Theories of Mergers and Acquisitions
Reasons or theories for M & A
Many theories exist to explain the reasons of mergers and acquisitions.
Reason may be due to increase buying power with suppliers, backward integration, achieve distribution net work etc.
One common desire – strength the existing business and create growth /synergy.
These explanations have later become testable hypotheses/theories.
But, acquirers have their own agenda which is not visible to market. It may be over confidence/personal gain etc.
Reasons or theories for M & A
WHY are some corporate heads so gung-ho about mergers and acquisitions (M&A) when the empirical evidence available strongly suggests that the value created by these exercises accrues almost completely to shareholders of the target company rather than to those of the acquiring firm?
If the popular assumption that corporate chiefs act rationally is valid, why do so many mergers and acquisitions nevertheless take place? Does this mean that the assumption about the rationality of all corporate heads may, not be entirely valid?
These are some of the questions addressed in a recent study titled Who Makes Acquisitions? CEO Overconfidence and the Market's Reaction, by Ulrike M. Malmendier, assistant professor of finance at the Graduate School of Business, Stanford University, and Geoffrey A. Tate, assistant professor of finance at the Wharton School of the University of Pennsylvania.
Reasons or theories for M & A
In their study, which has been in circulation in the US as a National Bureau of Economic Research working paper, the authors argue that "overconfidence among acquiring CEOs is an important explanation of merger activity", which they describe as "among the most significant and disruptive activities undertaken by large corporations."
Reasons or theories for M & A
Strategic realignment. Due to dynamically changing environment, mergers provide perhaps fastest route to respond the changes in industry and market.
Undervaluation by market. This means the target is generally undervalued by the market. This may not be due to inefficiency of the target and that is what differentiate this theory from the inefficiency theory. The undervaluation may be only due to non-release of private information which only the bidder have at that point of time.
Information and signaling. There are two versions of this theory. Sitting on the golden mine. The tender offer by a bidder it self signifies undervaluation and lead to revaluation of shares by market.
Second, kick in the pants, which means, the offer itself inspires the target to implement more powerful strategy. The tender offer on target firm signals that there is a potential untapped in the target. Use of stock by bidder to finance acquisition, means, one, stock is over valued and second, the expected benefits from the acquisition is not certain.
Reasons or theories for M & A
Agency and managerialsm. As explained earlier, managers initiate mergers to gain private benefits from the transaction irrespective of loss (or loss of profit) to the shareholders. Managers also tend to involve in mergers as they tend to be arrogant or overconfident about the success of the deal and land up entering into often inefficient transactions. This is also called HUBRIS hypothesis.
Market power. Mergers are initiated by dominating the market. This is different from economies of scale discussed earlier. Increased relative market share of the bidder provides it a potential to realize monopoly gains.
Through market power, a firm gets the ability to set prices at levels that are not sustainable in competitive market. E.G. WALL Mart.
Market power can be achieved through product differentiation, entry barriers and market share.
Reasons or theories for M & A
The q – ratio and buying under valued shares.
The q ratio is defined as ratio of market value of acquiring firm’s shares to the replacement cost of its sales.
Firms which are interested in expansion always look to acquire a firm whose market value is less than the replacement cost of its assets. This is the main reason more M & A in 1970s since inflation and high interest rates hiked up the replacement cost. Further, time involved in acquiring the cost.
E.g. TATA- CORUS – it would have taken 30 years for TATAs to build the green field plant similar to the size of CORUS – Mr. Muthuraman, CMD, TATA Steel.
Reasons or theories for M & A
The valuation theory: Acquisitions or mergers are carried out by executives who have access to more accurate information on the real value of the company to be taken over than can be found from the investment market.
* The empire-building theory: managers who are responsible for formulating and applying strategies, have one aim in mind: to maximize their use.
Theories of M & A
The process theory: attempts to justify acquisitions and mergers by attributing them to
the limited rational of management teams that
make this decision, without bothering to carry
out a deeper analysis of the alternatives.
The economic disturbance theory: acquisitions
and mergers succeed one another in waves.
They are caused by economic disturbances that
modify individual behavior patterns and expectation
Differential efficiency theory
It is nothing but extension of managerial synergy. Theory assumes that management not performing up to potential.
According to this theory, if one firm is more efficient than the other , efficient shall acquire less efficient firm and bring it up to level of own standards. It is question of relativity in efficiency
Underlying logic/reasoning – less efficient is more vulnerable since efficient will identify such firms. It will help to utilize surplus resources and improve the less efficient firm’s performance. Thus , merger may create synergy since surplus managerial resources of the acquirer combine with non managerial capital of acquired firm.
E.g. Jet & Sahara Airways.
Some times firms looking for diversification compulsion (due to saturation in own industry/country),may try to gain foot hold in another industry so that acquiring firm's organizational capital can be exploited.
Caution – acquiring firm is over optimistic and over estimation to improve firm’s performance. This may result in over estimation of value also and performance not happening as per assumptions.
Inefficient management theory
Inefficient management means incompetent in complete sense.
It could be the basis for conglomerate mergers.
Another firm is in position to manage more efficiently.
This is the strategy of L N Mittal – acquiring weak firms and make them viable and profitable
Synergy Theory
One of the main reasons for M & A is synergy which may arise in
1.Finanacial synergy -
2. Operating synergy – King Fisher – Air Decan
3. Cross border synergy – Birla acquiring Novalis , an American company who has the client base of Pepsi, Coke etc
4. Distribution synergy - P & G & Gillette
5. R & D synergy. TATA - CORUS
Synergy Theory – expects that there is really “something out there” which enables the merged entity to create shareholders value
Simply defined, it means that the whole is greater than the sum of the individual parts
Drivers of Synergy
Synergy - WHAT IS IT?
*Popular definition: 1 + 1 = 3
*Roundabout definition: If am I willing to pay 6 for the business market-valued at 5 there has to be the Synergy justifying that
*More technical definition: Synergy is ability of merged company to generate higher shareholders wealth than the standalone entities
Synergy
Means type of benefit that may happen when 2 firms may create more value which is greater than the individual values of both.
It means 2+2 = 5
in anticipation of such synergy, acquirer is prepared to pay premium and incur acquisition expenses.
NAV = VAB (VA + VB) – P – C
VAB = combined value of 2 firms.
VB = market value of firm B
VA = market value of firm A
P = premium paid for B
C = Cost of acquisition
Synergy – failures
operating synergy.
This states that even when both the target as well as bidder are equally efficient, simply combining their resources would lead to synergistic benefits due to economies of scale and complementary benefits. Thus, mergers are driven by synergy.
It may result in economies of scale. Individually it may not be possible to exploit such synergy.E.g. spreading of fixed cost over increasing level of production in a industry having substantial over head expenses.
Operating economies of scale is achieved through Horizontal, Vertical and conglomerate mergers. Operating economies may occur when fixed assets such as men. Material are indivisible.
E.g. an expensive equipment in a pharma company.
operating synergy.
Operating economies may be achieved through R & D , marketing etc.
E.g. P&G marketing skill with Gillette distribution net work will give an competitive edge vis-à-vis HLL & Colgate & Unilever in global market.
Operating economies is achieved through in management for planning and controlling since it requires minimum staff to get that. A mid size firm may not have that. But acquirer may have that.
Vertical merger ( acquiring a supplier) may save in terms of price, time etc. E.g. RIL & RPL.
Financial synergy
Tax saving
Increasing the debt capacity
Companies with different cash flows – if cash flows are not perfectly co related , it may reduce the risk. Instability in cash flow may reduced by acquired firm. E.g. Conglomerates – one cyclical and another in non cyclical industry.
Diversification
Diversification.
This is based on principle of diversification per se. Diversification may have value in reducing the risk of overall business portfolio. Demand for diversification may be by managers, employees, for preservation of organisation, and reputation capital.
Diversification through external growth rather than internal is preferred because firm may lack internal resources or capabilities.
Diversification
Employees – employees have a specific skill set developed over a period of time and it is only valuable only to that firm No alternative employment . But share holders can diversify. Employees seek job security , stability and growth. These needs to be fulfilled through diversification.
Owner manager - diversify and reduce risk but also keep corporate control.
Firm and employees – firm has full information on employees about skill profile. It may shift from un productive activities to productive ones through diversification
Financial and tax benefits – utilize huge cash surplus . Reduce tax liability etc.
Cost & benefit of M & A
A plans to acquire B.
Merger is expected to bring in PV of Re 10 million.
A offers 2,50,000 shares in exchange for 5,00,000 shares of to B share holders
Cost and benefit
Cost = aPVAB – PVB
a represents a fraction of the combined entity received by share holders of B.
Share of B in the combined entity is
A = (2,50,000/ (10,00,000+2,50,000)) = 0.2
PVAB = PVA + PVB + Benefit.
= 100 +20+10 = Re 130 Million
Cost = aPVAB – PVB = 0.2 x 130 – 20 = 6
NPV to A = benefit – cost = 10-6= Re 4 million
NPV to B = Re 6 million
Changing business environment
Change in business environment may necessitate M & A.
Changing environment may include regulatory, tax, technology / Globalization impact etc.
E.g. Banking/Insurance/Telecom/ Pharma /FMCG/Aviation etc
Some times the firm may have limited period of growth.
Adjustment through internal adjustment may take time. So, external acquisition will help to reduce time involved.
Otherwise, competitors may exploit the situation
Sunday, December 12, 2010
Financial Markets and Institutions-DEBT market
DEBT MARKET –Why?
For financing Govt.- short t & long
Long term assets for pension funds
Risk diversification
Less reliance on bank credit for corporates
To manage Monetary policy by RBI – controlling inflation or deflation. E.g. recent hike in REPO and CRR.
What is debt market?
Market for issuance , trading and and settlement in fixed/floating income (debt) securities.
Securities can be issued by Central & State government,PSU,Banks, FIs & corporates etc
Securities include Government/PSU/Corporate debt.
Government debt – G-Sec/T-bills.
Public sector undertakings – bonds/debentures/ certificate of deposits etc
Corporates (PVT. Banks/Corporates) – commercial paper/bonds / debentures etc
Indian Debt market
Size of global market is around $ 31.4 trillion.
US bond market is around 13.5 trillion and the largest one.
Total size of Indian debt market is estimated to be $ 92 to 100 bn which is 30% of GDP.
Indian debt market is primarily a whole sale market and restricted to institutional investors.
RBI regulates Government debt and short term Money market instruments (up to one year) and SEBI regulates debt market (instruments having a maturity period of more than 1 year )
Primary dealers
PD can be referred as Merchant bankers to GOI
Functions –
Commit participation as principals in GOI issues through bidding process
Provide under writing services
Offer firm buy-sell/bid-ask quotes for T.Bills/dated securities
Development of secondary Debt market
Products in the Debt market
Debentures: Bonds issued by a company bearing a fixed rate of interest usually payable half yearly on specific dates and principal amount repayable on particular date on redemption of the debentures. Debentures are normally secured/ charged against the asset of the company in favour of debenture holder.
Bond: A negotiable certificate evidencing indebtedness. It is normally unsecured. A debt security is generally issued by a company, municipality or government agency. A bond investor lends money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified maturity date. The issuer usually pays the bond holder periodic interest payments over the life of the loan. The various types of Bonds are as follows-
Zero Coupon Bond: Bond issued at a discount and repaid at a face value. No periodic interest is paid. The difference between the issue price and redemption price represents the return to the holder. The buyer of these bonds receives only one payment, at the maturity of the bond.
Convertible Bond: A bond giving the investor the option to convert the bond into equity at a fixed conversion price.
Products in Debt market
Commercial Paper: A short term promise to repay a fixed amount that is placed on the market either directly or through a specialized intermediary. Issued at discount and redeemed at par
It is usually issued by companies with a high credit standing in the form of a promissory note redeemable at par to the holder on maturity and therefore, doesn’t require any guarantee.
Commercial paper is a money market instrument issued normally for a tenure of 7 days and up to 1 year
Treasury Bills: Short-term (up to 14/91/182/364 days) bearer discount security issued by the Government as a means of financing its temporary cash requirements.
Certificate of deposit – issued by banks for short term borrowing. 7 days to 1 year with a minimum amount of Re 1.00 lacs. Mainly in OTC market.
Products in Debt market
Government securities (G-Secs): These are sovereign (credit risk-free) coupon bearing instruments which are issued by the Reserve Bank of India on behalf of Government of India, in lieu of the Central Government's market borrowing programme.
These securities have a fixed coupon that is paid on specific dates on half-yearly basis. These securities are available in wide range of maturity dates ( up to thirty years).
Government debt
Central
State
Local bodies
Instruments – dated securities,T.Bills, Capital index bonds, etc
RBI – Nodal agency to raise funds
Covers major segment of debt market
Participants in the Debt market
Central/State Govt/local bodies
RBI
Primary dealers – develop G sec market & also underwriters
PSUs
Corporates
Banks/FIs/FIIs/MFs/PF
Trust/Societies
Rating agencies
G-SEC –Central Govt.
Object – to fund fiscal deficit & temporary liquidity crunch
Intermediary - RBI
Instruments – mainly dated securities(1-20 yrs) &T.Bill(14,91,182 & 364 days)
SGL – Subsidiary General Ledger. Record of holding securities in the name of various investors by RBI in “D” mat form (electronic form)
Constituent SGL
Price/Coupon based on auction system
Indian Debt market
Retail trading in G-Sec started from 16.01.03. as per guidelines of SEBI.
G-Sec auctions with a reservation of 5% of the issue amount for non competitive bids by retails investors.
Non competitive bidding is open to individuals/HUFs/firms/companies/corporate bodies/PF/trust etc as prescribed by RBI.
Requirement not more than 1 crore and do not have SGL a/c (securities General Ledger a/c) with RBI
Apply through PD/Bank
Minimum bidding Re 1o,ooo and multiples thereof.
Money market
Market –maturity profile of instruments vary from 1 day to 1 year
Call money – over night/ Notice money – 1-14 days and term money > 15 days to 1 year.
Purpose – to mange short term liquidity
Participants –Banks/NBE (lending only)
Not meant for corporates
Transactions –unsecured OTC – to fund short term requirements e.g.. reserve requirements, build up of short term funds etc
Call rates – short term liquidity conditions influence –supply side- deposit mobilization, capital inflows, etc.
Demand side – tax outflows, Govt. borrowings, credit off take, reserve requirements etc
Money Market Instruments(2)
Certificates of Deposit
Commercial Paper
Inter-bank participation certificates
Inter-bank term money
Treasury Bills
Bill rediscounting
Call/notice/term money
CBLO
Market Repo
Money market instruments
T-Bill – 14/91/182/364 days.
REPO (Repurchase option)/RRPO ( Reverse Repurchase option
Certificate of deposit- by banks for a period of 7 days to 1 year
Commercial paper
Call – over night
Notice money – >1 to 15 days mainly among banks
Term money – maturity 15 days & up to 1 year
Issue of G-Sec trough auction
Securities are issued through auction (by RBI) either on price or yield basis.
Where the issue is price basis, coupon is predetermined and bidders quote price per Re 100 face value of the security.
Where the issue is yield basis, coupon of the security is decided in the auction.
On the basis of bids received, RBI detemines the cut off price or yield.
Allotment – Uniform price (Dutch auction) or Differential (French auction )
Non competitive bidding (RBI guidelines)
Introduced from Dec,2001.
Eligibility: Participation on a non-competitive basis in the auctions of dated GOI securities will be open to investors who satisfy the following:
1. do not maintain current account (CA) or Subsidiary General Ledger (SGL) account with the Reserve Bank of India.
Exceptions: Regional Rural Banks (RRBs) and Cooperative Banks shall be covered under this Scheme in view of their statutory obligations.
2. make a single bid for an amount not more than Rs. two crore (face value) per auction
3. submit their bid indirectly through any one bank or PD offering this scheme.
Exceptions: Regional Rural Banks (RRBs) and Cooperative Banks that maintain SGL account and current account with the Reserve Bank of India shall be eligible to submit their non competitive bids directly.
Coverage: Subject to the conditions mentioned above, participation on "non-competitive" basis is open to any person including firms, companies, corporate bodies, institutions, provident funds, trusts, and any other entity as may be prescribed by RBI. The minimum amount for bidding will be Rs.10,000 (face value) and thereafter in multiples in Rs.10,000 as hitherto for dated stocks.
Allotment under the non-competitive segment to the bank or PD will be at the weighted average rate of yield/price that will emerge in the auction on the basis of the competitive bidding. The securities will be issued to the bank or PD against payment on the date of issue irrespective of whether the bank or PD has received payment from their clients.
Non competitive bidding (RBI Guidelines)
In case the aggregate amount of bid is more than the reserved amount (5% of notified amount), pro rata allotment would be made. In case of partial allotments, it will be the responsibility of the bank or PD to appropriately allocate securities to their clients in a transparent manner.
In case the aggregate amount of bids is less than the reserved amount, the shortfall will be taken to competitive portion.
Security would be issued only in SGL form by RBI. RBI would credit either the main SGL account or the CSGL account of the bank or PD as indicated by them. The facility for affording credit to the main SGL account is for the sole purpose of servicing investors who are not their constituents. Therefore, the bank or PD would have to indicate clearly at the time of tendering the non-competitive bids the amounts (face value) to be credited to their SGL account and the CSGL account. Delivery in physical form from the main SGL account is permissible at the instance of the investor subsequently.
It will be the responsibility of the bank or the PD to pass on the securities to their clients. Except in extraordinary circumstances, the transfer of securities to the clients shall be completed within five working days from the date of issue.
Liquidity Adjustment facility
Collateralized Lending Facility – for Banks & PDs
Purpose- to meet day to day liquidity mismatches in the system
REPOS & Reverse REPOs through auctions by RBI
REPO – liquidity is pumped in to the system and vice versa for reverse REPO. E.g. RBI lends money to market.
RREPO – RBI borrows from the market.
Tenor – 1 to14 days
Bench mark for short term money market rates
Liquidity Adjustment facility
Conducted on daily basis (Monday to Friday excepting holidays)
Rate of interest – fixed.
Pricing of securities will be at face value.
Minimum bid size Re 5 cr
Participants- Sch.commercial banks,PDs, having current and SGL with RBI.
Eligible securities – SLR securities of GOI.
Membership
Why CBLO ?
The drawback, of course, in the `Repos' is that there is no flexibility, as the obligations can be squared up only on the due date.
Even if the borrower's liquidity position improves, he cannot `prepay'.
If the lender's position dries up and forces him to call back the money, he cannot call back his lending.
CORPORATE DEBT
In vogue since 1980 and interest rates regulated
Regulator – SEBI – SE traded debt
RBI – OTC traded debt
Different structures –Debentures, NCD, CP,Deep discount bonds,secured promissory notes etc
Mostly private placement
Corporate debt – SEBI guidelines
The issue of debt securities having maturity period of more than 365 days by listed companies (i.e. which have any of their securities, either equity or debt, offered through an offer document, and listed on a recognized stock exchange and also includes Public Sector Undertakings whose securities are listed on a recognized stock exchange) on private placement basis must comply with the conditions prescribed by SEBI from time to time for getting them listed on the stock exchanges.
Further, unlisted companies/statutory corporations/other entities, if they so desire, may get their privately placed debt securities listed on the stock exchanges, by complying with the relevant conditions. Briefly, these conditions are
Corporate debt – SEBI guidelines
Compliance with disclosure requirements under Chapter VI of the SEBI (Disclosure and Investor Protection) Guidelines, 2000, Listing Agreement with the exchanges and provisions of the Companies Act.
Such disclosures may be made through the web site of the stock exchanges where the debt securities are sought to be listed if the privately placed debt securities are issued in the standard denomination of Re. 10 lakhs.
The company shall sign a separate listing agreement with the exchange in respect of debt securities.
The debt securities shall carry a credit rating from a Credit Rating Agency registered with SEBI.
Corporate debt – SEBI guidelines
The company shall appoint a debenture trustee registered with SEBI in respect of the issue of the debt securities.
The debt securities shall be issued and traded in Demat form.
All trades with the exception of spot transactions, in a listed debt security, shall be executed only on the trading platform of a stock exchange.
Why corporate market is not growing?
In local markets, dealers call it dead market. Why?
Average annual issuance Re 70,000 cr and daily volumes is around Re 100 cr.predominantly through private placement.
Institutions appetite especially banks is low. Lending to corporate attracts lower riks provisions unlike investing in bonds where the bank face the risk of taking hit when bonds yield rise.
Lower rated issuers find it difficult to play ie in SE due to stringent listing norms
Lack of exit route due to liquidity since there is no active market for trading.
Banks lend at attractive sub PLR rates.
Regulatory arbitrage - Raising a loan in over seas is lot easier than in domestic market.
What is the need for corporate debt market?
Corproates need diversified funding sources.
Entities like provident fund and insurance funds to diversify for risk management and returns
Banks do not all the money to meet corporate demand.
For financing Govt.- short t & long
Long term assets for pension funds
Risk diversification
Less reliance on bank credit for corporates
To manage Monetary policy by RBI – controlling inflation or deflation. E.g. recent hike in REPO and CRR.
What is debt market?
Market for issuance , trading and and settlement in fixed/floating income (debt) securities.
Securities can be issued by Central & State government,PSU,Banks, FIs & corporates etc
Securities include Government/PSU/Corporate debt.
Government debt – G-Sec/T-bills.
Public sector undertakings – bonds/debentures/ certificate of deposits etc
Corporates (PVT. Banks/Corporates) – commercial paper/bonds / debentures etc
Indian Debt market
Size of global market is around $ 31.4 trillion.
US bond market is around 13.5 trillion and the largest one.
Total size of Indian debt market is estimated to be $ 92 to 100 bn which is 30% of GDP.
Indian debt market is primarily a whole sale market and restricted to institutional investors.
RBI regulates Government debt and short term Money market instruments (up to one year) and SEBI regulates debt market (instruments having a maturity period of more than 1 year )
Primary dealers
PD can be referred as Merchant bankers to GOI
Functions –
Commit participation as principals in GOI issues through bidding process
Provide under writing services
Offer firm buy-sell/bid-ask quotes for T.Bills/dated securities
Development of secondary Debt market
Products in the Debt market
Debentures: Bonds issued by a company bearing a fixed rate of interest usually payable half yearly on specific dates and principal amount repayable on particular date on redemption of the debentures. Debentures are normally secured/ charged against the asset of the company in favour of debenture holder.
Bond: A negotiable certificate evidencing indebtedness. It is normally unsecured. A debt security is generally issued by a company, municipality or government agency. A bond investor lends money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified maturity date. The issuer usually pays the bond holder periodic interest payments over the life of the loan. The various types of Bonds are as follows-
Zero Coupon Bond: Bond issued at a discount and repaid at a face value. No periodic interest is paid. The difference between the issue price and redemption price represents the return to the holder. The buyer of these bonds receives only one payment, at the maturity of the bond.
Convertible Bond: A bond giving the investor the option to convert the bond into equity at a fixed conversion price.
Products in Debt market
Commercial Paper: A short term promise to repay a fixed amount that is placed on the market either directly or through a specialized intermediary. Issued at discount and redeemed at par
It is usually issued by companies with a high credit standing in the form of a promissory note redeemable at par to the holder on maturity and therefore, doesn’t require any guarantee.
Commercial paper is a money market instrument issued normally for a tenure of 7 days and up to 1 year
Treasury Bills: Short-term (up to 14/91/182/364 days) bearer discount security issued by the Government as a means of financing its temporary cash requirements.
Certificate of deposit – issued by banks for short term borrowing. 7 days to 1 year with a minimum amount of Re 1.00 lacs. Mainly in OTC market.
Products in Debt market
Government securities (G-Secs): These are sovereign (credit risk-free) coupon bearing instruments which are issued by the Reserve Bank of India on behalf of Government of India, in lieu of the Central Government's market borrowing programme.
These securities have a fixed coupon that is paid on specific dates on half-yearly basis. These securities are available in wide range of maturity dates ( up to thirty years).
Government debt
Central
State
Local bodies
Instruments – dated securities,T.Bills, Capital index bonds, etc
RBI – Nodal agency to raise funds
Covers major segment of debt market
Participants in the Debt market
Central/State Govt/local bodies
RBI
Primary dealers – develop G sec market & also underwriters
PSUs
Corporates
Banks/FIs/FIIs/MFs/PF
Trust/Societies
Rating agencies
G-SEC –Central Govt.
Object – to fund fiscal deficit & temporary liquidity crunch
Intermediary - RBI
Instruments – mainly dated securities(1-20 yrs) &T.Bill(14,91,182 & 364 days)
SGL – Subsidiary General Ledger. Record of holding securities in the name of various investors by RBI in “D” mat form (electronic form)
Constituent SGL
Price/Coupon based on auction system
Indian Debt market
Retail trading in G-Sec started from 16.01.03. as per guidelines of SEBI.
G-Sec auctions with a reservation of 5% of the issue amount for non competitive bids by retails investors.
Non competitive bidding is open to individuals/HUFs/firms/companies/corporate bodies/PF/trust etc as prescribed by RBI.
Requirement not more than 1 crore and do not have SGL a/c (securities General Ledger a/c) with RBI
Apply through PD/Bank
Minimum bidding Re 1o,ooo and multiples thereof.
Money market
Market –maturity profile of instruments vary from 1 day to 1 year
Call money – over night/ Notice money – 1-14 days and term money > 15 days to 1 year.
Purpose – to mange short term liquidity
Participants –Banks/NBE (lending only)
Not meant for corporates
Transactions –unsecured OTC – to fund short term requirements e.g.. reserve requirements, build up of short term funds etc
Call rates – short term liquidity conditions influence –supply side- deposit mobilization, capital inflows, etc.
Demand side – tax outflows, Govt. borrowings, credit off take, reserve requirements etc
Money Market Instruments(2)
Certificates of Deposit
Commercial Paper
Inter-bank participation certificates
Inter-bank term money
Treasury Bills
Bill rediscounting
Call/notice/term money
CBLO
Market Repo
Money market instruments
T-Bill – 14/91/182/364 days.
REPO (Repurchase option)/RRPO ( Reverse Repurchase option
Certificate of deposit- by banks for a period of 7 days to 1 year
Commercial paper
Call – over night
Notice money – >1 to 15 days mainly among banks
Term money – maturity 15 days & up to 1 year
Issue of G-Sec trough auction
Securities are issued through auction (by RBI) either on price or yield basis.
Where the issue is price basis, coupon is predetermined and bidders quote price per Re 100 face value of the security.
Where the issue is yield basis, coupon of the security is decided in the auction.
On the basis of bids received, RBI detemines the cut off price or yield.
Allotment – Uniform price (Dutch auction) or Differential (French auction )
Non competitive bidding (RBI guidelines)
Introduced from Dec,2001.
Eligibility: Participation on a non-competitive basis in the auctions of dated GOI securities will be open to investors who satisfy the following:
1. do not maintain current account (CA) or Subsidiary General Ledger (SGL) account with the Reserve Bank of India.
Exceptions: Regional Rural Banks (RRBs) and Cooperative Banks shall be covered under this Scheme in view of their statutory obligations.
2. make a single bid for an amount not more than Rs. two crore (face value) per auction
3. submit their bid indirectly through any one bank or PD offering this scheme.
Exceptions: Regional Rural Banks (RRBs) and Cooperative Banks that maintain SGL account and current account with the Reserve Bank of India shall be eligible to submit their non competitive bids directly.
Coverage: Subject to the conditions mentioned above, participation on "non-competitive" basis is open to any person including firms, companies, corporate bodies, institutions, provident funds, trusts, and any other entity as may be prescribed by RBI. The minimum amount for bidding will be Rs.10,000 (face value) and thereafter in multiples in Rs.10,000 as hitherto for dated stocks.
Allotment under the non-competitive segment to the bank or PD will be at the weighted average rate of yield/price that will emerge in the auction on the basis of the competitive bidding. The securities will be issued to the bank or PD against payment on the date of issue irrespective of whether the bank or PD has received payment from their clients.
Non competitive bidding (RBI Guidelines)
In case the aggregate amount of bid is more than the reserved amount (5% of notified amount), pro rata allotment would be made. In case of partial allotments, it will be the responsibility of the bank or PD to appropriately allocate securities to their clients in a transparent manner.
In case the aggregate amount of bids is less than the reserved amount, the shortfall will be taken to competitive portion.
Security would be issued only in SGL form by RBI. RBI would credit either the main SGL account or the CSGL account of the bank or PD as indicated by them. The facility for affording credit to the main SGL account is for the sole purpose of servicing investors who are not their constituents. Therefore, the bank or PD would have to indicate clearly at the time of tendering the non-competitive bids the amounts (face value) to be credited to their SGL account and the CSGL account. Delivery in physical form from the main SGL account is permissible at the instance of the investor subsequently.
It will be the responsibility of the bank or the PD to pass on the securities to their clients. Except in extraordinary circumstances, the transfer of securities to the clients shall be completed within five working days from the date of issue.
Liquidity Adjustment facility
Collateralized Lending Facility – for Banks & PDs
Purpose- to meet day to day liquidity mismatches in the system
REPOS & Reverse REPOs through auctions by RBI
REPO – liquidity is pumped in to the system and vice versa for reverse REPO. E.g. RBI lends money to market.
RREPO – RBI borrows from the market.
Tenor – 1 to14 days
Bench mark for short term money market rates
Liquidity Adjustment facility
Conducted on daily basis (Monday to Friday excepting holidays)
Rate of interest – fixed.
Pricing of securities will be at face value.
Minimum bid size Re 5 cr
Participants- Sch.commercial banks,PDs, having current and SGL with RBI.
Eligible securities – SLR securities of GOI.
Membership
Why CBLO ?
The drawback, of course, in the `Repos' is that there is no flexibility, as the obligations can be squared up only on the due date.
Even if the borrower's liquidity position improves, he cannot `prepay'.
If the lender's position dries up and forces him to call back the money, he cannot call back his lending.
CORPORATE DEBT
In vogue since 1980 and interest rates regulated
Regulator – SEBI – SE traded debt
RBI – OTC traded debt
Different structures –Debentures, NCD, CP,Deep discount bonds,secured promissory notes etc
Mostly private placement
Corporate debt – SEBI guidelines
The issue of debt securities having maturity period of more than 365 days by listed companies (i.e. which have any of their securities, either equity or debt, offered through an offer document, and listed on a recognized stock exchange and also includes Public Sector Undertakings whose securities are listed on a recognized stock exchange) on private placement basis must comply with the conditions prescribed by SEBI from time to time for getting them listed on the stock exchanges.
Further, unlisted companies/statutory corporations/other entities, if they so desire, may get their privately placed debt securities listed on the stock exchanges, by complying with the relevant conditions. Briefly, these conditions are
Corporate debt – SEBI guidelines
Compliance with disclosure requirements under Chapter VI of the SEBI (Disclosure and Investor Protection) Guidelines, 2000, Listing Agreement with the exchanges and provisions of the Companies Act.
Such disclosures may be made through the web site of the stock exchanges where the debt securities are sought to be listed if the privately placed debt securities are issued in the standard denomination of Re. 10 lakhs.
The company shall sign a separate listing agreement with the exchange in respect of debt securities.
The debt securities shall carry a credit rating from a Credit Rating Agency registered with SEBI.
Corporate debt – SEBI guidelines
The company shall appoint a debenture trustee registered with SEBI in respect of the issue of the debt securities.
The debt securities shall be issued and traded in Demat form.
All trades with the exception of spot transactions, in a listed debt security, shall be executed only on the trading platform of a stock exchange.
Why corporate market is not growing?
In local markets, dealers call it dead market. Why?
Average annual issuance Re 70,000 cr and daily volumes is around Re 100 cr.predominantly through private placement.
Institutions appetite especially banks is low. Lending to corporate attracts lower riks provisions unlike investing in bonds where the bank face the risk of taking hit when bonds yield rise.
Lower rated issuers find it difficult to play ie in SE due to stringent listing norms
Lack of exit route due to liquidity since there is no active market for trading.
Banks lend at attractive sub PLR rates.
Regulatory arbitrage - Raising a loan in over seas is lot easier than in domestic market.
What is the need for corporate debt market?
Corproates need diversified funding sources.
Entities like provident fund and insurance funds to diversify for risk management and returns
Banks do not all the money to meet corporate demand.
Bank Accounts basic
RETAIL BANKING DEPOSITS
Balance Sheet of a Bank
LIABILITIES
Capital I & II
Free reserves
Borrowings- ST/LT
Deposits
CD/SB – ST
TD – LT
CL & Provisions
ASSETS
Cash on hand
Cash with RBI
Fixed assets
Investments –ST/LT
Loans & Advances
CC/OD/DL/Bills -ST
T/L - LT
Current Assets
IA- Losses /VRS etc
Multi-channel delivery of a comprehensive retail product portfolio
Definition of Deposit
Legal perspective -RBI directives
No interest on current a/c
No discrimination in the matter of interest on deposit among the customers except for deposits of Re 15 lacs and above and deposits meant for senior citizens
No brokerage/commission for canvassing deposit a/cs except commission paid to the agents employed to collect deposits under special scheme.
No launching of prize/lottery/free trips either in India or abroad
No loans against fixed deposits of other banks
No interest on margin money held in current a/c. E.g. issuance Bank Guarantee.
Legal perspective
Depositor Bank – creditor and debtor relationship
*, DEPOSIT INSURANCE CORPORATION ESTABLISHED BY ACT OF PARLIAMENT ON 01.07.1962 FROM 15.07.1978- RENAMED DI & CGC to protect retail depositors.
ELIGIBILITY- 1. ALL CBS,RRBS.CO-OP BANKS. 2. ALL DEPOSITORS OTHER THAN CENTRAL & STATE GOVT., BANKS, FOREIGN GOVTS.,
AMOUNT - UPTO RS. 1 LAKH PER DEPOSITOR PER BANK
CONDITION - payable on closure of bank
DEPOSITS
Introduction
KYC norms
Protection under Sec 131 under Negotiable Instruments Act1881.
Introduction can be given by any person to the bank viz existing a/c holder, staff member etc.
Types of customers
Individuals
Institutions – Corporate, Partnership, HUF, Trust, Government agencies, Associations , Society , banks etc
Requirements
Appropriate Account opening forms + photo
Requisite documents according to type of a/c Partnership- Partnership Deed
Corporate - Memorandum of Association, Articles of association, Certificate of incorporation and commencement & Board resolution
Introduction by an existing account holder or persons known to the bank.
Operating instructions – single or joint or PA
Establishing relationship
Applicant to submit identity of proof – pass port, driving license, Employee ‘ I” card, PAN card, Photo credit card, Pension book etc.
Proof of communication address – electricity bill, Telephone bill, statement of a./c of credit card, letter from employer, Lease agreement, Gas connection etc
Submission of photographs
Pan card copy
Nomination
Savings account
Running account
Minimum balance
No maturity
Meant for mainly for savings purpose. It cannot be opened for business purposes.
Cheque book facility
Single or joint account
Interest is fixed by RBI. Presently @ 3.5%.Paid on minimum credit balance maintained between 10th and last day of each calendar month. Paid every half year.
Can be operated by single or joint a/c holders.
Generally, no overdraft is permitted
No frills account as suggested by RBI to make accessible to vast section of population. Account with either Nil or low minimum balance and low service charges. It is meant for financial inclusion i.e. banking service to cover major portion of population.
Banker’s perspective – low cost deposit and more dependable source of deposit since it is mainly for savings.
Savings account
Cannot be opened for business purposes.
Nomination only in the name of individuals and it can be only one.
Restrictions on deposits and withdrawals.
Risk – low interest rate.
Liquidity – withdraw able on demand
Current account
No fixed maturity and running a/c
Non interest bearing
Mainly meant for business requirements
Cheque book and nomination facility in case of individuals and proprietor
Individuals and institutions can open the a/c
Minimum balance requirement
No restriction on deposit and withdrawal.
BCTT (banking cash transaction tax) applicable –
Others – with drawls exceeding Re 1.00 lac.
Liquidity – most liquid
Bank’s perspective – most attractive since no interest is payable.
Fixed/Term deposits
Objective – savings/tax planning . Different banks devise products according to their ALM requirement
Fixed maturity – 7 days to 10 years.
Interest – according to tenor. Free or Floating
Nomination – only individual.
Target group – mostly senor citizens/house wives. Trust etc
TDS – Interest income Re 5000 & above
Tax saving – up to Re 1.00 lac with maturity period of 5 years under sec 80 cc of IT Act
Customized for different target group such as monthly income, quarterly, reinvestment plan etc
Loan to the extent of 90 percent of the accumulated amount (principal + interest) in the account
Liquidity – premature closure .
Bank’s perspective – high cost but stable due to fixed maturity
Fixed/Term deposits
Transferable from one branch to another
Auto Sweep/Reverse Sweep a/c – money over the thresh hold limit is automatically transferred (auto sweep) from savings a/c and invested in fixed deposit a/c. Fixed deposit is linked to savings a/c. Linked fixed deposit is automatically broken to meet short fall in savings a/c.
Most liquid market instrument
RECURRING DEPOSIT
Purpose – for people who cannot put money in one lump sum
Amount deposited in Installments
Period – 12 to 60 months
Monthly installment starts from Rs 100
Premature closure
Loan facility
Free from TDS
RECURRING DEPOSIT
Target group – people who have fixed income-
Petty traders
House wives
Employed persons
Students
Non Resident a/cs
Non Resident Ordinary a/c – Rupee deposit a/c. No repatriation (flow of capital from the foreign country to the country of origin) except interest. All types of a/c’s
Non Resident External a/c - Rupee deposit a/c. Repatriation permitted. All types of a/cs. Exemption from tax liability.
Foreign currency Non resident a/c – nly in foreign currency fixed deposit a/c. Exemption form tax liability.
Balance Sheet of a Bank
LIABILITIES
Capital I & II
Free reserves
Borrowings- ST/LT
Deposits
CD/SB – ST
TD – LT
CL & Provisions
ASSETS
Cash on hand
Cash with RBI
Fixed assets
Investments –ST/LT
Loans & Advances
CC/OD/DL/Bills -ST
T/L - LT
Current Assets
IA- Losses /VRS etc
Multi-channel delivery of a comprehensive retail product portfolio
Definition of Deposit
Legal perspective -RBI directives
No interest on current a/c
No discrimination in the matter of interest on deposit among the customers except for deposits of Re 15 lacs and above and deposits meant for senior citizens
No brokerage/commission for canvassing deposit a/cs except commission paid to the agents employed to collect deposits under special scheme.
No launching of prize/lottery/free trips either in India or abroad
No loans against fixed deposits of other banks
No interest on margin money held in current a/c. E.g. issuance Bank Guarantee.
Legal perspective
Depositor Bank – creditor and debtor relationship
*, DEPOSIT INSURANCE CORPORATION ESTABLISHED BY ACT OF PARLIAMENT ON 01.07.1962 FROM 15.07.1978- RENAMED DI & CGC to protect retail depositors.
ELIGIBILITY- 1. ALL CBS,RRBS.CO-OP BANKS. 2. ALL DEPOSITORS OTHER THAN CENTRAL & STATE GOVT., BANKS, FOREIGN GOVTS.,
AMOUNT - UPTO RS. 1 LAKH PER DEPOSITOR PER BANK
CONDITION - payable on closure of bank
DEPOSITS
Introduction
KYC norms
Protection under Sec 131 under Negotiable Instruments Act1881.
Introduction can be given by any person to the bank viz existing a/c holder, staff member etc.
Types of customers
Individuals
Institutions – Corporate, Partnership, HUF, Trust, Government agencies, Associations , Society , banks etc
Requirements
Appropriate Account opening forms + photo
Requisite documents according to type of a/c Partnership- Partnership Deed
Corporate - Memorandum of Association, Articles of association, Certificate of incorporation and commencement & Board resolution
Introduction by an existing account holder or persons known to the bank.
Operating instructions – single or joint or PA
Establishing relationship
Applicant to submit identity of proof – pass port, driving license, Employee ‘ I” card, PAN card, Photo credit card, Pension book etc.
Proof of communication address – electricity bill, Telephone bill, statement of a./c of credit card, letter from employer, Lease agreement, Gas connection etc
Submission of photographs
Pan card copy
Nomination
Savings account
Running account
Minimum balance
No maturity
Meant for mainly for savings purpose. It cannot be opened for business purposes.
Cheque book facility
Single or joint account
Interest is fixed by RBI. Presently @ 3.5%.Paid on minimum credit balance maintained between 10th and last day of each calendar month. Paid every half year.
Can be operated by single or joint a/c holders.
Generally, no overdraft is permitted
No frills account as suggested by RBI to make accessible to vast section of population. Account with either Nil or low minimum balance and low service charges. It is meant for financial inclusion i.e. banking service to cover major portion of population.
Banker’s perspective – low cost deposit and more dependable source of deposit since it is mainly for savings.
Savings account
Cannot be opened for business purposes.
Nomination only in the name of individuals and it can be only one.
Restrictions on deposits and withdrawals.
Risk – low interest rate.
Liquidity – withdraw able on demand
Current account
No fixed maturity and running a/c
Non interest bearing
Mainly meant for business requirements
Cheque book and nomination facility in case of individuals and proprietor
Individuals and institutions can open the a/c
Minimum balance requirement
No restriction on deposit and withdrawal.
BCTT (banking cash transaction tax) applicable –
Others – with drawls exceeding Re 1.00 lac.
Liquidity – most liquid
Bank’s perspective – most attractive since no interest is payable.
Fixed/Term deposits
Objective – savings/tax planning . Different banks devise products according to their ALM requirement
Fixed maturity – 7 days to 10 years.
Interest – according to tenor. Free or Floating
Nomination – only individual.
Target group – mostly senor citizens/house wives. Trust etc
TDS – Interest income Re 5000 & above
Tax saving – up to Re 1.00 lac with maturity period of 5 years under sec 80 cc of IT Act
Customized for different target group such as monthly income, quarterly, reinvestment plan etc
Loan to the extent of 90 percent of the accumulated amount (principal + interest) in the account
Liquidity – premature closure .
Bank’s perspective – high cost but stable due to fixed maturity
Fixed/Term deposits
Transferable from one branch to another
Auto Sweep/Reverse Sweep a/c – money over the thresh hold limit is automatically transferred (auto sweep) from savings a/c and invested in fixed deposit a/c. Fixed deposit is linked to savings a/c. Linked fixed deposit is automatically broken to meet short fall in savings a/c.
Most liquid market instrument
RECURRING DEPOSIT
Purpose – for people who cannot put money in one lump sum
Amount deposited in Installments
Period – 12 to 60 months
Monthly installment starts from Rs 100
Premature closure
Loan facility
Free from TDS
RECURRING DEPOSIT
Target group – people who have fixed income-
Petty traders
House wives
Employed persons
Students
Non Resident a/cs
Non Resident Ordinary a/c – Rupee deposit a/c. No repatriation (flow of capital from the foreign country to the country of origin) except interest. All types of a/c’s
Non Resident External a/c - Rupee deposit a/c. Repatriation permitted. All types of a/cs. Exemption from tax liability.
Foreign currency Non resident a/c – nly in foreign currency fixed deposit a/c. Exemption form tax liability.
Letter of Credit
Issues in International trade
Buyer & seller not known to each other
Default risk
Different political entities
Different Regulatory system
Different currencies
Different market conditions
Methods of payment
Documentation
Expectations
Seller(Exporter)
Payment on shipment
Payment in own country & currency
Buyer – compliance of regulatory requirements
Documentation as per international standards
Importer ( Buyer)
Payment on reciept of goods
Payment
Seller compliance – terms of sale & regulatory
Documentation
Methods of settlement
Advance Payments
Collection
Open account
Consignment
Letter of Credit
ADVANCE PAYMENT
Advance payment - buyer sends the money in advance to the seller.
For seller- Buyers credibility is doubtful, Political/ economic instability/ no need to lock in working capital funds
Buyers – assurance for supply of goods / blocking of capital / Risk of default
COLLECTION
Seller sends the documents first and gets the paymnet subsquently.
Seller – payment may not be immediate /blocking of funds / Default
Buyer – Advantageous. Payment on receipt of goods/ No blocking of funds
OPEN ACCOUNT
Seller and buyer exchange goods and payments only on the basis of trust. No invoice matching i.e. payment is not as per invoice (normal trade practice) but as per convenience of buyer.
Seller – High degree of trust . Risk of default. Blocking of funds. Uncertain cash flows
Buyer – Beneficial since payment after sales. Flexible cash flow.
Consignment
Seller sends the goods to the agent in over seas market. He receives the goods after the sale of goods.
Trust worthiness of the agent.
Cash flow is uncertain
What is best settlement system for exports and imports ?
Letter of Credit
A letter of credit is issued by a bank on behalf of the importer.
The bank agrees to honor a draft drawn on the importer, provided the bill of lading and other details are in order.
The bank is essentially substituting its credit for that of the importer.
WHAT IS L/C -
An arrangement of making payment against documents.
It is link between buyer & seller established through the banks
It assure seller receipt against delivery of goods and the buyer against payment against delivery
It satisfies aspirations of both
Documentary credits – Letters of credit
Seller – financial security since credit risk is assumed by the bank
Regulations of the importers’ country is taken care.No need for introduction.
Buyer – supply of goods assured. Regulations taken care.
Buyer and seller can extend their area of trade.
LC - Process
Contract between seller & buyer
At the request of buyer(applicant)buyers’ bank(Issuing bank) opens a LC fvg. Seller. Under UCPDC ( Uniform Customs and Procedure on Documentary Credit issued by International Chamber of Commerce, Parris).
UCPDC –Defines the role of importer, exporter, banks , transporters and insurance companies. Under FEMA provisions, every Indian bank opening LC, has to put a notation is subject to UCPDC.
Issuing bank requests a bank(advising) in sellers’ country to advise the LC to the seller(beneficiary)
Another bank may confirm the LC
Seller ships the goods and present the documents either to his own banker or confirming bank
Seller gets the payment
LC - Process
Negotiating the claims the reimbursement
Documents sent to issuing bank
After scrutiny ,issuing bank delivers the doc to buyer.
Buyer makes the payment
Process of a Typical Foreign Trade Transaction
International Trade Finance
Parties to LC
Applicant ( buyer or importer)
Beneficiary (seller or exporter)
LC opening bank (normally buyer's bank)
Advising bank ( informing seller or exporter about opening of LC)
Confirming bank ( payment obligation under taken when standing of LC issuing bank is not acceptable to seller)
Negotiating bank (who handles the documents and gives value to exporter )
Reimbursing bank ( paying bank who acts on behalf of issuing bank)
LC - documentation
LC application by the buyer (importer)
Invoice
Bill of exchange (Hundi)
License if under restricted catageory
Bill of Lading/Airway bill
Certificate of origin to certify that gooods have been originated from the specified country say India E.g. Basmati rice
Inspection certificate to ensure required quality and quantity
Packing list
Insurance
LC – case study
Contract between GE of USA and L & T of India
Contract value USD 1 mn for supply of machinery with in period of 6 months .
SBI opened a LC fvg. GE at the request of L&T
CITI bank in NY is GEs’ banker & advised LC to GE
GE submits documents to CITI . If documents are in order, payment will be made to GE
Documents sent to SBI, India
CITI will claim reimbursement from Bank of America
Bank of America will debit SBI $ a/c maintained with them.
SBI will scrutinse and ensure that all conditions of LC are complied with and then delivers the documents to L & T against payment .
Types of LC
Irrevocable – cancellation is possible only with the consent of all the parties such as banks, buyer, seller etc
Revocable – cancellation with out consent from others
Documents against acceptance – acceptance of documents first and then payment at later date.
Documents against payment - payment and delivery of documents simultaneously done.
Transferable
Red clause – certain amount is permitted to beneficiary (seller) of LC
Green clause – certain amount is permitted for storage expenses to be incurred by the seller
Revolving – automatic renewal of LC
Deferred – payment under LC in installments
Back to back – one LC is opened on the basis of another LC
Stand by LC
A guarantee of payment issued by a bank on behalf of a client that is used as "payment of last resort" should the client fail to fulfill a contractual commitment with a third party.
Standby letters of credit are created as a sign of good faith in business transactions, and are proof of a buyer's credit quality and repayment abilities.
The bank issuing the SBLC will perform brief underwriting duties to ensure the credit quality of the party seeking the letter of credit, then send notification to the bank of the party requesting the letter of credit (typically a seller or creditor).
BG VS LC
Bank Guarantee A bank guarantee enables the customer (debtor) to acquire goods, buy equipment, or draw down loans, and thereby expand business activity.
http://www.investopedia.com/ask/answers/06/202005.asp
Guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it.
Import finance - means
Suppliers. credit
Buyers’ credit
Shot term loans As per RBI notification – loans up to USD 20 mn – Period – 3 yr for capital goods and 1 yr for others.
Maturit y period exceeding 3 years is treated as ECB
Rupee credit – CC/OD/TL
Foreign currency credit - ECB
Risk Management
Currency risk
Interest risk
Counter party risk
Commercial risk
Buyer & seller not known to each other
Default risk
Different political entities
Different Regulatory system
Different currencies
Different market conditions
Methods of payment
Documentation
Expectations
Seller(Exporter)
Payment on shipment
Payment in own country & currency
Buyer – compliance of regulatory requirements
Documentation as per international standards
Importer ( Buyer)
Payment on reciept of goods
Payment
Seller compliance – terms of sale & regulatory
Documentation
Methods of settlement
Advance Payments
Collection
Open account
Consignment
Letter of Credit
ADVANCE PAYMENT
Advance payment - buyer sends the money in advance to the seller.
For seller- Buyers credibility is doubtful, Political/ economic instability/ no need to lock in working capital funds
Buyers – assurance for supply of goods / blocking of capital / Risk of default
COLLECTION
Seller sends the documents first and gets the paymnet subsquently.
Seller – payment may not be immediate /blocking of funds / Default
Buyer – Advantageous. Payment on receipt of goods/ No blocking of funds
OPEN ACCOUNT
Seller and buyer exchange goods and payments only on the basis of trust. No invoice matching i.e. payment is not as per invoice (normal trade practice) but as per convenience of buyer.
Seller – High degree of trust . Risk of default. Blocking of funds. Uncertain cash flows
Buyer – Beneficial since payment after sales. Flexible cash flow.
Consignment
Seller sends the goods to the agent in over seas market. He receives the goods after the sale of goods.
Trust worthiness of the agent.
Cash flow is uncertain
What is best settlement system for exports and imports ?
Letter of Credit
A letter of credit is issued by a bank on behalf of the importer.
The bank agrees to honor a draft drawn on the importer, provided the bill of lading and other details are in order.
The bank is essentially substituting its credit for that of the importer.
WHAT IS L/C -
An arrangement of making payment against documents.
It is link between buyer & seller established through the banks
It assure seller receipt against delivery of goods and the buyer against payment against delivery
It satisfies aspirations of both
Documentary credits – Letters of credit
Seller – financial security since credit risk is assumed by the bank
Regulations of the importers’ country is taken care.No need for introduction.
Buyer – supply of goods assured. Regulations taken care.
Buyer and seller can extend their area of trade.
LC - Process
Contract between seller & buyer
At the request of buyer(applicant)buyers’ bank(Issuing bank) opens a LC fvg. Seller. Under UCPDC ( Uniform Customs and Procedure on Documentary Credit issued by International Chamber of Commerce, Parris).
UCPDC –Defines the role of importer, exporter, banks , transporters and insurance companies. Under FEMA provisions, every Indian bank opening LC, has to put a notation is subject to UCPDC.
Issuing bank requests a bank(advising) in sellers’ country to advise the LC to the seller(beneficiary)
Another bank may confirm the LC
Seller ships the goods and present the documents either to his own banker or confirming bank
Seller gets the payment
LC - Process
Negotiating the claims the reimbursement
Documents sent to issuing bank
After scrutiny ,issuing bank delivers the doc to buyer.
Buyer makes the payment
Process of a Typical Foreign Trade Transaction
International Trade Finance
Parties to LC
Applicant ( buyer or importer)
Beneficiary (seller or exporter)
LC opening bank (normally buyer's bank)
Advising bank ( informing seller or exporter about opening of LC)
Confirming bank ( payment obligation under taken when standing of LC issuing bank is not acceptable to seller)
Negotiating bank (who handles the documents and gives value to exporter )
Reimbursing bank ( paying bank who acts on behalf of issuing bank)
LC - documentation
LC application by the buyer (importer)
Invoice
Bill of exchange (Hundi)
License if under restricted catageory
Bill of Lading/Airway bill
Certificate of origin to certify that gooods have been originated from the specified country say India E.g. Basmati rice
Inspection certificate to ensure required quality and quantity
Packing list
Insurance
LC – case study
Contract between GE of USA and L & T of India
Contract value USD 1 mn for supply of machinery with in period of 6 months .
SBI opened a LC fvg. GE at the request of L&T
CITI bank in NY is GEs’ banker & advised LC to GE
GE submits documents to CITI . If documents are in order, payment will be made to GE
Documents sent to SBI, India
CITI will claim reimbursement from Bank of America
Bank of America will debit SBI $ a/c maintained with them.
SBI will scrutinse and ensure that all conditions of LC are complied with and then delivers the documents to L & T against payment .
Types of LC
Irrevocable – cancellation is possible only with the consent of all the parties such as banks, buyer, seller etc
Revocable – cancellation with out consent from others
Documents against acceptance – acceptance of documents first and then payment at later date.
Documents against payment - payment and delivery of documents simultaneously done.
Transferable
Red clause – certain amount is permitted to beneficiary (seller) of LC
Green clause – certain amount is permitted for storage expenses to be incurred by the seller
Revolving – automatic renewal of LC
Deferred – payment under LC in installments
Back to back – one LC is opened on the basis of another LC
Stand by LC
A guarantee of payment issued by a bank on behalf of a client that is used as "payment of last resort" should the client fail to fulfill a contractual commitment with a third party.
Standby letters of credit are created as a sign of good faith in business transactions, and are proof of a buyer's credit quality and repayment abilities.
The bank issuing the SBLC will perform brief underwriting duties to ensure the credit quality of the party seeking the letter of credit, then send notification to the bank of the party requesting the letter of credit (typically a seller or creditor).
BG VS LC
Bank Guarantee A bank guarantee enables the customer (debtor) to acquire goods, buy equipment, or draw down loans, and thereby expand business activity.
http://www.investopedia.com/ask/answers/06/202005.asp
Guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it.
Import finance - means
Suppliers. credit
Buyers’ credit
Shot term loans As per RBI notification – loans up to USD 20 mn – Period – 3 yr for capital goods and 1 yr for others.
Maturit y period exceeding 3 years is treated as ECB
Rupee credit – CC/OD/TL
Foreign currency credit - ECB
Risk Management
Currency risk
Interest risk
Counter party risk
Commercial risk
BANKING
What is a Bank Guarantee?Bank guarantee
By Suhail Rajani
What is BG ?
A bank guarantee is a commercial instrument in the nature of a contract, intended between two parties, to secure compliance with the contract. It is an off-shoot of the main contract between two parties. In simple terms, a bank guarantee is defined as an accessory contract, whereby the promisor undertakes to be answerable to the promisee for the debt, default or miscarriage of another person, whose primary liability to the promisee must exist or be contemplated.
Bank Guarantees are financial instruments through which a Bank guarantees payment/ liability on behalf of individuals and /or entities to a third party.
In other words, banks agree to indemnify the beneficiary any loss which may arise due to default of another person (customer of the bank)
Performance guarantee
It is a guarantee by which customer of the bank has to complete given work with in a given period. In case he fails to perform, bank has to make payment to the beneficiary.
E.g. Your company has awarded a contract to construct a factory building costing 10 crores with in a period of 12 months. SBI has issued a guarantee favouring company. In case contractor fails to complete the construction with in stipulated period, on demand from your company, SBI will make payment say 50% of value of the contract.
Financial guarantee
It involves settling financial liabilities say tax demand from government,.
A guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it.
A guarantee that enables a buyer to recover an advance payment made under a contract or order if the supplier fails to fulfill its contractual obligations. E.g. importer in India makes advance payment to an exporter in Malaysia for import of Palm oil.
Parties to BG
An guarantee is a tri-partite (3 parties) agreement involving the surety, the debtor and the creditor.
Surety – Bank (Who issues the BG)
Debtor – Beneficiary ( in whose favour BG is issued )
Creditor – Applicant ( on whose behalf BG is issued)
Need for BG
The instances when a bank guarantee may be given are as follows:
A bank guarantee may be given by a buyer to a seller as a guarantee for the future payment. E.g.. Sale of goods.
A bank guarantee may be given by the contractor as a guarantee for any amount advanced. E.g. Government ay grant advance for execution of contracts say construction of bridge/road etc
A bank guarantee (letter of credit), given by an importer to safeguard against governmental policy changes and as a guarantee of due payment. E.g. payment of customs duty.
Since this guarantees is called a bank guarantee as it is provided by a bank or a financial institution.
Why BG ?
Guarantee is required either to secure a debt or a performance. For example if you have borrowed money from some one then a bank can guarantee the lender for repayment of the debt. in the second case if you have taken up some construction work and supply of machinery warranting a good performance or completion within a time limit the bank may give a guarantee for due performance to the party for whom you have undertaken the job.
How do bank guarantees help in commercial contracts?
Liquidity – applicant need not block the money.
Confidence and trust – since bank is acting as intermediary, beneficiary is confidence of compensation in case of default.
Highly useful in international transactions where parties operate in different countries/political system/regulatory environment.
Fee based income for the bank.
Invocation of BG
Invocation means beneficiary asking for payment of money from the bank due to default. Bank on receipt of written confirmation from the beneficiary , has to make payment.
The invocation of a bank guarantee by the beneficiary can be restrained by an injunction under the Civil Procedure Code, 1908, or the Specific Relief Act, 1963. However, the normal considerations, which apply in granting an injunction, will not apply in cases of a bank guarantee. Courts are usually reluctant to grant an injunction against a bank guarantee. If a bank guarantee has to be restrained, it has to satisfy the following conditions:
" Fraud; " Irretrievable injustice or injury.
Can the invocation of a bank guarantee be prevented by initiating arbitration proceedings?
If the bank guarantee is unconditional, arbitration proceedings would in no way affect the enforcement of the guarantee. This is because an unconditional bank guarantee is independent of the main contract which refers disputes to arbitration. However, if the bank guarantee includes a clause to the effect that it could not be invoked prior to the decision of the arbitrators, such a bank guarantee, which is conditional, cannot be invoked and an injunction can be granted.
What is the difference between a bank guarantee and a usual guarantee?
Following are some points of difference between a bank guarantee and a usual guarantee:
A usual guarantee is governed by Sec. 126 of the Indian Contract Act, 1872. A bank guarantee is not directly governed by Sec. 126.
An guarantee is a tri-partite (3 parties) agreement involving the surety, the debtor and the creditor.
In an ordinary guarantee, the contract between the surety and the creditor arises as a subsidiary to the contract between the creditor and the principal debtor. The bank guarantee is independent of the main contract.
An ordinary guarantee does not have any time limit before which the debt has to be claimed. Bank guarantees generally have a specific time within which they are functional.
By Suhail Rajani
What is BG ?
A bank guarantee is a commercial instrument in the nature of a contract, intended between two parties, to secure compliance with the contract. It is an off-shoot of the main contract between two parties. In simple terms, a bank guarantee is defined as an accessory contract, whereby the promisor undertakes to be answerable to the promisee for the debt, default or miscarriage of another person, whose primary liability to the promisee must exist or be contemplated.
Bank Guarantees are financial instruments through which a Bank guarantees payment/ liability on behalf of individuals and /or entities to a third party.
In other words, banks agree to indemnify the beneficiary any loss which may arise due to default of another person (customer of the bank)
Performance guarantee
It is a guarantee by which customer of the bank has to complete given work with in a given period. In case he fails to perform, bank has to make payment to the beneficiary.
E.g. Your company has awarded a contract to construct a factory building costing 10 crores with in a period of 12 months. SBI has issued a guarantee favouring company. In case contractor fails to complete the construction with in stipulated period, on demand from your company, SBI will make payment say 50% of value of the contract.
Financial guarantee
It involves settling financial liabilities say tax demand from government,.
A guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it.
A guarantee that enables a buyer to recover an advance payment made under a contract or order if the supplier fails to fulfill its contractual obligations. E.g. importer in India makes advance payment to an exporter in Malaysia for import of Palm oil.
Parties to BG
An guarantee is a tri-partite (3 parties) agreement involving the surety, the debtor and the creditor.
Surety – Bank (Who issues the BG)
Debtor – Beneficiary ( in whose favour BG is issued )
Creditor – Applicant ( on whose behalf BG is issued)
Need for BG
The instances when a bank guarantee may be given are as follows:
A bank guarantee may be given by a buyer to a seller as a guarantee for the future payment. E.g.. Sale of goods.
A bank guarantee may be given by the contractor as a guarantee for any amount advanced. E.g. Government ay grant advance for execution of contracts say construction of bridge/road etc
A bank guarantee (letter of credit), given by an importer to safeguard against governmental policy changes and as a guarantee of due payment. E.g. payment of customs duty.
Since this guarantees is called a bank guarantee as it is provided by a bank or a financial institution.
Why BG ?
Guarantee is required either to secure a debt or a performance. For example if you have borrowed money from some one then a bank can guarantee the lender for repayment of the debt. in the second case if you have taken up some construction work and supply of machinery warranting a good performance or completion within a time limit the bank may give a guarantee for due performance to the party for whom you have undertaken the job.
How do bank guarantees help in commercial contracts?
Liquidity – applicant need not block the money.
Confidence and trust – since bank is acting as intermediary, beneficiary is confidence of compensation in case of default.
Highly useful in international transactions where parties operate in different countries/political system/regulatory environment.
Fee based income for the bank.
Invocation of BG
Invocation means beneficiary asking for payment of money from the bank due to default. Bank on receipt of written confirmation from the beneficiary , has to make payment.
The invocation of a bank guarantee by the beneficiary can be restrained by an injunction under the Civil Procedure Code, 1908, or the Specific Relief Act, 1963. However, the normal considerations, which apply in granting an injunction, will not apply in cases of a bank guarantee. Courts are usually reluctant to grant an injunction against a bank guarantee. If a bank guarantee has to be restrained, it has to satisfy the following conditions:
" Fraud; " Irretrievable injustice or injury.
Can the invocation of a bank guarantee be prevented by initiating arbitration proceedings?
If the bank guarantee is unconditional, arbitration proceedings would in no way affect the enforcement of the guarantee. This is because an unconditional bank guarantee is independent of the main contract which refers disputes to arbitration. However, if the bank guarantee includes a clause to the effect that it could not be invoked prior to the decision of the arbitrators, such a bank guarantee, which is conditional, cannot be invoked and an injunction can be granted.
What is the difference between a bank guarantee and a usual guarantee?
Following are some points of difference between a bank guarantee and a usual guarantee:
A usual guarantee is governed by Sec. 126 of the Indian Contract Act, 1872. A bank guarantee is not directly governed by Sec. 126.
An guarantee is a tri-partite (3 parties) agreement involving the surety, the debtor and the creditor.
In an ordinary guarantee, the contract between the surety and the creditor arises as a subsidiary to the contract between the creditor and the principal debtor. The bank guarantee is independent of the main contract.
An ordinary guarantee does not have any time limit before which the debt has to be claimed. Bank guarantees generally have a specific time within which they are functional.
Introduction
I want to keep it short use this blog for your notes, ideas and knowlegde and much more stay in touch to get the updates
Subscribe to:
Posts (Atom)