FINANCIAL SERVICES AND MARKETING

There has been an upsurge in the financial services provided by various banks and
financial institutions since 1990. Efficiency of emerging financial system depends upon
the quality and variety of financial services provided by the banking and non-banking
financial companies. Financial services, through the network of elements such as
financial institutions, financial markets and financial instruments, serve the needs of
individuals, institutions and corporates. It is through these elements that the functioning
of the financial system is facilitated. In fact, an orderly functioning of the financial
system depends, to a great extent, on the range and the quality of financial services
extended by a host of providers.

MEANING OF FINANCIAL SERVICES

The Indian Financial services industry has undergone a metamorphosis since 1990. During
the late seventies and eighties, the Indian financial service industry was dominated by
commercial banks and other financial institutions which cater to the requirements of the
Indian industry. Infact the capital market played a secondary role only. The economic
liberalization has brought in a complete transformation in the Indian financial services
industry.
Prior to the economic liberalization, the Indian financial service sector was characterized by
so many factors which retarded the growth of this sector. Some of the significant factors
were:
(i) Excessive controls in the form of regulations of interest rates, money rates etc.
(ii) Too many control over the prices of securities under the erstwhile Controller
of Capital Issues.
(iii) Non-availability of financial instruments on a large scale as well as on
different varieties.
(iv) Absence of independent credit rating and credit research agencies. : 3 :
 (v) Strict regulation of the foreign exchange market with too many restrictions on
foreign investment and foreign equity holding in Indian companies.
(vi) Lack of information about international developments in the financial sector.
(vii) Absence of a developed Government securities market and the existence of
stagnant capital market without any reformation.
(viii) Non-availability of debt instruments on a large scale.
However, after the economic liberalisation, the entire financial sector has undergone a
sea-saw change and now we are witnessing the emergence of new financial products and
services almost everyday. Thus, the present scenario is characterized by financial
innovation and financial creativity and before going deep into it, it is imperative that one
should understand the meaning and scope of financial services.
In general, all types of activities which are of a financial nature could be brought under
the term ‘financial services’. The term “Financial Services” in a broad sense means
“mobilizing and allocating savings”. Thus, it includes all activities involved in the
transformation of saving into investment.
The ‘financial service’ can also be called ‘financial intermediation’ Financial
intermediation is a process by which funds are moblised from a large number of savers
and make them available to all those who are in need of it and particularly to corporate
customers. Thus, financial services sector is a key are and it is very vital for industrial
developments. A well developed financial services industry is absolutely necessary to
mobilize the savings and to allocate them to various investable channels and thereby to
promote industrial development in a country.

CLASSIFICATION OF FINANCIAL SERVICES INDUSTRY

The financial intermediaries in India can be traditionally classified into two:
(i) Capital market intermediaries and :
 (ii) Money market intermediaries.
The capital market intermediaries consist of term lending institutions and investing
institutions which mainly provide long term funds. On the other hand, money market
consists of commercial banks, co-operative banks and other agencies which supply only
short term funds. Hence, the term ‘financial services industry’ includes all kinds of
organizations which intermediate and facilitate financial transactions of both individuals
and corporate customers.

SCOPE OF FINANCIAL SERVICES

Financial services cover a wide range of activities. They can be broadly classified into
two namely:
(i) Traditional activities
(ii) Modern activities

Traditional activities
Traditionally, the financial intermediaries have been rendering a wide range of services
encompassing both capital and money market activities. They can be grouped under two
heads viz;
(i) Fund based activities and
(ii) Non-fund based activities
Fund based activities : The traditional services which come under fund based activities
are the following:
(i) Underwriting of or investment in shares, debentures, bonds etc. of new issues
(primary market activities)
(ii) Dealing in secondary market activities.
(iii) Participating in money market instruments like commercial papers, certificate
of deposits, treasury bills, discounting of bills etc. : 5 :
 (iv) Involving in equipment leasing, hire purchase, venture capital, seed capital
etc.
(v) Dealing in foreign exchange market activities.
Non-fund based activities : Financial intermediaries provide services on the basis of
non-fund activities also. This can also be called “fee based” activity. Today, customers
whether individual or corporate are not satisfied with mere provision of finance. They
expect more from financial service companies. Hence, a wide variety of services, are
being provided under this head. They include the following :
(i) Managing the capital issues i.e., management of pre-issue and post-issue
activities relating to the capital issue in accordance with the SEBI
guidelines and thus enabling the promoters to market their issues.
(ii) Making arrangements for the placement of capital and debt instruments with
investment institutions.
(iii) Arrangement of funds from financial institutions for the clients’ project cost
or his working capital requirements.
(iv) Assisting in the process of getting all Government and other clearances.

Modern activities
Besides the above traditional services, the financial intermediaries render innumerable
services in recent times. Most of them are in the nature of non-fund based activity. In
view of the importance, these activities have been discussed in brief under the head ‘New
financial products and services’. However, some of the modern services provided by
them are given in brief hereunder:
(i) Rendering project advisory services right from the preparation of the project
report till the raising of funds for starting the project with necessary
Government approval.
(ii) Planning for mergers and acquisitions and assisting for their smooth carry out.
:6:
(iii) Guiding corporate customers in capital restructuring.
(iv) Acting as Trustees to the debenture-holders.
(v) Recommending suitable changes in the management structure and
management style with a view to achieving better results.
(vi) Structuring the financial collaboration/joint ventures by identifying suitable
joint venture partner and preparing joint venture agreement.
(vii) Rehabilitating and reconstructing sick companies through appropriate scheme
of reconstruction and facilitating the implementation of the scheme.
(viii) Hedging of risk due to exchange rate risk, interest rate risk, economic risk
and political risk by using swaps and other derivative products.
(ix) Managing the portfolio of large Public Sector Corporations.
(x) Undertaking risk management services like insurance services, buy-back
options etc.
(xi) Advising the clients on the question of selecting the best source of funds
taking into consideration the quantum of funds required, their cost, lending
period etc.
(xii) Guiding the clients in the minimization of the cost of debt and in the
determination of the optimum debt-equity mix.
(xiii) Undertaking services relating to the capital market such as:
(a) Clearing services,
(b) Registration and transfers,
(c) Safe-custody of securities,
(d) Collection of income on securities.
(xiv) Promoting credit rating agencies for the purpose of rating companies which
want to go public by the issue of debt instruments. : 7 :
Sources of revenue
Accordingly, there are two categories of sources of income for a financial service
company namely: (i) fund-based and (ii) fee-based.
Fund-based income comes mainly from interest spread (difference between the interest
paid and earned), lease rentals, income from investments in capital market and real estate.
On the other hand, fee-based income has its sources in merchant banking, advisory
services, custodial services, loan syndication etc. In fact, a major part of the income is
earned through fund-based activities. At the same time, it involves a large share of
expenditure also in the form of interest and brokerage. In recent times, a number of
private financial companies have started accepting deposits by offering a very high rate
of interest. When the cost of deposit resources goes up, the lending rate should also go
up. It means that such companies should have to compromise the quality of its
investments.
Fee-based income, on the other hand, does not involve much risk. But, it requires a lot of
expertise on the part of a financial company to offer such fee-based services.
CAUSES FOR FINANCIAL INNOVATION
Financial intermediaries have to perform the task of financial innovation to meet the
dynamically changing needs of the economy and to help the investors cope with an
increasingly volatile and uncertain market place. There is a dire necessity for the financial
intermediaries to go for innovation due to the following reasons:
(i) Low profitability : The profitability of the major financial intermediary, namely the
banks has been very much affected in recent times. There is a decline in the profitability
of traditional banking products. So, they have been compelled to seek out new products
which may fetch high returns.
(ii) Keen competition : The entry of many financial intermediaries in the financial sector
market has led to severe competition amount themselves. This keen competition : 8 :
has paved the way for the entry of varied nature of innovative financial products so as to
meet the varied requirements of the investors.
(iii) Economic Liberalisation : Reform of the financial sector constitutes the most
important component of India’s programme towards economic liberalization. The recent
economic liberalization measures have opened the door to foreign competitors to enter
into our domestic market. Deregulation in the form of elimination of exchange controls
and interest rate ceilings have made the market more competitive. Innovation has become
a must for survival.
(iv) Improved communication technology : The communication technology has
become so advanced that even the world’s issuers can be linked with the investors in the
global financial market without any difficulty by means of offering so many options and
opportunities. Hence, innovative products are brought into the domestic market in no
time.
(v) Customer Service : Now-a-days, the customer’s expectations are very great. They
want newer products at lower cost or at lower credit risk to replace the existing ones. To
meet this increased customer sophistication, the financial intermediaries are constantly
undertaking research in order to invent a new product which may suit to the requirement
of the investing public. Innovations thus help them in soliciting new business.
(vi) Global impact : Many of the providers and users of capital have changed their roles
all over the world. Financial intermediaries have come out of their traditional approach
and they are ready to assume more credit risks. As a consequence, many innovations have
taken place in the global financial sector which have its own impact on the domestic
sector also.
(vii) Investor awareness : With a growing awareness amongst the investing public, there
has been a distinct shift from investing the savings in physical assets like gold, silver,
land etc. to financial assets like shares, debentures, mutual funds etc. Again, within : 9 :
the financial assets, they go from ‘risk free’ bank deposits to risky investments in shares.
To meet the growing awareness of the public, innovation has become the need of the
hour.

Financial Engineering
Thus, the growing need for innovation has assumed immense importance in recent times.
This process is being referred to as financial engineering. Financial engineering is the
lifeblood of any financial ability. “Financial engineering is the design, the development
and the implementation of innovative financial instruments and processes and the
formulation of creative solutions to problems in finance”.

NEW FINANCIAL PRODUCTS AND SERVICES

Today, the importance of financial services is gaining momentum all over the world. In
these days of complex finance, people expect a Financial Service Company to play a very
dynamic role not only as a provider of finance but also as a departmental store of finance.
With the injection of the economic liberation policy into our economy and the opening of
the economy to multinationals, the free market concept has assumed much significance.
As a result, the clients both corporates and individuals are exposed to the phenomena of
volatility and uncertainty and hence they expect the financial service company to
innovate new products and service so as to meet their varied requirements.
As a result of innovations, new instruments and new products are emerging in the capital
market. The capital market and the money market are getting widened and deepened.
Moreover, there has been a structural change in the international capital market with the
emergence of new products and innovative techniques of operation in the capital market.
Many financial intermediaries including banks have already started expanding their
activities in the financial services sector by offering a variety of new products. As a
result, sophistication and innovations have appeared in the arena of financial
intermediations. Some of them are discussed below : : 10 :
(i) Merchant Banking : A merchant banker is a financial intermediary who helps to
transfer capital from those who posses it to those who need it. Merchant banking
includes a wide range of activities such as management of customers securities,
portfolio management, project counseling and appraisal, underwriting of shares
and debentures, loan syndication, acting as banker for the refund orders, handling
interest and dividend warrants etc. Thus, a merchant banker renders a host of
services to corporates and thus promotes industrial development in the country.
(ii) Loan Syndication : This is more or less similar to ‘consortium financing’. But, this
work is taken up by the merchant banker as a lead-manager. It refers to a loan
arranged by a bank called lead manager for a borrower who is usually a large
corporate customer or a Government Department. The other banks who are willing
to lend can participate in the loan by contributing an amount suitable to their own
lending policies. Since a single bank cannot provide such a huge sum as loan, a
number of banks join together and form a syndicate. It also enables the members
of the syndicate to share the credit risk associated with a particular loan among
themselves.
(iii) Leasing : A lease is an agreement under which a company or a firm, acquires a right
to make use of a capital asset like machinery, on payment of a prescribed fee
called “rental charges”. The lessee cannot acquire any ownership to the asset, but
he can use it and have full control over it. he is expected to pay for all maintenance
charges and repairing and operating costs. In countries like the U.S.A., the U.K.
and Japan equipment leasing is very popular and nearly 25% of plant and
equipment is being financed by leasing companies. In India also, many financial
companies have started equipment leasing business. Commercial banks have also
been permitted to carry on this business by forming subsidiary companies.
(iv) Mutual Funds : A mutual fund refers to a find raised by a financial service company
by pooling the savings of the public. It is invested in a diversified portfolio with a
view to spreading and minimizing risk. The fund provides : 11 :
investment avenue for small investors who cannot participate in the equities of big
companies. It ensures low risk, steady returns, high liquidity and better capital
appreciation in the long run.
(v) Factoring : Factoring refers to the process of managing the sales ledger of a client by
a financial service company. In other words, it is an arrangement under which a
financial intermediary assumes the credit risk in the collection of book debts for its
clients. The entire responsibility of collecting the book debts passes on to the
factor. His services can be compared to a del credre agent who undertakes to
collect debts. But, a factor provides credit information, collects debts, monitors the
sales ledger and provides finance against debts. Thus, he provides a number of
services apart from financing.
(vi) Forfeiting : Forfeiting is a technique by which a forfeitor (financing agency)
discounts an export bill and pay ready cash to the exporter who can concentrate on
the export front without bothering about collection of export bills. The forfeitor
does so without any recourse to the exporter and the exporter is protected against
the risk of non-payment of debts by the importers.
(vii) Venture Capital : A venture capital is another method of financing in the form of
equity participation. A venture capitalist finances a project based on the
potentialities of a new innovative project. It is in contrast to the conventional
“security based financing”. Much thrust is given to new ideas or technological
innovations. Finance is being provided not only for ‘start-up capital’ but also for
‘development capital’ by the financial intermediary.
(viii) Custodial Services : It is another line of activity which has gained importance, of
late. Under this, a financial intermediary mainly provides services to clients,
particularly to foreign investors, for a prescribed fee. Custodial services provide
agency services like safe keeping of shares and debentures, collection of interest
and dividend and reporting of matters on corporate developments and corporate
securities to foreign investors. : 12 :
(ix) Corporate Advisory Service : Financial intermediaries particularly banks have set
up corporate advisory service branches to render services exclusively to their
corporate customers. For instance, some banks have extended computer terminals
to their corporate customers to that they can transact some of their important
banking transactions by sitting in their own office. As new avenues of finance like
Euro loans, GDRs etc. are available to corporate customers, this service is of
immense help to the customers.
(x) Securitisation : Securitisation is a technique whereby a financial company converts
its ill-liquid, non-negotiable and high value financial assets into securities of small
value which are made tradable and transferable. A financial institution might have
a lot of its assets blocked up in assets like real estate, machinery etc. which are
long term in nature and which are non-negotiable. In such cases, securitisation
would help the financial institution to raise cash against such assets by means of
issuing securities of small values to the public. Like any other security, they can be
traded in the market. it is best suited to housing finance companies whose loans
are always long term in nature and their money is locked up for a considerable
long period in real estates. Securitisation is the only answer to convert these ill-
liquid assets into liquid assets.
(xi) Derivative Security : A derivative security is a security whose value depends upon
the values of other basic variables backing the security. In most cases, these
variables are nothing but the prices of traded securities. A derivative security is
basically used as a risk management tool and it is resorted to cover the risk due to
price fluctuations by the investments manager. Just like a forward contract which
is a derivative of a spot contract, a derivative security is derived from other trading
securities backing it. Naturally the value of a derivative security depends upon the
values of the backing securities. Derivative helps to break the risks into various
components such as credit risk, interest rates risk, exchange rates risk and so on. It
enables the various risk components to be identified precisely and priced them and
: 13 :
even traded them if necessary. Financial intermediaries can go for derivatives since they
will have greater importance in the near future. In India some forms of derivatives
are in operation.
(xii) New Products in Forex Market : New products have also emerged in the forex
markets of developed countries. Some of these products are yet to make full entry
in Indian markets. Among them, the following are the important ones :
(a) Forward Contracts : A forward transaction is one where the delivery of a
foreign currency takes place at a specified future date for a specified price. It
st st
may have a fixed maturity for e.g. 31 May or a flexible maturity for e.g. 1
st
to 31 May. There is an obligation to honour this contract at any cost, failing
which, there will be some penalty. Forward contracts are permitted only for
genuine business transactions. It can be extended to other transactions like
interest payments.
(b) Options : As the very name implies, it is a contract wherein the buyer of the
option has a right to buy or sell a fixed amount of currency against another
currency at a fixed rate on a future date according to his option. There is no
obligation to buy or sell, but it is completely left to his option. Options may
be of two types namely call options and put options. Under call options, the
customer has an option to buy and it is the option to sell under put options.
Options trading would lead to speculation and hence there are much
restrictions in India.
(c) Futures : It is a contract wherein there is an agreement to buy or sell a stated
quantity of foreign currency at a future date at a price agreed to between the
parties on the stated exchange. Unlike options, there is an obligation to buy
or sell foreign exchange on a future date at a specified rate. it can be dealt
only in a stock exchange. : 14 :
 (d) Swaps : A swap refers to a transaction wherein a financial intermediary buys
and sells a specified foreign currency simultaneously for different maturity
dates-say, for instance, purchase of spot and sale of forward or vice versa
with different maturities. Thus swaps would result in simultaneous buying
and selling of the same foreign currency of the same value for different
maturities to eliminate exposure risk. It can also be used as a tool to enter
arbitrage operations, if any, between two countries. It can also be used in the
interest rate market also.
(xiii) Lines of Credit (LOC) : It is an innovative funding mechanism for the import of
goods and services on deferred payment terms. LOC is an arrangement of
financing institution/bank of one country with another institution/bank/agent to
support the export of goods and services to as to enable the importers to import no
deferred payment terms. This may be backed by a guarantee furnished by the
institution/bank in the importing country. The LOC helps the exporters to get
payment immediately as soon as the goods are shipped, since, the funds would be
paid out of the pool account with the financing agency and it would be debited to
the account of the borrower agency/importer whose contract for availing the
facility is already approved by the financing agency on the recommendation of the
overseas institution. It acts as conduct of financing which is for a certain period
and on certain terms for the required goods to be imported. The greatest advantage
is that it saves a lot of time and money on mutual verification of bonafides, source
of finance etc. It serves as a source of forex.

EXPLAIN THE VARIOUS FINANCIAL INSTRUMENTS

In recent years, innovation has been the key word behind the phenomenal success of
many of the financial service companies and it forms an integral part of all planning and
policy decisions. This has helped them to keep in tune with the changing times and
changing customer needs. Accordingly, many innovative financial instruments have : 15 :
come into the financial market in recent times. Some of them have been discussed
hereunder :
(i) Commercial Paper : A paper is a short-term negotiable money market instrument. It
has the character of an unsecured promissory note with a fixed maturity of 3 to 6
months. Banking and non-banking companies can issue this for raising their short
term debt. It also carries an attractive rate of interest. Commercial papers are sold
at a discount from their face value and redeemed at their face value. Since its
denomination is very high, it is suitable only to institutional investors and
companies.
(ii) Treasury Bill : A treasury bill is also a money market instrument issued by the
Central Government. It is also issued at a discount and redeemed at par. Recently,
the Government has come out with short term treasury bills of 182-days bills and
364-days bills.
(iii) Certificate of Deposit : The scheduled commercial banks have been permitted to
issue certificate of deposit without any regulation on interest rates. This is also a
money market instrument and unlike a fixed deposit receipt, it is a negotiable
instrument and hence it offers maximum liquidity. As such, it has a secondary
market too. Since the denomination is very high, it is suitable to mainly
institutional investors and companies.
(iv) Inter-bank Participations (IBPs) : The scheme of inter-bank participation is
confined to scheduled banks only for a period ranging between 91 days and 180
days. This may be ‘with risk’ participation or ‘without risk’ participation.
However, only a few banks have so far issued IBPs carrying an interest rate
ranging between 14 and 17 per cent per annum. This is also a money market
instrument. : 16 :
(v) Zero Interest Convertible Debenture/Bonds : As the very name suggests, these
instruments carry no interest till the time of conversion. These instruments are
converted into equity shares after a period of time.
(vi) Deep Discount Bonds : There will be no interest payments in the case of deep
discount bonds also. Hence, they are sold at a large discount to their nominal
value. For example, the Industrial Development Bank of India issued in February
1996 deep discount bonds. Each bond having a face value of Rs.2,00,000 was
issued at a deep discounted price of Rs.5300 with a maturity period of 25 years. Of
course, provisions are there for early withdrawal or redemption in which case the
deemed face value of the bond would be reduced proportionately. This bond could
be gifted to any person.
(vii) Index-Linked Guilt Bonds : These are instruments having a fixed maturity. Their
maturity value is linked to the index prevailing as on the date of maturity. Hence,
they are inflation-free instruments.
(viii) Option Bonds : These bonds may be cumulative or non-cumulative as per the
option of the holder of the bonds. In the case of cumulative bonds, interest is
accumulated and is payable only on maturity. But, in the case of non-cumulative
bond, the interest is paid periodically. This option has to be exercised by the
prospective investor at the time of investment.
(ix) Secured Premium Notes : These are instruments which carry no interest of three
years. In other words, their interest will be paid only after 3 years, and hence,
companies with high capital intensive investments can resort to this type of
financing.
(x) Medium Term Debentures : Generally, debentures are repayable only after a long
period. But, these debentures have a medium term maturity. Since they are secured
and negotiable, they are highly liquid. These types of debt instruments are very
popular in Germany. : 17 :
(xi) Variable Rate Debentures : Variable rate debentures are debt instruments. They
carry a compound rate of interest, but this rate of interest is not a fixed one. It
varies from time to time in accordance with some pre-determined formula as we
adopt in the case of Dearness Allowance calculations.
(xii) Non-Convertible Debentures with Equity Warrants : Generally debentures are
redeemed on the date of maturity. but, these debentures are redeemed in full at a
premium in instalments as in the case of anticipated insurance policies. The
th th th th
instalments may be paid at the end of 5 , 6 , 7 and 8 year from the date of
allotment.
(xiii) Equity with 100% Safety Net : Some companies make “100% safety net” offer to
the public. It means that they give a guarantee to the issue price. Suppose, the
issue price is Rs.40/- per share (nominal value of Rs.10/- per share), the company
is ready to get it back at Rs.40/- at any time, irrespective of the market price. That
is, even if the market price comes down to Rs.30/- there is 100% safety net and
hence the company will get it back at Rs.40/-.
(xiv) Cumulative convertible Preference Shares : These instruments along with capital
and accumulated dividend must be compulsorily converted into equity shares in a
period of 3 to 5 years from the date of their issue, according to the discretion of the
issuing company. The main object of introducing it is to offer the investor an
assured minimum return together with the prospect of equity appreciation. This
instrument is not popular in India.
(xv) Convertible Bonds : A convertible bond is one which can be converted into equity
shares at a per-determined timing neither fully or partially. There are compulsory
convertible bonds which provide for conversion within 18 months of their issue.
There are optionally convertible bonds which provide for conversion within 36
months. There are also bonds which provide for conversion after 36 months and
they carry ‘call’ and ‘put’ features. : 18 :
(xvi) Debentures with ‘Call’ and ‘Put’ Feature : Sometimes debentures may be issued
with ‘Call’ and ‘Put’ feature. In the case of debentures with ‘Call feature’, the
issuing company has the option to redeem the debentures at a certain price before
the maturity date. In the case of debentures with ‘Put features’, the company gives
the holder the right to seek redemption at specified times at predetermined prices.
(xvii) Easy Exit Bond : As the name indicates, this bond enables the small investors
to encash the bond at any time after 18 months of its issue and thereby paving a
way for an easy exit. It has a maturity period of 10 years with a call option any
time after 5 years. Recently the IDBI has issued this type of bond with a face
value of Rs.5000 per bond.
(xviii) Retirement Bond : This type of bond enables an investor to get an assured
monthly income for a fixed period after the expiry of the ‘wait period’ chosen
by him. No payment will be made during the ‘wait period’. The longer the wait
period, the higher will be the monthly income. Besides these, the investor will
also get a lump sum amount on maturity. For example, the IDBI has issued
Retirement Bond ‘96 assuring a fixed monthly income for 10 years after the
expiry of the wait period. This bond can be gifted to any person.

(xix) Regular Income Bond : This bond offers an attractive rate of interest payable half
yearly with the facility of early redemption. The investor is assured of regular and
fixed income. For example, the IDBI has issued Regular Income Bond ’96
carrying 16% interest p.a. It is redeemable at the end of every year from the expiry
of 3 years from the date of allotment.
(xx) Infrastructure Bond : It is a kind of debt instrument issued with a view to giving
tax shelter to investors. The resources raised through this bond will be used for
promoting investment in the field of certain infrastructure industries. Tax
concessions are available under Sec.88, Sec.54 EA and Sec.54EB of the Income
Tax Act. HUDCO has issued for the first time such bonds. Its face value is : 19 :
Rs.1000 each carrying an interest rate of 15% per annum payable semi annually. This
bond will also be listed in important stock exchanges.
(xxi) Carrot and Stick bonds : Carrot bonds have a low conversion premium to
encourage early conversion, and sticks allow the issuer to call the bond at a
specified premium if the common stock is trading at a specified percentage above
the strike price.
(xxii) Convertible Bonds with a Premium put : These are bonds issued at face value
with a put, which means that the bond holder can redeem the bonds for more than
their face value.
(xxiii) Debt with Equity Warrant : Sometimes bonds are issued with warrants for the
purchase of shares. These warrants are separately tradable.
(xxiv) Dual Currency Bonds : Bonds that are denominated and pay interest in one
currency and are redeemable in another currency come under this category. They
facilitate interest rate arbitrage between two markets.
(xxv) ECU Bonds (European Currency Unit Bonds) : These bonds are denominated in
a basket of currencies of the 10 countries that constitute the European community.
They pay principal and interest in ECUs or in any of the 10 currencies at the
option of the holder.
(xxvi) Yankee Bonds : If bonds are raised in U.S.A., they are called Yankee bonds and if
they are raised in Japan, they are called Samurai Bonds.
(xxvii) Flip-Flop Notes : It is a kind of debt instrument which permits investors to switch
between two types of securities e.g. to switch over from a long term bond to a
short term fixed-rate note.
(xxviii) Floating Rate Notes (FRNs) : These are debt instruments which facilitate
periodic interest rate adjustments. : 20 :
(xxix) Loyalty Coupons : These are entitlements to the holder of debt for two to three
years to exchange into equity shares at discount prices. To get this facility, the
original subscriber must hold the debt instruments for the said period.
(xxx) Global Depository Receipt (GDR) : A global depository receipt is a dollar
denominated instrument traded on a stock exchange in Europe or the U.S.A./ or
both. It represents a certain number of underlying equity shares. Though the GDR
is quoted and traded in dollar terms, the underlying equity shares are denominated
in rupees. The shares are issued by the company to an intermediary called
depository in whose name the shares are registered. It is the depository which
subsequently issues the GDRs.

EXPLAIN CHALLENGES FACING THE FINANCIAL SERVICES SECTOR IN

INDIA
However, the financial service sector has to face many challenges in its attempt to fulfill
the ever growing financial demands of the economy. Some of the important challenges
are reported hereunder :
(i) Lack of qualified personnel : The financial services sector is fully geared to the task
of ‘financial creativity’. However, this sector has to face many challenges. In fact,
the dearth of qualified and trained personnel is an important impediment in its
growth. Hence, it is very vital that a proper and comprehensive training must be
given to the various financial intermediaries.
(ii) Lack of investor awareness : The introduction of new financial products and
instruments will be of no use unless the investor is aware of the advantages and
uses of the new and innovative products and instruments. Hence, the financial
intermediaries should educate the prospective investors/users of the advantages of
the innovative instruments through literature, seminars, workshops, advertisements
and even through audio-visual aids.
(iii) Lack of transparency : The whole financial system is undergoing a phenomenal
change in accordance with the requirements of the national and global : 21 :
environments. It is high time that this sector gave up their orthodox attitude of keeping
accounts in a highly secret manner. Hence, this sector should opt for better levels
of transparency. In other words, the disclosure requirements and the accounting
practices have to be in line with the international standards.
(iv) Lack of specialization : In the Indian scene, each financial intermediary seems to
deal in different financial service lines without specializing in one or two areas. In
other words, each intermediary is acting as a financial super market delivering so
many financial products and dealing in different varieties of instruments. In other
countries, financial intermediaries like Newtons, Solomon Brothers etc. specialize
in one or two areas only. This helps them to achieve high levels of efficiency and
excellence. Hence, in India also, financial intermediaries can go for specialization.
(v) Lack of recent data : Most of the intermediaries do not spend more on research. It is
very vital that one should build up a proper data base on the basis of which one
could embark upon ‘financial creativity’. Moreover, a proper data base would
keep oneself abreast of the recent developments in other parts of the whole world
and above all, it would enable the fund managers to take sound financial decisions.
(vi) Lack of efficient risk management system : With the opening of the economy to
multinationals and the exposure of Indian companies to international competition,
much importance is given to foreign portfolio flows. It involves the utilization of
multi currency transactions which exposes the client to exchange rate risk, interest
rate risk and economic and political risk. Unless a proper risk management system
is developed by the financial intermediaries as in the West, they would not be in a
position to fulfil the growing requirements of their customers. Hence, it is
absolutely essential that they should introduce Futures, Options, Swaps and other
derivative products which are necessary for an efficient risk management system.
ate, mutual funds have become a hot favourite of millions of people all over the
world. The driving force of mutual funds is the ‘safety of the principal’ guaranteed, plus
the added advantage of capital appreciation together with the income earned in the form
of interest or dividend. People prefer mutual funds to bank deposits, life insurance and
even bonds because with a little money, they can get into the investment game. One can
own a string of blue chips like ITC, TISCO, Reliance etc., through mutual funds. Thus,
mutual funds act as a gateway to enter into big companies hitherto inaccessible to an
ordinary investor with his small investment.
 EXPLAIN MUTUAL FUNDS IN INDIA
To state in simple words, a mutual fund collects the savings from small investors, invest
them in Government and other corporate securities and earn income through interest and
dividends, besides capital gains. It works on the principle of ‘small drops of water make a
big ocean’. For instance, if one has Rs.1000 to invest, it may not fetch very much on its
own. But, when it is pooled with Rs. 1000 each from a lot of other people, then, one
could create a ‘big fund’ large enough to invest in a wide varieties of shares and
debentures on a commanding scale and thus, to enjoy the economies of large scale
operations. Hence, a mutual fund is nothing but a form of collective investment. It is : 3 :
formed by the coming together of a number of investors who transfer their surplus funds
to a professionally qualified organization to manage it. To get the surplus funds from
investors, the fund adopts a simple technique. Each fund is divided into a small fraction
called “units” of equal value. Each investor is allocated units in proportion to the size of
his investment. Thus, every investor, whether big or small, will have a stake in the fund
and can enjoy the wide portfolio of the investment held by the fund. Hence, mutual funds
enable millions of small and large investors to participate in and derive the benefit of the
capital market growth. It has emerged as a popular vehicle of creation of wealth due to
high return, lower cost and diversified risk.
The Securities and Exchange Board of India (Mutual Funds) Regulations, 1993 defines a
mutual fund as “a fund established in the form of a trust by a sponsor, to raise monies by
the trustees through the sale of units to the public, under one or more schemes, for
investing in securities in accordance with these regulations”.
These mutual funds are referred to as Unit Trusts in the U.K. and as open end investment
companies in the U.S.A. Therefore, Kamm, J.O. defines an open end investment
company as “an organization formed for the investment of funds obtained from
individuals and institutional investors who in exchange for the funds receive shares which
can be redeemed at any time at their underlying asset value”.
According to Weston J. Fred and Brigham, Eugene, F., Unit Trusts are “Corporations
which accept dollars from savers and then use these dollars to buy stocks, long term
bonds, short term debt instruments issued by business or government units; these
corporations pool funds and thus reduce risk by diversification”.
Thus, mutual funds are corporations which pool funds by selling their own shares and
reduce risk by diversification.
Fund Unit Vs. Share : Just like shares, the price of units of a fund is also quoted in the
market. This price is governed basically by the value of the underlying investments held
by that fund. At this juncture, one should not confuse a mutual fund investment on units :
4:
with that of an investment on equity shares. Investment on equity share represents
investment in a particular company alone. On the other hand, investment on an unit of a
Fund represents investment in the parts of shares of a large number of companies. This
itself gives an idea how safe the units are. If a particular company fails the share-holders
of that company are affected very much whereas the unit holders of that company are
able to withstand that risk by means of their profitable holdings in other companies
shares.
Again, investment on equity shares can be used as a tool by speculators and inveterate
stock market enthusiasts with a view to gaining abnormal profits. These people play an
investment game in the stock market on the basis of daily movement of prices. But,
mutual funds cannot be invested for such purposes and the mutual fund is not at all
concerned with the daily ebbs and flows of the market. In short, mutual fund is not the
right investment vehicle for speculators. Mutual funds are, therefore, suitable only to
genuine investors whereas shares are suitable to both the genuine investors and the
speculators.

Origin of the Fund

The origin of the concept of mutual fund dates back to the very dawn of commercial
history. It is said that Egyptians and Phoenicians sold their shares in vessels and caravans
with a view to spreading the risk attached with these risky ventures. However, the real
credit of introducing the modern concept of mutual fund goes to the Foreign and Colonial
Government Trust of London established in 1868. Thereafter, a large number of close-
ended mutual funds were formed in the U.S.A. in 1930’s followed by many countries in
Europe, the Far East and Latin America. In most of the countries, both open and close-
ended types were popular. In India, it gained momentum only in 1980, though it began in
the year 1964 with the Unit Trust of India launching its first fund, the Unit Scheme 1964.
:5:
EXPLAIN SEVERAL TYPES OF FUNDS/CLASSIFICATION OF FUNDS
In the investment market, one can find a variety of investors with different needs,
objectives and risk taking capacities. For instance, a young businessman would like to get
more capital appreciation for his funds and he would be prepared to take greater risk than
a person who is just on the verge of his retiring age. So, it is very difficult to offer one
fund to satisfy all the requirements of investors. Just as one shoe is not suitable for all
legs, one fund is not suitable to meet the vast requirements of all investors. Therefore,
many types of funds are available to the investor. It is completely left to the discretion of
the investor to choose any one of them depending upon his requirement and his risk
taking capacity.
Mutual fund schemes can broadly be classified into many types as given below:

1. On the basis of execution and operation

(A) Close-ended Funds

Under this scheme, the corpus of the fund and its duration are prefixed. In other words,
the corpus of the fund and the number of units are determined in advance. Once the
subscription reaches the pre-determined level, the entry of investors is closed. After the
expiry of the fixed period, the entire corpus is disinvested and the proceeds are
distributed to the various unit holders in proportion to their holding. Thus, the fund ceases
to be a fund, after the final distribution.
Features : The main features of the close-ended funds are:
(i) The period and/or the target amount of the fund is definite and fixed
beforehand.
(ii) Once the period is over and/or the target is reached, the door is closed for the
investors. They cannot purchase any more units.
(iii) These units are publicly traded through stock exchange and generally, there is
no repurchase facility by the fund. : 6 :
 (iv) The main objective of this fund is capital appreciation.
(v) The whole fund is available for the entire duration of the scheme and there will
not be any redemption demands before its maturity. Hence, the fund
manager can manage the investments efficiently and profitably without the
necessity of maintaining and liquidity.
(vi) At the time of redemption, the entire investment pertaining to a closed-end
scheme is liquidated and the proceeds are distributed among the unit
holders.
(vii) From the investor’s point of view, it may attract more tax since the entire
capital appreciation is realized in toto at one stage itself.
(viii) If the market condition is not favourable, it may also affect the investor since
he may not get the full benefit of capital appreciation in the value of the
investment.
(ix) Generally, the prices of closed-end scheme units are quoted at a discount of
upto 40 percent below their Net Asset Value (NAV).

(B) Open-ended Funds

It is just the opposite of close-ended funds. Under this scheme, the size of the fund and/or
the period of the fund is not pre-determined. The investors are free to buy and sell any
number of units at any point of time. For instance, the Unit Scheme (1964) of the Unit
Trust of India is an open ended one, both in terms of period and target amount. Anybody
can buy this unit at any time and sell it also at any time at his discretion.

The main features of the Open-Ended Funds are :

(i) The investor is assured of regular income at periodic intervals, say half-yearly
or yearly and so on.
(ii) The main objective of this type of Fund is to declare regular dividends and not
capital appreciation. : 7 :
 (iii) The pattern of investment is oriented towards high and fixed income yielding
securities like debentures, bonds etc.
(iv) This is best suited to the old are retired people who may not have any regular
income.
(v) It concerns itself with short run gains only.

(B) Pure Growth Funds (Growth Oriented Funds)

Unlike the Income Funds, Growth Funds concentrate mainly on long run gains i.e.,
capital appreciation. They do not offer regular income and they aim at capital
appreciation in the long run. Hence, they have been described as “Nest Eggs”
investments.

The main features of the Growth Funds are :

(i) The growth oriented fund aims at meeting the investors’ need for capital
appreciation.
(ii) The investment strategy therefore, conforms to the fund objective by investing
the funds predominantly on equities with high growth potential.
(iii) The fund tries to get capital appreciation by taking much risks and investing
on risk bearing equities and high growth equity shares.
(iv) The fund may declare dividend, but its principal objective is only capital
appreciation.
(v) This is best suited to salaried and business people who have high risk bearing
capacity and ability to defer liquidity. They can accumulate wealth for
future needs.

(C) Balanced Funds

This is otherwise called income-cum-growth fund. It is nothing but a combination of both
income and growth funds. It aims at distributing regular income as well as capital : 8 :
appreciation. This is achieved by balancing the investments between the high growth
equity shares and also the fixed income earning securities.

(D) Specialised Funds

Besides the above, large number of specialised funds are in existence abroad. They offer
special schemes so as to meet the specific needs of specific categories of people like
pensioners, widows etc. There are also funds for investments in securities of specified
areas. For instance, Japan Fund, South Korea Fund etc. In fact, these funds open the door
for foreign investors to invest on the domestic securities of these countries.
Again certain funds may be confined to one particular sector or industry like fertilizer,
automobiles, petroleum etc. These funds carry heavy risk since the entire investment is in
one industry. But, there are high risk taking investors who prefer this type of fund. Of
course, in such cases, the rewards may be commensurate with the risk taken. At times, it
may be erratic. The best example of this type is the Petroleum Industry Funds in the
U.S.A.

(E) Money-Market Mutual Funds (MMMFs)

These funds are basically open ended mutual funds and as such they have all the features
of the open ended fund. But, they invest in highly liquid and safe securities like
commercial paper, banker’s acceptances, certificates of deposits, treasury bills etc. These
instruments are called money market instruments. They take the place of shares,
debentures and bonds in a capital market. They pay money market rates of interest. These
funds are called ‘money funds’ in the U.S.A. and they have been functioning since 1972.
Investors generally use it as a “parking place” or “stop gap arrangement” for their cash
resources till they finally decide about the proper avenue for their investment i.e., long
term financial assets like bonds and stocks.
Since MMMFs are a new concept in India, the RBI has laid down certain stringent
regulations. For instance, the entry to MMMFs is restricted only to scheduled commercial
banks and their subsidiaries. MMMFs can invest only in specified short term money : 9 :
market instruments like certificate of deposits, commercial papers and 182 days treasury
bills. They can also lend to call market. These funds go for safe and liquid investment.
Frequent realization of interest and redemption of fund at short notice are the special
features of the fund. These funds will not be subject to reserve requirements. The re-
purchase could be subject to a minimum lock in period of 3 months.

(F) Taxation Funds

A taxation fund is basically a growth oriented fund. But, it offers tax rebates to the
investors either in the domestic or foreign capital market. It is suitable to salaried people
who want to enjoy tax rebates particularly during the month of February and March. In
India, at present the law relating to tax rebates is covered under section 88 of the Income
Tax Act, 1961. An investor is entitled to get 20% rebate in Income Tax for investments
made under this fund subject to a maximum investment of Rs.10,000/- per annum. The
Tax Saving Magnum of SBI Capital Market Limited is the best example for the domestic
type. UTI’s US $60 million India Fund, based in the USA, is an example for the foreign
type.

OTHER CLASSIFICATION

(G) Leveraged Funds

These funds are also called borrowed funds since they are used primarily to increase the
size of the value of portfolio of a mutual fund. When the value increases, the earning
capacity of the fund also increases. The gains are distributed to the unit holders. This is
resorted to only when the gains from the borrowed funds are more than the cost of
borrowed funds.

(H) Dual Funds

This is a special kind of closed end fund. It provides a single investment opportunity for
two different types of investors. For this purpose, it sells two types of investment stocks
viz., income shares and capital shares. Those investors who seek : 10 :
current investment income can purchase income shares. They receive all the interest and
dividends earned from the entire investment portfolio. However, they are guaranteed a
minimum annual dividend payment. The holders of capital shares receive all the capital
gains earned on those shares and they are not entitled to receive any dividend of any type.
In this respect, the dual fund is different from a balanced fund.

(I) Index Funds

Index funds refer to those funds where the portfolios are designed in such a way that they
reflect the composition of some broad based market index. This is done by holding
securities in the same proportion as the index itself. The value of these index linked funds
will automatically go up whenever the market index goes up and vice-versa. Since the
construction of portfolio is entirely based upon maintaining proper proportions of the
index being followed, it involves less administrative expenses, lower transaction costs,
less number of portfolio managers etc. It is so because only fewer purchases and sales of
securities would take place.

(J) Bond Funds

These funds have portfolios consisting mainly of fixed income securities like bonds. the
main thrust of these funds is mostly on income rather than capital gains. They differ from
income funds in the sense income funds offer an average returns higher than that from
bank deposits and also capital gains lesser than that in equity shares.

(K) Aggressive Growth Funds

These funds are just the opposite of bond funds. These funds are capital gains oriented
and thus the thrust area of these funds is capital gains. Hence, these funds are generally
invested in speculative stocks. They may also use specialised investment techniques like
short term trading, option writing etc. Naturally, these funds tend to be volatile in nature.
: 11 :
(L) Off-Shore Mutual Funds
Off-shore mutual funds are those funds which are meant for non-residential investors. In
other words, the sources of investments for these funds are from abroad. So, they are
regulated by the provisions of the foreign countries where those funds are registered.
These funds facilitate flow of funds across different countries, with free and efficient
movement of capital for investment and repatriation. Off-shore funds are preferred to
direct foreign investment, since, it does not allow foreign domination over host country’s
corporate sector. However, these funds involve much currency and country risk and
hence they generally yield higher return.
In India, these funds are subject to the approval of the Department of Economic Affairs,
Ministry of Finance and the RBI monitors such funds by issuing directions then and
there. In India, a number of off-shore funds exist. ‘India Fund’ and ‘India Growth Fund’
were floated by the UTI in U.K. and U.S.A. respectively. The State Bank of India floated
the India Magnum Fund in Netherlands. ‘The Indo-Suez Himalayan Fund N.V.’ was
launched by Canbank Mutual Fund in collaboration with Indo-Suez Asia Investment
Services Ltd. It also floated ‘Commonwealth Equity Fund’.

6.4 IMPORTANCE OF MUTUAL FUNDS

The mutual fund industry has grown at a phenomenal rate in the recent past. One can
witness a revolution in the mutual fund industry in view of its importance to the investors
in general and the country’s economy at large. The following are some of the important
advantages of mutual funds :

(i) Channelising Savings for Investment

Mutual funds act as a vehicle in galvanizing the savings of the people by offering various
schemes suitable to the various classes of customers for the development of the economy
as a whole. A number of schemes are being offered by MFs so as to meet the varied
requirements of the masses, and thus, savings are directed towards capital : 12 :
investments directly. In the absence of MFs, these savings would have remained idle.
Thus, the whole economy benefits due to the cost efficient and optimum use and
allocation of scarce financial and real resources in the economy for its speedy
development.

(ii) Offering Wide Portfolio Investment

Small and medium investors used to burn their fingers in stock exchange operations with
a relatively modest outlay. If they invest in a select few shares, some may even sink
without a trace never to rise again. Now, these investors can enjoy the wide portfolio of
th investment held by the mutual fund. The fund diversifies its risks by investing on a
large varieties of shares and bonds which cannot be done by small and medium investors.
This is in accordance with the maxim ‘Not to lay all eggs in one basket’. These funds
have large amounts at their disposal, and so, they carry a clout in respect of stock
exchange transactions. They are in a position to have a balanced portfolio which is free
from risks. Thus MF’s provide instantaneous portfolio diversification. The risk
diversification which a pool of savings through mutual funds can achieve cannot be
attained by a single investor’s savings.

(iii) Providing Better Yields

The pooling of funds from a large number of customers enables the fund to have large
funds at its disposal. Due to these large funds, mutual funds are able to buy cheaper and
sell dearer than the small and medium investors. Thus, they are able to command better
market rates and lower rates of brokerage. So, they provide better yields to their
customers. They also enjoy the economies of large scale and can reduce the cost of
capital market participation. The transaction costs of large investments are definitely
lower than that of small investments. In fact, all the profits of a mutual fund are passed on
to the investors by way of dividends and capital appreciation. The expenses pertaining to
a particular scheme alone are charged to the respective scheme. Most of the mutual funds
so far floated have given a dividend at the rate ranging between 12% p.a. and 17% p.a. It
: 13 :
is fairly a good yield. It is an ideal vehicle for those who look for long term capital
appreciation.

(iv) Rendering Expertise Investment Service at Low Cost

The management of the fund is generally assigned to professionals who are well trained
and have adequate experience in the field of investment. The investment decisions of
these professionals are always backed by informed judgement and experience. Thus,
investors are assured of quality services in their best interest. Due to the complex nature
of the securities market, a single investor cannot do all these works by himself or he
cannot go to a professional manager who manages individual portfolios. In such a case,
he may charge hefty management fee. The intermediation fee is the lowest being one per
cent in the case of a mutual fund.

(v) Providing Research Service

A mutual fund is able to command vast resources and hence it is possible for it to have an
in depth study and carry out research on corporate securities. Each fund maintains a large
research team which constantly analyses the companies and the industries and
recommends the fund to buy or sell a particular share. Thus, investments are made purely
on the basis of a thorough research. Since research involves a lot of time, efforts and
expenditure, an individual investor cannot take up this work. By investing in a mutual
fund, the investor gets the benefit of the research done by the fund.

(vi) Offering Tax Benefits

Certain funds offer tax benefits to its customers. Thus, apart from dividends, interest and
capital appreciation, investors also stand to get the benefit of tax concession. For
instance, under section 80L of the Income Tax Act, a sum of Rs.10,000 received as
dividend (Rs.13000 to UTI) from a MF is deductible from the gross total income. Under
the wealth Tax Act, investments in MF are exempted upto Rs. 5 lakhs. : 14 :
The mutual funds themselves are totally exempt from tax on all income on their
investments. But, all other companies have to pay taxes and they can declare dividends
only from the profits after tax. But, mutual funds to do not deduct tax at source from
dividends. This is really a boon to investors.

(vii) Introducing Flexible Investment Schedule

Some mutual funds have permitted the investors to exchange their units from one scheme
to another and this flexibility is a great boon to investors. Income Units can be exchanged
for growth units depending upon the performance of the funds. One can not derive such a
flexibility in any other investments.

(viii) Providing Greater Affordability and Liquidity

Even a very small investor can afford to invest in mutual funds. They provide an
attractive and cost effective alternative to direct purchase of shares. In the absence of
MFs, small investors cannot think of participating in a number of investments with such a
meager sum. Again, there is grater liquidity. Units can be sold to the fund at anytime at
the Net Asset Value and thus quick access to liquid cash is assured. Besides, branches of
the sponsoring bank is always ready to provide loan facility against the unit certificates.

(ix) Simplified Record Keeping

An investor with just an investment in 500 shares or so in 3 or 4 companies has to keep
proper records of dividend payments, bonus issues, price movements, purchase or sale
instruction, brokerage and other related items. It is very tedious and consumes a lot of
time. One may even forget to record the rights issue and may have to forfeit the same.
Thus, record keeping is the biggest problem for small and medium investors. Now, a
mutual fund offers a single investment source facility, i.e., a single buy order of 100 units
from a mutual fund is equivalent to investment in more than 100 companies. The investor
has to keep a record of only one deal with the Mutual Fund. Even if he does not keep a :
15 :
record, the MF sends statements very often to the investor. Thus, by investing in MFs, the
record keeping work is also passed on to the fund.

(x) Supporting Capital Market

Mutual funds play a vital role in supporting the development of capital markets. The
mutual funds make the capital market active by means of providing a sustainable
domestic source of demand for capital market instruments. In other words, the savings of
the people are directed towards investments in capital markets through these mutual
funds. Thus, funds serve as a conduit for dis-intermediating bank deposits into stocks,
shares and bonds. Mutual Funds also provide a valuable liquidity to the capital market,
and thus, the market is made very active and stable. When foreign investors and
speculators exit and re-enter the markets en masse, mutual funds keep the market stable
and liquid. In the absence of mutual funds, the prices of shares would be subject to wide
price fluctuation due to the exit and re-entry of speculators into the capital market en
masse. Thus, it is rending an excellent support to the capital market and helping in the
process of institutionalization of the market.

(xi) Promoting Industrial Development

The economic development of any nation depends upon its industrial advancement and
agricultural development. All industrial units have to raise their funds by resorting to the
capital market by the issue of shares and debentures. The mutual funds not only create a
demand for these capital market instruments but also supply a large source of funds to the
market, and thus, the industries are assured of their capital requirements. In fact the entry
of mutual funds has enhanced the demand for India’s stock and bonds. Thus, mutual
funds provide financial resources to the industries at market rates.

(xii) Acting as Substitute for Initial Public Offerings (IPOs)

In most cases investors are not able to get allotment in IPOs of companies because they
are often oversubscribed many time. Moroever, they have to apply for a minimum of : 16
:
500 shares which is very difficult particularly for small investors. But, in mutual funds,
allotment is more or less guaranteed. Mutual Funds are also guaranteed a certain
percentage of IPOs by companies. Thus, by participating in MFs, investors are able to get
the satisfaction of participating in hundreds of varieties of companies.

(xiii) Reducing the Marketing Cost of New Issues

Moreover the mutual funds help to reduce the marketing cost of the new issues. The
promoters used to allot a major share of the Initial Public offering to the mutual funds and
thus they are saved from the marketing cost of such issues.

(xiv) Keeping the Money Market Active

An individual investor can not have any access to money market instruments since the
minimum amount of investment is out of his reach. On the other hand, mutual funds keep
the money market active by investing money on the money market instruments. In fact,
the availability of more money market instruments itself is a good sign for a developed
money market which is very essential for the successful functioning of the central bank in
a country.
Thus mutual funds provide stability to share prices, safety to investors and resources to
prospective entrepreneurs.

6.5 RISKS ASSOCIATED WITH MUTUAL FUNDS

Mutual Funds are not free from risks. It is so because basically the mutual funds also
invest their funds in the stock market on shares which are volatile in nature and are not
risk free. Hence, the following risk are inherent in their dealings :

(i) Market Risks

In general, there are certain risks associated with every kind of investment on shares.
They are called market risks. These market risks can be reduced, but cannot be
completely eliminated even by a good investment management. The prices of shares are :
17 :
subject to wide price fluctuations depending upon market conditions over which nobody
has a control. Moreover, every economy has to pass through a cycle-boom, recession,
slump and recovery. The phase of the business cycle affects the market conditions to a
larger extent.

(ii) Scheme Risks

There are certain risks inherent in the scheme itself. It all depends upon the nature of the
scheme. For instance, in a pure growth scheme, risks are greater. It is obvious because if
one expects more returns as in the case of a growth scheme, one has to take more risks.

(iii) Investment Risk

Whether the Mutual Fund makes money in shares or loses depends upon the investment
expertise of the Asset Management Company (AMC). If the investment advice goes
wrong, the fund has to suffer a lot. The investment expertise of various funds are
different and it is reflected on the returns which they offer to investors.

(iv) Business Risk

The corpus of a mutual fund might have been invested in a company’s shares. If the
business of that company suffers any set back, it cannot declare any dividend. It may
even go to the extent of winding up its business. Though the mutual fund can withstand
such a risk, its income paying capacity is affected.

(v) Political Risks

Successive Governments bring with them fancy new economic ideologies and policies. It
is often said that many economic decisions are politically motivated. Changes in
Government bring in the risk of uncertainty which every player in the financial service
industry has to face.
The structure of mutual fund operations in India envisages a three tier establishment
namely :
(i) A sponsor institution to promote the fund
(ii) A team of trustees to oversee the operations and to provide checks for the
efficient, profitable and transparent operations of the fund and
(iii) An Asset Management Company AMC) to actually deal with the funds.
Sponsoring Institution : The company which sets up the Mutual Fund is called the
sponsor. The SEBI has laid down certain criteria to be met by the sponsor. These criteria
mainly deal with adequate experience, good past track record, net worth etc.
Trustees : Trustees are people with long experience and good integrity in their respective
fields. They carry the crucial responsibility of safeguarding the interest of investors. For
this purpose, they monitor the operations of the different schemes. They have wide
ranging powers and they can even dismiss Asset Management Companies with the
approval of the SEBI.
Asset Management Company (AMC) : The AMC actually manages the funds of the
various schemes. The AMC employs a large number of professionals to make
investments, carry out research and to do agent and investor servicing. In fact, the success
of any Mutual Fund depends upon the efficiency of this AMC. The AMC submits a
quarterly report on the functioning f the mutual fund to the trustees who will guide and
control the AMC.
 Hence, a MF backed by a bank will be in a better position to tap the savings
effectively and vigorously for the capital market.
(iii) Indian investors, particularly small and medium ones, are not very keen in
investing any substantial amount directly in capital market instruments.
They may also hesitate to invest in an indirect way through private financial
intermediaries. On the other hand, if such intermediary has the backing of a
bank, investors may have confidence and come forward to invest. Thus,
banks have the advantage of public confidence which is very essential for
the success of mutual funds.
(iv) Earlier banks were not permitted to tap the capital market for funds or to
invest their funds in the market. Now, a green signal has been given to them
enter into this market and reap the maximum benefits.
(v) Banks can provide a wider range of products/services in mutual funds by
introducing innovative schemes and extend their professionalism to the
mutual funds industry.
(vi) Banks, as merchant banks have wide experience in the capital market and
hence managing a mutual fund may not be a big problem for them.
(vii) The entry of banks would provide much needed competition in the mutual
fund industry which has been hitherto monopolized by the U.T.I. This
competition will improve customer service and widen customer choice also.
(viii) In the Indian economy, the eighties witnessed the operation of both the
process of intermediation and dis-intermediation. The dis-intermediation
process can be easily harnessed by commercial banks through mutual
funds. The process of dis-intermediation of time deposits into mutual funds
would benefit the capital market because it would provide a sustainable
domestic source of demand.

ROLE OF MUTUAL FUNDS IN INDIA

In India, the Mutual Fund industry has been monopolized by the Unit Trust of India ever
since 1963. Now, the commercial banks like the State bank of India,
Bank, Indian Bank, Bank of India and the Punjab National Bank have entered into the
field. To add to the list are the LIC of India and the private sector banks and other
financial institutions. These institutions have successfully launched a variety of schemes
to meet the diverse needs of millions of small investors. The Unit Trust of India has
introduced huge portfolio of schemes like Unit 64, Mastergain, Mastershare, etc. It is the
country’s largest mutual fund company withover 25 million investors and a corpus
exceeding Rs.55,000 crores, accounting for nearly 10% of the country’s stock market
capitalization. The total corpus of the 13 other mutual funds in the country is less than
Rs.15,000 crore. The SBI fund has a corpus of Rs.2925 crore deployed in its 16 schemes
servicing over 2.5 million shareholders.
There are also mutual funds with investments sourced abroad called ‘Offshore Funds’.
They have been established for attracting NRI investments to the capital market in India.
The India Fund unit scheme 1986 traded in the London Stock Exchange and the India
Fund Unit Scheme 1988 traded in the New York Stock Exchange were floated by the
Unit Trust of India and ‘the India Magnum Fund’ was floated by the State Bank of India.
At present, there are more than 15 different offshore Indian funds which have brought
about $2.7 billion to the Indian market.
Besides this, the LIC and the GIC have also entered into the market. Again many private
organizations have entered into the filed. Most of the schemes have declared a dividend
ranging between 13.5% and 17%. In most of the cases it is around 14% only. The private
sector which entered the arena in 1993 is concentrating on the primary market. It is so
because, investments in new shares fetch appreciation between 30 and 1500 per cent in a
very short period. Promoters too give preferential treatment to mutual funds because it
reduces their marketing cost. Again, they go for fund-participation in a venture even
before it goes public. They see potential for immense appreciation in unlisted securities
which intended to go to public with a short period of one year.
In India, mutual funds have been preferred as an avenue for investment by the household
savers only from 1990s. The sales of units of UTI which were Rs.890 crores in : 33 :

REASONS FOR SLOW GROWTH

Of late, mutual funds find their going very tough. Most of the funds are not able to collect
the targetted amount from small investors. Investors tend to keep out of the new issue
mutual funds and they prefer to buy units from the secondary market even by paying a
brokerage fee of 3 per cent. The mutual fund industry has to face many problems also.
Some of them are :

(i) Disparity Between NAV and Listed Price

Small investors are really bewildered at the lack of proper pricing for their units. Though
the NAV seems to be good, the listed prices are awfully poor. Of course, the NAV is used
as a parameter to rate the performance of the mutual funds. However, in practice, almost
all the mutual fund schemes are deeply discounted to their NAV by as much as 30 to 40
per cent. Thus, the real dilemma for the investor is this disparity between the NAV and
the listed price. Due to this factor, investors are not able to dispose off their units in the
market and hence there is no liquidity at all.

(ii) No Uniformity in the Calculation of NAV

It is interesting to note that there is no standard formula for the calculation of the NAV.
With the result, different companies apply different formula, and hence, any fruitful
comparison of one fund with another is not at all possible. Hence, small investors cannot
form a concrete opinion on the performance of different funds. : 34 :
(iii) Lack of Transparency
Mutual funds in India are not providing adequate information and materials to the
investors. It was expected that they would provide a detailed investment pattern of their
various schemes. They would also have frequent and continuing communications with
the unit-holders Unfortunately, most of the funds are not able to send even quarterly
report to their members. For the success of mutual funds it is very essential that they
should create a good rapport with the investors by declaring their entire holdings to them.

(iv) Poor Investor Servicing

Mutual Funds have failed to build up investor-confidence by rendering poor services.
Due to the recurring transfer problems and non-receipt of dividend in time, people are
hesitant to touch the mutual fund script. Instances are there where people have to wait for
more than six months to get their unit certificates. Again, the percentages of units under
objection with the funds is also very high ranging between 3 per cent and 10 per cent. It
is also said that the fake certificates are also very high. This deteriorated after-sales
service to the investors has positively affected the growth of this industry. Many investors
have been driven out of this mutual fund industry due to this poor servicing. In the case
of a company, there is a statutory obligation to convene the meeting of the shareholders
and place before them important matters for discussion. there is no such meeting in the
case of a mutual fund company.

(v) Too much Dependence on outside Agencies

In India, most of the funds depend upon outside agencies to collect data and to do
research. There is no doubt that research-driven funds can ensure good returns to its
members. But, one should not rely on borrowed research. Since research involves a lot of
money, mutual funds think that their overhead cost will go up and thereby their
administrative expenses will go beyond the 3 per cent level fixed by the SEBI. In practice
it may not be so. Infact, they have to pay more for borrowed research and even that : 35 :
cannot be fully relied upon. Unless they set up their own research cell, they cannot
succeed in the business.

(vi) Investor’s Psychology

Investors often compare units with that of shares and expect a high listing price. They
don’t realize that unit is a low-risk long term instrument. Indeed, mutual funds are only
for those who have the patience to wait for a long period say 3 to 5 years. But, in practice,
people don’t have the patience. Hence, units are not popular among the public.

(vii) Absence of Qualified Sales Force

Efficient management of a fund requires expertised knowledge in portfolio management
and skill in execution. Without professional agents and intermediaries, it cannot be
managed efficiently. Unfortunately such professional people are rare. One can find a
network of qualified broker to deal in shares and stocks. Such persons are conspicuously
absent in the mutual fund industry and this absence of large and qualified sales force
makes the industry suffer a set back.

(viii) Other Reasons

Few funds which have not performed well have actually demoralized the investing
public. Moreover, the listing of close ended funds on the stock exchanges has compelled
the medium and small investors to go back to the stock market and face the hassels and
headaches of its dealing. Above all, there is a lack of investor education in the country.
Most of the investors are not aware of the mutual fund industry and the various products
offered by it.

6.18 MUTUAL FUNDS FOR WHOM?

These funds can survive and thrive only if they can live upto the hopes and trust of their
individual members. These hopes and trust echo the peculiarities which support the
emergence and growth of such institutions irrespective of the nature of economy where :
36 :
these are to operate. Mutual funds come to the rescue of those people who do not excel at
stock market due to certain mistakes they commit which can be minimized with mutual
funds. Such mistakes can be lack of sound investment strategies, unreasonable
expectations of making money, untimely decisions of investing or disinvesting, acting on
advise given by others, putting all their eggs in one basket i.e. failure to diversify. Mutual
funds come to the rescue of such investors who face following constraints while making
direct investments :
i) Limited resources in the hands of investors quite often take them away from
stock market transactions.
ii) Lack of funds forbids investors to have a balanced and diversified portfolio.
iii) Lack of professional knowledge associated with investment business enables
investors to operate gainfully in the market. Small investors can hardly
afford to have expensive investment consultations.
iv) To buy shares, investors have to engage share brokers who are the members of
the stock exchange and have to pay their broker age.
v) They hardly have access to price sensitive information in time.
vii) It is difficult for him to know the developments taking place in share market
and corporate sector.
vii) Firm allotments are not possible for small investors when there is a trend of
 EXPLAIN THE MERCHANT BANKING
Financial Service is rendered through numerous intermediaries who are known by
different names. One of the prominent intermediaries is known as merchant banker. Their
scope of operation differs from country to country. Merchant banking as it is known in
present days had its origin in U.K and U.S.A in early fifties. But the roots of this service
rendering industry can be traced as back as in late eighteenth century and early nineteenth
century. There were merchants, who traded overseas, built reputation and later shared
their goodwill with newer traders to facilitate their merchant activities especially by
providing guarantees for payments. Subsequently they entered any field which added to
their business depending on the demand of time. Thus, as time changed their role
changed, consequently it has never been possible to pinpoint their role. As Sir Edward
Reid of Baring Brothers & Co. commented, it is (merchant banking) sometimes applied
to banks which are not merchants, merchants who are not banks and sometimes to houses
who are neither merchants nor banks." Report of the Committee on the Working of
Monetary System (1961) observed that origin of merchant bankers is associated with a
variety of financial services including accepting. This is why merchant bankers are
popular as 'issue houses' or 'accepting houses' in U.K. In U.S.A investment bankers have
been performing the task being performed by merchant bankers elsewhere. Whether these
are called accepting house or investment banker or merchant bankers, their common
object is to facilitate trade and industry. Meeting their diverse and dynamic needs with
the change in time and complexities in business has always been a challenge for merchant
banking.
CONCEPT AND NATURE OF MERCHANT BANKING
Despite the fact that merchant banking is emerging as one of the prominent segment of
financial service sector, it is difficult to define what merchant banking is. The reason is
very obvious as its limits have never been adequately and strictly defined and it caters to
wide variety of financial activities. Dictionary of Banking and Finance explains merchant
bank as an organisation that underwrites securities for corporations, advises : 3 :
such clients on mergers and is involved in the ownership of commercial ventures.
Securities and Exchange Board of India (Merchant Bankers) Rules 1992 defines
merchant bankers as “any person who is engaged in the business of issue management
either by making arrangement regarding selling, buying or subscribing to securities or
acting as manager, consultant, adviser or rendering corporate advisory services in relation
to such issue management. The Guidelines for Merchant Bankers (issued by Ministry of
Finance, Deptt. of Economic Affairs, Stock Exchange Division on 9-4-1990) instead of
defining merchant banking stated that these guidelines shall apply to those presently
engaged in merchant banking activity including as managers to issue and undertakes
authorised activities. These activities interalia include underwriting, portfolio
management etc. Thus. to defines merchant bankers a definite better approach is to
include those agencies as merchant bankers which do what a merchant banker does.
To understand nature of merchant banking well, a contrast may be involved, between
commercial banking and merchant banking. Although the terms 'Merchant' and
'Commercial' have similar connotations yet commercial banking and merchant banking
are different. Commercial bankers are basically a financing agency where as merchant
banks provide basically financial (not financing) services. Commercial bankers are
comparatively retail banking activity where as merchant banking is a whole sale banking
(even if it provides financing services also). A merchant banking firm does not undertake
commercial banking where as its, reverse is possible. Commercial banking involves
collections of savings and putting it, to optimum use as per plans and guidelines where as
merchant banking refers to just an agency facilitating transfer capital from those who
own to those who can use it without handling the amount of its own. Merchant bankers is
more of an intermediary. In the same context a merchant bank can be distinguished from
a development bank since the latter is more involved in fund raising and lending. Like
commercial banks, development banks may also have separate merchant banking
division. : 4 :
EXPLAIN THE FUNCTIONS OF MERCHANT BANKER
Setting up of new industrial units, expansion, diversification and modernisation of
existing units have been the central plank of the rapid industrialisation in any economy.
This process besides adequate financial resources requires sound technical and
managerial inputs. Though, a number of financial agencies are instituted to cater to the
needs of rapid industrialisation, the task of financing has become more complicated, thus
requiring a fresh look. In view of increasing specialisation in every sphere the process of
industrialisation from the primary planning stages of setting up a new unit to that of
research and development including expansion, diversification or modernisation requires
the services of specialists or professionals. Thus, the need for having expert advice,
guidance of specialists or professionals in the field has become an absolute necessity with
rapid economic growth and spectacular industrial development in India. It has also been
necessitated by the plethora of regulations for industry, capital, issues, foreign investment
and collaboration, amalgamations, Companies Act, SEBI, Government policy regarding
backward area development, export promotion and import substitution etc. A few
agencies are able to provide expert advice in the diversified areas mentioned above. But it
is inconvenient to entrepreneurs industrialists to knock at the doors of several agencies in
getting the guidance of specialists and professionals. Hence, it is highly essential to
provide expert advice in diversified areas under a single roof to provide a comfortable
cushion to entrepreneurs to accelerate industrial development. This is where merchant
bankers come to picture. Although is it is very difficult to spellout all the areas where
merchant bankers can interact, yet, some important areas where merchant bankers have
decisive role are discussed here. These role can broadly be divided into two parts. One is
service based another is fund based. : 5 :
A. Service based Functions

i) Project counselling
The first step to launch a business unit is selection of a viable project. Merchant bankers
undertake this assignment on a very large scale since they have experts with them in
diverse fields. Project counselling covers a variety of sub assignments. Illustrative list of
services which can be rendered under this category is :
• Guidance in relation to project viability i.e. project identification and counselling. It
may be for setting up new units, expansion or improvement of existing facilities.
• Selection of consultants for preparation of project reports/market surveys etc.
Sometimes merchant bankers also engage in preparation of project reports or
market surveys.
• Advice on various procedural steps including obtaining of governmental approvals
clearance etc. e.g. for foreign collaboration.
• Proposing a suitable capital structure laying broad as well as specific features.
• Teachno- economic soundness of the project and marketing aspects. Financial
engineering i.e. selection of right mix of financing pattern specifically for short
term requirements.
• Organisation and management set up for a strong base and efficient working of the
project.

ii) Credit syndication

Normally every project has to raise debt funds for different sources as per need.
Substantial debt raising may be required for a new and capital intensive project. For such
project merchant bankers may undertake credit syndication. Credit syndication is credit
procurement service. As per the requirements, such syndication can be from national as
well as international sources. Some of the important credit syndication services offered
are. : 6 :
 • Preparing applications for financial assistance to be submitted to financial
institutions and banks.
• Monitoring the sanction of funds while acting as a specialised liaison agency.
• Negotiating the term of assistance on behalf of client.
• Post sanction formalities with these institutions and banks.
• Assistance in drawl of term loans and or bridging loans.
• Assessing working capital requirements and arranging it.

Need of syndication arises due to the fact that specially in big projects one institution
may hesitate to meet the whole debt requirement of the project. They want to spread the
risk. Further shortage of funds availability with one lender also requires credit
syndication. The merchant banker by rendering credit syndication services saves the time
of the borrower.
The modus operandi of a syndication is really quite simple. The borrower approaches
several banks which might be willing to syndicate a loan, specifying the amount and the
tenor for which loan is to be syndicated. On receiving a query, the syndicator scouts for
banks who may be willing to participate in the syndicate. Based on an informal survey, it
communicates its desire to syndicate the loan at an indicative price to the corporate
borrower, all in a matter of days. After reviewing the bids from various banks, the
borrower awards the mandate to the bank that offers him the best terms.
The syndicator, on his part, can underscore his willingness to syndicate the loan on a firm
commitment basis or on a best-efforts basis. The former is akin to underwriting and will
attract capital adequacy requirements. That may reduce the bank's flexibility. "In India,
given the fact that banks may not be willing to maintain capital in the interim period,
most syndicates the likely to be done on a best-efforts basis."
Best-efforts, as the name suggests, limits the obligation of the syndicator, as he is not
compelled to provide the loan on his own, in case he fails to arrange the loan. : 7 :
However, more often than not, the syndicator would try to fulfill his commitments for the
inability to do so would tarnish his reputation. Once the syndicator has been awarded a
mandate, the borrower has to sign a 'clear market clause' which stops him from seeking a
syndicated loan from any other bank, till such time as the documentation for the
syndication is drawn up by the syndicate manager. This may take about three-four weeks.
In the interim period, the syndicate manager gets the banks to agree to syndicating the
loan. It can do this on a 'broadcast' basis, by sending taxes to the concerned banks
inviting participation. If the company is well known, the loan uncomplicated and the
market liquid, such a method would work well. However, if the corporate tends to keep a
low profile and the loan structure is complicated, the syndicate manager would have to
woo the participant banks with offer documents or an information memorandum on the
company. The document is similar to a prospects but less detailed. Nevertheless drawing
up such a document does call for a lot of homework. The syndicate manager has to be
very careful because he can be held responsible for any inaccuracy or omission of
material facts.
The participants, after reviewing the prospects, decide whether or not to join the
syndicate. However, given the fact that most of the participants may be smaller Indian
banks, they may take weeks to give the final nod. Once the bank decides to become a
member of the syndicate, it indicates the amount and the price that it is likely to charge
on the loan. Based on information received from all participants, the syndicate manager
prepares a common document to be signed by all the members of the syndicate and the
borrowing company. The document usually lists out details of the agreement with regard
to tenor, interest prepayment clause, security, covenants, warranties and agency clause.
iii) Issue management
Traditionally this is one of the main functions of merchant banker. When ever an issue is
made whether it is public issue or private placement and further whether it is for equity
shares, preference shares or debentures, the merchant banker has a crucial role to play.
Raising of funds from public has many dimensions and formalities which are not : 8 :
possible for the concerned. companies to comply with, where merchant banker comes to
their rescue. Marketing effort to convince the prospective investor needs special
attention. Here again merchant bankers are specialists. The specific important activities
related to issue management performed by merchant banks are mentioned here:
• Advise the company about the quantum and terms of raising funds.
• Advise as to what type of security may be acceptable in the market as well as
to the concerned lending institutions at the time of issue.
• Advise as to whether a fresh issue to be made or right issue to be made or if
both, then in what proportion, obtaining the desired consents, if any, from
government or other authorities.
• Advice on the appointment of bankers, brokers to the issue.
• Advice on the selection of issue house or Registrar to the issue, printer
advertising agency etc.
• Fixing the terms of the agencies engaged to facilitate making a public issue.
• Preparation of a complete action plan and budget for total expenses of the
issue.
• Drafting of documents like prospectus, letter of offer and getting approval
from concerned agencies.
• Assisting in advertisement campaigns, holding the press, brokers' and
investors' conferences etc. for grooming the issue.
• Advise the company for the issue period and days of opening and closing the
issue.
• Monitoring the collection of funds in public issue.
• Coordination with underwriters, brokers and bankers to the issue and stock
exchange etc.
• Strict compliance of post issue activities.
:9:
iv) Corporate counselling
Although the functions discussed up till now are also covered under corporate
counselling but here other dimensions will be deliberated. Corporate counselling is to
rejuvenate the corporate units which are otherwise having signals to low productivity,
low efficiency and low profitability. The merchant bankers can play a substantial role in
reviving the sick units. They make mergers and acquisition exercise smooth, They can
advise on improvement in the systems operating in managing the show of a corporate
unit. Some of the specific assignments for the merchant banker are:-
• Rejuvenating old line and ailing/sick unit or appraising their technology and
process, assessing their requirements and. restructuring their capital base.
• Evolving rehabilitation programmes/packages which can be acceptable to the
financial institutions and banks.
• Assisting in obtaining approvals from Board for Industrial and Financial
Reconstruction (BlFR) and other authorities under the Sick Industrial
Companies (special provisions) Act1985 (SICA).
• Monitoring implementation of schemes of rehabilitation.
• Advice on financial restructuring involving redeployment of corporate assets
to refocus companies line of business.
• Advice on rearranging the portfolio of business assets through acquisition etc.
• Assisting in valuing the assets and liabilities.
• Identifying potential buyers for disposal of assets if required. Identify the
candidates for take over.
• Advice on tactics in approaching potential acquisition.
• Assisting in deciding the mode of acquisition whether friendly or unfriendly
or hostile.
: 10 :
 • Designing the transaction to reap the maximum tax advantages. Acting as an
agent for leveraged buyout (LBO) involving heavy use of borrowed funds
to purchase a company or division of a company.
• Facilitating Management Buy outs (MBO) i.e selling a part of business to
their own managers by a company.
• Clearly spelling out organisation goals.
• Evolving corporate strategies to achieve the laid down goals.
• Designing or restructuring the organisational pattern and size.
• Evolving Management Information System.

Corporate advisory services should offer real value addition to the client. Highly
specialised in nature, these services should be clearly distinguished from the gamut of
other financial services offered by NBFCs such as underwriting or fund-based activities
of leasing and hire purchase. In India corporate advisory has a good potential. The Indian
industry is going through an unprecedented churning, bracing itself for global com-
petition. The Indian corporate sector has been on a restructuring spree. Groups have been
shedding companies. Companies in turn, have been dropping divisions as they struggle to
become fit to survive in the new milieu. Free pricing of issues and the opportunity to tap
the international market through the Euro-issue route has greatly enhanced the need for
expert advisory services. In areas of restructuring, strategic alliances and corporate
planning is now advising foreign companies in their plans for development of
infrastructure in India. Merchant bankers have a great role to play.
Strategic product consolidation is another recent phenomenon. Units in which the
company does not plan to become a market leader are spun off to others. A good
corporate advisor is always on the alert to seize such opportunities. The process of
acquisition cannot be done overnight. It requires a patient search for the right company
which can be acquired, the proper evaluation of the financial impact of the acquisition, a
sound strategy in blending the business acquired within the fold of the group, followed by
negotiation and execution of the agreement. Occasionally, advisory services are required
: 11 :
in cases of splits within the family group. In such cases, there is a need to split the
company into different units amongst the disputing family members. At the same time,
the shareholders interest is to be kept in mind by the corporate advisor.
v) Portfolio management
Merchant bankers as a body of professionally qualified persons also undertake
assignments of managing an individual investor's portfolio. Portfolio management is
being practised as an investment management counselling in which the investor is
advised to seek financial assets like government securities, commercial papers,
debentures, shares, warrants etc. that would grow in value and/or provide income. The
investors whether local or foreigner with substantial amount for investment in securities
seek portfolio management services of authorised merchant bankers. The functioning of
portfolio manager can be regulated or unregulated. Portfolio manager may use totally his
discretion or may act only after getting signal from investor for each transaction of sale or
purchase. A diverse range of services which may be rendered by merchant banker
include: -
• Advising what and when to sell and buy.
• Arranging sale or purchase of securities.
• Communicating changes in investment market to the client investor
• Compliance of regulations of different regulating bodies for sale of purchase
of portfolio.
• Collection of returns and reinvest as per directions of clients.
• Evaluating the portfolio at regular intervals or at direction of investors.
• Advising on tax matters pertaining to income from and investment in
portfolio
• Safe custody of securities.
: 12 :
vi) Stock broking and dealership
The merchant bankers who have requisite professional knowledge and experience may
also act as share broker on a stock exchange and even as dealer for Over The Counter
trading. To venture into this area it is normally desired that the merchant banker has
reasonable network. Their actions and activities are regulated by rules and regulations of
the concerned stock exchange. They are at liberty to appoint sub brokers and sub dealers
to ensure wider net work of their operations. They can be broker for inland as well as
foreign stock exchanges. In India the merchant bankers who desire to act as brokers are
regulated by SEBI (Stock Broker and Sub-brokers) Rules 1992.
vii) Joint venture abroad
Depending on economic and political considerations many countries may permit joint
ventures by local businessmen abroad. Here again merchant bankers can play a decisive
role. They facilitate meeting of foreign partner, get sanctions under various provisions,
make techno economic surveys, legal documentations under local as well as foreign legal
provisions etc.
viii) Debenture trusteeship
The merchant bankers can get themselves registered to act as trustee. These trustees are
to protect the interests of debenture holders as per the terms laid down in trust deed. They
are, as trustees, to undertake redressal of grievances of debenture holders. They are to
ensure that refund monies are paid and debenture certificates are dispatched in
accordance with the Companies Act. Debenture trustees are expected to observe high
standards of integrity and fairness in discharging their functions. They can call for
periodical reports from the body corporate. They charge fee for such services. : 13 :
B. Fund based Functions

(i) Bill discunting

Bill discounting is a service against which merchant banker has to arrange funds against
the bills which have been discounted. This service is undertaken by merchant bankers
generally if bill market is big as well as mature. Otherwise bill discounting is undertaken
by banks only. Depending on their credibility they may also undertake the assignment of
bill acceptance. These bills accepted and or discounted can be foreign and merchant
bankers can specify what types of bills they entertain. They charge commission for these
services.

(ii) Venture capital

Venture capital is the organized financing of relatively new enterprises to achieve
substantial capital gains. Such new companies are chosen because of their potential for
considerable growth due to advance technology, new products or services or other
valuable innovations. A high risk is implied in the term and is implicit in this type of
investment. Since certain ingredients necessary for success of such projects are missing
in the begging but are added later on. Merchant bankers undertake to arrange and if
necessary, to provide such venture capital since traditional sources of finance like banks,
financial institutions or public issue etc. may not be available. Since expected returns on
projects involving venture capital is high, these are normally provided on soft terms.
Such scheme is also popular as seed capital or risk capital scheme. Merchant bankers
deeply study such proposals before releasing the money. At opportune time such
investment can be disinvested to keep the cycle of venture capital more on.

(iii) Bought out deals

When a promoter envisages that if public issue made to raise capital will not clinch, he
may approach merchant bankers (bought out dealer or sponsor) and places the shares of
company initially with him which are offered to public at a later stage, this : 14 :
route is known as bought out deal. Many a time a syndicate of merchant bankers jointly
sponsor a bought out deal to spread the risk involved. In contract to venture capital, there
is no role to be played by non traditional technology. Such bought shares by sponsor can
be disposed off at an opportune time on ‘over the counter’ or other stock exchanges.

(iv) Lease financing and hire purchase

Depending on the funds available, merchant bankers can also enter the field of lease or
hire purchase financing. Lease is an agreement where by the lessor (merchant banker in
our case) conveys to the lessee (the user), in return for rent, the right to use an asset for an
agreed period of time. On the other hand in hire purchase the user at the end of the agreed
period has an option to purchase the asset which he has used till date. The merchant
bankers can advise the client to go in for leasing or hire purchase system of financing an
asset. A comparative study may be communicated to the prospective client showing
benefits of these alternatives. The client can also depend on merchant banker for
acquiring the needed asset and complying with all formalities.

(v) Factoring

Factoring is a novel financing innovation. It is a mixed service having financial as well as

non financial aspects. On one hand it involves management and collection of books debts
which arise in process of credit sale. The merchant bankers can take up this assignment
and are required to perform activities like sales ledger administration, credit collection,
credit protection, evolving credit policy, arranging letter of credit etc. On the other hand
there is involvement of finance. Against factored debts the merchant banker may provide
advance with a certain margin. The released funds can be used by client to manage its
liquidity and working capital. Merchant bankers are entitled to service charges for
factoring services. The merchant banker’s role is thus to :
• Maintain the books of accounts pertaining to credit sales
: 15 :
 • Make a systematic analysis of relevant information for credit monitoring and
control.
• Provide full or partial protection against bad debts and accepting the risk of non
realization.
• Provide financial assistance to the client.
• Provide information about prospective buyers.
• Provide financial counseling and assisting managing the liquidity.

vi) Underwriting
It refers to a contract by means of which merchant banker gives an assurance to the
issuing company that the former would subscribe to the securities offered in the event of
non-subscription by the persons to whom it was offered. The liability of merchant banker
arises if the issue is not fully subscribed and this liability is restricted to the commitment
extended by him. The merchant bankers undertaking underwriting make efforts on their
own to induce the prospective investors to subscribe to the concerned issue. Such
assignment is accepted after evaluating viz :
• Company’s standing and its past record.
• Competence of the management.
• Purpose of the issue.
• Potentials of the project being financed.
• Offer price and terms of the issue.
• Business environment.

The financial involvement of merchant banker in underwriting arises in case of

development. To get their blocked funds released, the merchant bankers have stock
exchange as exit route. They get underwriting commission.
These are some of the prominent activities being undertaken by merchant bankers world
over. The practices may differ from country to country depending on maturity of : 16 :
financial sector of their economy. The multifarious activities of the corporate sector and
spectacular growth of industry gives new dimensions to merchant banking activities. In
the phase of globalisation of economies merchant bankers are facing new challenges. The
changing international financing environment has rather pushed merchant bankers to
operate at international level creating more opportunities to serve the world business
community in diverse ways.

EXPLAIN THE MERCHANT BANKING REGULATIONS

SEBI (Merchant Bankers’) Regulations 1992 define merchant banker as “any person who
is engaged in the business of issue management either by making arrangements regarding
selling, buying or subscribing to securities or acting as manager, consultant, adviser or
rendering corporate advisory service in relation to such issue management.” Thus
regulations are applicable only to limited activities undertaken by merchant banker. On
the basis of regulations, merchant banking activities can be categorised as ‘authorised’
and ‘not authorised’ activities. The merchant bankers are required to get themselves
registered under regulations only for authorized activities. The authorized activities are
undertaking issue management assignment, as manager, consultant, adviser, underwriter
port folio manager.
a) Merchant Banking Activities not requiring SEBI’s registration are :
• Project Counselling
• Corporate Counselling
• Factoring
• Credit Rating
• Bill acceptance and discounting
• Loan syndication
• Merger and amalgamation
: 17 :
b) Merchant Banking Activities requiring SEBI’s registration under different regulations
but not under Merchant Banking regulations :
• Venture Capital
• Mutual Funds
• Depository
• Portfolio Management
• Trusteeship of debentures
• Share Broking
• Custodian Service
• Foreign Institution of Investor
• Share Transfer

Another angle from which authorized activities can be identified is the activities specified
for each categories of merchant banker.

Categories of Merchant Bankers

The merchant banking regulations require that any body seeking registration as merchant
banker has to apply in one of the following four categories :
Category I : These merchant bankers can carry on any activity of the issue management,
which will inter-alia consist of preparation of prospectus and other information relating
to the issue, determining financial structure, tie up of financiers and final allotment and
refund of subscription. They can also act as adviser, consultant, manager, underwriter,
portfolio manager.
Category II : Such merchant bankers can act as adviser, consultant, co-manager,
underwriter and portfolio manager. This means they can not undertake issue management
of their own. : 18 :
Category III : These merchant bankers can neither undertake issue management nor act
as co-manager. They cannot conduct business of portfolio management. Thus the area of
their operation restricts to act as underwriter, adviser and consultant to the issue.
Category IV : Such merchant bankers do not undertake any activities requiring funds.
They can act only as adviser or consultant to an issue.

Registration
Any agency to operate as merchant banker has to register it self under SEBI Regulations.
Application is to be submitted in the prescribed format. To get registration and certificate
to operate as merchant banker, the agency has to fulfill two sets of criteria
(i) Operational capabilities.
(ii) Capital adequacy.
i) Operational capabilities : As mentioned earlier, the regulations desire the merchant
banker to be professional, fair and competent to serve investors. In this context SEBI
before granting ‘certificate to operate as merchant banker’ makes sure that concerned
agency is competent on these parameters. To be more specific these are :
a) It is necessary that to serve the clients and investors the merchant banker should
have sufficient physical infrastructure. It is desired that the applicant has the
necessary infrastructure like adequate office space, equipments and manpower
to effectively discharge his activities.
b) To ensure that services rendered are the best, SEBI desires the applicant to have
atleast two persons who have the experience to conduct the business of the
merchant banker.
(c) In order to avoid excessive registration SEBI makes sure that a person directly or
indirectly connected with the applicant has not been already granted
registration. Such persons include an associate, subsidiary, interconnected or
group company of the applicant. : 19 :
 (d) The applicant or his partner or director should be man of integrity. SEBI requires
that applicant or its main officials should not be involved in any litigation
connected with the securities market which has an adverse bearing on the
business of the applicant.
• They should not at any time be convicted for any offence involving mortal
turpitude or has been found guilty of any economic offence.
• The applicant is to have professional qualification from any recognized
institution.
• SEBI is to make sure that such registration should be in the interest of
investors.

Only those applicants who qualify on all these points are granted registration.
(ii) Capital adequacy : In the categories where in fund based activities are involved,
SEBI desires them to have sufficient capital. The concept of adequate capital is expressed
in terms of ‘net worth’. ‘Net worth’ means the value of capital contributed to the business
plus free reserves. At the time of registration as well as subsequently following pattern of
‘net worth’ should be at least maintained :
Category of Merchant Banker Minimum Networth
Category I Rs. 5,00,00,000
Category II Rs. 50,00,000
Category III Rs. 20,00,000
Category IV NIL
Those applicants who qualify on both fronts are granted registration. The registered
applicants are granted certificate of registration in ‘Form B’ in which SEBI specifies for
which category registration has been granted. If the applicant is granted a category lower
than applied for, the applicant is free to approach SEBI for higher category but with in
one year from date of such registration. When certificate is finally granted the registered
merchant bankers are to submit required fees. Registration is : 20 :
granted for three years at one time. To keep the registration operative, merchant bankers
are to pay registration fee. The registration fee pattern is as under :
Category Fee for first two years Third year
Category I Rs. 2.5 lakh per year Rs. 1 lakh
Category II Rs. 1.5 lakh per year Rs. 0.5 lakh
Category III Rs. 1 lakh per year Rs. 0.25 lakh
Category IV Rs. 5,000 per year Rs. 1,000.
Once registration granted is about to expire, merchant bankers are to get this registration
renewed. Application for such renewal is again to be made. To ensure that there is no
break in registration, such application has to be made with in 3 months before the expiry
of the certificate. Although it is termed as renewal, but application is processed as for
new registration, that is why application is again made in ‘Form A’. Once registration is
renewed due fee is to be paid which is as under :

Category Fee for first two years Third year

Category I Rs. 1 lakh per year Rs. 0.2 lakh
Category II Rs. 0.75 lakh per year Rs. 0.1 lakh
Category III Rs. 0.50 per year Rs. 0.05 lakh
Category IV Rs. 0.05 per year Rs. 0.02 lakh

Code of Conduct
Once merchant bankers are registered to ensure that they maintain high standard of
services, regulations require them to adhere to a code of conduct specified in the
Schedule III of the Regulations while acting as merchant bankers. Some important
provisions of code are as under :
• Maintain high standard of service.
: 21 :
 • Exercise due diligence, ensure proper care and exercise independent professional
judgement.
• Disclose to the clients, possible sources of conflicts of duties and interest while
providing unbaised services.
• Conduct business observing high standard of integrity and fairness in all his
dealings with clients and other merchant bankers.
• Maintain secrecy about client.
• Do no engage in unfair competition.
• Not to make misrepresentation.
• Provide true and adequate information to investors.
• Not to create false market or engage in price rigging.

Lead Manager
It is required under regulations that every issue should be managed by at least one
merchant banker acting as ‘lead manager’. Such lead manager is not required if :
• the issue is right issue.
• the size of issue is not exceeding rupees 50 lakh.

The merchant banker acting as lead manager must enter into an agreement with the
concerned company. This agreement must state their mutual rights, liabilities and
obligations relating to such issue. Agreement terms pertaining to particulars to
disclosures, allotment and refund should be clearly defined, allocated and determined.
In bigger issues more than one lead managers can be appointed but their number is
subject to norms laid down by SEBI.
Size of issue Maximum number of
led manager
a) Less than rupees fifty crore Two
b) Rupees 50 crore but less than Rs.100 crore. Three : 22 :
c) Rs.100 crore but less than Rs.200 crore Four
d) Rs.200 crore but less than Rs.400 crore Five
e) Rs.400 crore and above Five or more as
agreed by SEBI

Duties of Merchant Banker/Lead Manager

a) In case more than one merchant bankers are engaged as lead manager, they have to
clearly demark their duties and responsibilities. A statement of such division of
job and responsibilities is to be furnished to SEBI at least one month before
opening of the issue. Where the circumstances warrant joint and several
responsibility of lead manager for a particular activity, a coordinator designated
from among the lead managers shall furnish to SEBI with report, comments etc.
on the matters relating to the joint responsibility. The activities where division is
normally sought is on ‘pre-issue activities’ and ‘post issue activities’, SEBI
requires that ‘post issue activities’ should be the responsibility of one lead
manager. It involves essential follow up steps like finalisation of basis of
allotment/weeding out multiple applications, listing of instrument, dispatch of
certificates and refunds etc.
b) A merchant banker can not be a lead manager to an issue made by any body
corporate which is an associate of the lead merchant banker.
c) A lead manager is not to associate with an issue if any merchant banker associated
with the issue is not holder of certificate of registration.
d) A lead manager who is category I merchant banker has to accept a minimum
underwriting obligation of 5 per cent of the total underwriting commitment or
Rs.25 lakh which ever is less. This is to ensure his financial involvement in the
issue. : 23 :
e) It is his duty to submit SEBI a due diligence certificate in ‘Form C’. This is to
ensure that the contents of the prospectus or letter of an offer are verified and are
reasonable. This certificate is to reach at least two weeks prior to opening of an
issue.
f) SEBI requires lead manager to submit specified documents like particulars to the
issue, draft letter of offer or prospectus.
g) Lead manager to incorporate changes in prospectus etc. if desired by SEBI.
h) Lead manager has to continue as lead manager with the issue till the subscribers
have received the certificates or refunds of excess money.
i) Merchant bankers are prohibited from entering into any transaction, directly or
indirectly in securities on the basis of unpublished price sensitive information
obtained by them during the course of any professional assignment. It is referring
to insider trading.
j) SEBI is to be informed, by merchant banker about the acquisition of securities of
the boy corporate whose issue is being managed by the merchant banker, within
15 days from the date of entering into such transaction.
k) A merchant banker has to disclose to SEBI the following information :
i) his responsibilities with regard to the management of the issue.
ii) any change in the information or particulars previously furnished which have a
bearing on the certificate granted to it.
iii) the name of body corporate whose issues he has managed or has been
associated with.
iv) any default in capital adequacy requirements.
v) his activities as a manager, underwriter, consultant or adviser to an issue as the
case may be. : 24 :
 l) Every merchant banker shall keep and maintain the required books of accounts,
records and documents like balance sheet, income statement, auditor’s report, a
statement of financial statement. Such records are to be maintained for 5 years.
They are to submit half yearly unaudited financial results when required by SEBI
with a view to monitor the capital adequacy of the merchant banker.
m) When SEBI initiates inspection of the said records, the merchant banker has to
cooperate. SEBI shall give notice before inspection.

Liabilities of Merchant Bankers

Many provisions are incorporated in the MB Regulations to regulate the activities of
merchant bankers. To make them more responsible and accountable SEBI has provisions
to impose penalty in case of defaults by them. The merchant bankers are subject to
penalty if they
a) fail to comply the conditions subject to which certificate has been granted
b) fail to comply with the provisions of the concerned rules and regulations
Two types of penalties can be imposed by SEBI on defaulting merchant bankers. One is
suspension of registration and second is cancellation of registration.

a) Suspension of registration
Under the following circumstances the registration of a merchant is banker stands
suspended when a merchant banker :
i) violates the provisions of the Act, rules and regulations and terms of registration
ii) fails to furnish required information to SEBI or provides false information
iii) fails to satisfy the investors and SEBI about the complaints of investors
iv) manipulates or rigs the price of securities
v) misconducts or adopts unprofessional practices
vi) fails to maintain required capital adequacy or pay the required fees : 25 :
b) Cancellation of registration
In cases where there are grave misconducts or defaults, the registration of a merchant
banker can even be cancelled. Some of such situations are where a merchant banker :
i) indulges in deliberate manipulation or price rigging or other activities against
the interest of investors.
ii) fails to maintain satisfactory financial status which may lead to dilution in
services to investors.
iii) involves in fraud or is convicted of a criminal offence
iv) indulges repeatedly in defaults resulting in suspension of registration.
In these regulations SEBI has deviated from the earlier penalty point system announced
by SEBI in guidelines for merchant bankers in 1991. Defaults were categorized in four
types, general default (Type I), minor defaults (Type II), major defaults (Type III) and
serious defaults (Type IV). Penalty points are assigned to each type of defaults these
being one, two, three and four respectively. The defaults in each type was specified
specifically e.g.
a) non receipt of :
i) draft prospectus,
ii) inter-se allocation of responsibilities,
iii) due diligence certificate etc. constituted general default,
b) i) exaggerated information
ii) non compliance of advertisement code
iii) delay in refunds
iv) allotment of securities etc. constituted minor default,
c) i) failure to take mandatory underwriting, : 26 :
ii) engaging more lead manager than warranted under guidelines
iii) association with unauthorized merchant banker etc. were termed as major defaults and
d) i) unethical practices
ii) violation of code of conduct
iii) non cooperaton with SEBI constituted serious defaults.
Any merchant banker reaching cumulative penalty points of ‘eight’ attracted action from
SEBI.
EXPLAIN THE LEASING CONCEPT
Traditionally firms acquire productive assets and use them as owners. The sources
of finance to a firm for procuring assets may be internal or external. Over the years there
has been a declining trend in the internally generated resources due to low profitability.
The financial institutions experience paucity of funds at their disposal to meet the
increasing needs of borrowers. Further, modern business environment is becoming more
and more complex. To succeed in the situation, the firms aim at growth with stability. To
accomplish this objective, firms are required to go for massive expansion, diversification
and modernisation. Essentially such projects involve a huge amount of investment. High
rate of inflation, severe cost escalation, heavy taxation and meagre internal resources
forced many companies to look for alternative means of financing the projects. Leasing
has emerged as a new source of financing capital assets.
Leasing, as a financing concept, is an arrangement between two parties, the leasing
company or lessor and the user or lessee, whereby the former arranges to buy capital
equipment for the use of the latter for an agreed period of time in return for the payment
of rent. The rentals are predetermined and payable at fixed intervals of time, : 3 :
according to the mutual convenience of both the parties. However, the lessor remains the
owner of the equipment over the primary period.
By resorting to leasing, the lessee company is able to exploit the economic value
of the equipment by using it as if he owned it without having to pay for its capital cost.
Lease rentals can be conveniently paid over the lease period out of profits earned from
the use of the equipment and the rent is cent percent tax deductible.
Conceptually, a lease may be defined as a contractual arrangement /transaction in
which a party owning an asset/equipment (lessor) provides the asset for use to
another/transfers the right to use the equipment to the user (lessee). Over a certain/for an
agreed period of time for consideration in the form of/in return for periodic payment
(rentals) with or without a further payment (premium). At the end of the period of
contract (lease period), the asset/ equipment reverts back to the lessor unless there is a
provision for the renewal of the contract. Leasing essentially involves the divorce of
ownership from the economic use of an asset/equipment. It is a device of financing the
cost of an asset. It is a contract in which a specific equipment required by the lessee is
purchased by the lessor (Financier) from a manufacturer/vendor selected by the lessee.
The lessee has possession and use of the asset on payment of the specified rentals over a
predetermined period of time. Lease financing is thus a device of financing/money
lending. The real function or a lessor is not renting of asset but lending of
funds/finance/credit and lease financing is in effect a contract of lending money. The
lessor (financier) is the nominal owner of the asset as the possession and economic use to
the equipment vests in the lessee. The lessee is free to choose the asset according to his
requirements and the lessor dose not take recourse to the equipment as long as the rentals
are regularly paid to him.
The essential elements of leasing are the following :
1. Parties to the Contract : There are essentially two parties to a contract of lease
financing, viz, the owner and the user, respectively called the lessor and the lessee
Lessors as well as lessees may be individuals, partnerships, joint stock companies,
:4:
corporations or financial Institution. Sometimes. there may be joint lessors or joint
lessess, particularly where the properties or the amount of finance involved is
enormous. Besides, there may be a lease-broker who acts as an intermediary in
arranging lease deals. Merchant banking divisions of certain foreign banks in
India, subsidiaries of some Indian banks and even some private merchant bankers
are acting as lease brokers. They charge certain percentage of fees for their
services, ranging between 0.50 to I per cent. Besides, a lease contract may involve
a 'lease financier', who refinances the lessor, either by providing term loans or by
subscribing to equity or under a specific refinance scheme.
2. Asset : The asset, property or equipment to be leased is the subject matter of a contract
of lease financing. The asset may be an automobile, plant and machinery,
equipment, land and building, factory, a running business, aircraft, etc. The asset
must, however, be of the lessee's choice suitable for his business needs.
3. Ownership Separated from user : The essence of a lease financing contract is that
during the lease tenure, ownership of the asset vests with the lessor and its use is
allowed to the lessee. On the expiry of the lease tenure, the asset reverts to the
lessor.
4. Term of Lease : The term of lease is the period for which the agreement of lease
remains in operation. Every lease should have a definite period, otherwise it will
be legally inoperative. The lease period may sometimes stretch over the entire
economic life of the asset (i.e., financial lease) or a period shorter than the useful
life of the asset (i.e, operating lease). The lease may be perpetual, i.e., with an
option at the end of the lease period to renew the lease for a further specific
period.
5. Lease Rentals : The consideration which the lessee pays to the lessor for the lease
transaction is the lease rental. The lease rentals are so structured as to compensate
the lessor for the investment made in the asset (in the form of depreciation), the
interest on the investment, repairs, etc. if any borne by the : 5 :
1essor and servicing charges over the lease period.
6. Modes of Terminating Lease : At the end ot the lease period, the lease is terminated
and various courses are possible, viz.,
(a) The lease is renewed on a perpetual basis or for a definite period,
(b) The asset reverts to the lessor,
(c) The asset reverts to the lessor and the lessor sells it to a third party,
(d) The lessor sells the asset to the lessee.
The parties may mutually agree to and choose any of the aforesaid alternatives at the
beginning of the lease nature.

8.3 CLASSIFICATION OF LEASING

An equipment lease transaction can differ on the basis of (1) the extent to which
the risks and rewards of ownership are transferred, (ii) number of parties to the
transaction, (iii) domiciles of the equipment manufacturer, the lessor and the lessee, etc.
Risk with reference to leasing refers to the possibility of loss arising on account of under-
utilization or technological obsolescence of the equipment while reward means the
incremental net cash flows that are generated from the usage of the equipment over its
economic life and the realization of the anticipated residual value on expiry of the
economic life. On the basis of these variations, leasing can be classified into the
following types:
(a) Finance lease and operating lease
(b) Sales and lease back, and direct lease
(c) Single investor lease and leveraged lease
(d) Domestic lease and International lease
(a) Finance Lease and Operating Lease
Finance Lease : According to the International Accounting Standards ( IAS-17 ), in a
finance lease the lessor transfers to the lessee, substantially all the risks and rewards : 6 :
incidental to the ownership of the asset whether or not the title is eventually transferred. It
involves payment of rentals over an obligatory non-cancelable lease period, sufficient in
total to amortize the capital outlay of the lessor and leave some profit. In such leases, the
lessor is only a financier and is usually not interested in the assets. It is for this reason
that such leases are also usually not interested in the assests, It is for this reason that such
leases are also called full payout leases as they enable a lessor to recover his investment
in the lease and device a profit types of assets. Included under such lease are ships,
aircraft, railway wagons, lands, building heavy machinery, diesel generating sets and so
on.
The IAS-17 stipulates that a substantial part of the ownership related risks and
rewards in leasing are transferred when :
(i) The ownership of the equipment is transferred to the lease by the end of the lease term
or
(ii) The lease has the option to purchase the asset at a price which is expected to be
sufficiently lower than the fair market value at the date the option becomes
exercisable and at the stipulation of the lease it is reasonable certain that the option
will be exercise
(iii) The lease term is for a major part of the useful life of the asset. The title may not
eventually be transferred. The useful life of an asset refers to the minimum of its :
1) Physical life in terms of the period for which it can perform its function,
2) Technological life in the sense of the period in which it does not become
obsolete.
3) Product market life deemed as the period during which its product enjoys
satisfactory market.
The criterion/cut-off point is that if the lease term exceeds 75 per cent of the useful
life of the equipment, it is a finance lease.
(iv) The present value of the minimum lease payment is greater than, or substantially : 7 :
equal to, the fair market value of the asset at the inception of the lease (cost or
equipment). The title may or may not be eventually transferred. The cut-off point
is that the present value exceeds 90 per cent of the fair market value of the
equipment. The present value should be computed using a discount rate equal to
the rate implicit in the lease in the case of lessor and, in the case of the lessee,
upon the incremental borrowing rate
In India, however, a lease is a finance lease, if one of the last two conditions, is
satisfied. A lease agreement with any of the first two conditions is treated as hire-
purchase agreement.
A finance lease is structured to include the following features :
(i) The lessee (the intending buyer) selects the equipment according to his requirement
from its manufacturer or distributor.
(ii) The lessee negotiates and settles with the manufacturer or distributor, the price, the
delivery schedule, installation, terms of warranties, maintenance and payment, etc.
(iii) The lessor purchases the equipment either directly from the manufacturer or
distributor (under straight-forward leasing) or from the lessee after the equipment
is delivered (under sale and lease back).
(iv) The lessor then leases out the equipment to the lessee. The lessor retains the
ownership while lessee is allowed to use the equipment.
(v) A finance lease may provide a right or option, to the lessee, to purchase the equipment
at a future date. However, this practice is rarely found in India
(vi) The lease period spreads over the expected economic life of the asset. The lease is
originally for a non-cancelable period called the primary lease period during
which the lessor seeks to recover his investment along with some profit. During
this period cancellation of lease is possible only at a very heavy cost. Thereafter,
the lease is subject to renewal for the secondary lease period, during which the
rentals are substantially low. : 8 :
(vii) The lessee is entitled to exclusive and peaceful use of the equipment during the
entire lease period provided he pays the rentals and complies with the terms of the
lease.
(viii) As the equipment is chosen by the lessee, the responsibility of its suitability, the
risk of obsolescence and the liability for repair, maintenance and insurance or the
equipment rest with the lessee.

Operating Lease: According to the IAS-17, an operating lease is one which is not a
finance lease. In an operating lease, the lessor does not transfer all the risks and rewards
incidental to the ownership of the asset and the cost of the asset is not fully amortized
during the primary lease period. The lessor provides services (other than the financing of
the purchase price) attached to the leased asset, such as maintenance, repair and technical
advice. For this reason, operating lease include a cost for the services provided, and the
lessor does not depend on a single lessee for recovery of his cost. Operating lease is
generally used for computers, office equipments, automobiles, trucks, telephones, etc.

An operating lease is structured with the following features :

(i) An operating lease is generally for a period significantly shorter than the
economic life of the leased asset. In some cases it may be even on hourly,
daily, weekly or monthly basis. The lease is cancelable by either party during
the lease period.
(ii) Since the lease periods are shorter than the expected life of the asset, the lease
rentals are not sufficient to totally amortize the cost of the assets.
(iii) The lessor does not rely on the single lessee for recovery of his investment.
He has the ultimate interest in the residual value of the asset. The lessor bears
the risk of obsolescence, since the lessee is free to cancel the lease at any
time. : 9 :
 (iv) Operating lease normally include maintenance clause requiring the lessor to
maintain the leased asset and provide services such as insurance, support
stair, fuel, etc.
Examples of Operating leases are:-
(a) Providing mobile cranes with operators,
(b) Chartering of aircraft and ships, including the provision of crew, fuel and
support services.
(c) Hiring of computers with operators,
(d) Hiring of taxi for a particular travel, which includes service of driver, provision
for maintenance, fuel immediate repairs, etc.

(b) Sale and Lease Back and Direct Lease

Sale and Lease back : In a way, it is an indirect from of leasing. The owner of an
equipment/asset sells it to a leasing company (Lessor) which leases it back to the owner
(lessee). A classic example of this type of leasing is the sale and lease back of safe
deposits values by banks under which banks sell them in their custody to a leasing
company at a market price substantially higher than the book value. The leasing company
in turn offers these lockers on a long-term basis to the bank. The bank subleases the
lockers to its customers. The lease back arrangement in sale and lease back type of
leasing can be in the form of finance lease or operating lease.
Direct Lease : In direct lease, the lessee, and the owner of the equipment are two
different entities a direct lease can be of two types : Bipartite and Tripartite Lease.
Bipartite Lease : There are two parties in the lease transaction, namely,
(i) equipment supplier-cum-lessor
(ii) lessee. Such a type of lease is typically structured as an operating lease with
inbuilt facilities, like up gradation of the equipment (Upgrade Lease),
addition to the original equipment configuration and so on. The lessor : 10 :
 maintains the asset and, if necessary, replaces it with a similar equipment in
working conditions (Swap Lease).
Tripartite Lease : Such type of lease involves three different parties in the lease
agreement : equipment supplier, lessor and lessee. An innovative variant of tripartite
lease is the sales-aid lease under which the equipment supplier arranges for lease finance
in various company;
• Providing reference about the customer to the leasing company,
• Negotiating the terms of the lease with the customer and completing all the
formalities on behalf of the leasing company,
• Writing the lease on his own account and discounting the lease receivables with
the designated leasing company. The effect is that the leasing company owns
the equipment and obtains an assignment of lease rental.

The sales-aid lease is usually with recourse to the supplier in the event of default by the
lessee either in the form of offer from the supplier to buy back the equipment from the
lessor or a guarantee on behalf of the lessee.

(c) Single Investor Lease and Leveraged Lease

Single Investor Lease : There are only two parties to the lease transaction – the lessor
and the lessee. The leasing company (lessor) funds the entire investment by an
appropriate mix of debt and equity funds. The debts raised by the leasing company to
finance the asset are without recourse to the lessee, i.e. in the case of default in servicing
the debt by the leasing company, the lender is not entitled to payment from the lessee.
Leveraged Lease : There are three parties to the transaction : (i) lessor (equity investor),
(ii) lender and (iii) lessee. In such type of lease, the leasing company (equity investor)
buys the asset through substantial borrowing. The lender (loan participant) obtains an
assignment of the lease and a first mortgaged asset on the leased asset. The transaction is
routed through a trustee who looks after the interest of the lender and lessor. On receipt
of the rentals from the lessee, the trustee remits the debt service component of the rental :
11 :
to the loan participant and the balance to the lessor.
Like other lease transactions, leveraged lease entitles the lessor to claim tax
shields on depreciation and other capital allowances on the entire investment cost
including the non-recourse debt. The return on equity (profit after tax divided by net
worth) is, therefore, high. From the lessee's point of view, the effective rate of interest
implicit in the lease arrangement is less than on a straight loan as the lessor passes on the
portion of the tax benefits to the lessee in the form of lower rental payments. Leveraged
lease packages are generally structured for leasing investment-intensive assets like
aircrafts, ships, etc,

(d) Domestic Lease and International Lease

Domestic Lease: A lease transaction is classified as domestic if all parties to the
agreement, namely, equipment supplier, lessor and the lessee, are domiciled in the same
country.
International Lease : If the parties to the lease transaction arc domiciled in different
countries, it is known as international lease, This type of lease is further sub-classified
into ( I) Import Lease and (2) cross-border lease.
Import Lease : In an import lease, the lessor and the lessee are domiciled in the same
country, but the equipment supplier is located in a different country The lessor imports
the asset and leases it to the lessee.
Cross-border Lease : When the lessor and the lessee are domiciled in different
countries, the lease is classified as cross-border lease, The domicile of the supplier is
immaterial.
Operationally, domestic and international leases are differentiated on the basis of risk.
The latter type of lease transaction is effected by two additional risk factors, i,e, country
risk and currency risk. The country risk arises from the need to structure the lease
transaction in the light of an understanding of the political and economic climate and a
knowledge or the tax and regulatory environment governing them in the foreign
period of time.
Financial Lease: A lease is defined as a financial lease if it transfers a substantial part of
the risks and rewards associated with ownership from the lessor to the lessee.
Operating Lease: An lease other than a finance lease is known an operating lease.
Hire Purchase: Hire purchase refers to a transaction of finance whereby goods are
bought and sold under certain terms and conditions, such as payment of periodic
instalments, immediate possession of goods to the buyer etc.
 INTRODUCTION CREDIT RATING

1. India was perhaps the first amongst developing countries to set up a credit rating
agency in 1988. The function of credit rating was institutionalized when RBI made it
mandatory for the issue of Commercial Paper (CP) and subsequently by SEBI, when
it made credit rating compulsory for certain categories of debentures and debt
instruments. In June 1994, RBI made it mandatory for Non-Banking Financial
Companies (NBFCs) to be rated. Credit rating is optional for Public Sector
Undertakings (PSUs) bonds and privately placed non-conve11ible debentures upto
Rs. 50 million. Fixed deposits of manufacturing companies also come under the
purview of optional credit rating. Securities. Credit Rating is valuable information,
widely used measure for the riskiness of the companies and bonds. It is expensive
information; costly to obtain. Credit Rating prediction is important for investors to
estimate riskiness of unrated companies and for companies to monitor the companies’
credit rating, predict the future rating.

WHAT IS A CREDIT RATING?

 A credit rating assesses the credit worthiness of an individual, corporation, or even a

country.

 Credit ratings are calculated from financial history and current assets and liabilities.

 A credit rating tells a lender or investor the probability of the subject being able to pay
back a loan.

 A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high
interest rates.

 Credit is important since individuals and corporations with poor credit will have
difficulty finding financing ,and will more likely have to pay more due to risk of default.

 The ratings are expressed in code numbers which can be easily comprehend by lay
investors.

 Credit rating, as exists in India, is done for a specific security and for the company as a
whole.

 A credit rating does not create fiduciary relationship between the agency & the users.
  CRA play a key role in the infrastructure of the modern financial system.

For investors, credit rating agencies increase the range of investment alternatives and provide
independent, easy-to-use measurements of relative credit risk; this generally increases the
efficiency of the market, lowering costs for both borrowers& lenders. .
CRISIL (Credit rating and information services of India ltd.)
CRISIL, India's first credit rating agency, is incorporated, promoted by the erstwhile ICICI Ltd,
along with UTI and other financial institutions. The head office of the company is located at
mumbai and it has established offices outside india. it is a global analytical company providing
ratings ,research and risk and policy advisory services.it is the largest credit rating agency in
India. CRISIL’s majority shareholder is STANDARD and POOR’s.

WIth sustainable competitive advantage arising from their strong brand, unmatched credibility,
market leadership across businesses, and large customer base, they deliver analysis, opinions,
and solutions that make markets function better.

they defining trait is our ability to convert data and information into expert judgements and
forecasts across a wide range of domains, with deep expertise and complete objectivity.

At the core of their credibility, built up assiduously over the years, are our values: Integrity,
Independence, Analytical Rigour, Commitment and Innovation.

 CRISIL launches Education Grading, beginning with business schools

 CRISIL Rating enhances access to funding for SMEs; Announces 20,000th SME Rating
 CRISIL Ratings launches Solar grading
 CRISIL Research launches Gold and Gilt Index
 CRISIL Global Research & Analytics receives NASSCOM Exemplary Talent Practices
Award

CRISIL was set up in the year 1987 in order to rate the firms and then entered into the field of
assessment service for the banks. Highly skilled members manage the agency. Ms. Roopa Kudva
who acts as the Managing Director and Chief Executive Officer of the company heads it. The
company has set up large number of committees to look after dispersal of various services
offered by the company for example, investor grievance committee, investment committee,
rating committee, allotment committee, compensation committee and so on. The head office of
the company is located at Mumbai and it has established offices outside India also.

CRISIL Ratings is the only ratings agency in India to operate on the basis of sectoral
specialization. CRISIL Ratings plays a leading role in the development of the debt markets in
India. CRISIL has also spearheaded the formation of the Cari CRIS, the world's first regional
credit rating agency.
LONG TERM SHORT-TERM
INSTRUMENT
I NSTRUMENTS

CRISIL AAA Instruments with this rating are CRISIL A1

(Highest Safety) considered to have the highest
degree of safety regarding timely
servicing of financial obligations.
Such instruments carry lowest credit
risk.

CRISIL AA Instruments with this rating are CRISIL A2

(High Safety) considered to have high degree of
safety regarding timely servicing of
financial obligations. Such
instruments carry very low credit
risk.

CRISIL A Instruments with this rating are CRISIL A3

(Adequate Safety) considered to have adequate degree
of safety regarding timely servicing
of financial obligations. Such
instruments carry low credit risk.

CRISIL BBB Instruments with this rating are CRISIL A4

(Moderate Safety) considered to have moderate degree
of safety regarding timely servicing
of financial obligations. Such
instruments carry moderate credit
risk.

CRISIL BB Instruments with this rating are CRISIL D

(Moderate Risk) considered to have moderate risk of
default regarding timely servicing of
financial obligations.

CRISIL B Instruments with this rating are

(High Risk) considered to have high risk of
default regarding timely servicing of
financial obligations.

CRISIL C Instruments with this rating are

(Very High Risk) considered to have very high risk of
default regarding timely servicing of
financial obligations.

CRISIL D Instruments with this rating are in

Default default or are expected to be in
default soon.
 Venture Capital in India

A venture capitalist is a person who invests in a business venture, providing capital for
start-up or expansion. The majority of venture capital (VC) comes from professionally-
managed public or private firms who seek a high rate of return by (typically) investing in
promising startup or young businesses that have a high potential for growth but are also
high risk. VC firms typically invest in business sectors such as IT, bio-pharmaceuticals,
clean technologies, semiconductors, etc.
An investment from a venture capitalist is a form of equity financing - the VC investor
supplies funding in exchange for taking an equity position in the company. Equity
financing is normally used by non-established businesses that are unable to
securebusiness loans from financial institutions (debt financing) due to insufficient cash
flow, lack of collateral, or high risk profile.
VC investments in businesses are typically long-term (the average is from five to eight
years). This is normally how long it takes for a young business to mature to the point
where its equity shares have value and the company goes public or is bought out. VC
firms expect returns on investment of 25% or greater given the risk profile of the
companies they invest in.

VC firms obtain investment capital by pooling money from pension funds, insurance
companies, and wealthy investors. The firm makes the decisions about which
businesses to invest in and receives management fees and a percentage of the profits
as compensation. VC firms range in size from small (capital pools of a few million
dollars, typically investing in only a few new businesses each year) to huge (billions of
dollars in assets and invested in hundreds of companies).

A venture may be defined as a project prospective converted into a process with an adequate
assumed risk and investment. With few exceptions, private equity in the first half of the 20th century
was the domain of wealthy individuals and families

TYPES OF VENTURE CAPITAL

The first professional investor to a deal at the start-up stage is referred to

as the Series A investor. This investment is followed by middle and later
stage funding – the Series B, C, and D rounds. The final rounds include
mezzanine, late stage and pre-IPO funding. A VC may specialize in provide
just one of these series of funding, or may offer funding for all stages of the
business life cycle. It's important to know the preferences of the VC you're
approaching, and to clearly articulate what type of funding you're seeking:

1. Seed Capital . If you're just starting out and have no product or

organized company yet, you would be seeking seed capital. Few VCs
fund at this stage and the amount invested would probably be small.
Investment capital may be used to create a sample product, fund
market research, or cover administrative set-up costs.
2. Startup Capital. At this stage, your company would have a sample
product available with at least one principal working full-time. Funding
at this stage is also rare. It tends to cover recruitment of other key
management, additional market research, and finalizing of the
product or service for introduction to the marketplace.
3. Early Stage Capital . Two to three years into your venture, you've
gotten your company off the ground, a management team is in place,
and sales are increasing. At this stage, VC funding could help you
increase sales to the break-even point, improve your productivity, or
increase your company's efficiency.
4. Expansion Capital . Your company is well established, and now you
are looking to a VC to help take your business to the next level of
growth. Funding at this stage may help you enter new markets or
increase your marketing efforts. You should seek out VCs that
specialize in later stage investing.
5. Late Stage Capital . At this stage, your company has achieved
impressive sales and revenue and you have a second level of
management in place. You may be looking for funds to increase
capacity, ramp up marketing, or increase working capital.

You may also be looking for a partner to help you find a merger or
acquisition opportunity, or attract public financing through a stock offering.
There are VCs that focus on this end of the business spectrum, specializing
in initial public offerings (IPOs), buyouts, or recapitalizations. If you are
planning an IPO, a VC may also assist with mezzanine or bridge financing
– short-term financing that allows you to pay for the costs associated with
going public.

A key factor for the VC will be risk versus return. The earlier a VC invests,
the greater are the inherent risks and the longer is the time period until the
VC's exit. It follows that the VC will expect a higher return for investing at
this early stage, typically a 10 times multiple return in four to seven years. A
later stage VC may be seeking a two to four times multiple return within two
years.

Students will be concentration on capital markets, money markets,

mutual funds, venture capital, leasing types, credit rating types …..

Prepared by

Principal

Dr .D.V.Rao, M.Com., M.phil ., P.hd., Sanjeev Institute of Management

Kakinada.