CHAPTER NINTEEN

Mutual Funds, Securities Trading, Universal Banking and Credit Rating

CHEPTER STRUCTURE

Section I Mutual Funds

Section II Trading in Securities/Shares

Section III Universal Banking

Section IV Credit Rating Services

KEY TAKEAWAYS FROM THE CHAPTER

• Understand the basics of financial services, such as mutual funds, bancassurance, securities trading.
• Learn the mechanism of universal banking.
• Understand the trends and progress of financial services sector.

SECTION I

MUTUAL FUNDS

Amutual fund is a trust that pools the savings of a number of investors who share a common financial goal. The money, thus, collected is then invested in capital market instruments, such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realized is shared by its unit holders in proportion to the number of units owned by them. Thus, a mutual fund could be considered as one of the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost. Mutual funds can be broadly divided as open-ended and closed-ended funds. Companies, such as Franklin Templeton, Prudential, Unit Trust of India, Nomura Securities, etc. offer mutual funds for investors.

Advantages of Mutual Funds

• Professional management and research: Mutual funds are managed by professional fund managers who regularly monitor market trends and economic trends for taking investment decisions. They also have dedicated research professionals working with them who make an in-depth study of the investment option to take an informed decision.
• Convenience: With features like dematerialized account statements, easy subscription and redemption processes, availability of Net Asset Values (NAVs) and performance details through journals, newspapers and updates and lot more; mutual funds can be considered as a convenient way of investing.
• Liquidity: One of the greatest advantages of mutual fund investment is liquidity. Open-ended funds provide option to redeem on demand, which is beneficial during rising or falling markets.
• Tax advantages: Investment in mutual funds also enjoys certain tax advantages. Dividends from some specific mutual funds are tax-free in the hands of the investor in many countries. Also capital gain accrued from mutual fund investment for a period of over 1 year is treated as long-term capital appreciation and is tax-free in most of the countries.

Types of Mutual Funds

• Equity-based funds: The investments of these schemes will predominantly be in the stock markets. The purpose is to provide investors the opportunity to benefit from the higher returns which stock markets can provide. However, they are exposed to the volatility of stock markets. Therefore, investors should choose this type of mutual funds based on their risk-taking capacities and willingness to think long term.
• Debt funds: Debt Funds invest only in debt instruments, such as corporate bonds, government securities and money market instruments. They completely avoid investments in the stock markets. Hence, they are safer than equity funds. At the same time, the expected returns from debt funds would be lower. Such investments are advisable for the risk-averse investor.
• Hybrid funds: Hybrid funds invest in a mix of equity and debt investments. Hence, they are less risky than equity funds, but at the same time provide lower returns. Some people prefer this type of funds because they believe hybrid funds offer optimum returns.

Important Terms

Net Asset Value Net asset value is the market value of the assets of the scheme minus its liabilities. The per unit NAV is the NAV of the scheme divided by the number of units outstanding on the valuation date.

Sale Price The Sale price refers to the price you pay when you invest in a scheme. Also called ‘offer price’, it may include a sales load (also known as Entry Load).

Repurchase Price Repurchase price refers to the price at which a close-ended scheme repurchases its units and it may include a back-end load. This is also called ‘bid price’.

Redemption Price This is the price at which open-ended schemes repurchase their units and close-ended schemes redeem their units on maturity. Such prices are NAV-related.

Sales Load Sales load is a charge collected by a scheme when it sells the units. It is also called ‘front-end’ load. Schemes that do not charge a load are called ‘no-load’ schemes.

Exit Load or Repurchase Exit load refers to a charge collected by a `mutual fund` company when it buys back the units from the holders.

SECTION II

TRADING IN SECURITIES/SHARES

The rapidly advancing technology, particularly the Internet, has drastically changed the economic landscapes and every aspect of our daily life. In the securities industry, the Internet has facilitated online trading, changing the way the market works, as well as the way the investors access the market.

‘Online trading’ is broadly defined as a trading mechanism where investors place orders and confirm trading results via electronic communication channels, such as the Internet, mobile phones and personal digital assistants. The whole process of securities transactions, from order placement and execution to trade confirmation, is fully automated, thus, enabling the investors who have placed orders to confirm their trading results within a few seconds in many countries.

Factors Behind growth of online Trading

The drastic growth of online trading in the world did not happen by chance. Initially, online trading was not well received by investors, as the concept of e-commerce was new to them. Once the investors recognized its advantages, however, online trading flourished rapidly, especially among individual investors.

Key factors that have fostered the growth are as follows:

1. First, the rapid growth of Internet-using population
2. Liberalization of brokerage commissions allowing securities companies to determine their own rates autonomously. The liberalization of brokerage commission triggered a price competition among securities companies, ending up with the reduction of fees for online trading.
3. The speed and lower transaction costs of online trading encouraged investors to trade frequently in pursuit of short swing profits, making day trading prevalent in the market.

Impact on Securities Market

The prevalence of online trading had significant impacts on the trading patterns of investors and trading volume. Let us see the extent of impact one-by-one.

1. Online trading has significantly contributed to the growth in trading volume.
2. Transaction costs have been significantly lowered after online trading was introduced. Initially, a 0.5 per cent of brokerage commissions were applied to both online and traditional transactions. Due to the price competition, brokerage commissions for online trading continued to be lowered to as low as 0.2 per cent charged by a few broking houses.
3. Lowering of the capital requirements for the establishment of broking-only securities firms prompted establishment of several broking-only securities firms, which are exclusively engaged in online trading businesses. The low fee strategies of these securities firms further accelerated price competition.
4. Lastly, after online trading was introduced, individual investors could have an easy and speedy access to market information. The number of securities market-related Web sites increased rapidly, providing a variety of information, including quotation information, corporate disclosure, financial information, research papers and financial news, on a real-time basis.
5. Excessive day trading increased the price volatility and some devious large investors attempted to mislead investors by placing fake orders.

SECTION III

UNIVERSAL BANKING

The term ‘universal banking’ in general refers to the combination of commercial banking and investment banking, i.e., issuing, underwriting, investing and trading in securities. In a very broad sense, however, the term ‘universal banks’ refers to those banks that offer a wide range of financial services, beyond commercial banking and investment banking, such as insurance. However, universal banking does not mean that every institution conducts every type of business with every type of customer. In the spectrum of banking, specialized banking is on the one end and the universal banking on the other.

Financial institutions with focus on ‘universal banking’ offer the entire range of financial services. They sell insurance, underwrite securities and carry out securities transactions on behalf of others. In other words, a ‘universal bank’ is a ‘one-stop’ supplier for all financial products and activities like deposits, short-term and long-term loans, insurance, investment banking, etc.

There are multi-product firms in the financial services sector whose complexity is difficult to manage. In their organizational structure and strategic direction, universal banks constitute multi-product firms within the financial services sector. This profile of universal banks presents shareholders with an anagram of distinct businesses that are linked together in a complex network.

The structural form of universal banking appears to depend on the ease with which operating efficiencies and scale and scope economies can be exploited—determined in large part by product and process technologies—as well as the comparative organizational effectiveness in optimally satisfying client requirements and bringing to bear market power.

Many bankers argue that ‘bigger is better’ from a shareholder perspective, and usually point to economies of scale as a major reason for ‘universal banking’ activity.

It seems that banks of roughly the same size and providing the same range of services may have very different cost levels per unit of output. The reasons may involve efficiency—differences in the use of labour and capital, effectiveness in the sourcing and application of available technology and perhaps in the acquisition of skilled labour, strategy, organizational design, compensation and incentive systems—and just plain better management.

Size and Market Power

Universal banks are able to extract economic rents from the market by application of market power. However, in many national markets for financial services, these types of organizations suppliers have shown a tendency towards oligopoly, but may be prevented by regulation or international competition from fully exploiting monopoly positions.

Diversification—Insurance and Securities

There are potential risk-reduction gains from diversification in universal financial service organizations. Indeed, these gains increase with the number of activities undertaken. The main gains appear to arise from combining commercial banking with insurance activities, rather than with securities activities.

Core of Universal Banking

A bank uses its lending power activities to tie-in a customer and uses it as an opportunity for cross-selling securities and insurance products.

Impartial Investment Advice

There is a lengthy list of problems, involving potential conflicts between banks’ commercial and investment roles. For example, there may be possible conflict between the investment banker’s promotional role and commercial banker’s obligation to provide impartial advice.

Benefits to Banks

‘Universal Banking’ enables banks to leverage from economies of scale and scope. What it means is that a bank can reduce average costs and, thereby, improve spreads if it expands its scale of operations and diversifies its activities.

By diversifying, a bank can use its existing expertise and infrastructure in one type of financial service to provide the other types of services. So, it entails less cost in performing all the functions by one entity instead of separate specialized organizations. A bank possesses information on the risk characteristics of its clients, which it can use to pursue other activities with the same clients. This again saves cost compared to the case of different entities catering to the different needs of the same clients. A bank has an existing network of branches, which can act as shops for selling products like insurance. This way a big bank can reach the remotest client without having to appoint many agents. Many financial services are inter-linked activities, e.g., insurance and lending. A bank can use its instruments in insurance to borrower and vice versa, and exploit the other, e.g., lending to the same firm which has purchased insurance from the bank.

Benefits to Customers

The idea of ‘one-stop-shopping’ saves a lot of transaction costs and increases the speed of economic activity. Another manifestation of universal banking is a bank holding stakes in a firm (sometimes, banks undertake this kind of activity). A bank’s equity holding in a borrower firm acts as a signal for other investors on the health of the firm, since the lending bank is in a better position to monitor the firm’s activities. This is useful from the investors’ point of view.

Challenges

Having explained the benefits, let us talk about the problems of ‘universal banking’. These benefits have to be weighed out against the problems. The obvious drawback is that ‘universal banking’ leads to an imperfectly competitive market structure like oligopoly.

SECTION IV

CREdIT RaTIng SERvICES

Credit rating has become a benchmark criterion for investors, borrowers, banks and financial institutions while taking decisions. The ‘rating’ mechanism helps the organizations to compare the performance of financial service providers, and work as a basis for strategy formulation in this era of competition. This section is an outcome of an attempt to look at the prospects and consequences of ‘credit rating’ system in the financial sector. The goal is to discuss the rationale for credit rating, benefits of the system for investors, issuers, regulators and the functioning of rating agencies.

Credit Rating—An Overview

The trend of establishing local credit rating agencies started only in the 1970s. Prior to this, the two international rating agencies, namely, Standard & Poor’s and Moody’s Investors Service, dominated the rating world. However, since the establishment of the first known local rating agency, the Canadian Bond Rating Services in 1972, local rating agencies have proliferated across the globe, both in the developed markets (Australia, France and Japan) and also in a large number of emerging markets. Currently, there are ratings agencies in Argentina, Brazil, Chile, Columbia, India, Israel, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Portugal, Sri Lanka, South Africa, Thailand, Tunisia and Venezuela, which are duly recognized and are in operation. It is interesting to note that in several other important emerging markets in the East European countries and republics of the former Soviet Union, rating agencies still have to be established or are in the process of being established. The main motivation for the establishment of local rating agencies is the recognition of their critical role in promoting bond or other fixed-income securities markets. At the same time, there is increasing realization that rating agencies are likely to impart efficiency to the financial and capital markets. The experience of these emerging markets provides ample evidence of the positive impact of rating agencies. Credit rating provides an important tool for guiding the decisions of investors, issuers as well as regulators.

Information to Investors

Traditionally, ratings were used mainly for investment decisions covering acquisition of fixed-income securities in the primary market. As long as the risk level of the security, indicated by the rating, conformed to the investor’s risk preference, there was a tendency to acquire and hold to maturity. However, this traditional approach has changed since the credit rating mechanism came to be recognized as a continuing evaluation rather than a one-time exercise. Currently, all rating agencies feel obliged to continuously monitor the ratings and upgrade or downgrade them as warranted by any significant developments. This process provides added advantage to investors to adjust their portfolio by maintaining a consistent risk profile.

Credit ratings are often used by banks and other financial intermediaries to support decisions on their own corporate lending. Banks, e.g., may use bank deposit ratings to guide their decisions on inter-bank loans, trade finance, swap agreements and other counterparty risks. Increasingly, corporate treasurers are also using ratings to evaluate the credit risk of banks, securities firms and other counterparties.

As the credit rating agencies develop organizationally and their coverage includes a critical mass, they acquire the capacity to provide vital information to the market through dissemination of ratings. It is generally recognized that information available in credit rating reports is of greater value than that generally available through other sources of corporate financial data. Rating agencies are, therefore, being increasingly viewed as providers of professional credit research services that major institutional investors use to supplement their internal credit evaluation.

Benefits to Issuers

Although the principal beneficiaries of credit rating are investors, the cost of this service is borne by the issuers of fixed-income securities. It follows, therefore, that unless corporate issuers see any measurable benefit, there would be little interest in exposure to additional scrutiny and cost that a rating process involves.

Cost savings with rated debt instruments may also show up in comparison with other forms of financing alternatives. For example, some investors who otherwise could have required a bank guarantee to purchase a given debt security may instead accept a sufficiently high rating from a recognized agency. Depending on the situation, the cost of the credit rating may be less than that of a bank guarantee. As the credit rating culture develops, it is likely that the cost of issuing rated short-term commercial paper is lower than the cost of bank credit facilities.

The ratings and associated analysis of an independent agency can also help debt issuers to manage investor perceptions of credit risk over time—and consequently to maximize access to the capital market even in times of stress. For example, a news item could adversely affect the prices of a company’s outstanding bonds, and some investors may, thus, be disinclined to make further investments in new issues by the company. An appropriate rating action by an independent rating agency—accompanied by an analytical statement about how the new situation will affect the company’s financial strength—could help to maintain investor confidence.

Benefit to the Regulators

Financial regulators have also found that ratings may service a variety of uses. In the United States, e.g., many state and federal agencies use ratings as an independent yardstick to regulate the eligibility of some issuers to offer new debt securities. Many regulators also use independent credit ratings to help them monitor the financial soundness of the insurance companies and public utilities. While there is no consistent pattern about the extent of reliance by regulators on ratings in different countries, there is increasing recognition that use of ratings facilitates the regulatory role. In countries like France, Japan, India, Malaysia, Thailand and Australia, regulators of the financial capital markets can use different variants of mandatory ratings. The mandatory ratings of all local rating agencies are, therefore, not unique and are generally in line with the current global practice.

Differences of Opinion in the Credit Rating Industry

Some studies have suggested, that among the many variables considered, only size and bond issuance history are consistently related to the probability of having third ratings. These variables probably reflect differences in the relative costs of third ratings across firms.

Rating-dependent financial regulators assume that the same letter ratings from different agencies imply the same levels of default risk. Most ‘third’ agencies, however, assign significantly higher ratings on average than Moody’s and Standard & Poor’s. Contrary to the claims of some rating industry professionals, sample selection bias can account for at most half of the observed average difference in ratings.

An attempt has been done to investigate the economic rationale used by multiple rating agencies. Among the many variables considered, only size and bond-issuance history are consistently related to the probability of an issuer seeking third ratings. The probability appears unrelated to uncertainty over default risk or firms’ opportunities to improve their standing under rating-dependent regulations.

Regulators, like investors, value the cost savings achieved through the use of credit ratings in credit evaluation. As a result, they have come to rely on a variety of specific letter ratings as thresholds for determining capital charges and investment prohibitions. The regulatory use of ratings, however, does not account for the fact that some rating agencies appear to have different absolute scales, some rating bonds higher or lower on average on jointly rated issues than Moody’s and Standard and Poor’s (S&P), the two leading agencies. At present, the ratings of the four major U.S. agencies are used interchangeably in regulations issued by the Securities and Exchange Commission (SEC) and the National Association of Insurance Commissioners. Critics of the current system have recommended that regulatory usage be limited only to those agencies that have demonstrated a market impact, or that ratings should not be used at all by financial regulators.

While for decades, Moody’s and S&P’s have automatically assigned ratings to all corporations issuing in the U.S. public bond markets, Fitch and Duff & Phelps—the two other major agencies—have issued ratings only upon request. These ‘third’ agencies have argued that their ratings have often been sought when there is a strong expectation by issuers of improving upon Moody’s and S&P’s ratings. However, whenever Fitch and Duff & Phelps would have rated lower, their ratings would not have been purchased.

Certainly, the mechanism of reputation should serve as a powerful incentive to maintain ratings that are not too out-of-line with established standards. The rationale for obtaining credit ratings has traditionally been viewed in the finance literature to be the economies of scale in information collection and the reduction of agency costs in the issuance of debt. If investors were to lose confidence in an agency’s ratings, issuers would no longer believe they could lower their funding costs by obtaining its ratings. To this extent, we might expect the credit rating agency’s reputation in the bond market to play a role similar to that of the underwriter’s in the initial public offering market, where reputation checks the degree to which low-quality issues are brought to the market.

It is possible that the reputation mechanism works imperfectly in a credit rating industry characterized by regulation-related demand. Firms may purchase an agency’s ratings in order to meet regulatory guidelines independent of how that agency’s ratings are viewed in the marketplace. As a result, concerns over ‘rating shopping’ have prompted the SEC to reconsider the use of ratings in regulations and its procedures for identifying with agencies’ ratings it recognizes.

Ultimately, whether observed rating differences reflect different credit standards is an empirical question. Are the default risks associated with a particular letter grade higher for some agencies than for others? Or, do the third agencies appear to have lower credit standards just because they provide ratings only upon request? In addition, do firms systematically employ credit rating agencies to clear regulatory hurdles?

The bond ratings of the four agencies are comparable in the sense that they attempt to measure the likelihood of the default or delayed payment of a security. But while each agency’s ranking of relative default risks is fairly straightforward, the correspondence between their symbols and absolute levels of default risk has not been made explicit by the agencies. Standard & Poor’s, Duff & Phelps and Fitch use the same basic set of rating symbols, but Moody’s uses a slightly different system.

As ratings have gained greater acceptance in the marketplace, regulators of financial markets and institutions have increasingly used them to simplify the task of prudential oversight. The reliance on ratings extends to virtually all financial regulators, including the public authorities that oversee banks, thrifts, insurance companies, securities firms, capital markets, mutual funds and private pensions.

CHAPTER SUMMARY

• The creation of bancassurance operations has a material impact on the financial services industry at large. Banks, insurance companies and traditional fund management houses are converging towards a model of global retail financial institution offering a wide array of products. It leads to the creation of ‘one-stop shop’ where a customer can apply for mortgages, pensions, savings and insurance products.
• Banks’ desire to increase fee income works as motivating factor for them to look at insurance. Insurance carriers and banks can become part of the vision through strategic partnerships.
• Online trading can flourish when certain conditions are in place and interact with each other positively. Among others, large Internet-using population, well-established communication infrastructure, the provision of incentives for online trading, deregulation and favourable market conditions are necessary to encourage online trading. It should be kept in mind that online trading has both positive and negative effects on the securities market. It is necessary to address the negative effects. Ignoring the risks involved, one might be drowned while sailing the ocean.

TEST YOUR UNDERSTANDING

1. Name three companies offering mutual fund services.
2. Mutual funds offer the following types of funds:
   1. Equity, debt and hybrid types,
   2. Equity and debt funds
   3. Only equity-based funds
   4. Only hybrid funds
3. The market value of the assets of a mutual fund scheme minus its liabilities is known as:
   1. NAV
   2. GAV
   3. Entry load
   4. Exit load
4. Bancassurance in its simplest form is the distribution of insurance products through a bank’s distribution channels.
   State whether this statement is true or false.

TOPICS FOR FURTHER DISCUSSION

• Discuss the synergies of universal banking.
• Compare and examine different type of mutual fund products.
• Discuss the scope of credit rating services.

SELECT REFERENCES

1. Seethapathi K (2001), Financial Services, edited, ICFAI Hyderabad.
2. Masahiko Egami and Hideki Iwaki (2008), An Optimal Life Insurance Policy in the Investment-Consumption Problem in an Incomplete Market, Paper Presented at the Asian Finance Association 2008 International Conference held during 6–9 July 2008, Tokyo, Japan.
3. AMFI (2007–08), Annual report.
4. Paul, Justin (2009), Business Environment, 2nd edition, McGraw-Hill.
5. Ravi Mohan R (2000), ‘Credit Rating: A Paradigm Shift’, Chartered Financial Analyst, December, pp 71– 73.
6. Reddy Y. V (2000), ‘Credit Rating: Changing Perspectives’, RBI Bulletin, May, P 507.
7. Rating Scan (2004), CRISIL publication.
8. www.crisil.com, accessed on 30 January, 2009.
9. www.icraindia.com, accessed on 15 December 2008.