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Foundation Course in Banking & Capital Markets

VERSION: 1.1 DATE: 26-MAY-2009

Cognizant Technology Solutions 500 Glenpointe Centre West Teaneck, NJ 07666 Ph: 201-801-0233 www.cognizant.com

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Cognizant Confidential

Foundation Course in Banking and Capital Markets

CONTENTS
1.0 1.1 1.2 1.3 1.4 2.0 2.1 3.0 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 4.0 4.1 4.2 4.3 4.4 4.5 5.0 5.1 5.2 5.3 5.4 6.0 6.1 6.2 6.3 6.4 6.5 6.6 6.6 7.0 7.1 7.2 7.3 8.0 8.1 BFS CONCEPTS ............................................................................................................................. 4 CONCEPT OF MONEY ........................................................................................................................... 4 FINANCIAL INSTRUMENTS ........................................................................................................... 10 FINANCIAL MARKETS ................................................................................................................... 19 FINANCIAL STATEMENTS .................................................................................................................... 26 BANKING ................................................................................................................................... 38 INTRODUCTION TO BANKING ...................................................................................................... 38 RETAIL BANKING ....................................................................................................................... 45 INTRODUCTION ................................................................................................................................ 45 DEPOSIT PRODUCTS ...................................................................................................................... 47 RETAIL CHANNELS ............................................................................................................................ 49 INSTRUMENTS ............................................................................................................................. 53 RETAIL PAYMENTS............................................................................................................................ 55 ELECTRONIC BANKING ................................................................................................................ 56 SALES AND MARKETING..................................................................................................................... 57 A SCHEMATIC OF A RETAIL BANK ......................................................................................................... 58 MORTGAGES AND CONSUMER LENDING ................................................................................... 60 MORTGAGE .................................................................................................................................... 60 OTHER RETAIL LOANS........................................................................................................................ 67 COMMUNITY BANKS, CREDIT UNIONS & BUILDING SOCIETIES .................................................................. 75 FARM CREDIT .................................................................................................................................. 77 RETAIL LENDING CYCLE ...................................................................................................................... 78 CARDS AND PAYMENTS ............................................................................................................. 81 INTRODUCTION ................................................................................................................................ 81 CREDIT CARD MARKET OVERVIEW ...................................................................................................... 86 MAJOR PLAYERS .............................................................................................................................. 93 RECENT DEVELOPMENTS ................................................................................................................... 93 WHOLESALE BANKING AND COMMERCIAL LENDING ................................................................. 98 INTRODUCTION ........................................................................................................................... 98 CORPORATE LENDING PROCESS .................................................................................................. 98 CREDIT DERIVATIVES ................................................................................................................. 105 TREASURY SERVICES .................................................................................................................. 107 CASH MANAGEMENT ................................................................................................................ 115 TRADE FINANCE......................................................................................................................... 123 PAYMENTS NETWORK ..................................................................................................................... 134 INVESTMENT MANAGEMENT .................................................................................................. 138 INTRODUCTION .............................................................................................................................. 138 INVESTMENT MANAGEMENT PROCESSES ............................................................................................. 139 DIFFERENT CLASSES OF INVESTMENT MANAGEMENT FIRMS .................................................................... 152 INVESTMENT BANKING AND BROKERAGE .............................................................................. 170 DEFINITION OF INVESTMENT BANKS ......................................................................................... 170

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Foundation Course in Banking and Capital Markets FUNCTION OF INVESTMENT BANKS: ......................................................................................... 170 MAJOR INVESTMENT BANKS: .................................................................................................... 170 DIVISIONS WITHIN AN INVESTMENT BANK ............................................................................... 171 INVESTMENT BANKING POST ECONOMIC CRISIS: ..................................................................... 173 BROKERAGE............................................................................................................................... 173 UNDERWRITING ........................................................................................................................ 175 THE FLOOR OF THE EXCHANGE.................................................................................................. 177 ORDER TYPES ................................................................................................................................. 179 THE OVER-THE-COUNTER (OTC) MARKET ................................................................................. 180 HOW DOES A BROKERAGE FIRM LOOK LIKE?............................................................................. 181 MARKET INDICES ....................................................................................................................... 185

8.2 8.3 8.4 8.5 8.6 8.7 8.9 8.10 8.11 8.12 8.13 9.0 9.1 9.2 9.3 9.4 10.0 10.1 10.2 10.3 11.0 11.1 11.2 11.3 12.0

CUSTODY AND CLEARING ........................................................................................................ 187 INTRODUCTION ......................................................................................................................... 187 SECURITIES MARKETPLACE ............................................................................................................... 188 TRADING AND SETTLEMENT ...................................................................................................... 191 ASSET SERVICING ...................................................................................................................... 202 CLEARING AND SETTLEMENT ................................................................................................... 206 TRADING ...................................................................................................................................... 206 CLEARING ..................................................................................................................................... 208 SETTLEMENT ................................................................................................................................. 210 RISK MANAGEMENT ................................................................................................................ 216
CONCEPT OF RISK ........................................................................................................................... 216

TYPES OF RISK ............................................................................................................................... 216 RISK MANAGEMENT ....................................................................................................................... 220 CORPORATE SERVICES ............................................................................................................. 232

12.1 BENEFITS ADMINISTRATION ........................................................................................................... 232 13.0 13.1 13.2 13.3 14.0 15.0 15.1 15.2 RECENT DEVELOPMENTS ......................................................................................................... 238 USA PATRIOT ACT ...................................................................................................................... 238 SARBANES OXLEY ACT ............................................................................................................... 242 SUB-PRIME MORTGAGE CRISIS ......................................................................................................... 243 GLOSSARY ............................................................................................................................... 248 REFERENCES ............................................................................................................................ 254 WEBSITES .................................................................................................................................. 254 BOOKS ....................................................................................................................................... 254

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1.0
1.1

BFS CONCEPTS
CONCEPT OF MONEY

1.1.1 DEFINING MONEY


Money is a standardized unit of exchange. The practical form of money is currency. It varies across countries whereas money remains the same. For example, in India, the currency is the Indian Rupee (INR) and in the US, it is the US Dollar (USD). Due to various economic factors, the value of each countrys currency is not equal. For example, if the exchange rate between US Dollars (USD) and Indian Rupees (INR) is USD 1 = INR 46.70, it implies that one U.S dollar is equivalent to 46.70 Indian Rupees. The USD is normally taken as a benchmark against which to compare the value of each currency.

1.1.2 THE CONCEPT OF INTEREST: SIMPLE INTEREST AND COMPOUND INTEREST


Interest is the amount earned on money; there is such an earning because present consumption of the lender is being sacrificed for the future; it is letting somebody else use the money for present consumption. Using an analogy, interest is the rent charged for delaying present consumption of money. Interest rates are not constant and will vary depending on different economic factors A. Simple interest Simple interest is calculated only on the beginning principal. Simple Interest = P*r*t/100 where: P is the Principal or the initial amount borrowed or deposited, to earn or charge interest on, r is the interest rate and t is the time period. Example If someone were to receive 5% interest on a beginning value of $100, the first year they would get: 0.05*$100 = $5 If they continued to receive 5% interest on the original $100 amount, over five years the growth in their investment would look like this: Year 1: (5% of $100 = $5) + $100 = $105 Year 2: (5% of $100 = $5) + $105 = $110 Year 3: (5% of $100 = $5) + $110 = $115 Year 4: (5% of $100 = $5) + $115 = $120

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Year 5: (5% of $100 = $5) + $120 = $125 B. Compound interest With compound interest, interest is calculated not only on the beginning interest, but on any interest accumulated with the initial principal in the meantime. Compound interest = [P*(1+r/100)^t P], where: P is the Principal or the initial amount initially borrowed or deposited, to earn or charge interest on, r is the interest rate and t is the time period. Example If someone were to receive 5% compound interest on a beginning value of $100, the first year they would get the same thing as if they were receiving simple interest on the $100, or $5. The second year, though, their interest would be calculated on the beginning amount in year 2, which would be $105. So their interest would be: .05 x $105 = $5.25 If this were to continue for 5 years, the growth in the investment would look like this: Year 1: (5% of $100.00 = $5.00) + $100.00 = $105.00 Year 2: (5% of $105.00 = $5.25) + $105.00 = $110.25 Year 3: (5% of $110.25 = $5.51) + $110.25 = $115.76 Year 4: (5% of $115.76 = $5.79) + $115.76 = $121.55 Year 5: (5% of $121.55 = $6.08) + $121.55 = $127.63 Note that in comparing growth graphs of simple and compound interest, investments with simple interest grow in a linear fashion and compound interest results in geometric growth. So with compound interest, the further in time and investment is held the more dramatic the growth becomes.

1.1.3 INFLATION
Inflation captures the rise in the cost of goods and services over a period of time. For example, if Rs.100 today can buy 5 kg of groceries, the same amount of money can only buy 5/ (1+I) kgs of groceries next year, where `I refers to the rate of inflation beyond today. Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand & supply and other market conditions hold), next year, one can only buy 5/ (1.05) worth of groceries. A quantitative estimate of inflation in a particular economy can be calculated by measuring the ratio of Consumer Price Indices or CPI of two consecutive years. Thats right, the CPI that one hear of, is the weighted average price, of a predefined basket of basic goods. The % increase of the CPI this year vs. the CPI of last year, gives the inflation, or rise in price of consumer goods, over last year.

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Inflation results in a decrease in the value of money over time. The link between the interest rates, nominal and real, and inflation enables one to identify this impact.

1.1.4 NOMINAL INTEREST


Nominal rate of interest (N) refers to the stated interest rate in the economy. For example, if counter-party demands 110 rupees after a year in return for 100 rupees lent today, the nominal rate of interest is 10%. This, as one see, includes the inflation rate. Example A person lent out 100 rupees, at 10%, for one year. On maturity, he gets a profit, so he thinks, of 10 rupees. But this sum of 110 rupees buys less than 110 rupees did a year ago, due to inflation! Thus, the value of 110 rupees today is actually, or really, less than the value of 110 rupees a year ago, and it is less by the inflation rate. Thus the real interest he earned is less than 10%.

1.1.4

REAL RATE OF INTEREST

Real rate of interest (R) refers to the inflation-adjusted rate of interest. It is less than the nominal rate of interest for economies having positive rate of inflation. The relationship between the R (real rate of interest), N (nominal rate of interest) and I (rate of inflation) is as: R= N-I (This is a widely used approximation; the exact formula takes into account time value of inflation etc.) Why is it important to know the real rate of return? Take an example where a business is earning a net profit of 7% per annum. But, inflation is also standing at 7%. So, real profit is actually at zero. Example Nominal rate (N) = 10%, Inflation (I) = 5% Therefore, real interest is: R = N I = 5%

Therefore, the real rate of return is not 10% but 5%.

1.1.5 TIME VALUE CONCEPT OF MONEY


Time value of money, which serves as the foundation for many concepts in finance, arises from the concept of interest. Because of interest, money on hand now is worth more than the same money available at a later point of time. To understand time value of money and related concepts like Present value and future value, we need to understand the basic concepts of simple and compound interest described above. Future Value

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Future Value is the value that a sum of money invested at compound interest will have after a specified period. The formula for Future Value is: FV = PV*(1 + i) n Where: FV PV i n : Future Value at the end of n time periods : Beginning value OR Present Value : Interest rate per unit time period : Number of time periods If one were to receive 5% per annum compounded interest on $100 for five

Example years,

FV = $100*(1.05)5 = $127.63 Intra-Year Compounding If a cash flow is compounded more frequently than annually, then intra-year compounding is being used. To adjust for intra-year compounding, an interest rate per compounding period must be found as well as the total number of compounding periods. The interest rate per compounding period is found by taking the annual rate and dividing it by the number of times per year the cash flows are compounded. The total number of compounding periods is found by multiplying the number of years by the number of times per year cash flows are compounded. Example Suppose someone were to invest $10,000 at 8% interest, compounded semiannually, and hold it for five years, Interest rate for compounding period = 8%/2 = 4% Number of compounding periods = 5*2 = 10 Thus, the future value FV = 10,000*(1+0.04) ^10 = $14,802.44 Present value Present Value is the current value of a future cash flow or of a series of future cash flows. It is computed by the process of discounting the future cash flows at a predetermined rate of interest. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because we do not have it in our hand now, in the present. To find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future. To calculate present value, or the amount that we would have to invest today, we must subtract the (hypothetical) accumulated interest from the

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$10,000. To achieve this, we can discount the future amount ($10,000) by the interest rate for the period. The future value equation given above can be rearranged to give the Present Value equation: PV = FV / (1+I) ^n In the above example, if interest rate is 5%, the present value of the $10,000 which we will receive after one year, would be: PV = 10,000/(1+0.05) = $ 9,523.81 Net Present Value (NPV) Net Present Value (NPV) is a concept often used to evaluate projects/investments using the Discounted Cash Flow (DCF) method. The DCF method simply uses the time value concept and discounts future cash flows by the applicable interest rate factor to arrive at the present value of the cash flows. NPV for a project is calculated by estimating net future cash flows from the project, discounting these cash flows at an appropriate discount rate to arrive at the present value of future cash flows, and then subtracting the initial outlay on the project. NPV of a project/investment = Discounted value of net cash inflows Initial cost/investment. The project/investment is viable if NPV is positive while it is not viable if NPV is negative. Example An investor has an opportunity to purchase a piece of property for $50,000 at the beginning of the year. The after-tax net cash flows at the end of each year are forecast as follows: Year 1 2 3 4 5 6 7 8 9 10 Cash Flow $9,000 8,500 8,000 8,000 8,000 8,000 8,000 7,000 4,500 51,000 (property sold at the end of the 10th year)

Assume that the required rate of return for similar investments is 15.00%. NPV = - 50000 + 9000/ (1+0.15) ^1 + 8500/ (1+0.15) ^2 + .. +51000/ (1+0.15) ^10 = $612.96

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However, if we assume that the required rate of return is 16.00%, NPV = - 50000 + 9000/ (1+0.16) ^1 + 8500/ (1+0.16) ^2 + .. +51000/ (1+0.16) ^10 = ($1360.77) Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a project: Increases with increase in future cash inflows for a given initial outlay Decreases with increase in initial outlay for a given set of future cash inflows Decreases with increase in required rate of return Internal Rate of Return (IRR) Internal Rate of Return (IRR), also referred to as Yield is often used in capital budgeting. It is the implied interest rate that makes net present value of all cash flows equal zero. In the previous example, the IRR is that value of required rate of return that makes the NPV equals zero. IRR = r, where NPV = - 50000 + 9000/(1+r)^1 + 8500/(1+r)^2 + .. +51000/ (1+r) ^10 = $0.00 IRR can be calculated using trial and error methods by using various values for r or using the IRR formula directly in MS Excel. Here, IRR = 15.30%. In other terms, IRR is the rate of return at which the project/investment becomes viable.

1.1.6 COST OF CAPITAL


We have seen how different entities such as individuals, corporations and governments raise money. We have also realized that there is a cost for raising money, known as cost of capital. Costs will vary depending on the type of the financing such as equity or debt, who the borrower is (their past record and repayment capacity), and finally the market timing of the borrowings. In case of debt, additionally, the amount of collateral provided and how long the capital is required is also considered. The cost of capital includes interest payable in case of debt and expected returns including dividends in case of equity, apart from the cost of raising such as investment banks fees, regulatory fees and advertising. The tax factor is also considered while computing cost of capital for debt capital since interest paid is a tax deductive expense. Computing cost for different means of finance such as equity shares, preference shares, debentures or term loan is beyond the purview of this learning program. Since there is a limit to the amount of resources that corporations can raise from any source, they use more than a single source for financing their needs. Also, funds will be raised at different points in time depending on need, availability, and market timing etc. In such cases after computing cost of each source, the firm arrives at a weighted average cost of capital, commonly referred to as cost of capital. Let us take an example:

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The Good works Company Inc. has Rs. 300 million through different means. The firm has raised Rs. 107 mn through equity, Rs. 13 mn through preference capital, Rs. 80 mn by issuing debentures and Rs. 100 mn by taking a loan a financial institution. Source of finance Equity capital Preference capital Debenture capital Term loan Average cost of capital Cost (per cent) 16.64 15.73 11.08 10.25 Weight 107/300 13/300 80/300 100/300 Product of cost and weight 5.93 0.68 2.95 3.42 12.99 per cent

Looked at it with a different perspective, the cost of capital is the rate of return the firm must earn on its investments in order to satisfy the expectations of investors who provide long-term funds to it. It is an important concept for financing decisions.

1.2

FINANCIAL INSTRUMENTS

1.2.1 RAISING CAPITAL


Corporations need capital to finance business operations. They raise money by issuing Securities in the form of Equity and Debt. Equity represents ownership of the company and takes the form of stock. Debt is funded by issuing Bonds, Debentures and various certificates. The use of debt is also referred to as Leverage Financing. The ratio of debt/equity shows a potential investor the extent of a companys leverage. Investors choose between debt and equity securities based on their investment objectives. Income is the main objective for a debt investor. This income is paid in the form of Interest, usually as semi-annual payments. Capital Appreciation (the increase in the value of a security over time) is only a secondary consideration for debt investors. Conversely, equity investors are primarily seeking Growth, or capital appreciation. Income is usually of lesser importance, and is received in the form of Dividends. Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on stock. It also means that if the company ceases to do business and liquidate its assets, that the debt holders have a senior claim to those assets.

1.2.2 SECURITY
Security is a financial instrument that signifies ownership in a company (a stock), a creditor relationship with a corporation or government agency (a bond), or rights to ownership (an option). Financial instruments can be classified into:

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Debt Equity Hybrids Derivatives DEBT Debt is money owed by one person or firm to another. Bonds, loans, and commercial paper are all examples of debt. BOND An investor loans money to an entity (company or government) that needs funds for a specified period of time at a specified interest rate. In exchange for the money, the entity will issue a certificate, or bond, that states the interest rate (coupon rate) to be paid and repayment date (maturity date). Interest on bonds is usually paid every six months (semiannually). Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal Only and Fully Registered Bonds. Bearer bonds are like cash since the bearer of the bond is presumed to be the owner. These bonds are Unregistered because the owners name does not appear on the bond, and there is no record of who is entitled to receive the interest payments. Attached to the bond are Coupons. The bearer clips the coupons every six months and presents these coupons to the paying agent to receive their interest. Then, at the bonds Maturity, the bearer presents the bond with the last coupon attached to the paying agent, and receives their principal and last interest payment. Bonds that are registered as to principal only have the owners name on the bond certificate, but since the interest is not registered these bonds still have coupons attached. Bonds that are issued today are most likely to be issued fully registered as to both interest and principal. The transfer agent now sends interest payments to owners of record on the interest Payable Date. Book Entry bonds are still fully registered, but there is no physical certificate and the transfer agent keeps track of ownership. U.S. Government Negotiable securities (i.e., Treasury Bills, Notes and Bonds) are issued book entry, with no certificate. The customers Confirmation serves as proof of ownership. Principal and Interest Bondholders are primarily seeking income in the form of a semi-annual coupon payment. The annual rate of return (also called Coupon, Fixed, Stated or Nominal Yield) is noted on the bond certificate and is fixed. The factors that influence the bond's initial coupon rate are prevailing economic conditions (e.g., market interest rates) and the issuer's credit rating (the higher the credit rating, the lower the coupon). Bonds that are In Default are not paying interest. Example IBM can issue 10 year bonds with a coupon of 5.5%. Priceline can issue similar 10 year bonds at 8% The difference in coupon is due to their credit rating!

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The principal or par or Face amount of the bond is what the investor has loaned to the issuer. The relative "safety" of the principal depends on the issuers credit rating and the type of bond that was issued. CORPORATE BOND A bond issued by a corporation. Corporations generally issue three types of bonds: Secured Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures. All corporate bonds are backed by the full faith and credit of the issuer, but a secured bond is further backed by specific assets that act as collateral for the bond. In contrast, unsecured bonds are backed by the general assets of the corporation only. There are three basic types of Secured Bonds: Mortgage Bonds are secured by real estate owned by the issuer Equipment Trust Certificates are secured by equipment owned and used in the issuers business Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (Usually U.S. Government securities) Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor status; they are the first to be paid principal or interest and are thus the safest of an issuers securities. Unsecured Bonds include debentures and subordinated debentures. Debentures have a general creditor status and will be paid only after all secured creditors have been satisfied. Subordinated debentures have a subordinate creditor status and will be paid after all senior and general creditors have first been satisfied. Case Study Enron set up power plant at Dabhol, India The cost of the project (Phase 1) was USD 920 Million Funding o Equity USD 285 mio o Bank of America/ABN Amro USD 150 mio o IDBI & Indian Banks USD 95 mio o US Govt OPIC USD 100 mio o US Exim Bank USD 290 mio Enron US declared bankruptcy in 2002 Enron Indias assets are mortgaged to various banks as above. 2.1.3 MUNICIPAL BOND (MUNIS) Due to interest payments and depreciation, assets are worth considerably less A bond issued USD 920 mio. than by a municipality. These are generally tax free, but the interest rate is usually lower than a taxable bond. money back? And how much? Who will get their TREASURY SECURITIES Treasury bills, notes, and bonds are marketable securities the U.S. government sells in order to pay off maturing debt and raise the cash needed to run the federal government. When an investor buys one of these securities, he/she is lending money to the U.S. government.

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Treasury bills are short-term obligations issued for one year or less. They are sold at a discount from face value and don't pay interest before maturity. The interest is the difference between the purchase price of the bill and the amount that is paid to the investor at maturity (face value) or at the time of sale prior to maturity. Treasury notes and bonds bear a stated interest rate, and the owner receives semi-annual interest payments. Treasury notes have a term of more than one year, but not more than 10 years. Treasury bonds are issued by the U.S. Government. These are considered safe investments because they are backed by the taxing authority of the U.S. government, and the interest on Treasury bonds is not subject to state income tax. T-bonds have maturities greater than ten years, while notes and bills have lower maturities. Individually, they sometimes are called "Tbills," "T-notes," and "T-bonds." They can be bought and sold in the secondary market at prevailing market prices. Savings Bonds are bonds issued by the Department of the Treasury, but they aren't are not marketable and the owner of a Savings Bond cannot transfer his security to someone else. ZERO COUPON BONDS Zeros generate no periodic interest payments but they are issued at a discount from face value. The return is realized at maturity. Zeros sell at deep discounts from face value. The difference between the purchase price of the zero and its face value when redeemed is the investor's return. Zeros can be purchased from private brokers and dealers, but not from the Federal Reserve or any government agency. The higher rate of return the bond offers, the more risky the investment. There have been instances of companies failing to pay back the bond (default), so, to entice investors, most corporate bonds will offer a higher return than a government bond. It is important for investors to research a bond just as they would a stock or mutual fund. The bond rating will help in deciphering the default risk. COMMERCIAL PAPER An unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories. It is usually issued at a discount to face value, reflecting prevailing market interest rates. It is issued in the form of promissory notes, and sold by financial organizations as an alternative to borrowing from banks or other institutions. The paper is usually sold to other companies which invest in short-term money market instruments. Since commercial paper maturities don't exceed nine months and proceeds typically are used only for current transactions, the notes are exempt from registration as securities with the United States Securities and Exchange Commission. Financial companies account for nearly 75 percent of the commercial paper outstanding in the market. There are two methods of marketing commercial paper. The issuer can sell the paper directly to the buyer or sell the paper to a dealer firm, which re-sells the paper in the market. The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding

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companies. Direct issuers of commercial paper usually are financial companies which have frequent and sizable borrowing needs, and find it more economical to place paper without the use of an intermediary. On average, direct issuers save a dealer fee of 1/8 of a percentage point. This savings compensates for the cost of maintaining a permanent sales staff to market the paper. Interest rates on commercial paper often are lower than bank lending rates, and the differential, when large enough, provides an advantage which makes issuing commercial paper an attractive alternative to bank credit. Commercial paper maturities range from 1 day to 270 days, but most commonly is issued for less than 30 days. Paper usually is issued in denominations of $100,000 or more, although some companies issue smaller denominations. Credit rating agencies like Standard & Poor rate the CPs. Ratings are reviewed frequently and are determined by the issuer's financial condition, bank lines of credit and timeliness of repayment. Unrated or lower rated paper also is sold in the market. Investors in the commercial paper market include private pension funds, money market mutual funds, governmental units, bank trust departments, foreign banks and investment companies. There is limited secondary market activity in commercial paper, since issuers can closely match the maturity of the paper to the investors' needs. If the investor needs ready cash, the dealer or issuer usually will buy back the paper prior to maturity. EQUITY Equity (Stock) is a security, representing an ownership interest. Equity refers to the value of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). COMMON STOCK Common stock represents an ownership interest in a company. Owners of stock also have Limited Liability (i.e.) the maximum a shareholder can lose is their original investment. Most of the stock traded in the markets today is common. An individual with a majority shareholding or controlling interest controls a company's decisions and can appoint anyone he/she wishes to the board of directors or to the management team. Corporations seeking capital sell it to investors through a Primary Offering or an Initial Public Offering (IPO). Before shares can be offered, or sold to the general public, they must first be registered with the Securities and Exchange Commission (SEC). Once the shares have been sold to investors, the shareholders are usually free to sell or trade their stock shares in the Secondary Markets (such as the New York Stock Exchange NYSE). From time to time, the Issuer may choose to repurchase the stock they previously issued. Such repurchased stock shares are referred to as Treasury Stock, and the shares that remain trading in the secondary market are referred to as Shares Outstanding. Treasury Stock does not have voting rights and is not entitled to any declared dividends. Corporations may use Treasury Stock to pay a stock dividend, to offer to employees. STOCK TERMINOLOGY

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Public Offering Price (POP) The price at which shares are offered to the public in a Primary Offering. This price is fixed and must be maintained when Underwriters sell to customers. Current Market Price The price determined by Supply and Demand in the Secondary Markets. Book Value The theoretical liquidation value of a stock based on the company's Balance Sheet. Par Value An arbitrary price used to account for the shares in the firms balance sheet. This value is meaningless for common shareholders, but is important to owners of Preferred Stock. Example When Cognizant Technology Solutions came out with its Initial Public Offering on NASDAQ in June 1998, the Public Offering Price (POP) was set at $10 per share. The stock was split twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003. As of Dec 6, 2003, the Current Market Price stood at $46.26. However, if the stock-splits are taken into consideration the actual market price would stand at 6 times the Current Market Price at whopping $253.56!! PREFERRED STOCK Preference shares carry a stated dividend and they do not usually have voting rights. Preferred shareholders have priority over common stockholders on earnings and assets in the event of liquidation. Preferred stock is issued with a fixed rate of return that is either a percent of par (always assumed to be $100) or a dollar amount. Although preferred stock is equity and represents ownership, preferred stock investors are primarily seeking income. The market price of income seeking securities (such as preferred stock and debt securities) fluctuates as market interest rates change. Price and yield are inversely related. There are several different types of preferred stock including Straight, Cumulative, Convertible, Callable, Participating and Variable. With straight preferred, the preference is for the current years dividend only. Cumulative preferred is senior to straight preferred and has a first preference for any dividends missed in previous periods. Convertible preferred stock can be converted into shares of common stock either at a fixed price or a fixed number of shares. It is essentially a mix of debt and equity, and most often used as a means for a risky company to obtain capital when neither debt nor equity works. It offers considerable opportunity for capital appreciation. Non-convertible preferred stock remains outstanding in perpetuity and trades like stocks. Utilities represent the best example of nonconvertible preferred stock issuers. AMERICAN DEPOSITORY RECEIPTS (ADR) The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is a receipt for a specified number of foreign shares owned by an American bank. ADRs trade like shares, either on a U.S. Exchange or Over the Counter. The owner of an ADR has voting rights and also has the right to receive any declared dividends. An example would be Infosys ADRs that are traded in NASDAQ.

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HYBRIDS Hybrids are securities, which combine the characteristics of equity and debt. CONVERTIBLE BONDS Convertible Bonds are instruments that can be converted into a specified number of shares of stock after a specified number of days. However, till the time of conversion the bonds continue to pay coupons. Case Study Tata Motors Ltd. (previously known as TELCO) recently issued convertible bond aggregating to $100 million in the Luxemburg Stock Exchange. The effective interest rate paid on the issue was just 4% which was much lower than what it would have to pay if it raised the money in India, where it is based out of. The company would use this money to pay-back existing loans borrowed at much higher interest rates. Why doesnt every company raise money abroad if it has to pay lower interest rates? Will there is Will there be any effect on existing Tata Motors share-holders due to the convertible issue? If Yes, when will this be? WARRANTS Warrants are call options variants of equity. They are usually offered as bonus or sweetener, attached to another security and sold as a Unit. For example, a company is planning to issue bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so they sweeten the bonds by adding warrants that give the holder the right to buy the issuers stock at a given price over a given period of time. Warrants can be traded, exercised, or expire worthless. DERIVATIVES A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, foreign exchange, commodity or any other item. For example, if the settlement price of a derivative is based on the stock price, which changes on a daily basis, then the derivative risks are also changing on a daily basis. Hence derivative risks and positions must be monitored constantly. FORWARD CONTRACT A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into. FUTURES CONTRACT A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Index futures are all futures contracts where the underlying is the stock index and helps a trader to take a view on the market as a whole.

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HEDGING Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. ARBITRAGE Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the lookout for such imperfections. OPTIONS An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. There are two kinds of options: Call Options and Put Options. Call Options are options to buy a stock at a specific price on or before a certain date. Call options usually increase in value as the value of the underlying instrument rises. The price paid, called the option premium, secures the investor the right to buy that certain stock at a specified price. (Strike price) If he/she decides not to use the option to buy the stock, the only cost is the option premium. For call options, the option is said to be in-the-money if the share price is above the strike price. Example The Infosys stock price as of Dec 6th, 2003 stood at Rs.5062. The cost of the Dec 24th, 2003 expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was Rs.90. This would mean that to break-even the person buying the Call Option on the Infosys stock, the stock price would have to cross Rs.5290 as of Dec 24th, 2003!! Put Options are options to sell a stock at a specific price on or before a certain date. With a Put Option, the investor can "insure" a stock by fixing a selling price. If stock prices fall, the investor can exercise the option and sell it at its "insured" price level. If stock prices go up, there is no need to use the insurance, and the only cost is the premium. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. The primary function of listed options is to allow investors ways to manage risk. Their price is determined by factors like the underlying stock price, strike price, time remaining until expiration (time value), and volatility. Because of all these factors, determining the premium of an option is complicated. Types of Options There are two main types of options: American options can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are of this type. European options can only be exercised at the end of their life.

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Long-Term Options are options with holding period of one or more years, and they are called LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to control and manage risk or even speculate, they are virtually identical to regular options. LEAPS, however, provide these opportunities for much longer periods of time. LEAPS are available on most widely-held issues. Exotic Options: The simple calls and puts are referred to as "plain vanilla" options. Non-standard options are called exotic options, which either are variations on the payoff profiles of the plain vanilla options or are wholly different products with "optionality" embedded in them. Open Interest is the number of options contracts that are open; these are contracts that have not expired nor been exercised. SWAPS Swaps are the exchange of cash flows or one security for another to change the maturity (bonds) or quality of issues (stocks or bonds), or because investment objectives have changed. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates. Currency Swap involves the exchange of principal and interest in one currency for the same in another currency. Forward Swap agreements are created through the synthesis of two different swaps, differing in duration, for the purpose of fulfilling the specific timeframe needs of an investor. Sometimes swaps don't perfectly match the needs of investors wishing to hedge certain risks. For example, if an investor wants to hedge for a five-year duration beginning one year from today, they can enter into both a one-year and six-year swap, creating the forward swap that meets the requirements for their portfolio. Swaptions - An option to enter into an interest rate swap. The contract gives the buyer the option to execute an interest rate swap on a future date, thereby locking in financing costs at a specified fixed rate of interest. The seller of the swaption, usually a commercial or investment bank, assumes the risk of interest rate changes, in exchange for payment of a swap premium. Case Study The World Bank borrows funds internationally and loans those funds to developing countries. It charges its borrowers a cost plus rate and hence needs to borrow at the lowest cost. In 1981 the US interest rate was at 17 percent, an extremely high rate due to the anti-inflation tight monetary policy of the Fed. In West Germany the corresponding rate was 12 percent and Switzerland 8 percent. IBM enjoyed a very good reputation in Switzerland, perceived as one of the best managed US companies. In contrast, the World Bank suffered from bad image since it had used several times the Swiss market to finance risky third world countries. Hence, World Bank had to pay an extra 20 basis points (0.2%) compared to IBM

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In addition, the problem for the World Bank was that the Swiss government imposed a limit on the amount World Bank could borrow in Switzerland. The World Bank had borrowed its allowed limit in Switzerland and West Germany At the same time, the World Bank, with an AAA rating, was a well established name in the US and could get a lower financing rate (compared to IBM) in the US Dollar bond market because of the backing of the US, German, Japanese and other governments. It would have to pay the Treasury rate + 40 basis points. IBM had large amounts of Swiss franc and German deutsche mark debt and thus had debt payments to pay in Swiss francs and deutsche marks. World Bank borrowed dollars in the U.S. market and swapped the dollar repayment obligation with IBM in exchange for taking over IBM's SFR and DEM loans. It became very advantageous for IBM and the World Bank to borrow in the market in which their comparative advantage was the greatest and swap their respective fixed-rate funding.

1.3

FINANCIAL MARKETS

1.3.1 WHAT ARE FINANCIAL MARKETS?


A financial transaction is one where a financial asset or instrument, such as cash, check, stock, bond, etc are bought and sold. Financial Market is a place where the buyers and sellers for the financial instruments come together and financial transactions take place.

1.3.2

TYPES OF FINANCIAL MARKETS

PRIMARY MARKETS Primary market is one where new financial instruments are issued for the first time. They provide a standard institutionalized process to raise money. The public offerings are done through a prospectus. A prospectus is a document that gives detailed information about the company, their prospective plans, potential risks associated with the business plans and the financial instrument. SECONDARY MARKETS Secondary Market is a place where primary market instruments, once issued, are bought and sold. An investor may wish to sell the financial asset and encash the investment after some time or the investor may wish to invest more, buy more of the same asset instead, the decision influenced by a variety of possible reasons. They provide the investor with an easy way to buy or sell.

1.3.3 THE DIFFERENT FINANCIAL MARKETS


A financial market is known by the type of financial asset or instrument traded in it. So there are as many types of financial markets as there are of instruments. Typical examples of financial markets are:

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Stock market Bond (or fixed income) market Money market Foreign exchange (Forex or FX for short) market (also called the currency market). Stock and bond markets constitute the capital markets. Another big financial market is the derivatives market. CAPITAL MARKETS Why businesses need capital? All businesses need capital, to invest money upfront to produce and deliver the goods and services. Office space, plant and machinery, network, servers and PCs, people, marketing, licenses etc. are just some of the common items in which a company needs to invest before the business can take off. Even after the business takes off, the cash or money generated from sales may not be sufficient to finance expansion of capacity, infrastructure, and products / services range or to diversify or expand geographically. Some financial services companies need to raise additional capital periodically in order to satisfy capital adequacy norms. What is the role of Capital Markets? For businesses to thrive and grow, presence of vibrant and efficient capital markets is extremely important. Capital markets have following functions: 1. Channeling funds from savings pool to investment pool channeling funds from those who have money to those who need funds for business purpose. 2. Providing liquidity to investors i.e. making it easy for investors, to buy and sell financial assets or instruments. Capital markets achieve this in a number of ways and it is particularly important for institutional investors who trade in large quantities. Illiquid markets do not allow them to trade large quantities because the orders may simply not get executed completely or may cause drastic fluctuations in price. 3. Providing multitude of investment options to investors this is important because the risk profile, investment criteria and preferences may differ for each investor. Unless there are many investment options, the capital markets may fail to attract them, thus affecting the supply of capital. 4. Providing efficient price discovery mechanism efficient because the price is determined by the market forces, i.e. it is a result of transparent negotiations among all buyers and sellers in the market at any point. So the market price can be considered as a fair price for that instrument. STOCK MARKETS Stock markets are the best known among all financial markets because of large participation of the retail investors. The important stock exchanges are as follows: New York Stock Exchange (NYSE) National Association of Securities Dealers Automated Quotations (NASDAQ) London Stock Exchange (LSE)

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Bombay Stock Exchange (BSE), National Stock Exchange of India (NSE) Stock Exchanges provide a system that accepts orders from both buyers and sellers in all shares that are traded on that particular exchange. Exchanges then follow a mechanism to automatically match these trades based on the quoted price, time, quantity, and the order type, thus resulting in trades. The market information is transparent and available real-time to all, making the trading efficient and reliable. Earlier, before the proliferation of computers and networks, the trading usually took place in an area called a Trading Ring or a Pit where all brokers would shout their quotes and find the counter-party. The trading ring is now replaced in most exchanges by advanced computerized and networked systems that allow online trading, so the members can log in from anywhere to carry out trading. For example, BOLT of BSE and Super DOT of NYSE. What determines the share price and how does it change? The share price is determined by the market forces, i.e. the demand and supply of shares at each price. The demand and supply vary primarily as the perceived value of the stock for different investors varies. Investor will consider buying the stock if the market price is less than the perceived value of the stock according to that investor and will consider selling if it is higher. A large number of factors have a bearing on the perceived value. Some of them are: Performance of the company Performance of the industry to which it belongs State of the countrys economy where it operates as well as the global economy Market sentiment or mood relating to the stock and on the market as a whole Apart from these, many other factors, including performance of other financial markets, affect the demand and supply. BOND MARKETS As the name suggests, bonds are issued and traded in these markets. Government bonds constitute the bulk of the bonds issued and traded in these markets. Bond markets are also sometimes called Fixed Income markets. While some of the bonds are traded in exchanges, most of the bond trading is conducted over-the-counter (OTC), i.e. by direct negotiations between dealers. Lately there have been efforts to create computer-based market place for certain type of bonds. Participants in the Bond Market Since Government is the biggest issue of bonds, the central bank of the country such as Federal Reserve in US and Reserve Bank of India in India, is the biggest player in the bond market. Like stock markets, one needs to be an authorized dealer of Govt. securities, to subscribe to the bond issues. Typically, the Govt. bond issues are made by way of auctions, where the dealers bid for the bonds and the price is fixed based on the bids received. The dealers then sell these bonds in the secondary market or directly to third parties, typically institutions and companies. If the interest rate is fixed for each bond, why do the bond prices fluctuate? Bond prices fluctuate because the interest rates as well as the perceptions of investors on the direction of interest rates change. Remember, bond pays interest at a fixed coupon rate

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determined at the time of issue, irrespective of the prevailing market interest rate. Market interest rates are benchmark interest rates, such as Treasury bill rates, which are subject to change because of various factors such as inflation, monetary policy change, etc. So when the prevailing market interest rates change, price of the bond (and not the coupon) adjusts, so that the effective yield for a buyer at the time (if the bond is held to maturity) matches the market interest rate on other bonds of equal tenure and credit rating (risk). So when the market interest rates go up, prices of bonds fall and vice-versa. Therefore, price of bonds changes when market interest rate changes, all bonds have an interest rate risk. If the market interest rates shoot up, then the bond price is affected negatively and an investor who bought the bond at a high price (when interest rates were low) stands to lose money or at least makes lesser returns than expected, unless the bond is held to maturity. Example Bond Price calculation can be summed by an easy formula:

where B represents the price of the bond and CFk represents the kth cash flow which is made up of coupon payments. The Cash Flow (CF) for the last year includes both the coupon payment and the Principal. What would be the bond price for a 3-Year, Rs.100 principal, bond when the interest rate (i) is 10% and the Coupon payments are Rs.5 annually? Would the bond price increase/decrease if the coupon is reduced? What would be happen to bond price if the interest rates came down? FOREIGN EXCHANGE MARKET Foreign exchange markets are where the foreign currencies are bought and sold. For example, importers need foreign currency to pay for their imports. Government needs foreign currency to pay for its imports such as defense equipment and to repay loans taken in foreign currency. Foreign exchange rates express the value of one currency in terms of another. They involve a fixed currency, which is the currency being priced and a variable currency, the currency used to express the price of the fixed currency. For example, the price of a US Dollar can be expressed in different currencies as: USD (US Dollar) 1 = Indian Rupee (INR) 46, USD 1 = Great Britain Pound (GBP) 0.6125, USD 1 = Euro 0.8780 etc. In this example, USD is the fixed currency and INR, GBP, Euro are the variable currencies. US Dollar, British Sterling (Pound), Euro and Japanese Yen are the most traded currencies worldwide, since maximum business transactions are carried out in these currencies. The exchange rate at any time depends upon the demand supply equation for the different currencies, which in turn depends upon the relative strength of the economies with respect to the other major economies and trading partners. Participants

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Only authorized foreign exchange dealers can participate in the foreign exchange market. Any individual or company, who needs to sell or buy foreign currency, does so through an authorized dealer. Currency trading is conducted in the over-the-counter (OTC) market. The role of the Central Bank in the foreign exchange market The central bank regulates the markets to ensure its smooth functioning. The degree of regulation depends on the economic policies of the country. The central bank may also buy or sell their currency to meet unusual demand supply mismatches in the markets. The foreign exchange rate and transactions are closely monitored because the fluctuations in Forex markets affects the profitability of imports and exports of domestic companies as well as profitability of investments made by foreign companies in that country. Regulators try to ensure that the fluctuations are not caused by any factor other than the market forces. Example The Bank of Japan plays the role of central bank in Japan. It strictly monitors the exchange rates to ensure that the importers/exporters are not hurt due to any exchange rate fluctuations. Still, the USD/JPY, which is the second most traded currency pair in the world, maintains a long-standing reputation of sharp increases in short-term volatilities. MONEY MARKET Money market is for short term financial instruments, usually a day to less than a year. The most common instrument is a repo, short for repurchase agreement. A repo is a contract in which the seller of securities, such as Treasury Bills, agrees to buy them back at a specified time and price. Treasury bills of very short tenure, commercial paper, certificates of deposits etc. are also considered as money market instruments. Since the tenure of the money market instruments is very short, they are generally considered safe. In fact they are also called cash instruments. Repos especially, since they are backed by a Govt. security, are considered virtually the safest instrument. Therefore the interest rates on repos are the lowest among all financial instruments. Money market instruments are typically used by banks, institutions and companies to park extra cash for a short period or to meet the regulatory reserve requirements. For short-term cash requirements, money market instruments are the best way to borrow. Participants Whereas in stock market the typical minimum investment is equivalent of the price of 1 share, the minimum investment in bond and money markets runs into hundreds of thousands of Rupees or Dollars. Hence the money market participants are mostly banks, institutions, companies and the central bank. There are no formal exchanges for money market instruments and most of the trading takes place using proprietary systems or shared trading platforms connecting the participants.

1.3.4 REGULATION OF CAPITAL MARKETS


There are many reasons why the financial markets are regulated by governments:

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Since the capital markets are central to a thriving economy, Governments need to ensure their smooth functioning. Governments also need to protect small or retail investors interests to ensure there is participation by a large number of investors, leading to more efficient capital markets. Governments need to ensure that the companies or issuers declare all necessary information that may affect the security prices and that the information is readily and easily available to all participants at the same time. Typically the government designates one or more agencies as regulator(s) and supervisor(s) for the financial markets. Thus India has Securities and Exchange Board of India (SEBI) and the US has Securities and Exchange Commission (SEC). These regulatory bodies formulate rules and norms for each activity and each category of participant. For example, Eligibility norms for a company to be allowed to issue stock or bonds, Rules regarding the amount of information that must be made available to prospective investors, Rules regarding the issue process, Rules regarding periodic declaration of financial statements, etc. Regulators also monitor the capital market activity continuously to ensure that any breach of laws or rules does not go unnoticed. To help this function, all members and issuers have to submit certain periodic reports to the regulator disclosing all relevant details on the transactions undertaken.

1.3.5 FINANCIAL MARKET SYSTEMS


The demands of the capital market transactions, the need for tracking and managing risks, the pressure to reduce total transaction costs and the obligation to meet compliance requirements make it imperative that the functions be automated using advanced computer systems. Some of the major types of systems in capital market firms are briefly described below. TRADING SYSTEMS The volume of transactions in capital markets demands advanced systems to ensure speed and reliability. Due to proliferation of Internet technology, the trading systems are also now accessible online allowing even more participants from any part of the world to transact, helping to increase efficiency and liquidity. The trading systems can be divided into front-end order entry and back-end order processing systems. Order entry systems also offer functions such as order tracking, calculation of profit and loss based on real-time price movements and various tools to calculate and display risk to the value of investments due to price movement and other factors. Back-office systems validate orders, route them to the exchange(s), receive messages and notifications from the exchanges, interface with external agencies such as clearing firm, generate management, investor and compliance reports, keep track of member account balances etc. EXCHANGE SYSTEMS

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The core exchange system is the trading platform that accepts orders from members, displays the price quotes and trades, matches buy and sell orders dynamically to fill as many orders as possible and sends status messages and trade notifications to the parties involved in each trade. In addition, exchanges need systems to monitor the transactions, generate reports on transactions, keep track of member accounts, etc. PORTFOLIO MANAGEMENT SYSTEMS These systems allow the investment managers to choose the instruments to invest in, based on the requirements or inputs such as amount to be invested, expected returns, duration (or tenure) of investment, risk tolerance etc. and analysis of price and other data on the instruments and issuers. The term portfolio refers to the basket of investments owned by an investor. A portfolio of investments allows one to diversify risks over a limited number of instruments and issuers. ACCOUNTING SYSTEMS The accounting systems take care of present value calculations, profit & loss etc. - of investments and funds and not the financial accounts of the firms.

SUMMARY
Financial markets facilitate financial transactions, i.e. exchange of financial assets such stocks, bonds, etc. Financial markets bring buyers and sellers in a financial instrument together, thus reducing transaction costs, channeling funds, improving liquidity and provide a transparent price discovery mechanism. Each financial market is segmented into a Primary market, where new instruments are issued and a Secondary market, where the previously issued instruments are bought and sold by investors. Stock markets, bond markets, money markets, foreign exchange markets and derivatives markets are prominent examples of financial markets. Shares (stock) of a company are issued and traded in the stock markets. Bond markets are where bonds such as treasury bonds, treasury notes, corporate bonds, etc. are traded. Money markets, like bonds markets, are also fixed income markets. Instruments traded in money markets have very short tenure. Foreign exchange markets trade in currencies. Derivatives markets trade derivatives, which are complex financial instruments, whose returns are based upon the returns from some other financial asset called as the underlying asset. Price of any financial instrument depends basically on demand and supply, which in turn depend upon multiple different factors for different markets. Each financial instrument has a differing level of inherent risk associated with it. Money market instruments are considered the safest due to their very short tenure.

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Regulators play a very important role in the development and viability of financial markets. Regulators try to ensure that the markets function in a smooth, transparent manner, that there is sufficient and timely disclosure of information, that the interest of small investors is not compromised by the large investors, and so on, which is critical for overall vibrancy, efficiency and growth of the market and the economy.

1.4 1.4.1

FINANCIAL STATEMENTS INTRODUCTION TO FINANCIAL ACCOUNTING

Why does the concept of Accounting and Financial Statements exist? Here are two main reasons: 1. The managers of the business will want to know how things are going. They need financial information in order to plan for the future; they need more up-to-date information in order to check whether actual performance is on target. So accounting is the first step in what we call management accounting. 2. There are several other groups of people who may have an interest in the finances of the business (often referred to as 'stakeholders'). The law says that they have a legal right to certain information. The whole process of providing this information (and of maintaining a book-keeping system which is capable of providing it) is known as financial accounting. The stakeholders of any firm could be any or all of the following: 1. Shareholders 2. Employees 3. Management 4. Customers 5. Government 6. Trade Unions and others Question: Who owns the firm - management or shareholders? Answer: Shareholders of course, as they hold shares of the company. However Management personnel/directors of a company are also encouraged to hold shares of the company to align the interest of management and shareholders. ) For Accounting purpose, Company is considered as a Legal Entity that is, a person or organization that has the legal standing to enter into contracts and may be sued for failure to perform as agreed in the contract, e.g., a child under legal age is not a legal entity, while a corporation is a legal entity since it is a person in the eyes of the law.

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In order that the stakeholders mentioned above understand the financial position of a company, there are standardized financial statements that are prepared. The main ones are: 1. Balance Sheet 2. Income Statement or Profit and Loss Account 3. Cash-Flow statement Now, let us study them one at a time (why do we need to do that? Well, one of the aims of this course is to ensure that we are familiar with the basic concepts and terms used in Finance. And the above statements are as basic as it gets. SO read on) BALANCE SHEET A Balance sheet is a statement that lists the total assets and the total liabilities of a given business to portray its net worth at a given moment of time. Thus, if we look at any balance sheet, it is As on March 31st 200X (Or whatever the financial year ending date) So, it indicates the health of the firm at a point of time. What are the individual items in a Balance Sheet? First of all its called a balance sheet because the Asset and Liabilities in a Balance sheet balance, meaning they equal each other its as simple as that! An Asset is anything owned by an individual or a business, which has commercial value. Claims against others also qualify as Assets. (That is, if someone owes us something, then it is also an asset, as it actually belongs to us and is of commercial value) A Liability is a debt payable by the firm to its creditors. It represents an economic obligation to pay cash, or provide goods and services, in some future period. (Thus, if we buy a bike on installments, Bike is of course an asset as it has capability to provide us service for next few years, but the loan amount which we need to pay out in installments is a Liability we incur.) The typical heads in a balance sheet are shown below with a sample: Consolidated Statements of Financial Positions (All number in thousands) Assets Current Assets Cash and Cash Equivalents Short Term Investments Receivables $100 100 200 Liabilities Current Liabilities Payables and Accrued Expenses Short Term Loans Debt due in the next 1 year $50 150 100

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Inventory Other Current Assets Total Current Assets Long Term Assets

50 50 500

Other Current Liabilities

50

Total Current Liabilities Long term Liabilities Long term debt

350

Net Fixed Assets (Land, Properties 200 and Equipments) Intangible Assets Goodwill Other Assets 100 50 50

200

Deferred Liabilities Other Liabilities Total Liabilities Shareholders Equity Equity Retained Earnings

50 100 700

100 100 200

Total Long Term Assets Total Assets Lets look at each item closely: ASSETS: CURRENT ASSETS

400 900

Total Shareholders Equity

Total Liabilities and Shareholders 900 Equity

Current Assets are those assets of a company that are reasonably expected to be realized in cash, or sold, or consumed in the next one year. Some current assets are listed below: Cash and Cash Equivalents: Cash And Cash Equivalents means all cash, securities, which can be converted into cash at a very short notice, and other near-cash items (E.g. checks, drafts, cash in bank accounts etc). Short Term Investments: All investments, which will be converted in Cash in the next one year. All the assets (bonds etc) with less than one year time to maturity will be accounted under this item (E.g. short term securities). Receivables: Also referred to as Account receivables. This indicates the money due to the firm, for service rendered or goods sold on credit. Inventory: Inventory for companies includes raw materials, items available for sale or in the process of being made ready for sale (work in process). For a stockbroker, it will be the securities bought and held by him, for resale.

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Other Current Assets: Anything else which could not be categorized in one of the items above but we know that its a current asset can be accounted for here. LONG-TERM ASSETS Long-term assets are those assets that are not consumed during the normal course of business, e.g. land, buildings and equipment, goodwill, etc. They include: Fixed Assets: Fixed Assets are assets of a permanent nature required for the normal conduct of a business, and which will not normally be converted into cash during the next fiscal period. For example, furniture, fixtures, land, and buildings are all fixed assets. Fixed asset is value of all property, plant, and equipment, net of depreciation. Depreciation We all understand that if we buy a car today, after 5 years of service the value of the car would not be same. We will not be able to sell the car after 5 years at the same price at which we bought the car. This means that assets lose their value as they provide service. This loss of value, or spreading of cost, is called depreciation. Calculating deprecation can get complex, but heres one simple way of calculating depreciation. Say, we know that life of a computer is 3 years and we bought it for $ 3000. So at the end of the 3 years the asset will have a Zero value. What is the true value of the asset at the end of each year? Just depreciate the value of the Asset by $ 1000 (3000/3) each year. Thus: Value of Asset $ (3000-1000)=$ 2000 $1000 $0 End of Year 1 2 3

Usually, instead of the value coming all the way down to zero, it is said to have a scrap value: say, $100. At this point, the asset is removed from the business books, or said to be written off . INTANGIBLE ASSETS: Intangible Asset is an asset that is not physical in nature. Examples are things like copyrights, patents, intellectual property, or goodwill. We can look at more details through an example of Goodwill below. Goodwill Goodwill is that intangible possession which enables a business to continue to earn a profit that is in excess of the normal or basic rate of profit earned by other businesses of similar type. Say, a company such as Hindustan levers, has built up a lot of goodwill over the years. Customers

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would prefer to buy their products versus an unknown brand. This is an intangible factor, yet worth a lot of money!

OTHER ASSETS: Again, any other asset, which could not be classified under any of the categories above, but one is sure its an asset, can be accounted for here. LIABILITIES CURRENT LIABILITIES Current Liabilities are amounts, or goods and services, to be paid or executed, within next one year. Payables and Accrued Expenses: A Company might have suppliers who supply on credit, and this is an Account Payable. An accrued expense is an expense that the company has already incurred but company has not paid for it so far. Short Term Loans: All the loans that have to be paid in the next one year. Debt payments due in the next year: Loans of 10-15 years duration are sometimes repaid in installments every year, and so just the money that has to be paid in the next one year would be accounted here. Other Current Liabilities: Any liabilities, which cannot be categorized under any of the headings above. LONG-TERM LIABILITIES Long-term debt: All debt, including bonds, debentures, bank debt, mortgages, deferred portions of long-term debt, and capital lease obligations. Please note that part of the loan that is due only after next one year is indicated here. Deferred Liabilities/Provisions: Deferred, in accounting, is any item where the asset or liability is not realized until a future date, e.g. annuities, charges, taxes, income, etc. So in this case, one knows that there will be some expenses, but the exact amount and dates are not known. Other Liabilities: Any liabilities, which cannot be categorized under any of the headings above. Equity This is basically equity share capital, which is capital raised by an entity through the sale of common shares in the primary market. This is also called share capital. Retained Earnings Retained Earnings are profits of the business that have not been distributed to the owners as of the balance sheet date. The earnings have been "retained" for planned activities such as business expansion - so they actually belong to the owners (shareholders), but have been retained.

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Quiz: How do the three items above change when company declares dividend? Answer: Nothing changes till the company pays out dividends. Quiz: How do these items change when company pays out dividends? Answer: Retained earnings go down by amount of dividend.

Advanced Quiz: Are stock options same as shares held by employees? Are these captured in these statements? Answer: A stock option is the right of an employee to buy company shares at a pre-specified price, which may be above or below the market price, as on date of the exercising of option. If the option price is below the market price, the employee may buy at the option price & sell at market price & thus realize a profit. If option price is above the market price as on that date, obviously the employee will not prefer to exercise the option. Hence, the options cannot be categorized as shares. However, in some balance sheets, provision may be made for these stock options under the liability head. INCOME (P & L) STATEMENTS Profit And Loss Statement (P&L) is also known as an income statement. It shows business revenue and expenses for a specific period of time (such as the financial year so if we look at any P & L statement, it always specifies a period of time, as: For the Financial Year Ended 31st December 2003. The difference between the total revenue and the total expense is the business net income. A key element of this statement, and one that distinguishes it from a balance sheet, is that the amounts shown on this statement represent transactions over a period of time while the items represented on the balance sheet show information as of a specific date (or point in time). So in engineering terms, Balance sheet has a memory like Flip-flops, while Income statement doesnt have a memory. It is important to understand that for a company Profit need not equal the Cash it has generated during a period. It might so happen that company has provided the service but the client has not yet paid and so company makes a Profit but not Cash. To account for cash generated during a period, companies also report Cash flow statement. A sample P&L statement is shown below. P&L ACCOUNT STATEMENT Revenue Direct Cost Direct Material A B = (C+D) C

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Direct Labor Gross Profit

D E = (A-B)

Operating Expenses (Based on the type of business, some of F = (G+ H+I+J+K) these items would qualify as indirect Cost) Administration R&D Marketing and Selling Expenses Any one time expenses (e.g. ex-gratia etc) Other Expenses Operating Income Other Income Other Expenses EBIT (Earnings Before Interest and Taxes) Interest Expenses Profit Before Tax (PBT) Income Taxes Net Income or PAT (Profit after Tax) G H I J K L = (E-F) M N O = (L+M-N) P Q = (O-P) R S= (Q-R)

EPS (Earnings Per Share) P/E Ratio Lets look at each item closely: Revenue

T = S/ Number of shares Market price/T

Revenue is the inflows of assets (may be Cash or Receivables, Remember!) from selling goods or providing services to customers. This is also referred to as the Top line (as it is the top line in the P& L statement!) Direct Cost Direct Cost is that portion of cost that is directly expended in providing a product or service for sale e.g. material and labor.

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Gross Profit Gross Profit is one of the key performance indicators. Gross profit shows the relationship between sales and the direct cost of products/services sold. It is measured as indicated in the table above. Indirect Cost Indirect Cost is that portion of cost that is indirectly expended in providing a product or service for sale (cannot be traced to a given project, in our case, in an economically feasible manner) e.g. rent, utilities, equipment maintenance, etc. Operating Expenses Operating Expenses is all selling and general & administrative expenses. This includes depreciation, but not interest expense. Operating Income Operating Income is revenue less cost of goods sold (Direct and Indirect costs) and related operating expenses that are applied to the day-to-day operating activities of the company. It excludes financial related items (i.e., interest income, dividend income, and interest expense), and taxes. EBIT (Earnings before Interest and Taxes) Its the earnings before any interest or taxes. Interest Expenses Interest expense captures all the finance charges incurred on any borrowed capital. Profit before Tax (PBT) Profit earned before accounting for Taxes. Income Taxes Amount of tax paid. This is a % of PBT. Net Income or PAT (Profit after Tax) This is the profit after all the obligations, which can be distributed to shareholders. This is also referred as the Bottom-line (as this is the bottom line in a P &L statement, or the final profit net of expenses & tax. EPS (Earnings per Share)

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Earnings per Share (EPS) is the amount of net income (earnings) related to each share; computed by dividing net income by the number of shares outstanding during the period. P/E Ratio Price to Earnings Ratio (P/E) is a performance benchmark that can be used as a comparison against other companies or within the stock's own historical performance. For instance, if a stock has historically run at a P/E of 35 and the current P/E is 12, we may want to explore the reasons for the drastic change. If we believe that the ratio is too low, we may want to buy the stock. There are a number of other ratios that help analysts to analyze the financial statements of companies to understand the current performance and future prospects; we are not discussing those here. CASH FLOW STATEMENT Statement accounting for all the inflows and outflows of cash is captured in this statement. Why do we need a separate Cash-flow statement? Isnt it covered in Balance sheet or Income statement? All the accounting is done based on the method wherein, revenue and expenses are recorded in the period in which they are earned or incurred regardless of whether cash is received or disbursed in that period. So when a good is sold or some service rendered, it will show in Balance sheet and Income statement, but it will not show in the Cash Flow statement till cash is received for the same. Quiz: How will we explain a scenario where company is reporting a large profit but company doesnt have the cash to pay salary to its employees? Where is the cash going or did it come at all? Answer: It means that the company is selling goods and also making profits but has not received cash payments from its customers! Exercise 1. Day 1: We borrow Rs 100 from a bank for a business to produce t-shirts. How would our balance sheet look like at the end of the day? 2. Day 2: We purchase raw material for your products for Rs 50. How would our balance sheet look like at the end of the day? 3. Day 3 to 29: Workers work with the rented machines to produce the finished goods. The product is ready to be shipped to customer. 4. Day 30: We pay the workers Rs 20 as their salary, pay Rs 10 as the machine rent, pay other expenses such as floor rent, electricity bills etc totaling Rs 10. At the end of the

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day the product is shipped to the customer. Customer has promised to pay you Rs 120 after checking the quality, which will take 5 days. How would our balance sheet look like at the end of the day? How would our Income statement look like? 5. Day 35: You get Rs 120 from customer. You also get admission in a Business School and so you plan to wind up the business. Prepare all the financial statements (Balance sheet and Profit and loss statement at the end of day 35). Useful Information: Bank charges 12% simple interest rate. We need to pay tax @ 10% of the net income. Inflation for the period was 5%. Advanced Exercise Infosys has all its revenue in Dollars. Direct cost for the company is 60% of its revenue. Of this 60%, 30% in incurred in dollars (onsite component) while 70% (offshore component) is incurred in rupees. Indirect cost for the company is 20%. Of this 20%, 70% (Selling and Marketing, US infrastructure etc) is incurred in dollars while rest (Indian infrastructure, entertainment etc) is incurred in rupees. By what percentage, will the profit increase/decrease if the rupee appreciates by 1% from its current level of Rs. 50 per dollar? Understanding Cognizants Financial Statements COGNIZANTS BALANCE SHEET
In Millions of USD (except for per share items) Cash & Equivalents Short Term Investments Cash and Short Term Investments Accounts Receivable Trade, Net Receivables - Other Total Receivables, Net Total Inventory Prepaid Expenses Other Current Assets, Total Total Current Assets Property/Plant/Equipment , Total - Gross Goodwill, Net Intangibles, Net Long Term Investments Other Long Term Assets, Total Total Assets Accounts Payable Accrued Expenses Notes Payable/Short Term Debt Current Port. of LT Debt/Capital Leases Other Current liabilities, Total Total Current Liabilities Long Term Debt Capital Lease As of 2008-12-31 As of 2007-12-31 As of 2006-12-31 As of 2005-12-31

735.07 27.51 762.58 579.64 579.64 125.90 1,468.12 654.44 154.03 47.79 161.69 87.67 2,374.56 39.97 298.17 0.00 49.44 387.58 -

339.85 330.58 670.42 436.46 436.46 135.30 1,242.18 499.03 148.79 45.56 0.00 45.73 1,838.31 36.18 272.34 0.00 32.16 340.68 -

265.94 382.22 648.16 298.48 298.48 93.76 1,040.39 315.69 27.19 20.46 17.78 1,325.98 27.84 200.54 0.00 21.13 249.50 -

196.94 227.06 424.00 176.70 176.70 62.73 663.42 211.72 18.22 16.28 24.99 869.89 16.42 119.29 0.00 18.08 153.79 -

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Obligations Total Long Term Debt Total Debt Deferred Income Tax Minority Interest Other Liabilities, Total Total Liabilities Redeemable Preferred Stock, Total Preferred Stock - Non Redeemable, Net Common Stock, Total Additional Paid-In Capital Retained Earnings (Accumulated Deficit) Treasury Stock Common Other Equity, Total Total Equity Total Liabilities & Shareholders' Equity Shares Outs - Common Stock Primary Issue Total Common Shares Outstanding

Foundation Course in Banking and Capital Markets

0.00 0.00 7.29 14.11 408.98 2.92 541.74 1,430.40 -9.48 1,965.58 2,374.56 291.67

0.00 0.00 15.14 14.27 370.10 2.88 450.57 999.56 15.20 1,468.21 1,838.31 288.01

0.00 0.00 0.00 2.98 252.48 2.85 408.59 650.28 11.78 1,073.50 1,325.98 285.03

0.00 0.00 1.95 155.75 1.39 293.15 417.48 2.12 714.14 869.89 278.69

COGNIZANTS INCOME STATEMENT.


In Millions of USD (except for per 3 months 3 months 3 months 3 months 3 months share items) ending 2009- ending 2008-12- ending 2008-09- ending 2008-06- ending 2008-0303-31 31 30 30 31 Revenue 745.86 753.04 734.73 685.43 643.11 Other Revenue, Total Total Revenue 745.86 753.04 734.73 685.43 643.11 Cost of Revenue, Total 419.71 419.75 405.94 380.87 366.26 Gross Profit 326.15 333.30 328.79 304.56 276.84 Selling/General/Admin. Expenses, 166.87 169.38 166.69 167.10 148.85 Total Research & Development Depreciation/Amortization 21.15 21.25 19.47 17.78 16.29 Interest Expense(Income) - Net Operating Unusual Expense (Income) Other Operating Expenses, Total Total Operating Expense 607.73 610.38 592.10 565.75 531.41 Operating Income 138.13 142.67 142.63 119.68 111.69 Interest Income(Expense), Net NonOperating Gain (Loss) on Sale of Assets Other, Net -5.11 -12.34 -14.78 -0.48 3.95 Income Before Tax 135.49 136.09 133.20 124.06 121.87 Income After Tax 113.13 112.29 112.83 103.86 101.87 Minority Interest Equity In Affiliates Net Income Before Extra. Items 113.13 112.29 112.83 103.86 101.87 Accounting Change Discontinued Operations Extraordinary Item Net Income 113.13 112.29 112.83 103.86 101.87 Preferred Dividends Income Available to Common Excl. 113.13 112.29 112.83 103.86 101.87 Extra Items Income Available to Common Incl. 113.13 112.29 112.83 103.86 101.87 Extra Items

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Basic Weighted Average Shares Basic EPS Excluding Extraordinary Items Basic EPS Including Extraordinary Items Dilution Adjustment Diluted Weighted Average Shares Diluted EPS Excluding Extraordinary Items Diluted EPS Including Extraordinary Items Dividends per Share - Common Stock Primary Issue Gross Dividends - Common Stock Net Income after Stock Based Comp. Expense Basic EPS after Stock Based Comp. Expense Diluted EPS after Stock Based Comp. Expense Depreciation, Supplemental Total Special Items Normalized Income Before Taxes Effect of Special Items on Income Taxes Income Taxes Ex. Impact of Special Items Normalized Income After Taxes Normalized Income Avail to Common Basic Normalized EPS Diluted Normalized EPS 297.99 0.38 0.00 0.38 297.57 0.38 0.00 0.38 0.00 299.81 0.38 0.00 0.38

Foundation Course in Banking and Capital Markets


0.00 299.33 0.35 0.00 0.35 0.00 299.05 0.34 0.00 0.34

COGNIZANTS CASHFLOW STATEMENT.


In Millions of USD (except for 3 months 12 months 9 months 6 months 3 months per share items) ending 2009-03- ending 2008-12- ending 2008-09- ending 2008-06- ending 2008-0331 31 30 30 31 Net Income/Starting Line 113.13 430.85 318.56 205.73 101.87 Depreciation/Depletion 21.15 74.80 53.54 34.07 16.29 Amortization Deferred Taxes 3.94 -5.03 9.90 7.01 -6.67 Non-Cash Items 10.63 37.97 24.47 12.45 10.58 Changes in Working Capital -73.76 -108.88 -169.69 -162.23 -99.82 Cash from Operating Activities 75.09 429.70 236.79 97.03 22.26 Capital Expenditures -20.47 -169.41 -146.32 -85.21 -53.42 Other Investing Cash Flow Items, -23.07 114.40 112.87 110.90 119.58 Total Cash from Investing Activities -43.55 -55.01 -33.45 25.69 66.16 Financing Cash Flow Items 1.82 16.99 16.26 15.16 4.04 Total Cash Dividends Paid Issuance (Retirement) of Stock, -4.12 27.04 20.98 40.29 12.83 Net Issuance (Retirement) of Debt, 0.00 Net Cash from Financing Activities -2.30 44.03 37.24 55.45 16.88 Foreign Exchange Effects -5.74 -23.51 -11.16 3.18 4.60 Net Change in Cash 23.50 395.22 229.42 181.35 109.89 Cash Interest Paid, Supplemental Cash Taxes Paid, Supplemental 82.80 -

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2.0
2.1

BANKING
INTRODUCTION TO BANKING

2.1.1 WHAT IS A BANK?


The term Bank is used generically to refer to any financial institution that is licensed to accept deposits and issue credit through loans. Banks are the backbone of any economy, as all monetary transactions end up touching banks. The main functions of banks are to: Channelize Savings Provide credit facilities to borrower Provide investment avenues to investors Facilitate the trade and commerce dealings Provide financial backbone to support economic growth of the country Minimize Cash Transactions

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Provide Services

2.1.2 WHY DO WE NEED A BANK?


They provide a return (pay interest) on our saving Safety of principal and interest Convenience of being able to write checks and use debit cards Raising funds when we need From the business or economic point of view, however, banks are the primary source of finance. Since the deposits of the small investors are protected, bank deposits are considered a low risk investment avenue. Due to their access to a large source of funds at very low cost, owing largely to the low interest rate on savings and term deposits, banks are in the best position to lend to businesses and individuals at competitive interest rates.

2.1.3

WHAT IS THE CENTRAL BANK AND WHAT ARE ITS ROLES?

The Central bank of any country can be called the bankers bank. It acts as a regulator for other banks, while providing various facilities to facilitate their functioning. It also acts as the Governments bank. The Federal Reserve is the central bank of the United States, while Reserve Bank of India is the central bank in India. The main objective of a central bank is to provide the nation with a safer, more flexible, and more stable monetary and financial system. They have the following responsibilities: Conducting the nation's monetary policy. Central banks define the monetary policy and then take necessary actions to create an environment to make those policies feasible. E.g. if the central bank wants to maintain soft interest rate, they can reduce the CRR to pump in more money in the economy. Supervising and regulating banking institutions and protecting the rights of consumers Maintaining the stability of the financial system, i.e. stability of interest rates and foreign exchange rate. Ensuring that the interest rates remain at such a level as to make business viable Ensuring that sufficient funds are available for long term investment to businesses as well as government, without causing inflation to rise Providing certain financial services to the government, the public, financial institutions, and foreign official institutions Monitoring the foreign currency assets and liabilities and monitoring the inflow and outflow of foreign currency

2.1.4

BANKS, ECONOMY AND AMOUNT OF MONEY

Banks facilitate the creation of money in the economy. The primary function of banks is to put account holders' money to use by lending it out to others who can then use it to buy homes, businesses etc.

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Lets look at an example as how banks do this. The amount of money that banks can lend is directly affected by the reserve requirement set by the Central Bank. That is, every bank needs to maintain a certain percentage of its total deposits as cash, to ensure liquidity. This reserve requirement is also known as the CRR (Cash Reserve Ratio). When a bank gets a deposit of $100, assuming a reserve requirement of 10%, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it. In this way, money grows and flows throughout the community in a much greater amount than physically exists. This is also called multiplier effect. In the picture below, an initial deposit of $100 has created a reserve of $27, and loan of $244. Thus, banks facilitate the investing/spending of money that multiply funds through circulation and this is known as Money Multiplier effect.

2.1.5

HOW DO BANKS MAKE MONEY?

Banks are like any other regulated business; the product they deal with is Money. So they borrow money from individual or businesses who have money, and lend it to those who need money, by adding a mark up, to pay for expenses and profit. The difference between the rates, which banks offer to depositors and lenders, is generally referred to as Spread. Understandably, the spread in this business is low; hence increasing the turnover (volume) is the key to making profit. Hence, in practice, banks offer a number of options often termed as products - to both investors and borrowers to meet their different requirements and preferences and thus increase business. They also provide fee-based services such as managing cash for corporate clients, to increase business and improve profit margin.

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2.1.6

SERVICE OFFERINGS OF BANKS

Service offerings of banks are organized along following divisions: Corporate Banking o Trade Finance o Cash Management Retail Banking o Deposits Checking, Savings, Retirement accounts, Term deposits o Branch & Electronic Banking o Credit Card services o Retail Lending Personal Loans, Home Mortgages, Consumer Loans, Vehicle Loans o Private Banking & Wealth Management o SME/Business Banking for SMEs Investment Banking o Private Equity o Corporate Advisory o Capital Raising o Proprietary Trading o Emerging Markets o Sales, Trading & Research Equity Fixed Income Derivatives

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2.1.7 TOP 50 BANKS IN THE US BY ASSET SIZE


Listed below are the Top 50 bank holding companies (BHCs) as of 12/31/2008 Rank Institution Name 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 JPMORGAN CHASE & CO. CITIGROUP INC. BANK OF AMERICA CORPORATION WELLS FARGO & COMPANY HSBC NORTH AMERICA HOLDINGS INC. TAUNUS CORPORATION PNC FINANCIAL SERVICES GROUP, INC., THE U.S. BANCORP BANK OF NEW YORK MELLON CORPORATION, THE SUNTRUST BANKS, INC. STATE STREET CORPORATION CAPITAL ONE FINANCIAL CORPORATION CITIZENS FINANCIAL GROUP, INC. BB&T CORPORATION REGIONS FINANCIAL CORPORATION TD BANKNORTH INC. FIFTH THIRD BANCORP KEYCORP HARRIS FINANCIAL CORP. NORTHERN TRUST CORPORATION BANCWEST CORPORATION UNIONBANCAL CORPORATION COMERICA INCORPORATED M&T BANK CORPORATION MARSHALL & ILSLEY CORPORATION BBVA USA BANCSHARES, INC. Total Assets $2,175,052,000 $1,938,470,000 $1,822,068,028 $1,309,639,000 $434,715,911 $396,659,000 $291,092,876 $267,032,000 $237,652,000 $189,137,961 $176,632,334 $165,913,451 $160,444,183 $152,015,025 $146,253,935 $122,745,454 $119,763,812 $105,231,004 $88,258,094 $82,053,626 $79,858,266 $70,121,446 $67,912,580 $65,815,757 $62,517,618 $62,305,413

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27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50

ZIONS BANCORPORATION HUNTINGTON BANCSHARES INCORPORATED POPULAR, INC. SYNOVUS FINANCIAL CORP. NEW YORK COMMUNITY BANCORP, INC. RBC BANCORPORATION (USA) FIRST HORIZON NATIONAL CORPORATION COLONIAL BANCGROUP, INC., THE ASSOCIATED BANC-CORP BOK FINANCIAL CORPORATION FIRST BANCORP WEBSTER FINANCIAL CORPORATION COMMERCE BANCSHARES, INC. FBOP CORPORATION TCF FINANCIAL CORPORATION FIRST CITIZENS BANCSHARES, INC. FIRST NATIONAL OF NEBRASKA, INC. CITY NATIONAL CORPORATION FULTON FINANCIAL CORPORATION W HOLDING COMPANY, INC. NEW YORK PRIVATE BANK & TRUST CORPORATION SUSQUEHANNA BANCSHARES, INC. SOUTH FINANCIAL GROUP, INC., THE BANCORPSOUTH, INC.

$55,339,951 $54,355,998 $38,883,000 $35,786,269 $32,488,105 $32,434,425 $31,022,768 $25,816,306 $24,198,697 $22,840,287 $19,491,268 $17,600,122 $17,545,887 $17,346,706 $16,782,760 $16,745,662 $16,725,869 $16,458,765 $16,185,106 $15,317,974 $14,744,507 $13,682,988 $13,600,077 $13,499,414

2.1.8 UNIVERSAL BANKING


The universal banking concept permits banks to provide commercial bank services, as well as investment bank services at the same time.

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Glass-Steagall Act of 1933, created a Chinese wall between commercial banking and securities businesses in US. That act was intended to address the perceived causes of bank failures during the Great Depression of 1929. Today, Glass-Steagall restrictions have become outdated and unnecessary. It has become clear that promoting stability and best practices cannot be done through artificially separating these business areas. Over the years, banks and securities firms have been forced to find various loopholes in the Glass-Steagall barriers. The restrictions undermined the ability of American banks to compete with the other global banks which were not covered by such legislation. Most of Glass-Steagall provisions have been repealed in the US in 1990s enabling the banks to offer a full range of commercial and investment banking services to their customers. Provisions that prohibit a bank holding company from owning other financial companies were repealed on November 12, 1999, by the Gramm-Leach-Bliley Act. The Glass-Steagall Act prohibited a bank from offering investment, commercial banking, and insurance services. The Gramm-Leach-Bliley Act (GLBA) allowed commercial and investment banks to consolidate Example In the late 1990s, before legislation officially eradicated the Glass-Steagall Acts restrictions, the investment and commercial banking industries witnessed an abundance of commercial banking firms making forays into the I-banking world. The mania reached a height in the spring of 1998. In 1998, NationsBank bought Montgomery Securities, Socit Gnerale bought Cowen & Co., First Union bought Wheat First and Bowles Hollowell Connor, Bank of America bought Robertson Stephens (and then sold it to BankBoston), Deutsche Bank bought Bankers Trust (which had bought Alex. Brown months before), and Citigroup was created in a merger of Travelers Insurance and Citibank. While some commercial banks have chosen to add I-banking capabilities through acquisitions, some have tried to build their own investment banking business. J.P. Morgan stands as the best example of a commercial bank that has entered the I-banking world through internal growth. J.P. Morgan actually used to be both a securities firm and a commercial bank until federal regulators forced the company to separate the divisions. The split resulted in J.P. Morgan, the commercial bank, and Morgan Stanley, the investment bank. Today, J.P. Morgan has slowly and steadily clawed its way back into the securities business, and Morgan Stanley has merged with Dean Witter to create one of the biggest I-banks on the Street.

SUMMARY
Banks are an integral part of any economy channelizing savings from lenders to borrowers Bank deposits are low risk investments The Central bank is the Bankers Bank and it regulates other banks in an economy. Central banks define a nations monetary policy A bank makes a profit by investing or lending money that is earning a higher rate of interest than it pays to its depositors.

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A bank is required to keep a certain amount of "cash reserves" by regulation to maintain liquidity, i.e. to ensure that the banking system does not face a cash crunch due to higher withdrawals, which can lead to panic among investors and a run on a bank. Banks create a Money Multiplier effect Banks are generally organized as corporate banking, investment banking, retail banking, and private banking functions. Universal banks provide commercial banking as well as investment bank services under one roof

3.0
3.1

RETAIL BANKING
INTRODUCTION

Retail banking addresses the banking and financial services needs of individuals also called Consumers and small medium enterprises (SME) or Small Businesses with say less than 1 M USD in revenue, otherwise called retail customers. Retail transactions are typically large volume low value but strongly governed by consumer friendly regulations and are critical to a bank. Retail banks or stores offer various services such as - Deposits (savings and checking accounts), Loans (mortgages, personal), debit cards, credit cards, investment products and so on. This is a typical mass-market banking in which individual customers use local branches, ATMs, Online banking, Phone Banking, Contact Centers and recently mobile banking for their financial / banking needs. In some geography such as Europe, APAC, Middle East retail banks also offer investment services such as wealth management, brokerage accounts, private banking and retirement planning for High Nett-worth Individuals.

3.1.1 VARIANTS OF RETAILS BANKS


There are various flavors of retail banks. Even though all of them cater to individual customers, they basically differ in some aspects like regulating bodies, types of customer, services provided. The US has Community Banks, Credit Unions and Savings Bank whereas Europe has Postal Savings Bank, Offshore Banks, Private Banks and so on. A. Community development banks (CDBs) In the United States, Community development banks provide retail banking services to the residents of the community and spur

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economic development in low- to moderate-income (LMI) geographical areas (typically the underserved community of the economy) . CDBs can apply for formal certification as a Community Development Financial Institution (CDFI) from the Community Development Financial Institutions Fund of the U.S. Department of the Treasury. E.g.: The largest and oldest community development bank is Shore Bank, headquartered in the South Shore neighborhood of Chicago. B. Credit Union: A credit union is a cooperative financial institution that is owned and controlled by its members, and operated for the purpose of promoting thrift, providing credit at reasonable rates, and providing other financial services to its members. Many credit unions exist to further community development or sustainable international development on a local level. C. Private Banks manage the assets of high net worth individuals. Private Banks are banks that are not incorporated, owned by either an individual or a general partner(s). In any such case, the creditors can look to both the "entirety of the bank's assets" as well as the entirety of the sole-proprietor's/general-partners' assets. E.g.: There are a few private banks remaining in the U.S. One is Brown Brothers Harriman & Co. D. Offshore banks are banks located in jurisdictions with low taxation and regulation. Many offshore banks are essentially private banks. An offshore bank is a bank located outside the country of residence of the depositor, typically in a low tax jurisdiction (or tax haven) that provides financial and legal advantages. E.g.: Banks in Channel Islands, the Caribbean Islands, Jersey etc. E. Savings banks primary purpose is accepting savings deposits. It also provides other services such as payments, credit and insurance. They differ from commercial banks by their broadly decentralized distribution network, providing local and regional outreach. E.g.: The first chartered savings bank in the United States was the Boston Provident Savings Institution, incorporated December 13, 1816. F. Postal savings banks leverage the postal network with a broad distribution arm to provide sales and service to its customers. Many nations' post offices operated, or continue to operate postal savings systems, to provide depositors who did not have access to banks a safe, convenient method to save money and to promote saving among the poor. The first nation to offer such an arrangement was Great Britain in 1861. The United States began a similar system in 1911 under the Act of 1910 but it was abolished by the Act of 1966.

3.1.2 ASSETS AND LIABILITIES IN BANKING:


The money that a bank receives as deposits from its depositors becomes a banks liability. The Loan provided by a Bank to its customers is a receivable and hence an asset to the bank .Further Loans are a source of providing interest income and deposit interests are an expense to the

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bank. The Bank further makes an income based on the lending rate-deposit rate spread. The chart shown here depicts how this process works.

This section of the document (Retail Banking) deals with only Retail Bank Liabilities or in other terms Deposit Products and Services. The retail bank assets (Cards and Payments, Consumer Lending, Mortgages) are dealt in separate sections.

3.2

DEPOSIT PRODUCTS

Banks offer the facility of holding excess cash of a consumer and pay an interest for the money placed with it. Deposits can be of two types Demand deposits are accounts that allow money to be deposited and withdrawn by the account holder on Demand (Savings, Checking). Another Class of deposits is placed with a bank for a specified term and is called Term Deposits. Banks may charge a maintenance fee for this service, while others may pay the customer interest on the funds deposited. Features of Deposit Products: 1. A customer can deposit and withdraw money from his Deposit Account. The frequency and limit of withdrawal differs from account to account. 2. Checks can be issued by the customer to withdraw or transfer money from his account. There may be restrictions as to number of checks issued in a month. 3. Interest is generally paid for all deposit products except for certain type of accounts like checking accounts.

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4. A minimum balance needs to be maintained in most of the accounts, failing which the bank will charge a penalty. But there are certain types of accounts like No frill accounts or Zero Balance accounts in which the customer need not maintain any balance. 5. Given below is the snap shot comparison of all the major types of accounts in a retail bank:

A. Basic or No Frill Banking Accounts Many institutions offer accounts that provide a limited set of services for a low price often referred to as "basic" or "no frill" accounts. They are usually checking accounts, but they may limit the number of checks written and the number of deposits and withdrawals made. Interest generally is not paid on basic accounts. B. Credit Union Accounts Credit unions offer accounts that are similar to accounts at other depository institutions, but have different names. Credit union members have "share draft" accounts (rather than checking), "share" accounts (rather than savings), and "share certificate" accounts (rather than certificate of deposit). C. Individual Retirement Accounts (IRA) An Individual Retirement Arrangement (or IRA) is a retirement plan account that provides some tax advantages for retirement savings in the United States. These allow a customer to save for his retirement by investing it in the IRA and using it as a channel to

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invest in other products. Withdrawal before the stipulated time incurs heavy penalty and foregoing taxes for the period used. There are a number of different types of IRAs, which may be either employer-provided or self-provided plans. The types include: Roth IRA - contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Traditional IRA - contributions are often tax-deductible (often simplified as "money is deposited before tax" or "contributions are made with pre-tax assets"), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted). SEP IRA - a provision that allows an employer (typically a small business or selfemployed individual) to make retirement plan contributions into a Traditional IRA established in the employee's name, instead of to a pension fund account in the company's name. SIMPLE IRA - a simplified employee pension plan that allows both employer and employee contributions, similar to a 401(k) plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately. Self-Directed IRA - a self-directed IRA that permits the account holder to make investments on behalf of the retirement plan.

3.3

RETAIL CHANNELS

3.3.1 BRANCH BANKING

A banking system in which there is a head office and interconnected branches providing financial services in different parts of the country Branch networks have re-emerged as combined centers for advice-based product sales and service, in addition to traditional banking transactions These are full-service centers -- from banking products to brokerage services Branches are being transformed from transaction processing centers into customer-centric, financial sales and service centers

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A typical Retail branch at a Bank has these two primary activities: o Teller Operations o Relationship Managers

TELLER OPERATIONS A bank teller is an employee of a bank who deals directly with most customers. In some places this employee is known as a cashier. Tellers are considered a "front line" in the banking business. This is because they are the first people that a customer sees at the bank and are also the people most likely to detect and stop fraudulent transactions in order to prevent losses at a bank (i.e. counterfeit currency and checks, identity theft, con artist schemes, etc.). The position also requires tellers to be friendly and interact with the customers, providing them with information about customers' accounts and bank services. Most tellers have a window (or wicket), a computer terminal, and a cash drawer from which they perform their transactions. These transactions include, but are not limited to: Check cashing, depositing Savings deposits, withdrawals Consignment item issuances (i.e. Cashier's Checks, Traveler's Checks, Money Orders, Federal Draft issuances, etc.) Payment collecting Promotion of the financial institution's products (loans, mortgages, etc.) Business referrals (i.e. Trust, Insurance, lending, etc.) Cash advances Savings Bonds purchase or redemption Resolving customer issues Balancing the vault, cash drawers, ATMs, and TAUs May include ordering products for the customer (checks, deposit slips, etc.) RELATIONSHIP MANAGERS/PRODUCT SPECIALISTS: Relationship Managers are the Banks single point of contact to the customer. They have day-today personal contact with the Client for new account opening, account maintenance and product sales and also develop tailored banking solutions for each Client. Generally, a Banks Global Relationship Manager coordinates the efforts of local Relationship Managers and Product Specialists around the world. The Global Network of Relationship Managers ensures a global level oversight of the client relationship.

3.3.2 CORE BANKING/MULTI BRANCH BANKING


It is a special facility that allows a customer to operate his Accounts through a network of branches of the bank where he has an account. All Multi Branch Banking account holders are eligible for Multi City Check (Pay At par Check) facilities. Under this service, the customer of one

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branch is able to transact on her account, from any other Networked branch of the Bank. The advantages of this is that there are quicker turnarounds in clearing, payments and the customer is not subjected to any systemic delays due to geographical constraints. This is usually facilitated by the implementation of a set of software called banking applications which handle the transactions end to end from booking to posting to the customer accounts and GLs and also interface with other applications of the bank. Some core banking vendors of repute are Fidelity, Temenos, Infosys (Finacle), Oracle (FLEXCUBE).

3.3.3 ATM
An automated teller machine (ATM) is a computerized telecommunications device that provides the customers with access to financial transactions in a public space without the need for a human clerk or bank teller. The customer is identified by inserting a plastic ATM card with a magnetic strip or a plastic smartcard with a chip that contains a unique card number and some security information, such as an expiration date or CVC (CVV). Security is provided by the customer entering a personal identification number (PIN). ATMs are known by various other names including automated banking machine, money machine, bank machine, cash machine, hole-in-the-wall, cash point, Bancomat (in various countries in Europe and Russia), Multibanco (after a registered trade mark, in Portugal), and Any Time Money (in India). Typical ATM Services o Cash withdrawal Limit per day restricted by respective bank guidelines o Money Transfer between accounts o Cash/ Check Deposits o Utility Bill Payments o Balance enquiry /Account Statements o Mobile Top Ups An interbank network, also known as an ATM consortium or ATM network, is a computer network that connects the ATMs of different banks and permits these ATMs to interact with the ATM cards of non-native banks. E.g.: Cirrus, Maestro, Plus, etc Debit cards and ATM cards are used to transact in ATMs and PoS (Point of Sale) Terminals. Visa and Master networks are large global networks that service ATMs The Bank / Entity that issue the card to the customer is called an Issuer while the Bank/Entity that acquires the transaction through the ATM / PoS terminal is an acquirer. The network handles the routing of the transaction from the Acquirers terminal to the accounting systems of the Issuer and processes the settlements through the intermediary networks.

3.3.4 TELEPHONE BANKING


Telephone banking allows customers to perform transactions over the telephone. Most telephone banking configurations use an automated phone answering system (IVR/VRU) with phone keypad response or voice recognition capability.

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Voice Response Unit (VRU), is a computer telephony integration (CTI) term that refers to the interaction between a human (typically a caller) and a computer that is programmed to respond to the human's requests. Also referred to as interactive voice response (commonly abbreviated to IVR), this is a computer phone application that accepts touch-phone keypad selection input from the caller and provides appropriate information in the form of voice answers or a connection to a "live" operator in a Contact Center. With the obvious exception of cash withdrawals and deposits, it offers virtually all the features of an automated teller machine: account balance information and list of latest transactions, electronic bill payments, funds transfers between a customer's accounts, etc.

3.3.5 CONTACT CENTRE/CALL CENTRE


Usually, customers want to speak to a live representative located in a call centre, although this feature is not guaranteed to be offered 24/7. In addition to the self-service transactions listed earlier in Phone Banking, telephone banking representatives are usually trained to do what was traditionally available only at the branch: loan applications, investment purchases and redemptions, check book orders, debit card replacements, change of address, etc. The contact centre /Call centre handle inbound service calls, technical support requests and sales enquiries, Sell products and advice through outbound calls. Web enabled services too are part of the mix. Outbound services originate at the lead generation teams which aim at sales/marketing, collections and surveys. Apart from Telephonic services, the contact centers provide web enabled services. - Email, Live chat and Live support.

3.3.6 ONLINE BANKING


Online banking (or Internet banking) allows customers to conduct financial transactions on a secure website operated by their bank or credit union. The common features fall broadly into the following broad categories: Account Management: - Enquiries , Transactions , Account Opening (Assets and Liability) Investment Services and Advisory Personal finance management Bill Pay and Recurring payments Statements : Monthly or quarterly bank statements Fund transfer: Funds transfer between a customers own checking and savings accounts or to another customers account

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Secure mail and chat Collaboration blogs , podcasts, RSS Feeds

3.3.7 MOBILE BANKING


Mobile banking (also known as M-Banking, mbanking, SMS Banking etc.) is a term used for performing balance checks, account transactions, payments etc. via a mobile device such as a mobile phone, PDA, Blackberry, iPhone etc. Given below is the list of services offered by retail banks through mobile banking. Account Information: Mini-statements and checking of account history Alerts on account activity PIN Set, Reset, Change Blocking of (lost, stolen) cards

Transactions: Domestic and international fund transfers Micro-payment handling Bill payment processing

Investments: Portfolio management services Real-time stock quotes Personalized alerts and notifications on security prices

Support: Check book and card requests Exchange of data messages and email, including complaint submission and tracking

Content Services: General information such as weather updates, news

3.4

INSTRUMENTS

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Instruments are used to move and /or transfer funds from one account to another. The account can be of the same person or different individuals. Instruments are also modes of payment. Some of the common instruments are as follows: Checks Cashiers check Certified Check Travelers Check

A check is a bill of exchange and is an instrument instructing a financial institution to pay a specific amount of a specific currency from an account holders specific demand account held in that bank. The receiver of the check is payee and the amount will be either credited into the payee account or the payee can encash the check from the makers bank (drawer). Given below are the various methods of processing a check. 3.4.1 PAPER CHECK PROCESSING Paper check processing is the traditional physical check processing. The drawer issues the check in the name of the Payee. The Payee presents the check in the drawer/makers bank to the credit of his account. 3.4.2 CHECK IMAGING/CHECK TRUNCATION When checks are deposited, they are converted into digital files. These images can be then exchanged between financial intermediaries via the web, e-mail, CD-ROM or faxes instead of actual transportation of paper checks. Once digitized, this information can be used to settle and debit accounts. The image can be used as the check writers receipt for the transaction. This clearing and settlement process is known as Check-truncation. By introducing check-truncation, intra-city clearing turn-around-times can be reduced dramatically. 3.4.3 RETURNED/ITEM PROCESSING Not all checks move easily through the check collection system, however. Sometimes a check is returned for various reasons like insufficient funds, improper details, signature not clear etc. If a bank refuses to honor a check, the check must be returned to the bank where the check was first deposited within a certain period specified by law. The bank then investigates the item and takes corrective action to process the check. These are called exceptions or returned items. 3.4.4 ELECTRONIC CHECK CONVERSION An electronic check is a transaction that starts at the cash register with a paper check for payment, but the payment is converted to an electronic debit, which is processed via

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the ACH network. ECC converts a paper check into an electronic payment at the point of sale or elsewhere. The following are the typical steps followed in a check conversion In a store, the customer can present a check to a store cashier. The check can be processed through an electronic system that captures the banking information and the amount of the check. Once the check is processed, the customer signs a receipt authorizing the store to present the check to the bank electronically and deposit the funds into the stores account. The customer gets a receipt of the electronic transaction and the check is returned to the customer. It should be voided or marked by the merchant so that it can't be used again.

3.5

RETAIL PAYMENTS

Retail payments usually involve transactions between consumers and businesses. Although there is no definitive division between retail and wholesale payments, retail payment systems generally have higher transaction volumes and lower average dollar values than wholesale payments systems. This section provides background information on payments typically classified as retail payments. Consumers generally use retail payments in one of the following ways: Purchase of Goods and ServicesPayment at the time the goods or services are purchased. It includes attended (i.e., traditional retailers), unattended (e.g., vending machines), and remote purchases (e.g., Internet and telephone purchases). A variety of payment instruments may be used, including cash, check, credit, or debit cards. Bill PaymentPayment for previously acquired or contracted goods and services. Payment may be recurring or nonrecurring. Recurring bill payments include items such as utility, telephone, and mortgage/rent bills. Non-recurring bills include items such as medical bills P2P PaymentsPayments from one consumer to another. The vast majority of consumer-to-consumer payments are conducted with checks and cash, with some transactions conducted using electronic P2P payment systems. Cash Withdrawals and AdvancesUse of retail payment instruments to obtain cash from merchants or automated teller machines (ATMs). For example, consumers can use a credit card to obtain a cash advance through an ATM or an ATM card to withdraw cash from an existing demand deposit or transaction account. Consumers can also use personal identification number (PIN)-based debit cards to withdraw cash at an ATM or receive cash-back at some point-of-sale (POS) locations. Important Trends in Retail Payments:

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Shift from paper to electronic payments: Recent research has found that consumer use of electronic payments has grown significantly in recent years, and the trend will accelerate. Increase in Online Transactions: Debit and credit cards were one of the key drivers for much of the growth in electronic payments. Although on-line, or PIN-based, debit cards were introduced in the early 1980s, rapid adoption has only occurred since the early 1990s. Off-line, or signature-based, debit cards, introduced in the late 1980s, have experienced significant growth since the mid 1990s, and recent surveys have found that off-line debit card transactions have now overtaken on-line debit card transactions by almost a three-to-one margin. Growth in ACH Payments: Consumers traditionally used checks for a large portion of bill payments in the United States. However, consumers are increasingly using direct bill payment through the ACH. Despite the increase in electronic bill payment, many consumers still rely on checks to make a significant portion of their bill payments. More recently, retail firms have employed check to ACH conversion processes to allow electronic settlement, thus reducing the number of checks that flow through the payment system. Internet Banking and Internet Payment Processors PayPal, Google Expedited Bill Payments Internet-based bill payment systems are transaction origination platforms that allow customers to initiate bill payments using existing payment systems. Depending on the bill payment software, service provider, and payment receiver used, the payment transaction may be processed as an electronic funds transfer (EFT), ACH, or check

3.6

ELECTRONIC BANKING

For many of us, electronic banking means 24-hour access to cash through an automated teller machine (ATM) or Direct Deposit of paychecks into checking or savings accounts. But electronic banking now involves many different types of transactions like Electronic Bill presentment, Mobile banking, Online Banking, Electronic Check Conversion etc. Electronic banking, also known as electronic fund transfer (EFT), uses computers and payment networks as a substitute for checks and other paper transactions. EFT is initiated through devices like cards or codes that let the customer access their account. Many financial institutions use ATM or debit cards and Personal Identification Numbers (PINs) for this purpose. Some use other forms of debit cards such as those that require, at the most, signature or a scan. The federal Electronic Fund Transfer Act (EFT Act) covers some electronic consumer transactions Automated Teller Machines (ATMs) Direct Deposit Phone Banking/Mobile Banking- (IVR/VRU) Internet Banking Debit card purchase transactions

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Electronic Check Conversion Call centre/Contact centre Check Imaging /Check Truncation

ELECTRONIC BILLING PRESENTATION AND PAYMENT (EBPP)


Electronic Bill Payment allows a depositor to send money from his / her demand account to a creditor or vendor such as a public utility or a department store to be credited against a specific account. Presentment and Payment Electronic bill presentment and payment (EBPP) is a process that enables bills to be created, delivered, and paid over the Internet. Customers can pay their utility bills such as Electricity, Telephone, Gas, and insurance premiums online. The following figure shows the flow between various parties in EBPP.

Once a consumer has enrolled for EBPP services, the biller generates the electronic version of the Consumers Billing information. The biller may outsource this using BSP (Bill Service Provider). The BSPs /Billers provide such services as electronic bill translation, formatting, data parsing, notifying the consumer of pending bill. The consumer logs on to the specified website where he is allowed to view/print the E-bill. He can initiate payment directly from the same website.

3.7

SALES AND MARKETING

Banking has evolved from its traditional role as the place of Savings and Deposits. With the prevailing competition in the market among the banks, a serious effort has to be made by each

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bank to promote themselves and their products. A Retail bank will typically concentrate in the following areas: Product Development : Increase the knowledge about the market place, Check the new product viability, competitively price the product and identify new innovations. Marketing, Sales and Customer Development : Improve knowledge about the overall market, identify new customer segments, improve effectiveness of sales force (salesmen, online ads, offers, etc), maintain optimum product mix, increase effectiveness of marketing campaign, estimate and improve the sales channel performance and maintain the sales collateral. Customer Service and Branch Operations : Effectiveness of the Customer Service Manager or Relationship manager, Generate new business from existing customers, retain the most valuable customers and maintain customer satisfaction levels. Transactions and Back-office support: Improve the service quality, streamline transactions & optimize delivery through phone banking, Net Banking, Mobile Banking, etc., effectively manage data and business analysis.

3.8

A SCHEMATIC OF A RETAIL BANK

The banking operations are basically divided in to three; Front office, Middle Office and Back Office. Front office is what we otherwise call the Banking channels Branch, ATM, Banks Website, etc. where the customers contact the Banks representatives for their financial services. Middle Office is where the decisions are made about the product, interest rate, credit policies, Compliance monitored etc. Back office mostly does the data base management, data processing, transaction processing etc. The Middle Office and Back Office operations are generally not exposed to the customers. The picture below gives an overview of all the operations in retail bank.

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SUMMARY Retail banking pertains to banking service to individuals and SMEs. Retail banks have various flavors such as Community Development Banks, private Banks, Offshore Banks, Savings Banks and Postal Banks. Retail Banking has both assets and liabilities and only Liabilities (deposit products) are dealt in this document The various deposit products are o Checking accounts o Money Market Accounts o Savings Accounts o Time Deposits o Basic or No frill Banking o Credit Union Accounts o IRA Retail banking channels are o Branch Banking o Core Banking o ATM o Telephone Banking o Call Centre

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o o

Online Banking Mobile Banking

Checks can be processed in various modes: Paper check processing, check imaging /Check truncation, Electronic Check conversion. Consumers generally use one of these retail payments systems: Purchase of Goods and Services, Bill Payment, P2P payments, Cash withdrawals and Advances. Electronic banking, also known as electronic fund transfer (EFT), uses computer and electronic technology as a substitute for checks and other paper transactions. The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic customer transactions. EBPP is a mode of transaction involving the use of electronic means, such as email or a short message, for rending a bill. Sales and marketing strategies have gained importance currently. Every bank is seriously working towards promoting their products in the market.

4.0
4.1

MORTGAGES AND CONSUMER LENDING


MORTGAGE

A mortgage represents transfer of interest on a property/house to a lender as a security of debt which is usually a loan taken for buying a house. This loan has to be paid over a specified period of time. Think of it as customer personal guarantee that he will repay the money he has borrowed to buy his home. Strangely enough, the word "mortgage" comes from the French word "mort," which means "dead," and "gage," from Old English which means "pledge". Nowadays, the term mortgage is commonly used to refer to a loan for the purpose of purchasing a property. We don't associate anyone's death with it! Most mortgage loans are negotiated for a set time period and Interest rate. Interest rate could be fixed for the entire loan term or floating or Hybrid (Fixed for certain period). Generally, customer can pay off a loan in full or in part at any time, although bank may charge a penalty depending upon the terms and conditions.

4.1.1 RESIDENTIAL MORTGAGE


A residential mortgage is a loan made using residential property as collateral to secure repayment. In United States, single family homes that have maximum up to 4 units qualify for a residential mortgage. The residential mortgages are taken on by individual borrowers for buying a house, an apartment, or renovation of house or apartment.

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The majority of residential mortgages require the borrower to make a monthly payment which is enough to pay off the loan over a 10 to 25 year time frame. There are many types of mortgage loans in the market. These are designed to suit various requirements of the borrowers including the length of mortgage, capability for initial payment, and the other financial obligations.

4.1.2 COMMERCIAL MORTGAGE


A commercial mortgage is a loan made using commercial real estate, like multifamily property, or an office complex etc. as collateral to secure repayment. A commercial mortgage is similar to a residential mortgage, except the collateral is a commercial building or other business real estate, not residential property. In addition, commercial mortgages are typically taken on by businesses instead of individual borrowers. The borrower may be a partnership, incorporated business, or limited company, so assessment of the creditworthiness of the business can be more complicated than is the case with residential mortgages. The majority of Commercial Mortgages require the borrower to simply make a monthly payment small enough to pay off the loan over a 20 to 30 year time frame. The borrower most likely will attempt at that time to refinance the loan or sell the property. The length of the loan can vary from a matter of days to 30 years. Common applications of commercial mortgage loans include acquiring land or commercial properties, expanding existing facilities or refinancing existing debt.

4.1.3 MORTGAGE PROCESS FLOW


The various stages involved in a loan life cycle are shown below:

ORIGINATION This is a process by which a mortgage is secured by a borrower is called origination. This involves the borrower submitting an application and documentation related to his/her financial history and/or credit history to the underwriter. A borrower is required to lock a certain rate scenario, out of the given scenarios, after which his loan can go for processing. PROCESSING This process ensures that documentary requirements are fulfilled and regulatory checks are done. The borrower may be asked for additional information and supporting documentary

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proof(s) about his employment credentials, financial position, property details and other assets and liabilities associated with the borrower. Various reports, like credit report, property appraisal etc. are also required for file processing, which are fired at this stage. UNDERWRITING This is a process by which a lender determines if the risk of lending to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three Cs of underwriting: Credit, Capacity and Collateral. To help the underwriter assess the quality of the loan, banks and lenders create guidelines and even computer models that analyze the various aspects of the mortgage and provide recommendations regarding the risks involved. However, it is always up to the underwriter to make the final decision on whether to approve or decline a loan. CLOSING AND FUNDING After the loan has been underwritten and the borrower agrees with the loan terms, the loan moves into the Closing and Funding stage(s) when the actual contracts are signed and sent, the property is registered and the seller payments are cleared. LOAN SERVICING Loan servicing (sometimes also referred to a Loan Administration) refers to the part of the mortgage value chain that starts after the closure of the loan and extends till the loan is fully repaid and settled. It includes activities such as cash management for periodic payments and disbursements, investor accounting, investor reporting, customer servicing, delinquency management, records management etc.

As shown in the schematic above, Loan Servicing involves collecting monthly payments from borrowers, remitting the payments to the investors (or security holders), handling contacts with borrowers about payments & delinquencies, maintaining records, initiating foreclosure

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procedures and handling taxes and insurance premiums (through escrow accounts as applicable). The collection of mortgage payments and the periodic remittance of these payments to the investors (or conduits) is the major task of servicers. In addition, servicers are the primary repository of information on the mortgage loans. Thus, they must maintain accurate and up-to date information on mortgage balances, status and history and provide timely reports to investors.

4.1.4 MORTGAGE LOAN TYPES BASED ON REPAYMENT PATTERNS


Lending industry has developed variety of mortgage loan programs based on interest rate charged to borrowers. Following are widely used mortgage loan programs: Loan Type Fixed Rate Balloon Mortgage How it works A fixed Rate Mortgage (FRM) is a mortgage loan where the interest rate on the note remains the same through the term of the loan Payment Balloon Payment Mortgage has a fixed rate for the term of the loan followed by the ending balloon payment.

An Adjustable Rate Mortgage (ARM) is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of Adjustable Rate indices such as 1-year constant-maturity Treasury (CMT) securities, the Mortgage (ARM) Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indices. A graduated payment mortgage loan, often referred to as GPM, is a mortgage with low initial monthly payments which gradually increase Graduated Payment over a specified time frame. These plans are mostly geared towards Mortgage young people who cannot afford large payments now, but can realistically expect to do better financially in the future. An interest-only loan is a loan in which for a set term the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the interest-only term the borrower may pay the principal, or (with some lenders) convert the loan to a principal and interest payment loan at his option. Amortization refers to gradual decrease of principal balance of the loan as the loan is repaid gradually over its term. Negative Amortization occurs whenever the loan payment for any period is less than the interest charged over that period and so the outstanding balance of the loan increases. Such a practice is agreed

Interest Only Loan

Negative Amortization

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Loan Type

How it works upon before shorting the payment so as to avoid default on payment.

Standard Variable Same as a standard ARM loan - but one receive a substantial cash sum Rate with Cash Back (Example 35% of the amount borrowed) when we take up the loan. Base Rate Tracker Similar to a standard variable rate mortgage but the interest rate is guaranteed to be a set amount above the base rate and alters in line with changes in that rate. The payments are variable, but they are set at less than that lenders going rate for a fixed period of time. At the end of the period, one is charged the lenders standard variable rate. The payments go up and down as the mortgage rate changes but are guaranteed not to go above a set level (the cap) during the period of the deal. Capped rate Sometimes, they cannot fall below a set minimum level either (the collar or floor). At the end of the period, one is charged the lenders standard variable rate.

Discounted rate

interest

4.1.5 MORTGAGE LOAN TYPES BASED ON MORTGAGE LOAN PROGRAMS

Loan Program

How it works FHA loans are meant for lower income Americans to borrow money for the purchase of a home that they would not otherwise be able to afford. FHA loan is a federal assistance mortgage loan in the United States insured by the Federal Housing Administration. The loan may be issued by federally qualified lenders. The basic intention of the VA direct home loan program is to supply home financing to eligible veterans in areas where private financing is not generally available and to help veterans purchase properties with no down payment. The VA loan was designed to offer long-term financing to American veterans or their surviving spouses provided they do not remarry. These are loans without any government backing. These are the loans issued by Government Sponsored Entities (GSEs) such as Federal National Mortgage Association (Fannie Mae), Federal

FHA Loan

VA Loan

Conventional Loans Agency Loans

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Loan Program

How it works Home Loan Mortgage Corporation (Freddie Mac) and Government National Mortgage Association (Ginnie Mae).

4.1.6 MORTGAGE BACKED SECURITY


Mortgage backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by an accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution. When we invest in a mortgage-backed security we are essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets.

4.1.7 MORTGAGE LENDING: UNITED KINGDOM


There are currently over 200 significant separate financial organizations supplying mortgage loans to house buyers in Britain. The major lenders include building societies, banks, specialized mortgage corporations, insurance companies, and pension funds. Over the years, the share of the new mortgage loans market held by building societies has declined. Between 1977 and 1987, it fell drastically from 96% to 66% while that of banks and other institutions rose from 3% to 36%. Though the building societies did subsequently recover a significant amount of the mortgage lending business lost to the banks, they still only had about two-thirds of the total market at the end of the 1980s. However, banks and building societies were by now becoming increasingly similar in terms of their structures and functions. When the Abbey National building society converted into a bank in 1989, this could be regarded either as a major diversification of a building society into retail banking or as significantly increasing the presence of banks in the residential mortgage loans market. Research organization Industrial Systems Research has observed that trends towards the increased integration of the financial services sector have made comparison and analysis of the market shares of different types of institution increasingly problematical. It identifies as major factors making for consistently higher levels of growth and performance on the part of some mortgage lenders in the UK over the years: The introduction of new technologies, mergers, structural reorganization and the realization of economies of scale, and generally increased efficiency in production and marketing operations insofar as these things enable lenders to reduce their costs and offer more price-competitive and innovative loans and savings products;

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Buoyant retail savings receipts, and reduced reliance on relatively expensive wholesale markets for funds (especially when interest rates generally are being maintained at high levels internationally); Lower levels of arrears, possessions, bad debts, and provisioning than competitors; Increased flexibility and earnings from secondary sources and activities as a result of political-legal deregulation; and Being specialized or concentrating on traditional core, relatively profitable mortgage lending and savings deposit operations. Mortgage types Since 1982, when the market was substantially deregulated, there has been substantial innovation and diversification of strategies employed by lenders to attract borrowers. This has led to a wide range of mortgage types. As lenders derive their funds either from the money markets or from deposits, most mortgages revert to a variable rate, either the lender's standard variable rate or a tracker rate, which will tend to be linked to the underlying Bank of England (BoE) repo rate (or sometimes LIBOR). Initially they will tend to offer an incentive deal to attract new borrowers. This may be: A fixed rate; where the interest rate remains constant for a set period; typically for 2, 3, 4, 5 or 10 years. Longer term fixed rates (over 5 years) whilst available, tend to be more expensive and/or have more onerous early repayment charges and are therefore less popular than shorter term fixed rates. A capped rate; where similar to a fixed rate, the interest rate cannot rise above the cap but can vary beneath the cap. Sometimes there is a collar associated with this type of rate which imposes a minimum rate. Capped rate are often offered over periods similar to fixed rates, e.g. 2, 3, 4 or 5 years. A discount rate; where there is set margin reduction in the standard variable rate (e.g. a 2% discount) for a set period; typically 1 to 5 years. Sometimes the discount is expressed as a margin over the base rate (e.g. BoE base rate plus 0.5% for 2 years) and sometimes the rate is stepped (e.g. 3% in year 1, 2% in year 2, 1% in year three). A cash back mortgage; where a lump sum is provided (typically) as a percentage of the advance e.g. 5% of the loan. To make matters more confusing these rates are often combined: For example, 4.5% 2 year fixed then a 3 year tracker at BoE rate plus 0.89%. With each incentive the lender may be offering a rate at less than the market cost of the borrowing. Therefore, they typically impose a penalty if the borrower repays the loan within the incentive period or a longer period (referred to as an extended tie-in). These penalties used to be called a redemption penalty or tie-in, however since the onset of Financial Services Authority regulation they are referred to as an early repayment charge.

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Self Cert" mortgage Mortgage lenders usually use salaries declared on wage slips to work out a borrower's annual income and will usually lend up to a fixed multiple of the borrower's annual income. This mortgage is similar to alt-doc (low-doc) mortgage in US market. Self Certification Mortgages, informally known as "self cert" mortgages, are available to employed and self employed people who have a deposit to buy a house but lack the sufficient documentation to prove their income. This type of mortgage can be beneficial to people whose income comes from multiple sources, whose salary consists largely or exclusively of commissions or bonuses, or whose accounts may not show a true reflection of their earnings. Self cert mortgages have two disadvantages: the interest rates charged are usually higher than for normal mortgages and the loan to value ratio is usually lower. 100% mortgages Normally when a bank lends customer money, they want to protect their money as much as possible; they do this by asking the borrower to fund a certain percentage of the property purchase in the form of a deposit. 100% mortgages are mortgages that require no deposit (100% loan to value). These are sometimes offered to first time buyers, but almost always carry a higher interest rate on the loan. Together/Plus mortgages A development of the theme of 100% mortgages is represented by Together/Plus type mortgages, which have been launched by a number of lenders in recent years. Together/Plus Mortgages represent loans of 100% or more of the property value - typically up to a maximum of 125%. Such loans are normally (but not universally) structured as a package of a 95% mortgage and an unsecured loan of up to 30% of the property value. This structure is mandated by lenders' capital requirements which require additional capital for loans of 100% or more of the property value.

4.2

OTHER RETAIL LOANS

4.2.1 STUDENT LOANS


Student Loans are Loans availed by eligible students to pursue graduate and post graduate studies in Schools/Colleges/Universities. These loans are usually provided by banks, Credit Unions and other financial institutions. Often they are supplemented by student grants which do not have to be repaid. STUDENT LOANS - UNITED STATES Students Loans offered can be categorized broadly into two types:

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Federally sponsored loans These loans are federally insured and provide protection against default. The department of Education guarantees up to 98% and even 100% in some cases Non-federally sponsored loans These are insured by the private sector and have no government backing. The guarantee in this case is only from the private insurers or from the reserves pledged to securitization Federally sponsored loans are of two types Federal Family Education Loan Program (FFELP) - These loans are made by financial institutions primarily with a floating rate that is adjusted once a year. The interest rate is capped at 8.25% and the Fed subsidizes the difference between the actual loan rate and the rate cap through Special Allowance Payments (SAP). The rates are usually specified by indexing them to the US Treasury bill rates. Federal Direct Loan (FDLP)- where the department of Education directly provides the loans FFELP or the Federal Family Education Loan Program can further be divided into four types Federal Stafford Federal Stafford loans are the most common source of education loan funds in the US. This is available to both graduate and undergraduate students. This loan could be either subsidized or unsubsidized by the federal government. The interest rate is a floating rate that is indexed to the 91 day T-Bill and is capped at 8.25%. Sample rates of during the year 2003-04 were 1. 2. 2.82% in school, grace and deferment 3.42% in repayment and forbearance

Federal PLUS - PLUS loans are availed by the parents of a full- or half-time undergraduate student. This requires a credit check and hence the parent must have a good credit history and should have been a citizen or permanent resident of US. The loans dont require any collateral and the interest payments are tax deductible. Consolidation loans - A consolidation loan involves two or more existing federally sponsored loans into one single loan. The interest rate for this is determined by the weighted average of the loan rates prevailing at that time and capped at 8.25% There are three principal advantages of consolidation Convenience By combining loans the borrower is able to focus on repaying one single loan than handle multiple loans Interest rate In a low rate scenario the borrower can reduce his cost of borrowing by taking a new loan at the low prevailing low rates Repayment The repayment period is extended to 30 years and this reduces the installment to paid each month

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Graduate Plus - The Graduate PLUS loan or Grad PLUS loan is a low, fixed interest rate student loan guaranteed by the U.S. Government. The Grad PLUS loan is a non-need credit based loan similar to a private student loan, but with the benefit of having a fixed interest rate and federal guarantee. The Grad PLUS Loan allows graduate students to borrow the total cost for their graduate school needs, including tuition, room and board, supplies, lab expenses, and travel, less any other aid.

The Key Entities in the Student Loan System are Federal government, Schools, Lenders, Servicers and guarantors and the borrower. Federal government: Sponsors and authorizes funds for grants and loan programs. School: The school is certified by the department of education as an eligible school to participate in the FFELP or FDLP loan programs. Schools are responsible for determining borrowers eligibility, recommends and certifies loan amounts, monitors the enrollment status Lenders: are the institutions approved by the DOE for voluntary participation in any or all of the FFELP student loan programs. Typical lenders are usually Banks, credit unions, S&L institutions, insurance companies and other institutions. Servicer: is an entity that collects payments on a loan and performs other administrative tasks associated with maintaining a loan portfolio. The normal functions include disburse loans funds, monitor loans while the borrowers are in school, collect payments, process deferments and forbearances, respond to borrower inquiries and ensuring regulatory compliance. Guarantor is a state agency, which guarantees or insures the loan and is a not-forprofit agency. It protects the lenders against loss due to borrower default, death of borrower, total and permanent disability, bankruptcy, closed school, and ineligible borrower. Borrower: is the student / parent who avails of the loan. STUDENT LOANS OTHER COUNTRIES - AUSTRALIA As a general rule, all students who attend Australian tertiary education institutions (universities) are charged higher education fees. However, several measures are in place to relieve the costs of tertiary education in Australia. Most students are Commonwealth supported. This means that they are only required to pay a part of the cost of tuition, called the "student contribution", while the Commonwealth pays the balance; and students are able to defer payment of their contribution as a HELP (Higher Education Loan Programme) loan. Other domestic students are full fee-paying (non-Commonwealth supported) and receive no other direct government contribution to the cost of their education. They can also obtain subsidized HELP loans from the Government up to a lifetime and up to a certain limit. Australian citizens and (with some limitations) permanent residents are able to obtain interest free loans from the government under the HELP which replaced the Higher Education Contribution Scheme (HECS). HELP is jointly administered by the Department of Education, Science and Training (DEST) and the Australian Taxation Office (ATO).

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Overseas students are charged fees for the full cost of their education and are ineligible for any loans from the Commonwealth, but may apply for international scholarships. HELP debts do not attract interest, but are instead indexed to the Consumer Price Index (CPI) on 1 June each year, based on the annual CPI to March of that year. HELP account debtors can make voluntary repayments. As making voluntary repayments does not exempt the person from compulsory repayments, if the person intends to pay off the total debt voluntarily, it is financially advantageous for them to do it before lodging the tax return. Even factoring in the 10% bonus on voluntary repayments, many people elect not to pay off their debt in advance of the required repayments because it still works out to be probably the cheapest loan someone will ever receive. If a person with a HELP debt dies, the debt is cancelled.

STUDENT LOANS OTHER COUNTRIES - UNITED KINGDOM British undergraduate and PGCE (postgraduate certificate of education) students can apply for a student loan through their local education authority (LEA) in England and Wales, the Student Awards Agency for Scotland (SAAS), or their local education and library board in Northern Ireland. The LEA, SAAS, or education and library board then assesses the application and determines the amount that the student is eligible to borrow, as well as how much tuition fees, if any, the students' parents must pay. The family's income; whether the student will be living at home, away from home, or in London; disabilities; and other factors are taken into account. Loans are provided by the Student Loans Company and do not have to be repaid until the April of the year after students have completed their course and are earning 15,000 a year. The interest rate is updated annually and is tied to inflation. The loan is normally repaid using the PAYE (Pay as you earn) system, with 9% of the graduate's gross salary over 15,000 automatically being deducted to pay back the loan. The Higher Education Act 2004 made significant changes to the loans system in England, Wales and Northern Ireland from 2006. Those with sufficient private funding can still pay tuition fees 'upfront' but everyone who satisfies residence criteria - regardless of their income - is now entitled to take out a loan to pay their fees. Student Finance England For all students whose 'domicile' (family or full-time home base) is in England, radical changes are underway to enhance and improve the student finance system. Now known as Student Finance England, this is a comprehensive new service which is being phased in between 2008 and 2012 and is being based on widespread consultation with students, prospective students, parents and other 'sponsors' helping a student through university. It seeks to reduce significantly the amount of time and effort required to apply for finance. The time scale of application is being changed, so that a student will be able to apply for finance at the same time as they apply for a university place. First year students will have to deal with just two agencies Universities & Colleges Admissions Service (UCAS, to apply for a place) and the Student Loans Company, which will share much of the information, supplied to UCAS and will then assess the applicant's eligibility for finance and make the appropriate payments.

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4.2.2 AUTO LOANS


Retail Auto lending is basically lending to the individual customers for cars, two wheelers, recreational vehicles and boats for their personal use. Now-a-days there are plenty of options available for auto finance or auto loans. Banks, Credit Unions, Dealerships, and even auto manufacturers are also into auto financing. Some of the auto finance companies are Citicorp, JP Morgan Chase, General Motors Acceptance Corporation, Ford Motor Credit, Bank of America, Toyota Motor Credit, Hyundai Motor Finance Company (HMFC) etc. On the other hand wholesale lending is about financing the auto dealer. The dealer is financed with a variety of loan products, mainly floor plans for financing the purchase of cars from the automobile manufacturer. GMAC has definitely led the way in the car loan business. But, of course, the other major manufacturers also recognized the profitability associated with the auto loan business and entered the market. These companies are known as captive finance companies. Captive Finance is a term to signify that the lending company is wholly owned by the automobile manufacturer. Examples, other than GMAC, are NMAC (Nissan Motor Acceptance Corporation), Ford Credit (Ford Motor Credit Company), Hyundai Motor Finance Company (HMFC), Chrysler Credit (Daimler-Chrysler). The following section describes the multiple mechanisms by which the financing for auto loans is normally done. Types of Financing Mechanism Direct Lending: The Bank or the finance company directly lends to the buyer or the borrower in this case. A number of lending institutions are offering such loans on their websites. Dealer financing: This is a type of loan available through the dealer. The lending and repayments are done by/to the dealer. Basically the dealer tells the customer how much down payment and monthly Installment is to be paid against the vehicle. The effective cost to the customer most of the times is generally more than the original price. Leasing: Vehicle/ Auto lease is a contract between the borrower and an auto leasing company. The borrower agrees to pay the leasing company for the use of the vehicle for a certain amount of time, usually 24 to 36 months. During that time the borrower agrees to make monthly lease payments, keep the car in good repair, insure the car and not drive the car more miles that stipulated in the contract. The Key entities in a lease agreement are the lessee and the lessor. Lessee or the borrower: The party to whom the vehicle is leased. In a consumer lease, the lessee is the consumer. The lessee is required to make payments and to meet other obligations specified in the lease agreement.

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Lessor or the lender or the lending institution is the original owner of the vehicle or property being leased The lease can be closed ended or open ended as defined below: Closed end lease - A lease agreement that establishes a non-negotiable residual value for the leased auto and fee amounts due at the end of the lease term. Open End lease - A lease term that requires the lessee to pay the difference between residual value and fair market value at the end of the lease term if the fair market value is lower In a lease, the factors such as the ownership, upfront costs and monthly payments as against the direct lending are: Ownership: We do not own the vehicle. We get to use it but must return it at the end of the lease unless we choose to buy it. Up-front costs: Up-front costs may include the first month's payment, a refundable security deposit, a capitalized cost reduction (like a down payment), taxes, registration and other fees, and other charges. Monthly payments: Monthly lease payments are usually lower than monthly loan payments because we are paying only for the vehicle's depreciation during the lease term, plus rent charges (like interest), taxes, and fees. The Key Entities in an Auto Loan process are: Borrower: is the one who needs to use/own the automobile and approaches a dealer/lender for getting financing for the same Dealer: Typically a franchisee of the manufacturer, involved in selling and delivery of the vehicle to the buyer Lender: Provides capital to the borrower for buying the vehicle. This can be captive financiers, the banks, Credit unions and auto finance companies. Credit bureau: Tracks and maintains credit history of borrowers and forward it to lenders during new application processing. This is used for deciding whether the loan should be provided to a customer or not. Appraiser: Assesses and establishes the fair market value of collateral offered as underlying security to the credit asked for. Insurer: The Insurance company insures the vehicle owner against specific liabilities caused to and from the vehicle during the course of its use upon the payment of a premium and signing of a contract

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Loan servicer: is the one who provides various services during the life cycle of a loan starting from loan origination to loan closure. Collection agencies: These are typically third party agencies that assist auto lenders with chronic delinquent accounts. Repossession agencies: These are third party agencies which assist auto lenders with repossession of vehicles. Valuation agencies: Black book and ALG help auto lenders with valuation of vehicles Auto loan process The Auto Finance Loan process can be divided into Loan origination, Servicing, and Secondary marketing. Loan Origination is the process by which a borrower applies for a new loan, and a lender processes that application. Origination generally includes all the steps from taking a loan application through disbursal of funds (or declining the application). Credit decision is the major milestone during loan origination process. This would depend on many factors like the credit rating of the customer provided by the credit bureaus, capacity of the customer to repay back the loan amount, the nature of the vehicle requested to be financed, and the amount of downpayment offered. The credit decision can also be done for a very good application meeting all credit policies and guidelines by the loan processing system automatically thereby reducing the time required for manual processing by the Analysts. Or it would reject the application based on these factors, the rejected application would be sent to Credit Analyst for further processing. Once the decision is taken lender would contact the customer through phone, fax or e-mail to let him know the decision. US Legislations mandate the distribution of hard-copy letters to the Applicants informing them of the reasons in case of a denial of credit or for a counter offer. Loan servicing generally covers the process post disbursement of the funds until the loan is fully paid off or charged off. Some of the major sub processes under loan servicing are:
1. 2.

Managing monthly repayments Customer Service Managing customer communication, communications sent to customers at different events like late payment, change in customer details, making changes in the loan terms and conditions etc. Managing premature closure of loan partially or fully. Managing payment defaults in case customer doesnt pay the installment amount. This involves following up the customer for payments. In case of payment default the account is termed to be a delinquent account. The lender can repossess the vehicle if payments are not forthcoming despite follow up. The outstanding amount under a delinquent account is charged off (off the books) beyond a certain amount of days past due.

3. 4.

Auto loan receivables can be securitized into pools called as Asset Backed Securities (ABS. This offers liquidity advantages to an auto lender.

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4.2.3 PERSONAL AND CONSUMER LOANS


Personal loans are amount borrowed by individuals to cover their personal expenses. The details of such expenses are never of any interest to the lenders. Some of the features of personal loans are: The financer is not interested in the intention of the loan. No security Short term loans Rate of interest is very steep. Ideally should be used only in case of an emergency All banks/finance companies offer these loans Loan amount is directly linked to borrowers repayment capacity.

4.2.4 LEASE AND HIRE PURCHASE


Lease is a long-term rental agreement for the asset, while Hire Purchase allows the user to own the asset after all the payments have been made to the lender. Lease Two main types operating, financial The Financier owns the asset. Depreciation is claimed by the financier. Tax deduction can be claimed for the full value of the rental paid. Financier takes care of maintenance, insurance etc. Hire Purchase The asset is owned by the financier. Depreciation can be claimed by the borrower. Tax deduction can be claimed only to the extent of the interest repayment.

4.2.5 OPEN ENDED LOANS


Open ended loan allow the borrower to borrow additional amount subject to the maximum amount less than a set value. Similar to overdraft facilities provided by banks. Interest is calculated on the daily outstanding balance. Usually a card (similar to a Credit Card) is issued by the lending institution.

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The lending institution has tie-ups with various merchant establishments. Also allow us to withdraw Cash. Important Terms; a. Limit (L) max outstanding allowed b. Margin (M) percentage of limit that can be drawn c. Asset value (AV) value of underlying asset d. Drawing Power (DP) - lower of L and (1-M)*AV Example: Limit =$ 1000; Margin = 30%; Asset Value (initial) = $1000 Date 1st Jan 2004 1st Feb 2004 1st Mar 2004 1st Apr 2004 Asset Value (AV) $1000 $1600 $2000 $500 Drawing Power (DP) $700 $1000 $1000 $350

4.3

COMMUNITY BANKS, CREDIT UNIONS & BUILDING SOCIETIES

4.3.1 COMMUNITY BANKS


In the United States, Community development banks (CDBs) are banks designed to serve residents and spur economic development in low- to moderate-income (LMI) geographical areas. When CDBs provide retail banking services, they usually target customers from "financially underserved" demographics. Community development banks can apply for formal certification as a Community Development Financial Institution (CDFI) from the Community Development Financial Institutions Fund of the U.S. Department of the Treasury. All Federally chartered CDBs are regulated primarily by the Office of the Comptroller of the Currency. According to the OCC Charter Licensing Manual, CDBs are required "to lend, invest, and provide services primarily to LMI individuals or communities in whom it is chartered to conduct business." State-chartered Community Development Banks are subject to regulations, qualifications, and definitions that vary from state to state. Some institutions use the terms CDB and community development financial institution, or CDFI, interchangeably. Notable community development banks

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The largest and oldest community development bank is Shore Bank, headquartered in the South Shore neighborhood of Chicago. Through its holding company Shore Bank Corporation, Shore Bank promotes its community development mission by operating CDBs and other affiliates in certain U.S. cities. Other CDBs include: Albina Community Bank in Portland, OR Carver Federal Savings Bank in New York, NY Central Bank of Kansas City in Kansas City, MO City First Bank of D.C. in Washington, D.C. Dryades Savings Bank in New Orleans, LA Liberty Bank & Trust in New Orleans, LA Louisville Community Development Bank in Louisville, KY Neighborhood National Bank in San Diego, CA Southern Bancorp in Arkadelphia, AR University National Bank in St. Paul, MN

4.3.2 CREDIT UNIONS


A credit union is a cooperative financial institution that is owned and controlled by its members, and operated for the purpose of promoting thrift, providing credit at reasonable rates, and providing other financial services to its members. Many credit unions exist to further community development or sustainable international development on a local level. Worldwide, credit union systems vary significantly in terms of total system assets and average institution asset size since credit unions exist in a wide range of sizes, ranging from volunteer operations with a handful of members to institutions with several billion dollars in assets and hundreds of thousands of members. Yet credit unions are typically smaller than banks; for example, the average U.S. credit union has $93 million in assets, while the average U.S. bank has $1.53 billion, as of 2007. The World Council of Credit Unions (WOCCU) defines credit unions as "not-for-profit cooperative institutions." In practice however, legal arrangements vary by jurisdiction. For example in Canada credit unions are regulated as for-profit institutions, and view their mandate as earning a reasonable profit to enhance services to members and ensure stable growth. This difference in viewpoints reflects credit unions' unusual organizational structure, which attempts to solve the principal-agent problem by ensuring that the owners and the users of the institution are the same people. In any case, credit unions generally cannot accept donations and must be able to prosper in a competitive market economy.

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Credit unions differ from banks and other financial institutions in that the members who have accounts in the credit union are the owners of the credit union and they elect their board of directors in a democratic one-person-one-vote system regardless of the amount of money invested in the credit union. A credit union's policies governing interest rates and other matters are set by a volunteer Board of Directors elected by and from the membership itself. Credit unions offer many of the same financial services as banks, often using a different terminology; common services include: share accounts (savings accounts), share draft (checking) accounts, credit cards, share term certificates (certificates of deposit), and online banking. Normally, only a member of a credit union may deposit money with the credit union, or borrow money from it. As such, credit unions have historically marketed themselves as providing superior member service and being committed to helping members improve their financial health. In the microfinance context, "Credit unions provide a broader range of loan and savings products at a much cheaper cost [to their members] than do most microfinance institutions."

4.3.3 BUILDING SOCIETIES


A building society is a financial institution, owned by its members, that offers banking and other financial services, especially mortgage lending. Building societies are prevalent only in UK. The term building society first arose in the 19th century, in the United Kingdom, from cooperative savings groups. In the UK today building societies actively compete with banks for most personal banking services, especially mortgage lending and deposit accounts. At the start of 2008, there were 59 building societies in the UK with total assets exceeding 360 billion. Every building society in the UK is a member of the Building Societies Association. The number of societies in the UK fell by four during 2008 due to a series of mergers brought about, to a large extent, by the consequences of the financial crisis of 2007-2009, and further mergers are planned for the first few months of 2009.

4.4

FARM CREDIT

The Farm Credit System is a federally chartered network of borrower-owned lending institutions composed of cooperatives and related service organizations. Cooperatives are organizations that are owned and controlled by their members who use the cooperatives products, supplies or services. The U.S. Congress authorized the creation of the first System institutions in 1916. Their mission is to provide sound and dependable credit to American farmers, ranchers, producers or harvesters of aquatic products, their cooperatives, and farm-related businesses. They do this by making appropriately structured loans to qualified individuals and businesses at competitive rates and providing financial services and advice to those persons and businesses. Consistent with their mission of serving rural America, they also make loans for the purchase of rural homes, to finance rural communication, energy and water infrastructures, to support agricultural exports, and to finance other eligible entities. Farm Credit institutions are chartered by the federal government and must operate within limits established by the Farm Credit Act. The Farm Credit System is regulated by an independent federal agency, the Farm Credit Administration, which has all of the enforcement, regulatory and oversight authority as other federal financial regulators. Farm Credit is a government-

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sponsored enterprise, or GSE a privately owned set of institutions established by Congress to address the needs of a specific sector of the economy. Farm Credit delivers the financial power of Wall Street to agriculture and rural America by issuing debt in the national and international money markets and using this capital to provide borrowers with access to reliable and competitive credit. The full financial strength of all of the Farm Credit banks stands behind the debt issued on behalf of the System. In addition, investors in Farm Credit debt are protected by the assets of the self-funded Farm Credit System Insurance Fund, which is administered by an independent agency of the federal government. The Farm Credit Systems total loans equaled $158.063 billion at September 30, 2008, an increase of $15.157 billion since December 31, 2007. Approximately one third of the credit needs of U.S. agriculture are financed by the 99 Farm Credit associations and banks nationwide.

4.5

RETAIL LENDING CYCLE

1. Loan application management and processing Receipt of loan/card application o o o o o o o Application Processing Duplicate check Negative list check Document Verification Calculate loan eligibility, IRR, processing fees Credit scoring Field Investigation Credit Approval

Disbursement o Check issuance o Credit to account o Payment to third party Formulating the repayment schedule. 2. Loan repayments and termination Post-Dated checks o PDCs are collected & their information captured. o Checks are presented in clearing on due dates o Bounced/ hold checks are marked for further action. Salary deductions o Employer wise receipt batches are created. o Employer check details are captured o Payment receipt is marked for corresponding employees. Direct receipts

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o o

Cash/Check information is captured Checks are cleared in batches.

Auto payments / Direct debits o Bank wise receivable batches are created. o Short receipts are marked. o Release receipt batch to mark receipts Kinds of repayments o EMI same installment amount o Fixed Principal constant principal, decreasing interest amt o Step-up principal amount increases in steps o Step-down principal amount decreases in steps o Balloon notional amount initially, large last payment o Bullet interest payment initially, entire principal at one shot o Random schedule & amount of installments undecided o Special products combination of above 3. Delinquencies identification and collections Case Processing o Categorization of cases based on predefined rules o Allocation of cases to collectors Standard Cases o Collector follow-up (desk/field) o Repayment by customer o Check issuance Exception Cases (death/fraud etc.) o Initiate process based on case specifics (legal/other means) o Track/follow up the case developments till repayment o Case closed

Submit Proposal

Scrutinize

OK

Appraisal

Repayment

NO

Follow-up/Action

Decision

Monitoring

OK
Compliance Conditions for borrower

Disbursement

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SUMMARY The loans given to retail customer would come under Mortgages and other consumer loans There are two types of Mortgages o Residential Mortgages o Commercial Mortgages The main sub processes under Mortgage process flow are 1. Loan Production o Origination o Processing o Under writing o Closing and Funding 2. Loan Servicing o Cash management o Investor accounting and reporting o Escrow Administration o Document custodianship o Delinquency management o Customer service The following are the various types of Mortgages based on repayment patterns o Fixed Rate o Balloon Payment Mortgage o Adjustable Rate Mortgage (ARM) o Graduated Payment Mortgage o Interest Only Loan o Negative Amortization o Standard Variable Rate with Cash Back o Base Rate Tracker o Discounted interest rate o Capped rate Mortgage backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. There are five major types of other consumer Loans / Lease o Student Loans o Auto Loans o Personal loans o Lease and Hire purchase o Open ended loans Other than commercial banks there are Community development Banks, Credit Unions & Building Societies which provides Mortgages and / or Consumer Loans.

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5.0
5.1

CARDS AND PAYMENTS


INTRODUCTION

Cards are the fastest growing means of non-cash payments, accounting for 55% of payment volumes worldwide, demonstrating the importance of non-cash payment mechanisms to trade and consumer spending in our globalised economy as a new research into the global payments market has found. As per Tower Group Research report for the period between 2005 to 2007, Usage of Pin Debit grew by 18 %, Volume of credit card grew by 5%, Usage of check declined by 9%, Usage of EBPP is increasing at a CAGR of 18%, Online bill payment increased at a CAGR rate of 29.6 %, Online bill payments at bank and biller Web sites comprised 42% of total monthly payments, followed by 31% of bills paid by check.

5.1.1 NON-CASH PAYMENT INSTRUMENTS


A. CHECK-BASED PAYMENTS

The traditional method of collecting a check is to deposit it at a depository institution, which, if the check is drawn on a different institution (an interbank check), then collects the funds by presenting the original paper check to the institution responsible for paying it, the paying bank.

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With the changes governing check processing resulting from the Check 21 law, banks may now truncate all checks and replace them with electronic images, presenting them electronically to paying banks that agree or as paper substitute checks to those that require paper. During March April 2007, 13.3 billion original interbank checks and about 3.0 billion substitute interbank checks were being presented .Another 6.6 billion interbank checks were being presented electronically (28.3 percent of interbank checks). Most of these (6.4 billion) were presented as images. B. DEBIT Debit cards enable the holder to make purchases and to charge those purchases directly to a current account at the bank issuing the payment card. Debit cards are either on-line (PIN-based) or off-line (Signature-based). There are two types of debit card processing. PIN or online debit card processing: The debit card holder is required to enter a PIN (personal identification number) in to a PIN pad. This is used as a verification method and access to account is provided instantaneously. The access to funds is real time. Signature or offline debit card processing: In this method verification is done by the signature of the card holder. A hold is placed on the funds available in some cases when this method of processing is used. ATM An ATM card (also known as a bank card, client card, key card or cash card) is an ISO 7810 card issued by a bank, credit union or building society. ATM cards provide a convenient way to get cash, make deposits and check how much money is available in the bank account. ATMs make cash available 24 hours a day, seven days a week at many locations. ATM cards can be used at ATMs that are located at all of the bank's locations as well as those at other banks, grocery and drug stores, office buildings, and street corners across the country and worldwide. In other words, ATM cards cannot be used at merchants that only accept credit cards. CREDIT A Credit Card represents an account that extends credit to consumers, permits consumers to purchase items while deferring payment, and allows consumers to make payments to multiple vendors at one time. Credit cards can have revolving credit arrangements allowing customers to make a minimum payment in each billing cycle (two to three % of their total balance) rather than requiring payment of the full balance. However, if a cardholder revolves i.e. carries over a balance to the next billing cycle, then the interest will be charged not only to the balance amount but also to any new purchases in that billing cycle. There are cards that have a shortterm, fixed-period, and credit arrangement. SMART CARD CARDS-BASED PAYMENTS

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A smart card is a plastic card about the size of a credit card, with an embedded microchip that can be loaded with data and can be used to perform several functions. The most common smart card applications are: Credit cards, Electronic cash, Computer security systems, Wireless communication, Loyalty systems (like frequent flyer points), Banking, Satellite TV, Government identification. Smart cards can hold all sorts of unique information about its carrier, such as credit and debit account balances, insurance coverage, access credentials, and subscription information. CO BRANDED CARD They are credit cards, which are associated with a particular firm like an airlines or retail outlet. These cards can be used just like regular credit cards but they also offer benefits to users of the relevant product like frequent travel points and special discounts. Cardholders may be given incentives, such as discounts on merchandise, rebates, or discounts off purchases. A co-branded card has a tie-in with a specific merchant rather than an association or professional group. It also can be used at other merchants. AFFINITY CARD These are Credit cards promoted under a sponsoring agreement between an organization and a card issuing bank. In exchange for making available its membership list, the sponsor receives some compensation from the issuing bank, usually part of issuer's net interest income. The issuer may waive annual fees for affinity cardholders, or even offer the card at a lower rate than ordinary bank cards. CORPORATE / COMMERCIAL CARD Corporate credit card is normally used for business purposes and it helps corporate consumers to effectively organize their business expenditure. Most corporate credit cards, especially cards which have been issued to employees of a company are termed as individual corporate cards because these cards have individual responsibility, not any corporate obligations. PREPAID CARD Prepaid Credit Card originated in Canada. It is not a stereotype credit card but can be used in a similar way. The consumer has to buy the credit card from a company and then has to load it with the required amount of money. Only after that he/she could use it for further buying but strictly within limit of the loaded money. Hence, it is also known as Stored-Value Cards. Some common examples are Gift Cards, Phone Cards, Mall Cards, and Gas Cards.

C.

THE AUTOMATED CLEARING HOUSE (ACH) NETWORK

NACHA The Electronic Payments Association oversees, the ACH Network which is a highly reliable and efficient nationwide batch-oriented electronic funds transfer system. It is governed by the NACHA OPERATING RULES which provide for the interbank clearing of electronic payments for participating depository financial institutions. The Federal Reserve and Electronic Payments Network act as ACH Operators, central clearing facilities through which financial institutions transmit or receive ACH entries.

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ACH payments include: Direct Deposit of payroll, Social Security and other government benefits, and tax refunds; Direct Payment of consumer bills such as mortgages, loans, utility bills and insurance premiums; B2B payments; Electronic checks; E-commerce payments; Federal, state and local tax payments. The following is a typical ACH payment processing cycle:

Originator is individual, corporation or other entity that initiates entries into the Automated Clearing House Network Originating Depository Financial Institution (ODFI) is a participating financial institution that originates ACH entries at the request of and by (ODFI) agreement with its customers. ODFI's must abide by the provisions of the NACHA Operating Rules and Guidelines Receiving Depository Financial Institution is any financial institution qualified to receive ACH entries that agrees to abide by the NACHA Operating Rules and Guidelines Receiver is an individual, corporation or other entity that has authorized an Originator to initiate a credit or debit entry to a transaction account held at an RDFI. NACHA the Electronic Payments Association NACHA The Electronic Payments Association is a not-for-profit association that oversees the Automated Clearing House (ACH) Network, a safe, efficient, green, and high-quality payment system. More than 15,000 depository financial institutions originated and received 18.2 billion ACH payments in 2008. NACHA is responsible for the administration, development, and enforcement of the NACHA Operating Rules and sound risk management practices for the ACH Network. Through its industry councils and forums, NACHA brings together hundreds of

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payments system stakeholder organizations to encourage the efficient utilization of the ACH Network and develop new ways to use the Network to benefit its diverse set of participants. D. EMERGING PAYMENTS

ONLINE BILL PAY (EBPP, EIPP) Online services that enable customers to receive, review, and execute payment of their bills over the Internet. PERSON-TO-PERSON PAYMENTS (P2P) On-line P2P payments, or e-mail payments, use existing retail payment networks to provide an electronically initiated transfer of value from one individual to another. INTERNET CURRENCIES / DIGITAL CASH / E-WALLETS Similar to P2P payments, individuals can transfer electronic cash value to other individuals or businesses. Most electronic cash applications exist on the Internet. Consumers can use the cash payment instruments for purchases at retailers Web sites or they can transfer cash to other individuals through e-mail. Individuals use a credit card or signature-based debit card number to pre-fund the Web certificate or electronic account, and recipients redeem the value with the Issuer. ELECTRONIC BENEFITS TRANSFER (EBT) Electronic system that allows a recipient to authorize transfer of his/her government benefits from a Federal account to a retailer account to pay for products received. EBT is currently used to issue food stamps and other benefits in the US. MOBILE PAYMENTS Mobile Payment is paying for goods or services with a mobile device such as a mobile phone, Personal Digital Assistant (PDA), or other such device. They can be used in a variety of payment scenarios. Typical usage entails the user electing to make a mobile payment, being connected to a server via the mobile device to perform authentication and authorization, and subsequently being presented with confirmation of the completed transaction. There are mainly two types of mobile payments depending on the location of the user: Remote Payments - These transactions are conducted independent of the users location. Examples include prepaid top-up services, delivery of digital services, mTickets, digital cash, peer-to-peer payments, etc. Proximity/Local Payments - These transactions involve a mobile device communicating locally (e.g., via Bluetooth, IrDA, RF, Near Field Communication) with a POS/ATM, e.g. payments at unattended machines, mParking, payments at traditional POS, or money withdrawals from a banks ATM.

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CONTACTLESS PAYMENTS Contactless payment system is a new emerging payment system where a payment transaction can be initiated without the device coming in direct contact with the POS, such as swipe of a card. This payment mechanism is made possible through use of new technologies such as Radio Frequency (RFID), NFC (Near Field communication), Carrier Based or Bluetooth technology for making payments. Payment using this technology can be made using Form Factors such as credit cards, key fobs, smart cards or mobile phones. The consumer waves the device over a reader at the POS and the embedded chip and antenna enables initiation of the transaction. The consumer is not required to sign a slip or enter a PIN making it extremely convenient. Contactless payments are typically useful for small value transactions and are targeted towards eliminating or reducing cash transactions at the retail counter.

5.1.2 GENERIC FRAMEWORK FOR PAYMENT INSTRUMENTS


The diagram below depicts the common model on which most payment systems are based.
Four Corner Payment System Model
Payer
Present Non-cash Payment instrument Goods / Services

Payee

Network

Financial Institution or Third party


Solid line indicates flow of information

Financial Institution or Third party

While the flow of funds, information, and data are different, in most cases, the set of participants are similar. The initiator of the payment (payer) is typically a consumer and the recipient of the payment (payee), typically a merchant. The payer and the payee are shown to have a relationship with their respective financial institutions. The payment network routes the transactions between the financial institutions

5.2

CREDIT CARD MARKET OVERVIEW

There were 984 million bank-issued Visa and MasterCard credit card and debit card accounts in the U.S in 2006.The top 10 credit card issuers controlled approximately 88 percent of the credit card market at the end of 2006, based on credit card receivables outstanding. U.S Visa cardholders alone conduct more than $1 trillion in annual volume. Consumers carry more than 1 billion Visa cards worldwide. More than 450 million of those cards are in the United States.

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2007 global market share of general-purpose cards (cards in distribution) Total among these five brands: 3.03 billion, up 13.6 percent in one year 1. Visa -- 65 percent 2. MasterCard -- 30 percent 3. American Express -- unknown 4. JCB -- unknown 5. Diners Club -- unknown (Source: Nilson Report, May 2008) 2007 global market share of general-purpose cards (purchase volume) 1. Visa -- 60 percent 2. MasterCard -- 28 percent 3. American Express -- 10.5 percent 4. JCB -- 0.9 percent 5. Diners Club -- 0.5 percent (Source: Nilson Report, May 2008) A Credit card is a type of a payment card product. A payment card product is a set of entitlements. It allows the client to access the features the provider (e.g., financial institution) attaches to the card. A sample of possible payment card entitlements is shown below: Access Convenience Affordability Credit Worldwide acceptance Interest rate Deposits 24 hour availability Fees Merchants Portability Benefits ATMs Monthly statements Payment terms To create an actual payment card product, these entitlements are grouped together to appeal to a target segment consumer or business. A card is issued to a cardholder and usually displays cardholder name, account number, expiration date, location acceptance logos (e.g., Visa/MasterCard) and issuing organization. Most cards are plastic with a magnetic stripe. Some of the new cards contain chips that store information such as additional customer information and stored value. A card usually is linked to some type of financial account (e.g., credit card to a credit line and a debit card to a checking/savings account).

5.2.1 CREDIT CARDS

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A credit card is a plastic card with a magnetic strip containing data, and is a financial instrument allowing the holder for pay for goods or services on credit and in lieu of cash. While credit card companies provide the infrastructure to settle the transactions, the cards are issued by banks and increasingly by retail outlets and other consumer-oriented entities. Credit cards allow customers to buy goods and services immediately and then settle the bill for aggregated transactions at a later date.

5.2.2 CREDIT CARD MARKET MAJOR BUSINESS ENTITIES AND THEIR ACTIVITIES
The following diagram depicts typical activities in transaction processing using a card involving all the entities described above -

The following table shows lists the description of the various entities involved in a Credit card processing Entity Issuing Bank Cardholder Account Description This is a bank / financial institution that issues a credit product Cardholder portfolio account is created when a credit application is approved.

Business Portfolio This defines the processing rules for all the accounts under a business venture of the same card offering type. This entity may hold billing rules, Account auth limits, collection strategies, and other properties that can be defined at this level. Examples of Business portfolio account may include Chase Visa Classic, Chase Visa Gold, etc Card Product Authorization Engine Identifies the different card types that the Credit system supports. Examples may be proprietary cards, Visa, MasterCard Authorization engines are used to authorize credit transactions. The authorization engine uses the account information, merchant information, and other related information to approve / decline / refer an authorization transaction. There can be more than one authorization engines for a business portfolio. Provides credit scores that are used by Issuers to process card applications Third party to whom Issuer outsources the cardholder collection activities An outside company with which the Issuer contracts to provide cardholder transaction processing activities.

Credit Bureau Collection Agency Issuer Processor Issuer Bank

Clearing Bank designated by the Issuer to receive the Issuers daily net settlement advisement. The clearing bank (may be the Issuer itself) will also conduct funds transfer activities with the net settlement bank and maintain the Issuers clearing account. This is a bank / financial institution that acquires merchant transactions Clearing Bank designated by Acquirer to receive the Acquirers daily net settlement advisement. The clearing bank (may be the Acquirer itself) will also conduct funds transfer activities with the net settlement bank and maintain the Acquirers clearing account. An outside company with whom the Acquirer contracts to provide merchant processing services A merchant account is created when a merchant application is approved. A merchant account is necessary for a merchant to accept payment by credit card Contains presentments and other financial messages that need to be matched with corresponding authorizations This file is for enabling member settlement

Acquirer Acquirer Bank

Acquirer Processor Merchant Account

Clearing file Funding file

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The credit card process flow is illustrated with an example. An individual, who desires to have a credit card, applies for one in MBNA. The issuer, MBNA collects the applicants financial and other details and does the necessary credit appraisal through assistance from its processor. The credit processing will involve a sequence of events like verifications, credit scoring, credit check, etc. and a decision will be taken by MBNA on whether a card can be issued to the applicant or not. If the applicant is found eligible to be given a card, MBNA will issue a credit card with his card details embossed along with the logos of the issuer and the association. Now that the applicant has become a card member, he may wish to buy some commodity using his VISA card, bearing the logo of the issuer MBNA, in payment. The merchant swipes the card through a card reader, which reads the data on the magnetic stripe and adds information that identifies the merchant and the dollar value of the purchase. This electronic message is automatically sent via telephone line to an IT system maintained by the merchants acquirer, also a member of the association. The message is then transmitted to the association's system, which routes the request to the appropriate Issuer to verify that the cardholder has a credit balance sufficient to cover the purchase. The response (approval or denial) from the issuer is routed back along the same path to the originating POS terminal. This entire process typically happens within 10 seconds and in case of an approval, the cardholder is expected to sign the credit card charge slip. The merchant submits a request for payment to its acquirer, who in turn sends it to VISA. VISA consolidates the transaction with all other transactions that day and settles the accounts among banks i.e. Funds are transferred from the Issuer to the Acquirer and to the merchant. At the end of the credit period, the customer makes his settlement with the Issuer.

5.2.3 CREDIT CARD TRANSACTION ECONOMICS

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The credit card transaction starts when the merchant swipes a customer's credit card through a dial-in terminal that would automatically dial the correct network depending on the association being used. The card holder, in this way, informs the Issuer to pay the merchant.The merchant then passes this message on to his acquirer, who then sends it through the Credit Card Association to the card issuer. The return path of the $100 dollars is essentially the same except that each party deducts some amount of money for its efforts. Following is the share of each of the entities: The card issuer will bill the card holder and keep an interchange fee which in this example is 1.3%, or $1.30. However, he must pass the remaining money back to the card association and pay an issuer transaction fee of .07% or $.07. The card association takes the $98.77, deducts a merchant transaction fee (.09%) and returns $98.61 to the acquirer. The acquirer keeps .06% and deposits $98 in the merchants account. The merchant then sees $98 dollars return from the $100 dollar purchase. This charge of $2, or 2%, is called the discount rate and is the basis for much of the competition between the banks of a credit card association.

5.2.4 TRANSACTION TYPES


Entity Cardholder transactions Transaction Type Purchase Remarks Sale of Merchandise - Triggered by the cardholder. Authorization/Verification is the default transaction type. Transaction approval response from Issuer to Merchant Preauthorization - The merchant is provided with the ability to add a tip to a credit card transaction after having presented the cardholder with the transaction record Merchandise return Credit of transaction amount to the Cardholder This transaction is an action on a previous transaction and is used to cancel the previous transaction and

Authorization/Verification

Preauthorization

Merchandise return

System Generated Transactions

Reversal

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ensure it does not get sent for settlement. Exception Transactions Adjustment Chargeback & Reversal Representment Administrative Network Reconciliation File Maintenance Fee transactions Used to correct errors that occur at Chargeback point of transaction or in a participants system

Others

These are routine transactional activities to ensure completion of the various activities involved in a transaction processing cycle

5.2.5 CHARGEBACK & CHARGEBACK REVERSALS


At any time (currently limited to 60 days after statement date), cardholder may contact the Issuer to question whether a transaction is legitimate and request a copy of the transaction from the merchant. If the cardholder does not receive a copy of transaction, she may request a chargeback a financial reversal of the transaction. Even if the retrieval request is fulfilled, cardholder still may request the Issuer to initiate a chargeback. However, if the merchant disputes the chargeback, the disputed transaction is dealt with through a defined dispute process. Following diagram depicts the process of chargeback and chargeback reversal

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5.3

MAJOR PLAYERS

The following table shows some of the leading card organizations and their respective roles in the Credit card industry: Leading Card Organizations Banks Non-Banks Association Organization Visa (Card Association, Processor) MasterCard (Card Association, Processor) JCB (Card Association) /

Citigroup (Issuer) MBNA (Issuer) America

First Data Corp (Processor) TSYS (Processor) Vital (Acquirer & Processor) American Express (Acquirer, Organization & Issuer) Card

JPMorgan Chase / Bank One (Acquirer & Issuer) Bank of America (Acquirer & Issuer) Capital (Issuer) One

Discover (Acquirer, Card Organization & Issuer) Diners Club (Card Organization & Issuer) Equifax (Processor) Sears ( Acquirer, Card Organization & Issuer) GE Card Services (Processor) US Government (Acquirer & Issuer)

Wells Fargo (Acquirer & Issuer) Wachovia (Issuer) Natwest (Issuer) Barclays (Issuer)

5.4

RECENT DEVELOPMENTS

5.4.1 SEPA: IN A NUTSHELL


SEPA is an objective set by the European Union for the purpose of creating a single payment market, within which everyone can make payments simply and safely, at the same cost and as efficiently as those presently being made at the national level. The project will make it possible for individuals, companies, government agencies and others, no matter where they are located in Europe, to make and receive Euro payments, to engage in direct debits and to use credit and debit cards with standardized basic conditions, rights and obligations in every country.

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The expanse of SEPA is all EU Member States (currently 27), other EEA Member States (Norway, Iceland and Liechtenstein) and Switzerland. There are three main payment instruments forming part of the SEPA objective: Pan-European Credit Transfer (SEPA Credit Transfer (SCT)) Pan-European Direct Debit (SEPA Direct Debit (SDD)) Debit and account-linked cards (SEPA Cards Framework (SCF))

SCF: AN INTRODUCTION SEPA Cards Framework (SCF) spells out high level principles and rules which when implemented by banks, schemes, and other stakeholders, will enable European customers to use general purpose cards to make payments and cash withdrawals in Euro throughout the SEPA area with the same ease and convenience than they do in their home country. The vision of SEPA Cards Framework is as follows: There should be no differences whether European customers use their card(s) in their home country or somewhere else within SEPA. No general purpose card scheme designed exclusively for use in a single country, as well as no card scheme designed exclusively for cross-border use within SEPA, should exist any longer. Impact On Customers / Card holders - Since the beginning of the year 2009, all the newly issued cards will be equipped with the chip technology and their usability within the SEPA zone will be the same as of standard international bank cards. Cards will be used in compliance with the EMV standard. On Merchants / Traders - Traders will continue to be able to decide which offered card products they will accept and with which bank a receiver - they will cooperate. The bank and the trader will contractually agree on the trade terms and conditions for acceptance of bank cards, type of accepted bank cards, including charges, and other relevant particulars. As long as a payment terminal is owned by a bank, the bank is entitled to decide whether a trader may use a given terminal also for cooperation with another bank. Payment terminals will accept both SCF compatible products and products without the EMV chip technology due to the need to safeguard the acceptance of bank cards issued in non- SEPA countries. On Banks - The preparatory phase for implementation of SEPA will mean investments into the technologies used within the process of issue and acceptance of bank cards (cards, POS, ATM) and adjustment of affected information systems

5.4.2 EMV-GLOBAL FRAMEWORK FOR SMART CARD PAYMENTS

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EMV is the standard devised by Europay, MasterCard and Visa (EMVCo.) for smart card based credit and debit cards to replace the existing magnetic based stripe cards. With the acquisition of Europay by MasterCard in 2002, and JCB (Japan Credit Bureau) joining the organization in 2004, EMVCo currently comprises of JCB International, MasterCard Worldwide and Visa, Inc. The primary aim of EMV is to define a set of specifications that will offer interoperability between the smart card (chip based), POS terminals, and ATMs throughout the world. The key purposes served by EMV can be summed up as Benefits Some of the Key benefits of EMV implementation are Increased Interoperability of card acceptance, security and payment functions Fraud Prevention Reduce counterfeit and lost and stolen fraud Avoid being the weakest link - prevent migration of fraud to own card base as other banks implement Avoid card scheme liability shift Improved Control Reduce and improve management of bad debt by utilizing chip parameters e.g. to restrict below floor limit spending. Apply different levels of control according to cardholder profile Provides authentication and platform for ID Customer centric decisions at the terminal, control managed within the application on the chip Maintain Competitiveness Maintain credibility in customers and competitors eyes. Endorse Brand with reliable, secure and innovative product. A migration path for loyalty and multi-application products. A set of specifications for global card interoperability Enable cardholder verification and transaction authorization in a secure way Offer multiple facilities and advantages on a single card making it easy to operate

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Operational savings from reduced chargeback/authorization costs Impact on existing cards Master and Visa have planned a global migration scheme to initiate credit and debit card transactions with the use of a chip in card and authenticating the transaction using a PIN (Personal Identification Number) instead of the magnetic stripe. This will have a direct impact on the existing credit and debit cards as they are based on card holder terminals which can read magnetic stripes and performs cardholder verification through signature instead of PIN. SUMMARY Cards are one of the most widely used mechanisms for transactions worldwide. There are several types of cards used o Debit cards o ATM cards o Credit cards o Smart cards o Co Branded card o Affinity card o Commercial card o Prepaid card ACH enables batch-processed, value-dated electronic funds transfer between originating and receiving financial institutions. Emerging payments systems are o Online Bill Payment (EBPP, EIPP) o Person to Person Payments (P2P) o Internet currencies, digital cash, e-Wallet o Electronic Benefit Transfer (EBT) o Mobile payments o Contactless payments There are various entities involved in the credit card transaction processing cycle o Issuer o Acquirer o Third party Processor o Independent Sales organization o Association o Merchant o Card holder Transaction Economics A credit card transaction involves various fees. / Charges such as interchange fee, merchant transaction fee and issuer transaction fee. The merchant

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discount rate is the basis for much of the competition between the banks of a credit card association. Chargeback and Chargeback reversals are legitimate ways to cancel the credit card transactions within a limited time frame SEPA Cards Framework and EMV Global Framework for Smart Card Payments are some of the recent developments in the Cards arena.

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6.0
6.1

WHOLESALE BANKING AND COMMERCIAL LENDING


INTRODUCTION

Corporate Lending refers to various forms of loans extended by banks to corporate bodies like proprietorship, partnership, private limited companies or public limited companies. Banks lend to such entities on the strength of their balance sheet and business cash flows. Corporate loans are provided by banks for various purposes like new projects, capacity expansion or plant modernization, daily cash flow requirements (working capital) etc. Depending on the nature of the requirement, loans may be long-term or short-term in nature. Loans can be either secured or unsecured in nature. In case of secured loans, if the corporate defaults on payment of principal or interest on the loan, the bank can take possession of the security and sell off the same to meet principal or interest payment on the loan. Security is usually in the form of land, buildings, plant and machinery, physical stock of the raw material, goods for sale etc.

6.2

CORPORATE LENDING PROCESS

The following is the typical stages in a corporate lending process: Corporate approaches the relationship manager of the bank with a request for a loan. The corporate provides details like: past financial statements, details of the loan requirement, cash flow projection for the period of the loan, details of the security being provided etc. Depending on the loan type and bank requirements, information should be provided by the corporate. The concerned division of the bank prepares the detailed analysis of the corporate financial statements. A detailed study is also done on the corporates products, market segment, competitors etc to ascertain the strength of the corporates business. A report is prepared to capture the above details. Based on the above report, the concerned division of the bank assigns a rating to the corporate. The rating captures various factors like strength of business, financial state of the corporate, ability to repay the loan based on cash flow projections, promoter background etc. A committee of the bank evaluates the loan proposal and decides to sanction/reject the same. Once sanctioned, the bank provides a sanction letter to the corporate providing details of the loan terms and conditions. After the corporate accepts the same, a loan agreement is signed between the bank and the corporate. The loan agreement captures various conditions of the loan like repayment

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mode, repayment period, interest payable, security provided, other conditions etc. The loan becomes committed at this stage. The bank disburses the required amount under the loan committed. This amount is called the disbursed amount under the loan. Interest is usually paid on the disbursed amount of the loan. In some cases, a nominal interest if also payable on the committed amount of the loan. Also, in most cases, the corporate would have to pay a certain amount as processing fees for the loan. This would cover the banks overhead costs in the loan process.

CORPORATE CREDIT RATING


Before sanctioning a loan to a corporate, the bank does a detailed assessment of its financials and business strength as discussed in the earlier section. This process ends with the bank assigning a rating to the corporate for the loan facility. Ratings are usually specified in alphanumeric terminologies. Rating levels might vary from AAA (highest), AA+, AA- to default ratings like D. Rating terminologies might vary across banks and across various loan tenures. The rating level specifies a certain probability of default of the loan. It also takes in to account the protection offered by the security of the loan. For corporate with higher ratings, banks provide loans at lower interest rates and vice versa. In most cases, banks do a rating process for each of its corporate clients at the end of say, every year or every quarter. This helps banks to continuously track the financials and market position of the corporate.

CREDIT ENHANCEMENTS
Credit enhancement is a mechanism used to increase the original rating of a loan for a corporate. Credit enhancements can be in the form of pledge of shares, cash collateral, corporate or bank guarantees etc.

Example: A corporate rated BB (low rating) requires a loan of USD 5.0 million from a bank. To enhance the loan rating and thus reduce interest payable on the loan, the promoters pledges their share holding in the company with the bank. Thus, whenever there is a default on repayment of the loan, the bank has the right to sell the shares in the market. Based on the historic volatility of the shares and the current market value of USD 6.0 mn, the bank upgrades the rating of the loan to BBB+.

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6.2.1 TYPES OF LOANS


TERM LOANS These loans can either be short term loans or long term loans. Long-term loans are extended for purposes like new projects, capacity expansion or plant modernization. These loans are usually repayable over a 2-7 year period after an initial moratorium period (period during which loan repayments are not required) to help the corporate complete implementation of the project before revenue generation takes place.

Example On April 15, 2004, AT&T borrows a term loan of USD 200 million from Citibank for funding their IT modernization project across the nation. The loan is repayable in 16 quarterly installments starting April 15, 2005, after an initial moratorium of 4 quarters. The interest payable would be LIBOR+0.5% payable quarterly. The loans would be secured by AT&T equipment at their HQ, worth USD 300 mn. Short term loans are extended usually for meeting working capital requirements. The loans can be repayable in various tenures starting from a week to as long as 1 year. The loans are either repayable in fixed installments or in one bullet installment at the end of the period. In some cases, short term loans are backed by promissory notes which are legal instruments that guarantee payment of a certain amount on a specified due date. CORPORATE BONDS Corporate bonds are used for the same purpose as term loans, but the loan is backed by a transferable instrument which guarantees payment from the corporate as per specified conditions. Thus, corporate bonds are tradable and banks can sell them to a third party who receives the right to get payments from the corporate. Bonds are rated depending on the rating of the corporate and depending on the rating, the market demands varying amounts of interest. A certain class of bonds called junk bonds is issued by corporate with very low credit ratings and carry very high rates of interest. WORKING CAPITAL For any business, there would be current assets in the form of cash, receivables, raw material inventory, goods for sale inventory etc while there would be current liabilities in the form of payables and other short term liabilities. Part of the current assets would be funded through current liabilities while the rest would have to be funded through a mixture of short term and long term loans. As per norms, 25% of the working capital gap would have to be funded by long term sources like equity or term loans while the rest 75% can be funded through short term loans and overdraft limits.

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Banks conduct a detailed assessment of the current assets and liabilities for a corporate and arrive at a suitable working capital limit. For purpose of calculating limits, banks typically include only receivables which are less than 6 months old. Also within the specified limit, banks keep reviewing the current asset and current liability position of a company to arrive at the drawing power for each month. Corporate are allowed to borrow up to the working capital limit or the drawing power, whichever is lower. Overdraft limits are extended to help the corporate manage the day-to-day cash flow needs of the business. The bank makes available a certain sum of money for a period of time (say, USD 20.0 million for a period of 1 year). There would be a separate account called the overdraft account created to monitor withdrawals under this loan. Whenever the corporate has a deficit in its main business account, it can draw money from the overdraft account (up to the limit of USD 20.0 million). It can also put back money in the overdraft account as and when they have surpluses in the business account. Interest is calculated by the bank on the various end-of-day deficits in the overdraft account and is usually payable by the corporate at the end of every month. LINES OF CREDIT These are short term loans sanctioned for a fixed validity period, allowing the corporate to draw the loan as and when required within the validity period and repay the loan after a certain period (repayment period). Interest is either repayable in certain intervals or in one bullet installment at the end of the repayment period. In many cases, the lines of credit are of a revolving nature. The same is explained via the example provided below: Example Citibank sanctions a line of credit of USD 10.0 mn to AT&T, valid for a period of 3 years. Within the 3 year period, AT&T can borrow any amount at any point of time, such that the cumulative outstanding is below USD 10.0 mn on any date. Each of these borrowals are repayable with interest at the end of 30 days from the date of borrowals. Since AT&T can thus revolve the limit any number of times within the specified limit and validity period, these are called revolving lines of credit. BILL DISCOUNTING Bill discounting is another form of working capital financing. A bill (Bill of Exchange) is a financial instrument by which one party promises to pay the other party a certain amount of money on a specified due date. This is transferable and the final holder of the bill holds the right to receive the payment from the concerned party. The corporate would have bills of exchange which are drawn on their dealers, which entitle the corporate to receive certain amounts of money from the dealer after a pre-defined credit period. The corporate can then transfer the bill to the bank and get a discounted amount upfront. The bank collects the interest on the bill amount for the specified period upfront in this process called bill discounting. On the due date, the bank collects the payment from the concerned party directly.

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COMMERCIAL PAPER Commercial Paper (CPs as commonly known) is an instrument by which a corporate borrows money from banks for short periods of time. A CP binds the corporate to make a payment equal to the face value of the CP to the issuing bank on a specified due date. In this sense, a CP is like a short term unsecured loan. However, a CP is tradable in the market the bank can sell the CP to a third party. For this reason, banks charge lesser interest on CPs than normal short term loans. However, since CPs are unsecured and are to be tradable in the market, banks provide CP lending to only highly rated corporate. LEASING Leasing is another form of bank financing. In leasing, the bank purchases real estate, equipment, or other fixed assets on behalf of the corporate and grants use of the same for a specified time to the corporate in exchange for payment, usually in the form of rent. The owner of the leased property is called the lessor, the user the lessee. Lease payments (which include principal and interest payments usually) can be shown by corporate as operating expenses and hence leases are used by some corporate as a substitute for loans to get better tax benefits. SUPPLIER AND DEALER LOANS These are short term loans provided by banks to suppliers and dealers of large companies. These loans usually have conditions which ensure that there is sufficient support from the corporate in case the supplier or a dealer defaults. Thus, using the support from the corporate, the suppliers/dealers can borrow money from the bank at a lower rate of interest than otherwise possible. Such loans help the corporate to develop a stronger base of suppliers and dealers, which often helps them in improving their business. ASSET SECURITISATION LOANS Asset Securitization loans are loans which are backed by specified future cash flows or other assets of the corporate. These loans help corporate to release excess cash flows from existing receivables or future receivables.

Example Citibank provides a loan of USD 250.0 mn to Royal Dutch Shell, securitizing cash flows from future monthly sale of oil explored from its specified offshore rig. In this case, there would be a mechanism to ensure that money from monthly sale of oil explored from the specified rig for the period of the loan would be used to service payment of interest and principal of the loan to Citibank. Citibank would do a detailed assessment of oil exploration potential, study oil prices and ensure proper cash flow trapping mechanisms before disbursing the loan to Royal Dutch Shell.

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6.2.2 CLASSIFICATION OF LOANS BY THE BANK


CLASSIFICATION OF DRAWN LOANS Loans are classified and accounted for as follows: AccrualLoans that management has the intent and the ability to hold for the foreseeable future or until maturity/loan payoff. Accrual loans are reported on the balance sheet at the principal amount outstanding, net of charge-offs, allowance for loan losses, unearned income, and any net deferred loan fees. Held-for-saleLoan or loan portfolios that management intends to sell or securitize. TradingLoans where management has the ability and intent to trade or make markets (i.e., sell/hedge the credit risk.) Loans held for trading purposes are included in Trading Assets and are carried at fair value, with the gains and losses included in Trading Revenue provided that the criteria outlined in this policy are met. CLASSIFICATION OF UNDRAWN LOAN COMMITMENTS Loan commitments are generally classified as accrual and recorded off-balance sheet. Differences between loan and commitment are as follows; Loans are reflected in the asset side of the banks balance sheet. Commitments are offbalance sheet items and are reflected in the contingent asset side of the balance sheet. The amount of the loan that is disbursed is credited to the account of the borrower. In case of a commitment, there is no disbursement or credit to a borrowers account. The fee charged on a loan is a function of the disbursed amount. The fee charged on commitment is a function of the amount of commitment that is not utilized.

6.2.3 LOAN SYNDICATION


A syndicated loan is a lending facility defined by a single loan agreement in which 2 or more banks participate WHY SYNDICATION A borrower wants to raise relatively large amount of money quickly and conveniently The amount exceeds the exposure limits or appetite of any one lender The borrower does not want to deal with multiple lenders KEY ENTITIES IN SYNDICATION

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1. Arranger / Lead Manager: This the bank / lender the prospective borrower has mandated to arrange loan 2. Underwriting Bank: The bank that commits to supply funds to the borrower. If necessary from own sources if the loans are not fully subscribed. It may the arranging bank or another bank 3. Participating Bank: The bank that participates in the syndication by lending a portion of the total amount required 4. Facility Manager / Agent: The entity who takes care of the administrative arrangements over the term of the loan (Example: disbursements, repayments, compliance) STAGES IN SYNDICATION 1. Pre-mandate Phase: Prospective borrower will liaise with a single bank and the bank may agree to act as lead bank. The lead bank needs to; a. Identify the needs of the borrower b. Design an appropriate loan structure c. Develop a persuasive credit proposal d. Obtain internal approval 2. Placing the loan: The lead bank will start to sell the loan in the market place and to sell the loan it needs to; a. Prepare an information memorandum b. Prepare a term sheet c. Prepare legal documentation d. Approach selected banks and invite participation 3. Post-closure phase: Post closure, agents will handle the day to day running of the loan facility FEES AND CHARGES Fee Arrangement fee Front end Type Remarks Also called praecipium. Received and retained by the lead arrangers in return for putting the deal together Remuneration of the legal advisor Price of the commitment to obtain financing during the first level of syndication Received by participants the senior

Legal fee

Front end

Underwriting fee

Front end

Participation fee

Front end

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Facility fee Commitment fee

Per annum Per annum charged undrawn part

Received by participants

the

senior

on Paid as long as the facility is not used, to compensate the lender for tying up the capital corresponding to the commitment on Boosts the lenders yield; enables the borrower to announce a lower spread to the market than is actually being paid Remuneration of the agent banks service Remuneration of the conduit bank Penalty for prepayment

Utilization fee

Per annum charged undrawn part

Agency fee

Per annum

Conduit fee

Front end

Prepayment fee

One-off if prepayment

6.3

CREDIT DERIVATIVES

Credit derivatives are financial contracts that transfer credit risk from one party to another, facilitating greater efficiency in the pricing and distribution of credit risk among market players. Example The holder of a debt security issued by XYZ Corp. enters into a contract with a derivatives dealer whereby he will make periodic payments to the dealer in exchange for a lump sum payment in the event of default by XYZ Corp. during the term of the derivatives contract. As a result of such a contract, the investor has effectively transferred the risk of default by XYZ Corp. to the dealer. In market parlance, the corporate bond investor in this example is the buyer of protection, the dealer is the protection seller, and the issuer of the corporate bond is called the reference entity.

6.3.1 USES OF CREDIT DERIVATIVES


Like any other derivative instrument, credit derivatives can be used either to take on more risk or to avoid (hedge) it. A market player who is exposed to the credit risk of a given corporation can hedge such an exposure by buying protection in the credit derivatives market. Likewise, an investor may be willing to take on that credit risk by selling protection and thus enhance the expected return on his portfolio.

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Credit derivatives can be used to create positions that can otherwise not easily be established in the cash market. For instance, consider an investor who has a negative view on the future prospects of a given corporation. One strategy for such an investor would be to short the bonds issued by the corporation, but the corporate repo market for taking short positions in corporate is not well developed. Instead, the investor can buy protection by way of credit default swap. If the corporation defaults, the investor is able to buy the defaulted debt for its recovery value in the open market and sell it to its credit derivatives counterparty for its face value. Banks use credit derivatives both to diversify their credit risk exposures and to free up capital from regulatory constraints. As an example, consider a bank that wants to diminish its exposure to a given client, but does not want to incur the costs of transferring loans made to that client to another bank. The bank can, without having to notify its client, buy protection against default by the client in the credit derivatives market: Even though the loans remain on the bank's books, the associated credit risk has been transferred to the bank's counterparty in the credit derivative contract. The above example can also be used to illustrate banks' usage of credit derivatives to reduce their regulatory capital requirements. Under current Basle standards, for a corporate borrower, the bank is generally required to hold 8 percent of its exposure as a regulatory capital reserve. However, if its credit derivatives counterparty happens to be a bank located in an OECD country, and the bank can demonstrate that the credit risk associated with the loans has been effectively transferred to the OECD bank, then the bank's regulatory capital charge falls from 8 percent to 1.6 percent. Example Let us visualize a bank, say Bank A which has specialized itself in lending to the office equipment segment. Out of experience of years, this bank has acquired a specialized knowledge of the equipment industry. There is another bank, Bank B, which is, say, specialized in the cotton textiles industry. Both these banks are specialized in their own segments, but both suffer from risks of portfolio concentration. Bank A is concentrated in the office equipment segment and bank B is focused on the textiles segment. Understandably, both the banks should diversify their portfolios to be safer. One obvious option for both of them is: Bank A should invest in an unrelated portfolio, say textiles. And Bank B should invest in a portfolio in which it has not invested still, say, office equipment. Doing so would involve inefficiency for both the banks: as Bank A does not know enough of the textiles segment as bank A does not know anything of the office equipment segment. Here, credit derivatives offer an easy solution: both the banks, without transferring their portfolio or reducing their portfolio concentration, could buy into the risks of each other. So bank B buys a part of the risks of the portfolio that is held by Bank A, and vice versa, for a fee. Both continue to hold their portfolios, but both are now diversified. Both have diversified their risks. And both have also diversified their returns, as the fees being earned by the derivative contract is a return from the portfolio held by the other bank.

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6.3.2 TYPES OF CREDIT DERIVATIVES


Credit derivatives can be classified in two main groups: Single name instruments are those that involve protection against default by a single reference entity. Multi-name credit derivatives are contracts that are contingent on default events in a pool of reference units.

6.4

TREASURY SERVICES

The Treasury Services department is concerned with managing the financial risks of the bank. Hence, the treasurer's job is to understand the nature of these risks, the way they interact with the business, and to minimize or to offset them. In many cases, the treasury services department also provides cash management solutions for customers of the bank. The Treasury services department of a bank performs the following functions: Managing the cash position of the bank, managing liquidity and associated risks Forex services: provides Forex services to corporate, enters in to deals with multiple counterparties to maintain a risk-managed position for the bank. Risk management services: provides risk management products like swaps, options etc to corporate and enters in to multiple deals with various counterparties to maintain a riskmanaged position for the bank. Conducts research on various market factors, monitors interest rate and economic scenario etc Cash Management services for corporate managing collections and payments Typically, the treasury has a front office desk which enters in to trades (in Forex, money markets, equity, treasury securities etc) with various market participants and a middle office/back office desk which monitors positions and provides operational support. Most large investment banks provide Treasury Services to their clients. Treasury domain includes Fixed Income: An investment that provides a return in the form of fixed periodic payments and eventual return of principle at maturity. Unlike a variable-income security where payments change based on some underlying measure, such as short-term interest rates, fixed-income securities payments are known in advance. Money Markets: The money market is a subsection of the fixed income market. The difference between the money market and the fixed income market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money market investments are also called cash investments because of their short maturities. Some of the popular money market instruments include Certificates of Deposit (CD), Commercial Paper (CP), Treasury Bills (T-Bills) Foreign Exchange: The market for buying and selling of currencies is called the Foreign Exchange market (FX ). It is a 24 hour non-stop market. Some of the major Currency traded include The US Dollar (USD), The Japanese Yen (JPY), The Euro (EUR), The Great Britain

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Pound (GBP), The Swiss Franc (CHF). FX rates express the value of one currency in terms of another currency. They involve o The commodity currency - the currency being priced, usually 1 unit or a fixed amount of currency. o The terms currency - the currency used to express the price of the commodity, in varying amounts of OTC Derivatives: Over the counter (OTC) markets are a form of Secondary markets. World over Secondary markets are classified as Listed and OTC. Listed markets typically are exchanges where a security is listed and traded. A decentralized market of securities not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor or electronic order matching systems. There is no central exchange or meeting place for this market. Typically Currency instruments are traded OTC. A derivative contract derives its value based on the value of some basic underlying. The underlying may be any instrument like a bond, a stock or a market index, currency or interest rates. Some of the instruments traded OTC include o Forward Rate Agreement (FRA) - A contract that determines the rate of interest, or currency exchange rate, to be paid, or received, on an obligation beginning at some future start date. It is also referred to as Future Rate Agreement. o Interest Rate Swap (IRS) - A deal between banks or companies where borrowers switch floating-rate loans for fixed rate loans in another country. These can be either the same or different currencies. The motive may be the competitive advantage of one company to have access to lower fixed rates than another company. The other company may be competitively placed to have access to lower floating rates. A swap would be beneficial to both. The swap is measured by its notional principal. FX Options: Forex Options give the holder the right to buy or sell a currency in terms of another currency at a particular rate on a particular date or within a period of time. The option to buy is called as a Call Option and the option to sell is called as a Put Option. Equity Options These are similar to FX options the only difference is the underlying. The underlying in case of Equity Options are stocks or stock market indices. When the underlying is a stock market index the term used is Index Option and the term used to refer options on individual stocks is Stock Option Credit Derivatives - Privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. Credit Derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments). For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.

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6.4.1 FUNCTIONS OF THE TREASURY MANAGER


Ensure availability of funds An integrated treasury typically would include debt market, money market and Forex transactions. Treasury manager needs to ensure that adequate funds are available to cover the settlement obligations of the said transactions. Manage all foreign currency transactions for the bank Manage various risks: o Liquidity Risk of asset and liability cash flow mismatch. A bank may not have adequate funds for the settlement of its transactions or to pay its customers because of mismatches in the tenor of its receivables o Interest rate Risk due to volatility of interest rates. A bank may have borrowed at floating rates of interest and lent at fixed rate of interest and the interest rates moves up o Currency Risk due to volatility in exchange rates. A bank may have its payment obligations in a currency say USD and the rate to purchase the said currency goes up Commodity Risk due to volatility in commodity prices. A bank may have an obligation to deliver a commodity in the future and the price of the commodity moves up Cash Management Services - CMS is a service provided by banks to its corporate clients for a fee to reduce the float on collections and to ease the bulk payment transactions of the client. The three elements of CMS are: o Receivables Management Helps the company to manage collection of its sale proceeds from remote upcountry regions o Payables Management Helps the company to manage its payments to its regular suppliers without keeping numerous bank accounts for various locations and then reconciles them periodically in a highly manual / paper-based environment o Liquidity Management Helps the company by ensuring direct and instant access to its bank accounts. It should not happen that a company has excess funds in one bank account and it needs to pay through another bank account where there are no funds Managing Liquidity & Interest Rate risks o Asset Liability Management A banks assets and liabilities need to necessarily match. If they dont the bank may have liquidity problems which would endanger its solvency. The long term assets should not be financed by short term sources of funds. The bank would not be able to serve its lenders if the timings of its inflows do not match its outflows. A bank typically uses mathematical tools like Duration, Gap Analysis to find out mismatches and take corrective actions Example A bank borrows USD 100MM at 3.00% for one year The bank uses this borrowed money to lend to a highly-rated borrower for 5 years at 3.20%. For simplicity, assume interest rates are annually compounded and all interest accumulates to the maturity of the respective obligations. The net transaction appears profitablethe bank is earning a 20 basis point spreadbut it entails considerable risk.

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At the end of one year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. Assume interest rates are at 4.00% at the end of the first year. The Bank will now have to pay a higher rate of interest (4.00%) on the new financing than the fixed 3.20 it is earning on its loan. It is going to be earning 3.20% on its loan and paying 4.00% on its financing. The problem in this simple example was caused by a maturity mismatch between assets and liabilities. As long as interest rates experienced only modest fluctuations, losses due to assetliability mismatches are small or trivial. However, in a period of volatile interest rates, the mismatches would become serious. The treasury asset-liability management (ALM) group assesses asset-liability risk and all banks have ALM committees comprised of senior managers to address the risk. Techniques for assessing asset-liability risk came to include gap analysis, duration analysis and scenario analysis. Gap analysis looks at amount of assets and liabilities in various maturity buckets while Duration analysis looks at weighted average maturity of cash flows to compare assets and liabilities. Since liquidity management is closely linked to asset-liability management, assessment and management of liquidity risk is also a function of ALM departments and ALM committees. ALM strategies often include securitization, which allows firms to directly address asset-liability risk by removing assets or liabilities from their balance sheets. This not only eliminates asset-liability risk; it also frees up the balance sheet for new business.

Interest rate risk management o Manage risks due to volatility of interest rates - Demand and supply of money go on changing from time to time making interests rates volatile. A bank may have accepted deposits at a fixed rate of interest historically. However current market rates may be lower when it wishes to lend. The banks portfolio value of investments in bonds and treasury also varies inversely with the interest rates. A higher interest rate diminishes the value of a banks portfolio and vice versa. Instruments like interest rate swaps and currency swaps help to address Interest Rate risks

6.4.2 CAUSES OF INTEREST RATE RISK


The causes of interest rate risk might vary: Repricing risk: The primary form of interest rate risk arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and offbalance-sheet (OBS) positions. For instance, a bank that funded a long-term fixed rate loan with a short-term deposit could face a decline in both the future income arising from the position and its underlying value if interest rates increase.

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Yield curve risk: Yield curve risk arises when unanticipated shifts of the yield curve (a plot of investment yields against maturity periods) have adverse effects on a bank's income or underlying economic value. Yield curves can shift parallel or change in steepness, posing different risks. For instance, the underlying economic value of a long position in 10-year government bonds hedged by a short position in 5-year government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve. Basis risk: Basis risk arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. For example, a strategy of funding a one year loan that reprices monthly based on the one month U.S. Treasury Bill rate, with a one-year deposit that reprices monthly based on one month Libor, exposes the institution to the risk that the spread between the two index rates may change unexpectedly. Optionality: An additional and increasingly important source of interest rate risk arises from the options embedded in many bank assets, liabilities and OBS portfolios. Options may be stand alone instruments such as exchange-traded options and over-the-counter (OTC) contracts, or they may be embedded within otherwise standard instruments. They include various types of bonds and notes with call or put provisions, loans which give borrowers the right to prepay balances, and various types of non-maturity deposit instruments which give depositors the right to withdraw funds at any time, often without any penalties. If not adequately managed, the asymmetrical payoff characteristics of instruments with optionality features can pose significant risk particularly to those who sell them, since the options held, both explicit and embedded, are generally exercised to the advantage of the holder and the disadvantage of the seller. Managing interest rate risk Bank treasuries measure interest rate sensitivity of securities (assets or liabilities) through Duration analysis. Duration is a mathematical concept which can be used to measure the sensitivity of a financial instruments price to changes in interest rate. On the basis of duration analysis, banks can increase/decrease holdings of long term and short term securities in response to anticipated changes in interest rate. Banks also use derivative instruments like interest rate swaps and options to manage interest rate risks (A derivative is a generic term often used to categorize a wide variety of financial instruments whose value depends on or is derived from the value of an underlying asset, reference rate or index). Some of them are: o Interest Rate Swap: An agreement to exchange net future cash flows. In its commonest form, the fixed-floating swap, the counterparty pays a fixed rate and the other pays a floating rate based on a reference rate, such as Libor. There is no exchange of principal. The interest rate payments are made on an agreed notional amount.

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Forward Rate Agreement (FRA): A FRA allows purchasers / sellers to fix the interest rate for a specified period in advance. One party pays fixed, the other an agreed variable rate. Maturities are generally out to two years and are priced off the underlying yield curve. The transaction is done in respect of an agreed nominal amount and only the difference between contracted and actual rates is paid. Interest Rate Guarantee: An option on a forward rate agreement (FRA), also known as a FRAtion. Purchasers have the right, but not the obligation, to purchase a FRA at a predetermined strike. Caps and Floors are strips of interest rate guarantees. Swaption: An option to enter an interest rate swap. A payer swaption gives the purchaser the right to pay fixed (receive floating), a receiver swaption gives the purchaser the right to receive fixed (pay floating).

Forex Management Similar to interest rates, the Forex rates of countries who have not pegged their currencies vary from time to time. This exposes its market participants to risk of adverse movements of exchange rates. FX Forwards and Forex Options provide a means of reducing exchange rate risks by entering into contracts at fixed rates thereby making the outcome predictable Foreign exchange is essentially about exchanging one currency for another. Forex rates between two currencies at any point of time are influenced by a variety of factors like state of the economy, interest rates & inflation rate, exchange rate systems (fixed/floating), temporary demand-supply mismatches, foreign trade position etc. Foreign exchange exposures for a financial entity arise from many different activities. A company which borrows money in a foreign currency is at risk when the local currency depreciates vis--vis the foreign currency. An exporter who sells its product in foreign currency has the risk that if the value of that foreign currency falls then the revenues in the exporter's home currency will be lower. An importer who buys goods priced in foreign currency has the risk that the foreign currency will appreciate thereby making the cost in local currency greater than expected. Generally the aim of foreign exchange risk management is to stabilize the cash flows and reduce uncertainty from financial forecasts. Since a bank is usually a counter party to the above transactions, it faces similar Forex Risk when the reverse happens.

6.4.3 BASICS OF FOREX


Currencies are quoted in one of the two ways: Direct Quotation (1 USD = INR 45.26) & Indirect Quotation (INR 100 = USD 2.21).

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Direct or Indirect are always vis--vis the US dollar perceptive. In practice, all currencies except the British Pound are quoted in the direct quotation method. Since rates for all currencies are quoted vis--vis the US dollar, cross currency rates (example: INR/Euro) would be obtained by combining the two primary currency quotes vis--vis the US dollar. Also, quotes usually have two parts: the bid rate (rate at which the bank will purchase US dollars against home currency in case of direct quotes) and the ask rate (rate at which the bank will sell US dollars against home currency in case of direct quotes). The bid rate will always be lesser than the ask rate to cover for operational charges and profit margins of the banks. Examples are: INR/USD quote: 45.26/.36 (here, 0.01 is the smallest count, referred to as one pip) EUR/USD quote: 1.2458/.2461 (here, 0.0001 is the smallest count, referred to as one pip) While the derived cross currency rate would be: INR/Euro quote: (45.26*1.2461)/ (45.36*1.2458) = 56.40/.51

Foreign currency deals in a particular currency necessary have to be settled in the home nation of the currency. Hence, banks taking part in international transactions need to maintain accounts in various countries to enable transacting in those currencies. These accounts are of multiple types: Nostro (Our/my account with you): Current account maintained by one bank with another bank abroad in the latters home currency Vostro (Their account with me/us): Current account maintained in the home currency by one bank in the name of another bank based abroad Typically, banks have vostro/nostro accounts with multiple foreign banks. SPOT AND FORWARD FOREIGN EXCHANGE CONTRACTS The most basics tools of Forex risk management are 'spot' and 'forward' contracts. These are contracts between end users and financial institutions that specify the terms of an exchange of two currencies. In any Forex contract there are a number of variables that need to be agreed upon and they are: The currencies to be bought and sold - in every contract there are two currencies the one that is bought and the one that is sold The amount of currency to be bought or sold The date at which the contract matures The rate at which the exchange of currencies will occur The exchange rates advertised either in the newspapers (and that mentioned above) or on the various information services assume a deal with a maturity of two business days ahead - a deal done on this basis is called a spot deal. In a spot transaction the currency that is bought will be

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receivable in two days whilst the currency that is sold will be payable in two days. This applies to all major currencies with the exception of the Canadian Dollar. Most market participants want to exchange the currencies at a time other than two days in advance but would like to know the rate of exchange now. This is done through a forward contract to exchange the currencies at a specified exchange rate at a specified date. In determining the rate of exchange in six months time there are two components: the current spot rate the forward rate adjustment The spot rate is simply the current market rate as determined by supply and demand. The forward rate adjustment is a slightly more complicated calculation that involves the interest rates of the currencies involved. Forward rate (Local currency/USD) = Spot rate *(1+ interest rate in US) / (1+ local interest rate), with interest rates adjusted for the period of the forward rate. The concept behind this equation is that if we defer the value date of a spot transaction each party will have the funds that they would have paid to invest. The difference between a Forex spot rate and the forward rate for a particular tenure is called the forward premium for that tenure. Currencies can have forward premiums or forward discounts vis--vis the US dollar. Forex risk can also be covered through Forex future contracts. Futures are exactly similar to forwards, except for the fact that these deals are brokered through an exchange, noncustomizable (only standard deals available) and hence, not prone to counter-party risk. BIFURCATION OF ALL MAJOR MARKETS (EQUITIES, BOND, FX, DERIVATIVES) Small and Larger Orders Equity markets are characterized by smaller orders as compared to the markets for other financial instruments because of more retail participation Liquidity Exchange traded instruments are more liquid Investor Profile Equity markets have a more retail investor profile as compared to markets for other financial instruments Routing Deals in the Equity markets are routed to multiple destinations where as deals in Forex as well as debt markets are matched internally Public v/s Private - Markets for equities are listed whereas certain Derivatives are OTC

6.4.4 TREASURY APPLICATIONS SEGMENTS & VENDORS


TREASURY MANAGEMENT SYSTEMS INTER-BANK Cross-Asset Trading and Risk Sungard / Front Arena - FRONT ARENA is the definitive integrated solution for sales, trading and risk management, operations and distribution across multiple asset classes. Its rich functionality enables traders to make critical decisions with assurance. It is flexible across a range of business areas gives which gives traders a competitive edge in trading activities.

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Summit - Summit is a core solution for treasury management for both financial and corporate institutions. Summits trading applications interact with operations and risk management platforms to provide a straight-through-processing solution. This allows front to back management of all products within four primary business areas viz Treasury, Fixed Income, Derivatives and Commercial lending Calypso - Calypso Technologies the worlds leading software provider of credit derivatives, cross asset trading, risk management, and processing. It offers a front-to-back office system that allows traders flexibility to plug in their own products. Wall Street Systems - Wall Street Systems delivers single-server, enterprise-wide solutions to the world's leading financial institutions and corporations The Wall Street System financial trading and treasury engine provides a multi-entity, multi-currency, multi-asset class environment which supports all front, middle and back office operations. TREASURY SALES BANK TO CUSTOMER Single-bank platform Cognotec Cognotec is the world's leading provider of automated trading solutions to financial enterprises across the globe. They provide Forex dealing solutions. They have partnered with world-leading technology providers, multi-bank platforms and industry organizations. Integral - Integral is at the forefront of the eFX market in developing new, highly innovative products. Integral is the provider of integrated electronic trading systems, offering intuitive and innovative products that automate and streamline the entire trading cycle. Multi-bank platform Reuters RET - Reuters Electronic Trading provides a comprehensive FX and money markets trading solution for banks.. It includes Automated Dealing, an internet based FX and money market automated dealing capability, to enable the Bank's dealing room to price, execute, confirm and manage FX and money market trading.

6.5

CASH MANAGEMENT

Cash Management Service (CMS) is a service provided by banks to its clients for a fee to reduce the float on collections and to ease the bulk payment transactions of the client. Large Corporations like GM or Ford need to manage cash well since they have: Payments to multiple parties at various locations Payments need to be made to suppliers across the country. Typically these have suppliers across the country to reduce dependence on one or a few suppliers Collections from multiple parties at various locations - How does a company collect its sale proceeds from remote upcountry regions? Multiple banking accounts at various locations o Ensure local deficits and surpluses are managed A corporate may be paying its employees salaries out of one bank account whereas it may be banking its receivables

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in another bank account another location leading to surpluses and deficits in their bank accounts Ensure net surplus is invested properly If a corporate is unable to identify surpluses, a corporate may risk keeping money idle leading to loss of interest income if it does not prudently invest its net surpluses leading to Reduce operational costs associated with payments & collections A CMS would help optimize wasted operational cost on payments and collections

Cash Management solutions help corporations: o Devise an effective account & investment strategy to manage surpluses and deficits Pooling, Netting, Zero-balance structures o Automate collections and payments process flows o Outsource collections and payments administration & reconciliation Example Consider a consumer goods company in Mid-west US, with dealerships spread through 12 states. The company has a manufacturing facility in Michigan and 4 depots, one each in Ohio, Michigan, Illinois and Texas. The company transports goods to the 4 depots which serves the respective local dealers and in some cases dealers in neighboring states. All the depots are treated as independent cost centers, with sales from respective regions and salaries and general expenses for these regions marked to the depot concerned. Collections from dealers in various locations are managed by local sales teams, one team for each state. The company wants to: Ensure daily monitoring of collections from various states Sweep all local collections daily to a central bank account at Michigan Ensure that local accounts do not remain in debit when the central account is in credit. Provide facility for temporary intra-day overdraft for the local accounts Ensure that surplus money in the central account is invested in an optimal fashion while allowing sufficient liquidity All payments from local accounts above $10,000 require an approval from the CFO sitting in Michigan This is a typical case where the company needs the services of a bank to manage its cash collections and payments. The company needs both cash management facilities and MIS of collections and payments that can allow it to track revenue and expenses in the manner required. Companies rarely fail because they are insolvent. They do fail because they are illiquid. Companies must focus on precise working capital management as a critical component of treasury strategy. Companies require: rich information, to parallel the companys cash flow cycle global cash concentration, through pooling mechanisms automated internal funding mechanisms for deficit positions

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Investment options to match individual profiles for liquidity, risk and return.

6.5.1 OFFERINGS IN CASH MANAGEMENT SERVICES


PAYMENT / DISBURSEMENT OFFERINGS Payment service for corporations/retail customers o Banks process payments on behalf of corporations CMS provides its customers the payment processing services which help corporations to reduce administrative hassles and costs in doing so. o Instruments - Checks/demand drafts/ Electronic Fund Transfer (EFT) help in processing payments Payment Initiation o Manual instruction Banks can act on manual instructions given by the corporations to their bankers for processing payments. They typically take the form of checks or drafts o Floppy/Electronic media instructions A list of beneficiaries and the corresponding amounts are given in either a floppy or another electronic media to their banks in the required formats which are used by the banks for processing payments o Electronic banking applications Electronic applications like ECS / EFT or individual bank specific software packages can be made use of by corporations to effect transfers Bulk payments CMS is very beneficial for processing repetitive / bulk payments in the nature listed below. Economies of scale and reduction of administrative and related costs can be gained by corporations o o Payroll processing Dividend warrants o Redemptions

COLLECTIONS SERVICES Collect funds around the globe CMS provides accurate and timely collection of receivables worldwide Funds are credited to the cash management account o Local collections Refer to collections from suppliers / debtors who issue local checks o Outstation collections - Refer to collections from customers not in the base location of the corporation

Banks have responded to the call for evolved cash management concepts. Accelerating accounts receivable and streamlining accounts payable via a single banking system interface provide the stepping stone to achieve optimal cash flow management. Some banks also provide aligned cash management with liquidity and investment offerings. They do so by:

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developing optimal account structures applying cash concentration techniques like pooling and sweeping providing investment vehicles to maximize cash flows implementing foreign exchange and interest rate exposure netting systems Establishing regional treasury and shared service centers. The final objective of most of these cash management solutions is to effectively outsource the corporates receivables and payables process and ensure the best possible liquidity and short term investment management strategy. Moreover, increasingly, cash management (both payments and collections) are moving over to a web-based environment where the corporate can manage his receivables, payables and liquidity position online. In many cases, there is almost-complete integration between the bank and the companys supply chain/ERP system which manages collection and payments data internally. Some of the common methods used for cash management are described below. CHECK COLLECTIONS LOCK BOX SERVICE There are possibilities for optimizing and streamlining a companys incoming payment flows. The most common collection mechanism is a checks lock box service a collecting service which enables companies to collect and settle checks locally (In a typical case, each of the corporates debtors would send checks along with accepted invoices to a designated post box, hence the lock box name). Banks undertake to collect checks at various pre-defined locations on behalf of the customer, send them for clearing and credit the amount s to a specified customer account. Once the checks are collected by the bank through person, courier or delivered by the company representative: the checks are sorted and batched post dated checks are kept for processing on the value date the image of the checks and the remittance advices are captured and sent to the corporate checks are sent for clearing, if required realized checks are tallied and amounts credited to the corporates bank account the information on checks collected is transmitted to the corporate for electronic reconciliation In enhanced versions of this facility, the bank manage the receivable books of the corporate managing collections, monitoring receivables ageing and providing reconciled collection reports which can be directly uploaded to corporate information/supply chain systems. ZERO BALANCE STRUCTURE - POOLING Pooling allows a company or several companies belonging to the same group profit from efficient liquidity management, centralized treasury and credit-line management and optimization of interest results. Banks offer both domestic and cross border zero balancing whereby all value balances of a set of 'participating' accounts are centralized at the end of each day in one central account. Thus the participating accounts will not bear any credit or debit

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interest, and all balances are concentrated in the central account enabling optimal management of our cash position. NETTING Netting is the fundamental method for centralizing and offsetting intra company and third party payments. Netting not only significantly reduces payment flows and costs, but also provides invaluable management information. Banks offer both domestic and cross-border netting solutions. CLEARING SERVICES Banks offer clearing services to other banks. In such cases, a bank with strong local branch coverage offers to participate in clearing arrangements on behalf of other banks with no physical presence at these locations. Also clubbed under correspondent banking services, this facility primarily helps use the branch networks of various banks on a complimentary basis. NEW ACT - CHECK 21 The Check Clearing for the 21st Century Act (Check 21) was signed into law on October 28, 2003, and became effective on October 28, 2004. The law facilitates check truncation by creating a new negotiable instrument called a substitute check, which permits banks to truncate original checks, to process check information electronically, and to deliver substitute checks to banks that want to continue receiving paper checks. A substitute check is the legal equivalent of the original check and includes all the information contained on the original check. The law does not require banks to accept checks in electronic form nor does it require banks to use the new authority granted by the Act to create substitute checks. o Electronic transmission of checks by Check imaging - Banks find that exchanging electronic images of checks with other banks is faster and more efficient than physically transporting paper checks. To address this need, Check 21 allows a bank to create and send a substitute check that is made from an electronic image of the original check. Faster / efficient check realization Since the electronic image of the check can be quickly transmitted electronically, time required for transporting the physical paper checks is greatly reduced thereby effecting faster check realizations

6.5.2 DEVELOPMENTS IN TREASURY & CASH MANAGEMENT


ASSET SECURITIZATION Financial institutions and banks need to raise fresh capital to fund continuous asset growth and portfolio management. This has become a major challenge for many financial institutions and banks due to tough capital market conditions and other market related factors. Asset securitization can offer an alternative cost efficient financing tool, enabling them to better manage liquidity and funding requirements.

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Asset securitization transactions have one basic concept: the identification and isolation of a separable pool of assets that generate revenue streams independently from the originating entity. The securities issued on these assets are then sold to investors who base their returns exclusively on the underlying assets performance. The structure is illustrated below:

All these entities need not be present in every transaction. The number of entities depends on the complexity of the transaction. An example would help understand the concept better. Example Bank of America (Originator) has 5000 home loans totaling more than $600 million. The individual loans are of various credit profiles and various repayment periods. Bank of America is constrained by lack of funds and wishes to sell off its loans to raise money. Thus, it decides to sell about 2000 home loans totaling $200 million. The steps followed are shown below: Bank of America conducts an internal study of the portfolio and ascertains that the average maturity of the pool of loans is about 12 years and the average credit rating would be AA-. It realizes that historically 10% of the total home loan owners default. So it would only realize $180 million instead of $200 million. Bank of America wants to enhance the rating so that it can sell the loans at a better price. It decides to provide cash security of $10 million (Credit enhancement) in the scenario of any repayment default by home loan borrowers. Bank of America appoints Credit rating agency X which analyses the pool of loans, and taking into account the cash security provided rates it AA+. Bank of America sells the pool of housing loans amounting to $200 million to an independent firm, Plexus SPV Ltd. Backed by these home loans future cash flows, Plexus SPV Ltd. issues debt certificates for

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$200 million to investors. Plexus pays back the investors the money from the repayments done by the home loan borrowers. Plexus SPV Ltd. pays $198 million to Bank of America after deducting service charges to cover operational costs. From now on, all EMI repayments on these home loans made by retail investors would flow through Plexus SPV Ltd and then reaches the investors.

The above example captures the gist of any securitization transaction, but there are a lot of structuring issues and legal and regulatory challenges involved in any such transaction. Fannie Mae and Ginnie Mae are examples of institutions specializing in securitization transactions of mortgage loans for US banks. They help US banks in having enough fresh funds for home loan disbursements. REAL TIME GROSS SETTLEMENT (RTGS) The current payment system involves settlement of payments on a settlement day and interest is invariably computed to accrue on a daily basis. Even in the wholesale markets for foreign exchange and money markets contracts, spot transactions mean two-business days. Settlement for clearing checks presented to the clearing houses takes place on a netting basis at a particular time either same day or on the next day. This system gives rise to risks such as credit risk, liquidity risk, legal risk, operational risk and systemic risk. RTGS is a system provides online settlement of payments between financial institutions. In this system payment instructions between banks are processed and settled individually and continuously throughout the day. This is in contrast to net settlements where payment instructions are processed throughout the day but inter-bank settlement takes place only afterwards typically at the end of the day. Participant banks will have to maintain a dedicated RTGS settlement account with the central bank for outward and inward RTGS payments. RTGS systems do not create credit risk for the receiving participant because they settle each payment individually, as soon as it is accepted by the system for settlement. RTGS system can require relatively large amounts of intraday liquidity because participants need sufficient liquidity to cover their outgoing payments. CONTINUOUS LINKED SETTLEMENT (CLS) The average daily turnover in global Forex transactions stand at almost USD 2 trillion, with participants in the market spread across various geographies and time zones. However, the difference in time zones and hence lack of synchronization of transactions has resulted in considerable amount of systematic risk. Typically, one leg of a Forex trade is affected at one point of time and there would be a delay before the other leg is executed because of time-zone differences. In such a situation, there is a heightened risk of one party defaulting.

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CLS eliminates this temporal settlement risk, making same-day settlement both possible and final. This is made possible by leveraging on the fact that there are significant overlaps between the main time zones. CLS provides a specific time window in which various settlement time zones can interact and pass settlement messages. The CLS system consists of the following entities: CLS Bank: The CLS bank is the central node for the CLS system. CLS Bank is owned by nearly 70 of the worlds largest financial groups throughout the US, Europe and Asia Pacific, who are responsible for more than half the value transferred in the world's FX market. Settlement Members: They are shareholders of the CLS bank, who can each submit settlement instructions directly to CLS Bank and receive information on the status of their instructions. Each Settlement Member has a multi-currency account with CLS Bank, with the ability to move funds. Settlement Members have direct access and input deals on their own behalf and on behalf of their customers. They can provide a branded CLS service to their third-party customers as part of their agreement with CLS Bank. User Members: User Members can submit settlement instructions for themselves and their customers. However, User Members do not have an account with CLS Bank. Instead they are sponsored by a Settlement Member who acts on their behalf. Each instruction submitted by a user member must be authorized by a designated Settlement Member. The instruction is then eligible for settlement through the Settlement Member's account. Third parties: Third parties are customers of settlement and user members and have no direct access to CLS. Settlement or user members must handle all instructions and financial flows, which are consolidated in CLS. Nostro agents: These agents receive payment instructions from Settlement Members and provide time-sensitive fund transfers to Settlement Members' accounts at CLS Bank. They receive funds from CLS Bank, User Members, third parties and others for credit to the Settlement Member account. The benefits of the CLS system are many: Traders can expand their FX business with counterparty banks without increasing limits. Treasury managers have more certainty about intraday and end-of-day cash positions. Global settlement can rationalize nostro accounts and leverage multi-currency accounts. The volume and overall value of payments is reduced, as are cash-clearing costs. Costly errors are minimized and any problems can be resolved fast. AUTOMATED CLEARING HOUSE FACILITIES (ACH) ACH transactions are electronic clearing transactions in which information about debits and credits are passed across the clearing system through electronic data files rather than physical

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instruments like checks, drafts etc. ACH electronic transactions are distinguished from wire transfers in that they are high volume, regularly scheduled, usually between the same parties, and are initiated via specifically formatted electronic files. Such transactions must usually be initiated one to two days prior to the settlement date, since they are batch processed and not for immediate payment. The most common ACH payment applications are: Direct deposit of payroll, where the bank debits the corporate account and credits employee accounts on the basis of a electronic file transmitted/provided by the corporate Corporate Disbursement Service, where the bank debits a client's account to initiate payments to vendors on their behalf Corporate Collection Service, where the bank enables its clients to collect payments and remittance data from vendors or trading partners. Collection of consumer payments over the telephone, through the Internet or via check-toACH conversion. ACH Accounts Receivable Check Conversion enables converting checks collected at a lockbox or remittance-processing center to ACH electronic debits, speeding payment collections and improving funds availability. These services allow the customer to increase transaction speed and improve accuracy and ease of reconciliation by electronic means and avoidance of physical instruments and clearing delays. ACH has been an area of very strong growth, with over 8.5 billion transactions being effected through this route in 2002. However, several security issues remain to be resolved in this area.

6.6

TRADE FINANCE

The main objective of trade finance is to facilitate transactions. There are many financing options available to facilitate international trade such as pre-shipment finance to produce or purchase a product, and post-shipment finance of the receivables.

PRE SHIPMENT LOANS


Banks provide Pre-shipment finance - working capital for purchase of raw materials, processing and packaging of the export commodities.

POST SHIPMENT LOANS


Post-shipment financing assists exporters to bridge their liquidity needs where exports are made under deferred payment basis. A typical example of post-shipment financing is bills discounting. Bills discounting facility serves to provide liquidity to an exporter by advancing him/her a portion of the face value of a trade bill drawn by the exporter, accepted by the buyer and endorsed to the Bank. In competitive supply situations, favorable terms of payment often ensure that the order is won. An exporter usually wants to get paid as quickly as possible and an importer will want to

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pay as late as possible preferably after they have sold the goods. Trade finance is often required to bridge these two disparate objectives.
Question Pre-shipment finance is liquidated only through realizations of export bills or amounts received through export incentives. Pre shipment finance should not normally remain outstanding beyond the original stipulated shipment date. In case it remains outstanding, can the non-adjusted amount be then transferred as post shipment finance?

FACTORS IN CHOOSING THE MODE OF FINANCING


Costs: The cost of different financing methods can vary, both in terms of interest rates and fees. These costs will impact the viability of a transaction Time Frame: Depending on the need, short, medium and long-term finance facilities may be available. The different possibilities should be explored with the finance provider prior to concluding a transaction. Long-term requirements should also be considered to ensure fees are not being paid out on a revolving facility that could be saved by using a different financing structure Risk Factors: The nature of the product or service, the buyers credit rating and country/political risks can all affect the security of a trading transaction. In some cases it will be necessary to obtain export insurance or a confirmed letter of credit. Increased risks will normally correspond to increased cost in a transaction and will normally make the funding of a particular transaction, harder to obtain Government Guarantee Programs: These can sometimes be obtained where there is some question over the exporters ability to perform or where increased credit is needed. If obtained, these may enable a lender to provide more finance than their usual underwriting limits would permit. Exporters Funds: If the exporter has sufficient resources, he/she may be able to extend credit without the need for third party financing. However, an established trade finance provider, offers other benefits like expert credit verification and risk assessment as well as an international network of offices and staff to ensure that the transaction is completed safely and satisfactorily

BILL OF LADING
A bill of lading or BOL is: A contract between a carrier and a shipper for the transportation of goods. A receipt issued by a carrier to a shipper for goods received for transportation. Evidence of title to the goods in case of a dispute.

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The BOL grants the carrier the right to sub-contract its obligations on any terms and would bind a shipper even if it meant that the shipper's goods could be detained and sold by the subcontractor.

CREDIT CHECK
Insuring payment starts long before a contract is signed. The seller, or his representative, performs due diligence or a reasonable assessment of the risks posed by the potential buyer. The sources of information include: Chambers of commerce, Business Bureaus or their equivalents Credit rating services such as TRW and Dun & Bradstreet which have international affiliates Trade associations and trade promotion organizations Freight forwarders, brokers, and banks Direct references from the buyer

PAYMENT METHODS
Once acceptable risks have been determined then the most appropriate payment method can be selected. The most common payment methods are described below: Cash in advance Letter of credit Documentary collection Open account or credit Counter-trade or Barter CASH IN ADVANCE Cash in advance is risk-free except for potential non-delivery of the goods by the seller. It is usually a wire transfer or a check. Although an international wire transfer is more expensive, it is often preferred because it is speedy and does not bear the danger of the check not being honored. The check can be at a disadvantage if the exchange rate has changed significantly by the time it arrives, clears and is credited. On the other hand, the check can make it easier to shop for a better exchange rate between different financial institutions. For wire transfers the seller must provide clear routing instructions in writing to the buyer or the buyers agent. These include: Full name, address, telephone, and telex of the sellers bank Banks SWIFT and/or ABA numbers Sellers full name, address, telephone, type of bank account, and account number.

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COMMERCIAL LETTER OF CREDIT The letter of credit (LC) allows the buyer and Seller to contract a trusted intermediary (a bank) that will guarantee full payment to the seller provided that he has shipped the goods and complied with the terms of the agreement. Features The LC serves to evenly distribute risk between buyer and seller. The seller is assured of payment when the conditions of the LC are met and the buyer is reasonably assured of receiving the goods ordered. This is a common form of payment, especially when the contracting parties are unfamiliar with each other. Since banks deal with documents and not with products, they must pay an LC if the documents are presented by the seller in full compliance with the terms, even if the buyer never receives the goods. Goods lost during shipment or embargoed are some examples. Iraq for example, never received goods that were shipped before its embargo but the LCs had to be paid anyway. LCs are typically irrevocable, which means that once the LC is established it cannot be changed without the consent of both parties. Therefore the seller, especially when inexperienced, ought to present the agreement for an LC to an experienced bank or freight forwarder so that they can verify if the LC is legitimate and if all the terms can be reasonably met. A trusted bank, other than the issuing or buyers bank can guarantee the authenticity of the document for a fee. Disadvantages If there are discrepancies in the timing, documents or other requirements of the LC the buyer can reject the shipment. A rejected shipment means that the seller must quickly find a new buyer, usually at a lower price, or pay for the shipment to be returned or disposed. One of the most costly forms of payment guarantee Usual cost is 0.5% to 1%. Sometimes, the costs can go up to 5 percent of the total value. LCs take time to draw up and usually tie up the buyers working capital or credit line from the date it is accepted until final payment, rejection for noncompliance, expiration or cancellation (requiring the approval of both parties) The terms of an LC are very specific and binding. Statistics show that approximately 50% of submissions for LC payment are rejected for failure to comply with terms. For example, if one of the required documents is incomplete or delivered late, then payment will be withheld even if all other conditions are fulfilled and the shipment received in perfect order. The buyer can sometimes approve the release of payment if a condition is not fulfilled; but changing terms after the fact is costly, time consuming and sometimes impossible. The mechanism Usually, four parties are involved in any transaction using an LC: 1. Buyer or Applicant

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2.

The buyer applies to his bank for the issuance of an LC. If the buyer does not have a credit arrangement with this issuing bank then he must pay in cash or other negotiable securities. Issuing bank The issuing or applicants bank issues the LC in favor of the beneficiary (Seller) and routes the document to the beneficiarys bank. The applicants bank later verifies that all the terms, conditions, and documents comply with the LC, and pays the seller through his bank.

3.

Beneficiarys bank The sellers or beneficiarys bank verifies that the LC is authentic and notifies the beneficiary. It, or another trusted bank, can act as an advising bank. The advising bank is used as a trusted bridge between the applicants bank and the beneficiarys bank when they do not have an active relationship. It also forwards the beneficiarys proof of performance and documentation back to the issuing bank. However, the advising bank has no liability for payment of the LC. The beneficiary, or his bank, can ask an advising bank to confirm the LC. The confirming bank charges a fee to ensure that the beneficiary is paid when he is in compliance with the terms and conditions of the LC.

4.

Beneficiary or Seller The beneficiary must ensure that the order is prepared according to specifications and shipped on time. He must also gather and present the full set of accurate documents, as required by the LC, to the bank.

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Letter Of Credit Diagram

1. Buyer and seller agree on a commercial transaction. 2. Buyer applies for a letter of credit. 3. Issuing bank issues the letter of credit (LC) 4. Advising bank advises seller than an LC has been opened in his or her favor. Seller sends merchandise and documents to the freight forwarder. 5. Seller sends copies of documents to the buyer. 6. Freight forwarder sends merchandise to the buyers agent (customs broker). 7. Freight forwarder sends documents to the advising bank. 8. Issuing bank arranges for advising bank to make payment. 9. Advising bank makes payment available to the seller. 10. Advising bank sends documents to the issuing bank.

Letter of Credit Diagram and the 14 steps have been reproduced from www.web.worldbank.org

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11. Buyer pays or takes loan from the issuing bank. 12. Issuing bank sends bill of lading and other documents to the customs broker. 13. Customs broker forwards merchandise to the buyer. Letters of credit can be flexible. Some LC variations include: Revolving, Negotiable, Straight, Red Clause, Transferable, and Restricted. But perhaps the safest type of letter of credit from the sellers point of view is the Standby letter of credit. Example An Asian Buyer from a Swedish Exporting company stated when he convinced the Exporter to sell to them on open account terms. The Asian Buyer obtained 60 days credit, which was to be calculated from the date of the invoice. The value of the order was USD 100, 000 and the goods were dispatched and invoiced by the Swedish Exporter on the 15th July 2003. The payment from Asia was due on the 14th Sept 2003. The payment eventually arrived on the 21st Nov 2003, over two months late. The delay in payment cost the Exporter USD 1700 as it resulted in his account being overdrawn by this amount for 68 days at 9% per annum. What if confirmed Letter of Credit had been required? If Swedish exporter had insisted on receiving a confirmed Letter of Credit through Allied Swedish Banks plc., the following costs (approximations) would have applied:

Confirmation Fee Acceptance Commission (@ 1.5% pa for 60 days) Negotiation / Payment Fee Out of Pocket Expenses (estimate) Total Letter of Credit Cost Interest Cost as a result of late payment Benefit of using Letter of Credit Advantages of Letter of Credit

USD USD USD USD USD USD USD

$250 $250 $150 $60 $710 ($1,700) $990

A Guarantee of payment on the due date from Allied Swedish Banks. (Provided the terms and conditions of the Letter of Credit were complied with). A definitive date for the receipt of funds, particularly important for devising proper currency hedging strategies. The opportunity to receive the payment in advance of the due date through non-recourse discounting of the receivable. Also note that the costs incurred in chasing the debt from the Asian buyer has not been accounted for the Irish Exporter. In addition if the Exporter had sold his foreign currency receivable on a forward basis to his bank for the original due date, they may have incurred a further cost in canceling or rearranging the forward contract. Letters of Credit provide real and

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tangible benefits to companies. In this case the Swedish exporter only lost US$ 1700. Of course if the Asian buyer had not paid at all they would have lost the whole USD 100,000 The standby LC is like a bank guarantee. It is not used as the primary payment method but as a failsafe method or guarantee for long-term projects. This LC promises payment only if the buyer fails to make an arranged payment or fail to meet pre-determined terms and conditions. Should the buyer default, the seller must then apply to the bank for payment - a relatively simple process without complicated documentation. Since the standby LC can remain valid for years (Evergreen Clause) it eliminates the cost of separate LCs for each transaction with a regular client. Back to Back LC allows a seller to use the LC received from his buyer as collateral with the bank to open his own LC to buy inputs necessary to fill his buyers order. DOCUMENTARY COLLECTION The seller sends a draft for payment with the related shipping documents through bank channels to the buyers bank. The bank releases the documents to the buyer upon receipt of payment or promise of payment. The banks involved in facilitating this collection process have no responsibility to pay the seller should the buyer default unless the draft bears the aval (ad valutem) of the buyers bank. It is generally safer for exporters to require that bills of lading be made out to shippers order and endorsed in blank to allow them and the banks more flexible control of the merchandise. Documentary collection carries the risk that the buyer will not or cannot pay for the goods upon receipt of the draft and documents. If this occurs it is the burden of the seller to locate a new buyer or pay for return shipment. Documentary collections are viable only for ocean shipments, as the bill of lading for ocean freight is a valid title to the goods and is a negotiable document whereas the comparable airway bill is not negotiable as an ownership title.

DRAFTS
A draft (sometimes called a bill of exchange) is a written order by one party directing a second party to pay a third party. Drafts are negotiable instruments that facilitate international payments through respected intermediaries such as banks but do not involve the intermediaries in guaranteeing performance. Such drafts offer more flexibility than LCs and are transferable from one party to another. There are two basic types of drafts: sight drafts and time drafts. SIGHT DRAFT After making the shipment the seller sends a sight draft, through his bank to the buyers bank, accompanied by agreed documentation such as the original bill of lading, invoice, certificate of origin, phyto-sanitary certificate, etc. The buyer is then expected to pay the draft when he sees it and thereby receive the documentation that gives him ownership title to the goods that were shipped. There are no guarantees made about the goods other than the information about quantities, date of shipment, etc. which appears in the documentation. The buyer can refuse to accept the draft thereby leaving the seller in the unpleasant position of having shipped goods to

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a destination without a buyer. There is no recourse with the banks since their responsibility ends with the exchange of money for documents. TIME DRAFTS/BANKERS' ACCEPTANCES Bankers' acceptances are negotiable instruments (time drafts) drawn to finance the export, import, domestic shipment or storage of goods. It demands payment after a specified time or on a certain date after the buyer accepts the draft and receives the goods. A bankers' acceptance is "accepted" when a bank writes on the draft its agreement to pay it at maturity. A bank may accept the draft for either the drawer or the holder. An ordinary acceptance is a draft or bill of exchange order to pay a specified amount of money at a specified time. A draft may be drawn on individuals, businesses or financial institutions. An acceptance doesn't reduce a bank's lending capacity. The bank can raise funds by selling the acceptance. Nevertheless, the acceptance is an outstanding liability of the bank and is subject to the reserve requirement unless it is of a type eligible for discount by the Federal Reserve Bank. Example Bankers Acceptances sell at a discount from the face value: Face value of Bankers Acceptance Minus 2% per annum commission for one year Amount received by exporter in one year $1,000,000 -$20,000 $980,000

HYBRID METHODS
In practice, international payment methods tend to be quite flexible and varied. Frequently, trading partners will use a combination of payment methods. For example: the seller may require that 50% payment be made in advance using a wire transfer and that the remaining 50% be made by documentary collection and a sight draft.

OPEN ACCOUNT
Open account means that payment is left open to an agreed-upon future date. It is one of the most common methods of payment in international trade and many large companies will only buy on open account. Payment is usually made by wire transfer or check. This can be a very risky method for the seller, unless he has a long and favorable relationship with the buyer or the buyer has an excellent credit rating. Still, there are no guarantees and collecting delinquent payments is difficult and costly in foreign countries especially considering that this method utilizes few legally binding documents. Contracts, invoices, and shipping documents will only be

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useful in securing payment from a recalcitrant buyer when his countrys legal system recognizes them and allows for reasonable settlement of such disputes.

OTHER PAYMENT METHODS


CONSIGNMENT The consignment method requires that the seller ship the goods to the buyer, broker or distributor but not receive payment until the goods are sold or transferred to another buyer. Sometimes even the price is not pre-fixed and while the seller can verify market prices for the sale date or hire an inspector to verify the standard and condition of the product, he ultimately has very little recourse. CREDIT CARD Some banks offer buyers special lines of credit that are accessible via credit card to facilitate even substantial purchases. It is convenient for both parties - but the seller should confirm the bank charges and also bear in mind that the laws that govern domestic credit card transactions differ from those govern international use. COUNTER-TRADE AND BARTER Counter-trade or barter is most often used when the buyer lacks access to convertible currency or finds that rates are unfavorable or can exchange for products or services desirable to the seller. Counter-trade indicates that the buyer will compensate the seller in a manner other than transfer or money or products. FACTORING Factoring is a discounting method without recourse. It is an outright sale of export accounts receivable to a third party, (the factor) who assumes the credit risk. The factor may be a factoring house or a department of a bank. The advantage to the exporter is the removal of contingent liabilities from its balance sheet, improved cash flow and elimination of bad debt risk. Factoring is for short-term receivables (under 90 days) and is more related to receivables against commodity sales. FORFAITING The exporter sells accounts receivables to a forfaiter on a non-recourse discount basis, and the exporter effectively passes all risks associated with the foreign debt to the forfaiter. The forfaiter may be a forfaiting house or a department of a bank. The benefits are same as factoring - maximize cash flow and eliminate the payment risk. It is a flexible finance tool that can be used in short, medium and long-term contracts. Forfaiting can be for receivables against which payments are due over a longer term, over 90 days and even up to 5 years.

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Example An Asian Importer wants to purchase machinery that he is unwilling or unable to pay for in cash until that machinery begins to generate income. At the same time, the exporter wants immediate payment in full in order to meet his ongoing business commitments Forfaiting solution works as follows 1. Commercial contracts are negotiated subject to finance; 2. The importer arranges for an Irrevocable Letter of Credit to be issued or for a series of Promissory Notes or Bills of Exchange to be drawn in favor of the exporter which the importer arranges to have guaranteed by his local bank; 3. The exporter contacts the discounting bank (the forfaiter) for a rate of discount which is then agreed; 4. The goods are shipped; 5. The notes or bills are sent with shipping documentation and invoices to the discounting bank via the exporter (who endorses the notes or bills "without recourse" to the order of the discounting bank);
6.

The discounting bank purchases the guaranteed notes or bills from the exporter at the agreed rate.

Result: the exporter receives payment in full immediately after shipping (against presentation of satisfactory documentation to the forfaiter); the importer gets his goods and can pay for them in installments over time; and the forfaiter has title to an asset which he may retain as an investment.

FOREIGN CREDIT INSURANCE UNDERWRITERS AND BROKERS The purpose of foreign credit insurance is to insure repayment of export credit against nonpayment due to political and/or commercial causes. It insures commercial risks of nonpayment by importers because of insolvency or other business factors and political risks of war, expropriation, confiscation, currency inconvertibility, civil commotion, or cancellation of import permits. THE BANKERS ASSOCIATION FOR FOREIGN TRADE (BAFT)

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The Bankers Association for Foreign Trade (BAFT) is a collection of banking institutions, dedicated to promoting American exports, international trade, and finance and investment between U.S. firms and their trading partners. BAFT has set up a trade finance database with a grant from the U.S. Department of Commerce. The database serves as an essential resource for assisting exporters seeking trade finance and banks that provide financial services.

6.6

PAYMENTS NETWORK

6.6.1 FEDWIRE
Fedwire is an electronic transfer system developed and maintained by the Federal Reserve System. The system connects Federal Reserve Banks and Branches, the Treasury and other government agencies, and more than 9,000 on-line and off-line depository institutions and thus plays a key role in US payments mechanism. The system is available on-line depository institutions with computers or terminals that communicate directly with the Fedwire network. These users originate over 99 percent of total funds transfers. The remaining customers have off-line access to Fedwire for a limited number of transactions. Fedwire transfers U.S. government and agency securities in book-entry form. It plays a significant role in the conduct of monetary policy and the government securities market by increasing the efficiency of Federal Reserve open market operations and helping to keep the market for government securities liquid. Depository institutions use Fedwire mainly to move balances to correspondent banks and to send funds to other institutions on behalf of customers. Transfers on behalf of bank customers include funds used in the purchase or sale of government securities, deposits, and other large, time-sensitive payments. Fedwire and CHIPS, a private-sector funds transfer network specializing in international transactions, handle most large-dollar transfers. In 2000, some 108 million funds transfers with a total value of $380 trillion were made over Fedwire -- an average of $3.5 million per transaction. All Fedwire transfers are completed on the day they are initiated, generally in a matter of minutes. They are guaranteed to be final by the Fed as soon as the receiving institution is notified of the credit to its account. Until 1980, Fedwire services were offered free to Federal Reserve member commercial banks. However, the Depository Institutions Deregulation and Monetary Control Act of 1980 required the pricing of Fed services, including funds and securities transfers, and gave nonmember depository institutions direct access to the transfer system. To encourage private-sector competition, the law requires the Fed's fees to reflect the full cost of providing the services, including an implicit cost for capital and profitability. How Fedwire Works

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Transfers over Fedwire require relatively few bookkeeping entries. Suppose an individual or a private or government organization asks a bank to transfer funds. If the banks of the sender and receiver are in different Federal Reserve districts, the sending bank debits the sender's account and asks its local Reserve Bank to send a transfer order to the Reserve Bank serving the receiver's bank. The two Reserve Banks settle with each other through the Inter-district Settlement Fund, a bookkeeping system that records Federal Reserve inter-district transactions. Finally, the receiving bank notifies the recipient of the transfer and credits its account. Once the transfer is received, it is final and the receiver may use the funds immediately. If the sending and receiving banks are in the same Federal Reserve district, the transaction is similar, but all of the processing and accounting are done by one Reserve Bank.

6.6.2. CHIPS
CHIPS, Clearing House Interbank Payments System, are the premier bank-owned payments system for clearing and settling large value payments. CHIPS is a real-time, final payments system for U.S. dollars that use bi-lateral and multi-lateral netting for maximum liquidity efficiency. CHIPS is the only large value system in the world that has the capability of carrying extensive remittance information for commercial payments. CHIPS processes over 267,000 payments a day with a gross value of over $1.37 trillion. It is a premier payments platform serving the largest banks from around the world, representing 22 countries worldwide.

6.6.3

SWIFT

The Society for Worldwide Interbank Financial Telecommunication (SWIFT) runs a worldwide network by which messages concerning financial transactions are exchanged among banks and other financial institutions. As of December 2001, it linked over 7000 financial institutions in 194 countries and estimates that it carried payments messages averaging more than six trillion US dollars per day. SWIFT network is used for transfers across different countries and in all currencies. SWIFT is a co-operative society under Belgian law, owned by its member financial institutions with offices around the world. SWIFTs headquarters are located in La Hulpe near Brussels. It was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to establish a common language for financial for financial transactions and a shared data processing system and worldwide communications network. Fundamental operating procedures, rules for liability, etc. were established in 1975 and the first message was sent in 1977.

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INTERNATIONAL PAYMENT INSTRUMENTS COMPARISON CHART

The above International Payments Comparison Chart is reproduced from US Department of Agriculture website - www.ams.usda.gov/ Pub.

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SUMMARY
FedWire is an electronic transfer system developed and maintained by the Federal Reserve System. The system connects Federal Reserve Banks and Branches, the Treasury and other government agencies, and depository institutions and thus plays a key role in US payments mechanism Clearing House Interbank Payment System (CHIPS) is a private sector funds transfer network mainly for international transactions. CHIPS transfers are settled on a net basis at the end of the day, using Fedwire funds transfers to and from a special settlement account on the books of the New York Fed.

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7.0
7.1

INVESTMENT MANAGEMENT
INTRODUCTION

Investment Management refers to the managing and investment of funds by financial institutions, on behalf of their customers. The investment is done in securities like stocks, bonds and derivatives, as well as other investment avenues like precious metals, real estate, commodities, etc. The role of the investment manager is to obtain for their customers a superior return on their capital. Superior return means adding value in the following ways: Making better decisions than their clients could, due to their research capacity and investment skills. Providing a level of investment diversification through the pooling of funds that their clients could not achieve. Using their breadth of knowledge to fulfill the investment objectives of the portfolio, e.g., providing an acceptable pension for their client. The return on investment is compared to a benchmark, often constructed from the returns obtained by rival asset managers, this comparison being used by investors to assess the asset managers performance. The investment manager is also responsible for ensuring that the clients individual preferences and needs are observed, e.g., level of risk-appetite, liquidity needs, tax implications, etc. Investment Managers usually look after more than one client, each clients capital being segregated into a fund or portfolio. Investment Management is also referred to variously as Asset Management, Fund management and Portfolio management; while managing of investment for high-net-worth individuals (HNI) is called Wealth management or Private Banking. INVESTMENT MANAGEMENT GOALS Investment Management aims at the following goals: Manage investors money efficiently and cost effectively Generate superior investment returns Ultimate objective is to deliver equity type returns with lesser volatility risk and achieve capital preservation In achieving the above goals, an Investment Manager uses the following approaches/principles: Asset Mix is the primary determinant of portfolio return, optimum portfolios are designed using asset allocation tools International Diversification - Investment in worldwide stocks reduces risk and improves returns

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Screens/Filters - Variety of quantitative and qualitative screens to identify candidate investments, interviews with fund managers prior to investing and continuous due diligence. Capital preservation - Preserve the wealth of investors and ensure erosion free investment Alternative Investments - Investing in hedge fund and futures to have strong returns. These assets generally earn returns consistent with those of equities. By combining alternative investments with equities, the asset manager can generate superior returns while reducing the ups and downs of the portfolio. Investment management services are usually offered by firms that specialize in managing an investors money. These firms employ individuals known as portfolio managers who are responsible for taking the decision on which type of assets to invest it to best suit the investors needs.

7.2

INVESTMENT MANAGEMENT PROCESSES

The end-to-end Investment Management process starts from acquisition of a client and opening a customer account, and ends with portfolio accounting, updating of shareholder account balances, and performance reporting. Following is a high-level chart showing the typical Investment Management processes:

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7.2.1 INVESTMENT MANAGEMENT FRONT OFFICE


SALES, MARKETING & ADVISORY The basic activity in any asset management process is to be able to get more and more people to subscribe to his activities in order to enlarge the scope of his activities and earn a higher fee. The Sales and marketing team of any Wealth Management company interfaces with the clients and ensures widening to new relationships and deepening of the existing ones. This division in turn draws heavily on the other functions of research, portfolio management and other areas in order to sell the Investment management companys services to the clients.

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Another related area for the Sales and Marketing team is often to be in touch with the issuers in order to get into lucrative deals that enable the company to generate better returns for its clients portfolio. Wealth Management service providers usually have sales and marketing offices in all big financial centers across the globe. The sales personnel keep in personal touch with prospects and usually communicate via phone or personal meetings. This is important as the clients usually are very rich and want to maintain secrecy about their financial matters. NEEDS ANALYSIS & INVESTOR PROFILING Needs Analysis process focuses on definition of what shareholder wants to achieve in a defined time frame. The Portfolio Manager would understand what needs the shareholder is trying to fulfill by making investments. This is an important process because no two shareholders are alike. The investments to be made should be channelized in instruments, which help the shareholder achieve his overall investment objective. The Portfolio Manager would also define the Life Events of the shareholder while doing needs analysis. Life events can be any event which specifically needs extra money to achieve like a wedding, buying a new house, buying the latest Porsche Carrera or retirement planning. The aim is to account for any intermediate requirements before meeting the overall goal. While a shareholder can define an objective and provide an initial sum of money to invest to start off, not all objectives can be necessarily met. Objectives set by the shareholder may need a certain amount of risk taking as otherwise the initial investment made by the shareholder might not be enough to get to the objectives. This tie up with the basic financial premise: Higher the risk involved in an investment, higher the expectation of the return from the investment. Portfolio Manager would hence typically administer the shareholder a questionnaire, which would help the manager decide what kind of the risk the shareholder can take. Using the answers provided by the shareholder, the Portfolio Manager would arrive at a Risk Profile for each individual investor. Risk profile defines how much risk the shareholder can take on a sustainable basis. It is a function of demographic factors like age, years remaining until retirement, and family structure, economic factors like current nature of job, earning potential and psychological factors like response to financially negative events, risk appetite, etc. ASSET ALLOCATION At the heart of Investment management are the investment managers whose job is to invest and divest client monies Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash,

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bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time After rationalizing the shareholders investment objectives using the risk profile, the Portfolio Manager would decide how to allocate the shareholders investment to various asset classes. An asset class is a group of financial instruments with similar risk and return characteristics. For example, Equities is an asset class. Similarly, Fixed Income instruments, Real Estate and Derivatives can all be classified as asset classes. Asset allocation is generally of two types: Passive -Depending on the risk preferences, cash needs and tax status of the investor a mix of assets is determined for diversification of asset allocation and taking into account the macro economic factors like recession and inflation Active - The mix of assets is determined by market views PASSIVE APPROACH The portfolio manager has to decide on the mix of assets that maximizes the after-tax returns subject to the risk and cash flow constraints. Thus the investors characteristics determine the right mix for the portfolio. In coming up with the mix, the asset manager uses diversification strategies; asset classes tend to be influenced differently by macroeconomic events such as recessions or inflation. Diversifying across asset classes will yield better tradeoffs between risk and return than investing in any one risk class. The same observation can be made about expanding portfolios to include both domestic and foreign assets. ACTIVE APPROACH Portfolio managers often deviate from the passive mix by using Market timing. To the extent that portfolio managers believe that they can determine which markets are likely to go up more than expected and which less than expected, they will alter the active-passive mix accordingly. Thus, a portfolio manager who believes that the stock market is overvalued and is ripe for a correction, while real estate is undervalued, may reduce the proportion of the portfolio that is allocated to equities and increase the proportion allocated to real estate. Market strategists at all of the major investment firms influence the asset allocation decision. There have been fewer successful market timers than successful stock pickers. This can be attributed to the fact that it is far more difficult to gain a differential advantage at market timing than it is at stock selection. For instance, it is unlikely that one can acquire an informational advantage over other investors at timing markets. But it is still possible, with sufficient research

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and private information, to get an informational advantage at picking stocks. Market timers contend that they can take existing information and use it more creatively or in better models to arrive at predictions for markets, but such approaches can be easily imitated.

ASSET ALLOCATION RESEARCH STYLE


Fund managers generally adopt an individual investment management style. The following are the two quantitative approaches to tactical global asset management: TOP DOWN APPROACH The "top down" investor begins by looking at the big picture - economy or broad trends in society to identify individual countries and then sectors that will benefit from the prevailing conditions. For example, a "top down" investor might say that since the huge baby-boomer generation is aging and moving toward retirement, companies that provide products and services to older people should benefit from that trend. This might lead to buying pharmaceutical stocks or health care shares or, stocks of insurers that provide retirement annuities. A "top down" investor may also make investments based on what he or she thinks lies ahead for the economy. So, for example, if a "top down" investor believed that a resurgent economy might re-ignite inflation fears, then he or she might consider buying gold or natural resource stocks, or jettisoning long-term bonds in favor of Treasury bills. So a "top down" investor starts with a concept and then looks for stocks that are compatible with it. Then they work systematically down from this very broad perspective translating these topdown views into more specific economic and market forecasts. This is an analytical process; trying to identify those profound structural changes in global economies and societies, seeing what effects are likely to filter down and in time affect the value of ordinary investments. An illustrative model of top down approach will look as follows: Build country-by-country forecasting models based on benchmark return Validation of models Forecast out of sample returns Sort country returns Invest in portfolio of highest expected return countries Information in both the volatility and correlation is used in determining optimal portfolio weights

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"Hedge" strategies are also possible. This involves taking long positions in the highest expected returns countries and short positions in the lowest expected returns countries. BOTTOM UP APPROACH The idea is to select individual securities. From a variety of methods, forecasted winners are purchased and forecasted losers are sold. Bottom up" investor would try to find investments that are attractive because of something particular to them -- i.e., their terrific growth potential, say, or the fact that their assets are selling for less than their intrinsic worth. So an investor who practices the "bottom up" approach might screen through a long list of stocks to find ones that look like a buy on the basis of their fundamentals. PORTFOLIO MANAGEMENT Portfolios are created after the asset allocation has been finalized. The next task is selecting rationally the kind of stocks and other financial instruments that should form part of the intended investment basket. Thereafter, it calls for constant revision of the portfolio depending, if so called for by the style of management chosen. Of course, as with any other assignment, there comes a time for the financial advisor to evaluate as to how the portfolio has fared both in absolute and relative terms. While managing a clients portfolio, it is imperative that the financial advisor looks for avenues and opportunities for making additional money through nonconventional ways for the client. Given the fact that a financial advisor is a fiduciary, he should do everything that is professionally possible to immunize the clients portfolio from unexpected risks and events. Performance of the portfolio is measured both in absolute and relative term. Portfolio performance is always measured with respect to the risks taken. Also, performance should be reckoned taking into account the circumstances and the restrictions. Another important aspect of Portfolio Management is Portfolio Performance Reporting. These reports contains details of annualized return, holding period return, dispersion of returns, portfolio risk measure, asset-class wise return, performance attribution information, etc. In respect of each asset class, there are drill-down reports made available to the client.

7.2.2 INVESTMENT MANAGEMENT - MIDDLE OFFICE


RESEARCH Research is one of the primary inputs towards deciding what kind of asset or financial instrument to invest in. It involves performing a variety of qualitative and quantitative analysis to determine the ideal portfolio mix. His includes an in depth analysis about the institution issuing the instrument, estimating future growth, industry analysis, trend analysis of historical prices etc. Some of the pre-requisites for performing meaningful research to aid investment decision making are as follows:

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RESEARCH TEAM The first step is to put together a dedicated research team. It is critical that the team members not only understand the financial market dynamics but also have knowledge on Model building and Econometrics. The success of the research team is usually evaluated relative to a benchmark return. DATA The research team must have easy access to a variety of data. The collection and maintenance of the database is very important. Tactical decisions need to be made quickly as new data keeps pouring in. It is best to invest in a database system that takes the new data and automatically runs the quantitative analyses. COMPUTING While most top-down data management exercises can be handled within Excel, the bottom up projects are not feasible within a spreadsheet. The bottom-up projects may include up to 10,000 securities along with vectors of attributes for each security. Investment firms have dedicated research teams, which take immense pride in data mining and coming out with their views on all sorts of investment opportunities available in the market. These research reports draw on a rich source of data, advice and statistical tools that are not readily available to small individual and institutional investors.

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Assessment of Industry Dynamics Interview of Company executives

Information

Analysis

Report

Analysis of competition

Information as available from Suppliers, Distributors, Major Customers and other Independent Sources

FIGURE 1: VIEW OF RESEARCH PROCESS PORTFOLIO VALUATION AND REBALANCING So an investor has established an asset-allocation strategy that is right for him, but at the end of the year, he finds that the weighting of each asset class in his portfolio has changed! What happened? Over the course of the year, the market value of each security within his portfolio earned a different return, resulting in a weighting change. As the value of his investments increases or decreases, or his life changes, he may want to modify his initial asset allocation. In fact, there are several situations when thats likely to be the case: 1. As he gets closer to retirement, he may want to shift some of his assets out of potentially volatile growth investments, such as stocks, into income-producing investments with more stable values. 2. He may want to rebalance his plan in response to major life events that have an impact on his financial situation, such as getting married or divorced, having children, or changing jobs. 3. If market performance increases or decreases the value of one asset class so that his actual portfolio allocation is significantly different from the allocation he selected, he may want to realign his holdings to get them back in balance.

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WHAT IS PORTFOLIO REBALANCING? Rebalancing is the process of buying and selling portions of ones portfolio in order to set the weight of each asset class back to its original state. In addition, if an investor's investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightings of each security or asset class in the portfolio to fulfill a newly devised asset allocation. Portfolio rebalancing is like a tune-up for ones car: it allows individuals to keep their risk level in check and minimize risk. Portfolio rebalancing helps to keep investments in line with the investment strategy. The idea behind rebalancing is to reduce risks created by the buildup of an inconsistent sum of money in any given market sector. Portfolio rebalancing is not an attempt to time the market, but rather a timely reassessment and modification of an investor's target goals. WHY REBALANCE? Rebalancing is a vital part of investment strategy. There can be no asset allocation target without a stated pledge to preserve the target. It is necessary to achieve the value added benefits of diversification. Periodically putting ones investments back in order by shifting money among asset classes is a necessary chore for investors who devise an asset-allocation strategy--whether the market goes up or down. The primary purpose of rebalancing is to maintain a consistent risk profile. It also provides a regular plan of action. Rebalancing accomplishes the reduction of assets that performed best (or worst) and the reinvestment of those proceeds into other assets to bring the portfolio to its original balance. Portfolio rebalancing is a powerful risk-control strategy. Over time, as a portfolios different investments produce different returns, the portfolio drifts from its target asset allocation, acquiring risk and return characteristics that may be inconsistent with an investors goals and preferences. A rebalancing strategy addresses this risk by formalizing guidelines about how frequently the portfolio should be monitored, how far an asset allocation can deviate from its target before its rebalanced, and whether periodic rebalancing should restore a portfolio to its target or to some intermediate allocation.

RISK MANAGEMENT Portfolio Risk Management is the process of measuring and assessing ones portfolio's exposure to market risk. There can be three views on risks, allowing us to compare our portfolio to the market portfolio (S&P 500) in terms of Risk-Adjusted Return, Value-at-Risk (VaR), and Market Risk Exposure (Alpha, Beta and R-squared). Portfolio Risk Analysis is important because it provides a powerful tool for assessing portfolio's risk, both relative to the market and to the risk level we desire to maintain. Various risks associated with an investment are as follows:

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1. Business Risk: This is the risk associated with the uncertainty of a company's future cash flows, which are affected by the operations of the company and the environment in which it operates. 2. Financial Risk: This is the risk associated with the uncertainty of a company's ability to manage the financing of its operations. Essentially, financial risk is the company's ability to pay off its debt obligations. 3. Liquidity Risk: This is the risk associated with the uncertainty of exiting an investment, both in terms of timeliness and cost. The ability to exit an investment quickly and with minimal cost greatly depends on the type of security being held. 4. Exchange Rate risk: This is the risk associated with investments denominated in a currency other than the domestic currency of the investor. For example, an American holding an investment denominated in Canadian dollars is subject to exchange-rate risk. 5. Country specific risk: This is the risk associated with the political and economic uncertainty of the foreign country in which an investment is made. These risks can include major policy changes, overthrown governments, economic collapses and war. VALUE-AT-RISK (VaR) is a category of risk metrics that describe probabilistically the market risk of a trading portfolio. Value-at-risk is widely used by banks, securities firms, commodity merchants, energy merchants, and other trading organizations. Such firms could track their portfolios' market risk by using historical volatility as a risk metric. They might do so by calculating the historical volatility of their portfolio's market value over a rolling 100 trading days. The problem with doing this is that it would provide a retrospective indication of risk. The historical volatility would illustrate how risky the portfolio had been over the previous 100 days. It would say nothing about how much market risk the portfolio was taking today. For institutions to manage risk, they must know about risks while they are being taken. If a trader mis-hedges a portfolio, his employer needs to find out before a loss is incurred. Value-atrisk gives institutions the ability to do so. Unlike retrospective risk metrics, such as historical volatility, value-at-risk is prospective. It quantifies market risk while it is being taken. ORDER MANAGEMENT Any investment management process shall deal with the most important activity of buying and selling of various securities depending upon the state of the market and the view taken by the portfolio manager. Such trading activities need a lot of monitoring and have to be settled in accordance with the market practices.

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The Order Management system provides functions for deal recording, compliance and back office integration. Dealers can record the detail of orders and track the confirmation process. The status of the orders can be monitored across all workstations in the dealing room. The system enables dealers to share a common database with the back office and provides the dealers on-line access to shareholders actual cash and investment positions and limits. Allocated deals are sent to the back office electronically for the computation of contract details (charges, commissions, etc), for printing the contract notes and to start the settlement process. ORDER TRANSMISSION AND EXECUTION An order represents intent to buy or sell. Market orders request execution at the most advantageous price obtainable after the order is presented in the market (Trading Crowd). Limit orders request execution at a specified price or better; they will be executed only if and when that price is reached. In addition to these two basic types of orders there are several order types specifying further conditions for execution (e.g., sell plus, buy minus, good til cancelled and stop loss). Orders also carry qualifications regarding trade settlement (e.g., regular way, cash, and next day). Finally, orders can be subdivided into member orders (for a members own account) or public orders (submitted by a member on behalf of a non-member, such as a retail client). Electronic trading system is replacing the earlier used Open outcry system. NYSE supports both electronic trading as well as Floor broker trading (that is Open Outcry). Most European exchanges support electronic trading.

7.2.3 INVESTMENT MANAGEMENT BACK OFFICE


POST TRADE PROCESSES Trade Reporting and Dissemination The Exchange disseminates, in real time, trade information consisting of symbol, execution price, trade size, and special trading conditions. Occasionally, the Exchange disseminates additional messages indicating, for example, delayed openings and trading halts. Exchanges require member firms to report both own-account and customer-account trades effected outside business hours as well as in foreign markets to the exchange. Member firms need not report program trading transactions they already report to the Exchange. Member firms must report the date and time of the transaction; symbol; price; number of shares; where the transaction was executed; whether the transaction was a buy, sell or cross; whether it was a principal or an agency transaction; and the name of the contra-side broker-dealer. Position Maintenance The function of Record Keeping and Position Maintenance is typically performed by Custodians. Custodians are settling entities in a Trade Cycle. It is mandatory for institutional investment

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managers to appoint a custodian. The custodian is responsible for the settlement of trades done by the broker/dealers. In case of physical settlement all post trade activities like the physical settlement of securities, getting the securities transferred; safe-keeping of the securities is done by the Custodian. In case of a paperless or electronic settlement environment, the Custodian maintains the securities account balances in electronic form. The account balances may be held at a Position level as well as a Tax Lot level. A Custodians systematic record keeping system helps to track the owner of the Security as on a particular date. Trade Allocation As described earlier, when a single investment manager is responsible for multiple fund accounts, the order for similar securities from such fund accounts are normally consolidated and sent to the trading desk. The trader can either place a single order for the portfolio order or merge/split several orders and send it as a block order for execution. Since a trade order is typically a block order on a security for multiple accounts or funds, when a notice of execution is received, it has to be allocated back to the accounts in the form of allocations. Portfolio Accounting Given the fact that a Pooled Investment Vehicle invests more or less its entire corpus primarily in such assets that undergo change in value every day, the overall value of its portfolio keeps varying dynamically. In turn, this means, the pro rata value of units held by individual investors also keeps changing from day to day. So, it is essential that pooled funds evaluate and publish the value of the units issued by them to their investors. This value is arrived on the basis of Net Asset Value (NAV) computation. NAV is the actual value of the investments made by the pooled fund for each unit issued by it. It changes almost on a daily basis as the market prices of individual securities in its portfolio fluctuate. It is computed by the formula given below: NAV = Market Value of Asset s Liabilities___ Number of units outstanding More specifically it will be: NAV = (Value of investments + Receivables +Accrued Income Accrued Expenses +Other Current Assets Liabilities) / Number of units outstanding Therefore a PIVs NAV would be affected by 4 sets of factors: Purchase and sale of investment securities Valuation of all investment securities (portfolio) held Other assets and liabilities Units sold or redeemed

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We know that the value of the mutual fund varies with the value of the portfolio, as the prices of the securities, which constitute the portfolio, fluctuate day to day. As the intrinsic value of the security represents the fair value of the security, the NAV represents the fair value of a unit in a mutual fund. The accounting team performs the all-important function of tracking the performance of the firm and drawing up its P&L. It calculates the fees, charges and other such heads that are to be recovered from the clients. The accounting team ensures that the overall financial impact of all the activities of the Wealth Management firm is recorded and taken into account. PERFORMANCE MEASUREMENT Fund performance is the acid test of investment management, and in the institutional context accurate measurement a sine qua non. For that purpose, institutions measure the performance of each fund (and usually for internal purposes components of each fund) under their management, and performance is also measured by external firms that specialize in performance measurement. The leading performance measurement firms (e.g. Frank Russell in the USA) compile aggregate industry data e.g. showing how funds in general performed against given indices and peer groups over various time periods. In a typical case (let us say an equity fund), then the calculation would be made (as far as the client is concerned) every quarter and would show a percentage change compared with the prior quarter (e.g. +4.6% total return in US dollars). This figure would be compared with other similar funds managed within the institution (for purposes of monitoring internal controls), with performance data for peer group funds, and with relevant indices (where available) or tailormade performance benchmarks where appropriate. The specialist performance measurement firms calculate quartile and decile data and close attention would be paid to the (percentile) ranking of any fund. Generally speaking it is probably appropriate that an institution should persuade its clients that performance be assessed over a longer period e.g. 3 or 5 years to smooth out very short term fluctuations in performance and the influence of the business cycle. This can be difficult however and, industry wide, there is a serious pre-occupation with short-term numbers and the effect on the relationship with clients (and resultant business risks for the institutions). TRANSACTION REPORTING AND COMPLIANCE Within each marketplace, a regulatory environment exists in order to ensure that the market operates in a fair and orderly manner. The regulator is the rule-setter and umpire of the game.

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This encompasses a number of facets of operation relating to stock exchange / market members such as: Transaction reporting Trading rule breaches Taking position that is disproportionate to the members financial position Closely associated with reporting is compliance. Compliance refers to knowing and operating in accordance with laws and rules existing in the country where the trade is taking place. In this context we shall cover some of the relevant Acts which different entities in the securities markets have to comply with. FEES AND BILLING Investment management is a fee based activity. In case of Fee based brokerage programs, the active traders pay a flat asset-based fee (usually about 1%) for all trading activity instead of a commission on individual trades. There is usually a limit on the number of trades per period. After that, the client is usually charged a commission. In case of hedge funds, the managers charge a fee based on performance rather than the asset size.

7.3

DIFFERENT CLASSES OF INVESTMENT MANAGEMENT FIRMS

7.3.1 WEALTH MANAGEMENT/PRIVATE BANKING


Private Banking covers banking services, including lending and investment management, Private banking primarily is a credit service, and is less dependent on accepting deposits than retail banking. The Federal Reserve Supervisory Letter defines private banking as personalized services such as money management, financial advice, and investment services for high net worth clients. Although high net worth is not defined, it is generally taken at a household income of at least $100,000 or net worth greater than $500,000. Larger private banks often require even higher thresholds - Several now require their new clients to have at least $1 million of investable assets. As per the World Wealth Report 2008 by Merrill Lynch / Cap Gemini, there are currently over 10.1 million millionaires in the world with a combined asset base exceeding US$ 40.7 trillion which is projected to grow to reach US$ 59.1 trillion by the end of 2012.

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CLIENT SERVICES A typical private banking division of a large bank would offer the following financial services to its Private clients: Investment Management and Advice A client relationship Manager understands the clients liquidity, capital and investment needs. He strives to develop an integrated approach to manage client investments and capital markets trading. Access to specialist advice and extensive research is a key feature of private banking. Self-directed or non-discretionary: This is largely investment advisory in which the bank offers investment recommendations based on the Clients approval. The client may choose to ignore this. Discretionary: In this case, the banks portfolio managers make investment decisions on behalf of the customer. Risk Management Strives to reduce exposures for its clients across the world through a variety of hedging tools, taking positions in derivative markets etc Liquidity Management of a Clients liquidity (cash etc) needs through short-term credit facilities, flexible cash management services etc. An exclusive cash management service with "sweep" facility is a Private Banking feature. The sweep automatically transfers excess funds over a pre-determined limit out of ones current account into a higher yielding reserve account, optimizing his/her return on short-term cash. Funds are on call so they remain easy to access. Structured Lending Provides tailored lending to provide long-term liquidity to clients, or investment capital Enhanced banking facilities Private clients enjoy a variety of exclusive banking services such as: Insurance Foreign exchange transactions Automatic credit entitlements etc Issuer Capital formation Providing clients with access to investment banking and other institutional services Private Bankers are high-end relationship managers, as well as money managers and advisors. Private clients trade in larger volumes, the fees and commissions are larger.

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Changes in the regulatory environment have redefined the competitive landscape of wealth management by allowing involvement of banks in insurance activities. A successful wealth manager must harness and deploy not just the standard activities of equity and fixed income investment management, but a plethora of other products and services: tax and estate planning, insurance products, 401(k) rollovers, and more. Most private banks segregate their clients based on net worth, investible assets, age etc. For example, one classification could be between young affluent and retired affluent. Private banking clients typically demand higher returns on their investment, and as a result banks offering these services are heavily dependent on efficient Portfolio Analysis and Asset Allocation techniques to achieve this. The consequent investment in technology is also very high. Private banking is a fee-driven business. Banks offering these services charge anything between 1-4 % for their service, depending on the nature of the service rendered. Return on equity for banks offering these services could be as high as 25%. COMMON PRIVATE BANKING PRODUCTS PERSONAL INVESTMENT COMPANIES (PICS) A PIC is a shell company set up by a Private Banks offshore division (e.g. trust division) for a client, usually in a tax haven like the Cayman Islands. The PIC has its own legal entity and the investor enjoys confidentiality as well as tax benefits. There is substantial startup fee involved for these, and banks charge annual administration fees. PAYABLE THROUGH ACCOUNT (PTA) PTAs are transaction deposit accounts that allow banks in one country to offer their foreign clients of a foreign bank, such services as check-writing. The foreign bank in this case plays the role of a correspondent bank. These accounts usually have a high transaction volume and attract dollar deposits from the foreign customers. HEDGE FUNDS This is a private investment partnership, and is usually run by Private Banks. Hedge funds are highly speculative and they use a variety of techniques such as leverage, short-selling, and use of derivatives. Several hedge funds also utilize some form of arbitrage, such as those where they can take advantage of movements expected to occur in the stock price of two companies undergoing a merger or other similar event. In most cases, investors in a hedge fund need to be duly accredited. ]

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CORE FUNCTIONS IN PRIVATE BANKING Sales and Marketing / Client Prospecting Client Management, Servicing and delivery Financial Planning Portfolio Analysis and Optimization Market Activities Research Compliance controls. PRIVATE BANKING WORKFLOW The high-level process flow for private banking is shown below. The roles and responsibilities of the various players are outlined below.

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7.3.2 INSTITUTIONAL ASSET MANAGEMENT


An asset is a property or investment, such as real estate, stock, mutual fund, or equipment that has monetary value that could be realized if sold. Asset Management in a generic sense is the systematic planning and control of any asset throughout its life. This may include the specification, buying, holding, modification (change in holding quantities) while in use, and its disposal when no longer required. Asset Management is the art of professionally managing premium clients assets with a view to maximize clients benefit. If the clients are large institutions like a corporations pension fund, university endowment fund, insurance company portfolio etc., it is called Institutional Asset Management. Institutional money managers are independent financial advisory firms organized and licensed under the Security and Exchange Commission or Banking Laws' oversight agency of the country. Institutional Asset Management service can be both Advisory or Fund handling and investing on behalf of the customer. Since, Institutional Asset Management is just another variant of Investment Management, so for all practical purposes, the processes, entities, business organization etc. will remain the same. The differences, if any, will be brought forward as we proceed along in the chapter. Distinction from generic Investment Management Institutional money managers are distinguished by the fact that: They are under greater regulatory scrutiny from both state and federal authorities They provide exclusive service to their clientele who are typically institutions having portfolios in excess of several million dollars. They are very selective in the clientele they service and first do an independent analysis of that client's financial needs, goals, objectives, and risk tolerance. They charge competitive fees due to the fact that their clients entrust millions of dollars to them for investing. Accordingly they are under greater scrutiny to provide attractive performance returns. They can most often take on the role of a treasury and cash manager for institutional clients, to manage their day to day liquidity requirements. A custodian is appointed to oversee the responsibility of safe-keeping the assets. Custodian also acts as trustee of the assets of the institutional clients in most cases.

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Asset Management Goals Asset Management aims to achieve the following goals: Manage investors money efficiently and cost effectively Generate superior investment returns Deliver equity type returns with lesser volatility risk and achieve capital preservation Capital preservation is an important consideration for all institutional clients. The reason is that these institutions can themselves be listed companies. While they want to make returns from their cash holdings, investing in markets is not their primary business objective. They are looking for better than bank returns, without taking too much of risk. Institutions are answerable to their shareholders and hence would never want to lose money in investments. Hence for institutional clients risk and liquidity management are very important features of the investment decisions. Risk levels in all investments should be carefully monitored and investments should be liquid that is it should be easy to buy and sell the instruments identified. Institutions might need cash at any point of time for meeting their core business objectives; hence they would not prefer to invest in illiquid instruments.

7.3.3 MUTUAL FUNDS


A mutual fund is a fund that pools together money from many investors and invests it on behalf of the group, in accordance with a stated set of objectives. Mutual funds raise the money by selling shares of the fund to investors that includes individuals and institutions, much like any other company can sell stock in itself to the public. These funds take the proceeds of the money from the sale of the shares and invest it in other instruments like bonds, stocks etc. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, depending upon the performance of the securities held by the fund. Now, one can raise a simple question: why do people buy mutual funds when they can directly buy the instruments that these mutual funds invest in? After all what is the need of having a middleman? There are numerous reasons for investing in the mutual fund. They are: Diversification: With a mutual fund one can diversify the investment both across companies and across asset classes. When some assets are falling in price, others are likely to be rising, so diversification results in less risk than if one purchased just one or two investments. Liquidity: Most mutual funds are liquid and it is easy to sell the share of a mutual fund.

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Low Investment Minimums: One doesnt need to be wealthy to invest in mutual funds. Most mutual funds will allow one to buy into the fund with as little $1,000 or $2,000. Convenience: When someone own a mutual fund, he/she doesn't need to worry about tracking the dozens of different securities in which the fund invests; rather, all he/she need to do is to keep track of the fund's performance. Low Transaction Costs: Mutual funds are able to keep transaction costs low because they benefit from reduced brokerage commissions for buying and selling large quantities of investments at a single time. Regulation: Mutual funds are regulated stringently by the government. Thus this reduces the risk for the end investor. Professional Management: Mutual funds are managed by a team of professionals, which usually includes one mutual fund manager and several analysts. So mutual funds are full of benefits. Now one must be wondering if the mutual fund what the disadvantages of mutual funds are. There are plenty of disadvantages: Fees and Expenses: Most mutual funds charge management and operating fees that pay for the fund's management expenses (usually around 1.0% to 1.5% per year). Moreover a few mutual funds charge high sales commissions. Poor Performance: Mutual funds do not guarantee a fixed or high return. On an average more than half of the mutual funds fail to do better than the market returns. Loss of Control: The mutual fund managers are the people who decide upon the strategy to invest. Thus the investor loses the control of his money to the fund manager. Inefficiency of Cash Reserves: Normally a Mutual fund maintains a large cash reserve to provide protection against simultaneous withdrawals. This provides investors with liquidity, but due to the large cash reserve the mutual funds do not invest all cash in asset and thus provide investor with lowered returns. CLASSIFICATION OF MUTUAL FUNDS The mutual fund schemes can be classified according to both their investment objective (like income, growth, tax saving) as well as the number of units (if these are unlimited then the fund is an open-ended one while if there are limited units then the fund is close-ended). BY STRUCTURE OPEN-ENDED PLANS Open-ended plans do not have a fixed maturity period. Investors can buy or sell units at NAVrelated prices from and to the mutual fund on any business day. These schemes have unlimited

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capitalization, there is no cap on the amount one can buy from the fund and the unit capital can keep growing. These funds are not generally listed on any exchange. Open-ended plans are preferred for their liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a daily basis. The advantages of open-ended funds over close-ended are as follows: Any time entry option: An open-ended fund allows one to enter the fund at any time and even to invest at regular intervals. Any time exit option: The issuing company directly takes the responsibility of providing any time entry and exit option. This provides ready liquidity to the investors and avoids reliance on transfer deeds, signature verifications and bad deliveries. CLOSE-ENDED PLANS Close-ended plans have fixed maturity periods. Investors can buy into these funds during the period when these funds are open in the initial issue. Such schemes cannot issue new units except in case of bonus or rights issue. However, after the initial issue, investor can buy or sell units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors expectations and other market factors BY NATURE OF INVESTMENTS Mutual funds can invest in financial and non-financial assets. Depending on the nature of investment (i.e., the type of asset in which the money is invested) we can have the following category of Funds: INDEX FUNDS "Index fund" describes a type of mutual fund or Unit Investment Trust (UIT) whose investment objective typically is to achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total Market Index. STOCK FUNDS "Stock fund" and "equity fund" describe a type of Investment Company (mutual fund, closedend fund, Unit Investment Trust (UIT)) that invests primarily in stocks or "equities". The types of stocks in which a stock fund will invest will depend upon the funds investment objectives, policies, and strategies. For example, one stock fund may invest in mostly established, "blue

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chip" companies that pay regular dividends whereas another stock fund may invest in newer, technology companies that pay no dividends but that may have more potential for growth. BOND FUNDS "Bond fund" and "income fund" are terms used to describe a type of Investment Company (mutual fund, closed-end fund, or Unit Investment Trust (UIT)) that invests primarily in bonds or other types of debt securities. The securities that bond funds hold will vary in terms of risk, return, duration, volatility, and other features. MONEY MARKET FUNDS A money market fund is a type of mutual fund that is required by law to invest in low-risk securities. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a "money market deposit account" at a bank, money market funds are not federally insured. Money market funds typically invest in government securities, certificates of deposits, commercial paper of companies, and other highly liquid and low-risk securities. While investor losses in money market funds have been rare, they are possible. BY INVESTMENT OBJECTIVE Mutual funds can be further classified based on their specific investment objective such as growth of capital, safety of principal, current income or tax-exempt income. In general mutual funds fall into three general categories: Growth Funds are those that invest for medium term to long-term capital appreciation. Income Funds invest for regular Income. Growth and Income/ Balanced Funds that tries to generate both regular income and long term capital appreciation. Sector Funds that have unique investment objectives. Special Funds are special types of Mutual Funds. NET ASSET VALUE Net asset value," or "NAV," of an investment company or a mutual fund is the company/funds total assets minus its total liabilities. For example, if an investment company has securities and other assets worth $100 million and has liabilities of $10 million, the investment companys NAV will be $90 million. Because an investment companys assets and liabilities change daily, NAV

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will also change daily. NAV might be $90 million one day, $100 million the next, and $80 million the day after. The investment company/fund calculates the NAV of a single share (or the "per share NAV") by dividing its NAV by the number of shares that are outstanding.

Some of the leading companies that offer mutual funds are: Fidelity Investments Vanguard ING Direct Bank of New-York Mellon

7.3.4 SEPARATELY MANAGED ACCOUNTS (SMA)


A separately managed account is a portfolio of securities owned directly by the investor and managed by professional money manager in lieu of an asset-based fee. SMA or the separately managed accounts provides the individual investors the same quality of service as offered to institutional investors. Separately managed accounts help investors build and manage their wealth by focusing on the investor's individual investment goals, time horizon, and risk tolerance. To determine these, a risk profile questionnaire is used. Clients receive a personalized Investment Policy Statement that outlines goals and the investment vehicles necessary to help achieve them. From there, the financial consultant chooses an asset allocation strategy that is used as a road map to achieve objectives. The financial consultant then recommends the investment managers best suited to manage the overall portfolio. Lastly, ongoing monitoring and review of the portfolio takes place at both the financial consultant and investment manager level. KEY FEATURES The key features of SMA are -: Direct ownership: The portfolio is held in a personal account rather than held as a part of fund, thereby giving direct control to the investors. Exclusivity: The arrangement gives exclusivity to the investor as investment preference, objectives and tax liability are not necessarily shared across a pool of investors. Customization: The security to be held and the investment pattern can be customized to individual needs. E.g. a customer may not want to invest in those companies that are in tobacco business. The portfolio can be customized to cater to his individual needs and preferences.

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Tax advantages: In the case of traditional mutual funds, individual taxes are not an issue. However, in case of SMA tax advantages to investor results from tax loss harvesting strategy. ADVANTAGES AND DISADVANTAGES Separately managed accounts provide the client with the following benefits: The investors get access to top Investment managers at an affordable rate that they would have been difficult otherwise. The fee structure is asset based and not commission based which offer a significant value to the customer. The client is relieved of portfolio management functionality and he can concentrate on other matters. The client gets better tax planning because of the tax-harvesting element in SMA. The transactions and the operations are more transparent to the customer as compared to traditional mutual fund. The client gets customized reports about his portfolio. Disadvantages There is no requirement for the reporting of the holding and there is no specific governing regulation unlike the mutual funds. There is no board in case of SMA, one hires the manager to manage the asset and there is no board to sue if something goes wrong. Closing an SMA would require moving the individuals security to another manager, which is a complicated and time consuming exercise. It is difficult to find an appropriate comparable to benchmark the performance of SMA. DIFFERENCE BETWEEN SMA AND MUTUAL FUNDS The key difference between a mutual fund and an SMA is that an SMA offers investors a customized approach to investing, rather than a generic product. Usually, the process begins with an assessment by an adviser of the individuals financial needs and goals. The adviser can then recommend a variety of portfolio strategy options, which are customized to meet each investors needs. Once the strategy has been agreed, a professional portfolio manager buys and sells stocks and bonds in the portfolio on the investors behalf. The financial adviser then keeps a close eye on the portfolios performance. As the portfolio is tailored to meet both long- and short-term cash needs, an SMA, unlike a mutual fund, can take into account personal investment preferences, such as not investing in

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particular stocks for personal, social or environmental reasons. For e.g. an investor may specify that his/her portfolio should not contain any stock belonging to TOBACCO companies. Also unlike mutual funds, the investor has direct ownership of the stocks and bonds within the portfolio. This can facilitate tax management strategies.

Some of the leading investment managers offering SMA services are: Merrill Lynch Investment Management ( now acquired by BOA) Brandes Investment Partners Nuveen Investments Alliance Capital Morgan Stanley Investment Management

7.3.5 PENSION PLANS


The first private pension plan in the United States was established in 1875 by the American Express Company and was soon followed by pensions provided by utilities, banking, and manufacturing companies. Almost all of the early pension plans were traditional pension plans known as defined benefit plans that paid workers a specific monthly benefit at retirement. A Retirement Pension Plan is any plan or program maintained and sponsored by an employer, an employee organization or both. It is designed to provide retirement income to employees or to give the employee an opportunity to defer income for retirement. Employer-sponsored retirement plans are intended to supplement Social Security benefits and personal savings, a concept often referred to as the "three-legged stool". The only leg of this stool that is mandatory is Social Security benefits. A retirement plan could be qualified or non-qualified. ADVANTAGES All private pension plans have favorable tax treatment. There are three tax advantages: Pension costs of a firm are, within limits, tax deductible; Investment income of a pension fund is tax exempt; and Pension benefits are taxed when paid to retirees, not when earned by workers.

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TYPES OF PLANS QUALIFIED PLANS A qualified retirement plan is a plan that meets specific requirements of the Internal Revenue Code (IRC), the Department of Labor (DOL) and Employee Retirement Income Security Act (ERISA). Qualified plans are afforded favorable tax treatment in exchange for meeting these requirements. The Internal Revenue Service (IRS) determines if the plan is qualified. ERISA provides these minimum standards for plan qualification. It requires that a plan: Be a definite, written, permanent program; Be communicated to employees; Abide by the Exclusive Benefit Rule; Must not discriminate in favor of any particular group of employees, such as Highly Compensated Employees (HCEs); and Must meet special nondiscrimination testing requirements. When the IRS determines that a plan meets all the requirements for a qualified plan, it sends a Letter of Determination to the plan administrator. NON-QUALIFIED PLANS Employers who wish to provide benefits to certain key employees on a discriminatory basis can do so through a non-qualified plan. A non-qualified plan may provide benefits to key employees, while excluding other employees. Contributions made to non-qualified plans do not enjoy the tax advantages of a qualified plan. OTHER TYPES OF RETIREMENT PLANS DEFINED BENEFIT PLAN (DB) This promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

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DEFINED CONTRIBUTION PLAN (DC) This on the other hand, does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee's individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These contributions generally are invested on the employee's behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans. CASH BALANCE PLANS Combine elements of both defined benefit and defined contributions plans, but do so in a way that gives the employer a more precise projection of future obligations. Typically, an employer contributes a defined amount annually, based on compensation and guarantees that the account will grow by a fixed percentage annually. A worker reaching retirement age can typically take the accrued amount either as a lump sum or an annuity. Converting existing defined benefit plans into cash balance plans has spawned some thorny legal questions about how to fairly deal with senior workers. After a spate of cash balance conversions by large employers, political controversy and an absence of government guidance on what transition rules are appropriate has deterred many employers interested in making such a change from doing so in recent years. INDIVIDUAL RETIREMENT ACCOUNTS (IRAS) These allow a person to set aside and invest a contribution each year in an individual account. There are several different types of IRAs, and in recent years Congress has expanded them for non-retirement purposes (such as education). IRAs are typically used as a holding vehicle for money that is "rolled over" from another retirement plan upon job change, such as a 401(k). KEOGH PLANS These are tax-deferred retirement accounts for self-employed workers or persons employed by unincorporated businesses.

7.3.6 HEDGE FUNDS


There is no exact definition to the term Hedge Fund; it is perhaps undefined in any securities laws. There is neither an industry wide definition nor a universal meaning for Hedge Fund. Hedge funds, including fund of funds are unregistered private investment partnerships, funds or

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pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are NOT subject to the same regulatory requirements as Mutual funds. The term is usually defined by considering the characteristics most commonly associated with hedge funds. Usually, hedge funds are organized as private investment partnerships or offshore investment corporations; use a wide variety of trading strategies involving position-taking in a range of markets; employ as assortment of trading techniques and instruments, often including shortselling, derivatives and leverage; pay performance fees to their managers; and have an investor base comprising wealthy individuals and institutions and relatively high minimum investment limit (set at US $100,000 or higher for most funds). The term Hedge Funds, first came into use in the 1950s to describe any investment fund that used incentive fees, short selling, and leverage. Over time, hedge funds began to diversify their investment portfolios to include other financial instruments and engage in a wider variety of investment strategies. Today, in addition to trading equities, hedge funds may trade fixed income securities, convertible securities, currencies, exchange traded futures, over the counter derivatives, futures contracts, commodity options and other non-securities investments. Furthermore, hedge funds today may or may not utilize the hedging and arbitrage strategies that hedge funds historically employed, and many engage in relatively traditional, long only equity strategies. DIFFERENCE BETWEEN A MUTUAL FUND AND HEDGE FUND Hedge funds are exempted from registration and disclosure requirements. Mutual funds are regulated by the SEC, the IRS and other agencies and entities. Hedge funds can use techniques such as short selling, leverage, concentrated investments and derivatives trading. Mutual funds have a limited choice of investment strategies and vehicles. Hedge fund managers are heavily invested in the funds they manage. Mutual fund managers are not invested in the funds they manage.

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Hedge fund managers get remunerated based on the returns they earn (called incentive fee). Thus, hedge fund managers get paid only when they generate positive returns. Mutual fund managers get remunerated based on the size of the assets they manage, regardless of performance. Hedge fund managers can change their investment strategy without prior investment consent thus providing flexibility to investment managers. Mutual fund managers require the consent of the investment committee of the fund in order to change their strategy. The lack of regulation and disclosure can result in managers taking excessive risk or the kind of risk whose nature they dont fully appreciate. Regulation and disclosure requirements result in fewer unpleasant surprises and lesser downside risk. MARKET BENEFITS OF HEDGE FUNDS: Hedge funds can provide benefits to financial markets by contributing to market efficiency and enhance liquidity. Many hedge fund advisors take speculative trading positions on behalf of their managed hedge funds based extensive research about the true value or future value of a security. They may also use short term trading strategies to exploit perceived miss-pricings of securities. Because securities markets are dynamic, the result of such trading is that market prices of securities will move toward their true value. Trading on behalf of hedge funds can thus bring price information to the securities markets, which can translate into market price efficiency. Hedge funds also provide liquidity to the capital markets by participating in the market. Hedge funds play an important role in a financial system where various risks are distributed across a variety of innovative financial instruments. They often assume risks by serving as ready counter parties to entities that wish to hedge risks. For example, hedge funds are buyers and sellers of certain derivatives, such as securitized financial instruments, that provide a mechanism for banks and other creditors to un-bundle the risks involved in real economic activity. By actively participating in the secondary market for these instruments, hedge funds can help such entities to reduce or manage their own risks because a portion of the financial risks are shifted to investors in the form of these tradable financial instruments. By reallocating financial risks, this market activity provides the added benefit of lowering the financing costs

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shouldered by other sectors of the economy. The absence of hedge funds from these markets could lead to fewer risk management choices and a higher cost of capital. Hedge fund can also serve as an important risk management tool for investors by providing valuable portfolio diversification. Hedge fund strategies are typically designed to protect investment principal. Hedge funds frequently use investment instruments (e.g. derivatives) and techniques (e.g. short selling) to hedge against market risk and construct a conservative investment portfolio one designed to preserve wealth. In addition, hedge funds investment performance can exhibit low correlation to that of traditional investments in the equity and fixed income markets. Institutional investors have used hedge funds to diversify their investments based on this historic low correlation with overall market activity. From time to time, allegations are made by market participants about collusion among hedge funds to manipulate markets. Like all other market participants, hedge funds are covered by both criminal and civil regimes that outlaw various forms of market manipulation and abuse. SUMMARY Investment Management aims at managing investors money efficiently and cost effectively to generate superior investment returns. The ultimate objective is to deliver equity type returns with lesser volatility risk and achieve capital preservation Front Office covers functions like Sales & Client prospecting, Contact Management, Account Aggregation and Financial Advisory services. Middle/Back Office covers functions like Asset Allocation, Research, Portfolio Analysis, Risk Management, Trade Processing, Compliance and Documentation An Asset Manager uses the following approaches/principles: o Asset Mix o International Diversification o Screens/Filters o Capital preservation o Alternative Investments Asset Allocation can be done passively or actively. o Passive Approach - The portfolio manager has to decide on the mix of assets that maximizes the after-tax returns subject to the risk and cash flow constraints. Thus the investors characteristics determine the right mix for the portfolio. o Active Approach - Portfolio managers often deviate from the passive mix by using Market timing. To the extent that portfolio managers believe that they can determine which markets are likely to go up more than expected and which less than expected, they will alter the active-passive mix accordingly.

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Fund managers generally adopt an individual "investment philosophy" which overlays their investment management style. The following are the two quantitative approaches to tactical global asset management. The "top down" investor begins by looking at the big picture - economy or broad trends in society to identify individual countries and then sectors that will benefit from the prevailing conditions. The bottom up investor selects individual securities. From a variety of methods, forecasted winners are purchased and forecasted losers are sold. Bottom up" investor would try to find investments that are attractive because of something special to the security. There are several variants of investment management that have manifested in terms of firms offering products to suit specific needs of investors. Some of them are o Private Banking\Wealth Management o Institutional Asset Management o Mutual Funds o Separately Managed Accounts o Hedge Funds o Pension Funds Private Banking covers personalized services such as money management, financial advice, and investment services for high net worth clients. High net worth is generally taken at a household income of at least $100,000 or net worth greater than $500,000. Larger private banks often require even higher thresholds of at least $1 million of investable assets Institutional money managers are independent financial advisory firms organized and licensed under the Security and Exchange Commission or Banking Laws' oversight agency of the country. A Mutual Fund (MF) is a type of Investment Company that pools the money of many investors shareholders and collectively invests that money in stocks, bonds, or money market instruments. A separately managed account is a portfolio of securities owned directly by the investor and managed by professional money manager for an asset-based fee. SMA or the separately managed accounts provides the individual investors the same quality of service as offered to institutional investors. Hedge funds, including fund of funds are unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are NOT subject to the same regulatory requirements as Mutual funds. Pension funds may be defined as forms of institutional investor, which collect, pool and invest funds contributed by sponsors and beneficiaries to provide for the future pension entitlements of beneficiaries

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8.0
8.1

INVESTMENT BANKING AND BROKERAGE


DEFINITION OF INVESTMENT BANKS

An investment bank is a financial institution that raises capital, trades in securities and manages corporate mergers and acquisitions. Investment banks profit from companies and governments by raising money through issuing and selling securities in the capital markets (both equity, bond) and insuring bonds (selling credit default swaps), as well as providing advice on transactions such as mergers and acquisitions The major activities include Investment Banking Trading in Securities Research The major activities of Investment Banking involve Securities Underwriting Corporate Advisory Services M&A Securitized Products Structuring complex structured products are offered which offers greater margins The difference between an investment bank and a commercial bank is that a commercial bank accepts deposits from retail investors whereas an investment bank does not accept deposits from retail investors.

8.2

FUNCTION OF INVESTMENT BANKS:

Some of the most important functions of investment banking are: Investment banks help public and private corporations in issuing securities in the primary market, guarantee by standby underwriting or best efforts selling. Other services include acting as intermediaries in trading for clients. The brokerage division of Investment banking provides financial advice to investors and serves them by assisting in purchasing securities, managing financial assets and trading securities Small firms providing services of investment banking are called boutiques. These mainly specialize in bond trading, advising for mergers and acquisitions, providing technical analysis or program trading

8.3

MAJOR INVESTMENT BANKS:

Prior to the financial crisis the bulge bracket investment banks were

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Goldman Sachs Merrill Lynch Bear Stearns Lehman Brothers JP Morgan Chase The aftermath of the financial crisis has resulted in a lot of changes

Bear Stearns has been acquired by JP Morgan Chase. Lehman Brothers has declared bankruptcy Merrill Lynch has been acquired by Bank Of America Until Sep 22, 2008 Goldman Sachs and Morgan Stanley were the largest investment banks however they converted to traditional banking institutions due to the financial crisis.

8.4

DIVISIONS WITHIN AN INVESTMENT BANK

Investment Banks have a number of divisions, some of which are listed below along with the descriptions.

8.4.1 CORPORATE FINANCE


The bread and butter of a traditional investment bank, corporate finance generally performs two different functions: Mergers and acquisitions advisory - Banks assist in negotiating and structuring a merger between two companies. If, for example, a company wants to buy another firm, then an investment bank will help finalize the purchase price, structure the deal, and generally ensure a smooth transaction. Underwriting - The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt).An Underwriter guarantees that the capital issue will be subscribed to the extent of his underwritten amount. He will make good of any shortfall. 8.4.2 SALES Salespeople take the form of: 1) The classic retail broker, 2) The institutional salesperson

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3) The private client service representative. Brokers develop relationships with individual investors and sell stocks and stock advice. Institutional salespeople develop business relationships with large institutional investors. Institutional investors are those who manage large groups of assets, for example pension funds or mutual funds. Private Client Service (PCS) representatives, have some of the characters similar to retail brokers and institutional salespeople, providing brokerage and money management services for high net worth individuals. Salespeople make money through commissions on trades made through their firms. 8.4.3 TRADING Traders facilitate the buying and selling of stock, bonds, or other securities such as currencies, either by carrying an inventory of securities for sale or by executing a given trade for a client. Traders deal with transactions large and small and provide liquidity (the ability to buy and sell securities) for the market. (This is often called making a market.) Traders make money by purchasing securities and selling them at a slightly higher price. This price differential is called the "bid ask spread." 8.4.4 RESEARCH Research analysts follow stocks and bonds and make recommendations on whether to buy, sell, or hold those securities. Stock analysts typically focus on one industry and will cover up to 20 companies' stocks at any given time. Some research analysts work on the fixed income side and will cover a particular segment, such as high yield bonds or U.S. Treasury bonds. Corporate finance bankers rely on research analysts to be experts in the industry in which they are working. Salespeople within the I-bank utilize research published by analysts to convince their clients to buy or sell securities through their firm. Reputed research analysts can generate substantial corporate finance business as well as substantial trading activity, and thus are an integral part of any investment bank. 8.4.5 SYNDICATE A very important part of investment banking is the syndicate. This provides a vital link between salespeople and corporate finance. Syndicate helps to place securities in a public offering. The process is a long one between and among buyers of offerings and the investment banks managing the process. In a corporate or municipal debt deal, syndicate also determines the allocation of bonds.

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8.5

INVESTMENT BANKING POST ECONOMIC CRISIS:


There have been major changes in the investment banking field post the economic crisis. Major investment banks Morgan Stanley and Goldman Sachs succumbed to a collapse in confidence in their financial stability by converting themselves into lower risk, tightly regulated commercial banks Universal banks, which marry investment banking and deposit-taking, are in the ascendant. Strict regulatory limits will be imposed which will restrict the banks from dabbling with exotic derivatives and credit instruments and decrease amount of debt Banks must also anticipate and manage regulatory changes as the shape new business models There will be a lot of emphasis on risk management going forward Investment banks will continue to play a major role in the world of finance, however the number of pure play investment banks will decrease.

8.6

BROKERAGE

8.6.1 DEFINITION:
Broker is a party that mediates between a buyer and a seller. A "brokerage" or a "brokerage firm" is a business that acts as a broker. A brokerage firm is a business that specializes in trading stocks. INITIAL PUBLIC OFFERINGS An initial public offering (IPO) is the process by which a private company transforms itself into a public company. The company offers, for the first time, shares of its equity (ownership) to the investing public. These shares subsequently trade on a public stock exchange like the New York Stock Exchange (NYSE) or the NASDAQ. The primary reason for going through the rigors of an IPO is to raise cash to fund the growth of a company. Often, the owners of a company may simply wish to cash out either partially or entirely by selling their ownership in the firm in the offering. Thus, the owners will sell shares in the IPO and get cash for their equity in the firm. The IPO process consists of these three major phases: A. HIRING THE MANAGERS This choosing of an investment bank is often referred to as a "beauty contest." Typically, this process involves meeting and interviewing investment bankers from different firms, discussing the firm's reasons for going public, and ultimately nailing down a valuation. In making a valuation, I-bankers, pitch to the company wishing to go public what they believe the firm is worth, and therefore how much stock it can realistically sell. Perhaps understandably, companies often choose the bank that provides the highest valuation during this beauty contest

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phase instead of the best-qualified manager. Almost all IPO candidates select two or more investment banks to manage the IPO process. B.DUE DILIGENCE AND DRAFTING This phase involves understanding the company's business as well as possible scenarios (called due diligence), and then filing the legal documents as required by the SEC. The SEC legal form used by a company issuing new public securities is called the S-1 (or prospectus) and Lawyers, accountants, I-bankers, and of course company management must all toil to complete the S-1 in a timely manner. C. MARKETING Once the SEC has approved the prospectus, the company embarks on a road show to sell the deal. A road show involves flying the company's management coast to coast (and often to Europe) to visit institutional investors potentially interested in buying shares in the offering. Typical road shows last from two to three weeks, and involve meeting literally hundreds of investors, who listen to the company's presentations, and then ask scrutinizing questions. Often, money managers decide whether or not to invest thousands of dollars in a company within just a few minutes of a presentation. The marketing phase ends abruptly with the placement of the stock, which results in a new security trading in the market. Successful IPOs trade up on their first day (increase in share price), and tend to succeed over the course of the next few quarters. THE CHINESE WALL Between corporate finance and research, firms build what is known as a Chinese Wall separating research analysts from both bankers and Sales & Trading. Often, bankers are privy to inside information at a company because of ongoing or potential M&A business, or because they know that a public company is in registration to file a follow-on offering. Either transaction is considered material non-public information and research analysts, privy to such information cannot change ratings or mention it, as doing so would effectively enable clients to benefit from inside information at the expense of existing shareholders. When it comes to certain information, a Chinese Wall also separates salespeople and traders from research analysts. The reason should be obvious. Analyst reports often move stock prices - sometimes dramatically. Thus, a salesperson with access to research information prior to it being published would give clients an unfair advantage over other investors. Research analysts even disguise the name of the company on a report until immediately before it is published. This way, if the report falls into the wrong hands, the information remains somewhat confidential.

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Insiders of the company cannot sell any shares for a specified period of time, this is known as the _______? (Holding Period, Lockup Period, Buy & Hold Period)

Foundation Course in Banking and Capital Markets

8.7

UNDERWRITING

An Underwriter is a broker/dealer or an investment bank. He guarantees that the capital issue will be subscribed to the extent of his underwritten amount. He will make good of any shortfall. The contract between the issuer and the Lead or Managing Underwriter is the Underwriting Agreement. The agreement states the terms and conditions of the offering, such as, the Underwriting Spread (the amount the underwriters make on sales), the Public Offering Price (POP), and the amount of proceeds from the offering that will go to the issuer. Three different levels of broker/dealers handle the underwriting process: Managing Underwriters The Manager (lead underwriter) is the broker/dealer awarded the issue, who generally handles the relationship with the issuer and oversees the underwriting process. Syndicate To share the risk, and more efficiently distribute the offering to the public, broker/dealers will join together in a Joint Trading Account. The syndicate profits by selling the securities and earning a Spread (i.e., the POP less the amount paid to the issuer). Syndicate members share the risk and are responsible for any unsold securities. Selling Group Selling group comprises of broker/dealers chosen to assist the syndicate in marketing the issue (in a broker capacity). Selling Group firms are not members of the syndicate, and are not at risk for the securities. All broker/dealers involved in the underwriting of non-exempt securities must be NASD member firms. Underwriters earn 3 types of Underwriting Spread: Manager's fee - The lead underwriter receives this fee on all securities sold. Underwriter's Allowance is the total spread minus the Manager's fee. This fee is shared by syndicate members based on the type of syndicate account. Concession - It is typically the largest part of the spread and is paid to the broker/dealer that actually took the clients order.

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8.7.1

TYPES OF UNDERWRITING

There are two basic types of commitments made by underwriters to issuers: FIRM COMMITMENT The issue is purchased from the issuer, marked-up and sold to the public. The underwriter here is acting as a dealer and is at risk for the unsold securities; whatever securities are not sold will remain in the underwriters inventory. Standby Underwriting is always used in a subsequent primary offering of stock that is preceded by a subscription or pre-emptive rights offering. During the rights offering, the underwriter stands by. After the rights offering period has ended and all rights have been either exercised or expired, the underwriters must take any unsubscribed securities on a firm commitment basis. BEST-EFFORTS UNDERWRITING The underwriters act as agents or brokers for the issuer, and attempt to sell all the securities in the market. The best efforts underwriter is not at risk, and any unsold securities remain with the issuer. Two sub-types of best efforts are All-or-None and Mini-max. An all-or-none underwriting may be canceled by the issuer if the entire issue is not sold in a given time period. A mini-max underwriting requires a minimum amount to be sold. If the underwriter sells the minimum, they may then attempt to sell the maximum (usually being the entire issue). However, if the minimum is not sold, the issuer may cancel the underwriting.
What is an agreement in which the underwriter is legally bound only to attempt to sell the securities in a public offering for the firm? When the investment banker bears the risk of not being able to sell a new security at the established price, what is this is known as? On the day that a lock-up period expires, the market value of the stock will most likely ________. (Increase/decrease/remain same.)

8.8

SECONDARY MARKET TRADING

The trading of outstanding issues takes place in the Secondary Markets. The secondary markets are broken down into four market types: 8.8.1 LISTED MARKET These are exchanges where an Auction method is used and specialists provide liquidity on the floor of an exchange. E.g. The New York Stock Exchange (NYSE)

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8.8.2 OVER-THE-COUNTER MARKET (OTC, Second Market, Unlisted) A negotiated market without a physical location where transactions are done via telecommunications. Broker/dealers acting as Market Makers provide the liquidity. 8.8.3 THIRD MARKET Where listed securities are traded OTC (over-the-counter), and broker/dealers acting as market markers offer an alternative to trading on the exchange itself. An example would be a broker/dealer that maintained an inventory of IBM stock (which trades on the NYSE), and buys and sells that stock to other brokers and customers using a negotiated, over-thecounter method of trading. 8.8.4 FOURTH MARKET The trading of exchange-listed securities between institutions on a private over-the-counter computer network, rather than over a recognized exchange such as the New York Stock Exchange (NYSE) or NASDAQ. Trades between institutions will often be made in large blocks and without a broker, allowing the institutions to avoid brokerage fees. All the stock exchanges are registered with the SEC, and they have a self regulation mechanism. The Maloney Act of1938 enabled the NASD to be the SRO (self-regulatory organization) for the second, third and fourth markets. SRO is self-regulatory organization. It is an organization that exercises some degree of regulatory authority over an industry or profession. The regulatory authority could be applied in addition to some form of government regulation, or it could fill the vacuum of an absence of government oversight and regulation

8.9

THE FLOOR OF THE EXCHANGE

NYSE (partially) and London are the only major exchanges which still use a trading floor. When an investor customer calls their broker to place a trade, the following sequence of activities happen: Brokerage Firm checks the customer's account for cash balance, restrictions etc Enter the order in its Order Match System. The rep notifies the broker/dealers Order or Wire Room to execute the trade. The Order room then wires the order to the Commission House Broker (CHB), an employee of the broker/dealer who trades on the floor of the exchange for that broker/dealer. The CHB makes their way over to the respective Trading Post. At the post, the CHB encounters other folks who want to trade IBM stock. Transaction Report Is sent to the originating brokerage firms (buying and selling). A market order through SuperDot to the specialist takes an average 15 seconds to complete. Reports are also sent to Consolidated Tape Displays world-wide, and to the Clearing operations.

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Post Trade Processing Matching of buyers and sellers -- the Comparison process -- takes place almost immediately. This is followed by a 3-day Clearing and Settlement cycle at which time transfer of ownership (shares for dollars or vice versa) is completed via electronic record keeping in the Depository. Brokerage Firm The transaction is processed electronically, crediting or debiting the customer's account for the number of shares bought or sold. Investor Receives a trade confirmation from his/her firm. If shares were purchased, the investor submits payment. If shares were sold, the investor's account is credited with the proceeds. Specialist Specialists conduct the auction as a broker or dealer and maintain a fair and orderly market by matching up buyers and sellers. The specialist is not an employee of the exchange and may trade for their own account, as well as trading as an agent for CHB orders. Broker Executes orders for others Acts as an Agent Charges Commission Dealer Executes orders for themselves Acts as a Principal (i.e., a market maker) Charges Mark-up and Mark-down

An individual firm could act as a broker on one trade and a dealer on another. When acting as a broker, the firm is taking customer orders and acting as their agent to buy or sell the security. For this service, the broker charges a commission. A firm acting as a dealer is the actual buyer or seller, taking the other side of a trade. The price at which market makers will buy or sell a particular security is known as the Bid or Ask Price. Market Maker Provide continuous bid and offer prices within a prescribed percentage spread for shares designated to them 4 to 40 (or more) market makers for a particular stock depending on the average daily volume. Play an important role in the secondary market as catalysts, particularly for enhancing stock liquidity Registered Representatives An individual who has passed the NASD's registration process and is licensed to work in the securities industry Usually a brokerage firm employee acting as an account executive for clients Sell to the public; they do not work on exchange floors

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8.10 ORDER TYPES


8.10.1 ORDER TYPES (BASED ON PRICE) There are five basic order types. 1. Market Orders is executed at once, "at the market." A market order guarantees execution, but does not guarantee a price. The final price is determined by supply and demand. 2. Limit Orders - Some investors may want to buy or sell, but only at a specific price. A Limit order is executed at a set price or better and will not be executed if that price is not met. For example, a customer owns XYZ stock, which is currently trading at $50/share. They would like to sell the stock, but only if they can get a price of $55 or more. The investors would place a Sell Limit at $55/share, an order that will be executed only if a price of $55 or better is available. Similarly an investor who seeks to buy, but only at a certain price or better, might enter a Buy Limit at $45/share. 3. Stop order - If the market price hits or passes through the stop price (Trigger), a market order is Elected. For example, an investor bought stock at $50/share. The investor wants the price of the stock to go up, but wishes to limit the losses if the stock price falls. Such an investor might place a Sell Stop order at $45, and now if the market price falls to $45 or below, the stop is triggered and a market order is elected. Another example might be a Technical Trader who believes that if the stock goes up to a certain price, it is signaling the beginning of a Bullish run. This investor might enter a Buy Stop at $51, for example. Now, if the stock rises to $51 or above, a market order is triggered to buy the stock. A potential problem with a stop order is that it triggers a market order, which does not guarantee a purchase or sale price. A stop order must be triggered (activated or elected) before execution as a market order. 4. Stop Limit order - If the investors placed an order for $51 Stop, $52 Limit, the order would be elected at $51, but would not be filled (executed) unless a price of $52 or better was available. Now, the investor has eliminated the risk of buying the stock without guaranteeing the price. A stop limit order, once triggered, becomes a limit order. 5. Do-not-reduce Order - Indicates that the order price should not be adjusted in the case of a stock split or a dividend payout.
A sell limit order can be filled at a lower price than your limit e.g. your sell limit is at 21.07 & you can be filled at 21.06? True/False If you want to limit your risk on a long position you can place a sell stop order? True/false If the market is currently bid 15.00 & offered at 15.01 you are guaranteed of buying at 15.01 if you place a market order? True/False

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8.10.2 ORDER TYPES (BASED ON TIME)


Day Order The order is valid till end of day and if it is unfilled at days end, it gets cancelled. Open Order or Good Till Cancelled (GTC) The order can remain open for up to six months. It is the responsibility of the registered representative to cancel at the customers direction. In addition, at the end of April and the end of October, all GTC orders must be reconfirmed or eliminated. 8.10.3 ORDER TYPES (BASED ON VOLUME) Fill or Kill (FOK) The order must be immediately filled in one trade or canceled completely. All or None (AON) - The entire order must be filled or canceled completely, but unlike FOK, AON can remain good till cancelled. Immediate or Cancel (IOC) must immediately be filled for as much of the order as possible in one trade, with the remainder being cancelled. Market Not Held order The floor broker has the discretion concerning time and price. A key point is that Market Not Held orders are never on the Specialist's Book.

8.11 THE OVER-THE-COUNTER (OTC) MARKET


Unlike listed securities that trade on an exchange, unlisted securities trade Over the Counter (OTC). Most securities actually trade OTC, since U.S. government, Municipal and most corporate securities trade OTC. Since there is no specialist book and no post to record transactions, OTC price information is either published periodically in paper form, disseminated over telephone lines, or displayed real-time electronically. Liquidity in the OTC market is provided by Market Makers (i.e., broker/dealers who maintain an inventory of a particular stock, and buy and sell the stock from and to customers). The largest system for displaying OTC market quotes is NASDAQ (The NASDs Automated Quotation system). Broker/Dealers subscribe to various levels of the NASDAQ system depending on their functional needs. Level 1 service (i.e., the Inside Quote or Representative Quote) is the highest bid and lowest ask prices of all market makers, and is used by registered reps. Level 2 service is for traders, and lists all market makers' firm quotes on price and size. Level 3 service also displays all quotes, and is used by market makers to enter quotes. The quotes look like the following: Dealer A Dealer B Dealer C Bid 9 8.75 9.1 Ask 9.5 9.25 9.8

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Dealer D

9.5

If we were selling stock, to whom would we sell? Dealer C has the highest bid of 9.1, while a buyer would go to Dealer B who has the lowest ask of 9.25. The inside quote, therefore, would be 9.1 9.25, the highest bid and the lowest ask.

8.12 HOW DOES A BROKERAGE FIRM LOOK LIKE?


A brokerage firm has the following departments: Sales New Accounts Order Room Purchase and Sales Cashiering Margin Corporate Actions Accounting Compliance

8.12.1 SALES
Sales team is responsible for canvassing business. They are staffed with Account Executives/Account Managers who solicit business from retail and wholesale customers. 8.12.2 NEW ACCOUNTS New Account department is responsible for receiving customer account opening applications and documenting the customer data. They are the custodians for various documents like New account form, Signature cards, Margin Agreements, Lending Agreements and Option Trading Agreements. Only when the required documents are received, the account can legally operate. New accounts can be of one of the following types: Individual Cash Account Only cash transactions are permitted. No margin trading is permitted. Margin Account Joint Account Power of Attorney Accounts 8.12.3 ORDER ROOM

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Orders are taken by dealers in order room and they are executed in the best possible manner. Every order has detailed instructions like: Buy/Sell Quantity Limit/Market Security details etc. We have covered the different order types in the earlier pages. The relationships among the various departments can be pictorially represented as below:

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Sales
Account executive (Home or Branch office Reports Order Tickets

Name Accounts (Name & Address)


Open Accounts Executing Changes

OTC Market
Execution Reports

Order Room

Execution recording

Exchanges

Confirming GTC orders Pending Orders

Contra Brokers Purchase & Sales (P&S) Clearing Corp (CNS)


Confirmation

Recording

Clients

Figuration (including accrued interest) Comparison (reconcilement) Booking

Depository
Cashiers Margin

Banks

Receive & Deliver

Account Maintenance
Sales support Issue checks Items due Extensions Close Outs Delivery of securities

Brokerages Transfer Agent

Vaulting Bank Loan Stock Loan/borrow Transfer Reorganization

Stock Record

Accounting

Account numbering & coding


Audits Security Movements

Bookkeeping

Daily cash record Adjusted trail balance Trail Balance P & L Statement

Dividend

Proxy

Cash Dividends
Stock splits Due bills Bond Interest

Proxy voting

Information flow to customers

8.12.4 PURCHASE AND SALES This department is responsible for the following activities: Recording the trade with a unique number using codes and tickets. Figuration to calculate the monetary value of the transaction

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Reconciliation of customer trades with counter-party transactions Customer Confirmation in a legally binding form. 8.12.5 MARGIN Margin or Credit Department monitors the status of the customer accounts. As explained in the previous pages, they are also responsible for margin calls. The typical activities of this department are: Account Maintenance Sales Support Clearing Checks Items pending (Money due, stocks due) Closing out 8.12.6 CASHIERING They are responsible for movement of securities and funds within the brokerage firm. They take care of the following functions: Receiving and delivering Vaulting Hypothecations Security Transfers Stock Lending 8.12.7 CORPORATE ACTION Corporate Action refers to dividend declarations, stock splits etc. The Corporate Action department makes sure that the rightful owners (as on the Record Date) receive the dividends, Splits etc. 8.12.8 ACCOUNTING The Accounting department records, processes and balances the movement of money in the brokerage firm. They produce the Daily Cash Records and Trial Balance, Balance Sheet and Profit & Loss statements on a periodic basis. 8.12.9 COMPLIANCE The Brokerage firms are regulated by SEC, by state regulatory agencies and industry wide Self Regulatory Organizations. The compliance department is responsible for ensuring that all the rules and regulations are complied with and reported on time.

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They also make sure that the newer regulations like Anti Money Laundering Act are implemented inside the firm.
Questions 1. All of these are different types of brokerage accounts except? a) Margin Account b) Cash Account c) IRA Account d) Nostro Account
2.

A market order that executes after a specified price level has been reached is called? a) Market Order b) Stop Order c) Fill or Kill Order d) Day Order

3.

A brokerage or analyst report will contain all of the following except? a) a detailed description of the company, and its industry. b) an opinionated thesis on why the analyst believes the company will succeed or fail. c) a recommendation to buy, sell, or hold the company. d) a target price or performance prediction for the stock in a year. e) a track record of the analyst writing the report.

8.13 MARKET INDICES


By Market Indices we mean the index of market prices of 8.13.1 INDEX TYPES VALUE WEIGHTED INDEX is a stock index in which each stock affects the index in proportion to its market value. Examples include NASDAQ Composite Index, S&P 500, Hang Seng Index, and EAFE Index. They are also called capitalization weighted index. PRICE WEIGHTED INDEX is a stock index in which each stock affects the index in proportion to its price per share. E.g. Dow Jones Industrial Average 8.13.2 KEY MARKET INDICES The important markets and the indices used are presented below: US Diversified market US Technology UK (London) Germany (Frankfurt) France (Paris) Dow Jones Industrial Average (Dow) NASDAQ 100 Financial Times Stock Exchange Index (FTSE) DAX CAC

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Switzerland (Zurich) Japan (Tokyo) Hong Kong Singapore

SMI Nikkei Hang Seng Strait Times Index (STI)

DOW JONES INDUSTRIAL AVERAGE (DJIA) The Dow is made up of 30 large companies from various industries. The stocks in the following chart comprise the index. 3M AlliedSignal AT&T Caterpillar Citigroup DuPont Exxon General Motors Hewlett-Packard International Paper Johnson & Johnson Merck Procter & Gamble Union Carbide Wal-Mart Alcoa American Express Boeing Chevron Coca-Cola Eastman Kodak General Electric Goodyear IBM J.P. Morgan McDonald Philip Morris Sears United Technology Walt Disney

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9.0
9.1

CUSTODY AND CLEARING


INTRODUCTION

The custody service business evolved from safekeeping and settlement services provided by banks to its customers for a fee. Banks, as a custodian originally provided only basic safekeeping services to their customers. The banks routinely settled trades and processed income for their own investments. Their customers kept and took their securities out of safekeeping to settle trades or for bond maturities. As time evolved, the banks realized that their expertise in securities processing and their image as a safe repository would be valuable to their customers and they began to promote their securities processing ability as an enhanced value-added service. Services offered by Custodians Services provided by a bank custodian are typically the settlement, safekeeping, and reporting of customers marketable securities and cash. A custody relationship is contractual, and services performed for a customer may vary. Users of Custody Services Institutional investors, money managers and broker/dealers are the primary customers for custodians and other market participants for the efficient handling of their worldwide securities portfolios. Assets held Under Custody Custodians hold a range of assets on behalf of their customers. These include equities, government bonds, corporate bonds, other debt instruments, mutual fund investments, warrants and derivatives. Business Drivers of Custody Services The following are the key drivers in the growth of custody services: The wide range of financial instruments and the emerging markets spreading across geographies resulted in growing interest of investors. The potential benefits associated with the investments resulted in growth of custody services. The increasing use of global custodians to replace their own networks of local custodians by Investment managers and banks. The state withdrawing from its role of primary pension provider, causing citizens to invest in defined contribution pensions and mutual funds in record numbers - with custody banks serving the pension funds and mutual funds, their money managers and the banks acting for high net worth individuals. The introduction of floating exchange rates and lifting of exchange controls in many major economies resulted in rapid development of the market for international debt instruments.

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The specialist fund managers running dedicated portfolios of foreign equities have increased in recent time. The gradual increase in equities and cross-border investments.

9.2

SECURITIES MARKETPLACE

Securities marketplace is a mechanism for bringing together those seeking investment and those seeking capital. These entities can be individual or institutional .The securities market can be classified as primary market and secondary market. For the purpose of the discussion we would concentrate on secondary market and its working mechanism.

9.2.1 MARKET CONSTITUENTS


Investors An investor is an entity that owns a financial asset. In general there are two types of investor, the individual and the institutional investor. Individual Investor Institutional Investor o Mutual Fund Managers o Pension Funds o Insurance companies o Hedge Funds Brokers Broker is an intermediary who executes customer orders for a pre-defined commission. A "broker" who specializes in stocks, bonds, commodities act as an agent and must be registered with the exchange where the securities are traded. The brokers can be classified based on the types of the services offered. Dealers Dealer is an entity who is ready and willing to buy a security for its own account (at its bid price) or sell from its own account (at its ask price). They are individual or firms acting as a principal in a securities transaction. Custodians A custodian is responsible for safekeeping the documentary evidence of the title to property like share certificates etc. The title to the custodians property remains vested with the original holder, or in their nominee(s), or custodian trustee, as the case may be. On confirmation from customers the clearing corporation assigns the obligation of settlement upon the custodian. In general the services provided by the custodians are classified in two main areas: Holding of Securities and Cash

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Movement of securities and/or cash Clearing Corporation Clearing Corporation is responsible for post-trade activities of a stock exchange. Its responsible for clearing and settlement and risk management of trades. The list of activities performed by a clearinghouse is: Clearing of trades Determining obligations of members, Arranging for pay-in of funds/securities, Receiving funds/securities, Processing for shortages in funds/securities, Arranging for pay-out of funds/securities to members, Guaranteeing settlement. Examples of important clearing corporations across the globe are National Stock Clearing Corporation in USA (NSCC), Sega Intersettle in Switzerland, Clearstream & Euroclear of European Union and so on. Depository The depository can be either domestic or international securities and depending upon that they are known as either National Central Securities Depository or International Central Securities Depositories (ICSDs).

Country India USA UK Japan Hong Kong Clearing Banks

Depository abbreviation NSDL DTC CREST JASDEC CCASS

Depository Full Name National Depository Ltd Crest Japan Securities Depository Center Central Clearing settlement system and Securities

Depository Trust Company

Clearing banks are a key link between the custodians and Clearing Corporation for funds settlement. Every custodian maintains a dedicated settlement account with one of the clearing banks. Based on his obligation as determined through Clearing Corporation, the clearing

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member makes funds available in the clearing account for the pay-in and receives funds in case of a payout. In most of the cases the custodians act as a clearing bank also.

9.2.2 SECURITIES MARKET


Primary Market: It is a market for new security issue. In this market the securities are directly purchased from the issuer. For e.g. an investor directly buying security issued by IBM. Secondary Market: A market in which an investor purchases a security from another investor rather than the issuer. We can divide the secondary market into wholesale and retail parts. The wholesale market is the market in which professionals, including institutional investors, trade with one another. Transactions are usually large. The retail market is the market in which the individual investor buys and sells securities. The principal OTC market is the National Association of Securities Dealers Automated Quotations (NASDAQ). The wholesale market for corporate equities is conducted on a number of exchanges as well as over the counter (OTC). The New York Stock Exchange (NYSE) dominates. Other U.S. exchanges include the American Stock Exchange (AMEX), also in New York City, and five regional exchanges the Midwest, Pacific, Philadelphia-Baltimore-Washington, Some other Markets are:Dealer Markets Auction Markets Hybrid Markets

9.2.3 SAFEKEEPING
A bank is responsible for maintaining the safety of custody assets held in physical form at one of the custodians premises, a sub-custodian facility, or an outside depository. The banks may hold assets either off-premises or on premises On-Premises The banks hold the securities/assets in physical form in its vault. The securities (e.g., jewelry, art, coins) are kept in physical form by the bank .The banks also holds the securities, which are not maintained in the book entry form. The banks providing the safekeeping services needs to follow certain norms related to the security and movement of securities. The bank provides security devices consistent with applicable law and sound custodial management. The bank ensures appropriate lighting, alarms, and other physical security controls. The banks ensure that assets are out of the only vault when it receives or delivers the assets following purchases, sales, deposits, distributions, corporate actions or maturities.

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Off-Premises The evolution of depository has resulted in vast majority of custodial assets being held in book entry form. Custodians reconcile changes in the depositorys position each day as a change in the position occurs, as well as completing a full-position reconcilement at least monthly. Depository position changes are generally the results of trade settlements, free deliveries (assets transferred off the depository position when no cash is received), and free receipts (assets being deposited or transferred to the depository position for new accounts when no cash is paid out).

9.3

TRADING AND SETTLEMENT

9.3.1 TRADE INITIATION


The trade process is initiated in a variety of ways in which a customer decides either to buy or sell securities. The customer goes to either a Broker/ Dealer or a banks trading desk through its investment manager. The bank in turn would coordinate with a broker who has access to the exchange. The client sends across his order details through communication network. The client order contains standard features like: Buy or Sell Specific Quantity Specific Security The brokers typically record the order if the order has been placed through a broker or otherwise the trader directly maintains the details of the order.

9.3.2 ORDER MANAGEMENT


The order is placed by the client usually through a telecommunication network and is normally passed to either the exchange floor or to over the counter-trading desk. The order management process consists of Entering orders, order modification, order cancellation. The order capture process is done through appropriate trade entry applications. The process is to capture the order details i.e. identification of the security to be traded, the quantity, limit price, order duration and exchanges. The client places the order and specify the Operation i.e. either buy/sell, Quantity, Security Name and the Price. The order condition can be attached to the timing; price and quantity of the order, which is considered when the broker executes/match the trade .The clients also modify/ cancel the order if the order has not been processed. Order Types There are two basic types of order: market orders and limit orders. Market orders are instructions to buy or sell stock at the best available price. They are the most common types of orders.

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Limit orders tell our broker to buy or sell stock at the limit price or better. The limit price is a price that the investor can set when placing the order. For a given purchase, it is the maximum amount the investor will pay; for a given sale, it is the minimum amount the investor will accept. A limit order can also be placed to buy along with one to sell. For example, if XYZ Corporation is currently trading at $42 per share, a limit order can be placed to buy 100 shares of XYZ at 40 or better (less) and to sell 100 shares XYZ at 45 or better (more). Order Conditions A buyer/seller can specify order conditions with which the trade is to be executed. These are the conditions that are typically an upper limit in buy price, a lower limit in sell price, stop loss trade orders, quantity conditions and time criteria. Time Conditions Quantity Conditions Price Conditions Market Stop orders Order Books An order book is a placeholder for every order entered into the system. As and when valid orders are entered or received by the trading system, they are first numbered, time stamped and then scanned for a potential match. If a match is not found, then the orders are stored in the books as per the price/time priority. Price priority means that if two orders are entered into the system, the order having the best price gets the higher priority. Time priority means if two orders having the same price is entered, the order that is entered first gets the higher priority. Best price for a sell order is the lowest price and for a buy order, it is the highest price Order Matching The buy and sell orders are matched based on the matching priority. The best sell order is the order with the lowest price and a best buy order is the order with the highest price. The unmatched orders are queued in the system by the following priority: STOP LOSS MATCHING All stop loss orders entered are stored in the stop loss book. These orders can contain two prices. Trigger Price. It is the price at which the order gets triggered from the stop loss book. Limit Price. It is the price for orders after the orders get triggered from the stop loss book. If the limit price is not specified, the trigger price is taken as the limit price for the order. The

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stop loss orders are prioritized in the stop loss book with the most likely order to trigger first and the least likely to trigger last. The priority is same as that of the regular lot book. The stop loss condition is met under the following circumstances: Sell Order - A sell order in the stop loss book gets triggered when the last traded price in the normal market reaches or falls below the trigger price of the order. Buy Order - A buy order in the stop loss book gets triggered when the last traded price in the normal market reaches or exceeds the trigger price of the order. When a stop loss order with IOC condition is there, the order is released in the market after it is triggered. Once triggered, the order scans the counter order book for a suitable match to result in a trade or else is cancelled by the system.

9.3.3 TRADE EXECUTION


The trade execution is carried out on a stock exchange after an order is placed. Order modification and/or order cancellation is required to handle any abnormality. An order in entered into the trading system by the brokers and they specify the information regarding the trade details. The trade details typically contain information like security Name, Quantity, Price, Order Duration etc. The order is entered into the order book and gets executed as per the time and price condition as specified in the order. The order matching for the execution takes place in the stock exchange. The order modification and order cancellation takes place before the order gets executed i.e. if the order is there in the order books of the exchange and is waiting to be executed the request for order modification is entertained by the stock exchange. The stock exchange prepares a NOE (Note of Execution) with the trade details and sends it across to the Broker/ Dealer and to the clearing corporation giving details of the trade. The date the trade is executed is known as the Trade Date, and is referred as T or T+0. The order execution process for a customer sell order (individual investor placing order through a broker) goes through the following cycle: Customer places a sell order through the Internet or to the account executive of the brokerage group. The account executive sends the order to its corresponding floor broker or to its trading desk. The order execution takes place on the floor of the exchange such as on NYSE, AMEX etc. The exchange sends a Notification of sell to the Firms representative on the exchange as well as the trading desk of the brokerage group.. The Firms representative on the exchange floor send a notification of the sell to the floor broker which is then matched with the counter party broker.

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The trade execution results in identifying the following trade components: Trade Date Trade Time Value Date Operation Quantity Security Price

9.3.4 TRADE ENRICHMENT


The process of trade enrichment involves the selection, calculation and attachment to a trade of relevant information necessary for efficiently servicing the clients. The trade components, which require enrichment, are: Calculation of cash value: The cash value calculation is done keeping the trade components in consideration. Counter party Trade confirmation requirement: The trade details needs to be enriched to determine if the counter party needs the trade confirmation and if at all it needs the trade confirmation, the format in which the confirmation would be send across to them. Selection of custodian details: The client might have multiple accounts with multiple or single custodian. The investor would send the custodian details at which the settlement would take place. The trade details are enriched with the account number of the custodian, which will handle the cash/ securities settlement. Method of Transaction reporting: The transaction reporting depends upon the security group as well as the country in which the transaction has occurred. For e.g. the UK equities may require one method of reporting whereas the international bonds would require another method.

9.3.5 TRADE VALIDATION


Trade validation is a process of checking the data contained in the fully enriched trade, in order to reduce the possibility of erroneous information being sent to the client (in case of institutional client) also the wrong trade related information can lead to delay in the settlement or even in settlement failure. The basic trade related information that are validated are following: Trade Date Trade Time Value Date Operation

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Quantity Security Price Trade Cash Value Methods of Trade Validation: The validation of trade can be effected manually or automatically according to the availability of the system. Manual Trade Validation Automatic Trade Validation

9.3.6 TRADE CLEARING


Clearing process signifies the execution of individual obligations with respect to a buyer and seller. Once the terms of a securities transaction have been confirmed, the respective obligations of the buyer and seller are established and agreed. This process is known as clearance and determines exactly what the counter parties to the trade expect to receive. Clearance is a service normally provided by a Clearing Corporation (CC).

Clearance can be carried out on a gross or net basis. When clearance is carried out on a gross basis, the respective obligations of the buyer and seller are calculated individually on a trade-bytrade basis. When clearance is carried out on a net basis, the mutual obligations of the buyer and seller are offset yielding a single obligation between the two counter parties. Accordingly, clearance on a net basis reduces substantially the number of securities/payment transfers that require to be made between the buyer and seller and limits the credit-risk exposure of both counter parties.

9.3.7 NETTING PROCESS


The Settlement process for the securities is expensive as moving securities and money involves costs. Since a given trader may engage in dozens or even hundreds of trades each day, these costs soon add up. One way to reduce these costs is through netting. If A sells 100 Microsoft shares to B on the expectation that the price of the Microsoft shares may fall from 80 to 60 in one hour. After one hour the price does fall to 60 and A decides to buy the same amount of Microsoft shares. By coincidence A buys the shares from B. Now instead of executing both these trades individually, both A & B can save a lot on transaction costs if the two transactions are netted and then executed. In that case B needs to pay 100*(80-60) = $2000 to A. B needs to pay only this amount and no shares transfer takes place. Continuous Net Settlement The Continuous Net Settlement (CNS) System is an automated book-entry accounting system that centralizes the settlement of compared security transactions and maintains an orderly flow

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of security and money balances. Throughout the CNS processing cycles, the system generates reports that provide participants with a complete record of security and money movements and related information. CNS provides clearance for equities, corporate bonds, Unit Investment Trusts and municipal bonds that are eligible at The Depository Trust Company (DTC). DTC is an institution that provides depository services in US. Clearing Process The process of clearing is explained in the following example: A deal is struck between A and B on Monday. That night the back-office personnel of A and B each send electronic notification of the trade to the computer of the National Securities Clearing Corporation (NSCC). The NSCC computer checks the two confirms against each other. If they match, the trade is compared. NSCC confirms to both A and B on Tuesday morning, with instructions for settlement the same Thursday. If the trade does not compare, both A and B are notified for sorting things out and resubmitting the trade before the settlement date. On Wednesday, the day before the settlement, NSCC interposes itself between the two parties to the transaction. That is, instead of the original deal between A and B, there are now two deals one between A and NSCC and the other between NSCC and B. Now, A has a deal to sell 10,000 shares of GE to NSCC at 80, and B has a deal to buy them from NSCC at the same price. A receives a notice to deliver the shares to NSCC; B receives a notice to make payment. By interposing itself in this way, NSCC is guaranteeing settlement to both A and B. Whether or not B pays up, A will get the money on time. Whether or not A delivers the shares, B will get 10,000 shares of GE on Thursday. The automated comparison is an important function of the clearing corporation because it enables the participant to ensure that the trade details agree with those of counter party prior to settlement.

9.3.8 TRADE AFFIRMATION/CONFIRMATION


The trade affirmation/confirmation process occurs when a depository forwards the selling brokers confirmation of the transaction to the buyers custodian. The custodian reviews the trade instructions from the depository and matches the information to instructions for the trade received from its customer. If the instructions match, the custodian affirms the trade. If the instructions do not match, then the custodian will DK (dont know, or reject) the trade or will instruct the selling broker how to handle the mismatch. The affirmation/confirmation process is generally completed by T+1 in a normal T+3 settlement cycle. On day T+2, depositories send settlement instructions to the custodian bank after affirmation and prior to settlement date. The instructions contain the details of the trade that has been affirmed and agreed to by the parties in the trade. Custodians will match the settlement instructions to their records and prepare instructions to send funds or expect funds from the depository on T+3 of the settlement cycle.

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The following media is used for the transmission of trade confirmation/affirmation Fax: Telex S.W.I.F.T e-mail Paper

9.3.9 TRADE SETTLEMENT FAILURE


Trade settlement is the act of buyer and seller exchanging securities and cash on or after the value date in accordance to the contractual agreement. Settlement is successful when the seller is able to deliver the securities and buyer is able to pay the cash it owns to the seller. In some cases the settlement fails primarily because the seller was awaiting the delivery of securities from its purchase and therefore could not deliver the securities to the buyer. It is mandatory now days to settle trade on the value date and whenever there is a settlement failure the authority imposes penalties to the party concerned. Causes of Settlement Failure NonMatching settlement instruction Insufficient Securities Insufficient Cash

9.3.10 TRADE SETTLEMENT


Trade settlement is the act of buyer and seller exchanging securities and cash on or after the value date in accordance to the contractual agreement. Settlement is successful when the seller is able to deliver the securities and buyer is able to pay the cash it owns to the seller. There are different settlement methods depending upon the payment mechanism, security types etc. In most of the markets the settlement is done on a rolling basis. In a Rolling Settlement, all trades outstanding at end of the day have to be settled, which means that the buyer has to make payments for securities purchased and seller has to deliver the securities sold. For instance, USA and UK follow a T+3 systems which means that a transaction entered into on Day 1 has to be settled on the Day 1 + 3 working days, when funds pay in or securities pay out takes place. SETTLEMENT TYPES

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The settlement process has evolved over the period. Traditionally the settlement used to take place with the physical delivery of the shares, but with advent of Certificate Immobilization the Book Entry settlement system has evolved.

Physical Settlement Book Entry Settlement SETTLEMENT PERIOD The settlement period is the time between the execution of the trade and the settlement of trade. It is time allowed before the securities sold must be delivered to the buyer. The settlement periods depend upon the type of the securities traded. Appendix C has the list of the settlement period for different types of security. SETTLEMENT PROCESS Trade settlement occurs when securities and money are exchanged to complete the trade. Settlement occurs on T+3 in a T+3 settlement cycle. Settlement of a securities transaction involves the delivery of the securities and the payment of funds between the buyer and seller. The payment of funds is effected in the settlement system via a banking/payments system. A depository typically carries out the delivery of securities. A trade is not declared settled until both (funds and securities) transfers are final. Trade Accounting & Reconciliation Trade accounting and Reconciliation is the internal control process used by custodians to manage trade transactions. In this process, the custodian determines that the customers account has the necessary securities on hand to deliver for sales, that the customers account has adequate cash or forecasted cash for purchases. It maintains the records of trades internally and tries to match it with outside world. It tries to match the positions by comparing positions of trades (Open and settled both). Risks associated with Trading & Settlement There are multiple risk associated with the trade execution process .The following example discusses the risk associated with the trading process from the point of view of a broker associated with an exchange. Broker A, on the floor of the Stock Exchange, has just agreed with broker B, to sell him 10,000 shares of GE at 80. To execute this transaction, the ownership of the shares needs to be transferred to B, and B needs to transfer the cash to A. In reality, once A and B agree on the terms, execution is handed over to others in the back office. The length of the process varies from market to market. Principal Risk Replacement Risk

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Liquidity Risk Operational Risk Systemic Risk

9.3.11 WORK FLOWS OF TRADING AND SETTLEMENT


The following example discusses how a typical equity trade takes place:

Trade Date (T): Step 1: The transaction begins with the investor wishing to invest in equity. He contacts his broker (buy side) with an order to buy and similarly an investor contacts his broker (sell side) to sell the securities. Step 2: The brokers place trade request on the exchange. Step 3: The trade execution takes place in the exchange as per the conditions specified in the order. The exchange prepares a NOE (Notice of Execution) and sends out to the Brokers and the clearing corporation.

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Step 4: The clearing corporation receives the matched instruction i.e. the trade details (quantity, price etc) from the exchange. The trade details are entered into the Continuous net settlement system to obtain the net positions for a broker at the end of the day. The clearing corporation prepares a contract sheet with end of day positions for broker and sends it across to the depository. Step 5: The Brokers sends a confirmation to the client about the trade details and the clients in turn inform their custodians about the receipt/delivery of shares.

Trade Date +1/2 (T+1/2) Step 1: The broker receives trade details from the clearing corporation and it enriches it with the fees, commission and other tax related details and send across the confirmation to the client. Step 2: The client prepares an Affirmation order and sends it across to the custodians about the possible pay in/out of securities and funds. Step 3: The clearing corporation prepares a final pay in/pay out details based on the affirmation received from the client and send it across to the depository.

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Step 4: The custodians also confirm with the depository about the pay in/ pay out details about the funds and securities.

Trade date + 3(T+3)

Step 1: Pay In of securities: Clearing corporation advises depository to debit account of sell side custodian and credit its account and the depository does it Step 2:Pay in of funds (Clearing corporation advises clearing banks to debit account of buy side custodian and credit its account and the clearing bank does it) Step 3:Pay Out of securities (Clearing corporation advises depository to credit account of buy side custodian and debit its account and depository does it) Step 4: Pay Out of funds (Clearing corporation advises clearing banks to credit account of sell side custodian and debit its account and clearing banks does it) Step 5: The custodian 1 confirms the receipt of shares to the buying client.

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Step 6: The custodian 2 confirms the delivery of shares to the selling client.

9.4

ASSET SERVICING

Asset servicing is a core ongoing service provided by custodians. This service includes collecting dividends and interest payments, processing corporate actions and applying for tax relief from foreign governments on behalf of customers.

9.4.1 CORPORATE ACTIONS


A corporate action is an event related to capital reorganization or restructure affecting a shareholder. Custodians are responsible for monitoring corporate actions for the securities they hold under custody. Once the Custodian gets notified of a corporate action, it identifies the accounts that hold the security. If the account holder has a specified time to decide whether to accept the corporate action, the customer should be promptly contacted. The custodians have a process to monitor the corporate action to ensure that the customer has given a complete response by the due date. When a customers instructions are received, the custodian sends the instructions to the company for execution. The custodian monitors the status of the action to ensure timely settlement. The custodians procedures for corporate actions also include documentation of all customer directions. Business Process of Corporate Action Processing Receiving Corporate Action: The information regarding the corporate action is received from a number of external sources. As the same corporate action data is supplied by many different sources, a hierarchy of sources is maintained to prioritize the obtained data. Maintaining Corporate Action: The Corporate actions are classified as either mandatory or voluntary Mandatory Actions It is a type of corporate action wherewith the shareholders are not given the option to conditionalize their tender. e.g. stock splits, mergers and acquisitions, liquidations, bankruptcies, reorganizations, redemptions, bonus issues etc Voluntary action It is a type of corporate action wherewith the shareholders are given the option to conditionalize their tender. They include rights offers, tender offer, purchase order, exchange order etc. Notification of Corporate Action: The notification is generated for the client of Voluntary and Mandatory Corporate Actions. The notification process ensures that the client receives the information of the corporate action. Maintaining Response of Corporate Action: The corporate action response is maintained for voluntary corporate action responses against expiration dates on a daily basis until the client responds with instructions.

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Processing of Corporate Action :In this stage the Processing of corporate action is done to update the records of the banks. As per the feedback received from the client in case of voluntary actions, the records for the client are updated in the records of the banks. A similar method is followed for the mandatory types of corporate action.

9.4.2 INCOME PROCESSING


Custodians are responsible for collecting income payments received from the assets held under custody. The income payments typically take the form of dividends on equity securities and interest on bonds and cash equivalents. Custodians calculate the projected payments and inform the customers accordingly in advance. This enables the customers to plan investment decisions and use the proceeds effectively. The banks internal controls for income collection also include an income map procedure that details each clients expected income from a particular security. Contractual income payments are posted to the customers account on the date they are due rather than the date they are received by the custodian whereas the actual income payments are posted to the customers account on the date they are received by the custodian Business process of Income Processing Receiving Corporate Announcement: The custodians are dependent on external vendors to receive corporate action information. These vendors are specialized in providing information across the globe. Some of the common vendor feeds used are from JJ Kenny, DTC, Telekurs, and Reuters etc. The information collected is announcements regarding interest (coupon) payments for registered bonds, dividend payment for equities, income payment for ADR securities, mutual funds, private placement securities etc. Generating Payment Obligation: A payment obligation is liability owned by a client. The payment obligation for a client is generated from the data regarding the corporate announcement. The payment obligation is generated for the pending payments that are due to the client. Also the cash projection for the client depending upon corporate announcements is calculated. Account Maintenance: Details regarding the trade are tracked and the corresponding account is updated. The trade details are maintained and the details regarding the transaction are captured and recorded. Payment Settlement: The payment settlement stage encompasses entire process of Payment receipt, payment reconciliation, and payment reversal

9.4.3 PROXY VOTING


Custodians provide proxy-voting service to clients who want to exercise their rights as shareholders of a company during the general meetings. If personal attendance is not possible, the shareholder may appoint a representative to attend the meeting and vote by proxy. A

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custodian helps investor to exercise their votes by providing a proxy voting service for all manner of general meetings wherever this service is available. Business Process Involved in Proxy Services Receiving Corporate Announcement: The corporate announcement regarding the agenda of General Body Meeting or Extraordinary General Body Meeting is captured from external vendors. Notification to Client: The custodians notify the clients about the proxy services by providing the details of the corporate announcement. Maintaining Response of Client: The clients response to the corporate announcement is maintained on a daily basis until the client responds with instructions. The client response is typically obtained from either email, fax etc. The response is typically like receiving client authorization to represent him at the meeting and vote on his behalf.

9.4.4 TAX PROCESSING


Custodians provide services to minimize foreign withholding taxes or reclaim taxes withheld for their customers. The tax treaties between countries often reduce withholding taxes and exempt capital gains from taxes. The purpose of tax treaties is to reduce the possibility of double taxation on income earned in foreign countries. In addition, some countries provide reduced tax withholding rates for certain types of investments (government bonds, for example) or for certain types of investors (investors exempt from taxation in their home country, for example). Tax treaty benefits may provide for reduced withholding tax at the time the interest or dividend is paid (relief at source), while other treaties may require the investor to file for a refund after the fact (reclaim). Custodian files a form or statement on behalf of the client, certifying the investors tax status and country of residence for tax purposes. A custodian keeps track of the tax rates for each of the countries in which it provides custody. Dividends, interest, and capital gains may all be taxed at different rates. The custodian also maintains information about the tax treaties within its custody network, and whether its customers qualify for relief under the treaty. Business Process of Tax Handling Maintaining Tax Information: The tax related information like standard tax rates, exemptions and reductions available under local law are maintained. The details specifying the reduced rates available by virtue of double taxation treaties are made available to the client. The market tax reports, summarizing local taxes for each market are provided to the client. Tax Calculation: The tax calculation process captures trade details and applies the corresponding tax rates for computation of the tax. Tax Reclamation: The tax reclamation process is used to reclaim the extra tax paid by the client. It can be of two types:

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Contractual Tax Reclaims: In this kind of reclamation the client's cash account is credited with entitlements to tax relief according to a pre-determined schedule of time-frames, in place of when the tax refund monies are received. The contractual time frame may be n months after the income pay date (where the value of n varies according to the market concerned) or payment may be made, less a discount, with income payment. This can greatly assist clients in managing available funds. Non-contractual Tax Reclaims: In this type where tax relief is not obtained at source, the excess tax withholding is reclaimed. The bank prepares the required reclaim form and completes the associated reclaim process, pursuing items as appropriate and reporting their status to clients.

9.4.5 CASH SWEEP


Cash sweep is a value added service provided by custodian banks to its customers. This service ensures that the surplus cash in customers accounts are effectively invested in short-term investment funds i.e. STIF (may be as short as an overnight fund) to generate additional returns. The sweep can be done intra-day based on projected earnings of the particular account or endof-day based on actual surplus cash in the account. The STIFs invest money in money market or euro dollar Deposit.

9.4.6 RISKS ASSOCIATED WITH CUSTODY SERVICES


Many banks currently offer custodian services. The primary risks associated with custody services are: transaction, compliance, credit strategic and reputation. Transaction Risk Compliance Risk Credit Risk Strategic Risk Reputation Risk

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10.0 CLEARING AND SETTLEMENT


10.1 TRADING 10.1.1 WHAT IS AN EXCHANGE?

An exchange is a regulated market place, where buyers and sellers come together to exchange what they want. Finding a buyer or seller for a trade by oneself will be difficult and expensive. The exchange facilitates the process of buying and selling. Thus, like any other market, exchanges reduce transaction cost and provide liquidity. In simple terms, if one wants to buy/sell something, he/she can place an order with an exchange. Exchange receives buy/sell orders from multiple parties and tries to match them, based on the price quoted and quantity available/desired. If exchange is able to find counterparty for his/her trade, it will bring together both the parties for transaction to happen. Examples: Stock Exchanges: NYSE, AMEX We have different exchanges that deal with different asset types (stocks, commodities, futures, etc.).

10.1.2

OVER THE COUNTER MARKET

Over The Counter (OTC) market is different from the exchanges in the sense that there is no single physical location for members, and members (generally called market makers in OTC markets) negotiate price to finalize deals rather than use any auction mechanism to derive prices. In OTC markets, traders/dealers negotiate with each other through computer networks or simply over the phone to strike deals. So traders/dealers assume the responsibility of exchanges too, to find counter-party for a trade. NASDAQ is a good example of OTC market. Certain other asset types trade in markets that are typically not regulated (e.g., currencies).

10.1.3

HOW DOES A TYPICAL TRADE CYCLE LOOK?

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Decision to trade Security/Fund Transfer Market Participants (e.g. Exchange, Brokers/Dealers, Custodians, Depositories, Clearing Corporation etc) Place an Order

Settlement of Trades

Trade Matching

Clearing of Trades

Trade Execution

Based on the market news, risk analysis and investment philosophy, a customer decides to place an order to buy 100 IBM shares at the market price. Customer calls his broker (or goes to the online trading interface provided by the broker), and places the order with the broker dealer. Broker dealer in turn forwards the order to an exchange. Exchange gets multiple orders from different broker dealers. They maintain all the orders in an order book and use a matching system to find counter-party for an order. In this case, this order lies in the order book of the exchange until someone places a Sell order for 100 IBM shares (please note that even partial fill is possible, in case somebody places an order to sell 50 shares). At this point in time, exchange finds a match between two trades. Exchange matches these two orders to register a trade and informs the trade details to all the associated parties. At the end of the day, obligation for each participant is determined by the exchange and communicated to each participant. As per the settlement cycle, broker dealer provide the funds or security to the clearing house by a particular date and time. Clearinghouse transfers the security and funds to the appropriate party.

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10.2 CLEARING
Clearing in the securities business is the process that occurs between trading and settlement, involving the balancing of positions between the different parties to establish agreement on what each party is due, prior to the establishment of final positions for settlement. Once a trade is executed, the next step is to ensure that the counterparties to the trade (the buyer and the seller) agree on the terms of the transaction - the security involved, the price, the amount to be exchanged, the settlement date and the counterparty. This step is referred to in some markets as trade matching and in others as trade comparison or checking. In automated trade execution systems counterparties often agree that trades will settle as recorded at the time of execution unless both agree to a cancellation. Such trades are referred to as locked-in trades. In other trade execution systems, Matching is typically performed by an exchange, a clearing corporation or trade association, or by the settlement system. Direct market participants may execute trades not only for their own accounts but also for the accounts of customers, including institutional investors and retail investors. In this case, the direct market participant may be required to notify its customer (or its agent) of the details of the trade and allow the customer to positively affirm the details, a process referred to as trade confirmation or affirmation. Trade matching and confirmation set the stage for trade clearance, that is, for the computation of the obligations of the counterparties to make deliveries or payments on the settlement date. The obligations arising from securities trades are sometimes subject to netting. Multilateral netting arrangements, for example, include position netting schemes as well as systems that involve substitution of a central counterparty and novation of trades with that central counterparty. What are the benefits of Netting? Settlement on net basis reduces the number of transactions to be settled drastically reducing the overall transaction cost for everyone. As per an estimate, netting reduces the number of settlements needed by more than 95%. Role of Clearinghouses We understand that there are two parties to a trade, one who buys something and the other one who sells something. Now imagine a situation where one party (who had to deliver securities) defaults on its obligation, what impact would it have on the other party? Other party would not like to suffer because of this, as its the exchange that found a match. So clearing house comes into the picture. To mitigate any counter-party risk (risk that a party involved in the trading doesnt meet its commitment), clearing house positions itself as the counter-party for both the legs of the trade. Thus, buyer buys it from the clearinghouse and seller sells it to clearing house. This way buyer and seller both are shielded from any counter-party risk, as clearing house stands to meet its commitment to a trading party irrespective of whether the other party meets its commitment or not.

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This process of transferring obligation from one party to the other is also known as Novation. Lets look at the following example of stock trades. Following table captures the activity of a broker on a particular day at NYSE.
Time 10:00 10:30 11:00 11:30 12:00 3:30 Buy/Sell Buy Sell Buy Sell Sell Sell Quantity 100 50 100 20 10 30 Sock IBM IBM MSFT IBM MSFT IBM Price $10.00 $10.50 $20.00 $11.00 $20.50 $9.00

Broker has completed 6 transactions on that particular date but exchange would not settle these transactions individually and would apply the concept of netting to determine the obligation of broker. Deals executed during a particular trading period (in this case one trading day) are netted at the end of that trading period and settlement obligations are computed. In the example above: Net position for IBM: +100 50-20-30 = 0 Net position for MSFT: +100 10 = 90 So broker would not receive any IBM shares from the exchange as he sold all the shares that he bought during the day. But exchange will need to deliver 90 MSFT shares to the broker. This was what exchange owes to broker. Now lets look at what broker owes to exchange: Buy/Sell Buy Sell Buy Quantity 100 50 100 Price $10.00 $10.50 $20.00 Amount ($1,000.00) $525.00 ($2,000.00)

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Sell Sell Sell Total

20 10 30

$11.00 $20.50 $9.00

$220.00 $205.00 $270.00 ($1,780.00)

So the broker has to pay $1780 only and he gets 90 MSFT shares from the exchange. It is important to understand that netting across stocks is not possible, similarly netting across different market (for examples trades executed at NASDAQ and NYSE) is not possible. Each market would have its own rule to determine the period, for which transactions need to be netted. This concept of clearing based on netting is true for most financial transactions, and the case of stock exchange has been taken just as an illustrative example. Even when one submits a check issued by ICICI Bank in his/her HDFC bank account, it means that ICICI pays money to HDFC bank, which in turn deposits the money in his/her HDFC bank account. But HDFC and ICICI have millions of bank holders and so it doesnt make sense to settle the individual transactions, instead ICICI would aggregate (for different customers) its entire obligation to different banks and then reduce it by amount that ICICI has to get from these banks and only the net amount would be settled by the banks. Clearing house facilitates the whole process. It is worth understanding that, we have some markets where settlement happens on a gross basis, meaning no netting is done and all the transactions need to be settled individually. This is prevalent in Fixed Income markets in the US and the settlement mechanism is known as Real Time Gross Settlement (RTGS).

10.3 SETTLEMENT
Settlement is the legal transfer of title, normally by exchanging a security against money or assets. Depending on the system, there are several ways of paying. Delivery versus payment (DVP) the simultaneous exchange of cash and securities and delivery free of payment (FOP) delivery of securities without payment of funds are some of the more common. The typical actor carrying out settlement is a Central Securities Depository (CSD). The concept of a securities settlement system is generally defined in a wide sense to embrace the full set of institutional arrangements in the settlement process, i.e. confirmation of terms for securities trading, clearance/clearing of transactions and determination of rights and obligations, settlement and custody/safekeeping of securities. In a narrower sense, settlement is defined as the completion and finalization of a transaction through final transfer of securities

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and funds (payment) between buyer and seller. The interaction of these elements is illustrated in more detail in Figure 1.

10.3.1 SETTLEMENT CYCLE


Most markets have the concept of a Settlement Cycle. The cycle starts immediately after the trade execution. The length of the cycle determines the level of efficiency in the post trade process and consequently the entire Trade life cycle in the country in question. Markets are said to be efficient when the gap between the Trade Date and Settlement Date is as close as possible. Account Period Settlement In an account period settlement cycle the Trading occurs for a period of time (number of days). All the trades done during this period are aggregated as at the end of the predefined number of days, netted and settled. For example trading may occur from Monday through Friday, All the trades done till Friday from Monday may be netted on the following Monday and settled on the following Friday. Rolling Settlement In this type of settlement every Trading Day is considered separately. Trades are not aggregated for a period of time as is the case with Account Period Settlement. Thus every Trade Date will have a corresponding Settlement Date. Trades done on a given date are netted and settled on

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the Settlement Date. Thus for instance a T+3 Rolling Settlement would indicate that for Trades done on day T the settlement would occur on Day T+3 Once the obligations of the market participants have been calculated, whether on a gross basis or on a net basis, the instructions to transfer the securities and funds (monies) necessary to discharge the obligations are transmitted to the entity or entities that operate the settlement system. These instructions may be prepared by the counterparties themselves or by an exchange or clearing system. If trades have not previously been matched, the settlement system would typically perform this function before initiating processing of the transfer instructions. Other action may be required of participants before settlement can proceed, such as the prepositioning of securities, funds or collateral. Settlement of a securities trade involves the transfer of the securities from the seller to the buyer and the transfer of funds from the buyer to the seller. Historically, securities transfers involved the physical movement of certificates. However in recent years, securities transfers have increasingly occurred by book-entry. This has been possible due to establishment of central securities depositories that provide a facility for holding securities in either a certificated or an uncertificated (dematerialized) form and permit the transfer of these holdings through book entry. A central securities depository may also offer funds accounts and permits funds transfers as a means of payment, or funds transfers. Often a transfer that has been executed by such Settlement Systems, in the sense that books have been debited and credited, is a provisional transfer, that is, a conditional transfer in whom one or more parties retain the right by law or agreement to rescind the transfer. If the transfer can be rescinded by the sender of the instruction (the seller of the security or the payer of money), the transfer is said to be revocable. Even if the transfer is an irrevocable transfer, some other party (often the system operator) may have authority to rescind it, in which case it would still be considered provisional. Not until a later stage does the transfer become a final transfer, that is, an irrevocable and unconditional transfer that affects a discharge of the obligation to make the transfer. Only the final transfer of a security by the seller to the buyer constitutes delivery, while only final transfer of funds from the buyer to the seller constitutes payment. When delivery and payment have occurred, the settlement process is completed.

What do T+1, T+2 and T+3 mean?


Whenever one buy or sell a stock, bond or mutual fund, there are two important dates of which one should always be aware of: the transaction date and the settlement date. The abbreviations T+1, T+2, and T+3 refer to the settlement date of security transactions and denote that the settlement occurs on a transaction date plus one day, plus two days, and plus three days. As its name implies, the transaction date represents the date on which the transaction occurs. For instance, if one buys 100 shares of a stock today, then today is the transaction date. This date doesn't change whatsoever as it will always be the date on which one made the transaction.

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However, the settlement date is a little trickier because it refers to the date on which ownership of the security is actually transferred and money is exchanged between buyer and seller. Now, it's important to understand that this doesn't always occur on the transaction date and varies depending on the type of security with which one is dealing. Treasury bills are about the only security that can be transacted and settled on the same day. What's the reason behind this delay in actual settlement? In the past, security transactions were done manually rather than electronically. Investors would have to wait for the delivery of a particular security, which was in actual certificate form and would not pay until reception. Since delivery times could vary and prices could fluctuate, market regulators set a period of time in which securities and cash must be delivered. Some years ago, the settlement date for stocks was T+5, or five business days after the transaction date. Today it's T+3, or three business days after the transaction date in US and T+ 2 in India.

10.3.2

DELIVERY VERSUS PAYMENT (DVP) PRINCIPLE

DVP is an important characteristic of efficient settlement systems. The goal of DVP is achieve a simultaneous exchange of securities and payment. High quality of payments must be received by the clearing and settlement organization. Certainty, finality, irrevocability and unconditionality are the characteristics of high quality payments. By far the largest source of credit risk in securities settlement and, therefore, the most likely source of systemic risk is the principal risk that may arise on the settlement date. Such principal risk can be eliminated if the securities settlement system adheres to the principle of delivery versus payment (DVP), that is, if it creates a mechanism that ensures that delivery occurs if and only if payment occurs. Furthermore, by eliminating concerns about principal risk, DVP reduces the likelihood that participants will withhold deliveries or payments when financial markets are under stress, thereby reducing liquidity risk. However, not all securities settlement arrangements currently achieve DVP. In some cases the linkage that exists between delivery and payment is, nonetheless, sufficiently strong to make a loss of principal by a participant seem a remote possibility. But in other cases book-entry securities transfer systems have been created that neither provide, nor are linked to, a money transfer system.

10.3.3 THE INSTITUTIONAL ARRANGEMENTS FOR SECURITIES SETTLEMENT SYSTEMS


Several institutions may be involved in the process of securities settlement. Most markets have established central securities depositories (CSDs) which dematerializes physical securities and transfer ownership by means of book entries to electronic accounting systems. However, other institutions often perform additional critical functions in the settlement process. Confirmation of trade is usually carried out by a stock exchange rather than by the CSD. In some markets, a central counterparty (CCP) interposes itself between buyers and sellers. The CCP thus becomes the buyer to every seller and the seller to every buyer. Accounts at the respective central bank

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or at one or more private commercial banks are used for settlements and transfers of funds. Funds may nevertheless be transferred through internal accounts at the CSD. Securities can be held at accounts at the CSD or through a custodian. The custodian may hold the securities of its customer through a sub custodian.

The whole Clearing & Settlement process and other Post Trade Activities have been captured in the diagram below:

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SUMMARY The process of clearing and settling a securities trade includes several key steps: o Confirmation of the terms of the trade by the direct market participants o Calculation of the obligations of the counterparties resulting from the confirmation process, known as clearance; o Final transfer of securities (delivery) in exchange for final transfer of funds (payment) in order to settle the obligations. The process begins with the execution of the trade. Once a trade is executed, the next step is to ensure that the counterparties to the trade (the buyer and the seller) agree on the terms of the transaction - the security involved, the price, the amount to be exchanged, the settlement date and the counterparty. This step is referred to in some markets as trade matching and in others as trade comparison or checking Trade matching and confirmation set the stage for trade clearance, that is, for the computation of the obligations of the counterparties to make deliveries or payments on the settlement date. The obligations arising from securities trades are sometimes subject to netting. Once the obligations of the market participants have been calculated, whether on a gross basis or on a net basis, the instructions to transfer the securities and funds (monies) necessary to discharge the obligations are transmitted to the entity or entities that operate the settlement system. Settlement of a securities trade involves the transfer of the securities from the seller to the buyer and the transfer of funds from the buyer to the seller. Only the final transfer of a security by the seller to the buyer constitutes delivery, while only final transfer of funds from the buyer to the seller constitutes payment. When delivery and payment have occurred, the settlement process is completed.

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11.0 RISK MANAGEMENT


11.1 CONCEPT OF RISK
Risk is the degree of uncertainty associated with an action, such as project implementation within time and budget, profitability of a project, market returns on an investment etc.,. Its an exposure to uncertain future outcome, i.e. risk is the chance that the actual outcome will be different from the expected. Risk is directly proportional to level of uncertainty. Higher the uncertainty, higher is the risk. The risk of an investment is equivalent to the distribution of potential outcomes, where the distribution consists of all possible outcomes weighted by their relative probability of occurrence. The more extreme the distribution of outcomes, the riskier the project. Two projects could have the same expected return (the weighted average of all possible outcomes) but differ in their risk, if one project had a broader range of outcomes or a higher probability of extreme outcomes than the other. Risk is often the single largest factor determining the rate of return that an activity will provide. Annualized standard deviation of return is the generic measurement of risk in most markets, but asset and liability managers also look at the entire probability distribution of returns and the maximum cost of adverse developments to assess the risk. Financial Institutions need to manage different kinds of risks, with seemingly opposing needs. For example - providing liquidity to the depositors on demand as well as credits to its borrowers with the ultimate objective to maximize returns.

11.1.1 THE RISK REWARD PRINCIPLE


The higher the risk, the higher is the potential reward and the lower the risk, the lower is the potential reward. The lower the credit rating of the borrower, the higher is the risk of lending money but higher also is the interest rate that can be charged! Note that the word used here is potential reward. There is no set formula to say how much reward will justify a certain amount of risk. Also, sometimes the reward may depend upon the persons or the organizations ability to take advantage. However, the risk-reward principle should be the guiding principle while deciding on a risk management strategy.

11.2 TYPES OF RISK


With respect to the financial institutions, risk can be classified into the following types Operational Risk Credit Risk

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Market Risk Interest Rate Risk Currency Risk Equity Risk Commodity Risk

Liquidity risk Legal Risk

11.2.1 OPERATIONAL RISK


Operational risk can be defined as the exposure to potential monetary losses resulting from inadequate or failed people, systems and internal processes or from external events. As the name implies, internal operational risk arises primarily from day to day operations and transactions of a financial institution. The most important challenge in Operational risk is to identify the risks and evolve procedures for managing the same. Managing operational risk involves identifying causes for risk, adopting a formalized approach to monitor and control risk and managing loss data. The identification and measurement of operational risk is a real and live issue for modern-day banks, particularly since the decision by the Basel Committee on Banking Supervision (BCBS) to introduce a capital charge for this risk as part of the new capital adequacy framework (Basel II).

11.2.2 CREDIT RISK


Credit risk is the risk due to uncertainty in counterpartys (also called an obligor or creditor's) ability to meet its obligations. The term obligation refers to making debt payments on a timely basis. The failure to make these payments is called default. For this reason, credit risk is also known as default risk. The payments can themselves be classified into two broad groups: Principal: This is the amount borrowed by the counterparty, or that part of the amount borrowed which remains unpaid. Interest: This is the fee charged by the lender to the borrower for the use of the borrowed money. Credit risk can be experienced by both companies as well as individuals. Example - Companies carry credit risk when, for example, they do not demand up-front cash payment for products or services. By delivering the product or service first and billing the customer later, the company is carrying a risk between the delivery and payment.

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11.2.3 MARKET RISK


Different types of Market risk are INTEREST RATE RISK Interest rate risk captures the exposure of an institution or an individuals financial condition to adverse movements in interest rates. It captures the potential actual and notional monetary losses arising from assets and liabilities due to changes in interest rates. Interest rate risk is associated with fixed interest securities like bonds, whose prices drops as interest rates rise. Financial Institutions face interest rate risk in their deposit taking and lending process - the risk that spread income will suffer because of a change in interest rates. Interest rate risk can be faced by both companies as well as individuals. Example When the inflation runs high, the central bank of the country will usually tighten the grip on money supply by increasing the lending interest rates. Say a person had taken a home loan under normal inflation scenario in the economy. After 1 year, inflation has considerably increased and the central bank decides to intervene and pull inflation back to normal. One of the measures it can adopt is to increase its lending rates to the banks. In turn the banks will increase their lending rates. This will finally affect the person who has taken the floating rate home loan because, due to the increase in the loan interest rate, now he has to pay an increased sum of money as interest. This explains the fact that the person is exposed to interest rate risk. CURRENCY RISK Currency Risk captures the potential losses arising from unanticipated exchange rate changes. Financial institutions face currency risk mainly due to foreign exchange positions taken on behalf of clients and indirect exposure as a result of conducting business with companies exposed to currency risk. Exchange risk can also be defined as a potential gain or loss that occurs as a result of an exchange rate change. Example, if an individual owns a share in Hitachi, the Japanese company, he or she will lose if the value of the yen drops. EQUITY RISK Equity Risk is the risk arising due to volatility in a stock price. The level of volatility of the investment is directly proportional to the potential gains (and losses). Companies or Individuals face equity risk due to holding equity shares for trading or investment purposes. Equity risk premium is the excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are

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compensated COMMODITY RISK

with

higher

premium.

Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. Different types of commodity risks are Price risk, Quantity risk, Cost risk and Political risk. The following entities can face Commodity risk Producers (farmers, plantation companies, and mining companies) face price risk, cost risk on the prices of their inputs and quantity risk Buyers (cooperatives, commercial traders and trait ants) face price risk between the time of up-country purchase buying and sale, typically at the port, to an exporter. Exporters face the same risk between purchase at the port and sale in the destination market; and may also face political risks with regard to export licenses or foreign exchange conversion. Governments face price and quantity risk with regard to tax revenues, particularly where tax rates rise as commodity prices rise or if support or other payments depend on the level of commodity prices. LIQUIDITY RISK Liquidity risk is the inability to meet financial commitments, as they fall due, through ongoing cash flow or asset sale at fair market value. It is a financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden, unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. The term liquidity is used in various ways, all relating to availability of, access to, or convertibility into cash. An institution is said to have liquidity if it can easily meet its needs for cash either because it has cash on hand or can otherwise raise or borrow cash. A market is said to be liquid if the instruments it trades can easily be bought or sold in quantity with little impact on market prices. An asset is said to be liquid if the market for that asset is liquid.

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The common theme in all three contexts is cash. A corporation is liquid if it has ready access to cash. A market is liquid if participants can easily convert positions into cashor conversely. An asset is liquid if it can easily be converted to cash. The liquidity of an institution depends on: The institution's short-term need for cash; Cash on hand; Available lines of credit; The liquidity of the institution's assets; The institution's reputation in the marketplacehow willing will counterparty is to transact trades with or lend to the institution. Examples of assets that tend to be liquid include foreign exchange; stocks traded on the New York Stock Exchange or recently issued (on-the-run) Treasury bonds. Assets that are often illiquid include limited partnerships, thinly traded bonds or real estate. LEGAL RISK A Legal Risk can be defined as a potential economical loss deriving from the infringement of a legal norm. The loss can derive from a sanction or the deprival of possible advantages. Infringing behavioral norms may cause pecuniary penalties or tort claims, whereas infringement of norms regarding contracting may lead to unenforceable claims, damages or performance obligations. Infringement of legal norms may also lead to economical loss caused by damaged reputation. The expected loss due to the infringement of a legal norm can be calculated by multiplying the potential loss with the probability of the loss being suffered. Legal risk arises due to uncertainty of legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations.

11.3 RISK MANAGEMENT


Risk management is a central part of any organizations strategic management. It is the process whereby organizations methodically address the risks attaching to their activities with the goal of achieving sustained benefit within each activity and across the portfolio of all activities. The focus of good risk management is the identification and treatment of these risks. Its objective is to add maximum sustainable value to all the activities of the organization. It marshals the understanding of the potential upside and downside of all those factors which can affect the organization. It increases the probability of success, and reduces both the probability of failure and the uncertainty of achieving the organizations overall objectives.

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Risk management should be a continuous and developing process which runs throughout the organizations strategy and the implementation of that strategy. It should address methodically all the risks surrounding the organizations activities past, present and in particular, future. It must be integrated into the culture of the organization with an effective policy and a program led by the most senior management. It must translate the strategy into tactical and operational objectives, assigning responsibility throughout the organization with each manager and employee responsible for the management of risk as part of their job description. It supports accountability, performance measurement and reward, thus promoting operational efficiency at all levels.

11.3.1 RISK MANAGEMENT BASEL 2 NORMS


INTRODUCTION TO BASEL 2 The revised capital adequacy framework, commonly known as Basel II, sets out the details of the agreed Framework for measuring capital adequacy and the minimum standards for adopting more risk-sensitive minimum capital requirements for banking organizations. Basel II builds on the Basel I Accords basic structure by aligning capital requirements more closely to the risk of credit loss and by introducing a new capital charge for operational risk. It is being prepared by the Basel Committee on Banking Supervision, a group of central banks and bank supervisory authorities in the G10 countries, which developed the first standard, Basel I, in 1988. The new framework, Basel II, reinforces the risk-sensitive requirements by laying out principles & guidelines for banks: To assess the adequacy of their capital To review internal risk and capital assessment processes to ensure banks have adequate capital to support their risk profile. To strengthen market discipline by enhancing transparency in banks financial reporting Basel II will apply to all financial services providers in the 110 countries that have signed the new Capital Accord, including security firms and asset managers with operations in banking and Capital markets. EU member states will require all domestic and foreign financial services providers to comply, and the G-10 countries are including it into their regulatory environments in order to meet the Basel II implementation deadline of December 2006. Many of the over 25,000 banks around the world are expected to adopt Basel II as well, in order to maintain their competitiveness. This Framework will apply on a consolidated basis to internationally active banks in order to preserve the integrity of capital in banks with subsidiaries, by eliminating double gearing. The Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group.

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All banking and other relevant financial activities, excluding insurance entities and activities, (both regulated and unregulated) conducted within a group containing an internationally active bank will be captured through consolidation. The Framework will also apply to all internationally active banks at every tier within a banking group, also on a fully consolidated basis. Basel II will impact the entire spectrum of banking, including corporate finance, retail banking, asset management, payments and settlements, commercial banking, trading and sales, retail, brokerage, and agency and custody services. BASEL II THREE PILLARS The underlying principle for the Basel II accord is that safety and soundness in todays dynamic and complex financial system can be attained only by the combination of effective bank-level management, market discipline, and supervision. Basel II is based on three mutually reinforcing pillars viz., Minimum capital requirement, Supervisory review and Market Discipline. The first pillar represents a significant strengthening of the minimum requirements set out in the 1988 Accord, while the second and third pillars represent innovative additions to capital supervision. Minimum capital requirements: Focus is on the banks internal risk assessments and management processes. Basel II improves the capital frameworks sensitivity to the risk of credit losses generally by requiring higher levels of capital for those borrowers thought to present higher levels of credit risk, and vice versa. Three options are available to allow banks and supervisors to choose an approach that seems most appropriate for the sophistication of a banks activities and internal controls. Data must be sufficiently granular and capture historical trends to get a detailed view of risk across the enterprise. It describes the calculation for regulatory capital for credit, operational and market risk. Credit risk regulatory capital requirements are more risk based than the 1988 Accord. An explicit operational risk regulatory capital charge is introduced for the first time while market risk requirements remain the same as in the Current Accord. Supervisory review: Internal risk and capital assessment processes will be evaluated for sound practices. Supervisors will evaluate the activities and risk profiles of individual banks to determine whether those organizations should hold higher levels of capital than the minimum requirements in Pillar 1 would specify and to see whether there is any need for remedial actions. It intended to bridge the gap between regulatory and economic capital requirements and gives supervisors discretion to increase regulatory capital requirements if weaknesses are found in a lender's internal capital assessment process. Market discipline: Enhanced reporting and disclosure requirements on items such as capital structure, risk measurement and management practices, risk profile, and capital adequacy.

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RISK MANAGEMENT AND BASEL II Basel II strengthens the link between regulatory capital and risk management. Under the advanced approaches, in particular, banks will be required to adopt more-formal, quantitative risk-measurement and risk-management procedures and processes. For instance, Basel II establishes standards for data collection and the systematic use of the information collected. These standards are consistent with broader supervisory expectations that high-quality risk management at large complex organizations will depend upon credible data. Enhancements to technological infrastructure--combined with an appropriate database--will, over time, allow firms to better price exposures and measure and manage risk. The emphasis on improved data standards in the revised Accord should not be interpreted solely as a regulatory capital requirement, but rather as a foundation for risk-management practices that will strengthen the value of the banking franchise. Even the best processes for evaluating risk and performance suffer if the data used are flawed. In this broader sense, "data integrity" can refer not only to the consistency, accuracy, and appropriateness of the information in the database and model, but also to the processes that produce and use this information. Used this way, "data integrity" includes quality of credit files, tracking of key customer characteristics, internal processes and controls, and even the training that supports them all. If banks do not create an appropriate environment in which their quantitative risk measures and associated models are used--in other words, if an institution considers internal controls to be just a checklist--risk measures will not provide the performance the bank hopes to achieve. Pillar 2 requires each bank to develop its own viable internal process for assessing capital adequacy that contributes to the determination of the amount of capital actually held. For instance, each institution must correct for Pillar 1 assumptions that may not apply to that particular bank--for example, if the "well diversified" assumption of Basel II is not met by an individual bank because of its geographic or sectoral concentrations. In essence, the bank should determine whether its capital levels are appropriate in light of any deviations from Pillar 1 assumptions. The added transparency in Pillar 3 should also generate improved market discipline for these large organizations, in some cases forcing them to run a better business. Market discipline is not possible if counterparties and rating agencies do not have good information about banks' risk positions and the techniques used to manage those positions. Indeed, market participants play a useful role by requiring banks to hold more capital than implied by minimum regulatory capital requirements--or sometimes their own economic capital models--and by demanding additional disclosures about how risks are being identified, measured, and managed. Greater transparency also offers an opportunity for market participants to monitor banks' progress over time and identify if they are keeping up with the latest techniques.

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11.2.3 RISK MANAGEMENT PROCESS


The four stages of the Risk Process are detailed under this topic, at each stage the key activities and outputs are highlighted together with detail on the techniques and stakeholders involved. The four stages are: Identify - Find, list and characterize elements of Risk. Analyze Measure and Prioritize identified Risks against agreed criteria. Manage Treating risk by developing relevant risk management strategies. IDENTIFY This stage of the iterative process identifies the widest possible range of risks associated with a particular project. Identification includes the preparation of lists of activities, the identification of risks associated with each activity and possible counters to each risk. All stakeholders should be consulted, and external opinions should be sought where appropriate and practical. Also it is important to identify interdependencies between various risks and any consequential risks i.e. those risks associated with mitigations to the primary risks. After risks have been identified they should be validated in terms of both the probable truth of the information as initially elicited about the risk and the accuracy of the description initially built up of the risk's characteristics. ANALYZE Once the risks have been identified, the next step is to choose the quantitative and qualitative measures of those risks. Risk is essentially measured in terms of the following factors: a. The probability of an unfavorable event occurring b. The estimated monetary impact on organization because of the event The unfavorable events differ for different types of risk. For example, in case of market risk, future events refer to market scenarios. These scenarios impact each portfolio prices differently depending on its composition. Risk measurement is a combination of management, quantitative analysis and information technology. Serious technology investment is required for accurate measurement and reporting. One of the commonly used methodologies for market risk is Value At Risk The balance between qualitative and quantitative analysis will vary from project to project and have to be determined by the availability of data and the need to remain cost-effective.

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Credit Risk, Operational Risk and Market Risk are the 3 main risk types as defined by the Basel 2 norms. So it is important to know the measurement techniques adopted for each of these 3 risk types. 1. Market Risk Measurement technique - Value at Risk (VaR) Value at Risk is an estimate of the worst expected loss on a portfolio under normal market conditions over a specific time interval at a given confidence level. It is also a forecast of a given percentile, usually in the lower tail, of the distribution of returns on a portfolio over some period. VaR answers the question: how much one can lose. Another way of expressing this is that VaR is the lowest quantile of the potential losses that can occur within a given portfolio during a specified time period. For an internal risk management model, the typical number is around 5%. Suppose that a portfolio manager has a daily VaR equal to $1 million at 1%. This means that there is only one chance in 100 that a daily loss bigger than $1 million occurs under normal market conditions. Suppose portfolio manager manages a portfolio which consists of a single asset. The return of the asset is normally distributed with annual mean return 10% and annual standard deviation 30%. The value of the portfolio today is $100 million. We want to answer various simple questions about the end-of-year distribution of portfolio value: What is the distribution of the end-of-year portfolio value? What is the probability of a loss of more than $20 million dollars by year end? With 1% probability what is the maximum loss at the end of the year? This is the VaR at 1%. Value-at-Risk (VaR) is an integrated way to deal with different markets and different risks and to combine all of the factors into a single number which is a good indicator of the overall risk level. VaR Calculation A generic step-wise approach to calculate would be to: Get price data for the portfolio holdings. Convert price data in to log return data. (Log Return: ui = ln (Si / Si-1) where Si is the price of the asset on day i) Calculate standard deviations of each instrument or each proxy. Calculate preferred confidence level. 99% = 2.33 * standard deviation. Multiply position holdings by their respective Standard Deviation at a 99% confidence level. This results in a position VaR at a 99% confidence level.

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Example VaR Calculation Assume that you have a holding in IBM Stock worth $10 million. You have calculated the standard deviation (SD) of change over one day in IBM is $ 0.20. Therefore for the entire position, SD of change over 1 day = $200,000 The SD of change over 10 days = $200,000 * (10) = $632,456 The 99% VaR over 10 days = 2.33 * 632,456 = $1,473,621

2. Operational Risk 2.1 Measurement technique Basic Indicator Approach

The basic approach or basic indicator approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Basel II requires all banking institutions to set aside capital for operational risk. Basic indicator approach is much simpler compared to the alternative approaches (i.e. standardized approach (operational risk) and advanced measurement approach) and this has been recommended for banks without significant international operations. Based on the original Basel Accord, banks using the basic indicator approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average. The fixed percentage alpha is typically 15 percent of annual gross income. 2.2 Measurement technique Standardized Approach

Standardized approach falls between basic indicator approach and advanced measurement approach in terms of degree of complexity. Based on the original Basel Accord, under the Standardized Approach, banks activities are divided into eight business lines: corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for the industrywide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. The total capital charge is calculated as the three-year average of the simple summation of the regulatory capital charges across each of the business lines in each year. In any given year,

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negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit. In order to qualify for use of the standardized approach, a bank must satisfy its regulator that, at a minimum: Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework; It has an operational risk management system that is conceptually sound and is implemented with integrity; and It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas. 2.3 Measurement technique Advanced Measurement Approach

Under this approach the banks are allowed to develop their own empirical model to quantify required capital for operational risk. Banks can use this approach only subject to approval from their local regulators. In order to qualify for use of the AMA a bank must satisfy its supervisor that, at a minimum: Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework; It has an operational risk management system that is conceptually sound and is implemented with integrity; and It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas. 3. Risk type Credit Risk 3.1 Measurement technique Foundation Internal Ratings Based Approach

The term Foundation IRB or F-IRB is an abbreviation of foundation internal ratings-based approach and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Under this approach the banks are allowed to develop their own empirical model to estimate the PD (probability of default) for individual clients or groups of clients. Banks can use this approach only subject to approval from their local regulators.

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Under F-IRB banks are required to use regulator's prescribed LGD (Loss Given Default) and other parameters required for calculating the RWA (Risk Weighted Asset). Then total required capital is calculated as a fixed percentage of the estimated RWA. 3.2 Measurement technique Probability of Default (PD)

Probability of default (PD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. This is an attribute of a bank's client. The probability of default is the likelihood that a loan will not be repaid and will fall into default. PD is calculated for each client who has a loan or for a portfolio of clients with similar attributes. The credit history of the counterparty / portfolio and nature of the investment are taken into account to calculate the PD. There are many alternatives for estimating the probability of default. Default probabilities may be estimated from a historical data base of actual defaults using modern techniques like logistic regression. Default probabilities may also be estimated from the observable prices of credit default swaps, bonds, and options on common stock. The simplest approach, taken by many banks, is to use external ratings agencies such as Egan Jones, Fitch, Moody's Investors Service, or Standard and Poors for estimating PDs from historical default experience. For small business default probability estimation, logistic regression is again the most common technique for estimating the drivers of default for a small business based on a historical data base of defaults. These models are both developed internally and supplied by third parties. 3.3 Measurement technique Loss Given Default (LGD)

Loss Given Default or LGD is a common parameter in Risk Models and also a parameter used in the calculation of Economic Capital or Regulatory Capital under Basel II for a banking institution. This is an attribute of any exposure on bank's client. LGD is the fraction of Exposure at Default (EAD) that will not be recovered following default. Loss Given Default is facility-specific because such losses are generally understood to be influenced by key transaction characteristics such as the presence of collateral and the degree of subordination. 'Gross' LGD is calculated by dividing total losses Exposure at Default (EAD). 3.4 Measurement technique Loss Given Default (LGD)

Exposure at default (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. This is an attribute of any exposure on bank's client. In general EAD can be seen as an estimation of the extent to which a bank may be exposed to counterparty in the event of, and at the time of, that counterpartys default. It is a measure of

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potential exposure as calculated by a Basel Credit Risk Model for the period of 1 year or until maturity whichever is sooner. Under Basel II a bank needs to provide an estimate of the exposure amount for each transaction, commonly referred to as Exposure at Default (EAD), in banks internal systems. All these loss estimates should seek to fully capture the risks of an underlying exposure. 3.5 Other Risk Measurement Techniques

Monte-Carlo Simulation It is a simulation technique. First, some assumptions about the distribution of changes in market prices and rates (for example, by assuming they are normally distributed) are made, followed by data collection to estimate the parameters of the distribution. The Monte Carlo then uses those assumptions to give successive sets of possible future realizations of changes in those rates. For each set, the portfolio is revalued. This should result in a set of portfolio revaluations corresponding to the set of possible realizations of rates. From that distribution the 99th percentile loss can be taken as the VaR. Historical Simulation Like Monte Carlo, it is a simulation technique, but it skips the step of making assumptions about the distribution of changes in market prices and rates. Instead, it assumes that whatever the realizations of those changes in prices and rates were in the past is the best indicator for the future. It takes those actual changes, applies them to the current set of rates and then uses those to revalue the portfolio. When done, a set of portfolio revaluations corresponding to the set of possible realizations of rates is obtained. From that distribution, we can calculate the standard deviation and take the 99th percentile loss as the VaR. Variance-Covariance method This is a very simplified and speedy approach to VaR computation. It is so, because it assumes a particular distribution for both the changes in market prices and rates and the changes in portfolio value. It incorporate the covariance matrix (correlation effects between each asset classes) primarily developed by JP Morgan Risk Management Advisory Group in 1996. It is often called Risk Metrics Methodology. It is reasonably good method for portfolio with no option type products. Thus far, it is the computationally fastest method known today. But this method is not suited for portfolio with major option type financial products. MANAGE There are multiple strategies to manage risks. Some of the commonly followed ones are: o Diversification

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o o

Hedging or Insurance Setting Risk Limits

All the above strategies will reduce the risk but may not eliminate them. The top management will determine its risk policy (i.e.) its appetite for risk. The Risk Manager in a bank will be responsible for identifying the risks, setting up tolerance limits, measuring the risk on a day to day basis and take action whenever the limits are breached. HANDLING OPTIONS There are four options for handling risk Option Terminate (Avoid) Tolerate (Accept) Description Some risks will only be treatable, or containable to acceptable levels, by terminating or avoiding the activity or activities that give rise to the risk. The ability to do anything about some risks may be limited, or the cost of taking any action may be disproportionate to the potential benefit gained. In these cases the response may be toleration. For some risks the best response may be to transfer them. Namely, shift the responsibility or burden of loss to another party through legislation, contract, insurance or other means. Partial transfers are known as risk sharing or risk assignment. By far the greater number of risks will belong to this category. The purpose of treatment is not necessarily to eliminate the risk, but more likely to contain the risk to an acceptable level.

Transfer

Treat (Reduce)

OTHER RISKS Strategic risk Strategic risk is the current and prospective risk to earnings or capital arising from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. Country risk

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Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit. Political risk Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment. Investment risk This is defined as the risk that an investment's actual return will be lower than its expected return. Investment risk includes the possibility of an investment losing market value, and may be reduced through diversification.

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12.0 CORPORATE SERVICES


12.1 BENEFITS ADMINISTRATION
Employee benefit plans are established or maintained by an employer or by an employee organization (such as a union), or both, that provides retirement income or defers income until termination of covered employment or beyond. There are a number of types of retirement plans, including the 401(k) plan and the traditional pension plan, known as a defined benefit plan. The Employee Retirement Income Security Act (ERISA) covers most private sector pension plans. Among other things, ERISA provides protections for participants and beneficiaries in employee benefit plans, including providing access to plan information. Also, those individuals who manage plans (and other fiduciaries) must meet certain standards of conduct under the fiduciary responsibilities specified in the law. The Employee Benefits Security Administration (EBSA) of the Department of Labor is responsible for Administering and enforcing these provisions of ERISA. As part of carrying out its responsibilities, the agency provides consumer information on pension plans, as well as compliance assistance for employers; plan service providers, and others to help them comply with ERISA. The primary employee benefits are Defined Benefits Defined Contribution Health and Welfare

DEFINED BENEFITS
Defined Benefit plans are the oldest retirement plans that exist in the Pension Industry. They promise to pay a specified benefit at retirement age. They define the amount of retirement income to be paid. The actual monthly (or annual) benefit is calculated using a specific formula stated in the plan document. The benefit is usually paid at a specified time such as attainment of age 65. A Defined Benefit Plan is an employer-sponsored retirement plan in which retirement benefits are based on a formula indicating the exact benefit that one can expect upon retiring. Investment risk is borne by the employer and portfolio management is entirely under the control of the company. There are restrictions on when and how participant can withdraw these funds without penalties. A private defined benefit plan is typically not contributory i.e. there are usually no employees contributions, no individual accounts are maintained for each employee. The employer makes

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regular contributions to the entire plan to fund the future benefits of the entire cohort of participants. The employer, rather than the participant, bears the investment risk. Usually, the promised benefit is tied to the employee's earnings, length of service, or both. A Defined Benefit plan provides a guaranteed level of benefits on retirement and the cost is unknown for the employer. If the plan assets earn less than expected, the employer must make larger contributions to ensure that the plan will have sufficient funds to pay promised benefits. If the plan assets earn more than expected, the employer's contributions will decrease.

DEFINED CONTRIBUTION
A Defined Contribution Plan is a type of retirement plan that sets aside a certain amount of money each year for an employee. The amount to be contributed to each participant's account under the plan each year is defined (by either a fixed formula or by giving the employer the discretion to decide how much to contribute each year). The size of a participant's benefit will depend on: The amounts of money contributed to the individual's account by the employer and, perhaps, by the employee as well; The rate of investment growth on the principal; How long the money remains in the plan (in most cases, the employee, upon retirement, has the option of either receiving the payment in a lump sum or by taking partial payments on a regular basis while the balance continues to earn interest); and Whether the forfeitures of participants who leave before they are fully vested can be shared among the remaining participants as a reward to long-term employees. Since benefits accumulate on an individual basis, these plans are sometimes referred to as "individual account plans." In these plans, unlike in defined benefit plans, the risk (and reward) of investment experience is borne by the participant. Defined contribution plans can permit, and sometimes require, that employees make contributions to the plan on either a pre-tax basis (as in a 401(k) plan) or an after-tax basis (as in a thrift plan). They may also, but are not required to, permit employees to decide how the monies contributed into their accounts will be invested. Defined contribution plans have gained popularity as employers have begun to ask their employees to share responsibility for their retirement. The main purpose of a defined contribution plan is to provide an investment vehicle for employees to accumulate retirement income.

Defined Benefit Plan The employer funds it.

Defined Contribution Plan Employee and employer contributions are allocated to individual participants

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The employer bears the investment risk The participant bears the investment risk. (the potential for investment gain or loss). It is generally difficult to communicate. It is easier to communicate.

The final benefit is defined as it is The final retirement benefit is unknown as it is formula driven taking definite decided by the performance of participant parameters (like salary, number of years selected investment funds. of service etc.) as input data The benefit is expressed as an annuity (a The benefit is expressed as an account specified annual or monthly payment to balance. a pensioner over a specified period of time or based on life expectancy) payable at normal retirement age, usually age 65.

The following plans are designated as defined contribution plans: Profit Sharing Plans Cash Or Deferred Arrangements Or 401(k) Plans Stock Bonus Plans And Employee Stock Ownership Plans Simplified employee pensions (SEP) Tax Sheltered Annuities Or 403(b) Arrangements Business entities involved in the Defined Contribution Pension Administration process have strong interdependency in-terms of flow of information, fund and assets (stocks). The diagram below depicts the main entities in the plan administration business and their relations with each other.

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Fig 2.1

Sponsor delegates responsibilities to plan administrator Participant contributes for the plan to the sponsor. Trust owns the funds of the plan contributed by the sponsor and the participants and delegates management of the same to Investment Manager Trust and plan administrator submit compliance reports to Federal Agencies which in turn would qualify the plan. Participants direct the Investment manager on their investment preferences. Record Keepers provide information on Participant, plan and account information to Plan Administrators, trustee, Sponsor and Participant.

Following diagram explains the basic processes involved in benefits administration

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HEALTH AND WELFARE


In the early days when the Social Security was adopted, Health insurance was taken care by private sectors. Later the escalating health costs and wage freezes of the post WW II era, prompted many companies to offer non-cash rewards in the form of Health care benefits. The challenges due to competitive benefits for maintaining the fiscal responsibility and changes in tax code made the employers to offer greater benefit choices with certain tax incentives. Health and Welfare benefit plans can be either Defined-Benefit or Defined Contribution plans. Defined Benefit health and welfare plans specify a determinable benefit, which may be in the form of reimbursement to the covered plan participant or a direct payment to providers or third party insurers for the cost of specified services. Even when a plan is funded pursuant to agreements that specify a fixed rate of employer contribution, it cannot be a Defined benefit health and welfare plan. Defined Contribution health and welfare plans on the other hand maintain an individual account for each plan participant. The benefits a plan participant will receive are limited to the amount

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contributed to the participants account, experience, expenses etc. Health and Welfare plans generally are subject to certain fiduciary, reporting and other requirements of the ERISA (Employee Retirement Income Security Act, 1974). Categories of health and welfare plans Health Care o Medical o Prescription drug o Behavioral health o Dental o Vision o Long-term care Disability Income o Sick leave o Short-term disability o Long term disability Survivor Benefits o Term life

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13.0 RECENT DEVELOPMENTS


13.1 USA PATRIOT ACT ***
US Government passed the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT Act) in response to the terrorists attacks of September 11, 2001. The key features are: The Act gives federal officials greater authority to track and intercept communications, both for law enforcement and foreign intelligence gathering. It vests the Secretary of the Treasury with regulatory powers to combat corruption of U.S. financial institutions for foreign money laundering purposes. It seeks to further close our borders to foreign terrorists and to detain and remove those within US borders. It creates new crimes, new penalties, and new procedural efficiencies for use against domestic and international terrorists. The anti money laundering rules are very important from a banking point of view. They are described in greater detail later in the chapter.

CRIMINAL INVESTIGATIONS: TRACKING AND GATHERING COMMUNICATIONS


Federal communications privacy law currently features a three tiered system, erected for the dual purpose of protecting the confidentiality of communications while enabling authorities to identify and intercept criminal communications. The first level prohibits electronic eavesdropping on telephone conversations, face-to-face conversations, or computer and other forms of electronic communications in most instances. However, in serious criminal cases, law enforcement officers may seek a court order authorizing them to secretly capture conversations on a statutory list of offenses for the permitted duration. The next tier of privacy protection covers telephone records, e-mail held in third party storage, and the like. The law permits law enforcement access, ordinarily pursuant to a warrant or court order or under a subpoena in some cases. There is also a procedure that governs court orders approving the governments use of trap and trace devices and pen registers, a secret caller id, which identify the source and destination of calls made to and from a particular telephone.

***

Extracted from Congressional Research Service, US and Federation of American Scientists www.fas.org

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FOREIGN INTELLIGENCE INVESTIGATIONS


The Act eases some of the restrictions on foreign intelligence gathering within the United States, and affords the U.S. intelligence community greater access to information unearthed during a criminal investigation, but it also establishes and expands safeguards against official abuse. It permits roving surveillance (court orders omitting the identification of the particular instrument, facilities, or place where the surveillance is to occur when the court finds the target is likely to thwart identification).

MONEY LAUNDERING
In federal law, money laundering is the flow of cash or other valuables derived from, or intended to facilitate, the commission of a criminal offence. Federal authorities attack money laundering through regulations, criminal sanctions, and forfeiture. The Act bolsters federal efforts in each area. The Act expands the authority of the Secretary of the Treasury to regulate the activities of U.S. financial institutions, particularly their relations with foreign individuals and entities. Regulations have been promulgated covering the following areas: Securities brokers and dealers as well as commodity merchants, advisors and pool operators must file suspicious activity reports (SARs); Requiring businesses, which were only to report cash transactions involving more than $10,000 to the IRS, to file SARs as well; Imposing additional special measures and due diligence requirements to combat foreign money laundering; Prohibiting U.S. financial institutions from maintaining correspondent accounts for foreign shell banks; Preventing financial institutions from allowing their customers to conceal their financial activities by taking advantage of the institutions concentration account practices; Establishing minimum new customer identification standards and record-keeping and recommending an effective means to verify the identity of foreign customers; Encouraging financial institutions and law enforcement agencies to share information concerning suspected money laundering and terrorist activities; and Requiring financial institutions to maintain anti-money laundering programs which must include at least a compliance officer; an employee training program; the development of internal policies, procedures and controls; and an independent audit feature. Crimes: The Act contains a number of new money laundering crimes, as well as amendments and increased penalties for earlier crimes. Outlaws laundering the proceeds from foreign crimes of violence or political corruption; Prohibits laundering the proceeds from cybercrime or supporting a terrorist organization; Increases the penalties for counterfeiting;

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Seeks to overcome a Supreme Court decision finding that the confiscation of over $300,000 for attempt to leave the country without reporting it to customs Provides explicit authority to prosecute overseas fraud involving American credit cards; and Permit prosecution of money laundering in the place where the predicate offence occurs. Forfeiture: The act allows confiscation of all of the property of participants in or plans an act of domestic or international terrorism; it also permits confiscation of any property derived from or used to facilitate domestic or international terrorism. Procedurally, the Act: Allows confiscation of property located in this country for a wider range of crimes committed in violation of foreign law; Permits U.S. enforcement of foreign forfeiture orders; Calls for the seizure of correspondent accounts held in U.S. financial institutions for foreign banks who are in turn holding forfeitable assets overseas; and Denies corporate entities the right to contest if their principal shareholder is a fugitive. Alien Terrorists and Victims The Act contains provisions designed to prevent alien terrorists from entering the US, to enable authorities to detain and deport alien terrorists and those who support them; and to provide humanitarian immigration relief for foreign victims of the September 11. Other Crimes, Penalties, & Procedures New crimes: The Act creates new federal crimes, for terrorist attacks on mass transportation facilities, for biological weapons offenses, for harbouring terrorists, for affording terrorists material support, for money laundering, and for fraudulent charitable solicitation. New Penalties: The Act increases the penalties for acts of terrorism and for crimes which terrorists might commit. Other Procedural Adjustments: The Act increases the rewards for information in terrorism cases, authorizes sneak and peek search warrants etc

Anti Money Laundering GUIDELINES Treasury expects all financial institutions covered by the customer identification regulations to have their customer identification program drafted and approved by October 1, 2003 as scheduled.

FOREIGN ISSUED IDENTIFICATION DOCUMENTS:


An effective program for identifying new customers must allow financial institutions the flexibility to use methods of identifying and verifying the identity of their customers appropriate to their individual circumstances. For example, some financial institutions open accounts via the Internet, never meeting customers face-to-face.

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Rather than dictating which forms of identification documents financial institutions may accept, the final rule employs a risk-based approach that allows financial institutions flexibility, within certain parameters, to determine which forms of identification they will accept and under what circumstances. However, with this flexibility comes responsibility. When an institution decides to accept a particular form of identification, they must assess risks associated with that document and take whatever reasonable steps may be required to minimize that risk. Federal regulators will hold financial institutions accountable for the effectiveness of their customer identification programs. Additionally, federal regulators have the ability to notify financial institutions of problems with specific identification documents allowing financial institutions to take appropriate steps to address those problems.

CUSTOMER IDENTIFICATION PROGRAM


The rule requires that financial institutions develop a Customer Identification Program (CIP) that implements reasonable procedures to: 1. Collect identifying information about customers opening an account 2. Verify that the customers are who they say they are 3. Maintain records of the information used to verify their identity 4. Determine whether the customer appears on any list of suspected terrorists or terrorist organizations Collecting information: As part of a Customer Identification Program (CIP), financial institutions will be required to develop procedures to collect relevant identifying information including a customers name, address, date of birth, and a taxpayer identification number for individuals, this will likely be a Social Security number. Foreign nationals without a U.S. taxpayer identification number could provide a similar government-issued identification number, such as a passport number. Verifying identity: A CIP is also required to include procedures to verify the identity of customers opening accounts. Most financial institutions will use traditional documentation such as a drivers license or passport. However, the final rule recognizes that in some instances institutions cannot readily verify identity through more traditional means, and allows them the flexibility to utilize alternate methods to effectively verify the identity of customers. Maintaining records: As part of a CIP, financial institutions must maintain records including customer information and methods taken to verify the customers identity.

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Checking terrorist lists: Institutions must also implement procedures to check customers against lists of suspected terrorists and terrorist organizations when such lists are identified by Treasury in consultation with the federal functional regulators. Reliance on other financial institutions: The final rule also contains a provision that permits a financial institution to rely on another regulated U.S. financial institution to perform any part of the financial institutions CIP. For example, in the securities industry it is common to have an introducing broker who has opened an account for a customer conduct securities trades on behalf of the customer through a clearing broker. Under this regulation, the introducing broker is required to identify and verify the identity of their customers and the clearing broker can rely on that information without having to conduct a second redundant verification provided certain criteria are met. The following financial institutions are covered under the rule: Banks and trust companies Savings associations Credit unions Securities brokers and dealers Mutual funds Futures commission merchants and futures introducing brokers

13.2 SARBANES OXLEY ACT


The Sarbanes-Oxley Act was signed into law on 30th July 2002, and introduced significant legislative changes to financial practice and corporate governance regulation. The act is named after its main architects, Senator Paul Sarbanes and Representative Michael Oxley, and of course followed a series of very high profile scandals, such as Enron. It is also intended to "deter and punish corporate and accounting fraud and corruption, ensure justice for wrongdoers, and protect the interests of workers and shareholders" It introduced stringent new rules with the stated objective: "to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws". It also introduced a number of deadlines, the prime ones being: - Most public companies must meet the financial reporting and certification mandates for any end of year financial statements filed after June 15th 2004 - smaller companies and foreign companies must meet these mandates for any statements filed after 15th April 2005. The Sarbanes-Oxley Act itself is organized into eleven titles, although sections 302, 404, 401, 409, 802 and 906 are the most significant with respect to compliance. In addition, the Act also created a public company accounting board, to oversee the audit of public companies that are

Extracted from Sarbanes-Oxley forum

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subject to the securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for, public investors. Section 201 prohibits non audit services like bookkeeping, financial information systems design and implementation, actuarial services, management services etc from the scope of practice of auditors. They can however be taken up with the pre approval of the audit committee on a case by case basis. Section 401 specifies enhanced financial disclosures specifically: Accuracy of financial reports Off-balance sheet transactions Commission rules on pro forma figures Section 501 seeks to improve objectivity of research by recommending rules designed to address conflicts of interest that can arise when securities analysts recommend equity securities in research reports. These rules are designed to foster greater public confidence in securities research, and to protect the objectivity and independence of securities analysts.

13.3 SUB-PRIME MORTGAGE CRISIS 13.3.1 SUB-PRIME LOAN


A subprime loan is a loan given to borrowers that are considered more risky, or less likely to be able to make their loan payments, in relation to high quality borrowers because of problems with their credit history. When a person goes applies for a loan he needs to get a credit check, and what results from this credit check is something that is known as the FICO score. A FICO score is a number which represents how credit worthy that person is considered which is based on factors such as the amount of money that he earns, his record of paying back past debts, and how much debt he currently holds. The higher the score the better his credit is considered, and the more likely he is to get a loan.

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13.3.2 SUB-PRIME CRISIS The subprime mortgage crisis is an ongoing financial crisis triggered by the rapid fall in house prices and an attendant rise in mortgage delinquencies and foreclosures in the United States, particularly among a class of loans that grew dramatically in the closing years of the 20th century - subprime mortgages. Major adverse consequences for banks and financial markets have been felt around the globe. The crisis became apparent in 2007 and has exposed pervasive weaknesses in financial industry regulation and the global financial system. 13.3.3 OVERVIEW

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For more than a decade, a massive amount of money flowed into the United States from investors abroad. This large influx of money to U.S. banks and financial institutions along with low interest rates made it easier for Americans to get credit. Easy credit combined with the faulty assumption that home values would continue to rise led to excesses and bad decisions. Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on. Both individuals and financial institutions increased their debt levels relative to historical norms during the past decade significantly. Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages (i.e., those with initially low rates that later rise) who had been planning to sell or refinance their homes before the adjustments occurred was unable to refinance. As a result, many mortgage holders began to default as the adjustments began. These widespread defaults (and related foreclosures) had effects far beyond the housing market. Home loans are often packaged together, and converted into financial products called "mortgage-backed securities." These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value. Credit rating agencies gave them high-grade, safe ratings. Two of the leading sellers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put the financial system at risk. The decline in the housing market set off a domino effect across the U.S. economy. When home values declined and adjustable rate mortgage payment amounts increased, borrowers defaulted on their mortgages. Investors globally holding mortgage-backed securities (including many of the banks that originated them and traded them among themselves) began to incur serious losses. Before long, these securities became so unreliable that they were not being bought or sold. Investment banks such as Bear Stearns and Lehman Brothers found themselves saddled with large amounts of assets they could not sell. They ran out of the money needed to meet their immediate obligations. And they faced imminent collapse. Other banks found themselves in severe financial trouble. These banks began holding on to their money, and lending dried up, and the gears of the American financial system began grinding to a halt. The crisis has gone through stages. First, during late 2007, over 100 mortgage lending companies went bankrupt as subprime mortgage-backed securities could no longer be sold to investors to acquire funds. Second, starting in Q4 2007 and in each quarter since then, financial institutions have recognized massive losses as they adjust the value of their mortgage backed securities to a fraction of their purchased prices. These losses as the housing market continued to deteriorate meant that the banks have a weaker capital base from which to lend. Third, during Q1 2008, investment bank Bear Stearns was hastily merged with bank JP Morgan with $30 billion in government guarantees, after it was unable to continue borrowing to finance its operations.

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Fourth, during September 2008, the system approached meltdown. In early September Fannie Mae and Freddie Mac, representing $5 trillion in mortgage obligations, were nationalized by the U.S. government as mortgage losses increased. Next, investment bank Lehman Brothers filed for bankruptcy. In addition, two large U.S. banks (Washington Mutual and Wachovia) became insolvent and were sold to stronger banks. The world's largest insurer, AIG, was 80% nationalized by the U.S. government, due to concerns regarding its ability to honor its obligations via a form of financial insurance called credit default swaps. These sequential and significant institutional failures, particularly the Lehman bankruptcy, involved further seizing of credit markets and more serious global impact. The interconnected nature of Lehman was such that its failure triggered system-wide (systemic) concerns regarding the ability of major institutions to honor their obligations to counterparties. The interest rates banks charged to each other increased to record levels and various methods of obtaining short-term funding became less available to non-financial corporations. It was this "credit freeze" that some described as a near-complete seizing of the credit markets in September that drove the massive bailout procedures implemented by world-wide governments in Q4 2008. Prior to that point, each major U.S. institutional intervention had been ad-hoc; critics argued this damaged investor and consumer confidence in the U.S. government's ability to deal effectively and proactively with the crisis. Further, the judgment and credibility of senior U.S. financial leadership was called into question. 13.3.4 MARKET DATA The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, [9] with over 7.5 million first-lien subprime mortgages outstanding. Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%. Between 2004-2006 the share of subprime mortgages relative to total originations ranged from 18%-21%, versus less than 10% in 2001-2003 and during 2007. Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43% of the foreclosures started during the third quarter of 2007.[16] During 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively versus 2006. Foreclosure filings including default notices, auction sale notices and bank repossessions can include multiple notices on the same property. During 2008, this increased to 2.3 million properties, an 81% increase over 2007. Between August 2007 and September 2008, an estimated 851,000 homes were repossessed by lenders from homeowners. Foreclosures are concentrated in particular states both in terms of the number and rate of foreclosure filings. Ten states accounted for 74% of the foreclosure filings during 2008; the top two (California and Florida) represented 41%. Nine states were above the national foreclosure rate average of 1.84% of households. The mortgage market is estimated at $12 trillion with approximately 6.41% of loans delinquent and 2.75% of loans in foreclosure as of August 2008. The estimated value of subprime adjustable-rate mortgages (ARM) resetting at higher interest rates is U.S. $400 billion for 2007 and $500 billion for 2008. Reset activity is expected to increase to a monthly peak in March 2008 of nearly $100 billion, before declining. An average of 450,000 subprimes ARM are scheduled to undergo their first rate increase each quarter in 2008.

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An estimated 8.8 million homeowners (nearly 10.8% of the total) have zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage. This provides an incentive to "walk away" from the home, despite the credit rating impact. By January 2008, the inventory of unsold new homes stood at 9.8 months based on December 2007 sales volume, the highest level since 1981. Further a record of nearly four million unsold existing homes was for sale, including nearly 2.9 million that were vacant. This excess supply of home inventory places significant downward pressure on prices. As prices decline, more homeowners are at risk of default and foreclosure. According to the S&P/Case-Shiller price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their Q2 2006 peak and by May 2008 they had fallen 18.4%. The price decline in December 2007 versus the year-ago period was 10.4% and for May 2008 it was 15.8%. Housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels. 13.3.5 TARP The Troubled Asset Relief Program (TARP) is a program of the United States government to purchase assets and equity from financial institutions in order to strengthen its financial sector. It is the largest component of the government's measures in 2008 to address the subprime mortgage crisis. The Act requires financial institutions selling assets to TARP to issue equity warrants (a type of security that entitles its holder to purchase shares in the company issuing the security for a specific price), or equity or senior debt securities (for non-publicly listed companies) to the Treasury. In the case of warrants, the Treasury will only receive warrants for non-voting shares, or will agree not to vote the stock. This measure is designed to protect taxpayers by giving the Treasury the possibility of profiting through its new ownership stakes in these institutions. Ideally, if the financial institutions benefit from government assistance and recover their former strength, the government will also be able to profit from their recovery.

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14.0 GLOSSARY
Agency bonds: Agencies represent all bonds issued by the federal government, except for those issued by the Treasury (i.e. bonds issued by other agencies of the federal government). Examples include the Federal National Mortgage Association (FNMA), and the Guaranteed National Mortgage Association (GNMA). Arbitrage: The trading of securities to profit from a temporary difference between the price of security in one market and the price in another. This temporary difference is often called market inefficiency. Annualized Percentage or Return: The periodic rate times the number of periods in a year. For example, a 5% quarterly return has an A.P.R. of 20%. It depends on the following: How much repayment How frequently Which component of loan interest or principal Authorization (Credit Cards): The act of ensuring that the cardholder has adequate funds available against their line of credit. A positive authorization results in generation of an authorization code a hold being placed on those funds. A "hold" means that the cardholder's available credit limit is reduced by the authorized amount. Beauty contest: The informal term for the process by which clients choose an investment bank. Some of the typical selling points when competing with other investment banks for deals are: "Look how strong our research department is in this industry. Our analyst in the industry is a real market mover, so if you go public with us, you'll be sure to get a lot of attention from her." Bloomberg: Computer terminals providing real time quotes, news, and analytical tools, often used by traders and investment bankers. Bond spreads: The difference between the yield of a corporate bond and a U.S. Treasury security of similar time to maturity. Bulge bracket: The largest and most prestigious firms on Wall Street like Goldman Sachs, Morgan Stanley Dean Witter, Merrill Lynch, Salomon Smith Barney, Lehman Brothers, Credit Suisse First Boston. Buy-side: The clients of investment banks (mutual funds, pension funds) that buy the stocks, bonds and securities sold by the investment banks. (The investment banks that sell these products to investors are known as the sell-side.) Capitalized Loan: A loan in which the interest due (not paid) is added to the principal balance of the loan is called Capitalized Loan. Capitalized interest becomes part of the principle of the

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loans; therefore, it increases the total cost of repaying the loan because interest will accumulate on the new, higher principle. Capture (Credit Cards): Converting the authorization amount into a billable transaction record. Transactions cannot be captured unless previously authorized. Commercial bank: A bank that lends, rather than raises money. For example, if a company wants $30 million to open a new production plant, it can approach a commercial bank for a loan. Commercial paper: Short-term corporate debt, typically maturing in nine months or less. Commodities: Assets (usually agricultural products or metals) that are generally interchangeable with one another and therefore share a common price. For example, corn, wheat, and rubber generally trade at one price on commodity markets worldwide. Comparable company analysis (Comps): The primary tool of the corporate finance analyst. Comps include a list of financial data, valuation data and ratio data on a set of companies in an industry. Comps are used to value private companies or better understand a how the market values and industry or particular player in the industry. Consumer Price Index: The CPI measure the percentage increase in a standard basket of goods and services. CPI is a measure of inflation for consumers. Coupon rate: The fixed interest paid on a bond as a percentage of its face value, each year, until maturity. In Thailand the coupon is usually paid semi-annually or annually. Discount rate: The rate at which federal banks lend money to each other on overnight loans. A widely followed interest rate set by the Federal Reserve to cause market interest rates to rise or fall, thereby causing the U.S. economy to grow more quickly or less quickly. Discount Rate for Credit Cards: A small percentage of each transaction that is withheld by the Acquiring Bank or ISO. This fee is basically what the merchant pays to be able to accept credit cards. The fee goes to the ISO (if applicable), the Acquiring Bank, and the Associations. Dividend: A payment by a company to shareholders of its stock, usually as a way to distribute profits to shareholders. Fed: Fed means the Federal Reserve which manages the country's economy by setting interest rates. Federal funds rate: The rate domestic banks charge one another on overnight loans to meet Federal Reserve requirements. This rate tracks very closely to the discount rate, but is usually slightly higher. Fixed income: Income from Bonds and other securities that earn a fixed rate of return. Bonds are typically issued by governments, corporations and municipalities.

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Float: The number of shares available for trade in the market. Generally speaking, the bigger the float, the greater the stock's liquidity. Floating rate: An interest rate that is benchmarked to other rates (such as the rate paid on U.S. Treasuries), allowing the interest rate to change as market conditions change. Glass-Steagall Act: Passed in 1933 during the Depression to help prevent future bank failures. The Glass-Steagall Act split America's investment banking (issuing and trading securities) operations from commercial banking (lending). For example, J.P. Morgan was forced to spin off its securities unit as Morgan Stanley. Since the late 1980s, the Federal Reserve has steadily weakened the act, allowing commercial banks such as NationsBank and Bank of America to buy investment banks like Montgomery Securities and Robertson Stephens. In 1999, Glass-Steagall was effectively repealed by the Graham-Leach-Bliley Act. Graham-Leach-Bailey Act: Also known as the Financial Services Modernization Act of 1999. Essentially repealed many of the restrictions of the Glass-Steagall Act and made possible the current trend of consolidation in the financial services industry. Allows commercial banks, investment banks, and insurance companies to affiliate under a holding company structure. Gross Domestic Product: GDP measures the total domestic output of goods and services in the United States. For reference, the GDP grew at a 4.2 percent rate in 1999. Generally, when the GDP grows at a rate of less than 2 percent, the economy is considered to be in recession. Hedge: To balance a position in the market in order to reduce risk. Hedges work like insurance: a small position pays off large amounts with a slight move in the market. High grade corporate bond: A corporate bond with a rating above BB. Also called investment grade debt. High yield debt (a.k.a. Junk bonds): Corporate bonds that pay high interest rates to compensate investors for high risk of default. Credit rating agencies such as Standard & Poor's rate a company's (or a municipality's) bonds based on default risk. Junk bonds rate below BB. Institutional clients or investors: Large investors, such as pension funds or municipalities (as opposed to retail investors or individual investors). Lead manager: The primary investment bank managing a securities offering. An investment bank may share this responsibility with one or more co-managers. League tables: Tables that rank investment banks based on underwriting volume in numerous categories, such as stocks, bonds, high yield debt, convertible debt, etc. High rankings in league tables are key selling points used by investment banks when trying to land a client engagement. Leveraged Buyout (LBO): The buyout of a company with borrowed money, often using that company's own assets as collateral. LBOs were common in 1980s, when successful LBO firms such as Kohlberg Kravis Roberts made a practice of buying up companies, restructuring them, and reselling them or taking them public at a significant profit

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LIBOR: London Inter-bank Offered Rate. A widely used short-term interest rate. LIBOR represents the rate banks in England charge one another on overnight loans or loans up to five years. LIBOR is often used by banks to quote floating rate loan interest rates. Typically the benchmark LIBOR is the three-month rate. Liquidity: The amount of a particular stock or bond available for trading in the market. For commonly traded securities, such as big cap stocks and U.S. government bonds, they are said to be highly liquid instruments. Small cap stocks and smaller fixed income issues often are called illiquid (as they are not actively traded) and suffer a liquidity discount, i.e. they trade at lower valuations to similar, but more liquid, securities. Long Bond: The 30-year U.S. Treasury bond. Treasury bonds are used as the starting point for pricing many other bonds, because Treasury bonds are assumed to have zero credit risk taking into account factors such as inflation. For example, a company will issue a bond that trades "40 over Treasuries." The 40 refers to 40 basis points (100 basis points = 1 percentage point). Making markets: A function performed by investment banks to provide liquidity for their clients in a particular security, often for a security that the investment bank has underwritten. The investment bank stands willing to buy the security, if necessary, when the investor later decides to sell it. Market Capitalization: The total value of a company in the stock market (total shares outstanding x price per share). Merchant Account: A special business account set up to process credit card transactions. A merchant account is not a bank account (even though a bank may issue it). Rather, it is designed to 1) process credit card payments and 2) deposit the funds into our (business) checking account (minus transaction fees). Money market securities: This term is generally used to represent the market for securities maturing within one year. These include short-term CDs, repurchase agreements, commercial paper (low-risk corporate issues), among others. These are low risk, short-term securities that have yields similar to Treasuries. Mortgage-backed bonds: Bonds collateralized by a pool of mortgages. Interest and principal payments are based on the individual homeowners making their mortgage payments. The more diverse the pool of mortgages backing the bond, the less risky they are. Municipal bonds ("Munis"): Bonds issued by local and state governments, a.k.a. municipalities. Municipal bonds are structured as tax-free for the investor, which means investors in muni's earn interest payments without having to pay federal taxes. Sometimes investors are exempt from state and local taxes, too. Consequently, municipalities can pay lower interest rates on muni bonds than other bonds of similar risk.

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Payment Gateway Fees (Credit Cards): The fees that payment gateways charge for their services. This generally includes a monthly fee and a small flat fee per transaction. These fees may be consolidated into a single bill by the acquiring bank or ISO, along with their fees. Pitch book: The book of exhibits, graphs, and initial recommendations presented by bankers to a prospective client when trying to land an engagement. Pit traders: Traders who are positioned on the floor of stock and commodity exchanges (as opposed to floor traders, situated in investment bank offices). P/E ratio: The price to earnings ratio. This is the ratio of a company's stock price to its earningsper-share. The higher the P/E ratio, the more expensive a stock is (and also the faster investors believe the company will grow). Stocks in fast-growing industries tend to have higher P/E ratios. Prime rate: The average rate U.S. banks charge to companies for loans. Producer Price Index: The PPI measure the percentage increase in a standard basket of goods and services. PPI is a measure of inflation for producers and manufacturers. Proprietary trading: Trading of the firm's own assets (as opposed to trading client assets). Prospectus: A report issued by a company (filed with and approved by the SEC) that wishes to sell securities to investors. Distributed to prospective investors, the prospectus discloses the company's financial position, business description, and risk factors. Red herring: Also known as a preliminary prospectus. A financial report printed by the issuer of a security that can be used to generate interest from prospective investors before the securities are legally available to be sold. Based on final SEC comments, the information reported in a red herring may change slightly by the time the securities are actually issued. Retail clients: Individual investors (as opposed to institutional clients). Return on equity: The ratio of a firm's profits to the value of its equity. Return on equity, or ROE, is a commonly used measure of how well an investment bank is doing, because it measures how efficiently and profitably the firm is using its capital. Risk arbitrage: When an investment bank invests in the stock of a company it believes will be purchased in a merger or acquisition. (Distinguish from risk-free arbitrage.) Road-show: The series of presentations to investors that a company undergoing an IPO usually gives in the weeks preceding the offering. Here's how it works: Several weeks before the IPO is issued, the company and its investment bank will travel to major cities throughout the country. In each city, the company's top executives make a presentation to analysts, mutual fund managers, and others attendees and also answer questions. Sales memo: Short reports written by the corporate finance bankers and distributed to the bank's salespeople. The sales memo provides salespeople with points to emphasize when hawking the stocks and bonds the firm is underwriting.

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Securities and Exchange Commission (SEC): A federal agency that, like the Glass-Steagall Act, was established as a result of the stock market crash of 1929 and the ensuing depression. The SEC monitors disclosure of financial information to stockholders, and protects against fraud. Publicly traded securities must first be approved by the SEC prior to trading. Securitize: To convert an asset into a security that can then be sold to investors. Nearly any income generating asset can be turned into a security. For example, a 20-year mortgage on a home can be packaged with other mortgages just like it, and shares in this pool of mortgages can then be sold to investors. Short-term debt: A bond that matures in nine months or less. Also called commercial paper. Syndicate: A group of investment banks that will together underwrite a particular stock or debt offering. Usually the lead manager will underwrite the bulk of a deal, while other members of the syndicate will each underwrite a small portion. Transaction Fee (Credit Cards): A small flat fee that is paid on each transaction. This fee is collected by the acquiring bank or ISO and pays for the toll-free dial out number and the processing network. T-Bill Yields: The yield or internal rate of return an investor would receive at any given moment on a 90-120 government treasury bill. Tombstone: The advertisements that appear in publications like Financial Times or The Wall Street Journal announcing the issuance of a new security. The tombstone ad is placed by the investment bank as information that it has completed a major deal. Yield: The annual return on investment. A high yield bond, for example, pays a high rate of interest.

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15.0 REFERENCES

15.1 WEBSITES
WWW.BIS.ORG WWW.IBRD.COM WWW.SIAINVESTOR.COM WWW.SIAC.COM WWW.CNBC.COM WWW.STOCKCHARTS.COM WWW.MONEYCENTRAL.COM WWW.MSNMONEY.COM WWW.NYSE.COM WWW.NASDAQ.COM WWW.AMERITRADE.COM WWW.ESCHWAB.COM HTTP://FINANCE.YAHOO.COM WWW.INVESTOPEDIA.COM WWW.FT.COM WWW.BLOOMBERG.COM WWW.VANGUARD.COM

15.2 BOOKS
The Bank Credit Card Business American Bankers Association Value At Risk Phillipe Jorions Principles of Corporate Finance Brearley Myers Securities Operations Michael T Reddy New York Institute of Finance After the Trade is Made David M Weiss New York Institute of Finance Investment Analysis & Portfolio Management -Frank K. Reilly & Keith C. Brown The Warren Buffet Way Robert Hagstrom Jr One Up on the Wall Street Peter Lynch