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INDIAN FINANCIAL ENVIRONMENT

OBJECTIVE : The present lesson discusses Indian Financial Environment including the
institutions and instruments comprising it.

STRUCTURE
12.1 Introduction
12.2 Financial Institutions
12.3 Financial Markets
12.3.1 Money Market
12.3.2 Capital Market
12.4 Financial Instruments
12.5 Summary
12.6 Self Assessment Questions

12.1 introduction
Economic growth and development of any country depends upon a well-knit financial
system. Financial System comprises, a set of sub-systems of financial institutions financial
markets, financial instruments and services which help in the formation of capital. It provides a
mechanism by which savings are transformed into investments. Thus, a financial system can be
said to play a significant role in the economic growth of a country by mobilizing the surplus
funds and utilizing them effectively for productive purposes.
The financial system is characterized by the presence of an integrated, organized and
regulated financial markets, and institutions that meet the short terms and long terms financial
need of both the household and corporate sector. Both financial markets and financial institutions
play an important role in the financial system by rendering various financial services to the
community. They operate in close combination with each other. The following are the four major
components that comprise the Indian Financial System :
1. Financial Institutions
2. Financial Markets
3. Financial Instruments/Assets/Securities

12.2 Financial Institutions

Financial institutions are the intermediaries who facilitate smooth functioning of the
financial system by making investors and borrowers meet. They mobilize savings of the surplus
units and allocate them in productive activities promising a better rate of return. Financial
institutions also provide services to entities (individual, business, government) seeking advice
on various issues ranging from restricting to diversification plans. They provide whole range of
services to the entities who want to raise funds from the markets or elsewhere.
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Financial Institutions are also termed as financial intermediaries because they act as
middlemen between the savers (by accumulating funds from them) and borrowers (by lending
these funds). Banks also act as intermediaries because they accept deposits from a set of
customers (savers) and lend these funds to another set of customers (borrowers). Like-wise
investing institutions such as GIC, LIC, mutual funds etc. also accumulate savings and lend these
to borrowers, thus performing the role of financial intermediaries.
Financial institution’s role as intermediary differs from that of a broker who acts as an
agent between buyer and seller of a financial instrument (equity shares, preference, debt); thus
facilitating the transaction but does not personally issue a financial instrument. Whereas,
financial intermediaries mobilize savings of the surplus units and lend them to the borrowers in
the form of loans and advances (i.e. by creating a financial asset). They earn profit from the
difference between rate of interest charged on loans and rate of interest paid on deposits
(savings). In short, they repackage the depositor’s savings into loans to the borrowers.

12.3 Financial Markets

Finance is the pre-requisite for modern business and financial institutions play a vital role in the
economic system. It is through financial markets and institutions that the financial system of an
economy works. Financial markets refer to the institutional arrangements for dealing in financial
assets and credit instruments of different types such as currency, cheques, bank deposits, bills,
bonds, etc.
Financial markets may be broadly classified as negotiated loan markets and open
markets. The negotiated loan market is a market in which the lender and the borrower personally
negotiate the terms of the loan agreement, e.g. a businessman borrowing from a bank or from a
small loan company. On the other hand, the open market is an impersonal market in which
standardized securities are treated in large volumes. The stock market is an example of an open
market. The financial markets, in a nutshell, are the credit markets catering to the various credit
needs of the individuals, firms and institutions. Credit is supplied both on a short as well as a
long term basis.

Functions
The main functions of the financial markets are :
(i) to facilitate creation and allocation of credit and liquidity;
(ii) to serve as intermediaries for mobilization of savings;
(iii) to assist the process of balanced economic growth;
iv) to provide financial convenience; and
(v) to cater to the various credit needs of the business houses.

Types of Financial Market

On the basis of credit requirement for short-term and long term purposes, financial
markets are divided into two categories :
1. Money Market
2. Capital Market
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12.3.1 Money Market

The term money market is used in a composite sense to mean financial institutions which
deal with short-term funds in the economy. It refers to the institutional arrangements facilitating
borrowing and lending of short-term funds. The money market brings together the lenders who
have surplus short term investible funds and the borrowers who are in need of short-term funds.
In a money market, funds can be borrowed for a short period varying from a day, a week, a
month, or 3 to 6 months and against different types of instruments, such as bill of exchange,
banker’s acceptances, bonds, etc., called ‘near money’. Thus money market has been defined by
Crowther as, “the collective name given to the various firms and institutions that deal in the
various grades of near money”.
The Reserve Bank of India describes the money market as, “the center for dealings,
mainly of a short-term character, in monetary assets, it meets the short-term requirements of
borrowers and provides liquidity or cash to the lenders”. The borrowers in the money market are
generally merchants, traders, manufacturers, business concerns, brokers and even government
institutions. The lenders in the money market, on the other hand, include the Central Bank of the
country, the commercial banks, insurance companies and financial concerns.
The organization of the money market is formed. There is no definite place or location
where money is borrowed and lent by the parties concerned, it is not necessary for the borrowers
and the lenders to have a personal contact with each other. Negotiations between the parties may
be carried through telephone, telegraph or mail. Thus, money market is simply an arrangement
that brings about a direct or indirect contact between the lender and the borrower.

Functions of the Money Market

The money market performs the following functions :
1. The basic function of money market is to facilitate adjustment of liquidity

position of commercial banks, business corporations and other non-bank financial

institutions.

2. It provides outlets to commercial banks, business corporations, non-bank financial

concerns and other investors for their short-term surplus funds.
3. It provides short-term funds to the various borrowers such as businessmen, industrialists,
traders etc.
4. Money market provides short-term funds even to the government institutions.
5. The money market constitutes a highly efficient mechanism for credit control. It serves as
a medium through which the Central Bank of the country exercises control on the
creation of credit.
6. It enables businessmen to invest their temporary surplus for a short-period.
7. It plays a vital role in the flow of funds to the most important uses.

Structure of Money Market

The structure of money market can be studied as follows :
Money Market
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Components Institutions Instruments

The Components or Sub Markets of Money Market

The money market is not homogenous in character. This is a loosely organized
institution with a number of divisions and sub-divisions. Each particular division or sub-
division deals with a particular type of credit operations. All the sub-markets deal in short-term
credit. The following are the important constituents or sectors of money markets :

Money Market

Call Money Collateral Loan Acceptance Bill Market

Market Market Market

1. Call Money Market

Call money market refers to the market for very short period. Bill brokers and dealers in
stock exchange usually borrow money at call from the commercial banks. These loans are given
for a very short period not exceeding seven days under any circumstances, but more often from
day-to-day or for overnight only i.e. 24 hours. There is no demand of collateral securities against
call money. They posses high liquidity, the borrowers are required to pay the loan as and when
asked for, i.e. at a very short notice. It is on account of this reason that these loans are called ‘call
money’ or call loans. Thus, call money market is an important component of the money market.
The investment of funds in the call market meets the need of liquidity but not that of
profitability because the rate of interest on call loans is very low and changes several times
during the courses of the day. Call loans are useful to the commercial banks because these can be
converted into cash at any time. They are almost like cash. It is a form of secondary cash
reserves for the commercial banks from which they earn some income too.

2. Collateral Loan Market

It is another specialized sector of the money market. The market for loans secured by
stocks and market is geographically most diversified and most loosely organized. The loans are
generally advanced by the commercial banks to private parties in the market. The collateral loans
are backed by the securities, stocks and bonds. The collateral securities may be in the form of
some valuable, say government bonds which are easily marketable and do not fluctuate much in
prices. The collateral money is returned to the borrower when the loan is repaid. Once the
borrower is unable to repay the loan, the collateral becomes the property of the lender. These
loans are given for a few months. The borrowers are generally the dealers in stocks and shares.
But even smaller commercial banks can borrow collateral loans from the bigger banks.

3. Acceptance Market
Bank’s acceptances are very old form of commercial credit. Acceptance market refers to
the market for banker’s acceptances involved in trade transactions. This market deals with
banker’s acceptances which may be defined as a draft drawn by a business firm upon a bank and
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accepted by it. It is required to pay to the order of a particular party or to the bearer a certain
specific amount at a specific date in the future. These acceptances emerge out of commercial
transactions both within the country and abroad. The market where the banker’s acceptances are
easily sold and discounted is known as acceptance market. Raymond P. Kent, in his book
‘Money and Banking’ has stated that banker’s acceptance is “a draft drawn by an individual or
firm upon a bank and accepted by the bank whereby it is ordered to pay to the order of a
designated party or to bearer a certain sum of money at a specified time in future.” There is a
distinction between a banker’s acceptance and a cheque. A banker’s acceptance is payable at a
specified future date whereas a cheque is payable on demand. Banker’s acceptances can be easily
discounted in the money market because they carry the signature of the bankers.
In case of acceptance houses, no bank funds are involved. The bank has merely added its
guarantee to the draft. But a note-worthy point is that the banker’s acceptances are used
primarily in international trade. In the London Money Market there are specialized firms known
as accepting houses which accept bills drawn on them by traders instead of drawing on the true
debtors. In the past the acceptance houses were very important in the London Money Market but
now their importance has declined considerably. In the Indian Money Market these have no
significance because there is no development of the acceptance market.

4. Bill Market
It is a market in which short term papers or bills are bought and sold. The important types
of short term papers are : (a) Bills of exchange (b) Treasury bills.
(a) Bills of exchange. Bills of exchange are commercial papers. A bill of exchange is a
written unconditional order which is signed by the drawer requiring the drawee to pay on
demand or at a fixed future time, a definite sum of money. Once the buyer signifies his
acceptance on the bill itself, it becomes a legal document. Such bills are discounted or
rediscounted by commercial banks to lend credit to the bill-holders or to borrow from the central
bank.
(b) Treasury bills. The treasury bills are government papers securities for a short period
usually of 91 days’ duration. The treasury bills are the promissory notes of the government to
pay a specified sum after a specified period. These are sold by the central bank on behalf of the
government. An important aspect of a treasury bills is that there is no fixing of rate of interest
beforehand. The treasury offers the bills on the basis of competitive bidding, so one who is
satisfied with minimum interest would be allotted the bills. Since the treasury bills are
government papers, they inspire public confidence in the minds of the investors. As no risk is
involved in their purchase, they become good papers for the commercial banks to invest their
short term funds. Since discounting is the main process of exchange, so it is called ‘discount
market’ also. A pertinent point is that the market for bonds, government long term loan market or
treasury bonds, and the stock exchange, etc. deal with a long period; so they cannot be regarded
as constituents of money market.
Thus from the above discussion it is clear that different markets form part of money
market. The call money market, for example, refers to the borrowing and lending of call loans
and advances. The loans backed by securities, stocks and bonds are called collateral loans. The
acceptance market refers to the acceptances of bills which leads to the discounting of bills. The
bill market refers to buying and selling of bills.
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The Institutions of Money Market

The institutions of money markets are those which deal in lending and borrowing of short
term funds. The institutions of money market are not the same in all the countries of the world,
rather they differ from country to country. The commercial banks, central banks, acceptance
houses, non-banking financial intermediaries (NBFI), brokers, etc. are the major institutions of
money market. These are discussed as under :
1. Commercial Banks. Commercial banks are the back bone of the money market. They
form one of the major constituents of money market. These banks use their short term deposits
for financing trade and commerce for short periods. The commercial banks invest their funds in
the discounting of bills of exchange, i.e. both exchange bills or commercial bills and treasury
bills or government bills to facilitate trade and commerce by mobilizing the flow of money. The
commercial banks lend against promissory notes and through advances and overdrafts. The call
money loans are also provided by these banks to the bill brokers and dealers in the stock
exchange market. The commercial banks put their excess reserves in different forms or channels
of investments which satisfy their conflicting principles of liquidity and profitability. The aim is
that the funds invested not only remain liquid in form but also earn high interest or yield income
on them. A noteworthy point is that in addition to commercial banks there are cooperative
banks, savings banks, financial companies, etc. also which form part of the money market.
2. Central Bank. The central bank plays a vital role in the money market. It is the
monetary authority and is regarded as an apex institution. No money market can exist without the
central bank. The central bank is the lender of the last resort and controller and guardian of the
money market. The member banks may approach the central bank for loans and advances during
emergency. It controls and guides the institutions working in the money market. It raises or
reduces the money supply and credit to ensure economic stability in the economy.
In other words, it helps in averting the possibilities of inflation and deflation. A pertinent
point is that the performance of the central bank depends on the character and composition of the
money market. But the central bank does not enter into direct transactions, it controls the money
market through changes in the bank rate and open market operations.
3. Acceptance Houses. The acceptance houses and bill brokers are the main institutions
dealing in the bill market. The institution of acceptance houses developed in England where
merchant bankers transferred their headquarters to London Money Market in the late 19th and the
early 20th century. They function as intermediaries between importers and exporters, and
between lenders and borrowers in the short period. In the London Money Market the acceptance
houses performed a very useful role as merchant bankers. These houses specialized in the
acceptance of trade bills/commercial bills. They accepted those bills which were drawn on
merchants whose financial standing was not known in order to make the bills negotiable in the
London Money Market. In this way, they handled the international transactions without any
problem. A noteworthy point is that by accepting a trade bill, they guaranteed the payment of the
bill on maturity. For this guarantee, these houses charged a commission. The discounting of
such accepted bills was done by another specialized agency known as ‘discount houses’. This
institution was an important segment of the London Money Market in the past but now its
importance has declined because the commercial banks have undertaken the business of
acceptance houses.
4. Non-banking Financial Intermediaries. In addition to commercial banks, there are
non-banking financial intermediaries who resort to lending and borrowing of short term funds in
the money market. In non-banking financial intermediaries, savings banks, investment houses,
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insurance companies, building societies, provident funds and other business corporations like
chit funds are included.
5. Bill Brokers. In the developed money markets like the London Money Market and the
New York Money Market, private companies act as discount houses. The main function of these
companies is to discount bills on behalf of others. Besides these companies, there are bill-brokers
who work as intermediaries between the borrowers and lenders by discounting bills of exchange
at a small commission. In an under-developed money market, bill brokers are quite important
intermediaries.

Money Market Instruments

The following are the money market instruments :
(a) Treasury Bill. Treasury bill represents short-term borrowings of the government.
Treasury bill market refers to the market where treasury bills are bought and sold. Treasury bills
may be classified into four categories :
14-day treasury bill : it was introduced on May 20, 1997. The auction of 14-day treasury
bills are held on a weekly basis. The 14-day intermediate treasury bills were introduced on April,
1997. It was introduced to cater to the needs of investing the surplus funds of state government,
foreign and central banks, etc.
91-day treasury bills : There are two types of 91-day treasury bills, namely, (i) ordinary
treasury bills and (ii) ad hoc treasury bills. ‘Ordinary’ treasury bills are issued to the public and
other financial institutions for meeting the short-term financial requirements of the central
government. These bills are freely marketable; can be bought and sold at any time; and have a
secondary market.
‘Ad hoc ‘ treasury bill is always issued in favour of the RBI. These are not sold through
tender or auction. The ad hoc treasury bills are purchased by the RBI on tap and RBI is
authorized to issue currency notes against them. The holder of these bills can always sell them
back to the RBI.
182-day treasury bills : These are introduced by RBI and initially issued by RBI on
monthly basis. RBI does not purchase the treasury bills before the maturity period but they can
be sold by the investors in the secondary market through Discount and Finance House of India
(DFHI). The DFHI makes advances getting the financial support from RBI.
364-day treasury bills : It was introduced in at the end of April 1992. These are sold
through auction which is conducted once in a fortnight. The 364-day treasury bills have become
popular due to their higher yield with liquidity and safety. These bills are not rediscountable with
the Reserve Bank of India.
(b) Commercial bills : Banks make advances to the customers against commercial bills. In
the needs of fund by bankers it can be rediscounted in the money market to get ready money.
This rediscount period is 90 days but it can be rediscounted earlier in the secondary market.
(c) Inter bank call money : The inter bank call money market is the core of the formal
money market. Banks borrow from the call money market in order to meet sudden demand for
funds for payments and to obtain funds to meet any likely shortfalls in their cash reserves to
meet the Cash Reserve Ratio (CRR) stipulation. In India, inter bank call money market is the
single most important source for banks for getting overnight and short-term funds.
(d) Commercial paper : Commercial paper is a short-term unsecured instrument issued by
a company in the form of promissory notes with fixed maturities. The maturity period ranges
from 15 days to less than 1 year. Since it is a short-term debt, the issuing company is required
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to meet dealers’ fees, rating agency fees, and any other relevant charges. Commercial Paper (CP)
has gained popularity all over the world because it provides funds at a relatively lower cost.
Another important feature of CP is that through this instrument the firm may raise large amount
of funds which is not possible through a single bank.
Eligibility for issue of commercial paper. In India, the emergence of CP has added a new
dimension to the money market. Hence, the RBI has relaxed the initial guidelines which were
laid down for the issue of CPs. The following are the guidelines governing the issue of
commercial paper :
(i) The CP has to be issued at discount in the forms of promissory note where interest is
always front-ended and maturity value is always equal to face value.
(ii) The issuing firm must have a net worth of at least Rs. 4 crores and the company

should have fund based working capital limit of Rs. 4 crores.

(iii) The current ratio should be 1.33:1 and debt-equity ratio not more than 1.5:1.
(iv) It must have a credit rating of P2/A2 or higher from the CRISIL/ICRA of not less than
two months old at the time of issue of CP but this condition has become optional since
the latter part of 1994.
(v) The RBI has made mandatory for banks, consortia, and syndicates to restrict the cash
credit component to 75 per cent of the maximum permissible bank finance and the overall
capacity of each borrower to issue CPs is 56 per cent of a borrower’s maximum
permissible bank finance.
(vi) The company must be listed on one or more stock exchanges but the Government
companies are exempted from this stipulation.
(vii) The issue of a CP also bears the expenses of stamp duty and requires to obtain the
approval of the Reserve Bank for each issue of the commercial paper.
(viii) Now the RBI has abolished the facility of stand by arrangement as a result, it is no longer
mandatory for banks to automatically restore the cash credit limits of corporate bodies.
(ix) CP can be issued to any person or corporate bodies registered or incorporated in India
(including banks), as well as non-incorporated bodies.
(x) The issuing company is required to appoint a bank or leader of the consortium bank to
verify the signature of the issuing company who have signed in the CP.
(xi) The issuing company is required to appoint a dealer who would arrange the investor for
the commercial paper.
(xii) CP is generally issued at a discount and is freely transferable by endorsement. Its delivery
is not subject to tax deducted at source.
(xiii) The face value of a single commercial paper should not be less than Rs. 25 Lakh and in
multiples of Rs. 5 Lakh thereafter.
(xiv) The commercial paper shall be issued for a minimum maturity period of 15 days to one
year.
(xv) The minimum size of an issue is R. 1 crore and the minimum unit of subscription is Rs.
25 lakh.
Advantage of commercial papers : The advantage of CPs lies in the simplicity they offer, as large amounts can be raised without
having any underlying transaction. Secondly, CPs provide flexibility to the company to raise funds in the money market wherever it is
favorable. Thirdly, CPs can raise fund from the inter corporate market which is not under the control of any monetary authority. Also CPs
provide cheapen finance to the borrowers and at the same time offer good rate of return to the investors.
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(e) Certificate of Deposit (CD) : This is a bearer certificate and is negotiated in the market.
CDs can be issued by scheduled commercial banks at a discount on face value and the discount
rates are determined by the market. CDs were introduced in June 1989. The minimum
denomination of CD was reduced to Rs. 1 Lakh in June 2002, and new and outstanding CDs
were converted to demat form by October 2002. It should be noted that maturity period and
interest rates are no longer controlled by RBI and the instrument has now become a market
determined instrument. The RBI guidelines for the issue of CDs can be listed as follows :
RBI guidelines
(i) The denomination of CDs should be in multiples of Rs. 5 lakh subject to the
condition that minimum size of an issue to a single investor is Rs. 25 Lakh.
(ii) CDs can be issued to individuals, corporations, companies, trust funds, associations,
etc. Non Resident Indians can also subscribe to CDs but only on non- repatriation basis.
(iii) The maturity period of CDs should not be less than 3 month and not more than a year.
The minimum lock-in-period for CDs is 15 days.
(iv) Banks have to maintain CRR and SLR on the price of issue of CDs.
(v) CDs are freely transferable by endorsement and delivery but only after 45 days of the
date of issue to the primary investor.
(v) CDs are freely transferable by endorsement and delivery but only after 45 days of the
date of issue to the primary investor.
(vi) CDs are issued in the form of usual promissory notes payable on a fixed date
without any grace period. CDs are subject to the payment of stamp duty.
(vii) Banks cannot grant loans against CDs an neither can they buy back their own CDs
before maturity.
(f) Repurchase option : The major development in the government securities market is the
introduction of a repurchase facility. This instrument of Repurchase Agreement (REPOs)
between the RBI and commercial banks started in December 1992. REPO includes the
acquisition of funds through sale of agreed securities and is simultaneously committed to
repurchase the same at a predetermined price, generally within a period of 14 days to one year.
REPO is thus a collateral borrowing and represents a liability to the seller at the purchase price,
and effects the conceptual obligations to transfer funds to the banks on the date of maturity of
agreement. To improve the transmission mechanism of monetary policy and further develop the
money and debt markets in the light of the recommendations made by the “Narasimhan
Committee” it has been decided to develop the REPOs market with appropriate regulatory
safeguards. These safeguards include delivery versus payment, uniform accounting, valuation
and disclosure norms, and restricting REPOs to instruments held in dematerialized form with a
depository. These prudential safeguards have been designed to ensure transparency and
accountability as also at the same time increasing liquidity and depth in the securities market.
Accordingly, it has been decided to allow UTI, LIC, IDBI and other non-bank participants in the
money market to access short-term liquidity through REPOs thereby facilitating their cash
management and gradual move out of the call money market.
(g) Money market mutual funds : In order to create an additional short-term avenue for
investment and to bring money market instrument within the reach of individuals and smaller
bodies, the Reserve Bank of India set up money market mutual funds (MMMFs) in April 1991.
The MMMFs invariably and excessively invest their investing resources in very high quality
money market instruments. Recently, some liquid schemes of private sector mutual funds have
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started offering ‘cheque writing’ facility. Such facility provides more liquidity to unit holders
and hence has been advocated in the interest of the savers investors.
RBI guidelines for setting up MMMFs : The RBI announced norms for setting money market
mutual funds on April 21, 1992. The following are the guidelines for setting up MMMFs:
1. Eligibility : Scheduled commercial banks and public financial institutions can set up
MMMFs under section 4A of the Companies Act, 1956 or through their existing mutual
funds/subsidiaries engaged in funds management.
2. Structure : MMMFs can be set up departmentally in the form of a division/department
of the bank i.e. “in house” MMMFs wherein the assets and liabilities of such MMMFs
would form a part of the banks’ balance sheet or a separate entity i.e. a “trust”.
(i) MMMFs can be operated either as money market deposit accounts or MMMFs. Money
market deposit accounts scheme can be operated either by issuing a deposit receipt or
through the issue of passbook without cheque book facilities. The MMMFs can float both open-
ended and schemes. According to the RBI’s credit policy announced on October 29, 1999
MMMFs can be set up only as trusts for operational convenience.
(ii) When MMMFs are set up as a trust, the sponsoring bank should appoint a board of
trustees to manage it.
(iii) The day-to-day management of the schemes under the fund, as may be delegated by the
board of trustees where the fund is set up as a trust, should be looked after by a full time
executive trustee or a separate fund manager if set up as division of a bank or a financial
institution.
(iv) The banks and public financial institutions are free to formulate special schemes as
per their requirements, subject to the guidelines stipulated by the RBI. The
MMMFs have to forward the details of the scheme together with the copies of
the offer letter, application form and so on to the RBI, at least one month before
announcing the launch of any scheme.
3. Size of MMMFs : There is no restriction on the minimum size of MMMFs. There are
also no ceilings for raising resources under various schemes by MMMFs.
4. Subscriber : MMMFs can be issued only to individuals. Individuals, inclusive of Non
Resident Indians (NRIs), may also subscribe to shares/units of MMFs on a repairable
basis.
5. Minimum size of investment : MMMFs are free to determine the minimum size of
investment by a single investor. The investor cannot be guaranteed a minimum rate of
return on investment while announcing any scheme.
6. Minimum period : The minimum lock-in-period is 15 days.
7. Investments : The resources mobilized are invested exclusively in various money market
instruments like treasury bills, call/notice money, commercial paper, and certificates of
deposits.
8. Resource requirements : Resource requirements do not apply to stamp duty.
9. Stamp duty : The shares/units issued by MMMFs are a subject to stamp duty.
10. Insurance cover : The funds invested in a MMMFs do not come under the insurance
cover from the Deposits Insurance and Credit Guarantee Corporation of India. This
aspect must be clearly stated in the offer document of the MMMFs.
11. Delivery of instrument : MMMFs should invariably take delivery of the money market
instruments purchased and must give delivery of the instrument sold.
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12. Format of certificates of MMMFs : The units of MMMFs should be issued in the form
of a certificate indicating the number of units purchased by the investor.
13. Application form : MMMFs may devise suitable application form for subscribing to
their schemes.
14. Security aspect : Since the units are freely transferable, due care must be exercised by
the MMMFs in the matters of printing or ensuring safe custody of the instruments. They
should be signed by two or more authorized signatories.
15. Regulatory authority : The setting up of MMMFs requires prior authorization of
Reserve Bank of India. MMMFs started by a financial institution are required to comply
with the guidelines that may be issued by RBI from time to time.
16. Accounting : The accounts of the MMMFs are to be kept distinct and separate from
those of their parent institutions. In the case of “in house” MMMFs, it is to be ensured
that there is no conflict of interest between the MMMFs and their parent organization.
The transfer of assets between the MMMFs and the sponsoring institutions has to be at
the market rates and is subject to the approval of the Sponsoring Institution Board.
17. Statement of accounts and disclosures : The MMMFs have to maintain a separate
account of each scheme launched by it, segregating the assets under each scheme. They
have to prepare an annual statement of accounts which contain, inter alia, statement of the
assets and liabilities, and the income and expenditure account duly audited by qualified
auditors, other than the auditors of the parent organization. An abridged version of the
annual accounts together with the reports of the auditors has to be published for the
information of the subscriber to the concerned schemes.
18. Management of MMMFs : In house MMMFs have to take adequate measures to ensure
that the management, accounting, and custody of their assets are kept distinct and
separate from those relating the sponsoring institutions.
19. Net asset value : The MMMFs have to calculate the NAV of each scheme and disclose it
periodically for the benefit of the investor. To start with , NAV can be determined and
disclosed once a week.
20. Expenses : The total expenses of the fund including pre-issue expenses, trusteeship
fees/management fees, etc. are to be kept at reasonable levels and disclosed fully in the
fund’s annual reports or balance sheets.
21. Furnishing report to Reserve Bank of India : The sponsor banks and the financial
institutions should furnish to Reserve Bank of India, in duplicate, the following reports
on a regular basis :

(i) The quarterly report indicating the performance of the MMMF as a whole
and each scheme thereof.
(ii) The audited annual statement of accounts, together with the reports of the
auditors.
(iii) Scheme–wise details of the investment portfolio of the funds, value of such
investment charges in portfolio since the annual report and asset-wise exposure.

Discount and Finance House of India (DFHI)

The Discount and Finance House of India (DFHI) was set up in April 1988 in pursuance
of the recommendations of the working group on money market under the chairmanship of Mr.
N. Vaghul. The DFHI was set up jointly by the Reserve Bank of India, public sector banks, and
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financial institutions to deal in short-term money market instruments. The paid – up capital of
Rs. 100 crores was contributed jointly by the RBI (Rs. 51 crores), public sector banks (Rs. 33
crores), and financial institutions (Rs. 16 crores). The main objectives of DFHI are to :

• provide liquidity to money market instruments.

• provide safe and risk free short- term investments avenues to institutions.

• facilitate money market transactions of small- and medium – sized institutions that are
not regular participants in the market.
The main functions of DFHI are as follows :
(1) To discount, discount, purchase and sell treasury bills, trade bills, bills of

exchange, commercial bills and commercial papers.

(2) To play an important role as a lender, borrower, or broker in the inter-bank call money
market.
(3) To promote and support company funds, trusts and other organizations for the
development of short-term money market.
(4) To advise governments, banks, and financial institutions in evolving schemes for growth
and development of money market.
The DFHI participates in the call, notice and term markets as a borrower and as a lender.

Features of the Indian Money Market

In money market short term surplus funds with banks, financial institutions and others are
bid by borrowers i.e., individuals, companies and the Government. In the Indian money market
RBI occupies the pivotal position. The Indian money market can be divided into two sectors i.e.
unorganized and organized. The organized sector comprises of Reserve Bank of India, SBI group
and commercial banks foreign, public sector and private sector. The unorganized sector consists
of indigenous bankers and money lenders. The organized money market in India has number of
sub-markets such as the treasury bills market, the commercial market and inter-bank call money
market. The following are the characteristics of the Indian Money Market :
1. Existence of Unorganized Money Market. The most important defect of the Indian
money market in the existence of unorganized segment. In this segment of the market the
purpose as well period are not clearly demarcated. In fact, this segment thieves on this
characteristic. This segment undermines the role of the RBI in the money market. Efforts
of RBI to bring indigenous bankers within statutory frame work have not yielded much
result.
2. Lack of Integration. Another important deficiency is lack of intergration of different
segments or functionaries. However, with the enactment of the Banking Companies
Regulation Act 1949, the position has changed considerably. The RBI is now almost fully
effective in this area under various provisions of the RBI Act and the Banking
Companies Regulation Act.
3. Disparity in interest rates. There have been too many interest rates prevailing in the
market at the same time like borrowing rates of government, the lending rates of
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commercial banks, the rates of cooperative banks and rats of financial institutions. This
was basically due to lack of mobility of funds from one sub-segment to another.
However, with changes in financial sector the different rates of interest have been
quickly adjusting to changes in the bank rate.
4. Seasonal Diversity of Money Market. A notable characteristic is the seasonal
diversity. There are very wide fluctuations in the rates of interest in the money market
from one period to another in the year. November to June is the buy period. During this
period crops from rural areas are moved to cities and parts. The wide fluctuations create
problems in the money market. The Reserve Bank of India attempts to lessen the seasonal
fluctuations in the money market.
5. Lack of Proper Bill Market. Indian Bill market is an underdeveloped one. A well
organized bill market or a discount market for short term bills is essential for establishing
an effective link between credit agencies and Reserve Bank of India. The reasons for the
situation are historical, like preference for cash to bills etc.
6. Lack of very well Organized Banking System. Till 1969, the branch expansion was
very slow. There was tremendous effort in this direction after nationalization. A well
developed banking system is essential for money market. Even, at present the lack of
branches in rural areas hinders the movement of funds. With emphasis on profitability,
there may be some problems on this account.

In totality it can be said that Indian Money Market is relatively under developed. In no
case it can be compared with London Money Market or New York Money Market. There are
number of factors responsible for it in addition to the above discussed characteristics. For
example, lack of continuous supply of bills, a developed acceptance market, commercial bills
market, dealers in short term assets and coordination between different sections of the money
market.

12.3.2 Capital Market

Capital Market is generally understood as the market for long-term funds. This market
supplies funds for financing the fixed capital requirement of trade and commerce as well as the
long-term requirements of the Government. The long-term funds are made available through
various instruments such as debentures, preference shares, and common shares. The capital
market can be local, regional, national, or international. The capital market is classified into two
categories, namely, (i) primary market or new issue market, and (ii) secondary market or stock
exchange. As a rule, only when a country’s primary market is alone, it is possible to ensure a
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good degree of activity in the secondary market because it is the primary market which ensures a
continuous flow of securities to the secondary market. On the contrary, if secondary marker is
only active but not transparent and disciplined, it becomes difficult to develop and sustain the
cult of equity and related investment in the primary market. This is because the liquidity which
the secondary market imparts to such investments in the hands of the investors is adversely
affected.

Importance of Capital Market

Capital markets are markets where productive capital is raised and made available for
industrial purposes. It provides an avenue for investors and household sector to invest in
financial assets which are more productive than physical assets. A developed capital market can
solve the problem of paucity of funds. It facilitates increase in production and productivity in the
economy and hence enhances the economic welfare of the society. Indian capital market acts as
an intermediary to mobilize savings and to channelize the same for productive use consistent
with national priorities. The industrial securities issued through the primary market are traded in
the secondary market which provides liquidity and short-term as well as long-term yields. An
efficient primary market prepares base for effective and cost efficient mobilization of resources
by bringing together the users and investors of funds. Thus, both the primary and secondary
markets helps each other and make the capital market efficient, healthy, and strong. The number
of listed companies and the investors. Table I shows the upsurge of market capitalization, trading
volume, and number of listed companies for the years 1990-2003.

Table I Growth in the Indian Capital Market

At the end No. of No. of No. of Market Turnover SGL Derivatives
of financial stock brokers Listed capitalization turnover turnover
year exchange companies
1990-91 20 - 6229 1,10,279 - - -
1991-92 20 - 6480 3,54,106 - - -
1992-93 22 - 6925 2,28,780 - - -
1993-94 23 - 7811 4,00,077 2,03,703 - -
1994-95 23 6711 9077 4,73,349 1,62,905 50,569 -
1995-96 23 8476 9100 5,72,257 2,27,368 1,27,179 -
1996-97 23 8867 9890 4,88,332 6,46,116 1,22,941 -
1997-98 23 9005 9833 5,89,816 9,08,681 1,85,708 -
1998-99 23 9069 9877 5,74,064 10,23,382 2,27,228 -
1999-00 23 9192 9871 11,92,630 20,67,031 5,39,232 -
2000-01 23 9782 9954 7,68,683 28,80,990 6,98,121 4038
2001-02 23 9687 9644 7,49,248 8,95,817 15,55,653 1,03,847
2002-03 23 9519 9413 6,31,921 9,86,908 19,55,731 4,42,343
The growth in the Indian capital market is presented in the Table I The number of stock
exchanges increased from 9 in 1980 to 23 in 2002-03. All the exchanges are fully computerized
and offer 100% online trading. 9,413 companies were available for trading on stock exchanges
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at the end of March 203. The market capitalization grew ten fold between 1990-91 and 1999-
2000. All India market capitalization is estimated at Rs. 6,31,921 crores at the end of March
2003. The trading volumes on exchanges have been witnessing phenomenal growth during
1990s. The average daily turnover grew from about Rs. 150 crores in 1990 to Rs. 12,000 cores in
2000, peaking at over Rs. 20,000 crores. However it declined substantially to Rs. 9,86,908 crores
in 2002-03.
The resource mobilization from the primary market is depicted in the Table II Average
annual capital mobilization by non-government public companies from the primary market
increased manifold during the 1980s, with the amount raised in 1990-91 being Rs. 4312 crores.
Again the capital raised by these companies rising sharply to
Rs. 26,417 crores in 1994-95. However, it decreased to 1,878 crores in 2002-03. The market
appears to have dried up since 1995-96 due to interplay of demand and supply side forces.
 Table II : Resource mobilization from the primary market

Issues Year 90-91 91-92 92-93 93-94 94-95 95-96 96-97 97-98 98-99 99-00

Corporate Securities 14,219 16,366 23,537 ,44,498 48,084 36,689 37,147 42,125 60,192 72,450
Domestic Issues 14,219 16,366 23,286 37,044 41,974 36,193 33,872 ,37,738 59,044 68,963
Non Govt.
Public Co. 4,312 6,193 19,803 19,330 26,417 16,075 10,410 3,138 5,013 5,153
PSU Bonds 5,663 5,710 1,062 5,586 3,070 2,292 3,394 2,982 -- --
Govt. Companies -- -- 430 819 888 1,000 650 43 -- --
Banks & Fls -- -- 356 3,843 425 3,465 4,352 1,476 4,352 2,551
Private Placement 4,244 4,463 1,635 7,466 11,174 13,361 15,066 30,099 49,679 61,259
Euro Issues -- -- 702 7,898 6,743 1,297 5,594 4,009 1,148 3,487
Government Securities 11,558 12,284 17,690 54,533 43,231 46,783 42,688 67386 106,067 113,336
Central Government 8,989 8,919 13,8856 50,388 38,108 40,509 36,152 59,637 93,953 99,630
State Governments 2,569 3,364 3,805 4,145 5,123 6,274 6,536 7,749 12,114 13,706
Total 25,777 28,650 41,227 99,031 91,315 83,472 79,835 109,511 166,259 185,786
Mutual Funds 7508 11,253 13,021 11,244 12,274 -5,833 -2,036 4,064 3,611 19,953
 - 287 - : 287 :

Indian market is getting integrated with the global market though in a limited way
through Euro issues. Since 1992, Indian companies have raised over Rs. 40,000 crores through
ADRs/GDRs. By the end of December 2003, 517 FIIs were registered with SEBI. They had net
cumulative investments of over US$ 23 billion by the end of December 2003.
In the total amount raised through the public offerings, share of equity in relation to
debentures and bonds has increased significantly over the years which is shown in the Tables III.
It is evident that Indian capital market has become an even more important place of
activity in the newly unveiled economic regime. Thus the growth of capital market has posed
new challenges to economic and financial stability. As a result, a number of new innovative
financial instruments have surfaced in recent years as an offshoot of the wide ranging
developments taking place in the financial sector throughout the world.

Distinction Between Capital Market and Money Market

The capital market should be distinguished from money market. The capital market is the
market for long-term funds. On the other hand money market is primarily the market for short-
term funds. However, the two markets are closely related as the same institution many a times
deals in both types of funds, i.e. short-term as well as long-term.
The main points of distinction between the two markets are as under :

Capital Market Money Market

1. It provides finance/money capital for 1. It provides finance/money for short-term
long-term investment. investment.

2. The finance provided by the capital 2. The finance provided by money market is
market may be used both for fixed and utilized, usually for working capital.
working capital.
3. Mobilisation of resources and effective 3. Lending and borrowing are its principal
utilization of resources through lending functions to facilitate adjustment of
are its main functions. liquidity position.

4. It’s one of the constituents, Stock 4. It does not provide such facilities. The main
Exchange acts as an investment market components include call loan market,
for buyers and sellers of securities. collateral loan market, bill market and
acceptance houses.
5. It acts as a middleman between the 5. It acts as a link between the depositor and
investor and the entrepreneur. the borrower.

6. Underwriting is one of its primary 6. Underwriting is a secondary function.

activities.
7. Its investment institutions raise capital 7. It provides outlets to commercial banks,
from public and invest in selected business corporations, non-bank financial
securities so as to give the highest concerns and other for their short-term
possible return with the lowest risk. surplus funds.
 - 288 - : 288 :

8. It provides long-term funds to Central 8. It provides short-term funds to Government

and State Governments, public and local by purchasing treasury bills and to others
bodies for development purposes. by discounting bills of exchange etc.

12.4 Financial Instruments

The following are some of the new innovative financial instruments devised for raising
funds :-
Euro convertible bond : Euro convertible bond is an unsecured security which can be converted
into depository receipts or local shares. It offers the investors an option to convert the bond into
equity at a fixed price after a minimum lock-in-period. Thus call option allows the company to
force conversion if the market price exceeds the particular percentage of the conversion price.
Indian companies prefer to issue GDRs whereas foreign investors favour convertible bonds.
Fully convertible cumulative preference shares (Equipref) : Equipper is a very recent
introduction in the market. The shares have to be listed on one or more stock exchanges in the
country. It has two parts. The first part is convertible into equity shares automatically and
second part is converted into equity shares after a lock-in-period at the request of the investors.
Conversion into equity shares after the lock-in-period takes place at a price which is 30% lower
than the average market price. The dividend on fully convertible cumulative preference shares is
fixed and shall be given only for the portion that represents second part shares. Only a few
companies have tried this instrument. Equiprefs are presently being offered largely to the
financial institutions like the UTI. Uniworth International Ltd. (UIL)was the first company to
issue these shares and succeeded in mopping up to Rs. 16 crores. UIL’s equipref shares were a
combination of equity and preference shares.
Table III New capital issues by non-government public limited companies
(Rs. in crores)

Security & Types of issue 2001-02 2002-03 2002-03 2003-04

(April-March) (April-March) (April- January) (April-January)
No. of Amount No. of Amount No. of Amount No. of Amount
issues issues issues issues
1 2 3 4 5 6 7 8 9
(1) Equity shares (a+b) 6 860.4 5 460.2 3 431.6 8 674.6
(a) Prospectus 4 852.7 3 206.7 1 178.1 6 577.9
(2) (653.7) (3) (201.0) (1) (176.4) (4) (539.3)
(b) Rights 2 7.7 2 253.5 2 253.5 2 96.7
(1) (0.6) (2) (190.2) (2) (190.2) (1) (26.0)
(2) Preference shares - - - - - - - -
(a+b)
(a) Prospectus - - - - - - - -
(b) Rights - - - - - - - -
(3) Debentures (a+b) 4 774.0 1 217.5 1 217.5 - -
(a) Prospectus 1 69.5 - - - - - -
(b) Rights 3 704.5 1 217.5 1 217.5 - -
of which :
(i) Convertible (a+b) 3 518.1 1 217.5 1 217.5 - -
(a) Prospectus 1 69.5 - - - - - -
(b) Rights 2 448.6 1 217.5 1 217.5 - -
(ii) Non-Convertible 1 255.9 - - - - - -
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(a+b)
(a) Prospectus - - - - - - - -
(b) Rights 1 255.9 - - - - - -
(4) Bonds (a+b) 9 4,058.0 3 1,200.0 1 400.0 3 1,250.9
(a) Prospectus 9 4,058.0 3 1,200.0 1 400.0 3 1,250.9
(b) Rights - - - - - - - -
(5) Total (1+2+3+4) 19 5,692.4 9 1,877.7 5 1,049.1 11 1,925.5
(a) Prospectus 14 4,980.2 6 1,406.7 2 578.1 9 1,828.8
(b) Rights 5 712.2 3 471.0 3 471.0 2 96.7
Triple option convertible debentures : Every debenture holder has an opportunity to acquire
two equity shares at par for each debenture. As regards the non-convertible portion which had
warrants attached to them, investors were given three options. They can retain the non-
convertible portion and sell the warrants and get equity shares in return or retain non-convertible
portion, surrounding the warrants and apply for equity shares.
Warrants : A warrant is an option, issued by a company, granting the buyer the right to
purchase a number of shares of its equity share capital at a given exercise price during a given
period.An equity warrant increases the marketability of debentures and reduces the need for the
efforts of brokers/sub-brokers by way of private placement. Thus, it provides an effective tool for
lesser dependence on financial institution and mutual funds for subscribing to the security. Many
companies including Deepak Fertilizers, Essar Gujarat, Reliance Industries, CEAT Tyres,
Ranbaxy Laboratories, Bharat Forge, Proctor & Gamble, ITC Agro-Tech, and Tata Steel have
issued warrants. In a situation, where the market is lukewarm in its response to new issues,
equity warrants can be an added attraction for investors to apply for the issues offering equity
warrants with their securities.
Secured premium notes (SPNs) : SPN is issued along with a detachable warrant, and is
redeemable after a notified period with features of medium to long-term notes. Each SPN has a
warrant attached to it which gives the holder the right to apply for, or seek allotment of one
equity share, provided the SPN is fully paid. The conversion of detachable warrant into equity
shares is done within the time limit notified by the company. There is a lock-in-period for SPN
during which no interest is paid for the invested amount. In July 1992, Tata Iron and Steel Co.
Ltd. (TISCO) was the first company to issue SPNs to the public along with the right issue. The
main objective of this issue was to raise money for its modernization programme without
expanding its equity excessively in the next few years. The SPN was issued with a face value of
Rs. 300 to be repaid in four equal annual installments of Rs. 75 each from the end of the fourth
year together, with an equal amount of Rs. 75 with each installment which will consist of a mix
of interest and premium on redemption. This instrument has a low borrowing cost and is
beneficial for capital intensive projects.
Zero interest convertibles : Also known as zero coupon bonds, the zero interest convertibles
refer to those convertibles which are sold at discount from their eventual maturing value and
have zero interest rate. One advantage from the investors’ point of view is that it eliminates
reinvestment risk. From the companies’ point of view, it is attractive to issue these convertibles
as there is no immediate interest commitment. The companies like Mahindra & Mahindra, and
HB Leasing and Finance have adopted this scheme.
Deep discount bonds (DDB) : Deep discount bonds pay a coupon rate which is substantially
lower than the market rate at the time of issue. One of the advantages of DDB is the elimination
of investment risk. It helps the companies which take time to stabilize their operations and
which have initial small cash flow rising steadily to a high level to take care of the redemption.
The investors also gain the benefit of capital gains taxation.
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Floating rate bonds (FRB) : Floating rate bonds made their first appearance in the Indian
capital market in 1993 when State Bank of India adopted a reference rate of the highest rate of
interest on fixed deposit receipt of the bank, providing floor rate for minimum interest payable
at 12% p.a. and call option to the bank after 5 years to redeem the bonds earlier than the
maturity period of 10 years at certain premium. The floating rates are set equal to the treasury
bill rate plus a predetermined spread.
Securitization : Securitization is a synthetic technique of conversion of assets into securities,
securities into liquidity and subsequently into assets, on an ongoing basis. This increases the
turnover of business and profit while providing for flexibility in yield, pricing pattern, issue, risk
and marketability of instruments used to the advantage of both borrowers and lenders. In
securitization, generally a financial institution holds a pool of individual loans and receivables,
creates securities against them, get them rated and sell them to investors at large. The most
suitable assets for securitization for the banks are housing loans, auto loans, lease rentals,
corporates trade receivables etc. Indian financial market is still at an infancy stage. So
securitization is emerging to be a very innovative technique enabling finance companies to retail
market their liabilities in order to lower their cost of funds besides increasing the liquidity. The
initial headway has already been made by Citi Bank in association with ICICI.
Layered premium issue : The layered premium issue was introduced by Merchant Bankers to
overcome the inherent dangers of fixing premia for issues. A floor rate is fixed with the
consensus of the shareholders. The underwriters will also be given the option of underwriting
from the highest premia to the lowest. The issue is then auctioned to the investors. This
innovation will provide tremendous flexibility to the issue.
Repurchase of shares : Repurchase of shares by companies is a part of the capitalization
process. The company repurchases the shares to reduce the share capital by two methods. As per
the first method, the shares are purchased from the floor of the stock exchanges. The second
method asks for purchasing the shares directly from the shareholders. Repurchase of shares is an
alternative to cash dividend.
Derivatives : Financial intermediaries abroad have created new varieties of instruments and
transaction called derivatives and to create risk managements tools such as options, futures and
swaps are used to transform one or more properties of an asset or liability. Financial
liberalization has brought inherent risk, and as a result, corporate and institutional investors are
looking towards derivatives for hedging the risks. Since the volume of international trade and
capital flows are rising, more and more banks are exposed to various currencies and the
emerging derivatives in foreign countries are increasingly used by banks to bring variations in
the sensitivity of their funds and also the underlying portfolio. So it is high time for the Forex
dealers in India to familiarize with the complexity of the instruments and acquire skills to handle
them.
Options : Options are basically derivatives in the nature of legal contracts. They are derived
from underlying assets which could be stocks, bonds, or currencies. An option contract gives the
holder the right to buy or sell the underlying stock at a price on a future date. This price is
referred to as the strike price. Depending on whether the holder is a buyer or a seller, the options
are termed put and call. A call option conveys the right of the holder to buy a specified quantity
of the stock while a put option conveys the right of the holder to sell. The buyer or the holder
gets the right as laid down in the option, while the writer is the one who has the obligation to
honour the terms when the option is exercised. Option trading has a good market in India since
there is enough scope for speculation.
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Futures : A future contract is essentially a series of forward contracts. Thee are two types of
people who deal in futures—speculators and hedgers. Speculators buy and sell futures for the
sole purpose of marketing a profit by selling them at a price that is higher than their buying
price. Such people neither produce nor use the asset in the ordinary course of business. In
contrast, hedgers buy and sell futures to offset an otherwise risky position in the spot market. In
the ordinary course of business, they either produce or use the asset. In a forward contract, the
trader who promises to buy is said to be in ‘Long position’ and the one who promises to sell is
said to be in ‘Short position’ in future. The long position in a future contract is the agreement to
take delivery and short position in a future contract is the legally binding agreement to deliver.
Swaps : A swap deal is a transaction in which the bank buys and sells the specified foreign
currency simultaneously for different maturity dates which would help banks to eliminate
exposure risk. It can also be used as a tool to enter arbitrary operations that led the economy to
be fully opened up.
Non-voting shares : Non-voting shares enable a company to raise capital without diluting the
promoter’s holding. The finance ministry guidelines say that non-voting shares should not
exceed 25% of the total paid-up capital of the company. Shareholders buying these shares gain
through a dividend which is 20% higher than on voting shares.
A major indicator of the level of development of an economy is the sophistication of its
capital market. Since liberalization has begun, the response measures for handling the capital
market has been enormous. It is visible with the creation of SEBI, NSE, regulated BSE, floating
of mutual funds, financing institutions, and credit rating system.

12.5 Summary
Four and half decades of Indian economic planning and subsequent liberalization had led
the country to an ecstatic phase of development. The development through disinter mediation,
deregulation, globalization, and emergence of vibrant capital market has contributed to the
expansion of opportunities. As a result, capital market has emerged as the major contributor to
the growth of foreign exchange reserves of the country. In fact, in the emerging world market,
India has beaten several developing countries. In the post liberalization era, the finance sector
has witnessed a complete metamorphosis. The recent economic reforms encompassed a series of
measures to promote investors protection and encourage the growth of capital market. Free entry
into capital market for new issues by companies and free pricing of shares for new issues has
been ensured. Different financial institutions and markets complete for a limited pool of savings
by offering different instruments. Money and capital markets increase competition between
suppliers. Capital market enables contractual savings and collective investment institutions to
play a more active role in the financial system.

Self Assessment Questions

1. “Financial markets and financial institution play an important role in financial system”.
Do you agree? Explain.

2. Discuss the types of financial markets. How the two markets are interrelated?
 - 292 - : 292 :

3. What functions does money market perform? Discuss the features of Indian money
market.

4. Discuss the various types of instruments that are dealt in money market.

5. State the objectives and functions of Discount and Finance House of India.

6. Explain the various new financial instruments introduced in the capital market.
 - 293 - : 293 :

BANKING AND FINANCIAL INSTITUTIONS

OBJECTIVE : The objective of the present lesson is to discuss the role of banking
and financial institutions in Indian Economy.

STRUCTURE
13.1 Origin and Growth of Banking
13.2 Meaning and Definition of a Bank
13.3 Types of Banks
13.4 Functions of Commercial Banks
13.5 Meaning of Financial Institutions
13.6 Types of Financial Institutions
13.7 Setting up of Financial Institutions
13.8 Role and Importance of Financial Institutions
13.9 Summary
13.10 Self Assessment Questions

13.1 Origin and Growth of Banking

As for as the origin of the present banking system in the world is concerned, the
first bank called the “Bank of Venice” is believed to be established in Italy in the year
1157. The first bank in India was started in the year 1770 by the Alexander & Co., an
English Agency as “Bank of Hindustan” which failed in 1782 due to the closure of the
Agency House in India. The first bank in the modern sense was established in the Bengal
Presidency as “Bank of Bengal” in the year 1806.
According to G. Crowther the modern banking has three ancestors in the history of
banking in this world namely (i) The Merchants (ii) The Goldsmiths and (iii) The
Money Lenders:
 - 294 - : 294 :

i) The Merchants: It were the merchant who first evolved the system of banking as
the trading activities required remittances of money from one place to another
place which is one of the important functions of a bank even now. Because of the
possibility of theft of money during physical transportation of money, the traders
began to issue the documents which were taken as titles of money. This system
gave rise to the institution of “Hundi” which means a letter of transfer whereby a
merchant directs another merchant to pay the bearer of Hundi the specified amount
of money in the Hundi and debit this amount against the drawer of Hundi.
ii) The Goldsmiths : The second stage in the growth of banking was the role of
goldsmiths. The business of goldsmiths was such that he had to secure safe to
protect the gold against theft and take special precautions. In a period when paper
was not in circulation and the money consisted of gold and silver, the people
started leaving their precious bullion and coins in the custody of goldsmiths. As
this practice spread, the goldsmiths started charging something for taking care of
the gold and silver. As the evidence of receiving valuables, he stared to issue a
receipt. Since the gold and silver coins had no mark of the owners, the goldsmiths
started lending them. The goldsmiths were prepared to issue an equal amount of
gold or silver money to the receipt holder, the goldsmith receipts became like
cheques as a medium of exchange and a means of payment by one merchant to the
other merchant.
iii) The money lenders : The third stage in the growth of banking system is the
changing of the character of goldsmiths into that of the money lenders. With the
passing of time and on the basis of experience the goldsmiths found that the
withdrawals of coins were much less than the deposits with them and it was not
necessary to hold the whole of the coins with them. After keeping the contingency
reserve, the goldsmiths started advancing the coins on loan by charging interest. In
this way the goldsmith money lender became a banker who started performing two
important functions of the modern banking system that of accepting deposits and
 - 295 - : 295 :

advancing loans. The only difference is that now it is the paper money and then its
was gold or silver coins.

13.2 Meaning and Definition of a Bank

It is very difficult to give a precise definition of a bank due to the fact that a
modern bank performs a variety of functions. Ordinarily a ‘Bank’ is an institution which
deals with the money and credit in such a manner that it accepts deposits from the public
and makes the surplus funds available to those who need them, and helps in remitting
money from one place to another safely. Different economists have given different
definition of a bank. Some of the important definitions are as under :
“A bank collects money from those who have it to spare or who are saving it out of their

incomes, and it lends this money to those who require it.”

G.Crother
“Banking means the accepting for the purpose of Indian companies lending or
investment, of deposits of money from the public, repayable on demand or otherwise, and
withdrawable by cheque, draft or otherwise.”
The Banking Companies (Regulation) Act, 1949
An ideal definition of a bank can be given as “A bank is a commercial
establishment which deals in debts and aims at earning profits by accepting deposits
from general public at large, which is repayable on demand or otherwise through
cheques or bank drafts and otherwise which are used for lending to the borrowers or
invested in Government securities.”

13.3 Types of Banks

Banks are of various types and can be classified :
A. On the basis of Reserve Bank Schedule.
B. On the basis of ownership.
C. On the basis of domicile.
 - 296 - : 296 :

D. On the basis of functions.

A. On the basis of Reserve Bank Schedule: Bank can be of the two types on the
basis of Second Schedule of the Reserve Bank of India Act, 1934 : (i) Scheduled Banks
and (ii) Non-scheduled Banks.

i) Scheduled Banks : All those banks which are included in the list
of Schedule Second of the Reserve Bank of India are called the Scheduled
Bank. Only those banks are included in the list of scheduled banks which
satisfy the following conditions :
a) That it must have a paid up capital and reserves of Rs.5 lakhs.
b) That it must ensure the Reserve Bank that its operations are not detrimental
to the interest of the depositors.
c) That it must be a corporation or a cooperative society and not a single owner
firm or a partnership firm.
ii) Non-scheduled Banks : The banks which are not included in the second
schedule of the Reserve Bank of India Act, 1934 are called non-scheduled banks. They
are not included in the second schedule because they does not fulfill the three pre-
conditions laid down in the act to qualify for the induction in the second schedule.
B. On the basis of Ownership : Banks can be classified on the basis of ownership in
the following categories : (i) Public Sector Banks (ii) Private Sector Banks and (iii)
Cooperative Banks
i) Public Sector Banks : The banks which are owned or controlled by the
Government are called “Public Sector Banks”. In 1955 the first public sector commercial
bank was established by passing a special Act of Parliament which is known as State
Bank of India. Subsequently the Government took over the majority of shares of other
State Banks which were operating at the state levels namely State Bank of Patiala, State
Bank of Bikaner & Jaipur, State bank of Travancore, State Bank of Mysore, State Bank
 - 297 - : 297 :

of Indore, State Bank of Saurashtra and State Bank of Hyderabad presently working as
subsidiaries of State Bank of India.
In the field of banking, the expansion of public sector was marked with the
nationalization of 14 major commercial banks by Mrs. Indira Gandhi on July 19, 1969
through an ordinance. Again on April 15, 1980 another group of 6 commercial banks
were nationalized with the deposits Rs.200 crores each, resulting in the total of 20 such
banks. But due to the merger of New Bank of India with the Punjab National Bank in
1993-94, the number of nationalized bank has been reduced to 19. The State Bank of
India and its seven subsidiaries had already been nationalized. The progressive
nationalization of bank has increased the role of public sector banking in the country.

Under the new liberalization policy of the Government, The Oriental Bank of
Commerce, State Bank of India, Corporation Bank, Bank of India and Bank of Baroda
have offered their share to the general public and financial institutions and therefore these
banks are no longer 100% owned by Government of India. Although majority of the
shares is still with the Government, therefore these are still public sector banks.

ii) Private Sector Banks: On the contrary Private Sector Banks are
those banks which are owned and controlled by the private sector i.e.
private individuals and corporations. The private sector played a strategic
role in the growth of joint stock banks in India. In 1951 there were in all 566
private sector banks of which 92 banks were scheduled banks and the
remaining 474 were non-scheduled banks. At the time there was not even
a single public sector bank. With the nationalization of banks in 1969 and
1980 their role in commercial banking had declined considerably. Since
then the number of private sector banks is decreasing and the number of
public sector banks is increasing.

iii) Co-operative Banks : The word ‘cooperative’ stands for working

together. Therefore cooperative banking means an institution which is
 - 298 - : 298 :

established on the principle of cooperation dealing in ordinary banking

business. Cooperative banks are special type of banks doing ordinary
banking business in which the members cooperate with each other for the
promotion of their common economic interests.

Features of Cooperative Banking: Following are the distinguishing main

features of a cooperative bank :-
i) Membership of Cooperative Banks is voluntary.
ii) Functions of a Cooperative Bank are common banking functions.
iii) Organization and management of a Cooperative Bank is based on
democratic principles.
iv) Main objectives of a Cooperative bank are to promote economic, social and
moral development of its members.
v) Basic principle of Cooperative Bank is equality.

C) On the basis of domicile : The banks can be classified into the

following two categories on the basis of domicile : (i) Domestic Banks
and (ii) Foreign Banks.

i) Domestic Banks: Those banks which are incorporated and

registered in the India are called domestic banks.

ii) Foreign Banks: Foreign Banks are those banks which are set up in a
foreign country with their control and management in the hands of head
office in their country of origin but having business branches in India.
Foreign Banks are also known as Foreign Exchange Banks or Exchange
Banks. Traditionally these banks were set up for financing the foreign trade
in India and discounting the foreign exchange bills. But now these banks
 - 299 - : 299 :

are also accepting deposits and making advances like other commercial
banks in India.

D) On the basis of functions: The banks can be classified on the basis

of functions in the following categories : (i) Commercial Banks (ii) Industrial
Banks (iii) Agricultural Banks (iv)Exchange Banks and (v) Central Bank.

i) Commercial Banks: Commercial Banks are those banks which

perform all kinds of banking business and functions like accepting deposits,
advancing loans, credit creation, and agency functions for their customers.
Since their major portion of the deposits are for the short period, they
advance only short term and medium term loans for business, trade and
commerce. Majority of the commercial banks are in the public sector. Of
late they have started giving long term loans also to compete in the
commercial money market.

ii) Industrial Banks: The Industrial banks are those banks which
provide medium term and long term finance to the industries for the
purchase of land and building, plant and machinery and other industrial
equipment. They also underwrite the shares and debentures of the
industries and also subscribe to them. The main functions of an Industrial
Banks are as follows :

i) They provide long term finance to the industries to purchase land and
buildings, plant and machinery and construction of factory buildings.

ii) They also accept long term deposits.

iii) They underwrite the shares and debentures of the industry and sometimes
subscribe to them.
 - 300 - : 300 :

In India there are number of financial institutions which perform the function of an
Industrial Bank. Major financial institutions are as under :-

i) Industrial Development Bank of India (IDBI)

ii) Industrial Finance Corporation of India (IFCI)

iii) State Industrial Development Corporation such as Haryana State Industrial

Development Corporation (HSIDC)

iii) Agriculture Banks : The needs of agricultural credit are different

from that of industry, business, trade and commerce. Commercial banks
and industrial banks do not deal with agriculture credit financing. An
agriculturist has both type of needs :
i) He requires short term credit to purchase seeds, fertilizers and other inputs
and
ii) He also requires long term credit to purchase land, to make permanent
improvement on land, to purchase agricultural machinery and equipment
such as tractors etc.
Agricultural credit is generally provided in India by the Cooperative institutions.
The Cooperative Agricultural Credit Institutions are divided into two categories :-
A) Short term agricultural credit institutions and
B) Long term agricultural credit institutions

A) Short term agricultural credit institutions : The short term

agricultural credit institutions cater to the short term financial needs of the
agriculturists which have the following three tier federal structure :-
a) At the Village level : Primary Agricultural Credit Societies
b) At the District level : Central Cooperative Banks
c) At the State level : State Cooperative Banks
 - 301 - : 301 :

B) Long term agricultural credit institutions: The long term

agricultural credit is provided by the Land Development Banks which were
earlier known as Land Mortgage Banks. The land development banks
provide long term to agriculturists for a period ranging from 5 years to 25
years.

iv) Exchange Banks : The exchange banks are those banks which deal
in foreign exchange and specialised in financing the foreign trade.
Therefore, they are also called foreign exchange banks. Foreign Exchange
Banks are those banks which are set up in a foreign country with their
control and management in the hands of head office in their country of
origin but having business branches in India.

v) Central Bank: The Central Bank is the apex bank of a country which
controls, regulates and supervises the banking, monetary and credit
system of the country. The Central Bank is owned and controlled by the
Government of the country. The Reserve Bank of India is the Central Bank
in India. The important function of central bank are as follows :-
i) It acts as banker to the Government of the country.
ii) It also acts as agent and financial advisor to the Government of the country.
iii) It has the monopoly to issue currency of the country.
iv) It serves as the lender of the last resort.
v) It acts as the clearing house and keeps cash reserves of commercial banks.

13.4 Functions of Commercial Banks

The Commercial Banks perform a variety of functions which can be divided in the
following three categories namely (a) Basic Functions (b) Agency Functions and (c)
General Utility Functions
 - 302 - : 302 :

1. Basic Functions: The basic functions of bank are those functions without
performing which an institution cannot be called a banking institution at all. That is why
these functions are also called primary or acid test function of a bank. The
basic/primary/acid test function of a bank are Accepting Deposits, Advancing of Loans
and Credit Creation.

a) Accepting Deposits : The first and the most important function of a

bank is to accept deposits from those people who can save and spare for
the safe custody with the bankers. It serves two purposes for the
customers. On one hand their money is safe with the bank without any fear
of theft and on the other hand they also earn interest as per the kind of
saving they have made. For this purpose the banks have different kinds of
deposit accounts to attract the people which are as Saving Deposit
Account, Fixed Deposit Account, Current Deposit Account, Recurring
Deposit Account and Home Loan Account.

i) Saving Deposit Account: The Saving Bank Account is the most

common bank account being utilized by the general public. The basic
purpose of this account is to mobilize the small savings of the general
public. Certain restrictions are imposed on the depositors regarding the
number of withdrawals and amount to be withdrawn in a given period of
time. Generally the rate of interest paid by the bank on these deposits is
low as compared to recurring or fixed deposit account. Cheque facility is
also provided to the depositors with certain extra restrictions on the
depositors.

ii) Fixed Deposit Account: This is an account where money can be

deposited for a fixed period of time say one year or two years or three
years of five years and so on. Once the money is deposited for a fixed
 - 303 - : 303 :

period of time, the depositor is prohibited from withdrawal of money from

the bank before the expiry of the stipulated period of time. The basic
advantage to be customer is that he is offered interest at the higher rate of
interest and the banker is free to utilize the money for that fixed period.
iii) Current Deposit Account: In the savings bank account there are restrictions on
the number of withdrawals that can be made. Therefore it does not suit to the needs of
traders and businessmen who has to make several payments daily and deposits money in
a similar manner. Therefore, there is a facility for them in the shape of another account
called Current Deposit Account. Money from this account can be withdrawn by the
account holder as many times as desired by the customer. Normally bank does not pay
any interest on these current accounts, rather some incidental charges are charged by the
banker as service charges. These accounts are also called demand deposits or demand
liabilities.
iv) Recurring Deposit Account: To encourage regular savings by the general public,
another account is opened in the banks called Recurring Deposit Account. This account is
preferred by the fixed income group, because a particular amount fixed at the time of
opening the account has to be deposited in the account every month for a stipulated
period of time. Generally the bank pays rate of interest higher than that of a saving
account and just equal to the fixed deposit account on such recurring deposit accounts.
v) Home Loan Account: Home loan account facility has been introduced in some
scheduled commercial banks to encourage savings for the purchasing of or construction
of a house to live. In this account the customer is required to deposit a particular amount
per month or half yearly or even yearly for a period of five years. After the stipulated
period bank provide three to five times of the deposited amount a loan to the subscribers
to purchase or construct a house. Rate of interest is also very attractive on this account
nearly equal to that of the fixed deposit account. Even the rebate of Income Tax is also
available on the amount contributed in this account under Section 88 of the Income Tax
Act, 1961. Facility to close the account after the stipulated period of time is also allowed.
 - 304 - : 304 :

b) Advancing of Loans: Advancing of loans is the second acid test

function of the commercial banks. After keeping certain cash reserves, the
banks lend their deposits to the needy borrowers. It is one of the primary
functions without which an institution can not be called a bank. The bank
lends a certain percentage of the cash lying in the deposits on a higher rate
of interest than it pays on such deposits. The longer the period for which
the loan is required the higher is the rate of interest. Similarly higher the
amount of loan, the higher shall be the rate of interest. Before advancing
the loans the bank satisfy themselves about the credit worthiness of the
borrowers. This is how a bank earns profits and carries on its banking
business. There are various types of loans which are provided by the banks
to the borrowers. Some of the important ways of advancing loans are as (i)
Call Money Advances (ii) Cash Credits (iii) Overdrafts (iv) Discounting Bills
of Exchange and (v) Term Loans

i) Call Money Advances: The Call Money Market which is also known
as inter-bank call money market deals with very short period loans called
call loans. The Call Money Market is a very important constituent of the
organized money market which functions as an immediate source of very
short term loans. The major suppliers of the funds in the call money market
are All Commercial Banks, State Bank of India (SBI), Life Insurance
Corporation of India (LIC), General Insurance Corporation (GIC), Unit Trust
of India (UTI) and Industrial Development Bank of India (IDBI) and the
major borrowers are the scheduled Commercial Banks. No collateral
securities are required against these call money market loans.
As the participants are mostly banks, it is also called inter-bank call money
market. The Scheduled Commercial Banks use their surplus funds to lend for very short
 - 305 - : 305 :

period to the bill brokers. The bill brokers and dealers in the stock exchanges generally
borrow money at call from the commercial banks. The bill brokers in turn use them to
discount or purchase the bills. Such funds are borrowed at the call rate which varies with
the volume of funds lent by the commercial banks. When the brokers are asked to pay off
the loans immediately, then they borrow from SBI, LIC, GIC, and UTI etc. These loans
are granted by the commercial banks for a very short period, not exceeding seven days in
any case. The borrowers have to repay the loan immediately when ever the lender bank
call them back.

ii) Cash Credits: This is a type of loan which is provided to the

businessmen against their current assets such as shares, stocks, bonds
etc. These loans are not based on credit worthiness or personal security of
the customers. The bank provides this loan through opening an account in
the name of the customer and allows them to withdraw borrowed amount of
loan from time to time upto the limit fixed by the bank which is determined
by the value of security provided by the borrowers. Interest is charge only
on the amount of money actually withdrawn from the banks and not on the
amount of the sanctioned amount of loan.
iii) Overdrafts : The facility of overdrafts is provided to the traders and businessmen
through current accounts for which the banks charge interest on the outstanding balance
of the customers. A limit is fixed by the bankers for withdrawal of over drafts and the
customer is not allowed to withdraw more than that limit from his Over Draft Current
Account. This facility is required by the traders and businessmen because they issue
several cheques in a day and similarly deposits so many cheques daily in their current
accounts. They may not be knowing at a particular day that whether there is a balance in
the account or not and their issued cheques are not dishonored so they are provided with
the facility of overdrafts.
 - 306 - : 306 :

iv) Discounting Bills of Exchange: This is another popular type of

lending by the commercial banks. A holder of a bill of exchange can get it
discounted with a commercial bank. Bills of Exchange are also called the
Commercial Bills and the market dealing with these bills is also called
commercial bill market. Bills of exchange are those bills which are issued
by the businessmen or firms in exchange of goods sold or purchased. The
bill of exchange is a written unconditional order signed by the drawer
(seller) requiring the drawee (buyer) to pay on demand or at a fixed future
date, (usually three months after date written on the bill of exchange), a
definite sum of money. After the bill has been drawn by the drawer (seller),
it is accepted by the drawee (buyer) by countersigning the bill. Once the
buyer puts his acceptance on the bill by signing it, it becomes a legal
document. They are like post dated cheques issued by the buyers of goods
for the goods received. The bill holder can get this bill discounted in the bill
market if he wants the amount of the bill before its actual maturity. These
bills of exchange are discounted and re-discounted by the commercial
banks for lending credit to the bill brokers or for borrowing from the central
bank. The bill of exchange market is not properly developed in India. The
Reserve Bank of India introduced the bill market scheme in 1952. Its main
aim was to provide finance against bills of exchange for 90 days. The
scheduled commercial banks were allowed to convert a part of their
advances into promissory notes for 90 days for lodging as collateral
security for advances from Reserve Bank of India.
v) Term Loan : Earlier the commercial banks were advancing only short
term loans. The commercial banks have also started advancing medium
term and long term loans. Now the maturity period of term loans is more
than one year. The amount of the loan sanctioned is either paid to the
 - 307 - : 307 :

borrower or it is credited to the account of the borrower in the bank. The

interest is charged on the whole amount of loan sanctioned irrespective of
the amount withdrawn by the borrower from his account. Repayment of the
loan is accepted in lump sum or in the installments.

c) Credit Creation : Credit Creation is one of the basic functions of a

commercial bank. A bank differ from the other financial institutions because
it can create credit. Like other financial institutions the commercial banks
also aim at earning profits. For this purpose they accept deposits and
advance loans by keeping a small cash in reserve for day-to-day
transactions. In the layman’s language when a bank advances a loan, the
bank creates credit or deposit. Every bank loan creates an equivalent
deposit in the bank. Therefore the credit creation means multiple expansion
of bank deposits. The word creation refers to the ability of the bank to
expand deposits as a multiple of its reserves.
The credit creation refers to the unique power of the banks to multiply loans and
advances, the hence deposits. With a little cash in hand, the banks can create additional
purchasing power to a considerable extent. It is because of this multiple credit creation
power that the commercial banks have been named the “factories of creating credit” or
manufacturers of money.
2. Agency Functions : The commercial banks also perform certain agency functions for
and on behalf of their customers. The bank acts as the agent of the customer while
performing these functions. Such services of the banks are called agency services. Some
of the important agency services are as under
i) Remittance of funds: Commercial banks provide a safe remittance of funds of
their customers from one place to another through cheques, bank drafts, telephone
transfers etc.
 - 308 - : 308 :

ii) Collection and Payment of Credit Instruments : The commercial banks used to
collect and pay various negotiable instruments like cheques, bills of exchange,
promissory notes, hundis, etc.
 - 309 - : 309 :

iii) Execution of Standing Orders : The commercial banks also

execute the standing orders and instruments of their customers for making
various periodic payments like subscriptions, rents, insurance premiums
and fees on behalf of the customers out of the accounts of their customers.

iv) Purchase and Sale of Securities : The commercial banks also

undertake the sale and purchase of securities like shares, stocks, bonds,
debentures etc., on behalf of their customers performing the function as a
broker agent.

v) Collection of dividends on shares and interest on debentures :

Commercial banks also make collection of dividends announces by the
companies of which the customer of the bank is a shareholder, and also
collects the interest on the debentures which becomes due on particular
dates generally half yearly or annually.

vi) Trustees and Executors of wills: The commercial banks preserves

the wills of their customers as their trustees and execute the wills after the
death of the customer as per the will as the executors.

vii) Representation and Correspondence : The commercial banks also

act as the representative and correspondents of their customers and get
passports, traveler’s tickets, book vehicles and plots for their customers on
the directions of the customers.

3. General Utility Functions : In addition to basic functions and agency

functions the commercial banks also provide general utility services for
their customers which are needed in the various walks of life and the
commercial banks provide a helping hand in solving the general
 - 310 - : 310 :

problems of the customers, like safety from loss or theft and so many
other facilities some them are locker facility, traveler’s cheque facility,
gift cheque facility, letter of credit, underwriting contract, provides
statistical data, foreign exchange facilities, merchant banking services
and acting as referee.

13.5 Meaning of Financial Institutions

Financial institutions are the intermediaries who facilitate smooth functioning of
the financial system by making investors and borrowers meet. They mobilize saving of
the surplus units and allocate them in productive activities promising a better rate of
return. Financial institutions also provide services to entities (individual, business,
government) seeking advice on various issues ranging from restructing to diversification
plans. They provide whole range of services to the entities who want to raise funds from
the markets or elsewhere.
Financial Institutions are also termed as financial intermediaries because they act
as middlemen between the savers (by accumulating funds from them) and borrowers (by
lending these funds). Banks also act as intermediaries because they accept deposits from
a set of customers (savers) and lend these funds to another set of customers (borrowers).
Like-wise investing institutions such as GIC, LIC, mutual funds etc. also accumulate
savings and lend these to borrowers, thus performing the role of financial intermediaries.
Financial institution's role as intermediary differs from that of a broker who acts as
an agent between buyer and seller of a financial instrument (equity shares, preference,
debt); thus facilitating the transaction but does not personally issue a financial instrument.
Whereas, financial intermediaries mobilize savings of the surplus units and lend them to
the borrowers in the form of loans and advances (i.e. by creating a financial asset). They
earn profit from the difference between rate of interest charged on loans and rate of
interest paid on deposits (savings). In short, they repackage the depositor's savings into
loans to the borrowers. As financial intermediaries, they meet the short-term as well as
 - 311 - : 311 :

long-term needs of the borrowers and provide liquidity to the savers. Deposits are
payable on demand by the customers. Banks are in a position to avoid the situation of ill-
liquidity while borrowing for short periods and lending for long term by mobilizing
savings from diversified set of depositors. RBI also has made it mandatory for the banks
to keep a certain percentage of deposits as cash reserves with itself to avoid the situation
of ill-liquidity.

13.6 Types of Financial Institutions

Financial institutions can be classified into two categories :
I. Banking Institutions
II. Non-Banking Financial Institutions

I. Banking Institutions
Indian banking industry is subject to the control of the Central Bank (i.e. Reserve
Bank of India). The RBI as the apex institution organizes, runs, supervises, regulates and
develops the monetary system and the financial system of the country. The main
legislation governing commercial banks in India is the Banking Regulation Act, 1949.
The Indian banking institutions can be broadly classified into two categories :
1. Organized Sector
2. Unorganized Sector

1. Organized Sector: The organized banking sector consists of

commercial banks, cooperative banks and the regional rural banks.
(a) Commercial Banks : The commercial banks may be scheduled banks or non-
scheduled banks. At present only one bank is a non-scheduled bank. All other banks are
scheduled banks. The commercial banks consist of 27 public sector banks, private sector
banks and foreign banks.
Traditionally, commercial banks accepted deposits and met the short and medium
term funding needs of the industry. But now, since 1990's, banks are also funding the
 - 312 - : 312 :

long terms needs of the industry particularly the infrastructure sector. The liberalization
measures initiated in the Indian economy, led to the entry of large private sector banks in
1993. This has increased competition among public sector banks and quality of services
has improved. A major development in the Indian banking industry was the entry of
major banks in merchant banking. The merchant bankers are financial intermediaries
providing a range of financial services to the corporate and investors. Some of the
merchant banker's activities include issue management and underwriting, project
counseling and finance, mergers and acquisition advice, portfolio management service
etc.
(b) Co-operative Banks: An important segment of the organized sector of Indian
banking is the co-operative banking. The segment is represented by a group of societies
registered under the Acts of the States relating to co-operative societies. In fact, co-
operative societies may be credit societies or non-credit societies.
Different types of co-operative credit societies are operating in the Indian
economy. These institutions can be classified into two broad categories : (a) Rural credit
societies which are primarily non-agricultural. For the purpose of agricultural credit there
are different co-operative credit institutions to meet different kinds of needs. For
example, short and medium term credit is provided through three tier federal structure. At
top is the apex body i.e., state co-operative bank ; in the middle there are district co-
operative banks or central co-operative banks, at the grass root level i.e., village level
there are primary agricultural credit societies. For medium to long terms loans to
agriculture, specialized co-operative societies have been formed. These are called 'Land
Development Banks'. The Land Development Banks movement started in 1929. In the
beginning they were named "Central Land Mortgage Banks". Land development banking
is a two tier structure. At the state level there are state or central land development banks.
At local level there are branches of these banks and primary land development banks. At
the national level they have formed All-India Land Development Bank's Union.
(c) Regional Rural Banks (RRBs) : Regional Rural Banks were set by the state
government and the sponsoring commercial banks with the objective of developing the
 - 313 - : 313 :

rural economy. Regional rural banks provide banking services and credit to small
farmers, small entrepreneurs in the rural areas. The regional rural banks were set up with
a view to provide credit facilities to weaker sections. They constitute an important part of
the rural financial architecture in India. There were 196 RRBs at the end of June 2002, as
compared to 107 in 1981 and 6 in 1975. RBI extends refinance assistance at a
concessional rate of 3 per cent below the bank rate to RRBs. IDBI, NABARD and SIDBI
are also required to provide managerial and financial assistance to RRBs under the
Regional Rural Bank Act.
Government decided to restructure the RRB's on the recommendation of Bhandari
Committee in 1994-95. As a result, an amount of Rs.360 crores was allocated towards the
restructuring programme. The State Bank of India took several measures of managerial
and financial restructuring including enhancement of issued capital and placement of
officers of proven ability to head the RRBs. NABARD took several policy measures such
as quarterly / half yearly review of RRBs by the sponsor banks, framing of Appointment
and Promotion Rules (1998) for the staff of RRBs, introduction of Kissan Credit Cards,
introduction of self- help groups etc., for improving the overall performance of RRBs.
(d) Foreign Banks : Foreign Banks have been in India from British days. ANZ
Grindlays Bank has its presence in number of places with 56 branches. The Standard and
Chartered Bank has 24 branches and Hongkong Bank has 21 branches. All other foreign
banks have branches less than 10. Obviously, these banks have concentrated on corporate
clients and have been specializing in area relating to international banking. With the
deregulation of banking in 1993, a number of foreign banks are entering India or have got
the licenses. Such new foreign banks are : Barclays Bank, Bank of Ceylon,Bank
Indonesia International, State Commercial Bank of Mauritius, Development Bank of
Singapore, Chase Manhattan Bank, Dresdner Bank, Overseas Chinese Bank Corporation,
Chinatrust Commercial Bank, Krug Thai Banking Public Company Ltd., Cho Hung
Bank, Commerz Bank, Fuji Bank and Toronto Dominion Bank. The list is indicative of
the fact that India is going to have greater presence of foreign banks in future. However,
 - 314 - : 314 :

despite low deposits these foreign banks reflect greater degree of efficiency and
productivity.
2. Unorganized Sector : In the unorganized banking sector are the indigenous
bankers, money lenders, seths, sahukars carrying out the function of banking.
(a) Indigenous Bankers : Indigenous bankers are the fore gathers of modern
commercial banks. These are the individuals or partnership firms performing the banking
functions. They also act as financial intermediaries. As the term indigenous indicates,
they are the local bankers. The geographical area covered by the indigenous bankers is
much larger than the area covered by commercial banks. They can be found in all parts of
the country although their names, styles of functioning and the functions performed by
the them may differ. In west India they may be known as Gujarati shroffs or Marwar, in
South India they may be called Chettiars, in North India they may be called sahukars, etc.
Indigenous bankers provide finance for productive purpose directly to trade and
industries, and indirectly, through money lenders and traders to agriculturists with whom
they find it difficult to establish direct relations. They keep in touch with traders and
small industrialists and finance marketing on a sizeable scale. Lending is conducted on
the basis of promissory notes, or receipts signed by borrowers acknowledging loans, and
stating the agreed rate of interest, or bonds written out on stamped legal forms, or through
signing of bankers books by borrowers. For large land, houses or other property are held
as mortgage.
(b) Money Lenders : Money lenders depends entirely on their own funds for the
working capital. Money lenders may be rural or urban, professional or non-professional.
They include large farmers merchants, traders, arhatias, goldsmiths, village shopkeepers,
sardars of labourers, etc. The methods and areas of operation differ from money lender to
money lender.

II NON-BANKING INSTITUTIONS
The non-banking institutions may be categorized broadly into two groups :
(a) Organized Financial Institutions.
 - 315 - : 315 :

(b) Unorganized Financial Institutions.

(a) Organized Financial Institutions: The organized non-banking financial
institutions include :
1. Development Finance Institutions : These include :
(a) The institutions like IDBI, ICICI, IFCI, IIBI, IRDC, at all India level.
(b) State Finance Corporation (SFCs), State Industrial Development Corporation (SIDCs)
at the state level.
(c) Agriculture Development Finance Institutions as NABARD, Land Development
Banks etc.
Development banks provide medium and long term finance to the corporate and
industrial sector and also takes up promotional activities for economic development of
the country.
2. Investment Institutions : It includes those financial institutions which mobilize
savings of the public at large through various schemes and invest these funds in corporate
and government securities. These include LIC, GIC, UTI, and mutual funds.
(b) Unorganized Financial Institutions : The unorganized non-banking financial
institutions include number of non-banking financial companies (NBFCs) providing
whole range of financial service. These include hire-purchase and consumer finance
companies, leasing companies, housing finance companies, factoring companies, credit
rating agencies, merchant banking companies etc. NBFCs mobilize public funds and
provide loanable funds. There has been remarkable increase in the number of such
companies since 1990's.

13.7 SETTING UP OF FINANCIAL INSTITUTIONS

Government control over the sources of credit and finance led to the establishment
of many financial institutions in the public sector. The main objective was to provide
medium and long-term industrial finance to the corporate sector. These financial
institutions included :
 - 316 - : 316 :

Development Finance Institutions

Development banks are the institutions engaged in the promotion and development
of industry, agriculture and other key sector. A number of development finance
institutions at National/All India Level as well as Regional/State Level were set up.

The foreign rulers in India did not take much interest in the industrial development
of the country. They were interested to take raw materials to England and bring back
finished goods to India. The Government did not show any interest for setting up
institutions needed for industrial financing. The recommendation for setting up industrial
financing institutions was made in 1931 by Central Banking Enquiry Committee but no
concrete steps were taken. In 1948, Reserve Bank had undertake a detailed study to find
out the need for specialized institutions. It was in 1948 that the first development bank
i.e. industrial Finance Corporation of India (IFCI) was established. IFCI was assigned the
role of a gap- filler which implied that it was not expected to compete with the existing
channels of industrial finance. It was expected to provide medium and long term credit in
industrial concerns only when they could not raise sufficient finances by raising capital or
normal banking accommodation.

In view of the vast size of the country and needs of the economy it was decided to
set up regional development banks to cater to the needs of the small and medium
enterprises. In 1951, Parliament passed State Financial Corporation Act. Under this Act
state governments could establish financial corporation for their respective regions. At
present there are 18 State Financial Corporations (SFC's) in India.

The IFCI and State Financial Corporation served only a limited purpose. There
was a need for dynamic institution which could operate as true development agencies.
National Industrial Development Corporation (NIDC) was established in 1954 with the
objective of promoting industries which could not serve the ambitious role assigned to it
and soon turned to be a financing agency restricting itself to modernization and
rehabilitation of cotton and jute textile industries.
 - 317 - : 317 :

The Industrial Credit and Investment Corporation India Ltd. (ICICI) was
established in 1955 as a joint stock company. ICICI was supported by Government of
India, World Bank, Common Wealth Development Finance Corporation and other
foreign institutions. It provides term loans and take an active part in the underwriting of
and direct investment in the shares of industrial units. Though ICICI was established in
private sector but its pattern of shareholding and methods of raising funds gives it the
characteristic of a public sector financial institution. ICICI Ltd. has now merged into
ICICI Bank.

Another institution, Refinance Corporation for Industry Ltd. (RCI) was set up in
1958 by Reserve Bank of India, LIC and Commercial Banks. The purpose of RCI was to
provide refinance to commercial banks and SFC's against term loans granted by them to
industrial concerns in private sector. In 1964, Industrial Development Bank of India
(IDBI) was set up as an apex institution in the area of industrial finance. RCI was merged
with IDBI, IDBI was a wholly owned subsidiary of RBI and was expected to co-ordinate
the activities of the institutions engaged in financing, promoting to developing industry.
However, it is no longer a wholly owned subsidiary of the Reserve Bank of India.
Recently it made a public issue of shares to increase its capital.

In order to promote industries in the state another type of institutions, namely, the
State Industrial Development Corporations (SIDC's) were established in the sixties to
promote medium scale industrial units. The state owned corporation have promoted a
number of projects in the joint sector and assisted sector. At present there are 28 SIDC's
in the country. The State Small Industries Development Corporations (SSIDC's) were
also set up to cater to the needs of industry at state level. These corporations manage
industrial estates, supply raw materials, run common service facilities and supply
machinery on hire-purchase basis. Some states have established specialized corporations
for the development of infrastructure, agro–industries, etc.

Investing Institutions
 - 318 - : 318 :

A number of other institutions also participated in industrial financing by

mobilizing public savings through introduction of insurance schemes, mutual funds, units
etc. These institutions also called investing included Unit Trust of India (UTI) established
in 1964, Life Insurance Corporation of India in 1956 and General Insurance Corporation
in 1973.

Other Institutions

Some more units were set up to provide help in specific areas such as
rehabilitation of sick units, export finance, agriculture and rural development. Industrial
Reconstruction Corporation of India Ltd. (RCI) was set up in 1971 for the rehabilitation
of sick units. In 1982 the Export – Import Bank of India (Exim Bank) was established to
provide financial assistance to exporters and importers. In order to meet credit needs of
agriculture and rural sector, National Bank for Agriculture and Rural Development
(NABARD) was set up in 1982. It is responsible for short term, medium – term and long
term financing of agriculture and allied activities. The institutions such as Film Finance
Corporation, Tea Plantation Finance Scheme, Shipping Development Fund, Newspaper
Finance Corporation, Handloom Finance Corporation, Housing Development Finance
Corporation also provide financial and other facilities in various areas.

Indian financial system has undergone massive changes since the announcement
of new economic policy in 1991. Liberalization/globalisation/deregulation has
transformed Indian economy from closed to open economy. The corporate industrial
sector structure has also undergone changes due to deli censing of industries, financial
sector reforms or reforms in banking/capital market, disinvestments in public sector
undertakings(PSUs), reforms in taxation and company law etc. Government role in the
distribution of finance and credit has declined over the years. Financial system is
focusing more attention towards the development of capital market which is emerging as
the main agency for the allocation of resources among the public, private sector and state
government. Major development that have taken place in the Indian financial system are
briefly discussed below :
 - 319 - : 319 :

1. Entry of Private Sector : Since 90's, Government control over financial

institutions has diluted in a phased manner. Public/Development Financial Institutions
have been converted into companies, allowing them to issue equity/bonds to the public.
Government has allowed private sector to enter into banking and insurance sector. IFCI
has been converted into a public company.

2. Changing Role of Development Finance Institutions (DFIs) : DFIs performed

the role of term-lending institutions extending loans for project finance, underwriting,
direct subscription, lease financing etc. They received funds from the Government and
the RBI. But now, there is remarkable shift in the activities of DFIs :

(a) DFIs are engaged in non-fund based financial activities such as merchant banking,
project counseling, portfolio management services, mergers and acquisitions, new
issue management etc.

(b) DFIs raise funds through issue of bonds carrying floating rate of interest or bonds
without government guarantee.

(c) Earlier, DFIs sponsored infrastructural institutions such as Technical Consultancy

Organisation (TCOs), Management Development Institution (MDI) and The
Institute for Financial Management and Research (IFMR). Then, focus shifted to
development of capital market. As a result, following institutions were promoted
by the DFIs.

(i) Credit Rating Information Services of India Ltd. (CRISIL).

(ii) Investment Information and Credit Rating Agency Ltd. (ICRA)

(iii) Credit Analysis and Research Ltd. (CARE)

(iv) Over the Counter Stock Exchange of India. (OTCEI) Ltd.

(v) National Stock Exchange (NSE) Ltd.

(vi) Stock Holding Corporation of India (SHCI) Ltd.

(vii) IFCI Financial Services Ltd.

 - 320 - : 320 :

(viii) IFCI Investors Services Ltd.

(ix) IFCI Custodial Services Ltd.

(x) ICICI- Securities and Finance Ltd.

3. Emergence of Non- Banking Financial Companies (NBFCs) : In the

unorganized non-banking sector, number of non-banking financial companies have
emerged providing financial services partly fee-based and partly asset/fund based. Their
activities include equipment leasing, hire-purchase finance, bills discounting,
loans/investments, venture capital, housing finance etc. Fee based services include
portfolio management, issue management, loan syndication, merger and acquisition etc.

4. Growth of Mutual Funds Industry : Initially, UTI was the single organisation
issuing the mutual funds units. But presently, the mutual funds are sponsored not only by
UTI but also by banks, insurance organisation. FIIs, private sector. There are off-
share/country funds being sponsored by FIIs and Indian FIs. Mutual funds are gaining
popularity among the small investors due to (i) tax exemption on income from mutual
funds and (ii) units of mutual funds if held for 12 months are to be treated as long-term

asset, for the purpose of capital gains tax.

5. Securities and Exchange Board of India (SEBI) : The Securities and Exchange
Board of India was established under the SEBI Act, 1992 with the following purposes : -
(i) to protect the interest of investors in securities;
(ii) to promote the development of the securities market;
(iii) to regulate the securities market; and
(iv) for matters connected therewith or incidental thereto.

Significant Changes in Financial System

Some of the significant changes that have taken place over the last few years and
that may have implications on the Indian financial system are listed below.
 - 321 - : 321 :

1. The Unit Trust of India, the leading mutual fund organisation has been split into
two parts as a consequence of the repeal of the UTI Act.
2. Private sector has been allowed in the insurance sector thus breaking the
monopoly of LIC and GIC. GIC has been delinked from its four subsidiaries.
3. The introduction of derivative trading including index/stock/interest futures and
options has also been one of the significant development having implications on
the financial system.

4. The merger of the ICICI Ltd. and IDBI into ICICI Bank and IDBI and respectively
and the proposed merger of IFCI into Punjab National Bank.

13.8 ROLE AND IMPORTANCE OF FINANCIAL INSTITUTIONS

Financial institutions (intermediaries) are business organisations serving as a link

between savers and investors and so help in the credit–allocation process. Good financial
institutions are vital to the functioning of an economy. If finance were to be described as
the circulatory system of the economy, financial institutions are its brain. They make
decisions that tell scarce capital where to go and ensure that it is used most efficiently. It
has been confirmed by research that countries with developed financial institutions grow
faster and countries with week ones are more likely to undergo financial crises.

Lenders and borrowers differ in regard to terms of risk, return and term of
maturity. Financial institutions assist in resolving this conflict between lenders and
borrowers by offering claims against themselves and, in turn, acquiring claims on the
borrowers. The former claims are referred to as indirect (secondary) securities and the
latter as direct (primary) securities.

Financial institutions provide three transformation services :

(i) Liability, asset and size transformation consisting of mobilization of funds, and
their allocation by providing large loans on the basis of numerous small deposits.
 - 322 - : 322 :

(ii) Maturity transformation by offering the savers tailor-made short–term claims or

liquid deposits and so offering borrowers long-term loans matching the cash flows
generated by their investment.

(iii) Risk transformation by transforming and reducing the risk involved in direct
lending by acquiring diversified portfolios.

Through these services, financial institutions are able to tap savings that are
unlikely to be acceptable otherwise. Moreover, by facilitating the availability of finance,
financial institutions enable the consumer to spend in anticipation of income and the
entrepreneur to acquire physical capital.

Financial institutions provide means and mechanism of transferring resources

from those who have an excess of income over expenditure to those who can make
productive use of the same. The commercial banks and investment institutions mobilize
savings of people and channelize them into productive uses. Economic development of a
country needs sufficient financial resources, adequate infrastructural faculties and persons
who can take the initiative of setting up units for providing goods and services. Financial
institutions provide all types of assistance required for development. These institutions
help economic development in the following ways :
1. Providing Funds. The underdeveloped countries have low levels of capital
formation. Due to low incomes, people are not able to save sufficient funds which are
needed for setting up new units and also for expansion, diversification and modernization
of existing units. These persons who have the capability of starting a business but does
not have requisite help approach financial institutions for help. These institutions help
large number of persons for taking up some industrial activity. The addition of new
industrial units and increasing the activities of existing units will certainly help in
accelerating the pace of economic development. Financial institutions have large
investible funds which are used for productive purpose.
2. Infrastructural Facilities. Economic development of a country is linked to the
availability of infrastructural facilities. There is a need for roads, water, sewerage,
 - 323 - : 323 :

communication facilities, electricity etc. Financial institutions prepare their investment

policies by keeping national priorities in mind. The institutions invest in those areas
which can help in increasing the development of the country. Indian industry and
agriculture is facing acute shortage of electricity. All Indian institutions are giving
priority to invest funds in projects generating electricity. These investments will certainly
increase the availability of electricity. Small entrepreneurs cannot spare funds for creating
infrastructural facilities. To overcome this problem institutions at state level are
developing industrial estates and provide sheds, having all facilities, at easy installments.
So financial institutions are helping in the creation of all those facilities which are
essential for the development of a country.
3. Promotional Activities. An entrepreneur faces many problems while setting up a
new unit. One has to undertake a feasibility report, prepare project report, complete
registration formalities, seek approval from various agencies etc. All these things require
time, money and energy. Some people are not able to undertake this exercise or some do
not even take initiative. Financial institutions have the expertise and manpower resources
for undertaking the exercise of starting a new unit. So these institutions take up this work
on behalf of entrepreneurs. Some units may be set up jointly with some financial
institutions and in that case the formalities are completed collectively. Some units may
not have come up had they not received promotional help from financial institutions. The
promotional role of financial institutions is helpful in increasing the development of a
country.
4. Development of Backward Areas. Some areas remain neglected because
facilities needed for setting up new units are not available there. The entrepreneurs set up
new units at those places which are already developed. It causes imbalance in economic
development of some areas. In order to help the development of backward areas,
financial institutions provide special assistance to entrepreneurs for setting up new units
in these areas. IDBI, IFCI, ICICI give priority in giving assistance to units set up in
backward areas and even charge lower interest rates on lending. Such efforts certainly
encourage entrepreneurs to set up new units in backward areas. The industrial units in the
 - 324 - : 324 :

these areas improve basic amenities and create employment opportunities. These
measures will certainly help in increasing the economic development of backward areas.
5. Planned Development. Financial institutions help in planned development of the
economy. Different institutions earmark their spheres of activities so that every business
activity is helped. Some institutions like SIDBI, SFC's especially help small scale sector
while IFCI and SIDC's finance large scale sector or extend loans above a certain limit.
Some institutions help different segments like foreign trade, tourism etc. In this way
financial institutions devise their roles and help the development in their own way.
Financial institutions also follow the development priorities set by central and state
Governments. They give preference to those industrial activities which have been
specified in industrial policy statements and in five year plans. Financial institutions help
in the overall development of the country.
6. Accelerating Industrialization. Economic development of a country is linked to
the level of industrialization there. The setting up of more industrial units will generate
direct and indirect employment, make available goods and services in the country and
help in increasing the standard of living. Financial institutions provide requisite financial,
managerial, technical help for setting up new units. In some areas private entrepreneurs
do not want to risk their funds or gestation period is long but the industries are needed for
the development of the area, financial institutions provide sufficient funds for their
development. Since 1947, financial institutions have played a key role in accelerating the
pace of industrialization. The country has progressed in almost all areas of economic
development.
7. Employment Generation. Financial institutions have helped both direct and
indirect employment generation. They have employed many persons to man their offices.
Besides office staff, institutions need the services of experts which help them in finalizing
lending proposals. These institutions help in creating employment by financing new and
existing industrial units. They also help in creating employment opportunities in
backward areas by encouraging the setting up of units in those areas. Thus financial
institutions have helped in creating new and better job opportunities.
 - 325 - : 325 :

In India, various financial institutions were set up after independence. The

Government of India has taken steps to set up institutions which assist various sectors of
the economy. The working of some financial institutions is discussed in the following
pages :

1. IFCI and Industrial Finance

Financial Assistance
The sanctions of financial assistance by IFCI went up to Rs.6579.7 crores in 1995-
96 from Rs.32.3 crores in 1970-71. But it declined to Rs. 778.0 crores by 2001-02. The
figures in Table show that the sanctions of financial assistance again went up to Rs.
2035.1 in 2002-03 crores registering an increase of 161.6% over the last year. Up to
March 2003, total sanctioned assistance was Rs. 45426.7 crore while disbursements were
Rs. 44169.2 crore.

Table I : Trend in Assistance Sanctioned and Disbursed

(Rs. Crore)
Growth Growth
Year Sanctions Disbursements
Rate (%) Rate (%)
1970-71 32.3 17.4
1971-72 28.7 -11.1 23.3 33.9
1972-73 45.7 59.2 28.0 20.2
1973-74 41.9 -8.3 31.9 13.9
1974-75 29.2 30.3 37.0 16.0
1975-76 51.3 75.7 34.7 -6.2
1976-77 76.6 49.3 54.9 58.2
1977-78 113.4 48.0 57.5 4.7
1978-79 138.5 22.1 73.5 27.8
1979-80 137.9 -0.4 91.0 23.8
1980-81 206.6 49.8 108.9 19.7
 - 326 - : 326 :

1981-82 218.1 5.6 169.4 55.6

1982-83 230.2 5.5 196.1 15.8
1983-84 321.9 39.8 224.5 14.5
1984-85 415.4 29.0 272.9 21.6
1985-86 499.2 20.2 403.9 48.0
1986-87 798.1 59.9 451.6 11.8
1987-88 922.6 15.6 657.1 45.5
1988-89 1635.5 77.3 997.5 51.8
1989-90 1817.0 11.1 1121.8 12.5
1990-91 2429.8 33.7 1574.3 40.3
1991-92 2421.2 -0.4 1604.4 1.9
1992-93 2347.9 -3.0 1733.4 8.0
1993-94 3745.9 59.5 2163.1 24.8
1994-95 4327.0 15.5 2838.7 31.2
1995-96 6579.7 52.1 4586.5 61.6
1996-97 3952.2 -39.9 5175.5 12.8
1997-98 5708.2 44.4 5615.0 8.5
1998-99 3622.7 -36.5 4836.4 -13.9
1999-2000 2045.6 -43.5 3374.3 -30.2
2000-2001 1417.9 -30.7 2152.7 -36.2
2001-2002 778.0 -45.1 1069.9 -49.0
2002-2003 2035.1 161.6 1796.5 63.8
Cumulative upto
45426.7 44169.2
end March 2003
Source : IDBI Report.
Product-Wise Assistance
IFCI has been substantially increasing financial assistance to industrial sector.
IFCI provides direct financial assistance for financing projects in terms of rupee loans,
foreign currency loans and by underwriting and direct subscription to shares, debentures
and bonds. It also provides direct financial assistance for financing equipments/asset, for
meeting working capital requirements, for equipment leasing etc. It also provides
discounting facilities and undertakes investments in shares/bonds of FIs. The product-
wise assistance sanctioned and disbursed by IFCI for the last 5 years is presented in table
II below.
The table II shows that upto March, 2003 total project finance sanctioned
amounted to Rs. 37122.6 crore out of total assistance of Rs. 45426.7 crore. Most of the
funds were disbursed in terms of rupee loans which accounted for Rs. 22516.0 crore upto
 - 327 - : 327 :

March, 2003 out of the total funds disbursed for project finance which stood at a figure of
Rs. 35926.4 crore.
Equipment Finance. IFCI has been operating a scheme of Equipment Finance since
1984-85 to help industrial concern in purchasing capital equipment. Under the scheme
assistance of the order of Rs. 3971.8 crore was sanctioned and disbursed up to March,
2003.
 Table II : Product-Wise Assistance Sanctioned And Disbursed

Sr. Product Sanctions Disbursments

No. 1998-99 1999-2000 2000-01 2001-02 2002-03 Commul- 1998-99 1999-2000 2000-01 2001-02 2
ative upto
end March
2003
1. Direct Finance
A. Project Finance
(i) Loans
(a) Rupee loans 2097.8 1282.0 710.4 539.8 1531.9 23269.6 2339.2 1690.4 1081.4 810.6
(b) Foreign currency loans 9.7 -- 145.7 -- 45.8 5276.8 366.1 252.1 138.3 29.7
(ii) Underwriting & direct
subscription
(a) Shares 35.7 152.3 73.6 31.5 220.6 1029.9 139.8 66.4 100.1 66.3
(b) Debentures/bonds 557.5 345.3 325.9 115.9 173.1 3699.0 550.3 492.6 291.6 132.0
(iii) Deferred payment 428.9 120.6 115.5 34.2 50.3 3784.3 834.2 525.7 481.8 27.0
guarantees
Sub Total (A) 3129.6 1900.2 1371.1 721.4 2021.7 37122.6 4229.6 3027.2 2093.2 1065.6
B. Non-Project Finance
(i) Asset credit/equipment 241.7 25.2 -- -- -- 3971.8 222.3 146.7 6.0 --
finance
(ii) Corporate loans 123.7 46.3 -- 3.5 -- 1198.1 142.8 101.1 1.7 8.2
(iii) Working capital/short- 50.2 14.7 35.0 35.0 9.7 2201.6 55.7 5.0 35.0 5.0
term loans
(iv) Equipment leasing 13.0 -- -- -- -- 763.2 121.5 35.1 5.0 --
Sub Total (B) 428.6 86.2 35.0 38.5 9.7 8134.7 542.3 287.9 47.7 13.2
Total (1) 3558.2 1986.4 1406.1 759.9 2031.4 45257.3 4771.9 3315.1 2140.9 1078.8
2. Direct discounting -- -- 3.8 -- -- 3.8 -- -- 3.8 --
3. Loans to and investments in 64.5 59.2 8.0 18.1 3.7 165.6 64.5 59.2 8.0 18.1
shares/bonds of FIs
Grand Total (1+2+3) 3622.7 2045.6 1417.9 778.0 2035.1 45426.7 4836.4 3374.3 2152.7 1096.9
Source : IDBI Report, 2002-2003
 : 329 :

Equipment Leasing. IFCI also provides financial assistance by way of leasing

arrangement for the equipment indigenous/imported to the existing industrial concerns.
The overall sanctions under the scheme up to 31st March, 2003 accounted to Rs. 763.2
crore out of which Rs. 747.1 crore were disbursed.
Investment in Shares/Bonds. IFCI has been investing in the shares and bonds of
financial Institutions. Up to March, 2003 loans and investments in shares/bonds of FIs
stood at a figure of Rs. 165.6 crore.

Purpose-wise Assistance
In the purpose-wise sanctions and disbursements, new projects got Rs. 15919.6
crore which is 35.17 percent of total sanctions up to March 31, 2003. The second
category which got more funds sanctioned was expansion/ diversification programmes.

Table III : Purpose –wise Assistance sanctioned and disbursed upto

March, 2003
(Rs. crore)
S.No. PURPOSE Sanctions Disbursements
1. New 15919.6 15611.3
2. Expansion/diversification/
acquisition 6649.2 6547.5
3. Rehabilitation 115.7 114.1
4. Modernization/balancing
equipment 5459.7 5480.4
5. Working Capital 837.5 774.2
6. Others(a) 16279.4 15476.1
Total 45261.1 44003.6
(a) Others include corporate loans, short – term loans, bridge loans, overruns, financial
restricting etc.
Source : IDBI Report.
The table III depicts that modernization schemes got Rs. 5459.7 crore as sanctions
while Rs. 837.5 crore was provide for meeting working capital needs. So the main thrust
has been on new projects, expansion and modernization schemes.

Sector-Wise Assistance
The corporation provided maximum financial assistance to the private sector by
sanctioning Rs. 40660.9 cores as on March, 2003. This constituted over 89 per cent of the
 : 330 :

total assistance sanctioned by IFCI. The public sector got sanctioned and disbursed Rs.
1541.1 crore and Rs. 1539.1 crore respectively. Till 31st March, 2003, cooperative sector
received assistance to the tune of Rs. 838.4 crore out of Rs. 44003 crore disbursed.

Table IV : Sector-wise Assistance Sanctioned and disbursed as on

31st March, 2003
(Rs. Crore)
S.No. Sector Sanctions Disbursements
1. Public 1541.1 1539.1
2. Joint 2192.0 2146.0
3. Co-operative 867.1 838.4
4. Private 40660.9 39480.1
Total 45261.1 44003.6

2. Financial Performance of IDBI

The main objective of IDBI is to provide term finance and financial
services for establishment of new project as well as the expansion, diversification,
modernization and technology upgradations of existing industrial enterprises. It is one of
the important financial institutions which has provided lot of funds for industrial
activities in the country.

Purpose- wise Assistance Sanctioned

TABLE –V PURPOSE –WISE ASSISTANCE SANCTIONED
Sr. Purpose Sanctions
No. 1998-99 1999-2000 2000-01 2001-02 2002-03 Cumulative up to
end-March 2003
1 New 5743.9 6987.4 7954.6 2596.8 830.2 67498.8
2 Expansion/
diversification/ 6608.5 3809.8 4383.1 2104.4 212.1 50627.3
acquisition
3 Modernization/
balancing equipment 1339.6 1095.6 1145.8 371.6 102.2 12976.5
4 Rehabilitation 13.4 99.3 672.5 133.7 114.0 1415.8
5 Working capital 5138.4 9099.4 8283.1 7781.5 1464.3 44086.5
Total 18843.8 21091.5 22439.1 12988.0 2722.8 176604.9

Source : IDBI Report.

IDBI was setup to provide financial assistance to both new as well as to the
existing ones for expansion diversification purposes. Almost one third of the total
 : 331 :

assistance amounting to Rs. 67498.8 crore was extended to finance new projects as on
March, 2003. Rs. 50627.3 crore (i.e. 28.6% of the total assistance) was provided for
expansion/diversification programmes, Rs. 44086.5 crore(i.e. almost one – fourth of the
total assistance of Rs. 176604.9 crore) was provided for meeting working capital needs.
The cumulative assistance disbursed for all purposes under direct finance upto end
March, 2003 amounted to Rs. 1,31,112. 3 crore.

Sector-wise Distribution of Assistance Sanctioned

IDBI meets the financial need of public, private, cooperative and trusts also. Table
VI exhibits sector-wise distribution of IDBI's assistance. The private sector has been the
main beneficiary as 77% of the total assistance (i.e. Rs. 169304.4 crore out of Rs.
217873.3 crore) was extended to private sector as on March 2003.

Table VI: Sector-wise Assistance Sanctioned and disbursed as on March, 2003

(Rs. crore)
S.No. SECTOR Amount Percentage

Public 34963.0 16.05

1.
Joint 11753.7 5.39
2.
Co-operative 1802.2 .83
3.
Private 169304.4 77.71
4.
Trust .02
5. 50.0
Total 217873.3 100.0

Table VI depicts that 16.05 per cent share in finance sanctioned was enjoyed by
the public sector, remaining 6-7 per cent was shared by joint, cooperative and trusts.

Institution-wise Assistance
Institution–wise finance was provided to SFCs and SIDCs by IDBI under
refinance scheme. The finance sanctioned declined from Rs. 129.8 crore in 2000-01 to
 : 332 :

Rs. 87.7 crore in 2001-02 in case of SFCs and from Rs. 233.2 crore in 2000-01 to Rs.
99.6 crore in 2000.02 in respect of SIDCs (see table VII).

Table VII: Institution wise Refinance Assistance

(Rs. crore)
S.No. 2000-01
Institution 2001-02

SFCs 129.8 87.7

1.
SIDCs 233.2 99.6
2.
Total 363.0 187.3

3. Working of ICICI
The primary aim of setting up ICICI was to provide foreign currency
finance to industrial project and promote industries in private sector. In due course of
time it diversified into a number of other activities and now offers a complete package of
financial services either directly or through its subsidiaries. It has also been managing
United States Agency for International Development (US AID) and World Bank funds
through its technological financing programmes. ICICI provides financial packages for
research and development, commercialization of technology, venture capital and special
technologies relating to pollution control and environment protection.
The trend in assistance sanctioned and disbursed by ICICI has been shown
in Table VIII. The cumulative sanctions up to end March, 2002 amounted to Rs.
2,83,510.9 crore whereas disbursements amounted to Rs. 1,71,698.3 crore. Project- wise
assistance sanctioned and disbursed has been presented in Table IX. Table X shows
sector-wise and Table-XI purpose-wise assistance sanctioned and disbursed.
 : 333 :

TABLE VIII : TREND IN ASSISTANCE SANCTIONED AND DISBURSED

Year Sanctions Growth Distribution Growth
Rate (%) Rate (%)
1970-71 43.9 28.9
1971-72 39.7 9.6 30.0 4.8
1972-73 49.4 24.4 39.7 31.0
1973-74 61.1 23.7 43.5 9.6
1974-75 62.9 2.9 45.4 4.4
1975-76 78.6 25.0 61.1 34.6
1976-77 98.7 25.6 67.3 10.1
1977-78 108.3 9.7 91.6 36.1
1978-79 182.8 68.8 109.2 19.2
1979-80 204.3 11.8 135.8 24.4
1980-81 314.1 53.7 185.3 36.5
1981-82 302.4 -3.7 264.7 42.8
1982-83 392.1 29.7 282.2 6.6
1983-84 507.6 29.5 334.2 18.4
1984-85 620.7 22.3 292.7 17.5
1985-86 708.2 14.1 482.2 22.8
1986-87 1118.3 57.9 695.5 44.2
1987-88 1231.7 10.1 771.2 10.9
1988-89 1978.1 60.6 1085.6 40.8
1989-90 2850.6 44.1 1357.1 25.0
1990-91 3744.0 31.3 1967.5 45.0
1991-92 4094.9 9.4 2351.3 19.5
1992-93 5771-8 41.0 3315.2 41.0
1993-94 8491.4 47.1 4413.3 33.1
1994-95 14527.9 71.1 6879.3 55.9
1995-96 14594.9 0.5 7120.4 3.5
1996-97 14083.8 -3.5 11180.9 57.0
1997-98 24717.5 75.5 15806.9 41.4
1998-99 32370.6 31.0 19225.1 21.6
1999-2000 43522.8 34.5 25835.7 34.4
2000-01 55815.2 28.2 31664.5 22.6
2001-02 36229.2 -35.1 25831.0 -18.4
Cumulative 283510.9 171698.3
upto
end-March
2002
Note : Following the merger of ICICI Ltd. along with two of its subsidiaries with ICICI
Bank Ltd., effective May 3,2002, ICICI Ltd. ceased to exist.
Source : IDBI Report.
 Table IX : Product-Wise Assistance Sanctioned And Disbursed

Sr. Product Sanctions Disbur

No. 1998-99 1999-2000 2000-01 2001-02 Commul- 1998-99 1999-2000 2000
ative upto
end March
2002
1. Direct Finance
A. Project Finance
(i) Loans
(a) Rupee loans 15605.0 16511.1 19744.0 12297.0 99713.8 10632.2 10473.6 10
(b) Foreign currency loans 2694.6 5529.7 5985.0 987.2 42941.0 1183.6 2947.4 3
(ii) Underwriting & direct
subscription
(a) Shares 329.4 2270.0 1200.5 1103.6 10537.0 116.8 716.8
(b) Debentures/bonds 3390.5 5735.9 6502.7 3689.0 33186.9 2336.3 4530.7 3
(iii) Deferred payment guarantees 2655.3 2317.5 4661.9 3880.4 25316.1 15.3 36.2
Sub Total (A) 24674.8 32364.2 38094.1 21957.7 211700.0 14284.7 18704.7 18
B. Non-Project Finance
(i) Asset credit/equipment finance 2008.2
(ii) Corporate loans 4431.8 5878.5 6857.4 3345.8 30019.0 3294.7 4139.4 4
(iii) Working capital/short-term 3511.5 1462.7 4974.2 3
loans
(iv) Equipment leasing 1005.1 1621.5 1889.6 19.0 9700.0 683.1 953.1
Sub Total (B) 5436.9 7500.0 12258.5 4827.5 46701.4 3977.8 5092.5 9
Total (1) 30111.7 39864.2 50352.6 26785.2 258401.4 18262.0 23797.2 27
2. Direct discounting 1838.7 2722.1 1302.6 273.0 10421.7 542.9 1330.1
3. Loans to and investments in 420.2 936.5 4160.0 9171.0 14687.8 420.2 708.4 3
shares/bonds of FIs
Grand Total (1+2+3) 32370.6 43522.8 55815.2 36229.2 283510.9 19225.1 25835.7 31

Source: IDBI Report

 Table X : SECTOR -WISE ASSISTANCE SANCTIONED AND DISBURSED

Sr. Product Sanctions Disbursments

No. 1998-99 1999-2000 2000-01 2001-02 Commu- 1998-99 1999-2000 2000-01 2001-0
lative

1 Public 7301.1 11102.0 9568.5 7129.0 45976.5 3887.9 5706.8 6438.4 383
2 Joint 346.5 706.9 593.5 84.6 6733.0 718.4 516.9 470.8 2
3 Cooperative - 357.0 210.0 100.0 2465.6 0.1 253.5 310.0

4 Private 24723.0 31356.9 45443.0 28915.6 228335.8 14618.7 19358.5 24445.3 2197
Total 32370.6 43522.8 55815.0 36229.2 283510.9 19225.1 25835.7 31664.5 2583

Source: IDBI Report

Table XI : PURPOSE -WISE ASSISTANCE SANCTIONED AND DISBURSED

Sr. Product Sanctions Disbursments

No. 1998-99 1999-2000 2000-01 2001-02 1998-99 1999-2000 2000-0
1 New 5245.3 3302.3 8714.2 4149.2 1747.1 1037.4 16
2 Expansion/ Diversification/ 6639.1 7530.3 5073.5 693.9 3821.1 3517.3 26
Acquisition
3 Modernisation/ Balancing 2408.8 4328.0 4415.9 307.9 1685.3 2525.0 23
Equipment

4 Rehabilitation 5.0 3.2 2.7 3.0 3.4

5 Other 18072.4 28359.0 37608.9 31078.2 11968.6 18752.6 250
Total 32370.6 43522.8 55815.2 36229.2 19225.1 25835.7 3166
Source: IDBI Report
 : 336 :

4. Working of Industrial Investment Bank of India (IIBIL)

Product–wise Assistance
IIBIL offers a variety of financial products such as project finance, short duration
non-project asset- backed financing and working capital/other short-term loans to
companies.

Table XII : Sector-wise Assistance Sanctioned and disbursed as on

31st March, 2003

(Rs. Crore)
S.No. Product Sanctions
Disbursements
Direct Finance
(1)
(a) Project Finance 4252.1 3678.4
(b) Non-Project Finance 4370.2 4155.7
Total (1) 8622.3 7834.1
Secondary Market Operations 3240.2 3228.7
(2)
Grand Total 11862.5 11062.8
The IIBIL sanctioned almost equal amount to finance both project and non-project
purposes. As on 31st March, 2003 direct finance sanctioned and disbursed for financing
projects stood at Rs. 4252.1 crore and Rs. 3678.4 crore respectively. Where as the
corresponding figures for non-project category were Rs. 4370.2 crore and Rs. 4155.7
crore respectively. IIBIL also undertook investments in shares and debenture and bonds
of financial institutions in secondary market.

Trend in Assistance Sanctioned and Disbursed

Table XIII depicts that w.e.f. 1997-98 till 2000-01 there was remarkable increase
in the amount of assistance sanctioned and disbursed as compared to last 25 years. The
amount sanctioned stood at Rs. 816 crore during the year 1996-97 and it rose to
Rs.2338.1 crore by 1999-2000. By the end of March, 2003, total assistance provided was
Rs. 11862.5 crore as against Rs. 11062.8 crore disbursed.
 : 337 :

Table XIII Assistance Sanctioned and Disbursed

(Rs. crore)
Growth Growth
Year Sanctions Disbursements
rate (%) rate(%)
1971-72 6.6 1.1
1972-73 6.1 -7.6 3.5 218.2
1973-74 7.2 18.0 5.2 48.6
1974-75 7.6 -5.6 8.0 53.8
1975-76 5.3 -30.3 4.7 41.3
1976-77 10.0 88.7 10.8 129.8
1977-78 10.9 9.0 9.1 -15.7
1978-79 10.7 -1.8 12.6 38.5
1979-80 15.2 42.1 12.5 -0.8
1980-81 19.4 27.6 16.9 35.2
1981-82 50.4 159.8 28.4 68.0
1982-83 62.3 23.6 37.9 33.5
1983-84 69.5 11.6 41.4 9.2
1984-85 110.8 59.4 54.8 32.4
1985-86 75.2 -32.1 67.8 23.7
1986-87 149.9 98.0 94.7 39.7
1987-88 186.5 25.3 101.9 7.6
1988-89 208.8 12.0 116.5 -14.3
1989-90 146.6 29.8 141.1 21.1
1990-91 234.7 60.1 153.9 9.1
1991-92 277.7 18.3 185.2 20.3
1992-93 294.3 6.0 183.9 -0.7
1993-94 425.8 44.7 188.6 2.6
1994-95 777.9 82.7 397.6 110.8
1995-96 897.3 15.3 528.6 32.9
1996-97 816.0 -9.1 549.6 4.0
 : 338 :

1997-98 2061.0 152.6 1153.2 109.8

1998-99 21752 5.5 1688.5 46.4
1999-2000 2338.1 7.5 1439.6 -14.7
2000-01 2102.3 -10.1 1709.8 18.8
2001-02 1320.7 -37.2 1070.0 -37.4
2002-03 1206.4 -8.7 1091.9 2.0
Cumulative upto
end-March 2002 11862.5 11062.8

Source : IDBI Report.

Sector–wise Classification of Assistance

The IIBIL provides assistance to public, joint cooperative and private sectors.
However, the major beneficiary has been the private sector. Upto March, 2003, the
assistance sanctioned and disbursed to private sector stood at Rs. 8416.8 crore and Rs.
7691.7 crore respectively as shown in Table XIV below :

Table XIV Sector-wise Assistance Sanctioned and Disbursed

Sanctions as on 31 Disbursements as
Sr.No. Sector
March, 2003 on 31st March, 2003
1 Public 2813.0 2765.8

2 Joint 585.0 557.6

3 Co-operative 47.7 47.7

4 Private 8416.8 7691.7

Total 11862.5 11062.8

 : 339 :

Purpose–wise Distribution of Finance

IIBIL has provided assistance to new projects as well as existing one for their
expansion, diversification and modernization and for equipments finance. Recently, it has
started rendering assistance for meeting working capital margin, short, medium and long-
term resources, strengthening liquidity etc.
Table XV clearly depicts that IIBI has been providing more assistance for the
expansion, diversification purpose as the amount of assistance sanctioned stood at Rs.
4410.4 crore as compared to the assistance sanctioned for new projects which is just Rs.
1208.3 crore as on March, 2003. More than 20% of the total assistance accounted for
working capital.
 Table XV : PURPOSE–WISE ASSISTANCE SANCTIONED AND DISBURSE
Sr. Purpose Sanctions Disbursement
No.
1998- 1999- 2000-01 2001- 2002- Cumulative 1998- 1999- 2000
99 2000 02 03 to end – 99 2000 -01
March
2003
1 New 369.6 38.5 - - 1208.3 263.3 126.7 -
2 Modernization/
balancing 565.5 854.0 1335 397.3 117.6 4410.4 279.8 241.7 1196.1
equipment
3 Rehabilitation 33.1 - - - 873.6 25.7 - -
4 Working 823.8 626.4 766 162.5 105.5 2416.9 710.8 564.7 513.7
capital
5 Others 383.2 819.2 1 760.9 983.3 2953.3 408.9 506.5 -
Total 2175.2 2338.1 2102 1320.7 1206.4 11862.5 1688.5 1439.6 1709.8

Source : IDBI Report, 2002- 2003

 : 341 :

5. Operations of SFC's
State Financial Corporations have been framing lending policies depending
upon the requirements of the state. SFC's sanctioned a total amount of Rs. 30374.5
crore up to March 1999 and the amounts disbursed were Rs. 24867.8 crore. The
amounts sanctioned by these corporations have shown a decline in the last few
years. In the year 1994-95 the amounts sanctioned were Rs. 4188.5 crore and it
came down to Rs. 1864.2 crore in the year 1998-99. The small scale sector is the
main beneficiary of lendings of these corporations. These corporations have
been giving more emphasis on investing in new units and more than70 per cent of
their funds went to these units.
Rs. 273.2 crore in 1998-99 from Rs. 594.5 crore in 1996-97. There is an overall
decline in lending by SFC in the last some years which indicates a declining
industrial growth trend. The small scale sector is facing a stiff competition from
multinationals which have entered the country after globalization of Indian
economy. The quantitative restrictions on imports have completely been removed
by Govt. of India from April 1, 2001 and this will expose this sector to a global
competition.
State Financial Corporations have been framing lending policies depending upon the requirements of the state. The
amounts sanctioned by these corporations have shown a decline in the last few years. In the year 1995-96, the amounts sanctioned
were Rs. 4188.5 crore and it came down to Rs. 1864.2 crore in the year 1998-99. Similarly, Rs. 2790 crore were sanctioned during the
year 2000-2001 but it declined to Rs. 1855.9 crore during the year 2002-2003. The following table gives details of the amount
sanctioned and disbursed for the last few years.
 : 342 :

Financial Assistance Sanctioned and Disbursed (Rs. crore)

Period Amount Sanctioned Amount disbursed

1991-92 2190.3 1536.8
1992-93 2015.3 1557.4
1993-94 1908.8 1563.4
1994-95 2702.4 1880.9
1995-96 4188.5 2961.1
1996-97 3544.8 2782.7
1997-98 2626.1 2110.2
1998-99 1864.2 1624.7
1999-2000 2237.8 1825.1
2000-2001 2790.7 2008.1
2001-2002 2075.9 1762.5
2002-2003 1855.9 1454.0

Source : Economic Survey.

13.9 SUMMARY
Banks and financial institutions are intermediaries that mobilize savings
and facilitate the allocation funds in an efficient manner. Financial institutions can
be classified as banking and non-banking financial institutions. Banking
institutions are purveyors of credit. While the liabilities of banks are part of the
money supply, this may not be true in case of non-banking financial institutions.
In India, non-banking financial institutions are the major institutional purveyors of
credit. In the post reforms era, the role and nature of activity of financial
institutions have undergone tremendous change. Banks and financial institutions
have now undertaken non-bank activities and financial institutions are planning to
undertake banking function. Most of the financial institutions now resort to
financial markets for raising funds.
 : 343 :

13.10 Self Assessment Questions

1. Define financial institutions. Discuss the various type of financial
institutions.
2. Discuss the development that have taken place in Indian Financial
System since independence.
3. What role do financial institution play as a financial intermediary in
financial market ? Discuss.
 ROLE OF FOREIGN BANKS AND NBFCs

OBJECTIVE The present chapter explains the role of foreign banks and Non-Banking

Financial Companies in of Indian economy.

STRUCTURE

14.1 Introduction
14.2 Foreign Banks in India
14.3 Obstacle before Foreign Banks
14.4 Prospect of Foreign Banks in India
14.5 Non-Banking Finance Companies
14.6 Types of NBFCs
14.7 Growth of NBFCs
14.8 Regulations of NBFCs
14.9 Summary
14.10 Self-Test Questions
14.11 Suggested Readings

14.1 INTRODUCTION
The past decade has seen a transformation of the role of foreign banks in
emerging markets. It has been a process that has often aroused considerable
controversy, and featured prominently in many cases. The benefits foreign banks
can offer are now much more widely recognised. But it would be naive to pretend
that there are no drawbacks or no difficult choices for local supervisory
authorities. The supervisory response to the rapid rise of foreign banks is still
being refined - and, in some countries, remains an important task. Foreign banks
have become well established as key vehicles in the international integration of
the financial systems of emerging market economies. There has been a strategic
shift by foreign banks away from pursuing internationally active corporate clients
towards the exploration of business opportunities in the domestic market.
Financial sector reforms were initiated as part of overall economic reforms in the
country and wide ranging reforms covering industry, trade, taxation, external
sector, banking and financial markets have been carried out since mid 1991. A
decade of economic and financial sector reforms has strengthened the
fundamentals of the Indian economy and transformed the operating environment
for banks and financial institutions in the country. The sustained and gradual pace
of reforms has helped avoid any crisis and has actually fuelled growth. As pointed
 out in the RBI Annual Report 2001-02, GDP growth in the 10 years after reforms
i.e. 1992-93 to 2001-02 averaged 6.0% against 5.8% recorded during 1980-81 to
1989-90 in the pre-reform period. The most significant achievement of the
financial sector reforms has been the marked improvement in the financial health
of commercial banks in terms of capital adequacy, profitability and asset quality
as also greater attention to risk management. Further, deregulation has opened up
new opportunities for banks to increase revenues by diversifying into investment
banking, insurance, credit cards, depository services, mortgage financing,
securitisation, etc. At the same time, liberalisation has brought greater
competition among banks, both domestic and foreign, as well as competition from
mutual funds, NBFCs, post office, etc.

14.2 FOREIGN BANKS IN INDIA

The Hong Kong and Shanghai Banking Corporation's association with the

banking industry in India has been for about 150 years and is nearly as old as the

history of banking in the country. It goes back to 1853, when the Mercantile Bank

of India, China and London, was established in Mumbai, with its headquarters in

London. The following year saw the establishment of the Bank's first branch in

the city. It has since then, steadily grown not only in size but also in terms of its

reach. It currently has 31 operational branches spread across 14 cities in India.

Over such a long period, it has seen many a transition, but broadly speaking, it

needs to mention at least three major ones. First, the Pre-Independence period,

during which period, foreign banks dominated the trade scenario in India. Their

most important role then was to finance and facilitate the trade and

industrialization process in the country. Unlike Indian banks, these banks were

registered universally and therefore, enjoyed greater networking with so many

branches at the global level.

The second phase associated with the post-independence period, saw the

nationalization of major Indian banks in 1969 that led to Indian public sector
banks reaching 'commanding heights' in the country and, to some extent, stifled

the growth of foreign banks. The concept of 'reciprocity' was very strong at that

time. Opening branches in India implied not only going through rigorous

licensing formalities with the RBI, but also improving provisions for creating

corresponding opportunities for opening branches of Indian banks in respective

foreign countries.

The third phase truly belongs to the post-liberalization reforms, unleashed since

July 1991, marking a paradigm shift in the economic policies followed by India.

Undoubtedly, this has unfolded a new era for the entire banking industry. The

policy makers have realized the imperatives of liberalization, privatization and

globalization. Also, the realization that India has to move further beyond, from

manufacturing and production to service-oriented activities, continues to

accelerate the process. Today's world is one without barriers, where technology is

advanced enough to facilitate instant communication.

An urgent need was felt to encourage competitiveness in the banking industry and

hence a series of reforms were initiated. For foreign banks, this has been the most

opportune time thanks to the relaxation of stringent norms binding on their

operations for so long. Fortunately, successive governments have been pursuing

the process of liberalization, thereby building the confidence and commitment of

foreign banks.

With better international linkages and efficient distribution channels, foreign

banks offer better services to their customers. Since they operate in several

countries, they have varied experiences of customer handling and product

innovation in different environments in various parts of the world. Therefore, they

can follow a policy of 'plug and play', which gives them a scope to quickly

respond to market requirements by introducing new products and services tried

and tested already in other markets.

After the set up foreign banks in India, the banking sector in India also become

competitive and accurative. New rules announced by the Reserve Bank of India

for the foreign banks in India in this budget has put up great hopes among foreign

banks, which allows them to grow, unfettered. Now foreign banks in India are

permitted to set up local subsidiaries. The policy conveys that foreign banks in

India may not acquire Indian ones (except for weak banks identified by the RBI,

on its terms) and their Indian subsidiaries will not be able to open branches freely.

List of Foreign Banks in India is as follows:

1 ABN-AMRO Bank
2 Abu Dhabi Commercial Bank
3 Bank of Ceylon
4 BNP Paribas Bank
5 Citi Bank
6 China Trust Commercial Bank
7 Deutsche Bank
8 HSBC
9 JPMorgan Chase Bank
10 Standard Chartered Bank
11 Scotia Bank
12 Taib Bank

By the year 2009, the list of foreign banks in India is going to become more

quantitative as numbers of foreign banks are still waiting with baggage to start

business in India.

Generally, liberalization has brought about a remarkable transformation in the

banking industry in India. In the last few years, Indians have evolved as
discerning customers. Their aspirations and accordingly, their demands have

changed dramatically. They are now more open to the acceptance of new financial

products, and their changing requirements have encouraged banks to innovate

their financial products and their ways of offering banking services. Indeed, the

post-1991 period has been the most stimulating and by far, the best time for

foreign banks in India.

It is strongly believed that while regulatory and legislative changes are very

crucial, these per se would not be enough to facilitate the formation of a vibrant

International Financial Center (in Mumbai). There are a number of other tangible

and intangible factors responsible for its success, the most important being the

physical infrastructure. Of all Asian countries, Hong Kong and Singapore are the

only two cities, which have the configurations of mainline financial centres.

These countries have the basic framework of rules and regulations, a suitable

workforce, tax consultants, insurance companies, etc., underlying any financial

centre. Besides, any financial centre should have more stability. The presence of

good governance becomes very vital in this context, since it facilitates inflow of

foreign capital through avenues like FIIs, etc. Prospective investors should feel

confident about their investments. India has the advantage of a favourable climate

to attract FDIs. But inadequacies of a physical infrastructure are one of the major

drawbacks. In addition to focusing on regulatory aspects to accelerate

opportunities of international financial transactions, it is equally important to

concentrate on strengthening the physical infrastructure of the nation; we require

a more investor-friendly procedural set-up; and so on.

14.3 OBSTACLES BEFORE FOREIGN BANKS

Indian banks, particularly, private banks and the rapidly awakening public sector

banks are vigorous in their operations, making the banking scenario really

challenging. While evaluating the current situation, at the very outset, it must be

complimented that the policy-making authorities, especially the RBI for

responding proactively by introducing banking reforms. The present policy

framework is conducive to foreign bank operations in India. There are as such no

constraints on the expansion of foreign banks. It is emphasized that the 'regulatory

environment is far more conducive in India compared to most other countries in

South East Asia.' Foreign banks are now bestowed with greater scope to

participate in the Indian banking business. However, there are a few aberrations

and we are still subjected to some restrictions. For example, when foreign players

want to participate in the securities market in India, it is imperative for them to do

so in partnership with an Indian firm. Again, as far as the insurance sector is

concerned, the 26 percent cap is definitely a limitation, especially because raising

the limit will cause no harm. It appears that the regulators are still tentative about

raising the upper limit of foreign ownership in Indian banks, since they fear that it

may result in foreign players taking over the domestic market. This is not going

to be true. Take for example, deposits; foreign banks control only 6 to 7 percent

of the total bank deposits in India. The remaining is entirely with Indian banks.

Even if there was complete freedom of operation, only three or four foreign banks

may open additional branches.

 Take the case of mergers and acquisitions, which is becoming a very common

feature in today's corporate world. There are only 3 or 4 players like HSBC,

Citibank, Standard & Chartered and ABN AMRO, who have the capacity to bid

for the acquisition of some private or public sector banks. But most banks

operating at a global level, whose strategy is more consumer-oriented, will not

think of buying Indian banks. Even if foreign banks seek to buy out Indian banks,

the country will benefit in terms of greater flow of foreign direct investment.

14.4 PROSPECT OF FOREIGN BANKS IN INDIA

Looking at the future, it may be perceived that there are some major trends likely

to emerge: First, at present, we have a fairly large presence of foreign banks in the

country. However, effectively in terms of volume of business and operations, only

a few of them dominate the scene. Second, there is a strong prospect of

consolidation of banks through the route of M & A. This would indeed, stimulate

not only the financial sector, but also the real sector of the economy. In the

process of consolidation, it may be strongly recommended that the merger of a

strong bank with another strong bank, rather than the commonly perceived need

of encouraging the merger of a weak bank with a strong one. This is so, because

the merger of a weak bank with a strong one often tends to jeopardize the health

of the latter. Third, the introduction of stringent provisioning norms, Capital

Adequacy Ratio (CAR) as well as better control over NPAs through ordinances

dealing with the securitisation and reconstruction of financial assets will

strengthen the banking system as a whole. Lastly, India's effort towards opening

the financial sector in general and banking sector in particular will have to be
 compatible with expected changes in the framework of GATS and other related

WTO provisions.

14.5 NON-BANKING FINANCE COMPANIES (NBFCs)

NBFCs constitute an important segment of the financial system. NBFCs are

financial intermediaries engaged primarily in the business of accepting deposits

and delivering credit. They play an important role in channelising the scarce

financial resources to capital formation. NBFCs supplement the role of the

banking sector in meeting the increasing financial needs of the corporate sector,

delivering credit to the unorganised sector and to small local borrowers. NBFCs

have a more flexible structure than banks. As compared to banks, they can take

quick decisions; assume greater risks, and tailor-make their services and. charges

according to the needs of the clients. Their flexible structure helps in broadening

the market by providing the saver and investor a bundle of services on a

competitive basis.

Non-Banking Financial Company has been defined vide clause (b) of Section 45-I

of Chapter III B of Reserve Bank of India Act, 1934, as (i) a financial institution,

which is a company; (ii) a non-banking institution, which is a company and which

has as its principal business the receiving of deposits under any scheme or

arrangement or in any other manner or lending in any manner; and (iii) such other

non-banking institutions or class of such institutions, as the bank may with the

previous approval of the central government and by notification in the official

gazette, specify.
 NBFC has been defined under clause (xi) of paragraph 2(1) of Non-Banking

Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions,

1998, as: 'non-banking financial company' means only the non-banking institution

which is a loan company or an investment company or a hire purchase finance

company or an equipment leasing company or a mutual benefit finance company.

NBFCs provide a range of services such as hire purchase finance, equipment lease

finance, loans, and investments. Due to the rapid growth of NBFCs and a wide

variety of services provided by them, there has been a gradual blurring of

distinction between banks and NBFCs except that commercial banks have the

exclusive privilege in the issuance of cheques. NBFCs have raised large amount

of resources through deposits from public, shareholders, directors, and other

companies and borrowings by issue of non-convertible debentures, and so on. In

the year 1998, a new concept of public deposits meaning deposits received from

public, including shareholders in the case of public limited companies and

unsecured debentures/bonds other than those issued to companies, banks, and

financial institutions, was introduced for the purpose of focused supervision of

NBFCs accepting such deposits.

14.6 TYPES OF NBFCs

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

activities they undertake: (i) Hire Purchase Finance Company; (ii) Investment

Company including primary dealers; (iii) Loan Company; (iv) Mutual Benefit

Financial Company; (v) Equipment Leasing Company; (vi) Chit Fund Company;

and (vii) Miscellaneous non-banking company

The Reserve Bank of India either partially or wholly regulates the above-

mentioned entities.

The principal business of NBFCs is that of receiving deposits or that of a financial

institution, such as lending, investment in securities, hire purchase finance or
equipment leasing. The Residuary non-banking company (RNBC) Company
receives deposits under any scheme or arrangements, by whatever name called, in
one lump sum or in instalments by way of contributions or subscriptions or by
sale of units or certificates or other instruments, or in any manner.
Residuary Non-Banking Companies: RNBCs are a class of NBFCs that cannot

be classified as equipment leasing, hire purchase, loan, investment, nidhi or chit

fund companies, but which tap public savings by operating various deposit

schemes, akin to recurring deposit schemes of banks. The deposit acceptance

activities of these companies are governed by the provisions of Residuary Non-

Banking Companies (Reserve Bank) Directions, 1987. To safeguard the interest

of depositors, the Reserve Bank has directed RNBCs to invest not less than 80 per

cent of aggregate deposit liabilities as 'per the investment pattern prescribed by it

and to entrust these securities to all public sector banks to be withdrawn only for

repayment of deposits. Subject to compliance with the investment pattern, they

can invest 20 per cent of aggregate liabilities or ten times its net owned fund;

whichever is lower, in a manner decided by its Board of Directors. The RNBCs

are the only class of NBFCs for which the floor rate of interest for deposits is

specified by the Reserve Bank while there is no upper limit prescribed for them.

The floor interest rate prescribed is 4 per cent per annum (to be compounded

annually) on daily deposit schemes and 6 per cent per annum (to be compounded

annually) on other deposit schemes of higher duration or term deposits. The

Reserve Bank has also prescribed prudential norms for RNBCs. Compliance with
prudential norms is mandatory and a prerequisite for acceptance of deposits. The

Reserve Bank monitors and inspects these RNBCs from time to time. The

Reserve Bank received 106 applications for Certificate of Registration (CoR)

from NBFCs, which were functioning as RNBCs by accepting deposits under

some scheme or arrangement. In 2000-01, 12 companies converted themselves to

NBFCs and applications of 84 companies were rejected. Seven companies are still

functioning as RNBCs with total public deposits of Rs 11,625 crore constituting

about 64 per cent of the total deposits of all reporting companies.

Mutual Benefit Financial Companies: Mutual Benefit Financial Companies

(Nidhis) are NBFCs notified under Section 620 A of the Companies Act, 1956,

and primarily regulated by Department of Company Affairs (DCA) under the

directions/guidelines issued by them under section 637 A of the Companies Act,

1956. These companies are exempt from the core provisions of the RBI Act and

NBFC directions relating to acceptance of public deposits. However, the Reserve

Bank is empowered to issue directions in matters relating to deposit acceptance

activities and directions relating to ceiling on interest rate. They are also required

to maintain register of deposits, furnish receipt to depositors and submit returns to

the Reserve Bank. In order to facilitate healthy functioning of Nidhi companies

and restore the confidence of the investing public, the Government of India

constituted in March 2000, an Expert Committee under the Chairmanship of Shri

P Sabanayagam to suggest an appropriate policy framework for overall

improvement of these companies. The committee submitted its report to the

Government on September 28, 2000 which included recommendations such as

entry point barriers, minimum capital funds, liquid assets requirements,

restrictions on dividend, ceiling on interest rates on deposit and loans, regulations

of various managerial aspects, disclosure norms, prudential norms, adequate

supervisory framework, role of auditors and other measures for protection of

depositors' interest.

Miscellaneous Non-Banking Companies: Miscellaneous Non-Banking

Companies (MNBCs) are companies engaged in the chit fund business. The term

'deposit' as defined under section 451(bb) of the Reserve Bank of India Act, 1934,

does not include subscription to chit funds. The chit fund companies are exempted

from all the core provisions of chapter III B of the RBI Act. The Reserve Bank

regulates only the deposits accepted by these companies, but it does not regulate

their chit fund business. The respective state governments through the offices of

Registrars of Chits administer chit fund business. Chit fund companies, as per the

Miscellaneous Non-Banking Companies (RBI) Directions, can accept deposits

upto 25 per cent and 15 per cent of the net owned fund (NOF) from public and

shareholders, respectively, for a period of 6 months to 36 months, but cannot

accept deposits repayable on demand/notice. The RBI (Amendment) Act, 1997,

provides for compulsory registration with the Reserve Bank of all NBFCs,

irrespective of their holding of public deposits. The amended Act (1997) provides

an entry point norm of Rs 25 lakh as the minimum net owned funds (NOF), which

has been raised to Rs 2 Crore for new NBFCs seeking grant of Certificate of

Registration (CoR) on or from April 21, 1999. The provisions relating to

certificate of registration and minimum NOF were made mandatory (i) to ensure
 that only financially sound companies carry on the business; (ii) to reduce the

number of NBFCs to a manageable universe; and (iii) for effective regulation and

supervision.

As on June 30, 2002, RBI received 36,269 applications of which 14,077 were

approved and 19,111 were rejected. Of the total approvals, only 784 companies

have been permitted to acceptlho1d public deposits. Certain types of financial

companies, namely, insurance companies, housing finance companies, stock

broking companies, chit fund companies, companies notified as 'nidhis' under

section 620A of the Companies Act, 1956, and companies engaged in merchant

banking activities (subject to certain conditions), however, have been exempted

from the requirement of registration under the RBI Act, as they are regulated by

other agencies.

14.7 GROWTH OF NBFCs

NBFCs in India have existed since long. They came into limelight in the second half of the eighties and in the first half of the
nineties. NBFCs flourished during the stock market boom of the early 1990s. In the initial years of liberalisation, they not only
became prominent in a wide range of activities but they outpaced banks in deposit rising owing to their customised services.
Total assets/liabilities of NBFCs grew at an average annual rate of 36.7 per cent during the nineties (1991-98) as compared to
20.9 per cent during the eighties (1981-91). The growing importance of this segment and the surfacing of some scams compelled
the Reserve Bank to increase regulatory attention.

Income of reporting NBFCs continued to decline and the order of decline was

much larger during 2000-01 resulting in a net loss of Rs 325 Crore. This decline

was largely due to a drop in fund-based income, which contributed 91.4 per cent

of the decline in income. The decline in income was much larger than the decline

in operating expenses. NBFCs held public deposits of Rs 5,351 Crore, which

accounted for 82.8 per cent of total public deposits held by all the reporting

NBFCs, excluding RNBCs. A major portion of the assets of NBFCs (excluding

RNBCs) constituted hire purchase and equipment leasing assets followed by loans
 and inter-corporate deposits. The major sources of borrowings were corporates,

banks, central/state government, convertible debentures and financial institutions.

Capital adequacy norms were made applicable to NBFCs in 1998. Out of the 714

reporting NBFCs, 525 NBFCs had CRAR above 30 per cent as on March 31,

2001. However, the number of NBFCs having capital adequacy ratio of less than

10 per cent increased during the year 2000-01.

There is considerable diversity in the composition; structure and functioning of

NBFCs. Deposits of NBFCs witnessed a substantial increase since 1970s in

tandem with a manifold increase in the number of reporting companies from

2,242 in 1969 to 11,010 in 1993. Subsequent upon the introduction of the new

regulatory frameworks in 1997-98, the deposits of NBFCs have witnessed a

marked decline (Table 14.1).

Table 14.1: Deposits with NBFCs

14.8 REGULATION OF NBFCs

In the 1960s, the Reserve Bank made an attempt to regulate NBFCs by issuing directions relating to the maximum amount of
deposits, the period of deposits and rate of interest they could offer on the deposits accepted. Norms were laid down regarding
maintenance of certain percentage of liquid assets, creation of reserve funds, and transfer thereto every year a certain percentage
of profit, and so on. These directions and norms were revised and amended from time to time.

In 1977, the Reserve Bank issued two separate sets of guidelines, namely, (i)

NBFC Acceptance of Deposits Directions, 1977, for NBFCs and (ii) MNBD

Directions, 1977, for MNBCs. These directions were related to deposit-taking

activities ofNBFCs. The Reserve Bank made an attempt to regulate the asset side

of NBFCs in 1994 in pursuance of the Shah Committee recommendations.

However, it was not empowered to regulate the asset side of NBFCs.

NBFCs became prominent in the first half of the 1990s. The growth in aggregate

deposits of NBFCs outpaced that of banks. However, bank finance to NBFCs

dried up in 1995 after the Reserve Bank cautioned banks against such lending.

Therefore, NBFCs had to depend on fixed deposits often at rates upto 26 per cent.

To service high-cost deposits, NBFCs invested in bought-out deals, shares, real

estate and corporate financing-areas in which they had little experience. The

slackness in the capital and real estate markets and general industrial activities

resulted in sharp deterioration in NBFC's quality of assets.

Crores of rupees of small investors disappeared overnight as NBFCs like CRB

Capital Markets, JVG Finance, and Prudential Capital Markets failed in 1997.

This shook investor confidence, which resulted in a rush of withdrawals of public

deposits. This is the only sector which had a number of committees trying to

regulate its working. The first was the Shah Committee in 1992. The Shere

Committee, Khanna Committee, and various committees of the Reserve Bank of

India followed it. In 1997, the RBI Act was amended and the Reserve Bank was

given comprehensive powers to regulate NBFCs. The amended Act made it

mandatory for every NBFC to obtain a certificate of registration and have

minimum net owned funds. Ceilings were prescribed for acceptance of deposits,

capital adequacy, credit rating and net-owned funds. Net owned fund (NOF) of

NBFCs is the aggregate of paid-up capital and free reserves, netted by (i) the
amount of accumulated balance of loss (ii) deferred revenue expenditure and

other intangible assets, if any, and further reduced by investments in shares and

loans and advances to (a) subsidiaries (b) companies in the same group and (c)

other NBFCs, in excess of 10 per cent of owned fund. Norms relating to capital

adequacy, credit rating exposure, asset classification, and so on were laid down.

The Reserve Bank also developed a comprehensive system to supervise NBFCs

accepting/holding public deposits. Directions were also issued to the statutory

auditors to report non-compliance with the RBI Act and regulations to the RBI,

Board of Directors and shareholders of the NBFCs.

The Task Force constituted by Government of India under the Chairmanship of

Shri C M Vasudev submitted its report on October 28, 1998, after reviewing the

existing regulatory framework for NBFCs. The Government of India framed the

Financial Companies Regulation Bill, 2000; to implement the recommendations

requiring statutory changes, as also consolidate the law, relating to NBFCs and

unincorporated bodies with a view to ensuring depositor protection. According to

this bill, all the NBFCs will be known as Financial Companies instead of NBFCs.

14.8.1 IMPORTANT STATUTORY PROVISIONS OF CHAPTER IIIB OF

THE RBI ACT AS APPLICABLE TO NBFCS.

1. Certificate of registration: No company (nidhi and chit fund

companies exempted), other than those exempted by the RBI, can

commence or carry on the business of non-banking financial

institution without obtaining a CoR from RBI. The pre-requisite for

eligibility for such a CoR is that the NBFC should have a minimum
 NOF of Rs 25 lakh (since raised to Rs 2 crore on and from April 21,

1999, for any new applicant BBFC). The RBI considers grant of the

CoR after satisfying itself about the company's compliance with the

criteria enumerated in section 45-IA of the RBI Act.

2. Maintenance of Liquid Assets: NBFCs (nidhi and chit fund

companies exempted) have to invest in unencumbered approved

securities, valued at a price not exceeding current market price, an

amount which, at the close of business on any day, shall not be less

than 5.0 per cent but not exceeding 25.0 per cent specified by RBI, of

the deposits outstanding at the close of business on the last working

day of the second preceding quarter.

3. Creation of Reserve Fund: All non-banking financial company shall

create a reserve fund and transfer thereto a sum not less than 20.0 per

cent of its net profit every year as disclosed in the profit and loss

account and before any dividend is declared (nidhi and chit fund

companies exempted). Such fund is to be created by every NBFC,

irrespective of the fact whether it accepts public deposits or not.

Further, no appropriation can be made from the fund for any purpose

without prior written approval of RBI.

14.8.2 Directions applicable to NBFCs

The RBI has issued comprehensive deposit acceptance and asset side

regulations as under for the NBFCs. While all the prudential norms are
 applicable to public deposit accepting/holding NBFCs only, some of the

regulations are applicable to non-deposit accepting companies.

1. Ceiling on quantum of public deposits: Loan and investment

companies-l.56 times of NOF if the company has NOF of Rs 251akh,

minimum investment grade (MIG) credit rating, complies with all the

prudential norms and has CRAR of 15 per cent. Equipment leasing and

hire purchase finance companies-if company has NOF of Rs 25 lakh and

complies with all the prudential norms.(i) with MIG credit rating and 12

per cent CRAR - times of NOP; (ii) without MIG credit rating but CRAR

15 per cent or above-1.5 times of NOF, or Rs 10 Crore, whichever is less.

2. Investment in Liquid Assets: NBFCs-15 percent of outstanding public

deposit liabilities as at the close of business on the last working day of the

second preceding quarter, of which (i) not less than 10 per cent in

approved securities; and (ii) not more than 5 per cent in term deposits with

scheduled commercial banks. RNBCs-10 percent of outstanding deposit

liabilities as at close of business on last working day of second preceding

quarter. These liquid asset securities are required to be lodged with one of

the scheduled commercial banks or Stock Holding Corporation of India

Ltd., or a depository or its participant (registered with SEBI). Effective

October 1, 2002, government securities are to be necessarily held by

NBFCs either in Constituent's Subsidiary General Ledger Account with a

scheduled commercial bank or in a demat account with a depository

participant registered with SEBI. These securities cannot be withdrawn or

 otherwise dealt with for any purpose other than repayment of public

deposits.

3. Period of Deposits: No demand deposits.

NBFCs-12 to 60 months

RNBCs-12 to 84 months

MNBCs (Chit Funds)-6 to 36 months

4. Ceiling on Deposit rate: NBFCs, MNBCs and Nidhis-12.5 percent per

annum (effective November 1, 2001). RNBCs-Minimum interest of 4.0

per cent on daily deposits and 6.0 per cent on other than daily deposits.

Interest may be paid or compounded at periods not shorter than monthly

rests.

5. Advertisement and methodology for acceptance deposits/public

deposits: Every company which accepts deposits by advertisement has to

comply with the advertisement rules prescribed in this regard, the deposit

acceptance form should contain certain prescribed information, issue

receipt for deposits, maintain a deposit register, and so on.

6. Submission of returns: All NBFCs holding or accepting public deposits

have to submit periodical returns to RBI at Quarterly, half yearly and

annual intervals.

14.8.3 SUPERVISION

In order to ensure that NBFCs function on sound lines and avoid excessive risk

taking, the RBI has developed a four pronged supervisory framework based on:

(i) On-site inspection structured on the basis of assessment and evaluation of

CAMELS (Capital, Assets, Management, Earnings, Liquidity, and Systems)

approach; (ii) Off-site monitoring supported by state-of-the-art technology. It is

through periodic control reports from NBFCs. (iii) Use of Market Intelligence

System; and (iv) Exception reports of statutory auditors of NBFCs.

The RBI supervises companies not holding public deposits in a limited manner.

Companies with asset size of Rs 100 Crore and above are subject to annual

inspection while other non-public deposit companies are supervised by rotation

once in every five years. .

14.8.4 Role of Board for Financial Supervision in Monitoring NBFCs

With a view to having an integrated approach to the entire financial sector, the

supervision of NBFCs was brought under the jurisdiction of the Board for

Financial Supervision (BFS) with effect from July 1, 1995. BFS directs,

formulates, and oversees the implementation of policy as well as supervises

NBFCs. BFS also serves as an important forum for deciding the course of action

against problem companies and monitoring their status on an on-going basis. In

addition, quarterly and half-yearly reports on the performance of NBFCs are

discussed in BFS meetings.

14.8.5 Automatic Approval Route of RBI for NBFCs

Automatic approval for FDI / NRI investment allowed up to 100% in merchant

banking, underwriting, portfolio management services, investment advisory

services, financial consultancy, stock broking, asset management, venture capital,

custodial services, factoring, credit reference agencies, credit rating agencies,

leasing & finance, housing finance, forex broking, credit card business, money
 changing business, micro credit and rural credit subject to compliance with RBI

guidelines and minimum capitalization norms. Minimum capitalization norms for

fund based NBFCs: For FDI up to 51% - US $ 0.5 million to be brought upfront;

for FDI above 51% and up to 75% - US $ 5 million to be brought upfront; for

FDI above 75% and up to 100% - US $ 50 million out of which US $ 7.5 million

to be brought upfront and the balance in 24 months. Minimum capitalization

norms for non-fund based activities of US $ 0.5 million is applicable in respect

of all permitted non- fund based NBFCs with foreign investment. Foreign

investors can set up 100% operating subsidiaries without the condition to

disinvest a minimum of 25% of its equity to Indian entities, subject to bringing in

US $ 50 million as given above, without any restriction on number of operating

subsidiaries without bringing in additional capital. Joint venture operating NBFCs

that have 75% or less than 75% foreign investment are also allowed to set up

subsidiaries for undertaking other NBFC activities subject to the subsidiaries also

complying with the applicable minimum capital inflow as given above.

14.9 SUMMARY

The impact of foreign banks on India’s banking sector is limited at this stage although it

contributed to improving domestic banks’ management and balance sheets. While

foreign banks are to be allowed to engage in the local-currency activities under the WTO

framework, the Government should give in the next reform agenda the highest priority to

more drastic measures for reforming public sector banks and liberalizing the whole

commercial banking sector, through careful consideration of the various aspects

indicated above. The existence of remaining barriers, such as administered interest rates

on saving deposits and other saving schemes, may partly explain why financial deepening
 has taken place at a relatively mild pace in India, compared with the earlier period.

Household sector savings have remained at 20 percent of GDP, while physical savings

account for only 9% of GDP. Given India’s large population and relatively high-income

growth, there is room for the country’s banking sector to grow further through increased

deposit mobilization.

NBFCs in India have become prominent in a wide range of activities like hire

purchase finance, equipment lease finance, loans, investments, and so on. NBFCs

have greater reach and flexibility in tapping resources. In desperate times, NBFCs

could survive owing to their aggressive character and customised services.

NBFCs are doing more fee-based business than fund-based. They are focusing

now on retail sector-housing finance, personal loans, and marketing of insurance.

Many of the NBFCs have ventured into the domain of mutual funds and

insurance. NBFCs undertake life and general insurance, business as joint venture

participants in insurance companies. The strong NBFCs have successfully

emerged as 'Financial Institutions' in a short span of time and are in the process of

converting themselves into Financial Super Market -a one stop financial shop.

The NBFCs are taking initiatives to establish a self-regulatory organisation

(SRO). At present, NBFCs are represented by the Association of Leasing and

Financial Services (ALFS), Federation of Indian Hire Purchase Association

(FIHPA) and Equipment Leasing Association of India (ELA). The Reserve Bank

wants these three industry bodies to come together under one roof. The Reserve

Bank has emphasised on formation of SRO particularly for the benefit of smaller

NBFCs.

14.10 SELF-TEST QUESTIONS

 1. What in your opinion has been the role and contribution of foreign banks

since they began their operations in India and how have they been

instrumental in shaping the economy of India?

2. What have been the salient features of the banking scenario in the post-

liberalization period, with special reference to foreign banks?

3. What are the various financial products, services, and significant innovations

that have been initiated by foreign banks in course of their operations in

India?

4. What are the various obstacles faced by foreign banks in the expansion of

their businesses in India?

5. How do you envision the future of foreign banks in India?

6. What do you mean by NBFCs? What is the role of them in the Indian

Economy?

7. How can you say NBFCs are important to initialize to strengthen an economy

of a nation?

8. What type of regulation and provisions are followed by NBFCs in India?

14.11 SUGGESTED READINGS

1. Cherrunilam, Francis, (2003), Business Environment, New Delhi: Vikas

Publishing House Private Limited.

2. Rao, M.B. (2001), “WTO & International Trade”, New Delhi: Vikas Publishing

House Private Limited.

M19_MOFF8079_04_SE_C19.QXD 7/1/11 2:35 PM Page W-50

International Trade
Finance

Financial statements are like fine perfume: to be sniffed

but not swallowed. —Abraham Brilloff.

LEARNING OBJECTIVES
◆ Learn how international trade alters both the supply chain and general value chain of
the domestic firm, thereby beginning the globalization process in the trade phase.
◆ Consider what the key elements of an import or export transaction are in business.
◆ Discover how the three key documents in import/export, the letter of credit, the draft,
and the bill of lading, combine to both finance the transaction and to manage its risks.
◆ Identify what the documentation sequence is for a typical international trade
transaction.
◆ Learn how the various stages and their costs impact the ability of an exporter to enter a
foreign market and potentially compete in both credit terms and pricing.
◆ See what organizations and resources are available for exporters to aid in managing
trade risk and financing.
◆ Examine the various trade financing alternatives.

The purpose of this chapter is to explain how international trade, exports and imports, is
financed. The contents are of direct practical relevance to both domestic firms that just
import and export and to multinational firms that trade with related and unrelated entities.
The chapter begins by explaining the types of trade relationships that exist. Next, we
explain the trade dilemma: exporters want to be paid before they export and importers do
not want to pay until they receive the goods. The next section explains the benefits of the
current international trade protocols. This is followed by a section describing the elements of
a trade transaction and the various documents that are used to facilitate the trade’s comple-
tion and financing. The next section identifies international trade risks, namely, currency risk
and noncompletion risk. The following sections describe the key trade documents, including
letter of credit, draft, and bill of lading. The next section summarizes the documentation of a
typical trade transaction. This is followed by a description of government programs to help
finance exports, including export credit insurance and specialized banks such as the U.S.
Export-Import Bank. Next, we compare the various types of short-term receivables financing
and then the use of forfaiting for longer term receivables. The Mini-Case at the end of the
chapter, Crosswell International and Brazil, illustrates how an export requires the integra-
tion of management, marketing, and finance.
W-50
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International Trade Finance W-51

The Trade Relationship

As we saw in Chapter 1, the first significant global activity by a domestic firm is the importing
and exporting of goods and services. The purpose of this chapter is to analyze the
international trade phase for a domestic firm that begins to import goods and services from
foreign suppliers and to export to foreign buyers. In the case of Trident, this trade phase
began with suppliers from Mexico and buyers from Canada.
Trade financing shares a number of common characteristics with the traditional value
chain activities conducted by all firms. All companies must search out suppliers for the many
goods and services required as inputs to their own goods production or service provision
processes. Trident’s Purchasing and Procurement Department must determine whether each
potential supplier is capable of producing the product to required quality specifications, pro-
ducing and delivering in a timely and reliable manner, and continuing to work with Trident in
the ongoing process of product and process improvement for continued competitiveness. All
must be at an acceptable price and payment terms. As illustrated in Exhibit 19.1, this same
series of issues applies to potential customers, as their continued business is equally as critical
to Trident’s operations and success.
The nature of the relationship between the exporter and the importer is critical to under-
standing the methods for import-export financing utilized in industry. Exhibit 19.2 provides
an overview of the three categories of relationships: unaffiliated unknown, unaffiliated
known, and affiliated.
◆ A foreign importer with which Trident has not previously conducted business would be
considered unaffiliated unknown. In this case, the two parties would need to enter into a
detailed sales contract, outlining the specific responsibilities and expectations of the busi-
ness agreement. Trident would also need to seek out protection against the possibility that
the importer would not make payment in full in a timely fashion.
◆ A foreign importer with which Trident has previously conducted business successfully
would be considered unaffiliated known. In this case, the two parties may still enter into a
detailed sales contract, but specific terms and shipments or provisions of services may be
significantly looser in definition. Depending on the depth of the relationship, Trident may

EXHIBIT 19.1 Financing Trade: The Flow of Goods and Funds

Domestic Supplier Mexican Supplier

(United States) (Monterey, Mexico)

Mexican
Goods and US$ pesos Goods and
services services
flow from Trident U.S. flow from
supplier to (Los Angeles) supplier to
Trident to Trident to
buyer US$ Canadian $ buyer

Domestic Buyer Canadian Buyer

(United States) (Calgary, Alberta)
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W-52 PA R T 6 Topics in International Finance

EXHIBIT 19.2 Alternative International Trade Relationships

Trident as an Exporter

Importer is . . .

Unaffiliated Unaffiliated Affiliated

Unknown Party Known Party Party

A new customer A long-term customer A foreign subsidiary

with which Trident with which there is an of Trident,
has no historical established relationship of a business unit
business trust and performance of Trident

Requires: Requires: Requires:

1. A contract 1. A contract 1. No contract
2. Protection against 2. Possibly some protection 2. No protection against
nonpayment against nonpayment nonpayment

seek some third-party protection against noncompletion or conduct the business on an

open account basis.
◆ A foreign importer which is a subsidiary business unit of Trident, such as Trident Brazil,
would be an affiliated party (sometime referred to as intrafirm trade). Because both busi-
nesses are part of the same MNE, the most common practice would be to conduct the
trade transaction without a contract or protection against nonpayment. This is not, how-
ever, always the case. In a variety of international business situations it may still be in Tri-
dent’s best interest to detail the conditions for the business transaction, and to possibly
protect against any political or country-based interruption to the completion of the trade
transaction.

The Trade Dilemma

International trade must work around a fundamental dilemma. Imagine an importer and
an exporter who would like to do business with one another. Because of the distance
between the two, it is not possible to simultaneously hand over goods with one hand and
accept payment with the other. The importer would prefer the arrangement at the top of
Exhibit 19.3, while the exporter’s preference is shown at the bottom.
The fundamental dilemma of being unwilling to trust a stranger in a foreign land is
solved by using a highly respected bank as intermediary. A greatly simplified view is
described in Exhibit 19.4. In this simplified view, the importer obtains the bank’s promise to
pay on its behalf, knowing that the exporter will trust the bank. The bank’s promise to pay is
called a letter of credit.
The exporter ships the merchandise to the importer’s country. Title to the merchan-
dise is given to the bank on a document called an order bill of lading. The exporter asks
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International Trade Finance W-53

EXHIBIT 19.3 The Mechanics of Import and Export

1. Exporter ships the goods.

Importer Importer Preference Exporter

2. Importer pays after goods received.

1. Importer pays for goods.

Importer Exporter Preference Exporter

2. Exporter ships the goods after being paid.

the bank to pay for the goods, and the bank does so. The document to request payment is
a sight draft. The bank, having paid for the goods, now passes title to the importer, whom
the bank trusts. At that time or later, depending on their agreement, the importer reim-
burses the bank.
Financial managers of MNEs must understand these three basic documents. It is because
their firms will often trade with unaffiliated parties, but also because the system of documen-
tation provides a source of short-term capital that can be drawn upon even when shipments
are to sister subsidiaries.

EXHIBIT 19.4 The Bank as the Import/Export Intermediary

1. Importer obtains bank’s promise

to pay on importer’s behalf.
Importer

6. Importer pays
the bank. 2. Bank promises exporter
to pay on behalf of importer.
Bank
5. Bank “gives” merchandise
to the importer.
4. Bank pays the
exporter.

Exporter
3. Exporter ships “to the bank”
trusting bank’s promise.
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W-54 PA R T 6 Topics in International Finance

Benefits of the System

The three key documents and their interaction will be described later in this chapter. They
constitute a system developed and modified over centuries to protect both importer and
exporter from the risk of noncompletion and foreign exchange risk, as well as to provide a
means of financing.

Protection against Risk of Noncompletion

As stated above, once importer and exporter agree on terms, the seller usually prefers to
maintain legal title to the goods until paid, or at least until assured of payment. The buyer,
however, will be reluctant to pay before receiving the goods, or at least before receiving title
to them. Each wants assurance that the other party will complete its portion of the transac-
tion. The letter of credit, sight draft, and bill of lading are part of a system carefully constructed
to determine who bears the financial loss if one of the parties defaults at any time.

Protection against Foreign Exchange Risk

In international trade, foreign exchange risk arises from transaction exposure. If the transac-
tion requires payment in the exporter’s currency, the importer carries the foreign exchange
risk. If the transaction calls for payment in the importer’s currency, the exporter has the for-
eign exchange risk.
Transaction exposure can be hedged by the techniques described in Chapter 10, but in
order to hedge, the exposed party must be certain that payment of a specified amount will be
made on or near a particular date. The three key documents described in this chapter ensure
both amount and time of payment and thus lay the groundwork for effective hedging.
The risk of noncompletion and foreign exchange risk are most important when the inter-
national trade is episodic, with no outstanding agreement for recurring shipments and no sus-
tained relationship between buyer and seller. When the import/export relationship is of a
recurring nature, as in the case of manufactured goods shipped weekly or monthly to a final
assembly or retail outlet in another country, and when it is between countries whose curren-
cies are considered strong, the exporter may well bill the importer on open account after a
normal credit check. Banks provide credit information and collection services outside of the
system of processing drafts drawn against letters of credit.

Financing the Trade

Most international trade involves a time lag during which funds are tied up while the mer-
chandise is in transit. Once the risks of noncompletion and of exchange rate changes are dis-
posed of, banks are willing to finance goods in transit. A bank can finance goods in transit, as
well as goods held for sale, based on the key documents, without exposing itself to questions
about the quality of the merchandise or other physical aspects of the shipment.

International Trade: Timeline and Structure

In order to understand the risks associated with international trade transactions, it is helpful
to understand the sequence of events in any such transaction. Exhibit 19.5 illustrates, in prin-
ciple, the series of events associated with a single export transaction.
From a financial management perspective, the two primary risks associated with an inter-
national trade transaction are currency risk and risk of noncompletion. Exhibit 19.5 illustrates
the traditional business problem of credit management: the exporter quotes a price, finalizes a
contract, and ships the goods, losing physical control over the goods based on trust of the buyer
or the promise of a bank to pay based on documents presented. The risk of default on the part
of the importer is present as soon as the financing period begins, as depicted in Exhibit 19.5.
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EXHIBIT 19.5 The Trade Transaction Timeline and Structure

Time and Events

Price Export Goods Documents Goods Cash

quote contract are are are settlement
request signed shipped accepted received of the
transaction

Negotiations Backlog

Documents Are
Presented

Financing Period

In many cases, the initial task of analyzing the creditworth of foreign customers is similar
to procedures for analyzing domestic customers. If Trident has had no experience with a for-
eign customer but that customer is a large, well-known firm in its home country, Trident may
simply ask for a bank credit report on that firm. Trident may also talk to other firms that have
had dealings with the foreign customer. If these investigations show the foreign customer
(and country) to be completely trustworthy, Trident would likely ship to them on open
account, with a credit limit, just as they would for a domestic customer. This is the least costly
method of handling exports because there are no heavy documentation or bank charges.
However, before a regular trading relationship has been established with a new or unknown
firm, Trident must face the possibility of nonpayment for its exports or noncompletion of its
imports. The risk of nonpayment can be eliminated through the use of a letter of credit issued
by a creditworthy bank.

Key Documents
The three key documents described in the following pages—the letter of credit, draft, and bill of
lading—constitute a system developed and modified over centuries to protect both importer
and exporter from the risk of noncompletion of the trade transaction as well as to provide a
means of financing.The three key trade documents are part of a carefully constructed system to
determine who bears the financial loss if one of the parties defaults at any time.

Letter of Credit (L/C)

A letter of credit, (L/C), is a bank’s promise to pay issued by a bank at the request of an
importer (the applicant/buyer), in which the bank promises to pay an exporter (the benefici-
ary of the letter) upon presentation of documents specified in the L/C. An L/C reduces the
risk of noncompletion, because the bank agrees to pay against documents rather than actual
merchandise. The relationship between the three parties can be seen in Exhibit 19.6.
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EXHIBIT 19.6 Parties to a Letter of Credit (L/C)

Issuing Bank

The relationship between the The relationship between the

issuing bank and the exporter importer and the issuing bank is
is governed by the terms of the governed by the terms of the
letter of credit, as issued by application and agreement
that bank. for the letter of credit (L/C).

Beneficiary Applicant
(exporter ) (importer )

The relationship between the importer and the

exporter is governed by the sales contract.

An importer (buyer) and exporter (seller) agree on a transaction and the importer then
applies to its local bank for the issuance of an L/C. The importer’s bank issues an L/C and
cuts a sales contract based on its assessment of the importer’s creditworthiness, or the bank
might require a cash deposit or other collateral from the importer in advance. The
importer’s bank will want to know the type of transaction, the amount of money involved,
and what documents must accompany the draft that will be drawn against the L/C.
If the importer’s bank is satisfied with the credit standing of the applicant, it will issue an
L/C guaranteeing to pay for the merchandise if shipped in accordance with the instructions
and conditions contained in the L/C.
The essence of an L/C is the promise of the issuing bank to pay against specified docu-
ments, which must accompany any draft drawn against the credit. The L/C is not a guarantee
of the underlying commercial transaction. Indeed, the L/C is a separate transaction from any
sales or other contracts on which it might be based. To constitute a true L/C transaction, the
following elements must be present with respect to the issuing bank:
1. The issuing bank must receive a fee or other valid business consideration for issuing the L/C.
2. The bank’s L/C must contain a specified expiration date or a definite maturity.
3. The bank’s commitment must have a stated maximum amount of money.
4. The bank’s obligation to pay must arise only on the presentation of specific documents,
and the bank must not be called on to determine disputed questions of fact or law.
5. The bank’s customer must have an unqualified obligation to reimburse the bank on the
same condition as the bank has paid.
Commercial letters of credit are also classified as follows:
Irrevocable versus Revocable. An irrevocable L/C obligates the issuing bank to honor drafts
drawn in compliance with the credit and can be neither canceled nor modified without the
consent of all parties, including in particular the beneficiary (exporter). A revocable L/C can
be canceled or amended at any time before payment; it is intended to serve as a means of
arranging payment but not as a guarantee of payment.
Confirmed versus Unconfirmed. An L/C issued by one bank can be confirmed by another, in
which case the confirming bank undertakes to honor drafts drawn in compliance with the
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credit. An unconfirmed L/C is the obligation only of the issuing bank. An exporter is likely to
want a foreign bank’s L/C confirmed by a domestic bank when the exporter has doubts about
the foreign bank’s ability to pay. Such doubts can arise when the exporter is unsure of the
financial standing of the foreign bank, or if political or economic conditions in the foreign
country are unstable. The essence of an L/C is shown in Exhibit 19.7.
Most commercial letters of credit are documentary, meaning that certain documents
must be included with drafts drawn under their terms. Required documents usually include
an order bill of lading (discussed in more detail later in the chapter), a commercial invoice,
and any of the following: consular invoice, insurance certificate or policy, and packing list.

Advantages and Disadvantages of Letters of Credit

The primary advantage of an L/C is that it reduces risk—the exporter can sell against a
bank’s promise to pay rather than against the promise of a commercial firm. The exporter is
also in a more secure position as to the availability of foreign exchange to pay for the sale,
since banks are more likely to be aware of foreign exchange conditions and rules than is the
importing firm itself. If the importing country should change its foreign exchange rules dur-
ing the course of a transaction, the government is likely to allow already outstanding bank
letters of credit to be honored for fear of throwing its own domestic banks into international
disrepute. Of course, if the L/C is confirmed by a bank in the exporter’s country, the exporter
avoids any problem of blocked foreign exchange.
An exporter may find that an order backed by an irrevocable L/C will facilitate obtaining
pre-export financing in the home country. If the exporter’s reputation for delivery is good, a
local bank may lend funds to process and prepare the merchandise for shipment. Once the
merchandise is shipped in compliance with the terms and conditions of the credit, payment
for the business transaction is made and funds will be generated to repay the pre-export loan.

EXHIBIT 19.7 Essence of a Letter of Credit (L/C)

Bank of the East, Ltd.

[Name of Issuing Bank]

Date: September 18, 2011

L / C Number 123456

Bank of the East, Ltd. hereby issues this irrevocable documentary Letter
of Credit to Jones Company [name of exporter] for US$500,000, payable
90 days after sight by a draft drawn against Bank of the East, Ltd., in
accordance with Letter of Credit number 123456.

The draft is to be accompanied by the following documents:

1. Commercial invoice in triplicate

2. Packing list
3. Clean on board order bill of lading
4. Insurance documents, paid for by buyer

At maturity Bank of the East, Ltd. will pay the face amount of the draft
to the bearer of that draft.
Authorized Signature
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The major advantage of an L/C to the importer is that the importer need not pay out
funds until the documents have arrived at a local port or airfield and unless all conditions
stated in the credit have been fulfilled. The main disadvantages are the fee charged by the
importer’s bank for issuing its L/C, and the possibility that the L/C reduces the importer’s
borrowing line of credit with its bank. It may, in fact, be a competitive disadvantage for the
exporter to demand automatically an L/C from an importer, especially if the importer has a
good credit record and there is no concern regarding the economic or political conditions of
the importer’s country.

Draft
A draft, sometimes called a bill of exchange (B/E), is the instrument normally used in inter-
national commerce to effect payment. A draft is simply an order written by an exporter
(seller) instructing an importer (buyer) or its agent to pay a specified amount of money at a
specified time. Thus, it is the exporter’s formal demand for payment from the importer.
The person or business initiating the draft is known as the maker, drawer, or originator.
Normally, this is the exporter who sells and ships the merchandise. The party to whom the
draft is addressed is the drawee. The drawee is asked to honor the draft, that is, to pay the
amount requested according to the stated terms. In commercial transactions, the drawee is
either the buyer, in which case the draft is called a trade draft, or the buyer’s bank, in which
case the draft is called a bank draft. Bank drafts are usually drawn according to the terms of
an L/C. A draft may be drawn as a bearer instrument, or it may designate a person to whom
payment is to be made. This person, known as the payee, may be the drawer itself or it may be
some other party such as the drawer’s bank.

Negotiable Instruments
If properly drawn, drafts can become negotiable instruments. As such, they provide a conven-
ient instrument for financing the international movement of the merchandise. To become a
negotiable instrument, a draft must conform to the following requirements (Uniform Com-
mercial Code, Section 3104(1)):
1. It must be in writing and signed by the maker or drawer.
2. It must contain an unconditional promise or order to pay a definite sum of money.
3. It must be payable on demand or at a fixed or determinable future date.
4. It must be payable to order or to bearer.
If a draft is drawn in conformity with the above requirements, a person receiving it with
proper endorsements becomes a “holder in due course.” This is a privileged legal status that
enables the holder to receive payment despite any personal disagreements between drawee
and maker because of controversy over the underlying transaction. If the drawee dishonors
the draft, payment must be made to any holder in due course by any prior endorser or by the
maker. This clear definition of the rights of parties who hold a negotiable instrument as a
holder in due course has contributed significantly to the widespread acceptance of various
forms of drafts, including personal checks.

Types of Drafts
Drafts are of two types: sight drafts and time drafts. A sight draft is payable on presentation to
the drawee; the drawee must pay at once or dishonor the draft. A time draft, also called a
usance draft, allows a delay in payment. It is presented to the drawee, who accepts it by
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writing or stamping a notice of acceptance on its face. Once accepted, the time draft becomes
a promise to pay by the accepting party (the buyer). When a time draft is drawn on and
accepted by a bank, it becomes a banker’s acceptance; when drawn on and accepted by a busi-
ness firm, a trade acceptance.
The time period of a draft is referred to as its tenor. To qualify as a negotiable instrument,
and so be attractive to a holder in due course, a draft must be payable on a fixed or deter-
minable future date. For example, “60 days after sight” is a fixed date, which is established
precisely at the time the draft is accepted. However, payment “on arrival of goods” is not
determinable since the date of arrival cannot be known in advance. Indeed, there is no assur-
ance that the goods will arrive at all.

Bankers’ Acceptances
When a draft is accepted by a bank, it becomes a bankers’ acceptance. As such it is the uncon-
ditional promise of that bank to make payment on the draft when it matures. In quality the
bankers’ acceptance is practically identical to a marketable bank certificate of deposit (CD).
The holder of a bankers’ acceptance need not wait until maturity to liquidate the investment,
but may sell the acceptance in the money market, where constant trading in such instruments
occurs. The amount of the discount depends entirely on the credit rating of the bank that
signs the acceptance, or another bank that reconfirmed the bankers’ acceptance, for a fee.
The all-in cost of using a bankers’ acceptance compared to other short-term financing instru-
ments is analyzed later in this chapter.

Bill of Lading (B/L)

The third key document for financing international trade is the bill of lading (B/L). The bill of
lading is issued to the exporter by a common carrier transporting the merchandise. It serves
three purposes: a receipt, a contract, and a document of title.
As a receipt, the bill of lading indicates that the carrier has received the merchandise
described on the face of the document. The carrier is not responsible for ascertaining that
the containers hold what is alleged to be their contents, so descriptions of merchandise on
bills of lading are usually short and simple. If shipping charges are paid in advance, the bill
of lading will usually be stamped “freight paid” or “freight prepaid.” If merchandise is
shipped collect—a less common procedure internationally than domestically—the carrier
maintains a lien on the goods until freight is paid.
As a contract, the bill of lading indicates the obligation of the carrier to provide certain
transportation in return for certain charges. Common carriers cannot disclaim responsibility
for their negligence through inserting special clauses in a bill of lading. The bill of lading may
specify alternative ports in the event that delivery cannot be made to the designated port, or
it may specify that the goods will be returned to the exporter at the exporter’s expense.
As a document of title, the bill of lading is used to obtain payment or a written promise
of payment before the merchandise is released to the importer. The bill of lading can also
function as collateral against which funds may be advanced to the exporter by its local bank
prior to or during shipment and before final payment by the importer.

Characteristics of the Bill of Lading

The bill of lading is typically made payable to the order of the exporter, who thus retains title
to the goods after they have been handed to the carrier. Title to the merchandise remains
with the exporter until payment is received, at which time the exporter endorses the order
bill of lading (which is negotiable) in blank or to the party making the payment, usually a
bank. The most common procedure would be for payment to be advanced against a
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documentary draft accompanied by the endorsed order bill of lading. After paying the draft,
the exporter’s bank forwards the documents through bank clearing channels to the bank of
the importer. The importer’s bank, in turn, releases the documents to the importer after pay-
ment (sight drafts); after acceptance (time drafts addressed to the importer and marked
D/A); or after payment terms have been agreed upon (drafts drawn on the importer’s bank
under provisions of an L/C).

Example: Documentation in a Typical

Trade Transaction
Although a trade transaction could conceivably be handled in many ways, we shall now turn
to a hypothetical example that illustrates the interaction of the various documents. Assume
that Trident U.S. receives an order from a Canadian Buyer. For Trident, this will be an export
financed under an L/C requiring a bill of lading, with the exporter collecting via a time draft
accepted by the Canadian Buyer’s bank. Such a transaction is illustrated in Exhibit 19.8.
1. The Canadian Buyer (the Importer in Exhibit 19.8) places an order with Trident (the
Exporter in Exhibit 19.8), asking if Trident is willing to ship under an L/C.
2. Trident agrees to ship under an L/C and specifies relevant information such as prices and
terms.

EXHIBIT 19.8 Steps in a Typical Trade Transaction

1. Importer orders goods. 3. Importer

arranges L /C
with its bank.
2. Exporter agrees to fill order.

Exporter Importer
6. Exporter ships
goods to importer.

11. Bank X 12. Bank I obtains

7. Exporter presents 13. Importer
pays importer’s note
draft and documents pays
exporter. and releases
to its bank, Bank X. its bank.
shipment.
8. Bank X presents draft
and documents to Bank I.
Bank X Bank I

9. Bank I accepts draft, promising

to pay in 60 days, and returns
accepted draft to Bank X.
5. Bank X
advises 4. Bank I sends
exporter L / C to Bank X.
of L / C.
Public
Investor
10. Bank X sells 14. Investor presents acceptance
acceptance to investor. and is paid by Bank I.
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3. The Canadian Buyer applies to its bank, Northland Bank, for an L/C to be issued in favor
of Trident for the merchandise it wishes to buy.
4. Northland Bank issues the L/C in favor of Trident and sends it to the Southland Bank
(Trident’s bank).
5. Southland Bank advises Trident of the opening of an L/C in Trident’s favor. Southland
Bank may or may not confirm the L/C to add its own guarantee to the document.
6. Trident ships the goods to the Canadian Buyer.
7. Trident prepares a time draft and presents it to Southland Bank (Trident’s bank). The
draft is drawn (i.e., addressed to) Northland Bank in accordance with Northland Bank’s
L/C and accompanied by other documents as required, including the bill of lading. Tri-
dent endorses the bill of lading in blank (making it a bearer instrument) so that title to
the goods goes with the holder of the documents—Southland Bank at this point in the
transaction.
8. Southland Bank presents the draft and documents to Northland Bank for acceptance.
Northland Bank accepts the draft by stamping and signing it making it a bankers accep-
tance, takes possession of the documents, and promises to pay the now-accepted draft at
maturity—say, 60 days.
9. Northland Bank returns the accepted draft to Southland Bank. Alternatively, Southland
Bank might ask Northland Bank to accept and discount the draft. Should this occur,
Northland Bank would remit the cash less a discount fee rather than return the accepted
draft to Southland Bank.
10. Southland Bank, having received back the accepted draft, now a bankers’ acceptance,
may choose between several alternatives. Southland Bank may sell the acceptance in the
open market at a discount to an investor, typically a corporation or financial institution
with excess cash it wants to invest for a short period of time. Southland Bank may also
hold the acceptance in its own portfolio.
11. If Southland Bank discounted the acceptance with Northland Bank (mentioned in step
9) or discounted it in the local money market, Southland Bank will transfer the proceeds
less any fees and discount to Trident. Another possibility would be for Trident itself to
take possession of the acceptance, hold it for 60 days, and present it for collection. Nor-
mally, however, exporters prefer to receive the discounted cash value of the acceptance
at once rather than wait for the acceptance to mature and receive a slightly greater
amount of cash at a later date.
12. Northland Bank notifies the Canadian Buyer of the arrival of the documents. The
Canadian Buyer signs a note or makes some other agreed upon plan to pay North-
land Bank for the merchandise in 60 days, Northland Bank releases the underlying
documents so that the Canadian Buyer can obtain physical possession of the ship-
ment at once.
13. After 60 days, Northland Bank receives from the Canadian Buyer funds to pay the
maturing acceptance.
14. On the same day, the 60th day after acceptance, the holder of the matured acceptance
presents it for payment and receives its face value. The holder may present it directly to
Northland Bank, or return it to Southland Bank and have Southland Bank collect it
through normal banking channels.
Although this is a typical transaction involving an L/C, few international trade transac-
tions are probably ever truly typical. Business, and more specifically international business,
requires flexibility and creativity by management at all times. The Mini-Case at the end of
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this chapter presents an application of the mechanics of a real business situation. The result is
a classic challenge to management: when and on what basis do you compromise typical pro-
cedure in order to accomplish strategic goals?

Government Programs to Help Finance Exports

Governments of most export-oriented industrialized countries have special financial institu-
tions that provide some form of subsidized credit to their own national exporters. These
export finance institutions offer terms that are better than those generally available from the
private sector. Thus, domestic taxpayers are subsidizing sales to foreign buyers in order to
create employment and maintain a technological edge. The most important institutions usu-
ally offer export credit insurance and a government supported bank for export financing.

Export Credit Insurance

The exporter who insists on cash or an L/C payment for foreign shipments is likely to lose
orders to competitors from other countries that provide more favorable credit terms. Bet-
ter credit terms are often made possible by means of export credit insurance, which pro-
vides assurance to the exporter or the exporter’s bank that, should the foreign customer
default on payment, the insurance company will pay for a major portion of the loss.
Because of the availability of export credit insurance, commercial banks are willing to pro-
vide medium- to long-term financing (five to seven years) for exports. Importers prefer
that the exporter purchase export credit insurance to pay for nonperformance risk by the
importer. In this way, the importer does not need to pay to have an L/C issued and does not
reduce its credit line.
Competition between nations to increase exports by lengthening the period for which
credit transactions can be insured may lead to a credit war and to unsound credit decisions.
To prevent such an unhealthy development, a number of leading trading nations joined
together in 1934 to create the Berne Union (officially, the Union d’Assureurs des Credits
Internationaux) for the purpose of establishing a voluntary international understanding on
export credit terms. The Berne Union recommends maximum credit terms for many items
including, for example, heavy capital goods (five years), light capital goods (three years), and
consumer durable goods (one year).

Export Credit Insurance in the United States

In the United States, export credit insurance is provided by the Foreign Credit Insurance
Association (FCIA). This is an unincorporated association of private commercial insurance
companies operating in cooperation with the Export-Import Bank (see below).
The FCIA provides policies protecting U.S. exporters against the risk of nonpayment by
foreign debtors as a result of commercial and political risks. Losses due to commercial risk
are those that result from the insolvency or protracted payment default of the buyer. Political
losses arise from actions of governments beyond the control of buyer or seller.

Export-Import Bank and Export Financing

The Export-Import Bank (also called Eximbank) is another independent agency of the U.S.
government, established in 1934 to stimulate and facilitate the foreign trade of the United
States. Interestingly, the Eximbank was originally created primarily to facilitate exports to
the Soviet Union. In 1945, the Eximbank was re-chartered “to aid in financing and to facili-
tate exports and imports and the exchange of commodities between the United States and
any foreign country or the agencies or nationals thereof.”
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The Eximbank facilitates the financing of U.S. exports through various loan guarantee
and insurance programs. The Eximbank guarantees repayment of medium-term (181 days to
five years) and long-term (five years to ten years) export loans extended by U.S. banks to for-
eign borrowers. The Eximbank’s medium- and long-term, direct-lending operation is based
on participation with private sources of funds. Essentially, the Eximbank lends dollars to bor-
rowers outside the United States for the purchase of U.S. goods and services. Proceeds of
such loans are paid to U.S. suppliers. The loans themselves are repaid with interest in dollars
to the Eximbank. The Eximbank requires private participation in these direct loans in order
to: 1) ensure that it complements rather than competes with private sources of export financ-
ing; 2) spread its resources more broadly; and 3) ensure that private financial institutions will
continue to provide export credit.
The Eximbank also guarantees lease transactions, finances the costs involved in the
preparation by U.S. firms of engineering, planning, and feasibility studies for non-U.S. clients
on large capital projects; and supplies counseling for exporters, banks, or others needing help
in finding financing for U.S. goods.

Trade Financing Alternatives

In order to finance international trade receivables, firms use the same financing instruments
as they use for domestic trade receivables, plus a few specialized instruments that are only
available for financing international trade. Exhibit 19.9 identifies the main short-term financ-
ing instruments and their approximate costs. The last section describes a longer term instru-
ment called forfaiting.
Bankers’ Acceptances. Bankers’ acceptances, described earlier in this chapter can be used to
finance both domestic and international trade receivables. Exhibit 19.9 shows that bankers’
acceptances earn a yield comparable to other money market instruments, especially mar-
ketable bank certificates of deposit. However, the all-in cost to a firm of creating and dis-
counting a bankers’ acceptance also depends upon the commission charged by the bank that
accepts the firm’s draft.
The first owner of the bankers’ acceptance created from an international trade transac-
tion will be the exporter, who receives the accepted draft back after the bank has stamped it
“accepted.” The exporter may hold the acceptance until maturity and then collect. On an
acceptance of, say, $100,000 for three months the exporter would receive the face amount less
the bank’s acceptance commission of 1.5% per annum:

EXHIBIT 19.9 Instruments for Financing Short-Term Domestic and International

Trade Receivables

Instrument Cost or Yield for 3-Month Maturity

Bankers’ acceptances* 1.14% yield annualized
Trade acceptances* 1.17% yield annualized
Factoring Variable rate but much higher cost than bank credit lines
Securitization Variable rate but competitive with bank credit lines
Bank credit lines 4.25% plus points (fewer points if covered by export credit insurance)
Commercial paper* 1.15% yield annualized
*These instruments compete with 3-month marketable bank time certificates of deposit that yield 1.17%.
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Face amount of the acceptance $100,000

Less 1.5% per annum commission for three months - 375 (.015 * 3/12 * $100,000)
Amount received by exporter in three months $ 99,625

Alternatively, the exporter may “discount”—that is, sell at a reduced price—the accep-
tance to its bank in order to receive funds at once. The exporter will then receive the face
amount of the acceptance less both the acceptance fee and the going market rate of discount
for bankers’ acceptances. If the discount rate were 1.14% per annum as shown in
Exhibit 19.9, the exporter would receive the following:

Face amount of the acceptance $100,000

Less 1.5% per annum commission for three months - 375 (.015 * 3/12 * $100,000)
Less 1.14% per annum discount rate for three months - 285 (.0114 * 3/12 * $100,000)
Amount received by exporter at once $ 99,340

Therefore, the annualized all-in cost of financing this bankers’ acceptance is as follows:
Commission + discount 360 $375 + $285 360
* = * = .0266 or 2.66%
Proceeds 90 $99,340 90
The discounting bank may hold the acceptance in its own portfolio, earning for itself the
1.14% per annum discount rate, or the acceptance may be resold in the acceptance market to
portfolio investors. Investors buying bankers’ acceptances provide the funds that finance the
transaction.

Trade Acceptances. Trade acceptances are similar to bankers’ acceptances except that the
accepting entity is a commercial firm, like General Motors Acceptance Corporation
(GMAC), rather than a bank. The cost of a trade acceptance depends on the credit rating of
the accepting firm plus the commission it charges. Like bankers’ acceptances, trade accep-
tances are sold at a discount to banks and other investors at a rate that is competitive with
other money market instruments (see Exhibit 19.9).

Factoring. Specialized firms, known as factors, purchase receivables at a discount on either a

non-recourse or recourse basis. Non-recourse means that the factor assumes the credit, polit-
ical, and foreign exchange risk of the receivables it purchases. Recourse means that the factor
can give back receivables that are not collectable. Since the factor must bear the cost and risk
of assessing the creditworth of each receivable, the cost of factoring is usually quite high. It is
more than borrowing at the prime rate plus points.
The all-in cost of factoring non-recourse receivables is similar in structure to accep-
tances. The factor charges a commission to cover the non-recourse risk, typically
1.5%–2.5%, plus interest deducted as a discount from the initial proceeds. On the other
hand, the firm selling the non-recourse receivables avoids the cost of determining credit-
worth of its customers. It also does not have to show debt borrowed to finance these receiv-
ables on its balance sheet. Furthermore, the firm avoids both foreign exchange and political
risk on these non-recourse receivables. Global Finance in Practice 19.1 provides an exam-
ple of the costs.

Securitization. The securitization of export receivables for financing trade is an attractive

supplement to bankers’ acceptance financing and factoring. A firm can securitize its export
receivables by selling them to a legal entity established to create marketable securities based
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GLOBAL FINANCE IN PRACTICE 19.1 at first sight appear expensive, the firm would net the pro-
ceeds in cash up-front, not having to wait 90 days for pay-
Factoring in Practice ment. And it would not be responsible for collecting on the
receivable. If the firm were able to “factor-in” the cost of
A U.S.-based manufacturer that may have suffered significant factoring in the initial sale, all the better. Alternatively, it
losses during the global credit crisis and the following global might offer a discount for cash paid in the first 10 days after
recession is cash-short. Sales, profits, and cash flows, have shipment.
fallen. The company is now struggling to service its high lev-
els of debt. It does, however, have a number of new sales
Face amount of receivable $5,000,000
agreements. It is considering factoring one of its biggest new
sales, a sale for $5 million to a Japanese company. The Non-recourse fee (1.5%) - 75,000
receivable is due in 90 days. After contacting a factoring Factoring fee (2.5% per month * 3 months) - 375,000
agent, it is quoted the numbers in the table. Net proceeds on sale (received now) $4,550,000
If the company wishes to factor its receivable it will net
$4.55 million, 91% of the face amount. Although this may

on a package of individual export receivables. An advantage of this technique is to remove

the export receivables from the exporter’s balance sheet because they have been sold with-
out recourse.
The receivables are normally sold at a discount. The size of the discount depends on four
factors:
1. The historic collection risk of the exporter
2. The cost of credit insurance
3. The cost of securing the desirable cash flow stream to the investors
4. The size of the financing and services fees
Securitization is more cost effective if there is a large value of transactions with a known
credit history and default probability. A large exporter could establish its own securitization
entity. While the initial setup cost is high, the entity can be used on an ongoing basis. As an
alternative, smaller exporters could use a common securitization entity provided by a finan-
cial institution, thereby saving the expensive setup costs.
Bank Credit Line Covered by Export Credit Insurance. A firm’s bank credit line can typically
be used to finance up to a fixed upper limit, say 80%, of accounts receivable. Export receiv-
ables can be eligible for inclusion in bank credit line financing. However, credit information
on foreign customers may be more difficult to collect and assess. If a firm covers its export
receivables with export credit insurance, it can greatly reduce the credit risk of those receiv-
ables. This insurance enables the bank credit line to cover more export receivables and lower
the interest rate for that coverage. Of course, any foreign exchange risk must be handled by
the transaction exposure techniques described in Chapter 10.
The cost of using a bank credit line is usually the prime rate of interest plus points to
reflect a particular firm’s credit risk. As usual, 100 points is equal to 1%. In the United States,
borrowers are also expected to maintain a compensating deposit balance at the lending insti-
tution. In Europe and many other places, lending is done on an overdraft basis. An overdraft
agreement allows a firm to overdraw its bank account up to the limit of its credit line. Inter-
est at prime plus points is based only on the amount of overdraft borrowed. In either case, the
all-in cost of bank borrowing using a credit line is higher than acceptance financing as shown
in Exhibit 19.9.
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W-66 PA R T 6 Topics in International Finance

Commercial Paper. A firm can issue commercial paper—unsecured promissory notes—to

fund its short-term financing needs, including both domestic and export receivables. However,
it is only the large well-known firms with favorable credit ratings that have access to either the
domestic or euro commercial paper market. As shown in Exhibit 19.9, commercial paper
interest rates lie at the low end of the yield curve and compete directly with marketable bank
time certificates of deposit.

Forfaiting: Medium- and Long-Term Financing

Forfaiting is a specialized technique to eliminate the risk of nonpayment by importers in
instances where the importing firm and/or its government is perceived by the exporter to be
too risky for open account credit. The name of the technique comes from the French à forfait,
a term that implies “to forfeit or surrender a right.”

Role of the Forfaiter

The essence of forfaiting is the non-recourse sale by an exporter of bank-guaranteed promis-
sory notes, bills of exchange, or similar documents received from an importer in another
country. The exporter receives cash at the time of the transaction by selling the notes or bills
at a discount from their face value to a specialized finance firm called a forfaiter. The forfaiter
arranges the entire operation prior to the actual transaction taking place. Although the
exporting firm is responsible for the quality of delivered goods, it receives a clear and uncon-
ditional cash payment at the time of the transaction. All political and commercial risk of non-
payment by the importer is carried by the guaranteeing bank. Small exporters who trust their
clients to pay find the forfaiting technique invaluable because it eases cash flow problems.
During the Soviet era expertise in the technique was centered in German and Austrian
banks, which used forfaiting to finance sales of capital equipment to eastern European,
“Soviet Bloc,” countries. British, Scandinavian, Italian, Spanish, and French exporters have
now adopted the technique, but U.S. and Canadian exporters are reported to be slow to use
forfaiting, possibly because they are suspicious of its simplicity and lack of complex docu-
mentation.1 Nevertheless, some American firms now specialize in the technique, and the
Association of Forfaiters in the Americas (AFIA) has more than 20 members. Major export
destinations financed via the forfaiting technique are Asia, Eastern Europe, the Middle East,
and Latin America.2

A Typical Forfaiting Transaction

A typical forfaiting transaction involves five parties, as shown in Exhibit 19.10. The steps in
the process are as follows:
Step 1: Agreement. Importer and exporter agree between themselves on a series of imports
to be paid for over a period of time, typically three to five years. However, periods up to
10 years or as short as 180 days have been financed by the technique. The normal minimum
size for a transaction is $100,000. The importer agrees to make periodic payments, often
against progress on delivery or completion of a project.
Step 2: Commitment. The forfaiter promises to finance the transaction at a fixed discount
rate, with payment to be made when the exporter delivers to the forfaiter the appropriate

1User’sGuide—Forfaiting: What is it, who uses it and why? British-American Forfaiting Company, P.O. Box 16872,
St. Louis, Missouri 63105, www.tradecompass.com.
2Association of Forfaiters in the Americas (AFIA), 2 Park Avenue, Suite 1522, New York, NY, 10016.
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EXHIBIT 19.10 Typical Forfaiting Transaction

Step 1 Importer
Exporter
(private firm or government
(private industrial firm)
purchaser in emerging market)

Step 2 Step 4 Step 3

Forfaiter
(subsidiary of a
Step 5 European bank)
Step 6

Step 7 Importer’s Bank

Investor
(usually a private bank in
(institutional or individual)
the importer’s country)

promissory notes or other specified paper. The agreed-upon discount rate is based on the
cost of funds in the Euromarket, usually on LIBOR for the average life of the transaction,
plus a margin over LIBOR to reflect the perceived risk in the deal. This risk premium is
influenced by the size and tenor of the deal, country risk, and the quality of the guarantor
institution. On a five-year deal, for example, with 10 semiannual payments, the rate used
would be based on the 2 1/4 year LIBOR rate. This discount rate is normally added to the
invoice value of the transaction so that the cost of financing is ultimately borne by the
importer. The forfaiter charges an additional commitment fee of from 0.5% per annum to
as high as 6.0% per annum from the date of its commitment to finance until receipt of the
actual discount paper issued in accordance with the finance contract. This fee is also nor-
mally added to the invoice cost and passed on to the importer.
Step 3: Aval or Guarantee. The importer obligates itself to pay for its purchases by issuing a
series of promissory notes, usually maturing every six or twelve months, against progress on
delivery or completion of the project. These promissory notes are first delivered to the
importer’s bank where they are endorsed (that is, guaranteed) by that bank. In Europe, this
unconditional guarantee is referred to as an aval, which translates into English as “backing.”
At this point, the importer’s bank becomes the primary obligor in the eyes of all subsequent
holders of the notes. The bank’s aval or guarantee must be irrevocable, unconditional, divisi-
ble, and assignable. Because U.S. banks do not issue avals, U.S. transactions are guaranteed by
a standby letter of credit (L/C), which is functionally similar to an aval but more cumber-
some. For example, L/Cs can normally be transferred only once.
Step 4: Delivery of Notes. The now-endorsed promissory notes are delivered to the exporter.
Step 5: Discounting. The exporter endorses the notes “without recourse” and discounts them
with the forfaiter, receiving the agreed-upon proceeds. Proceeds are usually received two
days after the documents are presented. By endorsing the notes “without recourse,” the
exporter frees itself from any liability for future payment on the notes and thus receives the
discounted proceeds without having to worry about any further payment difficulties.
Step 6: Investment. The forfaiting bank either holds the notes until full maturity as an invest-
ment or endorses and rediscounts them in the international money market. Such subsequent
sale by the forfaiter is usually without recourse. The major rediscount markets are in London
and Switzerland, plus New York for notes issued in conjunction with Latin American business.
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Step 7: Maturity. At maturity, the investor holding the notes presents them for collection to
the importer or to the importer’s bank. The promise of the importer’s bank is what gives the
documents their value.
In effect, the forfaiter functions both as a money market firm and a specialist in packag-
ing financial deals involving country risk. As a money market firm, the forfaiter divides the
discounted notes into appropriately sized packages and resells them to various investors
having different maturity preferences. As a country risk specialist, the forfaiter assesses the
risk that the notes will eventually be paid by the importer or the importer’s bank and puts
together a deal that satisfies the needs of both exporter and importer.
Success of the forfaiting technique springs from the belief that the aval or guarantee of a
commercial bank can be depended on. Although commercial banks are the normal and pre-
ferred guarantors, guarantees by government banks or government ministries of finance are
accepted in some cases. On occasion, large commercial enterprises have been accepted as
debtors without a bank guarantee. An additional aspect of the technique is that the endorsing
bank’s aval is perceived to be an “off balance sheet” obligation, the debt is presumably not
considered by others in assessing the financial structure of the commercial banks.

Summary of Learning Objectives

Learn how international trade alters both the supply chain ◆ In the L/C, the bank substitutes its credit for that of
and general value chain of the domestic firm, thereby the importer and promises to pay if certain documents
beginning the globalization process in the trade phase. are submitted to the bank. The exporter may now rely
◆ International trade takes place between three cate- on the promise of the bank rather than on the promise
gories of relationships: unaffiliated unknown parties, of the importer.
unaffiliated known parties, and affiliated parties.
Identify what the documentation sequence is for a typical
◆ International trade transactions between affiliated
international trade transaction.
parties typically do not require contractual arrange-
ments or external financing. Trade transactions ◆ The exporter typically ships on an order bill of lading,
between unaffiliated parties typically require con- attaches the order bill of lading to a draft ordering
tracts and some type of external financing, such as that payment from the importer’s bank, and presents these
available through letters of credit. documents, plus any of a number of additional docu-
ments, through its own bank to the importer’s bank.
Consider what the key elements of an import or export ◆ If the documents are in order, the importer’s bank
transaction are in business. either pays the draft (a sight draft) or accepts the draft
(a time draft). In the latter case, the bank promises to
◆ Over many years, established procedures have arisen pay in the future. At this step, the importer’s bank
to finance international trade. The basic procedure acquires title to the merchandise through the bill of lad-
rests on the interrelationship between three key docu- ing, and it then releases the merchandise to the importer
ments, the L/C, the draft, and the bill of lading. against payment or promise of future payment.
◆ Variations in each of the three key documents, the ◆ If a sight draft is used, the exporter is paid at once. If a
L/C, the draft, and the bill of lading, provide a variety time draft is used, the exporter receives the accepted
of ways to accommodate any type of transaction. draft, now a bankers’ acceptance, back from the bank.
The exporter may hold the bankers’ acceptance until
Discover how the three key documents in import/export, maturity or sell it at a discount in the money market.
the letter of credit, the draft, and the bill of lading, combine
to both finance the transaction and to manage its risks. Learn how the various stages and their costs impact the
◆ In the simplest transaction, in which all three docu- ability of an exporter to enter a foreign market and poten-
ments are used and in which financing is desirable, tially compete in both credit terms and pricing.
an importer applies for and receives an L/C from ◆ The total costs of an exporter entering a foreign market
its bank. include the transaction costs of the trade financing,
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International Trade Finance W-69

the import and export duties and tariffs applied by stimulate and facilitate the foreign trade of the
exporting and importing nations, and the costs of for- United States.
eign market penetration, which include distribution
expenses, inventory costs, and transportation expenses. Examine the various trade financing alternatives.
◆ Trade financing uses the same financing instruments
See what organizations and resources are available for as in domestic receivables financing, plus some spe-
exporters to aid in managing trade risk and financing. cialized instruments that are only available for financ-
◆ Export credit insurance provides assurance to ing international trade.
exporters (or exporters’ banks) that should the for- ◆ A popular instrument for short-term financing is a
eign customer default on payment, the insurance com- bankers’ acceptance. Its all-in cost is comparable to
pany will pay for a major portion of the loss. other money market instruments, such as marketable
◆ In the United States, export credit insurance is pro- bank certificates of deposit.
vided by the Foreign Credit Insurance Association ◆ Other short-term financing instruments with a domes-
(FCIA), an unincorporated association of private com- tic counterpart are trade acceptances, factoring, secu-
mercial insurance companies operating in cooperation ritization, bank credit lines (usually covered by export
with the Export-Import Bank of the U.S. government. credit insurance), and commercial paper.
◆ The Export-Import Bank of the U.S. government ◆ Forfaiting is an international trade technique that can
(Eximbank) is an independent agency established to provide medium- and long-term financing.

MINI-CASE $38.32 per case, is termed CFR (cost and freight). Finally,
the insurance expenses related to the potential loss of the
Crosswell International and Brazil
goods while in transit to final port of destination, export
Crosswell International is a U.S.-based manufacturer and insurance, are $0.86 per case. The total CIF (cost, insurance,
distributor of health care products, including children’s dia- and freight) is $39.18 per case, or 97.95 Brazilian real per
pers. Crosswell has been approached by Leonardo Sousa, case, assuming an exchange rate of 2.50 Brazilian real (R$)
the president of Material Hospitalar, a distributor of health per U.S. dollar ($). In summary, the CIF cost of R$97.95 is
care products throughout Brazil. Sousa is interested in dis- the price charged by the exporter to the importer on arrival
tributing Crosswell’s major diaper product, Precious, but in Brazil, and is calculated as follows:
only if an acceptable arrangement regarding pricing and
payment terms can be reached. CIF = FAS + freight + export insurance
= ($34.00 + $4.32 + $0.86) * R$2.50/$
Exporting to Brazil = R$97.95
Crosswell’s manager for export operations, Geoff Mathieux
followed up the preliminary discussions by putting together The actual cost to the distributor in getting the diapers
an estimate of export costs and pricing for discussion through the port and customs warehouses must also be cal-
purposes with Sousa. Crosswell needs to know all of the culated in terms of what Leonardo Sousa’s costs are in real-
costs and pricing assumptions for the entire supply and ity. The various fees and taxes detailed in Exhibit 1 raise the
value chain as it reaches the consumer. Mathieux believes fully landed cost of the Precious diapers to R$107.63 per
it critical that any arrangement that Crosswell enters into case. The distributor would now bear storage and inventory
results in a price to consumers in the Brazilian market- costs totaling R$8.33 per case, which would bring the costs
place that is both fair to all parties involved and competi- to R$115.96. The distributor then adds a margin for distri-
tive, given the market niche Crosswell hopes to penetrate. bution services of 20% (R$23.19), raising the price as sold
This first cut on pricing Precious diapers into Brazil is to the final retailer to R$139.15 per case.
presented in Exhibit 1. Finally, the retailer (a supermarket or other retailer of
Crosswell proposes to sell the basic diaper line to the consumer health care products) would include its expenses,
Brazilian distributor for $34.00 per case, FAS (free along- taxes, and markup to reach the final shelf price to the cus-
side ship) Miami docks. This means that the seller, Cross- tomer of R$245.48 per case. This final retail price estimate
well, agrees to cover all costs associated with getting the now allows both Crosswell and Material Hospitalar to eval-
diapers to the Miami docks. The cost of loading the diapers uate the price competitiveness of the Precious Ultra-Thin
aboard ship, the actual cost of shipping (freight), and associ- Diaper in the Brazilian marketplace, and provides a basis
ated documents is $4.32 per case. The running subtotal, for further negotiations between the two parties.
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W-70 PA R T 6 Topics in International Finance

EXHIBIT 1 Export Pricing for the Precious Diaper Line to Brazil

The Precious Ultra-Thin Diaper will be shipped via container. Each container will hold 968 cases of diapers. The costs and prices
below are calculated on a per case basis, although some costs and fees are assessed by container.

Exports Costs and Pricing to Brazil Per Case Rates and Calculation
FAS price per case, Miami $34.00
Freight, loading and documentation 4.32 $4180 per container/968 = $4.32
CFR price per case, Brazilian port (Santos) $38.32
Export insurance 0.86 2.25% of CIF
CIF to Brazilian port $39.18
CIF to Brazilian port, in Brazilian real R$97.95 2.50 Real/US$ * $39.18
Brazilian Importation Costs
Import duties 1.96 2.00% of CIF
Merchant marine renovation fee 2.70 25.00% of freight
Port storage fees 1.27 1.30% of CIF
Port handling fees 0.01 R$12 per container
Additional handling fees 0.26 20.00% of storage and handling
Customs brokerage fees 1.96 2.00% of CIF
Import license fee 0.05 R$50 per container
Local transportation charges 1.47 1.50% of CIF
Total cost to distributor in real R$107.63
Distributor’s Costs and Pricing
Storage cost 1.47 1.50% of CIF * months
Cost of financing diaper inventory 6.86 7.00% of CIF * months
Distributor’s margin 23.19 20.00% of Price + storage + financing
Price to retailer in real R$139.15
Brazilian Retailer Costs and Pricing
Industrial product tax (IPT) 20.87 15.00% of price to retailer
Mercantile circulation services tax (MCS) 28.80 18.00% of price + IPT
Retailer costs and markup 56.65 30.00% of price + IPT + MCS
Price to consumer in real R$245.48

Diaper Prices to Consumers Diapers Per Case Price Per Diaper

Small size 352 R$0.70
Medium size 256 R$0.96
Large size 192 R$1.28

Mathieux provides the above export price quotation, an descriptions of regional sales forces, and sales forecasts for
outline of a potential representation agreement (for Sousa the Precious diaper line. These last requests by Crosswell
to represent Crosswell’s product lines in the Brazilian are very important for Crosswell to be able to assess
marketplace), and payment and credit terms to Leonardo Material Hospitalar’s ability to be a dependable, credit-
Sousa. Crosswell’s payment and credit terms are that worthy, and capable long-term partner and representative
Sousa either pay in full in cash in advance, or with a con- of the firm in the Brazilian marketplace. The discussions
firmed irrevocable documentary L/C with a time draft that follow focus on finding acceptable common ground
specifying a tenor of 60 days. between the two parties and working to increase the
Crosswell also requests from Sousa financial state- competitiveness of the Precious diaper in the Brazilian
ments, banking references, foreign commercial references, marketplace.
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International Trade Finance W-71

Crosswell’s Proposal 1. Wait the full time period of the time draft of
The proposed sale by Crosswell to Material Hospitalar, at 60 days and receive the entire payment in full
least in the initial shipment, is for 10 containers of 968 ($379,262.40).
cases of diapers at $39.18 per case, CIF Brazil, payable in 2. Receive the discounted value of this amount today.
U.S. dollars. This is a total invoice amount of $379,262.40. The discounted amount, assuming U.S. dollar interest
Payment terms are that a confirmed L/C will be required rate of 6.00% per annum (1.00% per 60 days):
of Material Hospitalar on a U.S. bank. The payment will
be based on a time draft of 60 days, presentation to the $379,262.40 $379,262.40
= = $375,507.33
bank for acceptance with other documents on the date of (1 + 0.01) 1.01
shipment. Both the exporter and the exporter’s bank will
expect payment from the importer or importer’s bank Because the invoice is denominated in U.S. dollars,
60 days from this date of shipment. Crosswell need not worry about currency value changes
(currency risk). And because its bank has confirmed the
What Should Crosswell Expect? Assuming Material L/C, it is protected against changes or deteriorations in
Hospitalar acquires the L/C and it is confirmed by Material Hospitalar’s ability to pay on the future date.
Crosswell’s bank in the United States, Crosswell will ship
the goods after the initial agreement, say 15 days, as illus- What Should Material Hospitalar Expect? Material
trated in Exhibit 2. Hospitalar will receive the goods on or before day 60. It
Simultaneous with the shipment, in which Crosswell has will then move the goods through its distribution system
lost physical control over the goods, Crosswell will present to retailers. Depending on the payment terms between
the bill of lading acquired at the time of shipment with the Material Hospitalar and its buyers (retailers), it could
other needed documents to its bank requesting payment. either receive cash or terms for payment for the goods.
Because the export is under a confirmed L/C, assuming all Because Material Hospitalar purchased the goods via the
documents are in order, Crosswell’s bank will give Cross- 60-day time draft and an L/C from its Brazilian bank, total
well two choices: payment of $379,262.40 is due on day 90 (shipment and

EXHIBIT 2 Export Payment Terms on Crosswell’s Export to Brazil

Time (day count ) and Events

0 3 10 15 30 60 90

Crosswell Crosswell’s Crosswell Goods

agrees to ship bank confirms ships arrive at
under an L /C L /C and notifies goods Brazilian
Crosswell port
Material
Hospitalar
applies to its
bank in São Period of outstanding
Paulo for an account receivable
L /C (60-day time draft )

Brazilian bank approves Crosswell presents

L /C and issues in favor documents to its bank
of Crosswell; L /C sent to for acceptance and
Crosswell’s bank payment of $379,262
(today is “sight”)

Crosswell’s bank pays Material Hospitalar

discounted value of makes payment to
acceptance of $375,507 its bank of $379,262
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W-72 PA R T 6 Topics in International Finance

presentation of documents was on day 30 + 60 day time significantly to Crosswell’s landed prices in the Brazilian
draft) to the Brazilian bank. Material Hospitalar, because marketplace.
it is a Brazilian-based company and has agreed to make
payment in U.S. dollars (foreign currency), carries the cur- CASE QUESTIONS
rency risk of the transaction.
1. How are pricing, currency of denomination, and
financing interrelated in the value-chain for Cross-
Crosswell/Material Hospitalar’s Concern
well’s penetration of the Brazilian market? Can you
The concern the two companies hold, however, is that the
summarize them using Exhibit 2?
total price to the consumer in Brazil, R$245.48 per case, or
R$0.70/diaper (small size), is too high. The major competi- 2. How important is Sosa to the value-chain of Cross-
tors in the Brazilian market for premium quality diapers, well? What worries might Crosswell have regarding
Kenko do Brasil (Japan), Johnson and Johnson (U.S.), and Sosa’s ability to fulfill his obligations?
Procter and Gamble (U.S.), are cheaper (see Exhibit 3). 3. If Crosswell is to penetrate the market, some way of
The competitors all manufacture in-country, thus avoiding reducing its prices will be required. What do you
the series of import duties and tariffs, which, have added suggest?

EXHIBIT 3 Competitive Diaper Prices in the Brazilian Market (in Brazilian real)

Price per diaper by size

Company (Country) Brand Small Medium Large
Kenko (Japan) Monica Plus 0.68 0.85 1.18
Johnson and Johnson (U.S.) Sempre Seca Plus 0.65 0.80 1.08
Procter and Gamble (U.S.) Pampers Uni 0.65 0.80 1.08
Crosswell (U.S.) Precious 0.70 0.96 1.40

6. Letter of Credit. Identify each party to a letter of

Questions credit (L/C) and indicate its responsibility.
1. Unaffiliated Buyers. Why might different documen-
7. Confirming a Letter of Credit. Why would an
tation be used for an export to a non-affiliated foreign
exporter insist on a confirmed letter of credit?
buyer who is a new customer as compared to an
export to a non-affiliated foreign buyer to whom the 8. Documenting an Export of Hard Drives. List the
exporter has been selling for many years? steps involved in the export of computer hard disk
drives from Penang, Malaysia, to San Jose, California,
2. Affiliated Buyers. For what reason might an exporter
using an unconfirmed letter of credit authorizing
use standard international trade documentation (letter
payment on sight.
of credit, draft, order bill of lading) on an intrafirm
export to its parent or sister subsidiary? 9. Documenting an Export of Lumber from Portland to
Yokohama. List the steps involved in the export of
3. Related Party Trade. What reasons can you give for
lumber from Portland, Oregon, to Yokohama, Japan,
the observation that intrafirm trade is now greater
using a confirmed letter of credit, payment to be
than trade between non-affiliated exporters and
made in 120 days.
importers?
10. Inca Breweries of Peru. Inca Breweries of Lima,
4. Documents. Explain the difference between a letter
Peru, has received an order for 10,000 cartons of beer
of credit (L/C) and a draft. How are they linked?
from Alicante Importers of Alicante, Spain. The beer
5. Risks. What is the major difference between will be exported to Spain under the terms of a letter
“currency risk” and “risk of noncompletion?” How of credit issued by a Madrid bank on behalf of
are these risks handled in a typical international trade Alicante Importers. The letter of credit specifies that
transaction? the face value of the shipment, $720,000 U.S. dollars,
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will be paid 90 days after the Madrid bank accepts a

draft drawn by Inca Breweries in accordance with the
Problems
terms of the letter of credit. 1. Nikken Microsystems (A). Assume Nikken Micro-
The current discount rate on 3-month bankers’ systems has sold Internet servers to Telecom España
acceptance is 8% per annum, and Inca Breweries for :700,000. Payment is due in three months and will
estimate its weighted average cost of capital to be be made with a trade acceptance from Telecom
20% per annum. The commission for selling a España Acceptance. The acceptance fee is 1.0% per
bankers’ acceptance in the discount market is 1.2% annum of the face amount of the note. This accep-
of the face amount. tance will be sold at a 4% per annum discount. What
How much cash will Inca Breweries receive from is the annualized percentage all-in cost in euros of
the sale if it holds the acceptance until maturity? Do this method of trade financing?
you recommend that Inca Breweries hold the accep-
tance until maturity or discount it at once in the U.S. 2. Nikken Microsystems (B). Assume that Nikken
bankers’ acceptance market? Microsystems prefers to receive U.S. dollars rather
than euros for the trade transaction described in
11. Swishing Shoe Company. Swishing Shoe Company problem 2. It is considering two alternatives: 1) sell
of Durham, North Carolina, has received an order for the acceptance for euros at once and convert the
50,000 cartons of athletic shoes from Southampton euros immediately to U.S. dollars at the spot rate of
Footware, Ltd., of England, payment to be in British exchange of $1.00/: or 2) hold the euro acceptance
pounds sterling. The shoes will be shipped to until maturity but at the start sell the expected euro
Southampton Footware under the terms of a letter of proceeds forward for dollars at the 3-month forward
credit issued by a London Bank on behalf of rate of $1.02/:.
Southampton Footware. The letter of credit specifies a. What are the U.S. dollar net proceeds received at
that the face value of the shipment, £400,000, will be once from the discounted trade acceptance in
paid 120 days after the London bank accepts a draft alternative 1?
drawn by Southampton Footware in accordance with b. What are the U.S. dollar net proceeds received in
the terms of the letter of credit. three months in alternative 2?
The current discount rate in London on 120-day c. What is the break-even investment rate that
bankers’ acceptances is 12% per annum, and South- would equalize the net U.S. dollar proceeds from
ampton Footware estimates its weighted average cost both alternatives?
of capital to be 18% per annum. The commission for d. Which alternative should Nikken Microsystems
selling a bankers’ acceptance in the discount market choose?
is 2.0% of the face amount.
a. Would Swishing Shoe Company gain by holding 3. Motoguzzie (A). Motoguzzie exports large-engine
the acceptance to maturity, as compared to motorcycles (greater than 700cc) to Australia and
discounting the bankers’ acceptance at once? invoices its customers in U.S. dollars. Sydney
b. Does Swishing Shoe Company incur any other Wholesale Imports has purchased $3,000,000 of
risks in this transaction? merchandise from Motoguzzie, with payment due in
six months. The payment will be made with a bankers’
12. Going Abroad. Assume that Great Britain charges acceptance issued by Charter Bank of Sydney at a fee
an import duty of 10% on shoes imported into the of 1.75% per annum. Motoguzzie has a weighted
United Kingdom. Swishing Shoe Company, in average cost of capital of 10%. If Motoguzzie holds
question 11, discovers that it can manufacture shoes this acceptance to maturity, what is its annualized
in Ireland and import them into Britain free of any percentage all-in-cost? What is its annualized
import duty. What factors should Swishing consider in percentage all-in cost?
deciding to continue to export shoes from North
Carolina versus manufacture them in Ireland? 4. Motoguzzie (B). Assuming the facts in problem 1,
Bank of America is now willing to buy Motoguzzie’s
13. Governmentally Supplied Credit. Various govern- bankers’ acceptance for a discount of 6% per annum.
ments have established agencies to insure against What would be Motoguzzie’s annualized percentage all-
nonpayment for exports and/or to provide export in cost of financing its $3,000,000 Australian receivable?
credit. This shifts credit risk away from private banks
and to the citizen taxpayers of the country whose 5. Nakatomi Toyota. Nakatomi Toyota buys its cars from
government created and backs the agency. Why Toyota Motors (U.S.), and sells them to U.S. customers.
would such an arrangement be of benefit to the One of its customers is EcoHire, a car rental firm that
citizens of that country? buys cars from Nakatomi Toyota at a wholesale price.
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W-74 PA R T 6 Topics in International Finance

Final payment is due to Nakatomi Toyota in six Interest would be at the prime rate of 5% plus 150
months. EcoHire has bought $200,000 worth of cars basis points per annum. Sunny Coast Enterprises
from Nakatomi, with a cash down payment of $40,000 would need to maintain a compensating balance of
and the balance due in six months without any 20% of the loan’s face amount. No interest will be
interest charged as a sales incentive. Nakatomi paid on the compensating balance by the bank or 2)
Toyota will have the EcoHire receivable accepted by Use its bank credit line but purchase export credit
Alliance Acceptance for a 2% fee, and then sell it at a insurance for a 1% fee. Because of the reduced risk,
3% per annum discount to Wells Fargo Bank. the bank interest rate would be reduced to 5% per
a. What is the annualized percentage all-in cost to annum without any points.
Nakatomi Toyota? a. What are the annualized percentage all-in costs of
b. What are Nakatomi’s net cash proceeds, including each alternative?
the cash down payment? b. What are the advantages and disadvantages of
each alternative?
6. Forfaiting at Umaru Oil (Nigeria). Umaru Oil of c. Which alternative would you recommend?
Nigeria has purchased $1,000,000 of oil drilling
equipment from Gunslinger Drilling of Houston, 8. Sunny Coast Enterprises (B). Sunny Coast Enterprises
Texas. Umaru Oil must pay for this purchase over the has been approached by a factor that offers to
next five years at a rate of $200,000 per year due on purchase the Hong Kong Media Imports receivable
March 1 of each year. at a 16% per annum discount plus a 2% charge for a
Bank of Zurich, a Swiss forfaiter, has agreed to non-recourse clause.
buy the five notes of $200,000 each at a discount. The a. What is the annualized percentage all-in cost of
discount rate would be approximately 8% per annum this factoring alternative?
based on the expected 3-year LIBOR rate plus 200 b. What are the advantages and disadvantages of the
basis points, paid by Umaru Oil. Bank of Zurich also factoring alternative compared to the alternatives
would charge Umaru Oil an additional commitment in Sunny Coast Enterprises (A)?
fee of 2% per annum from the date of its commit- 9. Whatchamacallit Sports (A). Whatchamacallit Sports
ment to finance until receipt of the actual discounted (Whatchamacallit) is considering bidding to sell
notes issued in accordance with the financing con- $100,000 of ski equipment to Phang Family Enterprises
tract. The $200,000 promissory notes will come due of Seoul, Korea. Payment would be due in six months.
on March 1 in successive years. Since Whatchamacallit cannot find good credit
The promissory notes issued by Umaru Oil will be information on Phang, Whatchamacallit wants to
endorsed by their bank, Lagos City Bank, for a 1% protect its credit risk. It is considering the following
fee and delivered to Gunslinger Drilling. At this financing solution.
point, Gunslinger Drilling will endorse the notes Phang’s bank issues a letter of credit on behalf of
without recourse and discount them with the for- Phang and agrees to accept Whatchamacallit’s draft
faiter, Bank of Zurich, receiving the full $200,000 for $100,000 due in six months. The acceptance fee
principal amount. Bank of Zurich will sell the notes would cost Whatchamacallit $500, plus reduce Phang’s
by re-discounting them to investors in the interna- available credit line by $100,000. The bankers’ accep-
tional money market without recourse. At maturity, tance note of $100,000 would be sold at a 2% per
the investors holding the notes will present them for annum discount in the money market. What is the
collection at Lagos City Bank. If Lagos City Bank annualized percentage all-in cost to Whatchamacallit
defaults on payment, the investors will collect on the of this bankers’ acceptance financing?
notes from Bank of Zurich.
a. What is the annualized percentage all-in cost to 10. Whatchamacallit Sports (B). Whatchamacallit could
Umaru Oil of financing the first $200,000 note due also buy export credit insurance from FCIA for a 1.5%
March 1, 2011? premium. It finances the $100,000 receivable from
b. What might motivate Umaru Oil to use this Phang from its credit line at 6% per annum interest.
relatively expensive alternative for financing? No compensating bank balance would be required.
a. What is Whatchamacallit’s annualized percentage
7. Sunny Coast Enterprises (A). Sunny Coast all-in cost of financing?
Enterprises has sold a combination of films and b. What are Phang’s costs?
DVDs to Hong Kong Media Incorporated for c. What are the advantages and disadvantages of this
US$100,000, with payment due in six months. Sunny alternative compared to the bankers’ acceptance
Coast Enterprises has the following alternatives for financing in Whatchamacallit (A)? Which alter-
financing this receivable: 1) Use its bank credit line. native would you recommend?
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currently apply. (Added note, the Export-Import

Internet Exercises Bank’s Web page provides some of the best Web site
1. Letter of Credit Services. Commercial banks world- links in international business and statistics.)
wide provide a variety of services to aid in the financ- Export-Import Bank www.exim.gov
ing of foreign trade. Contact any of the many major of the United States
multinational banks (a few are listed below) and
determine what types of letter of credit services and 3. Finance 3.0. The Finance 3.0 Web site is the
other trade financing services which they are able to equivalent of a social networking site for those
provide. interested in discussing a multitude of financial issues
in greater depth and breadth. There is no limit to
Bank of America www.bankamerica.com
breadth of topics in finance and financial
Barclays www.barclays.com management which are posted and discussed.
Deutsche Bank www.deutschebank.com
Finance 3.0 www.finance30.com/forum/
Union Bank of Switzerland www.unionbank.com categories/corporate-finance-
Swiss Bank Corporation www.swissbank.com valuation/listForCategory

2. Export-Import Bank of the United States. The 4. Global Reach. This Web site is the official blog for
EXIM Bank of the United States provides financing the United States Census Bureau’s Office of Foreign
for U.S.-based exporters. Like most major industrial Trade. The site carries a multitude of resources
country trade-financing organizations, it is intended including helpful guides on expanding start-up export
to aid in the export sale of products in which the businesses, the latest in U.S. trade statistics, and
buyer needs attractive financing terms. Use the helpful planning practices for exporting products to a
EXIM Bank’s Web site to determine the current variety of countries.
country limits, fees, and other restrictions which Global Reach blogs.census.gov/globalreach