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CHAPTER 2

INDIAN FINANCIAL SYSTEM


Objectives of the Session
To understand

• Financial System And Its Function


• Classification Of Financial Markets
• Money Market Instruments
• Capital Markets Instruments
• Government Securities Market
FINANCIAL SYSTEM

It is an orderly mechanism and structure that is available


in an economy to mobilize the monetary resources/capital
from various surplus sectors of the economy and allocate
and distribute the same to various needy sectors.
The term financial system is a set of inter-related
activities/services working together to achieve some
predetermined purpose or goal. It includes different
markets, the institutions, instruments, services and
mechanisms which influence the generation of savings,
investment capital formation and growth.
• Van Horne defined the financial system as the purpose of
financial markets to allocate savings efficiently in an
economy to ultimate users either for investment in real
assets or for consumption.
• Christy has opined that the objective of the financial system
is to "supply funds to various sectors and activities of the
economy in ways that promote the fullest possible utilization
of resources without the destabilizing consequence of price
level changes or unnecessary interference with individual
desires.“
• According to Robinson, the primary function of the system is
"to provide a link between savings and investment for the
creation of new wealth and to permit portfolio adjustment in
the composition of the existing wealth."

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Inter-relationship in the
Financial System

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FUNCTIONS OF FINANCIAL SYSTEM

Savings

Policy Liquidity
Financial
System

Risk Payment
CLASSIFICATION OF FINANCIAL
MARKETS

• Financial Markets: Market in which financial


assets are created or transferred.
• Financial Markets can be classified as:

1. Money Market: Deals with transactions


related to short-term instruments with maturity
period less than one year

2. Capital Market: Deals with transactions


related to long-term instruments with maturity
period greater than one year.
MONEY MARKET INSTRUMENTS
• Call money

• Commercial Papers

• Certificate of Deposits
CALL MONEY/NOTICE MONEY

• Call money : Money lent for 1 day


• Notice money: Money lent for 2-14 days.

• Purpose: - To help commercial banks by discounting


commercial bills. - To help the banks in meeting the CRR
requirement - To meet the sudden demands for funds
- To meet the temporary mismatches.
CALL MONEY/NOTICE MONEY

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Can both lend and borrow:


•Participants: (e.g. Commercial banks,
DFHI, STCI etc.)

Can only lend


(e.g. LIC, UTI, Mutual funds etc.)
COMMERCIAL PAPERS
– Short-term, unsecured promissory notes issued at a
discount to face value by well known companies with a
high credit- rating.
– Commercial Paper (CP) is popular, among highly rated
entities, as a tool for diversifying their sources of short
term borrowings and for reducing the cost of such
borrowings.
– It was introduced in India in 1990.
– Corporates, primary dealers (PDs) and the All-India
Financial Institutions (FIs) are eligible to issue CP.
– Maturity period: 15 days – 1 year.
– Issued in multiples of Rs. 5 lakh ;the amount invested by a
single investor should not be less than Rs. 5 lakh.
– They usually have a buy-back facility.
– Negotiable by endorsement and delivery
– Highly flexible instruments.
CERTIFICATE OF DEPOSIT
• This scheme was introduced in July 1989, to enable the banking
system to mobilise bulk deposits from the market, which they
can have at competitive rates of interest.
• Issued by banks in the form of usance promissory notes.
The major features are:
• Who can issue: Scheduled commercial banks (except RRBs) and
All India Financial Institutions within their `Umbrella limit’.
• CRR/SLR: Applicable on the issue price in case of banks
• Investors: Individuals (other than minors), corporations,
companies, trusts, funds, associations etc
• Maturity Min: 7 days Max : 12 Months (in case of FIs minimum 1
year and maximum 3 years).
• Amount Min: Rs.1 lac, beyond which in multiple of Rs.1 lac

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continued
• Interest Rate: Market related. Fixed or floating
• Loan Against collateral of CD not permitted
• Pre-mature cancellation Not allowed
• Transfer Endorsement & delivery. Any time
• Nature Usance Promissory note. Can be issued in
Dematerialisation form only only wef June 30, 2002
Other conditions
• If payment day is holiday, to be paid on next
preceding business day
• Issued at a discount to face value
• Duplicate can be issued after giving a public notice &
obtaining indemnity

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Money Market Mutual Funds
• MMMFs were set up to make available the
benefits of investing in money markets to
small investors.
• MMMFs invest primarily in money market
instruments of very high quality and of very
short maturities.
• MMMFs can be set up by commercial
banks,RBI and public financial institutions
either directly or through their existing mutual
fund subsidiaries.
• MMMfs are regulated and governed by SEBI.
• Schemes offered can either be open- ended or
close – ended.
CAPITAL MARKETS

• They deal with securities with


maturity period > 1 year.

CAPITAL MARKETS

PRIMARY SECONDARY
MARKETS MARKETS
PRIMARY MARKETS

• Helps companies in raising funds through issue of


securities like shares and debentures.
• Governed by SEBI (Securities and Exchange Board
of India).
• Methods of issuing securities in Primary Market:
- Public Issue
- Rights Issue
- Bonus Issue
- Private Placement
- Bought-out Deals
SECONDARY MARKET

• Securities already issued in the primary market


are traded in the secondary market.

• Provides liquidity to the securities held by the


investors.

• Operates through stock exchanges that regulate


the trading activities in this market.
STOCK EXCHANGES

• They are auction markets for securities.


• Transaction at stock exchange occur by
placing an order.
• Types of Orders:
– Limit Orders
– Best Rate Order
– Immediate or cancel order
– Limited Discretionary Order
– Stop Loss Order
– Open Order
• Delivery of share certificate after execution of
order may be spot, specified or hand delivery
GOVERNMENT SECURITIES MARKET

• Securities that are issued by the


Central government, state
governments and entities that are
wholly owned by the government.

• Fully secured in nature.


GOVERNMENT SECURITIES MARKET

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Forms in which government
securities can be held:
- Stock Certificate
- Promissory Notes
- Bearer Bonds

Examples of Government
Securities:
-Treasury Bills
-Public Sector Bonds
TREASURY BILLS
• Short-term promissory notes issued by the government to meet
their short-term obligations.
• They are useful in managing short-term liquidity.
• At present, the Government of India issues three types of
treasury bills through auctions, namely, 91-day, 182-day and
364-day.
• There are no treasury bills issued by State Governments.
• The RBI acts as an agent for issuing T-Bills.
• Subscribers: Banks, primary dealers, financial institutions,
insurance companies, provident funds, NBFCs, FIIs and state
governments.
• Treasury bills are available for a minimum amount of Rs.25,000
and in multiples of Rs. 25,000.
• Treasury bills are issued at a discount and are redeemed at par.
TREASURY BILLS

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Issued for a minimum amount of Rs.
25,000 and in multiples of 25,000 thereof.

Maturity Period: 91 days and 364 days


PUBLIC SECTOR BONDS
• Bonds issued by public sector companies
• Secured in nature.
• Maturity Period: 5 to 7 years.
• Investors: Banks, Insurance Companies, Corporate,
Provident Funds, Mutual Funds, Individuals.
• Interest income eligible for deduction under Section
80L of I.T. Act.
Summary

Financial System And Its Function


Classification Of Financial Markets
Money Market Instruments
Capital Markets Instruments
Government Securities Market
Section II: Indian Financial
System

Objectives of the Session:


To understand
• INTERNATIONAL CAPITAL MARKETS
• FINANCIAL INSTITUTIONS
• BANKING SYSTEM
• INSURANCE
• NON-BANKING FINANCIAL COMPANIES

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INTERNATIONAL CAPITAL MARKETS

• INSTRUMENTS IN INTERNATIONAL MARKETS

Equity Instruments
Debt Instruments
-Global Depository Receipts
-Euro Bonds
-American Depository Receipts
-Foreign Bonds
-Euro Notes

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GLOBAL DEPOSITORY RECEIPTS & AMERICAN
DEPOSITORY RECEIPTS
• A GDR or ADR means any instrument in the form of a
Depository receipt or certificate, created by the Overseas
Depository Bank (ODB) outside India and issued to non-
resident investors against the issue of ordinary shares or
foreign currency convertible bonds of issuing company.

• These are negotiable instruments denominated in US $


representing a non-US company’s publicly traded, local
currency equity shares.

• The issue of such instruments involves the delivery of ordinary


shares of an Indian company to a domestic custodian bank in
India, which in turn instructs an overseas depository bank to
issue GDR/ADR on a predetermined ratio.

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• The GDR/ADR can be sold outside India in their existing
form.

• The underlying shares (arising after redemption of


GDR/ADR) can also be sold in India.

• While ADRs are listed on the US stock exchanges, the


GDRs are usually listed on a European stock exchange.

• A GDR/ADR may evidence one or more GDS/ADS.

• Each GDS/ADS represent underlying share of Issuing


company.

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EURO BONDS
• Eurobonds are bonds that are issued for sale outside the issuer’s home country.
• They can be issued in the currency of the foreign country, or another currency.
• Interest payments and principal are to be returned to the holder in the currency in which
the bond was issued.
• In most cases, the interest is paid annually.
• The Eurobond marketis extremely liquid. While the majority of the trading is centralized
around London’s trading hours.
• Eurobond trading takes place 24 hours a day worldwide.
• Eurobonds are named after the currency they are denominated in. For example, Euroyen
and Eurodollar bonds are denominated in Japanese yen and American dollars respectively.
• A Eurobond is normally a bearer bond, payable to the bearer.

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FOREIGN BONDS
Bonds issued by foreign entities for raising medium to long-term financing from domestic money

centers in their domestic currencies.
A bond issued in a particular country by a foreign borrower (or) a bond sold by a foreign

borrower, denominated in the currency of country in which it is sold and is underwritten &
syndicated by national underwriting syndicate in the lending country .
Foreign bonds are floated in the domestic capital markets (and are in the domestic currency of

those markets) by nonresident entities.
These bonds are different from Euro bonds in the sense that they are governed by the

regulations of the country in which they are issued whereas Euro bonds are not.
The bonds are generally named on the basis of the capital markets in which they are floated.

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Types of Foreign Bonds
• Yankee Bonds: Yankee bond is a dollar
denominated bond issued in U.S by a non-U.S.
borrower in the U.S. market.
• Samurai bond: Samurai bonds are yen denominated
bonds issued in Japan by a non-Japanese borrower.
• Bulldog bonds: Bulldog bonds are pound
denominated bonds issued in U.K. domestic market
by a non U.K. borrower.

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FOREX MARKETS

• Foreign Exchange Market: Deals with


transactions in currencies other than one’s
own currency.
• Exchange rate: The rate at which one
currency can be converted into another
currency

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FOREX MARKETS
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Participants:

Exporters
Importers
Commercial Banks
Central Banks
Authorized Dealers and Money
Changers
Brokers

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DERIVATIVES MARKET
• Financial derivative is a product derived from the market of an
underlying asset.
Participants:
- Hedgers: Hedgers wish to eliminate or reduce the price risk
to which they are already exposed
- Speculators: Speculators are those class of investors who
willingly take price risks to profit from price changes in the
underlying.
- Arbitrators : Arbitrageurs profit from price differential
existing in two markets by simultaneously operating in two
different markets.
Types of Derivatives:
- Futures
- Options
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FINANCIAL INSTITUTIONS

• Industrial Development Bank of India


• Industrial Finance Corporation of India
• Industrial Credit and Investment Corporation of India
• Industrial Investment Bank of India
• Export and Import Bank of India
• State Financial Corporations
• Investment Institutions

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ORGANIZATION OF BANKING SYSTEM
Reserve Bank of India

Scheduled Banks Non-Scheduled Banks

State Co-op Commercial Central Co-operative Commercial


Bank Banks Banks and Primary Banks
Credit Societies
Indian Foreign

Public Sector Private Sector


Banks banks
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RESERVE BANK OF INDIA

• It is the central bank of India.


• Established to guide, monitor, regulate, promote and guide
the Indian financial system.

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FUNCTIONS OF RBI
• Currency issuing authority
• Acts as banker the central and state governments
• Serves as banker’s bank
• Foreign exchange control authority
• Exercises monetary control through:
-Bank Rate
-Reserve requirements: CLR and SLR
-Open market operations
• Undertakes developmental activities

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COMMERCIAL BANKS
• Most important depositors and disbursers of finance.
• They are expected to hold a part of the deposits in
the form of ready cash, known as cash reserves as
prescribed by RBI.

SCHEDULED BANKS
• Scheduled banks are those that are included in the
second schedule of Banking Regulation Act, 1949;
the others are non-scheduled banks.

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SCHEDULED BANKS
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Requirements that should be fulfilled to be a


Scheduled bank:

A bank must have a paid-up capital and reserve of


not less than Rs. 5 lakh,

It must ensure that its affairs are not conducted in


a manner detrimental to the interests of its
depositors.

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LIABILITIES AND ASSETS OF A BANK
LIABILITIES ASSETS

1. Demand deposits 1. Cash in hand


a. Current deposits 2. Balances with RBI
b. Savings deposits 3. Assets with the banking system
c. Call deposits 4. Investments in Government and
2. Time deposits other approved securities
3. Other liabilities 5. Bank Credit
(e.g. borrowings form RBI, a. Demand and Term loans
refinance form IDBI, b. Cash Credit/Overdraft
NABARD etc.) arrangement
c. Bill financing

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INSURANCE

From an individual’s point of view, insurance is an


economic device whereby the individual can substitute a
small definite cost (premium) for a large uncertain
financial loss [the contingency insured against] that would
have to be borne if insurance was not available.

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CLASSIFICATION OF INSURANCE
BUSINESS
1.Life Insurance: A life policy covers risk of death due to natural
causes as also due to accidents.
2.General Insurance: Insurance other than the life insurance fall
under the category of general insurance.
a.Fire Insurance
b.Marine Insurance
c.Miscellaneous Insurance

Insurance Regulatory and Development Authority:


Regulates, promotes and ensures orderly growth of the insurance
business and reinsurance business.

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NON BANKING FINANCIAL COMPANIES
• Investment Trusts and Investment Companies
• Mutual Benefit Funds
• Merchant Banks
• Hire Purchase Finance Companies
• Lease Finance Companies
• Housing Finance Companies
• Non-Housing Bank
• Venture Capital Funding Companies

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Summary
FINANCIAL SYSTEM AND ITS FUNCTION
CLASSIFICATION OF FINANCIAL MARKETS
MONEY MARKET INSTRUMENTS
CAPITAL MARKETS INSTRUMENTS
GOVERNMENT SECURITIES MARKET
INTERNATIONAL CAPITAL MARKETS
FINANCIAL INSTITUTIONS
BANKING SYSTEM
INSURANCE
NON-BANKING FINANCIAL COMPANIES
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