To recap – Asset & Structured Finance in India is the investment banking division which co-ordinates lending to a company from its own balance sheet. To help you understand this structure, I would like to revisit the basics of lending.
Retail banks accept public deposits. These are, by far, the cheapest funds that anyone can access. When I say ‘cheap’ – I am referring to their cost i.e. the associated interest rate. This is because interest rate is directly proportional to risk associated with the deposit – and since your deposit in a nationalized bank is viewed as super-safe, the bank can get away with paying you a relatively low rate of interest.
After paying its various overheads (including administrative expenses, salaries and statutory reserves) on top of the interest payments it makes to depositors, the bank arrives at a ‘Cost of Funds’. The bank then slaps on a small premium to allow it to make a profit and then arrives at an interest rate at which lending is feasible.
The bank then makes loans to people and corporates at rates (ideally) above its cost of funds in order to generate revenues. To protect itself from default, the bank may take upward of one time the amount of the loan and up to thrice the amount of the loan in the form of security. The profit that they make is in the form of a ‘Net Interest Margin’ which is widely reported.
Investment banks, however, are not allowed to accept public deposits. This is because their operations are inherently risky and it is not intelligent to allow public depositors to put their life savings in a firm that makes riskier investments.
So where do the investment banking firms get their money from? Well, they borrow from other lenders (they could do this by issuing debt in the markets in the form of bonds). However, in this case, the risk is measured based on the bank’s credit profile and not on the borrower’s credit profile.
These investment banks are technically called NBFCs (Non-Banking Financial Company). The ‘non-banking’ part comes about from the fact that they’re not allowed to participate in retail banking operations. (Even if they open a retail bank under the same umbrella brand, they’re not allowed to use the retail bank’s public deposits toward this lending).
Since the investment bank usually has a much better credit profile than the borrower, this allows the investment bank to access funds at a cheaper rate than if the borrower had attempted to borrow money on his own from the market.
What, then, would compel a CFO with a fully-functional brain to borrow at premium rates from an investment bank? Recall the part where I mentioned that the PSU banks that provide debt also take security? Well, what if the only security you had was one which the bank refuses to accept?
Securities that encapsulate considerable value but are unacceptable by PSU banks are shares. A lot of companies have a ton of shares in a sister company or in another company and are willing to pledge these shares to a lending entity in order to access debt.
However, since the value of the shares (ordinarily) may fluctuate on a daily basis, the bank may not have the ability to mechanism to monitor the value of their security if they were to accept shares as collateral.
In banks which have a Structured Finance division, there also exists a credit risk monitoring & ratings division which rates various borrowers and then recommends security margins and internal ratings. Based on these internal ratings, the borrowers are subject to differing interest rates.
That’s where the Structured Finance division of an investment bank comes in. The banks have substantial infrastructure which actively monitor the price of shares and associated security.
They can then request the borrower to bring in more security should the value of the shares pledged as security fall below a certain threshold. Their systems enable them to lend based on more risky security. Of course, this isn’t free – and results in a higher cost of funds for the lender and therefore a higher lending rate.
One last thing – NBFC’s lend at various rates. PSU Banks lend at various rates. You can see a bank’s Prime Lending Rate (PLR) on its website. Usually PSU banks’ PLR’s are within 50 basis points (0.5%) of each other. NBFC’s prefer to use blended rates (mixtures of other NBFCs).
One popular rate that they like is the MIBOR which is the Mumbai Inter-bank Offer Rate. The MIBOR is the Indian version of the LIBOR which is the London Inter-Bank Offer Rate. When banks lend, therefore, they lend with a ‘spread’ over the benchmark rate.
Read the other articles in the series: Introduction to Investment Banking