A. I.M. : The Investor’s Guide to a Listed Company

 

 

Last month SEBI issued a discussion paper on Annual Information Memorandum (AIM) to be filed by the listed companies in India. Genesis of the paper lies in the background that under the present system, companies file a detailed memorandum for the information of the investors only at the time of launch of the Initial Public Offer (IPO). Post IPO, companies are required to submit various information through notifications to Stock Exchanges and Regulators. There is no single point reference document for the information of the investors. The happening of material events after the listing of the security is known to the investors over a period of time, and investors also find it difficult to access all relevant information for the purpose of making an informed investment decision.  This situation specially affects the secondary market investors.

In light of the above, need was felt for introduction of an annual AIM to be filed by listed companies, and accordingly, SEBI launched the discussion paper in the matter. As per the discussion paper, frequency for preparation of AIM shall be yearly. For companies which are planning IPOs, the requirement of AIM would commence with the IPO. This would require that the disclosures made by the companies at the IPO stage be updated on an annual basis so as to ensure that at any point of time, updated information about them is available in public domain. AIM shall be disseminated within 135 days from the end of financial year. AIM may be disseminated electronically by uploading the same on the company’s website and simultaneous filing with stock exchanges.AIM shall be approved by Board of Directors at their meeting prior to dissemination. SEBI has set a implementation timeline of financial year 2014-15 for the top 200 companies based on their market capitalization as on March 31, 2014, and FY 2015-16 for all others listed companies.

Considering, the spirit of making the AIM as one point source for all the important information. it would be good if the annual AIM includes some of the other critical information related to the happenings during the related Financial Year, viz:

(1) Credit Rating of the company, risk concerns raised by rating agency and response towards the same by the company.

(2) CIBIL Report scores (as on last March 31) of the Board of Directors along with comments on any negative information appearing in the reports.

(3) Brief Summary of the CIBIL Report (as on last March 31) of the company along with any negative information viz. overdues etc) appearing in the report, and comments on the same by company.

(4) No. of instances of Letter of Credit devolvements, Amount involved; Bank Guarantees invocations, Amount Involved; and clarifications from the company on these devolvement/invocations.

(5) No. of defaults incurred but the company in making payments to its lenders and current position as on the date of approval of AIM by Board.

(6) No. of instances of ad-hoc limits utilized by the company from lenders, justification from the company on the same, plans for meeting such requirements in future.

(7) Workings of Debt Equity Ratio, Total Debt to Total Liabilities Ratio, Current Ratio and Asset Coverage Ratio (Book Value Basis and Market Value Basis) [SEBI may also prescribe the method for calculation of these ratios so that there is no ambiguity].

(8) Tabular information on financial performance of the subsidiaries, associate companies, joint ventures and SPVs [SEBI may prescribe the tabular format].

(9) Details of any overdues/defaults/devolvement/invocation under the financial facilities availed by subsidiaries/associates from banking sector, present status of the same.

(10) Undertaking from the Managing Director that company does not foresee any sign/need for financial restructuring in the next financial year OR if yes, then explanatory note on the same.

(11) Note on any Financial Restructuring approved by lenders in the past five years and current status of implementation and compliance with the terms and conditions.

(12) Explanatory note on resignations of key executives viz. CFO, Head Treasury, Directors etc.

(13) Tabular information on instances of name change of the company and need for the same.

(14) Copy of RoC search report regarding the charge created on the assets of the company.

(15) Negative comments appearing in the Stock Audit Report and clarification on the same from company.

(16) Forex Risk with the company and addressing the same under the Hedging Policy and measures adopted by the company.

(17) Financial Projections for next two years (Stand-alone and Consolidated basis) along with key ratios as mentioned above and also the Debt Services Coverage Ratio,

(18) Comparison of actual financial performance for the last financial year covered in AIM with the projections for the same made during previous year. Note on achievements/non achievements of the financial projections with clarifications.

(19) Suggested names of the competitors in the local and international markets, which the management feels, can be considered by investors for comparison analysis.

(20) Note on any particular concentration risks viz. Any particular customer forming more than 25% of the sales, Any particular supplier forming more than 25% of the total procurement, Exposure of the company to risk associated with the volatility in commodity (forming more than 40% of the production cost) pricing etc.

These suggestions if implemented would be helpful for the entire financial sector including the secondary market investors and lenders, in understanding the financial strengths and hidden weaknesses of the company. The serious implications of the information under these suggestions, would bring more discipline in financial management by the listed companies.

MCA clarification on section 185 of the Companies Act 2013

Ministry of Corporate Affairs (MCA) had notified 98 sections of Companies Act 2013 in September 2013. These 98 sections included Section 185 of the Act also. The Section 372A of Companies Act 1956 is still to be repealed and Section 186 of Companies Act 2013 is pending to be notified.

Under Companies Act 1956, the section 372A deals with the Inter-Corporate Loans and Investments by Public companies. The section 186 under Companies Act 2013, regulates Inter-Corporate Loans and Investments and since this section of the new act is pending to be notified, its corresponding provision, Section 372A of the 1956 Act, continues to be in force.

Section 185 of Companies Act 2013 (replaces the old section 295 of the Companies Act, 1956) provides for loans to directors, and is applicable to private and public companies, while the old section 295 was not applicable to private companies, unless such private company was the subsidiary of a public company.

Section 372A of the Companies Act, 1956, specifically exempts any loans made, guarantee given or security provided or any investment made by a holding company to its wholly owned subsidiary.

As against section 372A, the new section 185 of Companies Act 2013, prohibits guarantee given or security provided by a holding company in respect of loans taken by its subsidiary company except in ordinary course of business.

The above situation of contradiction between provisions of Sec 185 and Sec 372A lead to the confusion. In light of this, MCA has vide its circular dated February 14, 2014 issued a clarification regarding the applicability of Sec 372A till it is repealed and notified. MCA has clarified that any guarantee given or security provided by a holding company in respect of loans made by a bank or financial institution to its wholly owned subsidiary company, exemption as provided in clause (d) of sub-section (8) of Section 372A of the Companies Act, 1956 shall be applicable. MCA has specifically added that this clarification will, however, be applicable to cases where loans so obtained are exclusively utilized by the subsidiary for its principal business activities.

The MCA circular on clarification is available at :

http://www.mca.gov.in/Ministry/pdf/General_Circular_3_2014.pdf

Issue of applicability of TDS in Bills Discounting

 

 

Recently, I read about the Income Tax Appellate Tribunal giving ruling regarding issue of applicability of deduction of tax at source (TDS) in bills discounting facility.

 

A ‘Bill’ is a written, unconditional order by one party (the drawer) to another (the drawee) to pay a certain sum, either immediately (a sight bill) or on a fixed date (a term bill), for payment of goods and/or services received. The drawee accepts the bill by signing it, thus converting it into a post-dated cheque and a binding contract.

Under bill discounting facility offered by financiers, the financier takes the bill drawn by Supplier/borrower on his (borrower's) customer and pay him immediately deducting some amount as discount/commission. The financier then presents the bill to the borrower's customer on the due date of the bill and collects the total amount.

In the given case at Income Tax Appellate Tribunal, party ‘X’ appointed ‘Y’ as its agent. Y sells the products manufactured by the X to the customers and also provides guarantee to X for payment from customers. X generates sales bills on customers with a mention that payment is guaranteed by Y. Y gets the bills discounted from financiers. The tax authorities made a case that such discounting charges are interest as per Indian Tax Laws (ITL) and attracts deduction of tax at source. Since, Y did not withheld TDS therefore the discounting charges were not allowed as expenses while calculating the business income of Y.

As per Y, when receivables are sold to financier, the ownership of the same is also passed on to the financier. Therefore there is no advance made by the financier to Y and hence there is no debtor-credit relationship between Y and financier. In case of non payment by customer, the financier will have lien over the goods sold but not on the moneys paid to Y. Y relied on Central Board of Direct Taxes (CBDT) circular which mentions that the amount paid by the banks, after deducting the bill discounting charges from the bill amount, is in the nature of price paid for the bills.

The Appellate Tribunal while taking decision in the case referred to the definition of ‘Interest’ as defined under the Interest Tax Act 1974 and also the ‘Interest’ as defined under the Indian Tax Law.

Under ITL, interest is defined to mean interest payable in any manner in respect of any moneys borrowed or debt incurred and includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilized.

Under the Interest Tax Act, 1974 interest is defined to mean interest on loans and advances made in India and includes commitment charges, discount on promissory notes and bills of exchange made in India.

The Appellate Tribunal noted that while the Interest Tax Act mentions discounting charges as ‘interest’ despite that ITL has consciously not included the same in its definition. Appellate Tribunal ruled in favour of Y to allow it recognizing discounting charges as expense without deduction of tax on the same.

Stressed Assets: Upcoming RBI Norms and Long Term Plans

 

 

Recently, Reserve Bank of India (RBI) launched a discussion paper on early recognition of borrowers having financial distress and prompt steps proposed for resolutions and fair recovery for lenders. The highlights of the paper included the following points:

(a) Early formation of a lenders’ committee with timelines to agree to a plan for resolution.

(b) Incentives for lenders to agree collectively and quickly to a plan.

(c) Improvement in current restructuring process.

(d) More expensive future borrowing for borrowers who do not co-operate with lenders in resolution.

(e) More liberal regulatory treatment of asset sales:-

(i) Lenders can spread loss on sale over two years provided loss is fully disclosed. This incentive will be available upto March 31, 2015. Further, the promoters of the company/defaulting borrowers shall be barred from directly/ indirectly buying back the asset from the ARCs.

(ii) Takeout financing/refinancing possible over a longer period and will not be construed as restructuring.

(iii) Leveraged buyouts will be allowed for specialised entities for acquisition of ‘stressed companies’.

(iv) Steps to enable better functioning of Asset Reconstruction Companies mooted.

(v) Sector-specific Companies/Private equity firms encouraged to play active role in stressed assets market.

For early recognition of Non Performing Assets (NPAs), the paper mentions introduction of new asset category namely Special Mention Accounts (SMA) having three brackets: (1) SMA – Non Financial (NF) : signals of incipient stress; (2) SMA – 1 : Principal or interest payment overdue between 31-60 days; and (3) SMA – 2 : Principal or interest payment overdue between 61-90 days.

Under these proposed plans, RBI will set up a Central Repository of Information on Large Credits (CRILC) to collect, store, and disseminate credit data to lenders. Banks will mandatorily have to furnish credit information to CRILC on all their borrowers having aggregate fund-based and non-fund based exposure of Rs.5 crore and above. NBFC-SI (Systemically Important) will also be asked to furnish such information.

Under the guidelines to start with, reporting of an account as SMA-2 by one or more lending banks/NBFC-SIs will trigger the mandatory formation of a Joint Lenders’ Forum (JLF) and formulation of Corrective Action Plan (CAP) for accounts having aggregate fund-based and non-fund based exposures of Rs.100 crore and above.

JLF may explore various options to resolve the stress in the account which may include restructuring, rectification, or resorting to recovery. For prompt action the proposed plan stipulates timelines also i.e. deciding CAP options within 30 days from the SMA2 reporting date, Signing detailed final CAP within next 30 days. If the JLF decides on restructuring the account as a CAP, it will refer the account to CDR Cell for restructuring. CDR Cell will not prepare another preliminary TEV under its guidance, and will directly prepare the final TEV study and restructuring plan in consultation with JLF within 30 days from the date of reference to it by JLF. For accounts with aggregate exposure of less than Rs.500 crore, the cases referred to CDR Cell by JLF will have to be finally decided by the CDR EG within the next 30 days. If approved by CDR EG, the restructuring package should be approved by all lenders and conveyed to the borrower within the next 15 days for implementation.

Lenders can also resort to transfer of the promoters’ holdings to a security trustee or an escrow arrangement till turnaround of company. For restructuring of dues in respect of listed companies, lenders may be ab-initio compensated for their loss/sacrifice by way of issuance of equities of the company upfront. In such cases, the restructuring agreement shall not incorporate any right of recompense clause. In order to safeguard promoters’ control over companies, the equity so issued may bestow ‘call’ option/‘right of first refusal’ to the promoters group before the banks sell the same. However, such call option/right of first refusal can only be exercised, after the entire loan and the recompense has been repaid. Further, the price of shares under such call has to be equal to the fair value of the shares at the time of exercise. If acquisition of such equity shares results in breaching the extant regulatory Capital Market Exposure (CME) limit, RBI will give exemption to the lenders from the CME limit on a case-by-case basis.

Under the refinancing structure by way of take-out, the new lender can provide exaggerated repayment tenor which will not be treated as restructuring. The incentive to lenders for quick implementation of restructuring package will be retention of existing asset class of the account prevailing on the date of formation of JLF, as per extant guidelines. This incentive will be available for all the restructuring done before April 1, 2015. If the lenders fail to convene the JLF or fail to agree upon a common CAP within the stipulated time frame, the account will be subjected to accelerated provisioning as provided in the plans. Further, if the escrow maintaining bank under JLF/CDR Mechanism does not appropriate proceeds of repayment by the borrower among the lenders as per agreed terms resulting into down-gradation of asset classification of the account in books of other lenders, the account with the escrow maintaining bank would attract the asset classification which is lowest among the lending member banks. 

The plans also propose maintenance of a new database by RBI of Non Co-operative Borrowers (NCBs). NCB has been broadly defined as one who does not provide necessary information required by a lender to assess its financial health even after 2 reminders; or denies access to securities etc. as per terms of sanction or does not comply with other terms of loan agreements within stipulated period; or is hostile / indifferent / in denial mode to negotiate with the bank on repayment issues; or plays for time by giving false impression that some solution is on horizon; or resorts to vexatious tactics such as litigation to thwart timely resolution of the interest of the lender(s). Such borrowers will be given 30 days’ notice to clarify their stand before their names are reported as NCBs. Any new loan sanctioned to such NCB promoted company or a company in which NCB is present on Board, will attract higher/accelerated provisioning as provided in the plans.

The plans propose to allow sale of assets between Asset Reconstruction Companies (ARCs) which is not permitted at present and also allow ARCs to raise debt funds for rehabilitation of the units. Banks/NBFCs will not be allowed to sale assets to their own promoted (10% or more equity control) ARCs. Further, presently, an NPA in the books of a bank can be sold to other bank only after it has remained in the books for a period of two years. RBI will withdraw this minimum holding period for any initial loan sale. However, the bank purchasing the NPA will, have to hold the asset in its books for at least one year before selling the asset.

Presently, banks are not allowed to finance acquisition of promoters’ stake in Indian companies. Under the proposed plans, RBI would allow banks to extend finance to ‘specialized’ entities put together for acquisition of troubled companies.

Need for Long Terms Plans

The above mentioned proposed plans would be good measures by RBI for effective control of stressed assets. However, these are ‘Corrective Plans’. Regulators should also consider long term plans for managing the stress in borrowing entities. It is experienced that when a borrower faces stress, most of the time it does not have sufficient liquid capital for bringing its own contribution to support the CAP/Promoter’s Contribution. Under the BASEL III norms for maintenance of Capital by banks, there is provision for maintenance of Counter Cycle Capital Buffer to absorb shocks. The same principle needs to be applied for borrowers also i.e. by way of compulsory maintenance of Borrower Counter Cycle Capital Fund (BCCCF) from the profits before deduction of dividends. This could be minimum 2% to 10% of the net profit and may be accelerated with increase in secured borrowings. The funds may be allowed to be managed in the form of liquid assets (mix of debt funds, fixed deposits etc. and small part in equity funds etc). It would be good to link such BCCCF with net profit instead of net cash accruals because then borrowers would be a bit less aggressive in presenting very rosy financial performances. The implementation of such fund may be done over a period for existing borrowers and with immediate effect for new borrowers (i.e. companies not having any secured borrowing in their books at present). When a borrower undergoes restructuring, it may be allowed to dip into this pool for bringing its contribution. Over the period of restructuring, depending on the restructuring plan, the pool may be restored.

Yes, these types of plans may not be easy to implement without hiccups. However, as it is said ‘where there is a will there is a way’, solutions can be found for all the intricacies involved. There would be many difficult situations to be resolved for implementation of such plans, like:

If a zero debt company goes for a Rs.5,000 crore debt program, does it mean that at the rate of 10% crisis pool management, it will have to first arrange Rs.500 crore for the BCCCF?

If a company is presently having Rs.2000 crore of debt, and plans to raise Rs.500 crore additional debt, does it mean that it will have to arrange Rs.250 crore for the BCCCF?

Obviously, these looks to be very high targets to be achieved if these are to be achieved at one go. However, if these funds are saved over the years, borrowers would not face the difficulty, and that is the actual spirit of this proposal. These types of plans cannot be implemented over night. These are to be implemented over a period in phases say: 1% pool to be ensured in two years, to be increased to 5% in five years etc. OR say immediately out of the new IPO proceeds, OR say providing structures to ensure build-up of crisis fund (by way of quasi equity, unsecured debt etc.) OR with many other options taking into confidence the industry associations. The point is that maintenance of BCCCF would make borrowers more responsible for their debt, control presentations of very rosy financial performances, and conserve funds from earnings in good times, directly linked to debt levels.

Need of the Hour: Innovating the Cash Credit System

 

 

It has been disappointing to experience many borrowers defaulting in servicing their working capital (WC) dues in the current economic slowdown World over. But when it is economic slowdown then automatically the need for WC should get reduced since the need for Cash Credit (CC)/WC facility ultimately depends on the business volumes. In a downturn, volumes cannot be predicted to be high! So why is there need for more credit or non availability of the same resulting in default on the name of cash crunch? Many people give the argument that the slowdown is resulting into increased receivable period due to competition, inventory is not available, many of the receivables are turning out to be junk etc. Ok, agreed. But then it should be a one-time exercise when corporate/borrower analyzes its receivable pool and segregates the junk in a separate pool. The lender can come forward and analyze the pool to decide on the liquidity required as a one-time measure. But generally  corporates do not come forward for this, they keep on hiding the bad under the good, keep on extending the goods on credit to customers and ultimately putting the lenders funds on risk. Such practices lend the Corporate into undesirable Corporate Debt Restructuring (CDR).

 

Well, this is a fact and we have to live with this until we decide to think differently. If we think for a second holistically, it can be noted that over the years the war strategies have changed. The game strategies have changed. The communication technology has revolutionalized. Everything has been innovating, and not only innovating but also flourishing using the technology. In this scene, why are we sticking to same years old Cash Credit system of lending? Don’t we want to innovate and improve the lending system? Are we not open to reward the borrowers who practice good corporate governance and are open to justifiable use of the borrowed funds, leaving no room for misutilization?

In case of heritage Cash Credit (CC) style of lending, the total CC limit is decided based on the MPBF analysis. The actual CC limit is released when borrower submits the monthly Stock Statement, carrying brief details of inventory and receivables based on which drawing power is calculated by the bank and CC is disbursed to the borrower to finance its funds trapped in creating those inventory and receivables.

We need to give a thought that in an innovative World what is the need of Stock Statement when with the help of technology, banks can directly fund the suppliers and debtors of borrower?

The issue with the traditional CC operations is that the lender has to depend on the monthly Stock and Receivable statement prepared by the borrower. The only check on the authenticity of this statement by a third party is the annual stock audit which is also not very effective if the borrower has multiple factories at various locations. This system encourages many borrowers to miss use the CC facility. The lender does not have strong mechanism to check whether actually there is sufficient stock or the receivables as mentioned in the monthly Stock Statement. This lacuna needs to be corrected. But how?

There are some existing lending solutions available one of which is banks stop funding the receivables. The receivable may be made to be funded only by factoring agencies (which are mostly floated and funded by banks) as these agencies are fully focused on receivables funding so have hands on due diligence excellence of the debtors of corporate.

For inventory funding, banks may also rigorously pursue vendor financing/bills discounting under which the vendors are directly funded by banks.

Apart for meeting these major heads of funding the current asses, the other small requirement can be funded by long term working capital term loans which come with a fixed tenor and repayment schedule.

The out of box and revolutionary things to make it possible would be innovation to connect the inventory and stock management software of the borrower with the controls of the banks. This will provide a system under which the borrower and its suppliers both are connected with the lender and as soon as the sale of material by supplier/vendor to the corporate happens, the cost can automatically be debited to the borrower’s Cash Credit Account and credited to supplier’s Account subject to online approval of the transaction by the borrower. Such systems would bring more transparency in CC utilization and lenders would be also able to analyze the stocks and receivable position on real time basis.

I would like readers to contribute on this to bring more thoughts on improving the working capital lending system.

Corporate Finance 2013 : Lessons learnt

Credit Rating: Do or die but maintain it

The year saw difficult time with liquidity almost drained out, financial performances dwindling, foreign money out of sight, existing lenders shying away, and all this making the job of Finance Managers worst. The existing lenders were shying away due to decline in performance or instances of occasional delay in payments due to increasing liquidity crunch. The Panacea that worked for the finance team was a good credit rating. They realized the power of a good credit rating which helped them in convincing new lenders on short notice for taking fresh exposures thereby facilitating liquidity. These managers would now swear that a good credit rating not only reflects a good health BUT ALSO HELPS IN MAINTAINING A GOOD HEALTH so do or die but maintain it otherwise ICU would be only resort !!    

Don’t repeat the mistake: Using short term for long term

Many corporates which resorted to short term funding on roll over basis for funding their long term plans discovered that this wheel may not be running for ever. And if it stops when the fuel is not there in the market then the journey may be over! Many finance managers had resorted to short term to take the advantage of low interest rates. During the year, Lenders called off these short term lines and corporate found it difficult to tie up the long term funding in the time of turmoil. The year 2013 taught to finance managers the very essence of timely tie up of long term funds and not to interchange it with short term !!

Videshi Banks: Friends of good times

Indian corporates were already finding it difficult to raise finance due to falling performances. In this difficult time, their existing foreign lenders got the message from their Head Quarters in US and Europe to reduce exposure in emerging markets including India. So, the existing funding lines to the corporates in India were put on run off basis by these lenders which acted as last nail in the coffin. In this turbulent time, when the corporates needed their lenders to provide more support, the foreign lenders showed door to these corporates. The public sector banks supported most of the suitable corporates wherever possible to make them float successfully.

Forex Hedging: It’s not so simple

Gone are the days when simple forex hedging policies of 50 per cent or some per cent of the foreign exchange exposure could help corporates in managing forex exposure. During 2013, the profits of the companies (specially the mid and small size companies) turned into losses due to huge volatility in exchange rates specially the Dollar-INR. The year 2013 taught to take forex most seriously, simple forward bookings policies does not work anymore, advisory of forex professional firms essential, and DYNAMIC FOREX MANAGEMENT POLICIES being the need of the hour.

Banking partners: few are not good

Corporate’s in relationships with few banks learnt that in difficult time everyone has a limitation on walking that extra mile but if everyone walks a bit, then its not difficult to tide over the situation. If one of your banking partners is not willing, you have other ready relationships nurtured slowly over the years to help you. The year 2013 taught that in good times its you who dictate but in bad times it’s the relationships which works and relationship cannot be created overnight. So its prudent to have a good number of banking/lenders relationships.

Business Diversification: Helps to float in rough weathers

Company’s diversified in two or three unrelated segments were in a comfortable position since downturn in one segment was balanced by better performance of other segments. So, its better to keep your business diversified as it helps to keep you floating in rough weathers.

Financing: You need soldiers and captains with War experience

Company’s enjoying good reputation, dictating terms to lenders were suddenly in a difficult position due to dwindling performance resulting in defaults on some occasions. Worst was the finance teams & promoters not having experience/in depth knowledge of managing in times of crisis. The year 2013 taught that it is prudent to have people at senior and middle management level with experience of working in such difficult times with legal and practical knowledge (RESTRUCTURING, STAY ORDERS, REVERSING TAX DEPARTMENT NOTICES ETC.) for all the required timely actions (BECAUSE ACTION MUST BE TAKEN BEFORE THE DAMAGE IS CAUSED).

Tie up > Interest Rate & other terms

When everything is good, you dictate to avail the loan, but 2013 taught that for mid and small size companies with credit rating of ‘A plus’ and below, its better to take disbursements as soon as you have tie up of funds in place, AND LATER NEGOTIATE ON TERMS, since there is nothing more important than having access to funds, and nobody knows when the changes in market conditions would change the policies of the lenders for increasing exposures !!

-Wish you all a very Happy and Prosperous New Year 2014

The World of Regulatory Rates

As a lender or borrower the regulatory rates and controls that set a direction to the liquidity and financial markets are important, and I thought to share a note on the same. Hope this is useful as a refreshing tool of those definitions:

Suppose a bank has USD 100 million of equity. Now what is the limit upto which this bank is allowed to raise funds from public in the form of deposits, and what is the limit (of its own equity and deposits raised from public) upto which it is allowed to lend to borrowers?

There is a concept of capital adequacy which controls the lending by banks. The concept explains that the more own capital the bank has the more it can lend. The concept prescribes the minimum capital as a percentage of total credit given by the bank, which is required to be maintained by the bank at all time. So say minimum capital prescribed is 10% of total credit issued, and total credit issued is USD 1000 million, then the minimum capital required to be maintained is USD 100 million. The 10% limit translates that bank is allowed to lend 10 times (i.e. 100/10=10 times) of the capital it maintains. Now suppose that this minimum capital required ratio is reduced to 9% then? This reduction translates into 11.11 times (i.e. 100/9=11.11) of the capital bank can lend. So in our example, the capital of the bank is USD 100 million and reduction in capital adequacy ratio increases its capacity of lending to USD 1111.11 million (USD 100 million X 11.11=USD 1111.11 million) which means the bank can further lend USD 111.11 million (USD 1000 million – USD 1111.11 million=USD 111.11 million). This results in release of funds in the market by bank, thereby improving the liquidity in market. The concept of minimum capital adequacy acts a lever to control lending by banks. Hope sounds simple.

For controlling the deposit raising by banks from public, there is a concept of cash and other form of securities to be kept aside by banks as percentage of total deposits/liabilities mobilized by them. These funds cannot be used by banks for lending. These controls are in the form of Cash Reserve Ratios (CRR) and Statutory Liquidity Ratio (SLR). Under Cash Reserve Ratio a bank has to keep certain percentage of deposits/liabilities raised from public/banking system with RBI in the form of cash. Therefore, the entire funds raised by bank from public are not entirely available to it for lending.

Similarly, under Statutory Liquidity Ratio, a bank is required to keep certain percentage of deposits/net demand & time liabilities raised from public, in the form of approved liquid securities (Cash, Dated Securities, Gold, Treasury Bills etc). Therefore, the bank is not allowed to lend entire funds (equity and deposits from public/liabilites) available with it.

RBI has levers in the form of interest rates at which banks can lend to or borrow huge lot of money and these bulk borrowing or lending rates set the direction of interest rates as well as liquidity in the market. So the high rates, less is liquidity, and low rates more liquidity. These interest rates levers of RBI are Repo Rate, Reverse Repo Rate, Bank Rate, Marginal Standing Facility Rate. Push & pull of these levers sets the tone of interest rates and liquidity on your corporate loans and home loans! Gotcha.

Cash Reserve Ratio (CRR): It is the amount of funds that the banks have to keep with the RBI. For example, when a bank’s deposits increase by Rs.100, and if the cash reserve ratio is 4 per cent, the banks will have to hold additional Rs. 4 with RBI and bank will be able to use only Rs. 96 for investments and lending / credit purpose. Therefore, higher the CRR, the lower is the amount that banks will be able to use for lending and investment.

RBI uses the CRR to drain out excessive cash from the system.  CRR is calculated as a percentage of the total of the Net Demand and Time Liabilities (NDTL), on a fortnightly basis. RBI can prescribe CRR for scheduled banks between 3 per cent and 20 per cent.

NDTL: is sum of demand and time liabilities (deposits) of banks with public and other banks wherein assets with other banks is subtracted to get net liabilities of the other banks.

Repo Rate:  The rate at which the RBI lends money (short term overnight lending) to commercial banks is called Repo Rate. Whenever banks have any shortage of funds they can borrow from the RBI by selling the approved securities. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa. Repo rate is used by RBI to control inflation. In the event of inflation, RBI increases Repo Rate as this acts as a disincentive for banks to borrow. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

RBI takes the contrary position in the event of a fall in inflationary pressures. Repo and Reverse Repo rates form a part of the Liquidity Adjustment Facility(LAF). Repo Rate mainly targets for short term effect to control the liquidity in the market and inflation. Banks can borrow in the RBI Repo auction upto to 0.5 per cent of their NDTL.

Reverse Repo Rate:  Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend their idle cash (which they are not able to deploy) to the RBI since their money is in safe hands with a good interest.

An increase in Reverse Repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which is used by the RBI to drain excess money out of the banking system. In May 2011, RBI decided that Reverse Repo Rate will not be announced separately, but will be linked to Repo rate and it will always be 100 bps (i.e. 1 per cent) below the Repo rate.

Bank Rate: This is the rate at which RBI lends money (long term) to banks or financial institutions. If the bank rate goes up, long-term interest rates also tend to move up, and vice-versa. Thus, it can be said that in case bank rate is hiked, in all likelihood banks will hikes their own lending rates to ensure that they continue to make profit. Bank Rate mainly targets for long term effect to control the liquidity in the market and inflation. Bank Rate is also known as Discount Rate. In contrast, Repo Rate is also called Repurchase Rate.

The Bank Rate involves loans while the Repo Rate involves securities. Bank Rate doesn’t involve collateral of any kind while the Repo Rate (especially the repurchase agreement) requires the securities as the collateral in the agreement.

The Bank Rate is usually higher compared to the Repo Rate. A high Bank Rate will reflect in the high lending rate of the commercial bank to its clients. On the other hand, the Repo Rate may not be not passed to the clients of the commercial banks.

The bank rate also has importance since this impacts inter-corporate loans & investments. As per Sub Section (3) of Sec 372A “No loan to any Body Corporate shall be made at a rate of interest lower than the prevailing bank rate, being the standard rate made public under section 49 of the RBI Act, 1934 (2 of 1934)”. In case of banks failing in maintaining their required CRR and SLR ratio penal interest is charged by RBI which is linked to Bank Rate.

Liquidity Adjustment Facility (LAF): RBI’s liquidity adjustment facility helps banks to adjust their daily liquidity mismatches. LAF has two components: Repo (Repurchase Agreement) and Reverse Repo. When banks need liquidity to meet its daily requirement, they borrow from RBI through Repo. The rate at which they borrow fund is called the Repo Rate. When banks are flush with fund, they park with RBI through the Reverse Repo mechanism at Reverse Repo Rate.

Statutory Liquidity Ratio (SLR): Every bank is required to maintain at the close of business every day on fortnightly basis, a minimum proportion of their NDTL as liquid assets in the form of cash, gold and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities is known as SLR. Present SLR is 23%. RBI is empowered to increase this ratio up to 40%. An increase in SLR restrict the bank’s leverage position to pump more money into the economy.

Marginal Standing Facility (MSF):  Earlier there was no limit on borrowing under Repo by banks. A bank only had to maintain the SLR Ratio and any government securities it owned above that limit could be used for Repo borrowing. Later on cap of 0.50 percent of NDTL for maximum borrowing under Repo was introduced. Now, when a bank is in need to borrow more than what it can under Repo after exhausting its excess SLR securities, it can borrow under MSF by offering its SLR securities (i.e. securities already used for maintaining its SLR Ratio). Under MSF banks can borrow upto 2 percent of their respective NDTL outstanding at the end of the second preceding fortnight. Banks borrow funds through MSF during acute shortage of liquidity.  MSF Rate is kept higher than the Repo rate to make it as penal rate.

For availing MSF, the securities which can be offered to RBI include all SLR-eligible transferable Government of India (GoI) dated Securities/Treasury Bills and State Development Loans (SDL). 

MSF rate increase is done by RBI to control excess availability of the rupee and to control its depreciation with respect to the dollar. MSF represents the upper band of the interest corridor and Reverse Repo as the lower band and the Repo Rate in the middle.

Capital to Risk Weighted Assets Ratio (CRAR):  Capital Adequacy Ratio (CAR) is also known as CRAR. It is the measure of a bank's capital and is expressed as a percentage of a bank's risk weighted credit exposures.

CAR = Total Capital / Total Risk Weighted Assets

Total capital comprises of the bank's Tier I and Tier II capital. Total risk weighted assets takes into account credit risk, market risk and operational risk. This ratio is maintained to ensure that banks have enough capital to sustain operating losses while still honoring withdrawals.

Current Rates (as on December 23, 2013):

Bank Rate : 8.75 per cent

Repo Rate : 7.75 per cent

Reverse Repo Rate : 6.75 per cent

MSF Rate : 8.75 per cent

CRR : 4 per cent

SLR : 23 per cent

CRAR: 9 per cent