Debt relief is the partial or total forgiveness of debt , or the
slowing or stopping of debt growth, owed by individuals,
corporations, or nations. Traditionally, from antiquity through the
19th century, it refers to domestic debts, particularly
agricultural debts and freeing of debt slaves. In the late 20th
century it came to refer primarily to Third World debt , which
started exploding with the Latin American debt crisis (Mexico 1982,
etc.). In the early 21st century, it is of increased applicability
to individuals in developed countries, due to credit bubbles and
housing bubbles .
Contents
1 International debt relief
1.1 War reparations
1.2 Third world debt
1.3 Arguments against debt relief
2 Personal debt relief
2.1 Origins
2.2 Contemporary
2.2.1 Tax treatment
3 Bankruptcy and non-recourse loans
4 Alternatives
4.1 Historical
4.2 Contemporary
5 Inflation
6 Debt relief in art
7 References
8 See also
1.1 War reparations
1.2 Third world debt
1.3 Arguments against debt relief
2.1 Origins
2.2 Contemporary
2.2.1 Tax treatment
2.2.1 Tax treatment
4.1 Historical
4.2 Contemporary
International debt relief
War reparations
In the mid-20th century, the 1953 Agreement on German External
Debts , which substantially reduced German's war reparations , was
a notable example of international debt relief. Part of the
reasoning was that German's World War I reparations were deeply
resented in Germany, and credited internationally as a cause of
World War II , and thus debt relief helped reconciliation and peace
in Europe.
Third world debt
Debt relief for heavily indebted and underdeveloped developing
countries was the subject in the 1990s of a campaign by a broad
coalition of development NGOs , Christian organizations and others,
under the banner of Jubilee 2000 . This campaign, involving, for
example, demonstrations at the 1998 G8 meeting in Birmingham , was
successful in pushing debt relief onto the agenda of Western
governments and international organizations such as the
International Monetary Fund and World Bank . Ultimately the Heavily
Indebted Poor Countries (HIPC) initiative was launched to provide
systematic debt relief for the poorest countries, whilst trying to
ensure the money would be spent on poverty reduction .
The HIPC programme has been subject to conditionalities similar to
those often attached to IMF and World Bank loans, requiring
structural adjustment reforms, sometimes including the
privatisation of public utilities , including water and
electricity. To qualify for irrevocable debt relief, countries must
also maintain macroeconomic stability and implement a Poverty
Reduction Strategy satisfactorily for at least one year. Under the
goal of reducing inflation, some countries have been pressured to
reduce spending in the health and education sectors.
The Multilateral Debt Relief Initiative (MDRI) is an extension of
HIPC. The MDRI was agreed following the G8 's Gleneagles meeting in
July 2005 . It offers 100% cancellation of multilateral debts owed
by HIPC countries to the World Bank , IMF and African Development
Bank .
Arguments against debt relief
Opponents of debt relief argue that it is a blank cheque to
governments, and fear savings will not reach the poor in countries
plagued by corruption. Others argue that countries will go out and
contract further debts, under the belief that these debts will also
be forgiven in some future date. They use the money to enhance the
wealth and spending ability of the rich, many of whom will spend or
invest this money in the rich countries, thus not even creating a
trickle-down effect . They argue that the money would be far better
spent in specific aid projects which actually help the poor. They
further argue that it would be unfair to third-world countries that
managed their credit successfully, or don't go into debt in the
first place, that is, it actively encourages third world
governments to overspend in order to receive debt relief in the
future. Others argue against the conditionalities attached to debt
relief. These conditions of structural adjustment have a history,
especially in Latin America, of widening the gap between the rich
and the poor, as well as increasing economic dependence on the
global North.
Personal debt relief
Origins
Debt relief existed in a number of ancient societies:
Debt forgiveness is mentioned in the Book of Leviticus , in which
God councils Moses to forgive debts in certain cases every Jubilee
year – at the end of Shmita , the last year of the seven year
agricultural cycle or a 49-year cycle, depending on
interpretation.
This same theme was found in an ancient bilingual Hittite - Hurrian
text entitled the "The Song of Debt Release".
Debt forgiveness was also found in Ancient Athens , where in the
6th century BCE, the lawmaker Solon instituted a set of laws called
seisachtheia , which canceled all debts and retroactively canceled
previous debts that had caused slavery and serfdom, freeing debt
slaves and debt serfs.
Contemporary
Personal debt has become an increasingly large problem in many
developed countries in recent years, due to credit bubbles . For
instance, it is estimated that the average US household has $19,000
in non-mortgage debt. With such large debt loads, many individuals
have difficulty making repayments on debts and are in need of
help.
There are many companies who offer debt consolidation services.
However, such services may not always be in the best interests of
the person involved and may involve taking out a loan secured by a
person's home. Marketing materials are designed to persuade
customers to take up the company's offer rather than offering a
personal best solution for reducing debt. Where debt has become a
problem, it is often best to turn to an independent consumer's
association for advice before calling debt consolidation companies
as consumer's associations often have great experience with such
problems and may be able to advise the most effective avenues for
debt relief.
As long as some form of Chapter 7 bankruptcy debt relief exists
within American law, the credit card companies must pay attention,
and do as much as they can to help their clients repay debts
through relatively traditional means (depending upon the service
those clients have entered). Even leaving bankruptcy aside, it is
in the best interest of credit card companies that their debtors at
least feel some motivation to continue repaying their accounts and
not simply disappear or view those ever growing balances as
untouchable.
Tax treatment
In US tax law, debt forgiven is treated as income, as it reduces a
liability, increasing the taxpayer's net worth . In the context of
the bursting of the United States housing bubble , the Mortgage
Forgiveness Debt Relief Act of 2007 provides that debt forgiven on
a primary residence is not treated as income, for debts forgiven in
the 3-year period 2007–2009. The Emergency Economic
Stabilization Act of 2008 extended this by 3 years to the 6-year
period 2007–2012.
Bankruptcy and non-recourse loans
The primary mechanism of debt relief in modern societies is
bankruptcy , where a debtor who cannot or chooses not to pay their
debts files for bankruptcy and renegotiates their debts, or a
creditor initiates this. As part of debt restructuring , the terms
of the debt are modified, which may involve the debt owed being
reduced. In case the debtor chooses bankruptcy despite being able
to service the debt, this is called strategic bankruptcy .
Certain debts can be defaulted on without a general bankruptcy;
these are non-recourse loans , most notably mortgages in common law
jurisdictions such as the United States . Choosing to default on
such a loan despite being able to service it is called strategic
default .
Alternatives
Historical
If a debt cannot be or is not repaid, alternatives which were
common historically but are now rare include debt bondage –
including debt peonage : being bound until the debt is repaid; and
debt slavery , when the debt is so great (or labor valued so low)
that the debt will never be repaid – and debtors' prison
.
Debt slavery can persist across generations, future generations
being made to work to pay off debts incurred by past generations.
Debt bondage is today considered a form of "modern day slavery " in
international law, and banned as such, in Article 1(a) of the
United Nations 1956 Supplementary Convention on the Abolition of
Slavery . Nevertheless, the practice continues in some nations. In
most developed nations, debts cannot be inherited.
Debtors' prison has been largely abolished, but remains in some
forms in the US, for example if one fails to make child support
payments.
Contemporary
In modern times, the most common alternatives to debt relief in
cases where debt cannot be paid are forbearance and debt
restructuring . Forbearance meaning that interest payments
(possibly including past due ones) are forgiven, so long as
payments resume. No reduction of principle occurs, however.
In debt restructuring, an existing debt is replaced with a new
debt. This may result in reduction of the principal (debt relief),
or may simple change the terms of repayment, for instance by
extending the term (replacing a debt repaid over 5 years with one
repaid over 10 years), which allows the same principal to be
amortized over a longer period, thus allowing smaller payments.
Personal debt that can be repaid from income but is not being
repaid may be obtained via garnishment or attachment of earnings ,
which deduct debt service from wages .
Inflation
Inflation - the reduction in the nominal value of currency -
reduces the real value of debts, thus providing categorical debt
relief. Inflation has been a contentious political issue on this
basis, with debasement of currency a form of or alternative to
sovereign default , and the free silver in late 19th century
America being seen as a conflict between debtor farmers and
creditor bankers.
Debt relief in art
Debt relief plays a significant role in some artworks: in the play
The Merchant of Venice by William Shakespeare , c. 1598, the
heroine pleads for debt relief (forgiveness) on grounds of
Christian mercy . In the 1900 novel The Wonderful Wizard of Oz , a
primary political interpretation is that it treats free silver ,
which engenders inflation and hence reduces debts. In the 1999 film
Fight Club (but not the novel on which it is based ), the climactic
event is the destruction of credit card records – dramatized
as the destruction of skyscrapers – effecting debt
relief.
References
See also
Agreement on German External Debts
Anti-globalisation movement
Conditionality
International development
International Monetary Fund | World Bank
Managing for development results
Globalization and Health
Survie NGO activist group against Third World debt
Odious debt
Third World debt
Jubilee USA
Eurodad
Debt is that which is owed ; usually referencing assets owed, but
the term can also cover moral obligations and other interactions
not requiring money. In the case of assets, debt is a means of
using future purchasing power in the present before a summation has
been earned. Some companies and corporations use debt as a part of
their overall corporate finance strategy. [ citation needed ]
A debt is created when a creditor agrees to lend a sum of assets to
a debtor . In modern society, debt is usually granted with expected
repayment; in many cases, plus interest . Historically, debt was
responsible for the creation of indentured servants .
Contents
1 Etymology
2 Payment
3 Types of debt
4 Debt Syndication
5 Fund Base
6 Non Fund Base
7 Accounting debt
10 Effects of debt
11 Arguments against debt
12 Levels and flows
13 See also
14 References
//
Etymology
The word comes from the Old French dette and ultimately Latin
debere (to owe), from de habere (to have). The letter b in the word
debt was reintroduced in the 17th century, possibly by Samuel
Johnson in his Dictionary of 1755— several other words that
had existed without a b had them reinserted at around that
time.
Payment
Before a debt can be made, both the debtor and the creditor must
agree on the manner in which the debt will be repaid, known as the
standard of deferred payment . This payment is usually denominated
as a sum of money in units of currency , but can sometimes be
denominated in terms of goods . Payment can be made in increments
over a period of time , or all at once at the end of the loan
agreement .
Types of debt
A company uses various kinds of debt to finance its operations .
The various types of debt can generally be categorized into: 1)
secured and unsecured debt, 2) private and public debt, 3)
syndicated and bilateral debt, and 4) other types of debt that
display one or more of the characteristics noted above. [ 1 ]
A debt obligation is considered secured if creditors have recourse
to the assets of the company on a proprietary basis or otherwise
ahead of general claims against the company. Unsecured debt
comprises financial obligations, where creditors do not have
recourse to the assets of the borrower to satisfy their claims.
Private debt comprises bank-loan type obligations, whether senior
or mezzanine . Public debt is a general definition covering all
financial instruments that are freely tradeable on a public
exchange or over the counter, with few if any restrictions.
Loan syndication is a risk management tool that allows the lead
banks underwriting the debt to reduce their risk and free up
lending capacity.
A basic loan is the simplest form of debt. It consists of an
agreement to lend a principal sum for a fixed period of time , to
be repaid by a certain date. In commercial loans interest ,
calculated as a percentage of the principal sum per year, will also
have to be paid by that date.
In some loans, the amount actually loaned to the debtor is less
than the principal sum to be repaid; the additional principal has
the same economic effect as a higher interest rate (see point
(mortgage) ), and is sometimes referred to as a banker's dozen , a
play on " baker's dozen " – owe twelve (a dozen), receive a
loan of eleven (a banker's dozen). Note that the effective interest
rate is not equal to the discount: if one borrows $10 and must
repay $11, then this is ($11–$10)/$10 = 10% interest;
however, if one borrows $9 and must repay $10, then this is
($10–$9)/$9 = 11 1/9 % interest. [ 2 ]
A syndicated loan is a loan that is granted to companies that wish
to borrow more money than any single lender is prepared to risk in
a single loan, usually many millions of dollars. In such a case, a
syndicate of banks can each agree to put forward a portion of the
principal sum.
A bond is a debt security issued by certain institutions such as
companies and governments . A bond entitles the holder to repayment
of the principal sum, plus interest . Bonds are issued to investors
in a marketplace when an institution wishes to borrow money. Bonds
have a fixed lifetime, usually a number of years ; with long-term
bonds, lasting over 30 years, being less common. At the end of the
bond's life the money should be repaid in full. Interest may be
added to the end payment, or can be paid in regular installments
(known as coupons ) during the life of the bond. Bonds may be
traded in the bond markets , and are widely used as relatively safe
investments in comparison to equity .
Debt Syndication
There are two types of debt syndication: fund base and non fund
base.
Fund Base
Cash Credit
This is the primary method in which Banks lend money against the
security of commodities and debt. It runs like a current account
except that the money that can be withdrawn from this account is
not restricted to the amount deposited in the account. Instead, the
account holder is permitted to withdraw a certain sum called
"limit", "credit facility" in excess of the amount deposited in the
account. Cash Credits are, in theory, payable on demand. These are,
therefore, counter part of demand deposits of the Bank.
Working capital:
Firms need cash to pay for all their day-to-day activities. They
have to pay wages, pay for raw materials, pay bills and so on. The
money available to them to do this is known as the firm's working
capital. The main sources of working capital are the current assets
as these are the short-term assets that the firm can use to
generate cash. However, the firm also has current liabilities and
so these have to be taken account of when working out how much
working capital a firm has at its disposal.
Working capital is therefore:- WORKING CAPITAL = Current Assets ||
stock + debtors + cash - Current liabilities Thus working capital
is the same as net current assets, and is an important part of the
top half of the firm's balance sheet. It is vital to a business to
have sufficient working capital to meet all its requirements. Many
businesses have gone under, not because they were unprofitable, but
because they suffered from shortages of working capital. Working
Capital Cycle
Bank Overdraft:
The word overdraft means the act of overdrawing from a Bank
account. In other words, the account holder withdraws more money
from a Bank Account than has been deposited in it. An overdraft
occurs when withdrawals from a bank account exceed the available
balance which gives the account a negative balance - a person can
be said to be "overdrawn".
If there is a prior agreement with the account provider for an
overdraft protection plan, and the amount overdrawn is within this
authorised overdraft, then interest is normally charged at the
agreed rate. If the balance exceeds the agreed terms, then fees may
be charged and higher interest rate might apply
Term loan:
Term Loan are the counter parts of Fixed Deposits in the Bank.
Banks lend money in this mode when the repayment is sought to be
made in fixed, pre-determined installments. This type of loan is
normally given to the borrowers for acquiring long term assets i.e.
assets which will benefit the borrower over a long period
(exceeding at least one year). Purchases of plant and machinery,
constructing building for factory, setting up new projects fall in
this category. Financing for purchase of automobiles, consumer
durables, real estate and creation of infra structure also falls in
this category.
Bill discounting:
Bill discounting is a major activity with some of the smaller
Banks. Under this particular type of lending, Bank takes the bill
drawn by borrower on his(borrower's) customer and pay him or her
immediately deducting some amount as discount/commission. The Bank
then presents the Bill to the borrower's customer on the due date
of the Bill and collect the total amount. If the bill is delayed,
the borrower or his customer pay the Bank a pre-determined interest
depending upon the terms of transaction.
Project Financing:
Project finance is the financing of long-term infrastructure and
industrial projects based upon a complex financial structure where
project debt and equity are used to finance the project, rather
than the balance sheets of project sponsors. Usually, a project
financing structure involves a number of equity investors, known as
sponsors, as well as a syndicate of banks that provide loans to the
operation.
Non Fund Base
Letter of Credit:
The LC can also be the source of payment for a transaction, meaning
that redeeming the letter of credit will pay an exporter. Letters
of credit are used primarily in international trade transactions of
significant value, for deals between a supplier in one country and
a customer in another. They are also used in the land development
process to ensure that approved public facilities (streets,
sidewalks, stormwater ponds, etc.) will be built. The parties to a
letter of credit are usually a beneficiary who is to receive the
money, the issuing bank of whom the applicant is a client, and the
advising bank of whom the beneficiary is a client. Almost all
letters of credit are irrevocable, i.e., cannot be amended or
canceled without prior agreement of the beneficiary, the issuing
bank and the confirming bank, if any. In executing a transaction,
letters of credit incorporate functions common to giros and
Traveler's cheques. Typically, the documents a beneficiary has to
present in order to receive payment include a commercial invoice,
bill of lading, and a document proving the shipment was insured
against loss or damage in transit. However, the list and form of
documents is open to imagination and negotiation and might contain
requirements to present documents issued by a neutral third party
evidencing the quality of the goods shipped, or their place of
origin.
Corporate finance
Working capital management
Cash conversion cycle
Return on capital
Economic value added
Just In Time
Economic order quantity
Discounts and allowances
Factoring (finance)
Capital budgeting
Capital investment decisions
The investment decision
The financing decision
Sections
Managerial finance
Financial accounting
Management accounting
Mergers and acquisitions
Balance sheet analysis
Business plan
Corporate action
Finance series
Financial market
Financial market participants
Corporate finance
Personal finance
Public finance
Banks and Banking
Financial regulation
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Accounting debt
In national accounting, debts are added according to those who are
indebted. Household debt is the debt held by households. "National"
or Public debt is the debt held by the various governmental
institutions (federal government, states, cities ...). Business
debt is the debt held by businesses. Financial debt is the debt
held by the financial sector (from one financial institution to
another). Total debt is the sum of all those debts, excluding
financial debt to prevent double accounting. These various types of
debt can be computed in debt/GDP ratios. Those ratios help to
assess the speed of variations in the indebtness and the size of
the debt due. For example, the USA has a high consumer debt and a
low public debt, while in eastern European countries the opposite
tends to be true.
There are differences in the accounting of debt for private and
public agents. If a private agent promises to pay something later,
it has a debt, and this debt is enforceable by public agents. If a
public body passes a law stating that it'll pay something later (a
kind of promise), it keeps the right to change the law later (and
not to pay). This is why, for instance, the money governments
promised to pay for retirements does not show up in the public debt
assessment, whereas the money private companies promised to pay for
retirements do.
Securitization
Main article: Securitization
Securitization occurs when a company groups together assets or
receivables and sells them in units to the market through a trust.
Any asset with a cashflow can be securitized. The cash flows from
these receivables are used to pay the holders of these units.
Companies often do this in order to remove these assets from their
balance sheets and monetize an asset. Although these assets are
"removed" from the balance sheet and are supposed to be the
responsibility of the trust, that does not end the company's
involvement. Often the company maintains a special interest in the
trust which is called an "interest only strip" or "first loss
piece". Any payments from the trust must be made to regular
investors in precedence to this interest. This protects investors
from a degree of risk, making the securitization more attractive.
The aforementioned brings into question whether the assets are
truly off-balance-sheet given the company's exposure to losses on
this interest.
Debt, inflation and the exchange rate
As noted below, debt is normally denominated in a particular
monetary currency , and so changes in the valuation of that
currency can change the effective size of the debt. This can happen
due to inflation or deflation , so it can happen even though the
borrower and the lender are using the same currency . Thus it is
important to agree on standards of deferred payment in advance, so
that a degree of fluctuation will also be agreed as acceptable. It
is for instance common [ citation needed ] to agree to " US dollar
denominated" debt.
The form of debt involved in banking accounts for a large
proportion of the money in most industrialised nations (see money ,
broad money , and demand deposits for a discussion of this). There
is therefore a relationship between inflation , deflation , the
money supply , and debt. The store of value represented by the
entire economy of the industrialized nation, and the state's
ability to levy tax on it, acts to the foreign holder of debt as a
guarantee of repayment, since industrial goods are in high demand
in many places worldwide.
Inflation indexed debt
Borrowing and repayment arrangements linked to inflation-indexed
units of account are possible and are used in some countries. For
example, the US government issues two types of inflation-indexed
bonds , Treasury Inflation-Protected Securities (TIPS) and I-bonds.
These are one of the safest forms of investment available, since
the only major source of risk — that of inflation — is
eliminated. A number of other governments issue similar bonds, and
some did so for many years before the US government.
In countries with consistently high inflation, ordinary borrowings
at banks may also be inflation indexed.
Debt ratings, risk and cancellation
Risk free interest rate
Main article: risk-free interest rate
Standards
ISO 31000
International Financial Reporting
Economic history
Stock market bubble
Recession
Stock market crash
History of private equity
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Lendings to stable financial entities such as large companies or
governments are often termed "risk free" or "low risk" and made at
a so-called " risk-free interest rate ". This is because the debt
and interest are highly unlikely to be defaulted. A good example of
such risk-free interest is a US Treasury security - it yields the
minimum return available in economics, but investors have the
comfort of the (almost) certain expectation that the US Treasury
will not default on its debt instruments. A risk-free rate is also
commonly used in setting floating interest rates, which are usually
calculated as the risk-free interest rate plus a bonus to the
creditor based on the creditworthiness of the debtor (in other
words, the risk of him or her defaulting and the creditor losing
the debt). In reality, no lending is truly risk free, but borrowers
at the "risk free" rate are considered the least likely to
default.
However, if the real value of a currency changes during the term of
the debt, the purchasing power of the money repaid may vary
considerably from that which was expected at the commencement of
the loan. So from a practical investment point of view, there is
still considerable risk attached to "risk free" or "low risk"
lendings. The real value of the money may have changed due to
inflation, or, in the case of a foreign investment, due to exchange
rate fluctuations.
The Bank for International Settlements is an organisation of
central banks that sets rules to define how much capital banks have
to hold against the loans they give out.
Ratings and creditworthiness
Specific bond debts owed by both governments and private
corporations is rated by rating agencies , such as Moody's , Fitch
Ratings Inc., A. M. Best and Standard & Poor's . The government
or company itself will also be given its own separate rating. These
agencies assess the ability of the debtor to honor his obligations
and accordingly give him or her a credit rating . Moody's uses the
letters Aaa Aa A Baa Ba B Caa Ca C , where ratings Aa-Caa are
qualified by numbers 1-3. Munich Re , for example, currently is
rated Aa3 (as of 2004 [update] ). S&P and other rating agencies
have slightly different systems using capital letters and +/-
qualifiers.
A change in ratings can strongly affect a company, since its cost
of refinancing depends on its creditworthiness . Bonds below
Baa/BBB (Moody's/S&P) are considered junk- or high risk bonds.
Their high risk of default (approximately 1.6% for Ba) is
compensated by higher interest payments. Bad Debt is a loan that
can not (partially or fully) be repaid by the debtor. The debtor is
said to default on his debt. These types of debt are frequently
repackaged and sold below face value. Buying junk bonds is seen as
a risky but potentially profitable form of investment.
Cancellation
Main article: Debt relief
Short of bankruptcy, it is rare that debts are wholly or partially
relinquished. Traditions in some cultures demand that this be done
on a regular (often annual) basis, in order to prevent systemic
inequities between groups in society, or anyone becoming a
specialist in holding debt and coercing repayment – see debt
relief . An example is the Biblical Jubilee year , described in the
Book of Leviticus .
Under English law , when the creditor is deceived into
relinquishing the debt, this is a crime : see Theft Act 1978 .
International Third World debt has reached the scale that many
economists are convinced that debt cancellation is the only way to
restore global equity in relations with the developing nations
.
Effects of debt
Debt allows people and organizations to do things that they would
otherwise not be able, or allowed, to do. Commonly, people in
industrialised nations use it to purchase houses, cars and many
other things too expensive to buy with cash on hand. Companies also
use debt in many ways to leverage the investment made in their
assets , "leveraging" the return on their equity . This leverage ,
the proportion of debt to equity, is considered important in
determining the riskiness of an investment; the more debt per
equity, the riskier. For both companies and individuals, this
increased risk can lead to poor results, as the cost of servicing
the debt can grow beyond the ability to pay due to either external
events (income loss) or internal difficulties (poor management of
resources).
Excesses in debt accumulation have been blamed for exacerbating
economic problems. [ 3 ] For example, prior to the beginning of the
Great Depression debt/GDP ratio was very high. Economic agents were
heavily indebted. This excess of debt, equivalent to excessive
expectations on future returns, accompanied asset bubbles on the
stock markets. When expectations corrected, deflation and a credit
crunch followed. Deflation effectively made debt more expensive
and, as Fisher explained, this reinforced deflation again, because,
in order to reduce their debt level, economic agents reduced their
consumption and investment. The reduction in demand reduced
business activity and caused further unemployment. In a more direct
sense, more bankruptcies also occurred due both to increased debt
cost caused by deflation and the reduced demand.
It is possible for some organizations to enter into alternative
types of borrowing and repayment arrangements which will not result
in bankruptcy. For example, companies can sometimes convert debt
that they owe into equity in themselves. In this case, the creditor
hopes to regain something equivalent to the debt and interest in
the form of dividends and capital gains of the borrower. The
"repayments" are therefore proportional to what the borrower earns
and so can not in themselves cause bankruptcy. Once debt is
converted in this way, it is no longer known as debt.
Arguments against debt
Main article: Criticism of debt
Some argue against debt as an instrument and institution, on a
personal, family, social, corporate and governmental level. Islam
forbids lending with interest even today, while the Catholic church
allowed it from 1822 onwards, and the Torah states that all debts
should be erased every 7 years and every 50 years (in the Jubilee
year , as described in the Book of Leviticus ).
Debt will increase through time if it is not repaid faster than it
grows through interest. This effect may be termed usury , while the
term "usury" in other contexts refers only to an excessive rate of
interest, in excess of a reasonable profit for the risk
accepted.
In international legal thought, Odious debt is debt that is
incurred by a regime for purposes that do not serve the interest of
the state. Such debts are thus considered by this doctrine to be
personal debts of the regime that incurred them and not debts of
the state.
In an economy with high interest rates, debt will be more costly to
a business than more flexible dividends on equity investment. It
may be easier for a struggling business to be financed through
equity investment as it may be possible to avoid paying a dividend
if times are hard.
Levels and flows
Main article: Debt levels and flows
Global debt underwriting grew 4.3% year-over-year to $5.19 trillion
during 2004. It is expected to rise in the coming years if the
spending habits of millions of people worldwide continue the way
they do.
Debit and credit are formal bookkeeping and accounting terms. They
are the most fundamental concepts in accounting, representing the
two sides of each individual transaction recorded in any accounting
system. A debit transaction indicates an asset or an expense
transaction, a credit indicates a transaction that will cause a
liability or a gain. A debit transaction can also be used to reduce
a credit balance or increase a debit balance. A credit transaction
can be used to decrease a debit balance or increase a credit
balance.
An account represented in a way opposite to what would be expected,
such as an asset account recorded as a credit , is referred to as a
contra account. An example would be depreciation , which is a
contra asset account, as it reduces the value of an asset.
Contents
1 Introduction
2 Origin of the terms debit and credit
3 Operational Principles
4 Debit and Credit principle
Introduction
Debits and credits are a system of notation used in bookkeeping to
determine how and where to record any financial transaction. In
bookkeeping, instead of using addition '+' and subtraction '-'
symbols, a transaction uses the symbol DR (Debit) or CR (Credit).
In double-entry bookkeeping debit is used for asset and expense
transactions and credit is used for liability, gain and equity
transactions. For bank transactions, money in is treated as a debit
transaction and money out is treated as a credit transaction.
Traditionally, transactions are recorded in two columns of numbers:
debits in the left hand column, credits in the right hand column.
Keeping the debits and credits in separate columns allows each to
be recorded and totalled independently. Where the total of the
debit value amounts is lower than the total of the credit value
amounts a balancing debit value is posted to that nominal ledger
account. That nominal ledger account is now "balanced". An account
can have either a credit value balance or a debit value balance but
not both.
Origin of the terms debit and credit
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2010)
The term debit comes from Middle French debet from Latin debitum
"that which is owed" (the neuter past participle of debere "to
owe"). Debit is abbreviated to Dr (for debtor). The term credit
comes from the Latin creditum meaning "that which is entrusted or
loaned" from the past participle of credere "to trust or entrust".
Credit is abbreviated to Cr (for creditor).
Operational Principles
Debit generally represents any depletion in the resources held by
the entity while credit represents increment of the resources held
by the entity. Hence, debits to an account are negative /
depletions in the accounting entity's resources while credits are
positive / increments in the same.
Real Accounts
In real accounts any increment in assets held by the entity is
reflected by increasing the relevant asset account and depletion by
crediting the asset account.
If any asset account is debited then it is on account of increment
in the value or acquisition of that liability or owner's equity
which decreases the resources held by the entity.
As the total resources held by the entity cannot indigenously
increment themselves the depletion has to be matched with a fall in
resources within the entity.
Personal Accounts
In Personal Accounts debiting the personal account of any external
entity increases the value of the liabilities receivable from that
entity thus augmenting the resources of the accounting entity.
Similarly crediting the personal account of any external entity
reduces the value of monies receivable from that entity thus
reducing the resources of the accounting entity.
Nominal Accounts
In Nominal Accounts the Expense accounts whenever debited are done
as the Expense incurred represents the Goods and/or Services
acquired for ssumption by the entity and hence are temporary
increments in the resources of the consumers.
In Nominal Accounts the Income accounts are credited as the Income
earned represents the Epistolary representation of an entity
Cross-Application over Different Types of Accounts
The principles apply uniformly to all combinations of accounting
entries involving different types of accounts based on varying
circumstances.
Real Account Debited
Personal Account Debited
Nominal Account Debited
Real Account Credited
Acquisition of an Asset in Cash - Machinery Account Debited, Cash
Account Credited
Sale of an Asset on Credit - Buyer's Account Debited, Machinery
Account Credited
Amortisation or Depreciation of an Asset - Depreciation Account
Debited, Machinery Account Credited
Personal Account Credited
Acquisition of an Asset on Credit - Machinery Account Debited,
Seller's Account Credited
Transfer of a Debt Receivable to another - New Debtor's Account
Debited, Old Debtor's Account Credited
Accrual of Expenditure - Electricity Account Debited, Electricity
Company's Account Credited
Nominal Account Credited
Capitalisation of Expenditure - Machinery Account Debited, Research
and Development Account Credited
Sale of Goods on Credit - Buyer's Account Debited, Sales Account
Credited
Inter head transfer of Expenditure - New Expenditure Head Debited,
Old Expenditure Head Credited
Simple Thumb Rules to remember which accounts to credit and which
to debit:
Personal accounts: Debit: the receiver; Credit: the giver
Real/Asset Accounts: Debit: what comes in; Credit: what goes
out
Nominal/Expense Accounts: Debit: all expenses/losses; Credit: all
income/gains
Debit and Credit principle
Each transaction consists of debits and credits, and for every
transaction they must be equal.
For Every Transaction: The Value of Debits = The Value of
Credits
The extended accounting equation must also balance: 'A + E = L + OE
+ R'
(where A = Assets, E = Expenses, L = Liabilities, OE = Owner's
Equity and R = Revenues)
So 'Debit Accounts (A + E) = Credit Accounts (L + R + OE)'
Debits are on the left and increase a debit account and reduce a
credit account.
Credits are on the right and increase a credit account and decrease
a debit account.
Examples
when you pay rent with cash: you increase rent (expense) by
debiting, and decrease cash (asset) by credit.
when you receive cash for a sale: you increase cash (asset) by
debiting, and increase sales (revenue) by credit.
when you buy equipment (asset) with cash: You increase equipment
(asset) by debiting, and decrease cash (asset) by credit.
when you borrow with a cash loan: You increase cash (asset) by
debiting, and increase loan (liability) by credit.
When you Pay salary with cash: you increase salary (expenses) by
debiting, and decrease cash (asset) by credit.
Account
Debit
Credit
1.
Rent
100
Cash
100
2.
Cash
50
Sale
50
3.
Equip.
5200
Cash
5200
4.
Cash
11000
Loan
11000
5.
Salary
5000
Cash
5000
'T' Accounts
The process of using debits and credits creates a ledger format
that resembles the letter 'T'. The term 'T' account is commonly
used when discussing bookkeeping.
A 'T' account showing debits on the left and credits on the
right.
Debits
Credits
TYPE
DEBIT
CREDIT
Asset
+
−
Liability
−
+
Income
−
+
Expense
+
−
Capital
−
+
Therefore, if an Asset account is debited, the Asset amount (value)
is increased. Same with an Expense account. If a Liability or an
Income account is debited, the numerical figure will decrease, etc.
If a particular account is credited, there must be a corresponding
Debit in another account in order to balance the transaction.
As used in banking terminology, 'Debits" refer to withdrawals, not
necessarily in the same context as discussed here.
Debt settlement , also known as debt arbitration or debt
negotiation , is an approach to debt reduction in which the debtor
and creditor agree on a reduced balance that will be regarded as
payment in full. [ 1 ]
As long as consumers continue to make minimum monthly payments,
creditors will not negotiate a reduced balance. However, when
payments stop, balances continue to grow because of late fees and
ongoing interest. [ 1 ]
Consumers can arrange their own settlements by using advice found
on web sites, hire a lawyer to act for them, or use debt settlement
companies. [ 1 ] In a New York Times article Cyndi Geerdes, an
associate professor at the University of Illinois law school,
states "Done correctly, (debt settlement) can absolutely help
people". However, some settlement companies may charge a large fee
up front; or take a monthly fee from customer bank accounts for
their service, possibly reducing the incentive to settle with
creditors quickly. One expert advises consumers to look for
companies that charge only after a settlement is made, and charge
about 20 percent of the amount by which the outstanding balance is
reduced. [ 1 ]
Contents
1 History
2 How Debt Settlement Works
3 Professional Debt Settlement
3.1 The Positive Side
3.2 The Negative Side
4 Do-It-Yourself Debt Settlement
4.1 The Positive Side
4.2 The Negative Side
5 Creditor’s incentives
6 Common Objections to Debt Settlement
7 Criticism
8 Trade associations
9 See also
10 References
11 External links
//
History
As a concept, lenders have been practicing debt settlement for
thousands of years. [ 2 ] However, the business of debt settlement
became prominent in America during the late 1980s and early 1990s
when bank deregulation , which loosened consumer lending practices,
followed by an economic recession placed consumers in financial
hardships.
With charge-offs (debts written-off by banks) increasing, banks
established debt settlement departments staffed with personnel who
were authorized to negotiate with defaulted cardholders to reduce
the outstanding balances in hopes to recover funds that would
otherwise be lost if the cardholder filed for Chapter 7 bankruptcy
. Typical settlements ranged between 25% and 65% of the outstanding
balance. [ 3 ]
Alongside the unprecedented spike in personal debt loads, there has
been another rather significant (even if criminally under reported)
change – the 2005 passage of legislation that dramatically
worsened the chances for average Americans to claim Chapter 7
bankruptcy protection. As things stand, should anyone filing for
bankruptcy fail to meet the Internal Revenue Service regulated
‘means test’, they would instead be shelved into the
Chapter 13 debt restructuring plan. Essentially, Chapter 13
bankruptcies simply tell borrowers that they must pay back some or
all of their debts to all unsecured lenders. Repayments under
Chapter 13 can range from 1% to 100% of the amounts owed to
unsecured creditors, based on the ability of the debtor to pay.
Repayment periods are 3 years (for those who earn below the median
income) or 5 years (for those above), under court mandated budgets
that follow IRS guidelines, and the penalties for failure are more
severe.
How Debt Settlement Works
Essentially, debt settlement is the process of negotiating with
creditors to reduce overall debts in exchange for a lump sum
payment. A successful settlement occurs when the creditor agrees to
forgive a percentage of total account balance. Only unsecured debts
not secured by real assets like homes or autos can be settled.
Unsecured debts include medical bills and credit card debts - not
student loans, auto financing or mortgages. For the debtor, this
makes obvious sense, they avoid the stigma and intrusive
court-mandated controls of bankruptcy while still lowering,
sometimes by more than 50%, their debt balances. Whereas, for the
creditor, they regain trust that the borrower intends to pay back
what he can of the loans and not file bankruptcy (in which case,
the creditor risks losing all monies owed).
Negotiating with a collection agency or junk debt buyer is somewhat
similar to negotiating with a credit card company or other original
creditor. However, many collection agencies (or junk debt buyers)
will agree to take less of the owed amount than the original
creditor, because the junk debt buyer has purchased the debt for a
fraction of the original balance. [ 4 ] . As a part of the
settlement, the consumer can request that collection is removed
from the credit report , which is generally not the case with the
original creditor. Even if the removal of the collection account
from the consumer credit report has been successfully achieved as a
condition of settlement during negotiations, the negative marks
from the original credit card company will still remain, according
to Maxine Sweet, a spokeswoman for credit reporting agency
Experian. [ 5 ]
Professional Debt Settlement
In order to work with a debt settlement company, a consumer needs
lump sum cash (best scenario), or needs to build up enough funds
over pre-determined period of time. For consumers who have no cash
to make a lump sum settlement offer, debt settlement companies set
up a third party "trust" account where funds accumulate for the
settlement process. A legitimate company will use an FDIC insured
trust account. Once enough funds are built up the negotiation
process can begin with each creditor individually. Accounts can be
held by creditors or may be sold to collections agency for an
average of $0.15 on the dollar, in which case debt can still be
negotiated. [ citation needed ]
The Positive Side
Settlement companies generally package their settlements into a
larger bulk settlement with the creditor for 35% - 50% of the
existing balances. [ citation needed ] The debt settlement
companies typically have built up a relationship during their
normal business practices with the credit card companies and can
come to a settlement agreement quicker and at a more favorable rate
than a debtor acting on their own. With the current economic crisis
, more and more credit card companies may be willing to settle
existing credit card debts rather than add to their already large
written off bad debt.
The Negative Side
Debt settlement companies generally take a percentage of the
savings of the forgiven debt as the fee for their services. The
drop out rate of debt settlement programs is high because these
programs generally last between 12-60 months and consumers who find
themselves in these sorts of debt situations tend to have trouble
sticking to a structured payment program for an extended period of
time. [ 6 ] Credit card accounts typically go into collection after
they are charged off, typically 180 days after the last payment on
the account. [ citation needed ] The debt settlement companies may
not handle calls from the credit card companies, nor the collection
agencies. [ citation needed ] Debtors can be sued by creditors
seeking to recover debts and interest. This can be avoided by using
companies with good standings and practices that protect consumers
from these procedures. [ citation needed ]
Do-It-Yourself Debt Settlement
It's possible for a consumer to imitate the methods of professional
debt settlement companies and many people report success in
negotiating a debt settlement for themselves [ 5 ] . Initiation of
negotiations can begin by calling the customer service department
of the credit card company. In general, the credit card company
will only deal with a consumer when the consumer is behind on
payments but capable of making a lump sum payment. A payment plan
is not an option; the credit card company will demand that the
consumer make a lump sum payment of the settlement amount.
The Positive Side
By negotiating debts on their own, debtors are able to save in fees
that would otherwise be paid to a debt settlement company or an
attorney. This option also gives the debtor more control over the
process which may, or may not, be a motivational factor to continue
successfully completing the process.
The Negative Side
While the do-it-yourself option offers the debtor more control and
reduced fees, there are negatives generally associated with this
option. Creditors have their own policies regarding debt settlement
and certain creditors will not settle directly with consumers.
Additionally, consumers may face less advantageous settlement rates
on their own, as opposed to debt settlement companies that have
relationships with creditors and can often package bulk
settlements. Consumers may face difficulty getting through to
decision makers or long delays in any negotiations or paperwork
processing with the creditors. Furthermore, every creditor has
different processes and procedures in how they determine settlement
offers and terms. Not knowing those can leave a consumer in the
dark. Settlement Companies have a Customer service department to
assist consumers with any questions or difficulties that arise
during their program. This support can be particularly valuable,
especially in cases where creditors become aggressive. If an
account were to escalate to legal status, a consumer settling on
their own would need to seek out a third party for help.
Unfamiliarity of the settlement process can be intimidating and
mistakes can be made. You will need to beware of fine print and
carefully review any correspondence, proposed settlement or
agreement with a creditor. Settlement Agreements should be reviewed
very carefully, perhaps by a third party, to make sure that all the
terms are those that are agreed upon. Settling one’s debt can
be an emotionally draining and difficult process.
Creditor’s incentives
The creditor’s primary incentive is to recover funds that
would otherwise be lost if the debtor filed for bankruptcy. The
other key incentive is that the creditor can often recover more
funds than through other collection methods. Collection agencies
and collection attorneys charge commissions as high as 40% on
recovered funds. Bad debt purchasers buy portfolios of delinquent
debts from creditors who give up on internal collection efforts and
these bad debt purchasers pay between 1 and 12 cents on the dollar,
depending on the age of the debt, with the oldest debts the
cheapest. [ 4 ] Collection calls and lawsuits sometimes push
debtors into bankruptcy, in which case the creditor often recovers
no funds.
Common Objections to Debt Settlement
Damages Credit - Credit reports will show evidence of debt
settlements and the associated FICO scores will be lowered
temporarily as a result. However, if a "paid in full" letter is
obtained from the creditor, the debtor's credit report should show
no sign of a debt settlement. Additionally, as debtors settle their
accounts the score starts to go back up again. Some Debt Settlement
companies offer Credit Repair in their programs in order to erase
some of the negative remarks on credit reports.
Potential for Lawsuits - Though few creditors wish to push
borrowers toward bankruptcy, (and the potential of governmental
protection against all debts),there’s always the possibility
of a lawsuit whenever debts lay unpaid. In the debt settlement
process the debtor's accounts remain in default. While the debts
are still in default the creditor or its assignee can still file a
lawsuit against a debtor. Most creditors and debt collectors want a
lump sum payment to settle for less than the full debt. Although a
debtor may make monthly payments to the debt settlement company,
the amount is too small to successfully negotiate a settlement
until after the debtor has made several months' worth of
payments.
Eligibility of Debts - In addition, the specific debts of the
borrowers themselves affect the success of negotiations. Tax liens
and domestic judgments, for reasons that should be clear, remain
unaffected by attempts at settlement. Student loans, even those not
federally subsidized, have been granted special powers by recent
legislation to attach bank accounts without possibility of Chapter
7 bankruptcy protection. Also, some individual creditors, including
Discover Card, for example, tend to have an aggressive resistance
against negotiations.
Tax Consequences - Another common objection to debt settlement is
that debtors whose debts are partially canceled outside the
bankruptcy system will need to report the canceled portion of the
debt as taxable income . (IRS Publication Form 982) The IRS
considers $600 or more of forgiven debt as taxable income. [
citation needed ] The forgiving creditor must provide the taxpayer
with a 1099-C tax form. This form will list the amount of forgiven
debt and interest in Box 2. Taxpayers with portions of personal
loans forgiven may not subtract the interest reported in Box 3 from
the amount of reportable income on this form.
However, the IRS does not require taxpayers to report forgiven debt
if the tax payer was insolvent at the time the creditor forgave the
debt. Being insolvent means that the amount of a debtor’s
debts are greater than his/her assets (how much money and property
the debtor owns). However, the IRS adds that “you cannot
exclude any amount of canceled debt that is more than the amount by
which you are insolvent.” [ 7 ]
For example, if a taxpayer is $10,000 in debt and owns $3,000 in
assets, he/she cannot exclude more than $7,000 of forgiven debt
from his/her income tax . Any forgiven debt over $7,000 that year
must be reported as taxable income.
Criticism
In May 2009, the New York Attorney General issued subpoenas to
fourteen "debt settlement" companies, looking for violations of New
York law [ 8 ] . On May 19, 2009, the New York Attorney General
filed suit against two "debt settlement" firms and their
affiliates, alleging violations related to fraudulent business
practices and false advertising. [ 9 ]
A March 2010 CBS " Early Show " story on the debt settlement
industry cast a harsh light on major debt settlement firm Credit
Solutions of America 's business practices, and provided consumer
advice for debt settlement counseling. [ 10 ]
The Better Business Bureau has adopted an automatic downgrading
policy for all debt settlement companies. In a written statement,
the Council of Better Business Bureaus stated, "Debt
negotiation/settlement businesses are downgraded in the BBB rating
system based on BBB concerns with the debt negotiation/settlement
industry. The FTC held a workshop on debt negotiation/settlement
last fall, and similar concerns were expressed as to how the
industry operates and the likelihood that debt
negotiation/settlement benefits a significant number of consumers."
The Association of Settlement Companies (TASC), the professional
association for the debt settlement industry, warned in a written
statment that "under the BBB’s new rating system, it is
virtually impossible for a debt settlement company to be rated
anything other than a ‘D’ or ‘F’,". In a
February letter TASC sent to the National Council of Better
Business Bureaus, the organization alleged that “there are
critical flaws in the BBB’s consumer grading system as it
applies to settlement firms.” The letter expressed concern
that all settlement companies will be given poor ratings,
regardless of the number of consumer complaints, how those
complaints have been resolved, or the business practices of the
settlement firm under review. TASC says the dispute stems from the
fact that the BBB does not consider debt settlement a viable option
for consumers who cannot afford to pay back their debts and want
professional help to negotiate lower payments. [ citation needed
]
Trade associations
Due to the rise of debt settlement as a debt relief alternative to
bankruptcy , groups working in the industry established trade
associations to help secure industry standards that will protect
consumers against unethical business practices. [ 11 ] These trade
associations were also established to lobby state governments
because many state legislatures are passing laws that restrict
out-of-state companies from providing debt negotiation services to
in-state residents. The two major trade associations are the United
States Organization for Bankruptcy Alternatives (USOBA) and The
Association of Settlement Companies (TASC). Both of these
organizations publish on their websites information about debt
settlement and the debt settlement industry. Individual debt
settlement consultants receive certification training
(accreditation) from the International Association of Professional
Debt Arbitrators (IAPDA).
See also
Debt
Bankruptcy
Credit Counseling
List of finance topics
A credit card is a small plastic card issued to users of a system
of payment . It allows its holder to buy goods and services based
on the holder's promise to pay for these goods and services. [ 1 ]
The issuer of the card grants a line of credit to the consumer (or
the user) from which the user can borrow money for payment to a
merchant or as a cash advance to the user. Usage of the term
"credit card" to imply a credit card account is a metonym .
A credit card is different from a charge card : a charge card
requires the balance to be paid in full each month. In contrast,
credit cards allow the consumers a continuing balance of debt,
subject to interest being charged. Most credit cards are issued by
banks or credit unions , and are the shape and size specified by
the ISO/IEC 7810 standard as ID-1. This is defined as
85.60 × 53.98 mm
(3.370 × 2.125 in) (3 3 / 8 × 2 1 / 8
in) in size.
Contents
1 How credit cards work
1.1 Advertising, solicitation, application and approval
1.2 Interest charges
1.3 Benefits to customers
1.4 Detriments to customers
1.4.1 High interest and bankruptcy
1.4.2 Inflated pricing for all consumers
1.5 Grace period
1.6 Benefits to merchants
1.7 Costs to merchants
1.8 Parties involved
1.9 Transaction steps
1.10 Secured credit cards
1.11 Prepaid "credit" cards
11 Credit card numbering
12 Credit cards in ATMs
13 Credit cards as funding for entrepreneurs
14 Standardization
15 See also
16 References
17 External links
//
How credit cards work
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Credit card
An example of the front in a typical credit card:
Issuing bank logo
EMV chip on "smart cards"
Hologram
Credit card number
Card brand logo
Expiration Date
Card Holder Name
contactless chip
An example of the reverse side of a typical credit card:
Magnetic Stripe
Signature Strip
Card Security Code
Credit cards are issued after an account has been approved by the
credit provider, after which cardholders can use it to make
purchases at merchants accepting that card.
When a purchase is made, the credit card user agrees to pay the
card issuer. The cardholder indicates consent to pay by signing a
receipt with a record of the card details and indicating the amount
to be paid or by entering a personal identification number (PIN).
Also, many merchants now accept verbal authorizations via telephone
and electronic authorization using the Internet, known as a
'Card/Cardholder Not Present' (CNP) transaction.
Electronic verification systems allow merchants to verify in a few
seconds that the card is valid and the credit card customer has
sufficient credit to cover the purchase, allowing the verification
to happen at time of purchase. The verification is performed using
a credit card payment terminal or Point of Sale (POS) system with a
communications link to the merchant's acquiring bank . Data from
the card is obtained from a magnetic stripe or chip on the card;
the latter system is called Chip and PIN in the United Kingdom and
Ireland , and is implemented as an EMV card.
For transactions at which the buyer is not present and the card not
shown (e.g., eCommerce , mail order , and telephone sales),
merchants additionally verify that the customer is in physical
possession of the card and is the authorised user by asking for
additional information such as the security code printed on the
back of the card, date of expiry, and billing address.
Each month, the credit card user is sent a statement indicating the
purchases undertaken with the card, any outstanding fees, and the
total amount owed. After receiving the statement, the cardholder
may dispute any charges that he or she thinks are incorrect (see
Fair Credit Billing Act for details of the US regulations).
Otherwise, the cardholder must pay a defined minimum proportion of
the bill by a due date , or may choose to pay a higher amount up to
the entire amount owed. The credit issuer charges interest on the
amount owed if the balance is not paid in full (typically at a much
higher rate than most other forms of debt). Some financial
institutions can arrange for automatic payments to be deducted from
the user's bank accounts, thus avoiding late payment altogether as
long as the cardholder has sufficient funds.
Advertising, solicitation, application and approval
Credit card advertising regulations include the Schumer box
disclosure requirements. A large fraction of junk mail consists of
credit card offers created from lists provided by the major credit
reporting agencies . In the United States, the three major US
credit bureaus (Equifax, TransUnion and Experian) allow consumers
to opt out from related credit card solicitation offers via its Opt
Out Pre Screen program.
Interest charges
Credit card issuers usually waive interest charges if the balance
is paid in full each month, but typically will charge full interest
on the entire outstanding balance from the date of each purchase if
the total balance is not paid.
For example, if a user had a $1,000 transaction and repaid it in
full within this grace period, there would be no interest charged.
If, however, even $1.00 of the total amount remained unpaid,
interest would be charged on the $1,000 from the date of purchase
until the payment is received. The precise manner in which interest
is charged is usually detailed in a cardholder agreement which may
be summarized on the back of the monthly statement. The general
calculation formula most financial institutions use to determine
the amount of interest to be charged is APR/100 x ADB/365 x number
of days revolved. Take the Annual percentage rate (APR) and divide
by 100 then multiply to the amount of the average daily balance
(ADB) divided by 365 and then take this total and multiply by the
total number of days the amount revolved before payment was made on
the account. Financial institutions refer to interest charged back
to the original time of the transaction and up to the time a
payment was made, if not in full, as RRFC or residual retail
finance charge. Thus after an amount has revolved and a payment has
been made, the user of the card will still receive interest charges
on their statement after paying the next statement in full (in fact
the statement may only have a charge for interest that collected up
until the date the full balance was paid...i.e. when the balance
stopped revolving).
The credit card may simply serve as a form of revolving credit , or
it may become a complicated financial instrument with multiple
balance segments each at a different interest rate, possibly with a
single umbrella credit limit, or with separate credit limits
applicable to the various balance segments. Usually this
compartmentalization is the result of special incentive offers from
the issuing bank, to encourage balance transfers from cards of
other issuers. In the event that several interest rates apply to
various balance segments, payment allocation is generally at the
discretion of the issuing bank, and payments will therefore usually
be allocated towards the lowest rate balances until paid in full
before any money is paid towards higher rate balances. Interest
rates can vary considerably from card to card, and the interest
rate on a particular card may jump dramatically if the card user is
late with a payment on that card or any other credit instrument ,
or even if the issuing bank decides to raise its revenue.
Benefits to customers
The main benefit to each customer is convenience. Compared to debit
cards and checks, a credit card allows small short-term loans to be
quickly made to a customer who need not calculate a balance
remaining before every transaction, provided the total charges do
not exceed the maximum credit line for the card. Credit cards also
provide more fraud protection than debit cards. In the UK for
example, the bank is jointly liable with the merchant for purchases
of defective products over £100. [ 2 ]
Many credit cards offer rewards and benefits packages, such as
offering enhanced product warranties at no cost, free loss/damage
coverage on new purchases, and points which may be redeemed for
cash, products, or airline tickets. Additionally, carrying a credit
card may be a convenience to some customers as it eliminates the
need to carry any cash for most purposes.
Detriments to customers
High interest and bankruptcy
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Please help improve this article by adding citations to reliable
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2010)
Low introductory credit card rates are limited to a fixed term,
usually between 6 and 12 months, after which a higher rate is
charged. As all credit cards charge fees and interest, some
customers become so indebted to their credit card provider that
they are driven to bankruptcy . Some credit cards often levy a rate
of 20 to 30 percent after a payment is missed; in other cases a
fixed charge is levied without change to the interest rate. In some
cases universal default may apply: the high default rate is applied
to a card in good standing by missing a payment on an unrelated
account from the same provider. This can lead to a snowball effect
in which the consumer is drowned by unexpectedly high interest
rates. Further most card holder agreements enable the issuer to
arbitrarily raise the interest rate for any reason they see
fit.
Inflated pricing for all consumers
Merchants that accept credit cards must pay interchange fees and
discount fees on all credit-card transactions. [ 3 ] [ 4 ] In some
cases merchants are barred by their credit agreements from passing
these fees directly to credit card customers, or from setting a
minimum transaction amount. [ 5 ] The result, at least in the
United States, is that merchants may charge all customers
(including those who do not use credit cards) higher prices to
cover the fees on credit card transactions. [ 4 ] In the United
States in 2008 credit card companies collected a total of $48
billion in interchange fees, or an average of $427 per family, with
an average fee rate of about 2% per transaction. [ 4 ]
Grace period
A credit card's grace period is the time the customer has to pay
the balance before interest is assessed on the outstanding balance.
Grace periods vary, but usually range from 20 to 50 days depending
on the type of credit card and the issuing bank. Some policies
allow for reinstatement after certain conditions are met.
Usually, if a customer is late paying the balance, finance charges
will be calculated and the grace period does not apply. Finance
charges incurred depend on the grace period and balance; with most
credit cards there is no grace period if there is any outstanding
balance from the previous billing cycle or statement (i.e. interest
is applied on both the previous balance and new transactions).
However, there are some credit cards that will only apply finance
charge on the previous or old balance, excluding new
transactions.
Benefits to merchants
An example of street markets accepting credit cards. Most simply
display the logos (shown in the upper-left corner of the sign) of
all the cards they accept.
For merchants , a credit card transaction is often more secure than
other forms of payment, such as checks, because the issuing bank
commits to pay the merchant the moment the transaction is
authorized, regardless of whether the consumer defaults on the
credit card payment (except for legitimate disputes, which are
discussed below, and can result in charges back to the merchant).
In most cases, cards are even more secure than cash, because they
discourage theft by the merchant's employees and reduce the amount
of cash on the premises.
Prior to credit cards, each merchant had to evaluate each
customer's credit history before extending credit. That task is now
performed by the banks which assume the credit risk . Credit cards
can also aid in securing a sale, especially if the customer does
not have enough cash on his or her person or checking account.
For each purchase, the bank charges the merchant a commission
(discount fee) for this service and there may be a certain delay
before the agreed payment is received by the merchant. The
commission is often a percentage of the transaction amount, plus a
fixed fee (interchange rate). In addition, a merchant may be
penalized or have their ability to receive payment using that
credit card restricted if there are too many cancellations or
reversals of charges as a result of disputes. Some small merchants
require credit purchases to have a minimum amount to compensate for
the transaction costs.
In some countries, for example the Nordic countries , banks
guarantee payment on stolen cards only if an ID card is checked and
the ID card number/civic registration number is written down on the
receipt together with the signature. In these countries merchants
therefore usually ask for ID. Non-Nordic citizens, who are unlikely
to possess a Nordic ID card or driving license, will instead have
to show their passport, and the passport number will be written
down on the receipt, sometimes together with other information.
Some shops use the card's PIN for identification, and in that case
showing an ID card is not necessary.
Costs to merchants
Merchants are charged several fees for the privilege of accepting
credit cards. The merchant is usually charged a commission of
1%-3%+ of the value of each transaction paid for by credit card.
The merchant may also pay a variable charge, called an interchange
rate , for each transaction. [ 3 ] In some instances of very
low-value transactions, use of credit cards will significantly
reduce the profit margin or cause the merchant to lose money on the
transaction. Merchants must accept these transactions as part of
their costs to retain the right to accept credit card transactions.
Merchants with very low average transaction prices or very high
average transaction prices are more averse to accepting credit
cards. In some cases merchants may charge users a "credit card
supplement", either a fixed amount or a percentage, for payment by
credit card. [ 6 ]
In certain countries, merchants are required to pay the acquiring
banks a monthly terminal rental fee [ citation needed ] if the
terminals are provided by the acquiring banks. Merchants can apply
to the acquiring banks for waivers of the fees, which the banks
usually agree to for merchants with a high volume of sales, but not
for smaller ones. [ citation needed ]
Parties involved
Cardholder: The holder of the card used to make a purchase; the
consumer .
Card-issuing bank: The financial institution or other organization
that issued the credit card to the cardholder. This bank bills the
consumer for repayment and bears the risk that the card is used
fraudulently. American Express and Discover were previously the
only card-issuing banks for their respective brands, but as of
2007, this is no longer the case. Cards issued by banks to
cardholders in a different country are known as offshore credit
cards .
Merchant: The individual or business accepting credit card payments
for products or services sold to the cardholder.
Acquiring bank : The financial institution accepting payment for
the products or services on behalf of the merchant.
Independent sales organization : Resellers (to merchants) of the
services of the acquiring bank.
Merchant account : This could refer to the acquiring bank or the
independent sales organization, but in general is the organization
that the merchant deals with.
Credit Card association: An association of card-issuing banks such
as Visa , MasterCard , Discover , American Express , etc. that set
transaction terms for merchants, card-issuing banks, and acquiring
banks.
Transaction network: The system that implements the mechanics of
the electronic transactions. May be operated by an independent
company, and one company may operate multiple networks.
Affinity partner: Some institutions lend their names to an issuer
to attract customers that have a strong relationship with that
institution, and get paid a fee or a percentage of the balance for
each card issued using their name. Examples of typical affinity
partners are sports teams, universities, charities, professional
organizations, and major retailers.
The flow of information and money between these parties —
always through the card associations — is known as the
interchange, and it consists of a few steps.
This section requires expansion .
Transaction steps
Authorization : The cardholder pays for the purchase and the
merchant submits the transaction to the acquirer (acquiring bank).
The acquirer verifies the credit card number, the transaction type
and the amount with the issuer (Card-issuing bank) and reserves
that amount of the cardholder's credit limit for the merchant. An
authorization will generate an approval code, which the merchant
stores with the transaction.
Batching : Authorized transactions are stored in "batches", which
are sent to the acquirer. Batches are typically submitted once per
day at the end of the business day. If a transaction is not
submitted in the batch, the authorization will stay valid for a
period determined by the issuer, after which the held amount will
be returned back to the cardholder's available credit (see
authorization hold ). Some transactions may be submitted in the
batch without prior authorizations; these are either transactions
falling under the merchant's floor limit or ones where the
authorization was unsuccessful but the merchant still attempts to
force the transaction through. (Such may be the case when the
cardholder is not present but owes the merchant additional money,
such as extending a hotel stay or car rental.)
Clearing and Settlement : The acquirer sends the batch transactions
through the credit card association, which debits the issuers for
payment and credits the acquirer. Essentially, the issuer pays the
acquirer for the transaction.
Funding : Once the acquirer has been paid, the acquirer pays the
merchant. The merchant receives the amount totaling the funds in
the batch minus either the "discount rate," "mid-qualified rate",
or "non-qualified rate" which are tiers of fees the merchant pays
the acquirer for processing the transactions.
Chargebacks : A chargeback is an event in which money in a merchant
account is held due to a dispute relating to the transaction.
Chargebacks are typically initiated by the cardholder. In the event
of a chargeback , the issuer returns the transaction to the
acquirer for resolution. The acquirer then forwards the chargeback
to the merchant, who must either accept the chargeback or contest
it. A merchant is responsible for the chargeback only if she has
violated the card acceptance procedures as per the merchant
agreement with card acquirers. [ citation needed ]
Secured credit cards
A secured credit card is a type of credit card secured by a deposit
account owned by the cardholder. Typically, the cardholder must
deposit between 100% and 200% of the total amount of credit
desired. Thus if the cardholder puts down $1000, they will be given
credit in the range of $500–$1000. In some cases, credit card
issuers will offer incentives even on their secured card
portfolios. In these cases, the deposit required may be
significantly less than the required credit limit, and can be as
low as 10% of the desired credit limit. This deposit is held in a
special savings account . Credit card issuers offer this because
they have noticed that delinquencies were notably reduced when the
customer perceives something to lose if the balance is not
repaid.
The cardholder of a secured credit card is still expected to make
regular payments, as with a regular credit card, but should they
default on a payment, the card issuer has the option of recovering
the cost of the purchases paid to the merchants out of the deposit.
The advantage of the secured card for an individual with negative
or no credit history is that most companies report regularly to the
major credit bureaus. This allows for building of positive credit
history.
Although the deposit is in the hands of the credit card issuer as
security in the event of default by the consumer, the deposit will
not be debited simply for missing one or two payments. Usually the
deposit is only used as an offset when the account is closed,
either at the request of the customer or due to severe delinquency
(150 to 180 days). This means that an account which is less than
150 days delinquent will continue to accrue interest and fees, and
could result in a balance which is much higher than the actual
credit limit on the card. In these cases the total debt may far
exceed the original deposit and the cardholder not only forfeits
their deposit but is left with an additional debt.
Most of these conditions are usually described in a cardholder
agreement which the cardholder signs when their account is
opened.
Secured credit cards are an option to allow a person with a poor
credit history or no credit history to have a credit card which
might not otherwise be available. They are often offered as a means
of rebuilding one's credit. Fees and service charges for secured
credit cards often exceed those charged for ordinary non-secured
credit cards, however, for people in certain situations, (for
example, after charging off on other credit cards, or people with a
long history of delinquency on various forms of debt), secured
cards can often be less expensive in total cost than unsecured
credit cards, even including the security deposit.
Sometimes a credit card will be secured by the equity in the
borrower's home .
Prepaid "credit" cards
See also: Stored-value card
A prepaid credit card is not a true credit card, [ 7 ] since no
credit is offered by the card issuer: the card-holder spends money
which has been "stored" via a prior deposit by the card-holder or
someone else, such as a parent or employer. However, it carries a
credit-card brand (Visa, MasterCard, American Express or Discover)
and can be used in similar ways just as though it were a regular
credit card. [ 7 ] Unlike debit cards, prepaid credit cards do not
require a PIN.
After purchasing the card, the cardholder loads the account with
any amount of money, up to the predetermined card limit and then
uses the card to make purchases the same way as a typical credit
card. Prepaid cards can be issued to minors (above 13) since there
is no credit line involved. The main advantage over secured credit
cards (see above section) is that you are not required to come up
with $500 or more to open an account. [ 8 ] With prepaid credit
cards you are not charged any interest but you are often charged a
purchasing fee plus monthly fees after an arbitrary time period.
Many other fees also usually apply to a prepaid card. [ 7 ]
Prepaid credit cards are sometimes marketed to teenagers [ 7 ] for
shopping online without having their parents complete the
transaction. [ 9 ]
Because of the many fees that apply to obtaining and using
credit-card-branded prepaid cards, the Financial Consumer Agency of
Canada describes them as "an expensive way to spend your own
money". [ 10 ] The agency publishes a booklet, "Pre-paid cards", [
11 ] which explains the advantages and disadvantages of this type
of prepaid card.
Features
As well as convenient, accessible credit, credit cards offer
consumers an easy way to track expenses , which is necessary for
both monitoring personal expenditures and the tracking of
work-related expenses for taxation and reimbursement purposes.
Credit cards are accepted worldwide, and are available with a large
variety of credit limits, repayment arrangement, and other perks
(such as rewards schemes in which points earned by purchasing goods
with the card can be redeemed for further goods and services or
credit card cashback ).
Some countries, such as the United States , the United Kingdom ,
and France , limit the amount for which a consumer can be held
liable due to fraudulent transactions as a result of a consumer's
credit card being lost or stolen.
Security problems and solutions
Main article: Credit card fraud
See also: Wireless identity theft
Credit card security relies on the physical security of the plastic
card as well as the privacy of the credit card number. Therefore,
whenever a person other than the card owner has access to the card
or its number, security is potentially compromised. Once, merchants
would often accept credit card numbers without additional
verification for mail order purchases. It's now common practice to
only ship to confirmed addresses as a security measure to minimise
fraudulent purchases. Some merchants will accept a credit card
number for in-store purchases, whereupon access to the number
allows easy fraud, but many require the card itself to be present,
and require a signature. A lost or stolen card can be cancelled,
and if this is done quickly, will greatly limit the fraud that can
take place in this way. For internet purchases, there is sometimes
the same level of security as for mail order (number only) hence
requiring only that the fraudster take care about collecting the
goods, but often there are additional measures. [ citation needed ]
European banks can require a cardholder's security PIN be entered
for in-person purchases with the card.
The PCI DSS is the security standard issued by The PCI SSC (Payment
Card Industry Security Standards Council). This data security
standard is used by acquiring banks to impose cardholder data
security measures upon their merchants.
A smart card , combining credit card and debit card properties. The
3 by 5 mm security chip embedded in the card is shown enlarged in
the inset. The contact pads on the card enable electronic access to
the chip.
The low security of the credit card system presents countless
opportunities for fraud . [ according to whom? ] This opportunity
has created a huge [ specify ] black market in stolen credit card
numbers , which are generally used quickly before the cards are
reported stolen. [ citation needed ]
The goal of the credit card companies is not to eliminate fraud,
but to "reduce it to manageable levels". [ 12 ] This implies that
high-cost low-return fraud prevention measures will not be used if
their cost exceeds the potential gains from fraud reduction - as
would be expected from organisations whose goal is profit
maximisation.
Internet fraud may be by claiming a chargeback which is not
justified (" friendly fraud "), or carried out by the use of credit
card information which can be stolen in many ways, the simplest
being copying information from retailers, either online or offline
. Despite efforts to improve security for remote purchases using
credit cards, security breaches are usually the result of poor
practice by merchants. For example, a website that safely uses SSL
to encrypt card data from a client may then email the data,
unencrypted, from the webserver to the merchant; or the merchant
may store unencrypted details in a way that allows them to be
accessed over the Internet or by a rogue employee; unencrypted card
details are always a security risk. Even encryption data may be
cracked.
Controlled Payment Numbers which are used by various banks such as
Citibank (Virtual Account Numbers), Discover (Secure Online Account
Numbers, Bank of America (Shop Safe), 5 banks using eCarte Bleue
and CMB's Virtualis in France, and Swedbank of Sweden's eKort
product are another option for protecting against credit card
fraud. These are generally one-time use numbers that front one's
actual account (debit/credit) number, and are generated as one
shops on-line. They can be valid for a relatively short time, for
the actual amount of the purchase, or for a price limit set by the
user. Their use can be limited to one merchant. If the number given
to the merchant is compromised, it will be rejected if an attempt
is made to use it again.
A similar system of controls can be used on physical cards. For
example if a consumer has a Chip and PIN ( EMV ) enabled card the
card can be limited so that it be used only at point of sale
locations (i.e. restricted from being used on-line) [ citation
needed ] and only in a given territory (i.e. only for use in
Canada). This technology provides the option for banks to support
many other controls too that can be turned on and off and varied by
the credit card owner in real time as circumstances change (i.e.,
they can change temporal, numerical, geographical and many other
parameters on their primary and subsidiary cards). Apart from the
obvious benefits of such controls: from a security perspective this
means that a customer can have a Chip and PIN card secured for the
real world, and limited for use in the home country. In this
eventuality a thief stealing the details will be prevented from
using these overseas in non chip and pin (EMV) countries. Similarly
the real card can be restricted from use on-line so that stolen
details will be declined if this tried. Then when card users shop
online they can use virtual account numbers. In both circumstances
an alert system can be built in notifying a user that a fraudulent
attempt has been made which breaches their parameters, and can
provide data on this in real time. This is the optimal method of
security for credit cards, as it provides very high levels of
security, control and awareness in the real and virtual world.
Furthermore it requires no changes for merchants at all and is
attractive to users, merchants and banks, as it not only detects
fraud but prevents it. [ citation needed ]
Additionally, there are security features present on the physical
card itself in order to prevent counterfeiting . For example, most
modern credit cards have a watermark that will fluoresce under
ultraviolet light . A Visa card has a letter V superimposed over
the regular Visa logo and a Mastercard has the letters MC across
the front of the card. Older Visa cards have a bald eagle or dove
across the front. In the aforementioned cases, the security
features are only visible under ultraviolet light and are invisible
in normal light. Similar security features are present in paper
currency and certain ID cards in the United States, as well. [
citation needed ]
The Federal Bureau of Investigation and U.S. Postal Inspection
Service are responsible for prosecuting criminals who engage in
credit card fraud in the United States, but they do not have the
resources to pursue all criminals. In general, federal officials
only prosecute cases exceeding US$5,000. Three improvements to card
security have been introduced to the more common credit card
networks but none has proven to help reduce credit card fraud so
far. First, the on-line verification system used by merchants is
being enhanced to require a 4 digit Personal Identification Number
(PIN) known only to the card holder. Second, the cards themselves
are being replaced with similar-looking tamper-resistant smart
cards which are intended to make forgery more difficult. The
majority of smart card (IC card) based credit cards comply with the
EMV (Europay MasterCard Visa) standard. Third, an additional 3 or 4
digit Card Security Code (CSC) is now present on the back of most
cards, for use in "card not present" transactions. Stakeholders at
all levels in electronic payment have recognized the need to
develop consistent global standards for security that account for
and integrate both current and emerging security technologies. They
have begun to address these needs through organizations such as PCI
DSS and the Secure POS Vendor Alliance . [ 13 ]
Code 10
Code 10 calls are made when merchants are suspicious about
accepting a credit card. The phrase "Code 10 authorization" is used
to avoid alerting the customer to the fact that the merchant is
suspicious of their card [ citation needed ] .
The operator then asks the merchant a series of YES or NO questions
to find out whether the merchant is suspicious of the card or the
cardholder. The merchant may be asked to retain the card if it is
safe to do so.
Credit history
The way credit card owners pay off their balances has a tremendous
effect on their credit history . Two of the most important factors
reported to a credit bureau are the timeliness of the debt payments
and the amount of debt to credit limit. Lenders want to see
payments made as agreed, usually on a monthly basis, and a credit
balance of around one-third the credit limit. The credit
information stays on the credit report generally for 7 years.
However, there are a few jurisdictions and situations where the
timeframe might differ.
Profits and losses
In recent times, credit card portfolios have been very profitable
for banks, largely due to the booming economy of the late nineties.
However, in the case of credit cards, such high returns go hand in
hand with risk, since the business is essentially one of making
unsecured (uncollateralized) loans, and thus dependent on borrowers
not to default in large numbers.
Costs
Credit card issuers (banks) have several types of costs:
Interest expenses
Banks generally borrow the money they then lend to their customers.
As they receive very low-interest loans from other firms, they may
borrow as much as their customers require, while lending their
capital to other borrowers at higher rates. If the card issuer
charges 15% on money lent to users, and it costs 5% to borrow the
money to lend, and the balance sits with the cardholder for a year,
the issuer earns 10% on the loan. This 10% difference is the "net
interest spread" and the 5% is the "interest expense".
Operating costs
This is the cost of running the credit card portfolio, including
everything from paying the executives who run the company to
printing the plastics, to mailing the statements, to running the
computers that keep track of every cardholder's balance, to taking
the many phone calls which cardholders place to their issuer, to
protecting the customers from fraud rings. Depending on the issuer,
marketing programs are also a significant portion of expenses.
Charge offs
When a consumer becomes severely delinquent on a debt (often at the
point of six months without payment), the creditor may declare the
debt to be a charge-off . It will then be listed as such on the
debtor's credit bureau reports ( Equifax , for instance, lists "R9"
in the "status" column to denote a charge-off.) The item will
include relevant dates, and the amount of the bad debt. [ citation
needed ]
A charge-off is considered to be "written off as uncollectable." To
banks, bad debts and even fraud are simply part of the cost of
doing business.
However, the debt is still legally valid, and the creditor can
attempt to collect the full amount for the time periods permitted
under state law, which is usually 3 to 7 years. This includes
contacts from internal collections staff, or more likely, an
outside collection agency . If the amount is large (generally over
$1500–$2000), there is the possibility of a lawsuit or
arbitration .
In the United States, as the charge off number climbs or becomes
erratic, officials from the Federal Reserve take a close look at
the finances of the bank and may impose various operating
strictures on the bank, and in the most extreme cases, may close
the bank entirely. [ citation needed ]
Rewards
Many credit card customers receive rewards, such as frequent flyer
points, gift certificates, or cash back as an incentive to use the
card. Rewards are generally tied to purchasing an item or service
on the card, which may or may not include balance transfers , cash
advances , or other special uses. Depending on the type of card,
rewards will generally cost the issuer between 0.25% and 2.0% of
the spread. Networks such as Visa or MasterCard have increased
their fees to allow issuers to fund their rewards system. Some
issuers discourage redemption by forcing the cardholder to call
customer service for rewards. On their servicing website, redeeming
awards is usually a feature that is very well hidden by the
issuers. Others encourage redemption for lower cost merchandise;
instead of an airline ticket, which is very expensive to an issuer,
the cardholder may be encouraged to redeem for a gift certificate
instead [ citation needed ] . With a fractured and competitive
environment, rewards points cut dramatically into an issuer's
bottom line, and rewards points and related incentives must be
carefully managed to ensure a profitable portfolio . Unlike unused
gift cards, in whose case the breakage in certain US states goes to
the state's treasury, unredeemed credit card points are retained by
the issuer.
Fraud
In relative numbers the values lost in bank card fraud are minor,
calculated in 2006 at 7 cents per 100 dollars worth of transactions
(7 basis points ) [ 14 ] . In 2004, in the UK, the cost of fraud
was over £500 million. [ 15 ] When a card is stolen, or an
unauthorized duplicate made, most card issuers will refund some or
all of the charges that the customer has received for things they
did not buy. These refunds will, in some cases, be at the expense
of the merchant, especially in mail order cases where the merchant
cannot claim sight of the card. In several countries, merchants
will lose the money if no ID card was asked for, therefore
merchants usually require ID card in these countries. Credit card
companies generally guarantee the merchant will be paid on
legitimate transactions regardless of whether the consumer pays
their credit card bill. Most banking services have their own credit
card services that handle fraud cases and monitor for any possible
attempt at fraud. Employees that are specialized in doing fraud
monitoring and investigation are often placed in Risk Management,
Fraud and Authorization, or Cards and Unsecured Business . Fraud
monitoring emphasizes minimizing fraud losses while making an
attempt to track down those responsible and contain the situation.
Credit card fraud is a major white collar crime that has been
around for many decades, even with the advent of the chip based
card (EMV) that was put into practice in some countries to prevent
cases such as these. Even with the implementation of such measures,
credit card fraud continues to be a problem.
Promotion
Promotional purchase is any purchase on which separate terms and
conditions are set on each individual transaction unlike a standard
purchase where the terms are set on the cardholder’s account
record and their pricing strategy. All promotional purchases that
post to a particular account will be carrying its own balance
called as Promotional Balance.
Revenues
Offsetting costs are the following revenues:
Interchange fee
Main article: Interchange fee
In addition to fees paid by the card holder, merchants must also
pay interchange fees to the card-issuing bank and the card
association. [ 16 ] [ 17 ] For a typical credit card issuer,
interchange fee revenues may represent about a quarter of total
revenues. [ 18 ] .
These fees are typically from 1 to 6 percent of each sale, but will
vary not only from merchant to merchant (large merchants can
negotiate lower rates [ 18 ] ), but also from card to card, with
business cards and rewards cards generally costing the merchants
more to process. The interchange fee that applies to a particular
transaction is also affected by many other variables including: the
type of merchant, the merchant's total card sales volume, the
merchant's average transaction amount, whether the cards were
physically present, how the information required for the
transaction was received, the specific type of card, when the
transaction was settled, and the authorized and settled transaction
amounts. In some cases, merchants add a surcharge to the credit
cards to cover the interchange fee, encouraging their customers to
instead use cash , debit cards , or even cheques .
[ edit ] Interest on outstanding balances
Interest charges vary widely from card issuer to card issuer.
Often, there are "teaser" rates in effect for initial periods of
time (as low as zero percent for, say, six months), whereas regular
rates can be as high as 40 percent. In the U.S. there is no federal
limit on the interest or late fees credit card issuers can charge;
the interest rates are set by the states, with some states such as
South Dakota, having no ceiling on interest rates and fees,
inviting some banks to establish their credit card operations
there. Other states, for example Delaware, have very weak usury
laws . The teaser rate no longer applies if the customer doesn't
pay his bills on time, and is replaced by a penalty interest rate
(for example, 24.99%) that applies retroactively.
Fees charged to customers
The major fees are for:
Late payments or overdue payments
Charges that result in exceeding the credit limit on the card
(whether done deliberately or by mistake), called overlimit
fees
Returned cheque fees or payment processing fees (e.g. phone payment
fee)
Cash advances and convenience cheques (often 3% of the amount)
Transactions in a foreign currency (as much as 3% of the amount). A
few financial institutions do not charge a fee for this.
Membership fees (annual or monthly), sometimes a percentage of the
credit limit.
Exchange rate loading fees (sometimes these might not be reported
on the customer's statement, even when applied). [ 19 ] The
variation of exchange rates applied by different credit cards can
be very substantial, as much as 10% according to a Lonely Planet
report in 2009 [ 20 ] .
Over limit charges
Consumers who keep their account in good order by always staying
within their credit limit, and always making at least the minimum
monthly payment will see interest as the biggest expense from their
card provider. Those who are not so careful and regularly surpass
their credit limit or are late in making payments are exposed to
multiple charges that were typically as high as £25 -
£35 [ 21 ] until a ruling from the Office of Fair Trading [
22 ] that they would presume charges over £12 to be unfair
which led the majority of card providers to reduce their fees to
exactly that level.
US
The Credit CARD Protection Act of 2009, signed into law by
President Obama, will require that consumers "opt-in" to over-limit
charges. Consumers who choose not to opt-in will be unable to make
purchases over the limit; the card will simply be declined and no
fees will be imposed. This legislation took effect on February 22,
2010.
UK
The higher level of fees originally charged were claimed to be
designed to recoup the costs of the card operator's overall
business and to ensure that the credit card business as a whole
generated a profit, rather than simply recovering the cost to the
provider of the limit breach which has been estimated as typically
between £3-£4. Profiting from a customer's mistakes is
arguably not permitted under UK common law, if the charges
constitute penalties for breach of contract, or under the Unfair
Terms In Consumer Regulations 1999.
Subsequent rulings in respect of personal current accounts suggest
that the argument that these charges are penalties for breach of
contract is weak, and given the OFT's ruling it seems unlikely that
any further test case will take place.
Whilst the law remains in the balance, many consumers have made
claims against their credit cards providers for the charges that
they have incurred, plus interest that they would have earned had
the money not been deducted from their account. It is likely that
claims for amounts charged in excess of £12 will succeed, but
claims for charges at the OFT's £12 threshold level are more
contentious.
Neutral consumer resources
Canada
The Government of Canada maintains a database of the fees,
features, interest rates and reward programs of nearly 200 credit
cards available in Canada. This database is updated on a quarterly
basis with information supplied by the credit card issuing
companies. Information in the database is published every quarter
on the website of the Financial Consumer Agency of Canada
(FCAC).
Information in the database is published in two formats. It is
available in PDF comparison tables that break down the information
according to type of credit card, allowing the reader to compare
the features of, for example, all the student credit cards in the
database.
The database also feeds into an interactive tool on the FCAC
website. [ 23 ] The interactive tool uses several interview-type
questions to build a profile of the user's credit card usage habits
and needs, eliminating unsuitable choices based on the profile, so
that the user is presented with a small number of credit cards and
the ability to carry out detailed comparisons of features, reward
programs, interest rates, etc.
History
The concept of using a card for purchases was described in 1887 by
Edward Bellamy in his utopian novel Looking Backward . Bellamy used
the term credit card eleven times in this novel. [ 24 ]
The modern credit card was the successor of a variety of merchant
credit schemes. It was first used in the 1920s, in the United
States, specifically to sell fuel to a growing number of automobile
owners. In 1938 several companies started to accept each other's
cards. Western Union had begun issuing charge cards to its frequent
customers in 1921. Some charge cards were printed on paper card
stock, but were easily counterfeited.
The Charga-Plate was an early predecessor to the credit card and
used in the U.S. from the 1930s to the late 1950s. It was a 2 1/2"
x 1 1/4" rectangle of sheet metal, similar to a military dog tag ,
and embossed with the customer's name, city and state. It held a
small paper card for a signature. In recording a purchase, the
plate was laid into a recess in the imprinter, with a paper "charge
slip" positioned on top of it. The record of the transaction
included an impression of the embossed information, made by the
imprinter pressing an inked ribbon against the charge slip. [ 25 ]
Charga-Plate was a trademark of Farrington Manufacturing Co.
Charga-Plates were issued by large-scale merchants to their regular
customers, much like department store credit cards of today. In
some cases, the plates were kept in the issuing store rather than
held by customers. When an authorized user made a purchase, a clerk
retrieved the plate from the store's files and then processed the
purchase. Charga-Plates speeded back-office bookkeeping that was
done manually in paper ledgers in each store, before computers.
The concept of customers paying different merchants using the same
card was implemented in 1950 by Ralph Schneider and Frank X.
McNamara , founders of Diners Club , to consolidate multiple cards.
The Diners Club, which was created partially through a merger with
Dine and Sign, produced the first "general purpose" charge card ,
and required the entire bill to be paid with each statement. That
was followed by Carte Blanche and in 1958 by American Express which
created a worldwide credit card network (although these were
initially charge cards that acquired credit card features after
BankAmericard demonstrated the feasibility of the concept).
However, until 1958, no one had been able to create a working
revolving credit financial instrument issued by a third-party bank
that was generally accepted by a large number of merchants (as
opposed to merchant-issued revolving cards accepted by only a few
merchants). A dozen experiments by small American banks had been
attempted (and had failed). In an odd coincidence, both of the
products that finally succeeded were born in the U.S. state of
California . In September 1958, Bank of America launched the
BankAmericard in Fresno, California . BankAmericard became the
first successful recognizably modern credit card (although it
underwent a troubled gestation during which its creator resigned),
and with its overseas affiliates, eventually evolved into the Visa
system. In 1966, the ancestor of MasterCard was born when a group
of California banks established Master Charge to compete with
BankAmericard; it received a significant boost when Citibank merged
its proprietary Everything Card (launched in 1967) into Master
Charge in 1969.
Early credit cards in the U.S., of which BankAmericard was the most
prominent example, were mass produced and mass mailed to bank
customers who were thought to be good credit risks; that is, they
were unsolicited. These mass mailings were known as "drops" in
banking terminology, and were outlawed in 1970 due to the financial
chaos that they caused, but not before 100 million credit cards had
been dropped into the U.S. population. After 1970, only credit card
applications could be sent unsolicited in mass mailings.
The fractured nature of the U.S. banking system under the
Glass-Steagall Act meant that credit cards became an effective way
for those who were traveling around the country to move their
credit to places where they could not directly use their banking
facilities. In 1966 Barclaycard in the UK launched the first credit
card outside of the U.S.
There are now countless variations on the basic concept of
revolving credit for individuals (as issued by banks and honored by
a network of financial institutions), including
organization-branded credit cards, corporate-user credit cards,
store cards and so on.
In contrast, although having reached very high adoption levels in
the US, Canada and the UK, it is important to note that many
cultures were much more cash-oriented in the latter half of the
twentieth century, or had developed alternative forms of cash-less
payments, such as Carte bleue or the Eurocard (Germany, France,
Switzerland, and others). In these places, the take-up of credit
cards was initially much slower. It took until the 1990s to reach
anything like the percentage market-penetration levels achieved in
the US, Canada, or the UK. In many countries acceptance still
remains poor as the use of a credit card system depends on the
banking system being perceived as reliable. Of particular note is
Japan , which remains a very cash oriented society, with credit
card adoption being limited to only the largest of merchants,
although an alternative system based on RFIDs inside cellphones has
seen some acceptance.
In contrast, because of the legislative framework surrounding
banking system overdrafts, some countries, France in particular,
were much faster to develop and adopt chip-based credit cards which
are now seen as major anti-fraud credit devices.
The design of the credit card itself has become a major selling
point in recent years. The value of the card to the issuer is often
related to the customer's usage of the card, or to the customer's
financial worth. This has led to the rise of Co-Brand and Affinity
cards - where the card design is related to the "affinity" (a
university, for example) leading to higher card usage. In most
cases a percentage of the value of the card is returned to the
affinity group.
Collectible credit cards
A growing field of numismatics (study of money), or more
specifically exonumia (study of money-like objects), credit card
collectors seek to collect various embodiments of credit from the
now familiar plastic cards to older paper merchant cards, and even
metal tokens that were accepted as merchant credit cards. Early
credit cards were made of celluloid plastic, then metal and fiber ,
then paper, and are now mostly plastic.
Controversy
Credit card debt has increased steadily. Since the late 1990s,
lawmakers , consumer advocacy groups , college officials and other
higher education affiliates have become increasingly concerned
about the rising use of credit cards among college students. The
major credit card companies have been accused of targeting a
younger audience, in particular college students, many of whom are
already in debt with college tuition fees and college loans and who
typically are less experienced at managing their own finances.
Credit card debt may also negatively affect their grades as they
are likely to work more both part and full time positions. [ 26
]
Another controversial area is the universal default feature of many
North American credit card contracts. When a cardholder is late
paying a particular credit card issuer, that card's interest rate
can be raised, often considerably. With universal default, a
customer's other credit cards, for which the customer may be
current on payments, may also have their rates and/or credit limit
changed. The universal default feature allows creditors to
periodically check cardholders' credit portfolios to view trade,
allowing these other institutions to decrease the credit limit
and/or increase rates on cardholders who may be late with another
credit card issuer. Being late on one credit card will potentially
affect all the cardholder's credit cards. Citibank voluntarily
stopped this practice in March 2007 and Chase stopped the practice
in November 2007. [ 27 ] The fact that credit card companies can
change the interest rate on debts that were incurred when a
different rate of interest was in place is similar to adjustable
rate mortgages where interest rates on current debt may rise.
However, in both cases this is agreed to in advance, and is a trade
off that allows a lower initial rate as well as the possibility of
an even lower rate (mortgages, if interest rates fall) or
perpetually keeping a below-market rate (credit cards, if the user
makes his debt payments on time). It should be noted that the
Universal Default practice was actually encouraged by Federal
Regulators, particularly those at the Office of the Comptroller of
the Currency (OCC) as a means of managing the changing risk
profiles of cardholders.
Another controversial area is the trailing interest issue. Trailing
interest is the practice of charging interest on the entire bill no
matter what percentage of it is paid. U.S Senator Carl Levin raised
the issue of millions of Americans affected by hidden fees,
compounding interest and cryptic terms. Their woes were heard in a
Senate Permanent Subcommittee on Investigations hearing which was
chaired by Senator Levin, who said that he intends to keep the
spotlight on credit card companies and that legislative action may
be necessary to purge the industry. [ 28 ] In 2009, the C.A.R.D.
Act was signed into law, enacting protections for many of the
issues Levin had raised.
In the United States, some have called for Congress to enact
additional regulations on the industry; to expand the disclosure
box clearly disclosing rate hikes, use plain language, incorporate
balance payoff disclosures, and also to outlaw universal default .
At a congress hearing around March 1, 2007, Citibank announced it
would no longer practice this, effective immediately. Opponents of
such regulation argue that customers must become more proactive and
self-responsible in evaluating and negotiating terms with credit
providers. Some of the nation's influential top credit card
issuers, who are among the top fifty corporate contributors to
political campaigns, successfully opposed it.
Hidden costs
In the United Kingdom, merchants won the right through The Credit
Cards (Price Discrimination) Order 1990 [ 29 ] to charge customers
different prices according to the payment method. As of 2007, the
United Kingdom was one of the world's most credit-card-intensive
countries, with 2.4 credit cards per consumer, according to the UK
Payments Administration Ltd . [ 30 ]
In the United States, until 1984 federal law prohibited surcharges
on card transactions. Although the federal Truth in Lending Act
provisions that prohibited surcharges expired that year, a number
of states have since enacted laws that continue to outlaw the
practice; California, Colorado, Connecticut, Florida, Kansas,
Massachusetts, Maine, New York, Oklahoma, and Texas have laws
against surcharges. As of 2006, the United States probably had one
of the world's if not the top ratio of credit cards per capita,
with 984 million bank-issued Visa and MasterCard credit card and
debit card accounts alone for an adult population of roughly 220
million people. [ 31 ] The credit card per US capita ratio was
nearly 4:1 as of 2003 [ 32 ] and as high as 5:1 as of 2006. [ 33
]
Credit reimbursement/balance refund
This section requires expansion .
Credit card numbering
Main article: Credit card number
The numbers found on credit cards have a certain amount of internal
structure, and share a common numbering scheme.
The card number's prefix , called the Bank Identification Number ,
is the sequence of digits at the beginning of the number that
determine the bank to which a credit card number belongs. This is
the first six digits for MasterCard and Visa cards. The next nine
digits are the individual account number, and the final digit is a
validity check code.
In addition to the main credit card number, credit cards also carry
issue and expiration dates (given to the nearest month), as well as
extra codes such as issue numbers and security codes . Not all
credit cards have the same sets of extra codes nor do they use the
same number of digits.
Credit cards in ATMs
Many credit cards can also be used in an ATM to withdraw money
against the credit limit extended to the card, but many card
issuers charge interest on cash advances before they do so on
purchases. The interest on cash advances is commonly charged from
the date the withdrawal is made, rather than the monthly billing
date. Many card issuers levy a commission for cash withdrawals,
even if the ATM belongs to the same bank as the card issuer.
Merchants do not offer cashback on credit card transactions because
they would pay a percentage commission of the additional cash
amount to their bank or merchant services provider, thereby making
it uneconomical.
Many credit card companies will also, when applying payments to a
card, do so at the end of a billing cycle, and apply those payments
to everything before cash advances. For this reason, many consumers
have large cash balances, which have no grace period and incur
interest at a rate that is (usually) higher than the purchase rate,
and will carry those balance for years, even if they pay off their
statement balance each month.
Credit cards as funding for entrepreneurs
Credit cards are a risky way for entrepreneurs to acquire capital
for their start ups when more conventional financing is
unavailable. It's widely reported that Len Bosack and Sandy Lerner
used personal credit cards [ 34 ] to start Cisco Systems . It is
rumoured that Larry Page and Sergey Brin 's start up of Google was
financed by credit cards to buy the necessary computers and office
equipment, more specifically "a terabyte of hard disks ". [ 35 ]
Similarly, filmmaker Robert Townsend financed part of Hollywood
Shuffle using credit cards. [ 36 ] Director Kevin Smith funded
Clerks in part by maxing out several credit cards. Actor Richard
Hatch also financed his production of Battlestar Galactica: The
Second Coming partly through his credit cards. Famed hedge fund
manager Bruce Kovner began his career (and, later on, his firm
Caxton Associates ) in financial markets by borrowing from his
credit card. UK entrepreneur James Caan (as seen on Dragon's Den )
financed his first business using several credit cards.
Settlement (of securities) is a business process whereby securities
or interests in securities are delivered, usually against payment ,
to fulfill contractual obligations, such as those arising under
securities trades .
The settlement date for marketable stocks is usually 3 (three)
business days after the trade is executed, and for listed options
and government securities it is usually 1 (one) day after the
execution.
As part of performance on the delivery obligations entailed by the
trade, settlement involves the delivery of securities and the
corresponding payment.
A number of risks arise for the parties during the settlement
interval, which are managed by the process of clearing , which
follows trading and precedes settlement. Clearing involves
modifying those contractual obligations so as to facilitate
settlement, often by netting and novation .
Contents
1 Nature of settlement
1.1 Traditional settlement
1.2 Electronic settlement
2 Legal significance
3 Immobilisation and dematerialisation
3.1 Immobilisation
3.2 Dematerialisation
4 Direct and indirect holding systems
5 See also
6 External links
//
Nature of settlement
Settlement involves the delivery of securities from one party to
another. Delivery usually takes place against payment, but some
deliveries are made without a corresponding payment. Examples are
the delivery of securities collateral against a loan of securities,
and a delivery made pursuant to a margin call .
Traditional settlement
Traditionally, securities settlement has involved the physical
movement of paper instruments, or certificates and transfer forms.
Payment was usually made by cheque . It was also risky, inasmuch as
paper instruments, certificates, and transfer forms were relatively
easy to lose, steal, and forge (see indirect holding system ). The
United States markets experienced what has become known as "the
paper crunch," as settlement delays threatened to disrupt the
operations of the securities markets.
This led to the formation of the Depository Trust Company ( DTC ),
and ultimately its parent, the Depository Trust & Clearing
Corporation . In the United Kingdom , the weakness of paper-based
settlement was exposed by a programme of privatisation of
nationalised industries in the 1980s, and the Big Bang of 1986 led
to an explosion in the volume of trades, and settlement delays
became significant. In the market crash of 1987, many investors
sought to limit their losses by selling their securities, but found
that the failure of timely settlement left them exposed.
Electronic settlement
The electronic settlement system came about largely as a result of
Clearance and Settlement Systems in the World's Securities Markets
, a major report in 1989 by the Washington-based think tank, the
Group of Thirty . This report made nine recommendations with a view
to achieving more efficient settlement. This was followed up in
2003 with a report, Clearing and Settlement: A Plan of Action ,
with 20 recommendations.
In an electronic settlement system, electronic settlement takes
place between participants. If a non-participant wishes to settle
its interests, it must do so through a participant acting as a
custodian. The interests of participants are recorded by credit
entries in securities accounts maintained in their names by the
operator of the system. It permits both quick and efficient
settlement by removing the need for paperwork, and the
synchronisation of the delivery of securities with the payment of a
corresponding cash sum (called delivery versus payment , or
DVP).
The recent development of electronic securities trading has brought
about settlement pressures akin to the paper crunch of the 1970s
and 1980s, rendering the need for further efficiencies urgent.
Legal significance
After the trade and before settlement, the rights of the purchaser
are contractual and therefore personal . Because they are merely
personal, their rights are at risk in the event of the insolvency
of the vendor. After settlement, the purchaser owns securities and
their rights are proprietary . Settlement is the delivery of
securities to complete trades. It involves upgrading personal
rights into property rights and thus protects market participants
from the risk of the default of their counterparties.
Immobilisation and dematerialisation
Immobilisation and dematerialisation are the two broad goals of
electronic settlement. Both were identified by the influential
report by the Group of Thirty in 1989.
Immobilisation
"Economic immobilization" redirects here. For the concept in
macroeconomics, see Economic immobility .
Immobilisation entails the use of securities in paper form and the
use of depositaries, which are electronically linked to a
settlement system. Securities (either constituted by paper
instruments or represented by paper certificates) are immobilised
in the sense that they are held by the depositary at all times. In
the historic transition from paper-based to electronic practice,
immoblisation often serves as a transitional phase prior to
dematerialisation.
The Depository Trust Company in New York is the largest immobilizer
of securities in the world. Euroclear and Clearstream Banking ,
Luxembourg are two important examples of international
immobilisation systems. Both originally settled eurobonds , but now
a wide range of international securities are settled through them
including many types of sovereign debt and equity securities .
Dematerialisation
Dematerialisation involves dispensing of paper instruments and
certificates altogether. Dematerialised securities exist only in
the form of electronic records. The legal impact of
dematerialisation differs in relation to bearer and registered
securities respectively.
Direct and indirect holding systems
In a direct holding system , participants hold the underlying
securities directly. The settlement system does not stand in the
chain of ownership, but merely serves as a conduit for
communications of participants to issuers.
Debt is that which is owed ; usually referencing assets owed, but
the term can also cover moral obligations and other interactions
not requiring money. In the case of assets, debt is a means of
using future purchasing power in the present before a summation has
been earned. Some companies and corporations use debt as a part of
their overall corporate finance strategy. [ citation needed ]
A debt is created when a creditor agrees to lend a sum of assets to
a debtor . In modern society, debt is usually granted with expected
repayment; in most cases, plus interest . Historically, debt was
responsible for the creation of indentured servants .
Contents
1 Etymology
2 Payment
3 Types of debt
4 Debt Syndication
5 Fund Base
6 Non Fund Base
7 Accounting debt
10 Effects of debt
11 Arguments against debt
12 Levels and flows
13 See also
14 References
//
Etymology
The word comes from the French dette and ultimately Latin debere
(to owe), from de habere (to have). The letter b in the word debt
was reintroduced in the 17th century, possibly by Samuel Johnson in
his Dictionary of 1755— several other words that had existed
without a b had them reinserted at around that time.
Payment
Before a debt can be made, both the debtor and the creditor must
agree on the manner in which the debt will be repaid, known as the
standard of deferred payment . This payment is usually denominated
as a sum of money in units of currency , but can sometimes be
denominated in terms of goods . Payment can be made in increments
over a period of time , or all at once at the end of the loan
agreement .
Types of debt
A company uses various kinds of debt to finance its operations .
The various types of debt can generally be categorized into: 1)
secured and unsecured debt, 2) private and public debt, 3)
syndicated and bilateral debt, and 4) other types of debt that
display one or more of the characteristics noted above. [ 1 ]
A debt obligation is considered secured if creditors have recourse
to the assets of the company on a proprietary basis or otherwise
ahead of general claims against the company. Unsecured debt
comprises financial obligations, where creditors do not have
recourse to the assets of the borrower to satisfy their claims.
Private debt comprises bank-loan type obligations, whether senior
or mezzanine . Public debt is a general definition covering all
financial instruments that are freely tradeable on a public
exchange or over the counter, with few if any restrictions.
Loan syndication is a risk management tool that allows the lead
banks underwriting the debt to reduce their risk and free up
lending capacity.
A basic loan is the simplest form of debt. It consists of an
agreement to lend a principal sum for a fixed period of time , to
be repaid by a certain date. In commercial loans interest ,
calculated as a percentage of the principal sum per year, will also
have to be paid by that date.
In some loans, the amount actually loaned to the debtor is less
than the principal sum to be repaid; the additional principal has
the same economic effect as a higher interest rate (see point
(mortgage) ), and is sometimes referred to as a banker's dozen , a
play on " baker's dozen " – owe twelve (a dozen), receive a
loan of eleven (a banker's dozen). Note that the effective interest
rate is not equal to the discount: if one borrows $10 and must
repay $11, then this is ($11–$10)/$10 = 10% interest;
however, if one borrows $9 and must repay $10, then this is
($10–$9)/$9 = 11 1/9 % interest. [ 2 ]
A syndicated loan is a loan that is granted to companies that wish
to borrow more money than any single lender is prepared to risk in
a single loan, usually many millions of dollars. In such a case, a
syndicate of banks can each agree to put forward a portion of the
principal sum.
A bond is a debt security issued by certain institutions such as
companies and governments . A bond entitles the holder to repayment
of the principal sum, plus interest . Bonds are issued to investors
in a marketplace when an institution wishes to borrow money. Bonds
have a fixed lifetime, usually a number of years ; with long-term
bonds, lasting over 30 years, being less common. At the end of the
bond's life the money should be repaid in full. Interest may be
added to the end payment, or can be paid in regular installments
(known as coupons ) during the life of the bond. Bonds may be
traded in the bond markets , and are widely used as relatively safe
investments in comparison to equity .
Debt Syndication
See also: Syndicated loan
Fund Base
Cash Credit
This is the primary method in which Banks lend money against the
security of commodities and debt. It runs like a current account
except that the money that can be withdrawn from this account is
not restricted to the amount deposited in the account. Instead, the
account holder is permitted to withdraw a certain sum called
"limit", "credit facility" in excess of the amount deposited in the
account. Cash Credits are, in theory, payable on demand. These are,
therefore, counter part of demand deposits of the Bank.
Working capital:
Firms need cash to pay for all their day-to-day activities. They
have to pay wages, pay for raw materials, pay bills and so on. The
money available to them to do this is known as the firm's working
capital. The main sources of working capital are the current assets
as these are the short-term assets that the firm can use to
generate cash. However, the firm also has current liabilities and
so these have to be taken account of when working out how much
working capital a firm has at its disposal.
Working capital is therefore:- WORKING CAPITAL = Current Assets ||
stock + debtors + cash - Current liabilities Thus working capital
is the same as net current assets, and is an important part of the
top half of the firm's balance sheet. It is vital to a business to
have sufficient working capital to meet all its requirements. Many
businesses have gone under, not because they were unprofitable, but
because they suffered from shortages of working capital. Working
Capital Cycle
Bank Overdraft:
The word overdraft means the act of overdrawing from a Bank
account. In other words, the account holder withdraws more money
from a Bank Account than has been deposited in it. An overdraft
occurs when withdrawals from a bank account exceed the available
balance which gives the account a negative balance - a person can
be said to be "overdrawn".
If there is a prior agreement with the account provider for an
overdraft protection plan, and the amount overdrawn is within this
authorised overdraft, then interest is normally charged at the
agreed rate. If the balance exceeds the agreed terms, then fees may
be charged and higher interest rate might apply
Term loan:
Term Loan are the counter parts of Fixed Deposits in the Bank.
Banks lend money in this mode when the repayment is sought to be
made in fixed, pre-determined installments. This type of loan is
normally given to the borrowers for acquiring long term assets i.e.
assets which will benefit the borrower over a long period
(exceeding at least one year). Purchases of plant and machinery,
constructing building for factory, setting up new projects fall in
this category. Financing for purchase of automobiles, consumer
durables, real estate and creation of infra structure also falls in
this category.
Bill discounting:
Bill discounting is a major activity with some of the smaller
Banks. Under this particular type of lending, Bank takes the bill
drawn by borrower on his(borrower's) customer and pay him or her
immediately deducting some amount as discount/commission. The Bank
then presents the Bill to the borrower's customer on the due date
of the Bill and collect the total amount. If the bill is delayed,
the borrower or his customer pay the Bank a pre-determined interest
depending upon the terms of transaction.
Project Financing:
Project finance is the financing of long-term infrastructure and
industrial projects based upon a complex financial structure where
project debt and equity are used to finance the project, rather
than the balance sheets of project sponsors. Usually, a project
financing structure involves a number of equity investors, known as
sponsors, as well as a syndicate of banks that provide loans to the
operation.
Non Fund Base
Letter of Credit:
The LC can also be the source of payment for a transaction, meaning
that redeeming the letter of credit will pay an exporter. Letters
of credit are used primarily in international trade transactions of
significant value, for deals between a supplier in one country and
a customer in another. They are also used in the land development
process to ensure that approved public facilities (streets,
sidewalks, stormwater ponds, etc.) will be built. The parties to a
letter of credit are usually a beneficiary who is to receive the
money, the issuing bank of whom the applicant is a client, and the
advising bank of whom the beneficiary is a client. Almost all
letters of credit are irrevocable, i.e., cannot be amended or
canceled without prior agreement of the beneficiary, the issuing
bank and the confirming bank, if any. In executing a transaction,
letters of credit incorporate functions common to giros and
Traveler's cheques. Typically, the documents a beneficiary has to
present in order to receive payment include a commercial invoice,
bill of lading, and a document proving the shipment was insured
against loss or damage in transit. However, the list and form of
documents is open to imagination and negotiation and might contain
requirements to present documents issued by a neutral third party
evidencing the quality of the goods shipped, or their place of
origin.
Corporate finance
Working capital
Cash conversion cycle
Return on capital
Economic value added
Just in time
Economic order quantity
Discounts and allowances
Factoring (finance)
Capital budgeting
Capital investment decisions
The investment decision
The financing decision
Sections
Managerial finance
Financial accounting
Management accounting
Mergers and acquisitions
Balance sheet analysis
Business plan
Corporate action
Finance series
Financial market
Financial market participants
Corporate finance
Personal finance
Public finance
Banks and Banking
Financial regulation
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Accounting debt
In national accounting, debts are added according to those who are
indebted. Household debt is the debt held by households. "National"
or Public debt is the debt held by the various governmental
institutions (federal government, states, cities ...). Business
debt is the debt held by businesses. Financial debt is the debt
held by the financial sector (from one financial institution to
another). Total debt is the sum of all those debts, excluding
financial debt to prevent double accounting. These various types of
debt can be computed in debt/GDP ratios. Those ratios help to
assess the speed of variations in the indebtness and the size of
the debt due. For example, the USA has a high consumer debt and a
low public debt, while in eastern European countries the opposite
tends to be true.
There are differences in the accounting of debt for private and
public agents. If a private agent promises to pay something later,
it has a debt, and this debt is enforceable by public agents. If a
public body passes a law stating that it'll pay something later (a
kind of promise), it keeps the right to change the law later (and
not to pay). This is why, for instance, the money governments
promised to pay for retirements does not show up in the public debt
assessment, whereas the money private companies promised to pay for
retirements do.
Securitization
Main article: Securitization
Securitization occurs when a company groups together assets or
receivables and sells them in units to the market through a trust.
Any asset with a cashflow can be securitized. The cash flows from
these receivables are used to pay the holders of these units.
Companies often do this in order to remove these assets from their
balance sheets and monetize an asset. Although these assets are
"removed" from the balance sheet and are supposed to be the
responsibility of the trust, that does not end the company's
involvement. Often the company maintains a special interest in the
trust which is called an "interest only strip" or "first loss
piece". Any payments from the trust must be made to regular
investors in precedence to this interest. This protects investors
from a degree of risk, making the securitization more attractive.
The aforementioned brings into question whether the assets are
truly off-balance-sheet given the company's exposure to losses on
this interest.
Debt, inflation and the exchange rate
As noted below, debt is normally denominated in a particular
monetary currency , and so changes in the valuation of that
currency can change the effective size of the debt. This can happen
due to inflation or deflation , so it can happen even though the
borrower and the lender are using the same currency . Thus it is
important to agree on standards of deferred payment in advance, so
that a degree of fluctuation will also be agreed as acceptable. It
is for instance common [ citation needed ] to agree to " US dollar
denominated" debt.
The form of debt involved in banking accounts for a large
proportion of the money in most industrialised nations (see money ,
broad money , and demand deposits for a discussion of this). There
is therefore a relationship between inflation , deflation , the
money supply , and debt. The store of value represented by the
entire economy of the industrialized nation, and the state's
ability to levy tax on it, acts to the foreign holder of debt as a
guarantee of repayment, since industrial goods are in high demand
in many places worldwide.
Inflation indexed debt
Borrowing and repayment arrangements linked to inflation-indexed
units of account are possible and are used in some countries. For
example, the US government issues two types of inflation-indexed
bonds , Treasury Inflation-Protected Securities (TIPS) and I-bonds.
These are one of the safest forms of investment available, since
the only major source of risk — that of inflation — is
eliminated. A number of other governments issue similar bonds, and
some did so for many years before the US government.
In countries with consistently high inflation, ordinary borrowings
at banks may also be inflation indexed.
Debt ratings, risk and cancellation
Risk free interest rate
Main article: risk-free interest rate
Credit counseling (known in the United Kingdom as debt counseling)
is a process offering education to consumers about how to avoid
incurring debts that cannot be repaid through establishing an
effective Debt Management Plan and Budget. Credit counseling is
usually less typified by functions of credit education or the
psychology of spending habits, rather credit counseling establishes
a planned method of debt relief, typically through a Debt
Management Plan.
Credit counseling often involves negotiating with creditors to
establish a debt management plan (DMP) for a consumer. A DMP may
help the debtor repay his or her debt by working out a repayment
plan with the creditor. DMPs, set up by credit counselors, usually
offer reduced payments, fees and interest rates to the client.
Credit counselors refer to the terms dictated by the creditors to
determine payments or interest reductions offered to consumers in a
debt management plan.
Contents
1 Common features of Debt Management Programs
2 History of credit counseling
3 Criticism of credit counseling (USA)
4 Cautions regarding credit counseling (Canada)
5 See also
6 References
7 External links
//
Common features of Debt Management Programs
After joining a DMP, the creditors will close the customer's
accounts and restrict the accounts to future charges. The most
common benefit of a DMP as advertised by most agencies is the
consolidation of multiple monthly payments into one monthly
payment, which is usually less than the sum of the individual
payments previously paid by the customer. This is because credit
cards banks will usually accept a lower monthly payment from a
customer in a DMP than if the customer were paying the account on
their own. Some DMPs advertise that payments can be cut by 50%,
although a reduction of 10-20% is more common.
The second feature of a DMP is a reduction in interest rates
charged by creditors. A customer with a defaulted credit card
account will often be paying an interest rate approaching 30%. Upon
joining a DMP, credit card banks sometimes lower the annual
percentage rates charged to 5-10%, and a few eliminate interest
altogether. This reduction in interest allows the counseling
agencies to advertise that their customers will be debt free in
periods of 3-6 years, rather than the 20+ years that it would take
to pay off a large amount of debt at high interest rates.
A third benefit offered by credit counseling agencies is the
process of bringing delinquent accounts current. This is often
called "reaging" or "curing" an account. This usually occurs after
making a series of on-time payments through the debt management
program as a show of good faith and commitment to completion of the
program. For example, a client with an account with a monthly
payment of $50 which has not been paid in two months might be
considered by the creditor to be 60 days past due. After joining
the DMP and making three consecutive monthly payments, the creditor
could reage the account to reflect a current status. Thereafter the
monthly payment due on the statements would be the monthly payment
negotiated by the DMP, and the account report as current to the
credit bureaus. This process does not eliminate the prior
delinquencies from the credit bureau reports. It merely gives a
fresh start and an opportunity for the client to begin building a
positive credit history. Like all derogatory credit information,
the passage of time will lessen the impact of the negative marks
when credit scores are calculated.
History of credit counseling
The first credit counseling agencies were created in 1951 in the
United States when credit grantors created The National Foundation
for Credit Counseling , or NFCC. According to W. Patrick Boisclair,
Chairman of the NFCC's Board of Trustees, "the NFCC initially
monitored legislative and regulatory activity for its retail credit
members" and "also conducted public awareness campaigns on credit."
(source) Their stated objective was to promote financial literacy
and help consumers avoid bankruptcy, but they did not serve as
collection agencies for the creditors. The first local credit
counseling franchises emerged in the 1960s, offering education and
counseling directly to consumers.
In 1993, the “Association of Independent Consumer Credit
Counseling Agencies,” or AICCCA, was founded, citing a need
for “industry-wide standards of excellence and ethical
conduct.” This formally organized the NFCC’s
competition. The AICCCA was formed from the group of counselors who
favored telephone delivery of debt management programs. The NFCC
was, in the beginning, strongly opposed to this telephone business
model, primarily favoring face-to-face counseling as a more
effective solution. Eventually, all organizations practiced both
phone and face-to-face processes with some agencies using large
inbound call centers driven by mass media advertising.
The credit counseling industry’s third major trade
organization is its largest: the American Association of Debt
Management Organizations, or AADMO.
However, not all credit counseling agencies belong to a trade
organization, nor are they required to do so; there are well over
1,000 active credit counseling organizations in the United
States.
In 2005, the Bankruptcy Abuse Prevention and Consumer Protection
Act of 2005 made credit counseling a requirement for consumer
debtors filing for Bankruptcy in the United States . In order to
meet this requirement, during the 180-day period preceding the
filing of bankruptcy, the debtor must complete a program with an
approved nonprofit budget and credit counseling agency. Such a
program may include, but is not limited to, one counseling session
conducted by phone or over the internet. In addition, a post-filing
debtor education credit counseling session is required in order to
complete the bankruptcy process and to have your debts
discharged.
Credit Counseling is also a growing industry in Europe , both for
profit-making debt management companies and charities such as
Christians Against Poverty and the Consumer Credit Counselling
Service , Britain's largest debt advice charity.
Criticism of credit counseling (USA)
This article may contain original research . Please improve it by
verifying the claims made and adding references . Statements
consisting only of original research may be removed. More details
may be available on the talk page . (January 2008)
In the late 1980s and early 1990s, the number of credit and debt
counseling agencies in America increased significantly. An
antitrust lawsuit was filed against the NFCC, arguing that the
presence of creditors on the NFCC’s Board of Directors
constituted monopolistic practices. As a result of this litigation,
creditors agreed to fund non-NFCC member agencies as well.
These sharp increases of credit counseling activity also created
other, more serious issues in the industry. By the early 1990s,
abuses by certain credit counseling organizations were so
significant, it led to criticism of the entire industry.
A credit counseling agency typically receives most of its
compensation from the creditors to whom the debt payments are
distributed. This funding relationship has led many to believe that
credit counseling agencies are merely a collections wing of the
creditors. This fee income, known as “Fair Share,” are
contributions from the creditors that originally earned the agency
15% of the amount recovered. However, in recent years, Fair Share
contributions have dwindled steadily, with contributions of 4-10%
being the most common.
Still the NFCC considers bankcard companies to be one of their
primary "constituents," and the NFCC website promotes the fact that
they collect $5 billion for creditors each year. It also promotes
their efforts to steer consumers away from bankruptcy.
The Federal Trade Commission has filed lawsuits against several
credit counseling agencies, and continues to urge caution in
choosing a credit counseling agency. The FTC has received more than
8,000 complaints from consumers about credit counselors, many
concerning high or hidden fees and the inability to opt out of
so-called “voluntary” contributions. The Better
Business Bureau also reports high complaint levels about credit
counseling.
The IRS also has weighed in on the subject of credit counseling,
and has denied nonprofit 501(c)(3) tax-exempt status to around 30
of the nation's 1000 credit counseling agencies. Those 30 credit
counseling agencies account for more than half of the industry's
revenue. Audits of non-profit credit counseling agencies by the IRS
are ongoing.
Other organizations have voiced criticisms of the credit counseling
industry, often citing the Fair Share funding model as evidence
that credit counselors serve the interests of the creditors over
the interests of consumers, and that credit counselors are not
forthcoming in speaking out about the actions of creditors for fear
of losing what little funding remains. Credit counselors respond
that their job is not to take sides but to negotiate with all
parties equally to help successfully resolve debts. They further
argue that the steady decline in Fair Share funding belies the
notion that creditors are in control of the credit counseling
industry.
Another common criticism of credit counseling is the assertion that
participating in a Debt Management Plan will ruin a
consumer’s credit. Fair Isaac Corporation , the company that
pioneered the use of credit scores, states that participation in a
Debt Management Plan has no effect on a consumer's FICO credit
score . However, the participation in such a plan may appear on
consumer credit reports, and the client may have more difficulty
obtaining a car or home loan and be denied any further unsecured
credit, such as a credit card. This is because lenders often use
multiple risk factors to determine creditworthiness. The major
factor holding consumers back is the amount of debt they have
relative to their income (the debt to income ratio) and not
enrollment in a credit counseling plan. While credit card banks
offering relatively low-credit-line cards may use a credit score
alone to approve a new account, a mortgage or car lender typically
will scrutinize the entire credit report more extensively and
verify employment and income information. Some lenders view a
prospective customer's participation in a Debt Management Plan as
indicative of the customer being unfit to manage their
finances.
Additionally, mortgage loans backed by federal programs such as HUD
or FHA have additional government underwriting guidelines in
addition to the lender's own policies. HUD/FHA states their
position on credit counseling is neutral and that a factor they
will consider is whether the client has been adhering to the
payment plan initially established through the credit counseling
agency. [ 1 ] The FHA recommends credit counseling programs to
those who fear being denied a mortgage loan due to credit approval.
[ 2 ]
Counseling agencies have also been criticized for understating
their clients' future responsibilities during the initial
enrollment process. Agencies have been accused of telling clients
to stop paying creditors directly and to then keep the first
payment made by the client into the DMP to cover fees. This can
result in accounts being charged off during the period that the
client transitions into the DMP. Many clients come to the DMP with
current accounts; they are simply seeking lower interest rates
rather than needing help bringing their accounts current. Since a
DMP is designed for consumers who are having trouble meeting
obligations it is usually the case that any consumer joining a DMP
already has past due accounts. For consumers who do not have past
due accounts they must be aware that creditors will carry them past
due since that creditor is giving the consumer a concession on the
amount of interest charged. In this way a client's credit can be
damaged as the accounts unintentionally fall past due.
Given this criticism, the industry is likely to be changed forever
in the immediate future as it is scrutinized by both the consumer
and government regulators over how they will be paid for the
services they perform. In meantime, there will be no shortage of
debt-burdened consumers who will now be facing a burgeoning, and
more traditional, collection industry.
Cautions regarding credit counseling (Canada)
The Financial Consumer Agency of Canada (FCAC) advises Canadians to
do their homework about credit counseling services before entering
into an agreement. According to the Agency, consumers should shop
around and compare services of credit counseling bodies and take
note of the different fee structures of for-profit and
not-for-profit credit counseling, as well as what services are
offered for those fees. Consumers considering entering into a DMP
should also be aware that an R7 credit rating will be entered in
their credit report and that their credit report will show that
they used credit counseling, a notation that will remain on the
report for at least two to three years after you complete your
counseling program. Prospective lenders, employers and landlords
may view information in an individual's credit report, if the
application forms consumers sign grant them permission to do
so.
See also
Credit counseling (known in the United Kingdom as debt counseling)
is a process offering education to consumers about how to avoid
incurring debts that cannot be repaid through establishing an
effective Debt Management Plan and Budget. Credit counseling is
usually less typified by functions of credit education or the
psychology of spending habits, rather credit counseling establishes
a planned method of debt relief, typically through a Debt
Management Plan.
Credit counseling often involves negotiating with creditors to
establish a debt management plan (DMP) for a consumer. A DMP may
help the debtor repay his or her debt by working out a repayment
plan with the creditor. DMPs, set up by credit counselors, usually
offer reduced payments, fees and interest rates to the client.
Credit counselors refer to the terms dictated by the creditors to
determine payments or interest reductions offered to consumers in a
debt management plan.
Contents
1 Common features of Debt Management Programs
2 History of credit counseling
3 Criticism of credit counseling (USA)
4 Cautions regarding credit counseling (Canada)
5 See also
6 References
7 External links
//
Common features of Debt Management Programs
After joining a DMP, the creditors will close the customer's
accounts and restrict the accounts to future charges. The most
common benefit of a DMP as advertised by most agencies is the
consolidation of multiple monthly payments into one monthly
payment, which is usually less than the sum of the individual
payments previously paid by the customer. This is because credit
cards banks will usually accept a lower monthly payment from a
customer in a DMP than if the customer were paying the account on
their own. Some DMPs advertise that payments can be cut by 50%,
although a reduction of 10-20% is more common.
The second feature of a DMP is a reduction in interest rates
charged by creditors. A customer with a defaulted credit card
account will often be paying an interest rate approaching 30%. Upon
joining a DMP, credit card banks sometimes lower the annual
percentage rates charged to 5-10%, and a few eliminate interest
altogether. This reduction in interest allows the counseling
agencies to advertise that their customers will be debt free in
periods of 3-6 years, rather than the 20+ years that it would take
to pay off a large amount of debt at high interest rates.
A third benefit offered by credit counseling agencies is the
process of bringing delinquent accounts current. This is often
called "reaging" or "curing" an account. This usually occurs after
making a series of on-time payments through the debt management
program as a show of good faith and commitment to completion of the
program. For example, a client with an account with a monthly
payment of $50 which has not been paid in two months might be
considered by the creditor to be 60 days past due. After joining
the DMP and making three consecutive monthly payments, the creditor
could reage the account to reflect a current status. Thereafter the
monthly payment due on the statements would be the monthly payment
negotiated by the DMP, and the account report as current to the
credit bureaus. This process does not eliminate the prior
delinquencies from the credit bureau reports. It merely gives a
fresh start and an opportunity for the client to begin building a
positive credit history. Like all derogatory credit information,
the passage of time will lessen the impact of the negative marks
when credit scores are calculated.
History of credit counseling
The first credit counseling agencies were created in 1951 in the
United States when credit grantors created The National Foundation
for Credit Counseling , or NFCC. According to W. Patrick Boisclair,
Chairman of the NFCC's Board of Trustees, "the NFCC initially
monitored legislative and regulatory activity for its retail credit
members" and "also conducted public awareness campaigns on credit."
(source) Their stated objective was to promote financial literacy
and help consumers avoid bankruptcy, but they did not serve as
collection agencies for the creditors. The first local credit
counseling franchises emerged in the 1960s, offering education and
counseling directly to consumers.
In 1993, the “Association of Independent Consumer Credit
Counseling Agencies,” or AICCCA, was founded, citing a need
for “industry-wide standards of excellence and ethical
conduct.” This formally organized the NFCC’s
competition. The AICCCA was formed from the group of counselors who
favored telephone delivery of debt management programs. The NFCC
was, in the beginning, strongly opposed to this telephone business
model, primarily favoring face-to-face counseling as a more
effective solution. Eventually, all organizations practiced both
phone and face-to-face processes with some agencies using large
inbound call centers driven by mass media advertising.
The credit counseling industry’s third major trade
organization is its largest: the American Association of Debt
Management Organizations, or AADMO.
However, not all credit counseling agencies belong to a trade
organization, nor are they required to do so; there are well over
1,000 active credit counseling organizations in the United
States.
In 2005, the Bankruptcy Abuse Prevention and Consumer Protection
Act of 2005 made credit counseling a requirement for consumer
debtors filing for Bankruptcy in the United States . In order to
meet this requirement, during the 180-day period preceding the
filing of bankruptcy, the debtor must complete a program with an
approved nonprofit budget and credit counseling agency. Such a
program may include, but is not limited to, one counseling session
conducted by phone or over the internet. In addition, a post-filing
debtor education credit counseling session is required in order to
complete the bankruptcy process and to have your debts
discharged.
Credit Counseling is also a growing industry in Europe , both for
profit-making debt management companies and charities such as
Christians Against Poverty and the Consumer Credit Counselling
Service , Britain's largest debt advice charity.
Criticism of credit counseling (USA)
This article may contain original research . Please improve it by
verifying the claims made and adding references . Statements
consisting only of original research may be removed. More details
may be available on the talk page . (January 2008)
In the late 1980s and early 1990s, the number of credit and debt
counseling agencies in America increased significantly. An
antitrust lawsuit was filed against the NFCC, arguing that the
presence of creditors on the NFCC’s Board of Directors
constituted monopolistic practices. As a result of this litigation,
creditors agreed to fund non-NFCC member agencies as well.
These sharp increases of credit counseling activity also created
other, more serious issues in the industry. By the early 1990s,
abuses by certain credit counseling organizations were so
significant, it led to criticism of the entire industry.
A credit counseling agency typically receives most of its
compensation from the creditors to whom the debt payments are
distributed. This funding relationship has led many to believe that
credit counseling agencies are merely a collections wing of the
creditors. This fee income, known as “Fair Share,” are
contributions from the creditors that originally earned the agency
15% of the amount recovered. However, in recent years, Fair Share
contributions have dwindled steadily, with contributions of 4-10%
being the most common.
Still the NFCC considers bankcard companies to be one of their
primary "constituents," and the NFCC website promotes the fact that
they collect $5 billion for creditors each year. It also promotes
their efforts to steer consumers away from bankruptcy.
The Federal Trade Commission has filed lawsuits against several
credit counseling agencies, and continues to urge caution in
choosing a credit counseling agency. The FTC has received more than
8,000 complaints from consumers about credit counselors, many
concerning high or hidden fees and the inability to opt out of
so-called “voluntary” contributions. The Better
Business Bureau also reports high complaint levels about credit
counseling.
The IRS also has weighed in on the subject of credit counseling,
and has denied nonprofit 501(c)(3) tax-exempt status to around 30
of the nation's 1000 credit counseling agencies. Those 30 credit
counseling agencies account for more than half of the industry's
revenue. Audits of non-profit credit counseling agencies by the IRS
are ongoing.
Other organizations have voiced criticisms of the credit counseling
industry, often citing the Fair Share funding model as evidence
that credit counselors serve the interests of the creditors over
the interests of consumers, and that credit counselors are not
forthcoming in speaking out about the actions of creditors for fear
of losing what little funding remains. Credit counselors respond
that their job is not to take sides but to negotiate with all
parties equally to help successfully resolve debts. They further
argue that the steady decline in Fair Share funding belies the
notion that creditors are in control of the credit counseling
industry.
Another common criticism of credit counseling is the assertion that
participating in a Debt Management Plan will ruin a
consumer’s credit. Fair Isaac Corporation , the company that
pioneered the use of credit scores, states that participation in a
Debt Management Plan has no effect on a consumer's FICO credit
score . However, the participation in such a plan may appear on
consumer credit reports, and the client may have more difficulty
obtaining a car or home loan and be denied any further unsecured
credit, such as a credit card. This is because lenders often use
multiple risk factors to determine creditworthiness. The major
factor holding consumers back is the amount of debt they have
relative to their income (the debt to income ratio) and not
enrollment in a credit counseling plan. While credit card banks
offering relatively low-credit-line cards may use a credit score
alone to approve a new account, a mortgage or car lender typically
will scrutinize the entire credit report more extensively and
verify employment and income information. Some lenders view a
prospective customer's participation in a Debt Management Plan as
indicative of the customer being unfit to manage their
finances.
Additionally, mortgage loans backed by federal programs such as HUD
or FHA have additional government underwriting guidelines in
addition to the lender's own policies. HUD/FHA states their
position on credit counseling is neutral and that a factor they
will consider is whether the client has been adhering to the
payment plan initially established through the credit counseling
agency. [ 1 ] The FHA recommends credit counseling programs to
those who fear being denied a mortgage loan due to credit approval.
[ 2 ]
Counseling agencies have also been criticized for understating
their clients' future responsibilities during the initial
enrollment process. Agencies have been accused of telling clients
to stop paying creditors directly and to then keep the first
payment made by the client into the DMP to cover fees. This can
result in accounts being charged off during the period that the
client transitions into the DMP. Many clients come to the DMP with
current accounts; they are simply seeking lower interest rates
rather than needing help bringing their accounts current. Since a
DMP is designed for consumers who are having trouble meeting
obligations it is usually the case that any consumer joining a DMP
already has past due accounts. For consumers who do not have past
due accounts they must be aware that creditors will carry them past
due since that creditor is giving the consumer a concession on the
amount of interest charged. In this way a client's credit can be
damaged as the accounts unintentionally fall past due.
Given this criticism, the industry is likely to be changed forever
in the immediate future as it is scrutinized by both the consumer
and government regulators over how they will be paid for the
services they perform. In meantime, there will be no shortage of
debt-burdened consumers who will now be facing a burgeoning, and
more traditional, collection industry.
Cautions regarding credit counseling (Canada)
The Financial Consumer Agency of Canada (FCAC) advises Canadians to
do their homework about credit counseling services before entering
into an agreement. According to the Agency, consumers should shop
around and compare services of credit counseling bodies and take
note of the different fee structures of for-profit and
not-for-profit credit counseling, as well as what services are
offered for those fees. Consumers considering entering into a DMP
should also be aware that an R7 credit rating will be entered in
their credit report and that their credit report will show that
they used credit counseling, a notation that will remain on the
report for at least two to three years after you complete your
counseling program. Prospective lenders, employers and landlords
may view information in an individual's credit report, if the
application forms consumers sign grant them permission to do
so.
See also
Debt is that which is owed ; usually referencing assets owed, but
the term can also cover moral obligations and other interactions
not requiring money. In the case of assets, debt is a means of
using future purchasing power in the present before a summation has
been earned. Some companies and corporations use debt as a part of
their overall corporate finance strategy. [ citation needed ]
A debt is created when a creditor agrees to lend a sum of assets to
a debtor . In modern society, debt is usually granted with expected
repayment; in most cases, plus interest .
Contents
1 Etymology
2 Payment
3 Types of debt
4 Debt Syndication
5 Fund Base
6 Non Fund Base
7 Accounting debt
10 Effects of debt
11 Arguments against debt
12 Levels and flows
13 See also
14 References
//
Etymology
The word comes from the French dette and ultimately Latin debere
(to owe), from de habere (to have). The letter b in the word debt
was reintroduced in the 17th century, possibly by Samuel Johnson in
his Dictionary of 1755— several other words that had existed
without a b had them reinserted at around that time.
Payment
Before a debt can be made, both the debtor and the creditor must
agree on the manner in which the debt will be repaid, known as the
standard of deferred payment . This payment is usually denominated
as a sum of money in units of currency , but can sometimes be
denominated in terms of goods or services. Payment can be made in
increments over a period of time , or all at once at the end of the
loan agreement .
Types of debt
A company uses various kinds of debt to finance its operations .
The various types of debt can generally be categorized into: 1)
secured and unsecured debt, 2) private and public debt, 3)
syndicated and bilateral debt, and 4) other types of debt that
display one or more of the characteristics noted above. [ 1 ]
A debt obligation is considered secured if creditors have recourse
to the assets of the company on a proprietary basis or otherwise
ahead of general claims against the company. Unsecured debt
comprises financial obligations, where creditors do not have
recourse to the assets of the borrower to satisfy their claims.
Private debt comprises bank-loan type obligations, whether senior
or mezzanine . Public debt is a general definition covering all
financial instruments that are freely tradeable on a public
exchange or over the counter, with few if any restrictions.
A basic loan is the simplest form of debt. It consists of an
agreement to lend a principal sum for a fixed period of time , to
be repaid by a certain date. In commercial loans interest ,
calculated as a percentage of the principal sum per year, will also
have to be paid by that date.
In some loans, the amount actually loaned to the debtor is less
than the principal sum to be repaid; the additional principal has
the same economic effect as a higher interest rate (see point
(mortgage) ), and is sometimes referred to as a banker's dozen , a
play on " baker's dozen " – owe twelve (a dozen), receive a
loan of eleven (a banker's dozen). Note that the effective interest
rate is not equal to the discount: if one borrows $10 and must
repay $11, then this is ($11–$10)/$10 = 10% interest;
however, if one borrows $9 and must repay $10, then this is
($10–$9)/$9 = 11 1/9 % interest. [ 2 ]
A syndicated loan is a loan that is granted to companies that wish
to borrow more money than any single lender is prepared to risk in
a single loan, usually many millions of dollars. In such a case, a
syndicate of banks can each agree to put forward a portion of the
principal sum. Loan syndication is a risk management tool that
allows the lead banks underwriting the debt to reduce their risk
and free up lending capacity.
A bond is a debt security issued by certain institutions such as
companies and governments . A bond entitles the holder to repayment
of the principal sum, plus interest . Bonds are issued to investors
in a marketplace when an institution wishes to borrow money. Bonds
have a fixed lifetime, usually a number of years ; with long-term
bonds, lasting over 30 years, being less common. At the end of the
bond's life the money should be repaid in full. Interest may be
added to the end payment, or can be paid in regular installments
(known as coupons ) during the life of the bond. Bonds may be
traded in the bond markets , and are widely used as relatively safe
investments in comparison to equity .
Debt Syndication
See also: Syndicated loan
Fund Base
Cash Credit
This is the primary method in which Banks lend money against the
security of commodities and debt. It runs like a current account
except that the money that can be withdrawn from this account is
not restricted to the amount deposited in the account. Instead, the
account holder is permitted to withdraw a certain sum called
"limit", "credit facility" in excess of the amount deposited in the
account. Cash Credits are, in theory, payable on demand. These are,
therefore, counter part of demand deposits of the Bank.
Working capital:
Firms need cash to pay for all their day-to-day activities. They
have to pay wages, pay for raw materials, pay bills and so on. The
money available to them to do this is known as the firm's working
capital. The main sources of working capital are the current assets
as these are the short-term assets that the firm can use to
generate cash. However, the firm also has current liabilities and
so these have to be taken account of when working out how much
working capital a firm has at its disposal.
Working capital is therefore:- WORKING CAPITAL = Current Assets ||
stock + debtors + cash - Current liabilities Thus working capital
is the same as net current assets, and is an important part of the
top half of the firm's balance sheet. It is vital to a business to
have sufficient working capital to meet all its requirements. Many
businesses have gone under, not because they were unprofitable, but
because they suffered from shortages of working capital. Working
Capital Cycle
Bank Overdraft:
The word overdraft means the act of overdrawing from a Bank
account. In other words, the account holder withdraws more money
from a Bank Account than has been deposited in it. An overdraft
occurs when withdrawals from a bank account exceed the available
balance which gives the account a negative balance - a person can
be said to be "overdrawn".
If there is a prior agreement with the account provider for an
overdraft protection plan, and the amount overdrawn is within this
authorised overdraft, then interest is normally charged at the
agreed rate. If the balance exceeds the agreed terms, then fees may
be charged and higher interest rate might apply
Term loan:
Term Loan are the counter parts of Fixed Deposits in the Bank.
Banks lend money in this mode when the repayment is sought to be
made in fixed, pre-determined installments. This type of loan is
normally given to the borrowers for acquiring long term assets i.e.
assets which will benefit the borrower over a long period
(exceeding at least one year). Purchases of plant and machinery,
constructing building for factory, setting up new projects fall in
this category. Financing for purchase of automobiles, consumer
durables, real estate and creation of infra structure also falls in
this category.
Bill discounting:
Bill discounting is a major activity with some of the smaller
Banks. Under this particular type of lending, Bank takes the bill
drawn by borrower on his(borrower's) customer and pay him or her
immediately deducting some amount as discount/commission. The Bank
then presents the Bill to the borrower's customer on the due date
of the Bill and collect the total amount. If the bill is delayed,
the borrower or his customer pay the Bank a pre-determined interest
depending upon the terms of transaction.
Project Financing:
Project finance is the financing of long-term infrastructure and
industrial projects based upon a complex financial structure where
project debt and equity are used to finance the project, rather
than the balance sheets of project sponsors. Usually, a project
financing structure involves a number of equity investors, known as
sponsors, as well as a syndicate of banks that provide loans to the
operation.
Non Fund Base
Letter of Credit:
The LC can also be the source of payment for a transaction, meaning
that redeeming the letter of credit will pay an exporter. Letters
of credit are used primarily in international trade transactions of
significant value, for deals between a supplier in one country and
a customer in another. They are also used in the land development
process to ensure that approved public facilities (streets,
sidewalks, stormwater ponds, etc.) will be built. The parties to a
letter of credit are usually a beneficiary who is to receive the
money, the issuing bank of whom the applicant is a client, and the
advising bank of whom the beneficiary is a client. Almost all
letters of credit are irrevocable, i.e., cannot be amended or
canceled without prior agreement of the beneficiary, the issuing
bank and the confirming bank, if any. In executing a transaction,
letters of credit incorporate functions common to giros and
Traveler's cheques. Typically, the documents a beneficiary has to
present in order to receive payment include a commercial invoice,
bill of lading, and a document proving the shipment was insured
against loss or damage in transit. However, the list and form of
documents is open to imagination and negotiation and might contain
requirements to present documents issued by a neutral third party
evidencing the quality of the goods shipped, or their place of
origin.
Corporate finance
Working capital
Cash conversion cycle
Return on capital
Economic value added
Just in time
Economic order quantity
Discounts and allowances
Factoring (finance)
Capital budgeting
Capital investment decisions
The investment decision
The financing decision
Sections
Managerial finance
Financial accounting
Management accounting
Mergers and acquisitions
Balance sheet analysis
Business plan
Corporate action
Finance series
Financial market
Financial market participants
Corporate finance
Personal finance
Public finance
Banks and Banking
Financial regulation
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edit
Accounting debt
In national accounting, debts are added according to those who are
indebted. Household debt is the debt held by households. "National"
or Public debt is the debt held by the various governmental
institutions (federal government, states, cities ...). Business
debt is the debt held by businesses. Financial debt is the debt
held by the financial sector (from one financial institution to
another). Total debt is the sum of all those debts, excluding
financial debt to prevent double accounting. These various types of
debt can be computed in debt/GDP ratios. Those ratios help to
assess the speed of variations in the indebtness and the size of
the debt due. For example, the USA has a high consumer debt and a
low public debt, while in eastern European countries the opposite
tends to be true.
There are differences in the accounting of debt for private and
public agents. If a private agent promises to pay something later,
it has a debt, and this debt is enforceable by public agents. If a
public body passes a law stating that it'll pay something later (a
kind of promise), it keeps the right to change the law later (and
not to pay). This is why, for instance, the money governments
promised to pay for retirements does not show up in the public debt
assessment, whereas the money private companies promised to pay for
retirements do.
Securitization
Main article: Securitization
Securitization occurs when a company groups together assets or
receivables and sells them in units to the market through a trust.
Any asset with a cashflow can be securitized. The cash flows from
these receivables are used to pay the holders of these units.
Companies often do this in order to remove these assets from their
balance sheets and monetize an asset. Although these assets are
"removed" from the balance sheet and are supposed to be the
responsibility of the trust, that does not end the company's
involvement. Often the company maintains a special interest in the
trust which is called an "interest only strip" or "first loss
piece". Any payments from the trust must be made to regular
investors in precedence to this interest. This protects investors
from a degree of risk, making the securitization more attractive.
The aforementioned brings into question whether the assets are
truly off-balance-sheet given the company's exposure to losses on
this interest.
Debt, inflation and the exchange rate
As noted below, debt is normally denominated in a particular
monetary currency , and so changes in the valuation of that
currency can change the effective size of the debt. This can happen
due to inflation or deflation , so it can happen even though the
borrower and the lender are using the same currency . Thus it is
important to agree on standards of deferred payment in advance, so
that a degree of fluctuation will also be agreed as acceptable. It
is for instance common [ citation needed ] to agree to " US dollar
denominated" debt.
The form of debt involved in banking accounts for a large
proportion of the money in most industrialised nations (see money ,
broad money , and demand deposits for a discussion of this). There
is therefore a relationship between inflation , deflation , the
money supply , and debt. The store of value represented by the
entire economy of the industrialized nation, and the state's
ability to levy tax on it, acts to the foreign holder of debt as a
guarantee of repayment, since industrial goods are in high demand
in many places worldwide.
Inflation indexed debt
Borrowing and repayment arrangements linked to inflation-indexed
units of account are possible and are used in some countries. For
example, the US government issues two types of inflation-indexed
bonds , Treasury Inflation-Protected Securities (TIPS) and I-bonds.
These are one of the safest forms of investment available, since
the only major source of risk — that of inflation — is
eliminated. A number of other governments issue similar bonds, and
some did so for many years before the US government.
In countries with consistently high inflation, ordinary borrowings
at banks may also be inflation indexed.
Debt ratings, risk and cancellation
Risk free interest rate
Main article: risk-free interest rate
Finance
Financial markets
Bond market
Stock market (equity market)
Foreign exchange market
Derivatives market
Commodity market
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Over the counter
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Financial market participants :
Investor and speculator
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Financial instruments
Cash :
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( Redistribution )
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deficit spending
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ISO 31000
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History of private equity
v • d • e
Lendings to stable financial entities such as large companies or
governments are often termed "risk free" or "low risk" and made at
a so-called " risk-free interest rate ". This is because the debt
and interest are highly unlikely to be defaulted. A good example of
such risk-free interest is a US Treasury security - it yields the
minimum return available in economics, but investors have the
comfort of the (almost) certain expectation that the US Treasury
will not default on its debt instruments. A risk-free rate is also
commonly used in setting floating interest rates, which are usually
calculated as the risk-free interest rate plus a bonus to the
creditor based on the creditworthiness of the debtor (in other
words, the risk of him or her defaulting and the creditor losing
the debt). In reality, no lending is truly risk free, but borrowers
at the "risk free" rate are considered the least likely to
default.
However, if the real value of a currency changes during the term of
the debt, the purchasing power of the money repaid may vary
considerably from that which was expected at the commencement of
the loan. So from a practical investment point of view, there is
still considerable risk attached to "risk free" or "low risk"
lendings. The real value of the money may have changed due to
inflation, or, in the case of a foreign investment, due to exchange
rate fluctuations.
The Bank for International Settlements is an organisation of
central banks that sets rules to define how much capital banks have
to hold against the loans they give out.
Ratings and creditworthiness
Specific bond debts owed by both governments and private
corporations is rated by rating agencies , such as Moody's , Fitch
Ratings Inc., A. M. Best and Standard & Poor's . The government
or company itself will also be given its own separate rating. These
agencies assess the ability of the debtor to honor his obligations
and accordingly give him or her a credit rating . Moody's uses the
letters Aaa Aa A Baa Ba B Caa Ca C , where ratings Aa-Caa are
qualified by numbers 1-3. Munich Re , for example, currently is
rated Aa3 (as of 2004 [update] ). S&P and other rating agencies
have slightly different systems using capital letters and +/-
qualifiers.
A change in ratings can strongly affect a company, since its cost
of refinancing depends on its creditworthiness . Bonds below
Baa/BBB (Moody's/S&P) are considered junk- or high risk bonds.
Their high risk of default (approximately 1.6% for Ba) is
compensated by higher interest payments. Bad Debt is a loan that
can not (partially or fully) be repaid by the debtor. The debtor is
said to default on his debt. These types of debt are frequently
repackaged and sold below face value. Buying junk bonds is seen as
a risky but potentially profitable form of investment.
Cancellation
Main article: Debt relief
Short of bankruptcy, it is rare that debts are wholly or partially
relinquished. Traditions in some cultures demand that this be done
on a regular (often annual) basis, in order to prevent systemic
inequities between groups in society, or anyone becoming a
specialist in holding debt and coercing repayment – see debt
relief . An example is the Biblical Jubilee year , described in the
Book of Leviticus .
Under English law , when the creditor is deceived into
relinquishing the debt, this is a crime : see Theft Act 1978 .
International Third World debt has reached the scale that many
economists are convinced that debt cancellation is the only way to
restore global equity in relations with the developing nations
.
Effects of debt
Debt allows people and organizations to do things that they would
otherwise not be able, or allowed, to do. Commonly, people in
industrialised nations use it to purchase houses, cars and many
other things too expensive to buy with cash on hand. Companies also
use debt in many ways to leverage the investment made in their
assets , "leveraging" the return on their equity . This leverage ,
the proportion of debt to equity, is considered important in
determining the riskiness of an investment; the more debt per
equity, the riskier. For both companies and individuals, this
increased risk can lead to poor results, as the cost of servicing
the debt can grow beyond the ability to pay due to either external
events (income loss) or internal difficulties (poor management of
resources).
Excesses in debt accumulation have been blamed for exacerbating
economic problems. [ 3 ] For example, prior to the beginning of the
Great Depression debt/GDP ratio was very high. Economic agents were
heavily indebted. This excess of debt, equivalent to excessive
expectations on future returns, accompanied asset bubbles on the
stock markets. When expectations corrected, deflation and a credit
crunch followed. Deflation effectively made debt more expensive
and, as Fisher explained, this reinforced deflation again, because,
in order to reduce their debt level, economic agents reduced their
consumption and investment. The reduction in demand reduced
business activity and caused further unemployment. In a more direct
sense, more bankruptcies also occurred due both to increased debt
cost caused by deflation and the reduced demand.
It is possible for some organizations to enter into alternative
types of borrowing and repayment arrangements which will not result
in bankruptcy. For example, companies can sometimes convert debt
that they owe into equity in themselves. In this case, the creditor
hopes to regain something equivalent to the debt and interest in
the form of dividends and capital gains of the borrower. The
"repayments" are therefore proportional to what the borrower earns
and so can not in themselves cause bankruptcy. Once debt is
converted in this way, it is no longer known as debt.
Arguments against debt
Main article: Criticism of debt
Some argue against debt as an instrument and institution, on a
personal, family, social, corporate and governmental level. Islam
forbids lending with interest even today, while the Catholic Church
allowed it from 1822 onwards, and the Torah states that all debts
should be erased every 7 years and every 50 years (in the Jubilee
year , as described in the Book of Leviticus ).
Debt will increase through time if it is not repaid faster than it
grows through interest. This effect may be termed usury , while the
term "usury" in other contexts refers only to an excessive rate of
interest, in excess of a reasonable profit for the risk
accepted.
In international legal thought, Odious debt is debt that is
incurred by a regime for purposes that do not serve the interest of
the state. Such debts are thus considered by this doctrine to be
personal debts of the regime that incurred them and not debts of
the state.
In an economy with high interest rates, debt will be more costly to
a business than more flexible dividends on equity investment. It
may be easier for a struggling business to be financed through
equity investment as it may be possible to avoid paying a dividend
if times are hard.
Levels and flows
Main article: Debt levels and flows
Global debt underwriting grew 4.3% year-over-year to $5.19 trillion
during 2004. It is expected to rise in the coming years if the
spending habits of millions of people worldwide continue the way
they do.
See also
Derivative (finance)
Debt bondage
Debtors' prison
Financial markets
List of finance topics
Nonfinancial debt
Odious debt
Revolving account
Saving
Equity
Time value of money
Thomson Financial League Tables
Settlement (of securities) is a business process whereby securities
or interests in securities are delivered, usually against (in
simultaneous exchange for) payment of money, to fulfill contractual
obligations, such as those arising under securities trades.
In the U.S., the settlement date for marketable stocks is usually 3
(three) business days after the trade is executed, and for listed
options and government securities it is usually 1 (one) day after
the execution.
As part of performance on the delivery obligations entailed by the
trade, settlement involves the delivery of securities and the
corresponding payment.
A number of risks arise for the parties during the settlement
interval, which are managed by the process of clearing , which
follows trading and precedes settlement. Clearing involves
modifying those contractual obligations so as to facilitate
settlement, often by netting and novation .
Contents
1 Nature of settlement
1.1 Traditional (physical) settlement
1.2 Electronic settlement
2 Legal significance
3 Immobilisation and dematerialisation
3.1 Immobilisation
3.2 Dematerialisation
4 Direct and indirect holding systems
5 Regular Business Days from Trade Date; Dates/Terms to Settle
Instruments
6 See also
7 External links
//
Nature of settlement
Settlement involves the delivery of securities from one party to
another. Delivery usually takes place against payment, but some
deliveries are made without a corresponding payment (sometimes
referred to as a free delivery ). Examples of a delivery without
payment are the delivery of securities collateral against a loan of
securities, and a delivery made pursuant to a margin call .
Traditional (physical) settlement
Prior to modern financial market technologies and methods such as
depositories and securities held in electronic form, securities
settlement had involved the physical movement of paper instruments,
or certificates and transfer forms. Payment was usually made by
paper check upon receipt by the registrar or transfer agent of
properly negotiated certifcates and other requisite documents.
Physical settlement securities still exist in modern markets today
mostly for private (restricted or unregistered) securities as
opposed to those of publicly (exchange) traded securities, however
payment of money today is typically made via electronic funds
transfer (in the U.S., a bank wire transfer made through the
Federal Reserve 's Fedwire system). Physical/paper settlement
involves higher risks, inasmuch as paper instruments, certificates,
and transfer forms are subject to risks electronic media are not
more or less such as loss, theft, counterfeit, and forgery (see
indirect holding system ).
The U.S. securities markets experienced what became known as "the
paper crunch," as settlement delays threatened to disrupt the
operations of the securities markets which led to the formation of
electronic settlement via a Central Securities Depository ,
specifically the Depository Trust Company ( DTC ), and ultimately
its parent, the Depository Trust & Clearing Corporation . In
the United Kingdom , the weakness of paper-based settlement was
exposed by a programme of privatisation of nationalised industries
in the 1980s, and the Big Bang of 1986 led to an explosion in the
volume of trades, and settlement delays became significant. In the
market crash of 1987, many investors sought to limit their losses
by selling their securities, but found that the failure of timely
settlement left them exposed.
Electronic settlement
The electronic settlement system came about largely as a result of
Clearance and Settlement Systems in the World's Securities Markets
, a major report in 1989 by the Washington-based think tank, the
Group of Thirty . This report made nine recommendations with a view
to achieving more efficient settlement. This was followed up in
2003 with a report, Clearing and Settlement: A Plan of Action ,
with 20 recommendations.
In an electronic settlement system, electronic settlement takes
place between participants. If a non-participant wishes to settle
its interests, it must do so through a participant acting as a
custodian. The interests of participants are recorded by credit
entries in securities accounts maintained in their names by the
operator of the system. It permits both quick and efficient
settlement by removing the need for paperwork, and the simultaneous
delivery of securities with the payment of a corresponding cash sum
(called delivery versus payment , or DVP) in the agreed upon
currency.
Legal significance
After the trade and before settlement, the rights of the purchaser
are contractual and therefore personal . Because they are merely
personal, their rights are at risk in the event of the insolvency
of the vendor. After settlement, the purchaser owns securities and
their rights are proprietary . Settlement is the delivery of
securities to complete trades. It involves upgrading personal
rights into property rights and thus protects market participants
from the risk of the default of their counterparties.
Immobilisation and dematerialisation
Immobilisation and dematerialisation are the two broad goals of
electronic settlement. Both were identified by the influential
report by the Group of Thirty in 1989.
Immobilisation
"Economic immobilization" redirects here. For the concept in
macroeconomics, see Economic immobility .
Immobilisation entails the use of securities in paper form and the
use of a Central Securities Depository or more than one, which
is/are electronically linked to a settlement system. Securities
(either constituted by paper instruments or represented by paper
certificates) are immobilised in the sense that they are held by
the depository at all times. In the historic transition from
paper-based to electronic practice, immoblisation often serves as a
transitional phase prior to dematerialisation.
The Depository Trust Company in New York is the largest immobilizer
of securities in the world. Euroclear and Clearstream Banking ,
Luxembourg are two important examples of international
immobilisation systems. Both originally settled eurobonds , but now
a wide range of international securities are settled through them
including many types of sovereign debt and equity securities .
Dematerialisation
Dematerialisation involves dispensing of paper instruments and
certificates altogether. Dematerialised securities exist only in
the form of electronic records. The legal impact of
dematerialisation differs in relation to bearer and registered
securities respectively.
Direct and indirect holding systems
In a direct holding system , participants hold the underlying
securities directly. The settlement system does not stand in the
chain of ownership, but merely serves as a conduit for
communications of participants to issuers.
Regular Business Days from Trade Date; Dates/Terms to Settle
Instruments
Instrument
Days to Settle
Stocks
3 ("T+3")
Money Market Mutual Fund
Typically 1 ("T+1" or "next day"), though can be 0 ("same day")
Options
1
It is important to note that, in the U.S., the settlement
date/terms for a securities trade is also associated with the
character or basis on which the securities trade and settle:
Regular way (RW) - that is, the normal time frames and manner -
example, stocks normally are T+3
When issued (WI) - short for "when, as, if issued" - signifying a
conditional transaction in a security authorized for issue which
has not yet been or may never be actually issued. Settlement occurs
if and when the security is actually issued and/or the exchange or
NASD/FINRA rules that the trades are to be settled. Based on the
nature of some securities, sometimes when issued's are never
actually issued. For example, US Treasury securities, stock splits
and new issues typically trade on a "WI" basis
Cash - same day settlement, that is, delivery on trade date.
Delayed delivery - securities are expected to be delivered past
normal timeframes/windows. Example, new issue muni's (municipal
bonds) often trade on a DD or WI basis (often a month after trade
date as disclosed in the note of sale to allow for printing and
shipping of the debenture/certificates). Like equities though,
muni's can be settled RW, WI or cash, as well as DD or other
mutually agreed terms.
Ex-dividend - the terms of the stock trade are that the price and
settlement amount "excludes" a pending dividend declaration (buyers
of a stock on or after ex-dividend declaration date but prior to
payable date).
Ex-rights - similar in effect as ex-dividend. A security that
trades/settles without any entitlement to a pending rights offering
declared on the stock.
See also
Herstatt Risk/Settlement risk
Continuous linked settlement
CREST
Subprime mortgage crisis
T2S - being developed harmonised settlement platform in Europe
Settlement (of securities) is a business process whereby securities
or interests in securities are delivered, usually against (in
simultaneous exchange for) payment of money, to fulfill contractual
obligations, such as those arising under securities trades.
In the U.S., the settlement date for marketable stocks is usually 3
(three) business days after the trade is executed, and for listed
options and government securities it is usually 1 (one) day after
the execution.
As part of performance on the delivery obligations entailed by the
trade, settlement involves the delivery of securities and the
corresponding payment.
A number of risks arise for the parties during the settlement
interval, which are managed by the process of clearing , which
follows trading and precedes settlement. Clearing involves
modifying those contractual obligations so as to facilitate
settlement, often by netting and novation .
Contents
1 Nature of settlement
1.1 Traditional (physical) settlement
1.2 Electronic settlement
2 Legal significance
3 Immobilisation and dematerialisation
3.1 Immobilisation
3.2 Dematerialisation
4 Direct and indirect holding systems
5 Regular Business Days from Trade Date; Dates/Terms to Settle
Instruments
6 See also
7 External links
//
Nature of settlement
Settlement involves the delivery of securities from one party to
another. Delivery usually takes place against payment, but some
deliveries are made without a corresponding payment (sometimes
referred to as a free delivery ). Examples of a delivery without
payment are the delivery of securities collateral against a loan of
securities, and a delivery made pursuant to a margin call .
Traditional (physical) settlement
Prior to modern financial market technologies and methods such as
depositories and securities held in electronic form, securities
settlement had involved the physical movement of paper instruments,
or certificates and transfer forms. Payment was usually made by
paper check upon receipt by the registrar or transfer agent of
properly negotiated certifcates and other requisite documents.
Physical settlement securities still exist in modern markets today
mostly for private (restricted or unregistered) securities as
opposed to those of publicly (exchange) traded securities, however
payment of money today is typically made via electronic funds
transfer (in the U.S., a bank wire transfer made through the
Federal Reserve 's Fedwire system). Physical/paper settlement
involves higher risks, inasmuch as paper instruments, certificates,
and transfer forms are subject to risks electronic media are not
more or less such as loss, theft, counterfeit, and forgery (see
indirect holding system ).
The U.S. securities markets experienced what became known as "the
paper crunch," as settlement delays threatened to disrupt the
operations of the securities markets which led to the formation of
electronic settlement via a Central Securities Depository ,
specifically the Depository Trust Company ( DTC ), and ultimately
its parent, the Depository Trust & Clearing Corporation . In
the United Kingdom , the weakness of paper-based settlement was
exposed by a programme of privatisation of nationalised industries
in the 1980s, and the Big Bang of 1986 led to an explosion in the
volume of trades, and settlement delays became significant. In the
market crash of 1987, many investors sought to limit their losses
by selling their securities, but found that the failure of timely
settlement left them exposed.
Electronic settlement
The electronic settlement system came about largely as a result of
Clearance and Settlement Systems in the World's Securities Markets
, a major report in 1989 by the Washington-based think tank, the
Group of Thirty . This report made nine recommendations with a view
to achieving more efficient settlement. This was followed up in
2003 with a report, Clearing and Settlement: A Plan of Action ,
with 20 recommendations.
In an electronic settlement system, electronic settlement takes
place between participants. If a non-participant wishes to settle
its interests, it must do so through a participant acting as a
custodian. The interests of participants are recorded by credit
entries in securities accounts maintained in their names by the
operator of the system. It permits both quick and efficient
settlement by removing the need for paperwork, and the simultaneous
delivery of securities with the payment of a corresponding cash sum
(called delivery versus payment , or DVP) in the agreed upon
currency.
Legal significance
After the trade and before settlement, the rights of the purchaser
are contractual and therefore personal . Because they are merely
personal, their rights are at risk in the event of the insolvency
of the vendor. After settlement, the purchaser owns securities and
their rights are proprietary . Settlement is the delivery of
securities to complete trades. It involves upgrading personal
rights into property rights and thus protects market participants
from the risk of the default of their counterparties.
Immobilisation and dematerialisation
Immobilisation and dematerialisation are the two broad goals of
electronic settlement. Both were identified by the influential
report by the Group of Thirty in 1989.
Immobilisation
"Economic immobilization" redirects here. For the concept in
macroeconomics, see Economic immobility .
Immobilisation entails the use of securities in paper form and the
use of a Central Securities Depository or more than one, which
is/are electronically linked to a settlement system. Securities
(either constituted by paper instruments or represented by paper
certificates) are immobilised in the sense that they are held by
the depository at all times. In the historic transition from
paper-based to electronic practice, immoblisation often serves as a
transitional phase prior to dematerialisation.
The Depository Trust Company in New York is the largest immobilizer
of securities in the world. Euroclear and Clearstream Banking ,
Luxembourg are two important examples of international
immobilisation systems. Both originally settled eurobonds , but now
a wide range of international securities are settled through them
including many types of sovereign debt and equity securities .
Dematerialisation
Dematerialisation involves dispensing of paper instruments and
certificates altogether. Dematerialised securities exist only in
the form of electronic records. The legal impact of
dematerialisation differs in relation to bearer and registered
securities respectively.
Direct and indirect holding systems
In a direct holding system , participants hold the underlying
securities directly. The settlement system does not stand in the
chain of ownership, but merely serves as a conduit for
communications of participants to issuers.
Regular Business Days from Trade Date; Dates/Terms to Settle
Instruments
Instrument
Days to Settle
Stocks
3 ("T+3")
Money Market Mutual Fund
Typically 1 ("T+1" or "next day"), though can be 0 ("same day")
Options
1
It is important to note that, in the U.S., the settlement
date/terms for a securities trade is also associated with the
character or basis on which the securities trade and settle:
Regular way (RW) - that is, the normal time frames and manner -
example, stocks normally are T+3
When issued (WI) - short for "when, as, if issued" - signifying a
conditional transaction in a security authorized for issue which
has not yet been or may never be actually issued. Settlement occurs
if and when the security is actually issued and/or the exchange or
NASD/FINRA rules that the trades are to be settled. Based on the
nature of some securities, sometimes when issued's are never
actually issued. For example, US Treasury securities, stock splits
and new issues typically trade on a "WI" basis
Cash - same day settlement, that is, delivery on trade date.
Delayed delivery - securities are expected to be delivered past
normal timeframes/windows. Example, new issue muni's (municipal
bonds) often trade on a DD or WI basis (often a month after trade
date as disclosed in the note of sale to allow for printing and
shipping of the debenture/certificates). Like equities though,
muni's can be settled RW, WI or cash, as well as DD or other
mutually agreed terms.
Ex-dividend - the terms of the stock trade are that the price and
settlement amount "excludes" a pending dividend declaration (buyers
of a stock on or after ex-dividend declaration date but prior to
payable date).
Ex-rights - similar in effect as ex-dividend. A security that
trades/settles without any entitlement to a pending rights offering
declared on the stock.
See also
Herstatt Risk/Settlement risk
Continuous linked settlement
CREST
Subprime mortgage crisis
T2S - being developed harmonised settlement platform in Europe
