COMPONENTS OF INDIAN FINANCIAL
Services that are financial in nature are known as
SERVICES AND MARKET
Financial stability is crucial for sustained economic growth
but this cannot be achieved without strong financial
systems.' (Financial Stability Institute, Basel)
The financial sector in India is witnessing an era of
innovations. Since liberalization, there has been a
broadening and deepening of financial markets. Several new
instruments and products have been introduced and some
sectors have been opened to new private players to operate
in. This has given a strong impetus to the development and
modernization of the financial sector. The financial sector
has acquired greater strength, efficiency and stability by the
combined effect of competition, regulatory measures, policy
environment and motivation among the market players
including banks. The financial markets, especially money
market, government securities and forex markets are
nurtured and developed because of their role in the
transmission mechanism of monetary policy.
The changes that have taken place in the financial markets
are: (a) easing of controls on interest rates and their
realignment with market rates, (b) gradual reduction in
resource pre-emption by the government, (c) relaxation of
stipulations on concessional lending and (d) denial of access
to concessional resources for financial institutions. New
players have adopted international best practices and
modern technology to offer a more sophisticated range of
financial services to corporate and retail customers. This
process has clearly improved the range of financial services
and the number of service providers available to Indian
customers. The entry of new players has led even the
existing players to upgrade their products and distribution
channels. This growth has been backed by Internet
penetration. E-services have changed the entire spectrum of
financial service sector. Exposure to global practices has
made the Indian investor more discerning and demanding.
The service sector of the Indian economy plays a leading
role and has contributed around 68.6 per cent of the overall
average growth in GDP between 2002-03 and 2006-07. The
service sector, witnessed a growth of 11 per cent in the year
2006-07 as against 9.8 per cent in 2005-06. The major
sectors to have attracted foreign investment include
financial services, telecommunications, power and
information technology. Financial services, which comprise
banks, real estate, insurance and business services
witnessed a rise of 11.1 per cent during 2006-07 against the
10.9 per cent growth in the previous year. It has displayed
stability for the last several years, even when other markets
in the Asian region faced crises. This stability was ensured
through the resilience that has been built into the system
over time. The financial sector has kept pace with the
growing needs of corporate and other borrowers. Banks,
capital market participants and insurers have developed a
wide range of products and services to suit varied customer
requirements.
FINANCIAL SERVICES
financial services. They are a part of the financial system
consisting of financial institutions, financial markets,
financial instruments and services that facilitate the
transfer of funds. All four are interrelated. Financial
institutions operate in the financial markets and provide
financial services. For example, merchant bankers
provide services for issuing financial products such as
equity shares, bonds and debentures, while stock brokers
provide services to the investors in the buying and selling
of securities in stock exchanges
Special Features of Financial Services
 Financial services are intangible in nature. The
advisory services offered by merchant bankers
can be cited as an example for this.
 Financial services are inseparable from the
provider, for example, credit rating services, not
being a material product, cannot be separated
from the credit rating agency of the provider.
 Financial services are customer-centric. Services
are provided, depending on the needs of the
customer for example, leasing finance service
may be needed by an industrial consumer, while
merchant banker's services may be needed by a
company issuing new equity shares in the market.
 Financial services are dynamic in nature. With the
changes in the economic and social environment,
innovative services have to be provided.
Securitization of receivables can be cited as an
example.
 The credibility of the providers is very important
in financial services. Clients' confidence and trust
depends on the quality and worth of the service
provider. Issue management is generally handled
by reputed merchant bankers.
Functions of Financial Services
The functions of financial services are:
Mobilization of funds: Financial services aid in the
mobilization of funds from investors, individuals,
institutions and corporate entities. Funds are mobilized
through various financial instruments like equities, bonds
and mutual funds. Financial institutions, corporate
entities and the government utilize the mobilized funds.
Effective employment of funds: The mobilized funds
should be employed effectively. Financial services help in
this matter through services such as factoring, credit
rating and securitization of debts. Credit rating services
provided by credit rating agencies enable the investors to
make wise decisions in the selection of
bonds/debentures. Likewise, the services provided by
merchant bankers in mergers and acquisitions, help
companies effectively utilize their funds.
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Provision of need-based services: Depending on the
needs of individuals and corporate, specific services are
provided. Venture capital financing, lease financing and
factoring services are provided to entrepreneurs in need
of capital. Credit cards, housing finance and insurance
services are provided to individuals. For a corporate
approaching the capital market in order to raise funds,
pre-issue and post-issue management services are
offered by merchant bankers.
Provision of regulated services: All the services that are
provided in the financial market are well regulated by
rules and regulations. The Reserve Bank of India (RBI),
Securities Exchange Board of India (SEBI) and Insurance
Regulatory and Development Authority of India (IRDA)
regulate the providers of financial services. This provides
safety to the users of financial services.
Enhancement of economic development: Through the
mobilization and deployment of funds, financial services
help accelerate the economic development of the
country. Idle savings of individuals are channelized into
productive purposes through financial services.
Developed countries are known for their structured and
well developed financial markets and services system.
Types of Financial Services: Financial services are of
many kinds. Many financial services are specialized in
nature to suit the specific needs of corporate and
individuals. Some of these have been explained here.
Leasing: A financial lease is a means of financing capital
equipments. It gives impetus to the investment activity
and facilitates the flow of savings into real investment.
Factoring: It is a financial service designed to manage the
receivables, improve the seller's cash flow and cover risk.
Bills discounting: This is a practice of lending against the
commercial bills of a trader.
Securitization: It is the process of pooling and
repackaging of homogenous illiquid financial assets into
marketable securities that can be sold to investors.
Venture capital: It deals with a form of equity financing
designed especially for funding high risk and return
projects.
Credit rating: It indicates an opinion on the future ability
of the issuer to make timely payments of principal and
interest of fixed income security.
Mutual funds: Mutual funds are financial intermediaries
that collect the savings of small investors and invest them
in a diversified portfolio of securities to minimize risk and
maximize returns for their participants.
Credit card: It entitles the holder to a revolving line of
credit which is determined by the user's income. A credit
card allows the cardholder to pay for purchases made
over a period.
Merchant banking: Offering 'of specialized services like
issue management, credit syndication, capita-
restructuring, etc., by financial institutions is known as
merchant banking.
Constituents of Financial Service Sector
The financial service sector consists of four major
constituents: market participants, providers, services and
regulatory bodies.
Market participants: Market participants are of different
categories. They range from individuals to corporate
entities, banks, financial institutions, mutual funds and
merchant bankers.
Financial service providers: Financial service providers
are financial institutions, banks, non-banking financial
institutions, insurance, leasing and factoring companies,
and mutual funds. Banks, financial institutions,
companies and agencies either carry out a particular
service or several services. Leasing companies (The First
Leasing Company of India Ltd., The Twentieth Century
Finance Corporation Ltd.), factoring agencies (Can
Factoring Agency), credit rating agencies (Credit Rating
and Information Services of India—CRISIL), Investment
And Credit Rating Agency of India Ltd. ICRAI), venture
capital funds (Credit Capital Venture India Ltd.) and
merchant banking division of several banks are some of
the institutions rendering specific financial services.
Regulatory bodies: Reserve Bank of India, Securities and
Exchange Board of India, Department of Finance, and
Department of Banking and Insurance of the Central
Government and several self-regulatory bodies regulate
financial services. All parts of the financial system are
interconnected with one another and the jurisdictions of
the RBI and the SEBI overlap in many areas.
FINANCIAL MARKETS
Brigham and Eugene defined the financial market as a
place where people and organizations wanting to borrow
money are brought together with those having surplus
funds. Financial market does not refer to a physical
location. Formal trading rules and communication
networks for originating and trading financial securities
link market participants. Transferring of funds from the
surplus sector to the deficit sector is the main function of
the financial market. The credit requirements of the
corporate sector are greater than their savings. The
savings of the household sector are channelized into the
corporate and public sectors for productive purposes.
The market participants in financial markets are investors
or buyers of securities, borrowers or sellers of securities,
intermediaries and regulatory bodies. Securities are
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financial instruments that represent the holder's claim on
a stream of income or a fixed amount from a corporate or
government.
Constituents of Financial Market: The financial market is
broadly categorized into money market, capital market
and forex market.
Money Market: Monetary assets, which are short term in
nature and less than one year, are traded in the money
market. Money market facilitates RBI's conduct of
monetary policy. There was a paucity of instruments in
the money market for a long time. After the mid- 1990s
the money market in India experienced significant
development in terms of refinements of existing money
market instruments and introduction of new instruments.
The money market instruments in general are close
substitutes to money. The various money market
instruments have been given next-
 Call/ Notice/ Term Money
 Repos
 Treasury Bills
 Certificate of Deposits (CD)
 Commercial Papers (CP)
 Inter Bank Participation Certificates
 Inter Bank Term Money
 Interest Rate Swaps/Forward Rate Agreements
and
 Bills Rediscounting
Components of Financial Market
Components: The money market has two components
namely the organized and the unorganized. The
participants of the organized money market are the
Reserve Bank of India, Life Insurance Corporation,
General Insurance Corporation, and Unit Trust of India,
Securities Trading Corporation of India Ltd., Discount and
Finance House of India, other primary dealers,
commercial banks and mutual funds. The mainstay of the
money market is the inter-bank call money market where
short-term money borrowing/lending is carried out to
manage temporary liquidity mismatches.
Capital Market
The capital market provides long-term funds for
corporates, central and state governments. The capital
market has sub-markets like debt market, equity market
and derivative market.
 Fixed income securities of various types and
features are issued and traded in the debt
market. Debt markets are therefore markets for
fixed income securities issued by Central and
state governments, municipal corporations,
government bodies and commercial entities like
financial institutions, banks, public sector
undertakings, public limited companies and
structured finance instruments.
 In the equity market, variable income securities
like equity shares are issued and traded. Equity
shares are issued by the companies and financial
institutions.
 In the derivative market, financial products and
commodity based derivatives like options and
futures are traded. Commodity options and
futures on precious metals, oil and agricultural
products are traded on the commodity
exchanges. Financial product derivatives like stock
options and futures, stock index futures and
options, and interest rate futures are traded on
the stock exchanges.
Equity and debt instruments are issued in the primary
market. The primary market is also known as new issue
market. An already listed company or unlisted company
can make a fresh issue of securities to the public. The
primary market has no physical location. A host of
intermediaries like lead manager, registrar, underwriter,
custodian and depository are involved in the primary
market. SEBI regulates the new issue market. Under SEB1
guidelines, no company shall make a public issue or right
issue of debt instruments (whether convertible or not)
unless credit rating is obtained from at least one credit
rating agency registered with SEBL The issuer also has to
prominently display the ratings in all the marketing
literature and advertisements related to the particular
debt instrument. The issued securities are listed in the
stock exchanges.
Stock exchanges are the backbone of both the equity and
debt markets. The issued securities are listed in the stock
exchanges. The secondary market .provides a trading
place to buy and sell the securities already issued. It also
provides liquidity to the initial buyers in the primary
market to re-offer the securities to any interested buyer
at any price, if mutually accepted. An active secondary
market promotes the growth of primary market and
capital formation because investors in the primary
market are assured of a continuous market and can
liquidate their investments. The secondary market
consists of 23 stock exchanges including the National
Stock Exchange (NSE), Over-the-Counter Exchange of
India (OTCEI) and Inter Connected Stock Exchange of
India Ltd. (ISE).
Foreign Exchange Market
The foreign exchange market is the market for foreign
currencies. Foreign currency transactions take place in
the case of exports, imports, capital movement, interest
and repayment of loans. In the foreign exchange market,
central-banking institutions, commercial banks and
merchant bankers act as dealers under the control of RBI
and Foreign Exchange Dealers Association of India
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(FEDAI). Star hotels, travelling agencies, individuals and
institutions are permitted to act as money changers
under the provisions of RBI and FEDAI.
Features of Efficient Financial Market
An efficient financial market leads the economy towards
efficient use of factors and allocation of factors for
socially productive purposes. An efficient financial market
has the following features.
Operational efficiency: Efficient market structure and
their linkages minimize the administrative and
transaction costs of transfer of funds.
Information efficiency: All the available information is
absorbed by the prices of securities. The quickness with
which the prices reflect all the relevant information
indicates the information efficiency. The probability of
getting an abnormal profit is much limited in a perfect
market.
Valuation efficiency: In an efficient market, the market
price of the security should be equal to its intrinsic value.
The true economic worth of the asset is its intrinsic value.
In a perfectly competitive market, the price of an asset
reflects its intrinsic value.
Hedging efficiency: Efficient market provides hedging
facilities to reduce risk. Hedging lowers the risk of
incurring loss. Options and futures markets provide
hedging facilities.
Factors Affecting the Financial Services and Markets
Financial services and markets are affected by macro-
economic factors as they are a part and parcel of the
economy. The health of the economy is reflected by the
vibrant growth of the markets and availability of
innumerable services. If the economy is developed, the
money and capital markets show the signs of
development. The following factors of the economy
affect the market and services:
 Gross domestic product: Gross domestic product
of the country decides the standard of living of
people and indicates the growth of industry. If the
GDP grows at a faster rate, it shows that the real
sectors in the economy are growing at a faster
rate. This leads to active money and capital
markets. To meet the needs of the industry, a
wide variety of financial services are evolved.
 Rate of savings: There is a consistent uptrend in
the savings rate, which was almost 30 per cent of
GDP in 2004-05. This has to be deployed to
greater effect within the domestic formal
financial system.
 Inflation and deflation: Inflation means upward
movement of prices of commodities and factors
of production. The money value declines during
the inflationary period. Inflation affects the cost
of production: when there is a rise in the cost of
production, there will be a fall in profit leading to
depressive market conditions. The securities
markets and services are affected by the rising
price.
 Business cycles: Business cycles are periodic
fluctuations of economic activity consisting of
boom, recession, depression and recovery
phases. These phases alternate periodically;
during the boom period stock market and money
market flourish and the demand for the financial
services are also high whereas during the
depression period the economy and the markets
experience a slump.
 Balance of payment: The balance of payment of a
country shows the health of the economy. The
balance of payment is a systematic record of all
economic transactions of a country with the rest
of the world in an accounting year. Deficit in the
balance of payment leads to a fall in the value of
the exchange rate of the concerned currency. This
affects the imports as well as exports which in
turn affects the growth of economy and the
markets. To set things right, the government
would follow a tight money policy. This has an
impact on the interest rate and money market.
FINANCIAL SECTOR IN THE PRE- AND POST-
LIBERALIZATION PERIODS
This can be discussed as follows:
Pre-Liberalization Period: The Indian financial system
was unorganized up to the 1970s. Fragmented and less
transparent stock, and commodity spot and futures
markets with limited volume of trade were prevalent. The
capital account was closed. The commodity derivative
market had a large number of trader defaults during the
period of three consecutive drought years and was closed
in the latter part of the 1960s. With the nationalization of
the 14 major private sector banks on 19 July 1969, the
Indian banking system became predominantly owned by
the government. Interest rates were controlled by the
Reserve Bank of India. Elaborate price and quantity
controls were enforced on the financial sector. Large
public sector monopolies dominated the financial service
sector.
The State developed monolithic finance companies to
provide financial services. Development financial
institutions (Industrial Development Corporation of
India—1948, Industrial Development Bank of India—
1964, State Financial Corporation), insurance (Life
Insurance Corporation—1956, General Insurance
Corporation-1973) and fund management (Unit Trust of
India-1964 for mutual funds) were established. However,
they were monopolies in their respective areas of
functioning. These public sector organizations had rigid
investment guidelines.
The Controller of Capital Issues (CCI) dictated whether,
and at what price, firms could sell shares to the public in
the primary market. The secondary market witnessed
scams and irregularities but, the price discovery was also
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relatively free in the secondary market. The following key
weaknesses were found in the pre-liberalization period in
the financial sector in India.
Service Sector Reforms
 Interest rates were administered and pegged at
Some of the significant reforms that took place in the
unrealistically low levels. Resources were widely
financial service sector along with their impact have been
drawn from the banking system, to finance fiscal
listed.
deficit.
 The banking industry was predominately public
sector in nature and the participation of the
private sector was negligible. The quality of the
banking system was largely determined by the
public sector banks.
 Insurance sector was under the state monopoly.
A limited range of life and non-life insurance
products was available to the public. Financial
products which combined the features of life
insurance and equity related instruments were
inadequately developed.
 Mutual funds industry was also a public sector
monopoly in terms of both the number of funds
and their market share till 1992.
 Foreign firms were not permitted to operate in
insurance sector or mutual fund industry.
 Banks, pension funds and insurance companies
were forced to purchase government bonds as
their primary investments.
 There were no financial derivative markets except
the presence of a small currency forward market
and local commodity derivatives markets.
 Prudential regulations were not adequate in the
financial sector.
 Debt and money markets were not fully
developed.
 Institutional and technological structures in the
capital markets were outdated. Bombay Stock
Exchange (BSE) did not have appropriate
structures for governance and regulation.
 Limited usage of bank cards prevailed among the
customers.
Post-Liberalization Period
The Financial services sector and financial markets were
targets for financial sector j reforms in the period after
199-1. Structural changes were introduced in the
financial sector. Factors that necessitated reforms are
given below-
 The balance of payment crisis of the 1990s
threatened the international credibility of the
country. Non-debt capital inflows were required
to fund the current account deficit.
 Foreign equity capital through FDI and portfolio
investment was needed for accelerating industrial
growth.
 There was a considerable growth in the size of the
stock market and stock investment culture. This
required regulations to protect investors'
interests.
 Mutual fund service, once the monopoly of UTI,
was opened to national and international private
players. A plethora of mutual funds with diverse
portfolio mixes were issued and traded in the
secondary market.
 Amendments to SEBI (Merchant Bankers)
Regulations, 1992 were made. Only body
corporate was allowed to function as merchant
banker.
 The merchant bankers were required to seek
separate registration if they wished to act as an
underwriter or a portfolio manager.
 Also, merchant bankers were prohibited from
carrying on fund-based activities other than those
related exclusively to the capital market. In effect,
the activities undertaken by NBFCs such as
accepting deposits, leasing, bill discounting, etc.,
are not allowed to be undertaken by a merchant
banker.
 Insurance Regulatory and Development Authority
Act, 1999 (IRDA Act) was enacted. The insurance
sector was opened up for competition from
Indian private insurance companies.
 As per the provisions of IRDA Act, 1999, Insurance
Regulatory and Development Authority (IRDA)
was established on 19 April 2000 to protect the
interests of holders of insurance policy and to
regulate, promote and ensure orderly growth of
the insurance industry.
 To regulate the credit rating agencies, The
Securities and Exchange Board of India (Credit
Rating Agencies) Regulations, 1999 was given.
 The Act namely, The Securitization and
Reconstruction of Financial Assets and
Enforcement of Security Interest Ordinance, 2002'
(SARFASI) was enacted. Its purpose was to
promote the setting up of asset
reconstruction/securitization companies to take
over the Non Performing Assets (NPA)
accumulated with banks and public financial
institutions.
 SEBI Investment Advice by Intermediaries
(Amendment) Regulations 2001 insisted on the
appointment of a compliance officer by market
intermediaries like bankers to an issue, credit
rating agencies, debenture trustees, stock brokers
and mutual funds to independently report to SEBI
on non-compliance with rules/regulations issued
by government and regulators.
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Capital Market Reforms
The major reform in the capital market was the abolition
of Capital Issues Control Act and the introduction of free
pricing of equity issues in 1992-
 The Securities and Exchange Board of India (SEBI)
was set up as an apex regulator of the Indian
capital markets in 1988. SEBI has framed
regulations on a number of matters relating to
capital markets.
 The depository and share dematerialization
systems were introduced to enhance the
efficiency of the transaction cycle.
 Rolling settlement replaced the flexible, but often
exploited, forward trading mechanism to bring
transparency.
 Online trading was introduced in all stock
exchanges.
 Stock exchanges were corporatized.
 Foreign Institutional Investors (FIIs) were
permitted in the Indian stock market. « Many
new instruments were introduced in the markets,
including index futures, index options besides
options and futures in select stocks.
 Entry norms for capital issues were tightened.
 Disclosure requirements were improved.
 Margining system was rigorously enforced.
 Regulations were framed for insider trading.
 Regulatory framework for takeovers was
revamped.
Money Market Reforms
The Reserve Bank of India has introduced several reforms
to foster balanced development of different segments of
the money market.
 A phased exit of non-banks from the call/notice
money market was started in May 2001 to
transform the call/notice money market into a
pure inter-bank market with participation of
banks and primary dealers (PDs). Non-bank
participants were completely phased out of the
call money market from 6 August 2005.
 A full-fledged Liquidity Adjustment Facility (LAF)
replaced the traditional refinance support on
fixed terms.
 The development of the payment system
infrastructure was strengthened with the
introduction of the Negotiated Dealing System
(NDS), formation of the Clearing Corporation of
India Ltd. (CCIL) and the implementation of Real
Time Gross Settlement (RTGS) system.
 Measures were also taken to make various other
money market instruments (such as CDs, CPs,
etc.,) freely accessible to non-bank participants.
Debt Market Reforms
 The government reduced its pre-emption of bank
funds and moved to market determined interest
rates on its borrowings.
 Substantial deregulation of interest rates took
place.
 A system of primary dealers for trading in
government securities was set up.
 Banks were permitted to retail government
securities.
 RBI enhanced the efficacy of NDS by
incorporating screen based anonymous order
matching system under its ambit with effect from
August 2005.
Impact of Reforms on Corporate Governance
Corporate financial management in India was relatively
simple until the early 1990s. This was because the
government regulated the price at which firms could
issue equity and rate of interest for bonds. Public sector
institutions provided a significant part of equity and debt.
Banks financed working capital at the interest rates laid
down by the central bank. Working capital finance was
related more to the credit need of the borrower than to
creditworthiness on the principle that bank credit should
be used only for productive purposes. However, the
reforms have had the much impact on corporate
governance. It can be discussed as follows:
Disintermediation of finance: Financial sector reforms
have made the companies rely on capital markets to a
greater degree for their capital needs. In the capital
markets, investors favour the performing companies.
Retail investors can bring the discipline of capital markets
by subscribing or not subscribing to the issue. They can
also sell their shares in the secondary market, thereby
depressing value of a particular company share, if the
performance of the company is not satisfactory. Capital
markets have always had the potential to exercise
discipline over corporate governance.
Higher standards of disclosure: Globalization of the
financial markets has exposed issuers, investors and
intermediaries to higher standards of disclosure and
corporate governance that prevail in the developed
capital markets.
Restructuring of capital: In the pre-reform period,
subsidized institutional finance was made available to
many companies. Most of the debt was institutional and
could usually be rescheduled at little cost. The reforms
changed all of these. The corporate sector was exposed
to international competition and subsidized finance gave
way to a regime of high real interest rates. One of the
first tasks for the Indian companies was substantial de-
leveraging. Equity market and the entry of foreign
institutional investors helped to accomplish this.
Better debt issue management: Rating agencies are
stringent in their rating standards. They pay greater
attention to key financial parameters like the interest
coverage ratio and the profitability of the companies.
Companies are required to pay more attention to their
financial position to get good rating from the rating
agency. They also have to maintain a sound financial
position to avoid negative ratings during the tenure of
the particular debt instrument.
Commercial papers and other forms of short-term
finance are very sensitive to the company's credit rating
and perceived creditworthiness. A company's
creditworthiness is under greater scrutiny than ever
before. Over a period of time, companies have to
strengthen their balance sheets significantly to ensure a
smooth flow of credit.
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Effective Cash-flow management: Debt has a fixed
repayment schedule and interest obligation. A company
that is unable to generate enough cash flow to meet this
debt service requirement faces insolvency or painful
restructuring of liabilities. Rescheduling is not an easy
option when the debt is raised in the market from the
public. Bonds are typically rescheduled only as part of a
bankruptcy proceeding or in the Board of Industrial and
Financial Reconstruction restructuring process. This leads
to effective cash flow management.
Factoring
Regular flow of working capital is needed for the smooth
functioning of any enterprise. Purchasers of goods and
services often delay their payments, resulting in working
capital problems for the suppliers. Even though banks
provide working capital credit to the enterprises, they are
not able to provide adequate supply of working capital.
However, expediting the collection of accounts
receivables could alleviate the difficulties of the suppliers
of goods and services. Therefore, factoring is a financial
service designed to help the companies to arrange the
payment of their receivables in a better manner.
Factoring is extensively used in developed countries.
THE CONCEPT
Factoring is a financial service whereby receivables are
purchased by the factor and a financial option for credit
sales is effected on open account terms. Factoring is a
package of services providing integrated receivables
management. Factoring is often used synonymously with
accounts receivable financing.
The word, factor is derived from the Latin word 'factor'
which means to make or do or get things done. In simple
terms, a factor is an agent who does things for his client
for a consideration called commission. In factoring, a
company or firm converts its receivables into cash by
selling them to a factoring agent or institution at a
discount. The factor assumes the, risk of collection and
the loss on account of bad debt falls on the factor.
According to the International Institute for Unification of
Private Law (UNIDROIT) Rome, factoring means an
arrangement between a factor and his client that
includes at least two of the following services to be
provided by the factor: 1) finance 2) maintenance of
accounts 3) collection of debts and 4) protection against
credit risk. Thus, factoring is a package of services
providing integrated receivables management.
The Process
The main function of factoring is the realization of credit
sales. Once the sales transaction is completed between
the firm and the buyer, the factor starts realizing the sale
proceeds. The seller/business entity enters into an
agreement with a factor whereby the factor provides the
facility of debt collection. Sometimes the seller's bank is
also involved in the factoring business. The seller hands
over the duly signed copy of invoice to the factor.
Generally, 80 per cent of the invoice value is given as
advance by the factor. The remaining 20 per cent is paid
against the realization. The factor collects service charge
and discount charge (comparable to bank interest rate)
from the seller/client. The factor furnishes periodical
statement to both, the seller/client and buyer/customer.
The maximum debt period permitted under factoring is
150 days inclusive of a maximum grace period of 60 days.
Process of Factoring
The Buyer
A buyer buys the material in accordance with the
negotiated terms from the business entity or firm. He
receives the delivery of goods with the invoice and an
instruction to settle the amount to the factor. If he is not
able to settle the amount, he has to get an extension of
time from the factor. However, in the case of default,
legal action is taken by the factor.
The Seller
A seller enters into an MoU with the buyer. He chooses
the customer invoices he wants to factor. He sells the
goods to the buyer as per the MoU. After the delivery of
goods, he sends copies of the invoice, delivery challan,
MoU and the instruction to make payment to the factor.
The seller receives advance payment from the factor for
selling the receivables from the buyer. Normally, this
ranges from 80 per cent to 90 per cent of the invoice
amount. The remaining amount is settled as per the
agreement.
The Factor
A client sends the business name, address and amount he
wants to factor for a particular business client. Credit is
verified and limits are established for the business client.
There is no charge for credit validation. The seller and the
factor enter into an agreement for availing the factoring
service. The factor after reviewing the invoice and other
documents makes payments to the seller. The factor
receives payments from the buyer on due dates and gives
the remaining amount due to the seller after deducting
his service charges.
The Essential Documents
Certain documents are essential for availing the factoring
service. These are:
 The invoice, bills or other documents by the seller
with a mention of factoring service.
 A written statement by the seller to ensure that
the bills are free from any encumbrances,
charges, lien, pledge, hypothecation, etc.
 Deed of assignment to enable the factor to
recover the money from the seller, if there is any
default.
 A letter of confirmation stating that all the
conditions of the sell-buy contract between the
buyer and the seller have been complied with and
the transaction is complete, should be issued by
the seller
 A letter of waiver in favour of the factor is
needed, if the banks have any charge over the
assets sold. The seller should arrange for the
letter of waiver.
Functions of Factor
The services provided by the factor are:
 Assumption of credit risk
 Maintenance of sales ledger
7
  Collection of accounts receivables
 Finance of trade debt
 Provision of advisory services
 Credit analysis of the customer
Assumption of credit risk: A factor undertakes the risk if
factoring is done without recourse. The credit limit is
fixed by the factor after consulting the seller. Within
these limits the factor buys all the accounts receivables.
When it buys the accounts receivables, the risk of default
by the customer falls on it. This relieves the client from
the work of collection of account receivables.
Maintenance of sales ledger: A factor provides the sales
ledger maintenance service to his clients. Open account
method is adopted in maintaining the ledger. Each
receipt is matched with the specific invoice provided by
the seller. The customer's account shows the various
open invoices outstanding on any given date. The factor
prepares periodic reports regarding the current status of
his receivables, receipts of payments from the customers
and other related information. Weekly or fortnightly
reports are provided to the clients depending on the
volume of transaction. Customer-wise record of
payments over a period is also maintained to identify the
defaulting accounts.
Collection of accounts receivables: When payment is due
from the customer, the factor undertakes the
responsibility of collecting the money. The factor has
trained manpower and well-equipped infrastructure
facilities for collection of debt. With a proper follow up
action and appropriate strategy, he can reduce the bad
debts.
Entrusting the collection work in the hands of a factor
saves manpower, time and effort for the client. Hence
the client can focus on other financial and functional
areas of the finance.
Financing trade debts: Factoring provides short-term
finance to the clients. The factor purchases the book debt
and gives full credit protection against any bad debts in
case the debt is factored without recourse. Extending
cash in advance against the book debts provides financial
assistance. The maximum advance given by the factor is
equal to the amount of the factored receivables after
deducting (a) factoring commission (b) interest on
advance and (c) reserve to cover bad debts losses. The
reserve ranges from 5 to 20 per cent depending on the
quality of the book debt.
Providing advisory services: A factor provides the
following financial consultancy services to the client.
 Provides information regarding the market trends
of the clients' products, marketing strategies and
competition and helps the client to assess the
credit worthiness of the customer.
 Makes systematic analysis to monitor and
manage the credit recovery.
 Audits the procedures for invoicing, delivery and
dealings with sales return.
 Provides facility for opening letters of credit by
the client.
Credit analysis of the customer: Factors with their vast
source of information advise the client on the credit
worthiness of potential customers. Thus, they help them
have a better credit control. The factor defines the
monthly sales turnover for each customer, which will be
covered by the approved credit limit. For example, if the
approved limit for a customer is Rs 6 lakh and average
collection period is 60 days, sales up to Rs 3 lakh (6 x
30/60) per month will be automatically covered. Factors
prepare periodic customer-wise outstanding and aging
schedules and send them to the clients. With these
reports the clients can assess the credit worthiness of the
customers. The factor collects the necessary information
from the credit rating reports, bank reports and trade
references. The financial statement of the customer is
analysed with the help of various ratios.
Benefits of Factoring
The benefits of factoring are as follows:
1. Immediate increase in cashflow: Under conventional
methods, a company must wait for 30, 60, 90 and
sometimes 120 days to collect credit sales. With
factoring, invoices are immediately purchased and
advances are paid up to 90 per cent of the invoice
amount. The margin is within 20 per cent of the invoice
amount. Thus, factoring provides instant finance against
each invoice. When the invoices are fully paid, the seller
receives the remaining amount less the fees.
2. Less cost: Practically the cost is less as compared to the
amount lost on account of waiting for sixty to ninety
days, to receive payment on services or products. No
penal rate is charged up to the grace period. This money
received from the factor could be placed in an interest
bearing account or be reinvested in the company to help
it grow and produce additional revenues. The labour and
other costs for debt collection and credit administration
are assumed by the factor, leaving the employees free for
other tasks-or allowing the seller to cut staff and costs.
Further, it replaces the high cost market credit.
3. Professional collections: A factor can handle
collections professionally and more productively. Each
invoice is followed up for payment.
4. Invoice processing: A factor handles much of the work
associated with processing invoices, including mailing
them to customers (addressing envelopes, stuffing them,
paying for postage), posting invoices to a computer
system, depositing cheques, entering payments on the
computer and producing regular reports. Again, this can
greatly reduce the current overhead cost associated with
these tasks.
5. Offer credit terms to customers: Availing the services
of a factor, helps the company offer credit terms (or
extended credit terms) to the customers without
impairing the cash flow.
6. Source of finance: Factoring is a source of financing.
Factoring accelerates turnover of receivables and
improves the operating cycle. This leads to more
production, larger sales, and higher profits and increased
ROI. This enables the seller to meet his financial
commitments without much difficulty.
Invoices are paid faster
Many people do not realize that some debtors pay
factored invoices faster than non-factored invoices. The
reason is that factors may report default experiences to
8
other credit agencies, most clients do not. A debtor who
is aware of this knows that he may impair his credit
rating-by paying a factor slowly, whereas paying the
client slowly may not affect his credit rating at all.
Credit screening: Factors provide credit information
about new customers, which enables the seller to make
better credit decisions. Factors also provide ongoing
credit monitoring of existing customers to make sure
there is no significant diminution in their credit status.
Factoring helps to build credit: Factoring provides
adequate cash flow. The company pays its bills promptly
and starts establishing or improving, its credit. This
improves its chances of getting better credit terms from
suppliers and improves its chances of getting
conventional financing in the future.
Cost of Factoring: Factoring is not carried out freely. They
charge different costs for different functions.
a) Finance charge for the purchase of receivables is
collected. The finance charge moves along with
the market interest rates. The rates are decided
on the basis of credit rating. This charge is 2 to 5
per cent over the prime rate of interest.
b) Service charge is for collection, follow-up,
administration, etc. The service charge varies
from 0.1 per cent to 2.0 per cent of the invoice
value. Service charge is determined on the basis
of value of invoices submitted to the factors.
Service charges are expected to be higher for
without recourse factoring since the factor
assumes entire credit risk.
c) A penal charge is levied for delayed payment. A
penal charge of 1 per cent for the first 30 days
beyond the approved credit period and 2 per cent
for delay beyond 30 days on the entire
outstanding amount over and above the finance
charge is levied.
Types of Factoring
The factoring services differ from each other depending
on the agreement entered into and the services provided.
The basic service of the factor, i.e., collection of
receivables and sales ledger administration is common in
all factoring services. The types of factoring are:
 Recourse and non-recourse factoring
 Advance and maturity factoring
 Undisclosed and disclosed factoring
 Domestic and International factoring
 Bulk/Agency factoring and
 Limited factoring and full factoring
Recourse and non-recourse factoring: In recourse
factoring, a factor has recourse to a client if the
receivable factored becomes irrecoverable. Here, a factor
provides the advance but not the credit cover. Whenever
there is a loss, the client makes it up. In other words, the
default risk is not borne by the factor. If there is a default,
the sales ledger maintenance and debt collection charge
plus the interest on the amount for the period, are
collected by a factor from a client.
Non-recourse factoring is different from recourse
factoring. Here, a factor does not have the right of
recourse. The default risk is assumed by a factor. The loss
due to irrecoverable receivables has to be borne by a
factor. This is the reason because of which a high
commission charge is collected by a factor. The additional
fee charged by a factor for bearing the risk is called, del
credere commission. Since a factor assumes the risk, he
actively participates in the process of grant of credit to
the customer by the client. The extension of credit line is
also evaluated by a factor.
Advance and maturity factoring: Under advance
factoring, a factor provides advance against factored
receivables at an agreed interest rate. The amount to be
advanced is pre-specified. It ranges from 75 per cent to
90 per cent. The balance is paid after the collection is
over or on the agreed date. A client has to pay the
interest for advance payment. Advance factoring may be
with or without recourse. However, under maturity
factoring services, no financial assistance is made
available to the client and the client gets the entire
amount from the factors only at the time of maturity. A
factor maintains the client's sales ledger and collects the
debts on maturity and pays the same to a client by
deducting the commission thereon. A factor also renders
advisory services to the client. In this type of factoring the
rate of commission is less than advance factoring.
Undisclosed and disclosed factoring: Undisclosed
factoring differs from other types of factoring services in
terms of disclosure of information about the factoring
agreement between a factor and client. In case of
undisclosed factoring, a client's customers are not aware
of the factoring agreement between the client and the
factor. They continue to make payment to a client. A
client takes up the responsibility of making payment to
the factors on the due date irrespective of whether a
customer makes the payment or not. The commission
charged by a factor depends on the nature of risk
involved in the factoring services. Companies of high
repute and sound financial base are considered for this
type of factoring. A factor provides short-term finance
against sales invoices. In disclosed factoring, the name of
the factor is disclosed in the invoice. A client is requested
to make payments to a factor. Depending on the nature
of agreement, factoring may be with or without recourse.
Domestic and international factoring: Domestic factoring
is carriedout within the country. In the domestic factoring
arrangement, all the three: the factor, the seller and the
buyer are in the same country. However, in the
international factoring arrangement, there are four
parties and they are (a) Exporter (client), (b) Importer
(customer), (c) Export factor and (d) Import factor.
Bulk/agency factoring: Here, a factor finances the book
debts. A client continues to administer credit and sales
ledger. A factor finances the book debts in bulk either
with or without recourse. The growth in the personal
9
computer market made this type of factoring popular.
Generally, companies with a good system of credit
administration but in need of temporary financial
accommodation prefer agency factoring.
Limited factoring and full factoring: In limited factoring a
factor discounts only certain invoices on a selective basis
and converts credit bills into cash in respect of these bills
only. Under full factoring a factor renders all services of
collection of receivables and maintenance of sales ledger,
credit collection, credit control and credit insurance. The
complete takeover of bills may be with or without
recourse. A factor also provides drawing limit based on
the outstanding bills as per their maturity and takes up
the corresponding risk depending on the nature of
agreement.
Origin of Factoring: In ancient Rome, rich manufacturers
and merchants used a mercantile agent or factor to
administer the sales of their merchandise. The use of the
factor/agent grew throughout the middle ages. From the
sixteenth century onwards, exporters of consumer goods
from Europe sought the help of the mercantile agents or
factors to promote their trade. The concept spread across
the Atlantic and grew rapidly in the US, UK and France, as
there was a significant demand for European
merchandise. These countries established specialized
financial institutions to assist the firms in meeting their
working capital requirements. During that period the
factors rendered the services like, taking physical
possession of the goods on consignment, storing them,
finding buyers and delivering the goods to them and
collecting payment from the buyers. Later, this was
extended to a number of countries.
Some of the companies providing factoring services are
given below.
SBI Factors and Commercial Services (SBIFACS) Ltd.: It
was the first factoring company which started functioning
in April 1991. It was promoted jointly by the State Bank of
India, Union Bank of India and Small Industries
Development Bank of India (SIDBI).
Canbank Factors Ltd., was jointly promoted by the
Canara bank, Andhra bank and SIDBI in August 1992.
Foremost Factors Ltd. (FFL) It was set up as a joint
venture with the National Bank of America in 1997.
Global Trade Finance Ltd. (GTF) It was promoted jointly
by Export-Import (EXIM) bank of India, International
Finance Corporation and West LB, Germany.
RBI Guidelines
The RBI issued guidelines in July 1990 to provide a
statutory framework to enable banks to carry out
factoring.
The banks are permitted to set up subsidiaries/investing
factoring companies jointly with other banks with the
prior approval of RBI. Banks are also permitted to
undertake factoring departmentally.
 Factoring Subsidiaries or companies should not
finance other companies or factoring companies.
 A bank can invest in the share of the factoring
companies including its factoring subsidiaries.
But, it should not exceed 10 per cent of the paid
up capital and reserve of the bank in the
aggregate.
EXPORT FACTORING
Factoring for export companies that sell goods and
services to customers outside India is called export
factoring. The government has evolved a system of
providing guarantee; insurance facility and liberal export
credit. However, the formalities involved in obtaining
these facilities are laborious. Factoring is the best
alternative for the exporters to maintain cash flow.
Export factoring, is similar to domestic factoring except
for some differences. The parties involved in export
factoring are (a) exporter (b) importer (c) export factor
and import factor. Here two factors are involved in the
process and thus it is also known as two-factor system of
factoring.
Agreements are made between the factoring company in
the seller's country, exporter (client) and the export
factor. Export factor is a factoring company in the seller's
country who purchases (factors) the export documents.
Import factor (IF) is a factoring company in the buyer's
country which handles collection and credit risks.
Export factor makes a preliminary enquiry about the
exporter's business. He analyses the present and
projected volume of annual exports, number of countries
to which he exports and the average value of each
invoice. Clients are chosen for factoring services on the
basis of this analysis.
The following steps are involved in export factoring:
(a) The exporter ships the goods to the importer.
(b) The exporter assigns his invoices through the
export factor to the import factor who assumes
the credit risk (as per prior arrangement).
(c) The export factor pre-pays the invoices.
(d) The importer pays the proceeds to the import
factor, which transfers the amount to the export
factor.
(e) The export factor deducts pre-payment already
made and other charges, and pays the balance
proceeds to the exporter.
Exporter's Benefits
 A factor assumes all commercial credits and
political risks.
 A cost and delay experienced in transacting
business under Letter of Credit (LC) is eliminated.
 An import factor offers credit risk protection in
case the buyer does not pay invoices within
ninety days of the due date.
 There is a reduction in the administrative cost as
the exporter is dealing with only one export
factor, irrespective of the number of countries
involved.
 It enables the exporter to offer open account
terms to qualified customers and compete with
overseas suppliers.
 Valuable information on the standing of the
foreign buyers on trade customs and market
potential is provided to the exporter to expand
the business. This eliminates the cost of gathering
credit information.
 An import factor follows the receivables and
speeds up the collections.
 An exporter has an improved cash flow as finance
is provided up to 90 per cent on export invoices.
10
Benefits to Importers
 He can pay invoices in the country locally.
 He deals with the local agency, i.e., the import
factor.
 Minimum documentation is required.
Payment is made to the exporter based on the factoring
arrangement. Domestic factoring commission is charged
by the factor for the services that they render. Usually it
ranges from 1 per cent to 2.5 per cent. The amount of
commission charged depends on the policy of a factor,
the annual sales volume of the client, average size of the
invoice and the number of active accounts of the client. If
the client takes advance from the factor, interest is
charged for that amount as well.
FORFAITING
The word 'forfait' in French means, 'to relinquish a right'.
In forfaiting, an exporter relinquishes his right to a
receivable due at a future date in exchange for
immediate cash payment, at an agreed discount, passing
all risks and responsibilities for collecting the debt to the
forfaiter. Forfaiting is the discounting of international
trade receivable on a 'non-recourse' basis (non-recourse
means that there is no comeback on an exporter if the
importer does not pay). A forfaiter deducts interest (in
the form of a discount), at an agreed rate for the full
credit period covered by the receivables. In exchange for
payment, a forfaiter takes over the responsibility for
claiming the debt from the importer. A forfaiter either
holds the notes until full maturity (as an investment), or
sells them to another investor on a non-recourse-basis.
Forfaiting was originally used to finance exports from
countries in Western Europe to eastern Europe in the
1960s. With the expansion of international trade,
forfaiting is widely used to finance trade with all
geographic areas and has also been extended to provide
pre-export finance, structured trade finance, project
finance and even working capital. In 1992, The Reserve
Bank of India (RBI) approved forfeiting as an export
financing option in India.
Forfeiting is generally suitable for high value exports like
heavy machinery, capital goods, consumer durables,
vehicles, bulk commodities, consultancy and construction
contracts, and project exports. However, not many
exporters have adopted this option because the major
deterrent is that the minimum amount of transaction
prescribed by foreign banks offering this service is
$2,50,000. This amount is too high for an average
exporter in India. Therefore, this has been reduced.
London-based West Merchant Bank, which is the front-
runner in providing forfaiting service in India, has fixed
the minimum amount of transaction at $ 1,00,000.
Features of Forfaiting
 A seller of the obligation gets 100 per cent
financing without recourse.
 A local bank guarantees or avals to support the
importer's obligation.
 Letters of credit, bills of exchange, promissory
notes, etc., provide evidence for the debt.
 Credit periods can range from 90 days to 10
years.
 Amount financed is above US $1,00,000.
 Contract in any of the world's major convertible
currencies can be financed.
Traditionally A forfaiter charges a fixed rate of interest. It
can however, be structured on the basis of a floating rate
of interest as well as for longer periods for up to 10 years
or shorter periods up to 90 days.
Forfaiting usually requires:
(a) Copy of supply contract or of its payment terms
(b) Copy of signed commercial invoice
(c) Copy of shipping documents including certificates of
receipt, railway bill, airway will, bill of lading or
equivalent documents
(d) Letter of assignment and notification to the guarantor
Letter of guarantee or aval
The aval is the forfaiters' preferred form of security of
payment of a bill or note. It has to be obtained from an
internationally recognized and credit worthy bank.
The Process of Forfaiting
The exporter who is in need of export credit asks for an
indicative quote from a forfaitor. A forfaitor, analyses the
credit worthiness and the nature of credit required and
provides an indicative offer. Once the commercial
contract is finalized, an exporter gets a firm offer from a
forfaitor.
An importer applies for the letter of credit/documentary
credit in the LC Opening Bank. This may be the importer's
bank with which he has financial dealings. LC is issued to
the LC negotiating bank or the exporter's bank. Then, the
product is shipped by the exporter. An! exporter presents
the documents to the LC negotiating bank, which in turn
forwards them for acceptance to the LC opening bank
and the bank gives the acceptance advice to the LC
negotiating bank. Then, a forfaitor accepts advice from
the LC negotiating bank and he makes payment to the
exporter by crediting the money in his account in the LC
negotiating bank. An importer pays the LC opening bank
and it in turn pays a forfaitor.
Charges
The pricing of a forfaiting transaction depends on a few
factors like the prevailing bank >ffer rate, country/bank
risk and the credit period. Higher margins are kept for
countries rtth high risk. Forfaiting banks differ in their
perceptions of risk for different countries lepending on
their spread in the countries. Briefly, the interest cost is
made up of a charge for the money received by a seller,
which covers a forfaiter's interest rate risk. In ffect, this
covers a forfaiter's refinancing costs and is invariably
based on the cost of unds in the Euro market. The
forfaiter calculates this charge on the LIBOR (LIBOR is the
-ondon Inter-bank Offer Rate), applicable to the average
life of the transaction. For example, on a five-year deal,
repayable by ten semi-annual Installments, the average
life of the transaction is 2-3/4 years. The calculation of
discount is based on the actual number of days to
11
maturity of the instruments plus the grace days. Grace
days are added, for covering the delay in the number of
days normally experienced in the transfer of payment
applicable to the country of risk. The RBI has given a
provision for the authorized dealers to charge a handling
fee.
RBI AND FORFAITING
According to the RBI, forfaiting is to be provided by an
international forfaiting agency through an authorized
dealer (RBI Circular No. 42 A. D. (M.A.) series dated 27
October 1997). Forflting proceeds, on a without recourse
basis, are to be received in India as soon as possible after
shipment but definitely within the 180 days as specified
by RBI for all exports. A forfaiting transaction is to be
routed through an authorized dealer, who apart from
handling documentation will also provide customs
certification for the purpose of GR (Guaranteed Receipt)
form. The purpose of GR form is to enable the RBI to
ensure that proceeds from the export are received in
India through proper banking channels within reasonable
time limits. The exporters must file copies of the GR form
prescribed by RBI with the banker for the purpose of
exchange control also.
VENTURE CAPITAL
An economic entity cannot function without required
capital as capital is needed to acquire machinery,
equipment and other productive facilities. Here, capital
refers to the financial capital of a company. The companies
engaged in traditional line of business can easily procure
necessary financial capital from the conventional capital
market sources like public issue, mutual funds, lease
financing, debt instruments, hire purchase, etc. But,
entrepreneurs who engage in risky lines of business and
have no time tested foundation in the market have a great
difficulty in mobilizing capital. The concept of venture
capital came into existence to help these entrepreneurs.
VENTURE CAPITAL
Venture capital (VC) is a fund that is available for investment
in an enterprise which offers the probability of profit along
with the possibility of loss. It is also called risk capital. The
term venture capital comprises two words, viz., venture and
capital. The dictionary meaning of venture is a course of
proceeding associated with risk whose outcome is
uncertain. The word capital here means the financial
resources to start an enterprise.
In simple terms, venture capital is the capital available for
ventures associated with new technology, products or
processes involving considerable amount of risk. This
financing is commonly associated with the equity
investment for a time period in a small/medium business
with high growth potential, high reward and risk. In such
cases, there is a possibility of high return or total loss.
It also means funding 'the expansion of companies that
have already demonstrated their business potential but do
not yet have access to the funding sources'. Venture capital
also provides management/leveraged buyout financing.
International Finance Corporation, Washington (IFCW),
defines venture capital as equity or equity featured capital
seeking investment in new ideas, new companies, new
products, new processes or new services that offer potential
of high returns on investment. It may also include
investment in turnaround situations.
The main features of venture capital are given below
 Investments are generally made in equity either
through private placements or bought-out deals.
 Investments are made in new enterprises, using
new technology, to produce new products, in
expectation of higher gains.
 A venture capital investor maintains a close contact
with an entrepreneur to safeguard his investment
but does not interfere in the management of the
enterprise.
 Venture capitalists’ approach differs from the stock
market investor and the banker. He continuously
keeps a close watch over business.
 Venture capital investment is not liquid. A venture
capitalist cannot realise his money on demand.
There is no repayment schedule. The investment is
lost if the enterprise is unsuccessful. ,
Venture Capital Fund
Venture Capital Fund (VCF) refers to a business entity whose
principal commercial activity is to make investment in the
highly risk oriented companies, with an expectation of
earning high returns in the form of capital gains. The
venture capital fund may be in the form of a trust, a
company including a body corporate and registered under
Securities and Exchange Board of India (Venture Capital
fund) Regulations, 1996. The fund:
 Has a dedicated pool of capital raised in the manner
specified under the regulations, and
 Invests in venture capital undertaking in accordance
with the regulations.
VCF contributes financial capital to new and young
enterprises in exchange of substantial equity position in the
enterprises. Generally, it takes five to eight years for the
assisted firm to gain maturity in commercial functioning.
After maturity, the equity value appreciates and the equity
holdings of the VCF are liquidated in the market to generate
returns. However, the fund has to wait for a long term.
Venture capital is different from seed capital and term
finance. Even though these three forms of financial
assistance seem to be the same, they are different from one
another. Seed capital is the finance provided to technocrats
or entrepreneurs to meet the promoters' contribution for
setting up of manufacturing activity. Term financing is
generally provided as loan to the entrepreneur for a fairly
long period, for an interest rate against collateral security.
Venture capital is provided in addition to the promoter's
contribution. The venture capital funds seek capital gain as
the primary return. Unlike term financing, the collateral
takes the form of intangible assets such as research results,
innovative marketing ideas, or managerial and technical
skills. The main attraction for a venture capitalist's growth
and earning potential of the equity capital rather than a
steady interest or dividend yield.
Types of Venture Capital Funds (VCFs)
Generally, there are three types of venture capital funds:
venture capital funds set up by angel investors, i.e., high net
worth individual investors; venture capital funds-as
subsidiaries of corporate entities and financial institutions
and private venture capital funds. Major corporate entities,
commercial banks, holding companies and other financial
institutions establish venture capital subsidiaries. Merchant
bankers, and NBFCs who specialize in 'bought out' deals also
fund companies. Some of venture funds in India are given
below.
 Financial institutions—Canbank Venture Capital
Fund, ICICI Ventures, RCTC, ILFS, etc.
 Private venture funds like Indus
12
  Regional funds—Warburg Pincus, JF Electra (mostly
operating out of Hong Kong), Draper, Walden, etc.
 Offshore funds-Barings, TCW, HSBC, etc.
Enterprises Eligible for Support
Venture capital undertaking means a domestic company
whose shares are not listed on any recognized stock
exchange and it engages in business for manufacturing or
for providing services. It does not include such activities or
sectors as are specified in the negative list by the SEBI
notification in the official gazette.
Venture capital support is given for:
 Adoption of a new process or production of a new
product on a commercial scale.
 Technological upgradation leading to lesser material
consumption, cost reduction, energy conservation
and innovative indigenous technology.
 Adoption of imported technology appropriate to
Indian conditions with indigenous efforts.
 Commercial production of laboratory proven
technology at recognized research laboratory or
university after testing it on pilot scale.
 Risky ventures in technology development and long
gestation technology development projects.
Benefits of Venture Capital
The various benefits of venture capital have been given.
To the entrepreneur
 Fills the gap in the owner's fund in relation to the
quantum of equity required in the launching of
the new business.
 Helps the enterprises to get their working capital
requirement.
 Assists the entrepreneurs to recruit professionally
qualified and skilled personnel to carry out
production and management smoothly.
To the investors
The risk of the new venture is borne by the venture
capital fund. The funds download their shares only after
profitable functioning of the companies. Since the
investors invest only after the company starts earning
profit, the risk is less and it ensures a healthy growth of
the capital market.
To the economy
 Venture capital provides finance to explore vast
unutilized potentials and talents.
 Promotes entrepreneurship and fosters the
growth of entrepreneurs for economic
development.
 Helps to attain industrial development.
 Promotes technological development, generates
employment and helps the economy to solve the
problem of unemployment, seed capital and term
financing.
VENTURE FINANCING PROCESS
Venture capital fund finances the proposed venture in
one, two or more identifiable stages of corporate growth.
The stages of investment differ from one another in
terms of time scale, risk perceptions and return.
Early Stage Finance
This can be explained as follows:
Seed capital
This stage is essentially related to 'applied research'
phase of the Research and Development department.
The concepts and ideas of the entrepreneur are the basis
for the pre-commercialization of the research project.
The projects are associated with university linked science
parks and the Indian Institute of Technology. The
entrepreneurs get the help of the universities and
research institutes. If they launch the business
successfully, a percentage of equity is committed to the
respective institutes. The risk involved here is that the
research may or may not lead to commercial production
of the product. The successful autcome of the product is
uncertain. The entrepreneur should be aware of the
market opportunity and the competition that could arise
from substitute products. Since the risk perceptions are
high, the venture capital funds generally consider the
following aspects to safeguard investments:
• Entrepreneurs' track record, previous experience in
similar products, technology, and market
• Managerial and production efficiency and
• Realistic future projections of the present plan
The finance may either take the form of debt or equity. If
it takes a debt-based package, the equity control of the
entrepreneur is preserved. If there is equity participation,
the borrowings are limited, but the equity control is
shared by an outside person.
Start up capital
As the name suggests, here the innovative concept is
materialized into commercial production. The
entrepreneur needs finance for product development
and market penetration. The essence of this stage is that
the product or service is commercialized for the first time
in association with the concerned venture capital
entrepreneur. In this stage, there is an indication of good
market potential for the product. The enterprise instead
of being controlled by a single individual, takes the form
of a limited company.
This stage attracts venture capital funds, since there is
scope for capital appreciation. The venture capital funds
would like to have equity participation rather than having
debt participation. However, the entrepreneur
experiences the equity dilution syndrome and resists the
dilution of equity control of the business. He prefers
debt-based finance for his business.
At this stage VCFs are very serious in assessing the
managerial ability and capacity of the entrepreneur
before making any financial investment. Likewise the
venture capitalist would also like to choose a VCF, which
provides finance, managerial skills, experience,
competence and continuous efforts to make the venture
a success. In reality, the market risk perception of the
13
product or service prevents many of the venture capital
funds from participating in the start-up stage finance.
Second round financing
At this stage, the product has been launched, but
business has mot become profitable to attract new funds.
The entrepreneur may need second round fmance either
because of negative or positive reasons. The negative
reasons, because of which funds are required are:
• There is an over-run of time and cost
• Negative earnings in the start up stage
• Debt is greater than the equity '
• Difficulty in finding new investors to provide funds
The positive reason is:
• Growing business and fund is required for business
expansion VCFs have to shoulder more risk if the
enterprise requires funds due to negative reasons. Since
they have to take high risk, they like to have greater
equity participation to make high capital gain. A part of
the finance is in the form of debt to get some regular
income. The venture capital fund has to be extra cautious
and monitor the enterprise closely to avoid losses.
In the case of fund requirement because of positive
reasons, VCFs are willing to invest in the business. The
successful implementation of the project and the
profitability of the business attract them. A venture
capitalist is also interested in getting further financial
backing along with new management skills and talents. A
sizeable shareholding is held by the venture capitalist to
have control over the enterprise, but at the same time,
the equity holdings become broad based. The risk is less
and the time scale is shorter than the start up stage. In
general, VCFs provide larger funds at this stage than at
earlier stages of financing.
Later Stage Financing
The business of the venture capitalist becomes
established, but requires additional credit support for
working capital and expansion of the business. Still, the
time is not mature for the venture capitalist to approach
the investor through public issue. Capital is required for
mezzanine expansion, replacement, turnarounds and
buyouts. The risk and waiting period involved in this stage
are less. Venture capital funds can have immediate
income in the form of dividend or capital gains. The type
of investment required depends on the entrepreneur's
financial resource, manpower and market. The later stage
requirement of funds differs from one another. Some
may need funds for expansion or development and
others may avail funds for turnaround or buyouts. The
different sub-stages of the later stage are given below.
(a) Expansion finance
The established enterprise records profit yet it has to
wait for some more time to raise capital in the capital
market. At this stage venture capitalist needs finance to:
• Purchase new equipment or plant
• Diversify the product
• Expand the market
• Strengthen the distributing channels
• Settle the existing debt
Funds for the above mentioned factors result in organic
growth of the enterprise. In the case of organic growth,
the venture capitalist retains the maximum equity
holding. Sometimes the venture capitalist requires funds
for acquisition or takeover of other businesses. Here the
equity holding of venture capitalist depends on the net
worth of the acquired business, its purchase price and the
amount raised from investors by the acquiring company.
The time period involved in the expansion finance is
short, ranging from one to three years. The risk is also
medium. Most of the venture capital funds are interested
in investing at this stage.
(b) Replacement finance
The venture capital funds may purchase existing shares
from entrepreneurs or their associates to reduce their
holdings in the unlisted companies. Persons other than
entrepreneurs or their associates sometimes sell shares,
which are known as 'money out' deal. Ordinary shares
may be bought by the venture capitalists and converted
into preference shares with a fixed rate of dividend.
These preference shares can be converted into ordinary
shares when the company gets listed in the stock
exchange. However, everything depends on the
negotiations. This form of finance is not commonly
prevalent.
fcj Turnarounds
Turnaround financing is provided to an entrepreneur for
acquiring a viable non-performing company and
strengthening its operation. Buying a sick unit needs
monetary and managerial input. A sick unit is in need of
equity funds for sustenance and key management skills
to monitor its operations. These factors have to be
provided by the venture capitalist. An original venture
capitalist or an entrepreneur may not be interested in a
sick unit. The financing resembles a relief package with
adequate funds, good management and operation
leadership. A new venture capitalist acquires majority
control. He plays a vital role in resetting the management
and decision making of the enterprise to overcome the
present crisis.
Once the turnaround happens, the venture capitalist can
get back his funds by listing the company in the stock
exchange or by sale of the shares in the Over the Counter
Exchange of India. The scope for capital gain is high in
turnaround finance within a short period of six months to
two years. But there is always a risk of dead loss and the
enterprise may not revive or recover. Hence, the venture
capitalist has to undertake a thorough study of the capital
structure, management and market potential for the
product.
(d) Buy-outs
This means the transfer of management control either
through management buy-outs or management buy-ins.
Buy-outs is a new from of investment in European
venture capital industry. US banks had first launched the
buy out practice in UK during the 1960s and 1970s. The
success of these buy-outs led to the growth of this
concept in other countries too.
(e) Buy-ins
In management buy-out, VCF provides finance to the
existing management/investors to acquire another
existing product line or business but in management buy-
ins, an outside group of managers is provided with funds
to buy an ongoing company. Here, three parties are
involved, a management team, a target company and the
VCF. The buy-ins are more risky because the outside team
of managers finds it difficult to analyse and assess a new
company. Usually sick units and weak performing units
are targeted for buy-ins. However, buy-outs are popular
because of the following reasons.
 The risk is less in the buy-outs because they
purchase an established business enterprise.
14
  There is a favourable climate in the developed
nations to create small enterprises as more
flexible profit centers.
 Larger corporations have been disposing off their
peripheral units to concentrate on their core
activity.
 Entrepreneurial development is possible with
buy-outs of small undertakings.
 In buy-out finance VCFs, bankers and
management work in close cooperation leading to
the success of the enterprise. Even though the
buy-outs are popular, the success of the buy-outs
is determined by:
o commitment of the management
o technical and financial expertise
o co-operation of trade union, and
o capacity to generate cash and liquid
assets to meet the borrowing cost and
earn profit.
In general, the risk perception in the buy-outs is low and
the time frame involved is also short.
Credit Rating
Indian capital market has witnessed a tremendous growth in
the last decade. The market is very competitive and offers a
wide variety of choice to investors. Since a lot of companies
raise money and each company proposes to raise capital
through different debt instruments, it is difficult for the
investors to judge, whether an investment is safe and
reliable or not. Sometimes companies have defaulted in
payment of interest on deposits and debentures and have
not repaid at the time of maturity. Therefore, to help the
investors make a decision on investments, the need for an
Independent and reliable agency was felt to rate debt
obligations of the companies. Thus, the credit rating agency
came into existence. Credit rating agency means a body
corporate, which is engaged in the business of rating of
securities offered by way of public or rights issue.
THE CONCEPT
Credit rating is simply an opinion on the future ability and
legal obligation of an issuer to make timely payments of
principal and interest on a specific fixed income security.
According to Credit Rating Agencies Regulations 1999, rating
means an opinion regarding securities
 Expressed in the form of standard symbols
 Assigned by a credit rating agency
 Used by an issuer of such securities
Rating is expressed in alphabetical or alphanumeric symbols
on the basis of the underlying credit quality of the debt
instruments. Credit rating is thus a symbolic indicator of the
current opinion of the relative capability of an issuer to
service its debt obligation in time. Grading assigned to the
instruments helps to analyze the credit risk associated with
various instruments.
The primary objective of rating is to provide guidance to
investors/creditors in determining a credit risk associated
with a debt instrument/credit obligations. It does not
recommend buying, holding or selling and it is not based on
audit. It only assesses and gives opinion for a specific
purpose. It does not give guarantee for the completeness or
accuracy of the information on which the rating is based.
Ratings can be revised, either upward or downward, on
assessing the various conditions and factors of an entity.
Thus, credit rating is flexible in nature.
Historical Perspective
The history of credit rating can be summarized as follows:
1841 - Louis Tappan established the first mercantile credit
rating agency. It rated the ability of the merchants to pay
their financial obligations.
1949 - John Bradstreet set up a rating agency and published
a rating book.
1859 - Robert Dun acquired Louis Tappan's rating agency
and published a rating guide.
1900 - John Moody founded Moody's Investors' Service.
1909 - John Moody introduced the first bond ratings and
published the manual of railroad securities.
1914 - Rating coverage was extended to major industries
and utilities.
1916 - Poor Publishing Company published its first rating.
1922 - Standard Statistics Company was established.
1933 - Robert Duns and John Bradstreet companies merged
and Dun & Bradstreet was formed.
1941 - The Standard Statistics Company and Poor
Publishing Company merged to form Standard & Poor.
1962 -. Dun & Bradstreet became the owner of Moody's
Investors Service.
1970 - From then, a number of rating agencies came into
existence. The major rating agencies that came into
existence include JBRI (The Japan Bond Research Institute,
Japan), D & P (Duff and Phelps, Chicago) and Fitch (Fitch's
Investor Service, New York). Credit rating agencies were
established in many countries such as Malaysia, Philippines,
Mexico, Indonesia, Israel, Pakistan, Cyprus. Korea, Thailand,
Australia and India.
1987 - CRISIL (Credit Rating and Information Services of
India Ltd.) was established.
1991 - ICRA (Investment and Credit Rating Agency of India
Ltd.) was set up.
1994 - CARE (Credit Analysis & Research Ltd.) came into
existence. 1996 - Duff and Phelps Credit Rating India Ltd.
was established.
15
Classification of Credit Rating
The classification is as follows:
Debenture and bond rating: Long-term instruments like
debentures and bonds of corporate bodies, governments or
quasi governments are rated by the rating agencies.
Debenture rating is the primary and major business of the
credit rating agency.
Equity rating: The rating of equities of the companies is
called equity grading. Equity rating is very common in
international capital market. At present, equity rating is
undertaken by rating agencies in India.
Fixed deposit and certificate of deposit rating: These
are the medium term instruments rated by the rating
agencies. The fixed deposit provisions offered by the finance
companies and corporate bodies are rated to ensure their
safety and security.
Commercial paper rating: This short-term instrument is
also rated by the agencies. Reputed and high sound
corporate bodies issue commercial papers to the public and
financial institutions. Its main objective is to raise short-
term capital. It has been made mandatory for the
commercial papers to get reviewed and rated by the rating
agency.
LPG/Kerosene dealers/firms rating: The Ministry of
Petroleum and Natural Gas recommended a mandatory
evaluation of all private companies selling LPG and
kerosene. Rating certificates have to be taken from
CRISIL/CARE/ICRA. The objective is to help the consumers
identify the genuine companies before applying for a
connection. It is made mandatory for the companies to
disclose their rating to the public.
Chit funds rating: Even though it is not mandatory for the
chit funds to get rated, some of them get themselves rated.
CRISIL rates chit funds incorporated as public or private
companies with a minimum net worth of Rs 5 lakh and an
operating track record of ten years.
Real estate developers rating: Usually, this rating is for a
particular project and not for the company as a whole.
Projects with approved plans and necessary planning
permits are taken up for rating. CRISIL undertakes the rating
of real estate projects.
Banks rating: The debt servicing ability of a bank is rated.
The Bank of Baroda and the State Bank have been rated by a
rating agency. ICRA has a tie up with the international
banking agency, IBCA Ltd. for rating of banks. CRISIL also
rates banks. The CRAMEL model has been adopted for
rating banks, i.e., C (capital adequacy), R (resource raising
ability), A (asset quality), M (management evaluation), E
(earning potential) and L (liquidity).
Rating of structured obligations: The structured
instruments are credit rated in the case of securitization.
Assessing the credit risk of the structured instrument is
difficult for the ordinary investors. Credit rating provides an
objective assessment of the default risk of the structured
instruments.
Sovereign rating: The credit worthiness of a country and
its credit probable risks are rated. Standard and Poor rates
the nation’s worthiness and indicates it through various
symbols. Depending on the potential and economic
development that takes place in a country, the sovereign
ratings are upgraded or downgraded.
Customer rating: Customer's paying capacity is rated with
regard to debt in due time.
Advantages of Credit Rating
Credit rating is an opinion on the future ability and legal
obligation of the issuing company to make timely payments
of its debt security. Therefore, it is beneficial to the investor,
the rated instrument issuing company, intermediaries and
others. The advantages for each group are listed here.
To investors
 Assessment of Credibility: Rating assesses the
strength and weakness of the company/ debt
instrument on the basis of certain predetermined
factors. The assessment is carried out judiciously
and impartially. Hence, it is beneficial to the
investor to understand the credibility of the issuing
company.
 Risk indicator. Ordinarily, the common investors'
risk perceptions largely depend on the reputation of
the names of the promoters or the collaborators
but evaluation based on 'name recognition' cannot
be an effective substitute for systematic risk
evaluation. A reputed name cannot assure success
or be free from default risk. However, a credit rating
agency rates the instrument after analysing the
various aspects of the company. All the investors
may not possess the required knowledge and
information for credit evaluation. In this context,
investors can identify the risk associated with them
with the symbols assigned to the instruments by the
credit rating agency. They can compare the return
and the risk involved in investing in a particular
security.
 Protects against bankruptcy: The financial
strength of the issuing company is assessed through
credit rating. High rating assigned to the debt
security of a company indicates a safe investment.
 Easy to understand: The rating is given in the
form of symbols. Once the symbols are clearly
explained, it is easy to understand and use them. No
analytical knowledge is required to understand the
rating.
 Enables quick decisions: An investor can take
quick decision based upon the rating. There is no
need for him to study or know the fundamentals of
the company, its actual strength, financial standing,
management details, etc. This saves the energy and
time of the investor and helps him to take quick
decisions.
 Independent decision: The investor can build his
own portfolio without the help of the portfolio
managers By carefully watching upgrades and
downgrades of the credit rating, he can alter his
portfolio mix.
 Portfolio diversification: Rating is not only helpful
to the individual/small investor but also to an
organized institutional investor. Large investors may
16
 use credit rating for portfolio diversification by
selecting appropriate instruments from a broad
spectrum of investment options.
 Rating surveillance: Rating is not a one-time
business. It is a continuous process. Rating agencies
continuously watch the financial strength and other
related factors of the company. If they find that the
situation is not up to the mark, they downgrade the
instruments and give a warning signal to the
investor and the company. The investor has to
reorganize his portfolio and the company has to
Rating helps the merchant bankers and other capital market
look for alternate ways for strengthening its
intermediaries in their ventures.
credibility.
 Other services: The rating agencies conduct
research studies and provide industry reports,
seminars and open access to analysts of the
agencies for discussion. Thus rating protects the
investors' interest and facilitates wise investment
decisions.
Advantages to the issuers
reduces the cost of the public issue. Further, rating
could be used as a benchmark for issue pricing.
 Motivates growth: Rating instils a feeling of
confidence and encourages the entrepreneurs to
undertake new projects and expand the existing
projects. With a higher credit rating, a company can
mobilize the needed funds from the public and
financial institutions.
Advantages to the intermediaries
 It enables proper planning, pricing, underwriting
and placement of the issues. Brokers and dealers
could use ratings to monitor their risk exposures.
 This saves their time, cost, energy and manpower in
analyzing the investment risk.
 Rating is also used in securitization of assets and
helps the special purpose vehicle to repackage the
assets.

 Lowers the cost of borrowing: The higher rating In general, credit rating:
for safety provided by the rating agencies builds the  Grades the debt instruments
investors' confidence in the payment of principal  Provides reliable information
and interest. The issuing company can capitalize on  Identifies strengths and weakness
this by lowering the rate of interest. The investors  Enhances marketability of debt securities
who are interested in the safety of the instrument  Widens the investor base
do not mind the marginal decline in the in the rate
of interest. The issuing company could borrow at a
low rate of interest as well.
 Widens investor base: The issuers of rated Rating Process
securities are likely to have access to a much wider
Rating involves a series of steps. It is an interactive
investor base as compared to unrated securities.
process as an issuer asks the rating agencies to gather
The opinions of the rating agency build up investors'
information and rate his instruments. The steps involved in
confidence which could enable the issuers to raise
the rating process are divided into four stages as given.
funds even in a slumped market. The rating itself is
used as an advertising tool to raise funds in various
media.
 Fosters a better image: The financial and
managerial performance of an issuer is analysed
and ratings are assigned to their instruments. Rating
creates a better image for an issuer. An issuer
himself improves his image when he has to get the
rating. Hence, it builds a better image for the rated
instrument.
The primary stage
 Induces self discipline: Rating requires the
disclosure of accounting system, financial reporting This stage consists of:
and management pattern. This disclosure imposes
self-discipline on the functioning of the company.  Rating request
An issuer tries to maintain the standard of rating  Assigning a rating team
attained by them or to improve the rating which
Rating request: An issuer of the instrument makes a
would help them to raise more funds. This makes
formal request or mandate to a rating agency in writing.
him have a code of self-discipline.
This formal request consists of the terms of the rating
 Lowers the cost of issue: A higher rating makes it
assignment. The terms are maintenance of confidentiality,
more accessible to the investor. The rating itself
right to accept or not to accept the rating, provision of
speaks volumes. There is no need to have wide
information needed for rating and acceptance of
publicity or adopt other ways of publicity like
subsequent surveillance of the rating agency. Along with the
organizing an investors' meet or brokers' meet. This
request for rating, they pay the initial non-refundable rating

17
fees and agree to pay the fee for surveillance. They also
enclose the audited annual reports of the company for the
past five years or as required by the agency. After receiving
a request, the rating agency makes a detailed agreement
specifying the terms and conditions of such assignment.
Assigning rating team: Based upon the request, a rating
agency assigns the work to a rating team. It generally
consists of two members. This team consists of the persons
who possess the necessary skill and expertise to evaluate
the relevant instrument.
Fact-finding and analysis
This is the second stage of the credit rating. It consists of
collection of information, meetings with management, plant
visits and preparation of report. The various steps in this
stage are given below:
Collection of information: Rating agencies give the
required list of information and the framework for
discussions. The issuer has to supply the required
information and data needed for analysis. The data
requirement is recorded on the basis of the previous
studies. Apart from primary data, a rating agency collects
secondary information about the industry as a whole to
which the company belongs. It draws secondary information
from its own research division. The credit rating agency also
has a panel of industry experts who provide guidance on
specific issues related to their areas of expertise.
Management meetings and plant visits: The future
earnings of the issuing company have to be assessed. It
requires assessment of qualitative factors. This could be
carried out with the help of discussions at the management
level. In general, the company's future plans, competitive
edge and financial policies are discussed.
Plant visits are arranged to know more about the
production process and raw material requirement, assess
the technology involved in production and evaluate the
quality of technical personnel. Credit rating agencies try to
form an opinion on the key variables that affect the cost of
production and the quality of production. They can also
assess the progress of the projects under implementation
through plant visits.
Rating stage
This stage consists of preview meeting and rating
committee meeting.
Preview meeting: After gathering all the required
information, the available data is analysed. The internal
committee discusses the findings in detail. The committee
consists of senior analysts of the credit rating agency. The
factors that affect the rating are identified. For example, the
bearing of government policy on that particular industry is
identified. In the same way, several factors that affect the
healthy functioning of the particular company and in turn
the performance of the instruments are analysed and
discussed. Based on these discussions, an opinion on the
rating of the instrument is arrived at.
Rating committee meeting: Every credit rating agency
has professional rating committees comprising members
who are adequately qualified and knowledgeable to assign
rating. All rating decisions including the ones regarding
changes in rating are taken up by the rating committee. This
committee has the final authority to assign ratings. The
rating team presents its findings about the issuer's business
and management. All the issues relevant to the rating are
discussed. The recommendations of the internal committee
are considered and analysed by the rating committee. Based
on the analysis, rating is assigned to the credit instrument.
Final stage
While rating a security, every credit rating agency exercises
due diligence in order to ensure that the rating given by it is
fair and appropriate. Once the instrument is rated, it has to
be communicated and reviewed and watched with the
passage of time. Hence the final stage consists of
communication of rating, review of rating and its
surveillance.
Communication of rating and acceptance: The rating
assigned to the credit instrument along with key issues is
communicated to the concerned top management. An
issuer retains the right to accept or reject the ratings. Once
the rating is accepted, the issuer discloses it to the public. If
the rating is not accepted, it is not disclosed and complete
confidentiality is maintained. Sometimes an issuer may
request for review of rating. The rating agency may ask for
fresh inputs and clarification before finalizing the rating for
the second time. The rating committee takes up the issuers
and if the clarifications provided are convincing, the initial
rating given to the credit instrument is revised.
Surveillance: This is one of the major benefits that an
investor derives from the rating agency. It monitors the
rating over the accepted tenure of the rated instrument.
Throughout the tenure, the issuer is bound to provide the
required information as agreed. Usually, rating is reviewed
once a year. However, there can be an early review of the
rating in case of an extraordinary circumstance.
Surveillance review retains the original rating, upgrades it or
downgrades it. Information regarding the new rating is
disseminated through press releases and websites. In the
case of listed securities, rating is informed to the stock
exchanges where the said securities are listed. If the client
does not cooperate with the credit rating agency, the
agency shall carry out the review on the basis of the best
available information. However, the credit rating agency
shall disclose to the investors that the rating is based on
best available information.
18
RATING FRAMEWORK
Rating provides an opinion on the relative credit risk
associated with the rated instrument. Rating is carried out
on the basis of the information related to primary and
secondary cash flows of the company. Primary cash flow is
the cash generated through the operations which is the
main source of servicing the obligations of the debt
instruments. Secondary cash flow is made of the available
marketable securities, which can be liquidated if required to
supplement the primary cash flow. Short-term rating
depends much on the secondary cash flow and long-term
rating on the adequacy of the primary cash flow. Cash flow
is affected by business, finance and fundamental factors.
Business risk analysis is related to:
 Industry
 Market
 Operational efficiency
 Legal position
 Management
Industry analysis: If any company belongs to a particular
industry, the risk attributed to the particular industry affects
the company as well. Demand, supply, structures of the
industry and government policies regarding the industry
have an impact on the company. Demand for the products
of a particular industry depends on the stage of growth and
maturity of market. The nature of demand may be seasonal
or cyclical or even continue throughout the year. The nature
of product and availability of close substitutes also affects
the demand for the product.
The supply conditions depend on the availability of raw
material, threat of forward integration and switching costs.
The cost structure of industry in terms of raw material,
labour and plant capacity has to be considered. The
competitive strength of the industry in the domestic and
international market has to be analysed. Government
regulation and policy indicate the government's attitude
towards industry. Government may either protect or be
liberal towards the new entrants. The government policies
may either induce growth or restrict its expansion. Upper
limit for the ranking is set with the help of industrial risk
analysis. Ratings are assigned to individual companies within
that limit.
Market Analysis: All the factors related to the marketing
of the product of a particular company are analysed in
detail. The factors analysed are:
 Market share
 Competitive edge
 Brand equity
 Distribution channels
 Research and development
The dominance and stability of market share show the
ability of a company to stand in the market in the face of
competition. The competitive advantage of a company is
further enhanced by the marketing and distribution,
strength and weakness and the marketing/ support services
provided. The strong brand equity commands better
grading. The research and development activities avoid
product obsolescence. Quality improvement commands
better marketing and grading as well.
The analysis of the above mentioned factors reflects the
ability of an issuer to maintain or improve its market share
and command difference in pricing. A company which
maintains a stable market share is able to get a favourable
long-term rating while companies with declining market
share are not rated favorably.
Operational Efficiency: The competitiveness of a
company's product is largely determined by cost and
operational efficiency of the company. Operational
efficiency leads to cost efficiency and price leadership. The
availability of raw material decides the unhindered
production of the product concerned. If a company depends
on imported raw material, government import policies and
the happenings in the international market affect the
company more severely than a company which depends on
the local raw material.
Location factor also provides advantages such as availability
of raw material and skilled labour. The ability of the
company to have vertical and horizontal integration
influences the operating efficiency of the company. The
operating efficiency of the firm is measured with the help of
cost effectiveness of plant and technology capital, labour
productivity and cost of energy.
Legal Position: The terms of debenture trust deed,
arrangements for timely payment of interest and principal,
arrangements for buy-back facilities or repurchases if any
and scope of a trustee's responsibilities are analysed to find
out the legal position of the company. Pending cases against
the company and the history of past legal battles are also
analysed. These analyses indicate the issuers' credit and
trustworthiness, which are essential in rating the debt
instrument.
Management: Good and capable management generates
profit to investors. The management of the firm should
efficiently plan, organize, activate and control the activities
of the company. The ability of the management is analysed
with the help of the management's record over the past
years. Its ability to maintain efficient production and expand
the markets is studied. The functional ability of
management to work with employees and unions is
analysed. Detailed discussion is held with the management
to get an insight into the qualities of the management.
Organization structure and information system are also
assessed. Timely project implementation, performance of
group companies and transactions with them are also
considered in understanding the management quality of the
rated company.
19
CREDIT RATING AGENCIES IN INDIA
The major credit rating agencies in India are:
 Credit Rating Information Services of India Ltd.
(CRISIL)
 Investment and Credit Rating Agency of India Ltd.
(ICRA)
 Credit Analysis and Research Ltd. (CARE)
Credit Rating Information Services of India
Ltd. (CRISIL)
This rating agency was established in the year 1987. It
was promoted by ICICI, UTI, rationalized and foreign
banks and insurance companies. It reached the public in
1992 by offering 20 lakh equity shares worth Rs 10 each
and listed in the stock exchanges. A strategic alliance with
Standard & Poor's rating group was made in 1995. A
subsidiary named 'Global Data Services of India Ltd.' was
incorporated in the year 2001. It collects data relating to
company, trade, industry, geographic and other ancillary
matters.
Objectives are:
 To assist both individuals and institutional
investors in making investment decisions in fixed
income securities
 To enable companies to mobilize funds from a
wider investor base in large amour: -and at a fair
cost
 To enable intermediaries to place debt
instruments with investors by providing them
with an effective marketing tool
 To provide regulations with a market driven
system for bringing about disciplined and healthy
growth of capital markets
The services
The services provided by CRISIL are rating services,
information services and advisory services.
Rating services: The primary objective of CRISIL was
rating the debt instruments issued by companies.
Gradually, the sphere was extended to other areas too. It
rates rupee denominated credit instruments for both
long and short term, which includes debt instruments
such as, bonds, debentures, fixed deposit programmes
and certificates of deposit. During 1995-96 it introduced
ratings on municipal bonds, liquefied petroleum gas (LPG)
and superior kerosene oil. Subsequently ratings on
mutual funds, bank loan ratings and public finance ratings
were launched.
CRISIL rates the structured obligations and asset
securitization programmes. The first Mortgage Backed
Securities (MBS) issue originated by HDFC and LIC
Housing Finance Ltd. was rated by CRISIL during 2000-01.
Assessing the credit quality of the state electric boards
and the state governments is carried out by CRISIL. It also
rates the real estate developers in association with
National Real Estate Development Council (NAREDCO)
Financial strength of the insurance companies is also
rated.
Information services: The investment research division
of CRISIL provides an analytics review of Indian economy,
capital markets, industry and companies through various
publications. Many of the institutional investors,
merchant bankers, commercial banks, financial
institutions, finance companies, brokers, mutual funds
and asset management companies are clients to this
division. Some of its publications are given below.
CRISIL Rating Scan: Announces new and current ratings
and disseminates CRISi_ rating rationale.
CRISIL Eco Scan: Provides detailed macro-economic
statistics with regular updates.
CRISIL View: Carries opinion on the credit quality of the
company and helps an investor to take proper investment
and lending decisions.
CRISIL Bancard: Gives information regarding select Indian
banks, their background and management of the bank.
Gives an analysis of funding and lending portfolio, finance
and productivity.
Bond Yield Tables: Serve as a reference table for calculating
yield to maturity on bonds in Indian debt market.
CRISIL Fund Scan: Provides an Internet product for
comprehensive mutual fund tracking and query. It also has
other two-business publications named CRISIL Insight and
CRISIL Alert Its website www.crisil.com provides the needed
information about functioning, publication and ratings
carried out by CRISIL.
Advisory services: A wide range of financial advisory
services are provided based on in-depth understanding of
business and industry conditions. It provides services on
restructuring, privatization, financial evaluation, credit
management and risk management. It also provides advice
on infrastructure, credit assessment, policy guidelines and
strategy for disinvestment. It conducts evaluation of bids for
projects, especially for the states and central governments,
development agencies and financial institutions. It evaluates
the bidders for prospective joint ventures. It assesses the
credit quality of the various state governments. It assesses
the utilities based on the fundamental strength in terms of
operating and efficiency, particularly state electricity
boards. It undertakes customized studies for Indian and
international consultants, project advisors and financiers.
Investment Information and Credit Rating
Agency of India Limited (ICRA)
This rating agency was promoted by IFCA and twenty-one
other share holders comprising nationalized and foreign
banks and insurance agencies. ICRA was established in 1991.
IFCA holds 26 per cent of share capital. In 1998, Moody
20
Investors' service took up a minority stake in the equity
capital of ICRA. Like CRISIL, ICRA also offers rating services,
advisory services and investment information services. ICRA
rates rupee denominated debt instruments such as bonds
and debentures (long term), fixed deposit programmes
(medium term), commercial papers and certificates of
deposit (short term), structured obligations and sector
specific debt obligations (issued by infrastructure
companies). ICRA also undertakes rating of LPG, kerosene,
firms/dealers and banks. In July 2001, ICRA and National
Real Estate Development Council (NAREDCO) had jointly
launched a programme to grade real estate developers. This
project was designed tn make the investors and buyers of
the property aware of the risks associated with the
developer's ability to deliver the products in accordance
with the terms, quality and safety standards stipulated and
to help the banks and financial institutions to form an
independent opinion on property developers.

Under advisory services, ICRA provides strategic counseling

and general assessment for restructuring of power, telecom
and postal departments. It carries out credit assessment of
companies which have planned to obtain special assistance
from banks, financial institutions, factoring companies and Limitations of Rating
financial services companies. The assessment indicates the The various limitations are as follows:
relative degree of capability of the company to repay the
interest and principal as per the terms of contract. Rating does not recommend buying or selling: A high
credit rating should not be considered as a recommendation
Investment information services of the ICRA include reports
for buying or selling. It is not necessary that if the debt issue
on specific industries, sectors and corporate equity related
of a company has a Triple A rating, the company's debt is
services like equity rating and equity assessment.
worth investing in. The company's earning and growth
prospect are more important. However, credit raters are
Credit Analysis and Research (CARE)
more interested in the company's solvency and its ability to
CARE was established in the year 1992. It was promoted by repay its debt, especially during recession.
IDBI and several other banks, insurance companies and
It is issue specific: Rating is given for a particular
investment institutions. It provides credit rating information
instrument or issue and not for the company. It is possible
services, equity research and rating of parallel markets of
for two issues of the same company to have different
LPG and kerosene. It rates all types of debt instruments like
ratings depending on the characteristics of the instrument.
debentures, fixed deposits, certificate of deposit,
Moreover, rating also depends on the terms and conditions
commercial papers and structured obligations. It covers
of the particular instrument. For example, an instrument
both short-term and long term debt instruments. Under
backed by collateral security will have a higher rating than
information services, it provides information on any
the one that is unsecured. This also means that strictly
company, local body, industry or the sector required by
speaking, a debenture AAA rating and a fixed deposit (which
business enterprise. These reports are specially meant for
is an unsecured instrument) AAA ratings are not strictly
the concerned institution, and strict confidentiality is
comparable.
maintained.
Possibility of getting different ratings: Credit ratings are
CARE also prepares credit reports on companies for the
opinions of the credit rating agencies on debt issues of
benefit of banks and other business and counter parties.
companies. It is quite possible to get different ratings for the
Equity research is carried out on the basis of fundamental
same company from two different agencies, and it happens
factors affecting the industry and economy. The market
often. For example, ICRA has rated Apple Credit's fixed
share of relative companies management capabilities and
deposit programme as MAA, higher than CRISIL's FA.
international competitiveness are analysed extensively far
the shares listed in the major stock exchanges. This helps Review lag: Rating agencies review ratings of a new issue
the investors to identify the potential growth stocks. before they hit the market. This means that there might
have been a change in the credit quality of the company in
Rating Symbols: To distinguish the credit quality of the
the interim period, which might not have been considered
instruments or borrower, different symbols have been used
by the rating agencies.
by different rating agencies. The symbols indicate highest
safely to highest risk. The symbols used by CRISIL, ICRA and
CARE for different instruments are given in separate tables.
21
CREDIT RATING AGENCIES AND SEBI
It can be clarified with the following:
Registration
Any person proposing to commence any activity as a credit
rating agency should get a certificate from SEBI for the
purpose. The board shall consider the application under
regulation 3, if a person belonging to any of the following
categories promotes the applicant.
(a) A public financial institution, as defined in section 4A of
the Companies Act, 1956 {1 of 1956).
(b) A scheduled commercial bank included for the time
being in the second schedule of RBI Act 1934.
(c) A foreign credit rating agency recognized by or under any
law for the time being in force in the country of its
incorporation, having at least five years of experience in
rating securities.
(d) Any company or a body corporate, having a continuous
net worth of minimum Rs 100 crore as per its audited
annual accounts for the previous five years prior to filing of
the application with the board for the grant of certificate
under these regulations.
General obligations
The general obligations to be fulfilled by the credit rating
agencies are given below:
i. Every credit rating agency has to enter into a
written agreement with each client whose securities
it proposes to rate. The terms and conditions should
be specified in the agreement.
ii. Every credit rating agency shall continuously
monitor the rating of securities rated by it during
the lifetime of such securities.
iii. The changes in the newly assigned ratings should be
promptly informed to the investing public through
press releases and websites.
iv. Every credit rating agency should frame appropriate
procedures and systems for monitoring the trading
of securities by its employees in the securities of its
clients in order to prevent contravenes. (Securities
and Exchange Board of India—Insiders Trading
Regulations 1992.)
v. Every credit rating agency should give the
definitions of its symbols and should state that the
rating does not constitute recommendations to buy,
hold or sell any securities.
vi. When the board calls for any information from a
credit rating agency for the purpose of these
regulations, including any report related to the
activities, it should pr it within the specified period.
vii. Every credit rating agency should comply with
guidelines, directives, circulars and instructions
issued by the board from time to time on the
subject of credit rating.
viii. Every credit rating agency shall, at the close of each
accounting period, furnish the board copies of its
balance sheet and profit and loss account.
ix. Every credit rating agency shall keep and maintain
the books of accounts and documents related to
credit rating for a minimum period of five years.
x. Every credit rating agency shall treat the
information supplied to it by the client as
confidential, and no credit rating agency shall
disclose the same to any other person except where
such disclosure is required or permitted by any law
in force for time being.
Restrictions on rating
Credit rating agency should not rate a security issued by its
promoter. In case the promoter is a lending institution, its
chairman, director or employee shall not be a chairman,
director or employee of the credit rating agency or its rating
committee.
No credit rating agency shall rate a security issued by an
entity which is a borrower of its promoter or a subsidiary of
its promoter or an associate of its promoter.
Inspection and investigation
SEBI may appoint one or more persons as inspecting officers
to undertake inspection or investigation of the books of
accounts and records of the credit rating agency. Inspection
is carried out
• To ascertain whether the books of accounts, records and
documents are being maintained properly
• To ascertain whether the provisions of the Act and the
regulations are being complied with
• To investigate the complaints received from investors,
clients or any other person on any matter with a bearing on
activities of the credit rating agency in the interest of the
securities market or in the interest of investors
Inspections to judge the appropriateness of ratings may be
ordered by the board, only in case of complaints which are
serious in nature.
It shall be the duty of the credit rating agency whose affairs
are being inspected a investigated and of every director,
officer or employee thereof, to produce to the inspection or
investigating officer such books, accounts and other
documents in its custody or control and furnish him with
such statements and information relating to its rating
activities required by the inspecting officer .within such
reasonable period specified by the said officer.
The inspecting officer on completion of the investigation
submits a report to the board. He may submit an interim
report if required by the board. The board after considering
-inspection report, communicates the findings to the agency
and gives it a reasonable opportunity of being heard in the
respective matter.
22
On the receipt of the explanation, the board may call upon
the credit rating agency to take such measures as the board
finds it fit in the interest of securities market and for due
compliance with the provisions of the Act and regulations.
Action in case of default: A credit rating agency which fails
to comply with any condition subject to which a certificate
has been granted or contravenes any of the provisions of
the Act, is liable to either of the penalties, i.e., suspension of
registration or cancellation of registration.
A penalty of cancellation of certificate of registration of
credit rating agency is imposed by the board if the credit
rating agency is found guilty of fraud and has been
convicted of an offence involving moral turpitude or an
economic offence. In case of repeated defaults of the
nature mentioned in sub-regulation (1) of regulation 34, the
credit rating agency is declared insolvent or wound up.
The order of suspension or cancellation of certificate of
registration shall be passed by the board, only after holding
an enquiry in accordance with procedure specified in
regulation 38. The enquiry is not necessary when the credit
rating agency is declared insolvent or wound up. The order
of suspension or cancellation of certificate of registration
shall be published by the board in at least two daily
newspapers.
Code of Conduct: According to the third schedule, the credit
rating agency should follow the code of conduct given
below. A credit rating agency shall:
 Observe high standards of integrity and fairness in
all its dealings with its clients and fulfill its
obligations in an ethical manner
 Render high standards of service, exercise due
diligence, ensure proper care and exercise
independent professional judgment at all times
 Endeavour to ensure that all professional dealings
are affected in a prompt and efficient manner
 Disclose possible sources of conflict of duties and
interests to the clients while providing unbiased
services wherever necessary
 Avoid any conflict of interest of any member of its
rating committee participating in the rating analysis;
disclose any potential conflict of interest to the
client
 Maintain an arm's length relationship between its
credit rating activity and any other activity. A credit
rating agency shall abide by the provisions of the
Act, regulations and circulars which may be
applicable and relevant to the activities of the credit
rating agency.
Further, the credit rating agency shall not:
 Indulge in unfair competition, nor shall it wean
away clients of any other rating agency on an
assurance of higher rating
 Make any exaggerated oral or written statement to
the client either about its qualification or its
capability to render certain services or its
achievements in regard to services rendered to
other clients
 Divulge to other clients, press or any other party,
any confidential information about its client which
has come to its knowledge without making
disclosure to the concerned person of the rated
company/client
 Make false statement or suppress any material fact
in any documents, reports, papers or information
furnished to the board or to the public or to the
stock exchange and
 Be a part to - (a) creation of false market; (b)
passing of price sensitive information to brokers,
members of the stock exchanges, other players in
the capital market or to any other person in respect
of issue of securities rated by it. It shall also not take
any other action which is unethical or unfair to the
investors.
Credit Cards (Plastic Money)
Plastic money has enhanced individuals' access to funds and
changed their attitude towards credit. In the mid-1990s
there were three or four credit card issuers with Citibank in
the lead. However, now with the establishment of new
private sector banks, there is stiff competition among the
banks to attract customers of the credit card segment. The
public sector and private sector banks offer wide varieties of
cards such as credit card, chars card, debit card and smart
card so as to suit the customer's need and the convenience
of the bank.
CONCEPT OF CREDIT CARD
A credit card is a plastic card with a magnetic strip on which
essential information such as:
 Card holder's account number
 The date of validity
 Name of the issuing bank
 Endorsed specimen signature of the card holder are
given
The word credit originated from the Latin word credo
meaning 'trust'. Credit card enables a card holder to
purchase goods, dine in a restaurant, stay in a hotel or
travel without making immediate payment. The bank makes
payment to the establishment concerned. The payment is
accommodated for the card holders for a specific period of
time, say for forty-five days. It enables the card holder to
purchase goods and services without cash at select places.
Origin of Credit Cards
The history of bank cards industry dates back to 1914 when
Western Union issued the first consumer charge card. Cards
were issued to the companies' preferred customers with the
objective of providing a variety of special services including
deferred payment without finance charge. During the first
half of this century, hotels, departmental stores and
23
gasoline companies issued charge cards. Diner's Club Card
was introduced in 1950. This card was accepted by a variety
of merchants. Diner's paid merchants after deducting a
small percentage as service charge. Card holders were billed
monthly and required to pay the full money on receipt of
statements.
In the late 1940s, a number of US banks started issuing their
customers 'scrips' that could be used like cash in local shops.
The Franklin National Bank formalized the practice by
introducing the first modern credit card in 1951. Soon after
that 100 banks issued cards. The Bank of America card, now
known as Visa International was first issued in 1958. It was
successful because it had the entire state of California as a
potential market and like other bank cards; it offered credit
to the card holders. It had an option of paying a part of the
outstanding amount as a finance charge.
A group of enterprising American bankers who were not
'franchisee' of Bank of America card decided to bank
together and create a network of their own accepting one
another's local credit cards to manage the interchange
functions of authorization, clearing and settlement In
August 1966, the Inter-Bank Card Association (ICA) was
formed. In 1967, ICA acquired a group of banks in California
and rights to the 'Master Charge' (now called Master Card
International). In 1975, INET (Inter bank Network for
Electronic Transfer) was implemented by Master Charge.
INET replaced the actual meaning of charge slips among
members by automating the clearing and settlement of
these slips. In 1979, Master Charge changed into Master
Card. As an anti-counterfeiting feature, Master Card
introduced laser holograms on the card in 1983.
Outside the US, Bank of America continued to license banks
to issue Bank Americard. There was resistance to issuing
cards in the name of Bank of America. Bank Americard
became Visa, retaining its distinctive Blue, White and Gold
bands. Before that in 1974, IBANCO was formed—a
multinational non-stock membership corporation to
administer the International Bank Americard programme.
Origin of Credit Card in India
The credit of introducing the card goes to Diner's Club India
Private Limited. The membership of the Diner's Club in India
was deliberately restricted to a much-selected category of
persons. As the banking network did not support this
scheme, it was not successful. Initially, the Reserve Bank of
India did not give permission to any bank to independently
issue cards in the market. The banks were required to
associate themselves with other card organizations.
Accordingly, banks in India formed a group to issue credit
cards. Andhra Bank, Bank of Baroda, Central Bank of India,
Canara Bank, Bank of India and Vijaya Bank embarked on
the credit card business.
The Central Bank of India, a public sector bank was a
pioneer in the field of launching credit cards in the Indian
Market. It launched the credit card on 11 August 1980.
Andhra Bank issued its Andhra visa card in 1981. At present,
many banks issue credit cards. These are Amex Green, ANZ
Gold, ANZ Silver, CitiGold, BoB Card, Cancard etc.
Working Mechanism
The credit card involves three parties:
a. The issuing organization or bank
b. Card holder (individuals, corporate bodies or non-
corporate bodies)
c. Member establishments
A credit card organization or bank enters into an agreement
with several establishments in different parts of the
country, to provide goods and services to the credit card
holders. Agreements are made with the establishments in
other countries too. The following diagram illustrates the
transactions that take place among the respective parties.
Transactions through credit card
 A credit card holder utilizes the services or buys the
product of a member establishment.
 A purchase statement is prepared by a member
establishment and submitted bi-monthly to a bank.
 Depending on the nature of agreement, discount is
deducted and the rest is paid to a member
establishment.
 Consolidated statement regarding the purchases
made or services availed by a credit card holder is
sent to the respective credit card holder.
 According to the established norms of the
respective bank, a credit card holder makes
payment to the bank on or before the stipulated
period.
Many business enterprises dealing in goods and services
such as retail outlets, departmental stores, restaurants,
hotels, hospitals, travel agencies, petrol stations and
railways accept credit cards. Indian Railways collects one
rupee per ticket in addition to the fare from the credit card
holders as a service charge. But, most of the business
outlets provide a certain percentage" of discount on the
credit card transactions to the user.
Steps Taken by the Member Establishment
A business enterprise or any other organization, which
accepts credit cards, takes some measures to avoid
fraudulent practices by customers.
 The validity period of a card is checked to ensure
that a card has not expired. The invalid card list is
checked. A bank or issuing organization sends
particulars about the cancelled/lost/withdrawn
cards to its member establishments.
24
  It is ascertained that the card holders' number or
name is not in the 'hot list' or warning bulletin.
 It is verified that the signature of the card holder
and the specimen signature are same.
 The card is also checked for tampering of number or
extension of date.
An establishment after ensuring the validity of the card gets
an impression of the card and signature of the card holder
and prepares the charge sheet with all details in triplicate.
All the three parties namely a card holder, establishment
and an issuer of the card have a copy of the charge sheet. A
merchant establishment consolidates all the transactions in
a summation sheet cum BAR defaulting in triplicate. It sends
the summation sheet cum BAR in duplicate and the charge
slip to the bank concerned. Money is paid within thirty days
from the date of receipt of charge slip. The bank settles the
amount after deducting the commission amount. The time
element related to the non-payment period varies from
bank to bank ranging from forty-five days to sixty days. In
some banks, it is extended up to ninety days. !fr
When a credit card holder does not pay the installment/bill
amount on time, he is considered as a defaulter. If the
debtor (credit card holder) does not repay the dues on time,
it is but natural for the bank to proceed against the
defaulter. The banks take three different types of action
such as blacklisting card holders, entrusting the
responsibility of recovering the dues through professional
agencies and initiating legal action against defaulters in
compelling situations. In order to protect the financial
interest of banks and to avoid further defaults, banks are
compelled to blacklist a particular card holder. If a bank
blacklists a particular card holder; it informs all the member
establishments.
Eligibility
Credit card allows a customer to make purchases without
any immediate cash payment for them. A bank makes
payment to the member establishments (stores or
restaurants) and customers pay the bank when the billing
statement is sent to them. To avoid nonpayment and
defaults, an issuer lays down the eligibility criteria for card
holders. The eligibility criteria depend mostly on the income
of the customers. Different cards are issued depending on
the income of the person for example:
 Standard Card is the most basic card without any
frills, offered by issuers.
 Gold Card/Executive Card is a credit card, which
offers a higher line of credit to a card holder than a
standard card. Income eligibility for this card is also
higher. In addition, issuers provide extra perks or
incentives to card holders.
 Platinum Card provides a higher credit limit and
additional perks than a gold card.
 Titanium Card offers even higher credit limit than a
platinum card. Cancard Visa and Cancard Master
Card have the eligibility criteria of gross annual
income of Rs 60,000. But, Cancard Visa International
(Gold), which is exclusively for exporters and
professionals frequently visiting abroad, asks for the
annual income of Rs 2,00,000. Likewise ICICI bank
has fixed for True Blue/Sterling Silver card, the
eligibility criteria of Rs 60,000 p.a. for the salaried,
and Rs 50,000 p.a. for a self-employed person. It
also offers Solid Gold card for Rs 1,20,000 p.a. for
the salaried and Rs 1,00,000 p.a. for the self-
employed.
Documents Needed
The applicant has to submit certain documents before being
issued a credit card. If he is a salaried person, he has to
submit service and salary certificate/pay slip and IT returns/
form no. 16.
Proprietorship/partnership/private Ltd. has to submit IT
returns, form 16, plus the latest six months banks statement
showing salary credit for employees. Some banks require
latest balance sheet, profit and loss account and board
resolutions. A self-employed person has to submit IT returns
form. Individuals are required to submit their photographs
as well.
CREDIT CARD CHARGES
Credit card involves a certain amount of cost to the holder.
These charges depend on the type of card requested and
the service levels of the issuing banks. Different banks may
charge differently for the same type of card. The following is
a listing of different charges associated with the credit card.
Entry fee: Entry fee is collected to issue a new credit card.
This charge ranges from Rs 100 to Rs 400 depending upon
the issuing bank and the nature of card requested. Often,
banks waive this charge.
Annual fee: The annual fee is not paid in cash, but is
included in the first billing statement received by the card
member. It is also payable in advance. It could be as low as
Rs 400 for a Cancard or as high as Rs 1500 for an HSBC Gold
Card.
Supplementary card/add-on card fee: To keep an additional
card for any member of his family like father, brother, sister
or spouse; a card holder has to pay a fee specified by an
issuing bank per additional card. This charge varies from Rs
125 to Rs 1000.
Cash advance (withdrawal) fee: This charge is paid to
withdraw cash using a credit card from an automatic teller
machine. Cash advance fees are very high and mostly in the
range of 2.5 per cent per transaction with a fixed minimum
of Rs 50 or 100 per transaction.
Lost card liability fee: This is paid on the expenses incurred
during the period between the loss of card and the time
taken by the card holder in reporting it to the bank. The lost
liability charge is mostly restricted to a maximum sum of Rs
1000. If a card is lost or stolen, then a card holder must
inform the bank immediately. The bank deactivates the
particular credit card; to prevent any fraud.
25
Late payment fee: As the term indicates, it is a charge
imposed on late payment, i.e., when payment is made after
the grace period. Generally finance charge (the interest on
the outstanding balance) and late payment charge are
collected. Some card issuers may also impose penalty rate if
there is more than one late payment within a fixed period.
The rate is levied under specific circumstances set out by
the card issuer. For example, if two late payments are made
within six months, a card issuer may raise the interest rate.
Outstanding Balance Calculation
Finance charge paid by a card holder depends on the
outstanding balance of a customer and the periodic rate
charged by a card issuer. The balance and timing of
purchases and payments affects the finance charges to be
paid. The outstanding balance is calculated in different
modes. These are:
(a) Average daily balance method
(b) Two cycle average daily balance method
(c) Previous balance method
Average balance method: This method is calculated in two
ways (i) including new purchases and (ii) excluding new
purchases. In the including new purchase method, the
balance is the sum of outstanding balances for every day in
the billing cycle (including new purchases and deducting
new payments and credit) divided by the number of days in
the billing cycle. However, in the excluding balance method,
balance is the sum of the outstanding balances for everyday
in the billing cycle (excluding new purchases and deducting
payments and credits), divided by the number of days in the
billing cycle.
Two Cycle Average Daily Balance Method: Here also one
type includes new purchases and the other type excludes
the new purchases. In including the new purchase, the
balance is the sum of the average daily balances for two
consecutive billing cycles. Daily balance for the current
billing cycle is ' calculated by summing the outstanding
balances for everyday in the billing cycle (including new
purchases and deducting payments and credits) and dividing
the total by the number of days in the billing cycle. The
other daily balance is from the preceding billing cycle.
Previous balance method: In this method, the balance is
the outstanding balance at the beginning of the billing cycle.
Billing: Payment towards card dues can either be in direct
billing or in account mode. In direct billing a card holder has
to pay the amount by means of demand drafts or cheques,
directly to the card division. Under debit to account mode,
the dues are automatically debited to the card holder's
account on the due date.
The billing dates are different for different cards. Even the
same issuer fixes different billing dates for the various cards
he issues. For example BOB card's billing date is ten of every
month; whereas the billing date for BOB Global and BOB
Exclusives is first of every month. For BOB Premium, it is
twentieth of every month.
Grace period: It is a period of about 25 days, during which
a card holder can pay without incurring a finance charge.
Under nearly all credit card plans, the grace period is
permissible only a card holder pays the full balance, each
month. It is not applicable, if a card holder carries a balance
forward. Also grace period usually does not apply to cash
advances that may accrue interest from the date of
transaction.
Payment: There are many easy ways to pay the monthly
credit card bill. It can be paid through ATM, Transferring the
bill amount from the savings account, Net banking, Through
standing instruction, Utilising drop box option or Over the
counter payment
TYPES OF CARDS
The various types of cards are:
Debit Card: A debit card has a direct access to the
customer's account. Whenever a customer uses it, his bank
account is debited immediately. Unlike credit cards, one
does get any credit period while using debit cards. The
purchase limit is equivalent to the balance in a customer's
account. A customer controls how much he spends and a
bank merely informs the balance amount. Mastercard
International introduced this in collaboration with Citibank.
An annual fee is charged for a debit card. A debit card
holder is charged for cash withdrawals, bank statements
and when the bank balance falls below the stipulated
minimum. Most of these cards come with reward schemes
and discounts. Citibank has a reward scheme with points as
for the credit cards. Standard Chartered has a travel cash
back scheme. In the case of Standard Chartered Grindlays,
some discount is offered if the debit card holder buys the
ticket using his card from IND travels. The debit cards may
be direct or deferred debit cards.
Direct Debit Card: It allows only online transactions. An
online transaction works like a straight ATM transaction. It is
an immediate electronic transfer of money from a card
holder's bank account to a merchant's account. This
requires a card holder to enter his or her Personal
Identification Number (PIN) at the store's terminal. The
system checks card holder's account to ensure if there is
enough money to cover the purchase.
Deferred Debit Card: This is similar to a credit card,
bearing a Visa or MasterCard logo and can be used
wherever the card's brand name is displayed. However it is
not a credit card. Rather, this card allows offline as well as
online transactions. Offline purchases resemble a credit
card Transaction. When the card is presented at a store or
establishment, it is 'swiped' on the EDC terminal.
The merchant's terminal reads the card and creates a debit
against the account. However, instead of debiting the
account immediately, the transaction is stored to be
processed later, usually within two to three days. Instead of
using a PIN, the customer signs a receipt as he would sign
with a credit card. Most offline transactions are verified
26
immediately to make sure that there is enough money in
the account.
Benefits of Debit Card
An account holder is eligible for a debit card too. Most
accounts come with a debit card. Debit cards can also be
used to access ATMs. There is no need to have any extra
card but a card holder is charged for using it at ATMs other
than that of the issuing bank. HDFC charges Rs 55 for any
transaction from other bank. Standard Charted provides
four transactions a month from any ATM and more than
that are charged. The main attraction of using a debit card is
that there is no need to make payments. This does away
with the need to carry cash and traveler’s cheques to a
great extent. The annual charges are also reasonable.
Standard Chartered Bank charges Rs 100 per for its debit
card. HDFC charges Rs 250 per annum and Rs 125 is
refunded if the card is used at a merchant location within
the first month of issue. Annual fee is waived for the first
year for up to one additional card. All the subsequent cards
are charged. It charges Rs 100 as issuance charge.
Another advantage of a debit card is that there is no way
that an account holder gets into debt. If the card holders do
not have money, they will not be able to spend. Wheareas,
in case of credit cards, delayed payment is penalized with
heavy interest rates of up to 30 percent per annum.
Many debit cards offer lost card insurance, purchase
protection and personal accident cover. These cards are
international and some can access ATMs across the world.
Banks get a commission from merchant establishments and
unlike in credit card there is no credit risk in debit cards.
Debit cards help the banks to some extent to acquire the
'savings bank' customers who are not offered this facility.
Finally, debit cards like ATMs can also reduce crowding of
bank branches, which in turn helps to bring down the
transaction costs.
Smart Card
With Internet revolution, card holders felt a need for an all-
in-one product, incorporate the salient features of a credit,
ATM and a debit card and taking care of various transact!:
Smart cards are cards with microprocessor chips.
Technologically, it is a migration fr magnetic stripe
technology to silicon chip but the operations are the same
as that; credit card. A smart card is dipped in a chip reader
instead of swiping a credit c -through a card terminal.
Therefore, a merchant or a department store should have a
c. reader in addition to a magnetic stripe reader.
Smart card helps a card holder to make purchases on the
Internet. It enables a card holder to work from any place
with the aid of laptop computers. An integrated circuit chip
with its enhanced memory and processing capacity can
accommodate several differ e: applications and hold more
information than credit cards. It helps to make secure
purchase over the Internet, anytime, anywhere and pay for
the public transportation and public phone calls, as well as
make traditional credit and debit purchases. The
application-chosen by the consumers for their cards depend
on their individual needs. Common smart card benefits
listed are:
a. Credit
b. Debit
c. Electronic cash payment
d. Electronic ticketing
e. Secured identification
f. Driver’s license
g. Health record
The smart card provides greater fraud control and better
credit risk control management. There are possibilities of
unauthorized and fraudulent use of both credit and debit
card-through fake electronic cards. Lost or stolen cards also
pose another threat. But smart cards offer more security.
The electronic proof of identity (validated by the bank) is
actual locked inside the card holder's personal computer.
The smart cards carry this electrons proof which allows
secure purchases everywhere.
Master card has developed the Mondex payment system,
which offers an alternative to paying cash for goods and
services. Mondex electronic smart cards store and dispense
cash electronically. This disposes the bills and coins. A single
card can store up to five different currencies. It transfers
funds over phone lines, making it easier to reload the card.
Person to person payment is allowed. It helps in electronic
payment.
Offers of the credit cards
The various offers are discussed as under:-
Reward points: Most credit card issuers provide rewards to
promote card usage among customers. Fixed number of
points is awarded on the amount charged on the card.
Depending on the amount of points accumulated, a card
holder is allowed to redeem them in return for products,
discount coupons, magazine subscriptions and so on. The
card issuer enters into an agreement with the participating
member establishment to offer such a reward scheme to
the card holder.
The member establishments are usually garment retailers,
publishers, restaurants, hotels, department stores,
jewellers, appliance manufactures and so on. This
agreement enables the card issuer to ensure the acceptance
of their reward certificates at these establishments. It also
gives the card issuer enough margins to pass on the
discount to the customer and to meet the expenses
involved in servicing the transaction. Citibank card holders
gain one point for every 100 rupees worth of purchases
made through the card. These points can be redeemed for
gifts, select product purchases and even for paying the
annual fees. Each point is equivalent to one rupee. The
Standard Chartered card holders get one reward point every
125 rupees worth of purchase made through the card.
27
Discount coupons: Card issuers tie up with establishments
and provide discounted sales, e.g., American Express has
come up with a scheme under which a card user can
accumulate bonus reward points when he makes purchases
using the American Express card at select retailers and
restaurants. However, most of these discount offers do not
serve the needs of the value-conscious salaried class which
incidentally constitutes the target chunk of regular card
users.
Personal loans: Many international banks offer a personal
loan up to the maximum credit limit available to a credit
card holder with a good credit history.
Insurance cover: While issuing credit cards, banks take into
account the possibility of unforeseen accidents and offer
insurance coverage. Road, rail, water and air accidents are
covered for the credit holders. Some of the public sector
banks operating in credit cards in India, extend
compensation to the card holders who are killed in
accidents. In case of personal accidents, Bank of Baroda
offers a compensation of Rs 3 lakh for road accidents and Rs
6 lakh for air accidents. Bank of India extends a sum of Rs 2
lakh in personal accidents and Rs 4 lakh for air crashes.
Foreign banks offering credit cards in India offer a
compensation ranging from Rs 2 lakh to Rs 10 lakh.
Baggage cover: Insurance cover to the card holder's
baggage is provided. This assures the safety of insurance in
the event of losing one's baggage while travelling. This is
useful for frequent travelers. Gold cards and international
credit cards offer this type of provision. This facility is not
available in other types of credit cards.
Advantages of Credit Card
Credit cards ensure a wide range of benefits to card holders,
issuers and member establishments.
For the Card holder: The advantages for the card holders
are:
 A card holder can purchase things without
immediately paying for them.
 A card holder can spend beyond the actual limit
through the overdraft facility provided by the bank.
 A card holder can pay later and can make use of the
money for some other purpose in the intervening
period
 It relieves the card holder from the danger of
carrying cash and protecting it.
 A credit card easy to carry and convenient to
operate.
 Credit card provides a status symbol to the card
holder.
 Many rewards, freebies and discount facilities can
be enjoyed by a card holder.
Advantages to the issuing banks:
 Credit cards enhance the earnings of a bank since it
charges different fees for different services. A high
rate of interest is charged if a card holder does not
pay within a stipulated period.
 Enables the banks to acquire new customers.
 It reduces the number of transactions by cheques.
 The banks get member establishment.
Advantages to the member establishmen
An establishment has guaranteed payment, when a charge
slip is submitted to the bank.
Speedy settlement of bills by banks.
Credit facilities are offered by issuing agencies, thus
removing the burden of providing credit facilities to the
customer if he needs it.
A credit card increases the volume of business transactions.
Disadvantages
The various disadvantages are as follows;
Heavy interest payment: A credit card does not come free
of cost. A card holder has to pay an annual fee, service
charge and interest charge beyond the grace period, e.g.,
assume that a bank: generates a bill for purchases made
between 12 March and 11 April, which is due on 30 April. If
the entire due amount is cleared on or before the due date,
no interest is charged. I Therefore, if the purchase was on
11 April, one enjoys 20 days of free credit and if the
purchase was on 12 March, the free credit period works out
to almost fifty days.
But once the due date is over and the all the dues have not
been cleared in full, the interest clause becomes effective.
This can work out to quite a hefty amount, because of the
manner in which the interest is charged. The interest
mentioned, usually between 1.99 per cent and 2.95 per cent
is the 'per month' interest rate. This works out to be an
astronomical 24 to 36 per cent on an annual basis.
Purchasing beyond capacity
Possessing a credit card tempts the customer to purchase
beyond his income limit. With no compulsion to settle the
entire bill at the end of the billing cycle, a holder may be
tempted to revolve the credit. This could be dangerous, if
done frequently.
Bogus credit cards: The process of making bogus credit
cards is called credit card cloning or skimming. Someone
acquires the credit card details of another person, copies
them on a bogus card, and begins using the credit card.
Usually bartenders, wait staff or shop assistants are bribed
to participate in this practice because they handle credit
cards. They swipe customer's credit cards with the help of a
pocket size scanning slot. This can be done within a few
seconds without the customer's knowledge. The device
copies the information held on the magnetic strip into
memory. This information can subsequently be copied to a
counterfeit card complete with security holograms.
Alternatively, the information can be used to overwrite a
stolen credit card, which becomes easier to handle. In UK, $
28
200mn was spent with cloned credit cards. At present,
smart chip credit cards are created to prevent the creation
of bogus credit cards.
Some of the disadvantages of credit cards to the member
establishments include the payment of heavy commission to
the issuing institutions and occasional delay in the
settlement of the bills by banks.
Merchant Banking
Indian banking system experienced a number of changes
during the seventies. It could not limit its activities to the
basic functions of mobilizing deposits and lending loans. It
had to cater to the needs of industry and trade. This led to
the launching of merchant banking, an innovative product
of banking. Merchant bankers offer a package of financial
services and funds. They are said to be at the helm of affairs
in the primary market. The depth and sophistication in the
merchant banking business have been improving since the
avenues for raising funds are widening and the demand for
funds is increasing.
THE CONCEPT OF MERCHANT BANKING
Merchant banks do not offer usual banking services to the
public. These banks specialize in activities that facilitate
trade and commerce. The dictionary meaning of merchant
banking is that any organization that underwrites corporate
securities and advises clients' issues of mergers, acquisition,
etc., of the commercial ventures.
Securities and Exchange Board of India (Merchant Banker's)
Rule 1992 has defined a merchant banker as any person
who is engaged in the business of issue management either
by making arrangements regarding the selling, buying or
subscribing to securities as a manager, consultant, advisor
or rendering corporate advisory service in relation to: such
issue management. The issue management consists of
preparation of prospectus and other information relating to
the issue, determination of the financial structure,
origination of the type of securities and nature of issue. It
also consists of final allocation of securities or refund of
subscription, corporate advisory services to the issue and
underwriting of the issue. ; The services of the merchant
bank also cover project counselling, pre-investment
activities, feasibility studies, project reports, design of
capital structure, issue management, underwriting, loan
syndication and mobilization of funds, foreign currency
finance and advising services for mergers, amalgamation,
takeover and venture capital. Merchant bankers can turn to
any of the activities depending upon resources, such as
capital, foreign tie-ups for overseas activities and skills. It is
not necessary for merchant bankers to do all the activities.
They may specialize in only one activity and take up other
activities which may be supportive to the specialized
activity.
History of Merchant Banks in India: The merchants from
the European countries particularly from Britain and France
introduced the concept of merchant banking in India, in the
late nineteenth century. The merchant bankers set up
agency houses. Advice was offered to the local merchants
but at a high rate. Some of them were Cropper Benson and
Rathbones (1820), Ogilvy Gillanders & Co (1824) and
Arbuthnot & Co (1833). Many of the merchant bankers
became bankrupt during the nineteenth century. They were
not able to withstand the competition of the new entrants.
In late sixties, managing agency system was popular in India,
and it subdued the functioning of merchant bankers. The
leading managing houses of the British were Andrew Yule,
Gillanders, Hendersons, Duncan Brothers, etc. The
renowned Indian managing Houses were Tatas, Birlas,
Dalmias, Singhanias, etc. However, the performance of the
managing agency system came under severe criticism. In
1970, the managing agency system was abolished.
The National Grindlays Bank took the lead in introducing
merchant banking service in India in 1967. The merchant
banking division of the Grindlays bank managed new capital
issue, carried out evaluation, promotion and appraisal of
projects and provided other services related to merchant
banking services. This induced City Bank to start merchant
banking operation in 1970. The various tasks performed are
assisting new entrepreneur, evaluating new projects and
raising funds through borrowing and issuing equity.
The Banking Commission (1972) in its report stressed the
necessity of establishing merchant banking services in a
developing economy like India. It suggested the setting up
of a separate institution for merchant banking services
other than banks and financial institutions. The need for
providing merchant banking services was very well received
by the banks. The State Bank of India was the first
commercial bank to start the merchant banking division in
1972. The encouraging performance of the merchant
banking division made the State Bank of India to organize a
wholly owned subsidiary named the SBI Capital Market Ltd.
in 1986 with an authorized share capital of Rs 50 crore with
a paid-up capital of Rs 20 crore. Followed by the State Bank
of India, Central Bank, Syndicate Bank, Bank of Baroda,
Standard Charted Bank started their own merchant banking
divisions/ subsidiaries.
The development financial institutions also started their
merchant banking division. ICICI established its merchant
banking division in 1973. The Industrial Finance Corporation
and Industrial Development Bank of India started their
merchant banking division in 1986 and 1991 respectively.
The leading broker firms like ITC Classic Finance, KOTAK
Mahindra Finance, Prudential Capital also offered merchant
banking services.
Merchant Banking Services Providers
The Banking Commission (1972) was in favour of setting a
separate institute for merchant banking to render
specialized services. However, merchant banking divisions
and subsidiaries were started by foreign banks, commercial
banks, financial institutions, and private finance companies.
29
Foreign Banks: Grindlays bank's merchant banking division
was the first to introduce merchant banking -ice in 1967.
Later, Citibank was the second bank to start merchant
banking activities in 1970. Along with this, Chartered Bank
and Hong Kong Bank were also active in offering merchant
banking services.
Indian Banks: In India, State Bank of India was the first bank
to take up merchant banking activities. SBI Capital Market
Limited was established by it. Private sector banks also set
up their merchant banking divisions. Mercantile bank set up
its merchant banking division in 1978. The merchant banks
affiliated to or subsidiaries of commercial banks have the ^
advantage of relying on the resources of the parent
institutions in the time of need.
Financial Institutions: These also started their merchant
banking divisions. Industrial Finance Corporation '\ of India
(IFCI) has its own merchant banking division.
Private Merchant Bankers: The wide range of activities that
the merchant bankers offered attracted the stock broking
houses and private financial companies to establish
merchant banking divisions or subsidiaries. Foreign financial
companies are also allowed to set up merchant banking
division or subsidiaries. Enam Financial Consultancy, Karvy
Investor Services Ltd., JM Morgan Stanley Ltd., DSP Merril
Lynch Ltd., etc. are some of the examples of the private
merchant bankers.
FUNCTIONS:
In the past, a merchant banker was a financial intermediary
facilitating the flow of capital among the concerned parties.
Today, a merchant banker plays multiple roles, which
include ' those of an issue manager, a management advisor,
an investment banker and a portfolio j manager. This shows
that the breadth and depth of a merchant banker's activity
has changed over the years. Functions of the merchant
banking are given below:
 Project advisory service
 Corporate advisory service
 Credit syndication
 Financial structuring
 Issue management
 Underwriting
 Portfolio management
Project Advisory Service: The entrepreneurs need project
advisory services to give a concrete form to their idea. The
project report has to be prepared. The financial
requirements are to be assessed and appraised.
Conceptualizing the project idea: This involves
developing a basic idea of an entrepreneur into a plan and
giving shape to a project. The plan for executing a basic idea
is given in a project report. In simple terms, the action plan
for a seed idea is conceptualized in a project report. A
feasibility report and a project report are more or less
similar. The technical process planned is studied under
technical feasibility report. Along with technical feasibility,
location, means of finance, market surveys and
management aspects are also included in the project report.
Financing pattern of the project: Financial pattern of the
project is prepared in accordance with a set of rules,
regulations and norms prescribed by the government and
the term lending financial institutions. Key contracts and
structures are reviewed. Financial modeling and sensitivity
analysis are carried out. Assistance is provided in financial
evaluation and negotiation. Foreign partners and investors
are also identified.
Appraisal: The basic parameters for project appraisal are
technical feasibility and commercial and financial viability. It
is also appraised on the basis of social-benefit,
environmental, managerial and social aspects. The
merchant bankers take efforts to co-integrate the above
areas in the project proposal.
Technical feasibility: Different norms are applied to conduct
techno-economic feasibility and viability test. Foreign
collaboration and the extent of transfer of latest technology
and other terms are appraised. It mainly analyses the
project from all angles to ascertain whether it is technically
feasible to execute the project.
Commercial viability: It is checked on the aspects of buying
procedures, selling arrangements, and market survey. The
merchant bankers scrutinize the accuracy of methods,
reliability of projections and predictions. The project should
be commercially viable and should not end up in loss.
Financial liability: It is appraised on two different aspects.
First mobilization of resources from different sources is
assessed. Then the projected working results, cost of
production estimates, sale and revenue generation are
assessed.
Contents of the Project Report
A well-written business plan is necessary to make the
investors or venture capitalists to become equity partners in
the company. They need to justify that an investor's money
will result in the desired return. A good report increases the
chances of success with lenders and investors. The
preparation of a business plan and presentation of report
have to address the following topics:
1. Executive summary : Activities and products,
history, market, target (who and where),
competitors and amount of funding required.
2. Vision and mission (Vision, Mission statements)
3. Company overview (Legal business description,
Company name, Legal form of business, Business
location, Government regulations, Management,
Management team and subsidiaries,
Responsibilities)
4. Product strategy (Current Product, Return on
investment and Useful features/benefits)
5. Market analysis (SWOT (strengths, weaknesses,
opportunities, threats) analysis of the industry,
Market segment, Competition, Environment risk:
30
 economic and natural, Observations and
conclusions)
6. Market Plan (Size of the markets, Industry trends,
Geographic location, Sales and profit potential by
country/continent, Customer profile, Customer
needs: problems with competitors' products,
Product benefits, Sales strategy, Advertising, and
Media objectives and strategy (television, radio,
newspapers, magazines, etc.)
7. Financial Plan (Business partners, Structure of the
primary market instruments, Key financial
contracts, financial modeling, financial forecast
and Risk analysis)
Corporate Advisory Services
These are needed to ensure better corporate
performance, successful existence and growth. In a wider
sense, these cover the subject matters dealt by the
business economists and financial consultants. Corporate
advisory service is different from secretarial counseling,
which is performed by a practicing secretary or a charted
accountant-Secretarial counseling is concerned with the
formation of a company, compliance of various
formalities under Companies Act and other legal
formalities, whereas a merchant banker advises the
corporate for its survival and growth. Therefore,
corporate advisory services cover the entire field of
merchant banking activities allowing the merchant
bankers to specialize in a particular area. Within the
ambit of corporate advisory service, fall the project
advisory services, capital restructuring, portfolio
management and financial engineering including venture
capital. Public issue management and loan syndication
also come under the purview of corporate advisory
services. The merchant banker investigates and analyses
the business problem and tries to solve the problematic
areas of the business with his skill and experience. Project
advisory service is generally given on:
• Equity and business valuation
• Mergers, acquisition and divestitures
• Business and financial restructuring
• Privatisation
• Restructuring/rehabilitation advice for weak units
• Asset sale and hive-offs
Merchant bankers study the company's life cycle and
assess the factors that affect the growth of its market
segment and the ability of the company to increase its
market share and profit margins. In mergers and
acquisitions, merchant bankers are generally interested
in companies with low asset bases in relation to
shareholders' value and which consume capital because
of their growth. Therefore providing a capital structure
acquisition is suggested.
In fragmented industries, consolidation can complement
a company's competitive position, improve customer
service and decrease product or service cost. The focus of
the merchant banker is to identify companies that have
the potential for significant improvement in profit.
Companies achieve success because of the quality of their
management. Consequently, merchant bankers
participate as active advisors and work with management
to establish realistic strategic and operational objectives.
Once these goals are established, the company's
management is responsible for all day-to-day business
decisions.
Credit Syndication
Merchant banker's functions related to obtaining credit
like acquiring rupee and foreign currency loans from
banks and financial institutions to finance the project are
known as credit syndication. Project advisory service and
loan syndication are interrelated with each other.
Generally, the merchant bankers perform the following
functions in credit syndication:
• Arrange loan for their clients by analysing their cash
flow pattern, so that the terms of borrowing meet the
client's cash requirements
• Offer assistance in loan documentation procedures
• Place equity with banks, financial institutions, mutual
funds and domestic and private equity funds
• Place preference shares and debentures with domestic
investors
• Organize the financial participation of multinational
agencies, international banks, and foreign banks and
export credit agencies
• Arrange buyers' line of credit/supplier's line of
credit/guarantee assistance, takeout financing and risk
participation
• Carry out the syndication of structured debt instruments
and external commercial borrowings
• Advice on the resolution of inter-creditor issues of off-
shore lenders (including ECA lenders) and domestic lenders
• Advice on commercial issues of loan/guarantee
documentation, sponsor documentation and security
documentation
Financial Structuring
Merchant bankers assist the management of the client
company to successfully restructure various activities, which
include mergers and acquisitions, divestitures, management
buy-outs, joint ventures and other such things. To help
companies achieve the objectives of these restructuring
strategies, a merchant banker participates in different
activities at various stages, which include understanding the
objectives behind the strategy (objectives could be either to
obtain financial, marketing or production benefits). They
help in finding a right partner in the strategic decision and
financial valuation of the proposal.
The merger and advisory services rendered by merchant
bankers may include one or more of the following specific
components or activities. These may either be on the buy-
side transaction, assisting companies to acquire, or on the
sell-side, assisting companies to divest, resulting into
merger, acquisition or other forms of organizational
restructuring. These are as follows:
31
(a) Strategic reviewing and establishing strategic rationale
for merger or acquisition
(b) Performing financial and business analysis
(c) Target screening, identification and evaluation
(d) Financial analysis and valuation of Target Company or
merging companies
(e) Carrying out financial and legal activities with due
diligence
(f) Analyzing the regulatory and tax implications and
evaluating alternative structures
(g) Deal structuring such as merger, friendly acquisition,
hostile bid, asset buy-out.
De-merger, slump sale etc. (h) Advising as to the means and
source of financing transactions and arranging finance
if required (i) Complying with regulatory, requirements
such as managing public offer under
SEBI's takeover regulations
(j) Counseling on biding strategy and tactics and (k)
Establishing negotiating positions and assisting negotiating
with the parties
Issue Management
This forms the 'bread and butter' operation for most of the
merchant bankers. The main area of service involves
management of primary issue, follow on offers, rights issue
of equity (public right), preference shares, convertibles,
partly convertible and non convertible debentures. A
memorandum of understanding (MoU) is entered between
a lead merchant banker and an issuing company. It specifies
their mutual rights, liabilities and obligations relating to an
issue. Along with a offer document, a MOU is also submitted
to the Securities Exchange Board of India. Merchant
bankers' services mainly consist of:
• Structuring of instruments
• Preparation of offer document
• Due diligence certificate
• Appointment of intermediaries
• Submission of offer document
• Management of book-built issues and
• Post-issue monitoring reports
Structuring of instruments
Whether an equity or a debt instrument is to be floated is
decided after analysing the capital structure, financial
requirements of the company and the market conditions.
This decision is made in consultation with the promoters. In
the case of debt instruments, it may be direct debt
instrument or convertible debt instrument.
Preparation of offer document
A merchant banker is responsible for drafting the offer
documents. The preparation depends on the nature of the
issue. If it is a direct public issue, a full prospectus has to be
prepared. However, in the case of a book building issue, a
red herring prospectus without indicating the price has to
be prepared. After the price is discovered, prospectus in full
form has to be issued.
Due diligence certificate
A lead merchant banker has to furnish to SEBI, a due
diligence certificate as specified in schedule III of Securities
and Exchange Board of India (disclosure and investor
protection) guidelines 2000, along with the draft
prospectus. In the case of a debenture issue, a lead
merchant banker shall also furnish to SEBI, a due diligence
certificate given by the^lebenture trustee in the format
specified by SEBI.
The standard of due diligence shall be such that a merchant
banker shall satisfy himself about all the aspects of offering,
veracity and adequacy of disclosure in the offer document.
A merchant banker has to confirm that the disclosures made
in the draft prospectus/letter of offer are true, fair, and
adequate to enable the investors to make a well informed
decision as to the investment in the proposed issue. The
due diligence investigation is normally carried out with the
knowledge and cooperation of the management of an
issuer. The lead managers who are responsible for
conducting this exercise with respect to contents of the
offer document sign the due diligence certificate.
Appointment of intermediaries
A merchant banker assists the selection of bankers, brokers,
registrars, printers, advertising agencies and other
intermediaries. A lead merchant banker shall ensure that
the other intermediaries being appointed are duly
registered with the board, wherever applicable. Before
advising an issuer on the appointment of other
intermediaries, a lead merchant banker shall independently
assess the capability and capacity of the various
intermediaries to carry out their assignments. He shall
ensure that an issuer company enters into a MOU with the
intermediary/intermediaries concerned whenever required.
Underwriters are also invited. A lead merchant banker
should be satisfied about the ability of the underwriters to
discharge their underwriting obligations. A lead merchant
banker has to incorporate a statement in the offer
document to the effect that in his opinion the underwriters'
assets are adequate to meet their underwriting obligations.
A written consent of the underwriters has to be obtained
before including their names as underwriters in the final
offer document.
Submission of offer document
Along with the offer document, a merchant banker has to
submit the following:
• Memorandum of understanding
• Inter-se allocation of responsibilities. In case more than
one, merchant banker manages an issue, the rights,
obligations and responsibilities of each merchant banker
have to be demarcated as specified in schedule II » Due
Diligence certificate
A lead merchant banker also furnishes the following
certificates duly signed by chartered accountants along with
the draft offer documents.
• All refund orders of the previous issues are despatched
within the prescribed time
and in the prescribed manner. « All security certificates are
despatched to the allottees within the prescribed time
and in the prescribed manner;
• The securities are listed on the stock exchanges as
specified in the offer documents.
A lead merchant banker while filing the draft offer
document with SEBI, shall also file the draft offer document
with the stock exchanges where the securities are proposed
32
to be listed. He also makes copies of the draft offer
document available to the public.
The draft and final offer documents have to be hosted on
the websites of the all the lead managers/syndicate
members associated with the issue. He also ensures that the
contents of documents hosted on the websites are the
same as that of their printed versions.
Management of book-built issues
An issuer company nominates one of the lead merchant
bankers as a book runner to the issue and his name is
mentioned in the prospectus. The primary responsibility of
building the book is with the lead book runner.
A book runner on receipt of the offers maintains the record
of the names, number of securities ordered and the price at
which the institutional buyer or underwriter is willing to
subscribe to securities under the placement portion. The
institutional investors also forward their orders, if any, to
the book runner.
On receipt of the information, a book runner and an issuer
company shall determine the price at which the securities
are to be offered to the public. The book runners/determine
the allocation to the qualified institutional buyers based on
prior commitment, investor quality, price aggression,
earliness of bids, etc.
Post-issue monitoring reports
Irrespective of the level of subscription, a lead merchant
banker shall ensure the submission of the post-issue
monitoring reports as per the format specified in Schedule
XVI. These reports shall be submitted within three working
days from the due dates.
A lead merchant banker shall maintain a close co-ordination
with registrars to an issue and arrange to depute its officers
to the offices of various intermediaries at regular intervals
after the closure of the issue. This is mainly to monitor the
flow of applications from collecting bank branches,
processing of the applications and other matters till the
basis of allotment is finalized, security certificates are
dispatched, refund orders completed and securities listed.
Underwriting
It means an agreement with or without conditions to
subscribe to the securities of a body corporate when the
existing shareholders of such body corporate or the public
do not subscribe to the securities offered to them. In
respect of every underwritten issue, the lead merchant
banker/bankers shall undertake a minimum underwriting
obligation of 5 per cent of the total underwriting
commitment or Rs 25 lakh whichever is less.
If a lead merchant banker is unable to accept the minimum
underwriting obligation, he shall make an arrangement for
having the issue underwritten to that extent by a merchant
banker associated with the issue and shall keep the board
informed of such an arrangement.
The outstanding underwriting commitments of a merchant
banker shall not exceed twenty times of its net worth at any
point of time. In respect of an underwritten issue, a lead
merchant banker shall ensure that the relevant details of
underwriters are included in the offer document.
(a) If an issue is proposed to be closed at the earliest closing
date, a lead merchant banker shall satisfy himself that the
issue is fully subscribed before announcing closure of the
issue.
(b) In case, there is no definite information about the
subscription figures, an issue shall be kept open for the
required number of days to take care of the underwriters'
interests and to avoid any dispute, at a later date, by the
underwriters in respect of their liability.
(c) In case there is a devolvement on underwriters, a lead
merchant banker shall ensure that the underwriters honour
their commitments within sixty days from the date of
closure of the issue.
Portfolio Management
The merchant bankers are authorized to render portfolio
management services. Originally, portfolio managers were
large brokers who managed portfolios mostly on an
unstructured basis. The brokers' investment decisions
depended on insider trading, personal contacts and
rumours. However, at present the merchant bankers and
brokers offer portfolio management in a professional
manner. Any individual organization that has a sizeable
amount for investment in securities can approach a
merchant banker or any other person authorized by SEBI to
render portfolio services.
Portfolio management is carried out on the basis of the
contracts signed between the party and the merchant
banker. The contracts specify the objectives of the portfolio
in terms of return and risk, competition of securities,
custody of securities, reporting requirement, fee payable
and repayment. A portfolio is managed as per the terms of a
contract. A contract may specify that every purchase or sale
of the security is to be done with the consent of a client or it
may give freedom to a portfolio manager to decide upon
purchase or sale within the broad parameters of the
contract.
The portfolio management service provided by merchant
banks shall be in the nature of investment consultancy. It is
carried out for an agreed fee. The fee structure is
independent of the return on a non return-sharing basis.
The risk is borne by the customer. As per the SEBI
guidelines, the portfolio manager does not guarantee any
return either directly or indirectly.
Consultancy service is provided to all the clients who need
it. The money can be invested in the money market
instruments and/or capital market instruments or both as
specified in the contract with the client. Money received
from a client for investment is to be deployed as soon as
possible for that purpose and the money due is payable to
the client. The portfolio managers are bound to take
adequate redressal of the grievances of their clients within
one month of the receipt.
A code of conduct has been prescribed for the portfolio
managers. Under it, every portfolio manager is required to
observe a high standard of integrity and fairness in all his
dealings. He should not be a party to the creation of a false
market for securities or price rigging.
Portfolio management services are offered to the non-
resident Indians also. The merchant bankers help them to
33
identify suitable venues of investment, provide guidance in
the purchase and sale of securities, and handle the
transactions. Market conditions are reviewed to give advice
regarding investments. The merchant bankers also provide
safe custody of documents and collect earnings due to the
client's investment. In addition to these they help the clients
to fulfill the necessary legal obligations required of them.
MERCHANT BANKERS' REGULATIONS
The buoyancy in the capital market led to the mushrooming
growth of merchant bankers in the capital market. This led
SEBI to regularize the merchant banking activities. SEBI
Merchant Bankers Regulations 1992 issued guidelines for
the establishment and functioning of the merchant bankers.
Thus, the functioning of merchant bankers was brought
under the ambit of SEBI. Now, the merchant bankers have
to function within a framework of rules and regulations to:
 To foster orderly growth of capital market
 To build investor's confidence and
 To raise funds effectively at a low cost
Registration
The merchant bankers have to be organized as a body
corporate. They have to be registered with SEBI. No person
shall carry on any activity as a merchant banker unless he
holds a registration certificate granted by SEBI. The
merchant bankers are registered under four different
categories.
Category I - eligible to carry on any activity related to issue
management, can act as adviser, consultant, manger,
underwriter and portfolio manager
Category II - act as adviser, consultant, co-manager,
underwriter and portfolio manager
Category III - act as underwriter, advisor or consultant to
the issue
Category IV - act only as advisor or consultant to an issue
Net Worth
The capital requirement depends upon the category. The
minimum net worth requirement for acting as a merchant
banker is given below:
Category I Rs 5 crores
Category II Rs 50 lakhs
Category III - Rs 20 lakhs
Category IV - nil
Registration Fee
Every merchant banker shall pay a sum of Rs 10 lakh as
registration fees at the time of the grant of certificate by
SEBI. A merchant banker shall pay a renewal fee of Rs 5 lakh
every three years, i.e., from the fourth year from the date of
initial registration to keep the registration in force. The
registration is valid for three years for renewal. A merchant
banker has to apply three months before the date of
expiring of registration.
Appointment of Lead Merchant Bankers
All issues should be managed by at least one merchant
banker functioning as the lead merchant banker. If in an
issue of offer of rights to the existing members with or
without the right of renunciation, the amount of an issue of
the body corporate does not exceed Rs 50 lakh, the
appointment of a lead merchant banker shall not be
essential.
Responsibilities of Lead Managers
No lead manager shall agree to manage or associate with
any issue unless h responsibilities relating to the issue
mainly those of disclosures, allotment and refund a clearly
defined, allocated, determined and a statement specifying
such responsibilities is i furnished to the board at least one
month before the opening of the issue for subscription, j
When there is more than one lead merchant banker to the
issue, the responsibilities of | each of such lead merchant
banker shall clearly be demarcated and a statement
specifying] such responsibilities shall be furnished to the
board at least one month before the opening! of the issue
for subscription.
No lead merchant banker shall agree to manage the issue
made by anybody corporate if such body corporate is an
associate of a lead merchant banker.
A lead merchant banker shall not be associated with any
issue if a merchant banker; who is not holding a certificate is
associated with the issue.
Code of conduct
A merchant banker has to observe the following code of
conduct in the course of his business.
1. He has to observe a high standard of integrity and
fairness in all his dealings with j his clients and other
merchant bankers.
2. He has to render high standards of service, exercise
due diligence, ensure proper care and exercise
independent professional judgment at all times.
3. He has to disclose the possible source of conflict of
duties and interests to the clients, while providing
unbiased services to them.
4. He should not make any statement or become privy
to any act, practice or unfair competition, which is
likely to be harmful to the interests of other
merchant bankers or is likely to place the other
merchant bankers in a disadvantageous position in
relation to him, while competing for or executing
any assignment.
5. He should not make any exaggerated statement,
whether oral or written, to the client either about
his qualification or the capability to render certain
services or his achievements with regard to the
services rendered to other clients.
6. A merchant banker shall always endeavor to:
34
 a. Render the best possible advice to the
clients having regard to the clients' needs
and the environment and his own
professional skill
b. Ensure that all the professional dealings are
effected in a prompt, efficient and cost
effective manner
7. A merchant banker shall not:
a. Divulge to other clients, press or any other
party any confidential information about his
client, which has come to his knowledge
b. deal in securities of any client company
without making disclosure to SEBI as
required under the regulations and also to
the board of directors of the client company
8. A merchant banker shall endeavor to ensure that:
a. The investors are provided with true and
adequate information without making any
misguiding or exaggerated claims and are
made aware of the attendant risks before
any investment decision is taken by them
b. Copies of prospectus, memorandum and
related literature are made to the
investors
c. Adequate steps are taken for fair
allotment of securities and refund of
application money without delay
d. Complaints from investors are adequately
dealt with.
9. A merchant banker shall not generally and
particularly in respect of issue of any securities be
party to:
a. Creation of false market
b. Price rigging or manipulation
c. Passing of price sensitive information to
brokers, members of the stock exchanges and
other players in the capital market, or take
any other action which is unethical or unfair
to the investors.
10. A merchant banker has to abide by the provisions of
the Act and rules and regulations which may be
applicable and relevant to the activities carried on
by the merchant banker.
General Obligations
Every merchant banker should maintain:
 Copy of the balance sheet for the accounting
period
 Profit and loss account
 Auditors report and
 Financial statement
Every merchant banker should furnish the above records
after the end of each accounting period. They should be
able to furnish such documents for any other five
accounting years if it is required by the SEBI. If SEBI asks
for half year unaudited financial results, they should be
able to submit these. They have to maintain the records
for a minimum period of five years. SEBI may appoint one
or more persons as inspecting authority to undertake
inspection of the books of accounts, records and
documents of a merchant banker. This is done:
a. To ensure that the books of accounts are
maintained in the manner required
b. To check that the provisions of the Act, rules,
regulations are compiled with
c. To investigate into the complaints received from
investors, other merchant bankers, or any other
person on any matter connected with the
activities of the merchant banker
d. To investigate into the interest of securities
business or investors interest in the affairs of the
merchant banker
Before undertaking an inspection, the SEBI shall give a
reasonable notice to a merchant banker for the purpose.
Inspection may be carried out for investigating a live
purpose, if there is any complaint against them by the
issuing company or by the investor. In the interest of an
investor SEBI has the prerogative to carry out the
inspection with or without prior notice. A qualified
auditor inspects the accounts.
If there is any breach of conduct, SEBI can respond or
cancel the registration depending on the nature of
default. The defaults are categorized into general, minor,
major and serious. Points are given accordingly. The
order of penalty of suspension or cancellation as the case
may be, shall be imposed only after holding an enquiry as
per the prescribed procedure.
Securitization
Securitization has been one of the prominent developments
in financial services. Traditionally, financial institutions held
the loans made by them till they became due. A loan is a
simple transaction, where a borrower wants money, and a
lender gives it at an interest rate. In the secured loan, a
borrower offers collaterals such as real estate or machinery.
The interest is paid until the loan is repaid. In some cases,
however borrower may be unable or unwilling to pay back
the loan. In case of a default, creditors can seize the assets
and sell them to recover their money. However, the seizure
of the asset is a lengthy process. Therefore, these
receivables are securitized now. The concept of
securitization originated in US in 1970s like most other
financial innovations. Today, the mortgage backed securities
market runs into trillions and securitization which is the sub-
sect of the debt market, is gaining popularity in Indian
financial markets too.
Securitization is the process of pooling and repackaging of
homogenous illiquid financial assets into marketable
securities that can be sold to investors. It is a systematic
process whereby loans and other receivables are pooled,
packaged, rated and sold in the market in the form 'of asset-
backed securities. The pooled financial assets and the
underlying cash flow are used to create guarantees for
securities that are offered on retail to institutional investors.
For example, a finance company with a portfolio of housing
loans can raise funds by selling these loans to another
entity.
A finance company can securitize its housing loan portfolios
into instruments with a fixed return which is based on the
35
maturity profile of the housing loans. If the company has Rs
150 crores worth of housing loans and is due to earn 15
percent income on them, it can securitize these loans into
instruments with 14% returns with safeguards against
defaults. These could be sold by one finance company to
another if it needs funds before these loans repayments are
due.
The principal and interest repayment on the securitized
instruments are met from the assets which are securitized.
Thus illiquid financial assets are transferred into a more
liquid form of assets and distributed to a broad range of
investors through the capital market. Securitization is
backed by a wide variety of assets such as vehicles,
construction equipment, real estate and personal loans.
Parties Involved
A securitization transaction generally involves some or all
the parties mentioned below. There are primarily three
parties to a securitization deal namely, originator, special
purpose vehicle (SPV) and investor.
 The originator: Any financial institution, bank or
any other entity, which has decided to adopt
securitization of assets, is known as the originator. It
is the prime mover of the deal, e.g., it sets up
necessary structures to execute the deal. The
originator sells the assets on its books and receives
the funds generated from such sale.
 Special purpose vehicle: The special purpose vehicle
is an entity with defined purposes and activities. It is
established to isolate the receivables and perform
other functions (e.g., restructuring cf cash flows and
provision of credit enhancement and liquidity
support). The pool of assets is transferred to SPV,
and it converts the receivables/ loans into
securities. It issues them in the capital market to the
investors. The capital base of SPV is generally low. It
is usually constituted as a trust under the Indian
Trust Act or as a company under the Companies Act.
The originator may also float SPV as a subsidiary in
the form of a limited company.
 The investor: The investors may be individuals or
institutional investors like financial institutions,
provident funds, pension funds, insurance
companies, etc. SEBI has recently permitted mutual
funds to invest in these securities. They buy the
securities issued by SPV and receive their payments
in the form of interest and principal as per the
agreed terms.
Apart from these primary parties, some parties like the
obligor, the rating agency, administrator, trustee and
the structurer are involved in the process of
securitization. The entire process is broken up into
separate parts with different parties specialising in the
origination of loans, raising funds from the capital
markets, servicing of loans, etc.
 The obligor: The original borrower is the obligor.
The amount due from the obligor is the securitized
asset. The original borrower should meet his
commitments on the due date; otherwise the cash
flow would be affected. Therefore, the whole
process greatly depends on the integrity of the
original borrower.
 Credit rating agency: Since the asset pool has its
own inherent risk, the security issued on the asset
basis has to be rated. The credit rating agencies rate
the securities on the basis of the underlying
strength of assets, the likely cash flow, degree of
risk to the investor, the structure of the issue and
the like. The rating agencies do not stop with one
time review, but keep reviewing the originators
continuously.
 Administrator: Collects payment due from
obligor(s) and passes it to the SPY. T-he
administrator also takes follow up action on
defaulting borrowers and pursues available legal
remedies against them. He is also called the
receiving and paying agent because of his function
of receiving and paying the installments to the
special purpose vehicle.
 Trustee: Is appointed to look after the interest of
the investor and has the responsibility of overseeing
that all parties in the securitization deal perform in
accordance with the securitization trust agreement.
 Structurer: Works as a coordinator of the whole
deal. Normally an investment banker shoulders this
responsibility. The structurer brings together the
originator, credit enhancer, investor and other
partners of a securitization deal. The structurer
works with the originator in structuring the deal. He
also structures the issue in a way to meet all legal,
regulatory, accounting, tax and other requirements.
In certain cases, he underwrites the issue and thus
adds credit to the issue.
Assets to be Securitized
Any pool of assets that has clearly defined predictable cash
flows with historical information on payment, defaults and
loss pattern, can be securitized. The assets should have
similar features in terms of the payment pattern,
documentation and nature of loan. Any form of receivables
like housing loans, consumer loans, and lease rental
receivables could be securitized. The housing loan
receivables are the most favoured asset for securitization.
Credit card loans, government receivables and trade
receivables are also securitized. For assets to be securitized,
a few given characteristics are essential.
 Assets should have consistent cash flow.
 Default rate should be low.
 Principal should be totally amortized at maturity.
 Underlying collateral should be liquid
 There should be diverse obligators so that risk is
diversified.
 Underlying assets should have standard
documentation.
36
The Process
Securitization of assets involves a series of steps. The three
major stages involved are:
A. Transfer of assets
B. Issue of securities
C. Servicing of securities
Each stage has its own features. The typical securitization
structure is given below
Securitization Process
A. Transfer of Assets
The originator or the lending institution has to identify the
receivables to be securitized. The receivables are segregated
into baskets or pools, based on the type of credit,
geographical area and maturity pattern. Mortgage pledges,
charge slips are aggregated into pools c: securities of similar
nature in terms of payment pattern and documentation.
Identified pools of assets are then transferred to the special
purpose vehicle. There are three basic methods of transfer:
Novation: The existing loan agreement between the
originator and the borrower is cancelled and substituted by
a new agreement. The buyer of the loan assumes the role of
original lender. The obligations of the borrower to the
original lender cease. The loan is therefore removed from
the balance sheet of the original lender. Novation is the best
way of selling a loan and effectively transferring both the
rights and obligations.
Assignment: Here, all the rights to principal and interest
are transferred from seller to buyer. The assignment
transfer may be a statutory assignment or an equitable
assignment. Statutory assignment involves transfer of both
legal and beneficial titles. All legal rights to principal and
interest are passed from the seller to buyer. It will also pass
all the legal remedies available against the borrower to
ensure discharge of debts from the seller to buyer.
In the case of equitable assignments, only the beneficial title
is transferred to the buyer. Legal rights are not transferred.
Therefore, in case of a default, the buyer may not be able to
proceed directly against a borrower.
Sub-participation: This is a non-recourse funding
arrangement. Sellers' rights, remedies and obligations
against the borrower are not transferred from the seller to
the buyer. It is entirely a separate arrangement under which
the buyer places funds with the seller. The payments made
by the borrower for the underlying loan are transferred to
the buyer. However, this does not involve the transfer of
loan.
Documentation: Legal agreements are required to define
the rights and obligations of the originator, SPV and the
investor. A transfer agreement is made between the
originator and SPV covering the sale of the existing
receivables, an obligation on the originator to repurchase at
breach of warranty, etc. An administration agreement is
signed between the originator and SPV covering the
administration fees, liability for acts and omissions, etc.
Security trust deed is made to create security in favour of
the investor over the SPV's assets.
B. Issue of Securities
The SPV comes out with securities, after acquiring the
assets. The securities issued may be pass through
certificates, pay through certificates, interest only or
principal only stripped structures and asset backed
commercial papers. The maturity of the issued securities is
structured to match the maturity of the securitized loans.
Issued securities are credit rated or guaranteed by any
external institution to enhance the marketability. While
rating the pass through securities, rating agencies normally
focus on the quality of the loan pool. Getting guarantee or
underwriting the issue provides credit enhancement which
has been explained separately under the heading credit
enhancement. A sense of confidence regarding timely
payment of the principal and interest by the SPV is instilled
by credit rating and enhancement.
C. Servicing of Securities
Repayment of the securitized loan and bill received by the
originator are passed onto the SPV. This facilitates the
servicing of securities to investors. Sometimes special
agents are appointed for collection of dues from the
obligors. This agency performs the job for a commission.
The originator may be appointed as a servicer. If the
originator is appointed as a servicer, his role is minimized to
a collection agent under securitization. Pass through
certificate holders hold the SPV responsible for payment of
their principal and interest.
Benefits of Securitization
Securitization offers a number of advantages to the seller,
investor and debt markets. Securitization increases the
number of debt instruments in the market for the financial
system. It also widens the market by attracting new players
on account of availability of superior assets.
37
A. To Originator: The benefits of Securitization to the
originator are:
Improves liquidity: There is no need for an originator to
hold onto the asset portfolio till it matures. The asset and
trade receivables can be securitized. The relatively illiquid
assets are transformed into cash flow. Long dated
mortgages are converted into cash through Securitization.
Better asset liability management: Securitization improves
the balance sheet of an originator. It removes the assets
from the balance sheet of the originator and thus liberates
the capital for other uses. It enables the restructuring of the
balance sheet by reducing large exposures or sectoral
concentration. An originator acts as a servicer for the
Securitization, receives fees for his service and improves his
financial position as well. The fees received are large when a
large asset portfolio is securitized.
No opportunity cost of capital: The additional revenue
generated through Securitization enables the originator to
take advantage of more profitable investment
opportunities. At the same time, its customer relationship is
retained as well.
Improves transparency: Transparency may be improved
since Securitization results in identifiable assets in the
balance sheet.
Provides market access: Borrowers have a better access to
the market through Securitization. Non-investment grade
financial institutions and originators can fund themselves at
investment pricing grade. Credit enhancement provides an
added comfort to the investor. This helps the originators to
access a wide range of investors. Credit rating helps the
originator to get capital for a longer tenure than normally
available.
Low cost funding: Better market access results in low cost
funding. Credit enhancement and diversification of risk
enables the originator to raise funds at a low cost. Asset
backed securities are generally welcomed by the investors.
Thus, securitized debts are cheaper than other forms of
debt.
Risk dispersal The sale of existing debts reduces the risk of
the issuer and helps it to spread over a large section of
public investors. It enables to repack the portfolio risk
namely, credit risk for expected losses. The originator
absorbs the credit risk for expected loss but second and
third in the line of risk are the credit enhancer and the
investor respectively.
B. For Investors: The benefits of Securitization to the
investors are:
More avenues: Securitization essentially provides an avenue
for relatively risk-free investment. Credit enhancement
provides good quality assets.
Reduces risk: As the pool of assets is spread over a large
geographical area comprising several units, the risk of
failure is reduced. Credit enhancement and credit rating
also reduce the risk. The prevalence of a secondary market
also offers liquidity.
Better Finance Management: Since a securitized instrument
carries regular monthly cash flows, it also provides an
opportunity for matching the cash flows.
MUTUAL FUND
THE CONCEPT OF MUTUAL FUND
Mutual fund is a mechanism for pooling resources by issuing
units in securities to the; investors and investing funds in
accordance with the objectives disclosed in the offer;
document. A mutual fund is a corporation, trust or
partnership, which manages the collected money with the
help of professional expertise. Different persons have
defined mutual funds different ways. 'A mutual fund is
almost like a cooperative society of investors. That is why
the word 'mutual' is used. It collects money from investors
by issuing mutual fund units, invests it in securities, and
divides whatever dividend or interest is received among its
members. (A.John Halin)
The SEBI Mutual Fund Regulations, 1993 defines mutual
fund as 'a fund established in the form of a trust by a
sponsor, to raise money by the trustees through sale of
units to the public, under one or more schemes, for
investing in securities in accordance with the regulations.
Mutual funds are financial intermediaries which bring a
wide variety of securities within the reach of the most
modest investors. The financial intermediary is known as
'Investment Company' in the US and most other countries.
They are called 'investment trusts' in the United Kingdom. In
India, they are known by the term 'mutual funds'.
The Origin of Mutual Fund
The history of mutual fund can be traced back to Europe
where William I established a society in Belgium for such a
purpose. The foreign and colonial Government Trust of Lund
in 1868 is considered to be the forerunner of the concept of
mutual fund. Massachusetts Investor's trust was the first
mutual fund set up in the US in the year 1929. The mutual
fund industry witnessed a boon in the US market after the
1990's and became a popular source of investment. In India,
the Unit Trust of India set up the first mutual fund in 1964.
MUTUAL FUNDS IN INDIA
Until 1987, Unit Trust of India was the sole mutual fund in
the country. This was due to the restrictive policies adopted
by the Government of India with regard to the financial
services industry. The growth of the mutual fund industry
has been divided into different phases.
Phase I: The mutual fund in India came into existence in
1964 when Unit Trust of India was incorporated as a
statutory corporation. The maiden scheme launched by the
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Unit Trust of India was the unit scheme of 1964, an open-
ended scheme, which is still in operation. At that time,
public awareness about mutual fund was limited. There was
no disclosure norm. The institution was modelled along the
lines of mutual funds in the UK. The name "Unit Trust' itself
has been borrowed from the UK where mutual funds are
called 'investment trusts'.
The Unit Trust of India played a commendable role by
launching a number of open as well as close ended
schemes, keeping in view the varied needs of the different
groups of investors. The schemes targeted everyone from a
newborn child to a retired individual.
Phase II: Unit Trust of India’s monopoly came to an end in
1987. The government of India amended the Banking
Regulation Act, permitting commercial banks in the public
sector to set up mutual funds. The first non UTI mutual fund
was launched by the State Bank of India in November 1987
by the name SBI Mutual Fund. Its first scheme, Magnum
Regular Income Scheme was launched in 1987 was well
received by the investors.
Canara Bank established its subsidiary, Canbank Mutual
Fund in Dec 1987. It la two schemes, i.e., Canstock (income
scheme) and Canshare (growth scheme), which were both
close ended. They were also followed by two open-ended
schemes—Cancigo and Cangilt- _ in the succeeding year.
Indian Bank, "Bank of India and Punjab National Bank
introduced mutual funds the year 1989-90. The Government
permitted insurance corporations in the public to establish
mutual funds. Life Insurance Corporation of India set up LIC
mutual fund in June 1989. It targeted small investors
particularly from rural and semi-urban areas. Unlike the
other mutual funds, LIC offered insurance protection to the
investors. This was addition to the benefits of liquidity,
safety and return. Shortly the General Insurance -
corporation of India also entered into the mutual fund
industry.
The Government of India issued comprehensive guidelines
in June 1990 covering mutual funds. Registration of mutual
funds with the SEBI was made compulsory; guidelines
covered the norms for registration, management,
investment object disclosure and pricing. The Securities
Exchange Board of India (mutual funds) Regulations 1993
came into effect on 20 January 1993. The establishment of
Asset Management Company (AMC) and the listing of close-
ended schemes became mandatory. Disclosure norms were
tightened to protect the small investors.
Phase III
The innovative promotional campaigns launched by
different mutual funds create investor awareness. Exclusion
of the private sector was widely criticized. The liberalization
policy and new economic policy advocated by Doctor
Manmohan Singh paved way for entry of private sector into
the mutual fund industry. The SEBI accorded approval
number of players in the private sector to launch mutual
funds in October 1993. Kothari group in collaboration with
the Pioneer fund, the oldest fund in U.S, launched Prima
fund in November 1993. The other private sector mutual
funds include Twentieth Century Mutual, Fund, Taurus
Mutual Fund, Morgan Stanley Mutual Fund, HDFC Mutual
Fund and Zurich Mutual Fund etc. After the entry of the
private sector, the declaration of Net Asset Value (NAV) of
the schemes became regular. At present NAVs are declared
weekly. The portfolios are also disclosed periodically.
Phase IV
After 1996, the mutual fund industry witnessed a healthy
growth. With the growth of investor’s interest in mutual
funds, the number of players operating in the industry
reached new heights. SEBI (Mutual Funds) Regulations, 1996
was introduced by SEBI to set uniform standards for all
mutual funds in India and safeguard the interest of the
investors. The Union Budget in 1999 exempted all dividend
incomes of the mutual funds in the hands of investors from
income tax. The SEBI and the Association of Mutual Funds in
India (AMFI) launched various Investor Awareness
Programmes to educate investors and inform them about
the mutual fund industry.
Phase V
The Unit Trust of India Act 1963 was repealed in 2003, and
Unit Trust of India was bifurcated into two separate entities.
The US 64 scheme which assured return and certain other
schemes were brought under the Specified Undertaking of
the Unit Trust of India with Rs 29,835 crore of assets under
the management as on January 2003. This Specified
Undertaking of Unit Trust of India does not come under the
purview of the Mutual Fund Regulations, but under the
rules framed by the Government of India.
The second is the UTI Mutual Fund Ltd., sponsored by SBI,
PNB, BOB and LIC. It is registered with SEBI and functions
under the Mutual Fund Regulations. It was in this phase that
the mutual fund industry witnessed a consolidation phase.
Mergers and acquisitions became common in the mutual
fund industry. Some examples of these are Birla Sun Life
mutual fund's acquisition of schemes of Alliance Mutual
Fund and Principal Mutual Fund's acquisition of Sun F&C
Mutual Fund and PNB Mutual Fund. Many international
mutual fund players like Fidelity, Franklin Templeton Mutual
Fund etc. have entered India. There were twenty-nine funds
in the end of March 2006. The growth phase is still
continuing in spite of the temporary oscillations in the
performance.
STRUCTURE OF A MUTUAL FUND
The formation and operations of the mutual funds are
governed by the Securities Exchange Board of India Mutual
Funds Regulation 1993. Later, it was replaced by the SEBI
Mutual Fund Regulations 1996. The mutual funds comprise
four separate entities, namely, sponsor, mutual fund
trustee, Asset Management Company and the custodian.
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They are assisted by independent entities such as banks,
registrars and transfer agents.
Sponsor: A mutual fund is to be established by a sponsor
and registered with the SEBI. A sponsor can be any person
acting alone or in combination with a corporate body.
However, a sponsor should have the following
requirements:
 Should have a sound track record
 Should have been carrying on business in financial
services for a period of not less than five years
 Should have a positive net worth in all the
preceding five years
 Should have profits after providing for depreciation,
interest and tax in three out of the immediately
preceding five years including the fifth year
 Should contribute at least 40 per cent of the net
worth of the Asset Management Company
 Should not have been guilty of fraud or convicted
for any offence
Trustee: Mutual funds are established in the form of a
trust. The trustees should be persons of ability, integrity and
standing. Two-third of them should be independent persons
(1998). A trustee should not be an associate or a subsidiary
or be associated with a sponsor in any manner. He should
be appointed with the prior approval of the SEBI. The
meeting of the trustees shall be held at least once in two
calendar months and at least six such meetings shall be held
in every year. An AMC or any of its officers/employees are
not eligible to act as trustees to any mutual funds.
The trustees have the responsibility to safeguard the
interest of the investors. They have wide powers to
overview, supervise and monitor the activities of an asset
management company. If the conduct of the business is not
in compliance with SEBI's regulations, they can take
remedial measures against an AMC as required. They have
powers to dismiss an AMC. Nevertheless, it should be
approved by SEBI.
Asset Management Company: A sponsor or the
trustees appoint an AMC, and it should be approved by the
board. An appointee can be terminated by a majority of the
trustees or 75 per cent of the unit holders of the scheme. An
AMC should have a sound track record, general reputation
and fairness in transactions. The directors of AMC should
possess adequate professional experience in finance and
financial services. An AMC should have a net worth of not
less than Rs 10 crore. Each director of an asset management
company is required to give the details of his dealings in
securities with the trustees, on a quarterly basis.
An AMC manages the various schemes of mutual funds with
the help of a team of professionals with adequate
experience. They carry out market research for building the
portfolio of a particular mutual fund. An AMC takes all
reasonable steps, exercises and due diligence to ensure that
investment of funds pertaining to any scheme is not
contrary to SEBI's regulations and trust deed.
Custodian: Mutual funds have a custodian. Custodians
carry out custodial services for the various schemes of a
fund. It is their duty to send intimation of the custodial
services rendered to the board. A custodian, or its directors,
or partners will not be directly or indirectly associated with
any AMC in any way. A custodian shall not be appointed in
case a sponsor or its associates hold 50 per cent or more of
the voting rights of the share capital of a custodian, or
where 50 per cent or more directors of the custodian
represent the interest of the sponsors or its associates.
TYPES OF MUTUAL FUNDS
A mutual fund scheme can be classified into close ended or
open ended depending on its maturity period.
Close-ended scheme: It has a prefixed maturity period,
e.g., five to seven years. Both the corpus amount and the
number of units are prefixed. The fund is open for
subscription only for a specified period after the launch of
the scheme. Mutual funds are required to dispatch
certificates or statements of accounts within six weeks from
the date of closure of the initial subscriptions of the
schemes. The investors can invest in the scheme during this
period. After the closure of the subscription period,
investors can buy and sell the units of the scheme at the
stock exchanges where the units are listed. They would
either get a demat account statement or unit certificates as
traded in the stock exchanges.
According to SEBI regulations, one or two exit routes should
be provided to the investors. It may be either in the form of
regular repurchase or by listing them in stock exchanges.
Some of the close-ended mutual funds provide the option of
selling back of the units to the mutual funds. The prices are
fixed on the basis of net asset value. The NAV of the
schemes is disclosed on a weekly basis.
The entire corpus is disinvested after the maturity period
and the proceeds are distributed among the investors in
proportion to their unit holdings.
Open-ended schemes: These are available for subscription
and repurchase on a continuous basis. These schemes do
not have a maturity period. Investors can buy and sell units
at prices fixed by a mutual fund. Prices are fixed on the basis
of NAV. The NAVs of these schemes are declared daily.'
Liquidity is the main advantage of the open-ended scheme.
The main difference between the open-ended and the
close-ended schemes is that the latter is traded on stock
40
exchanges, whereas the former is not. Also, open ended
schemes are available at all times, whereas the close-ended
schemes are available only for a prescribed period.
Schemes on the basis of investment objectives
Schemes are classified as growth scheme, income scheme
or balanced scheme as per the investment objectives. These
schemes may either be open-ended or close-ended. Some
of them are given below.
Index fund: These are equity funds that passively mimic a
market index. The portfolio of the index fund is designed to
reflect the composition of some stock market index. The
index funds avoid the risk of poor stock selection by the
fund manager. The aspects that are in favour of index funds
are:
 Low costs
 Predictability
 Diversification
All the index funds, which are currently in operation, are
modelled either on the Nifty or the Sensex. Several fund
houses have launched passive index funds in the past. Some
of them are Franklin Templeton India Index fund (formerly
Pioneer ITI Index fund, offering both Sensex and Nifty
Plans), UTI Nifty Index fund, UTI Master Index fund and IDBI
Principal Index fund.
These funds suffer because of tracking error. This error is
the percentage by which returns from the funds deviate
from the underlying index. If the error is positive, the funds
generate higher returns than that of the index. One of the
reasons cited for the tracking error is the transaction cost.
Index funds have to incur brokerage and other costs to
make changes in their portfolios in line with those in the
index. This results in increase in cost. Besides this, the lack
of depth in the Indian stock market also affects the index
funds.
Investment management fee affects the return and
recurring expenses such as advertisement, investor
communication costs and administration costs. Though
these expenses form a small portion of the returns each
year, the compounding effect over the years becomes quite
significant.
It is felt that if the index funds could track down broad
based market indices such as S&P CNX 500 and BSE 200, it
would help the investors to capture broad market trends
more accurately. However, lack of liquidity of many small
and mid-cap stocks would result in high transaction costs.
Exchange traded funds (ETFs): These are passively managed
funds that track a particular index and have the flexibility to
trade like a common stock. These types of funds combine
the attributes of mutual funds with those,of the stocks.
Without large investment, an average investor can have an
entire range of index stocks. It is different from the index
funds where units are issued in return for cash and
redeemed as per the net asset value in cash. However, ETF
issues units in lieu of shares and vice versa.
The ETFs are priced throughout the day. They can be bought
and sold at any time during a trading day just like a stock.
The fund may either represent market index or a specific
industry sector or an international sector. An investor can
buy it on a margin. Short selling can be carried out. The
expense ratio is similar to the open end mutual funds. They
range from 0.18 per cent of the value of the fund to 0.84
per cent.
ETFs came into existence in the US in 1993. The first ETFs
were based on the S & P 500 and were popularly known as
spiders. Presently, diamonds are the other type of ETFs
representing all thirty stocks in the Dow Jones Industrial
Average and traded in American stock exchange. The
Benchmark Asset Management Company (BAMC) has
launched Nifty 3eEs. It was listed on the capital market
segment of the NSE on 8 January 2002. Nifty BeEs tracks the
Standard Poor (S&P) CNX Nifty index. The minimum
investment for taking the index exposure through Nifty BeEs
is just one unit (around'l/10 of the Nifty).
Balanced funds
These funds invest both in equity and fixed income
securities. They are also called "income-cum-growth" funds.
They aim at regular income and capital appreciation. They
have the equity and debt portfolios to fulfill this objective.
The portfolio beta is less than one and the price of units
does not rise in proportion to the aggregate stock market
price because of the debt component in the portfolio. Some
of the balanced funds are: Prudential ICICI Balanced fund,
Kothari Balanced fund, Alliance 95 fund and DSP Merrill
Lynch Balanced fund. The performance of the balanced
funds differs due to the ratio of stocks to the fixed Income
securities that varies from fund to fund and their different
levels of exposure to individual sectors like IT, media or
telecom. The weightage of individual stock in funds _differs.
Hence, an investor has to go through the portfolios before
investing in the funds.
Money market funds or liquid funds: These funds were
initiated during 1973 in the US when interest rates on short
term money market securities were high. They are also
income funds and attempt to provide current income and
safety of principal by investing in short term securities such
as treasury bills, bank certificates of deposits, bank
acceptances, commercial papers and interbank call money.
Returns on these schemes fluctuate much less as compared
to the other funds. These funds are appropriate for
corporate and individual investors to invest their surplus
cash for a short period.
Gilt fund: These are also known as G-Sec funds. These invest
in the Government of India securities, and have gained
popularity in the Indian market. The Securities Exchange
Board of India has issued new guidelines in 2002 with an
aim to provide better checks and balances for the mutual
funds. The following are the salient features of the new
requirements:
 Mutual funds have to reconcile their balance with
the monthly RBI report
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  Internal audit, continuous checks by the auditors
and reports to audit committees form a part of the
requirements
 The same report must also be placed before the
boards of the asset management company and the
trustee company
 Mutual funds will have to submit a compliance
certificate to the RBI on a quarterly basis, indicating
their adherence to the norms
 Public debt offices of the RBI will issue monthly
statements to mutual funds maintaining SGL/CSGL
accounts
Growth funds: The main objective of these funds is to
provide capital appreciation over medium to long term.
They invest a major portion of their collected money in
equity. This makes them prone to risk. As per their
preference, the investors may either choose the option of
dividend or the option of capital appreciation. Investors
have to specify their choice while applying for units.
However, if they want to change at a later date, they are
permitted to do so. The year 1999-2000 was one of the best
periods for growth funds in the Indian market. Fresh sales
by growth schemes were about 1000 crore. Growth funds
outperform bench mark index in bull phas,e and
underperform in bearish times. Another common problem
cited by the fund managers is that investors put more
money when the NAVs are high and sell when NAVs are low,
making the managers busier in redemption than in
managing the funds.
Income/Debt-oriented funds: The objective of these
funds is to provide regular and steady income to investors.
A major part of the funds corpus is invested in fixed-income
securities such as bonds, corporate debentures,
government securities and money market instruments. The
scope for capital appreciation is limited in these schemes.
These funds carry only modest risks as compared to equity
funds.
The NAVs of debt funds are affected because of change in
interest rate in the country. If the interest rates increase,
NAVs of such funds are likely to fall in the short run and
vice-versa. For instance, debt funds lost heavily in July 2000,
when the RBI raised the interest rate to defend the rupee.
Thus, the debt funds are prone to risk because of changes in
the rate of interest. The NAV is calculated based on the
market price and not just the income earned from holding
from the bonds. The NAV fluctuates with the volatility of the
bond prices.
Like all instruments, the bond price is based on demand and
supply. This means that the bond prices will fall when supply
is relatively more than the demand. This happens when
rupee is falling sharply against the dollar or when the call
rates are very high. During this period, banks generate
resource by selling the bonds. The excessive supply of bonds
in the market pulls down the price.
Fall in the prices of bonds leads to fall in NAVs of the debt
funds. Thus the debt funds are also prone to market risk.
However, long-term investors prefer these funds. Some of
the debt funds/income funds include Birla Income Plus,
Prudential ICICI Income plan, SBI LiquiBond, UTI Bond fund
and DSP Merrill Lynch Bond fund.
Reinvestment risk is defined as the risk of having to reinvest
the intermediate cash flows (coupon payments at a lower
interest rate). In falling interest climate, the mutual funds
may earn a lower return by reinvesting the coupon
payment. To understand this, the funds should provide two
distinct NAVs—one inclusive of the coupon payments, and
other exclusive of the coupons. This would give an idea
about the reinvestment risk to the investors.
Sector specific funds: These funds/schemes invest in
securities of those sectors or industries specified in the offer
documents, e.g., information technology, pharmaceuticals,
fast moving consumer goods (FMCG) and petroleum, etc.
The returns on these funds depend on the performance of
these sectors. Since they are investing in a particular sector,
the risk is high as compared to the other funds. The
performance of the sector should be closely followed in
order to take the entry and exit decisions.
A complaint often leveled against these funds is that they
invest in sectors other than the ones suggested by their
name. This is because most offer documents spell out the
investment strategy in vague terms and this allows the
funds to move away completely from the nature of the
scheme as indicated by its name. For example, Tata Core
sector fund was designed to invest in the core sector (steel,
cement, power and infrastructure) in 1999, but it shifted out
of cyclical into technology stocks. By Nov 1999, 71 per cent
of its assets were invested in technology stocks.
Tax saving schemes: These schemes provide tax rebates
to the investors under the supervision of the Income Tax Act
1961. The government offers tax incentives for investment
in specified avenues. Equity linked savings schemes and
pension schemes offered by mutual funds offer tax benefits.
These schemes resemble the equity-oriented schemes and
invest mostly in equities.
Load and no load funds: In load funds, a fee is charged for
the entry and exit. The charge is a percentage of NAV.
Whenever an investor buys or sells units in the fund; he has
to pay a charge. If the entry as well as exit load is one per
cent to buy a unit worth Rs 10, he has to pay Rs 10.10.
Likewise if he sells a unit, he will get Rs 9.90 per unit. The
load factor affects the return and the investor has to
consider the load factor before investing in a mutual fund.
No load funds do not charge a fee for entry or exit. No
additional charges are levied on the purchase or sale of
units. However, SEBI regulations allow no load funds to hike
the investment management fees by up to one per cent per
annum until they recover their initial expenses.
BENEFITS OF MUTUAL FUNDS
An investor can invest directly in individual securities or
indirectly through a financial intermediary. Globally, mutual
42
funds have established themselves as the means of
investment for the retail investor.

1. Professional Management: An average investor lacks

the knowledge of capital market operations and does not
have large resources to reap the benefits of investment.
Hence, he requires the help of an expert. It is not only
expensive to hire the services of an 'expert' but it is more
difficult to identify a real expert. Mutual funds are managed
by professional managers who have the requisite, skills and
experience to analyse the performance and prospects of
companies. They make possible an organised investment
strategy, which is hardly possible for an individual investor.

2. Portfolio Diversification: An investor undertakes risk if

he invests all his funds in a single scrip. Mutual funds invest
in a number of companies across various industries and
sectors. This diversification reduces the riskiness of the
investments. .

3. Reduction in Transaction Costs: Compared to direct

investing in the capital market, investing through the funds
is relatively less expensive as the benefit of economies of
scale is passed on to the investors.

4. Liquidity: Often,; investors cannot sell the securities held

easily, while in case of mutual funds. they can easily encash
their investment by selling their units to the fund if it is an
open-ended scheme or selling them on a stock exchange if it
is a close-ended scheme.

5. Convenience: Investing in mutual fund reduces

paperwork, saves time and makes investment easy.

6. Flexibility: Mutual funds offer a family of schemes, and

investors have the option of transferring their holdings from
one scheme to the other.

7. Tax Benefits: Mutual fund investors now enjoy income

tax benefits. Dividends received from mutual funds' debt
schemes are tax exempt to the overall limit of Rs 9,000
allowed under section SOL of the Income Tax Act.

8. Transparency: Mutual funds transparently declare their

portfolio every month. Thus, an investor knows where
his/her money is being deployed and in case they are not
happy with the portfolio they can withdraw at a short
notice.

9. Stability to the Stock Market: Mutual funds have a large

amount of funds which provide those economies of scale by
which they can absorb any losses in the stock market and
continue investing in the stock market. In addition, mutual
funds increase liquidity in the money and capital market. .

10. Equity Research: Mutual funds can afford information

and data required for investments as they have large
amount of funds and equity research teams available with
them.

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