Financial Companies.

All the above categories of DPs provide operations with same safety levels.

NATIONAL SECURITIES DEPOSITORIES LIMITED.

The NSDL is the first and largest depository in India, established in August 1996 was promoted

by institutions of national importance. It has established a state-of-the-art infrastructure that

handles most of the securities held and settled in dematerialized form in the Indian capital market.

Although India had a vibrant capital market which is more than a century old, the paper-based

settlement of trades caused substantial problems like bad delivery and delayed transfer of title, etc.

The enactment of Depositories Act in August 1996 paved the way for establishment of NSDL.

By using innovative and flexible technology systems, NSDL works to support the investors and

brokers in the Indian capital market. NSDL aims at ensuring the safety and soundness of Indian

marketplaces by developing settlement solutions that increase efficiency, minimize risk and reduce

costs. The NSDL plays a central role in developing products and services that continue to nurture

the growing needs of the financial services industry. In the depository system, securities are held

in depository accounts, which is similar to holding funds in bank accounts. Transfer of ownership

of securities is done through simple account transfers. This method does away with all the risks

and hassles normally associated with paperwork. Consequently, the cost of transacting in a

depository environment is considerably lower as compared to transacting in certificates.

NSDL provides variety of services to end investors, stock brokers, stock exchanges, custodians,

issuer companies etc. through its network of more than 260 Depository Participants / Business

Partners. NSDL has been able to win the trust of crores of investors and other intermediaries,

thereby becoming worthy of its tag line −Technology, Trust and Reach. NSDL believes that

‘Every Indian should not only become an ‘Investor’ but a ‘Prudent Investor’ indeed.

NSDL is promoted by Industrial Development Bank of India (IDBI) - the largest development

bank of India, Unit Trust of India (UTI) - the largest mutual fund in India and National Stock

Exchange (NSE) - the largest stock exchange in India. Some of the prominent banks in the country

have taken a stake in NSDL.

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THE PROMOTERS.

1. Industrial Development Bank of India Limited (Now IDBI Bank Limited).

2. Unit Trust of India (Now, administrator of the Specified Undertaking of the UTI).

3. National Stock Exchange of India Limited.

THE SHARE HOLDERS.

1. State Bank of India.

2. HDFC Bank Limited.

3. Deutsche Bank AG.

4. Axis bank Limited.

5. Citibank NA.

6. Standard Chartered bank.

7. The Hongkong land Shanghai Banking Corporation Limited.

8. Union Bank of India.

9. Canara Bank.

10. Kotak Mahindra Bank Limited.

11. Dena Bank.

12. Kotal Mahindra Life Insurance Company Limited.

As a part of its on-going market reforms, the Government of India promulgated the Depositories

Ordinance in September 1995. Based on this ordinance, Securities and Exchange Board of India

(SEBI) notified its Depositories and Participants Regulations in May 1996. The enactment of

the Depositories Act the following August paved the way for the launch of National Securities

Depository Ltd. (NSDL) in November 1996. The Depositories Act has provided

dematerialization route to book entry-based transfer of securities and settlement of securities trade.

In exercise of the rights conferred by the Depositories Act, NSDL framed its Bye

Laws and Business Rules. The Bye Laws are approved by SEBI. While the Bye Laws define the

scope of the functioning of NSDL and its business partners; the Business Rules outline the

operational procedures to be followed by NSDL and its “Business Partners”.

In view of the SEBI (Depositories and Participants) (Amendment) Regulations, 2012, NSDL has

adopted Code of Conduct for its Directors and Code of Ethics for its Directors and Key

Management Personnel as prescribed under Regulation 9D of the aforesaid regulations. The Code

of Ethics for Directors and Key Management Personnel of NSDL is aimed at improving the

professional and ethical standards in the functioning of the company thereby creating better

investor confidence in the integrity of the market.

Depository System - Business Partners.

NSDL carries out its activities through various functionaries called "Business Partners" who

include Depository Participants (DPs), Issuing companies and their Registrars and Share Transfer

Agents, Clearing corporations/ Clearing Houses of Stock Exchanges. NSDL is electronically

linked to each of these business partners via a satellite link through Very Small Aperture Terminals

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(IPVSAT) or through MPLS (Multi-protocol label switching). The entire integrated system

(including the electronic links and the software at NSDL and each business partner's end) is called

the "NEST" [National Electronic Settlement & Transfer] system.

BENEFITS OF THE DEPOSITORY SYSTEM.

In the depository system, the ownership and transfer of securities takes place by means of

electronic book entries. At the outset, this system rids the capital market of the dangers related to

handling of paper. NSDL provides numerous direct and indirect benefits like

Elimination of bad deliveries - In the depository environment, once holdings of an investor are

dematerialized, the question of bad delivery does not arise i.e. they cannot be held "under

objection". In the physical environment, buyer was required to take the risk of transfer and face

uncertainty of the quality of assets purchased. In a depository environment good money certainly

begets good quality of assets.

Elimination of all risks associated with physical certificates - Dealing in physical securities

have associated security risks of theft of stocks, mutilation of certificates, loss of certificates during

movements through and from the registrars, thus exposing the investor to the cost of obtaining

duplicate certificates etc. This problem does not arise in the depository environment.

No stamp duty for transfer of any kind of securities in the depository. This waiver extends to

equity shares, debt instruments and units of mutual funds.

Immediate transfer and registration of securities - In the depository environment, once the

securities are credited to the investors account on pay out, he becomes the legal owner of the

securities. There is no further need to send it to the company's registrar for registration. Having

purchased securities in the physical environment, the investor has to send it to the company's

registrar so that the change of ownership can be registered. This process usually takes around three

to four months and is rarely completed within the statutory framework of two months thus

exposing the investor to opportunity cost of delay in transfer and to risk of loss in transit. To

overcome this, the normally accepted practice is to hold the securities in street names i.e. not to

register the change of ownership. However, if the investors miss a book closure the securities are

not good for delivery and the investor would also stand to lose his corporate entitlements.

Faster settlement cycle - The settlement cycle follows rolling settlement on T+2 basis i.e. the

settlement of trades will be on the 2nd working day from the trade day. This will enable faster

turnover of stock and more liquidity with the investor.

Faster disbursement of non-cash corporate benefits like rights, bonus, etc. - NSDL provides

for direct credit of non-cash corporate entitlements to an investors account, thereby ensuring faster

disbursement and avoiding risk of loss of certificates in transit.

Reduction in brokerage by many brokers for trading in dematerialized securities - Brokers

provide this benefit to investors as dealing in dematerialized securities reduces their back-office

cost of handling paper and also eliminates the risk of being the introducing broker.

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Reduction in handling of huge volumes of paper.

Periodic status reports to investors on their holdings and transactions, leading to better controls.

Elimination of problems related to change of address of investor - In case of change of address,

investors are saved from undergoing the entire change procedure with each company or registrar.

Investors have to only inform their DP with all relevant documents and the required changes are

effected in the database of all the companies, where the investor is a registered holder of securities.

Elimination of problems related to transmission of demat shares - In case of dematerialized

holdings, the process of transmission is more convenient as the transmission formalities for all

securities held in a demat account can be completed by submitting documents to the DP whereas,

in case of physical securities the surviving joint holder(s)/legal heirs/nominee has to correspond

independently with each company in which shares are held

Elimination of problems related to selling securities on behalf of a minor - A natural guardian

is not required to take court approval for selling demat securities on behalf of a minor.

Ease in portfolio monitoring since statement of account gives a consolidated position of

investments in all instruments.

Safety Measures Adopted by the Depository System.

There are various checks and measures in the depository system to ensure safety of the investor

holdings. These include

A DP can be operational only after registration by SEBI, which is based on the recommendation

from NSDL and their own independent evaluation. SEBI has prescribed criteria for becoming a

DP in the regulations.

DPs are allowed to effect any debit and credit to an account only on the basis of valid instruction

from the client.

Every day, there is a system driven mandatory reconciliation between DP and NSDL.

All transactions are recorded at NSDL Central System and in the databases maintained by business

partners.

There are periodic inspections into the activities of both DP and R&T agent by NSDL. This also

includes records based on which the debit/credit are effected.

All investors have a right to receive their statement of accounts periodically from the DP

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Every month NSDL forwards statement of account to a random sample of investors as a counter

check.

In the depository, the depository holds the investor accounts on trust. Therefore, if the DP goes

bankrupt the creditors of the DP will have no access to the holdings in the name of the clients of

the DP. These investors can transfer their holdings to an account held with another DP

The data interchange between NSDL and its business partners is protected by protection measures

of international standards such as encryption hardware lock. The protection measures adopted by

NSDL are more than what is prescribed in the SEBI Regulations.

Freeze Facility. A depository account holder (beneficiary account) may freeze securities lying in

the account for as long as the account holder wants it. By freezing the account, account holder can

prevent unexpected debits or credits or both, creeping into its account. The following types of

freeze facility available in the NSDL system may be availed of by submitting freeze instruction to

the DP in the prescribed form.

Freeze for debits only

Freeze for debits as well as credits

Freeze a particular ISIN in the account

Freeze a specific number of securities held under an ISIN in an account

Certification in Depository Operations : NSDL has introduced a Certification Programme in

Depository Operations (popularly known as NCFM certification), and it has been made

compulsory for all DPs to appoint a person qualified in this certification in each of its branches.

This way, NSDL wants to ensure that each branch of a DP that services investors has atleast one

person who has thorough knowledge about depository system.

Investor grievance: All grievances of the investors are to be resolved by the concerned business

partner. If they fail to do so, the investor has the right to approach NSDL at the following address:

Officer-In-Charge Investor Relationship Cell

NSDL

4th floor, A Wing, Trade World

Kamala Mills Compound

Senapati Bapat Marg

Lower Parel, Mumbai- 400013

The investor relationship cell of NSDL work towards resolution of the grievance.

Insurance Cover: NSDL has taken a comprehensive insurance policy to help DP to indemnifying

investors for the loss accrued to them due to errors, omissions, commission or negligence of DP.

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Computer and communication infrastructure: NSDL and its business partners use hardware,

software and communication systems, which conform to industry standards. Further, the systems

are accepted by NSDL only after a rigorous testing procedure. NSDL's central system comprises

an IBM mainframe system with a back-up facility and a remote disaster back-up site.

Machine level back-up: The IBM mainframe in which the data is processed has adequate

redundancy built into its configuration. There is a standby central processing unit (CPU) to which

processing can be switched over to in case of main system CPU failure. The disk has RAID

implementation, which ensures that a failure of hard disk will not lead to loss in data. System has

spare disk configuration where data is automatically copied from the main disk upon encountering

the first failure (due to RAID implementation - first failure does not result in loss of data).All

network components like router, communication controllers etc., have on-line redundancy and thus

a failure does not result in loss of transaction.

Back-up in case of power failure: Continuity in power supply to the main systems is assured by

providing for:

a) Dual uninterrupted power supply (UPS) for IBM-Mainframe and related components

wherein the two UPSs are connected in tandem. In case of failure of primary UPS, the

secondary UPS takes over instantaneously and thus, there is no interruption in operation,

and

b) Back-up diesel generator sets.

Periodic Review: The NSDL hardware, software and communication systems are continuously

reviewed in order to make them more secure and adequate for the size of business. These reviews

are a part of an ongoing exercise wherein security considerations are given as much importance as

operational efficiency.

Charges.

NSDL provides depository services to investors and clearing members through market

intermediaries called Depository Participants (DPs). NSDL does not charge the investors directly

but charges its DPs, who are free to have their own charge structure for their clients. NSDL charges

to DPs are uniform for all DPs. Some charges are payable by Issuers and other users also.

NSDL Facts & Figures.

As on August 31, 2018

Number of certificates eliminated (Approx.) (in Crore) 3134

Number of companies in which more than 75% shares

are dematted

8783

Average number of accounts opened per day since

November 1996

3970

Presence of demat account holders in the country 99.28% of all incodes in the

country

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NSDL at a Glance (September 30, 2018).

Client Accounts Active 17,700,239

Accounts having Debt

instruments

920,468

Depository Participants

DPs 276

DP Service Centers 30,729

DP Geographical Coverage

(Cities/Towns)

1,935

Companies Joined 20,946

Demat Custody Quantity

(mn. securities)

1,583,552

Demat Custody Value (Rs.

Crore)

17,633,015 US$ 2,432(billion)

Demat Custody Instruments Value (in Rs. Million)

Shares 21,363 133,576,542

Debt/Bonds 14,906 28,178,077

CP 2,182 5,763,208

Settlement (01/09/2018 - 30/09/2018) (single side)

Equity Shares Qty (in Million) Value (in Rs. Million)

NSE 7,831 2,380,680

BSE 1,232 466,028

Total 9,063 2,846,709

Debt/Bonds

Settlement

1,090,700

Questions.

1. Explain the meaning of depository, role of Depositories and their Services.

2. Explain the advantages of Depository System.

3. Explain the Functioning of Depository System.

4. Write short notes on NSDL and CSDL.

5. Write a note on Depository Participants and their Role.

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MODULE FOUR

CHAPTER EIGHT

PREVIEW.

1. Meaning, Obligations and Responsibilities of Custodians.

2. Code of Conduct.

MEANING, OBLIGATIONS AND RESPONSIBILITIES OF CUSTODIANS.

According to SEBI (Custodian of Securities) Regulations 1996, Chapter One, para 2(d) & (e),

"custodian of securities" means any person who carries on or proposes to carry on the business of

providing custodial services;

"custodial services" in relation to securities of a client or gold or gold related instruments

held by a mutual fund or title deeds of real estate assets held by a real estate mutual fund

scheme in accordance with the Securities and Exchange Board of India (Mutual Funds)

Regulations, 1996 means, safekeeping of such securities or gold or gold related instruments or

title deeds of real estate assets and providing services incidental thereto, and includes:

(i) maintaining accounts of securities or gold or gold related instruments or title deeds of

real estate assets of a client;

(ia) undertaking activities as a Domestic Depository in terms of the Companies (Issue of

Indian Depository Receipts) Rules, 2004;

(ii) collecting the benefits or rights accruing to the client in respect of securities or gold or gold

related instruments or title deeds of real estate assets;

(iii) keeping the client informed of the actions taken or to be taken by the issuer of securities,

having a bearing on the benefits or rights accruing to the client; and

(iv) maintaining and reconciling records of the services referred to in subclauses(i) to (iii);

(f) "custody account" means an account of a client maintained by a custodian of securities

in respect of securities;

(g) "Form" means any of the forms set out in the First Schedule;

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(h) "inspecting officer" means an inspecting officer appointed by the Board Under regulation

21;

(i) "Schedule" means a Schedule annexed to these regulations.

SECURITIES AND EXCHANGE BOARD OF INDIA (CUSTODIAN OF SECURITIES)

REGULATIONS, 1996 CODE OF CONDUCT.

1. The custodian of securities shall maintain the highest standard of integrity, fairness and

professionalism in the discharge of his duties.

2. The custodian of securities shall be prompt in distributing dividends, interest or any such

accruals of income received or collected by him on behalf of his clients on the securities

held in custody.

3. The custodian of securities shall be continuously accountable for the movement of

securities in and out of custody account, deposit, and withdrawal of cash from the client's

account and shall provide complete audit trail, whenever called for by the client or

Securities and Exchange Board of India.

4. The custodian of securities shall establish and maintain adequate infrastructural facility to

be able to discharge custodial services to the satisfaction of clients, and the operating

procedures and systems of the custodian of securities shall be well documented and backed

by operations manuals.

5. The custodian of securities shall maintain client confidentiality in respect of the client's

affairs.

6. Where custodian records are kept electronically, the custodian of securities shall take

precautions necessary to ensure that continuity in record keeping is not lost or destroyed

and that sufficient back up of records is available.

7. The custodian of securities shall create and maintain the records of securities held in

custody in such manner that the tracing of securities or obtaining duplicate title documents

is facilitated, in the event of loss of original records for any reason.

8. The custodian of securities shall extend to other custodial entities, depositories and clearing

organizations all such co-operation that is necessary for the conduct of business in the areas

of inter custodial settlements, transfer of securities and transfer of funds.

9. The custodian of securities shall ensure that an arms-length relationship is maintained, both

in terms of staff and systems, from his other businesses.

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10. Every custodian of securities shall exercise due diligence in safe-keeping and

administration of the assets of his clients in his custody for which he is acting as custodian

of securities.

11. (a) A custodian of securities or any of his employees shall not render, directly or indirectly

any investment advice about any security in the publicly accessible media, whether real-

time or non-real-time, unless a disclosure of his interest including long or short position in

the said security has been made, while rendering such advice.

(b) In case an employee of the custodian of securities is rendering such advice, he shall

also disclose the interest of his dependent family members and employer including their

long or short position in the said security, while rendering such advice.

CENTRAL SECURITIES DEPOSITORIES LIMITED (CSDL).

A Depository facilitates holding of securities in the electronic form and enables securities

transactions to be processed by book entry. The Depository Participant (DP), who as an agent of

the depository, offers depository services to investors. According to SEBI guidelines, financial

institutions, banks, custodians, stockbrokers, etc. are eligible to act as DPs. The investor who is

known as beneficial owner (BO) has to open a demat account through any DP for dematerialization

of his holdings and transferring securities.

The balances in the investors account recorded and maintained with CDSL can be obtained through

the DP. The DP is required to provide the investor, at regular intervals, a statement of account

which gives the details of the securities holdings and transactions. The depository system has

effectively eliminated paper-based certificates which were prone to be fake, forged, counterfeit

resulting in bad deliveries. CDSL offers an efficient and instantaneous transfer of securities.

CDSL was initially promoted by BSE Ltd. which has thereafter divested its stake to leading banks

as "Sponsors" of CDSL.

CDSL was set up with the objective of providing convenient, dependable and secure depository

services at affordable cost to all market participants. Some of the important milestones of CDSL

system are:

1. CDSL received the certificate of commencement of business from SEBI in February 1999.

2. Honorable Union Finance Minister, Shri Yashwant Sinha flagged off the operations of

CDSL on July 15, 1999.

3. Settlement of trades in the demat mode through BOI Shareholding Limited, the clearing

house of BSE Ltd., started in July 1999.

4. All leading stock exchanges like the BSE Ltd, National Stock Exchange and Metropolitan

Stock Exchange of India have established connectivity with CDSL.

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The unique features of CSDL are as follows:

CONVENIENCE.

Wide DP Network. CDSL has a wide network of DPs, operating from over 17,000 sites, across

the country, offering convenience for an investor to select a DP based on his location.

On-line DP Services. The DPs are directly connected to CDSL thereby providing on-line and

efficient depository service to investors.

Wide Spectrum of Securities Available for Demat. The equity shares of almost all A, B1 & B2

group companies are available for dematerialization on CDSL, consisting of Public (listed &

unlisted) Limited and Private Limited companies. These securities include equities, bonds, units

of mutual funds, Govt. securities, Commercial papers, Certificate of deposits; etc. Thus, an

investor can hold almost all his securities in one account with CDSL.

Competitive Fees Structure. CDSL has kept its tariffs very competitive to provide affordable

depository services to investors.

Internet Access. A Depository Participant is required to mandatorily register with CDSL.

DEPENDABILITY.

On-line Information to Users. CDSL's system is built on a centralized database architecture and

thus enables DPs to provide on-line depository services with the latest status of the investor's

account.

Convenient to DPs. The entire database of investors is stored centrally at CDSL. If there is any

system-related issues at DPs end, the investor is not affected, as the entire data is available at

CDSL.

Contingency Arrangements. CDSL has made provisions for contingency terminals, which

enables a DP to update transactions, in case of any system related problems at the DP's office.

Meeting User's Requirements. Continuous up-dation of procedures and processes in tune with

evolving market practices is another hallmark of CDSL's services.

Audit and Inspection. CDSL conducts regular audit of its DPs to ensure compliance of

operational and regulatory requirements.

Dormant Account Monitoring. CDSL has in place a mechanism for monitoring dormant

accounts.

Helpdesk. DPs and investors can obtain clarifications and guidance from CDSL's prompt and

courteous helpline facility.

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SECURITY.

Computer Systems. All data held at CDSL is automatically mirrored at the Disaster Recovery site

and is also backed up and stored in fireproof cabinets at the main and disaster recovery site.

Unique BO Account Number. Every BO in CDSL is allotted a unique account number, which

prevents any erroneous entry or transfer of securities. If the transferor's account number is wrongly

entered, the transaction will not go through the CDSL system, unless corrected.

Data Security. All data and communications between CDSL and its users are encrypted to ensure

its security and integrity.

Claims on DP. If any DP of CDSL goes into liquidation, the creditors of the DP will have no

access to the holdings of the BO.

Insurance Cover. CDSL has an insurance cover in the unlikely event of loss to a BO due to the

negligence of CDSL or its DPs.

CDSL STATUS AS ON 30TH SEPTEMBER 2018.

CDSL Update Date : 30-Sep-2018

Investor accounts(Excluding closed accounts) 1,60,57,407

Securities available for demat

Equity 10,512

Debt instruments including debentures, bonds, Government securities,

certificates of deposits, commercial paper, pass through certificates and Others

14,221

Mutual fund units 15,861

Depository Participants

Number of Depository Participants 595

Number of branches with LIVE Connectivity 211

Number of cities/ towns with LIVE connectivity 104

Number of locations with LIVE connectivity 298

Demat Custody

Number of securities in million 3,10,791

Value (INR in million) 1,95,09,357

Questions.

1. Explain the meaning, obligations and role of Custodians.

2. Write a note on the Code of Conduct for custodians.

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