Project on Indian Financial Market Structure
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Money Market Structure Contd.

Commercial Paper

Commercial Paper (CP) is issued by non-banking companies and all-India Financial Institutions (AIFIs) as an unsecured promissory note or in a demateriaslied form at a rate of discount not tied to any transaction. It is privately placed with investors through the agency of banks. Banks act as both principals (i.e., as counter parties in purchases and sales) and agents in dealership and placement. Banks are not allowed to either underwrite or co-accept issue of CP.

Conditions relating to issuing of CPs have been relaxed gradually with a view to broad-basing the market. For instance, the maturity period has been changed from 91 days - 6 months earlier to 15 days - 1 year. The minimum size of CPs has also been reduced from Rs.1 crore to Rs. 5 lakh. The issuer base has been widened by allowing PDs, SDs and AIFIs, apart from corporates, to issue CPs to access short-term funds.

The limit for issuance of CP, which was initially carved out of the maximum permissible bank finance (MPBF), was later linked to the cash credit component of MPBF. With the cash credit component gradually shrinking and, thereby, restricting the development of CP, the issuance limit was delinked from the cash credit limit in October 1997. Initially, banks were required to restore the cash credit limit on the maturity of the paper, guaranteeing the issuer funds at the point of redemption. This "stand-by" facility was withdrawn in October 1994 to impart a measure of independence to CP as a money market instrument. Banks could be approached for a restoration of the original cash credit limit at a later date, the sanction of which was left to their discretion. The credit rating requirement, initially an enabling condition for issuing CP, gradually turned to signal the issuer's position in the market. The Reserve Bank converted CP into a stand-alone product effective October 2000, with a view to enabling the issuers in the services sector to meet short-term working capital requirements and, at the same time, according banks and FIs the flexibility to fix working capital limits after taking into account the resource pattern of companies' finances including CPs. Trading in the dematerialised form, which was introduced recently, is likely to reduce transactions costs.

The pricing of CP usually lies between the scheduled commercial banks' lending rate (since corporates do not otherwise have the incentive to issue CP) and some representative money market rate (which represents the opportunity cost of bank funds). The Indian CP market is driven by the demand for CP by scheduled commercial banks, which, in turn, is governed by bank liquidity. Banks' investments in CP, despite a positive interest rate differential between the bank loan rate and the CP rate, may be explained by two factors, viz., (i) the higher transactions costs of bank loans, and (ii) the relative profitability of CP as an attractive short-term instrument to park funds during times of high liquidity. As inter-bank call rates are typically lower than the CP rates, some banks also fund CP by borrowing from the call money market and, thus, book profit through arbitrage between the two money markets. Most of the CPs seem to have been issued by the manufacturing companies for a maturity period of approximately three months or less, mainly due to the fact that investors do not wish to lock funds for long periods of time. In most international markets, CP is issued on a short-term basis with a roll-over facility; this facility, however, is not allowed in the Indian CP market.

The secondary activity is subdued in most CP markets on account of the investors' preference to hold the instrument due to higher risk-adjusted return relative to those of other instruments. However, mutual funds find the secondary market relatively remunerative, since stamp duty for the issuer will be higher in case the buyer is a mutual fund rather than a bank. Hence, there is a tendency to route a CP through an institution (usually a bank), which attracts lower stamp duty in the primary market, to a mutual fund in the secondary market.

Certificates of Deposit (CD), introduced in June 1989, are essentially securitised short-term time deposits issued by banks during periods of tight liquidity, at relatively high interest rates (in comparison with term deposits). But the transaction cost of CDs is often lower as compared with that of retail deposits. When credit picks up, placing pressure on banks' liquidity, banks try to meet their liquidity gap by issuing CDs, often at a premium. The required amounts are mobilised in larger amounts through CD, often for short periods in order to avoid interest liability overhang in the subsequent months when credit demand slackens. As banks offer higher interest rates on CDs, subscribers find it profitable to hold CDs till maturity. As a result, the secondary market for CDs has been slow to develop.

The Reserve Bank initially limited the issuance of CDs at a certain percentage of the fortnightly average of the outstanding aggregate deposits of 1989-90. Over-time, bank-wise limits were raised and subsequently abolished, effective October 16, 1993, enabling the CD to emerge as a market determined instrument. The reduction in the minimum maturity of time deposits and the permission to allow banks to pay different interest rates based on deposit size, reduced the relative attractiveness of CDs. With a view to broadening the CD market, the minimum issuance size was gradually scaled down to Rs.5 lakh and the minimum maturity reduced to 15 days in April 2000. Again, in order to provide flexibility and depth to the secondary market, the restriction on transferability period for CDs issued by both banks and financial institutions was withdrawn effective October 10, 2000.

The issuance of CDs and subscription to CPs by scheduled commercial banks and the interest rate on the two instruments broadly reflected the liquidity conditions of banks (Table 4.2 and Chart IV.2). The outstanding amount of CP increased to Rs.3,264 crore as at end-March 1994 from Rs.577 crore as at end-March 1993, while CDs declined to Rs.5,571 crore from Rs.9,803 crore. As liquidity conditions tightened with the increased demand for bank credit and capital outflows, the outstanding amount of CDs increased steadily to scale a peak of Rs.16,316 crore as at end-March 1996, while CP issues dwindled to Rs.76 crore. As liquidity conditions eased, the outstanding amount of CDs declined to Rs.12,134 crore as at end-March 1997 but increased to Rs.14,296 crore as at end-March 1998 following the Reserve Bank's monetary tightening measures on January 16, 1998. CDs declined to Rs.3,717 crore at end-March 1999 as a result of slackening of credit demand and capital inflows and remained limited to an average of around Rs.1,500 crore during 1999-2000. The outstanding amount of CP picked up, after the limits were enlarged in October 1997, to Rs.4,770 crore as at end-March 1999 and further to Rs.5,663 crore as at end-March 2000.

The commercial bill market in India is very limited, as evidenced by the fact that commercial bills rediscounted by commercial banks with financial institutions stay often well below Rs.1,000 crore. The commercial bills market was constricted by the cash credit system of credit delivery where the onus of cash management rested with banks. The Reserve Bank withdrew the interest rate ceiling of 12.5 per cent on rediscounting of commercial bills, effective May 1, 1989. The success of the bills discounting scheme is contingent upon financial discipline on the part of borrowers. As such discipline did not exist, the Reserve Bank, in July 1992, restricted the banks to finance bills to the extent of working capital needs based on credit norms. However, in order to encourage the 'bills' culture, the Reserve Bank advised banks in October 1997 that at least 25 per cent of inland credit purchases of borrowers should be through bills. The Working Group on Bills Discounting by Banks (Chairman: Shri U.R. Ramamoorthy) has recently submitted its report to the Reserve Bank.

In April 1992, scheduled commercial banks and public financial institutions were allowed to set up MMMFs, subject to certain terms and conditions. The prescribed restrictions were relaxed subsequently between November 1995 and July 1996 in order to impart more flexibility, liquidity and depth to the market. MMMFs are allowed to invest in rated corporate bonds and debentures with a residual maturity of one year. The minimum lock-in period for units of MMMFs was relaxed from 30 days to 15 days in May 1998. In 1999-2000, MMMFs were allowed to offer 'cheque writing facility' in a tie-up with banks to provide more liquidity to unit holders. MMMFs, which were regulated under the guidelines issued by the Reserve Bank, have been brought under the purview of the SEBI regulations since March 7, 2000. Banks are now allowed to set up MMMFs only as a separate entity in the form of a trust. Currently, there are only three MMMFs in operation.