Other Financial

Services

BLOCK 4
EMERGING ISSUES IN FINANCIAL
SERVICES

385
Fund Based Services

386
UNIT 15 MANAGING RISK IN FINANCIAL Managing Risk in
Financial Services

SERVICES

Objectives

After reading this unit you will able to:

• Understand meaning risk and risk management

• Know various risks and risk management process
• Understand how lending institutions manage financial risk in fund based
financial services
• Know how risk is managed in fee based financial services
• Understand legal previsions on risk management
• Know role of regulator and board of directors in risk management

Structure

15.1 Introduction
15.2 Meaning of Risk
15.3 Risk Management Process
15.4 Types of Risks
15.5 Financial Services Business and Risk Management
15.6 Risk Management in Financial Services
15.7 Legal Provisions on Risk Management
15.8 Role of Regulator and Board of Directors in Risk Management
15.9 Summary
15.10 Key Words
15.11 Self-Assessment Questions
15.12 Further Readings

15.1 INTRODUCTION
Financial system of a country is comprised of financial markets, financial
institutions, financial services and regulator(s). Banks, non-bank financial
companies, All India Term Financial Institutions and capital market
intermediaries offer variety of traditional and new financial services or
products to their clients with the following objectives:

• to encourage savings of household and corporate sector

• to make available funds to the borrowers for the productive and other
purpose
• to help corporate in raising finances from the domestic and international
money and capital market 387
Emerging Issues in • to facilitate settlement of cash and credit transactions as well as transfer
Financial Services
of cash and effective cash management
• to ensure effective functioning of commercial enterprises.

By offering financial services to their clients, financial services providers

increase as well as diversify their business and thus are able to face
challenges arising from cut-throat but growing competition within the
market. The financial services can be categorized into two categories namely
fund based financial services and fee based financial services. While
undertaking business of financial services, lending and other commercial
enterprises are exposed to various risks.

15.2 MEANING OF RISK

Risk is possibility of monetary losses from futuristic business. Future is
uncertain and hence risk can be defined as the degree of uncertainty of future
returns and transactions. In view of this, future business may likely to suffer
monetary losses. In order to face uncertainty confidently and reduce future
losses lenders and other financial service providers focus on Risk
Management. Risk management is a structured approach to manage
uncertainty regarding business operations so as to minimize losses, through
a sequence of logical steps that includes identification of a risk, risk
assessment, monitoring and strategies to manage it, and mitigation of risk
using various techniques.

Relevance of Risk Management

• Deregulation of Markets - Various markets such as money, securities and

commodity are deregulated by various regulators. Because of this,
interest rates and prices of securities and commodities are decided by
market forces i.e. demand and supply. Banks and NBFCs are free to
decide interest rates on their deposit and loan products. In view of this
lending institutions are exposed to interest rate risk and price risk.

• Lending institutions actively participate in the primary and secondary

markets. Further because of nature of business such as borrowing and
lending, lending institutions are exposed to liquidity risk.

• Due to large number of domestic and multinational lending institutions,

markets for various financial services have become very competitive.
This has adverse impact on their business and earnings. This has forced
them to take more risk in financial services business. (Higher the Risk
Higher will be profit)

• Regulators have issued detailed guidelines on risk management. For

example Reserve Bank of India (RBI) has issued master circular on risk
management for banks, All India Term Financial Institutions and Non –
banking finance companies (NBFCs) who offer various financial
services to their customers. In view of this lending institutions have to
388
 frame an appropriate risk management policy keeping in view RBI’s Managing Risk in
Financial Services
guidelines and ensure that the same policy is being implemented.

15.3 RISK MANAGEMENT PROCESS

The following steps are involved in the risk management process.

1) Risk Identification

This is the first stage in risk management exercise. Based on nature of

business activities it is essential to identify various types of risks. For
example, in case of leasing and hire purchase finance business known risks
are credit risk, interest rate risk, liquidity risk and operational risk. In case of
merchant banking business most important risks are liquidity and operational
risk. In case of primary dealers business most important risks are interest rate
risk and liquidity risk. Risk identification exercise can be objective oriented,
scenario based and common risk checking approach. It is continuous process.
It is essential to identify new risk based on dynamics of business and market
conditions.

2) Risk Measurement

In this process risk is measured or quantified through use of suitable method

and its impact on business organization is studied. Risk analysis can be both
quantitative and qualitative in its nature. Application of statistical and
mathematical techniques in data analysis to determine the probabilities of
various adverse events and estimate of expected and unexpected losses under
various business scenarios is termed as quantitative risk analysis. As against
this if action is taken to define the threats devising counter measures for
mitigation and determining the extent of vulnerabilities is termed as
qualitative risk analysis.

3) Risk Mitigation

Once risk is properly analyzed then lending institution has to decide how to
control the same. If risk can be controlled internally with the help of skilled
and experienced staff then it is well and good. Otherwise organization may
like to take help of external professional agency to control the risk. Large
organizations have enough financial resources to mitigate risk internally.
Small organizations depend on external agency/entity for risk mitigation
exercise. Risk mitigation is the entire process of procedures, systems, policies
which an enterprise needs to manage prudently all risks which may arise.
Example If the lending institution has floating rate liabilities equal to floating
rate assets with the assumption that change in interest rate will be the same
on both side then its balance sheet gets immunized from gap or repricing
interest rate risk.

389
Emerging Issues in 4) Risk Transfer
Financial Services
If the risk is not manageable then one cannot retain the same. Then best
option could be to transfer the risk to another party which is willing to bear
the risk. This may be done in three ways.

The first is to transfer the asset itself. For example, a lending institution may
like to transfer loan asset along with credit risk to another party through asset
securitization transaction or direct assignment and thereby transfer the credit
risk involved in it. The second way is to transfer the risk without transferring
the title of the asset or liability. This may be done by hedging through various
derivatives instruments like forwards, futures, swaps and options. The third
way is through arranging for a third party to pay for losses if they occur,
without transferring the asset itself. This is possible with the help of
insurance company. For example under without recourse factoring
arrangement a factor or lending institution may like to transfer credit risk to a
insurance company which will absorb losses from credit risk.

5) Risk Monitoring

Risk monitoring is the last stage in which all the previous steps are reviewed
and evaluated. Risk monitoring must be carried out regularly and on
continuous basis as internal and external business environment and
organizational behavior are dynamic and ever changing. Risks should be
monitored to ensure that the desired results of risk management are achieved.
If not, then it is essential to identify the reasons behind this and carry out
detailed review of what went wrong in the previous stages and make
necessary changes in the risk management process according to the changing
scenario.

15.4 TYPES OF RISK

15.4.1 Unsystematic Risk v/s Systematic Risk
The combined risks can be classified into unsystematic and systematic risks.
Both these types of risks are explained below:

Unsystematic Risk: Such risk is unique to a commercial enterprise and thus

can be predicted and controlled at micro level. Top management of
commercial enterprise can easily manage such risk. It can be easily quantified
with the use of simple techniques. If such risk is not controlled then it will
affect financial performance of an individual enterprise. Examples of such
risks are credit risk, financing risk, compliance risk and operational risk etc.

Systematic Risk: Such risk is common to all commercial enterprises that

operate under the same market environment. Hence it is analyzed at macro
level. Such risk can be predicated to a large extent with the help of statistical
techniques and information technology. However, it cannot be fully assessed
and anticipated in advance in terms of timing and probable losses. Examples
390 of such risks are interest rate risk and price risk etc.
15.4.2 Financial v/s Non Financial Risk Managing Risk in
Financial Services
The combined risks can be categorized into financial risk and non financial
risk. Both these risks are commonly found in business. Hence these risks
must be understood and managed properly.

Financial Risk: This risk has direct impact on profitability and financial
position of business enterprise. Examples of such risks are credit risk, interest
rate risk, liquidity risk and operational risk etc. If such risk is not properly
managed then commercial enterprise is likely to incur heavy losses and its
capital will get wiped out.

Non-Financial Risk: Such types of risk do not have immediate impact on

profitability and financial position of commercial enterprise. Examples of
such risks are compliance risk, reputation risk, regulatory risk and disaster
risk etc. If such risk is not properly managed then commercial enterprise may
incur penalty from regulator/government and loss of business and customers
etc.

15.4.3 Types of Financial risk

1) Liquidity Risk

This is the risk of having inadequate or no liquidity (cash) at all. Thus,

liquidity risk is the inability of a lending institution’s to meet such obligations
as they become due, without adversely affecting the organization’s financial
condition. The objectives of liquidity risk management are as follows:

• to ensure adequate liquid assets at all times

• to comply with guidelines/regulations issued by regulator
• to fix and follow liquidity risk limits
• to monitor liquidity gap profile under short term buckets/periods and
identity sources of funding
• to hold high quality liquid assets as cushion to use during extraordinary
liquidity crisis

There are two types of liquidity risk namely Funding liquidity risk and
Market liquidity risk.

i) Funding Liquidity Risk: Such risk arises when short term deposits or
borrowings are used to originate long term loan assets or invest in long
term securities which are illiquid. This results into inability of a lending
institution to meet payment obligations. This means that the lending
institution has no adequate cash to pay to the depositors and other
creditors on demand and other commitments and guarantees.

ii) Market Liquidity Risk: This risk arises when the lending institution
unable to sell liquid assets at normal market price. This happens when the

391
Emerging Issues in size of the trade is much larger than normal trading lots or trading in
Financial Services
liquid assets is suspended or market is closed or inadequate market depth.

2) Interest Rate Risk

This risk refers to the effect of changes in interest rates on Net Interest
Income (NII) and Net Interest Margin (NIM) of a lending institution. It also
affects values of interest bearing assets and interest bearing liabilities which
results into change in the value of equity of the lending institution. Interest
rate risk arises from interest rate volatility. Hence for managing IRR it is
necessary to forecast direction of change i.e. increase or decrease in interest
rate and degree of change i.e. whether 25 or 50 basis points change in interest
rate. Change in interest rate can be forecasted on the basis of analysis of past
data on interest rate fluctuations, internal and regulator’s guidelines, analyst’s
own experience and judgment. The objectives of interest rate risk
management are as follows:

• to maintain existing net interest margin or improve the same. In case if

there is a fall in the net interest margin then control the same.
• to reduce losses in respect of trading book.
• to minimize negative impact of interest rate shock on net worth of
lending institution and thus protect interest of shareholders.
• to comply with guidelines/regulations issued by regulator
• to fix and follow interest rate risk limits

There are different types of interest rate risk. Few of these are discussed
below:

i) Gap Risk or Repricing Risk: A gap or repricing risk emanates from

holding assets, liabilities and off balance sheet items having different
principal amounts, maturity dates, and repricing dates etc. In view of
such mismatches, any change in the interest rate affects the income and
thus economic value of a lending institution. For example, if a lending
institution has originated three years long term loan asset at a fixed rate
from six months fixed deposit then in a rising interest rate scenario cost
of deposit will increase. However, yield on loan asset will remain the
same. This will reduce the spread between yield on assets and cost of
liabilities (i.e. Net Interest In come)

ii) Basis Risk: Movements in interest rates will not have the same impact or
change on different instruments. The risk that the interest rate of
different assets, liabilities and off balance sheet items may change in
different degree is termed as basis risk. This is so because there is
imperfect correlation between the indices or reference rates underlying
asset and liability interest rates. For example. deposit rate is linked with
repo rate of RBI and loan interest rate is linked with prime lending rate
(PLR) then there is no guarantee that 50 bp change in repo rate will imply
392 50 bp change in PLR. This means that if the spread between different
 indices changes suddenly earnings and net worth will change even if Managing Risk in
Financial Services
assets and liabilities are maturity matched. The degree of basis risk is
likely to be high in respect of those lending institutions which have
composite assets created from composite liabilities.

iii) Yield Curve Risk: This risk refers to the effect of non-parallel shifts of
yield curve segments on cost of liabilities and yield on assets of different
maturities. For example if two years loan is funded by six month deposits
then the lending institution’s spread might change sharply when the yield
curve flatters. The yields on assets and costs of liabilities move in a
different way. For example yields on T-bills of different maturities, and
on other money market instruments move differently. Yields on certain
instruments like yield on 364 day bills, overnight call money rates and
repo rate are used as a benchmark by lending institutions to price their
assets and liabilities under floating rate scenario. It is necessary to
analyze changes in yield curves and as probable impact on spread as well
as on the net worth.

iv) Embedded Options Risk: Options risk refers to the effect of options
embedded in various assets, liabilities and off balance sheet items of
lending institutions. For example, depositors of a bank have option (right)
to withdraw from their term deposits before maturity date subject to the
organization’s terms and conditions. The depositors holding term deposits
are likely to exercise such option when market interest rates rise and
reinvest the proceeds at a higher interest rate. Similarly borrowers having
term loans may like to prepay their term loans when market interest rates
fall. Such situation will result in to sharp changes in cash flows that will
lead to fall in spread, increase in cost of refinance and fall in net worth of
the organization.

v) Price Risk: Price risk arises when assets like securities which are part of
trading book are valued regularly and provision is made for fall in the
value of securities. It is well established fact that in a secondary market,
movements in interest rates and prevalent prices of securities are
inversely related. If interest rate increases, then bond prices go down and
accordingly value of trading portfolio falls. The lending institution having
trading portfolio is required to make adequate provision for fall in the
value against profit as per the regulator’s guidelines. This is nothing but
notional loss.

vi) Reinvestment Risk: This risk emanates from the uncertainty regarding
the interest rate at which future cash flows can be reinvested. For
example, a lending institution has invested in AAA rated corporate bond
with a coupon of 8 per cent. Subsequent to this, if there is a fall in interest
rate by 100 bp (1%) the future cash flows on account of interest income
will be reinvested at a return of 7 per cent with a loss of 1 per cent
interest income. This is called as reinvestment risk.

393
Emerging Issues in 3) Credit Risk
Financial Services
Credit risk is dominant risk in fund based financial service business. It can be
defined as potential losses associated with diminution in the credit quality of
borrowers or obligors. In case of portfolio of loans, and leasing etc., losses
steam from outright default due to inability or unwillingness of a customer or
obligor to meet commitments in relation fund based facility, settlement and
other financial transactions. The credit risk arises on account of various
external and internal factors. The external factors are comprised of condition
of Indian economy and global economy, trade restriction, economic
sanctions, government policies, political stability and natural calamities etc,.
The internal factors are the factors which may be internal to the borrowers or
internal to the lending institutions. The internal factors to the borrowing
entity may be bad business planning and execution, costly capital structure,
poor liquidity, mismanagement of working capital funds and poor marketing
etc,. The factors internal to the lending institutions relate to the deficiencies
in loan policies and administration, poor credit appraisal, inadequate risk
pricing, absence of loan review mechanism and post sanction surveillance
etc.

The focus of credit risk is generally on the aspects of default and credit
quality. These two aspects are discussed below.

i) Default: It is a situation in which the lending institution does not receive

the amount from the borrower on due date. Default may be divided into
payment default and legal definition of default. The payment default
refers to unpaid obligations on due date. This may arise due to the
situations like (i) a technical reason, for example a disruption in transfer
of funds through NEFT or RTGS in case of electronic payments and (ii) a
temporary liquidity problem.

Default also could be understood in the context of regulator’s definition

of default. It includes (i) based on data and other evidence the lending
institution has presumed that the borrower is unlikely to meet its debt
obligations (principle, interest and other dues),or (ii) the borrower is past
due more than 90 days on any credit obligation and/ or (iii) the borrower
has filed application for bankruptcy in a court of law or before
appropriate authority.

ii) Credit Quality: Credit quality of fund based credit facility is assessed on
the basis of credit rating of a borrower. Such rating is carried out either
by external recognized credit rating agency or through the process of
internal credit rating mechanism. Change in credit rating may occur due
to reasons specific to the borrower rather than to general market
conditions. If there is deterioration in credit rating of the borrower then it
is presumed that there will be default in repayment of loan installment.
Credit risk management is more of proactive approach to maintain high
quality of loan assets rather than reactive approach.
394
4) Operational Risk Managing Risk in
Financial Services
Due to significant increase in scale of business operations and extensive use
of information technology operational risk has become one of the important
financial risks in financial services enterprises. This is also recognized by
various market regulators and international committees including Basel
Committee. Operational risk is the risk of direct or indirect loss/losses
resulting from inadequate or failed internal processes in human actions,
systems, or due to external events. Operational risk is pervasive, complex and
dynamic in its nature. Unlike other financial risks like liquidity risk and
interest rate risk which relates to specific line of business activity, operational
risk is found in the business activities and processes. It may manifest in a
variety of ways in the financial services industry. Now a day’s legal and
information technology risk is considered as a part of operational risk. The
objectives of operational risk management are as follows:

• to reduce losses from day to day business operations.

• to ensure adequate capital to absorb losses from operational risk
• to comply with guidelines/regulations issued by regulator

The Basel Committee has identified the following types of operational risk
events as having potential to result in substantial financial losses.

1) Internal frauds such as intentional misreporting or wrong reporting of

transactions or positions, employee theft, insider trading by employee

2) External frauds such as robbery, forgery and computer hacking

3) Employment practices workplace safety that includes workers

compensation claims, violation of employee health and safety rules,
discrimination claims general liability.

4) Customers, products and business practices: This includes fiduciary

braches, misuse of confidential customer information, frauds in
proprietary trading account of enterprise, money laundering and sale of
unauthorized and banned products.

5) Damage to physical assets: This includes terrorism, vandalism, natural

calamities like earthquake, fires and floods.

6) Business disruption and system failures: This includes computer

hardware and software failures, telecommunication problems and utility
outages.

7) Execution, delivery and process management: This includes data entry

errors, collateral management failure, incomplete and faulty legal
documents, unauthorized access given to customer accounts and vendor
dispute etc.

395
Emerging Issues in 15.4.4 Types of Non-Financial Risk
Financial Services
1) Compliance Risk - This risk arises due to non compliance or violations
of various provisions of applicable laws and regulator’s
guidelines/directives by business enterprises. This results in heavy
monetary penalty and restrictions on business activities and operations of
enterprises. This affects reputation of such commercial enterprises in the
domestic and international markets which affects their future business. In
the past RBI has penalized many banks and non banking finance
companies for non compliance of legal provisions of certain acts and its
guidelines. Similarly capital market regulator SEBI has penalized many
capital market intermediaries that includes mutual funds, merchant
bankers, rating agencies and stock brokers etc, for non-compliance of
provisions of various laws and its guidelines and regulations.

2) Reputation Risk - This risk arises from the negative public opinion or
perception. Such risk may occur in case lending institution fails to
manage financial risks and non-financial risk such as compliance risk.
The RBI in its Master Circular dated July 1, 2015 has defined the
Reputation Risk as the risk arising from negative perception on the part of
customers, counterparties, shareholders, investors, debt holders, market
analysts, other relevant parties or regulators that can adversely affect a
lending institution’s ability to maintain existing or establish new business
relationships and continued access to sources of funding (e.g. through
inter-bank or securitization markets. Reputational risk is multi-
dimensional and reflects the perception of other market participants. If
reputation risk is not properly managed it will have following effects:

• Negative impact on brand value

• Continuous fall in the share value.
• It will ruin strategic business relationship.
• Regulatory relationship will come under stress and this may lead to
stringent regulatory norms.
• It will not be able to attract qualified and experienced people from
the market for recruitment.
• In order to ensure proper management of reputation risk, the
following points may be considered.
• A compressive risk management policy can be put in place and
effectively implemented.
• Effective working of Board of Directors and Its resolutions/
decisions are implemented immediately without any further delay.
• Image building exercise is carried out through effective
communication and advertisement.
• Best corporate governance practices and corporate values are
followed .
396
 • Continuous interaction and feedback from the various stakeholders Managing Risk in
Financial Services
and their interest is protected.
• Strong internal controls and checks and compliance culture within
the organization.

3) Disaster Risk - This risk relates to the natural calamities like floods, fire.
earthquake, and man made calamities like destruction of business premise
or ATM centers on account of riots. Such risk can be hedged by taking
suitable insurance policy from non life insurance companies. In case if
there is loss from such risk then the same will be recovered from
insurance policy.

4) Industry risk - Industry Risk' refers to the external factors that can
impact both positively and negatively a particular industry segment,
which can in turn affect financial performance of companies belonging to
the sector. For example, Government’s policy on housing sector
including stamp duty charges on registration of housing property and
changes in banks policy on housing finance including interest rate will
have impact on performance of housing finance companies.

15.5 FINANCIAL SERVICES BUSINESS AND

RISK MANAGEMENT
15.5.1 Fund Based Financial Services Business
In India, banks, financial institutions and non-bank finance companies
(NBFCs) offer various fund based financial services in the form of loans and
lease finance to their customers. Along with this, these organizations have
other fund based business in the form investment in financial assets. Few of
these services are as follows:

1) Short Term Loans like Overdraft, Cash Credit, Finance against

receivables and stock, bill discounting etc
2) Term loan and Infrastructure Loans
3) Housing loans, Loans against property, gold, and shares
4) Vehicle loans, Consumer loans, Personal Loans, Agriculture Loans
5) Lease and Hire Purchase Finance
6) Investment and trading in Government Securities and corporate bonds
7) Investment and trading in shares of companies

15.5.2 Fee Based Financial Services

Such services are offered to the customers so as to earn other income (non-
interest income) like fees and commission, etc. As the funds are not required
in such services, it helps to increase off the balance sheet business. Thus, the
business of fee based financial services can be carried out without
requirement of capital and credit risk exposure (except in few cases). 397
Emerging Issues in Sources of Non-Interest Income
Financial Services
The sources of non-interest income can be identified under the following four
categories.

I. Execution / processing fees (Traditional Services)

a) Electronic funds transfer

b) Letter of Credit (collection) fees
c) Guarantee fees
d) Credit cards fees
e) Loan syndication fees

Lending institutions have not succeeded to generate reasonable fee and

commission income from traditional services. In fact, the customers expect
services like credit card freely or at reduced cost. In view of this,
organizations can not charge fee beyond a certain limit and hence are not in a
position to increase more income from such services. They focus on
following financial services.

II. Agency Commission

a) Acting as an agent for collection of accounts receivables of the

borrowers

b) Acting as an agent for providing forfaiting facilities

c) Acting as an agent for retailing of government securities, mutual

funds schemes and insurance products

III. Capital Market Services

a) Merchant banking activities (acting as a lead manager to a public

issue).
b) Underwriting support to the public issue.
c) Portfolio management (investment advisory) services to the investors

IV. Corporate Advisory Services

a) Designing suitable capital structure and advising on appropriate

financial plan.
b) Merger, acquisition and demerger.
c) Raising of funds by corporate from the money market, domestic and
international capital market.
d) Structuring of asset securitization deal.
e) Other corporate advisory services.

The above list of sources is by no means complete but it is indicative of the

categorization of fee based financial services. Most of commercial banks and
398
capital market intermediaries have been offering the above mentioned fee Managing Risk in
Financial Services
based financial services to their clients. For example, banks offer most of the
services mentioned above as a part of universal banking business. Capital
market intermediaries such as independent merchant bankers undertake the
merchant banking and underwriting business and also offer corporate
advisory services.

15.6 RISK MANAGEMENT IN FINANCIAL

SERVICES
The Finance Company which offers fund based financial services is exposed
to the financial risk that includes market risk comprising of liquidity risk and
interest rate risk, credit risk and operational risk. In case of fee based
financial services business, operational and settlement risks are relevant.

15.6.1 Management of Liquidity risk

The financial service companies are required to manage liquidity risk as
many of their liabilities are payable on demand or at very short notice.
Further, they must visualize and evaluate liquidity needs (based on certain
assumptions) under different business scenarios. Irrespective of size of a
finance company, adequate liquidity is essential to meet commitments when
due and to undertake new transactions when desirable. Considering the
importance of managing liquidity risk, each organization is required to have a
comprehensive policy in this regard which must cover, inter alia, objectives
of liquidity management, framework for assessing and managing liquidity,
funding strategies and internal norms including delegation of authority etc,.
As mentioned earlier, an organization is required to measure and manage its
own-liquidity position on continuous basis. One approach in this regard is to
use stock approach viz. measuring liquidity position at any point of time by
using certain relevant accounting ratios. Few of these ratios are given below
for illustrative purpose.
1. Short Term Assets to Short Term liabilities (having maturities up to one
year).
2. Loans to total assets.
3. Credit Deposit Ratio
4. Borrowing Funds to Total funds.
5. Liquidity Coverage Ratio (LCR)
The stock approach does not reveal a true liquidity position of the bank or
finance company therefore, use of ratios does not seem to be appropriate
approach to manage liquidity risk on continuous basis. Instead of stock
approach, cash flow approach is used effectively to measure and manage
liquidity position. The use of this approach involves the process of
preparation of maturity profile statement under different scenarios, and
calculation of cumulative surplus or deficit of funds under select maturity
buckets. 399
Emerging Issues in Maturity Profile Statement
Financial Services
Maturity profile statement is prepared with a view to compare future cash
inflows to its future cash outflows and to find out cash flow mismatches over
a series of specified time periods or buckets. Though mismatch is considered
as an inherent feature of financial service business, steps have to be taken to
avoid mismatch otherwise it will expose the organization to the liquidity
risk. The Reserve Bank of India (RBI) through its Circular on Guidelines on
Liquidity Risk Management Framework for NBFCs has mandated
following time buckets for measuring future cash flows and mismatches.

i) 1 day to 7 days
ii) 8 days to 14 days
iii) 15 days to 30/31 days (one month)
iv) Over one month and up to 2 months
v) Over two months and up to 3 months
vi) Over 3 months and up to 6 months
vii) Over 6 months and up to 1 year
viii) Over 1 year and up to 3 years
ix) Over 3 years and up to 5 years
x) Over 5 years

In preparing maturity profile statement, it is necessary to allocate or place

future cash inflows and outflows under each time period or bucket. Cash
inflows are comprised of maturing assets, proceeds from sale of non-
maturing assets and established line of credit and tapping of funds through
creation of liability. Similarly, cash outflows comprise of maturing of
liabilities on due dates, purchase or creation of assets and contingent
liabilities. Once projected cash flows are identified and allocated under each
bucket then find out excess or deficit of funds and thus cash flow mismatches
under each time bucket. Further, one has to take a combined view about the
liquidity position by calculating the cumulative excess (surplus) or shortage
(deficit) of funds under select time buckets. Mismatch between cash inflows
and cash outflows is nothing but liquidity gap which is worked out under
each time bucket and also cumulative liquidity gap at the end of each time
bucket. Once a liquidity gap is worked out, then decide about whether it is a
positive or negative gap. A positive liquidity gap will arise if residual
maturities of assets are in excess of residual maturities of liabilities. On the
other hand, a negative liquidity gap will arise if residual maturities of
liabilities are in excess of residual maturities of assets. While the mismatches
up to one year would be relevant since these provide early warning signals of
impending liquidity problems, the main focus shall be on the short-term
mismatches, viz., 1-30/31 days and that too on negative gaps. The net
cumulative negative mismatches in the Statement of Structural Liquidity in
the maturity buckets 1-7 days, 8-14 days, and 15-30 days shall not exceed
400
10%, 10% and 20% of the cumulative cash outflows in the respective time Managing Risk in
Financial Services
buckets. NBFCs, however, are expected to monitor their cumulative
mismatches (running total) across all other time buckets up to 1 year by
establishing internal prudential limits with the approval of the Board. NBFCs
shall also adopt the above cumulative mismatch limits for their structural
liquidity statement for consolidated operations.

While estimating future cash inflows and outflows under different time
buckets, the NBFC is required to have its judgment based on rational
assumptions with regard to assets, liabilities and off-balance sheet's items.
Assumptions with regard to future behaviour of assets, liabilities and off
balance sheet items will have to be based on (i) historical patterns of deposits
and loan behaviour (including customer by customer assessment for its larger
accounts) and (ii) statistical analysis taking into account seasonal factors,
interest rate sensitivities and other macro economic factors etc.

While identifying the cash flows associated with the assets, the NBFC is
required to look into the following aspects.

a) How much amount of maturing assets will be rolled over or renewed.

b) To what extent there will be an increase in the loans as well as in

investments and fixed assets.

c) How much amount of assets can be treated as a part of liquid and near
liquid assets and other assets based on their potential marketability.

Similarly, in order to evaluate the cash flows arising from a bank's liabilities,
the following aspects may be examined.

How much amount of time deposits and other liability will be rolled over.

What will be the normal growth in new deposit accounts.

How much of funds can be tapped from other banks or market to overcome
adverse liquidity position.

A NBFC must look into cash flows from its off balance sheet transactions
and examine its impact on its short term as well as long term liquidity
position.

A simple illustration of maturity profile statement and liquidity gap is given

in Table 15.1

401
Emerging Issues in Table 15.1: Statement showing Maturity Profile of Assets & Liabilities
Financial Services
and Liquidity Gap of ABC Leasing & Hire Purchase Finance Company

(Rs. in Crore)

Maturity Maturing Maturing Liquidity Cumulative

buckets Assets (Cash Liabilities Gap Liquidity
Inflows) (Cash Gap
Outflows)

1 to 7 days 100 200 (100) (100)

8 to 14 days 150 200 (50) (150)

15 days & up 200 250 (50) (200)

to 30 days

Over 1 100 100 (0) (200)

month & up
to 3 months

Over 3 200 150 50 (150)

months & up
to 6 months

Over 6 150 50 100 (50)

months &
up to 1 year

Over 1 year 100 50 50 0

The cumulative gap will always be zero at the end of last bucket because
assets are equal to liabilities including equity.

Looking at Table 15.1 it is observed that under first bucket there is negative
gap of Rs 100 crore which is 50 per cent of cash outflow. If prescribed
negative limit for first bucket is 10 percent, then actual limit is higher by 40
percent. Therefore, actual limit needs to be brought within prescribed limit
i.e. 10 percent as fixed by the Board. For this any one of the following
strategies may be adopted based on internal policy and market conditions to
manage liquidity gaps.

i) Assets Restructuring Strategy

Under assets restructuring strategy long term liquid assets like marketable
securities may be sold and cash is invested in short term assets. This strategy
helps to restructure assets based on prevailing market conditions.

402
ii) Liabilities Restructuring Strategy Managing Risk in
Financial Services
Under liabilities restructuring strategy long term deposits say for 1 year or 2
years are accepted at a higher interest rate and funds are used to repay the
Liabilities of depositors and other creditors. Other option is to renew or
rollover existing short-term liabilities which are to be repaid at higher interest
rates. This strategy will help to focus on liabilities mix for liquidity purpose.

iii) Growth strategy

Under growth strategy long term deposits are accepted at higher interest rates
and such deposits are invested in short term assets. This strategy helps to
increase size of the balance sheet of a Non-Banking Finance Company

iv) Shrinkage Strategy

Under this strategy long term liquid assets like marketable securities are sold
and payment is made to the liability holders. This strategy brings down the
size of balance sheet.

Irrespective of use of any of the strategy as mentioned above, final outcome

will be fall in the Net Interest Income (NII) of a NBFC. Therefore, while
managing liquidity one has to pay the price which is nothing but fall in net
interest income or margin.

It is common practice to estimate liquidity gap by preparing maturity profile

statement under normal business conditions or going concern scenarios,
which provides a benchmark for managing its day to day funds including
deposits, other liabilities, and assets. Such an approach will facilitate to
manage its net funding requirements without any difficulties or constraints.
Similar to that of normal business conditions, a maturity profile statement
may be prepared under organization’s specific problems such as inability of
to roll-over its deposits or withdrawal of deposits before maturity as well as
under general crisis conditions such as it may not be able to raise funds from
disposal of near-liquid assets such as marketable securities etc. Such
statements will help for assessing its liquidity position under adverse
conditions and to take precautionary measures accordingly.

Strategies for Effective Liquidity Management

Therefore, in order to ensure continuous growth in their business, NBFCs

have to design and implement suitable strategies for managing liquidity risk
and thus ensuring effective liquidity management. A few of these strategies
are given below for illustration.

As stated earlier, each NBFC has to formulate a suitable but specific liquidity
policy which should specify, inter alia, liquidity reporting system and
division of responsibility etc. In most of the organizations asset-liability
management committee (ALCO) has been assigned the task of managing risk
along with interest-rate risk. Therefore, ALCO committee has to take
responsibility in managing liquidity position on continuous basis. The 403
Emerging Issues in committee will have to be provided required information in time for quick
Financial Services
decision. The committee must take periodical review of reports on liquidity
position. Such reviews must lead to re-examine and redefine organization’s
liquidity policy and practices in the context of developments in the markets
and thus changes in the business.

Based on the past information and data, ALCO or liquidity management

committee must bring desired changes in the composition of assets and
liabilities.

The NBFC must look into its profile of customers. It must maintain
continuous customer relationship with large borrowers, depositors and other
liability holders etc. Continuous relationship with large lenders and other
liability holders will help the organization to secure required funds during
liquidity crisis.

Repo instrument can be used for liquidity purpose. NBFC can borrow from
market repo or from tri party repo market. It can securitize lease and hire
purchase portfolio, infrastructure loans and housing loans for improving
liquidity position. The NBFC should prepare contingency funding plan
including arrangement for line of credit from banks and financial institutions.

15.6.2 Managing Interest Rate Risk

Use of Simple Gap Analysis for Managing Gap Risk (Repricing Risk)

This is the most commonly used technique for managing gap risk. Under this
technique interest rate sensitive assets and liabilities are worked out and a gap
between them is measured. The interest rate sensitive assets and liabilities
are those on which interest rates are repriced contractually during the interval
with reference to changes in the reference rate such as RBI’s repo rate, call
money rate, etc. The gap is the difference between Rate Sensitive Assets
(RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. NBFC will
experience a positive gap if it has RSAs are more than RSLs. As against this
it will experience a negative if it has RSL more than RSAs. In a situation
where interest rates are rising or likely to rise, the positive gap is always
beneficial for financial service enterprises. Therefore, under these
circumstances NBFC should try for more rate sensitive assets and fixed
interest liabilities. As against this, in an environment wherein interest rates
are falling or likely to fall, NBFC should try for a negative gap.

TABLE 15.2: Impact of changes in Interest Rates on NII

Change in Change in Net Interest Income

Type of a Gap
Interest Rate (NII)

1. Positive Gap
Increase NII increases
(RSA>RSL)

2. Positive Gap Decrease NII decreases

404
(RSA>RSL) Managing Risk in
Financial Services

3. Negative Gap
Increase NII decreases
(RSL>RSA)

4. Negative Gap
Decrease NII increases
(RSL>RSA)

In case of a NBFC the RBI has recommended that gaps based on interest rate
sensitivity of assets and liabilities, may be put into the following time
buckets: (i) 1-7 days, (ii) 8 -14 days,(iii) 15-30/31 days,(iv) Over 1 months
and up to 2 months, (v) Over 2 months and up to 3 months (vi) Over 3
months to 6 months (vii) Over 6 months to 1 year (viii) Over 1 year to 3
years (ix) Over 3 years to 5 years (x) Over 5 years and (xi) non-sensitive.

The size of the gap in a given time bucket must be analyzed to study the
interest rate exposure and a possible impact on Net Interest Income. Each
NBFC has to set prudential limits on each bucket wise gaps with the approval
of the Board/Asset-Liability Committee (ALCO).

Example 1- Application of Simple Gap Analysis

Balance Sheet of Indian Growth Finance Ltd. as on March 31, 2022 is as

under

(Amount in Rs. crore)

Liabilities Amount Assets Amount

Paid up capital 250 Cash on hand 50

Reserves 1750 Balances in current account 100
with other banks
Deposits

2 years fixed rate deposits 10000

@ 7%
Floating rate deposits @ 8000 Money invested in market 650
6% (to be reset after repo segment @ 5.50 %
every quarter) for 3 months

Borrowing from the 2000 Investment portfolio 6000

market @ 6.50% to be rate sensitive securities
Renewed after 3 months interest rate @ 6.50%

Non rate sensitive 4000

securities interest rate @
7.50%
Advances

405
Emerging Issues in Floating rate (to be reset 3750
Financial Services
after each quarter) @ 8.5%

Fixed rate loan @ 9% 6600

Fixed assets 850

Total 22,000 Total 22,000

Find out:

1) Net interest income (NII) for a quarter ending on March 31, 2022 based
on the above balance sheet figures.

2) Assuming that interest rate is likely to increase by 100 basis point, work
out its impact on net interest income (NII)

3) Assuming that interest rate is declined by 50 basis point, work out its
impact on net interest income (NII)

Suggest: strategies to be pursued so as to manage NII.

Solution

Total of Rate Sensitive Assets Total of Rate Sensitive Liabilities

(Rs in Crore) (Rs in Crore)
Money invested in 650 Floating Rate 8000
Market Repo Deposits
Borrowings 2000
Investment Portfolio 6000
(Rate Sensitive)
Floating Rate Loan 3750
(RSA) 10350 (RSL) 10000

Positive Gao = Rate Sensitive Assets > Rate sensitive Liabilities

= Rs.10,350 crore – Rs. 10,000 crore = Rs. 350 crore.

Interest Cost on Deposits & Interest Income on Earning Assets Borrowi

Floating Rate Deposits

6 3
8000 120.00
100 12
Fixed Rate Deposits Money invested in = 8.9375
Market Repo

406
 7 3 5.50 3 Managing Risk in
10000 175.00 650 Financial Services
100 12 100 12

Borrowings Investment = 97.500

6.50 3 6.5 3
2000 32.50 6000
100 12 100 12

 7.5 3 
 4000 × × 
 100 12 
= 75.000 Advances
 8.5 3 
 3750 × × 
 100 12 
 9 3
 6600 × × 
= 79.687  100 12 

= 48.50
------------ -------------
327.50 409.6185
------------ -------------

1)
Interest Income = 409.6185 Crore
Interest Expense = 327.5000 Crore
--------------
Net Interest Income = 82.1185 Crore
(NII) for the quarter -------------
Ending on March22

2) Change in NII = Gap x ∆ r

Rise in interest rates by 100 BP
= Rs.350 crore × 1 %
= Rs.3.50 crore
Existing NII for the quarter = 82.1185 crore
Expected Rise in NII = 0.875 (3.50 crore x 1/4)
-----------
Expected NIM for the = Rs 82.9935
Next quarter

3)
Change in NII = Gap × ∆ r
= Rs. 350 crore × – 0.50 %
= --- Rs. 1.75 crore
1
Change in NII for the Quarter = ----- 1.75 crore × = – 0.4375
4
Existing NII = Rs 82.1185 crore
Expected Fall in NII = Less Rs 0.4375 crore
In a quarter ----------------------
Expected NII for the Rs 81.681 Crore
next quarter ------------------------
407
Emerging Issues in Strategies to be pursued so as to arrest fall in NII
Financial Services
i) New assets as well as renewal of existing assets should be at fixed rates.
If the assets are to be created at floating rate, then the repricing period
must be of longer tenor.

ii) New Deposits as well as renewal of existing deposits should be at floating

rates. If this is not possible, then such deposits should be accepted at
fixed rates for a short period.

Example No 2

AFC Housing Finance Corporation Ltd. has earning assets worth Rs 19,800
crore and a net interest margin (NIM) of 4 per cent. In a policy decision
made by the Management it has been decided that a 1.5 per cent
increase/decrease in the NIM can be the acceptable limit. It further forecasts
a 0.50 per cent increase in the interest rate. Kindly assess the target gap
which the corporation can maintain to remain within the acceptable limits of
the NIM.

Solution to Example No. 2

NII = Earning Assets × NIM
∆ NII = Earning Assets × NIM × ∆ c
∆ NII = Gap × ∆ r
Gap x ∆ r = Earning Assets × NIM × ∆ c

Therefore

Gap = Earning Assets × NIM × ∆ c

--------------------------------------
∆r
NIM = Net Interest Margin
∆c = Acceptable change in the NIM
∆r = Expected change in interest rates
Target Gap = ∆c × Earnings Assets × NIM
----------------------------------------
∆r

= 0.015 × 19800 × 0.04

------------------------- = Rs. 2376 crore
0.0050

Housing Finance Company can maintain a ± Rs. 2376 crore gap in order to
manage interest rate exposure for a 0.50 per cent increase in interest rate.

Since the forecast is an increase in interest rates, the Housing Finance

Company should attempt to maintain a positive Gap of Rs. 2376.00 crore.

Use of Duration and Modified Duration in Managing Interest Rate Risk

(i. e. Price Risk)

408
Duration concept is used for assessing and managing price risk in respect of Managing Risk in
Financial Services
various interest bearing assets and liabilities. The duration of a financial
asset like bond or loan is nothing but weighted average maturity of its cash
flow stream where the weights are proportional to the present value of cash
flows. The duration of a financial asset having well defined terms to maturity
can be calculated by using following formula.

(PVCF1 ) × 1 + (PVCF2 ) × 2 
 + .... + (PVCFn ) × n 
Duration =  
Vo or ∈ PVCFs

Where = PVCF is present value of future cash flows or receipts

= 1, 2,  n. at the end of the year
= ∈ PVCF = Total of present value of future cash flows.
(i.e. Vo = Current or exp ected price of a financial asset.)

A hypothetical illustration is given below to exhibit how a duration of a

financial asset like a bond can be worked out:

Duration Calculation

Example 3: Details of a bond are as under

Maturity 5 years
Coupon 10.00 %
YTM 12.00 %
Face value is Rs. 100.

Find out duration and modified duration.

Year Cash Flows PVF (Discount PVCFs PVCFs x W1

(1) (2) Rate) 12% (3) (4) (5 = 4 x 1)

1 10 0.893 8.93 8.93

2 10 0.797 7.97 15.94

3 10 0.712 7.12 21.36

4 10 0.636 6.36 25.44

5 10 0.567 5.67 28.35

100 0.567 56.70 283.50

Total 92.75 383.52

409
Emerging Issues in Duration =
Financial Services
PVCF1 1 PVCF2 2 PVCF3 3 PVCF4 4 PVCF5 5
PVCFs
383.52
4.14 years
92.57
Duration
Modified Duration =
1 YTM
4.14
= 3.97
1.12

If the bond having 5 years terms to maturity is held for 4 years and 14% of
remaining 1 year at 12% YTM, then this bond is considered to be immunized
from price risk as well as re investment risk. The concept of duration for a
single financial asset can be extended to all the interest bearing asset and
liabilities. Accordingly by using weighted average method, duration of assets
and duration of liabilities can be worked out. A higher duration of a financial
asset or group of assets indicates that such assets are more price sensitive and
therefore carries more price risk. The same can be considered in case of
interest bearing Liabilities. The difference between duration of assets (DA)
and duration of Liabilities (DL) is the bank’s net duration. Accordingly ratio
can be worked out as under :
Duration of Assets (DA)
Duration Ratio = ---------------------------------
Duration of Liabilities (DL)

If the net duration is positive (DA>DL) a decrease in interest rates will have a
positive impact on the market value of the equity of the organization. When
the duration gap is negative (DL>DA) the market value of equity of
organization increases when the interest rate increases. Thus the technique of
duration analyses the impact of changes in interest rates on net interest
income as well as market value of equity of a finance company.

Example No. 4 : Use of Duration in Asset Liability Management

Following is the information provided by Sterling Finance Ltd:

Market value of liabilities = Rs 18,000 crore

Market value of assets = Rs 20,000 crore

Duration of assets = 5 years

Duration of liabilities = 4 years

Interest rate = 10 per cent

Change in interest rates = +2 per cent

As a Financial Consultant, assess the change in the market value of the

finance company due to the interest rate fluctuation.
410
Solution Managing Risk in
Financial Services
Change in market value (M.V.) =
-D × (Change in Interest Rate) × Current market value of assets or liabilities
--------------------------------------------------------------------------------------------
(1 + YTM )

D = Duration of asset or liability

YTM = Yield to Maturity

Change in Market Value Original Market Value New Market Value
(Rs in crore) (Rs. In crore)
Assets = –5(0.02) × 20000 20000 18182
---------------------
(1 + 0.1)

Liabilities = –4(0.02) × 18000 18000 16691

---------------------
(1 + 0.1)
---------------------------------------------------
Market value of Equity 2000 1491
---------------------------------------------------
Impact

i) The fall in the value of assets (9%) is greater than the fall in the value of
liabilities (7%)

ii) There has been a decline in the equity value of a firm

iii) The capital ratio which is ratio of the surplus to total assets declined from
10% to 8.2%. This implies that there is a fall in the returns on total
assets

15.6.3 Management of Credit Risk

Credit risk is a major risk in fund based financial service business. Each
Finance Company has to prepare a comprehensive policy document on credit
risk management in line with the RBI’s guidelines on credit risk management
and constitute credit risk management committee (CRMC). This policy
document inter alia should cover sources of credit risk, its quantification, risk
grading, risk mitigation techniques and reporting, documentation, Legal
aspect and management of non-performing assets.

Credit risk needs to be managed at transactional level as well as portfolio

level. In order to ensure better credit risk management following points may
be considered.

a) Fund and non fund based maximum limit can be fixed for a single
borrower and group of companies.

b) Credit exposure maximum limit may be fixed for various sectors such as
cement, power, automobile, housing and road etc,.

411
Emerging Issues in c) Credit portfolio can be diversified by making funds available under
Financial Services
different financial products to various customers that include retail, small
and medium size enterprises and large companies in different regions.

d) Credit rating of the borrower is the main technique in quantifying credit

risk. In high value loan transactions say Rs 1 crore and above the lender
have to use credit rating given by external rating agency in credit
appraisal. Besides this, internal credit rating based on internal rating
model also can be used in such credit appraisal. In small ticket loan
transactions say less than Rs 1 crore, internal credit rating can be used in
credit appraisal. Further credit rating can be used in pricing of loans, lease
fiancé and hire purchase finance etc.

e) Credit appraisal and monitoring process is standardized and documented.

The same process is followed by officers who are involved in credit
appraisal of loan, lease finance and hire purchase finance applications and
monitoring of the same accounts. The objective is to ensure that existing
funds based facilities have remained as standard fund based assets all the
time.

f) Operating staffs who are involved in various stages of credit management

that includes appraisal, sanction, disbursement, review/renewal, and post
sanction follow-up must remain alert and take proactive steps to avoid
excessive credit risk and business losses.

g) Leasing company can collect lease rentals in advance for six months to
one year period or security deposit of 15% to 20% of cost of funds (which
may or may not carry interest) to take care of credit risk in lease
transactions.

h) Hire purchase finance company may propose borrower/intending buyer to

pay 25% to 30% of cost of asset as cash down payment to the seller of the
goods and may like to take credit exposure to the extent of 70% cost of
assets on the borrower through hire purchase arrangement. This will help
hire purchase finance company to reduce credit exposure on the counter
party.

15.6.4 Management of Operational Risk

Now a days operational risk has become important risk in all types of
financial services irrespective of funds based or fee based financial service
business. Operational risk is pervasive, complex and dynamic in its nature.
Operational risk relates to internal and external frauds, system failure, cyber
crimes, and faulty business documents etc,. NBFC is expected to have Board
approved comprehensive policy on operational risk management. Such a
policy should inter alia cover sources or types of operational risk, proper
reporting system, criteria for reporting transactions involving frauds and
financial losses, monitoring such transactions and losses, feedback from
operating staff and customers, compliance with reporting losses from
412
operational risk to the regulator, etc. Corporate office and its branches are Managing Risk in
Financial Services
involved in business processes and transactions. Therefore an effective
management information system is needed for collection and analysis of data
relating to losses from operational risk.

A proper monitoring mechanism is vital for effective management of

operational risk. Regular monitoring of events or transactions leading to
operational losses helps the organization to detect and correct deficiencies in
the policy, processes and procedures relating to operational risk management.
Early detection of deficiencies in the business and transactions processes will
reduce the potential frequency and/or severity of loss events. In addition to
this, financial service company should identify relevant indicators that
provide early warning which may lead to losses from operational risk in
future. Such indicators should be forward looking and should reflect potential
sources of operational risk. Threshold limits may be fixed for different
indicators for reporting loss events and quantum of loss. For example internal
fraud with a small value of Rs 500 may be reported to the head of branch or
controlling office for action. As against this if internal fraud has taken place
involving huge amount running into millions of rupees then such event needs
to be reported to top executives and to the Board of organization for
information and necessary action. Management information system (MIS) for
operational risk should be transparent and objective oriented which will help
the organization to act upon reported fraud events immediately and take
proactive steps so that such frauds will not repeat again.

15.7 LEGAL PROVISIONS ON RISK

MANAGEMENT
The certain provisions of the Companies Act, 2013 and SEBI’s Listing
Obligations and Disclosure Regulations (LODR) 2015, on risk management
are applicable in case of banks, financial institutions, NBFCs and capital
market intermediaries which are registered under the said act and listed on
the recognized stock exchange.

The section 134(3) (n) of the Companies Act 2013 provides that a statement
indicating development and implementation of a risk management policy for
the company including identification therein of elements of risk if any, which
in the opinion of the Board may threaten the existence of the company must
be included in the Board of Director’s report to be attached in the financial
statement of the company.

The regulation 21 of SEBI (LODR) Regulations 2015, requires that every

listed company should have a Risk Management Committee. This regulation
also provides that company shall lay down procedures to inform Board
members about the risk assessment and minimization procedures. The Board
shall be responsible for framing, implementing and monitoring the risk
management plan for the company.

413
Emerging Issues in
Financial Services
15.8 ROLE OF REGULATOR AND BOARD OF
DIRECTORS IN RISK MANAGEMENT
15.8.1 Role of Regulator
The Reserve Bank of India (RBI) has issued detailed guidelines on risk
management through master circulars/directives for NBFCs, Financial
Institutions and banks which are part of financial services industry.

Non-deposit taking NBFCs with asset size of Rs.1 billion and above,
systematically important Core Investment Companies and all deposit taking
NBFCs (except Type 1 NBFC-ND4, Non-Operating Financial Holding
Company and Standalone Primary Dealer) shall adhere to the RBI’s
guidelines on Liquidity Risk Management Framework. The guidelines deal
with following aspects of Liquidity Risk Management framework.

A. Liquidity Risk Management Policy, Strategies and Practices

B. Management Information System (MIS)
C. Internal Controls
D. Maturity profiling
E. Liquidity Risk Measurement – Stock Approach
F. Currency Risk
G. Managing Interest Rate Risk
H. Liquidity Risk Monitoring Tools

Each NBFC has to appoint Chief Risk Officer (CRO) who shall be involved
in the process of identification, measurement and mitigation of liquidity risks.
Each NBFC has to constitute Risk Management Committee (RMC), Asset
Liability Management Committee (ALCO) and ALCO support group to
ensure that market risk including liquidity risk is being managed as per the
RBI guidelines and its own policy on risk management.

As per the existing guidelines NBFCs with deposits, strategic important

NBFCs and housing finance companies are required to maintain minimum
capital risk asset ratio (CRAR) of 15 per cent of risk weighted assets based
on credit risk exposure. The RBI has issued revised scale based regulatory
framework on October 22, 2021. This will be effective from October 1, 2022.
As per these guidelines, NBFCs are classified into four categories – base,
middle, upper and top layers based on their size, activity, and perceived
riskiness. NBFCs have to carry out rigorous internal assessments to ensure
that capital provisions are commensurate with the risks in their business. This
internal assessment shall be on similar lines as ICAAP prescribed for
commercial banks. NBFCs are required to make a realistic assessment of
credit risk, market risk, operational risk and all other residual risks as per
methodology to be determined internally. The methodology for internal
assessment of capital shall be proportionate to the scale and complexity of
414
operations as per their Board approved policy. The objective of this is to Managing Risk in
Financial Services
ensure availability of adequate capital to support all risks in business as also
to encourage NBFCs to develop and use better internal risk management
techniques for monitoring and managing their risks. As per the revised
guidelines, in order to enhance the quality of regulatory capital, NBFC-Upper
Level shall maintain Common Equity Tier 1 capital of at least 9 per cent of
Risk Weighted Assets. Tier I capital includes paid up capital, reserves and
surplus, securities premium capital reserves and revaluation reserves.

The RBI has issued very comprehensive guidelines on risk management for
banks that includes guidelines on Credit Risk Management, Asset Liability
Management covering market risk, Operational Risk Management, Foreign
Exchange Risk Management and Country Risk Management. Based on these
guidelines banks are required to prepare policy documents on various
financial risks and ensure that appropriate system is put in place to manage
such risks. Each bank is required to appoint Chief Risk Officer(CRO) who
shall be in charge of risk management department Such department is
comprised of three groups namely credit risk group, market risk group and
operational risk group. In order to make banks financially strong and viable
and adequate liquidity with them The RBI, in line with Basel III Accord, has
introduced new norms on Capital Risk Asset Ratio (CRAR) and Liquidity
Ratios. Both these norms, which are part of Pillar I under Basel Accord III,
are discussed below:

i) Capital risk asset ratio: Minimum capital risk asset ratio 9% plus capital
conservation buffer (equity capital) 2.5% is prescribed. This makes a
combined capital risk asset ratio of 11.5%. This prudential norm will
help the banks to absorb unexpected losses from credit risk, market risk
and operational risk.

ii) Liquidity Coverage Ratio (LCR ): This ratio is introduced with a view to
ensure that a bank has an adequate stock of unencumbered high quality
liquid assets that consist of cash and near cash assets to meet its liquidity
needs in the next 30 calendar days. This will help a bank to survive until
30th day of the stress liquidity scenario.

iii) Net Stable Funding Ratio (NSFR): This ratio is introduced with a view to
ensure long term assets are funded from stable liabilities. It will help the
banks to avoid mismatch between assets and liabilities.

The RBI has also issued guidelines on risk management for All India
Financial Institutions. The RBI has issued guidelines on Basel III, credit risk,
market risk and asset liability management for All India Financial
Institutions. Such institutions are required to maintain capital risk asset ratio
(CRAR) of 11.5 per cent of risk weighted assets. This includes minimum
capital risk asset ratio of 9 per cent plus capital conservation buffer (CCB) of
2.5 per cent of risk weighted assets.

415
Emerging Issues in 15.8.2 Role of Board of Directors
Financial Services
The Board of Directors has to play a significant role in the risk management
of the organization. The board has to constitute Risk Management Committee
(RMC) at the Board level. The Board has to approve a comprehensive policy
on Risk Management. The Board has to identify the extent and type of risks it
faces and do planning to manage and mitigate the same for uninterrupted
growth in business and profitability for the benefit of all the stakeholders.
Further the Board has to define risk philosophy and the extent to which it is
willing to accept expected and unexpected business losses from taking of
risks by the organization. Along with approving limits for various risks for
the organization, the Board has to lay down effective risk strategies and
ensure that this is made an integral part of business policies and operations.
The Board members must get actively involved in risk management and have
a proper understanding of the key risks faced by the organization. The Board
should carry out a review of risk management system at least once in a year.
As part of the annual review the Board should review risk policies and
procedures and assess risks on an ongoing basis. The annual review of risk
management should include analysis of past data covering expected and
unexpected losses from different risks and lessons to be learnt from mistakes.

15.9 SUMMARY
Risk is inherent in the financial services business. On account of deregulation
of various markets, growing competition in local and global markets, increase
in the size of business and extensive use of information technology in
business etc., proper risk management is essential for survival of financial
services organizations in the economy. Risk management is a structured
approach to manage uncertainty regarding business operations so as to
minimize losses, through a sequence of logical steps that includes
identification of a risk, risk assessment, monitoring and strategies to manage
it, and mitigation of risk using various techniques. The various risks can be
minimized but it cannot be eliminated altogether. The combined risks can be
analyzed under systematic risk v/s unsystematic risk. The systematic risk is
common to all the lending and other financial service enterprises. Hence such
risk stands at macro level and difficult to control the same. Unsystematic is
unique to the specific enterprise and hence studied at micro level. Such risk
can be controlled with the help of risk mitigation techniques. The total risks
can broadly be classified into financial risks v/s non financial risk. Financial
risks include liquidity risk, interest rate risk, operational risk and credit risk.
Such risks have immediate adverse impact on profitability and financial
position of business. Non financial risks include compliance risk, reputation
risk and disaster risk etc,. Such risks do not have immediate impact on
profitability and financial position of business but its consequences are
serious and later on may have adverse financial impact. All the listed
financial service enterprises have to set up a risk management committee at

416
the Board level who shall be responsible for framing, implementing and Managing Risk in
Financial Services
monitoring the risk management plan for the company.

15.10 KEY WORDS

Risk: Risk is possibility of monetary losses from futuristic business.

Unsystematic Risk: Such risk is unique to a commercial enterprise and thus

can be predicted and controlled at micro or enterprise level. Example of such
risk is credit risk.

Systematic Risk: Such risk is common to all commercial enterprises that

operate under the same market environment. Hence it is analyzed at macro
level. Example of such risk is interest rate risk

Financial Risk: This risk has direct impact on profitability and financial
position of business enterprise. Examples of such risks are credit risk, interest
rate risk, liquidity risk and operational risk etc.

Non-Financial Risk: Such types of risk do not have immediate impact on

profitability and financial position of commercial enterprise. Examples of
such risks are compliance risk, reputation risk, regulatory risk and disaster
risk etc.

Liquidity Risk: This is the risk of having inadequate or no liquidity (cash) at

all. Thus liquidity risk is the inability of a lending institution’s to meet such
obligations as they become due, without adversely affecting the
organization’s financial condition.

Interest Rate Risk: This risk refers to the effect of changes in interest rates
on Net Interest Income (NII) and Net Interest Margin (NIM) of a lending
institution. It also affects values of interest bearing assets and interest bearing
liabilities which results into change in the value of equity of the lending
institution. Interest rate risk arises from interest rate volatility.

Credit Risk: It can be defined as potential losses associated with diminution

in the credit quality of borrowers or obligors.

Operational Risk: Operational risk is the risk of direct or indirect loss/losses

resulting from inadequate or failed internal processes in human actions,
systems, or due to external events.

15.11 SELF-ASSESSMENT QUESTIONS

1) What do you mean by risk management? Explain its relevance in
financial service company

2) Following is the information provided by Global Mahan Housing Finance

Ltd.

Market value of Liabilities = 2850 crore

417
Emerging Issues in Market value of assets = 3000 crore
Financial Services
Duration of Asset = 4 years
Duration of Liabilities = 5 years
Current interest Rate or Yield = 11%
Expected fall in interest rate = 100 BP (1%)

As a Financial Service Professional, assess the change in the market value of

the Housing Finance Company due to the changes in interest rates.

3) R P Finance Company has earning assets worth Rs.3500 crore and net
interest margin (NIM) of 3.5%. It has been decided that a 1.5 per cent
increase / decrease in NIM can be the acceptable limit. If further forecasts
a 50 BP decrease in the interest rate.

Assuming that you are in charge of Risk Management Department kindly

assess the target Gap which R P Finance Company can maintain to
remain within the acceptable limit of NIM.

4) Explain in brief the management of liquidity and interest rate risk

5) Distinguish between systematic risk and unsystematic risk
6) Write Short Note on
i) Compliance Risk
ii) Reputation Risk
7) Explain the process of risk management

15.12 FURTHER READINGS

1. The New Business of Banking, George M Bollenabacher, Bankers
Publishing Company, Chicago, Illionis, Latest Edition

2. John A Haslem, "Bank Funds Management", Text & Reading, Reston

Publishing, Latest Edition

3. RBI’s Guidelines on Risk Management System in Bank, NBFCs and

Financial Institutions

4. RBI’s Master Circular/ Directives on Asset-Liability Management

System in Banks,

5. Financial Institutions and NBFCs, Latest Master Circular

6. RBI’s Liquidity Risk Management Framework for Non-Banking

Financial Companies and

7. Core Investment Companies, November 4, 2019

8. RBI’s Circular on Basel III Framework on Liquidity Standards—

Liquidity Coverage
418
9. Ratio(LCR) , Liquidity Risk Monitoring Tools and LCR Disclosure Managing Risk in
Financial Services
Standards , June 9, 2014.

10. Latest Reports of select rating agencies such as CRISIL,ICRA and CARE
on Credit Risk

11. and Credit Risk Metrics

12. Wilson J S G, “Managing Bank Assets and Liabilities” , Euro money,

London, U.K. , Latest Edition

13. Sundaram Jankiraman, “Derivatives and Risk Management”, Pearson,

Chennai, Latest

14. Edition

419
Emerging Issues in
Financial Services UNIT 16 TECHNOLOGY AND FINANCIAL
SERVICES

Objectives
After going through this unit, you will be able to:
• Understand the evolution of technology and its application in financial
sector in India
• To get a detailed understanding of the technologies used in Banking
services like ATMs, Cards, Mobile Payments and Biometric Payments
• Understand the new age banking technologies and their applications in
financial services.

Structure
16.1 Introduction
16.2 Chronological progress of Technology in Banking
16.3 Technology and Payments Revolution
16.4 Payment Products
16.5 New Age Banking Technologies
16.6 Summary
16.7 Key Words
16.8 Self-Assessment Questions
16.9 Further Reading

16.1 INTRODUCTION
In the previous unit we have discussed the risks inherent in the financial
services business. The liberalization and globalization of the Indian economy
has thrown up new challenges to the financial sector in the form of
competition from new breed of private sector banks, foreign banks and other
non-banking financial institutions, apart from the growing expectation from
the customers and the government, and to achieve international standards.
The transformation from the traditional and computerized accounting to a
totally digital environment calls for mobilization of all available resources as
well as to equip the staff to manage affairs in the new environment. Some of
these technologies being used in the financial sector, especially the banking
sector are being discussed here.

420
16.2 CHRONOLOGICAL PROGRESS OF Technology and
Financial Services
TECHNOLOGY IN BANKING
Year Technology Purpose
1770 Cheques Cheques were introduced by the Bank of
Hindoostan, the first joint stock bank
1960 Credit Cards Diners Card was the first company to
introduce cards in India. In the 1960s, people
who lived or traveled to foreign countries
were the only ones who opted for the Diners
Card in India. The adoption towards credit
cards was so slow that it took 15 years to
reach 8,000 Diners Card registered users in
India.
1980 First Credit Card of The Central Bank of India launched the first
India bank credit card in 1980, which was followed
by Andhra Bank in the same year – supported
by Visa. Master Card was introduced to
Indian consumers by Vijaya Bank in 1988.
1987 First ATM in India The first ATM in India was set up in 1987 by
HSBC in Mumbai
1986 Magnetic Ink The rapid growth of cheque volumes in the
Character eighties made the task of manual sorting and
Recognition listing a very difficult task. Banks were unable
(MICR) based to cope with the huge volume of cheques
mechanized cheque which had to be physically handled prior to
processing their presentation in the clearing house.
technology The existing cheques had to be redesigned
incorporating a MICR code line which could
be read by document processing machines
called reader-sorters. The RBI introduced two
types of reader-sorters - the Medium Speed
Reader Sorters, capable of processing 300
instruments per minute for Inter-city
instruments and the High-Speed Reader Sorter
Systems (HSRS) with speeds of 2400
documents per minute, for the clearing of
local instruments
1991 BANKNET Commissioned in 1991, BANKNET is a
packet switched X.25 based network with
nodes at Mumbai, Delhi, Chennai and
Calcutta, and a switching centre at Nagpur
with a mesh topology.

421
Emerging Issues in It allowed for both intra and inter banks
Financial Services
communications
1991 SWIFT India was the 74th country to join the Society
for Worldwide Inter-bank Financial
Telecommunication (SWIFT) network on
December 2, 1991
SWIFT was created to help banks
communicate faster and more securely among
themselves in relation to the processing of
international payments
1997 SWADHAN ATM The Indian Banks' Association (IBA) created
SHARING the Swadhan Shared ATM network for Banks
NETWORK to share their ATM services.
Swadhan had connected 32 banks -- public
sector banks, private sector banks, foreign
banks and co-operative banks -- with more
than 1,000 ATMs (both online and offline). It
was started with the intention of reducing the
investment that is required to deploy ATMs in
different locations.
1999 INFINET Countrywide communication backbone for
Banks and Financial Institutions, INFINET
(Indian Financial Network) is the network
platform which caters mainly to inter-bank
applications like RTGS, Delivery Vs
Payment, Government Transactions,
Automatic Clearing House, etc.
2001 SFMS Structured Financial Messaging System
(SFMS). SFMS was launched on December
14, 2001, at IDRBT (Institute for
Development and Research in Banking
Technology). It is an Indian standard similar
to SWIFT (Society for World-wide Interbank
Financial Telecommunications) which is the
international messaging system used for
financial messaging globally.
2004 RTGS It is a secure Electronic Fund Transfer
System, providing real-time on-line settlement
for inter-bank transactions and customer-
based inter-bank transactions of any amount
across the country.
2004 NFS The National Financial Switch was launched
by the IDRBT on 27 August 2004, connecting
the ATMs of three banks, Corporation Bank,
Bank of Baroda and ICICI Bank
422
 The IDRBT then worked towards bringing all Technology and
Financial Services
major banks in India on board and by
December 2009, the network had grown to
connect 49,880 ATMs of 37 banks, thereby
emerging as the largest network of shared
ATMs in the country.
2005 NEFT NEFT enables bank customers in India to
transfer funds between any two NEFT-
enabled bank accounts on a one-to-one basis.
It is done via electronic messages.
2007 CTS Implementation of Cheque Truncation System
2007 RBI – Payment and The Act gave RBI powers to authorize a
Settlement Systems central umbrella entity, and NPCI was
Act conceptualized
2008 NECS National Electronic Clearing System is used
by institutions for making bulk payment of
amounts towards distribution of dividend,
interest, salary, pension, etc., or for bulk
collection of amounts towards telephone /
electricity / water dues, cess / tax collections,
loan instalment repayments, periodic
investments in mutual funds, etc.
2010 NPCI The National Payments Corporation of India
was set up as an umbrella entity to oversee
and create new products in the retail payments
space.
2010 NFS from IDRBT The shared ATM network service, NFS was
to NPCI transferred to NPCI
2010 IMPS Immediate Payment Service, one of the
world’s first instant and interoperable
payment systems
2011 CTS was CTS (Cheque Truncation System) was
transferred to NPCI transferred to NPCI to over see its operations
and expand the network
2012 NPCI launches NACH (National Automated Clearing House)
NACH was launched to replace the ECS system
2012 RuPay is launched RuPay was launched in March 2012 with a
domestic debit card product targeted at the
mass market.
2013 APBS, AePS The Aadhaar enabled payment services and
bridge services serve as a back bone to
biometric based payments
2014 *99# USSD (Unstructured Supplementary Service
423
Emerging Issues in Data) mode of payments were meant to cater
Financial Services
to the feature phone user for mobile based
instant payments
2016 UPI, BHIM, NETC Details in the following pages
2017 Aadhaar Pay, Details in the following pages
Bharat QR, BBPS
2018 UPI 2.0 Details in the following pages

16.3 TECHNOLOGY AND PAYMENTS

REVOLUTION
NPCI was set up under the Payment and Settlement Systems Act 2007 as a
‘not-for-profit’ organization conceived on the recommendation of the
Payment and Banking Systems Board set up by RBI in 2005
NPCI was incorporated in 2008 as a joint initiative of the Reserve Bank of
India (RBI) and the Indian Banks’ Association (IBA) with an ambitious
vision of becoming the “best payments network globally” and a mission to
touch “every Indian with one or other payment services”. The government
envisioned NPCI a robust ‘backbone’ to digitize the economy.
NCPI started off in 2008 by taking over the National Financial Switch (NFS)
from the Institute of Development and Research in Banking Technology
(IDRBT), and began formal operations in 2010. Since then, it has made rapid
progress as the pioneer of the fintech revolution in India over the last decade.
It came up with a range of services and products: IMPS, CTS, NACH, UPI,
RuPay, BHIM and AePS to name a few, all of which have helped the
financial sector to diversify their digital portfolios and also aid in the
financial inclusion goals of the country.
In just one decade, NPCI has grown 10 times—from handling 2 mn
transactions per day to 22 mn transactions per day — and is well on its way
to its target to process 100 mn transactions per day.

Technology for Transactions available for Banks – Target Segments

Sl. Business Business Channels NPCI Products

No Type
1 C2B Kirana Stores, Gas Stations, RuPay, BHIM, UPI, IMPS,
Mobile Recharge Outlets AEPS, BBPS, *99#
2 B2B Retailers to Suppliers, RuPay, BHIM, UPI, IMPS,
Distributors NACH, BBPS, *99#
3 P2P Person to Person Remittances BHIM, UPI, IMPS, AEPS, *99#
4 B2C Salary Payments NACH
5 P2G Tax, Public Transit, Utility RuPay, BHIM, UPI, IMPS,
payments BBPS, NETC, NACH, CTS,
*99#
6 G2P DBT, Wages, Social Security NACH, CTS
schemes

424
16.4 PAYMENT PRODUCTS Technology and
Financial Services

In this section we will take a closer look at the products of NPCI

16.4.1 National Financial Switch

National Financial Switch (NFS) is the largest network of shared automated
teller machines (ATMs) in India. It was designed, developed and deployed
with the aim of inter-connecting the ATMs in the country and facilitating
convenience banking.

Eligibility:
(a) Any scheduled banks with RTGS membership

(b) Any bank (without RTGS membership) but with round-the-clock core
banking solution capabilities, with/out ATMs, can also join the National
Financial Switch (NFS) through a Sponsor Bank.

Services on the NFS Network

• Cash withdrawal
• Balance Inquiry
• Mini Statement
• PIN change
• Card to Card Fund Transfer
• Cheque book request
• Statement request
• Mobile Banking registration
• Aadhaar Number seeding

Around January 2022, there were 1,203 members that includes 111 Direct,
1,045 Sub members, 43 RRBs and 4 WLAOs using NFS network connected
to more than 2.55 Lac ATM (including cash deposit machines/recyclers).

Activity 16.1
How is NFS technology useful?

…………………………………………………………………………………
…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………
…………………………………………………………………………………

…………………………………………………………………………………

425
Emerging Issues in
Financial Services

Figure 16.1: Transaction Flow of an ATM on the NFS Network

a. Card Holder of Bank B approaches the ATM of Bank A for Cash

withdrawal and inserts his card (1)
b. The transaction flows to Bank A (2) and the it is forwarded (3) to the
National Financial Switch
c. The NFS forwards the card transaction based on the card number to the
Bank B (4)
d. Bank B authorizes the transaction (5) and sends it to the CBS to check
balances and honor the payment (6)
e. The CBS sends positive response if the account has sufficient balance (7)
and the bank then sends the response back to the ATM to dispense cash
(8,9,10,11)

16.4.2 IMPS - Immediate Payment Service

IMPS (Immediate Payment Service) is an instant, 24×7, interbank, electronic
fund transfer service through mobile phones. IMPS facilitates use of mobile
instrument as a channel for accessing bank accounts – thereby, enabling
interbank fund transfers in a highly secured manner (with immediate
confirmation).

Eligibility:
(a) Any scheduled banks with RTGS membership

(b) Any bank (without RTGS membership) but with round-the-clock core
banking solution capabilities, with/out ATMs, can also join the National
Financial Switch (NFS) through a Sponsor Bank.

Services:
• IMPS Funds Transfer

• P2P: Using Mobile No. and MMID

• P2A: Using A/c No. and IFSC code

426 • P2U: Using Aadhaar No. of beneficiary

• IMPS Merchant Payments Technology and
Financial Services
• P2M (Send Payment): Using ‘push’ model

• P2M (Collect Request): Using ‘pull’ model

o Other Transactions Supported Balance Enquiry, Mini Statement,
Generate/Retrieve/Cancel MMID and Generate OTP.
As on April 2022, there were 647 Member Banks, which processed 471.62
million transactions worth Rs. 444,669.88 Cr.

Figure 16.2: Transaction Flow of IMPS

• Sender inputs receiver mobile number, MMID (Mobile Money

Identification Number), amount and sends the transaction to the sender
bank by authenticating through MPIN (Mobile banking Personal
Identification Number).
• Sender Bank does the MPIN validation, account verification and debits
the sender account and sends SMS to the sender
• Sender Bank then sends the transaction to the NPCI – NFS.
• Receiving Bank receives the transaction, identifies the account basis the
MMID and credits the receiver’s account and also sends the SMS to the
receiver

Activity 16.2
What if there was no IMPS?
…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

16.4.3 Cheque Truncation System

The Cheque Truncation System (CTS) was launched in April 2011 to provide
for faster clearance of instruments. Since MICR and image data travel
together in this system, reconciliation amounts are not required; cheques are
not lost, tampered or pilfered; and the risk of data manipulation during transit
is mitigated. All these features provide enhanced security and automation.
This process also eliminates paper movement and provides for fraud
management. Furthermore, data and image manipulation are prevented
through the use of digital signatures and encryption.
427
Emerging Issues in In the CTS system, the physical instrument is truncated at the presenting
Financial Services
bank’s end either at the branch level or at the service branch level. The
captured images and data are then transported electronically to the drawee
bank on the same day for processing. The clearing locations are divided into
3 regional grids, and all clearing houses of a grid are settled together on a
T+1 basis.

Services: Speedy Cheque Processing

Activity 16.3
Give the importance of Cheque Truncation System (CTS).
…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………
…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

16.4.4 National Automated Clearing House (NACH)

The NACH is a web-based platform to facilitate high volume interbank
electronic transactions that are repetitive in nature. This channel can be used
for bulk transactions to give subsidies, interests, dividends, pensions, salaries
etc. and for payment collections for utility services like telephone, electricity
and water, as also investments in mutual funds, loans, insurance premiums,
etc.

As per the directions of the RBI, it is necessary for the customer to provide a
mandate to corporates for initiating debit request to his/her bank for
collections. In the ECS platform, the mandates were physically exchanged
between banks; and this process took up to 30 working days. The
introduction of the Mandate Management system (MMS) under the NACH
helped reduce the turnaround time to a maximum of 10 working days. Under
NACH, banks were required to send the mandate image along with data
instead of the physical mandate. NPCI also introduced E-Mandate, to migrate
from the paper-based model to an electronic model, through which customers
could authorise transactions by themselves. This helped in reducing the
turnaround time further.

NACH is an important platform that supports the goal of financial inclusion

set by the government and enables direct benefit transfer related transactions
pursuant to Aadhaar linking.

Services: Mandate Management, Bulk Transactions, E Mandate

428
Activity 16.4 Technology and
Financial Services
What if there was no NACH?
…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………

…………………………………………………………………………………
…………………………………………………………………………………

16.4.5 Aadhaar Enabled Payment System (AePS)

AePS (Aadhaar Enabled Payment System) empowers bank customers to
access their bank accounts with the help of their Aadhaar number. It is a bank
led model which allows online interoperable financial inclusion transaction at
PoS (Micro ATM) through the Business Correspondent (BS) of any bank
using the Aadhaar authentication.
AePS allows the customer of the bank to perform various card less
transactions based on his Aadhaar Number and Biometric data through Micro
ATMs installed at Bank Premises, BC Locations in the network of the bank
and NFS.

Services:
• Card-less Transactions using Aadhaar No. and Biometrics

• Balance Enquiry

• Mini Statement

• Cash Withdrawal

• Cash Deposit
• Fund Transfer: Aadhaar to Aadhaar (Intra and Inter Bank)

• Funds Transfer: Aadhaar to Account (Intra Bank only)

• Purchase

• Best Finger Detection (BFD) – UIDAI has come up with the BFD
service for better biometric match during authentication

A large population of India, was lacking bank accounts and associated cards
for financial transactions. Illiteracy was a factor in the low recall of the PIN
and its usage.

Financial transactions using Aadhaar biometrics paved the way for opening
more bank accounts and more Indians coming into the fold of the banking
and financial services. Customers never needed a card and there was no
hassle of remembering the PIN, the fingerprints were the “PIN”.
429
Emerging Issues in Transaction Flow of AePS
Financial Services

Figure 16.3: Person-to-Person Transaction using Biometrics (AePS)

Source: National Payments Corporation of India and the Remaking of Payments in India
William Cook And Anand Raman

16.4.6 RuPay Cards

RuPay was launched by the NPCI in March 2012 as a card payment scheme
to achieve the RBI’s vision of introducing a domestic card. In fact, the very
name “RuPay” was coined to invoke a feeling of nationality among users.
The logo has two arrows — in orange and green resembling the national flag
— indicating a nation on the move, and service that complements the pace.
The blue colour indicates tranquillity.

RuPay carries out transactions domestically, making it very affordable by

keeping the cost of clearing and the settlement very low. India is now the
sixth nation globally to have its own gateway for national payments,
following USA, Japan, China, Singapore and Brazil. RuPay ensures that
customer data and transactions data reside in India, adding a layer of
protection for consumers. RuPay targets hitherto untapped rural, thanks to its
attractively priced product offering. Banks benefit from use of RuPay cards
by saving at least 25-30% of the switching and cardholding cost compared to
its counterparts Master Card and Visa.

Before RuPay only around 40 banks out of the 1500 + Banks in India were
issuing debit/ credit cards. RuPay made it possible for all these banks (big,
medium, small, rural, cooperative) to issue RuPay Cards to their customers
thus enabling government schemes and PMJDY to reach the far-flung areas
of India. The Banks also save on expensive fees and interchanges to be paid
to the foreign card networks like Mastercard and Visa

Activity 16.5
List the benefits of RuPay Cards to the rural population.

430 …………………………………………………………………………………
………………………………………………………………………………… Technology and
Financial Services
…………………………………………………………………………………

Entities involved in the transaction:

• Merchant location: Entity selling goods and services
• Acquiring Bank: The bank which has installed the POS terminal at the
merchant location
• Card network: RuPay/ Visa / MasterCard, etc. (transaction routing and
settling agency)
• Customer / Consumer: Cardholder
• Issuing Bank: The bank which has issued the card to the customer

Type of transactions:

ON-US Transaction: where the issuing bank and the acquiring bank are the
same entity

OFF-US Transaction: where the issuing bank and acquiring bank are
different entities

Figure 16.4 Flow of a Card Transaction

a. A consumer purchases some goods / services and uses a debit / credit

card to pay the merchant.
b. The merchant (terminal) sends the encrypted transaction data to the
acquiring bank system / switch for authorization.
c. The acquiring bank sends the transaction data to the consumer’s (card
issuing) bank over the card payment network.
d. The issuing bank authenticates the card / cardholder details; based on
successful authentication and after checking availability of balance (for
debit card) or credit limit (for credit card) authorizes the amount and
issues an authorization code or declines the transaction.
e. The acquiring bank notifies the merchant that the transaction either has
been authorized or declined; the merchant then completes the transaction
(if successful, then print receipt and hand over the goods, etc.)
431
Emerging Issues in f. Subsequently, the merchant, through the acquiring bank, will claim the
Financial Services
settlement for funds. The inter-bank settlement (between issuing bank
and acquiring bank) will take place through the card network.

* In case of debit card, the customer’s account is debited by the card issuing
bank after authentication of the credentials and if balance is available. In the
case of credit card, the bank will reduce the available credit limit in the
customer’s card account and the same will be reflected in the credit card
statement.

RuPay Contactless
‘RuPay Contactless’ refers to an open-loop chip-based payment cards
product launched by NPCI. This card can be useful for all kinds of payments
such as transport, toll collection, shopping etc. For payments lower than
Rs.2,000 in value, customers can simply tap their card to process transactions.
The card does not require a second factor authorization through a PIN, it uses
RFID (Radio Frequency Identification) or NFC (Near Field Communication)
technology for data transmission, making it more convenient. It is compatible
with devices like mobile phones, smart watches, key fobs; even accessories
like rings and pendants. Comparable contactless payment cards include
Samsung Pay, Apple Pay, Google Pay, Fitbit Pay

16.4.7 *99# Service

The innovative payment service *99# works on Unstructured Supplementary
Service Data (USSD) channel. This service allows mobile banking
transactions using basic feature mobile phone, there is no need to have
mobile internet data facility for using USSD based mobile banking. It is
envisioned to provide financial deepening and inclusion of underbanked
society in the mainstream banking services.

*99# service has been launched to take the banking services to every
common man across the country. Banking customers can avail this service by
dialling *99#, a “Common number across all Telecom Service Providers
(TSPs)” on their mobile phone and transact through an interactive menu
displayed on the mobile screen.

Services:
• Interbank account to account fund transfer,
• Balance enquiry,
• Mini statement

16.4.8 Unified Payments Interface (UPI)

Unified Payments Interface is a real-time payment system that allows sending
or requesting money from one bank account to another. Any UPI client app
may be used and multiple bank accounts may be linked to a single app.
Money can be sent or requested by using a user-created Virtual Payment
Address (VPA) or UPI ID that helps in sending or requesting money from a
bank account using the know your customer (KYC) linked mobile number.
432
UPI also generates a specific QR code for each user account for the purpose Technology and
Financial Services
of contact-less payment.

With UPI, you do not need to collect or share your sensitive bank information
such as your account number, IFSC, bank branch and bank name every time
you wish to transfer money.

UPI ID (also called Virtual Payment Address or VPA) is a unique ID for

using UPI. The UPI ID can be created by registering with one of the UPI
enabled mobile applications (App) using your bank account details.

Services:
• Creation of UPI ID
• Works with any Payment Apps
• Send Money
• Pay to Merchants
• Pay for online goods

How UPI Works

To process a UPI transaction, the following entities are involved:

1. Payer app/PSP: PSP stands for a Payment Service Provider. Payer PSPs
are apps that allow customers to initiate/complete transactions. For
example: Gpay, Phonepe, Bhim, PayTM, etc.

These apps have replaced the traditional bank apps and allow users to
create UPI handles to make or accept a transaction. Any customer can
install these apps and can create their UPI handle. NPCI takes care of the
app certification and as of now, there are 20+ third party apps certified
by NPCI for issuing UPI handles. However, all these UPI apps need a
sponsor bank to start onboarding users.

List of major UPI apps and their respective sponsor banks:

UPI App/PSPs Sponsor Banks Handles

GPay Axis @okaxis
ICICI @okicici
HDFC @okhdfcbank
SBI @oksbi
PhonePe Yes @ybl
ICICI @ibl
Axis @axl
Amazon Pay Axis @apl
2. National Payments Corporation of India (NPCI): NPCI is a non-
profit organisation set up by RBI and funded by different major banks. It
acts as a trusted switch to connect banks and Payment Service Providers
(PSPs). Similar to the role played by VISA in the case of Card payments,
433
Emerging Issues in NPCI makes sure that data flow between banks and payment apps are
Financial Services
routed to the correct and verified destinations.
NPCI, in the case of UPI payments, has made the banking services
interoperable. Users can use any UPI app to link any of their bank
accounts and can transfer or accept payments. NPCI also exposes a
bunch of non-financial interoperable APIs (Application Programming
Interfaces) for everyone in the ecosystem. For example: Validate (Virtual
Payment Address) VPA/UPI ID, Bank list, etc.
3. Issuing Bank (Sender’s Bank): In the case of UPI payment, the money
is transferred from the issuing/sender’s bank account to the acquiring
(merchant/receiver’s) bank account. The issuing bank has to debit money
on NPCI’s request and send a debit response to NPCI once the debit is
successfully done.
4. Acquiring Bank (Receiver’s bank): The acquiring (receiver) bank’s job
is to credit money on NPCI’s request and send a credit response to NPCI
once the credit is successfully done.
5. Payee PSP: This is the acquirer or payment gateway used by the
merchant in the case of P2M (Person to Merchant) transactions.
Transaction Flow of UPI is as shown in figure 16.5 (Source: National
Payments Corporation of India and the Remaking of Payments in India
William Cook And Anand Raman)

Figure 16.5: Person-to-Person Transaction using UPI

16.4.9 Bharat Bill Payment System

Bharat Bill Payment System (BBPS) is a one-stop bill payment ecosystem
conceptualised by the Reserve Bank of India (RBI) and driven by the
National Payments Corporation of India (NPCI). It is an integrated,
interoperable and accessible bill payment system. Using BBPS, payments can
be made across a wide range of categories such as electricity, telecom, DTH,
cable, gas, water, municipal taxes, school fees, housing society maintenance,
hospital bills, EMIs, recurring deposits, insurance premium and many more.
Customers can pay using a wide network of 68+ banks, 10+ payment apps
and 2.5 lakh+ retail agents. Multiple modes of payment are available and the
434
customer receives instant confirmation. Settlement to billers is guaranteed by Technology and
Financial Services
the NPCI. All entities on the BBPS platform have the trusted brand connect
of NPCI-BBPS.

Biller: A biller is any entity such as a municipal corporation, telecom

services company, school, college, housing society, hospital, mutual fund,
insurance company, etc, who offers some services to its customers / members
and has to collect recurring payments from them.

Agent: Agent and Agent Institutions are customer touch points and service
points who are currently offering or wish to offer bill payment services to
customers through digital or physical channels.

Customers: A customer is required to make multiple payments of bills and

dues on a regular basis. A customer pays phone, electricity, gas and cable
bills, school fees for their children, housing society maintenance fees, club
membership fees, municipal taxes and many other payments.
Services: BBPS will provide interoperability so that consumers can pay the
bills of any biller at a single point and facilitate payments via multiple modes
i.e. Cash, Debit Cards, Credit Cards, Prepaid payment instruments including
wallets and other electronic payment options such as Net banking, UPI,
IMPS, NEFT, etc.

16.4.10 BHIM
BHIM is an app (available on the Google Play Store) launched by the NPCI
in December 2016 that enables customers to make quick payments in a
simple manner by using the Unified Payments Interface (UPI). Bank-to-bank
payments can be done instantly by using only a mobile number or Virtual
Address (UPI ID). Money can be sent through BHIM by just entering a
Virtual Address (UPI ID), or an account number with a QR code scan.
Money can be collected by entering the Virtual Address (UPI ID). BHIM
provides payments easily through a ‘Scan and Pay’ facility. The BHIM app
allows the user to view their transaction history and pending UPI collect
requests. Complaints can be raised for declined transactions through the
‘Report’ option. Each customer is provided a static QR code and permanent
address, which is linked to a BHIM account. Downloadable QR codes can be
shared through different social platforms like WhatsApp and email.
Customers can switch between different bank accounts via the BHIM app,
which also provides options for changing PIN and checking balances. The
app is currently available in many languages. For additional security, users
who send or collect requests from unknown sources can be blocked or
reported for spam. Users can also schedule payments according to their
convenience through the app. The BHIM Aadhaar Pay enables merchants to
perform digital payments with customers over the counter using Aadhaar-
based authentication. The only requirement is that the merchant must have a
smartphone and a standard biometric scanner linked to the smart phone via
USB, and both merchant and customer must have their Aadhaar numbers
linked to their respective bank accounts.

435
Emerging Issues in 16.4.11 FASTag-e National Electronic Toll Collection
Financial Services
FASTag is a device that employs Radio Frequency Identification (RFID)
technology for making toll payments directly from the prepaid account linked
to it. It is affixed on the windscreen of your vehicle and enables you to drive
through toll plazas, without stopping for cash transactions.
FASTag is a perfect new-age solution for payment at toll plazas. FASTag is
Promoted by MORTH (Ministry of Road Transport and Highways), NHAI
(National Highways Authority of India), IHMCL (Indian Highways
Management Company Limited) and NPCI (National Payments Corporation
of India).

FASTag Benefits
Saves Fuel and Time: Operating via RFID, a FASTag benefits your road-
trips by saving on both fuel and time. Tag readers which are available on toll
booths scan your FASTag and the due charges are paid from the linked
account.

SMS Alerts: Every time you pay a toll using FASTag, you will receive an
SMS bearing the details of your transaction on your registered mobile
number. Enabling you to keep a track on your Expenses

Manage Online: Once activated, your FASTag can be linked to a bank

account/e-wallet of your choice whereby it can be re-charged and managed
completely online.

Doorstep Delivery: With FASTag being made mandatory on National

Highways, Some Banks offers you the option to apply for your FASTag
online and have it delivered to you.
Ease of Use: Using a FASTag involves simply affixing it on the interior pane
of your car’s windshield. Toll plazas are equipped with a tag scanner and
complete your transactions in a contactless manner

16.4.12 Bharat QR
Bharat QR, as the name suggests, is a QR based payment solution and can be
used to make P2M (Person to Merchant) digital payments. This means that
you can directly scan the Bharat QR code deployed at merchant or seller
locations, using any Bharat QR enabled mobile application.

Bharat QR, developed by NPCI, Mastercard, and Visa, is an integrated

payment system in India. The system, facilitates users to transfer their money
from one source to another. The money transferred through Bharat QR is
received directly in the user's linked bank account. It provides a common
interface between RuPay, Mastercard, Visa, American Express as opposed to
other such systems used by startups, and is interoperable with all the banks.
Currently, BharatQR is supported on both Android and iOS devices.

Services:
• Bharat QR is a new transformative way to pay with your mobile phone.
There is no need to carry cash.
436
• Secure: Bharat QR is as secure as making a payment via UPI. Your card Technology and
Financial Services
details are not exposed to any third party.
• Interoperable: You can use any of the apps that support BharatQR and
pay using Cards (via Visa, MasterCard, Amex or RuPay) or BHIM-UPI
• No additional charges: There is no additional charge applied to customer
for making payments via Bharat QR

16.4.13 UPI 2.0

Launched in August 2018, UPI 2.0 is the second version of the fund transfer
platform. It supersedes the former version which was structured mainly to
facilitate peer-to-peer transactions with a platform that also accommodates
merchant payments. Through UPI 2.0, customers may be able to pre-
authorize a transaction and pay on a later date. That said, there are multiple
other features and benefits that the newly introduced upgrade seems to offer.

Key Features of UPI 2.0

One-time Mandate: Customers can now pre-authorize a transaction and pay
on a later date with UPI mandate feature. These mandates are created with
one-time block functionality for transactions that can be processed later while
making a commitment at present. Individual users and merchants can benefit
from these features tremendously, as mandates are generated instantly and
payments get deducted automatically on the authorized date.
Invoice Verification: The new UPI 2.0 features dispatch of online invoice to
the customer from the merchant. Now prior to making any payment, a
customer can have a view of the order amount as well as other details that are
important to verify the credentials of the merchant. After verifying the
amount and other details, the customer can make his payment directly to the
merchant.

Link an Overdraft Account: So far users were able to link their savings and
current accounts to UPI. However, with the new upgrade they can also link
their overdraft account to it and transact instantly. UPI 2.0 will now allow
users to access their overdraft accounts and digitally channelize their
payments. Also the transaction limit for UPI 2.0 has been raised from Rs 1
lakh to Rs 2 lakh.
Additional Security through Signed Intent and QR: While scanning a QR or
Quick Response code, customers can check the authenticity of merchants.
UPI 2.0 notifies the user with information to determine if the merchant is a
verified UPI merchant or not. According to NPCI, the customers will be
informed in case the receiver is not secured by way of notifications.

16.5 NEW AGE BANKING TECHNOLOGIES

16.5.1 Neo Banks
FinTech Startups are disrupting the existing products and services with a
focus on user experience, data mining, decreasing operation costs, and
increasing efficiency with their business models through advanced
437
Emerging Issues in technology. As fintech startups, Neobanks offer banking services digitally.
Financial Services
Anyone who wants to use their services does not need to visit a bank branch
or fill out paper documents. Each process is 100% digitized, and everything
can be done through the bank’s website or mobile application.

Neobanks are presented in several forms:

Neobanks with a banking license: These types of neobanks acquire a

license for banking activity from the Central Bank or the corresponding
authority. Among them are: “Atom” bank, “Revolut” in Great Britain and
“N26” in Europe. These banks single out one to three main services that can
be offered to customers, putting stress on their quality and convenience. For
example, Revolut mainly attracts by issuing credit cards with interesting
currency exchange offers

Neobanks collaborating with a licensed bank: This is a relatively easy way

and precedes the acquirement of a banking license as a rule. The British
neobank Monese, which has a license to conduct transactions with electronic
money instead of a banking license, operates similarly and works with a
number of European banks that keep customers’ funds, thus making banks
partners and not competitors.

Neobanks created by traditional banks. Traditional banks that follow the

pace of modern technologies and innovations are beginning to provide their
services through neobanks. Kotak Mahindra Bank in India has launched its
neobanking services as a new product in the form of 811 Digital Banks which
act separately.

Feature / Service Neobank Traditional bank

Credit card Depending on the type Yes
Maximum Deposit Medium High
Banking License Depending on the type Yes
Deposit guarantee Depending on the bank Yes
Branches No Yes
Face to Face No Yes
Communication
Application Yes Depending on the bank
Characteristics Agility Stability
Target Market SMEs, Younger Institutions, Large
Generation Businesses, General
Public

16.5.2 Open Banking

Open banking is a system under which banks open up their Application
Programming Interfaces (APIs), allowing third parties to access financial
information needed to develop new apps and services and providing account
holders greater financial transparency options.
438
Currently the Banks have broadly willed to create APIs and share data on the Technology and
Financial Services
following aspects:

• Personal: information such as phone number, email and address.

• Account: balances
• Product info: rates, fees and features of bank products
• Transaction details: amounts spent
For the customer the future benefits of Open Banking are:
• Signing up more easily for new credit or debit cards
• Getting a loan more easily
• Using budgeting tools that let you track and plan your spending
• Switching from one bank to another bank more easily
The participants in an Open Banking Ecosystem are:
1. Banks – owners of the accounts and other banking services
2. Fintechs are often called third party providers (TPPs) in open banking.
They can enable their customers to make better use of their financial
transaction data, make and receive payments directly from a bank
account, or benefit from new card-based offerings.
3. TSPs - Technical service providers (TSPs) collaborate with regulated
providers to securely provision the financial data that fuels open
banking-enabled products and services.

API Layer Third Parties /

Bank A with Customer
Fintech Company
Data Bank A Customers of
Apps
Bank A or Bank
B
Bank B with Customer API Layer
Data
Bank B

16.5.3 Cloud Banking

Cloud banking is a powerful deployment and delivery model. It enables
financial institutions to manage core banking platforms and applications in
the cloud, with on-demand access to increased computing power and
resources to deliver core financial services online. Similar to cloud
computing, cloud banking takes the work of managing the physical
infrastructure and complex technological network and provisioning of
hardware and software off of the financial institution's IT team.

Cloud Banking can offer financial institutions a number of advantages:

• Cost savings
• Usage-based billing
• Business continuity 439
Emerging Issues in • Business agility
Financial Services
16.5.4 Blockchain Technology
To understand Blockchain, it is important to understand DLT or Distributed
Ledger Technology. Distributed ledger technology (DLT) is a digital system
for recording the transaction of assets in which the transactions and their
details are recorded in multiple places at the same time. Unlike traditional
databases, distributed ledgers have no central data store or administration
functionality.
In a distributed ledger, each node processes and verifies every item, thereby
generating a record of each item and creating a consensus on its veracity. A
distributed ledger can be used to record static data, such as a registry, and
dynamic data, such as financial transactions.
DLT uses cryptography to securely store data, cryptographic signatures and
keys to allow access only to authorized users.
The technology also creates an immutable database, which means
information, once stored, cannot be deleted and any updates are permanently
recorded for posterity.

All relevant entities in a DLT can view and modify the ledger, as a result, all
other entities can see who is using and modifying the ledger. This
transparency of DLT provides a high level of trust among the participants and
practically eliminates the chance of fraudulent activities occurring in the
ledger.
Blockchain is a type of distributed ledger containing a continuously growing
list of ordered records called ‘blocks’. Each block contains a timestamp and a
link to a previous block. By design, blockchains are inherently resistant to
modification of the data – once recorded, the data in a block cannot be altered
retroactively. This distinguishes blockchain in a way that each ‘block’ is
linked and secured using cryptography. Trust is distributed, decentralized
along the chain and relies on cryptography eliminating the need for a trusted
third party to facilitate digital relationships and ledgers. Thus, a Distributed
Immutable Ledger is created and hence also called as Distributed Ledger
Technology or DLT.

440
By virtue of its features, DLTs provide a compelling set of benefits for the Technology and
Financial Services
Banking and Financial Services Industry:

Traceability: Products and assets can be followed and monitored in live time.
Once held in a ledger, the data is then immutable; access can be given by
those who participate in the system/network, while preventing private
information from being disseminated to any other sides.

Clarity: Every transaction is clear and easy to understand, thus building

customer trust in the system. Every transaction is also linked to a unique
cryptographic public key identity, thus allowing privacy, and the underlying
data structure allows for transparency. Thus, block allows for unmatched
level of transparency with privacy.
Accountability: Within the chain of blocks, transactions are kept in sequence
and indeterminably. This allows for accountability and auditability at every
stage, not needing any outside players.
Security: Each single transaction is verified by the network using
cryptographic algorithms, assuring the authenticity and immutability of the
information. The user can exercise control over the assets and each
transaction that they own with the use of cryptography. Blockchain is
therefore innately secure. Of course, there are theoretical scenarios where a
blockchain can be counterfeit, for example modifying one single transaction
in more than the 51% of the network, but technical limitations make this
scenario hypothetical, rather than a real threat to data integrity and
immutability.

Collaboration: DLTs enable each party to easily and securely share finance-
related trade data. The level of collaboration (which information each party
can share and who can access what) is determined by the configuration of the
network/system, so this is a highly customizable solution easily adaptable to
any regulatory, technical or functional requirement.
Efficiency: Transactions are completed between involved parties with no
intermediaries.

Uses of Blockchain / DLT in Financial Sector

• Faster Payments: By establishing a decentralized channel (e.g. crypto)
for payments, banking institutions can use emerging technologies to
facilitate faster payments and lower the fees of processing them. By
offering higher security and lower cost of sending payments, banks could
introduce a new level of service, bring new products to the market, and
finally, be able to, compete with innovative fintech startups. Moreover,
by adopting blockchain, banks will be able to cut down on the need for
verification from third parties and accelerate the processing times for
traditional bank transfers

• Clearance and Settlement Systems: A distributed ledger technology

like blockchain could enable bank transactions to be settled directly and
keep track of them better than existing protocols such as SWIFT. An

441
Emerging Issues in average bank transfer takes a few days to settle because it’s limited by
Financial Services
the way our financial infrastructure was built.

For example, if you’d like to send money from an account in a German

bank to one in the United States, that transfer will be executed through
the Society for Worldwide Interbank Financial Communications
(SWIFT). Every day, SWIFT members send 24 million messages to
some 10,000 different institutions.

The centralized SWIFT protocol processes only the payment orders. The
actual money is processed through a system of intermediaries. Each of
them comes at an additional cost and takes a lot of time.

A decentralized ledger of transactions like blockchain could enable

banks to keep track of all the transactions publicly and transparently.
Banks won’t need to rely on a network of custodial services and
regulatory bodies like SWIFT. They could simply settle transactions
directly on a public blockchain.

• Buying and Selling Assets: Buying and selling assets like stocks,
commodities, or debts are based on keeping track of who owns what.
Financial markets accomplish this through a complex network of
exchanges, brokers, clearing houses, central security depositories, and
custodian banks. All of these different parties have been constructed
around an outdated system of paper ownership. As you can guess, the
system is not only slow but riddled with errors and prone to deception.

Blockchain will revolutionize financial markets by creating a

decentralized database of digital assets. A distributed ledger allows
transferring the rights of an asset through cryptographic tokens that can
represent such assets
• Credit and Loans: Banks that process loan applications evaluate the risk
by looking at factors such as credit score, home ownership status, or debt
to income ratio. To get all of that information, they need to ask for your
credit report provided by specialized credit agencies. With blockchain,
we’re looking at the future of peer-to-peer loans, faster and more secure
loan processes.

• KYC identification: Banks wouldn’t be able to carry out online financial

transactions without identity verification. However, the verification
process consists of many different steps that consumers don’t like. It can
be face-to-face checking, a form of authentication (for example, every
time you log into the service), or authorization. For security reasons, all
of these steps need to be taken for every new service provider.
With blockchain, consumers and companies will benefit from accelerated
verification processes. That’s because blockchain will make it possible to
reuse identity verification for other services securely.

442
16.6 SUMMARY Technology and
Financial Services

The liberalization and globalization of the Indian economy has thrown up

new challenges to the financial sector in the form of competition from new
breed of private sector banks, foreign banks and other non-banking financial
institutions, apart from the growing expectation from the customers and the
government, to achieve international standards. The transformation from the
traditional and computerized accounting to a totally digital environment has
been elaborately discussed in this unit. Beginning with the chronological
technological developments in banking sector we have moved ahead to the
present day technologies in use. The different payment products like National
Financial Switch (NFS), AePS (Aadhaar Enabled Payment System), IMPS,
RuPay, Unified Payments Interface (UPI), BHIM etc. The new emerging
technologies like Open Banking, Cloud Banking, Block Chain Technology
etc. have been covered to a great extent.

16.7 KEY WORDS

National Financial Switch (NFS)- It is the largest network of shared
automated teller machines (ATMs) in India. It was designed, developed and
deployed with the aim of inter-connecting the ATMs in the country and
facilitating convenience banking.
IMPS (Immediate Payment Service) - is an instant, 24×7, interbank,
electronic fund transfer service through mobile phones.
UPI (Unified Payments Interface) - is a real-time payment system that
allows sending or requesting money from one bank account to another.

BHIM- is an app (available on the Google Play Store) launched by the NPCI
in December 2016 that enables customers to make quick payments in a
simple manner by using the Unified Payments Interface (UPI).
Bharat QR- Bharat QR, as the name suggests, is a QR based payment
solution and can be used to make P2M (Person to Merchant) digital
payments.
Open banking- is a system under which banks open up their application
programming interfaces (APIs), allowing third parties to access financial
information needed to develop new apps and services and providing account
holders greater financial transparency options.

Distributed ledger technology (DLT)- is a digital system for recording the

transaction of assets in which the transactions and their details are recorded in
multiple places at the same time.

Blockchain - is a type of distributed ledger containing a continuously

growing list of ordered records called ‘blocks’. Each block contains a
timestamp and a link to a previous block. By design, blockchains are
inherently resistant to modification of the data – once recorded, the data in a
block cannot be altered retroactively. This distinguishes blockchain in a way
that each ‘block’ is linked and secured using cryptography.
443
Emerging Issues in
Financial Services
16.8 SELF-ASSESSMENT QUESTIONS
1. Explain the chronological progress of technology and its application in
the financial sector.
2. Discuss in detail the National Financial Switch (NFS) and the Immediate
Payment Service (IMPS).
3. What do you understand by Unified Payments Interface (UPI)? Discuss
How UPI works and how Person-to-Person transaction takes place using
UPI?
4. What do you understand by the term FASTag? Discuss its benefits.
5. Discuss the emerging technologies and their applications in the financial
services sector.

16.9 FURTHER READINGS

https://www.npci.org.in

https://www.rbi.org.in

444
UNIT 17 PORTFOLIO MANAGEMENT Portfolio
Management

SERVICES Services

Objectives

After reading this unit you will able to:

• Understand the concept, features and relevance of portfolio management

services
• Understand the regulatory framework and guidelines on portfolio
management services
• Know status of portfolio management services in India

Structure

17.1 Introduction

17.2 Features of PMS

17.3 Relevance and Benefits of PMS

17.4 Types of PMS

17.5 Investment Strategies in Portfolio Management

17.6 Portfolio Management Services: Process, Working and Charges

17.7 Precautions to be taken by Investor

17.8 Performance Evaluation of PMS

17.9 SEBI-Regulatory Framework on PMS

17.10 Developments in Indian Market

17.11 Income Tax Aspect of PMS

17.12 Summary

17.13 Self-Assessment Questions

17.14 Further Readings

17.1 Introduction
Financial services are comprised of fund based financial services, non- fund
based financial services and fee based financial services. Portfolio
management service (PMS) is a part of fee based financial services group.
Portfolio management service is a facility offered by a portfolio manager
with the intent to achieve the required rate of return on the corpus within the
acceptable level of investment risk. An investment portfolio is comprised of
shares, fixed income securities, commodities, real estate, structured finance
products, and cash. A portfolio manager is a licensed investment professional 445
Emerging Issues in who specializes in analysing the investment objectives of the investor. The
Financial Services
portfolio manager has a vast professional knowledge of the financial and
commodities markets and investment management. On this backdrop the
portfolio manager is better positioned to make informed decisions for
investments in securities as opposed to a layman. The portfolio manager
helps to build and maintain a robust investment portfolio. PMS is a typical
customized service offered to High Net-worth Individuals (HNI) customers.
The service is tailored as per the investor’s return requirements and the
ability and willingness to assume the risk. The portfolio manager ensures that
the return requirements coincide with the risk profile. The various aspects of
portfolio management service are discussed in this unit.

17.2 FEATURES OF PMS

• The PMS is based on written contract between portfolio manager and
investor. Such contract must be in compliance with rules and regulations
of the regulator. Investors are mainly high net value individuals.
• The performance of the portfolio is fully dependent on the portfolio
manager’s ability to beat or outperform the market expectation.
Therefore, a crucial aspect of using PMS is to conduct due diligence of
the portfolio managers past and current performance. A portfolio
manager’s educational and professional background, experience and
expertise ultimately have significant impact on the performance of a
fund.
• The investor has to understand the investment strategy to be pursued by
funds manager before funds are committed. Under PMS arrangement,
funds manager share all the details of proposed investment portfolio
including structure and strategies to be pursued to achieve agreed
objectives. It makes sense for the investor to understand the strategy
before committing funds. If the strategies are complex, then the viability
of such strategies over the long-term period needs to be outlined with
complete transparency.
• The fee of the PMS is based on the performance of the portfolio
manager. It provides a win-win situation for both the parties. Fees
charged for the management of the portfolio is expected not to exceed
industry standards, which is in the range of 1 to 3 per cent of the total
value of investment. A hurdle rate clause ensures profit sharing with the
portfolio manager only if the performance of the portfolio beats the
minimum required hurdle rate. The profit-sharing of returns is typically
20 per cent.
• Customer support and transparency are valued by investors, especially
for discretionary portfolios. Portfolio manager appraising portfolio
performances frequently benefits from customer engagement and
establish a long-standing agreement.

446
How PMS is different from Mutual Funds Portfolio
Management
Services
PMS and mutual funds are considered for investment of funds and hence are
considered as a part of investment banking business. However PMS is
different from mutual funds. The following points bring out how PMS is
different from mutual funds.

• Customization: PMS is a complete customized service. Such service is

tailor made keeping in view the customer’s expectation and preference.
As against this, mutual fund is not fully customized product. It is
customized only to the extent of classification of schemes and portfolio
composition.
• Engagement: PMS is personalized service based on understanding
between the portfolio manager and investor. An investor can
communicate any changes in the profile of portfolio, selection of asset
mix and trade-off between risk and return to maximize returns and
trading profit. Mutual funds offer limited engagement with the investor
that includes purchase of units and sharing of financial data such as net
asset value of a unit and return per unit.
• Accountability: Portfolio managers under PMS are directly accountable
to the investors. Fund managers in mutual funds are directly accountable
to the trustees of mutual funds but not to the investors.
• Fee Structure: Under PMS arrangement portfolio manager share in the
profit over a specified rate of return (known as hurdle rate) in addition to
the annual maintenance fee or charges. Such arrangement of incentive is
highly preferred in the case of PMS so that the portfolio manager will be
motivated to take an appropriate investment decision in an attempt to
attain supernormal returns. Mutual funds charge a fixed fee attributed to
the entry and exit of investments as well as annual expenses for
maintenance (known as the expense ratio).
• Ownership of Asset Portfolio: Under PMS, the investor retains direct
ownership of portfolio of assets including shares of the companies.
However, investor only purchases units in the mutual fund and hence
investor is not owner of mutual fund assets.
• Size of Investment: Under PMS scheme investment portfolio must be
equal to or over the minimum limit of Rs 50, 00,000. In case of mutual
fund, investor is free to purchase units of any value. Therefore PMS
scheme is suited for wealthy investors. MFs are suitable for ordinary
investors as well as for wealthy investors.

17.3 RELEVANCE AND BENEFITS OF PMS

17.1.1 Relevance of PMS
Portfolio Management Services are relevant to certain segment of Investors,
who have huge financial resources (wealth) but do not have proper
understanding of financial markets and investment management. The 447
Emerging Issues in Investment services provided by portfolio manager under PMS cater to a
Financial Services
niche segment of investors. Such investors can be Individuals or Institutions
who belongs to the high net worth group. These investors look for -

a) investment in various asset classes like equity shares, fixed income

securities, structured finance products and commodities etc.,

b) personalized investment solutions and

c) long-term growth in wealth.

In today’s world due to deregulation of markets, globalisation and

comprehensive regulatory framework investment decisions and its execution
have become complex and riskier. In view of this, the investors experience
difficulties in managing their personal investment portfolio and optimizing
returns. On this backdrop the best option for these investors is to use services
of portfolio managers under PMS for managing their wealth. The Portfolio
Manager under PMS helps to manage customer’s investment portfolio by
making use of his expertise, innovative techniques and resources at his
command and thus helps to achieve investment objectives.

17.1.2 Benefits of PMS

There are various benefits from use of PMS. Few of these benefits are
discussed below:

• Professional Management: The portfolio manager under PMS provides

professional services in managing portfolio of various assets with the
objective of delivering consistent long-term financial returns while
controlling risk.
• Continuous Monitoring: With the help of portfolio manager it becomes
easy to monitor portfolio periodically and desired changes can be made
in the portfolio to optimize the financial results.
• Risk Control: A strong research team, which is attached to the portfolio
manager, helps portfolio manager to formulate the client's investment
strategy and manage risks in investment decisions and trading
operations.
• Hassle Free Operation: Portfolio Management Service provider gives
the client a customized service. The corporate entity takes care of all the
administrative aspects of the client's portfolio with a periodic reporting
(usually daily) on the overall status of the portfolio and performance.
• Transparency: Under PMS portfolio manager provides
communications, statements and comprehensive performance reports
regularly about portfolio to the customers. Web enabled access will
ensure that customer is just a click away from all information relating to
his investment. The account statement gives a complete information
about wned securities , along with the number of shares held and other
details such as a) the current value of the securities owned; b) the cost
448
 (purchase price) of each security; c) details of security transactions (such Portfolio
Management
as purchases, sales and dividends received or reinvested; d) portfolio's Services
asset allocation; e) portfolio's performance in comparison to a
benchmark; and f) market research from the Portfolio Manager.
• Customized Investment Advice: Under PMS portfolio manager offers
tailor made investment advisory services to their customers to achieve
their financial objectives. It helps the customers to take most profitable
investment decisions. A portfolio manager is permitted to invest in
derivatives for the purpose of hedging and portfolio rebalancing, through
a recognized stock exchange. Therefore portfolio manager offer tailor
made strategies for using derivative products in managing risk in
investment portfolio. The portfolio manager is a trustee acting in a
fiduciary capacity on behalf of the investor. Therefore, the tax liability
for a PMS investor would remain the same as if the investor is accessing
the capital market directly. The portfolio manager ideally provides
audited statement of accounts at the end of the financial year to aid the
investor in assessing his/ her tax liabilities.
• Personalized Approach: Some Portfolio Managers may provide a
personal investment management service to achieve the customer’s
investment objectives. The customers may gain direct personalized
access to the professional advice from portfolio managers who are
actively involved in managing customer’s portfolio. The interaction of
customer with portfolio manager and his management team may come in
different ways including in-person meetings, conference calls, written
research report, etc.

17.4 TYPES OF PMS

There are different types of PMS that includes discretionary, non-
discretionary and advisory portfolio management services. The details of
such services are discussed below.

i) Discretionary PMS

Under discretionary PMS, the choice of the investment decisions and timing
of implementing the same rest solely with the Portfolio Manager. This
provides portfolio managers with the flexibility to react quickly to fast
changing market conditions and economic circumstances. The portfolio
manager is given complete control of the portfolio and is free to adopt any
strategy which is suitable to achieve the objectives of portfolio. Such PMS
demand higher involvement for decision making justifying higher fees
associated with discretionary portfolio management. This is the best option
for clients with limited time and no knowledge of investment management.
Generally, in case of a discretionary PMS, the portfolio manager agrees on an
objective/s with the customer and set a benchmark before they start investing
funds in various financial assets. While investing funds in various assets
portfolio manager analyses various factors that includes expected return and
449
Emerging Issues in tolerance for risk. Often customers have their own views about the kind of
Financial Services
portfolio they want, and they communicate to the portfolio manager at the
commencement of the contract. The portfolio manager sends portfolio
transaction details after executing the same. Also account statements are
usually sent each quarter and valuations every six months, with a
performance comparison and a list of transactions.

ii) Non-discretionary PMS

Under Non-discretionary PMS, the portfolio manager only suggests the

investment ideas and desired composition of investment portfolio. The choice
as well as the timing of the investment decisions rest solely with the
customer. However, the execution of trade deals is done by the portfolio
manager.

iii) Advisory PMS

Under these services, the portfolio manager only suggests the investment
ideas. The choice as well as the execution of the investment decisions rest
solely with the Investor. Some investors are such that they prefer to have
more control over their portfolios, and thus in case of advisory services the
portfolio manager contact clients to make/ give recommendations for
managing investment portfolio and execution of deals. Sometimes, they also
deal on an execution only, an arrangement which suits experienced investors
who are prepared to take their own decisions.

17.5 INVESTMENT STRATEGIES IN

PORTFOLIO MANAGEMENT
Portfolio manager in consultation with the customer has to decide about an
appropriate strategy for managing investment portfolio. Broadly there are two
types of strategies for portfolio management namely active portfolio strategy
and passive portfolio strategy. The details of these two portfolio strategies are
discussed below:

17.5.1 Active Portfolio Strategy

Active portfolio strategy refers to a portfolio management strategy where the
portfolio manager makes specific investments with the objective of
outperforming an investment benchmark index. Under this strategy the
portfolio manager exploits market inefficiencies by purchasing securities that
are undervalued or by short selling securities that are overvalued. Either of
these two methods may be used alone or in combination. Depending on the
objectives of the specific investment portfolio, the portfolio manager may
like to ensure less volatility (or risk) than the benchmark index. The
reduction of risk may be instead of, or in addition to, the objective of creating
an investment return greater than the benchmark. Under this strategy the
portfolio manager may use a variety of factors and strategies to construct
customer’s portfolio(s). These include quantitative measures such as
450
price/earnings ratio (P/E ratios) and PEG ratios (Price/Earnings-to-Growth Portfolio
Management
ratio), sector investments that attempt to anticipate long-term macroeconomic Services
trends (such as a focus on energy or housing stocks), and purchasing stocks
of companies that are temporarily out-of-favour or selling at a discount to
their intrinsic value. The portfolio manager also pursues other strategies such
as arbitrage, short sale and use of stock exchange derivative products.

Advantages of Active Portfolio Strategy

The primary attraction of active portfolio management is that it allows

investment in a variety of financial instruments instead of investing in the
market sensex based instruments. Investors believe that some market
segments are less efficient in creating profits than others. The following are
advantages of active portfolio strategy.

• This strategy helps to manage market volatility by investing in less-risky,

high-quality companies rather than in the market as a whole, even at the
cost of slightly lower returns. Conversely, some investors may want to
take on additional risk in exchange for the opportunity of obtaining
higher-than-market returns.
• This strategy helps to diversify investment portfolio. Investments that are
not highly correlated to the market are useful to diversify portfolio and
may reduce overall portfolio volatility.

Disadvantages of Active Portfolio Strategy

The following are disadvantages of active portfolio strategy

• The fund manager may make bad investment decisions

• The portfolio manager may follow an unsound principle in managing the
portfolio.
• The fees associated with active portfolio management are higher than
those associated with passive management, even if frequent trading is not
present.
• Active fund management strategies that involve frequent trading
operations generate higher transaction costs which diminish the fund's
return. In addition, the short-term capital gains resulting from frequent
trades often have an unfavourable income tax impact when such funds
are held in a taxable account.

17.5.2 Passive Portfolio Strategy

Under this strategy a portfolio manager makes as few portfolio decisions as

possible, in order to minimize transaction costs, including the incidence of
capital gains tax. One popular method is to mimic the performance of an
externally specified index - called 'index funds’. Investors that do not aspire
to receive a return in excess of a benchmark index will often invest in an
index fund that replicates as closely as possible the investment weighting and
returns of that index; this is called passive portfolio management. Indexation 451
Emerging Issues in can be achieved by trying to hold all of the securities in the index, in the
Financial Services
same proportions as the index.

Advantages of Passive Portfolio Strategy

1) As the portfolio manager is only expected to replicate a given index, the

fee charged is very low compared to fee under active portfolio
management strategy. No highly paid stock pickers or analysts are needed
to pursue such strategy.

2) The investment objectives of index funds are easy to understand. Once an

investor knows the target index of an index fund, what securities the
index fund will hold can be determined directly. Managing one's index
fund holdings may be as easy as rebalancing every six months or every
year.

3) The transaction costs, resulting from securities turnover, are low as

compared to cost in active portfolio management as the portfolio
churning is at a minimum.

Disadvantages of Passive Portfolio Strategy

1) Incurring transaction costs leads to an overall return being lower than the
tracking index. The returns of the portfolio under this strategy are lower
as compared to the market returns.

2) An index fund seeks to match returns rather than outperform the target
index. Therefore, a good index fund will not generally outperform the
index, but rather produces a rate of return similar to the index minus
fund costs.

17.6 PORTFOLIO MANAGEMENT SERVICES:

PROCESS, WORKING AND CHARGES
As discussed above the PMS is based on written contract between the
portfolio manager and the investor. The level and extent of portfolio
management services to be provided by the portfolio manager should be
decided at the time of signing the agreement. As soon as agreement for PMS
is signed the portfolio manager has to understand the customer’s expectations
in terms of risk and return. This will help to frame a suitable investment
proposal and to establish an appropriate market benchmark. The portfolio
management process is the means, through which the portfolio manager
defines the investment objectives of the investor, translates them into
achievable objectives, allocates funds to various assets to achieve those
objectives, monitor the portfolio performance including returns and
restructure the portfolio for a given trade-off between the risks and return
profile of the portfolio. PMS provider should be very careful in their
processes to ensure that it does not come under a situation of conflicts of
interest. In case if it comes, it should have due processes and disclosures to
452 ensure that interest of the customer is protected.
17.6.1 PMS Process Portfolio
Management
Services
The three steps of the portfolio management process are as follows:

1) Planning: Planning is the first step of portfolio management and

involves the making of the Investor Policy Statement (IPS). Investor
policy statement defines the willingness and the ability to take risk from
the investor’s point of view. It also sets the objectives of the investors in
terms of their risk and return keeping in mind the IPS of the individuals.
2) Execution: Execution is the second step and involves allocation of the
investment corpus to various asset classes and various products within
the asset classes to match the risk-return profile stated in the IPS. The
portfolio managers are responsible for allocation of funds to various
asset groups. For the management of PMS company provides a policy
framework for asset allocation. Portfolio managers have to ensure that
portfolios do not diverge from the agreed asset allocation significantly,
or become too concentrated in individual shares or sectors. Portfolio
managers meet regularly to study research reports prepared by in house
research team and economists on markets, sectors and economy to
evaluate existing investment in different asset groups and to decide about
new investments.

As far as investment in shares is concerned, portfolio managers use

fundamental and technical analysis. With the help of fundamental analysis,
portfolio managers identify shares of financially strong companies and
undertake valuation exercise. In this regard growth investing strategy may be
thought. Under this strategy investment is made in those companies that
exhibit signs of above-average growth, even if the share price appears
expensive in terms of metrics such as price-to-earning or price-to-book value
ratios. There are many ways to execute an investment strategy. Some of these
include (1) investment in companies from emerging markets (2) investment
in blue chip companies (3) Investment in internet and technology companies.

Portfolio manager may also like to use value investing strategy. Under this
strategy undervalued shares are purchased. This means to purchase those
stocks which are traded below book value, have high dividend yields, have
low price-earnings ratios. Portfolio managers use technical analysis to decide
when to enter or exit secondary equity market based on view about
movements in the market prices of shares. As far as investment in Non-
Government fixed income securities is concerned, portfolio managers use
credit rating to manage credit risk and achieve balance between risks and
return.

1) Feedback: In the third and final step of portfolio management process,

the portfolio manager monitors the performance of the portfolio and
makes changes to the assets wherever they are falling short of their
expected returns. Rebalancing of the portfolio might be done to achieve

453
Emerging Issues in better returns or the portfolio might stay as it is if it is performing as per
Financial Services
expectation.

17.6.2 Working of PMS

Each PMS account is unique and the portfolio and valuation of each account
may differ from one another. There is no NAV for a PMS scheme; however,
the customer will get the valuation of his/her portfolio on a daily basis from
the PMS company. Every PMS scheme has a model portfolio and all the
investments for a particular investor are done in the Portfolio Management
Services on the basis of the model portfolio of the scheme. However, the
portfolio may differ from investor to investor. This is because of:

• Entry of investors at different times.

• The difference in the number of investments by the investors
• Redemptions/additional purchases done by the investor
• Market scenario – eg If the model portfolio has an investment in the
TATA Consultancy Services (TCS) , and the current view of the
portfolio manager on TCS is “HOLD”(and not “BUY”) a new investor
may not have TCS in his portfolio.

Under PMS schemes the portfolio manager interaction also takes place. The
frequency of meeting depends on the size of the customer’s portfolio and the
policy of Portfolio Management Services company. The larger the size of
portfolio, the frequency of interaction is more. Generally, the PMS company
arranges interaction between portfolio manager and customer on a
monthly/quarterly/half-yearly basis.

17.6.3 Charges for PMS

The PMS asset management companies charge fees for different services.
The charges are decided at the time of investment and are vetted by the
investor. The details are given below:

• Entry Load – In PMS schemes India may have an entry load of 3 per
cent . It is charged at the time of buying the PMS only.
• Management Charges – Every portfolio management services scheme
charges fund management charges. Fund management charges may vary
from 1 per cent to 3 per cent depending upon the policy of PMS
Company. It is charged on a quarterly basis to the PMS account.
• Profit-Sharing – Some PMS schemes also have profit-sharing
arrangements (in addition to the fixed fees), wherein the PMS Company
charges a certain amount of fees/profit over the stipulated return
generated in the fund. For example, PMS XYZ Ltd has fixed charges of
2 per cent plus a charge of 20 per cent of fees for return generated above
15 per cent in the year. In this case, if the return generated in the year by
the scheme is 25 per cent, the fees charged by the PMS XYZ Ltd will be
2 per cent + {(25%-15%)*20%}.
454
The Fees charged are different for every Portfolio Management Services Portfolio
Management
company and for every scheme. It is relevant for the investor to check the Services
charges of the scheme before entering into contract under PMS with the PMS
Company.

Apart from the charges mentioned above, the PMS Company also charges the
investors on the following matters as all the investments are done in the name
of the investor:

• Custodian Fee
• Demat Account opening charges
• Audit charges
• Transaction brokerage

17.6.4 Dissemination of Knowledge on PMS

In order to keep the investors updated about their portfolio, there is regular
flow of communication through monthly market report, periodic portfolio
performance report and such other reports from the Portfolio Management
team of the PMS Company. These reports help the investors to understand
current market scenarios and guide them in regards to when and where to
invest.

Few of these reports to be provided by the portfolio manager are as follows:

• Company reports: The portfolio services company provides reports of

initiating coverage of new companies and providing with update reports
of existing stocks under coverage.
• Sector Wise reports: Industry wise research reports. It includes reports
on performance of various industries like cement, automobile, coal and
oil and services sectors like information technology, health and hotel.
Such reports analyses current performance of and future prospects for
various industry sectors.
• Weekly reports: PMS Company generally provides a summary of every
week that's gone by, highlighting how the indices and select equities
have performed over the week. It gives a summary of the top gainers and
losers of the week. Below is the preview of such a report. Also in
addition to this, weekly reports educate the investors about the current
happenings in the financial markets or a particular topic such as credit
ratings, investment theories and so on.
• Blogs: Blogs are websites that maintain on-going chronicle of financial
and market information. Investors would find blogs on financial topics
by various practitioners with real life case studies more alluring than just
studying some theories in finance.
• Performance update report: Most of the fund managers would apprise
their clients on regular intervals as agreed upon them, however the PMS
companies comes out with an performance update report monthly or
455
Emerging Issues in quarterly. Generally, a performance report gives a brief overview stating
Financial Services
how the various asset classes have performed in the said time period. The
report provides the investors with how a particular portfolio or fund has
performed along with few details regarding the shuffling of portfolios
and so on.

17.7 PRECAUTIONS TO BE TAKEN BY

INVESTOR
Before entering into an agreement on PMS with PMS Company, the investor
has to take following precautions:

1) PMS Company has model portfolios that they furnish when soliciting
business from the customers. The investor has to assess the PMS model
portfolio for a track record of company selection and overall performance
against the market index.

2) The performance of the portfolio under PMS is solely dependent on the

portfolio manager’s ability to outperform the market. Therefore, a crucial
aspect of selecting PMS Company is conduct due diligence of the
portfolio manager. A portfolio manager’s educational and professional
background and experience ultimately point to the competency and
expertise that they bring to the fund.

3) The investment strategy is another parameter that can give PMS an upper
hand over other investment schemes available in the market. It is relevant
for the investor to understand the investment strategy before committing
funds. If the strategies are complex, the viability of such strategies over
the long-term should be outlined transparently.

4) The investor has to analyse various fee structure of PMS Company.

The fee arrangement of the PMS based on the performance of the
portfolio manager should serve a win-win situation. The profit-sharing of
returns is typically 20 per cent. Fees charged for the management of the
fund should not be over industry standards, which is in the range of 1 to 3
per cent. A hurdle rate clause ensures profit sharing with the manager
only if the performance of the fund beats the minimum required hurdle
rate.

17.8 PERFORMANCE EVALUATION OF PMS

Performance measurement is an important task for both the investor and the
portfolio manager. It must be calculated in context of investment objectives
including returns and risk tolerance. Returns are most commonly quoted
either in terms of absolute amount or in terms of ratios. However, it can be
compared with agreed benchmarks.

Pre requisite to evaluation of financial performance are Investment

objectives, Understanding the needs and expectations of the investor, to know
456
why one is investing is the first step in structuring a portfolio, as well as in Portfolio
Management
establishing a framework for viewing portfolio performance and Types of Services
risks and limits

It is important that the investor closely works with the portfolio manager to
achieve investment objectives and have optimal trade-off between risk and
return. Understanding risk is an integral factor in evaluating portfolio
performance. One can view risk as portfolio volatility, as the risk of not
achieving the set goals, or as the risk of permanent capital loss. There is a
positive co-relationship between risk and returns. Over the long term, an
increase in risk typically leads to higher expected returns, while lowering of
risk leads to lower expected returns. Goals and risk tolerance should be the
basis for establishing investment guidelines for one’s portfolio which enables
the portfolio manager to structure the portfolio and provide investors with a
framework that allows them to review and understand investment
performance.

Not all asset classes, or segments within asset classes, perform in line with
each other. Portfolio managers use this lack of correlation to lower volatility
in an overall portfolio, a fact one should always keep in mind when someone
evaluate portfolio performance. For example, if someone invest in small
capitalization stocks, it is possible that the stocks will perform very
differently from the market in general and from other market segments.

Relative Returns: While the absolute return of a portfolio is important,

investors must also look at portfolio performance on a relative basis. To do
this, compare your results to a relevant market index as well as to a peer
group. A peer group is a group of managers who invest with a similar style
and who have similar objectives. At the outset of the investment relationship,
you and your advisor should agree upon the peer group and the index. Use
these as a base to determine how well you are doing on a relative basis.

The qualitative and quantitative techniques are used in evaluating portfolio

performance

Qualitative Techniques

a) While evaluating a performance of portfolio manager one has to look at

his performance over the last 3 to 5 years and not just in few months.

b) The effectiveness of a 'portfolio manager depends on the timeliness of his

recommendation, if he recommends the stock after it has gained 5% -
10%, the stock might no longer be undervalued and therefore not
lucrative.

c) The relationship shared between the customer and the portfolio manager
is one of the qualitative ways of evaluating his performance. At the outset
of this relationship, establish the frequency of meetings for reviewing
one’s portfolio as well as a schedule for receiving written material.
457
Emerging Issues in d) The willingness on part of the portfolio manager to take the time to
Financial Services
review the investors' investment objectives, risk tolerance, and explain
how they have done on both a relative and an absolute basis forms an
important criteria.

e) An important aspect of evaluating a portfolio manager’s performance is

determining whether the portfolio manager has complied with the
industry's best practices and regulations of regulatory body.

Quantitative Techniques

1) Sharpe ratio: The Sharpe ratio is a measure of the excess return (or Risk
Premium) per unit of risk in an investment asset or a trading strategy. It is
also called as reward-to-variability ratio. The Sharpe ratio is used to
characterize how well the return of an asset compensates the investor for
the risk taken. When comparing two assets each with the expected return
against the same benchmark with return, the asset with the higher Sharpe
ratio gives more return for the same risk. Investors are often advised to
pick investments with high Sharpe ratios.
Expected Return on the portfolio - Risk free rate
Sharpe Ratio = ------------------------------------------------------------------------
Risk (standard deviation of portfolio)

2) Treynor ratio: The Treynor ratio is a measurement of the returns earned

in excess of that which could have been earned on an investment that has
no diversifyable risk. The Treynor ratio relates excess return over the
risk-free rate to the additional risk taken; however only systematic risk is
used. Whereas in sharpe ratio, the total risks both systematic and
unsystematic risks are used to calculate the per unit return of a portfolio.
Systematic risk is the market risk, which we cannot do away with, using
the principle of diversification. The higher the Treynor ratio, the better is
the performance of the portfolio.
Return on the portfolio - Average return on the Risk free rate
Treynor's Ratio = ---------------------------------------------------------------------- -
Systematic Risk (Beta of the Portfolio)

3) Jensen's Alpha: Jensen's alpha measures the risk adjusted performance

return on a portfolio over and above as predicted by the CAPM (Capital
Asset Pricing Model), given the portfolio's beta and the average market
return. The basic idea is that to analyse the performance of a portfolio
manager one must look not only at the overall return of a portfolio, but
also at the risk of that portfolio. For example, if there are two funds that
both have a 12% return, a rational investor will want the fund that is less
risky. Jensen's measure is one of the ways to help determine if a portfolio
is earning the proper return for its level of risk. If the value is positive,
then the portfolio is earning excess returns. In other words, a positive
value for Jensen's alpha means a portfolio manager has "beat the market"
with his or her stock picking skills.
458
Jensen's alpha = Portfolio Return - [Risk Free Rate + Portfolio Beta × Portfolio
Management
(Market Return - Risk Free Rate)] Services

17.9 SEBI REGULATORY FRAMEWORK ON

PMS
PMS is regulated by the Securities Exchange Board of India (SEBI). The
objective behind this regulation is to keep market for PMS free of fraudulent
activities and malpractices. Before 1993, PMS was unregulated business
activity. But as the PMS started gaining momentum, the SEBI felt need to
introduce regulations in respect of PMS to enhance the security of investor’s
funds and answerability of the portfolio managers. On June 7, 1993, the SEBI
issued detailed guidelines on PMS. With the introduction of these guidelines
the industry for PMS was formalised and recognised. As the market for PMS
grew, the rules and regulations governing the market for PMS also got
updated with time. Multiple amendments were made in the guidelines on
PMS from 1993 to 2021 to meet new challenges and demands from the PMS
industry.

17.9.1 SEBI Regulations for PMS

As stated above, considering PMS investment risk, the SEBI has introduced
many regulations for the PMS industry. Some of the important SEBI’s
regulations on PMS are as follows:

1) PMS Service provider should have a SEBI approved license for offering
PMS Services. PMS Service provider should furnish their financial
results to SEBI on a half yearly basis.

2) SEBI does not approve of any scheme or service related to the PMS. Both
portfolio manager and investor have to decide about PMS and enter into
an agreement for the same. The portfolio manager has to provide a
disclosure document to the customer at least two days prior to entering
into an agreement with the client. The disclosure document contains the
quantum and manner of payment of fees payable by the customer for each
activity, portfolio risks, complete disclosures in respect of transactions
with related parties, the performance of the portfolio manager and the
audited financial statements of the portfolio manager for the immediately
preceding three years.

3) The PMS minimum investment threshold for an investor or trader has

been set at Rs 50 lakh.

4) The agreement between a portfolio manager and investor must cover,

inter alia, relationship, liabilities, mutual rights and obligations about
fund (corpus) and portfolio management.

5) The fees of portfolio manager cannot be paid up front. It should be paid at

regular intervals until the investment is withdrawn. The operational fees
459
Emerging Issues in excluding brokerage cannot exceed 0.5 per cent per annum of the
Financial Services
customer’s average asset under management (AUM).

6) A maximum exit load of three per cent can be charged in the first year,
two per cent in the second year, and one per cent in the third year. No exit
load applicable after three years.

7) The customer’s will have to be on board directly, avoiding customer’s

engagement with the intermediaries and distributors.

8) A monthly report of the investment is sent to the investors by the

portfolio manager. This report , inter alia, must cover performance
reported net of expenses and after-tax. The performance return has to
include cash holdings, investments in liquid funds, the composition and
value of the portfolio along with a description of securities and goods and
aggregate value of the portfolio as on the date of the report.

9) It is mandatory for operators of PMS schemes to disclose the details of

distributors’ commissions to the investors every quarter.

10) The investors can get their complaints redressed by the investor relations
officer. The details of contact are mentioned in the disclosure document.

17.9.2 SEBI Regulations For Portfolio Manager Under PMS

The SEBI has issued regulations for portfolio managers. Some of the
important regulations are as follows:

1) Portfolio manager has to report regularly on investment portfolio

including performance of various asset groups to the investor.

2) Portfolio manager has to deal on portfolio management directly with

the customer without involving intermediary or third party in the
transaction/s.

3) Portfolio manager cannot accept fee for his/her services on upfront.

4) Portfolio manager has to use his/her own demat account or the

customer’s demat account for executing deals in financial assets like
shares, debentures and commercial papers etc,. on behalf of customers.

5) Portfolio manager is permitted to invest in derivatives for the purpose

of hedging and portfolio rebalancing, through a recognized stock
exchange. However, leveraging of portfolio is not permitted in respect
of investment in derivatives. The total exposure of the customer in
derivatives should not exceed his/her portfolio funds placed with the
portfolio manager.

6) Portfolio manager should basically invest and not borrow on behalf of

his/her customers.

460
7) Portfolio manager has to maintain an audit trail of all activities related Portfolio
Management
to the management of funds including order placement, trade execution Services
and allocation. Further, time stamping with respect to order placement,
order execution and trade allocation has to be maintained.

8) Portfolio Managers with assets under management (AUM) of Rs. 1000

crore or more under discretionary and non-discretionary services, must
have an automated system with minimal manual intervention for
ensuring effective funds and securities management.

9) Portfolio manager cannot offer indicative or guaranteed returns to the

customer.

10) Portfolio manager cannot impose a lock-in on the investment of their

customers. However, a portfolio manager can charge applicable exit
fees from the customer for early exit, as laid down in the agreement
subject to regulations of the SEBI.

11) Portfolio managers have to ensure that the ‘dealing team’ which is
responsible for order placement and execution has restricted access to
mobile phones, computers and other devices to protect sharing of
information.

12) Portfolio managers have to frame specific policies with respect to the
management of customer funds including the order placement,
execution of orders, trade allocation amongst customers and other
related matters.

17.9.3 Portfolio Manager Requirements

As per the SEBI’s regulations, to become a portfolio manager one needs to
fulfil a few criteria. Some of the mandatory requirements are as follows:

1) Portfolio manager must be registered with the SEBI.

2) The registration certificate for a portfolio manager is valid for three years.
Hence, once a period of three years gets over, it must be renewed.

3) The minimum net worth requirement for an investment advisor is Rs 50

lakhs.

4) The minimum net worth requirement for a portfolio manager is Rs 5

crore. Practising Chartered Accountant has to certify the minimum
specified net worth of portfolio managers of Rs 5 crore.

17.10 DEVELOPMENTS IN INDIAN MARKET

PMS can be offered only by entities having specific SEBI registration for
rendering portfolio management services. Currently in India PMS is offered
primarily by asset management companies (AMCs) and brokerage houses. As
per the SEBI norms, portfolio manager is considered as a capital market
intermediary. The portfolio managers are required to invest funds of their 461
Emerging Issues in customers in the securities listed and traded only on a recognised stock
Financial Services
exchange, money market instruments, units of mutual funds, and other
securities as specified by the board from time to time. SEBI has taken
several steps to bring transparency in the working of PMS that includes
standardised NAV (Net Asset Value) based returns and the details of the
sharing distribution fees.

The number of portfolio managers registered with the SEBI during 2016-17
to 2020-21 is given below:
Year Number of Portfolio Managers
------------ -----------------
2020-21 359
2019-20 351
2018-19 315
2017-18 290
2016-17 218

The above data shows that there has been continuous increase in the number
of registered portfolio managers. The asset management companies and
brokerage houses offer three types of PMS namely discretionary, non-
discretionary and advisory portfolio management services. By end of August
2022 ,Over 350 portfolio managers were providing discretionary, non-
discretionary and advisory portfolio management services in India,
collectively managing a whopping AUM of Rs 25.62 lakh crores with a
customer base of 124637. More than 85 per cent of total PMS business has
been in the nature of discretionary PMS.

Based on the ranking parameters such as returns, number of clients, charges,

support and goodwill, best PMS companies in India are as follows:

• Porinju Veliyath Equity Intelligence PMS

• Motilal Oswal Next Trillion-Dollar Opportunity PMS (NTDO)
• Birla Sunlife PMS
• Kotak PMS
• ICICI Prudential Portfolio Management Services

The table below lists the top PMS Companies in India with fee structure

PMS Fixed Fee Performance Fee Brokerage and Exit

Company (per annum) Load
Porinju 2% 10% of returns –
Veliyath above 10% p.a
Motilal 2% – 2.25% – 0.3% brokerage per
Oswal transaction; 1% – 2%
load
Kotak PMS 2.5% – 0.1% brokerage per
462
 transaction; 3%, 2%, Portfolio
1% year-wise load Management
Services
ICICI PMS 1% – 3% – 2% – 2.5% load
Birla Sun 2.5% – 1.2% – 2.2%
Life PMS

Source: PMS Websites, Tavaga Research

The fee arrangements are varied depending upon the strategy under PMS.
Some PMS Companies charge fees based on the commission model opted by
both the parties. Funds may also be subject to an exit load. Other
discretionary funds may outline the profit-sharing arrangement at the
inception of the agreement.

The Association of Portfolio Managers of India (APMI) was incorporated on

31st December 2021 as a self-regulatory organisation to support PMS
industry. The AMPI is expected to take all the necessary steps for
implementing the SEBI’s regulations and guidelines on PMS. SEBI has
mandated the portfolio managers to utilize the services of certified
distributors who have AMFI registration numbers or have cleared the NISM
Services V-A exam.

17.11 INCOME TAX ASPECT OF PMS

The portfolio manager is a trustee acting in a fiduciary capacity on behalf of
the investor. Therefore, the tax liability for a PMS investor would remain the
same as if the investor is accessing the capital market directly. Any income
from the Portfolio Management Services account is a business income. Each
Portfolio Management Services account is in the name of an investor and so
the tax treatment is done on an individual investor level. Profit on the same
can be considered as business income. Profit can be considered in the form of
Short Term Capital Gain [STCG (15%)] or Long Term Capital Gain [LTCG
(10%)]. It depends on the customer’s Chartered Accountant or the assessing
officer how he treats this Income. The PMS provider sends an audited
financial statement at the end of the financial year giving details of STCG
and LTCG. It is for the customer and his Chartered Accountant to decide
whether to treat it as capital gain or business income.

17.12 SUMMARY
Portfolio Management Service (PMS) is a distinct fee based financial service.
Such service is considered as a part of investment banking business. PMS is
altogether different from mutual fund. For an investor with limited time and
no knowledge of financial markets and investment management, PMS is a
suitable option for managing wealth given the investment management
institution is reputed and offers transparency of operations. PMS is a
customized service offered to High Net-worth Individuals (HNI) customers.
Under PMS portfolio manager manages portfolio of assets on behalf of a
customer. The portfolio of assets is comprised of company shares, fixed 463
Emerging Issues in income securities, cash, structured finance products and other securities. This
Financial Services
service is tailored as per the investor’s return requirements and the ability and
willingness to assume the investment risk. The PMS is offered in different
forms that includes discretionary, non-discretionary and advisory services.
PMS helps in better realization of diversification benefits than aimlessly
investing in any number of securities. The returns and the performance of the
portfolio are highly dependent on the accuracy of the security analysis done
by the portfolio manager and hence are highly dependent on the competency
of the investment management institution.

The market for PMS is regulated by Securities Exchange Board of India

(SEBI) who has issued detailed regulatory norms subject to which PMS can
be offered to the customers. The first time SEBI regulated the PMS industry
in 1993 and these regulations have been updated from time to time keeping in
view developments in financial markets, demand from industry and
information technological advancements. PMS is provided either by Asset
Management Companies (AMCs) or by Brokerage Firms. If AMC is
providing the PMS then they charge fees. But if PMS is provided by the
Brokerage House then they charge fees and commission. The SEBI in recent
past has taken several steps to develop market for PMS. The SEBI has been
striving to bring the PMS industry at par with the MF industry in terms of
investor-friendliness. Mutual funds have been unable to perform consistently,
and PMS’s have stepped in to gain market share. Investors who were
traditionally seen investing in real estate and mutual funds have now resorted
to PMS schemes. The spur in demand of PMS in India is in conjunction with
the regulatory ecosystem in place to prevent misappropriation of funds and
other malpractices.

17.13 KEY WORDS

Discretionary PMS: Under discretionary PMS, the choice of the investment
decisions and timing of implementing the same rest solely with the Portfolio
Manager. This provides portfolio managers with the flexibility to react
quickly to fast changing market conditions and economic circumstances. The
portfolio manager is given complete control of the portfolio and is free to
adopt any strategy which is suitable to achieve the objectives of portfolio.

Non-Discretionary PMS: Under Non-discretionary PMS, the portfolio

manager only suggests the investment ideas and desired composition of
investment portfolio. The choice as well as the timing of the investment
decisions rest solely with the customer. However, the execution of trade deals
is done by the portfolio manager.

Advisory PMS: Under these services, the portfolio manager only suggests
the investment ideas. The choice as well as the execution of the investment
decisions rest solely with the Investor. Some investors are such that they
prefer to have more control over their portfolios, and thus in case of advisory
services the portfolio manager contact clients to make/ give
464
recommendations for managing investment portfolio and execution of deals. Portfolio
Management
Services
Active Portfolio Management: This form of portfolio management aims at
beating the performance of a market index such as BSE Sensex or NSE Nifty.
An active portfolio manager will take different positions than that of the
tracking index, actively buy and sell securities as per institutional research to
create more returns than the index. However, to generate an excess return,
this strategy undertakes a higher level of risk.

Passive Portfolio Strategy: Under this strategy a portfolio manager makes

as few portfolio decisions as possible, in order to minimize transaction costs,
including the incidence of capital gains tax. One popular method is to mimic
the performance of an externally specified index - called 'index funds’.
Investors that do not aspire to receive a return in excess of a benchmark index
will often invest in an index fund that replicates as closely as possible the
investment weighting and returns of that index; this is called passive portfolio
management.

Portfolio Manager: A portfolio manager is a body corporate, which,

pursuant to a contract with a client, advises or directs or undertakes on
behalf of the client (whether as a discretionary portfolio manager or
otherwise) the management or administration of a portfolio of securities or
goods or funds of the client. Portfolio Management Service (PMS)

PMS: Portfolio management service is a fee based financial service. Under

PMS portfolio manager, who is an expert in investment management, provide
assistance to the customer in building up and maintaining a balanced
investment portfolio. The portfolio manager gives advice and acts to reduce
losses and maximize profit.

17.14 SELF-ASSESSMENT QUESTIONS

1) What do you mean by Portfolio Management Service? Explain how
portfolio management service is different from mutual fund

3) Explain the relevance of Portfolio Management Service

4) Who can provide portfolio management service? Explain SEBI’s

guidelines on portfolio management service.

5) Discuss various guidelines issued by SEBI on PMS

6) Define the following terms in the context of PMS

i) Discretionary Portfolio Management
ii) Non-discretionary Portfolio Management
iii) Advisory Portfolio Management
iv) Active Portfolio Strategy
v) Passive Portfolio Strategy
465
Emerging Issues in
Financial Services
17.15 FURTHER READINGS
1) Khan, M.Y., Financial Services, Latest Edition, Tata McGraw Hill
Publishing Co. Ltd.

2) Prasanna Chandra., Investment Analysis and Portfolio Management,

Latest Edition, Tata McGraw Hill Publishing Co Ltd.

3) Dr. G Ramesh Babu, Portfolio Management (including Security

Analysis), Latest Edition,

4) V Pattabhi Ram and S D Bala, First Lessons in Management Accounting

and financial Analysis, Snow White Publication, Chennai, Latest Edition.

5) Web Site of Securities and Exchange Board of India(SEBI) (SEBI’s

Regulations on PMS)

6) Vinod K Singhani, Taxmann’s Direct Taxes Ready Reckoner,

Assessment Years 2021-22 & 2022-23, Delhi.

7) Web Site of Leading PMS Asset Management Companies like Birla

Sunlife PMS, Kotak PMS, ICICI Prudential PMS, Motilal Oswal PMS,
HDFC PMS and Angel Broking

466