Chapter 18 - Money Market

 

J B GUPTA CLASSES

 

98184931932, [email protected] , www.jbguptaclasses.com   www.jbguptaclasses.com Copyright: Dr JB Gupta 

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MONEY MARKET Chapter Index  

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Bridge Loan Factoring Forfeiting Bill Discounting Commercial Papers

Certificates of Deposits Treasury Bills   RBI Regulations (i)  CRR, SLR and SGL (ii)  Primary Dealers System (iii)  Call Money/Notice Money (iv)  Repo and Reverse Repo rates (v)  Bank Participation Certificates C ertificates   International Trade (i)  Letter of Credit (ii)  Pre-shipment Credit (packing Credit) (iii)  Post-shipment Credit    

MONEY  market is that segment of financial market where short-term financial assets are dealt with; in this type of market where the funds can be raised as well invested from short-term point of view. Money markets channel short term funds from surplus entities to deficit entities. Q. No. 1: Write a short note on Bridge Financing. (Nov. 1997) Answer: A Bridge Loan is a loan that is used for a short duration of time until permanent financing is put in place. Bridge loan can be raised from banks/financial institutions. Non-Banking Finance Finance companies are not permitted to raise Bridge Loans.

 

 

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BRIDGE LOAN BY BANKS ( I ) The banks sanction bridge loans against term loans sanctioned by other bank(s)/financial institution(s) when such bank(s)/financial institution(s) are unable to disburse the sanctioned loans due to temporary liquidity constraints being faced by them. RBI has put four f our conditions in this case:   The bank extending the bridge loan must obtain the approval of the other bank(s)/financial institution(s) institution(s) which have sanctioned the loan.   The bank (providing bridge finance) must also obtain a commitment from the bank(s)/ financial institution(s) that the latter would directly remit the amount due on account of bridge loan to it at the time of disbursement of sanctioned loan. period of such loan should not not exceed four months. months.   The period   The bridge loan amount is to be utilized only for the purpose for which term loan has been sanctioned by the other bank(s)/financial institution(s). •

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(II) The banks also provide bridge loans to the companies against expected cash flows from equity issue (whether in India or abroad). BRIDGE LOAN BY FINANCIA FINANCIAL L INSTITUTIONS: INSTITUTION INSTITUTIONS: S: (i)  The FIs sanction bridge loan against commitments made by other bank(s)/financial institution(s) when the lending institution faces temporary liquidity constraints subject same four conditions which have been mentioned in the case of bridge loan by banks. (ii)  The FIs sanction bridge loans to the companies for commencing work on projects pending completion of formalities against their own commitments. (iii)  The financial institutions sanction bridge loans against expected cash flows of public equity issue (whether in India or abroad) However, FIs should not grant any advance against Rights issue. Q. No. 2: Write a note on factoring. Answer:  Factoring

is a trade financing vehicle. Factors buy a company's trade receivables (arising on account of genuine transactions) at a discount, thereby their immediately conversion into cash. Factoring is an ongoing arrangement between the client and factor, where invoices raised on account of sales of goods and services are regularly assigned to the factor for financing, collection and sales ledger administration. Most factoring is done on non-recourse basis, which means that the factor assumes the risk of bad debts. Factoring is just a complete financial package that combines working capital financing, credit risk protection, sales ledger maintenance and debt collection services. Factors usually insist on handling all the most or sales to avoid the risk of dealing with only risky receivables. Generally factors pay up to 80 per cent of receivables amount

 

 

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immediately and the balance paid on maturity. Factoring involves high costs (factoring commission and interest on funds advanced) but it is quite worthwhile because factors bear the risk of bad debts. In some cases, the companies submit all new orders (requiring credit facilities) to the factors. After evaluating the creditworthiness of the customer, the factor informs the company about its decision regarding factoring that order on non-recourse or recourse basis. (In case of recourse basis, the risk of bad debts is not born by the factor.) Factoring in India is governed by RBI. RBI allowed the conduct of factoring services from 1991 onwards. The factoring services have been moving at very slow pace in India. Two reasons are responsible for this: (1) The There re is no legal legal protection protection to this service. service. (2) When a debt is assigned, the stamp duty has to be paid. Q. No. 3: Write Short note on forfeiting.. (( Nov. Nov. 2002) Answer: Forfeiting is a mechanism of financing exports by discounting exports receivables evidenced by Bill of exchange/promissory note without recourse to the exporter. It is an act of buying an exporter's receivables at discount by making him 100 per cent payment immediately (net of deduction of service charges including interest, commission, etc). The forfeiter, i.e., the purchaser of the receivables, becomes the entity to whom the importer is obliged to pay. Forfeiting provides the exporter with immediate money and frees him from various risks like country risk, foreign exchange rates fluctuations, credit risk, possibility of delay in payments, etc. Forfeiting does not involve much risk for the forfeiter as the importer's obligations are generally supported by a Letter of Credit. Forfeiting is particularly beneficial for such export contracts which involve longer credit period, for example export of capital goods, projects exports, etc. Foreign banks are major players in Forfeiting market. A few years back RBI permitted EXIM Bank and Authorized Dealers (Banks) to offer Forfeiting services in India. Global Trade Finance Pvt. Ltd., a joint venture of EXIM Bank (India), WESTLB (Germany) and IFC (Washington), is a leading player in this t his field. Forfeiting has not been popular in India as concessional finance is abundant to exporters and the credit risk is taken care of by the letter of credit from the importer's bank. Q. No. No. 4: Distinguish between betwee n Forfeiting and factoring. facto ring.. (Nov. 2004) Answer: Factoring is a trade financing vehicle. Factors buy a company's trade receivables (arising on account of genuine transactions) at a discount, thereby

 

 

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their immediately conversion into cash. Factoring is an ongoing arrangement between the client and factor, where invoices raised on account of sales of goods and services are regularly assigned to the factor for financing and collection. Most factoring is done on non-recourse basis, which means that the factor assumes the risk of bad debts. Forfeiting is a mechanism of financing exports by discounting exports receivables evidenced by Bill of exchange/promissory note without recourse to the exporter. It is an act of buying an exporter's receivables at discount by making him 100 per cent payment immediately (net of deduction of service charges including interest, commission, etc). The forfeiter, i.e., the purchaser of the receivables, becomes the entity to whom the importer is obliged to pay. Forfeiting provides the exporter with immediate money and frees him from various risks like country risk, foreign exchange rates fluctuations, credit risk, possibility of delay in payments, etc. Some important points of distinction between the two are given below: Factoring 1. Does not involve Bill of exchange/ promissory note. 2. No refinancing facility for the factor

Forfeiting 1. Involves Bill of exchange/ promissory note. 2. There is refinancing facility for the forfeiting. 3. Factoring is an ongoing arrangement 3. It is generally for a specific between the client and factor, where transaction. invoices raised on account of sales of goods and services are regularly assigned to the factor for financing and collection. 4. A technique of short term financing 4. A technique of medium term financing. 5. This may be with or without 5. It is always without recourse. recourse to the client. ( Generally without recourse) 6. Factor has to bear only only one risk i.e. the risk of default ( only case of factoring without recourse)

6. Forfeiting involves risks of (i) default (though the risk is negligible as the money is being secured on account of Letter of credit) (ii) Currency fluctuation risk.

Write a short note on discounti discounting ng of Bill receivables. Q. No. 5 : Write

 

 

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Answer: Discounting of bills receivable from the banks is a source of working capital finance. Through this process, a business house can convert its credit sales to just like cash sales subject to bearing the discounting charges. This method of financing is preferred by banks because of the following reasons: (i)

Bills receivables represent the receivables receivables stage of of the operating cycle of a commercial activity.

(ii)

Short term in tenor.

(iii)

Self-liquidating in nature.

(iv)

Credit enhancement through acceptance by a third party (the drawee). drawee).

This method of financing working capital is not popular in India in spite of various efforts by the RBI. Two important steps by the RBI are: (i) Bill discounting is not linked with Prime Lending Rate, i.e., the banks can decide their own lending rate. (In other words bank can discount the bills even at a rate lower than their Prime Lending Rate.) (ii) Rediscounting facilities : the RBI has provided enough rediscounting facilities to the banks, they can get the bill rediscounted from other banks. Establishment of Discount and Finance House of India is a landmark step in this direction. (Rediscounting facilities increase the liquidity of the banks discounting the bills). RBI's guidelines regarding bill discounting by the commercial banks are as follows : (I)

(II) (III)

Only trade trade bill, representing sale of tangible goods, should be discounted discounted by the banks. Receivable on account of providing services are not to be discounted. Accommodation bills should not be discounted. Banks should take special care care in discounting the bills receivables of of large business houses which have been accepted by some other member of the group (to ensure that it is bill representing genuine trade transaction, i.e., it is neither an accommodation bill nor its amount is inflated to obtain bank credit).

(IV)

Bill rediscounting rediscounting should be restricted restricted to bill discounted discounted by other banks. banks. Banks should not rediscount the bill discounted by Non-Banking Non-Banking Financing Companies except the bills arising out of sale of commercial vehicles including light vehicles, three-wheelers and two-wheelers.

Q. No. 6: Distinguish between Factoring and Discounting. (May, 2002) Answer:

 

  Factoring In this case, the factor buy a company's trade receivables (arising on account of genuine transactions) at a discount, thereby their immediately conversion into cash. Loss on account of bad debts is generally borne by the factor. Factoring is an on-going process i.e. generally the factor factors all the credit sales. The process of factoring begins before sales. In many cases, all the orders received by the firm are reviewed by the factor and credit sale is made on the basis of creditworthiness judged by the factor. Factoring is not covered by any

6 Bill Discounting Discounting Through this process, a business house can convert its credit sales to just like cash sales subject to bearing the discounting charges.  charges. 

Loss on account of bad debts is borne by the party getting the bill discounted. Bill discounting is a specific requirement case. The process of Bill discounting begins not only after sales but after the bill has been accepted by the purchaser.

It is covered by Negotiable Instrument

specific law. Act. Factor is a complete process of It is a simply financing technique. management of debtors i.e. the factors sends reminders to the customers, collects the amounts and maintain the customers accounts. Q. No. 7 :: Write a short note on Commercial paper ( May, 2003) Answer : Commercial paper (CP) is an unsecured money market instrument issued in the form of a promissory note (CP can also be issued in dematerialized form through any depository registered with SEBI). It is to meet the short-term requirements of funds of the issuers. CP can be issued for maturities between a minimum of seven days and a maximum of one year from the date of issue. CP can be issued by (i) Corporate having minimum tangible net worth of not less than Rs. 4. Crores as per the latest audited balance, (ii) Primary Dealers, (iii) All India financial institutions. All eligible participants have to obtain the credit rating for issuance of CP from CRISIL or some other credit rating agency specified by RBI. The issuer shall ensure that at the time of issuance o off CP that the rating is current and has fallen due for review. Issuance of CP is governed by the guidelines issued by RBI from time to time. Every issuer must appoint some scheduled bank as Issuing and Paying Agent (IPA). CP can be issued in in denominations denominations of Rs. 5,00,000 or or multiples thereof. thereof. It is cheaper source of finance as generally the rate of interest on a CP is lower than

 

 

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that charged by banks. It is a liquid asset for the investors as it is transferable. Being a Promissory Note, it is subject to Stamp Duty. The issue of CP cannot be under written. It is issued at discount to the face value. Every issue of CP should be reported to RBI by Issuing and Paying Agent within 3 days from the date of completion of the issue. On maturity the holder CP will get payment through the Issuing and Paying Agent. Q. No. 8 :: Write a note on Certificate Of Deposit. Answer: A Certificate of Deposit (CD) is a negotiable money market instrument issued by some bank/eligible all-India Financial Institution as a promissory note against the funds deposited by the investor. The issuance of CDs is governed by the directives issued by RBI. The CDs are originally issued in dematerialized form but the investor can later on get the same converted into physical form. The CDs can be issued by the banks depending on their requirements. these can also be issued by select All India Financial Institutions that have been permitted by RBI to raise short-term resources within the limits fixed by RBI. Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted from a single investor should not be less than Rs.1 lakh (face value) and in the multiples of Rs. 1 lakh (face vale) thereafter. CDs can be issued to any Indian investor. CDs can also be issued to NRIs on non-repatriable basis. Some important guidelines of RBI regarding CDs are as follows: (i)

Maturity period for CDs issued by the banks should not not be less than 7 days and not more than one year. In case of other issuers, the period should not be less than 1 year and not more than 3 years from the date of issue.

(ii)

CDs may be issued issued at a discount discount (fixed rate) to the the face value. Alternatively, such certificates can be issued on floating coupon rate basis.

(iii) (iv)

Banks have to maintain cash reserve ratio and and Statutory Liquidity ratio. Physical form CDs are freely transferred transferred by endorsement and delivery, delivery, dematted CDs can be transferred as the procedure for transfer of dematted securities. NRIs do not enjoy the transferring facility.

(i)

Banks/FIs cannot cannot grant loans loans against CDs. Buy-back Buy-back are also not permitted.

(ii)

Since physical physical form CDs are transferable, it will be necessary for the banks to see that the CDs are printed on good quality security paper. Necessary precautions should be taken against tampering with the documents. They should be signed by two or more authorized signatories.

 

 

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  (iii)

On maturity, dematted CD CD holders should approach the depository; depository; they will get their payment through the depository. The physical form CDs should be presented to the issuers for redemption.

(iv) The issuers should submit fortnightly report to the RBI within 10 days from the end of the fortnight. Q. No.9 : Write short note on Treasury bills.

(Nov. 2003)

Answer : (i) T-bills are short-term securities issued by RBI on behalf of GOI, for maturities of 14, 91, 182 and a nd 364 days. (ii) Commercial banks, primary dealers, Mutual Funds, F unds, Corporates, Institutions and Insurance companies can participate. (iii) Periodic auctions are held for their issue and these are tradable in the secondary market, which is quite active. (iv) T-bills are issued at a discount to face value and are redeemable at par on maturity. Q. No.10: No.10: Write short notes on (i) (i ) Cash Reserve ratio (ii) Statutory Liquidity Ratio Ra tio and (iii) Subsidiary General ledger. Answer : CRR ::Banks have to maintain cash reserve ratio (it is ratio of “cash balance with RBI” to “demand and time liabilities”, it is decided by RBI from time to time without any floor rate or ceiling rate; currently it is 6 per cent). No interest is paid by RBI on this amount. Statutory Liquidity ratio of “cash, gold and approved securities” to “demand and time liabilities”, liabilities”, currently it is 25 per cent. (It is prescribed prescribed by RBI from time to time subject to maximum of 40%). Subsidiary General Ledger: The investors in government securities securitie s are mainly banks, FIs, insurance companies, primary dealers, mutual funds, provident funds & trusts and big corporate. Unless the investor requests specifically, Government securities are issued not in physical form but as entries in the Subsidiary General Ledger (SGL), which is maintained by RBI. Q. No.11: Write a short note on Primary Dealers System Answer : "Primary Dealer" means a financial institution which holds a valid letter of authorisation as a Primary Dealer issued by the Reserve Bank”. The Primary Dealers System has been developed by RBI for deepening and widening of the Government securities market. The objectives of the PD system are:

 

 

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i. to strengthen the government securities market in order to make it vibrant, liquid and broad based. ii. to ensure development of underwriting and market making capabilities for government securities outside the RBI. iii. to improve secondary market trading system, which would contribute to price discovery, enhance liquidity and turnover and encourage voluntary holding of government securities amongst a wider investor base. Obligations of the PDs: The Primary dealers channel securities from primary auctions to ultimate investors. They facilitate government securities trading through committed participation in primary market auctions and by creating an active secondary market in securities by giving two-way quotes. They have two main obligations: obligations:

  Support to Primary Market:  PDs  PDs are required to participate in auctions for issue of Government securities and Treasury Bills.They underwrite the issue of Government securities.

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  Market making in Government securities:   The PDs purchase government

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securities from the government when the securities are issued and then they deal in such securities by giving two way quotes i.e. .bid and ask. Facilities from RBI to PDs PDs   The Reserve Bank currently extends the following facilities to PDs to enable them to effectively fulfill their obligations: i. Access to Current Account facility with RBI. ii. Access to Subsidiary Subsidiary General General Ledger (SGL) Account Account facility (for Government securities) withtoRBI. iii. Permission borrow and lend in the call money market. iv. They can participate in Repo and Reverse Repo system of the RBI. v. The get underwriting commission for underwriting the issue of Government securities. vi. They can short sell the government securities. They can sell the securities after the announcement of their issue on ‘when issued’ basis and deliver the securities to the buyers when these are issued. Q. No. 12 12: Explain briefly ‘Call /Notice Money’ in the context of financial market.. (Adapted May, 2004) Answer:

 

 

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The money market is a market for short-term financial assets that are close substitutes of money. The most important feature of this money market instrument is its liquidity. The call/ Notice money market forms an important segment of the Indian money market. Under call money markets funds are borrowed/ lent on overnight ( Next working day ) basis. . Under notice money market, funds are borrowed / lent for the period between 2 days and 14 days. Deals in the call/ Notice money market can be done up to 5.00 pm on weekdays and 2.30 pm on Saturdays. RBI has permitted only banks and primary dealers for operating in call / Notice money market. The eligible participants are free to decide on interest rates in Call / Notice money market. Call / Notice money market enables its participants to even out their day-to-day deficits and surplus of money. The market helps in increasing the profits as well liquidity of the participants. Call/ money market as a market good indicator of quite the liquidity position in theNotice economy. The call / rates noticeacts money rates are volatile. There have been the cases when the rate were approaching 3 %; there also have been the cases when it crossed 50%. For participating in this market, both the borrower as well as lender must have their current accounts with the RBI. Q. No.13: What is a Repo and Reverse R everse Repo? ( Nov. 2005) Answer:

REPURCHASE OPTION (REPO)

It is a liquidity adjustment facility provided by the RBI to the participants of the repo market. The funds under LAF are used by the participants for their day-today mismatches in liquidity. The participants are (i) primary dealers (ii) Banks. The participants should have current accounts and SGL accounts with RBI.

Repo is used for injecting liquidity by RBI to the participants. If the participants of the repo market have less liquidity, they may borrow for overnight from the RBI. For this purpose, the participants sell Government of India securities( Including the treasuries Bills) to the RBI with the undertaking that they will buyback these securities from the RBI next day at the price determined at the time of selling the securities. The price at which the securities will be bought back is higher than the price at which these are sold. The difference represents interest at the rate announced by the RBI from time to time. Currently the repo rate is 5.25 per cent p.a.

 

 

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Reverse repo is a mirror image of repo. Under Reverse repo, the participants transfer their excess liquidity to the RBI (reverse repo is defined as the process by which RBI absorbs the extra liquidity with the participants of the repo market). If any participant has excess liquidity, it may lend (for overnight) to the RBI. For this purpose, the participant purchases Government of India Securities ( including the treasuries bills) from the RBI with the under taking that these will be sold back to the RBI next day at the price decided at the time of purchase of such securities. The price at which the securities will be sold back is higher than the price at which these are purchased. The difference is interest (from RBI to the participant). The rate of interest is announced by the RBI by time to time. Currently, the reverse repo rate is 3.75 per cent p.a. The amount of repo/reverse repo should be in the multiples of Rs. 5crores (with minimum of Rs. 5crores). Q. No.14: Write short note on Inter Bank Participation certificate.. (Nov. (Nov. 2006) Answer : The Reserve Bank of India (RBI) norms stipulate that banks must lend up to 40 per cent of their total portfolio as advances towards the priority sector. Of the 40 per cent, 18 per cent is towards agriculture loan, 10 per cent as loans towards the weaker section of the society and the balance towards SSI and home loans. Sometimes, a bank, say A Bank, finds that it has not achieved these limits i.e. the advances to the priority sector are less than the RBI’s requirement. Some other bank, B Bank, might have exceeded these limits. What these bank can do is that B Bank may sell its excess priority advances to A bank to purchased after some time, say 3 months. The interest on priority advances is less than other advances. A Bank has been gainer by advancing less amount to priority sector. This gain will be transferred by A Bank to B Bank by way to purchasing the portfolio of priority advances at a rate higher than the prevailing inter-bank offering rate. Through this process, A Bank could meet the requirements of RBI and B Bank could higher rate of interest. The banks are increasingly issuing IBPCs for this purpose. IBPCs are short term instruments to even out liquidity within the banking system. This is purely an inter bank instrument. The RBI has ha s authorized the banks to fund their short term needs from within the system through issuance of IBPC. Q. No. 15 : Write a short short note note on on Letter of credit. credit. Answer:

  A letter of credit is an instrument issued by the Importer’s bank promising to pay the exporter subject to compliance of the terms and conditions stipulated in the instrument.

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  It is a letter of guarantee by the bank to the exporter that if the exporter satisfies the terms of the terms of conditions of the contract between exporter and importer, the exporter will get its payment from the importer’s bank.

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  Through a letter of credit, the importer’s bank substitutes its own commitment to pay for that of its customer (the importer). The letter of credit, therefore, becomes a financial contract between the issuing bank and the exporter.

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  Sometimes, the L/C is issued by the borrower’s bank in favour of the lender promising to pay the lender the money lent by it to the borrower, on due date, in case the lender fails to meet its commitment.

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The advantages of L/C (from the point of exporter): (i)  An L/C eliminates credit risk and possibility of the payment being delayed. (ii)  An L/C reduces uncertainty. The exporter knows all the requirements for payment because they are clearly mentioned in the L/C. (iii)  The L/C guards against the pre-shipment risk as it eliminate the possibility of the order being cancelled. (iv)  Pre-shipment credit is easily available to the exporter. The advantages of L/C (from the point of view of importer importer): (i)  The conditions stipulated in the L/C safeguards the importer against any foul play by the exporter. The inspection report affirms the quality and quantity of goods shipped. The date by which the bill can be drawn ensures timely shipment of goods. (ii)  All documents received from the exporter are carefully examined by the experienced staff of the bank. Any oversight in this matter is the responsibility of the bank. (iii) (iv)

Cash in advance is not insisted by the exporter. As the exporter is sure about creditworthiness creditworthiness of the the deal, he offers favourable terms (like discount etc.) to the importer.

Q. No.16: Write a note on Pre-shipment credit / Packing credit. Answer: Packing credit means any credit facility granted by a bank to an exporter for financing the purchase, processing, manufacturing or packing of goods prior to shipment. This facility is granted at lower interest rate at the rates prescribed by the RBI (It is a part of priory sector lending by the banks). Currently the rate is Prime Lending Rate Minus 2.50%. Generally, it is granted on lodgment of letter of credit or confirmed and irrevocable order. This condition

 

 

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can be relaxed by the bank in favour of the exporters having good track record. Packing credit is available in Indian Rupee, Sterling Pound, USD, Euro and Japanese Yen. (Foreign currency credit is required in case of some imports for the exports) The period for which a packing credit may be given by a bank will depend upon the circumstances of the individual case, such as time required for procuring, manufacturing or processing (where necessary) and shipping the relative goods. It is primarily for the banks to decide the period for which a packing credit advance may be given having regard to the various relevant factors so that the period is sufficient to enable the exporter to ship the goods. Each packing credit sanctioned should be maintained as separate account for the purpose of monitoring the period of sanction and end use of the funds. The banks may release the funds in lump sum or in stages as per the requirements. The banks continue to keep a close watch on the end-use of the funds and ensure that the credit is used for the purpose for which it is granted. The credit may be liquidated (i) out of proceeds of bills drawn for such exports, (ii) converting the packing credit into post shipment credit, (iii) out of Exchange Earners Foreign Currency Account, and (iv) rupee resources of the exporters. Q. No. 17: Write a note on Post-shipment credit. Answer: Post-shipment Credit means any loan or advance granted or any other credit provided by a bank to an exporter of goods from India , after shipment of goods, from the date of extending credit to the date of realization of export proceeds, and includes any loan or advance granted to an exporter, in consideration of, or on the security of any duty drawback allowed by the Government from time to time. Post-shipment advance can mainly take the form of: (i) (ii)

Export bills purchased/discounted/nego purchased/discounted/negotiated. tiated. Advances against bills for collection.

(iii)  Advances against duty drawback receivable from Government. Such advances would be eligible for concessional rate of interest up to a maximum period of 90 days from the date of advance. Such advances are available in rupee only (not in foreign currency). This facility is granted at lower interest rate at the rates prescribed by the RBI (It is a part of priory sector advances by the banks). Currently the rate is Prime Lending Rate Minus 2.50%. This is useful to exporters who may otherwise suffer a long collection period.

 

   

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