Finance and

Management
 FM Notes 1 - Bonds
What is a bond?
A bond is a type of investment that represents a loan between a borrower and a lender. Think
of it as similar to getting a personal loan from a bank - except in this case you are the lender
(known as the investor or creditor) and the borrower is generally a government or corporation
(known as the issuer).
With bonds, the issuer promises to make regular interest payments to the investor at a specified
rate (the coupon rate) on the amount it has borrowed (the face amount / face value) until a
specified date (the maturity date).
Once the bond matures, the interest payments stop and the issuer is required to repay the face
amount of the principal to the investor. Because the interest payments are made generally at
set periods of time and are fairly predictable, bonds are often called fixed-income securities.
How are bonds different from stocks?
Bonds are considered debt investments. On the other hand, a stock purchase is considered an
equity investment because the investor (also known as the stockholder) becomes a part owner
of the corporation.
The issuers of stock or equity are typically companies; issuers of debt can be either
companies or governments.
While bonds generally don‟t provide an opportunity to share in the profits of the corporation,
the stockholder is entitled to receive a portion of the profits and may also be given voting
rights. Bondholders earn interest while stockholders typically receive dividends. Both may
experience capital gains or capital losses if the price at which they sell their holdings is,
respectively, higher or lower than the price at which they bought them.
Coupon rates are most often fixed - the rate of interest stays constant throughout the life of
the bond. However, some bonds have variable or floating coupon rates (interest payments
change from period to period based on a predetermined schedule or formula). Some bonds pay
no interest at all until maturity.
Because bondholders are creditors rather than part owners, if a corporation goes bankrupt,
bondholders have a higher claim on assets than stockholders. This provides added security to
the bond investor - but does not completely eliminate risk.
Finally, bonds also trade differently from stocks. Bonds typically trade in the Over The-Counter
(OTC) market - for example, from a broker to a broker at another firm directly - instead of on a
stock exchange.
Coupon rate
The coupon rate is stated as a percentage of the face value of a bond (typically, bonds pay
interest semi-annually) and is used to calculate the interest the bondholder receives.

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Example:
A bond with a ₹1, 000 face value and a six per cent coupon will pay its bondholder‘s ₹30 every six
months (or ₹60 per year) until the bond‘s maturity date. When the bond matures, the investor is
repaid the full ₹1,000 face value.
WHAT ARE THE BENEFITS OF IN VESTING IN BONDS?
Income predictability
If your objective is to maintain a specific, steady level of income from your portfolio, high quality
bonds can provide a series of predictable cash flows with minimal risk to your invested capital
(the principal).
Safety
Depending on their quality, bonds can offer you a high degree of certainty that the interest and
principal repayment will be received in full if the bond is held to maturity. The quality of the
bond - and the level of security that comes with it - is reflected in the credit rating of the issuer.
Diversification
Diversification means holding a mix of different asset classes in your portfolio. For example,
adding fixed-income securities like bonds to an equity portfolio helps you achieve greater
diversification. This is a way to reduce portfolio risk - the risk inherent in your combined
investment holdings - while potentially increasing returns over time, since even if one class
declines in value, there is still an opportunity for an increase in one or more of the other classes.
Choice
A wide range of bond issuers with a variety of coupon rates and maturity dates are available for
you to choose from. This allows you to find the bond(s) with cash flows that match your income
needs while complementing your other portfolio holdings.
Credit ratings
Credit ratings are assigned by various agencies based on how likely it is that the issuer will fail to
make its scheduled interest and principal payments. Most agencies follow a letter-based rating
scale. Typically, debt assigned a rating of AAA represents the lowest level of default risk. Debt
rated BBB or above is normally considered investment grade, whereas debt with a rating of BB
or below is considered speculative or non-investment grade.
Asset classes
Investments are categorized into three main asset classes:
1. Equities
2. Debt (e.g., bonds)
3. Cash and cash equivalents (e.g., guaranteed investment certificates or GICs and shorter term
money market securities, such as treasury bills).

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These different assets may be combined in different ways (for example, into mutual funds) that
allow investors to get the benefits of diversification without buying individual securities directly.
WHAT ARE THE RISKS OF BOND INVESTING?
There are a number of risks to bond investing and, as a rule, investment returns are lower when
risk is low; higher returns mean higher risk. Two key risks are the risk of default and price risk.
The risk of default (also known as credit risk)
An issuer of debt is said to be in default when the issuer is unable to repay the principle or
interest as scheduled. Government bonds / Government Securities have virtually no risk of
default. Corporate bonds are more exposed to default risk because companies cannot raise taxes
when there is a cash shortfall or take advantage of other options available to governments.
Because the financial health of a company may change during the life of a bond, it is important
to watch for changes. Investors can assess the likelihood of default inherent in a bond by
watching its credit rating.
Price risk
If you sell your bonds prior to their maturity, their price or market value may be lower than the
price at which you bought them. Price fluctuates throughout a bond‘s lifetime and may be
greater or less than its face or principal value.
If you buy a bond below par, you can expect to realize a capital gain when the bond matures;
similarly, if you bought the bond at a premium, you will have a capital loss at maturity.
A bond‘s price is a function of the bond‘s coupon rate as compared to the current level of
interest its remaining term to maturity, its credit or default risk and any special features it may
have.
Price quotations
Bond prices are quoted in numbers that represent a percentage of their face value. A bond
quoted at loo is trading at loo per cent of its face value, or at par.
Example:
A bond quoted at 94.50 is trading at 94.5 percent of its face value or par.
If the face value of the bond is ₹1,000, it would only cost ₹945.00 to purchase
(₹1,000 x .945). This bond is trading at a discount.
If the quote was 101.25, then the cost is 101.25 per cent of the face value, or ₹1,012.50. This
bond is trading at a premium.

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Coupon rate versus interest rate fluctuations
Fluctuations in interest rates usually have the biggest impact on the price of bonds- interest
rates can be affected by many things, including a change in inflation rates.
Generally speaking, bond prices move inversely to interest rates because the coupon rate usually
remains constant through to maturity. If current interest rates are higher than the coupon rate,
the bond is less attractive to investors and drops in value, since investors aren‘t willing to pay as
much for a series of lower coupon payments.
Bond prices increase when the coupon rate is higher than current interest rate levels. To an
investor who holds bonds through to maturity, price fluctuations may seem irrelevant. Not all
bond prices react in the same way to interest rate changes. Usually, the lower the coupon rate,
the more sensitive the bond price is to any changes in rates.
However, trading-oriented investors may take advantage of these fluctuations to enhance their
overall portfolio performance. As an example, a short-term interest rate decrease may be an
opportunity to sell bonds at a profit and move funds into noninterest-bearing investments with
anticipated higher returns.
Term to maturity
As bonds approach maturity, their market value approaches their face value. In general, the
longer the term to maturity and the lower the coupon rate, the more sensitive a bond is to any
changes in rate. When interest rates increase, bonds with distant maturity dates and low coupon
rates experience the greatest fall in price.
Risk
As a rule, you can expect to receive a full repayment of a bond‘s face value on the maturity date
as long as the issuer is able to repay the debt but if the credit rating changes during the life of
the bond, it may have an affect on the bond‟s price. For example, if the credit rating of debt
rated AAA‖ — the lowest level of default risk - changes due to large losses by the issuing company
that could affect the company‟s ability to repay interest or principal, the bond price will drop
even if there is no change in interest rates.
Special features
Many bonds have special features that may have a significant impact on their price, risk and the
returns you may earn. They can be called (repaid) early or they can be converted, for example,
into shares of the issuing company. Bonds can also be extended (repayment deferred from the
original term to a later date) or other special provisions can apply.
Demand and supply
The availability of bonds and the demand for them also affects the price of bonds. As demand
increases, prices rise, all other factors remaining the same. Also, as the supply of bonds
declines, for example, prices generally also rise. In both cases, if you are holding bonds, their
yield to maturity will increase. Similarly, when demand falls or supply increases, prices fall and
yield to maturity declines.
Yield: Yield is the return you get on a bond.

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The current yield is the annual return on the dollar amount paid for the bond. It is calculated by
dividing the dollar amount of the coupon rate by the purchase price. For example, a bond with a
₹1,000 face value and a 6.5 per cent coupon, purchased at par, has a current yield of 6.5 per
cent (annual interest of ₹65 divided by ₹1,000 purchase price). The same bond purchased at ₹950
(i.e., purchased at a discount) would have a current yield of 6.84 per cent (₹65 interest divided
by ₹950 purchase price). And, if the price rises to ₹1,100, the current yield drops to 5.90 per cent
(₹65 divided by ₹1,100).
The Yield To maturity (YTM) is a more meaningful calculation that tells you the total return
you will receive by holding the bond until it matures. YTM equals all the interest payments you
will receive (assuming you reinvest these interest payments at the same rate as the current yield
on the bond), plus any gain (if you purchased the bond at a discount) or loss (if you purchased the
bond at a premium) on the price of the bond. YTM is useful because it enables you to compare
bonds with different maturity dates and coupon rates.
Basis point
When you read or hear about bond quotes and yields, you may hear the words basis point.‖ A
basis point is a unit of measure; it equals 1/100th of one per cent or, alternatively, loo basis
points are equal to one per cent.
Example:
If a bond‘s yield increased from 5.10 per cent to 5.35 per cent, its yield is said to have increased
by 25 one-hundredth of a per cent or, more simply, by 25 basis points.

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 FM Notes 2 – Functions of RBI
Functions of RBI:
1. Monetary Policy
2. Issuer of Currency
3. Regulation
4. Financial Markets
5. Financial Inclusion and Development
6. Consumer Education and Protection
7. Banker and Debt Manager to Government
8. Banker to Banks
9. Foreign Exchange Management
10. Payment and Settlement Systems
11. Research and Data
1. Monetary Policy
The monetary authority, typically the central bank or a country, is vested with the responsibility
of conducting monetary policy.
Monetary policy refers to the use of instruments under the control of the central bank to regulate
the availability, cost and use of money and credit.
The goal(s) of monetary policy: Primarily price stability, while keeping in mind the objective
of growth.
In India, subsequent to the recommendations of the Dr. Urjit Patel Committee Report, the
Reserve Bank formally announced on January 28, 2014 a “glide path‟ for disinflation that
explicitly stated the objective of keeping CPI inflation below 8 percent by January 2015 and
below 6 per cent by January 2016.
The agreement on Monetary Policy Framework between the Government and the Reserve Bank
of India dated February 20, 2015 defines the price stability objective explicitly in terms of the
target for inflation - as measured by the consumer price index-combined (CPI-C) - in the near to
medium-term, i.e.,
a. Below 6 per cent by January 2016, and
b. 4 per cent (+/-) 2 per cent for the financial year 2016-17 and all subsequent years.
Price stability is a necessary (if not sufficient) precondition to sustainable growth and financial
stability. The relative emphasis assigned to price stability and growth objectives in the conduct
of monetary policy varies from time to time depending on the evolving macroeconomic
environment.
Financial stability is important for smooth transmission of monetary policy and, therefore,
regulatory and financial market policies, including macro-prudential policies, are often
announced along with monetary policy under Part-B of monetary policy statements.
2. Issuer of Currency

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Along with Government of India, we are responsible for the design, production and overall
management of the nation‘s currency, with the goal of ensuring an adequate supply of clean and
genuine notes.
The Government of India is the issuing authority of coins and supplies coins to the Reserve Bank
on demand. The Reserve Bank puts the coins into circulation on behalf of the Central Government.
In consultation with the Government of India, we work towards maintaining confidence in the
currency by constantly endeavouring to enhance integrity of banknotes through new design and
security features.
3. Regulation
A. Commercial Banking
Mandate /Goals: Regulation aimed at protecting depositors‘ interests, orderly development and
conduct of banking operations and fostering of the overall health of the banking system and
financial stability.
Evolution: Regulatory functions have evolved with the development of the Indian banking system
and adoption of prudential norms based on international best practices.
B. Cooperative Banking
The rural co-operative credit system in India is primarily mandated to ensure flow of credit to the
agriculture sector. It comprises short-term and long-term co-operative credit structures. The
short-term co-operative credit structure operates with a three - tier system - Primary
Agricultural Credit Societies (PACS) at the village level, Central Cooperative Banks (CCBs) at
the district level and State Cooperative Banks (StCBs) at the State level.
PACS are outside the purview of the Banking Regulation Act, 1949 and hence not regulated by
the Reserve Bank of India. StCBs/DCCBs are registered under the provisions of State Cooperative
Societies Act of the State concerned and are regulated by the Reserve Bank. Powers have been
delegated to National Bank for Agricultural and Rural Development (NABARD) under Sec 35 A of
the Banking Regulation Act (As Applicable to Cooperative Societies) to conduct inspection of
State and Central Cooperative Banks.
Primary Cooperative Banks (PCB5), also referred to as Urban Cooperative Banks (UCBs), cater to
the financial needs of customers in urban and semi-urban areas. UCBs are primarily registered as
cooperative societies under the provisions of either the State Cooperative Societies Act of the
State concerned or the Multi State Cooperative Societies Act, 2002 if the area of operation of the
bank extends beyond the boundaries of one state.
The sector is heterogeneous in character with uneven geographic spread of the banks. While
many of them are unit banks without any branch network, some of them are large in size and
operate in more than one state.
C. Non-Banking
India has financial institutions which are not banks but which accept deposits and extend
credit like banks. These are called Non-Banking Financial Companies (NBFCs) in India.

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NBFCs in India include not just the finance companies that the general public is largely familiar
with; the term also entails wider group of companies that are engaged in investment business,
insurance, chit fund, nidhi, merchant banking, stock broking, alternative investments, etc., as
their principal business. All are though not under the regulatory purview of the Reserve Bank.
4. Financial Markets
Major market segments under the regulatory ambit of the Reserve Bank are interest rate markets,
including Government Securities market and money markets; foreign exchange markets;
derivatives on interest rates/prices, repo, foreign exchange rates as well as credit derivatives.
In order to ensure the robustness and credibility of the financial system and to minimise the risks,
the Reserve Bank has designated industry bodies Fixed Income, Money Markets and Derivatives
Association of India (FIMMDA) and Foreign Exchange Dealers Association of India (FEDAI) as the
benchmark administrators for the Rupee interest rate and foreign exchange benchmarks,
respectively.
The FIMMDA, FEDAI and Indian Banks Association (IBA) have since jointly floated an independent
company for benchmark administration. Benchmark submission activities of banks and PDs
including their governance framework for submission are proposed to be brought under the
Reserve Bank‘s on-site and off-site supervision
5. Financial Inclusion and Development
Credit flow to priority sectors: Macro policy formulation to strengthen credit flow to the priority
sectors. Ensuring priority sector lending becomes a tool for banks for capturing untapped business
opportunities among the financially excluded sections of society.
Financial inclusion and financial literacy: Help expand Prime Minister‘s Jan Dhan Yojana
(PMJDY) to become a sustainable and scalable financial inclusion initiative.
Credit flow to MSME: Stepping up credit flow to micro, small and medium enterprises (MSME)
sector, rehabilitation of sick units through timely credit support.
Institutions: Strengthening institutional arrangements, such as, State Level Bankers Committees
(SLBCs), Lead bank scheme, etc., to facilitate achievement of above objectives.
6. Consumer Education and Protection
The Reserve Bank‘s initiatives in the field of customer service include the setting up of a
Customer Redressai Cell, creation of a Customer Service Department in 2006 which has been
recently rechristened as Consumer Education and Protection Department and the setting up of
the Banking Codes and Standards Board of India (BCSBI), an autonomous body for promoting
adherence to self-imposed codes by banks for committed customer service.
In order to strengthen the institutional mechanism for dispute resolution, the Reserve Bank in the
year 1995 introduced the Banking Ombudsman (BC) scheme. The BC is a quasi-judicial authority
for resolving disputes between a bank and its customers. There are 15 Banking Ombudsman
offices in the country at present.
The scheme covers grievances of the customers against Commercial Banks, Scheduled Primary
Cooperative Banks and Regional Rural Banks. In 2006, the Reserve Bank revised the BO scheme.

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Under the revised scheme, the BC and the attached staff are drawn from the serving employees
of the Reserve Bank. The new scheme is fully funded by the Reserve Bank and virtually covers all
banking transactions related grievances except credit decision of banks.
7. Banker and Debt Manager to Government
Since its inception, the Reserve Bank of India has undertaken the traditional central banking
function of managing the government‘s banking transactions. The Reserve Bank of India Act, 1934
requires the Central Government to entrust the Reserve Bank with all its money, remittance,
exchange and banking transactions in India and the management of its public debt. The
Government also deposits its cash balances with the Reserve Bank. The Reserve Bank may also,
by agreement, act as the banker and debt manager to State Governments.
Currently, the Reserve Bank acts as banker to all the State Governments in India (including Union
Territory of Puducherry), except Sikkim. For Sikkim, it has limited agreement for management
of its public debt.
The Reserve Bank has well defined obligations and provides several banking services to the
governments. As a banker to the Government, the Reserve Bank receives and pays money on
behalf of the various Government departments. The Reserve Bank also undertakes to float loans
and manage them on behalf of the Governments.
It provides Ways and Means Advances - a short-term interest bearing advance – to the
Governments, to meet temporary mismatches in their receipts and payments. Besides, like a
portfolio manager, it also arranges for investments of surplus cash balances of the Governments.
The Reserve Bank acts as adviser to Government, whenever called upon to do so, on monetary
and banking related matters.
The Central Government and State Governments may make rules for the receipt, custody and
disbursement of money from the consolidated fund, contingency fund, and public account. These
rules are legally binding on the Reserve Bank as accounts for these funds are with the Reserve
Bank.
The banking functions for the governments are carried out by the Public Accounts
Departments at the offices/branches of the Reserve Bank. As it has offices and sub - offices in
29 locations, the Reserve Bank appoints other banks to act as its agents for undertaking the
banking business on behalf of the governments.
The Reserve Bank pays agency bank charges to the banks for undertaking the government
business on its behalf. As of now, management of public debt, including floatation of new loans,
is done by the Internal Debt Management Department at the Central Office and Public Debt
Office at offices/branches of the Reserve Bank. Final compilation of Government accounts, of
the Centre and the States, is done at Nagpur office of the Reserve Bank which has a Central
Accounts Section.
8. Banker to Banks
Banks are required to maintain a portion of their demand and time liabilities as cash reserves
with the Reserve Bank. For this purpose, they need to maintain accounts with the Reserve Bank.
They also need to keep accounts with the Reserve Bank for settling inter-bank obligations, such
as, clearing transactions of individual bank customers who have their accounts with different

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banks or clearing money market transactions between two banks, buying and selling securities
and foreign currencies.
In order to facilitate a smooth inter-bank transfer of funds, or to make payments and to receive
funds on their behalf, banks need a common banker. By providing the facility of opening accounts
for banks, the Reserve Bank becomes this common banker, known as ‗Banker to Banks‘ function.
The function is performed through the Deposit Accounts Department (DAD) at the Reserve
Bank‟s Regional offices. The Department of Government and Bank Accounts oversees this
function and formulates policy and issues operational instructions to DAD.
9. Foreign Exchange Management
For a long time, foreign exchange in India was treated as a controlled commodity because of its
limited availability. The early stages of foreign exchange management in the country focussed on
control of foreign exchange by regulating the demand due to its limited supply. Exchange
control was introduced in India under the Defence of India Rules on September 3, 1939 on a
temporary basis.
The statutory power for exchange control was provided by the Foreign Exchange Regulation Act
(FERA) of 1947, which was subsequently replaced by a more comprehensive Foreign Exchange
Regulation Act, 1973. This Act empowered the Reserve Bank, and in certain cases the Central
Government, to control and regulate dealings in foreign exchange payments outside India, export
and import of currency notes and bullion, transfer of securities between residents and non-
residents, acquisition of foreign securities, and acquisition of immovable property in and outside
India, among other transactions.
Extensive relaxations in the rules governing foreign exchange were initiated, prompted by the
liberalisation measures introduced since 1991 and the Act was amended as a new Foreign
Exchange Regulation (Amendment) Act 1993. Significant developments in the external sector,
such as, substantial increase in foreign exchange reserves, growth in foreign trade,
rationalisation of tariffs, current account convertibility, liberalisation of Indian investments
abroad, increased access to external commercial borrowings by Indian corporates and
participation of foreign institutional investors in Indian stock market, resulted in a changed
environment.
Keeping in view the changed environment, the Foreign Exchange Management Act (FEMA) was
enacted in 1999 to replace FERA. FEMA became effective from June 1, 2000.
10. Payment and Settlement Systems
The central bank of any country is usually the driving force in the development of national
payment systems. The Reserve Bank of India as the central bank of India has been playing this
developmental role and has taken several initiatives for Safe, Secure, Sound, Efficient, Accessible
and Authorised payment systems in the country.
The Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), a sub-
committee of the Central Board of the Reserve Bank of India is the highest policy making body on
payment systems in the country. The BPSS is empowered for authorising, prescribing policies
and setting standards for regulating and supervising all the payment and settlement systems
in the country.

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The Department of Payment and Settlement Systems of the Reserve Bank of India serves as the
Secretariat to the Board and executes its directions. In India, the payment and settlement
systems are regulated by the Payment and Settlement Systems Act, 2007 (PSS Act) which was
legislated in December 2007. The PSS Act as well as the Payment and Settlement System
Regulations, 2008 framed thereunder came into effect from August 12, 2008.
In terms of Section 4 of the PSS Act, no person other than the Reserve Bank of India (RBI) can
commence or operate a payment system in India unless authorised by RBI. The Reserve Bank
has since authorised payment system operators of pre-paid payment instruments, card schemes,
cross-border in-bound money transfers, Automated Teller Machine (ATM) networks and
centralised clearing arrangements.
11. Research and Data
The Reserve Bank‘s economic research work is designed to:
a. Provide reliable, data-driven information for policy and decision-making
b. Supply accurate and timely data for academic research as well as to the general public
c. Provide support for collaborative research to research institutions/universities
d. To develop and maintain statistical data reporting systems
e. To conduct forward-looking surveys for monetary policy
f. Educate the public
g. The Reserve Bank‘s economic research focusses on study and analysis of domestic and
international macroeconomic issues. This is mainly done by the Department of Economic
and Policy Research and the Department of Statistics and Information Management.
h. The Reserve Bank has over time established a sound and rich tradition of policy - oriented
research and an effective mechanism for disseminating data and information. Like other
major central banks, the Reserve Bank has also developed its own research capabilities in
the field of economics, finance and statistics, which contribute to a better understanding
of the functioning of the economy and the ongoing changes in the policy transmission
mechanism.

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 FM Notes 3 - Conduct of Monetary Policy
The Reserve Bank‘s Monetary Policy Department (MPD) assists the Governor in formulating the
monetary policy. Views of all key stakeholders in the economy, advice of the Technical
Advisory Committee (TAC), and analytical work of the Reserve Bank contribute to the conduct
of Monetary Policy.
The Financial Markets Committee (FMC) meets daily to review the consistency between policy
rate, money market rates, and liquidity conditions.
Monetary policy refers to the use of instruments under the control of the central bank to
regulate the availability, cost and use of money and credit.
Monetary policy refers to the policy of the central bank with regard to the use of instruments
under its control to achieve the goals specified in the Act.
The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy
with the primary objective of maintaining price stability while keeping in mind the objective of
growth. This responsibility is explicitly mandated under the Reserve Bank of India Act, as
amended in 2016 and notified in the official Gazette on May 14, 2016.
The goal(s) of monetary policy primarily price stability, while keeping in mind the objective
of growth.
In India, subsequent to the recommendations of the Dr. Urjit Patel Committee Report, the
Reserve Bank formally announced on January 28, 2014 a ―glide path‖ for disinflation that
explicitly stated the objective of keeping CPI inflation below 8 per cent by January 2015 and
below 6 per cent by January 2016.
The Agreement on Monetary Policy Framework between the Government and the Reserve Bank of
India dated February 20, 2015 defines the price stability objective explicitly in terms of the
target for inflation - as measured by the consumer price index-combined (CPI-C) — in the near
to medium-term, i.e., (a) below 6 per cent by January 2016, and (b) 4 per cent (÷1-) 2 per cent
for the financial year 2016-17 and all subsequent years.
The amended RBI Act, has replaced the Agreement on Monetary Policy Framework, which
provides for inflation target to be set by the Government, in consultation with the Reserve Bank,
once in every five years. The Government shall notify the inflation target in the official Gazette.
Price stability is a necessary precondition to sustainable growth. The relative emphasis
assigned to price stability and growth objectives in the conduct of monetary policy varies from
time to time depending on the evolving macroeconomic environment.
Policy Framework
The framework aims at setting the policy (repo) rate based on a forward looking assessment
of inflation, growth and other macroeconomic risks, and modulation of liquidity conditions to
anchor money market rates at or around the repo rate. Repo rate changes transmit through the
money market to alter the interest rates in the financial system, which in turn influence
aggregate demand - a key determinant of inflation and growth.

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Once the repo rate is announced, the operating framework envisages liquidity management on a
day-to-day basis through appropriate actions, which aim at anchoring the operating target - the
Weighted Average Call Rate (WACR) - around the repo rate.
The operating framework is fine-tuned and revised depending on the evolving financial market
and monetary conditions, while ensuring consistency with the monetary policy stance. The
liquidity management framework accordingly was revised significantly in September 2014 and
again in April 2016.
The Monetary Policy Process
The Reserve Bank‘s Monetary Policy Department (MPD) assists the Governor in formulating the
monetary policy. Views of key stakeholders in the economy, advice of the Technical Advisory
Committee (TAC), and analytical work of the Reserve Bank contribute to the process for arriving
at the decision on policy repo rate.
The Financial Markets Operations Department (FMOD) operationalises the monetary policy,
mainly through day-to-day liquidity management operations. The Financial Markets Committee
(FMC) meets daily to review the consistency between policy rate, money market rates, and
liquidity conditions.
The amended RBI Act, 2016 provides a statutory basis for constitution of an empowered monetary
policy committee (MPC). The Central Government shall notify the constitution of the Monetary
Policy Committee. The Governor, one Deputy Governor and one officer of the Bank would be the
ex-officio members of the Committee. The other three members shall be appointed by the
Central Government as per the procedure laid down in the amended RBI Act. The Committee will
determine the policy interest rate required to achieve the inflation target.
Instruments of Monetary Policy
There are several direct and indirect instruments that are used in the implementation of
monetary policy.
Repo Rate: The (fixed) interest rate at which the Reserve Bank provides short-term (overnight)
liquidity to banks against the collateral of government and other approved securities under the
liquidity adjustment facility (LAF). The LAF consists of overnight and term repo auctions.
Progressively, the Reserve Bank has increased the proportion of liquidity injected in the LAF
through term-repos (of up to 56 days) at variable rates. The aim of term repo is to help develop
inter-bank term money market, which in turn can set market based benchmarks for pricing of
loans and deposits, and through that improve transmission of monetary policy.
Reverse Repo Rate: The (fixed) interest rate (currently 50 bps below the repo rate) at which the
Reserve Bank absorbs short-term liquidity, generally on an overnight basis, from banks against
the collateral of government and other approved securities under the LAF. The Reserve Bank also
conducts variable interest rate reverse repo auctions, as necessary.
Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can
borrow additional amount of overnight money from the Reserve Bank by dipping into their
Statutory Liquidity Ratio (SLR) portfolio up to a limit (currently two per cent of their net
demand and time liabilities deposits) at a penal rate of interest, currently 50 basis points
above the repo rate. This provides a safety valve against unanticipated liquidity shocks to the

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banking system. MSF rate and reverse repo rate determine the corridor for the daily movement in
the weighted average call money rate.
Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange
or other commercial papers. This rate has been aligned to the MSF rate and, therefore, changes
automatically as and when the MSF rate changes alongside policy repo rate changes.
Cash Reserve Ratio (CRR): The share of net demand and time liabilities that banks must maintain
as cash balance with the Reserve Bank.
Statutory Liquidity Ratio (SIR): The share of net demand and time liabilities that banks must
maintain in safe and liquid assets, such as, unencumbered government securities, cash and gold.
Changes in SLR often influence the availability of resources in the banking system for lending to
the private sector.
Open Market Operations (OMOs): These include both outright purchase/sale of government
securities for injection/absorption of durable liquidity, respectively.
Refinance facilities: Sector-specific refinance facilities aim at achieving sector specific
objectives through provision of liquidity at a cost linked to the policy repo rate. The Reserve
Bank has, however, been progressively de-emphasising sector specific policies as they interfere
with the transmission mechanism.
Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in
2004. Surplus liquidity of a more enduring nature arising from large capital inflows is
absorbed through sale of short-dated government securities and treasury bills. The mobilised
cash is held in a separate government account with the Reserve Bank.
Open and Transparent Monetary Policy-Making
a. The MPC will determine the policy rate required to achieve the inflation target.
b. The MPC will meet at least four times in a year.
c. The questions which come up before the MPC will be decided by majority of votes by the
members present in voting.
d. The resolution adopted by the MPC will be published after conclusion of every meeting of the
MPC.
On the 14th day, the minutes of the proceedings of the MPC will be published which include:
a. The resolution adopted by the MPC;
b. The vote of each member on the resolution, ascribed to such member; and
c. The statement of each member on the resolution adopted.
Once in every six months, the bank will publish a document called the Monetary Policy
Report which will explain:
a. The source of inflation; and
b. The forecast of inflation for 6-18 months ahead.
Legal Framework
Reserve Bank of India Act, 1934 as amended from time to time.

15
16
 FM Notes 4 - Financial Sector Reforms
A vibrant financial sector is of critical importance to the growth of every economy.
Following are the reform measures then in the Union Budget 2016-17.
1. A systemic vacuum exists with regard to bankruptcy situations in financial firms. A
comprehensive Code on Resolution of Financial Firms will be introduced as a Bill in the
Parliament during 2016-17. This Code will provide a specialized resolution mechanism to deal
with bankruptcy situations in banks, insurance companies and financial sector entities.
This Code, together with the Insolvency and Bankruptcy Code 2015, when enacted, will
provide a comprehensive resolution mechanism for our economy.
2. The RBI Act 1934, is being amended to provide statutory basis for a Monetary Policy
Framework and a Monetary Policy Committee through the Finance Bill 2016. A committee-
based approach will add lot of value and transparency to monetary policy decisions.
3. A Financial Data Management Centre under the aegis of the Financial Stability
Development Council (FSDC) will be set up to facilitate integrated data aggregation and
analysis in the financial sector.
4. To improve greater retail participation in Government securities, RBI will facilitate their
participation in the primary and secondary markets through stock exchanges and access to
NDS-OM trading platform.
5. New derivative products will be developed by SEBI in the Commodity Derivatives market.
6. To facilitate deepening of corporate bond market, a number of measures will be
undertaken. The enactment of Insolvency and Bankruptcy Code would provide a major boost
to the development of the corporate bond market.
MEASURES FOR DEEPENING OF CORPORATE BOND MARKET
1. LIC of India will set up a dedicated fund to provide credit enhancement to infrastructure
projects. The fund will help in raising the credit rating of bonds floated by infrastructure
companies and facilitate investment from long term investors.
2. RBI will issue guidelines to encourage large borrowers to access a certain portion of their
financing needs through market mechanism instead of the banks.
3. Investment basket of foreign portfolio investors will be expanded to include unlisted debt
securities and pass through securities issued by securitisation SPVs.
4. For developing an enabling eco system for the private placement market in corporate bonds,
an electronic auction platform will be introduced by SEBI for primary debt offer.
5. A complete information repository for corporate bonds, covering both primary and secondary
market segments will be developed jointly by RBI and SEBI.
6. A framework for an electronic platform for repo market in corporate bonds will be developed
by RBI.
7. To tackle the problem of stressed assets in the banking sector, Asset Reconstruction
Companies (ARCs) have a very important role. Therefore, Finance Minister proposed to make
necessary amendments in the SARFAESI Act 2002 to enable the sponsor of an ARC to hold
up to 100% stake in the ARC and permit non-institutional investors to invest in
Securitization Receipts.
8. In the recent past there have been rising instances of people in various parts of the country
being defrauded by illicit deposit taking schemes. The worst victims of these schemes are

17
 the poor and the financially illiterate. The operation of such schemes are often spread over
many States. Therefore Finance Minister proposed to bring in comprehensive Central
legislation in 2016-17 to deal with the menace of such schemes.
9. I also propose to amend the SEBI Act 1992 in the coming year to provide for more members
and benches of the Securities Appellate Tribunal.

18
 FM Notes 5 - SIDBI and MUDRA
Mission
―To facilitate and strengthen credit flow to MSMEs and address both financial and developmental
gaps in the MSME eco-system‖
Vision
To emerge as a single window for meeting the financial and developmental needs of the MSME
sector to make it strong, vibrant and globally competitive, to position SIDBI Brand as the
preferred and customer - friendly institution and for enhancement of share - holder wealth and
highest corporate values through modern technology platform.
History
Small Industries Development Bank of India (SIDBI), set up on April 2, 1990 under an Act of
Indian Parliament, acts as the Principal Financial Institution for the Promotion, Financing and
Development of the Micro, Small and Medium Enterprise (MSME) sector and for Co-ordination of
the functions of the institutions engaged in similar activities.
Business Domain of SIDBI
The business domain of SIDBI consists of Micro, Small and Medium Enterprises (MSMEs), which
contribute significantly to the national economy in terms of production, employment and exports.
MSME sector is an important pillar of Indian economy as it contributes greatly to the growth of
Indian economy with a vast network of around 4.6 crore units, creating employment of about 11
crore, manufacturing more than 6,000 products, contributing about 45% to manufacturing output
and about 40% of exports in terms of value, about 37% of GDP, directly and indirectly.
The business strategy of SIDBI is to address the financial and non-financial gaps in MSME eco-
system. Financial support to MSMEs is provided by way of
1. Indirect refinance to banks I Financial Institutions for onward lending to MSMEs and
2. Direct finance in the niche areas like risk capital/equity, sustainable finance, receivable
financing, service sector financing, etc. As on March 31, 2015, SIDBI has made cumulative
disbursements of over ₹3.90 lakh crore benefitting about 346 lakh persons. By this way, SIDBI
would be complementing and supplementing efforts of banks/ FIs in meeting diverse credit
needs of MSMEs.
Development Outlook
In order to promote and develop the MSME sector, SIDBI adopts a „Credit+‟ approach, under
which, besides credit, SIDBI supports enterprise development, skill upgradation, marketing
support, cluster development, technology modernisation, etc., in the MSME sector through its
promotional and developmental support to MSMEs.

19
MUDRA
MUDRA Vision
To be an integrated financial and support services provider par excellence benchmarked with
global best practices and standards for the bottom of the pyramid universe for their
comprehensive economic and social development.
MUDRA Mission
To create an inclusive, sustainable and value based entrepreneurial culture, in collaboration with
our partner institutions in achieving economic success and financial security.
MUDRA Purpose
Our basic purpose is to attain development in an inclusive and sustainable manner by supporting
and promoting partner institutions and creating an ecosystem of growth for micro enterprises
sector.
The Genesis of MU DRA
The Union Budget presented by the Honble Finance Minister Shri Arun Jaitley, for FY 2015-16,
announced the formation of MUDRA Bank. Accordingly MUDRA was registered as a Company in
March 2015 under the Companies Act 2013 and as a Non-Banking Finance Institution with the RBI
on 07 April 2015. MUDRA was launched by the Hon‘ble Prime Minister Shri Narendra Modi on 08
April 2015 at a function held at Vigyan Bhawan, New Delhi.
Micro Enterprises
Micro enterprises constitute a major economic segment in our country and provides large
employment after agriculture. This segment include micro units engaged in manufacturing,
processing, trading and services sector. It provides employment to nearly 10 crore people. Many
of these units are proprietary/ single ownership or Own Account enterprises and many a time
referred as Non Corporate Small Business sector.
The Non - Corporate Small Business Sector
Non-Corporate Small Business Sector (NCSBS) is the economic foundation of India. It is perhaps
one of the largest disaggregated business ecosystems in the world sustaining around 50 crore lives.
The sector comprises of myriad of small manufacturing units, shopkeepers, fruits / vegetable
vendors, truck & taxi operators, food-service units, repair shops, machine operators, small
industries, artisans, food processors, street vendors and many others.
Formal or institutional architecture has not been able to reach out to them to meet the financial
requirements of this sector. They are largely self-financed or rely on personal networks or
moneylenders. Addressing this need will give a big boost to the economy otherwise this segment
would remain unfunded and a portion of the productive labour force would remain unemployed.
Small business is big business. According to NSSO Survey (2013), there are 5.77 crore small
business units, mostly individual proprietorship. Most of these „Own Account Enterprises‟ (OAE)
are owned by people belonging to Scheduled Caste, Scheduled Tribe or Other Backward Classes.
They get very little credit, and that too mostly from non-formal lenders, or friends and relatives.

20
Providing access to institutional finance to such micro/small business units would turn them into
strong instruments of GDP growth and also employment.
The Non Corporate Small Business Sector (NCSBS) accounts for a large share of industrial units.
They feed large local and international value chains as well as domestic consumer markets as
suppliers, manufacturers, contractors, distributors, retailers and service providers. The gross
value addition of this sector is 6.28 lakh crore annually.
Mainstreaming these enterprises will not only help in improving the quality of life of these
entrepreneurs but will also contribute substantially to job creation in the economy thereby
achieving higher GDP growth.
The Micro Constraints
The major constraints faced by the myriad of the micro enterprises along the length and breadth
of the country include:
1. Access to Finance
2. Skill Development Gaps
3. Knowledge Gaps
4. Infrastructure Gaps
5. Policy Advocacy Needs
6. Information Asymmetry
7. Lack of growth orientation
8. Lack of Market Development / Market Making Entry Level Technologies
The biggest bottleneck to the growth of entrepreneurship in the NCSBS is lack of financial support
to this sector. The support from the Banks to this sector is meagre, with less than 15% of bank
credit going to Micro, Small and Medium Enterprises (MSMEs).
A vast part of the non-corporate sector operates as unregistered enterprises. They do not
maintain proper Books of Accounts and are not formally covered under taxation areas. Therefore,
the banks find it difficult to lend to them. Majority of this sector does not access outside sources
of finance.
The MUDRA
In the above backdrop the Micro Units Development & Refinance Agency Ltd (MUDRA) was set
up by the Government of India (Gol). MUDRA has been initially formed as a wholly owned
subsidiary of Small Industries Development bank of India (SIDBI) with 100% capital being
contributed by it. Presently, the authorized capital of MU DRA is 1000 crores and paid up
capital is 750 crore, fully subscribed by SIDBI. More capital is expected to enhance the
functioning of MUDRA.
This Agency would be responsible for developing and refinancing all Micro- enterprises sector by
supporting the finance Institutions which are in the business of lending to micro / small business
entities engaged in manufacturing, trading and service activities. MUDRA would partner with
Banks, MFIs and other lending institutions at state level / regional level to provide micro finance
support to the micro enterprise sector in the country

21
Micro Finance is an economic development tool whose objective is to provide income generating
opportunities to the people at the bottom of the pyramid. It covers a range of services which
include, in addition to the provision of credit, many other credit plus services, financial literacy
and other social support services.
Roles and Responsibilities of MUDRA
MUDRA has been formed with primary objective of developing the micro enterprise sector in the
country by extending various support including financial support in the form of refinance, so as to
achieve the goal of ―funding the unfunded‖. The GOl Press release of 2 March 2015 has laid down
the roles and responsibilities of MUDRA.
Subsequently GOl has also decided that MUDRA will provide refinance support, monitor the PMMY
data by managing the web portal, facilitate offering guarantees for loans granted under PMMY
and take up other activities assigned to it from time to time. Accordingly MUDRA has been
carrying out these functions over the last one year.
Monitoring of PMMY
Pradhan Mantri Mudra Yojana (PMMY) was launched along with the launching of MUDRA on 08
April 2015 and the detailed guidelines were issued by Government of India to all banks and MFIs.
MUDRA was given the responsibility of monitoring the programme by collecting the information
on regular basis. Accordingly, MUDRA has put in place a monitoring portal which captures the
data on lending under PM MY, in a granular fashion.

22
 FM Notes 6 – EXIM
Objectives
―... for providing financial assistance to exporters and importers, and for functioning as the
principal financial institution for coordinating the working of institutions engaged in financing
export and import of goods and services with a view to promoting the country‘s international
trade...‖
―... shall act on business principles with due regard to public interest‖ : The Export-Import Bank
of India Act, 1981
Export-Import Bank of India is the premier export finance institution of the country. It
commenced operations in 1982 under the Export-Import Bank of India Act 1981. Government of
India launched the institution with a mandate to not just enhance exports from India, but also to
integrate the country‘s foreign trade and investment with the overall economic growth.
Exim Bank of India has been both a catalyst and a key player in the promotion of cross border
trade and investment. Commencing operations as a purveyor of export credit, like other Export
Credit Agencies in the world, Exim Bank of India has evolved into an institution that plays a major
role in partnering Indian industries, particularly the Small and Medium Enterprises through a wide
range of products and services offered at all stages of the business cycle, starting from import of
technology and export product development to export production, export marketing, pre-
shipment and post-shipment and overseas investment.
FLAG SHIP PROGRAMS
1. Overseas Investment Finance
2. Project Finance
3. Line of Credit
4. Corporate Banking
5. Buyer‘s Credit Under NEJA
THE LEADERSHIP (Remember only latest)
Since its inception, Exim Bank has had, at the helm of its affairs, leading banking professionals as
Chief Executive Officers. Shri R.C. Shah, a seasoned banker, with vast commercial and
international banking experience, was the first Chairman and Managing Director of Exim Bank
during January 1982-January 1985. His vision helped the setting up of the institution as a unique
organizational model, with a flat, non-hierarchical culture, multi-disciplinary approach to
problem solving, access to the latest technology and a climate for innovation.
He was succeeded by Shri Kalyan Banerji, who was the Chairman and Managing Director during
February 1985-April 1993. Shri Banerji had long years of commercial banking experience, with
exposure to international banking. Ms. Tarjani Vakil took over as the Chairperson and Managing
Director of the Bank in August 1993 and guided the institution in its endeavors for export
capability creation, till October 1996. She was succeeded by Shri V.B. Desai, who was the
Managing Director of the Bank during August 1997-April 2001. Shri T.C. Venkat Subramanian then
took over as Chairman and Managing Director of Exim Bank in May 2001 and retired in October
2009. Smt. Ravneet Kaur, then Joint Secretary (IF) Department of Financial Services, Ministry of
Finance headed the institution from November 2009 to March 2010. She was succeeded by Shri

23
T.C.A. Ranganathan in April 2010 who headed the institution for over 3 years and retired in
November 2013. After the retirement of Shri Ranganathan, Shri Anurag Jam, Joint Secretary,
Department of Financial Services, Ministry of Finance held the interim charge of CMD till mid-
February.
Present Chairman and Managing Director
Shri. Yaduvendra Mathur has been appointed by the Government of India as Chairman and
Managing Director of Export-Import Bank of India (Exim Bank). Prior to this appointment, Shri.
Mathur was Chairman and Managing Director, Rajasthan Financial Corporation, since 2011.
Shri. Mathur is an Indian Administrative Service Officer of the 1986 batch. A First Class
Graduate in Economics and an MBA in Finance, Shri. Mathur has worked with Golden Tobacco and
Associated Cement Companies in Mumbai between 1982 - 1984 before joining the Indian Revenue
Services (Income Tax) in 1984 and then the JAS in 1986, topping his batch.
He has had long stints in various positions in the Finance Department including Principal
Secretary Finance, Government of Rajasthan. During his postings under the Department of
Economic Affairs (2001-2003) at Cote d‘Ivoire and Tunisia, Shri. Mathur worked as Assistant to the
Executive Director. He has had long stints (representing India, Norway, Denmark, Sweden,
Finland and Switzerland) of African Development Bank.
He was then actively engaged with the Export-Import Bank of India in enhancing and promoting
business opportunities for Indian companies in the African continent through Technical
Cooperation Agreements. As Energy Secretary of Rajasthan for over three years, Shri. Mathur
contributed in the setting up of three Greenfield power plants in the state. He was also Planning
Secretary, PHED Secretary and Director General Revenue Intelligence in Government of Rajasthan.
He also has experience as Managing Director of a Textile Mill at Bhilwara and as Chairman of
Indira Gandhi Canal Board. Shri. Mathur was Collector & District Magistrate of Bhilwara and
Bharatpur and has also served for over three years as Senior Deputy Director at the LaI Bahadur
Shastri National Academy of Administration, Mussoorie. Shri. Mathur has interests in
entrepreneurship development, infrastructure financing, regulatory issues and in behavioural
sciences.
THE BOARD
Exim Bank of India has been guided by expertise at the Board level, by senior policy makers,
expert bankers, leading players in industry and international trade as well as professionals in
exports or imports or financing thereof. As per the Exim Bank Act, at a particular point in time,
the Bank can have a maximum of 16 directors on its Board. Including Chairman and Managing
Director, the Bank‘s Board constitutes of 13 directors who are appointed by the Government of
India, they are five top level Government of India functionaries, three directors from scheduled
commercial banks and four directors who are industry/trade experts. Three other directors are
nominated by the Reserve Bank of India (RBI), Industrial Development Bank of India (IDBI) and
ECGC Ltd respectively.

24
25
 FM Notes 7 – NABARD
Genesis
At the instance of Government of India and Reserve Bank of India (RBI), constituted a
committee to review the arrangements for institutional credit for agriculture and rural
development (CRAFICARD) on 30 March 1979, under the Chairmanship of Shri B.Sivaraman,
former member of Planning Commission,
Government of India to review the arrangements for institutional credit for agriculture and rural
development.
The Committee, in its interim report, submitted on 28 November 1979, felt the need for a new
organisational device for providing undivided attention, forceful direction and pointed focus to
the credit problems arising out of integrated rural development and recommended the formation
of National Bank for Agriculture and Rural Development (NABARD).
The Parliament, through Act, 61 of 1981, approved the setting up of NABARD. The bank came
into existence on 12 July 1982 by transferring the agricultural credit functions of RBI and
refinance functions of the then Agricultural Refinance and Development Corporation (ARDC).
NABARD was dedicated to the service of the nation by the late Prime Minister Smt. Indira Gandhi
on 05 November 1982.
NABARD was set up with an initial capital of 100 crore. Consequent to the revision in the
composition of share capital between Government of India and RBI, the paid up capital as on 31
March 2015, stood at 5000 crore with Government of India holding 4,980 crore (99.60%) and
Reserve Bank of India 20.00 crore (0.40%).
Mission
Promote sustainable and equitable agriculture and rural prosperity through effective credit
support, related services, institution development and other innovative initiatives.
Functions of NABARD
1. Financial
2. Developmental
3. Supervisory

1. Financial

A. Refinance
 Short and Medium Term Loans
 Long Term Loans
 Eligible schemes for Refinance under Non-farm Sector Automatic Refinance Scheme (ARF)

B. Direct Finance
 Loans for Food Parks and Food Processing Units in Designated Food Parks new
 Loans to Warehouses, Cold Storage and Cold
 Chain Infrastructure
 Credit Facilities to Marketing Federations

26
  Rural Infrastructure Development Fund
 Direct Refinance to Cooperative Banks
 Financing and Supporting Producer Organisations
 More Direct Finance

2. Developmental
 Financial
 Developmental
 Supervisory
 Institutional Development
 Farm Sector
 Non-Farm Sector
 Financial Inclusion
 Micro Credit Innovations
 Research and Development
 Core Banking Solution to
 Co-operative Banks
 Climate Change

3. Supervisory
 Supervisory Function
 Objectives of Supervision
 Supervisory Process
 Credit Monitoring Arrangements (CMA)
 Board of Supervision (for SCBs, DCCBs and RRBs)
 Other Initiatives
 Penalties imposed on CCBs - 2011
 Latest Updates
 Supervisory Interventions and other initiatives

Recent initiatives taken by NABARD in the following areas

 Loans for Food Parks and Food Processing
 Units in Designated Food Parksnew
 Loans to Warehouses, Cold Storage and Cold
 Chain Infrastructure
 RuPay KCC
 Participatory Watershed Management
 Self Help Group-2
 Core Banking Solution to CCBs
 PACS as Multi-Service Societies
 Producers Organisation
 Venture Capital Fundnew
 Warehousing Infrastructure
 Financial Literacy Material for Financial Inclusion
Government Sponsored Schemes of NABARD

27
 1. Investment Credit
 Dairy Entrepreneurship Development Scheme
 Commercial production units of organic inputs
 Rural godowns
 Agriculture Marketing and Infrastructure Grading and Standardisations
 Agriclinic and Agribusiness Centres Scheme
 Solar Schemes
 Capital Investment Subsidy Scheme
 Pending List
 Agricultural Marketing Infrastructure
 National Livestock Mission
 GSS- Complaints received from Public

2. Production Credit
 Sugar Package
 Interest subvention Scheme
 Weavers Package
 Revival, Reform, Restructuring of the Handloom Sector

3. Farm Sector
 Cattle Development Programme
 Multi Activity Approach for Poverty Alleviation(MMPA)

4. Non-Farm Sector
 Swarojgar Credit Card Scheme
 Credit Linked Capital Subsidy Scheme (CLCSS)
 Livelihood Advancement Business School (LABS)

28
 FM Notes 8 – NHB and Housing Indices
National Housing Bank (NH B), a wholly owned subsidiary of Reserve Bank of India (RBI), was
set up by an Act of Parliament in 1987. NHB is an apex financial institution for housing. It
commenced its operations in 9th July 1988. NHB has been established with an objective to
operate as a principal agency to promote housing finance institutions both at local and regional
levels and to provide financial and other support incidental to such institutions and for matters
connected therewith NHB registers, regulates and supervises Housing Finance Company (HFCs),
keeps surveillance through On-site & Off-site Mechanisms and co-ordinates with other Regulators.

Genesis
The Sub-Group on Housing Finance for the Seventh Five Year Plan (1985-90) identified the
non-availability of long-term finance to individual households on any significant scale as a major
lacuna impeding progress of the housing sector and recommended the setting up of a national
level institution.

The Committee of Secretaries considered‘ the recommendation and set up the High Level Group
under the Chairmanship of Dr. C. Rangarajan, the then Deputy Governor, RBI to examine the
proposal and recommended the setting up of National Housing Bank as an autonomous
housing finance institution. The recommendations of the High Level Group were accepted by the
Government of India.

The Hon‘ble Prime Minister of India, while presenting the Union Budget for 1987-88 on 28
February 1987 announced the decision to establish the National Housing Bank (NHB) as an apex
level institution for housing finance. Following that, the National Housing Bank Bill (91 of 1987)
providing the legislative framework for the establishment of NHB was passed by Parliament in the
winter session of 1987 and with the assent of the Hon‘ble President of India on 23 December 1987,
became an Act of Parliament.

The National Housing Policy, 1988 envisaged the setting up of NHB as the Apex level institution
for housing.

In pursuance of the above, NHB was set up on 9 July 1988 under the National Housing Bank Act
1987. NHB is wholly owned by Reserve Bank of India, which contributed the entire paid-up capital.
The general superintendence, direction and management of the affairs and business of NHB vest
under the Act in a Board of Directors. The Head Office of NHB is at New Delhi.

Objectives:
NHB has been established to achieve, inter-Alia, the following objectives:
1. To promote a sound, healthy, viable and cost effective housing finance system to cater to
all segments of the population and to integrate the housing finance system with the
overall financial system.
2. To promote a network of dedicated housing finance institutions to adequately serve
various regions and different income groups.
3. To augment resources for the sector and channelise them for housing.
4. To make housing credit more affordable.

29
 5. To regulate the activities of housing finance companies based on regulatory and
supervisory authority derived under the Act
6. To encourage augmentation of supply of buildable land and also building materials for
housing and to upgrade the housing stock in the country.
7. To encourage public agencies to emerge as facilitators and suppliers of serviced land, for
housing.

RESIDEX
RESIDEX is the first index of residential property prices in India. It was launched by National
Housing Bank (NHB) of India in 2007 for tracking prices of residential properties in India, in view
of the prominence of housing and real estate in creating both physical and financial assets and its
role in overall National wealth.

RESIDEX started with a pilot study in 5 major cities, subsequently expanded to include more cities
and by Q4: 2012-13 the coverage was extended to 26 cities of India. NHB collects primary data on
housing prices from real estate agents by commissioning the services of private
consultancy/research organizations of national repute.

NHB also collects house price data from housing finance companies and banks based on housing
loans contracted by these institutions. Off-late, NHB initiated collection of property price data
from „Central Registry of Securitization, Asset Reconstruction and Security Interest of India
(CERSAI)‟. Actual transactions prices are considered for construction of RESIDEX. The housing
prices for various administrative zones/property tax zones in each city are compiled and RESIDEX
is constructed for each city using the weighted average methodology with Price Relative Method
using 2007 as base year.

Presently, the All India RESIDEX is not constructed. NHB is in an attempt to expand RESIDEX to 63
cities which are covered under the Jawaharlal Nehru National Urban Renewal Mission, in a
phased manner. It is envisaged to develop a residential property price index for select cities and
subsequently an all India composite index by suitably combining these city level indices to
capture the relative temporal change in the prices of houses at different levels.

House Price Index (HPI)

In India, it is mandatory to register all properties with the concerned registration authorities and
hence these authorities have transaction details of properties in their jurisdictions. The Reserve
Bank compiles House Price Index based on property transaction registration data obtained from
„Department of Registration and Stamps‟ of State Governments of select ten cities. The
transaction level data collected from various centres include, date of registration, registration
number, address, survey no., area, seller‘s name, buyer‘s name, consideration amount
(transacted price) and market value.

Residential Property Price Index (RPPI)

Reserve Bank of India initiated a „Residential Asset Price Monitoring Survey (RAPMS)‟ to collect
sale/resale prices of residential properties from select scheduled banks and Housing Finance
Companies (HFC) based on their housing loan transactions.

30
The survey is conducted on a quarterly basis and it collects data related to individual housing
loan transactions disbursed by select 35 banks/HFCs in select 13 cities. The information collected
includes floor space area of the structure, date of first disbursement of loan, cost of property,
valuated / estimated price of the property by the bank, first borrower (male/ female/
partnership firm/proprietary concerns/company/others), occupation of first borrower
(employed/self-employed/ others), gross assessed monthly income, loan amount, maturity period,
Equated Monthly Instalment (EMI) are also collected in the survey.

The survey data is used to compile City-wise and All-India Residential Property Price Index
(RPPI) and other useful indicators such as Loan-to-Value Ratio (LTV), EMI-to-Income ratio, House
Price-to-Income ratio and Loan-to-Income ratio, which have internal usage with policy
implications. The main advantage of this survey is the availability of electronic data in a much
shorter time span and thereby quicker compilation of RPPI vis-à-vis other indices. Further,
availability of data required for computation of LTV, EMI-to-Income ratio, House Price-to-Income
ratio etc. is a unique feature of RAPMS.

31
 FM Notes 9 – The Banking System in India
1. Reserve Bank of India:
Reserve Bank of India is the Central Bank of our country. It was established on 1st April 1935
under the RBI Act of 1934. It holds the apex position in the banking structure. RBI performs
various developmental and promotional functions.
It has given wide powers to supervise and control the banking structure. It occupies the pivotal
position in the monetary and banking structure of the country. In many countries central bank is
known by different names.
For example, Federal Reserve Bank of U.S.A, Bank of England in U.K. and Reserve Bank of India in
India. Central bank is known as a banker‘s bank. They have the authority to formulate and
implement monetary and credit policies. It is owned by the government of a country and has the
monopoly power of issuing notes.
2. Commercial Banks:
Commercial bank is an institution that accepts deposit, makes business loans and offer related
services to various like accepting deposits and lending loans and advances to general customers
and business man.
These institutions run to make profit. They cater to the financial requirements of industries and
various sectors like agriculture, rural development, etc. it is a profit making institution owned by
government or private of both. Commercial bank includes public sector, private sector, foreign
banks and regional rural banks:
a. Public sector banks:
It includes SBI, associate banks of SBI (merger process started) and nationalized banks.
b. Private sector banks:
Private sector banks are those whose equity is held by private shareholders. For example, ICICI,
HDFC etc. Private sector bank plays a major role in the development of Indian banking industry.
c. Foreign Banks:
Foreign banks are those banks, which have their head offices abroad. CITI bank, HSBC, Standard
Chartered etc. are the examples of foreign bank in India.
d. Regional Rural Bank (RRB):
These are state sponsored regional rural oriented banks. They provide credit for agricultural and
rural development. The main objective of RRB is to develop rural economy. Their borrowers
include small and marginal farmers, agricultural labourers, artisans etc. NABARD holds the apex
position in the agricultural and rural development.
3. Co-operative Bank:
Co-operative bank was set up by passing a co-operative act in 1904. They are organised and
managed on the principal of co-operation and mutual help. The main objective of co-operative
bank is to provide rural credit.
The cooperative banks in India play an important role even today in rural co-operative financing.
The enactment of Co-operative Credit Societies Act 1904, however, gave the real impetus to the

32
movement. The Cooperative Credit Societies Act, 1904 was amended in 1912, with a view to
broad basing it to enable organisation of non-credit societies.
Three tier structures exist in the cooperative banking:
I. State cooperative bank at the apex level.
II. Central cooperative banks at the district level.
III. Primary cooperative banks and the base or local level.

4. Scheduled and Non-Scheduled banks:

A bank is said to be a scheduled bank when it has a paid up capital and reserves as per the
prescription of RBI and included in the second schedule of RBI Act 1934.
Non-scheduled bank are those commercial banks, which are not included in the second schedule
of RBI Act 1934.
5. Development banks and other financial institutions:
A development bank is a financial institution, which provides a long term funds to the industries
for development purpose. This organisation includes banks like IDBI, ICICL IFCI etc. State level
institutions like SFC‘s SIDC‘s etc. It also includes investment institutions like UTI, UC, and GIC etc.

33
 FM Notes 10 – Important Glossary (Provided by RBI)

1. Capital

Capital Funds
Equity contribution of owners. The basic approach of capital adequacy framework is that a bank
should have sufficient capital to provide a stable resource to absorb any losses arising from the
risks in its business. Capital is divided into different tiers according to the characteristics I
qualities of each qualifying instrument. For supervisory purposes capital is split into two
categories: Tier I and Tier II.

Tier I Capital
A term used to refer to one of the components of regulatory capital. It consists mainly of share
capital and disclosed reserves (minus goodwill, if any). Tier I items are deemed to be of the
highest quality because they are fully available to cover losses Hence it is also termed as core
capital.

Tier II Capital
Refers to one of the components of regulatory capital. Also known as supplementary capital, it
consists of certain reserves and certain types of subordinated debt. Tier II items qualify as
regulatory capital to the extent that they can be used to absorb losses arising from a banks
activities. Tier II‘s capital loss absorption capacity is lower than that of Tier I capital.

Revaluation reserves
Revaluation reserves are a part of Tier-Il capital. These reserves arise from revaluation of assets
that are undervalued on the bank‘s books, typically bank premises and marketable securities, The
extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses
depends mainly upon the level of certainty that can be placed on estimates of the market values
of the relevant assets and the subsequent deterioration in values under difficult market
conditions or in a forced sale.

Leverage
Ratio of assets to capital.

Capital reserves
That portion of a company‘s profits not paid out as dividends to shareholders. They are also
known as un-distributable reserves and are ploughed back into the business.

Deferred Tax Assets

Unabsorbed depreciation and carry forward of losses which can be set-off against future taxable
income which is considered as timing differences result in deferred tax assets. The deferred Tax
Assets are accounted as per the Accounting Standard 22.

Deferred Tax Liabilities

Deferred tax liabilities have an effect of increasing future year‘s income tax payments, which
indicates that they are accrued income taxes and meet definition of liabilities.

34
Subordinated debt
Refers to the status of the debt. In the event of the bankruptcy or liquidation of the debtor,
subordinated debt only has a secondary claim on repayments, after other debt has been repaid.

Hybrid debt capital instruments

In this category, fall a number of capital instruments, which combine certain characteristics of
equity and certain characteristics of debt. Each has a particular feature, which can be considered
to affect its quality as capital. Where these instruments have close similarities to equity, in
particular when they are able to support losses on an ongoing basis without triggering liquidation,
they may be included in Tier II capital.

BASEL Committee on Banking Supervision

The BASEL Committee is a committee of bank supervisors consisting of members from each of the
610 countries. The Committee is a forum for discussion on the handling of specific supervisory
problems. It coordinates the sharing of supervisory responsibilities among national authorities in
respect of banks‘ foreign establishments with the aim of ensuring effective supervision of banks‘
activities worldwide.

BASEL Capital accord

The RASEL Capital Accord is an Agreement concluded among country representatives in 1988 to
develop standardised risk-based capital requirements for banks across countries. The Accord was
replaced with a new capital adequacy framework (RASEL II), published in June 2004. BASEL II is
based on three mutually reinforcing pillars hat allow banks and supervisors to evaluate properly
the various risks that banks face. These three pillars are: Minimum capital requirements, which
seek to refine the present measurement framework supervisory review of an institution‘s capital
adequacy and internal assessment process; market discipline through effective disclosure to
encourage safe and sound banking practices.

Risk Weighted Asset

The notional amount of the asset is multiplied by the risk weight assigned to the asset to arrive
at the risk weighted asset number. Risk weight for different assets vary e.g. 0% on a Government
Dated Security and 20% on a AAA rated foreign bank etc.

CRAR (Capital to Risk Weighted Assets Ratio)

Capital to risk weighted assets ratio is arrived at by dividing the capital of the bank with
aggregated risk weighted assets for credit risk, market risk and operational risk. The higher the
CRAR of a bank the better capitalized it is.

Credit Risk
The risk that a party to a contractual agreement or transaction will be unable to meet its
obligations or will default on commitments. Credit risk can be associated with almost any
financial transaction. RASEL-II provides two options for measurement of capital charge for credit
risk

35
1. Standardized approach (SA) - Under the SA, the banks use a risk-weighting schedule for
measuring the credit risk of its assets by assigning risk weights based on the rating assigned by
the external credit rating agencies.
2. Internal rating based approach (IRB) - The IRB approach, on the other hand, allows banks to
use their own internal ratings of counterparties and exposures, which permit a finer
differentiation of risk for various exposures and hence delivers capital requirements that are
better aligned to the degree of risks.
The IRB approaches are of two types:
a) Foundation IRB (FIRB): The bank estimates the Probability of Default (PD) associated with
each borrower, and the supervisor supplies other inputs such as Loss Given Default (LGD) and
Exposure At Default (EAD).
b) Advanced IRB (AIRB): In addition to Probability of Default (PD), the bank estimates other
inputs such as EAD and LGD. The requirements for this approach are more exacting. The adoption
of advanced approaches would require the banks to meet minimum requirements relating to
internal ratings at the outset and on an ongoing basis such as those relating to the design of the
rating system, operations, controls, corporate governance, and estimation and validation of
credit risk components, viz., PD for both FIRB and AIRB and LGD and EAD for AJRB. The banks
should have, at the minimum, PD data for five years and LGD and EAD data for seven years. In
India, banks have been advised to compute capital requirements for credit risk adopting the SA.

Market risk
Market risk is defined as the risk of loss arising from movements in market prices or rates away
from the rates or prices set out in a transaction or agreement The capital charge for market risk
was introduced by the BASEL Committee on Banking Supervision through the Market Risk
Amendment of January 1996 to the capital accord of 1988 (RASEL I Framework). There are two
methodologies available to estimate the capital requirement to cover market risks:
1) The Standardised Measurement Method: This method, currently implemented by the Reserve
Bank, adopts a ‗building block approach for interest-rate related and equity instruments which
differentiate capital requirements for ‗specific risk‘ from those of ‗general market risk‘. The
‗specific risk charge‘ is designed to protect against an adverse movement in the price of an
individual security due to factors related to the individual issuer. The ‗general market risk charge‘
is designed to protect against the interest rate risk in the portfolio.
2) The Internal Models Approach (IMA): This method enables banks to use their proprietary in-
house method which must meet the qualitative and quantitative criteria set out by the BCBS and
is subject to the explicit approval of the supervisory authority.

Operational Risk
The revised BASEL II framework offers the following three approaches for estimating capital
charges for operational risk:
1) The Basic Indicator Approach (BIA): This approach sets a charge for operational risk as a fixed
percentage (―alpha factor‖) of a single indicator, which serves as a proxy for the bank‘s risk
exposure.

36
2) The Standardised Approach (SA): This approach requires that the institution separate its
operations into eight standard business lines, and the capital charge for each business line is
calculated by multiplying gross income of that business line by a factor (denoted beta) assigned
to that business line.
3) Advanced Measurement Approach (AMA): Under this approach, the regulatory capital
requirement will equal the risk measure generated by the banks‘ internal operational risk
measurement system. In India, the banks have been advised to adopt the BIA to estimate the
capital charge for operational risk and 15% of average gross income of last three years is taken
for calculating capital charge for operational risk.

Internal Capital Adequacy Assessment Process (ICAAP)

In terms of the guidelines on BASEL II, the banks are required to have a board approved policy on
internal capital adequacy assessment process (ICAAP) to assess the capital requirement as per
ICAAP at the solo as well as consolidated level. The ICAAP is required to form an integral part of
the management and decision-making culture of a bank. ICAAP document is required to clearly
demarcate the quantifiable and qualitatively assessed risks. The ICAAP is also required to include
stress tests and scenario analyses, to be conducted periodically, particularly in respect of the
bank‘s material risk exposures, in order to evaluate the potential vulnerability of the bank to
some unlikely but plausible events or movements in the market conditions that could have an
adverse impact on the banks capital.

Supervisory Review Process (SRP)

Supervisory review process envisages the establishment of suitable risk management systems in
banks and their review by the supervisory authority. The objective of the SRP is to ensure that
the banks have adequate capital to support all the risks in their business as also to encourage
them to develop and use better risk management techniques for monitoring and managing their
risks.

Market Discipline
Market Discipline seeks to achieve increased transparency through expanded disclosure
requirements for banks.

Credit risk mitigation

Techniques used to mitigate the credit risks through exposure being collateralised in whole or in
part with cash or securities or guaranteed by a third party.

Mortgage Back Security

A bond-type security in which the collateral is provided by a pool of mortgages. Income from the
underlying mortgages is used to meet interest and principal repayments.

Derivative
A derivative instrument derives its value from an underlying product. There are basically three
derivatives
a) Forward Contract- A forward contract is an agreement between two parties to buy or sell an
agreed amount of a commodity or financial instrument at an agreed price, for delivery on an
agreed future date. Future Contract- Is a standardized exchange tradable forward contract

37
executed at an exchange. In contrast to a futures contract, a forward contract is not transferable
or exchange tradable, its terms are not standardized and no margin is exchanged. The buyer of
the forward contract is said to be long on the contract and the seller is said to be short on the
contract.
b) Options- An option is a contract which grants the buyer the right, but not the obligation, to
buy (call option) or sell (put option) an asset, commodity, currency or financial instrument at an
agreed rate (exercise price) on or before an agreed date (expiry or settlement date). The buyer
pays the seller an amount called the premium in exchange for this right. This premium is the
price of the option.
c) Swaps- Is an agreement to exchange future cash flow at pre-specified Intervals. Typically one
cash flow is based on a variable price and other on affixed one.

Duration
Duration (Macaulay duration) measures the price volatility of fixed income securities. It is often
used in the comparison of interest rate risk between securities with different coupons and
different maturities. It is defined as the weighted average time to cash flows of a bond where the
weights are nothing but the present value of the cash flows themselves. It is expressed in years.
The duration of a fixed income security is always shorter than its term to maturity, except in the
case of zero coupon securities where they are the same.

Modified Duration
Modified Duration = Macaulay Duration/ (1÷y/m), where y is the yield (%), m is the number of
times compounding occurs in a year. For example if interest is paid twice a year m=2. Modified
Duration is a measure of the percentage change in price of a bond for a 1% change in yield.

Non-Performing Assets (NPA)

An asset, including a leased asset, becomes non-performing when it ceases to generate income
for the bank.

Net NPA
Gross NPA - (Balance in Interest Suspense account + DICGC/ECGC claims received and held
pending adjustment + Part payment received and kept in suspense account + Total provisions
held).

Coverage Ratio
Equity minus net NPA divided by total assets minus intangible assets.

Slippage Ratio
(Fresh accretion of NPAs during the year/Total standard assets at the beginning of the year)*100

Restructuring
A restructured account is one where the bank, grants to the borrower concessions that the bank
would not otherwise consider. Restructuring would normally involve modification of terms of the
advances/securities, which would generally include, among others, alteration of repayment
period/repayable amount/the amount of instalments and rate of interest. It is a mechanism to
nurture an otherwise viable unit, which has been adversely impacted, back to health.

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Substandard Assets
A substandard asset would be one, which has remained NPA for a period less than or equal to 12
months. Such an asset will have well defined credit weaknesses that jeopardize the liquidation of
the debt and are characterised by the distinct possibility that the banks will sustain some loss, if
deficiencies are not corrected.

Doubtful Asset
An asset would be classified as doubtful if it has remained in the substandard category for a
period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that
were classified as substandard, with the added characteristic that the weaknesses make
collection or liquidation in full, - on the basis of currently known facts, conditions and values -
highly questionable and improbable.

Loss Asset
A loss asset is one where loss has been identified by the bank or internal or external auditors or
the RBI inspection but the amount has not been written off wholly. In other words, such an asset
is considered uncollectible and of such little value that its continuance as a bankable asset is not
warranted although there may be some salvage or recovery value.

Off Balance Sheet Exposure

Off-Balance Sheet exposures refer to the business activities of a bank that generally do not
involve booking assets (loans) and taking deposits. Off-balance sheet activities normally generate
fees, but produce liabilities or assets that are deferred or contingent and thus, do not appear on
the institutions balance sheet until and unless they become actual assets or liabilities.

Current Exposure Method

The credit equivalent amount of a market related off-balance sheet transaction is calculated
using the current exposure method by adding the current credit exposure to the potential future
credit exposure of these contracts. Current credit exposure is defined as the sum of the positive
mark to market value of a contract. The Current Exposure Method requires periodical calculation
of the current credit exposure by marking the contracts to market thus capturing the current
credit exposure. Potential future credit exposure is determined by multiplying the notional
principal amount of each of these contracts irrespective of whether the contract has a zero,
positive or negative mark-to-market value by the relevant add-on factor prescribed by RBI,
according to the nature and residual maturity of the instrument
2. Earnings

Total income
Sum of interest/discount earned, commission, exchange, brokerage and other operating income.

Total operating expenses

Sum of interest expended, staff expenses and other overheads.

Net operating profit

39
Operating profit before provision minus provision for loan losses, depreciation in investments,
write off and other provisions.

Profit before tax (PBT)

(Net operating profit +/- realized gains/losses on sale of assets)

Profit after tax (PAT)

Profit before tax - provision for tax.

Retained earnings
Profit after tax - dividend paid/proposed.

Average Yield
(Interest and discount earned/average interest earning assets)*100

Average cost
(Interest expended on deposits and borrowings/Average interest bearing liabilities)*100

Return on Asset (ROA) - After Tax

Return on Assets (RCA) is a profitability ratio which indicates the net profit (net income)
generated on total assets. It is computed by dividing net income by average total assets.
Formula- (Profit after tax/Av. Total assets)*100

Return on equity (ROE) - After Tax

Return on Equity (ROE) is a ratio relating net profit (net income) to shareholders‘ equity. Here
the equity refers to share capital reserves and surplus of the bank.
Formula - Profit after tax / (Total equity + Total equity at the end of previous year)/2}*100

Accretion to equity
(Retained earnings/Total equity at the end of previous year)*100

Net Non-Interest Income

The differential (surplus or deficit) between non-interest income and non-interest expenses as a
percentage to average total assets.

Net Interest Income (NIl)

The Nil is the difference between the interest income and the interest expenses.

Net Interest Margin

Net interest margin is the net interest income divided by average interest earning assets.

Cost income ratio (Efficiency ratio)

The cost income ratio reflects the extent to which non-interest expenses of a bank make a charge
on the net total income (total income - interest expense). The lower the ratio, the more efficient
is the bank. Formula: Non interest expenditure / Net Total Income * 100.
3. Funds and Investment

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CASA Deposit
Deposit in bank in current and Savings account.

High Cost Deposit

Deposits accepted above card rate (for the deposits) of the bank.

Liquid Assets
Liquid assets consists of: cash, balances with RBI, balances in current accounts with banks,
money at call and short notice, inter-bank placements due within 30 days and securities under
―held for trading‖ and ―available for sale‖ categories excluding securities that do not have ready
market.

Funding Volatility Ratio

Liquid assets [as above] to current and savings deposits - (Higher the ratio, the better)

Market Liability Ratio

Inter-bank and money market deposit liabilities to Average Total Assets

ALM
Asset Liability Management (ALM) is concerned with strategic balance sheet management
involving all market risks. It also deals with liquidity management funds management trading and
capital planning.

ALCO
Asset-Liability Management Committee (ALCO) is a strategic decision making body, formulating
and overseeing the function of asset liability management (ALM) of a bank.

Banking Book
The banking book comprises assets and liabilities, which are contracted basically on account of
relationship or for steady income and statutory obligations and are generally held till maturity.

Venture Capital Fund

A fund set up for the purpose of investing in start-up businesses that is perceived to have
excellent growth prospects but does not have access to capital markets.

Held Till Maturity (HTM)

The securities acquired by the banks with the intention to hold them up to maturity.

Held for Trading (HFT)

Securities where the intention is to trade by taking advantage of short-term price / interest rate
movements.

Available for Sale (AFS)

The securities available for sale are those securities where the intention of the bank is neither to
trade nor to hold till maturity. These securities are valued at the fair value which is determined

41
by reference to the best available source of current market quotations or other data relative to
current value.

Yield to maturity (YTM) or Yield

The Yield to maturity (YTM) is the yield promised to the bondholder on the assumption that the
bond will be held to maturity and coupon payments will be reinvested at the YTM. It is a measure
of the return of the bond.

Convexity
This represents the rate of change of duration. It is the difference between actual price of a
bond and the price estimated by modified duration.

Foreign Currency Convertible Bond

A bond issued in foreign currency abroad giving the investor the option to convert the bond into
equity at a fixed conversion price or as per a pre-determined pricing formula.

Trading Book
Investments in trading book are held for generating profits on the short term differences in
prices/yields. Held for trading (HFT) and Available for sale (AFS) category constitute trading book.

CRR
Cash reserve ratio is the cash parked by the banks in their specified current account maintained
with RBI.

SLR
Statutory liquidity ratio is in the form of cash (book value), gold (current market value) and
balances in unencumbered approved securities.

Stress testing
Stress testing is used to evaluate a bank‘s potential vulnerability to certain unlikely but plausible
events or movements in financial variables. The vulnerability is usually measured with reference
to the bank‘s profitability and /or capital adequacy.

Scenario Analysis
A method in which the earnings or value impact is computed for different interest rate scenario.

LIBOR
London Inter-Bank Offered Rate. The interest rate at which banks offer to lend funds in the
interbank market.

Basis Point
Is one hundredth of one percent is 1 basis point means 0.01%. Used for measuring change in
interest rate/yield.

Fraud
Frauds have been classified as under, based mainly on the provisions of the Indian Penal Code
a. Misappropriation and criminal breach of trust.

42
 b. Fraudulent encashment through forged instruments, manipulation of books of account or
through fictitious accounts and conversion of property.
c. Unauthorised credit facilities extended for reward or for illegal gratification.
d. Negligence and cash shortages.
e. Cheating and forgery.
f. Irregularities in foreign exchange transactions.
g. Any other type of fraud not coming under the specific heads as above.
4. Asset Securitization

Securitization
A process by which a single asset or a pool of assets are transferred from the balance sheet of the
originator (bank) to a bankruptcy remote SPV (trust) in return for an immediate cash payment.

Special Purpose Vehicle (SPV)

An entity which may be a trust company or other entity constituted or established by a ‗Deed‘ or
‗Agreement‘ for a specific purpose.

Bankruptcy remote
The legal position with reference to the creation of the SPV should be such that the SPV and its
assets would not be touched in case the originator of the securitization goes bankrupt and its
assets are liquidated.

Credit enhancement
These are the facilities offered to an SPV to cover the probable losses from the pool of
securitized assets. It is a credit risk cover given by the originator or a third party and meant for
the investors in any securitization process.

Custodian
An entity, usually a bank that actually holds the receivables as agent and bailee of the trustee.

First loss facility

First level of credit enhancement offered to an SPV as part of the process in bringing the
securities issued by SPV to investment grade.

Second loss facility

Credit enhancement providing the second or subsequent tier of protection to an SPV against
potential losses.

Value at Risk (VAR)

VAR is a single number (currency amount) which estimates the maximum expected loss of a
portfolio over a given time horizon (the holding period) and at a given confidence level. VAR is
defined as an estimate of potential loss in a position or asset/liability or portfolio of
assets/liabilities over a given holding period at a given level of certainty. The following are the
three main methodologies used to calculate VAR: Parametric Estimates - Estimates VAR using
parameters such as volatility and correlation. Accurate for traditional assets and linear
derivatives, but less accurate for non-linear derivatives. Monte Carlo simulation- Estimates VAR
by simulating random scenarios and revaluing positions in the portfolio. Appropriate for all types

43
of instruments, linear and nonlinear. Historical simulation- Estimates VAR by reliving history;
takes actual historical rates and revalues positions for each change in the market

Commercial real estate

Commercial real estate is defined as ―fund based and non-fund based exposures secured by
mortgages on commercial real estates (office buildings, retail space, multi-purpose commercial
premises, multi-family residential buildings, multi tenanted commercial premises, industrial or
warehouse space, hotels, land acquisition, development and construction etc.)‖

5. NDS-OM Web

Primary Member (PM)

A member of NDS-OM (having Constituent Subsidiary General Ledger (CSGL) and current account
with RBI) who authorizes their Gilt Account Holders to have direct access to the web enabled
NDS-OM system.

Gilt Account Holders (GAHs)

Non-NDS members who have gilt account and current account with PMs are termed as GAHs.
GAHs permitted by RBI include NBFCs, Provident Funds, Pension Funds,
Mutual Funds, Insurance Companies, Cooperative Banks, Regional Rural Banks, Trusts, Corporates,
Individuals etc.

Dedicated URL ndsind.com

Dedicated URL is a secure site, i.e., https// accessible only through deployment of requisite
digital certificates and tokens (for non-repudiation of transactions). The issuance and
management of digital certificates and security tokens would be the responsibility of the PM as
part of GAH creation and activation process. Regular renewals thereof would also be the PM‘s
responsibility.

Digital Certificates and e-tokens (PM)

Digital certificates are digital signatures to be obtained by PM from any Government Recognized
Certifying Authority designated by RBI, on behalf of GAH. For added security, the certificates
need to be installed in an e-token as per specifications approved. The digital certificate and
token specifications needs to be SHA 2 (2048 bit) compliant. Without the Digital certificate and
e-token, the GAH cannot log in to the NDS OM web based module. The Primary member will be
responsible for obtaining/renewal and intimating revocation to RBI/CCIL of the Digital Certificate
for such GAH users.

NDS OM Administrator (CCIL; NDS OM Admin)

The Administrator (CCIL) is the person who creates and activates the GAH in the web-based
system on the request of the PM and also authorizes the employees of GAH (GAH Users created by
PM) to access the system by generating login and password.

44
Authorized Users of Gilt Account Holder (GAH User)
Once GAH is created as a client of PM in the web-based system by CCIL (the NDS OM Admin),
Users of GAH are created by PM and later authorized by CCIL to access and operate the system.
While authorizing, CCIL generates the login ID and password for the GAH Users and forwards the
same to PM. PM in turn forwards the same to GAH to enable its employees (GAH Users) to log-in
to the Web Based Application (https://www.ndsind.com).

Client Head (PM)

The ‗Client Head is the super user at the PM end. Only ‗Client Head‘ has privileges to perform
actions like create GAH users, modify users, suspend users, unlock, log-off users, reset the login
password of users, set risk limits & take action on client bids etc. Only one user is possible in
every PM environment.

„Transactional‟ User (GAH)

These are GAH employees (GAH Users) who are authorized by PM to place, modify, cancel their
bids, view status of their bids and view the limits set by the PM & along with the current
utilization.

„View Only‟ User (GAH)

These are GAH employees (GAH Users) who have been provided with ‗View only‘ rights by the PM.
These employees have an aggregated view of all the activities and risk limits of all transactional
users under the respective GAH. It also includes view of issuance details and aggregate view of
bidding and allocation details of all transactional users.

Single Order Limit (SOL) for Trades

SOL shall mean the maximum order quantity (in terms of face value) that can be placed by the
concerned user through a single order.

Price/Yield Range Settings for Trades

NDS-OM Web shall validate that the price/yield of every order placed by a GAH user is within the
range specified by the Primary Member vis-à-vis the last traded price/yield for the concerned
security in the specific market.

Security Stock Balances Settings for Trades

Primary Members shall update the Security Stock Balances for each of their GAH. Once input,
NDS-OM shall automatically update the security balances based on activity undertaken on NDS-OM
Web on the same lines as that of NDS-OM. Adequacy of available free balances for each security
shall be validated before accepting a sale order(s) for any security. If the balance is not adequate,
the respective sale order shall be rejected.

Activity Control Settings for Trades

Primary Members shall assign Buy and / or Sell privileges to each of the Transactional Users of
their GAH through activity control settings.

Funding Limits Settings for Trades

45
Funding limits for trades represent the net aggregate settlement consideration amount up to
which the concerned GAH can accumulate net long fund positions arising out of trades concluded
on NDS-OM Web. This control shall be set for every GAH at the GAH user level. This limit
constitutes a trading limit which shall get reinstated at the beginning of every trading session for
every GAH.

Turnover Limits for Trades

Turnover limits represent the gross amount in face value terms computed by aggregating
individual ―buys‖ + ―sells‖ orders inputted on behalf of a GAH across all its users. This value is
expressed in consideration terms of the underlying security instrument and shall reflect the total
aggregate value that can be undertaken by the GAH for that trading session. This control shall be
set for every GAH at the user level. This limit constitutes a trading limit which shall get
reinstated at the beginning of every trading session for every GAH.

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 FM Notes 11 – Sovereign Gold Bond Scheme

1. What is Sovereign Gold Bond (SGB)? Who is the issuer?

SGBs are government securities denominated in grams of gold. They are substitutes for holding
physical gold. Investors have to pay the issue price in cash and the bonds will be redeemed in
cash on maturity. The Bond is issued by Reserve Bank on behalf of Government of India.
2. Why should I buy SGB rather than physical gold? What are the benefits?
The quantity of gold for which the investor pays is protected, since he receives the ongoing
market price at the time of redemption/ premature redemption. The 5GB offers a superior
alternative to holding gold in physical form. The risks and costs of storage are eliminated.
Investors are assured of the market value of gold at the time of maturity and periodical interest.
5GB is free from issues like making charges and purity in the case of gold in jewellery form. The
bonds are held in the books of the RBI or in demat form eliminating risk of loss of scrip etc.
3. Are there any risks in investing in SGBs?
There may be a risk of capital loss if the market price of gold declines. However, the investor
does not lose in terms of the units of gold which he has paid for.
4. Who is eligible to invest in the SGBs?
Persons resident in India as defined under Foreign Exchange Management Act, 1999 are eligible to
invest in SGB. Eligible investors include individuals, HUFs, trusts, universities, charitable
institutions, etc.
5. Whether joint holding will be allowed?
Yes, joint holding is allowed.
6. Can a Minor invest in 5GB?
Yes. The application on behalf of the minor has to be made by his/her guardian.
7. Where can investors get the application form?
The application form will be provided by the issuing banks/SHCIL offices/designated Post Offices/
National Stock Exchange of India Ltd. and Bombay Stock Exchange Ltd. /agents. It can also be
downloaded from the RBI‘s website. Banks may also provide online application facility.
8. What are the Know-Your-Customer (KYC) norms?
Know-Your-Customer (KYC) norms will be the same as that for purchase of physical form of gold.
Identification documents such as Aadhaar card/PAN or TAN /Passport / Voter ID card will be
required. KYC will be done by the issuing banks/SHCIL offices/Post Offices/ National Stock
Exchange of India Ltd. and Bombay Stock Exchange Ltd. /agents. No separate KYC will be needed
for receiving bank‘s own customers.

47
9. What is the minimum and maximum limit for investment?
The Bonds are issued in denominations of one gram of gold and in multiples thereof. Minimum
investment in the Bond shall be one gram with a maximum buying limit of
500 grams per person per fiscal year (April - March). In case of joint holding, the limit applies to
the first applicant.
10. Can I buy 500 grams in the name of each of my family members?
Yes, each family member can buy the bonds in his/her own name if they satisfy the eligibility
criteria as defined at Q No.4.
11. Can I buy 500 grams worth of 5GB every year?
Yes. One can buy 500 grams worth of gold every year as the ceiling has been fixed on a fiscal year
(April-March) basis.
12. Is the limit of 500 grams of gold applicable if I buy on the Exchanges?
The limit of 500 grams per financial year is applicable even if the bond is bought on the
exchanges.
13. What is the rate of interest and how will the interest be paid?
The Bonds bear interest at the rate of 2.75 per cent (fixed rate) per annum on the amount of
initial investment. Interest will be credited semi-annually to the bank account of the investor and
the last interest will be payable on maturity along with the principal.
14. Who are the authorized agencies selling the SGBs?
Bonds are sold through scheduled commercial banks (excluding RRB5), SHCIL offices, designated
Post Offices, National Stock Exchange of India Ltd. and Bombay Stock Exchange Ltd. either
directly or through their agents.
15. If I apply, am I assured of allotment?
If the customer meets the eligibility criteria, produces a valid identification document and remits
the application money on time, he/she will receive the allotment.
16. When will the customers be issued Holding Certificate?
The customers will be issued Certificate of Holding on the date of issuance of the SGB.
Certificate of Holding can be collected from the issuing banks/SHCIL offices/Post Offices/
National Stock Exchange of India Ltd. and Bombay Stock Exchange Ltd. /agents or obtained
directly from RBI on email, if email address is provided in the application form.
17. Can I apply online?
Yes. A customer can apply online through the website of the listed scheduled commercial banks.

48
18. At what price the bonds are sold?
Price of bond will be fixed in Indian Rupees on the basis of the previous week‘s (Monday - Friday)
simple average price for gold of 999 purity published by the India Bullion and Jewellers‟
Association Ltd. (IBJA). The issue price will be disseminated by the Reserve Bank of India
19. Will RBI publish the rate of gold applicable every day?
The price of gold for the relevant tranche will be published on RBI website two days before the
issue opens.
20. What will I get on redemption?
On maturity, the redemption proceeds will be equivalent to the prevailing market value of grams
of gold originally invested in Indian Rupees. The redemption price will be based on the simple
average of previous week‘s (Monday-Friday) closing gold price for 999 purity published by the
IBJA.
21. How will I get the redemption amount?
Both interest and redemption proceeds will be credited to the bank account furnished by the
customer at the time of buying the bond.
22. What are the procedures involved during redemption?
The investor will be advised one month before maturity regarding the ensuing maturity of the
bond. On the date of maturity, the maturity proceeds will be credited to the bank account as per
the details on record.
In case there are changes in any details, such as, account number, email ids, then the investor
must intimate the bank/SHCIL/PO/Stock Exchange promptly.
23. Can I encash the bond anytime I want? Is premature redemption allowed?
Though the tenor of the bond is 8 years, early encashment/redemption of the bond is allowed
after fifth year from the date of issue on coupon payment dates. The bond will be tradable on
Exchanges, if held in demat form. It can also be transferred to any other eligible investor.
24. What do I have to do if I want to exit my investment?
In case of premature redemption, investors can approach the concerned bank/SH CIL offices/Post
Office/National Stock Exchange of India Ltd. /Bombay Stock Exchange Ltd. /agent thirty days
before the coupon payment date. Request for premature redemption can only be entertained if
the investor approaches the concerned bank/post office/Stock Exchange at least one day before
the coupon payment date.
The proceeds will be credited to the customer‘s bank account provided at the time of applying
for the bond.
25. Can I gift the bonds to a relative or friend on some occasion?
The bond can be gifted/transferable to a relative/friend/anybody who fulfills the eligibility
criteria (as mentioned at Q.no. 4). The Bonds shall be transferable in accordance with the
provisions of the Government Securities Act 2006 and the Government Securities Regulations 2007

49
before maturity by execution of an instrument of transfer which is available with the issuing
agents.
26. Can I use these securities as collateral for loans?
Yes, these securities are eligible to be used as collateral for loans from banks, financial
Institutions and Non-Banking Financial Companies (NBFC). The Loan to Value ratio will be the
same as applicable to ordinary gold loan prescribed by RBI from time to time.
27. What are the tax implications on i) interest and ii) capital gain?
Interest on the Bonds will be taxable as per the provisions of the Income-tax Act, 1961 (43 of
1961). The capital gains tax arising on redemption of 5GB to an individual has been exempted.
The indexation benefits will be provided to long terms capital gains arising to any person on
transfer of bond.
28. Is tax deducted at source (TDS) applicable on the bond?
TDS is not applicable on the bond. However, it is the responsibility of the bond holder to comply
with the tax laws.
29. Who will provide other customer services to the investors after issuance of the bonds?
The issuing banks/SHCIL offices/Post Offices/Stock Exchanges/agents through which these
securities have been purchased will provide other customer services such as change of address,
early redemption, nomination, grievance redressal, transfer applications etc.
30. What are the payment options for investing in the Sovereign Gold Bonds?
Payment can be made through cash (upto ₹ 20000)/cheques/demand draft/electronic fund
transfer.
31. Whether nomination facility is available for these investments?
Yes, nomination facility is available as per the provisions of the Government Securities Act 2006
and Government Securities Regulations, 2007. A nomination form is available along with
Application form.
32. Is the maximum limit of 500 gms applicable in case of joint holding?
The maximum limit will be applicable to the first applicant in case of a joint holding for that
specific application.
33. Are institutions like banks allowed to invest in Sovereign Gold Bonds?
There is no bar on investment by banks in Sovereign Gold Bonds. These will qualify for SLR.
34. Can I get the bonds in demat form?
Yes. The bonds can be held in demat account. A specific request for the same must be made in
the application form itself. Till the process of dematerialization is completed, the bonds will be
held in RBIs books. The facility for conversion to demat will also be available subsequent to
allotment of the bond.

50
35. Can I trade these bonds?
The bonds are tradable from a date to be notified by RBI. (It may be noted that only bonds held
in demat form with depositories can be traded in stock exchanges) The bonds can also be sold
and transferred as per provisions of Government Securities Act, 2006
36. Can I get part repayment of these bonds at the time of exercising put option?
Yes, part holdings can be redeemed in multiples of one gm.
37. How do I contact RBI to address my queries regarding Sovereign Gold Bond?
A dedicated e-mail has been created by the Reserve Bank of India to receive queries from
members of public on Sovereign Gold Bonds. Investors can mail their queries to this email id.

51
 FM Notes 12 – Priority Sector Lending Certificates

1. What is the expiry date of Priority Sector Lending Certificates (PSLC)?

All PSLCs will be valid till March 31st and will expire on April 1st.
2. Whether PSLCs can be issued for a limited period i.e for one reporting quarter and
multiples thereof?
The duration of the PSLCs will depend on the date of issue with all PSLCs being valid till March
31st and expiring on April 1st.
3. Whether service tax/ stamp duty/ transaction tax will be applicable while paying fee for
PSLC?
PSLCs may be construed in the nature of goods, dealing in which has been notified as a
permissible activity under section 6(1) (0) of BR Act vide Government of India Notification dated
May 4, 2016. The tax implications on account of trading in PSLCs may be determined by the banks
in accordance with the applicable tax laws. Further, as per the extant guidelines, no transaction
charge / fees is applicable on the participating banks payable to RBI for usage of the PSLC
module on e-Kuber portal.
4. Whether PSLC - Weaker Sections or PSLC - Export Credit can be traded?
There are only four eligible categories of PSLCs i.e. PSLC General, PSLC Small and Marginal
Farmer, PSLC Agriculture & PSLC Micro Enterprises.
5. Whether Export Credit may form a part of PSLC General and whether banks surplus in
Exports can sell them as PSLC General?
‗Export Credit‘ can form a part of underlying assets against the PSLC - General. However, any
bank issuing PSLC-General against Export Credit shall ensure that the underlying ‗Export CrediV
portfolio is also eligible for priority sector classification by domestic banks.
6. Where can the banks look for market information like prevailing prices, lot size, and
historical transactions done by other market participants? Will this information be available
in E-Kuber?
The trade summary of PSLC market will be made available to the participants on weekly basis
through the e-Kuber portal shortly. The new functionality will be notified to the participants via
‗News & Announcements‘ section under e-Kuber portal.
7. Is secondary market allowed for PSLCs i.e., Sale of surplus at a later point in time post
purchase in anticipation of deficit at a prior point of time. Can the purchasing bank re-sell
the PSLCs? Will only the net PSLC position be reckoned for ascertaining the underlying asset?
A bank can purchase and issue PSLCs as per its requirements. The net position of PSLCs sold and
purchased has to be included while reporting the quarterly and annual priority sector returns.
However, with regard to ascertaining the underlying assets, as on March 31st, the bank must have
met the priority sector target by way of the sum of outstanding priority sector portfolio and net
of PSLCs issued and purchased.

52
8. What happens if the RBI inspection team, at a later date, de-classifies a particular PSLC
(which has been already traded by the bank as PSLC) ineligible?
The misclassifications, if any, will have to be reduced from the achievement of PSLC seller bank
only. There will be no counterparty risk for the PSLC buyer, even if, the underlying asset of the
traded PSLC gets misclassified.
9. While there is no transfer of assets, will there be any impact on the ANBC calculation?
The banks may refer to guidelines related to computation of ANBC for priority sector reporting as
advised vide Master Circular on Priority Sector Lending - Targets and Classification dated July 1,
2015.
10. The buyer would pay a fee to the seller of the PSLC which will be market determined. Is
there any standard/minimum fee prescribed by the RBI, for purchase of any PSLC?
The premium will be completely market determined. No floor/ceiling has been prescribed by RBI
in this regard.
11. How the charges/commission shall be paid through E-Kuber portal or separate RTGS is
required to be made?
There will be real time settlement of the matched premium and respective current accounts of
the participating banks with RBI will be debited/credited to the extent of matched premium
accordingly.
12. Will there be automatic matching of trades or can the buyer/seller select the
counterparty? Will partial matching also happen?
The order matching will be done on anonymous basis through the portal and the buyer/ seller
cannot select the counterparty. Partial matching will happen depending on the matching of
premium and availability of category wise PSLC lots for sale and purchase.

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 FM Notes 13 – Gold Monetisation Scheme

1. Query: Are banks required to obtain RBI approval to participate in the Gold Monetisation
Scheme, 2015?
Response: No. However, banks should submit to RBI the implementation details including names
of the CPTCs and refiners with whom they have entered into tripartite agreement and the
branches operating the scheme. Banks should also report the amount of gold mobilised under the
scheme by all branches in a consolidated manner on a monthly basis in the prescribed format.
2. Query: Can a deposit under the Scheme be made for 4 years or 8 years?
Response: No. However, a short term deposit initially made for 3 years could be rolled over for
another year. The roll over facility is not available for medium and long term deposits.
3. Query: Is it mandatory to complete the KYC for potential customers of GMS prior to
depositing gold?
Response: Yes, unless the potential depositor is already a bank‘s KYC compliant customer.
4. Query: How will a Collection and Purity Testing Centre (CPTC) know that a depositor is
already KYC compliant?
Response: Banks and the CPTCs may put in place a mutually acceptable procedure in this regard
and notify that to the relevant CPTCs.
5. Query: Can a customer get back his jewellery if the purity determined by the CPTC is not
acceptable to him/her and he/she does not want to invest in the GMS?
Response: The jewellery will be melted by the CPTC to conduct the fire assay and the customer
can get back gold only in post-melted form. The jewellery can be taken back in original form
before fire-assaying. Thus, the decision regarding taking back jewellery in original form has to be
taken by the customer after XRF test and before giving consent for fire-assaying.
6. Query: Will the refined amount of gold deposited be credited only after receipt from the
customer the Deposit Receipt issued by the CPTC? What if the customer produces the
certificate at the bank but no intimation from the CPTC and Refinery has been received?
Response: No, regardless of the submission of the Deposit Receipt by the customer, the deposit
taking bank will credit in the deposit account the amount of refined gold on receipt of intimation
from the CPTC about the deposit, and from the Refiner regarding the refined gold being ready for
use by the bank, but in any case not later than 30 days from the date of deposit at the CTPC. In
cases where the Deposit Receipt is submitted by the customer before receipt of the relevant
advice from the CPTC/Refinery, the bank should make enquiry with these entities and take
further action based on the response.
7. Query: In what form will the depositor get back his gold at maturity?
Response: If the depositor opts for redemption in the form gold, he will get back physical gold at
maturity in the form of bullion.

54
8. Query: Is the option of redeeming deposit in gold is available under both short term bank
deposits and medium and long term bank deposits?
Response: No, the option of redemption of the deposit in the form of gold is available only under
the Short Term Bank Deposits. The Medium and Long term deposits will be redeemed only in
Indian Rupees (INR).
9. Query: Can a bank make repayment of the partial amount of gold (less than one gram) in
INR in cases where the redemption is in gold?
Response: Yes. In case the maturity amount comes to, say 302.86 grams of gold, and the
customer has to be paid in gold, a bank can repay 302 grams in gold and 0.86 grams in equivalent
amount of INR.
10. Query: Who determines the rate of interest on the Medium and Long Term Deposits?
Response: It will be determined by the Central Government and advised to banks by RBI.
11. Query: Will a designated bank get any commission for servicing the MLTGD product?
Response: Yes.
12. Query: Is it compulsory for banks to participate in the auction of gold collected under the
Medium and Long Term Deposit schemes?
Response: No.
13. Query: Can a designated bank purchase/borrow gold from local banks and refiners to
replenish the GMS gold at maturity.
Response: Yes.
14. Query: Can banks hedge their gold exposures arising from operation of GMS?
Response: Yes, in international markets.
15. Query: Whether banks are allowed to hedge the price risk of gold under Gold
Monetization Scheme, 2015 in the local commodity exchanges?
Response: Yes. Banks are allowed to hedge their exposure in local commodity exchanges under
Gold Monetization Scheme.
16. Query: Whether rupee loan is allowed against collateral of GMS deposits?
Response: Yes. Rupee loans may be given against collateral of gold deposits under Gold
Monetization Scheme.
17. Query: What is the periodicity of interest payment under MLTGD?
Response: The periodicity of interest payment in case of Medium and Long Term Government
Deposit (MLTGD) is annual.
18. Query: Whether interbank lending of gold mobilized under GMS is allowed?

55
Response: Yes. Designated banks are allowed to lend gold mobilized under the Scheme to other
designated banks for similar use as prescribed under the scheme.

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 FM Notes 14 – Priority Sector Lending – Targets and
Classification

1. What are the different categories under priority sector?

Priority Sector includes the following categories:
1. Agriculture
2. Micro, Small and Medium Enterprises
3. Export Credit
4. Education
5. Housing
6. Social Infrastructure
7. Renewable Energy
8. Others
2. What are the Targets and Sub-targets for banks under priority sector?
The targets and sub-targets for banks under priority sector are as follows:

Domestic scheduled commercial banks and Foreign banks with less

Categories
Foreign banks with 20 branches above than 20 branches
Total Priority Sector 40 percent of Adjusted Net Bank Credit or 40 40 percent of Adjusted
percent of Credit Equivalent Amount of Net Bank Credit or
Off-Balance Sheet Exposure, whichever is Credit Equivalent
higher. Amount of Off-
Foreign banks with 20 branches and above have Balance Sheet
to Exposure,
achieve the Total Priority Sector within a Whichever is higher; to
maximum be achieved in a
period five years starting from April 1, 2013 and phased
ending on March 31, 2018 as per the action Manner by 2020.
plans submitted by them and approved by RBI.
Agriculture # 18 percent of ANBC or Credit Equivalent Amount Not Applicable
# Domestic banks of Off-Balance Sheet Exposure, whichever is
have been directed higher. Within the 18 percent target for
to agriculture, a Target of 8 percent of ANBC or
ensure that their Credit Equivalent
overall direct of Off-Balance Sheet Exposure, Whichever is
lending higher is prescribed for small and Marginal
to non-corporate Farmers, to be achieved in a phased manner
farmers does not i.e, 7 percent by
fall March 2016 and 8% by March 2017. Foreign
below the system- banks
wide average of the with 20 branches and above have to achieve the
last three years Agriculture target within a maximum period of
achievement. Five years starting from April 1, 2013 and ending
on
March 31, 2018 as per the action plans

57
 submitted by them and approved by RBI. The
Sub-target for
Small and Marginal farmers would be made
applicable post 2018 after a review in 2017.
Micro Enterprises 7.5 percent of ANBC or Credit Equivalent Not Applicable
Amount of Off-Balance Sheet Exposure,
whichever is higher to be achieved in a phased
manner i.e 7 percent by
March 2017. The Sub-target for Micro
Enterprises
for foreign banks with 20 branches and above
would
be made applicable post 2018 after a review
in2017.
Advances to weaker Advances to Weaker Sections 10 % percent of Not Applicable
Sectors ANBC or Credit Equivalent Amount of Off-
Balance Sheet Exposure, Whichever is higher.
Foreign banks with 20 branches and above have
to achieve the Weaker Section Target within a
maximum period of five years starting from
April 1, 2013 and ending on March 31, 2018 as
per the action plans submitted by them and
approved by RBI.

3. What are the categories under „Agriculture‟?

The activities covered under Agriculture are classified under three sub-categories viz. Farm
credit, Agriculture infrastructure and Ancillary activities.
4. Whether limits are prescribed for loans sanctioned to Micro, Small and Medium Enterprises
to be classified as priority sector?
For classification under priority sector, no limits are prescribed for bank loans sanctioned to
Micro, Small and Medium Enterprises engaged in the manufacture or production of goods under
any industry specified in the first schedule to the Industries (Development and Regulation) Act,
1951 and as notified by the Government from time to time. The manufacturing enterprises are
defined in terms of investment in plant and machinery under MSMED Act, 2006. Bank loans up to
₹5 crore per unit to Micro and Small Enterprises and ₹10 crore to Medium Enterprises engaged in
providing or rendering of services and defined in terms of investment in equipment under MSMED
Act, 2006 are eligible for classification under priority sector.
5. What is the applicable limit and purpose for social infrastructure loans under priority
sector?
Bank loans up to a limit of ₹5 crore per borrower for building social infrastructure for activities
namely schools, health care facilities, drinking water facilities and sanitation facilities (including
loans for construction/refurbishment of toilets and improvement in water facilities in the
household) in Tier II to Tier VI centres are eligible for classification under priority sector.

58
Bank credit to Micro Finance Institutions (MFI) extended for on-lending to Individuals/ members
of SHGs/ JLGs for water and sanitation facilities is also eligible for classification as priority sector
loans under a Social Infrastructure‘ subject to certain criteria.
6. What is the applicable limit and purpose for loans for renewable energy under priority
sector?
Bank loans up to a limit of ₹15 crore to borrowers for purposes like solar based power generators,
biomass based power generators, wind mills, micro-hydel plants and for non-conventional energy
based public utilities viz. Street lighting systems, and remote village electrification are eligible to
be classified under priority sector loans under Renewable Energy‘. For individual households, the
loan limit is ₹10 lakh per borrower.
7. What is the loan limit for education under priority sector?
Loans to individuals for educational purposes including vocational courses upto ₹10 lakh
irrespective of the sanctioned amount are eligible for classification under priority sector.
8. What is the limit for housing loans under priority sector?
Loans to individuals up to ₹28 lakh in metropolitan centres (with population of ten lakh and
above) and loans up to ₹20 lakh in other centres for purchase/construction of a dwelling unit per
family, are eligible to be considered as priority sector provided the overall cost of the dwelling
unit in the metropolitan centre and at other centres does not exceed ₹35 Iakh and ₹25 lakh,
respectively.
Housing loans to banks‘ own employees are not eligible for classification under priority sector.
9. What is included under Weaker Sections under priority sector?
Priority sector loans to the following borrowers are eligible to be considered under Weaker
Sections category:
1. Small and Marginal Farmers
2. Artisans, village and cottage industries where individual credit limits do not exceed ₹1 lakh
3. Beneficiaries under Government Sponsored Schemes such as National Rural Livelihoods
Mission (NRLM), National Urban Livelihood Mission (NULM) and Self Employment Scheme for
Rehabilitation of Manual Scavengers (SRMS)
4. Scheduled Castes and Scheduled Tribes
5. Beneficiaries of Differential Rate of Interest (DRI) scheme
6. Self Help Groups
7. Distressed farmers indebted to non-institutional lenders
8. Distressed persons other than farmers, with loan amount not exceeding ₹1 lakh per borrower
to prepay their debt to non-institutional lenders Individual women beneficiaries up to ₹1 lakh
per borrower
9. Persons with disabilities
10. Overdrafts upto ₹5,000I- under Pradhan Mantri Jan-DhanYojana (PMJDY) accounts, provided
the borrowers‘ household annual income does not exceed ₹100,000/- for rural areas and
₹l,60,000/- for non-rural areas
11. Minority communities as may be notified by Government of India from time to time

59
12. In States, where one of the minority communities notified is, in fact, in majority, item (12)
will cover only the other notified minorities. These States/ Union Territories are Jammu &
Kashmir, Punjab, Meghalaya, Mizoram, Nagaland and Lakshadweep.
10. Is bank credit to Micro Finance Institutions (M FIs) treated as priority sector lending?
Bank credit to MFIs extended for on-lending to individuals and also to members of SHGs / JLGs is
eligible for categorisation as priority sector advance under respective categories viz., Agriculture,
Micro, Small and Medium Enterprises, Social Infrastructure and Others.

11. What are Priority Sector Lending Certificates (PSLCs)?

Priority Sector Lending Certificates (PSLCs) are a mechanism to enable banks to achieve the
priority sector lending target and sub-targets by purchase of these instruments in the event of
shortfall. This also incentivizes surplus banks as it allows them to sell their excess achievement
over targets thereby enhancing lending to the categories under priority sector. Under the PSLC
mechanism, the seller sells fulfilment of priority sector obligation and the buyer buys the
obligation with no transfer of risk or loan assets.
12. What are the instructions to Banks with regard to acknowledgement of priority sector
loan applications?
Banks should provide acknowledgement for loan applications received under priority sector loan.
A time limit is required to be prescribed by the Bank Board within which the bank communicates
its decision in writing to the applicants.
13. What is the rate of interest for loans under priority sector?
The rate of interest on bank loans will be as per directives issued by the Department of Banking
Regulation of RBI, from time to time. Priority sector guidelines do not lay down any preferential
rate of interest for priority sector loans.

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 FM Notes 15 – Commercial Paper

1. What is Commercial Paper (CP)?

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note.
2. When it was introduced?
It was introduced in India in 1990.
3. Why it was introduced?
It was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to
diversify their sources of short-term borrowings and to provide an additional instrument to
investors. Subsequently, primary dealers and all-India financial institutions were also permitted
to issue CP to enable them to meet their short-term funding requirements for their operations.
4. Who can issue CP?
Corporates, primary dealers (PDs) and the All-India Financial Institutions (FIs) are eligible to issue
CR
5. Whether all the corporates would automatically be eligible to issue CP?
No. A corporate would be eligible to issue CP provided -
a. The tangible net worth of the company, as per the latest audited balance sheet, is not less
than ₹ 4 crore
b. Company has been sanctioned working capital limit by bank/s or all-India financial
institution/s; and
c. The borrowal account of the company is classified as a Standard Asset by the financing
bank/s/ institution/s.
6. Is there any rating requirement for issuance of CP? And if so, what is the rating
requirement?
Yes. All eligible participants shall obtain the credit rating for issuance of Commercial Paper
either from Credit Rating Information Services of India Ltd. (CRISIL) or the Investment
Information and Credit Rating Agency of India Ltd. OCRA) or the Credit Analysis and Research Ltd.
(CARE) or the FITCH Ratings India Pvt. Ltd. or such other credit rating agency (CRA) as may be
specified by the Reserve Bank of India from time to timer for the purpose.
The minimum credit rating shall be A-2 [As per rating symbol and definition prescribed by
Securities and Exchange Board of India (SEBI)]. The issuers shall ensure at the time of issuance of
CP that the rating so obtained is current and has not fallen due for review.
7. What is the minimum and maximum period of maturity prescribed for CP?
CP can be issued for maturities between a minimum of 7 days and a maximum of up to one year
from the date of issue. However, the maturity date of the CP should not go beyond the date up
to which the credit rating of the issuer is valid.

61
8. What is the limit up to which a CP can be issued?
The aggregate amount of CP from an issuer shall be within the limit as approved by its Board of
Directors or the quantum indicated by the Credit Rating Agency for the specified rating,
whichever is lower.
As regards FIs, they can issue CP within the overall umbrella limit prescribed in the Master
Circular on Resource Raising Norms for FIs, issued by DBOD and updated from time-to-time.
9. In what denominations a CP that can be issued?
CP can be issued in denominations of ₹5 lakh or multiples thereof.
10. How long can the CP issue remain open?
The total amount of CP proposed to be issued should be raised within a period of two weeks from
the date on which the issuer opens the issue for subscription.
11. Whether CP can be issued on different dates by the same issuer?
Yes. CP may be issued on a single date or in parts on different dates provided that in the latter
case, each CP shall have the same maturity date. Further, every issue of CP, including renewal,
shall be treated as a fresh issue.
12. Who can act as Issuing and Paying Agent (IPA)?
Only a scheduled bank can act as an IPA for issuance of CP.
13. Who can invest in CP?
Individuals, banking companies, other corporate bodies (registered or incorporated in India) and
unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIls) etc.
can invest in CPs. However, investment by FITs would be within the limits set for them by
Securities and Exchange Board of India (SEBI) from time-to-time.
14. Whether CP can be held in dematerilaised form?
Yes. CP can be issued either in the form of a promissory note (Schedule I given in the Master
Circular-Guidelines for Issue of Commercial Paper dated July 1, 2011 and updated from time —to-
time) or in a dematerialised form through any of the depositories approved by and registered
with SEBI. Banks, FIs and PDs can hold CP only in dematerialised form.
15. Whether CP is always issued at a discount?
Yes. CP will be issued at a discount to face value as may be determined by the issuer.
16. Whether CP can be underwritten?
No issuer shall have the issue of Commercial Paper underwritten or co-accepted.
17. Whether CPs are traded in the secondary market?
Yes. CPs are actively traded in the OTC market. Such transactions, however, are to be reported
on the FIMMDA reporting platform within 15 minutes of the trade for dissemination of trade
information to market participation thereby ensuring market transparency.

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18. What is the mode of redemption?
Initially the investor in CP is required to pay only 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,
a. When the CP is held in physical form, the holder of the CP shall present the instrument for
payment to the issuer through the IPA.
b. When the CP is held in demat form, the holder of the CP will have to get it redeemed
through the depository and receive payment from the IPA.
19. Whether Stand by facility is required to be provided by the bankers/FIs for CP issue?
CP being a ‗standalone‘ product it would not be obligatory in any manner on the part of banks
and FIs to provide stand-by facility to the issuers of CP.
However, Banks and FIs have the flexibility to provide for a CP issue, credit enhancement by way
of stand-by assistance/credit backstop facility, etc., based on their commercial judgment and as
per terms prescribed by them. This will be subjected to prudential norms as applicable and
subject to specific approval of the Board.
20. Whether non-bank entities/corporates can provide guarantee for credit enhancement of
the CP issue?
Yes. Non-bank entities including corporates can provide unconditional and irrevocable guarantee
for credit enhancement for CP issue provided:
a. The issuer fulfils the eligibility criteria prescribed for issuance of CP;
b. The guarantor has a credit rating at least one notch higher than the issuer by an approved
credit rating agency and
c. The offer document for CP properly discloses: the networth 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 will be invoked.
21. Role and responsibilities of the Issuer/Issuing and Paying Agent and Credit Rating Agency.
Issuer:
a. Every issuer must appoint an IPA for issuance of CP.
b. The issuer should disclose to the potential investors its financial position as per the standard
market practice.
c. After the exchange of deal confirmation between the investor and the issuer, issuing
company shall issue physical certificates to the investor or arrange for crediting the CP to
the investor‘s account with a depository.
Investors shall be given a copy of IPA certificate to the effect that the issuer has a valid
agreement with the IPA and documents are in order (Schedule II given in the Master Circular-
Guidelines for Issue of Commercial Paper dated July 1, 2011 and updated from time – to - time).

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Issuing and Paying Agent:
a. IPA would ensure that issuer has the minimum credit rating as stipulated by the RBI and
amount mobilised through issuance of CP is within the quantum indicated by CRA for the
specified rating or as approved by its Board of Directors, whichever is lower.
b. IPA has to verify all the documents submitted by the issuer viz., copy of board resolution,
signatures of authorised executants (when CP in physical form) and issue a certificate that
documents are in order. It should also certify that it has a valid agreement with the issuer
(Schedule II given in the Master Circular-Guidelines for Issue of Commercial Paper dated
July 1, 2011 and updated from time – to - time).
c. Certified copies of original documents verified by the IPA should be held in the custody of
IPA.
Credit Rating Agency:
a. Code of Conduct prescribed by the SEBI for CRAs for undertaking rating of capital market
instruments shall be applicable to them (CRAs) for rating CP.
b. Further, the credit rating agencies have the discretion to determine the validity period of
the rating depending upon its perception about the strength of the issuer. Accordingly, CRA
shall at the time of rating, clearly indicate the date when the rating is due for review.
c. While the CRAs can decide the validity period of credit rating, CRAs would have to closely
monitor the rating assigned to issuers vis-a-vis their track record at regular intervals and
would be required to make its revision in the ratings public through its publications and
website
22. Is there any other formalities and reporting requirement with regard to CP issue?
Fixed Income Money Market and Derivatives Association of India (FIMMDA), may prescribe, in
consultation with the RBI, any standardised procedure and documentation for operational
flexibility and smooth functioning of CP market.
Issuers / IPAs may refer to the detailed guidelines issued by FIMMDA on July 5, 2001 Every CP
issue should be reported to the Chief General Manager, Reserve Bank of India, Financial Markets
Department, Central Office, Fort, Mumbai through the Issuing and Paying Agent (IPA) within three
days from the date of completion of the issue, incorporating details as per Schedule III given in
the Master Circular Guidelines for Issue of Commercial Paper dated July 1, 2011 and updated
from time to-time.

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 FM Notes 16 – Goods and Services Tax (GST)

Question 1.What is GST? How does it work?

Answer: GST is one indirect tax for the whole nation, which will make India one unified common
market.
GST is a single tax on the supply of goods and services, right from the manufacturer to the
consumer. Credits of input taxes paid at each stage will be available in the subsequent stage of
value addition, which makes GST essentially a tax only on value addition at each stage. The final
consumer will thus bear only the GST charged by the last dealer in the supply chain, with set-off
benefits at all the previous stages.
Question 2. What are the benefits of GST?
Answer: The benefits of GST can be summarized as under:
- For business and industry
- Easy compliance: A robust and comprehensive IT system would be the foundation of the GST
regime in India.
- Therefore, all tax payer services such as registrations, returns, payments, etc. would be
available to the taxpayers online, which would make compliance easy and transparent.
- Uniformity of tax rates and structures: GST will ensure that indirect tax rates and structures
are common across the country, thereby increasing certainty and ease of doing business. In
other words, GST would make doing business in the country tax neutral, irrespective of the
choice of place of doing business.
- Removal of cascading: A system of seamless tax-credits throughout the value-chain, and
across boundaries of States, would ensure that there is minimal cascading of taxes. This would
reduce hidden costs of doing business.
- Improved competitiveness: Reduction in transaction costs of doing business would eventually
lead to an improved competitiveness for the trade and industry.
- Gain to manufacturers and exporters: The subsuming of major Central and State taxes in GST,
complete and comprehensive set-off of input goods and services and phasing out of Central
Sales Tax (CST) would reduce the cost of locally manufactured goods and services. This will
increase the competitiveness of Indian goods and services in the international market and give
boost to Indian exports. The uniformity in tax rates and procedures across the country will also
go a long way in reducing the compliance cos
For Central and State Governments
- Simple and easy to administer: Multiple indirect taxes at the Central and State levels are
being replaced by GST. Backed with a robust end-to-end IT system, GST would be simpler and
easier to administer than all other indirect taxes of the Centre and State levied so far.
- Better controls on leakage: GST will result in better tax compliance due to a robust IT
infrastructure. Due to the seamless transfer of input tax credit from one stage to another in
the chain of value addition, there is an in- built mechanism in the design of GST that would
incentivize tax compliance by traders.

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- Higher revenue efficiency: GST is expected to decrease the cost of collection of tax revenues
of the Government, and will therefore, lead to higher revenue efficiency.

For the consumer

- Single and transparent tax proportionate to the value of goods and services: Due to
multiple indirect taxes being levied by the Centre and State, with incomplete or no input tax
credits available at progressive stages of value addition, the cost of most goods and services in
the country today are laden with many hidden taxes. Under GST, there would be only one tax
from the manufacturer to the consumer, leading to transparency of taxes paid to the final
consumer.
- Relief in overall tax burden: Because of efficiency gains and prevention of leakages, the
overall tax burden on most commodities will come down, which will benefit consumers.
Question 3. Which taxes at the Centre and State level are being subsumed into GST?
Answer:
At the Central level, the following taxes are being subsumed:
- Central Excise Duty,
- Additional Excise Duty,
- Service Tax,
- Additional Customs Duty commonly known as Countervailing Duty, and
- Special Additional Duty of Customs.
At the State level,the following taxes are being subsumed:
- Subsuming of State Value Added Tax/Sales Tax,
- Entertainment Tax (other than the tax levied by the local bodies), Central Sales Tax (levied by
the Centre and collected by the States),
- Octroi and Entry tax,
- Purchase Tax,
- Luxury tax, and
- Taxes on lottery, betting and gambling.
Question 4. What are the major chronological events that have led to the introduction of
GST?
Answer: GST is being introduced in the country after a 13 year long journey since it was first
discussed in the report of the Kelkar Task Force on indirect taxes. A brief chronology outlining
the major milestones on the proposal for introduction of GST in India is as follows:
- In 2003, the Kelkar Task Force on indirect tax had suggested a comprehensive Goods and
Services Tax (GST) based on VAT principle.
- A proposal to introduce a National level Goods and Services Tax (GST) by April 1, 2010 was first
mooted in the Budget Speech for the financial year 2006-07.
- Since the proposal involved reform/restructuring of not only indirect taxes levied by the
Centre but also the States, the responsibility of preparing a Design and Road Map for the

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 implementation of GST was assigned to the Empowered Committee of State Finance Ministers
(EC).
- Based on inputs from Govt of India and States, the EC released its First Discussion Paper on
Goods and Services Tax in India in November, 2009.
- In order to take the GST related work further, a Joint Working Group consisting of officers
from Central as well as State Government was constituted in September, 2009.
- In order to amend the Constitution to enable introduction of GST, the Constitution (115th
Amendment) Bill was introduced in the Lok Sabha in March 2011. As per the prescribed
procedure, the Bill was referred to the Standing Committee on Finance of the Parliament for
examination and report.
- Meanwhile, in pursuance of the decision taken in a meeting between the Union Finance
Minister and the Empowered Committee of State Finance Ministers on 8th November, 2012, an
ECommittee on GST Designee, consisting of the officials of the Government of India, State
Governments and the Empowered Committee was constituted.
- This Committee did a detailed discussion on GST design including the Constitution (115th)
Amendment Bill and submitted its report in January, 2013. Based on this Report, the EC
recommended certain changes in the Constitution Amendment Bill in their meeting at
Bhubaneswar in January 2013.
- The Empowered Committee in the Bhubaneswar meeting also decided to constitute three
committees of officers to discuss and report on various aspects of GST as follows:
- Revenue Neutral Rates;
- Committee on dual control, threshold and exemptions;
- Committee on IGST and GST on imports.
- The Parliamentary Standing Committee submitted its Report in August, 2013 to the Lok Sabha.
The recommendations of the Empowered Committee and the recommendations of the
Parliamentary Standing Committee were examined in the Ministry in consultation with the
Legislative Department. Most of the recommendations made by the Empowered Committee
and the Parliamentary Standing Committee were accepted and the draft Amendment Bill was
suitably revised.
- The final draft Constitutional Amendment Bill incorporating the above stated changes were
sent to the Empowered Committee for consideration in September 2013.
- The EC once again made certain recommendations on the Bill after its meeting in Shillong in
November 2013. Certain recommendations of the Empowered Committee were incorporated in
the draft Constitution (115th Amendment) Bill. The revised draft was sent for consideration of
the Empowered Committee in March, 2014.
- The 115th Constitutional (Amendment) Bill, 2011, for the introduction of GST introduced in the
Lok Sabha in March 2011 lapsed with the dissolution of the 15th Lok Sabha.
- In June 2014, the draft Constitution Amendment Bill was sent to the Empowered Committee
after approval of the new Government.
- Based on a broad consensus reached with the Empowered Committee on the contours of the
Bill, the Cabinet on 17.12.2014 approved the proposal for introduction of a Bill in the
Parliament for amending the Constitution of India to facilitate the introduction of Goods and
Services Tax (GST) in the country. The Bill was introduced in the Lok Sabha on 19.12.2014, and
was passed by the Lok Sabha on 06.05.2015. It was then referred to the Select Committee of
Rajya Sabha, which submitted its report on 22.07.2015.
Question 5.How would GST be administered in India?

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Answer: Keeping in mind the federal structure of India, there will be two components of GST -
Central GST (CGST) and State GST (SGST). Both Centre and States will simultaneously levy GST
across the value chain.
Tax will be levied on every supply of goods and services. Centre would levy and collect Central
Goods and Services Tax (CGST), and States would levy and collect the State Goods and Services
Tax (SGST) on all transactions within a State. The input tax credit of CGST would be available for
discharging the CGST liability on the output at each stage. Similarly, the credit of SGST paid on
inputs would be allowed for paying the SGST on output. No cross utilization of credit would be
permitted.
Question 6.How would a particular transaction of goods and services be taxed simultaneously
under Central GST (CGST) and State GST (SGST)?
Answer: The Central GST and the State GST would be levied simultaneously on every transaction
of supply of goods and services except on exempted goods and services, goods which are outside
the purview of GST and the transactions which are below the prescribed threshold limits. Further,
both would be levied on the same price or value unlike State VAT which is levied on the value of
the goods inclusive of Central Excise.
A diagrammatic representation of the working of the Dual GST model within a State is shown in
Figure 1 below.

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Question 7.Will cross utilization of credits between goods and services be allowed under GST
regime?
Answer: Cross utilization of credit of CGST between goods and services would be allowed.
Similarly, the facility of cross utilization of credit will be available in case of SGST. However, the
cross utilization of CGST and SGST would not be allowed except in the case of inter-State supply
of goods and services under the IGST model which is explained in answer to the next question.
Question 8.How will be Inter State Transactions of Goods and Services be taxed under GST in
terms of IGST method?
Answer: In case of inter-State transactions, the Centre would levy and collect the Integrated
Goods and Services Tax (IGST) on all inter-State supplies of goods and services under Article 269A
(1) of the Constitution. The IGST would roughly be equal to CGST plus SGST. The IGST mechanism
has been designed to ensure seamless flow of input tax credit from one State to another.
The inter-State seller would pay IGST on the sale of his goods to the Central Government after
adjusting credit of IGST, CGST and SGST on his purchases (in that order). The exporting State will
transfer to the Centre the credit of SGST used in payment of IGST. The importing dealer will
claim credit of IGST while discharging his output tax liability (both CGST and SGST) in his own
State.
The Centre will transfer to the importing State the credit of IGST used in payment of SGST. Since
GST is a destination-based tax, all SGST on the final product will ordinarily accrue to the
consuming State.
A diagrammatic representation of the working of the IGST model for inter-State transactions is
shown in Figure 2 below.

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Question 9.How will IT be used for the implementation of GST?
Answer: For the implementation of GST in the country, the Central and State Governments have
jointly registered Goods and Services Tax Network (GSTN) as a not-for-profit, non-Government
Company to provide shared IT infrastructure and services to Central and State Governments, tax
payers and other stakeholders. The key objectives of GSTN are to provide a standard and uniform
interface to the taxpayers, and shared infrastructure and services to Central and State/UT
governments.
GSTN is working on developing a state-of-the-art comprehensive IT infrastructure including the
common GST portal providing frontend services of registration, returns and payments to all
taxpayers, as well as the backend IT modules for certain States that include processing of returns,
registrations, audits, assessments, appeals, etc. All States, accounting authorities, RBI and banks,
are also preparing their IT infrastructure for the administration of GST.
There would no manual filing of returns. All taxes can also be paid online. All mismatched returns
would be auto-generated, and there would be no need for manual interventions. Most returns
would be self-assessed.
Question 10.How will imports be taxed under GST?
Answer: The Additional Duty of Excise or CVD and the Special Additional Duty or SAD presently
being levied on imports will be subsumed under GST. As per explanation to clause (1) of article
269A of the Constitution, IGST will be levied on all imports into the territory of India. Unlike in

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the present regime, the States where imported goods are consumed will now gain their share
from this IGST paid on imported goods.
Question 11.What are the major features of the Constitution (122nd Amendment) Bill, 2014?
Answer: The salient features of the Bill are as follows:
- Conferring simultaneous power upon Parliament and the State Legislatures to make laws
governing goods and services tax;
- Subsuming of various Central indirect taxes and levies such as Central Excise Duty, Additional
Excise Duties, Service Tax, Additional Customs Duty commonly known as Countervailing Duty,
and Special Additional Duty of Customs; Subsuming of State Value Added Tax/Sales Tax,
Entertainment Tax (other than the tax levied by the local bodies), Central Sales Tax (levied by
the Centre and collected by the States), Octroi and Entry tax, Purchase Tax, Luxury tax, and
Taxes on lottery, betting and gambling;
- Dispensing with the concept of declared goods of special importance under the Constitution;
- Levy of Integrated Goods and Services Tax on inter-State transactions of goods and services;
- GST to be levied on all goods and services, except alcoholic liquor for human consumption.
Petroleum and petroleum products shall be subject to the levy of GST on a later date notified
on the recommendation of the Goods and Services Tax Council; Compensation to the States for
loss of revenue arising on account of implementation of the Goods and Services Tax for a
period of five years;
- Creation of Goods and Services Tax Council to examine issues relating to goods and services
tax and make recommendations to the Union and the States on parameters like rates, taxes,
cesses and surcharges to be subsumed, exemption list and threshold limits, Model GST laws,
etc. The Council shall function under the Chairmanship of the Union Finance Minister and will
have all the State Governments as Members.
Question 12.What are the major features of the proposed registration procedures under GST?
Answer: The major features of the proposed registration procedures under GST are as follows:
- Existing dealers: Existing VAT/Central excise/Service Tax payers will not have to apply afresh
for registration under GST.
- New dealers: Single application to be filed online for registration under GST.
- The registration number will be PAN based and will serve the purpose for Centre and State.
- Unified application to both tax authorities.
- Each dealer to be given unique ID GSTIN.
- Deemed approval within three days.
- Post registration verification in risk based cases only.
Question 13. What are the major features of the proposed returns filing procedures under
GST?
Answer: The major features of the proposed returns filing procedures under GST are as follows:
- Common return would serve the purpose of both Centre and State Government.
- There are eight forms provided for in the GST business processes for filing for returns. Most of
the average tax payers would be using only four forms for filing their returns. These are return
for supplies, return for purchases, monthly returns and annual return.

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- Small taxpayers: Small taxpayers who have opted corn position scheme shall have to file
return on quarterly basis.
- Filing of returns shall be completely online. All taxes can also be paid online
Question 14.What are the major features of the proposed payment procedures under GST?
Answer: The major features of the proposed payments procedures under GST are as follows:
- Electronic payment process- no generation of paper at any stage
- Single point interface for challan generation- GSTN
- Ease of payment - payment can be made through online banking, Credit Card/Debit Card,
NEFT/RTGS and through cheque/cash at the bank Common challan form with auto population
features
- Use of single challan and single payment instrument Common set of authorized banks Common
Accounting Codes

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 FM Notes 17 – HRD

HRD (Human Resources Development) has been defined by various scholars in various ways. Some
of the important definitions of HRD (Human Resources Development) are as follows:
1. According to Leonard Nadler, ‗Human resource development is a series of organized activities,
conducted within a specialized time and designed to produce behavioural changes.‖
2. In the words of Prof. T.V. Rao, ―HRD is a process by which the employees of an organization
are helped in a continuous and planned way to (i) acquire or sharpen capabilities required to
perform various functions associated with their present or expected future roles; (ii) develop
their journal capabilities as individual and discover and exploit their own inner potential for
their own and /or organizational development purposes; (iii) develop an organizational culture
in which superior- subordinate relationship, team work and collaboration among sub-units are
strong and contribute to the professional well-being, motivation and pride of employees.‖ .
3. According to M.M. Khan, ―Human resource development is the across of increasing knowledge,
capabilities and positive work attitudes of all people working at all levels in a business
undertaking.‖
Human resource development is an integral part of Human resource function of an organization
that deals with development of the human resource through trainings and experiential learning.
HRD develops the key competencies of a person through performance analysis, identifying the
gap and providing training to fill the gaps.
The efficiency of the system can be measured by comparing the performance of employees
before and after the various trainings, counselling etc. Human Resource development has a dual
objective of growth of the employee and the growth of organization. As this provides learning
and growth for employees, it also leads to higher levels of employee satisfaction. HRD is the
integrated use of: training and development, organizational development, and career
development to improve individual, group and organizational effectiveness.‖
Features of Human Resource Development HRD
The nature / scope / characteristics or features of HRD are as follows:
1. Training and Development
HRD involves training and developing the employees and managers. It improves their qualities,
qualifications and skills. It makes them more efficient in their present jobs. It also prepares them
for future higher jobs.
2. Organizational Development (OD)
HRD also involves Organizational Development. CD tries to maintain good relations throughout
the organization. It also solves problems of absenteeism, internal conflicts, low productivity and
resistance to change.
3. Career Development
HRD also involves career planning and development of employees. It helps the employees to plan
and develop their careers. It informs them about future promotions and how to get these
promotions. So HRD helps the employee to grow and develop in the organization.

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4. Performance Appraisal
HRD conducts Performance Appraisal, Potential Appraisal, etc. It informs the employees about
their strengths and weaknesses. It also advises them about how to increase their strengths and
how to remove their weaknesses.
5. Multidisciplinary
HRD is multidisciplinary. That is, it uses many different subjects. It uses education, management,
psychology, communication, and economics. HRD uses all these subjects for training and
developing the employees.
6. Key Element for solving problems
Now-a-days an organization faces many different problems. These problems are caused due to
the economic, technological and social changes. These problems can be solved only by knowledge,
skill and creative efforts. This knowledge, skill, etc. is achieved from HRD. Therefore, HRD is a
key element for solving problems in the organization.
7. Continuous in Nature
HRD is not a onetime affair. It is a continuous process. Development of human resources never
stops. This is because continuous changes happen in the organization and environment.
8. Integrated use of sub-systems
HRD system involves the integrated use of sub-systems such as performance appraisal, potential
appraisal, career planning, training, etc.
9. Placement
HRD places the right man in the right job. Placement is based on performance appraisal,
potential appraisal, training, etc. Proper placement gives satisfaction to the employee, and it
increases the efficiency.
10. Promotions and Transfer
HRD also gives promotions and transfers to the employees based on performance appraisals, etc.
11. Motivation by Rewards
HRD also motivates the employees by giving those rewards for performing and behaving better,
suggesting new ideas, etc. Financial and non-financial rewards are given.
12. Human resource development is a process in which employees of the organizations are
recognized as its human resource. It believes that human resource is most valuable asset of the
organization.
13. It stresses on development of human resources of the organization. It helps the employees of
the organization to develop their general capabilities in relation to their present jobs and
expected future role.
14. It emphasize on the development and best utilization of the capabilities of individuals in the
interest of the employees and organization.
15. It helps is establishing/developing better inter-personal relations. It stresses on developing
relationship based on help, trust and confidence.
16. It promotes team spirit among employees.

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17. It tries to develop corn petencies at the organization level. It stresses on providing healthy
climate for development in the organization.
18. HRD is a system. It has several sub-systems. All these sub-systems are inter related and
interwoven. It stresses on collaboration among all the sub-systems.
19. It aims to develop an organizational culture in which there are good senior- subordinate
relations, motivation, quality and sense of belonging.
20. It tries to develop competence at individual, inter-personal, group and organizational level to
meet organizational goal.
21. It is an inter-disciplinary concept. It is based on the concepts, ideas and principles of
sociology, psychology, economics etc.
22. It forms on employee welfare and quality of work life. It tries to examine/identify employee
needs and meeting them to the best possible extent.
23. It is a continuous and systematic learning process. Development is a lifelong process, which
never ends.
Difference between HRD and HRM
Both are very important concepts of management specifically related with human resources of
organization. Human resource management and human resource development can be
differentiated on the following grounds:
1. The human resource management is mainly maintenance oriented whereas human resource
development is development oriented.
2. Organization structure in case of human resources management is independent whereas
human resource development creates a structure, which is inter-dependent and inter-related.
3. Human resource management mainly aims to improve the efficiency of the employees whereas
aims at the development of the employees as well as organization as a whole.
4. Responsibility of human resource development is given to the personnel/human resource
management department and specifically to personnel manager whereas responsibility of HRD
is given to all managers at various levels of the organization.
5. HRM motivates the employees by giving them monetary incentives or rewards whereas
human resource development stresses on motivating people by satisfying higher-order needs.

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 FM Notes 18 – Performance Appraisal

Performance appraisal is a process of evaluating an employee‘s performance for a job in terms of

its requirements.
According to Mc Gregor, ―Formal Performance appraisal plans are designed to meet three needs,
one of the organization and the other two of the individual, namely:
I. They provide systematic judgments to back up salary increases, transfers, and demotions or
terminations.
II. They are means of telling a subordinate how he is doing and suggesting needed changes in his
behavioural attitudes, skills or job knowledge. They let him know ‗where he stands‘ with the
boss.
III. They are used as a base for coaching and counselling the individual by the superior.
Definitions
Performance appraisal has been defined by different scholars in various ways. Some of the
important definitions are as follows:
Heyel: ―It is the process of evaluating the performance and qualifications of the employees in
terms of the requirements of the job for which he is employed, for purposes of administration
including placement selection for promotions, providing financial rewards and other actions
which require differential treatment among the members of a group as distinguished from actions
affecting all members equally.‖
Dale S. Beach: ―Performance appraisal is systematic evaluation of the individual with respect to
his or her performance on the job and his or her potential for development‖.
Dale Yoder: ―Performance appraisal includes all formal procedures used to evaluated
personalities and contributions and potentials of group members in a working organization. Lt is a
continuous process to secure information necessary for making correct and objective decisions on
employees.‖
Randall S. Schuler: ―Performance appraisal is a formal, structured system of measuring and
evaluating an employee‘s job, related behaviour and outcomes to discover how and why the
employee is presently perfuming on the job and how the employee can perform more effectively
in the future so that the employee, organization, and society all benefit.
What should be rated?
The seven criteria for assessing performance are:
1. Quality: The degree to which the process or result of carrying out an activity approaches
perfection.
2. Quantity: The amount produced, expressed in monetary terms, number of units, or number of
completed activity cycles.
3. Timeliness: The degree to which an activity or a result produced.
4. Cost Effectiveness: The degree to which the use of the organization‘s resources (e.g., human,
monetary, technology, material) is maximized in the sense of getting the highest gain.

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5. Need for Supervision: The degree to which a job performer can carry out a job function
without supervisory assistance.
6. Interpersonal impact: The degree to which a performer promotes feelings of self-esteem,
goodwill and co-operation among co-workers and subordinates.
7. Training: Need for training for improving his skill‘s knowledge.
Approaches to Performance Appraisal
There is great degree of variation in the approaches, design and use of performance appraisal
system and also in the formats. Generally, now a days, there are three approaches used in
making performance appraisal.
The Traditional Approach: This approach is highly systematic and takes into account the
measurement of employees‘ characteristics and/or their contribution or both. In this system all
employees are rated in the same manner utilizing the same approach so that the rating of
separate personnel can be compared.
The Causal Approach: This is an unsystematic use and often haphazard appraisal system which
was commonly used in the past, but now it has given a place to more formal method, the main
basis being seniority or quantitative measures of quantity and quality of output for rank and file
personnel.
The Behavioural or Modern Approach: This approach is based upon mutual goal setting and
appraisal of progress by both appraiser and appraise. This lays emphasis on behavioural values of
fundamental trust in goodness, capability and responsibility of human beings.
Methods of Performance Appraisal
1. Traditional Methods
(a) Straight Ranking Methods: This is the oldest and simplest method of performance appraisal.
This yields a ranking from best to worst of all individuals comprising the group. The rater simply
picks out the individual he considers best, the one he thinks next best etc. and ranks them in
order on the basis of work. The ranks assigned by rater are then averaged and then relative
ranking of each individual in the group are assigned/determined.
(b) Paired Comparison: By this technique, each employee is compared with all the persons in
pairs one at a time. With this technique, the judgment is easier and simpler than ordinary ranking
method. The number of times each individual is compared with another is tallied on a piece of
paper. These numbers yield the rank order of the entire group. For example, if there are five
persons in a group, then A‘s performance is compared to B‘s and a decision is arrived at A, B to
whose is the better performance. Then A is compared to C, D and E in that order. Next B is
compared with all the others in the group individually. Since he has already been compared with
A, he is only compared with C, D and E. Similar comparison is made with respect to all the
individuals. Thus by this method, we arrive at ten decisions and only two are involved in each
decision. The results of decisions and comparisons are tabulated and a rank is assigned to each
individual.
(c) Man to Man Comparison: In this method, certain factors are selected for the purpose of
analysis such as leadership, dependability, initiative etc. and a scale is designed by the rater for
each factor awarded.

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(d) Grading Method: Under this system, the rater considers certain features and marks them
accordingly to the scale. Certain categories of worth are carefully established and defined. The
selected features may be analytical ability, co-operativeness, dependability, self-experience job
knowledge, judgement, leadership and organising ability etc.
These may be rated (i) Outstanding (ii) very good, (iii) good/average (iv) fair, (V) poor or any
other scale. The actual performance of an employee is then compared with these grade
definitions and he is allotted the grade which best describes his performance.
(e) Graphic or Linear Rating Scale: Under this system a printed form, one for each employee to
be rated is filled. There are various factors to be checked and rated as per the performance and
ability and as felt by the supervisors. The factors are of two type i.e.
(i)Employer characteristics such initiative, leadership, co-operativeness, dependability, attitude,
enthusiasm, loyalty etc.
(ii)Employee‘s contribution e.g. quality and quantity of work, the responsibilities assumed,
specific goals achieved, regularity of attendance, leadership offered, attitudes towards superiors
and associates versatility etc.
These traits are evaluated on a continuous scale or sometime a discontinuous scale is also used,
consisting of appropriate boxes or squares which are to be ticked off.
(f) Forced Choice Description Method: This rating form prepares a series of item or statements
which usually describe the degree of proficiency. The rater then chooses among the member of
each group in terms of how will be believes the statements describing the individual being rated
on various arrangements of items employed.
(g) Check List: Under this system, the rater does not evaluate an employer‘s performance. He
supplies report information about it and the final rating is done by the personnel department. A
series of questions are presented concerning an employee to his behaviour. The rater then checks
to indicate if the answer to a question about an employee is positive or negative. The value of
each question may be valued /weighed equally or certain questions may be weighed heavily than
others.
The following are some of the sample questions in the check list:
i. Is the employee really interested in the task assigned?
ii. Is he respected by his colleagues (Co-workers)?
iii. Does he give respect to his superiors?
iv. Does he follow instructions properly?
v. Does he make mistakes frequently?
(h) Free Essay Method: In this method, the supervisor makes a free form, open ended appraisal of
an employer in his own words and puts down his impression about the employer. The following
factors are taken into account by supervisor.
i. Relation with fellow supervisor and personnel assigned to him.
ii. General organisation and planning ability
iii. Job knowledge and potentials
iv. Employee characteristics and attitudes
v. Understanding and application of company policies and procedures

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 vi. Production, quality and cost control
vii. Physical conditions.
viii. Development needs for future.

(i) Critical Incident Method: The basis of the method is the principle that there are certain
significant acts in each employee‘s behaviour and performance which make all the difference
between success and failure on the job‘. The supervisor keeps a written record of the events that
can be easily recalled /referred and used in the course of periodical or formal appraisal.
Feedback is provided about the incidents during performance review session.
This method provides an objective basis for conducting a thorough discussion of an employee‘s
performance. This method avoids recency bias (most recent incidents get too much emphasis).
Most frequently, the critical incidents technique of evaluation is applied to evaluate the
performance of superiors rather than of peers of subordinates.
(j) Group Appraisal Method: Under this, employees are rated by an appraisal group, consisting of
their supervisors and three or four supervisors who have some knowledge of employee‘s
performance. The supervisor explains to the group the nature of his subordinate‘s job, the actual
performance of job holder, the causes of their particular level of performance and offers
suggestions for future improvement.
(k) Field Review Method: Under this method, a trained employer from personnel department
interviews the line supervisor to evaluate their respective subordinates.
The appraiser is fully equipped with definite test questions, usually memorized in advance, which
he puts to supervisors. The supervisor is required to give his opinion about the progress of his
subordinates, the level of performance of each subordinate, his weaknesses, his good points,
outstanding ability, promotability and possible plans of action in cases requiring further
consideration. The appraisal takes detailed notes of the answers, which are then approved by the
supervisors and placed in employee‘s personal file.
2 Modern Methods of Appraisal
(a) Appraisal by Results or Management by Objectives (MBO): This has been evolved by Peter
Drucker. MBO has been defined as a process whereby superior and subordinate managers of an
organisation jointly identify the goals which are common, define each individual‘s major area of
responsibility and set the targets and results which are expected of them and use these as guide
for unit operations and assessing, the contribution of each of its members.‘
Some features of MBO are:
1) MBO emphasizes participatively set goals that are tangible, verifiable and measurable.
2) MBO focuses attention on what must be accomplished (goals) rather than how it is to be
accomplished (Methods).
3) MBO, by concentrating on key result areas translates the abstract philosophy of management
into concrete phraseology. The technique can be put to general use (Non specialist technique).
Further it is a dynamic system which seeks to integrate the company‘s need to clarify and
achieve its profit and growth targets with the manager‘s need to contribute and develop himself.‘

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4) MBO is a systematic and rational technique that allows management to attain maximum results
from available resources by focussing on achievable goals. It allows the subordinate plenty of
room to make creative decisions on his own.
This process emphasizes the value of present and the future instead of past and focuses attention
on the results that are accomplished and not on personal traits.
(b) Assessment Centre Method: Under this method many evaluators join together to judge
employee‘s performance in several situations with the use of a variety of criteria. The
assessments are made /done with the help of couple of employees and involves a paper and
pencil test interviews and situational exercises such as in basket exercise, business game, a role
playing incident and leaderless group discussions.
(c) Human Assets Accounting Method: This method refers to the activity devoted to attaching
money estimates to the nature of a firm‘s internal human organisation and the external customer
goodwill. If able and will trained personnel leave the firm, the human organisation is worthless, if
they join it, its human assets increase. If distrust and conflict prevails the human enterprise is
devalued. If team work and high morale prevails, the human organisation is a very valuable asset.
(d) Behaviourally Anchored Rating Scales: The procedure for BARS is usually five stepped.
(i) Generate critical incidents
(ii) Develop performance dimensions
(iii) Reallocate incidents
(iv) Scale of incidents
(v) Develop final instrument

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 FM Notes 19 – Morale

Morale can be defined as the total satisfaction derived by an individual from his job, his work-
group, his superior, the organization he works for and the environment. It generally relates to the
feeling of individual‘s comfort, happiness and satisfaction.
According to Davis, ―Morale is a mental condition of groups and individuals which determines
their attitude.‖
In short, morale is a fusion of employees‘ attitudes, behaviours, manifestation of views and
opinions - all taken together in their work scenarios, exhibiting the employees‘ feelings towards
work, working terms and relation with their employers.
Morale includes employees‘ attitudes on and specific reaction to their job.
There are two states of morale:
High morale
High morale implies determination at work- an essential in achievement of management
objectives. High morale results in:
1. A keen teamwork on part of the employees.
2. Organizational Commitment and a sense of belongingness in the employees mind.
3. Immediate conflict identification and resolution.
4. Healthy and safe work environment.
5. Effective communication in the organization.
6. Increase in productivity.
7. Greater motivation.
Low morale
Low morale has following features:
1. Greater grievances and conflicts in organization.
2. High rate of employee absenteeism and turnover.
3. Dissatisfaction with the superiors and employers.
4. Poor working conditions.
5. Employee‘s frustration.
6. Decrease in productivity
7. Lack of motivation
Though motivation and morale are closely related concepts, they are different in following ways:
1) While motivation is an internal-psychological drive of an individual which urges him to behave
in a specific manner, morale is more of a group scenario.
2) Higher motivation often leads to higher morale of employees, but high morale does not
essentially result in greatly motivated employees as to have a positive attitude towards all
factors of work situation may not essentially force the employees to work more efficiently.
3) While motivation is an individual concept, morale is a group concept. Thus, motivation takes
into consideration the individual differences among the employees, and morale of the employees

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can be increased by taking those factors into consideration which influence group scenario or
total work settings.
4) Motivation acquires primary concern in every organization, while morale is a secondary
phenomenon because high motivation essentially leads to higher productivity while high morale
may not necessarily lead to higher productivity.
5) Things tied to morale are usually things that are just part of the work environment, and things
tied to motivation are tied to the performance of the individual.
Human behaviour is difficult to explain. A clerk working under an authoritarian boss might be
quite happy with himself, the boss and the organization. Yet an officer with a five figure salary
can experience moral problems. What affects the status of morale? Let‘s explain these factors in
greater detail.
1. The organization:
The goals of the organization influence the attitudes of employees greatly if the goals set by the
management are worthwhile, useful and acceptable, then workers develop positive feelings
towards the job and the organization. Likewise a clear structure with well-defined duties and
responsibilities encourages people to work with confidence. The reputation of the company is
another important factor worth mentioning here. Persons working in reputed organizations
experience feelings of pride and a spirit of loyalty.
2. Leadership:
The actions of managers exert a strong influence over the morale of the workforce Fair
treatment; equitable rewards and recognition for good work affect morale greatly. Workers feel
comfortable when they work under a sympathetic caring leader in place of one who is
authoritarian, dictatorial and dominating. Negativism, inconsiderateness and apathy are not
conducive to development of a good work climate.
3. Co-worker:
Poor attitude of co-workers influence others. Imagine working with a person who talks about the
negative points of an organization all day long. Such a person can make each workday an
unpleasant experience for others. He can cause co-workers to think negatively and even if they
don‘t such an attitude is certainly not a morale booster.
4. The nature of work:
Dull, monotonous repetitive work affects employees‘ morale adversely. On the other hand if an
employee is asked to do something interesting and challenging his morale may be high.
5. Work environment:
Morale is a direct function of the conditions in the workplace. Clean, safe, comfortable and
pleasant work conditions are morale boosters.
6. The employees:
How the employees look at him (the self-concept) also influences morale greatly. For example,
individuals who lack self-confidence or who suffer from poor physical or mental health frequently
develop morale problems.

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Further, how the employees‘ personal needs are satisfied can significantly influence their morale.
Salary fringe benefits, DA rates, allowances may affect employees morale in a positive or
negative manner, when they compare themselves with others doing similar jobs. Employees can
become disgruntled when they feel that their pay and benefits are not in line with current
industry rates or are not in keeping with rising prices.
Morale and productivity:
Generally it is believed that high morale will lead to high productivity. However, Prof Keith Davis
points out that there is not always a positive correlation between the two. A manager can push
for high productivity by using scientific management time studies and close supervision. High
production and low morale may result but it is doubtful whether this combination can last. The
opposite can also occur - there can be low production with high morale. In this case the manager
works so hard to please his subordinates that they are too happy to work hard for themselves.
Research carried out by Rensis Likert indicated the fact that there can be different combinations
of morale and productivity: high morale and low productivity; high morale and high productivity;
low morale and high productivity; and low morale and low productivity as shown below:
In the final analysis the manager has to work for improving the morale of his employees. High
morale makes the work more pleasant and will go a long way in improving the work climate.
It helps the work group to attain goals easily, smoothly and more importantly in a higher
cooperative manner.

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 FM Notes 20 – Financial Markets

Financial markets are an important component of the financial system. They are a mechanism for
the exchange trading of financial products under a policy framework.
The Participants in the financial markets are the borrowers (issuers of securities), lenders (buyers
of securities), and financial intermediaries. Financial markets comprise two distinct types of
markets:
1) The money market
2) The capital market
Money Market: A money market is a market for short-term debt instruments (maturity below one
year). It is a highly liquid market wherein securities are bought and sold in large denominations
to reduce transaction costs. Call money market, certificates of deposit, commercial paper, and
treasury bills are the major instruments / segments of the money market.
The functions of a money market are
1. To serve as an equilibrating force that redistributes cash balances in accordance with the
liquidity needs of the participants:
2. To form a basis for the management of liquidity and money for meeting their requirements at
realistic prices.
As it facilitates the conduct of monetary policy, a money market constitutes a very important
segment of the financial system.
Capital Market
A capital market is a market for long-term securities (equity and debt). The purpose of capital
market is to
a. Mobilize long-term savings to finance long-term investments;
b. Provide risk capital in the form of equity or quasi-equity to entrepreneurs;
c. Encourage broader ownership of productive assets;
d. Provide liquidity with a mechanism enabling the investor to sell financial assets;
e. Lower the costs of transactions and information; and
f. Improve the efficiency of capital allocation through a competitive pricing mechanism.
Money Market and Capital Market
There is strong link between the money market and the capital market:
1) Often, financial institutions actively involved in the capital market are also involved in the
money market.
2) Funds raised in the money market are used to provide liquidity for long-term investment and
redemption of funds raised in the capital market.
3) In the development process of financial markets, the development of the money market
typically precedes the development of the capital market.

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A capital market can be further classified into primary and secondary markets. The primary
market is meant for new issues and the secondary markets. The primary market is meant for new
issues and the secondary market is one where outstanding issues are traded. In other words, the
primary market creates long-term instruments for borrowings, whereas the secondary market
provides liquidity through the marketability of these instruments. The secondary market is also
known as the stock market.
Primary Capital Market and Secondary Capital Market
Even though the secondary market is many times larger than the primary market, they are
interdependent in many ways.
a) The primary market is a market for new issues, but the volume, pricing, and timing of new
issues are influenced by returns in the stock market. Returns in the stock market depend on
macroeconomic factors. Favourable macroeconomic factors help firms earn higher returns, which,
in turn, create favourable conditions for the secondary market. This in turn, influences the
market Price of the stock. Moreover, favourable macroeconomic factors necessitate raising fresh
market Price of the stock.
Moreover, favourable macroeconomic factors necessitate raising fresh capital to finance new
projects, expansion, and modernization of existing projects. A buoyant secondary market, in turn,
induces investors to buy new issues if they think that is a good decision. Hence, a buoyant
secondary market is indispensable for the presence of a vibrant primary capital market.
b) The secondary market provides a basis for the determination of prices at which new issues can
be offered in the primary market.
c) The depth of the secondary capital market depends upon the activities in the primary market
because the bigger the entry of corporate entities, the larger the number of instruments
available for trading in the secondary market, The secondary market volume surge in 2007-08 was
part driven by a rampant primary market as newly listed stocks tend to have a high turnover.
d) New issues of a large size and bunching of large issues may divert funds from the secondary
market to the primary market thereby affecting stock prices.
Characteristics of Financial Markets
1. Financial markets are characterized by a large volume of transactions and the speed with
which financial resources move from market to another.
2. There are various segments of financial markets such as stock markets, bond markets-Primary
and secondary segments, where savers themselves decide when and where they should invest
money.
3. There is scope for instant arbitrage among various markets and types of instruments.
4. Financial markets are highly volatile and susceptible to panic and distress selling as the
behaviour of a limited group of operators can get generalized.
5. Markets are dominated by financial intermediaries who take investment decisions as well as
risks on behalf of their depositors.
6. Negative externalities are associated with financial markets. A failure in any one segment of
these markets may affect other segments, including non-financial markets.

85
7. Domestic financial markets are getting integrated with worldwide financial markets. The
failure and vulnerability in a particular domestic market can have international ‗ramifications.‘
Similarly. Problems in external markets can affect the functioning of domestic markets.
In view of the above characteristics, financial markets need to be closely monitored and
supervised.
Functions of Financial Markets
The cost of acquiring information and making transaction creates incentives for the emergence of
financial markets and institutions. Different types and combinations of information and
transaction costs motivate distinct financial contracts, instruments and institutions.
Financial markets perform various functions such as:
a. Enabling economic units to exercise their time preference;
b. Separation, distribution, diversification, and reduction of risk;
c. Efficient payment mechanism;
d. Providing information about companies. This spurs investors to make inquiries themselves
and keep track of the companies‘ activities with a view to trading in their stock efficiently;
e. Transmutation or transformation of financial claims to suit the preferences of both savers
and borrowers;
f. Enhancing liquidity of financial claims through trading in securities; and
g. Providing portfolio management services.
A variety of services are provided by financial markets as they can alter the rate of economic
growth by altering the quality of these services.
FOREX Market:
A Foreign exchange market is a market in which currencies are bought and sold. It is to be
distinguished from a financial market where currencies are borrowed and lent.
General Features
Foreign exchange market is described as an OTC (Over the counter) market as there is no physical
place where the participants meet to execute their deals. It is more an informal arrangement
among the banks and brokers operating in a financing centre purchasing and selling currencies,
connected to each other by telecommunications like telex, telephone and a satellite
communication network, SWIFT.
The term foreign exchange market is used to refer to the wholesale a segment of the market
where the dealings take place among the banks. The retail segment refers to the dealings take
place between banks and their customers. The leading foreign exchange market in India is
Mumbai, Calcutta, Chennai and Delhi is other centers accounting for bulk of the exchange
dealings in India. The policy of Reserve Bank has been to decentralize exchanges operations and
develop broader based exchange markets. As a result of the efforts of Reserve Bank Cochin,
Bangalore, Ahmadabad and Goa have emerged as new centre of foreign exchange market.
Size of the Market Foreign exchange market is the largest financial market with a daily turnover
of over USD 2 trillion. Foreign exchange markets were primarily developed to facilitate
settlement of debts arising out of international trade. But these markets have developed on their

86
own so much so that a turnover of about 3 days in the foreign exchange market is equivalent to
the magnitude of world trade in goods and services. The largest foreign exchange market is
London followed by New York, Tokyo, Zurich and Frankfurt.
Rupee is not an internationally traded currency and is not in great demand. Much of the external
trade of the country is designated in leading currencies of the world, Viz., US dollar, pound
sterling, Euro, Japanese yen and Swiss franc. Incidentally, these are the currencies that are
traded actively in the foreign exchange market in India.
24Hours Market Currencies Traded In most markets, US dollar is the vehicle currency, Viz., the
currency used to denominate international transactions. This is despite the fact that with
currencies like Euro and Yen gaining larger share, the share of US dollar in the total turnover is
shrinking.
Physical Markets in few centers like Paris and Brussels, foreign exchange business takes place at a
fixed place, such as the local stock exchange buildings. At these physical markets, the banks
meet and in the presence of the representative of the central bank and on the basis of bargains,
fix rates for a number of major currencies. This practice is called fixing. The rates thus fixed are
used to execute customer orders previously placed with the banks.
An advantage claimed for this procedure is that exchange rate for commercial transactions will
be market determined, not influenced by any one bank. However, it is observed that the large
banks attending such meetings with large commercial orders backing up, tend to influence the
rates. Participants The participants in the foreign exchange market comprise;
1. Corporates
2. Commercial banks
3. Exchange brokers
4. Central banks
Bond Market in India:
The Bond Market in India with the liberalization has been transformed completely. The opening
up of the financial market at present has influenced several foreign investors holding upto 30% of
the financial in form of fixed income to invest in the bond market in India.
The bond market in India has diversified to a large extent and that is a huge contributor to the
stable growth of the economy. The bond market has immense potential in raising funds to
support the infrastructural development undertaken by the government and expansion plans of
the companies.
Sometimes the unavailability of funds becomes one of the major problems for the large
organization. The bond market in India plays an important role in fund raising for developmental
ventures. Bonds are issued and sold to the public for funds.
Bonds are interest bearing debt certificates. Bonds under the bond market in India may be issued
by the large private organizations and Government Company. The bond market in India has huge
opportunities for the market is still quite shallow. The equity market is more popular than the
bond market in India. At present the bond market has emerged into an important financial sector.
The different types of bond market in India
1. Corporate Bond Market

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 2. Municipal Bond Market
3. Government and Agency Bond Market
4. Funding Bond Market
5. Mortgage Backed and Collateral Debt Obligation Bond Market
The major reforms in the bond market in India
1. The system of auction introduced to sell the government securities.
2. The introduction of Delivery versus Payment (DvP) system by the Reserve Bank of India to
nullify the risk of settlement in securities and assure the smooth functioning of the securities
delivery and payment.
3. The computerization of the SGL.
4. The launch of innovative products such as capital indexed bonds and zero coupon bonds to
attract more and more investors from the wider spectrum of the populace.
5. Sophistication of the markets for bonds such as inflation indexed bonds.
6. The development of the more and more primary dealers as creators of the Government of
India bonds market.
7. The establishment of the a powerful regulatory system called the trade for trade system by
the Reserve Bank of India which stated that all deals are to be settled with bonds and funds.
8. A new segment called the Wholesale Debt Market (WDM) was established at the NSE to report
the trading volume of the Government of India bonds market.
9. Issue of ad hoc treasury bills by the Government of India as a funding instrument was
abolished with the introduction of the Ways And Means agreement.

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 FM Notes 21 – Money Market

The money market thus may be defined as a centre in which financial institutions congregate
for the purpose of dealing impersonally in monetary assets. In a wider spectrum, a money
market can be defined as a market for short-term money and financial assets that are near
substitutes for money.
The term short-term means generally a period upto one year and near substitutes to money is
used to denote any financial asset which can be quickly converted into money with minimum
transaction cost. Call money market, or inter-bank call money market, is a segment of the
money market where scheduled commercial banks lend borrow on call (i e., overnight) or at
short notice (i.e., for periods upto 14 days) to manage the day-to-day surpluses and deficits in
their cash-flows.
These day to day surpluses and deficits arise due to the very nature of their operations and the
peculiar nature of the portfolios of their assets and liabilities.
The Distinct features of Money Market
1. It is one market but collection of markets, such as, call money, notice money, repose, term
money, treasury bills, commercial bills, certificate of deposits, commercial papers, inter-
bank participation certificates, inter-corporate deposits, swaps futures, options, etc. and is
concerned to deal in particular type of assets, the chief characteristic is its relative liquidity.
2. The activities in the money market tend to concentrate in some centre which serves a region
or an area; the width of such area may vary considerably in some markets like London and
New York which have become world financial centres.
3. The relationship that characterizes a money market should be impersonal in character so
that competition will be relatively pure.
4. In a true money market, price differentials for assets of similar type (counterparty, maturity
and liquidity) will tend to be eliminated by the interplay of demand and supply.
5. Due to greater flexibility in the regulatory framework, there are constant endeavours for
introducing new instruments/innovative dealing techniques; and It is a wholesale market and
the volume of funds or financial assets traded in the
6. It has a simultaneous existence of both the organized money market as well as unorganized
money markets.
7. The demand for money in Indian money market is of a seasonal nature.
8. In the Indian money market the organized bill market is not prevalent
9. In our money market the supply of various instruments is very limited.
Pre-Conditions for an Efficient Money Market
1. Institutional development relative political stability and a reasonably well developed banking
and financial system.
2. Integrity is sine qua non. Thus banks and other players in the market may have to be licensed
and effectively supervised by regulators.
3. There must also exist a demand for temporarily available cash either by banks or financial
institutions for the purpose of adjusting their liquidity position and finance the carrying of
the relevant assets in their balance sheets.

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 4. Efficient payment systems for clearing and settlement of transactions.
5. Government/Central Bank intervention to moderate liquidity profile.
6. Strong Central Bank to ensure credibility in the system and to supervise the players in the
market.
7. The market should have varied instruments with distinctive maturity and risk profiles to
meet the varied appetite of the players in the market. Multiple instruments add strength and
depth to the market; and
8. Market should be integrated with the rest of the markets in the financial system to ensure
perfect equilibrium.
Rigidities in the Indian Money Market
The most important rigidities in the Indian money market are:
1. Markets not integrated,
2. High volatility,
3. Interest rates not properly aligned,
4. Players restricted,
5. Supply based-sources influence uses,
6. Not many instruments,
7. Players do not alternate between borrowing and lending,
8. Reserve requirements,
9. Lack of transparency, and,
10. Inefficient Payment Systems.
11. RBI should encourage banks to make use of Commercial Papers instead of Cash Transfer.
Institutions
The important institutions operating in money market are:
1. Reserve Bank of India (RBI) is the most important participant of money market which takes
requisite measures to implement monetary policy of the country.
2. Schedule Commercial Banks (SCBs) form the nucleus of money market. They are the most
important borrower/supplier of short term funds.
3. Co-operative Banks: Function similarly as the commercial banks.
4. Financial and Investment Institutions: These institutions (e.g. UC, UTLGIC, Development
Banks, etc.) have been allowed to participate in the call money market as lenders only.
5. Corporates: Companies create demand for funds from the banking system. They raise short-
term funds directly from the money market by issuing commercial paper. Moreover, they
accept public deposits and also indulge in inter-corporate deposits and investments.
6. Mutual Funds: Mutual funds also invest their surplus funds in various money market
instruments for short periods.
7. Discount and Finance House of India: The Discount and Finance House of India Limited (DFHI)
has been set up by the Reserve Bank of India jointly with public sector banks and all India
financial institutions to deal in short-term money market instruments.
Instruments
1. Call/Notice money:
The core of the Indian money market structure is the inter-bank call money market which is
centralised primarily in Mumbai, but with sub-markets in Delhi, Kolkata, Chennai and

90
 Ahmadabad. The activities in the call money are confined generally to inter-bank business,
predominantly on a overnight basis, although a small amount of business, known as notice
money was also transacted side by side with call money with a maximum period of 14 days.
2. Inter- Bank Term money:
This market which was exclusively for commercial banks and co-operative banks has been
opened up for select All India Development Financial Institutions in October, 1993. The DFIs are
permitted to borrow from the market for a maturity period of 3 to 6 months within the limits
stipulated by Reserve Bank of India for each institution. The interest rates in the market are
driven. The market is predominantly 90-days market.
3. Inter-Bank Participation Certificate (IBPC):
The IBPCs are short-term instruments to even-out the short-term liquidity within the banking
system. The IBPC is issued against an underlying advance, classified standard and the aggregate
amount of participation in any account time issue.
4. Inter Corporate Deposit:
The inter-corporate market operates outside the purview of regulatory framework. It provides
an opportunity for the corporates to park their short-term surplus funds at market determined
rates. The market is predominantly a 90 days market.
5. Treasury Bills (TBs):
Among money market instruments TBs provide a temporary outlet for short-term surplus as also
provide financial instruments of varying short-term maturities to facilitate a dynamic asset-
liabilities management. The TBs are short-term promissory notes issued by Government of India
at a discount for 14 days to 364 days. More relevant to the money market is the introduction of
14 days, 28 days, 91 days and 364 days TBs on auction basis. The amount to be auctioned will
be pre-announced and cut off rate of discount and the corresponding issue price will be
determined in each auction. The amount and rate of discount is determined on the basis of the
bids at the auctions.
6. Commercial Bills:
A commercial bill is one which arises out of a genuine trade transaction, i.e. credit transaction.
As soon as goods are sold on credit the seller draws a bill on the buyer for the amount due. The
buyer accepts it immediately agreeing to pay amount mentioned therein after a certain
specified date. Thus, a bill of exchange contains a written order from the creditor to the debtor,
to pay a certain sum, to a certain person, after a creation period. A bill of exchange is a ‗self-
liquidating‘ paper and negotiable; it is drawn always for a short period ranging between 3
months and 6 months.
7. Certificate of Deposits (CDs):
The CDs are negotiable term-deposits accepted by commercial bank from bulk depositors at
market related rates. The CDs can be issued by scheduled commercial banks (excluding RRB5)
at a discount to face value for a period from 7 days to one year. The CDs can be issued for
minimum amount of ₹1 lakhs to a single investor. CDs above ₹1 lakhs should be in multiples of
₹1 lakh.
8. Commercial Paper:
Commercial Paper (CP) is an unsecured debt instrument in the form of a promissory note issued
by highly rated borrowers for tenors ranging between 7 days and one year. Thus CP is a short

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 term unsecured promissory note issued by high quality corporate bodies directly to investors to
fund their business activities. It is generally issued at a discount freely determined by the
market to major institutional investors and corporations either directly by issuing corporation or
through a dealer bank. The CDs can be issued for minimum amount of ₹5 lakhs to a single
investor. CDs above ₹5 lakhs should be in multiples of ₹5 lakh.

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 FM Notes 22 – Alternate Resource of Finance

Alternate source of finance is the new buzz word in the financial sector. Very simply it is
innovation centered on various financial instruments that looks to simplify the borrowing and
lending process and help businesses in their financial goals. Alternative sources of funding
became very popular, especially after the financial crisis (2008) resulted in failure of number of
Banks and stringent Basel III
Capital adequacy norms being made applicable. Banks have stopped lending to ventures and
individuals they consider risky and as a result a large number of the population fell outside the
traditional channels of finance.
Very soon consumer behaviour shifted to new players, which came to be known as alternate
sources of finances, which looked to carry out financial activities digitally. Such has been the
growth of these alternate sources of funds, which are primarily peer-to-peer sites, that bankers
like Vikram Pandit, the former Citigroup chief executive, have also realized its importance
when he became part of a group that invested $2.7 million in a P2P site called Orchard.
As institutional investors increasingly look at grabbing a piece of peer-to-peer, many are calling
it as the next level of banking. A look at the segments fuelling the frenzy:
Equity based Crowd funding as an emerging alternative to fund business:
Equity based Crowd funding generally relates to startups and early stage companies generating
funds by offering equity in the company in lieu of money. In such a scenario the company
solicits funds online and does not tap into the primary capital markets. A crowd funding
platform in this case acts as an intermediary between investors and the company.
Private equity, VC firms, and angel investors have been the primary source of funding for
startups, but some have broken the shackles by offering equity to the general public at a very
early stage. Some examples of equity crowd funding platforms are Syndicate Room, Crowdcube,
Kickstarter and Seedrs.
Across the world there are different rules and regulations governing such platforms and in India,
SEBI is undertaking active discussions with stakeholders to come up with a suitable policy. Such
platforms and sites have gained popularity and is doing very well across the world as it provides
a viable alternative outside the traditional financial system for SMEs and startups to raise
money.
Taping the primary market in the form of IPOs is an expensive proposition and very time
consuming. Raising funds through the equity sale on a Crowd funding site is possible at a
fraction of a cost and is relatively faster. For the investor it provides a new investment product
and the ability to be a part of a company that can see the rapid growth and provide
considerable returns. On the risks, the greatest these sites face is that investors may not have
adequate understanding about the risks involved or knowledge of the product. Investor
protection seems to be an area of concern for raising equity funds through Crowd funding
platforms.

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 Business loan funding through peer to peer platforms: Traditionally, for every business the
primary source to raise loans to scale up or as working capital came from banks. However,
banks often want collaterals and small businesses and ones engaged in the service sector find it
extremely difficult. Also, compared to bigger and established companies, banks often charge a
higher rate of interest for smaller companies as they view such loans risky.
Online P2P sites seek to connect interested lenders with borrowers, thereby eliminating
intermediaries and costs. Borrowers now have an attractive option to raise money to fund their
business needs, mostly without the need for collaterals and at much lower rates compared to
banks, while investors that are sitting on idle cash have the option to get returns that are very
lucrative.
Globally platforms like Fundingcircle.com and in India platforms like Faircent.com provide
businesses an alternative source to raise working capital. In a validation of the model Google
has earlier this year tie-up with Lending Club in the US to provide small business loans to its
technology partners. In the UK even big banks have warmed up to the idea as Royal Bank of
Scotland entered into a deal with two peer to-peer lending platforms, Funding Circle and Assetz
Capital, to provide SMEs with another route of finance. This is in sync with the UK government‘s
overall plans to offer innovative and wider options in funding.
Personal loans financing through peer to peer platforms: Personal loans are one of the most
popular products on a P2P platform and sees active participation. An unsecured loan, personal
loan is used for different purpose like for a wedding, vacation, refurbishing their homes, paying
credit card outstanding among others. Often called an ‗all-purpose loan‖, personal loans are a
great source of liquidity. The flip side being personal loans carries a high rate of interest and
can cause a considerable burden to your wallet.
P2P platforms have become lucrative primarily because it can offer considerably lower rates of
interest. By connecting borrowers directly with lenders, rates of interest on a personal loan
have been considerably reduced. It also does away with the high cost of operation that banks
have to factor in. Personal loan on a P2P site is also helpful to people who may not be able to
secure a loan from a bank, but has an alternate source in raising funds when a private lender
may be willing to lend.
Sites like Lendingcub.com and Zopa.com and us in India have done brisk business in personal
loans. In fact Lending Club has gone on to become the largest P2P site in the US and is
preparing a $5bn initial public offering.
Crowd funding invoice financing companies like: Crowd funding invoice financing companies
are a boon for SMEs, who often face liquidity issue and are in need of cash. With invoice
financing, companies can sell their invoice immediately for cash at a small percentage rather
than wait for a month or more for the payment to come.
This enables companies to get cash almost immediately and ensure liquidity is not an issue. The
reverse also happens under Supply Chain Finance where a company‘s suppliers can be paid
within a short span of time by funders on the crowd platform.
The company in turn pays the funders the full amount on the original settlement day. This
ensures a company‘s supplier base stays healthy and they have good access to working capital

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 UK-based Platformblack.com is a great example of this and has been doing innovative work in
this sector.
Crowd funding education loans: Crowd funding education loans are in vogue in countries like
the US where the cost of education is considerably very high and the country faces about a
trillion dollar in student loan debt. On the backdrop of a slow economy, student loans today
have some of the highest delinquency rates. Social Finance (www. sofi.com) or SoFi is an
example of a P2P site that rallies a school‘s alumni to be accredited investors and then
refinance loans to current students and recent graduates. Such sites offer lower fixed rate of
interest and claims to provide good borrower protections.
Other sites like GoFundMe and Indiegogo are not exactly an education loan P2P site, but given
the option for a student to raise money in the form of donations to fund their study. The trend
has not caught up in India, but we do have social ventures like Milaap and Rangde that aims to
crowd fund education of underprivileged children.
Venture Capital
Venture capital is financing that investors provide to startup companies and small businesses
that are believed to have long-term growth potential. For startups without access to capital
markets, venture capital is an essential source of money.
Risk is typically high for investors, but the downside for the startup is that these venture
capitalists usually get a say in company decisions.
Angel Investor
Angel investors invest in small startups or entrepreneurs. Often, angel investors are among an
entrepreneur‘s family and friends. The capital angel investors provide may be a one-time
investment to help the business propel or an ongoing injection of money to support and carry
the company through its difficult early stages.
Good article on an alternative source of financing which will give RBI‘s views on alternate
source of finance (The author Dr.KC Chakrabarty was deputy governor, RBI)
Timely payments from customers will help SMEs in reducing their working capital requirements,
leading to lower interest costs, improved profitability and a positive impact on the long-term
health and sustainability of India‘s SME sector. Delays in settlement of dues affect the recycling
of funds and business operations of SMEs.
It is, therefore, critical to ensure that the small entities are able to raise liquidity against their
receivables. This problem can be institutionally tackled by factoring, which provides liquidity to
SMEs against their receivables and can be an alternative source of working capital.
World over, factoring is a preferred route of accessing working capital for SMEs and even larger
organizations. Some banks and financial institutions in India have already launched factoring
services and I would urge more banks to offer such services, particularly for the MSMEs.
Factoring service, which is perceived as complimentary to bank finance, enables the availability
of much-needed working capital finance for the small and medium-scale industries especially
those that have good quality receivables but may not be in a position to obtain enough bank
finance due to lack of collateral or credit profile.

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 By having a continuous business relationship with the factoring companies, small traders,
industries and exporters get the advantage of improving the cash flow and liquidity of their
business, as also the facility of availing ancillary services like sales ledger accounting,
collection of receivables, credit protection, etc. Factoring helps them to free their resources
and have a one-stop arrangement for various business needs, enabling smooth running of their
business.
The Kalyanasundaram Study Group set up by the Reserve Bank of India in January 1988 to
examine the feasibility and mechanics of starting factoring organizations in the country paved
the way for provision of domestic factoring services in India. The
Banking Regulation Act 1949 was amended to include factoring as a form of business in which
the banks might engage.
The Reserve Bank of India issued guidelines permitting the banks to set up separate subsidiaries
or invest in factoring companies jointly with other banks. However, it was generally felt that
absence of a Factoring Law was one of the major impediments in the growth of the factoring
business, including the heavy stamp duty over assignment deed, ambiguity in the legal rights of
Factors in respect of receivables, etc.
The government of India enacted the Factoring Regulations Act 2011 to bring in the much
needed legal framework for the factoring business. It has provided definitions for the terms
factoring, factor, receivables and assignment. The Act also specifies that any entity conducting
the factoring business would need to be registered with the RBI as NBFCs, while exempting
banks, government companies and corporations established under an Act of Parliament, from
the requirement of registration with the
RBI for conducting the factoring business.
The Act, thus, gave clarity to the activity of assignment of receivables and also granted
exemption from stamp duty on documents executed for the purpose of assignment of
receivables in favour of Factors, thereby making the business more viable. The Act also
envisages that all transactions of assignment of receivables shall be registered with the Central
Registry established under the Sarfaesi Act, 2002 to reduce the possibility of frauds and for
strengthening the due diligence process for the clients.
The Act has given powers to the Reserve Bank to stipulate conditions for the principal business
of a Factor, as also powers to give directions and collect information from Factors. Subsequent
to the passing of the Act, the Reserve Bank has created a separate category of NBFCs viz; NBFC-
Factors and issued directions for their regulation. The prudential norms as applicable to NBFCs
engaged in the lending business has also been extended to the NBFC-Factors. Further, bank
finance to factoring companies and the factoring business conducted by banks are also
regulated by the RBI.
Though the enactment of the Factoring Regulation Act has potentially removed all the major
impediments that the factoring sector faced in the country, nevertheless, the sector has a few
other items on its wish list, the primary among which are introduction of credit insurance in the
factoring business and extending the scope of the Sarfaesi Act to cover NBFCs for a speedy
enforcement of security interest.

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 As regards credit insurance, the finance minister, in the Union Budget 2013-14, has made an
announcement for setting up a Credit Guarantee Fund with Sidbi for factoring, with a R5-billion
corpus. As far as extension of the provisions of the Sarfaesi Act to NBFC is concerned, the final
call rests with the government of India.
The low penetration of the factoring business in the country still remains a challenge, which
could be on account of lack of awareness among the users. With the necessary law now in place,
sincere attempts need to be made by the industry through its associations and other fora for
articulating the benefits of factoring as not just an alternative source of finance but also an
avenue for providing a bouquet of financial services vis-vis traditional finance, to small scale
industries.
They should be able to identify the untapped potential clientele, especially in various SME
industry sectors, and create awareness on how the higher cost of factoring vis-vis the
traditional finance is justifiable and cost effective for the businesses in the long run. Factoring
companies should also constantly endeavour to upgrade their expertise on both the
technological front as also on the operational level for offering cost effective services to their
clientele.

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 FM Notes 23 – Changing Landscape of Banking Sector

The banking landscape is changing across the globe. The run-up to 2020 will see innovative
themes emerge, with banks‘ growth governed by several key factors, including:
Product penetration
Creation of a new market of people with no bank account (known as ―unbanked‖ customers)
and those who do not use financial institutions to their full potential (the so-called ―under
banked‖)
Digital wallet and payment banks such as PayPal. Which accept limited deposits but don‘t
lend money. Tight focus on regulatory and compliance aspects and cost reduction to meet the
bottom line. Finally, customer retention and product per customer will become the mantra
Indeed, the entire banking field is shifting its gravity and is acquiring a ―new normal. The
business services industry will have to be a step ahead before this change hits them. We see
five areas in which the organizations will have to act quickly:
Scalability and flexibility: The banks‘ collective challenge will be to accurately project
volumes and growth, but their ability to do so in this changing environment has yet to be tested.
The players will not only be required to have a global footprint but also near shore operations.
To some extent a larger geographic spread will help combat this uncertainty. The industry‘s
current concentration is in India and the Philippines, but eventually we will see a much wider
spread across the globe.
Pricing models: Static pricing models like full-time equivalents, log-in hours and transactions
need to be replaced by much more dynamic models. Clients are increasingly looking at partners
who have ―skin in the game‖ and are open to taking risks along with them.
Innovative service delivery: The lines between customer segmentation will blur.
Classifications like ―high net worth,‖ ―premium,‖ ―gold‖ and ―silver‖ will fall by the wayside.
The world will move toward treating each customer as a segment.
Customization at a customer level will become the key. The ―new normal‖ will be
differentiated customer experience in a de-segmented market.
Bundled offering and embedded analytics: A menu-based rate card offering will eventually
become a thing of the past. As the customer is becoming a segment in itself, the players cannot
rely on services like contact center, back office, originations, etc., as an offering. This way
each segment-i.e., the customer - will be serviced by multiple sets of people. The offering has
to be bundled up with an analytics umbrella overarching that bundle. The new normal will be
the value-based offer.
Regulatory and compliance: Geographical boundaries have now become almost nonexistent
from a banking standpoint, and the biggest threat is to prevent transactions crossing over the
line of regulations and compliance. Till now the business services players were completely
dependent on banks to manage this aspect. But now the intelligence and capability has to be

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 developed by the players in-house. The new normal will be that the service providers should act
as a consultant and gatekeeper for their banking clients.
Changing Landscape of Banking Sector
Following speech will help you to understand the topic in detail
A New Banking Landscape for New India
(Keynote address by Shri S. S. Mundra, Deputy Governor, Reserve Bank of India at the Mints
Annual Banking Conclave, 2015 on A New Banking Landscape for New India‘ on January 29,
2015)
Smt. Arundhati Bhattacharya, Chairman, State Bank of India; Smt. Chanda Kochhar, MD and CEO,
ICICI Bank Limited; Smt. Shikha Sharma, MD & CEO, Axis Bank Limited;
Shri Aditya Pun, MD, HDFC Bank Limited; Shri Sunil Kaushal, Regional Chief Executive, India &
South Asia, Standard Chartered Bank as also other senior members of the banking and financial
sector; members of the print and electronic media; ladies and gentlemen.
At the outset, let me thank Tamal and the Mint Management for inviting me to deliver the
keynote address at the Mint Annual Banking Conclave. This event has become one of the most
awaited events on the calendar of bankers. I last attended this event as a panelist in January
2014 when the topic for panel discussion was ―Indian Banking: A New Banking Landscape‖ and
this time it is enlarged to ―A New Banking Landscape for New India.‖
When I sat down to think about the theme of the Conclave, I wondered what is new about India.
Is it the new political regime and consequential policy changes? Is it the tag of being the new
growth leader in the world economy? Is it a more financially included India that is being thought
about or is it a ‗digital‘ or ‗connected‘
India that is new. I think it is a bit of all and beyond. We all know that political stability is a
necessary precursor to a sustained economic development anywhere in the world and a
democratically elected government with decisive mandate is capable of launching significant
pro-growth reforms.
Defining Contours of New India
What are the defining contours of the new India? What are the themes that would play out over
the next decade or two? To my mind, there are seven key themes which would define the
Indian economy and Indian banking sector in the days to come. These area.
a. Demography
b. Urbanization
c. Digitization
d. Industrialization
e. Education
f. Inclusion and
g. Global integration
Let me elaborate on a few of these in greater detail and delve upon the impact they could have
on the banking system going forward.

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 a) Demography
Much has been talked about the demographic dividend that India possesses. At its current pace
of growth, the Indian population is predicted to exceed China by 2025. Further, while China‘s
working-age population may peak around 2015 and shrink for a decade and a half thereafter,
68% of India population would be within the working age range (15-64) until 2030.
Life expectancy of the Indian population is also slated to increase to about 70 years by 2030.
While on the one hand the numbers present sustained opportunity for the banks in terms of new
stream of customers, it also presents challenges. These challenges are in the form of diverse
behaviour patterns that customers in different age groups display. The banks would need to
continuously foretell the customers‘ preferences and focus their strategies on meeting them
proactively.
b) Urbanisation
India is also witnessing a growing trend of urbanisation. By 2030, urban population is estimated
to rise to 631mn recording an annual increase of 2.6% as against an annual rise of 1.1% in the
overall population. This would mean that 41.8 % of the population would be living in urban
agglomerations as against 31% today.
While even at that percentage, the urban population would be far lower than the global
average at 50% presently; this would open up huge business opportunities for the banks for
creation of public infrastructure, housing, consumption, education needs of customers and so
on.
c) Digitization
Digitisation is another area which is being pursued relentlessly by the new Government. There
is massive focus on enhancing internet penetration in the country through accelerated
broadband connectivity. The internet penetration has seen a sharp growth over the last year,
however, the extent of internet penetration at 20% pales in comparison to other developing
countries like China (46%), Brazil (53%) and Russia (59%); let alone the developed nations like
US, UK and Japan where the number is in excess of 85%. In these low numbers lie the inherent
opportunities for the banking sector. As the number of internet users in the country grows, the
banks would be able to better utilize this medium as a delivery channel. On the other hand, the
mobile penetration in the country is significantly high at around 930.20 mn and beckons as an
opportunity to be tapped.
d) Industrialization
The new Governments ‗Make in India‘ pitch also touches the right cords and efforts are afoot to
increase the presently stagnant share of manufacturing in GDP to around 25-30 % by 2025 from
15% at present. If that materializes, it would mean addition of 90 million domestic jobs and
attendant corporate and retail business opportunities.
e) Education
Likewise, there is tremendous scope of improving the level of education in the country by
strategic focus on the four Es i.e. Expansion, Equity and Inclusion, Excellence & Employability.
It would entail significant changes in consumer awareness, needs, demands and expectations.

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 f) Financial Inclusion
The launch of the PMJDY scheme with a focus on linking each household with a bank account
has received extremely positive response. At last count, the number of accounts opened under
the scheme had reached 12.14 crore. I don‘t need to emphasize the avenues that this scheme
has opened for the bankers. Moreover, it is just a stepping stone. Major part of the work has to
commence now.
g) Global Integration
That brings me to the last theme of growing global integration, which I believe is already having
significant repercussions on the financial sector. Be it the quantitative easing by the advanced
economies and the subsequent withdrawal of it, convertibility of currency, making or breaking
of regional alliance of economies and currencies etc. There could be other hitherto unforeseen
developments too affecting the global structure of finance. Let me highlight two recent
headlines reported in Financial Times: One, the potential exclusion of Russia from the SWIFT
payment system and the other about withdrawal from correspondent banking relationships in 30
jurisdictions by three of the world‘s biggest banks. Ostensibly, the motivation for these banks
to sever their ties with the lenders in developing nations has been to limit the risk of being hit
by regulatory sanctions on account of breaches, money laundering and terrorist finance. Events
such as these, though having their origin in specific jurisdictions, have the potential to
significantly impact the business and finance elsewhere in the globe.
Under the circumstances, it would be important for the banks to keep track of emerging trends
and be prepared not only to negotiate through the imminent challenges, but simultaneously be
ready to latch on to the opportunities that present themselves.
Key actors/acts in the New Banking Landscape
Let us see what would be the impact of these themes/developments on the key actors/acts in
the new banking landscape.
Customers, employees, owners and regulators comprise the key stakeholders in the banking
system. In the emerging landscape, the banks would have to contend with a set of customers
who are more educated, better informed and well-networked. The banks may probably be
forced to hard sell their products and services using a variety of media across the physical and
the virtual world. As the complexity of the products/services demanded by the customer‘s
increases, the banks would have to not only focus on up-gradation of skillsets of their
employees but also on their retention. Also the new competition would potentially pull down
the ROEs that the owners currently enjoy rendering it difficult to persuade future investors to
put in more capital in the banks. In case of public sector banks, the ownership structure itself
may change with Government bringing down its stake in these banks. They would, thus, also
join the race to seek private capital.
As we have witnessed, the regulators across the globe have been particularly very severe on
failings of the regulated entities on the consumer protection, money laundering and fair market
conduct front. This regulatory activism is evident in the frequency and quantum of penalties
levied on banks worldwide. Post crisis, the banks in US and Europe alone have been forced to
cough up approximately $230 bn in penalties and legal cost so far. Next two years are likely to

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 see another $70 bn being forked out by the banks for the same reasons. These are staggering
numbers.
We have also seen some enforcement actions in our jurisdiction but these are pretty begin in
comparison. Believe me; Indian regulators have been relatively more tolerant thus far. Some of
you who have overseas operations are well aware of the tough stance that the host regulators
adopt. Banks would need to gear up to face stricter regulatory regime.
The new banking landscape would impact the processes currently in vogue in the sector. Let me
highlight some of these in greater detail.
Competition and Consolidation
Competition and consolidation in the sector is an impending development that the banks would
have to contend with sooner rather than later. Two new private sector banks should start
operating within this calendar year. Further, the small finance banks and payments banks might
mark their presence, may be, later in the year or by early next year and so. There could be
consolidation and mergers between the existing market players. No doubt, the pie is big enough
to accommodate new players and there is plenty of opportunity for the well-organised and
mainstream regulated players to wean away the customers from unregulated shadow banking
entities. But, the existing players can afford to stay in denial at their own peril. We have seen
competition giving a tough run to the monopoly players. It has happened in the aviation sector,
the telecom sector and there is no reason why it would not happen in the banking sector. And
believe me, this is not the end of new competition for you. RBI has been indicating about the
possibilities of the bank licensing process being put on tap or introducing more varieties of
differentiated banks. Also, there is a healthy appetite from the foreign banks to enter this
country.
The entry of new competitors alone would not mean dramatic changes soon. Banking is a
business of scale which the new players cannot build overnight. New banks would start small
and scale up over a period of time. Not only would there be a competition for business but also
for talent. The processes would be forced to be more efficient.
Technology
I have already talked about a paradigm shift being brought about by technology in the way the
social interactions are taking place. Growing mobile and internet penetration has opened new
avenues for the entrepreneurs. This is reflected in the way the new age customer transacts her
business. If all traditional businesses have been impacted by technology, banking could not
have remained unaffected. As a flip-side to its well-documented advantages in terms of
efficiency and effectiveness of service delivery, technology has also fast tracked the process of
customer alienation- first in the form of ATMs and then in the form of internet and mobile
banking. In this sense, banks have become faceless entities. This transition calls for a change in
the way the banks interact with and retain their customers. I will shortly return to the
expectations built around the integration of technology in the banking services and its impact
on the banks.
Risk Management

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 Risk Management in banks is of the same vintage as the banks themselves. The banks are in the
business of taking risks and hence they need to have a risk management framework in place.
It‘s been more than a decade and a half since RBI first released the risk management guidelines
for banks in India. But my own sense is that risk management has been pursued in our banking
system more under compliance compulsions and has not been dovetailed in the banks‘
businesses processes as much as they ought to have been. As the complexity in the financial
world grows, the banks would need to carefully consider and set their risk appetite after duly
evaluating their capital level as also the skillsets of the officials entrusted with the
management of risks.
As I said before, the defining elements of the new India would have far-reaching impact on
each of the actors and the acts in the new banking landscape. These elements would interplay
and provide shape to the new banking order. It would be interesting for you to pick up these 7
contours, 4 actors and 3 acts and interplay them to build probable business scenarios. You may
be amazed to see the range of possibilities and challenges. Let me now return to the subject of
technology, which is widely perceived as the ‗be all and end all‘ of the new in banking.
Technology- A Great Enabler
I would begin by quoting Brett King, the author of famous book ‗Bank 3.0‘. ―Customers don‘t
use channel or products in isolation of one another. Everyday customers would interact with
banks in various ways. They might wire money to a third party, visit ATM to withdraw cash, go
online to check salary credit pay an utility bill, use their credit card to purchase some goods
from a retailer, fill out a personal loan application online, ring up the call center to see what
their credit card balance is or report a lost card. More sophisticated they are, they may also
trade some stocks, transfer some cash from their Euro Nc to USD a/c put up a lump sum in a
Mutual Fund or sign up a home insurance policy online‖.
The above statement denotes the diverse set of banking applications which technology can
support, In fact there is a need of a single channel solution to multiple product offerings. It
must however, be remembered that technology is just an enabler and not a panacea for all ills.
Most, if not all, Indian banks have invested heavily in web-based and mobile-based delivery
solutions. Each of these channels is supported by a different vendor and each one uses different
technology which increases complexity and involves cost. Further, technology is ever evolving
and adoption of new technology for staying contemporaneous is a costly proposition. Hence,
unless we are able to optimally exploit all the capabilities of the technology enabled delivery
solutions, we could be looking at unproductive investments.
While there is a lot of euphoria around the adoption of mobile banking and mobile payments,
the model has been relatively less successful barring a few countries where the right
environmental factors existed. I am talking here about the delivery of financial and payment
services by using the mobile device rather than its use as an access channel for internet banking
etc. In the Indian context an objective analysis would reveal various reasons for slow adoption.
On the other hand, there are technical issues like type of handsets, variety of operating
systems, encryption requirements, inter-operable platforms or the lack of it, absence of
standardised communication structures, difficulty in downloading application, time lag in
activation etc. These get accentuated by the operational difficulties in on-boarding merchants
and customers and customer ownership issues. The interplay of these factors has stymied the
deployment and adoption of mobile banking as an effective and widely accepted delivery

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 channel. Issues of coordination and cooperation between banks and telcos, is another aspect
which acts as either a driver or a barrier to the adoption of mobile banking. These issues need
to be quickly resolved if the mobile has to serve as an influential delivery channel for
distributing banking products and services in India.
25. Let me also highlight some opportunities that technology throws up. Take for example the
results displayed on the Google search page which is personalized. Each time an individual runs
a search at Google, the website collates details of the sites visited/links clicked by that
individual and loads more of those websites his/her future searches. There are more ATM
transactions than searches on the Google webpage at present. However, the kind of persona
lisation Google has achieved in its searches has not been attempted in the area of
advertisement on ATMs. This could be an area for the banks and their software vendors to work
on in future so as to generate further sales leads.
Few Qs seeking As
26. Let me leave you with some questions that the banking profession and the bankers would
need to find answers to ensure their relevance in the emerging landscape.
(i) Can there be a possibility of account number portability on similar lines as mobile number
portability? So, if an individual is not happy with the service received at one bank, he can
possibly opt for shifting his banking relationship, lock, stock and barrel to another bank. Of
course, there could be issues around loan contracts etc. but there is no reason to believe that
such challenges cannot be surmounted and pave the way for a massive disruption in the way
banking is conducted today.
(ii) How long can the banks continue increasing their retail loan portfolio? Unless some means
to pool and distribute these loans to other investors in the market is created, the retail lending
pipeline can get chocked quite quickly.
(iii) How is crowd funding going to impact lending business of the banks in future? The amount
of funds raised by crowd funding platforms worldwide has increased progressively from $ 1.5 bn
in 2011 to $ 2.7 Bn in 2012 and further to $ 5.1 bn in 2013. I hear some of you say it is
negligible in volume. The pace of growth however, is quite fast and combined with the peer-to-
peer lending business this could create disruptions, at least for some of the players who
operate in the same segment.
(iv) If Mobile Banking were to succeed, would plastic money still be needed? Basically there are
two questions rolled in one. First, whether mobile banking can succeed and if that is the case
what implications would it have for the future of ATMs and the debit cards that have been
issued by banks. There is justifiably a growing need for reducing the reliance placed on cash by
the system and hence, if more and more people moved to mobile / internet based payments,
the plastic cards and the investments made thus far, would be rendered useless unless put to
more imaginative uses.
(v) What IFRS implementation would mean for the banking system? IFRS accounting could
potentially overstate assets or overstate capital position. The question is how prudential
regulation would exist alongside IFRS? Proposed impairment calculations under IFRS, accounting
for interest income on Effective Interest Rate basis and presence of multiple systems for
operations and accounting of different portfolios would mean that IT systems would have to be

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 upgraded/realigned for IFRS migration. Banks would also need to overcome challenges around
converging policies for financial accounting and tax accounting for preparation of financial
statements. The banks would need to train their staff in various departments like credit, and
treasury, etc. for acquiring proficiency in IFRS accounting.
(vi) Would the large corporates continue to borrow from the banks? Of late, the global markets,
particularly the emerging market economies, have been flush with funds flowing in on account
of variants of QEs launched by the Central Banks in the Advanced Economies. Many large
corporate houses have been able to access funds at very cheap rates without needing to reach
out to banks. The sustained deflationary trends in the Euro Area and Japan portend further
bouts of QEs which can adversely impact the lending business of banks in the emerging markets.
Further, the large corporates in developed countries normally access financial markets directly
for their funding requirements rather than commercial banks. Hence, even while this time-
specific event of QE5 might fade away, as Indian economy and the financial markets mature,
more and more large corporates could start bypassing banks for their funding requirements.
(vii) Would the pain from the loans restructured earlier return to haunt the banks? My
understanding is that the prolonged global economic slowdown might have thrown off the
projections made earlier at the time of restructuring the advances in the immediate aftermath
of the crisis. As the moratorium period comes to a close, the banks would need to take a hard
look at the techno-commercial viability of these projects and take the losses wherever the
viability seems in jeopardy. Timely decisions, including for recall/recovery of the loan,
wherever the financial prospects are unviable, would be critical.
Conclusion
27. Before I conclude, let me also give a perspective on the global regulatory reform and how it
might impact the Indian banks. Basel III norms have been announced and set to be implemented
as per the indicated timeline, with the liquidity regime already kicking in from January 1, 2015.
So you are well-versed with the new regulatory phrases- leverage, capital conservation buffers,
counter-cyclical capital buffers etc. The D-SIBs guidelines have also been announced and the
list of banks considered systemically important in the domestic context would be unveiled in
August 2015. Besides, being subjected to stricter capital and liquidity buffers, these banks may
also be nudged to prepare detailed ‗recovery and resolution plans‘.
Negotiations are also on at the Financial Stability Board level for implementation of a TLAC
(Total Loss Absorbency Capital) framework for the banks identified as G-SIBs. The essence of all
the above discussion is that the banks would need to substantially augment their capital bases
to stay in the business. The question is where do you find such capital?
28. I have covered much broader landscape than I had originally intended to. I believe the elite
panel gathered here today would deliberate on the issues raised and also reflect on them later.
I once again thank Mint for inviting me and wish you all a fruitful deliberation.

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 FM Notes 24 – Corporate Governance in Banks

Important Terminologies
Bank or banking organization: A bank, bank holding company or other company considered by
banking supervisors to be the parent of a banking group under applicable national law as
determined to be appropriate by the entity‘s national supervisor.
Board of directors, board: The body that supervises management. The structure of the board
differs among countries. The use of ―board‖ throughout this paper encompasses the different
national models that exist and should be interpreted in accordance with applicable law within
each jurisdiction.
Control functions: Those functions that have a responsibility independent from management to
provide objective assessment, reporting and/or assurance. This includes the risk management
function, the compliance function and the internal audit function.
Corporate governance: A set of relationships between a company‘s management, its board, its
shareholders and other stakeholders which provides the structure through which the objectives of
the company are set, and the means of attaining those objectives and monitoring performance.
It helps define the way authority and responsibility is allocated and how corporate decisions are
made.
Duty of care: The duty of board members to decide and act on an informed and prudent basis
with respect to the bank. Often interpreted as requiring board members to approach the affairs
of the company the same way that a ―prudent person‖ would approach his or her own affairs.
Duty of loyalty: The duty of board members to act in good faith in the interest of the company.
The duty of loyalty should prevent individual board members from acting in their own interest, or
the interest of another individual or group, at the expense of the company and shareholders.
Executive director: In jurisdictions where this is permitted, a member of the board (eg director)
who also has management responsibilities within the bank. A non-executive director is a member
of the board who does not have management responsibilities within the bank.
Independent director: For the purposes of this paper, a non-executive member of the board who
does not have any management responsibilities within the bank and is not under any other undue
influence, internal or external, political or ownership, that would impede the board member‘s
exercise of objective judgment.
Internal control system: A set of rules and controls governing the bank‘s organizational and
operational structure, including reporting processes, and functions for risk management,
compliance and internal audit.
Risk appetite: The aggregate level and types of risk a bank is willing to assume, decided in
advance and within its risk capacity, to achieve its strategic objectives and business plan.
Risk appetite framework (RAF): The overall approach, including policies, processes, controls and
systems, through which risk appetite is established, communicated and monitored. It includes a

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risk appetite statement, risk limits and an outline of the roles and responsibilities of those
overseeing the implementation and monitoring of the
RAF: The RAF should consider material risks to the bank, as well as to its reputation vis-à-vis
policyholders, depositors, investors and customers. The RAE aligns with the bank‘s strategy.
Risk appetite statement (RAS): The written articulation of the aggregate level and types of risk
that a bank will accept, or avoid, in order to achieve its business objectives. It includes
quantitative measures expressed relative to earnings, capital, risk measures, liquidity and other
relevant measures as appropriate. It should also include qualitative statements to address
reputation and conduct risks as well as money laundering and unethical practices.
Risk capacity: The maximum amount of risk a bank is able to assume given its capital base, risk
management and control capabilities as well as its regulatory constraints.
Risk culture: A bank‘s norms, attitudes and behaviours related to risk awareness, risk-taking and
risk management, and controls that shape decisions on risks. Risk culture influences the decisions
of management and employees during the day - to - day activities and has an impact on the risks
they assume.
Risk governance framework: As part of the overall corporate governance framework, the
framework through which the board and management establish and make decisions about the
bank‘s strategy and risk approach; articulate and monitor adherence to risk appetite and risk
limits vis-à-vis the bank‘s strategy; and identify, measure, manage and control risks.
Risk limits: Specific quantitative measures or limits based on, for example, forward- looking
assumptions that allocate the bank‘s aggregate risk to business lines, legal entities as relevant
specific risk categories, concentrations and, as appropriate, other measures.
Risk management: The processes established to ensure that all material risks and associated risk
concentrations are identified, measured, limited, controlled, mitigated and reported on a timely
and comprehensive basis.
Risk profile: Point-in-time assessment of a bank‘s gross risk exposures (i.e. before the
application of any mitigants) or, as appropriate, net risk exposures (i.e. after taking into account
mitigants) aggregated within and across each relevant risk category based on current or forward-
looking assumptions.
Effective corporate governance is critical to the proper functioning of the banking sector and the
economy as a whole. While there is no single approach to good corporate governance, the Basel
Committee‘s revised principles provide a framework within which banks and supervisors should
operate to achieve robust and transparent risk management and decision-making and, in doing so,
promote public confidence and uphold the safety and soundness of the banking system.
The Committee‘s revised set of principles supersedes guidance published by the Committee in
2010. The revised guidance emphasises the critical importance of effective corporate governance
for the safe and sound functioning of banks. It stresses the importance of risk governance as part
of a bank‘s overall corporate governance framework and promotes the value of strong boards and
board committees together with effective control functions. More specifically, the revised
principles:

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1. Expand the guidance on the role of the board of directors in overseeing the implementation of
effective risk management systems;
2. Emphasize the importance of the board‘s collective competence as well as the obligation of
individual board members to dedicate sufficient time to their mandates and to keep abreast of
developments in banking;
3. Strengthen the guidance on risk governance, including the risk management roles played by
business units, risk management teams, and internal audit and control functions (the three lines
of defence), as well as underline the importance of a sound risk culture to drive risk management
within a bank;
4. Provide guidance for bank supervisors in evaluating the processes used by banks to select
board members and senior management; and
5. Recognize that compensation systems form a key component of the governance and incentive
structure through which the board and senior management of a bank convey acceptable risk-
taking behaviour and reinforce the bank‘s operating and risk culture.
A consultative version of the Corporate governance principles for banks was published in October
2014. The Basel Committee wishes to thank all those who contributed time and effort to express
their views during the consultation process.
Report of the Committee to Review Governance of Boards of Banks in India
(Very Important)
The Committee to Review Governance of Boards of Banks in India was constituted by the RBI
Governor on 20th January, 2014. The Committee was expected to submit its report within three
months from the date of its first meeting. The Committee held five meetings, commencing 18th
February, 2014.
Committee Members:
Chairman:
P.J. Nayak: Former Chairman and CEO, Axis Bank, and Former Country Head, Morgan Stanley
India, Mumbai
Members:
S. Raman: Whole Time Member, SEBL Mumbai
Shubhalakshmi Panse: Chairperson & Managing Director, Allahabad Bank, Kolkata (since retired)
Pratip Kar: Former Executive Director, SEBI, Mumbai
Joydeep Sengupta: Director and Senior Partner, McKinsey and Company
Harsh Vardhan: Partner, Bain & Company, Mumbai
Somasekhar Sundaresan: Partner, J. Sagar Associates, Mumbai
Krishnamurthy Subramanian: Assistant Professor, Indian School of Business, Hyderabad

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Terms of Reference:
1. To review the regulatory compliance requirements of banks‘ boards in India, to judge what can
be rationalized and where requirements need to be enhanced.
2. To examine the working of banks‘ boards including whether adequate time is devoted to issues
of strategy, growth, governance and risk management.
3. To review central bank regulatory guidelines on bank ownership, ownership concentration and
representation in the board.
4. To analyse the representation on bank boards to see whether the boards have the appropriate
mix of capabilities and the necessary independence to govern the institution, and to investigate
possible conflicts of interest in board representation, including among owner representatives and
regulators. In this regard, to also assess and review the ‗fit and proper‘ criteria, for all categories
of directors of banks, including tenor of directorship.
5. To examine board compensation guidelines.
6. Any other issue relevant to the functioning of the banks‘ boards and the governance they
exercise.
List of Recommendations (Actual report is of 110 pages)
Recommendation 2.1: Given the lower productivity, steep erosion in asset quality and
demonstrated competitiveness of public sector banks over varying time periods (as evidenced by
inferior financial parameters, accelerating stressed assets and declining market share), the
recapitalisation of these banks will impose significant fiscal costs. If the governance of these
banks continues as at present this will impede fiscal consolidation, affect fiscal stability and
eventually impinge on the
Government‘s solvency. Consequently, the Government has two options: either to privatise these
banks and allow their future solvency to be subject to market competition, including through
mergers; or to design a radically new governance structure for these banks which would better
ensure their ability to compete successfully, in order that repeated claims for capital support
from the Government unconnected with market returns, are avoided.
Recommendation 2.2: There are several external constraints imposed upon public sector banks
which are inapplicable to their private sector competitors. These constraints encompass dual
regulation (by the Finance Ministry, and by the RBL which goes substantially beyond the discharge
of a principal shareholder function); the manner of appointment of directors to boards; the short
average tenures of Chairmen and Executive Directors; compensation constraints; external
vigilance enforcement and applicability of the Right to Information Act. Each of these constraints
disadvantages these banks in their ability to compete with their private sector competitors. The
Government and RBI need to move to rapidly eliminate or significantly reduce these constraints,
in the absence of which managements of public sector banks will continue to face an erosion of
competitiveness. Further, it is only after these external constraints have been addressed would it
be practicable for public sector banks to address a host of internal weaknesses which affect their
competitiveness.

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Recommendation 3.1: There is a need to upgrade the quality of board deliberation in public
sector banks to provide greater strategic focus. There are seven themes which appear critical to
their medium-term strengths comprising Business Strategy, Financial Reports and their Integrity,
Risk, Compliance, Customer Protection, Financial Inclusion and Human Resources. All other items
for discussion should be brought to the Boards by exception and should typically be discussed in
committees of boards. Among the seven themes identified for detailed board scrutiny, a
predominant emphasis needs to be provided to Business Strategy and Risk.
Recommendation 3.2: As the quality of board deliberation across firms is sensitive to the skills
and independence of board members, it is imperative to upgrade these skills in boards of public
sector banks by reconfiguring the entire appointments process for boards. Otherwise it is unlikely
that these boards will be empowered and effective. Specific recommendations for this purpose
are separately made in this report.
Recommendation 3.3: The Calendar of Reviews needs either to be revoked, or else to be freshly
designed so as to ensure that the time of the board is spent largely on the seven critical themes
listed in Recommendation 3.1, with specific attention given to business strategy and risk
management.
Recommendation 4.1: The Government needs to move rapidly towards establishing fully
empowered boards in public sector banks, solely entrusted with the governance and oversight of
the management of the banks. The transition path for this is contained in separate
Recommendations.
Recommendation 4.2: The Government should set up a Bank Investment Company (BIC) to hold
equity stakes in banks which are presently held by the Government. BIC should be incorporated
under the Companies Act, necessitating the repeal of statutes under which these banks are
constituted, and the transfer of powers from the Government to BIC through a suitable
shareholder agreement and relevant memorandum and articles of association.
Recommendation 4.3: While the Bank Investment Company (BIC) would be constituted as a core
investment company under RBI registration and regulation, the character of its business would
make it resemble a passive sovereign wealth fund for the Governments banks. The Government
and BIC should sign a shareholder agreement which assures BIC of its autonomy and sets its
objective in terms of financial returns from the banks it controls. It is also vital that the CEO of
BIC is a professional banker or a private equity investment professional who has substantial
experience of working in financial environments where investment return is the yardstick of
performance, and who is appointed through a search process. While the non- executive Chairman
and CEO of BIC would be nominated by the Government, it is highly desirable that all other
directors be independent and bring in the requisite banking or investment skills.
Recommendation 4.4: The CEO of the Bank Investment Company (BIC) would be tasked with
putting together the BIC staff team. BIC employees would be incentivised based on the financial
returns that the banks deliver. If such incentivisation requires the Government to hold less than
50 per cent of equity in BIC, the Government should consider doing so, as it will be the prime
financial beneficiary of BIC‘s success.
Recommendation 4.5: The Government should cease to issue any regulatory instructions
applicable only to public sector banks, as dual regulation is discriminatory. RBI should be the sole

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regulator for banks, with regulations continuing to be uniformly applicable to all commercial
banks.
Recommendation 4.6: The Government should also cease to issue instructions to public sector
banks in pursuit of development objectives. Any such instructions should, after consultation with
RBI, be issued by that regulator and be applicable to all banks.
Recommendation 4.7: The transfer of the Government holding in banks to the Bank Investment
Company (BIC), and the transitioning of powers to bank boards with the intent of fully
empowering them, needs to be implemented in phases.
Recommendation 4.8: It would be desirable for the bank licensing regime to move to a uniform
license across all broad-based banks, irrespective of ownership, subject to inter-jurisdictional
reciprocity considerations in respect of foreign banks, and niche licenses for banks with more
narrowly defined businesses.
Recommendation 4.9: Other than the Government‘s own stake, which would be unconstrained,
all other investment limits recommended in Chapter 6 for different categories of investors in
private sector banks should also be applicable to investors in public sector banks.
Recommendation 4.10: It is desirable for the Government to level the playing field for public
sector banks in relation to their private sector competitors. Reducing the proposed Bank
Investment Company‘s investment in a bank to less than 50 per cent will free the bank from
external vigilance emanating from the Central Vigilance Commission, from the Right to
Information Act, and from Government constraints on employee compensation.
Recommendation 5.1: In the context of the three-phase process earlier proposed, it would be
desirable to entrust the selection of the top management of public sector banks during Phase 1 to
a newly constituted Bank Boards Bureau (BBB). It is recommended that BBB be set up by an
executive order of the Government and comprise three senior bankers chosen from among those
who are either serving or retired Chairmen of banks, one of whom will be the Chairman of BBB.
They would be bankers of high standing and the Government should select them in consultation
with RBI. Where selections to top bank managements are proposed by BBB but not accepted by
the Government BBB will make a public disclosure.
Recommendation 5.2: The Chairman and each member of BBB should be given a maximum
tenure of three years. During this period the transfer of powers to the Bank Investment Company
(BIC) is envisaged and upon transfer to the BIC, tenure would cease. There will be no renewal of
their contract thereby ensuring that BBB‘s autonomy and independence is not compromised.
Their remuneration would be at least that of existing public sector bank Chairmen.
Recommendation 5.3: It is desirable to ensure a minimum five-year tenure for bank Chairmen
and a minimum three year tenure for Executive Directors. Given the very large retirements in
senior management positions expected in the next three years, well-designed personnel policies
to identify talented people who have demonstrated success would enable them to be groomed for
senior management. This could alter the demographic profile of top management with beneficial
consequences. With younger people of talent and successful track record in top management the
minimum tenures would get automatically ensured.

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Recommendation 5.4: Cases of vigilance enforcement against wholetime directors and other
bank employees for decisions taken by them must be based on evidence that the director or
employee personally made a wrongful gain. For levelling criminal charges, fraud must manifest
itself through evidence of self-benefit. In loan and expenditure cases, deviations from procedure
must not constitute the sole basis for initiating criminal action.
Recommendation 5.5: It is feasible and vital that in Phases 1-3 the selection process is initiated
in good time to complete the appointments approval before the expiry of tenures of the
incumbents. Delays presently occur because of vigilance clearance. It is recommended that this
clearance be conducted only at the stage when candidates are short-listed, and not resumed
after the Selection Committee recommends the candidate for appointment.
Recommendation 5.6: During Phase 1 of the three-stage empowerment of bank boards proposed
in Chapter 4, the selection of non-official directors should be entrusted to the Bank Boards
Bureau.
Recommendation 5.7: It is proposed that, from the second phase, the maximum term for any
director other than whole-time directors be restricted to seven years. Further, after any tenure
on a bank board, there would be a cooling-off period of five years, for the director to return to
the same bank board, and a two-year cooling-off period for the director to be appointed on the
board of any other bank.
Recommendation 5.8: Any director on the board of a public sector bank will be eligible to be a
director on the boards of at most six other listed companies.
Recommendation 5.9: A partner or employee of a firm auditing a bank would be conflicted in
becoming a director in another bank, in view of the client information which auditors have access
to. Likewise, for such partner or employee to be a director in the same bank being audited would
violate auditor independence. Therefore, no such partner or employee should be a director on
the board of any bank.
Recommendation 5.10: RBI directors should step down from bank boards during Phase 3 of the
transition process, unless a bank is troubled or raises special concerns.
Recommendation 5.11: The positions of bank Chairman and CEO should be separated during
Phase 3 of the transition process.
Recommendation 6.1: RBI should designate a specific category of investors in banks as
Authorised Bank Investors (ABI5), defined to include all funds with diversified investors which are
discretionally managed by fund managers and are deemed to be fit and proper. ABIs would
therefore include pension funds, provident funds, long-only mutual funds, long-short hedge funds,
exchange-traded funds and private equity funds (including sovereign wealth funds) provided they
are diversified, discretionally managed and found to be ‗fit and proper‘. ABIs would exclude all
proprietary funds (including those which are hedge funds or set up by corporates), non-banking
finance companies and insurance companies.
Recommendation 6.2: A single ABI should be permitted a maximum 20 per cent investment stake
in a bank without regulatory approval provided it possesses no right to appoint a board director.
An ABI which is given board representation, and thereby exercises a measure of influence, should

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be permitted a lower 15 per cent maximum investment limit without regulatory approval. Every
other investor should be permitted no more than 10 per cent without regulatory approval.
Recommendation 6.3: It would be impractical for either RBI or a bank to conduct a prior scrutiny
on whether an investor is ‗fit and proper‘ before an investment occurs. If, however, at any stage
and based on information laid before it, RBI concludes that an investor in a bank is not fit and
proper, RBI would be entitled to freeze the investor‘s voting rights in the bank and to seek its
disinvestment within a specified time period. As the initial onus of belief in being fit and proper
therefore falls on the investor, RBI should also consider offering an informal guidance service on
whether past regulatory or other action against an investor would disqualify categorisation as fit
and proper.
Recommendation 6.4: For promoter investors other than ABIs it is proposed that the continual
stake ceiling be raised to 25 per cent.
Recommendation 6.5: It would be inappropriate for regulation to stipulate a period within which
banks should be listed, particularly from a governance perspective, as premature listing could be
injurious to minority shareholder interests. It would therefore be desirable to modify the 2013
guidelines for new private sector banks accordingly.
Recommendation 6.6: For banks identified by RBI as distressed, it is proposed that private
equity funds, including sovereign wealth funds, be permitted to take a controlling stake of upto
40 per cent.
Recommendation 6.7: The principle of proportionate voting rights should constitute part of the
regulatory bedrock which fosters good bank governance, as it aligns investors‘ powers in
shareholder meetings with the size of their shareholding.
It is therefore desirable for RBI to raise the limit for voting rights to 26 per cent in accordance
with legislative changes recently enacted. It is also desirable to further amend legislation to
remove all constraints on voting rights in order to align it with company law.
Recommendation 6.8: Where the principal shareholder in an entrepreneur-led bank is also the
bank‘s CEO, RBI should satisfy itself that the board is adequately diversified and independent
with professionals of high standing. Where RBI lacks confidence of such independence, the
controlling shareholder should be asked to step down as CEO.
Recommendation 7.1: Wherever significant evergreening in a bank is detected by RBI, it is
recommended that RBI imposes penalties wherein:
1. Unvested stock options granted to officers who have indulged in the practice, and to all whole-
time directors, be cancelled in part or in full.
2. Monetary bonuses paid to such officers and to all whole-time directors, be clawed back by the
bank, in part or in full.
3. The Chairman of the audit committee be asked to step down from the board.
Recommendation 7.2: As the stance of RBI supervision has now moved from detailed to risk-
based supervision, it is desirable for supervisors to conduct random detailed checks on the
reported quality of banks‘ asset portfolio, particularly in those banks where compensation
through stock options is liberally provided.

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Recommendation 7.3: Boards of all banks, and particularly of the new private sector banks
because of their dominant market share, need to provide oversight on customer protection in the
distribution of third-party products, including matching the positioning of these products with
customer demographics, customer income and wealth, and customer risk-appetite; and ensuring
that product features are clearly explained to the customer.
Recommendation 7.4: Profit-based commissions for non-executive directors should be permitted
in, but not before, Phase 3 of the transition mechanism proposed in Chapter 4.
Recommendation 7.5: The minimum and maximum age prescribed by the Companies Act at the
time of appointment should be applicable to all directors of private sector banks. For whole-time
directors, the maximum age should be 65.
Recommendation 7.6: For old private sector banks where RBI has doubts about whether boards
are adequately independent of the controlling shareholders of the banks, RBI should mandate
that all director appointments be made with the prior approval of RBI. It should be RBI‘s
endeavour to ensure adequate director independence in the board.
Recommendation 7.7: In old private sector banks where RBI has doubts about whether the CEO
has full control over the executive management of the bank, it should examine the precise areas
of intervention by directors in bank committees and outside of it, and mandate a separation
between board oversight and executive autonomy.

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 FM Notes 25 – Derivatives Forward, Future and Swaps

1. What are derivatives?

Derivatives, such as futures or options, are financial contracts which derive their value from a
spot price, which is called the ―underlying‖. For example, wheat farmers may wish to enter into
a contract to sell their harvest at a future date to eliminate the risk of a change in prices by that
date. Such a transaction would take place through a forward or futures market.
This market is the ―derivatives market‖, and the prices of this market would be driven by the
spot market price of wheat which is the ―underlying‖. The term ―contracts‖ is often applied to
denote the specific traded instrument, whether it is a derivative contract in wheat, gold or
equity shares. The world over, derivatives are a key part of the financial system. The most
important contract types are futures and options, and the most important underlying markets are
equity, treasury bills, commodities, foreign exchange, real estate etc.
2. What is a forward contract?
In a forward contract, two parties agree to do a trade at some future date, at a stated price and
quantity. No money changes hands at the time the deal is signed.
3. Why is forward contracting useful?
Forward contracting is very valuable in hedging and speculation. The classic hedging application
would be that of a wheat farmer forward -selling his harvest at a known price in order to
eliminate price risk. Conversely, a bread factory may want to buy bread forward in order to assist
production planning without the risk of price fluctuations.
If a speculator has information or analysis which forecasts an upturn in a price, then he can go
long on the forward market instead of the cash market. The speculator would go long on the
forward, wait for the price to rise, and then take a reversing transaction making a profit.
4. What are the problems of forward markets?
Forward markets worldwide are afflicted by several problems:
(a) Lack of centralization of trading,
(b) Illiquidity, and
(c) Counterparty risk.
In the first two of these, the basic problem is that of too much flexibility and generality. The
forward market is like the real estate market in that any two persons can form contracts against
each other. This often makes them design terms of the deal which are very convenient in that
specific situation for the specific parties, but makes the contracts nontrade able if more
participants are involved. Also the ―phone market‖ here is unlike the centralization of price
discovery that is obtained on an exchange, resulting in an illiquid market place for forward
markets.
Counterparty risk in forward markets is a simple idea: when one of the two sides of the
transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic

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issue: the larger the time period over which the forward contract is open, the larger are the
potential price movements, and hence the larger is the counter- party risk.
Even when forward markets trade standardized contracts, and hence avoid the problem of
illiquidity, the counterparty risk remains a very real problem.
5. What is a futures contract?
Futures markets were designed to solve all the three problems (listed in Question 4) of forward
markets. Futures markets are exactly like forward markets in terms of basic economics. However,
contracts are standardized and trading is centralized (on a stock exchange).
There is no counterparty risk (thanks to the institution of a clearing corporation which becomes
counterparty to both sides of each transaction and guarantees the trade). In futures markets,
unlike in forward markets, increasing the time to expiration does not increase the counter party
risk. Futures markets are highly liquid as compared to the forward markets.
6. What are various types of derivative instruments traded at NSE?
There are two types of derivatives instruments traded on NSE; namely Futures and Options.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. All the futures contracts are settled in cash at NSE.
Options: An Option is a contract which gives the right but not an obligation, to buy or sell the
underlying at a stated date and at a stated price. While a buyer of an option pays the premium
and buys the right to exercise his option, the writer of an option is the one who receives the
option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types - Calls and Puts options:
―Calls‖ give the buyer the right but not the obligation to buy a given quantity of the underlying
asset at a given price on or before a given future date.
―Puts‖ give the buyer the right but not the obligation to sell a given quantity of underlying asset
at a given price on or before a given future date. All the options contracts are settled in cash.
Further the Options are classified based on type of exercise. At present the Exercise style can be
European or American.
American Option - American options are options contracts that can be exercised at any time
upto the expiration date. Options on individual securities available at NSE are American type of
options.
European Options - European options are options that can be exercised only on the expiration
date. All index options traded at NSE are European Options. Options contracts like futures are
Cash settled at NSE.
7. What are various products available for trading in Futures and Options segment at NSE?
Futures and options contracts are traded on Indices and on Single stocks. The derivatives trading
at NSE commenced with futures on the Nifty 50 in June 2000.
Subsequently, various other products were introduced and presently futures and options
contracts on the following products are available at NSE:

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1. Indices: Nifty 50, CNX IT Index, Bank Nifty Index, CNX Nifty Junior, CNX loo, Nifty Midcap 50,
Mini Nifty and Long dated Options contracts on Nifty 50.
2. Single stocks
8. Why to trade in derivatives?
Futures trading will be of interest to those who wish to:
1) Invest - take a view on the market and buy or sell accordingly.
2) Price Risk Transfer- Hedging - Hedging is buying and selling futures contracts to offset the
risks of changing underlying market prices. Thus it helps in reducing the risk associated with
exposures in underlying market by taking counter- positions in the futures market. For example,
an investor who has purchased a portfolio of stocks may have a fear of adverse market conditions
in future which may reduce the value of his portfolio. He can hedge against this risk by shorting
the index which is correlated with his portfolio, say the Nifty 50. In case the markets fall, he
would make a profit by squaring off his short Nifty 50 position. This profit would compensate for
the loss he suffers in his portfolio as a result of the fall in the markets.
3) Leverage- Since the investor is required to pay a small fraction of the value of the total
contract as margins, trading in Futures is a leveraged activity since the investor is able to control
the total value of the contract with a relatively small amount of margin. Thus the Leverage
enables the traders to make a larger profit (or loss) with a comparatively small amount of capital.
9. What are the benefits of trading in Index Futures compared to any other security?
An investor can trade the ‗entire stock market‘ by buying index futures instead of buying
individual securities with the efficiency of a mutual fund.
The advantages of trading in Index Futures are:
a. The contracts are highly liquid
b. Index Futures provide higher leverage than any other stocks
c. It requires low initial capital requirement
d. It has lower risk than buying and holding stocks
e. It is just as easy to trade the short side as the long side
f. Only have to study one index instead of 100s of stocks
10. How trading is done in the derivatives market at NSE?
Futures/ Options contracts in both index as well as stocks can be bought and sold through the
trading members of NSE. Some of the trading members also provide the internet facility to trade
in the futures and options market. You are required to open an account with one of the trading
members and complete the related formalities which include signing of member-constituent
agreement, Know Your Client (KYC) form and risk disclosure document. The trading member will
allot to you a unique client identification number. To begin trading, you must deposit cash
and/or other collaterals with your trading member as may be stipulated by him.

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11. What is the Expiration Day?
It is the last day on which the contracts expire. Futures and Options contracts expire on the last
Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on
the previous trading day.
12. Is there any Margin payable?
Yes. Margins are computed and collected on-line, real time on a portfolio basis at the client level.
Members are required to collect the margin upfront from the client & report the same to the
Exchange.
13. How are the contracts settled?
All the Futures and Options contracts are settled in cash on a daily basis and at the expiry or
exercise of the respective contracts as the case may be. Clients/Trading Members are not
required to hold any stock of the underlying for dealing in the Futures / Options market. All out
of the money and at the money option contracts of the near month maturity expire worthless on
the expiration date.
14. What are the Risks associated with trading in Derivatives?
Investors must understand that investment in derivatives has an element of risk and is generally
not an appropriate avenue for someone of limited resources/ limited investment and / or trading
experience and low risk tolerance. An investor should therefore carefully consider whether such
trading is suitable for him or her in the light of his or her financial condition. An investor must
accept that there can be no guarantee of profits or no exception from losses while executing
orders for purchase and I or sale of derivative contracts, Investors who trade in derivatives at the
Exchange are advised to carefully read the Model Risk Disclosure Document and the details
contained therein. This document is given by the broker to his clients and must be read, the
implications understood and signed by the investor. The document clearly states the risks
associated with trading in derivatives and advises investors to bear utmost caution before
entering into the markets.

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 FM Notes 26 – Financial Inclusion

Financial Inclusion refers to the delivery of financial services (Not only Banking) at an affordable
cost to the vast sections of the disadvantaged and low profile groups of the society.
So, Financial Inclusion helps vulnerable groups such as low income groups, weaker sections, etc.,
to increase incomes, acquire capital, manage risk and work their way out of poverty through
secure savings, appropriately priced credit and insurance products, and payment services.
Financial Inclusion should not be seen as a social responsibility of the Governments and the
banking system, but it is a potentially viable business proposition today which provides the poor
with opportunities to build savings make investments and get credit. The upcoming Tech
solutions such as UID project have a potential to make a difference.
Financial inclusion: Dr. Rangrajan Committee Recommendations
1. The broadening of Financial Services to those people who do not have access to financial
services sector.
2. The Deepening of Financial Services for people who have minimal financial services.
3. Greater Financial Literacy and Consumer Protection so that those who are offered the products
can make appropriate choices.
4. The imperative for financial inclusion is both a Moral one as well as one based on Economic
Efficiency.
5. We should give everyone the Tools and Resources to better themselves, and in doing so, better
the country.
6. By putting in place the Right Infrastructure and Enabling Regulation, we have to encourage the
development of the Products, Institutions, and Networks that will foster inclusion.
7. As we reach more and more of the population, we have to be sure that they understand the
products they are being sold and have the information to make Sensible Decisions. Caveat emptor
or let the buyer beware is typically the standard used in financial markets.
8. Technology, with its capacity to reduce transaction costs, is key to enabling the large volume
low ticket transaction that is at the center of financial inclusion. By collecting and processing
large volumes of data easily, technology can also improve the Quality of Financial Decision
Making.
9. When products have network effects, technology can ensure not just interoperability, key to
obtaining the benefits of networking, but also security, key to maintaining the confidence of
people and preventing them from withdrawing from the formal financial system once again.
10. The successful ICT industry can partner with the Finance Industry to revolutionize Financial
Inclusion in this country.
Whose Inclusion?

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The essence of Financial Inclusion is to ensure that a range of appropriate financial services is
available to every individual of the country. This should include:
Regular financial Intermediation such as Banking which includes basic no frills accounts for
sending and receiving money.
Saving Products which are suitable to the pattern of cash flow of the poor household. Availability
of the Money transfer facilities, Availability of small loans and overdrafts for productive, personal
and other uses.

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 FM Notes 27 – Disinvestment

It is an act of selling shares not exceeding 49% in profit-making public sector companies at a
market premium.
The objective is to raise money for the govt. to reduce its fiscal deficit.
As a word of caution, govt. will not go for disinvestment of more than 25% of its stake, for fears
of strategic investor.
As majority of the decisions of PSUs need to be approved by 3/4th majority, they can be blocked,
if govt. has less than 75% stake.
Strategic Investor is any person/group of person holding 26% of the shares.
Disinvestment Timeline in India
Disinvestment: When Government sells its shares of a PSU, to private sector company / individual.
Privatization: when Government sells so many shares, that it no longer remains the majority
shareholder of the given PSU.
1991
Interim budget, Government announced 20% disinvestment in selected PSUs.
Their shares were sold to Mutual funds and financial institutions (UTI, EPFO, UC etc.)
1992
Government decides to sells shares to Fils, PSU employees and banks.
1993
Rangarajan Committee suggests:
49% disinvestment in PSUs reserved for public sector
74% disinvestment in all other PSUs, Government did not implement.
1996
Disinvestment commission under GV Ramakrishna.
It was a non-statutory, advisory body (similar to U PA‘s NAC).
1998-2000
Vajpayee Government classifies PSUs into two parts
Strategic: arms-ammunition, railway, nuke energy etc. Here we won‘t do disinvestment
Non-strategic: those not in above category. here we will do disinvestment in a phased manner.
Hindustan Zinc, BALCO, Maruti Disinvestment taken up.

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To implement above policy, Department of disinvestment setup under Finance ministry. (first
there was disinvestment ministry, then department....not going into all ball by ball commentary)
2004
UPA comes into power, Common Minimum program (CMP) updates disinvestment policy
Sick PSUs will be revived
No disinvestment in profit making PSUs
PSUs will get commercial autonomy
2005
Whatever Money Government earns from selling its PSU shares- it‘ll goto National investment
fund (NIF). Click me to read more about it.
2005-09
Disinvestment remains stagnant because Left allies of the UPA Government stonewall everything.
2009 onwards
UPA-2 without left parties.
Government resumes disinvestment process.
All PSUs can be disinvested, but upper limit: 49%
Disinvestment Method: only public offer.
2013-14
Chindu wanted to earn 40,000 crores via disinvestment of Indian Oil, BHEL, NHPC, Neyveli lignite
etc. but hardly managed to get -16,000 crores. Main reasons for
# EPIC FAIL:
Oil ministry, mining ministry, trade unions opposed the move, files were delayed.
Lukewarm response from investors because sharemarket was down due to internal & external
factors.
2014
Mcdi cabinet approves disinvestment in NHPC, Coal India, ONGC
6 EPICFAIL PSUs will be closed down. 5 loss making but viable PSUs will be revived.
NITI Aayog submits proposals for divestment- I. The NITI Aayog has submitted two sets of
recommendations to the Centre for strategic disinvestment of State-owned companies. First is a
list of recommendations on each of the sick and loss-making government- owned companies &
there are about 74 such companies.
Suggested for about 25 companies in which revival plans were attempted but had failed. Their
assets, especially land holdings, could be disposed off and employees be offered voluntary

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retirement. In the remaining cases, either mergers with other public sector units or strategic
disinvestment is recommended. In some companies, the Aayog preferred to let revival plans run
their course, before taking a call on their future.
NITI Aayog submits proposals for divestment- II
The second set of suggestions is a separate list of 15 PSUs in which it has recommended strategic
disinvestment on priority. This list has been submitted to the Department of Investment and
Public Asset management in the Finance Ministry
The Cabinet Committee on Economic Affairs had directed the Aayog to identify PSUs that the
Department could take up for strategic disinvestment and also suggest norms for doing so. Any
disinvestment of government‘s shareholdings, closure or mergers of PSU will need the Union
Cabinet‘s approval.
Centre begins stake sale in 51 firms
The government plans to sell minority stakes in 51 listed as well as unlisted companies including
RIL, ICICI Bank, Axis Bank, L&T etc., and might exit in 3 years. A shareholding of less than 50% of
a company‘s equity capital which is not a controlling stake
Government holds minority stake in these companies through Specified Undertaking of UTI
(SUUTI). SUUTI was formed in 2003 as an offshoot of erstwhile Unit Trust of India (UTI) SUUTI is
looking at selling the investments either through an OFS, block deal, bulk deal or regular sale
through stock exchanges. Sale would help the government in meeting its ambitious disinvestment
targets
Department of Disinvestment is now „Dipam‟; notification issued
The Department of Disinvestment has been renamed as Department of Investment and Public
Asset Management or ‗Dipam, a decision aimed at proper management of Centre‘s investments in
equity including its disinvestment in central public sector undertakings.
The new department has been mandated to ―advise the government in the matters of financial
restructuring of central public sector enterprises and for attracting investment through capital
markets‖, as per a notification issued by the Cabinet Secretariat in this regard.
Finance Minister Arun Jaitley had announced renaming of the Department of Disinvestment in his
budget speech for 2016-17.
―We will adopt a comprehensive approach for efficient management of government investment in
Central Public Sector Enterprises by addressing issues such as capital restructuring, dividend,
bonus shares, etc. The Department of Disinvestment is being re-named as the Department of
Investment and Public Asset Management (Dipam),‖ he had said.
The Dipam will work under Finance Ministry and it will deal with ―all matters relating to
management of central government investments in equity including disinvestment of equity in
central public sector undertakings‖.
It will also deal with ―all matters relating to sale of central government equity through offer for
sale or private placement or any other mode in the erstwhile central public sector undertakings‖,
the notification reads.

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All other post disinvestment matters, including those relating to and arising out of the exercise of
call option by the strategic partner in the erstwhile central public sector undertakings, shall
continue to be handled by the administrative ministry or department concerned, where necessary,
in consultation with the Dipam, it said. AKV RG
Disinvestment Policy
The policy on disinvestment has evolved considerably through Presidents address to Joint Sessions
of Parliament and statement of the Finance Ministers in their Budget Speeches.
The salient features of the Policy are:
(i) Public Sector Undertakings are the wealth of the Nation and to ensure this wealth rests in the
hands of the people, promote public ownership of CPSEs;
(ii) While pursuing disinvestment through minority stake sale in listed CPSEs, the Government will
retain majority shareholding, i.e. at least 51 per cent of the shareholding and management
control of the Public Sector Undertakings;
(iii) Strategic disinvestment by way of sale of substantial portion of Government shareholding in
identified CPSEs upto 50 per cent or more, alongwith transfer of management control.
Approach for Disinvestment
(a) Disinvestment through minority stake sale on 5th November 2009, Government approved the
following action plan for disinvestment in profit making government companies:
(i) Already listed profitable CPSEs (not meeting mandatory shareholding of 10 per cent which
stands revised to 25 per cent) are to be made compliant through Offer for Sale‘ (OFS) by the
Government or by the CPSEs through issue of fresh shares or a combination of both;
(ii) Unlisted CPSEs with no accumulated losses and having earned net profit in three preceding
consecutive years to be listed;
(iii) Follow-on public offers would be considered, taking into consideration the needs for capital
investment of CPSEs on a case by case basis, and the Government could simultaneously or
independently offer a portion of its equity shareholding;
(iv) All cases of disinvestment are to be decided on a case by case basis;
(y) The Department of Investment and Public Asset Management (DIPAM) is to identify CPSEs in
consultation with respective administrative ministries and submit proposal to Government in
cases requiring Offer for Sale of Government equity.
(b) Strategic Disinvestment
(i) To be undertaken through a consultation process among different Ministries/Departments,
including NITI Aayog.
(ii) NITI Aayog to identify CPSEs for strategic disinvestment and advice on the mode of sale,
percentage of shares to be sold of the CPSE and method for valuation of the CPSE.

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(iii) The Core Group of Secretaries on Disinvestment (CGD) to consider the recommendations of
NITI Aayog to facilitate a decision by the Cabinet Committee on Economic Affairs (CCEA) on
strategic disinvestment and to supervise/monitor the process of implementation.
(c) Comprehensive management of Gol‟s investment in CPSEs
(i) The Government recognises its investment in CPSEs as an important asset for accelerating
economic growth and is committed to the efficient use of these resources to achieve optimum
return.
(ii) The Government will achieve these objectives by adopting a comprehensive approach for
addressing critical inter-linked issues such as leveraging of assets to attract fresh investment,
capital restructuring, financial restructuring, etc.
(iii) Different options for optimal utilization of Government‘s investment in CPSEs will be
assessed to adopt suitable investment management strategies to improve investors‘ confidence in
the CPSEs and support their market capitalization which is essential for raising fresh investment
from the capital market for their expansion and growth.
(iv) Efficient management of investment in CPSEs shall be ensured through rationalization of
decision making process for all related issues and seamless inter-departmental coordination in
the matter

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 FM Notes 28 – Finance Commission

Dr. Y. V. Reddy was appointed the Chairman of the Commission. Ms. Sushama Nath. Dr. M.
Govinda Rao and Dr. Sudipto Mundle were appointed full time
Members. Prof. Abhijit Sen was appointed as a part-time Member. Shri Ajay Narayan Jha was
appointed as Secretary to the Commission
Recommendations of the 14th Finance Commission (Summary)
1) The 14th Finance Commission is of the view that tax devolution should be the primary route
for transfer of resources to the States.
2) In understanding the States‘ needs, it has ignored the Plan and non-Plan distinctions
3) According to the Commission, the increased devolution of the divisible pool of taxes is a
―compositional shift in transfers‖ — from grants to tax devolution
4)In recommending an horizontal distribution, it has used broad parameters - population (1971),
changes in population since then, income distance, forest cover and area, among others.
5) It has recommended distribution of grants to States for local bodies using 2011 population data
with weight of 90 per cent and area with weight of 10 per cent
6) Grants to States are divided into two
7) One, grant to duly constituted gram panchayats
8) Two, grant to duly constituted municipal bodies
9) And, it has divided grants into two parts
10) A basic grant and a performance one for gram panchayats and municipal bodies
11) The ration of basic to performance grant is 90:10 for panchayats; and 80:20 for municipalities
12) The total grant recommended is ₹ 2,87,436 crore for a five-year period. Out of which, the
grant to panchayats is ₹2,00,292 crore. And, the reminder goes to municipalities
13) The Commission has significantly departed from previous commission vis-à-vis
recommendation of the principles governing grants-in-aid to the States by the Centre
14) It has chosen to take the entire revenue expenditure for this purpose. Hence, it has decided
to take into account a state‘s entire revenue expenditure needs without making a distinction
between plan and non-plan expenditure
15) The Commission is of the view that sharing pattern in respect to various Centrally-sponsored
schemes need to change. It wants the States to share a greater fiscal responsibility for the
implementation of such schemes.
Finance Commission of India is established by President of India as per Article 280 of the
constitution. The first finance commission was established in 1951. The Constitutional

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requirement for setting up a Finance Commission in India was an original idea, not borrowed from
anywhere. That is why it is called the original contribution.
Article 280
President should, within two years of commencement of the Constitution and thereafter on
expiry of every 5th year, or at such intervals as he/she thinks necessary, would constitute a
Finance Commission.
Members
Finance Commission would consist of a Chairman and 4 other members who are all will be
appointed by the President.
Functions
Since the commission has to be constituted at regular intervals, a certain measure of continuity
in the work of these commissions is ensured. Each commission benefits by the work of previous
commission.
Finance commission has to make recommendations to the President on two specific matters and
on any other mater referred to the commission by the president in the interest of Sound Finance.
The two specific matters are as follows:
How the net proceeds of taxes should be distributed between the Union and States?
On what principles, the grants-in-aid of the revenues of the State out of the Consolidated
Fund of India should be given to needy states?
The President, after considering the recommendations of the Finance Commission with regard to
income tax, prescribes by order the percentages and the manner of distribution. So, parliament is
not directly concerned with the assignment and distribution of the income tax.
Relevance of Finance Commission
The importance of the Finance Commission as a Constitutional instrument is capable of settling
many complicated financial problems that affect the relations of the Union and States. This is
evident from the recommendations of the last 14 finance Commissions appointed so far.
Report of Finance Commission in Parliament
Article 281 says that President shall cause every recommendation made by the Finance
Commission under the provisions of this Constitution together with an explanatory memorandum
as to the action taken thereon to be laid before each
House of Parliament.
Finance Commission does not tell the Union Government on how to increase its funds. Its work is
to make recommendations on distribution between the Union and the States of the net proceeds
of taxes and the principles which should govern the grants-in-aid of the revenues of the States
out of the Consolidated Fund of India and the sums to be paid to the States which are in need of
assistance by way of grants- in-aid of their revenues.

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Finance Commission suggests the measures needed to augment the Consolidated Fund of a State
to supplement the resources of the Panchayat and Municipalities in the State on the basis of the
recommendations made by the Finance Commission of the State. On Panchayat and Municipalities
The role of the Finance Commission has widened after the 73rd and 74th Constitutional
amendments to recognise the rural and urban local bodies as the third tier of government Article
280 (3) (bb) and
Article 280 (3) (c) of the Constitution mandate the Commission to recommend measures to
augment the Consolidated Fund of a State to supplement the resources of Panchayats and
Municipalities based on the recommendations of the respective State Finance Commissions (SFCs).
This also includes augmenting the resources of Panchayat and municipalities.

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 FM Notes 29 – Fiscal Policy and FRBM Act

The 2004-05 budget is claimed to have adequate provisions to achieve fiscal correction mandated
in the Fiscal Responsibility and Budget Management Act 2003 (FRBM) through enhancement of
revenue and reduction of revenue expenditure.
What is the FRBM Act?
The Fiscal Responsibility and Budget Management Act was enacted by Parliament in 2003 to bring
in fiscal discipline. It received the President‘s assent in August the same year. The United
Progressive Alliance (UPA) government had notified the FRBM Rules in July 2004. As Parliament is
the supreme legislative body, these will bind the present finance minister P Chidambaram, and
also future finance ministers and governments.
The main provisions of the FRBM Act in its original form were:
The revenue deficit as a ratio of GDP should be brought down by 0.5 per cent every year and
eliminated by 2007-08;
The fiscal deficit as a ratio of GDP should be reduced by 0.3 per cent every year and brought
down to 3 per cent by 2007-08;
The total liabilities of the Union Government should not rise by more than 9 per cent a year;
The Union Government shall not give guarantee to loans raised by PSUs and State governments
for more than 0.5 per cent of GDP in the aggregate;
Further, the Union Government should place three documents along with the budget, namely,
the Macroeconomic Framework Statement, the Medium Term
Fiscal Policy Statement and the Fiscal Policy Strategy Statement. In addition, the Finance
Minister will have to make a statement at the end of the second quarter on the trend of fiscal
indicators and corrective measures if they deviate from the budget estimates beyond the extent
stipulated in the FRBM.
N.K. Singh to head panel to review FRBM Act (The Hindu)
The government has announced the constitution of a panel under Former Revenue Secretary and
Rajya Sabha MP N.K. Singh to review the Fiscal Responsibility and Budget Management (FRBM) Act
of 2003.
The panel will also consider the possibility of replacing absolute fiscal deficit targets with a
target range that may be adjusted in line with the overall credit trends in the economy.
Mr.Singh will chair the five-member review committee promised by Finance Minister Arun Jaitley
in the Budget.
The ambit of the committee includes reviewing ―the working of the FRBM Act over last 12 years
and to suggest the way forward, keeping in view the broad objective of fiscal consolidation and
prudence and the changes required in the context of the uncertainty and volatility in the global
economy‖.

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The Committee is also to examine the feasibility of having a ‗fiscal deficit range‘ as the target
instead of the existing fixed numbers. The Committee is also tasked with examining ―the need
and feasibility of aligning the fiscal expansion or contraction with credit contraction or expansion
respectively in the economy.
―The moment you give any sort of leeway in terms of a fiscal deficit target band, there is always
the possibility of the government diluting the target, M. Govinda Rao, Professor Emeritus at the
National Institute of Public Finance and Policy, told The Hindu.
―But linking fiscal expansion to credit expansion means they are talking about counter-cyclical
measures,‖ Mr. Rao said.
Back to Basics
What is fiscal deficit?
The difference between total revenue and total expenditure of the government is termed as
fiscal deficit. It is an indication of the total borrowings needed by the government. While
calculating the total revenue, borrowings are not included.
Generally fiscal deficit takes place due to either revenue deficit or a major hike in capital
expenditure. Capital expenditure is incurred to create long-term assets such as factories,
buildings and other development. A deficit is usually financed through borrowing from either the
central bank of the country or raising money from capital markets by issuing different
instruments like treasury bills and bonds.
What is the difference between fiscal deficit and primary deficit?
Primary deficit is one of the parts of fiscal deficit. While fiscal deficit is the difference between
total revenue and expenditure, primary deficit can be arrived by deducting interest payment
from fiscal deficit. Interest payment is the payment that a government makes on its borrowings
to the creditors.
What are the views of different experts on fiscal deficit?
Economists differ widely on their views on fiscal deficit. According to John Maynard Keynes, a
deficit prevents an economy from falling into recession, while another school of thought is that a
country should not have fiscal deficit.
Many economists think that if the deficit is financed by raising debt from the central bank it may
lead to an inflationary scenario. Higher fiscal deficit is one of the reasons for the Indian economy
to have relatively higher inflation.
What is revenue deficit?
A mismatch in the expected revenue and expenditure can result in revenue deficit Revenue
deficit arises when the government‘s actual net receipts is lower than the projected receipts. On
the contrary, if the actual receipts are higher than expected one, it is termed as revenue surplus.
A revenue deficit does not mean actual loss of revenue.
Let‘s take a hypothetical example, if a country expects a revenue receipt of ₹100 and
expenditure worth ₹ 75, it can result in net revenue of ₹ 25. But the actual revenue of ₹ 90 is

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realised and an expenditure is ₹ 70. This translates into net revenue of ₹ 20, which is ₹ 5 lesser
than the budgeted net revenue and called as revenue deficit.
How will it help in redeeming the fiscal situation?
The FRBM Rules impose limits on fiscal and revenue deficit. Hence, it will be the duty of the
Union government to stick to the deficit targets. It also empowers RBI for taking measures to
control Inflation. The Act also provide exception to government in case of natural calamity and
national security.
As per the initial targets, revenue deficit which is revenue expenditure minus revenue receipts,
have to be reduced to nil in five years beginning 2004-05.
How are these targets monitored?
The Rules have mid-year targets for fiscal and revenue deficits. The Rules required the
government to restrict fiscal and revenue deficit to 45% of budget estimates at the end of
September (first half of the financial year).
In case of a breach of either of the two limits, the FM will be required to explain to Parliament
the reasons for the breach, the corrective steps, as well as the proposals for funding the
additional deficit.

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 FM Notes 30 – Forex Market

The forex market is the market in which participants are able to buy, sell, exchange and
speculate on currencies. The forex markets is made up of banks, commercial companies, central
banks, investment management firms, hedge funds, and retail forex brokers and investors. The
currency market is considered to be the largest financial market in the world, processing trillions
of dollars‘ worth of transactions each day.
The foreign exchange markets isn‘t dominated by a single market exchange, but involves a global
network of computers and brokers from around the world. Central banks use their massive buying
and selling capabilities to alter exchange rates through their open market activities and in many
cases will do so not with profit in mind, but rather for any number of policy reasons. Forex
brokers act as market makers as well, and may post bid and ask prices for a currency pair that
differs from the most competitive bid in the market.
Happenings in the foreign exchange market (henceforth forex market) form the essence of the
international finance. The foreign exchange market is not limited by any geographical boundaries.
It does not have any regular market timings, operates 24 hours 7 days week 365 days a year,
characterized by ever-growing trading volume, exhibits great heterogeneity among market
participants with big institutional investor buying and selling million of dollars at one go to
individuals buying or selling less than loo dollar.
In this module, a brief introduction to forex market details about trading volume, market
participants, different types of forex products are discussed. In addition, brief history and
evolution for exchange market would also be discussed.
Indian Foreign Exchange Market Recent Developments and the Road Ahead
(RBI‘s Views: No need to remember, just go through article.)
(Inaugural address delivered by Shri Harun R Khan, Deputy Governor, Reserve Bank of India at the
25th Annual Forex Assembly organized by the Forex Association of
India (FAT) at Gurgaon on October 4, 2014)
It is indeed a pleasure to address the trading professionals in the Indian foreign exchange market
at the Forex Association of India‘s 25th Annual Forex Assembly.
The emerging and enchanting city of Gurgaon provides the right backdrop for holding such a
conference as this city epitomizes phenomenal growth and development symbolizing the best of
―Made in India‖ and Make in India‖ and in a similar vein the Indian forex market has also
witnessed tremendous growth and development in terms of depth and breadth, particularly since
the adoption of market determined exchange rate regime about two decades ago.
2. The exchange rate of Rupee has witnessed both periods of intense volatility and periods of
stability since May 2013 when the Fed Chairman Bernanke first hinted at early tapering of Fed‘s
Quantitative Easing (QE) programme. Against this backdrop, I would like to start my address by
briefly touching upon the developments in the domestic forex market, especially after Chairman
Bernanke‘s testimony, and the measures taken by the RBI to restore orderly conditions in the
market. Then I would also like to focus on the possible risks to the stability of the forex market

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going forward and how well is India placed now as compared to 2008 and 2013 to cope with large
capital outflows if they were to materialize. Finally, I will discuss some of the major issues and
concerns pertaining to the Indian forex market which are presently engaging the attention of the
policy makers.
Developments in the forex market
3. In the aftermath of the global financial crisis and the Eurozone debt crisis, EMEs including India
faced enhanced uncertainty, especially in the external sector on the back of both local and
global developments. The worsening of India‘s external environment was amply reflected in the
deterioration in various external sector vulnerability indicators between end-March 2011 and end-
March 2013.
The external debt to GDP ratio increased from 18.2 per cent to 22.0 per cent. On the other hand,
the import cover of reserves, which stood at 9.5 months at end-March 2011 declined sharply to
about 7.0 months at end-March 2013. The CAD-GDP ratio deteriorated from 2.8 per cent to 4.7
per cent during the period. The weak macroeconomic environment was reflected in the form of
sharp deceleration in GDP growth rate (4.5 per cent in 2012-13 and 4.4 per cent in Ql of 2013-14),
high level of inflation (average CPI and average WPI inflation of 10.2 per cent and 7.4 per cent
respectively in 2012-13) and large fiscal deficit (4.8 per cent of GDP in 2012-13).
4. Though the trigger or the proximate cause for intense volatility witnessed in the domestic
forex market during the period May-August 2013 was the heightened concerns about the
possibility of early QE tapering, the more important cause was the existence of such weak macro-
economic fundamentals. The possibility of early tapering of QE programme by the US Fed
triggered large selloffs by the Fils, especially in the bond market leading to heightened volatility
of Rupee in line with other EME currencies. The hardening of long-term bond yields in the US and
other advanced economies increased their attractiveness, prompting foreign investors to pull
funds out of riskier emerging markets, which had received large capital inflows in search of
higher yields. The Indian Rupee became one of the worst performers during the period from the
second half of May 2013 to August 2013. Rupee depreciated sharply by around 19.4 per cent
against the US dollar from the level of 55.4 per US dollar on May 22, 2013 to a historic low of
68.85 per US dollar on August 28, 2013.
5. To stem the sharp and substantial depreciation of the Rupee, policy makers resorted to a mix
of policy measures including forex market intervention, monetary tightening through reduction in
banks‘ access to overnight LAF, increase in MSF rate and increase in daily minimum CRR
maintenance requirements and administrative measures, such as, import compression of non-
essential items like gold, opening of special dollar swap window for the PSU oil companies,
special concessional swap window for attracting FCNR (B) deposits, increase in overseas
borrowing limit of banks, bringing of outward FDI flows to the approval route, reduction in
Liberalised Remittance Scheme (LRS) entitlement disallowing banks from carrying proprietary
trading in exchange traded derivatives, etc. The Reserve Bank made net sales to the tune of
US$ 10.8 billion in the forex market during the period May-August 2013. The Reserve Bank also
intervened in the forward market resulting in doubling of net forward liabilities to US$ 9.1 billion
as at end-August 2013 from USS 4.7 billion in July 2013. Apart from monetary and administrative
measures, the flow encouraging measures, such as, enhancement of FII investment limit in
government debt by US$ 5 billion to US$ 30 billion was undertaken in June 2013.

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6. The special forex swap facilities extended by the Reserve Bank at concessional rate for fresh
longer term FCNR (B) deposits and banks‘ overseas borrowings along with enhancement in their
overseas borrowing limits led to forex inflows in excess of US$ 34 billion that aided in restoring
stability of the Rupee. The Reserve Bank undertook the concessional swap facility as an
exceptional measure with the broader public policy objective of bolstering the forex reserves for
strengthening Bank‘s market intervention capability. Similarly, the swap windows to meet oil
demand were conceived as a purely temporary dollar lending arrangement to OMCs. The swap
window did attract a fair amount of criticism from the perspective of execution of the second leg
but thankfully the Reserve Bank can look back at these temporary arrangements with a sense of
satisfaction of restoring confidence and stability in the foreign exchange market and India‘s
external sector outlook.
7. Alongside, various measures taken by the Reserve Bank and the Government of India including
the fiscal steps taken to compress gold demand helped in stabilizing the financial markets, in
general, and the forex market, in particular through sharp reduction in CAD and increase in
capital inflows. Consequently, the Rupee made a smart recovery in September-October 2013.
With the return of stability in the forex market, a calibrated unwinding of exceptional monetary
and administrative measures of July 2013 was undertaken from September 2013 onwards.
8. Despite the announcement on December 18, 2013 of commencement of tapering by the US Fed
starting from January 2014 and the subsequent announcements about the increase in its pace,
the Rupee has generally remained stable, which indicates that the markets have broadly shrugged
off QE tapering fears. The Rupee has remained relatively stable as compared to other major EME
currencies like Brazilian
Real, Turkish Lira South African Rand, Indonesian Rupiah and Russian Rouble. The daily volatility
(annualised) of Rupee during the period from January 1 to September 30, 2014 remained at 5.9
per cent as against South African Rand (11.5 per cent), Brazilian Real (10.8 per cent), Turkish Lira
(10.6 per cent), Russian Rouble (9.9 per cent) and Indonesian Rupiah (6.9 per cent). In terms of
point-to-point variation,
Rupee has marginally appreciated by about 0.5 per cent during the above period, while other
currencies have witnessed depreciation, viz. Russian Rouble (16.9 per cent depreciation), South
African Rand (7.4 per cent), Turkish Lira (5.8 per cent) and Brazilian Real (3.4 per cent).The
contagion effect of sharp fall in Argentine Peso against the US dollar in the second half of
January 2014 also did not have any major impact on the Rupee. Even the recent geo political
crises in Ukraine, Iraq and Gaza did not have any significant impact on the Indian financial
markets. This has led to some analysts describing Indian Rupee as the most agile out of the
fragile currencies of EMEs.
9. The fact that weak macroeconomic fundamentals have a tendency to accentuate the contagion
effect of any adverse external development was amply demonstrated during the May-August 2013
episode of volatility. Countries with large macroeconomic imbalances, especially large CAD, such
as, Brazil, Turkey, India, Indonesia, etc., experienced much larger volatility as compared to other
EDMEs with current account surplus/better fundamentals. In a scenario of intense volatility,
traditional monetary policy defence at times proves inadequate as was experienced by other
EDMEs like Turkey and Indonesia. Thus, a mix of measures, including administrative measures,
coupled with effective communication by central banks helps in containing the exchange rate

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volatility. I feel that the main lesson from this episode of volatility for an EMDE central bank is to
have sufficient tools in its toolkit and employ them in a flexible, proactive and pragmatic manner.
In this context, having large forex reserves, which was earlier considered wasteful on account of
quasi fiscal costs, has become a new virtue. Even the debate surrounding capital account
liberalisation has decisively veered towards having some necessary capital controls in place to
protect the EMDEs from the vagaries of international capital flows where a deluge is generally
followed by sudden stops. The need for the EMDEs to have prudent capital controls in place has
been duly recognised by the ardent votaries of full capital account liberalisation like the IMF.
Unfettered capital account liberalisation is now passé and the new mantra is having certain
necessary capital controls in place and use them proactively during episodes of heightened
volatility.
10. As regards the movement of Rupee during the recent period, it has remained largely range-
bound with strengthening bias on the back of sustained capital inflows and improving
macroeconomic fundamentals. In a comparative sense in Q2 of 2014-
15, the Indian Rupee depreciated 2.72 per cent against the US dollar while the Russian Rouble
depreciated about 13 per cent, Turkish Lira by 6.5 per cent the Brazilian Real by 10 per cent, and
the South African Rand by 5.5 per cent. There has been continuing FII inflows to the domestic
equity markets as well as resumption of FIl inflows to debt market especially since December
2013 (except in April 2014 when there was a net outflow). During 2014 so far, foreign portfolio
inflows to debt and equity markets have been around US$ 34 billion with the larger part going to
the debt segments.
The substantial reduction in gold imports and increase in exports led to significant reduction in
current account deficit to 1.7 per cent of GDP in Q1 2014-15 from 4.8 per cent in Q1 2013-14. In
the recent period, inflation has decelerated (7.8 per cent CPI inflation in August 2014), growth
has picked up (5.7 per cent in Ql of 2014-15 as compared to 4.7 per cent in Q1 of previous year),
fiscal deficit has reduced (4.5 per cent of GDP during 2013-14).
India‘s forex reserves have increased by around US$ 40.3 billion in the past one year to around
USS 316 billion as on September 12, 2014.While the country‘s external debt may have risen to 1.8
per cent for the quarter ended June 2014, the share of short-term debt in the total debt has
declined primarily due to restrictions on FII investments in the short end of the G-sec. It is
equally important to note that short term debt as a percentage of reserves have also declined
largely due to increase in the size of foreign exchange reserves.
The sharp increase in forex reserves and improvement in macroeconomic fundamentals, including
the short-term debt profile, have significantly enhanced the resilience of the economy to
external shocks. Political stability in terms of formation of a new Government with clear mandate,
Government‘s continued commitment to fiscal consolidation and sustained decline in oil prices
have boosted the confidence in the country‘s macro-economy. The recent upgrade in country‘s
outlook from negative to stable by S & P in a sense reflects and reinforces this new confidence.
Thus, it can be said that India is in a much better position to withstand large capital outflows
triggered by external developments. We, however, have to be alive to a few downside risks.
Downside Risks

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11. Downside risks in the form of still elevated retail inflation, continued weak economic
performance, uncertainty surrounding global economic recovery, potential slowdown of capital
flows to EMEs once interest rate cycle in advanced economies reverses, geopolitical risks, etc.,
remain. We need to be particularly cautious of the likely impact of headwinds arising due to
growing robustness in the growth outlook of the US and the strengthening of the US dollar and the
dovish stance of the
European Central Bank. These can cause problems to India‘s external sector. Additionally; the
recent surge in equity markets has created concerns about under-pricing of risks with attendant
implications for financial stability.
Any abrupt correction of such risks may result in sharp fall in asset prices and enhanced volatility
in global financial markets, especially in the EMDEs. Moreover, as we have seen while financial
risk taking has gone up substantially, aided by accommodative policies of central banks of AEs,
economic risk taking in conspicuously absent or muted. This has implications for global output
growth and in turn trade growth trajectory; WTO, for instance, has lowered its world trade
growth forecast for 2014 from 4.7 in in April to 3.1 in September.
Further, though macro-economic fundamentals and business sentiments in the country have
improved during the recent period, more needs to be done in terms of removing structural
impediments, building durable business confidence and creating fiscal space to support
investments in order to secure sustainable growth. In the long-run, the resilience and robustness
of the macro- economy in conjunction with the depth, breadth and orderliness of the financial
markets will determine the stability of the external sector as well as the overall financial sector.
12. Now I would like to turn to some of the major issues and concerns relating to the forex
market which are currently engaging the attention of the policy makers and, I hope, also of the
market players. Hedging of Currency Exposures by Corporates
13. In the recent period, the global financial markets have been going through a phase of low
volatility and the Indian markets have been no exception to this trend.
A supportive policy environment backed by accommodative monetary policy stance of the central
banks of the advanced economies (AE5) and visible signs of pick-up in growth in some of the AEs
have contributed, in a large measure, to reduction in volatility. On the flip side in India, there is
emerging anecdotal evidence of reduced propensity to hedge foreign exchange exposures arising
out of a sense of complacency.
The unhedged exposures in respect of External Commercial Borrowings (ECBs)/ Foreign Currency
Convertible Bonds (FCCBs) lead to large scale currency mismatches in view of the bulk amount
borrowed by domestic corporates for longer tenors with limited or no natural hedges. Further,
the increasing use of bond route for overseas borrowings exposes the domestic borrowers to
greater roll over risk.
As per indicative data available with the Bank, the hedge ratio for ECBs/FCCBs declined sharply
from about 34 per cent in FY 2013-14 to 24 per cent during April-August, 2014 with very low ratio
of about 15 per cent in July-August 2014. Large scale currency mismatches could pose serious
threat to the financial stability in case exchange rate encounters sudden depreciation pressure. It
is absolutely essential that corporates should continue to be guided by sound hedging policies and
the financing banks factor the risk of unhedged exposures in their credit assessment framework.

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Banks have expressed the difficulty faced by them in pricing the unhedged exposures of the
corporates in an environment of low pick up in credit growth. Given the implications of large
unhedged forex exposures on the financial stability, it is necessary for the banking industry to act
in unison to bring about an awareness amongst the corporates about the need for adopting and
implementing a well-deliberated hedging policy so that the Indian forex market is spared of
regular episodes of extreme volatility. Foreign Exchange Derivatives - Requirement of Underlying
Exposure
14. The access to the OTC foreign exchange derivatives has been subject to production of
documentary evidence in support of the underlying exposure except for hedging of probable
exposures and special dispensations offered to SMEs, individuals and firms. The primary objective
of the regulation has been to restrict the use of OTC foreign exchange derivatives by the
corporate clients for hedging their exchange rate risks and not for trading in the instruments.
Trading in derivatives requires sophisticated risk management skills and financial acumen which
are not the natural strengths of corporate entities barring a few large corporates who are into
treasury operations as an independent profit centre. Further, the trading activities of authorised
dealer banks are subject to strict governance and regulatory standards which the corporate
entities even with sophisticated treasuries are not subjected to.
The exchange rate being an important macroeconomic variable, unregulated trading in it has
potential adverse consequences for macroeconomic and financial stability. The Reserve Bank is
aware of active intra-day/short term trading by some corporate houses in the foreign exchange
government securities market. In the past the Reserve Bank has imposed restrictions on
cancellation and rebooking of forward contracts by the corporates so as to curb their speculative
trading that accentuates volatility of Rupee. As huge position taking by the corporates has the
potential of destabilizing the market particularly during periods of uncertainty, Reserve Bank
would expect adherence to the spirit of its regulations by such non-bank entities.
15. The Reserve Bank is fully aware of the need to put in place customer-friendly procedures to
encourage greater amount of hedging from the end-users. In the past the bank has taken several
measures to simplify the documentation requirements for facilitating easy access to foreign
exchange derivatives; recently it has increased the limit of hedging for resident individuals, firms
and companies based on simple declarations without documentation to US$ 250,000 from the
earlier limit of US$ 100,000.
The facility of hedging the probable exposures based on past performance in respect of trades in
merchandise goods and services has also provided flexibility in hedging in the absence of
underlying documents supporting contracted exposures. The Reserve Bank had imposed certain
restrictions in use of the past performance based facility by the importers in the backdrop of
heightened volatility in exchange rate of Rupee last year. It has gradually removed the
restrictions as the exchange rate started trading in a stable manner. As announced in the latest
Monetary Policy statement of September 30, 2014, the eligible limit for importers under the past
performance route has been restored to hundred percent.
The Way Forward
16. The Indian foreign exchange market has come a long way in terms of variety of instruments,
participants and the overall market turnover. Liberalization in exchange controls, simplification
of operating procedures and introduction of several new instruments has provided greater

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flexibility to the market participants in undertaking foreign exchange operations and managing
their currency risks.
Given the growing size of India‘s presence in international trade and finance, more of course
needs to be done to make the market broader, deeper and more vibrant. I have flagged certain
proximate concerns and issues, although the list is not exhaustive, for this gathering to ponder
over I am sure a congregation of this nature with a number of domain experts participating in the
business sessions would also discuss some of these issues of proximate concerns. These and other
strategic issues deliberated in such a forum would go a long way in delineating the future
trajectory of development and regulation of the foreign exchange market of an aspiring EMDE like
ours. I wish the conference a great success.
Thank you for your attention.

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 FM Notes 31 – Inflation

Definition: Inflation is the percentage change in the value of the Wholesale Price Index (WPI) on
a year-on year basis. It effectively measures the change in the prices of a basket of goods and
services in a year. In India, inflation is calculated by taking the WPI as base.
Formula for calculating Inflation=
(WPI in month of current year-WPI in same month of previous year) x 100
WPI in same month of previous year
Description: Inflation occurs due to an imbalance between demand and supply of money, changes
in production and distribution cost or increase in taxes on products.
When economy experiences inflation, i.e. when the price level of goods and services rises, the
value of currency reduces. This means now each unit of currency buys fewer goods and services.
It has its worst impact on consumers. High prices of day-to-day goods make it difficult for
consumers to afford even the basic commodities in life. This leaves them with no choice but to
ask for higher incomes. Hence the government tries to keep inflation under control.
Contrary to its negative effects, a moderate level of inflation characterizes a good economy. An
inflation rate of 2 or 3% is beneficial for an economy as it encourages people to buy more and
borrow more, because during times of lower inflation, the level of interest rate also remains low.
Hence the government as well as the central bank always strive to achieve a limited level of
inflation.
What creates inflation?
Long-lasting episodes of high inflation are often the result of lax monetary policy. If the money
supply grows too big relative to the size of an economy, the unit value of the currency
diminishes; in other words, its purchasing power falls and prices rise.
This relationship between the money supply and the size of the economy is called the quantity
theory of money, and is one of the oldest hypotheses in economics. Pressures on the supply or
demand side of the economy can also be inflationary.
Supply shocks that disrupt production, such as natural disasters, or raise production costs, such as
high oil prices, can reduce overall supply and lead to cost-push‖ inflation, in which the impetus
for price increases comes from a disruption to supply.
The food and fuel inflation episodes of 2008 and 2011 were such cases for the global economy -
sharply rising food and fuel prices were transmitted from country to country by trade. Poorer
countries were generally hit harder than advanced economies.
Conversely, demand shocks, such as a stock market rally, or expansionary policies, such as when
a central bank lowers interest rates or a government raises spending, can temporarily boost
overall demand and economic growth. If, however, this increase in demand exceeds an
economy‘s production capacity, the resulting strain on resources creates ―demand-pull‖ inflation.

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Policymakers must find the right balance between boosting growth when needed without over
stimulating the economy and causing inflation.
Expectations also play a key role in determining inflation. If people or firms anticipate higher
prices, they build these expectations into wage negotiations or contractual price adjustments
(such as automatic rent increases). This behaviour partly determines future inflation; once the
contracts are exercised and wages or prices rise as agreed, expectations have become self-
fulfilling. And to the extent that people base their expectations on the recent past, inflation will
follow similar patterns over time, resulting in inflation inertia.
What is Inflation or What is the meaning of Inflation:
In economics inflation means, a rise in general level of prices of goods and services in a economy
over a period of time. When the general price level rises, each unit of currency buys fewer goods
and services. Thus, inflation results in loss of value of money. Another popular way of looking at
inflation is ―too much money chasing too few goods‖. The last definition attributes the cause of
inflation to monetary growth relative to the output / availability of goods and services in the
economy.
In case the price of say only one commodity rise sharply but prices of other commodities fall, it
will not be termed as inflation. Similarly, in case due to rumors if the price of a commodity rise
during the day itself, it will not be termed as inflation.
What are different types of inflation?
Broadly speaking inflation is divided into two categories i.e.
(a) DEMAND - PULL INFLATION: In this type of inflation prices increase results from an excess of
demand over supply for the economy as a whole. Demand inflation occurs when supply cannot
expand any more to meet demand; that is, when critical production factors are being fully
utilized, also called Demand inflation.
(b) COST - PUSH INFLATION: This type of inflation occurs when general price levels rise owing to
rising input costs. In general, there are three factors that could contribute to Cost-Push inflation:
rising wages, increases in corporate taxes, and imported inflation. [Imported raw or partly-
finished goods may become expensive due to rise in international costs or as a result of
depreciation of local currency]
What is Deflation?
Deflation is the opposite of inflation. Deflation refers to situation, where there is decline in
general price levels. Thus, deflation occurs when the inflation rate falls below 0% (or it is
negative inflation rate). Deflation increases the real value of money and allows one to buy more
goods with the same amount of money over time.
Deflation can occur owing to reduction in the supply of money or credit. Deflation can also occur
due to direct contractions in spending, either in the form of a reduction in government spending,
personal spending or investment spending.
Deflation has often had the side effect of increasing unemployment in an economy, since the
process often leads to a lower level of demand in the economy.

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What is Stagflation?
Stagflation refers to economic condition where economic growth is very slow or stagnant and
prices are rising. The term stagflation was coined by British politician Tain Macleod, who used the
phrase in his speech to parliament in 1965, when he said: ―We now have the worst of both worlds
- not just inflation on the one side or stagnation on the other. We have a sort of ‗stagflation‘
situation.‖ The side effects of stagflation are increase in unemployment- accompanied by a rise
in prices, or inflation. Stagflation occurs when the economy isn‘t growing but prices are going up.
At international level, this happened during mid-1970s, when world oil prices rose dramatically,
fuelling sharp inflation in developed countries.
What is Hyperinflation?
Hyperinflation is a situation where the price increases are too sharp. Hyperinflation often occurs
when there is a large increase in the money supply, which is not supported by growth in Gross
Domestic Product (GDP). Such a situation results in an imbalance in the supply and demand for
the money. In this this remains unchecked; it results into sharp increase in prices and
depreciation of the domestic currency.
What is Headline Inflation?
Headline inflation refers to inflation figure which is not adjusted for seasonality or for the often
volatile elements of food & energy prices, which are removed in the Core CPI. Headline inflation
will usually be quoted on an annualized basis, meaning that a monthly headline figure of 4%
inflation equates to a monthly rate that, if repeated for 12 months, would create 4% inflation for
the year. Comparisons of headline inflation are typically made on a year-over-year basis. Also
known as ―top-line inflation‘.
What are the key differences between stagflation and hyperinflation?
Stagflation occurs when a period of high inflation coincides with a stagnant economy and
elevated unemployment. Hyperinflation happens when the rate of inflation reaches an extremely
high level. Inflation usually maintains a positive relationship with economic growth. When
productivity is high and the economy is growing at a healthy clip, prices rise to match income
growth and economic growth.
When inflation takes off at a pace not in sync with economic growth, hyperinflation occurs. Many
economists believe hyperinflation feeds on itself; once inflation reaches a certain rate, the
conditions that got it there keep pushing it higher until corrective action is taken.
Hyperinflation is vexing in terms of monetary policy. Methods effective for reducing inflation,
such as raising interest rates and constricting the money supply by selling Treasury bonds (T-
bonds), tend to slow economic growth and can even throw the economy into a recession.
Even more frustrating than hyperinflation is stagflation. The most infamous period of stagflation
in the United States occurred during the 1970s. Fixing stagflation requires reigning in inflation
and stimulating the economy at the same time, which is exceedingly difficult. Monetary policies
that stimulate the economy tend to exacerbate inflation, and policies that tamp down inflation
often suppress the economy.

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What is the difference between inflation and stagflation?
Inflation is a term used by economists to define broad increases in prices. Inflation is the rate at
which the price of goods and services in an economy increases. Inflation also can be defined as
the rate at which purchasing power declines.
Economic policy makers like the Federal Reserve maintain constant vigilance for signs of inflation.
Policy makers do not want an inflation psychology to settle into the minds of consumers. In other
words, policy makers do not want consumers to assume that prices always will go. Such beliefs
lead to things like employees asking employers for higher wages to cover the increased costs of
living, which strains employers and, therefore, the general economy.
Stagflation is a term used by economists to define an economy that has inflation, a slow or
stagnant economic growth rate and a relatively high unemployment rate.
Economic policy makers across the globe try to avoid stagflation at all costs. With stagflation, a
country‘s citizens are affected by high rates of inflation and unemployment. High unemployment
rates further contribute to the slowdown of a country‘s economy, causing the economic growth
rate to fluctuate no more than a single percentage point above or below a zero growth rate.
Definition of Core Inflation‟
Definition: An inflation measure which excludes transitory or temporary price volatility as in the
case of some commodities such as food items, energy products etc. It reflects the inflation trend
in an economy.
Description: A dynamic consumption basket is considered the basis to obtain core inflation. Some
goods and commodities have extremely volatile price movements. Core inflation is calculated
using the Consumer Price Index (CPI) by excluding such commodities.
If temporary price shocks are taken into account they may affect the estimated overall inflation
numbers in such a way that they are different from actual inflation.
To eliminate this possibility, core inflation is calculated to gauge the actual inflation apart from
temporary shocks and volatility.
What is Headline inflation WPI?
Number we get from all components viz, primary, fuel and mfg.
What is Core inflation WPI?
Core means, we should ignore food and fuel part.
So, core inflation = Only WPI of Non-food manufacturing industries.
Headline WPI - (primary + fuel + food mfg. industries)
Basic Goods
Any bulk raw material/product used in manufacture. High Speed Diesel, Aviation Fuel, Kerosene,
Urea, Cement all kinds, Granites, iron, copper and Electricity.

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Capital Goods
Plants, machinery and goods used for further investments. Boilers, compressors, engines,
Transformers, Commercial Vehicles and all machineries like Textile Machinery, Printing
Machinery etc.
Intermediate Goods
Used for manufacturing of another product. Cotton yarn, Plywood, Adhesives, Aluminium and
steel pipes etc.
Consumer durable
Can be used for more than 2/3 years. Pressure Cooker, AC, tyre, Tv, mobile, automobile, Gems
and Jewellery etc.
Consumer non-durable
Can‘t be used for long periods. Fruit Pulp, edible oil, milk powder, tea, Cigarettes, Apparels,
Newspapers, Antibiotics etc.

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 FM Notes 32 – Money Market

Definition: Money market basically refers to a section of the financial market where financial
instruments with high liquidity and short-term maturities are traded. Money market has become a
component of the financial market for buying and selling of securities of short-term maturities,
of one year or less, such as treasury bills and commercial papers.
Over-the-counter trading is done in the money market and it is a wholesale process. It is used by
the participants as a way of borrowing and lending for the short term.
Description: Money market consists of negotiable instruments such as treasury bills, commercial
papers. and certificates of deposit. It is used by many participants, including companies, to raise
funds by selling commercial papers in the market.
Money market is considered a safe place to invest due to the high liquidity of securities.
It has certain risks which investors should be aware of, one of them being default on securities
such as commercial papers. Money market consists of various financial institutions and dealers,
who seek to borrow or loan securities. It is the best source to invest in liquid assets.
The money market is an unregulated and informal market and not structured like the capital
markets, where things are organised in a formal way. Money market gives lesser return to
investors who invest in it but provides a variety of products.
Withdrawing money from the money market is easier. Money markets are different from capital
markets as they are for a shorter period of time while capital markets are used for longer time
periods.
Meanwhile, a mortgage lender can create protection against a fallout risk by entering an
agreement with an agency or private conduit for operational, rather than mandatory, delivery of
the mortgage. In such an agreement, the mortgage originator effectively buys an option, which
gives the lender the right, but not the obligation, to deliver the mortgage. Against that, the
private conduit charges a fee for allowing optional delivery.
What is Money Market?
While the Government securities market generally caters to the investors with a long term
investment horizon, the money market provides investment avenues of short term tenor. Money
market transactions are generally used for funding the transactions in other markets including
Government securities market and meeting short term liquidity mismatches. By definition, money
market is for a maximum tenor of up to one year. Within the one year, depending upon the
tenors, money market is classified into:
a. Overnight market - The tenor of transactions is one working day.
b. Notice money market - The tenor of the transactions is from 2 days to 14 days.
c. Term money market - The tenor of the transactions is from 15 days to one year.

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What are the different money market instruments?
Money market instruments include call money, repos, Treasury bills, Commercial Paper,
Certificate of Deposit and Collateralized Borrowing and Lending Obligations (CBLO).
Call money market
Call money market is a market for uncollateralized lending and borrowing of funds. This market is
predominantly overnight and is open for participation only to scheduled commercial banks and
the primary dealers.
Repo market
Repo or ready forward contact is an instrument for borrowing funds by selling securities with an
agreement to repurchase the said securities on a mutually agreed future date at an agreed price
which includes interest for the funds borrowed.
The reverse of the repo transaction is called ‗reverse repo‘ which is lending of funds against
buying of securities with an agreement to resell the said securities on a mutually agreed future
date at an agreed price which includes interest for the funds lent.
It can be seen from the definition above that there are two legs to the same transaction in a
repo/ reverse repo. The duration between the two legs is called the ‗repo period‘. Predominantly,
repos are undertaken on overnight basis, i.e., for one day period. Settlement of repo transactions
happens along with the outright trades in government securities.
The consideration amount in the first leg of the repo transactions is the amount borrowed by the
seller of the security. On this, interest at the agreed ‗repo rate‘ is calculated and paid along with
the consideration amount of the second leg of the transaction when the borrower buys back the
security. The overall effect of the repo transaction would be borrowing of funds backed by the
collateral of Government securities.
The money market is regulated by the Reserve Bank of India. All the above mentioned money
market transactions should be reported on the electronic platform called the Negotiated Dealing
System (NDS).
As part of the measures to develop the corporate debt market, RBI has permitted select entities
(scheduled commercial banks excluding RRBs and LABs, PDs, all-India FIs, N BECs, mutual funds,
housing finance companies, insurance companies) to undertake repo in corporate debt securities.
This is similar to repo in Government securities except that corporate debt securities are used as
collateral for borrowing funds. Only listed corporate debt securities that are rated ‗AA‘ or above
by the rating agencies are eligible to be used for repo. Commercial paper, certificate of deposit,
non-convertible debentures of original maturity less than one year are not eligible for the
purpose. These transactions take place in the OTC market and are required to be reported on
FIMMDA platform within 15 minutes of the trade for dissemination of information. They are also
to be reported on the clearing house of any of the exchanges for the purpose of clearing and
settlement.
Collateralized Borrowing and Lending Obligation (CBLO)
CBLO is another money market instrument operated by the Clearing Corporation of India Ltd.
(CCIL), for the benefit of the entities who have either no access to the interbank call money

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market or have restricted access in terms of ceiling on call borrowing and lending transactions.
CBLO is a discounted instrument available in electronic book entry form for the maturity period
ranging from one day to ninety days (up to one year as per RBI guidelines). In order to enable the
market participants to borrow and lend funds, CCIL provides the Dealing System through Indian
Financial Network (INFINET), a closed user group to the Members of the Negotiated Dealing
System (NDS) who maintain Current account with RBI and through Internet for other entities who
do not maintain Current account with RBI.
Membership to the CBLO segment is extended to entities who are RBI- NDS members, viz.,
Nationalized Banks, Private Banks, Foreign Banks, Co-operative Banks, Financial Institutions,
Insurance Companies, Mutual Funds, Primary Dealers, etc. Associate Membership to CBLO
segment is extended to entities who are not members of RBI- NDS, viz., Co-operative Banks,
Mutual Funds, Insurance companies, NBFCs, Corporates, Provident/ Pension Funds, etc.
By participating in the CBLO market, CCIL members can borrow or lend funds against the
collateral of eligible securities. Eligible securities are Central Government securities including
Treasury Bills, and such other securities as specified by CCIL from time to time. Borrowers in
CBLO have to deposit the required amount of eligible securities with the CCIL based on which
CCIL fixes the borrowing limits. CCIL matches the borrowing and lending orders submitted by the
members and notifies them.
While the securities held as collateral are in custody of the CCIL, the beneficial interest of the
lender on the securities is recognized through proper documentation.
Commercial Paper (CP)
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note. Corporates, primary dealers (PDs) and the all-India financial institutions (₹) that
have been permitted to raise short-term resources under the umbrella limit fixed by the Reserve
Bank of India are eligible to issue CP.
CP can be issued for maturities between a minimum of 7 days and a maximum up to one year
from the date of issue.
Certificate of Deposit (CD)
Certificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialised
form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial
institution for a specified time period. Banks can issue CDs for maturities from 7 days to one a
year whereas eligible FIs can issue for maturities 1 year to 3 years.
What are the role and functions of FIMMDA?
The Fixed Income Money Market and Derivatives Association of India (FIMMDA), an association of
Scheduled Commercial Banks, Public Financial Institutions, Primary Dealers and Insurance
Companies was incorporated as a Company under section 25 of the Companies Act, 1956 on June
3rd, 1998. FIMMDA is a voluntary market body for the bond, money and derivatives markets.
FIMMDA has members representing all major institutional segments of the market. The
membership includes Nationalized Banks such as State Bank of India, its associate banks and
other nationalized banks; Private sector banks such as ICICI Bank, HDFC Bank, IDBI Bank; Foreign
Banks such as Bank of America, ABN Amro, Citibank, Financial institutions such as IDFC, EXIM

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Bank, NABARD, Insu rance Companies like Life Insu rance Corporation of India (LIC), ICICI
Prudential Life Insurance Company, Birla Sun Life Insurance Company and all Primary Dealers.
The FIMMDA represents market participants and aids the development of the bond, money and
derivatives markets. It acts as an interface with the regulators on various issues that impact the
functioning of these markets. It also undertakes developmental activities, such as, introduction
of benchmark rates and new derivatives instruments, etc. FIMMDA releases rates of various
Government securities that are used by market participants for valuation purposes. FIMMDA also
plays a constructive role in the evolution of best market practices by its members so that the
market as a whole operates transparently as well as efficiently.
What is a Government Security?
A Government security is a tradable instrument issued by the Central Government or the State
Governments. It acknowledges the Government‘s debt obligation. Such securities are short term
(usually called treasury bills, with original maturities of less than one year) or long term (usually
called Government bonds or dated securities with original maturity of one year or more). In India,
the Central Government issues both, treasury bills and bonds or dated securities while the State
Governments issue only bonds or dated securities, which are called the State Development Loans
(SDLs).
Government securities carry practically no risk of default and, hence, are called risk free gilt-
edged instruments. Government of India also issues savings instruments (Savings Bonds, National
Saving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation of India bonds,
fertiliser bonds, power bonds, etc.). They are, usually not fully tradable and are, therefore, not
eligible to be SLR securities.
What are the Open Market Operations (OMOs)?
CMOs are the market operations conducted by the Reserve Bank of India by way of sale/purchase
of Government securities to/from the market with an objective to adjust the rupee liquidity
conditions in the market on a durable basis. When the RBI feels there is excess liquidity in the
market, it resorts to sale of securities thereby sucking out the rupee liquidity. Similarly, when
the liquidity conditions are tight, the RBI will buy securities from the market, thereby releasing
liquidity into the market.
What is meant by buyback of Government securities?
Buyback of Government securities is a process whereby the Government of India and State
Governments buy back their existing securities from the holders. The objectives of buyback can
be reduction of cost (by buying back high coupon securities), reduction in the number of
outstanding securities and improving liquidity in the Government securities market (by buying
back illiquid securities) and infusion of liquidity in the system. Governments make provisions in
their budget for buying back of existing securities. Buyback can be done through an auction
process or through the secondary market route, i.e., NDS/NDS-OM.
What is Liquidity Adjustment Facility (LAF)?
LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks
(excluding RRB5) and primary dealers to avail of liquidity in case of requirement or park excess

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funds with the RBI in case of excess liquidity on an overnight basis against the collateral of
Government securities including State
Government securities. Basically LAF enables liquidity management on a day to day basis. The
operations of LAF are conducted by way of repurchase agreements (repos and reverse repos —
please refer to paragraph numbers 30.4 to 30.8 under question no. 30 for details) with RBI being
the counter-party to all the transactions. The interest rate in LAF is fixed by the RBI from time to
time. Currently the rate of interest on repo under LAF (borrowing by the participants) is 6.25%
and that of reverse repo (placing funds with RBI) is 5.25%. LAF is an important tool of monetary
policy and enables RBI to transmit interest rate signals to the market.
What are the risks involved in holding Government securities? What are the techniques for
mitigating such risks?
Government securities are generally referred to as risk free instruments as sovereigns are not
expected to default on their payments. However, as is the case with any financial instrument,
there are risks associated with holding the Government securities. Hence, it is important to
identify and understand such risks and take appropriate measures for mitigation of the same. The
following are the major risks associated with holding Government securities.
Market risk - Market risk arises out of adverse movement of prices of the securities that are held
by an investor due to changes in interest rates. This will result in booking losses on marking to
market or realizing a loss if the securities are sold at the adverse prices. Small investors, to some
extent, can mitigate market risk by holding the bonds till maturity so that they can realize the
yield at which the securities were actually bought.
Reinvestment risk - Cash flows on a Government security includes fixed coupon every half year
and repayment of principal at maturity. These cash flows need to be reinvested whenever they
are paid. Hence there is a risk that the investor may not be able to reinvest these proceeds at
profitable rates due to changes in interest rate scenario.
Liquidity risk - Liquidity risk refers to the inability of an investor to liquidate (sell) his holdings
due to non-availability of buyers for the security, i.e., no trading activity in that particular
security. Usually, when a liquid bond of fixed maturity is bought, its tenor gets reduced due to
time decay. For example, a 10 year security will become 8 year security after 2 years due to
which it may become illiquid. Due to illiquidity, the investor may need to sell at adverse prices in
case of urgent funds requirement.
However, in such cases, eligible investors can participate in market repo and borrow the money
against the collateral of the securities.

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 FM Notes 33 – Portfolio Investment

A portfolio investment is a hands-off or passive investment of securities in a portfolio, and it is

made with the expectation of earning a return. This expected return is directly correlated with
the investment‘s expected risk. Portfolio investment is distinct from direct investment, which
involves taking a sizable stake in a target company and possibly being involved with its day-to-day
management.
Portfolio investments can span a wide range of asset classes such as stocks, government bonds,
corporate bonds, Treasury bills, real estate investment trusts (REITs), exchange-traded funds
(ETFs), mutual funds and certificates of deposit.
Portfolio investments can also include options, derivatives such as warrants and futures, and
physical investments such as commodities, real estate, land and timber.
The composition of investments in a portfolio depends on a number of factors. Some of the most
important include the investor‘s risk tolerance, investment horizon and amount invested. For a
young investor with limited funds, mutual funds or exchange-traded funds may be appropriate
portfolio investments. For a high net worth individual, portfolio investments may include stocks,
bonds, commodities and rental properties.
Portfolio investments for the largest institutional investors such as pension funds and sovereign
funds include a significant proportion of infrastructure assets like bridges and toll roads. Portfolio
investments for institutional investors generally need to have very long lives so that the duration
of their assets and liabilities match.
Who is a non-resident Indian (NRI)?
Non-Resident Indian (NRI) means a ―person resident outside India‖ who is a citizen of India or is a
person of Indian origin‖ [as per FEMA regulations]
What is a Portfolio Investment Scheme (PIS)?
Portfolio Investment Scheme (PIS) is a scheme of reserve bank of India under which - Non
Resident Indian (NRIs) can purchase/sell shares/convertible debentures of Indian companies on
Stock Exchanges under Portfolio Investment Scheme. For this purpose, the NRI/PIO has to apply
to a designated branch of a bank, which deals in Portfolio Investment. All sale/purchase
transactions are to be routed through the designated branch.
Portfolio investment
Investment which goes into the financial sector in the form of treasury bonds and notes, stocks,
money market placements, and bank deposits. Portfolio investment involves neither control of
operations nor ownership of physical assets.
Penny Stocks (U.S.)
Generic term for very low priced stocks- sometimes selling at a few pennies per share sometimes
for a dollar or two- in speculative companies.

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Fixed Asset
An item of value used in current operation that would normally be of use for more than one year.
Depreciation (Stock Markets)
A fall in value of a security or security index or a currency in terms of others or its purchasing
power.
Participatory Notes
Stock markets in India are regulated by SEBI and all Foreign Institutional Investors, who invest in
Indian stocks have to get registered with SEBI. The two broad categories of foreign Investments
viz. FDI and FII are highly regulated and need.
Foreign Direct Investment
The Foreign Direct Investment refers to the direct investment into the production and
management. This can be one by either buying a company or by expanding operations of an
existing business. One example is Unilever which has its own subsidiary and long term investment
here via its subsidiary Hindustan Unilever. This means that FDI brings foreign capital, technology
& management.
Foreign Institutional Investment
Foreign Institutional Investment and FPI (Foreign Portfolio Investment) are same things. The
foreign institutions invest in a capital / money market which is not their home country. Such
kinds of investments are seen in the Mutual Funds, Investment Companies, Pension Funds and
Insurance Houses. This means that FIl/ FPI brings only capital. FII is also called Foreign Indirect
Investment.
Qualified Foreign Investor
Qualified Foreign Investor is an individual, group or association, resident in a foreign country that
is compliant with Financial Action Task Force (FATF) standard and that is a signatory to
International Organization of Securities Commission‘s Multilateral Memorandum of Understanding.
Though, QFI are also portfolio investors, yet in context with India, QFIs do not include Foreign
Institutional Investors or Sub-accounts as per the regulations.
What attracts Foreign Direct Investment?
The growth rate of the source economy is an important determinant of FDI into the country. The
political and economic stability of the target region attracts FDI. Any FDI investment into the
target country depends upon how ‗open‘ the economy is towards foreign trade (both imports and
exports). Apart from that, the policies, rule, regulations and loopholes incidental thereto also
affect the flow of FDI. For example, Mauritius has been top FDI source for India due to the later
reasons.

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 FM Notes 34 – Role of eGovernance

Crime and Criminal Tracking Network & Systems

The Crime and Criminal Tracking Network &amp Systems (CCTNS) Scheme has been approved by
Cabinet Committee on Economic Affairs (CCEA) in June, 2009 with a provision of ₹ 2000 Crores as
a 100% Centrally sponsored Scheme to be implemented during the remaining part of the 11th five
year plan period (2009- 2012).
Crime and Criminal Tracking Network & Systems (CCTNS) MMP aims at creating a
comprehensive and integrated system for enhancing the efficiency and effective policing at all
levels and especially at the Police Station level through adoption of principles of e-Governance,
and creation of a nationwide networked infrastructure for evolution of IT-enabled state-of-the-
art tracking system.
Employment Exchange
Ministry of Labour & Employment is in the process of conceptualising this MMP. It is expected that
the MMP will help match the requirements of employers against employee database. It is also
expected that the MMP will have mechanisms to provide valuable guidance and career counselling
to the unemployed, and facilitate online registration of vacancies by employers.
Health
The Apex Committee for the National e-Governance Plan (NeGP) chaired by Cabinet Secretary has
approved the inclusion of Health as a Mission Mode Project (MMP) under the NeGP. ICT for
programme management has been undertaken by the Ministry of Health & Family Welfare in the
Mother and Child Tracking System (MCTS) programme and the Ministry envisages a more
comprehensive use of ICT including for Hospital Information Systems, supply chain management
for drugs and vaccines, providing ICT tools to ASHA and ANM workers, programme management of
National Rural Health Mission (NRHM), etc. through this MMP.
Education
Education is a Concurrent Subject under Constitution of India and involves an ecosystem that
comprises many activities of other Ministries and Departments both at the Centre and in the
States. Administration of mid-day meals, administration of hostels, disbursement of scholarships,
etc. are a few examples of activities that require coordination with other agencies of the
government.
Several flagship schemes of the Gol — Sarva Shiksha Abhiyan, Mid-Day Meal, Rashtriya
Madhayamik Shiksha Abhiyan, etc require ICT for their implementation and monitoring. MHRD is
working on a National Policy on ICT in School Education to provide guidelines to assist the States
in optimising the use of ICT in school education. Department of School Education and Literacy of
the Ministry of Human Resource Development (MHRD) has been made the nodal Department for
the design and implementation of this MMP.
Keeping in view the federal nature of its implementation, the MMP would be designed on the
principle of centralised planning and decentralised implementation. The Mission Mode Project (M
MP) in School Education needs to cover a multitude of stakeholders in the ecosystem and arrive

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at a set of end user- centric services that have an impact over an agreed project time frame.
Currently, a preliminary study to identify the services and possible ICT interventions is being
undertaken.
Public Distribution System
The Apex Committee for the National e-Governance Plan (NeGP) chaired by Cabinet Secretary has
approved the inclusion of Public Distribution System (PDS) as a Mission Mode Project (MMP) under
the NeGP. Computerisation of the PDS is envisaged as an end-to-end project covering key
functional areas such as supply chain management including allocation and utilisation reporting,
storage and movement of food grains, grievance redressal and transparency portal, digitisation of
beneficiary database, Fair Price Shop automation, etc.
Posts
The Apex Committee for the National e-Governance Plan (NeGP) chaired by Cabinet Secretary has
approved the inclusion of Posts as a Mission Mode Project (M MP) under the NeGP. Modernisation
of Postal Services has been undertaken by the Department of Posts through computerization and
networking of all post offices using a central server-based system, and setting up of computerised
registration centres (CRCs).
State Governments
Several State Governments have taken various innovative steps to promote e-Governance and
have drawn up a roadmap for IT implementation and delivery of services to the citizens online.
The applications that have been implemented are targeted towards providing Government to
Citizen (G2C), Government to Business (G2B) and Government to Government (G2G) services with
emphasis on use of local language.
Every State has the flexibility of identifying up to five additional State-specific Mission Mode
Projects (relevant for economic development within the State). In cases where Central Assistance
is required, such inclusions are considered on the advice of the concerned Line Ministries/
Departments. States have MMPs on Agriculture, Commercial Taxes, e-District, Employment
Exchange, Land Records,
Municipalities, Gram Panchayats, Police, Road Transport, Treasuries, etc. Apart from MMPs the
States have other e-Governance initiatives.
Central Government
In India, the main thrust for e-Governance was provided by the launching of NICNET in 1987 - the
national satellite-based computer network. This was followed by the launch of the District
Information System of the National Informatics Centre (DISNIC) programme to computerise all
district offices in the country for which free hardware and software was offered to the State
Governments.
NICNET was extended via the State capitals to all district headquarters by 1990. In the ensuing
years, with ongoing computerization, teleconnectivity and internet connectivity established a
large number of e-Governance initiatives, both at the Union and State levels.The formulation of
National e-Governance Plan (NeGP) by the Department of Electronics and Information

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Technology (DEITY) and Department of Administrative Reforms and Public Grievances
(DAR&PG) in 2006 has boosted the eGovernance process.
The Central initiatives include:
a. National e-Governance Plan (NeGP)
b. National e-Governance Division (NeGD)
c. e-Governance Infrastructure
d. Mission Mode Projects
e. Citizens Services
f. Business Services
g. Government Services
h. Projects and Initiatives
i. R&D in e-Governance
j. Model RFPs for e-Governance Project
National e-Governance Plan
National e-Governance PlanOver the years, a large number of initiatives have been undertaken by
various State Governments and Central Ministries to usher in an era of e-Government. Sustained
efforts have been made at multiple levels to improve the delivery of public services and simplify
the process of accessing them.
e-Governance in India has steadily evolved from computerization of Government Departments to
initiatives that encapsulate the finer points of Governance, such as citizen centricity, service
orientation and transparency. Lessons from previous e-Governance initiatives have played an
important role in shaping the progressive e-Governance strategy of the country. Due cognizance
has been taken of the notion that to speed up e-Governance implementation across the various
arms of Government at National, State, and Local levels, a programme approach needs to be
adopted, guided by common vision and strategy.
This approach has the potential of enabling huge savings in costs through sharing of core and
support infrastructure, enabling interoperability through standards, and of presenting a seamless
view of Government to citizens.
The National c-Governance Plan (NeGP), takes a holistic view of c-Governance initiatives across
the country, integrating them into a collective vision, a shared cause. Around this idea, a massive
countrywide infrastructure reaching down to the remotest of villages is evolving, and large-scale
digitization of records is taking place to enable easy, reliable access over the Internet. The
ultimate objective is to bring public services closer home to citizens, as articulated in the Vision
Statement of NeGP.
―Make all Government services accessible to the common man in his locality, through common
service delivery outlets, and ensure efficiency, transparency, and reliability of such services at
affordable costs to realise the basic needs of the common man‖
The Government approved the National e-Governance Plan (NeGP), comprising of 27 Mission Mode
Projects and 8 components, on May 18, 2006. In the year 2011, 4 projects - Health, Education,
PDS and Posts were introduced to make the list of 27 MMPs to 31 Mission Mode Projects (MMP5).

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The Government has accorded approval to the vision, approach, strategy, key components,
implementation methodology, and management structure for NeGP.
However, the approval of NeGP does not constitute financial approval(s) for all the Mission Mode
Projects (MMPs) and components under it. The existing or ongoing projects in the MMP category,
being implemented by various Central Ministries, States, and State Departments would be
suitably augmented and enhanced to align with the objectives of NeGP.
Mobile Governance (m-governance):
Mobile governance (m-governance) aims to leverage wireless and new media technology
platforms, mobile devices and applications for delivery of public information and services to all
citizens and businesses. It aims at widening the reach of, and access to, public services to all
citizens in the country, especially in the rural areas by exploiting the much greater penetration
of mobile phones in the country. It also leverages the innovative potential of mobile applications
in providing public services. The overall strategy aims at making India a world leader in
harnessing the potential of mobile governance for inclusive development. The initiative has been
conceptualized and formulated by the Department of Electronics and Information Technology
(MeitY), Government of India. Centre for Development of Advanced Computing (C-DAC), a MeitY
organization, is the technical implementing agency for the project.
What is Mobile Seva?
Mobile Seva is an innovative initiative aimed at mainstreaming mobile governance in the country.
It provides an integrated whole-of-government platform for all Government departments and
agencies in the country for delivery of public services to citizens and businesses over mobile
devices using SMS, USSD, IVRS, CBS, LBS, and mobile applications installed on mobile phones. The
diagram below depicts the various components of Mobile Seva.

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 FM Notes 35 – Private and Social Cost Benefit

Types of costs and their benefits in economics are as follows:

a. Private Costs and Benefits
b. External Costs and Benefits
c. Social Costs and Benefits

a. Private Costs and Benefits:

The rainforests, in the Amazon region of Brazil, are being cleared at a relatively rapid rate. The
firms that are engaged in logging, in the forests, are only taking into account private costs and
benefits. Private costs (as noted in the previous unit) are the costs borne by those who are
directly involved in the decision to consume or produce a product.
In the case of a logging company, private costs will include, for example, the cost of transporting
the wood and the cost of labour. Private benefits are the benefits received by those directly
involved in the consumption and production of a product.
The private benefit, logging company receives from selling the wood, is the revenue it earns. The
company will continue cutting down trees, as long as the revenue received by it exceeds it costs.
b. External Costs and Benefits:
When firms produce products and households consume them, they often affect other people. For
example, someone smoking in a factory may harm the health of other workers and a clothing firm,
that dumps waste into a river, may damage the fishing stocks of a fish farmer and harm the
environment.
The effects on third parties, due to the consumption and production activities of others, are
known as external costs and external benefits. External costs caused by the logging companies
may include damage to wildlife habitats, loss of plant species that could be used to develop
medicines, global warming and interference with the lifestyle of local tribes.
External benefits may include reduced transport costs for tourist firms in the area due to
construction of roads by logging companies. While making its decisions on the number of trees to
be cut down, a logging company will not take these external costs and benefits into account.
c. Social Costs and Benefits:
Social costs are the total costs of an economic activity to society. The social cost of cutting down
trees in the Amazon, will consist of both external and private costs.
When social costs exceed private costs, there are external costs involved. Social benefits are the
total benefits to the society, arising from an economic activity. They include both private and
external benefits. Again, where social benefits are greater than private benefits, external
benefits exist.
The level of output which will cause maximum benefit to the society (socially optimum output)
will occur when the social benefit of the last unit produced is equal to the social cost of that unit.

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If the social cost exceeds the social benefit, it implies that too many resources are being devoted
to the production of the product.
Society would benefit from reducing its output. In contrast if the benefit society would gain from
producing more of the product is greater than the cost to society of producing more output and
then more resources should be devoted to its production.
A case, where the social cost (in most countries) exceeds the social benefit is the use of road
space by private cars. When people are thinking of making a trip in their car, they take into
account the private costs and benefits, that is the cost and benefits to themselves. If the benefits
received by them by undertaking the journey exceed the costs - for example the cost of petrol
and wear and tear on the vehicles, they will make the journey.
What they do not consider is the external costs caused by them, including air pollution, noise
pollution, congestion and accidents. A number of governments, including Singapore and the UK,
have introduced road pricing schemes.
These seek to charge the full costs of their journeys. Different amounts are charged according to
when and where people drive. Someone driving along a deserted country road is likely to cause
lower external costs than someone driving into a city center at peak time.
What is the difference between private and social costs, and how do they relate to pollution
and production?
This is an important distinction to understand. Private costs to firms or individuals dc not always
equate with the total cost to society for a product, service, or activity. The difference between
private costs and total costs to society of a product, service, or activity is called an external cost;
pollution is an external cost of many products.
External costs are directly associated with producing or delivering a good or service, but they are
costs that are not paid directly by the producer. When external costs arise because
environmental costs are not paid, market failures and economic inefficiencies at the local, state,
national, and even international level may result.
Lets start by defining private costs, external costs, and social costs. Next, we will briefly examine
the impact external costs can have on prices, production, resource allocation, and competition.
Key Concepts:
Private Costs + External Costs = Social Costs
If external costs > 0, then private costs < social costs.
Then society tends to:
Price the good or service too low, and
Produces or consumes too much of the good or service.
Different Costs Matter:
Private costs for a producer of a good, service, or activity include the costs the firm pays to
purchase capital equipment, hire labor, and buy materials or other inputs.

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While this is straightforward from the business side, it also is important to look at this issue from
the consumers‘ perspective. Field, in his 1997 text, Environmental Economics provides an
example of the private costs a consumer faces when driving car.
The private costs of this (driving a car) include the fuel and oil, maintenance, depreciation, and
even the drive time experienced by the operator of the car.
Private costs are paid by the firm or consumer and must be included in production and
consumption decisions. In a competitive market, considering only the private costs will lead to a
socially efficient rate of output only if there are no external costs.
External costs, on the other hand, are not reflected on firms‘ income statements or in External
costs, on the other hand, are not reflected on firms‘ income statements or in consumers‘
decisions. However, external costs remain costs to society, regardless of who pays for them.
Consider a firm that attempts to save money by not installing water pollution control equipment.
Because of the firm‘s actions, cities located down river will have to pay to clean the water
before it is fit for drinking, the public may find that recreational use of the river is restricted,
and the fishing industry may be harmed. When external costs like these exist, they must be
added to private costs to determine social costs and to ensure that a socially efficient rate of
output is generated.
Social costs include both the private costs and any other external costs to society a rising from
the production or consumption of a good or service. Social costs will differ from private costs, for
example, if a producer can avoid the cost of air pollution control equipment allowing the firm‘s
production to imposes costs (health or environmental degradation) on other parties that are
adversely affected by the air pollution. Remember too, it is not just producers that may impose
external costs on society. Let‘s also view how consumers‘ actions also may have external costs
using Field‘s previous example on driving.
The social costs include all these private costs (fuel, oil, maintenance, insurance, depreciation,
and operator‘s driving time) and also the cost experienced by people other than the operator
who are exposed to the congestion and air pollution resulting from the use of the car.
The key point is that even if a firm or individual avoids paying for the external costs arising from
their actions, the costs to society as a whole (congestion, pollution, environmental cleanup,
visual degradation, wildlife impacts, etc.) remain. Those external costs must be included in the
social costs to ensure that society operates at a socially efficient rate of output.
Aside from the obvious environmental issues, one might ask why external costs are of
interest to economists?
Resource Implications
A socially efficient output rate in a competitive market is reached when social costs (both private
and external costs) are considered in production and consumption decisions.
The existence of external costs has implications for product prices, output levels, resource usage,
and competition. When significant external costs are associated with a good (or service), then
the price of the good is too low (because external costs are not being paid) and its output level is

157
too high, relative to the socially efficient rate of output for the good. The bottom line, unless
costs and prices include external costs, the market will not produce a socially efficient result.
Consider also the competitive issues: At the individual firm level, as well as across states or
nations, failure to pay for external costs would provide those firms or nations with a competitive
advantage over producers who are paying the external costs associated with the production of
their products. If you‘re interested, a graphic examination of the issue follows.
Summary
Society is better off when production and consumption decisions are based on social costs that
include external costs, because external costs really do matter in the real world. Policy makers
look for ways to make firms and consumers ‗internalize‘ or take into account the external costs
they create when they make production and consumption decisions.

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 FM Notes 36 – Public Private Partnership

Availability of quality infrastructure is a pre-requisite to achieve broad based and inclusive

growth on a sustained basis. Infrastructure is also critical for enhancing productivity and export
competitiveness. The XII Five Year Plan (2012-2017) has an ambitious target of infrastructure
investment and is envisaged at US $1 trillion. This projected investment is about twice the
investment envisaged in the XI Plan and 27 per cent of the gross domestic savings.
Given the enormity of the investment requirements and the limited availability of public
resources for investment in physical infrastructure, it is imperative to explore avenues for
increasing investment in infrastructure through a combination of public investment Public Private
Partnerships (PPP5) and occasionally, exclusive private investment wherever feasible The use of
PPP an as instrument of procurement for creation of infrastructure assets and delivery of public
services has been recognized globally.
Apart from bridging the deficit in financing of public projects, PPPs also brings new and cost
effective technology for creation of infrastructure assets, managerial efficiency, competency for
operation and maintenance of the created assets and the contractual accountability on the
private party to ensure timely and quality infrastructure service to the end users.
As a result, private investment in infrastructure has picked up in recent years, encouraging the
government to go for a more ambitious infrastructure creation drive through greater emphasis on
PPP mode of execution. The private sector is expected to contribute at least half of the over $1
trillion dollar investment planned in infrastructure in the XII plan (2012-17).
Government of India (Gol) is actively promoting Public Private Partnership (PPP) as an effective
tool for bringing private sector efficiencies in creation of economic and social infrastructure
assets and for delivery of quality public services. India, in the recent years has emerged as one of
the leading PPP markets in the world as a result of several policy and institutional initiatives
taken by the Central Government.
A PPP Cell has been set up in the Department of Economic Affairs (DEA), Ministry of Finance
(M0F). The PPP Cell is responsible for all matters concerning PPPs, including policies, schemes,
programmes and capacity building. Besides, the Cell also acts as the Secretariat for Public Private
Partnership Appraisal Committee (PPPAC), Em powered Committee (EC) and Empowered
Institution (El) for the projects posed for financial support through Viability Grant Fund (VGF).
Functions of PPP Cell
a. Matters and proposals relating to clearance by Public Private Partnership Appraisal
Committee (PPPAC)
b. Matters and proposals relating to the Scheme for Financial Support to Public Private
Partnerships in Infrastructure- Viability Gap Funding (VGF) Scheme
c. Matters and proposals relating to the Scheme for India Infrastructure Project Development
Fund
d. Policy matters related to Public Private Partnerships (including Model Concession Agreement)

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 e. Developing multi-pronged and innovative interventions and support mechanisms for
facilitating PPPs in the country, including Technical Assistance programmes from bilateral
and multilateral agencies on mainstreaming PPPs and support to State and local governments
f. Managing training programmes, strategies, exposures for capacity building for PPPs.
g. Subject of advocacy for greater acceptability towards PPPs Institution building for
mainstreaming PPPs
h. Matters relating to management of PPP related information, including www.pppinindia.com
and www.Infrastructurelndia.gov.in
i. The Toolkit for the use by PPP practitioners across India in both the public and private
sectors, http://toolkit.pppinindia.com
j. Other policy/Parliament related matters concerning PPPs.
Initiatives by Government of India for promoting PPPs
Public Private Partnership Appraisal Committee (PPPAC)
The Government of India is actively encouraging PPPs through several initiatives. The appraisal
mechanism for the PPP projects has been streamlined to ensure speedy appraisal of projects,
eliminate delays, adopt international best practices and have uniformity in appraisal mechanism
and guidelines. The appraisal mechanism notified includes setting up of the Public Private
Partnership Appraisal Committee (PPPAC) responsible for the appraisal of PPP projects in the
Central Sector.
Viability Gap Funding Scheme for PPP Projects
The Government has created a Viability Gap Funding Scheme for PPP projects. Infrastructure
projects are often not commercially viable on account of having substantial sunk investment and
low returns. However, they continue to be economically essential. Accordingly, the Viability Gap
Funding Scheme has been formulated which provides financial support in the form of grants, one
time or deferred, to infrastructure projects undertaken through public private partnerships with
a view to make them commercially viable.
The Scheme provides total Viability Gap Funding up to twenty per cent of the total project. The
Government or statutory entity that owns the project may, if it so decides, provide additional
grants out of its budget up to further twenty per cent of the total project cost. Viability Gap
Funding under the Scheme is normally in the form of a capital grant at the stage of project
construction.
India Infrastructure Finance Company Limited (UFCL)
The Government has also set up India Infrastructure Finance Company Limited (UFCL) with the
specific mandate to play a catalytic role in the infrastructure sector by providing long-term debt
for financing infrastructure projects. IIFCL funds viable infrastructure projects through Long Term
Debt, Refinance to Banks and Financial Institutions for loans granted by them, with tenor
exceeding 10 years or any other mode approved by the Government.
India Infrastructure Project Development Fund (IIPDF)
While quality advisory services are fundamental to developing well-structured, value- for- money
PPPs, the costs of procuring PPPs, and particularly the costs of transaction advisors, are
significant. Development of robust projects with a sound financial structure and optimal risk

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allocation is critical for evincing a market response in respect of the projects. The scheme for
‗India Infrastructure Project Development Fund‘ (IIPDF) has been launched to finance the cost
incurred towards development of PPP projects. The IIPDF supports up to 75 per cent of the
project development expenses.
PPP Structuring Toolkit
DEA has developed online PPP toolkits covering five infrastructure sectors namely, State
Highways, Water and Sanitation (W&S), Ports, Solid Waste Management (SWM) and Urban
Transport (Bus Rapid Transport Systems). The toolkit is a web- based resource that has been
designed to help improve decision-making for infrastructure PPPs in India and to improve the
quality of the PPPs that are developed. The toolkit can be accessed at
http://toolkitpppinindia.com/.
Post Award Contract Management Toolkit
DEA has also developed ―PPP Post-Award Contract Management Toolkit‖, which is a web-based
application that has been designed to help improve the contract management and project
execution of the infrastructure sector related PPP projects in India. It aims to do so by serving as
an efficient guide to the public sector entities involved in the execution of these projects. The
toolkit covers three infrastructure sectors namely, Highways, Ports and Schools. The toolkit can
be accessed at http://infrastructurei nd ia.gov.in/toolkit/.
Infrastructure Database
An infrastructure projects database (www.infrastructureindia.gov.in) has been developed by DEA,
which is a repository of infrastructure projects being implemented across the sectors in India. It
also provides key information on the status of infrastructure projects being executed in India.
Basic FAQ Related to PPP
Q1. What is PPP?
Public Private Partnership (PPP) means an arrangement between a Government / statutory entity
/ Government owned entity on one side and a private sector entity on the other, for the
provision of public assets and/or public services, through investments being made and/or
management being undertaken by the private sector entity, for a specified period of time, where
there is well defined allocation of risk between the private sector and the public entity and the
private entity who is chosen on the basis of open competitive bidding, receives performance
linked payments that conform (or are benchmarked) to specified and pre-determined
performance standards, measurable by the public entity or its representative.
Q2. What are the different types of PPP?
Public-private partnerships (PPPs) can take a wide range of forms varying in the degree of
purpose, involvement of the private entity, legal structure and risk sharing.
A PPP is generally memorialized in a contract or agreement to outline the responsibilities of each
party and clearly allocate risk. The broad contractual forms, as covered by extant policy include:
DBFOT/BOT: The most common form of PPP used where the private sector operator designs,
builds, finances, owns and constructs the facility and operates it commercially for the concession

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period, after which the facility is transferred to the authority. In this case legal ownership of the
asset vests with the public sector the concession period ends. The most common form of a BOT
project is a Toll Road project.

Operations & Maintenance (Service contract):

The Government bids out the right to deliver a specific service or gives part of the undertaking to
the private sector for operations and maintenance of the assets. Such contracts are normally of a
shorter duration than concession contracts.
Lease, Develop, Operate and Maintain (a variation of BOT):
Assets are leased out to the private sector under specific terms, to operate and maintain the
asset for the term of the concession period.
Ministry of Finance, Gol requires the Project sponsors to award PPP projects through a
transparent open competitive bidding process, for greater transparency and consistency to the
bid process and terms of contract, throughout the project life cycle and market discovery of
rates. Unsolicited proposals and subsequent award of such proposals through the Bonus and Swiss
challenge route is not supported as this introduces various asymmetries into the procurement
process.
These asymmetries, inter alia, includes informational asymmetry and bidding asymmetry between
an Original Proponent (GP) and its competitors as the OP essentially gets an opportunity to make
the BAFO (Best and Final Offer) after one or more rounds of negotiation- an opportunity that is
denied to its competitors who are not authorized to submit an equal number of negotiated
response. This would also lead to lack of robust bid submission by other potential bidders.
Q3. What are the various Government incentives for PPPs?
The Government has facilitated the PPP sector by offering:
Viability Gap Funding (VGF):
Viability Gap Funding of upto 40% of the cost of the project can be accessed in the form of a
capital grant.
India Infrastructure Project Development Fund (IIPDF):
Scheme supports the Central and the State Governments and local bodies through financial
support for project development activities (feasibility reports, project structuring etc.) for PPP
projects.
IIFCL:
Long-term debt for financing infrastructure projects that typically involve long gestation periods
since debt finance for such projects should be of a sufficient.
Foreign Direct Investment (FDI):
up to 100% FDI in equity of SPVs in the PPP sector is allowed on the automatic route for most
sectors.

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Q4. Does the government extend financial support for PPP projects?
The Viability Gap Funding Scheme of the Government of India for Financial Support to Public
Private Partnerships in Infrastructure, provides financial support of up to 40% of the Total Project
Cost in the form of grant (one time or deferred) to infrastructure projects undertaken through
public private partnerships with a view to making them commercially viable. Administered by the
Ministry of Finance, budgetary provisions are made in the Annual Plans on a year-to-year basis for
the Scheme.
Q5. What is the Viability Gap Funding scheme?
The scheme aims at supporting infrastructure projects that are economically justified but fall
marginally short of financial viability. Support under this scheme is available only for
infrastructure projects where private sector sponsors are selected through a process of
competitive bidding.
The total Viability Gap Funding under this scheme will not exceed twenty percent of the Total
Project Cost; provided that the Government or statutory entity that owns the project may, if it
so decides, provide additional grants out of its budget, upto a limit of a further twenty percent of
the Total Project Cost. VGF under this Scheme is normally in the form of a capital grant at the
stage of project construction.
Q6. What are the eligibility criteria for getting support under the VGF scheme?
In order to be eligible for funding under VGF Scheme, a PPP project should meet the following
criteria:
The project should be implemented (i.e. developed, financed, constructed, maintained and
operated) for the Project Term by a Private Sector Company to be selected by the Government or
a statutory entity through a process of open competitive bidding; provided that in case of railway
projects that are not amenable to operation by a Private Sector Company, the Empowered
Committee may relax this eligibility criterion.
The PPP Project should be from one of the following sectors:
- Roads and bridges, railways, seaports, airports, inland waterways; Power; Urban transport,
water supply, sewerage, solid waste management and other physical infrastructure in urban
areas;
- Infrastructure projects in Special Economic Zones and internal infrastructure in National
Investment and Manufacturing Zones;
- International convention centres and other tourism infrastructure projects;
- Capital investment in the creation of modern storage capacity including cold chains and post-
harvest storage;
- Education, health and skill development, without annuity provision;*
- Oil/Gas/Liquefied Natural Gas (LNG) storage facility (includes city gas distribution network);
- Oil and Gas pipelines (includes city gas distribution network);
- Irrigation (dams, channels, embankments, etc.);
- Telecommunication (Fixed Network) (includes optic fibre/wire/cable networks which provide
broadband/internet);
- Telecommunication towers;

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- Terminal markets;
- Common infrastructure in agriculture markets; and
- Soil testing laboratories.
That the Project Term cannot be increased for reducing the viability gap; and that the capital
costs are reasonable and based on the standards and specifications normally applicable to such
projects and that the capital costs cannot be further restricted for reducing the viability gap.

Q7. What is the procedure for getting Viability Gap Funding?

Project proposals may be posed by a Government or statutory entity which owns the underlying
assets. The proposals shall include the requisite information necessary for satisfying the eligibility
criteria specified above and be submitted in formats with annexure as specified in the guidelines.
Q8. What is India Infrastructure Project Development Fund (IIPDF)?
For providing financial support for quality project development activities for PPP projects to the
Central and the State Governments and local bodies, Scheme and Guidelines of India
Infrastructure Project Development Fund (IIPDF), have been notified The IIPDF would assist
ordinarily up to 75% of the project development expenses. On successful completion of the
bidding process, the project development expenditure would be recovered from the successful
bidder.
Q9. What is the purpose of the IIPDF fund?
The procurement costs of PPPs, particularly costs of engaging transaction advisory services, are
significant and often burden the budget of the Sponsoring Authority. Department of Economic
Affairs (DEA) has identified the IIPDF as a mechanism through which Sponsoring Authority can
source funding to cover a portion of the PPP transaction costs, thereby reducing the impact of
costs related to such procurement on their budgets. From the Government of India‘s perspective,
the IIPDF must increase the quality and quantity of bankable projects that are processed through
the Central or States‘ project pipeline.
Q10. What can the IIPDF funding be used for?
The IIPDF will be available to the Sponsoring Authorities for PPP projects for the purpose of
meeting the project development costs which may include the expenses incurred by the
Sponsoring Authority in respect of feasibility studies, environment impact studies, financial
structuring, legal reviews and development of project documentation, including concession
agreement, commercial assessment studies (including traffic studies, demand assessment,
capacity to pay assessment), grading of projects etc. required for achieving Technical Close of
such projects, on individual or turnkey basis, but would not include expenses incurred by the
Sponsoring Authority on its own staff.
Q11. What is the India Infrastructure Finance Company (IIFC)?
There is urgent need for providing long-term debt for financing infrastructure projects that
typically involve long gestation periods. Debt finance for such projects should be of a sufficient
tenure which enables cost recovery across the project life, as the Indian capital markets were
found deficient in long-term debt instruments; IIFC was set-up to bridge this gap.

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Q12. Has the approval process been streamlined for PPP projects?
Yes, the Cabinet Committee on Economic Affairs (CCEA) in its meeting of 27th October, 2005
approved the procedure for approval of public private partnership (PPP) projects sponsored by
Central Government Ministries/ Central Public Sector Undertakings (CPUs)/ statutory authorities
or other entities under their administrative control. Pursuant to this decision, a Public Private
Partnership

Appraisal Committee (PPPAC) was set up comprising of the following:

a. Secretary, Department of Economic Affairs (in the Chair)
b. Secretary, Planning Commission
c. Secretary, Department of Expenditure;
d. Secretary, Department of Legal Affairs; and
e. Secretary of the Department sponsoring a project.
The Committee would be serviced by the Department of Economic Affairs, who has set-up a
special cell for servicing such proposals. Proposals for the PPPAC are submitted to the DEA, PPP
cell.

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 FM Notes 37 – Public Sector Reforms

Important Developments:
NITI Aayog submits roadmap for PSU reforms to Prime Minister‟s Office
NEW DELHI: Kicking off PSU reforms, NITI Aayog has submitted to the Prime Minister‘s Office a
roadmap for closure and strategic sale of government stake in some public sector units.
―NITI Aayog has has submitted two separate lists of state-run companies, one comprising of sick
PSUs which may be closed down and the other a list of firms which should be privatised,‖ a
source said.
―Strategic sale means that the government will bring down its stake to 49 per cent or below.
NITI Aayog identifies 32 sick PSUs that may be shut: Report
NITI Aayug has identified 32 loss-making companies for strategic disinvestment including Central
Public Sector Enterprises (CPSEs) such as Bharat Pumps & Compressors, Tyre Corporation of India,
Central Inland Water Transport Corporation and Bengal Chemicals & Pharmaceuticals, among
others. Of the 32 companies, 10 could see strategic disinvestment right away while for the other
22 the suggestion is to revive while retaining a subsequent option for strategic disinvestment say
media reports.
―The government will now look into individual cases along with their respective administrative
ministries. The firms where we may get some valuations will be put on the block first‖ a govt
official was quoted as saying.
Of the total 74 loss-making companies 26 have been identified for closure or winding up, five for
long-term lease or management contract three have been proposed to be merged with the parent
company while two have been identified for maintaining status quo.
―In case of subsidiaries the revival process can be approached through merger with the parent
company,‖ the Aayog noted in its report.
Another government official aware of the deliberations said that any decision regarding strategic
sale will be taken once the NITI Aayog has submitted its recommendations on the strategic sale
policy.
Earlier, kicking off PSU reforms, NITI Aayog has submitted to the Prime Minister‘s Office a
roadmap for closure and strategic sale of government stake in some public sector units. ―NITI
Aayog has submitted two separate lists of state-run companies, one comprising of sick PSUs which
may be closed down and the other a list of firms which should be privatised,‖ a source said.
―Strategic sale means that the government will bring down its stake to 49 per cent or below in
such PSUs,‘ the source added.
Finance Minister Arun Jaitley had said in his Budget 2016-17 speech that NITI Aayog will identify
PSUs for strategic sale. Under the roadmap, the Aayog dealt with two sets of issues -- one
pertains to decision regarding sick firms which have been making losses, while the second is
disinvestment, or strategic sale where government wants to reduce its stake. Government has set

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a disinvestment target of ₹ 56,500 crore for this fiscal. Of this, ₹ 36,000 crore is to come from
minority stake sale in PSUs and ₹ 20,500 crore from strategic sale.
Government began the disinvestment programme for the current fiscal with 11.36 per cent stake
sale in NHPC. The government raised ₹ 2,700 crore through the process.
It has lined up as many as 15 PSUs, including Coal India, NMDC, MOIL, MMTC, National Fertilisers,
NALCO and Bharat Electronics, for stake sale in current fiscal. During 2015-16, the government
managed to notch up ₹ 25,312 crore through disinvestment, less than half the target of ₹ 69,500
crore.
It had raised around ₹ 24,500 crore in 2014-15 by selling stake in public companies; about ₹
16,000 crore in 2013-14 and ₹ 23,960 crore in 2012-13. It had raised around ₹ 14,000 crore in
2011-12 and over ₹ 22,100 crore in 2010-11.
Finance minister Arun Jaitley had said in his Budget 2016-17 speech that NITI Aayog will identify
PSUs for strategic sale.
Under the road map, the Aayog dealt with two sets of issues - one pertains to decision regarding
sick firms which have been making losses, while the second is disinvestment, or strategic sale
where government wants to reduce its stake.
Government has set a disinvestment target of ₹ 56,500 crore for this fiscal. Of this, ₹ 36,000
crore is to come from minority stake sale in PSUs and ₹ 20,500 crore from strategic sale.
NITI Aayog meet seeks reforms in public healthcare system
Outsourcing primary healthcare to private doctors, competition between govt, private hospitals
proposed.
India‘s public health system could be in for an overhaul if the government agrees to proposals on
universal healthcare discussed at a meeting of the NITI Aayog, the think tank that has replaced
the Planning Commission, on Monday.
The proposals call for outsourcing primary healthcare to private doctors and promoting
competition between government and private hospitals at the secondary level, which involves
services of medical specialists.
Access to healthcare for all Indians is possible through this model with a nominal increase in the
health sector‘s share of the Union budget if the Indian economy continues to grow 7-7.5% in the
next few years.
The proposals, discussed at the at the NITI Aayog by the Hyderabad-based Foundation for
Democratic Reforms (FDR) and the Mumbai-based non-governmental organization Loksatta
Movement, were based on the experiences of the UK‘s National Health Service, the government-
run health programme.
The proposal recommends that all MBBS doctors in rural India should be trained as family
physicians and be paid by the government for each patient they treat.
―Every area will have a select number of family doctors. Patients will have the choice to contact
any of them as they will be paid by the government. Doctors‘ merit will be based on the number

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of patients that they attract and will be promoted within the public health system accordingly,‖
said Surendra Srivastava, national president of the Loksatta Movement.
The Primary Health Centres (PHCs) will carry out government initiatives such as immunization
and provide laboratory services and free medicines. This is a radical shift from the current system
where the government funds pays salaries to physicians and specialists only in the PHCs.
At the secondary level, choice and competition are seen as the most cost-effective options.
Community health centres and private nursing homes will both be offered incentives by the
government for efficient treatment and whoever provides better services will get a more
attractive compensation.
In the current system, the government is responsible for strengthening only district hospitals. It
pays private doctors only when a public-private partnership (PPP) is announced for specific
services such as institutional deliveries.
―At the tertiary level, we believe a mix of AIIMS (All India Institute of Medical Sciences)-like
institutions and low-cost private models such as Sankara Nethralaya, Chennai, and Narayana
Hrudayalaya should be promoted. Corporate hospitals with high-cost treatment should not be
promoted,‖ said Srivastava.
This, too, is a radical shift because the model discourages any relationship between corporate
hospitals and the government, which is the norm currently.
Most joint ventures and PPPs for tertiary care exist between the government and corporate
hospitals, in addition to them being on the list of empanelled hospitals for government employees.
The proposal estimates that if the said model is put in place, primary and preventive healthcare
would cost ₹80,000 crore-1.2 trillion per year by the year 2022. Secondary care will cost ₹40,000
crore, while tertiary care will cost ₹93,000 crore, making it a total of ₹2.18-2.53 trillion.
Assuming a cost escalation of 50%, the amount needed will be ₹3.27 -3.80 trillion.
―If India‘s real growth rate continues to be 7% and nominal growth 11%, the country‘s gross
domestic product (GDP) will be ₹240 trillion. Through our model, universal health care will be
achieved by spending 1.67% of GDP,‖ said Jayaprakash
Narayan, general secretary, FDR. Currently, India spends approximately 1.3% of GDP on the
health sector.
―The officials at NITI Aayog were positive about the proposal made,‖ said Narayan, who was
present at the meeting.
Although universal health care was a promise under the 12th Five Year Plan (2012- 17), it has not
taken off as the Union and state governments have not reached a consensus on the model it
should be based on and the services it would offer.
The meeting at NITI Aayog is seen as beginning of a process of dialogue towards consensus.
Public Sector Reforms: An overview by C. Rangarajan is former Chairman of the Economic
Advisory Council to the Prime Minister and former Governor, Reserve Bank of India.

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The overwhelming evidence on view since 1991 is that reforms have to be an integral part of any
programme aimed at accelerating growth Mid-1991 saw a new dawn in the economic history of
India. The country then faced a severe economic crisis, triggered largely by an acute balance of
payments problem.
The response to the crisis was to put in place a set of policies aimed at stabilisation and
structural reform. While the stabilisation polices were aimed at correcting weaknesses that had
developed on the fiscal and balance of payment fronts, the structural reforms were meant to
remove rigidities that had entered various segments of the Indian economy and to make the
system more competitive and efficient. Thus the crisis was turned into an opportunity to effect
some fundamental changes in the content and approach to economic policy.
Break with the past
The break with the past came in three important directions. The first was to dismantle the
complex regime of licences, permits and controls that dictated almost every facet of production
and distribution. Barriers to entry and growth were dismantled. The second change in direction
was to reverse the strong bias towards state ownership of means of production and proliferation
of public sector enterprises in almost every sphere of economic activity.
Areas once reserved exclusively for the state were thrown open to private enterprise. The third
change in direction was to abandon the inward-looking trade policy. By embracing international
trade, India signalled it was boldly abandoning its export pessimism and was accepting the
challenge and opportunity of integrating into the world economy.
The genesis of reforms
On the genesis of reforms, some interesting questions have been raised. First, several people
have been curious to know the role of P.V. Narasimha Rao in the reform process. Was he an
ardent advocate or a reluctant reformer? Second, were the reforms of 1991 a continuation of a
process that had already begun in the 1980s or did they truly constitute a break? Third, since the
leaders and bureaucrats involved in the reform process were themselves part of the earlier
control regime, what compelled them to change their approach? How much of the change was
influenced by the International Monetary Fund (IMF) and other multilateral institutions?
Man Mohan Singh as Finance Minister spearheaded the new policy. He articulated the need for
change and provided not only the broad framework but also the details of the reforms. It was,
however, Rao as Prime Minister who provided the valuable political support and shield which
were very much needed. It must be noted that as Prime Minister, he also held the Industry
portfolio which was directly responsible for initiating changes that led to the dismantling of
various types of controls and licences relating to the industrial sector. This was indeed a key
element of the reform programme.
The Eighth Five Year Plan, in the writing of which I had a role, spelt out in some detail the
rationale for reforms. Rao, as Chairman of the Planning Commission, had read the draft and
approved it fully. However, as a matter of strategy, he couched the reforms in a language which
would appeal to the „old guard‟ of his own party. There is no doubt that reforms could not have
moved forward without his solid support and conviction.

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The 1980s saw some important changes in economic policy. A number of committees were set up
which recommended changes for improving the functioning of the economy. But most of these
recommendations were still within the framework of an overall system of controls. What was
attempted was only a relaxation of controls such as raising the threshold for licensing. They were
largely incremental in nature. On the other hand, the reforms of 1991 moved away from the
control regime and offered a consistent set of measures covering various segments of the
economy in line with the new approach.
What changed the mindset of the people who initiated the reforms was the enormity of the crisis
of 1991. India‘s foreign exchange resources had fallen to a level equivalent to only three weeks
of imports. The possibility of ‗default‘ loomed large. It became obvious that ‗business as usual‘
would no longer work.
We had to move fast and make fundamental changes in our economic policy. It was true that at
the time we were negotiating with the IMF and other multilateral institutions. Obviously they had
their own bias. They were in favour of a competitive economy with minimal controls. But the
decision we took to introduce reforms was entirely our own. The credit goes fully to our
leadership.
Questions on the reform process
In the first three years after reforms were launched, there was a flurry of activity. Reforms
covered all key sectors such as industries, external trade, foreign investment, exchange rate
system, banking, capital market and fiscal and monetary policies. The impact was quick. Growth
started picking up. The balance of payments situation improved and confidence in the economy
was restored. It was good that successive governments have adhered to the reform path.
The pace of reform has, however, varied over time. Nevertheless, what stands out is that growth
since the reforms has been faster. Between 2005-06 and 2010-11, the average annual growth rate
was 8.8 per cent. While the decline in growth rate seen in the last few years needs careful
analysis, reforms have to be an integral part of any programme aimed at accelerating growth.
On the progress of reforms itself, two questions from two opposite angles have been raised. First,
how far have we come in fulfilling the original goal of liberalisation?
How much more needs to be done? The second question is, how much of the benefit of growth
has gone to the lower deciles of the population? Has there been a perceptible impact on the
vulnerable and weaker groups?
As reforms progressed, more and more sectors of the economy were brought within the ambit of
liberalisation. However, there are still some segments which are subject to controls reminiscent
of the pre-1991 period. A good example is the sugar industry. Agriculture too as a sector needs
special attention. Reforms of the agricultural marketing system are overdue. The country is yet
to emerge as a single market. Administrative reforms need to be pursued with urgency. Thus the
scope for future reforms is still wide.
Despite faster growth, India still ranks low in the Human Development Index even though the
country is classified as a medium human development country. There is, however, evidence that
poverty is coming down. Whatever level of private consumption expenditure is used as the cut-off,

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the poverty ratio is falling. Having said this, one must recognise that the poverty ratio is still high
and we are lagging behind in meeting the Millennium Development Goals on several dimensions.
Growth does help in reducing poverty because of both the percolation effect and the ability to
raise more resources on the part of the government to provide for increased social sector
expenditures. Therefore, a twofold strategy is needed: letting the economy grow fast, and
focussing on targeted programmes to help the poor and disadvantaged.
Thus the emphasis on efficiency does not mean ignoring concerns relating to equity. As the role
of government as a producer of marketable goods and services goes down, its role as a regulator
and provider of public goods and services increases. In fact, even in the provision of public goods,
different combinations are possible. Public-private participation can combine the efficiency of
the private sector with larger public policy concerns.
Reforms have come to stay. There is a fair measure of agreement across political parties on the
need for reforms. However, individual measures may run into problems. This is inevitable in a
democracy when conflicting political pressures are at play. Persuasion and consensus-building are
qualities which political parties in power must nurture and cultivate. Reforms are the first
important step towards raising the growth rate. But as our experience over the last few years
shows, reforms alone are not enough. They must be supplemented by a proactive government
which is focused on development and not distracted by other considerations.

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 FM Notes 38 – Risk Management in Banking Sector

Growing number of high-profile operational loss events worldwide have led banks and supervisors
to increasingly view operational risk management as an integral part of the risk management
activity. Management of specific operational risks is not a new practice; it has always been
important for banks to try to prevent fraud, maintain the integrity of internal controls, and
reduce errors in transaction processing, and so on. However, what is relatively new is the view of
operational risk management as a comprehensive practice comparable to the management of
credit and market risk. ‗Management‘ of operational risk is taken to mean the ‗identification,
assessment and / or measurement monitoring and control / mitigation‘ of this risk.
Banking sectors plays a pivotal role in the management of the economy of a country.
You as the aspirants of RBI Grade B Officer needs to know about what the Risks of Banking sector,
Risk Management are and what is the role of RBI in the risk management.
Risk
Risk refers to ‗a condition where there is a possibility of undesirable occurrence of a particular
result which is known or best quantifiable and therefore insurable‘. A risk can be defined as an
unplanned event with financial consequences resulting in loss or reduced earnings. An activity
which may give profits or result in loss may be called a risky proposition due to uncertainty or
unpredictability of the activity of trade in future.
In other words, it can be defined as the uncertainty of the outcome. As risk is directly
proportionate to return, the more risk a bank takes, it can expect to make more money.
Type of Risks
The major risks in banking business as commonly referred can be broadly classified into:
a. Reputational Risk
b. Liquidity Risk
c. Interest Rate Risk
d. Market Risk
e. Credit Risk
f. Operational Risk

a. Reputational risk
The Financial Times Lexicon defines reputation risk as the possible loss of the organisation‘s
reputational capital. The Federal Reserve Board in the US defines reputational risk as the
potential loss in reputational capital based on either real or perceived losses in reputational
capital. Just like any other institution or brand, a bank faces reputational risk which may be
triggered by bank‘s activities, rumours about the bank, willing or unconscious non-compliance
with regulations, data manipulation, bad customer service, bad customer experience inside bank
branches and decisions taken by banks during critical situations. Every step taken by a bank is
judged by its customers, investors, opinion leaders and other stakeholders who mould a bank‘s
brand image.

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b. Liquidity Risk
The liquidity risk of banks arises from funding of long-term assets by short-term liabilities,
thereby making the liabilities subject to rollover or refinancing risk.
Three parts of liquidity risk are as follows:
1. Funding Risk: Funding Liquidity Risk is defined as the inability to obtain funds to meet cash
flow obligations. For banks, funding liquidity risk is crucial. This arises from the need to
replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and
retail).
2. Time Risk: Time risk arises from the need to compensate for non-receipt of expected inflows
of funds i.e., performing assets turning into non-performing assets.
3. Call Risk: Call risk arises due to crystallisation of contingent liabilities. It may also arise when
a bank may not be able to undertake profitable business opportunities when it arises.

c. Interest Rate Risk

Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity (MVE) of an
institution is affected due to changes in the interest rates.
IRR can be viewed in two ways - its impact is on the earnings of the bank or its impact on the
economic value of the bank‘s assets, liabilities and Off-Balance Sheet (OBS) positions. Interest
rate Risk can take different forms.
d. Market Risk
The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to
market movements, during the period required to liquidate the transactions is termed as Market
Risk. This risk results from adverse movements in the level or volatility of the market prices of
interest rate instruments, equities, commodities, and currencies. It is also referred to as Price
Risk.
The term Market risk applies to (i) that part of IRR which affects the price of interest rate
instruments, (ii) Pricing risk for all other assets/portfolio that are held in the trading book of the
bank and (iii) Foreign Currency Risk.
1. Forex Risk: Forex risk is the risk that a bank may suffer losses as a result of adverse exchange
rate movements during a period in which it has an open position either spot or forward, or a
combination of the two, in an individual foreign currency.
2. Market Liquidity Risk: Market liquidity risk arises when a bank is unable to conclude a large
transaction in a particular instrument near the current market price.
e. Credit Risk
Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail to
meet its obligations in accordance with the agreed terms. For most banks, loans are the largest
and most obvious source of credit risk. It is the most significant risk, more so in the Indian
scenario where the NPA level of the banking system is significantly high.

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1. Counterparty Risk: This is a variant of Credit risk and is related to non-performance of the
trading partners due to counterparty‘s refusal and or inability to perform. The counterparty risk
is generally viewed as a transient financial risk associated with trading rather than standard
credit risk.
2. Country Risk: This is also a type of credit risk where non-performance of a borrower or
counterparty arises due to constraints or restrictions imposed by a country. Here, the reason of
non-performance is external factors on which the borrower or the counterparty has no control
Credit Risk depends on both external and internal factors.
- The internal factors include Deficiency in credit policy and administration of loan portfolio,
Deficiency in appraising borrower‘s financial position prior to lending, Excessive dependence
on collaterals and Bank‘s failure in post-sanction follow-up, etc.
- The major external factors are the state of Economy, Swings in commodity price, foreign
exchange rates and interest rates, etc.
- Credit Risk can‘t be avoided but can be mitigated by applying various risk-mitigating processes
-
- Banks should assess the credit-worthiness of the borrower before sanctioning loan i.e., Credit
rating of the borrower should be done beforehand. Credit rating is the main tool of measuring
credit risk and it also facilitates pricing the loan.
- By applying a regular evaluation and rating system of all investment opportunities, banks can
reduce its credit risk as it can get vital information of the inherent weaknesses of the account.
- Banks should fix prudential limits on various aspects of credit – benchmarking Current Ratio,
Debt-Equity Ratio, Debt Service Coverage Ratio, Profitability Ratio etc.
- There should be maximum limit exposure for single/ group borrower.
- There should be provision for flexibility to allow variations for very special circumstances.
- Alertness on the part of operating staff at all stages of credit dispensation - appraisal,
disbursement, review/ renewal, post-sanction follow-up can also be useful for avoiding credit
risk.

f. Operational Risk
Basel Committee for Banking Supervision has defined operational risk as ‗the risk of loss resulting
from inadequate or failed internal processes, people and systems or from external events‘.
Managing operational risk has become important for banks due to the following reasons –
1. Higher level of automation in rendering banking and financial services
2. Increase in global financial inter-linkages
3. Scope of operational risk is very wide because of the above-mentioned reasons.
Two of the most common operational risks are discussed below -
1. Transaction Risk: Transaction risk is the risk arising from fraud, both internal and external,
failed business processes and the inability to maintain business continuity and manage
information.
2. Compliance Risk: Compliance risk is the risk of legal or regulatory sanction, financial loss or
reputation loss that a bank may suffer as a result of its failure to comply with any or all of the
applicable laws, regulations, codes of conduct and standards of good practice. It is also called

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integrity risk since a bank‘s reputation is closely linked to its adherence to principles of integrity
and fair dealing.

Other Risks
Apart from the above-mentioned risks, following are the other risks confronted by Banks in course
of their business operations -
1. Strategic Risk: Strategic Risk is the risk arising from adverse business decisions, improper
implementation of decisions or lack of responsiveness to industry changes.
2. Reputation Risk: Reputation Risk is the risk arising from negative public opinion. This risk may
expose the institution to litigation, financial loss or decline in customer base.
Risk Management
Risk Management is actually a combination of management of uncertainty, risk, equivocality and
error. Uncertainty - where the outcomes cannot be estimated even randomly, arises due to lack
of information and this uncertainty gets transformed into risk (where the estimation of outcome
is possible) as information gathering progresses.
Initially, the Indian banks have used risk control systems that kept pace with legal environment
and Indian accounting standards. But with the growing pace of deregulation and associated
changes in the customer‘s behaviour, banks are exposed to mark-to-market accounting.
Therefore, the challenge of Indian banks is to establish a coherent framework for measuring and
managing risk consistent with corporate goals and responsive to the developments in the market.
As the market is dynamic, banks should maintain vigil on the convergence of regulatory
frameworks in the country, changes in the international accounting standards and finally and
most importantly changes in the clients‘ business practices.
Therefore, the need of the hour is to follow certain risk management norms suggested by the RBI
and BIS.
Rote of RBI in Risk Management in Banks
The role of RBI in Risk Management.
CAMELS was used by RBI to evaluate the financial soundness of the Banks. CAMELS is the
collective tool of six components namely
1. Capital Adequacy
2. Asset Quality
3. Management
4. Earnings Quality
5. Liquidity
6. Sensitivity to Market risk
The CAMEL was recommended for the financial soundness of bank in 1988 while the sixth
component called sensitivity to market risk (s) was added to CAMEL in 1997.

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In India, the focus of the statutory regulation of commercial banks by RBI until the early 1990s
was mainly on licensing, administration of minimum capital requirements, pricing of services
including administration of interest rates on deposits as well as credit, reserves and liquid asset
requirements.
RBI in 1999 recognised the need of an appropriate risk management and issued guidelines to
banks regarding assets liability management of credit, market and operational risks. The entire
supervisory mechanism has been realigned since 1994 under the directions of a newly constituted
Board for Financial Supervision (BFS), which functions under the aegis of the RBL to suit the
demanding needs of a strong and stable financial system.
A process of rating of banks on the basis of CAMELS in respect of Indian banks and CACS (Capital,
Asset Quality, Compliance and Systems & Control) in respect of foreign banks has been put in
place from 1999.
Other types of risks.
Human risk: Potential losses due to a human error, done willingly or unconsciously
IT/System risk: Potential losses due to system failures and programming errors
Processes risk: Potential losses due to improper information processing, leaking or hacking of
information and inaccuracy of data processing
Operational risk may not sound as bad but it is. Operational risk caused the decline of Britain‘s
oldest banks, Barings in 1995. Since banks are becoming more and more digital and shifting
towards information technology to automate their processes, operational risk is an important risk
to be taken into consideration by the banks.
Moral hazard
Moral hazard is a risk that occurs when a big bank or large financial institution takes risks,
knowing that someone else will have to face the burden of those risks.
Economist Paul Krugman described moral hazard as ―any situation in which one person makes the
decision about how much risk to take, while someone else bears the cost if things go badly.

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 FM Notes 39 – Classical Theory

During the first half of the 20th century, a broader approach to organization was initiated by a
group of writers whose interest was mainly in formal organization structure and the basic
management process. March and Simon have characterized this body of knowledge as
administrative management theory‖. The main contention of the theory is that a science of
administration can be developed based on some principles and based on the experience of
administrators.
The most important concern of the formal organizations theory is the formulation of certain
universal principles of organization. It deals primarily with formal organization structure. The
theory assumes that there are certain fundamental principles on the basis of which as
organization can be established to achieve a specific objective.
The central propositions are probably best represented in the works of Henry Fayol, Luther
Gullick and Lyndall Urwick, Luther Gullick and Lyndall Urwick, Luther Gullick and Lyndall
Urwick‘s ―Papers on the science of Administration‖ is an outstanding example of administrative
management in Public Administration, although James D. Mooney and Alan C. Reiley‘s Principles
of Organization are more frequently cited as exemplary.
LUTHER GULLICK AND LYNDALL URWICK
Gullick and Urwick were great systematizes of the classical approach to administration. Gullick
was a well - known American administrative expert and reformer. He was one of the trailblazers
in American administrative theory. He was a professor at Columbia University when he
coauthored ―Papers on the Science of Administration. Urwick was management consultant and
historian.
Both Gullick and Urwick were greatly involved in the problems of American Public Administration.
They were confidantes of President Franklin D. Roosevelt, and they advised him on a variety of
administrative problems and managerial matters. They wrote many reports on administrative
reform and efficiency.
Gullick and Urwick edited their noted landmark volume called ―Papers on the Science of
Administration in 1937. The principles of orthodox Public Administration were more or less
codified in it. It contained the most comprehensive enunciation of the classical theory and
marked the high noon of orthodoxy and prestige for public administration. Gulick‘s own article in
this work, ―Notes on the Theory of Organization‘ has been of particular importance in the
classical tradition of administration. It examines the concepts of structure, departmentalization
etc.
Division of work co-ordination, unity of command, span of control, delegation of authority, the
principle of objectives, and the principles of responsibility are some of the principles presented
by Gullick and Urwick in their papers. To cullick, division of work and co-ordination are important
principles. He viewed division of labour as the fundamental key to economic rationality,
efficiency and productivity. But once the work is divided, it needs coordination which, in turn,
relies upon hierarchy. According to Gullick, the work of executives is aimed at maintaining
coordination and control.

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Gullick believed that the study of administration, guided by efficiency, could be made into a
science equal to other scholarly disciplines. Like Physics or chemistry, Gullick says,
administration is governed by principles. The object of the administrative principles is the
accomplishment of the work at hand with the least expenditure of people and materials.
Gullick enumerates 10 principles of organization:
1. Division of work or specialization:
2. Bases of departmental organization;
3. Coordination through hierarchy;
4. Deliberate coordination (by ideas)
5. Coordination through Committees;
6. Decentralization
7. Unity of Command.
8. Staff and Line
9. Delegation; and
10. Span of control
Among the ten principles of administration listed above, Gullick lays special emphasis on division
of work. He feels that division of work is the basis of organization; indeed, the key for
organization.
Luther Gullick identifies four bases on which work may be divided and departments created : the
purposes they serve, the processes they use, the persons or things they deal with, or the place
where they work. These are popularly known as the four P‘s of Gullick. This point can be
illustrated by showing how the four bases have been employed for departmentalization in the
Government of India.
CRITICISM OF THE CLASSICAL THEORY
The classical approach to Public Administration has been criticized on many grounds.
Firstly, the classical approach overemphasized the formal structure and underestimated the
importance of the human factor and informal groups in the functioning of an organization. It did
not give adequate attention to the social and psychological factors relating to human behaviour.
It ignored virtually all features of organizational life beyond the formal structure.
Secondly, this theory treats an organization as a closed system completely unconcerned with and
not influenced by its external environment. It turns a land eye to problems stemming from human
interactions on organizations.
Thirdly, the classical theory is full of contradictions for which it has come under severe criticism.
Herbert Simon, a distinguished behavioural theorist, has criticized the classical approach as
narrow and lacking realism.
Fourthly, classical theory has been most severally criticized by the behavioural scientists. It has
been characterized as too mechanistic and incompatible with human nature. March and Simon
have called it the ‗machine model‘ theory while warren Bennis has observed that the focus of
classical theory is on ‗organizations without people‘.
Fifthly, Chester Barnard and Simon argue that a managerial organization cannot be explained
purely in terms of a set of principles about formal organization structure. They suggest that the

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actual behaviour of organizational participants departs in many ways from the behaviour that is
planned.
Sixthly, L.D. White also criticizes these principles for they are not rules. ―They suggest only
working rules of conduct which wide experience seems to have validated‖.
Seventhly, Chris Argyris speaks of a basic incompatibility between the needs of a nature
personality and the requirements of formal organization designed on the classical principle of
rigid task specialization, span of control and unity of command.
Eighthly, V. Subramaniam points out two important limitations of the classical theories. In the
first place, there is lack of sophistication in the theories. They appear to be common place
general knowledge proposition which do not appeal to the intellectual curiosity of the
academician and practitioners of administration.

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 FM Notes 40 – Communication

Communication has come to be recognized as the first principle of administration.

According to Herbert A. Simon ―Not only is communication absolutely essential to organization,
but the availability of particular techniques of communication will in large part determine the
way in which decision making functions can and should be distributed throughout the
organization.‖
The essence of communication, thus, is not information but understanding. Millett has aptly
defined it as ―shared under-standing of shared purpose.‖
Tead expresses the same idea as ―The underlying aim of communication is a meeting of minds on
common issues.‖
Effective communication is vital to the successful achievement of agency objectives.
Peter Drucker has rightly said, ―Good communication is the foundation for sound administration.‖
Communication is as necessary to an organization as the blood-stream is to a person.
The effectiveness of an organization depends very largely on the effectiveness of its
communication — upon the quality and availability of information with the system.
The word communication‘ has been derived from the Latin word ―communist‖, which means
‗common‘. Thus ‗communication‘, strictly, stands for sharing of ideas in common.
Persons working for an organization will show greater devotion to it, take more interest in their
tasks and develop a large measure of identification with it if they understand the objectives of
organization, its policies and circumstances.
An effective way to evoke a person‘s enthusiastic and active cooperation is for the head of the
agency to take him into confidence.
Millett is right in regarding communication as ―the blood stream of administrative organization‖.
Piffner considers it ―the heart of management‖. This is an age of communication. The average
man, today, is much closer to his government and his neighbours; he identifies himself more with
the life around him.
Even in the international field, we are moving toward ‗one world‖.
Researches in group dynamics and human psychology have proved that the successful working of
an organization depends upon winning the cooperation of the person working in it.
Democracy demands that the public must be increasingly associated with administration.
Business and government alike, therefore, have felt the need for establishing better
communication channels in their organizations.
The term, as used here, however, has a wider connotation, and includes interchange of thoughts,
partaking of ideas, and a sense of participation and sharing.

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The third is related to the relationship among the agency‘s employees inter se.
Communication has also been classified ―up‖, ―down‖ and ―across‖.
“Up” communication is achieved by such methods as systematic, written and verbal reports of
performance and progress, statistical and accounting reports concerning work, written verbal
requests for guidance, suggestions and discussions. Means are, thus provided for the higher level
to obtain evidence about work problems.
“Down” communication is achieved through devices, such as, directives, manuals, specific,
written or verbal orders of instruction, staff conferences, budget sanctions and establishment
authorization.
Management has recognized the part that communication plays in promoting participation,
cooperation and team work on the part of the employees. There is ample evidence of the
recognition. Almost all civilized governments today have set up information, publicity and public
relations departments.
The literature on management is full of articles on communication. Conferences, work-shops and
other training programmes are being organized to develop communication skills, particularly in
the United Sates.
According to some, it is primarily concerned with the transmission of information in a
governmental organization e.g. grapewine, the complaint box, the grievance procedure or the
formal chain of command.
But the concept of communication with which we are primarily concerned is that it is the act of
inducting others to interpret an idea in the manner intended by the speaker or writer.
The term communication‘ has many and varied meanings. Popularly speaking, it refers to the
various means or media of transmitting information from one individual to another or form one
place to another, e.g. telephone, telegraph or television. If one person specks or writes
something which is not understandable to others, it is no communication.
Communication is used in the sense of imparting knowledge or transmitting information. The
higher level uses these devices not only for command and control, but to inform the lower
echelons concerning its attitude and ideas and to give advice, guidance and direction.
“Across” communication is achieved through exchange of written or verbal information and
reports, formal and informal and personal contacts, staff meetings and coordinating committees.
The aim is to bring together different but related parts of the organization.
Shobhana Khandwala writes. Communication is generally understood as spoken or written words.
But in reality, it is more than that. It is the sum total of directly or indirectly, unconsciously or
consciously transmitted words, attitudes, feelings, actions, gestures and tones.
Even silence is an effective form of communication. A twist in the face is often more expressive
of disapproval than hundreds of words put together...‖
In simple words, we can say that communication is a process of transmitting information,
thoughts, opinions, messages, facts, ideas or emotions and understanding from one person, place
or thing to another person, place or thing.

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When people communicate with each - other, they are exchanging messages upon which action
can be taken. Therefore communication may be taken to mean the transferring of a mental
concept from the brain of one individual to the brain of another.
In short, the entire concept of ‗communication‘ in administration includes.
- Transmission of information, orders and instruction from the top administrator to the middle
level administrator and down to the ordinary employees.
- Transmission of reports, ideas, suggestions, complaints, grievances from the lower cadre
employees to the top administration.
- Cross communication between management group and the worker groups.
- Communication to the employees or the administration through extra - administration agencies
such as union or other interest groups.
- Herbert A. simon observes, ―Communication may formally be defined as any process whereby
decisional premises are transmitted from one member of an organization to other.‖
MEDIA
- Media of communication may be grouped into three main types, audial, visual and audio visuals.
- Audial media is adopted through conferences, interviews, broad-casts, public meeting, etc.
- Visual media comprises written communication in the form of circulars, manuals, reports,
bulletins and handbooks and pictorial forms, photo graphs, pictures, cartoons, flags, slides etc.
- Audio visual medium is made use of through sound motion pictures, television and personal
demonstration.
Conference method of communication is attaining marked popularity. It avoids delay, minimizes
correspondence and reduces red tape. Millet eulogies this system as it (i) enables to gain
awareness of problems (ii) helps in problem solving (iii) promotes a sense of unity among the
official working in the organization; (iv) encourages an exchange of information among
administrative personal : and (y) helps in gaining acceptance and execution of decisions.
FORMAL AND INFORMAL COMMUNICATION
- In any organization, the formal system of communication is deliberately established.
- Who should report to whom in what frequency, how should written communication move in the
hierarchy, which is the first level where action should be initiated and then passed on to
successive higher levels- all these are formally laid down to guide communication along desired
lines. But as Simon pointed out even if.
- There is an elaborates system of formal communications, this system will always be
supplemented by a complementary system of informal communication.
- Information, advice and even orders flow, many a time, along informal channels and not along
the deliberately established for mal channels of communications.
- The informal network of communications is based on social relations within the organization.

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- Two persons at different elves in the organization may be communicating with each other in a
way not formally charted out in the organization.
- The social relations like friend ship or enmity may create such informal conditions of
communication.
- The phenomenon of informal communication has been acknowledged as the ‗grapevine‘ that
creates an actual system of relationships in the organization which is vastly different from what
is formally prescribed.
- In so far as the ‗grapevine‘ supplements the usefulness in organizational life, often the
tendency, however, is to discourage openness and spread rumour, hence the informal channels
may not always play a construction role.
- Yet as Simon observes, ―the grapevine is valuable as a barometer of ‗public opinion‘ in the
organization.
- If the administrator listens to it apprises him of the topics that are subjects of interest to
organization members, and their attitudes toward these topics.‖
- It needs to be cautioned that too much reliance on the informal channels may lead to the
undermining of the system of formal communications in the organizations.
THE IMPORTANCE OF COMMUNICATION IN ADMINISTRATION
- It is no exaggeration to say that the communication function is the means by which organized
activity like government administration is unified.
- It may be looked upon as the means of which social inputs are fed into social systems.
- It is also the means by which behaviour is modified, change is effected, information is made
productive and goals are achieved.
- Over the years, the importance of communication in organized effort has been recognized by
many authors.
- Chester L Barnard, form example viewed communication as the means by which people are
linked together in an organization to achieve‖‖ a common purpose.
- This is still the fundamental function of communication. Indeed, group activity is impossible
without communication, because coordination, because coordination and change cannot be
effected.
- An ex-President of the American Management Association once observed that ―the No. 1
Management problem today is communication.‖
- Barnard has called it the foundation of all group activity.
- ―In practice, effective communication is a basic pre-requisite for the attainment of
organizational goals, but it has remained one of the biggest problems facing modern
administration.
- ―The importance of communication in administration can be judged form the following points:

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- Communication is needed to establish and disseminate the goals of an enterprise.
- The smooth and unrestricted running of an enterprises depends in toto (completely or entirely)
on an effective system of communication.
- Communication helps the administration in arriving at vital decisions.
- Communication also helps a lot in planning and coordination.
- Communication is a tool of supervision.
- It is a basic tool for motivation and an increase in the moral of the employees largely depend
upon the effectiveness of communication.
- Communication is also a means of bringing about maximum production at the lowest cost by
maintaining good human relations in the organization.
THEORETICAL CONTRIBUTIONS
Fayol‘s Contribution: Early discussions of management gave very little emphasis to
communication. Although communications was implicit in the managerial function of command
and the structural principle of hierarchy, the early theorists never fully developed or integrated
it into management theory. But the pioneering management theorist Hen Fayol was about the
only one who gave a detailed analysis of, and supplied a meaningful solution to the problem of
communication.
He is gangplank concept has direct implication for horizontal communication systems in modern
formal organizations. Barnard also interwove communication into his concept of authority. He
emphasized that meaning and understanding must occur before authority can be communicated
from manager to subordinate. He listed seven specific communication factors which are
especially important in establishing and maintaining objective authority in an organization.
Simon‟s Contribution:
Herbert simon looks at communication as a process whereby decisional premises are transmitted
from one member of an organization to another. According to Simon, ―Without communication
there can be no organization, for there is no possibility then of the group influencing the
behaviour of the individual‖. Further, like Barnard,
Simon also places emphasis on informal channels of communication for the transmission of
information. To Simon, ―the informal communication system (Grapevine) is built around social
relationships of the members of the organization.
Weiner‘s Contribution: The contemporary approach to communication has been greatly
influenced by cybernetics, a term coined by Norbert Weiner in 1947. Weiner lays emphasis on the
natural tendency toward disorder and disintegration in society.
Entropy is a measure of the tendency of a system to disintegrate. Since entropy has to be fought
back by methodical information processing which is the hallmark of organization. Information is
an antidote to entropy. In a developed system, information is used to collect and transform
resources so that the system approaches a state of ‗negative entropy‘. The natural tendency of

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the system to disintegrate is thus arrested. He also introduces the idea of monitoring a system via
a feedback mechanism that signals deviations from the objectives of the system.
PROCESS
The concern with communication has produced several attempts to develop models of the
process. The most widely used model has evolved from the work of Shannon and Weaver. The
basic ingredients of the model include a source, an encoder, a receiver, feedback, and noise.
This is shown below:
- The source is usually a member with ideas, information and a purpose for communicating.
- The function of encoding is to provide a form in which ideas and purpose can be expressed as a
message for transmittal.
- The message is the actual physical product that is conveyed.
- Channels stand for the carriers of messages from the source to the receiver, including written,
telephone and numerous other modes.
- The message must be decoded in terms of relevance to the receiver, Each receiver decodes or
interprets the message in the light of his own. Previous and frame of reference.
- A feedback look provides channels for receiver responses. This enables the source to determine
whether the message has been received and has produces the planned response.
- Within the communication process, breakdown, interference, or deviation can occur. Shannon
and Weaver were the first to identify this concept as noise.
THE COMMUNICATION PROCESS
Communication in organization is a two - way process: it comprehends both the transmittal to a
decisional centre (an individual vested with the responsibility for making particular decisions) of
orders, information and advice ; and the transmittal of the decisions reached from this center to
other parts of the organization. Moreover, it is process that takes place upward, downward and
laterally thought-out the organization.
The communication processes in valves the sender, the transmission of a message through a
selected channel and the receiver. Let us examine closely the specific steps in the process:
- The Sender of the Message: Communication begins with the sender, who has a thought or an
idea which is then encoded in a way that can be understood by both the sender and the receiver.
- Use of Channel to transmit the message: The information is transmitted over a channel that
links the sender with the receiver. The message may be oral or written and it may be transmitted
through a memorandum, a computer, telephone, a telegram or television. Since many choices are
available, each with advantages and disadvantages, the proper selection of the channel is vital
for effective communication.
- The Receiver of the Message: The receiver has to be ready for the message so that it can be
decoded into thought. A person thinking about an exciting Cricket match may pay insufficient
attention to what is being said about a fine report, for example thus increasing the probability of

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a communication breakdown. The next step in the process is decoding, in which the receiver
converts the message into thought.
- Noise Hindering Communication: Unfortunately communication is affected by ‗noise‘, which is
anything whether in the sender, the transmission or the receiver that hinders communication. For
example: (a) a noise or a confined environment may hinder the development of a clear thought:
(b) Encoding may be faulty because of the use of ambiguous symbols (c) Inaccurate reception may
be caused by in attention ; (d) Understanding can be restricted by prejudices, etc.
- Feedback in Communication: To check the effectiveness of communication, a person must
have feedback. One can never be sure whether or not a message has been effectively encoded,
transmitted, decoded and understood unit it is confirmed by feedback.
BARRIERS AND DIFFICULTIES
1. Language Difficulties: Language is only an imperfect vehicle of our ideas and impressions. If
that is so in the case of ordinary language, it is more so in the case of administrative language.
Rodolf Flesch in his article entitled ―More About Gobbledygook‖ published in 1945 says that ‗all
official communications develop a curiously legalistic ring, humorously, called ―gobbledygook‘
language, which it becomes impossible for a lay man to understand, In a desire to be over exact,
over obstruct, and over impersonal, official language can become quite curt and even
disagreeable.‖
According to Terry, ―International words do not refer to something that can be pointed out. They
neither always connote an identical meaning to different persons nor the same meaning to the
same person at all times.‖
2. Ideological Barriers: Pfiffner said, Differences in background, education and expectation
results in different social and political views. These are probably the greatest handicaps to
effective communication and probably the most difficult to overcome.‖ Lack of common
experience and common background further add to the problem.
3. Filtering: Filtering refers to intentionally withholding or deliberate manipulation of
information by the sender, either because the sender believes that the receiver does not need all
the information or that the receiver is better of not knowing all aspects of a given situation. It
could also be that the receiver is simply told what he wants to hear. The extent of filtering my
also depend upon the number of levels in the organizational structure. The more vertical levels
there are, the more likely the filtering.
4. Lack of Will: Some administrators do not accept administration as a cooperative Endeavour or
a group effort. They are not prepared to share their ideas with their subordinates. In simple
words they do not relish communication from below. It develops sycophancy amongst the
subordinates who report only that information to the superior which is palatable to him.
5. Lack of recognized Means: Lack of definite and recognized means of communication
constitute a great barrier. Formal channels are not adequate. Hence informal channels are to be
set up. Appleby rightly opines that ―a good deal of circumvention of formal procedures is
essential to make the transaction of business possible.‖ Pfiffner also holds the same view. ―The
ability to short circuit formal channels is thus a necessary and valuable art.‖

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6. Size and Distance: The bigger an organization and the larger the number of its employees, the
greater is the difficulty of communication. Too many hierarchical levels also pose a problem. In
the worlds of Pfifner, ―Information must percolate through levels, each of which may include
empire builders who consciously modify or subvert higher authority. In addition, individuals
interpret facts differently and tend unconsciously to colour them in transmission.‖
MALFUNCTIONS
- Dogmatism: A person draws conclusions and establishes positions about certain issues in the
environment. Unfortunately, once these opinions, attitudes, and beliefs are formed, they may
prevent the individual from receiving accurate communication.
This is because we tend to longer or refuse to accept additional information which conflicts with
our present position.
- Stereotyping: Another fact that causes communication malfunction is stereotyping, in which
expectations determine communication content. In this instance, judgments are made between
the objects or events about which we communicate.
- Halo Effect: The halo effect is the result of two - valued thinking. In this situation, we see
things only as dichotomies good and bad, right and wrong, white and black, and so forth. Thus, if
we are listening to someone we admire and trust we will be predisposed to agree with what is
being said. Conversely, we will automatically tend to ignore or disagree with those persons we do
not like. The danger here is that most situations are not dichotomous and, therefore, such
thinking may oversimplify most real situations.
ESSENTIALS OF COMMUNICATION
The contents of effective communication are based on the following essentials:
- Communication should be clearly and precisely stated.
- Communication should be consistent with the expectations of the recipients.
- The communication should be adequate.
- Communication should be timely, neither too late nor too early.
- Communications should be uniform for all those who are expected to behave in the same
way.
- Uniformity should not bring about rigidity in the form or character of communication.
- Good communication is one which stimulates acceptance.
- Feedback should be encouraged.
According to Terry, eight factors are essential to make communication effective. They are as
follows:
- Inform yourself fully.
- Establish a mutual trust in each other
- Find common grounds of experience.
- Use mutually known words.
- Have regard for context.
- Secure and hold the receiver‘s attention.
- Employ examples and visual aids.
- Practice delaying reactions

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 FM Notes 41 – Decision Making Herbert Simon

- Decision Making is the Cognitive process leading to the selection of a course of action among
variations.
- Every decision making process produces a final choice.
- Decision making is a reasoning process which can be rational or irrational, and can be based on
explicit assumptions or tacit assumptions.
- Common examples include shopping, deciding what to eat, when to sleep, and deciding whom
or what to vote for in an election or referendum.
- Decision making can be defined as the selection based on some criteria of one behaviour
alternative from two or more possible alternatives.
- Decision making involves two or more alternatives because if there is only one alternative
there is no decision to be made.
- To decide means to cut off or in practical content to come to a decision.
- Decision making is said to be a psychological construct.
- This means that although we can never ―see‖ a decision, we can infer from observable
behaviour that a decision has been made.
- Therefore, we conclude that a psychological event that we call ―decision making‖ has
occurred.
- It is a construction that imputes commitment to action.
- Structured rational decision making is an important part of all science based professions,
where specialists apply their knowledge in a given area to making informed decisions. For
example, medical decision making often involves making a diagnosis and selecting an
appropriate treatment.
- Some research using naturalistic methods shows, however, that in situations with higher time
pressure, higher stakes or increased ambiguities, experts, use intuitive decision making rather
than structured approaches, following a recognition of primed decision approach to fit a set of
indicators into the experts‘ experience and immediately arrive at a satisfactory course of
action without weighing alternatives.
- Also, recent robust decision efforts have formally integrated uncertainty into the decision
making process.
- Indeed, Decision making is the process of choosing a course of action from among alternatives
to achieve a designed goal.
- It consists of activities an executive performs to come to a conclusion.
- In the Functions of the executive Barnard gave a comprehensive analytical treatment of
decision making and noted ―The processes of decision...are largely techniques for narrowing
choice.
- ―In the words of Weihrich and Knoontz, ―Decisions making is the selection of a course of action
from among alternatives, it is the core of planning.‖ According to Haynes and Massie,
―Decision making is a process of selection from set of alternative courses of action which is
thought to fulfil the objective of the decision problem more satisfactorily than others.
- Decision making is a process of selection and the aim is to select the best alternatives.
- This process consists of four interrelated phases: explorative (searching for decision occasions),
speculative (identifying the factors affecting the decision problem), evaluative (analyzing and
weighing alternative courses of action), and Selective (choice of the best course of action).

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- On the basis of the above description, the following features of decision making can be
identified:
- Decision making is a goal oriented process; Decisions are made to achieve some goals or
objectives. There may just be a decision not to decide.
- Decision making implies a set of alternatives. A decision problem arises only when there are
two or more alternatives. If there is only one alternative there is no decision to be made.
- Decision making is a dynamic process. It involves a time dimension and a time lag. The
techniques used for choice vary with the type of problem involved and the time available for
its solution. It is situational.
- Decision making is always related to the environment. An executive may take one decision in a
particular set of circumstances and another in a different set of circumstances.
- Decision making is a continuous or ongoing process. Administrators have to take a series of
decision and executive job is perpetually a decision making exercise.
- Decision making is an intellectual or rational process. Decisions are the products of
deliberations reasoning and evaluation. However, decision making cannot be completely
quantified. Many decisions are based on intuition and instincts.

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 FM Notes 42 – Henry Fayol

Henry Fayol was a French Engineer. He wrote a landmark book General and Industrial
Management, which was published in 1916 in French. The English version of the book saw the
light of the day in 1929. By way of his tremendous contribution to Classical Theory of Public
Administration be am to be regarded as father of Classical Theory in Public Administration.
Though he covered a wide range of topics in administrative analysis yet more particularly he
focused on three areas. That is -
1. Activities of Industrial Under takings.
2. Elements of Administration.
3. Principles of Administration.
Henry Fayol described that activities of an industrial undertaking can be categorized into six main
groups-
a. Technical Activities: Technical Activities include production, manufacture and exchange.
b. Commercial Activities: Commercial involve buying, selling and exchange on the one hand and
through knowledge of the market, strength of the competitors, long- term foresight and use of
contracts and price regulation on the other hand.
c. Financial Activities: Under financial activities, comes search for capital and how to utilize
that capital in an optimum manner for the success of the undertaking.
d. Security Activities: Protection of property as well as of person against theft, fire and flood
and other social disturbances including strike are the parts of social activities.
e. Accounting Activities: Stock - taking preparation of balance sheets cost working out costs and
charting of statistics can be mentioned under the head of Accounting Activities.
f. Managerial Activities: For Fayol, Management is function. It is a kind of activity. He divides
key managerial functions into main five managerial activities.
1. Planning: Planning concerns itself with the examination of future demands and then charting
out a strategy to meet these demands. The broad features of unity, continuity, flexibility and
precision should reflect in the process of planning.
2. Organization: According to Fayol, the activities pertaining to organization are of two types -
a. The material organization (organization of material resources).
b. The human organization (organization of human resources).
3. Command: The entire concept of command is built on the personal qualities and knowledge of
general principles of management. It focuses on the maintaining and sustaining activities among
the personnel.
4. Coordination: Harmonization of all activities and efforts so that the working of the
organization can be facilitated. In other words, it is all about ensuring that the activities and
efforts of one department should coincide with another department keeping in perspective the
broader and overall objectives of the organization.

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5. Control: Henry Fayol has mentioned the term control. In wider French sense, that is, watch,
monitor, check, audit and obtain feedback.
FAYOL ON PRINCIPLES OF ADMINISTRATION
Fayol specifically stated fourteen principles of management I administration. They are -
Division of work (Specialization) : According to Fayol, the division of work (specialization), being
in natural order, help in producing better work with the same effort.
Authority and Responsibility
In Fayol‘s words - authority is the right to give orders to exact obedience. Authority is not to be
conceived of apart from responsibility, that is apart from sanction reward or penalty which goes
with the exercise of power. Responsibility is a corollary of authority, it is natural consequence
and essential counterpart and wheresoever‘s authority is exercised, responsibility arises.
Discipline: Discipline is nothing but the observance of agreements between the organization and
its employees. In order to bring about discipline in the organization three means have to be
adopted.
a. Placing Good Superiors at all levels.
b. Fair and Clear Agreements.
c. Judicious applications of penalties or Sanctions.
Unity of Command: Fayol believed - that for any action what so ever an employee should receive
orders from one superior only.‖ He continues - ―should it (unity of command) be violated,
authority is undermined; discipline is in jeopardy, order disturbed and stability threatened.‖
Unity of Direction: In Fayol‘s words, Unity of direction is provided for by sound organization of
the body corporate, unity of command turns on the functioning of the personnel.‖ Unity of
Command cannot exist without unity of direction but does not flow from it.
Subordination of Individual Interest to General Interest:
By subordination of individual interest to general interest is meant the interest to general
interest is meant the interest of an employee/worker or a particular group of workers should not
prevail over the overall interest of that organization. That can be made possible when the
supervisors show firmness, by resorting to constant supervision.
Remuneration of Personnel:
The remuneration fixed should not only be fair to employee but should also afford satisfaction to
employer. The factors which play privotal role in determining the remuneration of personnel are
- general business conditions, (economic status of the business value of employee and the mode
of payment adopted by the employer.
He also suggested many modes of payments such as - job rates, time rates, piece rates, bonuses,
profit sharing and non-financial rewards.
Centralization: About centralization Fayol rote - ―in every organism animal or social, sensations
coverage towards the brain or directive part and from the brain or directive part and from the
brain or directive part orders are sent out which set all parts of the organism in movement.‖

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More or less, according to Fayol, centralization exists in every organization. He further elaborates.
―The question of centralization or decentralization is a simple question of proportion. Everything
which goes to increases the importance of the subordinate‘s role is decentralization, everything
which goes to reduce it is centralization.‖
Scalar Chain: Scalar Chain or hierarchical order is the line of authority from top down the bottom
ranging from ultimate superior authority to the lowest ranks. He asserts (though) it is an error to
depart needlessly from the line of authority, yet it is even greater one to keep to it when
detriment to the business ensures. The concept of scalar chain (hierarchy) is dictated by and runs
parallel to the principle of unity of command.
Order: Henry Fayol classified order, in any organization, into two types - (i) Material order (ii)
Human (Social) Order. In his word - ―a place for everything and everything in its place‖ is the
formula for material things or order. As for human order, he suggested, ―A place for everyone
and everyone In his place‖ To put it simply - ―Right man in right place‖.
Equity: The relationship, Fayol says, between employee and employer should be based on a
combination of kindness and justice. The employees must be encouraged to carry out their duties
towards the organization as fully devoted and loyal people. Therefore it is incumbent on the
employer or head to inspire confidence and trust by putting in place a mechanism / system of
equity at all levels of organization.
Stability of Tenure of Personnel: It takes time for an employee to get acquainted with the work
and be efficient in the work he is assigned to accomplish so the first thing to be done in this
regard is to establish and element of stability as to the tenure of personnel / employees. It will
turn out to be a harbinger of efficiency in the organization.
Initiative: Initiative means the ability to decide and act on a plan in such a manner as to ensure
its success. When initiative is taken on the part of the management it infuses zeal and energy
into employees at all levels of the organization. Thus functioning of the organization is radically
augmented.
Esprit de Corps:
Esprit de Corps represents harmony among personnel. It is union among the personnel. It is union
among the personnel of the organization. According to Henry Fayol in order to realize and
promote esprit de corps among personnel of the organization, the principle of unity of command
should strictly be adhered to, the absence of which may prove to be antithetical to esprit de
corps.

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 FM Notes 43 – Herzbergs Two Factor Theory
- The theory of motivation advanced by Fredrick Herzberg and his associates has been referred
to as the motivation - hygiene (M.H) theory, the motivation maintenance theory, and the two-
factor theory.
- He brought out two books. ―The motivation to work‖ (1959) along with B. Mausner and B.
Synderman, and ―Work and the Nature of Man‖ (1966).
- Herzberg conducted widely reported motivational study on about 200 accountants and
engineers employed by firms in and around Pittsburgh, Pennsylvania. He used the critical
incident method of obtaining data for analysis.
- The professional subjects in the study were essentially asked two questions (i) When did you
feel particularly good about your job what turned you on; and (ii) When did you feel
exceptionally bad about yourjob- what turned you off?
- Response obtained from this critical incident method were interesting and fairly consistent.
- Reported good feelings were generally associated with job experience and job content.
- Reported bad feelings, on the other hand, were generally associated with the surrounding or
peripheral aspects of the job-the job context. Tabulating these reported good and bad feelings,
Herzberg concluded that job satisfiers are related to job content and that job dissatisfies are
allied to job context.
- Herzberg labelled the satisfaction motivators, and he called the dissatisfies hygiene factors.
- The term ‗hygiene‘ refers (as it does in the health field) to factors that are preventive, in
Herzberg‘s theory the hygiene factors are those that prevent dissatisfaction.
- Taken together, the motivators and the hygiene factors have become known as Herzberg‘s two
factors theory of motivation. Herzberg also calls hygiene factors as maintenance factors and
motivators as growth factors. They are presented in the following table: -
Herzberg‟s Tow - Factor Theory
Herzberg found a duality of attitudes about work experience in the responses of workers on their
job. Job experiences leading to favourable reactions most often were related to the context in
which the job was performed, that is, the surroundings and factors on the periphery to task
content. As against this, factors causing unfavourable response were found to be related to
avoidance of discomfort. Again the factors causing good responses are related to personal growth,
or fulfilment of psychological needs. Herzberg labelled the factors associated with growth and
the task content of the job as ‗satisfiers. Factors associated with pain avoidance and ‘context/
surround‘ of the job were labelled dissatisfies:
DISSATISFIES OF HERZBERG‟S THEORY
The potential dissatisfies, or ‗hygiene factors (using an analogy to the medical use of the term,
meaning preventive and environmental) are: salary company policy and administration,
supervision, working conditions, and interpersonal relations.
Hygienic factors, such as working conditions, company administration, salary, supervisory
relations, and benefits and services are envisioned as environmental elements that have little or
no relationships to the motivation of specific job-related behaviour. The factors can motivate a
man to work harder according to Herzberg, include elements such as the work itself,
achievements, recognition, advancement and responsibility.

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These latter factors determine how an employee feels about his job, whereas hygiene factors
only determine how a worker feels about his company or organization in general. Expressed
somewhat differently, motivation factors are related to job context. In addition, Herzberg has
argued that an employee is either dissatisfied or not dissatisfied with hygiene factors, and he is
either satisfied or not satisfied with motivational job factors.
The implications being satisfaction and dissatisfaction are separate continuum and not the
opposite of each other. Instead, a neutral state exists as contrary to job satisfaction and job
dissatisfaction. A worker is either satisfied or not satisfied or not dissatisfied (neutral) with
hygienic factors.
The Herzberg relation able helps to explain why a worker may hate his job and yet remain with a
company or love his job and yet quite an organization. The reasons is because separate types of
factors influence these two separate and distinct feelings.
The elements that determine how an employee feels about his job are the motivational factors;
the variables that influence how a worker feels about his company are the environmental or
hygienic factors. Hygienic factors must be adequate, or employees will not be attracted to an
organization. Bu when employed, manipulating hygienic factors cannot motivate a worker to do a
better job.
Each set of factors are rarely involved in contributing to the other and each set is independent of
each other. What is important is that dissatisfies only produce short- term changes in human
attitudes and satisfiers produce long - term attitudes.
Dissatisfies describe man‘s relations with the context and environment in which he does the job.
They only serve to prevent job dissatisfaction and have very little effect in creating positive job
attitudes. On the other hand, satisfiers are related to what one does, job content nature of the
task, growth in task capability, etc. They are effective in motivating the individual for superior
performance. Herzberg calls hygienic factors as dissatisfies and also maintenance factors whereas
satisfiers are called motivators and growth factors.
As we have noted, these motivation and hygienic factors are separate and distinct and they are
not opposite or obverse of each other. For example, opposite of job satisfaction is not job
dissatisfaction but only indicates that there is no job satisfaction. Similarly, opposite of job
dissatisfaction is not job satisfaction, but only indicates that there is no job dissatisfaction.
Therefore, these two are made up of tow unipolar traits, each contributing very little to the
other.
Key Principles: The three key principles at the heart of the innovation – hygiene theory are:
1. The factors involved in producing job satisfaction are separate and distinct from the factors
that lead to job dissatisfaction. Growth occurs with achievement, and achievement requires a
task to perform. Hygiene factors are unrelated to tasks.
2. The opposite of satisfaction on the job is not dissatisfaction; it is not merely no job
satisfaction. Satisfaction and dissatisfaction are discrete feelings. They are not opposite ends of
the same continuum. Herzberg described them as ―unipolar traits‖.
3. The motivators have a much long - lasting effect on sustaining satisfaction than the hygiene
factors have on preventing dissatisfaction. The motivators in a work experience tend to be more

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self - sustaining and are not dependent upon constant supervisory attention. Hygiene needs,
however, are related to things for which our appetites are never satisfied completely.
Applications of hygiene improvement must be constantly reapplied, since the need for them
always recurs, usually with increased intensity. Hygiene must always be replenished. Most of the
methods used in work-related organizations to purchase motivated behaviour over the years have
appeared to be ineffective, since the traditional motivation problems still exist. This is the
inevitable result because only the things that surround the work itself were being improved, and
these things have no lasting effect on motivation of worker.
HYGIENE AND MOTIVATION SEEKERS
After explaining the significance of motivation as well as hygiene factors, Herzberg divided the
people working in organizations into two groups and calls them ‗hygiene seekers‘ and motivation
seekers. The following chart would explain his characteristics of both hygiene seekers as well as
motivation seekers.

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 FM Notes 44 – Human Related School Mayo and Others

- The criticism of the scientific and administrative management as advocated by Frederick

Taylor and Henry Fayol respectively gave birth to the human relations movement.
- The behavioural scientists criticized the early management approaches for their
insensitiveness to the human side of the organization.
- They discovered the exploitation of employees were considered as a mere part to be fixed in
the job structure disregarding their attitudes, values and ideas.
- The mechanistic and Taylor approach continued only up to 1920. Then a substantial segment
of industrial managers switched to paternalism.
- Paternalism is the concept that movement must assume a fatherly and protective attitude
towards employees.
- The cold, impersonal attitude of the commodity concept was replaced by a personal and
sometimes super - personal attitude of paternalism. This bent towards liberal attitude was due
to growth of the trade unionism during the World War I.
- However, workers could not be satisfied by the so-called paternal attitude, wherein the profit
motive was supreme rather than the service instinct. So the paternalism died during the
depression of the 1930s.
- The title of ‗Human Relations‘ received enough nourishment in 1930 from Elton Mayo and his
colleagues, who came up with the concept that the worker was indeed the most important
element in industry. Mayo pleaded that a worker is not a mere commodity, but a human being
first and worker next.
- Many sociologists and psychologists like Homans, McGregor, Likert and Simon contributed to
the development of human relations approach. However, Elton Mayo and Hugo Miberge are
considered to be pioneers.
- Elton Mayo of Harvard and his associates conducted famous study on human behaviour at the
Hawthorne plant of the Western Electric Company and this study formed the foundations of
this school of management thought.
Main Features of the Human Relations Theory
The Individual: The theory emphases the uniqueness of each individual. It is said that each
worker brings to the job his own attitudes, beliefs and ways of life as well as certain skills;
technical, social and logical. An organization cannot hire only a part of the man. It has to put up
with his attitude and beliefs; if it wants to use his skills.
Each person also has hopes and expectations form his ob. These also have to be taken into
account by the organization if it wants a motivated workforce to carry on its activities.
Work groups (informal organizations): The Second aspect of this theory is its emphasis upon the
social dimensions of the work groups. It is observed that man is a social being and has an
overriding need to belong, to be accepted by and stand well in his group. To a worker, therefore,
the work groups. It is observed that man is a social being and has an overriding need to belong, to
be accepted by and stand well in his group. To a worker, therefore, the work group is as
important, if not more, as the format organization.
Participative management: The third most important feature of the human relations theory is
participative management. It has emerged out of the increased emphasis on the individual and

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the work groups. Participative management in fact means participation of the workers in decision
making about their work conditions. To be meaningful, the participative managements should
ensure that the workers are able to influence the decisions that affect them.

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 FM Notes 45 – Leadership Theories
NEED FOR LEADERSHIP
- The crisis of administration in India today is the crisis of leadership. With the ‗public‘ sector
constantly on the increase, large and complex organizations are being built up under the aegis
of the ever-expanding ‗welfare‘ state.
- All these organizations, big and small, need administrative leadership.
- More schools, more hospitals, more industries, more steel plants, more corporations, more
institutes and laboratories call for one indispensable element, namely, administrative
leadership.
- Similarly, the successful implementation of thousands of programmes included in our Plans
depends for their success on good leadership.
- Barnard is, thus right in remarking ―that the necessary production of leaders to the population
has greatly increased.‖ Growth in technology and specialization too have made leadership
complex.
- In the words of Seckler - Hudson, ―The overwhelming significance of the problems of
leadership has mounted with the revolutionary growth of such factors of size, complexity,
specialization organizational entities, technical developments and social demands.
- Thus, the first and the foremost task of Management today is to provide leadership, that is to
direct, control, and coordinate the activities of a group of persons with a view to achieving the
desired goals of the organizations.
LEADERSHIPS DEFINED
Leadership may be defined as a position of power held by an individual in a group, which provides
him with an opportunity to exercise interpersonal influence on the group members for mobilizing
and directing their efforts towards certain goals.
The leader is at the centre of a group‘s power structure, keeps the group together, infuses life
into it, moves it towards its goals and maintains its momentum.
He may emerge in a group by virtue of his personality characteristics and qualities or by virtue of
common consent by group members.
In the latter case, the leader derives his power from the group members. He continues in the
leadership position at the pleasure of group members collectively.
Leadership position exists in most group setting irrespective of the size of the group. - For
example, a leader of national or international standing commands wide - spread influence over a
large number of people while the influence of the leader of a small work group in an
administrative organization is very limited. Both are leaders in their own right and fulfill our
definition of leadership.
There are many different views on what is meant by ‗leadership‘. Basically, it is the relationship
between a superior and a subordinate or fellow worker which ‗triggers a person‘s will - to - do
and transforms like ward desires for achievements into burning passions for successful
accomplishment.‖ (George R. Terry, Principles of Management)

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Tannenbaum defines leadership as ―interpersonal influence, exercised in situations and directed,
through the communication process, towards the attainment of goals‖.
This definition is similar to that of Terry who also describes leadership as ―the relationship in
which one person, or the leader, influences others to work together willingly on related tasks to
attain that which the leader desires.‖
In any group situation the leader has a few bases of power by virtue of which he is in a position to
influence the behaviour group members.
They are (a) knowledge, information and experience (b) resources for dispensing favours, rewards
and penalties (c) formal authority (d) charisma (e) distinct personality characteristics like for
example will to dominate, ability to establish rapport, skill to communicate, decisiveness and so
on. Skillful use of these power bases by a leader is likely to bring success to him; and success in
some cases adds to the power of the leader.
A successful leader gains more credibility in the eyes of people, they often tend to ignore other
deficiencies in him; they resolve to adhere to him and allow themselves to be further exposed to
his influence attempts.
In this way some leaders entrench themselves in their positions. Some even misuse their power
and often get away with it.
Power carries with it an equal amount of responsibility.
Leaders who relate their power with responsibility in a consistent manner are more successful in
their influence than otherwise.
Bases of Leadership: Administrative leadership needs three bases to be securely and adequately
built-up, namely;
a. Personal
b. Political
c. Institutional

a. Personal
- Good health, personal energy and physical endurance.
- A sense of mission and purpose, enthusiasm and self-confidence.
- A sense of friendliness and concern for others.
- Keen intelligence and profound knowledge of details. Also a quick facility to comprehend the
essential elements of necessary importance.
- Integrity and sense of moral duty and fairness.
- Persuasiveness, and
- Judgment capacity to know the strong and weak sides of problems and persons.

b. Political:
By political conditions is meant the responsiveness of the officer, and the administrative agency
over which he presides, to external political direction and control. Administrative leadership
must reflect the political attitudes and traditions of the country.

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But what is emphasized here is political responsiveness which should not be confused with
political meddlesomeness and fickleness of the top- management should not become a pawn in
the game of power politics but at the same time must not ignore the basic social, economic and
political ideas and aspiration of the people.
Chester I. Bernard has expressed this quality of administrative leadership in these words: ―The
democratic process either in government or in innumerable other organizations in which it may
be used, depends upon leaders strong enough to maintain their ambition under perplexities,
patient to endure its restraints, proud to be foremost among the free, humbly loyal to the
humble; wise enough to seek service above the illusions of power and the futilities of fame,
willing to be briefly spent in the long span of marching events.‖
c. Institutional Bases:
Administrative leadership must also fulfil the conditions necessary for the institutional well-
being of the administrative agency which he has to direct. The democratic administration has a
function as a co-partnership of the directing officers and the workers. For the purpose, the first
requirement is that a sense of security must be created in the minds of the employees.
Governments has recognized the financial aspects of this need for security and have provide for it
by means of fair wages, sound promotion systems and lay-offs, retirement plans, health insurance,
encouragement of employee credit schemes, grievance and arbitration procedure etc. But merely
financial well-being does not provide full security to the employees. They must psychologically be
secure.
THEORIES OF LEADERSHIP
The area of leadership, whether it is political, social or administrative, has always attracted a
wide range of theorists and thinkers, eager to reflect, analyses and explain the phenomenon.
Following theories of leadership have been advanced.
BEHAVIORAL THEORIES OF LEADERSHIP
The Behavioral theory concentrates on what leaders ‗do‘, how they lead and behave?
How they motivate their subordinates and what are different communications skills and
techniques they use? They concentrate on leadership style and functions. The major studies are:
Lowa University Leadership studies by Kurt Lewin Ronald Limppit and Ralph White. They found
three types of leadership style. Authoritarian Democratic and Laissez faire. According to this
study the best and most effective leadership style is democratic style.
Ohio state University leadership studies by E.A. Fleishman, E.F. harris and H.E. Burtt.
They found two variables of leadership. Initiating structure (Directive Type) and consideration
(participative type). According to this study the most effective leadership style is a combination
of both variables and that to a maximum degree.
Michigan University Leadership studies by Rensis Likert and his associates. They found two types
of leadership studies production centered and Employee centered. The finding of this study is
that employees centered leadership style is most effective in any organization.

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Four systems of Management leadership by Rasis Likert. The systems are system 1 (Exploitative —
Authoritative), system 2 (Benevolent — Authoritative), system 3 (Consultative) and system 4
(Participative Group) According to Likert system 4 is most effective way of leadership.
Management Grid by Robert Blake and June Mouton. They found five styles of leadership
impoverished (low concern for production and people). Country club (Low concern for production
and high concern for people) Task (high concern for production and low concern for people),
Middle of the Road (moderate corner for production of people) of team (high concern for
production and people). According to the study team leadership style is most effective in
motivating employees and increasing the production of organization.
THE SITUATION THEORY OF LEADERSHIP
According to the exponents of this theory. ―Leadership is specific and always relative to the
particular situation in which it occurs. ―In other words, leadership is the product of a situation in
a particular group. It is assumed that the traits and skills which characterize a good leader will
vary from group to group and from situation to situation. A leader in one situation is not
necessarily a leader in another situation, even in the same group. Various situations call for
different leadership responses.
The same leader may display different personality traits to deal with diverse problems. Thus,
situational theory of leadership stresses how leadership differs with situational variables or why a
person in a particular situation is successful or unsuccessful.
A basic fact about the situational approach is that a successful leader must be adaptive and
flexible. As the situation changes, so must the leader change his style of leadership.
The merit of this approach is that ―it focuses attention not on the personality of the leader as
such but on the personality of the organization as a whole. It is possible for almost anyone to
become a leader if circumstances allow him to perform the leadership functions determined by a
particular situation. An effective leader, according to the Situational Theory, is one who
understands the facts of a situation and deals with them effectively.
LEADERSHIP BEHAVIOR CONTINUUM THEORY
The adaption of leadership styles to different contingencies has been well characterized by
Robert Tannenbaum and Warren H. Schmidt developers of leadership continuum concept. They
see leadership as involving a variety of styles, ranging from one that is highly boss- centered to
on heat is highly subordinate centered.
The styles vary with the degree of freedom a leader or manager grants to subordinates. Thus,
instead of suggesting a choice between the two styles of leadership authoritarian or democratic
this approach offers a range of styles, with no suggestion that one is always right and another is
always wrong.
The Continuum Theory recognizes that which style of leadership is appropriate depends on the
leader, the followers and the situations. Leadership actions are related to the degree of authority
used by managers, and to the amount of freedom available to the subordinates in reaching
decisions.

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The managerial actions depicted on the left of the continuum characterize managers who
maintain a high degree of control, while those on the right designate mangers who delegate
decision making authority. It will be observed that at the one extreme end, the manger makes
decision, tells his subordinates and expects them to carry out that decision.
At the other extreme, the manager fully shares his decision making power with his subordinates,
allowing each member of the group to carry an equal voice one man, one vote, between these
two extremes fall a number of leadership styles, with the style selected dependent upon forces in
the manager himself, his operating group and the situation.
There is a relationship between the degree of authority used an the amount of freedom available
to subordinates in reaching decisions, This continuum is seen as a zero-sum game; as one gains,
the other loses, and vice-versa. The authors of the theory imply that leaders should not choose a
strict autocratic or democratic style, but should be flexible enough to cope with different
situations.
LIKERTS THEORY OF LEADERSHIP
The most important contribution of Likert lies in this conceptualization of different systems of
management along a continuum. He identified four distinction points along the continuum for
purpose of illustration of the characteristics of each of the management system.
System I management is described as ‗exploitive authoritative‘; its managers are highly
autocratic, have little trust in subordinates, motivate people through fear and punishment and
only occasional rewards, engage in downward communication and limit decision making to the
top.
System 2 management is called ‗benevolent‘ authoritative;‘ its managers have a patronizing
confidence and trust in subordinates, motivate with rewards and some fear and punishment
permit some upward communication, solicit some ideas and opinions from subordinates and allow
some delegation of decision making but with close policy control.
- System 3 management is referred to as ‗consultative‘. Managers in this system have substantial
but not complete confidence and trust in subordinates, usually try to make use of subordinates‘
ideas and opinions use rewards for motivation with occasional up, make broad policy and general
decision sat the top which allow specific decisions to be made at lower levels, and act
consultative in other ways.
Likert saw system 4 management as the most participative of all and referred to it as
―participative group‖. System 4 managers have complete trust and confidence in subordinates
and constructively use them. They engage in much communication down and up and with peers,
encourage decision making throughout the organization and operate among themselves and with
their subordinates as a group.
In general, Likert found that those managers who applied the System 4 approach to their
operations had the greatest success as leaders.
THE OHIO STATE LEADERSHIP STUDIES

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Initiated in 1945 the Bureau of Business Research Studies by Fleishman and others at the Ohio
State University identified two independent leadership dimensions called initiating structure and
consideration.
In the beginning, it was widely believed that the most effective leadership style was high on both
the initiating structure and consideration. But later the results amply demonstrated that no
single style emerged as the best.
In some situations, high initiating structure and high consideration style would prove effective,
but in some others, even low initiating structure and low consideration style could prove
effective.

THE MICHIGAN LEADERSHIP STUDIES

The Institute for Social Research at the University of Michigan conducted a number of studies to
identify styles of leader behavior that result in increased work — group performance and
satisfaction.
Their studies resulted in the development of two distinct styles of leadership (1) the job centered
(task oriented) leadership style emphasizing the use of rules, procedures and close supervision of
subordinates, and ii) the employee centered (relationship oriented) leadership style emphasizing
delegation of authority and responsibility and concern for employee welfare, needs,
advancement and personal growth.
The use of both styles led to increase in production, but it was slightly higher in the case of the
job entered leadership style. The Integrated Leadership Model-Leadership is a complex
phenomenon where the task of the leader is to achieve some sort of integration between the
varying and complex array of forces surrounding him and within him.
LEADERSHIP STYLES
Autocratic / authoritative I Directive Style: All authority and decision making is centered in an
autocratic leader. This central control results from the use of rewards, praise, or fear of criticism
or punishment. With this approach, the manager is free to set policy and to structure, interpret,
or modify the task as he wishes. Autocratic leadership consists of orders issued to subordinates.
An autocratic leader requires conformity from his decisions to be superior to those which is
inexperienced or unknowledgeable workers would offer to solve the problem at hand.
The Democratic or Participative Leaden Here the leader tries to lead or guide his subordinates
through persuasion and example instead of fear, status or force. He encourages participation in
decision making and takes decision after consultation with his followers. He encourages his
subordinates to function as a social unit and makes full use of their talents and abilities. He is the
conductor of an orchestra rather than a one-man band; and he realizes that his job is to
coordinate the willing work of his employees.‖
Laissez Fair /Free - rein Style:
The laissez fair of free rein style of leadership does not depend on the leader to provide external
motivation as do the autocratic and participative styles. The works motivate themselves based on

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their needs, wants, and desires, they are given a goal and left mostly p to their own to achieve it,
using their ingenuity. The leader principally assumes the role of a group member and supply
materials when asked.

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 FM Notes 46 – M.P. Follett and C.I. Barnard

Mary Parker Follett, a contemporary structural theorist contributed significantly to the

development of management thought but at the same time differed from other writers of the
period, organization was, to her, a social system and management a social process. Psychological
and sociological aspects of management were given prominence in her writings. Unlike most of
her contemporaries, she attached special significance to lateral coordination, authority
acceptance in an organization, integration of individuals and organization, and administrative
change.
Follett‘s popular books include ‗Creative Experience‘ (1924) and ―Dynamic Administration‘
(1941) ; the last one was posthumously edited by H. Metcalfe and L Urwick. To Follett conflicts
are inevitable in any organization, as views, attitudes and emotions of individuals vary
individually. She asserts, the conflicts should be viewed constructively and not to be abhorred.
To make constructive use of conflicts, she subscribed to integration, as opposed to domination
and compromise, to be the best way. She felt that giving of orders to someone may affect the
human dignity and may find resistance, and therefore, rejects the process of orders from
individual to individual.
She substitutes the process with what she calls the law of the situation; wherein orders flow from
situation. She highlights the importance of depersonalizing orders, to make a group a cohesive
one, heralding with concept, in place of under concept. She also applied the concept of
behaviouralism in her analysis of leadership, authority, responsibility, etc. She underpinned the
importance of functional and integrative unity and to achieve this she developed four principle of
coordination.
Follett can be considered as a link between the classical and behavioural theories. It is said that
chronologically the belonged to a scientific management era and philosophically to the social
man era. As a classicist she developed certain principles and strongly believed in their
universality. As a behavirouralist, she stressed the importance of human emotions. Thus, she was
a precursor of behaviorism and human relations movement.
MARY PARKER FOLLETT
Mary Parker Follett accords due place to the problems of conflict in her writings. She advances
the idea of constructive conflict recognizing these by that conflicts should be regarded as normal
process in any activity of an organization by which social valuable differences register themselves
for the enrichment of all concerned.
Conflict is not a wasteful outbreak of incompatibilities but normal process by which socially
valuable differences register themselves for the enrichment of all concerned. Insure of individual
differences, conflict is unavoidable, instead of criticizing it as something bad, one should try to
capitalize on it and make use of it to do something good.
To Follett conflict is a normal thing in the interaction of desires. Just as there are destructive
ways of dealing with such moments, then as also constructive ways, conflicts act the moment of
appearing and focusing of difference. It may be sign of health and a property of progress.
Drawing analogies from the universe she says: All polishing is done by friction.

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There are three ways of resolving a conflict:
Domination, compromise and integration.
1. Domination is a victory of one side over the other. It is the easiest way to resolve the conflict.
2. Compromise is generally the way people settle most of their conflicts. In this each side gives
up a little and settles the conflict so that the activity which has been interrupted by the
conflicts may go on.
3. Integration is the third method of resolving conflicts. Here, too desires are integrated and
neither side needs to sacrifice its desires.
Integration creates something new and leads to innovation and to the emergence of new values.
It leads to the use of both techniques and also saves time and resources. Integration goes to the
root of the problem and puts an end to the conflict permanently. Integration requires high
intelligence, keen perception and discrimination and brilliant inventiveness.
It is always easier to fight them to suggest better ways of doing a job. As long as intelligence and
inventiveness are not there, resolving conflicts through integration would be difficult.
Another obstacle is the people‘s habit of enjoying domination. Follett says that most people,
without even erasing the different principles that underlie giving orders, give orders every day.
To her, to know the principles that underlie any given activity is to take a conscious attitude.
After recognizing the different principles, one must think of what principles one should act on
and then to whom should give orders in accordance with invoice principles.
Many people think giving orders is very simple and expect that they should be obeyed without
question. But in practice, issuing of orders is surrounded by many difficulties ―Such as‖ past life,
training experience, emotions, beliefs and prejudices from certain habits of mind which the
psychologists call ‗habit patterns‘ action patterns‘ and motor sets‘.
Unless these habit patterns and certain mental attitudes are changed, one can‘t really change
people, Sometimes orders are not obeyed because the employees cannot go contrary to lifelong
habits.
For instance, Follett syss. The former has general disposition to manage to stand alone, and this
is being changed by the cooperatives. To bring about such a change, Follett suggests three things
viz.
a. Building up of certain attitudes
b. Providing for their released
c. Response as it is being carried out.
Follett gives special attention to the problems of power, control and authority. She reveals
profound, penetrating and strikingly original insight in her analysis of power.
She defines power as the ability to make things happen to be a causal agent, to initiate changes.
Power is the capacity to provide intended effects. It is an instinctive urge in level in all human
beings. She makes a distinction between ‗power over‘ and power with‘ The former may tend to
be coercive power while the latter is a jointly developed coactive power‘.

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Power with is superior to power over as it is a self-developing entity which promotes better
understanding, reduces friction and conflict and encourages cooperative Endeavour.
Follett defines authority as vested power, the right to develop and exercise power. Authority in
terms of status and the subordination of one to another offend human dignity and may cause
undesirable reaction and friction.
Therefore it cannot be the basis of organization. According to her authority stems from the task
being performed and form the situation and suggests that function is the true basis form which
authority is derived.
Therefore, she says that central authority from the chief executive should be replaced by
authority of function in which individual has final authority within the allotted functions.
CONTRIBUTION OF CHESTER I. BARNARD
Barnard wrote two books ―The Functions of the Executive‖ (1938) and ―Organization and
Management‖ (1948). In these books Barnard presented convincingly his views on organization as
a cooperative system. He is considered the spiritual father of the ‗social system‘ school.
Formal organization as a cooperative system: Barnard was not satisfied with the traditional
definition of organization which laid stress on ‗membership‘ and not on its functioning. In
Barnard‘s opinion, the hard core of the group concept is the ―system of interactions‖.
Correspondingly, Barnard regards an organization as ―a system of consciously coordinated or
forces of two or more persons, and then indicates that the executive is the most strategic factor
in organize or cooperative systems.
As a system, it is held together (i) by some common purpose, (ii) by the willingness of certain
people to contribute to the functioning of the organization, and iii) by the ability of such people
to communicate with each other. Thus, the existence of an organization, in Barnard‘s view,
presupposes three elements; common purpose, willingness to cooperate and communication.
Informal organization as a natural system: Barnard thought that formal organizations are artificial
systems and they grew out of informal organizations which are natural systems. The formal
organizations in turn give rise to new informal organizations which carry out three positive
functions:
1. To perform the communication of intangible facts, opinions, suggestions, suspicions that
cannot pause through formal channels without raising issues.
2. To maintain the social and psychological cohesiveness of the organization by creating
relationship among members that would not otherwise develop and develop and
3. To help maintain the feeling of personal integrity, of self-respect, of independent choice. It
may be regarded as ―a means of maintaining the personality of individual against certain
effects of formal organization which tend to disintegrate the personality.‖
In Barnard‘s words. ―They are interdependent aspects of the same phenomenon. A society is
structured by formal organizations, formal organizations are vitalized and conditioned by
informal organizations.‖ What is asserted is that there cannot be one without the other. If one
organization fails, the other will necessarily disintegrate.

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Barnard broadly agreed with the Human relations school when he disapproved the ‗economic man‘
concept and emphasized contribution satisfaction equilibrium. He traces the sources of
satisfaction to four ‗specific inducements viz.

He also pointed out four types of ‗general incentives‘. They are:

1. Associated attractiveness based upon compatibility with associates.
2. The adaptation of working conditions to habitual methods and attitudes.
3. The opportunity for the feeling of enlarged participation in the course of events; and
4. The conditions for communicating with others, a conditions based upon personal comfort in
social relations.

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 FM Notes 47 – Motivation

Meaning of Motivation
- Motivation may be defined as the complex of forces inspiring a person at work to intensify his
willingness to use his capacities for the achievement of certain objectives.
- Motivation is something that motivates a person into action and continues him in the course of
action enthusiastically. It determines the behaviour of a person to a great extent.
- The term ‗Motivation‘ is derived from the word ‗motive.
- Motive may be defined as needs, wants, drives or impulses within an individual.
- Motives or needs of a person are the starting point in the motivation process.
- Motives are directed towards the achievement of certain goals which in turn determine the
behaviour of individuals.
- Motives give direction to human behaviour because they are directed towards certain ‗goals‘
which may be conscious or sub conscious.
- A goal is an outward stimulus for the motives to work.
- Motivation has been defined by Michael J. Jucius as: ―the act of stimulating someone or
oneself to get a desired course of action, to push the right button to get a desired reaction.‖
- Dubin describes motivation as the complex of starting and keeping a person at work in an
organization.
- It starts and maintains an activity along a prescribed line.
- It is something that moves a person to action and continues him in the course of action already
initiated.
- Thus, motivation is a will to work‘.
SIGNIFICANCE OF MOTIVATION
Motivation is one of the most crucial factors that determine the efficiency and effectiveness of
an organization. All organizational facilities will remain useless unless people are motivated to
utilize these facilities in a productive manner. High motivation provides the following advantages.
- Motivated employees give greater performance than demotivated ones.
- Motivation inspires employees to make best possible use of different factors of production.
- Higher motivation leads to job satisfaction of workers. As a result, labour absenteeism and
turnover are low.
- Motivational schemes create integration of individual interests with organizational objectives.
TRADITIONAL THEORIES OF MOTIVATION
Some of the traditional theories of motivation are:
1. Fear and Punishment Theory
2. Reward Theory
3. Carrot and Stick Theory
1. Fear and Punishment Theory: This theory involves the use of coercion and threat, close
supervision and tight control of behaviour. The basic idea behind this theory is that people work
for the sake of money and that they will work only to ensure that the job is not lost. The theory
was authoritarian and military in tone and individual had no option but either to toe the line or
leave the job‘. In the present circumstances, this theory is unsuitable.

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2. Reward Theory: This theory involves the offer of some reward and good working conditions to
motivate people to work better and harder, their demands are satisfied and harmony achieved. It
is based on the assumption that people are motivated to work to the extent to which they are
rewarded. Frederick Taylor is said to be the originator of this theory as he said, ―Give a man
more money and he will produce more. However, sometimes satisfaction leads to indifferent
performance Peter Drucker says, ―: Satisfaction with monetary rewards is not a sufficient
motivation‖.
3. Carrot and Stick Approach of Motivation comes from the old story that the best way to make
a donkey move is to put a carrot in front of him or jab him with a stick from behind. The carrot is
the reward for moving and the stick is the punishment for not moving.
The carrot and the stick approach of motivation takes the same view. In motivating people for
behaviour that a desirable, some carrots - rewards are sued such as money, promotion, and other
financial and non-financial factors, some sticks such as money, promotion, and other financial
and non-financial factors, some sticks - punishments in the form of fear of loss of job, loss of
income, reduction of bonus, demotion, or some other penalty are used to push the people for
desired behaviour or to refrain from undesired behaviour.
Yet it is admittedly not the best kind. It often gives rise to defensive or retaliatory behaviour,
such as union organization, poor quality work, executive difference, failure of a manager to take
any risks in decision making, or even dishonesty. But fear of penalty cannot be overlooked. But
what is important is that the mixture of both carrot and stick should be used judiciously so that
both have positive effects on the motivational profile of the people in the organization.
MODERN THEORIES OF MOTIVATION
Some of the important modern theories of motivation are:
1. Maslow‘s Hierarchy of Needs
2. McGregor‘s theory X and Theory Y
3. Theory Z of Ouchi
4. Two factor theory of Herzberg.
5. Vroom‘s Expectancy Theory
1. Maslows Hierarchy of Needs: Motivation can be defined in a variety of ways, depending on
whom you ask. If you ask someone on the Street, you may get a response like. ―It‘s what drives us
or ―Motivation is what makes us do the things we do‖. As far as a formal definition, motivation
can be defined as ―forces within an individual that account for the level, direction, and
persistence of effort expended at work, ―according to Schemer horn, et al.
This is an excellent working definition for use in business. Now that we understand what
motivation is, we can look at the factors that help managers to be able to motivate and then
have a look at some of the theories on motivation.
Abraham Maslow was one of the earliest theorists who provided a systematic conceptual model of
human needs and the associated behaviour. In a classic paper (A Theory of Human Motivation)
published I 1943, he advanced his ―need Hierarchy. Theory‘ of human motivation to explain how
needs influence human behaviour.

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Maslow‘s interest and research in understanding human behaviour was the result of his early
career as a psychologist. He tried to understand human behaviour through psycho analysis. His
clinical experiences as a psychologist enabled him to develop his five level theory of need
hierarchy. He published his popular book ‗motivation and personality‘ in 1954.
Maslow‘s theory is based on the idea of prepotency of needs. Accordingly he developed a scale on
which at one end are lower order needs esteem and self- actualization needs. This hierarchy of
‗prepotency‘ or urgency of satisfaction means that the most urgent need will monopolize the
individuals‘ attention while less proponent needs are minimized, even forgotten.
A satisfied need gives place to another unsatisfied need and this process, goes on in a continuum
because man is a perpetually wanting animal. (A satisfied need no longer motivates a person).
Maslow‟s hierarchy of needs is shown below.
The progression of needs and their fulfilment along the hierarchy, is sequential and step-by-step
and on the basis of their dominance. Mas low argued that human beings generally strive to satisfy
their basic needs (lower order needs) first before looking for gratification of non - basic (higher
order) needs.
Methods for Managers to Gauge Motivation Probability
EMPLOYEE SELECTION
A manger‘s ability to motivate starts earlier than most people think with employee selection. The
hiring of employees that are self-motivated is crucial to the success of any business. If an
employee is motivated from within, then the ―motivator‖ aspect of manager‘s job is less difficult.
As with many ideas, this ―easier said than done‖.
There is a colossal barrier to only hiring those that are self-motivated. With the legal restraints
today in regard to discrimination, managers often give up trying to make ―good‖ hiring decisions
for fear of discriminating illegally. Therefore, most managers have become solely reliant on
intuition during the hiring process. The trick seems to be to try to hire those that are motivated
to do what is best for the organization without discriminating against those who may be
motivated, but not to work, and those that have the skills necessary for a position but lack the
motivation all together, It is this challenge that will puzzle today‘s managers and those of
tomorrow.
HIGH ORGANIZATIONAL EXPECTATIONS
Another method that managers can utilize to help them motivate their employees is
incorporating high organizational expectations. Some leaders and managers build important
productivity expectations into their organization cultures. These expectations include a sense of
responsibility, high productivity, and quality of output.
These expectations are impressed upon new employees. These managers show this by having new
employees watch ―pace setters‖ to demonstrate that these expectations are taken very seriously
throughout the organization.
By employing these two methods, managers, more than likely, will not need to motivate their
employees as much or as often. This is not to say that motivation can be neglected at any point.
Managers must continually motivate their employees, but this can be made easier by attempting

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to hire self-motivated employees and impressing high standards upon them and reinforcing the
standards on a daily basis.
Motivation Theories of the Early and Mid-Nineteenth Century
Ivan Pavlov
Pavlov did extensive studies on classical conditioning. Classical conditioning is ―a form of learning
through association that involves the manipulation of stimuli to influence behaviour.‖ More
simply, within organizations, employees associate an action with a following action, and then
they expect the following action each time the initial action appears. This is a natural reaction
for some. Pavlov‘s theory is difficult to argue with and is applicable today and probably will be
for a long time.
Abraham Maslow
Maslow developed a ―hierarchy of needs‖ or an order of needs that need to be fulfilled in each
person. If a manager embraces Maslow‘s hierarchy, he / she will motivate employees, keeping
the order of needs in mind. The hierarchy of needs is shown below:
1. Self-actualization - Need to grow and use abilities to the fullest: highest need.
2. Esteem - Need for respect prestige, and recognition from others as well as self- esteem and
personal sense of competence.
3. Social - Need for love, affection, and belongingness in one‘s relationship with others.
4. Safety - Need for security, protection, and stability in the personal events of everyday life.
5. Physiological - Most basic of human needs; need for food, water, and sustenance. Using this
theory, managers can use the hierarchy to motivate people by satisfying the most important
needs.
David I. McClelland
McClelland and his associates came up with a test to measure human needs. They came up with
three; need for achievement need for affiliation, and need for power.
According to McClelland urged managers to be able to identify these needs in others to help
themselves understand how to motivate individuals. Different motivation approaches would be
used depending upon which need is identified. Mcclelland‘s ideas are very good, according to this
author, and they can be applied today and tomorrow.
Frederick Herzberg
Herzberg developed his two factor theory, taking a different approach from others. Herzberg
argues that hygiene factors in the work setting are sources for job dissatisfaction. Also, he says
that motivator factors in work tasks are sources for job satisfaction. His theories can be
summarized by quoting from him, ―If you want people to do a good job, give them a good job to
do.‖ The theory of Herzberg may seem a little vague, but it is based on superb ideas. The two
factor theory may be as useful as, or more than other theories of the time, because job context
and content are major issues in the business world today.

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Victor Vroom
Vroom‘s expectancy theory argues that motivation is based in values and beliefs of individuals, or
how a person feels effort, performance and outcomes. He developed an equation to ―calculate‖
motivation using three factors:
1. Expectancy - The probability that effort will be followed by personal accomplishment.
2. Instrumentality - The probability that performance will lead to outcomes.
3. Valence - The value of an individual of an outcome.
Vroom argues that a manager can use the equation M= E * I * V to predict whether a particular
reward will motivate an individual. While the basis of Vroom‘s expectancy theory is very good,
the equation seems a little awkward today.
RECENT THEORY
Sheila Ritchie and Peter Martin
Ritchie and Martin developed their motivation management theory in the late 1990‘s. The basic
assumption is that ―the task of the manager is to find out what motivates people‘ and to make
them ‗smile more and carp less‖. From literature and their own observations, they identified
twelve ―motivational drivers‖. These include human needs for interesting work, achievement
self-development variety, creativity, power, influence social contact money and tangible rewards,
structure and rules, long term relationships, and good working conditions. They then developed a
motivational profile survey with thirty-three questions.
Knowing an individuals‘ profile, a manager can then tailor a monitions method for that person.
For instance, if a manager is considering giving an employee a raise and their profile shows that
creativity and variety motivate this person, the then manager should reward accordingly, not
with a raise. Ritchie and Martin claim that each of the twelve driers is independent of the others.
The motivation management theory of
Ritchie and Martin would be classified as a content theory, which suggests that motivation results
from the individual‘s attempts to satisfy needs. The order of the twelve drivers listed above
reflects the profile scores of the original sample. This is to say that among this group of managers,
the needs for interesting work and achievement were most important.
Comparison between the Two Generations.
Both generations of theory have strengths and weaknesses when compared to the other. We will
examine these differences in the following paragraphs.
Out With the Old, In With the New
Ritchie and Martin‘s study is based on contemporary data that is more credible in today‘s
business world, instead of data that is fifty to sixty years old. Motivation management can also
serve as a tool for self-analysis and for individual or group motivation profiles. Ritchie and Martin

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also recognize a wide range of individual differences, rather than one universal approach. Maslow
and Herzberg both argued that their respective theories applied to everyone. Lastly, it offers a
guide for managers who are seeking to improve individual and group motivation. Ritchie and
Martin advise managers to focus on the motivational profile of the person, regardless of
occupational or cultural background.
Motivation Theories Are Like Wine: They Get Better with Age
The factors of the older theories are based on evidence, and Ritchie and Martin‘s twelve drives
seem to be somewhat arbitrary. Sampling in the older theories was generally more diverse.
Motivation management was based on a study of all managers of training programs. Also, there
was no mention by the group of managers of the basic needs such as food, drink, sex, and
security. Many parallels are apparent in the motivational factors of motivation management and
its predecessors. All of the factors seen in this modern theory have been seen before, thus any
claim of originality would have to be considered somewhat suspect in the least.
Team Motivation - What is Motivation?
LEVELS OF NEEDS
Maslow and Herzberg determined that our needs are deviled into levels, from the most basic
survival needs to very sophisticated needs that nourish our inner spirit.
Maslow believed that we tend to satisfy our most basic needs first, then move to higher level
needs.
TYPES OF TEAMS
Today we find all kinds of team in society, and they generally fall into one of two primary groups:
Permanent teams and temporary teams. Here are some of the common types:
- Task Force: a temporary team assembled to investigate a specific issue or problem.
- Problem Solving Team: a temporary team assembled to solve a specific problem.
- Product Design Team: a temporary team assembled to design a new product or service.
- Committee: a temporary or permanent group of people assembled to act upon some matter.
- Work Group: a permanent group of works who receive direction from a designated leader.
1. The physiological Needs: Physiological needs may be synonymous with the biological needs of
the human beings like hunger, thirst, sex, etc. The grip of these needs on the human being is so
strong that unless these needs are satisfied there is no room for other needs. Moreover, to hungry
person the utopia is a world full of food.
A hungry person thinks not only about his food but also for some comfort to body and mind which
can be fulfilled by eating food, for a person who has missed most of the needs in his life,
physiological are the main motivating forces. For the people whose world is just fulfilment of
physiological need, all other things like freedom, love, community, life, etc. are unimportant for
people who have not faced any food problem and time in their lives, it is appetite need which is
the physiological need.
Such people have their need in a particular food which is to be fulfilled. Once a physiological
need is satisfied, the human organism loops for more social needs. ―If hunger is satisfied, it

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becomes unimportant in the current dynamics of the individual. ―People in whom a certain need
has always been satisfied are capable of tolerating its deprivation in future.
2. The Security Needs: Human being searches for security and safety from natural calamities,
dangers, and deprivations. Human organism is a safety seeking organisms. For a person whose
physiological needs are satisfied, his next goal is security. For him everything looks less important
than safety. The need for safety can be better observed in infants and children. It is not very
manifest in adults because they are taught to inhabit it.
Among infants and children, we can clearly see the reactions to bodily illness and injury. A child
who is sick, has a need of reassurance from his parents that the sickness will be cured and will
never repeat. Another feature of the need for security, very clearly seen in children, is their
preference for a rhythm and routine in daily life. Even, for that matter, adults are also normally
against any disturbing change in their life. In an orderly peaceful and civilized society, the safety
and security is taken care of, to the most extent, by the government.
In such societies safety needs is no longer a motivator. We can see the expression of safety needs
in people‘s preference for a job with tenure and protection, the desire for a savings bank account,
insurance, etc. In Indian society, the need to have a male child in a family is an expression of
security need.
3. The Belongings and Love Needs:
Man is a social animal. Once his physiological and safety needs are fulfilled, he seeks affection,
love and belongingness from other human beings and the society around him. A person with social
needs severely feels the absence of this friends, family. Wife and children. He craves for
affectionate relationships and place of belongingness with his people. The need for love is not
synonymous with sex. Sex needs may be studied as a mere physiological need.
4. The Esteem Needs: Esteem needs can be broadly divided into two groups, Achievement needs
are expressed in the form of desire to be with self-confidence, desire to process strength and
assertiveness and desire to be free from depending on others. Recognition needs are expressed in
the form of inspiring respect from others, reorganization in society, attracting attention and the
desire to become an important person. Satisfaction of esteem needs makes a person confident,
adequate and useful.
5. The need for Self - Actualization: Self-actualization (the term was first coined by Kurt
Goldstein) is considered to be the highest need in the hierarchy of needs and as such it is
directed towards searching the meaning and purpose in life. Even if all other needs are satisfied,
a human being feels restless and tries to achieve excellence in fields dearer to him.
The desire for self-fulfilments, actualization and living a meaningful life is reflected in this need.
The specific form this need takes varies from person to person. For example, one person to
person. For example, one person having a desire to become an ideal mother, another one having
a desire to become an ideal teacher and so on. At the same time, this need, not necessarily be a
need for creativity.
The emergence of this need depends upon the fulfilment of all other lower order‘s needs.
However in any society, satisfied people will always be very few and as such how many people
have this need for self-actualization is a question for further research. Despite this fact we have

216
examples of people who have reached heights of excellence in different fields in life. Maslow
himself felt that this need is a challenging problem in research.
Self- actualization is presumably the highest desire of any normal individual. Who, then is a self -
actualized person? What features or characteristics does such a person have? Maslow undertook
several studies to get answers to these studies narrated an exhaustive list of characteristics of a
self - actualized person. They are: A self - actualized person possesses an unusual ability to
detect the spurious, the fake, and the dishonest in the personality, and in general, to judge,
people correctly and efficiently.
They lack overriding guilt crippling shame and anxiety; spontaneity in behaviour, they are
problem centered rather than ego entered and have a mission and purpose in life: they like
solitude and privacy and at the same time they retain their dignity even in undignified
surrounding sand situations; they like autonomy and freedom to pursuer their Endeavour in life
and work; they derive ecstasy, inspiration and strength from the basic experience of life; they
have mystic experience; they have a deep feeling of identification, sympathy and affection for
mankind ; they maintain interpersonal relations with few people, they are democratic and they
can differentiate between ends and means and right and wrong; they have a sense of humour;
and they possess creativeness and originality.

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 FM Notes 48 – Scientific Management

Taylor‘s Scientific Management was heavily based on incentive schemes, which had their serious
weaknesses. Taylor extolled economic incentives at the expense of other incentives at the
expense of other factors which matter in human happiness such as personal liberty. The
uniformity of movement or monotony of continually handling the material can never be
compensated for by economic incentives, which must go side by side with social and welfare
incentives.
MAIN THESIS
Taylor‘s main thesis is that management rests upon clearly formulated laws and principles with
universal applicability in all organizations which entitles it to the status of a true science. To put
in his own words, ―management is a true science, resting upon clearly fixed laws, rules and
principles, as a foundation‖. He argued that management comprised a number of principles
which commanded applicability in all types of organizations.
―The same principles can be applied with equal force to all social activities; to the management
of our homes; the management of our farms; the management of the business of our tradesmen,
large and small; of our churches; our Philan tropic institutions: our universities and our
governmental departments‖.
Taylor‘s principles of management were ―scientific‖ to the extent that were based on first hand
experimentation and observations of work procedures and conditions in industrial enterprises.
MEANING AND FOCUS
Scientific management refers to application of science to management practices. It involves use
of scientific methods in decision making for solving management problems rather than depending
on rule of thumb or trial and error methods for the purpose. Essentially, scientific management
consists of observation and analysis of each task, determination of the standard of work,
selecting and training of men to perform their jobs, and ensuring that work is done in the most
efficient manner.
The Scientific Management stressed rationality, predictability, specialization and technical
competence. It focuses on the design and operation of production processes at the shop level of
the organization. In other words, scientific management addressed itself to the problems of the
‗shop floor‘ - that is, the bottom part of an organization where the work performed is of a
repetitive and routine nature.
The focus of scientific management was rather narrow, as it essentially concentrated on the work
done at the lowest level in the organizations. The purpose was to analyze the relationships
between the physical nature of work and the physiological nature of workers to determine job
definitions.
PRINCIPLES
As a guide to the practice of management. Taylor developed a number of principles of scientific
management which may be outlined below:

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Development of a Science for Each Element of Man‟s Work:
This principle suggests that the work assigned to any employee should be observed and analyzed
with respect to each element or part and the time involved in it, so as to decide the best way of
performing the work and to determine the standard output. This basic principle of scientific
management requires that application of scientific methods should replace rule of thumb
methods.
Scientific Selection, Training and Development of Workmen: It is essential for efficiency in
production that workers should be selected with due care. Their skill and experience must be
matched with the requirements of the respective jobs on the basis of tests and interview. The
workmen so selected must be given training for the specific tasks assigned. Training must also be
arranged to develop their abilities to improve performance.
The Bringing Together of the Science of Work and the Scientifically Selected and Trained
Men: To enable the worker to do his job and to ensure that he may not slip back to the earlier
methods of doing work, there must be somebody to inspire the workers. This Taylor felt is the
exclusive responsibility of the management.
He believed that workers are always willing co-operate with the management but there is more
opposition from side of management. Taylor maintained that this process of bringing together
causes ―the mental revolution.‖
The Division of Work and Responsibility between Management and Workers: In traditional
management theory, the worker bore the entire responsibility for work and management had
lesser responsibilities. But Taylor‘s scientific management assumes equal responsibility between
managers and workers unlike in the past manager is equally busy as the worker. This division of
work creates between them an understanding and mutual dependence. There will also be
constant and intimate cooperation between them. All this results in elimination of conflicts and
strikes.

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 FM Notes 49 – CPI & WPI

Inflation is a general and sustained increase in overall price level of goods and services. The
inflation rate is a key parameter basis which central government proposes its monetary and fiscal
policy from time to time. The monetary policy primarily focuses on price stability and hence its
concern for inflation is rather obvious.
Definition of Consumer Price Index
Definition: A comprehensive measure used for estimation of price changes in a basket of goods
and services representative of consumption expenditure in an economy is called consumer price
index.
Description: The calculation involved in the estimation of CPI is quite rigorous. Various
categories and sub-categories have been made for classifying consumption items and on the basis
of consumer categories like urban or rural. Based on these indices and sub-indices obtained, the
final overall index of price is calculated mostly by national statistical agencies. It is one of the
most important statistics for an economy and is generally based on the weighted average of the
prices of commodities. It gives an idea of the cost of living.
Definition of Wholesale Price Index
Definition: Wholesale Price Index (WPI) represents the price of goods at a wholesale stage i.e.
goods that are sold in bulk and traded between organizations instead of consumers. WPI is used
as a measure of inflation in some economies.
Description: WPI is used as an important measure of inflation in India. Fiscal and monetary policy
changes are greatly influenced by changes in WPI. In the United States, Producer Price Index (PPI)
is used to measure inflation.
WPI is an easy and convenient method to calculate inflation. Inflation rate is the difference
between WPI calculated at the beginning and the end of a year. The percentage increase in WPI
over a year gives the rate of inflation for that year.
HEADLINE INFLATION or WPI
It is the most commonly used measure of inflation in India. It is a measurement of price inflation
that takes into account all types of inflation that an economy can experience. Food items have a
much larger weight in the CPI vis-à-vis the WPI.
Unlike Core Inflation, headline inflation also counts changes in the price of volatile items like
food and energy. In India it is also referred to as ‗WPI‘. In India, WPI data is divided into three
broad groups (weightage given in brackets) - Primary Articles (20.12) - This is primary (not
manufactured) food items related inflation; Fuel Group (14.91); Manufactured Products (64.97)
(If we remove Food product inflation associated with manufactured items, we get ‗Core Inflation‘
or ‗Non Food‘ Inflation).
The WPI index does not cover non-commodity producing sectors viz, services and non-tradable
commodities. (That‘s why it‘s also accused of not representing the total spending of a consumer
and hence actual impact of rise in prices on consumer).

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Apart from CPI and WPI, another measure to measure inflation is GDP Deflator (It is the most
comprehensive out of the three measures). But it is released only once in 3 months.
Why WPI as a measure of inflation in India?
I. It is released more frequently (every 2 weeks) so policy analyst can use it more conveniently as
CPI is available on a gap of 1 month. However, from January 2012, this practice of weekly/bi-
weekly release of data was abandoned and frequency of WPI data too was fixed as 1 month as
there was considerable statistical aberrations.
II. Further, WPI is more comprehensive in terms of its coverage. Shortcomings of WPI as a
measure of inflation -
I. It excludes services which today form a major chunk of expenditure of a household
II. It also excludes the products of the unorganized sector that are estimated to constitute about
35% of the total manufactured output of the country
III. It measures prices at wholesale level, hence doesn‘t reflect the final prices Inflation reduces
savings, pushes up interest rates, dampens investment and leads to depreciation of currency thus
making imports costlier. Inflation can be demand pull, cost push or structural inflation.
CPI and WPI
CPI also includes fewer items
WPI doesn‘t include services
WPI is published by Commerce Ministry, but CPI is published by Statistics Ministry. A major reason
for the divergence between the CPI and the WPI is the formers higher weight on food items.
RBI has recently moved toward CPI as prime inflation number as it is generally higher and reflect
more realistic impact on consumer. Global practice is also the same.

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 FM Notes 50 – Time Value of Money

INTRODUCTION
Money has time value. A rupee today is more valuable than a year hence. It is on this concept
―the time value of money‖ is based. The recognition of the time value of money and risk is
extremely vital in financial decision making.
Most financial decisions such as the purchase of assets or procurement of funds, affect the firm‘s
cash flows in different time periods. For example, if a fixed asset is purchased, it will require an
immediate cash outlay and will generate cash flows during many future periods.
Similarly if the firm borrows funds from a bank or from any other source, it receives cash and
commits an obligation to pay interest and repay principal in future periods. The firm may also
raise funds by issuing equity shares. The firm‘s cash balance will increase at the time shares are
issued, but as the firm pays dividends in future, the outflow of cash will occur.
Sound decision-making requires that the cash flows which a firm is expected to give up over
period should be logically comparable. In fact the absolute cash flows which differ in timing and
risk are not directly comparable. Cash flows become logically comparable when they are
appropriately adjusted for their differences in timing and risk.
The recognition of the time value of money and risk is extremely vital in financial decision-
making. If the timing and risk of cash flows is not considered, the firm may make decisions which
may allow it to miss its objective of maximising the owner‘s welfare. The welfare of owners
would be maximised when Net Present Value is created from making a financial decision. It is
thus, time value concept which is important for financial decisions.
Thus, we conclude that time value of money is central to the concept of finance. It recognizes
that the value of money is different at different points of time. Since money can be put to
productive use, its value is different depending upon when it is received or paid. In simpler terms,
the value of a certain amount of money today is more valuable than its value tomorrow. It is not
because of the uncertainty involved with time but purely on account of timing. The difference in
the value of money today and tomorrow is referred as time value of money.
REASONS FOR TIME VALUE OF MONEY
Money has time value because of the following reasons:
1. Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash is in our control as
payments to parties are made by us. There is no certainty for future cash inflows. Cash inflows is
dependent out on our Creditor, Bank etc. As an individual or firm is not certain about future cash
receipts, it prefers receiving cash now.
2. Inflation: In an inflationary economy, the money received today, has more purchasing power
than the money to be received in future. In other words, a rupee today represents a greater real
purchasing power than a rupee a year hence.
3. Consumption: Individuals generally prefer current consumption to future consumption.

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4. Investment opportunities: An investor can profitably employ a rupee received today, to give
him a higher value to be received tomorrow or after a certain period of time. Thus, the
fundamental principle behind the concept of time value of money is that, a sum of money
received today, is worth more than if the same is received after a certain period of time. For
example, if an individual is given an alternative either to receive 10,000 now or after one year,
he will prefer 10,000 now. This is because, today, he may be in a position to purchase more
goods with this money than what he is going to get for the same amount after one year.
Thus, time value of money is a vital consideration in making financial decision. Let us take some
examples:
EXAMPLE 1: A project needs an initial investment of ₹1,00,000. It is expected to give a return of
20,000 per annum at the end of each year, for six years. The project thus involves a cash outflow
of ₹1,00,000 in the ‗zero year‘ and cash inflows of 20,000 per year, for six years. In order to
decide, whether to accept or reject the project, it is necessary that the Present Value of cash
inflows received annually for six years is ascertained and compared with the initial investment of
1,00,000.
The firm will accept the project only when the Present Value of cash inflows at the desired rate
of interest exceeds the initial investment or at least equals the initial investment of ₹ 1,00,000.
EXAMPLE 2: A firm has to choose between two projects. One involves an outlay of 10 lakhs with a
return of 12% from the first year onwards, for ten years. The other requires an investment of 10
lakhs with a return of 14% per annum for 15 years commencing with the beginning of the sixth
year of the project. In order to make a choice between these two projects, it is necessary to
compare the cash outflows and the cash inflows resulting from the project.
In order to make a meaningful comparison, it is necessary that the two variables are strictly
comparable. It is possible only when the time element is incorporated in the relevant calculations.
This reflects the need for comparing the cash flows arising at different points of time in decision
- making.
TIMELINES AND NOTATION
When cash flows occur at different points in time, it is easier to deal with them using a timeline.
A timeline shows the timing and the amount of each cash flow in cash flow stream. Thus, a cash
flow stream of 10,000 at the end of each of the next five years can be depicted on a timeline like
the one shown below.

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As shown above, O refers to the present time. A cash flow that occurs at time 0 is already in
present value terms and hence does not require any adjustment for time value of money. You
must distinguish between a period of time and a point of time1. Period 1 which is the first year is
the portion of timeline between point 0 and point 1.
The cash flow occurring at point 1 is the cash flow that occurs at the end of period 1. Finally, the
discount rate, which is 12 per cent in our example, is specified for each period on the timeline
and it may differ from period to period. If the cash flow occurs at the beginning, rather than the
end of each year, the timeline would be as shown in Part B. Note that a cash flow occurring at
the end of the year 1 is equivalent to a cash flow occurring at the beginning of year 2. Cash flows
can be positive or negative. A positive cash flow is called a cash inflow; and a negative cash flow,
a cash outflow.
VALUATION CONCEPTS
The time value of money establishes that there is a preference of having money at present than a
future point of time. It means
(a) That a person will have to pay in future more, for a rupee received today. For example:
Suppose your father gave you 100 on your tenth birthday. You deposited this amount in a bank at
10% rate of interest for one year. How much future sum would you receive after one year? You
would receive 110
Future sum = Principal + Interest
= 100 + 0.10 x 100
= 110
What would be the future sum if you deposited 100 for two years?
You would now receive interest on interest earned after one year.
Future sum = 100 x 1.102 = 121
We express this procedure of calculating as Compound Value or Future Value of a sum.
(b) A person may accept less today, for a rupee to be received in the future. Thus, the inverse of
compounding process is termed as discounting. Here we can find the value of future cash flow as
on today.
TECHNIQUES OF TIME VALUE OF MONEY
There are two techniques for adjusting time value of money. They are:
1. Compounding Techniques/Future Value Techniques
2. Discounting/Present Value Techniques
The value of money at a future date with a given interest rate is called future value. Similarly,
the worth of money today that is receivable or payable at a future date is called Present Value.
Compounding Techniques/Future Value Technique

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In this concept the interest earned on the initial principal amount becomes a part of the principal
at the end of the compounding period.
FOR EXAMPLE: Suppose you invest ₹1000 for three years in a saving account that pays 10 per
cent interest per year. If you let your interest income be reinvested, your investment will grow as
follows:

This process of compounding will continue for an indefinite time period. The process of investing
money as well as reinvesting interest earned there on is called Compounding. But the way it has
gone about calculating the future value will prove to be cumbersome if the future value over long
maturity periods of 20 years to 30 years is to be calculated.
A generalised procedure for calculating the future value of a single amount compounded annually
is as follows:

In this equation (1 + r) n is called the future value interest factor (FVIF).

Where, FV = Future value of the initial flow n year hence
PV = Initial cash flow, r = Annual rate of Interest, n = number of years

By taking into consideration, the above example, we get the same result.
n 3
FVn = PV(1 + r) = 1,000 (1.10)

FVn = 1331

To solve future value problems, we consult a future value interest factor (FVIF) table.

225
The table shows the future value factor for certain combinations of periods and interest rates. To
simplify calculations, this expression has been evaluated for various combination of r‘ and ‗n‘.
Exhibit 1.1 presents one such table showing the future value factor for certain combinations of
periods and interest rates.
Continued of Time Value of Money
Exhibit 1.1 Value of FVIFr,n for various combinations of r and n

Future Value of a Single Amount (Lumpsum)

The formula for calculating the Future Value of a single amount is as follows:
n
FVn = PV (1 + r)

ILLUSTRATION 1: If you deposit ₹55,650 in a bank which is paying a 12 per cent rate of interest
on a ten-year time deposit how much would the deposit grow at the end of ten years?
n
SOLUTION: FVn = PV (1 + r) or FVn = PV(FVIF12%, 10yrs)

FVn = ₹55, 650 (1.12)10 = ₹55,650 x 3.106 = ₹ 72,848.90

MULTIPLE COMPOUNDING PERIODS

Interest can be compounded monthly, quarterly and half-yearly. If compounding is quarterly,
annual interest rate is to be divided by 4 and the number of years is to be multiplied by 4.
Similarly, if monthly compounding is to be made, annual interest rate is to be divided by 12 and
number of years is to be multiplied by 12. The formula to calculate the compound value is

Where, FVn = Future value after ‗n‘ years

PV = Cash flow today

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r = Interest rate per annum
m = Number of times compounding is done during a year
n = Number of years for which compounding is done.
ILLUSTRATION 2: Calculate the compound value when ₹1000 is invested for 3 years and the
interest on it is compounded at 10% p.a. semi-annually.
SOLUTION: The formulae is

The compound value of Re. 1 at 5% interest at the end of 6 years is ₹1.340. Hence the value of
₹1000 using the table (FVIFr,n) will be

FVn = 1000 x 1.340 = ₹1,340

ILLUSTRATION 3: Calculate the compound value when ₹10,000 is invested for 3 years and
interest 10% per annum is compounded on quarterly basis.
SOLUTION: The formulae is

ILLUSTRATION 4: Mr. Ravi Prasad and Sons invests ₹500, ₹1,000, ₹1,500, ₹2,000 and ₹2,500 at
the end of each year. Calculate the compound value at the end of the 5th year, compounded
annually, when the interest charged is 5% per annum.
SOLUTION: Statement of the compound value

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FUTURE VALUE OF MULTIPLE CASH FLOWS
The above illustration is an example of multiple cash flows.
The transactions in real life are not limited to one. An investor investing money in instalments
may wish to know the value of his savings after ‗n‘ years. The formulae is

EFFECTIVE RATE OF INTEREST IN CASE OF MULTI-PERIOD COMPOUNDING

Effective interest rate brings all the different bases of compounding such as yearly, half-yearly,
quarterly, and monthly on a single platform for comparison to select the beneficial base. Now,
the question is which works out highest interest amount?

When interest is compounded on half-yearly basis, interest amount works out more than the
interest calculated on yearly basis. Quarterly compounding works out more than half-yearly basis.
Monthly compounding works out more than even quarterly compounding. So, if compounding is
more frequent, then the amount of interest per year works out more. Now, we want to equate
them for comparison.
Suppose, an option is given as the following:

Now, the question is which basis of compounding is to be accepted to get the highest interest
rate. The answer is to calculate ‗Effective Interest Rate‘

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The formulae to calculate the Effective Interest Rate is

Where EIR = Effective Rate of Interest

r = Nominal Rate of Interest (Yearly Interest Rate)
m = Frequency of compounding per year
Take nominal interest rate as the base and find-out the comparable rate of interest for half-
yearly, quarterly and monthly basis and select that which is most attractive.

ILLUSTRATION 5:
(1) A company offers 12% rate of interest on deposits. What is the effective rate of interest if the
compounding is done on
(a) Half-yearly
(b) Quarterly
(c) Monthly
(ii) As an alternative, the following rates of interest are offered for choice. Which basis gives the
highest rate of interest that is to be accepted?

229
230
Thus, out of all interest rate, interest rate of 11.75% on half-yearly compounding works out to be
the highest effective interest rate i.e., 12.09% so this option is to be accepted.

ILLUSTRATION 6: Find out the effective rate of interest, if nominal rate of interest is 12% and is
quarterly compounded.
SOLUTION:

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Growth Rate
The compound rate of growth for a given series for a period of time can be calculated by
employing the future value interest factor table (FVIF)
EXAMPLE:

How is the compound rate of growth for the above series determined?
This can be done in two steps:
(i) The ratio of profits for year 6 to year 1 is to be determined i.e.,

(ii) The FVIFr,n table is to be looked at. Look at a value which is close to 1.79 for the row for 5
years. The value close to 1.79 is 1.762 and the interest rate corresponding to this is 12%.
Therefore, the compound rate of growth is 12 per cent.

DISCOUNTING OR PRESENT VALUE CONCEPT

Present value is the exact opposite of future value. The present value of a future cash inflow or
outflow is the amount of current cash that is of equivalent value to the decision maker. The
process of determining present value of a future payment or receipts or a series of future
payments or receipts is called discounting. The compound interest rate used for discounting cash
flows is also called the discount rate. In the next chapter, we will discuss the net present value
calculations.

SIMPLE AND COMPOUND INTEREST

In compound interest, each interest payment is reinvested to earn further interest in future
periods. However, if no interest is earned on interest, the investment earns only simple interest.
In such a case, the investment grows as follows:
Future value = Present value [1 + Number of years x Interest rate]
For example, if ₹1,000 is invested @ 12% simple interest, in 5 years it will become
1,000 [1 + 5 x 0.12] = ₹1,600

The following table reveals how an investment of 1,2O0 grows over time under simple interest as
well as compound interest when the interest rate is 12 per cent.

From this table, we can feel the power of compound interest. As Albert Einstein once remarked,
―I don‘t know what the seven wonders of the world are, but I know the eighth - the compound
interest. You may be wondering why your ancestors did not display foresight. Hopefully, you will
show concern for your posterity‖.

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Value of ₹1,000 invested at 10% simple and compound interest

ILLUSTRATION 7: Mr. Rahul has deposited ₹1,00,000 in a saving bank account at 6 per cent
simple interest and wishes to keep the same, for a period of 5 years. Calculate the accumulated
Interest.
SOLUTION: S1 = P0 (I) (n)
Where S1 = Simple interest
P0 = Initial amount invested
I = Interest rate
n = Number of years
S1 = 1,00,000 x 0.06 x 5 years
S1 = 30,000

If the investor wants to know his total future value at the end of ‗n‘ years. Future value is the
sum of accumulated interest and the principal amount.
Symbolically
FVn = P0 + P0 (I) (n)
OR
S1 + P0

ILLUSTRATION 8: Mr. Krishna‘s annual savings is ₹1,000 which is invested in a bank saving fund
account that pays a 5 per cent simple interest. Krishna wants to know his total future value or
the terminal value at the end of a 8 years‘ time period.
SOLUTION: FVn = P0 + P0 (l) (n)
=₹1000 + ₹1000 (0.05) (8)
= ₹14,000

Compound Interest
ILLUSTRATION 9: Suppose Mr. Jai Singh Yadav deposited ₹10,00,000 in a financial institute which
pays him 8 percent compound interest annually for a period of 5 years. Show how the deposit
would grow.
8
SOLUTION: FV5 = P0 (1 + 1)
5
FV5 = 10,00,000 (1 + 0.08) = 10,00,000 (1.469) = FV5 = ₹14,69,000

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Note: See compound value of one rupee Table for 5 years at 8% interest.
Variable Compounding Periods/Semi-annual Compounding
ILLUSTRATION 10: How much does a deposit of ₹40,000 grow in 10 years at the rate of 6%
interest and compounding is done semi-annually. Determine the amount at the end of 10 years.

Alternatively, see the compound value for one rupee table for year 20 and 3% interest rate.

ILLUSTRATION 11: (Quarterly compounding): Suppose a firm deposits ₹50 lakhs at the end of
each year, for 4 years at the rate of 6 per cent interest and compounding is done on a quarterly
th
basis. What is the compound value at the end of the 4 year?

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Compound Growth Rate
n
Formula: gr- = V0 (1 + r) = Vn
Where, gr = Growth rate in percentages
V0 = Variable for which the growth rate is needed
Vn = Variable value (amount) at the end of year ‗n‘
n
(1 + r) = Growth rate.

ILLUSTRATION 12: From the following dividend data of a company, calculate compound rate of
growth for 2003 - 2008.

n
SOLUTION: gr = V0 (1 + r) = Vn
5
= 21 (1 + r) = 31
5
= (1 + r) = 21/31 = 1.476

Alternatively, the compound value one Rupee table for 5 years should be seen till closed value to
the compound factor is found. After finding the closest value, first above it is seen to get the
growth rate.

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 FM Notes 51 – Valuation of Bonds
Introduction
Assets can be real or financial; securities, like shares and bonds are called financial assets, while
physical assets like plant and machinery are called real assets, the concept of return and risk, as
the determinants of value, are as fundamental and valid to the valuation of securities as to that
of physical assets.
We must clarify at the outset that there is no easy way to predict the prices of shares and bonds
and thus, to become rich by a superior performance in the stock exchange. The unpredictable
nature of the security prices is, in fact, a logical and necessary consequence of efficient capital
markets.
Efficient capital market implies a well-informed, properly functioning capital market. We can
show why some securities are priced higher than others by using the concept of present value.
This will help the financial manager to know the variables, which influence the security prices.
He can then design his investment and financing activities in a manner, which exploits the
relevant variables to maximize the market value of shares.
It should also be noted that ordinary shares are riskier than bonds (or debentures), and also that
some shares are more risky than others. It, therefore, naturally follows that investors would
commit funds to shares only when they expect that rates of return are commensurate with risk.
We know from our earlier discussion in the preceding chapter that the present value formulae are
capable of taking into account both time and risk in the evaluation of assets and securities. What
they cannot do is measure the degree of risk? For the purpose of our discussion, we shall assume
risk as known. A detailed analysis of risk is deferred to the next chapter.
Concepts of Value
How are bonds and shares valued? What is the role of Earnings per Share (EPS) and Price-Earnings
(P/E) ratios in the valuation of shares?
EPS and P/E ratios are the most frequently used concepts by the financial community. Do they
really have significance in the valuation of shares? Let us emphasize that the present value is the
most valid and true concept of value. There are many other concepts of value that are used for
different purposes. They are explained below.
Book Value
Book Value is an accounting concept. Assets are recorded at historical cost, and they are
depreciated over years. Book value may include intangible assets at acquisition cost minus
amortized value. The book value of debt is stated at the outstanding amount. The difference
between the book values of assets and liabilities is equal to shareholders‘ funds or net worth.
Book value per share is determined as net worth divided by the number of share outstanding.
Book value reflects historical cost, rather than value. Value is what an asset is worth today in
terms of its potential benefits.

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Replacement Value
Replacement value is the amount that a company would be required to spend if it were to
replace its existing assets in the current condition. It is difficult to find cost of assets currently
being used by the company. Replacement value is also likely to ignore the benefits of intangibles
and the utility of existing assets.
Liquidation Value
Liquidation value is the amount that a company could realize if it sold its assets, after having
terminated its business. It would not include the value of intangibles since the operations of the
company are assumed to cease. Liquidation value is generally a minimum value, which a company
might accept if it sold its business.
Market Value
Market value of an asset or security is the current price at which the asset or the security is being
sold or bought in the market. Market value per share is expected to be higher than the book
value per share for profitable, growing firms.
A number of factors influence the market value per share, and therefore, it shows wide
fluctuations. What is important is the long-term trend in the market value per share.
In ideal situation, where the capital markets are efficient and in equilibrium, market value
should be equal to present (or intrinsic) value of a share.
Features of a Bond
A bond is a long-term debt instrument or security. Bonds issued by the governments do not have
any risk of default. The government will always honour obligations on its bonds. Bonds of the
public-sector companies in India are generally secured, but they are not free from the risk of
default.
The private sector companies also issue bonds, which are also called debentures in India. A
company in India can issue secured or unsecured debentures. In the case of a bond or debenture,
the rate of interest is generally fixed and known to investors. The principle of a redeemable bond
or bond with a maturity is payable after a specified period, called maturity period.
The main features of a bond or debenture are discussed below.
a. Face value Face value is called per value. A bond (debenture) is generally issued at a par
value of ₹ 100 or ₹ 1,000 and interest is paid on face value.
b. Interest rate Interest rate is fixed and known to bondholders (debenture-holders). Interest
paid on a bond/debenture is a tax deductible. The interest rate is also called coupon rate.
Coupons are detachable certificates of interest.
c. Maturity: A bond (debenture) is generally issued for a specified period of time. It is rapid on
maturity.
d. Redemption value the value that a bondholder (debenture-holder) will get on maturity is
called redemption, or maturity, value. A bond (debenture) may be redeemed at par or at a
premium (more than par value) or at a discount (less than par value)

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 e. Market Value A bond (debenture) may be traded in a stock exchange. The price at which it
is currently sold or bought is called the market value of the bond (debenture). Market value
may be different from par value of redemption value.

Bonds Values and Yields

It is relatively easy to determine the present value of a bond since its cash flows and the discount
rate can be determined without much difficulty. If there is no risk of default, then there is no
difficulty in estimating the cash flows associated with a bond.
The expected cash flows consist of annual interest payments plus repayment of principal. The
appropriate capitalization or discount rate would depend upon the risk of the bond. The risk in
holding a government bond is less than the risk associated with a debenture an issued by a
company. Consequently, a lower discount rate would be applied to the cash flows of the
government bond and a higher rate to the cash flows of the company debenture.
Bonds may be classified into three categories (a) bonds with maturity, (b) pure discount bonds
and (c) perpetual bonds.
Bond with Maturity
The government and companies mostly issued bonds, they specify the interest rate and the
maturity period. The present value of a bond (debenture) is the discounted value of its cash
flows; that is the annual interest payments plus bond‘s terminal or maturity value.
The discount rate is the highest rate that investors could earn on bonds with similar
characteristics. By comparing the present value of a bond with its current market value, it can be
determined whether the bond is overvalued or undervalued. Let us consider Illustration 3.1.
Value of Bond with Maturity
Suppose an investor is considering the purchase of a five year, ₹1, 000 par value bond, bearing a
nominal rate of interest of 7 per cent per annum. The investor‘s required rate of return is 8 per
cent. What should be willing to pay now to purchase the bond if it matures at par?
The investor will receive cash ₹70 as interest each year for 5 years and ₹1000 on maturity (i.e.,
at the end of the fifth year). We can thus determine the present value of the bond (B0) as
follows:

It may be observed that ₹70 is an annuity for 5 years and ₹1000 is received as a lump sum at the
end of the fifth year. Using the present value tables, given at the end of this book, the present
value of bond is:

B0 = 70 x 3.993 + 1000 x 0.681 = 279.51 + 681 = ₹60.51

This implies that ₹1000 bond is worth ₹960.51 for bond today. Note that ₹960.51 is a composite
of the present value of interest payments, ₹279.51 and the present value of the maturity value,
₹681.

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Since most bonds will involve payment of an annuity (equal interest payments each year) and
principal at maturity, we can use the following formula to determine the value of a bond:
Bond value = Present value of interest + Present value of maturity value:

Notice that B0 is the present value of a bond (debenture), INTL is the amount of interest in
period t (from year 1 to n), Kd is the market interest rate or the bond‘s required rate of return,
Bn is bond‘s terminal or maturity value in period n and n is the number of years of maturity.
In equation (1) m the right-hand side consists of an annuity of interest payments that are
constant i.e. IT1 = INT2…….INTt over the bond‘s life and final payment on maturity. Thus, we can
use the annuity formula to value interest payments as shown below:

Yield – to -Maturity
We can calculate a bond‘s yield or the rate of return when its current price and cash flows are
known. Suppose the market price of a bond is ₹883.40 (face value being ₹1000) the bond will pay
interest at 6 per cent per annum for 5 years, after which it will be redeemed at par. What is the
bond‘s rate of return?
The yield-to-maturity (YTM) is the measure of bond‘s rate of return that considers both the
interest income and any capital gain or loss. YTM is bond‘s internal rate of return. The yield-to
maturity of 5-year bond, paying 6 per cent interest on the face value of ₹1, 000 and currently
selling for ₹883.40 is 10 per cent as shown below:

We obtain YTM equal to 9 per cent by trial and error. It is, however, simpler to calculate a
perpetual bond‘s yield-to-maturity. It is equal to interest income divided by the bond‘s price. For

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example, if the rate of interest on ₹1000 par value perpetual bond is 8 per cent, and its price is
₹800, its YTM will be:

Current Yield
Yield-to-maturity is not the same as the current yield. Current yield is the annual interest divided
by the bond‘s current value. In the example, the annual interest is ₹60 on the current investment
of ₹ 883.40. Therefore, the current rate of return or the current yield is: 60/883.40 = 6.8 per
cent. Current Yield considers only the annual interest (₹60 in the examples) and does not account
for the capital gain or loss. On maturity, the bond price will increase to ₹1000 and there would
be a capital gain of ₹116.60 [₹1000 - ₹883.40).
Thus bonds overall rate of return over 5 years period would be more than the current yield. If the
bonds current price were less than its maturity value, its overall rate of return would be less than
the current yield.
Yield-to-Call
A number of companies issue bonds with buy back or call provision. Thus a bond can be redeemed
or called before maturity. What is the yield or the rate of return of a bond that may be redeemed
before maturity? The procedure for calculating the yield-to-call is the same as for the yield-to-
maturity.
The call period would be different from the maturity period and the call (or redemption) value
could be different from the maturity value. Consider the example.
Suppose the 10 per cent, 10-year, ₹1000 bond is redeemable (callable) in 5 years at a call price
of ₹1, 050. The bond is currently selling for ₹950. What is bond‘s yield-to-caIl? The bond‘s yield-
to-call is:

The yield-to-maturity is 11.2 per cent. If the bond is redeemed at par on maturity, then YTM is
10.8 per cent.
Bond Value and Amortization of Principal
A bond (debenture) may be amortized every year, i.e. repayment of principal every year rather
at maturity. In that case, the principal will decline with annual payments and interest will be
calculated on the outstanding amount. The cash flows of the bonds will be uneven. Let us
consider Illustration 3.2

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The government is proposing to sell a 5-year bond of ₹1000 at 8 per cent rate of interest per
annum. The bond amount will be amortized (rapid) equally over its life. If an investor has a
minimum required rate of return of 7 per cent, what is the bond‘s present value for him?
The amount of interest will go on reducing because the outstanding amount of bond will be
decreasing due to amortization. The amount of interest for five years will be:
₹1000 x 0.08 = ₹80 for the first year; (₹1000 - ₹200) x 0.08 = ₹64 for the second year; (₹800 -
₹200) x 0.08 = ₹ 48 for the third year, (₹600 - ₹200) x 0.08 = ₹ 32 for the fourth year and (₹400 -
₹200) x 0.08 = ₹16 for the fifth year. The outstanding amount of bond would be zero at the end
of fifth year.
Since the government will have to return ₹200 every year, the outflows every year will consist of
interest payment and repayment of principle: ₹ 200 + ₹80 = ₹ 280; ₹ 200 + ₹ 64 = ₹ 264; ₹200 + ₹
48 = ₹248; ₹ 200 + ₹32 = ₹ 232; ₹ 200 + ₹16 = ₹ 16 respectively from first through five years.
Referring to the present value table at the end of the book, the value of the bond is calculated as
follows:

Bond Values and Semi-annual Interest Payments

It is a practice of many companies in India to pay interest on bonds (or debentures) semi-annually.
The formula for bond valuation can be modified in terms of half yearly interest payments and
compounding periods as given below:

Semi-annual Interest Payment and Bond value

A 10-year bond of ₹ 1000 has an annual rate of interest of 12 per cent. The interest is paid half-
yearly. What is the value of the bond if the required rate of return is i) 12 per cent and (ii) 16 per
cent?
Given the required rate of return of 12 per cent, the value of the bond is

241
Pure Discount Bonds
Pure discount bonds do not carry an explicit rate of interest. They provide for the payment of a
lump sum amount at a future date in exchange for the current price of the bonds. The difference
between the face value of the bond and its purchase price gives the return or YTM to the investor.
For example, a company may issue a pure discount bond of ₹1000 face value for ₹520 today for a
period of five years. Thus, the debenture has (a) purchase price of ₹520, (b) maturity value
(equal to the face value) of ₹1000 and 9c) maturity period of five years. The rate of interest can
be calculated a follow:

You can also use the trial and error method to obtain YTM, which is 14 per cent. Pure discount
bonds are also called deep-discount bonds or zero-interest bonds or zero-coupon bonds. Industrial
Development Bank of India (IDBI) was the first to issue a deep-discount bond in India in January
1992.

The bond of a face value of ₹100,000 was sold for ₹2, 700 with a maturity period of 25 years. If
an investor held the IDBI deep-discount bond for 25 years, she would earn an implicit interest
rate of:
25
2,700 = 1, 00,000 / (1 + i) = 15.54 per cent. IDBI again issued a deep-discount bond in 1998 at
a price of ₹12,750, to be redeemed after 30 years at the face value of ₹500, 000. The implicit
interest rate for this bond works out to be 13 per cent.
It is quite simple to find the value of a pure discount bond as it involves one single payment (face
value) at maturity. The market interest rate, also called the market yield, is used as the discount
rate. The present value of this amount is the bond value.

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 0 n
Value of a pure discount bond = PV of the amount on maturity: B = Mn/(1÷Kd)

Consider the IDBI bond with a face value of ₹500, 000 with a maturity of 30 years. Suppose the
current market yield on similar bonds is 9 per cent. The value of the IDBI pure-discount bond
today is as follows:
0
B = 500,000/ (1.09)30 = ₹37, 685.57

Perpetual Bonds
Perpetual Bonds, also called consoles, have an indefinite life and therefore, have no maturity
value. Perpetual bonds or debentures are rarely found in practice. After the Napoleonic War,
England issued these types of bonds to pay off many smaller issues that had been floated in prior
years to pay for the war. In case of the perpetual bonds, as there is no maturity, or terminal
value, the value of the bonds would simply be the discounted value of the infinite stream of
interest flows.

Suppose that a 10 per cent, ₹1000 bond will pay ₹100 annual interest into perpetuity? What would
be its value of the bond if the market yield or interest rate were 15 per cent? The value of the
bond is determined as follows:

If the market yield is 10 per cent, the value of the bond will be ₹100 and if it is 20 per cent the
value will be ₹ 500. Thus the value of the bond will decrease as the interest rate increases and
vice-versa. Table 3.1 gives the value of a perpetual bond paying annual interest of ₹100 at
different discount (market interest) rates. Value of a Perpetual Bond at Different Bond at
Different Discount Rates

243