C) Balanced Funds This is also known as an income-cumulative-growth portfolio. It's nothing more than a mix of income and development funds. Its aim is to distribute both daily income and capital appreciation. This is accomplished by distributing portfolios between high-growth equity stocks and fixed-income securities. D) Specialized Funds Aside from the above, there are a large number of specialised funds outside of the United States. They have special programmes to cater to the needs of specific groups, such as seniors and widows. There are also funds that specialise in those types of securities. Japan Fund, South Korea Fund, and other similar funds exist. In fact, these funds allow foreign investors to invest in domestic securities of these countries. Certain funds, like fertiliser, cars, or petroleum, may be limited to a particular industry or sector. These funds carry a high degree of risk since the entire investment is in one market. High-risk investors, on the other hand, prefer this type of fund. Of course, in such cases, the rewards should be commensurate with the risk taken. The best example of this kind is the Petroleum Industry Funds in the United States of America. E) Money-Market Mutual Funds (MMMFs) These funds are basically closed-end mutual funds that share many of the features of open- end funds. They do, however, invest in highly liquid and stable securities like commercial paper, banker's acceptances, certificates of deposits, and treasury bills. These instruments are known as money market instruments. They are used to replace shares, debentures, and bonds in a stock market. They pay money market rates of interest. These programmes are known as \"capital funds\" in the United States, and they have been in place since 1972. Investors also use it as a \"parking spot\" or \"stop gap arrangement\" for cash before deciding on the best investment route, which is long-term financial assets like bonds and stocks. The Reserve Bank of India has put some stringent regulations on MMMFs because they are a new concept in India. Only scheduled commercial banks and their subsidiaries, for example, are permitted to invest in MMMFs. MMMFs can only invest in short-term money market instruments with a maturity of 182 days, such as certificates of deposit, commercial papers, and Treasury bills. They have the ability to lend on the call market as well. These funds are used to invest in assets that are both stable and liquid. Frequent interest realisation and fast redemption are two of the fund's unique characteristics. There will be no provision for a contingency fund for these assets. A three-month minimum lock-in period may apply to the repurchase. F) Taxation Funds 101 CU IDOL SELF LEARNING MATERIAL (SLM)
A taxation fund is a growth-oriented investment. However, it provides tax breaks to investors in both the domestic and international capital markets. It's best for salaried people who want to take advantage of tax breaks, particularly in the months of February and March. In India, the legislation governing tax rebates is currently covered by section 88 of the Income Tax Act, 1961. For investments made in this fund, an investor is eligible for a 20% income tax refund up to a limit of Rs. 10,000/- per year. For the domestic form, SBI Capital Market Limited's Tax Saving Magnum is the best example. The international category is exemplified by UTI's $60 million India Fund, which is located in the United States. OTHER CLASSIFICATION a. Leveraged Funds These funds are also known as borrowed funds because they are mainly used to increase the size of a mutual fund's portfolio value. As the fund's valuation rises, the fund's earning potential rises as well. The profits are allocated to the owners of the units. Only when the profits from borrowed funds exceed the expense of borrowed funds is this method used. b. Dual Funds This is a form of closed-end fund that is special. It offers two distinct types of investors a single investment opportunity. It offers two types of investment stocks for this purpose: income shares and capital shares. Income shares are available to investors looking for immediate investment income. They are entitled to all of the investment portfolio's interest and dividends. They will, however, receive a minimum annual dividend payment. Holders of capital shares are entitled to any capital profits gained on their shares, but they are not entitled to any dividends. The dual fund differs from a balanced fund in this regard. c. Index Funds Index funds are those whose portfolios are constructed to represent the composition of a large market index. This is accomplished by investing in shares in the same proportion as the index. When the stock index rises, the value of these index related funds rises as well, and vice versa. Since the portfolio is entirely dependent on maintaining proper proportions of the index being tracked, there are less operating costs, transaction costs, and portfolio managers involved. Since there will be less purchases and sales of shares, this is true. d. Bond Funds These funds' portfolios are mostly made up of fixed income instruments such as shares. These funds are mostly focused on dividends rather than capital gains. They vary from income funds in that income funds have higher total returns than bank deposits while still providing lower capital gains than equity shares. e. Aggressive Growth Funds 102 CU IDOL SELF LEARNING MATERIAL (SLM)
Bond funds are the polar opposite of these funds. These funds are geared toward capital returns, so capital gains are their main focus. As a result, most of these funds are invested in speculative stocks. They may also employ specialised investment strategies such as short- term trading and option writing. These funds, by their very nature, are highly volatile. f. Off-Shore Mutual Funds Off-shore mutual funds are those geared toward non-residential investors. In other words, these funds' investment sources are international. As a result, they are governed by the laws of the foreign countries in which the funds are registered. These funds make it easier to transfer money between countries, allowing for free and effective capital movement for investment and repatriation. Direct foreign investment is favoured over off-shore funds because it prevents foreign dominance in the host country's private sector. However, since these funds have a lot of currency and country risk, they usually have a higher return. In India, these funds must be approved by the Ministry of Finance's Department of Economic Affairs, and the Reserve Bank of India (RBI) keeps track of them by issuing directives on the spot. There are a host of off-shore funds in India. The UTI launched the ‘India Fund' and ‘India Growth Fund' in the United Kingdom and the United States, respectively. The India Magnum Fund was launched in the Netherlands by the State Bank of India. Can bank Mutual Fund and Indo-Suez Asia Investment Services Ltd collaborated to launch the Indo-Suez Himalayan Fund N.V. The ‘Commonwealth Equity Fund' was also launched. 10.4 OPERATIONS Mutual Fund Organizations' (MFO) activities can be summarised as follows: (a) collecting funds from the public; (b) investing funds raised from the public in the financial market (c) As a trustee for the money of the lender, proper portfolio management is important. The public's/investors' investment in the AMC under a scheme is divided into a number of units. The number of units allocated to the investor in the scheme would be proportional to the overall expenditure in the scheme. As a result, the investor is referred to as a unit holder. Mutual Fund Organizations (MFOs), which have a large pool of public investments and a team of specialists on staff, analyse investment opportunities in a variety of stocks, bonds, and financial investments. Investment decisions in the stock market to buy/sell shares will be made based on the specialists' valuation. After operating and other overhead costs are deducted, the benefit received in the form of capital appreciation is distributed among the scheme's investors. Who are the parties to mutual funds? 103 CU IDOL SELF LEARNING MATERIAL (SLM)
Besides investors the following three parties are involved in Mutual Funds Set up. 1. Trustees 2. Asset Management Company 3. SEBI the regulator. Trustees: Every mutual fund is organised as a trust with a sponsor, trustees, asset management company (AMC), and custodian. A sponsor or sponsors, such as a company promoter, create the trust. The mutual fund's property is held by the trustees for the benefit of the unit holders. SEBI-approved Asset Management Company (AMC) manages the funds by investing in different types of securities. The securities of the fund's various schemes are kept in custody by the custodian, who is registered with SEBI. The trustees have general management and oversight authority over AMC and are responsible for monitoring its performance and compliance with SEBI regulations. According to SEBI regulations, at least two-thirds of the directors of the trustee company or board of trustees must be independent of the sponsors. In addition, 50% of AMC's directors must be independent. Before launching any scheme, all mutual funds must be registered with SEBI. The Asset Management Company (AMC) is a company that manages assets. The Mutual Fund Organization (MFO) creates the Asset Management Company, which invests money in shares, deposits, bonds, and government securities, among other things. The AMC makes money or loses money by selling the properties it owns on a daily basis. An AMC's net worth should be at least Rs.10 crores. The AMC invests in companies with tiny, mid, and large market capitalizations. On the basis of market capitalization, companies are listed as small cap (under 150 crores), mid cap (between 150 crores and 1500 crores), and large cap (over 1500 crores). SEBI's position as a regulator: SEBI rules apply to mutual funds, and they are tracked and inspected by SEBI. SEBI published a collection of mutual fund regulations in 1993. Mutual funds funded by private sector firms have since been approved to participate in the stock market. The rules were fully revamped in 1996, and they have been updated on a regular basis since then. SEBI has issued guidelines to mutual funds on a regular basis to protect investors' interests. 10.5 INVESTORS RIGHT & FACILITIES Investor servicing is covered by the SEBI (MF) Regulations, which were enacted in 1993. As a result of these rules, investors are granted such rights. The following are the details: 1. Unit Certificates In the case of a closed ended scheme, an investor has the right to collect his unit certificates on allotment within 10 weeks of the date of closure of the subscription lists, and 6 weeks of the date of closure of the initial offer in the case of an open ended scheme. 104 CU IDOL SELF LEARNING MATERIAL (SLM)
2. Transfer of Units Within 30 days of the certificates being lodged with the appropriate transfer forms, an investor has the right to have his or her unit certificates transferred. 3. Refund of Application Money If a mutual fund is unable to raise the statutory minimum sum, it is required to return the application money as a refund within six weeks of the subscription lists being closed. If the refund is not received within this time frame, each applicant is entitled to a refund plus interest at the rate of 15% per year for the time spent waiting. 4. Audited Annual Report Every mutual fund owes it to its investors to publish the audited annual report and unaudited half-yearly report for each of its schemes in prominent newspapers within 6 months and 3 months, respectively, of the date of account closing. 10.6 NET ASSETS VALUE The price of repurchase is often compared to the Net Asset Value (NAV). The NAV is simply the market price of each unit in a specific scheme in relation to all of the scheme's properties. It's also known as the \"intrinsic worth\" of each unit. This number is a true reflection of the fund's results. If the NAV is greater than the unit's face value, it means the capital invested in that unit has appreciated and the fund has done well. Illustration For instance, Fortune Mutual Fund Has Introduced a Scheme Called Millionaire Scheme. The Scheme Size Is Rs.100 Crores. The Value of each Units Is Rs.10/-. It Has Invested All the Funds in Shares and Debentures and The Market Value of the Investment Comes to Rs.200 Crores. Now NAV = 200crores --------------- x value of each unit 100 crores 2 x 10 = 20 Thus, the value of each unit of Rs.10/- is worth Rs.20. Hence the NAV = Rs. 20. This NAV forms the basis for fixing the repurchase price and reissue price. The investor can call up the fund any time to find out the NAV. Some MFs publish the NAV weekly in two or three leading daily newspapers. 10.7 SELECTION OF A FUND 105 CU IDOL SELF LEARNING MATERIAL (SLM)
Mutual funds aren't magical entities that can turn millions of dollars into gold in a short period of time. To begin with, all funds are equal. But, over time, some will outperform the others. It all depends on the efficiency with which the fund is handled by the fund's professionals. As a result, when choosing a fund, the investor must exercise extreme caution. When assessing the output of any investment, he must consider the following considerations before deciding which one to choose: 1. Objective of Fund First and foremost, he must understand the fund's goal, whether it is income or development. Fixed interest bearing securities such as debentures and bonds are used to back income- oriented investments, while equities are used to back growth-oriented investments. Growth- oriented schemes are obviously riskier than income-oriented schemes, and as a result, the returns from these two types of investments are not comparable. An investor should equate one fund's specific scheme to another fund's similar scheme and perform a comparative analysis. His goal should also be the same as the goal of the scheme he proposes to implement. 2. Consistency of Performance Since a mutual fund's goal is to provide consistent long-term returns, investors can evaluate a fund's output over at least three years. Investors are more pleased with a fund that has a good and steady output rather than one that does well one year and then struggles the next. Quality consistency is a strong predictor of a company's investment expertise. 3. Historical Background Any fund's performance is determined by its management's competence, honesty, consistency, and experience. The fund's credibility should be unquestionable. A horse with a good track record could be a better choice than new funds. It follows the axiom, \"A known devil is preferable to an unknown angel.\" 4. Cost of Operation Mutual funds aim to do a better job of managing investible funds at a lower cost than individuals might. As a result, a potential investor should examine the fund's cost ratio and compare it to others. The higher the percentage, the lower the investor's real returns. 5. Capacity for Innovation The creative schemes that a fund manager has launched in the market to meet the diverse needs of investors can be used to assess a fund manager's performance. A good man is always an innovator. It is only rational for an investor to seek out funds that are capable of bringing new ideas to the stock market. 106 CU IDOL SELF LEARNING MATERIAL (SLM)
6. Investor Servicing The most crucial thing to remember is timely and effective service. Fast answer to investor questions and timely delivery of unit certificates are examples of services. Fast unit transfers, immediate encashment of units, and other measures would go a long way toward leaving a lasting impact on investors. 7. Market Trends Historically, the stock market index and inflation rate have been found to move in the same direction, while interest rates and the stock market index have been found to move in opposite directions. The stock market index, interest rate, and inflation rate are all things that a cautious investor can keep an eye on. Of course, there is a lot of science behind it. 8. Transparency of the Fund Management Again, a mutual fund's performance is largely determined by the fund's management's transparency. In these days of increased investor awareness, it is important that the fund discloses all relevant information about its operations. It will go a long way toward leaving a lasting impact on the investors, encouraging them to continue to support the fund in the future. Indeed, the increased variety of products/services provided by various funds has made investors more quality-conscious. He may now evaluate the quality of the products provided by mutual funds in the stock market. MFs cannot rely on lucrative ads to attract savings. The equity cult has spread to many small investors, who have become extremely picky when it comes to mutual funds. 10.8 GENERAL GUIDELINES The Government of India has framed the following essential guidelines for the proper functioning of mutual funds and to ensure investor protection: A. General I The RBI will govern money market mutual funds, while the Securities and Exchange Board of India will regulate other mutual funds (SEBI) (ii) Mutual funds must be formed as trusts under the Indian Trust Act and be authorised by the SEBI to conduct business. (iii) Only separately founded Asset Management Companies shall operate Mutual Funds (AMCs). (iv) Independent directors with no ties to the sponsoring company must make up at least half of the AMC Board of Directors. The directors must have at least ten years of practical experience in related fields such as portfolio management and financial administration. (v) At all times, the AMC should have a net worth of at least Rs.5 crores. 107 CU IDOL SELF LEARNING MATERIAL (SLM)
(vi) The SEBI has the authority to revoke any AMC's authorization if it is found to be serving the best interests of investors and the stock market. It does not apply to AMCs that are backed by a bank. B. Business Activities (vii) Trustees and AMCs should be viewed as two distinct legal entities. (viii) AMCs should not be allowed to engage in any other type of company except mutual funds. (ix) A mutual fund's AMC cannot be the same as the AMC for another mutual fund. C. Schemes (x) Before a mutual fund scheme can be floated in the market, it must be registered with the SEBI. (xi) Every closed-end scheme must have a minimum fund size of Rs.20 crores, while open- end schemes must have a minimum fund size of Rs.50 crores. (xii) Closed-end funds cannot be held open for more than 45 days for subscription. In the case of an open-ended system, the first 45 days should be taken into account when deciding the goal figure or minimum size. (xiii) If the minimum amount or 60% of the targeted amount is not increased, the entire subscription must be refunded to the investors. (xiv) Closed-end funds should be listed on stock exchanges to ensure continuous liquidity. Mutual funds selling and repurchasing units at pre-determined rates based on the Net Asset Value must be released at least once a week in the case of open-end schemes. (xv) Closed-end funds should be listed on stock exchanges to ensure continuous liquidity. Mutual funds selling and repurchasing units at pre-determined rates based on the Net Asset Value must be released at least once a week in the case of open-end schemes. (xvi) Each scheme should have its own fund manager who is responsible for it. D. Investment Norms (xvii) Mutual funds should only invest in transferable securities, such as stocks, bonds, and money market funds, as well as securitized debt. In the case of growth funds, it cannot exceed 10%, and in the case of income funds, it cannot exceed 40%. (xviii) A mutual fund should not invest more than 5% of its total corpus in any single company's stock. 108 CU IDOL SELF LEARNING MATERIAL (SLM)
(xix) If all of a mutual fund's schemes are added together, this list of 5% can be increased to 10%. (xx) No scheme can invest if it is part of the same AMC as another scheme. (xxi) Except in the case of those schemes that are expressly floated for investment in one or more specified industries, no mutual fund can invest more than 15% of its funds in the shares and debentures of any particular industry across all of its schemes. E. Expenses (xxii) Investment management and consulting fees may be charged by the AMC to the mutual fund. The prospectus should have disclosed certain fees. (xxii) The initial issue expenditures for each scheme do not exceed 6% of the funds collected. (xxiv) Except for the initial issue expenditures, all other expenses paid to the fund during the current year do not exceed 3% of the weekly average net assets outstanding. It must be made public by commercials, accounts, and other means. F. Income Distribution In any given year, all mutual funds must allocate at least 90% of their earnings. G. Disclosure and Reporting (xxv) The SEBI has broad authority to demand information about the activity of mutual funds and any of their schemes from the mutual fund or anyone affiliated with it, such as the AMC, Trustee, Sponsor, and so on. (xxvi) Every mutual fund must submit to the SEBI copies of its duly audited annual financial statements, six monthly unaudited financial statements, and quarterly statements of net asset movements for each of its schemes. (xxvii) The SEBI has the authority to develop accounting policies, as well as the format and content of financial statements and other reports. (xxviii) The SEBI would also create a uniform advertisement code that all mutual funds must follow. H. Accounting Norm (i) Earnings can be divided into three categories: current income, short-term capital gains, and long-term capital gains for all mutual funds. 109 CU IDOL SELF LEARNING MATERIAL (SLM)
(ii) All of the schemes' accounting must be performed for the same fiscal year. I. Winding Up (i) Once the predetermined time has passed, each closed-end scheme should be wound up or expanded with the SEBI's permission. (ii) An open-end scheme must be wound up if the total number of units remaining after repurchases falls below 50% of the total number of units originally issued at any point in time. J. Violation of Guidelines After a thorough investigation, the SEBI can impose penalties on mutual funds that have violated the guidelines. 10.9 SUMMARY Mutual funds are trusts that pool the investments of several small investors in order to invest in different financial instruments, such as the stock market and the money market, in order to generate a fair return. Mutual funds provide an easy way to save and an excellent way to spend small amounts of money. Mutual funds offer professional management in addition to a diversified investment opportunity. Furthermore, mutual funds have a diverse selection of products to meet the needs of a diverse range of investors. Open and closed ended schemes, income fund schemes, growth fund schemes, equity fund schemes, bond fund schemes, gilt funds, index funds, and so on are all relevant. The NAV of a mutual fund can be used to assess its operating performance. 10.10 KEYWORDS (NAV) Net Asset Value (MF) Mutual Funds (AMC) Asset Management Company (MFO) Mutual Fund Organizations (MMMFs) Money-Market Mutual Funds 10.11 LEARNING ACTIVITY 1. List down the total Mutual Funds Company in India. ___________________________________________________________________________ ___________________________________________________________________________ 110 CU IDOL SELF LEARNING MATERIAL (SLM)
2. Understand the process involved before on boarding a customer into Mutual Funds. ___________________________________________________________________________ ___________________________________________________________________________ 10.12 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain what is Net Asset Value? How is it computed? 2. Describe who are the parties to Mutual Fund? 3. Discuss briefly about Selection of Fund Long Questions 1. Define mutual fund. What are the risks associated with mutual funds? 2. “Mutual funds provide stability to share prices, safety to investors and resources to prospective entrepreneurs.” Discuss. 3. Explain what rights and facilities are available to an investor of a mutual fund? What factors should be considered before selecting a mutual fund? 4. Describe to what extent commercial banks in India are better fitted to take up the mutual fund business? What problems do they encounter in this direction? B. Multi Choice Questions 1. One of the above is the least likely benefit of investing in mutual funds? a. Diversification b. Professional management c. Convenience d. Mutual fund returns are normally higher than market average returns. 2. Which of the following companies owns an open-end mutual fund? 111 a. An investment company b. An investment advisory firm CU IDOL SELF LEARNING MATERIAL (SLM)
c. a “family of funds” mutual fund company d. Its shareholders 3. Which mutual fund class is most likely to subject its investors to the highest level of taxation? a. Index fund b. Municipal bond fund c. Income fund d. Growth fund. 4. Which mutual fund category is most likely to expose its investors to the least amount of total risk? a. Large-cap index fund b. Insured municipal bond fund c. Money market mutual fund d. Small-cap growth fund. 5. Which mutual fund form would not subject its investors to taxation? a. Index fund b. Municipal bond fund c. Income fund d. Growth fund. Answers 1 – d, 2 – c, 3 – d, 4 – d, 5 – a, 10.13 REFERENCES 112 Text Books: Bhole, L.M., Financial Institutions & Markets. Tata McGraw Hill, New Delhi Khan, M.Y.Financial Services Tata McGraw Hill, New Delhi Prasanna Chandra: Financial Management, Tata McGraw Hill. Reference Books: CU IDOL SELF LEARNING MATERIAL (SLM)
Sharpe, William F. etc. Investment. New Delhi, PHI Pandey, I.M., Financial Management, Vikas Publishing House, New Delhi 113 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 11 - RISK IN FINANCIAL SERVICES Structure 11.0 Learning Objective 11.1 Introduction 11.2 Types 11.3 Risk Management 11.4 Summary 11.5 Keywords 11.6 Learning Activity 11.7 Unit End Questions 11.8 References 11.0 OBJECTIVE After studying this unit, you will be able to: Describe nature of Risk in Financial Services Identify scope of Risk in Financial Services Benefits of Risk in Financial Services Process involved in Risk in Financial Services 11.1 INTRODUCTION CONCEPT Risk is comprised of two elements: uncertainty and visibility. If neither is present, there is no risk. When a man jumps out of a plane while wearing a parachute, he can be unsure whether the chute will open or not. Since he's struggling with uncertainty, he's taking a chance. If the chute does not open, he will suffer personally. In this case, a typical spectator on the ground would not endanger his or her life. They may be just as uncertain if the chute will open or not, but they have no vested interest in the result. Some exceptions which apply, such as a bystander who owes money to the man who jumped out of the plane. A spectator who is a member of the man's family. Spectators in this situation are at risk because if the man's chute does not open, they will suffer financially and/or emotionally. They are insecure and weak. Confusion is a synonym for ignorance. We're in danger because we're blind to the future. After all, if we were all-knowing, there would be no risk. Since ignorance is a personal 114 CU IDOL SELF LEARNING MATERIAL (SLM)
experience, danger is inherently subjective. Consider the example below: Someone is making their way to the airport to catch a flight. Since the weather is expected to be bad, the flight could be cancelled. The individual is exposed to the uncertainty surrounding the flight's status. His travel plans will be disrupted if the flight is cancelled. As a result, his life is in jeopardy. Assume that another person is already on their way to the airport to catch the same flight as you. By calling ahead, this individual ensured that the flight was not cancelled. As a result, he faces less risk and is less uncertain. Two parties are involved in the same incident in this case. Since they have different levels of uncertainty, they face different levels of risk. Risk is a subjective experience. Some threats can be reduced simply by analysing them. A bank's credit risk can be reduced by getting to know its borrowers. A trading firm can reduce market risk by staying informed about the markets in which it operates. Danger is a personal experience, not just because it is subjective, but also because risk has different effects on different people. Despite the fact that we speak about companies taking chances, they are simply conduits for hazard. All risks that flow through a company are collectively responsible for individual stockholders, creditors, employees, clients, board members, and others. 11.2 TYPES OF RISK Following are the types of risk: 1. Credit risk Credit risk stems from a lack of confidence in the capacity of a counterparty (also known as an obligor or creditor) to meet its obligations. Since there are so many different types of counterparties—from individuals to sovereign governments—and so many different types of obligations—from car loans to derivatives transactions—credit risk may take many different forms. Institutions deal with it in various ways. When assessing credit risk from a single counterparty, an organisation must consider three factors: Default probability: What are the chances that the counterparty will default on its obligation over the course of the obligation's existence or over a given time period, such as a year? This is known as the predicted default frequency, and it is calculated over a one-year horizon. (a) Credit exposure: How much will the outstanding obligation be in the event of a default? (b) Recovery rate: What portion of the exposure may be recovered in the event of default by bankruptcy or some other kind of settlement? When we talk about an obligation's credit rating, we're talking about the counterparty's willingness to meet its obligations. This includes the obligation's default probability as well as the expected recovery rate. Remember that any risk has two components: exposure and 115 CU IDOL SELF LEARNING MATERIAL (SLM)
uncertainty, to put credit exposure and credit quality into context. Credit exposure represents the first, and credit quality represents the second in terms of credit risk. Credit quality is usually measured through a credit scoring process for loans to individuals or small businesses. A bank or other lender will collect details about the party seeking a loan before extending credit. This may include the party's annual revenue, current debts, whether they rent or own a house, and so on, in the case of a bank issuing credit cards. A standard formula is applied to the data to generate a credit score, which is a number. The lending agency will determine whether or not to expand credit based on the credit score. The procedure is rather formulaic and systematic. Many types of credit risk, especially those associated with larger institutional counterparties, are complicated, unusual, or of such a nature that they merit a less formulaic assessment. Any method for determining a counterparty's credit quality is referred to as credit analysis. Although the word may refer to credit scoring, it is most widely used to refer to human judgment-based processes. The details about the counterparty will be reviewed by one or more credit analysts. This may include the balance sheet, income statement, recent market developments, global economic conditions, and so on. They can also determine the precise existence of a liability. Secured debt, for example, has a higher credit rating than subordinated debt from the same issuer. They allocate a credit rating to the counterparty (or the particular obligation) based on their study, which can be used to make credit decisions. Many banks, investment managers, and insurance firms employ their own credit analysts to prepare internal credit scores. Other companies, such as Standard and Poor's, Moody's, and Fitch, produce credit ratings for use by investors and other third parties. One or more of them are hired by institutions with publicly traded securities to prepare credit scores for their debt. The credit scores are then circulated to investors at a low or no cost. Credit ratings are also established by some regulators. The National Association of Insurance Commissioners publishes credit ratings for bond portfolios owned by insurance firms in the United States, which are used to calculate capital charges. The method for assessing credit risk is highly dependent on the extent of the obligation. If a bank lends money to a company, the outstanding balance on the loan can be used to determine the bank's credit exposure. Consider the case where a bank has provided a line of credit to a company but none of the funds have been used. The firm's immediate credit risk is zero, but this does not reflect the fact that the line of credit is available for use. Indeed, if the company is in financial trouble, it is likely to use the credit line before filing for bankruptcy. The bank should consider its credit exposure to be equal to the total line of credit, which is an easy solution. However, this can exaggerate the credit risk. Another option is to measure the 116 CU IDOL SELF LEARNING MATERIAL (SLM)
credit exposure as a percentage of the overall credit line, with the percentage calculated based on previous experience with similar credits. Credit risk is associated with derivative securities since they are contingent obligations. While it is possible to calculate derivatives' mark-to-market credit exposure based on their current market prices, this metric only gives part of the scene. Many derivatives, such as forwards and swaps, for example, have no market value when they are first entered into. Mark-to-market exposure does not account for the potential for market prices to rise over time because it is focused solely on existing market values. A probabilistic metric of future credit risk must be used for this reason. Credit risk can be controlled or mitigated in a variety of ways. To prevent extending credit to parties that pose an unnecessary credit risk, the first line of protection is to use credit scoring or credit review. Credit risk caps are a common practise. These typically define the maximum amount of risk a company is prepared to take with a counterparty. Industry or country limits may also be set to restrict the amount of credit risk a company is willing to take with counterparties in that industry or country. Calculating exposure under these parameters necessitates some kind of credit risk modelling. Collateralization or other credit upgrades can be used in transactions. Credit derivatives may be used to mitigate credit risks. Finally, companies may use resources to protect themselves against unpaid credit risks. 2. Legal risk Legal risk refers to the possibility of confusion as a result of legal decisions or the applicability or interpretation of contracts, rules, or regulations. Legal risk may include a variety of problems, depending on the circumstances of an institution: (d) Contract formation: What makes a contract legitimate? Is an oral agreement necessary, or does a legal contract need to be signed? (e) Capacity: Is a counterparty capable of engaging in a transaction? For example, the House of Lords of the United Kingdom ruled in 1992 that the London Borough of Hammersmith and Fulham lacked the capacity to trade interest rate derivatives. Contracts with the borough, which date back to the mid-1980s, were ruled null and void, as were contracts with over 130 other councils. A number of derivatives brokers lost money. (f) Legality of derivatives transactions: There is debate in some jurisdictions about whether such derivatives should be considered gambling contracts and therefore rendered unenforceable. In the early days of OTC derivatives markets, this was a major concern. (g) Perfection of a collateral interest: In the case of bankruptcy, a claim is perfected if it is senior to any current or potential third-party claims. A perfected interest is a form of collateral lien. The requirements for perfecting a claim can be complicated, and they differ depending on the jurisdiction and the type of collateral. (h) Closeout netting agreements: When will a closeout netting agreement be enforceable? 117 CU IDOL SELF LEARNING MATERIAL (SLM)
(i) Contract annoyance: Can unexpected conditions in a contract be used to justify it? Would a contract become void if it is related to an index or currency that no longer exists, for example? Legal risk is a specific issue for institutions that conduct cross-border business. They are not only subjected to confusion about the laws of various jurisdictions, but they are also unsure about which jurisdiction would have authority over any given legal question. 3. Liquidity risk A lack of liquidity creates a financial risk known as liquidity risk. If an institution's credit rating decreases, it has unusual cash outflows, or some other event causes counterparties to avoid trading with or lending to it, it may lose liquidity. A business is exposed to liquidity risk if the markets in which it depends suffer a loss of liquidity. The effects of other uncertainties tend to be amplified by liquidity risk. If a trading firm owns an illiquid asset, its inability to rapidly liquidate it increases its market risk. Assume a corporation has offsetting cash flows from two different counterparties on every given day. If a counterparty owes the company money and fails to pay, the company may be forced to borrow money from other sources to make the payment. It will revert to normal if it is unable to do so. In this scenario, liquidity risk is compounding credit risk. While a position can be hedged against market risk, it also comes with the risk of running out of cash. The two payments in the credit risk example above are offsetting, so they contain credit risk but not market risk. Another example is the Metallgesellschaft Debacle of 1993. Futures is used to hedge an OTC liability. Metallgescellschaft was forced to unwind the positions due to a liquidity crisis caused by staggering margin calls on the futures, even though it is debatable if the hedge was effective in terms of market risk. As a result, liquidity risk must be managed in addition to company, credit, and other risks. Since liquidity risk appears to compound other risks, it is difficult or impossible to distinguish. In all but the most basic of situations, comprehensive liquidity risk measurements are useless. Certain asset-liability management approaches may be used to determine liquidity risk. A basic measure for liquidity risk is to look at future net cash flows on a day- by-day basis. A substantial negative net cash flow on any given day is cause for concern. A stress assessment may be used in conjunction with such a study. In the event that a major counterparty defaults, track net cash flows on a regular basis. Obviously, contingent cash flows from derivatives or mortgage-backed securities cannot be factored into these equations. If an organization's cash flows are primarily dependent, liquidity risk can be assessed using scenario analysis. Create a number of market movement and default scenarios over a given time period. In each scenario, look at the daily cash flows. Since balance sheets differed too much from one business to the next. There is little continuity about how these experiments are conducted. The structural effects of liquidity risk are of primary concern to regulators. 118 CU IDOL SELF LEARNING MATERIAL (SLM)
4. Market risk Business operations come with a wide range of risks. We divide risk into various categories for ease of use: market risk, credit risk, liquidity risk, and so on. Although convenient, such categorization is just informal. The meanings and applications of the term differ. The lines between groups are becoming increasingly blurred. A loss caused by widening credit spreads could be classified as either a market or a credit loss, so market risk and credit risk are intertwined. Other risks, such as market risk and credit risk, are compounded by liquidity risk. It can't be separated from the dangers it creates. The distinction between market risk and business risk is significant but unclear. Market risk is the risk of a portfolio's market value fluctuating. A commodity forwards portfolio is held by a broker. She knows how much it's worth now, but she's not sure how much it'll be worth in a week. She is exposed to market risk. Business risk is exposure to economic value volatility that is not market risk. Business risk refers to exposure to economic value volatility that cannot be measured market-to-market. The distinction between market risk and business risk is similar to that between market-value and book-value accounting. Consider a forward contract for on-peak electricity generated over the next three months held by a New England electricity wholesaler. Since such electricity has an active forward market, the contract can be marked to market on a regular basis. The contract's daily gains and losses represent market risk. Assume the company also operates a power plant with a 30-year planned useful life. Power plants are rarely sold, and there are no electricity forward curves for the next 30 years. Since the plant cannot be marked to market on a regular basis, market risk is meaningless in the absence of market prices. Uncertainty about the power plant's economic value is a business concern. Since there is a large \"grey zone\" between consumer risk and business risk, the distinction between the two is hazy. There are markets for a variety of instruments, but they are illiquid. While mark-to-market values are rarely available, mark-to-model values are a close approximation of fair value. Are these instruments a source of market or business risk? Since companies use radically different strategies for handling the two risks, the decision is critical. Long-term planning is used to mitigate business risk. The diligent preparation of business strategies, as well as proper management supervision, are examples of techniques. Since book-value accounting is widely used, the question of day-to-day efficiency isn't a significant concern. The aim is to get a good return on investment for a long period of time. Market risk is dealt with in a short-term manner. Losses from one day to the next are stopped to prevent long-term losses. Traders and fund managers use a number of risk indicators to measure their risks on a tactical basis, including duration and convexity, the Greeks, beta, and so on. These allow them to detect and reduce any potentially harmful exposures. Organizations control market risk on a more strategic basis by imposing risk limits on traders' and portfolio managers' activities. Value-at-risk is increasingly being used to identify and track these limits. Some companies run stress tests on their portfolios as well. 119 CU IDOL SELF LEARNING MATERIAL (SLM)
Operational risk Financial companies and other businesses began to pay more attention to the new field of financial risk management in the 1990s. Concerns about the risks raised by the increasingly rising OTC derivatives markets; a string of high-profile financial losses, including those of Barings Bank, Orange Country, and Metallgesellschaft; and regulatory initiatives, especially the Basle Accord, prompted the move. Most of the emphasis in the early part of the decade was on methods for assessing and controlling market risk. This turned to strategies for calculating and controlling portfolio credit risk as the decade progressed. Firms and regulators were gradually focused on risks \"other than business and credit risk\" by the end of the decade. These were dubbed \"operational threats\" as a group. Employee accidents, system failures, fire, floods, or other physical asset damages, fraud, or other criminal activity is all included in this broad category of risks. Firms have often dealt with these threats in a variety of ways. The new objective was to do so in a more organised manner. The strategy will be similar to — and integrated with — others that had proven effective with market risk and credit risk. The role seemed to be difficult. Market and credit risk management required significant resources from financial institutions and regulators, and these were well-known, tightly identified risks. Operational risk was ill-defined at best. People were split on whether legal risks, tax risks, management incompetence, or reputational risks should be included in operational risks. The discussion went beyond academics. It will determine the nature of organisational risk management programmes. Another issue was that organisational contingencies did not always fit neatly into groups. Losses may occur as a result of a complicated chain of events, making it difficult to forecast or model contingencies. The trading floor of Credit Lyonnais was destroyed by fire in 1996. This may be classified as a fire-related loss. It may also be classified as a loss caused by fraud, as authorities believe employees set the fire on purpose to destroy proof of fraud. There was a lot of discussion about whether operational risks should be measured qualitatively or quantitatively. Value-at-risk and other quantitative instruments are commonly used to measure market risks. A mixture of quantitative and qualitative methods is used to determine credit risk. Quantitative models are used to forecast future credit exposure, evaluate portfolio credit risk, and assign credit scores, among other items. Even then, there are qualitative aspects to the method of evaluating corporate credit efficiency. Certain contingencies are especially amenable to quantitative techniques when it comes to operational risk. Settlement errors in a trading operation's back office, for example, occur with such regularity that they can be statistically modelled. Other unforeseen events impact financial institutions infrequently and are non-uniform in nature, making modelling difficult. 120 CU IDOL SELF LEARNING MATERIAL (SLM)
Examples include acts of terrorism, natural disasters and trader fraud. Regulators made significant progress in developing a system for managing operational risk when working to establish the Basle II accord. In a consultative paper, this was mentioned (2001). Initiatives were sought by researchers and financial institutions. Techniques were borrowed from actuarial science and engineering reliability research, among other areas. By 2002, there was a general structure for evaluating and managing operating risk. There is still more work to be done, and operational risk management can never be standardised to the same degree as market risk and credit risk management, if only because of the variations between financial institutions. General conclusions can, however, be drawn. Operational risk is described by the Basle Committee as the risk of direct or indirect loss as a result of insufficient or failed internal processes, people, and systems, as well as external events. This description has been widely used in the literature, either exactly or with minor variations in wording. Each organisation must apply its own interpretation of the term to its own business lines, processes, and systems. Each institution must determine the operational risks to which it is exposed. The majority of organisational risk is better handled within the departments where it occurs. System-related risks are best addressed by information technology experts. Back office personnel are best suited to deal with settlement risks, among other things. However, a centralised organisational risk management group should be in charge of overall preparation, coordination, and control. In an overall business risk management system, this should be closely coordinated with market risk and credit risk management departments. Contingencies are divided into two types: those that occur regularly and result in minor losses, and those that occur infrequently but result in significant losses. Qualitative approaches such as management oversight, employee questionnaires, exit evaluations, management self- assessment, and internal examination can and should be used to determine both. Quantitative methods may be used to analyse both. Using methods developed for property and casualty insurance, infrequent yet potentially catastrophic events can be modelled to some degree. Contingencies that occur more often, on the other hand, are more amenable to statistical analysis. Data is needed for statistical modelling. Data on past failure incidents and data on risk measures are also useful for organisational contingencies. Settlement errors, system failures, petty theft, consumer litigation, and so on are all examples of loss cases. Direct losses (such as theft) and indirect losses (such as damage to the institution's reputation) are also possible. Data on loss events can be classified in three ways: cause, occurrence, and effect. A mis- entered exchange, for example, is an example of an incident. Inadequate preparation, a device epidemic, or employee exhaustion may all be contributing factors. A business loss, damages charged to a counterparty, a lawsuit, or harm to the firm's image are all possible outcomes. 121 CU IDOL SELF LEARNING MATERIAL (SLM)
Any given incident may have a number of triggers or consequences. The construction of event matrices, which describe the frequency with which certain triggers are correlated with particular events and effects, is made easier by tracking all three dimensions of loss events. Even without further study, such matrices will define areas for improvement in practises, training, personnel, and other areas for management. Loss incidents vary from risk measures. They aren't linked to real losses, but they do reflect the overall level of operating risk. Back-office overtime, staffing levels, regular transaction volumes, employee turnover rates, and system downtime are all examples of risk indicators that a company should monitor. The purpose of modelling is to discover relationships between specific risk indicators and corresponding loss event rates. Risk measures can be used to classify periods of elevated operating risk if such relationships can be established. After operational risks have been measured, either qualitatively or quantitatively, the next step is to handle them in some way. Solutions can try to prevent some risks, embrace others while attempting to mitigate their effects, or simply accept some risks. Employee preparation, close management supervision, division of responsibilities, insurance purchase, employee background checks, and leaving those companies are some examples of specific strategies. A cost-benefit analysis would be used to determine which strategies to use. Some risks are inevitable or, from a cost-benefit perspective, worthwhile to take. These should be capitalised, so calculating fair capital charges is another phase in operational risk management. Operational risk capital charges are being incorporated into the capital allocation schemes of many financial institutions. 4. Model risk Model risk exists because financial institutions rely heavily on models to price financial transactions and track risks. This is the possibility of models being applied to activities for which they are ineffective or wrongly implemented. The following are some examples of model risk: To track market risk, a bank uses a value at risk (VAR). The bank's traders took no spread risk when the VAR measure was introduced. It was coded with the assumption of a fixed distribution. Since then, traders have begun to take considerable spread risk, despite the fact that the model has failed to capture it. A risk-neutral assumption is built into option pricing models. When used to measure risk or other quantities that are dependent on investor risk preferences, such models can produce erroneous results. In South America, a brokerage firm is expanding its derivatives business. They don't adjust their pricing models to account for the lack of liquidity in certain markets. As a result, they undervalue the risk of hedging their bets. Model risks are commonly classified as a type of operational risk. 122 CU IDOL SELF LEARNING MATERIAL (SLM)
11.3 RISK MANAGEMENT Risk management as we know it today originated in the early 1990s, although the word \"risk management\" had been used for a long time before that. It has been — and continues to be — used to characterise methods for dealing with insurable risks since the 1960s. Risk mitigation by protection, quality control, and hazard education, alternative risk funding, such as self- insurance and captive insurance, and the purchasing of conventional insurance products, as necessary, are all part of this type of risk management. Risk management, as defined by derivative dealers, is the use of derivatives to hedge or customise market-risk exposures. Derivative instruments are often referred to as \"risk control devices\" because of this. The modern model of risk management that emerged in the 1990s is unlike any of the previous ones. It sees derivatives as both a challenge and a solution. It focuses on organisational reporting, oversight, and job segregation. So, what exactly does this management entail? Risk management—or financial risk management, to differentiate it from other meanings of the term—can be described as the practises by which a company optimises the way it takes financial risk. Monitoring risk- taking practises, adhering to applicable policies and procedures, and disseminating risk- related reports are all part of it. It's important to note that risk management isn't about minimising risk in any way. That is the responsibility of the board of directors and senior management, who can collaborate with more tactical risk-takers like traders or portfolio managers. Risk management, on the other hand, is all about optimising how risk is taken. As a result, risk control has nothing to do with handling anything. It's just about making things easier. Enterprise risk management is a similar term that is, in several ways, the expansion of financial risk management to non-financial contingencies. It's a nebulous word that has different meanings for different people. Firms also tried merging financial risk management, insurance buying, and contingency planning into a single business entity. The culture clash between the finance and insurance industries has been an obstacle. Just a few practitioners are proficient in both. Financial risk management is applied in a variety of forms within organisations. A risk committee may exist within the board of directors. A risk oversight committee, usually made up of senior managers, is usually present. These two committees are known by a variety of names in operation. The risk oversight committee is headed by a senior manager known as the head of risk management or chief risk officer (CRO). This risk management director can be in charge of a single risk management department. Risk managers, who work in that department, are in charge of assisting all departments in the company in taking appropriate 123 CU IDOL SELF LEARNING MATERIAL (SLM)
financial risks, such as market risks, credit risks, and operational risks. There might be more specialisation in larger organisations. A head of risk management may be in charge of three people: a business risk manager, a credit risk manager, and a head of operational risk management. Everyone will be in charge of a different department. Other options are also available. Financial risk management is divided into four functional areas. A strong organisational culture, actively followed policies and practises, successful use of technology, and risk management practitioners' independence are all necessary for success. a) Culture It is a proven fact that an organisation can only handle risk if its members agree to do so. Every day, regulators face challenges. They have the power to compel a bank to put in place a multimillion-dollar value-at-risk scheme. They have the power to compel an insurance provider to follow hundreds of pages of protocol. They cannot, however, compel an organisation to handle risk effectively. Individuals are the ones that determine whether or not to handle organisational risk. Regrettably, there is a strong reason for them to refuse. The same behaviours that minimise organisational risk put people's lives in jeopardy. A clerk who blows the whistle on a trader, for example, can get the problem resolved or lose his job. A board member who wants to see risk management used more widely must take a risk. She would say, at the risk of sounding alarmist, that potentially serious issues are not currently being addressed. A trader can only handle risk if he first admits that he is capable of making errors, as his reward is based solely on his credibility within the company. An executive who wants to counter the threat of employee theft can end up alienating his own team. Risk management is all about upsetting the status quo, asking tough questions, and questioning the status quo. No one can handle risk unless they are willing to take it. While individual initiative is essential, the process is aided by corporate culture. The corporate culture of a company determines which behaviours will be tolerated and which will be avoided. Corporate culture is important in risk management because it determines the risks that individuals must take individually in order to assist in the management of organisational risks. A healthy risk culture is one that encourages personal responsibility and encourages risk taking. Among the characteristics are: Individuals making decisions: Where no one is held individually accountable, group decision- making can be inefficient. When a single person makes a decision—with or without the 124 CU IDOL SELF LEARNING MATERIAL (SLM)
assistance or approval of others—that person is responsible. His credibility is on the line, so he'll conduct a thorough investigation before recommending a course of action. Questioning: People in a constructive risk community ask a lot of questions. This not only identifies better ways to do things. It also ensures that processes are understood and appreciated. Acknowledgements of ignorance: Mark Twain once said, \"I was gratified to be able to react promptly.\" I said, 'I'm not sure.' Admitting that we don't know puts our lives in jeopardy. At any level of an enterprise, a healthy risk culture encourages such transparency. b) Policies and Procedures People tend to roll their eyes when you discuss policies and procedures because they associate them with red tape and bureaucracy. This is regrettable. Procedures, when used correctly, are a valuable risk management tool. The aim of policies and procedures is to give citizens more control. They decide how people will complete the tasks at hand. Policies and processes only become an impediment when they are ignored or violated. A constructive risk culture is essential to the effectiveness of policies and procedures. Hundreds of pages of procedures that are neatly typed and on a shelf are worthless if no one uses them. However, if people believe in them and take full responsibility for following them, even a basic collection of procedures can make a huge difference for an organisation. Procedures make the risk assessment process more systematic. Take into account business risk thresholds. These are a form of procedure that automates business risk management. They define how much risk is too much risk for any given portfolio section. Without risk limits, everyone will have to keep track of the risks that individual traders are taking and use their own subjective judgement to determine how much is too much. If they decide to act on their subjective judgement that a trader is taking too much risk, the affected trader may fairly believe the decision is unreasonable or unfair, asking, \"What about the market opportunity I was seeking or the client whose needs I was trying to meet?\" When there are no protocols in place, there is a higher risk of dispute, confusion, and conflict. Individuals must take more personal risk to handle organisational risk if there are no processes in place. As a result, a lack of protocols encourages inaction. People are empowered by effective practises, on the other hand. They specify exactly what people should do — and should not do — in a particular situation. They encourage action by reducing uncertainty (individual risk). Procedures include the following: Any board of directors or regulatory body should have a set of procedures in place that fix conflicts of interest, explain personal responsibilities, and make it easier to discuss and resolve complicated or contentious issues. 125 CU IDOL SELF LEARNING MATERIAL (SLM)
Reporting lines: Everybody in a company should report to a single individual. The reporting line should be clear. The Bank of England's study on the fall of Barings is a good example of this. According to the paper, four separate individuals may have been in charge of Nick Leeson's oversight. Trading authority: Before a company participates in a new type of market operation, such as using a new type of trade, implementing a new hedging strategy, or engaging in proprietary trading, it should go through a structured review and approval process. Any trader who is given new responsibilities should follow a streamlined process. Risk limits: Market and credit risk limits are risk management procedures. Procedures for setting and updating such limits should also be in place to ensure that the system of limits remains accurate. When it comes to modifying policies or practises, an organisation should have structured procedures in place. Proposals for a hasty or informal adjustment to procedures are often seen as an attempt to hide anything that current procedures might otherwise expose, according to experienced risk managers. Furthermore, since processes become obsolete over time, it is simple for companies to modify how they function without formally acknowledging the change. Informal behaviours emerge from habit rather than from a deliberate process. They, too, are a source of risk because they can be introduced out of necessity or convenience without realising how they affect organisational risk. Periods of transition are often associated with increased risk for an organisation. Procedures for modifying policies or procedures are a great way to allow people to notice changes as they happen and to formally discuss the risks they pose. Science and technology Risk evaluation and collaboration are the two most important functions of technology in risk management. When risks are taken, technology is used to measure or otherwise summarise them. It then relays this information to the relevant decision-makers. A VAR system or a portfolio credit risk system are examples of technology. Financial engineering technology can be used to label to market positions independently. It could include an interactive risk analysis that is sent to managers every day via email. Technology is a vital component of risk management for many institutions, such as banks and securities firms. Technology plays a smaller role in other organisations, such as non-financial companies or pension plans. For organisations that depend heavily on technology, there is always the possibility of putting the cart before the horse, with risk management focusing on technology. It's a red flag if a company begins a risk management programme by allocating funds to the project before releasing a request for proposal. A more staged approach begins by acknowledging that risk management is fundamentally about people— how they think and communicate with one another. Technology is merely a means to an end. It is worse than useless in the wrong hands, but when used correctly, it can transform an organisation. When it comes to introducing an enterprise risk management programme, it's a good idea to start with a small budget and make sure that board members, senior management, and other 126 CU IDOL SELF LEARNING MATERIAL (SLM)
managers are involved. Begin by devising a risk management approach that is devoid of any technology. This can be a liberating experience. It focuses on the procedural and cultural aspects of risk management for participants. In the end, these are the factors that decide an initiative's effectiveness. If you've settled on a risk-management approach, you'll need to consider where technology can be used or where it can help the strategy. c) Independence Risk managers must be independent of risk-taking roles within the company in order for risk management to work. Freedom, according to Holton (2004), is defined by the following four criteria: Risk managers have their own reporting lines apart from those of risk takers. Risk takers have no say in risk managers' performance reviews, compensation, or promotion, even at the highest levels, and risk managers have no say in risk takers' performance reviews, compensation, or promotion. Employees are unable to switch between roles. Those who are hired to work in risk management stay in risk management; those who are hired to work as risk takers stay as risk takers. Risk managers should not take risks on behalf of the company. They make no recommendations on which risks to take. They make no judgments about the value of any particular risk. The first three elements are self-explanatory. The fourth is a little more subtle— and maybe a little more divisive. It gets to the core of what risk management is all about. Let's take a quick look at the first three points before moving on to the question: what exactly is the role of risk management? The risk management history of Enron is instructive. Risk management was maintained by the company, which was staffed with qualified employees. In principle, reporting lines were fairly distinct, but in reality, they were not. Management was able to change the group's mark-to-market valuations. There were few career risk managers in the organisation. Enron's workforce was constantly changing. Employees were still looking for their next internal promotion. Risk management was no exception for those who rotated through it. A trader or structure whose deal was scrutinised by a risk manager one day may be in a position to give that risk manager a new job the next. Risk managers who were astute avoided burning bridges. Worse, risk managers were subjected to Enron's \"rank and yank\" performance evaluation scheme. Anyone could provide reviews on anyone under that scheme, and the effects of a negative review were serious. Risk managers who stymied deals could face a \"rank and yank\" penalty. Enron only met the first of the four requirements for freedom, but completely failed to meet the second and third. Risk management at Enron was a sham, despite the sophistication of individual employees. Moving on to the fourth freedom criterion, we must differentiate between risk taking and risk management. There are strategic and tactical risk takers in every company. The CEO and other senior executives are willing to take strategic risks. They devise a business plan that 127 CU IDOL SELF LEARNING MATERIAL (SLM)
includes taking some risks. They convey the plan to tactical risk takers, such as traders, structures, and fund managers, who are responsible for putting it into action. Where do risk managers fit in? This is how businesses have worked for hundreds of years, so where do they fit in? There are two rival models, which are seldom recognised. Strategic and tactical risk takers, according to one model, need assistance in taking risks. Super risk takers—risk managers— are expected to intervene under this principle. They determine which risks should be avoided and which risks should be taken. Risk managers assist less skilled strategic and tactical risk takers in doing their work in this way. This model is riddled with flaws. For starters, it is superfluous. If strategic or tactical risk takers are unable to complete their tasks, the solution is not to employ a super risk taker to complete them. Rather, it is to replace them with risk-takers who are capable of taking strategic and tactical risks. Second, transparency is harmed. Is it the trader's fault if a transaction goes bad, or is it the risk manager's fault for failing to stop the deal? Finally, it causes friction. Although strategic risk takers are never concerned that a super risk taker will usurp their authority, tactical risk takers are frequently concerned. The consequence has been a cold war between the front and middle offices at several companies. Finally, risk managers are ripe for being made scapegoats. With recent corporate scandals in the news, it's easy to see why some senior executives will be able to assign full responsibility for risk taking to a chief risk officer. Risk management, in this model, may become a tool for executives to control career risk rather than a tool for managing organisational risk. Risk managers, on the other hand, may be thought of as facilitators. Risk takers, both strategic and tactical, are in charge of choosing which risks to take. Risk managers make the process easier by ensuring that the two parties communicate effectively. Via policies, processes, and risk thresholds, they assist strategic risk takers in communicating. They assist tactical risk takers in communicating by creating risk reports that detail the risks they are taking. To avoid the pitfalls of the risk-managers-as-super-risk-takers model, risk managers must be unable to take risks on behalf of the company. They don't give advice on risk-taking because if their recommendations are consistently followed, they'll become de facto risk takers. They share no opinions about the desirability of taking any specific risks to prevent the appearance of providing advice. Measuring risk is one thing for a risk manager to do. It's quite another thing for a risk manager to say that the risk is too big or otherwise unworthy of taking. Tactical risk takers should not feel threatened because risk managers do not share their opinions... As a result, there is no cold war. When risk managers aren't in charge of taking chances, there's a slim chance the blame will be shifted to them when things go wrong. 128 CU IDOL SELF LEARNING MATERIAL (SLM)
11.4 SUMMARY Uncertainty and exposure are two components of danger. There is no danger if neither is present. There are six different forms of risk. Credit risk is the risk of a counterparty's ability to fulfil its obligations being questioned. Any method for determining a counterparty's credit quality is referred to as credit analysis. Legal risk is a specific issue for institutions that conduct cross-border business. If the markets in which a company relies experience a loss of liquidity, it is exposed to liquidity risk. Market risk is the risk of a portfolio's market value fluctuating. The majority of organisational threats are handled by the agencies in which they occur. Strong organisational culture, actively practised policies and practises, effective use of technology, and risk management practitioners' independence are four facets of financial risk management. 11.5 KEYWORDS Credit risk Credit risk is risk due to uncertainty in a counterparty’s (also called an obligor or credit’s) ability to meet its obligations Legal risk is risk from uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations Liquidity risk is a financial risk due to uncertain liquidity 11.6 LEARNING ACTIVITY 1. Identify 3 Top Risk Management companies in India. ___________________________________________________________________________ ___________________________________________________________________________ 2. Study the scams related to Mehul Choksi and the impact ___________________________________________________________________________ ___________________________________________________________________________ 11.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. How can Liquidity Risk be identified? 2. Explain briefly about Operational Risk. 3. Discuss in short about Market risk 129 CU IDOL SELF LEARNING MATERIAL (SLM)
Long Questions 1. Define risk. Discuss the various types of risk. 2. In assessing the credit risk, what factors should be kept in mind? Discuss. 3. What do you mean by risk management? Explain the different aspects of financial risk management. 4. Explain the impact of Credit Rating Agency & its Risk Assessments B. Multi Choice Questions 1. Losses arising due to a risk exposure retained or assured is known as ______________ a. Risk Reduction b. Risk Financing c. Risk Retention d. Risk Sharing 2. The measures aimed at avoiding, eliminating or reducing the chances of loss production is covered by ______________ a. Risk Control b. Risk Retention c. Risk Avoidance d. Risk Financing 3. The Person whose risk is insured is called ______________. a. Insured b. merchandiser c. marketer d. Agents 4. The risk management can be done by ______________. 130 a. Insurance CU IDOL SELF LEARNING MATERIAL (SLM)
b. Hedging c. Derivatives d. All of these 5. The first step in risk management process is ______________. a. Risk avoidance b. Risk Identification c. Insurance d. Risk Evaluation Answers 1 – c, 2 – a, 3 – a, 4 – d, 5 – b, 11.8 REFERENCES Text Books: Bhole, L.M., Financial Institutions & Markets. Tata McGraw Hill, New Delhi Khan, M.Y.Financial Services Tata McGraw Hill, New Delhi Meir, Kohn, Financial Institutions & Markets, Tata McGraw Hill, New Delhi Prasanna Chandra: Financial Management, Tata McGraw Hill. Reference Books: Kothari, C.R., Investment Banking & Customer Services Arihant Publishers, Jaipur Sharpe, William F. etc. Investment. New Delhi, PHI Pandey, I.M., Financial Management, Vikas Publishing House, New Delhi 131 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 12 - LEASING & HIRE PURCHASE Structure 12.0 Learning Objective 12.1 Introduction 12.2 Concept 12.3 Classification 12.4 Advantage & Disadvantage 12.5 Legal Aspects 12.6 Structure of Lease Industry 12.7 Problem & Prospects 12.8 Hire Purchase 12.9 Summary 12.10 Keywords 12.11 Learning Activity 12.12 Unit End Questions 12.13 References 12.0 LEARNING OBJECTIVE After studying this unit, you will be able to: Describe nature of Leasing & Hire Purchase Identify scope of Leasing & Hire Purchase Benefits of Leasing & Hire Purchase Process involved in Leasing & Hire Purchase 12.1 INTRODUCTION Firms have traditionally bought productive assets and used them as owners. Internal or external sources of funding can be used by a company to acquire properties. Internally produced resources have been decreasing in value over time due to low profitability. Financial institutions are finding it difficult to meet the growing demands of borrowers due to a lack of funds. In addition, the current market climate is becoming more complex. In order to thrive in this situation, businesses must strive for steady growth. To achieve this goal, 132 CU IDOL SELF LEARNING MATERIAL (SLM)
businesses must pursue massive growth, diversification, and modernization. Essentially, such ventures entail a large sum of money. Inflationary pressures, steep cost increases, high taxes, and limited internal capital compelled many businesses to seek alternative sources of funding for their ventures. Leasing has emerged as a major source of capital asset financing. 12.2 CONCEPT Leasing is a loan concept that refers to a contract between two parties, the leasing company or lessor and the user or lessee, in which the former arranges to buy capital equipment for the latter's use for a set period of time in return for rent. The rentals are predetermined and payable at predetermined times, based on the mutual convenience of both parties. The lessor, on the other hand, maintains control of the machinery throughout the primary period. The lessee company could take advantage of the equipment's economic benefits by using it as though it were his own, avoiding the capital cost. Leasing rentals are tax deductible to the maximum extent permitted by law and can be paid with income earned from the use of the equipment over the lease period. A lease is a contract under which the owner of an asset/equipment (lessor) provides the asset for use by another/transfers the right to use the equipment to the receiver (lessee). For consideration in the form of/in return for periodic payment (rentals) with or without a further payment over a certain/for an agreed period of time for consideration in the form of/in return for periodic payment (rentals) with or without a further payment over a certain/for an agreed period of time for consideration in the form of/in return for periodic payment (rentals) with or without a further payment (premium). If a contract extension is available, the asset/equipment reverts to the lessor at the end of the contract term (lease period). The separation of ownership from commercial use of an asset or piece of equipment is known as leasing. It's a way of financing an asset's purchasing price. It's a deal under which the lessor (financier) buys specific equipment for the lessee from a manufacturer or vendor of the lessee's choosing. The lessee has possession and use of the asset after paying the prescribed rents for a defined period of time. As a result, lease financing is a system of financing and money lending. A lessor's true job is to lend money, finance, or credit, and lease financing is simply a loan agreement. The lessor (financier) is the nominal owner of the estate since the lessee has possession and economic use of the equipment. The lessee has complete freedom in selecting the asset that best meets his needs, and the lessor is not obligated to use the equipment as long as the rentals are charged on time. The following are the basic elements of leasing: Parties to the Contract: The owner and the user, who are referred to as the lessor and lessee, respectively, are the parties to a lease financing deal. Lessees and lessors include individuals, unions, joint stock corporations, enterprises, and financial institutions. In certain cases, there might be joint lessors or joint lessees, particularly if the properties or the amount of money 133 CU IDOL SELF LEARNING MATERIAL (SLM)
involved are substantial. There may also be a lease-broker who serves as an agent in the negotiation of lease agreements. Merchant banking units of certain international banks in India, branches of some Indian banks, and even private merchant bankers are all examples of lease brokers. They charge a percentage fee, which can range from 0.50 to 1%, for their services. A 'lease financier,' who refinances the lessor by term loans, equity subscriptions, or a special refinance scheme, may be included in a lease agreement. 2. Asset: A lease financing arrangement covers the asset, property, or facilities that will be rented. Assets include automobiles, plant and machinery, equipment, land and buildings, warehouses, a running business, aircraft, and other products. The asset must, however, be of the lessee's choice and suitable for his business needs. 3. Ownership Separated from the user: The essence of a lease financing agreement is that during the lease period, the lessor retains possession of the asset while the lessee is allowed to use it. At the end of the lease period, the asset is returned to the lessor. 4. Lease Term: The lease term refers to how long the lease agreement will be in place. Any lease should be for a fixed period of time; otherwise, it is ineffective legally. The lease term may be longer than the asset's useful life (for example, a financial lease) or shorter than the asset's economic life (for example, an operational lease) (i.e., operating lease). The lease may be indefinite, which means that the tenant has the option to renew the lease for another time at the end of the current one. 5. The lease rental is the sum paid by the lessee to the lessor in return for the lease transaction. Over the contract period, the lease rentals are structured to repay the lessor for the asset's investment (in the form of depreciation), interest on the investment, any repairs, and service charges borne by the lessee. 6. Lease Termination Methods: The lease is terminated at the end of the lease period, and there are a number of options available, including: (a) The lease is renewed permanently or for a set period of time; b) The lessor receives the asset back; (c) The lessor receives the asset and sells it to a third party. (d) The lessor sells the asset to the lessee. The parties will mutually agree on and choose one of the above options at the start of the contract. 12.3 CLASSIFICATION OF LEASING The extent to which ownership costs and benefits are transferred, the number of parties 134 CU IDOL SELF LEARNING MATERIAL (SLM)
involved, the equipment manufacturer's, lessor's, and lessee's domiciles, and other factors may all affect the outcome of an equipment lease agreement. Risk refers to the likelihood of failure due to underutilization or technological obsolescence of the equipment in the sense of leasing, while reward refers to the incremental net cash flows generated from the equipment's usage during its economic life and the realisation of the anticipated residual value at the end of the economic life. Leasing can be divided into the following categories based on these variations: Finance and operating leases are two types of leases. b) Sales and leaseback, as well as direct leasing c) Leveraged and single investor leases d) Leases on a national and international scale a) Finance Lease and Operating Lease Finance Lease: According to International Accounting Standards, the lessor passes on to the lessee a large portion of the costs and benefits associated with asset possession, whether or not the title is ultimately transferred (IAS-17). It means paying rent over a fixed, non- cancellable lease period long enough to amortise the lessor's capital outlay and generate a profit. In such leases, the lessor is merely a financier who is usually uninterested in the land. As a result, full pay out leases are also known as benefit leases because they allow a lessor to recoup his lease investment while also making a profit. Ships, vessels, railway waggons, property, heavy construction equipment, diesel generator sets, and other things are all protected by such leases. According to IAS-17, when: I the equipment's ownership is transferred to the lease by the end of the lease period; or (i) the equipment's ownership is transferred to the lease by the end of the lease term, a large portion of the ownership-related risks and rewards in leasing are transferred. (ii) The lease has the option to purchase the asset at a price that is expected to be sufficiently less than the fair market value at the moment the option becomes exercisable, and the option would be exercised at the lease's stipulation. (iii) A large portion of the asset's useful life is covered by the lease term. It's likely that the title won't be moved at all. The following is the concept of an asset's minimum useful life: 1) Physical life, as measured by the amount of time it can perform its function; 2) The lifespan of technology in terms of how long it lasts before becoming obsolete. 3) Product market life refers to the length of time that a product has a viable market. 135 CU IDOL SELF LEARNING MATERIAL (SLM)
A finance arrangement meets the criterion/cut-off point when the lease term exceeds 75 percent of the equipment's useful life. (iv) The present value of the minimum lease rent is greater than or substantially equal to the asset's fair market value at the start of the contract (cost or equipment). In the future, the title will or may not be transferred. The cut-off point is when the equipment's present value approaches 90% of its fair market value. In the case of the lessor, the present value should be determined using a discount rate equal to the rate implied in the contract, and in the case of the lessee, the incremental borrowing rate. In India, however, the lease is called a finance lease if one of the last two conditions is met. A hire-purchase agreement is described as a lease that meets one of the first two requirements. A finance lease includes the following characteristics: (i) The lessee (potential buyer) selects equipment from a manufacturer or dealer that best suits his requirements. (ii) With the manufacturer or dealer, the lessee negotiates and decides on the price, delivery schedule, installation, warranty terms, repair, and payment. (iii) In straight-forward leasing, the lessor either buys the equipment directly from the manufacturer or distributor, or from the lessee after it has been delivered (under sale and lease back). (iv) The lessee then leases the equipment from the lessor. The equipment remains in the hands of the lessor while the lessee is allowed to use it. (v) A finance lease may provide the right or obligation for the lessee to purchase the equipment at a later date. However, this is a rare occurrence in India. (vi) The lease period spans the asset's expected economic life. The primary lease period is a non-cancellable period over which the lessor expects to recoup his investment while still making a profit. Lease termination is only available at a very high cost during this period. After that, the lease is up for renewal for the secondary lease period, during which the rentals are greatly reduced. (i) For the duration of the contract, the lessee has exclusive and peaceful use of the equipment if the lessee pays the rentals and observes the lease terms. (ii) Because the lessee chooses the equipment, he or she is responsible for its suitability, risk of obsolescence, and responsibility for the equipment's repair, maintenance, and insurance. Operating Lease: According to the IAS-17, an operating lease is one that is not a finance lease. In an operating contract, the lessor does not pass on all of the costs and benefits associated with asset ownership, and the asset's expense is not fully amortised over the 136 CU IDOL SELF LEARNING MATERIAL (SLM)
primary lease term. In addition to funding the purchase price, the lessor provides services related to the leased asset, such as maintenance, repair, and technical advice. As a result, operating leases necessitate a payment for the services provided, and the lessor's cost recovery is not dependent on a single lessee. Operating leases cover anything from computers and office equipment to vehicles, vans, and phones. An operating lease has the following characteristics: (i) An operating lease is normally for a shorter period of time than the economic life of the leased asset. In certain instances, it may be on an hourly, daily, weekly, or monthly basis. Any party can cancel the lease at any time during the lease period. (ii) The lease rents are inadequate to completely amortise the asset's expense since the lease terms are less than the asset's expected life. (iii) The lessor does not put his faith in a single lessee to pay back his money. He's most concerned with the asset's residual value. The lessor assumes the risk of obsolescence because the lessee has the option to terminate the lease at any time. In most operating leases, the lessor is required to maintain the leased asset and provide services such as insurance, support stair, power, and so on. Operating leases include the following: - a) Providing operators for mobile cranes (b) Aircraft and ship chartering, including provision of passengers, fuel, and support services. c) Machines with operators for hire (d) Hiring a taxi for a specific journey, which involves driver care, servicing, and immediate fuel repairs, among other things. Sale and Lease Back and Direct Lease Sale and Lease back: It is, in some ways, a kind of indirect leasing. The owner of an asset sells it to a leasing company (Lessor), who then leases it to the owner again (lessee). A classic example of this form of leasing is the sale and lease back of safe deposit values by banks, in which banks rent them in their custody to a leasing firm at a market price considerably higher than the book value. The bank then leases these lockers from the leasing company on a long-term basis. The bank offers customers the option of renting lockers. The lease back arrangement in the sale and lease back system of leasing may be either a finance lease or an operating lease. Direct Lease: In a direct lease, the lessee and the equipment owner are two different people. There are two types of direct leases: bipartite and tripartite leases. Bipartite Lease: In a bipartite lease, two parties are involved: the lessee and the lessee's lessee. 137 CU IDOL SELF LEARNING MATERIAL (SLM)
(i) Service supplier-cum-leeser: A lessee is a person who rents property. Such a lease is typically configured as an operating lease with built-in features including equipment upgrade (Upgrade Lease), addition to the original equipment configuration, and so on. The lessor is responsible for keeping the asset in good working order and, if possible, replacing it with similar equipment (Swap Lease). Tripartite Lease: A tripartite lease involves three parties: the equipment provider, the lessor, and the lessee. The sales-aid lease is a unique form of tripartite lease in which the equipment supplier arranges for lease funding from a variety of sources. • Providing a consumer guide to the leasing company • On behalf of the leasing firm, negotiating lease terms with customers and completing all relevant paperwork • He writes the contract and discounts the lease receivables with the designated leasing company on his own account. As a result, the leasing company obtains ownership of the equipment and a contract rental assignment. When a lessee defaults, the sales-aid lease usually has recourse to the supplier, either through a supplier offer to buy back the equipment from the lessor or through a guarantee on behalf of the lessee. Single Investor Lease and Leveraged Lease Single Investor Lease: In a single investor lease, there are only two parties involved: the lessor and the lessee. The leasing company (lessor) finances the whole project with a balanced combination of debt and equity capital. The leasing company's loans to fund the asset are without recourse to the lessee, which means that if the leasing company fails to service the loan, the lender is not entitled to payment from the lessee. There are three parties involved in a leveraged lease: (i) the lesser (equity investor), (ii) the lender and the borrower (iii) the lessee In this form of contract, the leasing company (equity investor) borrows heavily to purchase the asset. A lease assignment and a first mortgaged asset on the leased asset are obtained by the lender (loan participant). The deal is handled by a trustee who protects the interests of both the lender and the lessor. The trustee sends the debt service portion of the rental to the loan participant and the balance to the lessor after receiving the rentals from the lessee. Leveraged leases, like other lease transactions, allow the lessor to claim depreciation and other capital allowances on the entire investment expense, including non-recourse debt. As a result, the return on equity (profit after taxes divided by net worth) is high. The effective rate of interest inherent in the lease agreement is lower than a straight loan from the lessee's 138 CU IDOL SELF LEARNING MATERIAL (SLM)
perspective since the lessor passes on a portion of the tax benefits to the lessee in the form of lower rental payments. Leveraged lease packages are typically designed for leasing investment- intensive properties such as aircrafts, ships, and other similar assets. b) Domestic Lease and International Lease Domestic Lease: A lease agreement is considered domestic if all of the parties involved, such as the equipment owner, lessor, and lessee, are located in the same country. International Lease: An international lease is one in which the lease contract's parties are based in different countries. This form of lease is further divided into two categories: (I) import lease and (II) cross-border lease. Import Lease: An import lease occurs when the lessor and lessee are both located in the same country, but the equipment provider is located in a different country. The commodity is imported by the lessor and leased to the lessee. Cross-border Lease: A cross-border lease occurs when the lessor and lessee are located in different countries. The location of the supplier is unimportant. Operationally, domestic and foreign leases are separated based on risk. The latter type of lease transaction is affected by two additional risk factors: nation risk and currency risk. The country risk arises from the need to structure the lease transaction in light of knowledge of the political and economic climates of foreign countries, as well as the tax and regulatory environments that govern them. Since the payment to the supplier and the lease rentals are in separate currencies, any change in the exchange rate will put the currency in jeopardy. 12.4 ADVANTAGE & DISADVANTAGE To the Lessee: Lease financing has the following advantages to the lessee: Capital goods financing: - Lease financing allows the lessee to obtain up to 100% financing for large investments in property, buildings, plants, machinery, heavy equipment, and so on, without having an immediate down payment. As a result, the lessee can start his business almost immediately without having to spend any money (of course, he may have to invest the minimal sum of working capital needs). • Additional Source of Finance: - Leasing allows businesses to acquire equipment, plant, and machinery without having to make a large upfront investment, giving them a strategic advantage in mobilising their limited financial resources. It improves the working capital situation and makes internal accruals available for business operations. • Less Expensive: Leasing as a means of funding is less expensive than other options. • Financing Off-Balance-Sheet: The leased asset is not shown on the balance sheet, nor is the lease liability, with the exception of a footnote mentioning the lease agreement. As a result, 139 CU IDOL SELF LEARNING MATERIAL (SLM)
lease financing has little impact on a company's ability to raise leverage because the lessor's protection is still secured by the leased asset. The benefit, on the other hand, is more obvious than actual. Development banks and other lending institutions should not make lending decisions purely on the strength of the borrower's balance sheet. They undoubtedly need details on off-balance sheet liabilities in order to determine the true borrowing power. However, lenders who rely on financial statements can be misled by off-balance sheet financing. In summary, failing to disclose outstanding lease commitments and the value of leased properties on the balance sheet would result in an underestimate of the debt-to-equity ratio and (ii) an overstatement of the asset turnover ratio and return on investment. As a result of these factors, they underestimate the true danger and overestimate the firm's worth. The IAS-17 has proposed capitalization of finance leases in the lessee's books in consideration of the distortions implicit in non-disclosure of finance leases in the lessee's financial statements. Ownership Is Preserved: - Leasing offers financing without diluting the promoters' ownership or power. Other forms of long-term financing, such as equity or debentures, usually dilute the promoters' stake. • Avoid Conditionalities: Lease financing is preferred over institutional finance since there are no conditions in the former. Lease financing is advantageous because it is free of restrictive covenants and conditions, such as representation on the board of directors, debt conversion into equity, dividend payment, and so on, that typically accompany institutional finance and term loans from banks. • Rentals Structured with Flexibility: - The lease rentals can be arranged to suit the lessee's cash flow situation, making rental payment easy for him. Since the lease rentals are so customised, the lessee is able to pay them using funds raised from operations. The lease period is also chosen to accommodate the lessee's ability to pay rent while also taking into account the asset's operational life-span. • Ease of Negotiation: - A lease financing agreement is simple to negotiate and free of time- consuming processes, with quick and easy documentation. Institutional financing and term loans, on the other hand, demand strict adherence to covenants and formalities, as well as a large amount of paperwork, resulting in lengthy delays. • Tax Advantages: - Many tax benefits can be obtained by properly structuring lease rentals. If the lessee is a tax payer, the rental can be raised in order to reduce his taxable income. Since depreciation is allowed at the prescribed rates, the expense of the asset is amortised 140 CU IDOL SELF LEARNING MATERIAL (SLM)
more quickly than if the asset is owned by the lessee. If the lessor is a tax payer, the rentals can be reduced in order to pass on any of the tax savings to the lessee. As a result, the rentals can be changed to allow for tax postponement. • Risk of Obsolescence is Reduced: - In a lease agreement, the lessor, as the landlord, assumes the risk of obsolescence, while the lessee is still able to upgrade the asset with the most up-to-date technology. Message to the Lessor: - The following are some of the benefits of being a lessor: • Absolute Security: - The lessor's interest is completely protected because he owns the leased asset at all times and has the right to repossess it if the lessee defaults. Realizing an asset backed against a loan, on the other hand, is more complicated and time-consuming. • Tax Advantage: The biggest benefit to the lessor is the tax savings provided by depreciation. If the lessor is in a high tax class, he can lease properties with high depreciation rates and thereby significantly reduce his tax liability. Furthermore, the leases may be arranged in such a way that the lessees receive a tax gain. • High Profitability: - The leasing industry is extremely profitable because the rate of return exceeds the rate of return on the lessor's borrowings. In addition, the rate of return is higher than if you were to lend money directly. • Trading on Equity: - Lessors typically use more financial leverage in their activities, meaning they have a low equity capital and rely heavily on borrowed funds and deposits. As a result, the final return on equity is extremely high. • High Potential for Growth: The leasing industry has a lot of room for growth. Lessees can obtain equipment and machinery with the help of leasing financing. • Even if there is a depression, because they do not have to spend any money. As a result, even during a recession, leasing keeps the economy growing. LIMITATIONS OF LEASING Lease financing suffers from certain limitations too: Equipment Usage Restrictions: - A lease agreement can place restrictions on how the equipment is used, or include mandatory insurance, among other things. Furthermore, the lessee is not permitted to make additions or changes to the leased asset to meet his needs. 141 CU IDOL SELF LEARNING MATERIAL (SLM)
Financial Lease Limitations: - A financial lease can have higher pay out commitments if the equipment is found to be ineffective and the lessee chooses to terminate the lease agreement early. Furthermore, since the lessee is not the owner of the asset, he is not entitled to the benefit of express or implied warranties. • Loss of Residual Value: - The rented asset is never owned by the lessee. As a result, he is robbed of the asset's residual value, as well as any changes made by the lessor or induced by inflation or otherwise, such as an increase in the value of leasehold property. • Default Consequences: If the lessee fails to comply with any of the lease contract's terms and conditions, the lessor may terminate the lease and take possession of the leased asset. Damages and accelerated rental payments may be expected of the lessee in the case of a finance lease. • Lessee's Asset Underestimate: Since the leased assets are not included in the lessee's assets, there is an effective understatement of the lessee's assets, which may often result in a gross underestimation of the lessee. However, it is now standard accounting procedure to list leased properties in the balance sheet as a footnote. • Double Sales Tax: Due to changes in state sales tax laws, a lease financing deal can be subject to sales tax twice: once when the lessor buys the equipment and again when it's rented to the lessee. 12.5 LEGAL ASPECTS OF LEASING There is no separate statute for equipment leasing in India. The provisions relating to bailment in the Indian Contract Act govern equipment leasing agreements as well Section 148 of the Indian Contract Act define bailment as: - The delivery of goods by one person to another, for some purpose, upon a contract that they shall, when the purpose is accomplished, be returned or otherwise disposed of according to the directions of the person delivering them. The person delivering the goods is called the' bailor' and the person to whom they are delivered is called the ‘Bailee’. Since an equipment lease transaction is regarded as a contract of bailment, the obligations of the lessor and the lessee are similar to those of the bailor and the Bailee (other than those expressly specified in the least contract) as defined by the provisions of sections 150 and 168 of the Indian Contract Act. Essentially these provisions have the following implications for the lessor and the lessee. 1. The lessor has the duty to deliver the asset to the lessee, to legally authorize the lessee to use the asset, and to leave the asset in peaceful possession of the lessee during the currency of the agreement. 142 CU IDOL SELF LEARNING MATERIAL (SLM)
2. The lessee has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor's title to take reasonable care of the asset, and to return the leased asset on the expiry of the lease period. 12.6 STRUCTURE OF LEASING INDUSTRY IN INDIA The present structure of leasing industry in India consists of (i) Private Sector Leasing and (ii) Public Sector Leasing. The private sector leasing consists of: (i) Pure Leasing Companies. (ii) Hire Purchase and Finance Companies and (iii) Subsidiaries of Manufacturing Group Companies. The public sector leasing organization are dividing into: i) Leasing divisions of financial institutions. ii) Subsidiaries of public sector banks. iii) Other public sector leasing organisations. i) Pure Leasing Companies These businesses operate separately, with no links to or affiliations with other businesses or groups of businesses. This group includes the First Leasing Company of India Limited, the Twentieth Century Finance Corporation Limited, and Grover Leasing Limited. ii) Hire Purchase and Finance Companies The companies began doing hire purchase and finance business prior to 1980, mostly for cars, and added leasing to their operations in 1980. Some of them lease on a large scale as a tax planning tool, while others lease on a smaller scale as a tax planning tool. This group includes Sundaram Finance Limited and Motor and General Finance Limited. iii) Subsidiaries of Manufacturing Group Companies These companies consist of two categories vendor leasing and in house leasing Vendor leasing: This type of company is created to help promote and increase the selling of its parent company's goods by providing leasing options. In-house leasing or catch leasing companies are formed to meet the group's fund requirements or to escape the group's income tax liabilities. iv) Public Sector Leasing 143 CU IDOL SELF LEARNING MATERIAL (SLM)
Financial Institutions: Leasing divisions or subsidiaries have been established by financial institutions such as IFCI, ICICI, IRBI, and NSIC to conduct leasing business. The Shipping Credit and Investment Company of India provides clients with foreign currency leasing options for ships, deep sea fishing vessels, and associated equipment. (ii) Banks' Subsidiaries: Commercial banks in India will set up subsidiaries to engage in leasing activities under section 19(1) of the Banking Regulation Act, 1949. In 1986, the SBI became the first bank to establish a leasing subsidiary. SBI's leasing is handled by the bank's Strategic Business Unit (SBU). Each SBU is staffed by specially trained personnel and equipped with cutting-edge technology to meet the demands of top corporate clients. Leasing is seen as a high-growth sector for the bank as a whole. The bank is now solely focused on 'Big Ticket Leasing,' which is usually in the range of Rs. 5 crores and above. SBI has disbursed over Rs.300 crores in leasing so far, with the average deal size being Rs. 25 crores. Other public sector organisations, such as Bharat Electronics Limited, Hindustan Packaging Company Limited, and Electronic Corporation of India Limited, have begun to lease their equipment. 12.7 PROBLEM & PROSPECTS OF LEASING Leasing has a lot of scope in India. However, leasing in India faces significant obstacles that can stifle future development. The following are some of the issues: 1. Unfavourable Competition The amount of lessors has not kept pace with the growth of the leasing industry. As a result, there is an overabundance of lessors, which leads to competition. As the leasing market has become more dynamic, lessor profit margins have declined from four to five percent to 2.5 to three percent. Bank branches and financial institutions have a strategic advantage over private sector companies due to their low capital costs. 2. Inadequately trained staff Leasing necessitates the participation of well-trained and skilled operators. Top executives in the leasing industry should have expertise in accounting, finance, legal, and decision-making. Since leasing is a new concept in India, finding the right person to run a leasing business can be difficult. As a result, the leasing industry's operations will certainly suffer. 3. Taxes to Think About The majority of people believe lessees choose leasing because it offers tax benefits. In reality, the gain is only transferred, i.e. the lessee's tax shelter. the lessor's responsibility the lease becomes economically viable only when the effective tax rate on the transfer is low. The expense of rent is increased by taxes such as income tax, 144 CU IDOL SELF LEARNING MATERIAL (SLM)
inheritance tax, additional tax, surcharge, and others. As a result, leasing becomes more expensive than other lending options, such as hire purchase. 4. Stamp Duty The states consider a rental arrangement to be a lease when deciding whether or not it is taxable. However, the contract is treated as a pure lease transaction for stamp duty purposes. As a result, there is a heavy stamp duty on lease papers. This adds to the burden on the leasing industry. 5. Late payments and bad debts The cost of the lease is increased by late rent payments and bad debts. When calculating the rent at the time of the lease agreement, the lessor does not take this into account. The leasing industry's prospects will be jeopardised as a result of these problems. 6. Prospects for Leasing Currently, leasing accounts for 6% of India's total capital investment. Leasing will account for at least 15% of overall capital formation, making it a significant contributor to gross capital growth. The global leasing industry grew at a rate of 10% per year. A variety of leasing products, such as foreign currency leases, cross-border leases, equity leases, and so on, will be in high demand as the economy opens up. Leasing companies are projected to grow substantially in line with international trends. Leasing has a promising future in India. It is on the verge of a major breakthrough in industrial growth thanks to the government's liberalised economic policy initiatives. Leasing can be extremely beneficial to the industrial development process as a convenient and flexible financing option. With the government, the leasing industry has taken centre stage, and public sector undertakings are looking to the leasing industry to finance railway, telecommunications, transportation, energy, and infrastructure projects. Infrastructure financing, which is vital for economic growth, cannot be accelerated without the leasing market. The government has indicated that suggestions for enhancing existing policies are welcome. Such favourable circumstances, as well as a desire to avoid bottlenecks in taxation and other areas, will go a long way toward accelerating the industry's growth. 12.8 HIRE PURCHASE Hire purchase is a method of selling products. In a hire purchase contract, a financial company (creditor) leases the goods to the hire purchase customer (hirer). The buyer 145 CU IDOL SELF LEARNING MATERIAL (SLM)
must pay a set amount in quarterly instalments for a certain period of time. The land remains in the borrower's hands until the final instalment is paid, at which point it is transferred to the hirer. Features of a Hire Purchase Agreement 1. A hire purchase agreement allows the buyer to take immediate possession of the goods while agreeing to pay the total hire purchase price in instalments. 2. Each payment is treated as though it were a rent payment. 3. The hirer becomes the owner of the product until the final instalment is billed. 4. The seller has the right to cancel the contract if the buyer fails to pay any instalment. Right to reclaim possession of the goods from the buyer and retain the money already paid as if it were a rental fee 5. The hirer has the option to end the agreement before the property is moved. He has the option of returning the goods, in which case he will be released from all further obligations. He won't be able to get the money back because it was already paid as a hire fee on the goods in question. Legal Situation \"An arrangement in which goods are leased and the hirer has the option to buy them in compliance with the terms of the agreement in which: 1. Payment will be made in instalments over a fixed period of time,\" according to the Hire Purchase Act of 1972. 2. The owner receives possession of the property at the time of contracting. 3. The property in the goods passes to the purpose when the last instalment is charged. 4. Each instalment is treated as a hire fee since the instalment is forfeited if it is not charged on time. The seller reserves the right to delete goods from any instalment at any time. 5. The hirer / seller has the option of returning the product for free. Additional instalments are due after the return. Purchase Agreement for Hire A hire purchase agreement does not have to be in a specific format, but it must be written and signed by both parties. The following information must be included in a hire purchase agreement: (i) The representation of products in a way that allows them to be identified. (ii) The cost of the goods on hire purchase. 146 CU IDOL SELF LEARNING MATERIAL (SLM)
(iii) The effective date of the agreement. (iv) The number of instalments, the sum, and the due date for paying the hire purchase price. Purchase on credit and hire purchase The difference between a higher sales transaction and a credit sale is that the former is more expensive. In an actual sale, the property's title, or ownership and possession, is transferred to the buyer at the same time; however, in a hire purchase, ownership stays with the seller until the final instalment is charged. Purchase of a leased vehicle and the sale of a leased vehicle in instalments A hire purchasing agreement is not the same as a payment contract. When you use an instalment plan, not only do you get possession of the commodity, but you also get ownership of it at the end of the arrangement. Furthermore, if the buyer defaults on payments, the seller has no right to repossess the product. He has the exclusive right to sue the buyer for non-payment by returning the goods, but he also has the discretion to dispose of the goods as he sees fit. As ownership carries the risk, any loss of products should be borne solely by the buyer. Leasing and Hire Purchase The following factors distinguish hire purchase from leasing: 1. Possession The lessor retains possession of the products during the lease, and the lessee (hirer) has no option to buy them. 2. Sources of Funding Leasing is a way to finance business properties, while hire purchase is a way to finance both business and consumer goods. 3. Depreciation of assets The leasee cannot seek depreciation or investment allowance while leasing. The hirer will demand depreciation and investment allowance in a hire purchase agreement. 4. Tax Advantages The whole lease rental cost is tax deductible. The interest portion of the hire purchase instalment is the only part of the instalment that is tax deductible. 5. Recoverable Value Since the lessee is not the asset's owner, the asset's salvage value is not available to him. In a purchase, the hirer, as the asset's owner, benefits from the asset's salvage value. 147 CU IDOL SELF LEARNING MATERIAL (SLM)
6. Make a deposit The lessee is not expected to pay a deposit, while in hire purchase, a 20% deposit is required. 7. Rent-to-own We rent the goods with a contract, and we buy them with a hire purchase. 8. Financial Resources 100% funding is often the case for lease financing. It does not necessitate a down payment or margin money from the lessee right away. The hirer is required to pay a margin of 20-25 percent of the asset's cost in hire purchase. 9. Maintenance The hirer is responsible for the expense of maintaining the hired asset. The lessee is solely responsible for the management of the leased asset in the case of a finance contract. 10. Reporting is no exception. The hirer's balance sheet includes the asset on hire acquisition. The leased assets are only listed in the footnotes. 11. Hire Purchase Business: Bank Credit Commercial banks' subsidiaries lend to dealers or fund intermediaries who have already funded articles sold by dealers to hirers under a hire buy contract. The bank subsidiary must take special care when considering proposals from dealers or hire purchase financing firms, due to the unique nature of the transaction under a hire purchase contract. When a bank subsidiary is approached with this form of business, it evaluates the dealer's or hire purchase company's status and financial condition, as well as the principles of good lending, and follows the steps below: 12. The client When approached for a hire purchase service, the subsidiary could make an evaluation of the company customer's status and financial condition. 13. What is the goal? The type of goods used to fund a hire purchase transaction is extremely important. If the borrower defaults, the bank will consider repossessing and selling the goods to repay the loan. As a result, if the products can be easily sold elsewhere (for example, a relatively new car), these agreements have better protection than, say, camera agreements. Which of the two has a lower resale value? 148 CU IDOL SELF LEARNING MATERIAL (SLM)
14. Quantity Small individual loans should be discouraged by bank branches that enter the hire purchase market. It is therefore necessary to provide a floor cap on the number of individual hire purchase transactions in order to ensure proper servicing and monitoring. Although it is estimated to be around Rs. 50,000 in the car sector, it is estimated to be around Rs. 10,000 in the consumer durables sector. 15. Time limit Normally, the facility will be extended for three years. 16. Settlement of the debt The loan repayments are spread out equally, or as negotiated, over the term of the loan. The repayment schedule should be flexible to meet the needs of the hirer. The repayment may normally be tailored to match the income produced by the asset's use, making it self-financing. Repayment holidays are also permitted, and repayment is postponed until the asset is operational or profitable. It may be preferable to have institutional tie-ups with employers/employees' cooperative societies for which eligibility requirements can be laid down to ensure timely recovery in the case of car two-wheeler and consumer durable financing. 17. Safety and security Hire purchase advance is technically opposed to hypothecation of equipment/vehicles, promise of hundis / pro notes, and hire purchase agreement lodgements. To charge the protection under an equitable/hypothecation charge, the bank subsidiary will ask the borrower to complete the bank's form of security. If the applicant is a limited corporation with insufficient financial strength to qualify for an equitable / hypothecation facility and no adequate protection is available, it is common practise to obtain a debenture over the company's assets with a floating fee. If required, the bank subsidiary will ask the hirer to have a financial guarantor, and the bank will request that the guarantor approve the hundis as well. Some banks need an insurance policy to protect the bank against the hirer's default. The hirer would be responsible for the premiums. Given the high cost and complexity of repossession of a rapidly depreciating asset, the customer's capacity to repay is critical, and protection is not used. 18. Control and Monitoring The Bank must maintain leverage over the current situation. At monthly intervals, a quarterly certificate should be received from the finance firm, specifying the total amount of outstanding but excluding those hire purchase agreements that have become delinquent and are therefore suspicious. One or two months in arrears might be 149 CU IDOL SELF LEARNING MATERIAL (SLM)
appropriate, but more than that indicates a permanent default by the hirer. The Bank will hold a running total of these sums and refund any lapsed agreements to their customers. 12.9 SUMMARY Leasing is a financial arrangement that allows a business to use an asset without having to buy it outright. Leases come in a variety of shapes and sizes. A lease involves two parties: the lessor and the lessee. The lessor gives the parties involved in a lease arrangement a range of benefits. Leasing is beneficial to both the lessor and the lessee. Leasing enables quicker production and sales of goods, as well as tax benefits for the lessee, a boost to the stock market, a more affordable source of capital funds, and the avoidance of capital outlay. Leasing, on the other hand, has many drawbacks. Hire purchase is a contract under which the owner leases his goods to the hirer and gives the hirer the option to buy the goods at a later date if the terms of the contract are met. 12.10 KEYWORDS (IAS-17) International Accounting Standards (SBU) Strategic Business Unit Hire purchase is a method of selling goods. Bipartite Lease is an agreement between equipment supplier-cum- lessor Tripartite Lease is a lease between equipment supplier, lessor and lessee 12.11 LEARNING ACTIVITY 1. Create a Bipartite Lease agreement between a Supplier & Lessor. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a Tripartite Lease agreement between supplier, lessor & lessee. ___________________________________________________________________________ ___________________________________________________________________________ 12.12 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Discuss briefly about Operating Lease. 150 CU IDOL SELF LEARNING MATERIAL (SLM)
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