Financial Institutions And Markets

8/5/2009

Financial Institutions and markets EXPGP(PT)-2008-11 Session 9

• Money Markets contd…

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Call Money / Notice Money • What is it ? • The call money market is the most liquid of the short term money market segments. Call Money/ notice money represent the borrowings made for a period of 1 day to a fortnight. • The call/notice money market forms an important segment of the Indian Money Market. Under call money market, funds are transacted on overnight basis and under notice money market, funds are transacted for the period between 2 days and 14 days. • Participants in the call money market – All scheduled commercial banks ( except RRBs) – All co operative banks other than land development banks – Primary dealers like SBI-Discount and Finance House of India (SBIDFHI) and Securities Trading Corporation of India Limited( STCI) and others. 3

Call Money / Notice Money …. Contd.. • SBIDFHI : • It was set up jointly by RBI, SBI ,some other public sector banks and some other financial institutions in 1988. The main function of DFHI was to smoothen the short term liquidity imbalances by developing an active secondary market for the money market instruments in general ( basically to play the role of a market maker).

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Call Money / Notice Money …. Contd.. •

Securities Trading Corporation of India Ltd. (STCI) was a similar institution established by Reserve Bank of India (RBI) in May 1994, jointly with public sector banks and all-India financial institutions.

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the main objective was to foster the development of an active secondary market for Government securities and bonds issued by Public sector undertakings, FIs, Corporates etc.

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The Company was incorporated with an authorised and paid up capital of Rs. 500 crores of which RBI contributed 50.18 per cent. RBI later on divested its shares in favour of other shareholders.

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Presently Bank of India is the major shareholder with 29% followed by State Bank of India and Associates 10.5%, and IDFC 10%. The remaining portion is held by other Public Sector Banks and Financial Institutions.

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Call Money / Notice Money …. Contd.. • • • • •

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Primary Dealers are a group of market makers in government securities introduced in India in 1996 by RBI. Principal objectives were to strengthen the liquidity available in the money market securities, and to increase the transaction volume in the secondary market for efficient price discovery. Eligibility Criteria for being a PD: Should be incorporated under Companies Act,1956 and should have previous experience in securities business primarily Govt. securities. Should have minimum net owned fund of Rs.50 crores or above. Net owned funds represented by paid up capital, free reserves and balance in share premium account and other capital reserves less accumulated loss and book value of intangible assets). Some of the major PDs are ---Currently around 11 PDs are operating . Some of them are : Stand Alone Primary dealers like :SBI-DFHI,STCI Primary dealer Ltd. ICICI Securities and primary Dealership ltd, PNB Gilts ltd., IDBI Gilts ltd., Bank Primary dealers : BOB, Can Bank, HDFC Bank, HSBC Bank, Kotak Mahindra Bank etc.

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Call Money / Notice Money …. Contd.. • Purpose of Call money Market: • i)Provide a mechanism for dealing with very short term mismatches in inflows and outflows of funds. • Example : Banks mobilize savings deposits and deploy them at longer term investments to earn more returns. Now withdrawals by the customers vary ( since it is effectively a demand liability).Banks thus have to resort to borrowing from the money market to meet these short term maturity mismatches such as large payments and remittances. • ii) Secondly the banks borrow from the call money market to meet CRR requirements, which they should maintain with RBI on a fortnightly basis. Currently the CRR stands at around 5.5% of the NDTL( Net demand and time liabilities). • iii)Thirdly ,money is borrowed from the call/notice money markets for short periods to discount commercial bills.

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Call Money / Notice Money …. Contd.. • Turnover : • The daily turnover of the call money market varied between 15,000 to 30,000 crore during 2008-09. • Call rates: • The interest rates charged on call money is known as the call rate. • The call rate varies from day to day and often from hour to hour .The call rate reflects the demand supply situation of short term money. • Currently the call rate stands at 3.0-3.30 % 8

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LAF corridor and the call rate •

The call rate generally lies between a corridor set by the Repo rate ( rate at which banks take secured loans from RBI ) and reverse repo rate ( rate at which banks park excess funds with RBI against securities as collateral). The corridor is known as the LAF corridor or Liquidity Adjustment Corridor with the Repo rate and the reverse repo rate forming respectively the ceiling and floor of the corridor.

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The corridor may however be breached sometimes due to lack of demand from the respective ends.

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If the RBI is not absorbing enough liquidity( in case it is not having enough securities to keep as collateral ) then the banks with surplus funds may lend in the call money market at a rate lower than the Reverse repo rate and hence the floor will be breached , and if the banks do not have enough securities to keep as collateral with RBI they would rather take an unsecured loan in the call money market at a rate higher than the repo rate and thereby breach the ceiling .

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Dealing Session Deals in the call/notice money market can be done upto 5.00 pm on weekdays and 2.30 pm on Saturdays or as specified by RBI from time to time.

Call Money / Notice Money …. Contd.. • •

Operational Mechanism: The dealings happen through a screen-based negotiated quote-driven system (NDS-CALL) launched since September 18, 2006 , and once a deal is struck, the funds are immediately available to the borrowing bank and are repaid with interest on the next /due date.( also electronically).

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In case of lenders and borrowers who are non members of the NDS-call, the funds are lent and paid back through a banker’s pay order which is cleared by a special high value clearing cell of RBI.

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All dealings in call/notice money on NDS-call ,do not require separate reporting.

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For deals done outside the NDS-call, it is mandatory for all Negotiated Dealing System (NDS) members to report their call/notice money market deals on NDS. Deals should be reported within 15 minutes on NDS, irrespective of the size of the deal or whether the counterparty is a member of the NDS or not. In case there is repeated non-reporting of deals by an NDS member, it will be considered whether non-reported deals by that member should be treated as invalid. Deals between non-NDS members will be reported to the Financial Markets Department (FMD) of RBI by fax as per a prescribed form.

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The reporting time on NDS is upto 5.00 pm on weekdays and 2.30 pm on Saturdays or as decided by RBI from time to time.

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Repurchase Agreements (Repo) • A repurchase agreement (repo) is the sale of securities by a repo dealer( a bank) to a counterparty, combined with a simultaneous agreement by the repo dealer to buy back the securities at a future date at the original sale price plus interest. • The securities used in a repo transaction are usually govt. bills or bonds, or other very high quality issues. • Most repo trades are very short term, the repurchase date being typically between one week or two weeks from the date of transaction. • RBI is typically a lender to the banks through the repo. • If RBI is one of the parties it is called an RBI repo, if it is between two FIs it is called a market repo.

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Repurchase Agreements (Repo) • •

Although technically a sale of securities and its subsequent repurchase, a repo is essentially a short term secured loan with the collateral provided by the securities. Whereas an interbank loan is an unsecured loan , a repo is a secured short term loan.

Securities Initial Transaction (Sale)

Repo bank

Customer

Terminating Transaction (Repurchase)

Principal (Cash)

Securities

Customer

Repo bank

Principal Plus Interest (Cash)

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Repurchase Agreements (Repo) • A Typical Repo Agreement should specify the following : • Which of the securities held by the borrower will be acceptable to the lender as collateral. • How these securities should be valued and what price the lender would be willing to pay for them i.e how much could be made available against the securities. • What the term of the loan would be i.e what the sale and repurchase dates would be • What the repurchase price would be i.e what the interest rate for the loan would be.

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Repurchase Agreements (Repo) • •

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Margin/Haircut/additional margin Securities provided as collateral may fall in value during the term of the agreement. If this were to happen, the security held by the lender bank could even be less in value than the amount of the loan, and thus a part of the loan would become unsecured. Because repo is meant to be a secured loan arrangement, this situation should be unacceptable to the lender. This could be dealt with in two ways : – a) The borrower is required to provide securities as collateral with a market value in excess of amount of money borrowed. The difference between the value of securities provided and the amount of money lent is known as margin/ haircut.

– b) If the securities fall in value to the point where their current market value is less than the amount of funds lent, the borrower is required to provide additional securities with a market value sufficient to make up the deficit.

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Repurchase Agreements (Repo) • •

Settlement of Repo transactions: The transfer of securities and funds… normally done within T+1. Transactions happen through NDS .

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Repo transaction Mathematics: Example : Bank A wants to take a 7 day repo loan from bank B, of $50 million. Collateral will be provided by 8% US Treasury bonds with face value $100 ,that have a market value of 102.00. It is agreed that their value for the purpose of the repo should be 101.00, and the interest rate payable should be 7.5% per annum. What is the margin and what will be repurchase price of the bonds? ( Day count =actual/360) No of bonds obtained for $50 million = 50 million/101 = 495049 The market value will be 102 x 495049=$50,494,998 The margin is therefore = $494,998 The repo interest is =7.5%x $50 million x 7/360= $72,917 The amount paid finally = $50,072,917 The repurchase price = 50,072,917/495049=101.147

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Repurchase Agreements (Repo) • Reverse Repo: • Reverse repo is an agreement in which a dealer buys securities from a customer and at the same time promises to sell them back at a future date at an agreed price. • Whereas a repo is a form of money market lending, a reverse repo is a form of money market investment. Banks park their short term surplus with RBI using this rate. • In every repo transaction, while the borrower enters into a repo agreement, the lender virtually enters into a reverse repo agreement.

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Repurchase Agreements (Repo) • Why are Repos used? • Enables financial institutions and banks to carry their inventories of securities in the most cost effective ways. The securities can be used to raise temporary cash, and achieve lower interest costs on the borrowing because of the high quality of the bonds and bills provided as collateral. • From an investment point of view, repos offer investors( lenders) attractive yields on short term investments, combined with top quality collateral. • Monetary Policy tool used by the central bank: Increasing the repo rate would make borrowing expensive for banks and as such reduce the quantum of money in the economy. Reducing would imply the opposite. As and when the repo rate is adjusted the reverse repo rate is also adjusted in the same direction. • Currently the repo rate stands at 5% and the reverse repo rate at 3.5% 17

Repurchase Agreements (Repo) • Open Market Operations(OMO): • Purchase or selling securities by the govt. in the money market, primarily in order to inject money into the system, or siphon money out of the system, and thereby control the interest rate. • The measures resorted to by the Govt. are the following: – By purchasing or selling money market instruments – By making repo transactions – By short term direct lending to banks with a shortage of funds.

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Certificates of Deposits … CDs • Banking sector money market instrument…. Basically an IOU issued by a bank to the investor. • It is an instrument issued by a bank or savings institution in the form of a promissory note against a term deposit made. • Because a maturity date is mentioned a CD is a term security as opposed to a demand deposit. • Being negotiable instruments ,they are also referred to as Negotiable Certificates of deposit or NCDs. That means that CDs are bearer instruments i.e whoever holds the instrument at maturity receives the principal and interest. There fore the original investor after subscription can easily go to the secondary market and sell the security at a discount. 19

Certificates of Deposits … CDs… contd.. A Typical CD : Name of the bank/institution No.

Rs.__________ Dated:______________

NEGOTIABLE CERTIFICATE OF DEPOSIT _____________months/days after the date hereof, _________________,at _____________, hereby promise to pay to _______ __________ or order the sum of Rupees ____________________ only, upon presentation and surrender of this instrument at the said place, for deposit received. For ____________ Date of maturity _______________ without days of grace. ___________________________________________________________

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Certificates of Deposits … CDs… contd.. • Origin of CDs: • In India, CDs were introduced in 1989 based on recommendations by Vaghul Committee( 1987). • In US and UK they were in introduced in the 60s decade, while in some other developed countries like Japan, France, Germany, Australia, New Zealand, South Korea etc. they were introduced sometime in between 1970 and 1985.

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Certificates of Deposits … CDs… contd.. • Eligibility to issue: • As per the latest RBI guidelines, CDs can be issued by : • (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and • (ii) select all-India Financial Institutions (EXIM bank, NHB, NABARD and SIDBI)that have been permitted by RBI to raise short-term resources. • Subscribers: • CDs are available to individuals, corporations, companies, trusts, funds, associations etc. for subscription. • NRI s can also subscribe but on a non repatriable basis i.e they will have to hold till maturity--- cannot endorse to another NRI in the secondary market.

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Certificates of Deposits … CDs… contd.. • CDs and Time deposits compared : • Apparently the CDs and time deposits look similar. Both are obligations on the part of a bank or a savings institution, to pay a fixed sum of money at a specified date in future, against some initial deposit received. • Both have maturities ranging from 15 days to around 1 year. • The principal difference is however the negotiability attribute of CDs. They are bearer securities and freely tradable in a secondary market which the time deposits are not. This enhances the liquidity of CDs to a great extent and is a major advantage over ordinary time deposits. • Another principal difference is that for a time deposit, it is generally customary for banks to maintain uniform rates of interest across board for similar maturities. However for CDs the interest rate may be determined on a case to case basis. 23

Certificates of Deposits … CDs… contd.. • Criteria on maximum amount that can be issued : • Banks have the freedom to issue CDs depending on their requirements. But the fund mobilised by CD is considered a part of the normal deposits and will draw reserve requirements.

• An FI other than a bank (SIDBI, NABARD and NHB) may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments, viz., term money, term deposits, commercial papers and inter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.

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Certificates of Deposits … CDs… contd.. • Minimum Size of Issue and Denominations •

Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted from a single subscriber should not be less than Rs. 1 lakh and in the multiples of Rs. 1 lakh thereafter.

• Maturity • The maturity period of CDs issued by banks should be not less than 7 days and not more than one year. • The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the date of issue. 25

Certificates of Deposits … CDs… contd.. • Pricing of CDs:

• CDs are discount instruments. • But unlike bills and some other instruments where prices may be quoted as a discount rate, CD prices are generally quoted on yield to maturity basis. V • Therefore the price will b given by : P = YxD 1+ 365 • Where P is the sale price( initially)/purchase price( in secondary market) of the CD • V is the value of the sum payable at maturity • Y is the required yield on the CD • D is the number of days to maturity

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Certificates of Deposits … CDs… contd.. • Example 1.)A three month CD is issued on 6 September 1999, and matures on 6 December 1999 ( Maturity 91 days). The CD requires a deposit of Rs.20,000,000 by the investor and assures an interest rate of 5.45% to be paid at maturity along with the principal. What should be the secondary market proceeds for the CD on 11 October if the yield for short 60 -day paper is 5.60%? (Day count = actual/365) • Solution: • Maturity value = 20 million x(1 + 0.0545 x91/365) = 20,271,753 • No of days from 6 Sep to 11 Oct =35. Therefore remaining days to maturity = 56 days • P on 11 October =20,271,753/(1+0.056 x 56/365)=20,099,066

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Certificates of Deposits … CDs… contd.. • Example 2: A CD is issued for a deposit of Rs. 1 million with a term to maturity of 91 days. At the end of this term, accumulated interest rate will be Rs.16,000. Find the money market yield of the CD. If the initial buyer sells the CD, just 7 days after the issue when the yield of similar securities is 6.25% per annum find the proceeds from that sale? If the second buyer sells the CD after another 38 days when the yield for similar securities is 6.1% per annum, find his return over this holding period of 38 days. • • • • • •

Solution: Maturity value = Rs.1,016,000 Initial yield expected = ((1,016,000/1,000,000)-1)x365/91=6.4176% P after 7 days = 1,016,000/(1+ 0.0625x84/365)=1,001,594. P after another 38 days i.e after 45 days from issue or with 46 days remaining maturity =1,016,000/(1+0.061x46/365)= 1,008,248.914 Return to this investor will be = ((1,008,248.914/1,001,594)-1)x365/38=6.38%

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Certificates of Deposits … CDs… contd.. • Issue / Maturity payment: • CDs could be issued in physical or demat form. FIs can issue only in demat form. • For issuing in demat form, the issuer needs to have an agreement with a depository. The investor is required to fill a prescribed application form and submit it along with cheque/pay order for appropriate amount to the issuer. • Banks are not allowed to buy back their CDs prematurely. On maturity, the instrument is presented to the issuing bank and payment is made available to the holder. No grace period is normally allowed. 29

Certificates of Deposits … CDs… contd.. • Secondary market Trading : • CDs are freely transferable by endorsement and delivery in the secondary market, immediately after the issue. In fact they can be traded from the date of the issue itself . • In case the CD is in physical form, the buyer is supposed to receive the original CD duly endorsed in his favour by the seller. For a demat form, the seller needs to give instruction to his DP for a transfer. • Settlement takes place on T+1 basis unless otherwise mentioned specifically.

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