Banking Material

Workshop on Banking Symbiosis

Part I - Banking

2.1 Introduction

WHAT IS A BANK AND WHAT IS BANKING?

The present day banking has its origin in U.K. Their early role was to safe keep the money deposited by the local citizens and charge them a small fee for the same. Slowly the bankers started realising that they could use this money by lending it to those who needed it. That was the beginning of "deposit" and "loan". Thus "financial intermediary" was born - "financial intermediary" simply meaning that money flows through them from the "money-surplus" units to "money-needed" units.

The depositors would be paid certain amount and the borrowers of this money would be charged certain amount, called "interest". There would obviously be difference between the amount of interest paid to depositors and the amount of interest recovered from the borrowers. This would be the profit for the financial intermediary, which is a bank. This is the foundation for today's "retail banking".

With the growth in commerce, first within a country and then globally, banking started transcending first the regional boundaries and then the national boundaries. That is how "international banking" started. Even today, international banking caters to "international trade" to a major extent.

While primarily the banking function revolved around acceptance of deposits and granting of loans, the customers started feeling the need for other services. These services were: remittance of funds from one place to another place, purchase of securities on behalf of its customers, safe custody of important documents, safe deposit vault services etc. Thus slowly the services extended by banks went on expanding. Today in India, any medium sized or large commercial bank extends the following services:

Acceptance of deposits of various kinds – deposits that can be withdrawn on demand like Savings/Current Accounts or those deposits that have a fixed maturity date, like, Fixed Deposit Accounts, Recurring Deposit Accounts etc.

Extending loans to borrowers in the form of Loans and Overdraft (This overdraft facility in India is called "Cash Credit" facility in the case of business enterprises)

Extending financial assistance to exports on soft terms Remittance of funds from one place to another place by various modes like Mail

Transfer (M.T.), Telegraphic Transfer (T.T.), Demand Drafts (D.D.), Electronic Fund Transfer (E.F.T.) etc.

Collection of bills for commercial transactions tendered by its customers facilitating commerce within the country as well as outside the country.

Safe custody services for safe keeping of important documents Safe Deposit Vault services (SDV) for personal safe keeping of documents, cash,

jewellery etc.

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Workshop on Banking Symbiosis Foreign exchange transactions involving import/export of goods and remittance

of foreign exchange (both outward and inward) Issuing letters of undertaking to suppliers of goods and/or services through their

bankers which are called “Letters of Credit” (L/C) Issuing Bank Guarantees on behalf of its customers in favour of various

beneficiaries including Government Agencies (B/G) Obtaining credit reports from other Banks and specialised Credit Agencies on

customers (both within India and outside India) as well as providing Credit Information about its customers to other Credit Agencies.

Doing Government business, like payment of pension, collection of direct tax (like income tax) and indirect taxes (like excise duty).

Extending Counselling Services to its customers on International Trade, Loan Arrangements (Syndication), when to come out with public issue of equity shares etc.

Extending cash withdrawal facilities through Automated Teller Machines/Any Time Money (ATMs).

Carrying out standing instructions of customers for receipt of payments (amount credited to customers’ accounts) and making of payments (amount debited to the customers’ accounts).

Issue of International Money Orders (IMO), Travellers’ Cheques (TC), both in Indian Rupee and Foreign Currency to travellers, exchanging Indian Rupee for Foreign Currency Travellers cheques from foreign tourists/visitors, issue of Foreign Currency to those who travel abroad/exchanging foreign currency for Indian Rupee , payment to International Credit Card Agencies, issue of Credit Cards to domestic customers etc.

Acceptance of deposits from non-resident Indians Arrangement of international finance to its customers as well as managing issue

of Global Depository Receipts (GDR)/American Depository Receipts (ADR)/ Euro-Bonds etc.

Investment in Govt. securities, shares of blue chip companies etc. for its own portfolio.

Extending custodial services (please refer to chapter on banking terms)

DIFFERENCE BETWEEN RETAIL BANKING AND WHOLESALE BANKING

Wholesale banking typically involves a small number of very large customers such as big corporations and governments, whereas retail banking consists of a large number of small customers who consume personal banking and small business services. Wholesale banking is largely inter-bank; banks use the inter-bank markets to borrow from or lend to other banks/large customers, to participate in large bond issues and to engage in syndicated lending. Retail banking is largely intra-bank; the bank itself makes many small loans.

Most of the Indian public sector banks practise retail banking, while the concept of “wholesale banking” is slowly being practised by them. On the other hand, most of the well-established foreign banks in India and the recent private sector banks practise wholesale banking alongside retail banking.

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Workshop on Banking SymbiosisAs a result of this difference, the composition of income for a public sector bank and a well-established private sector bank is different. While a major portion of the income for large public sector banks is from lending operations, in the case of any private sector bank in India, the amount of non-operating income (other than interest income) is substantially higher. The composition of other income is - commission on bills/guarantees/letters of credit, counselling fees, syndication fees (arrangement for loans), credit report fees, loan processing fees, correspondent bank charges (please see next chapter for the meaning of correspondent bank) etc. Internationally also, in the case of any bank, the non-interest income is substantially more than interest income. This is considered as a healthy sign, as the investment required for earning non-interest income is negligible. Non-interest income is from activities, which are not fund based but fee-based. Hence very little capital is required to carry on such activities.

Note: The significance of important banking terms used in the course material is explained in the next chapter. "Global banking" activities are an extension of various activities listed above into the international market. Global banking primarily consists of trade in international banking services and establishment of branches and subsidiaries in foreign countries.

WHAT IS A SCHEDULED BANK IN INDIA?

In India, the Central Banking Authority is the Reserve Bank of India (RBI); it is also referred to as the "Apex Bank". It functions under an act called The Reserve Bank of India Act, 1934. All the banks and other financial institutions operating in India come under the monitoring and control of RBI. RBI controls the banking sector in India through an act called "The Banking Regulations Act". In the past, when there were very few banks, RBI used to include all the "scheduled" banks in its Schedule. Nowadays, when the number of banks has gone up substantially, RBI has to change the schedule every now and then. Hence irrespective of whether a bank finds its name in the schedule to the RBI Act or not, its "schedule status" can be found out from its banking licence. A bank that is not a scheduled bank is referred to as "non-scheduled" bank even in its banking licence.

The difference lies in the type of banking activities that a bank can carry out in India. In the case of a scheduled bank, it is licensed by the RBI to carry on extensive banking operations including foreign exchange operations, whereas, a non-scheduled bank can carry out only limited operations. There are a number of factors considered by RBI to declare a bank as a "scheduled bank", like the amount of share capital, type of banking activities that the bank is permitted to carry out etc. An example of difference between a scheduled and non-scheduled bank is dealing in "Foreign Exchange".

WHAT IS THE DIFFERENCE BETWEEN A COMMERCIAL BANK AND A CO-OPERATIVE BANK?

A commercial bank is run on commercial lines, for profits of the organisation. A co-operative bank on the other hand is run for the benefit of a group of members of the co-operative body. A co-operative bank distributes only a very small portion of its profit as dividend, retaining a major portion of it in business.

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Workshop on Banking SymbiosisAll the nationalised banks in India and almost all the private sector banks are commercial scheduled banks. There are a large number of private sector co-operative banks and most of them are non-scheduled banks. In the public sector also, within a state, starting from the State Capital, there are State Co-operative Banks (example: in Karnataka, we have Karnataka State Co-operative Bank) and District Central Co-operative Banks at the district level. Under the District Central Co-operative Bank, there are Co-operative Societies. At present, in India, the banks can be bifurcated into following categories.

Category 1 – Public Sector banks (also referred to as "nationalised banks"), which are commercial and scheduled. Examples: State Bank of India, Bank of India etc.

Category 2 – Private Sector banks, which are commercial and scheduled. These could be foreign banks as well as Indian Banks. Examples: Foreign Bank - CITI Bank, Standard Chartered Bank etc. Indian Bank - Bank of Rajasthan Limited, Vysya Bank Limited etc.

Category 3 – Private Sector banks, which are co-operative and scheduled. These are large co-operative sector banks but which are scheduled banks. Examples: Saraswat Co-operative Bank Limited, Shamrao Vithal Co-operative Bank Limited, Cosmos Co-operative Bank Limited etc.

Category 4 – Private Sector banks, which are co-operative and non-scheduled. These are small co-operative banks but which are non-scheduled. Examples: Local co-operative banks which operate within a town or a city, like Mahesh Sahakari Bank Limited etc.

Category 5 – Public Sector banks, which are co-operative and non-scheduled. These are state owned banks like the Maharashtra State Co-operative Bank (State level), Pune District Central Co-operative Bank (District level) and Junnar Co-operative Society etc (primary level).

Category 6 – Regional Rural Banks which are state owned and have different roles assigned to them. They are outside the purview of our discussions

Category 7 – Gramin Banks that are also state owned and have different roles assigned to them. They are also outside the purview of our discussions.

Note - During the course of the workshop, we will be discussing the activities of a scheduled bank.

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2.2 Banking Terms - Different Bank Accounts - Bank Facilities - Determination of interest on deposits and advances

DIFFERENT BANK ACCOUNTS - DEPOSITS

1. Deposit account offering withdrawal facility – Savings Bank Account as well as Current Account. The nomenclature of the Savings Bank Account is different in different countries. For example, Savings Bank Account with withdrawal facility through Cheques is referred to as "Check Accounts" in the USA. In India, while the balances in the Savings Bank Accounts get interest, the balances in the Current Accounts do not get interest.

2. Deposit account without withdrawal facility – different categories – Lump sum investment for specific periods, after which the principal amount is

paid back together with interest for the entire deposit period. This is on a cumulative basis or reinvestment basis.

Lump sum investment for specific periods and interest is paid on a periodic basis. The principal amount is paid back on maturity/due date.

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Workshop on Banking Symbiosis Lump sum investment for specific periods and interest together with a part of

the principal amount is paid periodically with last instalment payable on due date/maturity date.

Periodic investment, mostly on a monthly basis and repayment on a cumulative basis, both principal and interest amounts – example, recurring deposit accounts

Periodic investment, less frequent than the previous one but investment is usually substantial and repayment on a cumulative basis together with interest. Periodic investments may not be of the same size.

DIFFERENT BANK ACCOUNTS – ADVANCES AND LOANS

1. Overdraft – An extension of current account in which the customer is allowed to withdraw more than the credit balance lying in the account. This may be a temporary accommodation to tide over temporary cash crunch or on a regular basis. If permitted on a regular basis, withdrawals are allowed up to a ceiling (called "a limit"), subject to availability of sufficient security with the bank. For "security" please refer to the following section on "banking terms". It is a facility in which the customer can cancel the previous debit balance (amount withdrawn) by subsequent credits (amount deposited) and draw afresh as and when required, subject to a limit. In case the overdraft is given to business enterprises, it is for day-to-day operations, which is otherwise known as “working capital”.

2. Cash Credit – A credit facility under which a customer draws up to a pre-set limit, subject to availability of sufficient security with the bank. The difference between an Overdraft and a Cash Credit account is that while the former is extended more to individuals and less for business, the latter is extended only to business bodies. The Cash Credit facility is unique to India, as in most of the countries it is called "Overdraft". Further, the cash credit facility is more or less on a permanent basis so long as the business is going on. Internationally, at the end of a specific period, the overdraft facility is withdrawn and the customer is required to pay back the amount lent by the bank. The purpose of cash credit is for working capital. The operations are similar to Overdraft.

3. Loan – A lump sum amount given to the customer, either in one "tranche" or in two or three "tranches" and repayment over a period of time in monthly or quarterly or half-yearly or annual (very rarely) instalments. Interest may be recovered separately from the customer who is called "borrower" or combined with the instalment. In case it is combined with the instalment, it is known as “equated” instalment. If interest is recovered separately, it is usually on a quarterly basis, while instalment can be as mentioned above. Loan is very common abroad and given against specific assets like consumer durable, white goods, house property etc. Given to individuals as well as business bodies. Loans against property and for the purpose of owning flats/apartments/houses are known as "mortgage" loans.

Repayment period: Anywhere between 2 years to 5 years for other than housing loan. For housing loan, in India, between 10-15 years and abroad, it can be even up to 30 years. Withdrawal facility by cheque is not available unlike Overdraft or Cash Credit.

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Workshop on Banking SymbiosisBANKING TERMS OFTEN USED/ COMMON BANKING PRACTICES

1. Bill – usually mistaken for a commercial invoice. Actually bill in the banking parlance means a Bill of Exchange drawn by a seller on the buyer whenever he sells goods or services on "payment later" basis. Such a transaction is referred to as a "credit" transaction. The bill is routed through the bank for collection of amount from the buyer. Commercial invoice is a part of the documents submitted to a bank by the seller.

A Bill of Exchange is an order made to the buyer by the seller that in exchange for the goods or services sold by him on credit, the buyer is required to pay on a specific date, a certain amount with or without interest to him or to any other directed party (mostly a bank).

2. Discount – less than face value. If the value of the bill is $100 and in case the bank gives finance against the same, the amount of finance will be less than $ 100, say $ 98. $ 98 is the discounted value of the bill for $ 100, while the difference of $ 2, is known as “discount”. Discount is nothing but interest recovered up front, especially in the case of those bills for which payment will be forthcoming after a specific or expected period.

3. Remittance – A facility, by which funds are made available to the bank by its customer at one place and the bank in exchange, makes the funds available to the customer or any other specified party at the required place, within the same country or abroad.

There is more than one mode of remittance. It can be by Demand Draft (DD), Mail Transfer (MT), Telegraphic Transfer (TT), Electronic Mail Transfer (EMT) through computer networking (or through satellite channel), International Money Order (IMO) etc.

4. Letter of credit – Seller “A” enters into contract with Buyer “B”. One of the terms of supply is that buyer will establish a letter of credit in favour of the seller through his bank. The Buyer approaches his bank, which, on certain conditions, agrees to extend this facility. Under this facility, the buyer’s bank gives commitment of payment to the seller through his bank. The commitment is dependent upon the seller fulfilling specific conditions as per the L/C. The conditions are: the seller should furnish proof of despatch of goods or services and submit all the documents required under the L/C. Then, the buyer’s bank will pay the amount of the bill drawn by the seller on the buyer under this arrangement. International letters of credit are by and large, “irrevocable” (cannot be cancelled by the buyer without the consent from the seller)

Advantage – This facilitates global commerce through the banking channel which acts as the financial intermediary and based on the letter of credit established by the buyer’s bank, the seller’s bank will extend financial assistance to the seller till he gets the payment from the buyer’s bank.

Bill of exchange v. promissory note – BOE is an unconditional order to pay while promissory note is an unconditional undertaking to pay.

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Workshop on Banking Symbiosis5. Bank guarantee – Could be a finance guarantee or a performance guarantee.

Under finance guarantee, the bank guarantees the beneficiary (the person named in the guarantee to receive the guaranteed sum under stated circumstances), certain amount on behalf of its customer who has commercial relationship with the beneficiary. Under performance guarantee, the bank guarantees performance of a contract or goods/services supplied under a contract by its customer. However, even in the latter case, if its customer fails to deliver, it settles the claim of the beneficiary in money terms only; the bank does not fulfil the contract obligation of its customer.

Example of Finance guarantee - Two parties enter into a contract. One is the supplier and the other is the buyer. The terms of supply include 25% of advance to be given by the buyer. The buyer wants assurance of supply as per the contract with the seller. Hence he insists on a bank guarantee by the seller’s bank. The seller’s bank gives the same against some security given by the seller. In case the seller does not fulfil the contract, the beneficiary of the guarantee lodges a claim with the guarantee-issuing bank. The bank then pays the buyer the assured sum.

Example of Performance guaranteeSimilarly, in the case of an export contract, the foreign buyer, who is the importer may insist upon the seller’s bank issuing a performance guarantee to ensure that the seller sticks to the delivery schedule. The buyer will establish a letter of credit in favour of the seller through his bank only upon the buyer’s bank receiving the required performance guarantee from the seller’s bank.

Lodging a claim under a guarantee with the guarantee-issuing bank by the beneficiary is known as "invocation" of a guarantee.Cancellation of a guarantee is known as "revocation" of a guarantee.Letters of credit and bank guarantees play a very important role in international banking.

6. Negotiation – the term refers to the act of a bank extending finance to the seller against a letter of credit in his favour, once he furnishes proof of despatch and fulfils all conditions of the letter of credit, as laid down by the buyer. The conditions relate only to documents and not goods.

7. Cash Reserve Ratio – Called in short, CRR. It is in operation in India. Usually, in developed countries, CRR and SLR (refer to the next point) are not separately levied. They are together known as "statutory reserve". Suppose a bank has total deposits of $100 Bn. and is required to maintain a CRR of say 5%. This means that the bank should maintain in current accounts with the Central Bank or any other approved bank balances, not less than $ 5 Bn. This much amount is impounded and kept in the free form and the bank cannot lend this money. This acts as a buffer to the bank. In India, RBI decides from time to time and at present it is 8.5% of the deposits held by the bank.

8. Statutory Reserve Ratio – Called in short, SLR. In the above example, suppose the bank is supposed to maintain SLR of 15%. This means that over and above CRR, the bank is expected to keep aside an amount of $ 15 Bn. This will be kept in easy-to-encash securities like treasury bills of the Government of USA and any other approved securities. Here again, the Central Banking Authority in

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Workshop on Banking SymbiosisUSA, i.e., the Federal Bank, decides the ratio. In India, at present it is 25%. This again acts as buffer to the bank and prevents the bank from lending the entire amount of deposits kept with it by various customers.

Note pertaining to Reserve Ratio – the investment decision is taken not at the branch level. It is taken at the Head Office of the bank. In India, the department handling this, is known as "Treasury" department at the Head Office. This is natural, as this outfit is in touch with the market constantly. Further, compliance with SLR is to be done on the basis of deposits of the bank with all its branches and hence the Head Office is suitable for this purpose. The Head Office reports the position of deposits as well as investment under CRR/SLR to the Central Banking Authority once in a fortnight.

9. Credit to a customer’s account – Whenever any amount is received by the bank on behalf of its customer, it posts the amount in the credit column of its ledger account of the customer and enhances the balance in the account if it is a deposit account and reduces the balance in the account if it is a loan account or overdraft account.

10.Debit to a customer’s account – Whenever any amount is paid by the bank on behalf of its customer, it posts the amount in the debit column of its ledger account of the customer and reduces the balance in the account if it is a deposit account and enhances the balance in the account if it is a loan account or overdraft account.

11.Clearing operation – Suppose Customer “A” has his check account with Bank of New York, New York Branch (B.O.N.Y., N.Y.). He issues a cheque in favour of “B” who is a customer of Chemical Bank, New York Branch (C.B., N.Y.). “B” deposits the check in his account with C.B., N.Y., which presents the check to B.O.N.Y., N.Y. through a platform known as “clearing house”. The Federal Bank or its authorised bank in all the major centres mostly conducts this across the US.

12.B.O.N.Y., N.Y. credits C.B., N.Y. with the amount of the check after debiting the same to its customer “A” and on receipt of clearing advice, C.B., N.Y. debits B.O.N.Y., N.Y. and credits the account of Customer “B”. Thus clearing operations enable the banks to exchange instruments such as checks, international money orders, bank drafts etc. drawn on one another but within the same clearing zone and not outside it. If the instrument is drawn outside the clearing zone, the bank sends the instrument for collection, which takes a little more time than clearing.

13.Daily product basis – This is the basis on which interest is usually determined on credit facilities, like loan, overdraft, cash credit etc. For this, the basis is 365 days in a year. Some banks do take 360 days in a year also. There is no hard and fast rule in this behalf. For example Barclays Bank has given a customer an overdraft facility to the extent of $ 10000 for 45 days at 6% p.a. On a daily product basis, the interest is determined as under:

Step No. 1 – 10000 x 45 days = known as product = 450,000

Step No. 2 – determination of annual average as rate of interest is on annual basis, i.e., 450,000/365 = $ 1233. This means that on a 365 days per year

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Workshop on Banking Symbiosisbasis, drawing $ 10000 for 45 days is equivalent to drawing $ 1233 through out the year, i.e., on annual basis.

Step No. 3 – calculation of interest at 6% p.a. = 1233 x 0.06 = $ 73.98

This means that by adopting daily product basis we are converting the amount drawn for a period less than a year to its annual equivalent so that the rate of interest, which is universally on annual basis, can be applied to determine the quantum of interest.

One may ask, why this indirect method when all the above three steps can be combined into one? The answer is yes. The utility of daily product basis lies in determining the annual equivalent in cases wherein the amount drawn is likely to differ every now and then, like in the case of overdraft or cash credit. Refer to Specimen 1 for detailed calculation of interest on daily product basis in an overdraft account, in which balances differ every now and then.

Besides credit facilities, this is the method adopted by most of the US Banks for giving interest on current account balances also. For other deposit accounts, which are fixed in nature, yearly interest is straight away applied.

14.Monthly product basis – Suppose as in the case of India, in the savings account, the product is taken on a monthly basis. In India, the rule is interest is paid on the minimum balance in the account between the 10th and the last day of every month. This means that any credit to the account after the 10 th of the month is ignored for the particular month, while debit is taken into account. Accordingly let us say for example the following minimum credit balances existed in a savings account earning 2% p.a. interest in the US.

January 99 - $ 100February 99 - $ 80March 99 - $ 150April 99 - $ 250May 99 - $ 300June 99 - $ 30Total of the above = $ 910

Suppose the interest is payable every half-year and accordingly this customer will be entitled to 1% for the half-year ending June 1999. In order to determine the correct half-yearly interest, the sum of the monthly products is divided by 12 to find out annual equivalent of the deposit, that the customer has kept in his savings account at 2% p.a. interest. The annual equivalent amount is $ 75.83 and the interest at 2% p.a. for the half-year on this works out to $ 1.52. This is the way interest is found out on a monthly product basis.

15.Premature withdrawal of fixed deposit – Even though fixed deposit is a contract between two parties, banks usually allow premature withdrawal, i.e., withdrawal before maturity date. However, there will be penalty for premature withdrawal in the form of reduced interest. Suppose rate of interest is 6% p.a. for a three-year deposit and the depositor wants withdrawal after a year. The rate of interest relevant for this deposit is the one-year rate as the deposit has been

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Workshop on Banking Symbiosiskept only for one year. Suppose the rate of interest for one year is 5% p.a. The penalty may range between 1% to 2% and everything is bank dependent.

Some of the banks may not levy any penalty. Hence instead of paying interest at contract rate, interest will be paid at a rate as applicable to the period for which the deposit has been kept with the bank. This is okay so long as the deposit is on cumulative basis. On the other hand, in case the deposit is on a periodic payment basis, interest would already have been paid at the contract rate and the excess interest, if any, needs adjustment at the time of withdrawal. An example –

Amount of deposit - $ 10000Contract period – 2 yearsRate of interest – 6% p.a.Compounded annually in case interest is paid on maturityRequest for payment after 1 yearRelevant rate of interest for 1 year period – 5%p.a.

Alternative 1No penalty and relevant rate of interest is 5% p.a.Interest payable on maturity and no interest has been paidAmount payable on maturity on annual compounding of interest$ 10000 x 1.05 = $ 10,500

Alternative 2No penalty and rate of interest is 5% p.a.Interest payable half-yearly and hence no compoundingHalf-yearly interest paid at contract rate of 6% p.a. for the first half-year = $ 300Total interest payable for the period of deposit at 5% p.a. = $ 500Total amount payable including interest for the entire period = $ 10500Less interest already paid = $ 300Amount now payable = $ 10200

Alternative 3Penalty of 1% and rate of interest for one year deposit = 5% p.a.Interest payable on maturity and no interest has been paidAmount payable on maturity = $ 10000 x 1.04 = $ 10400

Alternative 4Penalty of 1% and rate of interest is 5% p.a.Interest payable half-yearly and hence no compoundingHalf-yearly interest paid at contract rate of 6% p.a. for the first half-year = $ 300Total interest payable for the period of deposit at 4% p.a. = $ 400Total amount payable including interest for the entire period = $ 10400Less interest already paid = $ 300Amount now payable = $ 10100

Note – In case the contract for deposit is for 5 years and the request for premature withdrawal is after 2 years and if the deposit is on regular payment of interest basis, it may so happen that excess interest paid as per contract rate,

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Workshop on Banking Symbiosisupon adjustment, may even reduce the principal amount. The amount to be adjusted depends upon the following factors:

Whether there is any penalty involved for premature withdrawal? What is the term for payment of interest, i.e., on a cumulative basis or on

periodic payment basis? What is the periodicity of compounding, i.e., monthly, quarterly, semi-annually

or annually?

16.Repayment holiday – Whenever a loan is taken especially for acquiring fixed assets, the repayment does not start immediately. It starts after the fixed asset starts giving a return especially in the case of business enterprises. This is not so in the case of personal loans. The period during which there is no repayment is known as “repayment holiday period”. This is also known as “Moratorium period”. This period is longer in the case of industrial loans and minimum or absent in the case of personal loans. It should be noted that during this period, interest is charged and there is no period for non-levy of interest, although there may be a period of non-recovery of interest, i.e., interest, although levied not recovered for a specific period. Again if this is the case, interest on interest is recovered.

17.Credit instruments – Any instrument that is drawn on a bank, against surrender of which the concerned bank will pay us the amount mentioned in the instrument. Examples – checks, drafts, mail transfers, travellers’ checks, international money orders etc.

18.Negotiable instruments – All the credit instruments that are transferable from one person to another by a process known as “endorsement” are called “negotiable” instruments. Suppose “A” is receiving payment by means of check from “C”. “A” owes money to “B”. The check is a negotiable instrument as it enables “A” to settle his dues to “B” by endorsing the same in favour of “B”. This renders the check a negotiable instrument. There may be some restriction on some of the above instruments, not allowing free transferability either by the banks or by the issuers of the instruments themselves.

19.NOSTRO Account – A current account which a bank has with another bank abroad, which is usually its correspondent bank and the currency in which the balance is maintained is foreign and not local. For example, CITI Bank, Baltimore has an account with Barclays Bank, London, expressed in British Pounds. It is said to have a NOSTRO Account with Barclays Bank in British Pounds. Thus, whenever we mention NOSTRO Account, it is necessary for us to know with whom it is maintained and in which currency. All the banks in India dealing in foreign exchange are required to maintain NOSTRO Accounts abroad with different correspondent banks in different currencies in different countries. In India at present, the RBI should know the names of correspondent banks with which such accounts are being maintained.

Further, payment for imports cannot be made in Indian Currency, as it is not fully convertible – means that other than Indians and travellers coming to India, others do not have any value for the Indian Rupee at this juncture. (The low exchange value of Indian Rupee vis-à-vis US $ or any other foreign currency is quite different from this. Even a currency whose unit value is less than that of

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Workshop on Banking SymbiosisIndian Rupee, say, Italian Lira is a universal currency. These two are different phenomena.)

Suppose Deutsche Software has account with Deutsche Bank, Bangalore. Deutsche Bank, Bangalore has NOSTRO Account with Bank of America, Seattle. When the export bill of Deutsche Software is routed through Deutsche Bank gets paid, Bank of America, Seattle, credits Deutsche Bank's NOSTRO Account with it. Once this advice is received, Deutsche Bank, Bangalore advises Deutsche Software and at the prevailing exchange rate between US $ and the Indian Rupees, converts the amount of credit (less their charges, if any) and credits the account of Deutsche Software with it.

Similarly let us see an example for import payment. Suppose Deutsche Software imports a testing kit from UK. The bill is raised in British Pounds. The bill will be routed through Deutsche Bank, Bangalore. Deutsche Bank, in order to settle this bill in British Pounds has to have a British Pound NOSTRO Account with a British Bank. Let us assume that it has with Standard Chartered Bank, London. Upon receiving debit instructions from Deutsche Bank, Bangalore, Standard Chartered Bank, London, debits its NOSTRO British Pound Account and credits the bank of the exporter with the same amount.

Thus we see whenever export payment is received NOSTRO Account is credited and whenever import payment is made NOSTRO Account is debited.

Note – Standard Chartered Bank, London is referred to as "Correspondent Bank" for Deutsche Bank, Bangalore. The current account that is maintained by Deutsche Bank with it in British Pounds is called a NOSTRO Account. Correspondent banks work on mutual arrangement basis. This is to say that while Standard Chartered, London, UK is the correspondent bank for Deutsche Bank, Bangalore, it will in turn be the Correspondent Bank for Standard Chartered, London, UK.

20.VOSTRO Account – The NOSTRO Account of Deutsche Bank, Bangalore with Standard Chartered, London, UK is a VOSTRO Account for Standard Chartered Bank, London, of Deutsche Bank, Bangalore. In short for a correspondent bank, whichever account it is holding on behalf of a foreign bank is its VOSTRO Account.

21.Foreign Exchange Reserves – These are primarily balances in the NOSTRO Accounts in various currencies (converted into equivalent Dollars) of all the banks in India. There are other constituents of the Foreign Exchange Reserves also, but the NOSTRO Accounts balances constitute the major portion of the reserves.

22.Acceptance – We have seen what a Bill of Exchange is. The buyer who has already received goods or services from the seller is required to acknowledge his debt to the seller by signing on the Bill of Exchange. This act of acknowledgement is called “acceptance”. At times in this, banks are also involved just to enhance the credibility of a bill of exchange. This is called banker's acceptance for which the bank charges commission. It is similar to giving bank guarantee.

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23.Credit Report – It is called by different names. At times, it is referred to as “Credit Information Report”. At other times, it is also called “Customer’s confidential report”. Banker’s report also means the same. With the growth of commerce within a country and abroad, most of the times, trade is done with organisations, about which you are in the dark. The banker provides good platform for knowing something about the business enterprise with which you are likely to deal. There are accepted abbreviations internationally for denoting the soundness or the lack of it of a business enterprise. These abbreviations are commonly used in such reports. You can seek confidential information about your prospective customers about whom you do not have sufficient knowledge. The banker provides this information for a fee, which includes the fees that they have to remit to International Credit Agencies.

24.Syndication – Making arrangement for loans for borrowers. Should not be confused with granting of loans. The bank may or may not participate in the loan process, but would assume responsibility for getting “in principle” sanction from all the participating banks and financial institutions. It is more common internationally and syndication fees are quite substantial abroad. Syndication fees are part of non-interest income as no funds are involved in the activity. For example an Indian company wants a Foreign Currency Loan of 100 M. $. Making arrangement for this is called syndication. Even if the arranging bank participates in the loan by granting a portion of it, syndication is different from it. It gets paid separately for this activity.

25.Depository – Depository for securities, i.e., shares/bonds etc. For this fees are charged, which is a non-interest income.

26.Custodial services - As per instructions of the customers, accepting dividend and interest warrants on shares and bonds/debentures respectively and credit the proceeds of the same to the customer’s account. For this also separately fees are charged, which is a non-interest income.

27.Charges in a letter of credit – Letter of credit opening charges which depend upon the period for which the

L/C will be valid L/C advising charges to be paid to the advising bank, which will mostly be

the correspondent bank L/C confirmation charges to be paid to the confirming foreign bank L/C negotiation charges to be paid to the bank which is negotiating, which

will mostly be the correspondent bank L/C amendment charges payable to the L/C opening bank whenever any term

of the L/C is changed.

28.Charges in a bill Commission for collection and recovery of postage/courier charges. Both of

these together are known as “handling charges”. Interest or discount in case bank finance is given to the customer against the

bill.

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Workshop on Banking Symbiosis29.Charges in a loan account

Processing fees for processing the application of the borrower which is ad-valorem, i.e., depending upon the amount of loan

Documentation and legal fees for preparation of documents and fees paid to firm of solicitors, if any.

Credit Management fee Annual fees recovered at the time of renewal of the limits every year

30.Security - Fixed assets like land, building, plant and machinery etc. as well as working capital assets like inventory or bills receivable are offered as security to a lender by a borrower for assurance of repayment of the loan taken by him. Suppose it is a housing loan. The value of the apartment is $30000. This is the value of security for the mortgage loan. The bank would give loan to the extent of certain prescribed % of the value of the security. Security can be paper security like shares, debentures, fixed deposit receipts, life insurance policies etc.

31.Margin – This is expressed in % of the value of security. In the above example, suppose the margin is 25%, it means that the housing loan would be to the extent of $ 22500. At times the margin is also expressed as the amount of loan in % terms to the value of security. Accordingly the margin would work out to be 75% in this case. This should be borne in mind while preparing the programme for a bank.

32.Foreign exchange – It is one of the most important aspects of international banking, as a result of the different currency systems in the two countries involved. For example an American company imports from France and the bill is in French Francs. It is obvious that the exporter wants French Francs in France. Where does the American importer get the French Francs from? He gets it from the banking system. He exchanges US $ for French Francs. In fact the importer need not possess French Francs at all. It is enough he surrenders US $ to his bank in the US and in exchange for the same, the US bank will give equivalent French Francs to the French exporter in France. This transaction will be through its NOSTRO Account as seen earlier, maintained with a correspondent bank in France.

Then the question comes as to who decides at what rate the exchange should take place. In a country like the USA, it is an open market system and hence the foreign exchange market decides the exchange rate between the French Franc (F.F.) and the US Dollar. The Foreign Exchange Market is a perfect market influenced by demand and supply. The market as soon as it opens in the morning starts giving quotations for all the major currencies in the world. The quotation will be a two-way quote – one price for purchase and the other purchase for sale. The purchase price has to be less than sale price. Foreign Exchange is like any other commodity. "Buy low" (at a lower price) and "sell high" (at a higher price) is the motto of this market.

For example, in the above case, 1 US $ = F.F. 7.818

This does not give a true picture, as it is not a two-way quote. The correct way to quote will be 1 US $ = F.F. 7.818/7.808. This quotation is known as bid/offer

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Workshop on Banking Symbiosisquote, thereby meaning that the former is the rate at which the bank will purchase F.F. from the market ("buy more" in quantity) and the latter is the rate at which the bank will sell F.F. to a buyer ("sell less" in quantity). In our case, as import is involved, the relevant rate is 1 US $ = F.F. 7.808. The difference between bid/offer rates is called as "the margin" or "spread" for the bank, representing his profit in the transaction. In this case, since the bank is purchasing F.F. the motto should be buy higher quantity of foreign currency for one unit of home currency (i.e., US $) and sell less quantity of foreign currency for one unit of home currency.

“Bid” means the bank wants to purchase. “Offer” means the bank wants to sell.

Thus in the case of any international trade, foreign exchange is involved and one currency gets converted into another currency at the market determined rates, in most of the developed countries. This may not be so in the case of “developing” markets like India. Developing markets in general and some of the developed markets too adopt a policy, which enables the Government or the Central Banking Authority of the country to monitor this market and intervene, if necessary. The international foreign exchange market every day transacts in trillions of dollars. Out of this volume more than 90% is for speculation and not backed by trade of services or goods. In India, speculation in foreign exchange market is not permitted. Even banks dealing in foreign exchange have some limits (periodically set by the RBI), up to which only, they can hold balances in permitted foreign currency/currencies, without the backing of commercial transactions with its customers.

Different types of quotations in the foreign exchange market depending upon the period of transaction:

A rate quoted today is for transaction to be put through at the end of 48 Hours. Hence this is called “spot rate”.

A rate quoted for transaction within 24 hours is known as “TOM”, acronym for “Tomorrow”

A rate quoted for transaction to be done immediately is known as “Cash” transaction

A rate quoted for transaction beyond 2 days is known as “forward rate” and a contract is entered into with the buyer of the foreign exchange/the seller of the foreign exchange. In the case of import, we happen to buy the foreign exchange and in the case of export, we happen to sell foreign exchange. This contract is known as "forward contract".

We will see some examples to familiarise ourselves with these terms and appreciate the effect of different trends in the forward rates on importer and exporter.

Example Spot rate for US$ in terms of French Franc, 1 US $ = FF 7.818/7.808Forward rate for transaction 1 month hence, 1 US $ = F.F. 7.808/7.796

This means that with the passage of time you are getting less F.F. for US $. This indicates that foreign currency is becoming dearer (costlier) vis-à-vis US $.

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Workshop on Banking SymbiosisWhat is the impact on an importer in the USA?This is not favourable for an importer in F.F., as he will be required to fork out more US $ for the same quantum of F.F. than in the past.

Then, what happens to an exporter from the USA in case the invoice is in US Dollars?This will not affect him as he is getting the quantum of US Dollars as per his invoice. However, the importer in France will be benefited, as he will require less amount of FF to pay for the import bill, as FF has increased in value vis-à-vis US Dollar.

What will be the scenario if the forward rate is 1 US $ = F.F. 7.828/7.818?This means that F.F. is becoming cheaper vis-à-vis US $. So, in the case of import in FF, the effect will be the opposite. The US importer will be benefited. The case of the US exporter will be the same as in the previous case. The US exporter will be affected only if the export done by him is in FF. Raising invoice for export from the US in a currency other than US Dollar is permitted by the US Federal Bank.

Thus it is seen that whenever you are exporting in a foreign currency you are benefited in case the foreign currency is becoming stronger and similarly whenever you are importing in a foreign currency you are benefited in case the home currency is becoming stronger.

The quotations in the foreign exchange market depend upon the type of transaction. This aspect is examined in the following paragraphs.

For example a simple remittance in F.F. will get a better quote than a quote for an import bill, as the bank is required to handle the documents in the case of an import bill. Similarly in the case of an export bill, a simple remittance will get better rate in comparison with an export bill. Let us see the following examples.

Spot rate 1 US = F.F. 7.818/7.808Let us assume that this rate is for simple remittance. Then for a bill transaction, the quote will be somewhat on the following lines.

1 US $ = F.F. 7.821/7.805. The analysis for this quote is as under:

For a simple remittance in F.F. into the US, the bank is prepared to give you US $ at the rate of 1 US $ = F.F. 7.818. This is called T.T. Buying quote.

For remittance of an export bill in F.F. into the US, the bank is prepared to give you US $ at the rate of 1 US $ = F.F.7.821, which means that you will get less US $. This is called Bill Buying quote or BC buying quote.

Similarly for a simple remittance in F.F. (outward) from the US, the bank is prepared to sell F.F. at the rate of 1 US $ = F.F. 7.808. This is called T.T. Selling quote.

For an import bill in F.F. the bank is prepared to sell F.F. at the rate of 1 US $ = F.F. 7.805 less F.F. than for a simple remittance. This means that for a given

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Workshop on Banking Symbiosisamount of F.F. you will be required to shell out more US $. This is called Bill Selling quote or BC selling quote.

Note – We will appreciate the above examples provided we keep the following in mind:

The US importer has US $ which he exchanges with the bank for acquiring F.F. to pay for import from France. Similarly in case the US exporter has raised invoice in FF, he acquires F.F. from the importer, at least abroad and does not have any use for the same in the US. Hence he wants to exchange it for the US $ which is the home currency. The examples can be better understood with a fictitious F.F. amount of 10000. (Please do this exercise for absorbing the fundamental difference between a foreign exchange quotation for ordinary remittance and that for a bill transaction)

In India, there is restriction on holding foreign currency assets. Companies and individuals are not permitted to hold foreign currency assets. The banks are permitted, as this is necessary for international trade. Selected Indian companies (depending upon their requirement and nature of business - for example, a software company operating in India and doing software export will be required to hold foreign currency deposit.) Hence RBI gives permission to such companies to have their own NOSTRO accounts abroad. Individuals are not permitted at present. (Do not confuse with non-resident Indians’ deposits, as they are not resident Indians).

As against this, in the US, even the individuals are permitted to hold foreign currency deposits with the permission of the Federal Bank through their individual banks. Hence in the instant case, the exporter earning F.F. may not feel the need to convert his F.F. earning into Indian Rupees, especially if he knows that F.F. is going to appreciate in the near future, thereby enabling him to earn more US $ for the same amount of F.F.

33.SecuritisationThis is the process whereby traditional bank assets, namely, mortgages are sold by the bank to a trust or a corporation, which in turn sells the assets as securities. This is very reliable way of raising resources for the banks and this concept is catching up well internationally.

INTERNATIONAL TRADE GLOSSARY – EXCLUDING TERMS ALREADY EXPLAINED ABOVE

AcceptanceA bill of exchange on the face of which the drawee has written the word “Accepted” over his signature. The date and place payable are usually indicated (Specimen 1)

AcceptorThe person to whom the Bill is addressed and who shows his assent by signing his name across the Bill indicating that he will pay the bill on maturity. (Specimen 2)

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Workshop on Banking SymbiosisAdvance against collectionProvide funds to an exporter by purchasing his collection documents with recourse to him should the collection not get paid

Advising BankThe bank, which advises the beneficiary that another bank, has opened a letter of credit. Has no obligation or responsibility, but will probably authenticate and ensure compliance with local regulations before passing on to the beneficiary.

Air Way Bill (AWB)A receipt for goods sent by air. Also a contract of carriage of goods. It is a part of international trade and the documents submitted to the seller’s bank, after despatch of goods. The goods will be handed to the consignee who is named in the AWB against identification only.

AmendmentThe terms of a letter of credit can be changed by amendment provided all parties agree.

Back to BackA letter of credit (L/C) has been opened by a bank in favour of a trader (frequently a middleman) covering certain goods. On the strength and security of this L/C, another bank opens a separate L/C on behalf of the trader in favour of the supplier of goods. Such an arrangement may be described as a Back to Back Credit.

Bank AcceptanceA Bill of Exchange drawn on and accepted by a bank.

BeneficiaryThe party in whose favour a Letter of Credit is opened – normally the seller.

Bid BondSupports a tender for a contract, guaranteeing compensation should the bidder win the contract but fail to sign it.

Bill of LadingA receipt issued by an ocean carrier for merchandise to be delivered to a person at some distant point. It is also evidence of a contract of carriage. Unlike in the case of AWB the bill of lading can be endorsed in some one else’s favour, unless this is restricted.

CarrierThe transport company (shipping company, airline etc.) carrying the goods from one destination to another destination.

Certificate of originA certificate issued by the proper authorities, e.g., a Chamber of Commerce, which accompanies the documents covering the shipment of goods. The certificate usually specifies the origin of material or labour used in the production of such merchandise.

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Clean Bill of LadingA term defining a bill of lading when the transportation company has not noted any irregularities in packing, general condition etc. of all or any part of the shipment.

Clean CreditA letter of credit, which is available to the beneficiary against presentation of only a bill of exchange duly, accepted by the buyer and/or receipt for goods issued by the buyer. This is rare. It means that the buyer has received the goods and hence no transport document like AWB or Bill of Lading is present.

Collecting BankIn the collection process, the bank in the vicinity of the drawee responsible for making presentation and collection proceeds.

Commercial InvoiceAn invoice of the seller of the goods or services, addressed to the buyer giving a description of the goods, quantity, rate, charges, if any etc.

Confirming BankThe bank, which adds its confirmation to the Irrevocable Letter of Credit of another bank, thereby adding its own guarantee that payment will be made by the L/C issuing bank. Protects against failure of L/C establishing bank to meet payment obligations.

C.I.F.Part of “INCO” terms. “INCO” is an acronym for “International Commercial”. This is one of the terms of supply in international trade. Means Cost, Insurance and Freight charges are included in the commercial invoice.

C. & F.Cost and Freight. Insurance is not included in the value of the invoice. It is the responsibility of the buyer.

C.F.S.Containerised Freight Service – Another INCO Term. This means that till the consignment reaches the specified Containerised Services Depot, all the charges are included in the cost and from the Containerised Services Depot, the charges will accrue and the consignment is the responsibility of the drawees from that point.

Deferred Payment Credit A credit giving the buyer a specified time in which to pay after presentation of documents, but without a bill of exchange. The seller should not be at a disadvantage for discounting his bills. Hence, wherever this is extended, it is backed by a bank guarantee. On the basis of the bank guarantee, bank finance is obtained.

Documentary creditA letter of credit, which is available to the beneficiary against presentation of a draft and certain specified documents.

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Documents against AcceptanceAn indication on the bill of exchange that the documents attached are to be released to the drawees upon acceptance of the bill of exchange.

Documents against paymentAn indication on the bill of exchange that the documents attached are to be released to the drawees upon payment only.

DraweeThe person on whom the bill of exchange is drawn, usually the buyer of goods or services. When he signs on the bill of exchange in acceptance of his liability to the seller of goods or services, he is called an “acceptor”.

DrawerThe person who draws the bill of exchange, usually the supplier of goods or services, thereby giving an order to the drawee to pay the amount of the bill to himself (drawer) or to the directed person on the specified date.

EndorsementA signature on the reverse of a negotiable instrument made primarily for the purpose of transferring the rights of the holder to another. It is a contract between the holder and all parties to the instrument. Each endorser orders the prior parties to fulfil the contract to his endorsee. He also agrees with the endorsee that if they do not, he will.

Expiry DateThe final date upon which drafts and documents under a letter of credit may be presented for negotiation or payment. A latest shipment date may also be specified and a time limit within which to present after shipment (21 days if not specified).

F.A.S. Free Alongside Ship – another INCO Term. The supply price includes all costs till it boards the ship. Even the cost of putting them on board is not included and the buyer is responsible for it.

F.O.B. Free on Board – another INCO Term. The supply price includes all costs including the boarding charges to put the consignment on board. Once the consignment is on board, the charges are to the buyer’s account and it is his responsibility.

Freight paid/collectA bill of lading will state whether freight has been paid or is to be collected. The shipping line has a lien on the goods until freight has been paid.

HolderThe holder who is in possession of a bill, who may either be the payee, an endorser, or the bearer.

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Holder for valueA person who holds a bill for which value has at some time been given though not necessarily by the holder himself.

HypothecationMaking over or assigning to lenders, as security, goods or documents of title thereto, by written agreement, creating a lien on the goods in favour of the lender.

Maturity DateThe date on which an accepted bill of exchange becomes due for payment.

Open AccountAn arrangement whereby a seller ships goods trusting his buyer to pay in due course, without the protection of a bank.

Performance Bond A bond supplied by one party to another, protecting the party against loss in the event of improper performance or completion of the terms of an existing contract.

PresentationA legal term used in connection with negotiable instruments. The act of presentation technically means the actual delivery of a negotiable instrument by a holder in due course to the drawee for acceptance, or the maker for payment.

RebateAn allowance, calculated at a rate of interest agreed for the purpose, made to the acceptor of a bill or to the person for whose account a bill has been accepted, when he puts up the money to meet the bill before its maturity date.

Red Clause Letter of CreditA letter of credit which authorises advances to the beneficiary before shipment and, therefore, before bills of lading can be lodged with the negotiating bank. These advances together with interest are liquidated from the proceeds of negotiation of the bill, which is drawn under the Credit when the Bill of Lading is available.

RediscountWhen the bank which finances a bill on discount basis, sells the bill to a third party, he is said to get the bill rediscounted.

Revolving CreditA letter of credit issued for a specific amount, which renews itself for the same amount over a given period. Usually the unused renewable portion of the credit is cumulative, so long as drafts are drawn before the expiration of the credit.

Sight DraftA bill of exchange payable on presentation to the drawees. This means that there is no credit period involved in the supply of goods or services.

Shipper

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Workshop on Banking SymbiosisThe exporter/seller whose goods are being shipped. Not the shipping company, which is referred to as the carrier.

Standby CreditA letter of credit that is only used by the beneficiary if the opener fails to meet a specified obligation.

StaleA bill of lading is termed stale if there is insufficient time to get it to the consignee before the expected arrival of the vessel.

TenorThe period of time, as stated or indicated on the bill, for which a bill is drawn to run before it matures. For example "At sight”; or “At 90 days after sight”; or “Three months after date”; or “on 30th June, fixed”.

Time DraftA Bill of Exchange, drawn to mature at a certain fixed time after presentation or acceptance. A Bill of Exchange drawn to mature on a fixed date, irrespective of the time of acceptance, for example 90 days after date is often referred to as a “date draft”.

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2.3 International Banking

As mentioned in the introduction, international banking revolves around the following: international trade tourism, remittance of funds from one place to another place, syndication of loans globally for large business houses and multinationals, accessing international markets for equity/borrowing in the form of bonds etc.

for corporate houses/multinationals Foreign exchange management etc.

The above give rise to the following transactions:

INTERNATIONAL TRADE

Letters of Credit, International Guarantees like performance guarantee, advance Money guarantee etc. Deferred Payment Credit backed by bank guarantee Bills for collection Foreign exchange involved in remittance of proceeds from the importing country to the exporting country

TOURISM -

International Travellers’ checks International Money Orders Foreign exchange involved in encashment of travellers’ checks

and International Money Orders/Demand Drafts/Telegraphic Transfer/SWIFT remittance etc.

Credit card business and international bills settlement under credit cards

REMITTANCE OF FUNDS FROM ONE PLACE TO ANOTHER PLACE BESIDES TOURISM/INTERNATIONAL TRADE

Routine transfer from persons employed abroad Donations/charity remittances Remittances for disbursement of loans (inward for the borrowing country) Remittances for repayment of loans (outward for the borrowing country)

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Workshop on Banking Symbiosis Remittance for payment of interest (outward for the borrowing country) Remittance of royalty, dividend (outward for remitting country)

SYNDICATION OF LOANS GLOBALLY FOR CORPORATE HOUSES

This does not involve any funds and it is a non-fund based activity earning non-interest income

ACCESSING INTERNATIONAL MARKET FOR EQUITY/BORROWING IN THE FORM OF ADR/GDR AND EURO BONDS ETC.

This again does not involve any funds and it is a non-fund based activity earning non-interest income

FOREIGN EXCHANGE MANAGEMENT

This is common to all the activities listed above, which involve funds. Such activities are called fund-based activities of the bank, unlike syndication and/or accessing international markets for GDR/ADR, Euro bonds etc., which are non-fund-based activities.

Note: A discussion about international banking is not complete without mention of electronic cash on the Internet or “E-cash”. This could easily become global currency, issued by Governments and private firms alike. The explosive growth of this phenomenon will tremendously influence globally the banking industry and hence everybody in the banking industry is watching this development with interest, awe and fear, all at the same time.

2.4 Profile of a bank

DIFFERENT LAYERS OF BANKING OPERATIONS IN INDIA IN GENERAL

Branch banking – This is the operating unit of a bank - a place wherein all the operations of a branch take place, both retail and wholesale. This is the place for operations and not for bank administration, although branch administration is a

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Workshop on Banking Symbiosispart of branch operations. A branch is responsible to itself and does not control another branch.

Bank administrative units which control branches within its territory/jurisdiction – These are at different levels, the first level being a Regional Office or a Divisional Office or an Area Office, the second level being a Zonal Office and the third and apex level being the Head Office. These administrative units do not carry on any banking operations like branches but monitor and control all the branches within its jurisdiction to ensure that the functioning is smooth and as per the guidelines of the Bank as a whole and the Reserve Bank of India (the country’s Central Banking Authority). Further in respect of decision making, starting from the branch to Head Office, there are different levels with each successive higher level having higher delegated powers than the previous level.

At the same time, we can easily visualise that among the operating units, i.e., branches, all the branches may not be at the same level in terms of delegated powers. The extent of powers enjoyed by a branch will depend upon its size, i.e., mix of deposits and advances at its command etc. Small branches will enjoy less authority; medium sized branches enjoy more authority, while large branches will enjoy maximum authority. The authority relates to the extent of finance that they can give at their level without any reference to the next higher level of authority (Regional Office or Zonal Office) or the highest level of authority (Head Office).

The designation of the controlling offices differs from bank to bank and no uniform practice is seen in India. The level of authority or extent of authority to be wielded by a particular layer is decided by the Board of Directors who meet in the respective Head Offices. The Board of Directors is headed by a Chairman and is assisted, most of the times by an Executive Director. In turn, the Executive Director is assisted by General Managers (some banks have additional posts called Chief General Manager, Deputy Chief General Manager etc.), Deputy General Managers, Assistant General Managers, Zonal Managers, Regional Managers, Branch Managers (at the branch level) etc. This is just to give an overall view of the possible hierarchical structure within a bank in India and not meant for giving the reader the organisation chart of a bank.

Most of the large size banks have an international banking department.

WHAT ARE THE DUTIES OF AN INTERNATIONAL BANKING DEPARTMENT?

1. Exchange operations2. Opening of documentary credits of importation as well as providing notices and

confirmation of export documentary credits.3. Remittance to correspondents of documents for collection and handling of

collection received from them.4. Issuing bond guarantees on foreign countries or issuing bonds or guaranties for

the account of foreign banks or firms in favour of local firms.5. Handling foreign currency assets of the bank.

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Workshop on Banking Symbiosis6. Granting lines of credit to banks or firms abroad and securing and handling lines

of credit granted to the bank by its correspondents.7. Maintaining public relation to assure permanent contact, directly or indirectly,

with customers within the country or abroad.8. Maintaining close supervision of relations with correspondent banks world-wide,

which, aside from credit and service aspects, also means permanent control over reciprocity received or given.

9. Compiling statistical data to evaluate the evolution of bank operations in the international sector.

TYPICAL DUTIES OF THE CHIEF DEALER OF FOREIGN EXCHANGE IN AN INTERNATIONAL BANKING DEPARTMENT

1. Execute and supervise the bank’s purchases and sales of foreign currencies.2. Provide all agencies and branches with duly buying and selling rates of different

currencies with which the bank normally deals.3. Provide current quotes for those same currencies for all operations about which

the dealer or desk has been consulted.4. Modify rates previously transmitted as well as suspend any authorisation given

to branches and agencies to operate freely up to certain limited amounts.5. Maintain contact with principal bank customers about foreign exchange matters.6. Review operations daily.7. Watch for irregularities.8. Monitor the foreign exchange position.9. Supervise the foreign currency cash assets that the bank holds in its

correspondent banks abroad.10.Carry out transfers or coverage transactions so that accounts abroad have the

least number of overdrafts thereby avoiding unnecessary interest charges.

2.5 Banking Transactions/Flow chart of activity in a bank

Having examined the various aspects of banking organisation, let us now examine the operations at the unit level, i.e., at the branch level.

DAILY ACTIVITIES IN A BRANCH

At start of Day

Prepare office for routine work

Close Previous day’s books of accounts

Working cash to be retrieved from Vault andDistributed to tellers

Process remittances from other banks

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Workshop on Banking Symbiosis Get the applicable rates for the day –

Exchange rates, interest rates, changes in fees, serviceCharges etc.

Initiate the computer system

During the Day

Handle mail from customers and process them

Process customer transactions at the teller counter

Execute standing instructions for customers

Prepare statements of accounts for customers

Perform tasks relating to Term Deposits/Loans

Process cheques for inward and outward clearing(Inward – cheques issued by various customers of the bankon the branch and outward- cheques deposited by variousCustomers of the bank drawn on other banks within the same banking centre)

DAILY ACTIVITIES IN A BRANCH (Contd.)

End of Day

Balance cash, instruments

Process vouchers to be sent for remittance

Prepare Day Books, Journals, Trial Balance

Prepare General Ledger for the Day

ROUTINE ACTIVITIES ( NOT ON DAILY BASIS)

PERIODICAL ACTIVITIES

Accrue Interest

Prepare Statutory Reports – Friday Reports for Controlling Authorities, i.e., the Central Banking Authority

Send pieces of advice to customers

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Prepare statistical reports for Internal MIS

OPENING OF ACCOUNTS

Accept Detailed Information about the customer

- Demographic profile

- Income, Age, Family size

- Employment Details

- Credit Cards, Insurance Details

Perform analysis required for the account typee.g., credit rating score of the customer to be eligible for a loan

Accept and scrutinise details mandatorily required for the Account type – e.g., loan accounting requiring collateral security.

Open the account – assign account no. Customer identity etc.

Issue certificates / agreements –e.g., term loan agreement, term deposit certificates etc.

ACCOUNT / ACCOUNT FACILITIES MAINTENANCE

Standing Instructions Details

Stop Cheque Details

Linking Accounts

Change Account Status

Change in Account Address

Group Interest Details

CUSTOMER DEPOSITS

Cash Deposits – Accept cash and credit the account

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Cheque deposits – Accept cheques and forward them for clearing

FX Purchased from the customer – Accept Foreign CurrencyCash and credit the account

Travellers’ cheques purchased from the customers –Accept unutilised TCs and credit the account

Draft Purchases –Accept unencashed drafts and credit the account

TYPICAL DEPOSIT TRANSACTIONS AT THE TELLER MACHINES

CHEQUE DEPOSIT

Accept cheques and note down the details

Calculate the date of realisation of the cheques and informThe customer suitably

Increase uncleared balance in the customer’s account

If transfer from some other account within the sameBranch initiate transfer processing like getting the Cheque debited to the issuer’s account with you,Recording the transaction in the books as a transferTransaction and then crediting the beneficiary’s accountWith you.

If clearing operation, initiate outward clearing by writingThe details of the cheques in the clearing register (outward)

CUSTOMER WITHDRAWALS

Cash withdrawals (withdrawal slips / cheques)Check account balance and handover cash

Cheque encashingValidate cheque and hand over cash

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Workshop on Banking Symbiosis Travellers cheque sale

Issue travellers cheques (own and other banks)

Draft sale – Issue Drafts (Own)

FX Sale – Hand over Foreign Currency to Customer

TYPICAL WITHDRAWAL TRANSACTIONS AT COUNTER

Cash Withdrawals

Verify account status

Verify sufficiency of Account Balances

Apply overdraft limits, Credit line limits etc.

Cheque Withdrawals

Verify signature, date, cheque no. etc.

Verify stop on cheques

Verify account status and operating instructions

FOREIGN EXCHANGE OPERATIONS

Exchange rates given by the Treasury at the beginningof the day

Rates may be different as TT/Bill etc.

Rates need fine tuning for a transaction/customer

Variance limits assigned for fine tuning depending uponUtility of the customer

Inform Treasury at Head Office level about High ValueTransactions to facilitate Exposure Management

Commission and charges usually charged in local Currency

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FOREIGN EXCHANGE TRANSACTION (F.X. = Acronym for Foreign Exchange)

FX Sale amount = $ 1000Commission = 1%Charges = Rs.100/-Exchange rate for conversion for customer to purchase 1 US $ =

Rs.43/-Indian Rupee equivalent of $ 1000 = Rs.43, 000/-Commission at 1% = Rs.430/-Charges = Rs.100/-Total amount to be debited to the customer’s account = Rs.Rs.43530/-

BILL PAYMENTS

Facilitates convenient payment to the account holder

Reduces processing volume and time for the beneficiary

Pre-authorised debits to the account

Examples of bill payments – Telephone bills, Electricity billsInsurance PremiumSchool Fees, Charity Payments,Club Subscriptions etc.

Account holder gives account details to the beneficiary

Account holder gives authorisation details to the bank

Beneficiary or his bank collates the amount due from the buyerAnd informs the buyer’s bank

Buyer’s bank debits all the charges to its customer’s account and credits the beneficiary’s account, provided he has account with the same bank or his bank through clearing operation etc.

FEATURES OF DIFFERENT INSTRUMENTS

CHEQUES

Processed through Transfer/Clearing

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Workshop on Banking Symbiosis Instant credit not given usually for clearing cheques

DRAFTS

Prepaid at the time of issue

Place of encashing the draft is known at the time of issue

Issued at one place and drawn on another place – mostly anotherBranch of the same bank – exception drafts drawn on correspondent Arrangements

Instant credit is released by the drawee branch, provided the beneficiaryIs having account with it or otherwise, through clearing operation.

PAY ORDERS OR BANKERS’ CHEQUES

For local use as opposed to draft which is for outstation use

Issued by the Bank (example Interest Payment by Cheque)

Issued at the request of a customer

Pay order should be presented to the same branch which is issuing the instrument. Means this can be used only locally by a customer who Does not have account with that branch or bank.

TRAVELLERS’ CHEQUES

Issued by a branch for domestic use or international use providedThe branch is authorised to deal in foreign exchange

Issued at the request of a customer

Place of encashing the instrument is not known

Can be encashed at Branch / Departmental stores etc.

Comes back to the Branch that issued it.

CHEQUES AND CLEARING OPERATIONS

PROCESSING OF CHEQUES

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Clearing - Outward

Inward

Collection - Outstation

Foreign

PARTIES TO A CHEQUE

Drawer – Person drawing or issuing the cheque

Drawee – The bank which is liable to pay the cheque

Payee – The beneficiary of the cheque, either whose name is Written on the cheque or who is the endorsee of the

Cheque

Collecting bank – The bank which receives payment on behalf

of its customer

Clearing Section – Designated Section which deals with Clearing operations

Clearing House – Physical Location where Cheques and other Credit Instruments are exchanged among the Banks. Usually it is the Central Banking Organisation which is responsible for running The Clearing House. Some times, its duly Authorised Representative also runs the Clearing House

WHEN A BANK IS OBLIGED TO PAY THE CHEQUE DRAWN ON IT?

The cheque is complete in all regards, i.e., with respect to details. The customer has sufficient funds in his account on which the cheque is drawn. The cheque is correctly presented by the collecting bank, i.e., the bank of the

Beneficiary of the cheque.

CHEQUE SCRUTINY

Signature – Genuineness and proper signing authority Alterations should be duly authenticated by the drawer/drawers The instrument should not be outdated (most of the countries the validity 6

months), undated or post-dated. The amount in words and figures should be the same and there should be no

discrepancy between them.

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Workshop on Banking Symbiosis There should be no restriction on the transferability of the instrument as

specified by the drawer and if there is any restriction, the same should be adhered to.

The cheque presented for cash payment across the counter should not be crossed, as crossing (general) means that encashment is debarred.

REFUSAL OF PAYMENT

If the signature differs Insufficient funds Material Alterations not properly authenticated Post-dated or out-dated Payment stopped Incompleteness Beneficiary’s bank has not properly presented or acted in accordance with the

intentions of the drawer – example, not transferable, the presenting bank is collecting on behalf of its customer who is not mentioned in the cheque as the beneficiary but who has come into possession of the cheque because of transfer by endorsement.

Drawer deceased Drawer Insolvent When refusing payment, the paying bank should give correct reason for such

refusal.

STEPS INVOLVED IN COLLECTION OF FOREIGN CHEQUES

Cheques are sent to the Correspondent Bank Correspondent bank presents in clearing or if drawn on itself, credits the

NOSTRO Account of the collecting bank Advises the collecting bank upon realisation of the cheque

CASH TRANSACTION – Refer to Specimen No. 2

OUTWARD CLEARING – Refer to Specimen No. 3

INWARD CLEARING – Refer to Specimen No. 4

TRANSFER TRANSACTION – Refer to Specimen No. 5

OUTSTATION CHEQUES - Refer to Specimen No. 6

FLOW CHART OF ACTIVITIES IN A BANK – Refer to Specimen No. 7

FRONT OFFICE OPERATIONS IN A BRANCH – Refer to Specimen No. 8

BACK OFFICE OPERATIONS IN A BRANCH – Refer to Specimen No. 9

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NOTE ON CALCULATION OF INTEREST ON LOANS AND DEPOSITS – Refer to Specimen No. 10

2.6 BANK ACCOUNTING

TRANSACTIONS ENTERING THE ACCOUNTING SYSTEM OF A BANK

1. Cash Operations (Tellers)2. Cheque deposits and Encashment3. ATM Transactions – Deposits and Withdrawal4. Funds Transfer5. FX Sale and Purchase6. Instruments Sale and Encashment – Drafts, TCs etc.7. Outward Clearing Instruments Deposited by bank’s customers8. Inward Clearing Instruments Received from Clearing House9. Regular Bank Administrative Operations from Administrative offices, purchase of

stationary, payment of salaries to staff etc.

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Workshop on Banking Symbiosis10.Computation and Accounting for Interest Receivable and Payable which is a

periodic activity.

FEATURES IN BANK ACCOUNTING PRACTICES AND SYSTEM

1. Every day the transactions books of the various departments have to tally with the control books called Cash Transactions Book, Clearing Transactions Book and Transfer Transactions Book.

2. Double Entry Booking System – means that every accounting transaction affects two account heads in an equal but opposite manner – means that in every transaction, one accounting head gets credited while the other gets debited with the same amount. For example for issuing draft by Pune Branch of State Bank of India, customer’s account has been debited with the amount of draft purchased by the customer and inter-branch account of the branch on whom the draft is drawn is credited.

3. Periodic checks and balances with balancing of books of customers and bank’s own administration accounts with the control book of the bank – general ledger into which on a daily basis the posting is done from the Day Book.

4. General Ledger and Subsidiary Ledger System5. Day Book and Daily Trial Balance6. Periodic application of interest on loan / cash credit / overdraft accounts and

periodic accrual of interest on savings accounts / fixed deposits / recurring deposit accounts etc.

7. Accounting for a number of contingent liabilities like letters of credit opened on behalf of the customer in the form of contingent liabilities in Final Accounts

ACCOUNTING EFFECTS OF TRANSACTIONS

Examples

S. No. Transaction Voucher Accounting Entry

1 Cash Deposit Cash Pay in slip Dr. CashCr. Customer’s Account

2 Cheque Deposit Cheque Pay in slip Dr. Clearing BranchCr. Customer’s AccountUpon realisation

3 Cash Withdrawal Withdrawal slip/ Dr. Customer’s Accountcheque Cr. Cash

4 DD/TT/MT Sale DD/TT/MT slip Dr. Cash by cash Cr. DD/MT/TT paying

branch of the same bankCr. CommissionCr. Postage (if any)

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Workshop on Banking Symbiosis5 DD/TT/MT sale DD/TT/MT slip Dr. Customer’s Account

by Cheque & cheque Cr. DD/MT/TT paying branch of the same bank

Cr. Commission Cr. Postage (if any)

6 TC sale by cash TC slip Dr. CashCr. TC AccountCr. Commission

7 TC sale by cheque TC slip Dr. Customer’s Account& Cheque Cr. TC Account

Cr. Commission

8 Interest on Deposits Vouchers Dr. Interest Expense(Dr./Cr. slips) Cr. Customer Account

OR Cr. Interest Payable

9 Interest on Advances Vouchers Dr. Customer’s Account(Dr./Cr. slips) OR Dr. Interest Receivable

Cr. Interest Income

10 General Expense Voucher Dr. Expense(Dr. slip) Cr. Cash

BOOKS OF ACCOUNTS AND TRANSACTIONS FLOW IN DAILY OPERATIONS

Customer Ledger

Cash Receipt Scroll

Cash Payment Scroll

Outward Clearing Register

Inward Clearing Register

Subsidiary Ledgers for General Ledger

Day Book

General Ledger

Other Memorandum Books and Registerse.g. Drafts Issue Register, Transfer scroll,TC Issue Register etc.

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Workshop on Banking SymbiosisGENERAL LEDGER

Contains all the account heads of Income,Expenditure, Assets, Liabilities, Head Office Account

For inter-branch transactions, Correspondent bank Accounts etc.

Posting from the Day Book

An extract of all the general ledger accounts givesTrial Balance at the end of the day

MAJOR ACCOUNT HEADS IN GENERAL LEDGER

Cash Account

Accounts with other banks

Accounts with other branches – Head Office/Inter-branch transactions

Various types of deposit accounts of customers Various types of loans and advances of customers

Share capital Account

All types of income accounts

All types of expense accounts

All types of Fixed Assets of the branch

END OF THE PERIOD ACCOUNTING ACTIVITIES

Interest Accrual and Capitalisation

Depreciation of Assets

Provision for Unpaid Expenses

Creation of Reserves

Revaluation of FCY Accounts

Provisional Closing and Transfer of Profit/Loss to HO

Reopening of Books and Back Dated Entries upon Finalisation of accounts for the branch

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Ascertainment of Contingent Liabilities

PERIODIC RECONCILIATION ACTIVITIES

Suspense Accounts

Inter-Branch and HO Accounts

Inter Bank Accounts

SUSPENSE ACCOUNT

Why Suspense Account?

Need for Control of Suspense Accounts and the RisksAssociated with Suspense Account

Reconciliation Process

- Matching Debits and Credits- Based on Doc. No. Value Date & Amount- Unreconciled entries to Account for balance

In the Account

INTER BRANCH ACCOUNT

For Remittances

For Clearing (Local Branches to Main BranchAnd Main Branch to Local Branches)

Originating and Responding Entries

Bills Transactions (outward and inward)

Instruments deposited by customers sent to Upcountry branches for collection (outward)And received from outstation branches (inward)

FCY Transactions Etc.

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Workshop on Banking SymbiosisINTER BANK ACCOUNTS

Correspondent Banks With Whom NOSTRO Accounts Are Maintained

Correspondent Banking ArrangementsWithin A Country on A Reciprocal Basis

Other Banks With Whom Current Accounts Are Maintained For Clearing Operations Etc.

Accounts With Federal OR Central Banking Authority OR Its Duly Authorised Representative Bank/s

NOSTRO Statements and Image Accounts

Reconciliation Based On- Doc. No. Value Date and Amount- DRS. Matched with Corresponding CRS.- Inter Bank Dues to be Reconciled periodically

PRECAUTION WHILE REMITTING FUNDS FROM ONE PLACE TO ANOTHER PLACE

This depends upon the mode of remittance:

1. Demand Draft - a branch of a bank usually draws it on another branch of the same bank. This is true of operations within the same country. However, it is quite common that internationally, drafts are drawn on correspondent bank in case the drawing bank does not have its own branch in that place. This mode of remittance has to ensure that the branch on which the draft is drawn is aware of the transaction by sending a suitable advice to the drawee branch immediately after issuing the draft. Neither the remitter nor the beneficiary needs to have a bank account with the bank issuing the draft. Authorised officials of the bank whose signatures are available with the paying branch alone should sign the demand drafts.

2. Mail Transfer – The customer has to have an account with the remitting branch

and the beneficiary has to have an account with another branch of the same bank, unlike in the case of demand drafts. The transfer is authorised by authorised officials of the bank whose signatures are on record with the paying branch.

3. Transfer by Wire or Telegraphic Transfer – Since this is an open mode of transfer, there is a need for coding and decoding. The coding involves various parameters as under:

The code of the remitting branch The code of the responding branch The date of the transaction The day of the transaction The month of the transaction The amount involved etc.

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Workshop on Banking SymbiosisUpon receipt of the telegraphic transfer communication, the responding branch will decode the entire message and will keep it in abeyance in case there is any discrepancy in the message. It will seek clarification from the remitting branch and only upon being thoroughly satisfied the message is responded to.

4. Electronic Mail Transfer – In case online connection is available within a bank among the branches through networking, as is the case with most of the foreign banks and recent private sector banks in India, remittance is done through this networking and the beneficiary's account gets credited on the same day anywhere in the country. This is the latest mode of remittance and has revolutionised remittances and customer service across the globe. Most of the US Banks have networking through satellite link and use exhaustively this mode for remittance from one place to another place not only within the country but also globally, at least in selected centres.

5. SWIFT Transfer – Society for World Wide Inter-Bank Financial Tele-communications. This was the most common mode of transfer before EMT came into existence. This used to ensure that communication for remittance is received within 48 hours of issue from one place. The message is as per pre-set format and is the most economical mode of communication. The receiving branch verifies the authenticity of the message before responding to it or acting on it.

SWIFT MESSAGE – Refer to Specimen No. 12

2.7 ADMINISTRATIVE FUNCTIONS IN A BANK

Different administrative units in a Bank

There is distinction between banking operations at a branch level and at administrative levels. The names of the administrative offices differ from one banking institution to another. Please refer to Section 2.4 – page no. 37 also in this behalf. To illustrate the same, let us study the following structure.

Tier No. 1 – Branches of various business mix and sizes of business, small, medium, large and very large.

Tier No. 2 – Regional Offices or Area Offices

Tier No. 3 – Zonal Offices or Divisional Offices

Tier No. 4 – Head Office

Tier No. 1 functions already seen.

Tier Nos. 2, 3 and 4 constitute the administrative units of the bank. It does not mean that at the branch level there is no administration. What the branch does is called “branch administration” as opposed to the function of these 3 tiers, known as “bank administration”.

Typical functions of different administrative units of a bank:

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Workshop on Banking Symbiosis1. To ensure conformity with the rules and regulations of Head Office by the

branches and other smaller administrative units under its control.2. To ensure conformity with the Central Banking Rules and Regulations as

applicable from time to time by all the branches and other smaller administrative units under control. (In India, the central banking agency is the Reserve Bank of India.

3. To grant loans and other credit facilities to branch borrowers whose requirements fall outside the delegated authority of the proposal referring branches/smaller administrative units, but within its own delegated authority.

4. To co-ordinate the activities of all the branches/smaller administrative units within its jurisdiction.

5. To administer the branches/smaller administrative units under its control in matters relating to leave of the managers of the branches, branch premises, other bank assets at the branch level, transfer of bank officers within the area of jurisdiction as per its delegated authority.

6. To recommend any proposal to the higher administrative unit of the bank for sanction of loans and other credit facilities whenever the requirements fall beyond the purview of its delegated authority.

7. To ensure periodic audit of the branches and other smaller administrative units of the bank by duly appointed teams of auditors, who are officers from the bank itself.

8. To maintain liaison with other banks in the same geographical location at a corresponding level – Area Office of one bank with similar administrative units of other banks operating in the same area etc.

9. At the Head Office level –

To maintain liaison with top administrative units of other banks. To maintain liaison with the Central Banking Authority To evolve policy every year relating to the bank in the areas of business development, branch expansion, opening of branches abroad etc. To maintain vigilance cell for detecting frauds within the bank, dealing with

errant bank officials, conducting personnel enquiries against bank employees etc.

To look after international wing of the bank, like opening of branches abroad, types of business to be undertaken there, where to open bank accounts, which banks abroad should be correspondent banks of the bank etc.

To hold negotiations with other banking institutions (globally) for establishing Lines of credit for utilisation within the country. To evolve policy and administer the same relating to personnel within the bank,

like promotion, transfer, recruitment, service rules and regulations, dismissals, superannuation benefits etc.

To decide about the delegated authority at various levels of the banks, like branches, administrative offices etc.

To co-ordinate in preparation of final accounts of the bank on an annual basis. To facilitate audit of the bank by the Central Banking Authority. To ensure co-operation with all Govt. Agencies within the country.

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Workshop on Banking Symbiosis To evolve on an on-going basis, suitable systems for smooth bank

administration. To do investment banking by investing funds set aside by way of CRR, SLR etc.

for the bank as a whole in suitable securities. To take decisions relating to raising resources by way of equity, preference

share capital, bonds (domestic as well as global), debentures (domestic as well as global), loans (domestic as well as global) etc.

To take decisions relating to lending resources to other financial institutions (domestic mostly).

2.8 Banking Business vs. Other Business

To conclude this course material, it is necessary for us to understand how banking business is different from other business. The following points indicate broadly the areas of difference between a banking business and other types of business, namely, manufacturing, services, trading etc.

1. Bank deals in money/finance unlike others and hence is required to evolve all checks and balances to ensure that the trust and confidence of the depositors and other customers is kept up. For this, suitable control measures like dual control (control in the same banking unit at two different levels with two different types of personnel) need to be evolved to prevent frauds in the bank.

2. Banking operations need to be automated much more than other business due to the need for control and the routine/repetitive nature of business. This will not only ensure better operating efficiency but also compliance with the control system.

3. In other business, profit and loss accounts are prepared may be once in a month, whereas a bank prepares the same every day. At the end of each day, the position relating to deposits, advances, profit or loss as the case may be will be known to the banking business unit, namely the branch.

4. In other business, the entire resources can be used excepting for a small portion kept in the form of cash, while in banking business, a substantial portion of resources gets locked up in investment as required by CRR/SLR.

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Workshop on Banking Symbiosis5. In other business, cash flow statement is prepared usually for a period of a

month, whereas in the banking business, every day it is required if not in great details, at least on a summary basis.

6. The Regulatory Authorities like the Central Banking Authority control a bank, whereas other business is not directly controlled by any statutory authority.

7. Bank’s contribution to growth of an economy is manifold as compared to the contribution to an economy even by the largest corporate conglomerate.

*** End of PART I of course material ***

Part II - Capital Markets

3.1 Terms associated with shares and securities

Primary market – This does not represent any market place. This is the platform on which the limited companies, public sector undertakings, corporations, financial institutions, banks etc. who require equity/preference share capital funds as well as debentures/bonds, raise these resources directly from the investors by issuing instruments of claim on themselves like share certificate, debenture certificate, bond etc. All public issues of share capital, debentures, bonds etc. are regulated by the Securities Exchange Board of India (S.E.B.I.).

Secondary market – This represents a market place in the form of stock exchanges controlled by the Securities Exchange Board of India who is the monitoring authority for monitoring the Securities Contracts Regulations Act and Rules. In this market, shares, bonds, debentures etc. which have been acquired in the primary market are exchanged among the investors for financial consideration. The corporates or companies, which have raised resources in the primary market are not connected with the secondary market and in no way are benefited from the transactions in the secondary market. It is not necessary that in the secondary market all the transactions are necessarily routed through stock exchanges only. Outside stock exchanges also, transactions take place. In case of transactions through stock exchanges, they are put through “brokers” who take their broking commission from the buyers/sellers. Outside stock exchanges, brokers may or not be involved.

Note- Both primary market and secondary market form an integral part of what is known as “the Capital Market”.

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Workshop on Banking SymbiosisLearning points –

Primary market is not exactly a market place, although it facilitates raising of resources by the users of these resources from the saving units in the economy;

While primary market taps the resources from the saving units, the secondary market enables an investor to dispose of his investment to another investor for monetary considerations;

The secondary market operations may increase the wealth of the shareholders but do not bring in any additional resources to the security issuing company.

Both primary markets, especially all public issues of debt and share capital and secondary markets, especially stock exchanges and brokers come under the monitoring and regulation of SEBI

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Workshop on Banking SymbiosisEquity share capital – Forms the major/entire portion of the share capital with a small component in the form of preference share capital. Any limited company should have this share capital, whereas preference share capital may not be there in all the companies. There is neither a commitment of dividend in the year of loss nor any ceiling on dividend rate in a year of outstanding profits. Entitled to voting rights on all issues relating to the business of the company. Gets dividend only after preference share capital and gets paid last in case of liquidation of the company after preference share capital. The company cannot pay equity share capital back to its owner, during the course of the existence of the limited company. The only way to dispose of equity share capital is to sell it off to somebody for monetary consideration. Any public issue of equity share capital requires approval of SEBI.

One of the major differences between the equity share capital and preference share capital is that equity share capital is entitled to “bonus shares” as well as participates in “rights issue”. The equity share capital owners enjoy absolute voting rights on all the matters concerning the company.

Preference share capital – Forms a small portion of share capital. Need not be in all the limited companies. Preferred for payment of dividend over equity shares but at an agreed rate. Paid back even during the course of business in case the preference shares are of redeemable variety (redemption – payment back to the investor). Gets preference at the time of liquidation of the company over equity shares. Can be of different varieties, like redeemable (payable back), convertible (convertible into equity shares after a specified period), cumulative (where dividend gets cumulated), non-cumulative (where dividend, if skipped in a year, is lost) etc. It should not be assumed that even in a year of loss, dividend is compulsorily paid on preference shares.

However, on resumption of dividend, the arrears of dividend on preference shares are cleared first before resuming dividend on equity shares. In the case of cumulative variety, dividend gets accumulated even for the loss years once dividend is resumed. The investors in preference shares are usually the promoters, financial institutions, banks, corporates, mutual funds etc. who park a part of their funds in this instrument for the sake of preference of dividend on this instrument over equity shares. Any public issue of preference share capital requires the approval of SEBI. The preference share capital owners do not have voting rights on the matters concerning the company, unlike the equity share capital owners.

Learning points:

While equity share capital forms the bulk of the share capital, preference share capital forms only a small percentage of share capital;

Equity capital owners are considered to be the true owners of the company and enjoy absolute voting rights on all issues concerning the company, while the preference share capital enjoy preference on dividend at the committed rate but do not enjoy any voting rights on any issue concerning the company, excepting where their dividend is in arrears.

Equity share capital and preference share capital constitute the share capital in a limited company.

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Workshop on Banking SymbiosisDebentures: Debentures are instruments issued by financial institutions, non-banking financial companies, manufacturing companies etc. These are usually repaid over a period of time or at one time after a specific period (bullet repayment or “single shot” repayment). The debentures are backed up by “security” in the form of “fixed assets” of the company, especially in the case of non-banking financial companies and manufacturing companies. In the case of financial institutions, they are usually “unsecured”, i.e., without the back up of any security of asset of the issuing company. Interest gets paid as per the terms of the contract, i.e., monthly, quarterly, half yearly or gets accumulated throughout the period of maturity and gets paid on maturity along with the principal amount. Any public issue of debentures requires the approval of Securities Exchange Board of India (SEBI).

Bonds: Till recently, only financial institutions were issuing bonds for raising resources. Of late, however, limited companies have started issuing bonds for this purpose. Example, Reliance’s 100 year and 30 year bonds, TELCO’s 25 year bond etc. These instruments are by and large “discounted” instruments. This means that right now, you invest “discounted” amount in the bond and get after a fixed period “maturity value”, which is also known as “Face value”. The discounted value is arrived at taking into consideration the following:

The coupon rate, which is the interest rate on the instrument

The period of the bond

The periodicity or frequency of compounding of interest, if it is more frequent than once a year, like, half yearly, quarterly or monthly.

Deep discounted bonds refer to the long period of investment and subsequently the long period over which the face value is discounted. This instrument is usually for “infrastructure” projects, which have long gestation period and low returns in the initial period. Any public issue of “bond” requires the approval of SEBI.

Learning points:

Bonds and debentures form a part of the debt capital of a limited company. While bond is mostly a discounted instrument with a nominal value payable after a specified period, debenture could be convertible, redeemable etc.

Both attract interest unlike the share capital Public issue of bond/debenture require SEBI approval Deep discounted bonds are discounted over a long period of time and hence

suitable for “infrastructure” projects, which have long gestation period.

Yield – Yield is the return that a shareholder, a bondholder or a debenture holder has earned on his investment, be it originally purchased from the issuing company or acquired from the market.

Yield to maturity – (I) The return obtained on holding a bond to maturity. The yield-to-maturity assumes that any coupon payments received before redemption can be reinvested at this yield. This implies a flat yield curve and is hence not a realistic assumption. (II) The discount rate that equates the P.V. of the cash flows to its market value.

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Redemption – Repayment of a bond or debenture on maturity. This is as per the date mentioned on the bond/debenture certificate. This could be at a premium or at par. If at premium, the investor gets more money than the face value and if at par, the investor gets the same money as the face value.

Mutual Funds – An investment organisation, which invests in shares, debentures, bonds, securities of public/private sector undertakings, Government bonds etc. for getting dividends/interest from these investments and passing on to the investors from whom they have raised resources for running the mutual funds. The unit of investment is called “units”. The periodic return is called “dividend”. Income of mutual funds in India is exempted from income tax. Examples - Unit Trust of India, Morgan Stanley Funds, Kothari Mutual Funds etc. This is called “Portfolio Management”. The mutual funds invest in various securities instead of direct investment by the investors themselves. This is the best example of “Portfolio Management”.

Money Markets – Short-term markets up to a period of 12 months. The players and the money market instruments are listed below:

Borrower Instrument/Markets Purpose

Government of India Treasury bills of To meet the fiscal deficit14days, 91 days estimated as per the annual182 and 364 days budget.

Commercial banks Call money markets To meet the shortfall in the

Statutory Liquidity Ratio/Cash Ratio requirements as per R.B.I. directives.

Limited companies Commercial paper Working capital – day to day Bills Discounted business requirement.Fixed depositsWithin 12 monthsInter-corporateDeposit

Learning points:

Budgetary deficit to an extent is financed by “Government Treasury Bills” which constitute claims on the Government of India through R.B.I.

Call money market is exclusively for banks and financial institutions and not available to corporates.

At par – A price equal to the face value of a security, which means it is neither at a premium nor at a discount.

At premium – A price which is more than the face value of the security.

At discount – A price, which is less than the face value of the security.

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Workshop on Banking SymbiosisFace value or nominal value: This is the amount mentioned in the share certificate by a company and represents the consideration paid by the original purchaser of the shares and not the subsequent purchasers in the secondary market. Usually face values for equity share capital in India are Rs.10/- or Rs.100/-, while in the case of preference shares or debentures, it is a minimum of Rs.100/-. Debentures could be in multiples of Rs.1000/- also. Bonds have usually maturity value and the minimum amount mostly is Rs.10000/-.

Book value: This is applicable only in the case of equity shareholders. The others are paid interest or fixed dividend as the case may be. They do not have any share in the profits retained in the form of “reserves”, to which only the equity shareholders are entitled, being the owners of the company. Suppose a company has raised share capital to the extent of Rs.500 lacs with face value of Rs.100/- per share. They will have issued 5lac shares. Suppose after 2 years, the net worth (Capital and reserves and surplus) increases to Rs.1000 lacs. This means that the book value of the share has doubled, i.e., from Rs.100/- to Rs.200/- per share.

In case there is preference share capital also in a company, then the book value of the share is calculated as under:

Net worth of the company (-) Preference share capitalNumber of equity shares

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Workshop on Banking SymbiosisLearning points: Companies can raise share capital at a premium also, i.e., more than the face

value of the shares. This excess money should be credited to a separate account called “share premium account” under Capital and Reserves.

Appreciation in book value is direct indicator about profits retained in business. Preference share capital is not a part of the book value of equity shares.

Bonus Issue: Suppose the equity share capital of a limited company is Rs.100 lacs and the net worth is Rs.500 lacs. Let us assume that there is no preference share capital. Hence the entire Rs.500 lacs belong to the equity shareholders. As seen in the earlier paragraph, the book value of the share is Rs.500/-, in case the face value is Rs.100/- for each share. As the book value is due to profit retention in business, as a matter of policy and to reward equity investors, management declares bonus shares out of the reserves. This means that equity investors do not have to invest any money to be able to get bonus shares. Let us assume that in this case, for every 1 equity share, 2 bonus shares are issued. This means that after the bonus issue, the net worth would be as under:

Share capital – Rs.300 lacs (Rs.100 lacs original paid-up capital + 200 lacs reserves capitalised) andReserves – Rs.200 lacsNet worth – Rs.500 lacs

Thus, we see that bonus issue does not increase the net worth of the company, as no fresh funds are introduced into the system. However, the equity share holder, who would have received till now dividend on say 100 shares, after the bonus issue would receive dividend on 300 shares. Even if the dividend rate comes down a bit, the dividend income increases tremendously. As regards the market price, let us assume in this case, before the “bonus issue”, it was Rs.300/-. The number of shares has tripled. However, by and large, in the case of strong companies, the market value would not be one third of the original price. It would be around 40% of the original price. This is the advantage of “bonus issue” to an equity investor.

CB – Cum-Bonus – The buyers of such shares are entitled to bonus shares in view of registration of shares in their names before the cut-off date announced by the company for issue of bonus shares. Usually, if the announcement has already been made of a bonus issue, the seller of the share is compensated for this also.

X-Bonus – The transaction is carried out after the bonus issue at the new market price after taking into consideration the increase in shares due to bonus issue.

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Rights Issue: In this case also, let us assume that the original equity share capital is Rs.100 lacs and the management wants to raise another Rs.200 lacs by way of equity share capital through “Rights Issue” and not “Public Issue”. Then all the equity investors are offered the “Rights” at the rate of 2 Rights for 1. The issue could be at “premium” or at “par” depending upon the confidence of the management to raise the resources from the existing shareholders. If the company is doing well, the chances are bright for it to make a successful issue even with “premium”.

After the “Rights”, the net worth of the company would in this case be Rs.300 lacs, in case the issue is at “par” and more in case the issue is at a “premium”. The company has to show the “premium” so collected separately under the head “share premium reserve or account”. Here also, the post-rights issue market price would be slightly higher than the pre-rights issue market price, with notable exceptions.

CR – Cum Rights Issue – The buyer of the share is entitled to “Rights Issue” as he has registered his purchase before the cut-off date announced by the company, which is issuing the rights shares. The usual practice is that the price is slightly higher in case the company has already made the announcement.

X-Rights – Transaction after the rights issue is over, i.e., at the new market price, after taking into consideration the increase in the number of shares etc.

Learning points:

Bonus shares are capitalisation of reserves without any fresh funds coming into the system;

Rights issue is further share capital from the existing equity share owners at a price, which could be at a premium.

The market takes into consideration the additional number of shares available ex-Rights and ex-Bonus and accordingly the price is adjusted.

Market value: This is independent of the face value and the book value. Ideally speaking, this should be higher than the book value of the share. At present, though in India, we have a number of scrips, which are selling less than even the face value of the shares, leave alone the book value.

Dividend: This is a share in the profit after tax of the company, which a limited company distributes among its equity shareholders. The balance is retained in business in the form of “Reserves” and is also called “Retained Earnings” or “Profit Retained in business”. The dividend declared is always a % on the face value of the share and does not have any co-relation with the market value of the share. As per the provisions of The Companies Act, a limited company, unlike a partnership firm, cannot distribute the entire profits after tax to the shareholders. Depending upon the percentage of dividend declared on the equity share capital, they are supposed to transfer a specified percentage of the profits after tax to “General Reserves”. Such dividend on the equity share capital is declared after paying dividend on the “preference share capital”, if any.

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Workshop on Banking SymbiosisCD or Cum-Dividend – The buyer of the share is entitled to dividend declared provided he buys the share before the book closure of the company. CD shares are sold at a slightly higher price than those that are sold after the book closure.

Dividend rate: This is the rate at which dividend is paid to the equity shareholders and is expressed in terms of % of the face value of the share. Suppose the face value of the share is Rs.100/- and the company is declaring dividend of 25%, it means that the dividend rate is 25% and the dividend amount is Rs.25/-.

Dividend pay out ratio: This is the amount of dividend expressed as a percentage of the profit after tax for the company. Suppose the profit after tax is Rs.100 lacs and the dividend declared is Rs.30 lacs, the dividend pay out ratio is 30%. This is different from the dividend rate.

Dividend yield: This is the relationship between the dividend value and the market value of one equity share. Suppose dividend declared is Rs.5/- on face value of Rs.10/- (dividend rate at 50%) and market value of Rs.50/- the dividend yield is 10% and not 50% which is the dividend rate.

Dividend policy: This is the policy adopted by a limited company on the matter of declaring dividend on equity share capital. This depends upon various factors as under:

Corporate philosophy of high/moderate/low dividend

Market expectations on dividend

Dividend rates of similar units in the same industry

Requirement of resources for the company, likes expansion of activity, diversification etc.

Requirement for cash for paying out the dividend in accordance with the rules in this behalf

Whether the company is going to the public for raising further equity, in which case, they may increase the dividend rate;

Are they going to declare bonus shares, in which case they may not increase the dividend rate and just maintain or even decrease the dividend rate?

Compulsions in the case of institutional investment or investment by foreign collaborators who want a certain percentage of dividend on their equity holding etc.

Learning points:

Both dividend and profit retained in business belong to the equity shareholders. Dividend is the portion of the profit distributed among the equity shareholders.

In terms of dividend yield, it is related to the market price of the equity share and not the face value;

With effect from 01/04/97, companies declaring dividend are required to pay 10% additional tax by way of profit distribution tax on the amount of dividend declared by them;

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Workshop on Banking Symbiosis While market conditions do exercise great influence on the dividend declared in

an industry, the corporate philosophy on dividend also plays an important role in the decision.

Returns: It is a combination of periodic return in the form of dividend and capital gains due to market capitalisation. For example, we purchase a Rs.10/- (Face Value) at Rs.100/- in the market. This is the market value of the share. Suppose dividend rate is 50% on the face value and we are able to sell the share in the market after one year at Rs.125/-. Let us determine the return on the share.

Dividend yield = 5/100 = 5% and capital gain is = 25/100 = 25%. Hence, dividend and capital gains together would work out to 30%.

Earning per share: (EPS)- This is a combination of “dividend per share” and “retained earnings per share”. Let us consider the following and determine the earning per share:Face value of the share – Rs.100/-Profit after tax – Rs.100 lacsDividend rate – 30% on Rs.100/-, i.e., Rs.30/- per share on 1lac shares and hence total dividend declared is Rs.30 lacsDividend per share = Rs.30/-Retained earnings per share = Profit after tax (-) total dividend declared/No. of equity shares = 100 lacs (-) 30 lacs/1lac shares = Rs.70/- per share.Thus the total earning per share called “EPS” is Rs.100/- in this case. This can be directly determined as under:

Profit after tax (-) dividend declared on preference share capital/No. of equity shares.In our example, we have assumed that there is no preference share capital. We know that preference share dividend is at a fixed rate and does not vary during its term. In case preference share capital is also there, then the above formula for earning per share would stand modified as under:

Profit after tax (-) dividend on preference share capital/No. of equity shares.

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Price earning ratio – This is the relationship between the earning per share and the market value of the share. Suppose face value of a share is Rs.10/-, the market value is Rs.50/- and the earning per share is Rs.8/-, then the price earning ratio is 50/8 = 6.25. Thus P/E ratio is dependent upon only the market price and not on the face value of a share. The three parameters, namely, earning per share, price earning ratio and the market value of the share are all inter-related.

EPS x P/E ratio = Market value of the share.

Hence, if two of three parameters are given, the third one can be found out. Now that the capital market is down in India, the P/E ratio for most of the companies is not very high, excepting the software industry. Generally, the market dictum is that you purchase shares with low P/E ratio, provided they have the future earning potential and sell off when the P/E ratio is high. This is a relative phenomenon and not an absolute one. This depends upon the sentiment in the market in general and towards a particular share specifically. During the share market boom times, our country had witnessed very high P/E ratios in the range of 30/40. The level of P/E indicates whether a particular share is under-priced (low P/E ratio with good potential) or over-priced (high P/E ratio and it has peaked out).

Market capitalisation – This is the total number of equity shares multiplied by the current market rate per share. The market capitalisation rate is the rate at which the market capitalisation increases over a specific period of time. This is the good indicator for the performance of an equity share.

Learning points:

Return on equity investment is a combination of dividend and capital gain in the market due to difference in purchase price and selling price.

Market capitalisation is an indication of the performance of a company in the stock markets.

P/E ratio is an indication about the timing of the decision to purchase or sell a share. If it is high and peaked out, it is time for sale and it is low and has earning potential, it is time for purchase and if it is moderate, it is time to hold and watch.

Terms associated with share markets:

Securities Exchange Board of India– Acronym SEBI. Established as per SEBI Act in 1992. Responsible for regulating the capital markets, both the primary market and secondary market. Hence, all the public issues of share capital, debentures, bonds etc. as well as operations in the secondary market through all stock exchanges

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Workshop on Banking Symbiosiscome under the purview of Securities Contracts Regulations Act and Rules, 1956. (S.C.R.A.)

Stock Exchanges: Stock Exchange is a place in which trading in securities takes place through “brokers”. All stock exchanges come under the control of “SEBI” and none else. This is as per S.C.R.A. Any security which is traded in the stock exchange should either be a listed security with that stock exchange for which the company concerned would have paid listing fees or an approved security which is listed on some other stock exchange. As per SEBI’s insistence, depending upon the size of the issue, a security is required to be listed with more than one stock exchange. Stock exchanges can be partnership firms, limited companies etc. They evolve their own byelaws and rules and regulations but within the purview of S.C.R.A. and rules in this behalf. All the brokers who participate in trading in an exchange are required to be registered with that particular stock exchange.

Broker – A securities merchant who is registered with a stock exchange and does buying or selling of securities on behalf of his customers through contracts with them. For this, he gets brokerage from his clients. A broker can be registered with more than one stock exchange.

Bulls – A class of market players in the secondary market, who go on “buying spree” in certain selected scrips so that these scrips rise in prices sharply.

Bears – A class of market players in the secondary market, who go on “selling spree” in certain selected scrips so that these scrips fall in prices sharply.

Going long – Being bullish about a scrip and going on a “buying” spree. Taking a purchase position.

Going short – short selling – speculating – being bearish about a scrip and taking a sale position without possessing the shares.

On line trading - A system in which the prices of all the scrips being traded are available on the computer terminal so that orders can be booked, based on these prices immediately without physically going to the stock exchange – example, the National Stock Exchange (NSE). Similar on line trading has been introduced in several stock exchanges since the

advent of NSE. BSE also has on line trading system installed now. This is also referred to as "screen based" trading. India is one of the very few markets in the developing world which has well integrated "on line" trading system in the secondary market for securities. All the stock exchanges in India are connected through satellite for this purpose.

Stop loss order – This is an order for sale of securities most of the times, as per which, the broker has to sell off the shares the moment the price of a particular scrip comes below a particular given level, so that any further reduction in the market price would not affect the securities holder. Invariably this is employed more often by people who trade in securities rather than the investors.

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Workshop on Banking SymbiosisBombay Stock Exchange Sensitive Index – BSE Index – An index of 30 selected scrips to show the market movement of these scrips, from the base level prices of these scrips at the end of a particular year.

BSE “A” group, “B1” group and “B2” group of shares – “A” group is also referred to as “specified” group or “forward” group. This covers about 150 scrips and the scrips keep on moving in and out of the list, depending upon the performance. The criteria for selection of particular scrip in “A” group are: large volumes; investors’ interest in the scrip, both by size of the shares and number of

shareholders; number of trades etc.

This group is also known as “forward” group as the settlement can be carried forward from one settlement period into another period. This allows for speculation and is absent in the National Stock Exchange. As a result of this speculation, we have two phenomena, called “Badla” and “Backwardation” or “ulta/undha badla”.

“B1” group represents more active scrips among the other scrips, which are listed in BSE for trading after deducting 150 scrips of “A” group. This is cash group, in the sense, it has to be settled for in cash within a settlement period and cannot be carried forward to the next settlement period. “B2” group represents less active scrips among the other scrips, which are listed in BSE for trading. This is also similar to “B1” group, in the sense, that it is settled for cash and not permitted to be carried forward to the next settlement period. Nowadays, the settlement period in BSE is one week. The settlement date on the NSE is every Tuesday. NSE does not have any bifurcation of scrips into groups unlike the BSE.

Badla:Permitted only in specified securities and involves carrying forward of one transaction from one settlement period to another settlement period. If this is at the instance of

the buyer, it is because he does not have the money to settle the transaction immediately. He has entered into a purchase contract, as he feels that the price is going to rise and hence he wants to purchase at the current market price. He is often referred to as the “bull”, as he speculates an increase in prices. He is supposed to be taking a “long” position, i.e., a position to purchase stocks without the money to settle the transaction within the first settlement period. Similarly, the seller is referred to as the “bear”, as he is speculating reduction in the price of particular scrip. He is supposed to be taking a “short” position. "Futures" trading are replacing "Badla" transactions. The "futures" contract is registered with a SE unlike the "badla" contracts.

Let us work out two possible scenarios under which we can work out the cash flows position.

A. The price on the settlement day is higher than the purchase price-Number of shares bought: 100Purchase price: Rs.120/- per sharePrice on the settlement day: Rs.130/- per share

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Workshop on Banking SymbiosisIn this case, on the settlement day, if the buyer and the seller decide to carry the transaction forward, the seller would pay the buyer the difference of Rs.10/- per share. A new transaction price would be assigned at Rs.130/- per share. This means that as and when the buyer takes delivery of the shares, Rs.130/- should be paid instead of Rs.120/-. As the amount is not settled immediately, this is an implied loan from the seller to the buyer on which he is entitled to receive interest from the buyer. If badla charges are 2% per month, for a typical 14-day settlement period, the buyer would pay the seller 1% on the transaction. Thus, for the above transaction, the buyer would pay at 1% on Rs.130/- Rs.1.30 per share or Rs.130/- for 100 shares. The seller would pay to the buyer Rs.1000/-, being the difference between the purchase price and settlement day price. Net cash inflow to the buyer would be Rs.1000/- (-) Rs.130/- or Rs.870/- during the first settlement period.

At the time of settlement of the transaction in the next settlement period, the buyer would purchase the share at Rs.130/- and close the transaction.

B. The price on the settlement day is lower than the purchase price:Number of shares: 100Purchase price: Rs.120/-Price on the day of settlement: Rs.110/-

In this case, on the settlement day, if the transaction has been carried forward, as the price has fallen, the buyer compensates the seller to the extent of Rs.10/- per share and the new transaction price would be Rs.110/- per share. If the interest rate is 2% per

month, again at 1%, the buyer would pay the seller, in all, Rs.1110/-, Rs.1000/- towards the difference in price and Rs.110/- towards badla charges. At the time of settlement of the transaction in the next settlement period, the buyer would purchase the share at Rs.110/- and close the transaction.

Backwardation It is not as if whenever a transaction is carried forward, it is always the buyer who has to pay the badla or the forwardation charge to the seller. We may have situations, when the buyer has enough resources to pay for his purchase of shares on the settlement day, but the seller is unable to deliver the share certificate. In such a case, the seller may have to pay a backwardation charge to the buyer. This is known as “undha badla” in the local stock exchange parlance. Just as “badla” is a charge the buyer pays the seller for his inability to pay the money for settlement of a contract, “undha badla” is a charge the seller pays the buyer for his inability to deliver the securities on the settlement day.

Beta – A measure of a security’s performance in relation to the general movement of the market. A share with a beta of 1 rises and falls corresponding exactly to the market. The rise or fall in a security with a beta higher than 1 is more than that of the market and the rise or fall in a security with a beta less than 1 is less than the rise or fall in the market index.

Buy back – Repurchase of convertible or non-convertible debentures or the non-convertible part of partly convertible debentures before the stipulated period, at par or at a discount, by companies. SEBI and the Companies Act have started

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Workshop on Banking Symbiosispermitting buy back of equity shares by public limited companies. As per this provision, public limited companies can buy back from shareholders, its own equity shares to improve its performance in EPS and market price.

Circuit-breakers or “Filters” – This is one of the measures employed by the stock exchanges to reduce the heat in a particular scrip which shows tremendous volatility during the course of a day’s trading itself. Both in the case of upward movement and downward movement, to control wild fluctuation, beyond or below a specified price, trading is suspended by the stock exchange in that scrip until the heat reduces and normal trading resumed.

Floating stock – The fraction of a company’s paid-up capital, which participates in day-to-day trading in the stock exchange.

Growth Fund – A mutual fund, which invests only in securities that have scope of good capital growth rather than current income.

Income Fund - A mutual fund with investment mostly in debentures bonds and high dividend shares. This type of fund attracts investors interested in income rather than growth of their investment.

Insider – A person working in a particular company in an important position in possession of crucial facts about the company such as contracts won, takeover bids, current results etc., which the public is unaware of. Insiders include owners, executives and consultants of a firm. It is illegal for an insider to indulge in speculative trading in the company’s shares.

Insider trading – Insider indulging in speculative activity in the shares of the company in which he is an insider;

Institutional investor – Mutual Funds, Unit Trust of India, L.I.C., G.I.C., banks, Financial Institutions etc. Their volumes are usually high and play a supportive role in the case of falling markets.

Kerb dealings – Transactions done among members after the closing of official trading hours and outside the stock exchange, even though such trading is strictly not legal. This accounts for sizeable percentage of total trading in the Indian stock exchanges.

Market-maker – An individual or an organisation which, in exchange for reduced dealing fees and other concessions, commits in certain securities, contracts or markets to continuously make two-way prices, both sale and purchase, at an agreed minimum spread differential and for an agreed minimum volume, during market hours.

Market lot – The minimum number of shares in a trading lot and mostly it is 100 and seldom higher than that. Very rarely, it is 10. If it is less than market lot, it is called “odd lot”. Owing to practice of trading in demat shares, the market lot is fast losing its significance.

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Workshop on Banking SymbiosisMoving average – An average of share prices for specified periods showing trends of price movements, rather than daily fluctuations. A monthly moving average will take a month’s prices until yesterday and for tomorrow’s average it will drop the earliest day and include today in its place.

Dematerialised shares also called (Demat shares) – This is perhaps the most significant reform that has taken place in the capital market in our country. As per SEBI regulations, any public limited company coming out with an issue of equity shares has to issue shares to its shareholders in the "demat" form only and not in the physical form. An applicant for equity share has however the option of getting shares in the physical form but he cannot trade in the secondary market in the physical form. He has to exchange the physical shares for demat shares.

At present, there are two Depository institutions in India. They are:National Securities Depositories Limited (NSDL) promoted mainly by the NSE andCentral Depository Services Limited (CDSL) promoted mainly by the BSE.All public limited companies in the private sector have to choose one of them for handling the demat shares at the Apex level (all India). The companies enter into suitable agreements with NSDL or CDSL. Both these depositories are duly registered with the SEBI. Under the depositories come "depository participants". Who can be a DP? A Scheduled Bank A Financial Institution (FI) A Foreign Institutional Investor (FII) A share broking firm/companyAt present, we have more than 300 DPs in India.

What is the main function of the DP?A DP maintains the Electronic Share Account (E.S. A/C) of an equity shareowner of any public limited company. This account is also referred to as "beneficiary's account". Any person who owns shares and is desirous of trading in shares in the secondary market has to get the E.S. A/C opened with a DP of his choice. He first surrenders the share certificate (physical form) against acknowledgement. The DP then forwards this share certificate to the Registrar who handles dematerialisation of physical shares. He dematerialises the shares and confirms with the DP. The DP then opens the E.S. A/C in the name of the shareholder and issues a passbook and a book that looks like a chequebook. It contains leaves with counterfoils that the shareholder can use for selling shares.

Once a leaf is issued for sale of demat shares, the transaction is put through the share broker through a recognised Stock Exchange and the shareholder gets his money from the buyer. His E.S. A/C is debited and personal bank account is credited. Similarly, the buyer's personal bank account is debited and E.S. A/C is credited. With the introduction of demat shares, trading can be done even in a single share, if needed. The concept of market lot (which was until recently, 100) has disappeared. The companies whose scrip is dematerialised, will get periodic statements from all the depositories showing the ownership of “demat” shares for the purpose of dividend, bonus shares, rights shares etc.

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Workshop on Banking SymbiosisSettlement period – For administrative purposes, stock exchanges divide the year into a number of settlement periods which are usually of one week duration or at the most of two weeks duration. A securities transaction in cash list has to be settled within one settlement period and a security in the forward list can be carried forward to the next settlement period. Recently NSE as well as BSE have introduced what is called "rolling settlement". This means "any time" buy and "any time" sale. This is possible because of "screen based" trading in the place of "ring" trading.

Stock option – It is the right to buy or sell a share at a particular price within a particular period, in order to hedge the investment. Nowadays issuing shares instead of share in profits or as part of remuneration package, especially in the IT industry, is quite common in India. SEBI has issued regulations in this regard. As employees are involved in this, it is often referred to as "Employees' stock option" (ESOP)

Volatile – A share subject to frequent and violent fluctuations is said to be volatile. If the volatility of a share is due to inherent factors like variability in its earnings, smallness of the issue, it is measured by the Alpha Factor. However, if the volatility is market related, it is measured by the Beta Factor.

Volatility – A measurement of the volatility rate (but not the direction) of the change in price over a given period.

Z security - It is of recent origin in India. This refers to a group of securities (equity shares) of companies that are defaulting in compliance with requirements of the stock exchanges on which its shares are listed. It also could be a company about which repeated complaints are being received from its investors.

*** End of Part II of course material ***

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What are Derivatives ?

Derivative is an instrument that derives its value from an underlying asset. The asset could be "commodity", "share/debenture" or "currency". For example, we enter into a contract for purchasing US Dollar from a prospective seller, in exchange for Indian Rupees, at Rs.48.00 on 20/03/2001 - 1000 US Dollars. This is called a "derivative".

The derivative used in Finance and Banking is called a "financial derivative". Financial derivative is based on a "financial asset". Financial asset is different from any fixed asset like building etc. A financial asset is money receivable by the asset holder due to any one or more of the following:Receivable due to sale of serviceReceivable due to sale of goodsReceivable due to lending

What could be the objective of a derivative in general?

To minimise cost of borrowing by locking into a suitable interest rate, especially when the market is going through increase in interest rates - Example - Fixed rate borrowing for more than one year, when the market rates are expected to go up. Floating rate of borrowing for more than one year, when the market rates are expected to come down. A switch from fixed rate into floating rate, in case the market conditions change. This is called "interest rate swap".

To minimise risk associated with acquiring an asset in terms of availability and cost in future - You want to buy ACC shares 2 months later, say, at 1000/- per share. The present market rate is Rs.950/-. You expect the rate to go up to Rs.1100/- two months hence. You are on the look out for a prospective seller who would sell to you at a price less than this amount. You get a seller who is prepared to sell to you at say, Rs.1050/-. This price is acceptable to you. Both of you enter into a contract and this contract is called "futures contract". How does it happen that somebody is prepared to sell it at Rs.1050/- when you expect it to go up. This is exactly what the market is about. Perceptions about future rate movements would differ from person to person. In the instant case, you perceive it to go up, whereas the seller perceives it to come down. Further he may require the money very urgently and badly.

To be in a better position to manage liability of loan, especially if the borrowing is in foreign currency by managing foreign exchange risk - Example - You want US Dollars 1000 three months hence. The present Exchange Rate is 1 US Dollar = Rs.46.50. The market is "bullish" on US Dollar. You expect the Exchange Rate to go up substantially. Hence you are exposed to Exchange Risk three hence months hence. You expect the US Dollar to go up to Rs.49/-. The Bank with whom you are dealing is prepared to sell three months later (known as "forward sale") 1 US Dollar @ Rs.48.50. You want to fix the Exchange Rate just now and accordingly enter into

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Workshop on Banking Symbiosisa contract with the bank. This is known as "forward sale contract".

There is one more product besides the above, called "option". This is an improvement on "futures". In case, one of the parties to any of the contracts as above wants to cancel the contract, he has to compensate the other party to the contract. In the case of an "option contract", for payment of a small premium, known as "option premium", the purchaser of the option contract acquires the "Right" but not the "obligation" to go through the contract. The writer of the contract is the seller and the holder of the contract is the purchaser. The writer receives the premium from the purchaser. This is quite often used in "bonds" issued by Corporations, Companies etc. We will see more of it later.

Now let us examine futures, swaps and options in detail. Future Contracts

A future contract is an agreement between a seller and a buyer that calls for the seller (called the short) to deliver to the buyer a specified quantity and the grade of an identified commodity/financial value, at a fixed time in future, and at a price agreed into when the contract is entered into. These are contracts are traded through an Exchange, standardized by the Exchange and guaranteed by a Clearing Corporation. Sometimes the contract is settled in cash value of the underlying. The principal features of futures contract are:

Futures contracts are traded on organised exchanges , so sellers and buyers are not directly known to each other.

Future contracts have standardised contract terms and periods. Generally future contracts are traded with expiration/ settlement period of one month , two months up till an year. Each month's contract is considered as a separate series and mostly maturity is in last week of the month. A open contract can also be closed before expiry by squaring off the position in the same series.

Futures segment has two-tier structure. A futures exchange where trading is done and a clearing house which undertakes clearing and settlement of all the executed trades on the exchange and also guarantees the fulfillment of the futures contracts by way of margins and trade guarantee funds..

Both exchange and clearing house have separate membership requirement. Thus a Trading Member, who is a member of the exchange, can choose to be member of the clearing house or else associate with a clearing member, who is member of clearing house, for the settlement of trading members trades.

Futures trading require margin payment by clearing members, i.e., the share brokers, who in turn can collect the same from their clients and settlement of trade takes place on a daily basis.

Mark-to-market: At the end of each trading session, all outstanding contracts are repriced at the settlement price of that trading session. This would mean that some participants would make a loss while others would

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Workshop on Banking Symbiosisstand to gain. The exchange adjusts this by debiting the margin accounts of losers and crediting margin accounts of gainers. In effect, its a zero sum market where some participants gain at the cost of losers.

Actual delivery is rare as most of the futures contract are offset by equally opposite contracts.

Index Futures: The index futures are the most popular futures contracts as they can be used in a variety of ways by various participants in the market. They offer different users different opportunities like hedging , speculation etc. Index futures derive its value from the underlying basket of index of securities. Generally popular indices, such as Sensex, Nifty etc. can be traded as they are reflective of market sentiments and mirror the movement of any fund's portfolio.

To explain it simply, suppose one wants to trade in futures contracts, say Nifty Index Futures. One can place orders through his broker to buy or sell Nifty contract (min contract size for Nifty is 200, so orders should be in multiple of 200) for any particular month (series). Before placing the order one has to place some amount as initial margin which can be a percentage of the value of his position. In exchange, different prices shall quoted for all the series of one two or three months of maturity. Suppose July, Aug and September series are traded at 1500, 1505 and 1515 respectively. An investor decides to buy 200 Nifty of August series at Rs. 1505 on July 07. This contract will remain a long (open) till the maturity of August series on 31-Aug-2000. This open position can be squared off by selling similar 200 Aug series on any day before maturity. Suppose on July 12, the quoted price of Aug series is 1550 and the investor chooses to close his position by selling 200 Nifty, then his cash flow or profit will be Rs 9000/- {( 1550-1505 ) * 200}. This cash flow shall be received in form of every day marked-to-market profit or loss. Each day his open contract will be marked at that day's closing price of the series. So next day his carried forward price will be taken as previous days closing.

E.g cash flow for 200 buy Aug. series is: Date Buy/CF price closing /Sell MTM 07-JUL 1505 1525 +4000 10-JUL 1525 1535 +2000 11-JUL 1535 1530 - 1000 12-JUL 1530 1550 +4000

NET MTM : +9000

After the investor has squared off his position he will receive a profit of Rs 9000/- as well as the initial margin deposited earlier with his broker. Initial margin could be 10% of the value of his position i.e Rs 30000/- approximately. ( 0.1 * 200 * 1505) Options

Options are similar to futures contract but it gives its holder the right (but not the obligation) to buy (known as "call option") or sell (known as "put option")

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Workshop on Banking Symbiosissecurities at a pre-determined price (known as "strike price" or "exercise price"), within or at the end of a specified period (known as "expiration period"). So an "Option holder" may or may not exercise his rights depending on the prevailing market conditions in future. In order to acquire the right of option, the option buyer pays to the option seller (known as "option writer") an Option Premium, which is the price paid for this right. The buyer of an option can lose no more than the option premium paid but his possible gain in unlimited. On the other hand, the option writer's possible loss is unlimited but his maximum gain is limited to the "option premium" charged by him to the holder. Therefore payoff in options is assymetric. The most critical aspect of options contracts is the evaluation of the fairness of option premium, i.e. option pricing. Most often, options go unexercised.

American options are exercisable at any time prior to expiration date while European options can be exercised only at the expiration date. Expiration can be similar to that of futures i.e one month, two-month and three-month. For the call option holder, it is worthwhile to exercise the right only if the price of the underlying securities/asset rises above the exercise price. For the put option holder, it is worthwhile to exercise the right only if the price falls below the exercise price. There can be options on commodities, currencies, securities, Stock Index, individual stocks and even on futures. Options strategies can be highly complicated.

Swaps

Financial swaps are a funding technique, which allows the flexibility of exchanging the mode of cash flow pay off on a notional predetermined asset. E.g., "Exchange" of

"Fixed interest" pay off for a "Floating interest" pay-off on a fixed notional principal amount. It permits a borrower to access one market and then exchange the liability for another type of liability. The global financial markets present borrowers and investors with a wide variety of financing and investment vehicles in terms of currency and type of coupon - fixed or floating. Floating rates are tied to an index which could be the London Inter-Bank borrowing rate (LIBOR), US treasury bill rate etc. This helps the investors exchange one type of asset for another for a preferred stream of cash flows. Swaps by themselves are not a funding instrument; they are a device to obtain the desired form of financing indirectly. The borrower might otherwise have found this too expensive or even inaccessible.

All swaps involve exchange of a series of periodic payments between two parties. A swap transaction usually involves an intermediary who is a large international financial institution. The two payment streams are estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant markets.

Types of Swaps

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Workshop on Banking SymbiosisThe two most widely prevalent types of swaps are interest rate swaps and currency swaps. A third is a combination of the two to result in cross-currency interest rate swaps. Of course, a number of variations are possible under each of these major types of swaps.

Interest Rate Swaps An interest rate swap as the name suggests involving an exchange of different payment streams, which fixed and floating in nature. Such an exchange is referred to as an exchange of borrowings or a coupon swap. In this, one party, B, agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. At the same time, party A agrees to pay party B cash flows equal to interest at a floating rate on the same notional principal for the same period of time. The currencies of the two sets of interest cash flows are the same. The life of the swap can range from two years to over 15 years. This type of a standard fixed to floating rate swap is also called a "plain vanilla swap" in the market jargon.

Currency Swaps Currency swaps involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an approximately equivalent loan in another currency. Suppose that a company A and company B are offered the fixed five-year rates of interest in U.S. dollars and sterling. Also suppose that sterling rates are generally higher than the dollar rates. Also, company A enjoys a better credit worthiness than company B as it is offered better rates on both dollar and sterling. What is important to the trader who

structures the swap deal is that difference in the rates offered to the companies on both currencies is not the same. Therefore, though company A has a better deal in both the currency markets, company B does enjoy a comparatively lower disadvantage in one of the markets. This creates an ideal situation for a currency swap. The deal could be structured such that company B borrows in the market in which it has a lower disadvantage and company A in which it has a higher advantage. They swap to achieve the desired currency to the benefit of all concerned.

A point to note is that the principal must be specified at the outset for each of the currencies. The principal amounts are usually exchanged at the beginning and the end of the life of the swap. They are chosen such that they are equal at the exchange rate at the beginning of the life of the swap. Market Participants

Exchanges: Derivatives are traded on Exchanges , which perform two functions : 1) provide and maintain market place to enter into a contract 2) Police and enforce ethical and financial standards applicable on exchange.

Trading Member (T.M): Trading Member performs functions similar to a brokerage house in the securities industry. All trades has to routed through a

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Workshop on Banking SymbiosisTM and they collect margins from their clients for their positions .

Clearing member (C.M): It acts as an intermediary between clearing house and the clients or non-clearing member TM's.

Clearing Corporation: They perform the vital function of clearing the transactions on the exchanges. Unlike clearing houses in security market , they guarantee the trades by acting as a counter party to the trade. For precaution , a margin is maintained on a mark-to-market basis everyday besides the initial margin.

Regulatory Authorities : Future Markets have self-regulatory and central regulatory authorities. They perform the function of market surveillance and keep a vigil on market manipulations.

Traders/Clients : They are the users of derivative market and take specific positions depending on their purpose viz . Hedging , Speculation etc.

*** End of Document ***

Part III - Foreign Exchange

1. Foreign Exchange is a commodity just like any other commodity like grain etc.

2. It is internationally considered a perfect market - characteristic feature of a perfect market is that only demand and supply influence the prices. Foreign Exchange rates across the world are generally influenced by this factor relating to any currency, at a given time, in the market.

3. Internationally, it is a highly speculative market. More than 90% of the transactions are for reasons of speculation and not backed by what is known as "Genuine Merchant Transactions" (GMT). In India, it is to be backed always by GMT, as per the Exchange Control Regulations of the RBI under FEMA. GMT could be for trade or services.

4. Corporations, brokers, dealers, banks, institutions, private funds like pensions funds, insurance funds, provident funds, Soros funds etc. take part in this market. As there are no restrictions in holding foreign exchange by these players, they indulge in it freely and take advantage of expected price fluctuations of various currencies.

5. The RBI is primarily responsible for regulating the Forex market as well as the Foreign Exchange Reserves in India. Exchange Control Regulations set ceiling on the amount of FX to be released by an Authorised Dealer (AD) for various purposes including business travel abroad.

6. FX Reserves are constituted by:

Gold Reserves with the RBI

Special Drawing Rights of India as sanctioned by IMF

Balances kept with other Central Banks in the world by the RBI

Balances kept outside India by the banks

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Workshop on Banking SymbiosisInvestment in FX bills, bonds by the Central Banking Authority in India, Indian Banks, Financial Institutions etc.

(*It should be noted that the FX held by Indian Companies in the private sector in their own names is not part of FX Reserves of the country)

7. Indian Resident cannot hold FX excepting up to US Dollars 2000 by way of gift, inward remittance etc. Anything in excess that he or she holds, should be surrendered to an AD.

8. In the case of any inward remittance for export of goods or services, gift, periodic remittance from NRIs abroad, loan taken, dividend etc., FX is credited to the NOSTRO Account of the AD or the Indian Company that is permitted to have NOSTRO Account in its own name. Similarly in the case of any outward remittance for import of goods or services, remittance of royalty, interest on FX Loans, dividend etc. FX is debited to the NOSTRO Account of the AD or the Indian Company as the case may be.

9. When the NOSTRO Account is credited on behalf of its customer, the AD gets an advice from its Correspondent abroad and converts the FX into Indian Rupees at the prevailing market rate. Similarly in the case of import, first the AD recovers Indian Rupees from its customer on whose behalf remittance is to be done. Then only, it advises its Correspondent abroad to debit its NOSTRO Account and effect remittance in favour of the foreign beneficiary.

10.All the A.D.s in India are members of a non-profit organisation known as "Foreign Exchange Dealers' Association of India" (FEDAI). It functions as a watchdog for the RBI.

11.At present the Indian Banks dealing in FX transactions can deal in 26 permitted currencies. The major currencies are:

American Dollars Swiss FrancsAustralian Dollars British PoundsNew Zealand Dollars Deutsche Mark of Germany

Singapore Dollars Japanese YenHong Kong Dollars Italian LiraSwedish Kroners French FrancsDutch Gilders Canadian Dollars

Similarly Foreign Banks would also have NOSTRO Indian Rupee Deposit Accounts with their counterpart in India. The Foreign Banks, however, have limited utility for Indian Rupee and hence their Indian Rupee Deposits would be minimum.

12.Correspondent Banking arrangement is on a reciprocal basis. The Foreign Correspondent Bank extends the following services:

Sending intimation to the Indian Bank whenever its NOSTRO Account is credited with all relevant details;

Sending periodic statement of all NOSTRO Accounts maintained by it for the purpose of records and reconciliation;

Acting on instructions by the Indian Bank to debit the NOSTRO Account and effect remittance to the foreign beneficiary.

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Workshop on Banking SymbiosisAt times, if needed, buy FX on behalf of the Indian Bank and credit the same to the NOSTRO Account. It will recover this amount from subsequent credits to the NOSTRO Account.

13.At present in India, even A.D.s are permitted to hold FX beyond what is required by GMT contracts with its customers, up to a prescribed limit. The RBI prescribes this limit. The quantum is less than US Dollars 10 Million.

14.A.D.s are permitted to hold Foreign TCs and foreign currency up to a prescribed limit by the RBI.

15.As per prevalent Exchange Control Regulations in India, Foreign Exchange is required to be credited to the NOSTRO Account of the exporter (in case it has been permitted by the RBI) or the AD within 180 days from the date of shipment. Similarly, in the case of imports, the payment is required to be made within the same period of 180 days from the date of shipment by debiting the NOSTRO A/C of the importer or the AD as the case may be.

16.Indian Rupee is not freely convertible into any other foreign currency. Hence it is said that Indian Rupee is not convertible on current account or capital account fully. There are restrictions by the RBI. Current account means - trade of goods and services, remittance for interest, dividend, royalty, etc. Capital account means - portfolio investment by the Foreign Institutional Investors (FII), equity investment in projects, Foreign Currency Loans, Lines of Credit both for import and export, gifts from one nation to another nation etc. Even Banks in India have to operate for loan, investment abroad etc. within prescribed limits by the RBI. As mentioned earlier, on a selective basis, the RBI permits Indian Companies to have their own NOSTRO accounts abroad. Indian Residents are not permitted to have any asset abroad.

17.At present, 100% Export-oriented units (EOU), in India can retain up to 35% of their earnings in FX, while others who are not 100% EOU, can retain up to 25% of their earnings in FX. Recently, to tide over the crisis in the FX market when the US Dollar was galloping unchecked, RBI had reduced the % holding from 100% to 35%.

18.FX rates given on a daily basis from Monday thru' Friday in India are not regulated by the RBI. They are by and large decided by the demand and supply in the FX market of any given currency. At present, US Dollar is being used as "reference currency". Hence, the FX rate of US Dollar vis-à-vis Indian Rupee is taken as the base rate for determining the FX rates for other currencies. For example, let us say, 1 US Dollar = Rs. 46.30. and 1 US Dollar = Stg. Pound 0.667. Hence, 1 Stg. Pound = Rs.69.41. Such a derivation is called a "cross currency" quotation.

19.The RBI in its capacity as the Apex Bank in the country does intervene in the FX market to stabilise it. The respective Central Banking Authorities do this all over the world. However, the impact of the Central Bank's intervention depends upon the volume of the FX market in the respective country; the larger the volume the less the impact and the less the volume, the greater the impact. The RBI sells FX in the Indian market if it requires cooling the overheated market due to excessive demand over supply. Similarly the RBI purchases FX, thereby creating artificial demand in case it feels that the FX rate of any specific currency is below an acceptable level.

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Workshop on Banking Symbiosis20.Although the A.D.s enter into FX contracts with its customers, the actual deals

are put through at the dealing room of the A.D. These specialised branches alone can operate the NOSTRO accounts maintained abroad. They are distributed geographically over the country to facilitate smooth operations any time. For example, a commercial bank of the size of the SBI will have 20 dealing rooms, at the most. They are maintaining the position of FX and hence called at times, "position maintaining branches". They report the position directly to RBI and the respective Head offices. The A.D.s as and when they sell or purchase FX on behalf of their customers, should report to the dealing room, under whose jurisdiction they operate.

21.In Europe, there is a common currency called "Euro". Some of the leading European nations are not members of the Euro, like the UK. However, till end 2001, transactions with the member countries, which have adopted Euro, can be done either in their respective Domestic Currency or Euro, as it suits the customer.

22.Suppose you are Deutsche Bank in Germany. Although you may hold deposits in other currencies, while reporting figures in your financial statements, you will be required to convert it into Domestic Currency namely, Deutsche Mark.

23.You are required to maintain FX accounts in various currencies. For each currency, you will open a separate ledger account. End of the period balances will be converted by applying direct rate (if available) or Cross Currency rates (if direct rate is not available) into Domestic Currency/Local Currency. For transactions with customers, depending upon the currency of transaction, the respective currency deposit account is credited or debited as the case may be, while recovering or paying the local currency to its customers.

*** End of the note ***

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Part IV - Fixed Income Securities

The word "security" refers to an asset that is offered by a borrower to a lender at the time of taking a loan. On the other hand, the word "securities" means instruments like "shares", "debentures", "bonds" etc. Securities are the means in the hands of "Resource Mobilisers" for raising resources from those who give financial resources to them, in exchange for securities issued by them in the form of share certificate etc.

When we refer to "Fixed Income Securities" ("FIS" hereafter), we mean instruments that give fixed income to its investors. The income does not vary from period to period, as say in the case of investment in equity share capital. In the case of "equity share", the dividend could vary from time to time, unlike "preference share capital (hereafter referred to as "preferred equity"). Equity shares do not come under FIS.

Constituents of FIS:BondsDebenturesPreferred EquityMortgage Backed SecuritiesAsset Backed Securities

We will examine each one of them briefly.

Bonds Can be issued by Governments, Public Sector Undertakings, Municipal

Corporations, Companies, Banking Institutions, Financial Institutions, Non-Banking Finance Companies etc.

If it is up to a period of 5 years, it is sometimes referred to as "Notes". If they have floating rate of interest, they are not a part of FIS. Federal Bank of the US on behalf of the US Government issues such notes. They are called Treasury Notes. This is not the practice in India. The Reserve Bank of India issues only Treasury Bills up to 1 year maturity

Can be secured with fixed assets or current assets or both Can be face value instrument (amount of investment = amount payable on

maturity) or discounted value instrument (amount of investment = Discounted value of amount payable on maturity)

Can be for periods from 3 years to 25/30 years. In case period is longer, it is called "Deep Discounted Bonds"

In India it is an emerging market, whereas bond market is a very well developed market

Has a fixed rate of interest mentioned in the case of face value instrument, which is called the "coupon rate"

Can be cumulative (interest paid on maturity) or non-cumulative (interest paid periodically)

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Workshop on Banking Symbiosis Can be converted into equity shares (called convertible bonds) - conversion

option, not to be confused with redemption option through "call" and "put" options

In the case of Discounted Bonds, some instruments do not carry any rate and hence are called "Zero Coupon Bonds". Only the amount payable on maturity is mentioned.

It can be redeemed with premium It can have options (refer to note on "derivatives"), both call (for the issuer for

early redemption) and put (for the investor to offer for early redemption)

Debentures

Can be issued by Financial Institutions, Non-Banking Financial Companies, Companies etc. Very rarely issued by Govt. Bodies and seldom by Governments, Municipal Corporations, Banking Institutions etc.

Is always a face value instrument In India it is by and large secured with fixed assets or current assets or both Can be cumulative or non-cumulative Can be convertible into equity shares Has a fixed coupon rate mentioned on the certificate Has a limited secondary market, but overall it is better established than the

emerging bond market in India. It is expected that in the near future, to keep up with the global practice, the bond market will replace the debenture market

Options are rare in debentures Redemption premium can be there

Preferred Equity

It is the same as what we, in India, call as "Preference Share Capital" It is a fixed income security, as the rate of dividend is fixed on the certificate,

irrespective of the rate of dividend on the "equity capital" It can be converted into equity at a later date The difference between interest on bonds and debentures and dividend that is

paid on preferred equity is that interest is an expense, whereas dividend is part of profit after tax distribution

Preferred equity can be paid back to the investor regularly in accordance with the relevant provisions of The Companies Act (as the Act is known in India - known by different names in different countries)

It is called "preferred equity" as it gets preference for payment of dividend and repayment once the company closes, over the "equity capital"

Has a limited secondary market Is not mandatory (legally compulsory in terms of provisions of The Companies

Act) to have it as capital, unlike "Equity", which is compulsory for all limited companies

It forms a small portion of the total share capital in most of the cases.

Mortgage Backed Security

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Workshop on Banking Symbiosis As the name suggests, its cash flow (cash coming in for paying back the investor

or paying periodic interest) is linked to cash flows of an underlying pool of mortgages

There are three types - Mortgage Pass Through Certificates (known as "PTC"), Collateralised Mortgage Obligations (CMO), and stripped mortgage backed securities.

Mortgage is the legal term of offering immovable fixed assets of land and building as security

It has mortgage loan receivables (repayment by the borrowers) as the underlying receivables for cash flow

PTC - Against the pool of mortgage receivables, the lenders raise further resources by issuing Pass Through Certificates or Shares (mostly of preferred equity nature) to the investors. Repayment to the investors linked to the cash flowing in from mortgage receivables. The pool may consist of a number of mortgage loans and the lenders may be more than one.

CMO - Against the pool of mortgage receivables, the lenders raise further resources by issuing bonds of different interest rates and redemption priority/dates. This is the most common type of Mortgage Backed Security. The "Z" class bond doesn't even get periodic interest in some cases till after the redemption of other class bonds. Obviously, the rate of interest will be higher.

The "Stripped" variety is not very popular in the US itself. It is complex in structure.

Rate of interest is flexible and market driven. It is mostly a fixed rate. Risk is less as cash flows are linked to cash flows from the pool of receivables These have a reasonable secondary market in the Western world but it is still

"novel" in India.

Asset Backed Securities

These have the backing of securities other than mortgages, like credit card receivables, consumer durable loan receivables, car loan receivables etc.

These form a small segment of the financial market This market is emerging Very limited secondary market Still considered very risky especially against pool of credit card receivables Not yet made its presence in India Have a fixed rate of interest

Secondary market for these securities and Clearing/Settlement system

Each country or an integrated Euro system consisting of more than one country has got its own clearing organisations who ensure that the ownership of securities traded is smoothly transferred from the original owner to the new owner. This should not be confused with the Stock Exchanges. Stock Exchanges function to provide a platform for trading in securities in the secondary market. They come under the respective statutory organisation like SEBI in India. They do not handle registration of security in the new owner's name etc. The sale/buy transactions are put through Stock Exchanges. The share brokers handle the sale/buy contracts through Stock Exchanges. In all the Stock Exchanges excepting NSE, there is a clearing system and a bank attached to it, for enabling transfer of security and

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Workshop on Banking Symbiosissettlement of dues. However the NSE does not have any place of operation. Hence it has an exclusive clearing and settlement system as described below.

NSE's exclusive clearing and settlement organisation is the National Securities Clearing Corporation Limited (NSCCL). This is based on similar organisations abroad. This is a wholly owned subsidiary of the National Stock Exchange and provides the means for exchange of securities and settlement of payment between seller and buyer in the secondary market, for contracts that are put through the NSE.

The operations are:Broker A - sell broker for Customer PBroker B - buy broker for Customer QThere will be contracts between the brokers and their customers The brokers go through NSE for transacting. Assume that they agree on the price for the transaction and in turn enter into contract. This contract is registered with the NSE. NSE like any other stock Exchange provides the platform for putting through the transaction in this case.

Exchange of money and exchange of security are yet to take place. This is the role of NSCCL. Once the contract is registered with the NSE, NSCCL comes in the picture. It ensures that the security is transferred from broker A to broker B and funds are transferred from broker B to broker A.

The brokers in the first place, would get the security and funds from their respective customers. Broker A will get the security from Customer P whereas Broker B gets funds from Customer Q. This is how clearing of securities and settlement take place in the secondary market.

In India, as explained under the Capital Market Terms, SEBI's regulations regarding securities that they should only be in "Demat" form apply only to the shares of Limited Companies. The "demat" form is yet to be introduced in a big way for debt instruments like "debentures" or "bonds", for Limited Companies. However, most of the Government securities, and Public Sector Corporation Bonds have been in the "demat" form to a large extent. The Depository Participant dealing with the Government Securities and PSU bonds is the Stock Holding Corporation of India Limited (SHCIL).

The clearing organisations in Europe are the most popular as they cover operations in more than one country. The two organisations are - CEDEL or Euro Clear. A broker can be a member of either of the organisations. Hence there is an arrangement for transaction involving both of them, called the "bridge".

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Part IV - Money Markets and Instruments

Money market refers to the short-term market, say up to 12 months. There is no fixed place for this market. The note discusses only such instruments as are having secondary market. Instruments like inter-corporate deposits and fixed deposits within 12 months, although belonging to the short-term debt market, have been excluded in view of this criterion only.

Money market instruments are as under:

Treasury bills of the Government of India through Reserve Bank of India; Certificate of deposits raised by banks depending upon their requirement for

large amounts; Commercial paper floated by Limited Companies to augment their working

capital resources or reduce the cost of borrowing; Call money market; Commercial bills discounted ( in some cases, co-accepted by the buyers’ banks)

and

Treasury bills:

It is the short-term instrument issued by the Government to tide over short-term liquidity problems. This is usually resorted to for mobilising resources in the short-

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Workshop on Banking Symbiosisterm to plug the budget deficit. Characteristic features of treasury bills are as under:

Highly liquid as anytime it can be liquidated by getting the bills rediscounted with another investor or DFHI (Discount and Finance House of India) even before redemption date;

Highly reliable as Government is involved and hence no risk is involved; Reserve Bank of India is the agent for Govt. of India. Issued by RBI either through auction or tap – adhoc treasury bills have been

discontinued; Currently the periods for which RBI raises resources through TBs are 14 days, 91

days, 182 days and 364 days. Treasury bills are discounted instruments with the face value being realised on

maturity only. Hence, if the market rate increases for short-term maturity and accordingly RBI is forced to offer a higher yield to TB investors, the amount that they will collect will be less – the higher the rate offered, the less the amount collected and vice-versa; Investors: Institutions like banks, FIs, NBFCs, Insurance Companies, Mutual Funds, State Governments, High Net Worth individuals, Limited companies and even the Reserve Bank of India (whenever the amount declared during the auction is not fully subscribed and the balance amount devolves on them); There are rediscounting facilities available for these treasury bills in case the investor wants to liquidate them either through Discount and Finance House of India Limited (DFHI) or by RBI, as the case may be;

If private investors are involved, certificates are issued for the treasury bills and in case of investment by Institutions, Governments and the RBI itself, their treasury bills accounts are maintained in the form of “Subsidiary General Ledger Accounts” with RBI. In these cases, as regular purchase and sale take place, certificates are not issued to the investors. This is the earliest example of securities in "demat" form;

Treasury bill yield is on 365 days calculation. If the TB is held till maturity, the return on it is called "Yield To Maturity (YTM)";

The auctioned treasury bills do offer the best rate of return to the investor and treasury bills on tap get the lowest rate of interest among the types of treasury bills and

Internationally, the respective Central Banks have treasury notes (up to 5/7 years) as well as treasury bonds (up to 30 years). We have only up to 1 year at present.

Yield on treasury bills:

It is always calculated on 365 days basis irrespective of the period of the bill, say 14 days, 91 days etc. The following example will illustrate this.

Suppose there is a 91day bill for Rs.100000/-. As TB is a discounted value instrument, in case RBI is able to get Rs. 97,500/- (net of discount). This means that the investor has got Rs.2,300/- on net investment up front. Hence the calculation on a 365 days basis would be:

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Workshop on Banking Symbiosis(1,00,000/97500) - 1 = yield in decimals for 91 days. Then we will have to convert into yield on 365 days basis. Yield for 91 days = 0.0256 or 2.56% for 91 daysHence yield for 365 days = (2.56) x 365/91 = 10.26% p.a. The yield goes on reducing as the TB goes towards maturity date. Thus on every successive discounting, the yield gets reduced. It is related to two parameters as under:

Remainder period for maturityDiscounted value paid by the new investor

Certificate of deposits:

This is more of an investment instrument for those having investible surplus, rather than an instrument for market borrowing. At present only Commercial banks have been permitted by the RBI to issue certificates of deposits depending on their requirement of funds in the short term up to 12 months by offering a higher rate of interest than on the regular deposits. In the international market, however, Limited Companies can issue certificates of deposit. Most of the developed countries do not have the fixed deposits system that we have in India.

Characteristic features of C.D.s:

Minimum maturity 1 month;Maximum maturity 12 months;They are negotiable instruments unlike the conventional fixed deposits;C.D.s can be issued up to 5% of their total deposits;High Net Worth Individuals, Limited Companies, Trusts etc. do invest in these instruments;They are issued at discount rate with the value of the deposit payable on maturity;Rate of interest to be determined by the individual banks and not controlled by the RBI;Issued in multiples of 5 lacs subject to a minimum of 10lacs andThey are freely transferable by endorsement and delivery but only after 45 days from the date of issue.

Note: It should be borne in mind that the terms keep on changing either depending upon the market conditions or RBI directives. Please keep yourselves updated on the latest terms instead of entirely depending upon the details given here.

Certificate of deposit is not a very popular instrument in the market at present. This is so because most of the banks are not experiencing any liquidity problem in the short-run.

Yield to maturity - also calculated on 365 days basis just like in the case of TBs

Commercial Paper (C.P.):

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Workshop on Banking SymbiosisCommercial papers are short term unsecured promissory notes issued at a discount value by large and well-established Limited Companies. The principal requirement is that the commercial paper issued by them should have the prescribed minimum credit rating by the RBI. It is a part of their working capital funds and to the extent of commercial paper borrowing, their working capital limits with the banks are reduced. As even today in India, the commercial banks’ lending for working capital purposes is significant, their permission is a must for issuing C.P.s. They are either issued directly to the investors or through merchant banks and security houses. The instrument has been welcome especially by the Limited Companies, who have been doing well. This is because their cost of borrowing in the short-term is reduced significantly, because the C.P. is always at a lower rate of interest than the rate of interest on working capital limits charged by the banks. Besides Limited Companies, NBFCs are permitted to issue commercial paper.

Of late, even financial institutions have started issuing commercial paper and some of the public sector undertakings too. However the guidelines if any, issued in these cases, are not available to the author of this hand out.

Yield to maturity - calculated on 365 days basis just as in the case of TB/COD.

Call money market:

It is a part of the national money market where day-to-day surplus funds, mostly of banks, are traded. The call money loans are of very short-term in nature and the maturity periods of these loans vary from 1 to 3 days. If the period exceeds 3 days, a notice is required to be given about repayment of the loan at the time of taking the loan. As notice is given, this is called "notice money market". The maximum period is 14 days for notice money market.

Purpose:The banks to meet various urgent requirements for funds as under resort to borrowing in the call money market as under:

Fill the temporary gaps in their deposit maturities in the case of over lending or overdue or premature payment of deposits of large amounts;Meet the Cash Reserve Ratio (CRR) requirements with RBI;Banks usually borrow to avoid any penalty from RBI for not meeting the CRR requirements.

Participants:Borrowers:Only Commercial banks.Lenders:Other Commercial banks, Insurance Companies, Financial Institutions, Mutual Funds etc. Limited Companies cannot participate in this market.

Note: Call money market rates fluctuate very much and this rate is used as an indicator for gauging the level of liquidity in the money market. If the rates firm up, it indicates tight money supply and vice-versa.

Rate of interest for Call Money Market operations quoted on p.a. basis

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Bills discounted:

These are the commercial bills of Limited Companies or business houses drawn on buyers and duly accepted by them. In some of the cases, the lender does insist on the co-acceptance of the bankers to the corporate or business house, as the case may be. This means that this borrowing is done with the full knowledge of the banks that have lent working capital funds to the Limited Companies. This is a highly unorganised market with no ground rules for operations. There is not much of a secondary market for bills discounted in India at present. This market has yet to develop in India; otherwise in the developed financial markets, the bills discounted constitute a sizeable portion of the financial markets. The number of times the bills discounted once get discounted in the international market is much higher than what is prevalent in India.

There is an added risk element in the bills discounting from the lender's point of view. This is the possibility that genuine trade may not have taken place. In such cases, the bills are called "accommodation bills". The borrowers are:Limited Companies whose working capital is blocked due to outstanding trade bills.

The lenders are:Commercial Banks, All-India Financial Institutions, NBFCs, Insurance Companies, UTI/other mutual funds, State and other co-operative banks etc.

Rates entirely depend upon the lender and to an extent are influenced by the credit rating of the drawer as well as the drawee, besides the liquidity in the market. Nowadays, in view of the fiasco in the Inter-Corporate Deposit (ICD) market, this market has also been affected to a large extent. The lenders have started insisting upon “post dated cheques” from the drawees besides their banks’ approval in some cases.

In the past, the commercial banks used to get the bills discounted by them, rediscounted with the RBI. It is not done at all now.

Rate of interest that is applied at the beginning of the transaction is on per annum basis. The drawer gets less than face value and the difference between the bill value and the discounted value is called discount. For bills discounted in India, the concept of yield to maturity is not applied. For each successive rediscounting, the rate progressively decreases and so also the amount of discount.

*** End of note ***

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Date post:	17-Nov-2014
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