Finance: Factoring-Part II

In an earlier article, we had studied the definition of Factoring.  In this article, we shall examine how a factoring transaction takes place practically.

Example:  M/s.Omega Foods is an upcoming  manufacturer of processed health foods for humans, based in Connecticut.   The Company’s products are gaining in popularity through the United States.   In the last year(2008), the Company had recorded sales of USD: 2.02 million.   The Omega range of health foods is widely available in the U.S., from the local Mom and Pop stores to some of the larger  Supermarkets.

M/s.Omega Foods distributes their merchandise in U.S.A. through a network of 65 distributors and dealers.   Further, they afford 35 days credit to them, on their bills drawn on these distributors and dealers, that is their buyers.

M/s.Omega Foods has an arrangement with Alpha Factors, a Company engaged in the business of Factoring, to avail of this facility to the extent of USD: 0.50 million at a time.   Under this arrangement, Alpha Factors advances money to Omega Foods, against their invoices drawn on their buyers.  

Let us assume that Omega Foods have made a sale of USD:0.25 million to M/s.Super Stores.   As per arrangement, Omega Foods notifies their buyer Super Stores of the factoring arrangement it has with Alpha Factors, and forwards a set of commercial documents including the invoice to Super Stores.   Simultaneously, it forwards another set of the documents to Alpha Factors.   Omega Foods have given 35 days credit to Super Stores to make good the payment for the merchandise supplied by them.

Alpha Factors scrutinize the documents submitted by Omega Foods, and finding them in order, remit USD:244,000.00 to Omega, as against the invoce value of USD:194,000.00.   Of the difference amount of USD:56,000.00, USD:50,000.00 represents the reserve amount retained by the Factor against possible payment default by the buyer,  USD:5,000.00 represents the discount at which the Factor has advanced money to the seller, and USD:1,000.00 represents the interest charged by the Factor for the 35 days that it will be out of funds, till the buyer reimburses it.

Let us assume that Super Stores have honored their committment under the factoring arrangement, and have remitted the amount of the invoice i.e. USD:250,000.00 to the Factor, within the stipulated time of 35 days.   Thereupon the Factor would release the reserve amount of USD:50,000.00 to the seller.   This would complete the transaction.

However, not all factoring transactions end happily.   Sometimes the debtor may default in paying the Factor and putting the Factor to financial risk/loss.   In the above example, let us assume that the buyer, Super Stores have defaulted and failed to pay the Factor in time.   The Factor, would, then have to either recover the money from Super Stores, or write it off eventually, as a bad debt.   The Factor does not have remedy against the seller, Omega Foods, unless the contract provides for a with recourse to seller provision.

In the with recourse to seller factoring contract, the Factor has the right to recover from the Seller, the amount defaulted in by the Buyer, that was advanced to the Seller (by the Factor).   In this example, if Super Stores were to default upon payment to the Factor, then Alpha Factors would have recourse to Omega Foods, and recover the same from them.   Usually this is done by submission of another invoice by the Seller to the Factor, who adjusts the outstanding from the earlier transaction, by advancing money against the new invoice.   Of course, the Seller has the choice to reimburse the Factor, with his own money.  

An important point to note in a with recourse to seller factoring transaction, the Factor would not get the same level of returns as in the without recourse factoring transaction, because of the elimination of risk in the latter case.   Another way out for the Factor is to obtain insurance against the Buyer’s default.

In future articles, we shall study the risks and prospects of factoring business to those involved in it.

                                                                                       To be concluded.

Financing: Factoring-Part I

Introduction:  One of the major stumbling blocks faced by a buiness is the financing of it.   A business requires money for various activities and purposes.   For example, a manufacturing concern requires money for procuring the raw materials, and processing the same into the finished goods.   That apart, money is required to pay the wages of the workforce,  servicing of the plant and machinery, upkeep of the premises, marketing of the products, etc.   Every stage of operations of the business requires infusion of money to ensure smooth functioning and to achieve the business goals.

Over a period of time, different methods of financing business have evloved.   The type of financing required by a business depends upon the nature of its activities, and related issues.   For example the type of financing required by a manufacturer of Televisions is different from that required by a Software Development Company.

Factoring:  Factoring is a type of financing available to any business that engages in sale of goods and services through the medium of the Invoice.   Practically, every business engaged in selling ‘raises’ an invoice on its buyer or client.   An invoice is a commercial document that provides details of the product or service being supplied, the unit price of each item of sale, the delivery terms, taxes where applicable, any discounts given, other charges if any, etc.   It also stipulates the time within which the buyer must pay for the goods and services.   This commercial document(invoice) represents the account receivables of the firm.   That is, the money that the firm will receive upon supply of the goods and services mentioned therein, from the buyer.

Now the seller of the goods and services as above, has two options to realize the proceeds of his sale.   One, he can wait for the buyer to make the payment in the normal course against the delivery of the goods/services as per the contract terms.   Second, the seller can also approach a ‘Factor’ to encash the invoice immediately.   The Factor is the financier who advances money to the seller against his invoices, that represent the seller’s receivables, at a discounted rate, and collects the full value of the invoice from the buyer. 

To clarify further, factoring is the financing of accounts receivables of the seller at a discount, and realizing the full proceeds form the buyer, now the debtor.   The factor first pays the seller, the realizable value of the goods and services evidenced in the invoice at a discount, and then recovers the full value of the invoice from the debtor, the buyer.

In a transaction like this, the factor, who is parting with his money, has to make sure of getting it back, not from the seller, but from the buyer.   Therefore, the financial standing and the creditworthiness of the debtor is of primary imoratance to the factor, more than that of the seller.   If the debtor defaults on payments, then the factor has  to suffer a loss.   As such, the factor would satisfy himself with the solvency of the debtor before engaging with him in this transaction.

There is another kind of factoring arrangement, called with recourse factoring.   It is similar to the regular or without recourse factoring, except that, in the event of default by the debtor, the factor has recourse to the seller, who has to make good the loss suffered by the factor.   That is the factor can recover the money advanced to the seller from the seller himself, alongwith his charges, etc., in case of the buyer’s default.

As can be seen, the with recourse factoring transaction is safer and more favorable to the factor.   However, for the same reason, that it is safer, it is also less remunerative to the factor.   The revenues and profits accruing to a factor are in proportion to the risk he undertakes under the transaction.

In future articles, we shall study how a factoring transaction actually looks like, the relative advantages and disadvantages of this type of financing for a business etc.

                                                                                          To Be Concluded

FINANCE: VENTURE CAPITAL PART II

In a previous article we studied what is Venture Capital.   In this article, we shall take a look at how it works.

How It Works:  Adam Kowalski is a Polish immigrant to U.S.A.   He is one of those millions of to-be-legends that came to New York with less than 50 Dollars in his pocket, and a brilliant idea in his mind.   Back in Warsaw, Poland, Adam was fascinated with cars, as a child.   But one thing that bothered him about cars was the fumes they spewed, that made him sick.   So he resolved, one day, to do something about it.   That ’something’ took the shape of a chemical treatment process for the car’s silencer that could reduce carbon monoxide emissions by about 25%!  

 The silencer is the last part of the machine from where the carbon monoxide laden fumes exit into the atmosphere.   Adam’s process cleansed the fumes before they ejected into the atmosphere, thereby reducing the carbon monoxide content by about 25%.   He conducted several experiments in his modest ‘lab’ in Warsaw, and was convinced that he was on to something with great potential.   The problem was how to get if off the lab table and into the real world.   That would be the real test for his ‘baby’.

So Adam, like millions around the world, packed his bags, and landed in New York, and started working to realize his dream.   To cut a long story short, Adam came in touch with one Mr. John Anderson, who ran a Venture Capital firm by name, Jack, Jones, and Associates.   The firm had contributors drawn from wealthy individuals, and a few mid size firms based in New York.  

 Anderson realized that Adam’s idea was brilliant, and had great potential for growth and profits.   However, it was equally risky.   In effect, this tecnology would mean, that every eleven cars on the road would spew out carbon monoxide equal to that of only ten cars.  That meant one car off the road for every ten fitted with this mechanism, in terms of carbon monoxide emissions.

But there were hurdles to be crossed before this product could see the light of the day.   It depended on how the car manufacturers would receive the new product, that  would mean investing additional dollars into the manufacture, and consequently increasing the cost of the machine to the consumer.   While an average car buyer would appreciate technology that would give him better mileage and save him some dollars,  to convince him to pay more for the car to ’save’ the environment was quite another thing.  

Moreover the political environment was also not favorable.   The Bush Administration was opposed to the Kyoto Protocol on Climate Change, and generally not in favor of any legislation, that was against the ‘American way of life’.   But Anderson knew that this technology had a lot of promise for growth and profits.   And the Bush Administration was on its last legs.   Soon there would be a change and things would look up, and cleaner and greener technologies would get a boost from the new Administration.

So, Anderson decided to back the project and helped set up a company called Greener America, and committed 50 million dollars of his V.C. firm’s money to it.    In return, he got a 50% share in the new venture, apart from say in the most important decisions of the new company, especially those related to finances, and recruitment.

As it so happened, the Bush Gang got a drubbing in the ensuing elections, and soon America was treading a new, uncertain path that held great promise, and potential, but was equally risky.   Just the kind of situation for a Venture Capitalist, in politics!

Anderson patted himself on the back for a wise decision taken.   He estimated that the new company would break even in about 2 year’s time, and thereafter, it would be ripe for either a sale, or public equity.

This is an example of how venture capital works.   To sum up, venture capital fills a need for financing of new ventures that are not mature enough for either Bank financing or public participation through IPOs.   Though the entreprenuer may not get the best deal possible, at least his idea becomes a reality, and brings him glory and money.

                                                                               Concluded                                       

 

FINANCE: VENTURE CAPITAL PART I

What is Venture Capital:    Venture Capital may be defined as capital infused in ventures that are new, untested and risky, but with high potential for growth and profits.   Venture Capital is financing of untested technologies, processes, systems, or products that have no guarantee of success, but tip the scales in favor of investing in them, on account of their high potential for growth and profits.  

Attraction and  Scope:  Success in a venture of this kind holds the promise of capturing the whole, or at least a good part of the market, for that particular product or service.   It is this tantalizing  prospect of cornering the market, and consequently driving away the gravy car home, that persuades a Venture Capitalist to risk his money on these ventures.   Of course, the prospect of such high growth and profits naturally begets with it, the risk of losing it all.   All or Nothing is a common feature of venture capital financing.  

Venture capital is akin to private placement.   The players involved here are high networth individuals, or institutions, who contribute or pool together their resources for investment through the medium of specialist investment firms.   These investment firms look out for opportunities of high returns against high risk, and identify projects that are relatively new and yet to establish themselves.   And because they are not established players, these new projects or ventures are not in a position to either raise Bank loans on favorable terms, or go in for public subscriptions(IPOs). 

This vulnerability of the venture attracts the Venture Capitalist, who offers to take a stake in the company on profit and loss basis.   That is, the Venture Capitalist is prepared to bear a loss also in the event of the venture not doing well, which is not the case with traditional financiers like Banks.  For the new venture, that has a brilliant idea to work on, but not in a position to crystallise the same on account of want of funds, this offer of the Venture Capitalist is irressistible.   However, there is also a flip side to it.   The Venture Capitalist also demands a significant control on the decisioin making within the venture.   This is, of course, in addition to his control over the ownership of the venture(to the extent of his investment).   This poses a classical dilemma to the inventor, or entreprenuer who is willy nilly forced to accept the proposition of the venture capitalist.

The Venture Capitalist, who may be a individual or a firm, pools finances from interested persons or companies, and invests in new ventures as discussed above, with the objective of making a neat profit by providing crucial and much needed financial support to the new venture when it needs such assistance most.   In return for taking the trouble and the risk of associating with a venture that is struggling to find its feet, the Venture Capitalist hopes to end up with his pot of gold, when the venture is either sold off, or goes public.   Of course he is prepared to lose his investment in the process.   But for the venture capitalist, it is a fair gamble.

Apart from providing finances, the Venture Capitalist may also contribute managerial and technical expertise to the venture.   This is to ensure that there is a reasonable chance for the venture to succeed.   Often, and especially, technically brilliant people lack the managerial and financial acumen to make their venture a commercial success.   They come up with a product that perfectly fills a void in that particular area, but inablility to handle the commercial aspects of the venture, be it financing, or marketing can prevent the venture from realizing its full potential, if not end up a flop.

In the next part of the article, we shall see how the V C system works.

                                                                                    To be continued.

BANKS AND CAMELS!

Introduction:   What does a Bank have to do with CAMELS?   Plenty!   It could be the deciding factor in a Bank being allowed to function, or even being shut up.   The higher the Bank climbs up the CAMELS, more the chances of it being done in!   This is one score a Bank would do well to keep low!

Actually, CAMELS is the acronym for the six factors that form the basis for an international Bank rating system.   These six factors are: Capital Adequacy, Asset Quality, Management Quality, Earnings, Liquidity, and Sensitivity to Market Risk.

Uner the CAMELS rating system, Banks are rated in relation to the quality of these six factors.   The strength of these six factors would determine the overall strength of the Bank.   The quality and strength of these six factors underlines the inner strength of the Bank and how far it can take care of itself against the market forces.   Further, it also enables the regulatory authorities to focus on the Banks that are not doing well and to pay special attention to them. 

The regulatory authorities not only study the financial statements of the Bank, but also carry out on site inspection, and thereafter rate the Bank.   The rating system is based on a scale of 1 to 5 with 1 being the highest score and 5 the lowest.   Banks scoring 1 would be considered as among the top bracket in regard to their financial soundness, and those scoring 5 would be seen to be at the bottom of the ladder.

Purpose:  The purpose of this rating system is to examine the financial and other soundness of the Bank, and  alert the top management of the Bank to take timely measures to address any deficiencies and stop the Bank from sliding to the bottom of the heap.

The CAMELS rating is carried out with reference to the following factors:

1)  Capital Adequacy:  Every Bank is expected to have sufficient capital to address its needs in relation to the risk it undertakes in its operations.   The ratio of the capital of a Bank in relation to its risk weighted assets must meet the minimum requirements.

The Basel II Accords promoted by the Bank for International Settlements, Basel, Switzerland, stipulates a minimum Capital Adequacy Ratio of 8%.   This is the bare minimum required, and Banks are strongly recommended to have a comfortable Capital Adequacy Ratio that takes care of any ontoward occurances.

The need for sufficient capital cannot be overestimated.   It is the base on which the Bank stands, and its strength can be guaged by the strength of its base.   The edifice of the Bank draws its strength and succour from the foundation of capital.

In line with the need for a strong capital base of a Bank, the Bank for International Settlements has come out with an elaborate set of erecommendations that are expected to put in place, a mechanism, that is proactive and responsive to the needs of the Bank in countering the threat to its well-being from the elements of risk.   For this purpose, weights are alloted to each type of risk the Bank faces in its day to day operations, and accordingly, the amount of capital required to face up to this risk is worked out.

2)  Asset Quality:  The term Asset Quality refers to the quality of the loan portfolio of the Bank.   Lending being one of the primary activities of a commercial Bank, the welfare of the Bank is dictated to a large extent, by the quality of its loan portfolio.   A sound loan portfolio means a steady income for the Bank, apart from adding to the solvency of the Bank and consequently its rating.

To ensure asset quality, the Bank has to follow a sound lending regimen that ensures compliance of all the related norms.   Some of the parameters for judging the soundness of a loan account are the components of safety, security, liquidity, purpose, profitability, etc.

In the process of lending, Bank has to take all reasonable precautions to ensure the safety of its funds.   The evaluation of credit proposals must focus on the technical feasibility and the financial viability of the project, or venture under consideration.   The purpose of the loan must be in consonance with acitivites that relate to productive application of capital.   The result of such application should be the generation of a stream of income necessary for repayment of the loan.   The quality of loan assets, to a large extent determines the viability of a Bank as a running concern.

3)  Management:  By Management is meant the art and science of accomplishing the goals of the institution by deploying all the necessary resources appropriately.   Management includes Planning, Organising, Staffing, Directing, and Controlling functions.

Planning is concerned with drawing up the blueprint for the objectives and goals of the Bank, and lay the path to reach them.   Planning is a all encompassing activity that touches upon all the activities of the Bank.

Organising is the next step after planning, and is concerned with putting in place the necessary infrastructure, including human resources to achieve the Bank’s corporate goals.

Staffing, as the term indicates, is concerned with filling up the various positions in the Bank with suitable people.

Directing means channeling the energies of the employees towards achieving the Bank’s corporate goals, by motivating the employees with rewards, both monetary, as well as in terms of their career goals.

Controlling is a function of management that involves establishing a performance standard for the employees and taking suitable steps in regard to the principle of reward and punishment.

A Bank that scores high in this area, namely, management, is bound to come up with a strong performance, and also contribute to the solidity of the Banking industry, as a whole.

4)  Earnings:  The earnings of a Bank refer to the net profit made by it.   Profit is the difference between income and expenditure.   The major sources of income for the Bank are interest earned on the loans and other income derived from general banking activities like, remittances, bills, etc.   Apart from these, related activities undertaken by the Bank like Bancassurance, etc, also contribute to the Bank kitty.

The expenditure of the Bank may relate, among other things, to salaries, wages, administrative overheads, rents, rates, taxes, etc.   The net surplus that remains after taking care of all the expenses is the net profit.

A healthy Bank should be able to generate decent profits regularly and keep itself, as well as its investors, in good health.

5)  Liquidity:  Liquidity is simply the ease with which an asset of the Bank can be encashed in times of need, or its fair value.   It is that quality of an asset,that enables a Bank to respond to any financial situation requiring urgent infusion of money or money’s worth.   This quality of the asset ensures that a Bank faces the minimum stress in dealing with such situations.

Apart from a financial cirsis or crisis like situations, liquidity is also required to meet regular financial obligations of the Bank, especially without dipping into its reserves.   Liquidity marks the ability of the Bank to field expected as well as unexpected financial problems and issues.

6)  Sensitivity to Market Risk:  Market forces are a major reason for shifts in the fortunes of businesses.    Favorable movements can boost the fortunes of a Bank, whiule  unfavorable ones can send the Bank packing to the cleaners.   Market forces generally relate to the changes in Interest Rates, Currency Rates, Commodity Rates, and Stock Prices.   Further these changes are inter-related in a complex way, and disturbances in one area are usually accompanied with the same in other areas.

A sound Bank is expected to hve  sound risk management practices in place, to take care of both known and unknown risks.   The asset-liability match of the Bank must be in consonance with risk management principles.

Conclusion:  The current Banking Crisis, which is quite unprecedented, underlines the importance of regulatory issues and the affects of incompetence in this area.

CAMELS, as a rating system for judging the soundness of Banks is a quite useful tool, that can help in mitigating the conditions and risks that lead to Bank failures.

BANKING AND FINANCE: DERIVATIVES

Introduction to Derivatives:  ”Necessity is the mother of invention”.   Humans have always been inventive through their sojourn in this world, and have come up with innumerable inventions that have made their lives comfortable.   Sometimes, though, they have done themselves and their world a lot of harm with their inventions.

While many of the human inventions fave fulfiled a genuine need, some inventions have served only their contrived needs, and yet  others have catered to the baser instincts of man, primarily, greed.

Into which of these above categories does the financial instrument called derivatives fit in?   Does it serve a genuine need or a contrived one, or only serves to pander to man’s greed?   In the light of the present Banking crisis, said to be triggered by the housing mortgage crisis, it would appear that derivatives fall in the last category, that is , to pander to man’s greed.

Be that as it may, it is worthwhile to study the subject of derivatives, if only to avoid such pitfalls in the future.

Definition:  A derivative is a kind of financial instrument that does not have a value of its own, but derives it from an underlying base.   This base may be an asset, or an index, or even a phenomenon.   In a way, a derivative resembles a parasite that feeds off its host.

Derivatives do not have an independent existence of their own.   They exist as offshoots of either assets like stocks, commodities, residential mortgages, etc.;  or indices relating to the stock market, consumer prices, exchange rates, etc;  or even phenomena like the weather conditions.   They derive their values and standing from the above assets etc, as listed above.

Purpose and Scope:  There are several purposes for which derivatives are put to use.   Sometimes it relates to genuine business transactions and the related risks, and sometimes to plain profit making.   Sometimes it is dictated by necessity, sometimes by inclination.   Some of the major purposes of derivatives are:

Risk Management:  The major purpose of having derivatives is to manage or counter risks faced in the business environment, especially that which cannot be dealt with conventionally.   It is also called Hedging.   Hedging occurs when the risk of the underlying asset is transferred through the medium of the derivative from one person to another.   A forward contract in a foreign exchange transaction like export and import is an example of hedging.  

Suppose an exporter of wheat based in Chicago exports a consignment of wheat to the United Kingdom, and expects the rate of the British Pound to decline against the U.S. Dollar, he may book a forward contract and sell his pounds at current rates against future delivery of wheat to the U.K.

Speculation:  Another purpose for which derivatives are used may be to book extra profits, or profits out of the ordinary, by taking advantage of the favorable movement of the value of the underlying asset.   Here the purpose of using derivatives is not hedging, or countering risk, but to scoop up additional profits.   This activity is called speculation.

Arbitrage:  Yet another purpose of derivatives is called as arbitrage, that is taking advantage of a lower current market value vis a vis future value of an asset.

Whereas the use of derivatives to counter business risks related to genuine busines transactions, may serve the purpose of utilizing derivatives, the same cannot be said of speculative activities, that have cause mayhem in the markets, more than once, in different parts of the world, notably the United States.

Types of Derivatives:  Like there are two types of medicines, viz, over the counter, and prescription ones, so also there are basically two types of derivatives, the Over-The-Counter derivatives(OTD), and the Exchange-Traded-Derivatives(ETD).

Based on these two classes of derivatives, there are three kinds of them like Futures, Options, and Swaps, that are briefly discussed below.

Futures and Forwards:  These are financial contracts with a committment to buy or sell an asset within a certain future date at today’s price.  That is future buy/sell at current rates.   While a forward contract is an examle of an OTC derivative, a futures contract is an example of an ETD.

Options:  These are contracts that entitle their owner to either buy or sell an asset without imposing an obligation to do so (buy or sell).   The option to buy relates to the call option and that to sell relates to the put option.  The price of the transaction is fixed at the time of making the contract, and is referred to as the strike price.   Another feature of this contract is the maturity date.   Here again, there are two options- the European option, and the American option.   Uner the European option, the owner may specifry maturity date only as date of Sale;  whereas in the American option, Sale is allowed to take place on any date upto the maturiey date.

Swaps:  Under this type of contract, the underlying values of currencies, bonds, commodities, stocks etc., are exchanged on or before a specified future date.

As can be seen from the foregoing, derivatives may be used to either hedge one’s risk, or to make super profits, or just settle for arbitrage.   As these instruments do not have a vlaue of their own, they are vulnerable to any kind of shift or change in the value of the underlying.   As such they may not be very reliable in countering risks unless the issues affecting the values of the underlying are properly understood and provided for.

It is pertinent to note here, how the derivatives have played havoc in the U.S. housing mortgage sector, that is the major reason for the current American Banking Crisis.   Based as they are, more on mathematical calculations than solid assets, or money’s worth, the derivatives, as financial instruments, were always a weak and vulnerable proposition for risk management, and when the first strong winds hit the derivatives market, they started spinning out of control, taking the whole banking industry with them.

From the way the derivatives market crashed, it has given rise to suspicions as to the competence of the ‘experts’ and ’specialists’ who spun out these instruments seemingly through a ‘divine’ combination of their super brains and computers.

As for the regulators, perhaps, they did not want to look like fools before the derivative whizkids, by posing mundane and ’stupid’ questions about what exactly these instruments were composed of, how they were valued, and indeed the necessity and viability of these financial instruments as a tool of risk management.   In the end, the regulators have ended up looking like bigger fools for not doing their mundane and ’stupid’ jobs.

BANKING ON BASEL II

Introduction:  The Basel Accords, as they are popularly known, are recommendations on Banking laws and regulations relating to the capital of a Bank vis a vis the risk faced by the Bank in its various activities, like Credit, Market or Investment, and Operations.

These Accords are the outcome of the deliberations of the Basel Committee on Banking Supervision, comprising of the Central Banks of the United States of America, the United Kingdom, Canada, Germany, France, Japan, Switzerland, Sweden, Italy, Belgium, the Netherlands, and Luxembourg, under the auspices of the Bank for International Settlements, Basel, Switzerland.

The Basel II Accords were initially mooted in 2004 to become operational from March, 2006, although certain countries like India, were granted more time to comply with them.

Purpose And Scope:  The purpose of these recommendations is to put in place, a practice of aligning the capital of a Bank with its risk exposure.   That is, the quantum of a Bank’s capital would have to be in line with the quantum and nature of the risk the Bank is exposed to, in its various operations, divided into Credit, Market, and Operations.   Simply speaking, more the risk the Bank is exposed to, more the capital required to be maintained by it.

A significant addition in the Basel II Accord, compared to its predecessor, the Basel I Accord, is the application of the Bank’s internal risk assessment processes in arriving at the required quantum of capital and reserves to address or counter the threat of risk to the Bank’s well being from its credit, market or investment and operational exposures. 

The focus of the new Accord is on Risk and Risk mitigation issues and techniques.   It is expected that such risk management practices, when become entrenched in the Banking system, would contribute immensely to the stability of the system.

Apart from the above, these new methods prescribed under Basel II are expected to contribute solidity to the Banking industry, and help prevent Bank failures.   As the capital reserves of a Bank move up in alignment with the risk faced by the Bank, the threat to the well-being of the Bank is effectively countered.   The net effect of this process would be to increase the strength and solvency of the Banking system.

Application:  The Basel II Accords, as we have seen, are concerned basically with providing sufficient capital support to the risk undertaken by the Bank in the areas of Credit, Market or Investment, and Operations.   The two areas where these Accords are applicable are Capital and Risk, and the same are discussed below in some detail.

Capital:   A Bank’ s Capital is divided into three parts according to its nature and purpose.   They are:

Tier I Capital:  The tier one capital of the Bank is composed of the core capital.   And the core capital is made up of the Capital proper, the shareholders’ contribution, Reserves, and Surpluses.   That apart, it also comprises of Perpetual Non-Cumulative Preference Shares, Investment Fluctuation Reserve, and Innovative Perpetual Debt Instruments.

Tier II Capital:  This part of the Capital consists of Undisclosed Reserves, Revaluation Reserves, General Provisions and Loss Reserves, and Subordinated Term Debt.   The tier two capital is also referred to as Supplementary Capital.

Tier III Capital:  This portion of the Capital is earmarked to meet the market risks faced by the Bank.   It is made up of Short Term subordinated Debt.   Not all Central Banks of the World have made this type of capital compulsory for their Banks.

Framework of Basel II Accord:  The Basel II Accord framework rests on 3 Pillars as it were-Minimum Capital Requirement, Supervisory Review of the Capital Adequacy, and Market discipline or disclosure.

Pillar I:  Minimum Capital Requirement:  The capital requirement of the Bank is fixed in relation to three types of risks that a Bank faces: Credit Risk, Market Risk and Operational Risk.   Each of these risks is  evaluated and accepted according to one of the three approaches specified,  namely, Standardized Approach, Internal Risk Based Approach, and Advanced Internal Rating Based Approach.   An appropriate approach is adopted to determine each type of risk.   The three types of risks are discussed below:

Credit Risk:  The capital to be allocated against the credit risk faced by the Bank is determined either with the help of Standardized approach or Internal Ratings Based Approach.   The Standardized Approach requires assignment of Risk Percentage to various kinds of exposures taken by the Bank.   For instance, the risk percentage assigned to Bank’s exposure to entities like the World Bank is Zero, whereas exposures against the security of commercial real estate would be awarded a risk percentage of upto 125%.

Apart from the Standardized Approach, there is the Internal Ratings Based Approach, that again may be a Foundation Approach, or the Advanced one.   These approaches are based on Bank’s internal systems of assessing risks arising to the Bank’s interests from various sources.

Market Risk:  Market Risk Assessment is based on the Standardized Approach and the Model Approach.

Operational Risk:  Operational Risk is assessed for the purpose of capital allocation on the Basic Indicator approach, the Standardized Approach, and the Advanced Measurement Approach.

The Pillar I of the Basel Accords II specifies a minimum capital requirement of 8%, after going through the above process of assigning risk percentages for various exposures of the Bank.

The Formula for calculating the Capital Adequacy Requirement is the Capital of the Bank, divided by the Credit Risk+Market Risk+Operations Risk.   The Result of this Equation must be 8%.

Pillar II:  Supervisory Review of Capital Adequacy:  “When the cat’s away, the mice will play!”   In order to ensure the well-being of the Bank, and guarantee its solvency, it is not enough to just prescribe ways and means to do it.   It is equally important to supervise and ensure compliance of the required laws by the Bank.

It is towards this end that the Second Pillar of the Basel Accords II is intended.   The Supervisory Review of Capital Adequacy is based on four principles,  namely:

1)  Banks must have in place, a mechanism to ensure that capital of the Bank is always sufficient to cover the corresponding risks.

2)  Constant vigial, measurement, and mitigation is expected to ensure compliance of the rules.   Supervisors must not be found wanting on this score.

3)  Not only the minimum capital requirement should be maintained by the Bank, but Bank must operate above the threshold level.   This is to ensure a safety margin in case of need.

4)  Timely intervention by Supervisors as soon as danger signals are noted, is  a critical requirement for success in this regard.   Supervisors are expected to be proactive in their approach.

Pillar III:  Market Discipline:  This Pillar addresses the need for the Bank to observe discipline in the matter of its Market operations, and the role it plays in the capital requirement of the Bank.   This is sought to be ensured through a system of semi-annual Disclosure relating to the underlying factors, such as the Tier I, Tier II, Tier III capital and its components.   Secondly, the approaches adopted by the Bank in relation to risk assessment and such other issues are taken into account.

Conclusion:  From the brief study above, of the Basel II Accords, it may be said that, in view of the current crisis in the Banking Industry, especially in the West, the importance of these recommendations, and their application by the Banking system is very much required.

RETAIL BANKING PART II

 In this article, we study the impact of the loans extended to the corporate client and the retail clients, by the Bank, by analyzing certain situations assumed as under.

Let us assume and analyze two situations applicable to Dolphin Paints Corp. and its employees, in respect of their individual loans from the Bank, and what implications it has for the Bank and its welfare.

In the first situation, let us assume that the company is in trouble. On account of unfavorable economic conditions, and the resulting market swings, the company has lost some of its standing in the market, and is not able to sustain operations at the earlier level, necessitating the laying off of about 500 employees. That apart, the company has initiated several steps to cope with the drop in business.

One of the most serious consequences of the above situation is that the company is finding it hard to service the debt it owes the ABC, and there is a risk of default on their part, that might force the Bank to reschedule the said debt. As a consequence, the Bank would have to make provisions for the loan outstanding against this company in their books, which is a nightmare to any Banker. The sum involved here is about USD: 8.00 million, assuming that the company had repaid USD: 2.00 million of the original loan of USD: 10.00 million. In other words, the Bank is now staring at a possible default of a loan to the tune of USD: 8.00 million by the company.

Now, let us take a look at the impact of this crisis on the employees of this company, and what implications it has for the Bank, in relation to the loans extended by it, to them.

As we have seen, the company had laid off 500 workers on account of its current problems. Let us assume, that out of these 500 employees, 400 of them had borrowed from the Bank, and are currently out of a job. The total amount of money lent to these 400 persons would come to USD: 1.20 million, and the Bank faces a similar situation here, as in the case of the company, in that, it has to consider rescheduling the loans to these 400 employees, and making provisions for the same. The difference, however, is the amount involved is much smaller, and the number of borrowers is much larger, and the amount of provision to be made is correspondingly less. Also, many of these laid off workers may get alternative employment soon, and start repaying their loan instalments. Whereas, it may not be that easy for the company to turn the corner, and regain its earlier health within a short span of time.

Now, in the second situation, let us assume the opposite of the earlier one. That is, the company is now doing exceedingly well, on account of a combination of favorable market conditions, and with a order book flowing and glowing bright, the company is now cash rich beyond its expectations.

In the above situation, it may not be wise for the company to continue to have such a big Bank loan of USD: 8.00 million and to pay interest on it, thereby affecting its bottomline. Rather, the company may want to repay the entire loan, or at least the major portion of it, to avoid paying interest on it.

This can present a ticklish problem for the lending Bank. On the one hand, it is happy to get back its money alongwith the interest, of course. But it had not factored for such early repayment of the loan, and as such, its expected revenues from this transaction have taken a hit. That apart, it may also affect the Bank’s asset liability equation, as the loan to the company was not expected to be repaid so soon. Therefore, the Bank has to take several steps, some of them expensive, to deal with the situation arising out of the company repaying its loan much earlier than as scheduled.

Coming to the employees of the company, who, let us assume, have all been given a raise on account of the exellent performance posted by the company, the Bank does not face the possibility, or the risk of all the 4500 employees who borrowed from it, prepaying their loans. So it does not have to take any special steps, as in the case of the company prepaying their loan, thus saving the Bank a lot of trouble and expenses.These are some of the differences in serving the corporate and the retail client for the Bank.

Other features of Retail Banking:  Retail Banking, as we have seen, is the provision of Banking services at the retail level, the individual level, as against the corporate or organizational level.   It follows logically, therefore, that Banks have to modify their approach and methods, while dealing with these different customer groups, in view of their different requirements and capacities.  

The nature and type of banking products required by a corporate are a bit different from those required by the retail client.   For example, whereas a corporate may require finance for purchase of plant and machinery for the manufacture of the products of their choice, and working capital to meet day to day expenses of running the business, the retail client may require loans for the purchase of consumer durables, like a music system, TV, Refrigerator;  or a home loan, or a car loan, or an educational loan,  etc.   Whereas the amount of loan in the case of the corporate would be huge, the loan required by the retail customer would be small.   Whereas the number of corporate clients may be less, the number of retail clients would be relatively large.

It is to be noted that some of the services and the delivery channels for such services extended to both the retail and the wholesale or corporate clients may be similar.

Conclusion:  Retail Banking, as a service, as well as a source of recurring revenues to the Bank, has  gained in importance, and is being rightly patronized by the Banking industry in earnest.   As corporate banking becomes more and more competitive, and the appetite of the corporates for concessional services grows without check, retail banking would become more and more attractive to the Banks.

 

 

 

 

 

 

RETAIL BANKING PART I

Introduction:  Banking, as a business of money lending, has been around for millenia.   Indigenous systems of Banking have long existed in societies, across the world, providing a vital service to communities, though the aggressive lending techniques adopted by the indigenous Banker had never been popular with anyone.   And like other services, Banking has also evolved over the centuries, reshaping itself time and again to acquire the present shape.   Today, banking, as a financial service caters to all kinds of financial needs  and services required by the community.

Typically, a commercial Bank is engaged in the business of accepting deposits for the purpose of extending loans, among other things.   Banks cater to practically every segment of society, and there is probably no member of society, that is not influenced by services offered by a Bank, in some way or the other.   It is, in fact, difficult to imagine a modern society, without commercial Banks occupying an important position, as facilitators of the myriad financial products and services demanded by modern society, in order to enjoy the creature comforts of life, of course, at a price.

Competition, the great leveller, has ensured, that Banks, that initially catered to the rich and the haves, were gradually forced to offer their services to one and all, resulting in the percolation of such benefits to society at large.   Also, Governmental regulations relating to non discriminatory business practices, and fair competition legislations have contributed to this process of the liberalization of high brow banking.   All these have made banking a viable proposition to the middle and lower classes, who now form the chunk of the business of a commercial Bank.

Even though niche Banking does exist today, catering to exclusive groups and interests, the fact is that the regular Commercial Bank is an egalitarian institution, servicing the collective mass of communities across the country.   Moreover, the attraction of servicing the corporates to the virtual exclusion of the small customer has diminished over time, and today, the small customer occupies an important place in the scheme of things of  Commercial Banks, who are wooing them like never before.   In fact, a distinct class of banking has emerged, called Retail Banking, which is the subject of this article.

Definition:  Retail Banking may be defined as the provision of a package of financial products and services to masses of people, through a network of convinient delivery channels.   In other words, the process of delivering a variety of financial services and products, through various media, to a mass of people, rather than catering to an exclusive group of people or organizations.

Typically, retail Banking involves offering various deposit products running accounts and fixed deposit accounts, and also different loan products like consumer loans, housing loans, car loans etc.   That apart, it also involves offering other products like Bancassurance, etc., in order to maximize revenues.  

The idea is to offer every possible facility to the smaller customers in a convinient and flexible package, to make life easier for them.   The USP of retail banking is the delivery of all kinds of financial products and services in one attractive package, making it easy for the retail customer to avail of them without much of a bother.  

Basically, Banks do the same things in retail banking, like offering deposit and loan products, apart from other services like insurance etc.   The difference lies in the size of the transactions, which is smaller when compared to those involving a Bank’s corporate clients apart from the different requirements of the respective category of the customers, who may require different products on account of their respective constitutions, their tax liabilities, and such other things.

As an example, supposing there is a paint manufacturing company in the city of Seattle, by name, Dolphin Paints Corp, that has a workforce of 5000.   Let us assume that this company has borrowed USD: 10 Million from the American Banking Corporation(ABC)  for the acquisition of plant and machinery, at an interest rate of 2.50% p.a.   On the other hand, the ABC has also extended personal loans to 4500 of the  staff of the company(Dolphin Paints Corp) according to their eligibility, with reference to their financial status, earnings, etc.   Let us assume, that the average loan amount to each of these 4500 employees works out to USD:3,000.00.   That means a total loan amount of USD: 13.50 Million.   And the Bank is charging these employees 3.25% rate of interest on their loans.

Now, let us analyze the above situation, from the Bank’s angle with regard to the various issues involved, like safety of Bank funds and the revenues expected from the loans extended to the corporate client, Dolphin Paints Corp., and the 4500 employees of the company respectively, who form the retail segment of business for the Bank from the particular company.  

 As seen above, Bank has lent an amount of USD: 10 Million to the company at only 2.50% rate of interest, whereas, it has lent a total of USD: 13.50 Million to the 4500 employees at a higher rate of interest at 3.25%.   On balance, it is evident here, that the Bank has gained more from lending to the employees, that is the retail segment, than by lending to the corporate.   The major reason being the higher rate of interest that it charges the retail customer, compared to the corporate client. 

The reason for this discriminatory interest regime is that, the corporate client, by virtue of its size, is able to command a more favorable interest rate from the Bank.   Apart from the favorable interest rate, the corporate is also able to squeeze out many concessional terms for the loan availed by it from the Bank.   Whereas the retail customer, being a small guy, is forced to accept the terms and conditions laid down by the Bank, and has limited scope for negotiating a better deal.   The bigger customer always seems to get a better deal compared to the smaller guy.   

However, when we examine the pros and cons of lending to the big and the small customer respectively, we come to know certain home truths that are enlightening.  

We shall study the interesting contrasts that present before the Bank in respect of its lending decisions, one relating to its corporate client, and the other to its retail segment in the next article.

                                                                               To be continued.

FINANCE: CREDIT CARDS PART II

In the previous article on Credit Cards, we had a glimpse at the credit card business, and how it works.   In this article, we shall take a look at the advantages and disadvantages of the credit card to the parties concerned.

 

Advantages of Credit Cards:  Credit Cards offer several advantages to the cardholers, the issuers and  the merchants alike.   Some of the important advantages are discussed below:

To Cardholders:  Among other things, the Cardholder is relieved of the burden of carrying large amounts of cash.   Carrying cash in large quantities is not only bothersome, but also risky, especially for old people.   The credit card is  a versatile payment system that gives flexibility to the Cardholder, who can buy goods and services from a vast choice of merchants, throughout the world practically.    And by doing a little research, he can the land the best  deals possible  from the merchants.   The card companies and their agents offer several incentives to cardholders to get them to use their cards.   They take advantage of special ocassions, like festivals, etc to offer special discounts and other such inducements to increase their business.   Credit card companies tie up with merchants and other vendors to offer special rates, discounts etc on usage of the cards.   Another popular incentive offered is called the ‘cash back’, wherein the cardholder is refunded a part of the money he spends on purchases through his card.    Credit cards also enable one to shop online, obviating the need to go physically to the market or the mall.   Especially during peak seasons of shopping, it can be quite tiresome, to go through the grind of visiting a shopping mall to make one’s purchases.   Credit cards are especially useful in making purchases of items that don’t require physical examination.

With increasing competition for the customers’ favors in this area, cardholders are enjoying a bonanza in the form of interest free credit, credit of points for amount spent that can be utilized for availing other services free of cost, or at concessional rate, so on and so forth. 

To Merchants:  In a way, credit cards increase the purchasing power of the consumer as they enable the cardholder to buy now and pay later.   And it is human nature to spend, if one can.   The credit afforded by the Banks through the credit cards  often means more business to the Merchants.  

That apart, they charge a commission on each  card transaction, as they do not get paid immediately for the sale.   Invariably, the amount of such commission charged by them is rounded up to the higher side.   That is they end up getting more than the loss by way of interest incurred by them.   Further, the risk of non payment is practically non existent, once the transaction is electronically authorized.   The merchant is assured of being reimbursed for the credit sale effected by him.   In due course, the merchant’s account with his Bank is credited with the amount of the credit sale.

Also the merchant saves money on  overheads and administrative expenses, when he transacts through the medium of credit card, as he does not have to deal with large amounts of cash, especially small notes and coins.

To Banks:  Banks that issue credit cards to their customers get a commission from the Card Issuer for each card they issue.   The facility of credit cards attracts more customers to a Bank, and generates other business for them.   It enables Banks to engage in cross-selling of products and maximize their revenues.

Further Banks charge very high interest rates for the credit offered through the credit cards.   Especially in case of default, the cardholder literally pays through his nose.   This interest charged by the Banks is way beyond the monetary loss suffered by them on account of late payments by the cardholder.

Disadvantages of Credit Cards:  Now a look at the negative side of the credit card business, and how it adversely affects the same parties that also enjoy its plus points.

To Cardholers:  “Neither a lender nor a Borrower be!”.   Of course, in the modern economic system, it may not be practicable to pursue this goal.   However, it  is a fact, that, credit cards have ruined many a life, on account of indiscriminate usage by the cardholders.   When credit is available easily, the tendency of the cardholder is to buy goods and services that he does not really need, or to buy more expensive items that he would normally do.   The availability of credit, and that too without going through documentation and other formalities, like in a conventional loan, makes it even more tempting for the cardholder to spend.   Then there is the necessity of keeping up  with the Joneses.

There are any number of cases of cardholders going bankrupt due to their inability to pay off their card dues.   Apart from that, there are security issues also involved like the loss or theft of cards, misuse of cards by  others through fraudulent means, etc.

To Merchants:  Disputes in credit card transactions are a not-so- rare occurance, resulting in a lot of avoidable administrative and sometimes, legal work and expenses, for the merchants.

Fraudulent usage of the cards by crooks, is another headache for the merchants.   With increasingly sophisticated methods being adopted by fraudsters, merchants are forced to be extra vigilant, and thereby incur additional expenditure in the process.

For Banks:  For the Banks, of course, the number one problem is with payment defaults.   Monitoring the usage of millions of cardholders, and ensuring prompt payments from the customers is indeed a mammoth task.   Further, collecting overdues from defaulting cardholders can present administrative and legal hassles costing good money.   And fraudulent usage of cards is equally worrisome to the Banks.

Unlike in a regular or conventional loan, Banks do not follow any formalities in allowing credit to the cardholders.   Once the Bank grants a credit card facility to the customer, and so long as the customer keeps within his limits, the Bank does not bother customer.

Conclusion:   On balance, it may be said, that credit cards have contributed a lot of good to society at large, facilitating payments, that would otherwise be quite cumbersome, and risky.   The negative aspects of the credit cards may have to do more with human psychology, though it cannot be denied that usurious interest rates charged for credit card transactions have given them a bad name.

                                                                                                    Concluded

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