Sources of finance: Banks

(A) Internal Self-Finance:

One source, quantitatively of big importance, is the saving of the unit itself. It may be the household, the business or the government.

Normally, the household not only invests out of its own saving but it also has surplus which it lends to other units via, financial institutions. Like banks, capital market etc.

The savings of the business, comprised of depreciation and the retained earnings, are normally short of its investment. Hence it also borrows from financial institutions. Government too finances a part of their investment from internally generated funds.

These arise from the excess of tax and other income over consumption spending plus transfers. For the shortfall, if and when it occurs, it also borrows from the financial system. Altogether, roughly half of all the investment is self-financed.

An advantage of investment through internally generated funds is that it combines the acts of saving and investment. As such certain costs are internalized and reduced. These costs pertain to collection of information in respect of borrowers, transactions with them, monitoring the use of funds, and enforcement of the conditions of borrowing.

These costs would have to be met if these funds were to be lent to someone else. Self- financing also reduces the risks of lending’s as it does not involve preparation of documents in respect of contract, collateral or security etc.

The shortcoming of this source is that it may fall short of investment opportunities or its use may be inefficient. That is funds may not be wholly or partly invested in the most productive lines.

(B) Equity, Debentures and Bonds:

A large part of finance for fixed investments [building, machines, etc.] comes from different types of equity or shares such as ordinary, cumulative and non-cumulative preference shares. These shares bear risks of different degrees and are tailored to suit the temperament of different investors.

The latest trend is to issue shares in small denominations of ten rupees so as to enable the largest number of people to participate in providing long-term finance. The credit-worthiness of promoters of industries and profitability of industries, determinate the extent to which savers invest their money in shares. In this way, industries are not burdened with interest, and therefore do not get involved in complications on this account during recession or depression.

Often industrial companies also get long-term finance through the issues of debentures and bonds. These are debt (loans), instruments. The buyers of those debentures and bonds are the creditors of companies. They get a fixed rate of interest on the money invested in these securities.

For this reason debentures are safer investments. Till recently, these debt-instruments were not very popular. At present many industries are tapping this source. Public sector undertakings too have started depending upon them. Since recently they have raised funds through the sale of bonds bearing fixed interest.

(C) Public Deposits:

Another source is public deposits. It is also a debt-instrument, mostly for short-term finance. Under this system, people keep their money as deposit with these companies or managing authorities for a period of six months, a year, two years, three years or so. Depositors receive a fixed interest.

They can ask for the refund of money at any time. This money is used by companies to meet their needs of working capital. However, this source of finance is unreliable because depositors can seek refund at any time.

And if the refund happens to coincide with the time when a company needs funds most, then it complicates matters. With the growth of banking habits and increase in dealings with other financial institutions, the importance of public deposits, as a source of finance, will decline.

(D) Loans from Banks:

Commercial banks can do also provide funds for meeting short-term needs or for working capital. Loans are given against the guarantee of government securities and stocks with companies. Loans are advanced in the form of overdraft and credit limit. Commercial banks are generally reluctant to put their money in the purchase of shares.

The reason is that the deposits that they receive from the public are generally for a short-term and therefore, banks can ill-afford to take any risk in investing public money in shares. They can, however, do something by way of buying debentures of companies.

They can earn fixed interest on such investment and at the time of need they can sell these debentures in the market and recover their money. Still, little has been achieved in this field because of the fear that banks may find it difficult to cash debenture precisely at a time when they need.

(E) The Managing Agency System:

The system of industrial finance, peculiar to India, and which prevailed till the recent times, is of little importance now days. Under this system an individual or a group of individuals finance the initial stage of the establishment of industries, and manage many activities of the company thus established very often, one managing agent controls more than one concern and uses fund of one concern to meet the needs of others under him.

In the past when there was a great shortage of industrial finance and almost complete lack of financial institutions, and capital market in the real sense had not even come into existence, managing agents did render a valuable service in the promotion of industries within the country. Of course, it is true that their funds were mostly used for the establishment of consumer goods industries.

In due course, however, the system developed certain drawbacks and came to be plagued by serious shortcomings. The management of so many units, good and bad, and producing a variety of products led to certain evils.

The payments which managing agents extracted for themselves, interest on their money, commission for their services etc., were too much and were out of proportion with the paying capacity of the companies and/or the work performed by those agents. It is for these reasons that the government put a ban on this system in 1970.

(F) Indigenous Bankers:

Inspite of the establishment of new financial institutions, indigenous bankers also advance financial help to a few large-scale industries, particularly during the time of stress, both for fixed capital and working capital. But mainly they have provided finance to small scale industries.

In the absence of adequate institutional finance, these industries have been forced to depend upon indigenous bankers. These banks charge a very heavy rate of interest, thus making finance a costly affair. However, the importance of these banks, even as a source of finance for small industries, is on the decline.

(G) Development Finance Institutions:

Established with the help of the Government to fill-in the gap in industrial finance and to promote the objective of planning, these institutions cater to the needs of large and small industries.

The new institutions supplying industrial finance are Industrial Development Bank of India, Industrial Finance Corporation of India, Unit Trust of India, and General Insurance Corporation of India, Industrial Reconstruction Bank of India, State Financial Corporations, and State Industrial Development Corporations.

These institutions provide huge quantity of finances for setting up of new industries, for meeting their several needs and in several forms. These also ensure and monitor the use of finance in pre-planned directions. As such these fit well with the modem scenario of industrial development.

(H) Foreign Capital:

As a supplement to domestic finance, external capital too has been made use of in meeting the needs of industrial finance, mostly for long-term needs. This has taken several forms. There is the foreign aid (i.e., loans on concessional term) from foreign governments and foreign institutions (like the World Bank) extended to the Government.

A part of this assistance has also gone to the private sector. A part of foreign funds has come through foreign companies which have Indian subsidiaries in our country or through Multinational Corporations which have branches in India.

Some foreign companies have given funds as part of direct investment or as part of collaborations with Indian companies. There are also non-resident Indians who have invested in collaboration with Indians. Indian companies have also raised loans from foreign markets.

The sources of industrial finance are thus of various types. And so are the instruments of finance. A number of them are modem Such as shares, debentures, and loans from the financial institutions. The old ones like, deposits from public, the finances of managing agents as also of indigenous bankers are on the decline. This is as it should be for these are neither enough, nor suitable for meeting the needs of the modern industrial growth.