Saturday, February 7, 2015

Derivatives Market

To understand the concept of Derivatives, first try to understand the following example -
Suppose you want to invest in shares, or bonds, or some other instruments. But you don't know what will happen to your investment, meaning, your (bought) share may give you profit, or give you loss (you often hear news, that someone has lost all his money in shares), because it all depends on the company how it works in the market (same thing applies for other investments too).

Certainly there is always a risk factor that works in your investment in these type of instruments. So, to reduce the risk, there is a concept of Derivatives.

A derivative is a contract / agreement between two or more parties, whose value depends on or associated with one or more underlying assets (e.g., shares, bonds, commodities, currencies, etc.)

Derivatives are one of the three main categories of financial instruments -
  1. Stocks (i.e,. equities or shares) (already discussed in previous post)
  2. Debt (i.e., bonds, mortgages) (already discussed in previous post)
  3. Derivatives (our topic of discussion)

Let's start with an example -
Suppose you want to buy an asset with Rs. 500 (example figure just to understand the concept). But you are worried what will be the market price of the asset after some months, and their is a high probability (your speculation) that the market price can become less than Rs. 400. So in that case you will make a loss of around Rs. 100.

Therefore, you decide to make an agreement with an investor, stating that you want to sell him the asset in Rs. 550 after 6 months (future agreement). The investor agrees with the agreement, because he thinks, he can sell the asset at a higher profit (may be Rs. 600, investor's speculation), if the market price is high.

Now analyze. If the market price of the asset after 6 months, becomes Rs. 650, then the investor will get a profit of Rs. (650 - 550) = Rs. 100. But you will get the fixed profit of Rs. (550 - 500) = Rs. 50, irrespective of the market price.
But if the market price of the asset becomes Rs. 420, then the investor will make a loss of Rs. (550 - 420) = Rs. 130, whereas you won't make any loss, but a fixed profit of Rs. (550 - 500) = Rs. 50.

Note that you won't make any loss, if you make the Derivatives agreement, however your profit will be fixed (may be less, if you don't make the agreement). You reduce the risk of any loss, in this type of derivatives agreement, and this process of reducing risk is known as Hedging.
Also note that, the value of the Derivatives is dependent on your asset (known as underlying asset).

Types of Derivatives
  • Forwards
  • Futures
  • Options, etc.

Forward Contracts
Forward contract (or forwards) is a non-standardized contract between two parties to buy or sell an asset at a specified future date, where the price is decided today (on agreement day) 

Points to be noted -
  • Buy/Sell will be done in future date
  • Price is decided today (reduces risk for the seller)
  • These are not standardized (no Future Exchange is involved. Contract is made just between buyer and seller - private agreement)

Future Contracts
Future contract (or futures) is a standardized contract between two parties to buy or sell an asset at a specified future date, where the price is decided today (on agreement day)

Points to be noted -
  • Buy/Sell will be done in future date
  • Price is decided today (reduces risk for the seller)
  • These are standardized (in contrast to Forwards). Contracts are negotiated at Future Exchanges, that acts as an intermediary between buyer and seller. There is also a guarantee from Clearing Houses)
Option Contracts
Option contract (or options) is an agreement/contract between two parties that gives purchaser the right to buy or sell  (option to buy/sell) an asset at a specified future date, where the price is decided today (on agreement day)

Points to be noted -
  • Buy/Sell will be done in future date
  • Price is decided today
  • Options are the right to buy or sell, not an obligation, meaning the purchaser of the option, could buy/sell the asset, but if he doesn't want to, then he has no obligation to buy/sell it. But in case of Forward and Future contracts, there is an obligation to buy/sell the asset (they are legally bound to buy/sell the asset).
There are other types of derivatives, like Warrants, Swaps, etc.

Hope this post will help you understand the concepts.
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Monetary aggregates - Narrow and Broad Money

Nowadays, money doesn't just mean cash and coins you have with you. It also comprises deposits with the banking system or post offices, which you can convert to cash and coins as per your wish.

Now think about the liquidity feature of them. Clearly, cash and coins (currency) are the most liquid in nature, because, they could be used for your day-to-day transactions. But demand deposits (savings or current account deposits) in banks are less liquid than the currency. Similarly time deposits (fixed or recurring deposits) which have a maturity period associated with it, are even less liquid than demand deposits.

Monetary Aggregates
The Working Group on Money Supply, chaired by Dr. Y.V.Reddy (former RBI governor), set up to examine the analytical aspects of the monetary survey, introduced the new monetary aggregates -

M1 - It comprises all currency in circulation among public, and the demand deposits (savings and current account deposits) made by public in banks (including other deposits with RBI).

M2 - It comprises Savings deposits with Post Office savings banks, along with, all currency, and demand deposits with banks
(M2 = M1 + Savings deposits with Post Office savings banks)

Note that the monetary agrregates - M1 & M2 - are most liquid in nature, because currency will be with public, and demand deposits will be with banks, which you can easily encash by ATM, or drawing cheque, transacting through online, or using Point of Sale (POS) terminal, etc. This type of money is most liquid, but comprises a small part of total aggregate money, hence termed as Narrow Money

M3 - It comprises all currency with public and all demand and time (fixed and recurring) deposits with banks.
(M3 = M1 + Time deposits with banks)

M4 - It contains all currency with public, along with all demand and time deposits in banks, and it also includes all types of deposits (not only savings deposits) with Post Office. But it excludes National Savings Certificate (NSC).
(M4 = M3 + All deposits with Post office savings banks, excluding National Savings Certificates)

Note that, time deposits are not as liquid, or instantly available as demand deposits or currency, but will be available at certain time (on date of maturity), or you can convert it to cash by paying some penalty. Time deposits are much larger than M1 and M2 money aggregates. M3 and M4 are the total money available, hence known as Broad Money (note the meaning of 'narrow' and 'broad').

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Thursday, February 5, 2015

Settlement Systems of India

India has two main electronic funds settlement system for one-to-one transactions -
  1. National Electronics Funds Transfer (NEFT)
  2. Real-time Gross Settlement (RTGS)

Transactions can be bulk (meaning one-to-many or many-to-one transactions) and repetitive (regularly happening, like monthly) in nature. This type of transactions are routed through Electronic Clearing Service (ECS), and of two types -
  1. ECS Credit
  2. ECS Debit

National Electronics Funds Transfer (NEFT) - one-to-one
NEFT payment system facilitates one-to-one funds transfer. In this system, individuals, firms and corporate can electronically transfer funds from any bank branch to any individual, firm or corporate, having an account with any other bank in the country which is NEFT-enabled.

Note that, recipient should have a bank account (so that transfer can be traced), but the person who is transferring fund need not have any account, but in that case, there is a maximum transfer limit of Rs. 50,000 (for this walk-in customers, need to provide their identity documents).

But if he/she transfer fund from an account, then there is no limit of maximum transfer, though per transaction max limit is Rs. 50,000. e.g., For transferring Rs. 1 lakh through NEFT, there will be 2 transactions.

Note that NEFT settles transactions on net-basis and works in hourly batches. Currently, there are 12 batches (8 am to 7 pm) on weekdays and 6 batches (8 am to 1 pm) on Saturdays. Banks wait and collect all the transactions made within an hour, and then settles the transaction (not individually, known as netting). For an example, if you make a transaction on 8:30 am, then your settlement will wait till the hourly batch of 9 am, and at 9:00 am, your transaction will be settled

Transaction Costs -
No inward transaction cost for NEFT
But for outward transactions -
  • Up to Rs. 10,000 - maximum Rs. 2.5 + Service Tax
  • Above Rs. 10,000 to Rs. 1 lakh - maximum Rs. 5 + Service Tax
  • Above Rs. 1 lakh to Rs. 2 lakhs - maximum Rs. 15 + Service Tax
  • Above Rs. 2 lakhs - maximum Rs. 25 + Service Tax

Real-Time Gross Settlement (RTGS) - one-to-one
In this system, settlements are done on real-time (meaning, instantly, or without delay, note that NEFT need to wait for an hourly batch) and on gross basis (meaning, individually, transaction will not be netted with others like NEFT which are settled in hourly batches). RTGS is the fastest possible money transfer system through the banking channel.

Note that RTGS is meant for high-value transactions, and there is a minimum transaction limit of Rs. 2 lakhs (no upper limit). All the transactions go through the books of RBI.

RBI on Dec 15, 2014, increased RTGS total business hours from 7 hours 30 minutes to 12 hours. Now the business hour will be 8 am to 8 pm on weekdays against the earlier 9 am to 4:30 pm.

Transaction Costs -
No inward transaction cost for RTGS
But for outward transactions -
  • Rs. 2 lakhs to Rs. 5 lakhs - maximum Rs. 30 per transaction
  • Above Rs. 5 lakhs - maximum Rs. 55 per transaction

ECS Credit - one-to-many (single debit, multiple credit)
ECS Credit facility is used by an institution, where it needs to pay several recipients on a regular basis (may be monthly). Here single debit is made on the payers account and multiple credit is made to the beneficiaries or recipients.
For example, for paying salary, dividend, pension, etc. one can use this ECS Credit facility (e.g., employers account is debited once, and several employees are paid salary, by crediting their accounts)

ECS Debit - many-to-one (multiple debit, single credit)
ECS Debit facility is used by an institution, for raising debits to a large number of accounts. E.g., bill payment for consumers of utility services (like electricity bills deducted from bank accounts of several customers, and credited to the electricity supplier's account), periodic investments in mutual fund, insurance premium, etc.

Note, that there are several other payment systems, like Immediate Mobile Payment System (IMPS, need to register mobile number), Aadhaar-enabled Payment System (AEPS, need an Aadhar card), etc. 

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Revenue, Fiscal and Primary Deficits

Revenue Deficit
For every financial year, government plans a budget. Government needs to predict how much it hopes to earn as revenue and how much to spend as expenditure.
Suppose, for a financial year, government predicts to earn revenue of Rs. 525 crore (just a figure to understand) and expects to spend Rs. 400 crore. Then the predicted Net Revenue will be predicted revenue minus predicted expenditure, i.e., Rs. (525 - 400) crore = Rs. 125 crore.

Note that this is just a prediction or expectation. After that financial year, the government calculates that it earned Rs. 500 crore as revenue and spent Rs. 420 crore (expenditure). Therefore, the actual Net Revenue is calculated as Rs. (500 - 420) crore = Rs. 80 crore.

You can see, that the government expected to earn a Net revenue of Rs. 125 crore, but actually it earned Rs. 80 crore. This mismatch is known as Revenue Deficit. The reverse case is Revenue Surplus (when predicted Net revenue is greater than the actual one)

You must notice that the government may not have an actual loss of revenue (in this case actual revenue is greater than actual expenditure, that means profit, not loss).

Same concept goes for business too.

Fiscal Deficit
In the Revenue Deficit/Surplus, deficit or surplus was calculated on the predicted and actual Net Revenue.
But, if the government actually makes the deficit, then we are talking about Fiscal Deficit. That means, if the government spends more than it earns in a financial year, then (obviously) the expenditure is greater than the revenue, leading to the Fiscal Deficit.

Note Fiscal Deficit means actual loss of revenue, while Revenue Deficit can mean actual loss, or actual profit, for the financial year.

Also note that, while calculating Fiscal Deficit, we need to exclude the borrowings of the government (because it certainly is not actual revenue, its a debt, that the government needs to pay back to the lender/investor)

Primary Deficit
After borrowing from the investors, government needs to pay interest on the borrowings. If these interests are deducted from the Fiscal Deficit, then we get the Primary Deficit

Fiscal Responsibility and Budget Management Act (FRBM), 2003
FRBM Act was legislated to institutionalize financial discipline and improve macroeconomic and public fund management, reduce fiscal deficit, by making a balanced budget. It was introduced by former finance minister Shri Yashwant Sinha.

The goal was to - 
  1. Eliminate Revenue Deficit of the country
  2. Build Revenue Surplus thereafter
  3. Then bring down the Fiscal Deficit to a manageable 3 % of GDP, by March 2008.
But it was suspended due to the international financial crisis (recession) of 2007.

Current scenario and targets
Finance Minister Shri Arun Jaitley promised in Union Budget 2014, to lower the fiscal deficit to 3.6 % of GDP by 2015-16, and 3 % by 2016-17 to meet the original target of 3 % of GDP set by FRBM Act.

For current fiscal year (2014-15), the government may be able to meet the fiscal deficit target of 4.1 % of GDP.

Hope this post will help you understand the concepts.
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Wednesday, February 4, 2015

Mutual Funds (MF)

Suppose you have surplus money after your monthly expenses. Now you want to invest those money to earn a good profit. But the problem is you don't know where and how much to invest, and you don't know the risks involved in buying shares. Even you may not know which company is better than other and less riskier to invest. In general, you may not have sufficient expertise in investment.

So it is better to seek help of some expert, than taking risk of self investment. Here comes the job of a Mutual Fund (MF). MFs are managed by professionals, who know very well where and how much to invest (as they are experienced in this field, but you are not, your expertise is elsewhere).

Mutual Fund pools money from several investors and then invests those money categorically to several investment securities, like stocks, bonds, short-term money market instruments, precious metals (e.g., gold), etc.

You will invest in a Mutual Fund (MF), and will forget about it. Professionals will manage the investments, and you will get your return after a certain period of time. You don't require to pay constant attention, you just let the portfolio manager (professional) make essential decisions for you.

Also, note that there is another reason for you to invest in MF - you have tax saving options on return amount, if you invest in a Mutual Fund.

MF structure
An MF is set up in the form of a trust that has a Sponsor, Trustees, Asset Management Company (AMC).

  • Sponsor - The trust is established by a sponsor (you can think it, like a promoter of a company). The Trust needs to be registered with SEBI (regulator of Capital Market).
  • Trustees - Trustees hold property of MF for the benefit of unit holders (you are one of those unit holders)
  • Asset Management Company (AMC) - AMCs manage the fund and makes investment in various types of securities (you don't need to take decisions, they will). AMCs should be approved by SEBI.
Note that, the trustees have the authority to provide direction over the AMC, and they monitor the performance and compliance of SEBI rules and regulations by the mutual fund.

Net Asset Value (NAV)
NAV is the total value of fund assets, excluding liabilitiesper unit of the fund, which is calculated by the Asset Management Company (AMC) after every business day. This is also known as bid value. It represents an MF's per share market valueInvestors buy fund shares at this price  (bid price, or NAV). 

NAV = (Current market value of all Assets - all Liabilities) / no. of unit outstanding shares

For an example, suppose an MF has assets of Rs. 100 lakh and liabilities of Rs. 20 lakh, and has total 4 lakh shares outstanding. Then the NAV or bid price (price per share value) would be
(100 - 20) / 4 = Rs. 20 per share

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Capital Market - Part I

While Money Market deals with short-term (up to 1 year) funds, Capital Market deals with medium and long term (more than 1 year) funds. It refers to all facilities and institutional arrangements for borrowings and lending medium and long term funds.

Borrowers - private business corporations, PSUs, government, etc.
Lenders - individual, institutional investors, banks, financial institutions, government, etc.

Capital Market
Capital market is the part of a financial market, where companies that need capital for its business purpose, issue stocks or bonds to the investors and raise money. Investors invest in capital market to earn profit from its investment.

They have two options for investment - either buy equity (stock) instrument, or debt (bonds, debentures) instrument. (Refer my previous post on Equity & Debts)

Primary and Secondary Market
Sometimes, a company directly approaches a market to get some investment and raise capital. For this purpose, they can work with lead managers or merchant bankers, who help them to raise money.
If investors directly provide money to the company (meaning, company raises capital directly from investors), then it means that the trading is in Primary Market.

After an investor has shares or bonds (whatever instrument he/she bought from the company in Primary Market), can sell his/her shares/bonds to other investors. All consequent buying or selling will be traded in the Secondary Market (meaning, investors doesn't buy instruments directly from the company in a Secondary market).

Issues in Primary Market
There are several type of Issues in a Primary market -

1.  Initial Public Offering (IPO) - A company when first time wants to raise money from the market, issues shares to the general public (meaning, previously shares held only by the founding members, or the company itself). This first time share issue is known as Initial Public Offering (IPO).
After IPO, the company becomes a public company, because the general public is also the shareholder/stakeholder of the company. It is now listed in one or more stock markets for trading in Secondary Market.

2. Follow-On Public Offering (FPO) - After sometimes (after IPO), suppose, the company again wants to issue shares (shares held by company) to the public, then it will be known as Follow-On Public Offering. Note that this is done in Primary Market (investors buy directly from company), not in Secondary market (investors buy from other investors, or stock markets)

Confusion - Don't confuse FPO as Secondary Market offering. As I discussed earlier, that Secondary market deals only within the investors, not with the company, whereas, IPO and FPO work between the company and the investor (hence in Primary Market).

Company in need of capital, can raise money, by issuing shares to its existing shareholders, or to non-shareholders. 

3.  Rights Issue If the company issues shares to existing shareholders in per share basis, then the percentage stake will not be diluted. This is known as Rights Issue.
For an example, suppose a company issues 1:3 Rights Issue @ Rs. 50/share. It means an existing shareholder having 3 shares already can buy 1 new share at Rs. 50. Note that the percentage stake is not diluted, because every shareholder again holds the same percentage of shares.

4.  Preferential Issue - If the company issues shares to some other selected (preferred) people who is not an existing shareholder, then it will be known as Preferential Issue. Note that percentage stake is diluted here, because new person becomes shareholder.

Trade in Secondary Market
After the IPO, investors have the securities they bought, and the company has the money/capital. The company then lists the securities on one or more Stock Exchanges (like BSE, NSE, Nasdaq, etc).
Companies apply to the respective stock exchanges to get their stocks listed, after paying a listing fee. Listing facilitates the subsequent buying and selling of the securities through current and prospective investors. This enables investors to make profits, reduce risks, invest in prospective growth areas, and so on (and making a lot of speculations! ups and downs in stock market)

Note that in Secondary market, investors can buy and sell their stocks from and to other investors.

Some Stock Exchanges -
Bombay Stock Exchange (BSE), National Stock Exchange (NSE), New York Stock Exchange (NYSE), NASDAQ, Japan Exchange Group, Euronext, London Stock Exchange, Hong Kong Stock Exchange, Deutsche Bourse, TMX Group, etc.

Hope this article will help to clear your doubts! Also you comment in the comment section below.
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Tuesday, February 3, 2015

Taxation & GST

Taxation in India
Taxes in India are levied by the Central government and the state governments. The authority to levy tax is derived from the Constitution of India.

Generally, there are two type of taxes -

  1. Direct Taxes - These are directly paid to the government by the taxpayer (individuals and organizations) e.g., Income tax (you pay directly to the government, as Income Tax File return, or Tax Deducted at Source (TDS)), Corporation Tax, Wealth Tax, etc.
  2. Indirect Taxes - These are indirectly paid to the government, and are applied on the manufacture or sale of goods and services. These are initially paid to the government by an intermediary, who then adds the amount of tax paid to the value of the goods and services, and passes on the total amount to the end user. e.g., Sales Tax, Service Tax, Excise Duty, VAT, etc.
Note that, Central Board of Direct Taxes (CBDT) generally controls the direct taxes, like Income tax, while Central Board of Excise and Custom (CBEC) generally controls indirect taxes like Customs, Excise, Service tax, Narcotics, etc.

Goods and Services Tax (GST)
GST is India's most ambitious indirect tax reform plan. Currently Indirect Taxes are levied by central and state governments in multiple stages of the supply chain, such as excise duty, sales tax, value added tax (VAT), etc. Moreover, the central and state governments (may) have different tax rates.

To bring all the indirect taxes under a single umbrella, goods and services tax (GST) is introduced.

Constitution Amendment
Hon'ble Finance Minister Shri. Arun Jaitley introduced Constitution Amendment Bill on GST in Lok Sabha, which proposes a new Article 246A in Constitution of India to confer powers both to the Parliament (Center) and the State legislatures (State) to make laws for levying GST on the supply of goods and services in the same transaction.

Center will compensate States for loss of revenue arising on account of implementation of the GST for a period of 5 years -
  • 100 % for first 3 years
  • 75 % in the 4th year
  • 50 % in the 5th year
GST purview
  1. Center level - Taxes like Central Excise Duty, Service Tax, Customs Duty, etc will be subsumed in GST
  2. State level - Taxes like VAT/Sales tax, entertainment tax, octroi and entry tax, luxury tax, etc. would be subsumed in GST.
All goods and services, except alcoholic liquor for human consumption, will be brought under the purview of GST. 

GST features
  • Both center and states will simultaneously levy GST across the value chain - Central GST (CGST) and State GST (SGST, at respective states)
  • The center would levy and collect the Integrated GST (IGST) on all inter-state supply of goods and services, and there will be seamless flow of input tax credit from one state to another state. 
  • GST rates will be uniform across the country, with some few exceptions may be.

GST advantages
  • Simple tax structure
  • Increased tax revenue collection
  • Competitive pricing
  • Boost in export 

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DEAF Scheme

There are several accounts in banks which are not operated for 10 years (or more), or there are deposits which are unclaimed for 10 years (or more). There is little possibility that the deposits will be reclaimed by the owner (as it is unclaimed for that long period).

RBI decided to acquire those unclaimed amounts and create a fund, which could be used for the good of the public. It amended the Banking Regulation Act, 1949, by adding Section 26A, which empowers RBI to establish the Depositor Education and Awareness Fund (DEAF).

All the unclaimed amounts in the banks need to be transferred within 3 months after becoming 10 years default, to the DEAF fund. Also note that the transfer is allowed only in electronic mode.

The goal of this DEAF fund is to promote depositor interest, like educating them, or creating awareness among them, or some other purpose.

Situational Question
If someone comes to your bank and claims for his/her deposit (which has already been transferred to DEAF fund, because it defaulted for 10 years), what will you do?

You will verify his/her claim, and after successful verification, will honor the claim.

Note that the bank would be liable to pay the amount to the depositor/claimant and claim refund of such amount from the DEAF fund (even after 10 years).

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Monday, February 2, 2015

Bank Assets and Liabilities

Bank Assets
Assets are something that you own, meaning you are the legal owner of the asset. Similarly, bank assets are those things that a bank owns. It can be physical property (like land, equipment, buildings, etc.) or financial property.

Banks generally have four types of assets -

  1. Physical Assets - These are relatively minor assets of banks, that generally doesn't earn money for bank. Physical assets include land, furniture, equipment, buildings, etc.
  2. Loans / Advances - These are the most important assets of bank, because these are the primary source of their earning. Banks get interest from the loans / advances they lend to customer.
  3. Reserves - Banks need to maintain some reserves, so that they can meet the demands of their customers and facilitate daily transactions (e.g., a customer comes to a bank, and demands to withdraw money, or encash a cheque. Banks need to maintain reserve in its vault to meet these).
  4. Investments - Banks invest some of its money in government securities, or other investment instruments (like, buying shares, etc.). Investments are less riskier than loan (loans can become NPA), and have less return (loans bear high interest return) for a bank.

Bank Liabilities
Liabilities are something that you owe, meaning assets (of some other person) you hold, which you need to return to its original owner. Similarly, bank liabilities are those things that a bank owes to its customers, or investors. It includes financial property and debts (for electricity, office supplies, employee wages, etc.)

Banks generally have several type of liabilities. (Note that this is not exhaustive list)
  1. Customer Deposits - These are the most important liabilities of a bank. These are the assets for customers, but liabilities for banks. Banks need to return the money on demand or after a maturity period.
  2. Certificate of Deposits (CD) - Banks issue Certificate of Deposits to the general public to raise money. These are also liabilities of a bank, because banks need to return the amount invested by the investor.
  3. Borrowings - Banks can borrow from other banks or financial institutions, including External Commercial Borrowings (ECB), which need to be returned. These are also liabilities of a bank.
  4. Other liabilities - There are several other type of liabilities, like wages, taxes, leases, pension obligations, etc.

(You can add more in these lists)
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Pre-2005 Banknotes and MG-2005 Series

Banknotes Series
Since Independence of India, three different series of banknotes are issued -

  1. Ashoka Pillar Banknotes - Issued in 1949
  2. Mahatma Gandhi (MG) Series 1996 - Issued in 1996
  3. Mahatma Gandhi (MG) Series 2005 - Issued from 2005 

MG Series - 2005 Banknotes
These series banknotes are issued in the denomination of Rs. 10, 20, 50, 100, 500 and 1000, and contain some additional new security features that MG Series-1996 doesn't have. Started from August 2005, MG Series - 2005 banknotes are currently being used in India.

It is very easy to distinguish MG-Series 2005 notes from its predecessors, because these notes bear the year of printing on the reverse side.

Withdrawal of Pre-2005 Banknotes
RBI changed the design of pre-2005 banknotes and introduce new security features primarily to minimize the risk of counterfeiting. So that the economy can be protected from counterfeiters or forgers.

Also, the withdrawal exercise is in conformity with the standard international practice of not having multiple series of notes in circulation at the same time.

Public can visit any bank branch, or RBI Issue Office to exchange pre-2005 banknotes.

Recently, the deadline of January 1, 2015 has been extended to June 30, 2015 by RBI.

Situational Question
RBI has given a deadline for the exchange of pre-2005 banknotes. What will happen to those notes (that will still remain in circulation) after the deadline? Will those remain a legal tender?

RBI has clarified that the public can continue to freely use those notes for any transaction and can unhesitatingly receive those notes in payment, as all such notes continue to remain legal tender.

But public is encouraged to exchange pre-2005 notes with MG Series-2005 notes.

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Base Rate

Base Rate System
Bank lends money to its customers by loans or advances or other credit facilities. It charges some interest on the lending credit. Does a bank need to follow any specific rules while providing money to its customers?

Yes, banks follow Base rate system, formulated by RBI. Base rate is the minimum chargeable interest for the credit sanctioned to the customer (meaning, no bank can offer loans to its customers below this interest rate).

Base rate system replaced the Benchmark Prime Lending Rate (BPLR) system on July 1, 2010.

Situational Question
Suppose you are an officer in a rural bank. A poor people comes in your branch seeking loan for his house (or some other reason). Can you offer him a loan, bearing interest below the Base Rate?

The answer is YES, if he is eligible for DRI scheme. (criteria described below)

There are some few exclusions, where you can grant loan below base rate, as -
  1. Differential Rate of Interest (DRI) Scheme beneficiaries
  2. Loans to bank's own employees (including retired employees)
  3. Loans to bank's depositors against their own deposits (e.g., granting loan on his own fixed deposit, etc.)

DRI Scheme
As per RBI guidelines, for lending under DRI scheme, banks are required to grant loans at concessional rate of interest to the eligible beneficiaries -
  • Family income ceiling per annum in rural and urban area should be less than Rs. 18,000 and Rs. 24,000 respectively
  • Borrower should not be benefited under any subsidy-linked schemes of government
  • Max. limit of loan - Rs. 15,000. For housing loan, it could be up to Rs. 20,000
  • Banks are required to lend 1 % of their total outstanding advances under DRI Scheme every year.

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Line of Credit (LoC)

Line of Credit (LoC) - What do we get from the term?
To what extent (i.e., line) we can get loan / advance (i.e., credit). Of course, LoC are generally given to the corporate for business purpose (though, often we hear news about government giving Rs. XXX Line of Credit to ZZZ country for development)

Note that this is generally given to corporate for business, on their Cash Credit (CC) Accounts (already discussed about CC in my previous post. Please refer that)

General Procedure
Banks analyze the audited Balance sheet of the prospective borrower (businessman) to appraise their needs and checking their capacity to absorb the credit. The borrowers need to furnish their financial details in the form of Credit Monitoring Arrangement (CMA) data to the bankers and file an application for loan.

This application is then processed by the bank and a suitable Line of Credit (LoC) (limit) is allowed to the borrower.

The overall limit (LoC) is structured into various types of facilities or accounts - each with its own limit under the overall LoC (meaning, several accounts, which to be formed, have their own limit, which collectively is under overall LoC).

The borrower is then asked to surrender the security or title to the bank (as collateral) and open suitable accounts (mostly Cash Credit Accounts, with different underlying securities) with the bank.

Thereafter, the borrower can operate these accounts within the limit, i.e., Line of Credit.

Note - Don't confuse Line of Credit with Letter of Credit, which is a different concept (refer to previous post on Letter of Credit)

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Cheque Truncation System (CTS)

As per Negotiable Instrument Act, 1881, each and every cheque is required to be presented to the drawee bank (paying bank) for the payment.

Earlier, cheques deposited by customers, used to be presented by the collecting bank (customer's bank) to the paying bank (cheque issuer's bank). Thus, it required the physical movement of the cheque from collecting bank to the paying bank, consuming a significant amount of time to clear the cheque. (Consider several cheque to be cleared in several paying banks! How much time it could take!)

Then, came the concept of Clearing house. Banks decided to meet in this clearing house, which acted as the central place and settle their net amounts of cheques. Thus it reduced cheque processing time because they need not visit several paying bank, taking several cheques.

Cheque Truncation System (CTS)
At present, we got a new concept of cheque clearing. Instead of sending the cheque physically by the collecting bank to the paying bank, an electronic image (scan copy, along with all necessary details) is transmitted to the drawee/paying bank for payment through the clearing house.

This reduced the time drastically, as CTS stopped the physical movement of cheque from one bank to another, and also the costs involved with it.

Grid-based CTS clearing
RBI implemented CTS in the National Capital Region (NCR) of New Delhi, Chennai and Mumbai with effect from February 1, 2008, September 24, 2011 and April 27, 2013 respectively.

After migration of the entire cheque volume from MICR system to CTS, the traditional MICR-based cheque processing has been discontinued in these 3 locations

Based on the advantages realized and experience gained, RBI decided to operationalize CTS across the country. Accordingly, Grid-based CTS clearing has been launched in these 3 locations. 
  1. New Delhi Grid - NCR of New Delhi, Haryana, Punjab, UP, Uttarakhand, Bihar, Jharkhand, Chandigarh
  2. Mumbai Grid - Maharashtra, Goa, Gujarat, MP, Chattisgarh
  3. Chennai Grid - Andhra Pradesh, Telengana, Karnataka, Kerala, Tamil Nadu, Odisha, West Bengal, Assam, Puducherry

CTS Clearing Cycle

Step 1 - The Collecting bank (or branch) captures the data (on MICR band), and the images of a cheque using their Capture System (comprising scanner, core banking or other application)
To ensure security, safety and non-repudiation of data/images, end-to-end Public Key Infrastructure (PKI) has been implemented in CTS.

Step 2 - The Collecting Bank sends the data and captured images duly signed and encrypted to the central processing location (Clearing House).
The Clearing House processes the data, and arrives at the settlement figure and transfers the images and requisite data to the Paying bank. This is known as presentation clearing.

Step 3 - The Paying Bank receives the images and data from the Clearing House for payment processing. The paying bank generates the return file for unpaid instruments. The return file/data are then sent to the Clearing House.

Step 4 - The return file/data is processed by the Clearing House in the return clearing session and in the same way as presentation clearing session. Then these are provided to the Collecting bank.

Step 5 - The Collecting bank processes the data received from Clearing House. The whole process is known as Clearing Cycle.

The Clearing Cycle is treated as complete once the Presentation clearing and the associated Return clearing sessions are successfully processed. 

Amendment in NIA Act, 1881 for CTS
RBI has confirmed that with amendments to Section 6 and 1(4) and with addition of Section 81A in the NIA Act, 1881, the truncation of cheques has been legalized.

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Sunday, February 1, 2015

Money Market - Part III

Please read previous posts on Money Market - Part I & II  (link in Blog Archive section)

Money Market Instruments (other than government issued)

1.  Call, Notice, Term Money
This is a method by which banks lend or borrow money from each other to maintain their daily needs. Note that no collateral security is needed, but interest need to be paid.

Call Money - deals in overnight (1 day) funds
Notice Money - deals in funds for 2 to 14 days
Term Money - deals in funds for 15 days - 1 year

Note that this is completely used in Inter-bank market. Eligible participants are -

  • Scheduled Commercial Banks (SCBs), excluding RRBs
  • Co-operative Banks, other than Land Development Banks
  • Primary Dealers (PDs)

2.  Certificates of Deposit (CD)
CDs are certificates issued by banks or other financial institutions (need to be qualified before issuing) to the general public, to raise short-term resources within the umbrella limit.

In the form of - Dematerialized (through Demat account) or Usance Promissory Notes

Issuer - Scheduled Commercial Banks (excluding RRBs), permit-granted Financial Institutions (FIs)
Issued to - individuals, corporations, companies (including banks), trusts, etc.

Maturity - Bank CDs (7 days - 1 year) and FI CDs (1 - 3 years)
Minimum size - Minimum amount of CD is Rs. 1 lakh, and multiple thereof

3.  Commercial Papers (CP)
CPs are unsecured instrument issued in the form of a promissory note (refer to my previous post to know more), that are issued by corporates.

In the form of - Promissory Notes

Issuer - Corporates, Primary Dealers (PDs), Financial Institutions (FIs). Note that all the corporates are not eligible for issuing CPs. They need a good rating (generally 'A-2', refer SEBI) from either rating agencies - CRISIL, ICRA, CARE, FITCH Ratings India Pvt. Ltd, etc.

Issued to - Individuals, banks, other corporates, NRI, FII (need SEBI approval)

Maturity - 7 days to 1 year
Minimum size - Minimum amount of CP is Rs. 5 lakh and multiple thereof

4.  Inter-Corporate Deposits (ICD)
These are issued by one corporate to other for their money requirements. You can think ICDs as analogous to Inter-bank deposits (call money, notice money, term money).

These are helpful for low-rated corporates, because they are not eligible to issue Commercial Papers (CP) to general public and raise money. So the alternative way for them, is to use ICDs.

This is not a full list. There are several other instruments in Money Market, that we are not discussing.

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Know Your Customer (KYC)

If you visit to a bank branch to open a bank account, you first need to let them know who you are, and where do you live. Without knowing these information, a bank will not open your account. This process of knowing about you (customer) is Know Your Customer (KYC).

It is obvious now, that KYC process has 2 components -
  1. Identity - Who are you?
  2. Address - Where do you live?
Two more things are necessary - your photograph and your signature / thumb impression (These two are the most important)

The government has notified 6 documents as 'Officially Valid Documents (OVDs) for the purpose of proving your identity -
  • Passport
  • Driving License
  • Voters' Identity Card
  • PAN Card
  • Aadhaar Card issued by UIDAI
  • NREGA Card
If these documents also contain your address, then no separate proof of address will be required. Otherwise, you need to provide another valid address proof.

Special case -
Suppose, you don't have any of the OVDs specified above to proof your identity. Then can you open an account?
The answer is YES
However, the account opened cannot be a normal account. It will be a limited facility account, termed as 'Small Account'. Limitations such as -
  • Balance at any point of time, shouldn't exceed Rs. 50,000
  • 1 year Total Credit shouldn't exceed Rs. 1,00,000
  • Total withdrawal and transfers shouldn't exceed Rs. 10,000 / month
  • Foreign remittances cannot be credited
Such accounts remain operational initially for a period of 12 months (1 year), and thereafter, for a further 1 year (if the holder can prove that he has applied for any of the OVDs in respective office within 1 year of opening the account).

Situational Question (asked in IBPS, SBI or other banking exams)
If a customer comes to your branch to open an account, but doesn't have any valid documents as proof of identity, then would you open an account for him?

The answer is YES (as you already know now!)
Take his photograph and make him sign or provide thumb impression. And tell him you are opening a 'Small Account' for him (also tell him about the limitations, and the need to submit valid documents within 1 year)
Please note that KYC should be completed within 1 year of opening Small Account, and KYC is mandatory.

Refer - RBI Press Release - Aug, 2014

It is electronic KYC. As the term means, here KYC will be done electronically (online). Note that it is possible only (or atleast for now) for those who have valid Aadhaar numbers with them. 

You have to authorize the UIDAI (the issuer of Aadhaar card), by explicit consent, to release your identity / address through biometric authentication to the bank branches (or, business correspondents (BC)).

UIDAI then will transfer your data (that was taken from you when you applied for Aadhar card) to the bank, and KYC will be done electronically.

If you have any query or doubt regarding this post, please feel free to ask (by commenting).
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Joint Liability Group (JLG)
Before understanding JLG, you have to know, what are different types of liability.

  • Jointly Liable - Suppose, two ore more persons have some liability (e.g., taken a loan). Then for a jointly liable system, they each are fully liable to the loan (meaning if one is unable to pay, then other is fully liable to pay the whole amount of loan)
  • Severally Liable - In this type of liability, each is liable only to his own portion of the liability (i.e., loan) (meaning if one is unable to pay for whatever reason, other will not be sued, or bothered, he will be liable for only his portion of loan)
Therefore, JLG is an informal group (comprising around 4-10 person) for the purpose of availing bank loan on individual basis (Severally Liable) or through group mechanism against mutual guarantee (Jointly Liable).

Generally, the members of JLG would engage in a similar type of economic activity in the Agriculture and Allied Sector. The members would offer a joint undertaking to the bank that enables them to avail loans. They support each other in carrying out their occupational and social activities.

Self Help Group (SHG)
SHG is a small voluntary group (less that 20) of poor people, generally from the same economic background. They promote small savings among their members, and make a common fund, which is kept in a bank

SHGs comprise poor people, and they generally do not have access to formal financial institutions (banks). So this concept helps them to directly connect with banks. Also they act as the forum for the members to provide space and support each other. 

Currently there are several SHG bank linkage program for this purpose.

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Nowadays, bank operations are not confined within a national border. Banks are opening branches in foreign countries. But the problem is - Is it possible for a bank to open branch in each and every country?
Obvious answer is no. Then what is the easiest way to handle this situation?

Open an account in the foreign countries' bank!!
Here Nostro, Vostro and Loro accounts come into play. Note that all these accounts are termed as one's own country-basis.

NOSTRO Account
Italian word 'nostro' means 'ours'. Hence, Nostro account points at - "Our account with you"
Nostro accounts are generally held in a foreign country (with a foreign bank), by a domestic bank (from our perspective, our bank). It obviates that account is maintained in that foreign currency.

For example, SBI account with HSBC in U.K. (may be)

VOSTRO Account
Italian word 'vostro' means 'yours'. Hence, Vostro account points at - "Your account with us"
Vostro accounts are generally held by a foreign bank in our country (with a domestic bank). It generally maintained in Indian Rupee (if we consider India)

For example, HSBC account is held with SBI in India. (may be)

LORO Account
Again, Italian word 'loro' means 'theirs'. Therefore, it points at - "Their account with them"
Loro accounts are generally held by a 3rd party bank, other than the account maintaining bank or with whom account is maintained.

For example, BOI wants to transact with HSBC, but doesn't have any account, while SBI maintains an account with HSBC in U.K. Then BOI could use SBI account. (again may be)

Hope this post is able to clear your doubts!
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