Fee-based Financial Services – AHSEC Class 12 Finance Chapter 18

Here is a comprehensive study note for the AHSEC Class 12 Finance textbook, focusing on Chapter 18: Fee-based Financial Services.

Chapter 18: Fee-based Financial Services

Summary Note

This chapter covers financial services where institutions earn income by charging fees for their expertise and services, rather than through interest or fund-based activities. The chapter focuses on three key fee-based services: Stock Broking, Credit Rating, and Merchant Banking.

Part 1: Stock Broking

• Meaning: Stock broking is a fee-based financial service rendered by a licensed broker or brokerage firm. The primary function is to act as an intermediary (agent) for investors in the buying and selling of securities on a stock exchange. In return for this service, they charge a fee known as brokerage.
• Functions of Stock Brokers:
  1. As Intermediary: Execute buy and sell orders for clients on the stock exchange.
  2. As Adviser to Clients: Provide market information and advice on which stocks to buy or sell.
  3. Provider of Personalized Services: Offer services like financial planning, tax advice, and retirement planning.
  4. Provides Margin Financing: Allow clients to borrow money to buy more stocks than their actual affordability (margin trading).
• General Duties of a Stock Broker:
  • Maintain fairness and integrity in all business dealings.
  • Exercise due skill, care, and honesty when dealing with clients.
  • Not indulge in manipulative or fraudulent transactions.
  • Comply with all statutory requirements and regulations set by SEBI.

Part 2: Credit Rating

• Meaning: Credit rating is an assessment, made by a specialized credit rating agency, of a borrower’s ability to repay their debt obligations in a timely manner. It is a quantitative expression (e.g., AAA, AA, B) of the rating agency’s opinion on the creditworthiness of a company or a specific debt instrument.
• Components of Credit Rating:
  1. Financial Instruments Rating: Rating bonds, debentures, commercial papers, etc.
  2. Customer Rating: Assessing the creditworthiness of a customer for credit sales.
  3. Borrower Rating: Assessing the ability of a borrower to repay a loan.
• Factors Considered for Credit Rating: History of the organization, accounting quality, profitability, capital structure, past performance, liquidity management, etc.
• Process of Credit Rating:
  1. A company applies to a rating agency.
  2. The agency appoints an analytical team.
  3. The team collects necessary information and analyzes the company’s creditworthiness.
  4. The agency prepares a rating report and assigns a rating score.
  5. The client company publishes the rating score.
• Advantages of Credit Rating: It provides investors with superior, low-cost information to make informed investment decisions and encourages companies to maintain financial discipline.
• Disadvantages of Credit Rating: Ratings can be biased, may differ between agencies, and can become outdated quickly.

Part 3: Merchant Banking

• Meaning: A merchant bank is a specialized financial institution that provides a wide range of fee-based services to corporate clients, such as issue management, corporate counseling, and project finance syndication. They are also known as ‘Investment Banks’.
• Role of Merchant Bankers: They act as lead managers for public issues, consultants, underwriters, and provide technical and managerial assistance to corporate clients.
• Functions of Merchant Bankers:
  1. Project Counselling Services: Help in identifying projects and preparing feasibility studies.
  2. Corporate Counselling: Advise clients on improving performance and reputation.
  3. Syndication of Loans: Help clients apply for and obtain loans from financial institutions.
  4. Issue Management: Manage the entire process of a public issue of shares and debentures.
  5. Provision of Working Capital: Assist clients in estimating and arranging for working capital.
  6. Lease Finance: Arrange lease finance facilities for clients.
• Difference between Merchant Banks and Commercial Banks:

Complete Textual Question Answers

Here are the answers to all the questions given at the end of Chapter 18.

A. Very Short Answer Questions (1 Mark each)

1. Credit Rating is a Fee based financial service. (True/False)
   Ans: True.
2. Stock brokers are commission agent-Whether True or False?
   Ans: True.
3. ‘License for undertaking Stock broking is not essential’-Whether True or False?
   Ans: False. (A license from SEBI is essential).
4. ‘Credit rating is done only to assess ability to return credits of Banks’- Whether true or False?
   Ans: False. (It is done for various debt instruments like bonds and debentures, not just bank credits).
5. Credit rating is done by the Commercial Banks-Whether true or False?
   Ans: False. (It is done by specialized credit rating agencies).
6. ‘Merchant banking is a non-banking activity’-Whether true or False?
   Ans: True.
7. ‘There is no difference between Merchant banking and Commercial Bank’-Whether true or False?
   Ans: False.
8. The first bank that started Merchant Banking in India is Grindlays Bank. (True/False)
   Ans: True.
9. ‘Accepting deposits is the main function of Merchant Banker”- Whether true or False?
   Ans: False. (Accepting deposits is a main function of a commercial bank).

B. Short Answer Questions (2 Marks each)

1. What is financial service.
   Ans: Financial services are activities of a financial nature performed by financial intermediaries for their clients. In a broad sense, they involve mobilizing savings and allocating them to investments.
2. What are the two types of financial services?
   Ans: The two broad types of financial services are:
   i. Fee-based financial services (e.g., stock broking, credit rating).
   ii. Fund-based financial services (e.g., leasing, hire-purchase).
3. What is stock broker?
   Ans: A stock broker is a commission agent who acts as an intermediary between buyers and sellers of securities. They are licensed members of a stock exchange who execute trades on behalf of their clients.
4. What is meant by Brokerage?
   Ans: Brokerage is the fee or commission charged by a stock broker for the service of buying or selling securities on behalf of their client.
5. What is Credit Rating.
   Ans: Credit rating is the assessment made by a rating agency regarding a borrower’s ability and willingness to pay their debt obligations in a timely manner. It is an opinion on creditworthiness, expressed as a symbol (e.g., AAA).
6. What is Merchant Banker.
   Ans: A merchant banker is a person or institution engaged in the business of issue management and providing corporate advisory services related to raising capital.
7. Mention two Credit Rating agencies of India.
   Ans: Two credit rating agencies of India are:
   i. Credit Rating Information Services of India Ltd. (CRISIL).
   ii. Investment Information and Credit Rating Agencies of India (ICRA).

C. Long Answer Questions (Type-1) (5 Marks each)

1. Write the functions of Stock brokers.
   Ans: (Refer to the “Functions of Stock Brokers” section in the summary and explain the points: As intermediary, As adviser to clients, Provider of personalized services, and Provides margin financing).
2. What are the general duties that Stock brokers expected to exercise?
   Ans: (Refer to the “General Duties of a Stock Broker” section in the summary and explain the four duties: Fairness in activities, Exercise of due skill and care, No Manipulation, and Compliance with statutory requirements).
3. What are the various factors considered in the process of Credit rating?
   Ans: (Refer to the “Factors Considered for Credit Rating” section in the summary and list and explain factors like history of the organization, accounting quality, liquidity management, profitability, and capital structure).
4. Explain the three components of Credit rating.
   Ans: (Refer to the “Components of Credit Rating” section in the summary and explain the three components: Financial instruments rating, Customer rating, and Borrower rating).
5. Distinguish between Commercial banking and Merchant banking functions.
   Ans: (Refer to the comparison table in the summary and explain the differences based on Meaning, Main functions, Nature of functions, Customers, and Earnings).

D. Long Answer Questions (Type-2) (8 Marks each)

1. Explain the steps involved in Credit rating process.
   Ans: (Refer to the “Process of Credit Rating” section in the summary and explain each of the five steps in detail, from the initial application by the company to the final publication of the rating score).
2. Explain the merits and demerits of Credit rating.
   Ans:
   Merits (Advantages) of Credit Rating:
   • Superior Information for Investors: Provides investors with expert and reliable information about the risk of a debt instrument at a low cost.
   • Quick Decision Making: Enables investors to make quick investment decisions based on the rating symbol.
   • Encourages Financial Discipline: Motivates borrowing companies to maintain good financial health to get a better rating.
   • Reduces Dependence on Brokers: Lessens the dependence of investors on the advice of brokers.
     Demerits (Disadvantages) of Credit Rating:
   • Possibility of Bias: The rating may be biased as the rating agency is paid by the company it is rating.
   • Ratings Can Become Outdated: A company’s financial health can change quickly, making a rating outdated. New ratings are required periodically.
   • Just an Opinion: A credit rating is just an opinion of the agency and may not reflect the actual status of the company.
   • Differences between Agencies: Different rating agencies may provide different ratings for the same instrument, causing confusion.
3. Write the functions performed by Merchant Bankers.
   Ans: (Refer to the “Functions of Merchant Bankers” section in the summary and explain each function in detail: Project counselling, Corporate Counselling, Syndication of loans, Issue management, Provision of working capital, and Lease finance).
4. Explain the services rendered by Stock brokers to their clients.
   Ans: (This is similar to C.1. Explain the services in detail. Start with the primary service of executing buy/sell orders. Then discuss advisory services, where brokers provide market research and recommendations. Explain personalized services like financial planning. Finally, describe margin financing, which allows clients to leverage their position).

Previous Year AHSEC Question Answers (2015-2025)

Short Questions (1-2 Marks)

• What is Credit Rating? (AHSEC 2016, 2020)
  Ans: Credit rating is an assessment, made by a specialized rating agency, of a borrower’s ability to repay their debt in a timely manner, expressed as a standardized symbol.
• What is Merchant Banking? (AHSEC 2017)
  Ans: Merchant banking refers to a range of fee-based financial services provided to corporate clients, primarily related to issue management (raising capital) and corporate advisory.
• Mention two functions of a stock broker. (AHSEC 2018)
  Ans: Two functions of a stock broker are: (i) to act as an intermediary to execute buy and sell orders for clients, and (ii) to act as an adviser to clients by providing market information.
• Write the full form of CRISIL. (AHSEC 2019)
  Ans: The full form of CRISIL is Credit Rating Information Services of India Limited.

Long Questions (5-8 Marks)

• Distinguish between a Commercial Bank and a Merchant Bank. (AHSEC 2017, 2021)
  Ans: (This answer is the same as the textual Long Answer Question C.5. Please refer to that answer above, using a table for clarity).
• Explain the functions of Merchant Bankers. (AHSEC 2018)
  Ans: (This answer is the same as the textual Long Answer Question D.3. Please refer to that answer above).

10 Most Important Questions

1. What is the primary difference between fee-based and fund-based financial services?
   Ans: In fee-based services, the institution earns income by charging a fee for its expertise (e.g., advice, management). In fund-based services, the institution deploys its own funds to earn income (e.g., through interest on loans or lease rentals).
2. Why must a stock broker be registered with SEBI?
   Ans: A stock broker must be registered with SEBI to ensure they operate under a regulated framework, which protects the interests of investors and maintains the integrity of the stock market.
3. What is the main purpose of credit rating for an investor?
   Ans: The main purpose is to help an investor understand the level of risk associated with a debt instrument before investing. A higher rating indicates lower risk, and a lower rating indicates higher risk.
4. Who is the primary regulator for Merchant Bankers in India?
   Ans: The primary regulator for Merchant Bankers in India is the Securities and Exchange Board of India (SEBI).
5. What is ‘issue management’ as a function of a merchant banker?
   Ans: Issue management is the process of managing a company’s public issue of shares or debentures. This includes everything from preparing the prospectus and getting approvals to marketing the issue and handling allotment.
6. Can a commercial bank perform merchant banking functions?
   Ans: Yes, many commercial banks in India perform merchant banking functions, often through their specialized subsidiaries (e.g., SBI Capital Markets is a subsidiary of SBI).
7. What is ‘margin financing’ provided by a stock broker?
   Ans: Margin financing is a facility where a stock broker lends money to a client, allowing the client to buy more stocks than they could with their own funds. This increases their potential profit but also increases their risk.
8. Name two well-known credit rating agencies in India.
   Ans: Two well-known credit rating agencies are CRISIL and ICRA.
9. How do merchant banks and commercial banks differ in their primary source of earnings?
   Ans: Commercial banks primarily earn from the interest spread (the difference between the interest they earn on loans and the interest they pay on deposits). Merchant banks primarily earn from the fees they charge for their advisory and management services.
10. What is the key difference in the clientele of a commercial bank versus a merchant bank?
    Ans: A commercial bank serves a broad clientele, including the general public, small firms, and corporates. A merchant bank’s clientele is more specialized, consisting mainly of large corporate bodies and high-net-worth individuals.