Series on Financial Markets - VI

After a brief gap (due to various preoccupations), let me resume my blogs.  Let me brief on the past posts in the above series.  The first one dealt with basics of real assets and financial assets.  The second one explained the characteristics of financial assets; the third one was about the financial system and the fourth and fifth dealt with raising funds (capital) from through borrowing and from the shareholders through the primary markets respectively.  The last post ended with a question: when raising funds directly from public involves lot of costs (in various forms), why do firms raise funds from the public?  Let me try to answer.

Let us first understand why firms do not like too much of debt.  Debt capital, though less costly as the interest rates are fixed and they do not participate in the profits of the firs, has its own disadvantages.  Firstly, the interest payments on debt are committed costs and the firm has to pay the same, irrespective of whether the firm makes profit or not and whether it has enough cash balance or not.  Default in payment payment leads to lot of complications like hampering the image of the firm, reduced credit rating, and even legal proceedings by the lenders in extreme cases.  Secondly, the lenders start insisting on certain operational restrictions.  They would require the firm to take them into confidence before implementing major decisions like expansion of business, payment of dividend, raising further funds etc.  Thirdly, as the going gets tough for a firm (may be due to unfavourable external environment), firms with more debt find it difficult to sail through, as they have to deal simultaneously with the hostile business conditions and the highly demanding lenders.  This is exactly what the aviation sector is facing now.

Now let me explain, why equity (owner's funds) may be attractive inspite of relatively higher costs.  The equity capital is almost a permanent source of capital.  The firm is under no obligation to repay this capital under any circumstances, except in case of winding up of business or buyback of shares.  Here again, the decision to buyback the shares is not demanded by the shareholders.  The firm is also not under any obligation as far as payment of dividend (the share of profit) is concerned.  A firm with more equity capital attracts a better image in the business circles and financial markets.  Such a firm also enjoys better bargaining power with the lenders, when it comes to raising additional funds through borrowing.

Series on Financial Markets - V

Continuing with the discussion on raising capital by business entities, unlike what I mentioned in my earlier post, capital can also be raised directly from the savers.  Small businesses borrow money from the friends/relatives of the promoter directly; whereas large corporate houses raise money from public at large.  (There are various reasons why businesses do not fully depend on banks and financial institutions for capital, which is not explained here).  A business enterprise can raise capital in the form of debt or equity (ownership).  When an enterprise raises capital directly from the public, it is said to be raising the money from the 'Primary Market'.  Unlike many other forms of market, primary market is a notional one, with no specific location or office.  However, this market is regulated by the government through appropriate regulatory bodies.

Since there is no specific location; and savers, who would be interested in supplying capital to the firm are geographically scattered throughout the country, the firm has to put in place a complete system to reach the prospective suppliers of capital.  It resorts to the following processes and depends on the respective intermediaries in the process.
(a) Obtaining regulatory approvals (wherever required)
(b) Releasing advertisement inviting public to subscribe to the bonds/shares
(c) Preparing and printing prospectus containing various details of the issue
(d) Printing application forms
(e) Approaching brokers/sub-brokers to promote the issue
(f) Appointing registrars to manage the issue
(g) Appointing bankers to collect the payment etc.

Thus, as against loan from a bank or financial institution, the process of raising capital directly from the public involves lot of money (spent on the above activities) and it is time consuming.  Then why do businesses raise capital directly from public?

Series on Financial Markets - IV

Let us now understand the role of Financial Institutions in an economy.  These institutions act as intermediaries between the suppliers of capital and those in need of it.  It is always possible for the business enterprises to raise capital directly from the individuals who have surplus money.  But there are few problems:
(a) many individuals may have only small amounts of money as surplus
(b) the individual investors do not have the expertise to analyse the business that the firm is engaged in
(c) the individuals find it difficult to understand and assume the risks involved
(d) there is a question of credibility as the business enterprise may cheat the investors

This is where the role financial institutions becomes relevant.  Lets take commercial banks for example.  Banks collect small as well as large amounts of money from those who are willing to invest their surplus, make a big pool of money, which is then used for lending to business enterprises or individuals placing demand for money.  Thus the surplus money that would have directly flowed from the investors to the firm, now takes a detour through the bank.  This solves most of the above concerns.  Lets see how:
(a) individuals can deposit even small amounts as banks pool the funds
(b) banks have the expertise to analyse the business projects
(c) banks can reduce the risk of lending as they lend to many enterprises and thus diversify the risk
(d) banks are regulated by the government which brings in credibility (though not all banks share the same credibility and risk)

Similarly, the financial institutions like insurance companies, mutual funds, pension funds etc. act as financial intermediaries.  They are all regulated, though the extent of regulation differs.  The process of financial institutions bringing suppliers and users of funds together is known as 'Financial Inter-mediation'.  

Series on Financial Markets - III

The first post in this series emphasized the significance of transfer of money from the savers (investors) to the borrowers and the second one talked about various instruments (financial assets) available for such transfer.  Now let us look at the system that facilitates the interaction between the two groups.  An economy is divided into three sectors: (a) household sector, comprising of individuals; (b) business sector, comprising of various business enterprises and (c) the government.  Each of these sectors constitute entities who save as well as borrow.  For example some individuals save whereas some others borrow.  Same is the case with business units and the government.  So lending (same as saving) and borrowing happens among the three sectors as well as within the three sectors.  However, household sector is almost always net saver (with savings exceeding the borrowing) and the government almost always net borrower.

In order to have smooth interaction between the lenders and the borrowers, the following becomes necessary:
(a) proper instruments to facilitate the interaction
(b) a platform for them to interact, and
(c) well-defined rules and regulations

We have already discussed about the instruments (financial assets).  Financial markets and various financial institutions provide the platform for interaction among the lenders and borrowers.  Financial markets can be divided into primary market and secondary market.  Financial institutions take various forms like commercial banks, insurance firms, mutual funds etc.  Various regulators like RBI, SEBI, FMC, IRDA etc. are involved in  framing rules and regulations and ensuring their implementation.  Thus the system comprising of financial markets, financial institutions and regulators is known as 'The Financial System'.  Every country has its own financial system, even though the level of development of these systems differ from country to country.  In the absence of a well-developed financial system, the basic economic process of capital formation becomes constrained.  

Series on Financial Markets - II

After getting a clear idea about what financial assets are, let us now look at some of its characteristics from an investor's (supplier of capital) point of view.  First, they allow individual investors to spread their consumption pattern.  Every individual goes through periods of excess income (young/middle age) as well as deficit income (retirement/old age) during his/her life.  Financial assets help individuals to save/invest during the excess income periods, so that they can meet their consumption needs during periods of deficit income.  Thus financial assets allow investors to spread their consumption.

Second, the financial assets allow individuals to derive income from real assets and allocate the risk.  An individual investor can not invest directly in productive real assets for two reasons: (a) it requires huge capital and (b) it involves huge risks.  For example, as an individual I may not start manufacturing steel, automobiles or even start a retail chain.  But with the help of financial assets, it is possible for me to invest in the businesses engaged in the above activities and enjoy the profits.  Further they allow me to allocate the risk, even if I have limited amount to invest.  So, if I am holding the shares/bonds of five different companies, it is as good as me getting engaged in five different businesses simultaneously.  Again, I can choose to allocate my risks through a combination of high risk instruments like equity and low risk instruments like bonds.

A third characteristic of financial assets is that they allow separation of ownership from management.  When you have large number of individuals contributing capital to a business, it is practically not possible to involve all of them in the day-to-day management.  Moreover, managers need to be professionally qualified and trained.  So, financial assets allow for sourcing capital from various individuals spread all over the country (or the world); whereas the management of the business vests with the professional managers.  They also allow transfer of ownership without any impact on the management of the business.  

Series on Financial Markets - I

Few days ago one of my ex-students, Nisha (who did not specialise in Finance) asked me whether I could write something on the functioning of stock markets through my blog.  Since it requires lot of discussion, I thought of doing so in a series of blogs, this one being the first.  Though some of my readers may find it elementary, I am sure you would enjoy reading the same.

We generally classify assets into two (a) real assets and (b) financial assets.  You might remember that in an earlier blog, I had mentioned that the wealth is always created with the help of real assets.  The real assets represent land, building, machinery, and all other physical resources required for production of goods and services.  All those involved in production of goods and services require capital for investment.  So they represent the demand for capital.  All those entities who have income in excess of their expenditure are looking out for avenues to invest the same; and they represent the supply of capital.  Like any other market, a market is required for the interaction between those who are in need (demand) of capital and those who have surplus capital (supply).  Financial markets provide a platform for the same.

How does the money move from one set of people to the other? Let us take an example from the real market.  When you place demand for a car, the manufacturer supplies the car to you and you pay him cash.  Here two real assets are exchanged.  But when you are providing money as a supplier of capital, what you are getting back is not a tangible asset; but a promise that the other party would return the same to you in future with interest.  So the supplier of capital has a claim on the other party.  The instruments that help us/ or through which we establish this claim are known as Financial Assets.  Bank pass book, Fixed Deposit receipt, NSC, Equity share, Debenture etc. are all examples of financial assets.  I will explain some characteristics of financial assets in my next blog in this series.