SUBJECT: FINANCIAL SYSTEMS

AUTHOR: Ms Pallavi Kudal

PREFACE
Financial system of a country plays a vital role in economic development of a
country. Financial systems of developing countries differ a lot from that of
developed countries. In developing countries there is variety of social factors
affecting the economy and hence the financial dualism plays an important role in
these countries. The book deals in better understanding of the financial systems in
developing countries like India. Indian financial systems have undergone a
considerable change in recent past.
Since 1991 the Indian economy saw a gradual metamorphosis. It has left the
backwaters and entered the sea of globalization. The book encompasses new
developments in the system and discusses various components such as financial
markets, institutions, instruments, agencies and regulations in an analytical and
critical manner. It is designed so that students have a better insight of the financial
systems of a country right from constitution to methods of raising funds from
domestic and foreign markets, different kinds of financial markets and their
instruments, modern techniques of financing etc. The book is lucid and interactive
in expression and full of cases for better understanding of the text. I express my
heartfelt gratitude to all those who were directly or indirectly associated with the
development of this course material.

Pallavi Kudal

Financial Systems
Course objectives
The objective of this course is to provide an in depth insight and conceptual
understanding to the students of the structure, organization and working of financial
systems.
Course Contents:
Module I:
Introduction to financial systems, importance of financial institutions, role of
financial intermediaries, constituents of financial systems. Financial System and
economic development
Module II :
Financial instruments:
Capital market instruments : Equity, debentures, preference shares, sweat equity
shares, non voting shares.
Money market instruments: Commercial bills, Treasury Bills, Certificate of
deposit, Commercial paper.
Other instruments: FCCB, ADR , GDR
Module III:
Primary market: Meaning , significance and scope, developments of primary
market, various agencies and institutions involved, role of intermediaries,
merchant bankers, registrars, underwriters , bankers to the issue and regulatory
agencies.
Secondary Market : Meaning , significance and scope, secondary market
intermediaries, brokers, sub brokers, functions and operations of secondary
market .
Debt Market: An overview of government securities market, Credit rating
agencies.
Module IV:
Mutual funds
Module V:
Private Foreign Investments: Introduction to Foreign direct Investments, Offshore
funds.
Module VI:
Non Banking Finance Companies: Overview of NBFCs

INDEX

Chapter
No.
1

Subject

Page No

Introduction to Indian Financial Systems

Financial instruments

22

Capital market instruments

45

Mutual funds

88

Private Foreign Investments

104

6
7

Non Banking Finance Companies: Overview of 123

NBFCs
Bibliography
134

Key to Questions

135

9.

Assignments

136

Chapter 1
Topic: Introduction to Indian Financial Systems
Contents:
1.1

Significance and Definition

1.2

The Organisation of the Financial System in India

1.3

Financial Markets

1.4

Interaction among the Components

1.5

Functions of the Financial System

1.6

Financial System Designs

1.7

Financial Markets

1.8

Financial System and Economic Development

1. Introduction to Financial System

A financial system plays a vital role in the economic growth of a country. It
intermediates with the flow of funds between those who save a part of their
income to those who invest in productive assets. It mobilizes and usefully
allocates scarce resources of a country. A financial system is a complex well
integrated set of sub systems of financial institutions, markets, instruments and
services which facilitates the transfer and allocation of funds, efficiently and
effectively.
The financial system is possibly the most important institutional and functional
vehicle for economic transformation. Finance is a bridge between the present and
the future and whether it be the mobilisation of savings or their efficient, effective
and equitable allocation for investment, it is the success with which the financial
system performs its functions that sets the pace for the achievement of broader
national objectives.
1.1 Significance and Definition
The term financial system is a set of inter-related activities/services working
together to achieve some predetermined purpose or goal. It includes different
markets, the institutions, instruments, services and mechanisms which influence
the generation of savings, investment capital formation and growth.
Van Horne defined the financial system as the purpose of financial markets to
allocate savings efficiently in an economy to ultimate users either for investment
in real assets or for consumption. Christy has opined that the objective of the
financial system is to "supply funds to various sectors and activities of the
economy in ways that promote the fullest possible utilization of resources without
the destabilizing consequence of price level changes or unnecessary interference
with individual desires."
According to Robinson, the primary function of the system is "to provide a link
between savings and investment for the creation of new wealth and to permit
portfolio adjustment in the composition of the existing wealth."
From the above definitions, it may be said that the primary function of the
financial system is the mobilisation of savings, their distribution for industrial
investment and stimulating capital formation to accelerate the process of economic
growth.

The process of savings, finance and investment involves financial institutions,

markets, instruments and services. Above all, supervision control and regulation
are equally significant. Thus, financial management is an integral part of the
financial system. On the basis of the empirical evidence, Goldsmith said that "... a
case for the hypothesis that the separation of the functions of savings and
investment which is made possible by the introduction of financial instruments as
well as enlargement of the range of financial assets which follows from the
creation of financial institutions increase the efficiency of investments and raise
the ratio of capital formation to national production and financial activities and
through these two channels increase the rate of growth"
The inter-relationship between varied segments of the economy is illustrated
below:

A financial system provides services that are essential in a modern economy. The
use of a stable, widely accepted medium of exchange reduces the costs of
transactions. It facilitates trade and, therefore, specialization in production.
Financial assets with attractive yield, liquidity and risk characteristics encourage
saving in financial form. By evaluating alternative investments and monitoring the
activities of borrowers, financial intermediaries increase the efficiency of resource
use. Access to a variety of financial instruments enables an economic agent to
pool, price and exchange risks in the markets. Trade, the efficient use of resources,
saving and risk taking are the cornerstones of a growing economy. In fact, the
country could make this feasible with the active support of the financial system.
The financial system has been identified as the most catalyzing agent for growth of
the economy, making it one of the key inputs of development.
1.2 The Organisation of the Financial System in India
The Indian financial system is broadly classified into two broad groups:
(i) Organised sector and (ii) unorganised sector.
"The financial system is also divided into users of financial services and providers.
Financial institutions sell their services to households, businesses and government.
They are the users of the financial services. The boundaries between these sectors
are not always clear cut.
In the case of providers of financial services, although financial systems differ
from country to country, there are many similarities. Major constituents of a
financial system are as follows:
(i) Central bank
(ii) Banks
(iii) Financial institutions
(iv) Money and capital markets and
(v) Informal financial enterprises.
i) Organized Indian Financial System
The organised financial system comprises of an impressive network of banks,
other financial and investment institutions and a range of financial instruments,
which together function in fairly developed capital and money markets. Short term
funds are mainly provided by the commercial and cooperative banking structure.
Nine-tenth of such banking business is managed by twenty-eight leading banks
8

which are in the public sector. In addition to commercial banks, there is the
network of cooperative banks and land development banks at state, district and
block levels. With around two-third share in the total assets in the financial system,
banks play an important role. Of late, Indian banks have also diversified into areas
such as merchant banking, mutual funds, leasing and factoring.
The organised financial system comprises the following sub-systems:
1. Banking system
2. Cooperative system
3. Development Banking system
(i) Public sector
(ii) Private sector
4. Money markets and
5. Financial companies/institutions.
Over the years, the structure of financial institutions in India has developed and
become broad based. The system has developed in three areas - state, cooperative
and private. Rural and urban areas are well served by the cooperative sector as
well as by corporate bodies with national status. There are more than 4,58,782
institutions channellising credit into the various areas of the economy.
ii) Unorganised Financial System
On the other hand, the unorganised financial system comprises of relatively less
9controlled moneylenders, indigenous bankers, lending pawn brokers, landlords,
traders etc. This part of the financial system is not directly amenable to control by
the Reserve Bank of India (RBI). There are a host of financial companies,
investment companies and chit funds etc., which are also not regulated by the RBI
or the government in a systematic manner.
However, they are also governed by rules and regulations and are, therefore within
the orbit of the monetary authorities.
Formal and Informal Financial Systems
The financial systems of most developing countries are characterized by co
existence and co operation between formal and informal financial sectors. This co
existence of two sectors is commonly referred to as financial dualism The
formal financial sector is characterized by the presence of an organized,
institutional and regulated system which caters to the financial needs of the
modern spheres of economy; the informal sector is an unorganized, non-

institutional and non regulated system dealing with the traditional and rural
spheres of the economy.
Components of formal financial system
The formal financial system consists of four segments or components. These are:
Financial Institutions, Financial markets, financial instruments and financial
services.
Financial Institutions: Financial Institutions are intermediaries that mobilize
savings and facilitate the allocation of funds in an efficient manner.
Financial institutions can be classified as banking and non banking financial
institutions. Banking institutions are creators of credit while non-banking financial
institutions are purveyors of credit. While the liabilities of banks are part of the
money supply, this may not be true of non banking financial institutions. Financial
institutions can also be classified as the term finance institutions such as IDBI
(Industrial development bank of India) ICICI (Industrial credit and investment
corporation of India)etc.
1.3 Financial Markets:
Financial markets are the mechanism enabling participants to deal in financial
claims. The markets also provide a facility in which their demands and
requirements interact to set a price for such claims. The main organised financial
markets in a country are normally money market and capital market. The first is
market for short term securities while the second is a market for long term
securities, i.e. securities having maturity period of one year or more.
Financial markets are also classified as primary, market and secondary market.
While the primary market deals in new issues, the secondary market deals for
trading in outstanding or existing securities. There are two components of the
secondary market, OTC (over the counter) market and Exchange traded market.
The government securities market is an OTC market, spot trades are negotiated or
traded for immediate delivery and payment while in the exchange traded market,
trading takes place over a trading cycle in stock exchanges. Derivatives markets
are OTC in some countries and exchange traded in some other countries.
Financial Instrument: A financial instrument is a claim against a person or an
institution for the payment at a future date a sum of money and/or a periodic
payment in the form of interest or dividend. The term and/or implies that either
of the payments will be sufficient but both of them may be promised.

10

Financial securities may be primary or secondary securities. Primary securities are

also termed as direct securities as they are directly issued by the ultimate
borrowers of the funds to the ultimate savers. Examples of primary or direct
securities include equity shares and debentures. Secondary securities are also
referred to as indirect securities, as they are issued by financial intermediaries to
the ultimate savers. Bank deposits, mutual fund units, and insurance policies are
secondary securities.
Financial instruments differ in terms of marketability, liquidity, reversibility, type
of options, return, risk and transaction costs. Financial instruments help the
financial markets and the financial intermediaries to perform the important role of
channelizing funds from lenders to borrowers.
Financial Services: Financial intermediaries provide key financial services such
as merchant banking, leasing, hire purchase, credit-rating, and so on. Financial
services rendered by the financial intermediaries bridge the gap between lack of
knowledge on the part of investors and increasing sophistication of financial
instruments and markets. These financial services are vital for creation of firms,
industrial expansion, and economic growth.
Before investors lend money, they need to be reassured that it is safe to exchange
securities for funds. This reassurance is provided by the financial regulator who
regulates the conduct of the market, and intermediaries to protect the investors
interests. The Reserve Bank on India regulates the money market and Securities
and Exchange Board of India (SEBI) regulates capital market.
1.4 Interaction among the Components
These four sub-systems do not function in isolation. They are interdependent and
interact continuously with each other. Their interaction leads to the development
of a smoothly functioning financial system.
Financial institutions or intermediaries mobilize savings by issuing different types
of financial instruments which are traded in financial markets. To facilitate the
credit allocation process, they acquire specialization and render specialized
financial services.
Financial intermediaries have close links with the financial markets in the
economy. Financial institutions acquire, hold, and trade financial securities which
not only help in the credit-allocation process but also make the financial markets
larger, more liquid, stable and diversified. Financial intermediaries rely on
financial markets to raise funds whenever they are in need of some. This increases
11

the competition between financial markets and financial intermediaries for

attracting investors and borrowers. The development of new sophisticated markets
has led to the development of complex securities and complex portfolios. The
evaluation of these complex securities, portfolios, and strategies requires financial
expertise which financial intermediaries provide through financial services.
1.5 Functions of the Financial System
A good financial system serves in the following ways:
One of the important functions of a financial system is to link the savers and
investors and thereby help in mobilizing and allocating the savings efficiently and
effectively. By acting as an efficient conduit for allocation of resources, it permits
continuous upgradation of technologies for promoting growth on a sustained basis.
A financial system not only helps in selecting projects to be funded but also
inspires the operators to monitor the performance of the investment. It provides a
payment mechanism for the exchange of goods and services and transfers
economic resources through time and across geographic regions and industries.
One of the most important functions of a financial system is to achieve optimum
allocation of risk bearing. It limits, pools, and trades the risks involved in
mobilizing savings and allocating credit. An efficient financial system aims at
containing risk within acceptable limits and reducing the cost of gathering and
analyzing information to assist operators in taking decisions carefully.
It makes available price-related information which is a valuable assistance to those
who need to take economic and financial decisions.
A financial system minimizes situations where the information is asymmetric and
likely to affect motivations among operators or when one party has the
information and the other party does not. It provides financial services such as
insurance and pension and offers portfolio adjustment facilities.
A financial system helps in the creation of a financial structure that lowers the cost
of transactions. This has a beneficial influence on the rate of return to savers. It
also reduces the cost of borrowing. Thus, the system generates an impulse among
the people to save more.
A well-functioning financial system helps in promoting the process of financial
deepening and broadening. Financial deepening refers to an increase of financial
assets as a percentage of Gross Domestic Product (GDP). Financial broadening

12

refers to building an increasing number and a variety of participants and

instruments.
1.6 Financial System Designs:
A financial system is a vertical arrangement of a well-integrated chain of financial
markets and financial institutions for providing financial intermediation. Different
designs of financial systems are found in different countries. The structure of the
economy, its pattern of evolution, and political, technical and cultural differences
affect the design (type) of financial system.
Two prominent polar designs can be identified among the varieties that exist. At
one extreme is the bank-dominated system, such as in Germany, where a few large
banks play a dominant role and the stock market is not important. At the other
extreme is the market-dominated financial system, as in the US, where financial
markets play an important role while the banking industry is much less
concentrated.
In bank-based financial systems, banks play a pivotal role in mobilizing savings,
allocating capital, overseeing the investment decisions of corporate managers, and
providing risk-management facilities. In market based financial systems, the
securities markets share centrestage with banks in mobilizing the societys savings
to firms, exerting corporate control, and easing risk management.
The other major industrial countries fall in between these two extremes. In India,
banks have traditionally been the dominant entities of financial intermediation.
The nationalization of banks, an administered interest rate regime, and the
government policy of favouring banks led to the predominance of a bank-based
financial system in India.
1.7 Financial Markets
Financial markets are an important component of the financial system. A financial
market is a mechanism for the exchange trading of financial products under a
policy framework. The participants in the financial markets are the borrowers
(issuers of securities), lender (buyers of securities), and financial intermediaries.
Financial markets comprise two distinct types of markets:
(a) Money market
(b) Capital market
Money market: A money market is a market for short-term debt instruments
(maturity below one year). It is a highly liquid market wherein securities are
13

bought and sold in large denominations to reduce transaction costs. Call money
market, certificates of deposit, commercial paper, and treasury bills are the major
instruments/segments of the money market.
The function of a money market is
i.
ii.
iii.

To serve as an equilibrating force that redistributes cash balances in

accordance with the liquidity needs of the participants;
To form a basis for the management of liquidity and money in the
economy by monetary authorities; and
To provide a reasonable access to the users of short-term money for
meeting their requirements at realistic prices.
As it facilitates the conduct of monetary policy, a money market
constitutes a very important segment of the financial system.

Capital market: A capital market is a market for long-term securities (equity and
debt). The purpose of capital market is to
i.
ii.
iii.
iv.
v.
vi.

Mobilize long-term savings to finance long-term investments;

Provide risk-capital in the form of equity or quasi-equity to entrepreneurs;
Encourage broader ownership to productive assets;
Provide liquidity with a mechanism enabling the investor to sell financial
assets;
Lower the costs of transactions and information; and
Improve the efficiency of capital allocation through a competitive pricing
mechanism.

A capital market can be further classified into primary and secondary markets.
The primary market is meant for new issues and the secondary market is a
market where outstanding issues are traded. In other words, the primary market
creates long-term instruments for borrowings, whereas the secondary market
provides liquidity through the marketability of these instruments. The
secondary market is also known as the stock market.
Money Market and Capital Market
There is strong link between the money market and the capital market:
i.
ii.

Often, financial institutions actively involved in the capital market are also
involved in the money market.
Funds raised in the money market are used to provide liquidity for longerterm investment and redemption of funds raised in the capital market.

14

iii.

In the development process of financial markets, the development of money

market typically precedes the development of the capital market.

Characteristics of Financial Markets

1. Financial markets are characterized by a large volume of transactions and a
speed with which financial resources move from one market to another.
2. There are various segments of financial markets such as stock markets,
bond markets primary and secondary segments, where savers themselves
decide when and where they should invest money.
3. There is scope of instant arbitrage among various markets and types of
instruments.
4. Financial markets are highly volatile and susceptible to panic and distress
selling as the behavior of a limited group of operators can get generalized.
5. Markets are dominated by financial intermediaries who take investment
decisions as well as risks on behalf of their depositors.
6. Negative externalities are associated with financial markets. A failure in any
one segment of these markets may affect many other segments of the
market, including the non financial markets.
7. Domestic financial markets are getting integrated with worldwide financial
markets. The failure and vulnerability in a particular domestic market can
have international ramifications. Similarly, problems in external markets
can affect the functioning of domestic markets.
In view of the above characteristics, financial markets need to be closely
monitored and supervised.
Functions of Financial Markets
The cost of acquiring information and making transactions creates incentives for
the emergence of financial markets and institutions. Different types and
combinations of information and transaction costs motivate distinct financial
contracts, instruments, and institutions.
Financial markets perform various functions such as
a) Enabling economic units to exercise their time preference;
b) Separation, distribution, diversification, and reduction of risk;
c) Efficient payment mechanism;
d) Providing information about companies. This spurs investors to make
inquiries themselves and keep track of the companies activities with a view
to trading in their stock efficiently;
e) Transmutation or transformation of financial claims to suit the preferences
of both savers and borrowers;
15

f) Enhancing liquidity of financial claims through trading in securities; and

g) Portfolio management.
A variety of services is provided by financial markets as they can alter the rate
of economic growth by altering the quality of these services.
1.8 Financial System and Economic Development
The role of financial system in economic development has been a much discussed
topic among economists. Is it possible to influence the level of national income,
employment, standard of living, and social welfare through variations in the
supply of finance?
In what way financial development is affected by economic development?
There is no unanimity of views on such questions. A recent literature survey
concluded that the existing theory on this subject has not given any generally
accepted model to describe the relationship between finance and economic
development.
The importance of finance in development depends upon the desired nature of
development. In the environment-friendly, appropriate-technology-based,
decentralized Alternative Development Model, finance is not a factor of crucial
importance. But even in a conventional model of modem industrialism, the
perceptions in this regard vary a great deal.
One view holds that finance is not important at all. The opposite view regards it to
be very important. The third school takes a cautionary view. It may be pointed out
that there is a considerable weight of thinking and evidence in favour of the third
view also. Let us briefly explain these viewpoints one by one.
In his model of economic growth, Solow has argued that growth results
predominantly from technical progress, which is exogenous, and not from the
increase in labor and capital. Therefore, money and finance and the policies about
them cannot contribute to the growth process.
Effects of Financial System on Saving and Investment
It has been argued that men, materials, and money are crucial inputs in production
activities. The human capital and physical capital can be bought and developed
with money. In a sense, therefore, money, credit, and finance are the lifeblood of
the economic system. Given the real resources and suitable attitudes, a well-developed financial system can contribute significantly to the acceleration of
16

economic development through three routes. First, technical progress is

endogenous; human and physical capital is its important sources and any increase
in them requires higher saving and investment, which the financial system helps to
achieve. Second, the financial system contributes to growth not only via technical
progress but also in its own right. Economic development greatly depends on the
rate of capital formation. The relationship between capital and output is strong,
direct, and monotonic (the position which is sometimes referred to as capital
fundamentalism). Now, the capital formation depends on whether finance is made
available in time, in adequate quantity, and on favourable terms-all of which a
good financial system achieves. Third, it also enlarges markets over space and
time; it enhances the efficiency of the function of medium of exchange and
thereby helps in economic development.
We can conclude from the above that in order to understand the importance of the
financial system in economic development, we need to know its impact on the
saving and investment processes. The following theories have analyzed this
impact:
(a) The Classical Prior Saving Theory,
(b) Credit Creation or Forced Saving or Inflationary Financing Theory,
(c) Financial Repression Theory,
(d) Financial Liberalisation Theory.
The Prior Saving Theory regards saving as a prerequisite of investment, and
stresses the need for policies to mobilise saving voluntarily for investment and
growth. The financial system has both the scale and structure effect on saving and
investment. It increases the rate of growth (volume) of saving and investment, and
makes their composition, allocation, and utilisation more optimal and efficient. It
activates saving or reduces idle saving; it also reduces unfructified investment and
the cost of transferring saving to investment. How is this achieved? In any
economy, in a given period of time, there are some people whose current
expenditures is less than their current incomes, while there are others whose
current expenditures exceed their current incomes. In well-known terminology, the
former are called the ultimate savers or surplus--spending-units, and the latter are
called the ultimate investors or the deficit-spending-units.
Modern economies are characterized
(a) By the ever-expanding nature of business organisations such as joint-stock
companies or corporations,
(b) By the ever-increasing scale of production,
(c) By the separation of savers and investors, and
(d) By the differences in the attitudes of savers (cautious, conservative, and
usually averse to taking risks) and investors (dynamic and risk takers).

17

In these conditions, which Samuelson calls the dichotomy of saving and

investment, it is necessary to connect the savers with the investors. Otherwise,
savings would be wasted or hoarded for want of investment opportunities, and
investment plans will have to be abandoned for want of savings. The function of a
financial system is to establish a bridge between the savers and investors and
thereby help the mobilisation of savings to enable the fructification of investment
ideas into realities. Figure below reflects this role of the financial system in
economic development.
Relationship between Financial System and Economic Development

A financial system helps to increase output by moving the economic system

towards the existing production frontier. This is done by transforming a given total
amount of wealth into more productive forms. It induces people to hold fewer
saving in the form of precious metals, real estate land, consumer durables, and
currency, and to replace these assets by bonds, shares, units, etc. It also directly
helps to increase the volume and rate of saving by supplying diversified portfolio
of such financial instruments, and by offering an array of inducements and choices
to woo the prospective saver. The growth of banking habit helps to activate
saving and undertake fresh saving. The saving is said to be institution-elastic
18

i.e., easy access, nearness, better return, and other favorable features offered by a
well-developed financial system lead to increased saving.
A financial system helps to increase the volume of investment also. It becomes
possible for the deficit spending units to undertake more investment because it
would enable them to command more capital. As Schumpeter has said, without
the transfer of purchasing power to an entrepreneur, he cannot become the
entrepreneur. Further, it encourages investment activity by reducing the cost of
finance and risk. This is done by providing insurance services and hedging
opportunities, and by making financial services such as remittance, discounting,
acceptance and guarantees available. Finally, it not only encourages greater
investment but also raises the level of resource allocational efficiency among
different investment channels. It helps to sort out and rank investment projects by
sponsoring, encouraging, and selectively supporting business units or borrowers
through more systematic and expert project appraisal, feasibility studies,
monitoring, and by generally keeping a watch over the execution and management
of projects.
The contribution of a financial system to growth goes beyond increasing priorsaving-based investment. There are two strands of thought in this regard.
According to the first one, as emphasized by Kalecki and Schumpeter, financial
system plays a positive and catalytic role by creating and providing finance or
credit in anticipation of savings. This, to a certain extent, ensures the independence
of investment from saving in a given period of time. The investment financed
through created credit generates the appropriate level of income. This in turn leads
to an amount of savings, which is equal to the investment already undertaken. The
First Five Year Plan in India echoed this view when it stated that judicious credit
creation in production and availability of genuine savings has also a part to play in
the process of economic development. It is assumed here that the investment out
of created credit results in prompt income generation. Otherwise, there will be
sustained inflation rather than sustained growth.
The second strand of thought propounded by Keynes and Tobin argues that
investment, and not saving, is the constraint on growth, and that investment
determines saving and not the other way round. The monetary expansion and the
repressive policies result in a number of saving and growth promoting forces:
(a) If resources are unemployed, they increase aggregate demand,
output, and saving;
(b) If resources are fully employed, they generate inflation which lowers
the real rate of return on financial investments. This in turn, induces
portfolio shifts in such a manner that wealth holders now invest
more in real, physical capital, thereby increasing output and saving;

19

(c) Inflation changes income distribution in favour of profit earners

(who have a high propensity to save) rather than wage earners (who
have a low propensity to save), and thereby increases saving; and
(d) Inflation imposes tax on real money balances and thereby transfers
resources to the government for financing investment.
The extent of contribution of the financial sector to saving, investment, and growth
is said to depend upon its being free or repressed (regulated). One school of
thought argues that financial repression and the low/ negative real interest rates
which go along with it encourage people
(i)
To hold their saving in unproductive real assets,
(ii)
To be rent -seekers because of non-market allocation of investible
funds
(iii) To be indulgent which lowers the rate of saving,
(iv) To misallocate resources and attain inefficient investment profile, and
(v)
To promote capital intensive industrial structure inconsistent with the
factor-endowment of developing countries. Financial liberalisation or
deregulation corrects these ill effects and leads to financial as well as
economic development. However, as indicated earlier, some economists
believe that financial repression is beneficial.

20

Review Questions
Multiple Choice Questions
Q1.

Primary function of financial system is :a)

Mobilisation of savings
b)
Increase in GDP.
c)
Poverty alleviation
d)
Unemployment removal

Q2.

The organised financial system comprises of :a)

Banking System
b)
Industrial Lenders
c)
Landlords
d)
Brokers

Q3.

The stock is:a)

Small units of equal value called shares
b)
Expressed in terms of money
c)
Expressed in terms of shares
d)
Fully paid up and partly paid up shares

Q4.

Money Market is :a)

Mobilize long term savings
b)
Market for short term debt instruments
c)
Provide risk capital in form of equity
d)
None of the above

Q5.

Which of these is true for money market & capital market:

a)
Linked with each other
b)
Not linked with each other
c)
Money market does not provide liquidity to capital market
d)
All are true

Q6.

Financial markets are characterized by :a)

Small volume of transactions
b)
High volatility
c)
Lone liquidity
d)
All of above

21

Q7.

Purpose of capital market is:a)

Provide liquidity to market
b)
Mobilise long term savings to finance
c)
Short term debt instruments
d)
Mobilize savings

Q8.

A well functioning financial system helps in promoting:

a)
Process of Policy formulation
b)
Political and technical process
c)
Investors for investment
d)
Process of financial deepening and broadening

Q9.

Intermediaries to financial markets are:a)

Grocery stores
b)
Central Banks
c)
Library
d)
Colleges

Q10. Investment is the :a)

Net additions made to the nations capital stocks.
b)
Persons commitment to buy a flat or a house
c)
Employment of funds on asset to earn returns.
d)
Employment of funds on goods for services that are used in
production process.

22

Chapter 2
Topic: Financial Markets
Contents:
2.1

Financial Markets

2.2

Financial Intermediation

2.3

Financial Instruments
(a) Money Market Instruments
(b) Capital Market Instruments

2.4

Instruments issued outside domestic country (Example of India)

23

2.1 Financial Markets

A Financial Market can be defined as the market in which financial assets are
created or transferred. As against a real transaction that involves exchange of
money for real goods or services, a financial transaction involves creation or
transfer of a financial asset. Financial Assets or Financial Instruments represents a
claim to the payment of a sum of money sometime in the future and /or periodic
payment in the form of interest or dividend.
Money Market- The money market is a wholesale debt market for low-risk,
highly-liquid, short-term instrument. Funds are available in this market for
periods ranging from a single day up to a year. This market is dominated mostly
by government, banks and financial institutions.
Capital Market - The capital market is designed to finance the long-term
investments. The transactions taking place in this market will be for periods over
a year.
Forex Market - The Forex market deals with the multicurrency requirements,
which are met by the exchange of currencies. Depending on the exchange rate that
is applicable, the transfer of funds takes place in this market. This is one of the
most developed and integrated market across the globe.
Credit Market- Credit market is a place where banks, Financial Institutions and
Non Banking Financial Corporations lend short, medium and long-term loans to
corporate and individuals.
Constituents of a Financial System

24

2.2 Financial Intermediation

Having designed the instrument, the issuer should then ensure that these financial
assets reach the ultimate investor in order to garner the requisite amount. When he
borrower of funds approaches the financial market to raise funds, mere issue of
securities will not suffice. Adequate information of the issue, issuer and the
security should be passed on to take place. There should be a proper channel
within the financial system to ensure such transfer. To serve this purpose,
Financial intermediaries came into existence. Financial intermediation in the
organized sector is conducted by a wide range of institutions functioning under the
overall surveillance of the Reserve Bank of India. In the initial stages, the role of
the intermediary was mostly related to ensure transfer of funds from the lender to
the borrower. This service was offered by banks, FIs, brokers, and dealers.
However, as the financial system widened along with the developments taking
place in the financial markets, the scope of its operations also widened. Some of
the important intermediaries operating ink the financial markets include;
investment bankers, underwriters, stock exchanges, registrars, depositories,
custodians, portfolio managers, mutual funds, financial advertisers financial
consultants, primary dealers, satellite dealers, self regulatory organizations, etc.
Though the markets are different, there may be a few intermediaries offering their
services in move than one market e.g. underwriter. However, the services offered
by them vary from one market to another.
Intermediary
Stock Exchange
Investment Bankers
Underwriters
Registrars,
Custodians

Depositories,

Market
Capital Market
Capital Market,
Market
Capital Market,
Market
Capital Market

Primary Dealers Satellite

Money Market
Dealers
Forex Dealers
Forex Market

25

Role
Secondary Market to securities
Credit Corporate advisory services,
Issue of securities
MoneySubscribe to unsubscribed portion
of securities
Issue securities to the investors on
behalf of the company and handle
share transfer activity
Market making in government
securities
Ensure exchange in currencies

2.3 Financial Instruments

2.3 (a) Money Market Instruments
Money market is a very important segment of the financial system of a country. It
is the market dealing in monetary assets of short term nature. Short term funds up
to one year and financial assets that are close substitutes for money are dealt in the
money market.
Features:
The money Market is a whole sale market. The volumes are very large and
generally transactions are settled on daily basis. Trading in the money market is
conducted over the telephone followed by written confirmation from both the
borrowers and lenders. There are large numbers of participants in the money
market: commercial banks, mutual funds, investment institutions, financial
institutions, and finally the central bank of a country. The banks operations ensure
that the liquidity and short term interest rates are maintained at the levels
consistent with the objective of maintaining price and exchange rate stability. The
central bank occupies a strategic position in the money market. The money market
can obtain funds from central bank either by borrowing or through sale of
securities. The bank influences liquidity and interest rates by open market
operations, REPO transactions, changes in Bank Rate , cash Reserve
Requirements and by regulating access to its accommodation. A well developed
money market contributes to an effective implementation of the monetary policy.
Some of the important money market instruments are briefly discussed below;
1.

Call/Notice Money

2.

Treasury Bills

3.

Term Money

4.

Certificate of Deposit

5.

Commercial Papers

26

1. Call /Notice-Money Market

Call/Notice money is the money borrowed or lent on demand for a very short
period. When money is borrowed or lent for a day, it is known as Call (Overnight)
Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus
money, borrowed on a day and repaid on the next working day, (irrespective of the
number of intervening holidays) is "Call Money". When money is borrowed or
lent for more than a day and up to 14 days, it is "Notice Money". No collateral
security is required to cover these transactions.
2. Inter-Bank Term Money
Inter-bank market for deposits of maturity beyond 14 days is referred to as the
term money market. The entry restrictions are the same as those for Call/Notice
Money except that, as per existing regulations, the specified entities are not
allowed to lend beyond 14 days.
3. Treasury Bills
Treasury Bills are short term (up to one year) borrowing instruments of the union
government. It is an IOU of the Government. It is a promise by the Government to
pay a stated sum after expiry of the stated period from the date of issue
(14/91/182/364 days i.e. less than one year). They are issued at a discount to the
face value, and on maturity the face value is paid to the holder. The rate of
discount and the corresponding issue price are determined at each auction.
4. Certificate of Deposits
Certificates of Deposit (CDs) is a negotiable money market instrument and issued
in dematerialized form or as a usance Promissory Note, for funds deposited at a
bank or other eligible financial institution for a specified time period. CDs are
similar to traditional term deposits but are negotiable and can be traded in the
secondary market. It is often a bearer security and there is a single payment
principal and a interest rate at the end of the maturity period. The bulk of the
deposits have a very short duration of 1,3 or 6 months. For long term CDs there is
a fixed coupon or a floating rate coupon. For CDs with floating rate coupons, the
life of CD is subdivided into sub periods of usually six months. Interest is fixed at
the beginning of each period and is based on LIBOR or US Treasury bill rate or
primary rate

27

5. Commercial Paper
CP is a note in evidence of the debt obligation of the issuer. On issuing
commercial paper the debt obligation is transformed into an instrument. CP is thus
an unsecured promissory note privately placed with investors at a discount rate to
face value determined by market forces. CP is freely negotiable by endorsement
and delivery. In India a company shall be eligible to issue CP provided - (a) the
tangible net worth of the company, as per the latest audited balance sheet, is not
less than Rs. 5 crores; (b) the working capital (fund-based) limit of the company
from the banking system is not less than Rs.4 crores and (c) the borrowed account
of the company is classified as a Standard Asset by the financing banks (d) shares
are listed on stock exchange (e) current ratio is 1:33:1. The minimum maturity
period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such
equivalent rating by other agencies.
Usance: Commercial paper should be issued for a minimum period of 30 days and
a maximum of one year. No grace period is allowed for payment and if the
maturity period falls on a holiday it should be paid on the previous working day.
Every issue of commercial paper is treated as a fresh issue.
Denomination: Commercial paper is issued in denomination of Rs 5 lakhs. But
the minimum lot or investment is Rs 25 lakhs (face value) per investor. The
secondary market transactions can be Rs 5 lakhs of multiples thereof. Total
amount to be proposed to be issued should be raised within two weeks from the
date on which the proposal is taken on record by the bank.
Investor: Commercial paper can be issued to any person, banks, companies and
other registered corporate bodies and unincorporated bodies. Issue to NRIs can
only be on a non-repatriable basis and is non transferable. The paper issued to the
NRI should state that it is non-repatriable and non-endorsable
Procedure of Issue: Commercial paper is issued only through the bankers who
have sanctioned working capital limits to the company. It is counted as a part of
working capital. Unlike public deposits, commercial paper really cannot augment
working capital resources. There is no increase in the overall short term borrowing
facilities.
2.3(b) Capital Market Instruments
The capital market generally consists of the following long term period i.e., more
than one year period, financial instruments; in the equity segment Equity shares,
preference shares, convertible preference shares, non-convertible preference shares
28

etc and in the debt segment debentures, zero coupon bonds, deep discount bonds
etc.
Hybrid Instruments
Hybrid instruments have both the features of equity and debenture. This kind of
instruments is called as hybrid instruments. Examples are convertible debentures,
warrants etc.
CAPITAL MARKET INSTRUMENTS
SHARES
Capital refers to the amount invested in the company so that it can carry on its
activities. In a company capital refers to "share capital". The capital clause in
Memorandum of Association must state the amount of capital with which
company is registered giving details of number of shares and the type of shares of
the company. A company cannot issue share capital in excess of the limit specified
in the Capital clause without altering the capital clause of the MA.
The following different terms are used to denote different aspects of share capital:1. Nominal, authorised or registered capital means the sum mentioned in the
capital clause of Memorandum of Association. It is the maximum amount which
the company raises by issuing the shares and on which the registration fee is paid.
This limit is cannot be exceeded unless the Memorandum of Association is altered.
2. Issued capital means that part of the authorised capital which has been offered
for subscription to members and includes shares allotted to members for
consideration in kind also.
3. Subscribed capital means that part of the issued capital at nominal or face value
which has been subscribed or taken up by purchaser of shares in the company and
which has been allotted.
4. Called-up capital means the total amount of called up capital on the shares
issued and subscribed by the shareholders on capital account. I.e if the face value
of a share is Rs. 10/- but the company requires only Rs. 2/- at present, it may call
only Rs. 2/- now and the balance Rs.8/- at a later date. Rs. 2/- is the called up share
capital and Rs. 8/- is the uncalled share capital.
5. Paid-up capital means the total amount of called up share capital which is
actually paid to the company by the members.
29

In India, there is the concept of par value of shares. Par value of shares means the
face value of the shares. A share under the Companies act, can either of Rs10 or
Rs100 or any other value which may be the fixed by the Memorandum of
Association of the company. When the shares are issued at the price which is
higher than the par value say, for example Par value is Rs10 and it is issued at
Rs15 then Rs5 is the premium amount i.e, Rs10 is the par value of the shares and
Rs5 is the premium. Similarily when a share is issued at an amount lower than the
par value, say Rs8, in that case Rs2 is discount on shares and Rs10 will be par
value.
Types of shares: Shares in the company may be similar i.e they may carry the
same rights and liabilities and confer on their holders the same rights, liabilities
and duties. There are two types of shares under Indian Company Law :1. Equity shares means that part of the share capital of the company which are not
preference shares.
2. Preference Shares means shares which fulfill the following 2 conditions.
Therefore, a share which is does not fulfill both these conditions is an equity share.
a. It carries Preferential rights in respect of Dividend at fixed amount or at
fixed rate i.e. dividend payable is payable on fixed figure or percent and
this dividend must paid before the holders of the equity shares can be paid
dividend.
b. It also carries preferential right in regard to payment of capital on winding
up or otherwise. It means the amount paid on preference share must be paid
back to preference shareholders before anything in paid to the equity
shareholders. In other words, preference share capital has priority both in
repayment of dividend as well as capital.
Types of Preference Shares
1. Cumulative or Non-cumulative : A non-cumulative or simple preference shares
gives right to fixed percentage dividend of profit of each year. In case no dividend
thereon is declared in any year because of absence of profit, the holders of
preference shares get nothing nor can they claim unpaid dividend in the
subsequent year or years in respect of that year. Cumulative preference shares
however give the right to the preference shareholders to demand the unpaid
dividend in any year during the subsequent year or years when the profits are
available for distribution . In this case dividends which are not paid in any year are
accumulated and are paid out when the profits are available.
2. Redeemable and Non- Redeemable : Redeemable Preference shares are
preference shares which have to be repaid by the company after the term of which
30

for which the preference shares have been issued. Irredeemable Preference shares
means preference shares need not repaid by the company except on winding up of
the company. However, under the Indian Companies Act, a company cannot issue
irredeemable preference shares. In fact, a company limited by shares cannot issue
preference shares which are redeemable after more than 10 years from the date of
issue. In other words the maximum tenure of preference shares is 10 years. If a
company is unable to redeem any preference shares within the specified period, it
may, with consent of the Company Law Board, issue further redeemable
preference shares equal to redeem the old preference shares including dividend
thereon. A company can issue the preference shares which from the very
beginning are redeemable on a fixed date or after certain period of time not
exceeding 10 years provided it comprises of following conditions :1. It must be authorised by the articles of association to make such an issue.
2. The shares will be only redeemable if they are fully paid up.
3. The shares may be redeemed out of profits of the company which otherwise
would be available for dividends or out of proceeds of new issue of shares
made for the purpose of redeem shares.
4. If there is premium payable on redemption it must have provided out of
profits or out of shares premium account before the shares are redeemed.
5. When shares are redeemed out of profits a sum equal to nominal amount of
shares redeemed is to be transferred out of profits to the capital redemption
reserve account. This amount should then be utilised for the purpose of
redemption of redeemable preference shares. This reserve can be used to
issue of fully paid bonus shares to the members of the company.
3. Participating Preference Share or non-participating preference shares:
Participating Preference shares are entitled to a preferential dividend at a fixed rate
with the right to participate further in the profits either along with or after payment
of certain rate of dividend on equity shares. A non-participating share is one which
does not such right to participate in the profits of the company after the dividend
and capitals have been paid to the preference shareholders.
Sweat Equity and Employee Stock Options
Sweat Equity Shares mean equity shares issued by the company to its directors
and / or employees at a discount or for consideration other than cash for providing
know how or making available the rights in the nature of intellectual property
rights or value additions. A company may issue sweat equity shares of a class of
shares already issued if the following conditions are fulfilled:31

i.
ii.

A special resolution to the effect is passed at a general meeting of the

company
The resolution specifies the number of shares, the current market price,
consideration, if any, and the class of employees to whom the shares are to
be issued

iii.

At least 1 year has passed since the date on which the company became
eligible to commence business.

iv.

In case of issue of such shares by a listed company, the Sweat Equity

Shares are listed on a recognized stock exchange in accordance with SEBI
regulations and where the company is not listed on any stock exchange, the
the prescribed rules are complied with.

DEBENTURES
A type of debt instrument that is not secured by physical asset or collateral.
Debentures are backed only by the general creditworthiness and reputation of the
issuer. Both corporations and governments frequently issue this type of bond in
order to secure capital. Like other types of bonds, debentures are documented in
an indenture.
Debentures have no collateral. Bond buyers generally purchase debentures based
on the belief that the bond issuer is unlikely to default on the repayment. An
example of a government debenture would be any government-issued Treasury
bond (T-bond) or Treasury bill (T-bill). T-bonds and T-bills are generally
considered risk free because governments, at worst, can print off more money or
raise taxes to pay these types of debts.
A debenture is a long-term debt instrument used by governments and large
companies to obtain funds. It is defined as "any form of borrowing that commits a
firm to pay interest and repay capital. In practice, these are applied to long term
loans that are secured on a firm's assets. Where securities are offered, loan stocks
or bonds are termed 'debentures' in the UK or 'mortgage bonds' in the US.
The advantage of debentures to the issuer is they leave specific assets burden free,
and thereby leave them open for subsequent financing. Debentures are generally
freely transferable by the debenture holder. Debenture holders have no voting
rights and the interest given to them is a charge against profit
There are two types of debentures:
1. Convertible Debentures, which can be converted into equity shares of the
issuing company after a predetermined period of time.
32

2. Non-Convertible Debentures, which cannot be converted into equity shares of

the liable company. They usually carry higher interest rates than the convertible
ones
A convertible note (or, if it has a maturity of greater than 10 years, a "convertible
debenture") is a type of bond that can be converted into shares of stock in the
issuing company or cash of equal value, at some pre-announced ratio. It is a hybrid
security with debt- and equity-like features. Although it typically has a low coupon
rate, the holder is compensated with the ability to convert the bond to common
stock at an agreed upon price and thereby participate in further growth in the
company's equity value.
From the issuer's perspective, the key benefit of raising money by selling
convertible bonds is a reduced cash interest payment. However, in exchange for
the benefit of reduced interest payments, the value of shareholder's equity is
reduced due to the stock dilution expected when bondholders convert their bonds
into new shares.
The convertible bond markets in the United States and Japan are of primary global
importance. These two domestic markets are the largest in terms of market
capitalization. Other domestic convertible bond markets are often illiquid, and
pricing is frequently non-standardised.

USA: It is a highly liquid market compared to other domestic markets.

Domestic investors have tended to be most active within US convertibles
Japan: In Japan, the convertible bond market is relatively more regulated
than other markets. It consists of a large number of small issuers.
Europe: Convertible bonds have become an increasingly important source
of finance for firms in Europe. Compared to other global markets, European
convertible bonds tend to be of high credit quality.
Asia (ex Japan): The Asia region provides a wide range of choice for an
investor. The maturity of Asian convertible bond markets varies widely.
Canada: Canadian convertible bonds are exchange traded. Most of the
Canadian convertible bond market consists of unsecured sub-investment
grade bonds with high yields that are reflective of the issuer's risk of
default.

Non Convertible Debentures are those that cannot be converted into equity shares
of the issuing company, as opposed to Convertible debentures, which can be. Nonconvertible debentures normally earn a higher interest rate than convertible
debentures do.
Bonds
33

In finance, a bond is a debt security, in which the authorized issuer owes the
holders a debt and is obliged to repay the principal and interest (the coupon) at a
later date, termed maturity.
A bond is simply a loan in the form of a security with different terminology: The
issuer is equivalent to the borrower, the bond holder to the lender, and the coupon
to the interest. Bonds enable the issuer to finance long-term investments with
external funds. Note that certificates of deposit (CDs) or commercial paper are
considered to be money market instruments and not bonds.
Bonds and stocks are both securities, but the major difference between the two is
that stock-holders are the owners of the company (i.e., they have an equity stake),
whereas bond-holders are lenders to the issuing company. Another difference is
that bonds usually have a defined term, or maturity, after which the bond is
redeemed, whereas stocks may be outstanding indefinitely.
Issuing bonds
Bonds are issued by public authorities, credit institutions, companies and
supranational institutions in the primary markets. The most common process of
issuing bonds is through underwriting. In underwriting, one or more securities
firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer
and re-sell them to investors. Government bonds are typically auctioned.
Features of bonds
The most important features of a bond are:

Nominal, principal or face amountthe amount on which the issuer pays

interest, and which has to be repaid at the end.

Issue pricethe price at which investors buy the bonds when they are first
issued, typically $1,000.00. The net proceeds that the issuer receives are
calculated as the issue price, less issuance fees, times the nominal amount.

Maturity datethe date on which the issuer has to repay the nominal
amount. As long as all payments have been made, the issuer has no more
obligations to the bond holders after the maturity date. The length of time
until the maturity date is often referred to as the term or tenure or maturity
of a bond. The maturity can be any length of time, although debt securities
with a term of less than one year are generally designated money market
instruments rather than bonds. Most bonds have a term of up to thirty years.
Some bonds have been issued with maturities of up to one hundred years,
and some even do not mature at all. In early 2005, a market developed in
34

Euros for bonds with a maturity of fifty years. In the market for U.S.
Treasury securities, there are three groups of bond maturities:
o short term (bills): maturities up to one year;
o medium term (notes): maturities between one and ten years;
o long term (bonds): maturities greater than ten years.

Couponthe interest rate that the issuer pays to the bond holders. Usually
this rate is fixed throughout the life of the bond. It can also vary with a
money market index, such as LIBOR, or it can be even more exotic. The
name coupon originates from the fact that in the past, physical bonds were
issued which had coupons attached to them. On coupon dates the bond
holder would give the coupon to a bank in exchange for the interest
payment.

Coupon datesthe dates on which the issuer pays the coupon to the bond
holders. In the U.S., most bonds are semi-annual, which means that they
pay a coupon every six months. In Europe, most bonds are annual and pay
only one coupon a year.

Indentures and Covenantsan indenture is a formal debt agreement that

establishes the terms of a bond issue, while covenants are the clauses of
such an agreement. Covenants specify the rights of bondholders and the
duties of issuers, such as actions that the issuer is obligated to perform or is
prohibited from performing. In the U.S., federal and state securities and
commercial laws apply to the enforcement of these agreements, which are
construed by courts as contracts between issuers and bondholders. The
terms may be changed only with great difficulty while the bonds are
outstanding, with amendments to the governing document generally
requiring approval by a majority (or super-majority) vote of the
bondholders.

Difference between bond & debenture

Debentures and Bonds
Debentures and bonds are similar, but bonds are more secure than debentures. In
the case of both, the company pays you a guaranteed interest that does not change
in value irrespective of the fortunes of the company. However, bonds are more
secure than debentures, and carry a lower interest rate. In the case of bonds, the
company provides collateral for the loan. Moreover, in case of liquidation,
bondholders will be paid off before debenture holders.

35

2.4 INSTRUMENTS ISSUED OUTSIDE DOMESTIC COUNTRY (Example of

INDIA)
Foreign Currency Convertible Bond (FCCB)

A type of convertible bond (debt instrument) issued in a currency different

than the issuer's domestic currency.

In other words, the money being raised by the issuing company is in the
form of a foreign currency.

A convertible bond is a mix between a debt and equity instrument. It acts

like a bond by making regular coupon and principal payments, but these
bonds also give the bondholder the option to convert the bond into stock.
These types of bonds are attractive to both investors and issuers.

The investors receive the safety of guaranteed payments on the bond and
are also able to take advantage of any large price appreciation in the
company's stock. (Bondholders take advantage of this appreciation by
means warrants attached to the bonds, which are activated when the price of
the stock reaches a certain point.)

Due to the equity side of the bond, which adds value, the coupon payments
on the bond are lower for the company, thereby reducing its debt-financing
costs.

The pricing of FCCB options is generally at a 30% -70% premium over the
prevailing market price giving sufficient cushion to the issuer.

The FCCB holder opts to convert the FCCB, in case the market price
exceeds the option price or if there is an intention to make a strategic
investment by the lender irrespective of the stock price in market.

In many cases, the FCCB issuer may also look forward for conversion so
that there is no fund outflow on redemption. Instead, the issuers reserves
are inflated by receipt of premium.

If however, the FCCB holders do not opt for conversion, the Issuer has
36

either to reissue the bonds to same holder or redeem.

The interest component or coupon on FCCBs is generally 30%40% less

than on normal debt paper or foreign currency loans or ECBs. This
translates to cost saving of approx 2-3 percent p.a. The yield-to-maturity
(YTM) in case of FCCBs normally ranges from 2 to 7%.

The FCCB issue proceeds need to confirm to external commercial

borrowing end use requirements. In addition, 25 per cent of the FCCB
proceeds can be used for general corporate restructuring.

Global Depositary Receipt (GDR)

Global Depository Receipt means any instrument in the form of a depository
receipt or certificate created by the overseas depository bank outside India and
issued to non-resident investors against the issue of ordinary shares or Foreign
Currency Convertible Bonds of issuing company.
Among the Indian Companies, Reliance Industries Ltd. was the first company to
raise funds through a GDR issue.
Benefits and Uses of a GDR
Benefits to An Issuing Company
Currently, there are over 1600 Depository Receipt programmes for companies
from over 60 countries. Companies have round that the establishment of a
depository receipt programme offers numerous advantages. The primary reasons
why a company would establish a depository receipt programme can be divided
into. The following are the considerations behind issue of GDRs:
Access to capital markets outside the home market to provide a mechanism
for raising capital or as a vehicle for an acquisition.
Enhancement of company visibility by. enhancement of image of the
companys products, services or financial instruments in a marketplace
outside its home country.
Expanded shareholder base which may increase or stabilize the share price.
May increase local share, price as a result of global demand/ trading
through a broadened and a more diversified investor exposure.
Increase potential liquidity by enlarging the market for the companys
shares.
Adjust share price to trading market comparables through ratio.
37

 Enhance shareholder communications and enable employees to invest

easily in the parent company.
Benefits to an Investor
Increasingly investors aim to diversify their portfolios internationally. Obstacles,
however, such as undependable settlements, costly currency conversions,
unreliable custody services, poor information flow, unfamiliar market practices,
confusing tax conventions and internal investment policy may discourage
institutions and private investors from venturing outside their local market. A5
negotiable securities, depository receipts are usually quoted in US dollars and pay
dividends or interest in US dollars. Deposit receipts overcome obstacles that
mutual funds, pension funds and other institutions may have in purchasing and
holding securities outside of their local market. Global custodian safe keeping
charges are eliminated, saving depository receipt investors 10 to 40 basis points
annually. Dividends and other cash distributions are converted into dollars at
competitive foreign exchange rates. Depository receipts are as liquid as the
underlying securities because the two are interchangeable.
Thus, the advantages of GDRs to the investor are
They facilitate diversification into foreign securities.
Trade, clear and settle in accordance with requirements of the market in
which they trade.
Eliminate custody charges.
Can be easily compared to securities of similar companies.
Permit prompt dividend payments and corporate action notifications.
If DRs are exchange listed, investors also benefit from accessibility of price
and trading information and research. In addition to the benefits DRs have
to offer to the issuing company and the investor, they are also increasingly
being used by governments to facilitate the process of privatization. They
have also been used to raise capital in the process of acquisition of other
companies by the issuer.
Characteristics

Global Depository Receipt (GDR) - certificate issued by international bank,

which can be subject of worldwide circulation on capital markets.

A financial instrument used by private markets to raise capital denominated

in either U.S. dollars or euros.

38

GDR's are emitted by banks, which purchase shares of foreign companies

and deposit it on the accounts.
Global Depository Receipt facilitates trade of shares, especially those from
emerging markets. Prices of GDR's are often close to values of related
shares.

Indian companies are allowed to raise equity capital in the international

market through the issue of GDR/ADRs/FCCBs.

These are not subject to any ceilings on investment.

An applicant company seeking Government's approval in this regard should

have a consistent track record for good performance (financial or
otherwise) for a minimum period of 3 years. This condition can be relaxed
for infrastructure projects such as power generation, telecommunication,
petroleum exploration and refining, ports, airports and roads.

There is no restriction on the number of GDRs/ADRs/FCCBs to be floated

by a company or a group of companies in a financial year.

There are no end-use restrictions on GDRs/ADRs issue proceeds, except for

an express ban on investment in real estate and stock markets.

American Depositary Receipt (ADR)

An American Depositary Receipt (or ADR) represents ownership in the

shares of a foreign company trading on US financial markets.

The stock (shares) of many non-US companies trades on US exchanges

through the use of ADRs.

ADRs enable US investors to buy shares in foreign companies without

undertaking cross-border transactions.

ADRs carry prices in US dollars, pay dividends in US dollars, and can be

traded like the shares of US-based companies.

Each ADR is issued by a US depositary bank and can represent a fraction of

a share, a single share, or multiple shares of foreign stock.

39

An owner of an ADR has the right to obtain the foreign stock it represents,
but US investors usually find it more convenient simply to own the ADR.

The price of an ADR is often close to the price of the foreign stock in its
home market, adjusted for the ratio of ADRs to foreign company shares.

Depositary banks have numerous responsibilities to an ADR holder and to

the non-US company the ADR represents. The largest depositary bank is
the Bank of New York.

The first ADR was introduced by JP Morgan in 1927, for the British
retailer Selfridges Co.

Norms for issue of ADR, GDR (Indian context)

Indian bidders allowed raising funds through ADRs, GDRs and external
commercial borrowings (ECBs) for acquiring shares of PSEs in the first
stage and buying shares from the market during the open offer in the second
stage.

Companies have been allowed to invest 100 per cent of the proceeds of
ADR/GDR issues (as against the earlier ceiling of 50%) for acquisitions of
foreign companies and direct investments in joint ventures and wholly
owned subsidiaries overseas.

Any Indian company which has issued ADRs/GDRs may acquire shares of
foreign companies engaged in the same area of core activity upto $100
million or an amount equivalent to ten times of their exports in a year,
whichever is higher. Earlier, this facility was available only to Indian
companies in certain sectors.

FIIs can invest in a company under the portfolio investment route upto 24
per cent of the paid-up capital of the company. It can be increased to 40%
with approval of general body of the shareholders by a special resolution.
This limit has now been increased to 49% from the present 40%.
External Commercial Borrowings (ECB) includes:

1.
2.
3.

Commercial Bank Loans,

Buyers Credit,
Suppliers Credit,
40

4.
5.
6.
7.

Securitized Instruments Such As Floating Rate Notes, Fixed Rate Bonds

Etc.
Credit From Official Export Credit Agencies,
Commercial Borrowings From The Private Sector Window Of
Multilateral Financial Institutions e.g. IFC
Investment By Foreign Institutional Investors (FIIs) In Dedicated Debt
Funds.

Characteristics of ECBs

ECB can be raised from any internationally recognized source like banks,
export credit agencies, suppliers of equipment, foreign collaborations,
foreign equity - holders, international capital markets etc.

ECBs can be used for any purpose (rupee-related expenditure as well as

imports) except for investment in stock market and speculation in real
estate.

They are a source of finance for Indian corporates for expansion of existing
capacity as well as for fresh investment.

ECBs provided an additional source of funds to the Indian companies,

allowing them to supplement domestically available resources and to take
advantage of lower international interest rates.

The focus of the ECB policy is to provide flexibility in borrowings by

Indian corporates, and at the same time maintain prudent limits for total
external borrowings.

The guiding principles of the policy are to keep borrowing maturities long,
costs low, and encourage infrastructure and export sector financing, which
are crucial for the overall growth of the economy.

ECB entitlement for new projects

All infrastructure and Greenfield
50% of the total project cost
projects
Telecom Projects

Upto 50% of the project cost (including

license fees)

41

42

SELECTION OF INSTRUMENTS-case study of INDIAN COMPANIES

Capital issue management is concerned with the management of issues for raising funds
through various types of instruments by the companies. Management of capital issues in
India is a professional service rendered by merchant bankers. In fact, a major function of
merchant bankers is issue management. This can be attributed to the tremendous growth of
public listed companies in number and size and the complexity arising due it the everincreasing SEBI guidelines and requirements. The issue can be a public issue through
prospectus, a rights (offer of sale) issue or private placement and so on. Issue management
involves the following function in respect of issues through prospectus:

1.
2.
3.
4.
5.
6.
7.
8.

Obtaining approval for the issue from the SEBI

Arranging underwriting for the proposed issue.
Drafting and finalizing of the prospectus and obtaining its clearance from the
various agencies concerned.
Drafting and finalization of other documents such as applications, forms,
newspaper advertisements and other statutory requirements.
Selection of registrar to the issues, printing press, advertising agencies,
brokers and bankers to the issue and finalization of the fees and charges to be paid to
them.
Arranging for the press conference and the investors conferences.
Coordinating printing, publicity and other work so as to get every thing ready
at the time of the public issue.
Complying with the SEBI guidelines after the issue is over (both in case of
over subscription or devolvement), by sending the various reports as required by the
authorities.

The procedure and steps for managing public issues fall under two phases: (1) pre-issue
management commencing with structuring of issues and up to the opening of subscription
list; (2) post issue management up to listing of securities on the stock exchange. The
management of capital issues in both the phases is regulated and monitored by the SEBI
through regulations, guidelines and so on. The present article dwells on the merchant
banking activities relating to capital issues in the form of public and rights issues.
Pre-Issue Job / Activity Card:
For public Issues

43

1) Prepare the project report after preliminary discussions with promoters. The
documents required from the promoters are to be annexed.
2) Fill the questionnaire meant to be filled by the lead manager to assess the
authenticity of the project.
3) The project report and the findings from the filled questionnaire to be filed before
the Board of Directors/Issue Acceptance Committee.
4) Finalization of the lead manager(s) is done and Memorandum of Understanding
(MOU) and inter se (if more than 1 merchant bankers are acting as lead manager
to the issue).
5) Check for the appraisal, if already done or not. If not done, then get it done, if so
required.
6) Memorandum of Association (MOA) after making desirable changes and Articles
of Association (AOA) are sent to the stock exchanges where the listing is
to be made.
7) Site visit is made and the promoter is made to fill the questionnaire
Preparation of the draft prospectus:
(a) A copy of draft prospectus is annexed (Annexure5)
(b)Auditors
report
and
tax
benefits
certificate
is
obtained.
(c)Permission from RBI is sought for allotment to NRIs, if any
(d)Other documents and permission are applied for, as required.
(e) Finalization of the registrar
(f) Legal advisor clear the issue
(g) Filing of draft prospectus with the SEBI and the stock exchanges where the listing
is sought.
8) Terms loans/working capital limits/inter-corporate deposits are arranged. Float
firm allotments for NRIs, MFs, FIIs and FIs.
9) Consent from directors and power of attorney to sign/correct the prospectus is
obtained. Corrections are made as per the queries sent by the SEBI and the stock
exchanges where the draft prospectus was sent and again file it with the SEBI as
per the required suggestions.
10) The form of getting the securities listed are filled for various stock exchanges and
filed along with the demand draft of Rs 7,500 the copy of initial listing
application form and the necessary documents.

44

Review Questions
Multiple Choice Questions
Q1.

Primary and Secondary Markets:

a) Complete with each other
b) Complement each other
c) Function independently
d) Control each other

Q2.

Commercial papers are:

a) Unsecured promissory notes
b) Secured promissory notes
c) Sold at a premium
d) Issued for a period of 1 to 2 years

Q3.

Which of the following is not a money market security?

a) Telephone Bills
b) Commercial Paper
c) Equity shares
d) Certificate of deposits

Q4.

Money markets can broadly be characterized as:

(a) wholesale markets
(b) direct markets
(c) primary markets
(d) indirect markets
(e) secondary markets

Q5.

In the money market:

(a) Money is traded.
(b) Short-term bonds are traded.
(c) Long-term bonds are traded.
(d) Stocks are traded.

Q6.

Financial securities are assets for the __________ and liabilities for the
_________.
(a) issuer, buyer.
(b) buyer, issuer.
(c) grantor, grantee.
(d) brokerage house, client.

45

Q7. Money market instruments do not include:

(a) Repos.
(b) Bankers acceptances.
(c) Commercial paper.
(d) Financial derivatives.
(e) U.S. Treasury bills.
(f) Loans through the federal funds market.
(g) Short term negotiable certificates of deposit.
Q8.

Money market instruments have maturity of less than:

(a) 90 days.
(b) six months.
(c) one year.
(d) ten years.

Q9.

The best-known capital market securities are.

(a) CDs and stocks.
(b) Mutual funds and bonds.
(c) Commodities and futures.
(d) Stocks and bonds.
(e) Puts and calls.

Q10. Bonds secured by tangible non-real estate property are called:

(a) Secured bonds.
(b) Collateralized bonds
(c) Mortgage bonds
(d) Equipment trust certificates.

46

Chapter 3
Topic: Financial Markets in India
Contents:

3.1

Primary market

3.2

Primary Market and Secondary Market: Difference

3.3

Methods of floatation of new issue

3.4

Parties involved in the Issue

3.5

Secondary Market

3.6

Some Basic Terminologies of stock market

3.7

Debt Instruments

47

3.1 Primary market

Introduction
The capital market is the market for long term funds. Capital markets discharge
the important function of transfer of savings , specially of household sector to
companies, governments and public sector bodies. Individuals or households with
surplus money invest their savings in exchange for shares, debentures and
securities of such companies and governments. The market for such long term
sources of finance (equity and debt ) is primary market. In the primary market,
new issues of equity and debentures are arranged in the form of new floatation,
either publicly or privately in form of a rights offer, to existing share holders.
Companies raise new cash in exchange for financial;; claims. The financial claims
may take the form of shares or debentures. Public sector undertakings also issue
share securities. The transactions in primary market result in capital formation.
The primary market consists of new issue market in which new securities are sold
by public limited companies through public issue of debt or equity and financing
through venture capitalists.
The venture capital firm (a new financial intermediary which emerged in the early
eighties) provides substantial amounts of capital mostly through equity purchases
and occasionally through debt offerings to help growth oriented firms to develop
and succeed.
3.2 PRIMARY MARKET AND SECONDARY Market: Difference
The Securities Market is divided into two segmentsthe Primary Market and the
Secondary Market. The main difference between these two lies in the facts that
while the former deals with the securities, which the issuer issues for the first time,
the latter deals in the existing securities.
Thus, the primary market facilitates the transfer of investible funds of the savers to
the corporates, which need them for - productive purposes. In the Secondary
Market, no new securities come into existence, rather the existing securities
change hands-one set of persons invest in them, while the other group disinvests.
The Primary Market, also called the New Issue Market, is of vital importance in
the economv of a country, as it leads to better utilisation of otherwise inactive
dormant monetary resources in the economy, These two markets are not isolated
from each other, rather they are very much inter-dependent. Activities in the new
issues market and the response of the investors to the near issues of securities
depend upon the prevailing conditions in the Secondary Market. If the secondary
48

market is vibrant and booming, issues of new securities in the Primary Market will
be easily able to mobilise support of a large number of investors and vice-versa.

Public issue of securities

Public issue of shares or debentures is made in the primary market. Funds
mobilized through the primary market constitute investment. There is no market
place for issue of new securities. They are literally offered to public through issue
of prospectus and public subscribes to them directly. Wide publicity about the
offers of course, made through different media newspapers, periodicals and
television. The intermediaries who organize the entire operation are merchant
bankers. Earlier, stock brokers used to organize the issue of shares to public. Now
merchant bankers facilitate the issue of new shares to the market.
3.3 Methods of floatation of new issue
There are three ways in which a company may raise capital in the primary market.
i)
ii)
iii)

Public Issue
Rights Issue
Private Placement

49

Public Issue
The most important mode of issuing securities is by issuing prospectus to the
public. If the issue has been made for the first time, by a corporate body, it is
known as Initial Public Offer (IPO).
The procedure followed in cases of public issue is as follows:
Invitation to subscribe the share is made through a document called 'prospectus'.
The applications on the prescribed form, along with application money, are invited
by the company. The subscription list is open for a period of 3 to 7 days.
No allotment can be made unless, the amount stated in the prospectus as the
minimum subscription has been subscribed, and the company has received sum
payable on application. Minimum subscription refers to the number of shares,
which should be subscribed. As per the SEBI guidelines, minimum subscription
has been fixed at 90% of entire public issue. Generally, the amount is mobilized in
two installments application money and allotment money. If the full amount is not
asked for at the time of allotment itself, the balance is called up in one or two calls
thereafter known as call money. The letter of allotment sent by the company is
exchangeable far share certificates. If the allottee fails to pay the calls, his shares
are liable to be forfeited. In that case, allottee is not eligible for any refund. The
public issue may also be underwritten by an underwriter.

50

Underwriting is not mandatory now. Underwriter gives an undertaking, to the

issuing company to take the unsubscribed shares. This is called devolvement of
shares on the underwriter for which they are paid a commission.
Rights Issue
A rights issue involves selling securities in the primary market by issuing rights to
the existing shareholders. In this method the company gives the privilege to its
existing shareholders for the subscription of the new shares on prorata basis. A
company making a rights issue sends a letter of offer along with a composite
application form consisting of four parts A, B, C, and D. Part A is meant for
acceptance of the offer. Part B is used if the shareholder wants to renounce his
rights in favour of someone else. Part C is filled by the person in whose favour the
renunciation has been made. Part D is used to request the split of the shares.
The composite application form must be mailed to the company within a stipulated
period, which is usually 30 days. The shares that remain unsubscribed will be
offered to the public for subscription. Sometimes an existing company, can come
out with a simultaneous 'Right cum Public Issue'.
The important characteristics of rights issue are:
1) The number of shares offered on rights basis to each existing shareholder is
determined by the issuing company. The entitlement of the existing shareholder
is determined on the basis of existing shareholding. For example one Rights
share may be offered for every 2 or 3 shares held by the shareholder.
2) The issue price per Rights share is left to the discretion of the company.
3) Rights are negotiable. The holder of rights can transfer these rights shares to
any other person, i.e. he can renounce his right to subscribe to these shares in
favour of any other person, who can apply to the company for the allotment of
these shares in his name.
4) Rights can be exercised during a fixed period, which is usually 30 days. If it is
not exercised within this period, it automatically lapses.
Private Placement
A Public Issue is a costly affair involving Press advertisements, brokers, fees and
Press conference, etc. Therefore, some of the companies find it easy and cheaper
to raise funds through private placement of bonds and shares.
In this method, the securities are issued to some selected investors like banks or
financial institutions. The private placement agreement is undertaken when the
issue size is not very big and the issuer does not want to spend much on floating

51

the issue. Private placement market has grown phenomenally. During the last few
years in India, the rate of growth of private placements has been higher than public
issues as well as right issues because of following advantages:
i) Accessibility: Whether it is a public limited company, or a private limited
company, or whether it is listed company or an unlisted one, it can easily
access the private placement market. It can accommodate issues of smaller
size, whereas public issue does not permit issue below a certain minimum size.
ii) Flexibility: There is a greater flexibility in working out the terms of issue. A
private placement results in the sale of securities by a company to one or few
investors. In case of private placement, there is no need for a formal prospectus
as well as under-writing arrangements. Generally, the terms of the issue are
negotiated between the company (issuing securities) and the investors. When a
nun-convertible debenture issue is privately placed, a discount may be given to
institutional investor to make the issue attractive.
iii) Speed: The time required, for completing a public issue is generally 6 months
or More because of several formalities that have to be gone through. On the
other hand, a private placement requires lesser time.
iv) Lower Issue Cost: A public issue entails several statutory and non-statutory
expenses associated with underwriting, brokerages etc. The sum of these costs
used to work out even up to 10 percent of issue. For a company going for a
private placement it is substantially less.
FIXATION OF PREMIUM (Indian perspective)
Companies are allowed to issue their securities at par, at a premium or at a
discount. When the issue price is equal to the face value of the security, it is issued
at par, if the former exceeds the latter, it is issued at a premium, and in the reverse
condition at a discount. The amount charged from the investors above the face
value is called 'Premium. For example, if the share of the face value of Rs. 10, is
issued for Rs. 15, the extra amount of Rs. 5/- is called Premium. Till May 1992,
companies were required to seek the permission of the Controller of Capital
Issues, under the Control on Capital Issues Act, to issue capital above the
permitted amount. The amount of premium was also determined by the Controller
of Capital Issues, taking into account various facts relating to the Company's
functioning.
In May 1992, the above Act was repealed and instead the Securities and Exchange
Board of India (SEBI, Regulatory authority for stock market operations in India)
was empowered to exercise control over the new issues market as well. The SEBI
subsequently permitted the companies to determine the premium themselves.
However, SEBI issued guidelines in this regard, which divided the companies into
three categories, and within each category, companies which fulfilled conditions of
52

consistent profit for specific number of years are permitted to charge premium.
Rest of them is permitted to issue the shares at par only. This led to great rush in
the new issues market and companies charged heavy premium for their issues.
Book Building Process
A new system to determine the amount of premium to be charged by a company
on its new issues was introduced in October 1995, when SEBI permitted the
system known as 'Book Building'. It is a pricing mechanism wherein new issues
are priced on the basis of demand feedback. Under this system, the price of the
new issue is based on real time feedback from the investors.
The mechanism adopted under the Book Building is as follows:
a A draft prospectus containing all information, except the price and the number
of securities, is filed by the Company with SEBI.
A lead merchant banker to the issue is appointed as Book Runner.
b The Book Runner will circulate copies of the prospectus amongst the
institutional investors and underwriters inviting offer for subscription to the
security.
c The Book Runner maintains a record of the offers received from the institutional
investors and underwriters mentioning the price they are ready to pay and the
number of securities they intend to buy.
d On the basis of these offers, the Company and the book runner will determine
the price of the security. The price so determined, will be the same for both
placement position and the public issue.
Thereafter, the Underwriting Agreement is entered into and prospectus is filed
with the Registrar of Companies. One-day prior to the public issue,
institutional investors are required to submit application forms along with
money to the extent the securities are proposed to be allotted to them.
Initially, the book-building process was optional to the companies, but
gradually, an element of compulsion has been introduced. During the fiscal
year 2000-0 1, the book-building route was made compulsory for companies,
which do not have the track record of profitability and networth as specified in
Entry norms prescribed by SEBI. Moreover, 60% of the offer made by them is
to be allotted to 'Qualified Institutional Buyers', comprising financial
institutions, banks, mutual funds, Foreign Institutional Investors (FIIs) and
venture Capital Funds registered with SEBI. Inability to meet this condition is
regarded as failure of the issue. The book-building route has also been made
compulsory for IPOs with issue size more than 5 times the pre-issue networth
and for public issues by listed companies worth more than 5 times the pre-issue
net worth. In these cases also, 60% of the 'offer should be allotted to QIBs.

53

REFORMS IN PRIMARY CAPITAL MARKET

SEBI has brought about several reforms in the new issues market during recent
years. Important reforms are as detailed below:
a) Minimum offer to public: SEBI (Disclosure and Investor Protection)
Guidelines' required a minimum offering of 25% of post-issue capital to the
public. This requirement was gradually relaxed to 10% for companies in all
sectors. For this purpose, SEBI also kept the minimum offering size at Rs.
100 crore and retained the existing limit of minimum public offering of 20
lakh shares. The Companies which are unable to meet these conditions are
required to make a minimum public offering of 25%.
b) Lock-in-period: The provisions for lock-in applicable to IPOs have been
rationalized. lock-in-period of or minimum promoters contribution of 20
per cent Continues to be 3 years, the balance of the entire pre IPO Capital
held by promoters and others shall have-lock-in period of 1 year& from the
date of allotment of the IPO. The shares issued on preferential basis by a
listed company to any person shall have a lock-in period of one year term
from the date of their allotment.
c) Allotment of Shares: The time for finalizing the allotment of share has
been reduced from 30 days to 15 days, in case, issues are made on bookbuilding basis.
d) Merchant bankers have been brought under SEBI regulatory framework and
a code of conduct is issued for them.
e) Companies are required to disclose all material facts and specific risks
factors associated with their projects while making public issues through
the prospectus.
f) Prohibition been imposed on payment of any direct or indirect discounts or
commission to person receiving any firm allotment of shares.
g) The requirement of 90% minimum subscription in case of offer for sale is
no longer applicable.
h) Underwriting of the issue made optional subject to the condition that if an
issue was not underwritten and was not able to collect at least 90% of
amount offered to public as subscription, the entire amount will be
refundable to investors.
i) SEBI introduced a code of advertisement for public issues for ensuring fair
and truthful disclosures

54

3.4 Parties involved in the Issue

Merchant Bankers (Indian Context )
In modern times, importance of merchant banker is very much, because it the key
intermediary between the company and issue of capital. Main activities of the
merchant bankers are Determining the composition of the capital structure,
drafting of prospectus and application forms, compliance with procedural
formalities, appointment of registrars to deal with the share application and
transfer, listing of securities, arrangement of underwriting / sub-underwriting,
placing of issues, selection of brokers, bankers to the issue, publicity and
advertising agents, printers and so on. Due to overwhelming importance of
merchant banker, it is now mandatory that merchant banker(s) functioning as lead
manager(s) should manage all public issues. In case of rights issue not exceeding
Rs.50 lakh, such appointments may not be necessary. The salient features of the
SEBI framework, related to merchant bankers are discussed as under.
Registration : Merchant bankers require compulsory registration with the SEBI to
carry out their activities. Previously there were four categories of merchant
bankers, depending upon the activities. Now, since Dec. 1997, there is only one
category of registered merchant banker and they perform all activities.
Grant of Certificate : The SEBI grants a certificate of registration to applicant if it
fulfills all the conditions like (i) it is a body corporate and is not a NBFC (ii) it has
got necessary infrastructure to support the business activity (iii) it has appointed at
least two qualified and experienced (in merchant banking) persons (iv) its
registration is in the general interest of investors.
Capital Adequacy Requirement: A merchant banker must have adequate capital to
support its business. Hence SEBI grants recognition to only those merchant
bankers who have paid up capital and free reserves of minimum Rs. 1 crore.
Fee: A merchant banker has to pay a registration fee of Rs. 5 lakh and renewal
fees of Rs. 2.5 lakh every three years from the fourth year from the date of
registration.
Code of Conduct: Every merchant banker has to abide by the code of conduct, so
as to maintain highest standards of integrity and fairness, quality of services, due
diligence and professional judgment in all his dealings with the clients and other
people. A merchant banker has always to endeavor to (a) render the best possible
advice to the clients regarding clients needs and requirements, and his own
professional skill and (b) ensure that all professional dealings are effected in a
prompt, efficient and cost effective manner.
55

Restriction on Business : No merchant banker, other than a bank/public financial

institution is permitted to carry on business other than that in the securities market
w.e.f. Dec.1997. However a merchant banker who is registered with RBI(Central
bank of India) as a primary dealer/satellite dealer may carry on such business as
may be permitted by RBI w.e.f. Nov.1999.
Maximum number of lead managers: The maximum number of lead managers is
related to the size of the issue. For an issue of size less than Rs. 50 crores, two lead
managers are appointed. For size groups of 50 to 100 crores and 100 to 200 crores,
the maximum permissible lead managers are three and four respectively. A
company can appoint five and five or more (as approved by SEBI) lead managers
in case of issue sizes between Rs.200 to 400 crores and above Rs.400 crores
respectively.
Responsibilities of Lead Managers: Every lead manager has to enter into an
agreement with the issuing companies setting out their mutual rights, liabilities
and obligation relating to such issues and in particular to disclosure, allotment and
refund. A statement specifying these is to be furnished to the SEBI at least one
month before the opening of the issue for subscription.It is necessary for a lead
manager to accept minimum underwriting obligation of 5% of the total
underwriting commitment or Rs. 25 lakh whichever is less.
Due diligence certificate: The lead manager is responsible for the verification of
the contents of a prospectus / letter of offer in respect of an issue and the
reasonableness of the views expressed in them. He has to submit to the SEBI at
least two weeks before the opening of the issue for subscription a due diligence
certificate.
Submission of documents: The lead managers to an issue have to submit at least
two weeks before the date of filing with the ROC/regional SE or both, particulars
of the issue, draft prospectus/ letter of offer, other literature to be circulated to the
investors / shareholders, and so on to the SEBI. They have to ensure that the
modifications/ suggestions made by it with respect to the information to be given
to the investors are duly incorporated.
Acquisition of Shares: A merchant banker is prohibited from acquiring securities
of any company on the basis of unpublished price sensitive information obtained
during the course of any professional assignment either from the client or
otherwise.
Disclosure to SEBI: As and when required, a merchant banker has to disclose to
SEBI (i) his responsibilities with regard to the management of the issue, (ii) any
change in the information/ particulars previously furnished which have a bearing
56

on the certificate of registration granted to it, (iii) names of the companies whose
issues he has managed or has been associated with (iv) the particulars relating to
the breach of capital adequacy requirements and (v) information relating to his
activities as manager, underwriter, consultant or advisor to an issue.
Action in case of Default: A merchant banker who fails to comply with any
conditions subject to which the certificate of registration has been granted by SEBI
and / or contravenes any of the provisions of the SEBI Act, rules or regulations, is
liable to any of the two penalties (a) Suspension of registration or (b) Cancellation
of registration.
Underwriters
Another important intermediary in the new issue/ primary market is the
underwriters to issue of capital who agree to take up securities which are not fully
subscribed. They make a commitment to get the issue subscribed either by others
or by themselves. Though underwriting is not mandatory after April 1995, its
organization is an important element of primary market. Underwriters are
appointed by the issuing companies in consultation with the lead managers /
merchant bankers to the issues.
Registration: To act as underwriter, a certificate of registration must be obtained
from SEBI. On application registration is granted to eligible body corporate with
adequate infrastructure to support the business and with net worth not less than Rs.
20 lakhs.
Fee: Underwriters had to pay Rs. 5 lakhs as registration fee and Rs. 2 lakhs as
renewal fee every three years from the fourth year from the date of initial
registration. Failure to pay renewal fee leads to cancellation of certificate of
registration.
General Obligations and responsibilities
Code of conduct: Every underwriter has at all times to abide by the code of
conduct; he has to maintain a high standard of integrity, dignity and fairness in all
his dealings. He must not make any written or oral statement to misrepresent (a)
the services that he is capable of performing for the issuer or has rendered to other
issues or (b) his underwriting commitment.
Agreement with clients: Every underwriter has to enter into an agreement with the
issuing company. The agreement, among others, provides for the period during
which the agreement is in force, the amount of underwriting obligations, the
period within which the underwriter has to subscribe to the issue after being
57

intimated by/on behalf of the issuer, the amount of commission/brokerage, and

details of arrangements, if any, made by the underwriter for fulfilling the
underwriting obligations.
General responsibilities: An underwriter cannot derive any direct or indirect
benefit from underwriting the issue other than by the underwriting commission.
The maximum obligation under all underwriting agreements of an underwriter
cannot exceed twenty times his net worth. Underwriters have to subscribe for
securities under the agreement within 45 days of the receipt of intimation from the
issuers.
Bankers to an Issue
The bankers to an issue are engaged in activities such as acceptance of
applications along with application money from the investor in respect of capital
and refund of application money.
Registration: To carry on activity as a banker to issue, a person must obtain a
certificate of registration from the SEBI. The applicant should be a scheduled
bank. Every banker to an issue had to pay to the SEBI an annual free for Rs. 5
lakhs and renewal fee or Rs. 2.5 lakhs every three years from the fourth year from
the date of initial registration. Non-payment of the prescribed fee may lead to the
suspension of the registration certificate.
General Obligations and Responsibilities
Furnish Information: When required, a banker to an issue has to furnish to the
SEBI the following information: (a) the number of issues for which he was
engaged as banker to an issue (b) the number of applications / details of the
applications money received (c) the dates on which applications from investors
were forwarded to the issuing company / registrar to an issue (d) the dates /
amount of refund to the investors.
Books of account/record / documents: A banker to an issue is required maintain
books of accounts/ records/ documents for a minimum period of three years in
respect of, inter alia, the number of applications received, the names of the
investors, the time within which the applications received were forwarded to the
issuing company / registrar to the issue and dates and amounts of refund money to
investors.
Agreement with issuing companies: Every banker to an issue enters into an
agreement with the issuing company. The agreement provides for the number of
collection centers at which application/ application money received is forwarded
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to the registrar for issuance and submission of daily statement by the designated
controlling branch of the baker stating the number of applications and the amount
of money received from the investor.
Code of Conduct: Every banker to an issue has to abide by a code of conduct. He
should observe high standards of integrity and fairness in all his dealings with
clients/ investors/ other members of the profession. He should exercise due
diligence. A banker to an issue should always endeavor to render the best possible
advice to his clients and ensure that all professional dealings are effected in a
prompt, efficient and cost-effective manner.
Brokers to the Issue
Brokers are persons mainly concerned with the procurement of subscription to the
issue from the prospective investors. The appointment of brokers is not
compulsory and the companies are free to appoint any number of brokers. The
managers to the issue and the official brokers organize the preliminary distribution
of securities and procure direct subscription from as large or as wide a circle of
investors as possible. A copy of the consent letter from all the brokers to the issue,
should be filed with the prospectus to the ROC. The brokerage applicable to all
types of public issue of industrial securities is fixed at 1.5%, whether the issue is
underwritten or not. The listed companies are allowed to pay a brokerage on
private placement of capital at a maximum rate of 0.5%.
Brokerage is not allowed in respect of promoters quota including the amounts
taken up by the directors, their friends and employees, and in respect of the rights
issues taken by or renounced by the existing shareholders. Brokerage is not
payable when the applications are made by the institutions/ bankers against their
underwriting commitments or on the amounts devolving on them as underwriters
consequent to the under subscription of the issues.
Registrars to an Issue and Share Transfer Agents
The registrars to an issue, as an intermediary in the primary market, carry on
activities such as collecting applications from the investors, keeping a proper
record of applications and money received from the investors or paid to the sellers
of securities and assisting companies in determining the basis of allotment of
securities in consultation with the stock exchanges, finalizing the allotment of
securities and processing / dispatching allotment letters, refund orders, certificates
and other related documents in respect of the issue of capital. To carry on their
business, the registrars must be registered with the SEBI. They are divided into
two categories: (a) Category I, to carry on the activities as registrar to an issue and
share transfer agent; (b) Category II, to carry on the activity either as registrar or
59

as a share transfer agent. Category I registrars mush have minimum net worth of
Rs. 6 lakhs and Category II, Rs. 3. Category I is required to pay a initial
registration fee of Rs. 50,000 and renewal fee of Rs.40,000 every three years,
where as Category II is required to pay Rs.30,000 and Rs. 25,000 respectively.
Code of Conduct: The registrars to an issue and the share transfer agents have to
maintain high standards of integrity and fairness in all dealings with their clients
and other registrars to the issue and share transfer agents in the conduct of the
business. They should endeavor to ensure that (a) enquiries from investors are
adequately dealt with, and (b) adequate steps are taken for proper allotment of
securities and refund of application money without delay and as per law. Also,
they should not generally and particularly in respect of any dealings in securities
to be a party to (a) creation of false market, (b) price rigging or manipulation (c)
passing of unpublished price sensitive information to brokers, members of stock
exchanges and other intermediaries in the securities market or take any other
action which is not in the interest of the investors and (d) no registrar to an issue,
share transfer agent or any of its directors, partners or managers managing all the
affairs of the business is either on their respective accounts, or though their
respective accounts, or through their associates or family members, relatives or
friends indulges in any insider trading.
Debenture Trustees A debenture trustee is a trustee for a trust deed needed for
securing any issue of debentures by a company. To act as a debenture trustee a
certificate from the SEBI is necessary. Only scheduled commercial banks, PFIs,
Insurance companies and companies are entitled to act as a debenture trustees. The
certificate of registration is granted to suitable applicants with adequate
infrastructure, qualified manpower and requisite funds. Registration fee is Rs. 5
lakhs and renewal fee is Rs. 2.5 lakhs every three years.
Responsibilities and obligations: Before the issue of debentures for subscription,
the consent in writing to the issuing company to act as a debenture trustee is
obligatory. He has to accept the trust deed which contains matters pertaining to the
different aspects of the debenture issue.
Duties: The main duties of a debenture trustee include the following :
i. Call for periodical report from the company.
ii. Inspection of books of accounts, records, registration of the company and the
trust property to the extent necessary for discharging claims.
iii. Take possession of trust property, in accordance with the provisions of the trust
deed.
iv. Enforce security in the interest of the debenture holders.
v. Carry out all the necessary acts for the protection of the debenture holders and
to the needful to resolve their grievances.
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vi. Ensure refund of money in accordance with the Companies Act and the stock
exchange listing agreement.
vii. Exercise due diligence to ascertain the availability of the assets of the
company by way of security as well as their adequacy / sufficiency to
discharge claims when they become due.
viii. Take appropriate measure to protect the interest of the debenture holders as
soon as any breach of trust deed/ law comes to notice.
ix. Ascertain the conversion / redemption of debentures in accordance with the
provisions / conditions under which they were offered to the holders.
x. Inform the SEBI immediately of any breach of trust deed / provisions of law.In
addition, it is also the duty of trustees to call or ask the company to call a
meeting of the debenture holders on a requisition in writing signed by
debenture holders, holding at least one-tenth of the outstanding amount, or on
the happening of an event which amounts to a default or which, in his opinion,
affects their interest.
Portfolio Managers
Portfolio manager are defined as persons who in pursuance of a contract with
clients, advice, direct, undertake on their behalf the management/ administration of
portfolio of securities/ funds of clients. The term portfolio means the total holdings
of securities belonging to any person. The portfolio management can be
(ii)
Discretionary or (ii) Non-discretionary.
The first type of portfolio management permits the exercise of discretion in regard
to investment / management of the portfolio of the securities / funds. In order to
carry on portfolio services, a certificate of registration from SEBI is mandatory.
The certificate of registration for portfolio management services is granted to
eligible applicants on payment of Rs.5 lakhs as registration fee. Renewal may be
granted by SEBI on payment of Rs. 2.5 lakhs as renewal fee (every three years).
Contract with clients: Every portfolio manager is required, before taking up an
assignment of management of portfolio on behalf of the a client, is enter into an
agreement with such clients clearly defining the inter se relationship, and setting
out their mutual rights, liabilities and obligations relating to the management of
the portfolio of the client. The contract should, inter alia, contains :
i. The investment objectives and the services to be provided.
ii. Areas of investment and restrictions, if any, imposed by the client with regards
to investment in a particular company or industry.
iii. Attendant risks involved in the management of portfolio.
iv. Period of the contract and provisions of early termination, if any.
v. Amount to be invested.
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vi. Procedure of setting the clients account including the form of repayment on
maturity or early termination of contract.
vii. Fee payable to the portfolio managers
viii. Custody of securities. The funds of all clients must be placed by the portfolio
manager in a separate account to be maintained by him in a scheduled
commercial bank. He can charge an agreed fee from the clients for rendering
portfolio management services without guaranteeing or assuring, either directly
or indirectly, any return and such fee should be independent of the returns to
the client and should not be on a return sharing basis.
Investment of Clients money: The portfolio manager should not accept money or
securities from his clients for less than one year. Any renewal of portfolio fund on
the maturity of the initial period is deemed as a fresh placement for a minimum
period of one year. The portfolio funds and is withdrawn or taken back by the
portfolio clients at his risk before the maturity date of the contract under the
following circumstances:
a. Voluntary or compulsory termination of portfolio management services by the
portfolio manager.
b. Suspension or termination of registration of portfolio manager by the SEBI.
c. Bankruptcy or liquidation in case the portfolio manager is a body corporate.
d. Permanent disability, lunacy or insolvency in case the portfolio manager is an
individual.
The portfolio manager can invest funds of his clients in money market instruments
or as specified in the contract, but not in bill discounting, badla financing or for
the purpose of lending
MARKET GUIDANCE FOR THE ISSUE OF SECURITIES
(Securities and Exchange Commission , Ghana)
The following guidelines are provided to aid the process of issuing
securities to the public. These guidelines will be used in all Initial
Public Offers (IPO) as well as Additional Listings in which case the
details will be varied as the case may be.
I. OFFER DOCUMENT SUBMISSION REQUIREMENTS
a. Time Frame
The circular of 5th December 2002, which was distributed to all Licensed Dealing
Members, the Stock Exchange, Investment Advisers, and Listed Companies,
refers. You are reminded that the circular requires draft prospectuses or
documents to be submitted to the Commission at least 6 weeks before the
proposed date for the opening of an offer.
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This does not mean that the Commission will take 6 weeks to process the
application in each case. The processing time may be more or less than 6 weeks
depending on how much review has to be done. It will also depend to a great
extent on the nature of the document, the gravity of the issues raised, and how
quickly sponsors respond to issues that will be raised during the process.
In every case the Commission will endeavour to act as quickly as possible.
b. Prospectus and Supporting Documents
An application for the approval of an offer document shall be addressed to the
Director General of the SEC. Every application for approval shall be accompanied
with two draft offer documents for review and examination. After the review has
been completed, ten copies of the final draft offer document shall be submitted
for onward submission to the members of the Approvals Committee.
Copies of the following documents should be submitted with the draft
prospectus/document:

All resolutions passed by shareholders in respect to the offer and the

company. Revaluation report on assets

Share price valuation

Company regulations

Audited financial statements for the relevant period

Certificate of Incorporation and Commencement of Business

An Escrow Account agreement

Any other documents that may have been referenced in the prospectus as
available for inspection during the offer period.
II. REVIEW PROCESS
The Commission will acknowledge receipt of a draft prospectus within five
working days. It is important to note that the minimum processing period of sixweeks shall be effective only when the Commission is satisfied with the
completeness on the face of it, of the draft prospectus, and this shall be
communicated to the Lead Manager. It is therefore the duty of the Lead Manager
to ensure the completeness and accuracy of the prospectus before submitting it to
the Commission.
The review process itself, is to establish that the prospectus has been prepared in
accordance with the Securities and Exchange Regulations, 2003 (L.I. 1728) and
contains adequate disclosure.

63

During the review the Commission will,

1. Schedule meetings with sponsor (and/or issuer) to discuss issues that need to be
discussed.
2. Advise amendments to the timetable as may be necessary in view of issues that
arise.
III. RESPONSIBILITIES OF THE SPONSOR AND ISSUER DURING THE
EXAMINATION AND APPROVAL PERIOD
The sponsor/issuer will be required to cooperate fully with the Commission during
the process. Any new material information regarding the issue/issuer that becomes
available during the period (from the submission of the application to the SEC
until the Offer closes) must be communicated to the SEC and incorporated in the
offer document. The Commission will treat any such information that is not
disclosed as material withheld. Appropriate sanctions will apply in the event of
such conduct.
The issuer may proceed on a publicity campaign during this period with the sole
intention of generating interest of the investing public and to solicit commitments
in the offer.
IV. LAUNCHING AND OPENING OF THE OFFER
The offer can be launched and declared open only after the Commissions
approval of the prospectus or offer document has been given in writing. It is only
then that the timetable for the offer can be fixed and presented to the Commission
for approval. The prospectus should then be made available to the public and
investors can formally apply for the shares. Where the issuer intends to use mini
prospectuses, the Commission needs to be informed about this. It should be stated
on the front cover that the Mini Prospectus should be read in conjunction with the
full prospectus. Full Prospectuses should be made available for inspection and for
applicants who wish to have them.
During the offer period the issuer can continue to advertise or promote the issue
to ensure success, but cannot introduce any new information that is not already
disclosed in the prospectus or offer document without prior permission from the
Commission. Both Manager and Issuer however, have an obligation to report to
the Commission on any new information that is material to the offer, and to do so
in a timely manner. Such new material information will be disclosed to the public
in the form of an addendum or by way of a publication or any other mode of
64

dissemination as the SEC may direct. The Commission has the power to invalidate
the offer should the circumstances so warrant.
V. USE OF THE ESCROW ACCOUNT
The Commission requires the use of an escrow account for the lodgement of all
subscription monies for any public issue of securities. A template for a typical
escrow agreement is available at the SEC for guidance. The following procedures
are to be followed in the use of an escrow account.
1. Open an Escrow account at a bank and submit the Agreement to the SEC.
2. Escrow accounts shall be non-interest bearing.
3. All subscription monies shall be paid directly into the escrow account.
4. The escrow account shall not be debited except as a result of returned cheques,
refund of over subscription monies, or the payment of the offer amount to the
issuer.
5. All refunds shall be paid out of the escrow account that received the monies.
6. Refunds shall be in the form of printed cheques (like dividend warrants) payable
to subscribers and may be opened for cash on request.
7. A statement of account of the escrow account shall be submitted to the
Commission within 14 days after the close of the offer.
8. A bank issuing shares to the public may not hold its own escrow account.
During the period of refunding money to subscribers the Commission shall be
furnished with periodic (fortnightly) reports on the status of the refund process.
VI. EXTENSION OF THE OFFER PERIOD
Sponsors of the offer may apply to the Commission for an extension of the offer
period. The following points should guide such requests.
1. Problems that may affect the success of the offer must be brought to the notice
of the Commission before the offer closes.
2. The Commission will consider applications for extension on a case-by-case
basis, especially in situations where market dynamics may have created a
situation that might have affected the overall response to an offer.
3. The sponsor/issuer is required to monitor the progress of the offer and the
market as a whole during the offer period, and this must be demonstrated to the
Commission. An application for extension therefore should be made at least
one week before the close of the offer(and not after the Offer has closed),
stating tangible reasons for the request. The Commission has the discretion to
approve or decline the request.
4. The Commission will respond to an extension request within 2 days of receipt
of the request in writing.
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VII. REPORT ON THE OUTCOME OF THE OFFER

Regulation 33 (5) of the L.I. 1728 requires a person performing the functions of an
issuing house or a manager of a public issue of securities to submit to the
Commission, a report on the offer. This report should be submitted within 14 days
(two weeks) after the close of the offer, and shall include among others
information on the Offer such as:
1. Total number of applications
2. Total subscription amount
3. Basis of allotment
4. Amount raised after allotments (if that is the case)
5. List of the top twenty after the flotation
6. Distribution of the shares
7. Statistics of the allotment
Anyone who contravenes the provision of this regulation is liable for the payment
of a penalty of 1m for each day that the default subsists.
The fee for the examination and approval of a prospectus or offer document shall
be based on the amount realized for the shares issued. This fee should accompany
the report. The fees as set out in Schedule 2 of L.I. 1728 are as follows:
a) 1 million for any offer where the value is less than or equal to 1 billion
b) 0.05% of the offer where the value of the offer is greater than 1 billion
VIII. REFUND OF MONEY IN THE CASE OF AN UNSUCCESSFUL
ISSUE
In the event that the minimum subscription is not attained, monies must be
returned to applicants immediately after the offer closes. The refund shall be made
in accordance with section 284 (4) of the Companies Code.
The Lead Manager/Issuer shall cause a publication in a newspaper of national
circulation and announcements on local radio stations on how and where
subscribers are to collect refunds.
IX. ALLOTMENT
Under the Plan of Distribution in schedule five of the L.I. 1728, the offer
document shall provide information on the allotment policy, which will be adopted
if applications exceed the securities on offer.
66

The regulations do not make any provision for an allotment period, especially in
the event of over-subscription or where the total applications for an issue far
exceed expectations. This has been taken into consideration in preparing these
guidelines, and should be factored into the structure of the offer timetable. The
responsibility of the Manager of a public issue of securities after the offer closes
includes the following:
1. Submitting a report pursuant to Regulation 33 (5)
2. Allotting the shares to successful applicants
3. Issuing and dispatching certificates to successful applicants
4. Refunding excess monies
5. Commence trading in the shares
In the light of recent developments with the floatation of IPOs, the Commission
reminds managers that they must ensure that they keep to the timetable set out in
offer documents and the Commission will enforce same.
X. REFUND OF MONEY OVERSUBSCRIBED SHARES
In the event that the shares on offer are over-subscribed, monies should be
returned to applicants within ten (10) days after the allotment of shares. Any
refunds that are returned after the deadline shall attract interest at the Bank of
Ghana Prime Rate.
The Commission hereby emphasises that proceeds from the offer shall be held in
the escrow account, and refunds shall be made out of this account directly to
subscribers.
The Commission shall consider refund as having been dispatched to subscribers
where the following conditions have been fulfilled:
1. As set out in the offer prospectus.

Using the stated mode of dispatch

By the stated date of dispatch

For the full refund amount (including the correct computation of

interest if that is the case)

If refund has been sent out by registered mail to individual

subscribers, evidence of such dispatch should be made available.

2. If the refund is being affected through receiving brokers, then dispatch shall be
considered concluded when the following are all in place,
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Brokers have received a list of subscribers and amount due to each,

Brokers have received the full refund amount, and
The public has been informed of the availability of refund monies at
The brokerage houses.

If refunds occur later than the date indicated in the prospectus, then the SEC shall
consider the process complete only when the Manager has notified subscribers of
the refund.
Until the refund process is complete the Commission will require periodic
(weekly) reports on the refund of excess subscription monies.
XI. DISPATCH OF CERTIFICATES AND THE COMMENCEMENT OF
TRADING
All share certificates must be dispatched at least one week before trading can
commence.
1. Mode of dispatch of Certificates shall be according to the provisions of the
prospectus.
2. If dispatch of certificates and or excess monies occurs later than the date
indicated in the prospectus, the manager for the floatation has an obligation to
inform applicants/subscribers of a new timetable via a medium that is
acceptable by the SEC.
NOTICE ON INITIAL PUBLIC OFFER (IPO) AND RIGHTS ISSUES
The following guidelines are provided to aid the process of issuing securities to
the public.
INITIAL PUBLIC OFFER (IPO) AND RIGHTS ISSUES
A. PUBLIC OFFERS
In the light of increased issues of securities to the public and recent developments
with the flotation of IPOs, it has become necessary for the Commission to provide
a guide to the market to streamline the process.
In furtherance of the above, the attached guidelines have been developed by SEC.
The guidelines are based on the provisions of the Securities and Exchange
Regulations 2003, LI 1728 and do not replace the Law and Regulations. The
Commission in addition to the provisions set out in Regulation 51 and Schedule 5
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Part II A of LI 1728, issues the following notices to guide market participants.

Issuers are reminded that the proceeds of any public offer/ rights issue are to be
used in strict accordance with the purpose(s) indicated in the offer document.
The Commission will continue to undertake Post-IPO /Post-Rights Issue
inspections to ascertain whether proceeds of the IPO / Rights Issue have been / are
being utilised as indicated in the offer document.
Issuers are required to disclose all fees to be paid out to persons or bodies in
pursuance of the IPO / Rights Issue. The Commission shall require the refund of
all amounts disbursed from the proceeds of the offer which were not disclosed e.g.
success fees and other such fees however described. The Lead Manager shall be
required to refund all such monies which were illegally paid out to recipients. The
Commission reserves the right to investigate all payments to be paid out to persons
or bodies in pursuance of the IPO / Rights Issue.
The Commission wishes to remind Issuers that full disclosure of use of proceeds
of IPO / Rights Issue is a requirement under the law as it enables investors to make
informed decisions.
B. APPROVAL REQUIRED IN THE INSTANCE OF CHANGE OF USE OF
THE IPO /RIGHTS ISSUE FUNDS AS CONTAINED IN PROSPECTUS
Issuers shall require the approval of the Issuers registered shareholders granted at
an Annual General Meeting or Extraordinary General Meeting before funds raised
by the offer are used for any other purpose other than those disclosed in the offer
document.
A resolution to this effect when taken shall be communicated to the Commission.
The involvement and / or decisions of shareholders in the above-mentioned action
at the AGM or EGM is necessary as the law requires that the shareholders receive
full disclosure of all information that will enable them to make an informed
decision.
C. FLOTATION EXPENSES
The Securities and Exchange Commission acknowledges that some expenses must
necessarily be incurred in any Initial Public Offer or Rights Issue. The
Commission has however noted with disquiet that the flotation expenses incurred
in some IPOs / Rights Issues amount to as much as 10% of the proceeds raised.
The Commission is concerned that such expenditure prejudices the purpose for
which the money was ostensibly raised, i.e. the proposed expansion of the Issuers
business. As the underlying purpose of the flotation is the increased value of the
shareholders investment, the Issuer should endeavour to increase or maximize the
net proceeds of the flotation for the expansion of the business. The Commission
therefore directs that total flotation costs should not exceed 5% of the total amount
to be raised.
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D. REPORTING ACCOUNTANT
LI 1728 Regulation 51 and Schedule 5 requires that an Offer Document should
contain a report by an accountant, i.e. normally referred to as the reporting
accountant. The law also requires that the reporting accountant should be an
accountant qualified to be appointed auditors of the issuer or other qualified
accountants acceptable to SEC. The offer document should contain disclosures, on
the identity and addresses of the issuers auditors and reporting accountants.
Further to these statutory requirements, the Commission has determined that for
the protection of investors and to ensure transparency and independence of
functions, the reporting accountant in a public issue:
1. shall not be the same as the Issuers external auditors;
2. shall not be the same as the Issuers accountants who may be carrying out
normal accounting functions or performing any other services for the Issuer.
E. INTRODUCTION OF PROCESSING FEE FOR REVIEW OF
PROSPECTUSES
The SEC in its review of prospectuses submitted by proposed Issuers, has found it
necessary to offer both technical advice and editorial services to Issuers in order
that their offer documents meet international standards. The SEC has on numerous
occasions had to perform this preliminary (and often extensive) screening before
the offer documents are laid before the Approval & Licensing Committee.
This service which the SEC has hitherto been providing gratis takes a heavy toll
on the SECs human resources and detracts from its other statutory duties.
The Commission is of the view that it is proper Issuers pay for this crucial and
invaluable service it provides as in other emerging markets. The Commission has
therefore proposed the following scale of processing fees for the review of
prospectuses with effect from 1st July 2006 (proposed starting date):
1. 20,000,000.00. for first submission
2. 10,000,000.00. for all re-submission due to material omissions or
discrepancies identified by the Commission after initial review at the first
submission.
ISSUED BY SECURITES AND EXCHANGE COMMISSION 2nd AUGUST
2006
(Source: http://www.secghana.org/aboutus/commissioners.asp
3.5 SECONDARY MARKET
Securities market : Trends and current market situation in Africa
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With a market capitalization of USD 600 billion, the South African (Johannesburg)
market is the fourth largest emerging market in the World (after Korea, Russia and
India; before Brazil, China and Hong Kong). Yet even Johannesburg is not a big
enough market to retain the primary listings of several of South Africas largest
companies. Altogether, 21 of the companies listed in Johannesburg have their
primary listings elsewhere, including the mining conglomerate Anglo American,
the banking group Investec, the brewing company SAB-Miller, the insurance giant
Old Mutual and the technology company Dimension Data, all of which have their
primary listings in London. This shows that the context in which African securities
markets are operating is one in which the larger companies will be looking abroad
as well as to the home market. There are 15 organized securities markets in Africa.
Several other projects are under discussion, or partly implemented, but without
any activity so far. (This does not count Cameroon and Gabon both of which
recently established stock exchanges but have not attracted any listings yet.) One
exchange, the BRVM headquartered in Abidjan, caters to the eight country
UEMOA zone, having been expanded from the Abidjan stock exchange created in
1976. Four other exchanges were started in the days of the British Empire, those
with headquarters at Nairobi, Lagos, Harare and Johannesburg, the latter two
having histories going back into the 19th Century. The older exchanges also have
the largest number of equities listed. These five, along with those established in
1988-89 in Botswana, Ghana and Mauritius, are the only exchanges with market
capitalization at end-2004 in excess of 10 per cent of GDP, even though market
capitalization has been increasing in recent years (Figure 2.15).
Trading data shows a different aspect of the contribution of stock exchanges in
developing countries. It is influenced by secondary market liquidity and also by
the degree to which a large fraction of the shares in developing markets are
effectively locked-up in the strategic stakes of controlling shareholders and are not
normally available for trading. It should be noted in this context that funds actually
raised on these as on most capital markets are but a tiny fraction of market
capitalization. The eight oldest exchanges also have the most trading, with value
traded fluctuating around 2 per cent of GDP for the past several years (Table 2.4).
Even these more active African exchanges (Johannesburg aside) cannot be
considered to have much trading.
Except for Johannesburg, turnover on all markets is less than 15 per cent of market
capitalization. There was no trading on the Maputo exchange in 2004. Low
turnover is reflected in, and feeds back onto, a lack of liquidity as illustrated by
large gaps between buy and sell orders, and high price volatility. This lack of
transactions is also somewhat reinforcing, as the transaction volume does not
justify investment in technology either by the exchange itself or member brokers.
Limited trading discourages listing and raising money on the exchanges. Even
linking different centers electronically (as for example in the BRVM, or with the
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case of Namibia whose stock exchange is now electronically linked to the JSE)
cannot guarantee much more trading and liquidity.

The small size and illiquidity of Africas stock exchanges partly reflects low levels
of economic activity, making it hard to reach a minimum efficient size or critical
mass, and partly also the state of company accounts and their reliability. Several of
the exchanges established in the late 1980s and 1990s were set up mainly in order
to facilitate privatization, and in the hope of attracting inward investment with the
modernization and technology transfer that that could convey (Moss, 2003). For
example, the stock exchange in Maputo was established in the process of
privatizing Mozambiques national brewery, which is still the only listed company
and which has to bear the operating costs of the stock exchange. To the extent that
their establishment was driven by outside influencesrather than emerging from a
realistic need felt in the market, whether by investors or issuersit is perhaps
unsurprising that many have so far struggled to reach an effective scale and
activity level. Pricing on all of the markets appears to build in a sizable risk
premium to judge for example from the low price-earnings ratios that have been
prevalent (Moss, 2003; Senbet and Otchere, 2005). The widespread limitations on
foreign holdings of listed shares, although diminishing in recent years, have also
contributed to low prices.24 High risk perceptions affect all countries, even those
with stable macroeconomic environment; indeed, most countries lack sovereign
credit ratings. The perceived risk is reflected also in the very small amount of
funds raised through new issues including IPOs and other public sales of equities.
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Nevertheless, issuing activity has been picking-up. Ghana had five new equity
issues in 2004, accounting for USD 60 million, the Kenya Electricity Generating
Company KenGen IPO of 2006 the first for five years in Kenya attracted
strong demand and enormous public interest raising over USD 100 million.26 In
Nigeria the equivalent of almost USD 3 billion in new capital was raised on the
exchange in 2003-5 in connection with the new capital requirements for banks.
Scale issues in equities have been mirrored in the bond market; only a limited
number of private bonds have been listed, with little secondary market trading. In
Tanzania, capitalization of corporate bonds amounts to TZS 89 billion (about USD
90 million) compared to equity market capitalization of TZS 2.3 trillion. Ghana
has three corporate bonds, compared to 30 listed companies. Bond market
capitalization of the BRVM is relatively higher about one-fifth of equity market
capitalization, most of the larger issues are governmental or from governmentowned enterprises, and trading is very light. African Governments27 have relied
more on foreign debt than on domestic debt, though about one in two have issued
significant domestic debt instruments (not all of them traded on an organized
market), eight of them with domestic debt to GDP ratios in excess of 20 per cent.
Banks tend to be the biggest holders, with about two-thirds of the stock outside of
the central bank. With an estimated 87 per cent of the debt having initial maturity
of 12 months or less, there is little secondary trading (Christensen, 2004). Longer
term issues have only recently been appearing (or re-appearing) on some of the
exchanges (with the 7 and 10 year issues of the regional development banks
BOAD and EADB being noteworthy, together with a handful of government and
corporate bonds); the absence of such issues in most currencies means a lack of
good reference rates for long-term finance.
(Source: Making Finance work for Africa: World Bank Report)
SECONDARY MARKET: Definition
The market for long term securities like bonds, Equity, stocks and preferred stocks
is divided into primary market and secondary market. The primary market deals
with the new issues of securities. Outstanding securities are traded in the
secondary market, which is commonly known as stock market or stock exchange.
In the secondary market, the investors can sell buy securities. Stock market
predominantly deals in the equity shares. Debt instruments like bonds and
debentures are also traded in the stock market. Well regulated and active stock
market promotes capital formation. Growth of the primary market depends on the
secondary market. The health of the economy is reflected by the growth of the
stock market.

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Functions of Stock Exchange:

Stock Exchanges are established for the purpose of assisting, regulating and
controlling business of buying, selling and dealing in securities. Stock Exchange
provides a market for the trading of securities to individuals and organizations
seeking to invest their saving or excess funds through the purchase of securities. It
provides a physical location for buying and selling securities that have been listed
for trading on that exchange. It establishes rules for fair trading practices and
regulates the trading activities of its members according to those rules
The exchange itself does not buy or sell the securities, nor does it set prices for
them. It Provides:
Fair dealing: The exchange assures that no investor will have an undue
advantage over other market participants
Efficient Market: This means that orders are executed and transactions are
settled in the fastest possible way
Transparency: Investor make informed and intelligent decision about the
particular stock based on information. Listed companies must disclose
information in timely, complete and accurate manner to the Exchange and
the public on a regular basis Required information include stock price,
corporate conditions and developments dividend, mergers and joint
ventures, and management changes etc
Doing Business: People who buy or sell stock on an exchange do so
through a broker The broker takes your order to the floor of the exchange
and looks for a broker representing someone wanting to buy or sell. If a
mutually agreeable price is found the trade is made
Maintains active Trading: A continuous trading on exchange increases the
liquidity or marketability of the shares traded on the stock exchange.
Fixation of prices: Price is determined by the transactions that flow from
investors demand and suppliers preferences. Usually the traded process is
made known to the public. This helps investors to make better decisions.
Ensure safe and fair dealing: The rules regulations and by laws of the stock
exchanges provide a measure of safety to the investors.
Aids in financing the industry: A continuous market for shares provides a
favorable climate for raising capital. The negotiability of the securities
helps the companies to raise long term funds. This simulates capital
formation.

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 Dissemination of information: Stock exchanges provide information

through various publications. They publish the shares prices on daily basis
along with the volume traded
Performance inducer: The prices of stocks reflect the performance of the
traded companies. This makes the corporate more concerned with its public
image and tries to maintain good performance.
Self regulating Organization: The stock exchanges are self regulating
organizations .The stock exchanges monitor the integrity of their members,
brokers and listed companies and clients. Continuous internal audit
safeguards the investors against unfair trade practices.
Regulatory Framework:
A three tier regulatory structure consist of Ministry of Finance, the Financial
Market regulator and the Central bank of the country.

MOF
Public Finance
Debt Management
Legislation

Primary market and

primary dealers

Central
Bank

Financial
Market
Regulator

Monetary Policy
Settlement systems

Market intermediaries
Collective investment
Secondary market

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Ministry of Finance: The ministry of finance has the power to approve the
appointments of executive chiefs and nomination of public representatives in the
governing Boards of the stock exchanges. It has the responsibility of preventing
undesirable speculation.
Central bank of a country: Central bank of a country through its operations keeps
a check on the operations of the stock market. It regulates the business of stock
exchange, other security market and even the mutual funds. Registration and
regulation of other market intermediaries are also carried out by Central bank.
Financial Market Regulators: Other financial market regulators are market
intermediaries (Securities and Exchange Commission ).They function particularly
when market is poorly organized.
They set minimum entry standards;
Requires to comply with standards for internal organization and control;
Sets limits for initial and ongoing capital;
It ensures proper management of risk;
It sets high standards of conducts;
Provides procedures for dealing with the failure of an intermediary.
For example: The primary Mission of the Ghana Securities and Exchange
Commission (SEC) is to protect investors and maintain the integrity of the
securities market. As more and more first-time investors begin to look upon the
securities market as an alternative investment opportunity and as a means of
securing their futures, paying for homes, and educating children, these goals are
more compelling than ever. The SEC has a governing board as per the law. The
governing board has the responsibility to maintain an orderly and well regulated
market.
Commissioners of SEC
The Securities Industry Law, 1993 (PNDCL 333) as amended by the Securities
Industry (Amendment) Act 2000 (Act 590) provides that Commissioners of the
SEC shall be composed of a maximum of Eleven (11) members.
Act 590 provides that the Commission's membership be made up of the
following:
1.
2.
3.
4.

A Chairman
The Director-General
The two Deputy Directors-General
A representative of the Bank of Ghana not below the rank of a
Director
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9. A representative of the Ministry of Finance not below the rank of

Director
10. The Registrar -General or his representative
11. Four other persons including either a judge of the Superior Court or a
lawyer qualified to be appointed a judge of the Superior Court.
The Commissioners of the SEC, who shall hold office for a period of 3 years, are
appointed by the President of the Republic acting in consultation with the Council of
State.
The Commissioners are eligible for re-appointment at the end of their three-year
term.
Committees of the Commission
Act 590 empowers the Commission to appoint Committees composed of
Commissioners or non-Commissioners or both to assist in the performance of the
functions of the Commission. A Committee so appointed may be assigned such
functions of the Commission as it may determine. A Committee composed
exclusively of non - Commissioners, however, may only advise the Commission.
Administrative Hearings Committee
Without prejudice to the general power of the Commission to appoint Committees as
indicated above, Act 590 has established an Administrative Hearings Committee of
the Commission.
The Administrative Hearings Committee, which has a composition of five (5)
members (who are all Commissioners), is chaired by the chairman of the
Commission.
The Administrative Hearings Committee has the function of examining and
determining complaints and disputes related to, in respect of, or arising out of any
matter to which PNDCL 333, Act 590 and Regulations made under these laws
applies. The Administrative Hearings Committee may also perform other related
functions referred to it from the Commission.
Act 590 also provides that any complaint, dispute or violation arising from Act 590,
PNDCL 333 or Regulations made thereunder shall, before redress is sought in the
courts be addressed by the Administrative Hearings Committee.

77

Commissioners
The Present Commissioners of the SEC were appointed by His Excellency, the
President of Ghana in consultation with the members of the Council of State as
required by Law on the 17th of January, 2002 and they were sworn into office on
the 17th of March, 2002.
(Source: http://www.secghana.org/aboutus/commissioners.asp)

3.6 SOME BASIC TERMINOLOGIES OF STOCK MARKET

Types of Orders
Buy and Sell orders re placed with the members of the stock exchange by the
investors. The orders are of different types:
Limit Orders: Orders are limited by a fixed price Buy Reliance Petroleum
at Rs.50.Here, the order has clearly indicated the price at which it has
bought and the investor is not willing to give more than Rs50.
Best rate Order: Here, the buyer or seller gives the freedom to the broker to
execute the order at the best possible rate quoted on that particular date for
buying. It may be the lowest rate for buying and the highest rate for selling.
Discretionary order: The investor gives the range of price for purchase and
sale. The broker can use his discretion to buy within the specified limit.
Generally the approximate price is fixed. The order stands as this : Buy
BRC 100 shares around Rs 40.
Stop Loss Order: The order is given to the limit the loss due to unfavorable
price movements in the market. A particular limit is given for waiting. If the
price falls below the limit, the broker is authorized to sell the shares to
prevent further losses. Ex: Sell BRC at Rs 25 , stop loss at Rs 22

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Types of stocks in Stock Market

Growth Stocks:
In the investment world we come across terms such as Growth stocks, Value
stocks etc. Companies, whose potential for growth in sales and earnings are
excellent, are growing faster than other companies in the market or other stocks in
the same industry are called the Growth Stocks. These companies usually pay little
or no dividends and instead prefer to reinvest their profits in their business for
further expansions.
Value Stocks:
The task here is to look for stocks that have been overlooked by other investors
and which may have a hidden value. These companies may have been beaten
down in price because of some bad event, or may be in an industry that's not
fancied by most investors. However, even a company that has seen its stock price
decline still has assets to its name - buildings, real estate, inventories, subsidiaries,
and so on. Many of these assets still have value, yet that value may not be
reflected in the stock's price. Value 38 investors look to buy stocks that are
undervalued, and then hold those stocks until the rest of the market realizes the
real value of the company's assets. The value investors tend to purchase a
company's stock usually based on relationships between the current market price
of the company and certain business fundamentals. They like P/E ratio being
below a certain absolute limit; dividend yields above a certain absolute limit; Total
sales at a certain level relative to the company's market capitalization, or market
value etc.
BID AND ASK PRICE IN STOCK MARKET
The Bid is the buyers price. It is this price that you need to know when you have
to sell a stock. Bid is the rate/price at which there is a ready buyer for the stock,
which you intend to sell.
The Ask (or offer) is what you need to know when you're buying i.e. this is the
rate/ price at which there is seller ready to sell his stock. The seller will sell his
stock if he gets the quoted Ask price. If an investor looks at a computer screen
for a quote on the stock of say XYZ Ltd, it might look something like this:

79

Here, on the left-hand side after the Bid quantity and price, whereas on the right
hand side we find the Ask quantity and prices. The best Buy (Bid) order is the
order with the highest price and therefore sits on the first line of the Bid side (1000
shares @ Rs. 50.25). The best Sell (Ask) order is the order with the lowest sell
price (2000 shares @ Rs. 50.35). The difference in the price of the best bid and ask
is called as the Bid-Ask spread and often is an indicator of liquidity in a stock. The
narrower the difference the more liquid or highly traded is the stock.
PORTFOLIO
A Portfolio is a combination of different investment assets mixed and matched for
the purpose of achieving an investor's goal(s). Items that are considered a part of
your portfolio can include any asset you own-from shares, debentures, bonds,
mutual fund units to items such as gold, art and even real estate etc. However, for
most investors a portfolio has come to signify an investment in financial
instruments like shares, debentures, fixed deposits, mutual fund units.
3.7 Debt Instruments
Introduction
Debt instrument represents a contract whereby one party lends money to another
on pre-determined terms with regards to rate and periodicity of interest, repayment
of principal amount by the borrower to the lender. In Indian securities markets, the
term bond is used for debt instruments issued by the Central and State
governments and public sector organizations and the term debenture is used for
instruments issued by private corporate sector.
Features of debt instruments
Each debt instrument has three features: Maturity, coupon and principal.
Maturity: Maturity of a bond refers to the date, on which the bond matures, which
is the date on which the borrower has agreed to repay the principal. Term-to80

Maturity refers to the number of years remaining for the bond to mature. The
Term-to-Maturity changes everyday, from date of issue of the bond until its
maturity. The term to maturity of a bond can be calculated on any date, as the
distance between such a date and the date of maturity. It is also called the term or
the tenure of the bond.
Coupon: Coupon refers to the periodic interest payments that are made by the
borrower (who is also the issuer of the bond) to the lender (the subscriber of the
bond). Coupon rate is the rate at which interest is paid, and is usually represented
as a percentage of the par value of a bond.
Principal: Principal is the amount that has been borrowed, and is also called the
par value or face value of the bond. The coupon is the product of the principal and
the coupon rate.
The name of the bond itself conveys the key features of a bond. For example, a GS
CG2008 11.40% bond refers to a Central Government bond maturing in the year
2008 and paying a coupon of 11.40%. Since Central Government bonds have a
face value of Rs.100 and normally pay coupon semi-annually, this bond will pay
Rs. 5.70 as six- monthly coupon, until maturity.
Interest payable by a debenture or a bond
Interest is the amount paid by the borrower (the company) to the lender (the
debenture-holder) for borrowing the amount for a specific period of time. The
interest may be paid annual, semi-annually, quarterly or monthly and is paid
usually on the face value (the value printed on the bond certificate) of the bond.
Segments in the Debt Market in India
There are three main segments in the debt markets in India, viz., (1) Government
Securities, (2) Public Sector Units (PSU) bonds, and (3) Corporate securities.
The market for Government Securities comprises the Centre, State and Statesponsored securities. In the recent past, local bodies such as municipalities have
also begun to tap the debt markets for funds. Some of the PSU bonds are tax free,
while most bonds including government securities are not tax-free. Corporate
bond markets comprise of commercial paper and bonds. These bonds typically are
structured to suit the requirements of investors and the issuing corporate, and
include a variety of tailor- made features with respect to interest payments and
redemption.

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Participants in the Debt Market

Given the large size of the trades, Debt market is predominantly a wholesale
market, with dominant institutional investor participation. The investors in the
debt markets are mainly banks, financial institutions, mutual funds, provident
funds, insurance companies and corporates.
Rating of Bonds for their credit quality
Most Bond/Debenture issues are rated by specialised credit rating agencies. Credit
rating agencies in India are CRISIL, CARE, ICRA and Fitch. The yield on a bond
varies inversely with its credit (safety) rating. The safer the instrument, the lower
is the rate of interest offered.
A credit rating agency (CRA) is a company that assigns credit ratings for issuers
of certain types of debt obligations as well as the debt instruments themselves. In
some cases, the services of the underlying debt are also given ratings. In most
cases, the issuers of securities are companies, special purpose entities, state and
local governments, non-profit organizations, or national governments issuing debtlike securities (i.e., bonds) that can be traded on a secondary market. A credit
rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its
ability to pay back a loan), and affects the interest rate applied to the particular
security being issued.
Investor can subscribe to bond issues made by the government/corporates in the
primary market. Alternatively, one can purchase the same from the
secondary market through the stock exchanges.

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Credit Rating Information Services of India Limited (CRISIL)

CRISIL was set up by ICICI and UTI in 1988.
CRISIL rates debentures, fixed deposits, commercial paper, preference shares
and structured obligations. The rating methodology followed by CRISIL
involves and analysis of the following factors :
(i) Business Analysis
(a) Industry risk, including analysis of the structure of the industry, the Demand
-supply position, a study of the key success factors, the nature and basis of
competition, the impact of government policies, cyclicity and seasonality of the
industry.
(b) Market position of the company within the industry including market shares,
product and customer diversity, competitive advantages, selling and distribution
arrangements.
(c) Operating efficiency of the company like locational advantages, labour
relationships, technology, manufacturing efficiency as compared to competitors.
(d) Legal position including the terms of the prospectus, trustees and their
responsibilities an systems for timely payments.
(ii) Financial Anaysis,
(a) Accounting quality like any overstatement or understatement of profits,
auditors qualifications in their reports, methods of valuation of inventory,
depreciation policy
(b) Earnings protection in terms of future earning growth for the company and
future profitability.
(c) Adequacy of cash flows to meet debt servicing requirements in addition to
fixed and working capital needs. An opinion would be formed on the
sustainability of cash flows in the future and the working capital management of
the company.
(d) Financial flexibility including the companys ability to source finds from
other sources like group companies, ability to defer capital expenditure and
alternative financing plans in times of stress.
(iii) Management Evaluation The quality and ability of the management would
be judged on the basis of the past track record, their goals, philosophies and
strategies their ability to overcome difficult situations, etc. In addition to ability
to repay, an assessment would be made of the managements willingness to pay
debt. This would involve an opinion of integrity of the management.
(iv) Regulatory and competitive environment and regulatory framework of the
financial system would be examined keeping in view their likely impact on the
company. Trends in regulation / deregulation are also examined keeping in view
their likely impact on the company.
(v) Fundamental Analysis
a) Capital adequacy, i.e. the true net work as compared to the
volume of business and risk profile assets.
83

b) Asset quality including the companys credit risk management, systems for
monitoring credit, exposure to individual borrowers and management of
problem credits.
c) Liquidity management. Capital structure, term matching of assets and
liabilities and policy on liquid assets in relation to financial commitments
would be some of the areas examined.
d) Profitability and financial position in terms of past historical profits, the
spread of funds deployed and accretion to reserves.
e) Exposure to interest are changes and tax law changes. The rating process
begins at the request of the company. A professionally Qualified team of
analysis visits the companys plants and meets with different levels of the
management including the CEO. On completion of the assignment, the team
interacts with a back-up team that has separately collected additional industry
information and prepares a report. This report is placed before an internal
committee and there is an open discussion to arrive at the rating. The rating is
presented to an external committee which then takes the final decision which
is communicated to the company. Should the company volunteer any further
information at that point which could affect the rating is passed on to the
external committee. Therefore, the company has the option to request for a
review of rating. CRISIL publishes the CRISIL ratings in SCAN which is a
quarterly publication in Hindi and Gujarathi besides English. CRISIL can rate
mutual funds, banks and chit funds. Rating of mutual funds has assumed
importance after the poor performance of mutual fund industry in 1995 to
1996. CRISI. Ventured into mutual fund rating market in 1997. It may also
start rating real estate developers and governments. CRISIL is equipped to do
equity grading.
CRISIL Rating Symbols
Debenture
AAA Highest Safety
AA High safety
A
Adequate safety
BBB Moderate safety
BB Inadequate safety
B
High risk
C
Substantial risk
D
Default
(Debenture rated D are in default and in arrears of interest or principal
payment or are expected to default on maturity. Such debentures are extremely
speculative and returns from these debentures may be realized only on
reorganization or liquidation), Crisil may apply plus or minus signs for ratings
from AA to D to reflect comparative standing within the category.
For rating preference shares, the letters pf are prefixed to the debentures rating
84

symbols, e.g. pfAAA (Trible A)

Fixed Deposit Program
FAAA
Highest Safety
FAA
High Safety
FA
Adequate safety
FB
Inadequate safety
FC
High risk
FD
Default or likely to be in default
Short term Instruments
P-1 Very Strong degree of safety
P-2 Strong degree of safety
P-3 Adequate degree of safety
P-4 Inadequate degree of safety
Structured Obligations
AAA (SO)
Highest Safety
AA (SO)
Higher Safety
A (SO)
Adequate safety
BBB (SO)
Moderate safety
BB (SO)
Inadequate safety
B(SO)
High risk
C(SO)
Substantial risk
D(SO)
Default
Investment Information and Credit Rating Agency (ICRA)
ICRA which was promoted IFCI in 1991 carries out rating of debt instruments
of manufacturing companies, finance companies and financial institutions.
The factors that ICRA takes into consideration for rating depend on the nature of
borrowing entity. The inherent protective factors, marketing strategies, competitive
edge, level of technological development, operational efficiency, competence and
effectiveness of management, human resource development policies and practices,
hedging of risks, trends in cash flows and potential liquidity, financial flexibility,
asset quality and past record of servicing of debt as well as government policies
affecting the industry and unit arc examined. ICRA commences work at the request
of the prospective issuer. A team of analysts collect data by going through the
companys books, interviewing executives and from the in-house research and data
base of ICRA. ICRA offers the company on opportunity to get the instrument rated
confidentially and also an option regarding the use of the rating. If the company
decided to use the rating. ICRA monitors it until redemption/repayment. In the case
of misstatement by the company ICRA can disclose the correct position.
ICRA Rating Symbols
Long-term including debentures, bonds and preferences shares
LAAA
Highest Safety
LAA
High Safety
LA
Adequate Safety
LBBB
Moderate Safety
85

LBB
Inadequate safety
LB
Risk prone
LC
Substantial risk
LD
Default
Medium term including fixed deposits
MAAA
Highest Safety
MAA
High Safety
MA
Adequate safety
MB
Inadequate safety
MC
Risk prone
MD
Default
A-1
Highest Safety
A-2
High Safety
A-3
Adequate safety
A-4
Risk prone
A-5
Default
Credit Analysis and Research Limited (CARE)
Credit Analysis and Research Limited is the third rating agency promoted by
IDBI jointly with investment institution, banks and finance companies in 1993.
They include Canara Bank, Unit Trust of India, Credit Capital Venture Fund
(India) Limited, (since taken over by Infrastructure Leasing and Financial
Services Ltd.). Sundaram Finance Limited, The Federal Bank Limited the Vysya
Bank Limited, First Leasing Company of India Limited, ITC Classic Finace,
Kolak Mahindra Finance among others. CARE commenced its rating operations
in October, 1993.
Credit rating by CARE covers all types of debt instruments such as debentures,
fixed deposits, commercial paper and structured obligations. It also undertakes
credit analysis of companies for the use of bankers, other lenders and business
enterprises.
CAREs Rating Symbols
For long-term and medium-term instruments.
CARE AAA Best quality investments.
CAREAAA Debt service payments protected by stable Cash flows with
good margin
CARE AA High quality but rated lower because of Somewhat lower
margin of protection

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CARE A

Upper medium grade. Safety adequate

CARE BBB Sufficient safety. But adverse changes in assumptions likely to

weaken the debt Servicing capabilities
CARE BB Speculative instruments. Inadequate
and principal payments.

protection for interest

CARE C

Highest investment risk.

CARE D

Lowest category. Likely to be in default soon.

In order of increasing risk, the ratings for short-term instruments are PR-1,PR2, PR-3 and PR-5 and CARE -1, CARE -2, CARE -3, CARE 4, and CARE
5 for credit analysis of companies.

87

Review Questions
Multiple Choice Questions
Q1. If you buy stock from a corporation newly-formed by your sibling when
the firm makes its initial public offering (IPO), you would be engaged in:
(a) direct primary financing.
(b) long-term debt financing.
(c) Part-mutual financing.
(d) short term equity financing.
(e) mutual funding.
Q2. Activities in primary markets would include the sale of:
(a) stock on the New York Stock Exchange.
(b) financial futures in the market for U.S. government bonds.
(c) penny stocks through the over-the-counter stock market.
(d) call options in commodity futures markets.
(e) stock in an initial public offering (IPO) by a fledgling corporation.
Q3. The markets in which the general public is least likely to learn about
activities are:
(a) primary markets.
(b) secondary markets.
(c) money market markets.
(d) residential real estate markets.
Q4. A corporation acquires new funds only when its securities are sold in the:
(a) secondary market by an investment bank.
(b) primary market by an investment bank.
(c) international money market by a stock exchange broker.
(d) secondary market by a commercial bank.
Q5. Security transactions that do not yield flows of funds to the issuers of the
financial instruments traded are financial investments involving:
(a) brokerage services by investment bankers.
(b) initial public offerings [IPOs].
(c) secondary markets.
(d) new issues of seasoned instruments.
(e) insider trading by corporate executives.

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Q6. Financial instruments issued by government agencies or corporations

that promise to pay certain amounts of money to the holder on specific
future dates are called:
(a) liens.
(b) preferred stock.
(c) chattel.
(d) bonds.
(e) common stock.
Q7.

Book Building is a
(a) Price Discovery mechanism
(b) Secondary market operation
(c) Offer of shares to public
(d) None of the above

Q8.

Merchant Bankers help in :a) Selling of shares in secondary market

b) Management of IPOs
c) Issue of Mutual funds
d) Setting up the prices

Q9.

Buy HCL 50 shares @Rs. 50 is a

a) Best rate order
b) Limit order
c) Stop loss order
d) Discretionary order

Q10. Debt instrument have :a) Fixed maturity

b) Fixed coupon rate
c) Fixed principal
d) All of the above

89

Chapter 4
Topic: Mutual Funds
Contents:
4.1

Mutual Funds: Introduction

4.2

Valuation of Mutual funds

4.3

Risks involved in investing in Mutual Funds

4.4

Different types of Mutual funds

4.5

Different investment plans that Mutual Funds offer

4.6

Structure of Mutual Funds

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4.1 Mutual Funds: Introduction:

Mutual funds are financial intermediaries which collect the savings of investors
and invest them in a large and well diversified portfolio of securities such as
money market instruments, corporate and Government bonds and equity shares of
joint stock companies. A mutual fund is a pool of commingle funds invested by
different investors, who have not contract with each other. Mutual funds are
conceived as institutions for providing small investors with avenues of
investments in the capital market.. Since small investors generally do not have
adequate time, knowledge, experience and resources for directly accessing the
capital market, they have to rely on an intermediary which undertakes informed
investment decisions and provides the consequential benefits of professional
expertise. The raison deter of mutual funds is their ability to bring down
transaction costs. The advantages for the investors are reduction in risk, export
professional management ,diversified portfolios, liquidity of investment and tax
benefits . By pooling their assets through mutual funds, investors achieve
economies of scale. The interests of the investors are protected by the SEBI which
acts as a watch dog. Mutual funds are governed by the SEBI (Mutual Funds)
Regulations,1993.
MUTUAL FUNDS IN INDIA:
The first mutual fund to be set up was the Unit Trust of India in 1964 under an
act of Parliament . During the years 1987-1992,even new mutual funds were
established in the public sector. In 1993, the government changed the policy to
allow the entry of private corporations and foreign institutional investors in to
the mutual fund segment. By the end of march 2000, apart from UTI there were 36
mutual funds, 9 in the public sector and 27 in the private sector.
The UTI dominated the mutual fund sector till 1994-95, accounting for 76.5% of the
total mobilization. But there were large repurchases by UTI in 1995-97, which resulted
in reverse flow funds. Meanwhile the number of mutual funds especially in the private
sector have grown along the number of schemes matching the preferences of the
investors. The year 1999-2000 was a watershed year in which mutual funds emerged as
an important investment conduit for investors at large. Net resource mobilization by all
mutual funds amounted to 21,972 crores. Growth was led mainly by private sector
mutual funds, which witnessed an inflow of the order of Rs. 17,171.0 crores. Fiscal
incentives provided in the union funds 1999-2000 exempted all income received by the
investors from UTI and other mutual funds from income-tax. All open-ended equity
oriented schemes along with the US 64 scheme were exempted from dividend tax for 3
years. Buoyant stock markets were also a
contributory factor. The outstanding net assets of all domestic schemes of mutual funds
stood at Rs 1,07,946 crores at the end of March 2000. The share of UTI in the
outstanding assets was 67%, public sector funds 10%, and private sector mutual funds
23%.
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Benefits of investing in Mutual Funds

There are several benefits from investing in a Mutual Fund:
Small investments: Mutual funds help you to reap the benefit of returns by a
portfolio spread across a wide spectrum of companies with small investments.
Professional Fund Management: Professionals having considerable expertise,
experience and resources manage the pool of money collected by a mutual fund.
They thoroughly analyse the markets and economy to pick good investment
opportunities.
Spreading Risk: An investor with limited funds might be able to invest in only
one or two stocks/bonds, thus increasing his or her risk. However, a mutual fund
will spread its risk by investing a number of sound stocks or bonds. A fund
normally invests in companies across a wide range of industries, so the risk is
diversified.
Transparency: Mutual Funds regularly provide investors with information on the
value of their investments. Mutual Funds also provide complete portfolio
disclosure of the investments made by various schemes and also the proportion
invested in each asset type.
Choice: The large amount of Mutual Funds offer the investor a wide variety to
choose from. An investor can pick up a scheme depending upon his risk/ return
profile.
Regulations: All the mutual funds are registered with SEBI and they function
within the provisions of strict regulation designed to protect the interests of the
investor.
4.2

Valuation of Mutual funds:

Mutual Funds are valued with the help of their NAVs.

NAV or Net Asset Value of the fund is the cumulative market value of the assets of
the fund net of its liabilities. NAV per unit is simply the net value of assets divided
by the number of units outstanding. Buying and selling into funds is done on the
basis of NAV-related prices. The NAV of a mutual fund are required to be
published in newspapers. The NAV of an open end scheme should be disclosed on
a daily basis and the NAV of a close end scheme should be disclosed at least on a
weekly basis
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Entry/Exit Load
A Load is a charge, which the mutual fund may collect on entry and/or exit from a
fund. A load is levied to cover the up-front cost incurred by the mutual fund for
selling the fund. It also covers one time processing costs. Some funds do not
charge any entry or exit load. These funds are referred to as No Load Fund.
Funds usually charge an entry load ranging between 1.00% and 2.00%. Exit loads
vary between 0.25% and 2.00%.
For e.g. Let us assume an investor invests Rs. 10,000/- and the current NAV is
Rs.13/-. If the entry load levied is 1.00%, the price at which the investor invests is
Rs.13.13 per unit. The investor receives 10000/13.13 = 761.6146 units. (Note that
units are allotted to an investor based on the amount invested and not on the basis
of no. of units purchased).
Let us now assume that the same investor decides to redeem his 761.6146 units.
Let us also assume that the NAV is Rs 15/- and the exit load is 0.50%. Therefore
the redemption price per unit works out to Rs. 14.925. The investor therefore
receives 761.6146 x 14.925 = Rs.11367.10.
4.3

Risks involved in investing in Mutual Funds

Mutual Funds do not provide assured returns. Their returns are linked to their
performance. They invest in shares, debentures, bonds etc. All these investments
involve an element of risk. The unit value may vary depending upon the
performance of the company and if a company defaults in payment of
interest/principal on their debentures/bonds the performance of the fund may get
affected. Besides incase there is a sudden downturn in an industry or the
government comes up with new a regulation which affects a particular industry or
company the fund can again be adversely affected. All these factors influence the
performance of Mutual Funds.
Some of the Risk to which h Mutual Funds are exposed to is given below:
Market risk
If the overall stock or bond markets fall on account of overall economic factors,
the value of stock or bond holdings in the fund's portfolio can drop, thereby
impacting the fund performance.

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Non-market risk
Bad news about an individual company can pull down its stock price, which can
negatively affect fund holdings. This risk can be reduced by having a diversified
portfolio that consists of a wide variety of stocks drawn from different industries.
Interest rate risk
Bond prices and interest rates move in opposite directions. When interest rates
rise, bond prices fall and this decline in underlying securities affects the fund
negatively.
Credit risk
Bonds are debt obligations. So when the funds invest in corporate bonds, they run
the risk of the corporate defaulting on their interest and principal payment
obligations and when that risk crystallizes, it leads to a fall in the value of the bond
causing the NAV of the fund to take a beating.
4.4

Different types of Mutual funds

Mutual funds are classified in the following manner:

(a) On the basis of Objective
Equity Funds/ Growth Funds
Funds that invest in equity shares are called equity funds. They carry the principal
objective of capital appreciation of the investment over the medium to long-term.
They are best suited for investors who are seeking capital appreciation. There are
different types of equity funds such as Diversified funds, Sector specific funds and
Index based funds.
Diversified funds
These funds invest in companies spread across sectors. These funds are generally
meant for risk-averse investors who want a diversified portfolio across sectors.
Sector funds
These funds invest primarily in equity shares of companies in a particular business
sector or industry. These funds are targeted at investors who are bullish or fancy
the prospects of a particular sector.
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Index funds
These funds invest in the same pattern as popular market indices like S&P CNX
Nifty or CNX Midcap 200. The money collected from the investors is invested
only in the stocks, which represent the index. For e.g. a Nifty index fund will
invest only in the Nifty 50 stocks. The objective of such funds is not to beat the
market but to give a return equivalent to the market returns.
Tax Saving Funds
These funds offer tax benefits to investors under the Income Tax Act.
Opportunities provided under this scheme are in the form of tax rebates under the
Income Tax act.
Debt/Income Funds
These funds invest predominantly in high-rated fixed-income-bearing instruments
like bonds, debentures, government securities, commercial paper and other money
market instruments. They are best suited for the medium to long-term investors
who are averse to risk and seek capital preservation. They provide a regular
income to the investor.
Liquid Funds/Money Market Funds
These funds invest in highly liquid money market instruments. The period of
investment could be as short as a day. They provide easy liquidity. They have
emerged as an alternative for savings and short-term fixed deposit accounts with
comparatively higher returns. These funds are ideal for corporates, institutional
investors and business houses that invest their funds for very short periods.
Gilt Funds
These funds invest in Central and State Government securities. Since they are
Government backed bonds they give a secured return and also ensure safety of the
principal amount. They are best suited for the medium to long-term investors who
are averse to risk.
Balanced Funds
These funds invest both in equity shares and fixed-income-bearing instruments
(debt) in some proportion. They provide a steady return and reduce the volatility

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of the fund while providing some upside for capital appreciation. They are ideal
for medium to long-term investors who are willing to take moderate risks.
b) On the basis of Flexibility
Open-ended Funds
These funds do not have a fixed date of redemption. Generally they are open for
subscription and redemption throughout the year. Their prices are linked to the
daily net asset value (NAV). From the investors' perspective, they are much more
liquid than closed-ended funds.
Close-ended Funds
These funds are open initially for entry during the Initial Public Offering (IPO)
and thereafter closed for entry as well as exit. These funds have a fixed date of
redemption. One of the characteristics of the close-ended schemes is that they are
generally traded at a discount to NAV; but the discount narrows as maturity nears.
These funds are open for subscription only once and can be redeemed only on the
fixed date of redemption. The units of these funds are listed on stock exchanges
(with certain exceptions), are tradable and the subscribers to the fund would be
able to exit from the fund at any time through the secondary market.
4.5 Different investment plans that Mutual Funds offer
The term investment plans generally refers to the services that the funds provide
to investors offering different ways to invest or reinvest. The different investment
plans are an important consideration in the investment decision, because they
determine the flexibility available to the investor. Some of the investment plans
offered by mutual funds in India are:
Growth Plan and Dividend Plan
A growth plan is a plan under a scheme wherein the returns from investments are
reinvested and very few income distributions, if any, are made. The investor thus
only realizes capital appreciation on the investment. Under the dividend plan,
income is distributed from time to time. This plan is ideal to those investors
requiring regular income.

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Dividend Reinvestment Plan

Dividend plans of schemes carry an additional option for reinvestment of income
distribution. This is referred to as the dividend reinvestment plan. Under this plan,
dividends declared by a fund are reinvested in the scheme on behalf of the
investor, thus increasing the number of units held by the investors.
Return form mutual funds: Investors on mutual funds can obtain the following
returns . They are:
1. Dividends.
2. Capital gains.
3. Increase or decrease in NAV
1.

Dividends:The dividend income of a mutual fund company form its

investments in share , both equity and preference, are phased on to the unit
holders. All income received by investors form mutual funds is exempt form
tax.
2.
Capital Gains: Mutual fund unit holders or owners also got benefits
of capital gains which are realized and described to them in cash or kind.
3.

Increase or Decrease in NAV: The increase or decrease in the NAV

are the result of unrealized gains or losses on the portfolio holdings of the
mutual fund.

Although mutual funds do not earn high rates of return, they are able to reduce risk
to the systematic level of market fluctuations. Most mutual funds earn in long run,
an average rate of return that exceeds the return on bank tern deposits.

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4.6

Structure of Mutual Funds:

Following is the structure of a typical mutual fund:

The Sponsor of a fund is the entity that sets up the mutual fund. The fund is
governed either by a Board of Trustees, or The Directors Of A Trustees
Company. The sponsor selects them. The Board of Trustee is responsible for
protecting the investors interests. The sponsor or the trustee if so authorized by
the Trust Deed appoints the Asset Management Company (AMC) for the
investment and administrative functions. The AMC does the research, and
manages the corpus of the fund. It launches the various schemes of the fund,
manages them, and then liquidates them at the end of their term. It also takes care
of the other administrative work of the fund. It receives annual management fees
from the fund from its services. The Custodians are appointed by the sponsor for
looking after the transfer and storage of the securities and co-ordinate with the
brokers.
Sponsor with Track Record:
A mutual fund in a private sector has to be sponsored by a limited company having
a track record. The mutual fund has to be established as a trust under the Indian
Trust Act,1882. The sponsoring company should have at least a 40 percent stake in
the paid-up capital of the asset management company. Mutual funds are required
to avail off the services of a custodian who has secured the necessary authorisation
form the SEBI.

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Asset Management Company: (AMC)

A mutual fund is managed by an Asset Management Company that is appointed by
the sponsor company or by the trustee. The asset management company has to be
registered under the Companies Act,1956, and has to be approved by the SEBI.
The AMC manages the affairs of the mutual funds and its schemes. AMC are
registered by the Registrar of Companies only after a draft memorandum and
articles of association are cleared by the SEBI.
The Trustee
A mutual fund in India is constituted in the form of a Public Trust created under
the Indian Trusts Act 1882. The Fund Sponsor acts as the Settler of the Trust,
contributing to its initial capital and appoints a trustee to hold the assets for the
benefit of the unit-holders, who are the beneficiaries of the trust. The fund then
invites investors to contribute their money in the common pool, by subscribing to
units issued by various schemes established by the trust, units being the evidence
of their beneficial interest in the fund.
The trust the mutual fund- may be managed by a Board of Trustees- a body of
individuals, or a trust company- a corporate body. The Board of Trustees manages
most of the funds in India. While the Provisions of the Indian Trusts Act, govern
the Board of Trustees where the Trustee is a corporate body, it would also be
required to comply with the provisions of the companies Act, 1956. The Board or
the trustee company, as an independent body, acts as protector of the unit-holders
interest the trustees do not directly manage the portfolio of securities.
For this specialist function, they appoint an Asset Management Company. They
ensure that the fund is managed by the AMC as per the defined objectives and in
accordance with the Trust Deed and SEBI Regulations.
The trustees being the primary guardians of the unit holders funds and assets, a
trustee has to be a person of high repute and integrity. He acts as a watchdog over
the AMC so that the investors money is safe and secure.
Fund Management
Active Fund Management
When investment decisions of the fund are at the discretion of a fund manager(s)
and he or she decides which company, instrument or class of assets the fund
should invest in based on research, analysis, market news etc. such a fund is called
as an actively managed fund. The fund buys and sells securities actively based on
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changed perceptions of investment from time to time. Based on the classifications

of shares with different characteristics, active investment managers construct
different portfolio.
Two basic investment styles prevalent among the mutual funds are Growth
Investing and Value Investing:
Growth Investment Style
The primary objective of equity investment is to obtain capital appreciation. A
growth manager looks for companies that are expected to give above average
earnings growth, where the manager feels that the earning prospects and therefore
the stock prices in future will be even higher. Identifying such growth sectors is
the challenge before the growth investment manager.
Value investment Style
A Value Manager looks to buy companies that they believe are currently
undervalued in the market, but whose worth they estimate will be recognized in
the market valuations eventually.
Passive Fund Management
When an investor invests in an actively managed mutual fund, he or she leaves the
decision of investing to the fund manager. The fund manager is the decisionmaker as to which company or instrument to invest in. Sometimes such decisions
may be right, rewarding the investor handsomely. However, chances are that the
decisions might go wrong or may not be right all the time which can lead to
substantial losses for the investor. There are mutual funds that offer Index funds
whose objective is to equal the return given by a select market index. Such funds
follow a passive investment style. They do not analyse companies, markets,
economic factors and then narrow down on stocks to invest in. Instead they prefer
to invest in a portfolio of stocks that reflect a market index, such as the Nifty
index. The returns generated by the index are the returns given by the fund. No
attempt is made to try and beat the index. Research has shown that most fund
managers are unable to constantly beat the market index year after year. Also it is
not possible to identify which fund will beat the market index.
Therefore, there is an element of going wrong in selecting a fund to invest in. This
has lead to a huge interest in passively managed funds such as Index Funds where
the choice of investments is not left to the discretion of the fund manager. Index
Funds hold a diversified basket of securities which represents the index while at
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the same time since there is not much active turnover of the portfolio the cost of
managing the fund also remains low.
This gives a dual advantage to the investor of having a diversified portfolio while
at the same time having low expenses in fund. There are various passively
managed funds in India today some of them are:
Principal Index Fund, an index fund scheme on S&P CNX Nifty launched by
Principal Mutual Fund in July 1999.
UTI Nifty Fund launched by Unit Trust of India in March 2000.
Franklin India Index Fund launched by Franklin Templeton Mutual
Fund in June 2000.
Franklin India Index Tax Fund launched by Franklin Templeton
Mutual Fund in February 2001.
Magnum Index Fund launched by SBI Mutual Fund in December 2001.
IL&FS Index Fund launched by IL&FS Mutual Fund in February 2002.
Prudential ICICI Index Fund launched by Prudential ICICI Mutual Fund in
February 2002.
HDFC Index Fund-Nifty Plan launched by HDFC Mutual Fund in July 2002.
Birla Index Fund launched by Birla Sun Life Mutual Fund in September 2002.
LIC Index Fund-Nifty Plan launched by LIC Mutual Fund in November 2002.
Tata Index Fund launched by Tata TD Waterhouse Mutual Fund in February 2003.
ING Vysya Nifty Plus Fund launched by ING Vysya Mutual Fund in January
2004.
Canindex Fund launched by Canbank Mutual Fund in September 2004
UNIT TRUST OF INDIA:
Unit Trust of India (UTI) is Indias first mutual fund organisation. It is the single largest
mutual fund in India, which came in to existence with the enactment of UTI Act in 1964.
The economic turmoil and the wars in the early sixties depressed the financial markets
making it difficult for both existing and new entrepreneurs to raise fresh capital. Then the
Finance Minister,T.,T.Krishnamachari, set up the idea of a Unit Trust n which would
mobilize savings of the community and invest these savings in the Capital market. His
ideas took the form of the Unit Trust of India, which commenced operations form likely
1964, with a view to encouraging savings and investment and participation in the income,
profits and gains accruing to the Corporation form the acquisition, holding, management
and disposals of securities. The regulation passed by the Ministry of Finance (MOF) and
the Parliament form time to time regulated the functioning of UTI. Different provisions
of the UTI Act laid down the structure of management, scope of business, powers and
functions of the Trust as well as accounting, disclosures, and regulatory requirements, for
the Trust. UTI was set up as a trust without ownership capital and with an independent
Board of Trustees. The Board of Trustees manages the affairs and business of UTI. The
Board performs its functions, keeping in view the interest of the Unit-holders under
various schemes.
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UTI was set up as a trust without ownership capital and with an independent
Board of Trustees. The Board of Trustees manages the affairs and business of
UTI. The Board performs its functions, keeping in view the interest of the unitholders under various schemes. UTI has a wide distribution network of 54 branch
offices, 266 chief representatives and about 67,000 agents. These Chief
representatives supervise agents. UTI manages 72 schemes and has an investors
base of 20.02 million investors. UTI has set up 183 collection centres to serve to
serve investors. It has 57 franchisee offices which accept applications and
distribute certificates to unit-holders.
UTIs mission statement is to meet the investors diverse income and liquidity
needs by creation of appropriate schemes, to offer best possible returns on his
investment, and render him prompt and efficient service, baying normal customer
expectations. UTI was the first mutual fund to launch India Fund, an offshore
mutual fund in 1986. The India Fund was launched as a close-ended fund but
became a multi-class , open ended fund in 1994. Thereafter, UTI floated the
India
Growth Fund in 1988, the Columbus India Fund in 1994, and the India Access
Fund in 1996. The India Growth Fund is listed on the New York Stock Exchange.
The India Access Fund is an Indian Index Fund, tracking the NSE 50 index.
UTIs Associates:
UTI has set up associate companies in the field of banking, securities trading ,
investor servicing, investment advice and training, towards creating a diversified
financial conglomerate and meeting investors varying needs under a common
umbrella.
UTI BANK Limited: UTI Bank was the first private sector bank to be set up in
1994. The Bank has a network of 121 fully computerized branches spread across
the country. The Bank offers a wide range of retail, corporate and forex services.
UTI Securities Exchange Limited: UTI Securities Exchange Limited was the
first institutionally sponsored corporate stock broking firm incorporated on
June28,1994, with a paid-up capital of Rs.300 million. It is wholly owned by UTI
and promoted to provide secondary market trading facilities, investment banking,
and other related services. It has acquired membership of NSE,BSE,OTCEI and
Ahmedabad Stock Exchange (ASE) UTI Investors Services Limited: UTI
Investor Services Limited was the first Institutionally sponsored Registrar and
Transfer agency set up in 1993. It helps UTI in rendering prompt and efficient
services to the investors.

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UTI Institute of Capital Markets: UTI Institute of Capital Market was set up in
1989 as a non-profit educational society to promote professional development of
capital market participants. It provides specialized professional development
programmes for the varied constituents of the capital market and is engaged in
research and consultancy services. It also serve as a forum to discuss ideas and
issues relevant to the capital market.
UTI Investment Advisory Services Limited: UTI Investment Advisory Services
Limited the first Indian Investment advisor registered with SEC,US, was set up in
1988 to provide investment research and back office support to other offshore
funds of UTI.
UTI International Limited: UTI International Limited is a 100 percent subsidiary
of UTI, registered in the island of Guernsey, Channel Islands. It was set up with the
objective of helping in the UTI offshore funds in marketing their products and
managing funds. UTI International Limited has an office in London, which is
responsible for developing new products, new business opportunities, maintaining
relations with foreign investors, and improving communication between UTI and
its clients and distributors abroad. UTI has a branch office at Dubai, which caters to
the needs of NRI investors based in Six Gulf countries, namely, UAE, Oman,
Kuwait, Saudi Arabia, Qatar, and Bahrain. This branch office acts as a liaison
office between NRI investors in the Gulf and UTI offices in India.
UTI has extended its support to the development of unit trusts in Sri Lanka and
Egypt. It has participated in the equity capital of the Unit Trust Management
Company of Sri Lanka.
Promotion of Institutions:
The Unit Trust of India has helped in promoting/co-promoting many institutions
for the healthy development of financial sector. These institutions are:

Infrastructure Leasing and Financial Services (ILFS)

Credit Rating and Information Services Limited (CRISIL)
Stock Holding Corporation of India Limited (SHCIL)
Technology Development Corporation of India Limited(TDCIL)
Over the Counter Exchange of India Limited (OCEIL)
National Securities Depository Limited (NSDL)
North-Eastern Development Finance Corporation Limited (NEDFCL)

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Review Questions
Multiple Choice Questions
Q1.

By pooling the funds provided by hundreds or thousands of savers,

financial intermediaries are able to:
a)
Provide each saver with a more diversified portfolio than he could
otherwise obtain.
b)
Make large loans that would not be possible if all transactions
involved one borrower and one lender.
c)
Provide small savers access to markets and instruments that would
otherwise be inaccessible.
d)
do all of the above.

Q2.

All else equal, the more diversified an investors portfolio is,

a)
The less risky that portfolio will be.
b)
The less liquid that portfolio will be.
c)
The lower that portfolios yield will be.
d)
None of the above.

Q3.

Money market mutual funds tend to invest in ___________ financial

instruments.
a)
highly liquid
b)
debt market
c)
low market- and default-risk
d)
all of the above

Q4.

The following are the advantages of investing in mutual funds:a)

Diversified investment
b)
Tax benefit
c)
Professional management
d)
Ease of investment for low net worth individuals
e)
All of the above

Q5. Which of the following benefit is not usually conferred by mutual

funds?
a) Diversified investment portfolio
b) Professional stock selection
c) Reduction in unsystematic risk
d) Tax benefit
e) Assured returns

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Q6.

Which of the following is not an advantage of mutual funds:a) Expertise in selection and timing of investment
b) Economics of scale
c) Dividends are tax free
d) Limited investment opportunities and hence no need for the investor to
have knowledge of investment management

Q7.

What is true for an AMC:a) It is constituted as a trust

b) It is appointed by sponsors
c) It has a stake in paid up capital

Q8.

Equity Funds invest in:a) Debt instruments

b) Equity shares
c) Sectoral shares
d) Technology shares.

Q9.

Balanced funds invest in

a) Only equity
b) Only debt
c) Both debt & equity
d) Treasury bills

Q10. Entry load is

a) Charge which is mutual fund collect on exit from fund
b) Charge which the mutual fund collect on entry in fund
c) Charge for operations
d) None of the above.

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Chapter 5
Topic: Foreign Direct Investment
Contents:
5.1

Foreign direct investment (FDI)

5.2

Foreign Institutional Investor

5.3

The Costs and Benefits of FDI

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Foreign Direct Investment is viewed as a major stimulus to economic growth in

developing countries. Its perceived ability to deal with major obstacles such
shortages of financial resources, technology, and skills. This has made it the center
of attention for policy makers in developing countries such as Africa. FDI refers to
investment made to acquire a lasting management interest (usually at least 10 % of
voting stock) and acquiring at least 10% of equity share in an enterprise operating
in a country other than the home country of the investor. FDI can take the form of
either greenfield investment (also called "mortar and brick" investment) or
merger and acquisition (M&A), depending on whether the investment involves
mainly newly created assets or just a transfer from local to foreign firms.
5.1 Foreign direct investment (FDI) in its classic form is defined as a company
from one country making a physical investment into building a factory in another
country. It is the establishment of an enterprise by a foreigner. Its definition can be
extended to include investments made to acquire lasting interest in enterprises
operating outside of the economy of the investor.The FDI relationship consists of a
parent enterprise and a foreign affiliate which together form a multinational
corporation (MNC). In order to qualify as FDI the investment must afford the
parent enterprise control over its foreign affiliate. The IMF (International
Monetary Fund) defines control in this case as owning 10% or more of the
ordinary shares or voting power of an incorporated firm or its equivalent for an
unincorporated firm; lower ownership shares are known as portfolio investment
Foreign direct investment (FDI) is also defined as "investment made to acquire
lasting interest in enterprises operating outside of the economy of the investor."
The FDI relationship consists of a parent enterprise and a foreign affiliate which
together form a transnational corporation (TNC). In order to qualify as FDI the
investment must afford the parent enterprise control over its foreign affiliate.
Types of FDI
I. By Direction
1. Inward
Inward foreign direct investment is when foreign capital is invested in local
resources.
Inward FDI is encouraged by:
Tax breaks, subsidies, low interest loans, grants, lifting of certain restrictions. The
thought is that the long term gain is worth short term loss of income.
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Inward FDI is restricted by:

Ownership restraints or limits
Differential performance requirements
2. Outward
Outward foreign direct investment, sometimes called "direct investment abroad",
is when local capital is invested in foreign resources.
Outward FDI is encouraged by:
Government-backed insurance to cover risk
Outward FDI is restricted by:
(ii)
(iii)

Tax incentives or disincentives on firms that invest outside of the

home country or on repatriated profits
Subsidies for local businesses

II. By Target
1. Greenfield investment
It is direct investment in new facilities or the expansion of existing facilities.
Greenfield investments are the primary target of a host nations promotional
efforts because they create new production capacity and jobs, transfer technology
and know-how, and can lead to linkages to the global marketplace.
Greenfield investments include research and development; and additional capital
investments.
Greenfield investments results in the loss of market share for competing domestic
firms.
The Profits are perceived to bypass local economies, and instead flow back
entirely to the multinational's home economy.

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2. Mergers and Acquisitions

Transfers of existing assets from local firms to foreign firms takes place; the
primary type of FDI. Cross-border mergers occur when the assets and operation of
firms from different countries are combined to establish a new legal entity.
Cross-border acquisitions occur when the control of assets and operations is
transferred from a local to a foreign company, with the local company becoming
an affiliate of the foreign company.
Unlike Greenfield investment, acquisitions provide no long term benefits to the
local economy-- even in most deals the owners of the local firm are paid in stock
from the acquiring firm, meaning that the money from the sale could never reach
the local economy.
Mergers and acquisitions are a significant form of FDI
3.Horizontal FDI
Investment in the same industry abroad as a firm operates in at home.
a) Vertical FDI
Backward Vertical FDI
Where an industry abroad provides inputs for a firm's domestic production
process.
Forward Vertical FDI
Where an industry abroad sells the outputs of a firm's domestic production.
III. By Motive
FDI can also be categorized based on the motive behind the investment from the
perspective of the investing firm:
1. Resource-Seeking
Investments which seek to acquire factors of production that are more efficient
than those obtainable in the home economy of the firm. In some cases, these
resources may not be available in the home economy at all (e.g. cheap labor and
natural resources)..
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2. Market-Seeking
Investments which aim at either penetrating new markets or maintaining existing
ones. FDI of this kind may also be employed as defensive strategy.
The businesses are more likely to be pushed towards this type of investment out of
fear of losing a market rather than discovering a new one.
3. Efficiency-Seeking
Investments which firms hope will increase their efficiency by exploiting the
benefits of economies of scale and scope, and also those of common ownership. It
is suggested that this type of FDI comes after either resource or market seeking
investments have been realized, with the expectation that it further increases the
profitability of the firm.
This type of FDI is mostly widely practiced between developed economies;
especially those within closely integrated markets (e.g. the EU).
4. Strategic-Asset-Seeking
A tactical investment to prevent the loss of resource to a competitor. For E.g., the
oil producers, whom may not need the oil at present, but look to prevent their
competitors from having it.
Foreign Direct Investment (FDI) in India is permitted as under the following
forms of investments.
1. Through financial collaborations.
2. Through joint ventures and technical collaborations.
3. Through capital markets via Euro issues.
4. Through private placements or preferential allotments.
ForbiddenTerritories:
FDI is not permitted in the following industrial sectors:
1. Arms and ammunition.
2. Atomic Energy.
3. Railway Transport.
4. Coal and lignite.
5. Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds,
copper, zinc.

FDI up to 100% is allowed under the automatic route in all

activities/sectors except the following which will require approval of the
Government :
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Activities/items that require an Industrial Licence;

Proposals in which the foreign collaborator has a previous/existing
venture/tie up in India in the same or allied field
All proposals relating to acquisition of shares in an existing Indian
company by a foreign/NRI investor.
All proposals falling outside notified sectoral policy/caps or under sectors
in which FDI is not permitted.

5.2 FOREIGN INSTITUTIONAL INVESTOR

An investor or investment fund that is from or registered in a country outside of
the one in which it is currently investing. Institutional investors include hedge
funds, insurance companies, pension funds and mutual funds.
The term is used most commonly in India to refer to outside companies investing
in the financial markets of India. International institutional investors must register
with the Securities and Exchange Board of India to participate in the market. One
of the major market regulations pertaining to FIIs involves placing limits on
FII ownership in Indian companies.
One who propose to invest their proprietary funds or on behalf of "broad based"
funds or of foreign corporates and individuals and belong to any of the following
categories can be registered for FII.
Pension Funds
Mutual Funds
Investment Trust
Insurance or reinsurance companies
Endowment Funds
University Funds
Foundations or Charitable Trusts or Charitable Societies who propose to
invest on their own behalf, and
Asset Management Companies
Nominee Companies
Institutional Portfolio Managers
Trustees
Power of Attorney Holders
Bank
Foreign Direct Investment (FDI) are usually preferred over other forms of external
finance because they are non-debt creative, non-volatile and their returns depend
on the performance of projects financed by the investors. FDI benefits domestic
industry as well as Indian consumer by providing opportunities for technological
upgradation, access to global managerial skills and practices, optimal utilisation of
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natural and human resources, making Indian industry internationally competitive,

opening up export markets, providing backward and forward linkages and access
to international quality goods and services. In a world of increased of competition
and rapid technological change, their complimentary and their catalytic role can be
very valuable.

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Here is an example of one of the state governments of India ( Tamil Nadu

government) which has followed certain strategies to attract FDIs

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WHY FDI IS SEEN AS IMPORTANT FOR AFRICA

The Economic Report on Africa by the United Nations Economic Commission for
Africa advocates that FDI is the key to solving Africas economic problems. Bodies
such as the IMF and the World Bank have suggested that attracting large inflows of
FDI would result in economic development. SubSaharan African governments are
very eager to attract FDI. They have changed from being generators of employment
and spillovers for the local economy to governors of states that promote competition
and search for foreign capital to fill the resource gap. This change is attributed to
changes that are caused through structural adjustment programmes and the
internalization of neo-liberal assumptions promoted by the World Bank and IMF.
All African countries are keen on attracting FDI. Their reasons would differ but may
be summarised as: trying to overcome scarcities of resources such as capital,
entrepreneurship; access to foreign markets; efficient managerial techniques;
technological transfer and innovation; and employment creation. In their attempts to
attract FDI, African countries design and implement policies; build institutions; and
sign investment agreements. These benefits of FDI to African countries are difficult
to assess but will differ from sector to sector depending on the capabilities of
workers, firm size, and the level of competitiveness of domestic industries.
In Southern Africa, the main five reasons governments want to attract FDI are:
FDI is seen as an important source of capital formation particularly when the
capital base is low. Capital inflow is seen as a way of creating a surplus in the
capital account of the balance of payments or to make up for the deficit on the
current account. Consumer Unity and Trust Society (CUTS) points out that there
has been cases where FDI have not led to capital formation but rather crowded
out domestic investment ( Chatterjee, undated),
Transfer of technologies is expected because foreign companies will use
technology from their home country. From a developmental perspective, it is
more important that technology is diffused with spill- over into the local production
process, and that technology be adopted and adapted by local enterprises. For
an economy to improve on quality, technological upgrading is crucial. Technical
inefficiency, in developing countries, can severely hinder the quality of products
produced and the ability to cope with new demands. At the moment, no studies have
shown that FDI had this diffusion-effect in Southern Africa. On the contrary,
foreign investment results in competition that tends to stifles local technology
development and diverts resources from technology development to attracting
FDI.
It is argued that FDI will lead to employment creation. International experience
shows that foreign direct investment is not always accompanied by substantial
employment creation and in most cases lead to job losses when public
companies are privatised. In a special ECONEWS report on Foreign Investment
in SADC, it was pointed out that FDI is not a good way to create jobs. While a
quarter expands employment, a third will contract employment. For example, in
Namibia, most FDI investments went into the mining industry that reduced its
workforce from 14000 to 5000 during the past 12 years.
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 Transfer of management skills, to local managers, takes place when investors set
up new plants, acquire companies or outsource to local subcontractors.. .
Increased export competitiveness is anticipated. This was an important argument
when South Africa introduced its Growth, Employment, and Redistribution
(GEAR) strategy. It emphasized the importance of attracting investment in
clusters of industries to develop local companies.
A closer analysis of the main reasons for attracting FDI, employment creation and
capital formation, dont really have the desired effect.
Employment creation: International experiences have shown that FDI is hardly
accompanied by substantial employment creation, and in some cases may even
lead to job losses. Another problem with employment through FDI is the kind of
employment it creates. In Namibian, for example, the government claimed that
the Export Processing Zone (EPZ) programme created jobs and thus reduced the
unemployment rate. However, the jobs that were created are mostly
characterized by poor working conditions and very low salaries. Most of the
employees do not have job security and little prospects of improving their
standards of living. It is thus important to examine the quantity and quality of jobs
created.
Capital Formation: Yash Tandon argues that any reasonable accounting of
capital flows must take into account what flows in and out of the country (Tandon,
2002). In the Investment Position Paper by COSATU, it was pointed out that FDI
flowing out of South Africa had increased rapidly, and since 1994, it has
exceeded direct capital flows. COSATU has indicated that between 1994 and
2000, FDI into the country came to R45 billion, while outflows of direct investment
came to R54 billion (COSATU, 2001).
2.1. Initiatives taken by African countries to attract FDI
African countries, like most other developing countries have taken various initiatives
to attract FDI. These initiatives include incentives, signing of investment treaties and
investment promotion activities.
2.1.1 Incentives
Incentives can be described as policies used to attract internationally mobile
investors. Through the EPZ programme, African countries offer incentives to attract
foreign investment in the form of tax holidays, exemptions on export and import
duties, subsidized infrastructures, and limits on workers rights. According to Jauch
and Endresen (2000), opinions about the importance of incentives vary significantly.
Governments consider them as a mean to obtain FDI whereas transnational
corporations perceive EPZs as providers of favourable investment sites. The case of
Namibia is instructive in this regard.

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In 1995, Namibia passed its EPZ Act. Four years later, LaRRI carried a study to
assess the socio-economic impact of Namibias EPZ programme. This study
revealed that Namibia had come short of the expectation in terms of the EPZ
programme. The government anticipated creating 25 000 jobs by the end of 1999.
The actual number of jobs created at the time of the study was 400. The study
carried out by LaRRi unraveled poor labour conditions that could lead to future
conflicts (LaRRI, 2000). This prediction was confirmed in 2002-2003 when
RAMATEX, a Chinese owned textile company producing for the US market from
Namibia had two strikes within months of each other. The reasons were poor
working conditions and poor salaries, typical conditions that prevail in EPZs.
African countries have improved their regulatory frameworks for FDI by opening their
economies, permitting profit repatriation and providing tax and other incentives to
attract investment. Improvements in the regulatory framework for FDI have been
stressed in many countries through the conclusion of international agreements on
FDI. Most African countries have concluded bilateral investment treaties with
countries whose main aim is the protection and promotion of FDI. They also clarify
the terms under which FDI can enter the host country (UNCTAD; 1999;P.6).
Since the 1980s, all SADC governments have relaxed regulations for foreign
investors:
By granting investors easier entry,
By relaxing the ability to borrow locally although it implies a constraint on a
countrys foreign currency reserves,
Relaxation of land and mining concession ownership,
By forming new kinds of partnerships with the private sector (public private
partnerships) in areas which were previously the responsibility of the government
e.g. water distribution.
The incentives offered by governments can be grouped into three categories such as
fiscal, financial and rule or regulatory-based:
Fiscal Incentives
Reduced tax rates
Tax holidays,
Subsidies,
Exemptions from import duties
Accelerated depreciation allowances
Investment and reinvestment allowances
Specific deductions from gross earnings for national income tax purposes
Deductions from social security contributions
Financial Incentives
Grants
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 Loan and loan guarantees

Rules-based incentives
Modifying rules on workers rights
Modifying environmental standards
Greater protection for intellectual property rights (CUTS, 2001)
2.1.2 Investment treaties
Incentives are only a part of what governments offer to attract foreign investors to their
countries for investment. Increasingly countries have entered into investment treaties, both
bilateral investment treaties and multilateral ones.
Bilateral investment treaties The bilateral treaties contribute to the establishment of
favourable investment climate between two countries by providing assurance and
guarantees to investors. In the SADC region, only South Africa did not have a law that
specifically dealt with FDI by the late 1990s. More and more bilateral treaties are being
signed by African countries
to safeguard the rights of the investors. Bilateral investment treaties are perceived as
contributing to the establishment of favourable investment climate because they include
the following:
Fair and equitable treatment for foreign investors in terms of applications for
investment approval and setting up their businesses,
Specific provisions on expropriation and non-commercial losses and
compensation for the same, and
Dispute or conflict settlement mechanism (CUTS, 2001).
2.1.3 Investment Promotion
More and more countries are engaging in pro-active policies to attract FDI. Most countries
have established investment promotion agencies (IPA) whose main purpose is to attract
FDI and to look after foreign firms once they have set operations. Many countries,
particularly in Africa, still suffer from a negative image. This makes the marketing role of
IPAs extremely important. Investment promotion agencies usually fulfill a dual role:
By acting as a one stop for investors to deal with regulatory and administrative
requirements, and
By changing or modifying investor perception of the country by attending and
organizing investor fairs and by distributing materials.
Investment promotion covers a range of activities, including investment generation,
investment facilitation, aftercare services, and policy advocacy to enhance the
competitiveness of a location.
According to the World Investment Report (2002) the majority of countries have moved
from the first generation of investment to the second generation of investment. First
generation investments mainly involve the opening up of an economy to FDI whereas
second generation investment actively involves a government in marketing its location by
setting up investment promotion agencies.

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 In order to increase the efficiency of investment generation and enhance the

chances of attracting export-oriented FDI, some IPAs go further and utilize part of their
FDI promotion resources for investor targeting. Third generation promotion can be an
efficiency policy tool, but it is not an easy task and involves certain risks, such as, the
process of investor targeting does not integrate with the overall development strategy of a
country. |Other risks involve utilising resources which may be focused on seeking
investments that do not materialize; attracting the wrong types of firms; and assuming the
governments ability to foresee which types of FDI are likely to have the greatest ability
to integrate and link with local investment (WIR, 2002).Such risks necessitates that
investment promotion agencies work closely with other parts of government to identify
and create comparative advantages that are sustainable and that developmental policies do
not offset each other.. Targeting needs to be a continuous process and should not be taken
as a once off initiative.
2.2 A targeted approach to FDI
According to the WIR (2002) targeting can be defined in different ways. In principle, it
involves the focusing of promotional resources to attract a defined sub-set of FDI flows,
rather than FDI in general. Some countries i.e. Singapore, Ireland and The Netherlands,
have practiced targeting export-oriented FDI for some time, with success. However, it is
only recently that targeting has become a more widely accepted tool among IPAs. The
WIR (2002) identifies some reasons as to why some countries have adapted the targeting
approach to attract export-oriented FDI:
First and foremost, a targeted approach can help countries achieve strategic objectives
related to such aspects as employment, technology transfer, exports and cluster
development which are in line with their overall development strategies. Effective
targeting involves a comprehensive approach to attracting investment that can contribute
to development and enhance the competitiveness of a location. It also requires the
adoption of government policies that underpin the specific marketing activities and
coordination of the relevant government agencies, including IPA, in order to define
investment priorities and the package of advantages offered in the framework of an
overall development strategy,
A second reason for engaging in investor targeting, that attracts export-oriented FDI, is
the increased competition for this kind of investment. Due to the fact that some countries
are better known to foreign investors in their capabilities to offer substantial domestic
markets, the smaller less well-known economies have to work twice as hard in their
targeting efforts, and
A third reason relates to cost-effectiveness. A focused approach to attract export oriented
investment is likely to be less costly than the one in which an IPA tries to attract new
investments in all sectors at the same time.
Once an IPA has decided to use targeting as part of its strategy to attract export oriented
FDI, the next challenge is to determine what industries; activities; countries; companies
and individual managers should be targeted. The starting point of the selection process is
careful assessment of the strengths of a location as a base for export production

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The recent trend amongst countries to liberalize investment policies in all respects may
not allow them to reap the full benefits from investment. In countries like Taiwan and
Korea, targeted investment policies placed requirements on investments to ensure the
transfer of skill and technology. Similarly other successful newly industrialized countries
also controlled the amount of investment in particular sectors, time periods and the
balance between direct investment and portfolio investment.
4. ACTUAL INVESTMENT FLOWS
FDI flows to developing countries surged in the 1990s and became their leading source of
external financing. In Africa, the main attractions for FDI are market-related, notably the
size and the growth of the local market and access to regional markets. In China and
India, the biggest attractions are the size of the domestic markets. In Latin America,
investment has been attracted by profitable opportunities from privatization. Most new
investment inflows go into non-tradable service and manufacturing industries producing
mostly for the domestic market. Investment flows to Africa have declined steadily. In the
1970s, Africa accounted for 25% of foreign direct investment to developing countries. In
1992 it only accounted for 5.2% whereas in 2000 it received 3.8% of the total FDI to the
developing world.
During the period of 1982-1999, most FDI flows to developing countries were directed
towards the South, East and South-Eastern Asia followed by Latin America. The SADC
region on the other hand experienced a decline from 0.9% to 0.3% between 1995 and
2000. According to the WIR (2001) FDI inflows to Africa declined from $10.5 billion in
1999 to $9.1 billion in 2000. African share of FDI in the world fell below 1 percent in
2000. The inflow to its top recipients, namely, Angola; Morocco; and South Africa have
fallen by half. The main sources of FDI to Africa were France, the United Kingdom, and
the United States, and to a lesser extent, Germany and Japan (WIR, 1999). On average
FDI flows to North Africa remained more or less the same as in the previous year, $2.6
billion. Flows declined into Morocco and Algeria but increased to Sudan (concentrated in
petroleum exploration) from $370 million to $392 million.
Egypt has remained the most important recipient of FDI flows in North Africa.
In sub-Saharan Africa, there has been a decrease in FDI from $8 billion in 1999 to
$6.5 billion by the year 2000. A sharp drop of inflows into two countries caused the
overall drop of inflows into Sub-Saharan Africa: Angola and South Africa. In South
Africa, the reduced inflow of M&As in the country played a role in the downturn. The
decline of inflows in Angola resulted in FDI flows to the least developed countries to
drop from $4.8 billion in 1999 to $3.9 billion in 2000.
More recently, a group of African countries including Botswana, Equatorial Guinea,
Ghana, Mozambique, Namibia, Tunisia and Uganda have attracted rapidly increasing
FDI inflows. The reasons I differ from country to country. In the case of Equatorial
Guinea it was mostly rich reserves of oil and gas. Natural resource reserves also
played a role in the case of Botswana, Ghana, Mozambique and Namibia.
Privatization has been pointed out as a factor which is attributed to attracting FDI to
countries like Mozambique, Ghana and Uganda.
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Angola has attracted most FDI in Africa, compared to its GDP, particularly in
offshore exploration of gas and petroleum. The Angolan case proves that it is
insufficient to base an analysis of FDI trends only on what business determines as
attractive for FDI. Angola attracted resource-seeking FDI despite being the site of
a longstanding war. After Angola, South Africa is attracting most FDI in the
Southern African region, mostly from the US and the UK. Even though South
Africa is supposed to be one of the recipients of FDI, the figures given by
UNCTAD do indicate that South Africa is also a massive exporter of capital. South
Africa is seen as the most attractive country for FDI by business (SOMO and
LaRRI, 2001). Flows by region: SADC
The Southern African Development Community (SADC) was established in 1992
out of the South African Development Coordination Conference. SADC
committed itself to develop protocol that should take into account the
heterogeneity of the region and interests of the different stakeholders
(International Investment Treaties in S.A). The SADC trade protocol was signed in
1996 by all member states and it provides for the creation of a free trade zone
among the member states. The main aim of the protocol is to contribute towards
the improvement of the climate for domestic, cross-border and foreign investment.
Due to the drop of FDI flows into Angola and South Africa, the overall SADC
region experienced a fall in flows from $5.3 billion in 1999 to $3.9 billion in 2000.
However, countries like Mauritius and Lesotho experience strong increases in FDI
whereas others, for example, Zimbabwe experienced a significant drop from $444
million in 1998 to $59 million in 1999 and only $30 million in 2000 (WIR, 2001).
The latest figures of FDI into SADC by UNCTAD (2001) reveal that the highest
amount of FDI inflow in absolute terms was recorded by Angola (US$ 1,8 billion),
followed by South Africa with an inflow of US$ 877 million. The rest of the
region accounted for FDI inflows of less than US$300 million in the year 2000.
Flows by sectors
Social Observatory Pilot Project Final Draft Report FDI
A large proportion of FDI is directed towards the primary sector, especially oil and
gas. Between 1996 and 1999, most investments in the SADC region went into the
metal industry and the mining sector and thereafter into the food, beverages and
tobacco sectors. Other sectors like tourism accounted for a small amount of FDI.
Sectors attracting FDI in the SADC region in order of priority are: the mining and
quarrying; financial services; food; beverages and tobacco; agriculture, forestry
and fishing; hotel; leisure and gaming; other manufacturing; energy and oil;
telecom and IT; retail and wholesale; and; construction (Hansohm et al, 2002).
(Source:
http://www.sarpn.org.za/documents/d0000883/P994African_Social_Observatory_PilotProject_FDI.pdf)
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5.3 THE COSTS AND BENEFITS OF FDI

Foreign Direct Investment as a development tool has its benefits and risks, and
will only lead to economic growth in the host country under certain conditions. It
is the responsibility of governments to make sure that certain conditions are in
place so that FDI can contribute to development goals rather than just generating
profits for the foreign investor. These conditions cover broad features of the
political and macroeconomic environment. The impact of FDI in a country would
depend on a number of factors such as:
The mode of entry (greenfield or merger and acquisition),
The activities undertaken, and whether these are already undertaken in the host
country,
Sources of finance for FDI (reinvested earnings, intra-company loans or the
equity capital from parent companies), and
The impact on the activities of domestic companies (CUTS, 2001).
The potential problems associated with FDI include:
Impact on domestic competition. FDI and in particular M&As are likely to have
a negative impact on the level of competition in the domestic market. This may
lead to restrictive business practices and abuse of dominance. TNCs may damage
host economies by suppressing domestic entrepreneurship and using their superior
knowledge, worldwide contacts, advertising skills, and a range of essential support
services to drive out local competitors and hinder the emergence of small scale
local enterprises.
Impact on the balance of payments. The trade deficit can be a real constraint for
developing countries. If investors import more that they export, FDI can end up
worsening the trade situation of the country.
Instability. Volatility is associated more with portfolio capital flows. Although
investment in physical assets is fixed, profits from investment are as mobile as
portfolio flows and can be reinvested outside the country at short notice. Profits
may surpass the initial investment value and FDI may thus contribute to capital
export.
Transfer pricing. This refers to the pricing of intra-firm transactions which does
not reflect the true value of products entering and leaving the country. This could
lead to a drain of national resources. Countries may lose out on tax revenue from
corporations, as they are able to juggle their accounts in such a manner as to avoid
their tax liabilities.
The impact of development, when FDI occur through TNCs is uneven. In many
situations TNC activities reinforce dualistic economic structures and acerbate
income inequalities. They tend to promote the interests of a small number of local
factory managers and relatively well paid modern-sector workers against the
interests of the rest of the population by widening wage differentials. They tend to
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worsen the imbalance between rural and urban economic opportunities by locating
primarily in urban export enclaves and contributing to the flow of rural-urban
migration.
TNCs use their economic power to influence government policies in directions
that usually do not favor development. They are able to extract sizable economic
and political concessions from competing governments in the form of excessive
protection, tax rebates, investment allowances and the cheap provisions of factory
sites and services. As a result, the profits of TNCs may exceed social benefits.

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Review Questions
Multiple Choice Questions
Q1.

FDI is
a) Method of raising finances in domestic market
b) Method of investment in foreign market
c) Method of investment in both foreign and domestic market
d) None of the above

Q2.

FDI investment has following features:a) Parent enterprise control over its foreign affiliate.
b) Issue of shares in foreign market
c) Having a joint venture in foreign market
d) None of the above

Q3.

This doent hold for Greenfield investments:a) Direct investment in new facilities or existing ones
b) Greenfield investments include research & development
c) They result in loss of market share for competing domestic firm.
d) Profits are bypassed to HNC economy.

Q4.

Horizontal FDI is when:

a) Investment is same industry aborad as a firm operates in at home.
b) An industry abroad sells the outputs of a firms domestic production.
c) An industry abroad sells the inputs of the firms domestic production.
d) None of the above.

Q5.

FDI is permitted through:a) Foreign grants

b) Foreign collaboration
c) Political linkage
d) None of the above

Q6.

Advantages of FDI are

a) They are debt creative
b) They bring obligation
c) They are non-debt creative
d) They increase the financial stability

Q7.

FDI is seen as a important source of capital formation when:

a) Capital base is low
b) Capital base is high
c) Economy is self sufficient
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d) All of the above

Q8.

In order to invite FDIs government should:a) Increase import duty

b) Decelerate depreciation allowances
c) Reduce tax rate
d) Reduce subsidies

Q9.

The mode of entry for FDI in a country is

a) Greenfield
b) Joint venture
c) Franchise
d) None of the above

Q10. Following are not the advantages of FDIs

a) Contribution to capital expert
b) Impact on domestic products and competition
c) Lead to economic growth
d) All of the above

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Chapter 6
Topic: NBFC
Contents:
6.1

NON BANKING FINANCIAL COMPANIES (Indian Perspective)

6.2

NBFCs can be classified into different segments depending on the type of

activities they undertake:

6.3

Regulatory Measures

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6.1 NON BANKING FINANCIAL COMPANIES (Indian Perspective)

Non-banking financial companies (NBFCs) in the Indian financial sector are a
force to reckon with rough estimates indicates that there are about 40,700 nonbanking finance companies in the country. Of course, the number includes many
small companies operating in the unorganised sector such as in this, chit funds,
etc. The NBFCs registered with the Reserve Bank of India (Central Bank in India)
number only about 745 of which about 121 have credit ratings with them. Till the
others are also brought under the ambit of the regulatory framework, the
guidelines and rules issued by the Re-serve Bank of India will continue to be
largely imposed on the registered NBFCs alone. We have to appreciate the fact
that it is a Herculean task to supervise effectively all the 40,000 odd finance
companies scattered all over the country. This task becomes all the more difficult
since these companies do not have a transparent, uniform or laid down accounting
standards, strict vigilance or audit systems or an effective supervisory system as
compared to those in the organised financial sector.
Definitions
A miscellaneous non-banking company is a company carrying on all or any of the
following types of business:
(a) Managing, conducting or supervising as a promoter, foreman or agent of any
transaction or arrangement by which the company enters into an agreement with a
specified number of subscribers that every one of them shall subscribe a certain
sum in installments over a definite period and that every one of such subscribers
shall in his turn, as determined by lot or by auction or by tender or in such manner
as may be provided for in the agreement be entitled to the prize amount.
(b) Conducting any other form of chit, which is different from the type of business
referred to in (a).
(c) Undertaking or carrying on or engaging in or executing any other busi-ness
similar to the business referred to in (a) and(b). A residuary non-banking company
is a company which receives any deposit under any scheme or arrangement, by
whatever name called, in one lump sum or in installments by way of contributions
or subscriptions or by sale of units or certificates or other instruments, or in any
other manner and which, according to the definitions contained in the Non
Banking Financial Companies (Reserve Bank) Directions, 1977 or the
Miscellaneous Non-Banking Companies (Reserve Bank) Directions, 1977, as the
case may be, is not (i) an equipment leasing company, (ii) a hire purchase finance
company, (iii) a housing finance company, (iv) an insurance company, (v) an
investment company, (vi) a loan company, (vii) a mutual benefit financial
company, and (viii) a miscellaneous non-banking company.

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A non-banking non-financial company is an industrial concern as defined in

Industrial Development Bank of India Act or a company whose principal activities
are agricultural operations or trading in goods and services or real estate and
which is not classified as financial or miscellaneous or residuary non-banking
company.
Regulated Deposit is a deposit, which is subject to certain ceilings, and other
restrictions as imposed by the regulatory measures. It includes unsecured
debentures, debentures secured by movable assets, deposits received by public
limited companies from its shareholders, deposits guaranteed by directors in their
personal capacity and fixed deposits, etc. received from public. Effective April 12,
1993 intercompany borrowings and money received from directors/shareholders of
private companies constitute regulated deposits. Exempted Deposit signifies
those types of deposits/borrowings, which are outside the scope of the regulatory
pleasures. It includes borrowings from banks and specified financial institutions,
money received from Central/State/foreign Governments, security deposits,
advances received against orders, etc. Taking into consideration the fact that the
operations of the NBFCs affect adversely the efficacy of fiscal and monetary
policy, a series of measures have been initiated during the last few years to
regulate their operations. The present chapter deals with these measures in a
chronological order.
6.2 NBFCs can be classified into different segments depending on the type of
activities they undertake:
Hire purchase finance company Investment company including primary dealers
Loan company
Mutual benefit financial company
Equipment leasing company
Chit fund company
Miscellaneous non-banking companies.
The above mentioned entities are either partially or wholly regulated by the RBI.
Before we proceed forward lets understand few terms as these are important for
further learning.
Deposits : Definition of the deposit is in its broadest sense to include any receipt
of money by way of deposit or loan or in any other form. The term excludes
following receipts :
i. Amount received from bank.
ii Amount received from development/ State financial
corporation or any other financial institution,

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iii. Amount received in the ordinary course of business by way of security deposit,
dealership deposit, earnest money, advance against order for goods/properties and
services.
iv. Amount received by way of subscription in respect of a chit and
v. Loan from Mutual Funds.
Financial Institutions : These mean any non-banking Institution / financial
companies engaged in any of the following activities :
vi. Financing by way of loans, advances and so on any activity except of its own.
vii. Acquisition of shares/ stocks/ bonds/ debentures/securities.
viii. Hire purchase.
ix. Any class of insurance, stock-broking etc.
x. Chit-funds and
xi. Collection of money by way of subscription/ sale or units or other
instruments/any other manner and their disbursement.
Now let us discuss various types of NBFCs.
Equipment Leasing Company : This means the company which is a financial
institution carrying on the activity of leasing (or lease financing) of equipments as
its principal (main) business.
Hire Purchase Finance Company : It is a company which is a financial
institution carrying on as its principal activity hire purchase transactions or the
financing of such transactions.
Investment Company : It means a company which is a financial institution
carrying on as its principal business the acquisition of securities.
Loan Company : It means any company which is a financial institution carrying
on the as its principal business the providing of finance whether by making loans
or advances or otherwise for any activity other than its own.
Mutual Benefit Finance Company (MBFC) : MBFC (also called Nidhis) are
NBFCs notified under section 620A of the Companies Act, 1956, and primarily
regulated by Department of Company Affairs (DCA) under the directions/
guidelines issued by them under section 637A of the Companies Act, 1956. These
companies are exempt from the core provision of the RBI Act and NBFC
directions relating to acceptance of public deposits. However, RBI is empowered
to issue direction in matters relating to deposit acceptance activities and directions
relating to ceiling on interest rate. They are also required maintain register of
deposits, furnish receipt to depositors and submit returns to the RBI.

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Regulatory Non-Banking Companies (RNBC) : RNBCs are a class of NBFCs

that cannot be classified as equipment leasing company, hire purchase, loan,
investment, nidhi or chit fund companies, but which tap public savings by
operating various deposit schemes, akin to recurring deposit schemes of Banks.
The deposit acceptance activities of these companies are governed by the
provisions of Residuary Non-Banking Companies (Reserve Bank) Directions,
1987. To safeguard the interest of depositors, the RBI has directed RNBCs to
invest not less than 80% of aggregate deposit liabilities as per the investment
pattern prescribed by it. They can invest only 20% of aggregate liabilities or 10
times of its net worth, whichever is lower, in a manner decided by its BOD. The
RNBCs are the only class of NBFCs for which, floor rate of interest is specified by
the RBI, while there is no upper limit prescribed for them. RBI has also prescribed
prudential norms for RNBCs, compliance with which is mandatory and
prerequisite for acceptance of deposits.
Miscellaneous Non-Banking Companies : MNBCs are companies engaged in
the chit fund business. The term deposit as defined under section 45I(bb) of the
RBI Act, 1934, does not include subscription to chit funds. The chit fund
companies are exempted from all the core provisions of the Chapter IIIB of the
RBI Act. RBI only controls the deposits accepted by these companies, whereas,
administration is regulated by the respective state governments.
6.3Regulatory Measures
The first serious attempt to regulate NBFCs (including nonbanking non-financial
companies) was taken in October 1966, by issuing two new directives, viz., (i)
Non-Banking Financial Companies (Reserve Bank) Directives, 1966 and (ii) NonBanking Non-Financial Companies (Reserve Bank) Directives,1966. These
directives extended the control of the Reserve Bankto all: (i) non-banking
financial companies and (ii) non-banking, non-financial companies accepting
deposits and they were brought into force with effect from 1 January 1967. The
directives pro-vided for restricting acceptance of deposits to 25 per cent of paid-up
capital and free reserves in the case of both non-banking financial and nonbanking non-financial companies (other than housing finance and hire-purchase
finance companies).
To obviate hardships, particularly to industrial undertakings, in com-plying with
the provisions of the directives within the specified time limit, the Reserve Bank
made certain modifications in the directives on 23 August 1967, as follows:
(i) In the case of all non-banking companies, financial or non-financial; the Bank
decided that any amount held in the statutory development rebate reserve, created
under section 4(3) of the Income Tax Act, 1961, may (notwithstanding the fact that
129

the period of 8 years specified in that section might not have been completed in
respect of all the assets) be counted as a free reserve and
(ii)In the case of industrial concerns as defined in the directives which (a) have
paid dividends on their equity shares at, six per cent or more per annum in the five
years or in five out of six years immediately preceding 1 January 1967, or (b) have
unencumbered fixed assets of a book value in excess of twice the amount of
deposits and the unsecured loans, the time limit of two years, for the adjustment of
the deposits already received in excess of 25 per cent of the paid-up capital and
free reserves including the development rebate reserve, will increase to five years,
i. e., upto the end of December 1971.
The directives issued to non-banking companies were amended in December 1971
so as to bring within their purview, unsecured loans from shareholders as also
loans guaranteed by directors, ex-managing agents or secretaries and treasurers.
Such loans, hitherto exempted from the restrictions relating to deposits, were
subjected to a separate ceiling of 25 per cent of the net owned funds of companies
with effect from 1 January 1972. A period of 3 years and 3 months was provided
for the adjustment of excess, if any, over the ceiling prescribed, of the unsecured
loans mentioned above. To provide for the genuine business requirements of
companies, however, certain categories of loans, particularly loans obtained on
guarantees furnished by Government and any loan obtained from foreign source
were specifically exempted from the purview of the directives.
During 1973, the Reserve Bank issued a new set of directions known as the
Miscellaneous Non-Banking Companies (Reserve Bank) Direc-tions, 1973 which
sought to regulate the acceptance of deposits by com-panies conducting prize
chits, lucky draws, savings schemes, etc. These directions which came into effect
from 1 September, 1973, had clarified that the amounts received by such
companies by way of contributions or subscriptions or by sale of units, certificates,
etc., or other instruments or any other manner or as membership fees or service
charges to or in respect of any savings, or mutual benefit, thrift or any other
scheme or arrangement also constitute deposits. It was further clarified that the
usual ceiling on deposits (25 per cent of paid-up capital plus free reserves less
accumulated balance of loss), would also apply to such deposits. Any amount in
excess of the ceiling existing on 1 September 1973 would have to be adjusted
before October 1976. All other requirements applicable to other non-banking
companies such as these relating to the issue of advertisements, acceptance of
deposits on the basis of application forms, maintenance of registers of deposits and
furnishing of receipts to depositors, would also apply to these companies.
However, companys coming within the purview of these directions would be
required to submit their returns to the Reserve Bank twice a year.

130

The two principal notifications containing the directions issued in October 1966,
respectively to non-banking companies were further amended during 1973. The
principal features of the amendments were: (i) any loan secured by the creation of
a mortgage or pledge of the assets of the company or any part thereof would be
exempt from the ceiling restrictions relating to deposits only if there is a margin of
only at least 25 per cent of the market value of the assets charged as security for
the loan, the mortgage or pledge, as the case may be, is created in favour, of a
trustee which should either be a scheduled commercial bank or an executor and
trustee company which is a subsidiary of such scheduled commercial bank and the
company has to execute a trust deed in favour of the scheduled commercial bank
or its subsidiary. If the Reserve Bank is satisfied that the mortgage or pledge
created by a company is not in the public interest, it may declare that the deposits
sought to be secured by such mortgage of pledge shall not be entitled to the benefit
of the aforesaid provision. Companies accepting such secured deposits will,
however, have to comply with all other provisions contained in the directions as
applicable to ordinary deposits or unsecured loans. (ii) Loans obtained from a
registered moneylender would henceforth be treated as deposits for the purposes
of the directions. After an examination of the recommendations of the Banking
Com-mission in regard to non-banking financial intermediaries and the Reserve
Banks view thereon, the Government of India, decided that statutory powers shall
be taken to prohibit acceptance of deposits by all unincorporated non-banking
institutions and that the existing legal provisions and the directions issued by the
Reserve Bank must be tightened to plug the loop-holes. In June 1974, the Reserve
Bank constituted a Study Group headed by Shri James S. Raj to examine in depth
all aspects of the matter and make suitable recommendations for implementing
Governments decision. In 1974, more powers were vested with the Reserve Bank
to exercise control over non-banking institutions receiving deposits from the
public and financial institutions under the Reserve Bank of India (Amendment)
Act, 1974. The amendments:
(a) Empower the Reserve Bank to inspect non-banking financial institutions
whenever such inspection is considered necessary or expedient by the Bank;
(b) Cast a statuary obligation on the auditor of a non-banking institution to report
to the Reserve Bank the aggregate amount of deposits held by it where the
institution had failed to furnish to return etc., required to be submitted by it.
(c) Insert the definition of the term deposit in statute itself so as to place beyond
any doubt that any money received by non-banking institutions otherwise than by
way of share capital constitutes deposits.
(d) Make the definition of the term financial institution precise and
comprehensive so as to plug the loop-holes;
(e) Make it compulsory not only for non-banking institutions but also for brokers
to disclose full particulars and information before soliciting deposits; and

131

(f) Provide for enhanced penalties for contravention of the provisions of the Act
and the directions issued by the Bank.
The ceiling of 25 per cent of the paid-up capital and free reserves less the balance
of accumulated loss, if any, imposed by the Reserve Bank with effect from January
1972, in respect of deposits accepted by non-banking companies in the form of
unsecured loans guaranteed by the directors, deposits raised from shareholders
(excluding those received by private companies from their shareholders subject to
certain stipulations) etc., was lowered by the Bank to 15 per cent with effect from
the 27th January 1975, by issue of three notifications amending the directions in
force. Non-banking financial and non-financial companies having deposits in
excess of the reduced ceiling were given time till 31st December 1975, to wipe out
the excess. Miscellaneous non-banking companies viz., those conducting prize
chits/lucky draws/savings schemes etc., which had been allowed time up to the
end of September 1976, to wipe out the excess over the ceiling of 25 per cent fixed
earlier were allowed further time up to the 31st December 1976, to bring down
their outstanding in respect of the unsecured loans, etc., within the reduced ceiling
of 15 per cent.
The Companies (Amendment Act), 1974 which came into force from the 1st
February 1975, has inserted anew Section 58 A in the Companies Act, 1955
regulating acceptance of deposits by non-banking companies. Under the powers
vested by the aforesaid Section, the Central Government has in consultation with
the Reserve Bank, framed rules governing acceptance of deposits by non-financial
companies. The rules came into force with effect from the 3rd February 1975.
Consequently, the directions issued by the Reserve Bank to non-financial
companies have since been withdrawn.
The Study Group headed by Shri James S. Raj referred to above submitted its
Report to the Reserve Bank on 14th July 1975.
The main recommendations of the Study Group cover nonfinancial companies,
financial companies and companies conducting prize chits and/or conventional
chits. These recommendations had been accepted in principle by the Reserve Bank
and the Government of India.
With regard to non-financial companies, the Study Group observed that the
acceptance of deposits by such companies may not be prohibited altogether but the
measures should be so designed as to ensure the efficacy of monetary policy and
to avoid disruption of the productive process consistent with need to safeguard the
depositors interests. At the same time the ultimate objective should be to
discourage further growth of these deposits and to roll them back gradually so that
they would cease to be a significant source of finance for industry and trade.
132

In the case of non-banking financial companies, the Study Group recommended

effective regulation of their activities considering the large number of depositors
involved as well as the incidence of malpractices in these companies. The Study
Group suggested that such companies should be subjected, by and large, to the
same type of controls as banks under the Banking Regulation Act, 1949. As the
operations of loan companies are analogous to those of banks, the Study Group
recommended a ceiling of ten times the net owned funds. In the opinion of Study
Group, avail-ability of funds to that extent would give them a reasonable chance of
profitable working and enable them to become, viable units. While in regard to
hire-purchase finance companies, which are at present exempt from ceiling
restriction, a ceiling (not exceeding ten times their net owned funds) as in the case
loan companies has been proposed, housing finance companies, however, will
continue to be exempted from the ceiling restrictions. Since such special
considerations will not be relevant in respect of investment companies, the
existing composite ceiling of 40 per cent of the net owned funds is proposed to be
reduced to 25 per cent in two stages. Apart from the restrictions on the quantum of
deposits that may be accepted by the companies, the Group has recommended
minimum capital requirements for starting new financial companies and also in
respect of existing companies other than nidhis. Some of the other
recommendations made by it relate to the creation of reserve funds, maintenance
of liquid assets, prohibition of grant of loans and advances to the directors and
firms and companies in which they are interested and enactment of the Provisions
on the lines of certain sections of the Banking Regulation Act, 1949. In view of the
substantive nature of the recommendations made by it for the purpose of
tightening the control over the deposit acceptance activities of the financial
companies as also the operational aspects relating to their working, it has been
decided to enact a separate comprehensive legislation in place of Chapter III B of
the Reserve Bank of India Act, 1934. The drafting of the legislation is in progress
and in the meantime, steps are also being taken to implement such of the
recommendations as could be given effect to by invoking the power vested in the
Reserve Bank under the existing provisions of Chapter III B of the said Act by
suitable amendments to the directions now force. The amendments to the
directions have been finalized.
As regards companies conducting prize chits benefit savings schemes, etc., the
Group had come to the conclusion that such schemes benefited primarily the
promoters and did not serve any social purpose. Such schemes were prejudicial to
public interest and also adversely affected the efficacy of fiscal and monetary
policy, It had, therefore, suggested that the conduct of such schemes should be
totally banned in the larger interests of the public and suitable legislative measures
should be taken for the purpose, the provisions of the existing enactment were
considered inadequate.

133

Review Questions
Multiple Choice Questions
Q1.

NBFC is a :
a) Is a trust
b) Is a company
c) Bank
d) Firm

Q2.

NBFC are different from banks as:a) They cannot accept demand deposits
b) NBFC can issue cheques
c) NBFC is a part of payment & settlement

Q3.

Following can be considered as NBFC

a) Depository services
b) Insurance
c) Asset finance company

Q4.

NBFC can accept deposits form NRIs

a) Above statement is true
b) Above statement is false
c) Partly true
d) None of the above

Q5.

What should be kept in mind while depositing with NBFC:a) Public deposits are secured
b) Public deposits are unsecured
c) Central bank holds a responsibility of NBFC.

Q6.

RNBC are:a) Chit fund company

b) Leasing company
c) Loan company
d) They tap public savings by operating various deposit schemes.

Q7.

MNBC are involved in:a) Leasing

b) Hire purchase
c) Chit fund business
d) Mutual funds
134

Q8.

Regulated deposit is one which:a) Deposits with minimum investment

b) Includes unsecured debentures
c) Does not have any

Q9.

Exempted deposits are under:

a) Regulatory ceiling
b) Does not have regulatory ceiling
c) None of the above.

Q10. NBFC should be registered with

a) Central Bank
b) Mutual Fund organisation
c) Security exchange commission
d) All of the above

135

Bibliography
Indian Financial System: HR MACHIRAJU
Security Analysis and Portfolio Management: Punithavathy Pandian
Indian Financial System: theory and Practice: M.Y. Khan
Investment and securities market in India: Avdhani
Financial markets and Institutions: M.K.Bhole
RBI Reports
www.secghana.org
www.wikepedia.com
www.nseindia.com

136

KEY TO QUESTIONS
Chapter One:
Q1. (a),
Q6. (b),

Q2.
Q7.

(a),
(b),

Q3.
Q8.

(b),
(d),

Q4.
Q9.

(b),
(b),

Q5. (a)
Q10. (c)

Q2.
Q7.

(a),
(d),

Q3.
Q8.

(c),
(c),

Q4.
Q9.

(a),
(d),

Q5. (b),
Q10. (a)

(a),
(d),

Q2.
Q7.

(e),
(a),

Q3.
Q8.

(a),
(b),

Q4.
Q9.

(b),
(b),

Q5. (c),
Q10. (d)

(d),
(d),

Q2.
Q7.

(a),
(b),

Q3.
Q8.

(d),
(b),

Q4.
Q9.

(e),
(c),

Q5. (e),
Q10. (b)

(b),
(c),

Q2.
Q7.

(a),
(a),

Q3.
Q8.

(d),
(c),

Q4.
Q9.

( a),
(a),

Q5. (b),
Q10. (b)

(b),
(d),

Q2.
Q7.

(a),
(c),

Q3.
Q8.

(c),
(b),

Q4.
Q9.

(b),
(b),

Q5. (b),
Q10. (a)

Chapter two:
Q1.
Q6.

(b),
(b),

Chapter three:
Q1.
Q6.
Chapter four:
Q1.
Q6.
Chapter five:
Q1.
Q6.
Chapter six:
Q1.
Q6.

137

CASE STUDY

US FINANCIAL SYSTEMS: Understanding financial systems of a

developed country

The Federal Reserve System (also known as the Federal Reserve, and
informally as The Fed) is the central banking system of the United States. It
was created in 1913 when the Federal Reserve Act was signed by Woodrow
Wilson. According to official Federal Reserve documentation, "It was
founded by Congress in 1913 to provide the nation with a safer, more
flexible, and more stable monetary and financial system. Over the years, its
role in banking and the economy has expanded."
It is a quasi-public banking system that comprises:
1. The presidentially appointed Board of Governors of the Federal
Reserve System in Washington, D.C.,
2. The Federal Open Market Committee (FOMC),
3. Twelve regional privately-owned Federal Reserve Banks located in
major cities throughout the nation, which divide the nation into 12
districts, acting as fiscal agents for the U.S. Treasury, each with its
own nine-member board of directors,
4. Numerous other private U.S. member banks, which subscribe to
required amounts of non-transferable stock in their regional Federal
Reserve Banks,
5. Various advisory councils
According to official documentation, the Federal Reserve's duties fall into
four general areas: (1) conducting the nation's monetary policy by
influencing the monetary and credit conditions in the economy in pursuit of
maximum employment, stable prices, and moderate long-term interest rates;
(2) supervising and regulating banking institutions to ensure the safety and
soundness of the nation's banking and financial system and to protect the
credit rights of consumers; (3) maintaining the stability of the financial
system and containing systemic risk that may arise in financial markets; and
(4) providing financial services to depository institutions, the U.S.
government, and foreign official institutions, including playing a major role
in operating the nation's payments system.
138

Within the Federal Reserve, the Federal Open Market Committee (FOMC) is
primarily responsible for the formulation of monetary policy. Seven of the
twelve members of the board are appointed by the President, and are called
the "Board of Governors." The remaining five are regional Reserve Bank
presidents. Since February 2006, Ben Bernanke has served as the Chairman
of the Board of Governors of the Federal Reserve System. Donald Kohn is
the current Vice Chairman (Term: June 2006June 2010).
o

Central banking in the United State

In early 1781 the Articles of Confederation & Perpetual Union were ratified
so that Congress had the power to emit bills of credit. It passed later that
year an ordinance to incorporate a privately subscribed national bank
following in the footsteps of the Bank of England. However, it was thwarted
in fulfilling its intended role as a nationwide central bank due to objections
of "alarming foreign influence and fictitious credit," favoritism to foreigners
and unfair competition against less corrupt state banks issuing their own
notes, such that Pennsylvania's legislature repealed its charter to operate
within the Commonwealth in 1785.
Four years after the U.S. constitution was ratified, the government adopted
another central bank, the First Bank of the United States, but it would
ultimately be shut down by President Madison. The Second Bank of the
United States, i.e. the second central bank, met a similar fate when its charter
expired under President Jackson. Both banks were, again, based upon the
Bank of England, but the increased Federal power, due to the constitution,
gave them more control over currency. Political opposition to central
banking was the primary reason for shutting down the banks, but there was
also a considerable amount of corruption in the second central bank.
Ultimately, the third national bank was established in 1913 and still exists to
this day. The time line of central banking in the United States is as follows:

17911811

First Bank of the United States

18111816
139

No central bank
18161836

Second Bank of the United States

18371862

Free Bank Era

1846-1921

Independent Treasury System

18631913

National Banks
1913Present
Federal Reserve System.
Creation of First and Second Central Bank

The first U.S. institution with central banking responsibilities was the First
Bank of the United States, chartered by Congress and signed into law by
President George Washington on February 25, 1791 at the urging of
Alexander Hamilton. This was despite strong opposition from Thomas
Jefferson and James Madison, among numerous others. The charter was for
twenty years and expired in 1811 under President James Madison.
In 1816, however, Madison revived it in the form of the Second Bank of the
United States. Early renewal of the bank's charter became the primary issue
in the reelection of President Andrew Jackson. After Jackson, who was
opposed to the central bank, was reelected, he pulled the government's funds
out of the bank. Nicholas Biddle, President of the Second Bank of the
United States, responded by contracting the money supply to pressure
Jackson to renew the bank's charter forcing the country into a recession,
which the bank blamed on Jackson's policies. The bank's charter was not
renewed in 1836. From 1837 to 1862, in the Free Banking Era there was no
formal central bank. From 1862 to 1913, a system of national banks was
instituted by the 1863 National Banking Act. A series of bank panics, in
1873, 1893, and 1907, provided strong demand for the creation of a
centralized banking system.
Purpose
140

The primary motivation for creating the Federal Reserve System was to
address banking panics. Other purposes are stated in the Federal Reserve
Act, such as "to furnish an elastic currency, to afford means of rediscounting
commercial paper, to establish a more effective supervision of banking in the
United States, and for other purposes." Before the founding of the Federal
Reserve, the United States underwent several financial crises. A particularly
severe crisis in 1907 led Congress to enact the Federal Reserve Act in 1913.
Today the Fed has broader responsibilities than only ensuring the stability of
the financial system.
Current functions of the Federal Reserve System include:

To address the problem of banking panics

To serve as the central bank for the United States
To strike a balance between private interests of banks and the
centralized responsibility of government
o To supervise and regulate banking institutions
o To protect the credit rights of consumers
To manage the nation's money supply through monetary policy to
achieve the sometimes-conflicting goals of
o maximum employment
o stable prices, including prevention of either inflation or
deflation
o moderate long-term interest rates
To maintain the stability of the financial system and contain systemic
risk in financial markets
To provide financial services to depository institutions, the U.S.
government, and foreign official institutions, including playing a
major role in operating the nations payments system
o To facilitate the exchange of payments among regions
o To respond to local liquidity needs
To strengthen U.S. standing in the world economy

Central bank
In its role as the central bank of the United States, the Fed serves as a
banker's bank and as the government's bank. As the banker's bank, it
helps to assure the safety and efficiency of the payments system. As the
government's bank, or fiscal agent, the Fed processes a variety of financial
transactions involving trillions of dollars. Just as an individual might keep an
account at a bank, the U.S. Treasury keeps a checking account with the
141

Federal Reserve through which incoming federal tax deposits and outgoing
government payments are handled. As part of this service relationship, the
Fed sells and redeems U.S. government securities such as savings bonds and
Treasury bills, notes and bonds. It also issues the nation's coin and paper
currency.
Federal funds
Federal funds are the reserve balances that private banks keep at their local
Federal Reserve Bank. These balances are the namesake reserves of the
Federal Reserve System. The purpose of keeping funds at a Federal Reserve
Bank is to have a mechanism through which private banks can lend funds to
one another. This market for funds plays an important role in the Federal
Reserve System as it is what inspired the name of the system and it is what
is used as the basis for monetary policy. Monetary policy works by
influencing how much money the private banks charge each other for the
lending of these funds.
Balance between private banks and responsibility of governments
The system was designed out of a compromise between the competing
philosophies of privatization and government regulation. In 2006 Donald L.
Kohn, vice chairman of the Board of Governors, summarized the history of
this compromise:
Agrarian and progressive interests, led by William Jennings Bryan, favored a
central bank under public, rather than banker, control. But the vast majority
of the nation's bankers, concerned about government intervention in the
banking business, opposed a central bank structure directed by political
appointees.
The legislation that Congress ultimately adopted in 1913 reflected a hardfought battle to balance these two competing views and created the hybrid
public-private, centralized-decentralized structure that we have today.
In the current system, private banks are for-profit businesses but government
regulation places restrictions on what they can do. The Federal Reserve
System is a part of government that regulates the private banks. The balance
between privatization and government involvement is also seen in the
structure of the system. Private banks elect members of the board of
directors at their regional Federal Reserve Bank while the members of the
142

Board of Governors are selected by the President of the United States and
confirmed by the Senate. The private banks give input to the government
officials about their economic situation and these government officials use
this input in Federal Reserve policy decisions. In the end, private banking
businesses are able to run a profitable business while the U.S. government,
through the Federal Reserve System, oversees and regulates the activities of
the private banks.
Government regulation and supervision
The Board of Governors in the Federal Reserve System has a number of
supervisory and regulatory responsibilities in the U.S. banking system, but
not complete responsibility. A general description of the types of regulation
and supervision involved in the U.S. banking system is given by the Federal
Reserve: The Board also plays a major role in the supervision and regulation
of the U.S. banking system. It has supervisory responsibilities for statechartered banks that are members of the Federal Reserve System, bank
holding companies (companies that control banks), the foreign activities of
member banks, the U.S. activities of foreign banks, and Edge Act and
agreement corporations (limited-purpose institutions that engage in a foreign
banking business). The Board and, under delegated authority, the Federal
Reserve Banks, supervise approximately 900 state member banks and 5,000
bank holding companies. Other federal agencies also serve as the primary
federal supervisors of commercial banks; the Office of the Comptroller of
the Currency supervises national banks, and the Federal Deposit Insurance
Corporation supervises state banks that are not members of the Federal
Reserve System.
Some regulations issued by the Board apply to the entire banking industry,
whereas others apply only to member banks, that is, state banks that have
chosen to join the Federal Reserve System and national banks, which by law
must be members of the System. The Board also issues regulations to carry
out major federal laws governing consumer credit protection, such as the
Truth in Lending, Equal Credit Opportunity, and Home Mortgage Disclosure
Acts. Many of these consumer protection regulations apply to various
lenders outside the banking industry as well as to banks.
Members of the Board of Governors are in continual contact with other
policy makers in government. They frequently testify before congressional
committees on the economy, monetary policy, banking supervision and
regulation, consumer credit protection, financial markets, and other matters.
143

The Board has regular contact with members of the Presidents Council of
Economic Advisers and other key economic officials. The Chairman also
meets from time to time with the President of the United States and has
regular meetings with the Secretary of the Treasury. The Chairman has
formal responsibilities in the international arena as well.
Organization of the Federal Reserve System

Whole
The nation's central bank
A regional structure with 12 districts
Subject to general Congressional authority and oversight
Operates on its own earnings
Board of Governors
7 members serving staggered 14-year terms
Appointed by the U.S. President and confirmed by the Senate
Oversees System operations, makes regulatory decisions, and sets
reserve requirements
Federal Open Market Committee
144

The System's key monetary policymaking body

Decisions seek to foster economic growth with price stability by
influencing the flow of money and credit
Composed of the 7 members of the Board of Governors and the
Reserve Bank presidents, 5 of whom serve as voting members on a
rotating basis

Federal Reserve Banks;

12 regional banks with 25 branches
Each independently incorporated with a 9-member board of directors,
with 6 of them elected by the member banks while the remaining 3 are
designated by the Board of Governors.
Set discount rate, subject to approval by Board of Governors.
Monitor economy and financial institutions in their districts and
provide financial services to the U.S. government and depository
institutions.
Member banks
Private banks
Hold stock in their local Federal Reserve Bank
Elect six of the nine members of Reserve Banks boards of directors.
This is the organization of US federal systems and different constituents
work in accordance with each other for efficient financial system of the
country.

145

ASSIGNMENT INSTRUCTION PAGE

AMITY Center for E-Learning
F-2, Block, II Floor,
Amity University, Uttar Pradesh
Sector-125 Campus, Noida (UP)
India 201301
ASSIGNMENTS
SUBJECT CODE :
SYSTEM

SUBJECT NAME : FINANCIAL

Subject Name & Code

Study Centre
Permanent Enrollment Number (PEN)
Student Name
INSTRUCTIONS:a) Students are required to submit three assignments
Assignment
Details
Marks
Assignment A
Five Subjective Questions
15
Assignment B
Three Subjective Questions + Case
15
Study
Assignment C
40 Objective Questions
10
b) Total Weight age given to these assignment is 40%
c) All assignments are to be completed in your own hand writing / typed.
d) All questions are required to be attempted.
e) All the three assignments are to be completed by due dates (specified from time to
time) and mailed / given by hand for evaluation at the ACeL office Noida / your
Study Centre.
f) The evaluated assignments can be collected from the study centre/ACeL office
after six weeks. Thereafter, these will be destroyed at the end of each semester.
g) The students have to attach a scan signature in the form.
Signature
Date

:
:

________________________
_________________________

() Tick Mark in front of the assignments submitted

Assignment A
Assignment B

146

Assignment C

ASSIGNMENT- A
Attempt these five analytical questions
Q1.

What do you understand by financial system of a country? Explain its definition,

significance and structure?

Q2.

Financial Markets are an important component of the financial system, what are
different types of financial markets ? Explain

Q3.

What are characteristics and functions of financial markets?

Q4.

What are money market instruments ? Explain

Q5.

What are bonds? Explain their features. How are they different from debentures?

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Assignment B
Q1.

How are primary market and secondary market different from each other? Explain

Q2.

What are mutual funds? Explain the benefit and risks involved in investing in
Mutual Funds.

Q3.

Write Short notes on:

a) FDI
b) NBFC

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CASE STUDY
The US-64 Controversy
They have cheated us. I am telling everyone to sell. If they are stupid and offering Rs
14.25 for paper worth Rs 9, why should I let go of the opportunity?
- An unhappy US-64 investor in 1998.
CAN OF WORMS
In 1998, investors of Unit Trust of India's (UTI) Unit Scheme-1964 (US-64) were shaken
by media reports claiming that things were seriously wrong with the mutual fund major.
For the first time in its 32 years of existence, US-64 faced depleting funds and
redemptions exceeding the sales. Between July 1995 and March 1996, funds declined by
Rs 3,104 crore. Analysts remarked that the depleting corpus coupled with the
redemptions could soon result in a liquidity crisis.
Soon, reports regarding the lack of proper fund management and internal control
systems at UTI added to the growing investor frenzy. By October 1998, US-64's equity
component's market value had come down to Rs 4200 crore from its acquisition price
of Rs 8200 crore. The net asset value (NAV) of US-64 also declined significantly
during 1993-1996 due to turbulent stock market conditions. A Business Today survey
cited US-64's NAV at Rs 9.68. The US-64 units, which were sold at Rs 14.55 and
repurchased at Rs 14.25 in October 1998, thus were around 50% and 47%, above their
estimated NAV.
Amidst growing concerns over the fate of US-64 investors, it became necessary for UTI
to take immediate steps to put rest to the controversy.
CREATING TRUST
UTI was established through a Parliament Act in 1964, to channelise the nation's savings
via mutual fund schemes. This was done as in the earlier days, raising the capital from
markets was very difficult for the companies due to the public being very conservative
and risk averse. By February 2001, UTI was managing funds worth Rs 64,250 crore
through over 92 saving schemes such as US-64, Unit Linked Insurance Plan, Monthly
Income Plan etc. UTI's distribution network was well spread out with 54 branch offices,
295 district representatives and about 75,000 agents across the country.
The first scheme introduced by UTI was the Unit Scheme-1964, popularly known as US64. The fund's initial capital of Rs 5 crore was contributed by Reserve Bank of India
(RBI), Financial Institutions, Life Insurance Corporation (LIC), State Bank of India (SBI)
and other scheduled banks including few foreign banks. It was an open-ended scheme ,
promising an attractive income, ready liquidity and tax benefits. In the first year of its
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launch, US-64 mobilized Rs 19 crore and offered a 6.1% dividend as compared to the
prevailing bank deposit interest rates of 3.75 - 6%. This impressed the average Indian
investor who until then considered bank deposits to be the safest and best investment
opportunity. By October 2000, US-64 increased its capital base to Rs 15993 crore, spread
over 2 crore unit holders all over the world.
However by the late 1990s, US-64 had emerged as an example for portfolio
mismanagement. In 1998, UTI chairman P.S.Subramanyam revealed that the reserves of
US-64 had turned negative by Rs 1098 crore. Immediately after the announcement, the
Sensex fell by 224 points. A few days later, the Sensex went down further by 40 points,
reaching a 22-month low under selling pressure by Foreign Institutional Investors (FIIs).
This was widely believed to have reflected the adverse market sentiments about US-64.
Nervous investors soon redeemed US-64 units worth Rs 580 crore. There was widespread
panic across the country with intensive media coverage adding fuel to the controversy.
DISTRUST IN TRUST
Unlike the usual practice for mutual funds, UTI never declared the NAV of US-64 - only
the purchase and sale prices for the units were announced. Analysts remarked that the
practise of not declaring US-64's NAV in the initial years was justified as the scheme was
formulated to attract the small investors into capital markets. The declaration of NAV at
that time would not have been advisable, as heavy stock market fluctuations resulting in
low NAV figures would have discouraged the investors. This seemed to have led to a
mistaken feeling that the UTI and US-64 were somehow immune to the volatility of the
Sensex.
Following the heavy redemption wave, it soon became public knowledge that the erosion
of US-64's reserves was gradual. Internal audit reports of SEBI regarding US-64
established that there were serious flaws in the management of funds.
Till the 1980s, the equity component of US-64 never went beyond 30%. UTI acquired
public sector unit (PSU) stocks under the 1992-97 disinvestment program of the union
government. Around Rs 6000-7000 crore was invested in scripts such as MTNL, ONGC,
IOC, HPCL & SAIL.
A former UTI executive said, Every chairman of the UTI wanted to prove himself by
collecting increasingly larger amounts of money to US-64, and declaring high dividends.
This seemed to have resulted in US-64 forgetting its identity as an income scheme,
supposed to provide fixed, regular returns by primarily investing in debt instruments.
Even a typical balanced fund (equal debt and equity) usually did not put more than 30%
of its corpus into equity. A Business Today report claimed that eager to capitalise on the
1994 stock market boom, US-64 had recklessly increased its equity holdings. By the late
1990s the fund's portfolio comprised around 70% equity.
While the equity investments increased by 40%, UTI seemed to have ignored the risk
factor involved with it. Most of the above investments fared very badly on the bourses,
causing huge losses to US-64. The management failed to offload the equities when the
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market started declining. While the book value of US-64's equity portfolio went up from
Rs 7,943 crore (June 1994) to Rs 13,627 (June 1998), the market value had actually
declined in the same period from Rs 18,334 crore to Rs 10,029 crore. Analysts remarked
that UTI had been pumping money into scrips whose market value kept falling. Raising
further questions about the fund management practices was the fact that there were hardly
any growth scrips'from the IT and pharma sectors in the equity portfolio.
In spite of all this, UTI was able to declare dividends as it was paying them out of its
yearly income, its reserves and by selling the stocks that had appreciated. This kept the
problem under wraps till the reserves turned negative and UTI could no longer afford to
keep the sale and purchase prices artificially inflated.
Following the public outrage against the whole issue, UTI in collaboration with the
government of India began the task of controlling the damage to US-64's image.
RESTORING THE TRUST
UTI realised that it had become compulsory to restructure US-64's portfolio and review
its asset allocation policy. In October 1998, UTI constituted a committee under the
chairmanship of Deepak Parekh, chairman, HDFC bank, to review the working of
scheme and to recommend measures for bringing in more transparency and
accountability in working of the scheme.
US-64's portfolio restructuring however was not as easy as market watchers deemed it to
be. UTI could not freely offload the poor performing PSU stocks bought under the GoI
disinvestment program, due to the fear of massive price erosions after such offloading.
After much deliberation, a new scheme called SUS-99 was launched.
The scheme was formulated to help US-64 improve its NAV by an amount, which was
the difference between the book value and the market value of those PSU holdings. The
government bought the units of SUS-99 at a face value of Rs 4810 crore. For the other
PSU stocks held prior to the disinvestment acquisitions, UTI decided to sell them through
negotiations to the highest bidder. UTI also began working on the committee's
recommendation to strengthen the capital base of the scheme by infusing fresh funds of
Rs 500 crore. This was to be on a proportionate basis linked to the promoter's holding
pattern in the fund.
The inclusion of the growth stocks in the portfolio was another step towards restoring
US-64's image. Sen, Executive Director, UTI said, The US-64 equity portfolio has been
revamped since June. During the last nine months the new ones that have come to occupy
a place among the Top 20 stocks from the (Satyam Computers, NIIT and Infosys) and
FMCG (HLL, SmithKline Beecham and Reckitt & Colman) sectors. US-64 has reduced
its weightage in the commodity stocks (Indian Rayon, GSFC, Tisco, ACC and
Hindalco.)

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To control the redemptions and to attract further investments, the income distributed
under US-64 was made tax-free for three years from 1999. To strengthen the focus on
small investors and to reduce the tilt towards corporate investors, UTI decided that retail
investors should be concentrated upon and their number should be increased in the
scheme.
UTI also decided to have five additional trustees on its board. To enable trustees to
assume higher degree of responsibility and exercise greater authority UTI decided to give
emphasis on a proper system of performance evaluation of all schemes, marked-tomarket valuation[5] of assets and evaluation of performance benchmarked to a market
index. The management of US-64 was entrusted to an independent fund management
group headed by an Executive Director. UTI made plans to ensure that full responsibility
and accountability was achieved with support of a strong research team. Two independent
sub-groups were formed to manage the equity and debt portion of US-64. An independent
equity research cell was formed to provide market analysis and research reports.
TABLE
HOW THINGS WERE SET RIGHT

PSU shares were transferred to a special unit scheme (SUS'99) subscribed

by the government in 1998-99.
Core promoters such as the Industrial Development Bank of India added
around Rs 450 crore to the unit capital, thus helping to bridge the reserves
deficit of Rs 2,800 crore in 1998-99.
Portfolios were recast in the current quarter to capitalise on the stock surge
as the BSE Sensex rose by 15%. Greater weightage was given to stocks such
as HLL, Infosys, Ranbaxy, M&M and NIIT.
In US-64's case exposure to IT, FMCG and Pharma stocks rose from
20.45% to 22.09%. This was replicated across funds. Between June 1999 September 1999, 21 out of UTI's 28 schemes have outperformed the Sensex.
UTI has become more proactive in fund management. For instance, it
bought into Crest at between
Rs 200 and Rs 210 in October 1999. The stock was trading at Rs 340 in
November 1999.
Stocks like Visual Software, Mastek and Gujarat Ambuja have entered the
top 50 equity holding list. Scrips like Thermax, Thomas Cook and Carrier
Aircon are out.
Complete exit from illiquid stocks such as Esab Industries. The divesture
of around 83 stocks released estimated Rs 300-500 crore of extra investible
cash.
Source: Business World, November 29, 1999.
UTI constituted an ad-hoc Asset Management Committee with 7 members comprising 5
outside professionals and 2 senior UTI officials. The committee's role was clearly defined
and its scope covered the following areas:
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 To ensure that US-64 complied with the regulations and guidelines and the prudential
investment norms laid down by the UTI board of trustees from time to time.
To review the scheme's performance regularly and guide fund managers on the future
course of action to be adopted.
To oversee the key issues such as product designing, marketing and investor servicing
along with the recommendations to Board of Trustees.
One of the most important steps taken was the initiative to make US-64 scheme NAV
driven by February 2002 and to increase gradually the spread between sale and
repurchase price. The gap between sale and repurchase price of US-64 was to be
maintained within a SEBI specified range. UTI announced that dividend policy of US-64
would be made more realistic and it would reflect the performance of the fund in the
market. US-64 was to be fully SEBI regulated scheme with appropriate amendment to the
UTI Act.
The real estate investments made by UTI for the US-64 portfolio were also a part of the
controversy as they were against the SEBI guidelines for mutual funds. UTI had Rs 386
crore worth investments in real estate. UTI claimed that since its investments were made
in real estate, it was safe and it could sell the assets whenever required. However, the
value of the real estate in US-64's portfolio had gone down considerably over the years.
The real estate investments were hence revalued and later transferred to the Development
Reserve Fund of the trust according to the recommendations of the Deepak Parekh
committee.
By December 1999, the investible funds of US-64 had increased by 60% to Rs 19,923
crore from Rs 12,433 crore in December 1998. The NAV had recovered from Rs 9.57 to
Rs 16 by February 2000 after the committee recommendations were implemented
DEAD END SCHEME?
Though UTI started announcing the dividends according to the market conditions, this
was not received well by the investors. They felt that though the dividend was tax-free, it
was not appealing as most of the investors were senior citizens and they did not come
under
the
tax
bracket.
The statement in media by UTI chairman that trust would try to attract the corporate
investors into the scheme was against the recommendation by the committee, which had
adviced the trust to attract the retail investors into the scheme. This led to doubts about
UTI's commitment towards the revival of the scheme.
However, led by improving NAV figures and image-building exercises on UTI's part, by
2000, US-64 was again termed as one of the best investment avenues by analysts and
market researchers. UTI had become more proactive in fund management with its scrips
rising in value, restoring the confidence of the small investor in the scheme. The National
153

Council of Applied Economic Research (NCAER) and SEBI surveys mentioned that US64 was once again perceived as a safe investment by the middle class income groups.
However, the euphoria seemed to be short lived as in 2001, US-64 was involved in yet
another scam due to its investments in the K-10 stocks . Talks of a drastically low NAV,
inflated prices, increasing redemption and GoI bailouts appeared once again in the media.
An Economic Times report claimed that there was a difference of over Rs 6000 crore
between the NAV and the sale prices. Doubts were raised as to US-64 being an inherently
weak scheme, which coupled with its mismanagement, had led to its downfall once again.
This however, was yet another story.
Source:www.icmrindia.org
QUESTIONS FOR DISCUSSION:
1.

Explain in detail the reasons behind the problems faced by US-64 in the mid
1990s. Were these problems the sole responsibility of UTI? Give reasons to
support your answer.

2.

Analyse the steps taken by UTI to restore investor confidence in US-64.

Comment briefly on the efficacy of these steps.

3.

As a market analyst, would you term US-64 a safe mode of investment? Justify
your stand with reasons.

154

ASSIGNMENT C
MULTIPLE CHOICE QUESTIONS
Q1.

Equity shareholders rights are listed below. One of the rights is incorrect.
(a)
rights to have first claim in the case of winding of the company
(b)
right to vote at the general body meeting of the company
(c)
right to share profits in the form of dividends
(d)
right to receive a copy of the statutory report

Q2.

In the case of non voting shares:

(a)
the rights of voting stocks and non voting stocks are similar
(b)
rights and bonus issues for non voting shares can be issued in the form of
voting shares
(c)
the non voting shares would become voting shares after a particular period
of time
(d)
non voting shares carry higher dividends instead of voting rights

Q3.

NBFCs offer higher interest rate because of

(a)
the best management funds
(b)
the competition among the NBFCs
(c)
the risk involved
(d)
the credit rating

Q4.

Primary and Secondary markets

(a)
compete with each other
(b)
complement each other
(c)
function independently
(d)
control each other

Q5.

The underwriter has to take up

(a)
the fixed portion of issued capital
(b)
the agreed portion of the unsubscribed part
(c)
the agreed portion or can refuse it
(d)
none of the above

Q6.

Book Building is a
(a)
method of placing an issue
(b)
method of entry in foreign market
(c)
price discovery mechanism in case of an IPO
(d)
none of the above

Q7.

Sell Reliance Petro Shares at Rs 60 This order is a

(a)
Best rate order
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(b)
(c)
(d)

Limit order
Discretionary order
Stop Loss Order

Q8.

Stock exchange helps in

(a)
fixation of stock prices
(b)
ensures safe and fair dealing
(c)
induces good performance by the company
(d)
all of the above

Q9.

In a limit order
(a)
Orders are limited by a fixed price
(b)
Investor gives a range of price for purchase and sale
(c)
Order is given but to a limit a loss
(d)
None of the above

Q10. Which one of these is not true for a broker?

(a)
Broker has to abide by the code of conduct laid down by security
exchange commission
(b)
Broker facilitates the secondary market operations
(c)
Broker is a bridge between stock market and investor
(d)
Broker should leak the inside information of stock exchange
Q11.

FIIs are permitted

(a)
To invest in listed companies only
(b)
To invest in listed and unlisted companies
(c)
Not to invest in debentures
(d)
To invest in shares of listed unlisted companies and debentures.

Q12. Marketability risk of Bond is

(a)
The market risk which affects all the bonds
(b)
Variation in return caused by difficulty in selling bonds
(c)
The failure to pay the agreed value of the bond by the issuer
(d)
(a) and (b) both.
Q13. The value of bond depends on
(a)
Coupon rate
(b)
Years to maturity
(c)
Expected yield to maturity
(d)
All of the above
Q14. Forex market deals with
(a)
multi currency
(b)
only domestic currency
(c)
none of the above
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Q15. Credit market is a place here

(a)
multi currency requirements are met
(b)
Long term financing is done
(c)
Banks, Financial Institutions and NBFCs lend short medium and long
term loans to corporate or individuals
(d)
None of the above
Q16. Money Market is a
(a)
retail market
(b)
wholesale market
(c)
retail and whole sale market
(d)
none of the above
Q17. What is true for call money?
(a)
Money is borrowed for a fortnight
(b)
Money is borrowed for a week
(c)
Money is borrowed for a day
(d)
None of the above
Q18. When money is borrowed or lent for more than a day and up to 14 days it is
called
(a)
Call money
(b)
Quick money
(c)
Notice money
(d)
Term money
Q19. Mutual funds are valued with help of their
(a)
NAVs
(b)
NFO
(c)
IPO
(d)
None of the above
Q20. Which one of the following is true
(a)
Primary market gives liquidity to secondary market
(b)
Secondary market gives liquidity to primary market
Q21. Right issue is:
(a)
issue of securities by issue of prospectus to the public
(b)
Securities are issued through some selected investors.
(c)
Selling securities in the primary market by issuing rights to the existing
shareholders.
(d)
None of the above
Q22. Private placement has following advantage:
(a)
Flexibility and high cost
(b)
Accessibility and speed
(c)
High cost and speed
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(d)

Speed and complexity

Q23. Book Building Process is completed with the help of a

(a)
Book runner
(b)
Underwriter
(c)
Registrar
(d)
Lead manager
Q24. Treasury bills are issued
(a)
on discount
(b)
at premium
Q25. Commercial papers are
(a)
Secured Promissory Note
(b)
Unsecured Promissory note
(c)
Issued by individuals
(d)
None of the above
Q26. Total amount of called up share capital which is actually paid to the company
by the members is called
(a)
Subscribed capital
(b)
Called up capital
(c)
Paid up share capital
(d)
None of the above
Q27. A shares par value is Rs 10 but it is issued at Rs 20 , then extra amount over
par value is called
(a)
Coupon
(b)
Interest
(c)
Premium
(d)
None of the above
Q28. Bad news about a company can pull down its stock prices. This is called
(a)
Market risk
(b)
Non market risk
(c)
Interest risk
(d)
Callable risk
Q29. Debt/Income funds invest in
(a)
Tax saving schemes
(b)
Money Market Instruments
(c)
High Rate fixed income bearing instruments
(d)
Both debt and equity
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Q30. Mutual Funds investor can not earn following return

(a)
Dividend
(b)
Capital Gain
(c)
Increase in NAV
(d)
Fixed interest earning
Q31. Trustees in India are registered under
(a)
Companys Act 1956
(b)
Indian Trust act 1882
(c)
SEBI
(d)
Central bank
Q32. Sweat
employees.
(a)
(b)
(c)
(d)

Equity are the Equity Shares issued by company to its directors or

As salary
As consideration
Both of the above
None of the above

Q33. Bond prices and interest rates move in opposite direction

a)
above statement is true
b)
Above statement is false
c)
Partially true
d)
Partially false
Q34. Balanced funds provide:
(a)
Steady return
(b)
High return
(c)
Increase volatility
(d)
None of the above
Q35. Stock exchanges should ensure:
(a)
Active trading and insider information
(b)
Active trading and transparency
Which of the following is true?
(a)
Both a and b
(b)
Only b
(c)
Only a
(d)
Neither a nor b
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Q36. Merchant bankers do not indulge in following activities

(a)
Drafting of prospectus
(b)
Appointment of Registrar
(c)
Selection of Promoter
(d)
Arrangement of underwriter
Q37. Private placement reduces ________________________ of public issue:
(a)
Cost
(b)
Subscription
(c)
Issue size
(d)
None of the above
Q38. NBFC can accept deposits form NRIs
e)
Above statement is true
f)
Above statement is false
g)
Partly true
h)
None of the above
Q39. FDI is seen as a important source of capital formation when:
e)
Capital base is low
f)
Capital base is high
g)
Economy is self sufficient
h)
All of the above
Q40. Preference shares means which fulfill the following two conditions
a)
It carries preferential rights in respect of dividend at fixed amount and
fixed rate
b)
It does not carry preferential rights in regard to payment of capital on
winding up .
WHICH ONE OF THESE IS TRUE:
(a)
Both a and b
(b)
Only a
(c)
Only b
(d)
Neither a nor b

160

KEY TO ASSIGNMENT C QUESTIONS

Question
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

Answers Question Answers

a
21 c
d
22 b
c
23 a
b
24 a
b
25 b
c
26 c
b
27 c
d
28 b
a
29 c
d
30 d
d
31 b
b
32 b
d
33 a
a
34 a
c
35 a
b
36 c
c
37 a
c
38 b
a
39 a
b
40 b

161