Commercial Banking

For

PGDM

Indian Institute of Management Calcutta

By

Praloy Majumder

(For Classroom discussion only)

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 Index

Chapter No Particulars Page No

One Role of Financial 3
System
Two Bank’s Liability 13
and Asset
Three Sources of Bank 17
Fund
Four Central Bank, 28
Money Supply
and Credit
Five Fixed Income 32
Securities
Market
Six Bond Portfolio 51
Management
Seven Assessment of 63
Fund Based and
Non Fund Based
Working Capital
Eight Process of Tying 97
up and
Utilisation of
Working Capital
from bank
Nine Different 106
Corporate
Banking Product
Ten Project 123
Financing
Eleven Trade Finance 144

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 Chapter One

Role of Financial System

Financial system is one of the most important inventions of the modern society. Its
primary task is to move scarce loanable funds from those who save to those who
borrow to buy goods and services and to make investments in new equipment and
facilities so that the overall economy can grow and increase the standard of living
enjoyed by the citizens. Without the financial system and the funds it supplies, each
of us would lead a much less enjoyable life.
The financial system determines both the cost of credit and how much credit will be
available to pay for the thousands of different goods and services we purchase daily.
The happening in this system has a powerful impact in the health of the overall
economy. For example, when credit becomes more costly and less available, total
spending for goods and services falls resulting in the increase in unemployment. This
will in turn reduce the growth and which will force the business houses to cut back
the production and lay off workers. In contrast, when the cost of credit declines the
loanable funds become more readily available and this will increase the total
spending in the economy. This will in turn creates more jobs and the economy
growth accelerates. In fact, the financial system is an integral part of the economy
system and we cannot be able to comprehend the economy system without knowing
the financial system.
Flows within the economic system
The basic function of any economy is to allocate scarce resources--- land, labor,
management skill and capital – to produce the goods and services needed by the
society. The economy system must combine inputs--- land, labor and management
skills, capital to produce out put in the form of goods and services. The economy
generates a flow of production in return for a flow of payments.

Flow of Production
Land & other natural
resources Goods and services sold
Flow of payments to the public.
Labor and managerial
skills

Capital equipment

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 Figure 1.1 : The Economic System

The flows of payments and production within the economic system can be depicted
as a circular flow between producing unit (mainly business and government) and
consuming unit (principally households). In modern economy, household provides
labor, management skill, and natural resources to business firms and governments in
return for income in the form of wages and other payments. Most of the income
received by the household is spent to purchase goods and services from business
and governments. This is shown below in Fig 1.2:

Flow of expenditure for consumption and taxes

Flow of production of goods and service

Producing units
(mainly business Consuming units
firms and govt) (mainly
households)

Flow of productive services

Flow of income

Fig 1.2: Flow of income, payments and production in the economic

system

The Role of Markets in the Economic System

Markets are channel through which buyers and sellers meet to exchange goods,
services and resources. The market place determines what goods and services will
be produced and in what quantity. This is accomplished through changes in the

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prices of goods and services offered in the market. If the price of an item rises, for
example, this stimulates business firms to produce and supply more of it to
consumers. In the long run, new firms may enter the market to produce those goods
and services experiencing increased demand and rising prices. A decline in price, on
the other hand, usually leads to reduce production of a good or service and in the
long run some firms may leave the market place.

Types of Markets:

There are essentially three types of markets within the economic system. They are
1. Factor Market
2. Product Market
3. Financial Market
1.Factor Market: In the factor market, the consuming units sell their labor and other
resources to those producing units offering the highest prices. The factor market
allocates factors of production --- land, labor and capital---- and distributes income--
- wages, rental payments etc--- to the owners of productive resources.
2. Product Market: In the product market, consuming units use most of their income
to purchase goods and services. Food, shelter, automobiles, theater tickets and
swimming pools are among the many goods and services sold in the product
markets.
3. Financial Market: It may be mentioned that not all the incomes of the consuming
unit are used up in the product market. The excess of income over the expenses is
saved. This savings are channelised from consuming unit to producing unit through
the financial market.
In an economy, there are three mainly three entities. They are
• Households
• Business Firms
• Governments
The definition of savings and investments varies in these three entities. They are
explained below:
Nature of Savings:
For Household: This is defined as the surplus of its current income over its current
expenses.
For Business Firms: It is retained earnings plus other non-cash expenses.
For Government: It is defined as current revenue minus current expenditures.
Nature of Investments:

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For Household: When it purchases new home, furniture, automobiles and other
durable goods this is classified as investment. However, purchases of food, clothing,
and fuel are considered to be consumption spending (i.e. expenditures on current
account).
Foe Business Firms: Expenditure on capital goods (fixed assets, such as building and
equipment) and for inventories are classified as investment.
For Government: When Government spends o build and maintains public facilities, it
is classified as investment.
Modern economy requires enormous amount of investment to produce goods and
services and to keep the economic growth on a continuous basis. However,
investment requires huge amount of funds, far beyond the resources available to the
investing units mainly Government and Business Firms. The financial markets meet
the requirement of funds as it acts as a conduit for the flow of fund from savers to
investors. The investors issue financial claims in the form of instruments of financial
markets and the savers lend the money to investors against these instruments.
These instruments are financial claims on the future income of the investors and the
savers invest the money in anticipation of the future income. This is made possible
because of the presence of the financial markets.
Functions performed by the financial systems and the financial markets:
The great importance of the financial system in our day-to-day life can be explained
by reviewing its different functions. The financial system in a modern economy
performs the following basic functions:
• Savings Function: As mentioned earlier, financial systems act as a conduit for
the public’s savings. Financial instruments in the form of Stock, Bonds etc are
sold in the financial markets and this provides a profitable, relatively low risk
outlet for the public’s savings. This helps the public’s savings to flow from the
savers to investors through the financial markets.
• Wealth Function: Financial instruments sold in the financial markets provide
an excellent way to store wealth (i.e. preserve the value of the assets we
hold) until funds are needed for spending. Although, one might choose to
store his wealth in things, such items are subject to depreciation and often
carry great risk of loss. However, bonds, stocks and other financial market
instruments do not wear out over time and usually generate income.
For any individual, business firms and government, wealth is the sum total of
it assets held. Some authorities prefer a concept called net wealth that equals

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 all the assets held by an economic unit minus debt (liabilities) it owes. Both
wealth and net wealth are built up by a combination of current savings plus
income earned on previously accumulated wealth. This can be represented in
the form of following equation:

Wt = St +Rt . Wt-1

Wt The change in wealth in the current period

St The savings in the current period
Rt The rate of return of the accumulated wealth
Wt-1 Initial value of all accumulated wealth

• Liquidity Function: For wealth stored in the financial instruments, the financial
market place provides a means of converting those instruments into cash with
little risk of loss. Thus, the financial markets provide liquidity for savers who
hold financial instruments but are in need of money.
• Credit Function: Besides providing the liquidity and facilitating the flow of
savings into investment to build wealth, the financial market furnishes credit
to finance consumption and investment spending. Credit consists of a loan of
funds in return for a promise of future payments.
• Payment Function: The financial system also provides a mechanism for
making payments for goods and services. Certain financial assets, mainly
checking accounts and negotiable instruments serve as a medium of
exchange in making payments. Plastic cards issued by banks are another
example of financial instruments facilitating payments.
• Risk Function: The financial markets offer business, consumers and
governments protection against life, health, property and income risks. This is
accomplished by the sale of insurance policies.
• Policy Function : In recent times , the financial markets are the principal
channel through which government has carried out its policy for stabilizing
the economy and avoid inflation .By manipulating interest rates and
availability of credit, government can affect the borrowing and spending plans

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 of the public, which, in turn , influence the growth of jobs, production and
prices.
Types of Financial Markets within the Financial System:
The financial markets can be classified in different ways. One way of classifying this
is to classify in respect of maturity of the instruments. Accordingly, the financial
markets can be classified into two main parts. They are
1. Money Market
2. Capital Market

1. Money Market : This is defined as that financial market where the maturity
period of financial instruments issued or traded is up to one year .
2. Capital Market : This is defined as that financial market where the maturity
period of financial instruments issued or traded is more than one year.
Within each market, there are several instruments, which can be distinguished in
terms of characteristics. The entire break up of financial markets is shown below:

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 Financial Markets

Money Market Capital Market

Negotiable Non Negotiable Debt Market Equity Market

Govt Instruments Non Government Instrument s

Primary Market Secondary Market

Fig: 1.3 Classifications of Financial Markets

Factors integrating all financial markets together:

Each corner of the financial system act as a different financial markets and each of
this market is separated by its own characteristics, characteristics of its instruments,
investors’ preference and also by rules and regulations. However, there are certain
factors that integrate these different markets. They are:
Credit, the common commodity: One unifying factor is the fact that the basic
commodity being traded in the most financial market is credit. Borrowers can switch
from one market to another depending on the cost of credit. Accordingly, the credit
plays an important role to keep the cost of such credit in different markets in sync.

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Speculation and Arbitrage: Both speculation and arbitrage help to keep the price of
securities in different financial markets within short range and there should not be
any major variance of such price.

The Evolution of Financial Transaction

All financial transactions perform at least one basic function- movement of scarce
fund from those who save and lend to those who wish to borrow and invest.
However, the transfer of funds from savers to borrowers can be accomplished in at
least three different ways . We label these methods of fund transfer as
• Direct Finance
• Semi direct Finance
• Indirect Finance
Direct Finance : In the direct finance, borrower and lender meet each other and
exchange funds in return for financial assets. One such example is the borrowal of
money from one individual from another in exchange of promissory notes ( signed by
the borrower) against money ( given by the lender) . The process is explained below
with the help of the following diagram:

Flow of funds
Borrowers Lenders
(deficit budget unit) (surplus budget unit)

Primary Securities

Fig: 1.4 Direct Finance (Direct lending gives rise to direct claims against
borrowers)

Limitation of this type of finance:

• Both borrower and lender must meet each other to carry out the transaction.
So cost of searching/information is high.
• Both borrower and lender must agree to exchange exactly identical amount of
money that is difficult.
• Lender must have faith on the security issued by the borrower, which is also
difficult to achieve.

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Semi direct Finance: In this type of finance , some individuals and business houses
become security brokers and dealers whose essential function is to bring surplus and
deficit budget units together, thereby reducing information costs. This is explained
below:

Primarysecurities Primary
Borrowers Security brokers, Lenders
Securities
(deficit budget dealers and (surplus budget
unit) investment unit)
Flow of funds
bankers Flow of funds

Fig 1.5 Semi direct Finance (Direct lending with the aid of market makers
who assist in the sale of direct claims against borrowers)
Semi direct finance is an improvement over the direct finance in the following
manner:
• Information cost for participants is reduced to a great extent
• The requirement of exact amount of money involved is eliminated as dealers
can split up securities and sale in smaller lots
• Both dealers and brokers help in the development of the secondary market
Still semi direct finance has limitations. The most important of them is:
• In this process also , the lender has to accept the security offered by the
borrower as an acceptable security.

Indirect Finance: The limitations of both direct and semi direct finance can be
removed in the Indirect Finance . In this form of finance, one financial intermediary
comes in between lenders and borrowers. The financial intermediaries performs the
following functions:
• The financial intermediary accepts money from the surplus budget unit in the
form of deposits. In return of the money deposited, the financial intermediary
issues secondary security. Since most of the financial intermediaries are
regulated by financial regulations in terms of financial strength, lenders are

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 more willing to accept this secondary security as gains the primary securities
issued by the borrower himself.
• The financial intermediary finds out the deficit budget units for giving loans
and collects money from the borrowing unit. The information and searching
cost are reduced.
The entire mechanism of indirect financing is shown below :

Primary Security Secondary Security

Ultimate Financial Ultimate lenders
borrowers Intermediaries ( surplus budget
(deficit budget (banks, Financial unit)
units) Institutions)
Flow of funds Flow of funds

Fig 1.6: Indirect Finance (The financial intermediation of funds)

Financial disintermediation : In the process of financial disintermediation , the

role of financial intermediary has been eliminated and the borrowers can raise the
fund directly from the lender with the help of either public issue or private placement
of securities. This can be performed with the help of stock exchanges. Though the
financial disintermediation has been progressing rapidly in the developed and
matured financial markets like USA , UK etc, it is yet to take momentum in Indian
market. This is due to the fact that to work financial disintermediation, stock market
has to perform to the satisfaction of the lenders. Considering the maturity stage of
our stock market, it is yet a long road to go for establishing financial
disintermediation as an established procedure.

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 Chapter Two

Bank’s Liability and Assets

As can be seen from the previous chapter that bank plays the role of an intermediary
where banks collects money from the depositor against issuance of its security and
then it lends to the corporate. Such system would operate as long as the bank is able
to keep its commitment to the investors. Since bank is an important financial
intermediary , the soundness of the bank is of paramount importance in the stability
of financial system. Accordingly, we need to know the basic financial structure of
bank and how it is different from normal corporate.

Let us draw a comparison of ICICI bank balance sheet and Tata Steel balance sheet
as on March 31 2007 . The liability comparison of both the entities are given below :

Comparison of Tata Steel and ICICI Bank

Liability
Sl No Particulars Tata Steel ICICI Bank

1 Equity 11.52% 0.37%

Reserves
and
2 Surplus 39.18% 11.35%

3 Loans 33.47% 82.75%

Other
4 Liabilities 3.26% 2.96%

Current
Liabilities
and
5 Provisions 12.57% 2.58%
Total 100.00% 100.00%

Fig : 2.1 Comparison of Tata Steel and ICICI Bank Balance Sheet Liability
Composition

As we see from the above that the capital structure of ICICI Bank is highly levered
compared to Tata Steel balance sheet . This is reflected in lower percentage of equity

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and reserves of total liability of ICICI bank compared to that of Tata Steel. Since we
know that a highly levered institution is highly risky entity , ICICI bank is a risky
entity compared to that of Tata Steel. This is true for all other banks . But at the
same time we are telling that banks at any point of time would have to keep its
commitment to its depositors and at the same time have to work within the risky
parameters. So bank will always have to operate under strict risk containing
mechanism as prescribed by central bank of a country. When we shall analyse the
bank performance , we have to always keep this in our mind. This is the rational
behind prudential norms, exposure norms, investment valuation norms , capital
adequacy norms, risk management and asset liability management systems of
banks.

After comparing the liability side of bank balance sheet we shall compare the asset
side of bank balance sheet with that of Tata Steel:

Comparison of Tata Steel and ICICI Bank

Asset
Sl No Particulars Tata Steel ICICI Bank

1 Net Fixed Assets 23.44% 1.03%

2 Investment 7.62% 27.88%

3 Current Assets 68.65% 65.95%

Misc.expenditure not
4 written off 0.29% 5.15%
Total 100.00% 100.00%

Fig 2.1 : Comparison Tata Steel and ICICI Bank Asset Composition
If we see the above , we find that majority of bank assets comprise of investment
and current assets. In the current assets we have included loan and advances given
by the bank to other entities. From the above , we see that net fixed asset is lower in
the bank balance sheet . This would be due to the reason that bank is created to
channelise fund to the productive sector. That is why banks are having restriction in
investment in Fixed assets. Banks are having significantly higher portion in the form
of investments and loans and advances. In India, Investment includes subscription

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to Govt of India securities. This is being carried out due to meeting the SLR
requirement . Banks need to invest 25% of its net demand and time liabilities in the
form of SLR securities which consist of GOI securities. Government issues securities
to bridge the fiscal deficit and bank has to invest fund on this instrument in the
form of SLR securities. With the implementation of FRBM act we expect that the SLR
requirement would go down in the near future as the fiscal deficit would go down
with the implementation of FRBM act. If we see, an early indication has been made
in this regard by lowering the floor of SLR as per Banking Regulation Act where the
floor has been reduced to 20% of NDTL . However, at present banks need to
maintain 25% . The effect of reduction of SLR would be good as more fund would be
available to the commercial sector and this would be used for increasing goods and
services in the country.

While bank raises fund and invest in asset it keeps in mind the following aspects :
1. While borrowing, it is borrowing from the depositor at a particular cost for a
particular period. But it does not mean that if the depositor comes before the
maturity date , it would deny the payment to the investor. In that case faith
on the banking system would be vanished. So Banks should make emergency
provisions while deploying such deposit in the form of different assets.
2. While investing in the form of investment , it has to adhere to certain
investment norms depending on the nature of investment. Since banks are
not permitted to invest freely in the equity securities and in India the
restriction is too high, in India bank’s are investing majority amount in the
fixed income securities for the reason mentioned above. As we know that
interest rate and price of a fixed income security is inversely proportional ,
banks have to keep this in mind at the time of investment. Investment can be
made under three category i.e. Held to Maturity, Held for Trading and
Available for Sales category and there are benefits and drawbacks under each
method. In the case of Held to Maturity , banks will not be able to derive any
trading profit and at the same time would not incur loss on account of
adverse movement of interest rates. In the case of Held for Trading ,a bank
has to realise the gain or loss within 90 days and depending on its prediction
it can earn profit or incur loss. In the case of Available for sale category, the
bank can incur losses or earn profit for first 90 days but this is notional in
nature. While investing, other important issue is that the bank can borrow

15
 against particular type of investment from dedicated lender in case of
emergency and this would help bank to overcome the emergency payment
requirement. So while investing ,bank would carry out some statistical
analysis of its liability and accordingly it would invest in the investment of a
particular security to this benefit.
3. While giving loans and advances to corporations, bank would keep in mind
the riskiness of the loan . Since different categories of loan are having
different risk weight , bank would try to lend to a loan of lower risk weight at
a given rate of interest. Besides, for certain category of loan and advances
like export credit, term loan to SSI , refinance facility would be available and
accordingly bank would be able to overcome sudden liquidity requirement in
case of urgency.

After giving proper consideration in the above mentioned factors, bank raises the
fund from its depositor and accordingly would invest in loans and advances.
However, bank has been permitted to borrow and lend its temporary surpluses in
certain other market due to its nature of operation to ensure liquidity. Banks can
lend and borrow from inter bank call money market and repurchase market.

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 Chapter Three
Sources of Bank Fund

As we have seen in chapter one and two that banks are financial intermediary which
help the movement of fund from the savings unit to the investment unit. So the
major sources of bank fund would be in from the savings unit i.e. individual .
Accordingly , the major sources of bank fund is deposits. There are two types of
deposits which banks issue to raise money. One is called demand deposit and the
other is called term deposit.

Demand Deposit : This is the deposit which does not have any maturity at the time
of raising the fund by the bank. Besides these deposit would not provide any interest
to the depositor. If any deposit scheme issued by bank is providing this
characteristics such deposit is called as demand deposit. Examples of demand
deposit is Current Account and part of Savings Account balance . Current Account
and Savings Account deposits are popularly known as CASA.

Current Account : These are accounts opened by the business entity to carry out
their day to day transaction . For a bank the benefit of current account is that banks
need not to pay interest on current account. So the cost of fund is very low in the
case of current account. Here one thing has to be kept in mind that in the case of
cost of fund , interest is not the only factors involved. Apart from interest part the
issue of cost of servicing the account should also be kept in mind while calculating
the cost of deposit.

Savings Account : In the case of savings bank account, individual would maintain
account with bank. The uniqueness of saving bank account is that individual keep a
portion of their liquidity requirement in the savings account. Since banks have to pay
interest at a rate of 3.5% on the minimum balance between 11 and last day of a
month, the interest cost of deposit is quite low. The portion of the savings bank
account balance between 1 to 10 is called as the demand deposit since this is not
interest earning deposit. Each savings bank account would be provided Cheque
books and also other facilities like internet banking , ATM services, Debit and Credit
Cards and other freebies.

A Bank which is having higher portion of CASA would be considered a good bank.

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A Bank of higher CASA is prone to lower degree of shock in the increased interest
rate scenario. The aim of a bank is to increase the CASA to a great extent. For this
banks can draw different strategies. Some of such strategies are given below :

• Opening of salary account : Banks can approach its advance clients and
accordingly it would ask employees of advance clients to open savings
account with the banks. Bank must use data mining techniques to achieve
this in a scientific manner.
• Opening of accounts of students: Banks can approach schools to open
students’ accounts. Here bank must design some product which would
provide attractive benefits to students. Students savings account with
insurance benefits for income earning parents would be an excellent product
for increasing the number of students accounts.
• Opening of current accounts of governments : Banks can approach
governments for opening of current accounts . This can be clubbed with cash
remittances facilities of government disbursement.
• Opening of accounts with traders: Banks can target trading communities to
open current accounts with them. This is important as floats available in such
account would be of great advantage to the banks.
However, increasing of CASA in a competitive market would not be easy. The
increase of CASA may take place if concerned banks use the following :
• Use of technology to increase the transaction mode with the clients . This
includes use of ATM, Internet Banking , Phone Banking and Mobile Banking;
• Use of branch net works to improve the flow of fund : Banks must use the
branch net work to collect the fund within shortest period of time.
• Better customer service : A proper mix of branch banking and remote banking
is must to improve the CASA .

Term Deposits :

Term deposit is a deposit which promises to pay interest at the time of opening the
deposit and also has a fixed maturity period for opening the deposit. The tenure of
term deposits can be from 7 days to 10 years for a bank. However banks take lot of
precaution before raising deposit for longer tenure.

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There are different versions of term deposit possible depending on the following
factors namely :

• Periodicity of payment of interest;

• Periodicity of compounding of interest;
• Periodicity of deposits of amount in the deposit account;

Reinvestment Scheme : Under this scheme the interest amount is reinvested at a

periodic interval at the contractual rate and on maturity the total amount is paid. If
the principal amount of deposit is Rs 10,000/- , the interest rate is 10% p.a. , the
periodicity of compounding is half yearly and the tenure of deposit is 2 years , the
maturity value is given as below :

Rs 10,000/- [ 1+ (10%/2)]4 = Rs 12,155/- .

Under this scheme the investor would get more money but would not get any
intermittent cash flow . So any investor who wants to have some periodic cash flow
would not prefer such scheme. However if some one is interested in end of period
money, the investor would prefer this scheme. In Indian banking scenario, this
scheme is mostly preferred by banks for canvassing retail deposits .

Periodic Interest Scheme: Under this scheme, banks pay interest in periodic interval
to investors on annually, half yearly , quarterly and monthly basis. However if the
interest is paid on monthly basis , interest amount is paid after discounting. This
type of investment is preferred by those investors who want periodic return like the
retired person , pensioners etc.

Flexible deposit scheme : Under this scheme , an investor can invest one single
amount and can withdraw in multiples of the invested amount at different period of
time. For example , an investor can invest Rs 10,000/- for 2 years at an interest rate
of 10% p.a. with interest paid at quarterly intervals. However the investor can
withdraw amount at a unit of Rs 1000/- at any time and the interest rate to be paid
on this withdrawal would be applicable rate for the tenure of the investment . If the
investor withdraws Rs 1,000/- after one month and the applicable rate for one month
is 6%, the investor would be paid interest rate of 6% on this Rs 1,000/- . However
the remaining Rs 9,000/- would continue to attract at an interest rate of 10% p.a.

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This type of deposit is beneficial for investor who does not want to make rigid
investment horizon.

Borrowing in the money market : The bank can also raise resources
from money market . By definition ,a money market instrument is that instrument
where the remaining maturity of the instrument is less than 1 year. Please keep in
mind that an instrument which was originally a capital market instrument will
become a money market instrument when it enters the last year of its maturity. For
example , a GOI security which was issued on 1991 for 15 years would become a
money market instrument in the year 2006.
In the money market, we have the following instrument:
• Call Money Instrument
• Notice Money Instrument
• Term Money Instrument
Call Money : If the tenure of instrument is overnight, it is called a call money
instrument. When money is borrowed under call money then the borrower would
issue a receipt and this receipt is called call money receipt. The receipt says that the
money would be paid on the next date. This is an example of call money
instrument.
Notice Money : If the tenure of the instrument is more than overnight but less
than seven days , it is called notice money. For example, when a bank borrows
money under Liquidity Arrangement Facility ( LAF) for 3 days, then the instrument
issued by the bank is an example of the notice money instrument.
Term Money : If the tenure of the instrument is equal and more than 7 days , it is
called a term money instrument. When a bank raises fixed deposits for 15 days ,
the deposit receipt it issues is a term money instrument.
Call Money Market : To under stand the concept of call money market one needs
to understand the bank balance sheet carefully. A sample analysis of consolidated
bank balance sheet of schedule commercial banks in India would reveal the
following :

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 In % of total
Liability Asset
Capital 0.43% Cash and Bank Balance 7.60%
with RBI
Reserves & Surplus 5.35% Balance with Bank and 2.13%
call
Deposits 81.19% Investments 26.44%
Borrowings 5.0% Loans and Advances 59.48%
Other Liabilities 8.02% Fixed Assets 0.95%
Other Assets 3.40%
Total 100.0% Total 100.0%

Fig 3.1: % composition of liability and assets of PSU Bank.

If we analyse the above, we find that majority of the source of fund for the
scheduled commercial banks is deposit which constitutes about 80% of the source of
the fund. The onus of the banks is to pay to the deposit holder the interest and
principle in time so that the faith reposed on the banking system by these deposit
holders are kept intact. So banks would basically try to invest in assets where the
repayment is more or less assured and the time of repayment is also known with
certainty.
Since the major source of fund is of debt in nature, the assets would also be debt in
nature. That is exactly is seen in the balance sheet of the banks where more than
83% investments is in the nature of the debt. This ensures that the principal of the
deposit holders are intended to be protected as the debt instrument carries a
commitment of protection of principal and interest.
The next step should address the issues on timing of payment of interest rate. The
maturity profile of liability and assets need to be analyzed . The maturity profile of
deposits of the banking system would reveal the following :

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 % of Total deposit
Type of Public Sector Old Private New Private Foreign
Banks Banks Sector Banks Sector Banks Banks
Maturity
Up to 1 year 44.1% 50.9% 57.1% 64.7%
More than 1 26.5% 35.5% 34.3% 33.3%
year to 3
years
More than 3 10.3% 7.7% 2.5% 0.4%
years to 5
years
More than 5 19.1% 6.0% 6.0% 1.6%
years

Fig 3.2 The Maturity profile of deposits in the banking system

It is obvious from the above that majority of the deposits are maturing within 3
years. So the bank needs to invest in assets ( mainly debt assets ) of this maturity.
However this is a very difficult task considering the SLR requirement of 25% of the
net demand and time liabilities of the banking system. This shows that about 20% of
the banking liability should be in the eligible SLR securities which is predominantly in
the long term in nature. So the system should be such that these securities can be
sold of before maturity and here lies the importance of secondary market for SLR
securities. Besides, the banks may not be able to find other investments for
matching the deposit profile and in this case banks should be provided with some
access to meet the requirement of the depositors in case depositors ask for money.
Previously banks were resorting to inter bank call money market to meet sudden
requirement of funds. Accordingly there was high volatility in the call money market.
Over the years, the central bank i.e. RBI introduced lot of avenues through which
banks can raise funds to meet the sudden requirement of funds from depositors.
The aim was to reduce the dependence on the call money market so that the interest
rate volatility in the call money market is reduced to a great extent. Besides, in the
other market, RBI decides the interest rate through auction mechanism and
accordingly RBI can control the call money market indirectly. This mechanism
worked out very well in the Indian context. Besides deciding the factors of the call

22
money market, let us first discuss the other sources for meeting the sudden
requirement of fund by the banking system.

Bill Rediscounting Facility : When bank gives loans and advances under bill
discounting scheme to its clients, it locks the fund up to the tenure of the bills. For
example, if a bank has lent Rs 100 crores under Bill Discounting scheme and as on
November 1, 2007 , the average maturity of such fund is 50 days then the bank
would get this Rs 100 crores after 50 days only. In the mean time if the bank
suddenly requires Rs 50 crores, it can get refinance against this facility which it can
repay either from realization of bills discounted or from fresh deposits mobilized. This
gives an option to bank for raising resources.
Export Refinance Facility : Banks can avail refinance against the export finance
lent to its customers. This would also help the bank to meet the sudden requirement
of funds.
SIDBI Refinance Facility : Banks can get refinance from SIDBI for the assistance
provided to small scale industry . This also helps the bank to fund the sudden
requirement .
Liquidity Adjustment Facility : Under this scheme, banks can get fund from RBI
for a period ranging from one day to 7 days. They get fund under repo scheme
where the approved securities are SLR securities. This refinancing window is made
available by RBI on a regular basis and the RBI decided the rate and quantum
through auction process.
Repo Facility : Under this scheme, the fund is available to be banks by RBI and
other banks for more than 7 days against repurchase of approved securities which
are mostly SLR securities.
Please keep in mind that all the above facilities are borrowing windows for banks to
meet sudden demand from the depositors and carries interest rate determined by
the market.
Because of these several sources, the dependence on inter bank call money market
is reduced to a great extent over the years. This is also the reason for reducing the
number of participants in the call money markets as entities can park their short
term funds in several other short term avenues as mentioned above.
The call money market , at present , would be used by banks only for meeting the
cash reserve ratio only. As mentioned in the previous chapter, CRR is an important
tools for money supply as it effects the high power money. RBI changes CRR from

23
time to time and CRR can be maintained by banks by keeping fund in the current
account with RBI. For maintenance of CRR, if bank finds that there is a shortfall, the
bank can borrow in the call money market till the time bank concerned arranges
deposits or other long term funds. For the lending banks point of view, banks can
lend only up to a certain amount linked to its net worth in the call money market. For
remaining surplus , it can lend in other short term avenues as mentioned above.
CRR and its maintenance : As mentioned earlier ,CRR is the cash reserve ratio.
The CRR is maintained on the Net Demand and Time Liabilities of the banking
system. Let us explain it with the help of an example :
Suppose on a particular Friday ( assuming it a reporting Friday ) , the total deposits
of a bank is say Rs 5000 crores. This consists of the following :
Demand Deposits : The deposits which is paid on demand and on which no interest is
paid.
Time Deposits: This represents deposits on which interest is paid and the original
date of maturity is after a specified period which is determined at the time of
receiving the deposits.
Let us also assume that the break up of this demand and time liabilities is as follows
:
Demand Deposit : Rs 500 crores
Time Deposit : Rs 4500 crores.
Another break up of this deposit is carried out. Suppose the demand deposit to the
banking system is say Rs 50 crores and the remaining amount , deposit to public is
Rs 450 crores. The similar bifurcation for time deposit is Rs 500 crores and Rs 4000
crores respectively . This is represented below :

Demand and Time Liability ( DTL) (Rs 5000 cr)

DTL Bank DTL Public

24
 Demand Time Demand Time
Deposit Deposit Deposit Deposit
(Rs 50 cr) ( Rs 500 cr) (Rs 450 cr) (Rs 4000 cr)

Fig 3.4 Break up of Demand Time Liabilities in the Banking System

From this Rs 5000 crores of deposits , the banks would invest in assets mainly in the
forms of loans and advances and investments. Out of the loans and advances and
investments , a bank can give loans and advances to other bank or can invest in the
securities of the other banks. These are called as Assets to the banking system . Let
us assume that in the above example the inter bank assets are of Rs 500 crores. So
the Net Demand and Time Liability (NDTL)= Demand and Time Liability(DTL) –
Asset to the Banking System .
If we define DTL= DTL to Others (I) + DTL to Bank (II)
And Asset to the Banking System as III
NDTL= I+II-III if II-III>0
NDTL= I if II-III <0

In the above mentioned case, the NDTL of the bank as on the reporting Friday is Rs
4450 cr + Rs 550 cr – Rs 500 cr = Rs 4500 crores .
If the Cash Reserve Ratio (CRR) is 5% then the CRR to be maintained is Rs 4500
crores * 5% = Rs 225 crores.
This means that the average balance on the Current account with the Reserve Bank
of India would be Rs 225 crores from Saturday to 14 days ending on next reporting
Friday. Besides this, the bank needs to maintain 85% or any percentage as
stipulated by RBI from time to time on a daily basis and the balance amount can be
adjusted on the last day of the fortnight. The banks do not earn interest on the
balance maintained on the Current Account of RBI up to the eligible CRR balance at
the rate of bank rate. Banks can borrow in the call money market only for
maintenance of CRR ,not for other purposes. Whenever , a bank fell short of CRR
balance, it would borrow in the call money market to meet the CRR requirement.
Similarly, if a bank has a surplus then it can lend for a day in the call money market
but there is a ceiling which is linked to the net worth of the lending bank.

25
Notice Money : When bank borrows fund for more than one day but less than 7
days it is called as notice money. Bank generally borrows under notice money when
it visualizes that the mismatch will continue for more than one day but less than
seven days and there is a probability that the call money interest rate would show an
upward trend in the next seven days . In such case the bank would borrow under
notice money from another bank and would try to replace this borrowing by taking
term money .
Term Money : When bank borrows for more than 7 days , it is called as term
money. When bank raises fixed deposits for more than 7 days it is called as term
money. Please keep it in mind that the term money also encompasses capital market
since the term money which is maturing over one year will come under term money.
Treasury Bills : This is short term money market instrument issued by RBI on
behalf of the government to meet the cash flow mismatch in the revenue account.
The tenure of T Bills would be from 14 days to 364 days. However , the most popular
T Bill is 91 days T Bill. T Bill is a discounted instruments and it is issued at a discount
to the face value. The yield on treasury bill helps one to build up a risk free pure
discount yield curve in the short term.

Certificate of Deposit : Certificate of deposit is also another money market

instrument and issued by banks . CD is a negotiable instrument issued by banks to
raise fund in large quantum. Banks can pay differential interest on CD.
Commercial Paper : Commercial paper is also another money market instrument
issued by corporations, primary dealers and financial institution.
Liquidity Adjustment Facility (LAF) : Under the scheme , repo auctions ( for
injection of liquidity ) and reverse repo scheme ( for absorption of liquidity ) will be
conducted on a daily basis. Under the reverse repo auctions, the RBI would sale the
securities to the commercial banks against which the banks would give fund. The RBI
agrees to buy back the security at a predetermined rate which reflects the interest
rate. Let us explain it with an example :
Suppose that RBI conducts reverse repo on November 15th 2005 for one day. The
interest rate would be 5% per annum. If a bank become successful in the reverse
repo auction , it would have to give Rs 1 crores. Since the bank would be
maintaining a current account with RBI, the account would be debited by this
amount . The bank will maintain a Subsidiary General Ledger (SGL) with RBI. Within
the SGL account , the bank will maintain Reverse Repo Constituents SGL account. In

26
this account the required amount of security would be credited. On the next day ,
the current account of the bank will be credited by an amount which is equal to the
principal amount of Rs 1 crores plus interest rate @ 5% per annum for a day and
corresponding quantity of securities would be debited from the Reverse Repo CSGL.
With this mechanism , an amount of Rs 1crores would withdrawn from the banking
system on November 15th 2005 .So with this mechanism the liquidity is withdrawn
from the system. Now if RBI wants to increase the interest rate in the call money
market, it would increase the repo rate under LAF .So a bank having surplus would
invest in the LAF rather than in the call money market.
Similarly in the repo transactions, the banks would deposit securities with RBI and
would receive money on the first day. On the second day , the bank would return
back the money and it would receive the securities . In the first day, the successful
bidder’s current account with RBI will be credited by the amount and its Repo
Constituents SGL account will be debited by the required quantity of eligible
securities. On the next day, the current account of the bank maintained with RBI will
be debited and RR Constituents SGL will be credited. So on the first day of the repo
of LAF , fund is injected in the system. So when RBI wants to reduce the call money
rate , it would reduce the repo rate under LAF , so banks shortage of funds will avail
the LAF instead of call money as long as it can avail the fund under LAF. Please keep
it in mind that for availing LAF the banks must have eligible security for requisite
amount . So first the bank would avail the LAF and then only it would avail the call
money market. In this way the call money market interest rate can be influenced by
RBI. For operational mechanism of LAF you can visit www.rbi.org.in and can go
through related circulars under notification section of the site.

27
 Chapter Four

Central Bank, Money supply and Credit

Money Stock Determination : Before understanding the central bank’s role on money
supply and credit, let us first defined different nomenclature of money. Depending on
the ease of conversion into cash and the different level of maturity of the economy,
the money component is arrived at. Presently there are four types of money
component:
• M1 = Currency with Public + Demand Deposit
• M2 =M1+Post Office Demand Deposit
• M3 = M1+ Time Deposit of Bank
• M4 = M3 + Time Deposit of Post Office
If you see the components of different money, as we move downward the liquidity
decreases and the interest bearing component increases. Among all the money ,
Reserve Bank of India (RBI) gives the most importance to M3 ,because this is the
component of money which can be changed by RBI policy. So we shall concentrate
mainly on the M3. If one looks at the component of M3 which is also called the broad
money , it consists mostly of deposits at bank which the RBI does not control
directly. In this particular chapter we begin to develop details of the process by
which the money supply is determined and particularly the role of the RBI.

Let us define money supply as the following :

M3 = Cp +BD
Where Cp = Currency with the public
BD= Bank deposit
The behavior of both the public and the bank affects the money supply .The public’s
demand for currency affects the currency component and its demand for bank
deposits affects the deposit component. The RBI has a part in determining the
money supply. The interactions among actions of the public, the banks and the RBI
determine the money supply.

28
The three variables which summarize the behavior of the public, banks and the RBI
in the money supply process are the currency deposit ratio, the reserve ratio and the
stock of high power money.

The Currency Deposit Ratio : The payment habits of the public determine how much
money is held relative to deposits. The currency deposit ratio is affected by the cost
and convenience of obtaining cash. It can be assumed that currency deposit ratio is
independent of interest rates and constant.
The Reserve Deposit Ratio: Bank reserves consist of notes and coin held by banks
and deposits the banks hold at the RBI. Bank holds reserves to meet a) the demands
of their customers for cash and b) payments their customers make by checks that
are deposited in other banks.

If we denote re the ratio of bank reserves to deposits, or the reserve deposit ratio,
the reserve deposit ratio is less than 1. This is because the bank would hold more
amount out of its deposit into other assets and less amount in the form of reserve.
The re is determined by two sets of consideration. First, the RBI sets minimum
reserve requirements. Reserves has to be held against deposits. The banks may also
want to hold excess reserves beyond the level of required reserves. In deciding how
much excess reserve to hold, the following factors are the determining factors :
• The market interest rate i, the higher the market interest rate lower
would be the excess reserve,
• The volatility of the deposits,σ, the higher the volatility, the higher
would be the excess reserve.
• The reserve requirement, rR, the higher the reserve requirement
higher would be the reserve deposit ratio.
• The discount rate iD, the higher the discount rate, the higher would be
the reserve deposit ratio.

High Power Money : High power money consists of currency and banks deposits with
the RBI. Part of the currency is held by the public .The remaining currency is held by
banks as part of their reserves. The RBI’s control over monetary base determines
the money supply.

29
The Money Multiplier :
In this section, we develop a simple approach to money stock determination, using
key variables of currency deposit ratio, the reserve deposit ratio, and high powered
money. The approach is organized around the supply of and demand for high
powered money. The RBI can control the supply of high powered money. The total
demand for high powered money comes from the public who want to use it as
currency, and the banks which need its reserves.
Before going into the details , we want to think briefly about the relationship
between the money stock and the stock of high powered money. At the top of the
following figure, we show the stock of high powered money .At the bottom we show
the stock of money. They are related by the money multiplier .The money multiplier
is the ratio of the stock of money to the stock of high powered money .

Currency Reserves High Powered Money (H)

Currency Deposits Money stock

Fig 4.1 The Money Multiplier

The precise relationship among the money stock ,M, the stock of high powered
money ,H, the reserve deposit ratio,re, and the currency deposit ratio,cu is derived
as follows :

M= [(1+cu)/(re+cu)]H

Where [(1+cu)/(re+cu)] is called as money multiplier.

It is clear that money multiplier is larger the smaller the reserve ratio re.The money
multiplier is larger smaller the currency deposit ratio.

The RBI tries to control the money supplier by controlling the high power money.

Controlling the stock of High Powered Money :

The following is the balance sheet of RBI.

30
 Liability Asset
Currency- with public (Cp) Gold and Foreign Exchange (FXRBI)
With Bank (Cb )

Bank Deposit at RBI (D) Reserve Bank Loans given to

Govt( LGRBI)
Bank (LBRBI)
Commercial Sector (LC RBI)

Net Other Assets (NO RBI)

Monetary Base Monetary Base

Fig 4.2 Balance Sheet of RBI

H = Cp +(Cb ) +D =(FXRBI)+ ( LGRBI)+ (LBRBI)+ (LC RBI)+ (NO RBI)

Cp =(FXRBI)+ ( LGRBI)+ (LBRBI)+ (LC RBI)+ (NO RBI)- Cb -D

The Bank Balance sheet is given below :

Liability Asset
Gold and Foreign Exchange (FXB)
Public Deposit with Bank (BD) Bank Loans given to
Govt( BGB)
Commercial Sector (BC B)

Cash Balance with Bank (Cb)

Bank Deposit with RBI (D)
Net Other Assets (NO B)
Total Total

Fig 4.3 Balance Sheet of Bank

M3 = Cp +(Cb ) +BD
From the above balance sheet of the bank , we get
BD = (FXB) +( BGB) +(BC B)+ (CB ) +(D) +(NO B)
So, M3 =(FXRBI)+ ( LGRBI)+ (LBRBI)+ (LC RBI)+ (NO RBI)- Cb -D+(FXB) +( BGB) +(BC
B)+ (Cb)+(D) +(NO B)
=(FXRBI)+ ( LGRBI)+ (LBRBI)+ (LC RBI)+ (NO RBI)+(FXB) +( BGB) +(BC B)+(NO
B )

Whenever RBI wants to change the money stock it can do so either by altering the
cash reserve ratio or by resorting to open market operation.

31
 Chapter Five
Fixed Income Security Market
After the money market we shall discuss the capital market. As can be viewed from
previous chapters, the capital market consists of debt market and equity market. In
the case of debt market, it can again be classified again into two parts namely
Government Securities market and non Government securities market. Since most of
the debt markets in India consists of Government of India securities market, we shall
discuss in detail about the Government of India securities market.
Before we discuss the GoI securities market , we need to know why GoI Securities
are issued at the first place. To find out the reasons for issuance of GoI securities,
we shall start with the central budget. The central budget consists of mainly two
accounts :
• Receipt
• Expenditure
Under Receipt we have the following bifurcations :
• Revenue Receipt (I)
o Tax Receipt (II)
o Non Tax Receipt (III)
• Capital Receipt (IV)
o Recovery of Loan (V)
o Other Receipt (VI)
o Borrowings (VII)
Under expenditure we have the following segregations:
• Non Plan Expenditure
o Revenue Account (VIII)
• Interest (IX)
• Others (X)
o Capital Account (XI)
• Plan Expenditure
o Revenue Account (XII)
o Capital Account (XIII)
Revenue Expenditure XIV= XII+VIII
Capital Expenditure XV= XI+XIII
Revenue Deficit XVI= XIV-I
Fiscal Deficit = XVI+XV-V-VI

32
It is seen from the above that the fiscal deficit is met by borrowings.
Gross Primary Deficit = Fiscal Deficit –IX
It indicates the amount of fresh borrowing going to meet the interest expenses.
It can be seen from the above that fiscal deficit is met by borrowings. It is also seen
from the above that the deficit in the revenue account is not good for an economy
where as the deficit in the capital account would go for the building up of productive
assets. So when the fiscal deficit would only go for meeting the capital account
deficit , it will go for productive investment. So the aim of the central government
would be to eliminate the revenue deficit as early as possible.
Now we shall see what are the options available to the government for raising funds
under the head borrowing mentioned above. Funds can be raised under the head
borrowing through the following methods :
• Small Savings,EPF and PPF
• RBI Bonds
• External Borrowings
• Market Borrowings
We shall see the pros and cons of all these different methods and then we shall see
which methods are mostly used by the government .
Small Savings,EPF and PPF : These are the methods by which resources are
raised directly from the public. Considering the social security aspect of the country ,
political issues associated such type of borrowing the interest rate can not be
reduced beyond a certain point. The best example would be the hue and cry raised
when the EPF rate was reduced in recent times although the rate is quite higher
compared to other types of borrowings. Besides, small savings are the major source
of funds for states as state gets a certain percentage of funds they mobilize under
the small savings scheme. So the interest rate can not be reduced to a great extent
under these methods. If government plans to borrow predominantly in this route, it
would have to pay more interest on its borrowing. So this will not be the most
preferred route of borrowing for government. At present government borrows
approximately about 25% of its total borrowing through this route.
RBI Bonds: This is a good tool for raising funds from high net worth individual. The
interest rate can be made lower compared to that of the previous mode of
borrowing. Besides, the borrowing is directly from the public so the securities are
widely distributed resulting in the lesser adverse effect on the financial system due
to adverse movement in price. Besides the effect of high power money is also

33
reduced if borrowing is carried out through this route. This would increase in share of
borrowings of the government in days to come. However, the difficulties in this type
of borrowing is that it is difficult to raise such huge funds from retail base within one
year.
External Borrowing : Another options of the government would be to borrow
from external sources. However, for borrowings from external sources, the
assistance comes with lots of strings attached . In a democratic country like ours
where there are opposition parties, this type of borrowing can raise several issues
which can be very embarrassing and politically unwise for the ruling party. So this
can be used only as last resorts.
Market Borrowing : This is the most preferred method of borrowing for
government of India to bridge the fiscal deficit. There is a captive market for this
type of borrowing. Schedule commercial banks in our country is supposed to keep
minimum 25% of their NDTL as Statutory Liquidity Ratio ( SLR) . It means that 25%
of NDTL as on a reporting Friday would be kept in SLR approved securities. Banks
can not default on this account. So banks have to keep 25% of NDTL in SLR
securities. Government of India (GoI) securities are SLR approved securities .So
government has a captive market for GoI securities in the form of schedule
commercial banks in the country. As long as SLR stipulation is there, the government
would not have any problem in getting fund up to the SLR requirement as banks do
not have any option other than investing in the GoI Securities. Besides, Pension
Funds , Insurance Companies are also legally bound to invest a certain portion of
their portfolio in GoI securities . This also creates a captive market for the
government. Besides, treasury profits generated by GoI securities prompts many
corporate houses to invest in GoI securities. Due to these factors the market
borrowing forms the major portion of borrowings of the central government and at
present 70% of the fiscal deficit are bridged in this fashion. The market borrowing
can be performed by any or combinations of the following methods :
• Issue of securities through Auctions
• Issue of securities through pre announced coupon rates
• Issue of securities through Tap Sale
• Issue of securities by conversion of T Bills/dated securities
• Issue of securities by any other modes as decided by Government from time
to time.

34
Issue of securities through auction: This is the most popular methods of raising
funds under market borrowing programme. Since market borrowing is the major
source of borrowing of the Government of India, this method is the mostly used
method for bridging the fiscal deficit by the central government. Once the budget is
announced in the month of February , the borrowing requirement can be determined
from the fiscal deficit figure. Then the government would seat with RBI for finalizing
the borrowing programme. The RBI will then announce a tentative borrowing
calendar so that this news are factored in the interest rate the beginning of the year.
This can be explained with the help of the Rational Expectation theory of interest
rate. Now, after the announcement , the RBI can borrow the money under two types
of auction process. In both the type of auction process the following steps are
followed:
1. The RBI will put a public announcement about the auction process. The
announcement would carry the issue size, type of auction, type of
warding to the successful bidder, the process of bidding i.e.
submission of application form and place and date of submission of
application form etc.
2. The advertisement would also state the amount reserved under non
competitive biddings. To promote the investment culture among larger
number of people, the RBI allocates a certain percentage of the issue
size under Non Competitive bidding. In this category , people have to
just quote the amount bidding for not the price or interest rate. The
bidders would be awarded at the price or interest rate at which the
competitive bidders are awarded. This would act as an incentive for an
entity to participate in the bidding process as he/she need not to
posses the specialist knowledge required for investing in fixed income
securities.
3. After the bids are submitted , the bids are opened as per the normal
procedures and name of successful bidders are published .
4. The successful bidders are required to deposit the money asked for
with the stipulated date as per the process mentioned in the
advertisement.
5. On receipt of the money, the RBI credit the securities in the Subsidiary
General Ledger (SGL) of the successful bidders who are having the
account with RBI , for others who do not maintain a SGL , the security

35
 is credited with Constituents Subsidiary General Ledger (CSGL)
account maintained or the amount can be issued in the Physical form
if the investors asked for it.
Now we shall discuss the different types of auction process first . There are
two types of auction process. They are :
• Yield Based Auction
• Price Based Auction
Yield Based Auction : Under this type of auction , the bidders are asked to
quote the biding amount along with the yield at which the amount is quoted.
This can be explained with the help of following examples :
As per the Government of India borrowing programme, the RBI is announcing
the following auction :
Govt. of India will borrow Rs 5000 crores under uniform price yield based
auction for standard coupon bearing securities of 20 years maturity. Out of
the above issues size 10% is reserved under non competitive category.
This means that the RBI is asking bid under uniform price yield based auction
for 20 years period. The coupon would be paid at half yearly interval . The
amount reserved for non competitive bidding is Rs 500 crores. It means
amount available for competitive bidding is Rs 4500 crores. Now let us take 4
different situations :
The following bidding is put by different banks :
Bank Name Bid Amount Type of Bidding Yield Quoted
( Rs Crores) (%)
Bank A 2000 C 5.50
Bank B 1500 C 5.45
Bank C 2500 C 5.40
Entity X 1 NC
Entity Y 5 NC
Entity Z 5 NC

C- Competitive
NC- Non Competitive
Situation I : Now if RBI decides that the cut off yield is 5.38% p.a. , then
none of the bidder under the competitive scheme would qualify and only the
non competitive bidder would get allotted at the cut of yield . The remaining

36
 amount i.e. Rs 4989 crores would be taken by Primary Dealers ( PD) as PDs
are the underwriter to the issue. We shall talk more about this issue and role
of RBI in the Government borrowing programme separately .
Situation II : If RBI decides a cut of yield of 5.40% , those who have quoted
at the cut off yield or below would qualify. In this case only Bank C would
qualify. Bank C would get Rs 2500 crores at 5.40% . The Non Competitive
bidders would get Rs 11 crores at 5.40% and the remaining amount Rs 2489
crores would be taken by PD. When the auction would be over the
government of India would issue securities with coupon rate 5.40% for 20
years. If the issue date is 25th November 2005, then the security would be
called as 5.40% 2025 GoI securities and the issuer would pay coupon on
each security an amount of Rs 540/- since the face value of a single security
is Rs 10000/-. The issuer would pay coupon for this amount on every 25th
May and 25th November till 2025 and on 25th November the face value of Rs
10000/- would also be paid by the issuer. The price of the security can be
found out from the following equation :

C1 C40 P0
Pt = + …………………+ + Eqn …5.1
1 40 40
[1+(r)] [1+(r)] [1+(r)]

This is the famous bond valuation equation. Here Ci is called as Coupon amount and
r is yield to maturity (YTM). Please keep it in mind Ci is kept constant during the
tenure of the security as this is the amount issuer will pay to the holder of the bond.
But r will keep on changing and r will reflect the market perception of the interest
rate for the remaining maturity of the security. Another important factor is that when
r is equal to the coupon , then the present price is equal to the face value of the
security . The bond equation can also be represented in the following format :
Pt = Ci [PVIFA](r%, n years) + P0 [PVIF](r%, n years) Eqn ………….5.2

In the above mentioned case since the coupon would be 5.40% p.a. and this also
reflect the YTM then the issue price of the security would be Rs 10000/- the face
value of the security. So in case of uniform price yield based auction successful
bidders would be issued security at face value.
Situation III : The cut off yield is 5.45% p.a. Here the successful bidders are Bank
B and Bank C as both of them have quoted at or below the cut off yield. So the total

37
amount to be awarded through competitive bidding is Rs 4000 crores and Rs 11
crores would be given to non competitive bidders at 5.45% p.a. and remaining Rs
989 crores would be taken by PD at 5.45% p.a. Now what would be the rate at which
Bank B and Bank C would be offered. Since the auction is uniform price auction,
every eligible bidder would get at the cut off yield irrespective of their individual bid.
In this case , although Bank C has quoted 5.40% p.a. , it will get 5.45% p.a.
Situation IV: If the cut of yield is kept at 5.50% p.a., then all the bidders have
quoted at or below the cut off yield. So all the bidders would be successful. Now ,
since the total bid amount under the competitive category is Rs 6000 crores against
the total available amount under the competitive category of Rs 4500 crores , first
the vacant amount under non competitive bidding would be allocated to the
competitive bidding amount. So the total amount for awarding would be Rs 4500
crores plus Rs 489 crores i.e. total of Rs 4989 crores. Next step would be to find out
the eligible amount under competitive bidding. Since the amount is Rs 6000 crores
which is more than the total available amount , the allotment would be under the
proportional allotment. So Bank A would get (Rs 2000/Rs 6000)*Rs 4989 crores .
Similarly Bank B and Bank C would get (Rs 1500/Rs 6000)*Rs 4989 crores and (Rs
2500/Rs 6000)*Rs 4989 crores respectively.
Now we take the same example of yield based auction but the awarding type is
differential pricing . In this case the following methodology would be pursued :
1. First determine the eligible bidder applying the same logic. Any bidder which
is quoting at or below the cut off yield would become eligible. So if we take
the situation IV , then all the banks become eligible.
2. Then the awarding would be in the process so that the total cost of the
borrowing is the least. In such case, Bank C would get Rs 2500 crores at
5.40% , Bank B would get Rs 1500 crores at 5.45% and bank C would Rs 989
crores at 5.50% p.a. The non competitive bidder would get 5.50% p.a. .
3. But Government of India would issue securities at uniform coupon rate and
the coupon rate would be at cutoff yield. So in this case the Government of
India would issue securities at 5.50% coupon and Bank B and Bank C would
pay more than the face value so that Government of India pays 5.45% and
5.40% respectively on their investment . The price is found out by putting r at
2.725% for bank B and r at 2.750% for Bank C in equation 7.1 where as the
coupon would be Rs 550/- and P0 is equal to Rs 10000/-. So in case of

38
 differential yield based auction, different investor would pay different price at
the time of subscription in the primary market.
It may be mentioned that the uniform price auction is also called as Dutch
Auction and the differential price auction is also called as French Auction.
Price Based Auction : In Price based auction, the bidder is asked to bid for the
price of a security where the coupon of the security would be mentioned at the time
of advertisement . Let us take an example ,
As per the Government of India borrowing programme, the RBI is announcing the
following auction :
Govern of India will borrow Rs 5000 crores under uniform price based mechanism
for price based auction for standard 10% standard coupon bearing securities of 20
years maturity. Out of the above issues size 10% is reserved under non competitive
category.
This means that the RBI is asking bid under uniform price based mechanism for price
based auction for 20 years period and the coupon of 10% coupon would be paid at
half yearly interval . The amount reserved for non competitive bidding is Rs 500
crores that means amount available for competitive bidding is Rs 4500 crores. Now
let us take 4 different situations :
The following bidding is put by different banks :
Bank Name Bid Amount Type of Bidding Price Quoted
( Rs Crores) Per Rs 100
Bank A 2000 C 154.1757
Bank B 1500 C 155.0043
Bank C 2500 C 155.8394
Entity X 1 NC
Entity Y 5 NC
Entity Z 5 NC

The above price has been quoted by these banks by taking into consideration that
the interest rate for 20 years as of the date of issue would be 5.40% for bank
C,5.45% for bank B and 5.50% for bank C. Now , putting these different values of r
in the equation 6.1 while keeping the C value at Rs 500/- and P0 at Rs 10,000/-, the
above mentioned prices are obtained.
Situation I : The RBI feels that the 20 years risk free rate is 5.40% p.a. So the cut
off price would be Rs 155.8394. So any one who has quoted at or above the cut off

39
price would become eligible for allotment. In this case, Bank C would become
eligible. So bank C would get 16,04,216 number of 10% coupon bearing securities
maturing at 25th November 2025. The participants under Non Competitive bidding
would get Rs 11 crores at the cut off price. The remaining amount would be issued to
PD and PD would give the remaining Rs 2489 crores to the government of India.
Situation II : The RBI feels that the 20 years risk free rate would be 5.50% p.a.
Then all the banks would become eligible and the process of allotment would be
same as mentioned in the yield based auction process.
Situation III : In case of uniform price price based auction , if the auction type is
differential price price based auction and the cutoff price has been decided as per
situation II mentioned above. In this case, the allotment mechanism would be such
that the cost of borrowing would be lowest. So C would get the maximum amount ,
then B and then A and the transfer of non competitive to competitive would follow
the same methodology.
So from the above we can find out that , the subscription price for an investor in a
Government of India securities would be at the face value only when the auction is
yield based and uniform price type. The subscription price would be different from
the face value if the auction is yield based , differential price type, price based
uniform price type and price based differential price type.
Now we shall discuss the merits of price based auction compared to that of yield
based auction. If one looks at the bond valuation formula as mentioned in equation
2.1 , one can issue a security with identical coupon which was issued earlier by
changing the price. If the present interest rate for the period of present borrowing
is less than the coupon rate to be offered in the security, the issue price would be
more than the face value. Similarly, if the present interest rate for the period of
present borrowing is more than the coupon rate to be offered in the security, the
issue price would be less than the face value of the security. Due to this property ,
reissuance of security is possible under the price based auction process. The
reissuance means issuance of a security which was earlier issued. Let us take an
example. Suppose on 25th November 1995 Govt. of India borrowed Rs 2500 crores
for 20 years under yield based auction by issuing a coupon of 11% p.a. This means
that on 25th November 1995, the interest rate for 20 years was 11% p.a. Now on
25th November 2005, the Govt. of India wants to borrow for 10 years. Let us assume
that 10 years interest rate as on November 25th 2005 is 4.95% p.a. In such case the

40
Govt. of India can issue 11% 25th November 2015 at a premium . This serves two
purposes .
1. With this mechanism the number of coupon as on a particular date increases
as newer securities are issued with the same identical coupon. If the
numbers of coupons are increased, all these coupons can be clubbed
together and sold as a separate instrument because the total value of such
instrument is increased. The principal can be traded separately. This improves
the liquidity of the security. Such trading is called Separate Trading for
Registered Interest and Principal Securities ( STRIPS).
2. It can be found out that the price sensitivity of a fixed income security is
lower in case of high coupon bond than a low coupon bond. So in such case,
even though the interest rate is low, by issuing high coupon security at a
premium, the issuer can provide a low price sensitivity to the investor.
Considering the mark to market valuation, this is an important factor when
the interest rate rises.
Issue of Securities through pre announced coupon rate : Government of India
can issue securities by announcing the coupon rate at the time of issuance it self.
This makes the investors task easy as the investor need not to quote the rate. The
securities are issued at par.
Issue of securities through tap sale : This is a method by which the securities
are sold through a selling window by RBI. The sale can be extended beyond one day
and the sale can be closed at any time during the day. This method can be used by
RBI to reduce the cost of borrowing for the government. Let us assume that on 1st
November 2008 , RBI announces a borrowing programme of Rs 2500 crores under
yield based auctions for 20 years. The RBI fixes the cut off yield at 4.95% p.a. The
yield quoted by all the bidders are more than the cut off yield. In such case the RBI
would take the entire issue in its books. RBI is also visualizing that there would be
some liquidity in the system because RBI is planning to carry out some sterilization
mechanism under which it would buy dollars against rupees. This inflow of rupees
would increase the money flow in the system and the interest rate would go down.
Besides this RBI also visualizing that there would be deposit growth in the next one
month which will also increase the money supply. Along with the deposit growth , the
banks would be required to invest incremental amount in GoI Securities because of
SLR requirement. At that time RBI can sale the securities on tap at the cut of yield at
which the issue was devolved on RBI.

41
Issue of securities by conversion of T Bills/dated securities : Though this is
one of the methods for issuing of GoI securities but this method is not an efficient
method. This is because treasury bills are supposed to the self liquidating in nature .
If the treasury bills are converted in to the GoI securities , it shows inefficiency in the
system . So this form is not encouraged .
Issue of securities by any other modes as decided by Government from time
to time : The Government can issue securities by any other modes as decided from
time to time. This clause is kept so that the Government can use any newer methods
developed in the future .

Price of a Fixed Income Securities :

In the above mentioned examples showing the price of the fixed income securities
we have assumed the following :
• The coupon payment date and the issue date is same.
• In the case of secondary market transaction, the above formulas would able
to give the price only at the coupon payment date. But the coupon payment
date would come only in once in the six month. So the above mentioned
formula would give the price of a fixed income securities accurately once in
six months.
Then how this problem is addressed. To understand the problem , we have to
understand the complete procedure of coupon payment. The coupon is paid to the
holder of the securities at the coupon payment date by the issuer of the security. Let
us take an example, Suppose A purchase a security from the issuer X on 3rd of
January 2009. The security is for five years and the coupon rate is 5% p.a. and the
coupon is paid on half yearly basis. The next coupon is to be paid on 3rd June 2009.
Now suppose A sells the security to B on 4th of March 2009 and B holds the security
to the next coupon payment date. It means that the issuer would pay Rs 250/- (
assuming the face value of the security is Rs 10000/-) to B on 3rd June 2009. There
are two implications of this transaction:
• A would not get the coupon from the issuer for the period it hold i.e. between
3rd January to 3rd March 2009. So it should get the payment for this period
from B.
• B would get interest for the period from 4th March 2009 till it holds and this
would be accounted for the price formula by applying the proper time scale in
the bond pricing formula.

42
Next step would be the calculation procedure for the time period passed after the
last coupon date. For this period the seller would get accrued interest.
Next step would be the calculation procedure for the time period left from the
purchase date to the next coupon payment date. This would be put in the bond price
formula to get the proper price for the trade.

There are many types of convention for calculating the days as mentioned above .
These are :
• 30/360 :Each month will have 30 days inclusive of February and total days in
a year is 360
• Actual /360 : Each month will have actual days and the total days in a year is
360.
• Actual/Actual : Each month will have actual days and the total actual days
between two coupon period
• Actual/365 : Each month will have actual days and the total days in a year
are 365 days.
Let us assume that we apply the Actual /360 formula . So the seller holds the
security from 3rd January to 3rd March i.e. (29+28+3)=60 days and total days
between two coupon period is 180 days as two coupon would be paid in a year.
So the seller would get the accrued interest for 60 days or he should get an amount
(60/180)* Rs 250/- at the time of selling the security in addition to the price of
selling. This is called the Dirty Price.
The sale price of the security would be found out by the following equation :

P0 = [ C1/(1+r)(dnc/dicp)] + [C1/(1+r){1+(dnc/dicp)}]+………..+ [Cn(1+r){(n-1)+(dnc/dicp)}]

Eqn …………………..5.3

Here dnc= days between the trading date and the next coupon payment date =
days between two coupon payment date- no of days already passed =180-60=120
days
dicp= days between two coupon payment date =180 days
So dnc/dicp= 120/180=2/3
If the YTM for 4years 10 months is 5.10% , then the price would be Rs 10040.2722.

43
The buyer would pay to the seller on March 4th 2009, Rs 10400.2722 plus accrued
interest of (60/180)* Rs 250/- .

After finding out the ways for arriving at the price, while investing the money in the
fixed income securities , one needs to look into the time horizon at which he/she is
investing. If one is investing for the entire life of the securities , then he should look
for a particular type of criteria . Similarly , if one is investing in a time horizon where
he/she would sale before the maturity period , he will look after certain other
criteria. For finding out such criteria for second category of investors , one need to
understand the price and yield relationship of a fixed income securities. These are
given below :
Before we proceed with the rules let us take the example of the following 4 fixed
income bonds :

Bond Coupon Maturity Initial YTM

A 12% 5 Years 10%
B 12% 30 Years 10%
C 3% 30 Years 10%
D 3% 30 Years 6%

Face Value of the bond is Rs 1000/- .

Coupon is paid annually.
If the YTM increases to 12% , then the bond A and B would be traded at par. So
when coupon is equal to the YTM of the bond the price of the bond will be the face
value.
Similarly, if the YTM is more than the coupon, the price of the bond would be lower
than the face value. In the above example, in Bond C the coupon is 3% and YTM is
10%. The price is Rs 340.12 less than the face value of the bond which is Rs 1000/-
. In such case, the bond is supposed to be traded at discount. Similarly, when the
YTM of the bond is less than the coupon, the bond’s price is more than the face value
and the bond is supposed to be traded at premium.
Now let us assume that YTM of all the bond becomes 11% p.a. . Then the price
would be :

44
 Bond A Bond B Bond C Bond D
Price at YTM 1036.96 1086.94 304.50 503.64
11%

Similarly if the YTM becomes 10% then prices of these bonds would be as follows :
Bond A Bond B Bond C Bond D
Price at YTM 1075.82 1188.54 340.12 587.06
10%
Now if the YTM becomes 9% then prices of these bonds would be as follows :
Bond A Bond B Bond C Bond D
Price at YTM 1116.69 1308.21 383.58 692.55
9%

The above table would give you the following rules of between bond price and yield :

1. There is an inverse relationship between price and yield of a fixed income

securities. If the YTM goes up price would fall and in case of downward
movement of YTM the price would go up.
2. An increase in a bond’s yield would result in smaller price decline than the
increase in price with the equal amount of fall in yield .This is explained with
the following table :

Bond A Bond B Bond C

Increase in Price 40.87 119.67 43.46
due to decrease in
YTM from 10% to
9%
Decrease in Price 38.86 101.60 35.62
due to increase in
yield from 10% to
11%

3.Long term bonds tend to be more price sensitive than the short term bonds.
This will be seen from the following table :

45
 Bond A Bond B Bond C Bond D
% change in -3.61% -8.55% -10.47% -14.21%
decline price
% change in 3.80% 10.07% 12.78% 17.97%
increase in
price
3. As maturity increases the price sensitivity increases at a decreasing rate.
4. Price sensitivity is inversely related to the coupon rate ( see Bond B and Bond
C) .
5. Price sensitivity is inversely related to the YTM at which the bond is selling.
Since the price would change during the holding period ( if the holding period is less
than the maturity period of the bond) depending on the holding period horizon one
tends to select bond by taking into account the above mentioned factors.
Duration of Bond : Another measure of the effective maturity of the bond is the
duration of the bond. This would be explained as below :
If we define as the maturity of a debt instrument is the time required to get all the
payment from the instrument then you see a unique feature of fixed income
securities :
In case of coupon bearing securities you get coupon before the maturity date of the
security and you get the principal on the maturity date of the security. So the
effective maturity is less than the maturity period of the fixed income instrument as
some payments are received before the maturity period. So the concept of weighted
average payment period is coming into picture . This weighted average payment
period is called the duration of a fixed income securities. This is explained with the
help of the following example :

There is a 8% coupon bearing bond with a remaining maturity of 2 years. The YTM of
the bond is 10% . The duration of the bond is calculated as below :

Time of Amount of Present Value Wt Effective

Payment (Yrs) Payment of Cash Flow at Period
( Rs ) 10%
A B C D E
0.5 40 38.095 0.0395 0.0197
1 40 36.281 0.0376 0.0376

46
 1.5 40 34.553 0.0358 0.0537
2.0 1040 855.611 0.8871 1.7742
Duration of the bond 1.8852

It is evident from the above that the duration of a fixed income coupon bearing
security is less than the maturity period of the securities while for a zero coupon bind
it is equal to the maturity period of the securities as no intermediate payments are
made.
Duration is very important due to the following equation :

∆P/P=-D[∆(1+y)/(1+y)] …………………………. Eqn 5.4

If we define D*= D/(1+y) then the above equation becomes
∆P/P =- D*∆y …………………………. Eqn 2.5

There are several rules for duration of a fixed income securities. These are :
Rule 1: The duration of a zero coupon bond is equal to its maturity.
Rule 2: Holding maturity constant, a bond’s duration is higher when the coupon rate
is lower . The higher the weight in earlier payment due to higher coupon lower would
be the weighted average maturity of the payment.
Rule 3: Holding the coupon rate constant, a bond’s duration generally increases with
its time to maturity.
Rule 4: Holding other factors constant, the duration of a coupon bearing bond is
higher when the bond’s YTM is lower.
Rule 5 : The duration of a level perpetuity is as follows :
(1+y)/y …………………………………………….. Eqn 5.6
Rule 6 : The duration of a level annuity is equal to the :
[(1+y)/y]- [T/{(1+y)T-1}]……………… Eqn 5.7
Rule 7 : The duration of corporate bond is equal to :

[(1+y)/y] –([ { (1+y)+T(C-y)}]/[C{(1+y)T-1}+y])… Eqn 5.8

Rule 8 : For coupon bonds selling at par value , the duration can be calculated as
follows :

47
 {(1+y)/y}[1 –{1/(1+y)T}] ……………..Eqn 5.9
For example , a 10% coupon bond with 20 years to maturity , paying coupon
semiannually , would have a 5% semiannual coupon and 40 payment period. If YTM
is 4% per half year period , we get
[1.04/0.04]-[{1.04+40(0.05-0.04)}/{0.05(1.0410-1)+0.04}=19.74 half year =
9.87 years
Duration and Convexity :
If one observes the equation 5.4 , he/she can find out that duration is nothing but
the slope of the curve obtained by plotting the change in yield in X axis and
percentage change in price in the Y axis. This is shown in the following figure :
Percentage change in bond price

Pricing error
Price Due to convexity

Duration

Change in YTM (%)

Fig : 5.1 Relationship between change in price of a bond and change in YTM

The duration measures assume the linear relation ship between the change in
price and change in yield where as actually the relationship is not linear. The
relationship is convex. Due to this if the change in yield is more there would
be error in the change in price value. If duration is used then it
underestimates the increase in bond price and over estimates the decrease in

48
bond price with decrease and increase in YTM respectively. So the effect of
convexity needs to be brought it to get the total effect when the change in
yield is significant.

We can quantify convexity as the rate of change of the slope of the price yield
curve , expressed as a fraction of the bond price . As a practical rule , one can
view bonds with higher convexity as exhibiting higher curvature in the price
yield relationship.
Convexity implies that the duration approximation for bond price changes can
be improved. Accordingly the equation 5.4 can be modified as follows :
∆P/P =- D*∆y +1/2*Convexity*(∆y)2 ……………. Eqn 5.10

Please note that to use the convexity rule one must express interest rates as
decimals rather than percentages.

The first term of Eqn 5.10 is the same as the duration rule . The second term
is the modification for convexity. For a bond with positive convexity , the
second term is positive , regardless of whether the yield rises or falls.
Let us use a numerical example to examine the impact of convexity . Suppose
a bank has 30 years of maturity , an 8 % coupon and sells at an initial YTM of
8%.Because the coupon rate equals to YTM , the bond sales at par. The
modified duration of the bond at an initial yield is 11.26 years and its
convexity is 212.4. If the bond’s yield increases from 8% to 10% , the bond
price will fall to Rs 811.46 , a decline of 18.85%.The duration rule , would
predict a price decline of
∆P/P =- D*∆y =-11.26*0.02=-0.2252 or –22.52%
which is considerably more than the bond price actually falls. The duration
with convexity rule is more accurate :
∆P/P =- D*∆y +1/2*Convexity*(∆y)2 =-0.1827 or –18.27%

The convexity of a bond is calculated with the help of the following formula :

Convexity=[1/{(P)*(1+y)2}]*∑ [(CFt/(1+y)t)*(t2+t)] Eqn …5.11

49
Where CFt is the cash flow paid to the bondholder at date t. CFt represents
either a coupon payment before maturity or final coupon plus par value at
maturity date.

50
 Chapter Six

Bond Portfolio Management

Once a treasurer invests in fixed income securities he/she creates a fixed income
portfolio. For creation of portfolio he would look in to the above mentioned criteria
depending on the investment horizon. During the investment horizon , the manager
would manage the portfolio of bonds. Now , we shall discuss about the basic
strategies followed by bond managers for managing the bond portfolio.
The portfolio of any financial securities can be managed by following two strategies.
They are :
• Passive Portfolio Management Strategy
• Active Portfolio Management Strategy.
So an equity portfolio can be managed by following the above mentioned strategy .
Similarly , in the case of debt same strategy is followed.
In the case of passive bond management strategy the underlying assumption is that
the pricing of the bonds available in the market are properly priced. They take that
the bond prices are fairly set and seek to control only the risk of their fixed income
portfolio. This can be done by any of the following process:
• Indexing Strategy
• Immunization strategy
Indexing Strategy: It attempts to replicate the performance of a given bond
index. The idea is to crate a portfolio that mirrors the composition of an index that
measures the broad market. But there are certain difficulties associated with this
strategy. In the case of developed bond index total number of securities are very
large. For example , any broad based US bond index consists of more than 5,000
securities. Moreover, the securities are constantly changing as securities having
remaining maturity less than one year would go out of the bond index. So manager
must rebalance the portfolio. This involves the transaction costs.
In practice it is deemed infeasible to precisely replicate the broad bond index.
Instead, a stratified approach is often pursued. First the bond market is stratified
into several sub classes. The criteria for stratification can be maturity, issuer, bond’s
coupon rate, credit risk of the issuer are taken into account. Next the percentage of
the entire universe (i.e. the bonds included in the index that is to be matched). Next

51
the sampling is carried out in such a way the selected sample represent most of the
characteristics of the bond index.
Immunization : In contrast to indexing strategies, many institution try to insulate
their portfolios from the interest rate risks altogether. Generally, there are two ways
of viewing this risk, depending on the circumstances of the particular investor. Some
institutions such as banks, are concerned with protecting the current net worth or
net market value of the firm against the interest rate fluctuations. Other investors,
such as pensions funds , may face an obligation to make payments after a given
number of years. These investors are more concerned with protecting the future
values of their portfolios.
The common risk with these two types of investors are the interest rate risks.
Immunization techniques refer to strategies used by such investors to shield their
overall financial status from exposure of interest rate fluctuations.
Net Worth Immunizations : Many banks and thrift institutions have a natural
mismatch between asset and liability maturity structures. Bank liabilities are
primarily the deposits owed to the customers, most of which are very short term in
nature and consequently of low duration. Bank assets are composed of largely of
outstanding commercial and consumer loans which are of longer duration than
deposits and their values are correspondingly more sensitive to interest rates.
Let us take an example that an insurance company issues a guaranteed investment
contract for Rs 10000/- . If the contract has a five year maturity and a guaranteed
interest rate of 8% , the insurance company is obligated to pay Rs 10000*(1.08)5
=Rs 14693.28 in five years.

52
 Payment Number Years remaining until Accumulated value of
obligation invested payment
A. Rates remain at 8%
1 4 800*(1.08)4=1088.39
2 3 800*(1.08)3 =1007.77
3 2 800*(1.08)2 =933.12
4 1 800*(1.08)1 =864.00
5 0 800*(1.08)0 =800.00
Sale of Bond 0 10800/(1.08) = 10000
Total 14,693.28
B. Rates falls to 7%
1 4 800*(1.07)4=1048.64
2 3 800*(1.07)3 = 980.03
3 2 800*(1.07)2 =915.92
4 1 800*(1.07)1 =856.00
5 0 800*(1.07)0 =800.00
Sale of Bond 0 10800/(1.07) = 10093.46
Total 14,694.05
C. Rates increases to 9%
1 4 800*(1.09)4=1129.27
2 3 800*(1.09)3 = 1036.02
3 2 800*(1.09)2 =950.48
4 1 800*(1.09)1 =872.00
5 0 800*(1.09)0 =800.00
Sale of Bond 0 10800/(1.09) = 9908.26
Total 14,696.02

The above table shows that if interest rates remain at 8% , the accumulated funds
will grow to exactly the Rs 14693.28 obligation. Over the five year period, the year
end coupon is reinvested at the prevailing market rate i.e. 8% . At the end of the
period the bonds can be sold for Rs 10000/- . Total income after five years from
reinvestment of bonds and sale of bond would is precisely Rs 14,693.28.
If interest rates change however two offsetting influences will affect the ability of the
fund to grow to the targeted value of Rs 14,693.28. If interest rates rise, the fund

53
will suffer a capital loss but the coupon reinvested at a higher rate would grow
faster. Reverse would happen if the interest rate falls. In other words, the fixed
income investors face two offsetting types of interest rate risk : price risk and
reinvestment risk. The first type of risk is the price risk and the second type is called
the reinvestment risk.
When a portfolio duration is set equal to the investor’s horizon date, the accumulated
value of the investment fund at the horizon date will be unaffected by interest rate
fluctuations. For a horizon equal to the portfolio’s duration , price risk and
reinvestment risk exactly cancels out.
The following figure depicts the price risk and reinvestment risk in the time horizon :

Accumulated value of invested fund

Funds

t* D t

Fig 6.1 : The growth of invested fund with time

54
The solid curve represents the growth of the portfolio value at the original interest
rate. If interest rate increase at time t*, the portfolio value initially falls but increases
subsequently at the faster rate represented by the broken curve. At time D (
duration) the curves crosses.
So to protect the interest rate risk one can adopt the immunization technique.
However the rebalancing of the portfolio is must. As interest rate and asset durations
change, a manger must rebalance the portfolio of fixed income assets continually to
realign its duration with the duration of the obligation. Moreover, if interest rate do
not change, assets durations will change solely because of the passage of the time.
Thus even if an obligation is immunized at the beginning , as time passes the
durations of assets and liability will fall at different rates. Without portfolio
rebalancing, durations will become unmatched and the goals of immunization will not
be realized. Obviously, immunization is a passive strategy only in the sense that it
does not involve attempts to identify undervalued securities .
Let us take another example about the need for rebalancing of the portfolio. Let us
consider a portfolio manager facing an obligation of Rs 19487 in 7 years , which at
current market interest rate of 10% , has a present value of Rs 10000/- . If the
manager wishes to immunize the obligation by holding only three year zero coupon
bonds and perpetuities paying annual coupons. At current interest rates, the
perpetuities have a duration of 1.10/10=11 years. The duration of a zero coupon
bond is 3 years.
For assets with equal yields, the duration of a portfolio is the weighted average of
the duration of assets comprising the portfolio. To achieve the desired portfolio
duration of 7 years , the managers would have to choose appropriate values for the
weights of the zero and the perpetuity in the overall portfolio. Then the weight of
investment in zero w must be chosen to satisfy the following equation :
W* 3 +(1-w)*11 =7 years …………………… Eqn 6.1
This implies that w=1/2. The manger invests Rs 5000/- in zero coupon bond and Rs
5000/- in perpetuity.
Next year even if the interest rate does not change, rebalancing will be necessary.
The present value of obligation has grown to Rs 11000/- , because it is one year
closer to maturity. The manager’s fund has also grown to Rs 11000/- .The zero
coupon bonds have increased in value from Rs 5000/- to Rs 5500/- with the passage
of time , while the perpetuity has paid its annual Rs 500/- coupon and still it is
worth of Rs 500/- However, the portfolio weight must be changed . The zero coupon

55
now will have 2 years duration while the perpetuity remains at 11 years. The
obligation is now due in 6 years. The weights must now satisfy the equation :
w* 2 +(1-w) *11=6
this implies w=5/9. So the manager must invest a total of Rs 11000*(5/9)= Rs
6111.11 in the zero. This requires that the entire Rs 500/- coupon payment be
invested in the zero and that an additional Rs 111.11 of the perpetuity be sold and
invested in the zero in order to maintain an immunized position.

However, rebalancing of portfolio entails transaction costs as assets are bought or

sold , so one can not rebalance continuously. In practice, an appropriate compromise
must be established between the desire for perfect immunization which requires
continual rebalancing and the need to control trading costs, which dictates less
frequent rebalancing.

Cash Flow Matching and Dedication: Cash flow matching on a multi period basis is
referred to as a dedication strategy. In this case, the manager selects either zero
coupon or coupon binds that provide total cash flows in each period that match a
series of obligations. The advantage of dedications is that it is a once and for all
approach to eliminating the interest rate risk. Once the cash flows are matched,
there is no need for rebalancing. The dedicated portfolio provides the cash necessary
to pay the firm’s liabilities regardless of the eventual path of interest rate. However
the problem in such strategies would be the availability of appropriate securities so
that exact cash flow matching takes place.

Other problems with conventional immunization :

If we look at the definition of the duration then we note that it uses the bond’s yield
to maturity for calculating the weight applied to the time until each coupon payment.
Given this definition and limitations on the proper use of yield to maturity , it is
perhaps not surprising that this notion of duration is strictly valid only for a flat yield
curve for which all payments are discounted at a common interest rate.
If the yield curve is not flat , then the definition of duration must be modified and
CFt/(1+y)t replaced with the present value of CFt where the present value of each
cash flow is calculated by discounting with the appropriate interest rate from the

56
yield curve corresponding to the date of the particular cash flow, instead by
discounting with the bond’s yield to maturity. Moreover, even with this modification,
duration matching will immunize the portfolios only for the parallel shift in the yield
curve. Clearly, this sort of restriction is unrealistic. As a result, much work has been
devoted to generalizing the notion of duration in the shape of the yield curve, in
addition to shifts in its level.
Finally, immunization can not be an appropriate goal in an inflationary situation.
Immunization is essentially a nominal notion and makes sense only for nominal
liabilities. It makes no sense to immunize a projected obligation that will grow with
the price level using nominal assets such as bonds.
Active Bond Management :
Sources of Potential Profit :
Broadly speaking there are two sources of potential value in active bond
management. The first is interest rate forecasting which tries to anticipate
movements across the entire spectrum of the fixed income market. If interest rate
declines are anticipated , managers will increase the portfolio duration ( or vice
versa) . The second source of potential profit is identification of relative mispricing
within the fixed income market.
These techniques will generate abnormal returns only if the analyst’s information or
insight is superior to that of the market. In this context it is worth mentioning that
interest rate forecasts have a notoriously poor track record.
One of the active bond portfolio management strategies is the bond swaps. There
are four types of bond swaps. In the first two types of bond swaps the investor
typically believes that the yield relationship between bonds or sectors is only
temporarily out of alignment. When the aberration is eliminated, gains can be
realized on the underpriced bonds. The period of realignment is called the workout
period.
1. The substitution swaps : The substitutions swap is an exchange of one
bond for a nearly identical substitute. The substitute bonds should be of
essentially equal coupon, maturity, quality call features, sinking fund
provisions, and so on. This swap would be motivated by a belief that the
market has temporarily mispriced the two bonds , and that the discrepancy
between the prices of the bonds represents a profit opportunity.
2. The intermarket swaps: It is pursued when an investor believes that the
yield spread between two sectors of the bond market is temporarily out of

57
 line. For example, if the current spread between corporate and government
bonds is considered too wide and is expected to narrow, the investor will shift
from government bonds into corporate bonds. If the yield spread does in fact
narrow, corporates will outperform governments,. But the investor must be
sure that there is actually mispricing between two bonds. The difference is not
due to some genuine reasons like credit downgrade etc.
3. The Rate anticipation swaps : It is pegged to interest rate forecasting. In
this case, if investors believe that rates will fall , they will swap into bonds of
longer duration. Conversely , when rates are expected to rise, they will swap
into shorter duration bonds .
4. The pure yield pick up swaps: It is pursued not in response to perceived
mispricing but as a means of increasing return by holding higher yield bonds.
When the yield curve is upward slopping , the yield pick up swaps entails
moving into longer term bonds. This must be viewed as an attempt to earn an
expected term premium in higher yield bonds. The investor is willing to bear
the interest rate risk that this strategy entails. The investor who swaps the
shorter term bond for the longer one will earn a higher rate of return as long
as the yield curve does not shift up during the holding period. Of course, if it
does, the longer duration bonds will suffer a greater capital loss.
Horizon Analysis :
One form of interest rate forecasting is called horizon analysis. The analysts using
this approach selects a particular holding period and predicts the yield curve at the
end of the period. Then bond’s end of period price is calculated from the yield curve.
Then the analysts add the coupon income and the perspective capital gain of the
bond to arrive at the total return on bond in the horizon period.

Suppose a 20 year maturity ,10% coupon bond currently yields 9% and sells at Rs
1092.01. An analyst with a 5 year time horizon would be concerned about the bond’s
price and the value of reinvested coupon five years hence .At that time the bond will
have 15 years maturity , so the analyst will predict the yield on 15 years maturity at
the end of 5 year period to determine the bond’s expected price . If the yield is
expected to be 8% , the bond’s end of period price will be
–50 * Annuity Factor ( 4% ,30)+1,000 PV Factor ( 4%,30)= Rs 1172.92 . The capital
gain on this bond will be Rs 80.91 . Meanwhile the coupon paid by the bond will be
reinvested over the five year period. The analyst must predict a reinvestment rate at

58
which the invested coupons can earn interest. Suppose the assumed rate is 4% per
half year period. If all the coupons are reinvested at this rate, the value of the ten
semiannual coupon payments with accumulated interest rate at the end of the five
year will be Rs 600.31. The total return proved by the bond over the holding period
is Rs 681.82/Rs 1092.01 i.e. 62.4% . The analyst repeats this procedure for many
securities and select the ones promising superior holding period return.

Contingent Immunization :
It is mixed passive –active strategy . Suppose that the interest rate at present is
10% per annum and a manager’s portfolio is worth Rs 10 million right now. At
current rate the manager can lock in via conventional immunization techniques, a
future portfolio value of Rs 12.1 million after 2 years. Now suppose that the manager
wants to pursue active management but is willing to risk losses only to the extent
that the terminal value of the portfolio would not drop lower than Rs 11 million.

Because only Rs 9.09 million ( Rs 11million/1.102) is required to achieve this

minimum acceptable terminal value , and the portfolio is currently worth Rs 10
million , the manager can afford to risk some losses at the outset and might start off
with an active strategy rather than immediately immunizing. The key is to calculate
the value of the fund required to lock in via immunization a future value of Rs 11
million at current rates. If T denotes the time left until the horizon date and r is the
market interest rate at any particular point of time , then the value of the fund
necessary to guarantee an ability to reach the minimum amount of terminal value is

Rs 11 million/(1+r)T, because this size portfolio if immunized will fetch Rs 11 million.

This value becomes the trigger point. When the actual portfolio value dips to the
trigger point , active management will cease. Contingent upon reaching the trigger ,
an immunization strategy is initiated

59
Rs in Million

Portfolio Value

Trigger Point

t* t
Horizon

Fig 1.2 Contingent Immunization

Rs in million
Portfolio Value

Horizon t
t*

60
Fig 6.3 : Contingent Immunization consisting of only active bond management
strategy

Interest Rate Swaps : An interest rate swap is a contract between two parties to
exchange a series of cash flows similar to those that would result if the parties
instead were to exchange equal dollar values of different types of bonds. Swaps
arose originally as a means of managing interest rate risk.
To illustrate how swaps work, let us consider the manager of large portfolio that
currently includes Rs 100 million par value of long term bonds paying an average
coupon rate of 7%. The manager believes that the interest rates are about to rise.
As a result , he would like to sell the bonds and replace them with either short term
or floating rate issues. However, it would be exceedingly expensive in terms of
transactions costs to replace the portfolio every time the forecast for interest rate is
updated. A cheaper and more flexible way to modify the portfolio is for the managers
to swap the Rs 7 million a year in interest income the portfolio currently generates
for an amount of money that is tied to the short term interest rate. That way, if rates
do rise, so will the portfolio’s interest income.
A swap dealer might advertise its willingness to exchange or swap a cash flow based
on the six month LIBOR rate for one based on a fixed rate of 7%. The portfolio
manager would then enter into a swap agreement with the dealer to pay 7% on
notional principal of Rs 100 million and receive payment of the LIBOR rate on the
amount of notional principal. In other words the manager swaps a payment of
0.07*Rs 100 million for a payment of LIBOR* Rs 100 million. The managers net cash
flow from the swap agreement is therefore (LIBOR-0.07)* Rs 100 million. Now
consider the net cash flow to the manager’s portfolio in three interest rate scenario:

LIBOR Rate
6.5% 7.0% 7.5%
Interest income from bond Rs 70,00,000 Rs 70,00,000 Rs 70,00,000
portfolio=(7% of Rs 100
million)
Cash Flow from Rs (500,000) 0 Rs 5,00,000
swap[=(LIBOR-7%)* notional
principal of Rs 100 million]

61
Total (=LIBOR*Rs 100 million) Rs 65,00,000 Rs 70,00,000 Rs 75,00,000
Please note that the total income on the overall position bonds plus swap
arrangement is now equal to LIBOR rate in each scenario times Rs 100 million.
Financial Engineering and Interest rate derivatives : Some of the more popular
mortgage derivative products are interest only and principal only strips. The interest
only (IO) strip gets all the interest payments from the mortgage pool and the
principal only (PO) strips gets all the principal payments. Both of these mortgage
strips have extreme and interesting interest rate exposures. In both cases, the
sensitivity is due to the effect of mortgage prepayments on the cash flows accruing
to the security holder.
PO securities exhibit very long effective durations. It means that their values are
very sensitive to interest rate fluctuations. When interest rate fall and mortgage
holders prepay their mortgages, PO holders receive their principal payments much
earlier than initially anticipated. Therefore, the payments are discounted for fewer
years than expected and have much higher present value. Hence PO strips perform
extremely well when rates fall. Conversely , interest rate increases slow mortgage
prepayments and reduce the value of PO strips.
The prices of interest only strips , on the other hand , fall when interest rate fall. This
is because mortgage prepayments abruptly end the flow of the interest payments
accruing to IO security holders. Because rising interest rates discourage
prepayments , they increase the value of IO strips. The IO s have negative effective
durations. They are good investments for an investor who wishes to bet on an
increase in interest rate, or they can be useful for hedging the value of a
conventional fixed income securities.

62
 Chapter Seven

Assessment of Fund Based and Non Fund Based Working Capital

By Fund Based ( FB) working capital facility, we mean products of banks through
which banks provide fund for meeting working capital requirement of the company .
If we recall the concept of building up of working capital discussed in the class, we
find that current assets represents the expenses which is incurred but not realized.
We have also said that part of the expenses can be deferred and this constitutes the
other current liability ( OCL).The expenses which can not be deferred would be paid
from borrowings. A part of the expenses are paid from Net Working Capital ( NWC)
and the remaining part of expenses would met from borrowing of the banking
system. We have also discussed the reason for bank’s being the major provider of
working capital facilities in our country. So Fund Based ( FB) working capital
represents that portion of current liability which is going to build up that portion of
current assets which are not financed by OCL and NWC.

After defining the FB working capital products, we shall now discuss about the entire
process of availing the Fund Based Working Capital facility of bank. The sequence of
availing the facility from bank is as follows:

1. Company assess its working capital requirement ;

2. After assessment, the company decides the type of banking;
3. Company initiates the process of tying up of fund from banking system;
4. Company avails the fund from the baking system;
5. In the next year, company follows the same process;

Assessment of Working Capital Requirement :

The working capital facility of a company consists of two types of facilities :

1. Fund Based Working Capital Facility

2. Non Fund Based Working Capital Facility

63
While the detail discussion on Non Fund Based facility would be done in the next
chapter, in this chapter we shall discuss the fund based facility.
Though the final assessment of fund based facility is carried out by the lender, the
process starts from company’s end. If company is aware of the process of
assessment of working capital , it would be able to sanction its working capital as per
its requirement.

Assessment is defined as the process by which one can determine the maximum
amount of fund can be availed from institutional lender to meets a company’s
working capital requirement. So assessment of working capital for a corporate means
the process of arriving at the maximum quantum of working capital requirement of a
corporate for a particular period.

Assessment of Fund Based Working Capital

In India, Fund Based working capital is carried out with the help of any of the three
following processes :
1. Maximum Permissible Bank Finance ( MPBF) Process
2. Cash Budget Process
3. Turn Over Process
MPBF Process : Under this method , the assessment of fund based working capital is
carried out by taking into account figures from Balance Sheet as on a particular date.
Before going into detail, let us make one concept very clear. Since a company is
carrying out assessment , it is trying to ascertain funds required in the future. The
past financials would indicate the company’s achieved performance and also
validates the future financials. But the assessment is carried out on the basis of
future financials.
When we talk about the future, there are two years. One is the current running year
and another is the next coming year. While the figures for the first one is called
Estimate , the later one is called the Projections. For example, a corporate
carrying out the assessment as on May 1,2008, the company has two choices. If it
follows the assessment based on estimates, it will take financial data for the FY
2008-09 and Balance Sheet data as on March 31,2009. If it follows the assessment
based on projections, it would use the datas for the FY 2009-10 and also Balance
Sheet Data as on March 31,2010.

64
Now coming back to MPBF process, under this process FB working capital
requirement would be carried out in any of the following three methods:
1. Method I
2. Method II
3. Method III
In all the above three methods, all the figures are taken from the balance sheets.
The figures are either from “Estimates” or from “Projections” but not from both.
While arriving at the assessment figure of Fund Based Working Capital requirement
under MPBF method, company needs to submit data in a specified format. This form
is called as “Credit Monitoring Arrangement or CMA” forms. CMA form consists of 6
separate forms representing different types of figures taken from Profit & Loss and
Balance Sheet of the company .The following tabular representation would make it
clear the content and implications of these 6 forms :

Form No Content of Form Justification

I Total Existing Borrowing of the
company as on the date of
application
II Profit and Loss Accounts
III Analysis of Entire Balance Sheet
of the company
The proposed lender would
decide to take a fresh
exposure depending on the
existing leverage and future
cash out flows from the
existing borrowing of the
company
Detail analysis of Profit & Loss
account of the company.Since
the funding for working capital
is predominantly for meeting
the expenses incurred but not
recovered in connection with
the production of goods and
services, major analysis is
carried out for expenses
associated with the
productions.
Detail Balance Sheet Analysis
of the company is carried out.

65

IV Analysis of Current Assets and
Other Current Liability
V Assessment of Fund Based
Working Capital
VI Fund Flow Analysis
Here some adjustment is
made to incorporate the effect
of certain off balance items
and also the immediate effect
of cash out flows
As we have already seen,
Working Capital Finance is
mainly to take care of Current
Assets and Other Current
Liability. Form IV aims to carry
out detail analysis of Current
Assets and Other Current
Liabilities in terms of months
of holding and other
parameters
This calculated the MPBF
depending on the methods
followed.
This explains detail calculation
of sources and uses of long
term funds and the utilization
of NWC towards individual
current assets.

Figure 7.1
Form I: Form I contains the existing borrowing of the company. This includes all
types of borrowing namely Term Loan, Debenture, Unsecured Loan and also Lease
Finance. It must contain data as on the application date .This information would help
the proposed lender to take a decision whether it should lend depending on the
leverage of the company, repayment capacity towards already existing commitment
of the company.
Form II : This form and Form III contain the financial data for 4 years. These contain
actual data for last 2 years , estimates for the current financial year and projections
for the next financial year. For example, a company applying for Fund Based Working

66
Capital under MPBF method on July 1,2009, should give the following 4 sets of data
in Form II & III:
1. Actual Data ( Audited Figure) for the financial year ended March 31,2008 and
March 31,2009.
2. Estimates Data for the financial year ending March 31,2010.
3. Projections Data for the Financial year ending March 31,2011.
For III is actually representation of Profit & Loss figure of the company with a special
emphasis on the cost associated with the production of goods and services.

Form III : This form comprises of data taken from the Balance Sheet of a company.If
one analyse the format of Form III, one can find out the following :
Form III starts with the Current Liability . In this form , current liability is segregated
into 2 parts. The first part consists of Bank Borrowing for working capital and the
second part consists of Other Current Liability ( OCL) .The Term Liability ( TL) is
presented and the total outside liability is arrived at. Then comes the Own Capital .It
starts with Equity and then figures representing reserves and other equity type of
instruments are taken in to account. The total of Out Side Liability ( Term Liability +
Current Liability) and Owned Fund represents the Total Liability of the company .

The Asset Side of the Form III starts with Current Assets. Then comes Gross Fixed
Asset , depreciation and Net Fixed Asset. Then the figures representing the Non
Current Assets ( NCA) are incorporated. Then, Intangible assets if any is also taken
in to account. Taking all these together ( Current Asset+ Net Fixed Asset +Non
Current Asset + Intangible Asset) , one arrives at the Total Asset figure of the
company.

There are some adjustments required to fill up Form III of CMA form. To understand
these adjustments in Form III of CMA form ,let us take the example of the following
:

67
 Balance sheet of X Limited as on March 31,2009
All amount in Rs Lacs
Sources of Fund :
Schedule Amount

Share Capital 1 100

Reserves 2 250

Secured Loans 3 125

Total Source of Fund 475
Uses of Fund : Schedule Amount

Fixed Asset 4 200

Less Depreciation 50
Net Fixed Asset 150

Investment 5 100

Current Assets ,Loans and Advances 285

Current Assets 225
Raw Material 6 70
Work In Progress 7 20
Finished Goods 8 30
Receivable 9 100
Cash at Bank 10 5
Loans and Advances 11 60
Loan to Group Companies 20
Loan to Staff 10
Other Advance 10
Tax Deduct at Source 5
Advance Tax Paid 15
Less Current Liability and Provision 60
Current Liability 12 40
Sundry Creditors 30
Advance from Customers 10

68
 Provision 13 20
Provision for Taxation 15
Provision for Dividend 5

Net Current Asset 225

Total Uses of Fund 475
Notes on Contingent Liabilities :

a. Bill discounted from Bank Rs 15 lacs.

Further Information from Schedules are Available as follows :

Schedule Description Amount ( Rs in lacs)

2 Reserves 250
Revaluation Reserves 20
Free Reserves 230
3 Secured Loan 125
Term Loan 50
( The term Loan to be paid
in 5 yearly installment of
Rs 10 lacs each )
Cash Credit for Working 75
Capital
5 Investment 100
Fixed Deposit in Bank 50
Investment in Group 30
Companies
Investment in Quoted 20
Shares
9 Receivable 100
Outstanding for more than 25
180 days
Outstanding for up to 75
than 180 days
Figure 6.2

69
In the actual accounts of a company, we get details of each schedule. In this section,
we have made only those schedules which are required for adjustment of figures in
filling Form III of CMA form.

1) The First adjustment is the bill discounted amount. When a company sells on
credit the following entry is passed :

Dr Receivable
Cr Sales

There is no cash flow associated with this entry. To improve the cash flow
the company can sell a part of its credit sales after drawing bill of
exchange. So the receivable can be segregated into two groups :
a. Accounts Receivable : This is simple credit and
there is no bills of exchange. This is also called as
Open Account Sales.
b. Bills Receivable : In this type of credit sales ,
apart from documents required under Open
Account Sales , additional document in the form
of Bills of Exchange also accompanies the
document. The buyer once accepts the bills of
exchanges would be liable to pay the bills of
exchange. Some additional protection under legal
statute is available for the Drawer of Bills of
Exchange since Bills of Exchange is a negotiable
instrument.
To improve the cash flow, the company discounts the bills of exchange to
bank. When the bill is discounted , the following entry would appear in the
balance sheet of the company :

Dr . Bank
Cr Receivable
But the amount outstanding under bills discounted will appear as the contingent
liabilities in the balance sheets of the company. Now, when one company fills up the

70
Form III, this amount is added both on the liability side and also on the asset side.
In the liability side, it is added under the head Bank Borrowing for working capital
under Current Liability and in the asset side this amount is added with the
receivable figure appearing on the balance sheet.
The amount of Rs 15 lacs would be added with the Cash Credit For Working Capital
head in the current liability portion of Form III and Rs 15 lacs would be added to the
Receivable on the asset side of Form III under the head Receivable.
The Second Adjustment : The secured loan consists of Term Loan and Cash Credit
for Working Capital .We shall first segregate the two. From schedule we get the
following :
Term Loan : Rs 50 lacs
Cash Credit : Rs 75 lacs
After this, the term loan needs to be segregated further into two parts. One part
must mention the installment to be paid within one year and the other part must
contain installment to be paid after one year. From the description of the schedule,
we can segregate the term loan portion as follows as on March 31,2005 :

Installment payable within 1 year : Rs 10 lacs

Installment payable more than 1 year : Rs 40 lacs
Now while filing up the Current Liability portion of Form III, this installment of term
loan payable within 1 year would be filled up in the current liability and the
installment of Term Loan to be payable after 1 year would appear on the term
liability .

So after adjustment of Bill Discounting , the total bank borrowing in the Form III
would be Rs (75+15)=Rs 90 lacs .

Third Adjustment : Here , the adjustment for Tax would be carried out. The Tax on
the Profit of a business entity is calculated as per the Income Tax Act ,1961. At the
beginning of the year , the company projects a certain profit as per the Calculation
under Income Tax Act 1961 and determines its tax. Let us take an example that
during FY 2005-06, the income tax calculated by the company is Rs 12 lacs. The
total amount of tax to be paid by the company during the Financial Year 2008-09
would be Rs 12 lacs. However, in certain services provided by a company, as per
Income Tax Act,1961 the receiver of service would have to deduct tax on the

71
payment at source ( TDS) and the same is deposited by the service receiving
company, against which Form 16A is issued by the service receiving company. The
company also makes an assessment of this TDS. The net amount i.e. the estimated
Tax Amount minus the TDS amount would be the amount in cash to be deposited by
the company to the exchequer. The company needs to pay this net amount in
Quarterly installment as specified under IT Act ,1961 under the head Advance Tax
Paid. So whenever there would be payment of tax on account of Advance Tax Paid,
the following entry is passed :
Dr . Advance Tax Paid
Cr Bank A/C
Similarly when TDS is calculated on the service , the following entry is passed :

At the time of booking income while providing service on credit ,

Dr Receivable say Rs 10 /-
Cr Income Rs 10/-
Now at the time of payment by the customer, it would deduct TDS , if applicable. If
the TDS percentage is 10% on bills value , then the following entry would be passed
in the books of selling company during the time of payment by the customer of
selling company .
Dr Bank Rs 9/-
Dr TDS Rs 1/-
Cr Receivable Rs 10/-
At the end of the year , say on April 15,2009, the company calculates the actual
profit under IT Act,1961 for the FY 2008-09 and the entire amount is provided in the
P&L account .The following book entry is passed :
Dr Profit & Loss Account for provision for taxation
Cr Balance sheet account under the head current liability and provision

Any difference between the Tax Paid ( advance tax paid +TDS) and the provision for
taxation would be paid in the bank .

So the head TDS and Advance Tax Paid in the Assets side of the balance sheet
would contain the amount of Tax paid by the company and the head provision for
taxation in the Current Liability side of the balance sheet would contain the amount
of tax required to be paid by the company. The company would not be able to know

72
the exact position in respect to the actual tax payment position unless the
assessment is carried out the department. Till the time assessment is over for a
particular year , the corresponding amounts would carry on both sides of the balance
sheet. Generally, it takes more than 1 year for getting the assessment of a FY . This
is because the last date for submission of Tax Return for a company is October 31st
of a particular year. So the tax return to be filled by a company for the financial
year ended March31,2009 is on September 30th ,2009. Generally the assessment
would be carried out by September 2010 and during that time the advance tax paid
,TDS amount and Provision For Taxation for the FY 2008-09 would appear on the
balance sheet. So at any point of time , the figures in Advance Tax Paid, TDS
account and provision for taxation would contain these figures for more than 1
financial year . Now in the above mentioned example the following segregation is
available :
Advance Tax Paid : Rs 15 lacs
TDS Rs 5 lacs
Provision for Taxation : Rs 15 lacs
Rs in lacs
Particulars FY 2007-08 FY 2008-09 Total
Advance Tax Paid 6 9 15
TDS 1.75 3.25 5
Provision for 7 8 15
Taxation

Fig 7.3
While filling up the form III , the net of figure ( i.e. the net of figure of Tax Paid , in
the form of TDS and Advance Tax Paid and Provision for Taxation is permitted). In
the above mentioned example, only Rs 5 lacs would appear on the asset side as TDS
because Advance Tax Paid and Provision for taxation cancels out each other.

Fourth Adjustment : In the asset side of the Form III, the investments are first
classified in terms of maturity. Besides maturity , the purpose of this investment
would also be analysed for its classification under Current Asset in Form III. In the
above mentioned example , the following break up is available :
Fixed Deposit in Bank : Rs 50 lacs
Investment in Group Companies : Rs 30 lacs

73
 Investment in quoted shares : Rs 20 lacs
While arriving at the fund based working capital limit, the classification of current
assets would be such that the bank finance would be made available for those
current assets which are related to production. In the case of a manufacturing
company, its main activity is the manufacturing of goods . Assuming the above
mentioned company is a manufacturing company . the investment in the form of
Group companies and quoted shares would not be classified as current asset even
though the maturity is less than 1 year. So under Form III, the fixed deposit in bank
amounting to Rs 50 lacs would be included in the current asset.
Fifth Adjustment : In the asset side of Form III, next adjustment is made for
receivable. In the case of receivable also, bank would also classify those receivable
whose maturity is up to 90 days in case of private debtors and in case of government
debtors it is 180 days. Any receivable having a maturity of more than this would be
classified as non current assets. Assuming the all the debtors outstanding up to 180
days is also outstanding up to 90 days, the classification of receivable would be as
follows :

Receivable to be classified as Current Asset : Rs 75 lacs

Receivable to be classified as Non Current Asset : Rs 25 lacs
Sixth Adjustment : In the asset side of Form III, next adjustment would be under
the head of Loans and Advances. Under this head an amount of Rs 20 lacs is given to
group company .Applying the same logic as mentioned above, the amount of Rs 20
lacs would not be included in the current asset . So after all these adjustment the
current asset as per Form III would be as follows :

Category of head in Particulars Amount appearing Amount Appear in

Form III in Balance Sheet Form III
Current Assets :
Fixed Deposits in Fixed Deposits kept 50 50
Bank in Bank
Receivable Receivable up to 90 100 90
days ( PVT) and
180 days ( Govt)
would be classified
as Current Asset in

74
 Form III and
receivable under
Bill Discounting
Scheme would be
added to the
receivable
Loans and Loans given to 40 20
Advances Group Company
would appear in
Non Current Asset
TDS and Advance 20 5
Tax would appear
as net basis after
adjustment with
Provision for
Taxation

Fig 7.4
Seventh Adjustment : This adjustment would be on account of Fixed Asset
revaluation . If the reserve contains any revaluation reserve , the same would be
deducted from the reserve of the liability side of form III and the same amount
would also be reduced from the Fixed Asset side of Form III. So in the liability side
of Form III, the reserve amount would be Rs 230 lacs and in the asset side of Form
III, the Fixed Asset amount would be Rs 180 lacs.

After all the adjustment , the Form III would contain the following :
Category of head in Particulars Amount Amount
Form III appearing in Appearing in
Balance Sheet Form III
( Rs lacs) ( Rs lacs)
Bank Borrowing For Bill discounted portion 75 90
Working Capital would also be added
Other Current

75
Liability
Sundry Creditor All types of Sundry 30 30
creditors is included
Advance from All types associated with 10 10
Customer regular operation of the
company are included
Term Loan As on the date of the 10
installment payable balance sheet, the term
within 1 year loan outstanding would be
segregated into two parts
one consisting o
installment payable within
1 year and installment
payable more than 1 year
; installment payable
within 1 year would
appear here
Provision for Depending on the net off 15
Taxation figure , either provision for
taxation or advance tax
would appear in Form III
Provision for This would appear in Form 5 5
Dividend III
Total Current 135 145
Liability
Term Liability
Term Loan Term Loan installment 50 40
payable beyond 1 year
would appear in the Form
III
Total Term Liability 50 40
Total Outside 185 185
Liability
Equity Capital All Equity capital would 100 100
appear here in Form III

76
Reserves Revaluation reserve would 250 230
be excluded from reserve
in Form III
Total Owned Fund 330 330
Total Liability 535 515

Category of head in Particulars Amount Amount

Form III appearing in Appearing in
Balance Sheet Form III
( Rs lacs) ( Rs lacs)
Current Assets
Fixed Deposit in Payable within 1 year 50 50
Bank would be classified
Raw Material 70 70
Work In Progress 20 20
Finished Goods 30 30
Receivable Receivable should include 100 90
the bill discounting figure
appearing as contingent
liability ;Receivable should
contain only receivable up
to maturity of 90 days for
pvt and 180 days for govt
Loans and Loans and advances to 40 20
Advances Group companies would
be included in non current
asset
Loans and Advance Tax and TDS 20 5
Advances would appear as net off
figure with provision for
taxation
Cash and Bank 5 5
Balance
Total Current asset 335 290

77
Fixed Asset
Net Fixed Asset The figure would be 150 130
reduced by the revaluation
figure
Other Non Current
Asset
Investment Investment not related to 50 50
production would be
included here even though
the maturity period of
investment is less than 1
year
Receivable Receivable of more than 3 25
moths ( Pvt) and more
than 6 months ( govt)
Loans Loans given to group 20
company
Total Non Current 50 95
Asset
Total Asset 535 515
Fig 7.5
Form IV : Form IV gives more analytical picture of current assets and other current
liability. In the case of current assets , the form gives the holding level of Raw
Material , Working in Progress , Finished Goods and Receivable. The Raw material
holding is expressed in terms of month of consumption, work in progress in terms of
months of cost of production, finished goods in terms of months of cost of sales and
receivable in terms of months of gross sales. The other current asset will also
appear in the form IV in absolute figure.
In the other current liability section , the creditor for trade is expressed in terms of
months of purchase of material . The other other current liability would appear as the
absolute figure .

Form V : This form calculates the quantum of working capital requirement under
MPBF method. A quick comparison of two methods i.e. Method I and Method II would
reveal the difference of the two assessment :

78
 Method I Method II
1 Current Asset ( CA) Current Asset Current Asset
2 Other Current Other Current Other Current
Liability (OCL) Liability Liability
3 Working Capital 1-2 1-2
Gap ( WCG)
4 Minimum NWC 25% of ( WCG) 25% of CA
5 Estimated Estimated/Projected Estimated/Projected
/Projected Net Net working capital Net working capital
working capital
6 Maximum Min of [(3-4) or (3- Min of [(3-4) or (3-
Permissible Bank 5)] 5)]
Finance ( MPBF)
Fig 7.6
An analytical view of the above stipulates :
• Up to the arrival of WCG both the method is same.
• The method varies only in the context of minimum NWC requirement. In the
case of Ist method, the minimum NWC is 25% on WCG while in the case of II
nd method, the minimum NWC is 25% of CA. So stipulation of minimum NWC
is more in case of II nd method compared to that of Ist method.
• Due to the above factor, MPBF is always more for 1st Method than 2nd Method.
Form VI : Form VI gives the details of sources of NWC. It also gives the utilization
details of NWC towards building up of individual component of Current Assets.

Important points for arriving at the assessment of fund based working capital under
MPBF method :
• The holding level of Raw Material, Work in Progress, Finished Goods and
Receivable should not go up from that of last two years actual in the
estimates and projections figure. If there is an increase, suitable justification
would be required.
• The percentage of other current asset as a percentage of total current asset
should not go up in the estimate and projection figure when compared with
last two years actual.

79
 • The holding level of creditor should not go down in the estimates and
projection figure.
• The percentage of other other current liability with respect to total other
current liability should not go down.
• The Current Ratio should not go down in the estimates and projection.If there
is any fall in current ratio , very convincing explanation should be given.
• The leverage ratio i.e. TOL/TNW should not increase beyond a certain point.
• The detail long term sources should be disclosed in detail.
• The sales estimates and projection should be commensurate with the industry
growth.
At the time of assessment , the above mentioned rules are followed.
After discussing in detail the fund based worked capital assessment under MPBF
method, it is clear that this method arrives at the requirement of Working Capital by
taking all the figures from Balance Sheet as on a particular date. If the assessment is
carried out based on the estimates figure then the figures from as on the last day of
the estimates year is taken for carrying out the assessment of the fund based
working capital limit. Another important aspect of MPBF method is that the last two
years figures should be in the audited format. Since the company has to submit its
audited figures to a large number of statutory bodies, the company coincides its
account closing in such a manner that most of the compliances are met from the
same accounts. This is the reason why most of the companies are closing their
accounts as on the March 31, of every year. If the company’s business does not
reflect any seasonality, there is no problem with this as the accounts of all the time
of the year would reflect the uniform patterns. However, if the business of company
has marked seasonality then there is a problem. If the company’s business season is
such that the peak business operation takes place at a time which is not coinciding
with the accounts closing date, the company’s accounts would not be able to capture
the true requirement of working capital. Please recollect the concepts we develop in
the first chapter. Current Assets represents the expenses which is incurred but not
realized. If the business cycle of a company has seasonality and the peak business
cycle is not coinciding with the accounting years, then the current asset as on the
balance sheet date would not represent the true expenses which is incurred but not
realized. Since the expenses would be more during the peak business cycle
compared to that of other time , the current asset level would be more during the
peak business cycle. So if the assessment would carry out as per MPBF method, it

80
would only take the figures from balance sheet as on the audited accounts date. But
there can be a point in between two account closing date which represents the peak
business cycle and the current asset at that point of time would reflect the true
representation of the maximum current asset of the company for the entire financial
year. So MPBF method of assessment would be leading to inadequate fund based
working capital for seasonal industry. For seasonal industry , the fund based
working capital requirement needs to be assessed through a separate methodology
i.e. called Cash Budget Method.
As we have already seen that the requirement of fund based working capital is due
to bridge the timing match between the expenses towards production of goods and
/or service incurred and money realized from the sale of the same goods and /or
service. While the expenses is associated with the outflow of cash where as the
realization from the products/services would be inflow of cash. Moreover, the long
term surplus would represents components of NWC of the company . So in the cash
budget method, the next twelve months monthly cash flow is drawn as per the
following format :

Revenue Account: Since working capital represents the expenses incurred for the
revenue account , the inflows and outflows of the revenue account are plotted in
each month. The heads under which inflows and outflows are put represents the
heads that will appear against current assets and liabilities. For example, the current
asset consists of Raw Material ,SIP and Finished Goods. Only when the sales are
made and money is realized one receives cash in the revenue account. So the Inflow
of revenue account would be the realization of receivable. Where as for selling the
finished goods one needs to purchase raw material and convert into finished goods
through different stages of production. While at the time of purchase of raw material
, the company can purchase it in cash or in credit. If it purchase in cash then there
would be immediate cash out flow and if it purchases in credit the creditor payment
would capture this cash flow after some time. Now after purchase of raw materials
there are other manufacturing expenses in the form of electricity, salary and wages
for production and other manufacturing expenses. Expenses are plotted against
these heads on monthly heads. Then after the finished goods stages are reached,
there are selling and distribution expenses .These expenses are plotted monthly wise
. After the selling and distribution expenses there are finance charges or interest
expenses. The interest expenses are divided into two groups ,interest on working

81
capital finance and interest on long term liabilities. However, both the interest would
come in the revenue account ( others wise debt trap like situation will arise) . Now
the tax payment would take place and also dividend payment would take place. Both
this would be incorporated in the cash out flow. So the cash outflow on a monthly
basis for the revenue account would contain the following :
For the Month 30th April 31st May 30th June
Ending
Inflow :
Inflow from Cash
Sales
Realization of
Receivable
Other Income
Total Inflow of
Revenue Account
Outflow:
Purchase of Raw
Materials in Cash
Payment of
creditors on
account of
purchase of raw
materials on credit
Payment of Power
and Fuel for
Production of goods
Payment of Wages
and Salaries
Payment on
account of Other
Manufacturing
Expenses
Payment on
account of salary
and other

82
establishment cost
for selling and
distribution
expenses
Payment on
account of selling
and distribution
expenses
Payment of account
of Interest
expenses
Payment on
account of Taxes
Payment on
account of
Dividends
Total Outflow on
Revenue Account
Revenue Account
Surplus/Deficit

Fig 7.7
In the Capital Account we can have the following inflows :

Inflows on account of induction of fresh equity capital

Inflows on account of fresh term liability in the form of term loan and debenture
Inflows on account of unsecured loan

In the capital account we can have the following outflows :

Outflows on account of purchase of fixed assets

Outflows on account of investments in financial assets
Outflows on account of repayment of term liability
Outflows on account of repayment of unsecured loan.

83
So the capital account cash flow is drawn as below :

For the Month 30th April 31st May 30th June

Ending
Inflow :
Inflow from
Induction of Equity
Capital
Inflow from Fresh
Term Loan
Inflow from Fresh
Debenture
Inflow from
Unsecured Loan
Total Inflow on
Capital Account
Outflow
Purchase of Fixed
Asset
Repayment of Term
Loan
Investment
Repayment of
Unsecured Loan
Total Outflow on
account of Capital
Account
Capital Account
Surplus/Deficit

We get the total cash requirement by combining the above two :

For the Month 30th April 31st May 30th June
Ending
Surplus/Deficit in

84
Revenue Account
Surplus/Deficit in
Capital Account
Overall
Surplus/Deficit
Opening Cash
balance
Closing Cash
Balance
Maximum Amount Maximum Amount Maximum Amount
of Drawal Allowed of Drawal Allowed of Drawal Allowed
in this Month in this Month in this Month

Fig 7.8
The Closing cash balance reflects the cumulative deficit of the company for the
coming year. The maximum limit would be peak deficit . If you see , in the cash
budget method the seasonality of business cycle is taken care off as the outflows and
inflows of cash in each month is taken into the account for arriving at the fund based
working capital limit. Actually, the cash budget method of assessment is more
scientific method of assessment of working capital and this can also be extended to
non-seasonal industry.

However, in India, even today most of the bankers follow the MPBF method of
assessment for working capital finance. This is due to the fact that for all non-
seasonal industry, MPBF being the method practiced for a quite long period of time.
So bankers are comfortable with this method of assessment. Since the number of
seasonal industries was significantly less compared to that of normal industry,
bankers carried out more number of assessments under MPBF method compared to
that of cash budget method. Accordingly, bankers have developed expertise over the
years on MPBF methodology. This is the reason why MPBF methods are still popular
with the bankers. Besides this , MPBF method is also a security based lending system
because MPBF is calculated by taking figures directly from the Balance Sheet. Since
the balance sheet contains figure of assets and liability and since a company can
offer security its assets only , the amount arrived under MPBF is based directly on
security of the company. Accordingly, it is called as security based lending system.

85
In the case of cash budget system, the company needs to submit the actual cash
budget vis a vis the statement given at the time of assessment and any negative
deviation needs to be explained properly. Even though this method is scientific and
takes care of each month working capital requirement more accurately, this method
also requires collation of figures more frequently and company needs to have a
strong MIS in place. Many corporations may not be having this kind of system in
place. These are the reasons why even today, MPBF method is the most popular
method of fund based working capital finance.
There is another method for assessment of fund-based working capital for a
company. This method is called as Turn Over Method. This method is applied for
small business houses. The assumption of this method is very simple. The working
capital cycle is 3 months i.e. the sales are rotated four times a year. The total
working capital requirement is 25 % of the projected sales. Out of this total
requirement, at least 5% is to be brought in from long term sources. So the
remaining 20% would be minimum amount of fund based working capital to be given
to a company. This method is called Turn Over Method and very simple to assess.
This is mainly followed for fund based working capital limit of up to Rs 200 lacs.

All the above methods are for assessment of fund based working capital for domestic
credit. However, for export credit the basis of assessment remains the same,
however the process of availing the credit is different. This is due to the fact that
the government gives certain incentives for promoting export in the form of
concessional interest cost. While providing such incentive, the government must also
draw some mechanism so that the fund which is given for export is not misused.
Generally the working capital for export is segregated in to two parts. They are :

1) Pre Shipment Credit

2) Post Shipment Credit
Pre Shipment Credit : As the name suggests, this is the working capital given up to
the point of shipment. The amount of fund based working capital given for pre
shipment credit should cover all the expenses till the shipment stage. This facility is
also known as Packing Credit . As mentioned earlier, the packing credit is the fund
based working capital facility given by the bank to meet the expenses incurred till
the shipment stage . The following expenses are incurred by an exporter till the
shipment stage :

86
 1) Expenses incurred for purchase of raw material
2) Expenses incurred for conversion of raw material to finished goods
3) Expenses incurred for ware housing of finished goods
4) Expenses incurred for putting the goods on board.
As mentioned earlier, the total assessment is carried out in the same manner as the
assessment for the domestic working capital and the required NWC of 25% of the
current assets is to be brought in by the company.
Since the fund is disbursed under concessional interest rate, there should be some
mechanism that the fund is going for the export purpose. So any packing credit is
disbursed against either LC or confirmed order and the disbursing bank make an
endorsement on the LC or Export order so that the company can not avail the export
packing credit against the same order from bank. Moreover, the fund under packing
credit needs to be repaid from the post shipment credit and for this purpose bank
maintains a diary of shipment .If it is liquidated from the domestic sources, a penal
interest rate well above the market is imposed. This prevents the company to misuse
the packing credit for domestic purpose.

After the goods is put on board of ship, the bank provides a post shipment credit to
the company. The post shipment credit is provided on the cost of the goods plus
Insurance plus freight . This is popularly known as CIF value. For promoting export,
apart from the concessional interest , the bank do not insists for any margin on Post
Shipment Credit. The entire amount which is disbursed against post shipment credit
would be credited to the pre shipment account and the pre shipment credit is
closed. So when the bank disburses the packing credit his main concern is the
shipment of the goods. Since once the shipment takes place, the packing credit is
liquidated. In the case of post shipment credit , the risk of the bank increases .This is
because in the pre shipment stage , the bank has the finished goods as the security
in the post shipment stage the bank is having only receivable which a piece of paper
only. To reduce the risk of any delinquency, bank insists on the following :

1) Generally bank asks for Letter of Credit for Post Shipment Credit
2) When LC is not available, banks gets credit rating of the overseas buyer from
the reputed agencies like Dun and Broad Street .

87
 3) Bank also insists for Export Credit Guarantee Commission ( ECGC) coverage
for Post Shipment Finance. This is an insurance coverage for counter party
risks.
4) Bank does not provide the Post Shipment Finance for exporting to countries
where there are significant country risk involved.
After the post shipment finance is disbursed, the same precaution to be taken so
that the purpose of concessional interest is not defeated. The post shipment finance
is to be realized only from the Realisation of export proceeds and the export
proceeds to be realized in all cases ( except the case of capital goods export) within
180 days. If it is not realized within 180 days , details to be given to RBI and the
writing off of export receivable requires fulfillment of many formalities. These
formalities would act as deterrent for reaping unscrupulous benefits of concessional
interest rate.

Assessment of Non Fund Based Limit

After discussing in detail the fund based worked capital assessment ,we shall now
discuss in detail about the Non Fund Based assessment. As we have seen in the
previous chapter that, fund based working capital facility is required to meet the
expenses incurred but can not be deferred and also for the payment made for the
continuance of the regular operation procedure. We have also seen that a part of the
expenses can be met by deferring the payment arising on account of such expenses.
Moreover, a company can take advances from the customer, in time. All these
consist of Other Current Liability .Non Fund Based facility is used by a company for
building up of Other Current Liability.

Non Fund Based facility is the facility provided by bank to a company without
involvement of any immediate involvement of fund. The examples of Non Fund
Based facility is Letter of Credit ( LC) and Bank Guarantee ( BG). A Non Fund Based
Facility consists of the following characteristics :

1. At the time of providing the facility , issuer of Non Fund Based facility would
not disburse any fund. Generally banks are the provider of Non Fund Based
facility. Banks can issue LC and BG on behalf of its customer and at the time
of issuance there is no fund involved. This would help bank to increase the
business without involvement of fund. If one analyses the balance sheet of

88
 Financial Intermediaries, majority of the fund generated by such
intermediaries are from the depositors. This is reflected in the high gearing
ratio of financial intermediaries. Since high leverage ratio is associated with a
significant in crease in risk of the concerned entity, the question can be asked
why such high leverage is permitted for financial intermediaries and how the
risk associated with such high leveraged intermediaries are addressed ?
The answer to the first question lies in the role of the financial intermediaries.
The role of financial intermediaries is to act as a channel for funds from the
saving unit to the investment unit. To channelise this fund, financial
intermediaries should be permitted to accept deposits from the savings unit
and naturally it would lead to high leverage ration.
While permitting the financial intermediaries to accept deposits , the risk
associated with such highly leveraged entity is addressed by the following
mechanism:
1. There is a supervisor which issues licenses. Generally the Central Bank
of the Country does this supervisory function.
2. The Supervisor imposes certain risk management measures in terms
of capital adequacy and prudential norms so that financial
intermediaries can not cross the limit of approved risk level.
Coming back to the issues of Non Fund Based facilities. As we have already
discussed , for this type of facility the financial intermediary need not to
part fund .So a financial intermediary can generate significant income by
resorting to non fund based business. This would basically help the
financial intermediary to earn income without the risk of asset liability
mismatch and interest rate risk on the liability and asset side. So the non
fund based facility is beneficial to both financial intermediaries and the
company.
However , another important characteristics of Non Fund Based facility is
that in the case the customer on behalf of whom the intermediary issues
this facility does not keep its commitment ( this process is called
devolvement ) , the financial intermediary would pay the amount. So incase
of devolvement , the non fund based facility is converted in to fund based
facility.
Letter of Credit :

89
 This is one of the most popular Non Fund Based products prevalent in the
world market. Whenever, one company sells goods to another , the first
company is called the seller and the second company is called the buyer. The
seller needs to establish a mechanism so that it get paid after the delivery of
goods while at the other hand, the buyer needs to establish a mechanism so
that it gets the goods it has asked for. The situation can arise when seller
sales goods and the buyer does not pay. The other side of the story is that
the buyer pays but it does not receive goods as per the requirement. To
address the concerns of both the party, LC mechanism can be resorted to .

The total work flow of LC is shown below:

8
Issuing Negotiating
3 11
Bank/ Bank
Opening
Bank
Advising
Bank/
2 9 10 Confirming 6 7
Bank 4

5
Applicant / Beneficiary
Buyer /Seller/Draw
/Draweee 1 er

Fig 2.9

Steps No Activity Chronological

Step of

90
 Transaction
1 The Buyer and Seller finalized the terms of sale. This is the first
The Buyer sends the Purchase Order to the seller step of a trade
.The Seller then sends the Invoice. transaction .
2 The Buyer goes to its bank and applies for a Letter This is the
of Credit as per the terms of purchase for opening Second Step of
of Letter of Credit from a sanctioned letter of the transaction .
credit limit.
3 The Buyer’s bank also known as applicant This is the 3rd
bank/issuing bank opens a letter of credit and the steps of the
same letter of credit is send to the seller through a transaction .
bank which is known to the seller. The Issuing
bank sends the LC to another bank familiar to the
beneficiary. This bank is called the Advising Bank.

4 The advising bank advises the LC to the seller. This is step four
Sometimes, the seller also requires some more of the
assurance as it can rely solely on the issuing bank transaction.
.In that case, the advising bank needs to add
confirmation to the LC and the advising bank is
called as Confirming bank.
5 The seller ships the goods to the buyer. Till now all The start of this
the process are of chronological order. Though the process is fifth
start of the process is after stage 4, the steps of the
completion of the process can be later than the transaction
subsequent stages. .However the
completion can
be after step 9.
6 The seller submits the documents to a bank called This is 6th Step
negotiating bank along with the LC. of the
transaction .
7 The Negotiating bank scrutinize the documents This 7th Step of
and if the document is in order, it disburses the the transaction.
payment to the seller.

91
 8 The Negotiating bank sends the document to the This is 8th step
Issuing Bank . of the
transaction .
9 The Issuing Bank sends the document to the This is 9th step
applicant for acceptance or rejections if any. The of the
buyer accepts the documents and returns the transaction.
accepted document to the Issuing Bank.On receipt
of the accepted document, the issuing bank
informs the negotiating bank and then release the
transport documents so that the buyer can release
the goods.
Completion The goods which is shipped at the beginning of the This is 10th step
of step 5 step 5 is released by the buyer . of the
transaction .
10 The buyer pays to the issuing bank on due date This is the 11th
i.e. at the end of the credit period. step of the
transaction.
11 The issuing bank pays to the negotiating bank. This the 12th
and final step of
the transaction.

Fig 7.10
If we analyse the utility of the LC, it is basically a credit enhancing mechanism. In
case the buyer does not pay, the issuing bank would pay provided the beneficiary
complies with the terms and conditions of the LC. So from the seller’s point of view
the payment is assured once it complies with the terms and conditions of LC. Now
here comes a very important aspect of LC.LC says that it deals with the documents
not with goods. From the above chronological steps, it is clear that the buyer will be
able to accept the documents before it can see the goods. Then the question is how
does buyer ensure that the goods supplied is the goods it asked for. Here lies the
expertise of LC opening. The buyer must stipulate documents and terms and
conditions which will force the seller to ship the correct goods. Special care should be
taken at the time of opening the LC by the buyer.

Similarly one can see that the negotiating bank pays in chronological stage 7th of the
transaction while it gets paid in chronological stage 12th of the transaction. Now the

92
question arises , how negotiating bank confirms that the seller fulfils all the terms
and conditions of the LC. It may happen that for negotiating bank certain terms and
conditions are accepted but the same may not be accepted by the issuing bank.
Since the ultimate fund would be remitted by the issuing bank , the fulfillment of
terms and conditions as accepted by the negotiating bank should also be accepted by
the issuing bank. To avoid any confusion and disputes between negotiating and
issuing bank, an uniform procedure is adopted by all the banks in the world. This
procedure is called as Uniform Conduct and Procedure for Documentary Credit (
UCPDC) version 600.This is framed by International Chamber of Commerce ( ICC)
.UCPDC 600 contains 49 clauses which describes the mode of operation of the entire
LC mechanism.

Before we proceed with the operational aspect of the LC, let us first know that how
the LC limit is assessed .By now, we know the specific requirement of LC. It is
basically used to purchase material on credit. In other words, LC is required to build
up a portion of Other Current Liability .To be precise LC is used to build up Sundry
Creditor ( Trade). A company wants to purchase material on Credit without giving
any LC. The reason being , with LC there are two aspects of the transaction :

1. Payment to be made on due date by the customer without fail. Since Bank is
giving the LC, in case of non payment to the bank by the customer on due
date, the issuing bank would pay from itself to the negotiating bank. This
would reduce the credit rating of the company in the books of the Issuing
Bank. In the case of simple credit, the company can delay the payment to the
supplier without loosing too much credibility .
2. When LC is opened , certain charges need to be paid to the banks concerned.
So, there is an additional cost for purchase under LC.
A company would always try to purchase material on Credit without LC. Only when
the company can not purchase without LC , generally then only it will agree to give
LC to the supplier.

The First Step of the LC assessment process is the arrival of the percentage of
purchase with LC. From the past experience , the percentage of total purchase under
LC is arrived at. The total purchase figure is obtained as below :

93
If the assessment is carried out on the basis of estimates, then the estimated
purchase figure is found out as follows :

Serial No Particulars Source

1 The Consumption of Raw Material and spares Form II
for the year under estimation
2 The Opening stock of Raw Material and Form III
Spares for the year under estimation i.e. the
closing stock of Raw Material and Spares as
on the previous year .
3 The Closing stock of Raw Material and Spares Form III
for the Year under estimation
4 Total Purchase 4= (2+3-1)
5 Out of the above purchase percentage of Y=x% of 4
purchase under LC

Fig 7.11
Depending on the payment period enjoyed by the applicant of the LC,LC can be of
two types. These are:
• Sight LC
• Usance LC
Sight LC : In this LC , the payment is made on sight of the document. Whenever, the
document is seen by the applicant, the applicant would pay the amount under LC.
Actually 7 days are given to pay the LC. Effectively the buyer does not get any credit
except the 7days period from the sight of the documents under LC.
Usance LC : Under this LC , the payment is made after a certain period from a
specified date. The specified date can be date of a document mentioned under LC.
This period is called usance period. The applicant enjoys credit for this period.

The weighted Average Usance Period ( AUP) under LC is arrived at by using historical
data. Besides this , there is a time taken to process the entire LC operation. This is
called the Lead Time ( LT). The LC period (LP) consists of AUP plus LT.
The number of times an LC is rotated is equal to =365/LP
The total LC requirement is (Y /365)*LP

94
Once the limit has been assessed by the bank , the bank issues a sanction letter for
LC.

Bank Guarantee :

Bank Guarantee (BG) is another Non Fund Based facility provided by Financial
Intermediary. Like any other non fund based facility , BG is also required to build up
other non current liability. Specially it is required to build up that portion of non
current liability for which advance is taken from a client. This can be explained with
the help of an example :

Suppose the Kolkata Metropolitan Development Authority (KMDA) decides to

construct a Bridge. It asks for bid from prospective construction companies ( civil
contractors) . After the successful bidding ,KMDA selects one contractor say A for the
job .Since the construction job is of very high volume in nature, KMDA would provide
advance for mobilization of the job. This is called the mobilization advance. Now,
KMDA also wants some kind of mechanism so that after taking the money A should
fulfill its responsibility . KMDA would ask a Bank Guarantee to be submitted by A . A
would approach its banker X to issue a Guarantee on its behalf to KMDA . The
Banker would issue a Bank Guarantee . In a bank guarantee there are following
parties :
1. The Applicant : Here the company A on whose behalf bank issues bank
guarantee.
2. The Beneficiary : Here KMDA for whose favour the Bank Guarantee is issued.
3. The Issuing Bank : The Bank which is guaranteeing the payment in case of
non performance of the applicant . Here X is the issuing bank.
We have seen that in both the case of LC and BG, these are credit-enhancing
mechanism. In both the cases, the interest of beneficiary is protected and in both
the cases banks are giving assurances to the beneficiary. Then where are the
differences ?
1. The First difference is the trigger which causes the payment in these two
types of instruments. In the case of LC, the Issuing Bank pays to the

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 negotiating bank only if the terms and conditions mentioned against LC is
fulfilled. So the payment of LC is triggered only because of performance of the
beneficiary. But in case of Bank Guarantee, the payment is triggered only
when the applicant does nor perform. So incase of Bank Guarantee , the
payment is made only in case of non performance of the applicant.
2. In the case of LC , most of the times payment is made.In case of BG only few
times the payment is made.
After understanding the guarantee instruments, now we shall discuss the different
types of guarantee before proceeding forward for assessment of the guarantee
requirement of a corporate. There are mainly two types of Bank Guarantee .They are
:
1. Financial Bank Guarantee : When a bank gives the guarantee for financial
performance of its client ( which is also applicant of the guarantee ) , it is
called the financial guarantee. Generally the guarantee issued for securing
Mobilisation Advance, Security Deposit are Financial Guarantee.
2. Performance Bank Guarantee : When a bank gives guarantee for physical
performance of its client ( which is also applicant of the guarantee ) , it is
called Performance Guarantee. Generally it is given to release the retention
money kept by the beneficiary for the defect liability period.
Assessment of Bank Guarantee :
The assessment process of Bank Guarantee is as follows :

• The company arrives at the opening bank guarantee at the start of the year
under consideration . (A)
• It classifies the guarantee into Performance and Financial Guarantee (A1 +A2 )
• It calculates the requirement of fresh guarantee during the period under
consideration in terms of Performance Guarantee and Financial Guarantee. (
B1 +B2)
• It calculates the guarantee to be returned during the year under consideration
. ( C1 +C2)

• Then the guarantee limit is arrived at by using the formula D=( (A1 + B1 - C1)
+ (A2 + B2 – C2 )
The first one reflects the limit for Performance Guarantee and the Second one
reflects the limit for Financial Guarantee.

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 Chapter Eight

Process of Tying up and utilization of Working Capital Finance from Bank

After discussing in detail the worked capital assessment both the Fund Based and
Non Fund Based facility ,we shall now discuss in detail about the entire process of
tying up and use of working capital assessment from banks. The process of tying up
of working capital consists of the following stages :
• Determination of quantum of working capital requirement. With the help of
the process mentioned in previous chapters, a company , now, can decide the
requirement of working capital both fund based and non fund based.
• Once the quantum is decided, then the company needs to take a decision
about the type of banking arrangements. There are three types of Banking
Arrangements .These are :
o Sole banking Arrangement: When the entire working capital facility is
taken from a single bank it is called sole banking arrangement .If the
working capital requirement is not very large, a company would prefer
sole banking arrangement.
o Consortium Banking Arrangement: When the working capital
requirement is large, a single bank may not be willing to lend such
large amount .In that case , the company must go for a banking
arrangement where more than one bank is involved. One type of
banking where more than one bank is involved is called Consortium
banking arrangement. Under this method, a bank assumes the role of
a leader and the bank is called Lead Bank. Lead bank assesses the
limit and then informs other bank about the limit. The other banks
joins an association and this is called as Consortium. Once the leader
assess the limit it informs the other member bank and other member
banks carry out its own assessment and inform the lead bank about
the share they are taking . Once this is formalized , a meeting called
consortium meeting is called and the process for disbursement of fund
takes place.
o Multiple Banking : When the requirement of working capital is large,
more than one banking would be involved. In this case, apart from the
consortium banking , multiple banking arrangement is also possible.

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 Under multiple banking arrangement , the limit is assessed by
individual banks and individual banks take exposure. The benefit of
multiple banking is that in case of consortium banking there is lot of
rigidity from the point of view of the company. In case there is more
requirement of working capital and even though other member banks
wants to disburse their share, they can not do anything unless the lead
bank approves the limit. This causes some delay which can hamper
the business of a company. In case of multiple banking, such problem
is not there.
Once the company decides the type of banking then it selects the bank by
keeping in mind the following criteria:
• The First Criteria for selection of Bank is the time the bank is
supposed to take to sanction the limit and make it available to
the company. It again depends on the organization structure of
banks. In banks, the sanctioning power is delegated at different
level. The degree of delegation is different in different banks.
For some banks , Scale IV officer can sanction a working
capital limit of Rs 3 crores where as for another bank same
Scale IV officer can sanction a working capital limit of Rs 1.25
crores. So depending on the delegation power and company’s
requirement company selects bank.
• After this, the next important criteria is the cost of the facility.
For fund based working capital facility , interest rate is the
charge the company pays to the bank. In the case of non fund
based working capital facility , commission is the charge the
company pays to the bank. In today’s context , different banks
charge different interest for the same borrower. The borrower
would apply to the banks where the total cost is lowest.
• After this the security issue needs to be taken into account.
Generally, all working capital assistances are in the form of
secured loan. Whenever a company borrows from other , the
amount would appear in the liability side of the balance sheet.
The liability can be secured liability and unsecured liability. In
the case of secured liability, the liability is backed by security.
The security can be created only on the Asset. In case of non

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 payment of liability , secured liability holder can enforce the
security for which it is holding charge and can realize cash after
liquidation of such securities. Security can be created by any of
the three processes:
• Lien : Under this process, security is created on financial
asset. The name of the liability holder is marked on the
face of the financial instrument as lien. Under this
system, the ownership is with the borrower where as the
possession is with the lender. The security is created on
financial assets.
• Pledge : Under this process , security is created on both
financial and physical assets. In the case of Pledge, the
ownership is with the borrower where as the possession
is with the lender. The lender can keep the assets in its
own premises or in other premises.
• Hypothecation : Under this process, security is created
on physical assets. In the case of hypothecation, both
the possession and ownership is with the borrower. For
creation of hypothecation, charge needs to be created
for limited company.
• Mortgage : For immovable property, mortgage is
created. In the case of mortgage, the possession and
ownership is with the borrower. But mortgage is created
on the immovable property where as the hypothecation
is created on movable physical assets.
Comparisons of all these four process are given below :

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A comparison of the above mentioned four charge making process is shown below :

Name of Ownership of Possession of Type of Asset Governing

Process the Asset the Asset on which Statute
During the During the charge is
tenure of the tenure of the created
loan loan
Lien Borrower Lender; At the Financial Asset Indian
Lender’s Contract Act
premises
Pledge Borrower Lender; At the Both Financial Indian
Lender’s Asset and Contract Act
premises or Movable
any other Physical Asset
place under
the custody of
lender
Hypothecation Borrower Borrower Movable Indian
Physical Asset Contract Act
Mortgage Borrower Borrower Immovable Transfer of
Physical Asset Immovable
Properties Act

Fig 8.1
Depending on the nature of security to be offered to the lender , the borrower can
decide on the types of charges to be created and the same is mentioned in the
application form.

While deciding a particular bank, another important aspect to be taken is the issue of
collateral security. Many bank insists for collateral security. Security can be classified
into two types. These are :
• Primary Security : A Primary Security with respect to a particular type of
finance is defined as the security which is created out of that finance. For

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 example, when working capital is provided , current assets are build up from
the working capital . In this case, the current asset is called as Primary
security.
• Collateral Security : A collateral security with respect to a particular type of
finance is defined as the security on which charge is created even though the
security is not created from the sad finance. For example, in case a charge
on the fixed asset of a company for working capital loan is created, the
collateral security is the fixed asset.

After deciding all these factors, a company submits the application to bank(s) for
working capital facility. While submitting the application form , the following
documents are given :
• Filled up Application Form as per the Bank’s Own Format
• Memorandum and Article of Association
• Certificate of Incorporation
• Copy of Board Resolution
• Last three years audited accounts along with Directors Report
• Filled Up CMA Forms/Cash Budget for next 12/18 months
• Detail assumption of estimates and projections.

The Bank then processes the application forms .Depending on the banks degree of
delegation power, efficiency level and business target , it usually takes 7 days to 60
days to sanction a fresh working capital limit.

Each bank has specified process note ( a copy of the same is provided along with
this material ) and the same note is signed by two officials. One official recommends
and another official sanction the limit. In the present decentralized structure most of
the banks have adopted the following structures :

1. Large Corporate Accounts : Under this category, financially very sound

companies are selected .For handling these companies, in all the major cities
of the country, dedicated branches are opened and the same branch can
directly deal with Head Office for sanctioning of proposal.

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2. Other Corporate Accounts : Other Corporate accounts follow three tier
structure:
a. Branch Level Sanction : For Fund Based and Non Fund Based limit up
to a particular amount, branch level sanction is given. Individual
branch can sanction limit and sends the proposal to the superior office
for ratification.
b. Zonal Level Sanction : Above the branch, Zonal Office is situated. The
loan sanctioned in Zonal Office would be ratified in the head office.
c. Head Office Level Sanction: Generally, the head office consists of
General Manager, Executive Director, Managing Director ,Chairman,
Committee of Directors, Board of Directors. Each of these authorities is
having sanctioning power and the sanction of loan by all these
authorities are ratified by the immediate higher authority.
Once the loan is sanctioned , the bank would inform the customer through a
letter called Sanction Letter. Some times it is also called as Credit
Arrangement Letter.

A Credit Arrangement Letter would contain the following :

Name of Customer :

Name of the Facility Sanctioned : e.g.Fund Based Working Capital

Type of Facility Sanctioned : e.g. Cash Credit

Limit Sanctioned :

Interest Rate : % Interest rate with reference to PLR or any other rate. Mode
of charging of interest i.e. either quarterly or monthly should be mentioned .

Security : The sanction letter would describe in details about the security to
be offered against the facility. The security can be Primary Security and /or
Collateral Security. The charge can be First Charge or Second Charge.
Similarly , the security can be on exclusive basis or on pari passu basis. After
discussing in detail about the Primary Security and collateral security , we
shall now discuss about the First Charge and Second Charge. An asset can be

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given security to a lender on the basis of first charge or the same asset can
be given security to a lender on the basis of second charge. In the case of a
first charge holder, the lender would get the first priority on the value realized
from the liquidation of the asset. Let us take an example .A lender provides a
working capital loan of Rs 25 lacs against a first charge on current assets of
the company values at Rs 32 lacs. In the case of liquidation of the company,
the lender on liquidation of the current assets would get Rs 32 lacs and it
would first appropriate Rs 25 lacs and the remaining Rs 7 lacs would go to the
second charge holder if any. Generally, the working capital banker would take
the first charge on current assets and second charge on fixed assets . The
term lender on the other hand take first charge on fixed assets and second
charge on current assets of the company .The purpose of taking second
charge of a company is to increase its security coverage.
Now the first charge can be on the basis of exclusive charge or can be on pari
passu basis. In the case of exclusive charge , a lender gets the entire
realization obtained from the liquidation of the asset. However , when the
credit facility is significantly large, more than one bank is involved .For
example, a company has been sanctioned a working capital limit of Rs 50
crores and the total amount of working capital facility would be provided by
say 4 banks each providing Rs 12.50 crores . Since all the banks are lending
against the same current assets of the company , the charge is created on
pari passu basis. Now if the value of the security is say Rs 60 crores, in case
the charge is created on pari passu basis, each bank are entitled to get Rs 15
crores each from the realization of the current assets of the company.
In many cases, Personal Guarantee of the promoter is stipulated. In other
cases, the corporate guarantee of another company is stipulated.
Margin : The margin is stipulated against different types of assets. Generally
a margin of 25% is stipulated on Inventory and slightly higher margin is
stipulated on Receivable.
After the security the negative covenant is stipulated by the lender in the
sanctioned letter.

After the sanctioned letter is received by the company , it needs to accepts

the letter in a board meeting. A board meeting is convened and in that

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meeting the letter is accepted and persons are authorized to accept the terms
and conditions of the sanctioned letter.

Once the letter is accepted by the company, the company would then execute
the documents with the lender. Generally, the following documents are
executed with the lender :
• Credit facility agreement executed between the lender and borrower
• Deed of lien/pledge/hypothecation executed by the borrower
• Documents executing the mortgage of a property by the borrower.
• Personal Guarantee Bond executed by the person concerned.
• Corporate Guarantee Bond executed by the company concerned.
Once the document is executed, the charge is created by the company. The
next step is that the charge is to be registered with the Registrar of
Companies at the office where the registered office of the company is
situated. The charge is registered by depositing specific form namely Form 8
and Form 13 duly executed by the lender and borrower to the ROC within 30
days from the date of executing of relevant documents. While filing the
charge with ROC, it is important to mention that any prior charge holder must
cede the charge and only then the charge can be created by any subsequent
lender.

Once the charge is created the lender is ready to disburse the fund. Before
disbursement of the fund the lender asks for a stock statement to calculate
the drawing power. Stock statement is a statement showing details of the
assets in terms of name , age, quantity and value of assets for which margin
is stipulated as well as security is created. The drawing power is arrived at
after deducting the margin from the value of the assets mentioned in the
stock statement. After arriving at the drawing power, the lender make
disbursement.
Monitoring of Accounts :
After disbursement the lender needs to monitor the company’s performance.
The lender should develop adequate mechanism so that any delinquency sign
is captured early enough so that rectification measures can be initiated and
any loss arising out of such delinquency can be minimized. A lender can
develop the following monitoring system :

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• Routine Submission of Statement: If we recollect , the sanction of
working capital facilities is based on either estimates /projection
figure taken for either MPBF method/Cash Budget method. In both the
cases, borrower’s performance against this estimates /projection is to
be monitored. For monitoring at periodic interval, the lender stipulates
the following statements :
o Monthly Statement : This consists of mainly position of
securities at the end of every month . Besides, the monthly
cash flow statement is stipulated for limit assessed under Cash
Budget mythology. The last date of submission of this
th
statement is 7 days of succeeding month. After receiving the
statement, the lender analyses the statement vis a vis the
estimates made based on which the limit is assessed .
o Quarterly statement : This statement contains the security
position at the end of the quarter and estimates for the next
quarter. The first statement is to be submitted within 6 weeks
after the end of the concerning quarter and the second
statement is to be submitted before the start of the quarter for
which the projections to be made.
o Half yearly statement : This statement contains the Profit and
Loss of the company on half yearly basis and the related fund
flow statement .The entire fund flow statement is segregated in
such a way that the operational fund, investment fund and
financing fund is found out clearly .
o Annual statement : Generally working capital facility is
sanctioned for 1 year. After the expiry of 1 year, the company
needs to submit the renewal data which contains all the
documents submitted during the sanction of the original
proposal. Once received by the bank, the entire process is
again repeated for renewal of the facility.

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 Chapter Nine
Different Corporate Banking Product

After discussing in detail about the entire methods of tying up of working capital limit
from the banking system , we shall now discus about the products by which this fund
based working capital can be raised by a company. Starting from 1991, the financial
liberalization has opened up newer vistas in terms of availability of newer products.
The development of a reasonably structured money market, the gradual liberalization
of the money ,debt and foreign exchange market contributed to the development a
large number of newer products for meeting the working capital requirement of
company.
A company can meet its fund based working capital requirement mainly through :
• Loan Product
• Investment Product
Loan Product : In the case of a loan product , the fund is provided by the bank in
the form of loans and advances. The loans and advances are classified as Loans and
advances in the balance sheet of the bank .The loans and advances are not traded in
the market and the value of the loan and advances would remain same. The typical
loan products are :
• Overdraft
• Cash Credit
• Bill Discounting
• FCNR ( B ) Loans
Overdraft : Overdraft is the facility by which an entity gets loan over and above the
value of the security. This can be explained with the help of the following example :
A company is having a fixed deposit of Rs 5 lacs maturing on 15th September
2005.The fixed deposit was made on 15th September 2004 and the interest rate was
6.5% p.a. payable at quarterly rest. Now , on September 1st, the company requires a
fund of Rs 5 lacs . The company has two options :
Option I : The company closes the fixed deposits prematurely and in the process , it
looses 1% interest. If the company exercise this option, it will earn interest to the
tune of Rs 27032/-.
Option II: The company can take a loan for 15 days against the fixed deposit and
continue with the deposit itself. The interest rate on loan of fixed deposit would be
1% higher than the interest rate of fixed deposit. In this case, the company pays

106
7.5% interest on Rs 5 lacs for 15 days . The company in this process would earn Rs
31760/- on its investment.
So in many cases, it is beneficial to avail an overdraft over the fixed deposit amount
. This facility is called the over draft. This is also a very popular retail banking
product.

Cash Credit : This is the most popular mode of loan product for funding the fund
based working capital requirement of a company. Once the fund based limit has
been assessed by the bank and the limit is in place after fulfilling all the steps , the
fund is made available through the cash credit product. The accounts operates like a
typical current account. At the time of first disbursement, the drawing power is fixed
from the stock statement and the company is allowed to operate within this limit till
the next month when a monthly stock statement would be submitted by the
company. The company would be able to draw fund up to the drawing power of the
company for the month. The company can deposit and withdraw the fund as many
times as it wants .The company would pay interest only on the outstanding amount
on a daily product basis and the interest is charged on monthly rests. This is
explained with the help of the following example :

A company has been sanctioned a fund based working capital limit of Rs 200 lacs
and interest rate is PLR +2% p.a, payable at quarterly rests.The present PLR of the
company is 11% . The company avails this facility through a cash credit route. The
stock statement submitted on 1st of September 2005, stipulates that the drawing
power would be Rs 190 lacs. The transaction of the company is as follows :

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 ( Rs in lacs)
Date Particulars Withdrawal Deposit Balance

3.9.09 To Electricity 15 15
5.9.09 To Salary 45 60
6.9.09 To Raw 100 160
Material
Supplier
10.9.09 To Other 30 190
creditor
11.9.09 By Sales 30 160
Proceeds
12.9.09 To purchase 25 185
16.9.09 By Sales 50 135
30.9.09 By Sales 80 55
Fig 9.1

Since the drawing power of the company is Rs 190 lacs the balance can not exceed
Rs 190 lacs.

The company can withdraw and deposit as many times as possible provided the
balance is within Rs 190 lacs. In the above mentioned example, the company
withdraws 5 times in a month and deposits 3 times in a month. This is one of major
advantage of the cash credit system enjoys by the corporate. The cash management
responsibility is shifted to the bank. The bank has to block the entire Rs 190 lacs for
this account throughout this month though the company has only drawn this amount
once i.e. on 10.9.09.

If we define the idle fund from this account is the difference in amount between the
drawing power and the amount availed and the opportunity cost is 7.00% p.a the
total opportunity cost is calculated below :

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 ( Rs in lacs)
Date DP Balance Idle Fund Period Cost
(days)
1.9.09 190 190 2 0.073
3.9.09 190 15 175 2 0.067
5.9.09 190 60 130 1 0.025
6.9.09 190 160 30 4 0.023
10.9.09 190 190 - 1 0.00
11.9.09 190 160 30 1 0.005
12.9.09 190 185 5 4 0.004
16.9.09 190 135 55 14 0.147
30.9.09 190 55 135 1 0.025
Total 30 0.369

In the case of cash credit facility , the bank looses this amount due to idle fund. If
the limit is substantially large, the idle fund cost is considerably higher. To help the
banks to overcome this , RBI stipulated a loan delivery mechanism for all the fund
based working capital limit . Under this system, 80% of the fund based working
capital would be disbursed through a product called Working Capital Demand
Loan ( WCDL) where the repayment is to be specified by the borrower at the time
of availing the disbursement. The maximum tenure of WCDL is 1 year and minimum
tenure can be 7 days. The remaining 20% of limit can be availed through the normal
cash credit route. In the case of WCDL, the cash management lies with the company
.
Bill Discounting : Once the assessment of the fund based working capital limit is
carried out , the company can avail this fund based working capital amount either
through a single product under loan component or through a combination of different
product under loan component or through a combination of different products under
loan and investment component.
Bill discounting is a product where a part of the receivable can be financed. Once the
assessment of the company is carried out, a portion of the assessed limit
representing part of the receivable can be financed through bill discounting mode.
When a company sales goods on credit, receivable is generated in the books of
accounts of the company. This receivable is of two types :

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 • Open Account sales : Under this process only sales invoice and other sales
related documents are drawn by the seller.
• Bills Receivable : Under this process, not only all the documents associated
with the open account sales are drawn but also a Bills of Exchange is drawn.
A typical Bills of Exchange would look like as follows :

Bills of Exchange

Rs ______________/- Date:

Please Pay ________________ ( Payee) or Order a sum of Rs -

(Rupees ________________only ) on 90 days ( Credit Period) from the

date of this document.

---------------------------- ---------------------------
( Name & Address of ( Name & Address of
Drawee) Drawer)

Fig 8.2
A close scrutiny of the above mentioned bills of exchange would reveal the following
:

• It is an order given by the drawer of the bill of exchange to the drawee to

pay to a party after certain days. Here the drawer is generally the seller and
the drawee is generally the purchaser. The payee is the bank from whom
the seller gets the credit under bill discounting scheme.
• Under normal circumstances, the seller would get the payment after 90 days
from the buyer. This is the credit period extended by the seller to the buyer.
This is also called the usance period of bills of exchange.
• To improve the cash flow, the seller can get the fund from the Payee,
immediately on submission of bills of exchange to a bank .The bank would

110
 send it for acceptance to the drawee and drawee accepts the bills of exchange
to pay on due date.
• On receipt of acceptance from the drawee, the bank would pay to the drawer
immediately.
• On due date the bank would collect the money from the drawee. Since the bill
of exchange is a negotiable instrument, protection under Negotiable
Instrument Act is available to the payee. In many cases , the credit
enhancement of bills of exchange can be increased with the help of a LC.

Now a days, this method of financing became very much popular for Small and
Medium Enterprise (SME) financing. Many large company outsourced their production
facility to SMEs. These SMEs may not be financially strong enough to attract very
competitive interest rate from the bank. The bank enters into arrangement where
the large company which is the buyer of goods of SME would accept the Bills of
Exchange drawn by the SME and in that case the exposure is shifted on the Large
Company. Under this mechanism , SME can get very finer interest rate.

FCNR(B) Loan: This is one of the most popular methods of working capital finance
for last couple of years. If you go through the accounts of any large corporate , you
will find the presence of this product. Before going to the benefits of the product, we
shall first discuss about the product itself. Foreign Currency Non Resident ( Bank) is
the name of a deposit scheme operated by Indian bank to collect deposits from Non
Resident Indians and Overseas Corporate Bodies ( OCB). These deposits are
collected in United States Dollars (USD), Japanese Yen (JPY),Euro ,Great Britain
Pounds (GBP),Canadian Dollar and Australian Dollar. The deposit can be taken for a
minimum period of 12 months and maximum period of 36 months. The interest and
principal is to be paid in foreign currency. When a bank accepts FCNR(B) deposits, it
accepts deposits in these foreign currencies. The Indian bank has the following
options before it :
1. It keeps the deposit in the dollar form and invest in overseas bank account.
The benefit of this mechanism is that the bank has fully hedged the currency
conversion risk and the counter party risk is nil. The drawback of this
mechanism is that in this process, the earning is substantially lower.
2. After accepting the deposits, the bank converts this foreign currency in to
the domestic currency. Subsequently , it lends the domestic currency to the

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 Indian company and earns domestic interest rate. On due date of payment of
interest and principal ,bank converts the Indian currency into foreign
currency as it has to pay back to the depositor both interest and principal in
foreign currency. The benefit of this mechanism is that the earning to the
bank is more .However, the drawback is that the bank incurs a foreign
exchange risk.
3. There can be another process by which some of the benefits from both the
alternative can be retained. Such process would lead to the development of
the product called FCNR(B) loan. In the case of FCNR(B) loan, bank can lend
to Indian corporate in foreign currency held by the bank under FCNR(B)
deposit .The benefit to the bank is that without incurring the conversion risk(
as mentioned under drawback in option 2), the bank can earn more as the
Indian corporate would pay more compared to that of the foreign bank ( as
mentioned in option 1 above).
The benefit to the corporate is that it can derive the interest rate benefit between
two countries. With strong foreign exchange reserves over the period of last couple
of years, the short term stability on rupee dollar exchange rate would help the
corporate to hedge the currency risk completely. This can be explained with the help
of the following example :

• A company is having a credit rating of AA from a bank. The Bank gives fund
at PLR plus 0.50 % to a AA rated customer. The company enjoys a fund
working capital limit of Rs 10 crores from the bank. The PLR of the bank is
11.00%. The company , if avails this loan through WCDL and CC route, the
interest rate would be 11.50%. The company can substitute about Rs 435
lacs i.e. USD 1 million through FCNR(B) loan from the bank. Since it is a
foreign currency loan, the interest rate would be linked to London Inter Bank
Offer Rate (LIBOR). Suppose the company gets LIBOR +2% on the loan for 6
months. With a very strong foreign exchange reserve, the 6 months Rs dollar
premium is actually very low say 2% p.a. The six months LIBOR is about
1.75% p.a. With a total hedge, the all inclusive cost of the company is
5.75% p.a. compared to 11.50% p.a. in the rupee loan. So the company
benefits substantially in reducing the cost.
• But there are some restriction in the use of FCNR(B) loan.This loan can only
be used for financing the working capital requirement .The corporate must

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 have a sanctioned working capital limit. This loan can not be used for any
speculative purpose.

After discussing the FCNR(B) loan , it would be better that we discuss something
about the External Commercial Borrowing ( ECB) and compare this two facilities.

Like FCNR(B) loan, a company can also take a foreign currency loan under External
Commercial Borrowing (ECB) and Trade Credit ( TC) scheme. The similarity of all
the three schemes are that these are routes by which an Indian company can raise
debt in foreign currency.

ECB : A company can raise foreign currency loan under the scheme ECB. The ECB
can be raised either through Automatic Approval Route or after obtaining permission
of Government and RBI. Under the automatic approval route the following need to
be fulfilled :

• ECB up to USD 20 million with minimum average maturity of 3 years

• ECB between USD 20 million with minimum average maturity of 5 years.
• Maximum ECB to be raised during a financial year is USD 500 million.
• Maximum Interest to be paid between three to five years maturity is
LIBOR+200 basis point and the same for more than five years maturity is
LIBOR+350 basis point.
• ECB can be used only for project finance but can not be used for working
capital finance.
Trade Credit (TC) : The trade credit refers to the credit extended by the overseas
supplier, banks and financial institution for original maturity of less than 3 years.
TC can take in the form of buyers credit or supplier credit. In the case of suppliers’
credit, it relates to credit for import in to India by overseas supplier, while buyers’
credit refers to the loan for payment of imports into India arranged by the importer
for a bank or financial institutions outside India for a maturity of less than 3 year .
This is for import of capital goods.

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The comparison of all the three facilities are given below:

FCNR(B) Loan TC ECB

Tenure Maximum 1 year Maximum 3 year Minimum 3 year
Purpose Meeting Working Import of goods ( For Investment in
Capital all goods including Real Sector, For
Requirement capital goods) .Part acquisition abroad
can be meeting
working capital
requirment.
Interest Rate No restriction Ceiling is Ceiling is
prescribed prescribed
Source of Fund Allready existing Fresh Liability in Fresh Liability in
NRI Liability in the Balance of Balance of
form of FCNR(B) Payment Payment
deposit
Permission No permission is Information needs Information needs
required. No to be submitted to be submitted
information to be
submitted.

Fig 9.2
In the case of a loan product, the interest rate is linked to the PLR of the lending
bank. For loan product in foreign currency like FCNR(B) loan, the interest rate is
linked to LIBOR. The PLR or Prime Lending Rate of the company is the reference
rate for lending under loans and advances. This rate does not change frequently
.The rate is arrived at by taking into the account the deposit rate and the other
overhead cost. Since the deposit rate of a bank does not change very frequently ,
the PLR of the bank does not change very frequently. Let us take an example. A
company has been sanctioned a cash credit limit of Rs 250 lacs at a rate of
PLR+1.00%. If the PLR is 11% p.a. the company needs to pay interest on the
drawing till Rs 250 lacs at an interest rate of 12% till it enjoys the facility or till the
PLR is changed whichever is earlier. So company’s interest liability is fixed for a
longer period. This kind of situation may lead to the loss if a soft interest rate
regime prevails in the economy.

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The company can take advantage of more prevalent interest rate if it is resorted to
borrowing through investment product. The characteristic of investment product is
that the interest rate is linked to money market interest rate. Since the money
market interest rate keeps changing on the daily basis, the company can take the
advantage of recent changes of the money market interest rate in the investment
product.
Another characteristics of investment product is that all the products are rated by
an external agencies. Since the product is rated by an external agencies, the
decision taking capacity of the bank is much faster compared to that of loan
product.
In Indian market, generally investment products are used to replace the traditional
loan product for availing the interest rate benefit. In all the cases, the company is
having a sanctioned working capital limit from a bank. The company uses the
investment product to substitute the loan product within the sanctioned limit to take
advantage of the interest rate.
The following investment products are widely used in India for funding the working
capital requirement of a company:
• Commercial Paper (CP)
• Mumbai Inter Bank Offer Rate ( MIBOR) linked debenture
• Non Convertible Debenture.
Commercial Paper ( CP) : CP is an unsecured money market instrument issued in
the form of a promissory note by corporation of high repute to diversify their source
of short term borrowing and to provide an additional instruments to investors.
Subsequently , Primary Dealers and Financial Institutions are also permitted to issue
CP.
• Who Can Issue a CP ? A company, Primary Dealer and All India Financial
Institutions can issue CP. In the case of a company the following criteria
needs to be fulfilled :
o The TNW of the company as per latest audited balance sheet should
not be less than Rs 4crores;
o The Company has been sanctioned a working capital limit by Banks
and /or all India Financial Institutions
o The Borrowal Account is classified as Standard assets by the bank/Fis.

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In the case of Primary Dealer and All India Financial Institutions , RBI
permits them to issue CP to meet their short term funding requirement
within an umbrella limit specified by the RBI .
• Rating Criteria : All eligible participants shall obtain the credit rating for
issuance of commercial paper from ICRA,CRISIL,CARE,FITCH Ratings India
Pvt Limited or any other credit rating agencies as prescribed by RBI from time
to time. The minimum credit rating should be P2 of CRISIL or equivalent of
other rating agencies . The issuer of CP should ensure that the rating is valid
at the time of issuance .
• Maturity : The CP can be issued for a minimum maturity of 7 days to
maximum maturity of 1year .Under no circumstances, the maturity date of CP
should not go beyond the date up to which the rating is valid.
• Denominations : CP can be issued in denominations of Rs 5 lacs or multiples
thereof.
• Limits and the amount of issue of CP: CP can be issued as a “Stand Alone ”
product. The aggregate amount of CP from an issuer ( company) shall be
within the limit as approved by its Board of Directors or the Quantum
indicated by the credit rating agencies for the specified rating, whichever is
lower. An FI can issue CP up to the umbrella limit fixed by RBI i.e. issue of
CP along with other instrument viz. term money borrowings, tem deposits
,Certificate of Deposits and Inter Corporate Deposits should not exceed 100
percent of its net owned fund, as per the latest audited balance sheet.
• Issue and Paying Agency : By now, we have seen the issuer of Cp needs to
fulfill a number of requirement. To verify that the issuer has fulfilled all the
requirement, an independent agencies should certify to that extent to the
investor. Issue and Paying Agencies (IPA) would play that role. Only schedule
commercial banks can act as a IPA.
• Investment in CP : CP may be issued to and held by an Individual, Banks, Fis,
NRIs and also FIIs .However, investment by FIIs would be within the limits
set for their investments by SEBI.
• Mode of Issuance : CP can be issued in Physical Mode or in Dematerialized
Mode through any of the depositories approved by and registered with
SEBI.CP can be issued at a discount to face value as may be decided by the
issuer.

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• Payment of CP : The initial investor would pay the discounted value of the CP
by means of a crossed account payee cheque to the account of the issuer
through IPA. On maturity of CP, when the CP is held in physical form, the
holder of instrument would present the instrument to the issuer through IPA.
However, when the CP is held in demat form, the holder of CP will have to get
it redeemed through depository and receive payment from the IPA.
• Stand by facility : In view of CP being a “Stand Alone ” product, it would not
be obligatory for bank and Fis to issue stand by facility to the issuer of CP.
However , banks and Fis have the flexibility to provide for a CP issue, credit
enhancement by way of stand by assistance/credit,back stop facility etc based
on their commercial judgment, subject to the prudential norms as applicable
and with specific approval of their board.
Non bank entities including corporates may also provide unconditional and
irrevocable guarantee for credit enhancement for CP issue provided:
1. The issuer fulfills the eligibility criteria prescribed for issuance of CP;
2. The guarantor has a credit rating at least one notch higher than the
issuer given by an approved rating agencies;
3. The offer documents for CP properly discloses the net worth of the
guarantor company, the names of the companies to which the
guarantor has issued similar guarantees, the extent of the guarantees
offered by the guarantor company, and the conditions under which the
guarantee would be invoked.
• Procedure for Issuance : Every issuer must appoint an IPA for issuance of
CP. The issuer should disclose to the potential investor its financial
positions as per the standard market practice. After the exchange of deal
confirmation between the investor and the issuer, the issuing company
shall issue physical certificates to the investor or arrange for crediting the
CP to the investor’s account with the depository. Investor shall be given a
copy of IPA certificate to the effect that the issuer has a valid agreement
with the IPA and the documents are in order.
When a company raises the fund through CP , it will pay discount rate which is
depended on the money market rate at the date of issuance. For example, a
company wants to raise Rs 5 crores through CP ( having a rating of P1+) for 90
days on 1st September 2005, the discount rate to be paid on the CP would
depend on the call money rate or MIBOR rate prevailing on 1st September

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2005.This discount rate is fixed for the company for the entire tenure of 90 days
from 1st September 2005. For example if the call money rate is 5% p.a. and a
P1+ CP would attract a discount rate of 0.75% above the MIBOR rate , then the
discount rate to be paid by the company would be 5.75% p.a. for 90 days from
1st September 2005.Now if the call money rate goes down to 4.75% on
September 15th 2005 , if the company could have raised the fund at that point of
time at an interest rate of 5.50% p.a. for 90 days. The benefits of daily
movement of interest rate would be possible in the case of MIBOR linked
debentures. Under this instruments, a company can raise working capital where
the interest rate is compounded on a daily basis based on the closing MIBOR rate
prevailing at the close of each day.
Factoring Services : In the international transaction factoring of receivable is
also a very important corporate banking product. In most of the international
trade transactions, besides the normal credit risks, it involves additional concepts
of country and therefore a sovereign risks comes into play. Sovereign risks in
international business is usually of three broad categories :
• Transaction Risk : It is linked to specific transaction that
involves a specific amount within a specific time frame, such as
an export sales on six months draft terms;
• Translation Risk: It stems form the obligation of multinational
companies to translate foreign currency assets and liabilities
into the parent company’s accounting currency regularly , a
process that can give rise to book keeping gains and losses
• Economic Risk : In the broadest sense , it encompasses all
changes in a company’s international operating environment
that generate, real economic gains or losses.
Export credit is quite distinct from the domestic counterpart is several
respects. The principal characteristics of export credit which distinguish it
from the domestic sales are as follows:
• Longer time scales for delivery , funds transfer and credit period;
• Extra time and distance require terms which provide a security for the
risks perceived;
• The expectation of local credit terms for each market
• Competition from other countries having different money costs and
government policies;

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 • The use of international standard terminology.
This feeling of insecurity and risks involved in international transactions has,
therefore, resulted in various methods of payment system, the most secure of
these being the Advance Payment or Cash with Order ( CWO) .The other two
prevalent methods of receiving payments are through the mechanism of Bills
of Exchange and Documentary Credit. In both these methods, the banking
system is the channel through which the transactions are normally carried
out. Though advantageous to the sellers, secured to a certain extent , except
the concept of clean bills of exchange ( here shipping documents are not
enclosed) , usually in a competitive environment, debtors are not inclined to
open letters of credit because of the cost and time involved. Further, the
entire mechanism of operations through letter of credit is gradually loosing its
impact throughout world primarily on account of what is known as Doctrine of
Strict Compliance. The seriousness of the problems is evident from a survey
conducted in United Kingdom which revealed that more than 50 percent of
documents failed to comply with the terms of letter of credit in first
presentation to the banks.
In view of the constraints of the existing systems, open account transactions
are also coming into existence in larger numbers than in the past. Under this
system, there is direct arrangement between the exporter and the importer to
complete the deal including the payment within a predetermined future date
usually between 60 days and 90 days from the date of invoice. The goods and
the shipping documents are sent directly to the importer enabling him to take
delivery of goods. The essential features of open account transaction are
listed as follows :
1. Complete confidence in the credit standing not only of the debtors but
also of his country so that proceeds of the goods can be realized within
the agreed period.
2. An efficient sales ledger administration often in multi currencies
coupled with credit control mechanism involving sound knowledge of
trade practices, law and knowledge of the importer’s country.
3. Sufficient liquidity source to grant competitive credit terms to the
importer.
In such situation , export factoring can play a very important role not only in
providing finance but also in providing a service package to exporters. Export

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factoring can broadly be defined as an agreement in which export receivables
arising out of sale of goods/services are sold to the factor, as a result of
which title to the goods/services represented by the said receivable passes on
to the factor. Henceforth, the factor becomes responsible for all credit control,
sales accounting and debt collection from the importers.
Advantages of International Factoring :
The distinct advantages of a factoring transaction over other methods of
finance/facilities provided to an exporter can be summarized as follows :
1. Immediate finance up to a certain percentage ( say 75-80 percent) of
the eligible export receivable. This prepayment facility s available
without a letter of credit –simply on the strength of the invoice(s)
representing the shipment of goods.
2. Credit checking of all the prospective debtors in importing countries
,through own databases o the export factor or by taking assistance
from his counterpart(s) in importing countries known as import factor
or established credit rating agencies.
3. Maintenance of entire sales ledger of the exporter including
undertaking asset management functions. Constant liaison is
maintained with the debtors in importing countries and collections are
affected in a diplomatic but efficient manner, ensuring faster payment
and safeguarding financial costs.
4. Accordingly bad debt protection up to full extent ( 100 percent) on all
approved sales to agreed debtors ensuring total predictability of cash
flows .
5. Undertaking cover operations to minimize potential losses arising from
possible exchange rate fluctuations.
6. Efficient and fast communication system through letters, telex,
telephone or in person in the buyer’s language and in line with the
national business practices.
7. Consultancy services in areas relating to special conditions and
regulations as applicable to the importing countries.
Types of International Factoring :
The most important form of factoring is two factor system.
Two Factor System :

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The transaction is based on operation of two factoring companies in two
different countries involving in all, four parties :Exporter, Importer, Export
Factor in exporter’s country and import factor in importer’s country.
The mechanics of operation in this arrangement works out as follows :

1. The exporter approaches the export factor with relevant information

which, inter alia, may include a) Type of business, b) Names and
addresses of the debtors in various importing countries ,c)Annual
expected export turnover to each country ,d) Number of
invoices/credit notes per country ,e)Payments terms and f) Line of
credit required for each debtor.
2. Based on the information furnished , the export factor would contact
his counterpart( import factor) in different countries to assess the
creditworthiness of the various debtors.
3. The import factor makes a preliminary assessment as to his ability to
give credit cover to the principal debtors.
4. Based on the positive response of the import factor, the factoring
agreement is signed between the exporter and export factor.
5. Goods are sent by the exporter to the importer along with the original
invoice which includes an assignment clause stipulating that the
payment must be made to the import factor. Simultaneously, two
copies of the invoice along with notifications of the debt are sent to
the export factor. At this stage, prepayment up to an agreed per cent
( say 75-80 percent) of the invoice(s) is made to the exporter by the
export factor.
6. A copy of the invoice is sent by the export factor to his counterpart,
that is the import factor. Henceforth , the responsibilities relating to
book keeping and collection of debts remain vested with the import
factor.
7. Having collected the debts, the proceeds are remitted by the import
factor to his counterpart, that is export factor. In case of payments
are not received from any of the debtor(s) at the end of the
previously agreed period on account of financial inability of the debtor
concerned, the import factor has to pay the amount of the bill to his
export counterpart from his own funds. However, this obligation will

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 not apply in case of any dispute regarding quality ,quantity, terms
and conditions of supply etc. If any dispute arises, the same has to be
settled between the parties concerned through the good offices of the
factoring companies , otherwise legal action may have to be initiated
by the import factor based on the instructions of the exporter/export
factor.
8. On receipt of the proceeds of the debts realized, the retention held
(say 15-20 percent) is released to the exporter. The entire factoring
fee is debited to the exporter’s account and the export factor remits
the mutually agreed commission to his importing counter part.
This, the export factor undertakes the exporter risk whereas the importer
risk is taken care of by the import factor.
The main functions of the export factor relate to :
• Assessment of the financial strength of the exporter
• Prepayment to the exporter after proper documentation and regular
audit and post sanction control
• Follow up with the import factor
• Sharing of commission with the import factor
The import factor is primarily engaged in the areas of :
• Maintaining books of exporter in respect of sales to the debtors of his
country
• Collection of debts from the importers and remitting proceeds of the
same to the export factor
• Providing credit protection in case of financial inability on part of any
of the debtors.
The two factor systems is by all means the best mode of providing the most
effective factoring facilities to a prospective exporter. However, the system is
also fraught with certain basic disadvantages, i.e. delay in operations like
credit decision, remittance of fund, etc, due to involvement of many parties.

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 Chapter 10
Project Financing

Project financing can be arranged when a particular facility or a related set of assets
is capable of functioning profitably as an independent unit. The sponsor(s) of such a
unit may find it advantageous to form a legal entity to construct, own, and operate
the project. If sufficient profit is predicted , the project company can finance
construction of the project on a project basis, which involves the issuance of equity
securities ( generally to the sponsors of the project ) and of debt securities that are
designed to be self liquidating from the revenues derived from project operations.

Although project financing has certain common features, financing on a project

basis necessarily involves tailoring the financing packages to the
circumstances of a particular project. Expert financial engineering is as critical to
the success of a large project as the engineering component of the project.

Description of Project financing :

Project financing may be defined as the raising of funds to finance an economically
separable capital investment project in which the providers of the funds look
primarily to the cash flow from the project as the source of the funds to service their
loans and to provide a return on the equity they invested in the project. The terms of
the debt and securities are tailored to the cash flow characteristics of the project.
Project financing typically include the following basic features :
1. An agreement by financially responsible parties to complete the project and to
make available to the project all funds necessary to achieve the completion.
2. An agreement by financially responsible parties ( typically taking the form of
a contract for the purchase of the project output) that, when project
completion occurs and operations commence , the project will have available
sufficient cash to enable it to meet all its operating expenses and debt service
requirements , even if the project fails to perform on account of force
majeure or any other reason.
3. Assurances by financially responsible parties that in the event a disruption in
operation occurs and funds are required to restore the project to operating
condition, the necessary funds will be made available through insurance
recoveries, advances against future deliveries or some other means.

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In the case of conventional direct financing, lenders to the firm look to the firm’s
entire assets portfolio to generate the cash flow to service their loan. The assets and
other financing are integrated into the firm’s asset and liability portfolios . The major
difference with this type of financing and the project financing is that the project is a
distinct legal entity; project assets, liabilities , project related contracts , project
related cash flows are segregated to a substantial degree from the sponsoring entity.
In a project financing , the sponsors provide, at most , limited recourse to cash flows
from other assets that are not part of the project.

Please note that project financing is not a means of raisings funds to finance an
economically weak project which is not capable of repaying its commitment to debt
and equity holder. The Figure 10.1 depicts the basic elements of a typical project
financing .
Lenders
Loan Funds Debt Repayment

Raw materials

Suppliers Assets comprising the project Purchasers

Supply contract(s)
Returns to Cash deficiency
Equity Fund investors agreement and
Other forms of credit
support
Equity Investors/
Investors Sponsors

Fig 10.1 Basic Elements of a Project Financing

Project financing can be beneficial to a company with a proposed project when

• The project output would be in such strong demand that purchasers would be
willing to enter into long term purchase contracts

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 • The contracts would have strong enough provisions that banks would be
willing to advance funds to finance construction on the basis of the contact.

Requirements For Project Financing :

A project has no operating history at the time of initial debt financing. So its credit
worthiness depends on the project’s anticipated profitability and on the indirect
credit support provided by the third parties through various contractual
arrangements. As a result, lenders require assurances that a) the project will be
placed into service and b) once operations begin, the project will constitute an
economically viable business entity. The sponsor must convince about the technical
feasibility and economically feasibility of the project to the lender.
Technical Feasibility : The sponsor must convince the lender about the technical
feasibility of the project. For a conventional technology , this is not much of a
problem but in the case of a new technology driven project convincing the lender
about the feasibility of the technology is a difficult tasks.
Economic Feasibility : By economic feasibility , we mean that the earning capacity
from the project. Like all the investment decision, the lender would also have to be
convinced about the earning potential of the money to be invested in the project.
The project must produce adequate revenues to cover up the operation cost and
debt repayment obligation and then compensate the equity lender of the project.
Availability of the Raw material and capable management: Natural resources
, raw materials and other factors of production that are required for successful
operation must be available in the quantities needed for the project to operate at its
design capacity over the entire life. To satisfy lenders , the quantities of raw
materials dedicated to the project must enable the project to produce and sell an
amount of output to ensure servicing of project debt in a timely manner. To achieve
this, unless the sponsor owns the raw material resources, adequate long term
contract for the project life should be put in place . Similarly if possible a long term
selling contract with a more credit worthy customer would be a very strong point for
arranging fund at a lower cost.
Besides the raw material, the project must have capable manpower to execute the
project both at the construction stage and operation stage. It may happen that the
sponsor does not have the expertise in construction and operation of the project as it
may have been in different line of activity. In such case, the sponsor may engage an

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Engineering firm for execution of the contract. A negotiated management service
agreement may be entered upon.

Appropriateness of project financing :

The projects which have the following features are the ideal projects for project
financing :
• Projects capable of functioning as independent economic units;
• Projects can be completed without undue uncertainty ;
• Projects after completion should be worth demonstrably more than the
completion cost;

Risk Sharing :

Often risks associated with a single project is so large that it would not be wise for a
single entity to go for the project alone. Project financing permits the sharing of
operating and financial risks among the various interested parties and it does so in a
more flexible manner than financing on the sponsor’s general credit. Risk sharing is
advantageous when economic, technical , environmental or regulatory risks are of
such magnitude that it would be impractical or imprudent for a single party to
undertake them. A financing structure that facilitates multiple ownership and risk
sharing is particularly attractive for projects such as electric power generating plants,
where significant economies of scale are possible and the project will provide
benefits to several parties.
Expansion of Sponsor’s debt capacity :
Financing on a project basis can expand the debt capacity of the project sponsors. In
many cases, it is possible to structure a project so that the project debt is not a
direct obligation of the sponsors and does not appear on the face of sponsor’s
balance sheet. In addition , the sponsor’s contractual obligations with respect to the
project may not come within the definition of indebtedness for the purpose of debt
limitations contained in the sponsors bond indentures or note agreements.

Because of the contractual arrangements that provide credit support for project
borrowings, the project company may be able to achieve significantly higher financial
leverage than the sponsor would feel comfortable with if it financed the project
entirely on its own balance sheet. The amount of leverage a project can achieve

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depends on the project’s profitability, the nature of project risks, the strength of the
project’s security arrangements and the credit worthiness of the parties committed
under those security arrangements.

Rationale for Project Financing

When a firm is contemplating a capital investment project, the following interrelated

questions may arise:
1. Should the firm undertake the project as part of its overall assets portfolio
and finance the project on its general credit, or should the firm form a
separate legal entity to undertake the project?
2. What amount of debt should separate legal entity incur?
3. How should the debt contact be structured – that is , what degree of recourse
to the project sponsors should lenders be permitted ?
Only in recent times, the true benefits of project financing are becoming evident .
But to reap the benefit of project financing a number of things should be performed .
In this section we shall try to analyse the rationale for project financing .
Before finding the rationale of project financing , we need to know the characteristics
of project financing. Unlike traditional financing , project financing involves large
amount of investment of fund without any asset at the time of investment. The
lender lends finance purely on the basis of the commitment made in the project by
all the parties involved in the project. So project financing arrangements invariably
involve strong contractual relationships among multiple parties . Project financing
can only work for those projects that can establish such relationships and
maintain them at a tolerable cost . The litmus test of soundness for a proposed
financing is whether all parties can reasonably expect to benefit under the proposed
financing arrangement. To achieve a successful project financing arrangement , the
financial engineer must design a financing structure – and embody that structure in a
set of contracts- that will enable each of party to gain from the arrangements.

The starting point of project financing is that fund is arranged by a separate legal
entity. Before going in to the procedural details of arranging fund, we need to know
the benefits of separate incorporation of an entity specifically designed for availing
project finance. When a firm undertakes multiple projects , the benefits of one
project is being distributed to other projects as the cash flows coming from each

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project is intermingled with others. This would lead to the owner’s discretion of
investing the surplus to projects on their own choice which may not the actual desire
of the lender. For example, A company is undertaking 4 projects with capital
investment to the tune of Rs 500 crores. The detail capital investment for different
projects is given below :
Project A Project B Project C Project D
Investment in 50 150 175 125
Rs crores
Debt in Rs 35 105 123 88
crores
Equity in Rs 15 45 52 37
crores

The project is being financed in the form of 70% debt and remaining in the form
equity from the large institutional investors. The tenure of the project is 5 years. The
cash flows of the project for next 5 years are given below :
( Rs crores )
Year 1 Year 2 Year 3 Year 4 Year 5
Project A 5 10 12 18 25
Project B 35 45 65 85 105
Project C 65 75 85 105 115
Project D 25 35 45 55 75

If the company has funded this project on its own capacity and if the entire loan is to
be repaid in equal 5 installment then the repayment obligation is as follows :

Year 1 Year 2 Year 3 Year 4 Year 5

Debt Payment commitment
Project A 7 7 7 7 7
Project B 21 21 21 21 21
Project C 24 24 24 24 27
Project D 17 17 17 17 21
Total 69 69 69 69 69

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Fund Available
Project A 5 10 12 18 25
Project B 35 45 65 85 105
Project C 65 75 85 105 115
Project D 25 35 45 55 75
Total 130 165 207 263 320
Funds available for refund to equity investor
Total 61 96 138 194 251

Since the fund is mingled , the company would decide how this surplus would be
distributed to equity holders. It may happen that a particular investor who has
invested in the project B would require money some money in the 2nd year but the
company decides to give dividend only in year 4th . In such a case the equity investor
in the project B would be the looser. Besides , if the financing is arranged within the
parent Company which may have highly levered, the additional burden of debt would
reduce its credit rating and this would lead to increase in cost of fund.
Special form of organization :
To overcome the above mentioned two problems , project financing can be preferred
over conventional method of financing. However , we need to know that project
financing differs from conventional direct financing at least in two aspects :
1. The project has a finite life : The project has a finite life as opposed to a
business entity. The legal entity of the project will be different which would
have the same life as that of the project.
2. The project entity would distribute the cash flows from the project directly to
lenders and to project equity investors . In such case, the return on equity
investor is not dependent on the decision of the managers or owners of the
company as a whole. In such a case the reinvestment decision lies with the
investors.

When to go for project financing?

First, if management can maintain control of all the projects it has under
consideration when they are entirely equity financed, it will not issue any debt. This
enable managers to avoid having lenders who will monitor (and restrict) their
activities. If management has comparable abilities (relative to potential rivals) in

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managing all the projects, then forming a single corporation to own all the projects
will be the predominating technique. If, on the other hand, management’s relative
abilities differ significantly across the projects, then it will be better to incorporate at
least some of the projects separately and hire separate management to run them.
Second, if management can not retain control of all the projects then it will finance
the projects by issuing a combination of debts and equity. If management’s relative
abilities are comparable across the projects, and the structure of the control benefits
is also similar , the project will be owned by a single corporation and partly financed
with corporate debt. If , on the other hand, management’s control benefits differ
significantly from one project to another , limited recourse project financing is
optimal. Management will operate all the projects but use limited – recourse
financing to limit its liability.
Third, when a firm must issue debt to maintain control, and management’s relative
abilities differ significantly across the various projects, it will be optimal to spin off
one or more of the separate firms. Shareholders will benefit if better managers take
over a spun off firm that was poorly managed.
Fourth, the optimal allocation of limited recourse project debt across different
projects depends on the structure of management’s control benefits. In general , a
project with smaller control benefits per dollar of total project value will have a
higher proportion of debt financing . Managers have less to loose if the higher
proportion of debt leads to tighter restrictions on their activities.
Fifth, when some of the projects are spun off, the optimal debt allocation is also
affected by management’s relative abilities across projects. Less well managed firms
are less able to support leverages.

Reallocating Free cash Flows:

In the traditional corporate form of organization , the board of directors determines
how the free cash flows is allocated between distributions to investors and
reinvestment . Free cash flow is what is left over after a company has paid all its
costs of production, has paid its lenders, and has made any capital expenditure s
required to keep its production facilities in good working order. Generally, when a
corporation decides to invest in a new project , cash flows from the existing portfolio
of projects will find the investment in the new one. Management has the option to
roll over the existing portfolio’s free cash flow into still newer ventures within the

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company later on – without necessarily exposing its decisions to the discipline of the
capital market.

Free cash flows and project financing :

Project financing can give investors control over free cash flow from the project.
Typically , all free cash flow is distributed to the project’s equity investors . As noted
, because a project financing is specific to a particular pool of assets, the entity
created to own and operate it has a finite life. Moreover, the project financing
documents that govern the terms of the equity investment in the project typically
spell our in writing the project entity’s “dividend policy” over the life of the project.

Benefits of project financing :

Managers when left to their own devices, may not be sufficiently demanding when
comparing projects that can be financed internally with other projects that must be
financed externally. Giving managers the discretion to reinvest free cash flow can
result in a loss of share holder value. Forcing the free cash flow to be dispersed
exposes the managers of the corporation to the discipline of the capital market
because investors control the uses to which the free cash flow will be put. Such a
shift in control should enhance shareholders value.
Project financing can be beneficial because direct ownership of assets places
investors in control when the time comes to make reinvestment decisions. Giving
investors control resolves potential conflicts of interest that can arise when
management has discretion over reinvestment. With project financing, funding for
the new project is negotiated with outside investors. As the project evolves, the
capital is returned to the investors, who decide for themselves how to reinvest it.
Reducing Asymmetric information and signaling cost :
In the case of debt securities, there is a contractual payment obligation of the
issuer. But there is no such contractual payment obligation for issuer of equity.
Issuing debt , rather than common stock signals that the firm expects to generate
sufficient cash flow to service the additional debt in a timely manner. Asymmetric
information occurs when managers have valuable information about a new project
that they can not communicate unambiguously to the capital market. Valuable
information about what makes an opportunity potentially profitable must be kept
from competitors in order to maintain a competitive advantage. Project financing
can solve such communication problem . Managers can reveal sufficient information

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about the project to a small group of investors and negotiate a fair price for the
project’s entity’s securities . In this way, the managers can obtain financing at a fair
price without having to reveal proprietary information to the public. The danger of an
information leak is small because investors have a financial stage in maintaining
confidentiality. Project financing is useful for projects that entail high informational
asymmetry costs. BY resorting to project financing , corporations preserve the
internally generated resources for financing the proprietary sensitive projects.
In this fashion, by resorting to project financing , firm can set aside the internally
generated cash for funding proprietary information sensitive projects which has
tremendous amount of growth potential and this would increase the shareholders
value in the long run.

More efficient structuring of debt contract:

The inherent conflicts between the lenders and shareholders lead to different types
of agency cost . Leaders deal with these agency costs by negotiating covenant
structures that are contained in loan agreements. Project financing can reduce these
agency costs . A project has a finite life. Even the equity investors demand the
distribution of free cash flow to the providers of capital. Management’s discretion to
reinvest this cash flow to the detrimental of the lender and equity holder is restricted
by way of covenants. This kind of covenants would try to reduce hazards associated
with the agency cost. In the case of project financing, framing a contract in this
form is much easier than for the entire firm.
More effective corporate organisation and management compensation :
In the case of project financing the cash flow is directly linked with the project rather
than with the company and in such case it is difficult to identify the effort of the
manager. Let us take an example . Suppose a company A is managing 4 projects
at the organization level and all the projects are financed at the organizational level.
All the project owners ( they are called as project managers ) have been awarded
stock option of the company . Out of the 4 projects, 2 are doing well and remaining
two are not doing well and the effect of the last two projects will be reflecting in the
share price of the Company . In such a case, the managers of the 2 good projects
would also be effected badly. But if finance has been arranged separately for
different projects, the rewards can be distributed as per the project as the cash flow
from a project under project finance scheme belongs to the project itself. So in such
a case the management compensation can directly be linked with the project.

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Advantages of Project Financing :
Project financing should be pursued when it will achieve a lower after tax cost of
capital than conventional financing . In an extreme case, the sponsors’ credit may be
so weak that it is unable to obtain sufficient funds to finance a project at a
reasonable cost on its own . Project financing may then offer the only practical
means available for financing the project.

Capturing an economic rent :

Economists refer to the portion of total return that represents excess return as an
economic rent. The project sponsors can monetize the economic rent by entering
into long term purchase contracts. These contracts provided they are properly
drafted can be used to secure project borrowings to finance the development of the
natural resources.

Achieving economies of scale :

Two or more producers can benefit from joining together to build a single facility
when there are economies of scale in production. For example, two medium size
steel factory in a location where there are shortage of power would be interested to
build up a power plant for both of their own consumption of power. In such a case
the economies of scale can be achieved by the project financing .

Risk Sharing :
When project is carried out by a consortium of parties , the risk is shared among the
parties. This may be possible because of existence of project financing where only
the risks associated with the project is shared among participating members of the
consortium.
Expanded debt capacity :
Project financing enables a project sponsor to finance the project on someone else’s
credit. Often , that someone else is the purchaser (s) of the project’s output. A
project can raise funds on the basis of contractual commitments when a) the
purchasers enter into long term contracts to ensure adequate cash flow to the
project , enabling it to service its debt fully under all reasonably foreseeable
circumstances. If there are contingencies in which cash flow might be inadequate ,
supplemental credit support arrangements will be required to cover these

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contingencies. The project Company may be able to finance with significantly greater
leverage than would be normal in the sponsor’s capitalization. A broad range of
projects have been financed with capitalization consisting of 70 % or more debt.
However, the degree of leverage a project can achieve depends on the strength of
the security arrangements , the risks borne by credit worthy participants , the type
of project and its profitability.
Lower over all cost of funds :
If the output purchasers credit standing is higher than that of the project sponsors ,
the project would be able to borrow funds more cheaply than the project sponsors
could on their own. Also, to the extent the project entity can achieve a higher degree
of leverage than the sponsors can comfortably maintain on their own, the project’s
cost of capital will benefit from the substitution of lower cost debt for equity.
Release for free cash flow :
The project entity has a typical life period . Its dividend policy is usually specified
contractually at the time any outside equity financing is arranged. Cash flow not
needed to cover operating expenses , pay debt service or capital reinvestment so
called free cash flow must normally be distributed back to the project’s equity
investors . Thus the equity investors , rather than professional managers get to
decide how the project’s free cash flow will be reinvested.
Reduced cost of solving distress:
The structure of a project’s liabilities will normally be less complex than the structure
of each sponsor’s liabilities. A project entity’s capital structure typically has just one
class of debt , and the number of other potential claimants is likely to be small . As a
general rule, the time and cost required to resolve the financial distress increase with
the number of claimants and with the complexity of the debtor’s capital structure.
Over time, a corporation tries to accumulate a large number of claims , including
pension claims, that may be difficult to handle in the event of insolvency or debt
default. An independent entity with one principal class of debt tends to emerge from
the financial distress more easily.

A questionable advantage :
Practitioners often argue that project financing is beneficial when it keeps project
debt off each sponsor’s balance sheet. It is important to recognize that financial risk
does not disappear simply because project related debt is not recorded on the face of

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the balance sheet. In a reasonably efficient market , the benefits of off balance
sheet items seem illusory.

Disadvantages of project financing:

Project financing will not necessarily lead to a lower cost of capital in all
circumstances. Project financings are costly to arrange, and these costs may
outweigh the above-mentioned advantages.

Complexities of project financing:

Project financing is structured around a set of contracts that must be negotiated by
all the parties to a project. They can be quite complex and therefore costly to
arrange. They normally take more time to arrange than a conventional financing.

Indirect credit support :

For any particular obligor of the project’s debt and any given degree of leverage in
the capital structure, the cost of debt is typically higher in a project financing than in
a comparable conventional financing because of indirect nature of credit support. The
credit support for project financing is provided through contractual commitments
rather than through a direct promise to pay. Lenders to a project will naturally be
concerned that the contractual commitments might somehow fail to provide an
uninterrupted flow of debt service in some unforeseen contingency.

Higher transactions cost :

Because of their greater complexity, project financing involve higher transaction
costs than comparable conventional financings. These higher transactions costs
reflect the legal expense with project related tax and legal issues and preparing the
necessary project ownerships, loan documentation and other contracts.
Project financing represents an alternative to conventional direct financing .Choosing
project financing over direct financing involves choosing an alternative organizational
form that is different from the traditional corporations in two fundamental aspects :
1) the project financing entity has a finite life and 2) the cash flows from the
project are paid directly to the project investors, rather than reinvested by the
sponsor. Project financing can :

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 • Reduce the agency costs of free cash flow by giving investors the right to
control reinvestment of the project’s free cash flow;
• Enhance a Company’s financial flexibility by giving it the ability to husband
internally generated cash flow for investment in projects that involve
proprietary information that it does not wish to disclose to investors at large;
• Facilitate the design of less costly debt contracts , which can be tailored to the
cash flow characteristics of the project.
Between the project financing and conventional financing , project financing is more
cost effective than conventional direct financing under the following two situations :
• Project financing permits a higher degree of leverage than the sponsor can
achieve on its own;
• The increase in leverage produces tax shield benefits sufficient to offset the
higher cost of debt funds , resulting in a lower overall cost of capital for the
project.

Analysis of Project Viability

Obtaining the financing needed to fund the construction cost of a project requires
satisfying prospective long term lenders of the project’s technical feasibility ,
economic viability and credit worthiness. Investors are concerned about all the risks
of a project . Both the sponsor and their financial advisors must be thoroughly
familiar with the technical aspects of the project and the risk involved, and they must
independently evaluate the project’s economics and its ability to service project
related borrowings.
Technical Feasibility :
Prior to start of the construction work, the project sponsors must undertake
extensive engineering work to verify the technological processes and design of the
proposed facility. If the project requires new or unproven technology , test facilities
or a pilot plan will normally have to be constructed to test the feasibility of the
processes involved and to optimize the design of the full scale facilities . Even if the
technology is proven, the scale envisioned for the project may be significantly larger
than existing facilities that utilize the same technology. A well executed design will
accommodate future expansion of the project. The related capital cost and the
impact of project expansion on operating efficiency are then reflected in the original
design specifications and financial projections.

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The design and ultimately the technical feasibility of a project may be influenced by
the environmental factors that may affect construction or operation. Project
sponsors often retain outside engineering consultants to assist with design work and
to provide an independent opinion concerning the project’s technological feasibility.
It is not unusual for long term lenders to require confirming opinions from
independent experts that 1) the project facilities can be constructed within the time
schedule proposed ,2) upon completion of construction , the facilities will be capable
of operating as planned ; 3) the construction cost estimates together with
appropriate contingencies for cost escalation , will prove adequate for completion of
the project. The project’s financial adviser must be apprised fully of any technological
uncertainties and their potential impact on the project’s financing requirements,
operational characteristics and profitability.

Project construction cost :

The detail project engineering and design work provides the basis for estimating the
construction costs for the project . Construction costs estimates should include the
cost of all facilities necessary for the project’s operation as a free standing entity. If
the project is to be located in a remote area or if it will require additional
infrastructure such as roads, electricity, schools or housing the project sponsors
must determine whether the cost of necessary infrastructure will be borne by the
project or by others ( such as host government , perhaps with some form of
international financial assistance ) .Construction cost thus estimated must also
include a contingency cost adequate to cover possible design errors or unforeseen
costs. The size of this factor depends on uncertainties that may affect construction
but, in most major projects , a 10 percent contingency factor ( i.e. 10% of direct
cost ) is normally viewed as sufficient if the design of the project facilities has
already been finalized.

Project sponsors or their advisors generally prepare a time schedule detailing the
activities that must be accomplished before and during the construction period. A
quarterly breakdown of capital expenditures normally accompanies the time
schedule. The time schedule should specify 1) the time expected to the required to
obtain regulatory or environmental approvals and permits for construction, 2) the
procurement lead time anticipated for major pieces of equipment and 3) the time
expected to be required for preconstruction activities .

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Economic Viability

The critical issue concerning economic viability is whether the project’s expected net
present value is positive ( how to calculate the net present value is given as
separately ) . It will be positive only if the expected present value of future free cash
flows exceeds the expected present value of the project’s construction cost.
Assuming that the project is completed on schedule and within budget, its economic
viability will depend primarily on the marketability of the project’s output ( price and
volume) . To evaluate marketability , the sponsors arrange for a study of projected
supply and demand conditions over the life of the project. The study would also
cover a scenario analysis . Depending on the factors influencing the future projected
cash flow we have to carry out either simulation or sensitivity analysis.

Adequacy of Raw Material Supplies

Lenders will insists at a minimum that the project have access to sufficient supplies
of raw materials to enable it to operate at design capacity over the term of the debt.
For natural resource projects, lenders generally insists that the project sponsors
engage independent geologists or engineering consultant to evaluate the quantity,
grade and rate of extraction that the mineral reserves available to the project are
capable of supporting. The accuracy of reserve estimates is subject to margin of
error and the uncertainty is typically taken into account by dividing the reserve
estimates into proven, probable and possible.

Creditworthiness :
Since a project has no operating history at the time of its initial debt financing (
unless its construction was financed on an equity basis and the project debt
financing funds out some portion of the construction financing ) . Consequently the
amount of debt the project can raise is a function of the project’s expected capacity
to service debt from project cash flow – or more simply its credit strength . In
general , a project’s credit strength derives from
1. the inherent value of the project;

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 2. the expected profitability of the project;
3. the amount of equity project sponsors have at risk ( after debt financing is
completed) and indirectly
4. the pledges of creditworthy third parties or sponsors involved in the project.

Credit derived from the inherent value of the project assets :

In a production payment financing , which is often used in connection with the

development of resources properties, the loans are secured by proven resource
reserves and are repaid from funds generated from the production and sale of
resource. This type of indebtedness is incurred by owner of a working interest in
proven reserves, where possible on non recourse basis. The purchaser of production
payment is entitled to a percentage of production revenues as reserves are
recovered during the specified production period. Such financing often used in oil
and gas industry , has also been used to finance the development of other types of
mineral reserves. Requirements for securing this type of financing include :
1. Adequate proven reserves ;
2. Proven technology to recover these resources ;
3. An assured market for the product;

Credit support derived indirectly from the pledges by third parties

Although lenders look principally to the revenues generated from the operations of
a project to determine its viability and creditworthiness , supplemental credit
support for a project may have to be provided by the sponsors or other credit
worthy parties benefiting from the project. The contractual agreements among the
operator/borrower , the sponsors , other third parties and the lenders , which are
designed to ensure debt repayment and servicing ,as well as credit standing of these
guarantors are necessary to provide adequate security to support the project’s
financing arrangement.

Financial Risk

If a significant portion of the debt financing for a project consist of loating rate debt ,
there is a risk that rising interest rate could jeopardize the project’s ability to service

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its debt. However, during the 1980s, various financial instruments were developed
that would enable a project’s sponsors to eliminate the project’s interest rate risk
exposure. The traditional method of eliminating such risk exposure involved
arranging fixed rate debt for the project. However, floating rate lenders , typically
commercial banks often willing to assuming greater completion or other business
risks than fixed rate lenders such as life insurance companies and pension funds.
The availability of interest rate risk hedging vehicles enables projected sponsors to
eliminate interest rate risk without having to accept a trade off involving other risk
exposures .

Interest Rate Cap contract :

An interest rate cap contract obligates the writer of the contract to pay the purchaser
of the contract the difference between the market interest rate and the specified cap
rate whenever the market interest rate exceeds the cap rate. For example , a 3
month LIBOR cap contract that specifies a cap rate of 6 % would pay the holder
whenever 3 months LIBOR rises above 6 % . Suppose the loan agreement specifies
an interest rate of LIBOR +125 basis point with quarterly rest and LIBOR is 8 % on
the interest rate reset date, the lender would to be paid 9.25% but the writer of
Interest Cap would pay to the borrower 2% ( the difference between 8% and 6%) .
So the cost of borrower would never go up beyond 7.25 %.

Interest Rate Swap

This is covered in the book Management of Banking .

Security Arrangement

Passive investors provide bulk of the capital for a project in the form of equity and
debt . However passive investors are seldom interested to bear operational risk of
the project . Accordingly , project financing entails developing a network of security
arrangements to insulate the passive investors from all non credit risks associated
with the project.

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In a project financing , lenders would require the sponsors or other credit worthy
parties involved with the project to provide assurances generated thorough
contractual obligations that :
• The project will be completed even if costs exceed those originally provided
for ( or if the project is not completed the debt would be paid in full) ;
• The project , when completed will generate cash sufficient to meet all its debt
service obligations;
• If for any reason , including force majeure, the project’s operations are
interrupted , suspended or terminated , the project will continue to service its
debt obligations.
The credit supporting a project financing comes in the first instance from the project
itself. Such credit strength often needs to be supplemented by a set of security
arrangements between the project and its sponsors pr other creditworthy parties.
The benefit of these arrangements is assigned to project lendrs. The security
arrangements provide that creditworthy entities will undertake to advance funds to
the project if needed to ensure completion. They usually provide some sort of
undertaking on the part of creditworthy entities to supplement the project’s cash
flow after completion , to the extent required to enable the project entity to meet its
debt service requirement .
Direct Security Interest in Project Facilities
Lenders will require a direct security interest in project facilities, usually in the form
of a first mortgage line on all project facilities. This security interest is often of
limited value prior to project completion. Accordingly, the lender would put condition
that in case the project fails to pass the completion tests, the borrower would pay
the debt immediately in full.
Several identifiable parties will normally have an interest in a project . Interested
parties may include the sponsors, the suppliers of raw materials , the purchasers of
project output and the host political jurisdiction’s government . The interests of these
parties may diverge. Often , a particular party may have more than one area of
interest. For example the purchaser of the project’s output is an equity investor in
the project. A sponsor seeks to earn a rate of return on his or her equity investment
that is commensurate with the project related risks the sponsor assumes. A
purchaser of the project’s output is interested in obtaining a long term source of
supply at the lowest possible price.

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Following completion of the project , the firs lien provides added security for project
loans. The lien gives lenders the ability to seize the project assets and sell them ( or
hire someone else ) if the project defaults in its debt commitment. It thus provides a
second possible source of debt repayment. However, the lender would expect the
debt commitment to be fulfilled from the first source i.e. the free cash flow of the
project.

Security Arrangement covering completion :

The security arrangement covering completion typically involve an obligation to bring

the project to completion or else repay all project debt. Lenders normally require
that the sponsors or other credit worthy parties provide an unconditional undertaking
to furnish any funds needed to complete the project in accordance with the design
specification and place it into service by a specified date. If the project is not
completed in time, the agreement would force the sponsors or other credit worthy
parties to repay the debt.
Completion is usually defined in terms of commercial completion . Commercial
completion occurs when the construction of substantially all elements of the project
is finished and an engineer’s certificate is obtained as a proof of that. A completion
undertaking requires that the sponsors stand by to provide whatever additional funds
are needed to complete the project in the event of a cost overrun occurs. Contractual
undertakings that provide legal recourse to the credit strength of third parties
normally form the nucleus of the security arrangements of a project. In most
circumstances , these obligations will be several ; each obligor’s liability would be
limited to a defined proportion of the total liability . The lenders assessment of the
adequacy of any security that is offered is likely to be strongly influenced by the
economics of the project.

Project debt is normally secured by the direct assignment to lenders of the project’s
right to receive payments under various contracts, such as a completion agreement ,
a purchase and sale contract or a financial support agreement . In addition , the
indenture under which project debt is issued usually grants lenders a first mortgage
line on the project’s assets. It will also contain certain negative covenants restricting
activities of the project companies. These covenants typically include limitations on :
• Permitted investment;

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 • Funded Indebtedness;
• Dividends to equity investors;
• Additional Liens or other encumbrances;
• Expansion of the projects;
• Sales and lease back of project assets;
In certain instances, lenders may also require the sponsors to agree to covenants
designed to prevent any dissipation of their credit strength until the project is
completed.

Security arrangements covering debt service :

After the project commences operations , contracts for the purchase and sale of the
project’s output or utilization of the project’s service normally constitute the principal
security arrangements for project debt.

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 Chapter Eleven
Trade Finance

Trade finance department of a bank consists of the following transactions :

• Export of goods and services ;
• Import of goods and services ;
• Export finance
• Import finance
• Domestic finance for bill financing
• Offering of non fund based facilities
• Offering of remittance services .

Since many areas of trade finances are associated with foreign exchange
transactions , people associated with trade finance must know the related provisions
of existing norms and regulations. The following regulations are governing the
foreign exchange regulations associated with trade finance :
• Foreign Exchange Management Act ( FEMA) ;
• Guidelines issued by DGFT;
• Guidelines issued by Reserve Bank of India ;
• Guidelines issued under UCPDC 600;
• Guidelines issued under INCO terms;

Export of Goods and Services

By exporting of goods and services India earns foreign currency which effect the
current account inflow. This is the permanent inflow of dollars. The inflow and
outflow of dollars can take place in the following ways :

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 Foreign
Exchange

Inflow Outflow

Export Liability Import Asset

Since export is permanent sources of foreign exchange inflow, government gives lot
of incentives for export. At the same time , government would penalize if the
incentives availed by the exporter is not used for export purpose. We have classified
the following important aspects of export of goods and services :
• Export invoice can be raised in Indian rupees. However the payment has to
be received in freely convertible currency . This means that an Indian
exporter can raise invoice of USA importer in Indian rupees , however the
payment has to be made by the USA importer in US dollars/Euros/JPY/GBP.

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• As a proof of export , exporters have to submit GR ( in case of physical
exports)/PP ( in case of postal exports )/Softex ( In case of exports in the
electronic mode ) . However, AD Category I banks may consider requests for
grant of GR waiver from exporters for export of goods free of cost, for export
promotion up to 2 per cent of the average annual exports of the applicant
during the preceding three financial years subject to a ceiling of Rs.5 lakhs.
For status holder exporters, the limit as per the present Foreign Trade Policy
is Rs.10 lakhs or 2 per cent of the average annual export realisation during
the preceding three licensing years (April-March), whichever is higher. Export
of goods not involving any foreign exchange transaction directly or indirectly
requires the waiver of GR/PP procedure from the Reserve Bank.
• The full amount of export proceeding would have to be realised in the
following manner :
o Bank draft , pay order or personal cheque;
o Foreign currency notes/foreign currency cheque during his visit in
India ;
o Payment out of funds held in FCNR /NRE Account maintained by the
buyer;
o International credit card of the buyer;
• Trade transactions between India and Nepal may be settled in Indian rupees.
However foreign currency settlement is possible if the importer is permitted
by Nepal Rashtra Bank.
• Trade transactions can be settled in precious metals Gold / Silver / Platinum
by the Gem & Jewellery units in SEZs and EOUs, equivalent to value of
jewellery exported on the condition that the sale contract provides for the
same and the approximate value of the precious metals is indicated in the
relevant GR / SDF / PP Forms.
• The export proceeds should be realized within a specific date from the date
of export which is given below :

Category of Exporter Time Period

Units in SEZ No time period
By status holder exporters as specified in Exim Within 12 months
policy
By 100 % Export Oriented Units ( EOUs) or Units Within 12 months

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 situated at STPI, EHTP and Bio Technology Parks
( BTP)
Goods exported to ware house established
outside India
In all other cases
As soon as it is
realised and in any
case within 15
months from the date
of shipment of goods
12 months with effect
from June 3, 2008

Foreign Currency Accounts :

This incentive is given to exporter. An exporter can open a foreign currency account
under following conditions:
• Participants of foreign trade fairs/exhibitions can open a foreign currency
account abroad. It can deposit the sales proceed in that account and then it
can remit the same through authorized channel to India within one month
from the date of closure of exhibitions /trade fair and full details have to be
submitted to AD I
• Exporters wants to open foreign currency account in India or abroad have to
apply to RBI through Indian bank where it wants to open the account or
giving the name of foreign bank where it wants to open the account ( this can
be used for fee based earning activities ) .
• An Indian entity can also open, hold and maintain a foreign currency account
with a bank outside India, in the name of its overseas office/branch, by
making remittance for the purpose of normal business operations of the said
office/branch or representative subject to conditions stipulated in Regulation 7
of Notification No. FEMA 10/2000-RB dated May 3, 2000 and as amended
from time to time.
• A unit located in a Special Economic Zone (SEZ) may open, hold and maintain
a Foreign Currency Account with an AD Category – I bank in India subject to
conditions stipulated in Regulation 6 (A) of Notification No. FEMA 10/2000-RB
dated May 3, 2000 and as amended from time to time.

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 • A person resident in India being a project / service exporter may open, hold
and maintain foreign currency account with a bank outside or in India, subject
to the standard terms and conditions in the Memorandum PEM.

Export Earners Foreign Currency Account (EEFC Account):

All categories of exporters are allowed to open this account and up to 100 percent of
the export amount can be credited in this account. This account has to be maintained
in the form of current account and no credit facilities can be offered by earmarking
the balance of EEFC account. All inward remittances in the form of export realisation
would be credited in this account. However, capital account receipt can not be
credited in this account. Exporter can provide loans to its constituents without any
limit from its EEFC account. The export packing credit (both in rupees and foreign
currency) can be paid off by using EEFC balances for the amount the export has
taken place (this provision can be used for taking exchange movement).

Setting up of offices abroad and acquisition of immovable property :

At the time of setting up of office, initial expenses up to 15% average annual turn
over for last two years or 25% of net worth which ever higher can be remitted. For
recurring expenses remittances up to 10 % of last two years average annual turn
over can be remitted.
AD Category – I banks may also allow remittances by a company incorporated in
India having overseas offices, within the above limits for initial and recurring
expenses, to acquire immovable property outside India for its business and for
residential purpose of its staff ( this can be used to purchase property in abroad .
Linkage with retail asset divisions exists) .

Advance payment received against export :

An exporter can receive advance payment against future export provided that :
• The exporter ships goods within one year from the date of receipt of advance
remittance ;
• The interest paid should not exceed LIBOR +100 basis point.

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 • The documents covering export should be routed through the AD through
which the advance remittance has been received;
If the exporter could not export within one year, it can not remit the advance
payment without the approval of RBI. Where the export agreement stipulates the
shipment beyond one year from the date of advance payment , RBI permission is
required.

GR approval for Trade Fair/Exhibitions abroad :

Whenever one takes goods for exhibitions it would have to declare in GR form . The
sold item would be realised and the same would be reflected through the export
proceeds. The unsold item can be handled in the following manner :
• The exporter has to produce Bill of Entry showing the proof of reimport in
India the unsold item;
• The sales proceeds have to be remitted as per the normal procedure;
• Such transactions have to audited internally 100 percent.

Consignment Export :

For export on consignment basis, AD Category – I banks, would forward shipping

documents to his overseas branch/correspondent and it would instruct the latter to
deliver them only against trust receipt/undertaking to deliver sale proceeds by a
specified date within the period prescribed for realisation of proceeds of the export.

This procedure should be followed even if, according to the practice in certain trades,
a bill for part of the estimated value is drawn in advance against the exports.
The agents/consignees may deduct from sale proceeds of the goods expenses
normally incurred towards receipt, storage and sale of the goods, such as landing
charges, warehouse rent, handling charges, etc. and remit the net proceeds to the
exporter. The agent should provide supporting document for such deduction .
In case of goods exported on consignment basis, freight and marine insurance must
be arranged in India.
AD Category – I banks may allow the exporters to abandon the books, which remain
unsold at the expiry of the period of the sale contract. Accordingly, the exporters
may show the value of the unsold books as deduction from the export proceeds in
the Account Sales.

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Direct dispatch of document by the exporter :

(i) AD Category – I banks should normally dispatch shipping documents to their

overseas branches/correspondents expeditiously. However, they may dispatch
shipping documents direct to the consignees or their agents resident in the country
of final destination of goods in cases where:
• Advance payment or an irrevocable letter of credit has been received for the
full value of the export shipment and the underlying sale contract/letter of
credit provides for dispatch of documents direct to the consignee or his agent
resident in the country of final destination of goods.
• The AD Category – I banks may also accede to the request of the exporter
provided the exporter is a regular customer and the AD Category – I banks
is satisfied, on the basis of standing and track record of the exporter and
arrangements have been made for realisation of export proceeds.
• Documents in respect of goods or software are accompanied with a
declaration by the exporter that they are not more than Rs. 25,000/- in value
and not declared on GR/SDF/PP/SOFTEX form.
(ii) AD Category – I banks may also permit `Status Holder Exporters' (as defined in
the Foreign Trade Policy), and units in Special Economic Zones (SEZ) to dispatch the
export documents to the consignees outside India subject to the terms and
conditions that:
• The export proceeds are repatriated through the AD banks named in the
GR Form.
• The duplicate copy of the GR form is submitted to the AD banks for
monitoring purposes, by the exporters within 21 days from the date of
shipment of export.
• AD Category - I banks may regularize cases of dispatch of shipping
documents by the exporter direct to the consignee or his agent resident in the
country of the final destination of goods, up to USD 1 million or its equivalent,
per export shipment, subject to the following conditions:
The export proceeds have been realized in full.
The exporter is a regular customer of AD Category - I bank for a
period of at least six months.

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 The exporter’s account with the AD Category – I bank is fully
compliant with Reserve Bank’s extant KYC / AML guidelines.
The AD Category – I bank is satisfied about the bonafides of the
transaction.
In case of doubt, the AD Category – I bank may consider filing Suspicious
Transaction Report (STR) with FIU_IND (Financial Intelligence Unit in India).

Invoicing for software exports :

For long duration contracts involving series of transmissions, the exporters should
bill their overseas clients periodically, i.e., at least once a month or on reaching the
‘milestone’ as provided in the contract entered into with the overseas client and the
last invoice / bill should be raised not later than 15 days from the date of completion
of the contract. It would be in order for the exporters to submit a combined SOFTEX
form for all the invoices raised on a particular overseas client, including advance
remittances received in a month.

Contracts involving only ‘one-shot operation’, the invoice/bill should be raised

within 15 days from the date of transmission.

The exporter should submit declaration in Form SOFTEX in triplicate in respect of

export of computer software and audio / video / television software to the
designated official concerned of the Government of India at STPI / EPZ /FTZ /SEZ for
valuation / certification not later than 30 days from the date of invoice / the date of
last invoice raised in a month, as indicated above. The designated officials may also
certify the SOFTEX Forms of EOUs, which are registered with them.

The invoices raised on overseas clients as at (i) and (ii) above will be subject to
valuation of export declared on SOFTEX form by the designated official concerned of
the Government of India and consequent amendment made in the invoice value, if
necessary.

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Time for submission of export document from the date of shipment :

Within 21 days from the date of export, the exporter should submit the documents to
the AD whose name is mentioned in the export document. Where Duplicate copy of
GR form is misplaced or lost, AD Category – I banks may accept another copy of
duplicate GR form duly certified by Customs. In the case of exports made under
deferred credit arrangement or to joint ventures abroad against equity participation
or under rupee credit agreement, the number and date of Reserve Bank approval
and/or number and date of the relative RBI circular should be recorded at the
appropriate place on the GR form.

In cases where exporters present documents pertaining to exports after the

prescribed period of 21days from date of export, AD Category – I banks may handle
them without prior approval of Reserve Bank, provided they are satisfied
with the reasons for the delay.

Consolidation of Air Cargo /Sea Cargo :

Consolidation of Air Cargo :

(i) Where air cargo is shipped under consolidation, the airline company’s Master
Airway Bill will be issued to the Consolidating Cargo Agent. The Cargo agent in turn
will issue his own House Airway Bills (HAWBs) to individual shippers.
(ii) AD Category – I Banks may negotiate HAWBs only if the relative letter of credit
specifically provides for negotiation of these documents in lieu of Airway
Bills issued by the airline company.

(b) Consolidation of Sea Cargo:

(i) AD Category – I Banks may accept Forwarder’s Cargo Receipts (FCR) issued
by steamship companies or their agents (instead of 'IATA' approved agents), in
lieu of bills of lading, for negotiation / collection of shipping documents, of export
transactions backed by letters of credit, only if the relative letter of credit

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specifically provides for negotiation of this document, in lieu of bill of lading.
(ii) Further, relative sale contract with the overseas buyer should also provide that
FCR may be accepted in lieu of bill of lading as a shipping document.

Handing Over Negotiable Copy of Bill of Lading to Master of

Vessel/Trade Representative :

AD Category – I banks may deliver one negotiable copy of the Bill of Lading to the
Master of the carrying vessel or trade representative for exports to certain
landlocked countries if the shipment is covered by an irrevocable letter of credit
and the documents conform strictly to the terms of the Letter of Credit which, inter
alia, provides for such delivery.

Follow up of overdue bills :

AD Category – I banks should closely watch realisation of bills and in cases

where bills remain outstanding, beyond the due date for payment or 12 months from
the date of export, the matter should be promptly taken up with the concerned
exporter. If the exporter fails to arrange for delivery of the proceeds within 12
months or seek extension of time beyond 12 months, the matter should be reported
to the RO concerned of the Reserve Bank stating, where possible, the reason for the
delay in realising the proceeds.

Change of buyer/consignee
Prior approval of Reserve Bank is not required if, after goods have been shipped,
they are to be transferred to a buyer other than the original buyer in the event of
default by the latter, provided the reduction in value, if any, involved does not
exceed 25 per cent of the invoice value and the realisation of export proceeds is
not delayed beyond the period of 12 months from the date of export.

Export Finance

Pre- Shipment Rupee export credit :

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'Pre-shipment / Packing Credit' means any loan or advance granted or any other
credit provided by a bank to an exporter for financing the purchase, processing,
manufacturing or packing of goods prior to shipment / working capital
expenses towards rendering of services on the basis of letter of credit opened in
his favour or in favour of some other person, by an overseas buyer or a confirmed
and irrevocable order for the export of goods / services from India or any other
evidence of an order for export from India having been placed on the exporter or
some other person, unless lodgement of export orders or letter of credit with the
bank has been waived.

The period for which pre shipment credit would be given depends on the bank.
However, if the pre shipment credit is not adjusted by submission of export
documents within 360 days from the date of advance , the credit would cease to
attract concessional interest. However , RBI would provide refinance up to 180 days
only .

Disbursement of packing credit :

Ordinarily, each packing credit sanctioned should be maintained as

separate account for the purpose of monitoring period of sanction and
end-use of funds. Banks may release the packing credit in one lump sum
or in stages as per the requirement for executing the orders / LC.

Banks may also maintain different accounts at various stages of

processing, manufacturing etc. depending on the types of goods / services
to be exported e.g. hypothecation, pledge, etc., accounts and may ensure
that the outstanding balance in accounts are adjusted by transfer from
one account to the other and finally by proceeds of relative export
documents on purchase, discount etc. Banks should continue to keep a
close watch on the end-use of the funds and ensure that credit at lower
rates of interest is used for genuine requirements of exports. Banks
should also monitor the progress made by the exporters in timely
fulfillment of export orders.

Liquidation of packing credit :

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General

The packing credit / pre-shipment credit granted to an exporter may be liquidated

out of proceeds of bills drawn for the exported commodities on its purchase, discount
etc., thereby converting pre-shipment credit into post-shipment credit. Further,
subject to mutual agreement between the exporter and the banker it can also be
repaid / prepaid out of balances in Exchange Earners Foreign Currency A/c (EEFC
A/c) as also from rupee resources of the exporter to the extent exports have actually
taken place. If not so liquidated / repaid, banks are free to decide the rate of interest
.

Packing credit in excess of export value

(a) Where by-product can be exported
Where the exporter is unable to tender export bills of equivalent value for
liquidating the packing credit due to the shortfall on account of wastage
involved in the processing of agro products like raw cashew nuts, etc., banks
may allow exporters, inter alia, to extinguish the excess packing credit by
export bills drawn in respect of by-product like cashew shell oil, etc
(b) Where partial domestic sale is involved : However, in respect of export of
agro-based products like tobacco, pepper, cardamom, cashew nuts etc., the exporter
has necessarily to purchase a somewhat larger quantity of the raw agricultural
produce and grade it into exportable and non-exportable varieties and only the
former is exported. The non-exportable balance is necessarily sold domestically. For
the packing credit covering such non-exportable portion, banks are required to
charge commercial rate of interest applicable to the domestic advance from the date
of advance of packing credit and that portion of the packing credit would not be
eligible for any refinance from RBI.
(c) Export of deoiled /defatted cakes : Banks are permitted to grant packing
credit advance to exporters of HPS groundnut and deoiled / defatted cakes to the
extent of the value of raw materials required even though the value thereof exceeds
the value of the export order. The advance in excess of the export order is required
to be adjusted either in cash or by sale of residual by-product oil within a period not
exceeding 30 days from the date of advance to be eligible for concessional rate of
interest.

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(iii) Banks have, however, operational flexibility to extend the following
relaxations to their exporter clients who have a good track record:
(a) Repayment / liquidation of packing credit with proceeds of export documents
will continue; however, this could be with export documents relating to
any other order covering the same or any other commodity exported
by the exporter. While allowing substitution of contract in this way, banks
should ensure that it is commercially necessary and unavoidable. Banks
should also satisfy themselves about the valid reasons as to why packing
credit extended for shipment of a particular commodity cannot be liquidated
in the normal method. As far as possible, the substitution of contract should
be allowed if the exporter maintains account with the same bank or it has the
approval of the members of the consortium, if any.
(b) The existing packing credit may also be marked-off with proceeds of export
documents against which no packing credit has been drawn by the exporter.
However, it is possible that the exporter might avail of EPC with one bank and
submit the documents to another bank. In view of this possibility, banks may
extend such facility after ensuring that the exporter has not availed of
packing credit from another bank against the documents submitted. If any
packing credit has been availed of from another bank, the bank to which the
documents are submitted has to ensure that the proceeds are used to
liquidate the packing credit obtained from the first bank.
(c) These relaxations should not be extended to transactions of sister /
associate / group concerns.

Rupee Pre-shipment Credit to Construction Contractors :

(i) The packing credit advances to the construction contractors to meet their
initial working capital requirements for execution of contracts abroad may be
made on the basis of a firm contract secured from abroad, in a separate
account, on an undertaking obtained from them that the finance is required
by them for incurring preliminary expenses in connection with the execution
of the contract e.g., for transporting the necessary technical staff and
purchase of consumable articles for the purpose of executing the contract
abroad, etc.

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 (ii) The advances should be adjusted within 365 days of the date of advance
by negotiation of bills relating to the contract or by remittances received from
abroad in respect of the contract executed abroad. To the extent the
outstandings in the account are not adjusted in the stipulated manner, banks
may charge normal rate of interest on such advance.

(iii) The exporters undertaking project export contracts including export of

services may comply with the guidelines/instructions issued by Reserve Bank
of India, Foreign Exchange Department, Central Office, Mumbai from time to
time.

Post shipment Rupee credit :

Post-shipment Credit' means any loan or advance granted or any other credit
provided by a bank to an exporter of goods / services from India from the date of
extending credit after shipment of goods / rendering of services to the date of
realisation of export proceeds as per the period of realization prescribed by FED, and
includes any loan or advance granted to an exporter, in consideration of, or on the
security of any duty drawback allowed by the Government from time to time. As per
the current instructions of FED, the period prescribed for realisation of export
proceeds is 12 months from the date of shipment.

Types of Post-shipment Credits:

Post-shipment advance can mainly take the form of -

(i) Export bills purchased/discounted/negotiated.
(ii) Advances against bills for collection.
(iii) Advances against duty drawback receivable from Government.

Liquidation of Post-shipment Credit:

Post-shipment credit is to be liquidated by the proceeds of export bills received from

abroad in respect of goods exported / services rendered. Further, subject to mutual

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agreement between the exporter and the banker it can also be repaid / prepaid out
of balances in Exchange Earners Foreign Currency Account (EEFC A/C) as also from
proceeds of any other unfinanced (collection) bills. Such adjusted export bills should
however continue to be followed up for realization of the export proceeds and will
continue to be reported in the XOS statement.

Rupee Post-shipment Export Credit

Period
(i) In the case of demand bills, the period of advance shall be the Normal
Transit Period (NTP) as specified by FEDAI.
(ii) In case of usance bills, credit can be granted for a maximum duration
of 365 days from date of shipment inclusive of Normal Transit Period (NTP)
and grace period, if any. However, banks should closely monitor the need for
extending post-shipment credit up to the permissible period of 365 days and
they should persuade the exporters to realise the export proceeds within a
shorter period.
(iii) 'Normal transit period' means the average period normally involved
from the date of negotiation / purchase / discount till the receipt of bill
proceeds in the Nostro account of the bank concerned, as prescribed by
FEDAI from time to time. It is not to be confused with the time taken for
the arrival of goods at overseas destination.
(iv) An overdue bill
(a) in the case of a demand bill, is a bill which is not paid before the expiry of
the normal transit period, plus grace period and
(b) in the case of a usance bill, is a bill which is not paid on the due date.

Export on Consignment Basis

Therefore, export on consignment basis should be at par with exports on

outright sale basis on cash terms in matters regarding the rate of interest
to be charged by banks on post-shipment credit. Thus, in the case of
exports on consignment basis, even if extension in the period beyond 365
days is granted by the Foreign Exchange Department (FED) for
repatriation of export proceeds, banks will charge appropriate concessive

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 rate of interest only up to the notional due date (depending upon the
tenor of the bills), subject to a maximum of 365 days.

Export of precious and semi-precious stones

Precious and semi-precious stones, etc. are exported mostly on consignment

basis and the exporters are not in a position to liquidate pre-shipment credit
account with remittances received from abroad within a period of 365 days
from the date of advance. Banks may, therefore, adjust packing credit
advances in the case of consignment exports, as soon as export takes place,
by transfer of the outstanding balance to a special (post-shipment) account
which in turn, should be adjusted as soon as the relative proceeds are
received from abroad but not later than 365 days from the date of export or
such extended period as may be permitted by Foreign Exchange Department,
Reserve Bank of India. Balance in the special (post-shipment) account will
not be eligible for refinance from RBI.
Extension of realization of export proceeds for period up to 12/15 months

RBI (FED) has been allowing in deserving cases, on application by individuals exports
with satisfactory track record a longer period up to 12 months from the date of
shipment for realization of proceeds of exports in case of following categories of
exporters.

a) Consignments Exports to CIS and East European Countries

b) Consignment exports to Russian Federation against repayment of State

Credit in rupees.

c) Exporters who have been certified as 'Status Holder' in terms of Foreign

Trade Policy.

d) 100 per cent Export Oriented Units and units set up under Electronic
Hardware Technology Park, Software Technology Park and Bio-Technology
Park Schemes.

FED vide AP (DIR series) circular No.50 dated June 3, 2008 has enhanced the period
of realization and repatriation of export proceeds from 6 months to 12 months, from
the date of export, subject to review after one year.

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Further in case of Exports through the Warehouse–cum-Display Centres abroad
realisation of export proceeds has been fixed upto 15 months from the date of
shipment.

Banks may extend post-shipment credit to such exporters for a longer period ab
initio. Accordingly, the interest rate up to 180 days from the date of advance will be
the rate applicable for usance bills for period up to 180 days. Beyond 180 days from
the date of shipment, the banks are free to decide on the rate of interest. In case the
sale proceeds are not realised within the sanctioned period, the higher rate of
interest as applicable for 'ECNOS'-post-shipment will apply for the entire period
beyond 180 days.
Refinance to banks against export credit would however, be available from RBI, up to
a period of 180 days only each at pre-shipment and post-shipment stages.

ECGC Whole Turnover Post-shipment Guarantee Scheme

The Whole Turnover Post-shipment Guarantee Scheme of the Export Credit

Guarantee Corporation of India Ltd. (ECGC) provides protection to banks against
non-payment of post-shipment credit by exporters. Banks may, in the interest of
export promotion, consider opting for the Whole Turnover Post-shipment Policy. The
salient features of the scheme may be obtained from ECGC.
As the post-shipment guarantee is mainly intended to benefit the banks, the cost of
premium in respect of the Whole Turnover Post-shipment Guarantee taken out by
banks may be absorbed by the banks and not passed on to the exporters.
Where the risks are covered by the ECGC, banks should not slacken their efforts
towards realisation of their dues against long outstanding export bills.

Interest on Post-shipment Credit

Early payment of export bills

(a) In the case of advances against demand bills, if the bills are realised before
the expiry of the normal transit period (NTP), interest at the concessive rate
shall be charged from the date of advance till the date of realisation of such
bills. The date of realisation of demand bills for this purpose would be the
date on which the proceeds get credited to the banks' Nostro accounts.
(b) In the case of advance/credit against usance export bills, interest

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 concessive rate may be charged only up to the notional/actual due date or the
date on which export proceeds get credited to the bank’s Nostro account abroad,
whichever is earlier,
irrespective of the date of credit to the borrower's/exporter's account in India. In
cases where the correct due date can be established before/immediately after
availment of credit due to acceptance by overseas buyer or otherwise, concessive
interest can be applied only up to the actual due date, irrespective of whatever
may be the notional due date arrived at, provided the actual due date falls before
the notional due date.
c) Where interest for the entire NTP in the case of demand bills or up to
notional/actual due date in the case of usance bills as stated at (b) above, has been
collected at the time of negotiation/purchase/discount of bills, the excess interest
collected for the period from the date of realisation to the last date of NTP/notional
due date/actual due date should be refunded to the borrowers.

Overdue Export Bills

(i) In case of export bills, the rate of interest decided by the bank within the
ceiling rate stipulated by RBI will apply up to the due date of the bill (up
to NTP in case of demand bill and specified period in case of usance bills).
(ii) For the period beyond the due date viz. for the overdue period, the
prescribed interest rate as applicable to post-shipment rupee export credit
(not exceeding BPLR minus 2.5 percentage points) may be applied up to
180 days from the date of advance, till further notice.

Interest on Post-shipment Credit Adjusted from Rupee Resources

Banks should adopt the following guidelines to ensure uniformity in charging interest
on post-shipment advances which are not adjusted in an approved manner due to
non-accrual of foreign exchange and advances have to be adjusted out of the funds
received from the Export Credit Guarantee Corporation of India Ltd. (ECGC) in
settlement of claims preferred on them on account of the relevant export
consignment:
(a) In case of exports to certain countries, exporters are unable to realise export
proceeds due to non-expatriation of the foreign exchange by the
governments/Central Banking Authorities of the countries concerned as a
result of their balance of payment problems even though payments have been

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 made locally by the buyers. In these cases ECGC offer cover to exporters for
transfer delays. Where ECGC have admitted the claims and paid the amount
for transfer delay, banks may charge interest as applicable to 'ECNOS'-post-
shipment even if the post-shipment advance may be outstanding beyond six
months from the date of shipment. Such interest would be applicable on the
full amount of advance irrespective of the fact that the ECGC admit the claims
to the extent of 90 percent/75 percent and the exporters have to bring the
balance 10 percent/25 percent from their own rupee resources.
(b) In a case where interest has been charged at commercial rate or 'ECNOS', if
export proceeds are realised in an approved manner subsequently, the bank
may refund to the borrower the excess amount representing difference between
the quantum of interest already charged and interest that is chargeable taking
into account the said realisation after ensuring the fact of such realisation with
satisfactory evidence. While making adjustments of accounts it would be better
if the possibility of refund of excess interest is brought to the notice of the
borrower.

Change of Tenor of Bill

(i) Banks have been permitted by RBI (FED) on request from exporters, to allow
change of the tenor of the original buyer/ consignee, provided inter alia, the
revised due date of payment does not fall beyond the maximum period
prescribed by FED for realization of export proceeds.
(ii) In such cases as well as where change of tenor up to twelve months from the
date of shipment has been allowed, it would be in order for banks to extend the
concessional rate of interest up to the revised notional due date, subject to the
interest rates Directive issued by RBI.

Export credit in foreign currency

The scheme is an additional window for providing pre-shipment credit to Indian

exporters at internationally competitive rates of interest. It will be applicable to
only cash exports. The instructions with regard to Rupee Export Credit apply to
export credit in Foreign Currency also mutatis mutandis, unless otherwise
specified.

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 The exporter will have the following options to avail of export finance:
(a) to avail of pre-shipment credit in rupees and then the post-shipment
credit either in rupees or discounting/ rediscounting of export bills
under EBR Scheme mentioned in paragraph 6.1.
(b) to avail of pre-shipment credit in foreign currency and discount/
rediscounting of the export bills in foreign currency under EBR Scheme.
(c) to avail of pre-shipment credit in rupees and then convert drawals into
PCFC at the discretion of the bank.
Choice of currency
(a) The facility may be extended in one of the convertible currencies viz. US
Dollars, Pound Sterling, Japanese Yen, Euro, etc.
(b) To enable the exporters to have operational flexibility, it will be in order
for banks to extend PCFC in one convertible currency in respect of an
export order invoiced in another convertible currency. For example, an
exporter can avail of PCFC in US Dollar against an export order invoiced
in Euro. The risk and cost of cross currency transaction will be that of the
exporter.
(c) Banks are permitted to extend PCFC for exports to ACU countries.
(d) The applicable benefit to the exporters will accrue only after the
realisation of the export bills or when the resultant export bills are
rediscounted on ‘without recourse’ basis.

Import of goods and services

Time limit for settlement of Import transactions :

In terms of the extant regulations, remittances against imports should be completed

not later than six months from the date of shipment, except in cases where
amounts are withheld towards guarantee of performance, etc.

AD Category – I banks may permit settlement of import dues delayed due to

disputes, financial difficulties, etc. Interest in respect of delayed payments, usance
bills or overdue interest for a period of less than three years from the date of
shipment may be permitted as per RBI guidelines.

Time limit for deferred payment arrangements

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Deferred payment arrangements, including suppliers and buyers credit, providing for
payments beyond a period of six months from date of shipment up to a period of less
than three years, are treated as trade credits for which the procedural guidelines laid
down in the Master Circular for External Commercial Borrowings and Trade Credits
may be followed.

Advance Remittance

Advance Remittance for import of goods

(i) AD Category – I bank may allow advance remittance for import of goods without
any ceiling subject to the following conditions:

(a) If the amount of advance remittance exceeds USD 100,000 or its equivalent, an
unconditional, irrevocable standby Letter of Credit or a guarantee from an
international bank of repute situated outside India or a guarantee of an AD Category
– I bank in India, if such a guarantee is issued against the counter-guarantee of an
international bank of repute situated outside India.

(b) In cases where the importer (other than a Public Sector Company or a
Department/Undertaking of the Government of India/State Governments) is unable
to obtain bank guarantee from overseas suppliers and the AD Category – I bank is
satisfied about the track record and bonafides of the importer, the requirement of
the bank guarantee / standby Letter of Credit may not be insisted upon for advance
remittances up to USD 5,000,000 (US Dollar five million). AD Category – I banks
may frame their own internal guidelines to deal with such cases as per a suitable
policy framed by the bank's Board of Directors.

(c) A Public Sector Company or a Department/Undertaking of the Government of

India / State Government/s which is not in a position to obtain a guarantee from an
international bank of repute against an advance payment, is required to obtain a
specific waiver for the bank guarantee from the Ministry of Finance, Government of
India before making advance remittance exceeding USD 100, 000.

(ii) All payments towards advance remittance for imports shall be subject to the
specified conditions.

Advance Remittance for Import of Rough Diamonds

(i) AD Category – I bank are permitted to allow advance remittance without any limit
and without bank guarantee or standby Letter of Credit, by an importer other than a

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Public Sector Company or a Department / Undertaking of the Government of India /
State Government/s), for import of rough diamonds into India from the under noted
mining companies, viz.

a) De Beers UK Ltd,

b) RIO TINTO, UK,

c) BHP Billiton, Australia,

d) ENDIAMA, E. P. Angola,

e) ALROSA, Russia,

f) GOKHARAN, Russia,

g) Rio Tinto, Belgium, and

h) BHP Billiton, Belgium.

(ii) While allowing the advance remittance, AD Category-I bank may ensure the
following:

(a)The importer should be a recognized processor of rough diamonds as per a list to

be approved by Gems and Jewellery Export Promotion Council (GJEPC) in this regard
and should have a good track record of export realisation;

(b) AD Category – I bank should undertake the transaction based on their

commercial judgment and after being satisfied about the bonafides of the
transaction;

(c) Advance payments should be made strictly as per the terms of the sale contract
and should be made directly to the account of the company concerned, that is, to the
ultimate beneficiary and not through numbered accounts or otherwise. Further, due
caution may be exercised to ensure that remittance is not permitted for import of
conflict diamonds;

(d) KYC and due diligence exercise should be done by the AD Category – I bank for
the Indian importer entity and the overseas company; and

(e) AD Category – I bank should follow up submission of the Bill of Entry /

documents evidencing import of rough diamonds into the country by the importer, in
terms of FEMA / Rules / Regulations / Directions issued in this regard.

(iii) In case of an importer entity in the Public Sector or a Department / Undertaking

of the Government of India / State Government/s, AD Category – I bank may permit

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advance remittance subject to the above conditions and a specific waiver of bank
guarantee from the Ministry of Finance, Government of India where the advance
payments is equivalent to or exceeds USD 100,000.

(iv) AD Category – I banks are required to submit a report (Annex-2) of all such
advance remittances made without a bank guarantee or standby Letter of Credit,
where the amount of advance payment is equivalent to or exceeds USD 5,000,000,
to the Chief General Manager, Reserve Bank of India, Foreign Exchange Department,
Trade Division, Central Office, Amar Building, Sir. P. M. Road, Fort, Mumbai – 400
001, on a half yearly basis, as at the end of September and March every year, in the
format annexed (Annex-2).The report should be submitted within 15 days from the
close of the respective half year.

Advance Remittance for Import of Aircrafts/Helicopters and other Aviation Related

purchases

As a sector specific measure, airline companies which have been permitted by the
Directorate General of Civil Aviation to operate as a schedule air transport service,
can make advance remittance without bank guarantee, up to USD 50 million.
Accordingly, AD Category – I banks may allow advance remittance, without obtaining
a bank guarantee or an unconditional, irrevocable standby Letter of Credit, up to
USD 50 million, for direct import of each aircraft, helicopter and other aviation
related purchases. The remittances for the above transactions shall be subject to the
following conditions:

(i) The AD Category - I banks should undertake the transactions based on their
commercial judgment and after being satisfied about the bonafide of the
transactions. KYC and due diligence exercise should be done by the AD Category - I
banks for the Indian importer entity and the overseas manufacturer company as
well. (ii) Advance payments should be made strictly as per the terms of the sale
contract and are made directly to the account of the manufacturer (supplier)
concerned.

(iii) AD Category - I bank may frame their own internal guidelines to deal with such
cases, with the approval of their Board of Directors.

(iv) In the case of a Public Sector Company or a Department / Undertaking of

Central /State Governments, the AD Category - I bank shall ensure that the

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requirement of bank guarantee has been specifically waived by the Ministry of
Finance, Government of India for advance remittances exceeding USD100,000.

(v) Physical import of goods into India is made within six months (three years in
case of capital goods) from the date of remittance and the importer gives an
undertaking to furnish documentary evidence of import within fifteen days from the
close of the relevant period. It is clarified that where advance is paid as milestone
payments, the date of last remittance made in terms of the contract will be reckoned
for the purpose of submission of documentary evidence of import.

(vi) Prior to making the remittance, the AD Category – I bank may ensure that the
requisite approval of the Ministry of Civil Aviation / DGCA / other agencies in terms
of the extant Foreign Trade Policy has been obtained by the company, for import.
(vii) In the event of non-import of aircraft and aviation sector related products, AD
Category - I bank should ensure that the amount of advance remittance is
immediately repatriated to India.

Prior approval of the concerned Regional Office of the Reserve Bank will be required
in case of any deviation from the above stipulations. 12

Interest on Import Bills

(i) AD – Category – I bank may allow payment of interest on usance bills or overdue
interest for a period of less than three years from the date of shipment at the rate
prescribed for trade credit from time to time.

(ii) In case of pre-payment of usance import bills, remittances may be made only
after reducing the proportionate interest for the unexpired portion of usance at the
rate at which interest has been claimed or LIBOR of the currency in which the goods
have been invoiced, whichever is applicable. Where interest is not separately claimed
or expressly indicated, remittances may be allowed after deducting the proportionate
interest for the unexpired portion of usance at the prevailing LIBOR of the currency
of invoice.

Remittances against Replacement Imports

Where goods are short-supplied, damaged, short-landed or lost in transit and the
Exchange Control copy of the import licence has already been utilised to cover the
opening of a letter of credit against the original goods which have been lost, the

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original endorsement to the extent of the value of the lost goods may be cancelled
by the AD Category – I bank and fresh remittance for replacement imports may be
permitted without reference to Reserve Bank, provided the insurance claim relating
to the lost goods has been settled in favour of the importer. It may be ensured that
the consignment being replaced is shipped within the validity period of the license.

Guarantee for Replacement Import

In case replacement goods for defective import are being sent by the overseas
supplier before the defective goods imported earlier are reshipped out of India, AD
Category – I banks may issue guarantees at the request of importer client for
dispatch/return of the defective goods, according to their commercial judgment.

Import of Equipment by Business Process Outsourcing (BPO) Companies

for their overseas sites

AD Category – I bank may, allow BPO companies in India to make remittances

towards the cost of equipment to be imported and installed at their overseas sites in
connection with the setting up of their International Call Centres (ICCs) subject to
the following conditions:

(i) The BPO company should have obtained necessary approval from the Ministry of
Communications and Information Technology, Government of India and other
authorities concerned for setting up of the ICC.

(ii) The remittance should be allowed based on the AD Category - I banks’

commercial judgment, the bonafides of the transactions and strictly in terms of the
contract.

(iii) The remittance is made directly to the account of the overseas supplier.

(iv) The AD Category – I banks should also obtain a certificate as evidence of import
from the Chief Executive Officer (CEO) or auditor of the importer company that the
goods for which remittance was made have actually been imported and installed at
overseas sites.

Receipt of Import Bills/Documents

Receipt of import documents by the importer directly from overseas suppliers

Import bills and documents should be received from the banker of the supplier by
the banker of the importer in India. AD Category – I bank should not, therefore,

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make remittances where import bills have been received directly by the importers
from the overseas supplier, except in the following cases:

(i) Where the value of import bill does not exceed USD 300,000.

(ii) Import bills received by wholly-owned Indian subsidiaries of foreign companies

from their principals.

(iii) Import bills received by Status Holder Exporters as defined in the Foreign Trade
Policy, 100% Export Oriented Units / Units in Special Economic Zones, Public Sector
Undertakings and Limited Companies.

(iv) Import bills received by all limited companies viz. public limited, deemed public
limited and private limited companies.

Receipt of import documents by the importer directly from overseas

suppliers in case of specified sectors

As a sector specific measure, AD Category - I banks are permitted to allow

remittance for imports up to USD 300,000 where the importer of rough diamonds,
rough precious and semi-precious stones has received the import bills / documents
directly from the overseas supplier and the documentary evidence for import is
submitted by the importer at the time of remittance. AD Category - I banks may
undertake such transactions subject to the following conditions:

(i) The import would be subject to the prevailing Foreign Trade Policy.

(ii) The transactions are based on their commercial judgment and they are satisfied
about the bonafides of the transactions.

(iii) AD Category - I banks should do the KYC and due diligence exercise and should
be fully satisfied about the financial standing / status and track record of the
importer customer. Before extending the facility, they should also obtain a report on
each individual overseas supplier from the overseas banker or reputed credit rating
agency overseas.

Receipt of import documents by the AD Category – I bank directly from

overseas suppliers

(i) At the request of importer clients, AD Category – I bank may receive bills directly
from the overseas supplier as above, provided the AD Category – I bank is fully
satisfied about the financial standing/status and track record of the importer
customer.

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(ii) Before extending the facility, the AD Category – I bank should obtain a report on
each individual overseas supplier from the overseas banker or a reputed credit
agency. However, such credit report on the overseas supplier need not be obtained
in cases where the invoice value does not exceed USD 300,000 provided the AD
Category – I bank is satisfied about the bonafides of the transaction and track record
of the importer constituent.

Evidence of Import

Physical Imports

(i) In case of all imports, where value of foreign exchange remitted/paid for import
into India exceeds USD 100,000 or its equivalent, it is obligatory on the part of the
AD Category – I bank through whom the relative remittance was made, to ensure
that the importer submits :-

(a) The Exchange Control copy of the Bill of Entry for home consumption, or

(b) The Exchange Control copy of the Bill of Entry for warehousing, in case of 100%
Export Oriented Units, or

(c) Customs Assessment Certificate or Postal Appraisal Form, as declared by the

importer to the Customs Authorities, where import has been made by post, as
evidence that the goods for which the payment was made have actually been
imported into India.

(ii) In respect of imports on D/A basis, AD Category – I bank should insist on

production of evidence of import at the time of effecting remittance of import bill.
However, if importers fail to produce documentary evidence due to genuine reasons
such as non-arrival of consignment, delay in delivery/customs clearance of
consignment, etc., AD bank may, if satisfied with the genuineness of request, allow
reasonable time, not exceeding three months from the date of remittance, to the
importer to submit the evidence of import.

Evidence of import in lieu of Bill of Entry

(i) AD Category – I bank may accept, in lieu of Exchange Control copy of Bill of Entry
for home consumption, a certificate from the Chief Executive Officer (CEO) or auditor
of the company that the goods for which remittance was made have actually been
imported into India provided :-

(a) the amount of foreign exchange remitted is less than USD 1,000,000 or its
equivalent,

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(b) the importer is a company listed on a stock exchange in India and whose net
worth is not less than Rs.100 crore as on the date of its last audited balance sheet,
or the importer is a public sector company or an undertaking of the Government of
India or its departments.

(ii) The above facility may also be extended to autonomous bodies, including
scientific bodies/academic institutions, such as Indian Institute of Science / Indian
Institute of Technology, etc. whose accounts are audited by the Comptroller and
Auditor General of India (CAG). AD Category – I bank may insist on a declaration
from the auditor/CEO of such institutions that their accounts are audited by CAG.

Non Physical Imports :

(i) Where imports are made in non-physical form, i.e., software or data through
internet / data com channels and drawings and designs through e-mail/fax, a
certificate from a Chartered Accountant that the software / data / drawing/ design
has been received by the importer, may be obtained.

(ii) AD Category – I bank should advise importers to keep Customs Authorities

informed of the imports made by them under this clause.

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