FINANCIAL MARKET AND INSTITUTIONS UNIT 4 TOPICS : 1.

ACTIVITIES & ROLE OF NBFC, REGULATORY

FRAMEWORK OF NBFC, CREDIT RATING , LEASING AND HIRE PURCHASE , FACTORING, HOUSING FINANCE, VENTURE CAPITAL , MERCHANT BANKING
1. NBFC :A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property. A non-banking institution which is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in installments by way of contributions or in any other manner, is also a non-banking financial company (Residuary non-banking company). NBFCs lend and make investments and hence their activities are akin to that of banks; however there are a few differences as given below: i. NBFC cannot accept demand deposits; ii. NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself; iii. deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks. NBFCs are categorized a) in terms of the type of liabilities into Deposit and Non-Deposit accepting NBFCs, b) non deposit taking NBFCs by their size into systemically important and other non-deposit holding companies (NBFC-NDSI and NBFC-ND) and c) by the kind of activity they conduct.

NBFCs are categorized a) in terms of the type of liabilities into Deposit and Non-Deposit accepting NBFCs, b) non deposit taking NBFCs by their size into systemically important and other non-deposit holding companies (NBFC-NDSI and NBFC-ND) and c) by the kind of activity they conduct. Within this broad categorization the different types of NBFCs are as follows: i. Asset Finance Company (AFC) : An AFC is a company which is a financial institution carrying on as its principal business the financing of physical assets supporting productive/economic activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines. Principal business for this purpose is defined as aggregate of financing real/physical assets supporting economic activity and income arising therefrom is not less than 60% of its total assets and total income respectively. ii. Investment Company (IC) : IC means any company which is a financial institution carrying on as its principal business the acquisition of securities, iii. Loan Company (LC) : LC means any company which is a financial institution carrying on as its principal business the providing of finance whether by making loans or advances or otherwise for any activity other than its own but does not include an Asset Finance Company. iv. Infrastructure Finance Company (IFC) : IFC is a non-banking finance company a) which deploys at least 75 per cent of its total assets in infrastructure loans, b) has a minimum Net Owned Funds of Rs. 300 crore, c) has a minimum credit rating of A or equivalent d) and a CRAR of 15%. v. Systemically Important Core Investment Company (CIC-ND-SI) : CIC-ND-SI is an NBFC carrying on the business of acquisition of shares and securities which satisfies the following conditions:a. it holds not less than 90% of its Total Assets in the form of investment in equity shares, preference shares, debt or loans in group companies; b. its investments in the equity shares (including instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the

date of issue) in group companies constitutes not less than 60% of its Total Assets; c. it does not trade in its investments in shares, debt or loans in group companies except through block sale for the purpose of dilution or disinvestment; d. it does not carry on any other financial activity referred to in Section 45I(c) and 45I(f) of the RBI act, 1934 except investment in bank deposits, money market instruments, government securities, loans to and investments in debt issuances of group companies or guarantees issued on behalf of group companies. e. f. vi. Its asset size is Rs 100 crore or above and It accepts public funds

Infrastructure Debt Fund: Non- Banking Financial Company (IDF-NBFC) : IDFNBFC is a company registered as NBFC to facilitate the flow of long term debt into infrastructure projects. IDF-NBFC raise resources through issue of Rupee or Dollar denominated bonds of minimum 5 year maturity. Only Infrastructure Finanace Companies (IFC) can sponsor IDF-NBFCs.

vii.

Non-Banking Financial Company - Micro Finance Institution (NBFC-MFI): NBFCMFI is a non-deposit taking NBFC having not less than 85% of its assets in the nature of qualifying assets which satisfy the following criteria: a. loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not exceeding Rs. 60,000 or urban and semi-urban household income not exceeding Rs. 1,20,000; b. loan amount does not exceed Rs. 35,000 in the first cycle and Rs. 50,000 in subsequent cycles; c. d. total indebtedness of the borrower does not exceed Rs. 50,000; tenure of the loan not to be less than 24 months for loan amount in excess of Rs. 15,000 with prepayment without penalty; e. f. loan to be extended without collateral; aggregate amount of loans, given for income generation, is not less than 75 per cent of the total loans given by the MFIs; g. loan is repayable on weekly, fortnightly or monthly instalments at the choice of the borrower

viii.

Non-Banking Financial Company Factors (NBFC-Factors): NBFC-Factor is a nondeposit taking NBFC engaged in the principal business of factoring. The financial assets in the factoring business should constitute at least 75 percent of its total assets and its income derived from factoring business should not be less than 75 percent of its gross income.

1. Credit rating is done for debt instruments such as debentures, fixed deposits, commercial papers, bonds, etc. the company which issues debt instruments is called an issuer or issuing company. The issuer, issues instruments to collect finance from investors. Investor looks at the credit rating of instrument and issuer before investing. 1. If the credit rating is a high, investor will invest in the company. That is, he will purchase the debentures, bonds, etc. issued by that company. 2. If the credit rating is low, investor will not purchase the debentures, bonds, etc. of that company. So, credit rating guides the investor while investing. Credit rating is an opinion about a debt instrument and its issuer. It tells an investor, whether the debt instrument is safe or risky. It tells whether the issuer will be able to pay the interest and repay the principal amount in time. Credit rating is only an opinion. It is not a recommendation. It does not ask an investor to buy, hold or sell an instrument. So, credit rating is an opinion about the future ability and legal obligation of the issuer to make timely payments of principal amount and interest on their debt instruments. Credit rating is done by independent credit-rating agencies like: 1. S & P, which is based in USA, 2. while CRISIL, CARE and ICRA Ltd., which are based in India. Credit rating is done by experts after examining various factors. The rating is expressed in alphabetical or alphanumeric symbols. Following are examples of credit rating: 1. If the rating of debenture is AAA (Triple A), then it is considered to have the highest safety for the investor. 2. If the credit rating is DDD (Triple D),, then the debenture is considered to have highest risk for the investor. The issuing company asks the credit-rating agency to rate its instrument. This is done before issuing the instrument. The agency collects and studies information about the issuing company. Then it rates the instrument. Credit rating is not permanent, and it is reviewed periodically.

Advantages of Credit Rating

The major advantage a good credit rating is that it eases financial transactions and keeps lowcost credit available. Some also claim that a high credit rating signals that a person is trustworthy and possesses good character. This is also a big help when searching for a job or obtaining security clearances for well-paying, high status work. With a sound credit background, you're also more likely to get loans and insurance at preferred rates with faster approval. A qualified consumer can also take advantage of the latest credit card offers that carry a low APR, discounts, gift certificates, airline miles and other rewards. Disadvantages of Credit Rating

Like the common adage that the rich grow richer as the poor grow poorer, such is the case with FICO scores. Just when you've lost employment and fallen behind with bills, or have a medical emergency, the FICO score drops and you face a hard time paying for things in times of need. A low score also creates difficulties getting a loan at a reasonable interest rate. To make things more difficult, credit rating are now used to weed out job candidates, leaving those who need employment the most with fewer quality-paying options than others. Credit ratings can also create a false picture of a consumer's personality, painting a more rosy picture on paper than their true character.

2. LEASING : A legal document outlining the terms under which one party agrees to rent property from another party. A lease guarantees the lessee (the renter) use of an asset and guarantees the lessor (the property owner) regular payments from the lessee for a specified number of months or years. Both the lessee and the lessor must uphold the terms of the contract for the lease to remain valid. Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments. The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The relationship between the tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called the term of the lease). The consideration for the lease is called rent. A gross lease is when the tenant pays a flat rental

amount and the landlord pays for all property charges regularly incurred by the ownership from lawnmowers and washing machines to handbags and jewelry.[1] Under normal circumstances, a freehold owner of property is at liberty to do what they want with their property, including destroy it or hand over possession of the property to a tenant. However, if the owner has surrendered possession to another (the tenant) then any interference with the quiet enjoyment of the property by the tenant in lawful possession is unlawful. Similar principles apply to real property as well as to personal property, though the terminology would be different. Similar principles apply to sub-leasing, that is the leasing by a tenant in possession to a sub-tenant. The right to sub-lease can be expressly prohibited by the main lease. Advantages[edit] For businesses, leasing property may have significant financial benefits:

Leasing is less capital-intensive than purchasing, so if a business has constraints on its capital, it can grow more rapidly by leasing property than by purchasing property.

Leasing can help businesses safeguard cash flow by paying for equipment as it generates revenue.

Capital assets may fluctuate in value. Leasing shifts risks to the lessor, but if the property market has shown steady growth over time, a business that depends on leased property is sacrificing capital gains.

Depreciation of capital assets has different tax and financial reporting treatment from ordinary business expenses. Lease payments are considered expenses rather than assets, which can be set off against revenue when calculating taxable profit at the end of the relevant tax accounting period.[4]

In some cases a lease may be the only practical option; for example, a small business may wish to open a location in a large office building within tight locational parameters.

Leasing may provide more flexibility to a business which expects to grow or move in the relatively short term, because a lessee is not usually obliged to renew a lease at the end of its term.

Disadvantages For businesses, leasing property may have significant drawbacks:

A net lease may shift some or all of the maintenance costs onto the tenant. If circumstances dictate that a business must change its operations significantly, it may be expensive or otherwise difficult to terminate a lease before the end of the term. In some cases, a business may be able to sublet property no longer required, but this may not recoup the costs of the original lease, and, in any event, usually requires the consent of the original lessor. Tactical legal considerations usually make it expedient for lessees to default on their leases. The loss of book value is small and any litigation can usually be settled on advantageous terms. This is an improvement on the position for those companies owning their own property. Although it can be easier for a business to sell property if it has the time, forced sales frequently realise lower prices and can seriously affect book value.

If the business is successful, lessors may demand higher rental payments when leases come up for renewal. If the value of the business is tied to the use of that particular property, the lessor has a significant advantage over the lessee in negotiations.

3. HIRE PURCHSE: A method of buying goods through making installment payments over time. The term hire purchase originated in the U.K., and is similar to what are called "rent-toown" arrangements in the United States. Under a hire purchase contract, the buyer is leasing the goods and does not obtain ownership until the full amount of the contract is paid. Hire purchase (abbreviated HP, colloquially sometimes never-never[1]) is the legal term for a contract, in which a purchaser agrees to pay for goods in parts or a percentage over a number of months. In Canada and the United States, a hire purchase is termed an installment plan although these may differ slightly as in a hire purchase agreement the ownership of the good remains with the seller until the last payment is made. Other analogous practices are described as closed-end leasing or rent to own. The hire purchase agreement was developed in the United Kingdom in the 19th century to allow customers with a cash shortage to make an expensive purchase they otherwise would have to delay or forgo. For example in cases where a buyer cannot afford to pay the asked price for an item of property as a lump sum but can afford to pay a percentage as a deposit, a hire-purchase contract allows the buyer to hire the goods for a monthly rent. When a sum equal to the original full price plus interest has been paid in equal installments, the buyer may then exercise an option

to buy the goods at a predetermined price (usually a nominal sum) or return the goods to the owner. If the buyer defaults in paying the installments, the owner may repossess the goods, a vendor protection not available with unsecured-consumer-credit systems. HP is frequently advantageous to consumers because it spreads the cost of expensive items over an extended time period. Business consumers may find the different balance sheet and taxationtreatment of hirepurchased goods beneficial to their taxable income. The need for HP is reduced when consumers have collateral or other forms of credit readily available. These contracts are most commonly used for items such as cars and high value electrical goods where the purchasers are unable to pay for the goods directly. Advantages Facility of buying People with small income can buy expensive articles such as car, house, furniture, etc. They can make payment in easy installments and thereby improve their standard of living. The buyer can return the goods if he is not satisfied with their quality or is unable to pay further installments. Thrift and savings Hire purchase system encourages people to reduce expenses and save money to pay installments at regular intervals. Higher sales Hire purchase system helps to widen market for costly goods. People who cannot buy such goods otherwise are tempted to purchase them on installments. The seller can take back the goods if buyer makes default in payment. Boon to small producers Small scale units and farmers can buy machinery and equipment and pay installments out of earnings. For example, an unemployed graduate can buy a taxi through hire purchase, earn money from the taxi and pay installments out of such income.

Disadvantages 1. Extravagance: Hire purchase system induces middle class people to buy luxury goods which they cannot otherwise afford. They are tempted to pledge their future income. They may not be able to pay installments in time. They suffer heavy loss when the seller takes back the goods on default of payment. 2. Higher prices: The buyer has to pay much higher prices than that payable on cash purchase. The seller adds a margin to cover interest and risk. The seller may pass on goods of doubtful quality by offering easy credit terms. The buyer does not get ownership of goods until last installment paid. He cannot sell the goods before final payment. 3. Risk of bad debts: When the buyer fails to pay installments, the seller may suffer loss. He may have to spend money and time to recover goods from the buyer. There is risk of loss of goods lying with the buyer. 4. Large investment: The hire purchase seller has to invest considerable funds because payments are received from buyers over a long period of time. Factoring : Factoring is a financial transaction in which a business sells its accounts

receivable (i.e., invoices) to a third party (called a factor) at a discount. In "advance" factoring, the business owner sells his receivables in the form of invoice to the factor, who makes an advance of 70-85% of the purchase price of the receivable amount. The factor collects the full amount from the customer in due course and pays the balance amount due to the business owner after deducting his commission and other charges. In "maturity" factoring, the factor makes no immediate advance on the purchased accounts; but sees to it that the customer pays the invoiced amount within the stipulated time i.e. on maturity. However, if the customer fails to make

payment within the stipulated time e.g. 30 days, the factor makes payment to the client and proceeds to collect the payment from the customer. Advantages Time Savings. Factoring can save you time and effort that would otherwise be spent on collecting from customers. That energy can be redirected to other business-building endeavors, like sales, marketing and client development.

Good Use for Growth. You can use the instant cash to generate growth, maybe hiring another salesperson who will bring in more business. Or buying an advertisement that will reach new customers. Or buying a piece of equipment that will accelerate production. Doesnt Require Collateral. Unlike traditional bank loans, factoring doesnt require you to risk your home or other property as collateral.

Qualify for More Funding. Factoring firms will typically give a cash advance on up to 80% of your receivables, says Napolitano. That may be more than you would be able to get from a bank. Factoring Disadvantages The Stigma. The most common thing small business owners dont know about factoring, Napolitano says, is that their customers are notified when a factor takes the receivables over. The customers are no longer paying you, theyre paying the factoring company, he says. That may alert them to your cash flow trouble.

Less Control. Once you accept cash for your receivables, you give up a measure of control. For example, the factoring company could deny your ability to do business with a particular customer because of its poor credit history or rating, says Napolitano.

The Cost. While it may be necessary to have immediate access to cash, it will come at higher price than loans. Factoring companies usually keep between 1% and 4% of a receivable as their fee. Additionally, Napolitano says, they charge interest on the cash advance, typically at prime rate plus 2%. That all can add up to more than 30% in annual interest.

Advantages of Factoring

LARGER AMOUNTS: Because accounts receivable factoring is based primarily upon accounts receivable, small businesses with large amounts of accounts receivable for goods or services sold to financially strong customers can often obtain a bigger line than they would qualify for with conventional bank lenders. This is because factoring is based on the credit strength of your customers. Banks look more at your businesses credit strength to support their loans. Consequently, often factoring companies can provide more financing more quickly than banks.

QUICKER SET UP AND FUNDING: Most accounts receivable factoring lines can be approved, set up, and actively funded in just a few weeks. Banks typically require more time to perform their credit review of your company perhaps even waiting for upcoming fiscal period closes or audit results. The faster set up of accounts receivable factoring lines is because factoring companies have simpler more streamlined underwriting requirements.

Again, they are able to do this because they are relying significantly on the credit strength of your customers.

EXPANDS QUICKLY WITH GROWTH: Most factoring companies can expand their financing for you as fast as your business grows, even if your company has little track record performing that much business. Factoring companies have no bureaucracy hindering the increase of a line size. So you are not likely to outgrow your line as easily. Just be sure you have a factoring company big enough to accommodate your growth ambitions.

NOT A LOAN: A factoring company is not making loans. They are purchasing the accounts receivable with cash. This has the same result of increasing working capital but many accountants would not show this as a liability on the balance sheet the way a bank loan would appear. So factoring, instead of borrowing, reduces balance sheet debt resulting in a lower debt to equity ratio.

LESS COSTLY THAN EQUITY: In need of financing many businesses turn to equity investors. For some business investment and expansion purposes, there is no substitute for equity capital. However, most equity investors expect higher returns than the costs of accounts receivable factoring and new equity contributions dilute the ownership stake of existing owners often even shifting control. Most factoring arrangements have no dilutive effect on shareholders.

IMPROVES YOUR TURN: Many factoring companies verify invoices with your customers and follow up promptly if your invoices are not paid on time. These gentle reminders to your

customers usually result in more timely payments and it frees you and your staff up from having to perform these administrative tasks to focus on your product or service delivery. Disadvantages of Factoring

MORE EXPENSIVE THAN A BANK LOAN: Accounts receivable factoring is more expensive than bank financing because of the transactional work with the invoices the factoring company does to advance more money more quickly. Costs vary significantly between factors and comparing rates and fees can be challenging. Consequently, invoice factoring cost drivers need to be carefully understood.

SHRINKS AS BUSINESS CONTRACTS: Factoring can grow rapidly with you but also contracts as quickly if your business is contracting. So factoring may not be a good solution for businesses with great seasonality or other significant downward fluctuations in revenue.

NOTIFICATION: Factoring companies typically require that you assign the accounts receivable to them. This means that your customers accounts payable departments will be notified to send payments to the factoring companys lockbox. Some businesses are concerned this will affect their customer relationships but factoring is such a commonly used form of financing that a professionally delivered factoring service rarely draws much notice from customers. Typically, the process is routinely handled in the Accounts Payable department. However, it is important to thoroughly understand the terms of a factoring agreement to know if costs or delays in payment may result from the notification process.

5. HOUSING FINANCE :

A situation where a seller provides customers with loans to purchase its goods or services. This is a well known practice in vehicle sales and has become increasingly popular with consumergoods retailers to give customers more payment flexibility, for example splitting the cost of a new television over several months rather than one up-front payment.

6. Venture capital : Advantages: The primary advantage of venture capital financing is an ability for company expansion that would not be possible through bank loans or other methods. This is essential for start-ups with limited operating histories and high upfront costs. In addition, repayment of VC

investors isn't necessarily an obligation like it would be for a bank loan. Rather, investors are shouldering the investment risk because they believe in the company's future success. In addition to financial capital, venture capitalists provide valuable expertise, advice and industry connections. A stipulation of many VC deals includes appointing a venture capitalist as a member of the company's board. This way, the VC firm has intimate involvement in the direction of the company. Venture capital is also associated with job creation (accounting for 2% of US GDP), the knowledge economy, and used as a proxy measure of innovation within an economic sector or geography. Disadvantages: Securing a VC deal can be a difficult process due to accounting and legal costs a firm must shoulder. The start-up company must also give up some ownership stake to the VC company investing in it. This results in a partial loss of autonomy that finds venture capitalists involved in decision-making processes. VC deals also come with stipulations and restrictions in composition of the start-up's management team, employee salary and other factors. Furthermore, with the VC firm literally invested in the company's success, all business operations will be under constant scrutiny. The loss of control varies depending on the terms of the VC deal.

7. Merchant banking

Merchant Banking is a combination of Banking and consultancy services. It provides consultancy to its clients for financial, marketing, managerial and legal matters. Consultancy means to provide advice, guidance and service for a fee. It helps a businessman to start a business. It helps to raise (collect)finance. It helps to expand and modernize the business. It helps in restructuring of a business. It helps to revive sick business units. It also helps companies to register, buy and sell shares at the stock exchange.

In short, merchant banking provides a wide range of services for starting until running a business. It acts as Financial Engineer for a business. Merchant banking was first started in India in 1967 by Grindlays Bank. It has made rapid progress since 1970. Functions of Merchant Banking 1. Raising Finance for Clients : Merchant Banking helps its clients to raise finance through issue of shares, debentures, bank loans, etc. It helps its clients to raise finance from the domestic and international market. This finance is used for starting a new business or project or for modernization or expansion of the business. 2. Broker in Stock Exchange : Merchant bankers act as brokers in the stock exchange. They buy and sell shares on behalf of their clients. They conduct research on equity shares. They also advise their clients about which shares to buy, when to buy, how much to buy and when to sell. Large brokers, Mutual Funds, Venture capital companies and Investment Banks offer merchant banking services. 3. Project Management : Merchant bankers help their clients in the many ways. For e.g. Advising about location of a project, preparing a project report, conducting feasibility studies, making a plan for financing the project, finding out sources of finance, advising about concessions and incentives from the government. 4. Advice on Expansion and Modernization : Merchant bankers give advice for expansion and modernization of the business units. They give expert advice on mergers and amalgamations, acquisition and takeovers, diversification of business, foreign collaborations and jointventures, technology up-gradation, etc. 5. Managing Public Issue of Companies : Merchant bank advice and manage the public issue of companies. They provide following services: i. ii. iii. Advise on the timing of the public issue. Advise on the size and price of the issue. Acting as manager to the issue, and helping in accepting applications and allotment of securities. iv. v. Help in appointing underwriters and brokers to the issue. Listing of shares on the stock exchange, etc.

6. Handling Government Consent for Industrial Projects : A businessman has to get government permission for starting of the project. Similarly, a company requires permission for expansion

or modernization activities. For this, many formalities have to be completed. Merchant banks do all this work for their clients. 7. Special Assistance to Small Companies and Entrepreneurs : Merchant banks advise small companies about business opportunities, government policies, incentives and concessions available. It also helps them to take advantage of these opportunities, concessions, etc. 8. Services to Public Sector Units : Merchant banks offer many services to public sector units and public utilities. They help in raising long-term capital, marketing of securities, foreign collaborations and arranging long-term finance from term lending institutions. 9. Revival of Sick Industrial Units : Merchant banks help to revive (cure) sick industrial units. It negotiates with different agencies like banks, term lending institutions, and BIFR (Board for Industrial and Financial Reconstruction). It also plans and executes the full revival package. 10. Portfolio Management : A merchant bank manages the portfolios (investments) of its clients. This makes investments safe, liquid and profitable for the client. It offers expert guidance to its clients for taking investment decisions. 11. Corporate Restructuring : It includes mergers or acquisitions of existing business units, sale of existing unit or disinvestment. This requires proper negotiations, preparation of documents and completion of legal formalities. Merchant bankers offer all these services to their clients. 12. Money Market Operation : Merchant bankers deal with and underwrite short-term money market instruments, such as: Government Bonds, Certificate of deposit issued by banks and financial institutions, Commercial paper issued by large corporate firms, Treasury bills issued by the Government (Here in India by RBI). 13. Leasing Services : Merchant bankers also help in leasing services. Lease is a contract between the lessor and lessee, whereby the lessor allows the use of his specific asset such as equipment by the lessee for a certain period. The lessor charges a fee called rentals. 14. Management of Interest and Dividend : Merchant bankers help their clients in the management of interest on debentures / loans, and dividend on shares. They also advise their client about the timing (interim / yearly) and rate of dividend. Advantages: Merchant banks perform functions that cannot be carried out by businesses on their own.

 Merchant banks have access to traders, financial institutions, and markets that companies or individuals could not possibly reach. By using their skills and contacts, merchant banks can get the best possible deals for their clients. Disadvantages: Merchant banks are really only for large corporate customers, or extremely wealthy smaller businesses owned by individual clients. Not all deals carried out by merchant banks meet with unqualified success. There is always risk attached to the kinds of deal that merchant banks undertake.

Unit 3 1. Rbi and sebi functions and objectives 2. Critical appraisal of uti in the Indian financial system 3. Mutual funds 4. Investment trust co. v/s unit trust 5. Mutual funds and regulations in ifs

RBI: The Reserve Bank of India performs various traditional central banking functions as well as undertakes different promotional and developmental measures to meet the dynamic requirements of the country. The broad objectives of the Reserve Bank are:

(a) Regulating the issue of currency in India; (b) keeping the foreign exchange reserves of the country; (c) establishing the monetary stability in the country; and (d) developing the financial structure of the country on sound lines consistent with the national socio-economic objectives and policies. Main functions of the Reserve Bank are described below: 1. Note Issue: The Reserve Bank has the monopoly of note issue in the country. It has the sole right to issue currency notes of all denominations except one-rupee notes. One-rupee notes are issued by the Ministry of Finance of the Government of India. The Reserve Bank acts as the only source of legal tender because even the one-rupee notes are circulated through it. The Reserve Bank has a separate Issue Department, which is entrusted with the job of issuing currency notes. The Reserve Bank has adopted minimum reserve system of note issue. Since 1957, it maintains gold and foreign exchange reserves of Rs. 200 crore, of which at least Rs. 115 crore should be in gold. 2. Banker to Government: The Reserve Bank acts as the banker, agent and adviser to Government of India: (a) It maintains and operates government deposits,

(b) It collects and makes payments on behalf of the government, (c) It helps the government to float new loans and manages the public debt, (d) It sells for the Central Government treasury bills of 91 days duration, (e) It makes 'Ways and Means' advances to the Central and State Governments for periods not exceeding three months, (f) It provides development finance to the government for carrying out five year plans, (g) It undertakes foreign exchange transactions on behalf of the Central Government, (h) It acts as the agent of the Government of India in the latter's dealings with the International Monetary Fund (IMF), the World Bank, and other international financial institutions, (i) It advises the government on all financial matters such as loan operations, investments, agricultural and industrial finance, banking, planning, economic development, etc. 3. Banker's Bank: The Reserve Bank acts as the banker's bank in the following respects: (a) Every Bank is under the statutory obligation to keep a certain minimum of cash reserves with the Reserve Bank. The purpose of these reserves is to enable the Reserve Bank to extend financial assistance to the scheduled banks in times of emergency and thus to act as the lender of the last resort. According to the Banking Regulation Act, 1949, all scheduled banks are required to maintain with the Reserve Bank minimum cash reserves of 5% of their demand liabilities and 2% of their time liabilities. The Reserve Bank (Amendment) Act, 1956 empowered the Reserve Bank to raise the cash reserve ratio to 20% in the case of demand deposits and to 8% in case of time deposits. Due to the difficulty of classifying deposits into demand and time categories, the amendment to the Banking Regulation Act in September 1972 changed the provision of reserves to 3% of aggregate deposit liabilities, which can be raised to 15% if the Reserve Bank considers it necessary, (b) The Reserve Bank provide financial assistance to the scheduled banks by discounting their eligible bilk and through loans and advances against approved securities,

(c) Under the Banking Regulation Act,1949 and its various amendments, the Reserve Bank has been given extensive powers of supervision and control over the banking system. These regulatory powers relate to the licensing of banks and their branch expansion; liquidity of assets of the banks; management and methods of working of the banks; amalgamation, reconstruction and liquidation of banks; inspection of banks; etc. 4. Custodian of Exchange Reserves: The Reserve Bank is the custodian of India's foreign exchange reserves. It maintains and stabilises the external value of the rupee, administers exchange controls and other restrictions imposed by the government, and manages the foreign exchange reserves. Initially, the stability of exchange rate was maintained through selling and purchasing sterling at fixed rates. But after India became a member of the international Monetary Fund (IMF) in 1947, the rupee was delinked with sterling and became a multilaterally convertible currency. Therefore the Reserve Bank now sells and buys foreign currencies, and not sterling alone, in order to achieve the objective of exchange stability. The Reserve Bank fixes the selling and buying rates of foreign currencies. All Indian remittances to foreign countries and foreign remittances to India are made through the Reserve Bank. 5. Controller of Credit: As the central bank of the country, the Reserve Bank undertakes the responsibility of controlling credit in order to ensure internal price stability and promote economic growth. Through this function, the Reserve Bank attempts to achieve price stability in the country and avoids inflationary and deflationary tendencies in the country. Price stability is essential for economic development. The Reserve Bank regulates the money supply in accordance with the changing requirements of the economy. The Reserve Bank makes extensive use of various quantitative and qualitative techniques to effectively control and regulate credit in the country. 6. Ordinary Banking Functions: The Reserve Bank also performs various ordinary banking functions: (a), It accepts deposits from the central government, state governments and even private individuals without interest,

(b) It buys, sells and rediscounts the bills of exchange and promissory notes of the scheduled banks without restrictions, (c) It grants loans and advances to the central government, state governments, local authorities, scheduled banks and state cooperative banks, repayable within 90 days, (d) It buys and sells securities of the Government of India and foreign securities, (e) It buys from and sells to the scheduled banks foreign exchange for a minimum amount of Rs. 1 lakh, (f) It can borrow from any scheduled bank in India or from any foreign bank, (g) It can open an account in the World Bank or in some foreign central bank. (h) It accepts valuables, securities, etc., for keeping them in safe custody. (i) It buys and sells gold and silver. 7. Miscellaneous Functions: In addition to central banking and ordinary banking functions, the Reserve Bank performs the following miscellaneous functions: (a) Banker's Training College has been set up to extend training facilities to supervisory staff of commercial banks. Arrangements have been made to impart training lo the cooperative personnel, (b) The Reserve Bank collects and publishes statistical information relating to banking, finance, credit, currency, agricultural and industrial production, etc. It also publishes the results of various studies and review of economic situation of the country in its monthly bulletins and periodicals. 8. Forbidden Business: Being the central bank of the country, the Reserve Bank: (a) Should not compete with member banks and (b) should keep its assets in liquid form to meet any situation of economic crisis.

Therefore, the Reserve Bank has been forbidden to do certain types of business: (a) It can neither participate in, nor directly provide financial assistance to any business, trade or industry, (b) It can neither buy its own shares not those of other banks or commercial and industrial undertakings, (c) It cannot grant unsecured loans and advances, (d) It cannot give loans against mortgage security, (e) It cannot give interest on deposits. (f) It cannot draw or accept bills not payable on demand, (g) It cannot purchase immovable property except for its own offices. 9. Promotional and Developmental Functions: Besides the traditional central banking functions, the Reserve Bank also performs a variety of promotional and developmental functions: (a) By encouraging the commercial banks to expand their branches in the semi-urban and rural areas, the Reserve Bank helps (i) to reduce the dependence of the people in these areas on the defective unorganised sector of indigenous bankers and money lenders, and (ii) to develop the banking habits of the people (b) By establishing the Deposit Insurance Corporation, the Reserve Bank helps to develop the banking system of the country, instills confidence of the depositors and avoids bank failures, (c) Through the institutions like Unit Trust of India, the (Reserve Bank helps to mobilise savings in the country, (d) Since its inception, the Reserve Bank has been mating efforts to promote institutional agricultural credit by developing cooperative credit institutions.

(e) The Reserve Bank also helps to promote the process of industrialisation in the country by setting up specialised institutions for industrial finance, (f) it also undertakes measures for developing bill market in the country. Main Objectives of RBI are the following:

Monetary Authority

Formulates implements and monitors the monetary policy Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors

Regulator and supervisor of the financial system

Prescribes broad parameters of banking operations within which the countrys banking and financial system functions Objective: maintain public confidence in the system, protect depositors interest and provide cost-effective banking services to the public.

Manager of Exchange Control

Manages the Foreign Exchange Management Act, 1999 Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency

Issues and exchanges or destroys currency and coins not fit for circulation Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.

Developmental role

Performs a wide range of promotional functions to support national objectives

Related Functions

Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker

Banker to banks: maintains banking accounts of all scheduled banks Owner and operator of the depository (SGL) and exchange (NDS) for government bonds

SEBI: Securities Exchange Board of India (SEBI) was set up in 1988 to regulate the

functions of securities market. SEBI promotes orderly and healthy development in the stock market but initially SEBI was not able to exercise complete control over the stock market transactions. It was left as a watch dog to observe the activities but was found ineffective in regulating and controlling them. As a result in May 1992, SEBI was granted legal status. SEBI is a body corporate having a separate legal existence and perpetual succession. OBJECTIVES OF SEBI : (1) To promote orderly and healthy growth of the securities market in India. (2) To protect the rights and interests of investors through necessary regulations. (3) To create proper market environment for orderly functioning of securities market. (4) To regulate operations of financial intermediaries such as brokers, underwriters, portfolio managers and mutual funds. In addition, to promote professionalism among the intermediaries. (5) To create healthy market environment so as to enable companies (issuers of capital) to raise adequate funds for their business through the sale of securities (shares, debentures and bonds). (6) To provide suitable education and guidance to investors so as to enable them to protect their interest.

In short, SEBI is for the protection of investors, regulation of stock exchanges and financial intermediaries and healthy growth of capital market in India. Functions of SEBI: The SEBI performs functions to meet its objectives. To meet three objectives SEBI has three important functions. These are: i. Protective functions ii. Developmental functions iii. Regulatory functions. 1. Protective Functions: These functions are performed by SEBI to protect the interest of investor and provide safety of investment. As protective functions SEBI performs following functions: (i) It Checks Price Rigging: Price rigging refers to manipulating the prices of securities with the main objective of inflating or depressing the market price of securities. SEBI prohibits such practice because this can defraud and cheat the investors. (ii) It Prohibits Insider trading: Insider is any person connected with the company such as directors, promoters etc. These insiders have sensitive information which affects the prices of the securities. This information is not available to people at large but the insiders get this privileged information by working inside the company and if they use this information to make profit, then it is known as insider trading, e.g., the directors of a company may know that company will issue Bonus shares to its shareholders at the end of year and they purchase shares from market to make profit with bonus issue. This is known as insider trading. SEBI keeps a strict check when insiders are buying securities of the company and takes strict action on insider trading. (iii) SEBI prohibits fraudulent and Unfair Trade Practices:

SEBI does not allow the companies to make misleading statements which are likely to induce the sale or purchase of securities by any other person. (iv) SEBI undertakes steps to educate investors so that they are able to evaluate the securities of various companies and select the most profitable securities. (v) SEBI promotes fair practices and code of conduct in security market by taking following steps: (a) SEBI has issued guidelines to protect the interest of debenture-holders wherein companies cannot change terms in midterm. (b) SEBI is empowered to investigate cases of insider trading and has provisions for stiff fine and imprisonment. (c) SEBI has stopped the practice of making preferential allotment of shares unrelated to market prices. 2. Developmental Functions: These functions are performed by the SEBI to promote and develop activities in stock exchange and increase the business in stock exchange. Under developmental categories following functions are performed by SEBI: (i) SEBI promotes training of intermediaries of the securities market. (ii) SEBI tries to promote activities of stock exchange by adopting flexible and adoptable approach in following way: (a) SEBI has permitted internet trading through registered stock brokers. (b) SEBI has made underwriting optional to reduce the cost of issue. (c) Even initial public offer of primary market is permitted through stock exchange. 3. Regulatory Functions:

These functions are performed by SEBI to regulate the business in stock exchange. To regulate the activities of stock exchange following functions are performed: (i) SEBI has framed rules and regulations and a code of conduct to regulate the intermediaries such as merchant bankers, brokers, underwriters, etc. (ii) These intermediaries have been brought under the regulatory purview and private placement has been made more restrictive. (iii) SEBI registers and regulates the working of stock brokers, sub-brokers, share transfer agents, trustees, merchant bankers and all those who are associated with stock exchange in any manner. (iv) SEBI registers and regulates the working of mutual funds etc. (v) SEBI regulates takeover of the companies. (vi) SEBI conducts inquiries and audit of stock exchanges. Investment Companies vs. Unit Trusts When selecting an investment fund it is important that you first clarify your objectives and requirements and then select a fund that is most suitable to meet these. It is worth considering all types of fund before investing to ensure that the one selected offers the best value at the time of purchase. Many of our recommended portfolios include a combination of Investment Companies, Unit Trusts and OEICs. Each type of fund has many different characteristics - these are listed below: Unit Trusts A trust where each unit holder is entitled to share in the assets of the trust in proportion to the number of units owned. Control is exercised by Managers, subject to approval by Trustees within the terms of the Trust Deed.

Open ended. All sales and purchases are dealt for cash and go to and from the managers. Net redemption's will lead to the managers having to sell some of the underlying investments to meet the demand for cash.

Price of a unit is based on net asset value (NAV) of the underlying investments. Dealing costs are normally front-end loaded with a bid offer spread on dual price funds and an initial charge on single priced funds.

UTs can have only one class of unit and all units are to be treated equally. UTs are allowed to advertise subject to approval by the Trustees. Annual management charges are typically 0.75% to 1.5% but this will depend upon whether 'clean' or 'retail' share classes are invested into. Our Advisers can explain this in more detail.

Unit Trusts : In a unit trust, instead of buying individual stock market or other assets directly, investors buy units which represent a share in the total trust fund. The value of these units fluctuate daily according to the market valuation of the assets held by the fund. Two prices are usually quoted - the offer price, which is the price you pay when buying units, and the bid price, which is the price paid to you when selling. There are many unit trusts to choose from, investing across a wide range of investment sectors. The managers of the trusts can buy and sell within the trust without having to pay any tax, but tax liabilities can arise on dividends and unit sales by the holder.

Investment Companies A public limited company whose shares are listed on the Stock Exchange. Management is exercised by Directors, subject to the Memorandum and Articles of Association.

Closed ended. Shares are dealt on a secondary market. Therefore, in the secondary market there is no cash flow into or out of the fund.

Price of a share is not laid down by any formula but set by normal market forces. This can result in a share price sitting at a discount to NAV or a premium to NAV and increases volatility compared with UTs.

Shares are bought and sold on the Stock Exchange and therefore costs include brokerage, stamp duty and PTM levy.

ICs may issue different classes of share. This can include long term borrowing, and introduces the concept of gearing.

Its are not allowed to advertise to the public to buy their shares (concessions are given for some new issues and IT savings schemes).

Annual management charges are typically around 1% although this can vary. Please speak to one of our advisers who will explain the specific charges for a particular investment.

OEICs

OEICs - Open-Ended Investment Companies - are similar to unit trusts but instead of buying units in a collective fund, the investor buys shares in the OEIC itself. The OEIC's share price is directly related to the value of its investment portfolio. Investors who buy shares in the OEIC pay the published share price at the time of purchase, plus an initial purchase charge. Sellers of shares receive the published price on the date of selling. OEICs now outnumber unit trusts and are gradually replacing the remaining trusts.

Investment Trusts

An investment trust is a company that invests in shares and other securities, and works just like an OEIC but with the important difference that it is not an 'open ended' investment. When there is an increasing demand by investors for an OEICs shares, the manager simply issues more shares to meet demand. An investment trust cannot do this because it is not an open ended investment vehicle, so if demand for its shares exceeds supply the result is a rise in its share price - and, conversely, a lack of demand could prompt the share price to fall. These price movements are not directly related to the current market values of the investments it has made, so unlike an OEIC an investment trust's share price does not directly reflect the underlying value of its investment portfolio. Where there is a disparity between the two, the investment trust is referred to as trading at a discount (or premium) to in NAV (net asset value - the underlying value of investments).

An important difference between an investment trust and a unit trust is that an investment trust manager is legally allowed to borrow capital to purchase stocks and shares for its investment portfolio. This 'leverage' may increase the potential for investment gains, but also increases the risk to the trust's investors.

From a tax perspective, investing in investment trusts is treated the same as investing directly in the company shares.

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Unit 2