Commercial Paper: Definition, Features, and Advantages!

What is a commercial paper? A commercial paper is an unsecured promissory note issued with a fixed maturity by a company approved by RBI, negotiable by endorsement and delivery, issued in bearer form and issued at such discount on the face value as may be determent by the issuing company. The concept of Commercial Paper: Definition, Features of Commercial Paper, and Advantages of Commercial Paper. Implications of Commercial Paper, Impact on commercial banks, Commercial Paper in India, Future of Commercial Paper in India, Commercial Paper Market in Other Countries, and RBI Guidelines on Commercial Paper Issue. Also learned, Merchant Banking, Commercial Paper: Definition, Features, and Advantages!

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Commercial paper is an unsecured and discounted promissory note issued to finance the short-term credit needs of large institutional buyers. Banks, corporations, and foreign governments commonly use this type of funding.

#Definition:

Commercial Paper or CP is defined as a short-term, unsecured money market instrument, issued as a promissory note by big corporations having excellent credit ratings. As the instrument is not backed by collateral, only large firms with considerable financial strength are authorized to issue the instrument.

Why Needed this?

Commercial paper is issued by a wide variety of domestic and foreign firms, including financial companies, banks, and industrial firms. Major investors in the commercial paper include money market mutual funds and commercial bank trust departments. These large institutional investors often prefer the cost savings inherent in using commercial paper instead of traditional bank loans.

#Features of Commercial Paper:

• Commercial paper is a short-term money market instrument comprising since promissory note with a fixed maturity.
• It is a certificate evidencing an unsecured corporate debt of short-term maturity.
• Commercial paper is issued at a discount to face value basis but it can be issued in interest-bearing form.
• The issuer promises to pay the buyer some fixed amount on some future period but pledge no assets, only his liquidity and established earning power, to guarantee that promise.
• Commercial paper can be issued directly by a company to investors or through banks/merchant banks.

#Advantages of Commercial Paper:

Simplicity:

The advantage of commercial paper lies in its simplicity. It involves hardly any documentation between the issuer and the investor.

Flexibility:

The issuer can issue commercial paper with the maturities tailored to match the cash flow of the company.

Easy To Raise Long-Term Capital:

The companies which are able to raise funds through commercial paper become better known in the financial world and are thereby placed in a more favorable position for rising such long them capital as they may, from time to time,  as required. Thus there is an inbuilt incentive for companies to remain financially strong.

High Returns:

The commercial paper provides investors with higher returns than they could get from the banking system.

Movement of Funds:

Commercial paper facilities securitization of loans resulting in the creation of a secondary market for the paper and efficient movement of funds providing cash surplus to cash deficit entities.

#Implications of Commercial Paper:

The issue of commercial paper is an important step in disintermediation bringing a large number of borrowers as well as investors in touch with each other, without the intervention of the banking system as the financial intermediary. Directly from borrowers can get at least 20% of their working capital requirements directly from the market at rates which can be more advantageous than borrowing through a bank.

The forts class borrowers have the prestige of joining the elitist commercial paper club with the approval of CRISIL, the banking system, and the RBI, however, RBI has presently stipulated that the working capital limits of the banks will be reduced to the extent of an issue of commercial paper. Industrialists have already made a plea that the issue of commercial paper should be outside the scheme of bank finance and other guidelines.

Such as, the recommendation of banks and approval of RBI has not accepted the plea at present as commercial paper is an unsecured borrowing and not related to a trade transaction. The main aim of the RBI is to ensure that commercial paper develops a sound money market instrument.si, in the initial stages emphasis should be on the quality rather than quantity.

#Impact on commercial banks:

The impact of the issue of commercial paper on commercial banks would be of two dimensions. One is that banks themselves can invest in commercial paper and show this as the short-term investment. The second aspect is that the banks are likely to lose interest on the working capital loan which has been hitherto lent to the companies, which have now started borrowing through commercial paper.

Further, the larger companies might avail of the cheap funds available in the market during the slack season worsening the bank’s surplus fund position\, but come to the banking system for borrowing during the busy season when funds are costly. This would mean the banks are the losers with a clear impact on profitability.

However, the banks stand to gain by charging the higher interest rate on reinstated portion especially of it done during the busy season and by way of service charge for providing standby facilities and issuing and paying commission. Further, when large borrowers are able to borrow directly from the market, banks will correspondingly be freed from the pressure on resources.

#Impact on the Economy:

The process of disintermediation is taking place in the free economies all over the world. With the introduction of CP financial disintermediation has been gaining momentum in the Indian economy. If CPs are allowed to free play, large companies, as well as banks, would learn to operate in a competitive atmosphere with more efficiently. This result greater excellence in the service of banks as well as management of finance by companies.

Recent Trends:

RBI has liberalized the terms of issues of CP from May 30, 1991.

According to the liberalized terms, the proposal by eligible companies for the issues of CP would not require the approval of RBI.

Such companies would have to submit the proposal to the financing bank which provided working capital facility either as a sole bank or as a leader of the consortium.

The bank, on being satisfied with the compliance of the norms would take the proposal on the record before the issue of commercial paper.

RBI has further relaxed the rules in June 1992,

The minimum working capital limit required by a company to issue CP has been reduced to Rs. 5 crores. The ceiling on the amount of which can be raised through CP has been raised to 75% of working capital.

A closely held company has also been permitted to borrow through CPs provided all the criteria are met. The minimum rating required from CRISIL has been lowered to P2 from 1994 – 95, the standby facility by banks for CP has been abolished.

When CPs are issued, banks will have to effect a pro-rata reduction in the criteria are met. The while minimum rating needed from ICRA is A2 instead of A1.

According to the RBI monetary policy for the second half of 1994 – 95,

The standby facility by banks for CP has been abolished. When CPs are issued, banks will have to effect a pro-rata reduction in the cash credit limit and it will be no longer necessary for banks to restore the cash credit limit to meet the liability on the maturity of CPs. This will import a measure of independence to CP as a money market instrument.

#Commercial Paper in India:

In India, on the recommendations of the Vaghul working Group, the RBI announced on 27th March 1989, that commercial paper will be introduced soon in the Indian money market. The recommendations of the Vaghul Working Group on the introduction of commercial paper in Indian money market areas flowers:

• There is a need to have a limited introduction of commercial paper. It should be carefully planned and the eligibility criteria for the issuer should be sufficiently rigorous to ensure that the commercial paper market develops on healthy lines.
• Initially, access to the commercial paper market should be registered to rated companies having a net worth of Rs. 5 cores and above with good dividend payment record.
• The commercial paper market should function within the overall discipline of CAS. The RBI would have to administer the entry on the market, the amount if each issue the total quantum that can be raised in a year.
• Ni restriction is placed on the commercial paper market except by way of the minimum size of the note. The size of the single issue should not be less than Rs. 1 core and the size of each lot should not be less than Rs. 5 lakhs.
• The commercial paper should be excluded from the stipulations on insecure advances in the case of banks.
• The commercial paper would not be tied to any transaction and the maturity period may be 7 days and above but not exceeding six months, backed up if necessary by a revolving underwriting facility of fewer than three years.
• The using company should have a net worth of not less than Rs. 5 cores, a debt quality ratio of not more than 105, current ratio of more than 1033, a debt servicing ratio closer to 2, and be listed on the stock exchange.
• The interest rate on commercial paper would be market dominated and the paper could be issued at a discount to face value or could be interest bearing.
• The commercial paper should not be subject to stamp duty at the time of issue as well as at the time transfer by endorsement and delivery.

On the recommendations of the Vaghul Working Group, the RBI announced on 27th March 1989 that commercial paper will be introduced soon in the Indian money market. Detailed guidelines were issued in December 1989, through non-Banking companies (acceptance of Deposits through commercial paper) Direction, 1989 and finally, the commercial papers were instructed in India from 1st January 1990.

RBI Guidelines on Commercial Paper Issue:

The important guidelines are:

• A company can issue commercial paper only if it has: 1) A tangible net worth of not less than Rs. 10croes as per the latest balance sheet. 2) The minimum current ratio of 1.33:1. 3) A fund based working capital limit of Rs. 25 crores or more. 4) A debt servicing ratio closer to 2. 5) The company is listed on a stock exchange. 6) Subject to CAS discipline. 7) It is classified under Health Code no. 1 by the financing banks, and. 8) The issuing company would need to obtain p1 from CRISIL.
• The commercial paper shall be issued in multiples of Rs. 25 lakhs but the minimum amount to be invested by a single investor shall be Rs. 1 crore.
• The commercial paper shall be issued for minimum maturity period of 7 days and the maximum period of 6 months from the date of issue. There will be no grace period on maturity.
• Another aggregate amount shall not exceed 20% of the issuer’s fund based working capital.
• The commercial paper is issued in the form of using promissory notes, negotiable by endorsement and delivery. The rate of discount could be freely determined by the issuing company. The issuing company has to bear all flotation cost, including stamp duty, dealers, fee and credit rating agency fee.
• The issue of commercial paper cannot be underwritten or co-opted in any manner. However, commercial banks can provide standby facility for the redemption of the paper on the maturity date.
• Investment in the commercial paper can be made by any person or banks or corporate bodies registered or incorporated in India and un-incorporated bodies too. Non-resident Indians can invest in the commercial paper on non-repatriation basis.
• The companies issuing commercial paper would be required to ensure that the relevant provisions of the various statutes such as companies Act, 1956, the IT At, 1961 and the Negotiable Instruments Act, 1981 are complied with.

Procedure and Time Frame Doe Issue Commercial Paper:

• Application to RBI through financing bank or leader of the consortium bank for working capital facilities together with a certificate from the credit rating agency.
• RBI to communicate in writing their decision on the amount of commercial paper to be issued to the lender bank.
• The issue of commercial paper to be completed within 2 weeks from the date of approval of RBI through a private placement.
• The issue may be spread shall bear the same maturity date.
• Issuing company to advise RBI through the bank/leader of the bank, the amount of actual issue of commercial paper within 3 days of completion of the issue.

Future of Commercial Paper in India:

Corporate enterprises requiring burgeoning funds to meet their expanding needs find it easier and cheaper to raise funds from the market by issuing commercial paper. Further, it provides the greater degree of flexibility in business finance to the issui9ng company in as much it can decide the quantum of CP and its maturity on the basis of its future cash flows. CPs have made a good start.

Since the inception of CPs in India in January 1990, 23 companies have issued CPs worth RS. 419.4 crore till June 1991. The total issues amounted to Rs. 9,000 crore in June 1994. The outstanding amount of CPs stood art Rs. 4,770 crore on March 31, 1999, and increased to Rs. 7,814 crore on March 31. 2000.

The issues of CPs declined to Rs. 5,663 crore on March 31, 2000. It shows that the CP market is moribund. There is no increase in issuer base. i.e. the same companies are tapping this market for funds. The secondary market is virtually non-existent. Only commercial banks pick these papers and hold till mortuary. No secondary market is allowed to develop on any significant scale. Further, trading is cumbersome as procedural requirements are onerous.

The stamp duty payable by banks subscribing charged to non-banking entities like primary dealer, corporate and non-banks instead of directly subscribing to them. The structural rigidities such as rating requirements, the timing of issue, terms of issue, maturity ranges denominational rang and interest rate stand in the way of developing the commercial paper market. The removal of stringent conditions and imposing o such regulatory measures justifiable to issues, investors and dealers will improve the potentiality of CP as a source of corporate financing.

Commercial Paper Market in Other Countries:

The roots of commercial paper can be traced way back to the early nineteenth century when the firms in the USA began selling open market paper as a substitute for bank loan needed for short-term requirements but it developed only in the 1920s. The development of consumer finance companies in the 1920s and the high cost of bank credit resulting from the incidence of compulsory reserve requirements in the 1960s contributed to the popularity of commercial paper in the USA.

Today, the US commercial paper market is the largest in the worlds. The outstanding amount at the end of 1990 in the US commercial paper market stood at $557.8 billion. The commercial paper issues in the US are exempted from the requirement if the issue of prospectus so long as proceeds are used to finance current transitions and the paper’s mortuary is less than 270 days.

Most of the commercial paper market in Europe is modeled on the lines of the US market. In the UK the Sterling Commercial Paper Market was launched in May 1986. In the UK, the borrower must be listed in the stock exchange and he must meet assets of least  $50 million. However, rating by credit agencies is not required. The maturities of commercial paper must be between 7 and 364 days. The commercial paper is exempted from stamp duty.

In finance, commercial papers were thought of as a fixable alternative to bank loans. The commercial paper was introduced in December 1985. Commercial paper can be issued only by non-bank French companies and subsidiaries of foreign companies. The papers are in bearer form. It can be either issued by dealers or placed directly.

The maturity ranges from ten days to seven years. Rating by credit agencies is essential. To protect investors. Law contains fairly extensive disclosure requirements and requires publication of regular finance statements by issue. The outstanding amount at the end of 1990 in France Commercial paper market was $31 billion.

The Canadian commercial paper market was launched in the 1950s. The commercial paper is generally used in terms of 30days to 365 days although terms such as overnight are available. The commercial paper issued by Canadian companies is normally secured by the pledge of assets. The outstanding amount at the end of 1990 in the commercial market was $26.8 billion.

In Japan, the yen commercial paper market was opened in November 1987. The commercial paper issues carry maturities from two weeks to nine months. Japan stands second in the commercial paper market in the world an outstanding amount of $117.3 billion in 1990.

In 1980s many other countries launched the commercial paper market, notably Sweden (early 1980s), Spain (1982s), Hong Kong (1982), Singapore (1984), Norway (1984).