This document discusses innovative financial instruments introduced by various institutions like the Reserve Bank of India and corporations in India and the United States. It provides details on instruments introduced by RBI like liquidity adjustment facility (repo and reverse repo), collateralized borrowing and lending obligations, and market stabilization scheme. It also describes corporate instruments in India like bonus debentures, zero coupon bonds, foreign currency convertible bonds, and shares with differential voting rights. The document further discusses financial instruments in the US that led to the 2008 financial crisis, such as collateralized debt obligations, mortgage-backed securities, credit default swaps, and subprime mortgages. It analyzes both the benefits and dangers of financial innovation.

1. Innovative Financial Instruments-B.V.Raghunandan,SVS College, Bantwal Department of Commerce and Management Studies, University of Calicut February 10,2010

2. Financial Instrument The basic documents issued to the large body of investors when an organisation or institution raises the funds from a large body of investors Standardised document as per statute or governing institution containing features of the relation between the fund raiser and the user Limited formats

3. Innovation in the Instrument Altering the terms of issue in a novel way in order to achieve the predetermined purpose

4. Purpose of Innovation Different Type of Credit Control and Macro-level Liquidity Management Matching Cash Flow Requirement of the Fund Raiser Satisfying other Objectives like Retaining Management Control More Effective Catering to the Needs of the Investors Better Treasury Managment

5. RBI Initiative Liquidity Adjustment Facility (LAF) {Repo and Reverse Repo} Collateralized Borrowing & Lending Obligations (CBLO) Market Stabilisation Scheme (MSS) Perpetual Bonds or Innovative Bonds

6. RBI-Liquidity Adjustment Facility (LAF) Repo and Reverse Repo as part of LAF since 2000 Designed to form the Interest Rate Platform within which all short-term interest rates will lie Together with CRR, it has become an effective short-term liquidity management tool Needed to manage the unexpected movement of funds into and out of the country due to Hedge Funds and Others

7. RBI-CBLO Introduced by CCIL in 2003 A Wider Call Money Market Participation by Pledging specified securities with CCIL Participation by NBFCs and Corporate also apart from usual Call Money Market Players One Day or more Better Treasury Management by Corporate Better Profitability of Banks Cheaper Market than Call Money Market

8. RBI-Market Stabilisation Scheme Launched in 2004 through an MOU between RBI and the Central Government Part of a Longer Period Sterilisation of Market Managing Liquidity Problems arising out of Forex Remittances RBI to issue after consultation with Government Sale of Treasury Bills and Dated Securities through Auction Better Fiscal Accountability as they are issued against cash maintained by the Government with RBI

9. Perpetual Bonds Introduced in 2005 Issued by Scheduled Commercial Bankss 15 year Tenure with a Roll on forever at the option of the Bank Part of Tier I Capital of Banks Enabling the Banks to meet Basel Norm regarding Capital Adequacy Ratio Insurance Companies are usually the investors

10. Corporate-India Bonus Debenture Zero Coupon Bonds FCCB Multiple Option Bonds Infrastructure Bonds Commercial Paper Certificate of Deposit Forex Backed Infrastructure Bonds Shares with Differential Voting Rights Bonus Preference Shares Time Share Plantation Share ADR/GDR Shares with Disproportionate Voting Rights

11. Bonus Debenture Rewarding Shareholder by better Treasury Management Hindustan Lever tried it in early 2000s Avoiding a Blown-up equity capital base Did not enthuse the investors much Concept did not catch the fancy of the market

12. Zero Coupon Bonds Interest in the form of discount on the face value of bonds Cross Border Investment Taxation benefit Better Treasury Management since postponing the payment of interest on redemption Where convertibility alone is the consideration, saving of interest

13. Foreign Currency Convertible Bonds Provisions of FEMA Convertibility is the cream Cross Border Investment Gained Popularity Recently

14. Multiple Option Bonds Reliance Industries pioneered it in India Appealing to Different Requirements of Investors for Income Planning Flexibility in Tax Planning of Investors Payment of Interest is staggered with varied options Became Popular and adopted for Infrastructure Bonds also

15. Commercial Paper short-term security Rated instrument Issued by listed companies Short-term source of finance for corporates Banks and other corporates invest SBI-DFHI tried to create a secondary market, but failed Securities are held until maturity

16. Certificate of Deposit Banks allowed to issue COD by RBI since 1989 though US banks were issuing since 1961 Tapping large deposits of corporates and HNI Tenure is short-term for 3 months to one year Held until maturity SBI-DFHI buys the CODs No secondary market exists as SBI-DFHI is not able to accumulate sufficient CODs

17. Forex Backed Infrastructure Bonds In 2009, For the First time RBI invested with a private fund The UK Subsidiary of India Infrastructure Finance Company Ltd issued the bonds The RBI used its foreign exchange reserve to invest in the bonds Indian firms operating in foreign countries can augment the resources by issuing such bonds

18. Shares with Differential Voting Rights A product for the M&A era Lesser Dilution of management control Each share carrying fraction of a vote Share issued at a discount Dividend is more than the dividend on the normal shares Tata Motors issued in 2008 (one tenth of vote, 305 against 340 per share and 5% more dividend)-Gujarat NRE Coke in the same year

19. Bonus Preference Shares In 2003, Sun Pharmaceuticals issued bonus preference shares Better cash management Better than bonus debentures as there is no compulsion of payment of interest Did not enthuse the shareholders like the bonus equity shares Did not catch the fancy of the market

20. Time Share Property sharing for a certain number of days per year Used by Resorts in Tourist Destinations Sterling Group and a few other organisations tapped the market well Fancy ruled only for a few years

21. Plantation Share Came out with big fanfare Promised fantastic returns in the distant future Many gullible investors were taken for a ride Least Liquid instrument Only a few firms have a token presence

22. ADR/GDR Instruments issued to foreign investors in lieu of the shares deposited with a custodian in the home country Mainly to get the instruments of Instruments of Indian companies listed in foreign bourses Enhanced the image of Indian companies and added a global perspective Contributed to the volatility of Indian Market

23. Shares with Disproportionate Voting Rights New Companies Bill is doing away with shares with differential voting rights In its place, shares with superior voting rights are being proposed Helping the promoters to ward off hostile take-overs Lacking fairness

24. Dangers of Innovation Creating a hype Not a proper study is made before the introduction Complexity Complexity leads to lack of correction of wrong steps IT enabled financial system enables excesses which endanger the very survival of the firm Short term growth for higher managerial remuneration

25. Corporate-USA Collateralised Debt Obligation (CDO) in 70s Mortgage Backed Securities (MBOs) (pioneered by Larry Fink of First Boston Corporation in 1984) Sub-prime Mortgages in 1990s due to the popularity of MBOs resulting in lowering rates of interest Credit Default Swaps (CDS) invented by Blythe Masters JP Morgan Chase in 1997 CDS reaching 62.1 trillion dollars in 2007(AIG being the main player)

26. The US Debacle 2000-03 –Alan Greenspan cuts Fed Rates from 6% - 1% Banks go on a Lending Spree 2004-Govt. Backed Lenders Fannie Mae, Ginnie Mae and Freddie Mac have nearly 20% of lending to sub-prime clients 2005-CDS market soars with increase in housing sector boom 2006-Interest Rates rise to 5+% 2007-08-the bubble burst in the housing sector

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