NBFC & Mutual Funds

Non Banking Finance Companies (As per Government of India specifications) Rahul Guhathakurta & Zardar Badami Indian Institute of Planning & Management Ahmedabad Cover Story Mutual Funds

As per Sec. 45 I (f) of RBI Act, 1934 A financial institution is an NBFC… … which has a principle business of receiving deposits under any scheme or an arrangement or lending in any manner, Approved by Central Government and Notified by Official Gazette What is an NBFC?

In April 1999, RBI further announced that identification of a company as an NBFC will depend on:

On the assets

The income pattern of the company

From the last audited balance sheet, RBI will decide on the principal business of the company

Identification Parameters for an NBFC given by RBI Factors Determining an NBFC Financial Assets of the Company Total Assets of the Company (Netted off against Tangible Assets ) 50% > Income from Financial Assets Gross Income 50% > … then the company will be treated as an NBFC

Chronology of the NBFC’s Regulatory Provisions Chapter III-B, III-C & V of Reserve Bank of India Act, 1934 The Miscellaneous Non-Banking Companies (RBI) Directions, 1977 Residuary Non-Banking Companies (RBI) Directions, 1987 Housing Finance Companies (NHB) Directions, 1989 Non Banking Financial Companies (RBI) Directions, 1998 Reserve Bank of India (Amendment) Act, March 1997

Initial Regulatory Environment as per RBI Act,1934 Entry barriers were low There were no capital adequacy Norms. No prudential norms Little restrictions on Interest rates Offered to the depositors Regulatory Factors

Call for an amendment in the Act & other Provisions

Reasons:

1. The regulations that existed seemed to be inadequate to protect the depositor’s interest.

2. Incidents of depositors loosing there money due to mismanagement or due to fraud were cropping up.

Consequently, three new sets of directions were issued by the RBI for governing the operations of NBFC's Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions 1998 Non-Banking Financial Companies Prudential Norms (Reserve Bank) Directions, 1998 Non-Banking Financial Companies Auditor’s Report (Reserve Bank) Directions, 1998

Further Classification of the NBFCs (aftermath of Directions issued in January 1998) Regulations for Deposits NBFCs Accepting Public Regulations for NBFCs Not Accepting Public Deposits Regulations for Core Investment Companies

Regulations for NBFCs Accepting Public Deposits Income Recognition Asset Classification Accounting Standards Provision for Bad & Doubtful debts Capital Adequacy Credit/Investment Concentration Prudential Norms The companies accepting public deposits are required to comply with all the Prudential Norms mentioned below… Note: The provision norms are on par with those of Commercial Banks

Eligibility Criteria for Accepting Public Deposit

An NBFC having Net Owned Funds of Rs. 200.00 lakhs and above only can accept Public Deposits

It has to obtain Minimum Stipulated Credit Rating from any one of the approved Credit Rating Agencies at least once in a year.

Copy of the Credit Rating should be sent to the RBI along with the Return on Prudential Norms.

The NBFC should have acquired a credit rating of not less than AAA rating or its equivalent in the previous year

Eligibility Criteria for Accepting Public Deposit

If the Credit Rating is either down graded or upgraded, the NBFC is required to report this fact to the RBI within 15 days from the date when it receives such information.

It is to be noted that the deposits taken by the NBFCs are repayable on demand and the Minimum period for which Public Deposits can be accepted is not less than 12 months with a maximum period of 84 months.

There is a ceiling provided for the quantum of deposits accepted by NBFCs.

Eligibility Criteria for Accepting Public Deposits

The CRAR has been fixed 12% and above.

(Rated NBFCs) and 15% & above

(Un-Rated NBFCs)

The Credit norms has been fixed at 15%

and The Investment Concentration norms

has been fixed at 25%

The Total Loan and Investments

have a ceiling of 25% & 40% of the

owned funds, respectively.

… depending on whether the exposure is To a single party or to an Industry group. … depending on whether the exposure is to a Single borrower or a Group of borrowers.

RBI Guidelines for Un-rated NBFCs

All EL/HP Finance companies that do not have:

The minimum investment grade credit rating

& mobilizing public deposits up to 1.5 times of their NOF or Rs. 10 Crore

… whichever is lower, should not have a CAR less than 15%.

NBFC’s comprise following Business Organizations Equipment Leasing Activities Loan Granting Activities Housing Finance Insurance Business Mutual Fund Finance Investment Activities Hire Purchase Finance NBFC’s Comprise Following Business Organizations

Classification based on purpose of acceptance of deposits by NBFC Directions 1998 Equipment Leasing (EL) Hire Purchase (HP) Investment Companies (IC) Loan Companies (LC) Source: Re Classification of NBFCs December 6 2006 ~ RBI / 2006-07/200 DNBS.PD. CC No. 85 / 03.02.089 /2006-07 Re-classification of NBFCs on December 6 , 2006 Asset Finance Companies (AFC) Investment Companies (IC) Loan Companies (LC)

Regulations for NBFCs not Accepting Public Deposits

As these companies do not accept Public Deposits, all regulations related to interest rates, period and ceilings on quantum of borrowing do not applied.

However, to ensure the disclosure of a true and fair picture of their financial health, these companies are subjected to Prudential Norms.

… excepting the CAR and Credit Concentration Norms

Regulations for Core Investment Companies

These companies are exempted from all the provisions of the directions except the statutory provisions for registration and creation of reserve fund.

Mother-of-All-Rules

“ According to RBI guidelines issued on April 1, 1999, All NBFCs are required to maintain liquid assets of 15% of public deposits held on the last working day of the secondary preceding quarter .”

Books and Records maintained by NBFCs Books & Records Maintained by an NBFC Cash Book & Bank Book Depositor’s Ledger Due Date & Renewal Register Interest Register Loan Ledger Investment Ledger General Ledger

General Recommendations General Recommend. Integrate domestic financial market by making NBFCs - channel partners to larger banks Reduction in interest cost and hence benefits the ultimate consumer Enhancing the credit delivery mechanisms Reversing the inverse relationship between the size of borrowing and the cost of borrowing Strengthening the professionalism of the NBFC sector through education and training

MUTUAL FUNDS An NBFC Cover Story

Introduction : Mutual Funds Mutual Funds A “ Pooling Concept” Portfolio of Stocks Portfolio of Bonds Portfolio of Other Investment Instruments All Mutual Funds aim at achieving one or more of the following:

Providing steady flow of income

Providing high capital appreciation

Providing capital appreciation with income

Providing income or capital appreciation with tax benefits

Types of Mutual Funds

An Open-Ended Fund

Unlimited Capitalization

No predetermined date of redemption

Sale & purchase of units at current net asset value (NAV)

No restrictions on entry & exit

Purchase of units directly from funds

Sale of units directly to the funds

A Close-Ended Fund

Constant Capitalization

Pre-determined date of redemption

Pre-determined date for closing subscription

Frequent lock-in-period

Purchase & sale of units at the traded prices at the stock exchanges

“ In India, additionally, the close-ended funds can be purchased from & sold back to the funds”

Functional Entities involved in Mutual Funds Operation Trust or Trustee Company Asset Management Company (AMC) Custodian Registrars/ Transfer Agents Distributors

They form mutual funds under the existing Trust or

Companies Acts.

Trust managed by the Trustees & Trustee Companies

are managed by the board of Directors.

Undertakes the administration & investment activities Of the fund He/She is an independent entity who is Responsible for safekeeping the fund’s assets i.e., stocks, bonds and cash

They handle sales and redemption related

activities of the fund.

They also maintain records of the shareholders and

send the payment cheques to the investors

They are the fund distributors/underwriters to

handle the sales of units.

The underwriters act as an wholesale selling units to the

brokers who in turn , sell to the retail investors

Fundamental Structure of Global Mutual Funds

Sponsor Company Establishes MF as a Trust Registers MF with SEBI Holds unit-holder’s fund in MF Ensures compliance to SEBI Enters into agreement with AMC Floats MF Funds Manages fund as per SEBI Guidelines &AMC agreements Provides necessary custodian services Provide Banking Services Mutual Fund Asset Management Company Custodian Bankers Registrar & Transfer Agents Managed by Board of Trustees Provide Registrar services and Act as an Transfer Agents Structure of Indian Mutual Funds

Categories of Mutual Funds Money Market Funds Lilliput Funds Index Funds Sector Funds Balanced Funds Bond Funds Income Funds Growth and Income Funds Asset Allocation Funds Growth Funds Aggressive Growth Fund Overseas Funds Guaranteed Funds Fund of Funds Venture Capital Funds

Basis for Classification

Risk

Sectoral funds are most risky; money market funds are least risky

Tenor

Equity funds require a long investment horizon; liquid funds are for the short term liquidity needs

Investment objective

Equity funds suit growth objectives; debt funds suit income objectives

Risk and Return Liquid funds ST debt funds Gilt funds Debt Funds Index funds Equity funds Sectoral funds Balanced funds Risk Return

Mutual Fund Taxation

Mutual fund is exempt from paying taxes (Section 10 (23D))

Income for investors

Dividend

Capital gain

Present position

Dividend exempt from tax.

Fund pays dividend distribution tax at 10%.

Open end funds with >50% in equity, fully exempt. No tax is paid by the fund or the investor.

Taxation:Finance Act 2002-03

Dividend fully taxable in the hands of investors

TDS @10% for dividends above Rs.1000

Deductions under Section 80L along with other interest and dividend income, up to Rs. 9000.

Section 88 benefit reduced

GTI less than 1.5 lakhs :20%

GTI >1.5 lakhs < 5 lakhs:15%

GTI > 5 lakhs, no rebate.

Asset Allocation and Model Portfolios

Deciding the allocation of funds amongst equity, debt and money market.

Incorporating product, investor profile and preferences in the portfolio.

Equity, debt and money market products are called asset classes. Allocating resources to each of these is called asset allocation.

Graham’s Model Portfolio

Based on the 50:50 rule.

Basic managed portfolio.

Basic indexed portfolio.

Simple managed portfolio.

Complex managed portfolio.

Readymade portfolio.

Bogle’s Strategic Asset Allocation

Combine age, risk profile and preferences in asset allocation

Older investors in distribution phase

50% equity;50% debt

Younger investors in distribution phase

60% equity; 40% debt

Older investors in accumulation phase

Younger investors in accumulation phase

Fixed and Flexible Asset Allocation

Fixed ratio between asset classes

Portfolio has to be periodically re-balanced

Disciplined approach

Enables investor to book profits in a rising market and invest more in a falling market.

Flexible allocation

No re-balancing; asset class proportions can vary when prices change.

If equity returns are higher than debt returns, equity allocation will go up at a faster rate.

Developing a Model Portfolio

Develop long term goals

Investment avenues, time horizon, return and risk

Determine asset allocation

Allocation to broad asset classes

Determine sector distribution

Allocation of sectors of the mutual fund industry

Select specific fund schemes for investment

Compare products and choose actual funds to invest in

Jacob’s Model Portfolios

Accumulation phase

Diversified equity: 65 - 80%

Income and gilt funds: 15 - 30%

Liquid funds: 5%

Distribution phase

Diversified equity: 15 - 30%

Income and gilt funds: 65 - 80%

Liquid funds: 5%

Regulatory Framework

SEBI (Mutual Fund) Regulations, 1996

RBI as regulator

Guarantees of sponsors in bank-sponsored mutual funds

Regulator of G-Secs and money markets

Stock exchange

listed mutual funds

Regulatory Framework cont’d…

Companies Act

AMCs and Trustee Company

DCA as regulator

RoC for Compliance

CLB for prosecution and penalties

Office of the public trustee

Registration

Complaints against trustees

Funds Rating in India Ratings of mutual funds has not yet been institutionalized in India, however some attempts are being made. The following agencies involved in rating process are as follows: CRISIL : Credit Rating and Investment Services Ltd [Est. – 1987] Duff & Phelps Credit Rating India Ltd [Est. 1996] – (Now Fitch IBCA) CARE: Credit Analysis and Research Ltd [Est. – 1993] ICRA : Investment Information and Credit Rating Agency of India [Est. – 1991] Credence (Mumbai) Value Research (New Delhi) Indian Mutual Fund Research Agencies

Bibliography

RBI Guideline from http://www.rbi.gov.in

Critical role for non-banking finance sector R. Vaidyanathan , Professor of Finance and Control, Indian Institute of Management Bangalore, [email_address]