Distance Learning Course- 2022-23

Certified Professional in Cooperative

Banking – Level-II

Module 01:
Advanced Bank
Management

2022

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Centre for Professional Excellence in Cooperatives (C-PEC) of
Bankers Institute of Rural Development (BIRD)

(NABARD’s Training Institution)

Sector-H, LDA Colony, Kanpur Road, Lucknow – 226 012, INDIA

Phone +91-522-2421799

Email [email protected]

Homepage https://bird-cpec.nabard.org, www.birdlucknow.in

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Table of Contents

Unit 1 Economic Analysis ............................................................................................2

1.1 Lesson No.1 Fundamentals of Economics .......................................................2
1.1.1 Objectives .................................................................................................3
1.1.2 Definition of Economics ............................................................................3
1.1.3 Macro economics ......................................................................................4
1.1.4 Microeconomics ........................................................................................8
1.1.5 Let us sum up ........................................................................................ 13
1.1.6 Key words/concepts................................................................................14
1.1.7 Check your progress ...............................................................................14
Key to check your progress ..................................................................................15
1.1.8 Terminal questions .................................................................................15
1.2 Lesson No.2 Money, banking and trade ......................................................... 16
1.2.1 Objectives ............................................................................................... 17
1.2.2 Introduction............................................................................................ 17
1.2.3 Monetary and credit policy ......................................................................19
1.2.4 Fiscal policy ............................................................................................ 24
1.2.5 Balance of payments ...............................................................................28
1.2.6 What is foreign exchange? ......................................................................33
1.2.7 Let us sum up ........................................................................................ 37
1.2.8 Key words ............................................................................................... 38
1.2.9 Check your progress ...............................................................................38
1.2.10 Terminal questions ..............................................................................39
1.3 Lesson No. 3 Interest rates ............................................................................40
1.3.1 Objectives ............................................................................................... 41
1.3.2 Introduction............................................................................................ 41
1.3.3 Base Rate Vs BPLR .................................................................................48
1.3.4 Marginal Cost of fund based Lending Rate (MCLR):.................................49
1.3.5 Let us sum up ........................................................................................ 51
1.3.6 Key words/concepts................................................................................51

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 1.3.7 Check your progress-questions ............................................................... 51
1.3.8 Terminal questions .................................................................................53
1.4 Lesson No. 4 Demand Analysis .....................................................................54
1.4.1 Objectives ............................................................................................... 55
1.4.2 Introduction (Demand) ............................................................................55
1.4.3 The Law of Supply ..................................................................................58
1.4.4 Shifts vs. Movement ................................................................................60
1.4.5 Elasticity.................................................................................................62
1.4.6 Demand forecasting ................................................................................67
1.4.7 Let us sum up ........................................................................................ 71
1.4.8 Key words/concepts................................................................................72
1.4.9 Check your progress ...............................................................................72
Key to check your progress ..................................................................................73
1.4.10 Terminal questions ..............................................................................73
1.4.11 Reference books for further reading ..................................................... 74
2 Unit 2 Business Mathematics and Statistics ....................................................... 76
2.1 Lesson No. 1 Basic statistical tools................................................................ 76
2.1.1 Objectives ............................................................................................... 77
2.1.2 Introduction to basic statistical tools ...................................................... 77
2.1.3 Correlation and Regression .....................................................................83
2.1.4 Trend analysis ........................................................................................ 96
2.1.5 Let us sum up ...................................................................................... 103
2.1.6 Key words/concepts.............................................................................. 104
2.1.7 Check your progress ............................................................................. 104
Key to check your progress ................................................................................ 105
2.1.8 Terminal questions ............................................................................... 105
2.2 Lesson No.2 Bond Valuation ....................................................................... 106
2.2.1 Objectives ............................................................................................. 107
2.2.2 Introduction.......................................................................................... 107
2.2.3 Current yield ........................................................................................ 111

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 2.2.4 Calculating Yield to Maturity ................................................................ 112
2.2.5 Rate of return ....................................................................................... 114
2.2.6 Rate of return versus yield to maturity.................................................. 115
2.2.7 Time value of money ............................................................................. 116
2.2.8 Risk ...................................................................................................... 116
2.2.9 Duration ............................................................................................... 117
2.2.10 Let us sum up ................................................................................... 120
2.2.11 Key words/concepts .......................................................................... 121
2.2.12 Check your progress .......................................................................... 121
2.2.13 Terminal questions ............................................................................ 122
2.3 Lesson No.3 Interest Rate Calculation ......................................................... 123
2.3.1 Objectives ............................................................................................. 124
2.3.2 Introduction-Interest Rate .................................................................... 124
2.3.3 Market interest rates ............................................................................ 126
2.3.4 Risk ...................................................................................................... 126
2.3.5 Interest rate calculation ........................................................................ 126
2.3.6 Types of interest rates ........................................................................... 127
2.3.7 Equated monthly installment - EMI ...................................................... 129
2.3.8 Let us sum up ...................................................................................... 130
2.3.9 Key words/concepts.............................................................................. 131
2.3.10 Check your progress .......................................................................... 131
2.3.11 Terminal questions ............................................................................ 132
2.4 Lesson No. 8 Sampling ................................................................................ 133
2.4.1 Objectives ............................................................................................. 134
2.4.2 Introduction-Sampling .......................................................................... 134
2.4.3 Data collection methods........................................................................ 136
2.4.4 Classification ........................................................................................ 137
2.4.5 Association, causation, and confounding .............................................. 140
2.4.6 Short- and long-term outcome .............................................................. 142
2.4.7 Let us sum up ...................................................................................... 143

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 2.4.8 Key words/concepts.............................................................................. 144
2.4.9 Check your progress ............................................................................. 144
2.4.10 Terminal questions ............................................................................ 145
2.4.11 References ......................................................................................... 145
3 Unit 3 Retail Banking and Bank Marketing ....................................................... 147
3.1 Lesson No. 1 Retail banking ........................................................................ 147
3.1.1 Objectives ............................................................................................. 148
3.1.2 Introduction to retail banking ............................................................... 148
3.1.3 What drives retail banking .................................................................... 151
3.1.4 Retail business and cooperative banks ................................................. 152
3.1.5 Retail products ..................................................................................... 155
3.1.6 Let us sum up ...................................................................................... 168
3.1.7 Key words/concepts.............................................................................. 169
3.1.8 Check your progress ............................................................................. 169
3.1.9 Terminal questions ............................................................................... 170
3.2 Lesson No. 2 Product Development and Launching (PDL) ............................ 171
3.2.1 Objectives ............................................................................................. 172
3.2.2 Introduction-Key Questions about PDL ................................................. 172
3.2.3 Let us sum up ...................................................................................... 175
3.2.4 Key words/concepts.............................................................................. 176
3.2.5 Check your progress- questions ............................................................ 176
3.2.6 Terminal questions ............................................................................... 177
3.3 Lesson No. 3- Marketing of bank products .................................................. 178
3.3.1 Objectives ............................................................................................. 179
3.3.2 Introduction - Marketing....................................................................... 179
3.3.3 The 7 Ps of services marketing .............................................................. 183
3.3.4 Let us sum up ...................................................................................... 184
3.3.5 Key words/concepts.............................................................................. 184
3.3.6 Check your progress ............................................................................. 185
3.3.7 Terminal questions ............................................................................... 185

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 3.3.8 References ............................................................................................ 186
3.4 Lesson No. 12: Customer Relationship Management in Banking ................. 187
3.4.1 Objectives ............................................................................................. 188
3.4.2 Introduction -Customer Relationship Management ............................... 188
3.4.3 Human aspects of customer service ...................................................... 190
3.4.4 What should a CRM solution offer? ....................................................... 192
3.4.5 Banking Ombudsman scheme .............................................................. 193
3.4.6 The Banking Codes and Standards ....................................................... 195
3.4.7 Let us sum up ...................................................................................... 198
3.4.8 Key words/concepts.............................................................................. 199
3.4.9 Check your progress- questions ............................................................ 199
3.4.10 Terminal questions ............................................................................ 200
3.4.11 Reference ........................................................................................... 200
4 Unit 4- Taxation ................................................................................................ 203
4.1 Lesson No. 1-Terminology ........................................................................... 203
4.1.1 Objective ............................................................................................... 204
4.1.2 Various terms used in tax laws ............................................................. 204
4.1.3 Key words/concepts ................................................................................. 210
4.1.4 Check your progress ............................................................................. 210
4.2 Lesson No. 14 Provision regarding calculation of taxable income under various
heads 212
4.2.1 Objectives ............................................................................................. 213
4.2.2 Introduction-Income tax ....................................................................... 213
4.2.3 Deductions ........................................................................................... 214
4.2.4 Individual heads of income ................................................................... 215
4.2.5 Deduction under chapter VI A .............................................................. 219
4.2.6 Let us sum up ...................................................................................... 230
4.2.7 Key words/concepts.............................................................................. 231
4.2.8 Check your progress- question ............................................................. 231
4.2.9 Terminal questions ............................................................................... 231
4.3 Lesson No. 15 Returns ................................................................................ 232
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 4.3.1 Objectives ............................................................................................. 233
4.3.2 Filing of Returns ................................................................................... 233
4.3.3 Types of IT returns................................................................................ 235
4.3.4 Let us sum up ...................................................................................... 236
4.3.5 Key words/concepts.............................................................................. 237
4.3.6 Check your progress ............................................................................. 237
4.3.7 Terminal questions ............................................................................... 237
4.4 Lesson No. 16 Appeals ................................................................................ 238
4.4.1 Objectives ............................................................................................. 239
4.4.2 Appeals ................................................................................................. 239
4.4.3 Revisions .............................................................................................. 241
4.4.4 Rectification .......................................................................................... 242
4.4.5 Appeals and revision ............................................................................. 245
4.4.6 Let us sum up ...................................................................................... 248
4.4.7 Key words/concepts.............................................................................. 248
4.4.8 Check your progress ............................................................................. 248
4.4.9 Terminal questions ............................................................................... 248
4.5 Lesson No. 17: Tax Deduction at Source (TDS) ............................................ 249
4.5.1 Objectives ............................................................................................. 250
4.5.2 Tax deducted at source ......................................................................... 250
4.5.3 TDS certificate ...................................................................................... 252
4.5.4 TDS rate chart financial year 2021-22 applicable for the resident of India (
other than a Company ) ..................................................................................... 253
4.5.5 TAN (Tax Deduction Account Number) .................................................. 256
4.5.6 Let us sum up ...................................................................................... 256
4.5.7 Key words/concepts.............................................................................. 257
4.5.8 Check your progress- questions ............................................................ 257
4.5.9 Key to the questions asked ................................................................... 257
4.5.10 Terminal questions ............................................................................ 257
4.6 Lesson No.18 Service Tax ............................................................................ 259
4.6.1 Objectives ............................................................................................. 261
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 4.6.2 Service Tax ........................................................................................... 261
4.6.3 What is Service Tax? ............................................................................. 261
4.6.4 Applicability of Service Tax ................................................................... 261
4.6.5 Service Tax Rate ................................................................................... 262
4.6.6 What is GST? How does it work?........................................................... 263
4.6.7 What are the benefits of GST? ............................................................... 263
4.6.7.13 GSTIN............................................................................................. 274
4.6.8 Let us sum up ...................................................................................... 274
4.6.9 Key words/concepts.............................................................................. 275
4.6.10 Check your progress- questions......................................................... 275
4.6.11 Terminal questions ............................................................................ 276
4.6.12 References ......................................................................................... 276
5 Unit 5 : Corporate Governance .......................................................................... 278
5.1 Lesson No. 19. Corporate Governance ......................................................... 278
5.1.1 Objectives ............................................................................................. 279
5.1.2 Corporate Governance .......................................................................... 279
5.1.3 Measures in Cooperative Acts ............................................................... 285
5.1.4 Issues of good governance in cooperative banks and internal control
systems286
5.1.5 Formation of committees ...................................................................... 288
5.1.6 Let us sum up ...................................................................................... 290
5.1.7 Key words/concepts.............................................................................. 291
5.1.8 Check your progress- questions ............................................................ 291
5.1.9 Terminal questions ............................................................................... 292
5.2 Lesson No. 20 Four Pillars .......................................................................... 293
5.2.1 Objectives ............................................................................................. 294
5.2.2 Introduction.......................................................................................... 294
5.2.3 Let’s us sum up .................................................................................... 298
5.2.4 Key words/concepts.............................................................................. 299
5.2.5 Check your progress- questions ............................................................ 299
5.2.6 Terminal questions ............................................................................... 300
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5.3 Lesson No. 21 Dos and Don’ts ..................................................................... 301
5.3.1 Objective ............................................................................................... 302
5.3.2 RBI Guidelines on Corporate Governance ............................................. 302
5.3.3 Measures taken by banks towards implementation of best practices .... 307
5.3.4 Measures taken towards corporate governance ..................................... 307
5.3.5 Let’s us sum up .................................................................................... 309
5.3.6 Key words/concepts.............................................................................. 310
5.3.7 Check your progress- questions ............................................................ 310
5.3.8 Terminal questions ............................................................................... 311
5.3.9 Reference .............................................................................................. 311

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Abbreviations

AGI Adjusted Gross Income

APR Annual Percentage Rate
ATM Automated Teller Machine
BoP Balance of Payments
BPLR Benchmark Prime Lending Rate
BCSBI The Banking Codes and Standards Board of India
CB Cooperative Bank
CBDT Central Board for Direct Taxes
CEO Chief Executive Officer
CII Confederation of Indian Industries
CPI Consumer Price Index
CRM Customer Relationship Management
CRR Cash Reserve Ratio
DSA Direct Sales Agent
ED Elasticity of Demand
ELSS Equity linked Savings Scheme
EMI Equated Monthly Installment
EPF Employees Provident Fund
FX Foreign Exchange
GATT General Agreement on Tariffs and Trade
GCC General Credit Card
GDP Gross Domestic Product
GoI Government of India
GST Goods and Service Tax
GSTIN Goods and Service Tax Identification Number
HRA House Rent Allowance
HNI High Networth Individuals
HUF Hindu Undivided Family
IMF International Monetary Fund

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IT Information Technology
ITR Income Tax Return
JLG Joint Liability Group
KCC Kisan Credit Card
KVIC Khadi and Village Industries Commission
KVP Kisan Vikas Patra
LPG Liberalisation Privatisation Globalisation
MA Moving Averages
MCLR Marginal Cost of Fund based Lending Rate
MoU Memorandum of Understanding
NABARD National Bank for Agriculture and Rural Development
NGO Non-Governmental Organisation
NSC National savings Certificate
OECD Organisation For Economic Cooperation And Development
OMO Open Market Operations
PACS Primary Agriculture Credit Society
PAN Permanent Account Number
PDL Product Development and Launching
PPF Production Possibility Frontier
PSU Public Sector Unit
PV Present Value
PVBP Price Value of a Basis Point
RBI Reserve Bank of India
SBI State Bank of India
SEBI Securities and Exchange Board of India
SHG Self Help Group
SLR Statutory Liquidity Ratio
SME Small and Medium Enterprise
SNA United Nations System of National Accounts
SSI Small Scale Industrial Units

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TAN Tax deduction Account Number
TCS Tax Collection at Source
TDS Tax Deduction at Source
TRP Tax Return Preparers
WTO World Trade Organisation
YTM Yield to Maturity

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 ADVANCED BANK MANAGEMENT

SYLLABUS

LESSON UNIT 01 : ECONOMIC ANALYSIS

Fundamentals of Definition of Economics - Micro Economic and

1
Economics Macro Economics
Types of money - Inflation - Monetary and credit
policy – Quantitative and qualitative
Money banking and
2 instruments (Repo and Reverse Repo) – Fiscal
Trade
policy – balance of payment – Foreign
Exchange.
Various Theories –– Bench Mark Prime Lending
3 Interest Rate
Rate (BPLR) - Base Rate (BR).
Demand, Law of Demand, Elasticity of Demand,
4 Demand Analysis
Demand Forecasting - Methods

UNIT 02 BUSINESS MATHEMATICS AND STATISTICS

Basic Statistical Mean- Median - Mode - Standard Deviation –

5
Tools Correlation – Regression and Trend analysis
Concepts – Types of Bonds - Duration and
6 Bond Valuation Modified Duration – YTM – Rate of Return and
Time Value of Money
Interest Rate
7 Fixed Rate - Floating Rate – EMI
Calculation
Meaning – Definition – Types – Data Collection,
8 Sampling
Tabulation - Analysis and Interpretation.

UNIT 03 RETAIL BANKING AND BANK MARKETING

Concept – Various Retail Products – Home
Loans, Vehicle Loans, Personal Loans,
9 Retail Banking Consumer Durable Loans, Mortgage Loans,
Reverse Mortgage Loans - Education Loan,
Credit / Debit Card
Product Innovation of new retail products based on the
10 Development and local needs and demands. Strategies for
Launching launching new products
Market Segmentation, Target Market and
Marketing of Bank Positioning (STP Strategy) - Delivery channels -
11
Products Branch Extension Centre - Point of Sale (POS)
– ATM - Mobile banking – Internet banking
Customer Concept – Role of Technology in CRM – CRM
12 Relationship process - Human aspects of customer service,
Management in Code of Conduct for Minimum Standard of
14
 Banking Banking Practices (BCSBI), Banking
OMBUDSMAN.

UNIT 04 TAXATION
Assessee, Previous year, Assessment year,
13 Terminology Capital/ Revenue – receipts and expenditure –
Gross total income, Total income
Provision regarding
Salary, Income from House Property, Profit and
calculation of
Gains of Business or Profession, Capital Gain,
14 taxable income
Income from Other Sources, Deductions Under
under various
Chapter VI – A, Assessment of Tax
Heads
Various Types of Benefits attracting Fringe
15 Fringe Benefits Tax
Benefit Tax
Various Types of Return, Filing of Return,
16 Returns
Electronic Form of Return

17 Appeals Appeals, Revision and Penalties.

Types of Income attracting TDS – Provisions
regarding TDS on Interest paid to Depositors,
Tax Deducted at Professional Fees, Payments made to
18
Source Contractor and Salary Paid to Employees,
Rates of TDS, Forms 15 G, 15 H, Form 16 and
16 A, Filling of Various Statements
Types of Services attracting Service Tax, Rates
19 Service Tax of Service Tax,
GST & Its importance
UNIT 05 CORPORATE GOVERNANCE IN COOPERATIVES
Concept of Governance and Management –
Corporate Importance, Need – Principles – Key Elements,
20
Governance Various Committees Viz. Investment, Audit,
Vigilance, Risk.
Accountability, Fairness, Transparency &
21 Four Pillars
Independence

22 Do’s and Don’ts As per RBI and NABARD Guidelines

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 Disclaimer

This book is meant for educational and learning purposes. The author of the
book has taken all reasonable care to ensure that the contents of the book do
not violate any existing copyright or other intellectual property rights of any
person/institution in any manner. Wherever possible,
acknowledgements/references have been given.

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 Unit-1 : Economic Analysis
Lesson No. 1 Fundamentals of Economics
Lesson No. 2 Money banking and Trade
Lesson No. 3 Interest Rates
Lesson No. 4 Demand Analysis
Lesson No. 5 Trial Balance, Profit & Loss and Balance Sheet

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 Unit 1 Economic Analysis

1.1 Lesson No.1 Fundamentals of Economics

1.1.1 Objectives
1.1.2 Definition of Economics
1.1.3 Macro Economics
1.1.3.1 National Output: GDP
1.1.3.2 Unemployment
1.1.3.3 Inflation
1.1.3.4 Demand & disposable income
1.1.3.5 Monetary policy
1.1.3.6 Fiscal policy
1.1.3.7 Bottom line
1.1.4 Micro Economics
1.1.4.1 Total and marginal utility
1.1.4.2 Opportunity costs
1.1.4.3 Market failure & competition
1.1.4.4 Conclusion
1.1.5 Let us sum up
1.1.6 Key words/concepts
1.1.7 Check your progress
1.1.8 Terminal questions

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1.1.1 Objectives

The objectives of this lesson are to understand:

 Definition of economics
 Macroeconomics
 Microeconomics
 Markets
1.1.2 Definition of Economics

Economics is the social science that analyzes the production, distribution

and consumption of goods and services. A focus of the subject is
how economic agents behave or interact and how economies work. Consistent
with this, a primary textbook distinction is between microeconomics and
macroeconomics. Microeconomics examines the behavior of basic elements in
the economy, including individual agents such as households and firms or as
buyers and sellers and markets, and their interactions. Macroeconomics
analyzes the entire economy and issues affecting it, including unemployment,
inflation, economic growth and monetary and fiscal policy.

Other broad distinctions include those between positive economics (describing

"what is") and normative economics (advocating "what ought to be"); between
economic theory and applied economics; between rational and behavioral
economics and between mainstream economics (more "orthodox" and dealing
with the "rationality-individualism-equilibrium nexus") and heterodox
economics (more "radical" and dealing with the "institutions-history-social
structure nexus”).

There are a variety of modern definitions of economics. Some of the differences

may reflect evolving views on the subject or different views among economists.
The philosopher Adam Smith (1776) defined what was then called political
economy as "an inquiry into the nature and causes of the wealth of nations". J
– B Say (1803), distinguishing the subject from its public policy uses, defines it
as the science of production, distribution, and consumption of wealth.

Alfred Marshall provides a still widely-cited definition in his textbook principles

of economics (1890) that extends analysis beyond wealth and from the societal
to the microeconomic level: Economics is a study of man in the ordinary
business of life. It enquires how he gets his income and how he uses it. Thus, it

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is on the one side, the study of wealth and on the other and more important
side, a part of the study of man.

Lionel Robbins (1932) developed implications of what has been termed

"perhaps the most commonly accepted current definition of the subject":
Economics is a science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses. Robbins
describes the definition as not classificatory in "picking out certain kinds of
behaviour" but rather analytical in "focusing attention on a particular aspect of
behaviour, the form imposed by the influence of scarcity.

1.1.3 Macro economics

When the price of a product you want to buy goes up, it affects you. But why
does the price go up? Is the demand greater than the supply? Did the cost go
up because of the raw materials that make the product? Or, was it a war in an
unknown country that affected the price? In order to answer these questions,
we need to turn to macroeconomics.

Macroeconomics is the study of the behaviour of the economy as a whole. This

is different from microeconomics, which concentrates more on individuals and
how they make economic decisions. Needless to say, macroeconomics is very
complicated and there are many factors that influence it. These factors are
analyzed with various economic indicators that tell us about the overall health
of the economy.

Macroeconomists try to forecast economic conditions to help consumers, firms

and governments make better decisions.

 Consumers want to know how easy it will be to find work, how much it
will cost to buy goods and services in the market, or how much it may
cost to borrow money.
 Businesses use macroeconomic analysis to determine whether expanding
production will be welcomed by the market. Will consumers have enough
money to buy the products, or will the products sit on shelves and collect
dust?
 Governments turn to the macro economy when budgeting, spending,
creating taxes, deciding on interest rates and making policy decisions.

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  Macroeconomic analysis broadly focuses on three things: national output
(measured by Gross domestic product (GDP)), unemployment
and inflation.
1.1.3.1 National Output: GDP

Output, the most important concept of macroeconomics, refers to the total

amount of goods and services a country produces, commonly known as the
gross domestic product. The figure is like a snapshot of the economy at a
certain point in time.

When referring to GDP, macroeconomists tend to use real GDP, which takes
inflation into account, as opposed to nominal GDP, which reflects only changes
in prices. The nominal GDP figure will be higher if inflation goes up from year
to year, so it is not necessarily indicative of higher output levels, only of higher
prices.

The one drawback of the GDP is that because the information has to be
collected after a specified time period has finished, a figure for the GDP today
would have to be an estimate. GDP is nonetheless like a stepping stone into
macroeconomic analysis. Once a series of figures is collected over a period of
time, they can be compared, and economists and investors can begin to
understand the business cycles, which are made up of the alternating periods
between economic recessions (slumps) and expansions (booms) that have
occurred over time. From there we can begin to look at the reasons why the
cycles took place, which could be government policy, consumer behaviour or
international phenomena, among other things. Of course, these figures can be
compared across economies as well. Hence, we can determine which countries
are economically strong or weak.

Based on what they learn from the past, analysts can then begin to forecast the
future state of the economy. It is important to remember that what determines
human behavior and ultimately the economy can never be forecast completely.

1.1.3.2 Unemployment

The unemployment rate tells macroeconomists how many people from the
available pool of labour are unable to find work. Macroeconomists have come to
agree that when the economy has witnessed growth from period to period,
which is indicated in the GDP growth rate, unemployment levels tend to be low.
This is because with rising (real) GDP levels, we know that output is higher,

5
and, hence, more laborers are needed to keep up with greater levels of
production.

1.1.3.3 Inflation

The third main factor that macroeconomists look at is the inflation rate, or the
rate at which prices rise. Inflation is primarily measured in two ways: through
the Consumer Price Index (CPI) and the GDP deflator. The CPI gives the current
price of a selected basket of goods and services that is updated periodically.
The GDP deflator is the ratio of nominal GDP to real GDP. If nominal GDP is
higher than real GDP, we can assume that the prices of goods and services
have been rising. Both the CPI and GDP deflator tend to move in the same
direction and differ by less than 1%.

1.1.3.4 Demand and disposable income

What ultimately determines output is demand. Demand comes from consumers

(for investment or savings - residential and business related), from the
government and from imports and exports.

Demand alone, however, will not determine how much is produced. What
consumers demand is not necessarily what they can afford to buy, so in order
to determine demand, a consumer's disposable income must also be measured.
This is the amount of money after taxes left for spending and/or investment.

In order to calculate disposable income, a worker's wages must be quantified

as well. Salary is a function of two main components: the minimum salary for
which employees will work and the amount employers are willing to pay in
order to keep the workers in employment. Given that the demand and supply
go hand in hand, the salary level will suffer in times of high unemployment,
and it will enhance when unemployment levels are low.

Demand inherently will determine supply (production levels) and equilibrium

will be reached; however, in order to feed demand and supply, money is
needed. The central bank prints all money that is in circulation in the
economy. The sum of all individual demand determines how much money is
needed in the economy. To determine this, economists look at the nominal GDP
which measures the aggregate level of transactions, to determine a suitable
level of money supply.

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Greasing the Engine of the Economy - What the Government Can Do?

1.1.3.5 Monetary policy

A simple example of monetary policy is the central bank's open- market

operations. When there is a need to increase cash in the economy, the central
bank will buy government bonds (monetary expansion). These securities allow
the central bank to inject the economy with an immediate supply of cash. In
turn, interest rates, the cost to borrow money, will be reduced because the
demand for the bonds will increase their price and push the interest rate down.
In theory, more people and businesses will then buy and invest. Demand for
goods and services will rise and, as a result, output will increase. In order to
cope with increased levels of production, unemployment levels should fall and
wages should rise.

On the other hand, when the central bank needs to absorb extra money in the
economy, and push inflation levels down, it will sell its T-Bills. This will result
in higher interest rates (less borrowing, less spending and investment) and less
demand, which will ultimately push down price level (inflation) but will also
result in less real output.

1.1.3.6 Fiscal policy

The government can also increase taxes or lower government spending in order
to conduct a fiscal correction. What this will do is lower real output because
less government spending means less disposable income for consumers. And,
because more of consumers' wages will go to taxes, demand as well as output
will decrease.

A fiscal expansion by the government would mean that taxes are decreased or
government/development spending is increased. Either way, the result will be
growth in real output because the government will stir demand with increased
spending. In the meantime, a consumer with more disposable income will be
willing to buy more.

A government will tend to use a combination of both monetary and fiscal

options when setting policies that deal with the macro economy.

1.1.3.7 The Bottom Line

The performance of the economy is important to all of us. We analyze the

macro economy by primarily looking at national output, unemployment and

7
inflation. Although it is consumers who ultimately determine the direction of
the economy, governments also influence it through fiscal and monetary policy.

1.1.4 Microeconomics

How do companies decide what price to charge for their sleek new gadgets?
Why are some people willing to pay more for a product than others? How do
consumer decisions play into how corporations price their products? The
answer to all of these questions and many more is microeconomics.

Microeconomics focuses on the role consumers and businesses play in the

economy, with specific attention paid to how these two groups make decisions.
These decisions include when a consumer purchases a good and for how
much, or how a business determines the price it will charge for its product.
Microeconomics examines smaller units of the overall economy; it is different
from macroeconomics which focuses primarily on the effects of interest rates,
employment, output and exchange rates on governments and economies as a
whole. Both microeconomics and macroeconomics examine the effects of
actions in terms of supply and demand. Microeconomics breaks down into the
following tenets:

 Individuals make decisions based on the concept of utility In other words,

the decision made by the individual is supposed to increase that individual's
happiness or satisfaction. This concept is called rational behavior or rational
decision-making.
 Businesses make decisions based on the competition they face in the
market. The more competition a business faces, the less leeway it has in
terms of pricing.
 Both individuals and consumers take the opportunity cost of their actions
into account when making their decisions.
1.1.4.1 Total and marginal utility

At the core of how a consumer makes a decision is the concept of individual

benefit, also known as utility. The more benefit a consumer feels a product
provides, the more that consumer is willing to pay for the product. Consumers
often assign different levels of utility to different goods, creating different levels
of demand. Consumers have the choice of purchasing any number of goods, so
utility analysis often looks at marginal utility, which shows the satisfaction

8
that one additional unit of a good brings. Total utility is the total satisfaction
the consumption of a product brings to the consumer.

Utility can be difficult to measure and is even more difficult to aggregate in

order to explain how all consumers will behave. After all, each consumer feels
differently about a particular product. Take the following example:

Think of how much you like eating a particular food, such as pizza. While you
might be really satisfied after one slice, that seventh slice of pizza makes your
stomach hurt. In the case of you and pizza, you might say that the benefit
(utility) that you receive from eating that seventh slice of pizza is not nearly as
great as that of the first slice. Imagine that the value of eating that first slice of
pizza is set to 14 (an arbitrary number chosen for the sake of illustration).
Figure 1, as follows, shows that each additional slice of pizza you eat increases
your total utility because you feel less hungry as you eat more. At the same
time, because the hunger you feel decreases with each additional slice you
consume, the marginal utility - the utility of each additional slice - also
decreases.

Slices of Pizza Marginal Utility Total Utility

1 14 14

2 12 26

3 10 36

4 8 44

5 6 50

6 4 54

7 2 56

In graph form, Total Utility and Marginal Utility would look like the following:

9
The decreasing satisfaction the consumer feels from additional units is referred
to as the law of diminishing marginal utility. While the law of diminishing
marginal utility isn't really a law in the strictest sense (there are exceptions), it
does help illustrate how resources spent by a consumer, such as the extra
dollar needed to buy that seventh piece of pizza, could have been better used
elsewhere. For example, if you were given the choice of buying more pizza or
buying a soda, you might decide to forgo another slice in order to have
something to drink. Just as you were able to indicate in a chart how much
each slice of pizza meant to you, you probably could also indicate how you felt
about combinations of different quantities of soda and pizza. If you were to plot
out this chart on a graph, you'd get an indifference curve, a diagram depicting
equal levels of utility (satisfaction) for a consumer faced with various
10
combinations of goods. Figure 2 shows the combinations of soda and pizza,
which you would be equally happy with.

1.1.4.2 Opportunity costs

When consumers or businesses make the decision to purchase or produce

particular goods, they are doing so at the expense of buying or producing
something else. This is referred to as the opportunity cost. If an individual
decides to use a month's salary for a vacation instead of saving, the immediate
benefit is the vacation on a sandy beach, but the opportunity cost is the money
that could have accrued in that account in interest, as well as what could have
been done with that money in the future.

When illustrating how opportunity costs influence decision making, economists

use a graph called the production possibility frontier (PPF). Figure 2 shows the
combinations of two goods A & B that a company or economy can produce.
Points within the curve are considered inefficient because the maximum
combination of the two goods is not reached, while points outside of the curve
cannot exist because they require a higher level of efficiency than what is
currently possible. Points outside the curve can only be reached by an increase
in resources or by improvements to technology. The curve represents
maximum efficiency.

11
The graph represents the amount of two different goods that a firm can
produce, but instead of always seeking to produce along the curve, a firm
might choose to produce within the curve's boundaries. The firm's decision to
produce less, than what is efficient, is determined by demand for the two types
of goods. If the demand for goods is lower than what can be efficiently
produced, then the firm is more likely to limit production. This decision is also
influenced by the competition faced by the firm.

A well-known example of the PPF in practice is the “guns and butter” model,
which shows the combinations of defense spending and civilian spending that a
government can support. While the model itself oversimplifies the complex
relationships between politics and economics, the general idea is that the more
a government spends on defense, the less it can spend on non-defense items.

1.1.4.3 Market failure and competition

While the term “market failure” might conjure up images of unemployment or a

massive economic depression, the meaning of the term is different. In fact it is
the failure of market forces in proper allocation of available resources. Market
failure exists when the economy is unable to efficiently allocate resources. This
can result in scarcity, a glut or a general mismatch between supply and
demand. Market failure is frequently associated with the role that competition
plays in the production of goods and services, but can also arise from
asymmetric information or from a misjudgment in the effects of a particular
action. The level of competition a firm faces in a market, as well as how this
determines consumer prices, is probably the more widely-referenced concept.
12
There are four main types of competition:

 Perfect competition - A large number of firms produce a good, and a

large number of buyers are in the market. Because so many firms are
producing, there is little room for differentiation between products, and
individual firms cannot affect prices because they have a low market
share. There are very few barriers to entry in the production of this good.
 Monopolistic competition - A large number of firms produce a good,
but the firms are able to differentiate their products. There are also some
barriers to entry.
 Oligopoly - A relatively small number of firms produce a good, and each
firm is able to differentiate its product from its competitors. Barriers to
entry are relatively high.
 Monopoly - One firm controls the market. The barriers to entry are very
high because the firm controls the entire share of the market.
The price that a firm sets for its products is determined by the competitiveness
of its industry, and the firm's profits are judged by how well it balances costs to
revenues. The more competitive the industry, the less choice the individual firm
has for setting its price.

1.1.4.4 Conclusion

We can analyze the economy by examining how the decisions of individuals

and firms alter the types of goods that are produced. Ultimately, it is the
smallest segment of the market - the consumer - who determines the course of
the economy by making choices that best fit the consumer's perception of cost
and benefit.

1.1.5 Let us sum up

Economics is the social science that analyzes the production, distribution

and consumption of goods and services.

Microeconomics examines the behavior of basic elements in the economy,

including individual agents (such as households and firms or as buyers and
sellers) and markets, and their interactions. Macroeconomics analyzes the
entire economy and issues affecting it, including unemployment, inflation,
economic growth, and monetary and fiscal policy.

13
While monetary policy enables the regulator to control money supply, fiscal
policy is the use of government revenue collection (taxation) and expenditure
(spending) to influence the economy.

1.1.6 Key words/concepts

Economics; production, distribution and consumption ; Microeconomics;

Macroeconomics; monetary policy; fiscal policy ; Perfect competition;
Monopolistic competition; Oligopoly; Monopoly.

1.1.7 Check your progress

1. The fundamental economic problem faced by all societies is:

a. unemployment b. Inequality
c. Poverty d. Scarcity

2. "Capitalism" refers to:

a. the use of markets b. government ownership of capital goods

c. private ownership of capital goods d. private ownership of homes & cars

3. The total resources in an economy:

a. Are always fixed b. Can never decrease

c. Always increase over time d. Are limited at any moment in time

4. Human wants are:

a. Always b. Limited
c. Unlimited d. Likely to decrease over time

5. Which one of the following is not one of the basic economic questions?

a. What to produce b. Who to produce for

c. How to produce d. How to minimize economic growth

6. A relatively small number of firms produce a good, and each firm is able
to differentiate its product from its competitors. Barriers to entry are
relatively high. Identify the competition.

14
a. Monopoly b. Monopolistic competition
c. Oligopoly d. Perfect competition

7. When the government decides to reduce its spending the policy decision
is part of

a. Monetary b. Credit policy

c. Fiscal policy d. National policy

Key to check your progress

1.d 2.c 3.d

4. c 5. d 6. c
7. c

1.1.8 Terminal questions

 Define economics
 Explain briefly the areas focused in between macroeconomics
 Discuss the 4 types of market competition

15
1.2 Lesson No.2 Money, banking and trade

1.2.1 Objectives
1.2.2 Introduction
1.2.2.1 Definition of money
1.2.2.2 Money supply
1.2.2.3 Types of money
1.2.3 Monetary & Credit Policy
1.2.3.1 Instruments of Monetary Policy
1.2.3.2 Liquidity Management
1.2.3.3 Interest Rate Management
1.2.3.4 Foreign Exchange Management
1.2.3.5 Quantitative Instruments of Monetary Policy
1.2.4 Fiscal Policy
1.2.4.1 Stances of Fiscal Policy
1.2.4.2 Main objectives of Fiscal Policy
1.2.5 Balance of Payments
1.2.5.1 Variation in the use of term of Balance of Payments (BOP)
1.2.5.2 IMF definition
1.2.5.3 Imbalances
1.2.5.4 BOP crisis
1.2.5.5 Balance mechanism
1.2.5.6 Balancing by changing Exchange Rates
1.2.5.7 Balancing by adjusting internal prices and demand
1.2.6 Foreign exchange
1.2.7 Let us sum up
1.2.8 Key words/concepts
1.2.9 Check your progress
1.2.10 Terminal questions

16
1.2.1 Objectives

The objectives of this lesson are to understand

 Monetary policy
 Instruments of the Monetary Policy
 Fiscal policy
 Balance of payments
 Foreign exchange
1.2.2 Introduction

1.2.2.1 Definition of Money

Money is any object or record that is generally accepted as payment for goods
and services and repayment of debts in a given socio-economic context
or country. The main functions of money are distinguished as: a medium of
exchange; a unit of account; a store of value and, occasionally in the past,
a standard of deferred payment. Any kind of object or secure verifiable record
that fulfills these functions can serve as money.

 When money is used to intermediate the exchange of goods and services,

it is performing a function as a medium of exchange.
 A unit of account is a standard numerical unit of measurement of the
market value of goods, services, and other transactions.
 To act as a store of value, money must be able to be reliably saved,
stored, and retrieved – and be predictably usable as a medium of
exchange when it is retrieved.
 A "standard of deferred payment" is an accepted way to settle a debt –
a unit in which debts are denominated, and the status of money as legal
tender, in those jurisdictions which have this concept, states that it may
function for the discharge of debts.
Money is historically a market phenomena establishing a commodity money,
but nearly all contemporary money systems are based on fiat money. Fiat
money is without intrinsic value as a physical commodity, and derives its value
by being declared by a government to be legal tender that is, it must be
accepted as a form of payment within the boundaries of the country, for "all
debts, public and private".
17
1.2.2.2 Money supply

The money supply of a country consists of currency (banknotes and coins)

and bank money (the balance held in checking accounts and savings
accounts). Bank money usually forms by far the largest part of the money
supply.

Modern monetary theory distinguishes among different ways to measure the

money supply, reflected in different types of monetary aggregates, using a
categorization system that focuses on the liquidity of the financial instrument
used as money. The most commonly used monetary aggregates (or types of
money) are conventionally designated M1, M2, M3 and M4.

The four measures of money supply for annual compilation developed in India
are as follows:

M1 = currency with public + demand deposits with the banking system + other
deposits with RBI

M2 = M1 + saving deposits with post office savings banks

M3 = M1 + time deposits with the banking system

M4 = M3 + all deposits with post office savings banks excluding National

Saving Certificates

1.2.2.3 Types of money

Commodity money such as naturally scarce precious metals conch shells

barley, beads etc., as well as many other things that are thought of as
having value. Commodity money value comes from the commodity out of which
it is made.

Representative money, consists of token coins or other physical tokens such

as certificates that can be reliably exchanged for a fixed quantity of a
commodity such as gold or silver.

Fiat money or fiat currency is money whose value is not derived from any
intrinsic value or guarantee that it can be converted into a valuable commodity
(such as gold). Instead, it has value only by government order (fiat). Fiat
money, if physically represented in the form of currency (paper or coins) can be
accidentally damaged or destroyed. However, fiat money has an advantage over
representative or commodity money, in that the same laws that created the
18
money can also define rules for its replacement in case of damage or
destruction.

Currency refers to physical objects generally accepted as medium of exchange.

These are usually notes and coins of a particular government, which comprise
physical aspects of a nation’s money supply.

Commercial bank money or demand deposits are claims against financial

institutions that can be used for the purchase of goods and services. A demand
deposit account is an account from which funds can be withdrawn at any time
by cheque or cash withdrawal without giving the bank or financial institution
any prior notice. Banks have the legal obligation to return funds held in
demand deposits immediately upon demand (or 'at call'). Demand deposit
withdrawals can be performed in person, via cheques or bank drafts,
using teller machines (ATMs), or through online banking.

1.2.3 Monetary and credit policy

Monetary policy is the strategy by which the monetary authority of a country

i.e. Reserve Bank Of India (RBI) controls the supply of money often targeting a
rate of interest for the purpose of promoting economic growth and stability. The
official goals usually include relatively stable prices and
low unemployment. Monetary theory provides insight into how to craft optimal
monetary policy. It is referred to as either being expansionary or
contractionary. While an expansionary policy increases the total supply of
money in the economy more rapidly than usual, a contractionary policy
expands the money supply more slowly than usual or even shrinks it.
Expansionary policy is traditionally used to try to combat unemployment in
a recession by lowering interest rates in the hope that easy credit will entice
businesses into expanding. Contractionary policy is intended to slow inflation
in hopes of avoiding the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy which refers to taxation, government
spending and associated borrowing.

Monetary policy rests on the relationship between the rates of interest in an

economy, that is, the price at which money can be borrowed, and the total
supply of money. Monetary policy uses a variety of tools to control one or both
of these, to influence outcomes like economic growth, inflation, exchange rates
with other currencies and unemployment. Where currency is under a monopoly
of issuance, or where there is a regulated system of issuing currency through
19
banks which are tied to a central bank, the monetary authority has the ability
to alter the money supply and thus influence the interest rate.

A policy is referred to as contractionary if it reduces the size of the money

supply or increases it only slowly, or if it raises the interest rate.
An expansionary policy increases the size of the money supply more rapidly, or
decreases the interest rate. Furthermore, monetary policies are described as
follows: accommodative, if the interest rate set by the central monetary
authority is intended to create economic growth; neutral, if it is intended
neither to create growth nor combat inflation; or tight if intended to reduce
inflation.

There are several monetary policy tools available to achieve these ends:
increasing interest rates by fiat; reducing the monetary base; and
increasing reserve requirements

1.2.3.1 Instruments of monetary policy

The Quantitative instruments at the disposal of the RBI for managing money
supply, interest rates and exchange rates are:

Liquidity Management
 Cash Reserve Ratio
 Open Market Operations
 Managing Credit Expansion
Interest Rate Management
 Repo Rate
 Bank rate
 Rates paid on government securities
Forex Management
 Market Intervention
1.2.3.2 Liquidity management

Cash Reserve Ratio (CRR):

Reserve Bank of India through Monetary Policy Committee (MPC) controls the
liquidity with the banks by changing the reserve ratios (preemptive ratios)
which in turn would restrict power to create credit.
20
Cash Reserve ratio (CRR): CRR is the percentage of Bank deposits which banks
are required to keep with RBI in the form of reserves or balances. The higher
the CRR the lower will be liquidity in the system and vice versa.

Presently, it is 4.5% of Net demand and time Liabilities.

Statutory Liquidity Ratio (SLR):

Banks are required to maintain a certain quantity of liquid assets in the form
of Govt. securities, other approved securities like bonds etc. at any point of
time. The ratio of these liquid assets to time and demand deposits is termed as
Statutory Liquidity Ratio. The higher the SLR the lower will be the liquidity in
the country and vice versa.

Presently it is 18% of net demand and time Liabilities.

Just as additional cash inflows enable the banking system to create credit, any
increase in CRR will require the banking system to contract credit by a large
amount. SLR (Statutory Liquidity ratio) is a requirement peculiar to India. In
addition to ensuring that banks can fall back on the readily saleable
government securities in the event of a run on the bank, it was a prescription
to divert bank deposits to meet government investment expenditure.

Open market operations:

Banks as well as other financial institutions, such as insurance companies,

mutual funds and corporate with surplus cash are big investors in government
securities. When RBI wishes to inject liquidity into the market, it has another
option of buying government securities. When RBI offers to buy the securities
at a rate that is better than the rate prevailing in the market, some of the
investors can sell their holdings and the cash inflow would lead to credit
creation of a large magnitude.

Similarly, when RBI sells government securities at a higher rate than market
rate, RBI absorbs funds and the banking system contracts credit by a large
magnitude to reduce liquidity. This is known as open market operation.

Managing credit expansion:

CRR and OMO reduce liquidity in the system and reduce the ability of banks to
create credit. RBI also controls sector specific expansion of credit by specifying
maximum amounts that can be lent, minimum margins to be maintained and
higher risk weights.
21
When RBI feels that banks have over extended themselves to certain sectors,
the flow of credit to certain sectors is leading to an imbalanced growth of the
economy or it wants to control the price of certain commodities by preventing
hoarding by wholesalers with borrowed funds, RBI makes sector specific or
commodity specific interventions.

1.2.3.3 Interest rate management

Repo:

Repo rate is the rate at which the RBI lends to its clients i.e. banks for a short
term generally against govt. securities. Increase or decrease in Repo rate will
result in increase or decrease in bank’s lending rates. Reduction in Repo rate
means banks get money from RBI at a cheaper rate consequently bank’s
lending rate will decrease which will usher credit expansion .Increase in Repo
rate means banks get money at a higher rate which will result in credit
contraction.

Reverse Repo:

Reverse Repo is the rate at which RBI borrows money from banks for a short
term. Increase in the rate means banks will lend more money to RBI which will
reduce liquidity and consequently lending by banks will be reduced. Decrease
in the rate will similarly decrease lending to RBI and consequently increase the
lending by banks.

Bank rate:

RBI provides refinance to banks against funds deployed by banks in specified

sectors such as exports. In the past, the bank rate used to be the
primary interest rate tool of RBI. But over a period of time the repo rate has
presently emerged as the primary interest rate tool and bank rate has lost
much of its relevance. Changes in the bank rate are a signal to the market
regarding the direction in which the RBI would like interest rates to move.

Rates paid on government securities:

RBI, as a banker to the government, helps government to borrow from the

market by selling their securities. RBI also determines the timing, size, and
rate paid on the issues. Rates offered by RBI on government securities are both
a reflection of the market and also an indicator to the market on the direction
of interest rate movements.

22
1.2.3.4 Foreign exchange management

Market intervention:

Large balance of payment surpluses and buildup of Forex reserves are bound
to strengthen the rupee in the exchange market. This market force cannot be
countered by RBI for long periods of time. However, by intervening in the
market by offering to buy or sell any amount of foreign currency at a particular
rate, RBI can prevent the sudden volatility of rupee. RBI seeks to smoothen the
movement of rates in either direction so that importers and exporters have time
to adjust to the changing exchange rate scenario and are not caught by
surprise by violent rate movements, which could cripple them.

1.2.3.5 Quantitative instruments of monetary policy

They are also known as selective instrument of credit control. They are called
qualitative tools, as they influence the type and composition of credit. These
instruments are very popular in developing countries like India. Some
important selective credit control measures are:

1) Credit Rationing: Under this, certain conditions are laid by the Central
Bank to see proper regulation of credit. This is to prevent excess expansion of
credit.

2) Direct Action: This includes charging penalty interest rates, qualitative

credit ceiling etc. on Commercial Bank lendings. It has its direction and
restrictive measures, which all the banks concerned should follow regarding
the lending and investment.

3) Margin Requirement: Here, margin refers to difference between market

value and amount borrowed against the securities. Banks, while advancing
loan against security, do not lend the full amount, but lend less. This is done
keeping in view the difference between the value of security and the amount of
advance to cover any loss. By stipulating minimum margins on desired
commodities RBI can control amounts that can be lent to the businesses
dealing in those items.

4) Moral Suasion: This is used by many countries. It has a great influence over
the loan policy of banks. There is a co-operation between them. Under this, the
Central Bank makes an informal request to Commercial Banks to contract
loans in the time of inflation and expand loans in depression. It helps the
Central Bank to secure the willingness and co-operation, but then that
23
depends on the amount of respect and authority the Central Bank enjoys
among the member banks.

1.2.4 Fiscal policy

In economics and political science Fiscal Policy is the use of government

revenue collection (taxation) and expenditure (spending) to influence the
economy. The two main instruments of fiscal policy are government taxation
and expenditure. Changes in the level and composition of taxation and
government spending can impact the following variables in the economy:

 Aggregate demand and the level of economic activity;

 The pattern of resource allocation;
 The distribution of income.
Fiscal policy refers to the use of the government budget to influence economic
activity.

1.2.4.1 Stances of Fiscal Policy

The three main stances of fiscal policy are:

 Neutral fiscal policy is usually undertaken when an economy is in

equilibrium. Government spending is fully funded by tax revenue and
overall the budget outcome has a neutral effect on the level of economic
activity.
 Expansionary fiscal policy involves government spending exceeding tax
revenue, and is usually undertaken during recessions.
 Contractionary fiscal policy occurs when government spending is lower
than tax revenue, and is usually undertaken to pay down government
debt.
However, these definitions can be misleading because, even with no changes in
spending or tax laws at all, cyclic fluctuations of the economy cause cyclic
fluctuations of tax revenues and of some types of government spending,
altering the deficit situation; these are not considered to be policy changes.
Therefore, for purposes of the above definitions, "government spending" and
"tax revenue" are normally replaced by "cyclically adjusted government
spending" and "cyclically adjusted tax revenue". Thus, for example, a
government budget that is balanced over the course of the business cycle is
considered to represent a neutral fiscal policy stance.
24
Fiscal policy has to decide on the size and pattern of flow of expenditure from
the government to the economy and from the economy back to the government.
So in broad terms, fiscal policy refers to, "that segment of national economic
policy which is primarily concerned with the receipts and expenditure of
central government." In other words, fiscal policy refers to the policy of the
government with regard to taxation, public expenditure and public borrowings.

The importance of fiscal policy is high in underdeveloped and developing

countries. The state has to play active and important role. In a democratic
society direct methods are not approved. So, the government has to depend on
indirect methods of regulations. In this way, fiscal policy is a powerful weapon
in the hands of government by means of which it can achieve the objectives of
development.

1.2.4.2 Main objectives of Fiscal Policy in India

The fiscal policy is designed to achieve certain objectives as follows:

1. Development by effective mobilization of resources

The principal objective of fiscal policy is to ensure rapid economic growth and
development. This objective of economic growth and development can be
achieved by Mobilization of Financial Resources.

The central and the state governments in India have used fiscal policy to
mobilise resources.

The financial resources can be mobilized by:

 Taxation: Through effective fiscal policies, the government aims to

mobilise resources by way of direct taxes as well as indirect taxes
because most important source of resource mobilisation in India is
taxation.
 Public savings: The resources can be mobilised through public savings
by reducing government expenditure and increasing surpluses of public
sector enterprises.
 Private savings: Through effective fiscal measures such as tax benefits,
the government can raise resources from private sector and households.
Resources can be mobilised through government borrowings by ways of
treasury bills, issue of government bonds, etc., loans from domestic and
foreign parties and by deficit financing.
25
2. Efficient allocation of financial resources

The central and state governments have tried to make efficient allocation of
financial resources. These resources are allocated for Development Activities
which include expenditure on railways, infrastructure, etc. While Non-
development Activities include expenditure on defense, interest payments,
subsidies, etc.

But generally the fiscal policy should ensure that the resources are allocated
for generation of goods and services which are socially desirable. Therefore,
India's fiscal policy is designed in such a manner so as to encourage
production of desirable goods and discourage those goods which are socially
undesirable.

3. Reduction in inequalities of income and wealth

Fiscal policy aims at achieving equity or social justice by reducing income

inequalities among different sections of the society. The direct taxes such as
income tax are charged more on the rich people as compared to lower income
groups. Indirect taxes are also more in the case of semi-luxury and luxury
items, which are mostly consumed by the upper middle class and the upper
class. The government invests a significant proportion of its tax revenue in the
implementation of Poverty Alleviation Programmes to improve the conditions of
poor people in society.

4. Price stability and control of inflation

One of the main objectives of fiscal policy is to control inflation and stabilize
price. Therefore, the government always aims to control the inflation by
reducing fiscal deficits, introducing tax savings schemes, Productive use of
financial resources, etc.

5. Employment generation

The government is making every possible effort to increase employment in the

country through effective fiscal measure. Investment in infrastructure has
resulted in direct and indirect employment. Lower taxes and duties on small-
scale industrial (SSI) units encourage more investment and consequently
generate more employment. Various rural employment programmes have been
undertaken by the Government of India to solve problems in rural areas.
Similarly, self-employment scheme is taken to provide employment to
technically qualified persons in the urban areas.
26
6. Balanced regional development

Another main objective of the fiscal policy is to bring about a balanced regional
development. There are various incentives from the government for setting up
projects in backward areas such as Cash subsidy, Concession in taxes and
duties in the form of tax holidays, Finance at concessional interest rates, etc.

7. Reducing the deficit in the balance of payment

Fiscal policy attempts to encourage more exports by way of fiscal measures like
Exemption of income tax on export earnings, Exemption of central excise
duties and customs, Exemption of sales tax and Octroi, etc.

The foreign exchange is also conserved by providing fiscal benefits to import

substitute industries, imposing customs duties on imports, etc. The foreign
exchange earned by way of exports and saved by way of import substitutes
helps to solve balance of payments problem. In this way adverse balance of
payment can be corrected either by imposing duties on imports or by giving
subsidies to export.

8. Capital formation

The objective of fiscal policy in India is also to increase the rate of capital
formation so as to accelerate the rate of economic growth. An underdeveloped
country is trapped in vicious (danger) circle of poverty mainly on account of
capital deficiency. In order to increase the rate of capital formation, the fiscal
policy must be efficiently designed to encourage savings and discourage and
reduce spending.

9. Increasing national income

The fiscal policy aims to increase the national income of a country. This is
because fiscal policy facilitates the capital formation. This results in economic
growth, which in turn increases the GDP, per capita income and national
income of the country.

10. Development of infrastructure

Government has placed emphasis on the infrastructure development for the

purpose of achieving economic growth. The fiscal policy measure such as
taxation generates revenue to the government. A part of the government's
revenue is invested in the infrastructure development. Due to this, all sectors
of the economy get a boost.
27
11. Foreign exchange earnings

Fiscal policy attempts to encourage more exports by way of Fiscal Measures

like, exemption of income tax on export earnings, exemption of sales tax and
octroi, etc. Foreign exchange provides fiscal benefits to import substitute
industries. The foreign exchange earned by way of exports and saved by way of
import substitutes helps to solve balance of payments problem.

1.2.5 Balance of payments

Balance of payments (BoP) accounts are an accounting record of all monetary

transactions between a country and the rest of the world. These transactions
include payments for the country's exports and imports of goods, services,
financial capital and financial transfers. The BoP accounts summarize
international transactions for a specific period, usually a year, and are
prepared in a single currency, typically the domestic currency for the country
concerned. Sources of funds for a nation, such as exports or the receipts of
loans and investments, are recorded as positive or surplus items. Uses of
funds, such as for imports or to invest in foreign countries, are recorded as
negative or deficit items.

When all components of the BOP accounts are included they must sum to zero
with no overall surplus or deficit. For example, if a country is importing more
than it exports, its trade balance will be in deficit, but the shortfall will have to
be counter-balanced in other ways – such as by funds earned from its foreign
investments, by running down central bank reserves or by receiving loans from
other countries.

While the overall BOP accounts will always balance when all types of payments
are included, imbalances are possible on individual elements of the BOP, such
as the current account, the capital account excluding the central bank's
reserve account, or the sum of the two. Imbalances in the latter sum can result
in surplus countries accumulating wealth, while deficit nations become
increasingly indebted. The term "balance of payments" often refers to this sum:
a country's balance of payments is said to be in surplus (equivalently, the
balance of payments is positive) by a certain amount if sources of funds (such
as export goods sold and bonds sold) exceed uses of funds (such as paying for
imported goods and paying for foreign bonds purchased) by that amount. There
is said to be a balance of payments deficit (the balance of payments is said to
be negative) if the former are less than the latter.

28
The two principal parts of the BOP accounts are the current account and
the capital account the current account shows the net amount a country is
earning if it is in surplus, or spending if it is in deficit. It is the sum of
the balance of trade (net earnings on exports minus payments for
imports), factor income (earnings on foreign investments minus payments
made to foreign investors) and cash transfers. It is called the current account
as it covers transactions in the "here and now" - those that don't give rise to
future claims.

The capital account records the net change in ownership of foreign assets. It
includes the reserve account (the foreign exchange market operations of a
nation's central bank), along with loans and investments between the country
and the rest of world (but not the future regular repayments/dividends that the
loans and investments yield; those are earnings and will be recorded in the
current account). The term "capital account" is also used in the narrower sense
that excludes central bank foreign exchange market operations: Sometimes the
reserve account is classified as "below the line" and so not reported as part of
the capital account. Expressed with the broader meaning for the capital
account, the BOP identity assumes that any current account surplus will be
balanced by a capital account deficit of equal size - or alternatively a current
account deficit will be balanced by a corresponding capital account surplus.

Current a/c + broadly defined capital a/c + balancing figure =0

The balancing item, which may be positive or negative, is simply an amount

that accounts for any statistical errors and ensures that the current and
capital accounts sum to zero. By the principles of double entry accounting, an
entry in the current account gives rise to an entry in the capital account, and
in aggregate the two accounts automatically balance. A balance isn't always
reflected in reported figures for the current and capital accounts, which might,
for example, report a surplus for both accounts, but when this happens it
always means something has been missed—most commonly, the operations of
the country's central bank—and what has been missed is recorded in the
statistical discrepancy term (the balancing item).

1.2.5.1 Variations in the use of term "Balance of Payments"

Economics writer J Orlin Grabbe warns the term balance of payments can be a
source of misunderstanding due to divergent expectations about what the term
denotes. Grabbe says the term is sometimes misused by people who aren't

29
aware of the accepted meaning, not only in general conversation but in
financial publications and the economic literature.

A common source of confusion arises from whether or not the reserve

account entry, part of the capital account, is included in the BOP accounts.
The reserve account records the activity of the nation's central bank. If it is
excluded, the BOP can be in surplus (which implies the central bank is
building up foreign exchange reserves) or in deficit (which implies the central
bank is running down its reserves or borrowing from abroad).

The term "balance of payments" is sometimes misused by non-economists to

mean just relatively narrow parts of the BOP such as the trade deficit which
means excluding parts of the current account and the entire capital account.

Another cause of confusion is the different naming conventions in use. Before

1973 there was no standard way to break down the BOP sheet, with the
separation into invisible and visible payments sometimes being the principal
divisions. The IMF has their own standards for BOP accounting which is
equivalent to the standard definition but uses different nomenclature, in
particular with respect to the meaning given to the term capital account.

1.2.5.2 The IMF definition

The International Monetary Fund (IMF) use a particular set of definitions for
the BOP accounts, which is also used by the Organisation for Economic
Cooperation and Development (OECD), and the United Nations System of
National accounts (SNA).

The main difference in the IMF's terminology is that it uses the term "financial
account" to capture transactions that would under alternative definitions be
recorded in the capital account. The IMF uses the term capital account to
designate a subset of transactions that, according to other usage, form a small
part of the overall capital account. The IMF separates these transactions out to
form an additional top level division of the BOP accounts. Expressed with the
IMF definition, the BOP identity can be written:

Current a/c + financial a/c + capital a/c + balancing figure = 0

The IMF uses the term current account with the same meaning as that used by
other organizations, although it has its own names for its three leading sub-
divisions, which are:

30
The goods and services account (the overall trade balance)

The primary income account (factor income such as from loans and
investments)

The secondary income account (transfer payments)

1.2.5.3 Imbalances

While the BOP has to balance overall, surpluses or deficits on its individual
elements can lead to imbalances between countries. In general there is concern
over deficits in the current account. Countries with deficits in their current
accounts will build up increasing debt and/or see increased foreign ownership
of their assets. The types of deficits that typically raise concern are:

 A visible trade deficit where a nation is importing more physical goods

than it exports (even if this is balanced by the other components of the
current account.)
 An overall current account deficit.
 A basic deficit which is the current account plus foreign direct
investment (but excluding other elements of the capital account like
short terms loans and the reserve account.)
There are conflicting views as to the primary cause of BOP imbalances, with
much attention on the US which currently has by far the biggest deficit. The
conventional view is that current account factors are the primary cause - these
include the exchange rate, the government's fiscal deficit, business
competitiveness, and private behaviour such as the willingness of consumers
to go into debt to finance extra consumption. An alternative view, argued at
length in a 2005 paper by Ben Bernanke, is that the primary driver is the
capital account, where a global savings glut caused by savers in surplus
countries, runs ahead of the available investment opportunities, and is pushed
into the US resulting in excess consumption and asset price inflation.

1.2.5.4 Balance of payments crisis

A BOP crisis, also called a currency crisis, occurs when a nation is unable to
pay for essential imports and/or service its debt repayments. Typically, this is
accompanied by a rapid decline in the value of the affected nation's currency.
Crises are generally preceded by large capital inflows, which are associated at
first with rapid economic growth. However a point is reached where overseas

31
investors become concerned about the level of debt their inbound capital is
generating, and decide to pull out their funds. The resulting outbound capital
flows are associated with a rapid drop in the value of the affected nation's
currency. This causes issues for firms of the affected nation who have received
the inbound investments and loans, as the revenue of those firms is typically
mostly derived domestically but their debts are often denominated in a reserve
currency. Once the nation's government has exhausted its foreign reserves
trying to support the value of the domestic currency, its policy options are very
limited. It can raise its interest rates to try to prevent further declines in the
value of its currency, but while this can help those with debts in denominated
in foreign currencies, it generally further depresses the local economy.

1.2.5.5 Balancing mechanisms

One of the three fundamental functions of an international monetary system is

to provide mechanisms to correct imbalances. Broadly speaking, there are
three possible methods to correct BOP imbalances, though in practice a
mixture including some degree of at least the first two methods tends to be
used. These methods are adjustments of exchange rates; adjustment of a
nations internal prices along with its levels of demand; and rules based
adjustment Improving productivity and hence competitiveness can also help, as
can increasing the desirability of exports through other means, though it is
generally assumed a nation is always trying to develop and sell its products to
the best of its abilities.

1.2.5.6 Rebalancing by changing the exchange rate

An upwards shift in the value of a nation's currency relative to others will make
a nation's exports less competitive and make imports cheaper and so will tend
to correct a current account surplus. It also tends to make investment flows
into the capital account less attractive so will help with a surplus there too.
Conversely a downward shift in the value of a nation's currency makes it more
expensive for its citizens to buy imports and increases the competitiveness of
their exports, thus helping to correct a deficit. Exchange rates can be adjusted
by government in a rules based or managed currency regime, and when left
to float freely in the market they also tend to change in the direction that will
restore balance. When a country is selling more than it imports, the demand
for its currency will tend to increase as other countries ultimately need the
selling country's currency to make payments for the exports. The extra demand
tends to cause a rise of the currency's price relative to others. When a country

32
is importing more than it exports, the supply of its own currency on the
international market tends to increase as it tries to exchange it for foreign
currency to pay for its imports, and this extra supply tends to cause the price
to fall. BOP effects are not the only market influence on exchange rates
however, they are also influenced by differences in national interest rates and
by speculation.

1.2.5.7 Rebalancing by adjusting internal prices and demand

When exchange rates are fixed by a rigid gold standard or when imbalances
exist between members of a currency union such as the Euro zone, the
standard approach to correct imbalances is by making changes to the domestic
economy. To a large degree, the change is optional for the surplus country, but
compulsory for the deficit country. In the case of a gold standard, the
mechanism is largely automatic. When a country has a favourable trade
balance, as a consequence of selling more than it buys it will experience a net
inflow of gold. The natural effect of this will be to increase the money supply,
which leads to inflation and an increase in prices, which then tends to make its
goods less competitive and so will decrease its trade surplus.

However, the nation has the option of taking the gold out of economy
(sterilising the inflationary effect) thus building up a hoard of gold and
retaining its favourable balance of payments. On the other hand, if a country
has an adverse BOP it will experience a net loss of gold, which will
automatically have a deflationary effect, unless it chooses to leave the gold
standard. Prices will be reduced, making its exports more competitive, and
thus correcting the imbalance.

1.2.6 What is foreign exchange?

Foreign exchange, or Forex is the conversion of one country's currency into

that of another. In a free economy, a country's currency is valued according to
factors of supply and demand. In other words, a currency's value can
be pegged to another country's currency, such as the U.S. dollar, or even to a
basket of currencies. A country's currency value also may be fixed by the
country's government. However, most countries float their currencies freely
against those of other countries, which keep them in constant fluctuation.

The value of any particular currency is determined by market forces based on

trade, investment, tourism, and geo-political risk. Every time a tourist visits a
country, for example, he or she must pay for goods and services using the
33
currency of the host country. Therefore, a tourist must exchange the currency
of his or her home country for the local currency. Currency exchange of this
kind is one of the demand factors for a particular currency. Another important
factor of demand occurs when a foreign company seeks to do business with a
company in a specific country. Usually, the foreign company will have to pay
the local company in their local currency. At other times, it may be desirable
for an investor from one country to invest in another, and that investment
would have to be made in the local currency as well. All of these requirements
produce a need for foreign exchange and are the reasons why foreign exchange
markets are so large.

To buy foreign goods or services, or to invest in other countries, companies and

individuals may need to first buy the currency of the country with which they
are doing business. Generally, exporters prefer to be paid in their country’s
currency or in U.S. dollars, which are accepted all over the world.

When Canadians buy oil from Saudi Arabia they may pay in U.S. dollars and
not in Canadian dollars or Saudi riyals, even though the United States is not
involved in the transaction.

The foreign exchange market, or the "FX" market, is where the buying and
selling of different currencies takes place. The price of one currency in terms of
another is called an exchange rate.

The market itself is actually a worldwide network of traders, connected by

telephone lines and computer screens—there is no central headquarters. There
are three main centers of trading, which handle the majority of all FX
transactions—United Kingdom, United States, and Japan.

1.2.6.1 Foreign exchange market participants

There are four types of market participants—banks, brokers, customers, and

central banks.

Banks and other financial institutions are the biggest participants. They earn
profits by buying and selling currencies from and to each other. Roughly two-
thirds of all FX transactions involve banks dealing directly with each other.

Brokers act as intermediaries between banks. Dealers call them to find out
where they can get the best price for currencies. Such arrangements are
beneficial since they afford anonymity to the buyer/seller. Brokers earn profit
by charging a commission on the transactions they arrange.
34
Customers, mainly large companies, require foreign currency in the course of
doing business or making investments. Some even have their own trading
desks if their requirements are large. Other types of customers are individuals
who buy foreign exchange to travel abroad or make purchases in foreign
countries.

Central banks, which act on behalf of their governments, sometimes participate

in the FX market to influence the value of their currencies.

1.2.6.2 Types of transactions

There are different types of FX transactions:

 Spot transactions: This type of transaction accounts for almost a third

of all FX market transactions. Two parties agree on an exchange rate and
trade currencies at that rate.

Spot Transaction: How it works

 A trader calls another trader and asks for a price of a currency, say
British pounds.
This expresses only a potential interest in a deal, without the caller
saying whether he/she wants to buy or sell.
 The second trader provides the first trader with prices for both
buying and selling (two-way price).
 When the traders agree to do business, one will send pounds and
the other will send dollars.
By convention the payment is actually made two days later.

Although spot transactions are popular, they leave the currency buyer exposed
to some potentially dangerous financial risks. Exchange rate fluctuations can
effectively raise or lower prices and can be a financial planning ordeal for
companies and individuals.

35
 Exchange Risks in Spot Transactions
Suppose a U.S. company orders machine tools from a company in Japan.
 Tools will be ready in six months and will cost 120 million yen.
 At the time of the order, the yen is trading at 120 to a dollar.
 U.S. company budgets $1 million in Japanese yen to be paid when
it receives the tools (120,000,00 yen / 120 yen per dollar =
$1,000,000)
There is no guarantee that the rate will remain the same six months later.
Suppose the rate drops to 100 yen per dollar:
 Cost in U.S. dollars would increase (120,000,000 / 100 =
$1,200,000) by $200,000.
Conversely, if the rate goes up to 140 yen to a dollar:
 Cost in U.S. dollars would decrease (120,000,000 / 140 =
$857,142.86) by over $142,000

One alternative for a company is to pay for the foreign good right away to avoid
the exchange rate risk. But no one wants to part with money any sooner than
necessary—if the company does pay the money in advance, it loses six months’
interest and risks losing out on a favorable change in exchange rates.

 Forward transaction: One way to deal with the FX risk is to engage in a

forward transaction. In this transaction, money does not actually change
hands until some agreed upon future date. A buyer and seller agree on
an exchange rate for any date in the future and the transaction occurs
on that date, regardless of what the market rates are then. The date can
be a few days, months or years in the future.
Futures: Foreign currency futures are forward transactions with standard
contract sizes and maturity dates — for example, 500,000 British pounds for
next November at an agreed rate. These contracts are traded on a separate
exchange set up for that purpose.
Swap: The most common type of forward transaction is the currency swap. In a
swap, two parties exchange currencies for a certain length of time and agree to
reverse the transaction at a later date.
In all of these transactions, market rates might change. However, the buyer
and seller are locked into a contract at a fixed price that cannot be affected by
any changes in the market rates. These tools allow the market participants to

36
plan more safely, since they know in advance what their FX will cost. It also
allows them to avoid an immediate outlay of cash.
Swap Transaction: How it works

Suppose a U.S. company needs 15 million Japanese yen for a three-

month investment in Japan.

It may agree to a rate of 150 yen to a dollar and swap $100,000 with a
company willing to swap 15 million yen for three months

After three months, the U.S. company returns the 15 million yen to the
other company and gets back $100,000, with adjustments made for
interest rate differentials

 Options: To address the lack of flexibility in forward transactions, the

foreign currency option was developed. An option is similar to a forward
transaction. It gives its option buyer the right to buy or sell a specified
amount of foreign currency at a specified price at any time up to a
specified expiration date, but not the obligation to buy or sell the
currency.

For a price, a market participant can buy the right, but not the obligation, to
buy or sell a currency at a fixed price on or before an agreed upon future date.
The agreed upon price is called the strike price.

Depending on which—the option rate or the current market rate—is more

favorable, the owner may exercise the option or let the option lapse, choosing
instead to buy/sell currency in the market. This type of transaction allows the
owner more flexibility than a swap or futures contract.

1.2.7 Let us sum up

Monetary policy is the process by which the monetary authority of a country

controls the supply of money often targeting a rate of interest for the purpose of
promoting economic growth and stability. The official goals usually include
relatively stable prices and low unemployment. Instruments of the Monetary
Policy include Liquidity Management; Interest rate Management; Forex
Management.

In economics and political science, fiscal policy is the use of government

revenue collection (taxation) and expenditure (spending) to influence the

37
economy. The two main instruments of fiscal policy are government taxation
and expenditure.

Main objectives of fiscal policy in India

 Development by effective Mobilisation of Resources; Efficient allocation

of Financial Resources; Reduction in inequalities of Income and Wealth;
Price Stability and Control of Inflation; Employment Generation;
Balanced Regional Development; Reducing the Deficit in the Balance of
Payment; Capital Formation; Increasing National Income; Development of
Infrastructure; Foreign Exchange Earnings;

Balance of payments (BoP) accounts are an accounting record of all monetary

transactions between a country and the rest of the world economy, these
transactions include payments for the country's exports and imports of goods,
services, financial capital and financial transfers.

Foreign exchange, or Forex is the conversion of one country's currency into

that of another. In a free economy, a country's currency is valued according to
factors of supply and demand.

1.2.8 Key words

Monetary policy; supply of money; stable prices; unemployment;fiscal

policy; government taxation;Capital Formation; Balance of Payment; National
Income; Foreign Exchange;

1.2.9 Check your progress

1. Expansionary monetary policy :

a. tends to lead to an appreciation of a b. usually has no effect on a currency's

nation's currency exchange value
c. tends to lead to a depreciation of the d. tends to lead to a depreciation of a
currencies of other nations nation's currency

2. Item that normally used by government and private entity as a long term
financing is:

a. Bond b. Common stock

c. Preferred stock d. Retained earnings

38
 3. When economists refer to "tight" monetary policy, they mean that the
Reserve Bank is taking actions that will

a. Increase the demand for money b. Decrease the demand for money
c. Expand the supply of money d. Contract the supply of money

4. To lower interest rates, the Reserve Bank could

a. Buy securities b. Decrease the chartered banks' reserves.

c. Decrease the money supply d. Raise the treasury bill rate.

5. Suppose an Indian firm imports Rs. 1,000 worth of bananas and sells
them for Rs. 2,000. The effect on GDP would be

a. To decrease the value of GDP by Rs. b. To increase the value of GDP by Rs.
3,000 3,000.
c. To increase the value of GDP by Rs. d. To increase the value of GDP by Rs.
2,000 1,000

6. Money market is defined as.

a. The financial market for securities with b. The financial market for stocks and
maturities of less than one year long-term debt (one year or longer)
c. The market in which corporations raise d. The market in which existing, already
new capital by issuing new securities outstanding and securities are traded
among investors

Key to check your progress

1. d 2.a 3.d
4.a 5.d 6.a

1.2.10 Terminal questions

1) Explain the 4 measures of money supply.

2) What are the instruments of money supply?
3) Define fiscal policy. What are the main objectives of fiscal policy?
4) Define balance of payments. Explain difference between current account
and capital account.
5) What are the determinants of foreign exchange rates?

39
1.3 Lesson No. 3 Interest Rates

1.3.1 Objectives

1.3.2 Introduction

1.3.3 Base Rate Vs Bank’s Prime lending rate

1.3.4 Marginal Cost of Fund based Lending Rate

1.3.5 Let us sum up

1.3.6 Key words

1.3.7 Check your progress

1.3.8 Terminal questions

40
1.3.1 Objectives

The objectives of this lesson are to understand:

 Yield Curve
 Interest rate theories
 Base rate
 BPLR
 MCLR
1.3.2 Introduction

An interest rate is the rate at which interest is paid by borrowers for the use of
money that they borrow from a lender. Specifically, the interest rate (I/m) is a
percent of principal (I) paid at some rate (m).

For example, a small company borrows funds from a bank to buy new assets
for their business, and in return the lender receives interest at a predetermined
interest rate for deferring the use of funds and instead lending it to the
borrower. Interest rates are normally expressed as a percentage of the principal
for a period of one year.

Interest rates targets are also a vital tool of monetary policy and are taken into
account when dealing with variables like investment, inflation
and unemployment.

Yield Curve

Yield Curve is a line that plots the interest rates, at a set point in time, of
bonds having equal credit quality, but differing maturity dates is called yield
curve. The most frequently reported yield curve compares the three-
month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is
used as a benchmark for other debt instruments in the market, such as
mortgage rates or bank lending rates. The curve is also used to predict changes
in economic output and growth.

41
Normal yield curve

Inverted yield curve

42
Humped yield curve

The shape of the yield curve is closely scrutinized because it helps to give an
idea of future interest rate change and economic activity. There are three main
types of yield curve shapes: normal, inverted and flat (or humped). A normal
yield curve (pictured here) is one in which longer maturity bonds have a higher
yield compared to shorter-term bonds due to the risks associated with time. An
inverted yield curve is one in which the shorter-term yields are higher than the
longer-term yields, which can be a sign of upcoming recession. A flat (or
humped) yield curve is one in which the shorter- and longer-term yields are
very close to each other, which is also a predictor of an economic transition.
The slope of the yield curve is also seen as important: the greater the slope, the
greater the gap between short- and long-term rates.

Theories of interest rates

There are three main economic theories attempting to explain how yields vary
with maturity. Two of the theories are extreme positions, while the third
attempts to find a middle ground between the former two.

Market expectations (pure expectations) hypothesis

43
This hypothesis assumes that the various maturities are perfect substitutes
and suggests that the shape of the yield curve depends on market participants'
expectations of future interest rates. These expected rates, along with an
assumption that arbitrage opportunities will be minimal, is enough information
to construct a complete yield curve. For example, if investors have an
expectation of what 1-year interest rates (ist) will be next year, the 2-year
interest rate can be calculated as the compounding of this year's interest rate
by next year's interest rate. More generally, rates on a long-term instrument (ilt)
are equal to the geometric mean of the yield on a series of short-term
instruments. This theory perfectly explains the observation that yields usually
move together. However, it fails to explain the persistence in the shape of the
yield curve.

Shortcomings of expectations theory: Neglects the risks inherent in investing in

bonds (because forward rates are not perfect predictors of future rates). 1)
Interest rate risk 2) Reinvestment rate risk

Liquidity preference theory

The Liquidity Preference Theory, also known as the Liquidity Premium Theory,
is an offshoot of the Pure Expectations Theory. The Liquidity Preference Theory
asserts that long-term interest rates not only reflect investors’ assumptions
about future interest rates but also include a premium for holding long-term
bonds (investors prefer short term bonds to long term bonds), called the term
premium or the liquidity premium. This premium compensates investors for
the added risk of having their money tied up for a longer period, including the
greater price uncertainty. Because of the term premium, long-term bond yields
tend to be higher than short-term yields, and the yield curve slopes upward.
Long term yields are also higher not just because of the liquidity premium, but
also because of the risk premium added by the risk of default from holding a
security over the long term. The market expectations hypothesis is combined
with the liquidity preference theory:

Where, rpn is the risk premium associated with a ‘n’ year bond.

Liquidity preference refers to the demand for money, considered as liquidity.

The concept was first developed by John Maynard Keynes (1936) to explain
determination of the interest rate by the supply and demand for money.
The demand for money as an asset was theorized to depend on the interest
44
foregone by not holding bonds. Interest rates, he argues, cannot be a reward
for saving as such because, if a person hoards his/her savings in cash, keeping
it under his/her mattress say, he/she will receive no interest, although he/she
has nevertheless refrained from consuming all his / her current income.
Instead of a reward for saving, interest in the Keynesian analysis is a reward
for parting with liquidity.

According to Keynes, demand for liquidity is determined by three motives:

Transactions motive: people prefer to have liquidity to assure basic

transactions, for their income is not constantly available. The amount of
liquidity demanded is determined by the level of income: the higher the income,
the more money demanded for carrying out increased spending.

Precautionary motive: people prefer to have liquidity in the case of social

unexpected problems that need unusual costs. The amount of money
demanded for this purpose increases as income increases.

Speculative motive: people retain liquidity to speculate that bond prices will
fall. When the interest rate decreases people demand more money to hold until
the interest rate increases, which would drive down the price of an existing
bond to keep its yield in line with the interest rate. Thus, the lower the interest
rate, the more money demanded (and vice versa).

The liquidity-preference relation can be represented graphically as a schedule

of the money demanded at each different interest rate. The supply of money
together with the liquidity-preference curve in theory interact to determine the
interest rate at which the quantity of money demanded equals the quantity of
money supplied.

Criticisms

Murray Rothbard rejected Keynes' theory of liquidity preference. In his

book America’s Great Depression Rothbard argued that interest rates are
instead determined by time preference. Says Rothbard, "Increased hoarding
can either come from funds formerly consumed, from funds formerly invested,
or from a mixture of both that leaves the old consumption-investment
proportion unchanged. Unless time preferences change, the last alternative will
be the one adopted. Thus, the rate of interest depends solely on time
preference, and not at all on "liquidity preference." In fact, if the increased
hoards come mainly out of consumption, an increased demand for money will
cause interest rates to fall—because time preferences have fallen”
45
Market Segmentation Theory

This theory is also called the segmented market hypothesis. In this theory,
financial instruments of different terms are not substitutable. As a result, the
supply and demand in the markets for short-term and long-term instruments
is determined largely independently. Prospective investors decide in advance
whether they need short-term or long-term instruments. If investors prefer
their portfolio to be liquid, they will prefer short-term instruments to long-term
instruments. Therefore, the market for short-term instruments will receive a
higher demand. Higher demand for the instrument implies higher prices and
lower yield. This explains the stylized fact that short-term yields are usually
lower than long-term yields. This theory explains the predominance of the
normal yield curve shape. However, because the supply and demand of the two
markets are independent, this theory fails to explain the observed fact that
yields tend to move together (i.e., upward and downward shifts in the curve).

In an empirical study, 2000 Alexandra E. MacKay, Eliezer Z. Prisman, and

Yisong S. Tian found segmentation in the market for Canadian government
bonds, and attributed it to differential taxation.

For a brief period in the last week of 2005, and again in early 2006, the US
Dollar yield curve inverted, with short-term yields actually exceeding long-term
yields. Market segmentation theory would attribute this to an investor
preference for longer term securities, particularly from pension funds and
foreign investors who prefer guaranteed longer term yields.

Irving Fisher's theory of interest rates

Irving Fisher's theory of interest rates relates the nominal interest rate i to the
rate of inflation π and the "real" interest rate r. The real interest rate r is the
interest rate after adjustment for inflation. It is the interest rate that lenders
have to have to be willing to loan out their funds. The relation Fisher
postulated between these three rates is:

(1+i) = (1+r) (1+π) = 1 + r + π + r π

This is equivalent to:

i = r + π (1 + r)

Thus, according to this equation, if π increases by 1 percent the nominal

interest rate increases by more than 1 percent.

46
This means that if r and π are known then i can be determined. On the other
hand, if i and π are known then r can be determined and the relationship is:

1+r = (1+i)/ (1+π)

or

r = (i - π)/ (1+π)

When π is small then r is approximately equal to i-π, but in situation involving

a high rate of inflation the more accurate relationship must be taken into
account.

The next step in the analysis is to take into account the effect of taxes on the
real rate of return. Let iC be the nominal risk-free interest rate in the country
with currency C and rC and πC be the corresponding real interest rate and
expected rate of inflation, respectively. Let tC be the corresponding tax rate on
interest income and r*C be the after-tax real rate of return. The rate of return
after-taxes is iC(1-tC). Then

r*C = [iC(1-tC)- πC] /(1+πC).

If we know r*C,tC and πC and want to determine iC the formula is:

iC = [r*C(1+πC)+ πC]/ (1-tC)

= r*C/(1-tC)

+ (1 + r*C)πC/(1-tC).

This means that when the rate of inflation increases, the nominal interest rate
increases by some multiple of the increase in the rate of inflation; i.e.,

∂iC/∂πC = (1+r*C)/(1-tC).

The preceding analysis presumes that the level of risk is the same in all
countries. If countries differ in risk, lenders and investors will need a risk
premium, an increment in the interest rate, to compensate them for accepting
higher levels of risk. Let sC be the risk premium required for country C. If the
international capital market is in equilibrium the real, after-tax rates of return
in the different countries must be equal. Then rC-sC=r* for all countries and
hence

47
(iC(1-tC)- πC)/ (1+πC) = r* + sC.

Thus,

iC = [(r*+sC)(1+πC) +πC)]/(1-tC)

Suppose tC = 0.4 so 1-tC=0.6 and r* + sC = 0.05. Then

iC = [0.05(1+πC) + πC]/0.6 = 0.0833 + 1.75πC)

So that, each 1 percent increase in the expected rate of inflation, gets

translated in to a 1.75 percent increase in the nominal interest rate.

1.3.3 Base Rate Vs BPLR

What is BPLR?

In banking parlance, the BPLR means the Benchmark Prime Lending Rate.
BPLR is the interest rate that commercial banks normally charge (or we can
say they are expected to charge) their most credit-worthy customers.

BPLR is the reference rate for banks for pricing their loan products. It is
calculated taking into account the cost of funds, operational expenses, and the
minimum margin to cover regulatory requirements of provisioning and capital
and profit margin. Banks are supposed to lend to their prime customers at
BPLR and increase the rate with risk premium in case of sub-prime customers
and tenor premium wherever applicable.

Problems with BPLR

Main problem with BPLR is that banks have resorted to sub-BPLR lending.
Secondly, BPLR failed to respond to the changes in the monetary policy.
Changes in monetary policy rates by RBI were not truly reflected in the BPLR.
This was true during both the tightening phase as well as easing phase. This
defeated the purpose of changes in these rates to some extent.

What is Base Rate?

The Base Rate is the minimum interest rate below which a bank cannot lend ,
except for DRI loans, loans to Employees, and against own Fixed Deposits. It is
the new benchmark for loan pricing. The elements include statutory liquidity
ratio, cash reserve ratio maintenance, cost of deposit, other operational cost,
and necessary profit margin. The actual rate would be base rate plus borrower

48
specific charges, which will include profit specific operating costs, credit risk
premium and tenure premium.

Expected impact of Base rate

It is expected that base rate system will increase transparency in credit pricing
and address the shortcomings of the BPLR system. Benchmark rate of most of
the banks will decline to single digit. Again with the base rate, including
negative carry on Cash Reserve Ratio (CRR) and Statutory Liquidity ratio (SLR)
it is anticipated that base rate will be directly impacted by the monetary
measures initiated by the RBI. Small borrowers such as farmers who are close
to BPLR rates would get credit at reasonable rates after the introduction of
base rate. At the same time, large corporations that earlier utilised their
negotiating power and bargained with banks in order to obtain loans at sub-
BPLR rates, could find it difficult due to the minimum rate fixed by banks.

What this means for banks?

Large banks that have higher percentage of low cost deposits and better
operating efficiency will have a lower base rate and thus they will be able to
price their loan products competitively. Small banks on the other hand will face
problems in extending credit to large corporate. This would render a number of
banks uncompetitive and enable big banks to increase their business.

What is the difference between BPLR and Base rate?

The Reserve bank of India committee on reviewing the BPLR recommended that
it be scrapped and a new bench mark rate that is more transparent be
introduced. Base rate is to be reviewed on at least quarterly basis by banks and
publicly disclosed. The calculations of BPLR were mostly not transparent and
banks would frequently lend at lower rates to prime borrowers.

1.3.4 Marginal Cost of fund based Lending Rate (MCLR):

MCLR replaced Base Rate system to determine the rate of interest of all
commercial banks in India with effect from 01.04.2016.However, the MCLR is
yet to be adopted by the Cooperative Banks. The MCLR take into account the
marginal cost of deposit of similar maturities of advance instead of earlier
average cost of deposit in determining the rate of interest and consequently this
rate is tenor linked cost of deposit.

49
MCLR is also linked to Repo rate. Hence it improves the transmission of RBI’s
repo rate cut to the end borrower. It is to be revised/reviewed every month.
Banks publish MCLR for at least five durations which are (1) overnight MCLR
(2)1 month MCLR (3) 3 months MCLR (4) 6 months MCLR (5) 1 year MCLR.

How to calculate MCLR

MCLR calculation is linked to the tenor or the amount of time a borrower has
to repay the loan. This tenor-linked benchmark is internal in nature. They
determine the actual lending rates by adding the elements spread to this tool.
The banks, then, publish their MCLR after careful review. The same process
applies for loans of different maturities – monthly or as per a pre-announced
cycle.
The four main elements of MCLR are made up of the following:
a. Tenor premium
There is uniformity in the tenor period for all sorts of loans for the said residual
tenor. This means that the tenor premium is not specific to a loan class or a
borrower.
b. Marginal cost of funds
The Marginal Cost of Borrowing is the average rate using which the deposits
with similar maturities were raised during a specific time period before the
review date. It will reflect in the bank’s books by their outstanding balance.
Marginal Cost of Borrowing has several components like the Return on Net
Worth and the Marginal Cost of Borrowings. Marginal Cost of Borrowings takes
up 92% while the Return on Net Worth accounts for 8%. This 8% is equivalent
to the risk of weighted assets as denoted by the Tier I capital for banks.
c. Operating Cost
Operational expenses include cost of raising the funds, barring the costs
recovered separately by means of service charges. It is, therefore, connected to
providing the loan product as such.
d. Negative carry on account of CRR
Negative carry on the CRR (Cash Reserve Ratio) takes place when the return on
the CRR balance is zero. Hence, when the actual return is less than the cost of
the funds, there arises the negative carry. This will impact the
mandatory Statutory Liquidity Ratio Balance (SLR) – reserve every commercial
bank must maintain.
50
1.3.5 Let us sum up

An interest rate is the rate at which interest is paid by a borrower for the use of
money that they borrow from a lender.

Yield Curve: A line that plots the interest rates, at a set point in time, of
bonds having equal credit quality, but differing maturity dates.

There are three main economic theories attempting to explain how yields vary
with maturity

 Market expectations (pure expectations) hypothesis

 Liquidity preference theory
 Market segmentation theory
Irving Fisher's theory of interest rates relates the nominal interest rate i to the
rate of inflation π and the "real" interest rate r. The real interest rate r is the
interest rate after adjustment for inflation.

In banking parlance, the BPLR means the Benchmark Prime Lending Rate.
BPLR is the interest rate that commercial banks normally charge (or we can
say they are expected to charge) their most credit-worthy customers.

The Base Rate is the minimum interest rate of a Bank below which it cannot
lend, except for DRI advances, loans to bank's own employees and loan to
banks' depositors against their own deposits

1.3.6 Key words/concepts

Interest Rate; Yield Curve; Market expectations (pure expectations) hypothesis;

Liquidity preference theory; Market segmentation theory; Irving Fisher's theory
of interest rates; BPLR; Base Rate .

1.3.7 Check your progress-questions

1) A normal yield curve is one in which

a. longer maturity bonds have a higher b. the shorter-term yields are higher than
yield compared to shorter-term bonds due the longer-term yields,
to the risks associated with time
c. the shorter- and longer-term yields are d. none of the above
very close to each other,

51
 2) The slope of the yield curve seems to predict the performance of the
economy with: (Select correct option)

a. Usually 3 months lag b. Usually two years lag

c. Usually within few weeks d. Usually one year lag

3) In liquidity preference theory the demand for liquidity is determined by 3

motives. One of the following is not ( identify it)

a. speculative b. precautionary
c. winning d. transactions

4) If inflation exists then real rate of return will be

a. lower than nominal rate of interest b. higher than nominal rate of interest
c. same as nominal rate of interest d. no connection between the two.

5) Minimum interest rate of a Bank below which it cannot lend

a. base rate b. benchmark prime lending rate

c. real rate d. nominal rate

6) If real value is greater than nominal value it could be because of

a. Inflation b. Deflation
c. Stagflation d. Inflexion

7) This hypothesis assumes that the various maturities are perfect

substitutes

a. Market expectations (pure expectations) b. Liquidity preference theory

hypothesis
c. Market segmentation theory d. Inflation theory

Key to questions asked

1. a b. d 3. c
4. a 5. a 6. b
7. a

52
1.3.8 Terminal questions

 Define interest rate. What is its connection with Yield curve? Explain the
3 main types of yield curve shapes.

 Explain the three main economic theories attempting to explain how

yields vary with maturity.

 Explain the relationship between nominal rates, inflation and real rates

 What is the difference between BPLR and base rate?

53
1.4 Lesson No. 4 Demand Analysis

1.4.1 Objectives
1.4.2 Introduction of Demand
1.4.2.1 Types of demand
1.4.2.2 What are factors that influence demand?
1.4.2.3 Law of demand
1.4.3 Law of supply
1.4.4 Shifts Vs Movements
1.4.5 Elasticity
1.4.5.1 Factors affecting demand elasticity
1.4.5.2 Income elasticity of demand
1.4.6 Demand forecasting
1.4.6.1 What is a demand forecast?
1.4.6.2 How is demand forecast determined?
1.4.6.3 Quantitative forecasting methods
1.4.6.4 Demand forecasting Vs sales forecasting
1.4.7 Let us sum up
1.4.8 Key words/concepts
1.4.9 Check your progress-questions
Key to questions asked
1.4.10 Terminal questions
1.4.11 Reference books for further reading/bibliography

54
1.4.1 Objectives

The objectives of this lesson are to understand

 The Law of Demand

 The Law of Supply
 Elasticity
 Demand Forecasting
1.4.2 Introduction (Demand)

Demand refers to how much (quantity) of a product or service is desired by

buyers. The quantity demanded is the amount of a product people are willing
to buy at a certain price; the relationship between price and quantity
demanded is known as the demand relationship

1.4.2.1 Types of demand

The different types of demands have been explained below as follows:

Individual demand:

It is the quantity of a commodity demanded by an individual consumer at a

particular price during a given period of time.

Market demand:

It is the total quantity of a commodity demanded by all the consumers in the

market during a given period of time.

Joint demand:

When two or more commodities are jointly needed to satisfy a single want, then
the demand for such goods are said to be joint demand.

Composite demand:

When a commodity is demanded for a number of uses, then the demand for
that commodity is said to composite in nature.

Competitive demand:

When two goods are close substitutes of one another, then the demand for
such goods is said to be competitive in nature.
55
Derived demand:

When demand for a commodity gives rise to demand for another commodity,
then it is said to be a derived demand.

Variation in demand:

It refers to extension or contraction in demand which is exclusively due to

change in the price of a product.

Changes in demand:

Change in demand refers to increase or decrease in demand which is due to

change factors other than price of the commodity.

Giffen goods:

A Giffen good is one which people paradoxically consume more of as the price
rises, violating the law of demand because the good is inferior, without
substitute, and its consumption is a major chunk of income.

Direct demand:

Goods which yield direct satisfaction to a customer can be termed as the direct
demand.

Induced demand, or latent demand:

The phenomenon that after supply increases, more of a good is consumed

Income demand:

Normal goods

In the case of normal goods, income and demand are directly related, meaning
that an increase in income will cause demand to rise and a decrease in income
causes demand to fall. For example, luxuries like cars and computers are
normal goods for most people.

Inferior goods

In the case of inferior goods income and demand are inversely related, which
means that an increase in income leads to a decrease in demand and a
decrease in income leads to an increase in demand. For example, necessities
like bread are often inferior goods. It should be noted that ‘normal’ and
56
‘inferior’ are purely relative concepts. Any good or service be an inferior one
under certain circumstances

Cross demand:

Demand for substitutes or competitive goods (e.g., tea & coffee, bread and rice)
Demand for complementary goods (e.g., pen & ink)

1.4.2.2 What are factors that influence demand?

 Number of consumers (naturally, more consumers means more

Demand(D))
 Income(Y) & normal goods (as Y increases, D for these goods increases)
 Income & inferior goods (as Y increases, D for these goods decreases)
 Preferences (obviously, if they prefer to buy it their D will increase)
 Price of a substitute (if the price of a substitute good increases, D for the
original good will increase)
1.4.2.3 The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the
price of a good, the less people will demand that good. In other words, the
higher the price, the lower the quantity demanded. The amount of a good that
buyers purchase at a higher price is less because as the price of a good goes
up, so does the opportunity cost of buying that good. As a result, people will
naturally avoid buying a product that will force them to forgo the consumption
of something else they value more. The chart below shows that the curve is a
downward slope.

57
Each point on the curve reflects a direct correlation between quantities
demanded (Q) and price (P). When the quantity demanded will be 1 and the
price will be 8, and so on. The demand relationship curve illustrates the
negative relationship between price and quantity demanded. The higher the
price of a good the lower the quantity demanded and the lower the price, the
more the good will be in demand.

1.4.3 The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will
be sold at a certain price. But unlike the law of demand, the supply
relationship shows an upward slope. This means that the higher the price, the
higher the quantity supplied. Producers supply more at a higher price because
selling a higher quantity at a higher price increases revenue.

58
Each point on the curve reflects a direct correlation between quantity supplied
(Q) and price (P).

When supply and demand are equal (i.e. when the supply function and
demand function intersect) the economy is said to be at equilibrium. At
this point, the allocation of goods is at its most efficient because the amount of
goods being supplied is exactly the same as the amount of goods being
demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the
current economic condition. At the given price, suppliers are selling all the
goods that they have produced and consumers are getting all the goods that
they are demanding.

Excess demand is created when price is set below the equilibrium price.
Because the price is so low, too many consumers want the good
while producers are not making enough of it.

59
In this situation, at price 2, the quantity of goods demanded by
consumers at this price is 9. Conversely, the quantity of goods that
producers are willing to produce at this price is 1. Thus, there are too few
goods being produced to satisfy the wants (demand) of the consumers.
However, as consumers have to compete with one other to buy the good at this
price, the demand will push the price up, making suppliers want to supply
more and bringing the price closer to its equilibrium at price 10.

Disequilibrium occurs at all points other than price equal to 10. If the price is
set too high, excess supply will be created within the economy and there will be
allocative inefficiency.

At price 18 the quantity of goods that the producers wish to supply is

indicated by 9. At the same price, however, the quantity that the
consumers want to consume is at 1, a quantity much less than 9. Hence,
too much is being produced and too little is being consumed. The suppliers are
trying to produce more goods, which they hope to sell to increase profits, but
those consuming the goods will find the product less attractive and purchase
less because the price is too high.

1.4.4 Shifts vs. Movement

For economics, the “movements” and “shifts” in relation to the supply and
demand curves represent very different market phenomena:

Movements: A movement refers to a change along a curve. On the demand

curve, a movement denotes a change in both price and quantity demanded
from one point to another on the curve. The movement implies that the
demand relationship remains consistent. Therefore, a movement along the
demand curve will occur when the price of the good changes and the quantity
60
demanded changes in accordance to the original demand relationship. In other
words, a movement occurs when a change in the quantity demanded is caused
only by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply curve
means that the supply relationship remains consistent. Therefore, a movement
along the supply curve will occur when the price of the good changes and the
quantity supplied changes in accordance to the original supply relationship. In
other words, a movement occurs when a change in quantity supplied is caused
only by a change in price, and vice versa.

Shifts: A shift in a demand or supply curve occurs when a good's quantity

demanded or supplied changes even though price remains the same. For
instance, if the price for a bottle of cola was 16 and the quantity
demanded decreased from 2 to 1, then there would be a shift in the demand
for cola.

Shifts in the demand curve imply that the original demand relationship has
changed, meaning that quantity demand is affected by a factor other than

61
price. A shift in the demand relationship could occur if, for instance, cola
suddenly becomes a drink not recommended.

Shift in demand for cola

Conversely, if the price for a bottle of cola was 6 and the quantity
supplied increased from 3 to 4, then there would be a shift in the supply.

Like a shift in the demand curve, a shift in the supply curve implies that the
original supply curve has changed, meaning that the quantity supplied is
affected by a factor other than price. A shift in the supply curve would occur
if, for instance, cola was the only drink available.

1.4.5 Elasticity

The degree to which a demand or supply curve reacts to a change in price is

the curve's elasticity. Elasticity varies among products because some
products may be more essential to the consumer. Products that are necessities
62
are more insensitive to price changes because consumers would continue
buying these products despite price increases. Conversely, a price increase of a
good or service that is considered less of a necessity will deter more consumers
because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price

leads to a sharp change in the quantity demanded or supplied. Usually these
kinds of products are readily available in the market and a person may not
necessarily need them in his or her daily life. On the other hand, an inelastic
good or service is one in which changes in price witness only modest changes
in the quantity demanded or supplied, if any at all. These goods tend to be
things that are more of a necessity to the consumer in his or her daily life.

To determine the elasticity of the supply or demand curves, we can use this
simple equation:
Elasticity = (% change in quantity / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic.

If it is less than one, the curve is said to be inelastic

As we mentioned previously, the demand curve is a negative slope, and if there

is a large decrease in the quantity demanded with a small increase in price, the
demand curve looks flatter, or more horizontal. This flatter curve means that
the good or service in question is elastic.

Meanwhile, inelastic demand is represented with a much more upright curve

as quantity changes little with a large movement in price.
63
Elasticity of supply works similarly. If a change in price results in a big change
in the amount supplied, the supply curve appears flatter and is considered
elastic. Elasticity in this case would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in
the quantity supplied, the supply curve is steeper and its elasticity would be
less than one.

64
1.4.5.1 Factors affecting demand elasticity

There are three main factors that influence a demand's price elasticity:

1. The availability of substitutes - This is probably the most important factor

influencing the elasticity of a good or service. In general, the more substitutes,
the more elastic the demand will be. For example, if the price of a cup of coffee
went up by 0.25, consumers could replace their morning coffee with a cup of
tea. This means that coffee is an elastic good because a rise in price will cause
a large decrease in demand as consumers start buying more tea instead of
coffee.
However, if the price of caffeine were to go up as a whole, we would probably
see little change in the consumption of coffee or tea because there are few
substitutes for caffeine. Most people are not willing to give up their morning
cup of caffeine no matter what the price. We would say, therefore, that caffeine
is an inelastic product because of its lack of substitutes. Thus, while a product
within an industry is elastic due to the availability of substitutes, the industry
itself tends to be inelastic. Usually, unique goods such as diamonds are
inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good - This factor affecting

demand elasticity refers to the total a person can spend on a particular good or
service. Thus, if the price of a can of Coke goes up from 0.50 to 1 and income
stays the same, the income that is available to spend on coke, which is 2, is
now enough for only two rather than four cans of Coke. In other words, the
consumer is forced to reduce his or her demand of Coke. Thus if there is an
increase in price and no change in the amount of income available to spend on
65
the good, there will be an elastic reaction in demand; demand will be sensitive
to a change in price if there is no change in income.
3. Time - The third influential factor is time. If the price of cigarettes goes up 2
per pack, a smoker with very few available substitutes will most likely continue
buying his or her daily cigarettes. This means that tobacco is inelastic because
the change in price will not have a significant influence on the quantity
demanded. However, if that smoker finds that he or she cannot afford to spend
the extra 2 per day and begins to kick the habit over a period of time, the price
elasticity of cigarettes for that consumer becomes elastic in the long run.

1.4.5.2 Income elasticity of demand

In the second factor outlined above, we saw that if price increases while income
stays the same, demand will decrease. It follows, then, that if there is an
increase in income, demand tends to increase as well. The degree to which an
increase in income will cause an increase in demand is called income elasticity
of demand, which can be expressed in the following equation:

If EDy is greater than one, demand for the item is considered to have a
high income elasticity. If however EDy is less than one, demand is considered
to be income inelastic. Luxury items usually have higher income elasticity
because when people have a higher income, they don't have to forfeit as much
to buy these luxury items. Let's look at an example of a luxury good: air travel.
Mr. B has just received a Rs. 10,000 increase in his salary, giving him a total of
Rs.80, 000 per month. With this higher purchasing power, he decides that he
can now afford air travel twice a year instead of his previous once a year. With
the following equation, we can calculate income demand elasticity:

66
Income elasticity of demand for B's air travel is seven - highly elastic.

With some goods and services, we may actually notice a decrease in demand as
income increases. These are considered goods and services of inferior quality
that will be dropped by a consumer who receives a salary increase. An example
may be the increase in the demand of DVDs as opposed to video cassettes,
which are generally considered to be of lower quality. Products for which the
demand decreases as income increases have an income elasticity of less than
zero. Products that witness no change in demand despite a change in income
usually have an income elasticity of zero - these goods and services are
considered necessities.

1.4.6 Demand forecasting

1.4.6.1 What is a demand forecast?

A demand forecast is the prediction of what will happen to your company's

existing product sales. It would be best to determine the demand forecast using
a multi-functional approach. The inputs from sales and marketing, finance,
and production should be considered. The final demand forecast is the
consensus of all participating managers. You may also want to put up a Sales
and Operations Planning group composed of representatives from the different
departments that will be tasked to prepare the demand forecast.

Demand forecasting is the activity of estimating the quantity of a product or

service that consumers will purchase. Demand forecasting involves techniques
including both informal methods, such as educated guesses, and quantitative
methods, such as the use of historical sales data or current data from test
markets. Demand forecasting may be used in making pricing decisions, in
assessing future capacity requirements, or in making decisions on whether to
enter a new market.

Determination of the demand forecasts is done through the following steps:

 Determine the use of the forecast

67
  Select the items to be forecast
 Determine the time horizon of the forecast
 Select the forecasting model(s)
 Gather the data
 Make the forecast
 Validate and implement results
The time horizon of the forecast is classified as follows:

Description Forecast Horizon

Short-range Medium-range Long-range

Duration Usually less than 3 months to 3 More than 3 years

3 months, years
maximum of 1
year

Applicability Job scheduling, Sales and New product

worker production development,
assignments planning, facilities planning
budgeting

1.4.6.2 How is demand forecast determined?

There are two approaches to determine demand forecast – (1) the qualitative
approach, (2) the quantitative approach. The comparison of these two
approaches is shown below:

Description Qualitative Approach Quantitative Approach

Applicability Used when situation is vague Used when situation is stable

& little data exist (e.g., new & historical data exist
products and technologies)
(e.g. existing products,
current technology)

Considerations Involves intuition and Involves mathematical

experience techniques

68
 Techniques Jury of executive opinion Time series models
Sales force composite Causal models
Delphi method
Consumer market survey

1.4.6.3 Quantitative forecasting methods

There are two forecasting models here – (1) the time series model and (2) the
causal model. A time series is a set of evenly spaced numerical data and is
obtained by observing responses at regular time periods. In the time series
model, the forecast is based only on past values and assumes that factors that
influence the past, the present and the future sales of your products will
continue.

On the other hand, the causal model uses a mathematical technique known as
the regression analysis that relates a dependent variable (for example, demand)
to an independent variable (for example, price, advertisement, etc.) in the form
of a linear equation. The time series forecasting methods are described below:

Time Series Description

Forecasting
Method
Naïve Assumes that demand in the next period is the same as
Approach demand in most recent period; demand pattern may not
always be that stable

For example:

If July sales were 50, then Augusts sales will also be 50

Time Series Description

Forecasting
Method
Moving MA is a series of arithmetic means and is used if little or no
Averages (MA) trend is present in the data; provides an overall impression
of data over time.
In financial applications a simple moving average (SMA) is
the unweighted mean of the previous n datum points. When
calculating successive values, a new value comes into the
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 sum and an old value drops out, meaning a full summation
each time is unnecessary for this simple case,
Equation:
S1 = (di+d2+d3)/3
S2= (d2+d3+d4)/3
Sn-2= (dn-2+dn-1+dn)/3
These figures give a smoother trend devoid of variations
which could have been distortions. Once the trend line is
drawn then we can extrapolate and forecast.
Some of the primary functions of a moving average are to
identify trends measure the strength of the momentum and
determine potential areas where an asset will find support
or resistance and use it to forecast.

A weighted moving average adjusts the moving average

method to reflect fluctuations more closely by assigning
weights to the most recent data, meaning, that the older
data is usually less important. The weights are based on
intuition and lie between 0 and 1 for a total of 1.0

Equation:
WMA 4 = (W3) (d3) + (W2) (d2) + (W1) (d1)

WMA – Weighted moving average, W – Weight, d – Demand,

No. – Period
Exponential The exponential smoothing is an averaging method that
Smoothing reacts more strongly to recent changes in demand by
assigning a smoothing constant to the most recent data
more strongly; useful if recent changes in data are the
results of actual change (e.g., seasonal pattern) instead of
just random fluctuations
F t + 1 = a d t + (1 - a ) F t
Where
F t + 1 = the forecast for the next period

70
 d t = actual demand in the present period
F t = the previously determined forecast for the present
period
a = a weighting factor referred to as the smoothing constant

Time Series The time series decomposition adjusts the seasonality by

Decomposition multiplying the normal forecast by a seasonal factor

1.4.6.4 Demand forecasting v/s sales forecasting

The two concepts are tightly related but not completely identical the distinction
being somewhat subtle.

Sales forecasting is the most straightforward: you take your sales history as
input in order to produce a sales forecast. For most retail products, this
approach is already fairly efficient. Indeed, sales are the only reliable
quantitative indicator available about the customer demand for products.

Yet, it happens that sales data end-up with bias, for example

 No products are left on the shelf, that's the inventory rupture. Sales go to
zero, although there is certainly a demand for the product. In that situation,
sales data are under-estimating the demand.
 A temporary promotion is applied to the product. Sales go up, but
mostly due to the promotion. Although there might be a residual effect after
the end of promotion, sales are going to decrease afterward. In this
situation, sales data are over-estimating the demand. If you want to
produce a demand forecast, then you need to use the demand history
as input.
1.4.7 Let us sum up

Demand refers to how much (quantity) of a product or service is desired by

buyers. The quantity demanded is the amount of a product people are willing
to buy at a certain price; the relationship between price and quantity
demanded is known as the demand relationship.

The law of demand states that, if all other factors remain equal, the higher the
price of a good, the less people will demand that good. In other words, the
higher the price, the lower the quantity demanded.

71
Like the law of demand, the law of supply demonstrates the quantities that will
be sold at a certain price. But unlike the law of demand, the supply
relationship shows an upward slope. This means that the higher the price, the
higher the quantity supplied.

The degree to which a demand or supply curve reacts to a change in price is

the curve's elasticity. Elasticity varies among products because some
products may be more essential to the consumer. Products that are necessities
are more insensitive to price changes because consumers would continue
buying these products despite price increases. Conversely, a price increase of a
good or service that is considered less of a necessity will deter more consumers
because the opportunity cost of buying the product will become too high.

Demand forecasting is the activity of estimating the quantity of a product or

service that consumers will purchase. Demand forecasting involves techniques
including both informal methods, such as educated guesses, and quantitative
methods, such as the use of historical sales data or current data from test
markets.

1.4.8 Key words/concepts

Demand; Price; quantity demanded; demand relationship; law of demand; law

of supply; Elasticity; Demand forecasting;

1.4.9 Check your progress

1. The law of demand states that:

a. as the quantity demanded rises, the b. as the price rises, the quantity
price rises demanded rises
c. as the price rises, the quantity d. as supply rises, the demand rises
demanded falls

2. The price elasticity of demand is the:

a. percentage change in quantity b. percentage change in price divided by

demanded divided by the percentage the percentage change in quantity
change in price demanded
c. Rupee change in quantity demanded d. percentage change in quantity
divided by the Rupee change in price demanded divided by the percentage
change in quantity supplied.

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 3. If the price elasticity of demand is unit then a fall in price

a. Reduces revenue b. Leaves revenue unchanged

c. Increases revenue d. Reduces costs

4. The price decreases from Rs 2,000 to Rs.1, 800. Quantity demanded per
year increases from 5000 to 6000 units. Which of the following is
correct?

a. The price elasticity of demand is -2 b. The good is inferior

c. Income elasticity is + 0.5 d. Income elasticity is + 2

5. A large number of firms produce a good, and a large number of buyers

are in the market. This means there is

a. perfect competition b. oligopoly

c. monopoly d. monopolistic competition

6. Income and demand are inversely related in case of

a. inferior goods b. normal goods

c. Giffen goods d. Complementary goods

Key to check your progress

1. c 2. a 3. b
4. a 5. a 6. a

1.4.10 Terminal questions

 Explain briefly the different types of demand

 State law of demand and law of supply
 When does disequilibrium occur?
 Explain elasticity of demand. What are the factors affecting price
elasticity of demand
 What are the steps in demand forecasting?
 Explain the two approaches to determine demand forecast – the
qualitative approach, the quantitative approach.

73
1.4.11 Reference books for further reading

 Investopedia on macro/microeconomics, demand law

 Wikipedia on demand law
 About.com economics
 Advanced placement economic teacher resource manual
 Yield curve theories by Eric Bank
Bibliography – further reading.

 Principles of Economics By N George Mankiw

 Principles of Macroeconomics By N George Mankiw
 Principles of Microeconomics By N George Mankiw

74
Unit-2 : Business Mathematics and Statistics
Lesson No. 1 Basic Statistical Tools
Lesson No. 2 Bond Valuation
Lesson No. 3 Interest Rate Calculation
Lesson No. 4 Sampling

75
 2 Unit 2 Business Mathematics and Statistics
2.1 Lesson No. 1 Basic statistical tools

2.1.1 Objectives
2.2.2 Introduction to Basic Statistical Tools
2.2.2.1 Mean
2.2.2.2 Median
2.2.2.3 Mode
2.2.3Correlation /Regression
1.2.3.1 Correlation
1.2.3.2 Regression
1.2.3.3 Least squares method
1.2.3.4 Coefficient of correlation
1.2.3.5 Coefficient of determination
1.2.3.6 Covariance
1.2.3.7 Solved examples on correlation & regression
2.2.4 Trend Analysis
1.2.4.1 Variation in time series
2.2.5 Let us sum up
2.2.6 Key words/concepts
2.2.7 Check your progress
2.2.8 Terminal questions

76
2.1.1 Objectives

The objectives of this lesson are to understand basic aspects of

 Statistics,
 Correlation
 Regression
 Trend Analysis
2.1.2 Introduction to basic statistical tools

Before you can begin to understand statistics, there are four terms you will
need to fully understand. The first term 'average' is something we have been
familiar with from a very early age when we start analyzing our marks on
report cards. We add together all of our test results and then divide it by the
sum of the total number of tests. We often call it the average. However,
statistically it's the Mean.

2.1.2.1 The Mean

Example:

Four tests results: 15, 18, 22, 20

The sum is: 75

Divide 75 by 4: 18.75

The 'Mean' (Average) is 18.75 (rounded to 19)

2.1.2.2 The Median

The Median is the 'middle value' in your list. When the totals of the list are odd,
the median is the middle entry in the list after sorting the list into increasing
order. When the totals of the list are even, the median is equal to the sum of
the two middle (after sorting the list into increasing order) numbers divided by
two. Thus, remember to line up your values, the middle number is the median!
Be sure to remember the odd and even rule.

Examples:

Find the Median of: 9, 3, 44, 17, 15 (Odd amount of numbers)

Line up your numbers: 3, 9, 15, 17, 44 (smallest to largest)

77
The Median is: 15 (The number in the middle)

Find the Median of: 8, 3, 44, 17, 12, 6 (Even amount of numbers)

Line up your numbers: 3, 6, 8, 12, 17, 44

Add the 2 middles numbers and divide by 2: (8 +12)/2 = 20 ÷ 2 = 10

The Median is 10.

2.1.2.3 The Mode

The mode in a list of numbers refers to the list of numbers that occur most
frequently.

Examples:

Find the mode of:

9, 3, 3, 44, 17, 17, 44, 15, 15, 15, 27, 40, 8,

Put the numbers in order for ease:

3, 3, 8, 9, 15, 15, 15, 17, 17, 27, 40, 44, 44,

The Mode is 15 (15 occurs the most at 3 times)

It is important to note that there can be more than one mode and if no
number occurs more than once in the set, then there is no mode for that
set of numbers.

Occasionally in Statistics you'll be asked for the 'range' in a set of numbers.

The range is simply the smallest number subtracted from the largest number
in your set. Thus, if your set is 9, 3, 44, 15, 6 - The range would be 44-3=41.
Your range is 41.

Probability

A natural progression once the 3 terms in statistics are understood is the

concept of probability. Probability is the chance of an event happening and is
usually expressed as a fraction.

Probability is all around us. Probability refers to the likelihood or relative

frequency for something to happen. The continuum of probability falls
anywhere between impossible to certain.

78
When we speak of chance or the odds; the chances or odds of winning the
lottery, we're also referring to probability. The chances or odds or probability of
winning the lottery is something like 18 million to 1. In other words, the
probability of winning the lottery is highly unlikely. Weather forecasters use
probability to inform us of the likelihood (probability) of storms, sun,
precipitation, temperature and along with all weather patterns and trends.
You'll hear that there's a 10% chance of rain. To make this prediction, a lot of
data is taken into account and then analyzed. The medical field informs us of
the likelihood of developing high blood pressure, heart disease, diabetes, the
odds of beating cancer etc.

Probability has become a topic in math that has grown out of societal needs.
The language of probability starts as early as kindergarten and remains a topic
through high school and beyond. The collection and analysis of data has
become extremely prevalent throughout the math curriculum. Students
typically do experiments to analyze possible outcomes and to calculate
frequencies and relative frequencies, because making predictions is extremely
important and useful. It's what drives our researchers and statisticians who
will make predictions about disease, the environment, cures, optimal health,
highway safety, and air safety to name a few. We fly because we are told that
there is only a 1 in 10 million chance of dying in an airplane crash. It takes the
analysis of a great deal of data to determine the probability/chances of events
and to do so as accurately as possible.

In school, students will make predictions based on simple experiments. For

instance, they roll dice to determine how often they'll roll a 4. (1 in 6) But they
will also soon discover that it is very difficult to predict with any kind of
accuracy or certainty what the outcome of any given roll will be. They will also
discover that the results will be better as the number of trials grows. The
results for a low number of trials are not as good as the results are for a large
number of trials.

With probability being the likelihood of an outcome or event, we can say that
the theoretical probability of an event is the number of outcomes of the event
divided by the number of possible outcomes. Hence a 4 in the throw of a dice is
a 1 out of 6. Typically, the math curriculum will require students to conduct
experiments, determine fairness, collect the data using various methods,
interpret and analyze the data, display the data and state the rule for the
probability of the outcome.

79
In summary, probability deals with patterns and trends that occur in random
events. Probability helps us to determine what the likelihood of something
happening will be. Statistics and simulations help us to determine probability
with greater accuracy. Simply put, one could say probability is the study of
chance. It affects so many aspects in life, everything from earthquakes
occurring to sharing a birthday. If you're interested in probability, the field in
math you'll want to pursue will be data management and statistics.

Standard Deviation

In statistics and probability theory, standard deviation shows how much

variation or "dispersion" exists from the average (mean, or expected
value). A low standard deviation indicates that the data points tend to be very
close to the mean, whereas high standard deviation indicates that the data
points are spread out over a large range of values.

There are two measures of Standard Deviation viz.

Population Standard Deviation

Sample Standard deviation:

Where μ and are the mean for population and the sample respectively.

For this exercise we will refer to only Sample Standard deviation.

Variance is the square of standard deviation.

s2 = Σ ( xi - )2 / ( n - 1)

Variance and Standard Deviation: Step by Step

1. Calculate the mean, .

2. Write a table that subtracts the mean from each observed value.

80
 3. Square each of the differences.

4. Add this column.

5. Divide by N -1 where N is the number of items in the sample. This is

the variance.

6. To get the standard deviation we take the square root of the variance.

Example

The owner of a restaurant is interested in how much people spend at the

restaurant. He/she examines 10 randomly selected receipts for parties of four
and writes down the following data.

44, 50, 38, 96, 42, 47, 40, 39, 46, 50

He/she calculated the mean by adding and dividing by 10 to get

x = 49.2

Below is the table for getting the standard deviation:

x x - 49.2 (x - 49.2 )2
44 -5.2 27.04
50 0.8 0.64
38 11.2 125.44
96 46.8 2190.24
42 -7.2 51.84
47 -2.2 4.84
40 -9.2 84.64
39 -10.2 104.04
46 -3.2 10.24
50 0.8 0.64
Total 2600.4

Now

2600.4 = 288.7

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 10 – 1

Hence the variance is 289 and the standard deviation is the square root of 289
= 17.

Since the standard deviation can be thought of measuring how far the data
values lie from the mean, we take the mean and move one standard deviation
in either direction. The mean for this example was about 49.2 and the
standard deviation was 17. We therefore have:

49.2 - 17 = 32.2 and 49.2 + 17 = 66.2

What this means is that most of the patrons probably spend between Rs
32.20 and Rs. 66.20? The variance and standard deviation describe how
spread out the data is. If the data all lies close to the mean, then the standard
deviation will be small, while if the data is spread out over a large range of
values, s will be large. Having outliers will increase the standard deviation.

One of the flaws involved with the standard deviation, is that it depends on the
units that are used. One way of handling this difficulty, is called the coefficient
of variation which is the standard deviation divided by the mean times 100%

CV = (s/m)*100%

In the above example, it is (17/49.2)*100% =34.6%.

This tells us that the standard deviation of the restaurant bills is 34.6% of the
mean.

Standard deviation is a measure of the volatility risk. Risk reflects the chance
that the actual return on an investment may be very different than the
expected return. One way to measure risk is to calculate the variance and
standard deviation of the distribution of returns.

Consider the probability distribution for the returns on

stocks A and B provided below.

State Probability Return on Return on

Stock A Stock B

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 1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
3 20% 20% -10%

The expected return on Stock A was found to be 12.5% and the expected return
on Stock B was found to be 20%.

The standard deviation of a random variable, statistical population, data set,

or probability distribution is the square root of its variance. It
is algebraically simpler though practically less robust than the average
absolute deviation. A useful property of standard deviation is that, unlike
variance, it is expressed in the same units as the data.

In addition to expressing the variability of a population, standard deviation is

commonly used to measure confidence in statistical conclusions. For example,
the margin of error in polling data is determined by calculating the expected
standard deviation in the results if the same poll were to be conducted multiple
times. The reported margin of error is typically about twice the standard
deviation – the radius of a 95 percent confidence interval. Researchers
commonly report the standard deviation of experimental data, and only effects
that fall far outside the range of standard deviation are considered statistically
significant– normal random error or variation in the measurements is in this
way distinguished from causal variation. Standard deviation is also important
in finance where the standard deviation on the rate of return on an
investment is a measure of the volatility of the investment.

2.1.3 Correlation and Regression

2.1.3.1 Correlation

In the world of finance, correlation is a statistical measure of how two

securities move in relation to each other. Correlations are used in advanced
portfolio management. Correlation is computed into what is known as the
correlation coefficient, which ranges between -1 and +1. Perfect positive
correlation (a correlation co-efficient of +1) implies that as one security moves,
either up or down, the other security will move in lockstep, in the same
direction. Alternatively, perfect negative correlation means that if one security
moves in either direction the security that is perfectly negatively correlated will

83
move in the opposite direction. If the correlation is 0, the movements of the
securities are said to have no correlation; they are completely random.

In real life, perfectly correlated securities are rare, rather you will find
securities with some degree of correlation.

Scatter plots are used by researchers to look for correlations. A correlation is a

relationship between the data, which can suggest that one event may affect
another event. For example, you might want to discover whether more hours
of studying will affect your Maths marks in school. Perhaps a scientist
wants to find out if the distance people live from a major city affects their
health.

15 15
Strong, positive Weak, positive

10
10
y y 5
5
0

0 -5
0 5 10 15 0 5 10 15
x x
15 20
Strong, negative Weak, negative
15
10
10
y y
5
5
0

0 -5
0 5 10 15 0 5 10 15
x x

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In order to use scatter plots in this way, you must have two sets of numerical
data. One set is plotted on the x-axis of a graph, and the other set is plotted on
the y-axis. The resulting scatter plot will often show at a glance whether a
relationship exists between the two sets of data.

A scatter diagram is a tool for analyzing relationships between two variables.

One variable is plotted on the horizontal axis and the other is plotted on the
vertical axis. The pattern of their intersecting points can graphically show
relationship patterns. Most often a scatter diagram is used to prove or disprove
cause-and-effect relationships. While the diagram shows relationships, it does
not by itself prove that one variable causes the other. In addition to showing
possible cause and-effect relationships, a scatter diagram can show that two
variables are from a common cause that is unknown or that one variable can
be used as a surrogate for the other.

When to use it:

Use a scatter diagram to examine theories about cause-and-effect relationships

and to search for root causes of an identified problem. Use a scatter diagram to
design a control system to ensure that gains from quality improvement efforts
are maintained.

Interpret the data

Scatter diagrams will generally show one of 5 possible correlations between the
variables:

Strong Positive Correlation The value of Y clearly increases as the value of X

increases.

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Strong Negative Correlation The value of Y clearly decreases as the value of X
increases.

Weak Positive Correlation The value of Y increases slightly as the value of X

increases.

Weak Negative Correlation The value of Y decreases slightly as the value of X

increases.

No Correlation There is no demonstrated connection between the two

variables, with points scattered all over.

2.1.3.2 Regression

A statistical measure that attempts to determine the strength of

the relationship between one dependent variable (usually denoted by Y) and a
series of other changing variables (known as independent variables).

The two basic types of regression are linear regression and multiple regression.
Linear regression uses one independent variable to explain and/or predict the
outcome of Y, while multiple regression uses two or more independent
variables to predict the outcome. The general form of each type of
regression is:

Linear Regression: Y = a + bX

b=∑ xy—n (mean x) (mean y)]/[∑x2-n x‾2 ]

a= (mean y – b. mean x)

Multiple Regression: Y = a + b1X1 + b2X2 + b3X3 + ... + btXt

Where:
Y= the variable that we are trying to predict

X= the variable that we are using to predict Y

a= the intercept

b= the slope

In multiple regression the separate variables are differentiated by using

subscripted Numbers.

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Regression takes a group of random variables, thought to be predicting
Y, and tries to find a mathematical relationship between them. This
relationship is typically in the form of a straight line (linear regression)
that best approximates all the individual data points. Regression is
often used to determine how many specific factors such as the price of a
commodity, interest rates, particular industries or sectors influence the
price movement of an asset.

2.1.3.3 Least squares method

A statistical technique to determine the line of best fit for a model. The least
squares method is specified by an equation with certain parameters to
observed data. This method is extensively used in regression analysis and
estimation. In the most common application - linear or ordinary least squares
- a straight line is sought to be fitted through a number of points to minimize
the sum of the squares of the distances (hence the name "least squares") from
the points to this line of best fit.

In contrast to a linear problem, a non-linear least squares problem has no

closed solution and is generally solved by iteration.

In a cause and effect relationship, the independent variable is the cause, and
the dependent variable is the effect. Least squares linear regression is a
method for predicting the value of a dependent variable Y, based on the value
of an independent variable X.

Correlation analysis is the statistical tool to describe the degree to which one
variable is linearly related to another. Often, correlation analysis is used in
conjunction with regression analysis to measure how well the regression line
explains the variation of the dependent variable Y.—To measure the degree of
association between the 2 variables.

We have 3 measures to describe this:

a. Coefficient of correlation
b. Coefficient of determination
c. Covariance
2.1.3.4 Coefficient of correlation

The quantity r, called the linear correlation coefficient, measures the strength
and the direction ofstand a linear relationship between two variables. The
87
linear correlation coefficient is sometimes referred to as the Pearson product
moment correlation coefficient in honor of its developer Karl Pearson.

The mathematical formula for computing r is:

Where n is the number of pairs of data.

 The value of r is such that -1 < r < +1. The + and – signs are used for
positive linear correlations and negative linear correlations, respectively.
 Positive correlation: If x and y have a strong positive linear
correlation, r is close to +1. An r value of exactly +1 indicates a perfect
positive fit. Positive values indicate a relationship
between x and y variables such that as values for x increase, values
for y also increase.
 Negative correlation: If x and y have a strong negative linear
correlation, r is close to -1. An r value of exactly -1 indicates a perfect
negative fit. Negative values indicate a relationship between x and y such
that as values for x increase, values for y decrease.
 No correlation if there is no linear correlation or a weak linear
correlation, r is close to 0. A value near zero means that there is a
random, nonlinear relationship between the two variables
 Note that r is a dimensionless quantity; that is, it does not depend on the
units employed.
 A perfect correlation of ± 1 occurs only when the data points all lie
exactly on a straight line. If r = +1, the slope of this line is positive. If r =
-1, the slope of this line is negative.
 A correlation greater than 0.8 is generally described as strong, whereas a
correlation less than 0.5 is generally described as weak. These values
can vary based upon the "type" of data being examined. A study utilizing
scientific data may require a stronger correlation than a study using
social science data.

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2.1.3.5 Coefficient of determination

A measure used in statistical model analysis to assess how well a model

explains and predicts future outcomes. It is indicative of the level of explained
variability in the model. The coefficient, also commonly known as R-square, is
used as a guideline to measure the accuracy of the model.

One use of the coefficient of determination is to test the goodness of fit of the
model. It is expressed as a value between zero and one. A value of one indicates
a perfect fit, and therefore, a very reliable model for future forecasts. A value of
zero, on the other hand, would indicate that the model fails to accurately model
the dataset.

 The coefficient of determination, r2, is useful because it gives the

proportion of the variance (fluctuation) of one variable that is predictable
from the other variable. It is a measure that allows us to determine how
certain one can be in making predictions from a certain model/graph.
 The coefficient of determination is the ratio of the explained variation to
the total variation.
 The coefficient of determination is such that 0 < r 2 < 1, and denotes the
strength of the linear association between x and y.
 The coefficient of determination represents the percent of the data that is
closest to the line of fit.
 For example, if r = 0.922, then r 2 = 0.850, which means that 85% of the
total variation in y can be explained by the linear relationship between x
and y (as described by the regression equation). The other 15% of the
total variation in y remains unexplained.
 The coefficient of determination is a measure of how well the regression
line represents the data. If the regression line passes exactly through
every point on the scatter plot, it would be able to explain all of the
variation. The further the line is away from the points, the less it is able
to explain.
2.1.3.6 Covariance

A measure of the degree to which returns on two risky assets move in tandem.
A positive covariance means that asset returns move together. A negative
covariance means returns move inversely. One method of calculating
covariance is by looking at return surprises (deviations from expected return)
89
in each scenario. Another method is to multiply the correlation between the two
variables by the standard deviation of each variable.

Possessing financial assets that provide returns and have a high covariance
with each other will not provide very much diversification.

For example, if stock A's return is high whenever stock B's return is high and
the same can be said for low returns, then these stocks are said to have a
positive covariance. If an investor wants a portfolio whose assets have
diversified earnings, he or she should pick financial assets that have low
covariance to each other.

Suppose that X and Y are random variables for a random experiment.

The covariance of X and Y is defined by

Cov (X, Y) = E {[X - E(X)][Y - E(Y)]};

Where E(X) and E(Y) are expected values of X and Y.

2.1.3.7 Solved examples in correlation and regression

A. Five children aged 2, 3, 5, 7 and 8 years old weigh 14, 20, 32, 42 and 44
kilograms respectively.
1. Find the equation of the regression line of age on weight.
2. Based on this data, what is the approximate weight of a six year old
child?
Solution:
xi yi x i2 yi2 xi*yi
2 14 4 196 28
3 20 9 400 60
5 32 25 1,024 160
7 42 49 1,764 294
8 44 64 1,936 352
25 152 151 5,320 894

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B) The success of a shopping center can be represented as a function of the
distance (in miles) from the center of the population and the number of clients
(in hundreds of people) who will visit. The data is given in the table below:

No. Customer (x) 8 7 6 4 2 1

Distance (y) 15 19 25 23 34 40

 Calculate the linear correlation coefficient.

 If the mall is located 2 miles from the center of the population, how many
customers should the shopping center expect?
 To receive 500 customers, at what distance from the center of the
population should the shopping centre be located?
Solution:
xi yi xi ·yi x i2 yi2
8 15 120 64 225
7 19 133 49 361
6 25 150 36 625
4 23 92 16 529
2 34 68 4 1,156
1 40 40 1 1,600
28 156 603 170 4,496

91
There is a very strong negative correlation.

C) The grades of five students in mathematics and chemistry are:

Mathematics 6 4 8 5 3. 5
Chemistry 6. 5 4. 5 7 5 4

Determine the regression lines and calculate the expected grade in chemistry
for a student who has a 7.5 in mathematics.

Solution:

xi yi x i2 yi2 xi *yi
6 6. 5 36 42.25 39
4 4. 5 16 20.25 18
8 7 64 49 56
5 5 25 25 25
3.5 4 12.25 16 14
26.5 27 153.25 152.5 152

92
A data set has a correlation coefficient of r = −0.9, with the means of marginal
distributions of = 1 and = 2. It is known that one of the following four
equations corresponds to the regression of y on x:

Select the correct line.

y = −x + 2 3x − y = 1 2x + y =4 y=x+1

Solution:

Since the linear correlation coefficient is negative, the slope of the line will also
be negative, thus ruling out the 2nd and 4th options.

A point on the line is ( , ), that is to say, (1, 2).

2 ≠ −1 + 2

2·1+2=4

The correct line is: 2x + y = 4.

The heights (in centimeters) and weight (in kilograms) of 10 basketball players
of a team are:

Height (X) 186 189 190 192 193 193 198 201 203 205
Weight (Y) 85 85 86 90 87 91 93 103 100 101

93
Calculate:

1. The regression line of y on x.

2. The coefficient of correlation.
3. The estimated weight of a player who measures 208 cm.
Solution:

xi yi x i2 yi2 xi ·yi
186 85 34,596 7,225 15,810
189 85 35,721 7,225 16,065
190 86 36,100 7,396 16,340
192 90 36,864 8,100 17,280
193 87 37,249 7,569 16,791
193 91 37,249 8,281 17,563
198 93 39,204 8,649 18,414
201 103 40,401 10,609 20,703
203 100 41,209 10,000 20,300
205 101 42,025 10,201 20,705
1,950 921 380,618 85,255 179,971

There is a strong positive correlation.

94
From the following data of hours worked in a factory (x) and output units (y),
determine the regression line of y on x, the linear correlation coefficient and
determine the type of correlation.

Hours (x) 80 79 83 84 78 60 82 85 79 84 80 62
Production
300 302 315 330 300 250 300 340 315 330 310 240
(y)

Solution:

xi yi x i2 yi2 xi*yi
80 300 6,400 90,000 24,000
79 302 6,241 91,204 23,858
83 315 6,889 99,225 26,145
84 330 7,056 108,900 27,720
78 300 6,084 90,000 23,400
60 250 3,600 62,500 15,000
82 300 6,724 90,000 24,600
85 340 7,225 115,600 28,900
79 315 6,241 99,225 24,885
84 330 7,056 108,900 27,720
80 310 6,400 96,100 24,800
62 240 3,844 57,600 14,880
936 3,632 73,760 1,109,254 285,908

95
There is a strong positive correlation.

2.1.4 Trend analysis

2.1.4.1 Variations in Time series

There are 4 types of variations in time series.

1. Secular trend
2. Cyclical Fluctuation
3. Seasonal Variation
4. Irregular Variation.
Secular trend

In the first type the variation or change comes over a long period of time. A
steady increase in cost of living recorded by Consumer Price Index is a good
example. From year to year there is a fluctuation but there is a steady
increase in the trend. Let us see the series given below.

Let us try to detect patterns in the information over regular intervals of time.
Then let us try to predict to cope with uncertainty.

Number of ships loaded in a harbour.

Year 1997 1998 1999 2000 2001 2002 2003

Number 98 105 116 119 135 156 177

Observations:

There is an increase over time -7 years. But the increases are not equal. This is
not an arithmetic progression.

Cyclical variation: Most common example of a cyclical fluctuation is a

business cycle. Over time, there are years when business cycle hits peak above
the trend line. Fluctuations in business activity occur many times, and they
have irregular periods and vary widely in amplitude from cycle to cycle. There
are also times when business activity slumps, and hits a point below the trend

96
line. The time between hitting peaks and lows are periods – it can be one or
many. The cyclical moves do not follow any regular pattern, they are irregular.

Seasonal variation: Here is a pattern of change within a year. A doctor can

expect the number of flu cases to increase in winter. Hill resorts can expect
more tourists during summer. These are regular patterns and can be used for
forecasting the amount of flu vaccines required during winter, the doctor’s
income during winter, the hotel bookings in resorts and availability of air and
train bookings.

Irregular variation: The value of the variable is unpredictable, changing in a

random manner. The effects of earthquake, floods, wars etc., cannot be
predicted. As a result of flood, the agriculture output suffers. Then the prices
go up at an unprecedented rate. This could not be predicted by using time
series.

Of the 4 variations, secular trend represents the long term direction. We can
visually fit a line in the graph sheet. The studying of the trend helps us to
understand historical patterns and events (for sudden unusual change).
Studying trend also helps us to project trends into the future. Even a sudden
change in the past due to a situation (like war etc.,) can be used to predict the
trend if a similar sudden change happens. (See graph).

Trends can be linear or curvilinear. Trends that can be described by a straight

line is called linear trend.

Equation for estimating a straight line. y= a+ bX

Y = estimated value of the dependent variable

X= independent variable

a= y intercept (the value of Y, when X=0)

b = the slope of the trend line.

Some trends like pollutants in the environment increase, but they need not be
a straight line. Another example of curvilinear relationship is the life cycle of a
business product. A product, when introduced its sales volume is low; as the
product gains recognition and success, the sales go up. After the product is
firmly established, there is a stable rate of growth. As the product reaches the
end of its cycle (new products, more competition etc.) the sales decrease.

97
There are 3 main reasons, why we should study the trends:

 We will be able to describe historical patterns, which will help us to

evaluate the success of previous policies. - Long term direction of the
time series is given by secular trend.
 Past trends will help us to project future – some growth rate of
population, GDP.
 We will be able to separate the trend component and eliminate it from
the series, to get an accurate idea of other components like seasonal
fluctuations.
We have already learnt about fitting straight line by drawing scatter graphs,
and by the method of least squares. For the best fitting regression line

b=∑xy—n (mean x) (mean y)]/ [∑x2-nx‾2]

a= (mean y – b. mean x)

Example:

The resort wants to establish the seasonal pattern of rooms demanded by

tourist. This will help them to plan and improve customer service. They will
employ more staff during peak period.

Number of rooms required per quarter

year 1 2 3 4
1998 1861 2203 2415 1908
1999 1921 2343 2514 1986
2000 1834 2154 2098 1799
2001 1837 2025 2304 1965
2002 2073 2414 2339 1967

Step 1: Compute seasonal index

a. Add total values of all four quarters of the 1st year. Write it in the middle
of the set of 4 values.
b. Then to get the moving total, start from second quarter of first year and
go up to first quarter of 2nd year. [drop the first value and add the fifth
value. –This is called ‘sliding’.]
c. In this way, continue the process of sliding till end. (See table col.4)
98
Step 2: Find the four quarter moving Average by dividing each value derived in
step 1 by 4. (col. 5)
Step 3.Since we have 4 quarters, the centering becomes necessary. If we have
odd number like a 7 day data for a week, then centering is not essential.
In order to center the moving averages, we again find the moving average for
the values in step 2—add 2 values and average it. Follow the process of sliding
col.6) (TSCI)
We can see that moving average has smoothed down the peaks and troughs of
the original time series. See graph.
Step 4. We will now calculate the percentage of actual value to moving average
values. Percentage= 100(actual value/ average). (Si) For example, we see that
for 1998, 3rd quarter, = 100 (2415/2104.25) =114.8

Quarterly
Year1 Step 1 step2 step3 step4 step5
occupancy

1998 I- 1861
II- 2203
III-2415 8387 2096.75 2104.25 114.8
IV-1908 8447 2111.75 2129.25 89.6
1999 1921 8587 2146.75 2159.125 89.0
2343 8686 2171.50 2181.25 107.4
2514 8764 2191.00 2180.125 115.3
1986 8677 2169.25 2145.625 92.6
2000 1834 8488 2122.00 2070.00 88.6
2154 8072 2018.00 1994.625 108.0
2098 7885 1971.25 1971.625 106.4
1799 7888 1972.00 1955.875 92.0
2001 1837 7759 1939.75 1965.5 93.5
2025 7965 1991.25 2012.00 100.6
2304 8131 2032.75 2062.25 111.7
1965 8367 2091.75 2140.375 91.8

99
2002 2073 8756 2189.00 2193.375 94.5
2414 8791 2197.75 2198.000 109.8
2339 8793 2198.25
1967

Step 5. Draw a new table to calculate the modified mean. [S] Calculate
modified mean by discarding the highest and the lowest value for each quarter.

Year Q1 Q2 Q3 Q4

1998 114.8 89.6

1999 89.0 107.4 115.3 92.6

2000 88.6 108.0 106.4 92.0

2001 93.5 100.6 111.7 91.8

2002 94.5 109.8

Modified means are:

91.25,107.7,113.25,91.90

Total of indices=404.1

By discarding the highest and lowest values of each quarter, we try to eliminate
the extreme cyclical and irregular components of variation in the time series.
When we average the remaining values, we further smooth the cyclical and
irregular components. Then modified mean is an index of the seasonality
component.

Step 6: Adjusting the modified mean to base 100. Note that the modified mean
is 404.1 in this case. Thus the four quarterly indices should total to 400. To
correct this error, we use the adjusting constant, (400/404.1)=0.9899. We
multiply the values of modified mean by this number.

Q1=91.25 x0.9899= 90.3; Q2 =106.6; Q3= 112.1; Q4 =91.0

100
Use of seasonal index

Seasonal indices are used to find out the seasonal variation. Then we remove
the seasonal variations, to get the residual cyclical and irregular variations. We
deseasonalise the time series, by dividing each of the actual value in the series
by the appropriate seasonal index (expressed as a fraction of 100). Working
with our data, for the year 1998,

We get the deseasonalised values as follows:

Q.1 1861⁄ (90.3/100) = 2061; Q.2 2203/ (106.6/100) =2067

Q 3. 2415/ (112.1/100) = 2154; Q4. 1908 / (91.0/100) =2097

This deseasonalised value reflects only the trend, cyclical and irregular
components of the time series.

Now we can compute the trend line and use it for prediction.

Suppose, our resort manager estimates from the deseasonalised trend line ,
that the deseasonalised average occupancy for the fourth quarter of next year
will be 2121.

Then to get the correct picture, we must take seasonality into account.
Therefore, multiply the deseasonalised predicted estimate by the fourth quarter
seasonal index and obtain the estimate for the season.

2121 x (91.0/100) = 1930. There will be an average occupancy of 1930 rooms

in the fourth quarter of next year.

A problem involving all four components (TSCI) of the time series

The data is given on a quarterly basis, and let us first deseasonalise the series.

This is sales per quarter of dresses, in a fashion store.

Sales per quarter (‘000)

4Q total 4Qm. av. 4Q center % of

actual/mv

64,63 16, 15.75 15.875 56.7

62,63,63,65 15.5, 15.75, 15.625 and so on.

101
Year Q1 Q2 Q3 Q4 Then find modified mean from the % of actual
to trend. , and the adjustment factor by
1 16 21 9 18 dividing 400 by sum of the modified means.
2 15 20 10 18

3 17 24 13 22

4 17 25 11 21

5 18 26 14 25

Modified mean Q1=94.45; Q2= 129.05; Q3 =60.80; Q4= 113.15

Sum of modified mean= 397.45 Adjusting factor= 400/397.45 =1.0064

Multiplying the adjusting factor and modified mean, find the seasonal indices.

Seasonal indices are Q1=95.1; Q2= 129.9; Q3= 61.2; Q4 = 113.9

Then the deseasonalised sales value = (actual x seasonal index)/100

Deseasonalised sales:

Year Q1 Q2 Q3 Q4

1 16.8 16.2 14.7 15.8

2 15.8 15.4 16.3 15.8

3 17.9 18.5 21.2 19.3

4 17.9 19.2 18 18.4

5 18.9 20 22.9 21.9

Now the second step is to develop the trend line. Apply least squares method to
the de-seasonalized time series. Code the time series- we have 20 values i.e.,
20 time intervals. This is even number. Then to avoid fraction, multiply by 2.

Mean =0 . yr1 q1= -9.5, then -8.5 and so on.

Then they become; -19,-17,-15,+17,+19.

Mean Y = ∑y/n 360.9/20=18.0

∑x=0; ∑ xy=420.3; ∑ (x.x) = 2660; b= 420.3/ 2660 =0.16

102
a = mean y = 18

Trend line Y^= a+bx; Trend line = 18+0.16x

Now we have identified seasonal and trend components of the time series.

Calculate the trend values.

Next we have to find cyclical variation around the trend line.

Use the Residual method. Find the percent of trend.

Percent of trend = (deseasonalised value/ trend value) 100

If we assume irregular variation is generally short term and relatively

insignificant, then we have analysed this time series fully.

See the graph for the original time series, moving average containing both
seasonal and cyclical components and the trend line (deseasonalised).

Suppose if the management wants to determine the sales value for the 3rd
quarter of year 6, estimate the same.

First code the time of 3rd q. of yr 6 . code= 19+ (2x3) =25

Substituting this value, y^= a+ bx = 18+0.16(25) =22

Thus the deseasonalised estimate = 22,000 units.

Now, seasonalise this data by multiplying it by the third q. seasonal index.

22,000 (61.2/100) =135

2.1.5 Let us sum up

In statistics, there are four terms you will need to fully understand

 The Mean(average)
 The Median( middle most term)
 The Mode(the most frequent term)
Probability which is a natural progression once the 3 terms in statistics are
understood is the concept of probability

103
In statistics and probability theory, standard deviation (represented by the
symbol σ) shows how much variation or "dispersion" exists from the average
(mean, or expected value). A low standard deviation indicates that the data
points tend to be very close to the mean, whereas high standard deviation
indicates that the data points are spread out over a large range of values.

In the world of finance, correlation is a statistical measure of how two

securities/variables move in relation to each other. Regression is a statistical
measure that attempts to determine the strength of the relationship between
one dependent variable (usually denoted by Y) and a series of other changing
variables (known as independent variables).

To measure the degree of association between the 2 variables, we have 3

measures to describe this: Coefficient of correlation; Coefficient of
determination; Covariance.

Time series analysis comprises methods for analyzing time series data in order
to extract meaningful statistics and other characteristics of the data. Time
series forecasting is the use of a model to predict future values based on
previously observed values. There are 4 types of variations in time series:
Secular trend; Cyclical Fluctuation; Seasonal Variation; Irregular Variation

2.1.6 Key words/concepts

Mean, Median, Mode, Probability standard deviation, variation, dispersion,

correlation, Regression, Coefficient of correlation; Coefficient of determination ;
Covariance., Secular trend; Cyclical Fluctuation; Seasonal Variation; Irregular
Variation

2.1.7 Check your progress

1. When there is zero correlation between x and y, ( same values of y for

different values of x)

a. the coefficient of determination is 1 b. the coefficient of determination is -1

c. the coefficient of determination is 0 d. the coefficient of determination cannot
be determined

2. Find the mode of the data set :5, 17, 21, 21, 7, 13, 1, 3

a. 5 b. 17

104
c. 21 d. 3

3. If coefficient of determination is 0.81

a. then coefficient of correlation ‘r’ is +0.9 b. then coefficient of correlation ‘r’ is -0.9
c. then coefficient of correlation ‘r’ is a or d. then coefficient of correlation ‘r’ is
b +0.65

4. Which of the following is the best definition of standard deviation?

a. The mean squared deviation from the b. The average of a set of scores.
average.
c. The 'average' of the sum of squared d. The typical amount by which scores
deviations from the mean differ from the mean of a set of scores

5. Which of the following is true?

a. Standard deviation is the square root of b. Standard deviation is the 'average'

variance variance
c. Standard deviation is variance divided d. Standard deviation is the square of the
by N - 1. variance.

Key to check your progress

1. c 2. c 3. c
4. d 5.a

2.1.8 Terminal questions

 Define and explain the use of probability

 Explain the role of standard deviation in risk evaluation
 Define correlation and regression. What is the role of least square
method in cause and effect relationship
 Define the 4 trends in time series analysis

105
2.2 Lesson No.2 Bond Valuation

2.2.1 Objectives
2.2.2 Introduction
2.2.3 Bond theory
Issuer
Priority
Coupon Rate
Redemption Features
Pricing Zero-Coupon Bonds
2.2.3 Current Yield
2.2.3.1 Theorems
2.2.3.2 Bond theorems
2.2.3.3 Duration theorems
2.2.4 Calculating Yield to Maturity
2.2.5 Rate of Return
2.2.6 Rate of Return versus Yield To Maturity
2.2.7 Time value of Money
2.2.8 Risk
2.2.8.1 Interest Rate Risk
2.2.8.2 Default risk
2.2.9 Duration
2.2.9.1 Duration: Other factors
2.2.9.2 Macaulay Duration
2.2.9.3 Modified Duration
2.2.4 Let us sum up
2.2.5 Key words/concepts
2.2.6 Check your progress-questions
2.2.7 Terminal questions

106
2.2.1 Objectives

The objectives of this lesson are to understand certain features of Bond theory

 Yield to maturity
 Duration
 Time value of money
2.2.2 Introduction

2.2.2.1 Bond theory

A bond is simply a contract between a lender and a borrower by which the

borrower promises to repay a loan with interest. However, bonds can take on
many additional features and/or options that can complicate the way in which
prices and yields are calculated. The classification of a bond depends on the
type of issuer, priority, coupon rate and redemption features.

Issuer

As the major determiner of a bond's credit quality, the issuer is one of the most
important characteristics of a bond. There are significant differences between
bonds issued by corporations and those issued by a state
government/municipality or national government. In general, securities issued
by the central government have the lowest risk of default while corporate bonds
are considered to be riskier ventures. Of course there are always exceptions to
the rule. In rare instances, a very large and stable company could have a bond
rating that is better than that of a municipality/quasi government corporation.
It is important for us to point out, however, that like corporate bonds,
government bonds carry various levels of risk; because all national
governments are different, so are the bonds they issue.

Priority

In addition to the credit quality of the issuer, the priority of the bond is a
determiner of the probability that the issuer will pay you back your money. The
priority indicates your place in line should the company default on payments. If
you hold an unsubordinated (senior) security and the company defaults, you
will be first in line to receive payment from the liquidation of its assets. On the
other hand, if you own a subordinated (junior) debt security, you will get paid
out only after the senior debt holders have received their share.

107
Coupon Rate

Bond issuers may choose from a variety of types of coupons, or interest

payments. This payment is known as the coupon because most bonds used to
have coupons that the investors clipped off and mailed to the bond issuer to
claim the interest payment. At maturity, the debt is repaid: the borrower pays
the bondholder the bond’s face value (or par value), as it is generally issued at
a discount.

Straight, plain vanilla or fixed-rate bonds pay an absolute coupon rate over a
specified period of time. Upon maturity the last coupon payment is made along
with the par value of the bond.

Floating rate debt instruments or floaters pay a coupon rate that varies
according to the movement of the underlying benchmark. These types of
coupons could, however, be set to be a fixed percentage above, below, or equal
to the benchmark itself. Floaters typically follow benchmarks such as the
three, six or nine-month T-bill rate or LIBOR.

Inverse floaters pay a variable coupon rate that changes in direction opposite to
that of short-term interest rates. An inverse floater subtracts the benchmark
from a set coupon rate. For example, an inverse floater that uses LIBOR as the
underlying benchmark might pay a coupon rate of a certain percentage, say
1%, minus LIBOR.

Zero coupon or accrual bonds do not pay a coupon. Instead, these types of
bonds are issued at a deep discount and pay the full face value at maturity.

Redemption features

Both investors and issuers are exposed to interest rate risk because they are
locked into either receiving or paying a set coupon rate over a specified period
of time. For this reason, some bonds offer additional benefits to investors or
more flexibility for issuers:

Callable or a redeemable bond features gives a bond issuer the right, but not
the obligation, to redeem his/her bonds before the bond's maturity. The issuer,
however, must pay the bond holders a premium. There are two subcategories of
these types of bonds: American callable bonds and European callable bonds.
American callable bonds can be called by the issuer any time after the call
protection period while European callable bonds can be called by the issuer
only on pre-specified dates. The optimal time for issuers to call their bonds is
108
when the prevailing interest rate is lower than the coupon rate they are paying
on the bonds. After calling its bonds, the company could refinance its debt by
reissuing bonds at a lower coupon rate.

Convertible bonds give bondholders the right but not the obligation to convert
their bonds into a predetermined number of shares at predetermined dates
prior to the bond's maturity. Of course, this only applies to corporate bonds.

Puttable bonds give bondholders the right but not the obligation to sell their
bonds back to the issuer at a predetermined price and date. These bonds
generally protect investors from interest rate risk. If prevailing bond prices are
lower than the exercise par of the bond, resulting from interest rates being
higher than the bond's coupon rate, it is optimal for investors to sell their
bonds back to the issuer and reinvest their money at a higher interest rate.

Bonds can be priced at a premium, discount or at par. If the bond's price is

higher than its par value, it will sell at a premium because its interest rate is
higher than current prevailing rates. If the bond's price is lower than its par
value, the bond will sell at a discount because its interest rate is lower than
current prevailing interest rates. When you calculate the price of a bond, you
are calculating the maximum price you would want to pay for the bond, given
the bond's coupon rate in comparison to the average rate most investors are
currently receiving in the bond market. Required yield or required rate of
return is the interest rate that a security needs to offer in order to encourage
investors to purchase it. Usually the required yield on a bond is equal to or
greater than the current prevailing interest rates.

Fundamentally, however, the price of a bond is the sum of all expected coupon
payments plus the present value of the par value at maturity. Calculating bond
price is simple: all we are doing is discounting the known future cash flows.
Remember that to calculate present value (PV) - which is based on the
assumption that each payment is re-invested at some interest rate once it is
received--we have to know the interest rate that would earn us a known future
value. For bond pricing, this interest rate is the required yield.

Here is the formula for calculating a bond's price, which uses the basic present
value (PV) formula:

109
 C = coupon payment
n = number of payments
i = interest rate, or required yield or yield to
maturity(YTM)
M = value at maturity, or par value

The succession of coupon payments to be received in the future is referred to

as an ordinary annuity which is a series of fixed payments at set intervals over
a fixed period of time. By incorporating the annuity model into the bond pricing
formula, which requires us to also include the present value of the par value
received at maturity, we arrive at the following formula:

Pricing Zero-Coupon Bonds

So what happens when there are no coupon payments? For the aptly-named
zero-coupon bond, there is no coupon payment until maturity. Because of this,
the present value of annuity formula is unnecessary. You simply calculate the
present value of the par value at maturity. Here's a simple example:

Example 2(a): Let's look at how to calculate the price of a zero coupon
bond that is maturing in five years, has a par value of Rs.1,000 and a required
yield of 6%.

Plug the amounts into the formula:

Zero coupon bond price = M / (i+1)n

=1000/(1.03)10

=Rs. 744.09

110
You should note that zero-coupon bonds are always priced at a higher
discount: if zero-coupon bonds were sold at par, investors would have no way
of making money from them and therefore no incentive to buy them.

The general definition of yield is the return an investor will receive by holding a
bond to maturity. So if you want to know what your bond investment will earn,
you should know how to calculate yield. Required yield, on the other hand, is
the yield or return a bond must offer in order for it to be worthwhile for the
investor. The required yield of a bond is usually the yield offered by other plain
vanilla bonds that are currently offered in the market and have similar credit
quality and maturity.

2.2.3 Current yield

It is annual income (interest or dividends) divided by the current price of the

security. This measure looks at the current price of a bond instead of its face
value and represents the return an investor would expect if he or
she purchased the bond and held it for a year. This measure is not an accurate
reflection of the actual return that an investor will receive in all cases because
bond and stock prices are constantly changing due to market factors.

For example, if a bond is priced at 95.75 and has an annual coupon of 5.10,
the current yield of the bond is 5.33%. If the bond is a 10-year bond with nine
years remaining and you were only planning to hold it for one year, you would
receive the 5.10, but your actual return would depend on the bond's price
when you sold it. If, during this period, interest rates rose and the price of your
bond fell to 87.34, your actual return for the period would be -3.5% (-
3.31/95.75) because although you gained 5.10 in dividends, your capital loss
was 8.41.

Because it focuses only on current income and ignores prospective price

increases or decreases, the current yield mis-measures the bond’s total rate of
return. It overstates the return of premium bonds and under states that of
discount bonds.

111
2.2.3.1 Theorems

Bond Pricing Theorems: A Summary

I. Bond prices and yields move inversely.

II. As maturity approaches, bond prices converge towards their face value at
an increasing rate, other things held constant.
III. Changes in bond prices are not symmetrical for a given basis point
increase/decrease in YTM, other things constant.
IV. Lower coupon bonds are more sensitive to yield changes than higher
coupon bonds, other things held constant.
V. Longer maturity bonds are more sensitive to yield changes than shorter
maturity bonds, other things held constant.
Duration theorems: A Summary

I. The duration of a zero coupon bond always equals it’s time to maturity.
II. The lower the coupon rate the longer the duration, other things held
constant.
III. The longer the maturity, the longer the duration, other things held
constant.
IV. The lower the yield to maturity, the longer the duration, other things held
constant
2.2.4 Calculating Yield to Maturity

The current yield calculation we learned above shows us the return the annual
coupon payment gives the investor, but this percentage does not take into
account the time value of money or, more specifically, the present value of the
coupon payments the investor will receive in the future. For this reason, when
investors and analysts refer to yield, they are most often referring to the yield to
maturity (YTM), which is the interest rate by which the present values of all the
future cash flows are equal to the bond's price.

An easy way to think of YTM is to consider it the resulting interest rate the
investor receives if he or she invests all of his or her cash flows (coupons
payments) at a constant interest rate until the bond matures. YTM is the
return the investor will receive from his or her entire investment. It is the

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return that an investor gains by receiving the present values of the coupon
payments, the par value and capital gains in relation to the price that is paid.

The yield to maturity, however, is an interest rate that must be calculated

through trial and error. Such a method of valuation is complicated and can be
time consuming, so investors (whether professional or private) will typically use
a financial calculator or program that is quickly able to run through the
process of trial and error. If you don't have such a program, you can use an
approximation method that does not require any serious mathematics.

To demonstrate this method, we first need to review the relationship between a

bond's price and its yield. In general, as a bond's price increases, yield
decreases. This relationship is measured using the price value of a basis
point (PVBP). By taking into account factors such as the bond's coupon rate
and credit rating, the PVBP measures the degree to which a bond's price will
change when there is a 0.01% change in interest rates.

The charted relationship between bond price and required yield appears as a
negative curve:

This is due to the fact that a bond's price will be higher when it pays a coupon
that is higher than prevailing interest rates. As market interest rates increase,
bond prices decrease. The second concept we need to review is the basic price-
yield properties of bonds:

Premium bond: Coupon rate is greater than market interest rates.

Discount bond: Coupon rate is less than market interest rates.

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Thirdly, remember to think of YTM as the yield a bondholder receives if he or
she reinvested all coupons received at a constant interest rate, which is the
interest rate that we are solving for. If we were to add the present values of all
future cash flows, we would end up with the market value or purchase price of
the bond.

The yield to maturity is defined as the discount rate that makes the present
value of the bond’s payments equal to its price.

The calculation can be presented as:

Thus it is measure of the total return on this bond, accounting for both coupon
income and price change, for someone who buys the bond today and holds it
until maturity. Bond investors often refer loosely to a bond’s “yield”. They are
usually talking about its yield to maturity rather than its current yield.

When the interest rate rises, the present value of the payments to be
received by the bondholder falls, and bond prices fall. Conversely,
declines in the interest rate increase the present value of those payments
and result in higher prices.

People sometimes confuse the interest rate- that is, the return that investors
currently require- with the interest, or coupon, payment on the bond. Although
interest rates change from day to day, coupon payments on our treasury bonds
are fixed when the bond is issued. Changes in interest rate affect the present
value of the coupon payments but not the payments themselves.

2.2.5 Rate of return

When you invest in a bond, you receive a regular coupon payment. As bond
prices change, you may also make a capital gain or loss. For example, suppose
you buy the 6 percent Treasury bond today for a price of Rs. 1,010.77 and sell
it the next year at a price of Rs.1, 020. The return on your investment is the
Rs. 60/- coupon payment plus the price change of Rs.1020-1010.77= Rs.9.33.

The rate of return on your investment of Rs.1010.77p is

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Rate of Return = (coupon income + price change)/ Investment

= (Rs.60 + Rs. 9.33)/ 1010.77 = 0.686 or 6.86%

Because bond prices fall when market interest rates rise and rise when market
rates fall, the rate of return that you earn on a bond also will fluctuate with
market interest rates. This is why we say bonds are subject to interest rate
risk.

Do not confuse the bond’s rate of return over a particular investment period
with its yield to maturity. The yield to maturity is defined as the discount rate
that equates the bond’s price to the present value of all its promised cash
flows. It is a measure of the average rate of return you will earn over the bond’s
life if you it to maturity. In contrast, the rate of return can be calculated for any
particular holding period and is based on the actual income and the capital
gain or loss on the bond over that period. The difference between yield to
maturity and rate of return for a particular period is emphasized in the
following example.

2.2.6 Rate of return versus yield to maturity

Our six year coupon bond with maturity 2007 has 3 years left until maturity
and sells today for Rs.1010.77p. Its yield to maturity is 5.6%. Suppose that by
the end of the year, interest rates have fallen and the bond’s yield to maturity
is now only 4 percent. What will be the bond’s rate of return?

At the end of the year, the bond will have only two years to maturity. If
investors then demand an interest of 4 percent, the value of the bond will be

PV at 4 % = 60/ (1.04) + 1060/ (1.04) 2 = Rs. 1037.72p

You invested Rs. 1010.77p. At the end of the year, you receive a coupon
payment of Rs. 60/- and have a bond worth Rs. 1037.72p. Your rate of return
is therefore

Rate of return = (60 + (1037.72 -- 1010.77))/ 1010.77 = .0860 or 8.60 %

The yield to maturity at the start of the year was 5.6%. However, because
interest rates fell during the year, the bond price rose and this increased the
rate of return.

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Is there any connection between yield to maturity and the rate of return during
a particular period? Yes: If the bond’s yield to maturity remains unchanged
during an investment period, its rate of return will equal that yield.

2.2.7 Time value of money

Discount rates and present value are the tools of the concept of Time Value of
Money. The notion that a rupee today is preferable to the rupee tomorrow is the
essence of the concept. Present value is a concept which shows that money
has a time value. It is an intuitive and simple concept, simple to calculate and
can be applied in a wide range of situations in corporate finance. We can use
this concept in buying a house, saving for a child’s education, picking a project
or more complex situations like valuing a buyout of a company share.

A cash flow in the future is worth less than a similar cash flow today because

 People prefer present consumption to future consumption. People would

have to be offered more in the future to give up present consumption.
 Due to inflation the value of money/currency depreciates or erodes over
a period of time. This happens due to inflation. The greater the inflation
the greater is the erosion in the value of the rupee today and in the
future.
 Due to the uncertainty of receiving the cash flow in the future the value
of the cash flow in the future reduces further. This means there is a risk
associated with receiving the cash flow in future and this reduces the
value associated with the cash flow. The greater the risk the greater the
erosion in value.
2.2.8 Risk

2.2.8.1 Interest rate risk

We have seen that bond prices fluctuate as interest rates change. In other
words, bonds exhibit interest rate risk. Bond investors cross their fingers that
market interest rates will fall, so that the price of their bond will rise. If they
are unlucky and the market interest rate rises, the value of their investment
falls.

But all bonds are not equally affected by the changing interest rates. You can
see that a 30 year bond is more sensitive to interest rate fluctuations than the
3 year bond. This should not surprise you. If you buy a three year bond when

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the interest rate is 5.6% and the rates then rise, you will be stuck with a bad
deal- you have just loaned your money at a lower interest rate than if you had
waited. However, think how much worse it would be if the loan had been for 30
years rather than three years.

2.2.8.2 Default risk

Our focus has so far been on Government bonds. But Governments are not the
only issuers of bonds. State Governments and local bodies as well as
corporates issue bonds. Bonds can be issued in different currencies also.
Normally governments do not go bankrupt- they print more money, so we do
not perceive a default risk. However bonds issued by corporates have a default
risk in case the company is not able to repay the money. The risk that the bond
issuer may default on his/her obligations is called default risk (or credit risk).
Thus companies have to offer a higher interest rate in order to compensate for
the higher risk of non-payment. The difference in the yield of a government
bond and the corporate bond is called default premium or risk premium.
Usually bonds are rated for safety by a rating agency. Rating agencies in India
like CRISIL and ICRA perform this task.

2.2.9 Duration

The term duration has a special meaning in the context of bonds. It is a

measurement of how long, in years, it takes for the price of a bond to be repaid
by its internal cash flows. It is an important measure for investors to consider,
as bonds with higher durations carry more risk and have higher
price volatility than bonds with lower durations.

It is also a measure of the sensitivity of the price (the value of principal) of a

fixed-income investment to a change in interest rates. Duration is expressed as
a number of years. Rising interest rates mean falling bond prices, while
declining interest rates mean rising bond prices.
The duration number is a complicated calculation involving present value,
yield, coupon, final maturity and call features. Fortunately for investors, this
indicator is a standard data point provided in the presentation of
comprehensive bond and bond mutual fund information. The bigger the
duration number, the greater the interest-rate risk or reward for bond prices.

It is a common misconception among non-professional investors that bonds

and bond funds are risk free. They are not. Investors need to be aware of two
main risks that can affect a bond's investment value: credit risk (default) and
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interest rate risk (rate fluctuations). The duration indicator addresses the latter
issue.

For each of the two basic types of bonds the duration is the following:

1. Zero-Coupon Bond – Duration is equal to its time to maturity.

2. Vanilla Bond - Duration will always be less than its time to maturity.

Let's first work through some visual models that demonstrate the properties of
duration for a zero-coupon bond and a vanilla bond.

2.2.9.1 Duration: other factors

Besides the movement of time and the payment of coupons, there are other
factors that affect a bond's duration: the coupon rate and its yield. Bonds with
high coupon rates and, in turn, high yields will tend to have lower durations
than bonds that pay low coupon rates or offer low yields. This makes empirical
sense, because when a bond pays a higher coupon rate or has a high yield, the
holder of the security receives repayment for the security at a faster rate.

2.2.9.2 Macaulay duration

The formula usually used to calculate a bond's basic duration is the Macaulay
duration, which was created by Frederick Macaulay in 1938, although it was
not commonly used until the 1970s. Macaulay duration is calculated by adding
the results of multiplying the present value of each cash flow by the time it is
received and dividing by the total price of the security. The formula for
Macaulay duration is as follows:

n = number of cash flows

t = time to maturity
C = cash flow
i = required yield
M = maturity (par) value
P = bond price

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Remember that bond price equals:

So the following is an expanded version of Macaulay duration:

Example 1: Betty holds a five-year bond with a par value of $1,000 and coupon
rate of 5%. For simplicity, let's assume that the coupon is paid annually and
that interest rates are 5%. What is the Macaulay duration of the bond?

= 4.55 years

2.2.9.3 Modified duration

Modified duration is a modified version of the Macaulay model that accounts

for changing interest rates. Because they affect yield, fluctuating interest rates
will affect duration, so this modified formula shows how much the duration
changes for each percentage change in yield. For bonds without any embedded
features, bond price and interest rate move in opposite directions, so there is
an inverse relationship between modified duration and an approximate 1%

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change in yield. Because the modified duration formula shows how a bond's
duration changes in relation to interest rate movements, the formula is
appropriate for investors wishing to measure the volatility of a particular bond.
Modified duration is calculated as the following:

OR

Let's continue to analyze Betty's bond and run through the calculation of her
modified duration. Currently her bond is selling at $1,000, or par, which
translates to a yield to maturity of 5%. Remember that we calculated Macaulay
duration of 4.55.

= 4.33 years

Our example shows that if the bond's yield changed from 5% to 6%, the
duration of the bond will decline to 4.33 years. Because it calculates how
duration will change when interest increases by 100 basis points, the modified
duration will always be lower than the Macaulay duration.

2.2.10 Let us sum up

A bond is simply a contract between a lender and a borrower by which the

borrower promises to repay a loan with interest. However, bonds can take on
many additional features and/or options that can complicate the way in which
prices and yields are calculated. The classification of a bond depends on its
type of issuer, priority, coupon rate and redemption features. Bonds can be

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priced at a premium discount or at par. If the bond's price is higher than its
par value, it will sell at a premium because its interest rate is higher than
current prevailing rates. If the bond's price is lower than its par value, the bond
will sell at a discount because its interest rate is lower than current prevailing
interest rates.

The general definition of yield is the return an investor will receive by holding a
bond to maturity. Yield to maturity (YTM), which is the interest rate by which
the present values of all the future cash flows are equal to the bond's price.

Because bond prices fall when market interest rates rise and rise when market
rates fall, the rate of return that you earn on a bond also will fluctuate with
market interest rates. This is why we say bonds are subject to interest rate
risk. Bonds issued by corporations have a default risk in case the company is
not able to repay the money. The risk that the bond issuer may default on
his/her obligations is called default risk. The term duration has a special
meaning in the context of bonds. It is a measurement of how long, in years, it
takes for the price of a bond to be repaid by its internal cash flows. It is an
important measure for investors to consider, as bonds with higher durations
carry more risk and have higher price volatility than bonds with lower
durations.

2.2.11 Key words/concepts

Bond; interest; coupon rate; redemption; yield to maturity (YTM); current yield;
zero coupon; interest rate risk; default risk; durations.

2.2.12 Check your progress

1. The ________ is used to calculate the present value of a bond.

a. Nominal yield b. Current yield

c. Yield to maturity d. Yield to call

2. Consider a 5-year bond with a 10% coupon that has a present yield to
maturity of 8%. If interest rates remain constant, one year from now the
price of this bond will be _______.

a. Higher b. Lower
c. Same d. Cannot be determined

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 3. If a 9% coupon bond (FV, 100) that pays interest every 182 days paid
interest 112 days ago, the accrued interest would be

a. 27.69 b. 27.35
c. 26.52 d. 25.68

4. A bond will sell at a discount when __________.

a. the coupon rate is greater than the b. the coupon rate is greater than yield to
current yield and the current yield is maturity
greater than yield to maturity
c. the coupon rate is less than the current d. the coupon rate is less than the current
yield and the current yield is greater than yield and the current yield is less than
the yield to maturity yield to maturity

5. The present price of a share is Rs. 150. The economic state is as follows

Economy Probability Price

Growth 0.7 180

Recession 0.3 120

Calculate the expected return for the stock

a. 12% b. 13%
c. 8% d. 7%

Key to check your progress

1.c 2.b 3.a

4.d 5.c

2.2.13 Terminal questions

 Explain the various characteristics of a bond.

 Explain current yield, YTM, rate of return, coupon rate.
 Define duration of a bond, describe the duration theorems.
 What are the risks in a bond investment?

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2.3 Lesson No.3 Interest Rate Calculation

2.3.1 Objectives
2.3.2 Interest Rate
2.3.2.1 Real Vs Nominal Interest Rates
2.3.3 Market Interest Rates
2.3.4 Risk
2.3.5 Interest Rate Calculation
2.3.6 Types of Interest Rates
2.3.6.1 Fixed Interest Rate
2.3.6.2 Floating Interest Rate
2.3.6.3 Choice between Fixed and Floating Interest Rates
2.3.7 Equated Monthly Installment – EMI
2.3.8 Let us sum up
2.3.9 Key words/ concepts
2.3.10 Check your progress-questions
2.3.11 Terminal questions

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2.3.1 Objectives

Objectives of this lesson are to understand

 Types of Interest rates

 Fixed/floating rates
 EMI
2.3.2 Introduction-Interest Rate

The amount charged, expressed as a percentage of principal, by a lender to a

borrower for the use of assets. Interest rates are typically noted on an annual
basis, known as the Annual Percentage Rate (APR). The assets borrowed could
include, cash, consumer goods and large assets, such as a vehicle or building.
Interest is essentially a rental, or leasing charge to the borrower, for the asset's
use. In the case of a large asset, like a vehicle or building, the interest rate is
sometimes known as the “lease rate”.

When the borrower is a low risk party, they will usually be charged a low
interest rate; if the borrower is considered high risk, the interest rate that they
are charged will be higher. Interest is charged by lenders as compensation for
the loss of the asset's use. In the case of lending money, the lender could have
invested the funds instead of lending them out. With lending a large asset, the
lender may have been able to generate income from the asset should they have
decided to use it themselves.

In the past two centuries, interest rates have been variously set either by
national governments or central banks. Interest rates targets are also a vital
tool of monetary policy and are taken into account when dealing with variables
like investment, inflation and unemployment.

Reasons for interest rate change

Political short-term gain: Lowering interest rates can give the economy a
short-run boost. Under normal conditions, most economists think a cut in
interest rates will only give a short term gain in economic activity that will soon
be offset by inflation. The quick boost can influence elections. Most economists
advocate independent central banks to limit the influence of politics on interest
rates.

Deferred consumption: When money is loaned the lender delays spending the
money on consumption goods. Since according to time preference theory people
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prefer goods now to goods later, in a free market there will be a positive interest
rate.

Inflationary expectations: Most economies generally exhibit inflation,

meaning a given amount of money buys fewer goods in the future than it will
now. The borrower needs to compensate the lender for this.

Alternative investments: The lender has a choice between using his/her money
in different investments. If he/she chooses one, he/she forgoes the returns
from all the others. Different investments effectively compete for funds.

Risks of investment: There is always a risk that the borrower will

go bankrupt, abscond, die, or otherwise default on the loan. This means that a
lender generally charges a risk premium to ensure that, across his/her
investments, he / she is compensated for those that fail.

Liquidity preference: People prefer to have their resources available in a form

that can immediately be exchanged, rather than a form that takes time or
money to realize.

Taxes: Because some of the gains from interest may be subject to taxes, the
lender may insist on a higher rate to make up for this loss.

2.3.2.1 Real Vs Nominal interest rates

The nominal interest rate is the amount, in percentage terms, of interest

payable.

For example, suppose a household deposits Rs.100 with a bank for 1 year and
they receive interest of Rs. 10. At the end of the year their balance is Rs. 110.
In this case, the nominal interest rate is 10% per annum.

The real interest rate, which measures the purchasing power of interest
receipts, is calculated by adjusting the nominal rate charged to take inflation
into account. If inflation in the economy has been 10% in the year, then the Rs.
110 in the account at the end of the year buys the same amount as the Rs.100
did a year ago. The real interest rate, in this case, is zero.

i = r + π (1 + r)

nominal interest rate = i

rate of inflation = π

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real interest rate = r.

2.3.3 Market interest rates

There is a market for investments which ultimately includes the money, bond,
stock and currency market as well as retail financial institutions like banks.
Exactly how these markets function are sometimes complicated. However,
economists generally agree that the interest rates yielded by any investment
take into account:

 The risk-free cost of capital

 Inflationary expectations
 The level of risk in the investment
 The costs of the transaction
This rate incorporates the deferred consumption and alternative
investments elements of interest.

2.3.4 Risk

The level of risk in investments is taken into consideration. This is why

very volatile investments like shares and junk bonds have higher returns than
safer ones like government bonds. The extra interest charged on a risky
investment is the risk premium. The required risk premium is dependent on
the risk preferences of the lender.

If an investment is 50% likely to go bankrupt, a risk neutral lender will require

their returns to double. So for an investment normally returning 100 they
would require 200 back. A risk averse lender would require more than 200
back and a risk loving lender less than 200. Evidence suggests that most
lenders are in fact risk-averse.

Generally speaking a longer-term investment carries a maturity risk premium,

because long-term loans are exposed to more risk of default during their
duration.

2.3.5 Interest rate calculation

Interest rate calculation is basically of two types. One which is flat rate (simple)
and the other is cumulative (compound).

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Using the simple interest formula:

Simple Interest = P (principal) x I (annual interest rate) x N (years) Borrowing

1,000 at a 6% annual interest rate for 8 months means that you would owe 40
in interest (1000 x 6% x 8/12).

Using the compound interest formula:

Compound interest = P (principal) x [(1 + I (interest rate) N (months)) - 1]

Borrowing 1,000 at a 6% annual interest rate for 8 months means that you
would owe 40.70.
The interest owed when compounding is taken into consideration is higher,
because interest has been charged monthly on the principal + accrued
interest from the previous months. For shorter time frames, the calculation of
interest will be similar for both methods. As the lending time increases,
though, the Disparity between the two types of interest calculations grows.
2.3.6 Types of interest rates

The interest rate to be paid on a loan/debt can be of two broad types:

 Fixed Interest Rate

 Floating Interest Rate
2.3.6.1 Fixed interest rate

In fixed interest rate the interest to be paid is fixed in advance when taking the
loan/debt. Thus the borrower knows the exact amount he/she needs to pay in
the future or at least he/she knows the exact interest rate to pay for the
outstanding loan at that time. For example, if a person borrows money at fixed
interest rate of 10% per annum for five years, then he/she would need to pay
an interest of 10% on the outstanding principal every year. Fixed interest rate
is beneficial for a person who would like to know his / her future cash outflows
in advance and plan accordingly.

One thing to keep in mind for fixed interest rate is that it is not necessary that
the interest rate remains same for the whole period of borrowing. The interest
rate just needs to be fixed and known in advance. For example a person may

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borrow Rs. 10,000 for three years at an interest rate of 5% for first year, 6% for
second year and 7% for third year. These rates are fixed in advance.

2.3.6.2 Floating interest rate

In case of floating Interest rate, the Interest rate is not determined while
borrowing/lending, but is dependent on some underlying. For example, a
person may borrow 10,000 at an Interest rate of LIBOR + 1% per annum.
LIBOR is the London Inter Bank Offered Rate, i.e. the Interest rate at which the
banks are ready to borrow money. This rate keeps on changing on a per day
basis and thus the interest rate at which the person borrowed would keep on
changing. However, the change is not made on a daily basis but is done once a
year/six months and the interest rate is thus fixed till the next update.

The calculation of the fixed Interest rate is actually based on the future
expectation of the floating rate and the loans are issued in a manner that the
present value of the loan at fixed interest rate is same as the 'expected' present
value of the loan at floating interest rate, other things being same. The
expected floating rates are published by many agencies, which aid in this
calculation.

By taking a floating Interest rate both the borrower and the lender are exposed
to a certain degree of risk. If the future interest rates turn out to be lower than
the expected interest rates, then the borrower will benefit, since she would
have to pay lower than if she would have chosen fixed interest rate. In the
other case, the lender will benefit.

2.3.6.3 Choice between fixed and floating interest rates

Investor: If you are an informed investor and hold a view on the future interest
rates which is different from the market, there is merit in opting one strategy
over the other for making monetary gains. For example, if you feel that future
interest rates are going to be higher that what are being projected by analysts,
there is a chance to make money by lending at floating rate and borrowing at
fixed rate. The present value of all cash and loans at the floating rate according
to your views would be higher than that of all cash and loans at fixed rate and
you would thus end up making money. On the other hand, if you feel that the
interest rates are going to be lower than expected, there is merit in borrowing
at floating rate and lending at fixed rate.

Personal loans: If you are borrowing for personal usage and are not aware of
the market dynamics, it is safer to opt for fixed interest loans since you would
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be aware of the interest rates to be paid in coming years in advance and would
be protected against sudden rise in the same. However, if you have a good
appetite for risk and have a view that interest rates are likely to fall, then
opting for a floating rate loan is not a bad strategy.

The term Annuity is used in finance theory this is to refer to any terminating
stream of fixed payments over a specified period of time. This usage is most
commonly seen in discussions of finance, usually in connection with the
valuation of the stream of payments, taking into account time value of money
concepts such as interest rate and future value.

Examples of annuities are regular deposits to a savings account, monthly home

mortgage payments and monthly insurance payments. Annuities are classified
by the frequency of payment dates. The payments (deposits) may be made
weekly, monthly, quarterly, yearly, or at any other interval of time.

2.3.7 Equated Monthly Installment - EMI

It is a fixed payment amount made by a borrower to a lender at a specified date

each calendar month. Equated monthly installments are used to pay off both
interest and principal each month, so that over a specified number of years,
the loan is paid off in full. In the initial years the interest is higher and the loan
component is lower than in the subsequent years.

With most common types of loans, such as real estate mortgages, the borrower
makes fixed periodic payments to the lender over the course of several years
with the goal of retiring the loan. EMIs differ from variable payment plans, in
which the borrower is able to pay higher payment amounts at his or
her discretion. In EMI plans, borrowers are usually only allowed one fixed
payment amount each month.

The benefit of an EMI for borrowers is that they know precisely how much
money they will need to pay toward their loan each month, making the
personal budgeting process easier.

This is the formula to calculate:

E = P × r × (1 + r)n/((1 + r)n - 1)

E is EMI ; where P is Principal Loan Amount;

r is rate of interest calculated on monthly basis, It should be = Rate of Annual

interest/12/100.
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If it is 10% annual, then it is 10/12/100=0.00833;

n is tenure in number of months.

2.3.8 Let us sum up

Interest is the amount charged, expressed as a percentage of principal, by a

lender to a borrower for the use of assets. Interest rate change because of
Political short-term gain; Deferred consumption; Inflationary expectations;
Alternative investment; Risks of investment; Liquidity preference; Taxes.

The nominal interest rate is the amount, in percentage terms, of interest

payable.

The real interest rate, which measures the purchasing power of interest
receipts, is calculated by adjusting the nominal rate charged to
take inflation into account.

The extra interest charged on a risky investment is the risk premium.

Interest rate calculation is basically of two types. One which is flat rate (simple)
and the other is cumulative (compound).

The interest rate to be paid on a loan/debt can be of two broad types:

Fixed Interest Rate

Floating Interest Rate

In case of fixed interest the interest to be paid is fixed in advance when taking
the loan/debt In case of floating Interest rate, the Interest rate is not
determined while borrowing/lending, but is dependent on some underlying.

Equated Monthly Installment - EMI

Equated monthly installments are used to pay off both interest and principal
each month, so that over a specified number of years, the loan is paid off in
full. In the initial years the interest is higher and the loan component is lower
than in the subsequent years.

It is a fixed payment amount made by a borrower to a lender at a specified date

each calendar month.

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2.3.9 Key words/concepts

Interest; nominal interest rate; real interest rate; inflation; risk premium; Fixed
Interest Rate; Floating Interest Rate; Equated Monthly Installment

2.3.10 Check your progress

1. Rs. 100 invested for 5 years at 10% will yield

a. Rs. 161.05 b. Rs. 165.00

c. Rs. 162.25 d. Rs 150.00

2. As compounding becomes less frequent then the effective rate

a. Increases b. Decreases
c. Does not change d. Change is marginal

3. If 9000 is borrowed for three years, principal repayable equal

installment. And interest rate is 5% 6% 7% for each of the 3 years. What
is the total interest paid?

a. 1,020 b.920
c. 1,050 d. 1,000

4. The formula for EMI is

a. E = P × r × (1 + r)n/((1 + r)n - 1) b. E = P × r × (1 + r)n/((1 + r)n + 1)

c. E = P × r × (1 - r)n/((1 + r)n + 1) d. E = P × r × (1 + r)n*((1 + r)n - 1)

where P is Principle Loan Amount, r is rate of interest, n is the number of

periods

5. While EMI is a constant figure one of the following is true

a. In the initial years the interest is higher b. In the initial years the interest is lower
and the loan component is lower than in and the loan component is higher than in
the subsequent years. the subsequent years.
c. In the initial years the interest is higher d. In the initial years the interest is lower
and the loan component is higher than in and the loan component is lower than in
the subsequent years. the subsequent years.

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Key to check your progress

1.a 2.b 3.a

4.a 5.a

2.3.11 Terminal questions

 What is interest rate? State the reasons for change in the rates.
 Distinguish between simple and compound interest rates.
 Under what conditions does one opt for fixed or floating rate of interest?
 What is EMI? Explain the movement of principal and interest over the
duration of a loan.

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2.4 Lesson No. 8 Sampling

2.4.1 Objectives

2.4.2 Sampling

2.4.2.1Types of sampling

2.4.3 Data collection methods

2.4.4 Classification

2.4.4.1 Data preparation, interpretation and analysis

2.4.5 Association, causation, and confounding

2.4.6 Short- and long-term outcome

2.4.7Let us sum up

2.4.8 Key words/concepts

2.4.9 Check your progress

2.4.10 Terminal questions

2.4.11 Bibliography and reference books for further reading

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2.4.1 Objectives

The objectives of this lesson are to understand:

 Types of sampling
 Classification of data
 Analysis
2.4.2 Introduction-Sampling

In statistics and survey methodology, sampling is concerned with the selection

of a subset of individuals from within a population to estimate characteristics
of the whole population.

Researchers rarely survey the entire population because the cost of a census is
too high. The three main advantages of sampling are that the cost is lower,
data collection is faster, and since the data set is smaller it is possible to
ensure homogeneity and to improve the accuracy and quality of the data.

Each observation measures one or more properties (such as weight, location,

color) of observable bodies distinguished as independent objects or individuals.
In survey sampling, weights can be applied to the data to adjust for the sample
design, particularly stratified sampling. Results from probability theory and
statistical theory are employed to guide practice. In business and medical
research, sampling is widely used for gathering information about a
population.

It is incumbent on the researcher to clearly define the target population. There

are no strict rules to follow, and the researcher must rely on logic and
judgment. The population is defined in keeping with the objectives of the study.
Sometimes, the entire population will be sufficiently small, and the researcher
can include the entire population in the study. This type of research is called a
census study because data is gathered on every member of the population.
Usually, the population is too large for the researcher to attempt to survey all
of its members. A small, but carefully chosen sample can be used to represent
the population. The sample reflects the characteristics of the population from
which it is drawn.

Sampling methods are classified as either probability or non-probability. In

probability samples, each member of the population has a known non-zero
probability of being selected. Probability methods include random sampling,

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systematic sampling, and stratified sampling. In non-probability sampling,
members are selected from the population in some nonrandom manner. These
include convenience sampling, judgment sampling, quota sampling, and
snowball sampling. The advantage of probability sampling is that sampling
error can be calculated. Sampling error is the degree to which a sample might
differ from the population. When inferring to the population, results are
reported plus or minus the sampling error. In non-probability sampling, the
degree to which the sample differs from the population remains unknown.

2.4.2.1 Types of sampling

Random sampling is the purest form of probability sampling. Each member of

the population has an equal and known chance of being selected. When there
are very large populations, it is often difficult or impossible to identify every
member of the population, so the pool of available subjects becomes biased.

Systematic sampling is often used instead of random sampling. It is also

called an Nth name selection technique. After the required sample size has
been calculated, every Nth record is selected from a list of population members.
As long as the list does not contain any hidden order, this sampling method is
as good as the random sampling method. Its only advantage over the random
sampling technique is simplicity. Systematic sampling is frequently used to
select a specified number of records from a computer file.

Stratified sampling is commonly used probability method that is superior to

random sampling because it reduces sampling error. A stratum is a subset of
the population that share at least one common characteristic. Examples of
stratums might be males and females, or managers and non-managers. The
researcher first identifies the relevant stratums and their actual representation
in the population. Random sampling is then used to select a sufficient number
of subjects from each stratum. "Sufficient" refers to a sample size large enough
for us to be reasonably confident that the stratum represents the population.
Stratified sampling is often used when one or more of the stratums in the
population have a low incidence relative to the other stratums.

Convenience sampling is used in exploratory research where the researcher is

interested in getting an inexpensive approximation of the truth. As the name
implies, the sample is selected because they are convenient. This non-
probability method is often used during preliminary research efforts to get a
gross estimate of the results, without incurring the cost or time required to
select a random sample.
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Judgment sampling is a common non-probability method. The researcher
selects the sample based on judgment. This is usually an extension of
convenience sampling. For example, a researcher may decide to draw the entire
sample from one "representative" city, even though the population includes all
cities. When using this method, the researcher must be confident that the
chosen sample is truly representative of the entire population.

Quota sampling is the non-probability equivalent of stratified sampling. Like

stratified sampling, the researcher first identifies the stratums and their
proportions as they are represented in the population. Then convenience or
judgment sampling is used to select the required number of subjects from each
stratum. This differs from stratified sampling, where the stratums are filled by
random sampling.

Snowball sampling is a special non-probability method used when the desired

sample characteristic is rare. It may be extremely difficult or cost prohibitive to
locate respondents in these situations. Snowball sampling relies on referrals
from initial subjects to generate additional subjects. While this technique can
dramatically lower search costs, it comes at the expense of introducing bias
because the technique itself reduces the likelihood that the sample will
represent a good cross section from the population.

2.4.3 Data collection methods

There are four main methods of data collection.

Census: A census is a study that obtains data from every member of

a population. In most studies, a census is not practical, because of the cost
and/or time required.

Sample survey: A sample survey is a study that obtains data from a subset of
a population, in order to estimate population attributes.

Experiment: An experiment is a controlled study in which the researcher

attempts to understand cause-and-effect relationships. The study is
"controlled" in the sense that the researcher controls (1) how subjects are
assigned to groups and (2) which treatments each group receives.

In the analysis phase, the researcher compares group scores on

some dependent variable Based on the analysis; the researcher draws a
conclusion about whether the treatment (independent variable) had a causal
effect on the dependent variable.
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Observational study: Like experiments, observational studies attempt to
understand cause-and-effect relationships. However, unlike experiments, the
researcher is not able to control (1) how subjects are assigned to groups and/or
(2) which treatments each group receives.

Each method of data collection has advantages and disadvantages.

Resources: When the population is large, a sample survey has a big resource
advantage over a census. A well-designed sample survey can provide very
precise estimates of population parameters - quicker, cheaper, and with less
manpower than a census.

Generalizability: Generalizability refers to the appropriateness of applying

findings from a study to a larger population. Generalizability requires random
selection. If participants in a study are randomly selected from a larger
population, it is appropriate to generalize study results to the larger
population; if not, it is not appropriate to generalize.
Observational studies do not feature random selection; so generalizing from the
results of an observational study to a larger population can be a problem.

Causal inference: Cause-and-effect relationships can be teased out when

subjects are randomly assigned to groups. Therefore, experiments, which allow
the researcher to control assignment of subjects to treatment groups, are the
best method for investigating causal relationships.

2.4.4 Classification

Classification is the way of arranging the data in different classes in order to

give a definite form and a coherent structure to the data collected, facilitating
their use in the most systematic and effective manner. It is the process of
grouping the statistical data under various understandable homogeneous
groups for the purpose of convenient interpretation. A uniformity of attributes
is the basis criterion for classification; and the grouping of data is made
according to similarity. Classification becomes necessary when there is
diversity in the data collected for meaningful presentation and analysis.
However, in respect of homogeneous presentation of data, classification may be
unnecessary.

Objectives of classification of data

 To group heterogeneous data under the homogeneous group of common

characteristics;
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  To facility similarity of various group;
 To facilitate effective comparison;
 To present complex, haphazard and scattered dates in a concise, logical,
homogeneous, and intelligible form;
 To maintain clarity and simplicity of complex data;
 To identify independent and dependent variables and establish their
relationship;
 To establish a cohesive nature for the diverse data for effective and
logical analysis;
 To make logical and effective quantification
A good classification should have the characteristics of clarity, homogeneity,
and equality of scale, purposefulness, accuracy, stability, flexibility, and
unambiguity.

Classification is of two types, viz., quantitative classification, which is on the

basis of variables or quantity; and qualitative classification (classification
according to attributes). The former is the way of grouping the variables, say
quantifying the variables in cohesive groups, while the latter group the data on
the basis of attributes or qualities. Again, it may be multiple classification or
dichotomous classification. The former is the way of making many (more than
two) groups on the basis of some quality or attributes, while the latter is the
classification into two groups on the basis of the presence or absence of a
certain quality. Grouping the workers of a factory under various income (class
intervals) groups comes under multiple classifications; and making two groups
into skilled workers and unskilled workers is dichotomous classification. The
tabular form of such classification is known as statistical series, which may be
inclusive or exclusive.

The classified data may be arranged in tabular forms (tables) in columns and
rows. Tabulation is the simplest way of arranging the data, so that anybody
can understand it in the easiest way. It is the most systematic way of
presenting numerical data in an easily understandable form. It facilitates a
clear and simple presentation of the data, a clear expression of the implication,
and an easier and more convenient comparison. There can be simple or
complex tables, and general purpose or summary tables. Classification and
tabulation are interdependent events in a research.

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2.4.4.1 Data preparation, interpretation and analysis

The purpose of the data analysis and interpretation phase is to transform the
data collected into credible evidence about the development of the intervention
and its performance.

Analysis can help answer some key questions:

 Has the program made a difference?

 How big is this difference or change in knowledge, attitudes, or behavior?
This process usually includes the following steps:

 Organizing the data for analysis (data preparation)

 Describing the data
 Interpreting the data (assessing the findings against the adopted
evaluation criteria)
Where quantitative data have been collected, statistical analysis can:

 help measure the degree of change that has taken place

 allow an assessment to be made about the consistency of data
Where qualitative data have been collected, interpretation is more difficult.

 Here, it is important to group similar responses into categories and

identify common patterns that can help derive meaning from what may
seem unrelated and diffuse responses.
 This is particularly important when trying to assess the outcomes of
focus groups and interviews.
It may be helpful to use several of the following 5 evaluation criteria as the
basis for organizing and analyzing data:

Relevance: Does the intervention address an existing need? (Were the

outcomes achieved aligned to current priorities in prevention? Is the outcome
the best one for the target group—e.g., did the program take place in the area
or the kind of setting where exposure is the greatest?)

Effectiveness: Did the intervention achieve what it was set out to achieve?

Efficiency: Did the intervention achieve maximum results with given

resources?
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Results/Impact: Have there been any changes in the target group as a result
of the intervention?

Sustainability: Will the outcomes continue after the intervention has ceased?

Particularly in outcomes-based and impact-based evaluations, the focus on

impact and sustainability can be further refined by aligning data around the
interventions

Extent: How many of the key stakeholders identified were eventually covered,
and to what degree have they absorbed the outcome of the program? Were the
optimal groups/people involved in the program?

Duration: Was the project’s timing appropriate? Did it last long enough? Was
the repetition of the project’s components (if done) useful? Were the outcomes
sustainable?

2.4.5 Association, causation, and confounding

One of the most important issues in interpreting research findings understands

how outcomes relate to the intervention that is being evaluated. This involves
making the distinction between association and causation and the role that
can be played by confounding factors in skewing the evidence.

Association

An association exists when one event is more likely to occur because another
event has taken place. However, although the two events may be associated,
one does not necessarily cause the other; the second event can still occur
independently of the first.

For example, some research supports an association between certain patterns

of drinking and the incidence of violence. However, even though harmful
drinking and violent behavior may co-occur, there is no evidence showing that
it is drinking that causes violence.

Causation

A causal relationship exists when one event (cause) is necessary for a second
event (effect) to occur. The order in which the two occur is also critical. For
example, for intoxication to occur, there must be heavy drinking, which
precedes intoxication.

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Determining cause and effect is an important function of evaluation, but it is
also a major challenge. Causation can be complex:

 Some causes may be necessary for an effect to be observed, but may not
be sufficient; other factors may also be needed.
 Or, while one cause may result in a particular outcome, other causes
may have the same effect.
Being able to correctly attribute causation is critical, particularly when
conducting an evaluation and interpreting the findings.

Confounding

To rule out that a relationship between two events has been distorted by other,
external factors, it is necessary to control for confounding. Confounding factors
may actually be the reason we see particular outcomes, which may have
nothing to do with what is being measured.

To rule out confounding, additional information must be gathered and

analyzed. This includes any information that can possibly influence
outcomes.

When evaluating the impact of a prevention program on a particular behavior,

we must know whether the program may have coincided with any of the
following:

 Other concurrent prevention initiatives and campaigns

 New legislation or regulations in relevant areas
 Relevant changes in law enforcement
For example, when mounting a campaign against alcohol-impaired driving, it is
important to know whether other interventions aimed at road traffic safety are
being undertaken at the same time. Similarly, if the campaign coincides with
tighter regulations around BAC limits and with increased enforcement and
roadside testing by police, it would be difficult to say whether any drop in the
rate of drunk-driving crashes was attributable to the campaign or to these
other measures.

Addressing possible confounders is an important element for proper

interpretation of results.

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  However, it is often impossible to rule out entirely the influence of
confounders.
 Care must be taken not to misinterpret the results of an evaluation and
to avoid exaggerated or unwarranted claims of effectiveness. This will
inevitably lead to loss of credibility.
 Any potential confounders should be openly acknowledged in the
analysis of the evaluation results.
 It is important to state all results in a clear and unambiguous way so
that they are easy to interpret.
2.4.6 Short- and long-term outcome

The outcomes resulting from an intervention may be seen in a number of

different areas, including changes in skills, attitudes, knowledge, or behaviors.

 ·Outcomes require time to develop. As a result, while some are likely to

become apparent in the short term, immediately following an
intervention, others may not be obvious until time has passed.
 It is often of interest to see whether short-term outcomes will continue to
persist over the medium- and long-term.
Evaluators should try to address short-, medium-, and long-term outcomes of
an intervention separately.

 If the design of a program allows, it is desirable to be able to monitor

whether its impact is sustained beyond the short term.
 Care should be taken to apply an intervention over a sufficiently long
period of time so that outcomes (and impact) can be observed and
measured.
Short- and long-term outcomes can be measured by using different
methodologies for collecting data.

 Cross-sectional studies involve measurement at a single point in time

after the intervention has been applied and allow short-term results to be
measured
 Longitudinal study designs, on the other hand, follow progress over
longer periods and allow measurements to be taken at two or more
different points in time. They can help assess outcomes into the medium-
and long-term
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Unfortunately, the reality is that, for most projects, resources and time frames
available are likely to allow only for the measurement of short- and perhaps
medium-term outcomes.

Providing the proper context

Interpreting results is only possible in the proper context. This includes

knowing what outcomes one can reasonably expect from implementing a
particular intervention based on similar interventions that have been
conducted previously.

For instance, when setting up a server training program, it is useful to know

that such interventions have in the past helped reduce the incidence of
violence in bars.

Therefore, once the intervention is over, if the results are at odds with what
others have observed, it is likely that the program was not implemented
correctly.

2.4.7 Let us sum up

Sampling is concerned with the selection of a subset of individuals from within

a population to estimate characteristics of the whole population.

Types of sampling includes:

Random sampling ;Systematic sampling ;Stratified sampling ;Convenience

sampling ;Judgment sampling ;Quota sampling ;Snowball sampling

There are four main methods of data collection viz. Census; Sample survey;
Experiment; Observational study

Classification is the way of arranging the data in different classes in order to

give a definite form and a coherent structure to the data collected, facilitating
their use in the most systematic and effective manner. It is the process of
grouping the statistical data under various understandable homogeneous
groups for the purpose of convenient interpretation.

The purpose of the data analysis and interpretation phase is to transform the
data collected into credible evidence about the development of the intervention
and its performance.

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2.4.8 Key words/concepts

Sampling; Classification; Census; Sample survey; Experiment; Observational

study; Random sampling ; Systematic sampling ; Stratified sampling ;
Convenience sampling ; Judgment sampling ; Quota sampling ; Snowball
sampling; Association; Causation; Confounding

2.4.9 Check your progress

1. When each member of a population has an equally likely chance of being

selected, this is called:

a. A nonrandom sampling method b. A quota sample

c. A snowball sample d. An Equal probability selection method

2. Which of the following techniques yields a simple random sample?

a. Choosing volunteers from an b. Listing the individuals by ethnic group

introductory psychology class to and choosing a proportion from within
participate each ethnic group at random.
c. Numbering all the elements of a d. Randomly selecting schools, and then
sampling frame and then using a random sampling everyone within the school.
number table to pick cases from the table.

3. There are 4 methods of data collection. Choose the most cost and time
ineffective method

a. census b. sample survey

c. experiments d. observational study

4. Which one of the following is not a characteristic of classification?

a. inflexibility b. clarity
c. homogeneity d. equality of scale

Key to check your progress

1.d 2.c 3.a

4.a

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2.4.10 Terminal questions

 Define sampling and explain its role in research studies

 List out the different types of sampling
 What are the four main methods of data collection?
 What are the objectives of data classification?
 What are the 5 evaluation criteria as the basis for organizing and
analyzing data?
2.4.11 References

 Financial Management - IIBF

 VITUTOR 2010
 Bibliography – further reading.
 Fundamentals of Statistics ; By S C Gupta
 Principles of Corporate Finance ; by Brealey and Myers

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Unit-3 : Retail Banking and Bank Marketing
Lesson No. 1 Retail banking
Lesson No. 2 Product Development and Launching
Lesson No. 3 Marketing of Bank Products
Lesson No. 4 Customer Relationship Management in Banking

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3 Unit 3 Retail Banking and Bank Marketing

3.1 Lesson No. 1 Retail banking

3.1.1 Objectives
3.1.2 Introduction to retail banking
3.1.2.1 Three basic characteristics of Retail banking
3.1.2.2 Retail Banking – an opportunity
3.1.2.3 Present day scenario
3.1.2.4 Advantages of retail banking
3.1.2.5 Planning in retail banking
3.1.3 What Drives Retail Banking
3.1.3.1 Economic factors
3.1.3.2 Demographic factors
3.1.4 Retail Business and cooperative banks
3.1.4.1 Automation in Cooperative Banks:
3.1.4.2 Business Facilitators
3.1.4.3 Electronic Banking
3.1.4.4 Financial Inclusion
3.1.5 Retail Products
3.1.5.1 Types of deposits
3.1.5.2 Introduction to Retail Loans
3.1.5.3 Retail Loans - Characteristics
3.1.5.4 Existing Business of Cooperative Banks
3.1.5.5 Kisan Credit Card (KCC) scheme
3.1.5.6 Diversification of products
3.1.5.7 Other Retail Loans by public and private sector banks
3.1.5.8 Other Retail Products
3.1.6 Let us sum up
3.1.7 Key words/concepts
3.1.8 Check your progress-questions
3.1.9 Terminal questions

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3.1.1 Objectives

The objectives of this lesson are to understand details of

 Retail Banking
 Retail Business and cooperative banks
 Retail Products
3.1.2 Introduction to retail banking

Meaning of Retail Banking

Retail means Trade of goods in small quantities. The person engaged in this
trade is called the “retailer”. He/she is a link between the wholesaler and the
customers. The retailer maintains a large variety of goods. Banking has come
to occupy a pivotal position in a nation’s economy. According to the modern
concept, banking is a business which not only deals with borrowings, lending
and remittance of funds, but is also an important instrument for fostering
economic growth.

Retail banking means mobilizing deposits from individuals and providing loan
facilities to them in the form of home loans, auto loans, credit cards, etc, which
is becoming popular. Earlier banks considered it as a tough proposition
because of the volume of operations involved but have now realized that the
only sustainable way to increase deposits is to look at small and middle class
consumer retail deposits and not the price sensitive corporate depositors. With
financial sector reforms gathering momentum, the banking system is facing
increasing competition from non-banks and the capital market. More and more
companies are tapping the capital market directly for finance. This is one of the
main reasons for the focus on the much ignored retail deposits. Another reason
is that margins in retail market are higher.

Increase, in general economic activity and increasing purchasing power of rural

household has greatly improved the scope of retail banking. India has 200
million households and 400 million middleclass population; more than 90% of
the savings come from the house hold sector. Nuclear family concept is gaining
much importance which may lead to large savings, large number of banking
services to be provided. Tax benefits are available for example in case of
housing loans. Banks with vision and insight are, thus, trying to woo the
growing middle class household market through a series of innovative

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additions to their products, services, technology and marketing methods. In
short, in the bold new world of retail banking the customer is crowned as king.

3.1.2.1 Characteristics of retail banking

Three basic characteristics of Retail banking:

 Multiple products such as deposits, cards, insurance

 Multiple channels of distribution such as ATMs
 Multiple customer groups
3.1.2.2 Retail Banking – an opportunity

Corporate customers today rely less on commercial banks as they have access
to other fund raising avenue. As this disintermediation takes place and
competition shrinks margins, retail banking has gained importance for banks
because of its apparently higher margins and potential for growth. With their
large branch networks, banks have secured sizeable deposits-23 percent of
GDP. On the assets side, however, retail advances account for a mere seven per
cent of total lending. The penetration of products like car loans or credit cards
is very low. Non-banking companies lack the minimum size to make the
necessary investments and address the challenges of retail banking. Customers
now have many more personal financial options, and there is an increasing
demand for lower interest rates. Banks realize that they need to be active. The
new private sector banks have made early inroads in the markets they serve,
while competition from non-banking companies is growing. In this respect,
older institutions have revamped their distribution capabilities, customer
management capabilities, operating culture, compensation system and
operations processing.

3.1.2.3 Present day scenario

In the new millennium, a revolution has changed the rules and everything we
have understood of the retail market, financial products and other services.
Economic boundaries are disappearing, and the global village is a reality –
where the retail customer will have a choice in a manner we may have never
imagined.

Providers of retail products and services battle for market and market share
and offer many innovations and the real winner will be the customer, through
better products, distribution, technology, pricing, and post transaction service.

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The quality and range of products have expanded exponentially–convenience of
usage, customization to individual needs, and a host of other user-friendly add-
ons will create a whole new frontier of applications.

Technology is the single largest driver of this retail thrust. The entire strategy
will evolve around the absolute ability of the organisation to be at the cutting
edge of technology. Being able to keep abreast, but more importantly, being
able to recognize the immense potential that technology provides at all stages
in the retail chain is of paramount importance. To leverage, exploit and link
technology will be the greatest challenge and it is certain that a higher share of
retail business will be with those organizations which rely more on technology.
Above all these, an organization’s attitude to the customer will be the basic
determinant of success for any retail operation.

3.1.2.4 Advantages of retail banking

Retail banking has inherent advantages outweighing certain disadvantages. On

the resource side, retail deposits are stable and constitute core deposits. Also
they are interest insensitive hence less bargaining thus constituting low cost
deposits. Effective customer relationship management with the retail
customers builds a strong customer base and could increases the subsidiary
business of the banks.

On the uses side retail business results in higher bottom line, and is presumed
to be of lower risk and NPA perception. Retail banking helps economic revival of
the nation through increased production activity, improves lifestyle and fulfills
aspirations of the people through affordable credit and reduces banks’
dependence on a few or single borrower.

3.1.2.5 Planning in retail banking

While planning to increase retail business there is need for extensive market
research and constant product innovation to match the requirements of the
customer segments. The quality of service that banks offer and the experience
that clients have, matter the most. Infrastructure development, tapping of
unexploited potential and new delivery channels are other major areas that will
require the banks’ attention. However while putting the plan into action there
are certain issues that need to be tackled:

 A proper structure needs to be put in place.

 Operating efficiency level needs to be very high.
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  Database on credit history is just being built up. There are constraints in
this area.
 “Know your Customer’ is a concept which is easier said than practiced.
 Collection mechanisms are less efficient as it involves a large number of
small accounts.
 Investments in technology are large.
In particular cooperative banks, which have a strong rural presence, need to
address the requirements of rural customers in a big way.

3.1.3 What drives retail banking

There are two major factors that drive retail banking viz.

3.1.3.1 Economic

 Shift in the pattern of GDP from hitherto agriculture and manufacturing

sectors to services sector with increase per capita income especially that
of the younger generation
 In order to improve the off take of certain retail products as housing
loans, banks are focusing on longer deployment periods
 Comparatively stable real estate prices during past couple of years have
seen spurt in demand for housing loans.
 Keenness shown by the consumer goods/ automobile manufacturers to -
push up finance schemes through market tie-up with banks with a view
to increasing their market share.
3.1.3.2 Demographic

 Growing concept of nuclear families than the joint families necessitating

need for housing units as well as other items of consumer durables.
 Increased number of dual income families resulting in higher income and
savings.
 Increased demand for dwelling units due to gradual shift of population
from rural/semi-urban centre to urban/metro centre for employment.
 Shift in the attitude of the Indian household from “save and buy” theory
to a “buy and repay” principle.
 Increased middle-income segment and their income levels.
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  Emergence of new sectors such as Information Technology, media, etc. in
the economy that resulted in higher income opportunities and major
impact on change in urban consumption pattern.
 Awareness and sophistication in urban and semi-urban households for
urban convenience. Social security and status have also contributed to
higher demand for housing units, cars, etc.
3.1.4 Retail business and cooperative banks

The present banking scenario in India is witnessing sea changes. Adoption of

policy reforms in Indian economy has resulted in the change of economic order
towards the process of Liberalization, Privatization and Globalization (LPG).
Though Cooperative banks are also operating in the same environment, they
became mute spectators to rapid changes happening in the present banking
sector. Increase in purchasing power and emergence of strong middle class,
development of retail market have increased the scope for retail banking in
India.

3.1.4.1 Automation in cooperative banks

The recent developments in banking technology and expansion of

telecommunication network have ushered in new banking experience.
Customers have benefited by way of quick and efficient service delivery. The
increase in level of efficiency has been translated into higher profits for the
banks. Most of the technology initiatives have been taken by new generation
banks and the Public Sector Banks have also followed suit. Of late technology
has penetrated into the Regional Rural banks as well. Similarly, in Cooperative
Banks technology has also been adopted in a big way. Computerization is no
doubt investment oriented and cooperative banks may not have the complete
need or resources to go ahead with computerization. Nevertheless, when the
entire country is marching ahead with computerization in the banking sector,
cooperative banks cannot lag behind.

3.1.4.2 Business facilitators

Banks have, of late, been using Business Facilitators Model viz. NGOs,
Farmers' clubs, Cooperatives, Community based organizations, IT enabled
rural outlets, post offices, insurance agents, Panchayats, village knowledge
centers, KVKs, and KVIC/KVIB units have been involved in the models.

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The scope of their activities/services are:

 Identification of borrowers and activities

 Collection and processing of loan applications
 Creating awareness about various bank products
 Advice on managing money and debt counselling
 Processing and submission of applications to banks
 Promotion and nurturing of SHGs and JLGs
 Post sanction monitoring
 Monitoring and handholding of SHGs/JLGs
 Follow up for recovery
 No approval of RBI is required for using intermediaries for these services
The cooperative banks undertake retail banking on traditional lines and do not
use technology in a big way. They are thus constrained as the cost of delivery
could be high in this case.

3.1.4.3 Electronic banking

One of the most exciting growth phases for the banking sector is the emergence
of technology-enabled business models, which led to geographic expansion,
wider product offerings and newer revenue streams.

Electronic Banking comprises of the following:

 Electronic Funds Transfer

 Electronic Clearing System
 Tele-banking/Mobile banking
 Automated Teller Machines
 Shared Payment Network System
 Credit Cards/Debit Cards
 Corporate Banking Terminals
 Point of Sale Terminal.
 Electronic Data Interchange

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3.1.4.4 Financial inclusion

Another area which will help promote retail business is financial inclusion By
financial inclusion, we mean the provision of affordable financial services, viz.,
access to payments and remittance facilities, savings, loans and insurance
services by the formal financial system to those who tend to be excluded. It is
important to recognize that, in the policy framework for development of the
formal financial system in India, the need for financial inclusion covering more
and more of the excluded population by the formal financial system has always
been consciously emphasized. Even after decades of such emphasis, there are
large segments of the society outside the financial system. Simultaneously, the
growth of the NGO and the self-help groups has been significant and their
linkage with banks has facilitated a greater financial inclusion. The SHG
movement in India has enabled social and economic inclusion of women. The
SHG-bank linkage movement, where SHGs are linked to banks in a gradual
way - initially through savings and later through loan products - has been able
to ensure financial inclusion to a certain extent.

Basic Savings and Bank Deposit Accounts (BSBD)

At the first stage, there is a need for lowering the entry barriers to the banking
system and simplifying procedures. Thanks to developments in micro finance,
one of the myths held earlier by the banking system that the poor cannot save,
has been demolished. Experience has shown that the poor can and do save,
may be by way of thrift, and all they need is an appropriate product and access
to the banking system. Holding a savings product to a substantial extent
reduces financial exclusion. Moreover, the act of saving, however little it may
be, reinforces longer-term thinking and a sense of responsibility for one’s
future. Keeping in view the need for the banking system to take urgent steps to
bring about financial inclusion in the country, the Reserve Bank of India, in
the Mid Term Review of the Annual Policy for the year 2005-06, exhorted banks
to make available a basic banking ‘no frills’ account either with nil or very low
balances as well as charges that would make such accounts accessible to vast
sections of the population.

Although such basic bank accounts are generally considered unprofitable,

provision of such deposit accounts has been accepted the world over as a
stepping stone to financial inclusion.

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General Credit Cards (GCC)

It is almost a cliché that rural credit should adhere to the basic requirements
of timeliness, adequacy and hassle-free delivery, apart from taking care of the
financial needs of the customer in a holistic manner, including consumption
credit. To address these issues, several 'credit card' schemes have been devised
and implemented by banks over a period of time. Such schemes have the
flexibility of use and they fulfill the above requirements to a substantial extent.
But all these schemes have so far been activity-specific, i.e. for farmers,
artisans etc. The latest in the line is the General Credit Card (GCC) which does
not target any specific functional group, but has the potential to address the
credit needs of persons with small means having some income-generating
activity, without bothering so much about the nature of the activity.

Micro Insurance

More than credit, the poor need access to some form of insurance, as they are
the most vulnerable to various types of risk to both life and property. They
need suitably designed schemes offering health, life or property insurance:
limited protection at a somewhat low contribution. It is heartening to know that
insurance companies are coming up with schemes aimed at poorer sections of
the population and designed to help them cover themselves collectively against
risks, the delivery channels being banks, NGOs and SHGs working in rural
areas.

Use of Business facilitators and correspondents

With the objective of ensuring greater financial inclusion and increasing the
outreach of the banking sector, the RBI has decided to enable banks to use the
services of NGOs/SHGs, micro-finance institutions (MFIS) and other civil
society organisations (CSOs) as intermediaries in providing financial and
banking services through the use of business facilitator and correspondent
models.

3.1.5 Retail products

Retail products include deposits, credit cards, insurance, investment and

securities management and retail loans. While not all these products be
pedaled by cooperative banks some of them are discussed below.

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3.1.5.1 Types of deposits

Types of deposits which characterize cooperative banks’ (CBs) retail business

are:
 Current
 Savings
Term deposit (Fixed, Cumulative, Recurring, Call deposits, Notice money, Cash
Certificates, etc.)
For each type of deposit, the CBs have framed appropriate rules with the
approval of their Board and, wherever necessary, got the same approved by the
Registrar of Cooperative Societies. The copies of the rules are also supplied to
customers and important rules are also printed on the pass books of the
relative deposits.

Essential features of Current Deposit

The current deposit mostly meets the daily liquidity requirements of business
community and CBs have enough scope to mobilise current deposits through
their branches from the business community in rural, semi urban and urban
areas. The most important feature of current deposits is that the depositor is
required to maintain minimum balance while he/she is permitted to make any
number of withdrawals and deposits in the account without any restriction.
This account is very suitable for the business community as they can deposit
their daily proceeds of business in the account and meet their cash
requirement as and when needed. No interest is paid by the bank for balances
in these deposit accounts because of its frequency in operation. Higher the
share of this deposit in total deposits, the better it is for the banks. Current
accounts are part of CASA deposits.

Features of SB deposits

The savings bank account is a hassle free account. It offers banking services to
a customer with a small minimum balance, unlimited number of withdrawals
and deposits in the account. Banks make provision of interest on savings bank
balances on a daily basis and actually credit interest to individual saving
accounts on a half years basis. Since savings account is a running account it
can be closed any time by the customer. Banks credit appropriate interest to
the savings account at the time of closure of the account.

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Hence, it forms a stable low cost resource base to the CBs. Higher the
proportion of this deposit in total deposits, the better. However, transaction
cost involved in servicing savings deposits is slightly higher.

Now a days all the banks are giving utmost importance for the growth of this
low cost deposits better known as CASA (Current Account and Savings
Accounts) deposits as it not only plays a pivotal role in reducing the cost of
deposits but also it helps in decreasing the rate of interest on Advances thereby
increasing level of Retail Advance.

Features of Term Deposits

The basic features of term deposits are that the amount is repayable at the end
of the fixed term. While in fixed deposits, the amount is deposited in full at a
time by the customer, the customer deposits the money in fixed installments at
periodical intervals case of in recurring deposits. The rate of interest payable on
term deposits is linked to tenure of the deposit; normally higher the term,
higher the rate of interest. Some fixed deposits offer quarterly compounding of
interest, thus, offering better returns to the depositor. In case the depositor has
any liquidity need, he/she could either foreclose the deposit at a lower rate
(applicable rate of interest less penal provision) or could raise a loan against
deposit @1- 2% ( as per the policy of the bank) above the rate of interest on the
term deposit concerned.

Some of the products which are the forte of larger public and private sector
banks are:

A Savings Bank product with an auto sweep facility to short-term

deposits.

The product has 2 components - a savings bank component and a fixed deposit
component. The product is being offered to individuals including minors,
salaried people, businessmen, self-employed, professionals, traders and high
net worth individuals (HNIs). Beneficially for customers, there isn't any
minimum or maximum balance requirement. If and when the customer needs
funds more than his / her savings / current account balance, a reverse sweep
order will immediately be auto-triggered to meet the customers liquidity needs.
To benefit customers with maximum returns, while reverse-sweep, LIFO system
(Last in first out) is followed. Thus the product offers customers dual benefit of
'liquidity' through the savings / current component and 'hi-return' through the
linked fixed deposit component.
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Monthly Deposit

It is a deposit product that enables customers to earn monthly interest on their

fixed deposits. This product facilitates customers in meeting their recurring
monthly expenses. While the minimum deposit amount is Rs. 10,000 there is
no maximum ceiling. Customers may fix their deposits from 1 to 5 years.
Interest as applicable will be paid every month on the date of initial deposit and
will be credited to the respective operative account. Customers may also avail
overdraft facility or loan up to 90% of deposit at applicable rate as per policy of
the Bank.

Annual Deposit

It is a deposit product offered to customers who wish to benefit from long-term

investment options with annual interest payout facility. The impressive feature
of Annual deposit is that the interest will be credited to the customer’s
operative account on a yearly frequency for fixed deposits with more than 1
year maturity. The customers would benefit from interest income credited to
their operative account annually, which otherwise gets accrued and paid only
on maturity. This annually credited interest income may be used by customers
to meet their one time annual commitments like Club Membership Fees,
Insurance Premiums, etc.

Deposits at Notice

Earns a higher rate of interest than on your Savings Deposit. These interest
rates are linked to base rate and vary upon the size and currency of deposit –
higher the deposit amount, higher is the interest rate. A prior notice of
withdrawal of funds is to be served as per the currency. Fresh funds can be
added to Notice Deposit account at any time.

3.1.5.2 Introduction to retail loans

India has emerged as one of the largest and fastest growing economies of the
world during the last decade. The strengthening of the economy in India has
been fuelled by the convergence of several key influences, like growth of the key
economy sectors, liberalization policies of the government, well-educated work
force and the emergence of a middle class population. India, having the second
largest population in the world, is on its way to become the world's fourth
largest economy in a span of 2 decades.

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Due to the restrictive regulatory environment and strict policies of the
government of India until the early 1990's the public sector banks and other
scheduled banks were the major lenders. Even with the entry of private banks,
in the initial phase, there was limited competition between the public sector
banks and private banks. Also, the thrust was not on developing the economy
consistently through credit growth. Hence, banks did not feel the need to foray
into the sectors that were under served.

In the current scenario, banks have been thriving on retail lending. The focus
of banks now, is to increase the probable profits while limiting possible losses.
An increase in market penetration brought about a change in the business
environment and in the way banks conducted their business. There was a
change in terms of innovation in products as well as processes to cater to the
demands of the new age customer on one hand and to protect the bank from
multiple risks on the other.

Retail exposure of banks includes various types of retail credit, such as

residential mortgages, consumer credit cards, automobile and personal loans,
loans against securities, and small business loans.

3.1.5.3 Retail loans - characteristics

 These are small size loans

 These loans meet the needs of a large number of customers with well
diversified portfolios
 The target customers are generally individuals or small organizations
 These loans offer standard products to customers. Very rarely a
customer's requirement is customized
 The operations of retail credit are centralized in most of the banks
 Bankers can make quick credit related decisions because of
centralization
 These loans are designed to cover varied segments of risks
 High volume business
 High number of transactions

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3.1.5.4 Existing business of cooperative banks

Generally Cooperative banks’ loan portfolio consists of more than 80% lending
to crop loans and remaining to small, petty business and CC lending.

Some of the banks have the following loan products in their portfolio.

 Crops loans to PACS through Kisan Credit Card (KCC) System

 Advances against fixed deposits
 Consortium financing along with State Cooperative Bank for loans &
advances to cooperative sugar mills
 Cash Credit to PACS for dealing in agricultural inputs, PDS items,
consumer goods etc.
 Cash Credit to Cooperative Sugar Mills for working capital requirements
 Cash Credit to Cooperative Marketing Societies for working capital
requirements
 Advance against pledge of sugar to Cooperative Sugar Mills
 Cash Credit to Cooperative Processing Societies for working capital
requirements
 Cash Credit to Cooperative Consumer Stores for working capital
requirements
 Cash Credit to Primary Weaver Cooperative Societies for working capital
requirements
 Cash Credit to Industrial Cooperative Societies for their working capital
requirements
 Medium Term Loans to Salary Earners’ Societies
 Medium Term (Conversion) Loans to PACS
 Medium Term Investment Credit to individual farmers for taking
agriculture and allied activities.
It may be seen from the above that the cooperative banks are mostly financing
units within the cooperative fold. With the implementation of Prof. Vaidynathan
Committee recommendations and Agricultural Debt Waiver & Debt Relief
Scheme and the cleansing of the balance sheet of the PACS, most of the PACS
would be eligible to borrow a higher quantum of credit from DCCBs. The
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cooperative banks would also have substantial funds which could be profitably
deployed.

3.1.5.5 Kisan Credit Card (KCC) scheme

Provision of timely and adequate credit has been one of the major challenges
for banks in India in dispensation of agricultural and rural credit. Constant
innovation is required in order to achieve the aim. Agricultural credit cards is
not a new concept in the field of agricultural banking in India. The scheme had
already been introduced in a number of public sector banks in a few states
much earlier. These schemes were niche-marketed and were exclusively
preserved for the privileged class of farmers and the small and marginal
farmers did not have much access to them. Similarly cash credit facilities were
being extended by several public sector banks and cooperative banks to
farmers with the view to improving their access to credit. Again this scheme
was used only selectively. The KCC scheme was started by the Government of
India (GoI) in consultation with the RBI (Reserve Bank of India) and NABARD
(National Bank for Agricultural and Rural Development) in 1998-99 to combine
the features of both these schemes and overcome their shortcomings.

Objective

The scheme aims at providing adequate and timely credit for the
comprehensive credit requirements of farmers for taking up agriculture and
allied activities under single window, with flexible and simplified procedure,
adopting the whole farm approach, including the short-term credit needs and a
reasonable component for consumption needs, through Kisan Credit Card
including repayment of farmer's dues to non-institutional lenders.

Area of operation

The KCC can be issued through all rural and semi urban branches.

Eligibility

 short term crop loans to farmers, those who are owner cultivators/share-
croppers/tenant farmers
 KCC can also be issued for meeting the short term production
needs/working capital needs in respect of the allied activities like
poultry, dairy, pisciculture, floriculture, horticulture, etc.
 KCC scheme also covers term credits for agriculture and allied activities
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  KCC is issued to individual borrower and JLG only on merit and not to
corporate body society, association, club, group, etc.
 Illiterate and blind persons intending to avail of this facility may be
allowed after taking proper safeguard against misuse and tampering.
Purpose

It is intended that both term as well as short term/working capital credit

facilities will be provided through single Kisan Credit Card. The passbook
provided to KCC holders are to be divided into three separate portions for
maintaining the records of:-

 short term credit/crop loans,

 working capital credit for activities allied to agriculture and
 term credit (repayable beyond 12 months)
However, it is to be ensured that transaction records of different loan facilities
are kept distinct.

3.1.5.6 Diversification through retail banking

One of the important covenants of the Prof. Vaidynathan Committee

recommendations was to effect suitable amendments in the Cooperative
Societies Act in each State, and with such amendments, freedom has been
given to Cooperative Banks regarding loan policies including loan decision to
its members keeping in view the interests of the society and its members.
Further, they need not take the approval of the RCS for all loan advanced
under short term, medium term and long term duration for which
RBI/NABARD formulated the loan scheme. Hence, the banks have to design
new products to suit the customers in the area of operation.

Thus, the time has come for cooperative banks to take up retail banking. If
banks have already commenced such line(s) of credit(s), they should review
their loan policies and safeguards being followed and upscale their activities.
Retail banking refers to provision of banking services to individual customers,
small account holders such as savings products, personal loans etc. to suit the
individual requirements. CBs, besides financing for agriculture and allied
activities, could also finance individuals, proprietary/partnership firms directly
against fixed deposits, Shares Debentures, Bonds, life insurance policies,
pledge of gold / silver ornaments, against Indira Vikas Patras (IVPs) & Kisan
Vikas Patras (KVPs )etc. for purchase of consumer durables and for other
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purposes. It may also provide cash credit facility to businessmen/traders
against collateral, pledge or hypothecation, temporary overdraft facility to
individuals, loans for purchasing auto rickshaw, taxi, other motor vehicles,
etc., and non-commercial vehicles like cars and two wheelers. The restrictions
imposed by the RBI in regard to financing of certain sectors as well as exposure
norms prescribed by RBI should also be adhered to.

3.1.5.7 Other retail loans

Home loan

 Purchase of plot of land for construction of a house.

 Repaying a loan already taken from other Housing Finance
Company/Bank.
 Repayment period up to 25 years (floating rate option).
 Loan available for repairs/renovation/improvement/extension of the
existing house.
 Loan available for purchase of furniture/fixtures/furnishing/other
gadgets such as fans, geysers, air conditioners etc. required, to:
 Our existing housing loan borrowers
 New borrowers
Loan against future rent receivables has been developed considering the
growth potential in the real estate in various metros and urban centers, where
many commercial properties/shopping malls are being developed and the
owners approach banks for loans against securitization of future rent
receivables from such properties.

The scope for the new product has been kept wide to cover the target groups,
viz. owners of immoveable properties (lessor) belonging to all types of the
constitution.

The minimum and maximum loan limits are extended as per the loan policy of
the Bank.

The amount of loan is generally based on the present value of all future
receivables less the initial down payment.

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Advance against securities

Enables a borrower to unlock the value of his/her investments in securities.

He/she can avail loan for productive purpose or for meeting contingency needs
of personal nature -

 Against National Savings Certificate ( NSC)/Kisan Vikas Patra (KVP)

 Against the security of Life Insurance Policies.
 Against the security of Relief Bonds/Government Bonds eligible for bank
finance and not restricted from availing Bank Finance.
Two-wheeler loan

Makes it possible to purchase a two-wheeler and pay back in easy monthly

installments, thereby reducing the burden of a one-time payment. All resident
Indians, salaried, professionals, self-employed, businessmen and farmers can
apply for this loan.

Reverse mortgage loan

Purpose: For supplementing the cash flow stream of senior citizens in order to
address their financial needs.

Eligibility: Should be Senior Citizen of India, above 60 years of age.

Married couples will be eligible as joint borrowers provided one of them is

above 60 years of age and age of spouse is not below 55 years at the time of
application.

Should be the owner of a residential property (house or flat) located in India in

his/her own name.

Residential property should be used as permanent primary residence (fully self-

occupied property).

Option to adjust payments: The Bank shall have the option to revise periodic
annuity amount, if lump-sum payment is taken or at the interval of every 5
years based on valuation of the property.

Repayment of loan: The loan shall become due and payable when the last
surviving borrower dies or would like to sell the home / permanently moves out
of the home for aged care to an institution or relatives. The loan will, as such,
become due for recovery and payable.
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Settlement of loan, along with accumulated interest, to be met by the proceeds
received out of sale of residential property.

The borrower(s) or his/her/their estate shall be provided with the first right to
settle the loan along with accumulated interest, without sale of property. A
reasonable period of 2 months may be provided when repayment is triggered,
for house to be sold.

Tenor: The tenor is for 15 years but may further be extended till survival of the
borrower/s subject to advance value of the property.

Loan against pledge of Gold ornaments (Jewels):

Eligibility: All individuals who are owners of the Gold Ornaments / Jewellery.
Nature of facility: Term Loan /Demand Loan

Purpose: Any purpose other than speculative purpose

Mortgage Loan

Mortgage loan is an innovative combination of a loan and over draft facility

with flexible repayment options against the security of immovable property.

Key benefits

 Ideal use of idle property - Generates additional income from an

otherwise idle property.
 Allows withdrawal of money as per need and savings on interest cost.
 Flexibility to deposit surplus money/regular income/salary and save
interest.
 Flexibility to withdraw money deposited earlier.
 Can be availed either as overdraft or demand loan as per need.
Education loan

Education loan presents a one of its kind finance option for parents of students
pursuing school education. These loans are available for studies from Nursery
to Senior Secondary School.

 No processing & documentation charges.

 No Margin.

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  No security required.
 Coverage of expenses for :
 Fee payable to college/school.
 Examination/library/laboratory Fee.
 Fee and other charges payable to hostel.
 Purchase of books/equipments/instruments/uniforms.
 Personal Computers/Laptops wherever required.
 Caution deposit/building fun /refundable deposit supported by
institution bills/receipts.
Higher education loans

A loan product specially designed for students pursuing Graduation, Post -

Graduation, Professional & Other courses in India. Banks extend a helping
hand to energize studies and promote education of the youth.

 No processing charges.
 No Margin on loans upto 4 lacs but Guarantee of Parents required.
 Free Debit Card.
 Terms & Conditions
 Courses eligible :
 All Graduation courses.
 All Post Graduation courses & Doctorate courses.
 Professional Courses
 Student Eligibility :
 Should be Resident Indian.
 Secured admission to either of above courses
Personal loan

Personal Loan offers financial help to meet personal requirements of the

borrower.

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Key Benefits:

 Helps take care of all kinds of expenses at a short notice.

 The Loan may be availed to meet expenses related to marriage, travel,
honeymoon, holiday and medical expenditure or for any other personal
use.
 The loan is also available to Pensioners/ Defense Pensioners
 Loan is also available for Earnest Money Deposits for buyers of
home/flat/plot.
Traders loan

The Traders Loan facility enables individuals, Proprietorships, bodies such as

Partnership firms and Co-op societies to avail of working capital or undertake
development of shop by way of loan/overdraft. Dealers in gold/ silver jewellery
are also covered under the scheme.

Key Benefits:

 Option to avail the credit facility as loan or overdraft.

 Loan can be repaid in a maximum period of 60 months.
 Security: Tangible collateral Securities in the form of mortgage of land
(not agricultural land) and building is acceptable as security
 National Savings Certificates, Government Bonds, our Bank's Term
Deposits, Assignment of Life Insurance Policies, standing in the name of
the borrower/proprietor/partner/director are acceptable as security.
3.1.5.8 Other retail products

Credit Card

A credit card is a payment card issued to users as a system of payment. It

allows the cardholder to pay for goods and services up to a pre-determined
limit and subject to certain terms and conditions. The issuer of the card
creates a revolving account and grants a line of credit to the consumer.

A credit card allows the consumers a limit which could be used, subject
to interest being charged. When a purchase is made, the credit card user
agrees to pay the card issuer. The cardholder indicates consent to pay by
signing a receipt with a record of the card details and indicating the amount to
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be paid. It can be used in POS (Point Of Sale) transaction to effect the payment
between a merchant and a customer when products and services are
purchased.

Debit Card

A debit card is a plastic card that provides the cardholder electronic access to
his or her bank account at a financial institution.

Debit cards usually also allow for instant withdrawal of cash, acting as
the ATM card for withdrawing cash. Merchants may also offer cash back
facilities to customers, where a customer can withdraw cash along with their
purchase. It can be used in POS (Point Of Sale) transaction to effect the
payment between a merchant and a customer when products and services are
purchased.

Investment and securities management

Investment management is the professional management of various securities

(shares, bonds and other securities) and assets in order to meet specified
investment goals for the benefit of the investors. Investors may be institutions
(insurance companies, pension funds, corporations, charities, educational
establishments etc.) or private investors

The term asset management is often used to refer to the investment

management of collective investments while the more generic fund
management may refer to all forms of institutional investment as well as
investment management for private investors. Investment managers who
specialize in advisory or discretionary management on behalf of (normally
wealthy) private investors may often refer to their services as wealth
management

3.1.6 Let us sum up

Retail banking means mobilizing deposit form individuals and providing loan
facilities to them in the form of home loans, auto loans, credit cards, etc, is
becoming popular. This used to be considered by the banks as a tough
proposition because of the volume of operations involved

Today’s retail banking sector is characterized by three basic characteristics:

 Multiple products (deposits, credit cards, insurance, investments and

securities)
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  Multiple channels of distribution (call center, branch, internet)
 Multiple customer groups (consumer, small business, and corporate).
Traditional lending to the corporate are slow moving along with high NPA risk,
treasure profits are now losing importance hence Retail Banking is now an
alternative available for the banks for increasing their earnings. Retail Banking
is an attractive market segment having a large number of varied classes of
customers. Retail Banking focuses on individual and small units.

Another area which will help promote retail business is financial inclusion By
financial inclusion, we mean the provision of affordable financial services, viz.,
access to payments and remittance facilities, savings, loans and insurance
services by the formal financial system to those who tend to be excluded the
growth of the NGO and the self-help groups has been significant and their
linkage with banks has facilitated a greater financial inclusion.

At the first stage, there is a need for lowering the entry barriers to the banking
system and simplifying procedures. Basic "no frills" bank accounts is an
important step in that direction.

3.1.7 Key words/concepts

Consumer, small business, corporate call center, branch, internet, deposits,

credit cards, insurance, investments , securities NGOs, self-help groups,
financial inclusion, "no frills" bank accounts

3.1.8 Check your progress

1. Retail banking is all but one of the following

a. home loans b. auto loans

c. credit cards d. loans against cement plant and
machinery

2. Which of the following not a basic characteristic of retail banking?

Multiple products such as deposits, Multiple channels of distribution

cards, insurance
Single customer group Multiple customer groups

3. No ‘frills’ bank account is an essential element of

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a. Core banking b. NRI accounts
c. Financial inclusion d. Investment banking

4. Business facilitators are all but one of the following:

a. NGOs b. SHGs
c. MFIS d. Insurance companies

5. Retail loan products

a. Are standard b. Are Large size

c. Have Low volume of business d. Have Low number of transactions

6. In reverse mortgage loan one of the following does not satisfy the
conditions necessary:

a. Should be Senior Citizen of India, above b. Married couples will be eligible as joint
60 years of age. borrowers provided one of them is above
60 years of age and age of spouse is not
below 55 years at the time of application.
c. Should be the owner of a residential d. Residential property can be self-
property (house or flat) located in India in occupied property or leased out
his/her own name.

Key to check your progress

1.d 2.c 3.c

4.d 5.a 6.d

3.1.9 Terminal questions

 What is the role of retail banking and its role in modern banking?
 What are the advantages in retail banking?
 What are the strategies for increasing retail banking?
 Describe briefly the retail banking products with special reference to
cooperative banks.

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3.2 Lesson No. 2 Product Development and Launching (PDL)

3.2.1 Objectives
3.2.2 Introduction to Key Questions about PDL
3.2.2.1 The current macroeconomic environment
3.2 2.2 The process of PDL
3.2.3 Let us sum up
3.2.4 Key words/concepts
3.2.5 Check your progress –questions
3.2.6 Terminal questions

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3.2.1 Objectives

The objectives of this lesson are to understand

Risks involved in launching of a new product (PDL)

The process of developing and launching a new product

3.2.2 Introduction-Key Questions about PDL

 What are the key factors in successful development of new financial

services products and services?
 How long does it take to develop a new financial product?
 Which strategic objectives are the most difficult to achieve?
 Which areas suffer most from lack of resources during new financial
product development?
Company size affects the speed at which new products are developed. Most
medium sized companies take 4 to 6 months to develop new products, for large
companies this lengthens to between 7 and 12 months...” Whilst pressure is
increasing for financial services firms to innovate, research has shown that
many in the finance sector lack the rigorous, disciplined approach necessary to
pick the right projects and see them come to fruition.

Marketing strategies

 Explaining the key benefits to the target market.

 Raising awareness about the new product.
 Staying consistent with the overall marketing strategy.
 Building a new brand.
 Creating a clear market position.
Marketers in order to improve the success rates of their brand building
activities should look through previous market research reports, or put
yourself in the position of a buyer, write down the four main reasons, in order
of importance, why one of your company brands is being purchased. Then
show an advertisement for this brand to one of your buyers and ask them to
identify the four key points they took from the message. If the results from the
first and second part of the exercise are the same, your brand is correctly

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appealing to customer choice criteria. Any discrepancy is indicative of
inappropriate brand marketing.

3.2.2.1 The current macroeconomic environment

The environmental drivers of risk remain broadly the same while the risks of
slow economic growth have increased. Many asset classes are still volatile.
Consumers respond to volatility by seeking security, but are constrained by
very low or negative real yields on traditional savings and investment products.
This leads consumers to be attracted by products that claim to offer a degree of
security but which promise returns that outperform cash. Firms have
responded by manufacturing and marketing products that aim to deliver
better-than-cash returns. In many cases, both the benefits and the risks of
these products are opaque.

Investigation of the structured investment products market following the

Lehmans collapse in 2008, had identified potential risks to consumers arising
from a number of factors, including:

 Poor identification of target market and borrowers

 Lack of due diligence on counterparties;
 Inadequate testing of product features;
 Lack of due diligence on distribution channels; and
 Poor use of customer feedback and other management information.
3.2.2.2 The process of PDL

In the process of PDL the following steps are to be followed.

Product approval procedures

 There has to be established a process for approving new structured

products.
 The structure and methodology of these processes may vary across firms.
Identification of target markets and idea generation

 Know customers through other products and services extended to them

through consumer research.

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  Identification of a target market or audience is crucial, not only for
generating ideas for products, but for avoiding failures later in the value
chain.
 target market identification by the provider helps to ensure that the right
product reaches the right customers through appropriate marketing
(whichever distribution channel is chosen),
Design and development of product features

 A key point among the features of a structured investment product is

whether capital is at risk i.e. subject to market risk (as opposed to
counterparty risk).
 Most banks have some kind of structured product design framework i.e.
an internal policy which set limits to what was and was not acceptable
for meeting the bank’s ‘house’ risk and other parameters.
Selection and monitoring of distribution channels

 Banks should decide whether their structured product is one where

customers would be wise to seek advice. If a structured product has
complex features which are difficult to explain to customers, banks
should take particular care with the use of non-advised distribution.
 Distributors should not be regarded as the ‘end customer’.
 Banks should review whether distribution in practice corresponds to
what was originally planned or envisaged for distributing their products,
given the target market
 Banks should carry out due diligence on distributors.
 Distributors should have good knowledge and understanding of
structured products.
Information to consumers

 Consumers are provided with clear information and are kept

appropriately informed before, during and after the point of sale.
 Banks should not rely on financial promotions to remedy earlier failings
in the product development process.

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  Banks should assess both the nature and complexity of a product, and
the financial capability of its target market, to determine the likely
information needs of consumers.
 The more complex a product’s structure and features are, the more
difficult it is likely to be to explain in a financial promotion without risk
of consumer misunderstanding.
 Banks should promote the features of their products in a fair and
balanced way
Post-sales responsibility

 Banks should periodically review their products

 Check the product is continuing to meet the needs of the target
customers that it was designed for;
 clearly articulate the criteria that such assessments are made against
the strategy they would use to contact customers and distributors in the
event of a market event that affected a product
 Banks should use both proactive and reactive post-sale information to
make necessary changes to the product development process,
 Banks should continue to provide support and help to distributors and
customers during the product lifecycle.
3.2.3 Let us sum up

In new product development and launch one has to be clear of the following:

 What are the key factors in successful development of new financial

services products and services?
 How long does it take to develop a new financial product?
 Which strategic objectives are the most difficult to achieve?
The environmental drivers of risk remain broadly the same while the risks of
slow economic growth have increased. Many asset classes are still volatile.
Consumers respond to volatility by seeking security, but are constrained by
very low or negative real yields on traditional savings and investment products.

In the process of PDL the following steps are to be followed.

 Product approval procedures

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  Identification of target markets and idea generation
 Design and development of product features
 Selection and monitoring of distribution channels
 Information to consumers
 Post-sales responsibility.
3.2.4 Key words/concepts

Product approval, Identification of target markets, Design and development,

Post-sales, Selection and monitoring

3.2.5 Check your progress- questions

1. In the Product development and Launching (PDL), the following

procedures are followed such as

i. Identification of target markets and idea generation

ii. Design and development of product features
iii. Products approval procedures
iv. Selection and monitoring of distribution channels
Choose the correct order
a. i, ii, iii, iv b. iii, i, ii, iv
c. iv, iii, ii, i d. ii, iii, iv, i

2. In ‘Identification of target markets and idea generation’ which of the

following does not apply

a. Know customers through other b. consumer research

products and services they supplied to
them
c. target market identification d. diligence on distribution channels

3. Choose the incorrect option

a. Banks should carry out due diligence b. Distributors should have good
on distributors. knowledge and understanding of
structured products
c. Distributors should be regarded as the d. diligence on distribution channels

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‘end customer’

4. Investigation of the structured investment products market, following the

Lehmans collapse in 2008, had identified potential risks to consumers arising
from a number of factors which includes:

a. Poor identification of target market and b. Lack of due diligence on counterparties

borrowers
c. Inadequate testing of product features d. All of the above

Key to check your progress

1.b 2.d 3.c

4.c

3.2.6 Terminal questions

 What are the key questions to be asked before a new product launch?
 What are the steps in new product launch?

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3.3 Lesson No. 3- Marketing of bank products

3.3.1 Objectives
3.3.2 Introduction
3.3.2.1 Definition of Marketing
3.3.2.2 Segmentation
3.3.3 Some novel ways of segmentation for financial services
3.3.4 The 7 Ps of services marketing
3.3.5 Delivery Channels
3.3.6 Let us sum up
3.3.7 Key words/concepts
3.3.8 Check your progress
3.3.9 Terminal questions
3.3.10 Bibliography and reference books for further reading

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3.3.1 Objectives

The objectives of this lesson are to understand some aspects of marketing like

 Segmentation
 Target Market
 Positioning
 The 7 Ps of services marketing
3.3.2 Introduction - Marketing

3.3.2.1 Definition of marketing

Marketing is an important function for any organisation. It has become more so

for banking industry because of the existence of intense competition, not only
within the industry but also from development banks, finance companies,
insurance companies, capital markets, etc. This has resulted in banks paying
increasing attention to marketing techniques. Banking industry is unique in
nature as compared to manufacturing or trading industry dealing with tangible
products. Marketing of banking products is a field of study that is evolving
rapidly.

A service is any act or performance that one party can offer to another that is
essentially intangible and does not result in the ownership of anything. It’s
production may or may not be tied to physical product. Banking products and
Services as opposed to physical products have the following characteristics:

 Intangible
 Heterogeneous
 Production, distribution and consumption are simultaneous processes.
 An activity
 Core value produced in buyer-seller interaction
 Customers participate in production
 Cannot be kept in stock
 No transfer of ownership
Intangibility, inseparability and heterogeneity are manifested at both strategic
and tactical levels in services marketing. Marketing strategy provides the
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organisation with a sustainable competitive advantage in the markets it
operates. Organization should understand consumer needs and identify how
those consumers should be grouped into different market segments. Product
attributes, pricing decisions, methods of distribution and communication
should all seek to reflect the chosen position.

Essentials for a Bank’s success

 Cannot exist without customer

 Create, win and keep customers
 Organizational design should be oriented to the customer
 Deliver total satisfaction to the customer
 Customer satisfaction is affected by the performance of all the personnel
of the bank.
3.3.2.2 Segmentation

Market segmentation is the first step in process. The general tried and tested
segmentation methods are based on Gender, Price, Interests, Location,
Religion, Income, Size of Household, Age, Education, Occupation, Social Class,
and Ethnicity. Nationality, End use (Example work or leisure) and track record.

An ideal market segment meets all of the following criteria:

 It is possible to measure;
 It has to be large enough to earn profit;
 It has to be stable enough that it does not vanish after some time;
 It is possible to reach potential customer via organization's promotion
and distribution channel.
 It is internally homogeneous (potential customers in the same segment
prefer the same product qualities).
 It is externally heterogeneous that is Heterogeneity between segments
(potential customers from different segments have basically different
quality preferences).
 It responds similarly to a market stimulus.
 It can be cost-effectively reached by market intervention.

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  Useful in deciding on marketing mix
The need for market segmentation arises as markets are becoming increasingly
diverse and it is rare for mass marketing to be a profitable strategy. Market
segmentation enables more accurate and effective communication of benefits in
relation to needs. Market segmentation also helps to identify growth
opportunities for the bank. Market for banking products can be segmented in a
number of ways.

Retail market can be segmented, as discussed above, on the basis of

demography, geography, social class and cultural values. Demographic
segmentation divides the market in terms of the characteristics of populations
such as age group, sex, size of family, level of income, occupation.

For example, fixed income earner demands different product than the variable
income earners. On the Other hand, geographic segmentation divides the
market on the basis of different geographic units such as urban market, rural
market, eastern market, western market, etc. There exists a major difference
between bank customers of different social class.

3.3.2.3 Some novel ways of segmentation for financial products

Volume based segmentation

The simplest and the most popular way to segment bank customers is volume-
based segmentation. The basic idea is to use some sort of volume indicator
(deposit volume, loan volume, a combination of both, or some other volume
indicator) to generate groups. Most commercial banks have employed volume
based segmentation at least in order to find target groups for "private banking"
activities. The volume indicators have usually been customer holdings in the
bank in the form of deposits and investment activities.

Developing a differentiated strategy based on relationship volume may be a

good solution as it is obvious that the banks’ ability to help the customer to
produce value for her/himself is evaluated using totally different criteria among
high volume customers compared to low volume customers. High volume
customers could be expected to be much more interested in how the bank
helps the customer to manage her/his assets whereas the low volume
customer is probably more interested in the payment brokering services of the
bank.

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Profitability based segmentation

The third possible way to segment the customer base is to base the grouping
directly on customer relationship profitability. There are two basic approaches
to do this: to base the grouping on relative profitability (relative to the total
customer base) or to group customers based on their absolute profitability.
Grouping customers according to their relative profitability in practice means
that the customers are grouped based on their importance for the profitability
of the total customer base.

Segmentation based on relationship volume and relationship profitability

The fourth way to segment customer bases is to combine volume-based

segmentation and profitability based segmentation. Four different groups of
customers that can be identified based on combining relationship volume (RV)
and customer relationship profitability (CRP).

Group I consists of low volume, unprofitable customers. Customers in this

group are unprofitable because of their unfavorable transaction behavior in
combination with their low volumes.

Group II consists of low volume, profitable customers. Most of these customers

are doubtless "passive" customers, i.e., customers with limited transaction
behaviors.

Group III consists of high volume, unprofitable customers. These are the "dogs”
of the customer base. Customers in this group may be unprofitable either
because of unfavorable pricing or because of excessive usage of low or un-
priced transactions.

Group IV consists of high volume, profitable customers. These are the "cash
cow" customers of the bank. Most of these customers are among the first
quartile in the profitability and thus the bank is very dependent of this group.

Using segmentation in customer retention

The basic approach to retention-based segmentation is that a company tags

each of its active customers with 3 values:

Is this customer at high risk of canceling the company's service? One of the
most common indicators of high-risk customers is a drop off in usage of the
company's service. For example, in the credit card industry this could be
signaled through a customer's decline in spending on his or her card.
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Is this customer worth retaining? This determination boils down to whether the
post-retention profit generated from the customer is predicted to be greater
than the cost incurred to retain the customer.

What retention tactics should be used to retain this customer? For customers
who are deemed “save-worthy”, it’s essential for the company to know which
save tactics are most likely to be successful. Tactics commonly used range from
providing “special” customer discounts to sending customers communications
that reinforce the value proposition of the given service.

3.3.3 The 7 Ps of services marketing

In services marketing, success is a mix of the 7P’s: Product, Price, Place,

Promotion, People, Process Physical evidence.

Product: These could be loans, credit card, demat, investment services, online
facilities, mobile banking, bancassurance etc.

Pricing: they are reflected in form of costs in terms of fees, charges that make
the product competitive. Steps in pricing is a process from developing
marketing strategies through, marketing mix decisions; estimates of demand
curve, then calculation of cost’

Place: Establishment of banking units appropriate to the needs of the

customers. Also provide technological benefits such as ATMs, online banking
etc.

Promotion: Through advertising, publicity, sales promotion, push pull

strategies, personal selling and Internal marketing (People)-employees. Quality
human resource can be a source of differentiation. Through all this CRM is
important. Quality of service during employer-buyer interaction is the key.

Process: It Involves systems that are used to provide service. It includes

standardized procedures, customized products, less paper work.

Physical evidence: It includes signage (logo), punch lines (philosophy),

tangibles (Pens, pads, etc.), and dress sense of employees.

3.3.3.1 Delivery channels

Importance of delivery channels cannot be overemphasized. Their main

functions include:

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  Provide market information
 Promotion of the products
 Maintain contact with prospective customers
 Matching the needs of the bank with those of the customers
 Provide accurate product information
 Be part of physical distribution of the products/services
Process of STP (Segmentations, Targeting , Positioning)

Identifying all segments for the product/service (Segmentation). The real

goal/objective in market that marketer want to reach is the ultimate user
(target). Eventually positioning is final aspect of this theory which is based on a
theory that strategy can only be planned in the mind of the consumer, not the
marketplace.

3.3.4 Let us sum up

Marketing is one of the important functions in any organisation. Marketing has

become important function in banking industry because of the existence of
intense competition, not only within the industry but also from development
banks, finance companies, insurance companies, capital markets.

Banking industry has unique nature compared to that of manufacturing or

trading industry dealing with tangible products. Marketing of banking products
is a field of study that is evolving rapidly. A service is any act or performance
that one party can offer to another that is essentially intangible and does not
result in the ownership of anything. Segmentation is the first step in process of
marketing. In services marketing, success is a mix of the 7P’s: Product, Price,
Place, Promotion, People, Process Physical evidence.

Importance of delivery channels cannot be overemphasized. Delivery channels

include ATMs, online banking, and banking units.

3.3.5 Key words/concepts

Segmentation, 7P’s: Product, Price, Place, Promotion, People, Process Physical

evidence, ATMs, online banking, banking units.

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3.3.6 Check your progress

1. In Segmentation Based on Relationship Volume and Relationship

Profitability, DOGs are____

a. Low volume, unprofitable customers b. Low volume, profitable customers

c. High volume, profitable customers d. High volume, unprofitable customers

2. In Segmentation Based on Relationship Volume and Relationship

Profitability cash cows are

a. Low volume, Unprofitable customers b. Low volume, Profitable customers

c. High volume, Profitable customers d. High volume, Unprofitable customers

3. In marketing, STP stands for :

a. Service, Targets, Positioning b. Segmentation, Targets, Pricing

c. Service, Targets, Pricing d. Segmentation, Targets, Positioning

4. Bank products as opposed to physical products are

a. Homogeneous b. Intangible
c. Can be stocked d. Identifiable

5. An ideal market segment meets all but one of the following criteria:
identify

a. It is possible to measure. b. It has to be large enough to earn profit.

c. It is externally homogeneous d. It has to be stable enough that it does
not vanish after some time

Key to the questions asked

1.d 2.c 3.d

4.b 5.c

3.3.7 Terminal questions

 Explain the role of segmentation in marketing

 Describe the novel methods of segmentation

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  Explain the 7 Ps of marketing
 What is the role of delivery channels?
3.3.8 References

 Bellis-Jones theory on volume and profitability segmentation

 Marketing by Dr. Onkarnath (PPT)
 Bank of Baroda Website
 RBI website
 NABARD website
 IIBF website
 Rural Retail banking India 2020 by Jayadeva M
 Corporate Governance by V Leeladhar
Bibliography – further reading

 Fundamentals of Retail Banking by O P Agarwal

 Retail banking by IIBF
 Cooperative banking operations by IIBF

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3.4 Lesson No. 12: Customer Relationship Management in Banking

3.4.1 Objectives
3.4.2 Customer Relationship Management
3.4.2.1 The main principles of CRM
3.4.3 Human Aspects of Customer Service
3.4.4 What should a CRM solution offer?
3.4.5 Banking Ombudsman scheme
3.4.6 The Banking Codes and Standards
3.4.6.1 Objectives of the Code
3.4.6.2 Application of Code
3.4.6.3 Key Commitments
3.4.7 Let us sum up
3.4.8 Key words/concepts
3.4.9 Check your progress
3.4.10 Terminal questions
3.4.11 Reference books and bibliography for further reading

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3.4.1 Objectives

Objectives of this lesson are to understand

 CRM process
 Human aspects of customer service,
 Code of Conduct for Minimum Standard of Banking Practices (BCSBI),
 Banking OMBUDSMAN.
3.4.2 Introduction -Customer Relationship Management

For long, Indian banks had presumed that their operations were customer-
centric, simply because they had customers. These banks ruled the roost,
protected by regulations that did not allow free entry into the sector. And to
their credit, when the banking sector was opened up, they survived by adapting
quickly to the new rules of the game. Many managed to post profits. For them
an unexpected bonanza came from government bonds in which most were
hugely invested.

Competitive banking market in India

As one of the most attractive emerging market destinations, India will see
foreign banks come in, grow and acquire. Therefore, Indian banks need to re-
focus on the customer (asset).

Customer Relationship Management (CRM) in the Indian banking system is

fundamental to building a customer-centric organization. CRM systems link
customer data into a single and logical customer repository. CRM in banking is
a key element that allows a bank to develop its customer base and sales
capacity.

CRM is a simple philosophy that places the customer at the heart of a business
organization’s processes, activities and culture to improve his/her satisfaction
of service and, in turn, maximize the profits for the organization. A successful
CRM strategy aims at understanding the needs of the customer and integrating
them with the organization’s strategy, people, and technology and business
process. Therefore, one of the best ways of launching a CRM initiative is to
start with what the organization is doing now and working out what should be
done to improve its interface with its customers. Then and only then, should it
link to an IT solution.

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There are several driving forces to support this move. Firstly, for years, the
Indian retail market was largely untapped. With retail lending at levels far
below those prevailing in other Asian countries, the opportunities are immense.

3.4.2.1 Main principles of CRM

The main principles of CRM can be grouped into seven guiding factors:

Customer focus

The foremost guiding principle in CRM is customer focus. Who is a customer?

This question is very fundamental. A customer is a person or group of persons
who receive the product or service—the final output of a process or group of
processes. A customer is the final arbiter of quality, value and price of a
product or service. A satisfied customer only assigns value to a service; on the
contrary, to a dissatisfied customer a product or service has no value, even if
the concerned service or product has been designed with lot of effort, energy
and cost after thorough planning.

Leadership

Persuasion, judgment and decision-making abilities are the main attributes

of quality leadership. When there is a slight chance of getting a business but
the client is hesitating, or unable to decide it should be followed up by the
relationship manager with patient hearing, mild counseling.

Process approach

A process transforms an input into desired output by the use of resources,

energies and time. In producing an output there maybe one single process or a
group of inter-related processes. In case of inter-related processes, often the
output from one process directly forms the input to the next.

Systems approach

Customer’s requirement is one level of commitment. That level implies a system

that is reactive and provides to customers what they want but the target
should be to achieve more and to exceed the customer’s expectation to
accommodate future requirement and to build a cushion against the
competitors’ attributes.

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Involvement of people

The fundamentals of CRM bear the genes of customer relationship through

involvement of people, i.e., the work-force at the disposal of the organization.
The whole gamut of CRM is for the people, of the people and by the people.
People involvement at all levels is essential for the success of a CRM program.

The bank managers and staff must be in a position to exploit the concept of
customer relationship completely.

Mutually beneficial customer relationship

A bank should not concentrate its attention towards earning of profits

only, but focus should be directed to the customers’ wealth creation or valueen
hancement with the motto of earning through service

Continual improvement in the customer relationship

The provision of value added services at favorable cost. Business processes in

the areas of finance, system integration, human resource management etc. are
to be automated and optimized with an aim to increase the efficiency and
effectiveness of operations.

3.4.3 Human aspects of customer service

To have quality staff that respects themselves, their management and

customers, it is imperative to have a good internal customer service program
for everyone to follow:

1. Create effective first impressions.

First (and critical) impression is the best impression. Posture, appearance,

attitude and communication skills can create a professional, welcoming
environment that encourages business or it can repel people even if our prices
are the best.

Meet and Greet–where the most common mistakes are made in the customer
service process. These first few moments set the tone for the entire interaction.
By energetically and professionally welcoming your customer, you make
successful customer interactions not only possible, but very likely.

Customers want to be 1) recognized, 2) appreciated, and 3) treated

with courtesy and understanding.

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To accomplish this, you have to be at your best in the meet and greet stage of
the service process and know what your customers truly want! You don’t want
customers to get turned off in the first few moments of their interaction by
someone making a negative impression so the customer chooses to take
his/her business elsewhere. A slovenly appearance, negative body language,
annoyance and lack of interest can send someone heading for the door. Be
open, focused, well groomed and looking at the situation from the customer’s
point of view. Think about the characteristics that make you want to do
business with someone.

Following are some relationship-damaging mistakes you want to avoid at

all costs:

Ignoring waiting customers: Sometimes we are short-staffed or too busy with

current customers to help a waiting customer immediately; HOWEVER, never
ignore a waiting customer. Establish eye contact, wave, or say something like
“I’ll be right with you” to let the customer know that you are aware of his/ her
presence and will get to him / her as soon as you can.

Distractions: It is easy to become distracted by other customers, other

responsibilities, and the variety of other things going on at the same time.
When customers see that you are distracted, they sense other priorities are
more important.

Answering questions or taking calls while assisting a customer: It

is challenging to make every customer feel equally valued, and some customers
try to push their way to the head of the line. Don’t let these customers overstep
earlier customers, rather, say a few friendly words to the individual indicating
that you will help them as soon as you are finished serving the current
customer.

Giving a bored, indifferent greeting: Greet the customer with energy and be
more creative than, “May I help you?” Make it a fun, personal challenge to say
something specific, which will make the greeting portion of the sales process
more interesting and rewarding. Get staff involved and create one specific one
for your company. “How can I help you with your computer selection today?”

Although customers are all different, certain basic principles apply to nearly all
of us, and you can safely assume that most customers are looking for the same
things in their interactions with you as you would with them.

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Today, more than ever before, the ability to maximize customer loyalty through
close and durable relationships is critical to retail banks’ ability to grow their
businesses. As banks strive to create and manage customer relationships,
several emerging trends affect the approach and tools banks employ to achieve
sustainable growth. These trends reflect a fundamental change in the way
banks interact with the customers they have − and those they want to acquire.

How can a retail bank drive growth? Traditionally, banks have grown through
an aggressive strategy of acquiring direct competitors and taking over their
branch networks. Today, that strategy is no longer sufficient, since it doesn’t
create organic growth for the financial institution. To build stronger customer
loyalty, banks need improved customer knowledge to develop products and
deliver services targeted at specific market segments; resulting in more direct
marketing, sales and service tactics.

To optimize customer relationships and loyalty, banks need to integrate

processes and technologies that enable them to build − and then act upon − a
detailed view of what each customer wants. This will require highly skilled
customer service professionals, with the right combination of linguistic,
culturally aligned and financial services skills, as well as the ability to deploy
customer service strategies quickly, efficiently and cost-effectively.

A fully integrated, enterprise wide CRM platform ensures banks have the core
capabilities to take full advantage of their customer relationships and capitalize
on these market dynamics, rather than losing out because of them.

 Gaining sales momentum

 Increasing acquisition of new customers
 Improving retention of existing Customers
 Increasing the profitability of customer relationships
 Improving distribution and channel management
 Maximizing the value of past CRM investments
3.4.4 What should a CRM solution offer?

A world-class CRM solution needs to embody six core “qualities” in order to

support a company’s ability to acquire new customers, increase retention and
ultimately, increase profitability.

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In order to address the market pressures banks are facing, a CRM solution
must be:

 Agile in its deployment – To allow new products and services to be

implemented by the bank in a creative and rapid manner as required
over time.
 Consistent in its execution of customer processes – To ensure processes,
technology and management deliver a consistent customer treatment
strategy across all channels in the enterprise platform.
 Scalable in its design and capacity – To allow for the bank’s future
growth, whether through improved organic strategies or acquisitions.
 Effective in its integration of business intelligence – To provide clear
insights into customer preferences by integrating business intelligence
and applying it to support product development and customer treatment
strategies.
 Measurable in its results – To allow reporting of operational, strategic
and customer service goals to measure if programs are achieving real
ROI for the bank.
 Secure in its handling of customer information – To ensure absolute
security and privacy around all information held and transmitted
through the system.
3.4.5 Banking Ombudsman scheme

Banking Ombudsman is a quasi-judicial authority functioning under India’s

Banking Ombudsman Scheme 2006, and the authority was created pursuant
to the a decision by the Government of India to enable resolution of complaints
of customers of banks relating to certain services rendered by the banks. The
Banking Ombudsman is a senior official, appointed by the Reserve Bank of
India to address grievances and complaints from customers, regarding
deficiencies in banking services. It covers all kinds of banks – PSU Banks,
Private Banks and Rural banks. Even though, it was originally setup in 1995,
there were major revisions in 2006 covering transactions related to complaints
of ATM cards, debit cards and credit cards, deduction of service charges by
banks without prior intimation, unfair practices of banks and non-compliance
by direct sales agents (DSA) of banks for services promised while opening an
account etc. It was last amended in Feb, 2009 to cover deficiencies arising out
of internet banking too.
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Type of complaints

The type and scope of the complaints which may be considered by a Banking
Ombudsman is very comprehensive, and it has been empowered to receive and
consider complaints pertaining to the following:

 Non-payment or inordinate delay in the payment or collection of cheques

drafts, bills, etc.;
 Non-acceptance, without sufficient cause, of small denomination notes
tendered for any purpose, and for charging of commission for this
service;
 Non-acceptance, without sufficient cause, of coins tendered and for
charging of commission for this service;
 Non-payment or delay in payment of inward remittances ;
 Failure to issue or delay in issue, of drafts, pay orders or bankers’
cheques;
 Non-adherence to prescribed working hours;
 Failure to honour guarantee or letter of credit commitments;
 Failure to provide or delay in providing a banking facility (other
than loans and advances) promised in writing by a bank or its direct
selling agents;
 Delays, non-credit of proceeds to parties' accounts, non-payment of
deposit or non-observance of the Reserve Bank directives, if any,
applicable to rate of interest on deposits in any savings, current or other
account maintained with a bank ;
 Delays in receipt of export proceeds, handling of export bills, collection of
bills etc., for exporters provided the said complaints pertain to the bank's
operations in India;
 Refusal to open deposit accounts without any valid reason for refusal;
 Levying of charges without adequate prior notice to the customer;
 Non-adherence by the bank or its subsidiaries to the instructions of
Reserve Bank on ATM/ debit card operations or credit card operations;

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  Non-disbursement or delay in disbursement of pension to the extent the
grievance can be attributed to the action on the part of the bank
concerned, (but not with regard to its employees);
 Refusal to accept or delay in accepting payment towards taxes, as
required by Reserve Bank/Government;
 Refusal to issue or delay in issuing, or failure to service or delay in
servicing or redemption of Government securities.
 Forced closure of deposit accounts without due notice or without
sufficient reason;
 Refusal to close or delay in closing the accounts;
 Non-adherence to the fair practices code as adopted by the bank; and
 Any other matter relating to the violation of the directives issued by the
Reserve Bank in relation to banking or other services.
 complaints from Non-Resident Indians having accounts in India in
relation to their remittances from abroad, deposits and other bank-
related matters;
The following types of complaints are not allowed:

 Sanction of Loans
 Matter taken to a Court of Law
 No written complaint has been made to the Bank concerned
 Time barred; one year limitation
 Suspected fraud & misbehavior
 No loss, damage or inconvenience; without sufficient cause
3.4.6 The Banking Codes and Standards

Reserve Bank of India, in its Monetary Policy Statement (April 2005)

announced setting up of the banking Codes and standards Board of India in
order to ensure that comprehensive code of conduct for fair treatment of
customers was evolved and adhered to.

The Banking Codes and Standards Board of India has been registered as a
separate society under the Societies Registration Act, 1860. Therefore, it would
function as an independent and autonomous body.
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The Banking Codes and Standards Board of India is not a Department of the
RBI. Reserve Bank has agreed to lend it financial support for a limited period.
It is an independent banking industry watch dog to ensure that the consumer
of banking services get what they are promised by the banks.

To ensure that the Board really functions as an autonomous and independent

watchdog of the industry, the Reserve Bank also decided to extend financial
support to the Board by way of meeting its full expenses for the first five years.
This was to enable the Board to reach its economic critical mass that will make
it truly independent in its functioning and take a view on any bank without its
existence coming under any threat. On its part, RBI would derive supervisory
comfort in case of banks which are members of the Board. In substance, the
Board has been set up to ensure that common man as a consumer of financial
services from the banking Industry is in a no way at a disadvantageous
position and really gets what it has been promised.

The banks have now adopted a code in line with a minimum standard that
need to be maintained and practiced.

Introduction

This is a voluntary Code, which sets minimum standards of banking practices

for banks to follow when they are dealing with individual customers. It provides
protection to you and explains how banks are expected to deal with you for
your day-to-day operations.

In the Code, 'you' denotes the customer and 'we', the bank the customer deals
with.

Objectives of the Code

The Code has been developed to

 Promote good and fair banking practices by setting minimum standards

in dealing with you;
 Increase transparency so that you can have a better understanding of
what you can reasonably expect of the services;
 Encourage market forces, through competition, to achieve higher
operating standards;
 Promote a fair and cordial relationship between you and your bank;

196
  Foster confidence in the banking system.
Application of code

Unless it says otherwise, all parts of this Code apply to all the products and
services listed below, whether they are provided by branches or subsidiaries
across the counter, over the phone, by post, through interactive electronic
devices, on the internet or by any other method. However, all products
discussed here may or may not be offered by all banks.

 Current accounts, savings account, term deposits, recurring deposit, PPF

accounts and all other deposit accounts.
 Payment services such as pension, payment orders, remittances by way
of Demand Drafts and wire transfers.
 Banking services related to Government transactions.
 Demat accounts, equity, government bonds.
 Indian currency notes exchange facility.
 Collection of cheques, safe custody services, safe deposit locker facility
 Loans and overdrafts.
 Foreign exchange services including money changing.
 Third party insurance and investment products sold through our
branches.
 Card products including credit cards, debits cards, ATM cards and
services (including credit cards offered by our subsidiaries/companies
promoted by us).
3.4.6.1 Key Commitments

 To Act Fairly and Reasonably In All Our Dealings with You

 To Help You to Understand How Our Financial Products And Services
Work
 To Help You Use Your Account Or Service By:
 To Deal Quickly and Sympathetically With Things That Go Wrong
 To Treat All Your Personal Information as Private and Confidential
 To Publicise the Code in a manner that will be accessible to all customer.

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  To adopt and practice a Non - Discrimination Policy
3.4.7 Let us sum up

Customer Relationship Management (CRM) in the Indian banking system is fun

damental to building a customer-centric organization. CRM systems link
customer data into a single and logical customer repository. CRM in banking is
a key element that allows a bank to develop its customer base and sales
capacity.

CRM is a simple philosophy that places the customer at the heart of a business
organization’s processes, activities and culture to improve his / her satisfaction
of service and, in turn, maximize the profits for the organization.

The main principles of CRM can be grouped into seven guiding factors:

 Customer focus
 Leadership
 Process approach
 Systems approach
 Involvement of people
 Mutually beneficial customer relationship.
 Continual improvement in the customer relationship
Banking Ombudsman is a quasi-judicial authority functioning under India’s
Banking Ombudsman Scheme 2006, and the authority was created pursuant
to the decision by the Government of India to enable resolution of complaints of
customers of banks relating to certain services rendered by the banks. The
Banking Ombudsman is a senior official, appointed by the Reserve Bank of
India to address grievances and complaints from customers, regarding
deficiencies in banking services.

The banks have now adopted a voluntary Code, which sets minimum
standards of banking practices for banks to follow when they are dealing with
individual customers. It provides protection to you and explains how banks are
expected to deal with you for your day-to-day operation.

198
3.4.8 Key words/concepts

Customer Relationship Management, Customer focus, Process

approach, Systems approach, Involvement of people, Banking Ombudsman,
BCSBI

3.4.9 Check your progress- questions

1. In CRM ‘Persuasion, judgment and decision-making abilities’ is part of

a. Customer focus b. Leadership

c. System approach d. Process approach

2. In CRM Scalable in its design and capacity means

a. To allow new products and services to b. To allow for the bank’s future growth
be implemented
c. To ensure processes, technology and d. To allow reporting of operational,
management deliver a consistent strategic and customer service goals to
customer treatment strategy across all measure if programs are achieving real
channels in the enterprise platform. ROI for the bank.

3. Which type of complaint is not allowed for bank ombudsman?

a. Non-adherence to prescribed working b. Failure to honour guarantee or letter of

hours credit commitments
c. Failure to provide or delay in providing d. Matter taken to a Court of Law
a banking facility (other than loans and
advances) promised in writing by a bank
or its direct selling agents

4. A key CRM technique is a sub-set of cross-selling, but in this case,

selling more expensive products. This is:

a. up-sell b. cross-sell
c. reactivation d. referral

5. In E-CRM, customer retention means

a. Encouraging customers to purchase b. Encouraging customers to purchase

more expensive products which may also further products through personalised
be in other categories. web and e-mail communications.

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c. Identifying the appropriate customers d. Attracting customers in the target
to target. profile to your site & encouraging them to
opt-in.

6. A key CRM technique is to encourage existing customers to recommend

friends or colleagues to purchase. This is:

a. Reactivation. b. Referral.
c. Up-sell. d. Cross-sell.

Key to the questions asked

1.b 2.b 3.d

4.a 5.b 6.b

3.4.10 Terminal questions

 What are the main principles of CRM?

 Explain the human resource factor in CRM
 Who is a bank ombudsman and what is his / her role?
 List out the type of complaints that can be presented before a bank
ombudsman
 What are the objectives of ‘code of conduct’ in bank operations and the
area of operations?
3.4.11 Reference

 Management paradise.com; project report on Retail Banking in India By

Gaurav Pandey
 Globalbusinessinsights.com
 Bellis-Jones theory on volume and profitability segmentation
 Marketing by Dr. Onkarnath (PPT)
 Bank of Baroda Website
 RBI website
 NABARD website
 IIBF website

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  Rural Retail banking India 2020 by Jayadeva M
 Corporate Governance by V Leeladhar
Bibliography – further reading

 Fundamentals of Retail Banking by O P Agarwal

 Retail banking by IIBF
 Cooperative banking operations by IIBF

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UNIT 4: TAXATION
Lesson No. 1 Terminology
Provision regarding Calculation of Taxable Income
Lesson No. 2
under Various Heads
Lesson No. 3 Returns
Lesson No. 4 Appeals
Lesson No. 5 Tax Deduction at Source
Lesson No. 6 Service tax

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4 Unit 4- Taxation

4.1 Lesson No. 1-Terminology

4.1.1 Objectives
4.1.2 Meaning of various terms used in Tax laws
4.1.3 Let us sum up
4.1.4 Key words/concepts
4.1.5 Check your progress-questions

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4.1.1 Objective

The objective of this lesson is to understand the distinguishing features of

various terminologies used in connection with income tax

4.1.2 Various terms used in tax laws

Advance tax

Tax paid before the assessment as required by the Act.

Arrears of tax

A legal obligation to pay an amount which has been ascertained or is easily

ascertainable and a default in the performance of that obligation

Assessable income

Income liable to be assessed to income tax.

Assessed tax

Tax on the basis of regular assessment reduced by the deductions permissible

Assessee

A person by whom any tax or a sum is payable under the Act.

Assessment year

It is the year in which you file your returns for the Income earned for the
financial year, which had just ended.

Capital gain

A gain arising out of the transfer of an asset

Commission

An allowance for service or labour in discharging certain duties such as for

instance of an agent, factor, broker or any other person who manages the
affairs or undertakes to do some work or renders some service to another.

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Concealment

Exists if the assesse fails to prove that the non-disclosure was not due to fraud
or willful conduct.

Cost of acquisition

The expenditure incurred in acquiring an asset.

Deduction

A reduction in the gross amount on which a tax is calculated; reduces taxes by

the percentage fixed for the taxpayer's income bracket

Depreciation

An annual deduction that allows taxpayers to recover the cost of property used
in a trade or business or held for the production of income.

Due

An existing obligation or a simple indebtedness without reference to the time of

payment.

Encumbrance

Interests in or burden or charge upon property.

Exemptions

Amount that taxpayers can claim for themselves, their spouses, and eligible
dependents.

File a return

Transmit to an IT authority the taxpayer's information, in specified format,

about income and tax liability.

Gift

Transfer by one person to another of an existing movable or immovable

property made voluntarily and without consideration.

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Gross income

Money, goods, services, and property a person receives that must be reported
on a tax return.

Hindu Undivided family

A family that consists of all persons lineally descended from a common

ancestor, including wives and unmarried daughters.

Income

Is a monetary return expected by the assesse for the labour and/or skill
bestowed, and/or capital invested by him/her; coming in from a definite
source, which need not be a legal source, in the sense that the failure to pay
the same need not be enforceable in a court of law; and excluding a receipt in
the nature of a mere windfall, which would mean a windfall in regard to its very
nature and not in regard to its extent or quantum.

Interest

It is the return or compensation for the retention by one person of a sum of

money belonging to or owed to another

Jurisdiction

Power, right or authority to take cognizance and decide any matter according to
law.

Levy

Imposition of a tax as well as its quantification and assessment.

Liable to tax

The existence of tax liability in person by reason of domicile, residence, place of

management place of incorporation or other criteria of a similar nature on the
date of making that claim under the law of the State of which the person is
claiming to be a resident.

Market value

Market value means the price that a willing purchaser would pay to a willing
seller for a property having due regard to its existing condition, with all its

206
existing advantages and its potential possibilities when laid out in its most
advantageous manner.

Permanent Account Number (PAN)

A unique alphanumeric combination issued to all juristic entities identifiable

under the Indian Income Tax Act 1961. It is issued by the IT department. It
also serves as an important ID proof.

Perquisite

A privilege, gain or profit incidental to an employment in addition to regular

salary or wages.

Previous year

It means twelve months ending on the 31st day of March of next preceding the
year for which the assessment is to be made.

Rebate

It is a remission or a payment back and of the nature of a deduction from the

gross amount.

Refund

Money owed to taxpayers when their total tax payments are greater than the
total tax. Refunds are received from the government.

Remuneration

It would include all that is quantifiable in money and paid to a person for his /
her services or work.

Rent

Any payment, by whatever name called, under any lease, sub-lease, tenancy or
any other agreement or arrangement for the use of any land or building
(including factory building), together with furniture, fittings and the land
appertaining thereto, whether or not such building is owned by the payee.

Reserves

An amount which is set apart to meet a contingency which is not known at the
time when the balance-sheet is prepared.
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Resident

If any of the following conditions are satisfied:

 he/she stayed in India for 182 days or more during the previous year, or
he/she stayed in India for 60 days in preceding year but stayed for 365
days or more during the four preceding years
 182 days in case of an Indian citizen or a person of Indian Origin coming
on a visit to India or 182 days in case of an Indian citizen going abroad
for an employment during the previous year. Stay in India for the above
criteria may be continuous or intermittent.
Revenue

The income the nation collects from taxes.

Regressive tax

A tax that takes a larger percentage of income from low-income groups than
from high-income groups.

Salary

All receipts from the employer in the form of wages, commission, bonus, profits
in lieu of or in addition to salary.

Source of income

The spring or fount from which a clearly defined channel of income flows.

Speculative transaction

Every transaction, in which a contract for the purchase or sale of any

commodity including stocks and shares, is periodically or ultimately settled
otherwise than by the actual delivery or transfer of the commodity or scrips,

Standard Deduction

A base amount of income that is not subject to tax and that can be used to
reduce a taxpayer's adjusted gross income (AGI).

TDS

TDS is pre-paid payment of tax in previous year in which incomes were

received/accrued. Under the scheme of TDS, person (payer) who is responsible
208
for making payment of income is liable to deduct tax at source at a specified
rate from the income. The tax so deducted from the income of the payee is
deemed to be payment of Income-tax by the recipient at the time of his / her
assessment.

Tax avoidance

An action taken to lessen tax liability and maximize after-tax income.

Tax deduction

An amount (often a personal or business expense) that reduces income subject

to tax.

Taxes

Required payments of money to governments that are used to provide public

goods and services for the benefit of the community as a whole.

Tax liability

The amount of tax that must be paid. Taxpayers meet (or pay) their federal
income tax liability through withholding, estimated tax payments, and
payments made with the tax forms they file with the government.

Tax exemption

A part of a person's income on which no tax is imposed.

Taxable income

The amount of income that is used to calculate an individual’s or a company’s

income tax due or gross income or adjusted gross income minus any
deductions, exemptions or other adjustments that are allowable in that tax
year.

Trade

It is the exchanging of goods for goods or goods for money.

Transfer of property

The passing of ownership rights in property from one person to another.

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Waiver

Abandonment of a right and it may be either express or implied from conduct,

but its basic requirement is that it must be an intentional act with knowledge.

Written down value

The value of an asset after accounting for depreciation or amortization.

4.1.3 Key words/concepts

Assessment year, Capital gain, Deduction, previous year, TDS

4.1.4 Check your progress

1. A legal obligation to pay an amount which has been ascertained or is

easily ascertainable and a default in the performance of that obligation is

a. Advance tax b. Assessed tax

c. Assessable income d. Arrears of tax

2. ----------is the year in which you file your returns for the Income earned
for the financial year, which had just ended.

a. Previous year b. Assessment year

c. Taxable year d. Fiscal year

3. -----------is twelve months ending on the 31st day of March of next

preceding the year for which the assessment is to be made.

a. Previous year b. Assessment year

c. Taxable year d. Fiscal year

4. Interests in or burden or charge upon property is known as.

a. due b. loan
c. encumbrance d. gift

5. Imposition of a tax as well as its quantification and assessment is known

as

210
a. liability b. levy
c. charge d. interest

Key to check your progress

1.d 2.b 3.a

4.c 5.b

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4.2 Lesson No. 14 Provision regarding calculation of taxable income
under various heads

4.2.1 Objectives
4.2.2 Income tax
4.2.2.1 Charge to Income-tax
4.2.2.2 Residential Status
4.2.3 Deductions
4.2.3.1 Basic rules for deduction
4.2.3.2 Categories of deductions
4.2.4 Individual Heads of Income
4.2.4.1 Income from salary
4.2.4.2 Perquisites and Exemptions u/s 10
4.2.4.3 Income from House property
4.2.4.4 Income from Business or Profession
4.2.4.5 Income from Capital Gains
4.2.4.6 Income from Other Sources
4.2.5 Deduction under chapter VI A
4.2.5.1 Section 80C Deductions
4.2.5.2 Section 80CCC for new personal cum-family pension scheme
4.2.5.3 Section 80CCD -deduction in respect of contribution to pension
scheme of central government
4.2.5.4 Section 80CCF: Investment in Infrastructure Bonds
4.2.5.5 Section 80E – deduction in respect of interest on loan taken for
higher education, charitable institutions etc
4.2.5.6 Section 80GG – deduction of rents paid
4.2.6 Let us sum up
4.2.7 Key words/concepts
4.2.8 Check your progress-questions
4.2.9 Terminal questions

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4.2.1 Objectives

The objectives of this lesson are to understand from the IT point of view

 Salary
 Profit and Gains of Business or Profession
 Capital Gain
 Deductions Under Chapter VI – A
 Assessment of Tax
4.2.2 Introduction-Income tax

The government of India imposes an income tax on taxable income of

individuals, Hindu Undivided Families (HUF), companies, firms, co-operative
societies and trusts (identified as body of individuals and association of
persons) and any other artificial person. Levy of tax is separate on each of the
persons. The levy is governed by the Indian Income Act, 1961. The Indian
Income Tax Department is governed by the Central Board for Direct Taxes
(CBDT) and is part of the Department of Revenue under the Ministry of
Finance, Government of India. There are close to 35 million income tax payers
in India.

4.2.2.1 Charge to Income-tax

Everyone whose income exceeds the maximum amount, which is not

chargeable to the income tax, is an assesse, and shall be chargeable to the
income tax at the rate or rates prescribed under the finance act for the relevant
assessment year, shall be determined on basis of his/ her residential status.
Income tax is a tax payable, at the rate enacted by the Union Budget (Finance
Act) for every Assessment Year, on the Total Income earned in the Previous
Year by every Person.

The chargeability is based on nature of income, i.e., whether it is revenue or

capital. The rates of taxation of income are.

The three residential status, viz.

Resident Ordinarily Residents

Under this category, person must be living in India at least 182 days during
previous year or must have been in India 365 days during 4 years preceding

213
previous year and 60 days in previous year. Ordinary residents are always
taxable on their income earned both in India and Abroad.

Resident but not Ordinarily Residents

Must have been a non-resident in India 9 out of 10 years preceding previous

year or have been in India in total 729 or less days out of last 7 years preceding
the previous year. Not residents are taxable in relation to income received in
India or income accrued or deemed to accrue or arise in India and income from
business or profession controlled from India.

Non Residents

Non Residents are exempt from tax if accrue or arise or deemed to be accrue or
arise outside India. Taxable if income is earned from business or profession
setting in India or having their head office in India.

4.2.3 Deductions

4.2.3.1 Following are the basic rules for deduction

The aggregate amount of deductions under sections 80C to 80U cannot exceed
gross total income(gross total income after excluding long term capital gains,
short term capital gain under section 111A, winnings from lottery, crossword
puzzles etc.)

These deductions are to be allowed only if the assesse claims these and gives
the proof of such investments/ expenditure/ income.

4.2.3.2 Categories of deductions

There are various kinds of deductions. Some of them are to encourage savings,
some are for certain personal expenditure, a few are for socially desirable
activities, and some are for economic growth. For the sake of better
understanding we have categorized them into four kinds. They are

 To encourage savings
 For certain personal expenditure
 For socially desirable activities
 For physically disabled persons

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Heads of Income

The total income of a person is divided into five heads:

 Salary income
 Income from house property,
 Income from business or profession
 Capital Gain and
 Income from other sources.
4.2.4 Individual heads of income

4.2.4.1 Income from Salary

All income received as salary under Employer-Employee relationship is taxed

under this head. Employers must withhold tax compulsorily, if income exceeds
minimum exemption limit, as Tax Deducted at Source (TDS), and provide their
employees with a Form 16 which shows the tax deductions and net paid
income. In addition, the Form 16 will contain any other deductions provided
from salary such as:

 Medical reimbursement: Up to Rs.15, 000 per year is tax free if

supported by bills.
 Transport allowance: Up to Rs.800 per month (Rs.9, 600 per year) is tax
free if provided as transport allowance. No bills are required for this
amount.
 Conveyance allowance: is tax exempt.
 Professional taxes: Most states tax employment on a per-professional
basis, usually a slabbed amount based on gross income. Such taxes paid
are deductible from income tax.
 House rent allowance: the least of the following is available as exemption
 Actual HRA received
 50%/ 40% (metro/non-metro) of basic salary
 Rent paid minus 10% of 'salary'. Basic Salary for this purpose is basic
+ DA forming part + commission on sale on fixed rate.

215
  The exemption for HRA u/s 10(13A) is the least of all the above three
factors.
4.2.4.2 Perquisites and Exemptions u/s 10

The term "Perquisite" includes value of any benefit or amenity/value of any

concession provided by the employer to the employees. Perquisite Valuation
does not include certain medical benefits. Section 10 exemptions are available
for the following perquisites:

 Leave Travel Concession u/s 10(5)

 Perquisites paid to Indian Citizens Employed Abroad 10(7) no
 Tax Paid on Behalf of Any Employee by the Employer 10(10CC)
 Any sum received under Life Insurance Company
 Dividend from Domestic company
4.2.4.3 Income from House property

Income from House property is computed by taking into account what is

called Gross Annual Value of the property. The annual value (Annual value in
case of a self-occupied house is to be taken as NIL. (However if there is more
than one self-occupied house then the annual value of the other house/s is
taxable.) From this, deduct Municipal Tax paid and you get the Net Annual
Value. From this Net Annual Value, deduct:

 30% of Net value as repair cost (This is a mandatory deduction)

 No other deduction available
 Interest paid or payable on a housing loan against this house
In the case of a self-occupied house interest paid or payable is subject to a
maximum limit of Rs.1, 50, 000 (if loan is taken on or after 1 April 1999 and
construction is completed within 3 years) and Rs.30, 000 (if the loan is taken
before 1 April 1999). For l non self-occupied homes, all interest is deductible,
with no upper limits. The balance is added to taxable income.

4.2.4.4 Income from business or profession

The income referred to in section 28, i.e., the incomes chargeable as "Income
from Business or Profession" shall be computed in accordance with the
provisions contained in sections 30 to 43D. However, there are few more

216
sections under this Chapter, viz., Sections 44 to 44DA (except sections 44AA,
44AB & 44C), which contain the computation completely within itself. Section
44C is a disallowance provision in the case non-residents. Section 44AA deals
with maintenance of books and section 44AB deals with audit of accounts.

In summary, the sections relating to computation of business income can be

grouped as under: -

 Deductible Expenses - Sections 30 to 38 [except 37(2)].

 Inadmissible Expenses - Sections 37(2), 40, 40A, 43B & 44-C.
 Deemed Incomes - Sections 33AB, 33ABA, 33AC, 35A, 35ABB & 41.
 Special Provisions - Sections 42 & 43D
 Self-Coded Computations - Sections 44, 44A, 44AD, 44AE, 44AF, 44B,
44BB, 44BBA, 44BBB, 44-D & 44-DA.
The computation of income under the head "Profits and Gains of Business or
Profession" depends on the particulars and information available.[6]

If regular books of accounts are not maintained, then the computation would
be as under: -

Income (including Deemed Incomes) chargeable as income under this head xxx

Less: Expenses deductible (net of disallowances) under this head xxx

Profits and Gains of Business or profession xxx

However, if regular books of accounts have been maintained and Profit and
Loss Account has been prepared, then the computation would be as under: -

Net Profit as per Profit and Loss Account xxx

Add : Inadmissible Expenses debited to Profit and Loss Account xxx
Deemed Incomes not credited to Profit and Loss Account xxx
Less: Deductible Expenses not debited to Profit and Loss Account xxx
Incomes chargeable under other heads credited to Profit & Loss A/c xxx
Profits and Gains of Business or Profession xxx

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4.2.4.5 Income from capital gains

Transfer of capital assets results in capital gains. A Capital asset is defined

under section 2(14) of the I.T. Act, 1961 as property of any kind held by an
assesse such as real estate, equity shares, bonds, jewellery, paintings, art etc.
but does not include some items like any stock-in-trade for businesses and
personal effects. Transfer has been defined under section 2(47) to include sale,
exchange, relinquishment of asset, extinguishment of rights in an asset, etc.
Certain transactions are not regarded as 'Transfer' under section 47.

For tax purposes, there are two types of capital assets: Long term and short
term. Long term asset is that which is held by a person for three years except
in case of shares or mutual funds which becomes long term just after one year
of holding. Sale of such long term assets gives rise to long term capital gains.
There are different scheme of taxation of long term capital gains. These are:

As per Section 10(38) of Income Tax Act, 1961 long term capital gains on
shares or securities or mutual funds on which Securities Transaction Tax (STT)
has been deducted and paid, no tax is payable. STT has been applied on all
stock market transactions since October 2004 but does not apply to off-market
transactions and company buybacks; therefore, the higher capital gains taxes
will apply to such transactions where STT is not paid.

In case of other shares and securities, person has an option to either index
costs to inflation and pay 20% of indexed gains, or pay 10% of non-indexed
gains. The indexation rates are released by the I-T department each year.

In case of all other long term capital gains, indexation benefit is available and
tax rate is 20%.

All capital gains that are not long term are short term capital gains, which are
taxed as such:

Under section 111A, for shares or mutual funds where STT is paid, tax rate is
10% From Asst Yr 2005-06 as per Finance Act 2004. For Asst Yr 2009-10 the
tax rate is 15%.

In all other cases, it is part of gross total income and normal tax rate is
applicable.

For companies abroad, the tax liability is 20% of such gains suitably indexed
(since STT is not paid).

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4.2.4.6 Income from other sources

This is a residual head, under this head income which does not meet criteria to
go to other heads is taxed. There are also some specific incomes which are to
be taxed under this head.

 Income by way of Dividends

 Income from horse races
 Income from winning bull races
 Any amount received from key man insurance policy as donation.
 Income from shares (dividend other than Indian company)
4.2.5 Deduction under chapter VI A

While an exemption is on income, some deduction in calculation of taxable

income is allowed for certain payments.

4.2.5.1 Section 80C Deductions

Section 80C of the Income Tax Act allows certain investments and expenditure
to be deducted from total income up to the maximum of 1 lac. The total limit
under this section is Rs.150, 000) which can be any combination of the below:

 Contribution to Provident fund or Public Provident fund PPF provides 8%

(presently for April 2019 to June2019 quarter) return compounded
annually. Maximum limit to contribute in it is 150,000 for each financial
year. It is a long term investment with complete withdrawal not possible
till 15 years though partial withdrawal is possible after 5 years. It can be
renewed for a period of 5 years each after initial period of 15 years.
Besides, there is employee provident fund which is deducted from the
salary of the person. This is about 10% to 12% of the BASIC salary
component. Recent changes are being discussed regarding reducing the
instances of withdrawal from EPF especially when one changes the job.
EPF has the option of full settlement on leaving the job, taking VRS,
retirement after 58/60. It also has options of withdrawal for certain
expenses related to home, marriage or medical. EPF contribution
includes 12% of basic salary from employee and employer. It is
distributed in ratio of 8.33:3.67 in Pension fund and Provident fund

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  Payment of life insurance premium. It is allowed on premium paid on
self, spouse and children even if they are not dependent on father or
mother.
 Investment in pension Plans. National Pension Scheme is meant to save
money for the post retirement which invests money in different
combination of equity and debt. Depending upon age up to 50% can go
in equity. Annuity payable after retirement is dependent upon age. NPS
has six fund managers. Individual can make minimum contribution of Rs
6,000/- . It has 22 point of purchase (banks).
 Investment in Equity Linked Savings schemes (ELSS) of mutual funds.
Among other investment opportunities, ELSS has the least lock-in period
of 3 years. However, one should note that after the Direct Tax Code is in
place, ELSS will no longer be an investment for 80C deduction.
 Investment in National Savings Certificates (interest of past NSCs is
reinvested every year and can be added to the Section 80 limit)
 Tax saving Fixed Deposits provided by banks for a tenure of 5 years.
Interest is also taxable.
 Payments towards principal repayment of housing loans. Also any
registration fee or stamp duty paid.
 Payments towards tuition fees for children to any school or college or
university or similar institution (Only for 2 children)
 Post office investments
The investment can be from any source and not necessarily from income
chargeable to tax.

4.2.5.2 Section 80CCC for new personal cum-family pension scheme

Section 80CCC provided that if an assessee being an individual pays or

deposits any amount out of his / her income chargeable to tax to effect or keep
in force a contract for any annuity plan of Life Insurance Corporation of
India or any other insurer for receiving pension from the fund referred to in
section 10(23 AAB), he / she shall be allowed a deduction of the amount equal
to the deposit or Rs. 1, 50,000 whichever is less.

The amount of pension received in the hands of the contributor or the

nominees shall be taxable.

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4.2.5.3 Section 80CCD -deduction in respect of contribution to
pension scheme of central government

Persons Covered- Individual in the employment of Central Government or any

other employer on or after 1-1-2004 or any other assessee being an individual.

Eligible Amount- Deposit or payment made by the employee and Central

Government or individual under a pension scheme notified by the Central
Government.

Employee’s contribution – Section 80CCD (1) Allowed to an individual who

makes deposits to his/her pension account. Maximum deduction allowed is
10% of salary (in case the taxpayer is an employee) or 10% of gross total
income (in case the taxpayer being self-employed) or Rs 1, 50, 000, whichever
is less.

From FY 2017-18 – In the case of a self-employed individual, maximum

deduction allowed is 20% of gross salary instead of 10% (earlier subject to
a maximum of Rs1, 50,000).

However, the combined maximum limit for section 80C, 80CCC and sec
80CCD (1) deduction is Rs 1, 50,000, which can be availed.

Deduction for self-contribution to NPS – section 80CCD (1B) A new section

80CCD (1B) has been introduced for an additional deduction of up to Rs
50,000 for the amount deposited by a taxpayer to their NPS account.
Contributions to Atal Pension Yojana are also eligible.

Employer’s contribution to NPS – Section 80CCD (2) Additional deduction is

allowed for employer’s contribution to employee’s pension account of up to 10%
of the salary of the employee. There is no monetary ceiling on this deduction.
4.2.5.4 Section 80CCF: Investment in Infrastructure Bonds

From April, 1 2011, a maximum of Rs. 20,000 is deductible under section

80CCF provided that amount is invested in infrastructure bonds. This is in
addition to the 100,000 deduction allowed under Section 80C. However this
deduction was not been extended from financial year 2012-13 onwards.

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Section 80D: Medical Insurance Premiums

Deduction is available up to Rs. 25,000/- to a taxpayer for insurance of self,

spouse and dependent children. If individual or spouse is more than 60 years
old the deduction available is Rs 30,000. An additional deduction for insurance
of parents (father or mother or both) is available to the extent of Rs. 25,000/– if
less than 60 years old and Rs 30,000 if parents are more than 60 years old. For
uninsured super senior citizens (more than 80 years old) medical expenditure
incurred up to Rs 30,000 shall be allowed as a deduction under section 80D.
Therefore, the maximum deduction available under this section is to the extent
of Rs. 60,000/-. (From AY 2016-17, within the existing limit a deduction of up
to Rs. 5,000 for preventive health check-up is available).

4.2.5.5 Section 80E – deduction in respect of interest on loan taken

for higher education

Section 80E has been substituted by a new Section with effect from the A.Y.
2006-07. The provisions of new Section are given below:

Conditions - The following conditions should be satisfied -

 The taxpayer is an individual.

 He / she had taken a loan for the purpose of pursuing his / her higher
education. ‘‘Higher education’’ for this purpose means full-time studies
for any graduate or post-graduate course in engineering, medicine,
management or for post-graduate course in applied sciences or pure
sciences including mathematics and statistics.
 The aforesaid loan was taken from any bank, an approved charitable
institution or a financial institution notified by the Government.
 During the previous year, the taxpayer has paid interest on such loan.
 Such interest is paid out of his / her income chargeable to tax.
Amount deductible – If the above conditions are satisfied, the entire amount
paid by way of interest is deductible under section 80E. However, the following
points should be noted

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  The above deduction is allowed in computing the taxable income of the
initial assessment year (i.e., the assessment year relevant to the previous
year in which the assessee starts paying the interest on the loan) and 7
immediately succeeding assessment years (or until the above interest is
paid in full, whichever is earlier).
 From the assessment year 2006-07, no deduction will be available under
section 80E in respect of repayment of principal amount.
 From assessment year 2008-09 onwards, deduction under this section is
also allowable for interest or Loan for higher education of assessee’s
relative
 Interest paid for a period of 8 years
Section 80G: Deduction for donations towards Social Causes

The various donations specified in Sec. 80G are eligible for deduction up to
either 100% or 50% with or without restriction as provided in Sec. 80G. 80G
deduction not applicable in case donation is done in form of cash for amount
over Rs 10,000.

From Financial Year 2017-18 onwards – Any donations made in cash exceeding
Rs 2000 will not be allowed as deduction. The donations above Rs 2000
should be made in any mode other than cash to qualify as deduction u/s 80G.
Donations with 100% deduction without any qualifying limit:

 National Defense Fund set up by the Central Government

 Prime Minister’s National Relief Fund
 National Foundation for Communal Harmony
 An approved university/educational institution of National eminence
 Zila Saksharta Samiti constituted in any district under the chairmanship
of the Collector of that district
 Fund set up by a State Government for the medical relief to the poor
 National Illness Assistance Fund
 National Blood Transfusion Council or to any State Blood Transfusion
Council

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  National Trust for Welfare of Persons with Autism, Cerebral Palsy, Mental
Retardation and Multiple Disabilities
 National Sports Fund
 National Cultural Fund
 Fund for Technology Development and Application
 National Children’s Fund
 Chief Minister’s Relief Fund or Lieutenant Governor’s Relief Fund with
respect to any State or Union Territory
 The Army Central Welfare Fund or the Indian Naval Benevolent Fund or
the Air Force Central Welfare Fund, Andhra Pradesh Chief Minister’s
Cyclone Relief Fund, 1996
 The Maharashtra Chief Minister’s Relief Fund during October 1, 1993
and October 6,1993
 Chief Minister’s Earthquake Relief Fund, Maharashtra
 Any fund set up by the State Government of Gujarat exclusively for
providing relief to the victims of earthquake in Gujarat
 Any trust, institution or fund to which Section 80G(5C) applies for
providing relief to the victims of earthquake in Gujarat (contribution
made during January 26, 2001 and September 30, 2001) or
 Prime Minister’s Armenia Earthquake Relief Fund
 Africa (Public Contributions — India) Fund
 Swachh Bharat Kosh (applicable from financial year 2014-15)
 Clean Ganga Fund (applicable from financial year 2014-15)
 National Fund for Control of Drug Abuse (applicable from financial year
2015-16)

Donations with 50% deduction without any qualifying limit.

 Jawaharlal Nehru Memorial Fund

 Prime Minister’s Drought Relief Fund
 Indira Gandhi Memorial Trust

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  The Rajiv Gandhi Foundation

Donations to the following are eligible for 100% deduction subject to 10% of
adjusted gross total income

 Government or any approved local authority, institution or association to

be utilised for the purpose of promoting family planning
 Donation by a Company to the Indian Olympic Association or to any
other notified association or institution established in India for the
development of infrastructure for sports and games in India or the
sponsorship of sports and games in India.

Donations to the following are eligible for 50% deduction subject to 10% of
adjusted gross total income

 Any other fund or any institution which satisfies conditions mentioned in

Section 80G(5)
 Government or any local authority to be utilised for any charitable
purpose other than the purpose of promoting family planning
 Any authority constituted in India for the purpose of dealing with and
satisfying the need for housing accommodation or for the purpose of
planning, development or improvement of cities, towns, villages or both
 Any corporation referred in Section 10(26BB) for promoting interest of
minority community
 For repairs or renovation of any notified temple, mosque, gurudwara,
church or other place.

4.2.5.6 Section 80GG – deduction of rents paid

A deduction in respect of any expenditure incurred by an assessee, who is not

in receipt of any income falling within clause (13A) of Section 10 of the Act, in
excess of 10% of his / her total income towards payment of rent in respect of
any furnished or unfurnished accommodation occupied by him/ her for the
purpose of his / her own residence to the extent of Rs. 2,000 per month or 25%
of his/her total income, whichever is less, will be allowed under Section 80GG.

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This deduction is allowable to only those assesses who do not own any
residential accommodation.

Persons Covered -Any assessee other than assessee having income falling u/s
10(13A) (i.e., House Rent Allowance).

Eligible Amount -Any expenditure incurred by him/her on payment of rent (by

whatever name called) in respect of any furnished or unfurnished
accommodation in excess of 10% of his / her total income, before making any
deduction under this section.

Relevant Conditions/Points

 Such accommodation is occupied by him / her for his /her own

residence.
 The assessee should file a declaration in Form No. 10BA along with
return of income.
 This section shall not apply to an assessee if residential accommodation
is, (a) owned by the assessee or by his / her spouse or minor child or
where such assessee is member of HUF, by such family, at the place
where he/she ordinarily resides or performs duties of his / her office or
employment or carries on his /her business or profession. OR (b) owned
by the assessee at any other place, being accommodation in the
occupation of the assessee, the value of which is to be determined u/s.
23(2)(a) or 23(4)(a).
Extent of Deduction -Lower of (a) Rs. 2,000 per month, or (b) 25% of the total
income (after allowing all deductions except under this section), or (c)
Expenditure incurred in excess of 10% of the total income (after allowing all
deductions except under this section).

Refund Status

State Bank of India (SBI) is the refund banker to the Indian Income Tax
Department (ITD). Your tax refund details are sent to SBI, by the Income tax
department. Then SBI will process the refund, and send you the refund
intimation. While filing your return you can choose any one of the two Refund
modes ECS or Paper (cheque).

Deductions on Contribution by Companies to Political Parties

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Section 80GGB: Deduction on contributions given by companies to Political
Parties

Deduction is allowed to an Indian company for amount contributed by it to any

political party or an electoral trust. Deduction is allowed for contribution done
by any way other than cash.

Political party means any political party registered under section 29A of the
Representation of the People Act. Contribution is defined as per section 293A of
the Companies Act, 1956.
Deductions on Contribution by Individuals to Political Parties

Section 80GGC: Deduction on contributions given by any person to

Political Parties

Deduction is allowed to a taxpayer for any amount contributed to any political

party or an electoral trust. Deduction is allowed for contribution done by any
way other than cash.

Political party means any political party registered under section 29A of the
Representation of the People Act.
Corporate Income Tax

Domestic Company

I. For the Assessment Year 2018-19, a domestic company is taxable at 30%.

However, tax rate would be 25% where turnover or gross receipt of the
company does not exceed Rs. 50 crore in the previous year 2015-16.

Add:

a) Surcharge: The amount of income-tax shall be increased by a

surcharge at the rate of 7% of such tax, where total income exceeds one
crore rupees but not exceeding ten crore rupees and at the rate of 12% of
such tax, where total income exceeds ten crore rupees. However, the
surcharge shall be subject to marginal relief, which shall be as under:

(i) Where income exceeds one crore rupees but not exceeding ten
crore rupees, the total amount payable as income-tax and
surcharge shall not exceed total amount payable as income-tax on
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 total income of one crore rupees by more than the amount of
income that exceeds one crore rupees.

(ii) Where income exceeds ten crore rupees, the total amount
payable as income-tax and surcharge shall not exceed total
amount payable as income-tax on total income of ten crore rupees
by more than the amount of income that exceeds ten crore rupees.

b) Education Cess: The amount of income-tax and the applicable

surcharge, shall be further increased by education cess calculated at the
rate of two per cent of such income-tax and surcharge.

c) Secondary and Higher Education Cess: The amount of income-tax

and the applicable surcharge, shall be further increased by secondary
and higher education cess calculated at the rate of one per cent of such
income-tax and surcharge.

II. For the assessment year 2019-20, a domestic company is taxable at 30%.
However, the tax rate would be 25% if turnover or gross receipt of the company
does not exceed Rs. 250 crore in the previous year 2016-17.

Add:

a) Surcharge: The amount of income-tax shall be increased by a surcharge at

the rate of 7% of such tax, where total income exceeds one crore rupees but not
exceeding ten crore rupees and at the rate of 12% of such tax, where total
income exceeds ten crore rupees. However, the surcharge shall be subject to
marginal relief, which shall be as under:

(i) Where income exceeds one crore rupees but not exceeding ten crore
rupees, the total amount payable as income-tax and surcharge shall not
exceed total amount payable as income-tax on total income of one crore
rupees by more than the amount of income that exceeds one crore
rupees.

(ii) Where income exceeds ten crore rupees, the total amount payable as
income-tax and surcharge shall not exceed total amount payable as
income-tax on total income of ten crore rupees by more than the amount
of income that exceeds ten crore rupees.

b) Health and Education Cess: The amount of income-tax and the applicable
surcharge, shall be further increased by health and education cess calculated
at the rate of four percent of such income-tax and surcharge.

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Co-operative Society

Assessment Year 2018-19 and Assessment Year 2019-20

Taxable income
Up to Rs. 10,000
Rs. 10,000 to Rs. 20,000
Above Rs. 20,000

Add:

a) Surcharge: The amount of income-tax shall be increased by a surcharge at

the rate of 12% of such tax, where total income exceeds one crore rupees.
However, the surcharge shall be subject to marginal relief (where income
exceeds one crore rupees, the total amount payable as income-tax and
surcharge shall not exceed total amount payable as income-tax on total income
of one crore rupees by more than the amount of income that exceeds one crore
rupees).

For Assessment Year 2019-20

b) Education Cess: The amount of income-tax and the applicable surcharge,

shall be further increased by education cess calculated at the rate of two per
cent of such income-tax and surcharge.

c) Secondary and Higher Education Cess: The amount of income-tax and the
applicable surcharge, shall be further increased by secondary and higher
education cess calculated at the rate of one per cent of such income-tax and
surcharge.

Tax Penalties

The major number of penalties initiated every year as a ritual by I-T Authorities
is under section 271(1)(c) which is for either concealment of income or for
furnishing inaccurate particulars of income.

"If the Assessing Officer or the Commissioner (Appeals) or the Commissioner in

the course of any proceedings under this Act, is satisfied that any person-

(b) Has failed to comply with a notice under sub-section (1) of section 142 or
sub-section (2) of section 143 or fails to comply with a direction issued under
sub-section (2A) of section 142, or

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(c) Has concealed the particulars of his / her income or furnished inaccurate
particulars of such income,

He/she may direct that such person shall pay by way of penalty,-

(ii) In the cases referred to in clause (b), in addition to any tax payable by
him/her, a sum of ten thousand rupees for each such failure;

(iii) In the cases referred to in clause (c), in addition to any tax payable by
him/her, a sum which shall not be less than, but which shall not exceed three
times, the amount of tax sought to be evaded by reason of the concealment of
particulars of his / her income or the furnishing of inaccurate particulars of
such income.

4.2.6 Let us sum up

The government of India imposes an income tax on taxable income of

individuals, Hindu undivided families (HUF), companies, firms, co-operative
societies and trusts (identified as body of individuals and association of
persons) and any other artificial person. Levy of tax is separate on each of the
persons

Everyone whose income exceeds the maximum amount, which is not

chargeable to the income tax, is an assesse, and shall be chargeable to the
income tax at the rate or rates prescribed under the finance act for the relevant
assessment year, shall be determined on basis of his /her residential status.

Income tax is a tax payable, at the rate enacted by the Union Budget (Finance
Act) for every Assessment Year, on the Total Income earned in the Previous
Year by every Person.

There are various kinds of deductions. Some of them are to encourage savings,
some are for certain personal expenditure, a few are for socially desirable
activities, and some are for economic growth. For the sake of better
understanding we have categorized them into four kinds.

They are:

 To encourage savings
 For certain personal expenditure
 For socially desirable activities

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  For physically disabled persons
4.2.7 Key words/concepts

Residential Status, Perquisites and Exemptions u/s 10, Capital Gains, Chapter
VI A, Corporate Income tax

4.2.8 Check your progress- question

1. Tax deductions have been categorized into the following kinds. Identify
the incorrect option

a. To encourage savings b. For certain personal expenditure

c. For social activities d. For physically disabled persons

2. Section 10 exemptions are available for

a. Any sum received under life insurance b. Donations

corporation
c. Income from house property d. Contribution to provident fund

3. Under section 80C the total investment and expenditure allowed as

deduction is

a. Rs. 2,00,000 b. Rs. 3,00,000

c. Rs. 50,000 d. Rs. 1,50,000

Key to the questions asked

1.c 2.a 3.d

4.2.9 Terminal questions

 Define income tax and describe the various kinds of deductions

 Describe the various heads of income
 Explain the important sections under chapter VIA

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4.3 Lesson No. 15 Returns

4.3.1 Objectives
4.3.2 Filing of Returns
4.3.2.1 Manner of filing the new Forms
4.3.2.2 Filling out acknowledgement
4.3.2.3 Intimation of processing under section 143(1)
4.3.2.4 Filing your return through Tax Return Preparers (TRPs)
4.3.2.5 Due dates for filing of returns
4.3.3 Types of IT returns
4.3.4 Let us sum up
4.3.5 Key words/concepts
4.3.6 Check your progress
Key to questions asked
4.3.7 Terminal questions

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4.3.1 Objectives

The objectives of this lesson are to understand the procedure related to

 Filing of Income Tax Return

 Various Types of Income Tax Returns
 Electronic Form of Income Tax Returns
4.3.2 Filing of Returns

Income-tax return is a legal document and it should be filed by the assessee

with due care and caution. There should be no corrections or overwriting and it
should be properly signed and verified by the person authorized to do so under
the provisions of the Income-tax Act. The following important points may be
taken care of while filling up the return forms:

Assessment year to which new forms are applicable

The new ITRs notified are applicable for the assessment years 2016-17
onwards only, for return of income relating to earlier assessment years return
is to be furnished in the appropriate form as applicable in that assessment
year. Each assessee has to identify the correct ITR Form applicable in its case
before filing the return of income.

No enclosures to the return

Rule 12(2) of the I.T Rules provides that the return of income and return of
fringe benefits required to be furnished in Form No. ITR-1, ITR-2, ITR-3, ITR-4,
ITR-5, ITR-6, or ITR-8 shall not be accompanied by a statement showing the
computation of tax payable on the basis of return, or proof of tax, if any,
claimed deducted or collected at source or the advance tax or tax on self-
assessment, if any, claimed to have been paid or any document or copy of any
account or form or report of audit required to be attached with the return of
income or return of fringe benefits under any provisions of the Act.

4.3.2.1 Manner of filing the new forms

These Forms can be submitted in the following manner:

 a paper form;
 (e-filing
 (a bar-coded paper return.
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Returns can be e-filed through the internet. E-filing of return is mandatory for
companies and firms requiring statutory audit u/s 44AB. E-filing can be done
with or without digital signatures and for individuals and HUFs with total
assessable incomes of Rs 10 lacs and above

 If the returns are filed using digital signature, then no further action is
required from the tax payers.
 If the returns are filed without using digital signature, then the tax
payers have to file ITR-V with the department within 15 days of e-filing.
 The tax payers can e-file the returns through an e-intermediary who
would e-file and assist him/her in filing of ITR-V within 15 days. Where
the form is furnished by using bar coded paper return then the tax
payers need to print two copies of Form ITR-V. Both copies should be
verified and submitted. The receiving official shall return one copy after
affixing the stamp and seal.
4.3.2.2 Filling out acknowledgement

Where the return is furnished in paper format, acknowledgement slip attached

with the return should be duly filled in. The new forms are not required to be
filed in duplicate.

4.3.2.3 Intimation of processing under section 143(1)

The acknowledgement of the return is deemed to be the intimation of

processing under section 143(1). No separate intimation will be sent to the
taxpayer unless there is a demand or refund.

Furnishing details of high value transactions.

In the return the details of high value transactions need to be compulsorily

stated, which are ordinarily reported through the annual information return
(AIR) and these details are cross checked and matched with the data in the
AIR.

4.3.2.4 Filing your return through Tax Return Preparers (TRPs)

If you are an individual or a HUF assessee and you are not required to get your
accounts audited (called ‘eligible person’) under the provisions of the Income
Tax Act, then you can use the services of a Tax Return Preparer (TRP).
However, if the ‘eligible person’ is not a resident in India during the previous

234
year relevant to such assessment year, he/she cannot avail of the services of a
TRP.

4.3.2.5 Due dates for filing of returns

The Due dates for filing Income Tax returns are:-

I. Where the assessee is a Company-30th September of the Assessment Year.

II. Where the assessee is a person other than a company:-

a) Where accounts of the assessee are to be audited under the Income Tax Act
or any other law- 30th September of the Assessment Year

or

A working partner of a firm whose accounts are required to be audited under

the Income Tax Act or any other law - 30th September of the Assessment Year

b) Any other assessee- 31st July of the Assessment Year.

4.3.3 Types of IT returns

Following table shall give you an idea of different forms applicable for different
type of returns:

ITR1 (Sahaj)

For Individuals having Income from Salary / Pension / Income from One House
Property (excluding loss brought forward from previous years) / Income from
Other Sources (Excluding Winning from Lottery and Income from Race Horses)
and is upto Rs 50 lakh and agriculture income upto Rs 5000/-.

ITR2

For Individuals and HUFs not having Income from Business or Profession

ITR3

For individuals and HUFs having income from profits and gains of business or
profession.

ITR4 Sugam

235
For Individuals, HUFs and Firms (other than LLP) being a resident having total
income upto Rs.50 lakh and having income from business and profession
which is computed under sections 44AD, 44ADA or 44AE

ITR5

For persons other than- (i) individual, (ii) HUF, (iii) company and (iv) person
filing Form ITR-7

ITR6

For Companies other than companies claiming exemption under section 11

ITR7

For persons including companies required to furnish return under sections

139(4A) or 139(4B) or 139(4C) or 139(4D) only

ITR8

Return for Fringe Benefits (no longer applicable)

ITRV

Where the data of the Return of Income in Form ITR-1 (SAHAJ), ITR-2, ITR-3,
ITR-4(SUGAM), ITR-5, ITR-7 filed but NOT verified electronically

4.3.4 Let us sum up

Income-tax return is a legal document and it should be filed by the assessee

with due care and caution.

The new ITRs notified are applicable for the assessment years 2008-09
onwards only, for return of income relating to earlier assessment years return
is to be furnished in the appropriate form as applicable in that assessment
year.

These Forms can be submitted in the following manner:

 a paper form;
 e-filing
 a bar-coded paper return.

236
4.3.5 Key words/concepts

Filing of Returns, a paper form;, e-filing. a bar-coded paper return., Types of IT

returns

4.3.6 Check your progress

1. For Individuals having Income from Salary / Pension / Income from One
House Property (excluding loss brought forward from previous years) /
Income from Other Sources (Excluding Winning from Lottery and Income
from race horses the return to be filed is___

a. ITR2 b. ITR1
c. ITR4 d. ITR5

2. For individuals & HUFs having income from a proprietary business or

profession the return to be filed is___

a. ITR2 b. ITR1
c. ITR4 d. ITR5

3. Who can use services of Tax Return Preparers?

a. a. Corporate b. All individuals

c. HUFs d. Individuals and HUFs whose accounts
need not be audited.

Key to the questions asked

1.b 2.c 3.d

4.3.7 Terminal questions

 Describe the different ways of filing an income tax return

 List out the various types of IT returns

237
4.4 Lesson No. 16 Appeals

4.4.1 Objectives

4.4.2 Appeals

4.4.3 Revisions

4.4.4 Rectifications

4.4.5 Appeals and Revision

4.4.6 Let us sum up

4.4.7 Key words/concepts

4.4.8 Check your progress

4.4.9 Terminal questions

238
 4.4.1 Objectives

The objectives of this lesson are to understand the rules related to IT:

 Appeals
 Revision
 Penalties
4.4.2 Appeals

Section Appellate Time Filing fees For Documents to be

Authority Limit m submitted/attached
No.
246A CIT(A) 1) 30 a) Court fee stamp of 35 1. Form No. 35 in
days 50 paise on Form No. duplicate.
from the 35 and of 65 paise on
2. Order appealed
date of copy of Assessment
against in duplicate
receipt of order.
duly certified.
notice of
b) Appeal fees: 1.
demand. 3. Grounds of Appeal
Rs.250.
Sec. and Statement of Facts
a) Where assessed
249(2) in duplicate
total income is Rs. 1
2) CIT (A) lakh or less. 4. Notice of Demand
has (original)
b) Where appeals are
power 5. In the case of appeal
filed on issues such as
to condo against penalty order
penalty order, TDS
ne delay copies of relevant
defaults, non-filing of
u/s Penalty order in
returns, etc. which
249(3) on duplicate.
cannot be linked with
showing
the assessed income. 6. Proof of payment of
Sufficient
2. Rs. 500, where appeal filing fee.
cause.
assessed total income 7. Affidavit stating
is more than Rs. 1 reasons for delay in
lakh but not more filing appeal beyond 30
than Rs. 2 lakhs. days for late filing.
3. Rs.1, 000, where
assessed total income
is more than Rs.2
lakhs.

239
Section Appellate Time Filing fees For Documents to be
Authority Limit m submitted/attached
No.
248 CIT(A) Same as Filing Fee 250/- 35 Same as above to the
above extent applicable.

253 ITAT (i) 60 Appeal fees: 36 1. Form No. 36 together

days with Grounds of appeal
a) Rs. 500.
from in triplicate.
the date 1) Where assessed
2. Order appealed
of service total income is Rs.1
against in duplicate
of CIT(A) lakh or less.
(including one certified
order Sec 2) Where appeals are copy)
.253(3) filed on issues such as
3. Order of AO in
(ii) S.253 TDS defaults,
duplicate.
(5) penalties, non-filing of
empower returns, etc. which 4. Grounds of Appeal
s the cannot be linked with before CIT (A) in
ITAT to the assessed income. duplicate.
condone 3) An application for 5. Statement of facts
the delay stay of demand. filed before CIT (A) in
on duplicate.
b) Rs.1, 500, if
showing
assessed income is 6. In the case of appeal
sufficient
above Rs. 1 lakh but against penalty order in
grounds.
not more than Rs. 2 duplicate of Assessment
lakhs. order.
c) 1% of assessed 7. In the case of appeal
income subject to against order u/s.
maximum of Rs.10, 143(3) read with
000 where assessed S.144A-Two copies of
income is more than the directions of the
Rs. 2 lakhs. Joint Commissioner
u/s. 144A
8. In the case of appeal
against order u/s. 143
read with S. 147 — Two
copies of original
assessment order, if
any.
9. Proof of payment of
240
Section Appellate Time Filing fees For Documents to be
Authority Limit m submitted/attached
No.
appeal filing fee.
10. Affidavit stating
reasons for delay in
filing appeal beyond 60
days in delayed filing.
253(4) ITAT 30 days NIL Same as above (except
(Cross of receipt instead of Form 36,
Objec of notice Form 36A)
tion) of appeal
by other
party

4.4.3 Revisions

Section Subject matter of revision Who Time limit

can
revise
263 Any order passed by the Assessing CIT 2 years from the end of the
Officer which is erroneous and financial year in which order
prejudicial to the interest of the revenue sought to be revised was
passed except in situation
enumerated u/s 263(3).
264 Any order passed by the officer CIT a) If CIT revises on his / her
subordinate to CIT Exception: own motion — 1 year
1. Applies to an order other than an b) If assessee makes an
order to which S. 263 applies. application-1 year from
date of communication/
2. Where appeal lies before CIT (A) /
knowledge of the order (CIT
ITAT or the time limit for filing the
has power to condone
appeal has not expired.
delay), order to be passed
within one year from the
end of the F.Y. in which
application is made.

241
 4.4.4 Rectification

Section Subject matter of rectification who can Time What can

rectify limit be
rectified
154 (a) Any order passed by an IT The Co- 4 years Any
authority under the provisions of IT ordinate from the mistake
Act. or end of ‘apparent’
superior the from the
(b) Intimation or deemed intimation
IT financial record.
u/s. 143(1)
authority year in
passing which
the order
original was
order passed.
254(2) Any order passed by ITAT ITAT 4 years -do-
from the
date of
the
order.

Penalties under Income Tax Act

Section Nature of Default Basis of Quantum of

Charge penalty
221(1) Failure to pay tax; i.e., non-payment of tax -- Amount of tax in
required by notice u/s. 156. arrears
271(1)(b) Non-compliance with notice u/s. 142(1) to file -- Rs. 10,000
returns or to produce documents required by (maximum for
assessing officer or u/s. 143(2) to produce each failure)
evidence on which assessee relies or u/s.
142(2A) to get accounts audited.
271(1)(c) Concealment of the particulars of income, Tax sought 100 % to 300 %
or furnishing inaccurate particulars thereof. to be evaded of tax sought to
be evaded
271A Failure to maintain books or documents u/s. -- Rs. 25,000
44AA.
271AA Failure to keep and maintain information and International 2% of
242
 documents u/s. 92D. transaction International
transaction
271B Failure to get accounts audited and furnish Total Sales, 0.5% of total
Tax Audit Report as required u/s. 44AB. Turnover, or sales, turnover
Gross or gross receipts,
Receipts or Rs. 1,00,000
whichever is less
271BA Failure to furnish a report as required u/s. -- Rs. 1,00,000
92E.
271C Failure to deduct the whole or part of the tax Tax failed to Equal to the
as required by or under Chapter XVII-B (Ss. be deducted amount failed to
192 to 196D) or failure to pay the whole or be deducted
part of tax u/s. 115-O.
271D Contravention of the provisions of S. 269SS; Amount Equal to
i.e., by taking or accepting any loan or deposit of loan or the amount
otherwise than by ways specified therein. deposit so of loan or deposit
taken or so taken or
accepted accepted
271E Contravention of S. 269T; i.e. repayment of Amount of Equal to
any deposit otherwise than by modes specified deposit so the amount of
therein. repaid deposit so repaid
271F Failure to furnish Return of Income under -- Rs. 5,000
sub-section (1) of S. 139 before the end of the
relevant Assessment Year.
Failure --
to
furnish
Return
of
Income
under
Rs. 5,000
proviso
to sub-
section
(1) of S.
139 by
the due
date.

243
271G Failure to furnish information or document International 2 % of such
u/s. 92D (3). transaction default.
272A(1) Failure to answer questions, sign statements, -- Rs. 10,000
attend summons u/s. 131(1), apply for
permanent account number u/s. 139A.
272A(2) Failure to: Rs. 100 for every
day during which
Comply with notice u/s.
the failure
94(6) furnishing information
continues.
regarding securities
Give notice of discontinuance of business - S.
176(3)
Furnish in due time returns, statements, or
particulars u/s. 133, 206 or 285B
Allow inspection of any register(s) - S. 134
Furnish returns u/s. 139(4A)
Deliver in due time a declaration mentioned in
S. 197A
Furnish a certificate u/s. 203.
Deduct and pay tax u/s. 226(2)
Furnish returns/ statements/ certificate u/s.
206C
Furnish a statement of particulars of
perquisites and profits in lieu of salary u/s.
192(2C)
272AA(1) Failure to furnish the prescribed information -- Rs. 1,000
required u/s. 133B (Refer to Form No. 45D).
272B Failure to apply for Permanent Account -- Rs. 10,000
Number (PAN)
272BB(1) Failure to apply for Tax Deduction Account -- Rs. 10,000
No. (TAN) (S. 203A)
272BBB Failure to apply for Tax Collection Account No. -- Rs. 10,000
(TCN)

Note: No penalty is imposable for any failure u/ss. 271(1)(b), 271A, 271AA,
271B, 271BA, 271BB, 271C, 271D, 271E, 271F, 271G, 272A(1)(c) or (d),

244
272(2), 272AA(1), 272B, 272BB(1) and 272BBB(1), if the person or assessee
proves that there was a reasonable cause for such failure (S. 273B).

4.4.5 Appeals and revision

E. - Revision by the Commissioner

263. Revision of orders prejudicial to revenue

(1) The Commissioner may call for and examine the record of any proceeding
under this Act, and if he/she considers that any order passed therein by the
Assessing Officer is erroneous in so far as it is prejudicial to the interests of the
revenue, he/she may, after giving the assessee an opportunity of being heard
and after making or causing to be made such inquiry as he/she deems
necessary, pass such order thereon as the circumstances of the case justify,
including an order enhancing or modifying the assessment, or cancelling the
assessment and directing a fresh assessment.

Explanation. For the removal of doubts, it is hereby declared that, for the
purposes of this sub-section,

(a) An order passed on or before or after the 1st day of June, 1988 by the
Assessing Officer shall include

(i) An order of assessment made by the Assistant Commissioner or

Deputy Commissioner or the Income-tax Officer on the basis of the
directions issued by the Joint Commissioner under section 144A;

(ii) an order made by the Joint Commissioner in exercise of the

powers or in the performance of the functions of an Assessing
Officer conferred on, or assigned to, him/her under the orders or
directions issued by the Board or by the Chief Commissioner or
Director General or Commissioner authorised by the Board in this
behalf under section 120;

(b) Record shall include and shall be deemed always to have included all
records relating to any proceeding under this Act available at the time of
examination by the Commissioner;

(c) Where any order referred to in this sub-section and passed by the
Assessing Officer had been the subject matter of any appeal filed on or
before or after the 1st day of June, 1988, the powers of the
Commissioner under this sub-section shall extend and shall be deemed
245
 always to have extended to such matters as had not been considered and
decided in such appeal.

(2) No order shall be made under sub-section (1) after the expiry of two years
from the end of the financial year in which the order sought to be revised was
passed.

(3) Notwithstanding anything contained in sub-section (2), an order in revision

under this section may be passed at any time in the case of an order which has
been passed in consequence of, or to give effect to, any finding or direction
contained in an order of the Appellate Tribunal, National Tax Tribunal, the
High Court or the Supreme Court.

Explanation. In computing the period of limitation for the purposes of sub-

section (2), the time taken in giving an opportunity to the assessee to be
reheard under the proviso to section 129 and any period during which any
proceeding under this section is stayed by an order or injunction of any court
shall be excluded.

264. Revision of other orders

(1) In the case of any order other than an order to which section 263 applies
passed by an authority subordinate to him/ her, the Commissioner may, either
of his / her own motion or on an application by the assessee for revision, call
for the record of any proceeding under this Act in which any such order has
been passed and may make such inquiry or cause such inquiry to be made
and, subject to the provisions of this Act, may pass such order thereon, not
being an order prejudicial to the assessee, as he / she thinks fit.

(2) The Commissioner shall not of his / her own motion revise any order under
this section if the order has been made more than one year previously.

(3) In the case of an application for revision under this section by the assessee,
the application must be made within one year from the date on which the order
in question was communicated to him/her or the date on which he/she
otherwise came to know of it, whichever is earlier:

Provided that the Commissioner may, if he/she is satisfied that the assessee
was prevented by sufficient cause from making the application within that
period, admit an application made after the expiry of that period.

246
(4) The Commissioner shall not revise any order under this section in the
following cases

(a) where an appeal against the order lies to the Deputy Commissioner
(Appeals) or to the Commissioner (Appeals) or to the Appellate Tribunal
but has not been made and the time within which such appeal may be
made has not expired, or, in the case of an appeal to the Commissioner
(Appeals) or to the Appellate Tribunal, the assessee has not waived
his/her right of appeal; or

(b) Where the order is pending on an appeal before the Deputy

Commissioner (Appeals); or

(c) Where the order has been made the subject of an appeal to the
Commissioner (Appeals) or to the Appellate Tribunal.

(5) Every application by an assessee for revision under this section shall be
accompanied by a fee of five hundred rupees.

(6) On every application by an assessee for revision under this sub-section,

made on or after the 1st day of October, 1998, an order shall be passed within
one year from the end of the financial year in which such application is made
by the assessee for revision.

Explanation. In computing the period of limitation for the purposes of this sub-
section, the time taken in giving an opportunity to the assessee to be re-heard
under the proviso to section 129 and any period during which any proceeding
under this section is stayed by an order or injunction of any court shall be
excluded.

(7) Notwithstanding anything contained in sub-section (6), an order in revision

under sub-section

(6) May be passed at any time in consequence of or to give effect to any finding
or direction contained in an order of the Appellate Tribunal, National Tax
Tribunal, the High Court or the Supreme Court.

Explanation 1.An order by the Commissioner declining to interfere shall, for

the purposes of this section, be deemed not to be an order prejudicial to the
assessee.

Explanation 2.For the purposes of this section, the Deputy Commissioner

(Appeals) shall be deemed to be an authority subordinate to the Commissioner.
247
4.4.6 Let us sum up

This lesson deals with appeals, revision and penalties relating to Income
Returns filed and any subsequent demand / query raised by the IT authorities.

4.4.7 Key words/concepts

Appeals, Revision, Penalties, Appellate Tribunal

4.4.8 Check your progress

1. Appeal under 246A has to be within ___ days.

a.30 b.60
c.45 d.50

2. Penalty for Failure to maintain books or documents u/s. 44AA is ___.

a. Rs. 50,000 b. Rs. 100.000

c. Rs. 25,000 d. Rs. 75,000

3. What is the penalty for failure to furnish a report as required u/s. 92E?

a. Rs. 100,000 b. Rs. 200,000

c. Rs. 150,000 d. Rs. 50,000

4. Section 271 (1)(c) applies to____

a. Concealment of the particulars of b. furnishing inaccurate particulars

income, thereof.
c. Neither d. both

Key to the questions asked

1.a 2.c 3.a

4.d

4.4.9 Terminal questions

 Explain briefly the provisions for appeal under sections 246A, 248, 253,
253(4)
 Describe the provisions for penalties under various sections
248
4.5 Lesson No. 17: Tax Deduction at Source (TDS)

4.5.1 Objectives
4.5.2 TDS (Tax Deducted at Source)
4.5.3 TDS certificate
4.5.4 TDS rate chart
4.5.5 TAN (Tax Deduction Account Number)
4.5.6 Let us sum up
4.5.7 Key words/ concepts
4.5.8 Check your progress- questions
4.5.9 Terminal questions

249
4.5.1 Objectives

The objectives of this lesson are to understand

 Types of Income attracting TDS

 Rates of TDS
 Forms 15 G, 15 H
 Form 16 and 16 A

4.5.2 Tax deducted at source

While some TDS rates are specified in the individual section which deal with
the tax treatment of the particular stream of income, some rates
are included as part of a separate schedule. These rates are modified every
year.

The genesis of the problem lies in the complicated nature of the tax laws. The
authorities complain that less than 2% of our population actually pays taxes.
However, simplifying the provisions is not viewed as a possible solution. On the
other hand, in an effort to bring more and more people into the tax net, the
lawmakers simply end up complicating the law.

TDS is final tax payable- at the time of filling his/her returns, the assessee
pays the balance if any or asks for refund, as the case maybe. Ergo, it behooves
the Department to have a standard uniform rate -convenient both for itself as
well as the taxpayers.

The most unfortunate part is that we could have easily done away with any
TDS provided the department had good infrastructure to apprehend assessees
avoiding tax.

What is TDS?

In a simple language, TDS stands for Tax Deducted at Source. It is a tax that is
deducted from the earning of the employee by the employer on an income
earned. It is deducted as per the Finance Act of that year. TDS should not be
confused with the income tax return. Tax deduction is useful to reduce income
tax and provide tax relief. TDS is deposited in the government treasury and
later on assigned to central government. TDS came into existence because
government wants to expand their tax bracket in the country.
250
Let us have a look at some of the income that is subjected to tax deduction at
source (TDS).

 Income through the salary

 PF Withdrawals
 Interest on securities; dividends
 Interest other than interest on securities
 Winnings from lottery or crossword puzzle
 Winnings from horse race;
 Payments to contractors and sub- contractors
 Insurance commission, payments to non-resident sportsmen/sports
associations
 Payment in respect of Life Insurance Policy
 Payments in respect of deposits under National Savings Scheme
 Payments on account of repurchase of units by Mutual Fund or Unit
Trust of India
 Commission, remuneration or prize on sale of lottery tickets
 Rent, Brokerage
 Sale of Immovable properties
 Fees for professional or technical services
 Income on units of specified mutual fund or of units of Unit Trust of
India
 Income of foreign companies referred to in section 196A(2)
 Income from units referred to in section 196B
 Income from foreign currency bonds or shares of an Indian company
referred to in section 196C
 Income of Foreign Institutional Investors from securities referred to in
section 196D

251
4.5.3 TDS certificate

Forms 16/16A

At the end of financial year, company must issue a form 16 which contains the
details about the salary earned by that employee and how much tax deducted.
It will have details on each month. In simple terms Form 16 contains details
about the tax deducted by the employer on behalf of employee. The same will
be paid to government by the company. Many people think that getting
the Form 16 alone is enough for the tax filing. Receiving the form 16 is
different from filing the tax returns. Tax payer has to use the Form 16 to file
the IT return every financial year end.

Form 16A is issued in all other cases mentioned above.

Forms 15G/15H

The conditions under which Form 15G and 15H may be filed are similar yet
with a significant difference. Basically, TDS is applicable to any interest above
Rs.10, 000 from most of the common investment instruments such as bank
fixed deposits, deposit under senior citizen savings scheme, post office deposits
and for senior citizens it is above Rs 50,000. Though, TDS, or withholding tax,
is in fact tax paid in advance and credit for the same can be claimed while
filing the return, the process is quite cumbersome especially for those investors
who aren’t liable to file a tax return in the first place.

In other words, from the final tax liability of the taxpayer, the amount
representing the TDS has to be reduced and only the balance will be the final
tax liability. Rule 29C of Income Tax Rules offers taxpayers the facility of
furnishing Form 15G or 15H, as the case may be, requesting the payer of
income not to deduct any tax.

The main difference between Forms 15G and 15H is that Form 15G is meant
for non-senior citizens whereas Form 15H is meant for senior citizens only.

252
 4.5.4 TDS rate chart financial year 2021-22 applicable for the resident
of India ( other than a Company )

Particulars TDS Rate

1. Section 192: Payment of salary Normal

Section 192A: Premature withdrawal from EPF Slab Rate
10%

2. Section 193: Interest on securities. 10%

a) any security of the Central or State Government;

b) any debentures or securities for money issued by 10%

any local authority or a corporation established
by a Central, State or Provincial Act;

c) any debentures (listed on a recognised stock 10%

exchange) issued by a company where such
debentures are ;

d) interest on any other security 10%

3. Section 194: Payment of any dividend 10%

4. Section 194A: Income in the form of interest (other than 10%

interest on securities).

5. Section 194B: Income by way of lottery winnings, card 30%

games, crossword puzzles, and other games of any type

6. Section 194BB: Income by way of horse race winnings 30%

7. Section 194C: Payment to contractor/sub-contractor.

a) Individuals/HUF 1%

b) Others 2%

8. Section 194D: Insurance commission 5%

9. Section 194DA: Payment of any sum in respect of a life 5%

insurance policy. W.e.f. 1st September 2019, the insurer
shall deduct tax (TDS) on the income portion comprised
in the insurance pay-out.
253
10. Section 194EE: Payment of amount standing to the 10%
credit of a person under National Savings Scheme (NSS)

11. Section 194F: Payment due to repurchase of a unit by 20%

Unit Trust of India (UTI) or a Mutual Fund

12. Section 194G: Payments such as commission, etc., on 5%

the sale of lottery tickets

13. Section 194H: Commission or brokerage 5%

14. Section 194-I: Rent on

a) Plant and Machinery 2%

b) Land/building/furniture/fitting w.e.f 1st April 10%

2019, tax deduction limit on rent is increased to Rs
2.4 lakhs p.a. from Rs 1.8 lakhs p.a.

15. Section 194-IA: Payment in consideration of transfer of 1%

certain immovable property other than agricultural land.

16. Section 194-IB: Rent payment by an individual or HUF 5%

not covered u/s. 194I

17. Section 194-IC: Payment under Joint Development

Agreements (JDA) to Individual/HUF 10%

18. Section 194J: Any sum paid by way of:

(a) Fee for professional services; 10%

(b) Remuneration/fee/commission to a director; 10%

(c) For not carrying out any activity in relation to any 10%
business;

(d) For not sharing any know-how, patent, copyright 10%

etc.

(e) Fee for technical services, and 2%

(f) Royalty towards the sale or distribution, or 2%

exhibition of cinematographic films.

254
 (g) Fees for technical services but payee is engaged in 2%
the business of operation of call centre

19. Section 194K: Payment of any income for units of a 10%

mutual fund as per section 10(23D) or from the
administrator or specified company

20. Section 194LA: Payment in respect of compensation on 10%

acquisition of certain immovable property.

21. Section 194LBA(1): Certain income distributed by a 10%

business trust to its unitholder

22. Section 194LBB: Certain income paid in respect of units 10%

of an investment fund to a unitholder.

23. Section 194LBC: Income from investment in

securitization fund
(a) Individual and HUF 25%

(b) Others 30%

24. Section 194M: Certain payments by Individual/HUF 5%

(Limit- Rs 50 Lakhs)

25. Section 194N: Cash withdrawal exceeding a certain 2%

amount (limit- Rs 1 crore).

In case Rs 20 lakh or more is withdrawn by the person

not-filing ITR for the last three years, for which the due
date of filing ITR has expired, the TDS rates shall be 2%
applicable as per below slabs-

For the amount more than Rs.20 lakh but up to Rs. 1 5%

crore, and for the amount exceeding Rs. 1 crore

26. Section 194O: For the sale of goods or provision of 1%

services by the e-commerce operator through its digital
or electronic facility or platform.

27. Section 194P: Tax deduction by specified banks while Tax on total
making payments (pension or interest) to specified senior income as
citizens or age 75 years or more. per rates in
force

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28. Section 194Q: Payments to residents for the purchase of 0.1%
goods if the aggregate value of goods exceeds Rs 50
lakhs.(TDS is deductible on value exceeding Rs 50 lakhs)

29. Any Other Income 10%

4.5.5 TAN (Tax Deduction Account Number)

Tax Deduction and Collection Account Number or TAN is a 10 digit alpha-

numeric number which is compulsory to be obtained by all persons who are
accountable for Tax Deduction at Source (TDS) and Tax Collection at Source
(TCS) on behalf of the Income Tax Department. The persons who deduct or
collect tax at source on behalf of the Income Tax Department are required to
apply for and obtain TAN. If a person responsible for TDS/TCS fails to apply for
TAN or does not comply with the provisions of the Act, he/she may have to pay
a penalty of Rs. 10,000/-.

The Income Tax Act makes it mandatory for all persons responsible for
TDS/TCS to quote TAN in all the TDS/TCS returns, all TDS/TCS payment
challans and all TDS/TCS certificates to be issued. TDS/TCS returns,
whether filed in paper or electronic format, will not be received by the authority
if TAN is not quoted. Also, banks will not accept any TDS/TCS challans on
which TAN is not quoted.

4.5.6 Let us sum up

TDS stands for tax deducted at source. It is a tax that is deducted from the
earning of the employee by the employer in other words it is a tax that is
deducted at source. It is deducted as per the finance act of that year.

TDS came into existence because government wants to expand their tax
bracket in the country.

At the end of financial year, company who deducts tax at source must issue
form 16/16A.

Those assesses who submit Forms 15G/15H do so to inform the deductor that
the person is not eligible to pay tax.

All persons who are accountable for Tax Deduction at Source (TDS) and Tax
Collection at Source (TCS) on behalf of the Income Tax Department have to

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have a 10 digit alpha numeric number called Tax Deduction and
Collection Account Number or TAN

4.5.7 Key words/concepts

Tax deducted at source, Forms 16/16A, Forms 15G/15H, Tax Deduction and
Collection Account Number or TAN

4.5.8 Check your progress- questions

1. Income deemed to accrue or arise in India is taxable in case of

a. Resident only b. Both ordinarily resident and NOR

c. Non-resident d. All the assesses

2. One of the following is exempt from TDS

a. Agricultural income is exempt provided b. Income through the salary

the Land is situated in India

c. For interest on securities; dividends d. interest other than interest on

securities

3. The deductor of TDS should have

a. TIN b. TAN

c. PAN d. PIN

4. TDS on lottery is____

a. 2% b. 10%

c. 30% d. 20%

4.5.9 Key to the questions asked

1.d 2.a 3.b

4.c

4.5.10 Terminal questions

 What is TDS and why was it introduced?

 List out some of the incomes subject to TDS
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 Describe forms 16, 16A, 15H, 15G and their use.

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4.6 Lesson No.18 Service Tax

4.6.1 Objectives

4.6.2 Introduction

4.6.3 What is Service Tax?

4.6.4 Applicability of Service Tax

4.6.5 Service Tax Rate

4.6.6 GST How it works

4.6.7 GST Benefits

4.6.7.1 GST Chronological events

4.6.7.2 GST How administered in India

4.6.7.3 CGST & SGST

4.6.7.4 GST Cross Utilization

4.6.7.5 GST Interstate transaction

4.6.7.6 IT & GST

4.6.7.8 Import & GST

4.6.7.9 GST 122nd Amendment of Constitution

4.6.7.10 GST Major Features

4.6.7.11 GST Returns filing

4.6.7.12 GST Payment procedures

4.6.7.13 GST Rates

4.6.7.14 GSTIN

4.6.8 Let us sum up

4.6.9 Key words /concepts

4.6.10 Check your progress-questions

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4.6.11 Terminal questions

4.6.12 References and bibliography for further reading

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4.6.1 Objectives

The objectives of this lesson are to understand

 Types of Services attracting Service Tax

 Rates of Service Tax
 Service Tax Credit
 Filling of Service Tax Return
4.6.2 Service Tax

When we use any service be it a phone bill payment or hire a room in a hotel
we have to pay out little more than the actual rates charged. Ever wondered
why? The reason is very meek, we are made to pay service tax over and above
the usual charge but the bigger question is What is Service Tax, why do we
have to pay Service Tax when the tax is applicable on the company providing
the service and what is the Service Tax Rate. If this question bothers you, find
answers below.

4.6.3 What is Service Tax?

Service Tax was a tax which is payable on services provided by the service
provider. Just like Excise duty is payable on goods which are manufactured,
similarly Service Tax is payable on Services provided.

This Tax was payable by the provider of Service to the Govt. of India. However,
the Service Provider can collect this Service Tax from the Consumer of Service
(also referred to as Recipient of Service) and deposit the same with the Govt.

4.6.4 Applicability of Service Tax

Service Tax came into effect in 1994 and was introduced by the then Hon’ble
Finance Minister Dr. Manmohan Singh.

Earlier Service Tax was payable only on a specified list of services but the then
Hon’ble Finance Minister Shri. Pranab Mukherjee while delivering his budget
speech on 16th March 2012 announced that Service Tax would be applicable
on all services except the negative list of services. Every Service provider was
required to apply for Service tax registration if the Value of Services provided by
him/her during a Financial Year was more than Rs. 9 Lakhs, but the Service
Tax used to be payable only when the Value of Services provided is more than
Rs. 10 Lakhs.
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All service providers in India, except those in the state of Jammu and Kashmir,
were required to pay a Service tax in India.

Earlier Service Tax was charged on cash basis for every service provider. Later,
it is charged on cash basis for Individual service providers and for companies it
was being charged on accrual basis i.e. companies’ liability to deposit tax arises
as soon as services are provided irrespective of the collection of funds on the
same.

However Individual Service Providers have to Deposit Service Tax only when the
Invoice Amount has been collected. Service Tax Payment was deposited by the
Service Provider with the Government; Quarterly in case of
Individuals/Partnership and Monthly in all other cases.

4.6.5 Service Tax Rate

The Service Tax Rate applicable before the implementation of the GST w.e.f.
01st July 2017 was 15%. The breakup was as under:

Service Tax Rate = 14%

(+) Swachh Bharat Cess @ 0.5% = 0.5%

(+) Krishi Kalyan Cess @ 0.5% = 0.5%

Effective Service Tax Rate was = 15%

Service Tax was required to be deposited on a Monthly/Quarterly basis. The

Service tax could be paid either by manually depositing in the Bank or through
Online payment. In case, of excess payment of Service Tax by the Service
Provider with the Government, the Service Provider can either adjust the excess
amount paid or can claim Refund of the Excess Tax deposited.

Services like metered taxis, auto rickshaws, betting, gambling, lottery, entry to
amusement parks, transport of goods or passengers and electricity
transmission or distribution by discoms have been kept in the negative list.
Other important services which was not attracting the tax include funeral,
burial, mutate services and transport of deceased. Coaching classes and
training institutions were coming under the net, though the tax was not levied
on school, university education and approved vocational courses.

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The government had widened the definition of ‘Services’ to bring in more
activities under the tax net. 119 services that was coming under ‘positive list’
were subject to the levy.

This new approach to taxation of services was intended to take the country and
the economy a step closer towards the introduction of Goods and Service Tax
(GST). The GST has been implemented in India w.e.f. 01st July 2017.

4.6.6 What is GST? How does it work?

GST is one indirect tax for the whole nation, which will make India one unified
common market.
GST is a single tax on the supply of goods and services, right from the
manufacturer to the consumer. Credits of input taxes paid at each stage will be
available in the subsequent stage of value addition, which makes GST
essentially a tax only on value addition at each stage. The final consumer will
thus bear only the GST charged by the last dealer in the supply chain, with
set-off benefits at all the previous stages.

4.6.7 What are the benefits of GST?

The benefits of GST can be summarized as under:

 For business and industry
Easy compliance: A robust and comprehensive IT system would be the
foundation of the GST regime in India. Therefore, all tax payer services such as
registrations, returns, payments, etc. would be available to the taxpayers
online, which would make compliance easy and transparent.

Uniformity of tax rates and structures: GST will ensure that indirect tax rates
and structures are common across the country, thereby increasing certainty
and ease of doing business. In other words, GST would make doing business in
the country tax neutral, irrespective of the choice of place of doing business.

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Removal of cascading: A system of seamless tax-credits throughout the value-
chain, and across boundaries of States, would ensure that there is minimal
cascading of taxes. This would reduce hidden costs of doing business.

Improved competitiveness: Reduction in transaction costs of doing business

would eventually lead to an improved competitiveness for the trade and
industry.

Gain to manufacturers and exporters: The subsuming of major Central and

State taxes in GST, complete and comprehensive set-off of input goods and
services and phasing out of Central Sales Tax (CST) would reduce the cost of
locally manufactured goods and services. This will increase the competitiveness
of Indian goods and services in the international market and give boost to
Indian exports. The uniformity in tax rates and procedures across the country
will also go a long way in reducing the compliance cost.

 For Central and State Governments

Simple and easy to administer: Multiple indirect taxes at the Central and State
levels are being replaced by GST. Backed with a robust end-to-end IT system,
GST would be simpler and easier to administer than all other indirect taxes of
the Centre and State levied so far.

Better controls on leakage: GST will result in better tax compliance due to a
robust IT infrastructure. Due to the seamless transfer of input tax credit from
one stage to another in the chain of value addition, there is an in-built
mechanism in the design of GST that would incentivize tax compliance by
traders.

Higher revenue efficiency: GST is expected to decrease the cost of collection of

tax revenues of the Government, and will therefore, lead to higher revenue
efficiency.

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  For the consumer

Single and transparent tax proportionate to the value of goods and

services: Due to multiple indirect taxes being levied by the Centre and State,
with incomplete or no input tax credits available at progressive stages of value
addition, the cost of most goods and services in the country today are laden
with many hidden taxes. Under GST, there would be only one tax from the
manufacturer to the consumer, leading to transparency of taxes paid to the
final consumer.

Relief in overall tax burden: Because of efficiency gains and prevention of

leakages, the overall tax burden on most commodities will come down, which
will benefit consumers.

Which taxes at the Centre and State level are being subsumed into GST?

At the Central level, the following taxes are being subsumed:

1. Central Excise Duty,
2. Additional Excise Duty,
3. Service Tax,
4. Additional Customs Duty commonly known as Countervailing Duty, and
5. Special Additional Duty of Customs.
At the State level, the following taxes are being subsumed:
1. Subsuming of State Value Added Tax/Sales Tax,
2. Entertainment Tax (other than the tax levied by the local bodies), Central
Sales Tax (levied by the Centre and collected by the States),
3. Octroi and Entry tax,
4. Purchase Tax,
5. Luxury tax, and
6. Taxes on lottery, betting and gambling.

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4.6.7.1 What are the major chronological events that have led to the
introduction of GST?

GST is being introduced in the country after a 13 year long journey since it was
first discussed in the report of the Kelkar Task Force on indirect taxes. A brief
chronology outlining the major milestones on the proposal for introduction of
GST in India is as follows:
1. In 2003, the Kelkar Task Force on indirect tax had suggested a
comprehensive Goods and Services Tax (GST) based on VAT principle.
2. A proposal to introduce a National level Goods and Services Tax (GST)
by April 1, 2010 was first mooted in the Budget Speech for the financial
year 2006-07.
3. Since the proposal involved reform/ restructuring of not only indirect
taxes levied by the Centre but also the States, the responsibility of
preparing a Design and Road Map for the implementation of GST was
assigned to the Empowered Committee of State Finance Ministers (EC).
4. Based on inputs from Govt of India and States, the EC released its First
Discussion Paper on Goods and Services Tax in India in November,
2009.
5. In order to take the GST related work further, a Joint Working Group
consisting of officers from Central as well as State Government was
constituted in September, 2009.
6. In order to amend the Constitution to enable introduction of GST, the
Constitution (115th Amendment) Bill was introduced in the Lok Sabha
in March 2011. As per the prescribed procedure, the Bill was referred to
the Standing Committee on Finance of the Parliament for examination
and report.
7. Meanwhile, in pursuance of the decision taken in a meeting between the
Union Finance Minister and the Empowered Committee of State
Finance Ministers on 8th November, 2012, a ‘Committee on GST
Design’, consisting of the officials of the Government of India, State
Governments and the Empowered Committee was constituted.

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 8. This Committee did a detailed discussion on GST design including the
Constitution (115th) Amendment Bill and submitted its report in
January, 2013. Based on this Report, the EC recommended certain
changes in the Constitution Amendment Bill in their meeting at
Bhubaneswar in January 2013.
9. The Empowered Committee in the Bhubaneswar meeting also decided to
constitute three committees of officers to discuss and report on various
aspects of GST as follows:-
(a) Committee on Place of Supply Rules and Revenue Neutral Rates;
(b) Committee on dual control, threshold and exemptions;
(c) Committee on IGST and GST on imports.
1. The Parliamentary Standing Committee submitted its Report in August,
2013 to the Lok Sabha. The recommendations of the Empowered
Committee and the recommendations of the Parliamentary Standing
Committee were examined in the Ministry in consultation with the
Legislative Department. Most of the recommendations made by the
Empowered Committee and the Parliamentary Standing Committee were
accepted and the draft Amendment Bill was suitably revised.
2. The final draft Constitutional Amendment Bill incorporating the above
stated changes were sent to the Empowered Committee for consideration
in September 2013.
3. The EC once again made certain recommendations on the Bill after its
meeting in Shillong in November 2013. Certain recommendations of the
Empowered Committee were incorporated in the draft Constitution
(115th Amendment) Bill. The revised draft was sent for consideration of
the Empowered Committee in March, 2014.
4. The 115th Constitutional (Amendment) Bill, 2011, for the introduction of
GST introduced in the Lok Sabha in March 2011 lapsed with the
dissolution of the 15th Lok Sabha.
5. In June 2014, the draft Constitution Amendment Bill was sent to the
Empowered Committee after approval of the new Government.

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 6. Based on a broad consensus reached with the Empowered Committee on
the contours of the Bill, the Cabinet on 17.12.2014 approved the
proposal for introduction of a Bill in the Parliament for amending the
Constitution of India to facilitate the introduction of Goods and Services
Tax (GST) in the country. The Bill was introduced in the Lok Sabha on
19.12.2014, and was passed by the Lok Sabha on 06.05.2015. It was
then referred to the Select Committee of Rajya Sabha, which submitted
its report on 22.07.2015.

4.6.7.2 How GST administered in India?

Keeping in mind the federal structure of India, there will be two components of
GST – Central GST (CGST) and State GST (SGST). Both Centre and States will
simultaneously levy GST across the value chain. Tax will be levied on every
supply of goods and services. Centre would levy and collect Central Goods and
Services Tax (CGST), and States would levy and collect the State Goods and
Services Tax (SGST) on all transactions within a State. The input tax credit of
CGST would be available for discharging the CGST liability on the output at
each stage. Similarly, the credit of SGST paid on inputs would be allowed for
paying the SGST on output. No cross utilization of credit would be permitted.

4.6.7.3 How would a particular transaction of goods and services be

taxed simultaneously under Central GST (CGST) and State GST
(SGST)?

The Central GST and the State GST would be levied simultaneously on every
transaction of supply of goods and services except on exempted goods and
services, goods which are outside the purview of GST and the transactions
which are below the prescribed threshold limits. Further, both would be levied
on the same price or value unlike State VAT which is levied on the value of the
goods inclusive of Central Excise.

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 A diagrammatic representation of the working of the Dual GST model within a
State is shown in Figure 1 below.

Figure 1: GST within State

4.6.7.4 Will cross utilization of credits between goods and services be

allowed under GST regime?

Cross utilization of credit of CGST between goods and services would be

allowed. Similarly, the facility of cross utilization of credit will be available in
case of SGST. However, the cross utilization of CGST and SGST would not be
allowed except in the case of inter-State supply of goods and services under the
IGST model which is explained in answer to the next question.

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4.6.7.5 How will be Inter-State Transactions of Goods and Services be
taxed under GST in terms of IGST method?

In case of inter-State transactions, the Centre would levy and collect the
Integrated Goods and Services Tax (IGST) on all inter-State supplies of goods
and services under Article 269A (1) of the Constitution. The IGST would
roughly be equal to CGST plus SGST. The IGST mechanism has been designed
to ensure seamless flow of input tax credit from one State to another. The
inter-State seller would pay IGST on the sale of his goods to the Central
Government after adjusting credit of IGST, CGST and SGST on his purchases
(in that order). The exporting State will transfer to the Centre the credit of
SGST used in payment of IGST. The importing dealer will claim credit of IGST
while discharging his output tax liability (both CGST and SGST) in his own
State. The Centre will transfer to the importing State the credit of IGST used in
payment of SGST. Since GST is a destination-based tax, all SGST on the final
product will ordinarily accrue to the consuming State.
A diagrammatic representation of the working of the IGST model for inter-State
transactions is shown in Figure 2 below.

Figure 2

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4.6.7.6 How will IT be used for the implementation of GST?

For the implementation of GST in the country, the Central and State
Governments have jointly registered Goods and Services Tax Network (GSTN)
as a not-for-profit, non-Government Company to provide shared IT
infrastructure and services to Central and State Governments, tax payers and
other stakeholders. The key objectives of GSTN are to provide a standard and
uniform interface to the taxpayers, and shared infrastructure and services to
Central and State/UT governments.
GSTN is working on developing a state-of-the-art comprehensive IT
infrastructure including the common GST portal providing frontend services of
registration, returns and payments to all taxpayers, as well as the backend IT
modules for certain States that include processing of returns, registrations,
audits, assessments, appeals, etc. All States, accounting authorities, RBI and
banks, are also preparing their IT infrastructure for the administration of GST.
There would no manual filing of returns. All taxes can also be paid online. All
mis-matched returns would be auto-generated, and there would be no need for
manual interventions. Most returns would be self-assessed.

4.6.7.7 How will imports be taxed under GST?

The Additional Duty of Excise or CVD and the Special Additional Duty or SAD
presently being levied on imports will be subsumed under GST. As per
explanation to clause (1) of article 269A of the Constitution, IGST will be levied
on all imports into the territory of India. Unlike in the present regime, the
States where imported goods are consumed will now gain their share from this
IGST paid on imported goods.

4.6.7.8 What are the major features of the Constitution

(122nd Amendment) Bill, 2014?

The salient features of the Bill are as follows:

1. Conferring simultaneous power upon Parliament and the State
Legislatures to make laws governing goods and services tax;

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 2. Subsuming of various Central indirect taxes and levies such as Central
Excise Duty, Additional Excise Duties, Service Tax, Additional Customs
Duty commonly known as Countervailing Duty, and Special Additional
Duty of Customs;
3. Subsuming of State Value Added Tax/Sales Tax, Entertainment Tax
(other than the tax levied by the local bodies), Central Sales Tax (levied
by the Centre and collected by the States), Octroi and Entry tax,
Purchase Tax, Luxury tax, and Taxes on lottery, betting and gambling;
4. Dispensing with the concept of ‘declared goods of special importance’
under the Constitution;
5. Levy of Integrated Goods and Services Tax on inter-State transactions of
goods and services;
6. GST to be levied on all goods and services, except alcoholic liquor for
human consumption. Petroleum and petroleum products shall be subject
to the levy of GST on a later date notified on the recommendation of the
Goods and Services Tax Council;
7. Compensation to the States for loss of revenue arising on account of
implementation of the Goods and Services Tax for a period of five years;
8. Creation of Goods and Services Tax Council to examine issues relating to
goods and services tax and make recommendations to the Union and the
States on parameters like rates, taxes, cesses and surcharges to be
subsumed, exemption list and threshold limits, Model GST laws, etc. The
Council shall function under the Chairmanship of the Union Finance
Minister and will have all the State Governments as Members.

4.6.7.9 What are the major features of the proposed registration

procedures under GST?

The major features of the proposed registration procedures under GST are as
follows:

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 1. Existing dealers: Existing VAT/Central excise/Service Tax payers will
not have to apply afresh for registration under GST.
2. New dealers: Single application to be filed online for registration under
GST.
3. The registration number will be PAN based and will serve the purpose for
Centre and State.
 Unified application to both tax authorities.
 Each dealer to be given unique ID GSTIN.
 Deemed approval within three days.
4. Post registration verification in risk based cases only.

4.6.7.10 What are the major features of the proposed returns filing
procedures under GST?

The major features of the proposed returns filing procedures under GST are as
follows:
1. Common return would serve the purpose of both Centre and State
Government.
2. There are eight forms provided for in the GST business processes for
filing for returns. Most of the average tax payers would be using only
four forms for filing their returns. These are return for supplies, return
for purchases, monthly returns and annual return.
3. Small taxpayers: Small taxpayers who have opted composition scheme
shall have to file return on quarterly basis.
4. Filing of returns shall be completely online. All taxes can also be paid
online.

4.6.7.11 What are the major features of the proposed payment

procedures under GST?

The major features of the proposed payments procedures under GST are as
follows:

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 1. Electronic payment process- no generation of paper at any stage
2. Single point interface for challan generation- Goods and Service Tax
Network (GSTN)
3. Ease of payment – payment can be made through online banking, Credit
Card/Debit Card, NEFT/RTGS and through cheque/cash at the bank
 Common challan form with auto-population features
 Use of single challan and single payment instrument
 Common set of authorized banks
4. Common Accounting Codes

Source: http://www.gstindia.com

4.6.7.12 GST Rates

GST is being charged at variable rates on variable goods and services. At

present broadly there are five different broad tax slabs for collection of GST i.e.
0%, 3 %, 5%, 12%, 18% and 28%.

Goods kept outside GST

Presently the following goods are kept out of GST network:

(1) Alcohol for human consumption

(2) Petrol and petroleum products i.e. petroleum crude, High Speed Diesel,
Motor Spirit (petrol), Natural gas, Aviation Turbine Fuel.

(3) Electricity.

4.6.7.13 GSTIN

All the business entities are to be assigned a state wise PAN based 15 digit
Goods and Service Tax Identification Number (GSTIN).

Note: The above details are for reference purpose only. C-PEC does not certify
the Authenticity of the source material. For additional details, candidates are
advised to refer to the Government of India Website http://www.cbec.gov.in

4.6.8 Let us sum up

Service Tax was a tax which is payable on services provided by the service
provider. Just like Excise duty is payable on goods which are manufactured,
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similarly Service Tax was payable on Services provided that Service Tax was
applicable on all services except the negative list of services.

Effective Service Tax Rate before implementation of GST w.e.f. 01st July 2017
was 15%

Service Tax was required to be deposited on a Monthly/Quarterly basis.

Services like metered taxis, auto rickshaws, betting, gambling, lottery, entry to
amusement parks, transport of goods or passengers and electricity
transmission or distribution by discoms have been kept in the negative list.

4.6.9 Key words/concepts

Service Tax, Negative list, GST, CGST & SGST, GSTIN

4.6.10 Check your progress- questions

1. One of the following was taxed under service tax:

a. Coaching classes and training b. Services like metered taxis, auto

institutions rickshaws
c. Services by way of training or coaching d. Services provided to or by an
in recreational activities relating to arts, educational institution in respect of
culture or sports education exempted from service tax,
by way of,-
(a) auxiliary educational services; or
(b) Renting of immovable property;

2. Every Service was required to apply for Service tax registration if the
Value of Services provided by him/her during a Financial Year was more
than Rs.

a. 9,00,000 b. 8,00,000
c. 10,00,000 d. 11,00,000

3. Service Tax was payable only when the Value of Services provided was
more than Rs.

a. 9,00,000 b. 8,00,000
c. 10,00,000 d. 11,00,000

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Key to the questions asked

1.a 2.a 3.c

4.6.11 Terminal questions

 Explain GST.

 What was Service tax?

 What is GSTIN

4.6.12 References

 Taxindia.com
 Legal glossary of Income Tax Dept.
 Income Tax Department website
Bibliography – further reading.

 Income Tax Act

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UNIT 5: Corporate Governance In Cooperatives
Lesson No. 1 Corporate Governance
Lesson No. 2 Four pillars
Lesson No. 3 Do’s and don’ts

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 5 Unit 5 : Corporate Governance

5.1 Lesson No. 19. Corporate Governance

5.1.1 Objectives
5.1.2 Corporate Governance
5.1.2.1 What is corporate governance?
5.1.2.2 What are the principles underlying corporate governance
5.1.2.3 Why is it important?
5.1.2.4 Evolution and Implementation of the Concept at Global Level.
5.1.2.5 Principles of Corporate Governance
5.1.2.6 Key elements of good corporate governance:
5.1.2.7 Corporate Governance – The Practical Aspect
5.1.2.8 Corporate Governance- Relevance and need for Cooperative Banks
5.1.3 Measures in Cooperative Acts
1.1.3.1 Hurdles or Lacunae In Implementing Corporate Governance
5.1.4 Issues of good governance and internal control systems
5.1.4.1 Governance structures - the President, Board and the General
Body:
5.1.4.2 Role of Board Members in managing change in organisation
5.1.4.3 Internal Checks and Control Systems
5.1.5 Formation of committees
5.1.5.1 The role of the audit committee shall include the following:
5.1.5.2 The Investment Committee
5.1.5.3 Role and Responsibilities of a Separate Risk Committee
5.1.6 Let us sum up
5.1.7 Key words/concepts
5.1.8 Check your progress-questions
5.1.9 Terminal questions

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5.1.1 Objectives

The objectives of this lesson are to understand

 Concept of Governance and Management

 Principles
 Key Elements
 Various Committees Viz. Investment, Audit, Vigilance, Risk

5.1.2 Corporate Governance

5.1.2.1 What is corporate governance?

Corporate governance refers to the set of systems, principles and processes by

which a company is governed. They provide the guidelines as to how the
company can be directed or controlled such that it can fulfill its goals and
objectives in a manner that adds to the value of the company and is also
beneficial for all stakeholders in the long term. Stakeholders in this case would
include everyone ranging from the board of directors, management,
shareholders to customers, employees and society. The management of the
company hence assumes the role of a trustee for all the others.

5.1.2.2 What are the principles underlying corporate governance?

Corporate governance is based on principles such as conducting the business

with all integrity and fairness, being transparent with regard to all
transactions, making all the necessary disclosures and decisions, complying
with all the laws of the land, accountability and responsibility towards the
stakeholders and commitment to conducting business in an ethical manner.
Another point which is highlighted in the SEBI report on corporate governance
is the need for those in control to be able to distinguish between what are
personal and corporate funds while managing a company.

5.1.2.3 Why is it important?

Fundamentally, there is a level of confidence that is associated with a company

that is known to have good corporate governance. The presence of an active
group of independent directors on the board contributes a great deal towards
ensuring confidence in the market. Corporate governance is known to be one of
the criteria that foreign institutional investors are increasingly depending on
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when deciding on which companies to invest in. It is also known to have a
positive influence on the share price of the company. Having a clean image on
the corporate governance front could also make it easier for companies to
source capital at more reasonable costs. Unfortunately, corporate governance
often becomes the centre of discussion only after the exposure of a large scam.

Good corporate governance helps an organization achieve several objectives

and some of the more important ones include:

 Developing appropriate strategies that result in the achievement of

stakeholder objectives
 Attracting, motivating and retaining talent
 Creating a secure and prosperous operating environment and improving
operational performance
 Managing and mitigating risk and protecting and enhancing the
company’s reputation.
It would also create a specific platform for:

 Better access to external finance

 Lower costs of capital – interest rates on loans
 Improved company performance – sustainability
 Higher firm valuation and share performance
 Reduced risk of corporate crisis and scandals
5.1.2.4 Evolution and implementation of the concept at global level

Corporate Governance evolved and introduced as remedial measures in

corporate sector for forbidding the wrongs or unethical practices. This led to
appointment of various committees at global level to address the issue and give
recommendations. Worldwide economic crisis and corporate debacles have
proven the inadequacy of regulatory framework to bring the best out in
corporate management. Establishment of GATT and WTO regulations also
emphasized the need of good corporate practices i.e. Corporate Governance.
OECD principles 1999 also dwelt upon the issue of Corporate Governance.

In India the issue of Corporate Governance came up mainly in the wake up

economic reforms characterized by liberalization and deregulation. In April
1998, Confederation of Indian Industries (CII) took issue of Corporate
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Governance Practices and made certain recommendations. SEBI committee on
Corporate Governance headed by Shri. Kumarmangalam Birla submitted its
report in February 2000. Clause 49 in Listing Agreement with stock exchanges
was made mandatory by SEBI to include disclosures about Corporate
Governance and its certification by Statutory Auditors in annual report of the
company.

But there were major challenges to corporate governance in India as under:

 Power of the dominant shareholder(s)

 Lack of incentives for companies to implement corporate governance
 reform measures (no direct correlation between putting expensive
governance systems and corresponding returns)
 Underdeveloped external monitoring systems
 Shortage of real independent directors
 Weak regulatory oversight including multiplicity of regulators
5.1.2.5 Principles of Corporate Governance

1. Rights and equitable treatment of shareholders: Organizations should

respect the rights of shareholders and help shareholders to exercise
those rights. They can help shareholders exercise their rights by openly
and effectively communicating information and by encouraging
shareholders to participate in general meetings.

2. Interests of other stakeholders: Organizations should recognize that

they have legal, contractual, social, and market driven obligations to
non-shareholder stakeholders, including employees, investors, creditors,
suppliers, local communities, customers, and policy makers.

3. Role and responsibilities of the board: The board needs sufficient

relevant skills and understanding to review and challenge management
performance. It also needs adequate size and appropriate levels of
independence and commitment.

4. Integrity and ethical behavior: Integrity should be a fundamental

requirement in choosing corporate officers and board members.
Organizations should develop a code of conduct for their directors and
executives that promotes ethical and responsible decision making.

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 5. Disclosure and transparency: Organizations should clarify and make
publicly known the roles and responsibilities of board and management
to provide stakeholders with a level of accountability. They should also
implement procedures to independently verify and safeguard the integrity
of the company's financial reporting. Disclosure of material matters
concerning the organization should be timely and balanced to ensure
that all investors have access to clear, factual information.

5.1.2.6 Key elements of good corporate governance

Independence of directors

If the directors of a company are also the owners and/or their family members,
entrepreneurs appointed by friends, or individuals who are involved in the daily
management of the company, the board is unlikely to be impartial. Having a
majority of non-executive independent directors will help avoid prejudice and
conflicts of interest between the board and the management. Independent
judgement is almost always in the best interest of the company.

Separation of 'strategic planner' role from 'operator' role

For small companies that do not have a board of directors, it is a good practice
for the strategic planner of the business to be someone other than the owner-
operator. This frees the planner from attending to day-to-day operational duties
and enables him/her or her to focus on long-term, strategic business planning.

An 'exit strategy' for company owners

Whether it is a succession plan for passing on a family business or a buy-sell

arrangement, an exit strategy should be planned and agreed upon by all
parties concerned (e.g. shareholders, family members) well in advance.

Reliable systems and procedures

Potential creditors feel more confident if they know that the company has
reliable systems and procedures in place. Such processes enable smaller SMEs
to operate in the owners' absence (e.g. due to illness) and allow for smooth
handover to other parties.

Credible accounts

Even for the smallest SMEs, credible accounts enable the entrepreneur to know
what is going on in the business and instills confidence in lenders.
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Key performance indicators

These indicators (e.g. financial strategy, marketing plan, product/operational

goal) are used for measuring the performance of the company, its management
and even the board of directors.

Remuneration and HR policies

Transparency in matters such as remuneration, incentives, discipline and

dismissal is essential for attracting good employees. It is especially important
for retaining non-family members in family businesses.

5.1.2.7 Corporate governance – the practical aspect

 While implementing and practicing the Corporate Governance it is

necessary to examine and introduce certain elements which stand as
Hallmarks of Corporate Governance.
 Establishing and well defining strategic objectives and set of corporate
values and means to attain them (vision and mission statement).
 Endeavour to enhance the value of stake holders and harmonizing their
interests.
 Competent Board with independent disposition assisted by its various
committees and senior management.
 Documentation of definition and understanding of the role, duties,
responsibilities, accountabilities of the Board, its Committees and Senior
Management.
 Appropriate supervision by senior management.
 Transparency at Board level and all levels of the management.
 Comprehensive risk management and control mechanism.
 Effective internal control and audit system.
 Assurance for compliance with applicable statutes.
5.1.2.8 Corporate Governance – Relevance and Need for Cooperative
Banks

Cooperative organizational structure is very unique. Proper understanding of

cooperative culture, cooperative ethics, values and principles is essential to
evaluate Corporate Governance in the context of cooperatives.
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Definition of Cooperatives

A co-operative is an autonomous association of persons united voluntarily to

meet their common economic, social and cultural needs and aspirations
through a jointly-owned and democratically controlled enterprise.

Cooperative Values Co-operatives are based on the values of self-

responsibility, democracy, equality and solidarity. In the tradition of their
founders, cooperative members believe in the ethical values of honesty,
openness, social responsibility and caring for others. The Cooperative Values
are vision statement for cooperatives.

Cooperative Principles

The Cooperative Principles, popularly called as Cooperative Rainbow are

guidelines by which Cooperative put their values into practice. They are
Mission Statements for Cooperatives.

Regulatory measures taken to introduce Corporate Governance in

Cooperative Banks (CBs)1

 Amendments in BR Act 1949, (AACS) to introduce professionalism in

Cooperative Banks.
 RBI guidelines prescribing Dos’ and Don’ts for directors.
 Appointment of Madhavdas Committee and its Recommendations in
1978.
 Amendments in BR Act 1949, to introduce professionalism in
Cooperative Banks.
 High Power Committee.
 Joint Parliamentary Committee 2003
 CAMEL Rating Guidelines.
 TAFCUB and MOUs with State or Central Government.
 Risk Based Supervision.
 Risk Management / Risk Management Audit.
1
The guidelines are for the Urban Cooperative banks. Nevertheless, many of the measures are relevant for
the rural cooperatives as well.

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5.1.3 Measures in Cooperative Acts

 Comprehensive provisions for composition of Board giving representation

to various sections of the society.
 Prohibitions on loans and advances to Directors and other restrictive
provisions to avoid malpractices.
 Explicit provisions for fixing accountability of the persons involved for
financial loss caused to the Bank, and also for negligence & false
reporting on financial state of affairs of the Bank.
 Provisions for appropriation of profit for sustainable growth, and serving
the cause of welfare of employees, promotion of cooperative movement
and society at large.
 Norms for Audit Classification.
 Effective provisions for loan recoveries.
 OTS for expediting recoveries.
5.1.3.1 Hurdles or lacunae In implementing corporate governance

 Inadequate understanding of banking principles at Board and senior

management level, obviously because co-operative societies/banks are
generally established by common people.
 Ignorance about self-sustainable growth with specific reference to
prudential norms.
 Preference to short term achievements at cost of long term objectives.
 Unhealthy competition among the Cooperative Banks.
 Wrong notions of Board of Directors/CEO about the growth and progress
of the Bank.
 Connected lending.
 Corrupt practices.
 Misconceptions or ignorance of the Board of Directors about their Role,
Accountability and Responsibility.
 Lack of professionalism.
 Chairman or CEO centric functioning.

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  Non-remunerative post of elected directors.
 Undue importance to the interests of the borrowers at the cost of welfare
depositors.
 Poor Risk Management and Control System.
 Politicization.
 No due importance to or Ineffective Internal Audit.
 No statutory restriction on tenure of directorship.
 Importance to electoral merits of directors rather than their qualitative
merits.
 Apathy of members/shareholders.
 Borrower dominated Boards.
5.1.4 Issues of good governance in cooperative banks and internal
control systems

Changes in cooperative law are being adopted which will lead to operational
flexibility. There is need to develop business through business development
planning for doing varied business in order to earn profit in the post reforms
era. For this to happen, the one major aspect required is the good governance
to take the organisation towards its goals. Let us now see the role of good
governance.

5.1.4.1 Governance structures - the President, Board and the General

Body

It is the responsibility of the President (aka Chairman) to direct and run the
Society in a proper and constructive manner. The Board functions within the
boundaries of the by-laws, policy decisions taken by the General Body and as
per the provisions of the Cooperative Societies Act /Rules. The General Body is
the highest / supreme authority of the society. Important policy directions are
given by the General Body only. Thus, the President, the Board of Directors
and the General Body are the important components of governance structure.
Carrying out the day-to-day work of the society and also the implementation of
the decisions taken by the Board is the responsibility of the Secretary, who is
also the CEO of Society.

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5.1.4.2 Good governance and role of board members in managing the
change process in the organisation

The basic principles of good governance are accountability, transparency,

informed decisions, decisions based on facts, non-corrupt ways of doing things
respect for the merit of each case and regulatory reporting to higher bodies.
While taking decisions in the Board meetings and directing the secretary to do
or not to do certain things like sanction of loans, non-recovery of dues, non-
attachment and discharge of the attached assets, the interest of the bank
should be kept uppermost in their mind. The duality of the role of the Board
Members as part of governance structure and as borrowers / customers,
should not cloud and vitiate their decision.

5.1.4.3 Internal checks and control systems

Every bank has its own internal control processes in the form of durable
mechanisms for reducing instances of frauds, misappropriation and errors of
omission and commission by the bank's employees or customers or others.
With the increase in volume of business and banking transactions, the internal
control systems have to become more extensive addressing various risks faced
by banks. Proper internal controls ensure that the bank's business is
conducted in an orderly, prudent manner in accordance with established
policies.

 A sound internal control system consists of :

 Management review and the control culture in the bank.
 Risk assessment system and follow-up action.
 Routine control activities based on sound banking norms and practices.
 Flow of information and communication at all organizational levels.
 Monitoring activities being ensured by supervisory and management
levels without negligence or incompetence.
Internal control system in Banks- Scope

The scope of a good internal controls and checks system comprises

 Risk assessment and control

 Accounts controls
 Administrative controls
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  Internal/concurrent audit
 Internal inspection including computer audit
 Vigilance cell and monitoring of frauds
 Review by Board of Directors
These must be in place in any bank as all internal control systems need to be
continuously evaluated and updated to meet changing requirements. These are
discussed below in brief.

5.1.5 Formation of committees

As part of the process of providing corporate governance the regulatory

authorities have directed the business to set up certain key committees to
oversee and regulate key functions viz investment, risk, audit and vigilance
committees. Each of these committees consists of directors, and has to adhere
to the specific norms laid down.

5.1.5.1 Audit Committee

Audit committee is important for successful implementation of Corporate

Governance. It should consist of the Chairman, three/four Directors, one or
more of such directors should be Chartered Accountant or have experience in
management, finance, accountancy, audit etc.

Role of audit committee

The role of the audit committee shall include the following:

 It should provide direction and oversee the operations of the total audit
function in the bank and maintain quality of internal audit and
inspection.
 Follow up on the statutory audit of the bank and inspection of the
Reserve Bank
 Strengthening housekeeping.
 Fixing accountability of inspecting/auditing officials for failure to detect
serious irregularities.
 Periodical review of the accounting policies/ internal control systems in
the bank with a view to ensuring greater transparency in the bank’s
accounts.
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  Sensitizing the Board about risk prone areas.
 Review of Risk Management measures to mitigate the risk.
 Ensure various statutory compliances applicable to the bank.
The Audit Committee should have discussions with the auditors periodically
about internal control systems, the scope of audit including the observations of
the auditors and review the half-yearly and annual financial statements before
submission to the Board and also ensure compliance of internal control
systems. The Audit Committee shall have authority to investigate into any
matter in relation to the items specified in this section or referred to it by the
Board and for this purpose, shall have full access to information contained in
the records of the company and external professional advice, if necessary.

5.1.5.2 The Investment Committee

The Investment Committee should comprise of the Directors. The role of the
Investment Committee would be to assist the Board on matters relating to the
review and management of the Company’s investment policies, strategies,
transactions and performance and to oversee management of the Company’s
capital and financial resources.

The Investment Committee should be responsible for:

 Overseeing investment policies and strategies;

 Delegating authority to execute individual transactions on behalf of the
Company within policies and limits approved by the Committee and to
approve investment transactions on behalf of the Company that exceed
such delegated limits;
 Reviewing investment transactions made on behalf of the Company and
the performance of these transactions;
 Reviewing the Company’s capital plan and providing guidance to the
Board on significant financial policies and matters, including the
Company’s dividend policy, share issuance or repurchase programs, and
the issuance of debt; and
 Overseeing the treasury management function on behalf of the Company.

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5.1.5.3 Role and responsibilities of a separate risk committee

“Risk oversight” describes the role of the board of directors in the risk
management process. The risk oversight process is the means by which the
board determines that the company has in place a robust process for
identifying, prioritizing, sourcing, managing and monitoring its critical risks
and that process is improved continuously as the business environment
changes. By contrast, “risk management” is what management does, which
includes appropriate oversight and monitoring to ensure policies are carried
out and processes are executed in accordance with management’s selected
performance goals and risk tolerances.

5.1.6 Let us sum up

Corporate governance refers to the set of systems, principles and processes by

which a company is governed. They provide the guidelines as to how the
company can be directed or controlled such that it can fulfill its goals and
objectives in a manner that adds to the value of the company and is also
beneficial for all stakeholders in the long term.

Corporate governance is based on principles such as conducting the business

with all integrity and fairness, being transparent with regard to all
transactions, making all the necessary disclosures and decisions, complying
with all the laws of the land, accountability and responsibility towards the
stakeholders and commitment to conducting business in an ethical manner.

Cooperative banks need to implement corporate governance if they have to

grow in a healthy manner

Cooperative organizational structure is very unique and innovative.

Proper understanding of cooperative culture, cooperative ethics, values and

principles is essential to evaluate Corporate Governance in the context of
cooperatives.

Changes in cooperative law are being adopted which will lead to operational
flexibility. There is need to develop business through business development
planning for doing varied business in order to earn profit in the post reforms
era. For this to happen, the one major aspect required is the good governance
to take the organisation towards its goals.

290
As part of the process of providing corporate governance the regulatory
authorities have directed the business to set up certain key committees to
oversee and regulate key functions viz. investment, risk, audit and vigilance
committees. Each of these committees consists of directors, and has to adhere
to the specific norms laid down.

5.1.7 Key words/concepts

Corporate governance, Stakeholders, Integrity and ethical behavior, Disclosure

and transparency, Independence of directors, Internal Checks and Control
Systems Risk.

5.1.8 Check your progress- questions

1. The governance framework determines

a. Whom the organisation is there to serve b. Whom the organisation is there to serve
and how the purposes and priorities of
the organisation should be decided.
c. The legal framework for the d. The regulatory framework in which the
administration of the organisation. organisation operates.

2. The main purpose of corporate governance is:

a. To separate ownership and b. To maximize shareholder value.

management control of organisations.
c. To separate ownership and d. To ensure that regulatory frameworks
management control of organisations and are adhered to.
to make organisations more visibly
accountable to a wider range of
stakeholders.

3. The desire for more accountability of public sector organisations has

resulted in:

a. Pressure on all public sector b. Public sector managers to become more

organisations to be operated on a profit professional
making basis.
c. Public sector organisations to develop d. An increased proportion of independent
plans for their strategic development. members on governing bodies.

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 4. An ethical stance is the extent to which

a. An organisation meets the expectations b. An organisation will exceed its

of its stakeholders. minimum obligations to stakeholders and
society at large
c. An organisation meets regulatory d. An organisation respects the dominant
requirements religious beliefs of the country in which it
operates

5. Stakeholders are the individuals or groups who:

a. Depend on the organisation to fulfill b. Are shareholders in key competitors.

their own goals and on whom the
organisation depend.
c. Dominate the strategy development d. Determine operational issues.
process in an organisation.

Key to the questions asked

1.b 2.c 3.d

4.b 5.a

5.1.9 Terminal questions

 Define corporate governance and its state underlying principles.

 What are the key elements of corporate governance?
 Explain the need for corporate governance in cooperative banks
 What are the hurdles in implementing corporate governance in banks?
 What is the role of internal control systems incorporate governance?
 Briefly describe the role of 4 committees that are to be set up for
overseeing corporate governance

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5.2 Lesson No. 20 Four Pillars

5.2.1 Objectives
5.2.2 Introduction
5.2.3 The four pillars of corporate governance
5.2.3.1 Accountability
5.2.3.2 Fairness
5.2.3.3 Transparency
5.2.3.4 Independence
5.2.4 Let us sum up
5.2.5 Key words/concepts
5.2.6 Check your progress (questions)
5.2.7 Terminal questions

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5.2.1 Objectives

The objectives of this lesson are to understand the four pillars namely

 Accountability
 Fairness
 Transparency
 Independence

5.2.2 Introduction

5.2.2.1 Four pillars of corporate governance

The four pillars of corporate governance have been broadly categorised as

Accountability, Fairness, Independence, and Transparency.

5.2.2.2 Accountability

Accountability is a concept in ethics and governance with several meanings. It

is often used synonymously with such concepts as answerability,
blameworthiness, liability and other terms associated with the expectation of
account-giving.

In sheer basic form it means

 Ensure that management is accountable to the Board

 Ensure that the Board is accountable to shareholders
Importance of accountability

The separation of ownership from management can cause conflict if there is a

breach of trust by managers either by intentional acts, omission of key facts
from reports, neglect, or incompetence. One way in which this can be avoided
is for entities (in their entirety) to act with transparency and be accountable to
the shareholders and other stakeholders. Therefore apart from just being a
component of corporate governance, there are many advantages of
accountability.

Firstly, it is a key to economic prosperity. If there is poor accountability by

players in the economy, stakeholders may lose the confidence they have in it
and hence become reluctant to put in their best. For instance; for some
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developing countries, lack of accountability may lead to a fall in the
participation rate in their development programmes by their cooperating
partners- a situation that leads to further deterioration in the development
process. Accountability is also a key to performance measurement. The more
accountable corporate governors are, the more likely it is that results of
performance measurement processes are going to be a true and fair
representative of the performance being measured.

Accountability is a very important pillar of corporate governance. Without it,

the agency problem would be hard to defeat. With it, the confidence of
stakeholders is increased. It is achieved through faithfulness in various aspects
of corporate governance especially reporting. The strength and accuracy of the
reporting is also strengthened by various standards and regulations.

5.2.2.3 Fairness

To begin with, one may ask, what is fairness? Fairness means treating people
with equality. It entails avoiding of bias towards one or more entities as
compared to the other(s).

How unfair can fairness get: importance of fairness

In economic development terminology, we usually meet the word fair several

times. For instance there are phrases such as the fair distribution of the
national wealth, fair value, fair play and so on. Fairness has in the recent past
been a controversial issue in corporate governance. If you know the
contentions that a bad decision as a result of bias can bring, then you already
know just how critical it is that fairness is practiced in the way companies are
directed and controlled.

Fairness is usually considered with various stakeholders of a company in

mind. The choice as to what is fair and will most likely be made by taking into
account the stakeholder’s position on the power-interest matrix. Some of the
stakeholders of a company include; shareholders (including institutional
investors), suppliers (creditors), employees, customers and the community at
large.

What do organisations do to enhance fairness in corporate governance

For many company boards, being fair is a very difficult thing. There are big
decisions to be made on which a normal person or group with some interest
(financial or otherwise) cannot just be fair. In transactions such as mergers or
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acquisitions for instance, it is very hard to be as fair as possible if you are on
the board. For this reason, many companies are turning to what is known as
fairness opinions. This involves calling in an independent knowledgeable entity
to assess a particular transaction and give their opinion on it’s fairness.

Another way that is being used as a tool to increase fairness is known as

corporate governance rating. Here, various companies are assessed on aspects
of their corporate governance and the results are published in order to help the
firm(s) improve performance on fairness. This is however not a widespread
practice and is most likely un-heard of in many developing countries.

Various solutions to the problem of unfairness are being developed. This is as a

result of the realisation by many firms that fairness is important in the way the
companies are directed and controlled. The fairer the entity appears to
stakeholders, the more likely it is that it can survive the pressure of these
interested parties.

In basic form fairness means

 Protect Stakeholders rights

 Treat all shareholders including minorities, equitably
 Provide effective redress for violations
5.2.2.4 Transparency

An objective of many proposed corporate governance reforms is increased

transparency. This goal has been relatively uncontroversial, as most observers
believe increased transparency to be unambiguously good. We argue that, from
a corporate governance perspective, there are likely to be both costs and
benefits to increased transparency, leading to an optimum level beyond which
increasing transparency lowers profits. This result holds even when there is no
direct cost of increasing transparency and no issue of revealing information to
regulators or product-market rivals. We show that reforms that seek to
increase transparency can reduce firm profits, raise executive compensation,
and inefficiently increase the rate of CEO turnover. We further consider the
possibility that executives will take actions to distort information. We show that
executives could have incentives, due to career concerns, to increase
transparency and that increases in penalties for distorting information can be
profit reducing.

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The corporate reporting environment has changed dramatically in recent years.
Today, corporate reporting is no longer restricted to the financial statements,
but encompasses a broad array of additional matters that must also be
disclosed. No longer focused on historic results, it now includes prospective
elements, such as guidance on future revenue and earnings targets. Moreover,
disclosure of a growing number of non-financial performance metrics is being
required, together with an ever-increasing number of financial metrics.

Transparency enables investors, creditors, and market participants to evaluate

the financial condition of an entity. In addition to helping investors make better
decisions, transparency increases confidence in the fairness of the markets.
Further, transparency is important to corporate governance because it enables
boards of directors to evaluate management's effectiveness and to take early
corrective actions, when necessary, to address deterioration in the financial
condition of companies. Therefore, it is critical that all public companies
provide an understandable, comprehensive and reliable portrayal of their
financial condition and performance.

If the information in financial reports is transparent, then investors and other

users of the information are less likely to be surprised by unknown
transactions or events. Investors and creditors expect clear, reliable,
consistent, comparable, and transparent reporting of events. Accounting
standards provide a framework that is intended to present financial
information in a way that facilitates informed judgments. For financial
statements to provide the information that investors and other decision-makers
require, meaningful and consistent accounting standards and comparable
practices are necessary.

In basic form transparency means

Ensure timely, accurate disclosure on all material matters, including the financial
situation, performance, ownership and corporate governance

5.2.2.5 Independence

In corporate governance, independence is therefore important in a number of

contexts. It is vital that external auditors are independent of their clients that
internal auditors are independent of the colleagues they are auditing, and that
non-executive directors have a degree of independence from their executive
colleagues on a board. But what do we mean by ‘independence’ as a concept?
Independence is a quality that can be possessed by individuals and is an
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essential component of professionalism and professional behaviour. It refers to
the avoidance of being unduly influenced by a vested interest and to being free
from any constraints that would prevent a correct course of action being taken.
It is an ability to ‘stand apart’ from inappropriate influences and to be free of
managerial capture, to be able to make the correct and uncontaminated
decision on a given issue.

In basic form independence means

 Procedures and structures are in place so as to minimize, or avoid

completely conflicts of interest
 Independent Directors and Advisers i.e. free from the influence of others
5.2.3 Let’s us sum up

The four pillars of corporate governance are accountability, fairness,

transparency, and independence.

Accountability is a concept in ethics and governance with several meanings. It

is often used synonymously with such concepts as answerability,
blameworthiness, liability and other terms associated with the expectation of
account-giving

Fairness means treating people with equality. It entails avoiding of bias

towards one or more entities as compared to the other(s).

Protect Stakeholders rights

Treat all shareholders including minorities, equitably

Provide effective redress for violations

An objective of many proposed corporate governance reforms is increased

transparency. This goal has been relatively uncontroversial, as most observers
believe increased transparency to be unambiguously good.

Transparency enables investors, creditors, and market participants to evaluate

the financial condition of an entity. In addition to helping investors make better
decisions, transparency increases confidence in the fairness of the markets.

In corporate governance, independence is therefore important in a number of

contexts. It is vital that external auditors are independent of their clients that
internal auditors are independent of the colleagues they are auditing, and that

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non-executive directors have a degree of independence from their executive
colleagues on a board.

5.2.4 Key words/concepts

Accountability, Fairness, Transparency, and Independence.

5.2.5 Check your progress- questions

1. Answerability, blameworthiness, liability relates to:

a. Fairness b. Accountability
c. Transparency d. Independence

2. In basic form fairness means:

a. Ensure timely, accurate disclosure on b. Procedures and structures are in place

all material matters, including the so as to minimise, or avoid completely
financial situation, performance, conflicts of interest
ownership and corporate governance
c. Protect Stakeholders rights d. Ensure that management is
accountable to the Board

3. In basic form independence means:

a. Ensure timely, accurate disclosure on b. Procedures and structures are in place

all material matters, including the so as to minimize, or avoid completely
financial situation, performance, conflicts of interest
ownership and corporate governance
c. Protect Stakeholders rights d. Ensure that management is
accountable to the Board

4. In basic form transparency means:

a. Ensure timely, accurate disclosure on b. Procedures and structures are in place

all material matters, including the so as to minimise, or avoid completely
financial situation, performance, conflicts of interest
ownership and corporate governance
c. Protect Stakeholders rights d. Ensure that management is
accountable to the Board

Key to the questions asked

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1.b 2.c 3.b
4.a

5.2.6 Terminal questions

Explain the importance of the 4 pillars in corporate governance

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5.3 Lesson No. 21 Dos and Don’ts

5.3.1 Objectives
5.3.2 RBI guidelines on Corporate Governance
5.3.2.1 Dos and Don’ts of RBI
5.3.2.2 Dos
5.3.2.3 Don’ts
5.3.3 Banks’ best practices
5.3.4 Regulatory measures
5.3.5 Let us sum up
5.3.6 Key words/concepts
5.3.7 Check your progress-questions
5.3.8 Terminal questions
5.3.9 Bibliography and reference books for further reading

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5.3.1 Objective

The objective of this lesson is to understand the details of RBI and NABARD
Guidelines on Corporate Governance

5.3.2 RBI Guidelines on Corporate Governance

Regulators are external pressure points for good corporate governance. Mere
compliance with regulatory requirements is not however an ideal situation in
itself. In fact, mere compliance with regulatory pressures is a minimum
requirement of good corporate governance and what are required are internal
pressures, peer pressures and market pressures to reach higher than
minimum standards prescribed by regulatory agencies. RBI’s approach to
regulation in recent times has some features that would enhance the need for
and usefulness of good corporate governance in the co-operative sector. The
transparency aspect has been emphasized by expanding the coverage of
information and timeliness of such information and analytical content.

Importantly, deregulation and operational freedom must go hand in hand with

operational transparency. In fact, the RBI has made it clear that with the
abolition of minimum lending rates for co-operative banks, it will be incumbent
on these banks to make the interest rates charged by them transparent and
known to all customers. Banks have therefore been asked to publish the
minimum and maximum interest rates charged by them and display this
information in every branch. Disclosure and transparency are thus key pillars
of a corporate governance framework because they provide all the stakeholders
with the information necessary to judge whether their interests are being taken
care of. RBI sees transparency and disclosure as an important adjunct to the
supervisory process as they facilitate market discipline of banks.

Another area which requires focused attention is greater transparency in the

balance sheets of co-operative banks. The commercial banks in India are now
required to disclose accounting ratios relating to operating profit, return on
assets, business per employee, NPAs, etc. as also maturity profile of loans,
advances, investments, borrowings and deposits. The issue now is how to
adapt similar disclosures suitably to be captured in the audit reports of co-
operative banks. RBI had advised Registrars of Co-operative Societies of the
State Governments in 1996 that the balance sheet and profit &loss account
should be prepared based on prudential norms introduced as a sequel to
Financial Sector Reforms and that the statutory/departmental auditors of co-
operative banks should look into the compliance with these norms.
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Auditors are therefore expected to be well-versed with all aspects of the new
guidelines issued by RBI and ensure that the profit & loss account and balance
sheet of cooperative banks are prepared in a transparent manner and reflect
the true state of affairs. Auditors should also ensure that other necessary
statutory provisions and appropriations out of profits are made as required in
terms of Co-operative Societies Act / Rules of the state concerned and the bye-
laws of the respective institutions. At the initiative of the RBI, a consultative
group, aimed at strengthening corporate governance in banks, headed by Dr.
Ashok Ganguli was set up to review the supervisory role of Board of banks. The
recommendations include the role and responsibility of independent
nonexecutive directors, qualification and other eligibility criteria for
appointment of non-executive directors, training the directors and keeping
them current with the latest developments. Private sector banks, etc. it is
unanimously accepted that the most crucial aspect of corporate governance is
that the organisation have a professional board which can drive the
organization through its ability to perform its responsibility of meeting
regularly, retaining full and effective control over the company and monitor the
executive management. Some of the important recommendations on the
constitution of the Board are:

 Qualification and other eligibility criteria for appointment of non-

executive directors,
 Defining role and responsibilities of directors including the recommended
“Deed of Covenant” to be executed by the bank and the directors in
conduct of the board functions.
 Training the directors and keeping them abreast of the latest
developments.
5.3.2.1 Dos and Don’ts as per RBI for Board of Directors of Co-operative
Banks2

The BODs of the bank should ensure that proper loan policies are adopted and
followed. It should be ensured that all circulars and other material relating to
policies issued by the Reserve Bank/Government are seen by every member of
the Board and also placed before the Board for suitable action.

2 The guidelines are for the Urban Cooperative banks. Nevertheless, many of the measures are
relevant for the rural cooperatives as well.

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A list of Do’s and Don’ts for guidance of the directors of banks is given below.
The list is illustrative and not exhaustive and is not to be regarded as a
substitute to the specified duties, responsibilities or rights of the BODs as
enunciated in the co-operative law and/or bye-laws of the respective banks.

5.3.2.2 DOs

(a) Discipline & Involvement: The directors should:

 Attend the Board meeting regularly and effectively. They should work in
a spirit of co-operation.
 Study the Board papers thoroughly and use the good offices of the Chief
Executive Officer for eliciting any information at the Board Meeting.
 Ask the chairman to furnish the Board papers and follow up reports on a
definite time schedule.
 Be familiar with the broad objectives of the bank and the policy laid
down by the Government and the Reserve Bank.
 Involve themselves thoroughly in the matter of formulation of general
policy and also ensure that performance of the bank is monitored
adequately at Board level.
(b) Constructive & Development Role: The directors should:

 Welcome all constructive ideas for the better management of the bank
and for making valuable contribution.
 Try to give as much of their wisdom, guidance and knowledge as possible
to the Management.
 Try to analyse the trends of economy, assist in the discharge of
Management’s responsibility to public and formulation of measures to
improve customer service and be generally of constructive assistance to
the bank management.
 Work as a team and not sponsor or be prejudiced against individual
proposals. Management on its part is supposed to furnish full facts and
complete papers in advance.

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(c) Business specific contribution

The directors should bestow attention on the following aspects of the bank’s
working:

 compliance with monetary and credit policies of the Reserve

Bank/Government
 observance of Cash Reserve and Statutory Liquidity Ratio
 efficient management of funds and improving profitability
 Compliance with guidelines on income recognition, asset classification,
provisioning towards non-performing assets.
 deployment of funds to priority sector/weaker sections
 Over dues and recovery – ensure that recoveries are made promptly and
over dues reduced to the minimum.
 Review of action taken on the Reserve Bank’s inspection /statutory audit
reports.
 vigilance, frauds and misappropriation
 Strengthening of internal control system and housekeeping viz. proper
maintenance of books of accounts and periodical reconciliation.
 reviews on several items as prescribed by the Reserve Bank/Government
 customer service
 development of a good management information system
 computerization
5.3.2.3 Don’ts

(a) Non-Interference: The directors should not:

 Interfere in the day-to-day functioning of the bank.

 Involve themselves in the routine or everyday business and in the
management functions.
 Send instructions/directions to any individual officer/employee of the
bank in any manner.

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(b) No Sponsorship: The directors should not:

 Sponsor any loan proposal, buildings and sites for bank’s premises,
enlistment or empanelment of contractors, architects, doctors, lawyers,
etc.
 Approach or influence for sanction of any kind of facility.
 Participate in the Board discussions, if a proposal in which they are
directly or indirectly interested, comes up for discussions. They should
disclose their interest, well in advance, to the Chief Executive Officer and
the Board.
 Sponsor any candidate for recruitment or promotion or interfere in the
process of selection/appointment or in transfers of staff.
 Do anything which will interfere with and/or be subversive of
maintenance of discipline, good conduct and integrity of the staff.
 Involve themselves in any matter relating to personnel administration –
whether it is appointment, transfer, posting or a promotion or a redressal
of individual grievances of any employee.
 Encourage the individual officer/employee or unions approaching them
in any matter.
(c) Confidentiality

 The directors should not reveal any information relating to any

constituent of the bank to anyone as he/she is under oath of secrecy and
fidelity.
 The directors are expected to ensure confidentiality of the bank’s agenda
papers/notes. The Board papers may ordinarily be returned to the bank
after the meeting.
 The directors should not directly call for papers/files/notes recorded by
various departments for scrutiny etc. in respect of agenda items to be
discussed in the meetings. All information/clarification that they may
require for taking a decision should be made available by the executive.
 A director may indicate his / her directorship of the bank on his / her
visiting card or letter head, but the logos of distinctive design of the bank
should not be displayed on the visiting card/letter head.

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  The directors should ensure that the bank’s funds are utilized in a
proper and judicious manner for the benefit of general members.

5.3.3 Measures taken by banks towards implementation of best practices

Prudential norms in terms of income recognition, asset classification, and

capital adequacy have been well assimilated by the Indian banking system. In
keeping with the international best practice, starting 31st March 2004, banks
have adopted 90 days norm for classification of NPAs. Also, norms governing
provisioning requirements in respect of doubtful assets have been made more
stringent in a phased manner. Beginning 2005, banks will be required to set
aside capital charge for market risk on their trading portfolio of government
investments, which was earlier virtually exempt from market risk requirement.

Capital Adequacy: All the Indian banks barring one today are well above the
stipulated benchmark of 9 per cent and remain in a state of preparedness to
achieve the best standards of CRAR.

On the Income Recognition Front, there is complete uniformity now in the

banking industry and the system therefore ensures responsibility and
accountability on the part of the management in proper accounting of income
as well as loan impairment.

ALM and Risk Management Practices – At the initiative of the regulators,

banks were quickly required to address the need for Asset Liability
Management followed by risk management practices. Both these are critical
areas for an effective oversight by the Board and the senior management which
are implemented by the Indian banking system on a tight time frame and the
implementation review by RBI. These steps have enabled banks to understand,
measure and anticipate the impact of the interest rate risk and liquidity risk,
which in deregulated environment is gaining importance.

5.3.4 Measures taken towards corporate governance

Reserve Bank of India has taken various steps furthering corporate governance
in the Indian Banking System. These can broadly be classified into the
following three categories:

 Transparency
 Off-site surveillance

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  Prompt corrective action
Transparency and disclosure standards are also important constituents of a
sound corporate governance mechanism. Transparency and accounting
standards in India have been enhanced to align with international best
practices. However, there are many gaps in the disclosures in India vis-à-vis
the international standards, particularly in the area of risk management
strategies and risk parameters, risk concentrations, performance measures,
component of capital structure, etc. Hence, the disclosure standards need to be
further broad-based in consonance with improvements in the capability of
market players to analyze the information objectively.

The off-site surveillance mechanism is also active in monitoring the movement

of assets, its impact on capital adequacy and overall efficiency and adequacy of
managerial practices in banks. RBI also brings out the periodic data on “Peer
Group Comparison” on critical ratios to maintain peer pressure for better
performance and governance. Prompt corrective action has been adopted by
RBI as a part of core principles for effective banking supervision. As against a
single trigger point based on capital adequacy normally adopted by many
countries, Reserve Bank in keeping with Indian conditions have set two more
trigger points namely Non-Performing Assets (NPA) and Return on Assets (ROA)
as proxies for asset quality and profitability. These trigger points will enable the
intervention of regulator through a set of mandatory action to stem further
deterioration in the health of banks showing signs of weakness.

Task Force on Revival of Cooperative Credit Institutions

The Task Force (Vaidyanthan Committee) which was set up to suggest

measures for revival of the rural cooperatives had observed that the
impairment in governance in the rural cooperatives is deep and is represented
by the composition of the Boards of Directors of the cooperatives and the
reporting systems. Because of the structural ordering, the lower tiers are
managed by the higher tiers in varying degrees of detail in different States. In
almost all States, the function of conducting elections for the cooperative
structure is vested with the State Government. Similarly, the function of
auditing is also vested with a State run audit system. By implication, the
cooperatives lose their right to self-governance and have to look up to the State
constantly for several of the functions that naturally fall in the domain of the
general body and the Board of Directors.

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The Task Force had therefore mentioned that while professionalism is
necessary in the governance and management of financial cooperatives, it
needs to be done with due regard for the characteristics of the membership of
the financial cooperatives. The Task Force had therefore recommended that
steps be taken by the RBI to have the B R Act suitably amended to ensure the
following:

 Bringing cooperative banks on par with commercial banks in terms of

prudent financial regulation.
 Prescribing fit and proper criteria consistent with the membership of
cooperatives for election to the Boards. To ensure professionalism in the
Boards, however, three or four members with prescribed qualifications
should be co-opted with voting rights in case members with prescribed
qualifications do not get elected.
 Prescribing minimum qualifications for CEOs of the cooperative banks
and approving their names.
 Prescribing capital adequacy norms for cooperative banks (to be
implemented in a phased manner)
 Prohibiting any cooperative other than a cooperative bank from accepting
public deposits from any person other than its members.
 Prohibiting any cooperative other than a cooperative bank, from using
the words “bank”, “banker”, “banking”, or any other derivative of the
word “bank”, in its registered name.

5.3.5 Let’s us sum up

Regulators are external pressure points for good corporate governance. Mere
compliance with regulatory requirements is not however an ideal situation in
itself. In fact, mere compliance with regulatory pressures is a minimum
requirement of good corporate governance and what are required are internal
pressures, peer pressures and market pressures to reach higher than
minimum standards prescribed by regulatory agencies. RBI’s approach to
regulation in recent times has some features that would enhance the need for
and usefulness of good corporate governance in the co-operative sector.

At the initiative of the RBI, a consultative group, aimed at strengthening

corporate governance in banks, headed by Dr. Ashok Ganguli was set up to
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review the supervisory role of Board of banks. The recommendations include
the role and responsibility of independent nonexecutive directors, qualification
and other eligibility criteria for appointment of non-executive directors, training
the directors and keeping them current with the latest developments.

Reserve Bank of India has taken various steps furthering corporate governance
in the Indian Banking System. These can broadly be classified into the
following three categories:

a) Transparency

b) Off-site surveillance

c) Prompt corrective action

The Task Force on Revival of the Rural Cooperatives had suggested important
measures for professionalizing the Boards of the rural cooperatives and for
improving corporate governance.

5.3.6 Key words/concepts

Constructive & Development Role, Non-Interference, Confidentiality, Capital

Adequacy, Transparency, Off-site surveillance, Prompt corrective action

5.3.7 Check your progress- questions

1. Ganguli committee on corporate governance has made 3 broad

recommendations. Identify the wrong option

a. Qualification and other eligibility b. Defining role and responsibilities of

criteria for appointment of non-executive directors including the recommended
directors, “Deed of Covenant” to be executed by the
bank and the directors in conduct of the
board functions.
c. Training the directors and keeping d. Directors should not be borrowers
them abreast of the latest developments.

2. RBI has laid down DONTs for the board of directors. One of the options is
not a DON’T.

Choose

a. interfere in the day-to-day functioning b. involve themselves in the routine or

everyday business and in the
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of the bank. management functions.
c. send instructions/directions to any d. review of action taken on the Reserve
individual officer/employee of the bank in Bank’s inspection /statutory audit
any manner. reports.

3. Three broad measures have been taken by RBI towards corporate

governance in banking system. Identify the option which is not a
measure by RBI

a. Transparency b. Off-site surveillance

c. weekly audit of activities d. Prompt corrective action

4. Off-site surveillance does not

a. monitor the movement of assets, b. evaluate its impact on capital adequacy

and overall efficiency
c. oversee assets and liabilities mismatch d. measure adequacy of managerial
practices in banks

Key to the questions asked

1.d 2.d 3.c

4.c

5.3.8 Terminal questions

 Describe the RBI guidelines on corporate governance

 List out the Dos and DONTs for directors of cooperative banks.
 Explain the 3 measures taken by RBI on corporate governance
5.3.9 Reference

 RBI website
 NABARD website
 Principles Relevance & Need for Urban Cooperative Banks by Sudhir
Pandit
 Indian Institute of Corporate affairs
 IIM Calcutta

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  Thought Arbitrage research Institute
Bibliography – further reading.

 Customer Service & Banking Codes and Standards

 Becht, Marco, Patrick Bolton, Ailsa Röell, "Corporate Governance and
Control"
 Clarke, Thomas & dela Rama, Marie (eds.) (2008) "Fundamentals of
Corporate Governance”
 Co- operative Banking Operations By IIBF

Note: In case any discrepancies observed in the module, may be

communicated to C-PEC at [email protected].

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