Commercial Paper

The working Group on Money Market in 1987 suggested the introduction of commercial paper in India. The Reserve bank introduced commercial papers in January 1990. Commercial papers have been in vogue in the United States since the nineteenth century and have become popular in money markets all over the world since the 1980s.

A commercial paper is an unsecured short term promissory note, negotiable and transferable by endorsement and delivery with a fixed maturity period. It is generally issued at a discount by a leading creditworthy and highly rated corporates. Depending upon the issuing company, a commercial paper is also known as finance paper, industrial paper, or corporate paper.

Initially only leading highly rated corporates could issue a commercial paper. The issuer base has now been widened to broad base the market. Commercial papers can now be issued by primary dealers, satellite dealers, and all-India financial institutions, apart from corporates, to access short term funds. Effective September 6, 1996 and June 17, 1998, primary dealers and satellite dealers were also permitted to issue commercial paper to access greater volume of funds to help increase their activities in the secondary market.

A commercial paper can be issued to individuals, banks, companies and other registered Indian corporate bodies and unincorporated bodies. Non-resident Indian can be issued a commercial paper only on a non-transferable and non–repatriable basis. Banks are not allowed to underwrite or co-accept the issue of a commercial paper.

A commercial paper is usually privately placed with investors, either through merchant bankers or banks. A specified credit rating of P 2 is to be obtained from credit rating agencies.

A commercial paper is issued as an unsecured promissory note or in a dematerialized form at a discount. The discount is freely determined by market forces. The paper is usually priced between the lending rate of scheduled commercial banks and a representative money market rate.

Corporates are allowed to issue CPs up to 100 per cent of their fund based working capital limits. The paper attracts stamp duty. No prior approval of the Reserve bank is needed to issue a CP and underwriting the issue is not mandatory.

Most CPs have been issued by manufacturing companies for a maturity period of approximately three months or less. During 2001-02, manufacturing and related companies issued 67.4 per cent of total CPs, whereas 21.5 per cent of the total was issued by leasing and finance companies and the balance of 11.1 per cent by financial institutions.

Scheduled commercial banks are the major investors in commercial paper and their investment is determined by bank liquidity conditions. Banks prefer commercial paper as an investment avenue rather than sanctioning bank loans. These loans involve transaction costs and money is locked for a longer time periods whereas a commercial paper in an attractive short term instrument for banks to park funds during times of high liquidity. Some banks fund commercial papers by borrowing from the all money market. Usually, the call money market rates are lower than the commercial paper rates. Hence, banks book profits through arbitrage between the two money markets. Moreover, the issuance of commercial papers has been generally observed to be inversely related to the money market rates.

Guidelines Relating to CPs:

With experience refinements were made to this instrument by the Reserve bank by removing / easing a number of restrictions on maturity, size of the commercial paper, requirement of minimum current ratio, restoration of working capital finance and so on.

The maturity period of a commercial appear has been brought down from 91 days – 6 months to 15 days – 1 year. The minimum size of the paper has been reduced from Rs 1 crore to Rs 5 lakh.

Until October 1994, a commercial paper was an important corporate instrument for financing working capital requirements. Corporates could have access to funds at rates lower than the prime lending rates through a commercial paper. This low interest rate advantage was due to the stand by facility wherein banks were required to restore the cash credit limit on the maturity of the paper, guaranteeing the issuer funds at the time of redemption. This ‘stand by’ facility was withdrawn on October 1994. The corporates were asked to access funds through a commercial paper on their own repayment strength. This withdrawal also imparted independence to the commercial paper as a money market instrument and its credit reflected the intrinsic strength of the issuer. The withdrawal of this stand by facility led to a crash in the primary market for commercial paper in 1994-95.

Later, the commercial paper was carved out of the cash credit (CC) limits of the maximum permissible bank finance (MPBF) that the corporates had with banks. Hence, if a corporate issued a commercial paper the cash credit that it had with its bank was reduced by the same amount, thereby lowering the attractiveness of this instrument for the corporates. This issuances limit was de-linked from the cash credit limit in October 1996. Corporates now have the freedom to utilize their entire baking limits for issuing commercials papers.

New guidelines were released in October 2000 for providing flexibility, depth, and vibrancy to the commercial paper market. The Reserve bank converted the paper into a stand alone product to enable companies in the services sector to meet their short term working capital needs more easily. Banks and financial institutions now have the flexibility to fix working capital limits after taking into account the resource pattern of a company’s financing including CPs. An important feature of the revised guidelines was the flexibility given to banks and financial institutions to provide stand by assistance / credit, back stop facility to issuers. This stand by facility was provided to aid the long term growth of the CP market. In addition, this facility assists banks to increase their fee based income. The Ahmedabad Electrcity Company was the first company to issue CPs worth Rs 40 crore with a stand by facility provided by the bank. Both the issuer and the bank provided unconditional stand by facility to the extent of Rs 40 crore for the entire period during which the paper remained outstanding. This issue was assigned a P 1 rating by CRISIL.