UNIT- IV

CREDIT RATING

Introduction (Financial Markets and Financial Services by Vasant Desai, Page no: 533-535)

Credit rating system is a symbolic indicator of the current opinion of a rating agency and of the
relative capability and willingness of an issuer of a debt programme to service the debt
obligations as per the terms of the contract. This group together a large number of similar (but
not necessarily identical) debt instruments under different categories according to their credit
quality as judged by their inherent protective factors. Ratings, usually expressed in alphabetical
symbols, are a simple and easily understood tool enabling the investor to differentiate between
debt instruments on the basis of the underlying credit quality. The credit rating is thus a symbolic
indicator of the current opinion of the relative capability of the issue to service its debt obligation
in a timely fashion, with specific reference to the instrument being rated.

Meaning

 A rating is an opinion on the future ability and legal obligation of the issuer to make
timely payments for principal and interest on a specific fixed income security. The rating
measures the probability that the issuer will default on the security over its life, which
depending on the instrument may be a matter of days to 30 years or more. In addition,
long-term ratings incorporate an assessment of the expected monetary loss should a
default occur. ---- Moody’s
 Credit ratings help investors by providing an easily recognizable, simple tool that couples
a possibly unknown issuer with an informative and meaningful symbol of credit quality.
--- Standard & Poor’s
 it can be defined an act of assigning values to credit instruments by estimating or
assessing the solvency, i.e., the ability of the borrower to repay debt, and expressing them
through pre-determined symbols.

Types of Credit rating

Credit ratings are of different types, depending upon the requirements of the rater and the rated.
The following are the common types of ratings.

 Bond rating: Rating the bonds or debt securities issued by a company, government or
quasi-government body is called bond rating. This occupies the major business of credit
rating agencies.
 Equity rating: The rating of equity of capital market is called equity rating

A.L.I.E.T 1 FINANCIAL MARKETS AND SERVICES

  Commercial paper rating: It is mandatory on the part of a corporate body to obtain the
ratings of an approved credit rating agency to issue commercial paper. In U.S.A., 100%
commercial paper volume is rated. In India, P1 rating is prescribed for issue of
commercial paper by corporate bodies.
 Sovereign rating: This includes rating a country as to its creditworthiness, probability to
risk, etc.

Features of Credit rating (Financial Institutions and Markets by L.M.Bhole, Page no: 13.35-13.35)

 Credit rating is done by specialized, expert, reputed and accredited institutions.

 It is mostly confined to debt instruments, but efforts have been made to rate equity shares
also.
 In credit rating, although the whole organization is not graded, it does reflect the issuer’s
strength, soundness of operations, quality of management, organizational behavior, and
composite performance.
 Credit rating may differ for different instruments issued by the same organization
 While assigning ratings, credit rating agencies take into account factors such as industry
risk, market position, operating efficiency, track record, planning and control systems,
accounting quality, financial flexibility, profitability, liquidity, and asset quality of the
borrower.
 Credit rating is based on information provided by the borrower and the one obtained by
credit rating agency independently.
 Ratings are continuously monitored by credit rating agency, and they can be changed,
suspended, and withdrawn by it at any time as result of new information or other
circumstances.

Key functions of Credit Rating Agencies

Web link: https://www.elearnmarkets.com/blog/brief-understanding-on-credit-rating-agencies/

Some of the key functions of credit rating agencies are discussed below:

 Low-cost information: The credit rating agency collects, analyses, interprets and makes
a proper conclusion of any complex data and transforms it into a very lucid and easily
understandable manner.

 Provides a basis for suitable risk and return: The instruments rated by rating agency
gets greater confidence amongst investor community. It also gives an idea regarding the
risk associated with the instrument.

 Helps in the formulation of Public policy: If debt instruments are professionally rated,
it becomes very easy to judge the eligibility of various securities for inclusion in the
institutional portfolio with greater confidence.

A.L.I.E.T 2 FINANCIAL MARKETS AND SERVICES

  Provides superior information: Credit rating agency being an independent rating
agency, due to highly trained and professional staffs and with the access to information
which is not publicly available information, these agencies are able to deliver superior
information.

 Enhances corporate image: Better credit rating for any credit investment enhances
visibility and corporate image in the industry.

BENEFITS OF CREDIT RATING (Financial Markets and Financial Services by Vasant Desai,
Page no: 536-536)

The benefits to various parties concerned with credit rating are listed below.

Investors:
 It enables the investors to get superior information at low cost
 It enables the investors to take calculated risk in their investment decisions
 It encourages the common man to invest his savings in corporate securities and get high
returns.

Corporate Borrowers:

 It facilitates companies with good rating to enter the capital market confidently and raise
funds at comparatively cheaper rates
 It can be used as a marketing tool
 It facilitates foreign collaborations
 It encourages discipline among the corporate borrowers.

Credit Rating companies:

 The existence and development of credit rating companies largely depends upon their
performance. Honest and impartial credit rating agencies would definitely thrive, as they
sustain their credibility.

Government:

 Fair and good ratings motivate the public to invest their savings in good shares, deposits
and debentures. Thus, the idle savings of the public are channelized for productive uses.
 It facilitates the formulation of public policy guidelines on institutional investments.
 Credit rating system plays a vital role in investor protection without casting burden for
that responsibility on the government.

A.L.I.E.T 3 FINANCIAL MARKETS AND SERVICES

RATING METHODOLOGY (Financial Markets and Financial Services by Vasant Desai, Page no:
536-537)

The rating exercise commences at the request of a company. A rating applies to a particular debt
obligation of the company and is not a general purpose of the company. The focus of the
evaluation is on the ability and the willingness of the company to meet the financial obligations
on the debt instrument in a timely manner.

In evaluation and monitoring ratings, both qualitative and quantitative criteria are employed. The
methodology involves an analysis of the past performance of the company and an assessment of
its future prospects, which involves judgment of the company’s competitive position and
evaluation of its management and strategies. In order to eliminate subjectivity, a multi-layered
decision making process is applied in assigning a rating, which ensures that no single individual
decides on a rating.

The rating process

Review of the public information on the client

Questionnaire

Meeting with client

Preparation of draft report

Draft report sent to subject client for review as to factual accuracy

Amended report (Following client comments) sent to rating committee members

Rating committee meeting/discussion and assignment of rating

Client advised of rating

Rating made public

A.L.I.E.T 4 FINANCIAL MARKETS AND SERVICES

GROWTH OF CREDIT RATING AGENCIES (Financial Services and System by Dr. S
Gurusamy, Page no: 87-87)

Year Credit Rating Agency

1841 Mercantile Credit Agency
1900 Moody’s Investor Service
1916 Poor Publishing Company
1922 Standard Statistics Company
1924 Fitch Publishing Company
1933 Dun& Bradstreet
1941 Standard & Poor
1966 McGraw Hill
1972 Canadian Bond Rating Service
1974 Thomson Bank watch
1975 Japanese Bond Rating Institute
1975 McCarthy Crisanti & Maffei
1977 Dominican Bond Rating Service
1978 IBCA Limited
1980 Duff& Phelps Credit Rating Company
1987 CRISIL
1991 ICRA
1994 CARE
1996 Duff and Phelps Credit Rating India (P) Limited

RATING FRAMEWOEK (Merchant Banking and Financial Services by Dr.K.Ravichandran, Page

no: 276-280)

The basic objective of rating is to provide an opinion on the relative credit is (or default risk)
associated with the instrument being rated. This, rating nutshell, includes estimating the cash
generation capacity of the user through operations (primary cash flow) vis-à-vis its requirements
or servicing obligations over the tenure of the instrument. Additionally, assessment is also made
of the available marketable securities secondary cash flows which can be liquidated, if required,
to supplement the primary cash flows.

 Operational efficiency: In a competitive market, it is critical for any business unit to

control the costs at all levels. This assumes greater importance in commodity or ‘me too’
business, where low cost producers almost always have an edge. Cost of production to a
large extent is influenced by:
- Location of the production
- Access to raw materials
- Scale of operations
- Quality of technology
- Level of integration
A.L.I.E.T 5 FINANCIAL MARKETS AND SERVICES
 - Experience
- Ability of the unit use its resources
 Management quality:
- Management plans
- Management objectives
- Strategies
- Competitive position and views about the last performance and future outlook of the
business.
- Organization structure
- Information system
- Labor relations
- Track record of meeting promises

 Funding policies: This determines the level of risk. Management’s views on funding
policies are.
- Future funding requirements
- Level of leveraging
- Views on retaining shareholding control
- Target returns for shareholders
- Views on interest rates
- Currency exposures including policies to control the currency risk
- Asset-liability tenure matching
 Financial flexibility: Ability of the issuer to draw on other sources, both internal and
external cash flow during period of stress.
- Availability of liquid investments
- Unutilized lines of credit
- Financial strength of group companies
- Market reputation
- Relationship with financial institutions and banks
- Investor’s perceptions and experience of tapping funds from different sources
 Past financial performance:
 Accounting quality: Consistent and fair accounting policies
 Indicators of financial performance: Financial Indicators over the last few years
(typically five years) are analyzed.
- Return on capital employed
- Return on net worth
- Gross operating margins
- Profitability
- Coverage ratios
- Level of leveraging
- Liquidity position (Inventory, Receivables, Payables)
 Cash flow analysis: Cash flows reflect the sources from which cash is generated and its
deployment.
A.L.I.E.T 6 FINANCIAL MARKETS AND SERVICES
  Future cash flow adequacy: The ultimate objective of the rating is to determine the
adequacy of cash generation to service obligations.

CREDIT RATING INFORMATION SERVICES OF INDIA LIMITED (CRISIL)

(Merchant Banking and Financial Services by Dr.K.Ravichandram, Page no: 280-282)

The first rating agency ‘Credit Rating Information Services of India Limited, CRISIL, was
promoted jointly in 1987 jointly by the ICICI and the UTI. Other shareholders included ADB,
LIC, HDFC Ltd, General Insurance Corporation of India and several other foreign and Indian
Banks. It pioneered the concept of credit rating in the country and since then has introduced new
concepts in credit rating services and has diversified into related areas of information and
advisory activities. It became public in 1993. In 1996, it formed a strategic alliance with S&P
rating group.

Objectives

 To provide a marketing tool to entitles placing debt with clients

 To provide regulators with a market driven system for bringing about the development of
the capital markets.
 To institutionalize a viable and market-driven system of credit rating in India
 To facilitate individuals in investing in financial instruments rather than in non-
productive assets.

Strategy

The strategy that emerged was three-fold

 Creating awareness of the concept amongst all market participants
 Winning credibility, confidence and trust of participants
 Generating ratings business that would increase in size as a system of market driver
interest rates into play.

Services offered by CRISIL

1. Credit Rating Services (CRS): The principle function of CRISIL is to rate mandated debt
obligations of Indian Companies chit fund, real estate developers, LPG Kerosene dealers,
NBFC, Indian states and so on.
 Rating of debt obligations: Debt obligation includes rupee denominated credit
instruments like debentures, preference shares, deposits, CD’s commercial papers and a
structured obligations of manufacturing, finance companies, banks, financial institutions
etc. It ensures stable and healthy growth of capital market by offering credit rating which
is widely acceptable. It provides increased disclosures, better accounting standards and
improved financial information to the users. It reduces cost of issue by direct

A.L.I.E.T 7 FINANCIAL MARKETS AND SERVICES

 mobilization of resources. It protects the interest of investors by constantly monitoring
the results of rated companies.
 Rating of structured obligations: It reflects CRISIL opinion regarding the capacity and
willingness of the company to make timely payments of financial obligations on rated
instruments.
 Rating of real-estate developers: CRISIL has developed framework for rating of real
estate projects. Such rating helps investors to identify their investment options. The rating
is expected to help developers mobilize funds for their projects. The methodology
assesses a project in terms of project risk factors and developer’s risk factors.
 Bond Fund ratings: The rating is an opinion of the quality of bond funds underlying
portfolio holdings. They mainly focus on fixed income securities. The rating
methodology takes into account the following factors i.e., credit associated with the
securities, the systems and procedures followed by the funds and management quality
and expertise.
 Bank loan rating: The creditworthiness of bank’s borrower is assessed offering
comments on the likelihood of repayment of loans. The methodology considers the
borrowers underlying assets liquidity and risk management initiative and for NBFC
quality of assets, loans and investment.
 Collective investment schemes: This covers rating of collective investment schemes
offering opinion on the degree of certainty of the scheme to deliver the assured returns in
terms of cash as mentioned in the offer document
 Grading of health care institutions: The grading for healthcare institutions is an
opinion on the relative quality of health care delivered by the institutions to the patients.
Grading is done taking into account facilities, quality, consistency in delivering the
service etc. Flowing are the grades given Grade A (Very good quality), Grade B (Good
Quality) , Grade C (Average Quality) and Grade D( Poor Quality).

2. CRICIL Advisory Services (CAS): The CAS offers consulting services that aim at
identifying and mitigating risk. The main focus of these services is transaction and policy
level assignments in the area of energy, transport, banking and finance disinvestment,
privatization and valuation.
 Energy group services: It offers advisory services to companies engaged in energy
sector like power, coal, oil and gas. The policy level assignments Include aspects like
sector reforms and structuring, regulatory framework privatization, corporate plan fuel
related services. Transaction level assignment include project scoping and structuring, bid
process management, financial viability analysis of projects, risk identification and
analysis and structuring of project contacts, security package, structuring and analysis.
 Transport and urban infrastructure group services: It provides financial advisory
services to transport and infrastructure service provider. Policy level assignments include
advice on transport sector privatization policy of state ports, development of risk
identification allocation, long term sector plans and state role. Transaction level
assignments include financial viability analysis, project structuring, bid process
management, negotiation of terms with successful bidders.
A.L.I.E.T 8 FINANCIAL MARKETS AND SERVICES
  Privatization and disinvestment group services: this group renders advisory services to
central state governments, public sector enterprises and private sector entities interested
in participating in privatization program, these services cover 3 aspects policy level,
enterprise level and reforms and restructuring.
3. Banking and finance group: CRISIL offers a wide range of services covering restructuring
and business reengineering, credit management, investment management and portfolio
insurance, equity valuation, resource mobilization studies and financial feasibility studies
Capital Market Group: This group provides customized research and advisory assistance to
meet specific transactional and strategic requirements of clients. It offers services like
diagnostic evaluation for valuation of Indian partner of a foreign asset management
company, technical assistance to AMFI, portfolio evaluation and portfolio analysis for
leading mutual funds, composite performance ranking of domestic mutual funds, and
assistance to government for the development of India’s financial sector.
4. Credibility first rating and evaluation Services:
5. Training Services:

Rating System for CRISIL

Credit Ratings - Long Term Scale

Rating Description

Instruments with this rating are considered to have the highest degree of
CRISIL AAA safety regarding timely servicing of financial obligations. Such
(Highest Safety) instruments carry lowest credit risk.

Instruments with this rating are considered to have high degree of safety
CRISIL AA regarding timely servicing of financial obligations. Such instruments carry
(High Safety) very low credit risk.

Instruments with this rating are considered to have adequate degree of

CRISIL A
safety regarding timely servicing of financial obligations. Such
(Adequate
instruments carry low credit risk.
Safety)

Instruments with this rating are considered to have moderate degree of

CRISIL BBB safety regarding timely servicing of financial obligations. Such

A.L.I.E.T 9 FINANCIAL MARKETS AND SERVICES

 (Moderate
instruments carry moderate credit risk.
Safety)

Instruments with this rating are considered to have moderate risk of default
CRISIL BB
regarding timely servicing of financial obligations.
(Moderate Risk)

CRISIL B Instruments with this rating are considered to have high risk of default
(High Risk) regarding timely servicing of financial obligations.

CRISIL C
Instruments with this rating are considered to have very high risk of
(Very High
default regarding timely servicing of financial obligations.
Risk)

CRISIL D Instruments with this rating are in default or are expected to be in default
Default soon.

Credit Ratings - Short Term Scale

Rating Description

Instruments with this rating are considered to have very strong degree of safety
CRISIL A1 regarding timely payment of financial obligations. Such instruments carry
lowest credit risk.

Instruments with this rating are considered to have strong degree of safety
CRISIL A2 regarding timely payment of financial obligations. Such instruments carry low
credit risk.

CRISIL A3 Instruments with this rating are considered to have moderate degree of safety

A.L.I.E.T 10 FINANCIAL MARKETS AND SERVICES

 regarding timely payment of financial obligations. Such instruments carry
higher credit risk as compared to instruments rated in the two higher categories.

Instruments with this rating are considered to have minimal degree of safety
CRISIL
regarding timely payment of financial obligations. Such instruments carry very
A4
high credit risk and are susceptible to default.

Instruments with this rating are in default or expected to be in default on

CRISIL D
maturity.

Credit Ratings - Long Term Structured Finance Scale

Rating Description

Instruments with this rating are considered to have the highest

CRISIL AAA (SO)
degree of safety regarding timely servicing of financial
(Highest Safety)
obligations. Such instruments carry lowest credit risk.

Instruments with this rating are considered to have high degree of

CRISIL AA (SO)
safety regarding timely servicing of financial obligations. Such
(High Safety)
instruments carry very low credit risk.

Instruments with this rating are considered to have adequate

CRISIL A (SO)
degree of safety regarding timely servicing of financial
(Adequate Safety)
obligations. Such instruments carry low credit risk.

Instruments with this rating are considered to have moderate

CRISIL BBB (SO)
degree of safety regarding timely servicing of financial
(Moderate Safety)
obligations. Such instruments carry moderate credit risk.

CRISIL BB (SO) Instruments with this rating are considered to have moderate risk
(Moderate Risk) of default regarding timely servicing of financial obligations.

A.L.I.E.T 11 FINANCIAL MARKETS AND SERVICES

 CRISIL B (SO) Instruments with this rating are considered to have high risk of
(High Risk) default regarding timely servicing of financial obligations.

Instruments with this rating are considered to have very high

CRISIL C (SO)
likelihood of default regarding timely payment of financial
(Very High Risk)
obligations.

CRISIL D (SO) Instruments with this rating are in default or are expected to be in
Default default soon.

Credit Ratings - Fixed Deposit Scale

Rating Description

This rating indicates that the degree of safety regarding timely payment
FAAA ("F Triple
of interest and principal is very strong.
A") Highest Safety

This rating indicates that the degree of safety regarding timely payment
FAA ("F Double of interest and principal is strong. However, the relative degree of safety
A") High Safety is not as high as for fixed deposits with 'FAAA' ratings.

This rating indicates that the degree of safety regarding timely payment
FA of interest and principal is satisfactory. Changes in circumstances can
Adequate Safety affect such issues more than those in the higher rated categories.

This rating indicates inadequate safety of timely payment of interest and

principal. Such issues are less susceptible to default than fixed deposits
FB Inadequate rated below this category, but the uncertainties that the issuer faces
Safety could lead to inadequate capacity to make timely interest and principal
payments.

A.L.I.E.T 12 FINANCIAL MARKETS AND SERVICES

 This rating indicates that the degree of safety regarding timely payment
of interest and principal is doubtful. Such issues have factors present
FC High Risk that make them vulnerable to default; adverse business or economic
conditions would lead to lack of ability or willingness to pay interest or
principal.

This rating indicates that the fixed deposits are either in default or are
FD Default
expected to be in default upon maturity.

Instruments rated 'NM' have factors present in them, which render the
NM Not outstanding rating meaningless. These include reorganisation or
Meaningful liquidation of the issuer, and the obligation being under dispute in a
court of law or before a statutory authority.

Credit Ratings - Corporate Credit Scale

Rating Description

CCR A 'CCR AAA' rating indicates Highest degree of strength with regard to
AAA ("CCR honoring debt obligations.
Triple A")

A 'CCR AA' rating indicates High degree of strength with regard to

CCR AA("CCR
honoring debt obligations.
Double A")

A 'CCR A' rating indicates Adequate degree of strength with regard to

CCR A honoring debt obligations.

A 'CCR BBB' rating indicates Moderate degree of strength with regard to

CCR BBB honoring debt obligations

A 'CCR BB' rating indicates Inadequate degree of strength with regard to

A.L.I.E.T 13 FINANCIAL MARKETS AND SERVICES

 CCR BB honoring debt obligations.

A 'CCR B' rating indicates High Risk and greater susceptibility with
CCR B
regard to honoring debt obligations.

A 'CCR C' rating indicates Substantial Risk with regard to honoring debt
CCR C
obligations.

A 'CCR D' rating indicates that the entity is in Default of some or all of its
CCR D
debt obligations.

A 'CCR SD' rating indicates that the entity has Selectively Defaulted on a
CCR SD specific issue or class of debt obligations, but will continue to meet its
payment obligations on other issues or classes of debt obligations.

INFORMATION AND CREDIT RATING AGENCY OF INDIA (ICRA) Merchant Banking

and Financial Services by Dr. K. Ravi chandram, Page no: 282-285)

Information and Credit Rating Services (ICRA) has been promoted by IFCI Ltd as the main
promoter and started operations in 1991. Other shareholders are UTI, Banks, LIC, GIC, EXIM
Bank, HDFC and ILFS. It provides Rating, Information and Advisory services ranging from
strategic consulting to risk management and regulatory practice.

Objectives of ICRA

 To assist investors both individual and institutional in making well informed decisions.
 To assist issuers in raising funds from a wider investor base.
 To enable banks, investment bankers, Brokers in placing debt with investors.
 To provide regulators with market driven systems to encourage the healthy growth of
capital markets.
 It provides rating services, information services and advisory services.

Services offered by ICRA

1. Rating services: ICRA rates debt instruments issued by manufacturing companies,

commercial banks, NBFCs, financial institutions, PSUs and municipalities. The
instruments rated by it include bonds/ debentures, fixed deposits commercial papers and
certificate of deposit. It also rates structured obligations in accordance with the terms of

A.L.I.E.T 14 FINANCIAL MARKETS AND SERVICES

 the structure based on risk assessment of the instrument. It rates sector specific debt
obligations issued by power, telecom and infrastructure companies. It also provides
corporate governance rating, rating of claims paying ability of insurance companies,
credit assessment of large medium and small scale companies to obtain assistance from
banks, FIs. It also provides services of general assessment of companies.
2. Information services: The information services division of ICRA focuses on providing
authentic data and value added products used by intermediaries, financial institutions,
banks, asset managers, institutions and investors. Value added services include equity
grading providing a critical input on a company's earnings prospects and inherent risks in
decision making process of equity investors and equity assessment. Other services
include corporate reports, equity assessment, mandate based studies (customized
research) and sector/industry specific publication.
3. Advisory services: The advisory services division of ICRA offers wide ranging
management advisory services. Under advisory services ICRA provides its understanding
on the business processes and relevant organizational issues to different players of
financial markets such as investors, issuers, regulators, intermediaries and media. The
advisory services include strategic consulting/ strategic practice, risk management (credit
risk, market risk and operations risk), regulatory practice, transaction practice,
information (content services). It focuses on sectors like banking and financial services,
infrastructure sector, manufacturing and service sector, government and regulatory
authorities.

Rating system for ICRA

ICRA’s Long-Term Rating Scale: Long-Term rating Scale All Bonds, NCDs, and other debt
instruments (excluding Public Deposits) with original maturity exceeding one year.

[ICRA]AAA Instruments with this rating are considered to have the highest degree of safety
regarding timely servicing of financial obligations. Such instruments carry lowest credit risk.

[ICRA]AA Instruments with this rating are considered to have high degree of safety regarding
timely servicing of financial obligations. Such instruments carry very low credit risk.

[ICRA]A Instruments with this rating are considered to have adequate degree of safety regarding
timely servicing of financial obligations. Such instruments carry low credit risk.

[ICRA]BBB Instruments with this rating are considered to have moderate degree of safety
regarding timely servicing of financial obligations. Such instruments carry moderate credit risk.

[ICRA]BB Instruments with this rating are considered to have moderate risk of default regarding
timely servicing of financial obligations.

[ICRA]B Instruments with this rating are considered to have high risk of default regarding

A.L.I.E.T 15 FINANCIAL MARKETS AND SERVICES

timely servicing of financial obligations.

[ICRA]C Instruments with this rating are considered to have very high risk of default regarding
timely servicing of financial obligations.

[ICRA]D Instruments with this rating are in default or are expected to be in default soon.

Note: For the rating categories [ICRA]AA through to [ICRA]C, the modifiers + (plus) or –
(minus) may be appended to the rating symbols to indicate their relative position within the
rating categories concerned. Thus, the rating of [ICRA]AA+ is one notch higher than
[ICRA]AA, while [ICRA]AA- is one notch lower than [ICRA]AA.

ICRA’s Medium-Term Rating Scale (only for Public Deposits): Medium-Term Rating
Scale All Public Deposit Programmes.

MAAA The highest-credit-quality rating assigned by ICRA. The rated deposits programme
carries the lowest credit risk.

MAA The high-credit-quality rating assigned by ICRA. The rated deposits programme carries
low credit risk.

MA The adequate-credit-quality rating assigned by ICRA. The rated deposits programme carries
average credit risk.

MB The inadequate-credit-quality rating assigned by ICRA. The rated deposits programme

carries high credit risk.

MC The risk-prone-credit-quality rating assigned by ICRA. The rated deposits programme

carries very high credit risk.

MD The lowest-credit-quality rating assigned by ICRA. The rated instrument has very low
prospects of recovery.

Note: For the rating categories MAA through to MC (pertaining to the Medium Term Rating
Scale), the modifiers + (plus) or – (minus) may be appended to the rating symbols to indicate
their relative position within the rating categories concerned. Thus, the rating of MAA+ is one
notch higher than MAA, while MAA- is one notch lower than MAA.

A.L.I.E.T 16 FINANCIAL MARKETS AND SERVICES

ICRA’s Short-Term Rating Scale

Short-Term Rating Scale All instruments with original maturity within one year.

[ICRA]A1 Instruments with this rating are considered to have very strong degree of safety
regarding timely payment of financial obligations. Such instruments carry lowest credit risk.

[ICRA]A2 Instruments with this rating are considered to have strong degree of safety regarding
timely payment of financial obligations. Such instruments carry low credit risk.

[ICRA]A3 Instruments with this rating are considered to have moderate degree of safety
regarding timely payment of financial obligations. Such instruments carry higher credit risk as
compared to instruments rated in the two higher categories.

[ICRA]A4 Instruments with this rating are considered to have minimal degree of safety
regarding timely payment of financial obligations. Such instruments carry very high credit risk
and are susceptible to default.

[ICRA]D Instruments with this rating are in default or expected to be in default on maturity.

Note: For the short-term ratings [ICRA]A1 through to [ICRA]A4, the modifier + (plus) may be
appended to the rating symbols to indicate their relative position within the rating levels
concerned. Thus, the rating of [ICRA]A1+ is one notch higher than [ICRA]A1 and so on.

CREDIT ANALYSIS AND RESEARCH LIMITED (Merchant Banking and Financial Services
by Dr.K.Ravichandram, Page no: 285-287)

Credit Analysis and Research Ltd or CARE is promoted by IDBI jointly with Financial
Institutions, Public/Private Sector Banks and Private Finance Companies. It commenced its
credit rating operations in October, 1993 and offers a wide range of products and Services in the
field of Credit Information and Equity Research. It also provides advisory services in the areas of
securitization of transactions and structuring Financial Instruments.

Services offered by CARE

1. Credit rating of debt instruments

2. Advisory services like securitization transactions, structuring financial instruments,
financing infrastructure projects and municipal finances
3. Information services like providing information to companies, industry and businesses.
4. Equity research

A.L.I.E.T 17 FINANCIAL MARKETS AND SERVICES

MUTUAL FUNDS

The Concept of Mutual Funds (Financial Institutions and Markets by L M Bhole, Page No: 12.2- 12.2)

Mutual funds are financial intermediaries in the investment business. They collect funds from
public and invest on behalf of the investors as ‘pass through entities’ with losses and gains
accruing to the investing only. Mutual funds sell their share to the investors; invest the proceeds
in a wide choice of securities in the financial market. Owners of shares receive pro rate shares of
the earnings from these assets, minus management and other fees assessed by the fund.

Definition

 A mutual fund as ‘ a fund established in the form of a trust by a sponsor, to raise monies
by the trustees through the sale of units to the public, under one or more schemes, for
investing in securities in accordance with these regulations’. ----Securities Exchange
Board of India (Mutual Funds) Regulations, 1993.
 A mutual fund is a pure intermediary which performs a basic function of buying and
selling of securities on behalf of its unit-holders, which the latter also can perform but not
as easily, conveniently, economically, and profitability.
 Mutually fund units are investment vehicles that provide a means of participation in the
stock market for people who have neither the time, nor the money, nor perhaps the
expertise to undertake direct investment in equities successfully.
 In simple a large number of investors pool their money in order to obtain a spread of
professionally managed stock exchange investments that they cannot obtain individually.

FUNCTIONS OF MUTUAL FUNDS (Financial Institutions and Markets by L M Bhole, Page No:
12.2- 12.2)

 Management: When you invest in a mutual fund, you benefit from professional money
managers and their research team. Spectacular returns aren't guaranteed just because
professionals run the fund, but you do know your funds lie in the hands of an experienced
crew who understand the financial markets. This means you don't have to spend a lot of
time researching stocks yourself, as you would if you were investing in individual stocks.
Instead, mutual fund managers track the financial markets and the day-to-day fluctuation
of different industries for you and then act accordingly.
 Diversification: When you buy into a mutual fund you have the opportunity to buy
multiple stocks, bonds or other assets, depending on the type of fund it is. This diversified
approach minimizes the effect of price fluctuations in a single asset. The more assets you
own, the less overall effect each individual asset has on your portfolio. Invest in a single
mutual fund and you are already more diversified than if you purchased a single stock.
Buying multiple funds, including bond, stock and money-market funds, provides a
diversification level nearly impossible to achieve by purchasing stocks and bonds one at a
time.
 Cost-Effectiveness: When you buy a fund, you will have to pay a commission as well as
a yearly management fee. Ranging from 1 percent of your total investment to several

A.L.I.E.T 18 FINANCIAL MARKETS AND SERVICES

 percentage points, this fee compensates the fund controllers for managing your money.
Don't let these fees deter you from investing. Remember that mutual funds hold multiple
assets. Purchasing all those assets individually to attain a similar diversification level on
your own could result in an even more expensive commission bill and higher brokerage
fees.
 Precision: Mutual funds let you tailor your portfolio to meet investment objectives by
purchasing different fund types. Mutual funds range from conservative and low-risk to
exotic and high-risk. Bonds and money-market funds are typically low-risk, providing
stable but relatively small returns. Funds invested in domestic and foreign stock are
riskier than bond funds, but over the long haul usually provide a higher return.

ORGANIZATION AND MANAGEMENT OF MUTUAL FUNDS (Financial Institutions and

Markets by L M Bhole, Page No: 12.4-12.4)

Mutual funds have a typical organization in which five key parties or players or special bodies or
constituents are involved. They are;

 The sponsors
 The Board Trustees (BOT) or Trust Company
 The Asset Management Company (AMC)
 The Custodian
 The Unit holders

There are usually formed by an investment adviser or manager or sponsors who select and
appoint a BOT, which, in turn, hires or contracts a separate AMC which is run by professional
managers. The AMC conducts the necessary research, and based on it, manages the fund or
portfolio. It is responsible for floating, managing, redeeming the schemes; it also handles the
administrative chores. It receives the fees for the services rendered by it. The custodian is
responsible for co-ordination with brokers, the actual transfer and storage of stocks, and handling
the property of the rust. He is answerable to the AMC.

As per the current regulations in force in India, every MF proposed by a sponsor has to be set up
as a trust under the India Trust Act, 1882 (and not as a company under the Companies Act,
1956). The UTI, however, was set up under a special UTI Act, 1963. All MFs have to be
registered with the SEBI. It is required that the first four constituents of the MF should maintain
an arm’s length relationship among themselves in order to reduce conflict of interest, and to
safeguard the interests of the investors.

Mutual funds can sell their units directly to the investors or they may employ the sales force of
brokers and agents for that purpose. Some MFs in US charge their investors a sales fee for the
costs involved in selling the fund, and they are known as ‘ load funds’ . Those who do not charge
such a fee are known as ‘no-load funds’. All funds charge their shareholders a management fee
which is paid out of the fund’s income.

A.L.I.E.T 19 FINANCIAL MARKETS AND SERVICES

ADVANTAGES OF INVESTING MUTUAL FUNDS (Financial Markets and Financial Services
by Vasant Desai, Page no: 448-448) (Financial Institutions and Markets by L M Bhole, Page No: 12.4-
12.4)

 Professional management:
 Diversification of portfolio: Mutual funds invest in a number of companies across a
broad cross-section of industries and sectors.
 Convenient administration: Investing in a mutual fund reduces paperwork and helps
you avoid many problems such as bad deliveries, delayed payments and unnecessary
follow-up with brokers and companies.
 High Return potential: Over a medium to long-term, mutual funds have the potential to
provide higher returns as they invest in a diversified basket of selected securities.
 Low brokerage and transaction costs: Mutual funds are relatively less expensive way
to invest compared to directly investing in the capital markets because benefits of scale in
brokerage, custodial and other fees translate into lower costs for investors.
 Liquidity: In open-ended schemes, you can get your money back promptly at net asset
value related prices from the mutual fund itself.
 Transparency: You get regular information on the value of your investment in addition
to disclosure on the specific investments made by your scheme, the proportion invested in
each class of assets and the fund manager’s investment strategy and outlook.
 Flexibility: Through features such as regular investment plans, regular withdrawal plans
and dividend reinvestment plans, you can systematically invest or withdraw funds
according to your needs and convenience.
 Wide Choice of schemes: Mutual funds offer a family of schemes t suits your varying
needs over a lifetime.
 Well regulated: All mutual funds are registered with SEBI and they function within the
provisions of strict regulations designed to protect the interest of investors.
 Tax benefits:

TYPES OF SCHEMES / TYPES OF FUNDS/ CLASSIFICATION OF FUNDS (Financial

Markets and Financial Services by Vasant Desai, Page no: 445-447)

1. Based on Asset Class

 Equity Funds: Primarily investing in stocks, they also go by the name stock funds. They
invest the money amassed from investors from diverse backgrounds into shares of
different companies. The returns or losses are determined by how these shares perform
(price-hikes or price-drops) in the stock market. As equity funds come with a quick
growth, the risk of losing money is comparatively higher.
 Debt Funds: Debt funds invest in fixed-income securities like bonds, securities and
treasury bills – Fixed Maturity Plans (FMPs), Gilt Fund, Liquid Funds, Short Term Plans,
Long Term Bonds and Monthly Income Plans among others – with fixed interest rate and
maturity date. Go for it, only if you are a passive investor looking for a small but regular
income (interest and capital appreciation) with minimal risks.

A.L.I.E.T 20 FINANCIAL MARKETS AND SERVICES

  Money Market Funds: Just as some investors trade stocks in the stock market, some
trade money in the money market, also known as capital market or cash market. It is
usually run by the government, banks or corporations by issuing money market securities
like bonds, T-bills, dated securities and certificate of deposits among others. The fund
manager invests your money and disburses regular dividends to you in return. If you opt
for a short-term plan (13 months max), the risk is relatively less.
 Hybrid Funds: As the name implies, Hybrid Funds (also go by the name Balanced
Funds) is an optimum mix of bonds and stocks, thereby bridging the gap between equity
funds and debt funds. The ratio can be variable or fixed. In short, it takes the best of two
mutual funds by distributing, say, 60% of assets in stocks and the rest in bonds or vice
versa. This is suitable for investors willing to take more risks for ‘debt plus returns’
benefit rather than sticking to lower but steady income schemes.

2. Mutual Fund Types Based on Structure: Mutual funds can be categorized based on
different attributes (like risk profile, asset class etc.). Structural classification – open-
ended funds, close-ended funds, and interval funds – is broad in nature and the difference
depends on how flexible is the purchase and sales of individual mutual fund units.
 Open-Ended Funds: These funds don’t have any constraints in a time period or number
of units – an investor can trade funds at their convenience and exit when they like at the
current NAV (Net Asset Value). This is why its unit capital changes constantly with new
entries and exits. An open-ended fund may also decide to stop taking in new investors if
they do not want to (or cannot manage large funds).
 Closed-Ended Funds: Here, the unit capital to invest is fixed beforehand, and hence
they cannot sell a more than a pre-agreed number of units. Some funds also come with
an NFO period, wherein there is a deadline to buy units. It has specific maturity tenure
and fund managers are open to any fund size, however large. SEBI mandates investors to
be given either repurchase option or listing on stock exchanges to exit the scheme.
 Interval Funds: This has traits of both open-ended and closed-ended funds. Interval
funds can be purchased or exited only at specific intervals (decided by the fund house)
and are closed the rest of the time. No transactions will be permitted for at least 2 years.
This is suitable for those who want to save a lump sum for an immediate goal (3-12
months).
3. Mutual Fund Types Based on Investment Goals
 Growth Funds: Growth funds usually put a huge portion in shares and growth sectors,
suitable for investors (mostly Millennial) who have a surplus of idle money to be
distributed in riskier plans (albeit with possibly high returns) or are positive about the
scheme.
 Income Funds: This belongs to the family of debt mutual funds that distribute their
money in a mix of bonds, certificate of deposits and securities among others. Helmed by
skilled fund managers who keep the portfolio in tandem with the rate fluctuations without
compromising on the portfolio’s creditworthiness, Income Funds have historically earned
investors better returns than deposits and are best suited for risk-averse individuals from a
2-3 years perspective.
A.L.I.E.T 21 FINANCIAL MARKETS AND SERVICES
  Liquid Funds: Like Income Funds, this too belongs to the debt fund category as they
invest in debt instruments and money market with tenure of up to 91 days. The maximum
sum allowed to invest is Rs 10 lakhs. One feature that differentiates Liquid Funds from
other debt funds is how the Net Asset Value is calculated – NAV of liquid funds are
calculated for 365 days (including Sundays) while for others, only business days are
calculated.
 Tax-Saving Funds: ELSS or Equity Linked Saving Scheme is gaining popularity as it
serves investors the double benefit of building wealth as well as save on taxes – all in the
lowest lock-in period of only 3 years. Investing predominantly in equity (and related
products), it has been known to earn you non-taxed returns from 14-16%. This is best-
suited for long-term and salaried investors.
 Aggressive Growth Funds: Slightly on the riskier side when choosing where to invest
in, Aggressive Growth Fund is designed to make steep monetary gains. Though
susceptible to market volatility, you may choose one as per the beta (the tool to gauge the
fund’s movement in comparison with the market). Example, if the market shows a beta of
1, an aggressive growth fund will reflect a higher beta, say, 1.10 or above.
 Capital Protection Funds: If protecting your principal is your priority, Capital
Protection Funds can serve the purpose while earning relatively smaller returns (12% at
best). The fund manager invests a portion of your money in bonds or CDs and the rest in
equities. You will not incur any loss. However, you need least 3 years (closed-ended) to
safeguard your money and the returns are taxable.
 Fixed Maturity Funds: Investors choose as the FY ends to take advantage of triple
indexation, thereby bringing down tax burden. If uncomfortable with the debt market
trends and related risks, Fixed Maturity Plans (FMP) – investing in bonds, securities,
money market etc. – presents a great opportunity. As a close-ended plan, FMP functions
on a fixed maturity period, which could range from 1 month to 5 years (like FDs). The
Fund Manager makes sure to put the money in an investment with the same tenure, to
reap accrual interest at the time of FMP maturity.
 Pension Funds: Putting away a portion of your income in a chosen Pension Fund to
accrue over a long period to secure you and your family’s financial future after retiring
from regular employment-it can take care of most contingencies (like a medical
emergency or children’s wedding). Relying solely on savings to get through your golden
years is not recommended as savings (no matter how big) get used up. EPF is an
example, but there are many lucrative schemes offered by banks, insurance firms etc.

4. Mutual Fund Types Based on Risks

 Very Low-Risk Funds: Liquid Funds and Ultra Short-term Funds (1 month to 1 year)
are not risky at all, and understandably their returns are low (6% at best). Investors
choose this to fulfill their short-term financial goals and to keep their money safe until
then.
 Low-Risk Funds: In the event of rupee depreciation or unexpected national crisis,
investors are unsure about investing in riskier funds. In such cases, fund managers
recommend putting money in either one or a combination of liquid, ultra short-term or
A.L.I.E.T 22 FINANCIAL MARKETS AND SERVICES
 arbitrage funds. Returns could be 6-8%, but the investors are free to switch when
valuations become more stable.
 Medium-risk Funds: Here, the risk factor is of medium level as the fund manager
invests a portion in debt and the rest in equity funds. The NAV is not that volatile, and
the average returns could be 9-12%.
 High-risk Funds: Suitable for investors with no risk aversion and aiming for huge
returns in the form of interest and dividends, High-risk Mutual Funds need active fund
management. Regular performance reviews are mandatory as they are susceptible market
volatility. You can expect 15% returns, though most high-risk funds generally provide
20% returns (and up to 30% at best).

5. Specialized Mutual Fund Types

 Sector Funds: Investing solely in one specific sector, theme-based mutual funds. As
these funds invest only in specific sectors with only a few stocks, the risk factor is on the
higher side. One must be constantly aware of the various sector-related trends, and in
case of any decline, just exit immediately. However, sector funds also deliver great
returns. Some areas of banking, IT and pharma have witnessed huge and consistent
growth in recent past and are predicted to be promising in future as well.
 Index Funds: Suited best for passive investors, index funds put money in an index. It is
not managed by a fund manager. An index fund simply identifies stocks and their
corresponding ratio in the market index and put the money in similar proportion in
similar stocks. Even if they cannot outdo the market (which is the reason why they are
not popular in India), they play it safe by mimicking the index performance.
 Funds of Funds: A diversified mutual fund investment portfolio offers a slew of
benefits, and ‘Funds of Funds’ aka multi-manager mutual funds are made to exploit this
to the tilt – by putting their money in diverse fund categories. In short, buying one fund
that invests in many funds rather than investing in several achieves diversification as well
as saves on costs.
 Emerging market Funds: To invest in developing markets is considered a steep bet and
it has undergone negative returns too. India itself a dynamic and emerging market and
investors to earn high returns from the domestic stock market, they are prone to fall prey
to market volatilities. However, in a longer-term perspective, it is evident that emerging
economies will contribute to the majority of global growth in the coming decade as their
economic growth rate is way superior to that of the US or the UK.
 International/ Foreign Funds: Favored by investors looking to spread their investment
to other countries, Foreign Mutual Funds can get investors good returns even when the
Indian Stock Markets do fare well. An investor can employ a hybrid approach (say, 60%
in domestic equities and the rest in overseas funds) or a feeder approach (getting local
funds to place them in foreign stocks) or a theme-based allocation (eg, Gold Mining).
 Global Funds: Aside from the same lexical meaning, Global Funds are quite different
from International Funds. While a global fund chiefly invests in markets worldwide, it
also includes investment in your home country. The International Funds concentrate
solely on foreign markets. Diverse and universal in approach, Global Funds can be quite
A.L.I.E.T 23 FINANCIAL MARKETS AND SERVICES
 risky to owing to different policies, market and currency variations, though it does work
as a break against inflation and long-term returns have been historically high.
 Real Estate Funds: In spite of the real estate boom in India, many are wary about
investing in such projects due to multiple risks. Real Estate Fund can be a perfect
alternative as the investor is only an indirect participant by putting their money in
established real estate companies/trusts rather than projects. A long-term investment, it
negates risks and legal hassles when it comes to purchasing a property as well as provide
liquidity to some extent.
 Commodity-focused Stock Funds: Ideal for investors with sufficient risk-appetite and
looking to diversify their portfolio, commodity-focused stock funds give a chance to
dabble in multiple and diverse trades. Returns are not periodic and are either based on the
performance of the stock company or the commodity itself. Gold is the only commodity
in which mutual funds can invest directly in India. The rest purchase fund units or shares
from commodity businesses.
 Market Neutral Funds: For investors seeking protection from unfavorable market
tendencies while sustaining good returns, Market-neutral Funds meet the purpose (like a
hedge fund). With better risk-adaptability, these funds give high returns and even small
investors can outstrip the market without stretching the portfolio limits.
 Inverse/leveraged Funds: While a regular index fund moves in tandem with the
benchmark index, the returns of an inverse index fund shift in the opposite direction.
Simply put, it is nothing but selling your shares when the stock goes down, only to buy
them back at an even lesser cost (to hold until the price goes up again).
 Asset Allocation Funds: Combining debt, equity and even gold in an optimum ratio, this
is a greatly flexible fund. Based on a pre-set formula or fund manager’s inferences on the
basis of the current market trends, Asset Allocation Funds can regulate the equity-debt
distribution. It is almost like Hybrid Funds but requires great expertise in choosing and
allocation of the bonds and stocks from the fund manager.
 Gift Funds: Yes, you can gift a mutual fund or a SIP to your loved ones to secure their
financial future.
 Exchange-traded Funds: It belongs to the Index Funds family and is bought and sold on
exchanges. Exchange-traded Funds have unlocked a world of investment prospects,
enabling investors to gain comprehensive exposure to stock markets abroad as well as
specialized sectors. An ETF is like a Mutual Fund that can be traded in real-time at a
price that may rise or fall many times in a day.

GUIDELINES FOR MUTUAL FUNDS

The regulator for markets in India, SEBI (Securities and Exchange Board of India), works for the
protection of investors’ interest in securities while regulating and promoting the securities’

A.L.I.E.T 24 FINANCIAL MARKETS AND SERVICES

market. The organisation has created guidelines for investors to gain awareness regarding the
manner in which mutual funds function by offering the required information. The regulator aims
to simplify the wide variety of schemes that tend to confuse investors due to their complexity.
The guidelines regarding the consolidation and merger of MF schemes are created in an effort to
make it easier for investors to compare different schemes made available by mutual fund
companies.

Guidelines Regarding Structure

The guidelines regarding the structure of schemes define a Guarantor as someone who introduces
a mutual fund. The guarantor’s role is to generate revenue through the launch of a mutual fund.
The fund is then handed to a fund manager.
A sponsor, according to the guidelines, is defined as someone who sets up schemes in keeping
with the regulations of the Indian Trust Act, 1882. Sponsors primarily have the role of listing the
schemes with the Securities and Exchange Board of India.
The Securities and Exchange Board of India is responsible for making policies related to mutual
funds. It also has the responsibility of regulating the industry and laying down the law so that
investors’ interest is safeguarded. So far as ‘asset allocation’ and ‘investment strategy’ are
concerned, mutual funds can be very different from one another. The new guidelines have
focused on uniformity so far as the functioning of schemes is concerned. Investors will,
therefore, find it easier to make investment decisions. To make things standard and to introduce
uniformity in schemes that are similar to one another, the following is the manner in which
mutual funds are categorised:
 Equity funds
 Debt funds
 Balanced or hybrid funds
 Solution-oriented funds
 Other funds

Major Highlights of SEBI Regulations for Investment in Mutual Funds

The following are the major highlights of the regulator’s guidelines regarding mutual funds:
 Mutual funds have been categorized into 5 groups – equity, debt, balanced, solution-
oriented, and others.
 Definitions of small, mid, and large cap have been made clearer to facilitate uniformity.
 Solution-oriented funds come with a lock-in period.
 Only one scheme is permitted in each category, apart from ETFs or index funds, thematic
or sectoral funds, and fund of funds.

SEBI Guidelines for Investors

Apart from laying down the law, the Securities and Exchange Board of India has also created
guidelines for investors.

A.L.I.E.T 25 FINANCIAL MARKETS AND SERVICES

  Assessing personal finances: Mutual funds are highly diverse investment options. As a
result, they carry some risk with them. Investors are urged to be clear when they assess
their financial standing. They are also asked to be careful when assessing their ability to
bear risk in case a scheme does not perform as expected. The risk appetite of investors
must be considered individually in keeping with each scheme.
 Research information regarding schemes: Before making investments in mutual funds,
it is essential for investors to attain detailed information regarding the scheme in which
they wish to invest. Equipping yourself with all the details regarding your investment
options will make it easy to make the right decision.
 Diversification of portfolios: Investors can spread their investments carefully by
diversifying their portfolios. As a result, the potential to mitigate risks or maximize
profits of potentially major losses increases. Diversification of portfolios is instrumental
in gaining sustainable long-term financial results.
 Refrain from cluttering portfolios: Select the right funds to create a portfolio needs
professional management of the schemes in addition to careful monitoring. Investors
should ensure that their portfolio is not cluttered while choosing the number of schemes
to add to their portfolio in order to ensure that the schemes can be well-managed
individually as well as collectively.
 Assign time frames: Investors are advised to ensure that a time frame is assigned to each
scheme in order to ensure that the plan grows. If there is stability in the maintenance of
the schemes, market fluctuations and volatility can be curbed significantly.

DEBT SECURITIZATION

Web link: https://theinvestorsbook.com/securitization.html

Concept of securitization

 Securitization is the process of converting a batch of debts into a marketable security

that is backed, or securitized, by the original debts.
 Securitization refers to pooling debts into homogeneous groups and selling the amount
realized from them in the form of securities to investors.

Concept of debt securitization

Debt securitization is a method of reusing funds. It is a process where loans are converted and
sold in the form of assets. In simple words, prime banking institution issues loans to several
intermediaries’ banks. These banks, also known as special purpose vehicles (SPV), further
converts this loan in the form of debt securities and sells it to various other buyers in the form of
marketable securities. However, these buyers should be qualified buyers (they are also known as
institutional buyers). Debt securitization helps in better balance sheet management.

A.L.I.E.T 26 FINANCIAL MARKETS AND SERVICES

In the above table state bank is performing the function of originator. Bank A, Bank B, Bank C is
performing the function of special purpose vehicle. This function is known as pooling function.
Institutional buyers are getting marketable securities. Thus, they are also known as qualified
institutional buyers.

Parties involved in debt securitization

There are always at least four parties involved in the debt securitization process.

 Borrower: The first is the borrower, who took out a loan and promised to repay it.
 Loan originator: The second is the loan originator, which is the bank that approved the
loan.
 Trust/ Special purpose entity (SPE) Special purpose vehicle( SPV)/ : The bank can
cash in immediately by selling this loan and others in its possession for face value or
close to it to a third party. That third party is usually operating as a trust. (In simple it
acts as a trust and is responsible for converting loans into marketable securities.
 Investor: The trust makes money by securitizing a number of the loans and repackaging
them as a newly-minted asset. The asset is then sold to investors, who make up the
fourth party in the chain.

Process and Functions of debt securitization

Securitization is a complex and lengthy process since it is the conversion of the receivables
(Loans) into bonds (Securities); it involves multiple parties.

The steps involved in the process of securitization are as follows:

A.L.I.E.T 27 FINANCIAL MARKETS AND SERVICES

  The origination function: The borrower approaches a bank or other financial institution
(originator) for a loan. The respective financial institution allows a certain sum as debts
in exchange for any collateral.
 The pooling function: Different loans are converted into homogenous groups and are
transferred in favor of special purpose vehicles. This special purpose vehicle acts as a
trustee. This pooling of assets in favor of special purpose vehicle is known as pooling
function.
 The securitization function: Once the assets are transferred in favor of a special purpose
vehicle, then the SPV issues its securities to the different qualified buyers. This function
of issuing securities to qualified institutional buyers is known as the securitization
function.

Types of Securitization
The different kinds of receivables determine the type of securitization it requires. Given below
are some of the most common types of securitization:

A.L.I.E.T 28 FINANCIAL MARKETS AND SERVICES

  Asset-Backed Securities (ABS): The bonds which are supported by underlying financial
assets. The receivables which are converted into ABS include credit card debts, student
loans, home-equity loans, auto loans, etc.
 Residential Mortgage-Backed Securities (MBS): These bonds comprise of various
mortgages like of property, land, house, jewellery and other valuables.
 Commercial Mortgage-Backed Securities (CMBS): The bonds that are formed by
bundling different commercial assets mortgage such as office building, industrial land,
plant, factory, etc.
 Collateralized Debt Obligations (CDO): The CDOs are the bonds designed by re-
bundling the personal debts, to be marketed in the secondary market for prospective
investors.
 Future Flow Securitization: The Company issues these instruments over its debts
receivable in a future period. The company meets the principal and interest through its
routine business operations, though such obligations are secured against its future
receivables.

Advantages and disadvantages of debt securitization

A.L.I.E.T 29 FINANCIAL MARKETS AND SERVICES

To the originator

 Unblocks Capital: Through securitization, the originator can recover the amount lent,
much earlier than the prescribed period.
 Provides Liquidity: The illiquid assets, such as the receivables on loans sanctioned by
the bank, are converted into liquid assets.
 Lowers Funding Cost: With the help of securitization, even the BB grade companies can
benefit by availing AAA rates if it has an AAA-rated cash flow.
 Risk Management: The financial institution lending the funds can transfer the risk of
bad debts by securitizing its receivables.
 Overcoming Profit Uncertainty: When the recovery of debts is uncertain, its
profitability, in the long run, is equally doubtful. Thus, securitization of such obligations
is a suitable option to avoid loss.
 Reduces Need for Financial Leverage: Securitization releases the blocked capital to
maintain liquidity; therefore, the originator need not seek to financial leverage in case of
any immediate requirement.
To the Investor
The investor’s aim is to accelerate the return on investment. Following are the different ways in
which securitization is worth investing:
 Quality Investment: The purchase of MBS and ABS are considered to be a wise
investment option due to their feasibility and reliability.

A.L.I.E.T 30 FINANCIAL MARKETS AND SERVICES

  Less Credit Risk: The securitized assets have higher creditworthiness since these are
treated separately from their parent entity.
 Better Returns: Securitization is a means of making a superior return on their
investment; however, it depends more on the investor’s risk-taking ability.
 Diversified Portfolio: The investor can attain a well-diversified portfolio on including
the securitized bonds; since these are very different from other instruments.
 Benefit Small Investors: The investors having minimal capital for investment can also
make a profit out of securitized bonds.

Disadvantages of Securitization
Securitization requires proper analysis and expertise; otherwise, it may prove to be quite unsound
to the investors. Let us now discuss its various drawbacks:

 Lack of Transparency: The SPV may not disclose the complete information about the
assets included in a securitized bond to the investors.
 Complex to Handle: The whole process of securitization is quite complicated involving
multiple parties; also, the assets need to be blended wisely.
 Quite Expensive: When compared to share flotation, the cost of a securitized bond is
usually high, including underwriting, legal, administration and rating charges.
 Investor Bears Risk: The non-repayment of debts by the borrower would ultimately end
up as a loss to the investors. Therefore, the investor is the sole risk-bearer in the process.
 Inaccurate Risk Assessment: Sometimes, even the originator fails to identify the value of
underlying assets or the associated credit risk.
 Loss from Prepayment: If the borrower pays off the sum earlier than the defined period,
the investors will not make superior gains on their investment value.

A.L.I.E.T 31 FINANCIAL MARKETS AND SERVICES

DE-MAT SERVICES

Overview
 With effect from 01.04.2011, all the new De-mat accounts and Online Trading accounts
will be opened in the books of SEBI Cap Securities Ltd.
 The existing De-mat accounts in the books of the Bank will continue to be maintained by
the Bank.
Therefore, in new 3 in one facility, Savings/Current account will be held with SBI while
De-mat and Online Trading account will be held in the books of SBI Cap Securities Ltd.
However, existing De-mat customers of SBI will continue to get the services from SBI as before.
SBI is a Depository Participant registered with both National Securities Depositories Limited
(NSDL) and Central Depository Services Limited (CDSL) and is operating its DP activity
through more than 1000 branches. Our Power De-mat Account offers you the following features:

Features & Benefits of a De-mat Account

As opposed to the earlier form of dealing in physical certificates with delays in transaction,
holding and trading in De-mat form has the following benefits:
 Account Maintenance & Safe custody: Facilitates Maintaining Security Balance in
electronic form
 Dematerialization: Facilitates converting physical share certificate into electronic
balances.
 Rematerialization: Facilitates converting the electronic balances to physical (share
certificate) form.

A.L.I.E.T 32 FINANCIAL MARKETS AND SERVICES

  Account Transfers: Facilitates delivery/receipt of electronic balances consequent to
market / off-market trades.
 Pledge/Hypothecation: Facilitates blocking securities balance of borrowers in favor of
lenders for obtaining Loans / advances against shares.
 Initial Public offer: Facilitates faster and direct credit of security balances into DP
account on allotment through public issue of companies
 Disbursement of corporate benefits: Facilitates faster and direct credit of security
balance into DP account on account of non-monetary corporate benefits as bonus and
rights issues.
 Security Lending: Facilitates earning extra income on your dematerialized holdings by
the way of securities lending.
 Online De-mat Statements: You can now view your De-mat account details, statement
of holdings, statement of transactions and statement of billing online.
 Mobile Alerts: Receive SMS alerts for all debits/credits as well as for any request which
cannot be processed.

ROLE OF NSDL & CSDL

Depository

A depository can be defined as an institution where the investors can keep their financial assets
such as equities, bonds, mutual fund units etc in the dematerialized form and transactions could
be effected on it.

Examples: National Securities Depository Limited, Central Depository Services Limited. An

effective and fully developed depository system is essential for maintaining and enhancing the
efficiency of a mature capital market. Before introduction of Depository system, the problems
faced by investors and corporate in handling large volume of paper were as follows:

 Bad deliveries
 Fake certificates
 Loss of certificates in transit
 Mutilation of certificates
 Delays in transfer
 Long settlement cycles
 Mismatch of signature
 Delay in refund and remission of dividend etc

Through a system of paperless securities, depositories have made the going easier to other
institutions as well such as Stock Exchanges and its clearing houses, stock broking firms, equity
issuing companies, share transfer agents etc.

NATIONAL SECURITIES DEPOSITORY LIMITED

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National Securities Depository Limited (NSDL) was promoted by the Industrial Development
Bank of India, the Unit Trust of India, the National Stock Exchange of India Ltd., and State Bank
of India. NSDL is the first depository in India established in 1996. It commenced its operations
on 8th November 1996. Since then it has been growing steadily.

Services of NSDL

Basic Services: Under the provisions of the Depositories Act, NSDL provides various
services to investors and other participants in the capital market like, clearing members, stock
exchanges, banks and issuers of securities.

 Account maintenance
 De-materialisation
 Re-materialisation
 Settlement of trades through market transfers
 Off market transfers & inter-depository transfers
 Distribution of non-cash corporate actions and nomination/ transmission.
.
 Value Added Services: Depository is a facility for holding securities electronically in which
securities transactions are processed by book entry. In addition to the core services of
electronic custody and trade settlement services, NSDL provides special services like
 Pledge
 Hypothecation of securities
 Automatic delivery of securities to clearing corporations
 Distribution of cash and non-cash corporate benefits (Bonus, Rights, IPOs etc.)
 Stock lending
 De-mat of NSC / KVP,
 Den-mat of warehouse receipts and Internet-based services such as SPEED-
e and IDeAS. NSDL has also set-up a facility that enables brokers to deliver contract
notes to custodians and/or fund managers electronically. This facility
called STEADY (Securities Trading - information Easy Access and Delivery) was
launched by NSDL on November 30, 2002. STEADY is a means of transmitting
digitally signed trade information with encryption across market participants
electronically, through Internet.

Functions of National Securities Depository Ltd

NSDL performs the following functions through its participants:

 It maintains investors’ holdings in the electronic form.

 It enables the surrender and withdrawal of securities to and from the depository.
 If effects settlement of securities traded on exchanges.
 It carries out settlements that have not been done on the stock exchanges.
 It makes allotment in electronic form, of initial public offerings (IPO).

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  It offers facility for freezing or locking of investors’ accounts.
 It facilitates offer of securities as a mortgage for loans.

Transactions of the NDSL

As we have seen already, the transactions of the stock market are divided into two categories
namely,

 New issues: Generally, the investor has the option to receive the shares either in physical
form or in the electronic mode. When shares are allotted to the investor, he should
specify his choice clearly. If he wishes to hold securities in the electronic form, he should
specify the depository participant to which, the allotted shares are to be delivered.

Shares will be allotted according to SEBIs guidelines but the dispatch of shares to the
depository participant will take place according to the instructions of the investor.
Nowadays, SEBI has made it mandatory for the companies to have new issues in the
dematerialized form.

 Secondary market: The trading procedures for the secondary market transactions are the
same but the settlement and clearing procedures are different. It may so happen that the
seller opts to deliver the shares from the depository while the buyer wishes to take
delivery in the physical form and vice versa.

That is, the seller has the shares in the physical mode while the buyer prefers the
electronic mode. When both, the buyer and the seller prefer the electronic mode, the
transaction would be smooth.

CENTRAL DEPOSITORY SERVICES (INDIA) LIMITED (CDSL)

The second depository Central Depository Services Limited (CDSL) has been promoted by
Bombay Stock Exchange and Bank of India. It was formed in February 1999. CDSL is the
second depository set up by the Bombay Stock Exchange (BSE) and co-sponsored by the State
Bank of India, Bank of India, Bank of Baroda, and HDFC bank,. BSE has a 45 per cent stake in
CDSL while the banks have a 55 per cent stake. CDSL commenced operations on March 22,
1999. The same year, five stock exchanges established connectivity with CDSL for offerings
trade in demat securities and 765 companies signed up with CDSL to get their securities
admitted for dematerialization. CDSL has 163 DPs in 91 cities across 168 locations covering 320
cities. With a net worth of Rs 104 crore, CDSL plans to offer facilities like inter-depository
transfer and linking of accounts through cell phones.

CDSL has been the preferred platform by the government of India for carrying out actual share
transactions. PSU disinvestments have been done through CDSL system.

Every transaction at CDSL is done at one e-space. The centralized system of CDSL keeps a
watch on every transaction.

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CDSL has also attained membership of the Asia Pacific Central Securities Depository Group
(ACG). The ACG is an organization that facilitates exchange of information and promotes
mutual assistance among member depositories and clearing organizations of the Asia-Pacific
region. It has 22 member organizations including depositories from Japan, Hong Kong,
Singapore, Malaysia; Australia’s clearing organization, and the Reserve Bank of New Zealand.
Membership of the organization is expected to help CDSL in enhancing its knowledge base and
contributing to the development of other member organizations in the best international
practices, settlement risk management, cross border linkages, and technological development.
This, in turn would help CDSL to secure foreign institutional investors’ business through their
custodians.

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