Financial Environment

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A few preliminaries• Reserves (R ): the portion of deposits that banks have

not lent.

• To a bank, liabilities include deposits,assets include reserves and outstanding loans

• 100-percent-reserve banking: a system in which banks hold all deposits as reserves.

• Fractional-reserve banking: a system in which banks hold a fraction of their deposits as reserves.

Money Supply 2

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SCENARIO 1: No Banks

With no banks, D = 0 and M = C = $1000.

we assume there’s $1000 in currency circulating in the economy. We then compare the size of the money supply in different scenarios about the

banking system: no banks, 100% reserve banking, and fractional reserve banking.

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SCENARIO 2: 100 Percent Reserve Banking

• After the deposit, C = $0, D = $1000, M = $1000.

• 100% Reserve Banking has no impact on size of money supply.

FIRSTBANK’S balance sheet

Assets Liabilitiesreserves $1000 deposits $1000

Initially C = $1000, D = $0, M = $1000. Now suppose households deposit the $1000 at “Firstbank.”

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SCENARIO 3: Fractional-Reserve Banking

The money supply now equals $1800:

The depositor still has $1000 in demand deposits,but now the borrower holds $800 in currency.

FIRSTBANK’S balance sheet

Assets Liabilitiesdeposits $1000

Suppose banks hold 20% of deposits in reserve, making loans with the rest.

Firstbank will make $800 in loans.

reserves $1000reserves $200loans $800

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SCENARIO 3: Fractional-Reserve Banking

The money supply now equals $1800:

The depositor still has $1000 in demand deposits,but now the borrower holds $800 in currency.

FIRSTBANK’S balance sheet

Assets Liabilities

reserves $200loans $800

deposits $1000

Thus, in a fractional-reserve banking system, banks create money.

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SCENARIO 3: Fractional-Reserve Banking

• But then Secondbank will loan 80% of this deposit

• and its balance sheet will look like this:

SECONDBANK’S balance sheet

Assets Liabilities

reserves $800loans $0

deposits $800

Suppose the borrower deposits the $800 in Secondbank.

Initially, Secondbank’s balance sheet is:

reserves $160loans $640

Maybe the borrower deposits the $800 in the bank. Or maybe the borrower uses the money to buy something from someone else, who then deposits it in the bank. In either case, the $800 finds its way back into the banking system.

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SCENARIO 3: Fractional-Reserve Banking

• Again, the person who borrowed the $640 will either deposit it in his own checking account, or will use it to buy something from somebody who, in turn, deposits it in her checking account. In either case, the $640 winds up in a bank somewhere, and that bank can then use it to make new loans.

THIRDBANK’S balance sheet

Assets Liabilities

reserves $640loans $0

deposits $640

If this $640 is eventually deposited in Thirdbank,

then Thirdbank will keep 20% of it in reserve, and loan the rest out:

reserves $128loans $512

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Finding the total amount of money:Original deposit = $1000

+ Firstbank lending = $ 800+ Secondbank lending = $ 640+ Thirdbank lending = $ 512+ other lending…

Total money supply = (1/rr ) $1000 where rr = ratio of reserves to deposits

In our example, rr = 0.2, so M = $5000

A fractional reserve banking system creates money,but it doesn’t create wealth:

bank loans give borrowers some new money

and an equal amount of new debt.

Financial Institutions

• DEFINITION• Institution which collects funds from the

public and places them in financial assets, such as deposits, loans, and bonds, rather than tangible property are called Financial Institution. In financial economics, a financial institution is an institution that provides financial services for its clients or member

What is a bank?

• A bank is a commercial or state institution that provides financial services, including issuing money in various forms, receiving deposits of money, lending money and processing transactions and the creating of credit.

1. Central Bank

• A central bank, reserve bank or monetary authority, is an entity responsible for the monetary policy of its country or of a group of member states, such as the European Central Bank (ECB) in the European Union, the Federal Reserve System in the United States of America, State Bank in Pakistan.

• Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a “lender of last resort” to the banking sector during times of financial crisis

2. Savings Bank

• A savings bank is a financial institution whose primary purpose is accepting savings deposits. It may also perform some other functions.

3. Life Insurance Companies

Insurance companies may be classified as 1. Life insurance companies, which sell life insurance, annuities and pensions products. 2. Non-life or general insurance companies, which sell other types of insurance.

4. Investment company

• Generally, an "investment company" is a company (corporation, business trust, partnership, or limited liability company) that issues securities and is primarily engaged in the business of investing in securities.

• An investment company invests the money it receives from investors on a collective basis, and each investor shares in the profits and losses in proportion to the investor’s interest in the investment company.

4. Pension Funds• A fund established by an employer to facilitate and organize the

investment of employees' retirement funds contributed by the employer and employees. The pension fund is a common asset pool meant to generate stable growth over the long term, and provide pensions for employees when they reach the end of their working years and commence retirement.

• Pension funds are commonly run by some sort of financial intermediary for the company and its employees, although some larger corporations operate their pension funds in-house. Pension funds control relatively large amounts of capital and represent the largest institutional investors in many nations.

5. Leasing Companies• A lease or tenancy is the right to use or occupy personal

property or real property given by a lessor to another person (usually called the lessee or tenant) for a fixed or indefinite period of time, whereby the lessee obtains exclusive possession of the property in return for paying the lessor a fixed or determinable consideration (payment).

6. Brokerage Houses

• Stock brokers assist people in investing, online only companies are called 'discount brokerages', companies with a branch presence are called 'full service brokerages' or 'private client services.

Financial Intermediation

• Financial intermediation consists of “channeling funds between surplus and deficit agents”. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans

• As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers).

Kinds of Financial Intermediation• Denomination Intermediation

– When small amounts of savings from individuals and others are collected and pooled so as to give loans to others

• Default-risk intermediation– occurs when financial intermediaries provide loans to risky

borrowers and simultaneously issue relatively safe and liquid securities to attract loanable funds from savers.

• Maturity intermediation– occurs when financial intermediaries borrow short-term

funds from savers and make long- term loans to borrower. Maturity intermediation is most often undertaken by many financial intermediaries.

Financial Products: Mutual Funds• A Mutual Fund is a trust that pools the savings of a number

of investors who share a common financial goal.

• The money thus collected is then invested in capital market instruments such as shares, debentures and other securities.

• The income earned through these investments and the capital appreciation realized are shared by its unit holders in proportion to the number of units owned by them.

• Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

chopra.rajiv@icai.org

Regulations• Governed by SEBI (Mutual Fund) Regulation 1996

– All MFs registered with it, constituted as trusts ( under Indian Trusts Act, 1882)

• Bank operated MFs supervised by RBI too

• AMC registered as Companies registered under Companies Act, 1956

• SEBI- Very detailed guidelines for disclosures in offer document, offer period, investment guidelines etc.– NAV to be declared everyday for open-ended, every week for closed

ended– Disclose on website, AMFI, newspapers– Half-yearly results, annual reports– Select Benchmark depending on scheme and compare

Types of Mutual Fund Schemes• By Structure

– Open-Ended – anytime enter/exit– Close-Ended Schemes – listed on exchange, redemption after period of

scheme is over.

• By Investment Objective– Equity (Growth) – only in Stocks – Long Term (3 years or more)– Debt (Income) – only in Fixed Income Securities (3-10 months)– Liquid/Money Market (including gilt) – Short-term Money Market (Govt.)– Balanced/Hybrid – Stocks + Fixed Income Securities (1-3 years)– Specialized Funds- particular industries, sectors or markets. Eg

Infrastructure funds– International- Only in foreign Markets– Global- Both Foregn and Domestic

• Other Schemes– Tax Saving Schemes– Special Schemes

• ULIP

• By Types of Investors– Some funds differ from other funds

because of investor profile. Pension Fund. These funds manage the pension moneys of their clients.

Advantages of Mutual Fund Schemes• Diversification Benefit

• Improves the risk-return profile of the portfolio• Small investors may not have the amount of capital that would allow optimal

Diversification• Low Transaction Cost

• Transactions are generally large• Large volumes attract lower brokerage commissions as a percentage of the

volume of transaction and other costs as compared to the smaller volumes of the transactions entered into by individual investors

• Availability of Various Schemes• Schemes to suit the requirements of the investors• Choose between regular income schemes and growth schemes, between

schemes that invest in money market and schemes that invest in Stock market• Professional Management

• Continuous monitoring of various securities• Liquidity

• Portfolio vs mutual funds

Disadvantages of Mutual Fund Schemes

• Investors cannot choose the securities they want to invest in or securities they want to sell.

• Investors face the risk of fund managers not performing well.• If Manager’s incentive is linked to the fund he may perform

well in the short run but hamper the long run• Management fees• Investors in Securities can decide the amount of earnings they want to

withdraw in a particular period, investors in MF have no such discretion as the amount of earnings that are to be paid out to the investors in a particular year is decidd by the mutual Fund

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Venture Capital

• Investment in• High risk projects• High return potential projects• Equity related instruments• Unlisted companies

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What is VC?

• Investment in• High risk projects• High return potential projects• Equity related instruments• Unlisted companies

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Types of risk financiers • Regular VCs • Corporate VCs• Angel investors

– An angel investor or angel (also known as a business angel or informal investor) is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity

• Incubators – A firm engaged in the business of fostering early-stage

companies through the developmental phases until such time as the company has sufficient financial, human and physical resources to function on its own.

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Stages of VCs investment

• Seed Stage• Early stage • Later stage• Turnaround

Changing patterns

• Earlier domestic funds• Now more offshore funds• Moved towards

globalisation with Indian funds investing outside and foreign funds investing inside India

• Fund of eg SIDBI, UTI • State governments have

their state specific funds, i.e. KITVEN

Changing trends• Successful entrepreneurs in

US turned financiers, TiE • Successful Indians • Foreign VCs directly

investing in India• NRI entrepreneurs tapping

Indian VC funds• Banks and other institutions

also looking at innovative ways to fund SMEs

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VC investment & exit

InitialMeetings

PrelimnaryProjectReview byVentureCapitalist

Term SheetSigned byVentureCapitalist &Promoters

DueDiligenceReview ofProject

VentureCapitalistwith Funds

PromoterswithProject

LegalDocuments/AgreementSigned

Investmentmade byVentureCapitalistin Project

Mentoring&Monitoringof Project

Divestment& ExitfromProject

Promoters

VentureCapitalist

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What a project must have

• Potential for high growth

• High upside potential• Potential for

extraordinary returns to investor

• Exit route plan

VC looks for

• Team – leadership, multidisciplinary, integrity, competence, domain knowledge

• Project, product, USP• Market, opportunity,

growth expected, barriers to competition

• Exit avenue

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Business Plans

Business plans…• are to be forward looking, based on past

knowledge of promoters and their work experience in the existing or new company

• Must discount revenues expected, account for all expected costs and project expected cash flows

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Due diligence reviews

• Investment decision based on DDR• Business• Market • Accounting• Tax and Legal• Technical• HR

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Term Sheet

• Term sheet is a letter of intent and may or may not be legally binding

• Term sheet terms give a summary of proposed principal terms of investment

• Term sheet is usually subject to satisfactory completion of due diligence reviews

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Term Sheet extract

Type of security Equity Shares

Pre-money valuation Rs. 300 million

Post-money valuation Rs. 400 million

Equity shareholding ofthe company postinvestment

Existing holders ofequity

Stock options pool

VC Investor Limited

abcdef

15%15%10%10% 5% 5%

15%

25%

Amount of investment Rs. 100 million

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Post Venture Capital investment

• Is a partner in the project• Mentors and monitors the project• Hand holds through the investment

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Post VC investment

• Networks on behalf of the investee, provides contacts, opens doors…

• flip side could be perceived as interfering, this depends on VC/entrepreneur relationship

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What a VC does

• Each fund manager mentors only a handful of projects

• While fund size is big, no. of investments cannot be too much, hence project size increases

• Unlike debt/other investor, VC is not silent spectator,often is on the Board of investee company

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VC investment

• Some VCs therefore have separate persons to look at investment and others to look at post investment, monitoring as the skill sets can be different

• Others have the same fund manager looking at project from day one of receiving proposal thru exit from investment

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Mature markets

• Different VCs may target different industries such as:– IT further split into niche areas– Agri related – Bioinformatics– Manufacturing - new materials – Service

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Future of VC in India

• Industry has not grown to meet needs of a variety of entrepreneurs

• Too much money chasing too few projects, in select industries, not in the majority

• Move towards consortium financing, risks spread for a smaller piece of pie

• Many have dropped out and many coming in - churn is there, as players are to get established

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Future of VC in India• Potential is there, needs to be tapped• Lack of appropriately trained persons to manage

funds• General public, including others like bank staff, CAs,

legal advisors etc. not completely aware of finer points of such funding

• The entrepreneurial ecosystem is yet to develop, of course some cities like Bangalore are slowly having a variety of experts in this space

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Future VCs in India

• There are limited takers for smaller projects• Real early stage, high growth, high risk projects,

finding it difficult to raise funding• There are issues of exit and other related issues

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Future VCs in India

• In the recent times some groups have showed interest in getting together those who need funds on the one hand and those who want to invest on the other, including high net worth individuals etc.

• This includes industry groups, academic institutions and other groups